[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2023 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          
          
          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.851 to 1.907)

                         Revised as of April 1, 2023

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2023
                    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........................    1059
      Alphabetical List of Agencies Appearing in the CFR......    1079
      Table of OMB Control Numbers............................    1089
      List of CFR Sections Affected...........................    1107

[[Page iv]]





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

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

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

[[Page v]]



                               EXPLANATION

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

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

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

LEGAL STATUS

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

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2023), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
dates and effective dates are usually not the same and care must be 
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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 
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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 
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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 
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not dropped in error.

INCORPORATION BY REFERENCE

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This material, like any other properly issued regulation, has the force 
of law.
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Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
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    (a) The incorporation will substantially reduce the volume of 
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    (b) The matter incorporated is in fact available to the extent 
necessary to afford fairness and uniformity in the administrative 
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CFR INDEXES AND TABULAR GUIDES

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separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Authorities 
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alphabetical list of agencies publishing in the CFR are also included in 
this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.

[[Page vii]]

    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
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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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Connect to NARA's website at www.archives.gov/federal-register.
    The eCFR is a regularly updated, unofficial editorial compilation of 
CFR material and Federal Register amendments, produced by the Office of 
the Federal Register and the Government Publishing Office. It is 
available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register
    April 1, 2023







[[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, 2023. The first fifteen volumes comprise part 1 
(Subchapter A--Income Tax) and are arranged by sections as follows: 
Sec. Sec.  1.0-1.60; Sec. Sec.  1.61-1.139; Sec. Sec.  1.140-1.169; 
Sec. Sec.  1.170-1.300; Sec. Sec.  1.301-1.400; Sec. Sec.  1.401-1.409; 
Sec. Sec.  1.410-1.440; Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; 
Sec. Sec.  1.641-1.850; Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; 
Sec. Sec.  1.1001-1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to 
end of part 1. The sixteenth volume containing parts 2-29, includes the 
remainder of subchapter A and all of Subchapter B--Estate and Gift 
Taxes. The last six volumes contain parts 30-39 (Subchapter C--
Employment Taxes and Collection of Income Tax at Source); parts 40-49; 
parts 50-299 (Subchapter D--Miscellaneous Excise Taxes); parts 300-499 
(Subchapter F--Procedure and Administration); parts 500-599 (Subchapter 
G--Regulations under Tax Conventions); and part 600 to end (Subchapter 
H--Internal Revenue Practice).

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

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

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




         (This book contains part 1, Sec. Sec.  1.851 to 1.907)

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

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

[[Page 3]]



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




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

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

Supplementary Publication: Internal Revenue Service Looseleaf 
  Regulations System.

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

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)





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



                  Normal Taxes and Surtaxes (Continued)

    Regulated Investment Companies and Real Estate Investment Trusts

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

                      Real Estate Investment Trusts

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

[[Page 6]]

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

                   Determination of Sources of Income

1.861-1 Income from sources within the United States.
1.861-2 Interest.
1.861-3 Dividends and income inclusions under sections 951, 951A, and 
          1293 and associated section 78 dividends.
1.861-4 Compensation for labor or personal services.
1.861-5 Rentals and royalties.
1.861-6 Sale of real property.
1.861-7 Sale of personal property.
1.861-8 Computation of taxable income from sources within the United 
          States and from other sources and activities.
1.861-8T Computation of taxable income from sources within the United 
          States and from other sources and activities (temporary).
1.861-9 Allocation and apportionment of interest expense and rules for 
          asset-based apportionment.
1.861-9T Allocation and apportionment of interest expense (temporary).
1.861-10 Special allocations of interest expense.
1.861-10T Special allocations of interest expense (temporary).
1.861-11 Special rules for allocating and apportioning interest expense 
          of an affiliated group of corporations.
1.861-11T Special rules for allocating and apportioning interest expense 
          of an affiliated group of corporations (temporary).
1.861-12 Characterization rules and adjustments for certain assets.
1.861-12T Characterization rules and adjustments for certain assets 
          (temporary).
1.861-13 Special rules for characterization of controlled foreign 
          corporation stock.
1.861-14 Special rules for allocating and apportioning certain expenses 
          (other than interest expense) of an affiliated group of 
          corporations.
1.861-14T Special rules for allocating and apportioning certain expenses 
          (other than interest expense) of an affiliated group of 
          corporations (temporary regulations).
1.861-15 Income from certain aircraft or vessels first leased on or 
          before December 28, 1980.
1.861-16 Income from certain craft first leased after December 28, 1980.
1.861-17 Allocation and apportionment of research and experimental 
          expenditures.
1.861-18 Classification of transactions involving computer programs.
1.861-20 Allocation and apportionment of foreign income taxes.
1.862-1 Income specifically from sources without the United States.
1.863-0 Table of contents.
1.863-0A Table of contents.
1.863-1 Allocation of gross income under section 863(a).
1.863-2 Allocation and apportionment of taxable income.
1.863-3 Allocation and apportionment of income from certain sales of 
          inventory.

   Regulations Applicable to Taxable Years Prior to December 30, 1996

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

[[Page 7]]

               Nonresident Aliens and Foreign Corporations

                      nonresident alien individuals

1.871-1 Classification and manner of taxing alien individuals.
1.871-2 Determining residence of alien individuals.
1.871-3 Residence of alien seamen.
1.871-4 Proof of residence of aliens.
1.871-5 Loss of residence by an alien.
1.871-6 Duty of withholding agent to determine status of alien payees.
1.871-7 Taxation of nonresident alien individuals not engaged in U.S. 
          business.
1.871-8 Taxation of nonresident alien individuals engaged in U.S. 
          business or treated as having effectively connected income.
1.871-9 Nonresident alien students or trainees deemed to be engaged in 
          U.S. business.
1.871-10 Election to treat real property income as effectively connected 
          with U.S. business.
1.871-11 Gains from sale or exchange of patents, copyrights, or similar 
          property.
1.871-12 Determination of tax on treaty income.
1.871-13 Taxation of individuals for taxable year of change of U.S. 
          citizenship or residence.
1.871-14 Rules relating to repeal of tax on interest of nonresident 
          alien individuals and foreign corporations received from 
          certain portfolio debt investments.
1.871-15 Treatment of dividend equivalents.
1.872-1 Gross income of nonresident alien individuals.
1.872-2 Exclusions from gross income of nonresident alien individuals.
1.873-1 Deductions allowed nonresident alien individuals.
1.874-1 Allowance of deductions and credits to nonresident alien 
          individuals.
1.874-1T Allowance of deductions and credits to nonresident alien 
          individuals (temporary).
1.875-1 Partnerships.
1.875-2 Beneficiaries of estates or trusts.
1.876-1 Alien residents of Puerto Rico, Guam, American Samoa, or the 
          Northern Mariana Islands.
1.879-1 Treatment of community income.

                          foreign corporations

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

                        miscellaneous provisions

1.891 Statutory provisions; doubling of rates of tax on citizens and 
          corporations of certain foreign countries.
1.892-1T Purpose and scope of regulations (temporary regulations).
1.892-2T Foreign government defined (temporary regulations).
1.892-3 Income of foreign governments.
1.892-3T Income of foreign governments (temporary regulations).
1.892-4T Commercial activities (temporary regulations).
1.892-5 Controlled commercial entity.
1.892-5T Controlled commercial entity (temporary regulations).
1.892-6T Income of international organizations (temporary regulations).
1.892-7T Relationship to other Internal Revenue Code sections (temporary 
          regulations).
1.893-1 Compensation of employees of foreign governments or 
          international organizations.

[[Page 8]]

1.894-1 Income affected by treaty.
1.895-1 Income derived by a foreign central bank of issue, or by Bank 
          for International Settlements, from obligations of the United 
          States or from bank deposits.
1.897-1 Taxation of foreign investment in United States real property 
          interests, definition of terms.
1.897-2 United States real property holding corporations.
1.897-3 Election by foreign corporation to be treated as a domestic 
          corporation under section 897(i).
1.897-4AT Table of contents (temporary).
1.897-5 Corporate distributions.
1.897-5T Corporate distributions (temporary).
1.897-6T Nonrecognition exchanges applicable to corporations, their 
          shareholders, and other taxpayers, and certain transfers of 
          property in corporate reorganizations (temporary).
1.897-7 Treatment of certain partnership interests, trusts and estates 
          under section 897(g).
1.897-7T Treatment of certain partnership interests as entirely U.S. 
          real property interests under sections 897(g) and 1445(e) 
          (temporary).
1.897-8T Status as a U.S. real property holding corporation as a 
          condition for electing section 897(i) pursuant to Sec.  1.897-
          3 (temporary).
1.897-9T Treatment of certain interest in publicly traded corporations, 
          definition of foreign person, and foreign governments and 
          international organizations (temporary).
1.897(l)-1 Exception for interests held by foreign pension funds.

              Income From Sources Without the United States

                           foreign tax credit

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

[[Page 9]]

1.904(f)-7 Separate limitation loss and the separate limitation loss 
          account.
1.904(f)-8 Recapture of separate limitation loss accounts.
1.904(f)-9--1.904(f)-11 [Reserved]
1.904(f)-12 Transition rules.
1.904(g)-0 Outline of regulation provisions.
1.904(g)-1 Overall domestic loss and the overall domestic loss account.
1.904(g)-2 Recapture of overall domestic losses.
1.904(g)-3 Ordering rules for the allocation of net operating losses, 
          net capital losses, U.S. source losses, and separate 
          limitation losses, and for recapture of separate limitation 
          losses, overall foreign losses, and overall domestic losses.
1.904(i)-0 Outline of regulation provisions.
1.904(i)-1 Limitation on use of deconsolidation to avoid foreign tax 
          credit limitations.
1.904(j)-0 Outline of regulation provisions.
1.904(j)-1 Certain individuals exempt from foreign tax credit 
          limitations.
1.905-1 When credit for foreign income taxes may be taken.
1.905-2 Conditions of allowance of credit.
1.905-3 Adjustments to U.S. tax liability and to current earnings and 
          profits as a result of a foreign tax redetermination.
1.905-4 Notification of foreign tax redetermination.
1.905-5 Foreign tax redeterminations of foreign corporations that relate 
          to taxable years of the foreign corporation beginning before 
          January 1, 2018.
1.907-0 Outline of regulation provisions for section 907.
1.907(a)-0 Introduction (for taxable years beginning after December 31, 
          1982).
1.907(a)-1 Reduction in taxes paid on FOGEI (for taxable years beginning 
          after December 31, 1982).
1.907(b)-1 Reduction of creditable FORI taxes (for taxable years 
          beginning after December 31, 1982).
1.907(c)-1 Definitions relating to FOGEI and FORI (for taxable years 
          beginning after December 31, 1982).
1.907(c)-2 Section 907(c)(3) items (for taxable years beginning after 
          December 31, 1982).
1.907(c)-3 FOGEI and FORI taxes (for taxable years beginning after 
          December 31, 1982).
1.907(d)-1 Disregard of posted prices for purposes of chapter 1 of the 
          Code (for taxable years beginning after December 31, 1982).
1.907(e)-1 [Reserved].
1.907(f)-1 Carryback and carryover of credits disallowed by section 
          907(a) (for amounts carried between taxable years that each 
          begin after December 31, 1982).

    Authority: 26 U.S.C. 7805.
    Sections 1.851-3 and 1.851-5 are also issued under 26 U.S.C. 851(c).
    Section 1.852-11 is also issued under 26 U.S.C. 852(b)(3)(C), 
852(b)(8), and 852(c).
    Section 1.853-1 also issued under 26 U.S.C. 901(j).
    Section 1.853-2 also issued under 26 U.S.C. 901(j).
    Section 1.853-3 also issued under 26 U.S.C. 901(j).
    Section 1.853-4 also issued under 26 U.S.C. 901(j) and 26 U.S.C. 
6011.
    Section 1.860A-0 also issued under 26 U.S.C. 860G(e).
    Section 1.860A-1 also issued under 26 U.S.C. 860G(b) and 860G(e).
    Section 1.860C-2 also issued under 26 U.S.C. 860C(b)(1) and 860G(e).
    Section 1.860D-1 also issued under 26 U.S.C. 860G(e).
    Section 1.860E-1 also issued under 26 U.S.C. 860E and 860G(e).
    Section 1.860E-2 also issued under 26 U.S.C. 860E(e).
    Section 1.860F-2 also issued under 26 U.S.C. 860G(e).
    Section 1.860F-4 also issued under 26 U.S.C. 860G(e) and 26 U.S.C. 
6230(k).
    Section 1.860F-4T also issued under 26 U.S.C. 860G(c)(3) and (e).
    Section 1.860G-1 also issued under 26 U.S.C. 860G(a)(1)(B), 
(d)(2)(E), and (e).
    Section 1.860G-2 also issued under 26 U.S.C. 860G(e).
    Section 1.860G-3 also issued under 26 U.S.C. 860G(b) and 26 U.S.C. 
860G(e).
    Section 1.861-2 also issued under 26 U.S.C. 863(a).
    Section 1.861-3 also issued under 26 U.S.C. 863(a).
    Section 1.861-8 also issued under 26 U.S.C. 250(c), 26 U.S.C. 
864(e)(7), and 26 U.S.C. 882(c).
    Sections 1.861-9 and 1.861-9T also issued under 26 U.S.C. 863(a), 26 
U.S.C. 864(e)(7), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Section 1.861-10(e) also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e)(7), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Section 1.861-11 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e)(7), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Section 1.861-12 also issued under 26 U.S.C. 864(e)(7).
    Section 1.861-13 also issued under 26 U.S.C. 864(e)(7).
    Section 1.861-14 also issued under 26 U.S.C. 864(e)(7).
    Section 1.861-17 also issued under 26 U.S.C. 864(e)(7).
    Sections 1.861-8T through 1.861-14T also issued under 26 U.S.C. 
863(a), 26 U.S.C. 864(e), 26 U.S.C. 865(i) and 26 U.S.C. 7701(f).
    Section 1.863-1 also issued under 26 U.S.C. 863(a).
    Section 1.863-2 also issued under 26 U.S.C. 863.
    Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and 26 
U.S.C. 936(h).

[[Page 10]]

    Section 1.863-4 also issued under 26 U.S.C. 863.
    Section 1.863-6 also issued under 26 U.S.C. 863.
    Section 1.863-7 also issued under 26 U.S.C. 863(a) and 871(m).
    Section 1.863-8 also issued under 26 U.S.C. 863(a), (b) and (d).
    Section 1.863-9 also issued under 26 U.S.C. 863(a), (d) and (e).
    Section 1.864-5 also issued under 26 U.S.C. 7701(l).
    Section 1.864-8T also issued under 26 U.S.C. 864(d)(8).
    Section 1.864(c)(8)-1 also issued under 26 U.S.C. 864(c)(8) and 
897(g).
    Section 1.864(c)(8)-2 also issued under 26 U.S.C. 864(c)(8)(E), 6001 
and 6031(b).
    Section 1.865-1 also issued under 26 U.S.C. 863(a) and 865(j)(1).
    Section 1.865-2 also issued under 26 U.S.C. 863(a) and 865(j)(1).
    Section 1.865-3 also issued under 26 U.S.C. 865(j).
    Section 1.871-1 also issued under 26 U.S.C. 7701(l).
    Section 1.871-7 also issued under 26 U.S.C. 7701(l).
    Section 1.871-9 also issued under 26 U.S.C. 7701(b)(11).
    Sections 1.871-15 and 1.871-15T also issued under 26 U.S.C. 871(m).
    Section 1.874-1 also issued under 26 U.S.C. 874.
    Section 1.881-2 also issued under 26 U.S.C. 7701(l).
    Section 1.881-3 also issued under 26 U.S.C. 7701(l).
    Section 1.881-4 also issued under 26 U.S.C. 7701(l).
    Section 1.882-4 also issued under 26 U.S.C. 882(c).
    Section 1.882-5 also issued under 26 U.S.C. 882, 26 U.S.C. 864(e), 
26 U.S.C. 988(d), and 26 U.S.C. 7701(l).
    Section 1.883-1 is also issued under 26 U.S.C. 883.
    Section 1.883-2 is also issued under 26 U.S.C. 883.
    Section 1.883-3 is also issued under 26 U.S.C. 883.
    Section 1.883-4 is also issued under 26 U.S.C. 883.
    Section 1.883-5 is also issued under 26 U.S.C. 883.
    Section 1.884-0 also issued under 26 U.S.C. 884 (g).
    Section 1.884-1 also issued under 26 U.S.C. 884.
    Section 1.884-1 also issued under 26 U.S.C. 884 (g).
    Section 1.884-1 (d) also issued under 26 U.S.C. 884 (c) (2) (A).
    Section 1.884-1 (d) (13) (i) also issued under 26 U.S.C. 884 (c) 
(2).
    Section 1.884-1 (e) also issued under 26 U.S.C. 884 (c) (2) (B).
    Section 1.884-2 also issued under 26 U.S.C. 884(g).
    Section 1.884-2T also issued under 26 U.S.C. 884 (g).
    Section 1.884-4 also issued under 26 U.S.C. 884 (g).
    Section 1.884-5 also issued under 26 U.S.C. 884 (g).
    Section 1.884-5 (e) and (f) also issued under 26 U.S.C. 884 (e) (4) 
(C).
    Section 1.892-1T also issued under 26 U.S.C. 892(c).
    Section 1.892-2T also issued under 26 U.S.C. 892(c).
    Section 1.892-3T also issued under 26 U.S.C. 892(c).
    Section 1.892-4T also issued under 26 U.S.C. 892(c).
    Section 1.892-5 also issued under 26 U.S.C. 892(c).
    Section 1.892-5T also issued under 26 U.S.C. 892(c).
    Section 1.892-6T also issued under 26 U.S.C. 892(c).
    Section 1.892-7T also issued under 26 U.S.C. 892(c).
    Section 1.894-1 also issued under 26 U.S.C. 894 and 7701(l).
    Sections 1.897-5T, 1.897-6T and 1.897-7T also issued under 26 U.S.C. 
897 (d), (e), (g) and (j) and 26 U.S.C. 367(e)(2).
    Section 1.897-7 also issued under 26 U.S.C. 897(g).
    Section 1.897(l)-1 also issued under 26 U.S.C. 897(l).
    Section 1.901(j)-1 also issued under 26 U.S.C. 901(j)(4).
    Sections 1.901(m)-1 through 1.901-8 also issued under 26 U.S.C. 
901(m)(7).
    Section 1.901(m)-5 also issued under 26 U.S.C. 901(m)(3)(B)(ii).
    Sections 1.902-1 and 902-2 also issued under 26 U.S.C. 902(c)(7).
    Section 1.904-1 also issued under 26 U.S.C. 904(d)(7).
    Section 1.904-2 also issued under 26 U.S.C. 904(d)(7).
    Section 1.904-3 also issued under 26 U.S.C. 904(d)(7).
    Section 1.904-4 also issued under 26 U.S.C. 250(c), 26 U.S.C. 
865(j), 26. U.S.C. 904(d)(2)(J)(i), 26 U.S.C. 904(d)(6)(C), 26 U.S.C. 
904(d)(7), and 26 U.S.C. 951A(f)(1)(B).
    Section 1.904-5 also issued under 26 U.S.C. 904(d)(7) and 26 U.S.C. 
951A(f)(1)(B).
    Section 1.904-6 also issued under 26 U.S.C. 904(d)(7).
    Section 1.904-7 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904(b)-1 also issued under 26 U.S.C. 1(h)(11)(C)(iv) and 
904(b)(2)(C).
    Section 1.904(b)-2 also issued under 26 U.S.C. 1(h)(11)(C)(iv) and 
904(b)(2)(C).
    Section 1.904(f)-(2) also issued under 26 U.S.C. 904 (f)(3)(b).
    Section 1.904(g)-3 also issued under 26 U.S.C. 904(g)(4).

[[Page 11]]

    Section 1.904(g)-3T also issued under 26 U.S.C. 904(g)(4).
    Section 1.904(i)-1 also issued under 26 U.S.C. 904(i).
    Section 1.905-3 also issued under 26 U.S.C. 989(c)(4).
    Sections 1.905-3T and 1.905-4T also issued under 26 U.S.C. 
989(c)(4).
    Section 1.905-4 also issued under 26 U.S.C. 989(c)(4), 26 U.S.C. 
6227(d), 26 U.S.C. 6241(11), and 26 U.S.C. 6689(a).
    Section 1.907(b)-1 is also issued under 26 U.S.C. 907(b).
    Section 1.907(b)-1T also issued under 26 U.S.C. 907(b).

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

    REGULATED INVESTMENT COMPANIES AND REAL ESTATE INVESTMENT TRUSTS



Sec.  1.851-1  Definition of regulated investment company.

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



Sec.  1.851-2  Limitations.

    (a) Election to be a regulated investment company. Under the 
provisions of section 851(b)(1), a corporation, even though it satisfies 
the other requirements of part I, subchapter M, chapter 1 of the Code, 
for the taxable year, will not be considered a regulated investment 
company for such year, within the meaning of such part I, unless it 
elects to be a regulated investment company for such taxable year, or 
has made such an election for a previous taxable year which began after 
December 31, 1941. The election shall be made by the taxpayer by 
computing taxable income as a regulated investment company in its return 
for the first taxable year for which the election is applicable. No 
other method of making such election is permitted. An election once made 
is irrevocable for such taxable year and all succeeding taxable years.
    (b) Gross income requirement--(1) General rule. A corporation will 
not be a regulated investment company for a taxable year unless 90 
percent of its gross income for that year is income described in 
paragraph (b)(1)(i) or (ii) of this section. Any loss from the sale or 
other disposition of stock or securities is not taken into account in 
the gross income computation.
    (i) Gross income amounts. Income is described in this paragraph 
(b)(1)(i) if it is gross income derived from:
    (A) Dividends;
    (B) Interest;
    (C) Payments with respect to securities loans (as defined in section 
512(a)(5));
    (D) Gains from the sale or other disposition of stocks or securities 
(as defined in section 2(a)(36) of the Investment Company Act of 1940, 
as amended);
    (E) Gains from the sale or other disposition of foreign currencies; 
or
    (F) Other income (including but not limited to gains from options, 
futures, or forward contracts) derived with respect to the corporation's 
business of investing in such stock, securities, or currencies.
    (ii) Income from a publicly traded partnership. Income is described 
in this paragraph (b)(1)(ii) if it is net income derived from an 
interest in a qualified publicly traded partnership (as defined in 
section 851(h)).
    (2) Special rules. (i) For purposes of section 851(b)(2)(A) and 
paragraph (b)(1)(i)(A) of this section, amounts included in gross income 
for the taxable year under section 951(a)(1)(A) or 1293(a) are treated 
as dividends only to the extent that, under section 959(a)(1)

[[Page 12]]

or 1293(c) (as the case may be), there is a distribution out of the 
earnings and profits of the taxable year that are attributable to the 
amounts included in gross income for the taxable year under section 
951(a)(1)(A) or 1293(a). For allocation of distributions to earnings and 
profits of foreign corporations, see Sec.  1.959-3.
    (ii) For purposes of subdivision (i) of this subparagraph, if by 
reason of section 959(a)(1) a distribution of a foreign corporation's 
earnings and profits for a taxable year described in section 959(c)(2) 
is not included in a shareholder's gross income, then such distribution 
shall be allocated proportionately between amounts attributable to 
amounts included under each clause of section 951(a)(1)(A). Thus, for 
example, M is a United States shareholder in X Corporation, a controlled 
foreign corporation. M and X each use the calendar year as the taxable 
year. For 1977, M is required by section 951(a)(1)(a) to include $3,000 
in its gross income, $1,000 of which is included under clause (i) 
thereof. In 1977, M received a distribution described in section 
959(c)(2) of $2,700 out of X's earnings and profits for 1977, which is, 
by reason of section 959(a)(1), excluded from M's gross income. The 
amount of the distribution attributable to the amount included under 
section 951(a)(1)(A)(i) is $900, i.e., $2,700 multiplied by ($1,000/
$3,000).
    (iii) If an amount is included in gross income of the corporation 
referred to in paragraph (b)(1) of this section under section 951(a)(1) 
or 1293(a) and is derived with respect to that corporation's business of 
investing in stock, securities, or currencies, then the amount is other 
income described in section 851(b)(2)(A) and paragraph (b)(1)(i)(F) of 
this section. Notwithstanding paragraph (d) of this section, a taxpayer 
may rely on the rule in this paragraph (b)(2)(iii) for taxable years 
that begin after September 28, 2016.
    (c) Diversification of investments. (1) Subparagraph (A) of section 
851(b)(4) requires that at the close of each quarter of the taxable year 
at least 50 percent of the value of the total assets of the taxpayer 
corporation be represented by one or more of the following:
    (i) Cash and cash items, including receivables;
    (ii) Government securities;
    (iii) Securities of other regulated investment companies; or
    (iv) Securities (other than those described in subdivisions (ii) and 
(iii) of this subparagraph) of any one or more issuers which meet the 
following limitations: (a) The entire amount of the securities of the 
issuer owned by the taxpayer corporation is not greater in value than 5 
percent of the value of the total assets of the taxpayer corporation, 
and (b) the entire amount of the securities of such issuer owned by the 
taxpayer corporation does not represent more than 10 percent of the 
outstanding voting securities of such issuer. For the modification of 
the percentage limitations applicable in the case of certain venture 
capital investment companies, see section 851(e) and Sec.  1.851-6.


Assuming that at least 50 percent of the value of the total assets of 
the corporation satisfies the requirements specified in this 
subparagraph, and that the limiting provisions of subparagraph (B) of 
section 851(b)(4) and subparagraph (2) of this paragraph are not 
violated, the corporation will satisfy the requirements of section 
851(b)(4), notwithstanding that the remaining assets do not satisfy the 
diversification requirements of subparagraph (A) of section 851(b)(4). 
For example, a corporation may own all the stock of another corporation, 
provided it otherwise meets the requirements of subparagraphs (A) and 
(B) of section 851(b)(4).
    (2) Subparagraph (B) of section 851(b)(4) prohibits the investment 
at the close of each quarter of the taxable year of more than 25 percent 
of the value of the total assets of the corporation (including the 50 
percent or more mentioned in subparagraph (A) of section 851(b)(4)) in 
the securities (other than Government securities or the securities of 
other regulated investment companies) of any one issuer, or of two or 
more issuers which the taxpayer company controls and which are engaged 
in the same or similar trades or businesses or related trades or 
businesses, including such issuers as are merely a part of a unit 
contributing to

[[Page 13]]

the completion and sale of a product or the rendering of a particular 
service. Two or more issuers are not considered as being in the same or 
similar trades or businesses merely because they are engaged in the 
broad field of manufacturing or of any other general classification of 
industry, but issuers shall be construed to be engaged in the same or 
similar trades or businesses if they are engaged in a distinct branch of 
business, trade, or manufacture in which they render the same kind of 
service or produce or deal in the same kind of product, and such service 
or products fulfill the same economic need. If two or more issuers 
produce more than one product or render more than one type of service, 
then the chief product or service of each shall be the basis for 
determining whether they are in the same trade or business.
    (d) Applicability date. The rules in paragraphs (b)(1) and (b)(2)(i) 
and (iii) of this section apply to taxable years that begin after June 
17, 2019.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4090, Apr. 28, 1962; T.D. 7555, 43 FR 32753, July 28, 1978; T.D. 9851, 
84 FR 9961, Mar. 19, 2019; 84 FR 17082, Apr. 24, 2019]



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

    (a) In general. In determining the value of the taxpayer's 
investment in the securities of an issuer, for purposes of subparagraph 
(B) of section 851(b)(3), there shall be included its proper proportion 
of the investment of any other corporation, a member of a controlled 
group, in the securities of such issuer. See Example 4 in Sec.  1.851-5. 
For purposes of Sec. Sec.  1.851-2, 1.851-4, 1.851-5, and 1.851-6, the 
terms ``controls,'' ``controlled group,'' and ``value'' have the meaning 
assigned to them by section 851(c). All other terms used in these 
sections have the same meaning as when used in the Investment Company 
Act of 1940 (15 U.S.C., chapter 2D), as amended.
    (b) Effective/applicability dates. The rules of this section apply 
to quarters that begin on or after December 14, 2015. For purposes of 
applying the first sentence of section 851(d)(1) to a quarter that 
begins on or after March 14, 2016, the rules of this section apply in 
determining whether the taxpayer met the requirements of section 
851(b)(3) and (c) at the close of prior quarters.

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



Sec.  1.851-4  Determination of status.

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

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



Sec.  1.851-5  Examples.

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

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

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

    (ii) Investment Company W owns all of the voting stock of 
Corporations A and B, 15 percent of the voting stock of Corporation C, 
and less than 10 percent of the voting stock of regulated investment 
companies and various other corporations. Neither Corporation A nor 
Corporation B owns:
    (A) 20 percent or more of the voting stock of any other corporation;
    (B) Securities issued by Corporation C; or

[[Page 14]]

    (C) Securities issued by any of the regulated investment companies 
or various corporations whose securities are owned by Investment Company 
W. Except for Corporation A and Corporation B, none of the corporations 
(including the regulated investment companies) is a member of a 
controlled group with Investment Company W.
    (iii) Investment Company W meets the requirements under section 
851(b)(3) at the end of its first quarter. It complies with subparagraph 
(A) of section 851(b)(3) because it has 55 percent of its assets 
invested as provided in that subparagraph. It complies with subparagraph 
(B) of section 851(b)(3) because it does not have more than 25 percent 
of its assets invested in the securities of any one issuer, of two or 
more issuers that it controls, or of one or more qualified publicly 
traded partnerships (as defined in section 851(h)).
    Example 2. (i) Investment Company V at the close of a particular 
quarter of the taxable year has its assets invested as follows:

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

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

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

    (ii) Investment Company X owns more than 20 percent of the voting 
power of Corporations B and C and less than 10 percent of the voting 
power of all of the other corporations. Corporation B manufactures 
radios and Corporation C acts as its distributor and also distributes 
radios for other companies. Investment Company X fails to meet the 
requirements of subparagraph (B) of section 851(b)(3) since it has 35 
percent of its assets invested in the securities of two issuers which it 
controls and which are engaged in related trades or businesses.
    Example 4. (i) Investment Company Y at the close of a particular 
quarter of its taxable year has its assets invested as follows:

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

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

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

    Example 5. Investment Company Z, which keeps its books and makes its 
returns on the basis of the calendar year, at the close of the first 
quarter of 2016 meets the requirements of section 851(b)(3) and has 20 
percent of its assets invested in Corporation A. Later during the 
taxable year it makes distributions to its shareholders and because of 
such distributions, it finds at the close of the taxable year that it 
has more than 25 percent of its remaining assets invested in Corporation 
A. Investment Company Z does not lose its status as a regulated 
investment company for the taxable year 2016 because of such 
distributions, nor will it lose its status as a regulated investment 
company for any subsequent year solely as a result of such 
distributions. See section 851(d)(1).
    Example 6. Investment Company Q, which keeps its books and makes its 
returns on the basis of the calendar year, at the close of the

[[Page 15]]

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

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

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

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

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

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



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

    (a) Qualifying requirements. (1) In the case of a regulated 
investment company which furnishes capital to development corporations, 
section 851 (e) provides an exception to the rule relating to the 
diversification of investments, made applicable to regulated investment 
companies by section 851(b)(4)(A). This exception (as provided in 
paragraph (b) of this section) is available only to registered 
management investment companies which the Securities and Exchange 
Commission determines, in accordance with regulations issued by it, and 
certifies to the Secretary or his delegate, not earlier than 60 days 
before the close of the taxable year of such investment company, to be 
principally engaged in the furnishing of capital to other corporations 
which are principally engaged in the development or exploitation of 
inventions, technological improvements, new processes, or products not 
previously generally available.
    (2) For the purpose of the aforementioned determination and 
certification, unless the Securities and Exchange Commission determines 
otherwise, a corporation shall be considered to be principally engaged 
in the development or exploitation of inventions, technological 
improvements, new processes, or products not previously generally 
available, for at least 10 years after the date of the first acquisition 
of any security in such corporation or any predecessor thereof by such 
investment company if at the date of such acquisition the corporation or 
its predecessor was principally so engaged, and an investment company 
shall be considered at any date to be furnishing capital to any company 
whose securities it holds if within 10 years before such date it had 
acquired any of such securities, or any securities surrendered in 
exchange therefor, from such other company or its predecessor.
    (b) Exception to general rule. (1) The registered management 
investment

[[Page 16]]

company, which for the taxable year meets the requirements of paragraph 
(a) of this section, may (subject to the limitations of section 
851(e)(2) and paragraph (c) of this section) in the computation of 50 
percent of the value of its assets under section 851(b)(4)(A) and 
paragraph (c)(1) of Sec.  1.851-2 for any quarter of such taxable year, 
include the value of any securities of an issuer (whether or not the 
investment company owns more than 10 percent of the outstanding voting 
securities of such issuer) if at the time of the latest acquisition of 
any securities of such issuer the basis of all such securities in the 
hands of the investment company does not exceed 5 percent of the value 
of the total assets of the investment company at that time. The 
exception provided by section 851(e)(1) and this subparagraph is not 
applicable to the securities of an issuer if the investment company has 
continuously held any security of such issuer or of any predecessor 
company (as defined in paragraph (d) of this section) for 10 or more 
years preceding such quarter of the taxable year. The rule of section 
851(e)(1) with respect to the relationship of the basis of the 
securities of an issuer to the value of the total assets of the 
investment company is, in substance, a qualification of the 5-percent 
limitation in section 851(b)(4)(A)(ii) and paragraph (c)(1)(iv) of Sec.  
1.851-2. All other provisions and requirements of section 851 and 
Sec. Sec.  1.851-1 through 1.851-6 are applicable in determining whether 
such registered management investment company qualifies as a regulated 
investment company.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following examples:

    Example 1. (i) The XYZ Corporation, a regulated investment company, 
qualified under section 851(e) as an investment company furnishing 
capital to development corporations. On June 30, 1954, the XYZ 
Corporation purchased 1,000 shares of the stock of the A Corporation at 
a cost of $30,000. On June 30, 1954, the value of the total assets of 
the XYZ Corporation was $1,000,000. Its investment in the stock of the A 
Corporation ($30,000) comprised 3 percent of the value of its total 
assets, and it therefore met the requirements prescribed by section 
851(b)(4)(A)(ii) as modified by section 851(e)(1).
    (ii) On June 30, 1955, the value of the total assets of the XYZ 
Corporation was $1,500,000 and the 1,000 shares of stock of the A 
Corporation which the XYZ Corporation owned appreciated in value so that 
they were then worth $60,000. On that date, the XYZ Investment Company 
increased its investment in the stock of the A Corporation by the 
purchase of an additional 500 shares of that stock at a total cost of 
$30,000. The securities of the A Corporation owned by the XYZ 
Corporation had a value of $90,000 (6 percent of the value of the total 
assets of the XYZ Corporation) which exceeded the limit provided by 
section 851(b)(4)(A)(ii). However, the investment of the XYZ Corporation 
in the A Corporation on June 30, 1955, qualified under section 
851(b)(4)(A) as modified by section 851(e)(1), since the basis of those 
securities to the investment company did not exceed 5 percent of the 
value of its total assets as of June 30, 1955, illustrated as follows:

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

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

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

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

[[Page 17]]



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

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

    (c) Limitation. Section 851(e) and this section do not apply in the 
quarterly computation of 50 percent of the value of the assets of an 
investment company under subparagraph (A) of section 851(b)(4) and 
paragraph (c)(1) of Sec.  1.851-2 for any taxable year if at the close 
of any quarter of such taxable year more than 25 percent of the value of 
its total assets (including the 50 percent or more mentioned in such 
subparagraph (A)) is represented by securities (other than Government 
securities or the securities of other regulated investment companies) of 
issuers as to each of which such investment company (1) holds more than 
10 percent of the outstanding voting securities of such issuer, and (2) 
has continuously held any security of such issuer (or any security of a 
predecessor of such issuer) for 10 or more years preceding such quarter, 
unless the value of its total assets so represented is reduced to 25 
percent or less within 30 days after the close of such quarter.
    (d) Definition of predecessor company. As used in section 851(e) and 
this section, the term ``predecessor company'' means any corporation the 
basis of whose securities in the hands of the investment company was, 
under the provisions of section 358 or corresponding provisions of prior 
law, the same in whole or in part as the basis of any of the securities 
of the issuer and any corporation with respect to whose securities any 
of the securities of the issuer were received directly or indirectly by 
the investment company in a transaction or series of transactions 
involving nonrecognition of gain or loss in whole or in part. The other 
terms used in this section have the same meaning as when used in section 
851(b)(4). See paragraph (c) of Sec.  1.851-2 and Sec.  1.851-3.



Sec.  1.851-7  Certain unit investment trusts.

    (a) In general. For purposes of the Internal Revenue Code, a unit 
investment trust (as defined in paragraph (d) of this section) shall not 
be treated as a person (as defined in section 7701(a)(1)) except for 
years ending before January 1, 1969. A holder of an interest in such a 
trust will be treated as directly owning the assets of such trust for 
taxable years of such holder which end with or within any year of the 
trust to which section 851(f) and this section apply.
    (b) Treatment of unit investment trust. A unit investment trust 
shall not be treated as an individual, a trust estate, partnership, 
association, company, or corporation for purposes of the Internal 
Revenue Code. Accordingly, a unit investment trust is not a taxpayer 
subject to taxation under the Internal Revenue Code. No gain or loss 
will be recognized by the unit investment trust if such trust 
distributes a holder's proportionate share of the trust assets in 
exchange for his interest in the trust. Also, no gain or loss will be 
recognized by the unit investment trust if such trust sells the holder's 
proportionate share of the trust assets and distributes the proceeds 
from such share to the holder in exchange for his interest in the trust.
    (c) Treatment of holder of interest in unit investment trust. (1) 
Each holder of an interest in a unit investment trust shall be treated 
(to the extent of such interest) as owning a proportionate share of the 
assets of the trust. Accordingly, if the trust distributes to the holder 
of an interest in such trust his proportionate share of the trust assets 
in exchange for his interest in the trust, no gain or loss shall be 
recognized by such holder (or by any other holder of an interest in such 
trust). For purposes of this paragraph, each purchase of an interest in 
the trust by the holder will be considered a separate interest in the 
trust. Items of income, gain, loss, deduction, or credit received by the 
trust or a custodian thereof shall be taxed to the holders of interests 
in the trust (and not to the trust) as though they had received their 
proportionate share of the items directly

[[Page 18]]

on the date such items were received by the trust or custodian.
    (2) The basis of the assets of such trust which are treated under 
subparagraph (1) of this paragraph as being owned by the holder of an 
interest in such trust shall be the same as the basis of his interest in 
such trust. Accordingly, the amount of the gain or loss recognized by 
the holder upon the sale by the unit investment trust of the holder's 
pro rata share of the trust assets shall be determined with reference 
the basis, of his interest in the trust. Also, the basis of the assets 
received by the holder, if the trust distributes a holder's pro rata 
share of the trust assets in exchange for his interest in the trust, 
will be the same as the basis of his interest in the trust. If the unit 
investment trust sells less than all of the holder's pro rata share of 
the trust assets and the holder retains an interest in the trust, the 
amount of the gain or loss recognized by the holder upon the sale shall 
be determined with reference to the basis of his interest in the assets 
sold by the trust, and the basis of his interest in the trust shall be 
reduced accordingly. If the trust distributes a portion of the holder's 
pro rata share of the trust assets in exchange for a portion of his 
interest in the trust, the basis of the assets received by the holder 
shall be determined with reference to the basis of his interest in the 
assets distributed by the trust, and the basis of his interest in the 
trust shall be reduced accordingly. For purposes of this subparagraph 
the basis of the holder's interest in assets sold by the trust or 
distributed to him shall be an amount which bears the same relationship 
to the basis of his total interest in the trust that the fair market 
value of the assets so sold or distributed bears to the fair market 
value of such total interest in the trust, such fair market value to be 
determined on the date of such sale or distribution.
    (3) The period for which the holder of an interest in such trust has 
held the assets of the trust which are treated under subparagraph (1) of 
this paragraph as being owned by him is the same as the period for which 
such holder has held his interest in such trust. Accordingly, the 
character of the gain, loss, deduction, or credit recognized by the 
holder upon the sale by the unit investment trust of the holder's 
proportionate share of the trust assets shall be determined with 
reference to the period for which he has held his interest in the trust. 
Also, the holding period of the assets received by the holder if the 
trust distributes the holder's proportionate share of the trust assets 
in exchange for his interest in the trust will include the period for 
which the holder has held his interest in the trust.
    (4) The application of the provisions of this paragraph may be 
illustrated by the following example:

    Example. B entered a periodic payment plan of a unit investment 
trust (as defined in paragraph (d) of this section) with X Bank as 
custodian and Z as plan sponsor. Under this plan, upon B's demand, X 
must either redeem B's interest at a price substantially equal to the 
fair market value of the number of shares in Y, a management company, 
which are credited to B's account by X in connection with the unit 
investment trust, or at B's option distribute such shares of Y to B. B's 
plan provides for quarterly payments of $1,000. On October 1, 1969, B 
made his initial quarterly payment of $1,000 and X credited B's account 
with 110 shares of Y. On December 1, 1969, Y declared and paid a 
dividend of 25 cents per share, 5 cents of which was designated as a 
capital gain dividend pursuant to section 852(b)(3) and Sec.  1.852-4. X 
credited B's account with $27.50 but did not distribute the money to B 
in 1969. On December 31, 1969, X charged B's account with $1 for 
custodial fees for calendar year 1969. On January 1, 1970, B paid X 
$1,000 and X credited B's account with 105 shares of Y. On April 1, 
1970, B paid X $1,000 and X credited B's account with 100 shares of Y. B 
must include in his tax return for 1969 a dividend of $22 and a long-
term capital gain of $5.50. In addition, B is entitled to deduct the 
annual custodial fee of $1 under section 212 of the Code.
    (a) On April 4, 1970, at B's request, X sells the shares of Y 
credited to B's account (315 shares) for $10 per share and distributes 
the proceeds ($3,150) to B together with the remaining balance of $26.50 
in B's account. The receipt of the $26.50 does not result in any tax 
consequences to B. B recognizes a long-term capital gain of $100 and a 
short- term capital gain of $50, computed as follows:
    (1) B is treated as owning 110 shares of Y as of October 1, 1969. 
The basis of these shares is $1,000, and they were sold for $1,100 (110 
shares at $10 per share). Therefore, B recognizes a gain from the sale 
or exchange of a capital asset held for more than 6 months in the amount 
of $100.

[[Page 19]]

    (2) B is treated as owning 105 shares of Y as of January 1, 1970, 
and 100 shares as of April 1, 1970. With respect to the shares acquired 
on April 1, 1970, there is no gain recognized as the shares were sold 
for $1,000, which is B's basis of the shares. The shares acquired on 
January 1, 1970, were sold for $1,050 (105 shares at $10 per share), and 
B's basis of these shares is $1,000. Therefore, B recognizes a gain of 
$50 from the sale or exchange of a capital asset held for not more than 
6 months.
    (b) On April 4, 1970, at B's request, X distributes to B the shares 
of Y credited to his account and $26.50 in cash. The receipt of the 
$26.50 does not result in any tax consequences to B. B does not 
recognize gain or loss on the distribution of the shares of Y to him. 
The bases and holding periods of B's interests in Y are as follows:

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

    (d) Definition. A unit investment trust to which this section refers 
is a business arrangement (other than a segregated asset account, 
whether or not it holds assets pursuant to a variable annuity contract, 
under the insurance laws or regulations of a State) which (except for 
taxable years ending before Jan. 1, 1969)--
    (1) Is a unit investment trust (as defined in the Investment Company 
Act of 1940);
    (2) Is registered under such Act;
    (3) Issues periodic payment plan certificates (as defined in such 
Act) in one or more series;
    (4) Possesses, as substantially all of its assets, as to all such 
series, securities issued by--
    (i) A single management company (as defined in such Act), and 
securities acquired pursuant to subparagraph (5) of this paragraph, or
    (ii) A single other corporation; and
    (5) Has no power to invest in any other securities except securities 
issued by a single other management company, when permitted by such Act 
or the rules and regulations of the Securities and Exchange Commission.
    (e) Investment in two single management companies. (1) A unit 
investment trust may possess securities issued by two or more separate 
single management companies (as defined in such Act) if--
    (i) The trust issues a separate series of periodic payment plan 
certificates (as defined in such Act) with respect to the securities of 
each separate single management company which it possesses; and
    (ii) None of the periodic payment plan certificates issued by the 
trust permits joint acquisition of an interest in each series nor the 
application of payments in whole or in part first to a series issued by 
one of the single management companies and then to any other series 
issued by any other single management company.
    (2) If a unit investment trust possesses securities of two or more 
separate single management companies as described in subparagraph (1) of 
this paragraph and issues a separate series of periodic payment plan 
certificates with respect to the securities of each such management 
company, then the holder of an interest in a series shall be treated as 
the owner of the securities in the single management company represented 
by such interest.
    (i) A holder of an interest in a series of periodic payment plan 
certificates of a trust who transfers or sells his interest in the 
series in exchange for an interest in another series of periodic payment 
plan certificates of the trust shall recognize the gain or loss realized 
from the transfer or sale as if the trust had sold the shares credited 
to his interests in the series at fair market value and distributed the 
proceeds of the sale to him.
    (ii) The basis of the interests in the series so acquired by the 
holder shall be the fair market value of his interests in the series 
transferred or sold.
    (iii) The period for which the holder has held his interest in the 
series so acquired shall be measured from the date of his acquisition of 
his interest in that series.
    (f) Cross references. (1) For reporting requirements imposed on 
custodians of unit investment trusts described in this section, see 
Sec. Sec.  1.852-4, 1.852-9, 1.853-3, 1.854-2, and 1.6042-2.

[[Page 20]]

    (2) For rules relating to redemptions of certain unit investment 
trusts not described in this section, see Sec.  1.852-10.

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



Sec.  1.852-1  Taxation of regulated investment companies.

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


See section 853(b)(1)(B) and paragraph (a) of Sec.  1.853-2 for amounts 
to be added to the dividends paid deduction, and section 855 and Sec.  
1.855-1, relating to dividends paid after the close of the taxable year.
    (2) Special rule for taxable years of regulated investment companies 
beginning before March 1, 1958. The provisions of part I of subchapter M 
(including section 852(c)) are not applicable to a regulated investment 
company for a taxable year beginning before March 1, 1958, unless such 
company meets the requirements of section 852(a) and subparagraph (1) 
(i) and (ii) of this paragraph.
    (b) Failure to qualify. If a regulated investment company does not 
meet the requirements of section 852(a) and paragraph (a)(1) (i) and 
(ii) of this section for the taxable year, it will, even though it may 
otherwise be classified as a regulated investment company, be taxed in 
such year as an ordinary corporation and not as a regulated investment 
company. In such case, none of the provisions of part I of subchapter M 
(other than section 852(c) in the case of taxable years beginning after 
February 28, 1958) will be applicable to it. For the rules relating to 
the applicability of section 852(c), see Sec.  1.852-5.

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



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

    (a) Imposition of normal tax and surtax. Section 852(b)(1) imposes a 
normal tax and surtax, computed at the rates and in the manner 
prescribed in section 11, on the investment company taxable income, as 
defined in section 852(b)(2) and Sec.  1.852-3, for each taxable year of 
a regulated investment company. The tax is imposed as if the investment 
company taxable income were the taxable income referred to in section 
11. In computing the normal tax under section 11, the regulated 
investment company's taxable income and the dividends paid deduction 
(computed without regard to the capital gains dividends) shall both be 
reduced by the deduction for partially tax-exempt interest provided by 
section 242.
    (b) Taxation of capital gains--(1) In general. Section 852(b)(3)(A) 
imposes (i) in the case of a taxable year beginning before January 1, 
1970, a tax of 25 percent, or (ii) in the case of a taxable year 
beginning after December 31, 1969, a tax determined as provided in 
section 1201(a) and paragraph (a)(3) of Sec.  1.1201-1, on the excess, 
if any, of the net long-term capital gain of a regulated investment 
company (subject to tax under part I, subchapter M, chapter 1 of the 
Code) over the sum of its net short-term capital loss and its deduction 
for dividends paid (as defined in section 561) determined with reference 
to capital gain dividends only. For the definition of capital gain 
dividend paid by a regulated investment company, see section 
852(b)(3)(C) and paragraph (c) of Sec.  1.852-4. In the case of a 
taxable year ending after December 31, 1969, and beginning before 
January 1, 1975, such deduction for dividends paid shall first be made 
from the amount subject to tax in accordance with section 1201(a)(1)(B), 
to the extent thereof, and then from the amount subject to tax in 
accordance with section 1201(a)(1)(A).

[[Page 21]]

See Sec.  1.852-10, relating to certain distributions in redemption of 
interests in unit investment trusts which, for purposes of the deduction 
for dividends paid with reference to capital gain dividends only, are 
not considered preferential dividends under section 562(c). See section 
855 and Sec.  1.855-1, relating to dividends paid after the close of the 
taxable year.
    (2) Undistributed capital gains--(i) In general. A regulated 
investment company (subject to tax under part I of subchapter M) may, 
for taxable years beginning after December 31, 1956, designate under 
section 852(b)(3)(D) an amount of undistributed capital gains to each 
shareholder of the company. For the definition of the term 
``undistributed capital gains'' and for the treatment of such amounts by 
a shareholder, see paragraph (b)(2) of Sec.  1.852-4. For the rules 
relating to the method of making such designation, the returns to be 
filed, and the payment of the tax in such cases, see paragraph (a) of 
Sec.  1.852-9.
    (ii) Effect on earnings and profits of a regulated investment 
company. If a regulated investment company designates an amount as 
undistributed capital gains for a taxable year, the earnings and profits 
of such regulated investment company for such taxable year shall be 
reduced by the total amount of the undistributed capital gains so 
designated. In such case, its capital account shall be increased--
    (a) In the case of a taxable year ending before January 1, 1970, by 
75 percent of the total amount designated,
    (b) In the case of a taxable year ending after December 31, 1969, 
and beginning before January 1, 1975, by the total amount designated 
decreased by the amount of tax imposed by section 852(b)(3)(A) with 
respect to such amount, or
    (c) In the case of a taxable year beginning after December 31, 1974, 
by 70 percent of the total amount designated. The earnings and profits 
of a regulated investment company shall not be reduced by the amount of 
tax which is imposed by section 852(b)(3)(A) on an amount designated as 
undistributed capital gains and which is paid by the corporation but 
deemed paid by the shareholder.

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



Sec.  1.852-3  Investment company taxable income.

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

[[Page 22]]



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

    (a) Ordinary income. (1) Except as otherwise provided in paragraph 
(b) of this section (relating to capital gains), a shareholder receiving 
dividends from a regulated investment company shall include such 
dividends in gross income for the taxable year in which they are 
received.
    (2) See section 853 (b)(2) and (c) and paragraph (b) of Sec.  1.853-
2 and Sec.  1.853-3 for the treatment by shareholders of dividends 
received from a regulated investment company which has made an election 
under section 853(a) with respect to the foreign tax credit. See section 
854 and Sec. Sec.  1.854-1 through 1.854-3 for limitations applicable to 
dividends received from regulated investment companies for the purpose 
of the credit under section 34 (for dividends received on or before 
December 31, 1964), the exclusion from gross income under section 116, 
and the deduction under section 243. See section 855 (b) and (d) and 
paragraphs (c) and (f) of Sec.  1.855-1 for treatment by shareholders of 
dividends paid by a regulated investment company after the close of the 
taxable year in the case of an election under section 855(a).
    (b) Capital gains--(1) In general. Under section 852(b)(3)(B), 
shareholders of a regulated investment company who receive capital gain 
dividends (as defined in paragraph (c) of this section), in respect of 
the capital gains of an investment company for a taxable year for which 
it is taxable under part I, subchapter M, chapter 1 of the Code, as a 
regulated investment company, shall treat such capital gain dividends as 
gains from the sale or exchange of capital assets held for more than 1 
year (6 months for taxable years beginning before 1977; 9 months for 
taxable years beginning in 1977) and realized in the taxable year of the 
shareholder in which the dividend was received. In the case of dividends 
with respect to any taxable year of a regulated investment company 
ending after December 31, 1969, and beginning before January 1, 1975, 
the portion of a shareholder's capital gain dividend to which section 
1201(d) (1) or (2) applies is the portion so designated by the regulated 
investment company pursuant to paragraph (c)(2) of this section.
    (2) Undistributed capital gains. (i) A person who is a shareholder 
of a regulated investment company at the close of a taxable year of such 
company for which it is taxable under part I of subchapter M shall 
include in his gross income as a gain from the sale or exchange of a 
capital asset held for more than 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977) any 
amount of undistributed capital gains. The term ``undistributed capital 
gains'' means the amount designated as undistributed capital gains in 
accordance with paragraph (a) of Sec.  1.852-9, but the amount so 
designated shall not exceed the shareholder's proportionate part of the 
amount subject to tax under section 852(b)(3)(A). Such amount shall be 
included in gross income for the taxable year of the shareholder in 
which falls the last day of the taxable year of the regulated investment 
company in respect of which the undistributed capital gains were 
designated. The amount of such gains designated under paragraph (a) of 
Sec.  1.852-9 as gain described in section 1201(d) (1) or (2) shall be 
included in the shareholder's gross income as gain described in section 
1201(d) (1) or (2). For certain administrative provisions relating to 
undistributed capital gains, see Sec.  1.852-9.
    (ii) Any shareholder required to include an amount of undistributed 
capital gains in gross income under section 852(b)(3)(D)(i) and 
subdivision (i) of this subparagraph shall be deemed to have paid for 
his taxable year for which such amount is so includible--
    (a) In the case of an amount designated with respect to a taxable 
year of the company ending before January 1, 1970, a tax equal to 25 
percent of such amount.
    (b) In the case of a taxable year of the company ending after 
December 31, 1969, and beginning before January 1, 1975, a tax equal to 
the tax designated under paragraph (a)(1) of Sec.  1.852-9 by the 
regulated investment company as his proportionate share of the capital 
gains tax paid with respect to such amount, or
    (c) In the case of an amount designated with respect to a taxable 
year

[[Page 23]]

of the company beginning after December 31, 1974, a tax equal to 30 
percent of such amount.


Such shareholder is entitled to a credit or refund of the tax so deemed 
paid in accordance with the rules provided in paragraph (c)(2) of Sec.  
1.852-9.
    (iii) Any shareholder required to include an amount of undistributed 
capital gains in gross income under section 852(b)(3)(D)(i) and 
subdivision (i) of this subparagraph shall increase the adjusted basis 
of the shares of stock with respect to which such amount is so 
includible--
    (a) In the case of an amount designated with respect to a taxable 
year of the company ending before January 1, 1970, by 75 percent of such 
amount.
    (b) In the case of an amount designated with respect to a taxable 
year of the company ending after December 31, 1969, and beginning before 
January 1, 1975, by the amount designated under paragraph (a)(1)(iv) of 
Sec.  1.852-9 by the regulated investment company, or
    (c) In the case of an amount designated with respect to a taxable 
year of the company beginning after December 31, 1974, by 70 percent of 
such amount.
    (iv) For purposes of determining whether the purchaser or seller of 
a share or regulated investment company stock is the shareholder at the 
close of such company's taxable year who is required to include an 
amount of undistributed capital gains in gross income, the amount of the 
undistributed capital gains shall be treated in the same manner as a 
cash dividend payable to shareholders of record at the close of the 
company's taxable year. Thus, if a cash dividend paid to shareholders of 
record as of the close of the regulated investment company's taxable 
year would be considered income to the purchaser, then the purchaser is 
also considered to be the shareholder of such company at the close of 
its taxable year for purposes of including an amount of undistributed 
capital gains in gross income. If, in such a case, notice on Form 2439 
is, pursuant to paragraph (a)(1) of Sec.  1.852-9, mailed by the 
regulated investment company to the seller, then the seller shall be 
considered the nominee of the purchaser and, as such, shall be subject 
to the provisions in paragraph (b) of Sec.  1.852-9. For rules for 
determining whether a dividend is income to the purchaser or seller of a 
share of stock, see paragraph (c) of Sec.  1.61-9.
    (3) Partners and partnerships. If the shareholder required to 
include an amount of undistributed capital gains in gross income under 
section 852(b)(3)(D) and subparagraph (2) of this paragraph is a 
partnership, such amount shall be included in the gross income of the 
partnership for the taxable year of the partnership in which falls the 
last day of the taxable year of the regulated investment company in 
respect of which the undistributed capital gains were designated. The 
amount so includible by the partnership shall be taken into account by 
the partners as distributive shares of the partnership gains and losses 
from sales or exchanges of capital assets held for more than 1 year (6 
months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) pursuant to section 702(a)(2) and paragraph 
(a)(2) of Sec.  1.702-1. The tax with respect to the undistributed 
capital gains is deemed paid by the partnership (under section 
852(b)(3)(D)(ii) and subparagraph (2)(ii) of this paragraph), and the 
credit or refund of such tax shall be taken into account by the partners 
in accordance with section 702(a)(8) and paragraph (a)(8)(ii) of Sec.  
1.702-1 and paragraph (c)(2) of Sec.  1.852-9. In accordance with 
section 705(a), the partners shall increase the basis of their 
partnership interests under section 705(a)(1) by the distributive shares 
of such gains, and shall decrease the basis of their partnership 
interests by the distributive shares of the amount of the tax under 
section 705(a)(2)(B) (relating to certain nondeductible expenditures) 
and paragraph (a)(3) of Sec.  1.705-1.
    (4) Nonresident alien individuals. If the shareholder required to 
include an amount of undistributed capital gains in gross income under 
section 852(b)(3)(D) and subparagraph (2) of this paragraph is a 
nonresident alien individual, such shareholder shall be treated, for 
purposes of section 871 and the regulations thereunder, as having 
realized a long-term capital gain in such amount on the last day of the 
taxable

[[Page 24]]

year of the regulated investment company in respect of which the 
undistributed capital gains were designated.
    (5) Effect on earnings and profits of corporate shareholders of a 
regulated investment company. If a shareholder required to include an 
amount of undistributed capital gains in gross income under section 
852(b)(3)(D) and subparagraph (2) of this paragraph is a corporation, 
such corporation, in computing its earnings and profits for the taxable 
year for which such amount is so includible, shall treat such amount as 
if it had actually been received and the taxes paid shall include any 
amount of tax liability satisfied by a credit under section 852(b)(3)(D) 
and subparagraph (2) of this paragraph.
    (c) Definition of capital gain dividend--(1) General rule. A capital 
gain dividend, as defined in section 852(b)(3)(C), is any dividend or 
part thereof which is designated by a regulated investment company as a 
capital gain dividend in a written notice mailed to its shareholders 
within the period specified in paragraph (c)(4) of this section. If the 
aggregate amount so designated with respect to the taxable year 
(including capital gain dividends paid after the close of the taxable 
year pursuant to an election under section 855) is greater than the 
excess of the net long-term capital gain over the net short-term capital 
loss of the taxable year, the portion of each distribution which shall 
be a capital gain dividend shall be only that proportion of the amount 
so designated which such excess of the net long-term capital gain over 
the net short-term capital loss bears to the aggregate amount so 
designated. For example, a regulated investment company making its 
return on the calendar year basis advised its shareholders by written 
notice mailed December 30, 1955, that of a distribution of $500,000 made 
December 15, 1955, $200,000 constituted a capital gain dividend, 
amounting to $2 per share. It was later discovered that an error had 
been made in determining the excess of the net long-term capital gain 
over the net short-term capital loss of the taxable year, and that such 
excess was $100,000 instead of $200,000. In such case each shareholder 
would have received a capital gain dividend of $1 per share instead of 
$2 per share.
    (2) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to subparagraph 
(1) of this paragraph by a regulated investment company with respect to 
a taxable year of the regulated investment company ending after December 
8, 1970, to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec.  1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
55th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the capital gain dividend shown on the notice received by the 
nominee pursuant to subparagraph (1) of this paragraph. The notice shall 
include the name and address of the nominee identified as such. This 
subparagraph shall not apply if the regulated investment company agrees 
with the nominee to satisfy the notice requirements of subparagraph (1) 
of this paragraph with respect to each holder of an interest in the unit 
investment trust whose shares are being held by the nominee as custodian 
and, not later than 45 days following the close of the company's taxable 
year, files with the Internal Revenue Service office where the company's 
income tax return is to be filed for the taxable year, a statement that 
the holders of the unit investment trust with whom the agreement was 
made have been directly notified by the regulated investment company. 
Such statement shall include the name, sponsor, and custodian of each 
unit investment trust whose holders have been directly notified. The 
nominee's requirements under this paragraph shall be deemed met if the 
regulated investment company transmits a copy of such statement to the 
nominee within such 45-day period; provided however, if the regulated 
investment company fails or is unable to satisfy the requirements of 
this subparagraph with respect to the holders of interest in the unit 
investment trust, it shall so notify the Internal

[[Page 25]]

Revenue Service within 45 days following the close of its taxable year. 
The custodian shall, upon notice by the Internal Revenue Service that 
the regulated investment company has failed to comply with the 
agreement, satisfy the requirements of this subparagraph within 30 days 
of such notice. If a notice under paragraph (c)(1) of this section is 
mailed within the 120-day period following the date of a determination 
pursuant to paragraph (c)(4)(ii) of this section, the 120-day period and 
the 130-day period following the date of the determination shall be 
substituted for the 45-day period and the 55-day period following the 
close of the regulated investment company's taxable year prescribed by 
this subparagraph (2).
    (3) Subsection (d) gain for certain taxable years. In the case of 
capital gain dividends with respect to any taxable year of a regulated 
investment company ending after December 31, 1969, and beginning before 
January 1, 1975 (including capital gain dividends paid after the close 
of the taxable year pursuant to an election under section 855), the 
company must include in its written notice under paragraph (c)(1) of 
this section a statement showing the shareholder's proportionate share 
of the capital gain dividend which is gain described in section 
1201(d)(1) and his proportionate share of such dividend which is gain 
described in section 1201(d)(2). In determining the portion of the 
capital gain dividend which, in the hands of a shareholder, is gain 
described in section 1201(d) (1) or (2), the regulated investment 
company shall consider that capital gain dividends for a taxable year 
are first made from its long-term capital gains for such year which are 
not described in section 1201(d) (1) or (2), to the extent thereof, and 
then from its long-term capital gains for such year which are described 
in section 1201(d) (1) or (2). A shareholder's proportionate share of 
gains which are described in section 1201(d)(1) is the amount which 
bears the same ratio to the amount paid to him as a capital gain 
dividend in respect of such year as (i) the aggregate amount of the 
company's gains which are described in section 1201(d)(1) and paid to 
all shareholders bears to (ii) the aggregate amount of the capital gain 
dividend paid to all shareholders in respect of such year. A 
shareholder's proportionate share of gains which are described in 
section 1201(d)(2) shall be determined in a similar manner. Every 
regulated investment company shall keep a record of the proportion of 
each capital gain dividend (to which this paragraph applies) which is 
gain described in section 1201(d) (1) or (2). If, for his taxable year, 
a shareholder must include in his gross income a capital gain dividend 
to which this paragraph applies, he shall attach to his income tax 
return for such taxable year a statement showing, with respect to the 
total of such dividends for such taxable year received from each 
regulated investment company, the name and address of the regulated 
investment company from which such dividends are received, the amount of 
such dividends, the portion of such dividends which was designated as 
gain described in section 1201(d)(1), and the portion of such dividends 
which was designated as gain described in section 1201(d)(2).
    (4) Mailing of written notice to shareholders. (i) Except as 
provided in paragraph (c)(4)(ii) of this section, the written notice 
designating a dividend or part thereof as a capital gain dividend must 
be mailed to the shareholders not later than 45 days (30 days for a 
taxable year ending before February 26, 1964) after the close of the 
taxable year of the regulated investment company.
    (ii) If a determination (as defined in section 860(e)) after 
November 6, 1978, increases the excess for the taxable year of the net 
capital gain over the deduction for capital gains dividends paid, then a 
regulated investment company may designate all or part of any dividend 
as a capital gain dividend in a written notice mailed to its 
shareholders at any time during the 120-day period immediately following 
the date of the determination. The aggregate amount designated during 
this period may not exceed this increase. A dividend may be designated 
if it is actually paid during the taxable year, is one paid after the 
close of the taxable year to which section 855 applies, or is a 
deficiency dividend (as defined in section 860(f)), including a 
deficiency dividend paid by an acquiring corporation to which section 
381(c)(25) applies. The

[[Page 26]]

date of a determination is established under Sec.  1.860-2(b)(1).
    (d) Special treatment of loss on the sale or exchange of regulated 
investment company stock held less than 31 days--(1) In general. Under 
section 852(b)(4), if any person, with respect to a share of regulated 
investment company stock acquired by such person after December 31, 
1957, and held for a period of less than 31 days, is required by section 
852(b)(3) (B) or (D) to include in gross income as a gain from the sale 
or exchange of a capital asset held for more than six months--
    (i) The amount of a capital gain dividend, or
    (ii) An amount of undistributed capital gains,


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

    Example. On December 15, 1958, A purchased a share of stock in the X 
regulated investment company for $20. The X regulated investment company 
declared a capital gain dividend of $2 per share to shareholders of 
record on December 31, 1958. A, therefore, received a capital gain 
dividend of $2 which, pursuant to section 852(b)(3)(B), he must treat as 
a gain from the sale or exchange of a capital asset held for more than 6 
months. On January 5, 1959, A sold his share of stock in the X regulated 
investment company for $17.50, which sale resulted in a loss of $2.50. 
Under section 852(b)(4) and this paragraph, A must treat $2 of such loss 
(an amount equal to the capital gain dividend received with respect to 
such share of stock) as a loss from the sale or exchange of a capital 
asset held for more than 6 months.

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

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



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

    (a) Any regulated investment company, whether or not such company 
meets the requirements of section 852(a) and paragraphs (a)(1) (i) and 
(ii) of Sec.  1.852-1, shall apply paragraph (b) of this section in 
computing its earnings and profits for a taxable year beginning after 
February 28, 1958. However, for a taxable year of a regulated investment 
company beginning before March 1, 1958, paragraph (b) of this section 
shall apply only if the regulated investment company meets the 
requirements of section 852(a) and paragraphs (a)(1) (i) and (ii) of 
Sec.  1.852-1.
    (b) In the determination of the earnings and profits of a regulated 
investment company, section 852(c) provides that such earnings and 
profits for any taxable year (but not the accumulated earnings and 
profits) shall not be reduced by any amount which is not allowable as a 
deduction in computing its taxable income for the taxable year. Thus, if 
a corporation would have had earnings and profits of $500,000 for the 
taxable year except for the fact that it had a net capital loss of 
$100,000, which amount was not deductible in determining its taxable 
income, its earnings and profits for that year if it is a regulated 
investment company would be $500,000. If the regulated investment 
company had no accumulated earnings

[[Page 27]]

and profits at the beginning of the taxable year, in determining its 
accumulated earnings and profits as of the beginning of the following 
taxable year, the earnings and profits for the taxable year to be 
considered in such computation would amount to $400,000 assuming that 
there had been no distribution from such earnings and profits. If 
distributions had been made in the taxable year in the amount of the 
earnings and profits then available for distribution, $500,000, the 
corporation would have as of the beginning of the following taxable year 
neither accumulated earnings and profits nor a deficit in accumulated 
earnings and profits, and would begin such year with its paid-in capital 
reduced by $100,000, an amount equal to the excess of the $500,000 
distributed over the $400,000 accumulated earnings and profits which 
would otherwise have been carried into the following taxable year.



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

    (a) Every regulated investment company shall maintain in the 
internal revenue district in which it is required to file its income tax 
return permanent records showing the information relative to the actual 
owners of its stock contained in the written statements required by this 
section to be demanded from the shareholders. The actual owner of stock 
includes the person who is required to include in gross income in his 
return the dividends received on the stock. Such records shall be kept 
at all times available for inspection by any internal revenue officer or 
employee, and shall be retained so long as the contents thereof may 
become material in the administration of any internal revenue law.
    (b) For the purpose of determining whether a domestic corporation 
claiming to be a regulated investment company is a personal holding 
company as defined in section 542, the permanent records of the company 
shall show the maximum number of shares of the corporation (including 
the number and face value of securities convertible into stock of the 
corporation) to be considered as actually or constructively owned by 
each of the actual owners of any of its stock at any time during the 
last half of the corporation's taxable year, as provided in section 544.
    (c) Statements setting forth the information (required by paragraph 
(b) of this section) shall be demanded not later than 30 days after the 
close of the corporation's taxable year as follows:
    (1) In the case of a corporation having 2,000 or more record owners 
of its stock on any dividend record date, from each record holder of 5 
percent or more of its stock; or
    (2) In the case of a corporation having less than 2,000 and more 
than 200 record owners of its stock, on any dividend record date, from 
each record holder of 1 percent or more of its stock; or
    (3) In the case of a corporation having 200 or less record owners of 
its stock, on any dividend record date, from each record holder of one-
half of 1 percent or more of its stock.


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



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

    Any person who fails or refuses to comply with the demand of a 
regulated investment company for the written statements which Sec.  
1.852-6 requires the company to demand from its shareholders shall 
submit as a part of his income tax return a statement showing, to the 
best of his knowledge and belief--
    (a) The number of shares actually owned by him at any and all times 
during the period for which the return is

[[Page 28]]

filed in any company claiming to be a regulated investment company;
    (b) The dates of acquisition of any such stock during such period 
and the names and addresses of persons from whom it was acquired;
    (c) The dates of disposition of any such stock during such period 
and the names and addresses of the transferees thereof;
    (d) The names and addresses of the members of his family (as defined 
in section 544(a)(2)); the names and addresses of his partners, if any, 
in any partnership; and the maximum number of shares, if any, actually 
owned by each in any corporation claiming to be a regulated investment 
company, at any time during the last half of the taxable year of such 
company;
    (e) The names and addresses of any corporation, partnership, 
association, or trust in which he had a beneficial interest to the 
extent of at least 10 percent at any time during the period for which 
such return is made, and the number of shares of any corporation 
claiming to be a regulated investment company actually owned by each;
    (f) The maximum number of shares (including the number and face 
value of securities convertible into stock of the corporation) in any 
domestic corporation claiming to be a regulated investment company to be 
considered as constructively owned by such individual at any time during 
the last half of the corporation's taxable year, as provided in section 
544 and the regulations thereunder; and
    (g) The amount and date of receipt of each dividend received during 
such period from every corporation claiming to be a regulated investment 
company.



Sec.  1.852-8  Information returns.

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



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

    (a) Regulated investment company--(1) Notice to shareholders. (i) A 
designation of undistributed capital gains under section 852(b)(3)(D) 
and paragraph (b)(2)(i) of Sec.  1.852-2 shall be made by notice on Form 
2439 mailed by the regulated investment company to each person who is a 
shareholder of record of the company at the close of the company's 
taxable year. The notice on Form 2439 shall show the name, address, and 
employer identification number of the regulated investment company; the 
taxable year of the company for which the designation is made; the name, 
address, and identifying number of the shareholder; the amount 
designated by the company for inclusion by the shareholder in computing 
his long-term capital gains; and the tax paid with respect thereto by 
the company which is deemed to have been paid by the shareholder.
    (ii) In the case of a designation of undistributed capital gains 
with respect to a taxable year of the regulated investment company 
ending after December 31, 1969, and beginning before January 1, 1975, 
Form 2439 shall also show the shareholder's proportionate share of such 
gains which is gain described in section 1201(d)(1), his proportionate 
share of such gains which is gain described in section 1201(d)(2), and 
the amount (determined pursuant to subdivision (iv) of this 
subparagraph) by which the shareholder's adjusted basis in his shares 
shall be increased.
    (iii) In determining under subdivision (ii) of this subparagraph the 
portion of the undistributed capital gains which, in the hands of the 
shareholder, is gain described in section 1201(d) (1) or (2), the 
company shall consider that capital gain dividends for a taxable year 
are made first from its long-term capital gains for such year which are 
not described in section 1201(d) (1) or (2), to the extent thereof, and 
then from its long-term capital gains for such year which are described 
in section 1201(d) (1) or (2). A shareholder's proportionate share of 
undistributed capital gains for a taxable year which is gain described 
in section 1201(d)(1) is the amount which bears the same ratio to the 
amount included in his income as designated undistributed capital gains 
for such year as (a) the aggregate amount of the company's gains for 
such year which are described in section 1201(d)(1)

[[Page 29]]

and designated as undistributed capital gains bears to (b) the aggregate 
amount of the company's gains for such year which are designated as 
undistributed capital gains. A shareholder's proportionate share of 
gains which are described in section 1201(d)(2) shall be determined in a 
similar manner. Every regulated investment company shall keep a record 
of the proportion of undistributed capital gains (to which this 
subdivision applies) which is gain described in section 1201(d) (1) or 
(2).
    (iv) In the case of a designation of undistributed capital gains for 
any taxable year ending after December 31, 1969, and beginning before 
January 1, 1975, Form 2439 shall also show with respect to the 
undistributed capital gains of each shareholder the amount by which such 
shareholder's adjusted basis in his shares shall be increased under 
section 852(b)(3)(D)(iii). The amount by which each shareholders' 
adjusted basis in his shares shall be increased is the amount includible 
in his gross income with respect to such shares under section 
852(b)(3)(D)(i) less the tax which the shareholder is deemed to have 
paid with respect to such shares. The tax which each shareholder is 
deemed to have paid with respect to such shares is the amount which 
bears the same ratio to the amount of the tax imposed by section 
852(b)(3)(A) for such year with respect to the aggregate amount of the 
designated undistributed capital gains as the amount of such gains 
includible in the shareholder's gross income bears to the aggregate 
amount of such gains so designated.
    (v) Form 2439 shall be prepared in triplicate, and copies B and C of 
the form shall be mailed to the shareholder on or before the 45th day 
(30th day for a taxable year ending before February 26, 1964) following 
the close of the company's taxable year. Copy A of each Form 2439 must 
be associated with the duplicate copy of the undistributed capital gains 
tax return of the company (Form 2438), as provided in subparagraph 
(2)(ii) of this paragraph.
    (2) Return of undistributed capital gains tax--(i) Form 2438. Every 
regulated investment company which designates undistributed capital 
gains for any taxable year beginning after December 31, 1956, in 
accordance with subparagraph (1) of this paragraph, shall file for such 
taxable year an undistributed capital gains tax return on Form 2438 
including on such return the total of its undistributed capital gains so 
designated and the tax with respect thereto. The return on Form 2438 
shall be prepared in duplicate and shall set forth fully and clearly the 
information required to be included therein. The original of Form 2438 
shall be filed on or before the 30th day after the close of the 
company's taxable year with the internal revenue officer designated in 
instructions applicable to Form 2438. The duplicate copy of form 2438 
for the taxable year shall be attached to and filed with the income tax 
return of the company on Form 1120 for such taxable year.
    (ii) Copies A of Form 2439. For each taxable year which ends on or 
before December 31, 1965, there shall be submitted with the company's 
return on Form 2438 all copies A of Form 2439 furnished by the company 
to its shareholders in accordance with subparagraph (1) of this 
paragraph. For each taxable year which ends after December 31, 1965, 
there shall be submitted with the duplicate copy of the company's return 
on Form 2438, which is attached to and filed with the income tax return 
of the company on Form 1120 for the taxable year, all copies A of Form 
2439 furnished by the company to its shareholders in accordance with 
subparagraph (1) of this paragraph. The copies A of Form 2439 shall be 
accompanied by lists (preferably in the form of adding machine tapes) of 
the amounts of undistributed capital gains and of the tax paid with 
respect thereto shown on such forms. The totals of the listed amounts of 
undistributed capital gains and of tax paid with respect thereto must 
agree with the corresponding entries on Form 2438.
    (3) Payment of tax. The tax required to be returned on Form 2438 
shall be paid by the regulated investment company on or before the 30th 
day after the close of the company's taxable year to the internal 
revenue officer with whom the return on Form 2438 is filed.
    (b) Shareholder of record not actual owner--(1) Notice to actual 
owner. In any case in which a notice on Form 2439 is

[[Page 30]]

mailed pursuant to paragraph (a)(1) of this section by a regulated 
investment company to a shareholder of record who is a nominee of the 
actual owner or owners of the shares of stock to which the notice 
relates, the nominee shall furnish to each such actual owner notice of 
the owner's proportionate share of the amounts of undistributed capital 
gains and tax with respect thereto, as shown on the Form 2439 received 
by the nominee from the regulated investment company. The nominee's 
notice to the actual owner shall be prepared in triplicate on Form 2439 
and shall contain the information prescribed in paragraph (a)(1) of this 
section, except that the name and address of the nominee, identified as 
such, shall be entered on the form in addition to, and in the space 
provided for, the name and address of the regulated investment company, 
and the amounts of undistributed capital gains and tax with respect 
thereto entered on the form shall be the actual owner's proportionate 
share of the corresponding items shown on the nominee's notice from the 
regulated investment company. Copies B and C of the Form 2439 prepared 
by the nominee shall be mailed to the actual owner--
    (i) For taxable years of regulated investment companies ending after 
February 25, 1964, on or before the 75th day (55th day in the case of a 
nominee who is acting as a custodian of a unit investment trust 
described in section 851(f)(1) and paragraph (d) of Sec.  1.851-7 for 
taxable years of regulated investment companies ending after December 8, 
1970, and 135th day if the nominee is a resident of a foreign country) 
following the close of the regulated investment company's taxable year, 
or
    (ii) For taxable years of regulated investment companies ending 
before February 26, 1964, on or before the 60th day (120th day if the 
nominee is a resident of a foreign country) following the close of the 
regulated investment company's taxable year.
    (2) Transmittal of Form 2439. The nominee shall enter the word 
``Nominee'' in the upper right hand corner of copy B of the notice on 
Form 2439 received by him from the regulated investment company, and on 
or before the appropriate day specified in subdivision (i) or (ii) of 
subparagraph (1) of this paragraph shall transmit such copy B, together 
with all copies A of Form 2439 prepared by him pursuant to subparagraph 
(1) of this paragraph, to the internal revenue officer with whom his 
income tax return is required to be filed.
    (3) Custodian of certain unit investment trusts. The requirements of 
this paragraph shall not apply to a nominee who is acting as a custodian 
of the unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec.  1.851-7 provided that the regulated investment 
company agrees with the nominee to satisfy the notice requirements of 
paragraph (a) of this section with respect to each holder of an interest 
in the unit investment trust whose shares are being held by such nominee 
as custodian and on or before the 45th day following the close of the 
company's taxable year, files with the Internal Revenue Service office 
where the company's income tax return is to be filed for the taxable 
year, a statement that the holders of the unit investment trust with 
whom the agreement was made have been directly notified by the regulated 
investment company. Such statement shall include the name, sponsor, and 
custodian of each unit investment trust whose holders have been directly 
notified. The nominee's requirements under this paragraph shall be 
deemed met if the regulated investment company transmits a copy of such 
statement to the nominee within such 45-day period; provided however, if 
the regulated investment company fails or is unable to satisfy the 
requirements of this paragraph with respect to the holders of interest 
in the unit investment trust, it shall so notify the Internal Revenue 
Service within 45 days following the close of its taxable year. The 
custodian shall, upon notice by the Internal Revenue Service that the 
regulated investment company has failed to comply with the agreement, 
satisfy the requirements of this paragraph within 30 days of such 
notice.
    (c) Shareholders--(1) Return and Recordkeeping Requirements--(i) 
Return requirements for taxable years beginning before January 1, 2002. 
For taxable years beginning before January 1, 2002, the

[[Page 31]]

copy B of Form 2439 furnished to a shareholder by the regulated 
investment company or by a nominee, as provided in Sec.  1.852-9(a) or 
(b) shall be attached to the income tax return of the shareholder for 
the taxable year in which the amount of undistributed capital gains is 
includible in gross income as provided in Sec.  1.852-4(b)(2).
    (ii) Recordkeeping requirements for taxable years beginning after 
December 31, 2001. For taxable years beginning after December 31, 2001, 
the shareholder shall retain a copy of Form 2439 for as long as its 
contents may become material in the administration of any internal 
revenue law.
    (2) Credit or refund--(i) In general. The amount of the tax paid by 
the regulated investment company with respect to the undistributed 
capital gains required under section 852(b)(3)(D) and paragraph (b)(2) 
of Sec.  1.852-4 to be included by a shareholder in his computation of 
long-term capital gains for any taxable year is deemed paid by such 
shareholder under section 852(b)(3)(D)(ii) and such payment constitutes, 
for purposes of section 6513(a) (relating to time tax considered paid), 
an advance payment in like amount of the tax imposed under chapter 1 of 
the Code for such taxable year. In the case of an overpayment of tax 
within the meaning of section 6401, see section 6402 and the regulations 
in part 301 of this chapter (Regulations on Procedure and 
Administration) for rules applicable to the treatment of an overpayment 
of tax and section 6511 and the regulations in part 301 of this chapter 
(Regulations on Procedure and Administration) with respect to the 
limitations applicable to the credit or refund of an overpayment of tax.
    (ii) Form to be used. Claim for refund or credit of the tax deemed 
to have been paid by a shareholder with respect to an amount of 
undistributed capital gains shall be made on the shareholder's income 
tax return for the taxable year in which such amount of undistributed 
capital gains is includable in gross income. In the case of a 
shareholder which is a partnership, claim shall be made by the partners 
on their income tax returns for refund or credit of their distributive 
shares of the tax deemed to have been paid by the partnership. In the 
case of a shareholder which is exempt from tax under section 501(a) and 
to which section 511 does not apply for the taxable year, claim for 
refund of the tax deemed to have been paid by such shareholder on an 
amount of undistributed capital gains for such year shall be made on 
Form 843 and copy B of Form 2439 furnished to such shareholder shall be 
attached to its claim. For other rules applicable to the filing of 
claims for credit or refund of an overpayment of tax, see Sec.  
301.6402-2 of this chapter (Regulations on Procedure and 
Administration), relating to claims for credit or refund, and Sec.  
301.6402-3 of this chapter, relating to special rules applicable to 
income tax.
    (3) Records. The shareholder is required to keep copy C of the Form 
2439 furnished for the regulated investment company's taxable years 
ending after December 31, 1969, and beginning before January 1, 1975, as 
part of his records to show increases in the adjusted basis of his 
shares in such company.
    (d) Penalties. For criminal penalties for willful failure to file a 
return, supply information, or pay tax, and for filing a false or 
fraudulent return, statement, or other document, see sections 7203, 
7206, and 7207.

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



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

    (a) In general. In computing that part of the excess of its net 
long-term capital gain over net short-term capital loss on which it must 
pay a capital gains tax, a regulated investment company is allowed under 
section 852(b)(3)(A)(ii) a deduction for dividends paid (as defined in 
section 561) determined with reference to capital gains dividends only. 
Section 561(b) provides that in determining the deduction for dividends 
paid, the rules provided in section 562 are applicable. Section 562(c) 
(relating to preferential dividends) provides that the amount of

[[Page 32]]

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

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

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


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

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

[[Page 33]]



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

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

    (a) Outline of provisions.
    (b) Scope.
    (1) In general.
    (2) Limitation on application of section.
    (c) Post-October capital loss defined.
    (1) In general.
    (2) Methodology.
    (3) October 31 treated as last day of taxable year for purpose of 
determining taxable income under certain circumstances.
    (i) In general.
    (ii) Effect on gross income.
    (d) Post-October currency loss defined.
    (1) Post-October currency loss.
    (2) Net foreign currency loss.
    (3) Foreign currency gain or loss.
    (e) Limitation on capital gain dividends.
    (1) In general.
    (2) Amount taken into account in current year.
    (i) Net capital loss.
    (ii) Net long-term capital loss.
    (3) Amount taken into account in succeeding year.
    (f) Regulated investment company may elect to defer certain losses 
for purposes of determining taxable income.
    (1) In general.
    (2) Effect of election in current year.
    (3) Amount of loss taken into account in current year.
    (i) If entire amount of net capital loss deferred.
    (ii) If part of net capital loss deferred.
    (A) In general.
    (B) Character of capital loss not deferred.
    (iii) If entire amount of net long-term capital loss deferred.
    (iv) If part of net long-term capital loss deferred.
    (v) If entire amount of post-October currency loss deferred.
    (vi) If part of post-October currency loss deferred.
    (4) Amount of loss taken into account in succeeding year and 
subsequent years.
    (5) Effect on gross income.
    (g) Earnings and profits.
    (1) General rule.
    (2) Special rule--treatment of losses that are deferred for purposes 
of determining taxable income.
    (h) Examples.
    (i) Procedure for making election.
    (1) In general.
    (2) When applicable instructions not available.
    (j) Transition rules.
    (1) In general.
    (2) Retroactive election.
    (i) In general.
    (ii) Deadline for making election.
    (3) Amended return required for succeeding year in certain 
circumstances.
    (i) In general.
    (ii) Time for filing amended return.
    (4) Retroactive dividend.
    (i) In general.
    (ii) Method of making election.
    (iii) Deduction for dividends paid.
    (A) In general.
    (B) Limitation on ordinary dividends.
    (C) Limitation on capital gain dividends.
    (D) Effect on other years.
    (iv) Earnings and profits.
    (v) Receipt by shareholders.
    (vi) Foreign tax election.
    (vii) Example.
    (5) Certain distributions may be designated retroactively as capital 
gain dividends.
    (k) Effective date.

    (b) Scope--(1) In general. This section prescribes the manner in 
which a regulated investment company must treat a post-October capital 
loss (as defined in paragraph (c) of this section) or a post-October 
currency loss (as defined in paragraph (d)(1) of this section) for 
purposes of determining its taxable income, its earnings and profits, 
and the amount that it may designate as capital gain dividends for the 
taxable year in which the loss is incurred and the succeeding taxable 
year (the ``succeeding year'').
    (2) Limitation on application of section. This section shall not 
apply to any post-October capital loss or post-October currency loss of 
a regulated investment company attributable to a taxable year for which 
an election is in effect under section 4982(e)(4) of the Code with 
respect to the company.
    (c) Post-October capital loss defined--(1) In general. For purposes 
of this section, the term post-October capital loss means--
    (i) Any net capital loss attributable to the portion of a regulated 
investment company's taxable year after October 31; or
    (ii) If there is no such net capital loss, any net long-term capital 
loss attributable to the portion of a regulated investment company's 
taxable year after October 31.
    (2) Methodology. The amount of any net capital loss or any net long-
term capital loss attributable to the portion of the regulated 
investment company's

[[Page 34]]

taxable year after October 31 shall be determined in accordance with 
general tax law principles (other than section 1212) by treating the 
period beginning on November 1 of the taxable year of the regulated 
investment company and ending on the last day of such taxable year as 
though it were the taxable year of the regulated investment company. For 
purposes of this paragraph (c)(2), any item (other than a capital loss 
carryover) that is required to be taken into account or any rule that 
must be applied, for purposes of section 4982, on October 31 as if it 
were the last day of the regulated investment company's taxable year 
must also be taken into account or applied in the same manner as 
required under section 4982, both on October 31 and again on the last 
day of the regulated investment company's taxable year.
    (3) October 31 treated as last day of taxable year for purpose of 
determining taxable income under certain circumstances--(i) In general. 
If a regulated investment company has a post-October capital loss for a 
taxable year, any item that must be marked to market for purposes of 
section 4982 on October 31 as if it were the last day of the regulated 
investment company's taxable year must also be marked to market on 
October 31 and again on the last day of the regulated investment 
company's taxable year for purposes of determining its taxable income. 
If the regulated investment company does not have a post-October capital 
loss for a taxable year, the regulated investment company must treat 
items that must be marked to market for purposes of section 4982 on 
October 31 as if it were the last day of the regulated investment 
company's taxable year as marked to market only on the last day of its 
taxable year for purposes of determining its taxable income.
    (ii) Effect on gross income. The marking to market of any item on 
October 31 of a regulated investment company's taxable year for purposes 
of determining its taxable income under paragraph (c)(3)(i) of this 
section shall not affect the amount of the gross income of such company 
for such taxable year for purposes of section 851(b)(2) or (3).
    (d) Post-October currency loss defined. For purposes of this 
section--
    (1) Post-October currency loss. The term post-October currency loss 
means any net foreign currency loss attributable to the portion of a 
regulated investment company's taxable year after October 31. For 
purposes of the preceding sentence, principles similar to those of 
paragraphs (c)(2) and (c)(3) of this section shall apply.
    (2) Net foreign currency loss. The term ``net foreign currency 
loss'' means the excess of foreign currency losses over foreign currency 
gains.
    (3) Foreign currency gain or loss. The terms ``foreign currency 
gain'' and ``foreign currency loss'' have the same meaning as provided 
in section 988(b).
    (e) Limitation on capital gain dividends--(1) In general. For 
purposes of determining the amount a regulated investment company may 
designate as capital gain dividends for a taxable year, the amount of 
net capital gain for the taxable year shall be determined without regard 
to any post-October capital loss for such year.
    (2) Amount taken into account in current year--(i) Net capital loss. 
If the post-October capital loss referred to in paragraph (e)(1) of this 
section is a post-October capital loss as defined in paragraph (c)(1)(i) 
of this section, the net capital gain of the company for the taxable 
year in which the loss arose shall be determined without regard to any 
capital gains or losses (both long-term and short-term) taken into 
account in computing the post-October capital loss for the taxable year.
    (ii) Net long-term capital loss. If the post-October capital loss 
referred to in paragraph (e)(1) of this section is a post-October 
capital loss as defined in paragraph (c)(1)(ii) of this section, the net 
capital gain of the company for the taxable year in which the loss arose 
shall be determined without regard to any long-term capital gain or loss 
taken into account in computing the post-October capital loss for the 
taxable year.
    (3) Amount taken into account in succeeding year. If a regulated 
investment company has a post-October capital loss (as defined in 
paragraph (c)(1)(i) or (c)(1)(ii) of this section) for any taxable year, 
then, for purposes of determining the amount the company may designate 
as capital gain dividends for the

[[Page 35]]

succeeding year, the net capital gain for the succeeding year shall be 
determined by treating all gains and losses taken into account in 
computing the post-October capital loss as arising on the first day of 
the succeeding year.
    (f) Regulated investment company may elect to defer certain losses 
for purposes of determining taxable income--(1) In general. A regulated 
investment company may elect, in accordance with the procedures of 
paragraph (i) of this section, to compute its taxable income for a 
taxable year without regard to part or all of any post-October capital 
loss or post-October currency loss for that year.
    (2) Effect of election in current year. The taxable income of a 
regulated investment company for a taxable year to which an election 
under paragraph (f)(1) of this section applies shall be computed without 
regard to that part of any post-October capital loss or post-October 
currency loss to which the election applies.
    (3) Amount of loss taken into account in current year--(i) If entire 
amount of net capital loss deferred. If a regulated investment company 
elects, under paragraph (f)(1) of this section, to defer the entire 
amount of a post-October capital loss as defined in paragraph (c)(1)(i) 
of this section, the taxable income of the company for the taxable year 
in which the loss arose shall be determined without regard to any 
capital gains or losses (both long-term and short-term) taken into 
account in computing the post-October capital loss for the taxable year.
    (ii) If part of net capital loss deferred--(A) In general. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer less than the entire amount of a post-October capital 
loss as defined in paragraph (c)(1)(i) of this section, the taxable 
income of the company for the taxable year in which the loss arose shall 
be determined by including an amount of capital loss taken into account 
in computing the post-October capital loss for the taxable year equal to 
the amount of the post-October capital loss that is not deferred. No 
amount of capital gain taken into account in computing the post-October 
capital loss for the taxable year shall be taken into account in the 
determination.
    (B) Character of capital loss not deferred. The capital loss 
includible in the taxable income of the company under this paragraph 
(f)(3)(ii) for the taxable year in which the loss arose shall consist 
first of any short-term capital losses to the extent thereof, and then 
of any long-term capital losses, taken into account in computing the 
post-October capital loss for the taxable year.
    (iii) If entire amount of net long-term capital loss deferred. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer the entire amount of a post-October capital loss as 
defined in paragraph (c)(1)(ii) of this section, the taxable income of 
the company for the taxable year in which the loss arose shall be 
determined without regard to any long-term capital gains or losses taken 
into account in computing the post-October capital loss for the taxable 
year.
    (iv) If part of net long-term capital loss deferred. If a regulated 
investment company elects, under paragraph (f)(1) of this section, to 
defer less than the entire amount of a post-October capital loss as 
defined in paragraph (c)(1)(ii) of this section, the taxable income of 
the company for the taxable year in which the loss arose shall be 
determined by including an amount of long-term capital loss taken into 
account in computing the post-October capital loss for the taxable year 
equal to the amount of the post-October capital loss that is not 
deferred. No amount of long term capital gain taken into account in 
computing the post-October capital loss for the taxable year shall be 
taken into account in the determination.
    (v) If entire amount of post-October currency loss deferred. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer the entire amount of a post-October currency loss, the 
taxable income of the company for the taxable year in which the loss 
arose shall be determined without regard to any foreign currency gains 
or losses taken into account in computing the post-October currency loss 
for the taxable year.
    (vi) If part of post-October currency loss deferred. If a regulated 
investment

[[Page 36]]

company elects, under paragraph (f)(1) of this section, to defer less 
than the entire amount of a post-October currency loss, the taxable 
income of the company for the taxable year in which the loss arose shall 
be determined by including an amount of foreign currency loss taken into 
account in computing the post-October currency loss for the taxable year 
equal to the amount of the post-October currency loss that is not 
deferred. No amount of foreign currency gain taken into account in 
computing the post-October currency loss for the taxable year shall be 
taken into account in the determination.
    (4) Amount of loss taken into account in succeeding year and 
subsequent years. If a regulated investment company has a post-October 
capital loss or a post-October currency loss for any taxable year and an 
election under paragraph (f)(1) is made for that year, then, for 
purposes of determining the taxable income of the company for the 
succeeding year and all subsequent years, all capital gains and losses 
taken into account in determining the post-October capital loss, and all 
foreign currency gains and losses taken into account in determining the 
post-October currency loss, that are not taken into account under the 
rules of paragraph (f)(3) of this section in determining the taxable 
income of the regulated investment company for the taxable year in which 
the loss arose shall be treated as arising on the first day of the 
succeeding year.
    (5) Effect on gross income. An election by a regulated investment 
company to defer any post-October capital loss or any post-October 
currency loss for a taxable year under paragraph (f)(1) of this section 
shall not affect the amount of the gross income of such company for such 
taxable year (or the succeeding year) for purposes of section 851(b)(2) 
or (3).
    (g) Earnings and profits--(1) General rule. The earnings and profits 
of a regulated investment company for a taxable year are determined 
without regard to any post-October capital loss or post-October currency 
loss for that year. If a regulated investment company distributes with 
respect to a calendar year amounts in excess of the limitation described 
in the succeeding sentence, then, with respect to those excess amounts, 
for the taxable year with respect to which the amounts are distributed, 
the earnings and profits of the company are computed without regard to 
the preceding sentence. The limitation described in this sentence is the 
amount that would be the required distribution for that calendar year 
under section 4982 if ``100 percent'' were substituted for each 
percentage set forth in section 4982(b)(1).
    (2) Special Rule--Treatment of losses that are deferred for purposes 
of determining taxable income. If a regulated investment company elects 
to defer, under paragraph (f)(1) of this section, any part of a post-
October capital loss or post-October currency loss arising in a taxable 
year, then, for both the taxable year in which the loss arose and the 
succeeding year, both the earnings and profits and the accumulated 
earnings and profits of the company are determined as if the part of the 
loss so deferred had arisen on the first day of the succeeding year.
    (h) Examples. The provisions of paragraphs (e), (f), and (g) of this 
section may be illustrated by the following examples. For each example, 
assume that X is a regulated investment company that computes its income 
on a calendar year basis, and that no election is in effect under 
section 4982(e)(4).

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

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

[[Page 37]]

 
                                                           (0)      (50)
                                                     -------------------
                                                           35        50
------------------------------------------------------------------------


X has a post-October capital loss of $75 for its 1988 taxable year due 
to a net long-term capital loss for the post-October period of 1988. X 
does not make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $75 long-term 
capital gain and the $150 long-term capital loss for the post-October 
period of 1988 in computing its net capital gain for this purpose. In 
computing its net capital gain for 1989 for the purposes of determining 
the amount it may designate as a capital gain dividend for 1989, X must 
take into account the $75 long-term capital gain and the $150 long-term 
capital loss for the post-October period of 1988 in addition to the 
long-term and short-term capital gains and losses for 1989. Accordingly, 
X may not designate any amount as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $75 long-term capital gain 
and the $150 long-term capital loss for its post-October period of 1988 
in its taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $25 and a net short-
term capital gain of $160. X's taxable income for 1989 will include a 
net capital gain of $60 and a net short-term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988. X 
must, however, include the $75 long-term capital gain and $150 long-term 
capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $260 of 
capital gain in its earnings and profits for 1988, includes $185 in its 
accumulated earnings and profits for 1988, and includes $130 of capital 
gain in its earnings and profits for 1989.
    Example 3. Same facts as example 2, except that X elects to defer 
the entire $75 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 2.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $75 long-term capital gain and the $150 long-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $75 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $160. X must include the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988 in 
its taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net long-term capital loss of $15 and a net short-
term capital gain of $70.
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $75 long-term capital gain and $150 long-term capital loss 
for the post-October period of 1988. In determining both its earnings 
and profits and its accumulated earnings and profits for 1989, X must 
include (in addition to the long-term and short-term capital gains and 
losses for 1989) the $75 long-term capital gain and $150 long-term 
capital loss for the post-October period of 1988 as if those deferred 
gains and losses arose on January 1, 1989. Thus, X will include $260 of 
capital gain in its earnings and profits for 1988 and $55 of capital 
gain in its earnings and profits for 1989.
    Example 4. Same facts as example 2, except that X elects to defer 
only $50 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same results as in example 2.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $75 long-term capital gain and $125 of the $150 
long-term capital loss for the post-October period of 1988 because it 
made an election to defer $50 of the $75 post-October capital loss for 
1988 under paragraph (f)(1) of this section. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $75 and a net short-
term capital gain of $160. X must include the $75 long-term capital gain 
and $125 of the $150 long-term capital loss for the post-October period 
of 1988 in its taxable income for 1989 in addition to the long-term and 
short-term capital gains and losses for 1989. Accordingly, X's taxable 
income for 1989 will include a net capital gain of $10 and a net short-
term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988. X 
must include $25 of the $150 long-term capital loss for the post-October 
period of 1988 in determining its accumulated earnings and profits for 
1988. In determining both its earnings and profits and its accumulated 
earnings and profits for 1989, X must include (in addition to the long-
term and short-term capital gains and losses for 1989) the $75 long-term 
capital gain and $125 of the $150 long-term capital loss for the

[[Page 38]]

post-October period of 1988 as if those deferred gains and losses arose 
on January 1, 1989. Thus, X includes $260 of capital gain in its 
earnings and profits for 1988, includes $235 in its accumulated earnings 
and profits for 1988, and includes $80 of capital gain in its earnings 
and profits for 1989.
    Example 5. X has the following capital gains and losses for the 
periods indicated:

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


X has a post-October capital loss of $25 for its 1988 taxable year due 
to a net capital loss for the post-October period of 1988. X does not 
make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $150 long-term 
capital gain, the $75 long-term capital loss, the $50 short-term capital 
gain, and the $150 short-term capital loss for the post-October period 
of 1988 in computing its net capital gain for this purpose. In computing 
its net capital gain for 1989 for purposes of determining the amount it 
may designate as a capital gain dividend for 1989, X must take into 
account the $150 long-term capital gain, the $75 long-term capital loss, 
the $50 short-term capital gain, and the $150 short-term capital loss 
for the post-October period of 1988 in addition to the long-term and 
short-term capital gains and losses for 1989. Accordingly, X may 
designate up to $105 as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $150 long-term capital gain, 
the $75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $135 (consisting of a 
net long-term capital gain of $175 and a net short-term capital loss of 
$40). X's taxable income for 1989 will include a net capital gain of $60 
and a net short-term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988. X 
must, however, include the $150 long-term capital gain, the $75 long-
term capital loss, the $50 short-term capital gain, and the $150 short-
term capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $160 of 
capital gain in its earnings and profits for 1988, includes $135 in its 
accumulated earnings and profits for 1988, and includes $130 of capital 
gain in its earnings and profits for 1989.
    Example 6. Same facts as example 5, except that X elects to defer 
the entire $25 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 5.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $150 long-term capital gain, the $75 long-term 
capital loss, the $50 short-term capital gain, and the $150 short-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $25 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $60. X must include the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net capital gain of $105 (consisting of a net long-
term capital gain of $135 and a net short-term capital loss of $30).
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $150 long-term capital gain, the $75 long-term capital 
loss, the $50 short-term capital gain, and the $150 short-term capital 
loss for the post-October period of 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the long-term and short-term capital 
gains and losses for 1989) the $150 long-term capital gain, the $75 
long-term capital loss, the $50 short-term capital gain, and the $150 
short-term capital loss for the post-October period of 1988 as if those 
deferred gains and losses arose on January 1, 1989. Thus, X will include 
$160 of capital gain in its earnings and profits for 1988

[[Page 39]]

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

------------------------------------------------------------------------
                                                        Long-    Short-
                                                        term      term
------------------------------------------------------------------------
01/01 to 10/31/88...................................      115        80
                                                          (15)      (20)
                                                     -------------------
                                                          100        60
                                                     ===================
11/01 to 12/31/88...................................       15        25
                                                          (75)      (10)
                                                     -------------------
                                                          (60)       15
                                                     ===================
01/01 to 10/31/89...................................       80        50
                                                           (5)     (100)
                                                     -------------------
                                                           75       (50)
                                                     ===================
11/01 to 12/31/89...................................       85        40
                                                           (0)      (20)
                                                     -------------------
                                                           85        20
------------------------------------------------------------------------


X has a post-October capital loss of $45 for its 1988 taxable year due 
to a net capital loss for the post-October period of 1988. X does not 
make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $15 long-term 
capital gain, the $75 long-term capital loss, the $25 short-term capital 
gain, and the $10 short-term capital loss for the post-October period of 
1988 in computing its net capital gain for this purpose. In computing 
its net capital gain for 1989 for purposes of determining the amount it 
may designate as a capital gain dividend for 1989, X must take into 
account the $15 long-term capital gain, the $75 long-term capital loss, 
the $25 short-term capital gain, and the $10 short-term capital loss for 
the post-October period of 1988 in addition to the long-term and short-
term capital gains and losses for 1989. Accordingly, X may designate up 
to $85 as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $15 long-term capital gain, 
the $75 long-term capital loss, the $25 short-term capital gain, and the 
$10 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $40 and a net short-
term capital gain of $75. X's taxable income for 1989 will include a net 
capital gain of $130 for 1989 (consisting of a net long-term capital 
gain of $160 and a net short-term capital loss of $30).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988. X must, 
however, include the $15 long-term capital gain, the $75 long-term 
capital loss, the $25 short-term capital gain, and the $10 short-term 
capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $160 of 
capital gain in its earnings

[[Page 40]]

and profits for 1988, includes $115 in its accumulated earnings and 
profits for 1988, and includes $130 of capital gain in its earnings and 
profits for 1989.
    Example 9. Same facts as example 8, except that X elects to defer 
the entire $45 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 8.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $15 long-term capital gain, the $75 long-term 
capital loss, the $25 short-term capital gain, and the $10 short-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $45 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $60. X must include the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988 in its 
taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net capital gain of $85 (consisting of a net long-
term capital gain of $100 and a net short-term capital loss of $15).
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $15 long-term capital gain, the $75 long-term capital 
loss, the $25 short-term capital gain, and the $10 short-term capital 
loss for the post-October period of 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the long-term and short-term capital 
gains and losses for 1989) the $15 long-term capital gain, the $75 long-
term capital loss, the $25 short-term capital gain, and the $10 short-
term capital loss for the post-October period of 1988 as if those 
deferred gains and losses arose on January 1, 1989. Thus, X will include 
$160 of capital gain in its earnings and profits for 1988 and $85 of 
capital gain in its earnings and profits for 1989.
    Example 10. Same facts as example 8, except that X elects to defer 
only $30 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same result as in example 8.
    (ii) Taxable income. X must compute its taxable income for 1988 by 
including $5 of the $75 long-term capital loss and the $10 short-term 
capital loss for the post-October period of 1988, but without regard to 
the $15 long-term capital gain, $70 of the $75 long-term capital loss, 
and the $25 short-term capital gain for the post-October period of 1988 
because it made an election to defer $30 of the $45 post-October capital 
loss for 1988 under paragraph (f)(1) of this section. Accordingly, X's 
taxable income for 1988 will include a net capital gain of $95 and a net 
short-term capital gain of $50. X must include the $15 long-term capital 
gain, $70 of the $75 long-term capital loss, and the $25 short-term 
capital gain for the post-October period of 1988 in its taxable income 
for 1989 in addition to the long-term and short-term capital gains and 
losses for 1989. Accordingly, X's taxable income for 1989 will include a 
net capital gain of $100 (consisting of a net long-term capital gain of 
$105 and a net short-term capital loss of $5).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988. In 
determining its accumulated earnings and profits for 1988, X must 
include $5 of the $75 long-term capital loss and the $10 short-term 
capital loss for the post-October period of 1988. In determining both 
its earnings and profits and its accumulated earnings and profits for 
1989, X must include (in addition to the long-term and short-term 
capital gains and losses for 1989) the $15 long-term capital gain, $70 
of the $75 long-term capital loss, and the $25 short-term capital gain 
for the post-October period of 1988 as if those deferred gains and 
losses arose on January 1, 1989. Thus, X includes $160 of capital gain 
in its earnings and profits for 1988, includes $145 in its accumulated 
earnings and profits for 1989, and includes $100 of capital gain in its 
earnings and profits for 1989 (consisting of a net long-term capital 
gain of $105 and a net short-term capital loss of $5).
    Example 11. X has the following foreign currency gains and losses 
attributable to the periods indicated:

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


X has a $100 post-October currency loss for its 1988 taxable year due to 
a net foreign currency loss for the post-October period of 1988. X does 
not make an election under paragraph (f)(1) of this section.
    (i) Taxable income. X must compute its taxable income for 1988 by 
including the $100 foreign currency loss for the post-October period of 
1988 because it did not make an election under paragraph (f)(1) of this 
section. Accordingly, X's taxable income for 1988 will include a net 
foreign currency gain of $100. X's taxable income for 1989 will include 
a net foreign currency gain of $150.

[[Page 41]]

    (ii) Earnings and profits. X must determine its earnings and profits 
for 1988 without regard to the foreign currency loss for the post-
October period of 1988. X must, however, include the $100 foreign 
currency loss for the post-October period 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $200 of 
foreign currency gain in its earnings and profits for 1988, includes 
$100 in its accumulated earnings and profits for 1988, and includes $150 
of foreign currency gain in its earnings and profits for 1989.
    Example 12. Same facts as example 11, except that X elects to defer 
the entire $100 post-October currency loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Taxable income. X must compute its taxable income for 1988 
without regard to the $100 foreign currency loss for the post-October 
period of 1988 because it made an election to defer the entire $100 
post-October currency loss for 1988 under paragraph (f)(1) of this 
section. Accordingly, X's taxable income for 1988 will include a net 
foreign currency gain of $200. X's taxable income for 1989 will include 
a net foreign currency gain of $50 because X must compute its taxable 
income for 1989 by including the $100 foreign currency loss for the 
post-October period of 1988 in addition to the foreign currency gains 
and losses for 1989.
    (ii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $100 foreign currency loss for the post-October period of 
1988. In determining both its earnings and profits and its accumulated 
earnings and profits for 1989, X must include (in addition to the 
foreign currency gains and losses for 1989) the $100 foreign currency 
loss for the post-October period 1988 as if that deferred loss arose on 
January 1, 1989. Thus, X will include $200 of foreign currency gain in 
its earnings and profits for 1988 and $50 of foreign currency gain in 
its earnings and profits for 1989.
    Example 13. Same facts as example 11, except that X elects to defer 
only $75 of the post-October currency loss under paragraph (f)(1) of 
this section for purposes of determining its taxable income for 1988.
    (i) Taxable income. X must compute its taxable income for 1988 by 
including $25 of the $100 foreign currency loss for the post-October 
period of 1988, but without regard to $75 of the $100 foreign currency 
loss for the post-October period of 1988 because it made an election to 
defer $75 of the $100 post-October currency loss for 1988 under 
paragraph (f)(1) of this section. Accordingly, X's taxable income for 
1988 will include a net foreign currency gain of $175. X's taxable 
income will include a net foreign currency gain of $75 for 1989 because 
X must compute its taxable income for 1989 by including $75 of the $100 
foreign currency loss for the post-October period of 1988 in addition to 
the foreign currency gains and losses for 1989.
    (ii) Earnings and profits. X must determine its earnings and profits 
for 1988 without regard to the $100 foreign currency loss for the post-
October period of 1988. X must, however, include $25 of the $100 foreign 
currency loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the foreign currency gains and losses for 
1989) the $75 of the $100 foreign currency loss for the post-October 
period of 1988 as if that loss arose on January 1, 1989. Thus, X 
includes $200 of foreign currency gain in its earnings and profits for 
1988, includes $175 in its accumulated earnings and profits for 1988, 
and includes $75 of foreign currency gain in its earnings and profits 
for 1989.

    (i) Procedure for making election--(1) In general. Except as 
provided in paragraph (i)(2) of this section, a regulated investment 
company may make an election under paragraph (f)(1) of this section for 
a taxable year to which this section applies by completing its income 
tax return (including any necessary schedules) for that taxable year in 
accordance with the instructions for the form that are applicable to the 
election.
    (2) When applicable instructions not available. If the instructions 
for the income tax returns of regulated investment companies for a 
taxable year to which this section applies do not reflect the provisions 
of this section, a regulated investment company may make an election 
under paragraph (f)(1) of this section for that year by entering the 
appropriate amounts on its income tax return (including any necessary 
schedules) for that year, and by attaching a written statement to the 
return that states--
    (i) The taxable year for which the election under this section is 
made;
    (ii) The fact that the regulated investment company elects to defer 
all or a part of its post-October capital loss or post-October currency 
loss for that taxable year for purposes of computing its taxable income 
under the terms of this section;
    (iii) The amount of the post-October capital loss or post-October 
currency loss that the regulated investment

[[Page 42]]

company elects to defer for that taxable year; and
    (iv) The name, address, and employer identification number of the 
regulated investment company.
    (j) Transition rules--(1) In general. For a taxable year ending 
before March 2, 1990 in which a regulated investment company incurred a 
post-October capital loss or post-October currency loss, the company may 
use any method that is consistently applied and in accordance with 
reasonable business practice to determine the amounts taken into account 
in that taxable year for purposes of paragraphs (e)(2), (f)(3), and (g) 
of this section and to determine the amount taken into account in the 
succeeding year for purposes of paragraphs (e)(3), (f)(4), and (g) of 
this section. For example, for purposes of paragraph (e), a taxpayer may 
use a method that treats as incurred in a taxable year all capital gains 
taken into account in computing the post-October capital loss for that 
year and an amount of capital loss for such period equal to the amount 
of such gains and that treats the remaining amount of capital loss for 
such period as arising on the first day of the succeeding year.


Similarly, for purposes of paragraph (e)(3), a taxpayer may use a method 
that treats as arising on the first day of the succeeding year only the 
excess of the capital losses from sales or exchanges after October 31 
over the capital gains for such period (that is, the net capital loss or 
net long-term capital loss for such period).
    (2) Retroactive election--(i) In general. A regulated investment 
company may make an election (a ``retroactive election'') under 
paragraph (f)(1) for a taxable year with respect to which it has filed 
an income tax return on or before May 1, 1990 (a ``retroactive election 
year'') by filing an amended return (including any necessary schedules) 
for the retroactive election year reflecting the appropriate amounts and 
by attaching a written statement to the return that complies with the 
requirements of paragraph (i)(2) of this section.
    (ii) Deadline for making election. A retroactive election may be 
made no later than December 31, 1990.
    (3) Amended return required for succeeding year in certain 
circumstances--(i) In general. If, at the time a regulated investment 
company makes a retroactive election under this section, it has already 
filed an income tax return for the succeeding year, the company must 
file an amended return for such succeeding year reflecting the 
appropriate amounts.
    (ii) Time for filing amended return. An amended return required 
under paragraph (j)(3)(i) of this section must be filed together with 
the amended return described in paragraph (j)(2)(i).
    (4) Retroactive dividend--(i) In general. A regulated investment 
company that makes a retroactive election under this section for a 
retroactive election year may elect to treat any dividend (or portion 
thereof) declared and paid (or treated as paid under section 852(b)(7)) 
by the regulated investment company after the retroactive election year 
and on or before December 31, 1990 as having been paid during the 
retroactive election year (a ``retroactive dividend''). This election 
shall be irrevocable with respect to the retroactive dividend to which 
it applies.
    (ii) Method of making election. The election under this paragraph 
(j)(4) must be made by the regulated investment company by treating the 
dividend (or portion thereof) to which the election applies as a 
dividend paid during the retroactive election year in computing its 
deduction for dividends paid in its tax returns for all applicable years 
(including the amended return(s) required to be filed under paragraphs 
(j)(2) and (3) of this section).
    (iii) Deduction for dividends paid--(A) In general. Subject to the 
rules of sections 561 and 562, a regulated investment company shall 
include the amount of any retroactive dividend in computing its 
deduction for dividends paid for the retroactive election year. No 
deduction for dividends paid shall be allowed under this paragraph 
(j)(4)(iii)(A) for any amount not paid (or treated as paid under section 
852(b)(7)) on or before December 31, 1990.
    (B) Limitation on ordinary dividends. The amount of retroactive 
dividends (other than retroactive dividends qualifying as capital gain 
dividends)

[[Page 43]]

paid for a retroactive election year under this section shall not exceed 
the increase, if any, in the investment company taxable income of the 
regulated investment company (determined without regard to the deduction 
for dividends paid (as defined in section 561)) that is attributable 
solely to the regulated investment company having made the retroactive 
election.
    (C) Limitation on capital gain dividends. The amount of retroactive 
dividends qualifying as capital gain dividends paid for a retroactive 
election year under this section shall not exceed the increase, if any, 
in the amount of the excess described in section 852(b)(3)(A) (relating 
to the excess of the net capital gain over the deduction for capital 
gain dividends paid) that is attributable solely to the regulated 
investment company having made the retroactive election.
    (D) Effect on other years. A retroactive dividend shall not be 
includible in computing the deduction for dividends paid for--
    (1) The taxable year in which such distribution is actually paid (or 
treated as paid under section 852(b)(7)); or
    (2) Under section 855(a), the taxable year preceding the retroactive 
election year.
    (iv) Earnings and profits. A retroactive dividend shall be 
considered as paid out of the earnings and profits of the retroactive 
election year (computed with the application of sections 852(c) and 855, 
Sec.  1.852-5, Sec.  1.855-1, and this section), and not out of the 
earnings and profits of the taxable year in which the distribution is 
actually paid (or treated as paid under section 852(b)(7)).
    (v) Receipt by shareholders. Except as provided in section 
852(b)(7), a retroactive dividend shall be included in the gross income 
of the shareholders of the regulated investment company for the taxable 
year in which the dividend is received by them.
    (vi) Foreign tax election. If a regulated investment company to 
which section 853 (relating to foreign taxes) is applicable for a 
retroactive election year elects to treat a dividend paid (or treated as 
paid under section 852(b)(7)) during the taxable year as a retroactive 
dividend, the shareholders of the regulated investment company shall 
consider the amounts described in section 853(b)(2) allocable to such 
distribution as paid or received, as the case may be, in the 
shareholder's taxable year in which the distribution is made.
    (vii) Example. The provisions of this paragraph (j)(4) may be 
illustrated by the following example:

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

                    Foreign Currency Gains and Losses

                            Gains and Losses

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

                        Capital Gains and Losses

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

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

    (5) Certain distributions may be designated retroactively as capital 
gain dividends. To the extent that a regulated investment company 
designated as capital gain dividends for a taxable year less than the 
maximum amount permitted under paragraph (e) of this section for that 
taxable year, the regulated investment company may designate an 
additional amount of dividends paid (or treated as paid under sections 
852(b)(7) or 855, or paragraph (j)(4) of this section) for the taxable 
year as capital gain dividends, notwithstanding that a written notice 
was not

[[Page 44]]

mailed to its shareholders within 60 days after the close of the taxable 
year in which the distribution was paid (or treated as paid under 
section 852(b)(7)).
    (k) Effective date. the provisions of this section shall apply to 
taxable years ending after October 31, 1987.

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



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

    (a) Applicability of section 852(a)(2)(A)--(1) In general. An 
investment company does not satisfy section 852(a)(2)(A) unless--
    (i) Part I of subchapter M applied to the company for all its 
taxable years ending on or after November 8, 1983; and
    (ii) For each corporation to whose earnings and profits the 
investment company succeeded by the operation of section 381, part I of 
subchapter M applied for all the corporation's taxable years ending on 
or after November 8, 1983.
    (2) Special rule. See section 1071(a)(5)(D) of the Tax Reform Act of 
1984, Public Law 98-369 (98 Stat. 1051), for a special rule which treats 
part I of subchapter M as having applied to an investment company's 
first taxable year ending after November 8, 1983.
    (b) Applicability of section 852(a)(2)(B)--(1) In general. An 
investment company does not satisfy section 852(a)(2)(B) unless, as of 
the close of the taxable year, it has no earnings and profits other than 
earnings and profits that--
    (i) Were earned by a corporation in a year for which part I of 
subchapter M applied to the corporation and, at all times thereafter, 
were the earnings and profits of a corporation to which part I of 
subchapter M applied;
    (ii) By the operation of section 381 pursuant to a transaction that 
occurred before December 22, 1992, became the earnings and profits of a 
corporation to which part I of subchapter M applied and, at all times 
thereafter, were the earnings and profits of a corporation to which part 
I of subchapter M applied;
    (iii) Were accumulated in a taxable year ending before January 1, 
1984, by a corporation to which part I of subchapter M applied for any 
taxable year ending before November 8, 1983; or
    (iv) Were accumulated in the first taxable year of an investment 
company that began business in 1983 and that was not a successor 
corporation.
    (2) Prior law. For purposes of paragraph (b) of this section, a 
reference to part I of subchapter M includes a reference to the 
corresponding provisions of prior law.
    (c) Effective date. This regulation is effective for taxable years 
ending on or after December 22, 1992.
    (d) For treatment of net built-in gain assets of a C corporation 
that become assets of a RIC, see Sec.  1.337(d)-5T.

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



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

    (a) In general. Under section 853, a regulated investment company, 
meeting the requirements set forth in section 853(a) and paragraph (b) 
of this section, may make an election with respect to the income, war-
profits, and excess profits taxes described in section 901(b)(1) which 
it pays to foreign countries or possessions of the United States during 
the taxable year, including such taxes as are deemed paid by it under 
the provisions of any income tax convention to which the United States 
is a party. If an election is made, the shareholders of the regulated 
investment company shall apply their proportionate share of such foreign 
taxes paid, or deemed to have been paid by it pursuant to any income tax 
convention, as either a credit (under section 901) or as a deduction 
(under section 164(a)) as provided by section 853(b)(2) and paragraph 
(b) of Sec.  1.853-2. The election is not applicable with respect to 
taxes deemed to have been paid under section 902 (relating to the credit 
allowed to corporate stockholders of a foreign corporation for taxes 
paid by such foreign corporation). In addition, the election is not 
applicable to any tax with respect to which the regulated investment 
company is not allowed a credit by reason of any provision of the

[[Page 45]]

Internal Revenue Code other than section 853(b)(1), including, but not 
limited to, section 901(j), section 901(k), or section 901(l).
    (b) Requirements. To qualify for the election provided in section 
853(a), a regulated investment company (1) must have more than 50 
percent of the value of its total assets, at the close of the taxable 
year for which the election is made, invested in stocks and securities 
of foreign corporations, and (2) must also, for that year, comply with 
the requirements prescribed in section 852(a) and paragraph (a) of Sec.  
1.852-1. The term ``value'', for purposes of the first requirement, is 
defined in section 851(c)(4). For the definition of foreign corporation, 
see section 7701(a).
    (c) Effective/applicability date. The final sentence of paragraph 
(a) of this section is applicable for RIC taxable years ending on or 
after December 31, 2007.

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



Sec.  1.853-2  Effect of election.

    (a) Regulated investment company. A regulated investment company 
making a valid election with respect to a taxable year under the 
provisions of section 853(a) is, for such year, denied both the 
deduction for foreign taxes provided by section 164(a) and the credit 
for foreign taxes provided by section 901 with respect to all income, 
war-profits, and excess profits taxes (described in section 901(b)(1)) 
which it has paid to any foreign country or possession of the United 
States. See section 853(b)(1)(A). However, under section 853(b)(1)(B), 
the regulated investment company is permitted to add the amount of such 
foreign taxes paid to its dividends paid deduction for that taxable 
year. See paragraph (a) of Sec.  1.852-1.
    (b) Shareholder. Under section 853(b)(2), a shareholder of an 
investment company, which has made the election under section 853, is, 
in effect, placed in the same position as a person directly owning stock 
in foreign corporations, in that he must include in his gross income (in 
addition to taxable dividends actually received) his proportionate share 
of such foreign taxes paid and must treat such amount as foreign taxes 
paid by him for the purposes of the deduction under section 164(a) and 
the credit under section 901. For such purposes he must treat as gross 
income from a foreign country or possession of the United States (1) his 
proportionate share of the taxes paid by the regulated investment 
company to such foreign country or possession and (2) the portion of any 
dividend paid by the investment company which represents income derived 
from such sources.
    (c) Dividends paid after the close of the taxable year. For 
additional rules applicable to certain distributions made after the 
close of the taxable year which may be designated as income received 
from sources within and taxes paid to foreign countries or possessions 
of the United States, see section 855(d) and paragraph (f) of Sec.  
1.855-1.
    (d) Example. This section is illustrated by the following example:

    Example. (i) Facts. X Corporation, a regulated investment company 
with 250,000 shares of common stock outstanding, has total assets, at 
the close of the taxable year, of $10 million ($4 million invested in 
domestic corporations, $3.5 million in Foreign Country A corporations, 
and $2.5 million in Foreign Country B corporations). X Corporation 
received dividend income of $800,000 from the following sources: 
$300,000 from domestic corporations, $250,000 from Country A 
corporations, and $250,000 from Country B corporations. All dividends 
from Country A corporations and from Country B corporations were 
properly characterized as income from sources without the United States. 
The dividends from Country A corporations were subject to a 10 percent 
withholding tax ($25,000) and the dividends from Country B corporations 
were subject to a 20 percent withholding tax ($50,000). X Corporation's 
only expenses for the taxable year were $80,000 of operation and 
management expenses related to both its U.S. and foreign investments. In 
this case, Corporation X properly apportioned the $80,000 expense based 
on the relative amounts of its U.S. and foreign source gross income. 
Thus, $50,000 in expense was apportioned to foreign source income 
($80,000 x $500,000 / $800,000, total expense times the fraction of 
foreign dividend income over total dividend income) and $30,000 in 
expense was apportioned to U.S. source income ($80,000 x $300,000 / 
$800,000, total expense times the fraction of U.S. source dividend 
income over total dividend income). During the taxable year, X 
Corporation distributed to its shareholders the entire $645,000 income 
that was available for

[[Page 46]]

distribution ($800,000, less $80,000 in expenses, less $75,000 in 
foreign taxes withheld).
    (ii) Section 853 election. X Corporation meets the requirements of 
section 851 to be considered a RIC for the taxable year and the 
requirements of section 852(a) for part 1 of subchapter M to apply for 
the taxable year. X Corporation notifies each shareholder by mail, 
within the time prescribed by section 853(c), that by reason of the 
election the shareholders are to treat as foreign taxes paid $0.30 per 
share of stock ($75,000 of foreign taxes paid, divided by the 250,000 
shares of stock outstanding). The shareholders must report as income 
$2.88 per share ($2.58 of dividends actually received plus the $0.30 
representing foreign taxes paid). Of the $2.88 per share, $1.80 per 
share ($450,000 of foreign source taxable income divided by 250,000 
shares) is to be considered as received from foreign sources. The $1.80 
consists of $0.30, the foreign taxes treated as paid by the shareholder 
and $1.50, the portion of the dividends received by the shareholder from 
the RIC that represents income of the RIC treated as derived from 
foreign sources ($500,000 of foreign source income, less $50,000 of 
expense apportioned to foreign source income, less $75,000 of foreign 
tax withheld, which is $375,000, divided by 250,000 shares).

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

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



Sec.  1.853-3  Notice to shareholders.

    (a) General rule. If a regulated investment company makes an 
election under section 853(a), in the manner provided in Sec.  1.853-4, 
the regulated investment company is required under section 853(c) to 
furnish its shareholders with a written notice mailed not later than 60 
days after the close of its taxable year. The notice must designate the 
shareholder's portion of creditable foreign taxes paid to foreign 
countries or possessions of the United States and the portion of the 
dividend that represents income derived from sources within each country 
that is attributable to a period during which section 901(j) applies to 
such country, if any, and the portion of the dividend that represents 
income derived from other foreign countries and possessions of the 
United States. For purposes of section 853(b)(2) and Sec.  1.853-2(b), 
the amount that a shareholder may treat as the shareholder's 
proportionate share of foreign taxes paid and the amount to be included 
as gross income derived from any foreign country that is attributable to 
a period during which section 901(j) applies to such country or gross 
income from sources within other foreign countries or possessions of the 
United States shall not exceed the amount so designated by the regulated 
investment company in such written notice. If, however, the amount 
designated by the regulated investment company in the notice exceeds the 
shareholder's proper proportionate share of foreign taxes or gross 
income from sources within foreign countries or possessions of the 
United States, the shareholder is limited to the amount correctly 
ascertained.
    (b) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to paragraph (a) 
of this section by a regulated investment company with respect to a 
taxable year of the regulated investment company ending after December 
8, 1970 to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (b) of Sec.  1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
70th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the amounts of creditable foreign taxes paid to foreign 
countries or possessions of the United States and the holder's 
proportionate share of the dividend that represents income derived from 
sources within each country that is attributable to a period during 
which section 901(j) applies to such country, if any, and the holder's 
proportionate share of the dividend that represents income derived from 
other foreign countries or possessions of the United States shown on the 
notice received by the nominee pursuant to paragraph (a) of this 
section. This

[[Page 47]]

paragraph shall not apply if the regulated investment company agrees 
with the nominee to satisfy the notice requirements of paragraph (a) of 
this section with respect to each holder of an interest in the unit 
investment trust whose shares are being held by the nominee as custodian 
and not later than 45 days following the close of the company's taxable 
year, files with the Internal Revenue Service office where such 
company's return for the taxable year is to be filed, a statement that 
the holders of the unit investment trust with whom the agreement was 
made have been directly notified by the regulated investment company. 
Such statement shall include the name, sponsor, and custodian of each 
unit investment trust whose holders have been directly notified. The 
nominee's requirements under this paragraph shall be deemed met if the 
regulated investment company transmits a copy of such statement to the 
nominee within such 60-day period: Provided however, if the regulated 
investment company fails or is unable to satisfy the requirements of 
this paragraph with respect to the holders of interest in the unit 
investment trust, it shall so notify the Internal Revenue Service within 
60 days following the close of its taxable year. The custodian shall, 
upon notice by the Internal Revenue Service that the regulated 
investment company has failed to comply with the agreement, satisfy the 
requirements of this paragraph within 30 days of such notice.
    (c) Effective/applicability date. This section is applicable for RIC 
taxable years ending on or after December 31, 2007. Notwithstanding the 
preceding sentence, for a taxable year that ends on or after December 
31, 2007, and begins before August 24, 2007, a taxpayer may rely on this 
section as it was in effect on August 23, 2007.

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



Sec.  1.853-4  Manner of making election.

    (a) General rule. To make an election under section 853 for a 
taxable year, a regulated investment company must file a statement of 
election as part of its Federal income tax return for the taxable year. 
The statement of election must state that the regulated investment 
company elects the application of section 853 for the taxable year and 
agrees to provide the information required by paragraph (c) of this 
section.
    (b) Irrevocability of the election. The election shall be made with 
respect to all foreign taxes described in paragraph (c)(2) of this 
section, and must be made not later than the time prescribed for filing 
the return (including extensions). This election, if made, shall be 
irrevocable with respect to the dividend (or portion thereof), and the 
foreign taxes paid with respect thereto, to which the election applies.
    (c) Required information. A regulated investment company making an 
election under section 853 must provide the following information:
    (1) The total amount of taxable income received in the taxable year 
from sources within foreign countries and possessions of the United 
States and the amount of taxable income received in the taxable year 
from sources within each such foreign country or possession.
    (2) The total amount of income, war profits, or excess profits taxes 
(described in section 901(b)(1)) to which the election applies that were 
paid in the taxable year to such foreign countries or possessions and 
the amount of such taxes paid to each such foreign country or 
possession.
    (3) The amount of income, war profits, or excess profits taxes paid 
during the taxable year to which the election does not apply by reason 
of any provision of the Internal Revenue Code other than section 853(b), 
including, but not limited to, section 901(j), section 901(k), or 
section 901(l).
    (4) The date, form, and contents of the notice to its shareholders.
    (5) The proportionate share of creditable foreign taxes paid to each 
such foreign country or possession during the taxable year and foreign 
income received from sources within each such foreign country or 
possession during the taxable year attributable to one share of stock of 
the regulated investment company.
    (d) Time and manner of providing information. The information 
specified in paragraph (c) of this section must be provided at the time 
and in the manner prescribed by the Commissioner and,

[[Page 48]]

unless otherwise prescribed, must be provided on or with a modified Form 
1118 ``Foreign Tax Credit--Corporations'' filed as part of the RIC's 
timely filed Federal income tax return for the taxable year.
    (e) Effective/applicability date. This section is applicable for RIC 
taxable years ending on or after December 31, 2007. Notwithstanding the 
preceding sentence, for a taxable year that ends on or after December 
31, 2007, and begins before August 24, 2007, a taxpayer may rely on this 
section as it was in effect on August 23, 2007.

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



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

    (a) In general. Section 854 provides special limitations applicable 
to dividends received from a regulated investment company for purposes 
of the exclusion under section 116 for dividends received by 
individuals, the deduction under section 243 for dividends received by 
corporations, and, in the case of dividends received by individuals 
before January 1, 1965, the credit under section 34.
    (b) Capital gain dividend. Under the provisions of section 854(a) a 
capital gain dividend as defined in section 852(b)(3) and paragraph (c) 
of Sec.  1.852-4 shall not be considered a dividend for purposes of the 
exclusion under section 116, the deduction under section 243, and, in 
the case of taxable years ending before January 1, 1965, the credit 
under section 34.
    (c) Rule for dividends other than capital gain dividends. (1) 
Section 854(b)(1) limits the amount that may be treated as a dividend 
(other than a capital gain dividend) by the shareholder of a regulated 
investment company, for the purposes of the credit, exclusion, and 
deduction specified in paragraph (b) of this section, where the 
investment company receives substantial amounts of income (such as 
interest, etc.) from sources other than dividends from domestic 
corporations, which dividends qualify for the exclusion under section 
116.
    (2) Where the ``aggregate dividends received'' (as defined in 
section 854(b)(3)(B) and paragraph (b) of Sec.  1.854-3) during the 
taxable year by a regulated investment company (which meets the 
requirements of section 852(a) and paragraph (a) of Sec.  1.852-1 for 
the taxable year during which it paid such dividend) are less than 75 
percent of its gross income for such taxable year (as defined in section 
854(b)(3)(A) and paragraph (a) of Sec.  1.854-3), only that portion of 
the dividend paid by the regulated investment company which bears the 
same ratio to the amount of such dividend paid as the aggregate 
dividends received by the regulated investment company, during the 
taxable year, bears to its gross income for such taxable year (computed 
without regard to gains from the sale or other disposition of stocks or 
securities) may be treated as a dividend for purposes of such credit, 
exclusion, and deduction.
    (3) Subparagraph (2) of this paragraph may be illustrated by the 
following example:

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

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


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

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

[[Page 49]]

a regulated investment company ending after July 31, 1954, and subject 
to the Internal Revenue Code of 1939, see Sec.  1.34-5 and Sec.  1.116-
2.

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



Sec.  1.854-2  Notice to shareholders.

    (a) General rule. Section 854(b)(2) provides that the amount that a 
shareholder may treat as a dividend for purposes of the exclusion under 
section 116 for dividends received by individuals, the deduction under 
section 243 for dividends received by corporation, and, in the case of 
dividends received by individuals before January 1, 1965, the credit 
under section 34, shall not exceed the amount so designated by the 
company in a written notice to its shareholders mailed not later than 45 
days (30 days for a taxable year ending before Feb. 26, 1964) after the 
close of the company's taxable year. If, however, the amount so 
designated by the company in the notice exceeds the amount which may be 
treated by the shareholder as a dividend for such purposes, the 
shareholder is limited to the amount as correctly ascertained under 
section 854(b)(1) and paragraph (c) of Sec.  1.854-1.
    (b) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to paragraph (a) 
of this section by a regulated investment company with respect to a 
taxable year of the regulated investment company ending after December 
8, 1970 to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec.  1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
55th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the amounts that may be treated as a dividend for purposes of 
the exclusion under section 116 for dividends received by individuals 
and the deduction under section 243 for dividends received by 
corporations shown on the notice received by the nominee pursuant to 
paragraph (a) of this section. This notice shall include the name and 
address of the nominee identified as such. This paragraph shall not 
apply if the regulated investment company agrees with the nominee to 
satisfy the notice requirements of paragraph (a) of this section with 
respect to each holder of an interest in the unit investment trust whose 
shares are being held by the nominee as custodian and not later than 45 
days following the close of the company's taxable year, files with the 
Internal Revenue Service office where such company's return is to be 
filed for the taxable year, a statement that the holders of the unit 
investment trust with whom the agreement was made have been directly 
notified by the regulated investment company. Such statement shall 
include the name, sponsor, and custodian of each unit investment trust 
whose holders have been directly notified. The nominee's requirements 
under this paragraph shall be deemed met if the regulated investment 
company transmits a copy of such statement to the nominee within such 
45-day period; provided however, if the regulated investment company 
fails or is unable to satisfy the requirements of this paragraph with 
respect to the holders of interest in the unit investment trust, it 
shall so notify the Internal Revenue Service within 45 days following 
the close of its taxable year. The custodian shall, upon notice by the 
Internal Revenue Service that the regulated investment company has 
failed to comply with the agreement, satisfy the requirements of this 
paragraph within 30 days of such notice.

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



Sec.  1.854-3  Definitions.

    (a) For the purpose of computing the limitation prescribed by 
section 854(b)(1)(B) and paragraph (c) of Sec.  1.854-1, the term 
``gross income'' does not include gain from the sale or other 
disposition of stock or securities. However, capital gains arising from 
the sale or other disposition of capital assets, other than stock or 
securities, shall not be excluded from gross income for this purpose.
    (b) The term ``aggregate dividends received'' includes only 
dividends received from domestic corporations

[[Page 50]]

other than dividends described in section 116(b) (relating to dividends 
not eligible for exclusion from gross income). Accordingly, dividends 
received from foreign corporations will not be included in the 
computation of ``aggregate dividends received''. In determining the 
amount of any dividend for purposes of this section, the rules provided 
in section 116(c) (relating to certain distributions) shall apply.



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

    (a) General rule. In--
    (1) Determining under section 852(a) and paragraph (a) of Sec.  
1.852-1 whether the deduction for dividends paid during the taxable year 
(without regard to capital gain dividends) by a regulated investment 
company equals or exceeds 90 percent of its investment company taxable 
income (determined without regard to the provisions of section 
852(b)(2)(D)),
    (2) Computing its investment company taxable income (under section 
852(b)(2) and Sec.  1.852-3), and
    (3) Determining the amount of capital gain dividends (as defined in 
section 852(b)(3) and paragraph (c) of Sec.  1.852-4 paid during the 
taxable year, any dividend (or portion thereof) declared by the 
investment company either before or after the close of the taxable year 
but in any event before the time prescribed by law for the filing of its 
return for the taxable year (including the period of any extension of 
time granted for filing such return) shall, to the extent the company so 
elects in such return, be treated as having been paid during such 
taxable year. This rule is applicable only if the entire amount of such 
dividend is actually distributed to the shareholders in the 12-month 
period following the close of such taxable year and not later than the 
date of the first regular dividend payment made after such declaration.
    (b) Election--(1) Method of making election. The election must be 
made in the return filed by the company for the taxable year. The 
election shall be made by the taxpayer (the regulated investment 
company) by treating the dividend (or portion thereof) to which such 
election applies as a dividend paid during the taxable year in computing 
its investment company taxable income, or if the dividend (or portion 
thereof) to which such election applies is to be designated by the 
company as a capital gain dividend, in computing the amount of capital 
gain dividends paid during such taxable year. The election provided in 
section 855(a) may be made only to the extent that the earnings and 
profits of the taxable year (computed with the application of section 
852(c) and Sec.  1.852-5) exceed the total amount of distributions out 
of such earnings and profits actually made during the taxable year (not 
including distributions with respect to which an election has been made 
for a prior year under section 855(a)). The dividend or portion thereof, 
with respect to which the regulated investment company has made a valid 
election under section 855(a), shall be considered as paid out of the 
earnings and profits of the taxable year for which such election is 
made, and not out of the earnings and profits of the taxable year in 
which the distribution is actually made.
    (2) Irrevocability of the election. After the expiration of the time 
for filing the return for the taxable year for which an election is made 
under section 855(a), such election shall be irrevocable with respect to 
the dividend or portion thereof to which it applies.
    (c) Receipt by shareholders. Under section 855(b), the dividend or 
portion thereof, with respect to which a valid election has been made, 
will be includible in the gross income of the shareholders of the 
regulated investment company for the taxable year in which the dividend 
is received by them.
    (d) Examples. The application of paragraphs (a), (b), and (c) of 
this section may be illustrated by the following examples:

    Example 1. The X Company, a regulated investment company, had 
taxable income (and earnings or profits) for the calendar year 1954 of 
$100,000. During that year the company distributed to shareholders 
taxable dividends aggregating $88,000. On March 10, 1955, the company 
declared a dividend of $37,000 payable to shareholders on March 20, 
1955. Such dividend consisted of the first regular quarterly dividend 
for 1955 of $25,000 plus an additional $12,000 representing that part of 
the

[[Page 51]]

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

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

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

[[Page 52]]

                      Real Estate Investment Trusts



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

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

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

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



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

    (a) In general. The term ``real estate investment trust'' means a 
corporation, trust, or association which (1) meets the status conditions 
in section 856(a) and paragraph (b) of this section, and (2) satisfies 
the gross income and asset diversification requirements under the 
limitations of section 856(c) and Sec.  1.856-2. (See, however, 
paragraph (f) of this section, relating to the requirement that, for 
taxable years beginning before October 5, 1976, a real estate investment 
trust must be an unincorporated trust or unincorporated association).
    (b) Qualifying conditions. To qualify as a ``real estate investment 
trust'', an organization must be one--
    (1) Which is managed by one or more trustees or directors,
    (2) The beneficial ownership of which is evidenced by transferable 
shares or by transferable certificates of beneficial interest,
    (3) Which would be taxable as a domestic corporation but for the 
provisions of part II, subchapter M, chapter 1 of the Code,
    (4) Which, in the case of a taxable year beginning before October 5, 
1976, does not hold any property (other than foreclosure property) 
primarily for sale to customers in the ordinary course of its trade or 
business,
    (5) Which is neither (i) a financial institution to which section 
585, 586, or 593 applies, nor (ii) an insurance company to which 
subchapter L applies,
    (6) The beneficial ownership of which is held by 100 or more 
persons, and
    (7) Which would not be a personal holding company (as defined in 
section 542) if all of its gross income constituted personal holding 
company income (as defined in section 543).
    (c) Determination of status. The conditions described in 
subparagraphs (1) through (5) of paragraph (b) of this section must be 
met during the entire taxable year and the condition described in 
subparagraph (6) of paragraph (b) of this section must exist during at 
least 335 days of a taxable year of 12 months or during a proportionate 
part of a taxable year of less than 12 months. The days during which the 
latter condition must exist need not be consecutive. In determining the 
minimum number of days during which the condition described in paragraph 
(b)(6) of this section is required to exist in a taxable year of less 
than 12 months, fractional days shall be disregarded. For example, in a 
taxable year of 310 days, the actual number of days prescribed would be 
284 \38/73\ days (\310/365\ of 335). The fractional day is disregarded 
so that the required condition in such taxable year need exist for only 
284 days.
    (d) Rules applicable to status requirements. For purposes of 
determining whether an organization meets the conditions and 
requirements in section 856(a), the following rules shall apply.
    (1) Trustee. The term ``trustee'' means a person who holds legal 
title to the property of the real estate investment trust, and has such 
rights and powers as will meet the requirement of ``centralization of 
management'' under paragraph (c) of Sec.  301.7701-2 of this chapter 
(Regulations on Procedure and Administration). Thus, the trustee must 
have continuing exclusive authority over the management of the trust, 
the conduct of its affairs, and (except as limited by section 856(d)(3)

[[Page 53]]

and Sec.  1.856-4) the management and disposition of the trust property. 
For example, such authority will be considered to exist even though the 
trust instrument grants to the shareholders any or all of the following 
rights and powers: To elect or remove trustees; to terminate the trust; 
and to ratify amendments to the trust instrument proposed by the 
trustee. The existence of a mere fiduciary relationship does not, in 
itself, make one a trustee for purposes of section 856(a)(1). The 
trustee will be considered to hold legal title to the property of the 
trust, for purposes of this subparagraph, whether the title is held in 
the name of the trust itself, in the name of one or more of the 
trustees, or in the name of a nominee for the exclusive benefit of the 
trust.
    (2) Beneficial ownership. Beneficial ownership shall be evidenced by 
transferable shares, or by transferable certificates of beneficial 
interest, and (subject to the provisions of paragraph (c) of this 
section) must be held by 100 or more persons, determined without 
reference to any rules of attribution. Provisions in the trust 
instrument or corporate charter or bylaws which permit the trustee or 
directors to redeem shares or to refuse to transfer shares in any case 
where the trustee or directors, in good faith, believe that a failure to 
redeem shares or that a transfer of shares would result in the loss of 
status as a real estate investment trust will not render the shares 
``nontransferable.'' For purposes of the regulations under part II of 
subchapter M, the terms ``stockholder,'' ``stockholders,'' 
``shareholder,'' and ``shareholders'' include holders of beneficial 
interest in a real estate investment trust, the terms ``stock,'' 
``shares,'' and ``shares of stock'' include certificates of beneficial 
interest, and the term ``shares'' includes shares of stock.
    (3) Unincorporated organization taxable as a domestic corporation. 
The determination of whether an unincorporated organization would be 
taxable as a domestic corporation, in the absence of the provisions of 
part II of subchapter M, shall be made in accordance with the provisions 
of section 7701(a) (3) and (4) and the regulations thereunder and for 
such purposes an otherwise qualified real estate investment trust is 
deemed to satisfy the ``objective to carry on business'' requirement of 
paragraph (a) of Sec.  301.7701-2 of this chapter. (Regulations on 
Procedure and Administration).
    (4) Property held for sale to customers. In the case of a taxable 
year beginning before October 5, 1976, a real estate investment trust 
may not hold any property (other than foreclosure property) primarily 
for sale to customers in the ordinary course of its trade or business. 
Whether property is held for sale to customers in the ordinary course of 
the trade or business of a real estate investment trust depends upon the 
facts and circumstances in each case.
    (5) Personal holding company. A corporation, trust, or association, 
even though it may otherwise meet the requirements of part II of 
subchapter M, will not be a real estate investment trust if, by 
considering all of its gross income as personal holding company income 
under section 543, it would be a personal holding company as defined in 
section 542. Thus, if at any time during the last half of the trust's 
taxable year more than 50 percent in value of its outstanding stock is 
owned (directly or indirectly under the provisions of section 544) by or 
for not more than 5 individuals, the stock ownership requirement in 
section 542(a)(2) will be met and the trust would be a personal holding 
company. See Sec.  1.857-8, relating to record requirements for purposes 
of determining whether the trust is a personal holding company.
    (e) Other rules applicable. To the extent that other provisions of 
chapter 1 of the Code are not inconsistent with those under part II of 
subchapter M there of and the regulations thereunder, such provisions 
will apply with respect to both the real estate investment trust and its 
shareholders in the same manner that they would apply to any other 
organization which would be taxable as a domestic corporation. For 
example:
    (1) Taxable income of a real estate investment trust is computed in 
the same manner as that of a domestic corporation;
    (2) Section 301, relating to distributions of property, applies to 
distributions by a real estate investment trust

[[Page 54]]

in the same manner as it would apply to a domestic corporation;
    (3) Sections 302, 303, 304, and 331 are applicable in determining 
whether distributions by a real estate investment trust are to be 
treated as in exchange for stock;
    (4) Section 305 applies to distributions by a real estate investment 
trust of its own stock;
    (5) Section 311 applies to distributions by a real estate investment 
trust;
    (6) Except as provided in section 857(d), earnings and profits of a 
real estate investment trust are computed in the same manner as in the 
case of a domestic corporation;
    (7) Section 316, relating to the definition of a dividend, applies 
to distributions by a real estate investment trust; and
    (8) Section 341, relating to collapsible corporations, applies to 
gain on the sale or exchange of, or a distribution which is in exchange 
for, stock in a real estate investment trust in the same manner that it 
would apply to a domestic corporation.
    (f) Unincorporated status required for certain taxable years. In the 
case of a taxable year beginning before October 5, 1976, a real estate 
investment trust must be an unincorporated trust or unincorporated 
association. Accordingly, in applying the regulations under part II of 
subchapter M of the Code with respect to such a taxable year, the term 
``an unincorporated trust or unincorporated association'' is to be 
substituted for the term ``a corporation, trust, or association'' each 
place it appears, and the references to ``directors'' and ``corporate 
charter or bylaws'' are to be disregarded.

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

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



Sec.  1.856-2  Limitations.

    (a) Effective date. The provisions of part II, subchapter M, chapter 
1 of the Code, and the regulations thereunder apply only to taxable 
years of a real estate investment trust beginning after December 31, 
1960.
    (b) Election. Under the provisions of section 856(c)(1), a trust, 
even though it satisfies the other requirements of part II of subchapter 
M for the taxable year, will not be considered a ``real estate 
investment trust'' for such year, within the meaning of such part II, 
unless it elects to be a real estate investment trust for such taxable 
year, or has made such an election for a previous taxable year which has 
not been terminated or revoked under section 856(g)(1) or (2). The 
election shall be made by the trust by computing taxable income as a 
real estate investment trust in its return for the first taxable year 
for which it desires the election to apply, even though it may have 
otherwise qualified as a real estate investment trust for a prior year. 
No other method of making such election is permitted. An election cannot 
be revoked with respect to a taxable year beginning before October 5, 
1976. Thus, the failure of an organization to be a qualified real estate 
investment trust for a taxable year beginning before October 5, 1976, 
does not have the effect of revoking a prior election by the 
organization to be a real estate investment trust, even though the 
organization is not taxable under part II of subchapter M for such 
taxable year. See section 856(g) and Sec.  1.856-8 for rules under which 
an election may be revoked with respect to taxable years beginning after 
October 4, 1976.
    (c) Gross income requirements. Section 856(c) (2), (3), and (4), 
provides that a corporation, trust, or association is not a ``real 
estate investment trust'' for a taxable year unless it meets certain 
requirements with respect to the sources of its gross income for the 
taxable year. In determining whether the gross income of a real estate 
investment trust satisfies the percentage requirements of section 856(c) 
(2), (3), and (4), the following rules shall apply:
    (1) Gross income. For purposes of both the numerator and denominator 
in the

[[Page 55]]

computation of the specified percentages, the term ``gross income'' has 
the same meaning as that term has under section 61 and the regulations 
thereunder. Thus, in determining the gross income requirements under 
section 856(c) (2), (3), and (4), a loss from the sale or other 
disposition of stock, securities, real property, etc. does not enter 
into the computation.
    (2) Lapse of options. Under section 856(c)(6)(C), the term 
``interests in real property'' includes options to acquire land or 
improvements thereon, and options to acquire leaseholds of land and 
improvements thereon. However, where a corporation, trust, or 
association writes an option giving the holder the right to acquire land 
or improvements thereon, or writes an option giving the holder the right 
to acquire a leasehold of land or improvements thereon, any income that 
the corporation, trust, or association recognizes because the option 
expires unexercised is not considered to be gain from the sale or other 
disposition of real property (including interests in real property) for 
purposes of section 856(c) (2)(D) and (3)(C). The rule in the preceding 
sentence also applies for purposes of section 856(c)(4)(C) in 
determining gain from the sale or other disposition of real property for 
the 30-percent-of-gross-income limitation.
    (3) Commitment fees. For purposes of section 856(c) (2)(G) and 
(3)(G), if consideration is received or accrued for an agreement to make 
a loan secured by a mortgage covering both real property and other 
property, or for an agreement to purchase or lease both real property 
and other property, an apportionment of the consideration is required. 
The apportionment of consideration received or accrued for an agreement 
to make a loan secured by a mortgage covering both real property and 
other property shall be made under the principles of Sec.  1.856-5(c), 
relating to the apportionment of interest income.
    (4) Holding period of property. For purposes of the 30-percent 
limitation of section 856(c)(4), the determination of the period for 
which property described in such section has been held is governed by 
the provisions of section 1223 and the regulations thereunder.
    (5) Rents from real property and interest. See Sec. Sec.  1.856-4 
and 1.856-5 for rules relating to rents from real property and interest.
    (d) Diversification of investment requirements--(1) 75-percent test. 
Section 856(c)(5)(A) requires that at the close of each quarter of the 
taxable year at least 75 percent of the value of the total assets of the 
trust be represented by one or more of the following:
    (i) Real estate assets;
    (ii) Government securities; and
    (iii) Cash and cash items (including receivables).


For purposes of this subparagraph the term ``receivables'' means only 
those receivables which arise in the ordinary course of the trust's 
operation and does not include receivables purchased from another 
person. Subject to the limitations in section 856(c)(5)(B) and 
subparagraph (2) of this paragraph, the character of the remaining 25 
percent (or less) of the value of the total assets is not restricted.
    (2) Limitations on certain securities. Under section 856(c)(5)(B), 
not more than 25 percent of the value of the total assets of the trust 
may be represented by securities other than those described in section 
856(c)(5)(A). The ownership of securities under the 25-percent 
limitation in section 856(c)(5)(B) is further limited in respect of any 
one issuer to an amount not greater in value than 5 percent of the value 
of the total assets of the trust and to not more than 10 percent of the 
outstanding voting securities of such issuer. Thus, if the real estate 
investment trust meets the 75-percent asset diversification requirement 
in section 856(c)(5)(A), it will also meet the first test under section 
856(c)(5)(B) since it will, of necessity, have not more than 25 percent 
of its total assets represented by securities other than those described 
in section 856(c)(5)(A). However, the trust must also meet two 
additional tests under section 856(c)(5)(B), i.e. it cannot own the 
securities of any one issuer in an amount (i) greater in value than 5 
percent of the value of the trust's total assets, or (ii) representing 
more than 10 percent of the outstanding voting securities of such 
issuer.

[[Page 56]]

    (3) Determination of investment status. The term ``total assets'' 
means the gross assets of the trust determined in accordance with 
generally accepted accounting principles. In order to determine the 
effect, if any, which an acquisition of any security or other property 
may have with respect to the status of a trust as a real estate 
investment trust, section 856(c)(5) requires a revaluation of the 
trust's assets at the end of the quarter in which such acquisition was 
made. A revaluation of assets is not required at the end of any quarter 
during which there has been no acquisition of a security or other 
property since the mere change in market value of property held by the 
trust does not, of itself, affect the status of the trust as a real 
estate investment trust. A change in the nature of ``cash items'', for 
example, the prepayment of insurance or taxes, does not constitute the 
acquisition of ``other property'' for purposes of this subparagraph. A 
real estate investment trust shall keep sufficient records as to 
investments so as to be able to show that it has complied with the 
provisions of section 856(c)(5) during the taxable year. Such records 
shall be kept at all times available for inspection by any internal 
revenue officer or employee and shall be retained so long as the 
contents thereof may become material in the administration of any 
internal revenue law.
    (4) Illustrations. The application of section 856(c)(5) and this 
paragraph may be illustrated by the following examples:

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

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


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

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


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

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


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

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


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

[[Page 57]]

stock of Corporation S worth $2,000, such acquisition will necessitate a 
revaluation of all of the assets of Trust R as follows:

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

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

Cash..........................................................    $4,000
Government securities.........................................     4,000
Receivables...................................................     4,000
Real estate assets............................................    68,000
Securities in Corporation P...................................    10,000
Securities in Corporation O...................................     5,000
Securities in Corporation U...................................     5,000
Securities in Corporation T...................................     5,000
Securities in Corporation S...................................     1,000
                                                               ---------
 Total assets.................................................   106,000
 


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

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

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



Sec.  1.856-3  Definitions.

    For purposes of the regulations under part II, subchapter M, chapter 
1 of the Code, the following definitions shall apply.
    (a) Value. The term ``value'' means, with respect to securities for 
which market quotations are readily available, the market value of such 
securities; and with respect to other securities and assets, fair value 
as determined in good faith by the trustees of the real estate 
investment trust. In the case of securities of other qualified real 
estate investment trusts, fair value shall not exceed market value or 
asset value, whichever is higher.
    (b) Real estate assets--(1) In general. The term ``real estate 
assets'' means real property, interests in mortgages on real property 
(including interests in mortgages on leaseholds of land or improvements 
thereon), and shares in other qualified real estate investment trusts. 
The term ``mortgages on real property'' includes deeds of trust on real 
property.
    (2) Treatment of REMIC interests as real estate assets--(i) In 
general. If, for any calendar quarter, at least 95 percent of a REMIC's 
assets (as determined in accordance with Sec.  1.860F-4(e)(1)(ii) or 
Sec.  1.6049-7(f)(3)) are real estate assets (as defined in paragraph 
(b)(1) of this section), then, for that

[[Page 58]]

calendar quarter, all the regular and residual interests in that REMIC 
are treated as real estate assets and, except as provided in paragraph 
(b)(2)(iii) of this section, any amount includible in gross income with 
respect to those interests is treated as interest on obligations secured 
by mortgages on real property. If less than 95 percent of a REMIC's 
assets are real estate assets, then the real estate investment trust is 
treated as holding directly its proportionate share of the assets and as 
receiving directly its proportionate share of the income of the REMIC. 
See Sec. Sec.  1.860F-4(e)(1)(ii)(B) and 1.6049-7(f)(3) for information 
required to be provided to regular and residual interest holders if the 
95-percent test is not met.
    (ii) Treatment of REMIC assets for section 856 purposes--(A) 
Manufactured housing treated as real estate asset. For purposes of 
paragraphs (b)(1) and (2) of this section, the term ``real estate 
asset'' includes manufactured housing treated as a single family 
residence under section 25(e)(10).
    (B) Status of cash flow investments. For purposes of this paragraph 
(b)(2), cash flow investments (as defined in section 860G(a)(6) and 
Sec.  1.860G-2(g)(1)) are real estate assets.
    (iii) Certain contingent interest payment obligations held by a 
REIT. If a REIT holds a residual interest in a REMIC for a principal 
purpose of avoiding the limitation set out in section 856(f) (concerning 
interest based on mortgagor net profits) or section 856(j) (concerning 
shared appreciation provisions), then, even if the REMIC satisfies the 
95-percent test of paragraph (b)(i) of this section, the REIT is treated 
as receiving directly the REMIC's items of income for purposes of 
section 856.
    (c) Interests in real property. The term ``interests in real 
property'' includes fee ownership and co-ownership of land or 
improvements thereon, leaseholds of land or improvements thereon, 
options to acquire land or improvements thereon, and options to acquire 
leaseholds of land or improvements thereon. The term also includes 
timeshare interests that represent an undivided fractional fee interest, 
or undivided leasehold interest, in real property, and that entitle the 
holders of the interests to the use and enjoyment of the property for a 
specified period of time each year. The term also includes stock held by 
a person as a tenant-stockholder in a cooperative housing corporation 
(as those terms are defined in section 216). Such term does not, 
however, include mineral, oil, or gas royalty interests, such as a 
retained economic interest in coal or iron ore with respect to which the 
special provisions of section 631(c) apply.
    (d) Real property. See Sec.  1.856-10 for the definition of real 
property. A regulation that adopts the definition of real property in 
this paragraph is to be interpreted as if it had referred to Sec.  
1.856-10.
    (e) Securities. The term ``securities'' does not include ``interests 
in real property'' or ``real estate assets'' as those terms are defined 
in section 856 and this section.
    (f) Qualified real estate investment trusts. The term ``qualified 
real estate investment trust'' means a real estate investment trust 
within the meaning of part II of subchapter M which is taxable under 
such part as a real estate investment trust. For purposes of the 75-
percent requirement in section 856(c)(5)(A), the trust whose stock has 
been included by another trust as ``real estate assets'' must be a 
``qualified real estate investment trust'' for its full taxable year in 
which falls the close of each quarter of the trust's taxable year for 
which the computation is made. For example, Real Estate Investment Trust 
Z for its taxable year ending December 31, 1963, holds as ``real estate 
assets'' stock in Real Estate Investment Trust Y, which is also on a 
calendar year. If Trust Y is not a qualified real estate investment 
trust for its full taxable year ending December 31, 1963, Trust Z may 
not include the stock of Trust Y as ``real estate assets'' in computing 
the 75-percent requirement as of the close of any quarter of its taxable 
year ending December 31, 1963.
    (g) Partnership interest. In the case of a real estate investment 
trust which is a partner in a partnership, as defined in section 
7701(a)(2) and the regulations thereunder, the trust will be deemed to 
own its proportionate share of each of the assets of the partnership and 
will be deemed to be entitled to the income of the partnership 
attributable to such

[[Page 59]]

share. For purposes of section 856, the interest of a partner in the 
partnership's assets shall be determined in accordance with his capital 
interest in the partnership. The character of the various assets in the 
hands of the partnership and items of gross income of the partnership 
shall retain the same character in the hands of the partners for all 
purposes of section 856. Thus, for example, if the trust owns a 30-
percent capital interest in a partnership which owns a piece of rental 
property the trust will be treated as owning 30 percent of such property 
and as being entitled to 30 percent of the rent derived from the 
property by the partnership. Similarly, if the partnership holds any 
property primarily for sale to customers in the ordinary course of its 
trade or business, the trust will be treated as holding its 
proportionate share of such property primarily for such purpose. Also, 
for example, where a partnership sells real property or a trust sells 
its interest in a partnership which owns real property, any gross income 
realized from such sale, to the extent that it is attributable to the 
real property, shall be deemed gross income from the sale or disposition 
of real property held for either the period that the partnership has 
held the real property of the period that the trust was a member of the 
partnership, whichever is the shorter.
    (h) Net capital gain. The term ``net capital gain'' means the excess 
of the net long-term capital gain for the taxable year over the net 
short-term capital loss for the taxable year.

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

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



Sec.  1.856-4  Rents from real property.

    (a) In general. Subject to the exceptions of section 856(d) and 
paragraph (b) of this section, the term ``rents from real property'' 
means, generally, the gross amounts received for the use of, or the 
right to use, real property of the real estate investment trust.
    (b) Amounts specifically included or excluded--(1) Charges for 
customary services. For taxable years beginning after October 4, 1976, 
the term ``rents from real property'', for purposes of paragraphs (2) 
and (3) of section 856(c), includes charges for services customarily 
furnished or rendered in connection with the rental of real property, 
whether or not the charges are separately stated. Services furnished to 
the tenants of a particular building will be considered as customary if, 
in the geographic market in which the building is located, tenants in 
buildings which are of a similar class (such as luxury apartment 
buildings) are customarily provided with the service. The furnishing of 
water, heat, light, and air-conditioning, the cleaning of windows, 
public entrances, exits, and lobbies, the performance of general 
maintenance and of janitorial and cleaning services, the collection of 
trash, and the furnishing of elevator services, telephone answering 
services, incidental storage space, laundry equipment, watchman or guard 
services, parking facilities, and swimming pool facilities are examples 
of services which are customarily furnished to the tenants of a 
particular class of buildings in many geographic marketing areas. Where 
it is customary, in a particular geographic marketing area, to furnish 
electricity or other utilities to tenants in buildings of a particular 
class, the submetering of such utilities to tenants in such buildings 
will be considered a customary service. To qualify as a service 
customarily furnished, the service must be furnished or rendered to the 
tenants of the real estate investment trust or, primarily for the 
convenience or benefit of the tenant, to the guests, customers, or 
subtenants of the tenant. The service must be furnished through an 
independent contractor from whom the trust does not derive or receive 
any income. See paragraph (b)(5) of this section. For taxable years 
beginning

[[Page 60]]

before October 5, 1976, the rules in paragraph (b)(3) of 26 CFR 1.856-4 
(revised as of April 1, 1977), relating to the furnishing of services, 
shall continue to apply.
    (2) Amounts received with respect to certain personal property--(i) 
In general. In the case of taxable years beginning after October 4, 
1976, rent attributable to personal property that is leased under, or in 
connection with, the lease of real property is treated under section 
856(d)(1)(C) as ``rents from real property'' (and thus qualified for 
purposes of the income source requirements) if the rent attributable to 
the personal property is not more than 15 percent of the total rent 
received or accrued under the lease for the taxable year. If, however, 
the rent attributable to personal property is greater than 15 percent of 
the total rent received or accrued under the lease for the taxable year, 
then the portion of the rent from the lease that is attributable to 
personal property will not qualify as ``rents from real property''.
    (ii) Application. In general, the 15-percent test in section 
856(d)(1)(C) is applied separately to each lease of real property. 
However, where the real estate investment trust rents all (or a portion 
of all) the units in a multiple unit project under substantially similar 
leases (such as the leasing of apartments in an apartment building or 
complex to individual tenants), the 15-percent test may be applied with 
respect to the aggregate rent received or accrued for the taxable year 
under the similar leases of the property, by using the average of the 
trust's aggregate adjusted bases of all of the personal property subject 
to such leases, and the average of the trust's aggregate adjusted bases 
of all real and personal property subject to such leases. A lease of a 
furnished apartment is not considered to be substantially similar to a 
lease of an unfurnished apartment (including an apartment where the 
trust provides only personal property, such as major appliances, that is 
commonly provided by a landlord in connection with the rental of 
unfurnished living quarters).
    (iii) Taxable years beginning before October 5, 1976. In the case of 
taxable years beginning before October 5, 1976, any amount of rent that 
is attributable to personal property does not qualify as rent from real 
property.
    (3) Disqualification of rent which depends on income or profits of 
any person. Except as provided in paragraph (b)(6)(ii) of this section, 
no amount received or accrued, directly or indirectly, with respect to 
any real property (or personal property leased under, or in connection 
with, real property) qualifies as ``rents from real property'' where the 
determination of the amount depends in whole or in part on the income or 
profits derived by any person from the property. However, any amount so 
accrued or received shall not be excluded from the term ``rents from 
real property'' solely by reason of being based on a fixed percentage or 
percentages of receipts or sales (whether or not receipts or sales are 
adjusted for returned merchandise, or Federal, State, or local sales 
taxes). Thus, for example, ``rents from real property'' would include 
rents where the lease provides for differing percentages or receipts or 
sales from different departments or from separate floors of a retail 
store so long as each percentage is fixed at the time of entering into 
the lease and a change in such percentage is not renegotiated during the 
term of the lease (including any renewal periods of the lease, in a 
manner which has the effect of basing the rent on income of profits. See 
paragraph (b)(6) of this section for rules relating to certain amounts 
received or accrued by a trust which are considered to be based on the 
income or profits of a sublessee of the prime tenant. The amount 
received or accrued as rent for the taxable year which is based on a 
fixed percentage or percentages of the lessee's receipts or sales 
reduced by escalation receipts (including those determined under a 
formula clause) will qualify as ``rents from real property''. Escalation 
receipts include amounts received by a prime tenant from subtenants by 
reason of an agreement that rent shall be increased to reflect all or a 
portion of an increase in real estate taxes, property insurance, 
operating costs of the prime tenant, or similar items customarily 
included in lease escalation clauses. Where in accordance with the

[[Page 61]]

terms of an agreement an amount received or accrued as rent for the 
taxable year includes both a fixed rental and a percentage of all or a 
portion of the lessee's income or profits, neither the fixed rental nor 
the additional amount will qualify as ``rents from real property''. 
However, where the amount received or accrued for the taxable year under 
such an agreement includes only the fixed rental, the determination of 
which does not depend in whole or in part on the income or profits 
derived by the lessee, such amount may qualify as ``rents from real 
property''. An amount received or accrued as rent for the taxable year 
which consists, in whole or in part, of one or more percentages of the 
lessee's receipts or sales in excess of determinable dollar amounts may 
qualify as ``rents from real property'', but only if two conditions 
exist. First, the determinable amounts must not depend in whole or in 
part on the income or profits of the lessee. Second, the percentages 
and, in the case of leases entered into after July 7, 1978, the 
determinable amounts, must be fixed at the time the lease is entered 
into and a change in percentages and determinable amounts is not 
renegotiated during the term of the lease (including any renewal periods 
of the lease) in a manner which has the effect of basing rent on income 
or profits. In any event, an amount will not qualify as ``rents from 
real property'' if, considering the lease and all the surrounding 
circumstances, the arrangement does not conform with normal business 
practice but is in reality used as a means of basing the rent on income 
or profits. The provisions of this subparagraph may be illustrated by 
the following example:

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

    (4) Disqualification of amounts received from persons owned in whole 
or in part by the trust. ``Rents from real property'' does not include 
any amount received or accrued, directly or indirectly, from any person 
in which the real estate investment trust owns, at any time during the 
taxable year, the specified percentage or number of shares of stock (or 
interest in the assets or net profits) of that person. Any amount 
received from such person will not qualify as ``rents from real 
property'' if such person is a corporation and the trust owns 10 percent 
or more of the total combined voting power of all classes of its stock 
entitled to vote or 10 percent or more of the total number of shares of 
all classes of its outstanding stock, or if such person is not a 
corporation and the trust owns a 10-percent-or-more interest in its 
assets or net profits. For example, a trust leases an office building to 
a tenant for which it receives rent of $100,000 for the taxable year 
1962. The lessee of the building subleases space to various subtenants 
for which it receives gross rent of $500,000 for the year 1962. The 
trust owns 15 percent of the total assets of an unincorporated 
subtenant. The rent paid by this subtenant for the taxable year is 
$50,000. Therefore, $10,000 (50,000/500,000 x $100,000) of the rent paid 
to the trust does not qualify as ``rents from real property''. Where the 
real estate investment trust receives, directly or indirectly, any 
amount of rent from any person in which it owns any proprietary 
interest, the trust shall submit, at the time it files its return for 
the taxable year (or before June 1, 1962, whichever is later), a 
schedule setting forth--

[[Page 62]]

    (i) The name and address of such person and the amount received as 
rent from such person; and
    (ii) If such person is a corporation, the highest percentage of the 
total combined voting power of all classes of its stock entitled to 
vote, and the highest percentage of the total number of shares of all 
classes of its outstanding stock, owned by the trust at any time during 
the trust's taxable year; or
    (iii) If such person is not a corporation, the highest percentage of 
the trust's interest in the assets or net profits of such person, owned 
by the trust at any time during its taxable year.
    (5) Furnishing of services or management of property must be through 
an independent contractor--(i) In general. No amount received or 
accrued, directly or indirectly, with respect to any real property (or 
any personal property leased under, or in connection with, the real 
property) qualifies as ``rents from real property'' if the real estate 
investment trust furnishes or renders services to the tenants of the 
property or manages or operates the property, other than through an 
independent contractor from whom the trust itself does not derive or 
receive any income. The prohibition against the trust deriving or 
receiving any income from the independent contractor applies regardless 
of the source from which the income was derived by the independent 
contractor. Thus, for example, the trust may not receive any dividends 
from the independent contractor. The requirement that the trust not 
receive any income from an independent contractor requires that the 
relationship between the two be an arm's-length relationship. The 
independent contractor must be adequately compensated for any services 
which are performed for the trust. Compensation to an independent 
contractor determined by reference to an unadjusted percentage of gross 
rents will generally be considered to be adequate where the percentage 
is reasonable taking into account the going rate of compensation for 
managing similar property in the same locality, the services rendered, 
and other relevant factors. The independent contractor must not be an 
employee of the trust (i.e., the manner in which he carries out his 
duties as independent contractor must not be subject to the control of 
the trust). Although the cost of services which are customarily rendered 
or furnished in connection with the rental of real property may be borne 
by the trust, the services must be furnished or rendered through an 
independent contractor. Furthermore, the facilities through which the 
services are furnished must be maintained and operated by an independent 
contractor. For example, if a heating plant is located in the building, 
it must be maintained and operated by an independent contractor. To the 
extent that services (other than those customarily furnished or rendered 
in connection with the rental of real property) are rendered to the 
tenants of the property by the independent contractor, the cost of the 
services must be borne by the independent contractor, a separate charge 
must be made for the services, the amount of the separate charge must be 
received and retained by the independent contractor, and the independent 
contractor must be adequately compensated for the services.
    (ii) Trustee or director functions. The trustees or directors of the 
real estate investment trust are not required to delegate or contract 
out their fiduciary duty to manage the trust itself, as distinguished 
from rendering or furnishing services to the tenants of its property or 
managing or operating the property. Thus, the trustees or directors may 
do all those things necessary, in their fiduciary capacities, to manage 
and conduct the affairs of the trust itself. For example, the trustees 
or directors may establish rental terms, choose tenants, enter into and 
renew leases, and deal with taxes, interest, and insurance, relating to 
the trust's property. The trustees or directors may also make capital 
expenditures with respect to the trust's property (as defined in section 
263) and may make decisions as to repairs of the trust's property (of 
the type which would be deductible under section 162), the cost of which 
may be borne by the trust.
    (iii) Independent contractor defined. The term ``independent 
contractor'' means--
    (a) A person who does not own, directly or indirectly, at any time 
during

[[Page 63]]

the trust's taxable year more than 35 percent of the shares in the real 
estate investment trust, or
    (b) A person--
    (1) If a corporation, not more than 35 percent of the total combined 
voting power of whose stock (or 35 percent of the total shares of all 
classes of whose stock), or
    (2) If not a corporation, not more than 35 percent of the interest 
in whose assets or net profits is owned, directly or indirectly, at any 
time during the trust's taxable year by one or more persons owning at 
any time during such taxable year 35 percent or more of the shares in 
the trust.
    (iv) Information required. The real estate investment trust shall 
submit with its return for the taxable year (or before June 1, 1962, 
whichever is later) a statement setting forth the name and address of 
each independent contractor; and
    (a) The highest percentage of the outstanding shares in the trust 
owned at any time during its taxable year by such independent contractor 
and by any person owning at any time during such taxable year any shares 
of stock or interest in the independent contractor.
    (b) If the independent contractor is a corporation such statement 
shall set forth the highest percentage of the total combined voting 
power of its stock and the highest percentage of the total number of 
shares of all classes of its stock owned at any time during its taxable 
year by any person owning shares in the trust at any time during such 
taxable year.
    (c) If the independent contractor is not a corporation such 
statement shall set forth the highest percentage of any interest in its 
assets or net profits owned at any time during its taxable year by any 
person owning shares in the trust at any time during such taxable year.
    (6) Amounts based on income or profits of subtenants. (i) Except as 
provided in paragraph (b)(6)(ii) of this section, if a trust leases real 
property to a tenant under terms other than solely on a fixed sum rental 
(for example, a percentage of the tenant's gross receipts), and the 
tenant subleases all or a part of such property under an agreement which 
provides for a rental based in whole or in part on the income or profits 
of the sublessee, the entire amount of the rent received by the trust 
from the prime tenant with respect to such property is disqualified as 
``rents from real property''.
    (ii) Exception. For taxable years beginning after October 4, 1976, 
section 856(d)(4) provides an exception to the general rule that amounts 
received or accrued, directly or indirectly, by a real estate investment 
trust do not qualify as rents from real property if the determination of 
the amount depends in whole or in part on the income or profits derived 
by any person from the property. This exception applies where the trust 
rents property to a tenant (the prime tenant) for a rental which is 
based, in whole or in part, on a fixed percentage or percentages of the 
receipts or sales of the prime tenant, and the rent which the trust 
receives or accrues from the prime tenant pursuant to the lease would 
not qualify as ``rents from real property'' solely because the prime 
tenant receives or accrues from subtenants (including concessionaires) 
rents or other amounts based on the income or profits derived by a 
person from the property. Under the exception, only a proportionate part 
of the rent received or accrued by the trust does not qualify as ``rents 
from real property''. The proportionate part of the rent received or 
accrued by the trust which is non-qualified is the lesser of the 
following two amounts:
    (A) The rent received or accrued by the trust from the prime tenant 
pursuant to the lease, that is based on a fixed percentage or 
percentages of receipts or sales, or
    (B) The product determined by multiplying the total rent which the 
trust receives or accrues from the prime tenant pursuant to the lease by 
a fraction, the numerator of which is the rent or other amount received 
by the prime tenant that is based, in whole or in part, on the income or 
profits derived by any person from the property, and the denominator of 
which is the total rent or other amount received by the prime tenant 
from the property. For example, assume that a real estate investment 
trust owns land underlying a

[[Page 64]]

shopping center. The trust rents the land to the owner of the shopping 
center for an annual rent of $10x plus 2 percent of the gross receipts 
which the prime tenant receives from subtenants who lease space in the 
shopping center. Assume further that, for the year in question, the 
prime tenant derives total rent from the shopping center of $100x and, 
of that amount, $25x is received from subtenants whose rent is based, in 
whole or in part, on the income or profits derived from the property. 
Accordingly, the trust will receive a total rent of $12x, of which $2x 
is based on a percentage of the gross receipts of the prime tenant. The 
portion of the rent which is disqualified is the lesser of $2x (the rent 
received by the trust which is based on a percentage of gross receipts), 
or $3x, ($12x multiplied by $25x/$100x). Accordingly, $10x of the rent 
received by the trust qualifies as ``rents from real property'' and $2x 
does not qualify.
    (7) Attribution rules. Paragraphs (2) and (3) of section 856(d) 
relate to direct or indirect ownership of stock, assets, or net profits 
by the persons described therein. For purposes of determining such 
direct or indirect ownership, the rules prescribed by section 318(a) 
(for determining the ownership of stock) shall apply except that ``10 
percent'' shall be substituted for ``50 percent'' in section 318(a) 
(2)(C) and (3)(C).

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

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



Sec.  1.856-5  Interest.

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

[[Page 65]]

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

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

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

[[Page 66]]



Sec.  1.856-6  Foreclosure property.

    (a) In general. Under section 856(e) a real estate investment trust 
may make an irrevocable election to treat as ``foreclosure property'' 
certain real property (including interests in real property), and any 
personal property incident to the real property, acquired by the trust 
after December 31, 1973. This section prescribes rules relating to the 
election, including rules relating to property eligible for the 
election. This section also prescribes rules relating to extensions of 
the general two-year period (hereinafter the ``grace period'') during 
which property retains its status as foreclosure property, as well as 
rules relating to early termination of the grace period under section 
856(e)(4). The election to treat property as foreclosure property does 
not alter the character of the income derived therefrom (other than for 
purposes of section 856(c)(2)(F) and (3)(F)). For example, if 
foreclosure property is sold, the determination of whether it is 
property described in section 1221(1) will not be affected by the fact 
that it is foreclosure property.
    (b) Property eligible for the election--(1) Rules relating to 
acquisitions. In general, the trust must acquire the property after 
December 31, 1973, as the result of having bid in the property at 
foreclosure, or having otherwise reduced the property to ownership or 
possession by agreement or process of law, after there was default (or 
default was imminent) on a lease of the property (where the trust was 
the lessor) or on an indebtedness owed to the trust which the property 
secured. Foreclosure property which secured an indebtedness owed to the 
trust is acquired for purposes of section 856(e) on the date on which 
the trust acquires ownership of the property for Federal income tax 
purposes. Foreclosure property which a trust owned and leased to another 
is acquired for purposes of section 856(e) on the date on which the 
trust acquires possession of the property from its lessee. A trust will 
not be considered to have acquired ownership of property for purposes of 
section 856(e) where it takes control of the property as a mortgagee-in-
possession and cannot receive any profit or sustain any loss with 
respect to the property except as a creditor of the mortgagor. A trust 
may be considered to have acquired ownership of property for purposes of 
section 856(e) even through legal title to the property is held by 
another person. For example, where, upon foreclosure of a mortgage held 
by the trust, legal title to the property is acquired in the name of a 
nominee for the exclusive benefit of the trust and the trust is the 
equitable owner of the property, the trust will be considered to have 
acquired ownership of the property for purposes of section 856(e). 
Generally, the fact that under local law the mortgagor has a right of 
redemption after foreclosure is not relevant in determining whether the 
trust has acquired ownership of the property for purposes of section 
856(e). Property is not ineligible for the election solely because the 
property, in addition to securing an indebtedness owed to the trust, 
also secures debts owed to other creditors. Property eligible for the 
election includes a building or other improvement which has been 
constructed on land owned by the trust and which is acquired by the 
trust upon default of a lease of the land.
    (2) Personal property. Personal property (including personal 
property not subject to a mortgage or lease of the real property) will 
be considered incident to a particular item of real property if the 
personal property is used in a trade or business conducted on the 
property or the use of the personal property is otherwise an ordinary 
and necessary corollary of the use to which the real property is put. In 
the case of a hotel, such items as furniture, appliances, linens, china, 
food, etc. would be examples of incidental personal property. Personal 
property incident to the real property is eligible for the election even 
though it is acquired after the real property is acquired or is placed 
in the building or other improvement in the course of the completion of 
construction.
    (3) Property with respect to which default is anticipated. Property 
is not eligible for the election to be treated as foreclosure property 
if the loan or lease with respect to which the default occurs (or is 
imminent) was made or entered into (or the lease or indebtedness

[[Page 67]]

was acquired) by the trust with an intent to evict or foreclose, or when 
the trust knew or had reason to know that default would occur 
(``improper knowledge''). For purposes of the preceding sentence, a 
trust will not be considered to have improper knowledge with respect to 
a particular lease or loan, if the lease or loan was made pursuant to a 
binding commitment entered into by the trust at a time when it did not 
have improper knowledge. Moreover, if the trust, in an attempt to avoid 
default or foreclosure, advances additional amounts to the borrower in 
excess of amounts contemplated in the original loan commitment or 
modifies the lease or loan, such advance or modification will be 
considered not to have been made with an intent to evict or foreclose, 
or with improper knowledge, unless the original loan or lease was 
entered into with that intent or knowledge.
    (c) Election--(1) In general. (i) An election to treat property as 
foreclosure property applies to all of the eligible real property 
acquired in the same taxable year by the trust upon the default (or as a 
result of the imminence of default) on a particular lease (where the 
trust is the lessor) or on a particular indebtedness owed to the trust. 
For example, if a loan made by a trust is secured by two separate tracts 
of land located in different cities, and in the same taxable year the 
trust acquires both tracts on foreclosure upon the default (or imminence 
of default) of the loan, the trust must include both tracts in the 
election. For a further example, the trust may choose to make a separate 
election for only one of the tracts if they are acquired in different 
taxable years or were not security for the same loan. If real property 
subject to the same election is acquired at different times in the same 
taxable year, the grace period for a particular property begins when 
that property is acquired.
    (ii) If the trust acquires separate pieces of real property that 
secure the same indebtedness (or are under the same lease) in different 
taxable years because the trust delays acquiring one of them until a 
later taxable year, and the primary purpose for the delay is to include 
only one of them in an election, then if the trust makes an election for 
one piece it must also make an election for the other piece. A trust 
will not be considered to have delayed the acquisition of property for 
this purpose if there is a legitimate business reason for the delay 
(such as an attempt to avoid foreclosure by further negotiations with 
the debtor or lessee).
    (iii) All of the eligible personal property incident to the real 
property must also be included in the election.
    (2) Time for making election. The election to treat property as 
foreclosure property must be made on or before the due date (including 
extensions of time) for filing the trust's income tax return for the 
taxable year in which the trust acquires the property with respect to 
which the election is being made, or April 3, 1975, whichever is later.
    (3) Manner of making the election. An election made after February 
6, 1981, shall be made by a statement attached to the income tax return 
for the taxable year in which the trust acquired the property with 
respect to which the election is being made. The statement shall 
indicate that the election is made under section 856(e) and shall 
identify the property to which the election applies. The statement shall 
also set forth--
    (i) The name, address, and taxpayer identification number of the 
trust,
    (ii) The date the property was acquired by the trust, and
    (iii) A brief description of how the real property was acquired, 
including the name of the person or persons from whom the real property 
was acquired and a description of the lease or indebtedness with respect 
to which default occurred or was imminent.


An election made on or before February 6, 1981 shall be filed in the 
manner prescribed in 26 CFR 10.1(f) (revised as of April 1, 1977) 
(temporary regulations relating to the election to treat property as 
foreclosure property) as in effect when the election is made.
    (4) Status of taxpayer. In general, a taxpayer may make an election 
with respect to an acquisition of property only if the taxpayer is a 
qualified real estate investment trust for the taxable year in which the 
acquisition occurs. If, however, the taxpayer establishes,

[[Page 68]]

to the satisfaction of the district director for the internal revenue 
district in which the taxpayer maintains its principal place of business 
or principal office or agency, that its failure to be a qualified real 
estate investment trust for a taxable year was to due to reasonable 
cause and not due to willful neglect, the taxpayer may make the election 
with respect to property acquired in such taxable year. The principles 
of Sec. Sec.  1.856.7(c) and 1.856.8(d) (including the principles 
relating to expert advice) will apply in determining whether, for 
purposes of this subparagraph, the failure of the taxpayer to be a 
qualified real estate investment trust for the taxable year in which the 
property is acquired was due to reasonable cause and not due to willful 
neglect. If a taxpayer makes a valid election to treat property as 
foreclosure property, the property will not lose its status as 
foreclosure property solely because the taxpayer is not a qualified real 
estate investment trust for a subsequent taxable year (including a 
taxable year which encompasses an extension of the grace period). 
However, the rules relating to the termination of foreclosure property 
status in section 856(e)(4) (but not the tax on income from foreclosure 
property imposed by section 857(b)(4)) apply to the year in which the 
property is acquired and all subsequent years, even though the taxpayer 
is not a qualified real estate investment trust for such year.
    (d) Termination of 2-year grace period; subsequent leases--(1) In 
general. Under section 856(e)(4)(A), all real property (and any 
incidental personal property) for which a particular election has been 
made (see paragraph (c)(1) of this section) shall cease to be 
foreclosure property on the first day (occurring on or after the day on 
which the trust acquired the property) on which the trust either--
    (i) Enters into a lease with respect to any of the property which, 
by its terms, will give rise to income of the trust which is not 
described in section 856(c)(3) (other than section 856(c)(3)(F)), or
    (ii) Receives or accrues, directly or indirectly, any amount which 
is not described in section 856(c)(3) (other than section 856(c)(3)(F)) 
pursuant to a lease with respect to any of the real property entered 
into by the trust on or after the day the trust acquired the property.


For example, assume the trust acquires, in a particular taxable year, a 
shopping center upon the default of an indebtedness owed to the trust. 
Also assume that the trust subsequently enters into a lease with respect 
to one of several stores in the shopping center that requires the lessee 
to pay rent to the trust which is not income described in section 
856(c)(3) (other than section 856(c)(3)(F)). In such case, the entire 
shopping center will cease to be foreclosure property on the day the 
trust enters into the lease.
    (2) Extensions or renewals of leases. Generally, the extension or 
renewal of a lease of foreclosure property will be treated as the 
entering into of a new lease only if the trust has a right to 
renegotiate the terms of the lease. If, however, by operation of law or 
by contract, the acquisition of the foreclosure property by the trust 
terminates a preexisting lease of the property, or gives the trust a 
right to terminate the lease, then for purposes of section 856(e)(4)(A), 
a trust, in such circumstances, will not be considered to have entered 
into a lease with respect to the property solely because the terms of 
the preexisting lease are continued in effect after foreclosure without 
substantial modification. The letting of rooms in a hotel or motel does 
not constitute the entering into a lease for purposes of section 
856(e)(4)(A).
    (3) Rent attributable to personal property. Solely for the purposes 
of section 856(e)(4)(A), if a trust enters into a lease with respect to 
real property on or after the day upon which the trust acquires such 
real property by foreclosure, and a portion of the rent from such lease 
is attributable to personal property which is foreclosure property 
incident to such real property, such rent attributable to the incidental 
personal property will not be considered to terminate the status of such 
real property (or such incidental personal property) as foreclosure 
property.
    (e) Termination of 2-year grace period; completion of construction--
(1) In general. Under section 856(e)(4)(B), all real property (and any 
incidental personal

[[Page 69]]

property) for which a particular election has been made (see paragraph 
(c)(1) of this section) shall cease to be foreclosure property on the 
first day (occurring on or after the day on which the trust acquired the 
property) on which any construction takes place on the property, other 
than completion of a building (or completion of any other improvement) 
where more than 10 percent of the construction of the building (or other 
improvement) was completed before default became imminent. If more than 
one default occurred with respect to an indebtedness or lease in respect 
of which there is an acquisition, the more-than-10-percent test 
(including the rule prescribed in this paragraph relating to the test) 
will not be applied at the time a particular default became imminent if 
it is clear that the acquisition did not occur as the result of such 
default. For example, if the debtor fails to make four consecutive 
payments of principal and interest on the due dates, and the trust takes 
action to acquire the property securing the debt only after the fourth 
default becomes imminent, the 10-percent test is applied at the time the 
fourth default became imminent (even though the trust would not have 
foreclosed on the property had not all four defaults occurred).
    (2) Determination of percentage of completion. The determination of 
whether the construction of a building or other improvement was more 
than 10 percent complete when default became imminent shall be made by 
comparing the total direct costs of construction incurred with respect 
to the building or other improvement as of the date default became 
imminent with the estimated total direct costs of construction as of 
such date. If the building or other improvement qualifies as more than 
10 percent complete under this method, the building or other improvement 
shall be considered to be more than 10 percent complete. For purposes of 
this subparagraph, direct costs of construction include the cost of 
labor and materials which are directly connected with the construction 
of the building or improvement.


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

[[Page 70]]

    (3) Modification of a building or improvement. Generally, the terms 
``building'' and ``improvement'' in section 856(e)(4)(B) mean the 
building or improvement (including any integral part thereof) as planned 
by the mortgagor or lessee (or other person in possession of the 
property, if appropriate) as of the date default became imminent. The 
trust, however, may estimate the total direct costs of construction and 
complete the construction of the building or other improvement by 
modifying the building or other improvement as planned as of the date 
default became imminent so as to reduce the estimated direct cost of 
construction of the building or improvement. If the trust does so modify 
the planned construction of the building or improvement, the 10-percent 
test is to be applied by comparing the direct costs of construction 
incurred as of the date default became imminent that are attributable to 
the building or improvement as modified, with the estimated total direct 
costs (as of such date) of construction of the building or other 
improvement as modified. The trust, in order to meet the 10-percent 
test, may not, however, modify the planned building or improvement by 
reducing the estimated direct cost of construction to such an extent 
that the building or improvement is not functional.


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


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

[[Page 71]]

use of such other building or improvement or are necessary for such 
other building or improvement to be utilized in the manner or for the 
purpose for which it is intended, or
    (ii) The buildings or improvements are intended to comprise 
constituent parts of an interdependent group of buildings or other 
improvements.


However, a building or other improvement will not be considered to be an 
integral part of another building or improvement unless the buildings or 
improvements were planned as part of the same overall construction plan 
or project before default became imminent. An additional building or 
other improvement (such as, for example, an outdoor swimming pool or a 
parking garage) may be considered to be an integral part of another 
building or improvement, even though the additional building or 
improvement was also intended to be used to provide facilities or 
services for use in connection with several other buildings or 
improvements which will not be completed. If the trust chooses not to 
undertake the construction of an additional building or other 
improvement which qualifies as an integral part of another building or 
improvement, so much of the costs of construction (including both the 
direct costs of construction incurred before the default became imminent 
and the estimated costs of completion) as are attributable to that 
``integral part'' shall not be taken into account in determining whether 
any other building or improvement was more than 10 percent complete when 
default became imminent. For example, assume the trust acquires on 
foreclosure a property on which the defaulting mortgagor has begun 
construction of a motel. The motel, as planned by the mortgagor, was to 
consist of a two-story building containing 30 units, and two detached 
one-story wings, each of which was to contain 20 units. At the time 
default became imminent, the defaulting mortgagor had completed more 
than 10 percent of the construction of the two-story structure but the 
two wings, an access road, a parking lot, and an outdoor swimming pool 
planned for the motel were each less than 10 percent complete. The trust 
may construct the two wings of the motel, the access road, the parking 
lot, and the swimming pool: Provided, That the motel and the other 
improvements which the trust undertakes to construct, taken together as 
a unit, were more than 10 percent complete when default became imminent. 
If, however, the trust chooses not to undertake construction of the 
swimming pool, the cost of construction attributable to the swimming 
pool, whether incurred before default became imminent or estimated as 
the cost of completion, shall not be taken into account in determining 
whether the trust can complete construction of the other buildings and 
improvements. For another example, assume that the trust acquires a 
planned shopping center on foreclosure. At the time default became 
imminent several large buildings intended to house shops and stores in 
the shopping center were more than 10 percent complete. Less than 10 
percent of the construction, however, had been completed on a separate 
structure intended to house a bank. The bank was planned as a component 
of the shopping center in order to provide, in conjunction with the 
other shops and stores, a specific range and variety of goods and 
services with which to attract customers to the shopping center. The 
trust may complete construction of the bank: Provided, That the bank and 
the other buildings and improvements which the trust undertakes to 
complete, taken together as a unit, were more than 10 percent complete 
when default became imminent. If the trust chooses not to construct the 
bank, no actual or estimated construction costs attributable to the bank 
are to be taken into account in applying the 10-percent test with 
respect to the other buildings and improvements in the shopping center. 
For a third example, assume that a defaulting mortgagor had planned to 
construct two identical apartment buildings, A and B, on the same tract 
of land, that neither building is to provide substantial facilities or 
services to be used in connection with the other, and that only building 
A was more than 10 percent complete when default became imminent. The 
trust, in this case, may not complete building B. On the other hand, if 
the facts are the same except that pursuant to the plans

[[Page 72]]

of the defaulting mortgagor, one of the buildings is to contain the 
furnace and central air conditioning machinery for both buildings A and 
B, the trust may complete both buildings A and B: Provided, That, taken 
together as a unit, the two buildings meet the more-than-10-percent 
test.
    (5) Repair and maintenance. Under this paragraph (e), 
``construction'' does not include--
    (i) The repair or maintenance of a building or other improvement 
(such as the replacement of worn or obsolete furniture and appliances) 
to offset normal wear and tear or obsolescence, and the restoration of 
property required because of damage from fire, storm, vandalism or other 
casualty,
    (ii) The preparation of leased space for a new tenant which does not 
substantially extend the useful life of the building or other 
improvement or significantly increase its value, even though, in the 
case of commercial space, this preparation includes adapting the 
property to the conduct of a different business, or
    (iii) The performing of repair or maintenance described in paragraph 
(e)(5)(i) of this section after property is acquired that was deferred 
by the defaulting party and that does not constitute renovation under 
paragraph (e)(2) of this section.
    (6) Independent contractor required. If any construction takes place 
on the foreclosure property more than 90 days after the day on which 
such property was acquired by the trust, such construction must be 
performed by an independent contractor (as defined in section 856(d)(3) 
and Sec.  1.856-4(b)(5)(iii)) from whom the trust does not derive or 
receive any income. Otherwise, the property will cease to be foreclosure 
property.
    (7) Failure to complete construction. Property will not cease to be 
foreclosure property solely because a trust which undertakes the 
completion of construction of a building or other improvement on the 
property that was more than 10 percent complete when default became 
imminent does not complete the construction. Thus, for example, if a 
trust continues construction of a building that was 20 percent complete 
when default became imminent, and the trust constructs an additional 40 
percent of the building and then sells the property, the property will 
not lose its status as foreclosure property solely because the trust 
fails to complete construction of the building.
    (f) Termination of 2-year grace period; use of foreclosure property 
in a trade or business--(1) In general. Under section 856(e)(4)(C), all 
real property (and any incidental personal property) for which a 
particular election has been made (see paragraph (c)(1) of this section) 
shall cease to be foreclosure property on the first day (occurring more 
than 90 days after the day on which the trust acquired the property) on 
which the property is used in a trade or business conducted by the 
trust, other than a trade or business conducted by the trust through an 
independent contractor from whom the trust itself does not derive or 
receive any income. (See section 856(d)(3) for the definition of 
independent contractor.)
    (2) Property held primarily for sale to customers. For the purposes 
of section 856(e)(4)(C), foreclosure property held by the trust 
primarily for sale to customers in the ordinary course of a trade or 
business is considered to be property used in a trade or business 
conducted by the trust. Thus, if a trust holds foreclosure property 
(whether real property or personal property incident to real property) 
for sale to customers in the ordinary course of a trade or business more 
than 90 days after the day on which the trust acquired the real 
property, the trade or business of selling the property must be 
conducted by the trust through an independent contractor from whom the 
trust does not derive or receive any income. Otherwise, after such 90th 
day the property will cease to be foreclosure property.
    (3) Change in use. Foreclosure property will not cease to be 
foreclosure property solely because the use of the property in a trade 
or business by the trust differs from the use to which the property was 
put by the person from whom it was acquired. Thus, for example, if a 
trust acquires a rental apartment building on foreclosure, the property 
will not cease to be foreclosure

[[Page 73]]

property solely because the trust converts the building to a condominium 
apartment building and, through an independent contractor from whom the 
trust derives no income, engages in the trade or business of selling the 
individual condominium units.
    (g) Extension of 2-year grace period--(1) In general. A real estate 
investment trust may apply to the district director of the internal 
revenue district in which is located the principal place of business (or 
principal office or agency) of the trust for an extension of the 2-year 
grace period. If the trust establishes to the satisfaction of the 
district director that an extension of the grace period is necessary for 
the orderly liquidation of the trust's interest in foreclosure property, 
or for an orderly renegotiation of a lease or leases of the property, 
the district director may extend the 2-year grace period. See section 
856(e)(3) (as in effect with respect to the particular extension) for 
rules relating to the maximum length of an extension, and the number of 
extensions which may be granted. An extension of the grace period may be 
granted by the district director either before or after the date on 
which the grace period, but for the extension, would expire. The 
extension shall be effective as of the date on which the grace period, 
but for the extension, would expire.
    (2) Showing required. Generally, in order to establish the necessity 
of an extension, the trust must demonstrate that it has made good faith 
efforts to renegotiate leases with respect to, or dispose of, the 
foreclosure property. In certain cases, however, the trust may establish 
the necessity of an extension even though it has not made such efforts. 
For example, if the trust demonstrates that, for valid business reasons, 
construction of the foreclosure property could not be completed before 
the expiration of the grace period, the necessity of the extension could 
be established even though the trust had made no effort to sell the 
property. For another example, if the trust demonstrates that due to a 
depressed real estate market, it could not sell the foreclosure property 
before the expiration of the grace period except at a distress price, 
the necessity of an extension could be established even though the trust 
had made no effort to sell the property. The fact that property was 
acquired as foreclosure property prior to January 3, 1975 (the date of 
enactment of section 856(e)), generally will be considered as a factor 
(but not a controlling factor) which tends to establish that an 
extension of the grace period is necessary.
    (3) Time for requesting an extension of the grace period. A request 
for an extension of the grace period must be filed with the appropriate 
district director more than 60 days before the day on which the grace 
period would otherwise expire. In the case of a grace period which would 
otherwise expire before August 6, 1976, a request for an extension will 
be considered to be timely filed if filed on or before June 7, 1976.
    (4) Information required. The request for an extension of the grace 
period shall identify the property with respect to which the request is 
being made and shall also include the following information:
    (i) The name, address, and taxpayer identification number of the 
trust,
    (ii) The date the property was acquired as foreclosure property by 
the trust,
    (iii) The taxable year of the trust in which the property was 
acquired,
    (iv) If the trust has been previously granted an extension of the 
grace period with respect to the property, a statement to that effect 
(which shall include the date on which the grace period, as extended, 
expires) and a copy of the information which accompanied the request for 
the previous extension,
    (v) A statement of the reasons why the grace period should be 
extended,
    (vi) A description of any efforts made by the trust after the 
acquisition of the property to dispose of the property or to renegotiate 
any lease with respect to the property, and
    (vii) A description of any other factors which tend to establish 
that an extension of the grace period is necessary for the orderly 
liquidation of the trust's interest in the property, or for an orderly 
renegotiation of a lease or leases of the property.


The trust shall also furnish any additional information requested by the 
district director after the request for extension is filed.

[[Page 74]]

    (5) Automatic extension. If a real estate investment trust files a 
request for an extension with the district director more than 60 days 
before the expiration of the grace period, the grace period shall be 
considered to be extended until the end of the 30th day after the date 
on which the district director notifies the trust by certified mail sent 
to its last known address that the period of extension requested by the 
trust is not granted. For further guidance regarding the definition of 
last known address, see Sec.  301.6212-2 of this chapter. In no event, 
however, shall the rule in the preceding sentence extend the grace 
period beyond the expiration of (i) the period of extension requested by 
the trust, or (ii) the 1-year period following the date that the grace 
period (but for the automatic extension) would expire. The date of the 
postmark on the sender's receipt is considered to be the date of the 
certified mail for purposes of this subparagraph. This subparagraph does 
not apply, however, if the date of the notification by certified mail 
described in the first sentence is more than 30 days before the date 
that the grace period (determined without regard to this subparagraph) 
expires. Moreover, this subparagraph shall not operate to allow any 
period of extension that is prohibited by the last sentence of section 
856(e)(3) (as in effect with respect to the particular extension).
    (6) Extension of time for filing. If a real estate investment trust 
fails to file the request for an extension of the grace period within 
the time provided in paragraph (g)(3) of this section, then the district 
director shall grant a reasonable extension of time for filing such 
request, provided (i) it is established to the satisfaction of the 
district director that there was reasonable cause for failure to file 
the request within the prescribed time and (ii) a request for such 
extension is filed within such time as the district director considers 
reasonable under the circumstances.
    (7) Status of taxpayer. The reference to ``real estate investment 
trust'' or ``trust'' in this paragraph (g) shall be considered to 
include a taxpayer that is not a qualified real estate investment trust, 
if the taxpayer establishes to the satisfaction of the district director 
that its failure to be a qualified real estate investment trust for the 
taxable year was due to reasonable cause and not due to willful neglect. 
The principles of Sec.  1.856-7(c) and Sec.  1.856-8(d) (including the 
principles relating to expert advice) shall apply for determining 
reasonable cause (and absence of willful neglect) for this purpose.

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

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



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

    (a) In general. A corporation, trust, or association which fails to 
meet the requirements of paragraph (2) or (3) of section 856(c), or of 
both such paragraphs, for any taxable year nevertheless is considered to 
have satisfied these requirements if the corporation, trust, or 
association meets the requirements of subparagraphs (A), (B), and (C) of 
section 856(c)(7) (relating to a schedule attached to the return, the 
absence of fraud, and reasonable cause).
    (b) Contents of the schedule. The schedule required by subparagraph 
(A) of section 856(c)(7) must contain a breakdown, or listing, of the 
total amount of gross income falling under each of the separate 
subparagraphs of section 856(c) (2) and (3). Thus, for example, the real 
estate investment trust, for purposes of listing its income from the 
sources described in section 856(c)(2), would list separately the total 
amount of dividends, the total amount of interest, the total amount of 
rents from real property, etc. The listing is not required to be on a 
lease-by-lease, loan-by-loan, or project-by-project basis, but the real 
estate investment

[[Page 75]]

trust must maintain adequate records on such a basis with which to 
substantiate each total amount listed in the schedule.
    (c) Reasonable cause--(1) In general. The failure to meet the 
requirements of paragraph (2) or (3) of section 856(c) (or of both 
paragraphs) will be considered due to reasonable cause and not due to 
willful neglect if the real estate investment trust exercised ordinary 
business care and prudence in attempting to satisfy the requirements. 
Such care and prudence must be exercised at the time each transaction is 
entered into by the trust. However, even if the trust exercised ordinary 
business care and prudence in entering into a transaction, if the trust 
later determines that the transaction results in the receipt or accrual 
of nonqualified income and that the amounts of such nonqualified income, 
in the context of the trust's overall portfolio, reasonably can be 
expected to cause a source-of-income requirement to be failed, the trust 
must use ordinary business care and prudence in an effort to renegotiate 
the terms of the transaction, dispose of property acquired or leased in 
the transaction, or alter other elements of its portfolio. In any case, 
failure to meet an income source requirement will be considered due to 
willful neglect and not due to reasonable cause if the failure is 
willful and the trust could have avoided such failure by taking actions 
not inconsistent with ordinary business care and prudence. For example, 
if the trust enters into a lease knowing that it will produce 
nonqualified income which reasonably can be expected to cause a source-
of-income requirement to be failed, the failure is due to willful 
neglect even if the trust has a legitimate business purpose for entering 
into the lease.
    (2) Expert advice--(i) In general. The reasonable reliance on a 
reasoned, written opinion as to the characterization for purposes of 
section 856 of gross income to be derived (or being derived) from a 
transaction generally constitutes ``reasonable cause'' if income from 
that transaction causes the trust to fail to meet the requirements of 
paragraph (2) or (3) of section 856(c) (or of both paragraphs). The 
absence of such a reasoned, written opinion with respect to a 
transaction does not, by itself, give rise to any inference that the 
failure to meet a percentage of income requirement was without 
reasonable cause. An opinion as to the character of income from a 
transaction includes an opinion pertaining to the use of a standard form 
of transaction or standard operating procedure in a case where such 
standard form or procedure is in fact used or followed.
    (ii) If the opinion indicates that a portion of the income from a 
transaction will be nonqualifed income, the trust must still exercise 
ordinary business care and prudence with respect to the nonqualified 
income and determine that the amount of that income, in the context of 
its overall portfolio, reasonably cannot be expected to cause a source-
of-income requirement to be failed. Reliance on an opinion is not 
reasonable if the trust has reason to believe that the opinion is 
incorrect (for example, because the trust withholds facts from the 
person rendering the opinion).
    (iii) Reasoned written opinion. For purposes of this subparagraph 
(2), a written opinion means an opinion, in writing, rendered by a tax 
advisor (including house counsel) whose opinion would be relied on by a 
person exercising ordinary business care and prudence in the 
circumstances of the particular transaction. A written opinion is 
considered ``reasoned'' even if it reaches a conclusion which is 
subsequently determined to be incorrect, so long as the opinion is based 
on a full disclosure of the factual situation by the real estate 
investment trust and is addressed to the facts and law which the person 
rendering the opinion believes to be applicable. However, an opinion is 
not considered ``reasoned'' if it does nothing more than recite the 
facts and express a conclusion.
    (d) Application of section 856(c)(7) to taxable years beginning 
before October 5, 1976. Pursuant to section 1608(b) of the Tax Reform 
Act of 1976, paragraph (7) of section 856(c) and this section apply to a 
taxable year of a real estate investment trust which begins before 
October 5, 1976, only if as the result of a determination occurring 
after October

[[Page 76]]

4, 1976, the trust does not meet the requirements of paragraph (2) or 
(3) of section 856(c), or both paragraphs, as in effect for the taxable 
year. The requirement that the schedule described in subparagraph (A) of 
section 856(c)(7) be attached to the income tax return of a real estate 
investment trust in order for section 856(c)(7) to apply is not 
applicable to taxable years beginning before October 5, 1976. For 
purposes of section 1608(b) of the Tax Reform Act of 1976 and this 
paragraph, the rules relating to determinations prescribed in section 
860(e) and Sec.  1.860-2(b)(1) (other than the second, third, and last 
sentences of Sec.  1.860-2(b)(1)(ii)) shall apply. However, a 
determination consisting of an agreement between the taxpayer and the 
district director (or other official to whom authority to sign the 
agreement is delegated) shall set forth the amount of gross income for 
the taxable year to which the determination applies, the amount of the 
90 percent and 75 percent source-of-income requirements for the taxable 
year to which the determination applies, and the amount by which the 
real estate investment trust failed to meet either or both of the 
requirements. The agreement shall also set forth the amount of tax for 
which the trust is liable pursuant to section 857(b)(5). The agreement 
shall also contain a finding as to whether the failure to meet the 
requirements of paragraph (2) or (3) of section 856(c) (or of both 
paragraphs) was due to reasonable cause and not due to willful neglect.

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

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



Sec.  1.856-8  Revocation or termination of election.

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


The revocation may be made only with respect to a taxable year beginning 
after October 4, 1976, and is effective for the taxable year in which 
made and for all succeeding taxable years. A revocation with respect to 
a taxable year beginning after October 4, 1976, that is filed before 
February 6, 1981, in the time and manner prescribed in Sec.  7.856(g)-1 
of this chapter (as in effect when the revocation was filed) is 
considered to meet the requirements of this paragraph.
    (b) Termination of election to be a real estate investment trust. An 
election of a corporation, trust, or association under section 856(c)(1) 
to be a real estate investment trust shall terminate if the corporation, 
trust, or association is not a qualified real estate investment trust 
for any taxable year (including the taxable year with respect to which 
the election is made) beginning after October 4, 1976. (This election 
terminates whether the failure to be a qualified

[[Page 77]]

real estate investment trust is intentional or inadvertent.) The term 
``taxable year'' includes a taxable year of less than 12 months for 
which a return is made under section 443. The termination of the 
election is effective for the first taxable year beginning after October 
4, 1976, for which the corporation, trust, or association is not a 
qualified real estate investment trust and for all succeeding taxable 
years.
    (c) Restrictions on election after termination or revocation--(1) 
General rule. Except as provided in paragraph (d) of this section, if a 
corporation, trust, or association has made an election under section 
856(c)(1) to be a real estate investment trust and the election has been 
terminated or revoked under section 856(g)(1) or (2), the corporation, 
trust, or association (and any successor corporation, trust, or 
association) is not eligible to make a new election under section 
856(c)(1) for any taxable year prior to the fifth taxable year which 
begins after the first taxable year for which the termination or 
revocation is effective.
    (2) Successor corporation. The term ``successor corporation, trust, 
or association'', as used in section 856(g)(3), means a corporation, 
trust, or association which meets both a continuity of ownership 
requirement and a continuity of assets requirement with respect to the 
corporation, trust, or association whose election has been terminated 
under section 856(g)(1) or revoked under section 856(g)(2). A 
corporation, trust, or association meets the continuity of ownership 
requirement only if at any time during the taxable year the persons who 
own, directly or indirectly, 50 percent or more in value of its 
outstanding shares owned, at any time during the first taxable year for 
which the termination or revocation was effective, 50 percent or more in 
value of the outstanding shares of the corporation, trust, or 
association whose election has been terminated or revoked. A 
corporation, trust, or association meets the continuity of assets 
requirement only if either (i) a substantial portion of its assets were 
assets of the corporation, trust, or association whose election has been 
revoked or terminated, or (ii) it acquires a substantial portion of the 
assets of the corporation, trust, or association whose election has been 
terminated or revoked.
    (3) Effective date. Section 856(g)(3) does not apply to the 
termination of an election that was made by a taxpayer pursuant to 
section 856(c)(1) on or before October 4, 1976, unless the taxpayer is a 
qualified real estate investment trust for a taxable year ending after 
October 4, 1976, for which the pre-October 5, 1976, election is in 
effect. For example, assume that Trust X, a calendar year taxpayer, 
files a timely election under section 856(c)(1) with respect to its 
taxable year 1974, and is a qualified real estate investment trust for 
calendar years 1974 and 1975. Assume further that Trust X is not a 
qualified real estate investment trust for 1976 and 1977 because it 
willfully fails to meet the asset diversification requirements of 
section 856(c)(5) for both years. The failure (whether or not willful) 
to meet these requirements in 1977 terminates the election to be a real 
estate investment trust made with respect to 1974. (See paragraph (b) of 
this section.) The termination is effective for 1977 and all succeeding 
taxable years. However, under section 1608(d)(3) of the Tax Reform Act 
of 1976, Trust X is not prohibited by section 856(g)(3) from making a 
new election under section 856(c)(1) with respect to 1978.
    (d) Exceptions. Section 856(g)(4) provides an exception to the 
general rule of section 856(g)(3) that the termination of an election to 
be a real estate investment trust disqualifies the corporation, trust, 
or association from making a new election for the 4 taxable years 
following the first taxable year for which the termination is effective. 
This exception applies where the corporation, trust, or association 
meets the requirements of section 856(g)(4)(A), (B) and (C) (relating to 
the timely filing of a return, the absence of fraud, and reasonable 
cause, respectively) for the taxable year with respect to which the 
termination of election occurs. In order to meet the requirements of 
section 856(g)(4)(C), the corporation, trust, or association must 
establish, to the satisfaction of the district director for the internal 
revenue district in which the corporation, trust, or association 
maintains its

[[Page 78]]

principal place of business or principal office or agency, that its 
failure to be a qualified real estate investment trust for the taxable 
year in question was due to reasonable cause and not due to willful 
neglect. The principles of Sec.  1.856-7(c) (including the principles 
relating to expert advice) will apply in determining whether, for 
purposes of section 856(g)(4), the failure of a corporation, trust, or 
association to be a qualified real estate investment trust for a taxable 
year was due to reasonable cause and not due to willful neglect. Thus, 
for example, the corporation, trust, or association must exercise 
ordinary business care and prudence in attempting to meet the status 
conditions of section 856(a) and the distribution and recordkeeping 
requirements of section 857(a), as well as the gross income requirements 
of section 856(c). The provisions of section 856(g)(4) do not apply to a 
taxable year in which the corporation, trust, or association makes a 
valid revocation, under section 856(g)(2), of an election to be a real 
estate investment trust.

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

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



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

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

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

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

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



Sec.  1.856-10  Definition of real property.

    (a) In general. This section provides definitions for purposes of 
part II, subchapter M, chapter 1 of the Internal Revenue Code. Paragraph 
(b) of this section defines real property, which includes land as 
defined under paragraph

[[Page 79]]

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

[[Page 80]]

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

[[Page 81]]

any other assets to which the asset relates to determine if the asset is 
real property, whether as land, an inherently permanent structure, or a 
structural component of an inherently permanent structure.
    (2) Facts and circumstances. The determination of whether a 
particular separately identifiable item of property is a distinct asset 
is based on all the facts and circumstances. In particular, the 
following factors must be taken into account:
    (i) Whether the item is customarily sold or acquired as a single 
unit rather than as a component part of a larger asset;
    (ii) Whether the item can be separated from a larger asset, and if 
so, the cost of separating the item from the larger asset;
    (iii) Whether the item is commonly viewed as serving a useful 
function independent of a larger asset of which it is a part; and
    (iv) Whether separating the item from a larger asset of which it is 
a part impairs the functionality of the larger asset.
    (f) Intangible assets--(1) In general. To the extent that an 
intangible asset, including an intangible asset established under 
generally accepted accounting principles (GAAP) as a result of an 
acquisition of real property or an interest in real property, derives 
its value from real property or an interest in real property, is 
inseparable from that real property or interest in real property, and 
does not produce or contribute to the production of income other than 
consideration for the use or occupancy of space, the intangible asset is 
real property or an interest in real property.
    (2) Licenses and permits. A license, permit, or other similar right 
that is solely for the use, enjoyment, or occupation of land or an 
inherently permanent structure and that is in the nature of a leasehold 
or easement generally is an interest in real property. A license or 
permit to engage in or operate a business is not real property or an 
interest in real property if the license or permit produces or 
contributes to the production of income other than consideration for the 
use or occupancy of space.
    (g) Examples. The following examples demonstrate the rules of this 
section. Examples 1 and 2 illustrate the definition of land as provided 
in paragraph (c) of this section. Examples 3 through 10 illustrate the 
definition of improvements to land as provided in paragraph (d) of this 
section. Finally, Examples 11 through 13 illustrate whether certain 
intangible assets are real property or interests in real property as 
provided in paragraph (f) of this section.

    Example 1. Natural products of land. A is a REIT. REIT A owns land 
with perennial fruit-bearing plants. REIT A leases the fruit-bearing 
plants to a tenant and grants the tenant an easement to enter the land 
to cultivate the plants and to harvest the fruit. The lease and easement 
are long-term and REIT A provides no services to the tenant. The 
unsevered plants are natural products of the land and are land within 
the meaning of paragraph (c) of this section. The tenant annually 
harvests fruit from the plants. Upon severance from the land, the 
harvested fruit ceases to qualify as land. Storage of the harvested 
fruit upon or within real property does not cause the harvested fruit to 
be real property.
    Example 2. Water space superjacent to land. REIT B leases a marina 
from a governmental entity. The marina is comprised of U-shaped boat 
slips and end ties. The U-shaped boat slips are spaces on the water that 
are surrounded by a dock on three sides. The end ties are spaces on the 
water at the end of a slip or on a long, straight dock. REIT B rents the 
boat slips and end ties to boat owners. The boat slips and end ties are 
water space superjacent to land that is land within the meaning of 
paragraph (c) of this section and, therefore, are real property.
    Example 3. Indoor sculpture. (i) REIT C owns an office building and 
a large sculpture in the atrium of the building. The sculpture measures 
30 feet tall by 18 feet wide and weighs five tons. The building was 
specifically designed to support the sculpture, which is permanently 
affixed to the building by supports embedded in the building's 
foundation. The sculpture was constructed within the building. Removal 
would be costly and time consuming and would destroy the sculpture. The 
sculpture is reasonably expected to remain in the building indefinitely. 
The sculpture does not manufacture, create, produce, convert, transport, 
or serve any similar active function.
    (ii) The sculpture is not an asset listed in paragraph 
(d)(2)(iii)(B) of this section, and, therefore, the sculpture is an 
asset that must be analyzed to determine whether it is an inherently 
permanent structure using the factors provided in paragraph (d)(2)(iv) 
of this section. The sculpture--

[[Page 82]]

    (A) Is permanently affixed to the building by supports embedded in 
the building's foundation;
    (B) Is not designed to be removed and is designed to remain in place 
indefinitely;
    (C) Would be damaged if removed and would damage the building to 
which it is affixed;
    (D) Will remain affixed to the building after any tenant vacates the 
premises and will remain affixed to the building indefinitely; and
    (E) Would require significant time and expense to move.
    (iii) The factors described in this paragraph (g) Example 3 (ii)(A) 
through (E) all support the conclusion that the sculpture is an 
inherently permanent structure within the meaning of paragraph (d)(2) of 
this section and, therefore, is real property.
    Example 4. Bus shelters. (i) REIT D owns 400 bus shelters, each of 
which consists of four posts, a roof, and panels enclosing two or three 
sides. REIT D enters into a long-term lease with a local transit 
authority for use of the bus shelters. Each bus shelter is prefabricated 
from steel and is bolted to the sidewalk. Bus shelters are disassembled 
and moved when bus routes change. Moving a bus shelter takes less than a 
day and does not significantly damage either the bus shelter or the real 
property to which it was affixed.
    (ii) The bus shelters are not permanently affixed enclosed 
transportation stations or terminals and do not otherwise meet the 
definition of a building in paragraph (d)(2)(ii) of this section nor are 
they listed as types of other inherently permanent structures in 
paragraph (d)(2)(iii)(B) of this section. Therefore, the bus shelters 
must be analyzed to determine whether they are inherently permanent 
structures using the factors provided in paragraph (d)(2)(iv) of this 
section. The bus shelters--
    (A) Are not permanently affixed to the land or an inherently 
permanent structure;
    (B) Are designed to be removed and are not designed to remain in 
place indefinitely;
    (C) Would not be damaged if removed and would not damage the 
sidewalks to which they are affixed;
    (D) Will not remain affixed after the local transit authority 
vacates the site and will not remain affixed indefinitely; and
    (E) Would not require significant time and expense to move.
    (iii) The factors described in this paragraph (g) Example 4 (ii)(A) 
through (E) all support the conclusion that the bus shelters are not 
inherently permanent structures within the meaning of paragraph (d)(2) 
of this section. Although the bus shelters serve a passive function of 
sheltering, the bus shelters are not permanently affixed, which means 
the bus shelters are not inherently permanent structures within the 
meaning of paragraph (d)(2) of this section and, therefore, are not real 
property.
    Example 5. Cold storage warehouse. (i) REIT E owns a refrigerated 
warehouse (Cold Storage Warehouse). REIT E enters into a long-term lease 
with a tenant. REIT E neither operates the Cold Storage Warehouse nor 
provides services to its tenant. The tenant uses the Cold Storage 
Warehouse to store perishable products. Certain components and utility 
systems that are integrated into the Cold Storage Warehouse have been 
customized to accommodate the tenant's need for refrigerated storage 
space. For example, the Cold Storage Warehouse has customized freezer 
walls and a central refrigeration system. Freezer walls within the Cold 
Storage Warehouse are specifically designed to maintain the desired 
temperature within the Cold Storage Warehouse. The freezer walls and 
central refrigeration system comprise a series of interconnected assets 
that work together to serve a utility-like function within the Cold 
Storage Warehouse, were installed during construction of the building, 
and will remain in place when the tenant vacates the premises. The 
freezer walls and central refrigeration system were designed to remain 
permanently in place.
    (ii) Walls and central refrigeration systems are listed as 
structural components in paragraph (d)(3)(ii) of this section and, 
therefore, are real property. The customization of the freezer walls 
does not affect their qualification as structural components of REIT E's 
Cold Storage Warehouse within the meaning of paragraph (d)(3) of this 
section. Therefore, the freezer walls and central refrigeration system 
are structural components of REIT E's Cold Storage Warehouse.
    Example 6. Data center. (i) REIT F owns a building that it leases to 
a tenant under a long-term lease. REIT F neither operates the building 
nor provides services to its tenant. To accommodate the particular 
requirements for housing computer servers, certain interior components 
and utility systems within the building have been customized to provide 
a higher level of functionality than a conventional office building. 
These customized systems are owned by REIT F and include an electrical 
distribution and redundancy system (Electrical System), a central 
heating and air-conditioning system, a telecommunication infrastructure 
system, an integrated security system, a fire suppression system, and a 
humidity control system (each, a System). In addition, the space for 
computer servers in REIT F's building has been constructed with raised 
flooring that is integrated into the building to accommodate the 
Systems. Each System is comprised of a series of interconnected assets 
that work together to serve a utility-like function within the building. 
The Systems are integrated

[[Page 83]]

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

[[Page 84]]

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

[[Page 85]]

space. Thus, the PV Modules are not structural components of REIT H's 
mounts within the meaning of paragraph (d)(3) of this section and, 
therefore, are not real property.
    (vii) The exit wire is buried under the ground and transmits the 
electricity produced by the PV Modules to the electrical power grid. The 
exit wire was installed during construction of the solar energy site and 
is designed to remain permanently in place. The exit wire is permanently 
affixed and is a transmission line, which is listed as an inherently 
permanent structure in paragraph (d)(2)(iii)(B) of this section. 
Therefore, the exit wire is real property.
    Example 9. Solar-powered building. (i) REIT I owns a solar energy 
site similar to that described in Example 8, except that REIT I's solar 
energy site assets (Solar Energy Site Assets) are mounted on land 
adjacent to an office building owned by REIT I. REIT I leases the office 
building and the solar energy site to a single tenant. REIT I does not 
operate the office building or the solar energy site and does not 
provide services to its tenant. Although the tenant occasionally 
transfers excess electricity produced by the Solar Energy Site Assets to 
a utility company, the Solar Energy Site Assets are designed and 
intended to produce electricity only to serve the office building. The 
size and specifications of the Solar Energy Site Assets were designed to 
be appropriate to serve only the electricity needs of the office 
building. Although the Solar Energy Site Assets were not installed 
during construction of the office building, no facts indicate either 
that the Solar Energy Site Assets will not remain in place indefinitely 
or that they may be removed if the tenant vacates the premises.
    (ii) With the exception of the occasional transfers of excess 
electricity to a utility company, the Solar Energy Site Assets serve the 
office building to which they are adjacent, and, therefore, the Solar 
Energy Site Assets are analyzed to determine whether they are a 
structural component using the factors provided in paragraph (d)(3)(iii) 
of this section. The Solar Energy Site Assets--
    (A) Are expensive and time consuming to install and remove;
    (B) Were designed with the size and specifications needed to serve 
only the office building;
    (C) Will be damaged, but will not cause damage to the office 
building, upon removal;
    (D) Serve a utility-like function with respect to the office 
building;
    (E) Serve the office building in its passive functions of 
containing, sheltering, and protecting the tenant and the tenant's 
assets;
    (F) Produce income from consideration for the use or occupancy of 
space within the office building;
    (G) Were not installed during construction of the office building; 
and
    (H) Will remain in place when the tenant vacates the premises.
    (iii) The factors described in this paragraph (g) Example 9 (ii)(A) 
through (C) (in part), (ii)(D) through (F), and (ii)(H) all support the 
conclusion that the Solar Energy Site Assets are a structural component 
of REIT I's office building within the meaning of paragraph (d)(3) of 
this section and, therefore, are real property. The factors described in 
this paragraph (g) Example 9 (ii)(C) (in part) and (ii)(G) would support 
a conclusion that the Solar Energy Site Assets are not a structural 
component, but these factors do not outweigh the factors supporting the 
conclusion that the Solar Energy Site Assets are a structural component.
    (iv) The result in this Example 9 would not change if, instead of 
the Solar Energy Site Assets, solar shingles were used as the roof of 
REIT I's office building. Solar shingles are roofing shingles like those 
commonly used for residential housing, except that they contain built-in 
PV modules. The solar shingle installation was specifically designed and 
constructed to serve only the needs of REIT I's office building, and the 
solar shingles were installed as a structural component to provide solar 
energy to REIT I's office building (although REIT I's tenant 
occasionally transfers excess electricity produced by the solar shingles 
to a utility company). The analysis of the application of the factors 
provided in paragraph (d)(3)(ii) of this section would be similar to the 
analysis of the application of the factors to the Solar Energy Site 
Assets in this paragraph (g) Example 9 (ii) and (iii).
    Example 10. Pipeline transmission system. (i) REIT J owns a natural 
gas pipeline transmission system that provides a conduit to transport 
natural gas from unrelated third-party producers and gathering 
facilities to unrelated third-party distributors and end users. REIT J 
enters into a long-term lease with a tenant for the pipeline 
transmission system. REIT J neither operates the pipeline transmission 
system nor provides services to its tenant. The pipeline transmission 
system is comprised of underground pipelines, isolation valves and 
vents, pressure control and relief valves, meters, and compressors. 
Although the pipeline transmission system as a whole serves an active 
function (transporting natural gas), one or more distinct assets within 
the system may nevertheless be inherently permanent structures that do 
not themselves perform active functions. Each of these distinct assets 
was installed during construction of the pipeline transmission system 
and will remain in place when the tenant vacates the pipeline 
transmission system. Each of these assets was designed to remain 
permanently in place.
    (ii) The pipelines are permanently affixed and are listed as other 
inherently permanent structures in paragraph (d)(2)(iii)(B) of this

[[Page 86]]

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

[[Page 87]]

to operate a casino is not a right for the use, enjoyment, or occupation 
of REIT M's building but is rather a license to engage in the business 
of operating a casino in the building. Therefore, the casino license is 
not real property.

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

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



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

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


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

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

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



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

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

[[Page 88]]

amount which bears the same proportion to the total dividends paid or 
considered as paid during the taxable year that otherwise meet the 
requirements for the deduction for dividends paid (as defined in section 
561) as the real estate investment trust taxable income (determined 
without regard to the deduction for dividends paid) bears to the sum 
of--
    (A) The real estate investment trust taxable income (determined 
without regard to the deduction for dividends paid), and
    (B) The amount by which the net income from foreclosure property 
exceeds the tax imposed on such income by section 857(b)(4)(A).


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

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

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



Sec.  1.857-3  Net income from foreclosure property.

    (a) In general. For purposes of section 857(b)(40(B), net income 
from foreclosure property means the aggregate of--

[[Page 89]]

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


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


The apportionment may be made on any reasonable basis.
    (e) Allocation and apportionment of interest. For purposes of 
determining the amount of interest attributable to the carrying of 
foreclosure property under paragraph (b) of this section, the following 
rules apply:
    (1) Deductible interest. Interest is taken into account under this 
paragraph (e) only if it is otherwise deductible under chapter 1 of the 
Code.
    (2) Interest specifically allocated to property. Interest that is 
specifically allocated to an item of property is attributable only to 
the carrying of that property. Interest is specifically allocated to an 
item of property if (i) the indebtedness on which the interest is paid 
or accrued is secured only by that property, (ii) such indebtedness was 
specifically incurred for the purpose of purchasing, constructing, 
maintaining, or improving that property, and (iii) the proceeds of the 
borrowing were applied for that purpose.

[[Page 90]]

    (3) Other interest. Interest which is not specifically allocated to 
property is apportioned between foreclosure property and other property 
under the principles of Sec.  1.861-8(e)(2)(v).
    (4) Effective date. The rules in this paragraph (e) are mandatory 
for all taxable years ending after February 6, 1981.

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

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



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

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

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

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



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

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

[[Page 91]]

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

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

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



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

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

[[Page 92]]

(relating to the determination of holding periods for purposes of the 
deduction for dividends received) shall be applied in determining 
whether, for purposes of section 857(b)(7)(B) and this paragraph, a 
share of real estate investment trust stock has been held for a period 
of less than 31 days. In applying those rules, however, ``30 days'' 
shall be substituted for the number of days specified in subparagraph 
(B) of such section.
    (3) Illustration. The application of section 857(b)(7) and this 
paragraph may be illustrated by the following example:

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

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

[[Page 93]]

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

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

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



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

    (a) Any real estate investment trust whether or not such trust meets 
the requirements of section 857(a) and paragraph (a) of Sec.  1.857-1 
for any taxable year beginning after December 31, 1960 shall apply 
paragraph (b) of this section in computing its earnings and profits for 
such taxable year.
    (b) In the determination of the earnings and profits of a real 
estate investment trust, section 857(d) provides that such earnings and 
profits for any taxable year (but not the accumulated earnings and 
profits) shall not be reduced by any amount which is not allowable as a 
deduction in computing its taxable income for the taxable year.

[[Page 94]]

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

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

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



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

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

[[Page 95]]

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

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

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



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

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

[[Page 96]]

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

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

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



Sec.  1.857-10  Information returns.

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

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

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



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

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

[[Page 97]]

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

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



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

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

[[Page 98]]

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

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

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

[[Page 99]]

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

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

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



Sec.  1.860-1  Deficiency dividends.

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

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

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



Sec.  1.860-2  Requirements for deficiency dividends.

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


[[Page 100]]



The amount of the deduction is subject to the applicable limitations 
under sections 562 and 860(f)(2). Thus, if the entity distributes to an 
individual shareholder property (other than money) which on the date of 
the distribution has a fair market value in excess of its adjusted basis 
in the hands of the entity, the amount of the deficiency dividend in the 
individual's hands for purposes of section 316(b)(3) is determined by 
using the property's fair market value on that date. Nevertheless, the 
amount of the deficiency dividend the entity may deduct is limited, 
under Sec.  1.562-1(a), to the adjusted basis of the property and the 
amount taxable to the individual as a dividend is determined by 
reference to the current and accumulated earnings and profits for the 
year to which the determination applies.
    (ii) The qualified investment entity does not have to distribute the 
full amount of the adjustment in order to pay a deficiency dividend. For 
example, assume that in 1983 a determination with respect to a calendar 
year regulated investment company results in an increase of $100 in 
investment company taxable income (computed without the dividends paid 
deduction) for 1981 and no other change. The regulated investment 
company may choose to pay a deficiency dividend of $100 or of any lesser 
amount and be allowed a dividends paid deduction for 1981 for the amount 
of that deficiency dividend.
    (4) Status of distributor. The corporation, trust, or association 
that pays the deficiency dividend does not have to be a qualified 
investment entity at the time of payment.
    (5) Certain definitions to apply. For purposes of sections 860(d) 
(defining adjustment) and (f)(2) (limitations) the definitions of the 
terms ``investment company taxable income,'' ``real estate investment 
trust taxable income,'' and ``capital gains dividends'' in sections 
852(b)(2), 857(b)(2), 852(b)(3)(C), and 857(b)(3)(C) apply, as 
appropriate to the particular entity.
    (b) Determination and claim for deduction--(1) Determination. For 
purposes of applying section 860(e), the following rules apply:
    (i) The date of determination by a decision of the United States Tax 
Court, the date upon which a judgment of a court becomes final, and the 
date of determination by a closing agreement shall be determined under 
the rules in Sec.  1.547-2(b)(1) (ii), (iii), and (iv).
    (ii) A determination under section 860(e)(3) may be made by an 
agreement signed by the district director or another official to whom 
authority to sign the agreement is delegated, and by or on behalf of the 
taxpayer. The agreement shall set forth the amount, if any, of each 
adjustment described in subparagraphs (A), (B), and (C) of section 
860(d) (1) or (2) (as appropriate) for the taxable year and the amount 
of the liability for any tax imposed by section 11(a), 56(a), 852(b)(1), 
852(b)(3)(A), 857(b)(1), 857(b)(3)(A), or 1201(a) for the taxable year. 
The agreement shall also set forth the amount of the limitation 
(determined under section 860(f)(2)) on the amount of deficiency 
dividends that can qualify as capital gain dividends and ordinary 
dividends, respectively, for the taxable year. An agreement under this 
subdivision (ii) which is signed by the district director (or other 
delegate) shall be sent to the taxpayer at its last known address by 
either registered or certified mail. For further guidance regarding the 
definition of last known address, see Sec.  301.6212-2 of this chapter. 
If registered mail is used, the date of registration is the date of 
determination. If certified mail is used, the date of the postmark on 
the sender's receipt is the date of determination. However, if a 
dividend is paid by the taxpayer before the registration or postmark 
date, but on or after the date the agreement is signed by the district 
director (or other delegate), the date of determination is the date of 
signing.
    (2) Claim for deduction. A claim for deduction for a deficiency 
dividend shall be made, with the requisite declaration, on Form 976 and 
shall contain the following information and have the following 
attachments:
    (i) The name, address, and taxpayer identification number of the 
corporation, trust, or association;
    (ii) The amount of the deficiency and the taxable year or years 
involved;
    (iii) The amount of the unpaid deficiency or, if the deficiency has 
been

[[Page 101]]

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

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

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

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



Sec.  1.860-3  Interest and additions to tax.

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

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

[[Page 102]]

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

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

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



Sec.  1.860-4  Claim for credit or refund.

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

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

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

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



Sec.  1.860-5  Effective date.

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

[[Page 103]]

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

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

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



Sec.  1.860A-0  Outline of REMIC provisions.

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

         Section 1.860A-1 Effective dates and transition rules.

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

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

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

                  Sec.  1.860D-1 Definition of a REMIC.

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

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

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

[[Page 104]]

    (d) Transfers to foreign persons.

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

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

                 Sec.  1.860F-1 Qualified liquidations.

                  Sec.  1.860F-2 Transfers to a REMIC.

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

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

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

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

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

[[Page 105]]

    (5) Interest disproportionate to principal.
    (i) In general.
    (ii) Exception.
    (6) Regular interest treated as a debt instrument for all Federal 
income tax purposes.
    (c) Residual interest.
    (d) Issue price of regular and residual interests.
    (1) In general.
    (2) The public.
    (e) Transition from certain interbank offered rates.
    (1) In general.
    (2) Change in reference rate for a regular interest after the 
startup day.
    (3) Contingencies of rate on a regular interest.
    (4) Reasonable expenses incurred to make covered modifications.

                       Sec.  1.860G-2 Other rules.

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

              Sec.  1.860G-3 Treatment of foreign persons.

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

[[Page 106]]

    (2) Excess inclusion income allocated by certain pass-through 
entities to a foreign person.

[T.D. 8458, 57 FR 61299, Dec. 24, 1992; 58 FR 15089, Mar. 19, 1993, as 
amended by T.D. 8614, 60 FR 42787, Aug. 17, 1995; T.D. 9004, 67 FR 
47453, July 19, 2002; T.D. 9128, 69 FR 26041, May 11, 2004; T.D. 9272, 
71 FR 43365, Aug. 1, 2006; T.D. 9415, 73 FR 40172, July 14, 2008; T.D. 
9463, 74 FR 47438, Sept. 16, 2009; T.D. 9961, 87 FR 175, Jan. 4, 2022]



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

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

[[Page 107]]

accruing to pass-thru entities after March 31, 1988.
    (4) Rate based on current interest rate--(i) In general. Section 
1.860G-1(a)(3)(i) applies to obligations (other than transition 
obligations described in paragraph (b)(4)(iii) of this section) intended 
to qualify as regular interests that are issued on or after April 4, 
1994.
    (ii) Rate based on index. Section 1.860G-1(a)(3)(i) (as contained in 
26 CFR part 1 revised as of April 1, 1994) applies to obligations 
intended to qualify as regular interests that--
    (A) Are issued by a qualified entity (as defined in Sec.  1.860D-
1(c)(3)) whose startup date (as defined in section 860G(a)(9) and Sec.  
1.860G-2(k)) is on or after November 12, 1991; and
    (B) Are either--
    (1) Issued before April 4, 1994; or
    (2) Transition obligations described in paragraph (b)(4)(iii) of 
this section.
    (iii) Transition obligations. Obligations are described in this 
paragraph (b)(4)(iii) if--
    (A) The terms of the obligations and the prices at which the 
obligations are offered are fixed before April 4, 1994; and
    (B) On or before June 1, 1994, a substantial portion of the 
obligations are transferred, with the terms and at the prices that are 
fixed before April 4, 1994, to investors who are unrelated to the 
REMIC's sponsor at the time of the transfer.
    (5) Accounting for REMIC net income of foreign persons. Section 
1.860G-3(b) is applicable to REMIC net income (including excess 
inclusions) of a foreign person with respect to a REMIC residual 
interest if the first net income allocation under section 860C(a)(1) to 
the foreign person with respect to that interest occurs on or after 
August 1, 2006.
    (6) Exceptions for certain modified obligations. Paragraphs 
(a)(8)(i), (b)(3)(v), (b)(3)(vi), and (b)(7) of Sec.  1.860G-2 apply to 
modifications made to the terms of an obligation on or after September 
16, 2009.
    (7) Exceptions for certain modifications of obligations that refer 
to certain interbank offered rates. (i) Paragraphs (e)(2) and (4) of 
Sec.  1.860G-1 apply with respect to a covered modification that occurs 
on or after March 7, 2022. However, paragraphs (e)(2) and (4) of Sec.  
1.860G-1 may be applied with respect to a covered modification that 
occurs before March 7, 2022. See section 7805(b)(7).
    (ii) Paragraph (e)(3) of Sec.  1.860G-1 applies to a regular 
interest in a REMIC issued on or after March 7, 2022. However, paragraph 
(e)(3) of Sec.  1.860G-1 may be applied to a regular interest in a REMIC 
issued before March 7, 2022. See section 7805(b)(7).

[T.D. 8458, 57 FR 61300, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; 58 FR 
15089, Mar. 19, 1993; T.D. 8614, 60 FR 42787, Aug. 17, 1995; T.D. 9272, 
71 FR 43365, Aug. 1, 2006; T.D. 9415, 73 FR 40172, July 14, 2008; T.D. 
9463, 74 FR 47438, Sept. 16, 2009; T.D. 9961, 87 FR 175, Jan. 4, 2022]



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

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

[[Page 108]]

a reasonable convention is ``30 days per month/90 days per quarter/360 
days per year.''
    (d) For rules on the proper accounting for income from inducement 
fees, see Sec.  1.446-6.

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



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

    (a) Treatment of gain or loss. For purposes of determining the 
taxable income or net loss of a REMIC under section 860C(b), any gain or 
loss from the disposition of any asset, including a qualified mortgage 
(as defined in section 860G(a)(3)) or a permitted investment (as defined 
in section 860G(a)(5) and Sec.  1.860G-2(g)), is treated as gain or loss 
from the sale or exchange of property that is not a capital asset.
    (b) Deductions allowable to a REMIC--(1) In general. Except as 
otherwise provided in section 860C(b) and in paragraph (b)(2) through 
(5) of this section, the deductions allowable to a REMIC for purposes of 
determining its taxable income or net loss are those deductions that 
would be allowable to an individual, determined by taking into account 
the same limitations that apply to an individual.
    (2) Deduction allowable under section 163. (i) A REMIC is allowed a 
deduction, determined without regard to section 163(d), for any interest 
expense accrued during the taxable year.
    (ii) For taxable years beginning after December 31, 2017, a REMIC is 
allowed a deduction, determined without regard to section 163(j), for 
any interest expense accrued during the taxable year.
    (3) Deduction allowable under section 166. For purposes of 
determining a REMIC's bad debt deduction under section 166, debt owed to 
the REMIC is not treated as nonbusiness debt under section 166(d).
    (4) Deduction allowable under section 212. A REMIC is not treated as 
carrying on a trade or business for purposes of section 162. Ordinary 
and necessary operating expenses paid or incurred by the REMIC during 
the taxable year are deductible under section 212, without regard to 
section 67. Any expenses that are incurred in connection with the 
formation of the REMIC and that relate to the organization of the REMIC 
and the issuance of regular and residual interests are not treated as 
expenses of the REMIC for which a deduction is allowable under section 
212. See Sec.  1.860F-2(b)(3)(ii) for treatment of those expenses.
    (5) Expenses and interest relating to tax-exempt income. Pursuant to 
section 265(a), a REMIC is not allowed a deduction for expenses and 
interest allocable to tax-exempt income. The portion of a REMIC's 
interest expense that is allocable to tax-exempt interest is determined 
in the manner prescribed in section 265(b)(2), without regard to section 
265(b)(3).

[T.D. 8458, 57 FR 61301, Dec. 24, 1992, as amended by T.D. 9905, 85 FR 
56842, Sept. 14, 2020]



Sec.  1.860D-1  Definition of a REMIC.

    (a) In general. A real estate mortgage investment conduit (or REMIC) 
is a qualified entity, as defined in paragraph (c)(3) of this section, 
that satisfies the requirements of section 860D(a). See paragraph (d)(1) 
of this section for the manner of electing REMIC status.
    (b) Specific requirements--(1) Interests in a REMIC--(i) In general. 
A REMIC must have one class, and only one class, of residual interests. 
Except as provided in paragraph (b)(1)(ii) of this section, every 
interest in a REMIC must be either a regular interest (as defined in 
section 860G(a)(1) and Sec.  1.860G-1(a)) or a residual interest (as 
defined in section 860G(a)(2) and Sec.  1.860G-1(c)).
    (ii) De minimis interests. If, to facilitate the creation of an 
entity that elects REMIC status, an interest in the entity is created 
and, as of the startup day (as defined in section 860G(a)(9) and Sec.  
1.860G-2(k)), the fair market value of that interest is less than the 
lesser of $1,000 or 1/1,000 of one percent of the aggregate fair market 
value of all the regular and residual interests in the REMIC, then, 
unless that interest is specifically designated as an interest in the 
REMIC, the interest is not treated as an interest in the REMIC for 
purposes of section 860D(a) (2) and (3) and paragraph (B)(1)(i) of this 
section.

[[Page 109]]

    (2) Certain rights not treated as interests. Certain rights are not 
treated as interests in a REMIC. Although not an exclusive list, the 
following rights are not interests in a REMIC.
    (i) Payments for services. The right to receive from the REMIC 
payments that represent reasonable compensation for services provided to 
the REMIC in the ordinary course of its operation is not an interest in 
the REMIC. Payments made by the REMIC in exchange for services may be 
expressed as a specified percentage of interest payments due on 
qualified mortgages or as a specified percentage of earnings from 
permitted investments. For example, a mortgage servicer's right to 
receive reasonable compensation for servicing the mortgages owned by the 
REMIC is not an interest in the REMIC.
    (ii) Stripped interests. Stripped bonds or stripped coupons not held 
by the REMIC are not interests in the REMIC even if, in a transaction 
preceding or contemporaneous with the formation of the REMIC, they and 
the REMIC's qualified mortgages were created from the same mortgage 
obligation. For example, the right of a mortgage servicer to receive a 
servicing fee in excess of reasonable compensation from payments it 
receives on mortgages held by a REMIC is not an interest in the REMIC. 
Further, if an obligation with a fixed principal amount provides for 
interest at a fixed or variable rate and for certain contingent payment 
rights (e.g., a shared appreciation provision or a percentage of 
mortgagor profits provision), and the owner of the obligation 
contributes the fixed payment rights to a REMIC and retains the 
contingent payment rights, the retained contingent payment rights are 
not an interest in the REMIC.
    (iii) Reimbursement rights under credit enhancement contracts. A 
credit enhancer's right to be reimbursed for amounts advanced to a REMIC 
pursuant to the terms of a credit enhancement contract (as defined in 
Sec.  1.860G-2 (c)(2)) is not an interest in the REMIC even if the 
credit enhancer is entitled to receive interest on the amounts advanced.
    (iv) Rights to acquire mortgages. The right to acquire or the 
obligation to purchase mortgages and other assets from a REMIC pursuant 
to a clean-up call (as defined in Sec.  1.860G-2(j)) or a qualified 
liquidation (as defined in section 860F(a)(4)), or on conversion of a 
convertible mortgage (as defined in Sec.  1.860G-2(d)(5)), is not an 
interest in the REMIC.
    (3) Asset test--(i) In general. For purposes of the asset test of 
section 860D(a)(4), substantially all of a qualified entity's assets are 
qualified mortgages and permitted investments if the qualified entity 
owns no more than a de minimis amount of other assets.
    (ii) Safe harbor. The amount of assets other than qualified 
mortgages and permitted investments is de minimis if the aggregate of 
the adjusted bases of those assets is less than one percent of the 
aggregate of the adjusted bases of all of the REMIC's assets. 
Nonetheless, a qualified entity that does not meet this safe harbor may 
demonstrate that it owns no more than a de minimis amount of other 
assets.
    (4) Arrangements test. Generally, a qualified entity must adopt 
reasonable arrangements designed to ensure that--
    (i) Disqualified organizations (as defined in section 860E(e)(5)) do 
not hold residual interests in the qualified entity; and
    (ii) If a residual interest is acquired by a disqualified 
organization, the qualified entity will provide to the Internal Revenue 
Service, and to the persons specified in section 860E(e)(3), information 
needed to compute the tax imposed under section 860E(e) on transfers of 
residual interests to disqualified organizations.
    (5) Reasonable arrangements--(i) Arrangements to prevent 
disqualified organizations from holding residual interests. A qualified 
entity is considered to have adopted reasonable arrangements to ensure 
that a disqualified organization (as defined in section 860E(e)(5)) will 
not hold a residual interest if--
    (A) The residual interest is in registered form (as defined in Sec.  
5f.103-1(c) of this chapter); and
    (B) The qualified entity's organizational documents clearly and 
expressly prohibit a disqualified organization from acquiring beneficial 
ownership of a residual interest, and notice of the

[[Page 110]]

prohibition is provided through a legend on the document that evidences 
ownership of the residual interest or through a conspicuous statement in 
a prospectus or private offering document used to offer the residual 
interest for sale.
    (ii) Arrangements to ensure that information will be provided. A 
qualified entity is considered to have made reasonable arrangements to 
ensure that the Internal Revenue Service and persons specified in 
section 860E(e)(3) as liable for the tax imposed under section 860E(e) 
receive the information needed to compute the tax if the qualified 
entity's organizational documents require that it provide to the 
Internal Revenue Service and those persons a computation showing the 
present value of the total anticipated excess inclusions with respect to 
the residual interest for periods after the transfer. See Sec.  1.860E-
2(a)(5) for the obligation to furnish information on request.
    (6) Calendar year requirement. A REMIC's taxable year is the 
calendar year. The first taxable year of a REMIC begins on the startup 
day and ends on December 31 of the same year. If the startup day is 
other than January 1, the REMIC has a short first taxable year.
    (c) Segregated pool of assets--(1) Formation of REMIC. A REMIC may 
be formed as a segregated pool of assets rather than as a separate 
entity. To constitute a REMIC, the assets identified as part of the 
segregated pool must be treated for all Federal income tax purposes as 
assets of the REMIC and interests in the REMIC must be based solely on 
assets of the REMIC.
    (2) Identification of assets. Formation of the REMIC does not occur 
until--
    (i) The sponsor identifies the assets of the REMIC, such as through 
execution of an indenture with respect to the assets; and
    (ii) The REMIC issues the regular and residual interests in the 
REMIC.
    (3) Qualified entity defined. For purposes of this section, the term 
``qualified entity'' includes an entity or a segregated pool of assets 
within an entity.
    (d) Election to be treated as a real estate mortgage investment 
conduit--(1) In general. A qualified entity, as defined in paragraph 
(c)(3) of this section, elects to be treated as a REMIC by timely 
filing, for the first taxable year of its existence, a Form 1066, U.S. 
Real Estate Mortgage Investment Conduit Income Tax Return, signed by a 
person authorized to sign that return under Sec.  1.860F-4(c). See Sec.  
1.9100-1 for rules regarding extensions of time for making elections. 
Once made, this election is irrevocable for that taxable year and all 
succeeding taxable years.
    (2) Information required to be reported in the REMIC's first taxable 
year. For the first taxable year of the REMIC's existence, the qualified 
entity, as defined in paragraph (c)(3) of this section, must provide 
either on its return or in a separate statement attached to its return--
    (i) The REMIC's employer identification number, which must not be 
the same as the identification number of any other entity,
    (ii) Information concerning the terms and conditions of the regular 
interests and the residual interest of the REMIC, or a copy of the 
offering circular or prospectus containing such information,
    (iii) A description of the prepayment and reinvestment assumptions 
that are made pursuant to section 1272(a)(6) and the regulations 
thereunder, including a statement supporting the selection of the 
prepayment assumption,
    (iv) The form of the electing qualified entity under State law or, 
if an election is being made with respect to a segregated pool of assets 
within an entity, the form of the entity that holds the segregated pool 
of assets, and
    (v) Any other information required by the form.
    (3) Requirement to keep sufficient records. A qualified entity, as 
defined in paragraph (c)(3) of this section, that elects to be a REMIC 
must keep sufficient records concerning its investments to show that it 
has complied with the provisions of sections 860A through 860G and the 
regulations thereunder during each taxable year.

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

[[Page 111]]



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

    (a) Excess inclusion cannot be offset by otherwise allowable 
deductions--(1) In general. Except as provided in paragraph (a)(3) of 
this section, the taxable income of any holder of a residual interest 
for any taxable year is in no event less than the sum of the excess 
inclusions attributable to that holder's residual interests for that 
taxable year. In computing the amount of a net operating loss (as 
defined in section 172(c)) or the amount of any net operating loss 
carryover (as defined in section 172(b)(2)), the amount of any excess 
inclusion is not included in gross income or taxable income. Thus, for 
example, if a residual interest holder has $100 of gross income, $25 of 
which is an excess inclusion, and $90 of business deductions, the holder 
has taxable income of $25, the amount of the excess inclusion, and a net 
operating loss of $15 ($75 of other income - $90 of business 
deductions).
    (2) Affiliated groups. If a holder of a REMIC residual interest is a 
member of an affiliated group filing a consolidated income tax return, 
the taxable income of the affiliated group cannot be less than the sum 
of the excess inclusions attributable to all residual interests held by 
members of the affiliated group.
    (3) Special rule for certain financial institutions--(i) In general. 
If an organization to which section 593 applies holds a residual 
interest that has significant value (as defined in paragraph (a)(3)(iii) 
of this section), section 860E(a)(1) and paragraph (a)(1) of this 
section do not apply to that organization with respect to that interest. 
Consequently, an organization to which section 593 applies may use its 
allowable deductions to offset an excess inclusion attributable to a 
residual interest that has significant value, but, except as provided in 
section 860E(a)(4)(A), may not use its allowable deductions to offset an 
excess inclusion attributable to a residual interest held by any other 
member of an affiliated group, if any, of which the organization is a 
member. Further, a net operating loss of any other member of an 
affiliated group of which the organization is a member may not be used 
to offset an excess inclusion attributable to a residual interest held 
by that organization.
    (ii) Ordering rule--(A) In general. In computing taxable income for 
any year, an organization to which section 593 applies is treated as 
having applied its allowable deductions for the year first to offset 
that portion of its gross income that is not an excess inclusion and 
then to offset that portion of its income that is an excess inclusion.
    (B) Example. The following example illustrates the provisions of 
paragraph (a)(3)(ii) of this section:

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

    (iii) Significant value. A residual interest has significant value 
if--
    (A) The aggregate of the issue prices of the residual interests in 
the REMIC is at least 2 percent of the aggregate of the issue prices of 
all residual and regular interests in the REMIC; and
    (B) The anticipated weighted average life of the residual interests 
is at least 20 percent of the anticipated weighted average life of the 
REMIC.
    (iv) Determining anticipated weighted average life--(A) Anticipated 
weighted average life of the REMIC. The anticipated weighted average 
life of a REMIC is the weighted average of the anticipated weighted 
average lives of all classes of interests in the REMIC. This weighted 
average is determined under the formula in paragraph (a)(3)(iv)(B) of 
this section, applied by treating all payments taken into account in 
computing the anticipated weighted average lives of regular and residual 
interests in the REMIC as principal payments on a single regular 
interest.

[[Page 112]]

    (B) Regular interests that have a specified principal amount. 
Generally, the anticipated weighted average life of a regular interest 
is determined by--
    (1) Multiplying the amount of each anticipated principal payment to 
be made on the interest by the number of years (including fractions 
thereof) from the startup day (as defined in section 860G(a)(9) and 
Sec.  1.860G-2(k)) to the related principal payment date;
    (2) Adding the results; and
    (3) Dividing the sum by the total principal paid on the regular 
interest.
    (C) Regular interests that have no specified principal amount or 
that have only a nominal principal amount, and all residual interests. 
If a regular interest has no specified principal amount, or if the 
interest payments to be made on a regular interest are 
disproportionately high relative to its specified principal amount (as 
determined by reference to Sec.  1.860G-1(b)(5)(i)), then, for purposes 
of computing the anticipated weighted average life of the interest, all 
anticipated payments on that interest, regardless of their designation 
as principal or interest, must be taken into account in applying the 
formula set out in paragraph (a)(3)(iv)(B) of this section. Moreover, 
for purposes of computing the weighted average life of a residual 
interest, all anticipated payments on that interest, regardless of their 
designation as principal or interest, must be taken into account in 
applying the formula set out in paragraph (a)(3)(iv)(B) of this section.
    (D) Anticipated payments. The anticipated principal payments to be 
made on a regular interest subject to paragraph (a)(3)(iv)(B) of this 
section, and the anticipated payments to be made on a regular interest 
subject to paragraph (a)(3)(iv)(C) of this section or on a residual 
interest, must be determined based on--
    (1) The prepayment and reinvestment assumptions adopted under 
section 1272(a)(6), or that would have been adopted had the REMIC's 
regular interests been issued with original issue discount; and
    (2) Any required or permitted clean up calls or any required 
qualified liquidation provided for in the REMIC's organizational 
documents.
    (b) Treatment of residual interests held by REITs, RICs, common 
trust funds, and subchapter T cooperatives. [Reserved]
    (c) Transfers of noneconomic residual interests--(1) In general. A 
transfer of a noneconomic residual interest is disregarded for all 
Federal tax purposes if a significant purpose of the transfer was to 
enable the transferor to impede the assessment or collection of tax. A 
significant purpose to impede the assessment or collection of tax exists 
if the transferor, at the time of the transfer, either knew or should 
have known (had ``improper knowledge'') that the transferee would be 
unwilling or unable to pay taxes due on its share of the taxable income 
of the REMIC.
    (2) Noneconomic residual interest. A residual interest is a 
noneconomic residual interest unless, at the time of the transfer--
    (i) The present value of the expected future distributions on the 
residual interest at least equals the product of the present value of 
the anticipated excess inclusions and the highest rate of tax specified 
in section 11(b)(1) for the year in which the transfer occurs; and
    (ii) The transferor reasonably expects that, for each anticipated 
excess inclusion, the transferee will receive distributions from the 
REMIC at or after the time at which the taxes accrue on the anticipated 
excess inclusion in an amount sufficient to satisfy the accrued taxes.
    (3) Computations. The present value of the expected future 
distributions and the present value of the anticipated excess inclusions 
must be computed under the procedure specified in Sec.  1.860E-2(a)(4) 
for determining the present value of anticipated excess inclusions in 
connection with the transfer of a residual interest to a disqualified 
organization.
    (4) Safe harbor for establishing lack of improper knowledge. A 
transferor is presumed not to have improper knowledge if--
    (i) The transferor conducted, at the time of the transfer, a 
reasonable investigation of the financial condition of the transferee 
and, as a result of the investigation, the transferor found that the 
transferee had historically paid its debts as they came due and

[[Page 113]]

found no significant evidence to indicate that the transferee will not 
continue to pay its debts as they come due in the future;
    (ii) The transferee represents to the transferor that it understands 
that, as the holder of the noneconomic residual interest, the transferee 
may incur tax liabilities in excess of any cash flows generated by the 
interest and that the transferee intends to pay taxes associated with 
holding the residual interest as they become due;
    (iii) The transferee represents that it will not cause income from 
the noneconomic residual interest to be attributable to a foreign 
permanent establishment or fixed base (within the meaning of an 
applicable income tax treaty) of the transferee or another U.S. 
taxpayer; and
    (iv) The transfer satisfies either the asset test in paragraph 
(c)(5) of this section or the formula test in paragraph (c)(7) of this 
section.
    (5) Asset test. The transfer satisfies the asset test if it meets 
the requirements of paragraphs (c)(5)(i), (ii) and (iii) of this 
section.
    (i) At the time of the transfer, and at the close of each of the 
transferee's two fiscal years preceding the transferee's fiscal year of 
transfer, the transferee's gross assets for financial reporting purposes 
exceed $100 million and its net assets for financial reporting purposes 
exceed $10 million. For purposes of the preceding sentence, the gross 
assets and net assets of a transferee do not include any obligation of 
any related person (as defined in paragraph (c)(6)(ii) of this section) 
or any other asset if a principal purpose for holding or acquiring the 
other asset is to permit the transferee to satisfy the conditions of 
this paragraph (c)(5)(i).
    (ii) The transferee must be an eligible corporation (defined in 
paragraph (c)(6)(i) of this section) and must agree in writing that any 
subsequent transfer of the interest will be to another eligible 
corporation in a transaction that satisfies paragraphs (c)(4)(i), (ii), 
and (iii) and this paragraph (c)(5). The direct or indirect transfer of 
the residual interest to a foreign permanent establishment (within the 
meaning of an applicable income tax treaty) of a domestic corporation is 
a transfer that is not a transfer to an eligible corporation. A transfer 
also fails to meet the requirements of this paragraph (c)(5)(ii) if the 
transferor knows, or has reason to know, that the transferee will not 
honor the restrictions on subsequent transfers of the residual interest.
    (iii) A reasonable person would not conclude, based on the facts and 
circumstances known to the transferor on or before the date of the 
transfer, that the taxes associated with the residual interest will not 
be paid. The consideration given to the transferee to acquire the 
noneconomic residual interest in the REMIC is only one factor to be 
considered, but the transferor will be deemed to know that the 
transferee cannot or will not pay if the amount of consideration is so 
low compared to the liabilities assumed that a reasonable person would 
conclude that the taxes associated with holding the residual interest 
will not be paid. In determining whether the amount of consideration is 
too low, the specific terms of the formula test in paragraph (c)(7) of 
this section need not be used.
    (6) Definitions for asset test. The following definitions apply for 
purposes of paragraph (c)(5) of this section:
    (i) Eligible corporation means any domestic C corporation (as 
defined in section 1361(a)(2)) other than--
    (A) A corporation which is exempt from, or is not subject to, tax 
under section 11;
    (B) An entity described in section 851(a) or 856(a);
    (C) A REMIC; or
    (D) An organization to which part I of subchapter T of chapter 1 of 
subtitle A of the Internal Revenue Code applies.
    (ii) Related person is any person that--
    (A) Bears a relationship to the transferee enumerated in section 
267(b) or 707(b)(1), using ``20 percent'' instead of ``50 percent'' 
where it appears under the provisions; or
    (B) Is under common control (within the meaning of section 52(a) and 
(b)) with the transferee.
    (7) Formula test. The transfer satisfies the formula test if the 
present value of the anticipated tax liabilities associated with holding 
the residual interest does not exceed the sum of--

[[Page 114]]

    (i) The present value of any consideration given to the transferee 
to acquire the interest;
    (ii) The present value of the expected future distributions on the 
interest; and
    (iii) The present value of the anticipated tax savings associated 
with holding the interest as the REMIC generates losses.
    (8) Conditions and limitations on formula test. The following rules 
apply for purposes of the formula test in paragraph (c)(7) of this 
section.
    (i) The transferee is assumed to pay tax at a rate equal to the 
highest rate of tax specified in section 11(b)(1). If the transferee has 
been subject to the alternative minimum tax under section 55 in the 
preceding two years and will compute its taxable income in the current 
taxable year using the alternative minimum tax rate, then the tax rate 
specified in section 55(b)(1)(B) may be used in lieu of the highest rate 
specified in section 11(b)(1).
    (ii) The direct or indirect transfer of the residual interest to a 
foreign permanent establishment or fixed base (within the meaning of an 
applicable income tax treaty) of a domestic transferee is not eligible 
for the formula test.
    (iii) Present values are computed using a discount rate equal to the 
Federal short-term rate prescribed by section 1274(d) for the month of 
the transfer and the compounding period used by the taxpayer.
    (9) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Transfer to partnership. X transfers a noneconomic 
residual interest in a REMIC to Partnership P in a transaction that does 
not satisfy the formula test of paragraph (c)(7) of this section. Y and 
Z are the partners of P. Even if Y and Z are eligible corporations that 
satisfy the requirements of paragraph (c)(5)(i) of this section, the 
transfer fails to satisfy the asset test requirements found in paragraph 
(c)(5)(ii) of this section because P is a partnership rather than an 
eligible corporation within the meaning of (c)(6)(i) of this section.
    Example 2. Transfer to a corporation without capacity to carry 
additional residual interests. During the first ten months of a year, 
Bank transfers five residual interests to Corporation U under 
circumstances meeting the requirements of the asset test in paragraph 
(c)(5) of this section. Bank is the major creditor of U and consequently 
has access to U's financial records and has knowledge of U's financial 
circumstances. During the last month of the year, Bank transfers three 
additional residual interests to U in a transaction that does not meet 
the formula test of paragraph (c)(7) of this section. At the time of 
this transfer, U's financial records indicate it has retained the 
previously transferred residual interests. U's financial circumstances, 
including the aggregate tax liabilities it has assumed with respect to 
REMIC residual interests, would cause a reasonable person to conclude 
that U will be unable to meet its tax liabilities when due. The 
transfers in the last month of the year fail to satisfy the 
investigation requirement in paragraph (c)(4)(i) of this section and the 
asset test requirement of paragraph (c)(5)(iii) of this section because 
Bank has reason to know that U will not be able to pay the tax due on 
those interests.
    Example 3. Transfer to a foreign permanent establishment of an 
eligible corporation. R transfers a noneconomic residual interest in a 
REMIC to the foreign permanent establishment of Corporation T. Solely 
because of paragraph (c)(8)(ii) of this section, the transfer does not 
satisfy the formula test of paragraph (c)(7) of this section. In 
addition, even if T is an eligible corporation, the transfer does not 
satisfy the asset test because the transfer fails the requirements of 
paragraph (c)(5)(ii) of this section.

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

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



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

    (a) Transfers to disqualified organizations--(1) Payment of tax. Any 
excise tax due under section 860E(e)(1) must be paid by the later of 
March 24, 1993, or

[[Page 115]]

April 15th of the year following the calendar year in which the residual 
interest is transferred to a disqualified organization. The Commissioner 
may prescribe rules for the manner and method of collecting the tax.
    (2) Transitory ownership. For purposes of section 860E (e) and this 
section, a transfer of a residual interest to a disqualified 
organization in connection with the formation of a REMIC is disregarded 
if the disqualified organization has a binding contract to sell the 
interest and the sale occurs within 7 days of the startup day (as 
defined in section 860G(a)(9) and Sec.  1.860G-2(k)).
    (3) Anticipated excess inclusions. The anticipated excess inclusions 
are the excess inclusions that are expected to accrue in each calendar 
quarter (or portion thereof) following the transfer of the residual 
interest. The anticipated excess inclusions must be determined as of the 
date the residual interest is transferred and must be based on--
    (i) Events that have occurred up to the time of the transfer;
    (ii) The prepayment and reinvestment assumptions adopted under 
section 1272(a)(6), or that would have been adopted had the REMIC's 
regular interests been issued with original issue discount; and
    (iii) Any required or permitted clean up calls, or required 
qualified liquidation provided for in the REMIC's organizational 
documents.
    (4) Present value computation. The present value of the anticipated 
excess inclusions is determined by discounting the anticipated excess 
inclusions from the end of each remaining calendar quarter in which 
those excess inclusions are expected to accrue to the date the 
disqualified organization acquires the residual interest. The discount 
rate to be used for this present value computation is the applicable 
Federal rate (as specified in section 1274(d)(1)) that would apply to a 
debt instrument that was issued on the date the disqualified 
organization acquired the residual interest and whose term ended on the 
close of the last quarter in which excess inclusions were expected to 
accrue with respect to the residual interest.
    (5) Obligation of REMIC to furnish information. A REMIC is not 
obligated to determine if its residual interests have been transferred 
to a disqualified organization. However, upon request of a person 
designated in section 860E(e)(3), the REMIC must furnish information 
sufficient to compute the present value of the anticipated excess 
inclusions. The information must be furnished to the requesting party 
and to the Internal Revenue Service within 60 days of the request. A 
reasonable fee charged to the requestor is not income derived from a 
prohibited transaction within the meaning of section 860F(a).
    (6) Agent. For purposes of section 860E(e)(3), the term ``agent'' 
includes a broker (as defined in section 6045(c) and Sec.  1.6045-
1(a)(1)), nominee, or other middleman.
    (7) Relief from liability--(i) Transferee furnishes information 
under penalties of perjury. For purposes of section 860E(e)(4), a 
transferee is treated as having furnished an affidavit if the transferee 
furnishes--
    (A) A social security number, and states under penalties of perjury 
that the social security number is that of the transferee; or
    (B) A statement under penalties of perjury that it is not a 
disqualified organization.
    (ii) Amount required to be paid. The amount required to be paid 
under section 860E(e)(7)(B) is equal to the product of the highest rate 
specified in section 11(b)(1) for the taxable year in which the transfer 
described in section 860E(e)(1) occurs and the amount of excess 
inclusions that accrued and were allocable to the residual interest 
during the period that the disqualified organization held the interest.
    (b) Tax on pass-thru entities--(1) Tax on excess inclusions. Any tax 
due under section 860E(e)(6) must be paid by the later of March 24, 
1993, or by the fifteenth day of the fourth month following the close of 
the taxable year of the pass-thru entity in which the disqualified 
person is a record holder. The Commissioner may prescribe rules for the 
manner and method of collecting the tax.
    (2) Record holder furnishes information under penalties of perjury. 
For purposes of section 860E(e)(6)(D), a record holder

[[Page 116]]

is treated as having furnished an affidavit if the record holder 
furnishes--
    (i) A social security number and states, under penalties of perjury, 
that the social security number is that of the record holder; or
    (ii) A statement under penalties of perjury that it is not a 
disqualified organization.
    (3) Deductibility of tax. Any tax imposed on a pass-thru entity 
pursuant to section 860E(e)(6)(A) is deductible against the gross amount 
of ordinary income of the pass-thru entity. For example, in the case of 
a REIT, the tax is deductible in determining real estate investment 
trust taxable income under section 857(b)(2).
    (4) Allocation of tax. Dividends paid by a RIC or by a REIT are not 
preferential dividends within the meaning of section 562(c) solely 
because the tax expense incurred by the RIC or REIT under section 
860E(e)(6) is allocated solely to the shares held by disqualified 
organizations.

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



Sec.  1.860F-1  Qualified liquidations.

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

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



Sec.  1.860F-2  Transfers to a REMIC.

    (a) Formation of a REMIC--(1) In general. For Federal income tax 
purposes, a REMIC formation is characterized as the contribution of 
assets by a sponsor (as defined in paragraph (b)(1) of this section) to 
a REMIC in exchange for REMIC regular and residual interests. If, 
instead of exchanging its interest in mortgages and related assets for 
regular and residual interests, the sponsor arranges to have the REMIC 
issue some or all of the regular and residual interests for cash, after 
which the sponsor sells its interests in mortgages and related assets to 
the REMIC, the transaction is, nevertheless, viewed for Federal income 
tax purposes as the sponsor's exchange of mortgages and related assets 
for regular and residual interests, followed by a sale of some or all of 
those interests. The purpose of this rule is to ensure that the tax 
consequences associated with the formation of a REMIC are not affected 
by the actual sequence of steps taken by the sponsor.
    (2) Tiered arrangements--(i) Two or more REMICs formed pursuant to a 
single set of organizational documents. Two or more REMICs can be 
created pursuant to a single set of organizational documents even if for 
state law purposes or for Federal securities law purposes those 
documents create only one organization. The organizational documents 
must, however, clearly and expressly identify the assets of, and the 
interests in, each REMIC, and each REMIC must satisfy all of the 
requirements of section 860D and the related regulations.
    (ii) A REMIC and one or more investment trusts formed pursuant to a 
single set of documents. A REMIC (or two or more REMICs) and one or more 
investment trusts can be created pursuant to a single set of 
organizational documents and the separate existence of the REMIC(s) and 
the investment trust(s) will be respected for Federal income tax 
purposes even if for state law purposes or for Federal securities law 
purposes those documents create only one organization. The 
organizational documents for the REMIC(s) and the investment trust(s) 
must, however, require both the REMIC(s) and the investment trust(s) to 
account for items of income and ownership of assets for Federal tax 
purposes in a manner that respects the separate existence of the 
multiple entities. See Sec.  1.860G-2(i) concerning issuance of regular 
interests coupled with other contractual rights for an illustration of 
the provisions of this paragraph.
    (b) Treatment of sponsor--(1) Sponsor defined. A sponsor is a person 
who directly or indirectly exchanges qualified mortgages and related 
assets for regular and residual interests in a REMIC. A person 
indirectly exchanges interests in qualified mortgages and related assets 
for regular and residual interests in a REMIC if the person transfers, 
other than in a nonrecognition transaction, the mortgages and related 
assets to another person who acquires a

[[Page 117]]

transitory ownership interest in those assets before exchanging them for 
interests in the REMIC, after which the transitory owner then transfers 
some or all of the interests in the REMIC to the first person.
    (2) Nonrecognition of gain or loss. The sponsor does not recognize 
gain or loss on the direct or indirect transfer of any property to a 
REMIC in exchange for regular or residual interests in the REMIC. 
However, the sponsor, upon a subsequent sale of the REMIC regular or 
residual interests, may recognize gain or loss with respect to those 
interests.
    (3) Basis of contributed assets allocated among interests--(i) In 
general. The aggregate of the adjusted bases of the regular and residual 
interests received by the sponsor in the exchange described in paragraph 
(a) of this section is equal to the aggregate of the adjusted bases of 
the property transferred by the sponsor in the exchange, increased by 
the amount of organizational expenses (as described in paragraph 
(b)(3)(ii) of this section). That total is allocated among all the 
interests received in proportion to their fair market values on the 
pricing date (as defined in paragraph (b)(3)(iii) of this section) if 
any, or, if none, the startup day (as defined in section 860G(a)(9) and 
Sec.  1.860G-2(k)).
    (ii) Organizational expenses--(A) Organizational expense defined. An 
organizational expense is an expense that is incurred by the sponsor or 
by the REMIC and that is directly related to the creation of the REMIC. 
Further, the organizational expense must be incurred during a period 
beginning a reasonable time before the startup day and ending before the 
date prescribed by law for filing the first REMIC tax return (determined 
without regard to any extensions of time to file). The following are 
examples of organizational expenses: legal fees for services related to 
the formation of the REMIC, such as preparation of a pooling and 
servicing agreement and trust indenture; accounting fees related to the 
formation of the REMIC; and other administrative costs related to the 
formation of the REMIC.
    (B) Syndication expenses. Syndication expenses are not 
organizational expenses. Syndication expenses are those expenses 
incurred by the sponsor or other person to market the interests in a 
REMIC, and, thus, are applied to reduce the amount realized on the sale 
of the interests. Examples of syndication expenses are brokerage fees, 
registration fees, fees of an underwriter or placement agent, and 
printing costs of the prospectus or placement memorandum and other 
selling or promotional material.
    (iii) Pricing date. The term ``pricing date'' means the date on 
which the terms of the regular and residual interests are fixed and the 
prices at which a substantial portion of the regular interests will be 
sold are fixed.
    (4) Treatment of unrecognized gain or loss--(i) Unrecognized gain on 
regular interests. For purposes of section 860F(b)(1)(C)(i), the sponsor 
must include in gross income the excess of the issue price of a regular 
interest over the sponsor's basis in the interest as if the excess were 
market discount (as defined in section 1278(a)(2)) on a bond and the 
sponsor had made an election under section 1278(b) to include this 
market discount currently in gross income. The sponsor is not, however, 
by reason of this paragraph (b)(4)(i), deemed to have made an election 
under section 1278(b) with respect to any other bonds.
    (ii) Unrecognized loss on regular interests. For purposes of section 
860F(b)(1)(D)(i), the sponsor treats the excess of the sponsor's basis 
in a regular interest over the issue price of the interest as if that 
excess were amortizable bond premium (as defined in section 171(b)) on a 
taxable bond and the sponsor had made an election under section 171(c). 
The sponsor is not, however, by reason of this paragraph (b)(4)(ii), 
deemed to have made an election under section 171(c) with respect to any 
other bonds.
    (iii) Unrecognized gain on residual interests. For purposes of 
section 860F(b)(1)(C)(ii), the sponsor must include in gross income the 
excess of the issue price of a residual interest over the sponsor's 
basis in the interest ratably over the anticipated weighted average life 
of the REMIC (as defined in Sec.  1.860E-1(a)(3)(iv)).
    (iv) Unrecognized loss on residual interests. For purposes of 
section

[[Page 118]]

860F(b)(1)(D)(ii), the sponsor deducts the excess of the sponsor's basis 
in a residual interest over the issue price of the interest ratably over 
the anticipated weighted average life of the REMIC.
    (5) Additions to or reductions of the sponsor's basis. The sponsor's 
basis in a regular or residual interest is increased by any amount 
included in the sponsor's gross income under paragraph (b)(4) of this 
section. The sponsor's basis in a regular or residual interest is 
decreased by any amount allowed as a deduction and by any amount applied 
to reduce interest payments to the sponsor under paragraph (b)(4)(ii) of 
this section.
    (6) Transferred basis property. For purposes of paragraph (b)(4) of 
this section, a transferee of a regular or residual interest is treated 
in the same manner as the sponsor to the extent that the basis of the 
transferee in the interest is determined in whole or in part by 
reference to the basis of the interest in the hands of the sponsor.
    (c) REMIC's basis in contributed assets. For purposes of section 
860F(b)(2), the aggregate of the REMIC's bases in the assets contributed 
by the sponsor to the REMIC in a transaction described in paragraph (a) 
of this section is equal to the aggregate of the issue prices 
(determined under section 860G(a)(10) and Sec.  1.86G-1(d)) of all 
regular and residual interests in the REMIC.

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



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

    (a) In general. Except as provided in paragraph (c) of this section, 
for purposes of subtitle F of the Internal Revenue Code, a REMIC is 
treated as a partnership and any holder of a residual interest in the 
REMIC is treated as a partner. A REMIC is not subject, however, to the 
rules of subchapter C of chapter 63 of the Internal Revenue Code, 
relating to the treatment of partnership items, for a taxable year if 
there is at no time during the taxable year more than one holder of a 
residual interest in the REMIC. The identity of a holder of a residual 
interest in a REMIC is not treated as a partnership item with respect to 
the REMIC for purposes of subchapter C of chapter 63.
    (b) REMIC tax return--(1) In general. To satisfy the requirement 
under section 6031 to make a return of income for each taxable year, a 
REMIC must file the return required by paragraph (b)(2) of this section. 
The due date and any extensions for filing the REMIC's annual return are 
determined as if the REMIC were a partnership.
    (2) Income tax return. The REMIC must make a return, as required by 
section 6011(a), for each taxable year on Form 1066, U.S. Real Estate 
Mortgage Investment Conduit Income Tax Return. The return must include--
    (i) The amount of principal outstanding on each class of regular 
interests as of the close of the taxable year,
    (ii) The amount of the daily accruals determined under section 
860E(c), and
    (iii) The information specified in Sec.  1.860D-1(d)(2) (i), (iv), 
and (v).
    (c) Signing of REMIC return--(1) In general. Although a REMIC is 
generally treated as a partnership for purposes of subtitle F, for 
purposes of determining who is authorized to sign a REMIC's income tax 
return for any taxable year, the REMIC is not treated as a partnership 
and the holders of residual interests in the REMIC are not treated as 
partners. Rather, the REMIC return must be signed by a person who could 
sign the return of the entity absent the REMIC election. Thus, the 
return of a REMIC that is a corporation or trust under applicable State 
law must be signed by a corporate officer or a trustee, respectively. 
The return of a REMIC that consists of a segregated pool of assets must 
be signed by a person who could sign the return of the entity that owns 
the assets of the REMIC under applicable State law.
    (2) REMIC whose startup day is before November 10, 1988--(i) In 
general. The income tax return of a REMIC whose startup day is before 
November 10, 1988, may be signed by any person who held a residual 
interest during the taxable year to which the return relates, or, as 
provided in section 6903, by a fiduciary, as defined in section 
7701(a)(6), who is acting for the REMIC and who has furnished adequate 
notice in the manner prescribed in Sec.  301.6903-1(b) of this chapter.

[[Page 119]]

    (ii) Startup day. For purposes of paragraph (c)(2) of this section, 
startup day means any day selected by a REMIC that is on or before the 
first day on which interests in such REMIC are issued.
    (iii) Exception. A REMIC whose startup day is before November 10, 
1988, may elect to have paragraph (c)(1) of this section apply, instead 
of paragraph (c)(2) of this section, in determining who is authorized to 
sign the REMIC return. See section 1006(t)(18)(B) of the Technical and 
Miscellaneous Revenue Act of 1988 (102 Stat. 3426) and Sec.  5h.6(a)(1) 
of this chapter for the time and manner for making this election.
    (d) Designation of tax matters person. A REMIC may designate a tax 
matters person in the same manner in which a partnership may designate a 
tax matters partner under Sec.  301.6231(a)(7)-1T of this chapter. For 
purposes of applying that section, all holders of residual interests in 
the REMIC are treated as general partners.
    (e) Notice to holders of residual interests--(1) Information 
required. As of the close of each calendar quarter, a REMIC must provide 
to each person who held a residual interest in the REMIC during that 
quarter notice on Schedule Q (Form 1066) of information specified in 
paragraphs (e)(1) (i) and (ii) of this section.
    (i) In general. Each REMIC must provide to each of its residual 
interest holders the following information--
    (A) That person's share of the taxable income or net loss of the 
REMIC for the calendar quarter;
    (B) The amount of the excess inclusion (as defined in section 860E 
and the regulations thereunder), if any, with respect to that person's 
residual interest for the calendar quarter;
    (C) If the holder of a residual interest is also a pass-through 
interest holder (as defined in Sec.  1.67-3T(a)(2)), the allocable 
investment expenses (as defined in Sec.  1.67-3T(a)(4)) for the calendar 
quarter, and
    (D) Any other information required by Schedule Q (Form 1066).
    (ii) Information with respect to REMIC assets--(A) 95 percent asset 
test. For calendar quarters after 1988, each REMIC must provide to each 
of its residual interest holders the following information--
    (1) The percentage of REMIC assets that are qualifying real property 
loans under section 593,
    (2) The percentage of REMIC assets that are assets described in 
section 7701(a)(19), and
    (3) The percentage of REMIC assets that are real estate assets 
defined in section 856(c)(6)(B), computed by reference to the average 
adjusted basis (as defined in section 1011) of the REMIC assets during 
the calendar quarter (as described in paragraph (e)(1)(iii) of this 
section). If the percentage of REMIC assets represented by a category is 
at least 95 percent, then the REMIC need only specify that the 
percentage for that category was at least 95 percent.
    (B) Additional information required if the 95 percent test not met. 
If, for any calendar quarter after 1988, less than 95 percent of the 
assets of the REMIC are real estate assets defined in section 
856(c)(6)(B), then, for that calendar quarter, the REMIC must also 
provide to any real estate investment trust (REIT) that holds a residual 
interest the following information--
    (1) The percentage of REMIC assets described in section 
856(c)(5)(A), computed by reference to the average adjusted basis of the 
REMIC assets during the calendar quarter (as described in paragraph 
(e)(1)(iii) of this section),
    (2) The percentage of REMIC gross income (other than gross income 
from prohibited transactions defined in section 860F(a)(2)) described in 
section 856(c)(3)(A) through (E), computed as of the close of the 
calendar quarter, and
    (3) The percentage of REMIC gross income (other than gross income 
from prohibited transactions defined in section 860F(a)(2)) described in 
section 856(c)(3)(F), computed as of the close of the calendar quarter. 
For purposes of this paragraph (e)(1)(ii)(B)(3), the term ``foreclosure 
property'' contained in section 856(c)(3)(F) has the meaning specified 
in section 860G(a)(8).


In determining whether a REIT satisfies the limitations of section 
856(c)(2), all REMIC gross income is deemed to be derived from a source 
specified in section 856(c)(2).

[[Page 120]]

    (C) For calendar quarters in 1987. For calendar quarters in 1987, 
the percentages of assets required in paragraphs (e)(1)(ii) (A) and (B) 
of this section may be computed by reference to the fair market value of 
the assets of the REMIC as of the close of the calendar quarter (as 
described in paragraph (e)(1)(iii) of this section), instead of by 
reference to the average adjusted basis during the calendar quarter.
    (D) For calendar quarters in 1988 and 1989. For calendar quarters in 
1988 and 1989, the percentages of assets required in paragraphs 
(e)(1)(ii) (A) and (B) of this section may be computed by reference to 
the average fair market value of the assets of the REMIC during the 
calendar quarter (as described in paragraph (e)(1)(iii) of this 
section), instead of by reference to the average adjusted basis of the 
assets of the REMIC during the calendar quarter.
    (iii) Special provisions. For purposes of paragraph (e)(1)(ii) of 
this section, the percentage of REMIC assets represented by a specified 
category computed by reference to average adjusted basis (or fair market 
value) of the assets during a calendar quarter is determined by dividing 
the average adjusted bases (or for calendar quarters before 1990, fair 
market value) of the assets in the specified category by the average 
adjusted basis (or, for calendar quarters before 1990, fair market 
value) of all the assets of the REMIC as of the close of each month, 
week, or day during that calendar quarter. The monthly, weekly, or daily 
computation period must be applied uniformly during the calendar quarter 
to all categories of assets and may not be changed in succeeding 
calendar quarters without the consent of the Commissioner.
    (2) Quarterly notice required--(i) In general. Schedule Q must be 
mailed (or otherwise delivered) to each holder of a residual interest 
during a calendar quarter no later than the last day of the month 
following the close of the calendar quarter.
    (ii) Special rule for 1987. Notice to any holder of a REMIC residual 
interest of the information required in paragraph (e)(1) of this section 
for any of the four calendar quarters of 1987 must be mailed (or 
otherwise delivered) to each holder no later than March 28, 1988.
    (3) Nominee reporting--(i) In general. If a REMIC is required under 
paragraphs (e) (1) and (2) of this section to provide notice to an 
interest holder who is a nominee of another person with respect to an 
interest in the REMIC, the nominee must furnish that notice to the 
person for whom it is a nominee.
    (ii) Time for furnishing statement. The nominee must furnish the 
notice required under paragraph (e)(3)(i) of this section to the person 
for whom it is a nominee no later than 30 days after receiving this 
information.
    (4) Reports to the Internal Revenue Service. For each person who was 
a residual interest holder at any time during a REMIC's taxable year, 
the REMIC must attach a copy of Schedule Q to its income tax return for 
that year for each quarter in which that person was a residual interest 
holder. Quarterly notice to the Internal Revenue Service is not 
required.
    (f) Information returns for persons engaged in a trade or business. 
See Sec.  1.6041-1(b)(2) for the treatment of a REMIC under sections 
6041 and 6041A.

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



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

    (a) Regular interest--(1) Designation as a regular interest. For 
purposes of section 860G(a)(1), a REMIC designates an interest as a 
regular interest by providing to the Internal Revenue Service the 
information specified in Sec.  1.860D-1(d)(2)(ii) in the time and manner 
specified in Sec.  1.860D-1(d)(2).
    (2) Specified portion of the interest payments on qualified 
mortgages--(i) In general. For purposes of section 860G(a)(1)(B)(ii), a 
specified portion of the interest payments on qualified mortgages means 
a portion of the interest payable on qualified mortgages, but only if 
the portion can be expressed as--
    (A) A fixed percentage of the interest that is payable at either a 
fixed rate or at a variable rate described in paragraph (a)(3) of this 
section on some or all of the qualified mortgages;

[[Page 121]]

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

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

[[Page 122]]

for interest payments that consist of a specified portion of the 
interest payable on the qualified mortgages under paragraph (a)(2)(i)(C) 
of this section.
    Example 3. (i) A sponsor transferred a pool of fixed rate mortgages 
to a trustee in exchange for two classes of certificates. The fixed 
interest rate payable on the mortgages varies from mortgage to mortgage, 
but all rates are between 8 and 10 percent. The Class E certificate 
holders are entitled to receive all principal payments on the mortgages 
and interest on outstanding principal at 7 percent. The Class F 
certificate holders are entitled to receive all interest on the 
mortgages in excess of the interest paid on the Class E certificates.
    (ii) The Class F certificates provide for interest payments that 
consist of a specified portion of the interest payable on the mortgages 
under paragraph (a)(2)(i) of this section. Although the portion of the 
interest payable to the Class F certificate holders varies from mortgage 
to mortgage, the interest payable can be expressed as a fixed percentage 
of the interest payable on each particular mortgage.

    (3) Variable rate. A regular interest may bear interest at a 
variable rate. For purposes of section 860G(a)(1)(B)(i), a variable rate 
of interest is a rate described in this paragraph (a)(3).
    (i) Rate based on current interest rate. A qualified floating rate 
as defined in Sec.  1.1275-5(b)(1) (but without the application of 
paragraph (b)(2) or (3) of that section) set at a current value, as 
defined in Sec.  1.1275-5(a)(4), is a variable rate. In addition, a rate 
equal to the highest, lowest, or average of two or more qualified 
floating rates is a variable rate. For example, a rate based on the 
average cost of funds of one or more financial institutions is a 
variable rate.
    (ii) Weighted average rate--(A) In general. A rate based on a 
weighted average of the interest rates on some or all of the qualified 
mortgages held by a REMIC is a variable rate. The qualified mortgages 
taken into account must, however, bear interest at a fixed rate or at a 
rate described in this paragraph (a)(3). Generally, a weighted average 
interest rate is a rate that, if applied to the aggregate outstanding 
principal balance of a pool of mortgage loans for an accrual period, 
produces an amount of interest that equals the sum of the interest 
payable on the pooled loans for that accrual period. Thus, for an 
accrual period in which a pool of mortgage loans comprises $300,000 of 
loans bearing a 7 percent interest rate and $700,000 of loans bearing a 
9.5 percent interest rate, the weighted average rate for the pool of 
loans is 8.75 percent.
    (B) Reduction in underlying rate. For purposes of paragraph 
(a)(3)(ii)(A) of this section, an interest rate is considered to be 
based on a weighted average rate even if, in determining that rate, the 
interest rate on some or all of the qualified mortgages is first subject 
to a cap or a floor, or is first reduced by a number of basis points or 
a fixed percentage. A rate determined by taking a weighted average of 
the interest rates on the qualified mortgage loans net of any servicing 
spread, credit enhancement fees, or other expenses of the REMIC is a 
rate based on a weighted average rate for the qualified mortgages. 
Further, the amount of any rate reduction described above may vary from 
mortgage to mortgage.
    (iii) Additions, subtractions, and multiplications. A rate is a 
variable rate if it is--
    (A) Expressed as the product of a rate described in paragraph 
(a)(3)(i) or (ii) of this section and a fixed multiplier;
    (B) Expressed as a constant number of basis points more or less than 
a rate described in paragraph (a)(3)(i) or (ii) of this section; or
    (C) Expressed as the product, plus or minus a constant number of 
basis points, of a rate described in paragraph (a)(3)(i) or (ii) of this 
section and a fixed multiplier (which may be either a positive or a 
negative number).
    (iv) Caps and floors. A rate is a variable rate if it is a rate that 
would be described in paragraph (a)(3)(i) through (iii) of this section 
except that it is--
    (A) Limited by a cap or ceiling that establishes either a maximum 
rate or a maximum number of basis points by which the rate may increase 
from one accrual or payment period to another or over the term of the 
interest; or
    (B) Limited by a floor that establishes either a minimum rate or a 
maximum number of basis points by which the rate may decrease from one 
accrual or payment period to another or over the term of the interest.
    (v) Funds-available caps--(A) In general. A rate is a variable rate 
if it is a

[[Page 123]]

rate that would be described in paragraph (a)(3)(i) through (iv) of this 
section except that it is subject to a ``funds-available'' cap. A funds-
available cap is a limit on the amount of interest to be paid on an 
instrument in any accrual or payment period that is based on the total 
amount available for the distribution, including both principal and 
interest received by an issuing entity on some or all of its qualified 
mortgages as well as amounts held in a reserve fund. The term ``funds-
available cap'' does not, however, include any cap or limit on interest 
payments used as a device to avoid the standards of paragraph (a)(3)(i) 
through (iv) of this section.
    (B) Facts and circumstances test. In determining whether a cap or 
limit on interest payments is a funds-available cap within the meaning 
of this section and not a device used to avoid the standards of 
paragraph (a)(3)(i) through (iv) of this section, one must consider all 
of the facts and circumstances. Facts and circumstances that must be 
taken into consideration are--
    (1) Whether the rate of the interest payable to the regular interest 
holders is below the rate payable on the REMIC's qualified mortgages on 
the start-up day; and
    (2) Whether, historically, the rate of interest payable to the 
regular interest holders has been consistently below that payable on the 
qualified mortgages.
    (C) Examples. The following examples, both of which describe a pass-
thru trust that is intended to qualify as a REMIC, illustrate the 
provisions of this paragraph (a)(3)(v).

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

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payable on the mortgages. Furthermore, historical data suggest that 
there is a significant possibility that, in the future, 400 percent of 
One-Year LIBOR will exceed the weighted average rate on the mortgages.
    (iii) The facts and circumstances here indicate that the use of 400 
percent of One-Year LIBOR with the above-described cap is a device to 
pass through to the Class X certificate holder contingent interest based 
on mortgagor profits. Consequently, the rate paid on the Class X 
certificate here is not a variable rate.

    (vi) Combination of rates. A rate is a variable rate if it is based 
on--
    (A) One fixed rate during one or more accrual or payment periods and 
a different fixed rate or rates, or a rate or rates described in 
paragraph (a)(3) (i) through (v) of this section, during other accrual 
or payment periods; or
    (B) A rate described in paragraph (a)(3) (i) through (v) of this 
section during one or more accrual or payment periods and a fixed rate 
or rates, or a different rate or rates described in paragraph (a)(3) (i) 
through (v) of this section in other periods.
    (4) Fixed terms on the startup day. For purposes of section 
860G(a)(1), a regular interest in a REMIC has fixed terms on the startup 
day if, on the startup day, the REMIC's organizational documents 
irrevocably specify--
    (i) The principal amount (or other similar amount) of the regular 
interest;
    (ii) The interest rate or rates used to compute any interest 
payments (or other similar amounts) on the regular interest; and
    (iii) The latest possible maturity date of the interest.
    (5) Contingencies prohibited. Except for the contingencies specified 
in paragraphs (b)(3) and (e)(4) of this section, the principal amount 
(or other similar amount) and the latest possible maturity date of the 
interest must not be contingent.
    (b) Special rules for regular interests--(1) Call premium. An 
interest in a REMIC does not qualify as a regular interest if the terms 
of the interest entitle the holder of that interest to the payment of 
any premium that is determined with reference to the length of time that 
the regular interest is outstanding and is not described in paragraph 
(b)(2) of this section.
    (2) Customary prepayment penalties received with respect to 
qualified mortgages. An interest in a REMIC does not fail to qualify as 
a regular interest solely because the REMIC's organizational documents 
provide that the REMIC must allocate among and pay to its regular 
interest holders any customary prepayment penalties that the REMIC 
receives with respect to its qualified mortgages. Moreover, a REMIC may 
allocate prepayment penalties among its classes of interests in any 
manner specified in the REMIC's organizational documents. For example, a 
REMIC could allocate all or substantially all of a prepayment penalty 
that it receives to holders of an interest-only class of interests 
because that class would be most significantly affected by prepayments.
    (3) Certain contingencies disregarded. An interest in a REMIC does 
not fail to qualify as a regular interest solely because it is issued 
subject to some or all of the contingencies described in paragraph 
(b)(3) (i) through (vi) of this section.
    (i) Prepayments, income, and expenses. An interest does not fail to 
qualify as a regular interest solely because--
    (A) The timing of (but not the right to or amount of) principal 
payments (or other similar amounts) is affected by the extent of 
prepayments on some or all of the qualified mortgages held by the REMIC 
or the amount of income from permitted investments (as defined in Sec.  
1.860G-2(g)); or
    (B) The timing of interest and principal payments is affected by the 
payment of expenses incurred by the REMIC.
    (ii) Credit losses. An interest does not fail to qualify as a 
regular interest solely because the amount or the timing of payments of 
principal or interest (or other similar amounts) with respect to a 
regular interest is affected by defaults on qualified mortgages and 
permitted investments, unanticipated expenses incurred by the REMIC, or 
lower than expected returns on permitted investments.
    (iii) Subordinated interests. An interest does not fail to qualify 
as a regular interest solely because that interest bears all, or a 
disproportionate share, of the losses stemming from cash flow

[[Page 125]]

shortfalls due to defaults or delinquencies on qualified mortgages or 
permitted investments, unanticipated expenses incurred by the REMIC, 
lower than expected returns on permitted investments, or prepayment 
interest shortfalls before other regular interests or the residual 
interest bear losses occasioned by those shortfalls.
    (iv) Deferral of interest. An interest does not fail to qualify as a 
regular interest solely because that interest, by its terms, provides 
for deferral of interest payments.
    (v) Prepayment interest shortfalls. An interest does not fail to 
qualify as a regular interest solely because the amount of interest 
payments is affected by prepayments of the underlying mortgages.
    (vi) Remote and incidental contingencies. An interest does not fail 
to qualify as a regular interest solely because the amount or timing of 
payments of principal or interest (or other similar amounts) with 
respect to the interest is subject to a contingency if there is only a 
remote likelihood that the contingency will occur. For example, an 
interest could qualify as a regular interest even though full payment of 
principal and interest on that interest is contingent upon the absence 
of significant cash flow shortfalls due to the operation of the Soldiers 
and Sailors Civil Relief Act, 50 U.S.C. app. 526 (1988).
    (4) Form of regular interest. A regular interest in a REMIC may be 
issued in the form of debt, stock, an interest in a partnership or 
trust, or any other form permitted by state law. If a regular interest 
in a REMIC is not in the form of debt, it must, except as provided in 
paragraph (a)(2)(iv) of this section, entitle the holder to a specified 
amount that would, were the interest issued in debt form, be identified 
as the principal amount of the debt.
    (5) Interest disproportionate to principal--(i) In general. An 
interest in a REMIC does not qualify as a regular interest if the amount 
of interest (or other similar amount) payable to the holder is 
disproportionately high relative to the principal amount or other 
specified amount described in paragraph (b)(4) of this section 
(specified principal amount). Interest payments (or other similar 
amounts) are considered disproportionately high if the issue price (as 
determined under paragraph (d) of this section) of the interest in the 
REMIC exceeds 125 percent of its specified principal amount.
    (ii) Exception. A regular interest in a REMIC that entitles the 
holder to interest payments consisting of a specified portion of 
interest payments on qualified mortgages qualifies as a regular interest 
even if the amount of interest is disproportionately high relative to 
the specified principal amount.
    (6) Regular interest treated as a debt instrument for all Federal 
income tax purposes. In determining the tax under chapter 1 of the 
Internal Revenue Code, a REMIC regular interest (as defined in section 
860G(a)(1)) is treated as a debt instrument that is an obligation of the 
REMIC. Thus, sections 1271 through 1288, relating to bonds and other 
debt instruments, apply to a regular interest. For special rules 
relating to the accrual of original issue discount on regular interests, 
see section 1272(a)(6).
    (c) Residual interest. A residual interest is an interest in a REMIC 
that is issued on the startup day and that is designated as a residual 
interest by providing the information specified in Sec.  1.860D-
1(d)(2)(ii) at the time and in the manner provided in Sec.  1.860D-
1(d)(2). A residual interest need not entitle the holder to any 
distributions from the REMIC.
    (d) Issue price of regular and residual interests--(1) In general. 
The issue price of any REMIC regular or residual interest is determined 
under section 1273(b) as if the interest were a debt instrument and, if 
issued for property, as if the requirements of section 1273(b)(3) were 
met. Thus, if a class of interests is publicly offered, then the issue 
price of an interest in that class is the initial offering price to the 
public at which a substantial amount of the class is sold. If the 
interest is in a class that is not publicly offered, the issue price is 
the price paid by the first buyer of that interest regardless of the 
price paid for the remainder of the class. If the interest is in a class 
that is retained by the sponsor, the issue price is its fair market 
value on the pricing date (as defined in Sec.  1.860F-2(b)(3)(iii)), if 
any, or, if none, the

[[Page 126]]

startup day, regardless of whether the property exchanged therefor is 
publicly traded.
    (2) The public. The term ``the public'' for purposes of this section 
does not include brokers or other middlemen, nor does it include the 
sponsor who acquires all of the regular and residual interests from the 
REMIC on the startup day in a transaction described in Sec.  1.860F-
2(a).
    (e) Transition from certain interbank offered rates--(1) In general. 
This paragraph (e) provides rules relating to the modification of the 
terms of a regular interest in a REMIC or the terms of an asset held by 
a REMIC as part of the transition away from the London Interbank Offered 
Rate and certain other interbank offered rates. For purposes of this 
paragraph (e), covered modification and discontinued IBOR have the 
meanings provided in Sec.  1.1001-6(h)(1) and (4), respectively. See 
Sec.  1.1001-6 for additional rules that may apply to an interest in a 
REMIC that provides for a rate referencing a discontinued IBOR.
    (2) Change in reference rate for a regular interest after the 
startup day. A covered modification of a regular interest in a REMIC 
that occurs after the startup day is disregarded in determining whether 
the modified regular interest has fixed terms on the startup day under 
paragraph (a)(4) of this section.
    (3) Contingencies of rate on a regular interest. An interest in a 
REMIC does not fail to qualify as a regular interest solely because it 
is subject to a contingency whereby a rate that references a 
discontinued IBOR and is a variable rate permitted under paragraph 
(a)(3) of this section may change to a fixed rate or a different 
variable rate permitted under paragraph (a)(3) of this section in 
anticipation of the discontinued IBOR becoming unavailable or 
unreliable.
    (4) Reasonable expenses incurred to make covered modifications. An 
interest in a REMIC does not fail to qualify as a regular interest 
solely because it is subject to a contingency whereby the amount of 
payments of principal or interest (or other similar amounts) with 
respect to the interest in the REMIC is reduced by reasonable costs 
incurred to effect a covered modification. In addition, payment by a 
party other than the REMIC of reasonable costs incurred to effect a 
covered modification is not a contribution to the REMIC for purposes of 
section 860G(d).

[T.D. 8458, 57 FR 61306, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; 58 FR 
15089, Mar. 19, 1993; T.D. 8614, 60 FR 42787, Aug. 17, 1995; T.D. 9961, 
87 FR 175, Jan. 4, 2022]



Sec.  1.860G-2  Other rules.

    (a) Obligations principally secured by an interest in real 
property--(1) Tests for determining whether an obligation is principally 
secured. For purposes of section 860G(a)(3)(A), an obligation is 
principally secured by an interest in real property only if it satisfies 
either the test set out in paragraph (a)(1)(i) or the test set out in 
paragraph (a)(1)(ii) of this section.
    (i) The 80-percent test. An obligation is principally secured by an 
interest in real property if the fair market value of the interest in 
real property securing the obligation--
    (A) Was at least equal to 80 percent of the adjusted issue price of 
the obligation at the time the obligation was originated (see paragraph 
(b)(1) of this section concerning the origination date for obligations 
that have been significantly modified); or
    (B) Is at least equal to 80 percent of the adjusted issue price of 
the obligation at the time the sponsor contributes the obligation to the 
REMIC.
    (ii) Alternative test. For purposes of section 860G(a)(3)(A), an 
obligation is principally secured by an interest in real property if 
substantially all of the proceeds of the obligation were used to acquire 
or to improve or protect an interest in real property that, at the 
origination date, is the only security for the obligation. For purposes 
of this test, loan guarantees made by the United States or any state (or 
any political subdivision, agency, or instrumentality of the United 
States or of any state), or other third party credit enhancement are not 
viewed as additional security for a loan. An obligation is not 
considered to be secured by property other than real property solely 
because the obligor is personally liable on the obligation.
    (2) Treatment of liens. For purposes of paragraph (a)(1)(i) of this 
section, the fair market value of the real property

[[Page 127]]

interest must be first reduced by the amount of any lien on the real 
property interest that is senior to the obligation being tested, and 
must be further reduced by a proportionate amount of any lien that is in 
parity with the obligation being tested.
    (3) Safe harbor--(i) Reasonable belief that an obligation is 
principally secured. If, at the time the sponsor contributes an 
obligation to a REMIC, the sponsor reasonably believes that the 
obligation is principally secured by an interest in real property within 
the meaning of paragraph (a)(1) of this section, then the obligation is 
deemed to be so secured for purposes of section 860G(a)(3). A sponsor 
cannot avail itself of this safe harbor with respect to an obligation if 
the sponsor actually knows or has reason to know that the obligation 
fails both of the tests set out in paragraph (a)(1) of this section.
    (ii) Basis for reasonable belief. For purposes of paragraph 
(a)(3)(i) of this section, a sponsor may base a reasonable belief 
concerning any obligation on--
    (A) Representations and warranties made by the originator of the 
obligation; or
    (B) Evidence indicating that the originator of the obligation 
typically made mortgage loans in accordance with an established set of 
parameters, and that any mortgage loan originated in accordance with 
those parameters would satisfy at least one of the tests set out in 
paragraph (a)(1) of this section.
    (iii) Later discovery that an obligation is not principally secured. 
If, despite the sponsor's reasonable belief concerning an obligation at 
the time it contributed the obligation to the REMIC, the REMIC later 
discovers that the obligation is not principally secured by an interest 
in real property, the obligation is a defective obligation and loses its 
status as a qualified mortgage 90 days after the date of discovery. See 
paragraph (f) of this section, relating to defective obligations.
    (4) Interests in real property; real property. The definition of 
``interests in real property'' set out in Sec.  1.856-3(c), and the 
definition of ``real property'' set out in Sec.  1.856-3(d), apply to 
define those terms for purposes of section 860G(a)(3) and paragraph (a) 
of this section.
    (5) Obligations secured by an interest in real property. Obligations 
secured by interests in real property include the following: mortgages, 
deeds of trust, and installment land contracts; mortgage pass-thru 
certificates guaranteed by GNMA, FNMA, FHLMC, or CMHC (Canada Mortgage 
and Housing Corporation); other investment trust interests that 
represent undivided beneficial ownership in a pool of obligations 
principally secured by interests in real property and related assets 
that would be considered to be permitted investments if the investment 
trust were a REMIC, and provided the investment trust is classified as a 
trust under Sec.  301.7701-4(c) of this chapter; and obligations secured 
by manufactured housing treated as single family residences under 
section 25(e)(10) (without regard to the treatment of the obligations or 
the properties under state law).
    (6) Obligations secured by other obligations; residual interests. 
Obligations (other than regular interests in a REMIC) that are secured 
by other obligations are not principally secured by interests in real 
property even if the underlying obligations are secured by interests in 
real property. Thus, for example, a collateralized mortgage obligation 
issued by an issuer that is not a REMIC is not an obligation principally 
secured by an interest in real property. A residual interest (as defined 
in section 860G(a)(2)) is not an obligation principally secured by an 
interest in real property.
    (7) Certain instruments that call for contingent payments are 
obligations. For purposes of section 860G(a)(3) and (4), the term 
``obligation'' includes any instrument that provides for total 
noncontingent principal payments that at least equal the instrument's 
issue price even if that instrument also provides for contingent 
payments. Thus, for example, an instrument that was issued for $100x and 
that provides for noncontingent principal payments of $100x, interest 
payments at a fixed rate, and contingent payments based on a percentage 
of the mortgagor's gross receipts, is an obligation.
    (8) Release of a lien on an interest in real property securing a 
qualified mortgage; defeasance. If a REMIC releases its lien on an 
interest in real property

[[Page 128]]

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

[[Page 129]]

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

    Example. (i) S services mortgage loans that are held by R, a REMIC. 
Borrower B is the issuer of one of the mortgage loans held by R. The 
original amount of B's mortgage loan was $100,000, and the loan was 
secured by real property X. At the time the loan was contributed to R, 
property X had a fair market value of $90,000. Sometime after the loan 
was contributed to R, B experienced financial difficulties such that it 
was reasonably foreseeable that B might default on the loan if the loan 
was not modified. Accordingly, S altered various terms of B's loan to 
substantially reduce the risk of default. The alterations included the 
release of the lien on property X and the substitution of real property 
Y for property X as collateral for the loan. At the time the loan was 
modified, its adjusted issue price was $100,000. The fair market value 
of property X immediately before the modification (as determined by a 
commercially reasonable valuation method)

[[Page 130]]

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

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

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

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defective obligation is a mortgage subject to any of the following 
defects.
    (i) The mortgage is in default, or a default with respect to the 
mortgage is reasonably foreseeable.
    (ii) The mortgage was fraudulently procured by the mortgagor.
    (iii) The mortgage was not in fact principally secured by an 
interest in real property within the meaning of paragraph (a)(1) of this 
section.
    (iv) The mortgage does not conform to a customary representation or 
warranty given by the sponsor or prior owner of the mortgage regarding 
the characteristics of the mortgage, or the characteristics of the pool 
of mortgages of which the mortgage is a part. A representation that 
payments on a qualified mortgage will be received at a rate no less than 
a specified minimum or no greater than a specified maximum is not 
customary for this purpose.
    (2) Effect of discovery of defect. If a REMIC discovers that an 
obligation is a defective obligation, and if the defect is one that, had 
it been discovered before the startup day, would have prevented the 
obligation from being a qualified mortgage, then, unless the REMIC 
either causes the defect to be cured or disposes of the defective 
obligation within 90 days of discovering the defect, the obligation 
ceases to be a qualified mortgage at the end of that 90 day period. Even 
if the defect is not cured, the defective obligation is, nevertheless, a 
qualified mortgage from the startup day through the end of the 90 day 
period. Moreover, even if the REMIC holds the defective obligation 
beyond the 90 day period, the REMIC may, nevertheless, exchange the 
defective obligation for a qualified replacement mortgage so long as the 
requirements of section 860G(a)(4)(B) are satisfied. If the defect is 
one that does not affect the status of an obligation as a qualified 
mortgage, then the obligation is always a qualified mortgage regardless 
of whether the defect is or can be cured. For example, if a sponsor 
represented that all mortgages transferred to a REMIC had a 10 percent 
interest rate, but it was later discovered that one mortgage had a 9 
percent interest rate, the 9 percent mortgage is defective, but the 
defect does not affect the status of that obligation as a qualified 
mortgage.
    (g) Permitted investments--(1) Cash flow investment--(i) In general. 
For purposes of section 860G(a)(6) and this section, a cash flow 
investment is an investment of payments received on qualified mortgages 
for a temporary period between receipt of those payments and the 
regularly scheduled date for distribution of those payments to REMIC 
interest holders. Cash flow investments must be passive investments 
earning a return in the nature of interest.
    (ii) Payments received on qualified mortgages. For purposes of 
paragraph (g)(1) of this section, the term ``payments received on 
qualified mortgages'' includes--
    (A) Payments of interest and principal on qualified mortgages, 
including prepayments of principal and payments under credit enhancement 
contracts described in paragraph (c)(2) of this section;
    (B) Proceeds from the disposition of qualified mortgages;
    (C) Cash flows from foreclosure property and proceeds from the 
disposition of such property;
    (D) A payment by a sponsor or prior owner in lieu of the sponsor's 
or prior owner's repurchase of a defective obligation, as defined in 
paragraph (f) of this section, that was transferred to the REMIC in 
breach of a customary warranty; and
    (E) Prepayment penalties required to be paid under the terms of a 
qualified mortgage when the mortgagor prepays the obligation.
    (iii) Temporary period. For purposes of section 860G(a)(6) and this 
paragraph (g)(1), a temporary period generally is that period from the 
time a REMIC receives payments on qualified mortgages and permitted 
investments to the time the REMIC distributes the payments to interest 
holders. A temporary period may not exceed 13 months. Thus, an 
investment held by a REMIC for more than 13 months is not a cash flow 
investment. In determining the length of time that a REMIC has held an 
investment that is part of a commingled fund or account, the REMIC may 
employ any reasonable method of accounting. For example, if

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

[[Page 134]]

    (2) Example. The following example, which describes a tiered 
arrangement involving a pass-thru trust that is intended to qualify as a 
REMIC and a pass-thru trust that is intended to be classified as a trust 
under Sec.  301.7701-4(c) of this chapter, illustrates the provisions of 
paragraph (i)(1) of this section.

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

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

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



Sec.  1.860G-3  Treatment of foreign persons.

    (a) Transfer of a residual interest with tax avoidance potential--
(1) In general. A transfer of a residual interest that has tax avoidance 
potential is disregarded for all Federal tax purposes if the transferee 
is a foreign person. Thus, if a residual interest with tax avoidance

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

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

[[Page 136]]

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

                   Determination of Sources of Income



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

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

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

[[Page 137]]



Sec.  1.861-2  Interest.

    (a) In general. (1) Gross income consisting of interest from the 
United States or any agency or instrumentality thereof (other than a 
possession of the United States or an agency or instrumentality of a 
possession), a State or any political subdivision thereof, or the 
District of Columbia, and interest from a resident of the United States 
on a bond, note, or other interest-bearing obligation issued, assumed or 
incurred by such person shall be treated as income from sources within 
the United States. Thus, for example, income from sources within the 
United States includes interest received on any refund of income tax 
imposed by the United States, a State or any political subdivision 
thereof, or the District of Columbia. Interest other than that described 
in this paragraph is not to be treated as income from sources within the 
United States. See paragraph (a)(7) of this section for special rules 
concerning substitute interest paid or accrued pursuant to a securities 
lending transaction.
    (2) The term ``resident of the United States'', as used in this 
paragraph, includes (i) an individual who at the time of payment of the 
interest is a resident of the United States, (ii) a domestic 
corporation, (iii) a domestic partnership which at any time during its 
taxable year is engaged in trade or business in the United States, or 
(iv) a foreign corporation or a foreign partnership, which at any time 
during its taxable year is engaged in trade or business in the United 
States.
    (3) The method by which, or the place where, payment of the interest 
is made is immaterial in determining whether interest is derived from 
sources within the United States.
    (4) For purposes of this section, the term ``interest'' includes all 
amounts treated as interest under section 483, and the regulations 
thereunder. It also includes original issue discount, as defined in 
section 1232(b)(1), whether or not the underlying bond, debenture, note, 
certificate, or other evidence of indebtedness is a capital asset in the 
hands of the taxpayer within the meaning of section 1221.
    (5) If interest is paid on an obligation of a resident of the United 
States by a nonresident of the United States acting in the nonresident's 
capacity as a guarantor of the obligation of the resident, the interest 
will be treated as income from sources within the United States.
    (6) In the case of interest received by a nonresident alien 
individual or foreign corporation this paragraph (a) applies whether or 
not the interest is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by such individual 
or corporation.
    (7) A substitute interest payment is a payment, made to the 
transferor of a security in a securities lending transaction or a sale-
repurchase transaction, of an amount equivalent to an interest payment 
which the owner of the transferred security is entitled to receive 
during the term of the transaction. A securities lending transaction is 
a transfer of one or more securities that is described in section 
1058(a) or a substantially similar transaction. A sale-repurchase 
transaction is an agreement under which a person transfers a security in 
exchange for cash and simultaneously agrees to receive a substantially 
identical securities from the transferee in the future in exchange for 
cash. A substitute interest payment shall be sourced in the same manner 
as the interest accruing on the transferred security for purposes of 
this section and Sec.  1.862-1. See also Sec. Sec.  1.864-5(b)(2)(iii), 
1.871-7(b)(2), 1.881-2(b)(2) and for the character of such payments and 
Sec.  1.894-1(c) for the application tax treaties to these transactions.
    (b) Interest not derived from U.S. sources. Notwithstanding 
paragraph (a) of this section, interest shall be treated as income from 
sources without the United States to the extent provided by 
subparagraphs (A) through (H), of section 861(a)(1) and by the following 
subparagraphs of this paragraph.
    (1) Interest on bank deposits and on similar amounts. (i) Interest 
paid or credited before January 1, 1977, to a nonresident alien 
individual or foreign corporation on--
    (a) Deposits with persons, including citizens of the United States 
or alien individuals and foreign or domestic partnerships or 
corporations, carrying

[[Page 138]]

on the banking business in the United States,
    (b) Deposits or withdrawable accounts with savings institutions 
chartered and supervised as savings and loan or similar associations 
under Federal or State law, or
    (c) Amounts held by an insurance company under an agreement to pay 
interest thereon, shall be treated as income from sources without the 
United States if such interest is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by such nonresident alien individual or foreign corporation. If 
such interest is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by such nonresident 
alien individual or foreign corporation, it shall be treated as income 
from sources within the United States under paragraph (a) of this 
section unless it is treated as income from sources without the United 
States under another subparagraph of this paragraph. For a special rule 
for determining whether such interest is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States, see paragraph (c)(1)(ii) or Sec.  1.864-4.
    (ii) Paragraph (b)(1)(i)(b) of this section applies to interest on 
deposits or withdrawable accounts described therein only to the extent 
that the interest paid or credited by the savings institution described 
therein is deductible under section 591 in determining the taxable 
income of such institution; and, for this purpose, whether an amount is 
deductible under section 591 shall be determined without regard to 
section 265, relating to deductions allocable to tax-exempt income. 
Thus, for example, such subdivision does not apply to amounts paid by a 
savings and loan or similar association on or with respect to its 
nonwithdrawable capital stock or on or with respect to funds held in 
restricted accounts which represent a proprietary interest in such 
association. Paragraph (b)(1)(i)(b) of this section also applies to so-
called dividends paid or credited on deposits or withdrawable accounts 
if such dividends are deductible under section 591 without reference to 
section 265.
    (iii) For purposes of paragraph (b)(1)(i)(c) of this section, 
amounts held by an insurance company under an agreement to pay interest 
thereon include policyholder dividends left with the company to 
accumulate, prepaid insurance premiums, proceeds of policies left on 
deposit with the company, and overcharges of premiums. Such subdivision 
does not apply to (a) the so-called ``interest element'' in the case of 
annuity or installment payments under life insurance or endowment 
contracts or (b) interest paid by an insurance company to its creditors 
on notes, bonds, or similar evidences of indebtedness, if the debtor-
creditor relationship does not arise by virtue of a contract of 
insurance with the insurance company.
    (iv) For purposes of paragraph (b)(1)(i) of this section, interest 
received by a partnership shall be treated as received by each partner 
of such partnership to the extent of his distributive share of such 
item.
    (2) Interest from a resident alien individual or domestic 
corporation deriving substantial income from sources without the United 
States. Interest received from a resident alien individual or a domestic 
corporation shall be treated as income from sources without the United 
States when it is shown to the satisfaction of the district director 
(or, if applicable, the Director of International Operations) that less 
than 20 percent of the gross income from all sources of such individual 
or corporation has been derived from sources within the United States, 
as determined under the provisions of sections 861 to 863, inclusive, 
and the regulations thereunder, for the 3-year period ending with the 
close of the taxable year of such individual or corporation preceding 
its taxable year in which such interest is paid or credited, or for such 
part of such period as may be applicable. If 20 percent or more of the 
gross income from all sources of such individual or corporation has been 
derived from sources within the United States, as so determined, for 
such 3-year period (or part thereof), the entire amount of the interest 
from such individual or corporation shall be treated as income from 
sources within the United States.

[[Page 139]]

    (3) Interest from a foreign corporation not deriving major portion 
of its income from a U.S. business. (i) Interest from a foreign 
corporation which, at any time during the taxable year, is engaged in 
trade or business in the United States shall be treated as income from 
sources without the United States when it is shown to the satisfaction 
of the district director (or, if applicable, the Director of 
International Operations) that (a) less than 50 percent of the gross 
income from all sources of such foreign corporation for the 3-year 
period ending with the close of its taxable year preceding its taxable 
year in which such interest is paid or credited (or for such part of 
such period as the corporation has been in existence) was effectively 
connected with the conduct by such corporation of a trade or business in 
the United States, as determined under section 864(c) and Sec.  1.864-3, 
or (b) such foreign corporation had gross income for such 3-year period 
(or part thereof) but none was effectively connected with the conduct of 
a trade or business in the United States.
    (ii) If 50 percent or more of the gross income from all sources of 
such foreign corporation for such 3-year period (or part thereof) was 
effectively connected with the conduct by such corporation of a trade or 
business in the United States, see section 861(a)(1)(D) and paragraph 
(c)(1) of this section for determining the portion of interest from such 
corporation which is treated as income from sources within the United 
States.
    (iii) For purposes of this paragraph the gross income which is 
effectively connected with the conduct of a trade or business in the 
United States includes the gross income which, pursuant to section 882 
(d) or (e) and the regulations thereunder, is treated as income which is 
effectively connected with the conduct of a trade or business in the 
United States.
    (iv) This paragraph does not apply to interest paid or credited 
after December 31, 1969, by a branch in the United States of a foreign 
corporation if, at the time of payment or crediting, such branch is 
engaged in the commercial banking business in the United States; 
furthermore, such interest is treated under paragraph (a) of this 
section as income from sources within the United States unless it is 
treated as income from sources without the United States under paragraph 
(b)(1) or (4) of this section.
    (4) Bankers' acceptances. Interest derived by a foreign central bank 
of issue from bankers' acceptances shall be treated as income from 
sources without the United States. For this purpose, a foreign central 
bank of issue is a bank which is by law or government sanction the 
principal authority, other than the government itself, issuing 
instruments intended to circulate as currency. Such a bank is generally 
the custodian of the banking reserves of the country under whose laws it 
is organized.
    (5) Foreign banking branch of a domestic corporation or partnership. 
Interest paid or credited on deposits with a branch outside the United 
States (as defined in section 7701(a)(9)) of a domestic corporation or 
of a domestic partnership shall be treated as income from sources 
without the United States, if, at the time of payment or crediting, such 
branch is engaged in the commercial banking business. For purposes of 
applying this paragraph, it is immaterial (i) whether the domestic 
corporation or domestic partnership is carrying on a banking business in 
the United States, (ii) whether the recipient of the interest is a 
citizen or resident of the United States, a foreign corporation, or a 
foreign partnership, (iii) whether the interest is effectively connected 
with the conduct of a trade or business in the United States by the 
recipient, or (iv) whether the deposits with the branch located outside 
the United States are payable in the currency of a foreign country. 
Notwithstanding the provisions of Sec.  1.863-6, interest to which this 
paragraph applies shall be treated as income from sources within the 
foreign country, possession of the United States, or other territory in 
which the branch is located.
    (6) Section 4912(c) debt obligations-- (i) In general. Under section 
861(a)(1)(G), interest on a debt obligation shall not be treated as 
income from sources within the United States if--
    (a) The debt obligation was part of an issue of debt obligations 
with respect to which an election has been made

[[Page 140]]

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


For purposes of this paragraph (b)(6)(iv), a foreign established 
securities market includes any foreign over-the-counter market as 
reflected by the existence of an inter-dealer quotation system for 
regularly disseminating to brokers and dealers quotations of obligations 
by identified brokers or dealers, other than quotations prepared and 
distributed by a broker or dealer in the regular course of his business 
and containing only quotations of such broker or dealer.
    (c) The requirements of this paragraph (c) are that, except as 
provided in paragraph (b)(6)(iv)(d) of this section, the underwriter is 
under no written or implied restriction imposed by the issuer with 
respect to whom he

[[Page 141]]

may resell the debt obligation and either--
    (1) Within 30 calendar days after he purchased the debt obligation 
the underwriter or underwriters either (i) sold it or (ii) sold at least 
95 percent of the face amount of the issue of which the debt obligation 
is a part, or
    (2)(i) The debt obligation is evidenced by an instrument which, 
under the laws of the jurisdiction in which it is issued, is either 
negotiable or transferable by assignment (whether or not it is 
registered for trading), and (ii) it appears from all the relevant facts 
and circumstances, including any written statements or assurances made 
by the purchasing underwriter or underwriters, that such debt obligation 
was purchased with a view to distribution through resale.
    (d) The requirements of paragraph (b)(6)(iv)(c) of this paragraph 
may be met whether or not the underwriter is restricted from reselling 
the debt obligations--
    (1) To a United States person (as defined in section 7701(a)(30)) or
    (2) To any particular person or persons pursuant to a restriction 
imposed by, or required to be met in order to comply with, United States 
or foreign securities or other law.
    (v) Statement with return. Any taxpayer who is required to file a 
tax return and who excludes from gross income interest of the type 
specified in this subparagraph must comply with the requirements of 
paragraph (d) of this section.
    (vi) Effect of termination of IET. If the interest equalization tax 
expires, the provisions of section 861(a)(1)(G) and this subparagraph 
shall apply to interest paid on debt obligations only with respect to 
which a section 4912(c) election was made.
    (vii) Definition of term underwriter. For purposes of section 
861(a)(1)(G) and this paragraph, the term ``underwriter'' shall mean any 
underwriter as defined in section 4919(c)(1).
    (c) Special rules--(1) Proration of interest from a foreign 
corporation deriving major portion of its income from a U.S. business. 
If, after applying the first sentence of paragraph (b)(3) of this 
section to interest to which that paragraph applies, it is determined 
that the interest may not be treated as income from sources without the 
United States, the amount of the interest from the foreign corporation 
which at some time during the taxable year is engaged in trade or 
business in the United States which is to be treated as income from 
sources within the United States shall be the amount that bears the same 
ratio to such interest as the gross income of such foreign corporation 
for the 3-year period ending with the close of its taxable year 
preceding its taxable year in which such interest is paid or credited 
(or for such part of such period as the corporation has been in 
existence) which was effectively connected with the conduct by such 
corporation of a trade or business in the United States bears to its 
gross income from all sources for such period.
    (2) Payors having no gross income for period preceding taxable year 
of payment. If the resident alien individual, domestic corporation, or 
foreign corporation, as the case may be, paying interest has no gross 
income from any source for the 3-year period (or part thereof) specified 
in paragraph (b)(2) or (3) of this section, or paragraph (c)(1) of this 
section, the 20-percent test or the 50-percent test, or the 
apportionment formula, as the case may be, described in such paragraph 
shall be applied solely with respect to the taxable year of the payor in 
which the interest is paid or credited. This paragraph applies whether 
the lack of gross income for the 3-year period (or part thereof) stems 
from the business inactivity of the payor, from the fact that the payor 
is a corporation which is newly created or organized, or from any other 
cause.
    (3) Transitional rule. For purposes of applying paragraph (b)(3) of 
this section, and paragraph (c)(1) of this section, the gross income of 
the foreign corporation for any period before the first taxable year 
beginning after December 31, 1966, which is from sources within the 
United States (determined as provided by sections 861 through 863, and 
the regulations thereunder, as in effect immediately before amendment by 
section 102 of the Foreign Investors Tax Act of 1966 (Pub. L. 89-809, 80 
Stat. 1541)) shall be treated as gross income for such period which is 
effectively connected with the conduct of a trade

[[Page 142]]

or business in the United States by such foreign corporation.
    (4) Gross income determinations. In making determinations under 
paragraph (b)(2) or (3) of this section, or paragraph (c) (1) or (3) of 
this section--
    (i) The gross income of a domestic corporation or a resident alien 
individual is to be determined by excluding any items specifically 
excluded from gross income under chapter 1 of the Code, and
    (ii) The gross income of a foreign corporation which is effectively 
connected with the conduct of a trade or business in the United States 
is to be determined under section 882(b)(2) and by excluding any items 
specifically excluded from gross income under chapter 1 of the Code, and
    (iii) The gross income from all sources of a foreign corporation is 
to be determined without regard to section 882(b) and without excluding 
any items otherwise specifically excluded from gross income under 
chapter 1 of the Code.
    (d) Statement with return. Any taxpayer who is required to file a 
return and applies any provision of this section to exclude an amount of 
interest from his gross income must file with his return a statement 
setting forth the amount so excluded, the date of its receipt, the name 
and address of the obligor of the interest, and, if known, the location 
of the records which substantiate the amount of the exclusion. A 
statement from the obligor setting forth such information and indicating 
the amount of interest to be treated as income from sources without the 
United States may be used for this purpose. See Sec. Sec.  1.6012-
1(b)(1)(i) and 1.6012-2(g)(1)(i).
    (e) Effective dates. Except as otherwise provided, this section 
applies with respect to taxable years beginning after December 31, 1966. 
For corresponding rules applicable to taxable years beginning before 
January 1, 1967, (see 26 CFR part 1 revised April 1, 1971). Paragraph 
(a)(7) of this section is applicable to payments made after November 13, 
1997.

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



Sec.  1.861-3  Dividends and income inclusions under sections 951, 951A, 
and 1293 and associated section 78 dividends.

    (a) General--(1) Dividends included in gross income. Gross income 
from sources within the United States includes a dividend described in 
subparagraph (2), (3), (4), or (5) of this paragraph. For purposes of 
subparagraphs (2), (3), and (4) of this paragraph, the term ``dividend'' 
shall have the same meaning as set forth in section 316 and the 
regulations thereunder. See subparagraph (5) of this paragraph for 
special rules with respect to certain dividends from a DISC or former 
DISC. See also paragraph (a)(6) of this section for special rules 
concerning substitute dividend payments received pursuant to a 
securities lending transaction.
    (2) Dividend from a domestic corporation. A dividend described in 
this paragraph (a)(2) is a dividend from a domestic corporation other 
than a corporation that has an election in effect under section 936. See 
paragraph (a)(5) of this section for the treatment of certain dividends 
from a DISC or former DISC.
    (3) Dividend from a foreign corporation--(i) In general. (a) A 
dividend described in this subparagraph is a dividend from a foreign 
corporation (other than a dividend to which subparagraph (4) of this 
paragraph applies) unless less than 50 percent of the gross income from 
all sources of such foreign corporation for the 3-year period ending 
with the close of its taxable year preceding the taxable year in which 
occurs the declaration of such dividend (or for such part of such period 
as the corporation has been in existence) was effectively connected with 
the conduct by such corporation of a trade or business in the United 
States, as determined under section 864(c) and Sec.  1.864-3. Thus, no 
portion of a dividend from a foreign corporation shall be treated as 
income from sources within the United States under section 861(a)(2)(B) 
if less than 50 percent of the gross income of such foreign corporation 
from all sources for such 3-year period (or part thereof) was 
effectively connected with the conduct by such corporation of a trade or 
business in the United States or if such foreign corporation had gross 
income for

[[Page 143]]

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

    Example 1. D, a domestic corporation, owns 80 percent of the 
outstanding stock of M, a foreign manufacturing corporation. M, which 
makes its returns on the basis of the calendar year, has earnings and 
profits of $200,000 for 1971 and 60 percent of its gross income for that 
year is effectively connected for 1971 with the conduct of a trade or 
business in the United States. For an uninterrupted period of 36 months 
ending on December 31, 1970, M has been engaged in trade or business in 
the United States and has received gross income effectively connected 
with the conduct of a trade or business in the United States amounting 
to 60 percent of its gross income from all sources for such period. The 
only distribution by M to D for 1971 is a cash dividend of $100,000; of 
this amount, $60,000 ($100,000 x 60%) is treated under subdivision (i) 
of this subparagraph as income from sources within the United States, 
and $40,000 ($100,000-$60,000) is treated under Sec.  1.862-1(a)(2) as 
income from sources without the United States. Accordingly, under 
section 245(a), D is entitled to a dividends-received deduction of 
$51,000 ($60,000 x 85%), and under subdivision (ii) of this subparagraph 
$40,000 ($100,000-[$51,000 x 100/85]) is treated as income from sources 
without the United States for purposes of determining under section 
904(a) (1) or (2) the limitation upon the amount of the foreign tax 
credit.
    Example 2. (a) The facts are the same as in example (1) except that 
the distribution for 1971 consists of property which has a fair market 
value of $100,000 and an adjusted

[[Page 144]]

basis of $30,000 in M's hands immediately before the distribution. The 
amount of the dividend under section 316 is $58,000, determined by 
applying section 301(b)(1)(C) as follows:

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

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

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

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

    (4) Dividend from a foreign corporation succeeding to earnings of a 
domestic corporation. A dividend described in this subparagraph is a 
dividend from a foreign corporation, if such dividend is received by a 
corporation after December 31, 1959, but only to the extent that such 
dividend is treated by such recipient corporation under the provisions 
of Sec.  1.243-3 as a dividend from a domestic corporation subject to 
taxation under chapter 1 of the Code. To the extent that this 
subparagraph applies to a dividend received from a foreign corporation, 
subparagraph (3) of this paragraph shall not apply to such dividend.

[[Page 145]]

    (5) Certain dividends from a DISC or former DISC--(i) General rule. 
A dividend described in this subparagraph is a dividend from a 
corporation that is a DISC or former DISC (as defined in section 992(a)) 
other than a dividend that--
    (a) Is deemed paid by a DISC, for taxable years beginning before 
January 1, 1976, under section 995(b)(1)(D) as in effect for taxable 
years beginning before January 1, 1976, and for taxable years beginning 
after December 31, 1975, under section 995(b)(1) (D), (E), and (F) to 
the extent provided in subdivision (iii) of this subparagraph or
    (b) Reduces under Sec.  1.996-3(b)(3) accumulated DISC income (as 
defined in subdivision (ii)(b) of this subparagraph) to the extend 
provided in subdivision (iv) of this subparagraph.


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


For purposes of subdivisions (i)(b) and (iv) of this subparagraph, if by 
reason of section 995(c), gain is included in the shareholder's gross 
income as a dividend, accumulated DISC income shall be treated as if it 
were reduced under Sec.  1.996-3(b)(3).
    (iii) Determination of source of income for deemed distributions, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1) (D), (E), and (F). (a) If for its taxable year a DISC 
does not have any nonqualified export taxable income, then for such year 
the entire amount treated, for taxable years beginning before January 1, 
1976, under section 995(b)(1)(D) as in effect for taxable years 
beginning before January 1, 1976, and for taxable years beginning after 
December 31, 1975, under section 995(b)(1) (D), (E), and (F) as a deemed 
distribution taxable as a dividend will be treated as gross income from 
sources without the United States.
    (b) If for its taxable year a DISC has any nonqualified export 
taxable income, then for such year the portion of the amount treated, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1) (D), (E), and (F) as a deemed distribution taxable as 
a dividend that will be treated as income from sources

[[Page 146]]

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

    Example 1. (a) Y is a corporation which uses the calendar year as 
its taxable year and which elects to be treated as a DISC beginning with 
1972. X is its sole shareholder. In 1973, Y has $18,000 of taxable 
income from qualified export receipts (none of which are interest and 
gains described in section 995(b)(1)(A), (B), and (C)) and $1,000 of 
nonqualified export taxable income. Under these facts, X is deemed to 
have received a distribution under section 995(b)(1)(D) as in effect for 
taxable years beginning before January 1, 1976, of $9,500, i.e., $19,000 
X \1/2\. X is treated under subdivision (iii)(b) of this subparagraph as 
having $500, i.e., $1,000 X $9,500/$19,000, from sources within the 
United States and $9,000 from sources without the United States.
    (b) For 1972, assume that Y did not have any nonqualified export 
taxable income. Pursuant to subdivision (v)(b) of this subparagraph, at 
the beginning of 1974, $500 of Y's accumulated DISC income is 
attributable to nonqualified export taxable income (iii)(a) of this 
subparagraph), i.e., $1,000--$500.
    Example 2. The facts are the same as in example (1) except that in 
1973, in addition to the taxable income described in such example, Y has 
$450 of taxable income from gross interest from producer's loans 
described in section 995(b)(1)(A). Under these facts, the deemed 
distribution of $450 under section 995(b)(1)(A) is treated in full under 
subdivision (i) of this subparagraph as gross income from sources within 
the United States. The deemed distribution under section

[[Page 147]]

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

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


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

(D).........................    $500,  i.e., \1/2\ x $1,000.
(E).........................   7,800,  i.e.,.40 x [$21,000 - $(550 + 450
                                        + 500)].
(F)(i)......................   5,850,  i.e., \1/2\ x [$21,000 - $550 +
                                        450 + 500 + 7,800)].
 (ii).......................     585,  i.e., $5,850 x .10
 (iii)......................    1,265
                             ---------
 Total......................   16,000  .................................
 

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


[[Page 148]]



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

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

    (6) Substitute dividend payments. A substitute dividend payment is a 
payment, made to the transferor of a security in a securities lending 
transaction or a sale-repurchase transaction, of an amount equivalent to 
a dividend distribution which the owner of the transferred security is 
entitled to receive during the term of the transaction. A securities 
lending transaction is a transfer of one or more securities that is 
described in section 1058(a) or a substantially similar transaction. A 
sale-repurchase transaction is an agreement under which a person 
transfers a security in exchange for cash and simultaneously agrees to 
receive substantially identical securities from the transferee in the 
future in exchange for cash. A substitute dividend payment shall be 
sourced in the same manner as the distributions with respect to the 
transferred security for purposes of this section and Sec.  1.862-1. See 
also Sec. Sec.  1.864-5(b)(2)(iii), 1.871-7(b)(2) and 1.881-2(b)(2) for 
the character of such payments and Sec.  1.894-1(c) for the application 
of tax treaties to these transactions.
    (b) Special rules--(1) Foreign corporation having no gross income 
for period preceding declaration of dividend. If the foreign corporation 
has no gross income from any source for the 3-year period (or part 
thereof) specified in paragraph (a)(3)(i) of this section, the 50-
percent test, or the apportionment formula, as the case may be, 
described in such paragraph shall be applied solely with respect to the 
taxable year of such corporation in which the declaration of the 
dividend occurs. This subparagraph applies whether the lack of gross 
income for the 3-year period (or part thereof) stems from the business 
inactivity of the foreign corporation, from the fact that such 
corporation is newly created or organized, or from any other cause.
    (2) Transitional rule. For purposes of applying paragraph (a)(3)(i) 
of this section, the gross income of the foreign corporation for any 
period before the first taxable year beginning after December 31, 1966, 
which is from sources within the United States (determined as provided 
by sections 861 through 863, and the regulations thereunder, as in 
effect immediately before amendment by section 102 of the Foreign 
Investors Tax Act of 1966 (Pub. L. 89-809, 80 Stat. 1541)) shall be 
treated as gross income for such period which is effectively connected 
with the conduct of a trade or business within the United States by such 
foreign corporation.
    (3) Gross income determinations. In making determinations under 
subparagraph (2) or (3) of paragraph (a) of this

[[Page 149]]

section, or subparagraph (2) of this paragraph--
    (i) The gross income of a domestic corporation is to be determined 
by excluding any items specifically excluded from gross income under 
chapter 1 of the Code.
    (ii) The gross income of a foreign corporation which is effectively 
connected with the conduct of a trade or business in the United States 
is to be determined under section 882(b)(2) and by excluding any items 
specifically excluded from gross income under chapter 1 of the Code, and
    (iii) The gross income from all sources of a foreign corporation is 
to be determined without regard to section 882(b) and without excluding 
any items otherwise specifically excluded from gross income under 
chapter 1 of the Code.
    (c) Statement with return. Any taxpayer who is required to file a 
return and applies any provision of this section to exclude any dividend 
from his gross income must file with his return a statement setting 
forth the amount so excluded, the date of its receipt, the name and 
address of the corporation paying the dividend, and, if known, the 
location of the records which substantiate the amount of the exclusion. 
A statement from the paying corporation setting forth such information 
and indicating the amount of the dividend to be treated as income from 
sources within the United States may be used for this purpose. See 
Sec. Sec.  1.6012-1(b)(1)(i) and 1.6012-2 (g)(1)(i).
    (d) Source of income inclusions under sections 951, 951A, and 1293 
and associated section 78 dividends. For purposes of sections 861 and 
862 and Sec. Sec.  1.861-1 and 1.862-1, and for purposes of applying 
this section, the amount included in gross income of a United States 
person under sections 951, 951A, and 1293 and the associated section 78 
dividend for the taxable year with respect to a foreign corporation are 
treated as dividends received directly by the United States person from 
the foreign corporation that generated the inclusion. See section 904(h) 
and Sec.  1.904-5(m) for rules concerning the resourcing of inclusions 
under sections 951, 951A, and 1293.
    (e) Applicability dates. Except as otherwise provided in this 
paragraph (e) this section applies with respect to dividends received or 
accrued after December 31, 1966. Paragraph (a)(5) of this section 
applies to certain dividends from a DISC or former DISC in taxable years 
ending after December 31, 1971. Paragraph (a)(6) of this section is 
applicable to payments made after November 13, 1997. For purposes of 
paragraph (a)(5) of this section, any reference to a distribution 
taxable as a dividend under section 995(b)(1)(F) (ii) and (iii) for 
taxable years beginning after December 31, 1975, shall also constitute a 
reference to any distribution taxable as a dividend under section 
995(b)(1)(F) (ii) and (iii) for taxable years beginning after November 
30, 1975, but before January 1, 1976. For corresponding rules applicable 
with respect to dividends received or accrued before January 1, 1967, 
see 26 CFR 1.861-3 (Revised as of January 1, 1972). Paragraph (a)(2) of 
this section applies to taxable years ending after April 9, 2008. 
Paragraph (d) of this section applies to taxable years ending on or 
after November 2, 2020.

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

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



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

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

[[Page 150]]

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

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


[[Page 151]]


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

[[Page 152]]

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

[[Page 153]]

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

[[Page 154]]

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

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

[[Page 155]]

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

[[Page 156]]

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

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

[[Page 157]]



Sec.  1.861-5  Rentals and royalties.

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

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



Sec.  1.861-6  Sale of real property.

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



Sec.  1.861-7  Sale of personal property.

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



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

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

[[Page 158]]

after gross income from sources without the United States has been 
determined. This section provides specific guidance for applying the 
cited Code sections by prescribing rules for the allocation and 
apportionment of expenses, losses, and other deductions (referred to 
collectively in this section as ``deductions'') of the taxpayer. The 
rules contained in this section apply in determining taxable income of 
the taxpayer from specific sources and activities under other sections 
of the Code, referred to in this section as operative sections. See 
paragraph (f)(1) of this section for a list and description of operative 
sections. The term section 861 regulations means this section and 
Sec. Sec.  1.861-8T, 1.861-9, 1.861-9T, 1.861-10, 1.861-10T, 1.861-11, 
1.861-11T, 1.861-12, 1.861-12T, 1.861-13, 1.861-14, 1.861-14T, 1.861-17, 
and 1.861-20.
    (2) Allocation and apportionment of deductions in general. A 
taxpayer to which this section applies is required to allocate 
deductions to a class of gross income and, then, if necessary to make 
the determination required by the operative section of the Code, to 
apportion deductions within the class of gross income between the 
statutory grouping of gross income (or among the statutory groupings) 
and the residual grouping of gross income. Except for deductions, if 
any, which are not definitely related to gross income (see paragraphs 
(c)(3) and (e)(9) of this section) and which, therefore, are ratably 
apportioned to all gross income, all deductions of the taxpayer (except 
the deductions for personal exemptions enumerated in paragraph (e)(11) 
of this section) must be so allocated and apportioned. As further 
detailed below, allocations and apportionments are made on the basis of 
the factual relationship of deductions to gross income.
    (3) Class of gross income. For purposes of this section, the gross 
income to which a specific deduction is definitely related is referred 
to as a ``class of gross income'' and may consist of one or more items 
(or subdivisions of these items) of gross income enumerated in section 
61, namely:
    (i) Compensation for services, including fees, commissions, and 
similar items;
    (ii) Gross income derived from business;
    (iii) Gains derived from dealings in property;
    (iv) Interest;
    (v) Rents;
    (vi) Royalties;
    (vii) Dividends;
    (viii) Alimony and separate maintenance payments;
    (ix) Annuities;
    (x) Income from life insurance and endowment contracts;
    (xi) Pensions;
    (xii) Income from discharge of indebtedness;
    (xiii) Distributive share of partnership gross income;
    (xiv) Income in respect of a decedent;
    (xv) Income from an interest in an estate or trust.
    (4) Statutory grouping of gross income and residual grouping of 
gross income. For purposes of this section, the term ``statutory 
grouping of gross income'' or ``statutory grouping'' means the gross 
income from a specific source or activity which must first be determined 
in order to arrive at ``taxable income'' from which specific source or 
activity under an operative section. (See paragraph (f)(1) of this 
section.) Gross income from other sources or activities is referred to 
as the ``residual grouping of gross income'' or ``residual grouping.'' 
In some instances, where the operative section so requires, the 
statutory grouping or the residual grouping may include, or consist 
entirely of, excluded income. See paragraph (d)(2) of this section with 
respect to the allocation and apportionment of deductions to excluded 
income.
    (b) Allocation--(1) In general. For purposes of this section, the 
gross income to which a specific deduction is definitely related is 
referred to as a ``class of gross income'' and may consist of one or 
more items of gross income. The rules emphasize the factual relationship 
between the deduction and a class of gross income. See paragraph (d)(1) 
of this section which provides that in a taxable year there may be no 
item of gross income in a class or less gross income than deductions 
allocated to the class, and paragraph (d)(2) of this section which 
provides that a class of

[[Page 159]]

gross income may include excluded income. Allocation is accomplished by 
determining, with respect to each deduction, the class of gross income 
to which the deduction is definitely related and then allocating the 
deduction to such class of gross income (without regard to the 
taxpayable year in which such gross income is received or accrued or is 
expected to be received or accrued). The classes of gross income are not 
predetermined but must be determined on the basis of the deductions to 
be allocated. Although most deductions will be definitely related to 
some class of a taxpayer's total gross income, some deductions are 
related to all gross income. In addition, some deductions are treated as 
not definitely related to any gross income and are ratably apportioned 
to all gross income. (See paragraph (e)(9) of this section.) In 
allocating deductions it is not necessary to differentiate between 
deductions related to one item of gross income and deductions related to 
another item of gross income where both items of gross income are 
exclusively within the same statutory grouping or exclusively within the 
residual grouping.
    (2) Relationship to activity or property. A deduction shall be 
considered definitely related to a class of gross income and therefore 
allocable to such class if it is incurred as a result of, or incident 
to, an activity or in connection with property from which such class of 
gross income is derived. Where a deduction is incurred as a result of, 
or incident to, an activity or in connection with property, which 
activity or property generates, has generated, or could reasonably have 
been expected to generate gross income, such deduction shall be 
considered definitely related to such gross income as a class whether or 
not there is any item of gross income in such class which is received or 
accrued during the taxable year and whether or not the amount of 
deductions exceeds the amount of the gross income in such class. See 
paragraph (d)(1) of this section with respect to cases in which there is 
an excess of deductions. In some cases, it will be found that this 
subparagraph can most readily be applied by determining, with respect to 
a deduction, the categories of gross income to which it is not related 
and concluding that it is definitely related to a class consisting of 
all other gross income.
    (3) Supportive functions. Deductions which are supportive in nature 
(such as overhead, general and administrative, and supervisory expenses) 
may relate to other deductions which can more readily be allocated to 
gross income. In such instance, such supportive deductions may be 
allocated and apportioned along with the deductions to which they 
relate. On the other hand, it would be equally acceptable to attribute 
supportive deductions on some reasonable basis directly to activities or 
property which generate, have generated or could reasonably be expected 
to generate gross income. This would ordinarily be accomplished by 
allocating the supportive expenses to all gross income or to another 
broad class of gross income and apportioning the expenses in accordance 
with paragraph (c)(1) of this section. For this purpose, reasonable 
departmental overhead rates may be utilized. For examples of the 
application of the principles of this paragraph (b)(3) to expenses other 
than expenses attributable to stewardship activities, see Examples 19 
through 21 of paragraph (g) of this section. See paragraph (e)(4)(ii) of 
this section for the allocation and apportionment of deductions 
attributable to stewardship expenses. However, supportive deductions 
that are described in Sec.  1.861-14T(e)(3) shall be allocated and 
apportioned in accordance with the rules of Sec.  1.861-14T and shall 
not be allocated and apportioned by reference only to the gross income 
of a single member of an affiliated group of corporations as defined in 
Sec.  1.861-14T(d).
    (4) Deductions related to a class of gross income. See paragraph (e) 
of this section for rules relating to the allocation and apportionment 
of certain specific deductions definitely related to a class of gross 
income. See paragraph (c)(1) of this section for rules relating to the 
apportionment of deductions.
    (5) Deductions related to all gross income. If a deduction does not 
bear a definite relationship to a class of gross income constituting 
less than all of gross income, it shall ordinarily be

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treated as definitely related and allocable to all of the taxpayer's 
gross income except where provided to the contrary under paragraph (e) 
of this section. Paragraph (e)(9) of this section lists various 
deductions which generally are not definitely related to any gross 
income and are ratably apportioned to all gross income.
    (c) Apportionment of deductions--(1) Deductions definitely related 
to a class of gross income. [Reserved]. For guidance, see Sec.  1.861-
8T(c)(1).
    (2) Apportionment based on assets. Certain taxpayers are required by 
paragraph (e)(2) of this section and Sec.  1.861-9T to apportion 
interest expense on the basis of assets. A taxpayer may apportion other 
deductions based on the comparative value of assets that generate income 
within each grouping, provided that this method reflects the factual 
relationship between the deduction and the groupings of income and is 
applied in accordance with the rules of Sec.  1.861-9T(g). In general, 
such apportionments must be made either on the basis of the tax book 
value of those assets or, except in the case of interest expense, on the 
basis of their fair market value. See Sec.  1.861-9(h). Taxpayers using 
the fair market value method for their last taxable year beginning 
before January 1, 2018, must change to the tax book value method (or the 
alternative tax book value method) for purposes of apportioning interest 
expense for their first taxable year beginning after December 31, 2017. 
The Commissioner's approval is not required for this change. In the case 
of any corporate taxpayer that both uses tax book value or alternative 
tax book value, and owns directly or indirectly (within the meaning of 
Sec.  1.861-12T(c)(2)(ii)(B)) 10 percent or more of the total combined 
voting power of all classes of stock entitled to vote in any other 
corporation (domestic or foreign) that is not a member of the affiliated 
group (as defined in section 864(e)(5)), the taxpayer must adjust its 
basis in that stock in the manner described in Sec.  1.861-12(c)(2). For 
the definition of related persons formerly contained in Sec.  1.861-
8T(c)(2), see paragraph (c)(4) of this section.
    (3) Deductions not definitely related to any gross income. If a 
deduction is not definitely related to any gross income (see paragraph 
(e)(9) of this section), the deduction must be apportioned ratably 
between the statutory grouping (or among the statutory groupings) of 
gross income and the residual grouping. Thus, the amount apportioned to 
each statutory grouping shall be equal to the same proportion of the 
deduction which the amount of gross income in the statutory grouping 
bears to the total amount of gross income. The amount apportioned to the 
residual grouping shall be equal to the same proportion of the deduction 
which the amount of the gross income in the residual grouping bears to 
the total amount of gross income.
    (4) Cross-referenced definition of related persons. The term related 
persons means two or more persons in a relationship described in section 
267(b). In determining whether two or more corporations are members of 
the same controlled group under section 267(b)(3), a person is 
considered to own stock owned directly by such person, stock owned by 
application of section 1563(e)(1), and stock owned by application of 
section 267(c). In determining whether a corporation is related to a 
partnership under section 267(b)(10), a person is considered to own the 
partnership interest owned directly by such person and the partnership 
interest owned by application of section 267(e)(3).
    (d) Excess of deductions and excluded and eliminated income--(1) 
Excess of deductions. Each deduction which bears a definite relationship 
to a class of gross income shall be allocated to that class in 
accordance with paragraph (b)(1) of this section even though, for the 
taxable year, no gross income in such class is received or accrued or 
the amount of the deduction exceeds the amount of such class of gross 
income. In apportioning deductions, it may be that, for the taxable 
year, there is no gross income in the statutory grouping (or residual 
grouping), or that deductions exceed the amount of gross income in the 
statutory grouping (or residual grouping). If there is no gross income 
in a statutory grouping or the amount of deductions allocated and 
apportioned to a statutory grouping exceeds the amount of gross income 
in the statutory grouping, the effects are

[[Page 161]]

determined under the operative section. If the taxpayer is a member of a 
group filing a consolidated return, such excess of deductions allocated 
or apportioned to a statutory grouping of income of such member is taken 
into account in determining the consolidated taxable income from such 
statutory grouping, and such excess of deductions allocated or 
apportioned to the residual grouping of income is taken into account in 
determining the consolidated taxable income from the residual grouping. 
See Sec.  1.1502-12.
    (2) Allocation and apportionment to exempt, excluded, or eliminated 
income--(i) In general. For further guidance, see Sec.  1.861-
8T(d)(2)(i).
    (ii) Exempt income and exempt asset defined--(A) In general. For 
purposes of this section, the term exempt income means any gross income 
to the extent that it is exempt, excluded, or eliminated for Federal 
income tax purposes. The term exempt asset means any asset to the extent 
income from the asset is (or is treated as under paragraph (d)(2)(ii)(B) 
or (C) of this section) exempt, excluded, or eliminated for Federal 
income tax purposes.
    (B) Certain stock and dividends. The term exempt income includes the 
portion of the dividends that are deductible under section 243(a)(1) or 
(2) (relating to the dividends received deduction) or section 245(a) 
(relating to the dividends received deduction for dividends from certain 
foreign corporations). Thus, for purposes of apportioning deductions 
using a gross income method, gross income does not include a dividend to 
the extent that it gives rise to a dividends-received deduction under 
either section 243(a)(1), section 243(a)(2), or section 245(a). In 
addition, for purposes of apportioning deductions using an asset method, 
assets do not include that portion of the value of the stock (determined 
in accordance with Sec.  1.861-9(g), and, as relevant, Sec. Sec.  1.861-
12 and 1.861-13) equal to the portion of dividends that would be offset 
by a deduction under either section 243(a)(1), section 243(a)(2), or 
section 245(a), to the extent the stock generates, has generated, or can 
reasonably be expected to generate such dividends. For example, in the 
case of stock for which all dividends would be allowed a deduction of 50 
percent under section 243(a)(1), 50 percent of the value of the stock is 
treated as an exempt asset. In the case of stock which generates, has 
generated, or can reasonably be expected to generate qualifying 
dividends deductible under section 243(a)(3), such stock does not 
constitute an exempt asset. However, such stock and the qualifying 
dividends thereon are eliminated from consideration in the apportionment 
of interest expense under the affiliated group rule set forth in Sec.  
1.861-11T(c), and in the apportionment of other expenses under the 
affiliated group rules set forth in Sec.  1.861-14T.
    (C) Foreign-derived intangible income and inclusions under section 
951A(a)--(1) Exempt income. The term ``exempt income'' includes an 
amount of a domestic corporation's gross income included in gross 
foreign-derived deduction eligible income (or gross FDDEI), and also 
includes an amount of a domestic corporation's gross income from an 
inclusion under section 951A(a) and the gross up under section 78 
attributable to such an inclusion, in each case equal to the amount of 
the deduction allowed under section 250(a) for such gross income (taking 
into account the reduction under section 250(a)(2)(B), if any). 
Therefore, for purposes of apportioning deductions using a gross income 
method, gross income does not include gross income included in gross 
FDDEI, an inclusion under section 951A(a), or the gross up under section 
78 attributable to an inclusion under section 951A(a), in an amount 
equal to the amount of the deduction allowed under section 250(a)(1)(A), 
(B)(i), or (B)(ii), respectively (taking into account the reduction 
under section 250(a)(2)(B), if any). The term gross foreign-derived 
deduction eligible income, or gross FDDEI, has the meaning provided in 
Sec.  1.250(b)-1(c)(16).
    (2) Exempt assets--(i) Assets that produce foreign-derived 
intangible income. The term ``exempt asset'' includes the portion of a 
domestic corporation's assets that produce gross FDDEI equal to the 
amount of such assets multiplied by the fraction that equals the amount 
of the domestic corporation's deduction allowed under section 
250(a)(1)(A) (taking into account the reduction under section

[[Page 162]]

250(a)(2)(B)(i), if any) divided by its gross FDDEI. No portion of the 
value of stock in a foreign corporation is treated as an exempt asset by 
reason of this paragraph (d)(2)(ii)(C)(2)(i), including by reason of a 
transfer of intangible property to a foreign corporation subject to 
section 367(d) that gives rise to gross FDDEI.
    (ii) Controlled foreign corporation stock that gives rise to 
inclusions under section 951A(a). The term ``exempt asset'' includes a 
portion of the value of a United States shareholder's stock in a 
controlled foreign corporation if the United States shareholder is a 
domestic corporation that is eligible for a deduction under section 
250(a) with respect to income described in section 250(a)(1)(B)(i) and 
all or a portion of the domestic corporation's stock in the controlled 
foreign corporation is characterized as GILTI inclusion stock. The 
portion of foreign corporation stock that is treated as an exempt asset 
for a taxable year equals the portion of the value of such foreign 
corporation stock (determined in accordance with Sec. Sec.  1.861-9(g), 
1.861-12, and 1.861-13) that is characterized as GILTI inclusion stock 
multiplied by a fraction that equals the amount of the domestic 
corporation's deduction allowed under section 250(a)(1)(B)(i) (taking 
into account the reduction under section 250(a)(2)(B)(ii), if any) 
divided by its GILTI inclusion amount (as defined in Sec.  1.951A-
1(c)(1) or, in the case of a member of a consolidated group, Sec.  
1.1502-51(b)) for such taxable year. The portion of controlled foreign 
corporation stock treated as an exempt asset under this paragraph 
(d)(2)(ii)(C)(2)(ii) is treated as attributable to the relevant 
categories of GILTI inclusion stock described in each of paragraphs 
(d)(2)(ii)(C)(3)(i) through (v) of this section based on the relative 
value of the portion of the stock in each such category.
    (3) GILTI inclusion stock. For purposes of paragraph 
(d)(2)(ii)(C)(2)(ii) of this section, the term GILTI inclusion stock 
means the aggregate of the portions of the value of controlled foreign 
corporation stock that are--
    (i) Assigned to the section 951A category under Sec.  1.861-
13(a)(2);
    (ii) Assigned to a particular treaty category under Sec.  1.861-
13(a)(3)(i) (relating to resourced gross tested income stock);
    (iii) Assigned under Sec.  1.861-13(a)(1) to the gross tested income 
statutory grouping within the foreign source passive category less the 
amount described in Sec.  1.861-13(a)(5)(iii)(A);
    (iv) Assigned under Sec.  1.861-13(a)(1) to the gross tested income 
statutory grouping within the U.S. source general category less the 
amount described in Sec.  1.861-13(a)(5)(iv)(A); and
    (v) Assigned under Sec.  1.861-13(a)(1) to the gross tested income 
statutory grouping within the U.S. source passive category less the 
amount described in Sec.  1.861-13(a)(5)(iv)(B).
    (4) Non-applicability to section 250(b). Paragraphs (d)(2)(ii)(C)(1) 
through (3) of this section do not apply when apportioning deductions 
for purposes of determining deduction eligible income or foreign-derived 
deduction eligible income under the operative section of section 250(b).
    (5) Example. The following example illustrates the application of 
the rules in this paragraph (d)(2)(ii)(C).
    (i) Facts. USP, a domestic corporation, directly owns all of the 
stock of CFC1 and CFC2, both of which are controlled foreign 
corporations. The tax book value of CFC1 and CFC2's stock is $10,000x 
and $9,000x, respectively. Pursuant to Sec.  1.861-13(a), $6,100x of the 
stock of CFC1 is assigned to the section 951A category under Sec.  
1.861-13(a)(2) (``section 951A category stock'') and the remaining 
$3,900x of the stock of CFC1 is assigned to the general category 
(``general category stock''). Additionally, $4,880x of the stock of CFC2 
is section 951A category stock and the remaining $4,120x of the stock of 
CFC2 is general category stock. Under section 951A and the section 951A 
regulations (as defined in Sec.  1.951A-1(a)(1)), USP's GILTI inclusion 
amount is $610x. The portion of USP's deduction under section 250 
described in section 250(a)(1)(B)(i) is $305x. No portion of USP's 
deduction is reduced by reason of section 250(a)(2)(B)(ii).
    (ii) Analysis. For purposes of apportioning deductions where section 
904 is the operative section, under paragraph (d)(2)(ii)(C)(1) of this 
section, $305x of USP's gross income attributable to its

[[Page 163]]

GILTI inclusion amount is exempt income. Under paragraph 
(d)(2)(ii)(C)(3) of this section, the GILTI inclusion stock of CFC1 is 
the $6,100x of stock that is section 951A category stock and the GILTI 
inclusion stock of CFC2 is the $4,880x of stock that is section 951A 
category stock. Under paragraph (d)(2)(ii)(C)(2) of this section, the 
portion of the value of the stock of CFC1 and CFC2 that is treated as an 
exempt asset equals the portion of the value of the stock of CFC1 and 
CFC2 that is GILTI inclusion stock multiplied by 50% ($305x/$610x). 
Accordingly, the exempt portion of the stock of CFC1 is $3,050x (50% x 
$6,100x) and the exempt portion of CFC2's stock is $2,440x (50% x 
$4,880x). Therefore, the stock of CFC1 taken into account for purposes 
of apportioning deductions is $3,050x of non-exempt section 951A 
category stock and $3,900x of general category stock. The stock of CFC2 
taken into account for purposes of apportioning deductions is $2,440x of 
non-exempt section 951A category stock and $4,120x of general category 
stock.
    (iii) Income that is not considered tax exempt. For further 
guidance, see Sec.  1.861-8T(d)(2)(iii).
    (A) For further guidance, see Sec.  1.861-8T(d)(2)(iii)(A) and (B).
    (B) [Reserved]
    (C) Dividends for which a deduction is allowed under section 245A;
    (D) Foreign earned income as defined in section 911 (however, the 
rules of Sec.  1.911-6 do not require the allocation and apportionment 
of certain deductions, including home mortgage interest, to foreign 
earned income for purposes of determining the deductions disallowed 
under section 911(d)(6)); and
    (E) Inclusions for which a deduction is allowed under section 
965(c). See Sec.  1.965-6(c).
    (iv) Value of stock attributable to previously taxed earnings and 
profits. No portion of the value of stock in a controlled foreign 
corporation is treated as an exempt asset by reason of the controlled 
foreign corporation having previously taxed earnings and profits. For 
example, no portion of the value of stock in a controlled foreign 
corporation is treated as an exempt asset by reason of the adjustment 
under Sec.  1.861-12(c)(2) in respect of previously taxed earnings and 
profits described in section 959(c)(1) or (c)(2) (including earnings and 
profits described in section 959(c)(2) by reason of section 951A(f)(1) 
and Sec.  1.951A-6(b)(1)). See also Sec.  1.965-6(c).
    (v) Dividends-received deduction and tax-exempt interest of 
insurance companies--(A) In general. For purposes of characterizing 
gross income or assets as exempt or not exempt under this section, the 
following rules apply on a company wide basis pursuant to the rules in 
paragraphs (d)(2)(v)(A)(1) and (2) of this section.
    (1) In the case of an insurance company taxable under section 801, 
the term exempt income includes the portion of dividends received that 
satisfy the requirements of deductibility under sections 243(a)(1) and 
(2) and 245(a) but without regard to any disallowance under section 
805(a)(4)(A)(ii) of the policyholder's share of the dividends or any 
similar disallowance under section 805(a)(4)(D), and also includes tax-
exempt interest but without reduction for the policyholder's share of 
tax-exempt interest that reduces the closing balance of items described 
in section 807(c), as provided under section 807(a)(2)(B) and 
807(b)(1)(B). The term exempt assets includes the corresponding portion 
of assets that generates, has generated, or can reasonably be expected 
to generate exempt income described in the preceding sentence. See Sec.  
1.861-8(e)(16) for a special rule concerning the allocation of reserve 
expenses to dividends received by a life insurance company.
    (2) In the case of an insurance company taxable under section 831, 
the term exempt income includes the portion of interest and dividends 
deductible under sections 832(c)(7) and (12) or sections 834(c)(1) and 
(7). Exempt income also includes the amounts reducing the losses 
incurred under section 832(b)(5) to the extent such amounts are not 
already taken into account in the preceding sentence. The term exempt 
assets includes the corresponding portion of assets that give rise to 
exempt income described in the preceding two sentences.
    (B) Examples. The following examples illustrate the application of 
paragraph (d)(2)(v)(A) of this section.

[[Page 164]]

    (1) Example 1--(i) Facts. U.S.C. is a domestic life insurance 
company that has $300x; of gross income, consisting of $100x of foreign 
source general category income and $200x of U.S. source passive category 
interest income, $100x; of the latter of which is tax-exempt interest 
income from municipal bonds under section 103. U.S.C.'s opening balance 
of its section 807(c) reserves is $50,000x; and USP's closing balance of 
its section 807(c) reserves is $50,130x. Under section 807(b)(1)(B), 
USP's closing balance of its section 807(c) reserves, $50,130x, is 
reduced by the amount of the policyholder's share of tax-exempt 
interest. The policyholder's share of tax-exempt interest under section 
812(b) is equal to 30 percent of the $100x of tax-exempt interest 
($30x). Therefore, under sections 803(a)(2) and 807(b), USP's reserve 
deduction is $100x ($50,130x of reserve deduction minus $30x (30 percent 
of $100x of tax-exempt interest), minus $50,000x). U.S.C. has no other 
income or deductions.
    (ii) Analysis--allocation. Under section 818(f)(1), U.S.C.'s reserve 
deduction is treated as an item that cannot be definitely allocated to 
an item or class of gross income. Accordingly, under paragraph (b)(5) of 
this section, U.S.C.'s reserve deduction is allocable to all of U.S.C.'s 
gross income as a class.
    (iii) Analysis--apportionment. Under paragraph (c)(3) of this 
section, the reserve deduction is ratably apportioned between the 
statutory grouping (foreign source general category income) and the 
residual grouping (U.S. source income) on the basis of the relative 
amounts of gross income in each grouping. For purposes of apportioning 
deductions under Sec.  1.861-8T(d)(2)(i)(B), exempt income is not taken 
into account. Under paragraph (d)(2)(v)(A)(1) of this section, in the 
case of an insurance company taxable under section 801, exempt income 
includes tax-exempt interest without regard to any reduction for the 
policyholder's share. U.S.C. has U.S. source income of $200x of which 
$100x is tax-exempt without regard to the reduction for the 
policyholder's share of tax-exempt interest that reduces the closing 
balance of items described in section 807(c). Thus, the gross income 
taken into account in apportioning U.S.C.'s reserve deduction is $100x 
of foreign source general category gross income and $100x of U.S. source 
gross income. Of U.S.C.'s $100x reserve deduction, $50x ($100 x $100x;/
$200x) is apportioned to foreign source general category gross income 
and $50x ($100x x $100x/$200x) is apportioned to U.S. source gross 
income.
    (2) Example 2--(i) Facts. U.S.C. is a domestic life insurance 
company that has $300x of gross income consisting of $10x of foreign 
source general category income and $200x of U.S. source general category 
dividend income eligible for the 50% dividends received deduction (DRD) 
under section 243(a)(1). Under section 805(a)(4)(A)(ii), U.S.C. is 
allowed a 50% DRD on the company's share of the dividend received. Under 
section 812(a), the company's share of the dividend is equal to 70% of 
the dividend income eligible for the DRD under section 243(a)(1), which 
results in a DRD of $70x (50% x 70% x $200), and under section 812(b), 
the policyholder's share of the dividend is equal to 30% of the dividend 
income eligible for the DRD under section 243(a)(1), which would result 
in a DRD of $30x (50% x 30% x $200x). U.S.C. is entitled to a $130x 
deduction for an increase in its life insurance reserves under sections 
803(a)(2) and 807(b). Unlike for tax-exempt interest income, there is no 
adjustment under section 807(b)(1)(B) to the reserve deduction for the 
policyholder's share of dividends that would be offset by the DRD under 
section 243(a)(1). U.S.C. has no other income or deductions.
    (ii) Analysis--allocation. Under section 818(f)(1), U.S.C.'s reserve 
deduction is treated as an item that cannot be definitely allocated to 
an item or class of gross income except that, under Sec.  1.861-
8(e)(16), an amount of reserve expenses of a life insurance company 
equal to the DRD that is disallowed because it is attributable to the 
policyholder's share of dividends is treated as definitely related to 
such dividends. Thus, U.S.C. has a life insurance reserve deduction of 
$130x, of which $30 (equal to the policyholder's share of the DRD that 
would have been allowed under section 243(a)(1)) is directly allocated 
and apportioned to U.S. source dividend income. Under paragraph (b)(5) 
of this section, the remaining portion of

[[Page 165]]

U.S.C.'s reserve deduction ($100x) is allocable to all of U.S.C.'s gross 
income as a class.
    (iii) Analysis--apportionment. Under paragraph (c)(3) of this 
section, the deduction is ratably apportioned between the statutory 
grouping (foreign source general category income) and the residual 
grouping (U.S. source income) on the basis of the relative amounts of 
gross income in each grouping. For purposes of apportioning deductions 
under Sec.  1.861-8T(d)(2)(i)(B), exempt income is not taken into 
account. Under paragraph (d)(2)(v)(A)(1) of this section, in the case of 
an insurance company taxable under section 801, exempt income includes 
dividends deductible under section 805(a)(4) without regard to any 
reduction to the DRD for the policyholder's share in section 
804(a)(4)(A)(ii). Thus, the gross income taken into account in 
apportioning $100x of U.S.C.'s remaining reserve deduction is $100x of 
foreign source general category gross income and $100x of U.S. source 
gross income. Of U.S.C.'s $100x remaining reserve deduction, $50x ($100x 
x $100x /$200x) is apportioned to foreign source general category gross 
income and $50x ($100x x $100x/$200x) is apportioned to U.S. source 
gross income.
    (e) Allocation and apportionment of certain deductions--(1) In 
general. Paragraphs (e)(2) and (e)(3) of this section contain rules with 
respect to the allocation and apportionment of interest expense and 
research and development expenditures, respectively. Paragraphs (e)(4) 
through (e)(8) of this section contain rules with respect to the 
allocation of certain other deductions. Paragraph (e)(9) of this section 
lists those deductions which are ordinarily considered as not being 
definitely related to any class of gross income. Paragraph (e)(10) of 
this section lists special deductions of corporations which must be 
allocated and apportioned. Paragraph (e)(11) of this section lists 
personal exemptions which are neither allocated nor apportioned. 
Paragraph (e)(12) of this section contains rules with respect to the 
allocation and apportionment of deductions for charitable contributions. 
Paragraphs (e)(13) and (14) of this section contain rules with respect 
to the allocation and apportionment of the deduction allowed under 
section 250(a). Paragraph (e)(15) of this section contains rules with 
respect to the allocation and apportionment of a taxpayer's distributive 
share of a partnership's deductions. Examples of allocation and 
apportionment are contained in paragraph (g) of this section.
    (2) Interest. [Reserved]. For guidance, see Sec.  1.861-8T(e)(2).
    (3) Research and experimental expenditures. For rules regarding the 
allocation and apportionment of research and experimental expenditures, 
see Sec.  1.861-17.
    (4) Stewardship and controlled services--(i) Expenses attributable 
to controlled services. If a taxpayer performs a controlled services 
transaction (as defined in Sec.  1.482-9(l)(1)), which includes any 
activity by one member of a group of controlled taxpayers (the renderer) 
that results in a benefit to a controlled taxpayer (the recipient), and 
the renderer charges the recipient for such services, section 482 and 
Sec.  1.482-1 provide for an allocation where the charge is not 
consistent with an arm's length result. The deductions for expenses 
incurred by the renderer in performing such services are considered 
definitely related to the amounts so charged and are to be allocated to 
such amounts.
    (ii) Stewardship expenses--(A) In general. Stewardship expenses are 
those expenses resulting from ``duplicative activities'' (as defined in 
Sec.  1.482-9(l)(3)(iii)) or ``shareholder activities'' (as defined in 
Sec.  1.482-9(l)(3)(iv)) that are undertaken for a person's own benefit 
as an investor in a related entity, which for purposes of this paragraph 
(e)(4)(ii) includes a business entity as described in Sec.  301.7701-
2(a) of this chapter that is classified for Federal income tax purposes 
as either a corporation or a partnership, or is disregarded as an entity 
separate from its owner (``disregarded entity''). Thus, for example, 
stewardship expenses include expenses of an activity the sole effect of 
which is to protect the investor's capital investment in the entity or 
to facilitate compliance by the investor with reporting, legal, or 
regulatory requirements applicable specifically to the investor. If an 
investor has a foreign or international department which exercises 
oversight functions

[[Page 166]]

with respect to related entities and, in addition, the department 
performs other functions that generate other foreign-source income (such 
as fees for services rendered outside of the United States for the 
benefit of foreign related corporations or foreign-source royalties), 
some part of the deductions with respect to that department are 
considered definitely related to the other foreign-source income. In 
some instances, the operations of a foreign or international department 
will also generate U.S. source income (such as fees for services 
performed in the United States). Stewardship expenses are allocated and 
apportioned on a separate entity basis without regard to the affiliated 
group rules in Sec.  1.861-14. See Sec.  1.861-14(e)(1)(i).
    (B) Allocation. In the case of stewardship expenses incurred to 
oversee a corporation, the expenses are considered definitely related 
and allocable to dividends received or amounts included, or to be 
received or included, under sections 78, 301, 951, 951A, 1291, 1293, and 
1296, from the corporation. In the case of stewardship expenses incurred 
to oversee a partnership, the expenses are considered definitely related 
and allocable to a partner's distributive share of partnership income. 
In the case of stewardship expenses incurred to oversee a disregarded 
entity, the expenses are considered definitely related and allocable to 
all gross income attributable to the disregarded entity. Stewardship 
expenses are allocated to income from a particular entity (or entities) 
related to the taxpayer if the expense is definitely related to the 
oversight of that entity or entities as provided in Sec.  1.861-8(b)(1) 
under all the facts and circumstances.
    (C) Apportionment. Stewardship expenses must be apportioned between 
the statutory and residual groupings based on the relative values of the 
entity or entities in each grouping that are owned by the investor 
taxpayer, and without regard to the relative amounts of gross income in 
the statutory and residual groupings to which the stewardship expense is 
allocated. In the case of stewardship expenses incurred to oversee a 
lower-tier entity owned indirectly by the taxpayer, the stewardship 
expenses must be apportioned based on the relative values of the owner 
or owners of the lower-tier entity that are owned directly by the 
taxpayer. In the case of stewardship expenses incurred to oversee a 
corporation, the corporation's value is the value of its stock as 
determined and characterized under the asset method in Sec.  1.861-9 
(and, as relevant, Sec. Sec.  1.861-12 and 1.861-13) for purposes of 
allocating and apportioning the taxpayer's interest expense. For 
purposes of the preceding sentence, if the corporation is a member of 
the same affiliated group as the investor, the value of the 
corporation's stock is determined under the asset method in Sec.  1.861-
9 and is characterized by the investor in proportion to how the 
corporation's assets are characterized for purposes of apportioning the 
group's interest expense. In the case of stewardship expenses incurred 
to oversee a partnership, the partnership's value is determined and 
characterized under the asset method in Sec.  1.861-9 (taking into 
account any adjustments under sections 734(b) and 743(b)). In the case 
of stewardship expenses incurred to oversee a disregarded entity, the 
disregarded entity's character and value is determined using the 
principles of the asset method in Sec.  1.861-9 as if the disregarded 
entity were treated as a corporation for Federal income tax purposes. 
For purposes of determining the tax book value of assets under this 
paragraph (e)(4)(ii)(C), section 864(e)(3) and Sec.  1.861-8(d)(2) do 
not apply.
    (5) Legal and accounting fees and expenses; damages awards, 
prejudgment interest, and settlement payments--(i) Legal and accounting 
fees and expenses. Fees and other expenses for legal and accounting 
services are ordinarily definitely related and allocable to specific 
classes of gross income or to all the taxpayer's gross income, depending 
on the nature of the services rendered (and are apportioned as provided 
in paragraph (c)(1) of this section). For example, accounting fees for 
the preparation of a study of the costs involved in manufacturing a 
specific product will ordinarily be definitely related to the class of 
gross income derived from (or which could reasonably have been

[[Page 167]]

expected to be derived from) that specific product. The taxpayer is not 
relieved from his responsibility to make a proper allocation and 
apportionment of fees on the grounds that the statement of services 
rendered does not identify the services performed beyond a generalized 
designation such as ``professional,'' or does not provide any type of 
allocation, or does not properly allocate the fees involved.
    (ii) Product liability and other claims for damages. Except as 
otherwise provided in this paragraph (e)(5), awards for litigation or 
arbitral damages, prejudgment interest, and payments in settlement of or 
in anticipation of claims for damages, including punitive damages, 
arising from claims relating to sales, licenses, or leases of products 
or the provision of services, are definitely related and allocable to 
the class of gross income of the type produced by the specific sales or 
leases of the products or provision of services that gave rise to the 
claims for damage or injury. Such damages and payments may include, but 
are not limited to, product liability or patent infringement claims. The 
deductions are apportioned among the statutory and residual groupings on 
the basis of the relative amounts of gross income in the relevant class 
in each grouping in the year in which the deductions are allowed. If the 
claims arise from an event incident to the production or sale of 
products or provision of services (such as an industrial accident), the 
payments are definitely related and allocable to the class of gross 
income ordinarily produced by the assets that are involved in the event. 
The deductions are apportioned among the statutory and residual 
groupings on the basis of the relative values (as determined under the 
asset method in Sec.  1.861-9 for purposes of allocating and 
apportioning the taxpayer's interest expense) of the assets that were 
involved in the event or (if the taxpayer no longer owns the assets 
involved in the event) the assets that are used to produce or sell 
products or services in the relevant class in each grouping; such values 
are determined in the year the deductions are allowed.
    (iii) Investor lawsuits. If the claims are made by investors in a 
corporation and arise from negligence, fraud, or other malfeasance of 
the corporation (or its representatives), then the damages, prejudgment 
interest, and settlement payments paid by the corporation are definitely 
related and allocable to all income of the corporation and are 
apportioned among the statutory and residual groupings based on the 
relative value of the corporation's assets in each grouping (as 
determined under the asset method in Sec.  1.861-9 for purposes of 
allocating and apportioning the taxpayer's interest expense) in the year 
the deductions are allowed.
    (6) Income taxes--(i) In general. The deduction for foreign income, 
war profits, and excess profits taxes allowed by section 164 is 
allocated and apportioned among the applicable statutory and residual 
groupings under Sec.  1.861-20. The deduction for state and local taxes 
(state income taxes) allowed by section 164 is considered definitely 
related and allocable to the gross income with respect to which such 
state income taxes are imposed. For example, if a domestic corporation 
is subject to state income taxation and the state income tax is imposed 
in part on an amount of foreign source income, then that part of the 
taxpayer's deduction for state income tax that is attributable to 
foreign source income is definitely related and allocable to foreign 
source income. In allocating and apportioning the deduction for state 
income tax for purposes including (but not limited to) the computation 
of the foreign tax credit limitation under section 904 of the Code and 
the consolidated foreign tax credit under Sec.  1.1502-4 of the 
regulations, the income upon which the state income tax is imposed is 
determined by reference to the law of the jurisdiction imposing the tax. 
Thus, if a state attributes taxable income to a corporate taxpayer by 
applying an apportionment formula that takes into consideration the 
income and factors of one or more corporations related by ownership to 
the corporate taxpayer and engaging in activities related to the 
business of the corporate taxpayer, then the income so attributed is the 
income upon which the state income tax is imposed. If the income so 
attributed to the corporate taxpayer includes foreign source income, 
then, in computing the

[[Page 168]]

taxpayer's foreign tax credit limitation under section 904, for example, 
the taxpayer's deduction for state income tax will be considered 
definitely related and allocable to a class of gross income that 
includes the statutory grouping of foreign source income. When the law 
of the state includes dividends that are treated under section 862(a)(2) 
as income from sources without the United States in taxable income 
apportionable to the state, but does not include factors of the 
corporation paying such dividends in the apportionment formula used to 
determine state taxable income, an appropriate portion of the deduction 
for state income tax will be considered definitely related and allocable 
to a class of gross income consisting solely of foreign source dividend 
income. A deduction for state income tax will not be considered 
definitely related to a hypothetical amount of income calculated under 
federal tax principles when the jurisdiction imposing the tax computes 
taxable income under different principles. A corporate taxpayer's 
deduction for a state franchise tax that is computed on the basis of 
income attributable to business activities conducted within the state 
must be allocated and apportioned in the same manner as the deduction 
for state income taxes. In determining, for example, both the foreign 
tax credit under section 904 of the Code and the consolidated foreign 
tax credit limitation under Sec.  1.1502-4 of the regulations, the 
deduction for state income tax may be allocable and apportionable to 
foreign source income in a statutory grouping described in section 
904(d) in a taxable year in which the taxpayer has no foreign source 
income in such statutory grouping. Alternatively, such an allocation or 
apportionment may be appropriate if a taxpayer corporation has no 
foreign source income in a statutory grouping, but its deduction is 
attributable to foreign source income in such grouping that is 
attributed to the taxpayer corporation under the law of a state which 
attributes taxable income to a corporation by applying an apportionment 
formula that takes into consideration the income and factors of one or 
more corporations related by ownership to the taxpayer corporation and 
engaging in activities related to the business of the taxpayer 
corporation. Example 30 of paragraph (g) of this section illustrates the 
application of this last rule.
    (ii) Methods of allocation and apportionment--(A) In general. A 
taxpayer's deduction for a state income tax is to be allocated (and then 
apportioned, if necessary, subject to the rules of Sec.  1.861-8(d)) by 
reference to the taxable income that the law of the taxing jurisdiction 
attributes to the taxpayer (``state taxable income'').
    (B) Effect of subsequent recomputations of state income tax. 
[Reserved]
    (C) Illustrations--(1) In general. Examples 25 through 32 of 
paragraph (g) of Sec.  1.861-8 illustrate, in the given factual 
situations, the application of this paragraph (e)(6) and the general 
rule of paragraph (b)(1) of this section that a deduction must be 
allocated to the class of gross income to which the deduction is 
factually related. In general, these examples employ a presumption that 
state income taxes are allocable to a class of gross income that 
includes the statutory grouping of income from sources without the 
United States when the total amount of taxable income determined under 
state law exceeds the amount of taxable income determined under the Code 
(without taking into account the deduction for state income taxes) in 
the residual grouping of income from sources within the United States. A 
taxpayer that allocates and apportions the deduction for state income 
tax in accordance with the methodology of Example 25 of paragraph (g) of 
this section must also apply the modifications illustrated in Examples 
26 and 27 of paragraph (g) of this section, when applicable. The 
modification illustrated in Example 26 is applicable when the deduction 
for state income tax is attributable in part to taxes imposed by a state 
which factually excludes foreign source income (as determined for 
federal income tax purposes) from state taxable income. The modification 
illustrated in Example 27 is applicable when the taxpayer has income-
producing activities in a state which does not impose a corporate income 
tax. The specific allocation of state income tax illustrated in

[[Page 169]]

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

[[Page 170]]

dividends in the apportionment formula used to determine state taxable 
income, the taxpayer shall allocate an appropriate portion of the 
deduction to a class of gross income consisting solely of foreign source 
portfolio dividends. The portion of the deduction so allocated, and the 
amount of foreign source portfolio dividends included in such class, 
shall be determined in accordance with the methodology illustrated in 
paragraph (ii) of Example 28 of paragraph (g). If a state income tax is 
determined based upon formulary apportionment of the total taxable 
income attributable to the taxpayer's unitary business, the taxpayer 
must also apply the methodology illustrated in paragraph (ii)(C) through 
(G) of Example 29 of paragraph (g) of this section to make specific 
allocations of appropriate portions of the deduction for state income 
tax on the basis of income that, under separate accounting, would have 
been attributed to other members of the unitary group. The taxpayer 
shall reduce its aggregate state taxable income by the amount of foreign 
source portfolio dividends and other income to which a specific 
allocation is made (the reduced amount being referred to hereinafter as 
``adjusted state taxable income'').
    (ii) Step Two--Adjustment of U.S. source federal taxable income. If 
the taxpayer has significant income-producing activities in a state 
which does not impose a corporate income tax or other state tax measured 
by income derived from business activities in the state, the taxpayer 
shall reduce its U.S. source federal taxable income (solely for purposes 
of this safe harbor method) by the amount of federal taxable income 
attributable to its activities in such state. This amount shall be 
determined in accordance with the methodology illustrated in paragraph 
(ii) of Example 27 of paragraph (g) of this section, provided that the 
taxpayer shall be required to use the rules of the Uniform Division of 
Income for Tax Purposes Act to attribute income to the relevant state. 
The taxpayer's U.S. source federal taxable income, as so reduced, is 
referred to hereinafter as ``adjusted U.S. source federal taxable 
income.''
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax (after reduction by the 
portion allocated to foreign source portfolio dividends and other income 
under Step One) in accordance with the methodology illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section. However, 
the taxpayer shall substitute for the comparison of aggregate state 
taxable income to U.S. source federal taxable income, illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section, a 
comparison of its adjusted state taxable income to an amount equal to 
110% of its adjusted U.S. source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the remainder of the deduction for state income tax is required, the 
taxpayer shall apportion that remaining deduction to U.S. source income 
in accordance with the methodology illustrated in paragraph (iii) of 
Example 25 of paragraph (g) of this section, substituting for domestic 
source income in that paragraph an amount equal to 110% of the 
taxpayer's adjusted U.S. source federal taxable income. The remaining 
portion of the deduction shall be apportioned to the statutory groupings 
of foreign source income described in section 904(d) of the Code in 
accordance with the proportion of the income in each statutory grouping 
of foreign source income described in section 904(d) to the taxpayer's 
total foreign source federal taxable income (after reduction by the 
amount of foreign source portfolio dividends to which tax has been 
specifically allocated under Step One, above).
    (3) Method Two--(i) Step One--Specific allocation to foreign source 
portfolio dividends and other income. Step One of this method is the 
same as Step One of Method One (as described in paragraph 
(e)(6)(ii)(D)(2)(i) of this section).
    (ii) Step Two--Adjustment of U.S. source federal taxable income. 
Step Two of this method is the same as Step Two of Method One (as 
described in paragraph (e)(6)(ii)(D)(2)(ii) of this section).
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax

[[Page 171]]

(after reduction by the portion allocated to foreign source portfolio 
dividends and other income under Step One) in accordance with the 
methodology illustrated in paragraph (ii) of Example 25 of paragraph (g) 
of this section. However, the taxpayer shall substitute for the 
comparison of aggregate state taxable income to U.S. source federal 
taxable income, illustrated in paragraph (ii) of Example 25 of paragraph 
(g) of this section, a comparison of its adjusted state taxable income 
to its adjusted U.S. source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the deduction is required, the taxpayer shall apportion to U.S. source 
income that portion of the deduction that is attributable to state 
income taxes imposed upon an amount of state taxable income equal to 
adjusted U.S. source federal taxable income. The taxpayer shall 
apportion the remaining amount of the deduction to U.S. and foreign 
source income in the same proportions that the taxpayer's adjusted U.S. 
source federal taxable income and foreign source federal taxable income 
(after reduction by the amount of foreign source portfolio dividends to 
which tax has been specifically allocated under Step One, above) bear to 
its total federal taxable income (taking into account the adjustment of 
U.S. source federal taxable income under Step Two and after reduction by 
the amount of foreign source portfolio dividends to which tax has been 
specifically allocated under Step One). The portion of the deduction 
apportioned to foreign source income shall be apportioned among the 
statutory groupings described in section 904(d) of the Code in 
accordance with the proportions of the taxpayer's total foreign source 
federal taxable income (after reduction by the amount of foreign source 
portfolio dividends to which tax has been specifically allocated under 
Step One, above) in each grouping.
    (7) Losses on the sale, exchange, or other disposition of property. 
See Sec. Sec.  1.865-1 and 1.865-2 for rules regarding the allocation 
and apportionment of certain losses.
    (8) Net operating loss deduction--(i) Components of net operating 
loss. A net operating loss is separated into components that are 
assigned to statutory or residual groupings by reference to the losses 
in each such statutory or residual grouping that are not allocated to 
reduce income in other groupings in the taxable year of the loss. For 
example, for purposes of applying this paragraph (e)(8)(i) with respect 
to section 904 as the operative section, the source and separate 
category components of a net operating loss are determined by reference 
to the amounts of separate limitation loss and U.S. source loss 
(determined without regard to adjustments required under section 904(b)) 
that are not allocated to reduce U.S. source income or income in other 
separate categories under the rules of sections 904(f) and 904(g) for 
the taxable year in which the net operating loss arose. See Sec.  
1.904(g)-3(d)(2). See Sec.  1.1502-4 for rules applicable in computing 
the foreign tax credit limitation and determining the source and 
separate category of a net operating loss of a consolidated group. 
Similarly, for purposes of applying this paragraph (e)(8)(i) with 
respect to another operative section (as described in Sec.  1.861-
8(f)(1)), a net operating loss is divided into component parts based on 
the amounts of the deductions that are assigned to the relevant 
statutory and residual groupings and that are not absorbed in the 
taxable year in which the loss is incurred under the rules of that 
operative section. Deductions that are considered absorbed for purposes 
of an operative section may differ from the deductions that are 
considered absorbed for purposes of another provision of the Code that 
requires determining the components of a net operating loss.
    (ii) Allocation and apportionment of section 172 deduction. A net 
operating loss taken as a deduction in computing taxable income for a 
particular taxable year as allowed under section 172 is allocated and 
apportioned to statutory and residual groupings by reference to the 
statutory and residual groupings of the components of the net operating 
loss (as determined under paragraph (e)(8)(i) of this section) that is 
deducted in the taxable year. Except as provided

[[Page 172]]

under the rules for an operative section, if the full net operating loss 
carryover is not taken as a deduction in a taxable year, the partial net 
operating loss deduction is treated as ratably comprising the components 
of a net operating loss. See, for example, Sec.  1.904(g)-3, which is an 
exception to the general rule described in the previous sentence and 
provides rules for determining the source and separate category of a 
partial net operating loss deduction for purposes of section 904 as the 
operative section.
    (9) Deductions which are not definitely related. Deductions which 
shall generally be considered as not definitely related to any gross 
income, and therefore are ratably apportioned as provided in paragraph 
(c)(3) of this section, are--
    (i) The deduction allowed by section 163 for interest described in 
subparagraph (2)(iii) of this paragraph (e);
    (ii) The deduction allowed by section 164 for real estate taxes on a 
personal residence or for sales tax on the purchase of items for 
personal use;
    (iii) The deduction for medical expenses allowed by section 213; and
    (iv) The deduction for alimony payments allowed by section 215.
    (10) [Reserved]
    (11) Personal exemptions. The deductions for the personal exemptions 
allowed by section 151, 642(b), or 873(b)(3) shall not be taken into 
account for purpose of allocation and apportionment under this section.
    (12) Deductions for certain charitable contributions--(i) In 
general. The deduction for charitable contributions that is allowed 
under sections 170, 873(b)(2), and 882(c)(1)(B) is definitely related 
and allocable to all of the taxpayer's gross income. The deduction 
allocated under this paragraph (e)(12)(i) shall be apportioned between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping on the basis of the relative amounts of 
gross income from sources in the United States in each grouping.
    (ii) Treaty provisions. If a deduction for charitable contributions 
not otherwise permitted by sections 170, 873(b)(2), and 882(c)(1)(B) is 
allowed under a U.S. income tax treaty, and such treaty limits the 
amount of the deduction based on a percentage of income arising from 
sources within the treaty partner, the deduction is definitely related 
and allocable to all of the taxpayer's gross income. The deduction 
allocated under this paragraph (e)(12)(ii) shall be apportioned between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping on the basis of the relative amounts of 
gross income from sources within the treaty partner within each 
grouping.
    (iii) Coordination with Sec. Sec.  1.861-14 and 1.861-14T. A 
deduction for a charitable contribution by a member of an affiliated 
group shall be allocated and apportioned under the rules of this 
section, Sec.  1.861-14(e)(6), and Sec.  1.861-14T(c)(1).
    (13) Foreign-derived intangible income. The portion of the deduction 
that is allowed for foreign-derived intangible income under section 
250(a)(1)(A) (taking into account the reduction under section 
250(a)(2)(B)(i), if any) is considered definitely related and allocable 
to the class of gross income included in the taxpayer's foreign-derived 
deduction eligible income (as defined in section 250(b)(4)). If 
necessary, the portion of the deduction is apportioned within the class 
ratably between the statutory grouping (or among the statutory 
groupings) of gross income and the residual grouping of gross income 
based on the relative amounts of foreign-derived deduction eligible 
income in each grouping.
    (14) Global intangible low-taxed income and related section 78 gross 
up. The portion of the deduction (taking into account the reduction 
under section 250(a)(2)(B)(ii), if any) that is allowed for the global 
intangible low-taxed income amount described in section 250(a)(1)(B)(i), 
and that is allowed for the section 78 gross up under section 
250(a)(1)(B)(ii), is considered definitely related and allocable to the 
class of gross income included under section 951A(a) and section 78, 
respectively. If necessary (for example, because a portion of the 
inclusion under section 951A(a) is passive category income or U.S. 
source income), the portion of the deduction is apportioned within the 
class ratably between the statutory grouping (or among the statutory

[[Page 173]]

groupings) of gross income and the residual grouping of gross income 
based on the relative amounts of gross income in each grouping.
    (15) Distributive share of partnership deductions. In general, if 
deductions are incurred by a partnership in which the taxpayer is a 
partner, the taxpayer's deductions that are allocated and apportioned 
include the taxpayer's distributive share of the partnership's 
deductions. See Sec. Sec.  1.861-9(e), 1.861-17(f), and 1.904-
4(n)(1)(ii) for special rules for apportioning a partner's distributive 
share of deductions of a partnership.
    (16) Special rule for the allocation and apportionment of reserve 
expenses of a life insurance company. An amount of reserve expenses of a 
life insurance company equal to the dividends received deduction that is 
disallowed because it is attributable to the policyholders' share of 
dividends received is treated as definitely related to such dividends. 
See paragraph (d)(2)(v)(B)(2) of this section (Example 2).
    (f) Miscellaneous matters--(1) Operative sections. The operative 
sections of the Code which require the determination of taxable income 
of the taxpayer from specific sources or activities and which give rise 
to statutory groupings to which this section is applicable include the 
sections described below.
    (i) [Reserved]
    (ii) Separate foreign tax credit limitations. Section 904(d)(1) and 
other sections described in Sec.  1.904-4(m) require that a separate 
foreign tax credit limitation be determined with respect to each 
separate category of income specified in those sections. Accordingly, 
the foreign source income within each separate category described in 
Sec.  1.904-5(a)(4)(v) constitutes a separate statutory grouping of 
income. U.S. source income is treated as income in the residual grouping 
for purposes of determining the limitation on the foreign tax credit.
    (iii) DISC and FSC taxable income. Sections 925 and 994 provide 
rules for determining the taxable income of a FSC and DISC, 
respectively, with respect to qualified sales and leases of export 
property and qualified services. The combined taxable income method 
available for determining a DISC's taxable income provides, without 
consideration of export promotion expenses, that the taxable income of 
the DISC shall be 50 percent of the combined taxable income of the DISC 
and the related supplier derived from sales and leases of export 
property and from services. In the FSC context, the taxable income of 
the FSC equals 23 percent of the combined taxable income of the FSC and 
the related supplier. Pursuant to regulations under section 925 and 994, 
this section provides rules for determining the deductions to be taken 
into account in determining combined taxable income, except to the 
extent modified by the marginal costing rules set forth in the 
regulations under sections 925(b)(2) and 994(b)(2) if used by the 
taxpayer. See Examples (22) and (23) of paragraph (g) of this section. 
In addition, the computation of combined taxable income is necessary to 
determine the applicability of the section 925(d) limitation and the 
``no loss'' rules of the regulations under sections 925 and 994.
    (iv) Effectively connected taxable income. Nonresident alien 
individuals and foreign corporations engaged in trade or business within 
the United States, under sections 871(b)(1) and 882(a)(1), on taxable 
income which is effectively connected with the conduct of a trade or 
business within the United States. Such taxable income is determined in 
most instances by initially determining, under section 864(c), the 
amount of gross income which is effectively connected with the conduct 
of a trade or business within the United States. Pursuant to sections 
873 and 882(c), this section is applicable for purposes of determining 
the deductions from such gross income (other than the deduction for 
interest expense allowed to foreign corporations (see Sec.  1.882-5)) 
which are to be taken into account in determining taxable income. See 
example 21 of paragraph (g) of this section.
    (v) Foreign base company income. Section 954 defines the term 
``foreign base company income'' with respect to controlled foreign 
corporations. Section 954(b)(5) provides that in determining foreign 
base company income the gross income shall be reduced by the deductions 
of the controlled foreign corporation ``properly allocable to such 
income''. This section provides rules for

[[Page 174]]

identifying which deductions are properly allocable to foreign base 
company income.
    (vi) Other operative sections. The rules provided in this section 
also apply in determining--
    (A) The amount of foreign source items of tax preference under 
section 58(g) determined for purposes of the minimum tax;
    (B) The amount of foreign mineral income under section 901(e);
    (C) [Reserved]
    (D) The amount of foreign oil and gas extraction income and the 
amount of foreign oil related income under section 907;
    (E) The tax base for individuals entitled to the benefits of section 
931 and the section 936 tax credit of a domestic corporation that has an 
election in effect under section 936;
    (F) The exclusion for income from Puerto Rico for bona fide 
residents of Puerto Rico under section 933;
    (G) The limitation under section 934 on the maximum reduction in 
income tax liability incurred to the Virgin Islands;
    (H) The income derived from the U.S. Virgin Islands or from a 
section 935 possession (as defined in Sec.  1.935-1(a)(3)(i)).
    (I) The special deduction granted to China Trade Act corporations 
under section 941;
    (J) The amount of certain U.S. source income excluded from the 
subpart F income of a controlled foreign corporation under section 
952(b);
    (K) The amount of income from the insurance of U.S. risks under 
section 953(b)(5);
    (L) The international boycott factor and the specifically 
attributable taxes and income under section 999; and
    (M) The taxable income attributable to the operation of an agreement 
vessel under section 607 of the Merchant Marine Act of 1936, as amended, 
and the Capital Construction Fund Regulations thereunder (26 CFR, part 
3). See 26 CFR 3.2(b)(3).
    (N) Deduction eligible income and foreign-derived deduction eligible 
income under section 250(b).
    (2) Application to more than one operative section. (i) Where more 
than one operative section applies, it may be necessary for the taxpayer 
to apply this section separately for each applicable operative section. 
In such a case, the taxpayer is required to use the same method of 
allocation and the same principles of apportionment for all operative 
sections.
    (ii) When expenses, losses, and other deductions that have been 
properly allocated and apportioned between combined gross income of a 
related supplier and a DISC or former DISC and residual gross income, 
regardless of which of the administrative pricing methods of section 994 
has been applied, such deductions are not also allocated and apportioned 
to gross income consisting of distributions from the DISC or former DISC 
attributable to income of the DISC or former DISC as determined under 
the administrative pricing methods with respect to DISC or former DISC 
taxable years beginning after December 31, 1986. Accordingly, Example 
(22) of paragraph (g) of this section does not apply to distributions 
from a DISC or former DISC with respect to DISC or former DISC taxable 
years beginning after December 31, 1986. This rule does not apply to the 
extent that the taxable income of the DISC or former DISC is determined 
under the section 994(a)(3) transfer pricing method. In addition, for 
taxable years beginning after December 31, 1986, in the case of 
expenses, losses, and other deductions that have been properly allocated 
and apportioned between combined gross income of a related supplier and 
a FSC and residual gross income, regardless of which of the 
administrative pricing methods of section 925 has been applied, such 
deductions are not also allocated and apportioned to gross income 
consisting of distributions from the FSC or former FSC which are 
attributable to the foreign trade income of the FSC or former FSC as 
determined under the administrative pricing methods. This rule does not 
apply to the extent that the foreign trade income of the FSC or former 
FSC is determined under the section 925(a)(3) transfer pricing method. 
See Example (23) of paragraph (g) of this section.
    (3) Special rules of section 863(b)--(i) In general. Special rules 
under section 863(b) provide for the application of

[[Page 175]]

rules of general apportionment provided in Sec. Sec.  1.863-3 to 1.863-
5, to worldwide taxable income in order to attribute part of such 
worldwide taxable income to U.S. sources and the remainder of such 
worldwide taxable income to foreign sources. The activities specified in 
section 863(b) are--
    (A) Transportation or other services rendered partly within and 
partly without the United States,
    (B) Sales of personal property produced by the taxpayer within and 
sold without the United States, or produced by the taxpayer without and 
sold within the United States, and
    (C) Sales within the United States of personal property purchased 
within a possession of the United States.


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

[[Page 176]]

year of which $1,000,000x was domestic sales and $500,000x was foreign 
sales. USP took a deduction for expenses incurred by its marketing 
department during the taxable year in the amount of $150,000x. These 
expenses were determined to be allocable to both domestic and foreign 
sales and are apportionable between such sales. On audit of USP's return 
for the taxable year, the IRS adjusted, under section 482, USP's sales 
to related foreign subsidiaries by increasing the sales price by a total 
of $100,000x, thereby increasing USP's foreign sales and total sales by 
the same amount. Before the audit, USP allocated and apportioned the 
marketing department deduction as follows:

                   Table 1 to Paragraph (f)(4)(ii)(A)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
To gross income from domestic sales: $150,000x x               $100,000x
 ($1,000,000x/$1,500,000x).................................
To gross income from foreign sales: $150,000x x ($500,000x/      50,000x
 $1,500,000x)..............................................
                                                            ------------
    Total..................................................     150,000x
------------------------------------------------------------------------

    (B) Analysis. As a result of the section 482 adjustment, the 
apportionment of the deduction for the marketing department expenses is 
redetermined as follows:

                   Table 2 to Paragraph (f)(4)(ii)(B)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
To gross income from domestic sales: $150,000x x                $93,750x
 ($1,000,000x/$1,600,000x).................................
To gross income from foreign sales:
    $150,000x x ($600,000x/$1,600,000x)....................      56,250x
                                                            ------------
    Total..................................................     150,000x
------------------------------------------------------------------------

    (5) Verification of allocations and apportionments. Since, under 
this section, allocations and apportionments are made on the basis of 
the factual relationship between deductions and gross income, the 
taxpayer is required to furnish, at the request of the District 
Director, information from which such factual relationships can be 
determined. In reviewing the overall limitation to the foreign tax 
credit of a domestic corporation, for example, the District Director 
should consider information which would enable him to determine the 
extent to which deductions attributable to functions performed in the 
United States are related to earning foreign source income, United 
States source income, or income from both sources. In addition to 
functions with a specific international purpose, consideration should be 
given to the functions of management, the direction and results of an 
acquisition program, the functions of operating units and personnel 
located at the head office, the functions of support units (including 
but not limited to engineering, legal, budget, accounting, and 
industrial relations), the functions of selling and advertising units 
and personnel, the direction and uses of research and development and 
the direction and uses of services furnished by independent contractors. 
Thus, for example when requested by the District Director, the taxpayer 
shall make available any of its organization charts, manuals, and other 
writings which relate to the manner in which its gross income arises and 
to the functions of organizational units, employees, and assets of the 
taxpayer and arrange for the interview of such of its employees as the 
District Director deems desirable in order to determine the gross income 
to which deductions relate. See section 7602 and the regulations 
thereunder which generally provide for the examination of books and 
witnesses. See also section 905(b) and the regulations thereunder which 
require proof of foreign tax credits to the satisfaction of the 
Secretary or his delegate.

[[Page 177]]

    (g) Examples. The following examples illustrate the principles of 
the rules in this section. In each example, unless otherwise specified, 
section 904 is the operative section. In addition, in each example, 
where a method of allocation or apportionment is illustrated as an 
acceptable method, it is assumed that such method is used by the 
taxpayers on a consistent basis from year to year. Further, it is 
assumed that each party named in each example operates on a calendar 
year accounting basis and, where the party is a U.S. taxpayer, files 
returns on a calendar year basis.
    (1)-(14) [Reserved]
    (15) Example 15: Payment in settlement of claim for damages 
allocated to specific class of gross income--(i) Facts. USP, a domestic 
corporation, sells Product A in the United States. USP also owns and 
operates a disregarded entity (FDE) in Country X. FDE, which constitutes 
a foreign branch of USP within the meaning of Sec.  1.904-4(f)(3)(vii), 
sells Product A inventory in Country X. FDE's functional currency is the 
U.S. dollar. In each of its taxable years from 2018 through 2020, USP 
earns $2,000x of U.S. source gross income from sales of Product A to 
customers in the United States. USP also sells Product A to FDE for an 
arm's length price and FDE sells Product A to customers in Country X. 
After the application of section 862(a)(6), Sec.  1.861-7(c), and the 
disregarded payment rules of Sec.  1.904-4(f)(2)(vi), the sales of 
Product A in Country X result in $1,500x of general category foreign 
source gross income and $500x of foreign branch category foreign source 
gross income in each of 2018 and 2019 and $2,500x of general category 
foreign source gross income and $500x of foreign branch category foreign 
source gross income in 2020. FDE is sued for damages in 2019 after 
Product A harms a customer in Country X in 2018. In 2020, FDE makes a 
deductible payment of $60x to the Country X customer in settlement of 
the legal claims for damages.
    (ii) Analysis. Under paragraph (e)(5)(ii) of this section, the 
deductible settlement payment is definitely related and allocable to the 
class of gross income of the type produced by the specific sales of 
property that gave rise to the damages claims, that is USP's gross 
income from sales of Product A in Country X. Claims that might arise 
from damages caused by Product A to customers in the United States are 
irrelevant in allocating the deduction for the settlement payments made 
to the customer in Country X. For purposes of determining USP's foreign 
tax credit limitation under section 904(d), because in 2020 that class 
of gross income consists of both foreign source foreign branch category 
income and foreign source general category income, the settlement 
payment of $60x is apportioned between gross income in the two 
categories in proportion to the relative amounts of gross income in each 
category in 2020, the year the deduction is allowed. Therefore, $10x 
($60x x $500x/$3,000x) is apportioned to foreign source foreign branch 
category income, and the remaining $50x ($60x x $2,500x/$3,000x) is 
apportioned to foreign source general category income.
    (16) Example 16: Legal damages payment arising from event incident 
to production and sale--(i) Facts. The facts are the same as in 
paragraph (g)(15) of this section (the facts in Example 15) except that 
instead of a product liability lawsuit relating to a 2018 event, in 2019 
there is a disaster at a warehouse owned by USP in the United States 
arising from the negligence of an employee. The warehouse is used to 
store Product A inventory intended for sale both by USP in the United 
States and by FDE in Country X. In 2020, the warehouse asset is 
characterized under Sec.  1.861-9T(g)(3)(ii) as a multiple category 
asset that is assigned 10% to the foreign source foreign branch 
category, 50% to the foreign source general category, and 40% to the 
residual grouping of U.S. source income. The inventory of Product A in 
the warehouse is destroyed and USP employees as well as residents in the 
vicinity of the warehouse are injured. USP's reputation in the United 
States suffers such that USP expects to subsequently lose market share 
in the United States. In 2020, USP makes deductible damages payments 
totaling $50x to injured employees and the nearby residents, all of whom 
are in the United States.
    (ii) Analysis. USP's warehouse in the United States is used in 
connection with sales of Product A to customers in

[[Page 178]]

both the United States and Country X. Thus, under paragraph (e)(5)(ii) 
of this section, the $50x damages payment arises from an event incident 
to the sales of Product A and is therefore definitely related and 
allocable to the class of gross income ordinarily produced by the asset 
(the warehouse) that is involved in the event--that is, the gross income 
from sales of Product A by USP in the United States and by FDE in 
Country X. Under paragraph (e)(5)(ii) of this section, the $50x 
deduction for the damages payment is apportioned for purposes of 
applying section 904(d) on the basis of the relative value in each 
grouping (as determined under Sec.  1.861-9(g) for purposes of 
allocating and apportioning USP's interest expense) of USP's warehouse, 
the asset involved in the event, in 2020, the year the deduction is 
allowed. USP's warehouse is a multiple category asset as described in 
Sec.  1.861-9T(g)(3)(ii) and 10% of the value of USP's warehouse is 
properly characterized as an asset generating foreign source foreign 
branch category in 2020. Accordingly, $5x (10% x $50x) of the deduction 
is apportioned to foreign source foreign branch category income. 
Additionally, 50% of the value of USP's warehouse is properly 
characterized as an asset generating foreign source general category 
income in 2020 and, accordingly, $25x (50% x $50x) is apportioned to 
such grouping. The remaining $20x (40% x $50x) is apportioned to U.S. 
source income.
    (17) Example 17: Payment following a change in law--(i) Facts. The 
facts are the same as in paragraph (g)(16) of this section (the facts in 
Example 16), except that the disaster at USP's warehouse occurred not in 
2019 but in 2016 and thus before the enactment of the section 904(d) 
separate category for foreign branch category income. The deductible 
damages payments are made in 2020.
    (ii) Analysis. USP's U.S. warehouse was used in connection with 
making sales of Product A in both the United States and Country X. Under 
paragraph (e)(5)(ii) of this section, the 2020 damages payment arises 
from an event incident to the sales of Product A and is therefore 
definitely related and allocable to the class of gross income ordinarily 
produced by the asset (the warehouse) that is involved in the event, 
that is the gross income from sales of Product A by USP in the United 
States and by FDE in Country X. Under the law in effect in 2016, the 
income earned from the Product A sales in Country X was solely general 
category income. Under paragraph (e)(5)(ii) of this section, the damages 
payment is definitely related and allocable to the class of gross income 
consisting of sales of Product A by USP in the United States and by FDE 
in Country X, and apportioned to the statutory and residual groupings 
based on the relative value in each grouping (as determined under Sec.  
1.861-9(g) for purposes of allocating and apportioning USP's interest 
expense) of USP's warehouse, the asset involved in the event, in 2020, 
the year in which the deduction is allowed. Accordingly, for purposes of 
determining USP's foreign tax credit limitation under section 904(d), 
the 2020 deductible damages payment of $50x is allocated and apportioned 
in the same manner as in paragraph (g)(16)(ii) of this section (the 
analysis in Example 16).
    (18) Example 18: Stewardship and supportive expenses--(i) Facts--(A) 
Overview. USP, a domestic corporation, manufactures and sells Product A 
in the United States. USP directly owns 100% of the stock of USSub, a 
domestic corporation, and each of CFC1, CFC2, and CFC3, which are all 
controlled foreign corporations. USP and USSub file separate returns for 
U.S. Federal income tax purposes but are members of the same affiliated 
group as defined in section 243(b)(2). USSub, CFC1, CFC2, and CFC3 
perform similar functions in the United States and in the foreign 
countries T, U, and V, respectively. USP's tax book value in the stock 
of USSub is $15,000x. USP's tax book value in the stock of each of CFC1, 
CFC2, and CFC3 is, respectively, $5,000x, $10,000x, and $15,000x.
    (B) USP Department expenses. USP's supervision department (the 
Department) incurs expenses of $1,500x. The Department is responsible 
for the supervision of its four subsidiaries and for rendering certain 
services to the subsidiaries, and the Department provides all the 
supportive functions necessary for USP's foreign activities. The

[[Page 179]]

Department performs three types of activities. First, the Department 
performs services that cost $900x outside the United States for the 
direct benefit of CFC2 for which a marked-up fee is paid by CFC2 to USP. 
Second, the Department provides services at a cost of $60x related to 
license agreements that USP maintains with subsidiaries CFC1 and CFC2 
and which give rise to foreign source general category income to USP. 
Third, the Department performs activities described in Sec.  1.482-
9(l)(3)(iii) that are in the nature of shareholder oversight, that 
duplicate functions performed by all four of the subsidiaries' own 
employees, and that do not provide an additional benefit to the 
subsidiaries. For example, a team of auditors from USP's accounting 
department periodically audits the subsidiaries' books and prepares 
internal reports for use by USP's management. Similarly, USP's treasurer 
periodically reviews the subsidiaries' financial policies for the board 
of directors of USP. These activities do not provide an additional 
benefit to the related corporations. The Department's oversight 
activities are related to all the subsidiaries. The cost of the 
duplicative activities is $540x.
    (C) USP's income. USP earns the following items of income: First, 
under section 951(a), USP has $2,000x of subpart F income that is 
passive category income. Second, USP has a GILTI inclusion amount of 
$2,000x. Third, USP earns $1,000x of royalties, paid by CFC1 and CFC2, 
that are foreign source general category income. Finally, USP receives a 
fee of $1,000x from CFC2 that is foreign source general category income.
    (ii) Analysis--(A) Character of USP Department services. The first 
and second activities (the services rendered for the benefit of CFC2, 
and the provision of services related to license agreements with CFC1 
and CFC2) are not properly characterized as stewardship expenses because 
they are not incurred solely to protect the corporation's capital 
investment in the related corporation or to facilitate compliance by the 
corporation with reporting, legal, or regulatory requirements applicable 
specifically to the corporation. The third activity described is in the 
nature of shareholder oversight and is characterized as stewardship as 
described in paragraph (e)(4)(ii)(A) of this section because the expense 
is related to duplicative activities.
    (B) Allocation. First, the deduction of $900x for expenses related 
to services rendered for the benefit of CFC2 is definitely related (and 
therefore allocable) to the fees for services that USP receives from 
CFC2. Second, the $60x of deductions attributable to USP's license 
agreements with CFC1 and CFC2 are definitely related (and therefore 
allocable) solely to royalties received from CFC1 and CFC2. Third, based 
on the relevant facts and circumstances and the Department's oversight 
activities, the stewardship deduction of $540x is related to the 
oversight of all of USP's subsidiaries and therefore is definitely 
related (and therefore allocable) to dividends and inclusions received 
or included from all the subsidiaries.
    (C) Apportionment. (1) No apportionment of USP's deduction of $900x 
for expenses related to the services performed for CFC2 is necessary 
because the class of gross income to which the deduction is allocated 
consists entirely of a single statutory grouping, foreign source general 
category income.
    (2) No apportionment of USP's deduction of $60x attributable to the 
services related to license agreements is necessary because the class of 
gross income to which the deduction is allocated consists entirely of a 
single statutory grouping, foreign source general category income.
    (3) For purposes of apportioning USP's $540x stewardship expenses in 
determining the foreign tax credit limitation, the statutory groupings 
are foreign source general category income, foreign source passive 
category income, and foreign source section 951A category income. The 
residual grouping is U.S. source income.
    (4) USP's deduction of $540x for the Department's stewardship 
expenses which are allocable to dividends and amounts included from the 
subsidiaries are apportioned using the same value of USP's stock in 
USSub, CFC1, CFC2, and CFC3 that is used for purposes of allocating and 
apportioning USP's interest expense. Pursuant to paragraph

[[Page 180]]

(e)(4)(ii)(A) of this section and Sec.  1.861-14(e)(1)(i), the value of 
USP's stock in USSub is included for purposes of apportioning USP's 
stewardship expense. The value of USSub's stock is $15,000x, and USSub 
only owns assets that generate income in the residual grouping of gross 
income from U.S. sources. Therefore, for purposes of apportioning USP's 
stewardship expense, all of the $15,000x value of the USSub stock is 
characterized as an asset generating U.S. source income. Although USSub 
stock would be eliminated from consideration as an asset under paragraph 
(d)(2)(ii)(B) of this section, for purposes of apportioning USP's 
stewardship expense section 864(e)(3) and paragraph (d)(2) of this 
section do not apply. USP uses the asset method described in Sec.  
1.861-12T(c)(3)(ii) to characterize the stock in its CFCs. After 
application of Sec.  1.861-13(a), USP determines that with respect to 
its three CFCs in the aggregate it has $15,000x of section 951A category 
stock in the non-section 245A subgroup, $6,000x of general category 
stock in the section 245A subgroup, and $9,000x of passive category 
stock in the non-section 245A subgroup. Although under paragraph 
(d)(2)(ii)(C)(2) of this section $7,500x of the stock that is section 
951A category stock is an exempt asset, for purposes of apportioning 
USP's stewardship expense section 864(e)(3) and paragraph (d)(2) of this 
section do not apply. Finally, even though USP may be allowed a section 
245A deduction with respect to dividends from the CFCs, no portion of 
the value of the stock of the CFCs is eliminated, because the section 
245A deduction does not create exempt income or result in the stock 
being treated as an exempt asset. See section 864(e)(3) and paragraph 
(d)(2)(iii)(C) of this section.
    (5) Taking into account the characterization of USP's stock in 
USSub, CFC1, CFC2, and CFC3 with a total value of $45,000x ($15,000x + 
$6,000x + $9,000x + $15,000x), the $540x of Department expenses is 
apportioned as follows: $180x ($540x x $15,000x/$45,000x) to section 
951A category income, $72x ($540x x $6,000x/$45,000x) to general 
category income, $108x ($540x x $9,000x/$45,000x) to passive category 
income, and $180x ($540x x $15,000x/$45,000x) to the residual grouping 
of U.S. source income. Section 904(b)(4)(B)(i) and Sec.  1.904(b)-3 
apply to $72x of the stewardship expense apportioned to the CFCs' stock 
that is characterized as being in the section 245A subgroup in the 
general category.
    (19) Example 19: Supportive expense--(i) Facts--(A) USP, a domestic 
corporation, purchases and sells products both in the United States and 
in foreign countries. USP has no foreign subsidiary and no international 
department. During the taxable year, USP incurs the following expenses 
with respect to its worldwide activities:

                   Table 3 to Paragraph (g)(19)(i)(A)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Personnel department expenses..............................     $50,000x
Training department expenses...............................      35,000x
General and administrative expenses........................      55,000x
President's salary.........................................      40,000x
Sales manager's salary.....................................      20,000x
                                                            ------------
    Total..................................................     200,000x
------------------------------------------------------------------------

    (B) USP has domestic gross receipts from sales of $750,000x and 
foreign gross receipts from sales of $500,000x and has gross income from 
such sales in the same ratio, namely $300,000x from domestic sources and 
$200,000x from foreign sources that is general category income.
    (ii) Analysis--(A) Allocation. The above expenses are definitely 
related and allocable to all of USP's gross income derived from both 
domestic and foreign markets.
    (B) Apportionment. For purposes of applying the foreign tax credit 
limitation, the statutory grouping is gross income from sources outside 
the

[[Page 181]]

United States in general category income and the residual grouping is 
gross income from sources within the United States. USP's deductions for 
its worldwide sales activities must be apportioned between these 
groupings. USP does not have a separate international division which 
performs essentially all of the functions required to manage and oversee 
its foreign activities. The president and sales manager do not maintain 
time records. The division of their time between domestic and foreign 
activities varies from day to day and cannot be estimated on an annual 
basis with any reasonable degree of accuracy. Similarly, there are no 
facts which would justify a method of apportionment of their salaries or 
of one of the other listed deductions based on more specific factors 
than gross receipts or gross income. An acceptable method of 
apportionment would be on the basis of gross receipts. The apportionment 
of the $200,000x deduction is as follows:

                   Table 4 to Paragraph (g)(19)(ii)(B)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Apportionment of the $200,000x expense to the statutory         $80,000x
 grouping of gross income: $200,000x x [$500,000x/
 ($500,000x + $750,000x)]
Apportionment of the $200,000x expense to the residual          120,000x
 grouping of gross income: $200,000x x [$750,000x/
 ($500,000x + $750,000x)]..................................
                                                            ------------
    Total apportioned supportive expense...................     200,000x
------------------------------------------------------------------------

    (20) Example 20: Supportive expense--(i) Facts. Assume the same 
facts as in paragraph (g)(19)(i) of this section (the facts in Example 
19), except that USP's president devotes only 5% of his time to the 
foreign operations and 95% of his time to the domestic operations and 
that USP's sales manager devotes approximately 10% of her time to 
foreign sales and 90% of her time to domestic sales.
    (ii) Analysis--(A) Allocation. The expenses incurred by USP with 
respect to its worldwide activities are definitely related, and 
therefore allocable to USP's gross income from both its foreign and 
domestic markets.
    (B) Apportionment. On the basis of the additional facts it is not 
acceptable to apportion the salaries of the president and the sales 
manager on the basis of gross receipts. It is acceptable to apportion 
such salaries between the statutory grouping (gross income from sources 
without the United States) and residual grouping (gross income from 
sources within the United States) on the basis of time devoted to each 
sales activity. Remaining expenses may still be apportioned on the basis 
of gross receipts. The apportionment is as follows:

                   Table 5 to Paragraph (g)(20)(ii)(B)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Apportionment of the $200,000x expense to the statutory
 grouping of gross income:
    President's salary: $40,000x x 5%......................      $2,000x
    Sales manager's salary: $20,000x x 10%.................       2,000x
    Remaining expenses: $140,000x x [$500,000x/($500,000x +      56,000x
     $750,000x)]...........................................
                                                            ------------
        Subtotal: Apportionment of expense to statutory          60,000x
         grouping..........................................
Apportionment of the $200,000x expense to the residual
 grouping of gross income:
    President's salary: $40,000x x 95%.....................      38,000x
    Sales manager's salary: $20,000x x 90%.................      18,000x
    Remaining expenses: $140,000x x [$750,000x/($500,000x +      84,000x
     $750,000x)]...........................................
                                                            ------------
        Subtotal: Apportionment of expense to residual          140,000x
         grouping..........................................
                                                            ------------

[[Page 182]]

 
            Total: Apportioned supportive expense..........     200,000x
------------------------------------------------------------------------

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

                   Table 6 to Paragraph (g)(21)(ii)(B)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Apportionment of general and administrative expense to the      $20,000x
 statutory grouping, gross income from sources within the
 United States: $100,000x x [$200,000x/($200,000x +
 $400,000x + $400,000x)]...................................
Apportionment of general and administrative expense to the       80,000x
 residual grouping, gross income from sources without the
 United States: $100,000x x [($400,000x + $400,000x)/
 ($200,000x + $400,000x + $400,000x)]......................
                                                            ------------
    Total apportioned general and administrative expense...     100,000x
------------------------------------------------------------------------

    (22)-(24) [Reserved]
    (25) Example 25: Income taxes--(i) Facts. USP, a domestic 
corporation, is a manufacturer and distributor of electronic equipment 
with operations in states A, B, and C. USP also has a foreign branch, as 
defined in section 904(d)(1)(B) and Sec.  1.904-4(f), in Country Y which 
manufactures and distributes the same type of electronic equipment. In 
Year 1, USP has taxable income from these activities, as described under 
the Code (without taking into account the deduction for state income 
taxes), of $1,000,000x, of which $200,000x is foreign source foreign 
branch category income and $800,000x is domestic source income. States 
A, B, and C each determine USP's income subject to tax within their 
state by making adjustments to USP's taxable income as determined under 
the Code, and then apportioning the adjusted taxable income on the basis 
of the relative amounts of

[[Page 183]]

USP's payroll, property, and sales within each state as compared to 
USP's worldwide payroll, property, and sales. The adjustments made by 
states A, B, and C all involve adding and subtracting enumerated items 
from taxable income as determined under the Code. However, in making 
these adjustments to taxable income, none of the states specifically 
exempts foreign source income as determined under the Code. On this 
basis, it is determined that USP has taxable income of $550,000x, 
$200,000x, and $200,000x in states A, B, and C, respectively. The 
corporate tax rates in states A, B, and C are 10%, 5%, and 2%, 
respectively, and USP has total state income tax liabilities of $69,000x 
($55,000x + $10,000x + $4,000x), which it deducts as an expense for 
Federal income tax purposes.
    (ii) Analysis--(A) Allocation. USP's deduction of $69,000x for state 
income taxes is definitely related and thus allocable to the gross 
income with respect to which the taxes are imposed. Since the statutes 
of states A, B, and C do not specifically exempt foreign source income 
(as determined under the Code) from taxation and since, in the 
aggregate, states A, B, and C tax $950,000x of USP's income while only 
$800,000x is domestic source income under the Code, it is presumed that 
state income taxes are imposed on $150,000x of foreign source income. 
The deduction for state income taxes is therefore related and allocable 
to both USP's foreign source and domestic source income.
    (B) Apportionment. For purposes of computing the foreign tax credit 
limitation, USP's income is comprised of one statutory grouping, foreign 
source foreign branch category gross income, and one residual grouping, 
gross income from sources within the United States. The state income tax 
deduction of $69,000x must be apportioned between these two groupings. 
Corporation USP calculates the apportionment on the basis of the 
relative amounts of foreign source foreign branch category taxable 
income and U.S. source taxable income subject to state taxation. In this 
case, state income taxes are presumed to be imposed on $800,000x of 
domestic source income and $150,000x of foreign source general category 
income.

                   Table 7 to Paragraph (g)(25)(ii)(B)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
State income tax deduction apportioned to foreign source        $10,895x
 foreign branch category income (statutory grouping):
 $69,000x x ($150,000x/$950,000x)..........................
State income tax deduction apportioned to income from            58,105x
 sources within the United States (residual grouping):
 $69,000x x ($800,000x/$950,000x)..........................
                                                            ------------
    Total apportioned state income tax deduction...........      69,000x
------------------------------------------------------------------------

    (26) Example 26: Income taxes--(i) Facts. Assume the same facts as 
in paragraph (g)(25)(i) of this section (the facts in Example 25), 
except that the language of state A's statute and the statute's 
operation exempt from taxation all foreign source income, as determined 
under the Code, so that foreign source income is not included in 
adjusted taxable income subject to apportionment in state A (and factors 
relating to USP's Country Y branch are not taken into account in 
computing the state A apportionment fraction).
    (ii) Analysis--(A) Allocation. USP's deduction of $69,000x for state 
income taxes is definitely related and thus allocable to the gross 
income with respect to which the taxes are imposed. Since state A 
exempts all foreign source income by statute, state A is presumed to 
impose tax on $550,000x of USP's $800,000x of domestic source income. 
USP's state A tax of $55,000x is allocable, therefore, solely to 
domestic source income. Since the statutes of states B and C do not 
specifically exclude all foreign source income as determined under the 
Code, and since states B and C impose tax on $400,000x ($200,000x + 
$200,000x) of USP's income of which only $250,000x ($800,000x-$550,000x) 
is presumed to be domestic source, the deduction for the

[[Page 184]]

$14,000x of income taxes imposed by states B and C is related and 
allocable to both foreign source and domestic source income.
    (B) Apportionment. (1) For purposes of computing the foreign tax 
credit limitation, USP's income is comprised of one statutory grouping, 
foreign source foreign branch category gross income, and one residual 
grouping, gross income from sources within the United States. The 
deduction of $14,000x for income taxes of states B and C must be 
apportioned between these two groupings.
    (2) Corporation USP calculates the apportionment on the basis of the 
relative amounts of foreign source foreign branch category income and 
U.S. source income subject to state taxation.

                 Table 8 to Paragraph (g)(26)(ii)(B)(2)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
States B and C income tax deduction apportioned to foreign       $5,250x
 source foreign branch category income (statutory
 grouping): $14,000x x ($150,000x/$400,000x)...............
States B and C income tax deduction apportioned to income         8,750x
 from sources within the United States (residual grouping):
 $14,000x x ($250,000x/$400,000x)..........................
                                                            ------------
    Total apportioned state income tax deduction...........      14,000x
------------------------------------------------------------------------

    (3) Of USP's total income taxes of $69,000x, the amount allocated 
and apportioned to foreign source foreign branch category income equals 
$5,250x. The total amount of state income taxes allocated and 
apportioned to U.S. source income equals $63,750x ($55,000x + $8,750x).
    (27) Example 27: Income tax--(i) Facts. Assume the same facts as in 
paragraph (g)(25)(i) of this section (the facts in Example 25), except 
that state A, in which USP has significant income-producing activities, 
does not impose a corporate income tax or other state tax computed on 
the basis of income derived from business activities conducted in state 
A. USP therefore has a total state income tax liability in Year 1 of 
$14,000x ($10,000x paid to state B plus $4,000x paid to state C), all of 
which is subject to allocation and apportionment under paragraph (b) of 
this section.
    (ii) Analysis--(A) Allocation. (1) USP's deduction of $14,000x for 
state income taxes is definitely related and allocable to the gross 
income with respect to which the taxes are imposed. However, in these 
facts, an adjustment is necessary before the aggregate state taxable 
incomes can be compared with U.S. source income on the Federal income 
tax return in the manner described in paragraphs (g)(25)(ii) and 
(g)(26)(ii) of this section (the analysis in Examples 25 and 26). Unlike 
the facts in paragraphs (g)(25)(i) and (g)(26)(i) of this section (the 
facts in Examples 25 and 26), state A imposes no income tax and does not 
define taxable income attributable to activities in state A. The total 
amount of USP's income subject to state taxation is, therefore, 
$400,000x ($200,000x in state B and $200,000x in state C). This total 
presumptively does not include any income attributable to activities 
performed in state A and therefore cannot properly be compared to total 
U.S. source taxable income reported by USP for Federal income tax 
purposes, which does include income attributable to state A activities.
    (2)(i) Accordingly, before applying the method used in paragraphs 
(g)(25)(ii) and (g)(26)(ii) of this section (the analysis in Examples 25 
and 26) to the facts of the example in this paragraph (g)(27), it is 
necessary first to estimate the amount of taxable income that state A 
could reasonably attribute to USP's activities in state A, and then to 
reduce federal taxable income by that amount.
    (ii) Any reasonable method may be used to attribute taxable income 
to USP's activities in state A. For example, the rules of the Uniform 
Division of Income for Tax Purposes Act (``UDITPA'') attribute income to 
a state on the basis of the average of three ratios that are based upon 
the

[[Page 185]]

taxpayer's facts--property within the state over total property, payroll 
within the state over total payroll, and sales within the state over 
total sales--and, with adjustments, provide a reasonable method for this 
purpose. When applying the rules of UDITPA to estimate U.S. source 
income derived from state A activities, the taxpayer's UDITPA factors 
must be adjusted to eliminate both taxable income and factors 
attributable to a foreign branch. Therefore, in the example in this 
paragraph (g)(27) all taxable income as well as UDITPA apportionment 
factors (property, payroll, and sales) attributable to USP's Country Y 
branch must be eliminated.
    (3)(i) Since it is presumed that, if state A had had an income tax, 
state A would not attempt to tax the income derived by USP's Country Y 
branch, any reasonable estimate of the income that would be taxed by 
state A must exclude any foreign source income.
    (ii) When using the rules of UDITPA to estimate the income that 
would have been taxable by state A in these facts, foreign source income 
is excluded by starting with federally defined taxable income (before 
deduction for state income taxes) and subtracting any income derived by 
USP's Country Y branch. The hypothetical state A taxable income is then 
determined by multiplying the resulting difference by the average of 
USP's state A property, payroll, and sales ratios, determined using the 
principles of UDITPA (after adjustment by eliminating the Country Y 
branch factors). The resulting product is presumed to be exclusively 
U.S. source income, and the allocation and apportionment method 
described in paragraph (g)(26) of this section (Example 26) must then be 
applied.
    (iii) If, for example, state A taxable income were determined to 
equal $550,000x, then $550,000x of U.S. source income for Federal income 
tax purposes would be presumed to constitute state A taxable income. 
Under paragraph (g)(26) of this section (Example 26), the remaining 
$250,000x ($800,000x-$550,000x) of U.S. source income for Federal income 
tax purposes would be presumed to be subject to tax in states B and C. 
Since states B and C impose tax on $400,000x, the application of Example 
25 would result in a presumption that $150,000x is foreign source income 
and $250,000x is domestic source income. The deduction for the $14,000x 
of income taxes of states B and C would therefore be related and 
allocable to both foreign source and domestic source income and would be 
subject to apportionment.
    (B) Apportionment. The deduction of $14,000x for income taxes of 
states B and C is apportioned in the same manner as in paragraph (g)(26) 
of this section (Example 26). As a result, $5,250x of the $14,000x of 
state B and state C income taxes is apportioned to foreign source 
foreign branch category income ($14,000x x $150,000x/$400,000x), and 
$8,750x ($14,000x x $250,000x/$400,000x) of the $14,000x of state B and 
state C income taxes is apportioned to U.S. source income.
    (h) Applicability date. (1) Except as provided in this paragraph 
(h), this section applies to taxable years that both begin after 
December 31, 2017, and end on or after December 4, 2018.
    (2) Paragraphs (d)(2)(ii)(B), (d)(2)(v), (e)(4) and (5), (e)(6)(i), 
(e)(8) and (16), and (g)(15) through (18) of this section apply to 
taxable years that begin after December 31, 2019. For taxable years that 
both begin after December 31, 2017, and end on or after December 4, 
2018, and also begin on or before December 31, 2019, see Sec.  1.861-
8(d)(2)(ii)(B), (e)(4) and (5), (e)(6)(i), and (e)(8) as in effect on 
December 17, 2019.
    (3) The last sentence of paragraph (d)(2)(ii)(C)(1) of this section 
and paragraph (f)(1)(vi)(N) of this section apply to taxable years 
beginning on or after January 1, 2021.
    (4) Paragraph (e)(4)(i) of this section applies to taxable years 
ending on or after November 2, 2020.

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

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



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

    (a) In general. (1) [Reserved]

[[Page 186]]

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


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

[[Page 187]]

be taken into consideration in determining whether a method of 
apportionment and its application are sufficiently precise. A method of 
apportionment described in this paragraph (c)(1) may not be used when it 
does not reflect, to a reasonably close extent, the factual relationship 
between the deduction and the groupings of income. Furthermore, certain 
methods of apportionment described in this paragraph (c)(1) may not be 
used in connection with any deduction for which another method is 
prescribed. The principles set forth above are applicable in 
apportioning both deductions definitely related to a class which 
constitutes less than all of the taxpayer's gross income and to 
deductions related to all of the taxpayer's gross income. If a deduction 
is not related to any class of gross income, it must be apportioned 
ratably as provided in paragraph (c)(3) of this section.
    (2) Apportionment based on assets. For further guidance, see Sec.  
1.861-8(c)(2).
    (3) [Reserved]
    (d) Excess of deductions and excluded and eliminated items of 
income. (1) [Reserved]
    (2) Allocation and apportionment to exempt, excluded or eliminated 
income--(i) In general. In the case of taxable years beginning after 
December 31, 1986, except to the extent otherwise permitted by Sec.  
1.861-13T, the following rules shall apply to take account of income 
that is exempt or excluded, or assets generating such income, with 
respect to allocation and apportionment of deductions.
    (A) Allocation of deductions. In allocating deductions that are 
definitely related to one or more classes of gross income, exempt income 
(as defined in paragraph (d)(2)(ii) of this section) shall be taken into 
account.
    (B) Apportionment of deductions. In apportioning deductions that are 
definitely related either to a class of gross income consisting of 
multiple groupings of income (whether statutory or residual) or to all 
gross income, exempt income and exempt assets (as defined in paragraph 
(d)(2)(ii) of this section) shall not be taken into account.


For purposes of apportioning deductions which are not taken into account 
under Sec.  1.1502-13 in determining gain or loss from intercompany 
transactions, as defined in Sec.  1.1502-13, income from such 
transactions shall be taken into account in the year such income is 
ultimately included in gross income.
    (ii) Exempt income and exempt asset defined--(A) In general. For 
further guidance, see Sec.  1.861-8(d)(2)(ii)(A).
    (B) Certain stock and dividends. For further guidance, see Sec.  
1.861-8(d)(2)(ii)(B).
    (C) Foreign-derived intangible income and inclusions under section 
951A(a). For further guidance, see Sec.  1.861-8(d)(2)(ii)(C).
    (iii) Income that is not considered tax exempt. The following items 
are not considered to be exempt, eliminated, or excluded income and, 
thus, may have expenses, losses, or other deductions allocated and 
apportioned to them:
    (A) In the case of a foreign taxpayer (including a foreign sales 
corporation (FSC)) computing its effectively connected income, gross 
income (whether domestic or foreign source) which is not effectively 
connected to the conduct of a United States trade or business;
    (B) In computing the combined taxable income of a DISC or FSC and 
its related supplier, the gross income of a DISC or a FSC; and
    (C) For further guidance, see Sec.  1.861-8(d)(2)(iii)(C) through 
(E).
    (D)-(E) [Reserved]
    (iv) Value of stock attributable to previously taxed earnings and 
profits. For further guidance, see Sec.  1.861-8(d)(2)(iv).
    (e) Allocation and apportionment of certain deductions. (1) 
[Reserved]. For further guidance, see Sec.  1.861-8(e)(1).
    (2) Interest. The rules concerning the allocation and apportionment 
of interest expense and certain interest equivalents are set forth in 
Sec. Sec.  1.861-9T through Sec.  1.861-13T.
    (3) Research and experimental expenditures. For further guidance, 
see Sec.  1.861-8(e)(3) through (15).
    (4)-(15) [Reserved]
    (f) Miscellaneous matters. For further guidance, see Sec.  1.861-
8(f) through (g).
    (g) [Reserved]
    (h) Effective/applicability date. (1) Paragraphs (f)(1)(vi)(E), 
(f)(1)(vi)(F), and (f)(1)(vi)(G) of this section apply to taxable years 
ending after April 9, 2008.

[[Page 188]]

    (2) Paragraph (e)(4), the last sentence of paragraph (f)(4)(i), and 
paragraph (g), Examples 17, 18, and 30 of this section apply to taxable 
years beginning after July 31, 2009.
    (3) Also, see paragraph (e)(12)(iv) of this section and 1.861-
14(e)(6) for rules concerning the allocation and apportionment of 
deductions for charitable contributions.

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

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



Sec.  1.861-9  Allocation and apportionment of interest expense 
and rules for asset-based apportionment.

    (a) In general. For further guidance, see Sec.  1.861-9T(a).
    (b) Interest equivalent--(1) Certain expenses and losses--(i) 
General rule. Any expense or loss (to the extent deductible) incurred in 
a transaction or series of integrated or related transactions in which 
the taxpayer secures the use of funds for a period of time is subject to 
allocation and apportionment under the rules of this section and Sec.  
1.861-9T(b) if such expense or loss is substantially incurred in 
consideration of the time value of money. However, the allocation and 
apportionment of a loss under this paragraph (b) and Sec.  1.861-9T(b) 
does not affect the characterization of such loss as capital or ordinary 
for any purpose other than for purposes of the section 861 regulations 
(as defined in Sec.  1.861-8(a)(1)).
    (ii) Examples. For further guidance, see Sec.  1.861-9T(b)(1)(ii).
    (2) Certain foreign currency borrowings. For further guidance, see 
Sec.  1.861-9T(b)(2) through (7).
    (3)-(7) [Reserved]
    (8) Guaranteed payments. Any deductions for guaranteed payments for 
the use of capital under section 707(c) are allocated and apportioned in 
the same manner as interest expense.
    (c) Allowable deductions. For further guidance, see Sec.  1.861-
9T(c) introductory text.
    (1) Disallowed deductions. For further guidance, see Sec.  1.861-
9T(c)(1) through (4).
    (2)-(4) [Reserved]
    (5) Section 163(j). If a taxpayer is subject to section 163(j), the 
taxpayer's deduction for business interest expense is limited to the sum 
of the taxpayer's business interest income, 30 percent of the taxpayer's 
adjusted taxable income for the taxable year, and the taxpayer's floor 
plan financing interest expense. In the taxable year that any deduction 
is permitted for business interest expense with respect to a disallowed 
business interest carryforward, that business interest expense is 
apportioned for purposes of this section under rules set forth in 
paragraph (d), (e), or (f) of this section (as applicable) as though it 
were incurred in the taxable year in which the expense is deducted.
    (d) Apportionment rules for individuals, estates, and certain 
trusts. For further guidance, see Sec.  1.861-9T(d).
    (e) Partnerships--(1) In general--aggregate rule. For further 
guidance, see Sec.  1.861-9T(e)(1).
    (2) Corporate partners whose interest in the partnership is 10 
percent or more. A corporate partner shall apportion its interest 
expense, including the partner's distributive share of partnership 
interest expense, by reference to the partner's assets, including the 
partner's pro rata share of partnership assets, under the rules of 
paragraph (f) of this section if the corporate partner's direct and 
indirect interest in the partnership (as determined under the 
attribution rules of section 318) is 10 percent or more. A corporation 
using the tax book value method or alternative tax book value method of 
apportionment shall use the partnership's inside basis in its assets, 
including adjustments under sections 734(b) and 743(b), if any, and 
adjusted to the extent required under Sec.  1.861-10T(d)(2).
    (3) Individual partners who are general partners or who are limited 
partners with an interest in the partnership of 10 percent or more. An 
individual partner is subject to the rules of this paragraph (e)(3) if 
either the individual is a general partner or the individual's direct 
and indirect interest (as determined under the attribution rules of 
section 318) in the partnership is 10 percent or more. The individual 
shall first classify his or her distributive share of partnership 
interest expense as interest incurred in the active conduct of a trade

[[Page 189]]

or business, as passive activity interest, or as investment interest 
under regulations issued under sections 163 and 469. The individual must 
then apportion his or her interest expense, including the partner's 
distributive share of partnership interest expense, under the rules of 
paragraph (d) of this section. Each such individual partner shall take 
into account his or her distributive share of the partnership gross 
income or pro rata share of the partnership assets in applying such 
rules. An individual using the tax book value or alternative tax book 
value method of apportionment shall use the partnership's inside basis 
in its assets, including adjustments under sections 734(b) and 743(b), 
if any, and adjusted to the extent required under Sec.  1.861-10T(d)(2).
    (4) Entity rule for less than 10 percent limited partners--(i) 
Partnership interest expense. A limited partner (whether individual or 
corporate), whose ownership, together with ownership by persons that 
bear a relationship to the partner described in section 267(b) or 
section 707, of the capital and profits interests of the partnership is 
less than 10 percent directly allocates its distributive share of 
partnership interest expense to its distributive share of partnership 
gross income. Under Sec.  1.904-4(n)(1)(ii), such a partner's 
distributive share of foreign source income of the partnership is 
treated as passive income (subject to the high-taxed income exception of 
section 904(d)(2)(B)(iii)(II)), except in the case of income from a 
partnership interest held in the ordinary course of the partner's active 
trade or business, as defined in Sec.  1.904-4(n)(1)(ii)(B). A partner's 
distributive share of partnership interest expense (other than 
partnership interest expense that is directly allocated to identified 
property under Sec.  1.861-10T) is apportioned in accordance with the 
partner's relative distributive share of gross foreign source income in 
each separate category and of gross domestic source income from the 
partnership. To the extent that partnership interest expense is directly 
allocated under Sec.  1.861-10T, a comparable portion of the income to 
which such interest expense is allocated is disregarded in determining 
the partner's relative distributive share of gross foreign source income 
in each separate category and domestic source income. The partner's 
distributive share of the interest expense of the partnership that is 
directly allocable under Sec.  1.861-10T is allocated according to the 
treatment, after application of Sec.  1.904-4(n)(1), of the partner's 
distributive share of the income to which the expense is allocated.
    (ii) Other interest expense of the partner. For further guidance, 
see Sec.  1.861-9T(e)(4)(ii).
    (5) Tiered partnerships. For further guidance, see Sec.  1.861-
9T(e)(5) through (7).
    (6)-(7) [Reserved]
    (8) Special rule for downstream partnership loans--(i) In general. 
For purposes of apportioning interest expense that is not directly 
allocable under paragraph (e)(4) of this section or Sec.  1.861-10T, the 
disregarded portion of a downstream partnership loan is not considered 
an asset of a downstream partnership loan lender (DPL lender). The 
disregarded portion of a downstream partnership loan is the portion of 
the value of the loan (as determined under paragraph (h)(4)(i) of this 
section) that bears the same proportion to the total value of the loan 
as the matching income amount that is included by the DPL lender for a 
taxable year with respect to the loan bears to the total amount of 
downstream partnership loan interest income (DPL interest income) that 
is included directly or indirectly in gross income by the DPL lender 
with respect to the loan during that taxable year.
    (ii) Treatment of interest expense and interest income attributable 
to a downstream partnership loan. If a DPL lender (or any other person 
in the same affiliated group as the DPL lender) takes into account a 
distributive share of downstream partnership loan interest expense (DPL 
interest expense), the DPL lender must assign an amount of DPL interest 
income corresponding to the matching income amount for the taxable year 
that is attributable to the same loan to the same statutory and residual 
groupings as the statutory and residual groupings of gross income from 
which the DPL interest expense is deducted (or would be deducted, 
without regard to any limitations on the

[[Page 190]]

deductibility of interest, such as section 163(j)) by the DPL lender (or 
any other person in the same affiliated group as the DPL lender).
    (iii) Anti-avoidance rule for third party back-to-back loans. If, 
with a principal purpose of avoiding the rules in this paragraph (e)(8), 
a person makes a loan to a person that is not related (within the 
meaning of section 267(b) or 707) to the lender, the unrelated person 
makes a loan to a partnership, and the first loan would constitute a 
downstream partnership loan if made directly to the partnership, then 
the rules of this paragraph (e)(8) apply as if the first loan was made 
directly to the partnership and the interest expense paid by the 
partnership is treated as made with respect to the first loan. Such a 
series of loans will be subject to this recharacterization rule without 
regard to whether there was a principal purpose of avoiding the rules in 
this paragraph (e)(8) if the loan to the unrelated person would not have 
been made or maintained on substantially the same terms but for the loan 
of funds by the unrelated person to the partnership. The principles of 
this paragraph (e)(8)(iii) also apply to similar transactions that 
involve more than two loans and regardless of the order in which the 
loans are made.
    (iv) Anti-avoidance rule for loans held by CFCs. A loan receivable 
held by a controlled foreign corporation with respect to a loan to a 
partnership in which a United States shareholder (as defined in Sec.  
1.904-5(a)(4)(vi)) of the controlled foreign corporation owns an 
interest, directly or indirectly through one or more other partnerships 
or other pass-through entities (as defined in Sec.  1.904-5(a)(4)(iv)), 
is recharacterized as a loan receivable held directly by the United 
States shareholder with respect to the loan to such partnership for 
purposes of this paragraph (e)(8) if the loan was made or transferred 
with a principal purpose of avoiding the rules in this paragraph (e)(8). 
An appropriate amount of income derived by the United States shareholder 
(or any other person in the same affiliated group as the United States 
shareholder) from the controlled foreign corporation is treated as DPL 
interest income. Appropriate adjustments must be made to the value and 
characterization of the stock of the controlled foreign corporation 
under Sec. Sec.  1.861-9 and 1.861-12 in order to reflect the portion of 
the downstream partnership loan held by the controlled foreign 
corporation that is disregarded under paragraph (e)(8)(i) of this 
section.
    (v) Interest equivalents. The principles of this paragraph (e)(8) 
apply in the case of a partner, or any person in the same affiliated 
group as the partner, that takes into account a distributive share of an 
expense or loss (to the extent deductible) that is allocated and 
apportioned in the same manner as interest expense under Sec. Sec.  
1.861-9(b) and 1.861-9T(b) and has a matching income amount (treating 
such interest equivalent as interest income or expense for purposes of 
paragraph (e)(8)(vi)(B) of this section) with respect to the transaction 
that gives rise to that expense or loss.
    (vi) Definitions. For purposes of this paragraph (e)(8), the 
following definitions apply.
    (A) Affiliated group. The term affiliated group has the meaning 
provided in Sec.  1.861-11(d)(1).
    (B) Matching income amount. The term matching income amount means 
the lesser of the total amount of the DPL interest income included 
directly or indirectly in gross income by the DPL lender for the taxable 
year with respect to a downstream partnership loan or the total amount 
of the distributive shares of the DPL interest expense of the DPL lender 
(or any other person in the same affiliated group as the DPL lender) 
with respect to the loan.
    (C) Downstream partnership loan. The term downstream partnership 
loan means a loan to a partnership for which the loan receivable is 
held, directly or indirectly through one or more other partnerships or 
other pass-through entities (as defined in Sec.  1.904-5(a)(4)), by a 
person (or any person in the same affiliated group as such person) that 
owns an interest, directly or indirectly through one or more other 
partnerships or other pass-through entities, in the partnership.
    (D) Downstream partnership loan interest expense (DPL interest 
expense). The

[[Page 191]]

term downstream partnership loan interest expense, or DPL interest 
expense, means an item of interest expense paid or accrued with respect 
to a downstream partnership loan, without regard to whether the expense 
was currently deductible (for example, by reason of section 163(j) or 
the election to waive deductions pursuant to Sec.  1.59A-3(c)(6)).
    (E) Downstream partnership loan interest income (DPL interest 
income). The term downstream partnership loan interest income, or DPL 
interest income, means an item of gross interest income received or 
accrued with respect to a downstream partnership loan.
    (F) Downstream partnership loan lender (DPL lender). The term 
downstream partnership loan lender, or DPL lender, means the person that 
holds the receivable with respect to a downstream partnership loan. If a 
partnership holds the receivable, then any partner in the partnership 
(other than a partner described in paragraph (e)(4)(i) of this section) 
is also considered a DPL lender.
    (vii) Examples. The following examples illustrate the application of 
the rules in this paragraph (e)(8).
    (A) Example 1--(1) Facts. US1, a domestic corporation, directly owns 
60% of PRS, a foreign partnership that is not engaged in a U.S. trade or 
business. The remaining 40% of PRS is directly owned by US2, a domestic 
corporation that is unrelated to US1. US1, US2, and PRS all use the 
calendar year as their taxable year. In Year 1, US1 loans $1,000x to 
PRS. For Year 1, US1 has $100x of interest income with respect to the 
loan and PRS has $100x of interest expense with respect to the loan. 
US1's distributive share of the interest expense is $60x. Under 
paragraph (e)(2) of this section, $45x of US1's distributive share of 
the interest expense is apportioned to U.S. source income and $15x is 
apportioned to foreign source foreign branch category income. Under 
paragraph (h)(4)(i) of this section, the total value of the loan between 
US1 and PRS is $1,000x.
    (2) Analysis. The loan by US1 to PRS is a downstream partnership 
loan and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this 
section, the matching income amount is $60x, the lesser of the DPL 
interest income included by US1 with respect to the loan for the taxable 
year ($100x) and US1's distributive share of the DPL interest expense 
($60x). Under paragraph (e)(8)(ii) of this section, US1 assigns $45x of 
the DPL interest income to U.S. source income and $15x of the DPL 
interest income to foreign source foreign branch category income. The 
source and separate category of the remaining $40x of US1's DPL interest 
income is determined under the generally applicable rules. Under 
paragraph (e)(8)(i) of this section, the disregarded portion of the 
downstream partnership loan is $600x ($1,000x x $60x/$100x).
    (B) Example 2--(1) Facts. The facts are the same as in paragraph 
(e)(8)(vii)(A)(1) of this section (the facts in Example 1), except that 
US1 and US2 are part of the same affiliated group, US2's distributive 
share of the interest expense is $40x, and under paragraph (e)(2) of 
this section, $30x of US2's distributive share of the interest expense 
is apportioned to U.S. source income and $10x is apportioned to foreign 
source foreign branch category income.
    (2) Analysis. The loan by US1 to PRS is a downstream partnership 
loan and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this 
section, the matching income amount is $100x, the lesser of the DPL 
interest income included by US1 with respect to the loan for the taxable 
year ($100x) and the total amount of US1 and US2's distributive shares 
of the DPL interest expense ($100x). Under paragraph (e)(8)(ii) of this 
section, US1 assigns $75x of the DPL interest income to U.S. source 
income and $25x of the DPL interest income to foreign source foreign 
branch category income. Under paragraph (e)(8)(i) of this section, the 
disregarded portion of the downstream partnership loan is $1,000x 
($1,000x x $100x/$100x).
    (C) Example 3--(1) Facts. US1, a domestic corporation, owns 80% of 
PRS, a foreign partnership that is not engaged in a U.S. trade or 
business. The remaining 20% of PRS is owned by US2, a domestic 
corporation that is unrelated to US1. US1, US2, and PRS all use the 
calendar year as their taxable year. In Year 1, US1 loans $3,000x to 
Bank and Bank loans $3,000x to PRS. US1

[[Page 192]]

makes the loan to Bank with a principal purpose of avoiding the rules in 
this paragraph (e)(8). For Year 1, US1 has $150x of interest income with 
respect to the loan to Bank and PRS has $175x of interest expense with 
respect to the loan from Bank. US1's distributive share of the interest 
expense is $140x. Under paragraph (e)(2) of this section, $126x of US1's 
distributive share of the interest expense is apportioned to U.S. source 
income and $14x is apportioned to foreign source foreign branch category 
income. Under paragraph (h)(4)(i) of this section, the total value of 
the loan between US1 and PRS is $3,000x.
    (2) Analysis. Under paragraph (e)(8)(iii) of this section, because 
the loan from US1 to Bank is made with a principal purpose of avoiding 
the rules of this paragraph (e)(8), the rules of this paragraph (e)(8) 
apply as if the loan by US1 to Bank was made directly to PRS. 
Accordingly, the loan by US1 to Bank is a downstream partnership loan 
and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this section, 
the matching income amount is $140x, the lesser of the DPL interest 
income included by US1 with respect to the loan for the taxable year 
($150x) and US1's distributive share of the DPL interest expense 
($140x). Under paragraph (e)(8)(ii) of this section, US1 assigns $126x 
of the DPL interest income to U.S. source income and $14x of the DPL 
interest income to foreign source foreign branch category income. The 
source and separate category of the remaining $10x of US1's DPL interest 
income is determined under the generally applicable rules. Under 
paragraph (e)(8)(i) of this section, the disregarded portion of the 
downstream partnership loan is $2,800x ($3,000x x $140x/$150x).
    (D) Example 4--(1) Facts. US1, a domestic corporation, directly owns 
all of the outstanding stock of CFC, a controlled foreign corporation, 
and 90% of PRS, a foreign partnership that is not engaged in a U.S. 
trade or business. The remaining 10% of PRS is owned by US2, a domestic 
corporation that is unrelated to US1 and CFC. US1, US2, and PRS all use 
the calendar year as their taxable year. In Year 1, US1 loans $900x to 
CFC and CFC loans $900x to PRS. CFC makes the loan with a principal 
purpose of avoiding the rules in this paragraph (e)(8). For Year 1, CFC 
has $90x of interest income and $90x of interest expense with respect to 
the loan to PRS, and US1 has $90x of interest income with respect to the 
loan to CFC. PRS has $90x of interest expense with respect to the loan, 
and US1's distributive share of the interest expense is $81x. Under 
paragraph (e)(2) of this section, $54x of US1's distributive share of 
the interest expense is apportioned to U.S. source income and $27x is 
apportioned to foreign source foreign branch category income. Under 
paragraph (h)(4)(i) of this section, the total value of the loan between 
CFC and PRS is $900x.
    (2) Analysis. Under paragraph (e)(8)(iv) of this section, because 
the loan from CFC to PRS is made with a principal purpose of avoiding 
the rules of this paragraph (e)(8), the loan from CFC to PRS is 
recharacterized as a loan receivable held directly by US1, and an 
appropriate amount of income derived by US1, in this case, the $90x of 
interest income from the loan to CFC, is treated as DPL interest income. 
Accordingly, the loan from CFC to PRS is a downstream partnership loan 
and US1 is a DPL lender. Under paragraph (e)(8)(vi)(B) of this section, 
the matching income amount is $81x, the lesser of the DPL interest 
income included by US1 ($90x) and US1's distributive share of the DPL 
interest expense ($81x). Under paragraph (e)(8)(ii) of this section, US1 
assigns $54x of the DPL interest income to U.S. source income and $27x 
of the DPL interest income to foreign source foreign branch category 
income. The source and separate category of the remaining $9x of US1's 
interest income is determined under the generally applicable rules. 
Under paragraph (e)(8)(i) of this section, the disregarded portion of 
the downstream partnership loan is $810x ($900x x $81x/$90x). 
Appropriate adjustments are made to the value and characterization of 
the stock of CFC under Sec. Sec.  1.861-9 and 1.861-12 in order to 
reflect the $810x disregarded portion of the downstream partnership 
loan.
    (9) Special rule for upstream partnership loans--(i) In general. For 
purposes of apportioning interest expense that is

[[Page 193]]

not directly allocable under paragraph (e)(4) of this section or Sec.  
1.861-10T, an upstream partnership loan debtor's (UPL debtor) pro rata 
share of the value of the upstream partnership loan (as determined under 
paragraph (h)(4)(i) of this section) is not considered an asset of the 
UPL debtor taken into account as described in paragraphs (e)(2) and (3) 
of this section.
    (ii) Treatment of interest expense and interest income attributable 
to an upstream partnership loan. If a UPL debtor (or any other person in 
the same affiliated group as the UPL debtor) takes into account a 
distributive share of upstream partnership loan interest income (UPL 
interest income), the UPL debtor (or any other person in the same 
affiliated group as the UPL debtor) assigns an amount of its 
distributive share of the UPL interest income equal to the matching 
expense amount for the taxable year that is attributable to the same 
loan to the same statutory and residual groupings using the same ratios 
as the statutory and residual groupings of gross income from which the 
upstream partnership loan interest expense (UPL interest expense) is 
deducted by the UPL debtor (or any other person in the same affiliated 
group as the UPL debtor). Therefore, the amount of the distributive 
share of UPL interest income that is assigned to each statutory and 
residual grouping is the amount that bears the same proportion to the 
matching expense amount as the UPL interest expense in that statutory or 
residual grouping bears to the total UPL interest expense of the UPL 
debtor (or any other person in the same affiliated group as the UPL 
debtor).
    (iii) Anti-avoidance rule for third party back-to-back loans. If, 
with a principal purpose of avoiding the rules in this paragraph (e)(9), 
a partnership makes a loan to a person that is not related (within the 
meaning of section 267(b) or 707) to the lender, the unrelated person 
makes a loan to a direct or indirect partner in the partnership (or any 
person in the same affiliated group as a direct or indirect partner), 
and the first loan would constitute an upstream partnership loan if made 
directly to the direct or indirect partner (or person in the same 
affiliated group as a direct or indirect partner), then the rules of 
this paragraph (e)(9) apply as if the first loan was made directly by 
the partnership to the partner (or affiliate of the partner), and the 
interest expense paid by the partner is treated as made with respect to 
the first loan. Such a series of loans will be subject to the 
recharacterization rule in this paragraph (e)(9)(iii) without regard to 
whether there was a principal purpose of avoiding the rules in this 
paragraph (e)(9) if the loan to the unrelated person would not have been 
made or maintained on substantially the same terms but for the loan of 
funds by the unrelated person to the direct or indirect partner (or 
affiliate of the partner). The principles of this paragraph (e)(9)(iii) 
also apply to similar transactions that involve more than two loans and 
regardless of the order in which the loans are made.
    (iv) Interest equivalents. The principles of this paragraph (e)(9) 
apply in the case of a partner, or any person in the same affiliated 
group as the partner, that takes into account a distributive share of 
income and has a matching expense amount (treating any interest 
equivalent described in paragraph (b) of this section and Sec.  1.861-
9T(b) as interest income or expense for purposes of paragraph 
(e)(9)(v)(B) of this section) that is allocated and apportioned in the 
same manner as interest expense under paragraph (b) of this section and 
Sec.  1.861-9T(b).
    (v) Definitions. For purposes of this paragraph (e)(9), the 
following definitions apply.
    (A) Affiliated group. The term affiliated group has the meaning 
provided in Sec.  1.861-11(d)(1).
    (B) Matching expense amount. The term matching expense amount means 
the lesser of the total amount of the UPL interest expense taken into 
account directly or indirectly by the UPL debtor for the taxable year 
with respect to an upstream partnership loan or the total amount of the 
distributive shares of the UPL interest income of the UPL debtor (or any 
other person in the same affiliated group as the UPL debtor) with 
respect to the loan.
    (C) Upstream partnership loan. The term upstream partnership loan 
means a loan by a partnership to a person (or

[[Page 194]]

any person in the same affiliated group as such person) that owns an 
interest, directly or indirectly through one or more other partnerships 
or other pass-through entities (as defined in Sec.  1.904-5(a)(4)(iv)), 
in the partnership.
    (D) Upstream partnership loan debtor (UPL debtor). The term upstream 
partnership loan debtor, or UPL debtor, means the person that has the 
payable with respect to an upstream partnership loan. If a partnership 
has the payable, then any partner in the partnership (other than a 
partner described in paragraph (e)(4)(i) of this section) is also 
considered a UPL debtor.
    (E) Upstream partnership loan interest expense (UPL interest 
expense). The term upstream partnership loan interest expense, or UPL 
interest expense, means an item of interest expense paid or accrued with 
respect to an upstream partnership loan, without regard to whether the 
expense was currently deductible (for example, by reason of section 
163(j) or the election to waive deductions pursuant to Sec.  1.59A-
3(c)(6)).
    (F) Upstream partnership loan interest income (UPL interest income). 
The term upstream partnership loan interest income, or UPL interest 
income, means an item of gross interest income received or accrued with 
respect to an upstream partnership loan.
    (vi) Examples. The following examples illustrate the application of 
this paragraph (e)(9).
    (A) Example 1--(1) Facts. US1, a domestic corporation, directly owns 
60% of PRS, a foreign partnership that is not engaged in a U.S. trade or 
business. The remaining 40% of PRS is directly owned by US2, a domestic 
corporation that is unrelated to US1. US1, US2, and PRS all use the 
calendar year as their taxable year. In Year 1, PRS loans $1,000x to 
US1. For Year 1, US1 has $100x of interest expense with respect to the 
loan and PRS has $100x of interest income with respect to the loan. 
US1's distributive share of the interest income is $60x. Under paragraph 
(e)(2) of this section, $75x of US1's interest expense with respect to 
the loan is allocated and apportioned to U.S. source income and $25x is 
allocated and apportioned to foreign source foreign branch category 
income. Under paragraph (h)(4)(i) of this section, US1's share of the 
total value of the loan between US1 and PRS is $600x.
    (2) Analysis. The loan by PRS to US1 is an upstream partnership loan 
and US1 is an UPL debtor. Under paragraph (e)(9)(iv)(B) of this section, 
the matching expense amount is $60x, the lesser of the UPL interest 
expense taken into account by US1 with respect to the loan for the 
taxable year ($100x) and US1's distributive share of the UPL interest 
income ($60x). Under paragraph (e)(9)(ii) of this section, US1 assigns 
$45x of the UPL interest income to U.S. source income ($60x x $75x/
$100x) and $15x of the UPL interest income to foreign source foreign 
branch category income ($60x x $25x/$100x). Under paragraph (e)(9)(i) of 
this section, the disregarded portion of the upstream partnership loan 
is $600x, and is not taken into account as described in paragraphs 
(e)(2) and (3) of this section.
    (B) Example 2--(1) Facts. The facts are the same as in paragraph 
(e)(9)(vi)(A)(1) of this section (the facts in Example 1), except that 
US1 and US2 are part of the same affiliated group with the same ratio of 
U.S. and foreign assets that US1 had in paragraph (e)(9)(vi)(A)(1), 
US2's distributive share of the interest income is $40x, and under 
paragraph (h)(4)(i) of this section US2's share of the total value of 
the loan between US1 and PRS is $400x.
    (2) Analysis. The loan by PRS to US1 is an upstream partnership loan 
and US1 is an UPL debtor. Under paragraph (e)(9)(iv)(B) of this section, 
the matching expense amount is $100x, the lesser of the UPL interest 
expense taken into account by US1 with respect to the loan for the 
taxable year ($100x) and the total amount of US1 and US2's distributive 
shares of the UPL interest income ($100x). Under paragraph (e)(9)(ii) of 
this section, US1 and US2 assign $75x of their total UPL interest income 
to U.S. source income ($100x x $75x/$100x) and $25x of their total UPL 
interest income to foreign source foreign branch category income ($100x 
x $25x/$100x). Under paragraph (e)(9)(i) of this section, the 
disregarded portion of the upstream partnership loan is $1,000x, the 
total amount of US1 and US2's share of the loan between US1 and PRS, and 
is not taken into account as described in paragraphs (e)(2) and (3) of 
this section.

[[Page 195]]

    (10) Characterizing certain partnership assets as foreign branch 
category assets. For purposes of applying this paragraph (e) to section 
904 as the operative section, a partner that is a United States person 
that has a distributive share of partnership income that is treated as 
foreign branch category income under Sec.  1.904-4(f)(1)(i)(B) 
characterizes its pro rata share of the partnership assets that give 
rise to such income as assets in the foreign branch category.
    (f) Corporations--(1) Domestic corporations. For further guidance, 
see Sec.  1.861-9T(f)(1).
    (2) Section 987 QBUs of domestic corporations--(i) In general. In 
the application of the asset method described in paragraph (g) of this 
section, a domestic corporation--
    (A) Takes into account the assets of any section 987 QBU (as defined 
in Sec.  1.987-1(b)(2)), translated according to the rules set forth in 
paragraph (g) of this section; and
    (B) Combines with its own interest expense any deductible interest 
expense incurred by a section 987 QBU, translated according to the rules 
under section 987.
    (ii) Coordination with section 987(3). For purposes of computing 
foreign currency gain or loss under section 987(3) (including section 
987 gain or loss recognized under Sec.  1.987-5), the rules of this 
paragraph (f)(2) do not apply. See Sec.  1.987-4.
    (iii) Example. The following example illustrates the application of 
the rules in this paragraph (f)(2).
    (A) Facts. X is a domestic corporation that operates B, a branch 
doing business in a foreign country. B is a section 987 QBU (as defined 
in Sec.  1.987-1(b)(2)) as well as a foreign branch (as defined in Sec.  
1.904-4(f)(3)(iii)). In 2020, without regard to B, X has gross domestic 
source income of $1,000x and gross foreign source general category 
income of $500x and incurs $200 of interest expense. Using the tax book 
value method of apportionment, X, without regard to B, determines the 
value of its assets that generate domestic source income to be $6,000x 
and the value of its assets that generate foreign source general 
category income to be $1,000x. Applying the translation rules of section 
987, X (through B) earned $500 of gross foreign source foreign branch 
category income and incurred $100x of interest expense. B incurred no 
other expenses. For 2020, the average functional currency book value of 
B's assets that generate foreign source foreign branch category income 
translated at the year-end rate for 2020 is $3,000x.
    (B) Analysis. The combined assets of X and B for 2020 (averaged 
under Sec.  1.861-9T(g)(3)) consist 60% ($6,000x/$10,000x) of assets 
generating domestic source income, 30% ($3,000x/$10,000x) of assets 
generating foreign source foreign branch category income, and 10% 
($1,000x/$10,000x) of assets generating foreign source general category 
income. The combined interest expense of X and B is $300x. Thus, $180x 
($300x x 60%) of the combined interest expense is apportioned to 
domestic source income, $90x ($300x x 30%) is apportioned to foreign 
source foreign branch category income, and $30x ($300x x 10%) is 
apportioned to foreign source general category income, yielding net U.S. 
source income of $820 ($1,000x-$180x), net foreign source foreign branch 
category income of $410 ($500x-$90x), and net foreign source general 
category income of $470x ($500x-$30x).
    (3) Controlled foreign corporations--(i) In general. For purposes of 
computing subpart F income and tested income and computing earnings and 
profits for all Federal income tax purposes, the interest expense of a 
controlled foreign corporation may be apportioned using either the asset 
method described in paragraph (g) of this section or the modified gross 
income method described in paragraph (j) of this section, subject to the 
rules of paragraphs (f)(3)(ii) and (iii) of this section.
    (ii) Manner of election. The election shall be made by filing the 
statement and providing the written notice described in Sec.  1.964-
1(c)(3)(ii) and (iii), respectively, at the time and in the manner 
described therein. For further guidance, see Sec.  1.861-9T(f)(3)(ii).
    (f)(3)(iii)-(iv) [Reserved] For further guidance, see Sec.  1.861-
9T(f)(3)(iii) and (iv).
    (4) Noncontrolled 10-percent owned foreign corporations.--(i) In 
general. For purposes of computing earnings and profits of a 
noncontrolled 10-percent

[[Page 196]]

owned foreign corporations (as defined in section 904(d)(2)(E)) for 
Federal tax purposes, the interest expense of a noncontrolled 10-percent 
owned foreign corporations may be apportioned using either the asset 
method described in Sec.  1.861-9T(g) or the modified gross income 
method described in Sec.  1.861-9T(j). A noncontrolled 10-percent owned 
foreign corporations that is not a controlled foreign corporation may 
elect to use a different method of apportionment than that elected by 
one or more of its shareholders. A noncontrolled 10-percent owned 
foreign corporations must use the same method of apportionment with 
respect to all its domestic corporate shareholders.
    (ii) Manner of election. The election to use the asset method 
described in Sec.  1.861-9T(g) or the modified gross income method 
described in Sec.  1.861-9T(j) may be made either by the noncontrolled 
10-percent owned foreign corporations or by the majority domestic 
corporate shareholders (as defined in Sec.  1.964-1(c)(5)(ii)) on behalf 
of the noncontrolled 10-percent owned foreign corporations. The election 
shall be made by filing the statement and providing the written notice 
described in Sec.  1.964-1(c)(3)(ii) and (iii), respectively, at the 
time and in the manner described therein.
    (iii) Stock characterization. The stock of a noncontrolled 10-
percent owned foreign corporation is characterized under the rules in 
Sec.  1.861-12(c)(4).
    (5) Other relevant provisions. For further guidance, see Sec.  
1.861-9T(f)(5).
    (g) Asset method--(1) In general. (i) For further guidance, see 
Sec.  1.861-9T(g)(1)(i).
    (ii) A taxpayer may elect to determine the value of its assets on 
the basis of either the tax book value or the fair market value of its 
assets. However, for taxable years beginning after December 31, 2017, 
the fair market value method is not allowed with respect to allocations 
and apportionments of interest expense. See section 864(e)(2). For rules 
concerning the application of an alternative method of valuing assets 
for purposes of the tax book value method, see paragraph (i) of this 
section. For rules concerning the application of the fair market value 
method, see paragraph (h) of this section.
    (iii) [Reserved]
    (iv) For rules relating to earnings and profits adjustments by 
taxpayers using the tax book value method for the stock in certain 10 
percent owned corporations, see Sec.  1.861-12(c)(2).
    (v) [Reserved]
    (2) Asset values--(i) General rule--(A) Average of values. For 
purposes of determining the value of assets under this section, an 
average of values (book or market) within each statutory grouping and 
the residual grouping is computed for the year on the basis of values of 
assets at the beginning and end of the year. For the first taxable year 
beginning after December 31, 2017 (post-2017 year), a taxpayer that 
determined the value of its assets on the basis of the fair market value 
method for purposes of apportioning interest expense in its prior 
taxable year may choose to determine asset values under the tax book 
value method (or the alternative tax book value method) by treating the 
value of its assets as of the beginning of the post-2017 year as equal 
to the value of its assets at the end of the first quarter of the post-
2017 year, provided that each member of the affiliated group (as defined 
in Sec.  1.861-11T(d)) determines its asset values on the same basis. 
Where a substantial distortion of asset values would result from 
averaging beginning-of-year and end-of-year values, as might be the case 
in the event of a major corporate acquisition or disposition, the 
taxpayer must use a different method of asset valuation that more 
clearly reflects the average value of assets weighted to reflect the 
time such assets are held by the taxpayer during the taxable year.
    (B) Tax book value method. Under the tax book value method, the 
value of an asset is determined based on the adjusted basis of the 
asset. For purposes of determining the value of stock in a 10 percent 
owned corporation at the beginning and end of the year under the tax 
book value method, the tax book value is determined without regard to 
any adjustments under section 961(a) or 1293(d), see Sec.  1.861-
12(c)(2)(i)(B)(1), and before the adjustment required by Sec.  1.861-
12(c)(2)(i)(A) to the basis of stock in the 10 percent owned 
corporation. The average of the tax book value of the stock at the 
beginning and end of

[[Page 197]]

the year is then adjusted with respect to earnings and profits as 
described in Sec.  1.861-12(c)(2)(i).
    (ii) Special rule for qualified business units of domestic 
corporations with functional currency other than the U.S. dollar--(A) 
Tax book value method. For further guidance, see Sec.  1.861-
9T(g)(2)(ii)(A).
    (1) Section 987 QBU. For further guidance, see Sec.  1.861-
9T(g)(2)(ii)(A)(1).
    (2) U.S. dollar approximate separate transactions method. In the 
case of a branch to which the U.S. dollar approximate separate 
transactions method of accounting described in Sec.  1.985-3 applies, 
the beginning-of-year dollar amount of the assets is determined by 
reference to the end-of-year balance sheet of the branch for the 
immediately preceding taxable year, adjusted for U.S. generally accepted 
accounting principles and Federal income tax accounting principles, and 
translated into U.S. dollars as provided in Sec.  1.985-3(c). The end-
of-year dollar amount of the assets of the branch is determined in the 
same manner by reference to the end-of-year balance sheet for the 
current taxable year. The beginning-of-year and end-of-year dollar tax 
book value of assets, as so determined, within each grouping is then 
averaged as provided in paragraph (g)(2)(i) of this section.
    (B) Fair market value method. For further guidance, see Sec.  1.861-
9T(g)(2)(ii)(B).
    (iii) Adjustment for directly allocated interest. For further 
guidance, see Sec.  1.861-9T(g)(2)(iii).
    (iv) Assets in intercompany transactions. For further guidance, see 
Sec.  1.861-9T(g)(2)(iv).
    (3) Characterization of assets. For further guidance, see Sec.  
1.861-9T(g)(3). In applying Sec.  1.861-9T(g)(3), for purposes of 
applying section 904 as the operative section, the statutory or residual 
grouping of income that assets generate, have generated, or may 
reasonably be expected to generate is determined after taking into 
account any reallocation of income required under Sec.  1.904-
4(f)(2)(vi).
    (4) Characterization of lower tier entities at the level of a CFC. 
In the case of a controlled foreign corporation that is applying the 
asset method, see for example Sec.  1.861-12T(c)(3)(ii) (requiring the 
application of Sec.  1.861-9T(g) at the level of the controlled foreign 
corporation) or paragraph (f)(3)(i) of this section, the controlled 
foreign corporation (and any lower-tier controlled foreign corporations) 
must characterize stock of a lower-tier 10 percent owned corporation by 
applying Sec.  1.861-12 and treating the controlled foreign corporation 
as the relevant taxpayer for such purposes. In the case of a controlled 
foreign corporation that owns stock in one or more lower-tier 
corporations, in applying the asset method, the first-tier controlled 
foreign corporation must take into account the stock in the lower-tier 
corporations. Therefore, the controlled foreign corporation (and any 
lower-tier controlled foreign corporations) must make basis adjustments 
in lower-tier 10 percent owned corporations under Sec.  1.861-12(c)(2) 
for purposes of valuing and characterizing the assets of such controlled 
foreign corporation. For purposes of this paragraph (g)(4), the stock of 
each such lower-tier corporation is characterized by reference to the 
assets owned during the lower-tier corporation's taxable year that ends 
during the first-tier controlled foreign corporation's taxable year. The 
analysis of assets under this paragraph (g)(4) and Sec.  1.861-12 of a 
controlled foreign corporation that is in a chain of 10 percent owned 
corporations must begin at the lowest-tier 10 percent owned corporation 
and proceed up the chain to the first-tier controlled foreign 
corporation. See also Sec.  1.861-12T(c)(3)(ii).
    (h) Fair market value method. An affiliated group (as defined in 
Sec.  1.861-11T(d)) or other taxpayer (the taxpayer) that elects to use 
the fair market value method of apportionment values its assets 
according to the methodology described in this paragraph (h). Effective 
for taxable years beginning after December 31, 2017, the fair market 
value method is not allowed for purposes of apportioning interest 
expense. See section 864(e)(2). However, a taxpayer may continue to 
apportion deductions other than interest expense that are properly 
apportioned based on fair market value according to the methodology 
described in this paragraph (h). See Sec.  1.861-8(c)(2).

[[Page 198]]

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

[[Page 199]]

statutory grouping and the residual grouping under the stock 
characterization rules of Sec.  1.861-12T(c)(3)(ii), except that the 
portion of the value of intangible assets of the taxpayer and related 
persons that is apportioned to the related person under Sec.  1.861-
9T(h)(2) shall be characterized on the basis of the net income before 
interest expense of the related person within each statutory grouping or 
residual grouping (excluding income that is passive under Sec.  1.904-
4(b)).
    (6) [Reserved]. For further guidance, see Sec.  1.861-9T(h)(6).
    (i) Alternative tax book value method--(1) Alternative value for 
certain tangible property. A taxpayer may elect to determine the tax 
book value of its tangible property that is depreciated under section 
168 (section 168 property) using the rules provided in this paragraph 
(i)(1) (the alternative tax book value method). The alternative tax book 
value method applies solely for purposes of apportioning expenses 
(including the calculation of the alternative minimum tax foreign tax 
credit pursuant to section 59(a)) under the asset method described in 
paragraph (g) of this section.
    (i) The tax book value of section 168 property placed in service 
during or after the first taxable year to which the election to use the 
alternative tax book value method applies shall be determined as though 
such property were subject to the alternative depreciation system set 
forth in section 168(g) (or a successor provision) for the entire period 
that such property has been in service.
    (ii) In the case of section 168 property placed in service prior to 
the first taxable year to which the election to use the alternative tax 
book value method applies, the tax book value of such property shall be 
determined under the depreciation method, convention, and recovery 
period provided for under section 168(g) for the first taxable year to 
which the election applies.
    (iii) If a taxpayer revokes an election to use the alternative tax 
book value method (the prior election) and later makes another election 
to use the alternative tax book value method (the subsequent election) 
that is effective for a taxable year that begins within 3 years of the 
end of the last taxable year to which the prior election applied, the 
taxpayer shall determine the tax book value of its section 168 property 
as though the prior election has remained in effect.
    (iv) The tax book value of section 168 property shall be determined 
without regard to the election to expense certain depreciable assets 
under section 179.
    (v) Examples. The provisions of this paragraph (i)(1) are 
illustrated in the following examples:

    Example 1. In 2000, a taxpayer purchases and places in service 
section 168 property used solely in the United States. In 2005, the 
taxpayer elects to use the alternative tax book value method, effective 
for the current taxable year. For purposes of determining the tax book 
value of its section 168 property, the taxpayer's depreciation deduction 
is determined by applying the method, convention, and recovery period 
rules of the alternative depreciation system under section 168(g)(2) as 
in effect in 2005 to the taxpayer's original cost basis in such 
property. In 2006, the taxpayer acquires and places in service in the 
United States new section 168 property. The tax book value of this 
section 168 property is determined under the rules of section 168(g)(2) 
applicable to property placed in service in 2006.
    Example 2. Assume the same facts as in Example 1, except that the 
taxpayer revokes the alternative tax book value method election 
effective for taxable year 2010. Additionally, in 2011, the taxpayer 
acquires new section 168 property and places it in service in the United 
States. If the taxpayer elects to use the alternative tax book value 
method effective for taxable year 2012, the taxpayer must determine the 
tax book value of its section 168 property as though the prior election 
still applied. Thus, the tax book value of property placed in service 
prior to 2005 would be determined by applying the method, convention, 
and recovery period rules of the alternative depreciation system under 
section 168(g)(2) applicable to property placed in service in 2005. The 
tax book value of section 168 property placed in service during any 
taxable year after 2004 would be determined by applying the method, 
convention, and recovery period rules of the alternative depreciation 
system under section 168(g)(2) applicable to property placed in service 
in such taxable year.

    (2) Timing and scope of election. (i) Except as provided in this 
paragraph (i)(2)(i), a taxpayer may elect to use the alternative tax 
book value method. For the taxpayer's first taxable year

[[Page 200]]

beginning after December 31, 2017, the Commissioner's approval is not 
required to switch from the fair market value method to the alternative 
tax book value method for purposes of apportioning interest expense. Any 
election made pursuant to this paragraph (i)(2)(i) shall apply to all 
members of an affiliated group of corporations as defined in Sec. Sec.  
1.861-11(d) and 1.861-11T(d). Any election made pursuant to this 
paragraph (i)(2)(i) shall apply to all subsequent taxable years of the 
taxpayer unless revoked by the taxpayer. Revocation of such an election, 
other than in conjunction with an election to use the fair market value 
method, for a taxable year prior to the sixth taxable year for which the 
election applies requires the consent of the Commissioner.
    (ii) Example. The provisions of this paragraph (i)(2) are 
illustrated in the following example:

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

    (3) Certain other adjustments. [Reserved]
    (j) Modified gross income method. For further guidance, see Sec.  
1.861-9T(j) introductory text.
    (1) For further guidance, see Sec.  1.861-9T(j)(1).
    (2) For further guidance, see Sec.  1.861-9T(j)(2) introductory 
text.
    (i) Step 1. For further guidance, see Sec.  1.861-9T(j)(2)(i).
    (ii) Step 2. Moving to the next higher-tier controlled foreign 
corporation, combine the gross income of such corporation within each 
grouping with its pro rata share (as determined under principles similar 
to section 951(a)(2)) of the gross income net of interest expense of all 
lower-tier controlled foreign corporations held by such higher-tier 
corporation within the same grouping adjusted as follows:
    (A) Exclude from the gross income of the higher-tier corporation any 
dividends or other payments received from the lower-tier corporation 
other than interest income received from the lower-tier corporation;
    (B) Exclude from the gross income net of interest expense of any 
lower-tier corporation any gross subpart F income, net of interest 
expense apportioned to such income;
    (C) Then apportion the interest expense of the higher-tier 
controlled foreign corporation based on the adjusted combined gross 
income amounts; and
    (D) Repeat paragraphs (j)(2)(ii)(A) through (C) of this section for 
each next higher-tier controlled foreign corporation in the chain.
    (k) Applicability dates. (1) Except as provided in paragraphs (k)(2) 
and (3) of this section, this section applies to taxable years that both 
begin after December 31, 2017, and end on or after December 4, 2018.
    (2) Paragraphs (b)(1)(i), (b)(8), and (e)(9) of this section apply 
to taxable years that end on or after December 16, 2019. For taxable 
years that both begin after December 31, 2017, and end on or after 
December 4, 2018, and also end before December 16, 2019, see Sec.  
1.861-9T(b)(1)(i) as contained in 26 CFR part 1 revised as of April 1, 
2019.
    (3) The last sentence of paragraph (g)(3) of this section applies to 
taxable years beginning on or after December 28, 2021.

[T.D. 8916, 66 FR 272, Jan. 3, 2001, as amended by T.D. 9120, 69 FR 
15675, Mar. 26, 2004; T.D. 9247, 71 FR 4814, Jan. 30, 2006; T.D. 9452, 
74 FR 27873, June 11, 2009; T.D. 9456, 74 FR 46346, Sept. 9, 2009; T.D. 
9676, 79 FR 41425, July 16, 2014; T.D. 9676, 79 FR 49683, Aug. 22, 2014; 
T.D. 9882, 84 FR 69064, Dec. 17, 2019; T.D. 9922, 85 FR 72038, Nov. 12, 
2020; T.D. 9959, 87 FR 326, Jan. 4, 2022]



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

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

[[Page 201]]

The term interest refers to the gross amount of interest expense 
incurred by a taxpayer in a given tax year. The method of allocation and 
apportionment for interest set forth in this section is based on the 
approach that, in general, money is fungible and that interest expense 
is attributable to all activities and property regardless of any 
specific purpose for incurring an obligation on which interest is paid. 
Exceptions to the fungibility rule are set forth in Sec.  1.861-10T. The 
fungibility approach recognizes that all activities and property require 
funds and that management has a great deal of flexibility as to the 
source and use of funds. When borrowing will generally free other funds 
for other purposes, and it is reasonable under this approach to 
attribute part of the cost of borrowing to such other purposes. 
Consistent with the principles of fungibility, except as otherwise 
provided, the aggregate of deductions for interest in all cases shall be 
considered related to all income producing activities and assets of the 
taxpayer and, thus, allocable to all the gross income which the assets 
of the taxpayer generate, have generated, or could reasonably have been 
expected to generate. In the case of the interest expense of members of 
an affiliated group, interest expense shall be considered to be 
allocable to all gross income of the members of the group under Sec.  
1.861-11T. That section requires the members of an affiliated group to 
allocate and apportion the interest expense of each member of the group 
as if all members of such group were a single corporation. For the 
method of determining the interest deduction allowed to foreign 
corporations under section 882(c), see Sec.  1.882-5.
    (b) Interest equivalents--(1) Certain expenses and losses--(i) 
General rule. For further guidance, see Sec.  1.861-9(b)(1)(i).
    (ii) Examples. The rule of this paragraph (b)(1) may be illustrated 
by the following examples.

    Example 1. W, a domestic corporation, borrows from X two ounces of 
gold at a time when the spot price for gold is $500 per ounce. W agrees 
to return the two ounces of gold in six months. W sells the two ounces 
of gold to Y for $1000. W then enters into a contract with Z to purchase 
two ounces of gold six months in the future for $1,050. In exchange for 
the use of $1,000 in cash, W has sustained a loss of $50 on related 
transactions. This loss is subject to allocation and apportionment under 
the rules of this section in the same manner as interest expense.
    Example 2. X, a domestic corporation with a dollar functional 
currency, borrows 100 pounds on January 1, 1987 for a three-year term at 
an interest rate greater than the applicable federal rate for dollar 
loans. At this time, the interest rate on the pound was approximately 
equal to the interest rate on dollar borrowings and the forward price on 
the pound, vis-a-vis the dollar, was approximately equal to the spot 
price. On January 1, 1987, X converted 100 pounds into dollars and 
entered into a currency swap that substantially hedged X's foreign 
currency exposure on the pound borrowing, both with respect to interest 
and principal. The borrowing, coupled with the swap, represents a series 
of related transactions in which the taxpayer secures the use of funds 
in its functional currency. Any net foreign currency loss on this series 
of transactions constitutes a loss incurred substantially in 
consideration of the time value of money and shall be apportioned in the 
same manner as interest expense. Thus, if the pound depreciates against 
the dollar, such that when the first payment on the pound borrowing is 
due the taxpayer has a currency loss on the swap payment hedging its 
first interest payment, such loss shall, even if the transaction is not 
integrated under section 988(d), be allocated and apportioned in the 
same manner as interest expense under the authority of this paragraph 
(b)(1).
    Example 3. On January 1, 1987, X, a domestic corporation with a 
dollar functional currency, enters into a dollar interest rate swap 
contract with Y, a domestic counterparty. Under the terms of this 
agreement, X agrees to pay Y floating rate interest with respect to a 
notional principal amount of $100 for five years. In return, Y agrees to 
pay X fixed rate interest at 10 percent with respect to a notional 
principal amount of $100 for five years. On the same day, Y prepays the 
fixed leg of the swap by making a lump sum payment of $37 to X. This 
lump sum payment represents the present value of five $10 swap payments. 
Because X secures the use of $37 in this transaction, any net swap 
expense arising from the transaction represents an expense incurred 
substantially in consideration of the time value of money. Assuming this 
lump sum payment is not otherwise characterized as a loan from Y to X, 
and that X must amortize the $37 lump sum payment under the principles 
of Notice 89-21, any net swap expense incurred by X with respect to this 
transaction (i.e., the excess, if any, of X's annual swap payment to Y 
over the annual amortization of the $37 lump sum payment that is taken 
into income by X) represents an expense equivalent to interest expense. 
The result would be the same if X sold

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the fixed leg to a third party for $37. While this example presents the 
case of a lump sum payment, the rules of paragraph (b)(1) would also 
apply to any transaction in which the swap payments are not 
substantially contemporaneous if the pricing of the transaction is 
materially affected by the time value of money. Thus, expenses and 
losses will be subject to apportionment under the rules of this section 
to the extent that such expenses or losses were incurred in 
consideration of the time value of money.

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

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

    (3) Losses on sale of certain receivables--(1) General rule. Any 
loss on the sale of a trade receivable (as defined in Sec.  1.954-2(h)) 
shall be allocated and apportioned, solely for purposes of this section 
and Sec. Sec.  1.861-10T, 1.861-11T, 1.861-12T, and 1.861-13T, in the 
same manner as interest expense, unless at the time of sale of the 
receivable, it bears interest at a rate which is at least 120 percent of 
the short term applicable federal rate (as determined under section 
1274(d) of the Code), or its equivalent in foreign currency in the case 
of receivables denominated in foreign currency, determined at the time 
the receivable arises. This treatment shall not affect the 
characterization of such expense as interest for other purposes of the 
Internal Revenue Code.
    (ii)(A) Exceptions. To the extent that a loss on the sale of a trade 
receivable exceeds the discount on the receivable that would be computed 
applying to the amount received on the sale of the receivable 120 
percent of the applicable federal rate (or its equivalent in foreign 
currency in the case of receivables denominated in foreign currency) for 
the period commencing with the date on which the receivable is sold and 
ending with the earlier of the date on which the receivable begins to 
bear interest at such rate or the anticipated payment date of the 
receivable, such

[[Page 203]]

excess shall not be allocated and apportioned in the same manner as 
interest expense but rather shall be allocated and apportioned to the 
gross income generated by the receivable. In cases of transfers of 
receivables to a domestic international sales corporation described 
Sec.  1.994-1(c)(6)(v), the rule of this paragraph (b)(3) shall not 
apply for purposes of computing combined taxable income.
    (B) Example. On October 1, X sells a widget to Y for $100 payable in 
30 days, after which the receivable will bear stated interest at 13 
percent. On October 4, X sells Y's obligation to Z for $98. Assume that 
the applicable federal rate for the month of October is 10 percent. 
Applying 120 percent of the applicable federal rate to the $98 received 
on the sale of the receivable, the obligation is discounted at a 12 
percent rate for a period of 27 days. At this discount rate, the 
obligation would have sold for $99.22. Thus, 88 cents of the $2 loss on 
the sale is apportioned in the same manner as interest expense, and 
$1.22 of the $2 loss on the sale is directly allocated to the income 
generated on the widget sale.
    (4) Rent in certain leasing transactions. [Reserved]
    (5) Treatment of bond premium--(i) Treatment by the issuer. If a 
bond or other debt obligation is issued at a premium, an amount of 
interest expense incurred by the issuer on that bond or other debt 
obligation equal to the amortized portion of that premium that is 
included in gross income for the year shall be allocated and apportioned 
solely to the amortized portion of premium derived by the issuer for the 
year.
    (ii) Treatment by the holder. If a bond or debt obligation is 
purchased at a premium, the portion of that premium amortized during the 
year by the holder under section 171 and the regulations thereunder 
shall be allocated and apportioned solely to interest income derived 
from the bond by the holder for the year.
    (6) Financial products that alter effective cost of borrowing--(i) 
In general. Various derivative financial products can be part of 
transactions or series of transactions described in paragraph (b)(1) of 
this section. Such derivative financial products, including interest 
rate swaps, options, forwards, caps, and collars, potentially alter a 
taxpayer's effective cost of borrowing with respect to an actual 
liability of the taxpayer. For example, a taxpayer that is obligated to 
pay interest at a fixed rate may, in effect, pay interest at a floating 
rate by entering into an interest rate swap. Similarly, a taxpayer that 
is obligated to pay interest at a floating rate may, in effect, limit 
its exposure to rising interest rates by purchasing a cap. Such a 
taxpayer may have gains or losses associated with such derivative 
financial products. This paragraph (b)(6) provides rules for the 
treatment of gains and losses from such derivative financial products 
(``financial products'') that are part of transactions described in 
paragraph (b)(1) of this section and that are used by the taxpayer to 
alter its effective cost of borrowing with respect to an actual 
liability. This paragraph (b)(6) shall only apply where the hedge and 
the borrowing are in the same currency and shall not apply to the extent 
otherwise provided in section 988 and the regulations thereunder. The 
allocation and apportionment of a loss under this paragraph (b) shall 
not affect the characterization of such loss as capital or ordinary for 
other purposes of the Code and the regulations thereunder.
    (ii) Definition of gain and loss. For purposes of this paragraph 
(b)(6), the term ``gain'' refers to the excess of the amounts properly 
taken into income under a financial product that alters the effective 
cost of borrowing over the amounts properly allowed as a deduction 
thereunder within a given taxable year. See. e.g., Notice 89-21. The 
term ``loss'' refers to the excess of the amounts properly allowed as a 
deduction under such a financial product over the amounts properly taken 
into income thereunder within a given taxable year.
    (iii) Treatment of gain or loss on the disposition of a financial 
product. [Reserved]
    (iv) Entities that are not financial services entities. An entity 
that does not constitute a financial services entity within the meaning 
of Sec.  1.904-4(e)(3) shall treat gains and losses on financial 
products described in paragraph (b)(6)(i) of this section as follows.

[[Page 204]]

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

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

    (7) Foreign currency gain or loss. In addition to the rules of 
paragraph (b)(1), (b)(2), and (b)(6) of this section, any foreign 
currency loss that is treated as an adjustment to interest expense under 
regulations issued under section 988 shall be allocated and apportioned 
in the same manner as interest expense. Any foreign currency gain that 
is treated as an adjustment to interest

[[Page 205]]

expense under regulations issued under section 988 shall offset 
apportionable interest expense.
    (8) Guaranteed payments. For further guidance, see Sec.  1.861-
9(b)(8).
    (c) Allowable deductions. In order for an interest expense to be 
allocated and apportioned, it must first be determined that the interest 
expense is currently deductible. A number of provisions in the Code 
disallow or suspend deductions of interest expense or require the 
capitalization thereof.
    (1) Disallowed deductions. A taxpayer does not allocate and 
apportion interest expense under this section that is permanently 
disallowed as a deduction by operation of section 163(h), section 265, 
or any other provision or rule that permanently disallows the deduction 
of interest expense.
    (2) Section 263A. Section 263A requires the capitalization of 
interest expense that is allocable to designated types of property. Any 
interest expense that is capitalized under section 263A does not 
constitute deductible interest expense for purposes of this section. 
Furthermore, interest expense capitalized in inventory or depreciable 
property is not separately allocated and apportioned when the inventory 
is sold or depreciation is allowed. Capitalized interest expense is 
effectively allocated and apportioned as part of, and in the same manner 
as, the cost of goods sold, amortization, or depreciation deduction.
    (3) Section 163(d). Section 163(d) suspends the deduction for 
interest expense to the extent that it exceeds net investment income. In 
the year that suspended investment interest expense becomes allowable 
under the rules of section 163(d), that interest expense is apportioned 
under rules set forth in paragraph (d)(1) of this section as though it 
were incurred in the taxable year in which the expense is deducted.
    (4) Section 469--(i) General rule. Section 469 suspends the 
deduction of passive activity losses to the extent that they exceed 
passive activity income for the year. Passive activity losses may 
consist in part of interest expense properly allocable to passive 
activity. In the year that suspended interest expense becomes allowable 
as a deduction under the rules of section 469, that interest expense is 
apportioned under rules set forth in paragraph (d)(1) of this section as 
though it were incurred in the taxable year in which the expense is 
deducted.
    (ii) Identification of the interest component of a suspended passive 
loss. A suspended passive loss may consist of a variety of items of 
expense other than interest expense. Suspended interest expense for any 
taxable year is computed by multiplying the total suspended passive loss 
for the year by a fraction, the numerator of which is passive interest 
expense for the year (determined under regulations issued under section 
163) and the denominator of which is total passive expenses for the 
year. The amount of the suspended interest expense that is considered to 
be deductible in a subsequent taxable year is computed by multiplying 
the amount of any cumulative suspended interest expense (reduced by 
suspended interest expense allowed as a deduction in prior taxable 
years) times a fraction, the numerator of which is the portion of 
cumulative suspended passive losses that become deductible in the 
taxable year and the denominator of which is the cumulative suspended 
passive losses for prior taxable years (reduced by suspended passive 
losses allowed as deductions in prior taxable years).
    (iii) Example. The rules of this paragraph (c)(4) may be illustrated 
by the following example.

    Example. On January 1, 1987, A, a United States citizen, invested in 
a passive activity. In 1987, the passive activity generated no passive 
income and $100 in passive losses, all of which were suspended by 
operation of section 469. The suspended loss included $10 of suspended 
interest expense. In 1988, the passive activity generated $50 in passive 
income and $150 in passive expenses which included $30 of interest 
expense. The entire $100 passive loss was suspended in 1988 and included 
$20 of interest expense ($100 suspended passive loss x $30 passive 
interest expense/$150 total passive expenses). Thus, at the end of 1988, 
A had total suspended passive losses of $200, including $30 of suspended 
interest expense. In 1989, the passive activity generated $100 in 
passive income and no passive expenses. Thus, $100 of A's cumulative 
suspended passive loss was therefore allowed in 1989. The $100 of 
deductible passive loss includes $15 of suspended interest expense ($30 
cumulative suspended interest expense x $100

[[Page 206]]

of cumulative suspended passive losses allowable in 1989/$200 of total 
cumulative suspended passive losses). The $15 of interest expense is 
apportioned under the rules of paragraph (d) of this section as though 
it were incurred in 1989.

    (5) Section 163(j). For further guidance, see Sec.  1.861-9(c)(5).
    (d) Apportionment rules for individuals, estates, and certain 
trusts--(1) United States individuals. In the case of taxable years 
beginning after December 31, 1986, individuals generally shall apportion 
interest expense under different rules according to the type of interest 
expense incurred. The interest expense of individuals shall be 
characterized under the regulations issued under section 163. However, 
in the case of an individual whose foreign source income (including 
income that is excluded under section 911) does not exceed a gross 
amount of $5,000, the apportionment of interest expense under this 
section is not required. Such an individual's interest expense may be 
allocated entirely to domestic source income.
    (i) Interest incurred in the conduct of a trade or business. An 
individual who incurs business interest described in section 
163(h)(2)(A) shall apportion such interest expense using an asset method 
by reference to the individual's business assets.
    (ii) Investment interest. An individual who incurs investment 
interest described in section 163(h)(2)(B) shall apportion that interest 
expense on the basis of the individual's investment assets.
    (iii) Interest incurred in a passive activity. An individual who 
incurs passive activity interest described in section 163(h)(2)(C) shall 
apportion that interest expense on the basis of the individual's passive 
activity assets. Individuals who receive a distributive share of 
interest expense incurred in a partnership are subject to special rules 
set forth in paragraph (e) of this section.
    (iv) Qualified residence and deductible personal interest. 
Individuals who incur qualified residence interest described in section 
163(h)(2)(D) shall apportion that interest expense under a gross income 
method, taking into account all income (including business, passive 
activity, and investment income) but excluding income that is exempt 
under section 911. For purposes of this section, any qualified residence 
that is rented shall be considered to be a business asset for the period 
in which it is rented, with the result that the interest on such a 
residence is not apportioned under this subdivision (iv) but instead 
under subdivisions (i) or (iii) of this paragraph (d)(1). To the extent 
that personal interest described in section 163(h)(2) remains deductible 
under transitional rules, individuals shall apportion such interest 
expense in the same manner as qualified residence interest.
    (v) Example. The following example illustrates the principles of 
this section.

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

[[Page 207]]

such interest must be apportioned on the basis of investment assets. 
Applying the asset method, A's investment assets consist of stock 
generating domestic source income with an adjusted basis of $40,000 and 
stock generating foreign source passive income with an adjusted basis of 
$60,000. Thus, 40 percent ($800) of A's investment interest is 
apportioned to domestic source income and 60 percent ($1,200) of A's 
investment interest is apportioned to foreign source passive income for 
purposes of section 904.
    (iv) Analysis of qualified residence interest. The $10,000 of 
qualified residence interest expense is apportioned under the rules of 
paragraph (d)(1)(iv) of this section on the basis of all of A's gross 
income. A's gross income consists of $60,000, $54,000 of which is 
domestic source and $6,000 of which is foreign source passive income. 
Thus, $9,000 of A's qualified residence interest is apportioned to 
domestic source income and $1,000 of A's qualified residence interest is 
apportioned to foreign source passive income.

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

[[Page 208]]

categories in the same manner as partnership interest expense (that is 
not directly allocable under Sec.  1.861-10T) is apportioned in 
subdivision (i) of this paragraph (e)(4). If the partner uses the tax 
book value method of apportionment, the partner's interest in the 
partnership must be reduced, for this purpose, to the extent that the 
partner's basis consists of liabilities that are taken into account 
under section 752. Under either the tax book value or fair market value 
method of apportionment, for purposes of this section only, the value of 
the partner's interest in the partnership must be reduced by the 
principal amount of any indebtedness of the partner the interest on 
which is directly allocated to its partnership interest under Sec.  
1.861-10T.
    (5) Tiered partnerships. If a partnership is a partner in another 
partnership, the distributive share of interest expense of a lower-tier 
partnership that is subject to the rules of paragraph (e)(4) shall not 
be reapportioned in the hands of any higher-tier partner. However, the 
distributive share of interest expense of lower-tier partnership that is 
subject to the rules of paragraph (e) (2) or (3) shall be apportioned by 
the partner of the higher-tier partnership or by any higher-tier 
partnership to which the rules of paragraph (e)(4) apply, taking into 
account the partner's indirect pro rata share of the lower-tier 
partnership's income or assets.
    (6) Example--(i) Facts. A, B, and C are partners in a limited 
partnership. A is a corporate general partner, owns a 5 percent interest 
in the partnership, and has an adjusted basis in its partnership 
interest, determined without regard to section 752 of the Code, of $5. 
A's investment in the partnership is not held in the ordinary course of 
the taxpayer's active trade or business, as defined in Sec.  1.904-
7(i)(2). B, a corporate limited partner, owns a 70 percent interest in 
the partnership, and has an adjusted basis in its partnership interest, 
determined without regard to section 752 of the Code, of $70. C is an 
individual limited partner, owns a 25 percent interest in the 
partnership, and has an adjusted basis in the partnership interest, 
determined without regard to section 752 of the Code, of $25. The 
partners' interests in the profits and losses of the partnership conform 
to their respective interests. None of the interest expense incurred 
directly by any of the partners is directly allocable to their 
partnership interest under Sec.  1.861-10T. The ABC partnership's sole 
assets are two apartment buildings, one domestic and the other foreign. 
The domestic building has an adjusted inside basis of $600 and the 
foreign building has an adjusted inside basis of $500. Each of the 
buildings is subject to a nonrecourse liability in the amount of $500. 
The ABC partnership's total interest expense for the taxable year is 
$120, both nonrecourse liabilities bearing interest at the rate of 12 
percent. The indebtedness on the domestic building qualifies for direct 
allocation under the rules of Sec.  1.861-10T. The indebtedness on the 
foreign building does not so qualify. The partnership incurred no 
foreign taxes. The partnership's gross income for the taxable year is 
$360, consisting of $100 in foreign source income and $260 in domestic 
source income. Under Sec.  1.752-1(e), the nonrecourse liabilities of 
the partnership are allocated among the partners according to their 
share of the partnership profits. Accordingly, the adjusted basis of A, 
B, and C in their respective partnership interests (for other than 
apportionment purposes) is, respectively, $55, $770, and $275.
    (ii) Determination of the amount of partnership interest expense 
that is subject to allocation and apportionment. Interest on the 
nonrecourse loan on the domestic building is, under Sec.  1.861-10T, 
directly allocable to income from that investment. The interest expense 
is therefore directly allocable to domestic income. Interest on the 
nonrecourse loan on the foreign building is not directly allocable. The 
interest expense is therefore subject to allocation and apportionment. 
Thus, $60 of interest expense is directly allocable to domestic income 
and $60 of interest expense is subject to allocation and apportionment.
    (iii) Analysis for Partner A. A's distributive share of the 
partnership's gross income is $18, which consists of $5 in foreign 
source income and $13 in domestic source income. A's distributive share 
of the ABC interest expense is $6,

[[Page 209]]

$3 of which is directly allocable to domestic income and $3 of which is 
subject to apportionment. After direct allocation of qualifying interest 
expense, A's distributive share of the partnership's gross income 
consists of $5 in foreign source income and $10 in domestic source 
income. Because A is a less than 10 percent corporate partner, A's 
distributive share of any foreign source partnership income is 
considered to be passive income. Accordingly, in apportioning the $3 of 
partnership interest expense that is subject to apportionment on a gross 
income method, one-third ($1) is apportioned to foreign source passive 
income and two-thirds ($2) is apportioned to domestic source income. In 
apportioning its other interest expense, A uses the tax book value 
method. A's adjusted basis in A's partnership interest ($55) includes 
A's share of the partnership's liabilities ($50), which are included in 
basis under section 752. For purposes of apportioning other interest 
expense, A's adjusted basis in the partnership must be reduced to the 
extent of such liabilities. Thus, A's adjusted basis in the partnership, 
for purposes of apportionment, is $5. For the purpose of apportioning 
A's other interest expense, this $5 in basis is characterized one-third 
as a foreign passive asset and two-thirds as a domestic asset, which is 
the ratio determined in paragraph (e)(4)(i).
    (iv) Analysis for Partner B. B's distributive share of the ABC 
interest expense is $84, $42 of which is directly allocable to domestic 
income and $42 of which is subject to apportionment. As a corporate 
limited partner whose interest in the partnership is 10 percent or more, 
B is subject to the rules of paragraph (e)(2) and paragraph (f) of this 
section. These rules require that a corporate partner apportion its 
distributive share of partnership interest expense at the partner level 
on the asset method described in paragraph (g) of this section by 
reference to its corporate assets, which include, for this purpose, 70 
percent of the partnership's assets, adjusted in the manner described in 
Sec.  1.861-10T(e) to reflect directly allocable interest expense.
    (v) Analysis for Partner C. C's distributive share of the ABC 
interest expense is $30, $15 of which is directly allocable to domestic 
income and $15 of which is subject to apportionment. As an individual 
limited partner whose interest in the partnership is 10 percent or more, 
C is subject to the rules of paragraph (e)(3) of this section. These 
rules require that an individual's share of partnership interest expense 
be classified under regulations issued under section 163(h) and then 
apportioned under the rules applicable to individuals, which are set 
forth in paragraph (d) of this section.
    (7) Foreign partners. The distributive share of partnership interest 
expense of a nonresident alien who is a partner in a partnership shall 
be considered to be connected with effectively connected income based on 
the percentage of the assets of the partnership that generate 
effectively connected income. No interest expense directly incurred by 
the partner may be allocated and apportioned to effectively connected 
income derived by the partnership.
    (8) Special rule for downstream partnership loans. For further 
guidance, see Sec.  1.861-9(e)(8) through (10).
    (9)-(10) [Reserved]
    (f) Corporations--(1) Domestic corporations. Domestic corporations 
shall apportion interest expense using the asset method described in 
paragraph (g) of this section and the applicable rules of Sec. Sec.  
1.861-10T through 1.861-13T.
    (2) Section 987 QBUs of domestic corporations. For further guidance, 
see Sec.  1.861-9(f)(2) through (f)(3)(i).
    (3)(i) [Reserved]
    (ii) Manner of election. The election to use the asset method 
described in paragraph (g) of this section or the modified gross income 
method described in paragraph (j) of this section may be made either by 
the controlled foreign corporation or by the controlling United States 
shareholders on behalf of the controlled foreign corporation. The term 
``controlling United States shareholders'' means those United States 
shareholders (as defined in section 951(b)) who, in aggregate, own 
(within the meaning of section 958(a)) greater than 50 percent of the 
total combined voting power of all classes of stock of the foreign 
corporation entitled to vote. In the case of a controlled foreign 
corporation in which the United States

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shareholders own stock representing more than 50 percent of the value of 
the stock in such corporation, but less than 50 percent of the combined 
voting power of all classes of stock in such corporation, the term 
``controlling United States shareholders'' means all the United States 
shareholders (as defined in section 951(b)) who own (within the meaning 
of section 958(a)) stock of the controlled foreign corporation. All 
United States shareholders are bound by the election of either the 
controlled foreign corporation or the controlling United States 
shareholders. For guidance relating to the time and manner of this 
election, see Sec.  1.861-9(f)(3)(ii).
    (iii) Consistency requirement. The same method of apportionment must 
be employed by all controlled foreign corporations in which a United 
States taxpayer and the members of its affiliated group (as defined in 
Sec.  1.861-11T(d)) constitute controlling United States shareholders. A 
controlled foreign corporation that is required by this paragraph 
(f)(3)(iii) to utilize a particular method of apportionment must do so 
with respect to all United States shareholders.
    (iv) Stock characterization. Pursuant to Sec.  1.861-12T(c)(2), the 
stock of a controlled foreign corporation shall be characterized in the 
hands of any United States shareholder using the same method that the 
controlled foreign corporation uses to apportion its interest expense.
    (4) Noncontrolled 10-percent owned foreign corporations. For further 
guidance, see Sec.  1.861-9(f)(4).
    (5) Other relevant provisions. Affiliated groups of corporations are 
subject to special rules set forth in Sec.  1.861-11T. Section 1.861-12T 
sets forth rules relating to basis adjustments for stock in 
nonaffiliated 10 percent owned corporations, special rules relating to 
the consideration and characterization of certain assets in the 
apportionment of interest expense, and to other special rules pertaining 
to the apportionment of interest expense. Section 1.861-13T contains 
transition rules limiting the application of the rules of Sec. Sec.  
1.861-8T through 1.861-12T, which are otherwise applicable to taxable 
years beginning after 1986. In the case of an affiliated group of 
corporations as defined in Sec.  1.861-11T(d), any reference in 
Sec. Sec.  1.861-8T through 1.861-13T to the ``taxpayer'' with respect 
to the allocation and apportionment of interest expense generally 
denotes the entire affiliated group of corporations and not the separate 
members thereof, unless the context otherwise requires.
    (g) Asset method--(1) In general. (i) Under the asset method, the 
taxpayer apportions interest expense to the various statutory groupings 
based on the average total value of assets within each such grouping for 
the taxable year, as determined under the asset valuation rules of this 
paragraph (g)(1) and paragraph (g)(2) of this section and the asset 
characterization rules of paragraph (g)(3) of this section and Sec.  
1.861-12T. Except to the extent otherwise provided (see, e.g., paragraph 
(d)(1)(iv) of this section), taxpayers must apportion interest expense 
only on the basis of asset values and may not apportion any interest 
deduction on the basis of gross income.
    (ii) For further guidance, see Sec.  1.861-9(g)(1)(ii) through 
(g)(2)(i).
    (iii)-(v) [Reserved]
    (2)(i) [Reserved]
    (ii) Special rule for qualified business units of domestic 
corporations with functional currency other than the U.S. dollar--(A) 
Tax book value method. In the case of taxpayers using the tax book value 
method of apportionment, the following rules shall apply to determine 
the value of the assets of a qualified business unit (as defined in 
section 989(a)) of a domestic corporation with a functional currency 
other than the dollar.
    (1) Section 987 QBU. In the case of a section 987 QBU (as defined in 
Sec.  1.987-1(b)(2)), the tax book value shall be determined by applying 
the rules of paragraphs (g)(2)(i) and (g)(3) of this section to the 
beginning-of-year and end-of-year functional currency amount of assets. 
The beginning-of-year functional currency amount of assets shall be 
determined by reference to the functional currency amount of assets 
computed under Sec.  1.987-4(d)(1)(i)(B) and (e) on the last day of the 
preceding taxable year. The end-of-year functional currency amount of 
assets shall be determined by reference to the functional currency 
amount of assets computed under

[[Page 211]]

Sec.  1.987-4(d)(1)(i)(A) and (e) on the last day of the current taxable 
year. The beginning-of-year and end-of-year functional currency amount 
of assets, as so determined within each grouping, must then be averaged 
as provided in paragraph (g)(2)(i) of this section.
    (2) U.S. dollar approximate separate transactions method. For 
further guidance, see Sec.  1.861-9(g)(2)(ii)(A)(2).
    (B) Fair market value method. In the case of taxpayers using the 
fair market value method of apportionment, the beginning-of-year and 
end-of-year fair market values of branch assets within each grouping 
shall be computed in dollars and averaged as provided in this paragraph 
(g)(2).
    (iii) Adjustment for directly allocated interest. Prior to 
averaging, the year-end value of any asset to which interest expense is 
directly allocated during the current taxable year under the rules of 
Sec.  1.861-10T (b) or (c) shall be reduced (but not below zero) by the 
percentage of the principal amount of indebtedness outstanding at year-
end equal to the percentage of all interest on the debt for the taxable 
year that is directly allocated.
    (iv) Assets in intercompany transactions. In the application of the 
asset method described in this paragraph (g), the tax book value of 
assets transferred between affiliated corporations in intercompany 
transactions shall be determined without regard to the gain or loss that 
is deferred under the regulations issued under section 1502.
    (v) [Reserved]
    (vi) Effective/applicability date. Generally, paragraph 
(g)(2)(ii)(A)(1) of this section shall apply to taxable years beginning 
on or after one year after the first day of the first taxable year 
following December 7, 2016. If pursuant to Sec.  1.987-11(b) a taxpayer 
applies Sec. Sec.  1.987-1 through 1.987-11 beginning in a taxable year 
prior to the earliest taxable year described in Sec.  1.987-11(a), then 
paragraph (g)(2)(ii)(A)(1) of this section shall apply to taxable years 
beginning on or after the first day of such prior taxable year.
    (3) Characterization of assets. Assets are characterized for 
purposes of this section according to the source and type of the income 
that they generate, have generated, or may reasonably be expected to 
generate. The physical location of assets is not relevant to this 
determination. Subject to the special rules of paragraph (h) concerning 
the application of the fair market value method of apportionment, the 
value of assets within each statutory grouping and the residual grouping 
at the beginning and end of each year shall be determined by dividing 
the taxpayer's assets into three types--
    (i) Single category assets. Assets that generate income that is 
exclusively within a single statutory grouping or the residual grouping;
    (ii) Multiple category assets. Assets that generate income within 
more than one grouping of income (statutory or residual); and
    (iii) Assets without directly identifiable yield. Assets that 
produce no directly identifiable income yield or that contribute equally 
to the generation of all the income of the taxpayer (such as assets used 
in general and administrative functions).


Single category assets are directly attributable to the relevant 
statutory or residual grouping of income. In order to attribute multiple 
category assets to the relevant groupings of income, the income yield of 
each such asset for the taxable year must be analyzed to determine the 
proportion of gross income generated by it within each relevant 
grouping. The value of each asset is then prorated among the relevant 
groupings of income according to their respective proportions of gross 
income. The value of each asset without directly identifiable income 
yield must be identified. However, because prorating the value of such 
assets cannot alter the ratio of assets within the various groupings of 
income (as determined by reference to the single and multiple category 
assets), they are not taken into account in determining that ratio. 
Special asset characterization rules that are set forth in Sec.  1.861-
12T. An example demonstrating the application of the asset method is set 
forth in Sec.  1.861-12T(d).
    (h) Fair market value method. For further guidance, see Sec.  1.861-
9(h).
    (1) Determination of values--(i) Valuation of group assets. The 
taxpayer shall first determine the aggregate value of the assets of the 
taxpayer on the last

[[Page 212]]

day of its taxable year without excluding the value of stock in foreign 
subsidiaries or any other asset. In the case of a publicly traded 
corporation, this determination shall be equal to the aggregate trading 
value of the taxpayer's stock traded on established securities markets 
at year-end increased by the taxpayer's year-end liabilities to 
unrelated persons and its pro rata share of year-end liabilities of all 
related persons owed to unrelated persons. In determining whether 
persons are related, Sec.  1.861-8T(c)(2) shall apply. In the case of a 
corporation that is not publicly traded, this determination shall be 
made by reference to the capitalization of corporate earnings, in 
accordance with the rules of Rev. Rul. 68-609. In either case, control 
premium shall not be taken into account.
    (ii) Valuation of tangible assets. The taxpayer shall determine the 
value of all assets held by the taxpayer and its pro rata share of 
assets held by other related persons on the last day of its taxable 
year, excluding stock or indebtedness in such persons, any intangible 
property as defined in section 936(h)(3)(B), or goodwill or going 
concern value intangibles. Such valuations shall be made using generally 
accepted valuation techniques. For this purpose, assets may be combined 
into reasonable groupings. Statistical methods of valuation may only be 
used in connection with fungible property, such as commodities. The 
value of stock in any corporation that is not a related person shall be 
determined under the rules of paragraph (h)(1)(i) of this section, 
except that no liabilities shall be taken into account.
    (iii) Computation of intangible asset value. The value of the 
intangible assets of the taxpayer and of intangible assets of all 
related persons attributable to the taxpayer's ownership in related 
persons is equal to the amount obtained by subtracting the amount 
determined under paragraph (h)(1)(ii) of this section from the amount 
determined under paragraph (h)(1)(i) of this section.
    (2) Apportionment of intangible asset value. The value of the 
intangible assets determined under paragraph (h)(1)(iii) of this section 
is apportioned among the taxpayer and all related persons in proportion 
to the net income before interest expense of the taxpayer and the 
taxpayer's pro rata share of the net income before interest expense of 
each related person held by the taxpayer, excluding income that is 
passive under Sec.  1.904-4(b). For this purpose, net income is 
determined before reduction for income taxes. Net income of the taxpayer 
and of related persons shall be computed without regard to dividends or 
interest received from any person that is related to the taxpayer.
    (3) Characterization of affiliated group's portion of intangible 
asset value. The portion of the value of intangible assets of the 
taxpayer and related persons that is apportioned to the taxpayer under 
paragraph (h)(2) of this section is characterized on the basis of net 
income before interest expense, as determined under paragraph (h)(2) of 
this section, of the taxpayer within each statutory or residual grouping 
of income.
    (4) [Reserved]. For further guidance see Sec.  1.861-9(h)(4).
    (5) [Reserved]. For further guidance, see Sec.  1.861-9(h)(5).
    (6) Adjustments for apportioning related person expenses. For 
purposes of apportioning expenses of a related person, the value of 
stock in a second related person as otherwise determined under paragraph 
(h)(4) of this section (which is determined on the basis of the 
taxpayer's percentage ownership interest in the second related person) 
shall be increased to reflect the first related person's percentage 
ownership interest in the second related person to the extent it is 
larger.

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

    (i) [Reserved]. For further guidance, see Sec.  1.861-9(i).

[[Page 213]]

    (j) Modified gross income method. Subject to rules set forth in 
paragraph (f)(3) of this section, the interest expense of a controlled 
foreign corporation may be allocated according to the following rules.
    (1) Single-tier controlled foreign corporation. In the case of a 
controlled foreign corporation that does not hold stock in any lower-
tier controlled foreign corporation, the interest expense of the 
controlled foreign corporation shall be apportioned based on its gross 
income.
    (2) Multiple vertically owned controlled foreign corporations. In 
the case of a controlled foreign corporation that holds stock in any 
lower-tier controlled foreign corporation, the interest expense of that 
controlled foreign corporation and such upper-tier controlled foreign 
corporation shall be apportioned based on the following methodology:
    (i) Step 1. Commencing with the lowest-tier controlled foreign 
corporation in the chain, allocate and apportion its interest expense 
based on its gross income as provided in paragraph (j)(1) of this 
section, yielding gross income in each grouping net of interest expense.
    (ii) Step 2. For further guidance, see Sec.  1.861-9(j)(2)(ii).
    (k) Effective/applicability dates. In general, the rules of this 
section apply for taxable years beginning after December 31, 1986. 
Paragraphs (b)(2) (concerning the treatment of certain foreign currency) 
and (d)(2) (concerning the treatment of interest incurred by nonresident 
aliens) of this section are applicable for taxable years commencing 
after December 31, 1988. Taxpayers may also apply paragraph (b)(6) of 
this section to any gain that was realized on any transaction described 
in paragraph (b)(6)(i) of this section that was entered into after 
September 14, 1988, and on or before August 11, 1989, if the taxpayer 
can demonstrate to the satisfaction of the Commissioner that 
substantially all of the arrangements described in paragraph (b)(6)(i) 
of this section to which the taxpayer became a party during that interim 
period were identified on the taxpayer's books and records with the 
liabilities of the taxpayer in a substantially contemporaneous manner 
and that all losses and expenses that are subject to the rules of 
paragraph (b)(6) of this section were treated in the same manner as 
interest expense. For this purpose, arrangements that were identified in 
a substantially contemporaneous manner with the taxpayer's assets shall 
be ignored. For further guidance, see Sec.  1.861-9(k).

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

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



Sec.  1.861-10  Special allocations of interest expense.

    (a) In general. This section applies to all taxpayers and provides 
exceptions to the rules of Sec.  1.861-9 that require the allocation and 
apportionment of interest expense based on all assets of all members of 
the affiliated group. Section 1.861-10T(b) provides rules for the direct 
allocation of interest expense to the income generated by certain assets 
that are subject to qualified nonrecourse indebtedness. Section 1.861-
10T(c) provides rules for the direct allocation of interest expense to 
income generated by certain assets that are acquired in an integrated 
financial transaction. Section 1.861-10T(d) provides special rules that 
apply to all transactions described in Sec.  1.861-10T(b) and (c). 
Paragraph (e) of this section requires the direct allocation of third-
party interest expense of an affiliated group to such group's 
investments in related controlled foreign corporations in cases 
involving excess related person indebtedness (as defined therein). See 
also Sec.  1.861-9T(b)(5), which requires the direct allocation of 
amortizable bond premium. Paragraph (f) of this section provides a 
special rule for certain regulated utility companies. Paragraph (g) of 
this section is reserved. Paragraph (h) of this section sets forth 
applicability dates.
    (b)-(d) [Reserved]
    (e) Treatment of certain related group indebtedness--(1) In general. 
If, for any taxable year beginning after December 31, 1991, a U.S. 
shareholder (as defined in paragraph (e)(5)(i) of this section) has 
both--

[[Page 214]]

    (i) Excess related group indebtedness (as determined under Step One 
in paragraph (e)(2) of this section) and
    (ii) Excess U.S. shareholder indebtedness (as determined under Step 
Two in paragraph (e)(3) of this section), the U.S. shareholder shall 
allocate, to its gross income in the various separate limitation 
categories described in section 904(d)(1), a portion of its interest 
expense paid or accrued to any obligee who is not a member of the 
affiliated group (as defined in Sec.  1.861-11T(d)) of the U.S. 
shareholder (``third party interest expense''), excluding amounts 
allocated under paragraphs (b) and (c) of Sec.  1.861-10T. The amount of 
third party interest expense so allocated shall equal the total amount 
of interest income derived by the U.S. shareholder during the year from 
related group indebtedness, multiplied by the ratio of the lesser of the 
foregoing two amounts of excess indebtedness for the year to related 
group indebtedness for the year. This amount of third party interest 
expense is allocated as described in Step Three in paragraph (e)(4) of 
this section.
    (2) Step One: Excess related group indebtedness. (i) The excess 
related group indebtedness of a U.S. shareholder for the year equals the 
amount by which its related group indebtedness for the year exceeds its 
allowable related group indebtedness for the year.
    (ii) The ``related group indebtedness'' of the U.S. shareholder is 
the average of the aggregate amounts at the beginning and end of the 
year of indebtedness owed to the U.S. shareholder by each controlled 
foreign corporation which is a related person (as defined in paragraph 
(e)(5)(ii) of this section) with respect to the U.S. shareholder.
    (iii) The ``allowable related group indebtedness'' of a U.S. 
shareholder for the year equals--
    (A) The average of the aggregate values at the beginning and end of 
the year of the assets (including stock holdings in and obligations of 
related persons, other than related controlled foreign corporations) of 
each related controlled foreign corporation, multiplied by
    (B) The foreign base period ratio of the U.S. shareholder for the 
year.
    (iv) The ``foreign base period ratio'' of the U.S. shareholder for 
the year is the average of the related group debt-to-asset ratios of the 
U.S. shareholder for each taxable year comprising the foreign base 
period for the current year (each a ``base year''). For this purpose, 
however, the related group debt-to-asset ratio of the U.S. shareholder 
for any base year may not exceed 110 percent of the foreign base period 
ratio for that base year. This limitation shall not apply with respect 
to any of the five taxable years chosen as initial base years by the 
U.S. shareholder under paragraph (e)(2)(v) of this section or with 
respect to any base year for which the related group debt-to-asset ratio 
does not exceed 0.10.
    (v)(A) The foreign base period for any current taxable year (except 
as described in paragraphs (e)(2)(v) (B) and (C) of this section) shall 
consist of the five taxable years immediately preceding the current 
year.
    (B) The U.S. shareholder may choose as foreign base periods for all 
of its first five taxable years for which this paragraph (e) is 
effective the following alternative base periods:
    (1) For the first effective taxable year, the 1982, 1983, 1984, 1985 
and 1986 taxable years;
    (2) For the second effective taxable year, the 1983, 1984, 1985 and 
1986 taxable years and the first effective taxable year;
    (3) For the third effective taxable year, the 1984, 1985 and 1986 
taxable years and the first and second effective taxable years;
    (4) For the fourth effective taxable year, the 1985 and 1986 taxable 
years and the first, second and third effective taxable years; and
    (5) For the fifth effective taxable year, the 1986 taxable year and 
the first, second, third and fourth effective taxable years.
    (C) If, however, the U.S. shareholder does not choose, under 
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to 
one or more taxable years beginning before January 1, 1992, the U.S. 
shareholder may not include within any foreign base period the taxable 
year immediately preceding the first effective taxable year. Thus, for 
example, a U.S. shareholder for which

[[Page 215]]

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

[[Page 216]]

    (1) For the first effective taxable year, the 1982, 1983, 1984, 1985 
and 1986 taxable years;
    (2) For the second effective taxable year, the 1983, 1984, 1985 and 
1986 taxable years and the first effective taxable year;
    (3) For the third effective taxable year, the 1984, 1985 and 1986 
taxable years and the first and second effective taxable years;
    (4) For the fourth effective taxable year, the 1985 and 1986 taxable 
years and the first, second and third effective taxable years; and
    (5) For the fifth effective taxable year, the 1986 taxable year and 
the first, second, third and fourth effective taxable years.
    (C) If, however, the U.S. shareholder does not choose, under 
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to 
one or more taxable years beginning before January 1, 1992, the U.S. 
shareholder may not include within any U.S. base period the taxable year 
immediately preceding the first effective taxable year. Thus, for 
example, a U.S. shareholder for which the first effective taxable year 
is the taxable year beginning on October 1, 1992, may not include the 
taxable year beginning on October 1, 1991, in any U.S. base period. 
Assuming that the U.S. shareholder does not elect the alternative base 
periods described in paragraph (e)(3)(v)(B) of this section, the initial 
U.S. base period for the U.S. shareholder will consist of the taxable 
years beginning on October 1, of 1986, 1987, 1988, 1989, and 1990. The 
U.S. base period for the U.S. shareholder for the following taxable 
year, beginning on October 1, 1993, will consist of the taxable years 
beginning on October 1, 1987, 1988, 1989, 1990, and 1992.
    (D) If the U.S. shareholder chooses the base periods described in 
paragraph (e)(3)(v)(B) of this section as U.S. base periods, it must 
make a similar election under paragraph (e)(2)(v)(B) of this section 
with respect to its foreign base periods.
    (vi) The ``debt-to-asset ratio'' of a U.S. shareholder for a year is 
the ratio between--
    (A) The unaffiliated indebtedness of the U.S. shareholder for the 
year (as determined under paragraph (e)(3)(ii) of this section); and
    (B) The average of the aggregate values at the beginning and end of 
the year of the assets of the U.S. shareholder. For this purpose, the 
assets of the U.S. shareholder include stock holdings in and obligations 
of related controlled foreign corporations but do not include stock 
holdings in and obligations of members of the affiliated group (as 
defined in Sec.  1.861-11T(d)).
    (vii) A U.S. shareholder is considered to have no excess 
indebtedness for the year if its debt-to-asset ratio (as determined 
under paragraph (e)(3)(vi) of this section) for the year does not exceed 
0.10.
    (4) Step Three: Allocation of third party interest expense. (i) A 
U.S. shareholder shall allocate to its gross income in the various 
separate limitation categories described in section 904(d)(1) a portion 
of its third party interest expense incurred during the year equal in 
amount to the interest income derived by the U.S. shareholder during the 
year from allocable related group indebtedness.
    (ii) The ``allocable related group indebtedness'' of a U.S. 
shareholder for any year is an amount of related group indebtedness 
equal to the lesser of--
    (A) The excess related group indebtedness of the U.S. shareholder 
for the year (determined under Step One in paragraph (e)(2) of this 
section); or
    (B) The excess U.S. shareholder indebtedness for the year 
(determined under Step Two in paragraph (e)(3) of this section).
    (iii) The amount of interest income derived by a U.S. shareholder 
from allocable related group indebtedness during the year equals the 
total amount of interest income derived by the U.S. shareholder during 
the year with respect to related group indebtedness, multiplied by the 
ratio of allocable related group indebtedness for the year to the 
aggregate amount of related group indebtedness for the year.
    (iv) The portion of third party interest expense described in 
paragraph (e)(4)(i) of this section shall be allocated in proportion to 
the relative average amounts of related group indebtedness held by the 
U.S. shareholder in each separate limitation category during the year. 
The remaining portion of

[[Page 217]]

third party interest expense of the U.S. shareholder for the year shall 
be apportioned as provided in Sec. Sec.  1.861-8T through 1.861-13T, 
excluding paragraph (e) of Sec.  1.861-10T and this paragraph (e).
    (v) The average amount of related group indebtedness held by the 
U.S. shareholder in each separate limitation category during the year 
equals the average of the aggregate amounts of such indebtedness in each 
separate limitation category at the beginning and end of the year. 
Solely for purposes of this paragraph (e)(4), each debt obligation of a 
related controlled foreign corporation held by the U.S. shareholder at 
the beginning or end of the year is attributed to separate limitation 
categories in the same manner as the stock of the obligor would be 
attributed under the rules of Sec.  1.861-12T(c)(3), whether or not such 
stock is held directly by the U.S. shareholder.
    (vi) The amount of third party interest expense of a U.S. 
shareholder allocated pursuant to this paragraph (e)(4) shall not exceed 
the total amount of the third party interest expense of the U.S. 
shareholder for the year (excluding any third party interest expense 
allocated under paragraphs (b) and (c) of Sec.  1.861-10T).
    (5) Definitions. For purposes of this paragraph (e), the following 
terms shall have the following meanings.
    (i) U.S. shareholder. The term ``U.S. shareholder'' has the same 
meaning as the term ``United States shareholder'' when used in section 
957, except that, in the case of a United States shareholder that is a 
member of an affiliated group (as defined in Sec.  1.861-11T(d)), the 
entire affiliated group is considered to constitute a single U.S. 
shareholder.
    (ii) Related person. For the definition of the term ``related 
person'', see Sec.  1.861-8T(c)(2). A controlled foreign corporation is 
considered ``related'' to a U.S. shareholder if it is a related person 
with respect to the U.S. shareholder.
    (6) Determination of asset values. A U.S. shareholder shall 
determine the values of the assets of each related controlled foreign 
corporation (for purposes of Step One in paragraph (e)(2) of this 
section) and the assets of the U.S. shareholder (for purposes of Step 
Two in paragraph (e)(3) of this section) for any year in accordance with 
the valuation method (tax book value or fair market value) elected for 
that year pursuant to Sec.  1.861-9T(g). However, solely for purposes of 
this paragraph (e), a U.S. shareholder may instead choose to determine 
the values of the assets of all related controlled foreign corporations 
by reference to their values as reflected on Forms 5471 (the annual 
information return with respect to each related controlled foreign 
corporation), subject to the translation rules of paragraph (e)(8)(i) of 
this section. This method of valuation may be used only if the taxable 
years of each of the related controlled foreign corporations begin with, 
or no more than one month earlier than, the taxable year of the U.S. 
shareholder. Once chosen for a taxable year, this method of valuation 
must be used in each subsequent taxable year and may be changed only 
with the consent of the Commissioner.
    (7) Adjustments to asset value. For purposes of apportioning 
remaining interest expense under Sec.  1.861-9T, a U.S. shareholder 
shall reduce (but not below zero) the value of its assets for the year 
(as determined under Sec.  1.861-9T (g) (3) or (h)) by an amount equal 
to the allocable related group indebtedness of the U.S. shareholder for 
the year (as determined under Step Three in paragraph (e)(4)(ii) of this 
section). This reduction is allocated among assets in each separate 
limitation category in proportion to the average amount of related group 
indebtedness held by the U.S. shareholder in each separate limitation 
category during the year (as determined under Step Three in paragraph 
(e)(4)(v) of this section).
    (8) Special rules--(i) Exchange rates. All indebtedness amounts and 
asset values (including current year and base year amounts and values) 
denominated in a foreign currency shall be translated into U.S. dollars 
at the exchange rate for the current year. The exchange rate for the 
current year may be determined under any reasonable method (e.g., 
average of month-end exchange rates for each month in the current year) 
if it is consistently applied to the current year and all base years. 
Once chosen for a taxable year, a method for determining an exchange 
rate must be used in each subsequent taxable year

[[Page 218]]

and will be treated as a method of accounting for purposes of section 
446. A taxpayer may apply a different translation rule only with the 
prior consent of the Commissioner. In this regard, the Commissioner will 
be guided by the extent to which a different rule would reduce the 
comparability of dollar amounts of indebtedness and dollar asset values 
for the base years and the current year.
    (ii) Exempt assets. Solely for purposes of this paragraph (e), any 
exempt assets otherwise excluded under section 864(e)(3) and Sec.  
1.861-8T(d) shall be included as assets of the U.S. shareholder or 
related controlled foreign corporation.
    (iii) Exclusion of certain directly allocated indebtedness and 
assets. Qualified nonrecourse indebtedness (as defined in Sec.  1.861-
10T(b)(2)) and indebtedness incurred in connection with an integrated 
financial transaction (as defined in Sec.  1.861-10T(c)(2)) shall be 
excluded from U.S. shareholder indebtedness and related group 
indebtedness. In addition, assets which are the subject of qualified 
nonrecourse indebtedness or integrated financial transactions shall be 
excluded from the assets of the U.S. shareholder and each related 
controlled foreign corporation.
    (iv) Exclusion of certain receivables. Receivables between related 
controlled foreign corporations (or between members of the affiliated 
group constituting the U.S. shareholder) shall be excluded from the 
assets of the related controlled foreign corporation (or affiliated 
group member) holding such receivables. See also Sec.  1.861-11T(e)(1).
    (v) Classification of loans between controlled foreign corporations. 
In determining the amount of related group indebtedness for any taxable 
year, loans outstanding from one controlled foreign corporation to a 
related controlled foreign corporation are not treated as related group 
indebtedness. For purposes of determining the foreign base period ratio 
under paragraph (e)(2)(iv) of this section for a taxable year that ends 
on or after November 2, 2020, the rules of this paragraph (e)(8)(v) 
apply to determine the related group debt-to-asset ratio in each taxable 
year included in the foreign base period, including in taxable years 
that end before November 2, 2020.
    (vi) Classification of hybrid stock. In determining the amount of 
its related group indebtedness for any taxable year, a U.S. shareholder 
must not treat stock in a related controlled foreign corporation as 
related group indebtedness, regardless of whether the related controlled 
foreign corporation claims a deduction for interest under foreign law 
for distributions on such stock. For purposes of determining the foreign 
base period ratio under paragraph (e)(2)(iv) of this section for a 
taxable year that ends on or after December 4, 2018, the rules of this 
paragraph (e)(8)(vi) apply to determine the related group debt-to-asset 
ratio in each taxable year included in the foreign base period, 
including in taxable years that end before December 4, 2018.
    (9) Corporate events--(i) Initial acquisition of a controlled 
foreign corporation. If the foreign base period of the U.S. shareholder 
for any year includes a base year in which the U.S. shareholder did not 
hold stock in any related controlled foreign corporation, then, in 
computing the foreign base period ratio, the related group debt-to-asset 
ratio of the U.S. shareholder for any such base year shall be deemed to 
be 0.10.
    (ii) Incorporation of U.S. shareholder--(A) Nonapplication. This 
paragraph (e) does not apply to the first taxable year of the U.S. 
shareholder. However, this paragraph (e) does apply to all following 
years, including years in which later members of the affiliated group 
may be incorporated.
    (B) Foreign and U.S. base period ratios. In computing the foreign 
and U.S. base period ratios, the foreign and U.S. base periods of the 
U.S. shareholder shall be considered to be only the period prior to the 
current year that the U.S. shareholder was in existence if this prior 
period is less than five taxable years.
    (iii) Acquisition of additional corporations. (A) If a U.S. 
shareholder acquires (directly or indirectly) stock of a foreign or 
domestic corporation which, by reason of the acquisition, then becomes a 
related controlled foreign corporation or a member of the affiliated 
group, then in determining excess related group indebtedness or excess 
U.S.

[[Page 219]]

shareholder indebtedness, the indebtedness and assets of the acquired 
corporation shall be taken into account only at the end of the 
acquisition year and in following years. Thus, amounts of indebtedness 
and assets and the various debt-to-asset ratios of the U.S. shareholder 
existing at the beginning of the acquisition year or relating to 
preceding years are not recalculated to take account of indebtedness and 
assets of the acquired corporation existing as of dates before the end 
of the year. If, however, a major acquisition is made within the last 
three months of the year and a substantial distortion of values for the 
year would otherwise result, the taxpaper must take into account the 
average values of the acquired indebtedness and assets weighted to 
reflect the time such indebtedness is owed and such assets are held by 
the taxpayer during the year.
    (B) In the case of a reverse acquisition subject to this paragraph 
(e)(9), the rules of Sec.  1.1502-75(d)(3) apply in determining which 
corporations are the acquiring and acquired corporations. For this 
purpose, whether corporations are affiliated is determined under Sec.  
1.861-11T(d).
    (C) If the stock of a U.S. shareholder is acquired by (and, by 
reason of such acquisition, the U.S. shareholder becomes affiliated 
with) a corporation described below, then such U.S. shareholder shall be 
considered to have acquired such corporation for purposes of the 
application of the rules of this paragraph (e). A corporation to which 
this paragraph (e)(9)(iii)(C) applies is--
    (1) A corporation which is not affiliated with any other corporation 
(other than other similarly described corporation); and
    (2) Substantially all of the assets of which consist of cash, 
securities and stock.
    (iv) Election to compute base period ratios by including acquired 
corporations. A U.S. shareholder may choose, solely for purposes of 
paragraph (e)(9) (i) and (iii) of this section, to compute its foreign 
and U.S. base period ratios for the acquisition year and all subsequent 
years by taking into account the indebtedness and asset values of the 
acquired corporation or corporations (including related group 
indebtedness owed to a former U.S. shareholder) at the beginning of the 
acquisition year and in each of the five base years preceding the 
acquisition year. This election, if made for an acquisition, must be 
made for all other acquisitions occurring during the same taxable year 
or initiated in that year and concluded in the following year.
    (v) Dispositions. If a U.S. shareholder disposes of stock of a 
foreign or domestic corporation which, by reason of the disposition, 
then ceases to be a related controlled foreign corporation or a member 
of the affiliated group (unless liquidated or merged into a related 
corporation), in determining excess related group indebtedness or excess 
U.S. shareholder indebtedness, the indebtedness and assets of the 
divested corporation shall be taken into account only at the beginning 
of the disposition year and for the relevant preceding years. Thus, 
amounts of indebtedness and assets and the various debt-to-asset ratios 
of the U.S. shareholder existing at the end of the year or relating to 
following years are not affected by indebtedness and assets of the 
divested corporation existing as of dates after the beginning of the 
year. If, however, a major disposition is made within the first three 
months of the year and a substantial distortion of values for the year 
would otherwise result, the taxpayer must take into account the average 
values of the divested indebtedness and assets weighted to reflect the 
time such indebtedness is owed and such assets are held by the taxpayer 
during the year.
    (vi) Election to compute base period ratios by excluding divested 
corporations. A U.S. shareholder may choose, solely for purposes of 
paragraph (e) (9) (v) and (vii) of this section, to compute its foreign 
and U.S. base period ratios for the disposition year and all subsequent 
years without taking into account the indebtedness and asset values of 
the divested corporation or corporations at the beginning of the 
disposition year and in each of the five base years preceding the 
disposition year. This election, if made for a disposition, must be made 
for all other dispositions occurring during the same taxable year or 
initiated in that year and concluded in the following year.

[[Page 220]]

    (vii) Section 355 transactions. A U.S. corporation which becomes a 
separate U.S. shareholder as a result of a distribution of its stock to 
which section 355 applies shall be considered--
    (A) As disposed of by the U.S. shareholder of the affiliated group 
of which the distributing corporation is a member, with this disposition 
subject to the rules of paragraphs (e) (9) (v) and (vi) of this section; 
and
    (B) As having the same related group debt-to-asset ratio and debt-
to-asset ratio as the distributing U.S. shareholder in each year 
preceding the year of distribution for purposes of applying this 
paragraph (e) to the year of distribution and subsequent years of the 
distributed corporation.
    (10) [Reserved]
    (11) The following example illustrates the provisions of this 
paragraph (e):

    Example. (i) Facts. X, a domestic corporation, elects to apply this 
paragraph (e) to its 1990 tax year. X has a calendar taxable year and 
apportions its interest expense on the basis of the tax book value of 
its assets. In 1990, X incurred deductible third-party interest expense 
of $24,960 on an average amount of indebtedness (determined on the basis 
of beginning-of-year and end-of-year amounts) of $249,600. X 
manufactures widgets, all of which are sold in the United States. X owns 
all of the stock of Y, a controlled foreign corporation that also has a 
calendar taxable year and is also engaged in the manufacture and sale of 
widgets. Y has no earnings and profits or deficit of earnings and 
profits attributable to taxable years prior to 1987. X's total assets 
and their average tax book values (determined on the basis of beginning-
of-year and end-of-year tax book values) for 1990 are:

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

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

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

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

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

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

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

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

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

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

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


[[Page 221]]

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

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

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

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

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

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

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

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

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

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

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

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


[[Page 222]]


    (f) Indebtedness of certain regulated utilities. If an automatically 
excepted regulated utility trade or business (as defined in Sec.  
1.163(j)-1(b)(15)(i)(A)) has qualified nonrecourse indebtedness within 
the meaning of the second sentence in Sec.  1.163(j)-10(d)(2), interest 
expense from the indebtedness is directly allocated to the taxpayer's 
assets in the manner and to the extent provided in Sec.  1.861-10T(b).
    (g) [Reserved]
    (h) Applicability dates. Except as provided in this paragraph (h), 
this section applies to taxable years ending on or after December 4, 
2018. Paragraph (e)(8)(v) of this section applies to taxable years 
ending on or after November 2, 2020, and paragraph (f) of this section 
applies to taxable years beginning on or after December 28, 2021.

[T.D. 8410, 57 FR 13022, Apr. 15, 1992; 57 FR 28012, June 23, 1992, as 
amended by T.D. 9882, 84 FR 69068, Dec. 17, 2019; T.D. 9959, 87 FR 326, 
Jan. 4, 2022]



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

    (a) In general. This section applies to all taxpayers and provides 
three exceptions to the rules of Sec.  1.861-9T that require the 
allocation and apportionment of interest expense on the basis of all 
assets of all members of the affiliated group. Paragraph (b) of this 
section describes the direct allocation of interest expense to the 
income generated by certain assets that are subject to qualified 
nonrecourse indebtedness. Paragraph (c) of this section describes the 
direct allocation of interest expense to income generated by certain 
assets that are acquired in integrated financial transaction. Paragraph 
(d) of this section provides special rules that are applicable to all 
transactions described in paragraphs (b) and (c) of this section. 
Paragraph (e) of this section requires the direct allocation of third 
party interest of an affiliated group to such group's investment in 
related controlled foreign corporations in cases involving excess 
related person indebtedness (as defined therein). See also Sec.  1.861-
9T(b)(5), which requires direct allocation of amortizable bond premium.
    (b) Qualified nonrecourse indebtedness--(1) In general. In the case 
of qualified nonrecourse indebtedness (as defined in paragraph (b)(2) of 
this section), the deduction for interest shall be considered directly 
allocable solely to the gross income which the property acquired, 
constructed, or improved with the proceeds of the indebtedness 
generates, has generated, or could reasonably be expected to generate.
    (2) Qualified nonrecourse indebtedness defined. The term ``qualified 
nonrecourse indebtedness'' means any borrowing that is not excluded by 
paragraph (b)(4) of this section if:
    (i) The borrowing is specifically incurred for the purpose of 
purchasing, constructing, or improving identified property that is 
either depreciable tangible personal property or real property with a 
useful life of more than one year or for the purpose of purchasing 
amortizable intangible personal property with a useful life of more than 
one year;
    (ii) The proceeds are actually applied to purchase, construct, or 
improve the identified property;
    (iii) Except as provided in paragraph (b)(7)(ii) (relating to 
certain third party guarantees in leveraged lease transactions), the 
creditor can look only to the identified property (or any lease or other 
interest therein) as security for payment of the principal and interest 
on the loan and, thus, cannot look to any other property, the borrower, 
or any third party with respect to repayment of principal or interest on 
the loan;
    (iv) The cash flow from the property, as defined in paragraph (b)(3) 
of this section, is reasonably expected to be sufficient in the first 
year of ownership as well as in each subsequent year of ownership to 
fulfill the terms and conditions of the loan agreement with respect to 
the amount and timing of payments of interest and original issue 
discount and periodic payments of principal in each such year; and
    (v) There are restrictions in the loan agreement on the disposal or 
use of the property consistent with the assumptions described in 
subdivisions (iii) and (iv) of this paragraph (b)(2).
    (3) Cash flow defined--(i) In general. The term ``cash flow from the 
property'' as used in paragraph (b)(2)(iv) of this section means a 
stream of revenue

[[Page 223]]

(as computed under paragraph (b)(3)(ii) of this section) substantially 
all of which derives directly from the property. The phrase ``cash flow 
from the property'' does not include revenue if a significant portion 
thereof is derived from activities such as sales, labor, services, or 
the use of other property. Thus, revenue derived from the sale or lease 
of inventory or of similar property does not constitute cash flow from 
the property, including plant or equipment used in the manufacture and 
sale or lease, or purchase and sale or lease, of such inventory or 
similar property. In addition, revenue derived in part from the 
performance of services that are not ancillary and subsidiary to the use 
of property does not constitute cash flow from the property.
    (ii) Self-constructed assets. The activities associated with self-
construction of assets shall be considered to constitute labor or 
services for purposes of paragraph (b)(3)(i) only if the self-
constructed asset--
    (A) Is constructed for the purpose of resale, or
    (B) Without regard to purpose, is sold to an unrelated person within 
one year from the date that the property is placed in service for 
purposes of section 167.
    (iii) Computation of cash flow. Cash flow is computed by subtracting 
cash disbursements excluding debt service from cash receipts.
    (iv) Analysis of operating costs. [Reserved]
    (v) Examples. The principles of this paragraph may be demonstrated 
by the following examples.

    Example 1. In 1987, X borrows $100,000 in order to purchase an 
apartment building, which X then purchases. The loan is secured only by 
the building and the leases thereon. Annual debt service on the loan is 
$12,000. Annual gross rents from the building are $20,000. Annual taxes 
on the building are $2,000. Other expenses deductible under section 162 
are $2,000. Rents are reasonably expected to remain stable or increase 
in subsequent years, and taxes and expenses are reasonably expected to 
remain proportional to gross rents in subsequent years. X provides 
security, maintenance, and utilities to the tenants of the building. 
Based on facts and circumstances, it is determined that, although 
services are provided to tenants, these services are ancillary and 
subsidiary to the occupancy of the apartments. Accordingly, the case 
flow of $16,000 is considered to constitute a return from the property. 
Furthermore, such cash flow is sufficient to fulfill the terms and 
conditions of the loan agreement as required by paragraph (b)(2)(iii).
    Example 2. In 1987, X borrows funds in order to purchase a hotel, 
which X then purchases and operates. The loan is secured only by the 
hotel. Based on facts and circumstances, it is determined that the 
operation of the hotel involves services the value of which is 
significant in relation to amounts paid to occupy the rooms. Thus, a 
significant portion of the cash flow is derived from the performance of 
services incidental to the occupancy of hotel rooms. Accordingly, the 
cash flow from the hotel is considered not to constitute a return on or 
from the property.
    Example 3. In 1987, X borrows funds in order to build a factory, 
which X then builds and operates. The loan is secured only by the 
factory and the equipment therein. Based on the facts and circumstances, 
it is determined that the operation of the factory involves significant 
expenditures for labor and raw materials. Thus, a significant portion of 
the cash flow is derived from labor and the processing of raw materials. 
Accordingly, the cash flow from the factory is considered not to 
constitute a return on or from the property.

    (4) Exclusions. The term ``qualified nonrecourse indebtedness'' 
shall not include any transaction that--
    (i) Lacks economic significance within the meaning of paragraph 
(b)(5) of this section;
    (ii) Involves cross collateralization within the meaning of 
paragraph (b)(6) of this section;
    (iii) Except in the case of a leveraged lease described in paragraph 
(b)(7)(ii) of this section, involves credit enhancement within the 
meaning of paragraph (b)(7) of this section or, with respect to loans 
made on or after October 14, 1988, does not under the terms of the loan 
documents, prohibit the acquisition by the holder of bond insurance or 
similar forms of credit enhancement;
    (iv) Involves the purchase of inventory;
    (v) Involves the purchase of any financial asset, including stock in 
a corporation, an interest in a partnership or a trust, or the debt 
obligation of any obligor (although interest incurred in order to 
purchase certain financial instruments may qualify for direct allocation 
under paragraph (c) of this section);

[[Page 224]]

    (vi) Involves interest expense that constitutes qualified residence 
interest as defined in section 163(h)(3); or
    (vii) [Reserved]
    (5) Economic significance. Indebtedness that otherwise qualifies 
under paragraph (b)(2) shall nonetheless be subject to apportionment 
under Sec.  1.861-9T if, taking into account all the facts and 
circumstances, the transaction (including the security arrangement) 
lacks economic significance.
    (6) Cross collateralization. The term ``cross collateralization'' 
refers to the pledge as security for a loan of--
    (i) Any asset of the borrower other than the identified property 
described in paragraph (b)(2) of this section, or
    (ii) Any asset belonging to any related person, as defined in Sec.  
1.861-8T(c)(2).
    (7) Credit enhancement--(i) In general. Except as provided in 
paragraph (b)(7)(ii) of this section, the term ``credit enhancement'' 
refers to any device, including a contract, letter of credit, or 
guaranty, that expands the creditor's rights, directly or indirectly, 
beyond the identified property purchased, constructed, or improved with 
the funds advanced and, thus effectively provides as security for a loan 
the assets of any person other than the borrower. The acquisition of 
bond insurance or any other contract of suretyship by an initial or 
subsequent holder of an obligation shall constitute credit enhancement.
    (ii) Special rule for leveraged leases. For purposes of this 
paragraph (b), the term ``credit enhancement'' shall not include any 
device under which any person that is not a related person within the 
meaning of Sec.  1.861-8T(c)(2) agrees to guarantee, without recourse to 
the lessor or any person related to the lessor, a lessor's payment of 
principal and interest on indebtedness that was incurred in order to 
purchase or improve an asset that is depreciable tangible personal 
property or depreciable tangible real property (and the land on which 
such real property is situated) that is leased to a lessee that is not a 
related person in a transaction that constitutes a lease for federal 
income tax purposes.
    (iii) Syndication of credit risk and sale of loan participations. 
The term ``syndication of credit risk'' refers to an arrangement in 
which one primary lender secures the promise of a secondary lender to 
bear a portion of the primary lender's credit risk on a loan. The term 
``sale of loan participations'' refers to an arrangement in which one 
primary lender divides a loan into several portions, sells and assigns 
all rights with respect to one or more portions to participating 
secondary lenders, and does not remain at risk in any manner with 
respect to the portion assigned. For purposes of this paragraph (b), the 
syndication of credit risk shall constitute credit enhancement because 
the primary lender can look to secondary lenders for payment of the 
loan, notwithstanding limitations on the amount of the secondary 
lender's liability. Conversely, the sale of loan participations does not 
constitute credit enhancement, because the holder of each portion of the 
loan can look solely to the asset securing the loan and not to the 
credit or other assets of any person.
    (8) Other arrangements that do not constitute cross 
collateralization or credit enhancement. For purposes of paragraphs 
(b)(6) and (7) of this section, the following arrangements do not 
constitute cross collateralization or credit enhancement:
    (i) Integrated projects. A taxpayer's pledge of multiple assets of 
an integrated project, provided that the integrated project. An 
integrated project consists of functionally related and geographically 
contiguous assets that, as to the taxpayer, are used in the same trade 
or business.
    (ii) Insurance. A taxpayer's purchase of third-party casualty and 
liability insurance on the collateral or, by contract, bearing the risk 
of loss associated with destruction of the collateral or with respect to 
the attachment of third party liability claims.
    (iii) After-acquired property. Extension of a creditor's security 
interest to improvements made to the collateral, provided that the 
extension does not constitute excess collateralization under paragraph 
(b)(6), determined by taking into account the value of improvements at 
the time the improvements are made and the value of the

[[Page 225]]

original property at the time the loan was made.
    (iv) Warranties of completion and maintenance. A taxpayer's warranty 
to a creditor that it will complete construction or manufacture of the 
collateral or that it will maintain the collateral in good condition.
    (v) Substitution of collateral. A taxpayer's right to substitute 
collateral under any loan contract. However, after the right is 
exercised, the loan shall no longer constitute qualified nonrecourse 
indebtedness.
    (9) Refinancings. If a taxpayer refinances qualified nonrecourse 
indebtedness (as defined in paragraph (b)(2) of this section) with new 
indebtedness, such new indebtedness shall continue to qualify only if--
    (i) The principal amount of the new indebtedness does not exceed by 
more than five percent the remaining principal amount of the original 
indebtedness,
    (ii) The term of the new indebtedness does not exceed by more than 
six months the remaining term of the original indebtedness, and
    (iii) The requirements of this paragraph (other than those of 
paragraph (b)(2) (i) and (ii) of this section) are satisfied at the time 
of the refinancing, and the exclusions contained in this paragraph 
(b)(4) do not apply.
    (10) Post-construction permanent financing. Financing that is 
obtained after the completion of constructed property will be deemed to 
satisfy the requirements of paragraph (b)(2) (i) and (ii) of this 
section if--
    (i) The financing is obtained within one year after the constructed 
property or substantially all of a constructed integrated project (as 
defined in paragraph (b)(9)(i) of this section) is placed in service for 
purposes of section 167; and
    (ii) The financing does not exceed the cost of construction 
(including construction period interest).
    (11) Assumptions of pre-existing qualified nonrecourse indebtedness. 
If a transferee of property that is subject to qualified nonrecourse 
indebtedness assumes such indebtedness, the indebtedness shall continue 
to constitute qualified nonrecourse indebtedness, provided that the 
assumption in no way alters the qualified status of the debt.
    (12) Excess collateralization. [Reserved]
    (c) Direct allocations in the case of certain integrated financial 
transactions--(1) General rule. Interest expense incurred on funds 
borrowed in connection with an integrated financial transaction (as 
defined in paragraph (c)(2) of this section) shall be directly allocated 
to the income generated by the investment funded with the borrowed 
amounts.
    (2) Definition. The term ``integrated financial transaction'' refers 
to any transaction in which--
    (i) The taxpayer--
    (A) Incurs indebtedness for the purpose of making an identified term 
investment,
    (B) Identifies the indebtedness as incurred for such purpose at the 
time the indebtedness is incurred, and
    (C) Makes the identified term investment within ten business days 
after incurring the indebtedness;
    (ii) The return on the investment is reasonably expected to be 
sufficient throughout the term of the investment to fulfill the terms 
and conditions of the loan agreement with respect to the amount and 
timing of payments of principal and interest or original issue discount;
    (iii) The income constitutes interest or original issue discount or 
would constitute income equivalent to interest if earned by a controlled 
foreign corporation (as described in Sec.  1.954-2T(h));
    (iv) The debt incurred and the investment mature within ten business 
days of each other;
    (v) The investment does not relate in any way to the operation of, 
and is not made in the normal course of, the trade or business of the 
taxpayer or any related person, including the financing of the sale of 
goods or the performance of services by the taxpayer or any related 
person, or the compensation of the taxpayer's employees (including any 
contribution or loan to an employee stock ownership plan (as defined in 
section 4975(e)(7)) or other plan that is qualified under section 
401(a)); and
    (vi) The borrower does not constitute a financial services entity 
(as defined in section 904 and the regulations thereunder).

[[Page 226]]

    (3) Rollovers. In the event that a taxpayer sells of otherwise 
liquidates an investment described in paragraph (c)(2) of this section, 
the interest expense incurred on the borrowing shall, subsequent to that 
liquidation, no longer qualify for direct allocation under this 
paragraph (c).
    (4) Examples. The principles of this paragraph (c) may be 
demonstrated by the following examples.

    Example 1. X is a manufacturer and does not constitute a financial 
services entity as defined in the regulations under section 904. On 
January 1, 1988, X borrows $100 for 6 months at an annual interest rate 
of 10 percent. X identifies on its books and records by the close of 
that day that the indebtedness is being incurred for the purpose of 
making an investment that is intended to qualify as an integrated 
financial transaction. On January 5, 1988, X uses the proceeds to 
purchase a portfolio of stock that approximates the composition of the 
Standard & Poor's 500 Index. On that day, X also enters into a forward 
sale contract that requires X to sell the stock on June 1, 1988 for 
$110. X identifies on its books and records by the close of January 5, 
1988, that the portfolio stock purchases and the forward sale contract 
constitute part of the integrated financial transaction with respect to 
which the identified borrowing was incurred. Under Sec.  1.954-2T(h), 
the income derived from the transaction would constitute income 
equivalent to interest. Assuming that the return on the investment to be 
derived on June 1, 1988, will be sufficient to pay the interest due on 
June 1, 1988, the interest on the borrowing is directly allocated to the 
gain from the investment.
    Example 2. X does not constitute a financial services entity as 
defined in the regulations under section 904. X is in the business of, 
among other things, issuing credit cards to consumers and purchasing 
from merchants who accept the X card the receivables of consumers who 
make purchases with the X card. X borrows from Y in order to purchase X 
credit card receivables from Z, a merchant. Assuming that the Y 
borrowing satisfies the other requirements of paragraph (c)(2) of this 
section, the transaction nonetheless cannot constitute an integrated 
financial transaction because the purchase relates to the operation of 
X's trade or business.
    Example 3. Assume the same facts as in Example 2, except that X 
borrows in order to purchase the receivables of A, a merchant who does 
not accept the X card and is not otherwise engaged directly or 
indirectly in any business transaction with X. Because the borrowing is 
not related to the operation of X's trade or business, the borrowing may 
qualify as an integrated financial transaction if the other requirements 
of paragraph (c)(2) of this section are satisfied.

    (d) Special rules. In applying paragraphs (b) and (c) of this 
section, the following special rules shall apply.
    (1) Related person transactions. The rules of this section shall not 
apply to the extent that any transaction--
    (i) Involves either indebtedness between related persons (as defined 
in section Sec.  1.861-8T(c)(2)) or indebtedness incurred from unrelated 
persons for the purpose of purchasing property from a related person; or
    (ii) Involves the purchase of property that is leased to a related 
person (as defined in Sec.  1.861-8T(c)(2)) in a transaction described 
in paragraph (b) of this section. If a taxpayer purchases property and 
leases such property in whole or in part to a related person, a portion 
of the interest incurred in connection with such an acquisition, based 
on the ratio that the value of the property leased to the related person 
bears to the total value of the property, shall not qualify for direct 
allocation under this section.
    (2) Consideration of assets or income to which interest is directly 
allocated in apportioning other interest expense. In apportioning 
interest expense under Sec.  1.861-9T, the year-end value of any asset 
to which interest expense is directly allocated under this section 
during the current taxable year shall be reduced to the extent provided 
in Sec.  1.861-9T(g)(2)(iii) to reflect the portion of the principal 
amount of the indebtedness outstanding at year-end relating to the 
interest which is directly allocated. A similar adjustment shall be made 
to the end-of-year value of assets for the prior year for purposes of 
determining the beginning-of-year value of assets for the current year. 
These adjustments shall be made prior to averaging beginning-of-year and 
end-of-year values pursuant to Sec.  1.861-9T(g)(2). In apportioning 
interest expense under the modified gross income method, gross income 
shall be reduced by the amount of income to which interest expense is 
directly allocated under this section.
    (e) Treatment of certain related group indebtedness. For further 
guidance, see Sec.  1.861-10(e).

[[Page 227]]

    (f) Effective/applicability date. (1) In general, the rules of this 
section apply for taxable years beginning after December 31, 1986.
    (2) Paragraphs (b)(3)(ii) (providing an operating costs test for 
purposes of the nonrecourse indebtedness exception) and (b)(6) 
(concerning excess collaterization of nonrecourse borrowings) of this 
section are applicable for taxable years commencing after December 31, 
1988.
    (3) Paragraph (e) (concerning the treatment of related controlled 
foreign corporation indebtedness) of this section is applicable for 
taxable years commencing after December 31, 1987. For rules for taxable 
years beginning before January 1, 1987, and for later years to the 
extent permitted by Sec.  1.861-13T, see Sec.  1.861-8 (revised as of 
April 1, 1986).

[T.D. 8228, 53 FR 35485, Sept. 14, 1988, as amended by T.D. 9456, 74 FR 
38875, Aug. 4, 2009; T.D. 9882, 84 FR 69068, Dec. 17, 2019]



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

    (a) In general. For further guidance, see Sec.  1.861-11T(a).
    (b) Scope of application--(1) Application of section 864(e)(1) and 
(5) (concerning the definition and treatment of affiliated groups). 
Section 864(e)(1) and (5) and the portions of this section implementing 
section 864(e)(1) and (5) apply to the computation of foreign source 
taxable income for purposes of section 904 (relating to various 
limitations on the foreign tax credit). Section 864(e)(1) and (5) and 
the portions of this section implementing section 864(e)(1) and (5) also 
apply in connection with section 907 to determine reductions in the 
amount allowed as a foreign tax credit under section 901. Section 
864(e)(1) and (5) and the portions of this section implementing section 
864(e)(1) and (5) also apply to the computation of the combined taxable 
income of the related supplier and a foreign sales corporation (FSC) 
(under sections 921 through 927) as well as the combined taxable income 
of the related supplier and a domestic international sales corporation 
(DISC) (under sections 991 through 997).
    (2) Nonapplication of section 864(e)(1) and (5) (concerning the 
definition and treatment of affiliated groups). For further guidance, 
see Sec.  1.861-11T(b)(2).
    (c) General rule for affiliated corporations. For further guidance, 
see Sec.  1.861-11T(c).
    (d) Definition of affiliated group--(1) General rule. For purposes 
of this section, in general, the term affiliated group has the same 
meaning as is given that term by section 1504. Section 1504(a) defines 
an affiliated group as one or more chains of includible corporations 
connected through 80-percent stock ownership with a common parent 
corporation which is an includible corporation (as defined in section 
1504(b)). In the case of a corporation that either becomes or ceases to 
be a member of the group during the course of the corporation's taxable 
year, only the interest expense incurred by the group member during the 
period of membership shall be allocated and apportioned as if all 
members of the group were a single corporation. In this regard, assets 
held during the period of membership shall be taken into account. Other 
interest expense incurred by the group member during its taxable year 
but not during the period of membership shall be allocated and 
apportioned without regard to the other members of the group.
    (2) [Reserved]
    (d)(3)-(6)(i) [Reserved]. For further guidance see Sec.  1.861-
11T(d)(3) through (6)(i).
    (ii) Any foreign corporation if more than 50 percent of the gross 
income of such foreign corporation for the taxable year is effectively 
connected with the conduct of a trade or business within the United 
States and at least 80 percent of either the vote or value of all 
outstanding stock of such foreign corporation is owned directly or 
indirectly by members of the affiliated group (determined with regard to 
this sentence). This paragraph (d)(6)(ii) applies to taxable years 
beginning on or after July 16, 2014. See 26 CFR 1.861-11T(d)(6)(ii) 
(revised as of April 1, 2014) for rules applicable to taxable years 
beginning after August 10, 2010, and before July 16, 2014. See 26 CFR 
1.861-11T(d)(6)(ii) (revised as of April 1, 2010)

[[Page 228]]

for rules applicable to taxable years beginning on or before August 10, 
2010.
    (7) Special rules for the application of Sec.  1.861-11T(d)(6). The 
attribution rules of section 1563(e) and the regulations under that 
section shall apply in determining indirect ownership under Sec.  1.861-
11T(d)(6). The Commissioner shall have the authority to disregard 
trusts, partnerships, and pass-through entities that break affiliated 
status. Corporations described in Sec.  1.861-11T(d)(6) shall be 
considered to constitute members of an affiliated group that does not 
file a consolidated return and shall therefore be subject to the 
limitations imposed under Sec.  1.861-11T(g). The affiliated group 
filing a consolidated return shall be considered to constitute a single 
corporation for purposes of applying the rules of Sec.  1.861-11T(g). 
For taxable years beginning after December 31, 1989, Sec.  1.861-
11T(d)(6)(i) shall not apply in determining foreign source alternative 
minimum taxable income within each separate category and the alternative 
minimum tax foreign tax credit pursuant to section 59(a) to the extent 
that such application would result in the inclusion of a section 936 
corporation within the affiliated group. This paragraph (d)(7) applies 
to taxable years beginning after December 31, 1986.
    (e)-(g) [Reserved]. For further guidance, see Sec.  1.861-11T(e) 
through (g).
    (h) Applicability dates. This section applies to taxable years that 
both begin after December 31, 2017, and end on or after December 4, 
2018.

[T.D. 8916, 66 FR 273, Jan. 3, 2001, as amended by T.D. 9676, 79 FR 
41426, July 16, 2014; T.D. 9882, 84 FR 69068, Dec. 17, 2019]



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

    (a) In general. Sections 1.861-9T, 1.861-10T, 1.861-12T, and 1.861-
13T provide rules that are generally applicable in apportioning interest 
expense. The rules of this section relate to affiliated groups of 
corporations and implement section 864(e) (1) and (5), which requires 
affiliated group allocation and apportionment of interest expense. The 
rules of this section apply to taxable years beginning after December 
31, 1986, except as otherwise provided in Sec.  1.861-13T. Paragraph (b) 
of this section describes the scope of the application of the rule for 
the allocation and apportionment of interest expense of affiliated 
groups of corporations, which is contained in paragraph (c) of this 
section. Paragraph (d) of this section sets forth the definition of the 
term ``affiliated group'' for purposes of this section. Paragraph (e) 
describes the treatment of loans between members of an affiliated group. 
Paragraph (f) of this section provides rules concerning the affiliated 
group allocation and apportionment of interest expense in computing the 
combined taxable income of a FSC or DISC and its related supplier. 
Paragraph (g) of this section describes the treatment of losses caused 
by apportionment of interest expense in the case of an affiliated group 
that does not file a consolidated return.
    (b) Scope of application--(1) Application of section 864(e)(1) and 
(5) (concerning the definition and treatment of affiliated groups). For 
further guidance, see Sec.  1.861-11(b)(1).
    (2) Nonapplication of section 864(e) (1) and (5) (concerning the 
definition and treatment of affiliated groups). Section 864(e) (1) and 
(5) and the portions of this section implementing section 864(e) (1) and 
(5) do not apply to the computation of subpart F income of controlled 
foreign corporations (under sections 951 through 964), the computation 
of combined taxable income of a possessions corporation and its 
affiliates (under section 936), or the computation of effectively 
connected taxable income of foreign corporations. For the rules with 
respect to the allocation and apportionment of interest expenses of 
foreign corporations other than controlled foreign corporations, see 
Sec. Sec.  1.882-4 and 1.882-5.
    (c) General rule for affiliated corporations. Except as otherwise 
provided in this section, the taxable income of each member of an 
affiliated group within each statutory grouping shall be determined by 
allocating and apportioning the interest expense of each member 
according to apportionment fractions which are computed as if all 
members of such group were a single corporation. For purposes of 
determining these apportionment fractions,

[[Page 229]]

stock in corporations within the affiliated group (as defined in section 
864(e)(5) and the rules of this section) shall not be taken into 
account. In the case of an affiliated group of corporations that files a 
consolidated return, consolidated foreign tax credit limitations are 
computed for the group in accordance with the rules of Sec.  1.1502-4. 
Except as otherwise provided, all the interest expense of all members of 
the group will be treated as definitely related and therefore allocable 
to all the gross income of the members of the group and all the assets 
of all the members of the group shall be taken into account in 
apportioning this interest expense. For purposes of this section, the 
term ``taxpayer'' refers to the affiliated group (regardless of whether 
the group files a consolidated return), rather than to the separate 
members thereof.
    (d)(1)-(2) [Reserved]. For further guidance, see Sec.  1.861-
11(d)(1) and (2).
    (3) Treatment of life insurance companies subject to taxation under 
section 801--(i) General rule. A life insurance company that is subject 
to taxation under section 801 shall be considered to constitute a member 
of the affiliated group composed of companies not taxable under section 
801 only if a parent corporation so elects under section 1504(c)(2)(A) 
of the Code. If a parent does not so elect, no adjustments shall be 
required with respect to such an insurance company under paragraph (g) 
of this section.
    (ii) Treatment of stock. Stock of a life insurance company that is 
subject to taxation under section 801 that is not included in an 
affiliated group shall be disregarded in the allocation and 
apportionment of the interest expense of such affiliated group.
    (4) Treatment of certain financial corporations--(i) In general. In 
the case of an affiliated group (as defined in paragraph (d)(1) of this 
section), any member that constitutes financial corporations as defined 
in paragraph (d)(4)(ii) of this section shall be treated as a separate 
affiliated group consisting of financial corporations (the ``financial 
group''). The members of the group that do not constitute financial 
corporations shall be treated as members of a separate affiliated group 
consisting of nonfinancial corporations (``the nonfinancial group'').
    (ii) Financial corporation defined. The term ``financial 
corporation'' means any corporation which meets all of the following 
conditions:
    (A) It is described in section 581 (relating to the definition of a 
bank) or section 591 (relating to the deduction for dividends paid on 
deposits by mutual savings banks, cooperative banks, domestic building 
and loan associations, and other savings institutions chartered and 
supervised as savings and loan or similar associations);
    (B) Its business is predominantly with persons other than related 
persons (within the meaning of section 864(d)(4) and the regulations 
thereunder) or their customers; and
    (C) It is required by state or Federal law to be operated separately 
from any other entity which is not such an institution.
    (iii) Treatment of bank holding companies. The total aggregate 
interest expense of any member of an affiliated group that constitutes a 
bank holding company subject to regulation under the Bank Holding 
Company Act of 1956 shall be prorated between the financial group and 
the nonfinancial group on the basis of the assets in the financial and 
nonfinancial groups. For purposes of making this proration, the assets 
of each member of each group, and not the stock basis in each member, 
shall be taken into account. Any direct or indirect subsidiary of a bank 
holding company that is predominantly engaged in the active conduct of a 
banking, financing, or similar business shall be considered to be a 
financial corporation for purposes of this paragraph (d)(4). The 
interest expense of the bank holding company must be further apportioned 
in accordance with Sec.  1.861-9T(f) to the various section 904(d) 
categories of income contained in both the financial group and the 
nonfinancial group on the basis of the assets owned by each group. For 
purposes of computing the apportionment fractions for each group, the 
assets owned directly by a bank holding company within each limitation 
category described in section 904(d)(1) (other than stock in affiliates 
or assets described in Sec.  1.861-9T(f)) shall be treated as owned pro

[[Page 230]]

rata by the nonfinancial group and the financial group based on the 
relative amounts of investments of the bank holding company in the 
nonfinancial group and financial group.
    (iv) Consideration of stock of the members of one group held by 
members of the other group. In apportioning interest expense, the 
nonfinancial group shall not take into account the stock of any lower-
tier corporation that is treated as a member of the financial group 
under paragraph (d)(4)(i) of this section. Conversely, in apportioning 
interest expense, the financial group shall not take into account the 
stock of any lower-tier corporation that is treated as a member of the 
nonfinancial group under paragraph (d)(4)(i) of this section. For the 
treatment of loans between members of the financial group and members of 
the nonfinancial group, see paragraph (e)(1) of this section.
    (5) Example. (i) Facts. X, a domestic corporation which is not a 
bank holding company, is the parent of domestic corporations Y and Z. Z 
owns 100 percent of the stock Z1, which is also a domestic corporation. 
X, Y, Z, and Z1 were organized after January 1, 1987, and constitute an 
affiliated group within the meaning of paragraph (d)(1) of this section. 
Y and Z are financial corporations described in paragraph (d)(4) of this 
section. X also owns 25 percent of the stock of A, a domestic 
corporation. Y owns 25 percent of the voting stock of B, a foreign 
corporation that is not a controlled foreign corporation. Z owns less 
than 10 percent of the voting stock of C, another foreign corporation. 
The foreign source income generated by Y's or Z's direct assets is 
exclusively financial services income. The foreign source income 
generated by X's or Z1's direct assets is exclusively general limitation 
income. X and Z1 are not financial corporations described in paragraph 
(d)(4)(ii) of this section. Y and Z, therefore, constitute a separate 
affiliated group apart from X and Z1 for purposes of section 864(e). The 
combined interest expense of Y and Z of $100,000 ($50,000 each) is 
apportioned separately on the basis of their assets. The combined 
interest expense of X and Z1 of $50,000 ($25,000 each) is allocated on 
the basis of the assets of the XZ1 group.

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

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

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


[[Page 231]]


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

    The XZ1 group would apportion its interest expense as follows:

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

    (6) Certain unaffiliated corporations. Certain corporations that are 
not described in paragraph (d)(1) of this section will nonetheless be 
considered to constitute affiliated corporations for purposes of 
Sec. Sec.  1.861-9T through 1.861-13T. These corporations include:
    (i) Any includible corporation (as defined in section 1504(b) 
without regard to section 1504(b)(4)) if 80 percent of either the vote 
or value of all outstanding stock of such corporation is owned directly 
or indirectly by an includible corporation or by members of an 
affiliated group, and
    (ii) [Reserved]. For further guidance see Sec.  1.861-11(d)(6)(ii).
    (7) Special rules for the application of Sec.  1.861-11T(d)(6). 
[Reserved]. For special rules for the application of Sec.  1.861-
11T(d)(6), see Sec.  1.861-11(d)(7).
    (e) Loans between members of an affiliated group--(1) General rule. 
In the case of loans (including any receivable) between members of an 
affiliated group, as defined in paragraph (d) of this section, for 
purposes of apportioning interest expense, the indebtedness of the 
member borrower shall not be considered an asset of the member lender. 
However, in the case of members of separate financial and nonfinancial 
groups under paragraph (d)(4) of this section, the indebtedness of the 
member borrower shall be considered an asset of the member lender and 
such asset shall be characterized by reference to the member lender's 
income from the asset as determined under paragraph (e)(2)(ii) of this 
section. For purposes of this paragraph (e), the terms ``related person 
interest income'' and ``related person interest payment'' refer to 
interest paid and received by members of the same affiliated group as 
defined in paragraph (d) of this section.
    (2) Treatment of interest expense within the affiliated group--(i) 
General rule. A member borrower shall deduct related person interest 
payments in the same manner as unrelated person interest expense using 
group apportionment fractions computed under Sec.  1.861-9T(f). A member 
lender shall include related person interest income in the same class of 
gross income as the class of gross income from which the member borrower 
deducts the related person interest payment.
    (ii) Special rule for loans between financial and nonfinancial 
affiliated corporations. In the case of a loan between two affiliated 
corporations only one of which constitutes a financial corporation under 
paragraph (d)(4) of this section, the member borrower shall allocate and 
apportion related person interest payments in the same manner as 
unrelated person interest expense using group apportionment fractions 
computed under Sec.  1.861-9T(f). The source of the related person 
interest income to the member lender shall be determined under section 
861(a)(1).
    (iii) Special rule for high withholding tax interest. In the case of 
an affiliated corporation that pays interest that is high withholding 
tax interest under Sec.  1.904-5(f)(1) to another affiliated 
corporation, the interest expense of the payor shall be allocated to 
high withholding tax interest.
    (3) Back-to-back loans. If a member of the affiliated group makes a 
loan to a nonmember who makes a loan to a member borrower, the rule of 
paragraphs (e) (1) and (2) of this section shall apply, in the 
Commissioner's discretion, as if the member lender made the loan 
directly to the member borrower, provided that the loans constitute a 
back-to-back loan transaction. Such loans will constitute a back-to-back 
loan for purposes of this paragraph (e) if the loan by the nonmember 
would not have been made or

[[Page 232]]

maintained on substantially the same terms irrespective of the loan of 
funds by the lending member to the nonmember or other intermediary 
party.
    (4) Examples. The rules of this paragraph (e) may be illustrated by 
the following examples.

    Example 1. X, a domestic corporation, is the parent of Y, a domestic 
corporation. X and Y were organized after January 1, 1987, and 
constitute an affiliated group within the meaning of paragraph (d)(1) of 
this section. Among X's assets is the note of Y for the amount of 
$100,000. Because X and Y are members of an affiliated group, Y's note 
does not constitute an asset for purposes of apportionment. The 
apportionment fractions for the relevant tax year of the XY group are 50 
percent domestic, 40 percent foreign general, and 10 percent foreign 
passive. Y deducts its related person interest payment using those 
apportionment fractions. Of the $10,000 in related person interest 
income received by X, $5,000 consists of domestic source income, $4,000 
consists of foreign general limitation income, and $1,000 consists of 
foreign passive income.
    Example 2. X is a domestic corporation organized after January 1, 
1987. X owns all the stock of Y, a domestic corporation. On June 1, 
1987, X loans $100,000 to Z, an unrelated person. On June 2, 1987, Z 
makes a loan to Y with terms substantially similar to those of the loan 
from X to Z. Based on the facts and circumstances of the transaction, it 
is determined that Z would not have made the loan to Y on the same terms 
if X had not made the loan to Z. Because the transaction constitutes a 
back-to-back loan, as defined in paragraph (e)(3) of this section, the 
Commissioner may require, in his discretion, that neither the note of Y 
nor the note of Z may be considered an asset of X for purposes of this 
section.

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

[[Page 233]]

the following adjustments among members are required in order to give 
effect to the group allocation of interest expense:
    (i) Losses created through group apportionment of interest expense 
in one or more limitation categories within a given member must be 
eliminated; and
    (ii) A corresponding amount of income of other members in the same 
limitation category must be recharacterized.


Such adjustments shall be accomplished, in accordance with paragraph 
(g)(2) of this section, without changing the total taxable income of any 
member and before the application of section 904(f). Section 904(f) 
(including section 904(f)(5)) does not apply to a loss created through 
the apportionment of interest expense to the extent that the loss is 
eliminated pursuant to paragraph (g)(2)(ii) of this section. For 
purposes of this section, the terms ``limitation adjustment'' and 
``recharacterization'' mean the recharacterization of income in one 
limitation category as income in another limitation category.
    (2) Mechanics of computation--(i) Step 1: Computation of 
consolidated taxable income. The members of an affiliated group must 
first allocate and apportion all other deductible expenses other than 
interest. The members must then deduct from their respective gross 
incomes within each limitation category interest expense apportioned 
under the rules of Sec.  1.861-9T(f). The taxable income of the entire 
affiliated group within each limitation category is then totalled.
    (ii) Step 2: Loss offset adjustments. If, after step 1, a member has 
losses in a given limitation category or limitation categories created 
through apportionment of interest expense, any such loss (i.e., the 
portion of such loss equal to interest expense) shall be eliminated by 
offsetting that loss against taxable income in other limitation 
categories of that member to the extent of the taxable income of other 
members within the same limitation category as the loss. If the member 
has taxable income in more than one limitation category, then the loss 
shall offset taxable income in all such limitation categories on a pro 
rata basis. If there is insufficient domestic income of the member to 
offset the net losses in all foreign limitation categories caused by the 
apportionment of interest expense, the losses in each limitation 
category shall be recharacterized as domestic losses to the extent of 
the taxable income of other members in the same respective limitation 
categories. After these adjustments are made, the income of the entire 
affiliated group within each limitation category is totalled again.
    (iii) Step 3: Determination of amount subject to recharacterization. 
In order to determine the amount of income to be recharacterized in step 
4, the income totals computed under step 1 in each limitation category 
shall be subtracted from the income totals computed under step 2 in each 
limitation category.
    (iv) Step 4: Recharacterization. Because any differences determined 
under step 3 represent deviations from the consolidated totals computed 
under Step 1, such differences (in any limitation category) must be 
eliminated.
    (A) Limitation categories to be reduced. In the case of any 
limitation category in which there is a positive change, the income of 
group members with income in that limitation category must be reduced on 
a pro rata basis (by reference to net income figures as determined under 
Step 2) to the extent of such positive change (``limitation 
reductions''). Each member shall separately compute the sum of the 
limitation reductions.
    (B) Limitation categories to be increased. In any case in which only 
one limitation category has a negative change in Step 3, the sum of the 
limitation reductions within each member is added to that limitation 
category. In the case in which multiple limitation categories have 
negative changes in Step 3, the sum of the limitation reductions within 
each member is prorated among the negative change limitation categories 
based on the ratio that the negative change for the entire group in each 
limitation category bears to the total of all negative changes for the 
entire group in all limitation categories.
    (3) Examples. The following examples illustrate the principles of 
this paragraph.

    Example 1. (i) Facts. X, a domestic corporation, is the parent of 
domestic corporations Y and Z. X, Y, and Z were organized after

[[Page 234]]

January 1, 1987, constitute an affiliated group within the meaning of 
paragraph (d)(1) of this section, but do not file a consolidated return. 
The XYZ group apportions its interest expense on the basis of the fair 
market value of its assets. X, Y, and Z have the following assets, 
interest expense, and taxable income before apportioning interest 
expense:

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

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

------------------------------------------------------------------------
     Apportioned interest expense          X       Y       Z      Total
------------------------------------------------------------------------
Domestic..............................   36.00    9.00   60.00    105.00
Foreign Passive.......................    1.20    0.30    2.00      3.50
Foreign General.......................   10.80    2.70   18.00     31.50
                                       ---------------------------------
    Total.............................   48.00   12.00   80.00    140.00
------------------------------------------------------------------------

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

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

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

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

    These adjustments yield the following adjusted taxable income 
figures:

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

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

[[Page 235]]

Accordingly, Z's domestic income is increased by $0.86.

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

    These recharacterization adjustments yield the following final 
taxable income figures:

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

    Example 2. (i) Facts. X, a domestic corporation, is the parent of 
domestic corporations Y and Z. X, Y, and Z were organized after January 
1, 1987, constitute an affiliated group within the meaning of paragraph 
(d)(1) of this section, but do not file a consolidated return. Moreover, 
X has served as the sole borrower in the group and, as a result, has 
sustained an overall loss. The XYZ group apportions its interest expense 
on the basis of the fair market value of its assets. X, Y, and Z have 
the following assets, interest expense, and taxable income before 
interest expense:

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

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

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

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

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

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

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

    These adjustments yield the following adjusted taxable income 
figures:

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

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

[[Page 236]]

adjusted taxable income of Z in the foreign general limitation category 
is $35. Therefore, $21 is drawn from Y and $10.50 is drawn from Z.
    The members must then separately compute the sum of the limitation 
reductions. Y has limitation reductions of $1.75 in the foreign passive 
limitation category and $21 in the foreign general limitation category, 
yielding total limitation reductions of $22.75. Under these facts, 
domestic income is the only limitation category requiring a positive 
adjustment. Accordingly, Y's domestic income is increased by $22.75. Z 
has limitation reductions of $1.75 in the foreign passive limitation 
category and $10.50 in the foreign general limitation category, yielding 
total limitation reductions of $12.25. Under these facts, domestic 
income is the only limitation category requiring a positive adjustment. 
Accordingly, Z's domestic income is increased by $12.25.

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

    These recharacterization adjustments yield the following final 
taxable income figures:

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

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

[T.D. 8228, 53 FR 35490, Sept. 14, 1988, as amended by T.D. 8916, 65 FR 
274, Jan. 3, 2001; T.D. 9456, 74 FR 38875, Aug. 4, 2009; T.D. 9571, 77 
FR 2227, Jan. 17, 2012; 77 FR 9844, Feb. 21, 2012; T.D. 9676, 79 FR 
41426, July 16, 2014; T.D. 9882, 84 FR 69069, Dec. 17, 2019]



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

    (a) In general. The rules in this section apply to taxpayers 
apportioning expenses under an asset method to income in the various 
separate categories described in Sec.  1.904-5(a)(4)(v), and supplement 
other rules provided in Sec. Sec.  1.861-9 through 1.861-11T. The 
principles of the rules in this section also apply in apportioning 
expenses among statutory and residual groupings for any other operative 
section. See also Sec.  1.861-8(f)(2)(i) for a rule requiring conformity 
of allocation methods and apportionment principles for all operative 
sections. Paragraph (b) of this section describes the treatment of 
inventories. Paragraph (c)(1) of this section concerns the treatment of 
various stock assets. Paragraph (c)(2) of this section describes a basis 
adjustment for stock in 10 percent owned corporations. Paragraph (c)(3) 
of this section sets forth rules for characterizing the stock in 
controlled foreign corporations. Paragraph (c)(4) of this section 
describes the treatment of stock of noncontrolled 10-percent owned 
foreign corporations. Paragraph (d)(1) of this section concerns the 
treatment of notes. Paragraph (d)(2) of this section concerns the 
treatment of notes of controlled foreign corporations. Paragraph (e) of 
this section describes the treatment of certain portfolio securities 
that constitute inventory or generate income primarily in the form of 
gains. Paragraph (f) of this section describes the treatment of assets 
that are funded by interest that is capitalized, deferred, or 
disallowed. Paragraph (g) of this section concerns the treatment of FSC 
stock and of assets of the related supplier generating foreign trade 
income. Paragraph (h) of this section concerns the treatment of DISC 
stock and of assets of the related supplier generating qualified export 
receipts.
    (b) Inventories. For further guidance, see Sec.  1.861-12T(b).
    (c) Treatment of stock--(1) In general. For further guidance, see 
Sec.  1.861-12T(c)(1).
    (2) Basis adjustment for stock in 10 percent owned corporations--(i) 
Taxpayers using the tax book value method--(A) General rule. For 
purposes of apportioning expenses on the basis of the tax book value of 
assets, the adjusted basis of any stock in a 10 percent owned 
corporation owned by the taxpayer either directly or indirectly through 
a partnership or other pass-through entity (after taking into account 
the adjustments described in paragraph (c)(2)(i)(B)(1) of this section) 
shall be--
    (1) Increased by the amount of the earnings and profits of such 
corporation (and of lower-tier 10 percent owned corporations) 
attributable to such

[[Page 237]]

stock and accumulated during the period the taxpayer or other members of 
its affiliated group held 10 percent or more of such stock; or
    (2) Reduced by any deficit in earnings and profits of such 
corporation (and of lower-tier 10 percent owned corporations) 
attributable to such stock for such period; or
    (3) Zero, if after application of paragraphs (c)(2)(i)(A)(1) and (2) 
of this section, the adjusted basis of the stock is less than zero.
    (B) Computational rules--(1) Adjustments to basis--(i) Application 
of section 961 or 1293(d). For purposes of this section, a taxpayer's 
adjusted basis in the stock of a foreign corporation does not include 
any amount included in basis under section 961 or 1293(d) of the Code.
    (ii) Application of section 965(b). For purposes of this section, if 
a taxpayer owned the stock of a specified foreign corporation (as 
defined in Sec.  1.965-1(f)(45)) as of the close of the last taxable 
year of the specified foreign corporation that began before January 1, 
2018, the taxpayer's adjusted basis in the stock of the specified 
foreign corporation for that taxable year and any subsequent taxable 
year is determined as if the taxpayer did not make the election 
described in Sec.  1.965-2(f)(2)(i) (regardless of whether the election 
was actually made) and is further adjusted as described in this 
paragraph (c)(2)(i)(B)(1)(ii). If Sec.  1.965-2(f)(2)(ii)(B) applied (or 
would have applied if the election had been made) with respect to the 
stock of a specified foreign corporation, the taxpayer's adjusted basis 
in the stock of the specified foreign corporation is reduced by the 
amount described in Sec.  1.965-2(f)(2)(ii)(B)(1) (without regard to the 
rule for limited basis adjustments in Sec.  1.965-2(f)(2)(ii)(B)(2) and 
the limitation in Sec.  1.965-2(f)(2)(ii)(C), and without regard to the 
rules regarding the netting of basis adjustments in Sec.  1.965-
2(h)(2)). The reduction in the taxpayer's adjusted basis in the stock 
may reduce the taxpayer's adjusted basis in the stock below zero prior 
to the application of paragraphs (c)(2)(i)(A)(1) and (2) of this 
section. No adjustment is made in the taxpayer's adjusted basis in the 
stock of a specified foreign corporation for an amount described in 
Sec.  1.965-2(f)(2)(ii)(A). To the extent that, in an exchange described 
in section 351, 354, or 356, a taxpayer receives stock of a foreign 
corporation in exchange for stock of a specified foreign corporation 
described in this paragraph (c)(2)(i)(B)(1)(ii), this paragraph 
(c)(2)(i)(B)(1)(ii) applies to such stock received.
    (2) Amount of earnings and profits. For purposes of this paragraph 
(c)(2), earnings and profits (or deficits) are computed under the rules 
of section 312 and, in the case of a foreign corporation, sections 
964(a) and 986 for taxable years of the 10 percent owned corporation 
ending on or before the close of the taxable year of the taxpayer. 
Accordingly, the earnings and profits of a controlled foreign 
corporation include all earnings and profits described in section 
959(c). The amount of the earnings and profits with respect to stock of 
a foreign corporation held by the taxpayer is determined according to 
the attribution principles of section 1248 and the regulations under 
section 1248. The attribution principles of section 1248 apply without 
regard to the requirements of section 1248 that are not relevant to the 
determination of a shareholder's pro rata portion of earnings and 
profits, such as whether earnings and profits (or deficits) were derived 
(or incurred) during taxable years beginning before or after December 
31, 1962.
    (3) Annual noncumulative adjustment. The adjustment required by 
paragraph (c)(2)(i)(A) of this section is made annually and is 
noncumulative. Thus, the adjusted basis of the stock (determined without 
regard to prior years' adjustments under paragraph (c)(2)(i)(A) of this 
section) is adjusted annually by the amount of accumulated earnings and 
profits (or deficits) attributable to the stock as of the end of each 
year.
    (4) Translation of non-dollar functional currency earnings and 
profits. Earnings and profits (or deficits) of a qualified business unit 
that has a functional currency other than the dollar must be computed 
under this paragraph (c)(2) in functional currency and translated into 
dollars using the exchange rate at the end of the taxpayer's current 
taxable year (and not the exchange rates for the years in which the 
earnings and

[[Page 238]]

profits or deficits were derived or incurred).
    (C) Examples. The following examples illustrate the application of 
paragraph (c)(2)(i) of this section.
    (1) Example 1: No election described in Sec.  1.965-2(f)(2)(i)--(i) 
Facts. USP, a domestic corporation, owns all of the stock of CFC1 and 
CFC2, both controlled foreign corporations. USP, CFC1, and CFC2 all use 
the calendar year as their U.S. taxable year. USP owned CFC1 and CFC2 as 
of December 31, 2017, and CFC1 and CFC2 were specified foreign 
corporations with respect to USP. USP's basis in each share of stock of 
each of CFC1 and CFC2 is identical. USP did not make the election 
described in Sec.  1.965-2(f)(2)(i), but if USP had made the election, 
Sec.  1.965-2(f)(2)(ii)(B) would have applied to the stock of CFC2 and 
the amount described in Sec.  1.965-2(f)(2)(ii)(B)(1) (without regard to 
the rule for limited basis adjustments in Sec.  1.965-2(f)(2)(ii)(B)(2) 
and without regard to the rules regarding the netting of basis 
adjustments in Sec.  1.965-2(h)(2)) with respect to the stock of CFC2, 
in aggregate, is $75x. For purposes of determining the value of the 
stock of CFC1 and CFC2 at the beginning of the 2019 taxable year, 
without regard to amounts included in basis under section 961 or 
1293(d), USP's adjusted basis in the stock of CFC1 is $100x and its 
adjusted basis in the stock of CFC2 is $350x (before the application of 
paragraph (c)(2)(i)(B) of this section).
    (ii) Analysis. Under paragraph (c)(2)(i)(B)(1)(ii) of this section, 
USP's adjusted basis in the stock of CFC1 is determined as if USP did 
not make the election described in Sec.  1.965-2(f)(2)(i). USP's 
adjusted basis in the stock of CFC2 is then reduced by $75x, the amount 
described in Sec.  1.965-2(f)(2)(ii)(B)(1), without regard to the rule 
for limited basis adjustments in Sec.  1.965-2(f)(2)(ii)(B)(2) and 
without regard to the rules regarding the netting of basis adjustments 
in Sec.  1.965-2(h)(2). No adjustment is made to USP's adjusted basis in 
the stock in CFC1. Accordingly, for purposes of determining the value of 
stock of CFC1 and CFC2 at the beginning of the 2019 taxable year, USP's 
adjusted basis in the stock of CFC1 is $100x and USP's adjusted basis in 
the stock of CFC2 is $275x ($350x-$75x).
    (2) Example 2: Election described in Sec.  1.965-2(f)(2)(i)--(i) 
Facts. USP, a domestic corporation, owns all of the stock of CFC1, which 
owns all of the stock of CFC2, both controlled foreign corporations. 
USP, CFC1, and CFC2 all use the calendar year as their U.S. taxable 
year. USP owned CFC1, and CFC1 owned CFC2 as of December 31, 2017, and 
CFC1 and CFC2 were specified foreign corporations with respect to USP. 
USP's basis in each share of stock of CFC1 is identical. USP made the 
election described in Sec.  1.965-2(f)(2)(i). As a result of the 
election, USP was required to increase its basis in the stock of CFC1 by 
$90x under Sec.  1.965-2(f)(2)(ii)(A)(1), and to decrease its basis in 
the stock of CFC1 by $90x under Sec.  1.965-2(f)(2)(ii)(B)(1). Pursuant 
to Sec.  1.965-2(h)(2), USP netted the increase of $90x against the 
decrease of $90x and made no net adjustment to the basis in the stock of 
CFC1. For purposes of determining the value of the stock of CFC1 at the 
beginning of the 2019 taxable year, without regard to amounts included 
in basis under section 961 or 1293(d), USP's adjusted basis in the stock 
of CFC1 is $600x (before the application of paragraph (c)(2)(i)(B) of 
this section).
    (ii) Analysis. Under paragraph (c)(2)(i)(B)(1)(ii) of this section, 
USP's adjusted basis in the stock of CFC1 is determined as if USP did 
not make the election described in Sec.  1.965-2(f)(2)(i). While USP 
made the election, no adjustment was made to the stock of CFC1 as a 
result of the election. However, USP's adjusted basis in the stock of 
CFC1 is then reduced by $90x, the amount described in Sec.  1.965-
2(f)(2)(ii)(B)(1), without regard to the rules regarding the netting of 
basis described in Sec.  1.965-2(h)(2). No adjustment is made to USP's 
basis in the stock of CFC1 for the amount described in Sec.  1.965-
2(f)(2)(ii)(A)(1). Accordingly, for purposes of determining the value of 
stock of CFC1 at the beginning of the 2019 taxable year, USP's adjusted 
basis in the stock of CFC1 is $510x ($600x-$90x).
    (3) Example 3: Adjusted basis below zero--(i) Facts. The facts are 
the same as in paragraph (c)(2)(i)(C)(1)(i) of this

[[Page 239]]

section (the facts in Example 1), except that for purposes of 
determining the value of the stock of CFC2 at the beginning of the 2019 
taxable year, without regard to amounts included in basis under section 
961 or 1293(d), USP's adjusted basis in the stock of CFC2 is $0 (before 
the application of paragraph (c)(2)(i)(B) of this section). 
Additionally, the adjusted basis of USP in the stock of CFC1 and CFC2 at 
the end of the 2019 taxable year is the same as at the beginning of that 
year, and as of the end of the 2019 taxable year, CFC1 has earnings and 
profits of $25x and CFC2 has earnings and profits of $50x that are 
attributable to the stock owned by USP and accumulated during the period 
that USP held the stock of CFC1 and CFC2.
    (ii) Analysis. The analysis is the same as in paragraph 
(c)(2)(i)(C)(1)(ii) of this section (the analysis in Example 1) except 
that for purposes of determining the value of stock of CFC1 and CFC2 at 
the beginning of the 2019 taxable year, USP's adjusted basis in the 
stock of CFC2 is -$75x ($0-$75x). Because USP's basis in the stock of 
CFC1 and CFC2 is the same at the end of the 2019 taxable year, prior to 
the application of the adjustments in paragraphs (c)(2)(i)(A)(1) and (2) 
of this section, USP's adjusted basis in the stock of CFC1 is $100x and 
USP's adjusted basis in the stock of CFC2 is -$75x. Under paragraph 
(c)(2)(i)(A)(1) of this section, for purposes of apportioning expenses 
on the basis of the tax book value of assets, USP's adjusted basis in 
the stock of CFC1 is $125x ($100x + $25x). Under paragraph 
(c)(2)(i)(A)(3) of this section, for purposes of apportioning expenses 
on the basis of the tax book value of assets, USP's adjusted basis in 
the stock of CFC2 is $0 because after applying paragraph (c)(2)(i)(A)(1) 
of this section, USP's adjusted basis in the stock of CFC2 is less than 
zero (-$75x + $50x).
    (4) Example 4: Election described in Sec.  1.965-2(f)(2)(i) and 
adjusted basis below zero--(i) Facts. The facts are the same as in 
paragraph (c)(2)(i)(C)(3)(i) of this section (the facts in Example 3), 
except that USP made the election described in Sec.  1.965-2(f)(2)(i) 
and, as result, recognized $75x of gain under Sec.  1.965-2(h)(3).
    (ii) Analysis. The analysis is the same as in paragraph 
(c)(2)(i)(C)(3)(ii) of this section (the analysis in Example 3).
    (2)(ii)-(vi) [Reserved]. For further guidance, see Sec.  1.861-
12T(c)(2)(ii) through (c)(2)(vi).
    (3) Characterization of stock of controlled foreign corporations--
(i) Operative sections--(A) Operative sections other than section 904. 
For purposes of applying this section to an operative section other than 
section 904, stock in a controlled foreign corporation (as defined in 
section 957) is characterized as an asset in the relevant groupings on 
the basis of the asset method described in paragraph (c)(3)(ii) of this 
section, or the modified gross income method described in paragraph 
(c)(3)(iii) of this section. Stock in a controlled foreign corporation 
whose interest expense is apportioned on the basis of assets is 
characterized in the hands of its United States shareholders under the 
asset method described in paragraph (c)(3)(ii) of this section. Stock in 
a controlled foreign corporation whose interest expense is apportioned 
on the basis of modified gross income is characterized in the hands of 
its United States shareholders under the modified gross income method 
described in paragraph (c)(3)(iii) of this section.
    (B) Section 904 as operative section. For purposes of applying this 
section to section 904 as the operative section, Sec.  1.861-13 applies 
to characterize the stock of a controlled foreign corporation as an 
asset producing foreign source income in the separate categories 
described in Sec.  1.904-5(a)(4)(v), or as an asset producing U.S. 
source income in the residual grouping, in the hands of the United 
States shareholder, and to determine the portion of the stock that gives 
rise to an inclusion under section 951A(a) that is treated as an exempt 
asset under Sec.  1.861-8(d)(2)(ii)(C). Section 1.861-13 also provides 
rules for subdividing the stock in the various separate categories and 
the residual grouping into a section 245A subgroup and a non-section 
245A subgroup in order to determine the amount of the adjustments 
required by section 904(b)(4) and Sec.  1.904(b)-3(c) with respect to 
the section 245A subgroup, and provides rules for determining the 
portion of the stock that gives rise to

[[Page 240]]

a dividend eligible for a deduction under section 245(a)(5) that is 
treated as an exempt asset under Sec.  1.861-8(d)(2)(ii)(B).
    (ii) Asset method. For further guidance, see Sec.  1.861-
12T(c)(3)(ii).
    (iii) Modified gross income method. Under the modified gross income 
method, the taxpayer characterizes the tax book value of the stock of 
the first-tier controlled foreign corporation based on the gross income, 
net of interest expense, of the controlled foreign corporation (as 
computed under Sec.  1.861-9T(j) to include certain gross income, net of 
interest expense, of lower-tier controlled foreign corporations) within 
each relevant category for the taxable year of the controlled foreign 
corporation ending with or within the taxable year of the taxpayer. For 
purposes of this paragraph (c)(3)(iii), however, the gross income, net 
of interest expense, of the first-tier controlled foreign corporation 
includes the total amount of gross subpart F income, net of interest 
expense, of any lower-tier controlled foreign corporation that was 
excluded under the rules of Sec.  1.861-9(j)(2)(ii)(B).
    (4) Characterization of stock of noncontrolled 10-percent owned 
foreign corporations--(i) In general. Except in the case of a 
nonqualifying shareholder described in paragraph (c)(4)(ii) of this 
section, the principles of Sec.  1.861-12(c)(3), including the relevant 
rules of Sec.  1.861-13 when section 904 is the operative section, apply 
to characterize stock in a noncontrolled 10-percent owned foreign 
corporation (as defined in section 904(d)(2)(E)). Accordingly, stock in 
a noncontrolled 10-percent owned foreign corporation is characterized as 
an asset in the various separate categories on the basis of either the 
asset method described in Sec.  1.861-12T(c)(3)(ii) or the modified 
gross income method described in Sec.  1.861-12(c)(3)(iii). Stock in a 
noncontrolled 10-percent owned foreign corporation the interest expense 
of which is apportioned on the basis of assets is characterized in the 
hands of its shareholders under the asset method described in Sec.  
1.861-12T(c)(3)(ii). Stock in a noncontrolled 10-percent owned foreign 
corporation the interest expense of which is apportioned on the basis of 
gross income is characterized in the hands of its shareholders under the 
modified gross income method described in Sec.  1.861-12(c)(3)(iii).
    (ii) Nonqualifying shareholders. Stock in a noncontrolled 10-percent 
owned foreign corporation is characterized as a passive category asset 
in the hands of a shareholder that either is not a domestic corporation 
or is not a United States shareholder with respect to the noncontrolled 
10-percent owned foreign corporation for the taxable year. Stock in a 
noncontrolled 10-percent owned foreign corporation is characterized as 
in the separate category described in section 904(d)(4)(C)(ii) in the 
hands of any shareholder with respect to whom look-through treatment is 
not substantiated. See also Sec.  1.904-5(c)(4)(iii)(B). In the case of 
a noncontrolled 10-percent owned foreign corporation that is a passive 
foreign investment company with respect to a shareholder, stock in the 
noncontrolled 10-percent owned foreign corporation is characterized as a 
passive category asset in the hands of the shareholder if such 
shareholder does not meet the ownership requirements described in 
section 904(d)(2)(E)(i)(II).
    (d) Treatment of notes--(1) General rule. For further guidance, see 
Sec.  1.861-12T(d)(1).
    (2) Characterization of related controlled foreign corporation 
notes. The debt of a controlled foreign corporation is characterized in 
the same manner as the interest income derived from that debt 
obligation. See Sec. Sec.  1.904-4 and 1.904-5(c)(2) for rules treating 
interest income as income in a separate category.
    (e) Portfolio securities that constitute inventory or generate 
primarily gains. For further guidance, see Sec.  1.861-12T(e).
    (f) Assets connected with capitalized, deferred, or disallowed 
interest--(1) In general. In the case of any asset in connection with 
which interest expense accruing during a taxable year is capitalized, 
deferred, or disallowed under any provision of the Code, the value of 
the asset for allocation and apportionment purposes is reduced by the 
principal amount of indebtedness the interest on which is so 
capitalized, deferred, or disallowed. Assets are connected with debt 
(the interest on which is capitalized, deferred, or disallowed) only if 
using the debt proceeds to acquire or

[[Page 241]]

produce the asset causes the interest to be capitalized, deferred, or 
disallowed.
    (2) Examples. The following examples illustrate the application of 
paragraph (f)(1) of this section.
    (i) Example 1: Capitalized interest under section 263A--(A) Facts. X 
is a domestic corporation that uses the tax book value method of 
apportionment. X has $1,000x of indebtedness and incurs $100x of 
interest expense. Using $800x of the $1,000x debt proceeds to produce 
tangible property, X capitalizes $80x of interest expense under the 
rules of section 263A. X deducts the remaining $20x of interest expense.
    (B) Analysis. Because interest on $800x of debt is capitalized under 
section 263A by reason of the use of debt proceeds to produce the 
tangible property, $800x of the principal amount of X's debt is 
connected to the tangible property under paragraph (f)(1) of this 
section. Therefore, for purposes of apportioning the remaining $20x of 
X's interest expense, the adjusted basis of the tangible property is 
reduced by $800x.
    (ii) Example 2: Disallowed interest under section 163(l)--(A) Facts. 
X, a domestic corporation, owns 100% of the stock of Y, a domestic 
corporation. X and Y file a consolidated return and use the tax book 
value method of apportionment. In Year 1, X makes a loan of $1,000x to Y 
(Loan A) and Y then uses the Loan A proceeds to acquire in a cash 
purchase all the stock of a foreign corporation, Z. Interest on Loan A 
is payable in U.S. dollars or, at the option of Y, in stock of Z.
    (B) Analysis. Under section 163(l), Loan A is a disqualified debt 
instrument because interest on Loan A is payable at the option of Y in 
stock of a related party to Y. Because Loan A is a disqualified debt 
instrument, section 163(l)(1) disallows Y's interest deduction for 
interest payable on Loan A. However, the value of the Z stock is not 
reduced under paragraph (f)(1) of this section because the use of the 
Loan A proceeds to acquire the stock of Z is not the cause of Y's 
interest deduction being disallowed. Rather, the Loan A terms allowing 
interest to be paid in stock of Z is the cause of Y's interest deduction 
being disallowed under section 163(l). Therefore, no adjustment is made 
to Y's adjusted basis in the stock of Z for purposes of allocating the 
interest expense of X and Y.
    (g) Special rules for FSCs. For further guidance, see Sec.  1.861-
12T(g) through (j).
    (h)-(j) [Reserved]
    (k) Applicability date. (1) Except as provided in paragraph (k)(2) 
of this section, this section applies to taxable years that both begin 
after December 31, 2017, and end on or after December 4, 2018.
    (2) Paragraph (f) of this section applies to taxable years that end 
on or after December 16, 2019. For taxable years that both begin after 
December 31, 2017, and end on or after December 4, 2018, and before 
December 16, 2019, see Sec.  1.861-12T(f) as contained in 26 CFR part 1 
revised as of April 1, 2019.

[T.D. 9452, 74 FR 27874, June 11, 2009, as amended by T.D. 9866, 84 FR 
29335, June 21, 2019; T.D. 9882, 84 FR 69069, Dec. 17, 2019; T.D. 9922, 
85 FR 72040, Nov. 12, 2020]



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

    (a) In general. For further guidance, see Sec.  1.861-12(a).
    (b) Inventories. Inventory must be characterized by reference to the 
source and character of sales income, or sales receipts in the case of 
LIFO inventory, from that inventory during the taxable year. If a 
taxpayer maintains separate inventories for any federal tax purpose, 
including the rules for establishing pools of inventory items under 
sections 472 and 474 of the Code, each separate inventory shall be 
separately characterized in accordance with the previous sentence.
    (c) Treatment of stock--(1) In general. Subject to the adjustment 
and special rules of paragraphs (c) and (e) of this section, stock in a 
corporation is taken into account in the application of the asset method 
described in Sec.  1.861-9T(g). However, an affiliated group (as defined 
in Sec.  1.861-11T(d)) does not take into account the stock of any 
member in the application of the asset method.
    (2) Basis adjustment for stock in nonaffiliated 10 percent owned 
corporations--
    (i)(A)-(C) [Reserved]. For further guidance, see Sec.  1.861-
12(c)(2)(i)(A) through (c)(2)(i)(C).

[[Page 242]]

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

[[Page 243]]

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


For this purpose, a portfolio security is a security in any entity other 
than a controlled foreign corporation with respect to which the taxpayer 
is a United States shareholder under section 957, a noncontrolled 
section 902 corporation with respect to the taxpayer, or a 10 percent 
owned corporation as defined in Sec.  1.861-12(c)(2)(ii). In taking 
gains into account, a taxpayer must treat all portfolio securities 
generating foreign source dividends and interest as a single asset and 
all portfolio securities generating domestic source dividends as a 
single asset and shall characterize the total value of that asset based 
on the source of all income and gain generated by those securities in 
the taxable year.
    (f) Assets connected with capitalized, deferred, or disallowed 
interest. For further guidance, see Sec.  1.861-12(f).
    (g) Special rules for FSCs--(1) Treatment of FSC stock. No interest 
expense shall be allocated or apportioned to stock of a foreign sales 
corporation (``FSC'') to the extent that the FSC stock is attributable 
to the separate limitation for certain FSC distributions described in 
section 904(d)(1)(H). FSC stock is considered to be attributable solely 
to the separate limitation

[[Page 244]]

category described in section 904(d)(1)(H) unless the taxpayer can 
demonstrate that more than 20 percent of the FSC's gross income for the 
taxable year consists of income other than foreign trading income.
    (2) Treatment of assets that generate foreign trade income. Assets 
of the related supplier that generate foreign trade income must be 
prorated between assets attributable to foreign source general 
limitation income and assets attributable to domestic source income in 
proportion to foreign source general limitation income and domestic 
source income derived from transactions generating foreign trade income.
    (i) Value of assets attributable to foreign source income. The value 
of assets attributable to foreign source general limitation income is 
computed by multiplying the value of assets for the taxable year 
generating foreign trading gross receipts by a fraction:
    (A) The numerator of which is foreign source general limitation 
income for the taxable year derived from transactions giving rise to 
foreign trading gross receipts, after the application of the limitation 
provided in section 927(e)(1), and
    (B) The denominator of which is total income for the taxable year 
derived from the transaction giving rise to foreign trading gross 
receipts.
    (ii) Value of assets attributable to domestic source income. The 
value of assets attributable to domestic source income is computed by 
subtracting from the total value of assets for the taxable year 
generating foreign trading gross receipts the value of assets 
attributable to foreign source general limitation income as computed 
under paragraph (g)(2)(i) of this section.
    (h) Special rules for DISCs--(1) Treatment of DISC stock. No 
interest shall be allocated or apportioned to stock in a DISC (or stock 
in a former DISC to the extent that the stock in the former DISC is 
attributable to the separate limitation category described in section 
904(d)(1)(F)).
    (2) Treatment of assets that generate qualified export receipts. 
Assets of the related supplier that generate qualified export receipts 
must be prorated between assets attributable to foreign source general 
limitation income and assets attributable to domestic source income in 
proportion to foreign source general limitation income and domestic 
source income derived from transactions during the taxable year from 
transactions generating qualified export receipts.
    (i)-(j) [Reserved]
    (k) Effective/applicability date. The rules of this section apply 
for taxable years beginning after December 31, 1986.

[T.D. 8228, 53 FR 35495, Sept. 14, 1988, as amended by T.D. 9260, 71 FR 
24526, Apr. 25, 2006, T.D. 9452, 74 FR 27875, June 11, 2009; T.D. 9456, 
74 FR 38875, Aug. 4, 2009; T.D. 9866, 84 FR 29336, June 21, 2019; T.D. 
9882, 84 FR 69070, Dec. 17, 2019; T.D. 9922, 85 FR 72041, Nov. 12, 2020]



Sec.  1.861-13  Special rules for characterization of controlled 
foreign corporation stock.

    (a) Methodology. For purposes of allocating and apportioning 
deductions for purposes of section 904 as the operative section, stock 
in a controlled foreign corporation owned directly or indirectly through 
a partnership or other pass-through entity by a United States 
shareholder is characterized by the United States shareholder under the 
rules described in this section. In general, paragraphs (a)(1) through 
(5) of this section characterize the stock of the controlled foreign 
corporation as an asset in the various statutory groupings and residual 
grouping based on the type of income that the stock of the controlled 
foreign corporation generates, has generated, or may reasonably be 
expected to generate when the income is included by the United States 
shareholder.
    (1) Step 1: Characterize stock as generating income in statutory 
groupings under the asset or modified gross income method--(i) Asset 
method. A United States shareholder of a controlled foreign corporation 
that apportions its interest expense on the basis of assets must 
characterize stock of the controlled foreign corporation using the asset 
method described in Sec.  1.861-12T(c)(3)(ii) to assign the assets of 
the controlled foreign corporation to the statutory groupings described 
in paragraphs (a)(1)(i)(A)(1) through (10) and (a)(1)(i)(B) of this 
section. If the controlled foreign corporation owns stock

[[Page 245]]

in a lower-tier noncontrolled 10-percent owned foreign corporation, the 
assets of the lower-tier noncontrolled 10-percent owned foreign 
corporation are assigned to a gross subpart F income grouping to the 
extent such assets generate income that, if distributed to the 
controlled foreign corporation, would be gross subpart F income of the 
controlled foreign corporation. See also Sec.  1.861-12(c)(4).
    (A) General and passive categories. Within each of the controlled 
foreign corporation's general category and passive category, each of the 
following subgroups within each category is a separate statutory 
grouping--
    (1) Foreign source gross tested income;
    (2) For each applicable treaty, U.S. source gross tested income 
that, when taken into account by a United States shareholder under 
section 951A, is resourced in the hands of the United States shareholder 
(resourced gross tested income);
    (3) U.S. source gross tested income not described in paragraph 
(a)(1)(i)(A)(2) of this section;
    (4) Foreign source gross subpart F income;
    (5) For each applicable treaty, U.S. source gross subpart F income 
that, when included by a United States shareholder under section 
951(a)(1), is resourced in the hands of the United States shareholder 
(resourced gross subpart F income);
    (6) U.S. source gross subpart F income not described in paragraph 
(a)(1)(i)(A)(5) of this section;
    (7) Foreign source gross section 245(a)(5) income;
    (8) U.S. source gross section 245(a)(5) income;
    (9) Any other foreign source gross income (specified foreign source 
general category gross income or specified foreign source passive 
category gross income, as the case may be); and
    (10) Any other U.S. source gross income (specified U.S. source 
general category gross income or specified U.S. source passive category 
gross income, as the case may be).
    (B) Section 901(j) income. For each country described in section 
901(j), all gross income from sources in that country.
    (ii) Modified gross income method. A United States shareholder of a 
controlled foreign corporation that apportions its interest expense on 
the basis of modified gross income must characterize stock of the 
controlled foreign corporation using the modified gross income method 
under Sec.  1.861-12(c)(3)(iii) to assign the modified gross income of 
the controlled foreign corporation to the statutory groupings described 
in paragraphs (a)(1)(i)(A)(1) through (10) and (a)(1)(i)(B) of this 
section. For purposes of this paragraph (a)(1)(ii), the rules described 
in Sec. Sec.  1.861-12(c)(3)(iii) and 1.861-9T(j)(2) apply to combine 
gross income in a statutory grouping that is earned by the controlled 
foreign corporation with gross income of lower-tier controlled foreign 
corporations that is in the same statutory grouping. For example, 
foreign source general category gross tested income (net of interest 
expense) earned by the controlled foreign corporation is combined with 
its pro rata share of the foreign source general category gross tested 
income (net of interest expense) of lower-tier controlled foreign 
corporations. If the controlled foreign corporation owns stock in a 
lower-tier noncontrolled 10-percent owned foreign corporation, gross 
income of the lower-tier noncontrolled 10-percent owned foreign 
corporation is assigned to a gross subpart F income grouping to the 
extent that the income, if distributed to the upper-tier controlled 
foreign corporation, would be gross subpart F income of the upper-tier 
controlled foreign corporation. See also Sec.  1.861-12(c)(4).
    (2) Step 2: Assign stock to the section 951A category. A controlled 
foreign corporation is not treated as earning section 951A category 
income. The portion of the value of the stock of the controlled foreign 
corporation that is assigned to the section 951A category (as defined in 
Sec.  1.904-4(g)) equals the value of the portion of the stock of the 
controlled foreign corporation that is assigned to the foreign source 
gross tested income statutory groupings within the general category 
(general category gross tested income stock) multiplied by the United 
States shareholder's inclusion percentage. Under Sec.  1.861-
8(d)(2)(ii)(C)(2)(ii), a portion of the

[[Page 246]]

value of stock assigned to the section 951A category may be treated as 
an exempt asset. The portion of the general category gross tested income 
stock that is not characterized as a section 951A category asset remains 
a general category asset and may result in expenses being disregarded 
under section 904(b)(4). See paragraph (a)(5)(ii) of this section and 
Sec.  1.904(b)-3. No portion of the passive category gross tested income 
stock or U.S. source gross tested income stock is assigned to the 
section 951A category.
    (3) Step 3: Assign stock to a treaty category--(i) Inclusions under 
section 951A(a). The portion of the value of the stock of the controlled 
foreign corporation that is assigned to a particular treaty category due 
to an inclusion of U.S. source income under section 951A(a) that was 
resourced under a particular treaty equals the value of the portion of 
the stock of the controlled foreign corporation that is assigned to the 
resourced gross tested income statutory grouping within each of the 
controlled foreign corporation's general or passive categories 
(resourced gross tested income stock) multiplied by the United States 
shareholder's inclusion percentage. Under Sec.  1.861-
8(d)(2)(ii)(C)(2)(ii), a portion of the value of stock assigned to a 
particular treaty category by reason of this paragraph (a)(3)(i) may be 
treated as an exempt asset. The portion of the resourced gross tested 
income stock that is not characterized as a treaty category asset 
remains a U.S. source general or passive category asset, as the case may 
be, that is in the residual grouping and may result in expenses being 
disregarded under section 904(b)(4) for purposes of determining entire 
taxable income under section 904(a). See paragraph (a)(5)(iv) of this 
section and Sec.  1.904(b)-3.
    (ii) Inclusions under section 951(a)(1). The portion of the value of 
the stock of the controlled foreign corporation that is assigned to a 
particular treaty category due to an inclusion of U.S. source income 
under section 951(a)(1) that was resourced under a treaty equals the 
value of the portion of the stock of the controlled foreign corporation 
that is assigned to the resourced gross subpart F income statutory 
grouping within each of the controlled foreign corporation's general 
category or passive category.
    (4) Step 4: Aggregate stock within each separate category and assign 
stock to the residual grouping. The portions of the value of stock of 
the controlled foreign corporation assigned to foreign source statutory 
groupings that were not specifically assigned to the section 951A 
category under paragraph (a)(2) of this section (Step 2) are aggregated 
within the general category and the passive category to characterize the 
stock as general category stock and passive category stock, 
respectively. The portions of the value of stock of the controlled 
foreign corporation assigned to U.S. source statutory groupings that 
were not specifically assigned to a particular treaty category under 
paragraph (a)(3) of this section (Step 3) are aggregated to characterize 
the stock as U.S. source category stock, which is in the residual 
grouping. Stock assigned to the separate category for income described 
in section 901(j)(1) remains in that category.
    (5) Step 5: Determine section 245A and non-section 245A subgroups 
for each separate category and U.S. source category--(i) In general. In 
the case of stock of a controlled foreign corporation that is held 
directly or indirectly through a partnership or other pass-through 
entity by a United States shareholder that is a domestic corporation, 
stock of the controlled foreign corporation that is general category 
stock, passive category stock, and U.S. source category stock is 
subdivided between a section 245A subgroup and a non-section 245A 
subgroup under paragraphs (a)(5)(ii) through (v) of this section for 
purposes of applying section 904(b)(4) and Sec.  1.904(b)-3(c). Each 
subgroup is treated as a statutory grouping under Sec.  1.861-8(a)(4) 
for purposes of allocating and apportioning deductions under Sec. Sec.  
1.861-8 through 1.861-14T and 1.861-17 in applying section 904 as the 
operative section. Deductions apportioned to each section 245A subgroup 
are disregarded under section 904(b)(4). See Sec.  1.904(b)-3. 
Deductions apportioned to the statutory groupings for gross section 
245(a)(5) income are not disregarded under section 904(b)(4); however, a 
portion of the stock assigned to those groupings is

[[Page 247]]

treated as exempt under Sec.  1.861-8T(d)(2)(ii)(B).
    (ii) Section 245A subgroup of general category stock. The portion of 
the general category stock of the controlled foreign corporation that is 
assigned to the section 245A subgroup of the general category equals the 
value of the general category gross tested income stock of the 
controlled foreign corporation that is not assigned to the section 951A 
category under paragraph (a)(2) of this section (Step 2), plus the value 
of the portion of the stock of the controlled foreign corporation that 
is assigned to the specified foreign source general category gross 
income statutory grouping.
    (iii) Section 245A subgroup of passive category stock. The portion 
of passive category stock of the controlled foreign corporation that is 
assigned to the section 245A subcategory of the passive category equals 
the sum of--
    (A) The value of the portion of the stock of the controlled foreign 
corporation that is assigned to the gross tested income statutory 
grouping within foreign source passive category income multiplied by a 
percentage equal to 100 percent minus the United States shareholder's 
inclusion percentage for passive category gross tested income; and
    (B) The value of the portion of the stock of the controlled foreign 
corporation that was assigned to the specified foreign source passive 
category gross income statutory grouping.
    (iv) Section 245A subgroup of U.S. source category stock. The 
portion of U.S. source category stock of the controlled foreign 
corporation that is assigned to the section 245A subgroup of the U.S. 
source category equals the sum of--
    (A) The value of the portion of the stock of the controlled foreign 
corporation that is assigned to the U.S. source general category gross 
tested income statutory grouping multiplied by a percentage equal to 100 
percent minus the United States shareholder's inclusion percentage for 
the general category;
    (B) The value of the portion of the stock of the controlled foreign 
corporation that is assigned to the U.S. source passive category gross 
tested income statutory grouping multiplied by a percentage equal to 100 
percent minus the United States shareholder's inclusion percentage for 
the passive category;
    (C) The value of the resourced gross tested income stock of the 
controlled foreign corporation that is not assigned to a particular 
treaty category under paragraph (a)(3)(i) of this section (Step 3);
    (D) The value of the portion of the stock of the controlled foreign 
corporation that is assigned to the specified U.S. source general 
category gross income statutory grouping; and
    (E) The value of the portion of the stock of the controlled foreign 
corporation that is assigned to the specified U.S. source passive 
category gross income statutory grouping.
    (v) Non-section 245A subgroup. The value of stock of a controlled 
foreign corporation that is not assigned to the section 245A subgroup 
within the general or passive category or the residual grouping is 
assigned to the non-section 245A subgroup within such category or 
grouping. The value of stock of a controlled foreign corporation that is 
assigned to the section 951A category, the separate category for income 
described in section 901(j)(1), or a particular treaty category is 
always assigned to a non-section 245A subgroup.
    (b) Definitions. This paragraph (b) provides definitions that apply 
for purposes of this section.
    (1) Gross section 245(a)(5) income. The term gross section 245(a)(5) 
income means all items of gross income described in section 245(a)(5)(A) 
and (B).
    (2) Gross subpart F income. The term gross subpart F income means 
all items of gross income that are taken into account by a controlled 
foreign corporation in determining its subpart F income under section 
952, except for items of gross income described in section 952(a)(5).
    (3) Gross tested income. The term gross tested income has the 
meaning provided in Sec.  1.951A-2(c)(1).
    (4) Inclusion percentage. The term inclusion percentage has the 
meaning provided in Sec.  1.960-2(c)(2).
    (5) Separate category. The term separate category has the meaning 
provided in Sec.  1.904-5(a)(4)(v).
    (6) Treaty category. The term treaty category means a category of 
income

[[Page 248]]

earned by a controlled foreign corporation for which section 904(a), 
(b), and (c) are applied separately as a result of income being 
resourced under a treaty. See, for example, section 245(a)(10), 865(h), 
or 904(h)(10). A United States shareholder may have multiple treaty 
categories for amounts of income resourced by the United States 
shareholder under a treaty. See Sec.  1.904-5(m)(7).
    (7) U.S. source category. The term U.S. source category means the 
aggregate of U.S. source income in each separate category listed in 
section 904(d)(1).
    (c) Examples. The following examples illustrate the application of 
the rules in this section.
    (1) Example 1: Asset method--(i) Facts--(A) USP, a domestic 
corporation, directly owns all of the stock of a controlled foreign 
corporation, CFC1. The tax book value of CFC1's stock is $20,000x. USP 
uses the asset method described in Sec.  1.861-12T(c)(3)(ii) to 
characterize the stock of CFC1. USP's inclusion percentage is 70%.
    (B) CFC1 owns the following assets with the following values as 
determined under Sec. Sec.  1.861-9(g)(2) and 1.861-9T(g)(3): Assets 
that generate income described in the foreign source gross tested income 
statutory grouping within the general category ($4,000x), assets that 
generate income described in the foreign source gross subpart F income 
statutory grouping within the general category ($1,000x), assets that 
generate specified foreign source general category gross income 
($3,000x), and assets that generate income described in the foreign 
source gross subpart F income statutory grouping within the passive 
category ($2,000x).
    (C) CFC1 also owns all of the stock of CFC2, a controlled foreign 
corporation. The tax book value of CFC1's stock in CFC2 is $6,000x. CFC2 
owns the following assets with the following values as determined under 
Sec. Sec.  1.861-9(g)(2) and 1.861-9T(g)(3): Assets that generate income 
described in the foreign source gross subpart F income statutory 
grouping within the general category ($2,250x) and assets that generate 
specified foreign source general category gross income ($750x).
    (ii) Analysis--(A) Step 1--(1) Characterization of CFC2 stock. CFC2 
has total assets of $3,000x, $2,250x of which are in the foreign source 
gross subpart F income statutory grouping within the general category 
and $750x of which are in the specified foreign source general category 
gross income statutory grouping. Accordingly, CFC2's stock is 
characterized as $4,500x ($2,250x/$3,000x x $6,000x) in the foreign 
source gross subpart F income statutory grouping within the general 
category and $1,500x ($750x/$3,000x x $6,000x) in the specified foreign 
source general category gross income statutory grouping.
    (2) Characterization of CFC1 stock. CFC1 has total assets of 
$16,000x, $4,000x of which are in the foreign source gross tested income 
statutory grouping within the general category, $5,500x of which are in 
the foreign source gross subpart F income statutory grouping within the 
general category (including the portion of CFC2 stock assigned to that 
statutory grouping), $4,500x of which are in the specified foreign 
source gross general category income statutory grouping (including the 
portion of CFC2 stock assigned to that statutory grouping), and $2,000x 
of which are in the foreign source gross subpart F income statutory 
grouping within the passive category. Accordingly, CFC1's stock is 
characterized as $5,000x ($4,000x/$16,000x x $20,000x) in the foreign 
source gross tested income statutory grouping within the general 
category, $6,875x ($5,500x/$16,000x x $20,000x) in the foreign source 
gross subpart F income statutory grouping within the general category, 
$5,625x ($4,500x/$16,000x x $20,000x) in the specified foreign source 
gross general category income statutory grouping, and $2,500x ($2,000x/
$16,000x x $20,000x) in the foreign source gross subpart F income 
statutory grouping within the passive category.
    (B) Step 2. The value of the portion of the stock of CFC1 that is 
general category gross tested income stock is $5,000x. USP's inclusion 
percentage is 70%. Accordingly, under paragraph (a)(2) of this section, 
$3,500x of the stock of CFC1 is assigned to the section 951A category 
and a portion thereof may be treated as an exempt asset under Sec.  
1.861-8(d)(2)(ii)(C)(2)(ii). The remainder, $1,500x, remains a general 
category asset.

[[Page 249]]

    (C) Step 3. No portion of the stock of CFC1 is resourced gross 
tested income stock or assigned to the resourced gross subpart F income 
statutory grouping in any treaty category. Accordingly, no portion of 
the stock of CFC1 is assigned to a treaty category under paragraph 
(a)(3) of this section.
    (D) Step 4--(1) General category stock. The total value of the 
portion of the stock of CFC1 that is general category stock is $14,000x, 
which is equal to $1,500x (the value of the portion of the general 
category stock of CFC1 that was not assigned to the section 951A 
category in paragraph (c)(1)(ii)(B) of this section (Step 2)) plus 
$6,875x (the value of the portion of the stock of CFC1 assigned to the 
foreign source gross subpart F income statutory grouping within the 
general category) plus $5,625x (the value of the portion of the stock of 
CFC1 assigned to the specified foreign source gross income statutory 
grouping within the general category).
    (2) Passive category stock. The total value of the portion of the 
stock of CFC1 that is passive category stock is $2,500x.
    (3) U.S source category stock. No value of the portion of the stock 
of CFC1 is U.S. source category stock.
    (E) Step 5--(1) General category stock. Under paragraph (a)(5)(ii) 
of this section, the value of the portion of the stock of CFC1 assigned 
to the section 245A subgroup of general category stock is $7,125x, which 
is equal to $1,500x (the value of the portion of the general category 
stock of CFC1 that was not assigned to the section 951A category in 
paragraph (c)(1)(ii)(B) of this section (Step 2)) plus $5,625x (the 
value of the portion of the stock of CFC1 assigned to the specified 
foreign source general category gross income statutory grouping). Under 
paragraph (a)(5)(v) of this section, the remainder of the general 
category stock of CFC1, $6,875x, is assigned to the non-section 245A 
subgroup of general category stock.
    (2) Passive category stock. No portion of the passive category stock 
of CFC1 is in the foreign source gross tested income statutory grouping 
or the specified foreign source passive category gross income statutory 
grouping. Accordingly, under paragraph (a)(5)(iii) of this section, no 
value of the portion of the stock of CFC1 is assigned to the section 
245A subgroup of passive category stock. Under paragraph (a)(5)(v) of 
this section, the passive category stock of CFC1, $2,500x is assigned to 
the non-section 245A subgroup of passive category stock.
    (3) Section 951A category stock. Under paragraph (a)(5)(v) of this 
section, all of the section 951A category stock, $3,500x, is assigned to 
the non-section 245A subgroup of section 951A category stock.
    (F) Summary. For purpose of the allocation and apportionment of 
expenses, $14,000x of the stock of CFC1 is characterized as general 
category stock, $7,125x of which is in the section 245A subgroup and 
$6,875x of which is in the non-section 245A subgroup; $2,500x of the 
stock of CFC1 is characterized as passive category stock, all of which 
is in the non-section 245A subgroup; and $3,500x of the stock of CFC1 is 
characterized as section 951A category stock, all of which is in the 
non-section 245A subgroup.
    (2) Example 2: Asset method with noncontrolled 10-percent owned 
foreign corporation--(i) Facts. The facts are the same as in paragraph 
(c)(1)(i) of this section (the facts in Example 1), except that CFC1 
does not own CFC2 and instead owns 20% of the stock of FC2, a foreign 
corporation that is a noncontrolled 10-percent owned foreign 
corporation. The tax book value of CFC1's stock in FC2 is $6,000x. FC2 
owns assets with the following values as determined under Sec. Sec.  
1.861-9(g)(2) and 1.861-9T(g)(3): Assets that generate specified foreign 
source general category gross income ($3,000x). All of the assets of FC2 
generate income that, if distributed to CFC1 as a dividend, would be 
foreign source gross subpart F income in the general category to CFC1.
    (ii) Analysis--(A) Step 1--(1) Characterization of FC2 stock. All of 
the assets of FC2 generate income that, if distributed to CFC1, would be 
foreign source gross subpart F income in the general category to CFC1. 
Accordingly, under paragraph (a)(1)(i) of this section, all of CFC1's 
stock in FC2 ($6,000x) is characterized as in the foreign source gross

[[Page 250]]

subpart F income statutory grouping within the general category.
    (2) Characterization of CFC1 stock. CFC1 has total assets of 
$16,000x, $4,000x of which are in the foreign source gross tested income 
statutory grouping within the general category, $7,000x of which are in 
the foreign source gross subpart F income statutory grouping within the 
general category (including the FC2 stock assigned to that statutory 
grouping), $3,000x of which are in the specified foreign source general 
category gross income statutory grouping, and $2,000x of which are in 
the foreign source gross subpart F income statutory grouping within the 
passive category. Accordingly, CFC1's stock is characterized as $5,000x 
($4,000x/$16,000x x $20,000x) in the foreign source gross tested income 
statutory grouping within the general category, $8,750x ($7,000x/
$16,000x x $20,000x) in the foreign source gross subpart F income 
statutory grouping within the general category, $3,750x ($3,000x/
$16,000x x $20,000x) in the specified foreign source general category 
gross income statutory grouping, and $2,500x ($2,000x/$16,000x x 
$20,000x) in the foreign source gross subpart F income statutory 
grouping within the passive category.
    (B) Step 2. The analysis is the same as in paragraph (c)(1)(ii)(B) 
of this section (the analysis of Step 2 in Example 1).
    (C) Step 3. The analysis is the same as in paragraph (c)(1)(ii)(C) 
of this section (the analysis of Step 3 in Example 1).
    (D) Step 4--(1) General category stock. The total value of the 
portion of the stock of CFC1 that is general category stock is $14,000x, 
which is equal to $1,500x (the value of the portion of the general 
category stock of CFC1 that was not assigned to the section 951A 
category in paragraph (c)(2)(ii)(B) of this section (Step 2)) plus 
$3,750x (the value of the portion of the stock of CFC1 assigned to the 
specified foreign source gross income statutory grouping within the 
general category general category) plus $8,750x (the value of the 
portion of the stock of CFC1 assigned to the foreign source gross 
subpart F income statutory grouping within the general category).
    (2) Passive category stock. The analysis is the same as in paragraph 
(c)(1)(ii)(D)(2) of this section (the analysis of Step 4 in Example 1).
    (E) Step 5--(1) General category stock. Under paragraph (a)(5)(ii) 
of this section, the value of the stock of CFC1 assigned to the section 
245A subgroup of general category stock is $5,250x, which is equal to 
$1,500x (the value of the portion of the general category stock of CFC1 
that was not assigned to the section 951A category in paragraph 
(c)(2)(ii)(B) of this section (Step 2)) plus $3,750x (the value of the 
portion of the stock of CFC1 assigned to the specified foreign source 
general category gross income statutory grouping). Under paragraph 
(a)(5)(v) of this section, the remainder of the general category stock 
of CFC1, $8,750x, is assigned to the non-section 245A subgroup of 
general category stock.
    (2) Passive category stock. The analysis is the same as in paragraph 
(c)(1)(ii)(E)(2) of this section (the analysis of Step 5 in Example 1).
    (3) Section 951A category stock. The analysis is the same as in 
paragraph (c)(1)(ii)(E)(3) of this section (the analysis of Step 5 in 
Example 1).
    (F) Summary. For purpose of the allocation and apportionment of 
expenses, $14,000x of the stock of CFC1 is characterized as general 
category stock, $5,250x of which is in the section 245A subgroup and 
$8,750x of which is in the non-section 245A subgroup; $2,500x of the 
stock of CFC1 is characterized as passive category stock, all of which 
is in the non-section 245A subgroup; and $3,500x of the stock of CFC1 is 
characterized as section 951A category stock, all of which is in the 
non-section 245A subgroup.
    (3) Example 3: Modified gross income method--(i) Facts--(A) USP, a 
domestic corporation, directly owns all of the stock of a controlled 
foreign corporation, CFC1. The tax book value of CFC1's stock is 
$100,000x. CFC1 owns all of the stock of CFC2, a controlled foreign 
corporation. USP uses the modified gross income method described in 
Sec.  1.861-12(c)(3)(iii) to characterize the stock in CFC1. USP's 
inclusion percentage is 100%.
    (B) CFC1 earns $1,500x of foreign source gross tested income within 
the general category and $500x of foreign source gross subpart F income 
within

[[Page 251]]

the passive category. CFC1 incurs $1,000x of interest expense.
    (C) CFC2 earns $3,000x of foreign source gross tested income within 
the general category, $2,000x of foreign source gross subpart F income 
within the general category, and $1,000x of specified foreign source 
general category gross income. CFC2 incurs $3,000x of interest expense.
    (ii) Analysis--(A) Step 1--(1) Determination of CFC2 gross income 
(net of interest expense). CFC2 has total gross income of $6,000x. 
CFC2's $3,000x of interest expense is apportioned among the statutory 
groupings of gross income based on the gross income of CFC2 to determine 
the gross income (net of interest expense) of CFC2 in each statutory 
grouping. As a result, $1,500x ($3,000x/$6,000x x $3,000x) of interest 
expense is apportioned to foreign source gross tested income within the 
general category, $1,000x ($2,000x/$6,000x x $3,000x) of interest 
expense is apportioned to foreign source gross subpart F income within 
the general category, and $500x ($1,000x/$6,000x x $3,000x) of interest 
expense is apportioned to specified foreign source general category 
gross income. Accordingly, CFC2 has the following amounts of gross 
income (net of interest expense): $1,500x ($3,000x - $1,500x) of foreign 
source gross tested income within the general category, $1,000x ($2,000x 
- $1,000x) of foreign source gross subpart F income within the general 
category, and $500x ($1,000x - $500x) of specified foreign source 
general category gross income.
    (2) Determination of CFC1 gross income (net of interest expense). 
Before including the gross income consisting of subpart F income (net of 
interest expense) of CFC2, CFC1 has total gross income of $4,000x, 
including $1500x of CFC2's foreign source gross tested income within the 
general category and $500x of CFC2's specified foreign source general 
category gross income which are combined with CFC1's items of gross 
income under Sec.  1.861-9(j)(2)(ii). CFC1's $1,000x of interest expense 
is apportioned among the statutory groupings of gross income of CFC1 to 
determine the gross income (net of interest expense) of CFC1 in each 
statutory grouping. As a result, $750x ($3,000x/$4,000x x $1,000x) of 
interest expense is apportioned to foreign source gross tested income 
within the general category, $125x ($500x/$4,000 x $1,000x) to foreign 
source gross subpart F income within the passive category, and $125x 
($500x/$4,000x x $1,000x) to specified foreign source general category 
gross income. Accordingly, CFC1 has the following amounts of gross 
income (net of interest expense) before including the gross income 
consisting of subpart F income (net of interest expense) of CFC2: 
$2,250x ($3,000x - $750x) of foreign source gross tested income within 
the general category, $375x ($500x - $125x) of foreign source gross 
subpart F income within the passive category, and $375x ($500 - $125x) 
of specified foreign source general category gross income. After 
including the gross income consisting of subpart F income (net of 
interest expense) of CFC2, CFC1 has the following amounts of gross 
income (net of interest expense): $2,250x of foreign source gross tested 
income within the general category, $1,000x of foreign source gross 
subpart F income within the general category, $375x of specified foreign 
source general category gross income, and $375x of foreign source gross 
subpart F income within the passive category.
    (3) Characterization of CFC1 stock. CFC1 is considered to have a 
total of $4,000x of gross income (net of interest expense) for purposes 
of characterizing the stock of CFC1. Accordingly, CFC1's stock is 
characterized as $56,250x ($2,250x/$4,000x x $100,000x) in the foreign 
source gross tested income statutory grouping within the general 
category, $25,000x ($1,000x/$4,000x x $100,000x) in the foreign source 
gross subpart F income statutory grouping within the general category, 
$9,375x ($375x/$4,000x x $100,000x) in the specified foreign source 
general category gross income statutory grouping, and $9,375x ($375x/
$4,000x x $100,000x) in the foreign source gross subpart F income 
statutory grouping within the passive category.
    (B) Step 2. The value of the portion of the stock of CFC1 that is 
general category gross tested income stock is $56,250x. USP's inclusion 
percentage is 100%. Accordingly, under paragraph (a)(2) of this section, 
all of the $56,250x of the stock of CFC1 is assigned to the

[[Page 252]]

section 951A category and a portion thereof may be treated as an exempt 
asset under Sec.  1.861-8(d)(2)(ii)(C)(2)(ii).
    (C) Step 3. No portion of the stock of CFC1 is resourced gross 
tested income or assigned to the resourced gross subpart F income 
statutory group in any treaty category. Accordingly, no portion of the 
stock of CFC1 is assigned to a treaty category under paragraph (a)(3) of 
this section.
    (D) Step 4--(1) General category stock. The total value of the 
portion of the stock of CFC1 that is general category stock is $34,375x, 
which is equal to $25,000x (the value of the portion of the stock of 
CFC1 assigned to the subpart F income statutory grouping within the 
general category income statutory grouping) plus $9,375x (the value of 
the portion of the stock of CFC1 assigned to the specified foreign 
source general category gross income statutory grouping).
    (2) Passive category stock. The total value of the portion of the 
stock of CFC1 that is passive category stock is $9,375x.
    (3) U.S. source category stock. No value of the portion of the stock 
of CFC1 is U.S. source category stock.
    (E) Step 5--(1) General category stock. All of the value of the 
general category gross tested income stock of CFC1 was assigned to the 
section 951A category in paragraph (c)(3)(ii)(B) of this section (Step 
2). Accordingly, under paragraph (a)(5)(ii) of this section, the value 
of the stock of CFC1 assigned to the section 245A subgroup of general 
category stock is $9,375x, which is equal to the value of the portion 
assigned to the specified foreign source general category gross income 
statutory grouping. Under paragraph (a)(5)(v) of this section, the 
remainder of the general category stock of CFC1, $25,000x, is assigned 
to the non-section 245A subgroup of general category stock.
    (2) Passive category stock. No portion of the passive category stock 
of CFC1 is in the foreign source gross tested income statutory grouping 
or the specified foreign source passive category gross income statutory 
grouping. Accordingly, under paragraph (a)(5)(iii) of this section, no 
value of the portion of the stock of CFC1 is assigned to the section 
245A subgroup. Under paragraph (a)(5)(v) of this section, the passive 
category stock of CFC1, $9,375x, is assigned to the non-section 245A 
subgroup of passive category stock.
    (3) Section 951A category stock. Under paragraph (a)(5)(v) of this 
section, all of the section 951A category stock, $56,250x, is assigned 
to the non-section 245A subgroup of section 951A category stock.
    (F) Summary. For purposes of the allocation and apportionment of 
expenses, $56,250x of the stock of CFC1 is characterized as section 951A 
category stock, all of which is in the non-section 245A subgroup; 
$34,375x of the stock of CFC1 is characterized as general category 
stock, $9,375x of which is in the section 245A subgroup and $25,000x of 
which is in the non-section 245A subgroup; and $9,375x of the stock of 
CFC1 is characterized as passive category stock, all of which is in the 
non-section 245A subgroup.
    (d) Applicability dates. This section applies for taxable years that 
both begin after December 31, 2017, and end on or after December 4, 
2018.

[T.D. 9882, 84 FR 69070, Dec. 17, 2019]



Sec.  1.861-14  Special rules for allocating and apportioning certain expenses 
(other than interest expense) of an affiliated group of corporations.

    (a)-(c) [Reserved]. For further guidance, see Sec.  1.861-14T(a) 
through (c).
    (d) Definition of affiliated group--(1) General rule. For purposes 
of this section, the term affiliated group has the same meaning as is 
given that term by section 1504. Section 1504(a) defines an affiliated 
group as one or more chains of includible corporations connected through 
80-percent stock ownership with a common parent corporation which is an 
includible corporation (as defined in section 1504(b)). In the case of a 
corporation that either becomes or ceases to be a member of the group 
during the course of the corporation's taxable year, only the expenses 
incurred by the group member during the period of membership shall be 
allocated and apportioned as if all members of the group were a single 
corporation. In this regard, the apportionment factor chosen shall 
relate only to the period of membership. For example, if apportionment 
on the basis of assets is

[[Page 253]]

chosen, the average amount of assets (tax book value or fair market 
value) for the taxable year shall be multiplied by a fraction, the 
numerator of which is the number of months of the corporation's taxable 
year during which the corporation was a member of the affiliated group, 
and the denominator of which is the number of months within the 
corporation's taxable year. If apportionment on the basis of gross 
income is chosen, only gross income generated during the period of 
membership shall be taken into account. If apportionment on the basis of 
units sold or sales receipts is chosen, only units sold or sales 
receipts during the period of membership shall be taken into account. 
Expenses incurred by the group member during its taxable year, but not 
during the period of membership, shall be allocated and apportioned 
without regard to other members of the group.
    (2) [Reserved]
    (3) Inclusion of financial corporations. For further guidance, see 
Sec.  1.861-14T(d)(3) through (4).
    (4) [Reserved]
    (e) Expenses to be allocated and apportioned under this section--(1) 
Expenses not directly allocable to specific income-producing activities 
or property. (i) The expenses that are required to be allocated and 
apportioned under the rules of this section are expenses that are not 
directly allocable to specific income-producing activities or property 
solely of the member of the affiliated group that incurred the expense, 
including (but not limited to) certain expenses related to research and 
experimental expenses, supportive functions, deductions under section 
250, legal and accounting expenses, and litigation damages awards, 
prejudgment interest, and settlement payments. Interest expense of 
members of an affiliated group of corporations is allocated and 
apportioned under Sec.  1.861-11T and not under the rules of this 
section. Expenses that are included in inventory costs or that are 
capitalized are not subject to allocation and apportionment under the 
rules of this section. In addition, stewardship expenses are not subject 
to allocation and apportionment under the rules of this section; 
instead, stewardship expenses of a taxpayer are allocated and 
apportioned on a separate entity basis without treating members of the 
affiliated group as a single taxpayer. See Sec.  1.861-8(e)(4)(ii)(A).
    (ii) For further guidance, see Sec.  1.861-14T(e)(1)(ii).
    (2) Research and experimental expenditures. R&E expenditures (as 
defined in Sec.  1.861-17(a)) in the case of an affiliated group are 
allocated and apportioned under the rules of Sec.  1.861-17 as if all 
members of the affiliated group were a single taxpayer. Thus, R&E 
expenditures are allocated to all gross intangible income of all members 
of the affiliated group reasonably connected with the relevant broad SIC 
code category. If fewer than all members of the affiliated group derive 
gross intangible income reasonably connected with that relevant broad 
SIC code category, then such expenditures are apportioned under the 
rules of this paragraph (e)(2) only among those members, as if those 
members were a single taxpayer.
    (3) Expenses related to supportive functions. For further guidance, 
see Sec.  1.861-14T(e)(3).
    (4) Section 250 deduction. Except as provided in this paragraph 
(e)(4), the deduction allowed under section 250(a) (the section 250 
deduction) to a member of an affiliated group is allocated and 
apportioned on a separate entity basis under the rules of Sec.  1.861-
8(e)(13) and (14). However, the section 250 deduction of a member of a 
consolidated group is not directly allocable to specific income-
producing activities or property solely of the member of the affiliated 
group that is allowed the deduction. See Sec.  1.1502-50 for rules on 
applying section 250 and Sec. Sec.  1.250-1 through 1.250(b)-6 to a 
member of a consolidated group. In such case, the section 250 deduction 
is allocated and apportioned as if all members of the consolidated group 
are treated as a single corporation.
    (5) Legal and accounting fees and expenses; damages awards, 
prejudgment interest, and settlement payments. Legal and accounting fees 
and expenses, as well as litigation or arbitral damages awards, 
prejudgment interest, and settlement payments, are allocated and 
apportioned under the rules of Sec.  1.861-8(e)(5). To the extent that 
under Sec.  1.861-14T(c)(2) and (e)(1)(ii) such expenses are

[[Page 254]]

not directly allocable to specific income-producing activities or 
property of one or more members of the affiliated group, such expenses 
must be allocated and apportioned as if all members of the affiliated 
group were a single corporation. Specifically, such expenses must be 
allocated to a class of gross income that takes into account the gross 
income which is generated, has been generated, or is reasonably expected 
to be generated by the other members of the affiliated group. If the 
expenses relate to the gross income of fewer than all members of the 
affiliated group as determined under Sec.  1.861-14T(c)(2), then those 
expenses must be apportioned under the rules of Sec.  1.861-14T(c)(2), 
as if those fewer members were a single corporation. Such expenses must 
be apportioned taking into account the apportionment factors contributed 
by the members of the group that are treated as a single corporation.
    (6) Charitable contribution expenses. A deduction for a charitable 
contribution by a member of an affiliated group shall be allocated and 
apportioned under the rules of Sec. Sec.  1.861-8(e)(12) and 1.861-
14T(c)(1).
    (f) Computation of FSC or DISC combined taxable income. For further 
guidance, see Sec.  1.861-14T(f) and (g).
    (g) [Reserved]
    (h) Special rule for the allocation and apportionment of section 
818(f)(1) items of a life insurance company--(1) In general. Except as 
provided in paragraph (h)(2) of this section, life insurance company 
items specified in section 818(f)(1) (``section 818(f)(1) items'') are 
allocated and apportioned as if all members of the life subgroup (as 
defined in Sec.  1.1502-47(b)(8)) were a single corporation (``life 
subgroup method''). See also Sec.  1.861-8(e)(16) for rules on the 
allocation of reserve expenses with respect to dividends received by a 
life insurance company.
    (2) Alternative separate entity treatment. A consolidated group may 
choose not to apply the life subgroup method and may instead allocate 
and apportion section 818(f)(1) items solely among items of the life 
insurance company that generated the section 818(f)(1) items (``separate 
entity method''). A consolidated group indicates its choice to apply the 
separate entity method by applying this paragraph (h)(2) for purposes of 
the allocation and apportionment of section 818(f)(1) items on its 
Federal income tax return filed for its first taxable year to which this 
section applies. A consolidated group's use of the separate entity 
method constitutes a binding choice to use the method chosen for that 
year for all members of the consolidated group and all taxable years of 
such members thereafter. The choice to use the separate entity method 
may not be revoked without the prior consent of the Commissioner.
    (i)-(j) [Reserved]
    (k) Applicability dates. Except as provided in this paragraph (k), 
this section applies to taxable years beginning after December 31, 2019. 
Paragraph (h) of this section applies to taxable years beginning on or 
after December 28, 2021.

[T.D. 8916, 66 FR 274, Jan. 3, 2001, as amended by T.D. 9211, 70 FR 
40663, July 14, 2005; T.D. 9882, 84 FR 69074, Dec. 17, 2019; T.D. 9922, 
85 FR 72041, Nov. 12, 2020; T.D. 9959, 87 FR 326, Jan. 4, 2022]



Sec.  1.861-14T  Special rules for allocating and apportioning certain expenses 
(other than interest expense) of an affiliated group of corporations 
          (temporary).

    (a) In general. Section 1.861-11T provides special rules for 
allocating and apportioning interest expense of an affiliated group of 
corporations. The rules of this Sec.  1.861-14T also relate to 
affiliated groups of corporations and implement section 864(e)(6), which 
requires affiliated group allocation and apportionment of expenses other 
than interest which are not directly allocable and apportionable to any 
specific income producing activity or property. In general, the rules of 
this section apply to taxable years beginning after December 31, 1986. 
Paragraph (b) of this section describes the scope of the application of 
the rule for the allocation and apportionment of such expenses of 
affiliated groups of corporations. Such rule is then set forth in 
paragraph (c) of this section. Paragraph (d) of this section contains 
the definition of the term ``affiliated group'' for purposes of this 
section. Paragraph (e) of this section describes the expenses subject to 
allocation and apportionment under the rules of this section. Paragraph 
(f)

[[Page 255]]

of this section provides rules concerning the affiliated group 
allocation and apportionment of such expenses in computing the combined 
taxable income of a FSC or DISC and its related supplier. Paragraph (g) 
of this section describes the treatment of losses caused by 
apportionment of such expenses in the case of an affiliated group that 
does not file a consolidated return. Paragraph (h) of this section 
provides rules concerning the treatment of the reserve expenses of a 
life insurance company. Paragraph (j) of this section provides examples 
illustrating the application of this section.
    (b) Scope--(1) Application of section 864(e)(6). Section 864(e)(6) 
and this section apply to the computation of taxable income for purposes 
of computing separate limitations on the foreign tax credit under 
section 904. Section 864(e)(6) and this section also apply in connection 
with section 907 to determine reductions in the amount allowed as a 
foreign tax credit under section 901. Section 864(e)(6) and this section 
also apply to the computation of the combined taxable income of the 
related supplier and a foreign sales corporation (FSC) (under sections 
921 through 927) as well as the combined taxable income of the related 
supplier and a domestic international sales corporation (DISC) (under 
sections 991 through 997).
    (2) Nonapplication of section 864(e)(6). Section 864(e)(6) and this 
section do not apply to the computation of subpart F income of 
controlled foreign corporations (under sections 951 through 964) or the 
computation of effectively connected taxable income of foreign 
corporations.
    (3) Application of section 864(e)(6) to the computation of combined 
taxable income of a possessions corporation and its affiliates. 
[Reserved]
    (c) General rule for affiliated corporations--(1) General rule. (i) 
Except as otherwise provided in paragraph (c)(2) of this section, the 
taxable income of each member of an affiliated group within each 
statutory grouping shall be determined by allocating and apportioning 
the expenses described in paragraph (e) of this section of each member 
according to apportionment fractions which are computed as if all 
members of such group were a single corporation. For purposes of 
determining these apportionment fractions, any interaffiliate 
transactions or property that are duplicative with respect to the 
measure of apportionment chosen shall be eliminated. For example, in the 
application of an asset method of apportionment, stock in affiliated 
corporations shall not be taken into account, and loans between members 
of an affiliated group shall be treated in accordance with the rules of 
Sec.  1.861-11T(e). Similarly, in the application of a gross income 
method of apportionment, interaffiliate dividends and interest, gross 
income from sales or services, and other interaffiliate gross income 
shall be eliminated. Likewise, in the application of a method of 
apportionment based on units sold or sales receipts, interaffiliate 
sales shall be eliminated.
    (ii) Except as otherwise provided in this section, the rules of 
Sec.  1.861-8T apply to the allocation and apportionment of the expenses 
described in paragraph (e) of this section. Thus, allocation under this 
paragraph (c) is accomplished by determining, with respect to each 
expense described in paragraph (e), the class of gross income to which 
the expense is definitely related and then allocating the deduction to 
such class of gross income. For this purpose, the gross income of all 
members of the affiliated group must be taken in account. Then, the 
expense is apportioned by attributing the expense to gross income 
(within the class to which the expense has been allocated) which is in 
the statutory grouping and to gross income (within the class) which is 
in the residual grouping. Section 1.861-8T(c)(1) identifies a number of 
factors upon which apportionment may be based, such as comparison of 
units sold, gross sales or receipts, assets used, or gross income. The 
apportionment method chosen must be applied consistently by each member 
of the affiliated group in apportioning the expense when more than one 
member incurred the expense or when members incurred separate portions 
of the expense. The apportionment fraction must take into account the 
apportionment factors contributed by all members of the affiliated 
group. In the case of an affiliated group of corporations

[[Page 256]]

that files a consolidated return, consolidated foreign tax credit 
limitations are computed for the group in accordance with the rules of 
Sec.  1.1502-4. For purposes of this section the term ``taxpayer'' 
refers to the affiliated group (regardless of whether the group files a 
consolidated return), rather than to the separate members thereof.
    (2) Expenses relating to fewer than all members. An expense relates 
to fewer than all members of an affiliated group if the expense is 
allocable under paragraph (e)(1) of this section to gross income of at 
least one member other than the member that incurred the expense but 
fewer than all members of the affiliated group. The taxable income of 
the member that incurred the expense shall be determined by apportioning 
that expense under the rules of paragraph (c)(1) of this section as if 
the members of the affiliated group that derive gross income to which 
such expense is allocable under paragraph (e)(1) were treated as a 
single corporation.
    (3) Prior application of section 482. The rules of this section do 
not supersede the application of section 482 and the regulations 
thereunder. Section 482 may be applied effectively to deny a deduction 
for an expense to one member of an affiliated group and to allow a 
deduction for that expense to another member of the affiliated group. In 
cases to which section 482 is applied, expenses shall be reallocated and 
reapportioned under section 864(e)(6) and this section after taking into 
account the application of section 482.
    (d)(1)-(2) [Reserved]. For further guidance, see Sec.  1.861-
14(d)(1) and (2).
    (e) Expenses to be allocated and apportioned under this section. (1) 
Expenses not directly traceable to specific income producing activities 
or property. (i) For further guidance, see Sec.  1.861-14(e)(1)(i).
    (ii) An item of expense is not considered to be directly allocable 
to specific income producing activities or property solely of the member 
incurring the expense if, were all members of the affiliated group 
treated as a single corporation, the expense would not be considered 
definitely related, within the meaning of Sec.  1.861-8T(b)(2), only to 
a class of gross income derived solely by the member which actually 
incurred the expense. Furthermore, the expense is presumed not to be 
definitely related only to a class of gross income derived solely by the 
member incurring the expense (and is, therefore, presumed not to be 
directly allocable to specific income producing activities or property 
of that member) unless the taxpayer is able affirmatively to establish 
otherwise. As provided in paragraph (c)(1) of this section, expenses 
described in this paragraph (e)(1) generally shall be apportioned by the 
member incurring the expense according to apportionment fractions 
computed as if all members of the affiliated group were a single 
corporation. Under paragraph (c)(2) of this section, however, an expense 
shall be apportioned according to apportionment fractions computed as if 
only some (but fewer than all) members of the affiliated group were a 
single corporation, if the expense is considered allocable to gross 
income of at least one member other than the member incurring the 
expense but fewer than all members of the affiliated group. An item of 
expense shall be considered to be allocable to gross income of fewer 
than all members of the group if, were all members of the affiliated 
group treated as a single corporation, the expense would not be 
considered definitely related within the meaning of Sec.  1.861-8T(b)(2) 
to gross income derived by all members of the group. In such case, the 
expense shall be considered allocable, for purposes of paragraph (c)(2) 
of this section, to gross income of those members of the group that 
generated (or could reasonably be expected to generate) the gross income 
to which the expense would be considered definitely related if the group 
were treated as a single corporation.
    (2) Research and experimental expenses. (i) For further guidance, 
see Sec.  1.861-14(e)(2)(i) and (ii).
    (ii) [Reserved]
    (3) Expenses related to supportive functions. Expenses which are 
supportive in nature (such as overhead, general and administrative, 
supervisory expenses, advertising, marketing, and other sales expenses) 
are to be allocated and apportioned in accordance with the rules of 
Sec.  1.861-8T(b)(3). To the extent that such expenses are not directly 
allocable under paragraph (e)(1)(ii) of this

[[Page 257]]

section to specific income producing activities or property of the 
member of the affiliated group that incurred the expense, such expenses 
must be allocated and apportioned as if all members of the affiliated 
group were a single corporation in accordance with the rules of 
paragraph (c) of this section. Specifically, such expenses must be 
allocated to a class of gross income that take into account gross income 
that is generated, has been generated, or could reasonably have been 
expected to have been generated by the members of the affiliated group. 
If the expenses relate to the gross income of fewer than all members of 
the affiliated group as determined under paragraph (c)(2) of this 
section, then those expenses must be apportioned under the rules of 
paragraph (c)(2) of this section, as if those fewer members were a 
single corporation. See Example (3) of paragraph (j) of this section. 
Such expenses must be apportioned between statutory and residual 
groupings of income within the appropriate class of gross income by 
reference to the apportionment factors contributed by the members of the 
affiliated group that are treated as a single corporation.
    (4) Section 250 deduction. For further guidance, see Sec.  1.861-
14(e)(4).
    (5) Legal and accounting fees and expenses; damages awards, 
prejudgment interest, and settlement payments. For further guidance, see 
Sec.  1.861-14(e)(5).
    (f) Computation of FSC or DISC combined taxable income. In the 
computation under the pricing rules of sections 925 and 994 of the 
combined taxable income of any FSC or DISC and its related supplier 
which are members of an affiliated group, the combined taxable income of 
such FSC or DISC and its related supplier shall be reduced by the 
portion of the expenses of the affiliated group described in paragraph 
(e) of this section that is incurred in connection with export sales 
involving that FSC or DISC. In order to determine the portion of the 
expenses of the affiliated group that is incurred in connection with 
export sales by or through a FSC or DISC, the portion of the total of 
the apportionment factor chosen that relates to the generation of that 
export income must be determined. Thus, if gross income is the 
apportionment factor chosen, the portion of total gross income of the 
affiliated group that consists of combined gross income derived from 
transactions involving the FSC or DISC and related supplier must be 
determined. Similarly, if units sold or sales receipts is the 
apportionment factor chosen, the portion of total units sold or sales 
receipts that generated export income of the FSC or DISC and related 
supplier must be determined. The amount of the expense shall then be 
multiplied by a fraction, the numerator of which is the export related 
apportionment factor as determined above, and the denominator of which 
is the total apportionment factor. Thus, if gross income is the 
apportionment factor chosen, apportionment is based on a fraction, the 
numerator of which is export related combined gross income of the FSC or 
DISC and related supplier and the denominator of which is the total 
gross income of the affiliated group. Similarly, if units sold or sales 
receipts is the apportionment factor chosen, the fraction is the units 
sold or sales receipts that generated export income of the FSC or DISC 
and related supplier over the total units sold or sales receipts of the 
affiliated group. Under this rule, expenses of other group members may 
be attributed to the combined gross income of a FSC of DISC and its 
related supplier without affecting the amount of expenses (other than 
any commission payable by the related supplier to the FSC or DISC) 
otherwise deductible by the FSC or DISC, the related supplier, or other 
members of the affiliated group. The FSC or DISC must calculate combined 
taxable income, taking into account any reduction by expenses attributed 
from other members of the affiliated group to determine the commission 
derived by the FSC or DISC or the transfer price of qualifying export 
property sold to the FSC or DISC.
    (g) Losses created through apportionment. In the case of an 
affiliated group

[[Page 258]]

that does not file a consolidated return, the taxable income in any 
separate limitation category must be adjusted under this paragraph (g) 
for purposes of computing the separate foreign tax credit limitations 
under section 904(d). As a consequence of the affiliated group 
allocation and apportionment of expenses required by section 864(e)(6) 
and this section, expenses of a group member may be apportioned for 
section 904 purposes to a limitation category with a consequent loss in 
that limitation category. For purposes of this paragraph, the term 
``limitation category'' includes domestic source income, as well as the 
types of income described in section 904(d)(1) (A) through (I). A loss 
of one affiliate in a limitation category will reduce the income of 
another member in the same limitation category if a consolidated return 
is filed. (See Sec.  1.1502-4.) If a consolidated return is not filed, 
this netting does not occur. Accordingly, in such a case, the following 
adjustments among members are required, in order to give effect to the 
group allocation of expense:
    (1) Losses created through group apportionment of expense in one or 
more limitation categories within a given member must be eliminated; and
    (2) A corresponding amount of income of other members in the same 
limitation category must be recharacterized.


Such adjustments shall be accomplished in accordance with the rules of 
Sec.  1.861-11T(g).
    (h) Special rule for allocation of reserve expenses of life 
insurance companies. For further guidance, see Sec.  1.861-14(h).
    (i) [Reserved]
    (j) Examples. The rules of this section may be illustrated by the 
following examples. All of these examples assume that section 482 has 
not been applied by the Commissioner.
    \1\ Examples 1 and 4 of this paragraph (j) apply to taxable years 
beginning before January 1, 2018.

    Example 1: (i) Facts. P owns all of the stock of X and all of the 
stock of Y. P, X and Y are domestic corporations. P is a holding company 
for the stock of X and Y. Both X and Y manufacture and sell a product 
which is included in a broad product category listed in Sec.  1.861-
8(e)(3)(i). During 1988, X incurred $100,000 on research connected with 
that product. All of the research was performed in the United States. In 
1988, the domestic sales by X of the product totalled $400,000 and the 
foreign sales of the product totalled $200,000; Y's domestic sales of 
the product totalled $200,000 and Y's foreign sales of the product 
totalled $200,000. In 1988, X's gross income is $300,000, of which 
$200,000 is from domestic sales and $100,000 is from foreign sales; Y's 
gross income is $200,000 of which $100,000 is from domestic sales and 
$100,000 is from foreign sales.
    (ii) P, X and Y are affiliated corporations within the meaning of 
section 864(e)(5) and this section. The research expenses incurred by X 
are allocable to all income connected with the relevant broad category 
listed in Sec.  1.861-8T(e)(3)(i). Both X and Y have gross income 
includible within the class of gross income related to that product 
category. Accordingly, the research and experimental expenses incurred 
by X are to be allocated and apportioned as if X and Y were a single 
corporation. The apportionment for 1988 is as follows:

              Tentative Apportionment on the Basis of Sales

Research expenses to be apportioned.............................$100,000
Exclusive apportionment to United States source gross income.....$30,000
Research expense to be apportioned on the basis of sales.........$70,000

Apportionment of research expense to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.018


Apportionment of research expense to United States source gross income:

[[Page 259]]

[GRAPHIC] [TIFF OMITTED] TC07OC91.019

Total apportioned deduction for research........................$100,000

Of which--

Apportioned to foreign source gross income.......................$28,000
Apportioned to U.S. source gross income ($30,000 + $42,000)......$72,000

          Tentative Apportionment on the Basis of Gross Income

Research expense apportioned to foreign source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.020

Research expense apportioned to United States income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.021

    Example 2: (i) Facts. P owns all of the stock of X, which owns all 
of the stock of Y. P, X and Y are all domestic corporations. P has 
incurred general training program expenses of $100,000 in 1987. 
Employees of P, X and Y participate in the training program. In 1987, P 
had United States source gross income of $200,000 and foreign source 
general limitation income of $200,000; X had U.S. source gross income of 
$100,000 and foreign source general limitation income of $100,000; and Y 
had U.S. source gross income of $300,000 and foreign source general 
limitation income of $100,000.
    (ii) Analysis. P, X and Y are an affiliated group of corporations 
within the meaning of section 864(e)(5). The training expenses incurred 
by P are not definitely related solely to specific income producing 
activities or property of P. The employees of X and Y also participate 
in the training program. Thus, this expense relates to gross income 
generated by P, X and Y. This expense is definitely related and 
allocable to all of the gross income from foreign and domestic sources 
of P, X and Y. It is assumed that apportionment on the basis of gross 
income is reasonable. The apportionment of the expense is as follows:

Apportionment of $100,000 expense to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.022


Apportionment of $100,000 expense to United States source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.023


[[Page 260]]


Total apportioned expense.......................................$100,000
    Example 3: (i) Facts. The facts are the same as in Example (2) 
above, except that only employees of P and X participate in the training 
program.
    (ii) Analysis. Because only the employees of P and X participate in 
the training program and they perform no services for Y, the expense 
relates only to gross income generated by P and X. Accordingly, the 
$100,000 expense must be allocated and apportioned as if P and X were a 
single corporation. The apportionment of the $100,000 expense is as 
follows:

Apportionment of $100,000 expense to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.024


Apportionment of $100,000 expense to U.S. source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.025

    Example 4: (i) Facts. P owns all of the stock of X which owns all of 
the stock of Y. P and X are domestic corporations; Y is a foreign 
corporation. In 1987 P incurred $10,000 of stewardship expenses relating 
to an audit of Y.
    (ii) Analysis. The stewardship expenses incurred by P are not 
directly allocable to specific income producing activities or property 
of P. The expense is definitely related and allocable to dividends 
received or to be received by X. Accordingly, the expense of P is 
allocated and apportioned as if P and X were a single corporation. The 
expense is definitely related to dividends received or to be received by 
X from Y, a foreign corporation. Such dividends are foreign source 
general limitation income. Thus, the entire amount of the expense must 
be allocated to foreign source dividend income.
    Example 5: (i) Facts. P owns all of the stock of X which owns all of 
the stock of Y. P, X and Y are all domestic corporations. In 1987, P 
incurred $10,000 legal expense relating to the testimony of certain 
employees of P in connection with litigation to which Y is a party. This 
expense is not allocable to specific income of Y. In 1987, Y had 
$100,000 foreign source general limitation income and $300,000 U.S. 
source gross income.
    (ii) Analysis. The legal expenses incurred by P are not definitely 
related solely to specific income producing activities or property of P. 
The expense is definitely related and allocable to the class of gross 
income which includes only gross income generated by Y. Accordingly, the 
expense of P is allocated and apportioned as if Y were the only member 
of the affiliated group, as follows:

Apportionment of legal expenses to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.026

Apportionment of legal expenses to U.S. source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.027

    Example 6: (i) Facts. P owns all of the stock of R, which owns all 
of the stock of F. P and R are domestic corporations, and F is a foreign 
sales corporation under section 922 of the Code. R and F have entered 
into an agreement whereby F is paid a commission with respect to sales 
of product A. In 1987, P had gross receipts of $1,000,000 from domestic 
sales of product A, and gross receipts of $1,000,000 from foreign sales 
of product A. R had gross receipts of $1,000,000 from domestic sales of 
product A, and $1,000,000 from export sales of product A. R's cost of 
goods sold attributable to export sales is $500,000. R has deductible 
expenses of $100,000 directly related to its export sales, and F has 
such deductible expenses of $100,000. During 1987, P incurred an expense 
of $100,000 for marketing studies involving the worldwide market for 
product A.
    (ii) Analysis. P and R are an affiliated group of corporations 
within the meaning of section 864(e)(5) and this section. The expense 
incurred by P for marketing studies regarding the worldwide market for 
product A is an expense that is not directly related solely to the 
activities of P, but also to the

[[Page 261]]

activities of R. This expense must be allocated and apportioned under 
the rules of paragraph (c)(1) of this section, as if P and R were a 
single corporation. The expense is allocable to the class of gross 
income that includes all gross income generated by sales of product A. 
Apportionment on the basis of gross receipts is reasonable under these 
facts. F, a foreign corporation, is not a member of the affiliated 
group. However, for purposes of determining F's commission on its sales, 
the combined gross income of F and R must be reduced by the portion of 
the marketing studies expense of P that is incurred in connection with 
export sales involving F under the rules of paragraph (f) of this 
section. The computation of the combined taxable income of R and F is as 
follows:

                   Combined Taxable Income of R and F
 
R's gross receipts from export sales.......................   $1,000,000
  R's cost of goods sold...................................     $500,000
                                                            ------------
Combined Gross Income......................................     $500,000
                                                            ------------
Less:
  R's other deductible expenses............................     $100,000
  F's other deductible expenses............................      100,000
  Apportionment of P's expense:
 

  [GRAPHIC] [TIFF OMITTED] TC07OC91.028
  

      Total..................................................   $225,000
                                                              ----------
Combined Taxable Income......................................   $275,000
                                                              ==========
 

    (k) Effective/applicability date. The rules of this section apply 
for taxable years beginning after December 31, 1986.

[T.D. 8228, 53 FR 35501, Sept. 14, 1988, as amended by T.D. 8916, 65 FR 
274, Jan. 3, 2001; T.D. 9143, 69 FR 44932, July 28, 2004; T.D. 9211, 70 
FR 40663, July 14, 2005; T.D. 9456, 74 FR 38875, Aug. 4, 2009; T.D. 
9922, 85 FR 72042, Nov. 12, 2020]



Sec.  1.861-15  Income from certain aircraft or vessels first leased on 
or before December 28, 1980.

    (a) General rule. A taxpayer who owns an aircraft or vessel 
described in paragraph (b) of this section and who leases the aircraft 
or vessel to a United States person (other than a member of the same 
controlled group of corporations (as defined in section 1563) as the 
taxpayer) may elect under paragraph (f) of this section to treat all 
amounts includible in gross income with respect to the aircraft or 
vessel as income from sources within the United States for any taxable 
year ending after the commencement of the lease. This paragraph (a) 
applies only with respect to taxable years ending after August 15, 1971, 
and only with respect to leases entered into after that date of aircraft 
or vessels first leased by the taxpayer on or before December 28, 1980. 
An election once made applies to the taxable year for which made and to 
all subsequent taxable years unless it is revoked or terminated in 
accordance with paragraph (g) of this section. A taxpayer need not be a 
United States person to be eligible to make the election under this 
section, unless otherwise required by a provision of law not contained 
in the Internal Revenue Code of 1954. In addition, the taxpayer need not 
be a bank or other financial institution to be eligible to make this 
election. The term ``United States person'' as used in this section has 
the meaning assigned to it by section 7701(a)(30).
    (b) Property to which the election applies--(1) Section 38 property. 
An election made under this section may be made only if the aircraft or 
vessel is section 38 property, or property which would be section 38 
property but for section 48(a)(5) (relating to property used by 
governmental units), at the time the election is made and for all 
taxable years to which the election applies. The aircraft or vessel must 
be property which qualifies for the investment credit under section 38 
unless the property does not qualify because it is described in section 
48(a)(5). If an aircraft is used predominantly outside the United States 
(determined under Sec.  1.48-1(g)(1)), it must qualify under the 
provisions of section 48(a)(2)(B)(i) and Sec.  1.48-1(g)(2)(i). If a 
vessel is used predominantly outside the United States, it must qualify 
under the provisions of section 48(a)(2)(B)(iii) and Sec.  1.48-
1(g)(2)(iii). The aircraft or vessel may not be suspension or 
termination period property described in section 48(h) or section 49(a) 
(as in effect before the enactment of the Revenue Act of 1978).

[[Page 262]]

See paragraph (g) (3) and (4) of this section for rules which apply if 
the property ceases to be section 38 property.
    (2) United States manufacture or construction. An election under 
this section may be made only if the aircraft or vessel is manufactured 
or constructed in the United States. The aircraft or vessel will be 
considered to be manufactured or constructed in the United States if 50 
percent or more of the basis of the aircraft or vessel is attributable 
to value added within the United States.
    (3) Exclusion of certain property used outside the United States. 
The term ``aircraft or vessel'' as used in this paragraph (b) does not 
include any property which is used predominantly outside the United 
States and which qualifies as section 38 property under--
    (i) Section 48(a)(2)(B)(v), relating to containers used in the 
transportation of property to and from the United States,
    (ii) Section 48(a)(2)(B)(vi), relating to certain property used for 
the purpose of exploring for, developing, removing, or transporting 
resources from the Outer Continental Shelf, or
    (iii) Section 48(a)(2)(B)(x), relating to certain property used in 
international or territorial waters.
    (c) Leases or subleases to which the election applies. At the time 
the election under this section is made and for all taxable years for 
which the election applies, the lessee of the aircraft or vessel must be 
a United States person. In addition, the aircraft or vessel may not be 
subleased to a person who is not a United States person unless the 
sublease is a short-term sublease. For purposes of this section, a 
short-term sublease is a sublease for a period of time (including any 
period for which the sublease may be renewed or extended) which is less 
than 30 percent of the asset guideline period of the aircraft or vessel 
leased (determined under section 167(m)). See paragraphs (g) (3) and (4) 
of this section for rules which apply if the requirements of this 
paragraph (c) are not met.
    (d) Income to which the election applies. An election under this 
section applies to all amounts derived by the taxpayer with respect to 
the aircraft or vessel which is subject to the election. The election 
applies to all amounts which are includible in the taxpayer's gross 
income whether or not includible during or after the period of a lease 
to which the election applies. Amounts derived by the taxpayer with 
respect to the aircraft or vessel include any gain from the sale, 
exchange, or other disposition of the aircraft or vessel. If by reason 
of the allowance of expenses and other deductions, there is a loss with 
respect to an aircraft or vessel, the election applies to treat the loss 
as having a source within the United States. Similarly, if the sale, 
exchange or other disposition of the aircraft or vessel which is subject 
to an election results in a loss, it is treated as having a source 
within the United States. See paragraph (e)(2) of this section for the 
application of an election under this section to the income of certain 
transferees or distributees.
    (e) Effect of election--(1) In general. An election under this 
section applies to the taxable year for which it is made and to all 
subsequent taxable years for which amounts in respect of the aircraft or 
vessel to which the election relates are includible in gross income. 
However, the election may be revoked under paragraph (g) (1) or (2) of 
this section or terminated under paragraph (g)(3) of this section.
    (2) Certain transfers involving carryover of basis. (i) If an 
electing taxpayer transfers or distributes an aircraft or vessel which 
is subject to the election under this section, the transferee or 
distributee will be treated as having made an election under this 
section with respect to the aircraft or vessel if the basis of the 
aircraft or vessel in the hands of the transferee or distributee is 
determined by reference to its basis in the hands of the transferor or 
distributor. This paragraph (e)(2)(i) applies even though the transferor 
or distributor recognizes an amount of gain which increases basis in the 
hands of the transferee or distributee and even though the transferee of 
distributee is a nonresident alien individual or foreign corporation. 
For example, if a corporation distributes a vessel which is subject to 
an election under this section to its parent corporation in a complete 
liquidation described in section 332(b), the parent corporation will be

[[Page 263]]

required to treat all amounts includible in its gross income with 
respect to the vessel as income from source within the United States if, 
unless the election is revoked or terminated under paragraph (g) of this 
section, the basis of the property in the hands of the parent is 
determined under section 334(b)(1) (relating to the general rule on 
carryover of basis). In further illustration, if a corporation 
distributes a vessel (subject to an election) in a distribution to which 
section 301(a) applies, the distributee will be treated as having made 
the election with respect to the vessel if its basis is determined under 
section 301(d)(2) (relating to basis of corporate distributees) even 
though the basis is the fair market value of the vessel under section 
301(d)(2)(A).
    (ii) If a member of an affiliated group which files a consolidated 
return transfers an aircraft or vessel subject to an election to another 
member of that group, the transferee will be treated as having made the 
election with respect to the aircraft or vessel. In addition, if a 
partnership distributes an aircraft or vessel subject to an election to 
a partner, the partner will be treated as having made the election with 
respect to the aircraft or vessel.
    (iii) If paragraph (e)(2) (i) and (ii) of this section do not apply, 
the election under this section with respect to an aircraft or vessel 
will not be considered as made by a transferee or distributee.
    (f) Election--(1) Time for making the election. The election under 
this section must be made before the expiration of the period prescribed 
by section 6511(a) (or section 6511(c) if the period is extended by 
agreement) for making a claim for credit or refund of the tax imposed by 
chapter 1 for the first taxable year for which the election is to apply. 
The period for that first taxable year is determined without regard to 
the special periods prescribed by section 6511(d).
    (2) Manner of making the election. An election under this section 
must be made by filing with the income tax return (or an amended return) 
for the first taxable year for which the election is to apply a 
statement, signed by the taxpayer, to the effect that the election under 
section 861(e) is being made. The statement must--
    (i) Set forth sufficient facts to identify the aircraft or vessel 
which is the subject of the election,
    (ii) State that the aircraft or vessel was manufactured or 
constructed in the United States,
    (iii) State that the aircraft or vessel is section 38 property 
described in Sec.  1.861-9(b) which was leased to a United States person 
(as defined in section 7701(a)(30) of the Code) pursuant to a lease 
entered into after August 15, 1971,
    (iv) State that the electing taxpayer is the owner of the aircraft 
or vessel,
    (v) State the lessee of the aircraft or vessel is not a member of a 
controlled group of corporations (as defined in section 1563) of which 
the taxpayer is a member,
    (vi) Give the name and taxpayer identification number of the lessee 
of the aircraft or vessel, and
    (vii) State that the aircraft or vessel is not subject to a sublease 
(other than a short-term sublease) to any person who is not a United 
States person.
    (3) Election by partnership. Any election under this section with 
respect to an aircraft or vessel owned by a partnership shall be made by 
the partnership. Any partnership election is applicable to each 
partner's partnership interest in the aircraft or vessel. However, an 
election made by a partner before August 8, 1979 will be recognized 
where the partnership made no election and the election can no longer be 
revoked without the consent of the Commissioner under paragraph (g)(1) 
of this section.
    (g) Termination of election--(1) Revocation without consent. A 
taxpayer may revoke an election within the time prescribed in paragraph 
(f)(1) of this section without the consent of the Commissioner. In such 
a case, the taxpayer must file an amended income tax return for any 
taxable year to which the election applied.
    (2) Revocation with consent. Except as provided in paragraph (g) (1) 
or (3) of this section, an election made under this section is binding 
unless consent to revoke is obtained from the Commissioner. A request to 
revoke the election must be made in writing and

[[Page 264]]

addressed to the Assistant Commissioner of Internal Revenue (Technical), 
Attention: T:C:C:3, Washington, DC 20224. The request must include the 
name and address of the taxpayer and be signed by the taxpayer or his 
duly authorized representative. It must specify the taxable year or 
years for which the revocation is to be effective and must be filed at 
least 90 days prior to the time (not including extensions) prescribed by 
law for filing the income tax return for the first taxable year for 
which the revocation of the election is to be effective or by November 
6, 1979 whichever is later. The request must specify the grounds which 
are considered to justify the revocation. The Commissioner may require 
such additional information as may be necessary in order to determine 
whether the proposed revocation will be permitted. Consent will 
generally not be given to revoke an election where the revocation would 
result in treating gross income with respect to the aircraft or vessel 
(including any gain from the sale, exchange, or other disposition of 
such aircraft or vessel) as income from sources without the United 
States where, during the period the election was in effect, there were 
losses from sources within the United States. A copy of the consent of 
the Commissioner to revoke must be attached to the taxpayer's income tax 
return (or amended return) for each taxable year affected by the 
revocation.
    (3) Automatic termination. If an aircraft or vessel subject to an 
election under section 861(e) ceases to be section 38 property, ceases 
to be leased by its owner directly to a United States person, or is 
subleased (other than a short-term sublease) to a person who is not a 
United States person, within the period set forth in section 6511(a) (or 
section 6511(c) if the period is extended by agreement) for making a 
claim for credit or refund of the tax imposed by chapter 1 for the first 
taxable year for which the election applied, then the election with 
respect to such aircraft or vessel will automatically terminate. If the 
election terminates, the taxpayer who made the election must file an 
amended tax return or claim for credit or refund, as the case may be, 
for any taxable year to which the election applied.
    (4) Factors not causing revocation or termination. The fact that an 
aircraft or vessel ceases to be section 38 property, ceases to be leased 
by its owner directly to a United States person, or is leased or 
subleased for any period of time to a person who is not a United States 
person, after expiration of the period set forth in section 6511(a) (or 
section 6511(c) if the period is extended by agreement) for making a 
claim for credit or refund of the tax imposed by chapter 1 for the first 
taxable year for which the election applied, will not cause a 
termination of the election made under this section with respect to the 
aircraft or vessel. For example, the electing taxpayer is not relieved 
from any of the consequences of making the election merely because the 
aircraft or vessel is subleased to a person who is not a United States 
person for a period in excess of that allowed for short-term subleases 
under paragraph (c) of this section after expiration of the later of 3 
years from the time the return was filed for the first taxable year to 
which the election applied or 2 years from the time the tax was paid for 
that year where the period set forth in section 6511(a) has not been 
extended by agreement.
    (5) Effect of revocation or termination. If an election is revoked 
or terminated under this paragraph (g), the taxpayer is required to 
recompute the tax for the appropriate taxable years without reference to 
section 861(e)(1).
    (6) Revocation or termination after December 28, 1980. The rules in 
paragraph (g)(1) through (g)(5) continue to apply with respect to any 
election made pursuant to this section even though the revocation or 
termination may occur after December 28, 1980.

[T.D. 7635, 44 FR 46457, Aug. 8, 1979, as amended by T.D. 7928, 48 FR 
55846, Dec. 16, 1983. Redesignated at 53 FR 35477, Sept. 14, 1988]



Sec.  1.861-16  Income from certain craft first leased after December 28, 1980.

    (a) General rule. If a taxpayer--
    (1) Owns a qualified craft (as defined in paragraph (b) of this 
section).
    (2) Leases such qualified craft after December 28, 1980, to a United 
States person that is not a member of the

[[Page 265]]

same controlled group of corporations as the taxpayer, and
    (3) The lease is the taxpayer's first lease of the craft and the 
taxpayer is not considered to have made an election with respect to the 
craft under Sec.  1.861-9(e)(2),


then the taxpayer shall treat all amounts includible in gross income 
with respect to the qualified craft as income from sources within the 
United States for each taxable year ending after commencement of the 
lease. If this section applies to income with respect to a craft, it 
applies to all such amounts that are includible in the taxpayer's gross 
income, whether or not includible during or after the period of a lease 
to a United States person. Amounts derived by the taxpayer with respect 
to the qualified craft include any gain from the sale, exchange, or 
other disposition of the qualified craft. If this section applies to 
income with respect to a craft and there is a loss with respect to that 
craft (either due to the allowance of expenses and other deductions or 
due to a sale, exchange, or other disposition of the qualified craft), 
such loss is treated as allocable or apportionable to sources within the 
United States. The fact that a craft ceases to be section 38 property, 
ceases to be leased by the taxpayer to a United States person, or is 
leased or subleased for any period of time to a person who is not a 
United States person will not terminate the application of this section.
    (b) Qualified craft--(1) In general. A qualified craft is a vessel, 
aircraft, or spacecraft that--
    (i) Is section 38 property (or would be section 38 property but for 
section 48(a)(5), relating to use by governmental units), and
    (ii) Is manufactured or constructed in the United States.
    (2) Vessel. The term ``vessel'' includes every type of watercraft 
capable of being used as a means of transportation on water, and any 
items of property that are affixed in a permanent fashion or are 
integral to the vessel. A vessel that is used predominately outside the 
United States must be described in section 48(a)(2)(B)(iii) and Sec.  
1.48-1(g)(2)(iii), relating to vessels documented for use in the foreign 
or domestic commerce of the United States, to be a qualified craft.
    (3) Aircraft. An aircraft used predominantly outside the United 
States must be described in section 48(a)(2)(B)(i) and Sec.  1.48-
1(g)(2)(i), relating to aircraft registered by the Administrator of the 
Federal Aviation Agency, and operated to and from the United States or 
operated under contract with the United States, to be a qualified craft.
    (4) Spacecraft. A spacecraft must be described in section 
48(a)(2)(B)(viii) and Sec.  1.48-1(g)(2)(viii), relating to 
communications satellites, or any interest therein, of a United States 
person, to be a qualified craft.
    (5) United States manufacture or construction. A craft will be 
considered to be manufactured or constructed in the United States if 50 
percent or more of the basis of the craft on the date of the lease to a 
United States person is attributable to value added within the United 
States.
    (c) United States person. For purposes of this section, the term 
``United States person'' includes those persons described in section 
7701(a)(30) and individuals with respect to whom an election under 
section 6013 (g) or (h) (relating to nonresident alien individuals 
married to United States citizens or residents) is in effect.
    (d) Controlled group. For purposes of paragraph (a)(2) of this 
section, whether a taxpayer and a United States person are members of 
the same controlled group of corporations is determined under section 
1563. Solely for purposes of this section, if at least 80% of the 
capital interest, or the profits interest, in a partnership is owned, 
directly or indirectly, by a member or members of a controlled group of 
corporations, then the partnership shall be considered a member of that 
controlled group of corporations. In addition, if at least 80% of the 
capital interest, or the profits interest, in a partnership is owned, 
directly or indirectly, by a corporation, then the partnership and that 
corporation shall be considered members of a controlled group of 
corporations.
    (e) Certain transfers and distributions--(1) Transfers and 
distributions involving carryover of basis. If--

[[Page 266]]

    (i) The income with respect to a craft is subject to this section,
    (ii) The taxpayer transfers or distributes such craft, and
    (iii) The basis of such craft in the hands of the transferee or 
distributee is determined by reference to its basis in the hands of the 
transferor or distributor,


then this section will apply to the income with respect to the craft 
includible in the gross income of the transferee or distributee. This 
paragraph (e)(1) applies even though the transferor or distributor 
recognizes an amount of gain that increases basis in the hands of the 
transferee or distributee and even though the transferee or distributee 
is a nonresident alien or foreign corporation. For example, if a 
corporation distributes a craft the income of which is subject to this 
section to its parent corporation in a complete liquidation described in 
section 332(b), the parent corporation will be treated as if it 
satisfied the requirements of paragraph (a) of this section with respect 
to such craft if the basis of the property in the hands of the parent 
corporation is determined under section 334(b) (relating to the general 
rule on carryover of basis in liquidations). In further illustration, if 
a corporation distributes a craft the income of which is subject to this 
section, in a distribution to which section 301(a) applies, the 
distributee will be treated as if it satisfied the requirements of 
paragraph (a) of this section with respect to such craft if its basis is 
determined under section 301(d)(2) (relating to basis of corporate 
distributees) even though the basis may be the fair market value of the 
craft under section 301(d)(2)(A).
    (2) Partnerships. If a partnership satisfies the requirements of 
paragraph (a)(1), (2), and (3) of this section, each partner shall treat 
all amounts includible in gross income with respect to the craft as 
income from sources within the United States for any taxable year of the 
partnership ending after commencement of the lease. In addition, if a 
partnership distributes a craft the income of which is subject to this 
section, to a partner, the partner will be treated as if he or she 
satisfied the requirements of paragraph (a) of this section with respect 
to such craft.
    (3) Affiliated groups. If a member of a group of corporations that 
files a consolidated return transfers a craft, the income of which is 
subject to this section, to another member of that same group, the 
transferee will be treated as if it satisfied the requirements of 
paragraph (a) of this section with respect to the craft.

[T.D. 7928, 48 FR 55846, Dec. 16, 1983. Redesignated by T.D. 8228, 53 FR 
35477, Sept. 14, 1988]



Sec.  1.861-17  Allocation and apportionment of research 
and experimental expenditures.

    (a) Scope. This section provides rules for the allocation and 
apportionment of research and experimental expenditures that a taxpayer 
deducts, or amortizes and deducts, in a taxable year under section 174 
or section 59(e) (applicable to expenditures that are allowable as a 
deduction under section 174(a)) (R&E expenditures). R&E expenditures do 
not include any expenditures that are not deductible expenses by reason 
of the second sentence under Sec.  1.482-7(j)(3)(i) (relating to CST 
Payments (as defined in Sec.  1.482-7(b)(1)) owed to a controlled 
participant in a cost sharing arrangement).
    (b) Allocation--(1) In general. The method of allocation and 
apportionment of R&E expenditures set forth in this section recognizes 
that research and experimentation is an inherently speculative activity, 
that findings may contribute unexpected benefits, and that the gross 
income derived from successful research and experimentation must bear 
the cost of unsuccessful research and experimentation. In addition, the 
method set forth in this section recognizes that successful R&E 
expenditures ultimately result in the creation of intangible property 
that will be used to generate income. Therefore, R&E expenditures 
ordinarily are considered deductions that are definitely related to 
gross intangible income (as defined in paragraph (b)(2) of this section) 
reasonably connected with the relevant SIC code category (or categories) 
of the taxpayer and therefore allocable to gross intangible income as a 
class related to the SIC code

[[Page 267]]

category (or categories) and apportioned under the rules in this 
section. For purposes of the allocation under this paragraph (b)(1), a 
taxpayer's SIC code category (or categories) are determined in 
accordance with the provisions of paragraph (b)(3) of this section. For 
purposes of this section, the term intangible property means intangible 
property (as defined in section 367(d)(4)), including intangible 
property either created or acquired by the taxpayer, that is derived 
from R&E expenditures.
    (2) Definition of gross intangible income. The term gross intangible 
income means all gross income earned by a taxpayer that is attributable 
to a sale or license of intangible property (including income from 
platform contribution transactions described in Sec.  1.482-7(b)(1)(ii), 
royalty income from the licensing of intangible property, or amounts 
taken into account under section 367(d) by reason of a transfer of 
intangible property), and the full amount of gross income from sales or 
leases of products or services if the income is derived directly or 
indirectly (in whole or in part) from intangible property. Gross 
intangible income also includes a distributive share of any amounts 
described in the previous sentence, but does not include dividends or 
any amounts included in income under section 951, 951A, or 1293. See 
Sec.  1.904-4(f)(2)(vi) for rules addressing the assignment of gross 
income, including gross intangible income, to a separate category by 
reason of certain disregarded payments to or from a taxpayer's foreign 
branch.
    (3) SIC code categories--(i) Allocation based on SIC code 
categories. Ordinarily, a taxpayer's R&E expenditures are incurred to 
produce gross intangible income that is reasonably connected with one or 
more relevant SIC code categories. Except as provided in paragraph 
(b)(3)(iv) of this section, where research and experimentation is 
conducted with respect to more than one SIC code category, the taxpayer 
may aggregate the categories for purposes of allocation and 
apportionment, provided the categories are in the same Major Group. 
However, the taxpayer may not subdivide any categories. Where research 
and experimentation is not clearly related to any SIC code category (or 
categories), it will be considered conducted with respect to all of the 
taxpayer's SIC code categories.
    (ii) Use of three digit standard industrial classification codes. A 
taxpayer determines the relevant Major Groups and SIC code categories by 
reference to the two digit and three digit classification, respectively, 
of the Standard Industrial Classification Manual (SIC code). The SIC 
Manual is available at https://www.osha.gov/pls/imis/sic_manual.html.
    (iii) Consistency. Once a taxpayer selects a SIC code category or 
Major Group for the first taxable year for which this section applies to 
the taxpayer, it must continue to use that category in following years 
unless the taxpayer establishes to the satisfaction of the Commissioner 
that, due to changes in the relevant facts, a change in the category is 
appropriate. Therefore, once a taxpayer elects a permissible aggregation 
of three digit SIC code categories into a two digit Major Group, it must 
continue to use that two digit category in following years unless the 
taxpayer establishes to the satisfaction of the Commissioner that, due 
to changes in the relevant facts, a change is appropriate.
    (iv) Wholesale trade and retail trade categories. A taxpayer must 
use a SIC code category within the divisions of ``wholesale trade'' or 
``retail trade'' if it is engaged solely in sales-related activities 
with respect to a particular category of products. In the case of a 
taxpayer that conducts material non-sales-related activities with 
respect to a particular category of products, all R&E expenditures 
related to sales of the products must be allocated and apportioned as if 
the expenditures were reasonably connected to the most closely related 
three digit SIC code category other than those within the wholesale and 
retail trade divisions. For example, if a taxpayer engages in both the 
manufacturing and assembling of cars and trucks (SIC code 371) and in a 
wholesaling activity related to motor vehicles and motor vehicle parts 
and supplies (SIC code 501), the taxpayer must allocate and apportion 
all R&E expenditures related to both activities as if they relate solely 
to the

[[Page 268]]

manufacturing SIC code 371. By contrast, if the taxpayer engages only in 
the wholesaling activity related to motor vehicles and motor vehicle 
parts and supplies, the taxpayer must allocate and apportion all R&E 
expenditures to the wholesaling SIC code 501.
    (c) Exclusive apportionment. Solely for purposes of applying this 
section to section 904 as the operative section, an amount equal to 
fifty percent of a taxpayer's R&E expenditures in a SIC code category 
(or categories) is apportioned exclusively to the residual grouping of 
U.S. source gross intangible income if research and experimentation that 
accounts for at least fifty percent of such R&E expenditures was 
performed in the United States. Similarly, an amount equal to fifty 
percent of a taxpayer's R&E expenditures in a SIC code category (or 
categories) is apportioned exclusively to the statutory grouping (or 
groupings) of foreign source gross intangible income in that SIC code 
category if research and experimentation that accounts for more than 
fifty percent of such R&E expenditures was performed outside the United 
States. If there are multiple separate categories with foreign source 
gross intangible income in the SIC code category, the fifty percent of 
R&E expenditures apportioned under the previous sentence is apportioned 
ratably to foreign source gross intangible income based on the relative 
amounts of gross receipts from gross intangible income in the SIC code 
category in each separate category, as determined under paragraph (d) of 
this section. Solely for purposes of determining whether fifty percent 
or more of R&E expenditures in a year are performed within or without 
the United States under this paragraph (c), a taxpayer's R&E 
expenditures with respect to a taxable year are determined by taking 
into account only the R&E expenditures incurred in such taxable year 
(without regard to whether such expenditures are capitalized under 
section 59(e) or any other provision in the Code), and do not include 
amounts that were capitalized in a prior taxable year and are deducted 
in such taxable year.
    (d) Apportionment based on gross receipts from sales of products or 
services--(1) In general. A taxpayer's R&E expenditures not apportioned 
under paragraph (c) of this section are apportioned between the 
statutory grouping (or among the statutory groupings) within the class 
of gross intangible income and the residual grouping within such class 
according to the rules in paragraphs (d)(1)(i) through (iv) of this 
section. See paragraph (b) of this section for defining the class of 
gross intangible income in relation to SIC code categories.
    (i) A taxpayer's R&E expenditures not apportioned under paragraph 
(c) of this section are apportioned in the same proportions that:
    (A) The amounts of the taxpayer's gross receipts from sales and 
leases of products (as measured by gross receipts without regard to cost 
of goods sold) or services that are related to gross intangible income 
within the statutory grouping (or statutory groupings) and in the 
residual grouping bear, respectively; to
    (B) The total amount of such gross receipts in the class.
    (ii) For purposes of this paragraph (d), gross receipts from sales 
and leases of products are related to gross intangible income if 
intangible property is embedded or used in connection with the 
manufacture or sale of such products, and gross income from services is 
related to gross intangible income if intangible property is 
incorporated in or directly or indirectly benefits such services. See 
paragraph (g)(7) of this section (Example 7). The amount of the gross 
receipts used to apportion R&E expenditures also includes gross receipts 
from sales and leases of products or services of any controlled or 
uncontrolled party to the extent described in paragraphs (d)(3) and (4) 
of this section. A royalty or other amount paid to the taxpayer for 
intangible property constitutes gross intangible income, but is not 
considered part of gross receipts arising from the sale or lease of a 
product or service, and so is not taken into account in apportioning the 
taxpayer's R&E expenditures to its gross intangible income.
    (iii) The statutory grouping (or groupings) or residual grouping to 
which the gross receipts are assigned is the grouping to which the gross 
intangible income related to the sale, lease,

[[Page 269]]

or service is assigned. In cases where the gross intangible income of 
the taxpayer is income not described in paragraph (d)(3) or (4) of this 
section, the grouping to which the taxpayer's gross receipts and the 
gross intangible income are assigned is the same. In cases where the 
taxpayer's gross intangible income is related to sales, leases, or 
services described in paragraph (d)(3) or (4) of this section, the gross 
receipts that will be used for purposes of this paragraph (d) are the 
gross receipts of the controlled and uncontrolled parties that are taken 
into account under paragraphs (d)(3) and (4) of this section. The 
grouping to which the controlled or uncontrolled parties' gross receipts 
are assigned is determined based on the grouping of the taxpayer's gross 
intangible income attributable to the license, sale, or other transfer 
of intangible property to such controlled or uncontrolled party as 
described in paragraph (d)(3)(i) or (d)(4)(i) of this section, and not 
the grouping to which the gross receipts would be assigned if the 
assignment were based on the income earned by the controlled or 
uncontrolled party. See paragraph (g)(1) of this section (Example 1). 
For purposes of applying this paragraph (d)(1)(iii) to section 250 or 
section 904 as the operative section, the assignment of gross receipts 
to the general and foreign branch categories is made after taking into 
account the assignment of gross intangible income to those categories as 
adjusted by reason of disregarded payments under the rules of Sec.  
1.904-4(f)(2)(vi), and by making similar adjustments to gross receipts 
under the principles of Sec.  1.904-4(f)(2)(vi).
    (iv) For purposes of applying this section to section 904 as the 
operative section, because a United States person's gross intangible 
income cannot include income assigned to the section 951A category, no 
R&E expenditures of a United States person are apportioned to foreign 
source income in the section 951A category.
    (2) Apportionment in excess of gross income. Amounts apportioned 
under this section may exceed the amount of gross income related to the 
SIC code category within the statutory or residual grouping. In such 
case, the excess is applied against other gross income within the 
statutory or residual grouping. See Sec.  1.861-8(d)(1) for applicable 
rules where the apportionment results in an excess of deductions over 
gross income within the statutory or residual grouping.
    (3) Sales or services of uncontrolled parties--(i) In general. For 
purposes of the apportionment within a class under paragraph (d)(1) of 
this section, if a taxpayer reasonably expects an uncontrolled party to 
(through a license, purchase, or transfer): Acquire intangible property 
that would arise from the taxpayer's current R&E expenditures; acquire 
products in which such intangible property is embedded or used in 
connection with the manufacture or sale of such products; or receive 
services that incorporate or directly or indirectly benefit from such 
intangible property, then the gross receipts of the uncontrolled party 
from sales, licenses, leases, or services of the particular products or 
services in which the taxpayer's intangible property is embedded or 
incorporated or which the taxpayer's intangible property directly or 
indirectly benefitted are taken into account. If the taxpayer has 
previously licensed, sold, or transferred intangible property related to 
a SIC code category to an uncontrolled party, the taxpayer is presumed 
to expect to license, sell, or transfer to that uncontrolled party all 
future intangible property related to the same SIC code category. The 
presumption described in the preceding sentence may be rebutted by the 
taxpayer with facts that demonstrate that the taxpayer reasonably 
expects not to license, sell, or transfer future intangible property to 
the uncontrolled party.
    (ii) Definition of uncontrolled party. For purposes of this 
paragraph (d)(3), the term uncontrolled party means a person that is not 
a controlled party as defined in paragraph (d)(4)(ii) of this section.
    (iii) Sales of components. In the case of a sale or lease of a 
product by an uncontrolled party that is derived from the taxpayer's 
intangible property but is incorporated as a component of a larger 
product (for example, where the product incorporating the intangible

[[Page 270]]

property is a component of a large machine), only the portion of the 
gross receipts from the larger product that are attributable to the 
component derived from the intangible property is included. For purposes 
of the preceding sentence, a reasonable estimate based on the principles 
of section 482 must be made. See paragraph (g)(4)(ii)(B)(3) of this 
section (Example 4).
    (iv) Reasonable estimates of gross receipts. If the amount of gross 
receipts of an uncontrolled party is unknown, a reasonable estimate of 
gross receipts must be made annually. Appropriate economic analyses, 
based on the principles of section 482, must be used to estimate gross 
receipts. See paragraph (g)(5)(ii)(B)(3)(ii) of this section (Example 
5).
    (4) Sales or services of controlled parties--(i) In general. For 
purposes of the apportionment within a class under paragraph (d)(1) of 
this section, if the controlled party is reasonably expected to (through 
a license, sale, or transfer): Acquire intangible property that would 
arise from the taxpayer's current R&E expenditures; acquire products in 
which such intangible property is embedded or used in connection with 
the manufacture or sale of such products; or receive services that 
incorporate or directly or indirectly benefit from such intangible 
property, then the gross receipts of the controlled party from all of 
its sales, licenses, leases, or services are taken into account. Except 
to the extent provided in paragraph (d)(4)(iv) of this section, if the 
taxpayer has previously licensed, sold, or transferred intangible 
property related to a SIC code category to a controlled party, the 
taxpayer is presumed to expect to license, sell, or transfer to that 
controlled party all future intangible property related to the same SIC 
code category. The presumption described in the preceding sentence may 
be rebutted by the taxpayer with facts that demonstrate that the 
taxpayer will not license, sell, or transfer future intangible property 
to the controlled party.
    (ii) Definition of a controlled party. For purposes of this 
paragraph (d)(4), the term controlled party means any person that has a 
relationship to the taxpayer specified in section 267(b) or 707(b), or 
is a member of a controlled group of corporations (within the meaning of 
section 267(f)) to which the taxpayer belongs. Because an affiliated 
group is treated as a single taxpayer, a member of an affiliated group 
is not a controlled party. See paragraph (e) of this section.
    (iii) Gross receipts not to be taken into account more than once. 
Sales, licenses, leases, or services among the taxpayer, controlled 
parties, and uncontrolled parties are not taken into account more than 
once; in such a situation, the amount of gross receipts of the selling 
person must be subtracted from the gross receipts of the buying person. 
Therefore, the gross receipts taken into account under paragraph 
(d)(4)(i) of this section generally reflect the gross receipts from 
sales made to end users.
    (iv) Effect of cost sharing arrangements. If the controlled party 
has entered into a cost sharing arrangement, in accordance with the 
provisions of Sec.  1.482-7, with the taxpayer for the purpose of 
developing intangible property, then ordinarily the controlled party is 
not reasonably expected to acquire rights in intangible property that 
would arise from the taxpayer's share of the R&E expenditures with 
respect to the cost shared intangibles as defined in Sec.  1.482-
7(j)(1)(i); acquire products in which such intangible property is 
embedded or used in connection with the manufacture or sale of such 
products; or receive services that incorporate or directly or indirectly 
benefit from such intangible property. Therefore, solely for purposes of 
apportioning a taxpayer's R&E expenditures (which do not include the 
amount of CST Payments received by the taxpayer; see paragraph (a) of 
this section) that are intangible development costs (as defined in Sec.  
1.482-7(d)) with respect to a cost sharing arrangement, the controlled 
party's gross receipts are not taken into account for purposes of 
paragraphs (d)(1) and (d)(4)(i) of this section. However, the rule in 
this paragraph (d)(4)(iv) does not apply, and the controlled party's 
sales are taken into account, to the extent the taxpayer licenses, or 
has licensed, to the controlled party intangible property resulting from 
a cost sharing arrangement with the controlled party.

[[Page 271]]

    (5) Application of section 864(e)(3). Section 864(e)(3) and Sec.  
1.861-8(d)(2) do not apply for purposes of this section.
    (e) Affiliated groups. See Sec.  1.861-14(e)(2) for rules on 
allocating and apportioning R&E expenditures of an affiliated group (as 
defined in Sec.  1.861-14(d)).
    (f) Special rules for partnerships--(1) R&E expenditures. For 
purposes of applying this section, if R&E expenditures are incurred by a 
partnership in which the taxpayer is a partner, the taxpayer's R&E 
expenditures include the taxpayer's distributive share of the 
partnership's R&E expenditures.
    (2) Purpose and location of expenditures. In applying exclusive 
apportionment under paragraph (c) of this section, a partner's 
distributive share of R&E expenditures incurred by a partnership is 
treated as incurred by the partner for the same purpose and in the same 
location as incurred by the partnership.
    (3) Apportionment based on gross receipts. In applying the remaining 
apportionment under paragraph (d) of this section, if a taxpayer is a 
partner in a partnership that incurs R&E expenditures described in 
paragraph (f)(1) of this section and the taxpayer is not reasonably 
expected to license, sell, or transfer to the partnership (directly or 
indirectly) intangible property that would arise from the taxpayer's 
current R&E expenditures, in the manner described in paragraph (d)(3)(i) 
or (d)(4)(i) of this section, then the taxpayer's gross receipts in a 
SIC code category include only the taxpayer's share of any gross 
receipts in the SIC code category of the partnership. For purposes of 
the preceding sentence, the taxpayer's share of gross receipts is 
proportionate to the taxpayer's distributive share of the partnership's 
gross income in the product category. However, if the taxpayer is 
reasonably expected to license, sell, or transfer to the partnership 
(directly or indirectly) intangible property that would arise from the 
taxpayer current R&E expenditures, in the manner described in paragraph 
(d)(3)(i) or (d)(4)(i) of this section, then the taxpayer's gross 
receipts in a SIC code category include the full amount of any gross 
receipts in the SIC code category of the partnership as provided in 
paragraph (d)(3)(i) or (d)(4)(i) of this section.
    (g) Examples. The following examples illustrate the application of 
the rules in this section.
    (1) Example 1: Controlled party and single product--(i) Facts. X, a 
domestic corporation, is a manufacturer and distributor of small 
gasoline engines for lawnmowers. Gasoline engines are a product within 
the category, Engines and Turbines (SIC Industry Group 351). Y, a wholly 
owned foreign subsidiary of X, also manufactures and sells these engines 
abroad. X owns no other foreign subsidiaries. During Year 1, X incurred 
R&E expenditures of $60,000x, which it deducts under section 174 as a 
current expense, to invent and patent a new and improved gasoline 
engine. All of the research and experimentation was performed in the 
United States. Also in Year 1, the domestic gross receipts of X from 
sales of gasoline engines total $500,000x and foreign gross receipts of 
Y from sales of gasoline engines total $300,000x. X provides technology 
for the manufacture of engines to Y through a license that requires the 
payment of an arm's length royalty. Because X has licensed its 
intangible property to Y related to the SIC code, it is presumed to 
reasonably expect to license the intangible property that would be 
developed from the current research and experimentation. In Year 1, X's 
gross income is $210,000x, of which $140,000x is U.S. source income from 
domestic sales of gasoline engines, $40,000x is income included under 
section 951A, all of which relates to Y's foreign source income from 
sales of gasoline engines, $20,000x is foreign source royalties from Y, 
and $10,000x is U.S. source interest income. None of the foreign source 
royalties are allocable to passive category income of Y, and therefore, 
under Sec. Sec.  1.904-4(d) and 1.904-5(c)(3), the foreign source 
royalties are general category income to X.
    (ii) Analysis--(A) Allocation. The R&E expenditures were incurred in 
connection with developing intangible property related to small gasoline 
engines and they are definitely related to X's items of gross intangible 
income related to the SIC code category 351, namely gross income from 
the sale of small gasoline engines in the United

[[Page 272]]

States and royalties received from subsidiary Y, a foreign manufacturer 
of gasoline engines. Accordingly, under paragraph (b) of this section, 
the R&E expenditures are allocable to the class of gross intangible 
income related to SIC code category 351, all of which is general 
category income of X. X's U.S. source interest income and income 
included under section 951A are not within this class of gross 
intangible income and, therefore, no portion of the R&E expenditures are 
allocated to the U.S. source interest income or foreign source income in 
the section 951A category.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory grouping 
of gross intangible income is foreign source general category income and 
the residual grouping of gross intangible income is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this section, 
because at least 50% of X's research and experimental activity was 
performed in the United States, 50% of the R&E expenditures, or $30,000x 
($60,000x x 50%), is apportioned exclusively to the residual grouping of 
U.S. source gross intangible income. The remaining 50% of the R&E 
expenditures is then apportioned between the statutory and residual 
groupings on the basis of the relative amounts of gross receipts from 
sales of small gasoline engines by X and Y that are related to the U.S. 
source sales income and foreign source royalty income, respectively.
    (3) Apportionment based on gross receipts. After taking into account 
exclusive apportionment, X has $30,000x ($60,000x-$30,000x) of R&E 
expenditures that must be apportioned between the statutory and residual 
groupings. Under paragraph (d)(4) of this section, Y's gross receipts 
within the SIC code are taken into account in apportioning X's R&E 
expenditures. Although X has gross intangible income of $140,000x from 
domestic sales and $20,000x in royalties from Y, X's R&E expenditures 
are apportioned to that gross intangible income on the basis of the 
relative amounts of gross receipts arising from the sale of products by 
X and Y (and not the relative amounts of X's gross intangible income) in 
the statutory and residual groupings. Therefore, under paragraphs (d)(1) 
and (4) of this section $11,250x ($30,000x x $300,000x/($500,000x + 
$300,000x)) is apportioned to the statutory grouping of X's gross 
intangible income attributable to its license of intangible property to 
Y, or foreign source general category income. No portion of the gross 
receipts by X or Y are disregarded under section 864(e)(3), regardless 
of whether the income related to those sales is eligible for a deduction 
under section 250(a)(1)(A). The remaining $18,750x ($30,000x x 
$500,000x/($500,000x + $300,000x)) is apportioned to the residual 
grouping of gross intangible income, or U.S. source income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $11,250x of X's R&E expenditures are apportioned to foreign 
source general category income, and $48,750x ($30,000x + $18,750x) of 
X's R&E expenditures are apportioned to U.S. source income.
    (2) Example 2: Controlled party and two products in same SIC code 
category--(i) Facts. The facts are the same as in paragraph (g)(1)(i) of 
this section (the facts in Example 1), except that X also spends 
$30,000x in Year 1 for research on steam turbines, all of which is 
performed in the United States, and X has steam turbine gross receipts 
in the United States of $400,000x. X's foreign subsidiary Y neither 
manufactures nor sells steam turbines. The steam turbine research is in 
addition to the $60,000x in R&E expenditures incurred by X on gasoline 
engines for lawnmowers. X thus has $90,000x of R&E expenditures. X's 
gross income is $260,000x, of which $140,000x is U.S. source income from 
domestic sales of gasoline engines, $50,000x is U.S. source income from 
domestic sales of steam turbines, $40,000x is income included under 
section 951A all of which relates to foreign source income derived from 
Y's sales of gasoline engines, $20,000x is foreign source royalties from 
Y, and $10,000x is U.S. source interest income.
    (ii) Analysis--(A) Allocation. X's R&E expenditures generate gross 
intangible income from sales of small gasoline engines and steam 
turbines. Both of these products are in the same three digit

[[Page 273]]

SIC code category, Engines and Turbines (SIC Industry Group 351). 
Therefore, under paragraph (a) of this section, X's R&E expenditures are 
definitely related to all items of gross intangible income attributable 
to SIC code category 351. These items of X's gross intangible income are 
gross income from the sale of small gasoline engines and steam turbines 
in the United States and royalties from foreign subsidiary Y, a foreign 
manufacturer and seller of small gasoline engines. X's U.S. source 
interest income and income included under section 951A is not within 
this class of gross intangible income and, therefore, no portion of X's 
R&E expenditures are allocated to the U.S. source interest income or 
income in the section 951A category.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory grouping 
of gross intangible income is foreign source general category income and 
the residual grouping of gross intangible income is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this section, 
because at least 50% of X's research and experimental activity was 
performed in the United States, 50% of the R&E expenditures, or $45,000x 
($90,000x x 50%), are apportioned exclusively to the residual grouping 
of U.S. source gross intangible income. The remaining 50% of the R&E 
expenditures is then apportioned between the statutory and residual 
groupings on the basis of the relative amounts of gross receipts of 
small gasoline engines and steam turbines by X and Y with respect to 
which gross intangible income is foreign source general category income 
and U.S. source income.
    (3) Apportionment based on gross receipts. After taking into account 
exclusive apportionment, X has $45,000x ($90,000x-$45,000x) of R&E 
expenditures that must be apportioned between the statutory and residual 
groupings. Although X has gross intangible income of $190,000x from 
domestic sales and $20,000x in royalties from Y, X's R&E expenditures 
are apportioned to that gross intangible income on the basis of the 
relative amounts of gross receipts arising from the sale of products by 
X and Y (and not the relative amounts of X's gross intangible income) in 
the statutory and residual groupings. Even though a portion of the R&E 
expenditures that must be apportioned are attributable to research 
performed with respect to steam turbines, and Y does not sell steam 
turbines, because Y is reasonably expected to license all intangible 
property related to SIC code category 351 from X, including intangible 
property related to steam turbines, under paragraphs (d)(1) and (4) of 
this section $11,250x ($45,000x x $300,000x/($500,000x + $400,000x + 
$300,000x)) is apportioned to the statutory grouping of gross intangible 
income, or foreign source general category income attributable to the 
royalty income to which the gross receipts of Y are related. The 
remaining $33,750x ($45,000x x ($500,000x + $400,000x)/($500,000x + 
$400,000x + $300,000x)) is apportioned to the residual grouping of gross 
intangible income, or U.S. source gross income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $11,250x of X's R&E expenditures are apportioned to foreign 
source general category income and $78,750x ($45,000x + $33,750x) of X's 
R&E expenditures are apportioned to U.S. source income.
    (3) Example 3: Cost sharing arrangement--(i) Facts--(A) Acquisitions 
and transfers by X. The facts are the same as in paragraph (g)(1)(i) of 
this section (the facts in Example 1) except that, in Year 2, X and Y 
terminate the license for the manufacture of engines that was in place 
in Year 1 and enter into a cost sharing arrangement, in accordance with 
the provisions of Sec.  1.482-7, to share the costs and risks of 
developing the intangible property related to the engines. Pursuant to 
the cost sharing arrangement, X has the exclusive rights to exploit the 
cost shared intangibles within the United States, and Y has the 
exclusive rights to exploit the cost shared intangibles outside the 
United States. X's and Y's shares of the reasonably anticipated benefits 
from the cost shared intangibles are 70% and 30%, respectively. In Year 
2, Y makes a PCT Payment (as defined in Sec.  1.482-

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7(b)(1)(ii)) of $50,000x that is characterized and sourced as a royalty 
for a license of small gasoline engine technology.
    (B) Gross receipts and R&E expenditures. In Year 2, X and Y continue 
to sell gasoline engines, with gross receipts of $600,000x in the United 
States by X and $400,000x abroad by Y. X incurs intangible development 
costs associated with the cost shared intangibles of $100,000x in Year 
2, which consist exclusively of research activities conducted in the 
United States. Y also makes a $30,000x CST Payment (as defined in Sec.  
1.482-7(b)(1)(i)) under the cost sharing arrangement. X is entitled to 
deduct $70,000x of its intangible development costs ($100,000x less the 
$30,000x CST Payment by Y) by reason of the second sentence under Sec.  
1.482-7(j)(3)(i) (relating to CST Payments).
    (C) Gross income of X. In Year 2, X's gross income is $360,000x, of 
which $200,000x is U.S. source income from domestic sales of small 
gasoline engines, $50,000x is foreign source general category income 
attributable to the PCT Payment, $100,000x is income included under 
section 951A (all of which relates to foreign source income derived from 
engine sales by Y), and $10,000x is U.S. source interest income.
    (ii) Analysis--(A) Allocation. The $70,000x of R&E expenditures 
incurred in Year 2 by X in connection with small gasoline engines are 
definitely related to the items of gross intangible income related to 
the SIC code category, namely gross income from the sale of small 
gasoline engines in the United States and PCT Payments from Y. 
Accordingly, under paragraph (a) of this section, the R&E expenditures 
are allocable to this class of gross intangible income. X's U.S. source 
interest income and income included under section 951A are not within 
this class of gross intangible income and, therefore, no portion of X's 
R&E expenditures is allocated to X's U.S. source interest income or 
section 951A category income.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory grouping 
of gross intangible income is foreign source general category income, 
and the residual grouping of gross intangible income is U.S. source 
income.
    (2) Exclusive apportionment. Under paragraph (c) of this section, 
because at least 50% of X's research and experimentation in Year 2 was 
performed in the United States, 50% of the R&E expenditures, or $35,000x 
($70,000x x 50%), is apportioned exclusively to the residual grouping of 
gross intangible income, U.S. source income.
    (3) Apportionment based on gross receipts. Although X has gross 
intangible income of $200,000x from domestic sales and $50,000x as a PCT 
Payment from Y, X's R&E expenditures are apportioned to its gross 
intangible income on the basis of the relative amounts of gross receipts 
arising from the sale of products by X (and not the relative amounts of 
X's gross intangible income) in the statutory and residual groupings. 
Under paragraph (d)(4)(iv) of this section, because of the cost sharing 
arrangement, Y's gross receipts from sales are not taken into account in 
apportioning X's R&E expenditures that are intangible development costs 
with respect to the cost sharing arrangement. Because all of the gross 
receipts from sales that are taken into account under paragraph (d)(1) 
of this section relate to gross intangible income that is included in 
the residual grouping, $35,000x is apportioned to the residual grouping 
of gross intangible income, or U.S. source income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $70,000x of X's R&E expenditures are apportioned to U.S. 
source income.
    (4) Example 4: Uncontrolled party--(i) Facts--(A) X's R&E 
expenditures. X, a domestic corporation, is engaged in continuous 
research and experimentation to improve the quality of the products that 
it manufactures and sells, which are floodlights, flashlights, fuse 
boxes, and solderless connectors. All of these products are in the same 
three digit SIC code category, Electric Lighting and Wiring Equipment 
(SIC Industry Group 364). X incurs $100,000x of R&E expenditures in Year 
1 that is performed exclusively in the United States. As a result of 
this research activity, X acquires patents that it uses in its own 
manufacturing activity.

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    (B) License to Y and Z. In Year 1, X licenses its floodlight patent 
to Y and Z, uncontrolled parties, for use in their own territories, 
Countries Y and Z, respectively. Y pays X a royalty of $3,000x plus 
$0.20x for each unit sold. Gross receipts from sales of floodlights by Y 
for the taxable year are $135,000x (30,000 units at $4.50x per unit), 
and the royalty is $9,000x ($3,000x + $0.20x/unit x 30,000 units). Y has 
sales of other products of $500,000x. Z pays X a royalty of $3,000x plus 
$0.30x for each unit sold. Z manufactures 30,000 floodlights in the 
taxable year, and the royalty is $12,000x ($3,000x + $0.30x/unit x 
30,000 units). The dollar value of Z's gross receipts from floodlight 
sales is not known to X because, in this case, the floodlights are not 
sold separately by Z but are instead used as a component in Z's 
manufacture of lighting equipment for theaters. However, a reasonable 
estimate of Z's gross receipts attributable to the floodlights, based on 
the principles of section 482, is $120,000x. The gross receipts from 
sales of all Z's products, including the lighting equipment for 
theaters, are $1,000,000x. Because X has licensed its intangible 
property to Y and Z related to the SIC code, it is presumed to 
reasonably expect to license the intangible property that would be 
developed from the current research and experimentation.
    (C) X's gross receipts and gross income. X's gross receipts from 
sales of floodlights for the taxable year are $500,000x and its sales of 
its other products (flashlights, fuse boxes, and solderless connectors) 
are $400,000x. X has gross income of $500,000x, consisting of U.S. 
source gross income from domestic sales of floodlights, flashlights, 
fuse boxes, and solderless connectors of $479,000x, and foreign source 
gross income from royalties of $9,000x and $12,000x from foreign 
corporations Y and Z, respectively. The royalty income is general 
category income to X under Sec.  1.904-4(b)(2)(ii).
    (ii) Analysis--(A) Allocation. X's R&E expenditures are definitely 
related to all of the gross intangible income from the products that it 
produces, which are floodlights, flashlights, fuse boxes, and solderless 
connectors. All of these products are in SIC code category 364. 
Therefore, under paragraph (b) of this section, X's R&E expenditures are 
definitely related to the class of gross intangible income related to 
SIC code category 364 and to all items of gross intangible income 
attributable to the class. These items of X's gross intangible income 
are gross income from the sale of floodlights, flashlights, fuse boxes, 
and solderless connectors in the United States and royalties from 
Corporations Y and Z.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory grouping 
of gross intangible income is foreign source general category income, 
and the residual grouping of gross intangible income is U.S. source 
income.
    (2) Exclusive apportionment. Under paragraph (c) of this section, 
because at least 50% of X's research and experimentation was performed 
in the United States, 50% of the R&E expenditures, or $50,000x 
($100,000x x 50%), is apportioned exclusively to the residual grouping 
of U.S. source gross intangible income.
    (3) Apportionment based on gross receipts. After taking into account 
exclusive apportionment, X has $50,000x ($100,000x-$50,000x) of R&E 
expenditures that must be apportioned between the statutory and residual 
groupings. Under paragraph (d)(3)(i) of this section, gross receipts 
from sales of Y and Z are taken into account in apportioning X's R&E 
expenditures. Although X has gross intangible income of $479,000x from 
domestic sales and $21,000x in royalties from Y and Z, X's R&E 
expenditures are apportioned to its gross intangible income on the basis 
of the relative amounts of gross receipts arising from the sale of 
products by X, Y and Z (and not the relative amounts of X's gross 
intangible income) in the statutory and residual groupings. In addition, 
under paragraph (d)(3)(iii) of this section only the portion of Z's 
gross receipts that are attributable to the floodlights that incorporate 
the intangible property licensed from X, rather than Z's total gross 
receipts, are used for purposes of apportionment. All of X's gross 
receipts from sales in the entire SIC code category are included for 
purposes of

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apportionment on the basis of gross intangible income attributable to 
those sales. Under paragraph (d)(1) of this section, $11,039x ($50,000x 
x ($135,000x + $120,000x)/($900,000x + $135,000x + $120,000x)) is 
apportioned to the statutory grouping of gross intangible income, or 
foreign source general category income. The remaining $38,961x ($50,000x 
x $900,000x/($900,000x + $135,000x + $120,000x)) is apportioned to the 
residual grouping of gross intangible income, or U.S. source income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $11,039x of X's R&E expenditures are apportioned to foreign 
source general category income and $88,961x ($50,000x + $38,961x) of X's 
R&E expenditures are apportioned to U.S. source income.
    (5) Example 5: Uncontrolled party and sublicense--(i) Facts. X, a 
domestic corporation, is a cloud storage service provider. Cloud storage 
services are a service within the category, Computer Programming, Data 
Processing, and other Computer Related Services (SIC Industry Group 
737). During Year 1, X incurs R&E expenditures of $50,000x to invent and 
copyright new storage monitoring and management software. All of the 
research and experimentation is performed in the United States. X uses 
this software in its own business to provide services to customers. X 
also licenses a version of the software that can be used by other 
businesses that provide cloud storage services. X licenses the software 
to uncontrolled party U, which sub-licenses the software to other 
businesses that provide cloud storage services to customers. U does not 
use the software except to sublicense it. As a part of the licensing 
agreement with U, U and its sub-licensees are only permitted to use the 
software in certain countries outside of the United States. Under the 
contract with U, U pays X a royalty of 50% on the amount it receives 
from its sub-licensees that use the software to provide services to 
customers. Because X has licensed its intangible property to U related 
to the SIC code and U has sublicensed it to other businesses, it is 
presumed that X is reasonably expected to license the intangible 
property that would be developed from its current research and 
experimentation to U and that U would sublicense it to other businesses. 
In Year 1, X earns $300,000x of gross receipts from providing cloud 
storage services within the United States. Further, in Year 1 U receives 
$10,000x of royalty income from its sub-licensees and pays a royalty of 
$5,000x to X. Thus, X earns $300,000x of U.S. source general category 
gross income and also earns $5,000x of foreign source general category 
royalty income from licensing its software to U for use outside of the 
United States.
    (ii) Analysis--(A) Allocation. The R&E expenditures were incurred in 
connection with the development of cloud computing software and they are 
definitely related to the items of gross intangible income related to 
the SIC Code category, namely gross income from the storage monitoring 
and management software in the United States and royalties received from 
U. Accordingly, under paragraph (b) of this section, the R&E 
expenditures are allocable to this class of gross intangible income.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory grouping 
of gross intangible income is foreign source general category income, 
and the residual grouping of gross intangible income is U.S. source 
income.
    (2) Exclusive apportionment. Under paragraph (c) of this section, 
because at least 50% of X's research and experimental activity was 
performed in the United States, 50% of the R&E expenditures, or $25,000x 
($50,000x x 50%), is apportioned exclusively to the residual grouping of 
U.S. source gross intangible income.
    (3) Apportionment based on gross receipts--(i) In general. After 
taking into account exclusive apportionment, X has $25,000x ($50,000x-
$25,000x) of R&E expenditures that must be apportioned between the 
statutory and residual groupings. Because X has licensed its intangible 
property related to the SIC code to U and U has licensed it to the sub-
licensees, under paragraph (d)(3)(i) of this section, gross receipts 
from sales of U's sublicensees are taken into

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account in apportioning X's R&E expenditures. Although X has gross 
intangible income of $300,000x from domestic sales of services and 
$5,000x in royalties from U, X's R&E expenditures are apportioned to its 
gross intangible income on the basis of the relative amounts of gross 
receipts arising from the sale of services by X and U's sub-licensees 
(and not the relative amounts of X's gross intangible income) in the 
statutory and residual groupings.
    (ii) Determination of U's sub-licensee's gross receipts. Under 
paragraph (d)(3)(iv) of this section, X can make a reasonable estimate 
of the gross receipts of U's sub-licensees from services incorporating 
the intangible property licensed by X by estimating, after an 
appropriate economic analysis, that U would charge a royalty of 5% of 
the sub-licensee's sales. U received a royalty of $10,000x from the sub-
licensees. X then determines U's sub-licensees' foreign sales by 
dividing the total royalty payments received by U by the royalty 
estimated rate ($10,000x/.05 = $200,000x).
    (iii) Results of apportionment based on gross receipts. Therefore, 
under paragraphs (d)(1) and (3) of this section, $10,000x ($25,000x x 
$200,000x/($300,000x + $200,000x)) is apportioned to the statutory 
grouping of gross intangible income, or foreign source general category 
income. The remaining $15,000x ($25,000x x $300,000x/($300,000x + 
$200,000x)) is apportioned to the residual grouping of gross intangible 
income, or U.S. source income.
    (4) Summary. Accordingly, for purposes of the foreign tax credit 
limitation, $10,000x of X's R&E expenditures are apportioned to foreign 
source general category income and $40,000x ($25,000x + $15,000x) of X's 
R&E expenditures are apportioned to U.S. source income.
    (6) Example 6: Foreign branch--(i) Facts--(A) Overview for X. X, a 
domestic corporation, owns FDE, a disregarded entity that is a foreign 
branch within the meaning of Sec.  1.904-4(f)(3)(vii). FDE conducts 
activities solely in Country Y. FDE's functional currency is the U.S. 
dollar. X is a manufacturer and distributor of small gasoline engines 
for lawnmowers in the United States. Gasoline engines are a product 
within the category, Engines and Turbines (SIC Industry Group 351). FDE 
also manufactures and distributes small gasoline engines but only in 
Country Y. During Year 1, X incurred R&E expenditures of $60,000x, which 
it deducts under section 174 as a current expense, to invent and patent 
a new and improved gasoline engine. All of the research and 
experimentation was performed in the United States. Also in Year 1, the 
domestic gross receipts of X from gasoline engines total $500,000x. X 
provides technology for the manufacture of engines to FDE through a 
license. FDE compensates X for the technology with an arm's length 
royalty payment of $10,000x, which is disregarded for Federal income tax 
purposes.
    (B) Overview for FDE. FDE accrues and records on its books and 
records $100,000x of gross income from sales of gasoline engines to 
unrelated persons. FDE's gross income is non-passive category income and 
is foreign source income. In Year 1, the foreign gross receipts of FDE 
from sales of gasoline engines total $300,000x. The disregarded royalty 
payment from FDE to X is not recorded on FDE's separate books and 
records (as adjusted to conform to Federal income tax principles) within 
the meaning of paragraph Sec.  1.904-4(f)(2)(i) because it is 
disregarded for Federal income tax purposes. However, the $10,000x 
disregarded royalty payment would be allocable to foreign source gross 
income attributable to FDE under Sec.  1.904-4(f)(2)(vi)(B)(1)(ii). 
Therefore, under Sec.  1.904-4(f)(2)(vi)(A) the amount of foreign source 
gross income attributable to FDE is adjusted downwards and the amount of 
foreign source gross income attributable to X is adjusted upward to take 
the $10,000x disregarded royalty payment into account.
    (C) Assignment of X's gross income to separate categories. In Year 
1, X has U.S. source general category gross income of $140,000x from 
domestic sales of gasoline engines. After application of Sec.  1.904-
4(f)(2)(vi)(A) to the disregarded payment made by FDE, X has $10,000x of 
foreign source general category gross income and X also has $90,000x of 
foreign source foreign branch category gross income.

[[Page 278]]

    (ii) Analysis--(A) Allocation. The R&E expenditures were incurred in 
connection with developing intangible property related to small gasoline 
engines and are definitely related to the items of gross intangible 
income related to the SIC code category 351, namely gross income from 
the sale of small gasoline engines in both the United States and Country 
Y.
    (B) Apportionment--(1) In general. For purposes of applying this 
section to section 904 as the operative section, the statutory groupings 
of gross intangible income are foreign source general category income 
and foreign source foreign branch category income, and the residual 
grouping of gross intangible income is U.S. source income.
    (2) Exclusive apportionment. Under paragraph (c) of this section, 
because at least 50% of X's research and experimental activity was 
performed in the United States, 50% of the R&E expenditures, or $30,000 
($60,000x x 50%), is apportioned exclusively to the residual grouping of 
U.S. source gross intangible income. The remaining 50% of the R&E 
expenditures is then apportioned between the statutory and residual 
groupings on the basis of the relative amounts of gross receipts from 
sales of small gasoline engines that are related to U.S. source income, 
foreign source general category income, and foreign source foreign 
branch category income.
    (3) Apportionment based on gross receipts. After taking into account 
exclusive apportionment, X has $30,000x ($60,000x-$30,000x) of R&E 
expenditures that must be apportioned between the statutory and residual 
groupings. Because X's gross intangible income is not described in 
paragraph (d)(3) or (4) of this section (that is, there is no gross 
intangible income related to sales, leases or services from controlled 
or uncontrolled parties that are incorporating intangible property that 
was licensed, sold, or transferred to controlled or uncontrolled 
parties), the groupings to which the taxpayer's gross receipts and gross 
intangible income are assigned is the same. However, because the 
assignment of X's gross income to the foreign branch and general 
categories is made by taking into account disregarded payments under 
Sec.  1.904-4(f)(2)(vi), the assignment of gross receipts between the 
general category and foreign branch category must be determined by 
making similar adjustments to X's gross receipts under the principles of 
Sec.  1.904-4(f)(2)(vi). See paragraph (d)(1)(iii) of this section. 
Foreign gross receipts of FDE from gasoline engines total $300,000x. 
However, those gross receipts are adjusted under the principles of Sec.  
1.904-4(f)(2)(vi) for purposes of apportioning the remaining R&E 
expenditures by reducing the gross receipts initially assigned to the 
foreign branch category by an amount equal to the ratio of the royalty 
income to FDE's gross income that is initially assigned to the foreign 
branch category. Accordingly, since the disregarded royalty payment of 
$10,000x caused an adjustment equal to 10% of FDE's initial gross income 
of $100,000x, 10% of the gross receipts or $30,000x (10% x $300,000x) 
are similarly assigned to the grouping of foreign source general 
category income, and the remaining $270,000x of gross receipts are 
assigned to the grouping of foreign source foreign branch category 
income. Therefore, under paragraph (d)(1) of this section, $1,125x 
($30,000x x $30,000x/($500,000x + $270,000x + $30,000x)) is apportioned 
to the statutory grouping of X's gross intangible income attributable to 
foreign source general category income. $10,125x ($30,000x x $270,000x/
($500,000x + $270,000x + $30,000x)) is apportioned to the statutory 
grouping of X's foreign source foreign branch category income. The 
remaining $18,750x ($30,000x x $500,000x/($500,000x + $270,000x + 
$30,000x)) is apportioned to the residual grouping of gross intangible 
income or U.S. source income.
    (7) Example 7: Indirectly derived gross intangible income--(i) 
Facts. P, a domestic corporation, develops and publishes an internet 
website that persons use (referred to as ``users'' and collectively 
referred to as ``user base'') without a fee. P incurs R&E expenditures 
to update software code and write new software code to maintain the 
website and develop new products that are incorporated into the website. 
P's activities consist of services that fall within SIC code category 
737 (computer programming, data processing, and other computer related 
services). P sells space on

[[Page 279]]

its website for businesses to advertise to its user base in exchange for 
a fee. P's technology allows it to collect data on users and to use that 
data to effectively target advertisements. P does not grant rights to 
the technology or other intangible property to the businesses 
advertising on its website. In Year 1, P incurs R&E expenditures of 
$60,000x, which it deducts under section 174. All the research and 
experimentation is performed in the United States. Also in Year 1, P 
earns gross receipts of $200,000x from the sale of advertisements, all 
of which gives rise to U.S. source gross income.
    (ii) Analysis--(A) Allocation. The R&E expenditures were incurred in 
connection with developing intangible property used for P's website. 
Accordingly, they are definitely related and allocable to gross 
intangible income derived directly or indirectly (in whole or in part) 
from that intangible property. Because P's advertising sales are 
dependent on the users attracted to its website, P's gross income from 
advertising is indirectly derived from intangible property and is 
included in gross intangible income. Accordingly, under paragraph (b) of 
this section, the R&E expenditures are allocable to the class of gross 
intangible income related to SIC code category 737, which consists of 
U.S. source income.
    (B) Apportionment. Because all gross receipts from services that the 
intangible property directly or indirectly benefits result in U.S. 
source income, no apportionment is required.
    (h) Applicability date. This section applies to taxable years 
beginning after December 31, 2019. However, taxpayers may choose to 
apply this section to taxable years beginning on or after January 1, 
2018, and before January 1, 2020, provided they apply this section in 
its entirety and for any subsequent year beginning before January 1, 
2020.

[T.D. 9922, 85 FR 72042, Nov. 12, 2020; 86 FR 54367, Oct. 1, 2021]



Sec.  1.861-18  Classification of transactions involving computer programs.

    (a) General--(1) Scope. This section provides rules for classifying 
transactions relating to computer programs for purposes of subchapter N 
of chapter 1 of the Internal Revenue Code, sections 367, 404A, 482, 551, 
679, 1059A, chapter 3, chapter 5, sections 842 and 845 (to the extent 
involving a foreign person), and transfers to foreign trusts not covered 
by section 679.
    (2) Categories of transactions. This section generally requires that 
such transactions be treated as being solely within one of four 
categories (described in paragraph (b)(1) of this section) and provides 
certain rules for categorizing such transactions. In the case of a 
transfer of a copyright right, this section provides rules for 
determining whether the transaction should be classified as either a 
sale or exchange, or a license generating royalty income. In the case of 
a transfer of a copyrighted article, this section provides rules for 
determining whether the transaction should be classified as either a 
sale or exchange, or a lease generating rental income.
    (3) Computer program. For purposes of this section, a computer 
program is a set of statements or instructions to be used directly or 
indirectly in a computer in order to bring about a certain result. For 
purposes of this paragraph (a)(3), a computer program includes any 
media, user manuals, documentation, data base or similar item if the 
media, user manuals, documentation, data base or similar item is 
incidental to the operation of the computer program.
    (b) Categories of transactions--(1) General. Except as provided in 
paragraph (b)(2) of this section, a transaction involving the transfer 
of a computer program, or the provision of services or of know-how with 
respect to a computer program (collectively, a transfer of a computer 
program) is treated as being solely one of the following--
    (i) A transfer of a copyright right in the computer program;
    (ii) A transfer of a copy of the computer program (a copyrighted 
article);
    (iii) The provision of services for the development or modification 
of the computer program; or
    (iv) The provision of know-how relating to computer programming 
techniques.
    (2) Transactions consisting of more than one category. Any 
transaction involving computer programs which consists of

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more than one of the transactions described in paragraph (b)(1) of this 
section shall be treated as separate transactions, with the appropriate 
provisions of this section being applied to each such transaction. 
However, any transaction that is de minimis, taking into account the 
overall transaction and the surrounding facts and circumstances, shall 
not be treated as a separate transaction, but as part of another 
transaction.
    (c) Transfers involving copyright rights and copyrighted articles--
(1) Classification--(i) Transfers treated as transfers of copyright 
rights. A transfer of a computer program is classified as a transfer of 
a copyright right if, as a result of the transaction, a person acquires 
any one or more of the rights described in paragraphs (c)(2)(i) through 
(iv) of this section. Whether the transaction is treated as being solely 
the transfer of a copyright right or is treated as separate transactions 
is determined pursuant to paragraph (b)(1) and (b)(2) of this section. 
For example, if a person receives a disk containing a copy of a computer 
program which enables it to exercise, in relation to that program, a 
non-de minimis right described in paragraphs (c)(2)(i) through (iv) of 
this section (and the transaction does not involve, or involves only a 
de minimis provision of services as described in paragraph (d) of this 
section or of know-how as described in paragraph (e) of this section), 
then, under paragraph (b)(2) of this section, the transfer is classified 
solely as a transfer of a copyright right.
    (ii) Transfers treated solely as transfers of copyrighted articles. 
If a person acquires a copy of a computer program but does not acquire 
any of the rights described in paragraphs (c)(2)(i) through (iv) of this 
section (or only acquires a de minimis grant of such rights), and the 
transaction does not involve, or involves only a de minimis, provision 
of services as described in paragraph (d) of this section or of know-how 
as described in paragraph (e) of this section, the transfer of the copy 
of the computer program is classified solely as a transfer of a 
copyrighted article.
    (2) Copyright rights. The copyright rights referred to in paragraph 
(c)(1) of this section are as follows--
    (i) The right to make copies of the computer program for purposes of 
distribution to the public by sale or other transfer of ownership, or by 
rental, lease or lending;
    (ii) The right to prepare derivative computer programs based upon 
the copyrighted computer program;
    (iii) The right to make a public performance of the computer 
program; or
    (iv) The right to publicly display the computer program.
    (3) Copyrighted article. A copyrighted article includes a copy of a 
computer program from which the work can be perceived, reproduced, or 
otherwise communicated, either directly or with the aid of a machine or 
device. The copy of the program may be fixed in the magnetic medium of a 
floppy disk, or in the main memory or hard drive of a computer, or in 
any other medium.
    (d) Provision of services. The determination of whether a 
transaction involving a newly developed or modified computer program is 
treated as either the provision of services or another transaction 
described in paragraph (b)(1) of this section is based on all the facts 
and circumstances of the transaction, including, as appropriate, the 
intent of the parties (as evidenced by their agreement and conduct) as 
to which party is to own the copyright rights in the computer program 
and how the risks of loss are allocated between the parties.
    (e) Provision of know-how. The provision of information with respect 
to a computer program will be treated as the provision of know-how for 
purposes of this section only if the information is--
    (1) Information relating to computer programming techniques;
    (2) Furnished under conditions preventing unauthorized disclosure, 
specifically contracted for between the parties; and
    (3) Considered property subject to trade secret protection.
    (f) Further classification of transfers involving copyright rights 
and copyrighted articles--(1) Transfers of copyright rights.

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The determination of whether a transfer of a copyright right is a sale 
or exchange of property is made on the basis of whether, taking into 
account all facts and circumstances, there has been a transfer of all 
substantial rights in the copyright. A transaction that does not 
constitute a sale or exchange because not all substantial rights have 
been transferred will be classified as a license generating royalty 
income. For this purpose, the principles of sections 1222 and 1235 may 
be applied. Income derived from the sale or exchange of a copyright 
right will be sourced under section 865(a), (c), (d), (e), or (h), as 
appropriate. Income derived from the licensing of a copyright right will 
be sourced under section 861(a)(4) or 862(a)(4), as appropriate.
    (2) Transfers of copyrighted articles. The determination of whether 
a transfer of a copyrighted article is a sale or exchange is made on the 
basis of whether, taking into account all facts and circumstances, the 
benefits and burdens of ownership have been transferred. A transaction 
that does not constitute a sale or exchange because insufficient 
benefits and burdens of ownership of the copyrighted article have been 
transferred, such that a person other than the transferee is properly 
treated as the owner of the copyrighted article, will be classified as a 
lease generating rental income. Income from transactions that are 
classified as sales or exchanges of copyrighted articles will be sourced 
under sections 861(a)(6), 862(a)(6), 863, 865(a), (b), (c), or (e), as 
appropriate. Income derived from the leasing of a copyrighted article 
will be sourced under section 861(a)(4) or section 862(a)(4), as 
appropriate.
    (3) Special circumstances of computer programs. In connection with 
determinations under this paragraph (f), consideration must be given as 
appropriate to the special characteristics of computer programs in 
transactions that take advantage of these characteristics (such as the 
ability to make perfect copies at minimal cost). For example, a 
transaction in which a person acquires a copy of a computer program on 
disk subject to a requirement that the disk be destroyed after a 
specified period is generally the equivalent of a transaction subject to 
a requirement that the disk be returned after such period. Similarly, a 
transaction in which the program deactivates itself after a specified 
period is generally the equivalent of returning the copy.
    (g) Rules of operation--(1) Term applied to transaction by parties. 
Neither the form adopted by the parties to a transaction, nor the 
classification of the transaction under copyright law, shall be 
determinative. Therefore, for example, if there is a transfer of a 
computer program on a single disk for a one-time payment with 
restrictions on transfer and reverse engineering, which the parties 
characterize as a license (including, but not limited to, agreements 
commonly referred to as shrink-wrap licenses), application of the rules 
of paragraphs (c) and (f) of this section may nevertheless result in the 
transaction being classified as the sale of a copyrighted article.
    (2) Means of transfer not to be taken into account. The rules of 
this section shall be applied irrespective of the physical or electronic 
or other medium used to effectuate a transfer of a computer program.
    (3) To the public--(i) In general. For purposes of paragraph 
(c)(2)(i) of this section, a transferee of a computer program shall not 
be considered to have the right to distribute copies of the program to 
the public if it is permitted to distribute copies of the software to 
only either a related person, or to identified persons who may be 
identified by either name or by legal relationship to the original 
transferee. For purposes of this subparagraph, a related person is a 
person who bears a relationship to the transferee specified in section 
267(b)(3), (10), (11), or (12), or section 707(b)(1)(B). In applying 
section 267(b), 267(f), 707(b)(1)(B), or 1563(a), ``10 percent'' shall 
be substituted for ``50 percent.''
    (ii) Use by individuals. The number of employees of a transferee of 
a computer program who are permitted to use the program in connection 
with their employment is not relevant for purposes of this paragraph 
(g)(3). In addition, the number of individuals with a contractual 
agreement to provide services to the transferee of a computer program 
who are permitted to use the program in connection with the

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performance of those services is not relevant for purposes of this 
paragraph (g)(3).
    (h) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. (i) Facts. Corp A, a U.S. corporation, owns the copyright 
in a computer program, Program X. It copies Program X onto disks. The 
disks are placed in boxes covered with a wrapper on which is printed 
what is generally referred to as a shrink-wrap license. The license is 
stated to be perpetual. Under the license no reverse engineering, 
decompilation, or disassembly of the computer program is permitted. The 
transferee receives, first, the right to use the program on two of its 
own computers (for example, a laptop and a desktop) provided that only 
one copy is in use at any one time, and, second, the right to make one 
copy of the program on each machine as an essential step in the 
utilization of the program. The transferee is permitted by the shrink-
wrap license to sell the copy so long as it destroys any other copies it 
has made and imposes the same terms and conditions of the license on the 
purchaser of its copy. These disks are made available for sale to the 
general public in Country Z. In return for valuable consideration, P, a 
Country Z resident, receives one such disk.
    (ii) Analysis. (A) Under paragraph (g)(1) of this section, the label 
license is not determinative. None of the copyright rights described in 
paragraph (c)(2) of this section have been transferred in this 
transaction. P has received a copy of the program, however, and, 
therefore, under paragraph (c)(1)(ii) of this section, P has acquired 
solely a copyrighted article.
    (B) Taking into account all of the facts and circumstances, P is 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been a sale of a copyrighted 
article rather than the grant of a lease.
    Example 2. (i) Facts. The facts are the same as those in Example 1, 
except that instead of selling disks, Corp A, the U.S. corporation, 
decides to make Program X available, for a fee, on a World Wide Web home 
page on the Internet. P, the Country Z resident, in return for payment 
made to Corp A, downloads Program X (via modem) onto the hard drive of 
his computer. As part of the electronic communication, P signifies his 
assent to a license agreement with terms identical to those in Example 
1, except that in this case P may make a back-up copy of the program on 
to a disk.
    (ii) Analysis. (A) None of the copyright rights described in 
paragraph (c)(2) of this section have passed to P. Although P did not 
buy a physical copy of the disk with the program on it, paragraph (g)(2) 
of this section provides that the means of transferring the program is 
irrelevant. Therefore, P has acquired a copyrighted article.
    (B) As in Example 1, P is properly treated as the owner of a 
copyrighted article. Therefore, under paragraph (f)(2) of this section, 
there has been a sale of a copyrighted article rather than the grant of 
a lease.
    Example 3. (i) Facts. The facts are the same as those in Example 1, 
except that Corp A only allows P, the Country Z resident, to use Program 
X for one week. At the end of that week, P must return the disk with 
Program X on it to Corp A. P must also destroy any copies made of 
Program X. If P wishes to use Program X for a further period he must 
enter into a new agreement to use the program for an additional charge.
    (ii) Analysis. (A) Under paragraph (c)(2) of this section, P has 
received no copyright rights. Because P has received a copy of the 
program under paragraph (c)(1)(ii) of this section, he has, therefore, 
received a copyrighted article.
    (B) Taking into account all of the facts and circumstances, P is not 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been a lease of a 
copyrighted article rather than a sale. Taking into account the special 
characteristics of computer programs as provided in paragraph (f)(3) of 
this section, the result would be the same if P were required to destroy 
the disk at the end of the one week period instead of returning it since 
Corp A can make additional copies of the program at minimal cost.
    Example 4. (i) Facts. The facts are the same as those in Example 2, 
where P, the Country Z resident, receives Program X from Corp A's home 
page on the Internet, except that P may only use Program X for a period 
of one week at the end of which an electronic lock is activated and the 
program can no longer be accessed. Thereafter, if P wishes to use 
Program X, it must return to the home page and pay Corp A to send an 
electronic key to reactivate the program for another week.
    (ii) Analysis. (A) As in Example 3, under paragraph (c)(2) of this 
section, P has not received any copyright rights. P has received a copy 
of the program, and under paragraph (g)(2) of this section, the means of 
transmission is irrelevant. P has, therefore, under paragraph (c)(1)(ii) 
of this section, received a copyrighted article.
    (B) As in Example 3, P is not properly treated as the owner of a 
copyrighted article. Therefore, under paragraph (f)(2) of this section, 
there has been a lease of a copyrighted article rather than a sale. 
While P does retain Program X on its computer at the end of the one week 
period, as a legal matter P no longer has the right to use the program 
(without further payment) and, indeed, cannot use the program without 
the electronic

[[Page 283]]

key. Functionally, Program X is no longer on the hard drive of P's 
computer. Instead, the hard drive contains only a series of numbers 
which no longer perform the function of Program X. Although in Example 
3, P was required to physically return the disk, taking into account the 
special characteristics of computer programs as provided in paragraph 
(f)(3) of this section, the result in this Example 4 is the same as in 
Example 3.
    Example 5. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp B, a Country Z corporation, and grants Corp 
B an exclusive license for the remaining term of the copyright to copy 
and distribute an unlimited number of copies of Program X in the 
geographic area of Country Z, prepare derivative works based upon 
Program X, make public performances of Program X, and publicly display 
Program X. Corp B will pay Corp A a royalty of $y a year for three 
years, which is the expected period during which Program X will have 
commercially exploitable value.
    (ii) Analysis. (A) Although Corp A has transferred a disk with a 
copy of Program X on it to Corp B, under paragraph (c)(1)(i) of this 
section because this transfer is accompanied by a copyright right 
identified in paragraph (c)(2)(i) of this section, this transaction is a 
transfer solely of copyright rights, not of copyrighted articles. For 
purposes of paragraph (b)(2) of this section, the disk containing a copy 
of Program X is a de minimis component of the transaction.
    (B) Applying the all substantial rights test under paragraph (f)(1) 
of this section, Corp A will be treated as having sold copyright rights 
to Corp B. Corp B has acquired all of the copyright rights in Program X, 
has received the right to use them exclusively within Country Z, and has 
received the rights for the remaining life of the copyright in Program 
X. The fact the payments cease before the copyright term expires is not 
controlling. Under paragraph (g)(1) of this section, the fact that the 
agreement is labelled a license is not controlling (nor is the fact that 
Corp A receives a sum labelled a royalty). (The result in this case 
would be the same if the copy of Program X to be used for the purposes 
of reproduction were transmitted electronically to Corp B, as a result 
of the application of the rule of paragraph (g)(2) of this section.)
    Example 6. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp B, a Country Z corporation, and grants Corp 
B the non exclusive right to reproduce (either directly or by 
contracting with either Corp A or another person to do so) and 
distribute for sale to the public an unlimited number of disks at its 
factory in Country Z in return for a payment related to the number of 
disks copied and sold. The term of the agreement is two years, which is 
less than the remaining life of the copyright.
    (ii) Analysis. (A) As in Example 5, the transfer of the disk 
containing the copy of the program does not constitute the transfer of a 
copyrighted article under paragraph (c)(1) of this section because Corp 
B has also acquired a copyright right under paragraph (c)(2)(i) of this 
section, the right to reproduce and distribute to the public. For 
purposes of paragraph (b)(2) of this section, the disk containing 
Program X is a de minimis component of the transaction.
    (B) Taking into account all of the facts and circumstances, there 
has been a license of Program X to Corp B, and the payments made by Corp 
B are royalties. Under paragraph (f)(1) of this section, there has not 
been a transfer of all substantial rights in the copyright to Program X 
because Corp A has the right to enter into other licenses with respect 
to the copyright of Program X, including licenses in Country Z (or even 
to sell that copyright, subject to Corp B's interest). Corp B has 
acquired no right itself to license the copyright rights in Program X. 
Finally, the term of the license is for less than the remaining life of 
the copyright in Program X.
    Example 7. (i) Facts. Corp C, a distributor in Country Z, enters 
into an agreement with Corp A, a U.S. corporation, to purchase as many 
copies of Program X on disk as it may from time-to-time request. Corp C 
will then sell these disks to retailers. The disks are shipped in boxes 
covered by shrink-wrap licenses (identical to the license described in 
Example 1).
    (ii) Analysis. (A) Corp C has not acquired any copyright rights 
under paragraph (c)(2) of this section with respect to Program X. It has 
acquired individual copies of Program X, which it may sell to others. 
The use of the term license is not dispositive under paragraph (g)(1) of 
this section. Under paragraph (c)(1)(ii) of this section, Corp C has 
acquired copyrighted articles.
    (B) Taking into account all of the facts and circumstances, Corp C 
is properly treated as the owner of copyrighted articles. Therefore, 
under paragraph (f)(2) of this section, there has been a sale of 
copyrighted articles.
    Example 8. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp D, a foreign corporation engaged in the 
manufacture and sale of personal computers in Country Z. Corp A grants 
Corp D the non-exclusive right to copy Program X onto the hard drive of 
an unlimited number of computers, which Corp D manufactures, and to 
distribute those copies (on the hard drive) to the public. The term of 
the agreement is two years, which is less than the remaining life of the 
copyright in Program X. Corp D pays Corp A an amount based on the number 
of copies of Program X it loads on to computers.
    (ii) Analysis. The analysis is the same as in Example 6. Under 
paragraph (c)(2)(i) of this

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section, Corp D has acquired a copyright right enabling it to exploit 
Program X by copying it on to the hard drives of the computers that it 
manufactures and then sells. For purposes of paragraph (b)(2) of this 
section, the disk containing Program X is a de minimis component of the 
transaction. Taking into account all of the facts and circumstances, 
Corp D has not, however, acquired all substantial rights in the 
copyright to Program X (for example, the term of the agreement is less 
than the remaining life of the copyright). Under paragraph (f)(1) of 
this section, this transaction is, therefore, a license of Program X to 
Corp D rather than a sale and the payments made by Corp D are royalties. 
(The result would be the same if Corp D included with the computers it 
sells an archival copy of Program X on a floppy disk.)
    Example 9. (i) Facts. The facts are the same as in Example 8, except 
that Corp D, the Country Z corporation, receives physical disks. The 
disks are shipped in boxes covered by shrink-wrap licenses (identical to 
the licenses described in Example 1). The terms of these licenses do not 
permit Corp D to make additional copies of Program X. Corp D uses each 
individual disk only once to load a single copy of Program X onto each 
separate computer. Corp D transfers the disk with the computer when it 
is sold.
    (ii) Analysis. (A) As in Example 7 (unlike Example 8) no copyright 
right identified in paragraph (c)(2) of this section has been 
transferred. Corp D acquires the disks without the right to reproduce 
and distribute publicly further copies of Program X. This is therefore 
the transfer of copyrighted articles under paragraph (c)(1)(ii) of this 
section.
    (B) Taking into account all of the facts and circumstances, Corp D 
is properly treated as the owner of copyrighted articles. Therefore, 
under paragraph (f)(2) of this section, the transaction is classified as 
the sale of a copyrighted article. (The result would be the same if Corp 
D used a single physical disk to copy Program X onto each computer, and 
transferred an unopened box containing Program X with each computer, if 
Corp D were not permitted to copy Program X onto more computers than the 
number of individual copies purchased.)
    Example 10. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp E, a Country Z corporation, and grants Corp 
E the right to load Program X onto 50 individual workstations for use 
only by Corp E employees at one location in return for a one-time per-
user fee (generally referred to as a site license or enterprise 
license). If additional workstations are subsequently introduced, 
Program X may be loaded onto those machines for additional one-time per-
user fees. The license which grants the rights to operate Program X on 
50 workstations also prohibits Corp E from selling the disk (or any of 
the 50 copies) or reverse engineering the program. The term of the 
license is stated to be perpetual.
    (ii) Analysis. (A) The grant of a right to copy, unaccompanied by 
the right to distribute those copies to the public, is not the transfer 
of a copyright right under paragraph (c)(2) of this section. Therefore, 
under paragraph (c)(1)(ii) of this section, this transaction is a 
transfer of copyrighted articles (50 copies of Program X).
    (B) Taking into account all of the facts and circumstances, P is 
properly treated as the owner of copyrighted articles. Therefore, under 
paragraph (f)(2) of this section, there has been a sale of copyrighted 
articles rather than the grant of a lease. Notwithstanding the 
restriction on sale, other factors such as, for example, the risk of 
loss and the right to use the copies in perpetuity outweigh, in this 
case, the restrictions placed on the right of alienation.
    (C) The result would be the same if Corp E were permitted to copy 
Program X onto an unlimited number of workstations used by employees of 
either Corp E or corporations that had a relationship to Corp E 
specified in paragraph (g)(3) of this section.
    Example 11. (i) Facts. The facts are the same as in Example 10, 
except that Corp E, the Country Z corporation, acquires the right to 
make Program X available to workstation users who are Corp E employees 
by way of a local area network (LAN). The number of users that can use 
Program X on the LAN at any one time is limited to 50. Corp E pays a 
one-time fee for the right to have up to 50 employees use the program at 
the same time.
    (ii) Analysis. Under paragraph (g)(2) of this section the mode of 
utilization is irrelevant. Therefore, as in Example 10, under paragraph 
(c)(2) of this section, no copyright right has been transferred, and, 
thus, under paragraph (c)(1)(ii) of this section, this transaction will 
be classified as the transfer of a copyrighted article. Under the 
benefits and burdens test of paragraph (f)(2) of this section, this 
transaction is a sale of copyrighted articles. The result would be the 
same if an unlimited number of Corp E employees were permitted to use 
Program X on the LAN or if Corp E were permitted to copy Program X onto 
LANs maintained by corporations that had a relationship to Corp E 
specified in paragraph (g)(3) of this section.
    Example 12. (i) Facts. The facts are the same as in Example 11, 
except that Corp E pays a monthly fee to Corp A, the U.S. corporation, 
calculated with reference to the permitted maximum number of users 
(which can be changed) and the computing power of Corp E's server. In 
return for this monthly fee, Corp E receives the right to receive 
upgrades of Program X when they become available. The agreement may be 
terminated by either party at the end of any month.

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When the disk containing the upgrade is received, Corp E must return the 
disk containing the earlier version of Program X to Corp A. If the 
contract is terminated, Corp E must delete (or otherwise destroy) all 
copies made of the current version of Program X. The agreement also 
requires Corp A to provide technical support to Corp E but the agreement 
does not allocate the monthly fee between the right to receive upgrades 
of Program X and the technical support services. The amount of technical 
support that Corp A will provide to Corp E is not foreseeable at the 
time the contract is entered into but is expected to be de minimis. The 
agreement specifically provides that Corp E has not thereby been granted 
an option to purchase Program X.
    (ii) Analysis. (A) Corp E has received no copyright rights under 
paragraph (c)(2) of this section. Corp A has not provided any services 
described in paragraph (d) of this section. Based on all the facts and 
circumstances of the transaction, Corp A has provided de minimis 
technical services to Corp E. Therefore, under paragraph (c)(1)(ii) of 
this section, the transaction is a transfer of a copyrighted article.
    (B) Taking into account all facts and circumstances, under the 
benefits and burdens test Corp E is not properly treated as the owner of 
the copyrighted article. Corp E does not receive the right to use 
Program X in perpetuity, but only for so long as it continues to make 
payments. Corp E does not have the right to purchase Program X on 
advantageous (or, indeed, any) terms once a certain amount of money has 
been paid to Corp A or a certain period of time has elapsed (which might 
indicate a sale). Once the agreement is terminated, Corp E will no 
longer possess any copies of Program X, current or superseded. Therefore 
under paragraph (f)(2) of this section there has been a lease of a 
copyrighted article.
    Example 13. (i) Facts. The facts are the same as in Example 12, 
except that, while Corp E must return copies of Program X as new 
upgrades are received, if the agreement terminates, Corp E may keep the 
latest version of Program X (although Corp E is still prohibited from 
selling or otherwise transferring any copy of Program X).
    (ii) Analysis. For the reasons stated in Example 10, paragraph 
(ii)(B), the transfer of the program will be treated as a sale of a 
copyrighted article rather than as a lease.
    Example 14. (i) Facts. Corp G, a Country Z corporation, enters into 
a contract with Corp A, a U.S. corporation, for Corp A to modify Program 
X so that it can be used at Corp G's facility in Country Z. Under the 
contract, Corp G is to acquire one copy of the program on a disk and the 
right to use the program on 5,000 workstations. The contract requires 
Corp A to rewrite elements of Program X so that it will conform to 
Country Z accounting standards and states that Corp A retains all 
copyright rights in the modified Program X. The agreement between Corp A 
and Corp G is otherwise identical as to rights and payment terms as the 
agreement described in Example 10.
    (ii) Analysis. (A) As in Example 10, no copyright rights are being 
transferred under paragraph (c)(2) of this section. In addition, since 
no copyright rights are being transferred to Corp G, this transaction 
does not involve the provision of services by Corp A under paragraph (d) 
of this section. This transaction will be classified, therefore, as a 
transfer of copyrighted articles under paragraph (c)(1)(ii) of this 
section.
    (B) Taking into account all facts and circumstances, Corp G is 
properly treated as the owner of copyrighted articles. Therefore, under 
paragraph (f)(2) of this section, there has been the sale of a 
copyrighted article rather than the grant of a lease.
    Example 15. (i) Facts. Corp H, a Country Z corporation, enters into 
a license agreement for a new computer program. Program Q is to be 
written by Corp A, a U.S. corporation. Corp A and Corp H agree that Corp 
A is writing Program Q for Corp H and that, when Program Q is completed, 
the copyright in Program Q will belong to Corp H. Corp H gives 
instructions to Corp A programmers regarding program specifications. 
Corp H agrees to pay Corp A a fixed monthly sum during development of 
the program. If Corp H is dissatisfied with the development of the 
program, it may cancel the contract at the end of any month. In the 
event of termination, Corp A will retain all payments, while any 
procedures, techniques or copyrightable interests will be the property 
of Corp H. All of the payments are labelled royalties. There is no 
provision in the agreement for any continuing relationship between Corp 
A and Corp H, such as the furnishing of updates of the program, after 
completion of the modification work.
    (ii) Analysis. Taking into account all of the facts and 
circumstances, Corp A is treated as providing services to Corp H. Under 
paragraph (d) of this section, Corp A is treated as providing services 
to Corp H because Corp H bears all of the risks of loss associated with 
the development of Program Q and is the owner of all copyright rights in 
Program Q. Under paragraph (g)(1) of this section, the fact that the 
agreement is labelled a license is not controlling (nor is the fact that 
Corp A receives a sum labelled a royalty).
    Example 16. (i) Facts. Corp A, a U.S. corporation, and Corp I, a 
Country Z corporation, agree that a development engineer employed by 
Corp A will travel to Country Z to provide know-how relating to certain 
techniques not generally known to computer programmers, which will 
enable Corp I to more efficiently create computer programs. These

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techniques represent the product of experience gained by Corp A from 
working on many computer programming projects, and are furnished to Corp 
I under nondisclosure conditions. Such information is property subject 
to trade secret protection.
    (ii) Analysis. This transaction contains the elements of know-how 
specified in paragraph (e) of this section. Therefore, this transaction 
will be treated as the provision of know-how.
    Example 17. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program Y to Corp E, a Country Z corporation, in exchange for 
a single fixed payment. Program Y is a computer program development 
program, which is used to create other computer programs, consisting of 
several components, including libraries of reusable software components 
that serve as general building blocks in new software applications. No 
element of these libraries is a significant component of any overall new 
program. Because a computer program created with the use of Program Y 
will not operate unless the libraries are also present, the license 
agreement between Corp A and Corp E grants Corp E the right to 
distribute copies of the libraries with any program developed using 
Program Y. The license agreement is otherwise identical to the license 
agreement in Example 1.
    (ii) Analysis. (A) No non-de minimis copyright rights described in 
paragraph (c)(2) of this section have passed to Corp E. For purposes of 
paragraph (b)(2) of this section, the right to distribute the libraries 
in conjunction with the programs created using Program Y is a de minimis 
component of the transaction. Because Corp E has received a copy of the 
program under paragraph (c)(1)(ii) of this section, it has received a 
copyrighted article.
    (B) Taking into account all the facts and circumstances, Corp E is 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been the sale of a 
copyrighted article rather than the grant of a lease.
    Example 18. (i) Facts. (A) Corp A, a U.S. corporation, transfers a 
disk containing Program X to Corp E, a country Z Corporation. The disk 
contains both the object code and the source code to Program X and the 
license agreement grants Corp E the right to--
    (1) Modify the source code in order to correct minor errors and make 
minor adaptations to Program X so it will function on Corp E's computer; 
and
    (2) Recompile the modified source code.
    (B) The license does not grant Corp E the right to distribute the 
modified Program X to the public. The license is otherwise identical to 
the license agreement in Example 1.
    (ii) Analysis. (A) No non-de minimis copyright rights described in 
paragraph (c)(2) of this section have passed to Corp E. For purposes of 
paragraph (b)(2) of this section, the right to modify the source code 
and recompile the source code in order to create new code to correct 
minor errors and make minor adaptations is a de minimis component of the 
transaction. Because Corp E has received a copy of the program under 
paragraph (c)(1)(ii) of this section, it has received a copyrighted 
article.
    (B) Taking into account all the facts and circumstances, Corp E is 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been the sale of a 
copyrighted article rather than the grant of a lease.

    (i) Effective date--(1) General. This section applies to 
transactions occurring pursuant to contracts entered into on or after 
December 1, 1998.
    (2) Elective transition rules--(i) Contracts entered into in taxable 
years ending on or after October 2, 1998. A taxpayer may elect to apply 
this section to transactions occurring pursuant to contracts entered 
into in taxable years ending on or after October 2, 1998. A taxpayer 
that makes an election under this paragraph (i)(2)(i) must apply this 
section to all contracts entered into in taxable years ending on or 
after October 2, 1998.
    (ii) Contracts entered into before October 2, 1998. A taxpayer may 
elect to apply this section to transactions occurring in taxable years 
ending on or after October 2, 1998 pursuant to contracts entered into 
before October 2, 1998 provided the taxpayer would not be required under 
this section to change its method of accounting as a result of such 
election, or the taxpayer would be required to change its method of 
accounting but the resulting section 481(a) adjustment would be zero. A 
taxpayer that makes an election under this paragraph (i)(2)(ii) must 
apply this section to all transactions occurring in taxable years ending 
on or after October 2, 1998 pursuant to contracts entered into before 
October 2, 1998.
    (3) Manner of making election. Taxpayers may elect, under paragraph 
(i)(2)(i) or (i)(2)(ii) of this section, to apply this section, by 
treating the transactions in accordance with these regulations on their 
original tax return.
    (4) Examples. The following examples illustrate application of the 
transition

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rule of paragraph (i)(2)(ii) of this section:
    (i) Example 1. Corp A develops computer programs for sale to third 
parties. Corp A uses an overall accrual method of accounting and files 
its tax return on a calendar-year basis. In year 1, Corp A enters into a 
contract to deliver a computer program in that year, and to provide 
updates for each of the following four years. Under the contract, the 
computer program and the updates are priced separately, and Corp A is 
entitled to receive payments for the computer program and each of the 
updates upon delivery. Assume Corp A properly accounts for the contract 
as a contract for the provision of services. Corp A properly includes 
the payments under the contract in gross income in the taxable year the 
payments are received and the computer program or updates are delivered. 
Corp A properly deducts the cost of developing the computer program and 
updates when the costs are incurred. Year 3 includes October 2, 1998. 
Assume under the rules of this section, the provision of updates would 
properly be accounted for as the transfer of copyrighted articles. If 
Corp A made an election under paragraph (i)(2)(ii) of this section, Corp 
A would not be required to change its method of accounting for income 
under the contract as a result of the election. Corp A would also not be 
required to change its method of accounting for the cost of developing 
the computer program and the updates under the contract as a result of 
the election. Therefore, under paragraph (i)(2)(ii) of this section, 
Corp A may elect to apply the provisions of this section to the updates 
provided in years 3, 4, and 5, because Corp A is not required to change 
from its method of accounting for the contract as a result of the 
election.
    (ii) Example 2. Assume the same facts as in Example 1 except that 
Corp A is entitled to receive payments for the computer program and each 
of the updates 30 days after delivery. Corp A properly includes the 
amounts due under the contract in gross income in the taxable year the 
computer program or updates are provided. Assume that Corp A properly 
uses the nonaccrual-experience method described in section 448(d)(5) and 
Sec.  1.448-2T to account for income on its contracts. If Corp A made an 
election under paragraph (i)(2)(ii) of this section, Corp A would be 
required to change from the nonaccrual-experience method for income as a 
result of the election, because the method is only available with 
respect to amounts to be received for the performance of services. 
Therefore, Corp A may not elect to apply the provisions of this section 
to the updates provided in years 3, 4, and 5, under paragraph (i)(2)(ii) 
of this section, because Corp A would be required to change from the 
nonaccrual-experience method of accounting for income on the contract as 
a result of the election.
    (j) Change in method of accounting required by this section--(1) 
Consent. A taxpayer is granted consent to change its method of 
accounting for contracts involving computer programs, to conform with 
the classification prescribed in this section. The consent is granted 
for contracts entered into on or after December 1, 1998, or in the case 
of a taxpayer making an election under paragraph (i)(2)(i) of this 
section, the consent is granted for contracts entered into in taxable 
years ending on or after October 2, 1998. In addition, a taxpayer that 
makes an election under paragraph (i)(2)(ii) of this section is granted 
consent to change its method of accounting for any contract with 
transactions subject to the election, if the taxpayer is required to 
change its method of accounting as a result of the election.
    (2) Year of change. The year of change is the taxable year that 
includes December 1, 1998, or in the case of a taxpayer making an 
election under paragraph (i)(2)(i) or (i)(2)(ii) of this section, the 
taxable year that includes October 2, 1998.
    (k) Time and manner of making change in method of accounting--(1) 
General. A taxpayer changing its method of accounting in accordance with 
this section must file a Form 3115, Application for Change in Method of 
Accounting, in duplicate. The taxpayer must type or print the following 
statement at the top of page 1 of the Form 3115: ``FILED UNDER TREASURY 
REGULATION Sec.  1.861-18.'' The original Form 3115 must be attached to 
the taxpayers original return for the year of change. A copy of

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the Form 3115 must be filed with the National Office no later than when 
the original Form 3115 is filed for the year of change.
    (2) Copy of Form 3115. The copy required by this paragraph (k)(l) to 
be sent to the national office should be sent to the Commissioner of 
Internal Revenue, Attention: CC:DOM:IT&A, P.O. Box 7604, Benjamin 
Franklin Station, Washington DC 20044 (or in the case of a designated 
private delivery service: Commissioner of Internal Revenue, Attention: 
CC:DOM:IT&A, 1111 Constitution Avenue, NW., Washington, DC 20224).
    (3) Effect of consent and Internal Revenue Service review. A change 
in method of accounting granted under this section is subject to review 
by the district director and the national office and may be modified or 
revoked in accordance with the provisions of Rev. Proc. 97-37 (1997-33 
IRB 18) (or its successors) (see Sec.  601.601(d)(2) of this chapter).

[T.D. 8785, 63 FR 52977, Oct. 2, 1998; 63 FR 64868, Nov. 24, 1998, as 
amended by T.D. 9870, 84 FR 33692, July 15, 2019]



Sec.  1.861-20  Allocation and apportionment of foreign income taxes.

    (a) Scope. This section provides rules for the allocation and 
apportionment of foreign income taxes, including allocating and 
apportioning foreign income taxes to separate categories for purposes of 
the foreign tax credit. The rules of this section apply except as 
modified under the rules for an operative section (as described in Sec.  
1.861-8(f)(1)). See, for example, Sec. Sec.  1.704-1(b)(4)(viii)(d)(1), 
1.904-6, 1.960-1(d)(3)(ii), and 1.965-5(b)(2). Paragraph (b) of this 
section provides definitions for the purposes of this section. Paragraph 
(c) of this section provides the general rule for allocation and 
apportionment of foreign income taxes. Paragraph (d) of this section 
provides rules for assigning foreign gross income to statutory and 
residual groupings. Paragraph (e) of this section provides rules for 
allocating and apportioning foreign law deductions to foreign gross 
income in the statutory and residual groupings. Paragraph (f) of this 
section provides rules for apportioning foreign income taxes among 
statutory and residual groupings. Paragraph (g) of this section provides 
examples that illustrate the application of this section. Paragraph (h) 
of this section provides the applicability date for this section.
    (b) Definitions. The following definitions apply for purposes of 
this section.
    (1) Corporation. The term corporation has the same meaning as set 
forth in Sec.  301.7701-2(b) of this chapter, and so includes a reverse 
hybrid.
    (2) Corresponding U.S. item. The term corresponding U.S. item means 
the item of U.S. gross income or U.S. loss, if any, that arises from the 
same transaction or other realization event from which an item of 
foreign gross income also arises. An item of U.S. gross income or U.S. 
loss is a corresponding U.S. item even if the item of foreign gross 
income that arises from the same transaction or realization event 
differs in amount from the item of U.S. gross income or U.S. loss. A 
corresponding U.S. item does not include an item of gross income that is 
exempt, excluded, or eliminated from U.S. gross income, nor does it 
include an item of U.S. gross income or U.S. loss that is not realized, 
recognized or taken into account by the taxpayer in the U.S. taxable 
year in which the taxpayer paid or accrued the foreign income tax, 
except as provided in the next sentence. If a taxpayer pays or accrues a 
foreign income tax that is imposed on foreign taxable income that 
includes an item of foreign gross income by reason of a transaction or 
other realization event that also gave rise to an item of U.S. gross 
income or U.S. loss, but the U.S. and foreign taxable years end on 
different dates and the event occurred in the last U.S. taxable year 
that ends before the end of the foreign taxable year, then the item of 
U.S. gross income or U.S. loss is a corresponding U.S. item.
    (3) Disregarded entity. The term disregarded entity means an entity 
described in Sec.  301.7701-2(c)(2) of this chapter that is disregarded 
as an entity separate from its owner for Federal income tax purposes.
    (4) Foreign capital gain amount. The term foreign capital gain 
amount means the portion of a distribution that under foreign law gives 
rise to gross income

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of a type described in section 301(c)(3)(A) or section 731(a).
    (5) Foreign dividend amount. The term foreign dividend amount means 
the portion of a distribution that is taxable as a dividend under 
foreign law.
    (6) Foreign gross income. The term foreign gross income means the 
items of gross income included in the base upon which a foreign income 
tax is imposed. This includes all items of foreign gross income included 
in the foreign tax base, even if the foreign taxable year begins in the 
U.S. taxable year that precedes the U.S. taxable year in which the 
taxpayer pays or accrues the foreign income tax.
    (7) Foreign income tax. The term foreign income tax has the meaning 
provided in Sec.  1.901-2(a).
    (8) Foreign law CFC. The term foreign law CFC means an entity that 
is a body corporate under foreign law, certain of the earnings of which 
are taxable to its shareholder under a foreign law inclusion regime.
    (9) Foreign law disposition. The term foreign law disposition means 
an event that foreign law treats as a taxable disposition or deemed 
disposition of property but that Federal income tax law does not treat 
as a disposition causing the recognition of gain or loss (for example, 
marking property to market under foreign law).
    (10) Foreign law distribution. The term foreign law distribution 
means an event that foreign law treats as a taxable distribution (other 
than by reason of a foreign law inclusion regime) but that Federal 
income tax law does not treat as a distribution of property within the 
meaning of section 317(a) (for example, a stock dividend described in 
section 305 or a foreign law consent dividend).
    (11) Foreign law inclusion regime. A foreign law inclusion regime is 
a foreign law tax regime similar to the subpart F or GILTI regime 
described in sections 951 through 959, or the PFIC regime described in 
sections 1293 through 1295 (relating to qualified electing funds), that 
imposes a tax on a shareholder of an entity based on an inclusion in the 
shareholder's taxable income of certain of the entity's current 
earnings, whether or not the foreign law deems the entity's earnings to 
be distributed.
    (12) Foreign law inclusion regime income. The term foreign law 
inclusion regime income means the items of foreign gross income included 
by a taxpayer with respect to a foreign law CFC by reason of a foreign 
law inclusion regime.
    (13) Foreign law pass-through income. The term foreign law pass-
through income means the items of a reverse hybrid, computed under 
foreign law, that give rise to an inclusion in a taxpayer's foreign 
gross income under the laws of a foreign country imposing tax by reason 
of the taxpayer's ownership of the reverse hybrid.
    (14) Foreign taxable income. The term foreign taxable income means 
foreign gross income reduced by the deductions that are allowed under 
foreign law.
    (15) 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.''
    (16) Partnership. The term partnership has the same meaning as set 
forth in Sec.  301.7701-2(c)(1) of this chapter.
    (17) Previously taxed earnings and profits. The term previously 
taxed earnings and profits has the meaning provided in Sec.  1.960-1(b).
    (18) Reverse hybrid. The term reverse hybrid means a corporation 
that 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.
    (19) Taxpayer. The term taxpayer has the meaning described in Sec.  
1.901-2(f)(1).
    (20) U.S. capital gain amount. The term U.S. capital gain amount 
means gain recognized by a taxpayer on the sale, exchange, or other 
disposition of stock or an interest in a partnership or, in the case of 
a distribution with respect to stock or a partnership interest, the 
portion of the distribution to which section 301(c)(3)(A) or 731(a)(1), 
respectively, applies. A U.S. capital gain amount includes gain that is 
subject to section 751 and Sec.  1.751-1, but does not include the 
portion of any gain recognized by a taxpayer that is included in gross 
income as a dividend under section 964(e) or 1248.
    (21) U.S. dividend amount. The term U.S. dividend amount means the 
portion of a distribution that is made out of

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earnings and profits under Federal income tax law, including 
distributions out of previously taxed earnings and profits described in 
section 959(a) or (b). It also includes amounts included in gross income 
as a dividend by reason of section 1248 or section 964(e).
    (22) U.S. equity hybrid instrument. The term U.S. equity hybrid 
instrument means an instrument that is treated as stock or a partnership 
interest for Federal income tax purposes but for foreign income tax 
purposes is treated as indebtedness or otherwise gives rise to the 
accrual of income to the holder with respect to such instrument that is 
not characterized as a dividend or distributive share of partnership 
income for foreign tax law purposes.
    (23) U.S. gross income. The term U.S. gross income means the items 
of gross income that a taxpayer recognizes and includes in taxable 
income under Federal income tax law for its U.S. taxable year.
    (24) U.S. loss. The term U.S. loss means the item of loss that a 
taxpayer recognizes and includes in taxable income under Federal income 
tax law for its U.S. taxable year.
    (25) U.S. return of capital amount. The term U.S. return of capital 
amount means, in the case of the sale, exchange, or other disposition of 
stock, the taxpayer's adjusted basis of the stock, or in the case of a 
distribution with respect to stock, the portion of the distribution to 
which section 301(c)(2) applies.
    (26) 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) General rule. A foreign income tax (other than certain in lieu 
of taxes described in paragraph (h) of this section) is allocated and 
apportioned to the statutory and residual groupings that include the 
items of foreign gross income included in the base on which the tax is 
imposed. Each such foreign income tax (that is, each separate levy) is 
allocated and apportioned separately under the rules in paragraphs (c) 
through (f) of this section. A foreign income tax is allocated and 
apportioned to or among the statutory and residual groupings under the 
following steps:
    (1) First, by assigning the items of foreign gross income to the 
groupings under the rules of paragraph (d) of this section;
    (2) Second, by allocating and apportioning the deductions that are 
allowed under foreign law to the foreign gross income in the groupings 
under the rules of paragraph (e) of this section; and
    (3) Third, by allocating and apportioning the foreign income tax by 
reference to the foreign taxable income in the groupings under the rules 
of paragraph (f) of this section.
    (d) Assigning items of foreign gross income to the statutory and 
residual groupings--(1) In general. Each item of foreign gross income is 
assigned to a statutory or residual grouping. The amount of the item is 
determined under foreign law. However, Federal income tax law applies to 
characterize the item and the transaction or other realization event 
from which the item arose, and to assign it to a grouping. Except as 
provided in paragraph (d)(3) of this section, if a taxpayer pays or 
accrues a foreign income tax that is imposed on foreign taxable income 
that includes an item of foreign gross income with respect to which the 
taxpayer also realizes, recognizes, or takes into account a 
corresponding U.S. item, then the item of foreign gross income is 
assigned to the grouping to which the corresponding U.S. item is 
assigned. See paragraph (g)(2) of this section (Example 1). If the 
corresponding U.S. item is a U.S. loss (or zero), the foreign gross 
income is assigned to the grouping to which a gain would be assigned had 
the transaction or other realization event given rise to a gain, rather 
than a U.S. loss (or zero), for Federal income tax purposes, and not (if 
different) to the grouping to which the U.S. loss is allocated and 
apportioned in computing U.S. taxable income. Paragraph (d)(3) of this 
section provides special rules regarding the assignment of the item of 
foreign gross income in particular circumstances.
    (2) Items of foreign gross income with no corresponding U.S. item--
(i) In general. The rules in paragraphs (d)(2)(ii) and (iii) of this 
section apply for purposes of characterizing an item of foreign gross 
income and assigning it to a

[[Page 291]]

grouping if the taxpayer does not realize, recognize, or take into 
account a corresponding U.S. item. But see paragraphs (d)(3)(i)(C) and 
(d)(3)(iii) of this section for special rules with respect to items of 
foreign gross income attributable to foreign law pass-through income and 
foreign law inclusion regime income.
    (ii) Foreign gross income from U.S. nonrecognition event, or U.S. 
recognition event that falls in a different U.S. taxable year--(A) In 
general. If a taxpayer recognizes an item of foreign gross income 
arising from a transaction or other foreign realization event that does 
not result in the recognition of gross income or loss under Federal 
income tax law in the same U.S. taxable year in which the foreign income 
tax is paid or accrued or (in the circumstance described in the last 
sentence of paragraph (b)(2) of this section) in the immediately 
preceding U.S. taxable year, then the item of foreign gross income is 
characterized and assigned to the grouping to which the corresponding 
U.S. item (or the items described in paragraph (d)(3) of this section 
that are used to assign certain items of foreign gross income to the 
statutory and residual groupings) would be assigned if the event giving 
rise to the foreign gross income resulted in the recognition of gross 
income or loss under Federal income tax law in the U.S. taxable year in 
which the foreign income tax is paid or accrued.
    (B) Foreign law distributions. An item of foreign gross income that 
a taxpayer includes as a result of a foreign law distribution with 
respect to either stock or a partnership interest is assigned to the 
same statutory or residual groupings to which the foreign gross income 
would be assigned if a distribution of property in the amount of the 
taxable distribution under foreign law were made for Federal income tax 
purposes on the date on which the foreign law distribution occurred. See 
paragraph (g)(6) of this section (Example 5). See paragraph (d)(3)(i)(B) 
of this section for rules regarding the assignment of foreign gross 
income arising from a distribution with respect to stock. For purposes 
of applying paragraph (d)(3)(i)(B) of this section to a foreign law 
distribution, the U.S. dividend amount, U.S. capital gain amount, and 
U.S. return of capital amount are computed as if the distribution 
occurred on the date the distribution occurs for foreign law purposes. 
See Sec.  1.960-1(d)(3)(ii) for rules for assigning foreign gross income 
arising from a foreign law distribution to income groups or PTEP groups 
for purposes of section 960 as the operative section, and paragraph 
(d)(3)(ii)(B) of this section for rules regarding the assignment of 
foreign gross income arising from a distribution by a partnership.
    (C) Foreign law dispositions. A foreign gross income item of gain 
that a taxpayer includes as a result of a foreign law disposition of 
property is assigned to the grouping to which a corresponding U.S. item 
of gain or loss would be assigned on a taxable disposition of the 
property under Federal income tax law in exchange for an amount equal to 
the gross receipts or other value used under foreign law to determine 
the amount of the items of foreign gross income arising from the foreign 
law disposition in the U.S. taxable year in which the taxpayer paid or 
accrued the foreign income tax. For example, an item of foreign gross 
income that results from a deemed disposition of stock under a foreign 
law mark-to-market regime is assigned under the rules of this paragraph 
(d)(2)(ii)(C) as though a taxable disposition of the stock occurred 
under Federal income tax law for an amount equal to the fair market 
value determined under foreign law for purposes of marking the stock to 
market. See paragraph (g)(3) of this section (Example 2).
    (D) Foreign law transfers between taxable units. This paragraph 
(d)(2)(ii) applies to an item of foreign gross income arising from an 
event that foreign law treats as a transfer of property, or as giving 
rise to an item of accrued income, gain, deduction, or loss with respect 
to a transaction, between taxable units (as defined in paragraph 
(d)(3)(v)(E) of this section) of the same taxpayer, and that would be 
treated as a disregarded payment (as defined in paragraph (d)(3)(v)(E) 
of this section) if the transfer of property occurred, or the item 
accrued, for Federal income tax purposes in the same U.S. taxable year 
in which the foreign income tax is

[[Page 292]]

paid or accrued. An item of foreign gross income to which this paragraph 
(d)(2)(ii) applies is characterized and assigned to the grouping to 
which a disregarded payment in the amount of the item of foreign gross 
income (or the gross receipts giving rise to the item of foreign gross 
income) would be assigned under the rules of paragraph (d)(3)(v) of this 
section if the event giving rise to the foreign gross income resulted in 
a disregarded payment in the U.S. taxable year in which the foreign 
income tax is paid or accrued. For example, an item of foreign gross 
income that a taxpayer recognizes by reason of a foreign law 
distribution (such as a stock dividend or a consent dividend) from a 
disregarded entity is assigned to the same statutory or residual 
groupings to which the foreign gross income would be assigned if a 
distribution of property in the amount of the taxable distribution under 
foreign law were made for Federal income tax purposes on the date on 
which the foreign law distribution occurred.
    (iii) Foreign gross income of a type that is recognized but excluded 
from U.S. gross income--(A) In general. If a taxpayer recognizes an item 
of foreign gross income that is a type of recognized gross income that 
Federal income tax law excludes from U.S. gross income, then the item of 
foreign gross income is assigned to the grouping to which the item of 
gross income would be assigned if it were included in U.S. gross income. 
See paragraph (g)(4) of this section (Example 3). Notwithstanding the 
first sentence of this paragraph (d)(2)(iii)(A), foreign gross income 
that is attributable to a base difference is assigned under paragraph 
(d)(2)(iii)(B) of this section.
    (B) Base differences. If a taxpayer recognizes an item of foreign 
gross income that is attributable to a base difference, then the item of 
foreign gross income is assigned to the residual grouping. But see Sec.  
1.904-6(b)(1) (assigning foreign gross income attributable to a base 
difference to foreign source income in the separate category described 
in section 904(d)(2)(H)(i)) for purposes of applying section 904 as the 
operative section). An item of foreign gross income is attributable to a 
base difference under this paragraph (d)(2)(iii)(B) only if the item 
results from the receipt of one of the following items:
    (1) Death benefits described in section 101;
    (2) Gifts and inheritances described in section 102;
    (3) Contributions to capital described in section 118;
    (4) Money or other property in exchange for stock described in 
section 1032 (including by reason of a transfer described in section 
351(a)); or
    (5) Money or other property in exchange for a partnership interest 
described in section 721.
    (3) Special rules for assigning certain items of foreign gross 
income to a statutory or residual grouping--(i) Items of foreign gross 
income that a taxpayer includes by reason of its ownership of an 
interest in a corporation--(A) Scope. The rules of this paragraph 
(d)(3)(i) apply to characterize and assign to a statutory or residual 
grouping an item of foreign gross income that a taxpayer includes in 
foreign taxable income as a result of its ownership of an interest in a 
corporation with respect to which there is a distribution under both 
foreign law and Federal income tax law, an inclusion of foreign law 
pass-through income, or a disposition under both foreign law and Federal 
income tax law.
    (B) Foreign gross income items arising from a distribution with 
respect to a corporation--(1) In general. If there is a distribution by 
a corporation that is treated as a distribution of property for both 
foreign law and Federal income tax purposes, a taxpayer first applies 
the rules of paragraph (d)(3)(i)(B)(2) of this section, and then (if 
necessary) applies the rules of paragraph (d)(3)(i)(B)(3) of this 
section to characterize and assign to the statutory and residual 
groupings the items of foreign gross income that constitute the foreign 
dividend amount and the foreign capital gain amount, if any, that arise 
from the distribution. See paragraph (g)(5) of this section (Example 4). 
For purposes of this paragraph (d)(3)(i)(B), the U.S. dividend amount, 
U.S. capital gain amount, and U.S. return of capital amount that result 
from a distribution (including a distribution that occurs on the same 
date, but in different taxable years, for

[[Page 293]]

foreign law purposes and Federal income tax purposes) are computed on 
the date the distribution occurred for Federal income tax purposes. See 
paragraph (d)(2)(ii)(B) of this section for rules for assigning foreign 
gross income arising from any portion of a distribution that is a 
foreign law distribution. See Sec.  1.960-1(d)(3)(ii) for rules for 
assigning foreign gross income arising from a distribution described in 
this paragraph (d)(3)(i)(B) to income groups or PTEP groups for purposes 
of section 960 as the operative section.
    (2) Foreign dividend amounts. The foreign dividend amount is, to the 
extent of the U.S. dividend amount, assigned to the same statutory and 
residual grouping (or ratably to the groupings) to which a distribution 
of the U.S. dividend amount is assigned under Federal income tax law. If 
the foreign dividend amount exceeds the U.S. dividend amount, the excess 
foreign dividend amount is an item of foreign gross income that is, to 
the extent of the U.S. return of capital amount, assigned to the same 
statutory and residual grouping (or ratably to the groupings) to which 
earnings of the distributing corporation would be assigned if they were 
recognized for Federal income tax purposes in the U.S. taxable year in 
which the distribution is made. These earnings are deemed to arise in 
the statutory and residual groupings in the same proportions as the 
proportions in which the tax book value of the stock of the distributing 
corporation is (or would be if the taxpayer were a United States person) 
assigned to the groupings under the asset method in Sec.  1.861-9 in the 
U.S. taxable year in which the distribution is made. Any additional 
excess of the foreign dividend amount over the sum of the U.S. dividend 
amount and the U.S. return of capital amount is an item of foreign gross 
income that is assigned to the statutory or residual grouping (or 
ratably to the groupings) to which the U.S. capital gain amount is 
assigned.
    (3) Foreign capital gain amounts. The foreign capital gain amount 
is, to the extent of the U.S. capital gain amount, assigned to the 
statutory and residual groupings to which the U.S. capital gain amount 
is assigned under Federal income tax law. If the foreign capital gain 
amount exceeds the U.S. capital gain amount, the excess is, to the 
extent of the U.S. return of capital amount, assigned to the statutory 
and residual groupings to which earnings equal to the U.S. return of 
capital amount would be assigned if they were recognized in the U.S. 
taxable year in which the distribution is made. These earnings are 
deemed to arise in the statutory and residual groupings in the same 
proportions as the proportions in which the tax book value of the stock 
of the distributing corporation is (or would be if the taxpayer were a 
United States person) assigned under the asset method in Sec.  1.861-9 
in the U.S. taxable year in which the distribution is made. Any excess 
of the foreign capital gain amount over the sum of the U.S. capital gain 
amount and the U.S. return of capital amount is assigned ratably to the 
statutory and residual groupings to which the U.S. dividend amount is 
assigned.
    (C) Foreign law pass-through income from a reverse hybrid. An item 
of foreign law pass-through income that a taxpayer includes in its 
foreign taxable income as a result of its direct or indirect ownership 
of a reverse hybrid is assigned to a statutory or residual grouping by 
treating the taxpayer's items of foreign law pass-through income as the 
foreign gross income of the reverse hybrid, and applying the rules in 
this paragraph (d) by treating the reverse hybrid as the taxpayer in the 
reverse hybrid's U.S. taxable year with or within which its foreign 
taxable year (under the law of the foreign jurisdiction imposing the 
owner-level tax) ends. See Sec.  1.904-6(f) for special rules that apply 
for purposes of section 904 with respect to items of foreign gross 
income that under this paragraph (d)(3)(iii) would be assigned to a 
separate category that includes income that gives rise to inclusions 
under section 951A.
    (D) Foreign gross income items arising from a disposition of stock. 
An item of foreign gross income that arises from a transaction that is 
treated as a sale, exchange, or other disposition for both foreign law 
and Federal income tax purposes of an interest that is stock in a 
corporation for Federal income tax purposes is assigned first, to the 
extent

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of any U.S. dividend amount that results from the disposition, to the 
same statutory or residual grouping (or ratably to the groupings) to 
which the U.S. dividend amount is assigned under Federal income tax law. 
If the foreign gross income item exceeds the U.S. dividend amount, the 
foreign gross income item is next assigned, to the extent of the U.S. 
capital gain amount, to the statutory or residual grouping (or ratably 
to the groupings) to which the U.S. capital gain amount is assigned 
under Federal income tax law. Any excess of the foreign gross income 
item over the sum of the U.S. dividend amount and the U.S. capital gain 
amount is assigned to the same statutory or residual grouping (or 
ratably to the groupings) to which earnings equal to such excess amount 
would be assigned if they were recognized for Federal income tax 
purposes in the U.S. taxable year in which the disposition occurred. 
These earnings are deemed to arise in the statutory and residual 
groupings in the same proportions as the proportions in which the tax 
book value of the stock is (or would be if the taxpayer were a United 
States person) assigned to the groupings under the asset method in Sec.  
1.861-9 in the U.S. taxable year in which the disposition occurs. See 
paragraph (g)(10) of this section (Example 9).
    (ii) Items of foreign gross income included by a taxpayer by reason 
of its ownership of an interest in a partnership--(A) Scope. The rules 
of this paragraph (d)(3)(ii) apply to assign to a statutory or residual 
grouping certain items of foreign gross income that a taxpayer includes 
in foreign taxable income by reason of its ownership of an interest in a 
partnership. See paragraphs (d)(1) and (2) of this section for rules 
that apply in characterizing items of foreign gross income that are 
attributable to a partner's distributive share of income of a 
partnership. See paragraph (d)(3)(iii) of this section for rules that 
apply in characterizing items of foreign gross income that are 
attributable to an inclusion under a foreign law inclusion regime.
    (B) Foreign gross income items arising from a distribution with 
respect to an interest in a partnership. If a partnership makes a 
distribution that is treated as a distribution of property for both 
foreign law and Federal income tax purposes, any foreign gross income 
item arising from the distribution (including foreign gross income 
attributable to a distribution from a partnership that foreign law 
classifies as a dividend from a corporation) is, to the extent of the 
U.S. capital gain amount arising from the distribution, assigned to the 
statutory and residual groupings to which the U.S. capital gain amount 
is assigned under Federal income tax law. If the foreign gross income 
item arising from the distribution exceeds the U.S. capital gain amount, 
such excess amount is assigned to the statutory and residual groupings 
to which a distributive share of income of the partnership in the amount 
of such excess would be assigned if such income were recognized for 
Federal income tax purposes in the U.S. taxable year in which the 
distribution is made. The items constituting this distributive share of 
income are deemed to arise in the statutory and residual groupings in 
the same proportions as the proportions in which the tax book value of 
the partnership interest or the partner's pro rata share of the 
partnership assets, as applicable, is assigned (or would be assigned if 
the partner were a United States person) for purposes of apportioning 
the partner's interest expense under Sec.  1.861-9(e) in the U.S. 
taxable year in which the distribution is made.
    (C) Foreign gross income items arising from the disposition of an 
interest in a partnership. An item of foreign gross income arising from 
a transaction that is treated as a sale, exchange, or other disposition 
for both foreign law and Federal income tax purposes of an interest that 
is an interest in a partnership for Federal income tax purposes is 
assigned first, to the extent of the U.S. capital gain amount arising 
from the disposition, to the statutory or residual grouping (or ratably 
to the groupings) to which the U.S. capital gain amount is assigned. If 
the foreign gross income item arising from the disposition exceeds the 
U.S. capital gain amount, such excess amount is assigned to the 
statutory and residual grouping (or ratably to the groupings) to which a 
distributive share of income of the partnership in the amount of

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such excess would be assigned if such income were recognized for Federal 
income tax purposes in the U.S. taxable year in which the disposition 
occurred. The items constituting this distributive share of income are 
deemed to arise in the statutory and residual groupings in the same 
proportions as the proportions in which the tax book value of the 
partnership interest, or the partner's pro rata share of the partnership 
assets, as applicable, is assigned (or would be assigned if the partner 
were a United States person) for purposes of apportioning the partner's 
interest expense under Sec.  1.861-9(e) in the U.S. taxable year in 
which the disposition occurred.
    (iii) Foreign law inclusion regime income. A gross item of foreign 
law inclusion regime income that a taxpayer includes in its capacity as 
a shareholder under foreign law of a foreign law CFC under a foreign law 
inclusion regime is assigned to the same statutory and residual 
groupings as the item of foreign gross income of the foreign law CFC 
that gives rise to the item of foreign law inclusion regime income of 
the taxpayer. The assignment is made by treating the gross items of 
foreign law inclusion regime income of the taxpayer as the items of 
foreign gross income of the foreign law CFC and applying the rules in 
this paragraph (d) by treating the foreign law CFC as the taxpayer in 
its U.S. taxable year with or within which its foreign taxable year 
(under the law of the foreign jurisdiction imposing the shareholder-
level tax) ends. See paragraphs (g)(7) and (8) of this section (Examples 
6 and 7). See Sec.  1.904-6(f) for special rules with respect to items 
of foreign gross income relating to items of the foreign law CFC that 
give rise to inclusions under section 951A for purposes of applying 
section 904 as the operative section.
    (iv) Gain on sale of disregarded entity. An item of foreign gross 
income arising from gain recognized on the sale, exchange, or other 
disposition of a disregarded entity that is characterized as a 
disposition of assets for Federal income tax purposes is assigned to 
statutory and residual groupings in the same proportion as the gain that 
would be treated as foreign gross income in each grouping if the 
transaction were treated as a disposition of assets for foreign tax law 
purposes. See paragraph (g)(9) of this section (Example 8).
    (v) Disregarded payments--(A) In general. This paragraph (d)(3)(v) 
applies to assign to a statutory or residual grouping a foreign gross 
income item that a taxpayer includes by reason of the receipt of a 
disregarded payment. In the case of a taxpayer that is an individual or 
a domestic corporation, this paragraph (d)(3)(v) applies to a 
disregarded payment made between a taxable unit that is a foreign 
branch, a foreign branch owner, or a non-branch taxable unit, and 
another such taxable unit of the same taxpayer. In the case of a 
taxpayer that is a foreign corporation, this paragraph (d)(3)(v) applies 
to a disregarded payment made between taxable units that are tested 
units of the same taxpayer. For purposes of this paragraph (d)(3)(v), an 
individual or corporation is treated as the taxpayer with respect to its 
distributive share of foreign income taxes paid or accrued by a 
partnership, estate, trust or other pass-through entity. The rules of 
paragraph (d)(3)(v)(B) of this section apply to attribute U.S. gross 
income comprising the portion of a disregarded payment that is a 
reattribution payment to a taxable unit, and to associate the foreign 
gross income item arising from the receipt of the reattribution payment 
with the statutory and residual groupings to which that U.S. gross 
income is assigned. The rules of paragraph (d)(3)(v)(C) of this section 
apply to assign to statutory and residual groupings items of foreign 
gross income arising from the receipt of the portion of a disregarded 
payment that is a remittance or a contribution. The rules of paragraph 
(d)(3)(v)(D) of this section apply to assign to statutory and residual 
groupings items of foreign gross income arising from disregarded 
payments, other than the portions of disregarded payments that are 
reattribution payments, in connection with disregarded sales or 
exchanges of property. Paragraph (d)(3)(v)(E) of this section provides 
definitions that apply for purposes of this paragraph (d)(3)(v) and 
paragraph (g) of this section.
    (B) Reattribution payments--(1) In general. This paragraph 
(d)(3)(v)(B) assigns to a statutory or residual grouping a

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foreign gross income item that a taxpayer includes by reason of the 
receipt by a taxable unit of the portion of a disregarded payment that 
is a reattribution payment. The foreign gross income item is assigned to 
the statutory or residual groupings to which one or more reattribution 
amounts that constitute the reattribution payment are assigned upon 
receipt by the taxable unit. If a reattribution payment comprises 
multiple reattribution amounts and the amount of the foreign gross 
income item that is attributable to the reattribution payment differs 
from the amount of the reattribution payment, foreign gross income is 
apportioned among the statutory and residual groupings in proportion to 
the reattribution amounts in each statutory and residual grouping. The 
statutory or residual grouping of a reattribution amount received by a 
taxable unit is the grouping that includes the U.S. gross income 
attributed to the taxable unit by reason of its receipt of the gross 
reattribution amount, regardless of whether, after taking into account 
disregarded payments made by the taxable unit, the taxable unit has an 
attribution item as a result of its receipt of the reattribution amount. 
See paragraph (g)(13) of this section (Example 12).
    (2) Attribution of U.S. gross income to a taxable unit. This 
paragraph (d)(3)(v)(B)(2) provides attribution rules to determine the 
reattribution amounts received by a taxable unit in the statutory and 
residual groupings in order to apply paragraph (d)(3)(v)(B)(1) of this 
section to assign foreign gross income items arising from a 
reattribution payment to the groupings. In the case of a taxpayer that 
is an individual or a domestic corporation, the attribution rules in 
Sec.  1.904-4(f)(2) apply to determine the reattribution amounts 
received by a taxable unit in the separate categories (as defined in 
Sec.  1.904-5(a)(4)(v)) in order to apply paragraph (d)(3)(v)(B)(1) of 
this section for purposes of Sec.  1.904-6(b)(2)(i). In the case of a 
taxpayer that is a foreign corporation, the attribution rules in Sec.  
1.951A-2(c)(7)(ii)(B) apply to determine the reattribution amounts 
received by a taxable unit in the statutory and residual groupings in 
order to apply paragraph (d)(3)(v)(B)(1) of this section for purposes of 
Sec. Sec.  1.951A-2(c)(3), 1.951A-2(c)(7), and 1.960-1(d)(3)(ii). For 
purposes of other operative sections (as described in Sec.  1.861-
8(f)(1)), the principles of Sec.  1.904-4(f)(2)(vi) or Sec.  1.951A-
2(c)(7)(ii)(B), as applicable, apply to determine the reattribution 
amounts received by a taxable unit in the statutory and residual 
groupings. The rules and principles of Sec.  1.904-4(f)(2)(vi) or Sec.  
1.951A-2(c)(7)(ii)(B), as applicable, apply to determine the extent to 
which a disregarded payment made by the taxable unit is a reattribution 
payment and the reattribution amounts that constitute a reattribution 
payment, and to adjust the U.S. gross income initially attributed to 
each taxable unit to reflect the reattribution payments that the taxable 
unit makes and receives. The rules in this paragraph (d)(3)(v)(B)(2) 
limit the amount of a disregarded payment that is a reattribution 
payment to the U.S. gross income of the payor taxable unit that is 
recognized in the U.S. taxable year in which the disregarded payment is 
made.
    (3) Effect of reattribution payment on foreign gross income items of 
payor taxable unit. The statutory or residual grouping to which an item 
of foreign gross income of a taxable unit is assigned is determined 
without regard to reattribution payments made by the taxable unit, and 
without regard to whether the taxable unit has one or more attribution 
items after taking into account such reattribution payments. No portion 
of the foreign gross income of the payor taxable unit is treated as 
foreign gross income of the payee taxable unit by reason of the 
reattribution payment, notwithstanding that U.S. gross income of the 
payor taxable unit that is used to assign foreign gross income of the 
payor taxable unit to statutory and residual groupings is reattributed 
to the payee taxable unit under paragraph (d)(3)(v)(B)(1) of this 
section by reason of the reattribution payment. See paragraph (e) of 
this section for rules reducing the amount of a foreign gross income 
item of a taxable unit by deductions allowed under foreign law, 
including deductions by reason of disregarded payments made by a taxable 
unit that

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are included in the foreign gross income of the payee taxable unit.
    (C) Remittances and contributions--(1) Remittances--(i) In general. 
An item of foreign gross income that a taxpayer includes by reason of 
the receipt of a remittance by a taxable unit is assigned to the 
statutory or residual groupings of the recipient taxable unit that 
correspond to the groupings out of which the payor taxable unit made the 
remittance under the rules of this paragraph (d)(3)(v)(C)(1)(i). A 
remittance paid by a taxable unit is considered to be made ratably out 
of all of the accumulated after-tax income of the taxable unit. The 
accumulated after-tax income of the taxable unit that pays the 
remittance is deemed to have arisen in the statutory and residual 
groupings in the same proportions as the proportions in which the tax 
book value of the assets of the taxable unit are (or would be if the 
owner of the taxable unit were a United States person) assigned for 
purposes of apportioning interest expense under the asset method in 
Sec.  1.861-9 in the taxable year in which the remittance is made. See 
paragraph (g)(11) and (12) of this section (Examples 10 and 11). If the 
payor taxable unit is determined to have no assets under paragraph 
(d)(3)(v)(C)(1)(ii) of this section, then the foreign gross income that 
is included by reason of the receipt of the remittance is assigned to 
the residual grouping.
    (ii) Assets of a taxable unit. The assets of a taxable unit are 
determined in accordance with Sec.  1.987-6(b), except that for purposes 
of applying Sec.  1.987-6(b)(2) under this paragraph 
(d)(3)(v)(C)(1)(ii), a taxable unit is deemed to be a section 987 QBU 
(within the meaning of Sec.  1.987-1(b)(2)) and assets of the taxable 
unit include stock held by the taxable unit, the portion of the tax book 
value of a reattribution asset that is assigned to the taxable unit, and 
the taxable unit's pro rata share of the assets of another taxable unit 
(other than a corporation or a partnership), including the portion of 
any reattribution assets assigned to the other taxable unit, in which it 
owns an interest. If a taxable unit owns an interest in a taxable unit 
that is a partnership, the assets of the taxable unit that is the owner 
include its interest in the partnership or its pro rata share of the 
partnership assets, as applicable, determined under the principles of 
Sec.  1.861-9(e). The portion of the tax book value of a reattribution 
asset that is assigned to a taxable unit is an amount that bears the 
same ratio to the total tax book value of the reattribution asset as the 
sum of the attribution items of that taxable unit arising from gross 
income produced by the reattribution asset bears to the total gross 
income produced by the reattribution asset. The portion of a 
reattribution asset that is assigned to a taxable unit under this 
paragraph (d)(3)(v)(C)(1)(ii) is not treated as an asset of the taxable 
unit making the reattribution payment for purposes of applying paragraph 
(d)(3)(v)(C)(1)(i) of this section.
    (2) Contributions. An item of foreign gross income that a taxpayer 
includes by reason of the receipt of a contribution by a taxable unit is 
assigned to the residual grouping. See, however, Sec.  1.904-6(b)(2)(ii) 
(assigning certain items of foreign gross income to the foreign branch 
category for purposes of applying section 904 as the operative section).
    (3) Disregarded payment that comprises both a reattribution payment 
and a remittance or contribution. If both a reattribution payment and 
either a remittance or a contribution result from a single disregarded 
payment, the foreign gross income is first attributed to the portion of 
the disregarded payment that is a reattribution payment to the extent of 
the amount of the reattribution payment, and any excess of the foreign 
gross income item over the amount of the reattribution payment is then 
to attributed to the portion of the disregarded payment that is a 
remittance or contribution.
    (D) Disregarded payments in connection with disregarded sales or 
exchanges of property. An item of foreign gross income that is 
attributable to gain recognized under foreign law by reason of a 
disregarded payment, other than the portion of the disregarded payment 
that is a reattribution payment, received in exchange for property is 
characterized and assigned under the rules of paragraph (d)(2) of this 
section. See paragraph (d)(3)(v)(B) of this section

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for rules for assigning an item of foreign gross income attributable to 
the portion of a disregarded payment that is a reattribution payment, 
including a reattribution payment received in exchange for property.
    (E) Definitions. The following definitions apply for purposes of 
this paragraph (d)(3)(v) and paragraph (g) of this section.
    (1) Attribution item. The term attribution item means the portion of 
an item of gross income, computed under Federal income tax law, that is 
attributed to a taxable unit after taking into account all reattribution 
payments made and received by the taxable unit.
    (2) Contribution. The term contribution means the excess amount of a 
disregarded payment, other than a disregarded payment received in 
exchange for property, made by a taxable unit to another taxable unit 
that the first taxable unit owns over the portion of the disregarded 
payment, if any, that is a reattribution payment.
    (3) Disregarded entity. The term disregarded entity means an entity 
described in Sec.  301.7701-2(c)(2) of this chapter that is disregarded 
as an entity separate from its owner for Federal income tax purposes.
    (4) Disregarded payment. The term disregarded payment means an 
amount of property (within the meaning of section 317(a)) that is 
transferred to or from a taxable unit, including a transfer of property 
that would be a contribution to capital described in section 118 or a 
transfer described in section 351 if the taxable unit were a corporation 
under Federal income tax law, a transfer of property that would be a 
distribution by a corporation to a shareholder with respect to its stock 
if the taxable unit were a corporation under Federal income tax law, or 
a payment in exchange for property or in satisfaction of an account 
payable, in connection with a transaction that is disregarded for 
Federal income tax purposes and that is reflected on the separate set of 
books and records of the taxable unit. A disregarded payment also 
includes any other amount that is reflected on the separate set of books 
and records of a taxable unit in connection with a transaction that is 
disregarded for Federal income tax purposes and that would constitute an 
item of accrued income, gain, deduction, or loss of the taxable unit if 
the transaction to which the amount is attributable were regarded for 
Federal income tax purposes.
    (5) Reattribution amount. The term reattribution amount means an 
amount of gross income, computed under Federal income tax law, that is 
initially assigned to a single statutory or residual grouping that 
includes gross income of a taxable unit but that is, by reason of a 
disregarded payment made by that taxable unit, attributed to another 
taxable unit under paragraph (d)(3)(v)(B)(2) of this section.
    (6) Reattribution asset. The term reattribution asset means an asset 
that produces one or more items of gross income, computed under Federal 
income tax law, to which a disregarded payment is allocated under the 
rules of paragraph (d)(3)(v)(B)(2) of this section.
    (7) Reattribution payment. The term reattribution payment means the 
portion of a disregarded payment equal to the sum of all reattribution 
amounts that are attributed to the recipient of the disregarded payment.
    (8) Remittance. The term remittance means the excess amount, other 
than an amount that is treated as a contribution under paragraph 
(d)(3)(v)(E)(2) of this section, of a disregarded payment, other than a 
disregarded payment received in exchange for property, made by a taxable 
unit to a second taxable unit (including a second taxable unit that 
shares the same owner as the payor taxable unit) over the portion of the 
disregarded payment, if any, that is a reattribution payment.
    (9) Taxable unit. In the case of a taxpayer that is an individual or 
a domestic corporation, the term taxable unit means a foreign branch, a 
foreign branch owner, or a non-branch taxable unit, as defined in Sec.  
1.904-6(b)(2)(i)(B). In the case of a taxpayer that is a foreign 
corporation, the term taxable unit means a tested unit, as defined in 
Sec.  1.951A-2(c)(7)(iv)(A).
    (vi) Foreign gross income included by reason of U.S. equity hybrid 
instrument ownership--(A) Foreign gross income included by reason of an 
accrual. Foreign gross income included by reason of an

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accrual under foreign law with respect to a U.S. equity hybrid 
instrument is considered to arise from the same transaction or 
realization event as a distribution of property described in paragraph 
(d)(3)(i) or (ii) of this section and is assigned to the statutory and 
residual groupings by treating each amount accrued as a foreign law 
distribution made on the date of the accrual under foreign law.
    (B) Foreign gross income included by reason of a payment. Foreign 
gross income included by reason of a payment of interest under foreign 
law with respect to a U.S. equity hybrid instrument is considered to 
arise from the same transaction or realization event as a distribution 
of property described in paragraph (d)(3)(i) or (ii) of this section and 
is assigned to the statutory and residual groupings by treating each 
payment as a distribution made on the date of the payment.
    (e) Allocating and apportioning deductions (allowed under foreign 
law) to foreign gross income in a grouping--(1) Application of foreign 
law expense allocation rules. In order to determine foreign taxable 
income in each statutory grouping, or the residual grouping, foreign 
gross income in each grouping is reduced by deducting any expenses, 
losses, or other amounts that are deductible under foreign law that are 
specifically allocable to the items of foreign gross income in the 
grouping under the laws of that foreign country. If expenses are not 
specifically allocated under foreign law, then the expenses are 
allocated and apportioned among the groupings under the principles of 
foreign law. Thus, for example, if foreign law provides that expenses 
will be apportioned on a gross income basis, the foreign law deductions 
are apportioned on the basis of the relative amounts of foreign gross 
income assigned to each grouping.
    (2) Application of U.S. expense allocation rules in the absence of 
foreign law rules. If foreign law does not provide rules for the 
allocation or apportionment of expenses, losses or other deductions to 
particular items of foreign gross income, then the principles of the 
section 861 regulations (as defined in Sec.  1.861-8(a)(1)) apply in 
allocating and apportioning such expenses, losses, or other deductions 
to foreign gross income. For example, in the absence of foreign law 
expense allocation rules, the principles of the section 861 regulations 
apply to allocate definitely related expenses to particular categories 
of foreign gross income and provide the methods for apportioning foreign 
law expenses that are definitely related to more than one statutory 
grouping or that are not definitely related to any statutory grouping. 
For purposes of this paragraph (e)(2), the apportionment of expenses 
required to be made under the principles of the section 861 regulations 
need not be made on other than a separate company basis. If the taxpayer 
applies the principles of the section 861 regulations for purposes of 
allocating foreign law deductions under this paragraph (e), the taxpayer 
must apply the principles in the same manner as the taxpayer applies 
such principles in determining the income or earnings and profits for 
Federal income tax purposes of the taxpayer (or of the foreign branch, 
controlled foreign corporation, or other entity that paid or accrued the 
foreign taxes, as the case may be). For example, a taxpayer must use the 
modified gross income method under Sec.  1.861-9T when applying the 
principles of that section for purposes of this paragraph (e) to 
determine the amount of foreign taxable income in each grouping if the 
taxpayer applies the modified gross income method in determining the 
income and earnings and profits of a controlled foreign corporation for 
Federal income tax purposes.
    (f) Allocation and apportionment of foreign income tax. Foreign 
income tax is allocated to the statutory or residual grouping or 
groupings to which the items of foreign gross income are assigned under 
the rules of paragraph (d) of this section. If foreign gross income is 
assigned to more than one grouping, then the foreign income tax is 
apportioned among the statutory and residual groupings by multiplying 
the foreign income tax by a fraction, the numerator of which is the 
foreign taxable income in a grouping and the denominator of which is all 
foreign taxable income on which the foreign income tax is imposed. If 
foreign law, including by reason of an income tax convention,

[[Page 300]]

exempts certain types of income from tax, or if foreign taxable income 
is reduced to or below zero by foreign law deductions, then no foreign 
income tax is allocated and apportioned to that income. A withholding 
tax (as defined in section 901(k)(1)(B)) is allocated and apportioned to 
the foreign gross income from which it is withheld. If foreign law, 
including by reason of an income tax convention, provides for a specific 
rate of tax with respect to certain types of income (for example, 
capital gains), or allows credits only against tax on particular items 
or types of income (for example, credit for foreign withholding taxes), 
then such provisions are taken into account in determining the amount of 
foreign tax imposed on such foreign taxable income.
    (g) Examples. The following examples illustrate the application of 
this section and Sec.  1.904-6.
    (1) Presumed facts. Except as otherwise provided in this paragraph 
(g), the following facts are assumed for purposes of the examples in 
paragraphs (g)(2) through (9) of this section:
    (i) USP and US2 are domestic corporations, which are unrelated;
    (ii) USP elects to claim a foreign tax credit under section 901;
    (iii) CFC, CFC1, and CFC2 are controlled foreign corporations 
organized in Country A, and are not reverse hybrids;
    (iv) All parties have a U.S. dollar functional currency and a U.S. 
taxable year and foreign taxable year that correspond to the calendar 
year;
    (v) No party has expenses for Country A tax purposes or expenses for 
U.S. tax purposes (other than foreign income tax expense); and
    (vi) Section 904 is the operative section, and terms have the 
meaning provided in this section or Sec. Sec.  1.904-4 and 1.904-5.
    (2) Example 1: Corresponding U.S. item--(i) Facts. USP conducts 
business in Country A that gives rise to a foreign branch (as defined in 
Sec.  1.904-4(f)(3)). In Year 1, in a transaction that is a sale for 
purposes of the laws of Country A and Federal income tax law, the 
foreign branch transfers Asset X to US2 for $1,000x. For Country A tax 
purposes, USP earns $600x of gross income from the sale of Asset X and 
incurs foreign income tax of $80x. For Federal income tax purposes, USP 
earns $800x of foreign branch category income from the sale of Asset X.
    (ii) Analysis. For purposes of allocating and apportioning the $80x 
of Country A foreign income tax, the $600x of Country A gross income 
from the sale of Asset X is first assigned to separate categories. The 
$800x of foreign branch category income from the sale of Asset X is the 
corresponding U.S. item to the Country A item of gross income. Under 
paragraph (d)(1) of this section, because USP recognizes a corresponding 
U.S. item with respect to the Country A item of gross income in the same 
U.S. taxable year, the $600x of Country A gross income is assigned to 
the same separate category as the corresponding U.S. item. This is the 
case even though the amount of gross income recognized for Federal 
income tax purposes differs from the amount recognized for Country A tax 
purposes. Accordingly, the $600x of Country A gross income is assigned 
to the foreign branch category. Additionally, because all of the Country 
A taxable income is assigned to a single separate category, the $80x of 
Country A tax is also allocated to the foreign branch category. No 
apportionment of the $80x is necessary because the class of gross income 
to which the tax is allocated consists entirely of a single statutory 
grouping, foreign branch category income.
    (3) Example 2: Foreign law disposition--(i) Facts. USP owns all of 
the outstanding stock of CFC, which conducts business in Country A. CFC 
sells Asset X for $1,000x. For Country A tax purposes, CFC's basis in 
Asset X is $600x, the sale of Asset X occurs in Year 1, and CFC 
recognizes $400x of foreign gross income and incurs $80x of foreign 
income tax. For Federal income tax purposes, CFC's basis in Asset X is 
$500x, the sale of Asset X occurs in Year 2, and CFC recognizes $500x of 
general category income.
    (ii) Analysis. For purposes of allocating and apportioning the $80x 
of Country A foreign income tax in Year 1, the $400x of Country A gross 
income from the sale of Asset X is first assigned to separate 
categories. There is

[[Page 301]]

no corresponding U.S. item because the sale occurs on a different date 
and in a different U.S. taxable year for U.S. and foreign tax purposes. 
Under paragraph (d)(2)(ii)(C) of this section, the item of foreign gross 
income (the $400x from the sale of Asset X) is characterized and 
assigned to the groupings to which the corresponding U.S. item would be 
assigned if for Federal income tax purposes Asset X were sold for 
$1,000x in Year 1, the same U.S. taxable year in which the foreign 
income tax accrued. This is the case even though the amount of gross 
income that would be recognized for Federal income tax purposes differs 
from the amount recognized for Country A tax purposes. Accordingly, the 
$400x of Country A gross income is assigned to the general category. 
Additionally, because all of the Country A taxable income is assigned to 
a single separate category, the $80x of Country A tax is also allocated 
to the general category. No apportionment of the $80x is necessary 
because the class of gross income to which the deduction is allocated 
consists entirely of a single statutory grouping, general category 
income.
    (4) Example 3: Foreign gross income excluded from U.S. gross 
income--(i) Facts. USP conducts business in Country A. In Year 1, USP 
earns $200x of interest income on a State or local bond. For Country A 
tax purposes, the $200x of income is included in gross income and incurs 
$10x of foreign income tax. For Federal income tax purposes, the $200x 
is excluded from gross income under section 103.
    (ii) Analysis. For purposes of allocating and apportioning the $10x 
of Country A foreign income tax, the $200x of Country A gross income is 
first assigned to separate categories. There is no corresponding U.S. 
item because the interest income is excluded from U.S. gross income. 
Thus, the rules of paragraph (d)(2) of this section apply to 
characterize and assign the foreign gross income to the groupings to 
which a corresponding U.S. item would be assigned if it were recognized 
under Federal income tax law in that U.S. taxable year. The interest 
income is excluded from U.S. gross income but is otherwise described or 
identified by section 103. Accordingly, under paragraph (d)(2)(iii)(A) 
of this section, the $200x of Country A gross income is assigned to the 
separate category to which the interest income would be assigned under 
Federal income tax law if the income were included in gross income. 
Under section 904(d)(2)(B)(i), the interest income would be passive 
category income. Accordingly, the $200x of Country A gross income is 
assigned to the passive category. Additionally, because all of the 
Country A taxable income is assigned to a single separate category, the 
$10x of Country A tax is also allocated to the passive category (subject 
to the rules in Sec.  1.904-4(c)). No apportionment of the $10x is 
necessary because the class of gross income to which the deduction is 
allocated consists entirely of a single statutory grouping, passive 
category income.
    (5) Example 4: Actual distribution--(1) Facts. USP owns all of the 
outstanding stock of CFC1, which in turn owns all of the outstanding 
stock of CFC2. CFC1 and CFC2 conduct business in Country A. In Year 1, 
CFC2 distributes $300x to CFC1. For Country A tax purposes, $100x of the 
distribution is the foreign dividend amount, $160x is treated as a 
nontaxable return of capital, and the remaining $40x is the foreign 
capital gain amount. CFC1 incurs $20x of foreign income tax with respect 
to the foreign dividend amount and $4x of foreign income tax with 
respect to the foreign capital gain amount. The $20x and $4x of foreign 
income tax are each a separate levy within the meaning of Sec.  1.901-
2(d). For Federal income tax purposes, $150x of the distribution is the 
U.S. dividend amount, $100x is the U.S. return of capital amount, and 
the remaining $50x is the U.S. capital gain amount. Under section 
904(d)(3)(D) and Sec. Sec.  1.904-4(d) and 1.904-5(c)(4), the $150x of 
U.S. dividend amount consists solely of general category income in the 
hands of CFC1. Under section 904(d)(2)(B)(i) and Sec.  1.904-
4(b)(2)(i)(A), the $50x of U.S. capital gain amount is passive category 
income to CFC1.
    (ii) Analysis--(A) In general. Because the $20x of Country A foreign 
income tax and the $4x of Country A foreign income tax are separate 
levies, the taxes are allocated and apportioned separately. For purposes 
of allocating and apportioning each foreign income

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tax, the relevant item of Country A gross income (the foreign dividend 
amount or foreign capital gain amount) is first assigned to separate 
categories. The U.S. dividend amount and U.S. capital gain amount are 
corresponding U.S. items. However, paragraph (d)(3)(i)(B) of this 
section (and not paragraph (d)(1) of this section) applies to assign the 
items of foreign gross income arising from the distribution.
    (B) Foreign dividend amount. Under paragraph (d)(3)(i)(B)(2) of this 
section, the foreign dividend amount ($100x) is, to the extent of the 
U.S. dividend amount ($150x), assigned to the same separate category 
from which the distribution of the U.S. dividend amount is made under 
Federal income tax law. Thus, $100x of foreign gross income that is the 
foreign dividend amount is assigned to the general category. 
Additionally, because all of the Country A taxable income included in 
the base on which the $20x of foreign income tax is imposed is assigned 
to a single separate category, the $20x of Country A tax on the foreign 
dividend amount is also allocated to the general category. No 
apportionment of the $20x is necessary because the class of gross income 
to which the deduction for foreign income tax is allocated consists 
entirely of a single statutory grouping, general category income. See 
also section 245A(d) for rules that may apply to disallow a credit or 
deduction for certain foreign taxes.
    (C) Foreign capital gain amount. Under paragraph (d)(3)(i)(B)(3) of 
this section, the foreign capital gain amount ($40x) is, to the extent 
of the U.S. capital gain amount ($50x), assigned to the same separate 
category to which the U.S. capital gain is assigned under Federal income 
tax law. Thus, the $40x of foreign gross income that is the foreign 
capital gain amount is assigned to the passive category. Additionally, 
because all of the Country A taxable income in the base on which the $4x 
of foreign income tax is imposed is assigned to a single separate 
category, the $4x of Country A tax on the foreign dividend amount is 
also allocated to the passive category. No apportionment of the $4x is 
necessary because the class of gross income to which the deduction is 
allocated consists entirely of a single statutory grouping, passive 
category income.
    (6) Example 5: Foreign law distribution--(i) Facts. USP owns all of 
the outstanding stock of CFC. In Year 1, for Country A tax purposes, CFC 
distributes $1,000x of its stock that is treated entirely as a dividend 
to USP, and Country A imposes a withholding tax on USP of $150x with 
respect to the $1,000x of foreign gross income. For Federal income tax 
purposes, the distribution is treated as a stock dividend described in 
section 305(a) and USP recognizes no U.S. gross income. At the time of 
the distribution, CFC has $800x of section 965(a) PTEP (as defined in 
Sec.  1.960-3(c)(2)(vi)) in a single annual PTEP account (as defined in 
Sec.  1.960-3(c)(1)), and $500x of earnings and profits described in 
section 959(c)(3). Section 965(g) is the operative section for purposes 
of this paragraph (g)(6). See Sec.  1.965-5(b)(2). Section 904 is also a 
relevant operative section, but is not addressed in this paragraph 
(g)(6).
    (ii) Analysis. For purposes of allocating and apportioning the $150x 
of Country A foreign income tax, the $1,000x of Country A gross income 
is first assigned to the relevant statutory and residual groupings for 
purposes of applying section 965(g) as the operative section. Under 
Sec.  1.965-5(b)(2), the statutory grouping is the portion of the 
distribution that is attributable to section 965(a) previously taxed 
earnings and profits and the residual grouping is the portion of the 
distribution attributable to other earnings and profits. There is no 
corresponding U.S. item because under section 305(a) USP recognizes no 
U.S. gross income with respect to the distribution. Under paragraph 
(d)(2)(ii)(B) of this section, the item of foreign gross income (the 
$1,000x distribution) is assigned under the rules of paragraph 
(d)(3)(i)(B) of this section to the same statutory or residual groupings 
to which the foreign gross income would be assigned if a distribution of 
the same amount were made for Federal income tax purposes in Year 1 on 
the date the distribution occurs for foreign law purposes. If recognized 
for Federal income tax purposes, a $1,000x distribution in Year 1 would 
result in a U.S. dividend amount of $1,000x. Under

[[Page 303]]

paragraph (d)(3)(i)(B)(2) of this section, the foreign dividend amount 
($1,000x) is, to the extent of the U.S. dividend amount ($1,000x), 
assigned to the same statutory or residual groupings from which a 
distribution of the U.S. dividend amount would be made under Federal 
income tax law. Thus, $800x of foreign gross income related to the 
foreign dividend amount is assigned to the statutory grouping for the 
portion of the distribution attributable to section 965(a) previously 
taxed earnings and profits and $200x of foreign gross income is assigned 
to the residual grouping. Under paragraph (f) of this section, $120x 
($150x x $800x/$1,000x) of the Country A foreign income tax is 
apportioned to the statutory grouping and $30x ($150x x $200x/$1,000x) 
of the Country A foreign income tax is apportioned to the residual 
grouping. See section 965(g)(2) and Sec.  1.965-5(b) for application of 
the applicable percentage (as defined in Sec.  1.965-5(d)) to the 
foreign income tax allocated and apportioned to the statutory grouping.
    (7) Example 6: Foreign law inclusion regime, CFC shareholder--(i) 
Facts. USP owns all of the outstanding stock of CFC1, which in turn owns 
all of the outstanding stock of CFC2. CFC2 is organized and conducts 
business in Country B. Country A has a foreign law inclusion regime that 
imposes a tax on CFC1 for certain earnings of CFC2, a foreign law CFC. 
In Year 1, CFC2 earns $400x of interest income and $200x of royalty 
income. CFC2 incurs no foreign income tax. For Country A tax purposes, 
the $400x of interest income and $200x of royalty income are each an 
item of foreign law inclusion regime income of CFC2 that are included in 
the gross income of CFC1. CFC1 incurs $150x of Country A foreign income 
tax with respect to the foreign law inclusion regime income. For Federal 
income tax purposes, with respect to CFC2, the $400x of interest income 
is passive category income under section 904(d)(2)(B)(i) and the $200x 
of royalty income is general category income under Sec.  1.904-
4(b)(2)(iii).
    (ii) Analysis. For purposes of allocating and apportioning CFC1's 
$150x of Country A foreign income tax, the $600x of Country A gross 
income is first assigned to separate categories. The $600x of foreign 
gross income is not included in the U.S. gross income of CFC1, and thus, 
there is no corresponding U.S. item. Under paragraph (d)(3)(iii) of this 
section, each item of foreign law inclusion regime income that is 
included in CFC1's foreign gross income is assigned to the same separate 
category as the items of foreign gross income of CFC2 that give rise to 
the foreign law inclusion regime income of CFC1. With respect to CFC2, 
the $400x of interest income and the $200x of royalty income would be 
corresponding U.S. items if CFC2 were the taxpayer. Accordingly, $400x 
of CFC1's foreign gross income is assigned to the passive category and 
$200x of CFC1's foreign gross income is assigned to the general 
category. Under paragraph (f) of this section, $100x ($150x x $400x/
$600x) of the Country A foreign income tax is apportioned to the passive 
category and $50x ($150x x $200x/$600x) of the Country A foreign income 
tax is apportioned to the general category.
    (8) Example 7: Foreign law inclusion regime, U.S. shareholder--(i) 
Facts. The facts are the same as in paragraph (g)(7)(i) of this section 
(the facts in Example 6), except that both CFC1 and CFC2 are organized 
and conduct business in Country B, all of the outstanding stock of CFC1 
is owned by Individual X, a U.S. citizen resident in Country A, and 
Country A imposes tax of $150x on foreign gross income of $600x under 
its foreign law inclusion regime on Individual X, rather than on CFC1. 
For Federal income tax purposes, in the hands of CFC2, the $400x of 
interest income is passive category subpart F income and the $200x of 
royalty income is general category tested income (as defined in Sec.  
1.951A-2(b)(1)). CFC2's $400x of interest income gives rise to a passive 
category subpart F inclusion under section 951(a)(1)(A), and its $200x 
of tested income gives rise to a GILTI inclusion amount (as defined in 
Sec.  1.951A-1(c)(1)) of $200x, with respect to Individual X.
    (ii) Analysis. The analysis is the same as in paragraph (g)(7)(ii) 
of this section (the analysis in Example 6) except that under Sec.  
1.904-6(f), because $50x of the Country A foreign income tax is 
allocated and apportioned under paragraph

[[Page 304]]

(d)(3)(iii) of this section to CFC2's general category tested income 
group to which Individual X's inclusion under section 951A is 
attributable, the $50x of Country A foreign income tax is allocated and 
apportioned in the hands of Individual X to the section 951A category.
    (9) Example 8: Sale of disregarded entity--(i) Facts. USP sells FDE, 
a disregarded entity that is organized and operates a trade or business 
in Country A, for $500x. FDE owns Asset X and Asset Y in Country A, each 
having a fair market value of $250x. For Country A tax purposes, FDE has 
a basis in Asset X of $100x and a basis in Asset Y of $200x, USP's basis 
in FDE is $100x, and the sale is treated as a sale of stock. Country A 
imposes foreign income tax of $40x on USP on the Country A gross income 
of $400x resulting from the sale of FDE, based on its rules for taxing 
capital gains of nonresidents selling stock of companies operating a 
trade or business in Country A. For Federal income tax purposes, USP has 
a basis of $150x in each of Assets X and Y, and so the sale of FDE 
results in $100x of passive category income with respect to the sale of 
Asset X and $100x of general category income with respect to the sale of 
Asset Y.
    (ii) Analysis. For purposes of allocating and apportioning USP's 
$40x of Country A foreign income tax, the $400x of Country A gross 
income resulting from the sale of FDE is first assigned to separate 
categories. Under paragraph (d)(3)(iv) of this section, USP's $400x of 
Country A gross income is assigned among the statutory groupings in the 
same percentages as the foreign gross income in each grouping that would 
have resulted if the sale of FDE were treated as an asset sale for 
Country A tax purposes. Because for Country A tax purposes Asset X had a 
built-in gain of $150x and Asset Y had a built-in gain of $50x, $300x 
($400x x $150x/$200x) of the Country A gross income is assigned to the 
passive category and $100x ($400x x $50x/$200x) is assigned to the 
general category. Under paragraph (f) of this section, $30x ($40x x 
$300x/$400x) of the Country A foreign income tax is apportioned to the 
passive category, and $10x ($40x x $100x/$400x) of the Country A foreign 
income tax is apportioned to the general category.
    (10) Example 9: Gain on disposition of stock--(i) Facts. USP owns 
all of the outstanding stock of CFC, which conducts business in Country 
A. In Year 1, USP sells all of the stock of CFC to US2 for $1,000x. For 
Country A tax purposes, USP's basis in the stock of CFC is $200x. 
Accordingly, USP recognizes $800x of gain on which Country A imposes 
$80x of foreign income tax based on its rules for taxing capital gains 
of nonresidents, which satisfy the requirement in Sec.  1.901-
2(b)(5)(i)(C). For Federal income tax purposes, USP's basis in the stock 
of CFC is $400x. Accordingly, USP recognizes $600x of gain on the sale 
of the stock of CFC, of which $150x is included in the gross income of 
USP as a dividend under section 1248(a) that, as provided in section 
1248(j), is treated as a dividend eligible for the deduction under 
section 245A(a). Under paragraphs (b)(20) and (21) of this section, 
respectively, the sale of CFC stock by USP gives rise to a $450x U.S. 
capital gain amount and a $150x U.S. dividend amount. Under Sec. Sec.  
1.904-4(d) and 1.904-5(c)(4), the $150x U.S. dividend amount is general 
category section 245A subgroup income, and the $450x U.S. capital gain 
amount is passive category income to USP. For purposes of allocating and 
apportioning its interest expense under Sec. Sec.  1.861-9(g)(2)(i)(B) 
and 1.861-13, USP's stock in CFC is characterized as general category 
stock in the section 245A subgroup.
    (ii) Analysis. For purposes of allocating and apportioning the $80x 
of Country A foreign income tax, the $800x of Country A gross income 
from the sale of the stock of CFC is first assigned to separate 
categories. Under paragraph (d)(3)(i)(D) of this section, the $800x of 
Country A gross income is first assigned to the separate category to 
which the $150x U.S. dividend amount is assigned, to the extent thereof, 
and is next assigned to the separate category to which the $450x U.S. 
capital gain amount is assigned, to the extent thereof. Accordingly, 
$150x of Country A gross income is assigned to the general category in 
the section 245A subgroup, and $450x of Country A gross income is 
assigned to the passive

[[Page 305]]

category. Under paragraph (d)(3)(i)(D) of this section, the remaining 
$200x of Country A gross income is assigned to the statutory and 
residual groupings to which earnings of CFC in that amount would be 
assigned if they were recognized for Federal income tax purposes in the 
U.S. taxable year in which the disposition occurred. These earnings are 
all deemed to arise in the section 245A subgroup of the general 
category, based on USP's characterization of its stock in CFC. Thus, 
under paragraph (d)(3)(i)(D) of this section the $800x of foreign gross 
income, and therefore the foreign taxable income, is characterized as 
$350x ($150x + $200x) of income in the general category section 245A 
subgroup and $450x of income in the passive category. This is the result 
even though for Country A tax purposes all $800x of Country A gross 
income is characterized as gain from the sale of stock, which would be 
passive category income under section 904(d)(2)(B)(i), because the 
income is assigned to a separate category based on the characterization 
of the gain under Federal income tax law. Under paragraph (f) of this 
section, the $80x of Country A tax is ratably apportioned between the 
general category section 245A subgroup and the passive category based on 
the relative amounts of foreign taxable income in each grouping. 
Accordingly, $35x ($80x x $350x/$800x) of the Country A tax is 
apportioned to the general category section 245A subgroup, and $45x 
($80x x $450x/$800x) of the Country A tax is apportioned to the passive 
category. See also Sec.  1.245A(d)-1 for rules that may disallow a 
credit or deduction for the $35x of Country A tax apportioned to the 
general category section 245A subgroup.
    (11) Example 10: Disregarded transfer of built-in gain property--(i) 
Facts. USP owns FDE, a disregarded entity that is treated for Federal 
income tax purposes as a foreign branch operating in Country A. FDE 
transfers Asset F, equipment used in FDE's trade or business in Country 
A, for no consideration to USP in a transaction that is a remittance 
described in paragraph (d)(3)(v)(E) of this section for Federal income 
tax purposes but is treated as a distribution of Asset F from a 
corporation to its shareholder, USP, for Country A tax purposes. At the 
time of the transfer, Asset F has a fair market value of $250x and an 
adjusted basis of $100x for both Federal and Country A income tax 
purposes. Country A imposes $30x of tax on FDE with respect to the $150x 
of built-in gain on a deemed sale of Asset F, which is recognized for 
Country A tax purposes by reason of the transfer to USP. If FDE had sold 
Asset F for $250x in a transaction that was regarded for Federal income 
tax purposes, FDE would also have recognized gain of $150x for Federal 
income tax purposes, and that gain would have been characterized as 
foreign branch category income under Sec.  1.904-4(f). Country A also 
imposes $25x of withholding tax, a separate levy, on USP by reason of 
the distribution of Asset F to USP.
    (ii) Analysis--(A) Net income tax on built-in gain. For purposes of 
allocating and apportioning the $30x of Country A foreign income tax 
imposed on FDE by reason of the transfer of Asset F to USP for Country A 
tax purposes, under paragraph (c)(1) of this section the $150x of 
Country A gross income is first assigned to a separate category. Because 
the transfer does not result in a deemed sale for Federal income tax 
purposes, there is no corresponding U.S. item. However, FDE would have 
recognized gain of $150x, which would have been the corresponding U.S. 
item, if the deemed sale had been recognized for Federal income tax 
purposes. Therefore, under paragraph (d)(2)(ii) of this section, the 
$150x item of foreign gross income is characterized and assigned to the 
grouping to which such corresponding U.S. item would have been assigned 
if the deemed sale were recognized under Federal income tax law. Because 
the sale of Asset F in a regarded transaction would have resulted in 
foreign branch category income, the foreign gross income is 
characterized as foreign branch category income. Under paragraph (f) of 
this section, the $30x of Country A tax is also allocated to the foreign 
branch category, the statutory grouping to which the $150x of Country A 
gross income is assigned. No apportionment of the $30x of Country A tax 
is necessary because the class of gross income to which the

[[Page 306]]

foreign gross income is allocated consists entirely of a single 
statutory grouping.
    (B) Withholding tax on distribution. For purposes of allocating and 
apportioning the $25x of Country A withholding tax imposed on USP by 
reason of the transfer of Asset F, under paragraph (c)(1) of this 
section the $250x of Country A gross income arising from the transfer of 
Asset F is first assigned to a separate category. For Federal income tax 
purposes, the transfer of Asset F is a remittance from FDE to USP, and 
thus there is no corresponding U.S. item. Under paragraph 
(d)(3)(v)(C)(1)(i) of this section, the item of foreign gross income is 
assigned to the groupings to which the income out of which the payment 
is made is assigned; the payment is considered to be made ratably out of 
all of the accumulated after-tax income of FDE, as computed for Federal 
income tax purposes; and the accumulated after-tax income of FDE is 
deemed to have arisen in the statutory and residual groupings in the 
same proportions as those in which the tax book value of FDE's assets in 
the groupings, determined in accordance with paragraph 
(d)(3)(v)(C)(1)(ii) of this section, are assigned for purposes of 
apportioning USP's interest expense. Because all of FDE's assets produce 
foreign branch category income, under paragraph (d)(3)(v)(C)(1) of this 
section the foreign gross income is characterized as foreign branch 
category income. Under paragraph (f) of this section, the $25x of 
Country A withholding tax is also allocated entirely to the foreign 
branch category, the statutory grouping to which the $250x of Country A 
gross income is assigned. No apportionment of the $25x is necessary 
because the class of gross income to which the foreign gross income is 
allocated consists entirely of a single statutory grouping.
    (12) Example 11: Disregarded payment that is a remittance--(i) 
Facts. USP wholly owns CFC1, which is a tested unit within the meaning 
of Sec.  1.951A-2(c)(7)(iv)(A) (the ``CFC1 tested unit''). CFC1 wholly 
owns FDE, a disregarded entity that is organized in Country B, which is 
a tested unit within the meaning of Sec.  1.951A-2(c)(7)(iv)(A) (the 
``FDE tested unit''). The sole assets of FDE (determined in accordance 
with paragraph (d)(3)(v)(C)(1)(ii) of this section) are all the 
outstanding stock of CFC3, a controlled foreign corporation organized in 
Country B. In Year 1, CFC3 pays a $400x dividend to FDE that is excluded 
from CFC1's foreign personal holding company income (``FPHCI'') by 
reason of section 954(c)(6). FDE makes no payments to CFC1 and pays no 
Country B tax in Year 1. In Year 2, FDE makes a $400x remittance to CFC1 
as defined in paragraph (d)(3)(v)(E) of this section. Under the laws of 
Country B, the remittance gives rise to a $400x dividend. Country B 
imposes a 5% ($20x) withholding tax (which is an eligible current year 
tax as defined in Sec.  1.960-1(b)) on CFC1 on the dividend. In Year 2, 
CFC3 pays no dividends to FDE, and FDE earns no income. For Federal 
income tax purposes, the $400x payment from FDE to CFC1 is a disregarded 
payment and results in no income to CFC1. For purposes of this paragraph 
(g)(12) (Example 11), section 960(a) is the operative section and the 
income groups described in Sec.  1.960-1(d)(2) are the statutory and 
residual groupings. See Sec.  1.960-1(d)(3)(ii)(A) (applying Sec.  
1.960-1 to allocate and apportion current year taxes to income groups). 
For Federal income tax purposes, in Year 2 the stock of CFC3 owned by 
FDE has a tax book value of $1,000x, $750x of which is assigned under 
the asset method in Sec.  1.861-9 (as applied by treating CFC1 as a 
United States person) to the general category tested income group 
described in Sec.  1.960-1(d)(2)(ii)(C), and $250x of which is assigned 
to a passive category FPHCI group described in Sec.  1.960-
1(d)(2)(ii)(B)(2)(i).
    (ii) Analysis. (A) The $20x Country B withholding tax on the Year 2 
remittance from FDE is imposed on a $400x item of foreign gross income 
that CFC1 includes in foreign gross income by reason of its receipt of a 
disregarded payment. In order to allocate and apportion the $20x of 
Country B withholding tax under paragraph (c) of this section for 
purposes of Sec.  1.960-1(d)(3)(ii)(A), paragraph (d)(3)(v) of this 
section applies to assign the $400x item of foreign gross dividend 
income to a statutory or residual grouping. Under paragraph 
(d)(3)(v)(C)(1) of this section,

[[Page 307]]

the $400x item of foreign gross income is assigned to the statutory or 
residual groupings of the CFC1 tested unit that correspond to the 
statutory and residual groupings out of which FDE made the remittance.
    (B) Under paragraph (d)(3)(v)(C)(1)(i) of this section, FDE is 
considered to have made the remittance ratably out of all of its 
accumulated after-tax income, which is deemed to have arisen in the 
statutory and residual groupings in the same proportions as the 
proportions in which the tax book value of FDE's assets would be 
assigned (if CFC1 were a United States person) for purposes of 
apportioning interest expense under the asset method in Year 2, the 
taxable year in which FDE made the remittance. Accordingly, $300x ($400x 
x $750x/$1,000x) of the remittance is deemed made out of the general 
category tested income of the FDE tested unit, and $100x ($400x x $250x/
$1,000x) of the remittance is deemed made out of the passive category 
FPHCI of the FDE tested unit.
    (C) Under paragraph (d)(3)(v)(C)(1)(i) of this section, $300x of the 
$400x item of foreign gross income from the remittance, and therefore an 
equal amount of foreign taxable income, is assigned to the income group 
that includes general category tested income attributable to the CFC1 
tested unit, and $100x of this foreign gross income item, and therefore 
an equal amount of foreign taxable income, is assigned to the income 
group that includes passive category FPHCI attributable to the CFC1 
tested unit. Under paragraph (f) of this section, the $20x of Country B 
withholding tax is ratably apportioned between the income groups based 
on the relative amounts of foreign taxable income in each grouping. 
Accordingly, $15x ($20x x $300x/$400x) of the Country B withholding tax 
is apportioned to the CFC1 tested unit's general category tested income 
group, and $5x ($20x x $100x/$400x) of the Country B withholding tax is 
apportioned to the CFC1 tested unit's passive category FPHCI income 
group. See Sec.  1.960-2 for rules on determining the amount of such 
taxes that may be deemed paid under section 960(a) and (d).
    (13) Example 12: Disregarded payment that is a reattribution 
payment--(i) Facts. (A) USP wholly owns CFC1, a tested unit within the 
meaning of Sec.  1.951A-2(c)(7)(iv)(A)(1) (the ``CFC1 tested unit''). 
CFC1 wholly owns FDE1, a disregarded entity organized in Country B, that 
is a tested unit within the meaning of Sec.  1.951A-2(c)(7)(iv)(A)(2) 
(the ``FDE1 tested unit''). Country B imposes a 20 percent net income 
tax on its residents. CFC1 also wholly owns FDE2, a disregarded entity 
organized in Country C, that is a tested unit within the meaning of 
Sec.  1.951A-2(c)(7)(iv)(A)(2) (the ``FDE2 tested unit''). Country C 
imposes a 15 percent net income tax on its residents. The net income tax 
imposed by each of Country B and Country C on their tax residents is a 
foreign income tax within the meaning of Sec.  1.901-2(a) and a separate 
levy within the meaning of Sec.  1.901-2(d). For purposes of this 
paragraph (g)(13) (Example 12), the operative section is the high-tax 
exclusion of section 951A(c)(2)(A)(i)(III) and Sec.  1.951A-2(c)(7), and 
the statutory groupings are the tested income groups of each tested 
unit, as defined in Sec.  1.951A-2(c)(7)(iv)(A).
    (B) FDE2 owns Asset A, which is intangible property with a tax book 
value of $12,000x that is properly reflected on the separate set of 
books and records of FDE2. In Year 1, pursuant to a license agreement 
between FDE1 and FDE2 for the use of Asset A, FDE1 makes a disregarded 
royalty payment to FDE2 of $1,000x that would be deductible if regarded 
for Federal income tax purposes. Because it is disregarded for Federal 
income tax purposes, the $1,000x disregarded royalty payment by FDE1 to 
FDE2 results in no income to CFC1 for Federal income tax purposes. Also, 
in Year 1, pursuant to a sub-license agreement between FDE1 and an 
unrelated third party for the use of Asset A, FDE1 earns $1,200x of 
royalty income for Federal income tax purposes (the ``U.S. gross 
royalty'') for the use of Asset A. The $1,200 of royalty income received 
by FDE1 from the unrelated third party is excluded from CFC1's foreign 
personal holding company income by reason of the active business 
exception in section 954(c)(2) because CFC1 satisfies the requirements 
of Sec.  1.954-2(d)(1). As a result, the $1,200x of royalty income that 
FDE1

[[Page 308]]

earns from the sub-license agreement is gross tested income (as defined 
in Sec.  1.951A-2(c)(1)), which is properly reflected on the separate 
set of books and records of FDE1.
    (C) Under the laws of Country B, the transaction that gives rise to 
the $1,200x item of U.S. gross royalty income causes FDE1 to include a 
$1,200x item of gross royalty income in its Country B taxable income 
(the ``Country B gross royalty''). In addition, FDE1 deducts its $1,000x 
disregarded royalty payment to FDE2 for Country B tax purposes. For 
Country B tax purposes, FDE1 therefore has $200x ($1,200x-$1,000x) of 
taxable income on which Country B imposes $40x (20% x $200x) of net 
income tax.
    (D) Under the laws of Country C, the $1,000x disregarded royalty 
payment from FDE1 to FDE2 causes FDE2 to include a $1,000x item of gross 
royalty income in its Country C taxable income (the ``Country C gross 
royalty''). FDE2 therefore has $1,000x of taxable income for Country C 
tax purposes, on which Country C imposes $150x (15% x $1,000x) of net 
income tax.
    (ii) Analysis--(A) Country B net income tax. (1) The Country B net 
income tax is imposed on foreign taxable income of FDE1 that consists of 
a $1,200x item of Country B gross royalty income and a $1,000x item of 
royalty expense. For Federal income tax purposes, the FDE1 tested unit 
has a $1,200x item of U.S. gross royalty income that is initially 
attributable to it under paragraph (d)(3)(v)(B)(2) of this section and 
Sec.  1.951A-2(c)(7)(ii)(B). The transaction that produced the $1,200x 
item of U.S. gross royalty income also produced the $1,200x item of 
Country B gross royalty income. Under paragraph (b)(2) of this section, 
the $1,200x item of U.S. gross royalty income is therefore the 
corresponding U.S. item for the $1,200x item of Country B gross royalty 
income of FDE1.
    (2) The $1,000x disregarded royalty payment from FDE1 to FDE2 is 
allocated under paragraph (d)(3)(v)(B)(2) of this section and Sec.  
1.951A-2(c)(7)(ii)(B) to the $1,200x of U.S. gross income of the FDE1 
tested unit to the extent of that gross income. As a result, the $1,000x 
disregarded royalty payment causes $1,000x of the $1,200x item of U.S. 
gross royalty income to be reattributed from the FDE1 tested unit to the 
FDE2 tested unit, and results in a $1,000x reattribution amount that is 
also a reattribution payment.
    (3) The $1,200x Country B gross royalty item that is included in the 
Country B taxable income of FDE1 is assigned under paragraph (d)(1) of 
this section to the statutory or residual grouping to which the $1,200x 
corresponding U.S. item is initially assigned under Sec.  1.951A-
2(c)(7)(ii), namely, the FDE1 income group. This assignment is made 
without regard to the $1,000x reattribution payment from the FDE1 tested 
unit to the FDE2 tested unit; none of the FDE1 tested unit's $1,200x 
Country B gross royalty income is reattributed to the FDE2 tested unit 
for this purpose. See paragraph (d)(3)(v)(B)(3) of this section. Under 
paragraph (f) of this section, all of the $40x of Country B net income 
tax on the $200x of Country B taxable income is allocated to the FDE1 
income group, the statutory grouping to which the $1,200x item of 
Country B gross royalty income of FDE1 is assigned. No apportionment of 
the $40x is necessary because the class of gross income to which the 
foreign gross income is allocated consists entirely of a single 
statutory grouping.
    (B) Country C net income tax. The Country C net income tax is 
imposed on foreign taxable income of FDE2 that consists of a $1,000x 
item of Country C gross royalty income. For Federal income tax purposes, 
under paragraph (d)(3)(v)(B)(2) of this section and Sec.  1.951A-
2(c)(7)(ii)(B), the FDE2 tested unit has a reattribution amount of 
$1,000x of U.S. gross royalty income by reason of its receipt of the 
$1,000x reattribution payment from FDE1. The $1,000x item of U.S. gross 
royalty income that is included in the taxable income of the FDE2 tested 
unit by reason of the $1,000x reattribution payment is assigned under 
paragraph (d)(3)(v)(B)(1) of this section to the statutory or residual 
grouping to which the $1,000x reattribution amount of U.S. gross royalty 
income that constitutes the reattribution payment is assigned upon 
receipt by the FDE2 tested unit under Sec.  1.951A-2(c)(7)(ii), namely, 
the FDE2 income group. Under paragraph

[[Page 309]]

(d)(3)(v)(B)(1) of this section, the $1,000x item of Country C gross 
royalty income is assigned to the statutory grouping to which the 
$1,000x corresponding U.S. item is assigned. Accordingly, under 
paragraph (f) of this section, all of the $150x of Country C net income 
tax is allocated to the FDE2 income group, the statutory grouping to 
which the $1,000x item of Country C gross royalty income of FDE2 is 
assigned. No apportionment of the $150x is necessary because the class 
of gross income to which the foreign gross income is allocated consists 
entirely of a single statutory grouping.
    (14) Example 13: Assets of a taxable unit that owns an interest in a 
lower-tier taxable unit--(i) Facts. USP wholly owns CFC1, a tested unit 
within the meaning of Sec.  1.951A-2(c)(7)(iv)(A) (the ``CFC1 tested 
unit''). CFC1 wholly owns FDE1, a disregarded entity that is organized 
in Country A, and FDE2, a disregarded entity that is organized in 
Country B. CFC1's interests in FDE1 and FDE2 are each tested units 
within the meaning of Sec.  1.951A-2(c)(7)(iv)(A) (the ``FDE1 tested 
unit'' and ``FDE2 tested unit,'' respectively). The FDE1 tested unit and 
FDE2 tested unit each own 50% of the interests in FDE3, a disregarded 
entity that is organized in Country C. CFC1's indirect interests in FDE3 
are also a tested unit within the meaning of Sec.  1.951A-2(c)(7)(iv)(A) 
(the ``FDE3 tested unit''). The FDE2 tested unit owns Asset A with a tax 
book value of $10,000x, and makes a reattribution payment to FDE3 that 
causes $5,000x of the tax book value of Asset A to be assigned to FDE3 
under paragraph (d)(3)(v)(C)(1)(ii) of this section. FDE3 owns Asset B, 
which has a tax book value of $5,000x.
    (ii) Analysis--(A) Assets of the FDE3 tested unit. The assets of the 
FDE3 tested unit consist of the portion of Asset A that is assigned to 
it under paragraph (d)(3)(v)(C)(1)(ii) of this section and any other 
assets determined in accordance with Sec.  1.987-6(b). The assets of the 
FDE3 tested unit thus consist of $5,000x of the tax book value of Asset 
A and all $5,000x of the tax book value of Asset B.
    (B) Assets of the FDE2 tested unit. The assets of the FDE2 tested 
unit consist of the tax book value of any assets that it owns directly 
plus its pro rata share of the assets of the FDE3 tested unit, including 
the portion of reattribution assets assigned to the FDE3 tested unit. 
Asset A is a reattribution asset under paragraphs (d)(3)(v)(C)(1)(ii) 
and (d)(3)(v)(E) of this section. The assets of the FDE2 tested unit 
therefore consist of the portion of Asset A that it owns directly and 
that was not assigned to the FDE3 tested unit (or $5,000x) plus its pro 
rata share of the portion of Asset A that was assigned to the FDE3 
tested unit, or $2,500x (50% of $5,000x). In addition, the assets of the 
FDE2 tested unit include its pro rata share of the tax book value of 
Asset B, or $2,500x (50% of $5,000x).
    (C) Assets of the FDE1 tested unit. The assets of the FDE1 tested 
unit consist of its pro rata share of the assets of the FDE3 tested 
unit, including the portion of reattribution assets assigned to the FDE3 
tested unit. Asset A is a reattribution asset under paragraphs 
(d)(3)(v)(C)(1)(ii) and (d)(3)(v)(E) of this section. The assets of the 
FDE1 tested unit therefore consist of its pro rata share of the portion 
of Asset A that was reattributed to the FDE3 tested unit, or $2,500x 
(50% of $5,000x), plus its pro rata share of the tax book value of Asset 
B, or $2,500x (50% of $5,000x).
    (h) Allocation and apportionment of certain foreign in lieu of taxes 
described in section 903. A tax that is a foreign income tax by reason 
of Sec.  1.903-1(c)(1) is allocated and apportioned to statutory and 
residual groupings in the same proportions as the foreign taxable income 
that comprises the excluded income (as defined in Sec.  1.903-1(c)(1)). 
See paragraph (f) of this section for rules on allocating and 
apportioning certain withholding taxes described in Sec.  1.903-1(c)(2).
    (i) Applicability dates. Except as provided in this paragraph (i), 
this section applies to taxable years beginning after December 31, 2019. 
Paragraphs (b)(19) and (23) and (d)(3)(i), (ii), and (v) of this section 
apply to taxable years that begin after December 31, 2019, and end on or 
after November 2, 2020. Paragraph (h) of this section applies to taxable

[[Page 310]]

years beginning after December 28, 2021.

[T.D. 9922, 85 FR 72049, Nov. 12, 2020; 86 FR 54367, Oct. 1, 2021, as 
amended by T.D. 9959, 87 FR 327, Jan. 4, 2022; 87 FR 45019, July 27, 
2022]



Sec.  1.862-1  Income specifically from sources without the United States.

    (a) Gross income. (1) The following items of gross income shall be 
treated as income from sources without the United States:
    (i) Interest other than that specified in section 861(a)(1) and 
Sec.  1.861-2 as being derived from sources within the United States;
    (ii) Dividends other than those derived from sources within the 
United States as provided in section 861(a)(2) and Sec.  1.861-3;
    (iii) Compensation for labor or personal services performed without 
the United States;
    (iv) Rentals or royalties from property located without the United 
States or from any interest in such property, including rentals or 
royalties for the use of, or for the privilege of using, without the 
United States, patents, copyrights, secret processes and formulas, 
goodwill, trademarks, trade brands, franchises, and other like property;
    (v) Gains, profits, and income from the sale of real property 
located without the United States; and
    (vi) Gains, profits, and income derived from the purchase of 
personal property within the United States and its sale without the 
United States.
    (2) In applying subparagraph (1)(iv) of this paragraph for taxable 
years beginning after December 31, 1966, gains described in section 
871(a)(1)(D) and section 881(a)(4) from the sale or exchange after 
October 4, 1966, of patents, copyrights, and other like property shall 
be treated, as provided in section 871(e)(2), as rentals or royalties 
for the use of, or privilege of using, property or an interest in 
property. See paragraph (e) of Sec.  1.871-11.
    (3) For determining the time and place of sale of personal property 
for purposes of subparagraph (1)(vi) of this paragraph, see paragraph 
(c) of Sec.  1.861-7.
    (4) Income derived from the purchase of personal property within the 
United States and its sale within a possession of the United States 
shall be treated as derived entirely from within that possession.
    (5) If interest is paid on an obligation of a nonresident of the 
United States by a resident of the United States acting in the 
resident's capacity as a guarantor of the obligation of the nonresident, 
the interest will be treated as income from sources without the United 
States.
    (6) For rules treating certain interest as income from sources 
without the United States, see paragraph (b) of Sec.  1.861-2.
    (7) For the treatment of compensation for labor or personal services 
performed partly within the United States and partly without the United 
States, see paragraph (b) of Sec.  1.861-4.
    (b) Taxable income. The taxable income from sources without the 
United States, in the case of the items of gross income specified in 
paragraph (a) of this section, shall be determined on the same basis as 
that used in Sec.  1.861-8 for determining the taxable income from 
sources within the United States.
    (c) Income from certain property. For provisions permitting a 
taxpayer to elect to treat amounts of gross income attributable to 
certain aircraft or vessels first leased on or before December 28, 1980, 
as income from sources within the United States which would otherwise be 
treated as income from sources without the United States under paragraph 
(a) of this section, see Sec.  1.861-9. For provisions requiring amounts 
of gross income attributable to certain aircraft, vessels, or spacecraft 
first leased by the taxpayer after December 28, 1980, to be treated as 
income from sources within the United States which would otherwise be 
treated as income from sources without the United States under paragraph 
(a) of this section, see Sec.  1.861-9A.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7378, 40 FR 45434, Oct. 2, 1975; 40 FR 48508, Oct. 16, 
1975; T.D. 7928, 48 FR 55847, Dec. 16, 1983]



Sec.  1.863-0  Table of contents.

    This section lists captions contained in Sec. Sec.  1.863-1 through 
1.863-10.


[[Page 311]]



     Sec.  1.863-1 Allocation of gross income under section 863(a).

    (a) In general.
    (b) Natural resources.
    (1) In general.
    (2) Additional production activities.
    (3) Definitions.
    (i) Production activity.
    (ii) Additional production activities.
    (4) Determination of fair market value.
    (5) Determination of gross income.
    (6) Tax return disclosure.
    (7) Examples.
    (i) Example 1. No additional production, foreign source gross 
receipts.
    (ii) Example 2. No additional production, U.S. source gross 
receipts.
    (iii) Example 3. Production in United States, foreign sales.
    (iv) Example 4. Production and sales in United States.
    (v) Example 5. Additional production.
    (c) Determination of taxable income.
    (d) Scholarships, fellowship grants, grants, prizes, and awards.
    (1) In general.
    (2) Source of income.
    (i) United States source income.
    (ii) Foreign source income.
    (iii) Certain activities conducted outside the United States.
    (3) Definitions.
    (4) Effective dates.
    (i) Scholarships and fellowship grants.
    (ii) Grants, prizes and awards.
    (e) Residual interest in a REMIC.
    (1) REMIC inducement fees.
    (2) Excess inclusion income and net losses.
    (f) Applicability date.

      Sec.  1.863-2 Allocation and apportionment of taxable income.

    (a) Determination of taxable income.
    (b) Determination of source of taxable income.
    (c) Applicability date.

Sec.  1.863-3 Allocation and apportionment of income from certain sales 
                              of inventory.

    (a) In general.
    (1) Scope.
    (2) Cross references.
    (b) Sourcing based solely on production activities.
    (c) Determination of the source of gross income from production 
activity.
    (1) Production only within the United States or only within foreign 
countries.
    (i) Source of income.
    (ii) Definition of production assets.
    (iii) Location of production assets.
    (2) Production both within and without the United States.
    (i) Source of income.
    (ii) Adjusted basis of production assets.
    (A) In general.
    (B) Production assets used to produce other property.
    (3) Anti-abuse rule.
    (4) Examples.
    (i) Example1. Source of gross income.
    (ii) Example 2. Location of intangible property.
    (iii) Example 3. Anti-abuse rule.
    (d) Determination of source of taxable income.
    (e) Income partly from sources within a possession of the United 
States.
    (1) In general.
    (2) Allocation or apportionment for Possession Production Sales.
    (3) Allocation or apportionment for Possession Purchase Sales.
    (i) Determination of source of gross income from Possession Purchase 
Sales.
    (ii) Determination of source of gross income from business activity.
    (A) Source of gross income.
    (B) Business activity.
    (C) Location of business activity.
    (1) Sales activity.
    (2) Cost of goods sold.
    (3) Expenses.
    (4) Examples.
    (i) Example 1: Purchase of goods manufactured in possession.
    (ii) Example 2: Purchase of goods manufactured outside possession.
    (5) Special rules for partnerships.
    (f) Special rules for partnerships.
    (1) General rule.
    (2) Exceptions.
    (i) In general.
    (ii) Attribution of production assets to or from a partnership.
    (iii) Basis.
    (3) Examples.
    (i) Example 1. Distributive share of partnership income.
    (ii) Example 2. Distribution in kind.
    (g) Applicability dates.

             Sec.  1.863-4 Certain transportation services.

    (a) General.
    (b) Gross income.
    (c) Allocation of costs or expenses.
    (d) Items not included as costs or expenses.
    (1) Taxes and interest.
    (2) Other business activity and general expenses.
    (3) Personal exemptions and special deductions.
    (e) Property used while within the United States.
    (1) General.
    (2) Average property.
    (3) Current assets.
    (f) Taxable income.
    (1) General.
    (2) Interest and taxes.
    (3) General expenses.
    (4) Personal exemptions.
    (5) Special deductions.

[[Page 312]]

    (g) Allocation based on books of account.

       Sec.  1.863-6 Income from sources within a foreign country.

  Sec.  1.863-7 Allocation of income attributable to certain notional 
                principal contracts under section 863(a).

    (a) Scope.
    (1) Introduction.
    (2) Effective/applicability date.
    (b) Source of notional principal contract income.
    (1) General rule.
    (2) Qualified business unit exception.
    (3) Effectively connected notional principal contract income.
    (c) Election.
    (1) Eligibility and effect.
    (2) Time for making election.
    (3) Manner of making election.
    (d) Example.
    (e) Cross references.

  Sec.  1.863-8 Source of income derived from space and ocean activity 
                          under section 863(d).

    (a) In general.
    (b) Source of gross income from space and ocean activity.
    (1) Space and ocean income derived by a United States person.
    (2) Space and ocean income derived by a foreign person.
    (i) In general.
    (ii) Space and ocean income derived by a controlled foreign 
corporation.
    (iii) Space and ocean income derived by foreign persons engaged in a 
trade or business within the United States.
    (3) Source rules for income from certain sales of property.
    (i) Sales of purchased property.
    (ii) Sales of property produced by the taxpayer.
    (A) General.
    (B) Production only in space or international water, or only outside 
space and international water.
    (C) Production both in space or international water and outside 
space and international water.
    (4) Special rule for determining the source of gross income from 
services.
    (5) Special rule for determining source of income from 
communications activity (other than income from international 
communications activity).
    (c) Taxable income.
    (d) Space and ocean activity.
    (1) Definition.
    (i) Space activity.
    (ii) Ocean activity.
    (2) Determining a space or ocean activity.
    (i) Production of property in space or international water.
    (ii) Special rule for performance of services.
    (A) General.
    (B) Exception to the general rule.
    (3) Exceptions to space or ocean activity.
    (e) Treatment of partnerships.
    (f) Examples.
    (1) Example 1. Space activity--activity occurring on land and in 
space.
    (2) Example 2. Space activity.
    (3) Example 3. Services as space activity--de minimis value 
attributable to performance occurring in space.
    (4) Example 4. Space activity.
    (5) Example 5. Space activity.
    (6) Example 6. Space activity--treatment of land activity.
    (7) Example 7. Use of intangible property in space.
    (8) Example 8. Performance of services.
    (9) Example 9. Separate transactions.
    (10) Example 10. Sale of property in international water.
    (11) Example 11. Sale of property in space.
    (12) Example 12. Sale of property in space.
    (13) Example 13. Source of income of a foreign person.
    (14) Example 14. Source of income of a foreign person.
    (g) Reporting and documentation requirements.
    (1) In general.
    (2) Required documentation.
    (3) Access to software.
    (4) Use of allocation methodology.
    (h) Applicability date.

  Sec.  1.863-9 Source of income derived from communications activity 
                   under section 863(a), (d), and (e).

    (a) In general.
    (b) Source of international communications income.
    (1) International communications income derived by a United States 
person.
    (2) International communications income derived by foreign persons.
    (i) In general.
    (ii) International communications income derived by a controlled 
foreign corporation.
    (iii) International communications income derived by foreign persons 
with a fixed place of business in the United States.
    (iv) International communications income derived by foreign persons 
engaged in a trade or business within the United States.
    (c) Source of U.S. communications income.
    (d) Source of foreign communications income.
    (e) Source of space/ocean communications income.
    (f) Source of communications income when taxpayer cannot establish 
the two points between which the taxpayer is paid to transmit the 
communication.
    (g) Taxable income.
    (h) Communications activity and income derived from communications 
activity.
    (1) Communications activity.

[[Page 313]]

    (i) General rule.
    (ii) Separate transaction.
    (2) Income derived from communications activity.
    (3) Determining the type of communications activity.
    (i) In general.
    (ii) Income derived from international communications activity.
    (iii) Income derived from U.S. communications activity.
    (iv) Income derived from foreign communications activity.
    (v) Income derived from space/ocean communications activity.
    (i) Treatment of partnerships.
    (j) Examples.
    (k) Reporting and documentation requirements.
    (1) In general.
    (2) Required documentation.
    (3) Access to software.
    (4) Use of allocation methodology.
    (l) Effective date.

     Sec.  1.863-10 Source of income from a qualified fails charge.

    (a) In general.
    (b) Qualified business unit exception.
    (c) Effectively connected income exception.
    (d) Qualified fails charge.
    (e) Designated security.
    (g) Effective/applicability date.

[T.D. 9921, 85 FR 79843, Dec. 11, 2020]



Sec.  1.863-0A  Table of contents.

    This section lists captions contained in Sec. Sec.  1.863-3A and 
1.863-3AT.

Sec.  1.863-3A Income from the sale of personal property derived partly 
         from within and partly from without the United States.

    (a) General.
    (1) Classes of income.
    (2) Definition.
    (b) Income partly from sources within a foreign country.
    (1) General.
    (2) Allocation or apportionment.
    (c) Income partly from sources within a possession of the United 
States.
    (1) General.
    (2) Allocation or apportionment.
    (3) Personal property produced and sold.
    (4) Personal property purchased and sold.

Sec.  1.863-3AT Income from the sale of personal property derived partly 
   from within and partly from without the United States (temporary).

    (a) [Reserved].
    (b) Income partly from sources within a foreign country.
    (1) [Reserved].
    (2) Allocation or apportionment.
    (c)(1) through (4) [Reserved].

[T.D. 9921, 85 FR 79845, Dec. 11, 2020]



Sec.  1.863-1  Allocation of gross income under section 863(a).

    (a) In general. Items of gross income other than those specified in 
section 861(a) and section 862(a) will generally be separately allocated 
to sources within or without the United States. See Sec.  1.863-2 for 
alternate methods to determine the income from sources within or without 
the United States in the case of items specified in Sec.  1.863-2(a). 
See also section 865(b) for rules for sourcing income from the sale of 
inventory property, within the meaning of section 865(i)(1) (inventory), 
generally, and section 865(e)(2) and Sec.  1.865-3 for sourcing income 
from the sale of personal property (including inventory) by a 
nonresident that is attributable to the nonresident's office or other 
fixed place of business in the United States. In the case of sales of 
property involving partners and partnerships, the rules of Sec.  1.863-
3(f) apply.
    (b) Natural resources--(1) In general. Notwithstanding any other 
provision of this part, except to the extent provided in paragraph 
(b)(2) of this section or Sec.  1.865-3, gross receipts from the sale 
outside the United States of products derived from the ownership or 
operation of any farm, mine, oil or gas well, other natural deposit, or 
uncut timber within the United States shall be treated as from sources 
within the United States, and gross receipts from the sale within the 
United States of products derived from the ownership or operation of any 
farm, mine, oil or gas well, other natural deposit, or uncut timber 
outside the United States shall be treated as from sources without the 
United States.
    (2) Additional production activities. Notwithstanding any other 
provision of this section, gross receipts from the sale of products 
derived by a taxpayer who performs additional production activities as 
defined in paragraph (b)(3)(ii) of this section are allocated between 
sources within and without the United States based on the fair

[[Page 314]]

market value of the product immediately prior to the additional 
production activities. The source of gross receipts equal to the fair 
market value of the product immediately prior to the additional 
production activities will be from sources where the farm, mine, oil or 
gas well, other natural deposit, or uncut timber is located. The source 
of gross receipts from the sale of the product in excess of the fair 
market value immediately prior to the additional production activities 
must be determined under Sec.  1.863-3. For purposes of applying Sec.  
1.863-3, only production assets used in the additional production 
activities are taken into account.
    (3) Definitions--(i) Production activity. For purposes of this 
section, production activity means an activity that creates, fabricates, 
manufactures, extracts, processes, cures, or ages inventory. See Sec.  
1.864-1. Except as otherwise provided in Sec.  1.1502-13 or 1.863-
3(f)(2), only production activities conducted directly by the taxpayer 
are taken into account.
    (ii) Additional production activities. For purposes of this section, 
additional production activities are substantial production activities 
performed directly by the taxpayer in addition to activities from the 
ownership or operation of any farm, mine, oil or gas well, other natural 
deposit, or uncut timber. Whether a taxpayer's activities constitute 
additional production activities will be determined under the principles 
of Sec.  1.954-3(a)(4) (except for Sec.  1.954-3(a)(4)(iv)). However, in 
no case will activities that prepare the natural resource itself for 
export, including those that are designed to facilitate the 
transportation of the natural resource, be considered additional 
production activities for purposes of this section.
    (4) Determination of fair market value. For purposes of this 
section, fair market value depends on all of the facts and circumstances 
as they exist relative to a party in any particular case. Where the 
products are sold to a related party in a transaction subject to section 
482, the determination of fair market value under this section must be 
consistent with the arm's length price determined under section 482.
    (5) Determination of gross income. To determine the amount of a 
taxpayer's gross income from sources within or without the United 
States, the taxpayer's gross receipts from sources within or without the 
United States determined under this paragraph (b) must be reduced by the 
cost of goods sold properly attributable to gross receipts from sources 
within or without the United States.
    (6) Tax return disclosure. A taxpayer that determines the source of 
its income under paragraph (b)(2) of this section shall attach a 
statement to its return explaining the methodology used to determine 
fair market value under paragraph (b)(4) of this section, and explaining 
any additional production activities (as defined in paragraph (b)(3)(ii) 
of this section) performed by the taxpayer. In addition, the taxpayer 
must provide such other information as is required by Sec.  1.863-3.
    (7) Examples. The following examples illustrate the rules of this 
paragraph (b):
    (i) Example 1. No additional production, foreign source gross 
receipts. U.S. Mines, a domestic corporation, operates a copper mine and 
mill in Country X. U.S. Mines extracts copper-bearing rocks from the 
ground and transports the rocks to the mill where the rocks are ground 
and processed to produce copper-bearing concentrate. The concentrate is 
transported to a port where it is dried in preparation for export, 
stored, and then shipped to purchasers in the United States. Because, 
under the facts and circumstances, none of U.S. Mines' activities 
constitute additional production activities, within the meaning of 
paragraph (b)(3)(ii) of this section, paragraph (b)(2) of this section 
does not apply, and under paragraph (b)(1) of this section, gross 
receipts from the sale of the concentrate will be treated as from 
sources without the United States.
    (ii) Example 2. No additional production, U.S. source gross 
receipts. U.S. Gas, a domestic corporation, extracts natural gas within 
the United States, and transports the natural gas to a Country X port 
where it is liquefied in preparation for shipment. The liquefied natural 
gas is then transported via freighter and sold without additional

[[Page 315]]

production activities in a foreign country. Under paragraph (b)(3)(ii) 
of this section, liquefaction of natural gas is not an additional 
production activity because liquefaction prepares the natural gas for 
transportation. Therefore, under paragraph (b)(1) of this section, gross 
receipts from the sale of the liquefied natural gas will be treated as 
from sources within the United States.
    (iii) Example 3. Production in United States, foreign sales. U.S. 
Gold, a domestic corporation, mines gold in Country X, produces gold 
jewelry using production assets located in the United States, and sells 
the jewelry in Country Y. Assume that the fair market value of the gold 
before the additional production activities in the United States is $40x 
and that U.S. Gold ultimately sells the gold jewelry in Country Y for 
$100x. Under paragraph (b)(2) of this section, $40x of U.S. Gold's gross 
receipts will be treated as from sources without the United States, and 
the remaining $60x of gross receipts will be treated as from sources 
within the United States under Sec.  1.863-3.
    (iv) Example 4. Production and sales in United States. U.S. Oil, a 
domestic corporation, extracts oil in Country X, transports the oil via 
a pipeline to the United States, refines the oil using production assets 
located in the United States, and sells the refined product in the 
United States to unrelated persons. Assume that the fair market value of 
the oil before refinement in the United States is $80x and U.S. Oil 
ultimately sells the refined product for $100x. Under paragraph (b)(2) 
of this section, $80x of gross receipts will be treated as from sources 
without the United States, and the remaining $20x of gross receipts will 
be treated as from sources within the United States under Sec.  1.863-3.
    (v) Example 5. Additional production. The facts are the same as in 
paragraph (b)(7)(i) of this section (the facts in Example 1), except 
that U.S. Mines also operates a smelter in Country X. The concentrate 
output from the mill is transported to the smelter where it is 
transformed into smelted copper. The smelted copper is exported to 
purchasers in the United States. Under the facts and circumstances, all 
the processes applied to make copper concentrate are considered mining. 
Therefore, under paragraph (b)(2) of this section, gross receipts equal 
to the fair market value of the concentrate at the smelter will be 
treated as from sources without the United States. Under the facts and 
circumstances, the conversion of the concentrate into smelted copper is 
an additional production activity in a foreign country within the 
meaning of paragraph (b)(3)(ii) of this section. Therefore, the source 
of U.S. Mines's excess gross receipts will be determined under Sec.  
1.863-3, pursuant to paragraph (b)(2) of this section.
    (c) Determination of taxable income. The taxpayer's taxable income 
from sources within or without the United States will be determined 
under the rules of Sec. Sec.  1.861-8 through 1.861-14T for determining 
taxable income from sources within the United States.
    (d) Scholarships, fellowship grants, grants, prizes and awards--(1) 
In general. This paragraph (d) applies to scholarships, fellowship 
grants, grants, prizes and awards. The provisions of this paragraph (d) 
do not apply to amounts paid as salary or other compensation for 
services.
    (2) Source of income. The source of income from scholarships, 
fellowship grants, grants, prizes and awards is determined as follows:
    (i) United States source income. Except as provided in paragraph 
(d)(2)(iii) of this section, scholarships, fellowship grants, grants, 
prizes and awards made by a U.S. citizen or resident, a domestic 
partnership, a domestic corporation, an estate or trust (other than a 
foreign estate or trust within the meaning of section 7701(a)(31)), the 
United States (or an instrumentality or agency thereof), a State (or any 
political subdivision thereof), or the District of Columbia shall be 
treated as income from sources within the United States.
    (ii) Foreign source income. Scholarships, fellowship grants, grants, 
prizes and awards made by a foreign government (or an instrumentality, 
agency, or any political subdivision thereof), an international 
organization (as defined in section 7701(a)(18)), or a person other

[[Page 316]]

than a U.S. person (as defined in section 7701(a)(30)) shall be treated 
as income from sources without the United States.
    (iii) Certain activities conducted outside the United States. 
Scholarships, fellowship grants, targeted grants, and achievement awards 
received by a person other than a U.S. person (as defined in section 
7701(a)(30)) with respect to activities previously conducted (in the 
case of achievement awards) or to be conducted (in the case of 
scholarships, fellowships grants, and targeted grants) outside the 
United States shall be treated as income from sources without the United 
States.
    (3) Definitions. The following definitions apply for purposes of 
this paragraph (d):
    (i) Scholarships are defined in section 117 and the regulations 
thereunder.
    (ii) Fellowship grants are defined in section 117 and the 
regulations thereunder.
    (iii) Prizes and awards are defined in section 74 and the 
regulations thereunder.
    (iv) Grants are amounts described in subparagraph (3) of section 
4945(g) and the regulations thereunder, and are not amounts otherwise 
described in paragraphs (d)(3) (i), (ii), or (iii) of this section. For 
purposes of this paragraph (d), the reference to section 4945(g)(3) is 
applied without regard to the identity of the payor or recipient and 
without the application of the objective and nondiscriminatory basis 
test and the requirement of a procedure approved in advance.
    (v) Targeted grants are grants--
    (A) Issued by an organization described in section 501(c)(3), the 
United States (or an instrumentality or agency thereof), a State (or any 
political subdivision thereof), or the District of Columbia; and
    (B) For an activity undertaken in the public interest and not 
primarily for the private financial benefit of a specific person or 
persons or organization.
    (vi) Achievement awards are awards--
    (A) Issued by an organization described in section 501(c)(3), the 
United States (or an instrumentality or agency thereof), a State (or 
political subdivision thereof), or the District of Columbia; and
    (B) For a past activity undertaken in the public interest and not 
primarily for the private financial benefit of a specific person or 
persons or organization.
    (4) Effective dates. The following are the effective dates 
concerning this paragraph (d):
    (i) Scholarships and fellowship grants. This paragraph (d) is 
effective for scholarship and fellowship grant payments made after 
December 31, 1986. However, for scholarship and fellowship grant 
payments made after May 14, 1989, and before June 16, 1993, the 
residence of the payor rule of paragraph (d)(2) (i) and (ii) of this 
section may be applied without applying paragraph (d)(2)(iii) of this 
section.
    (ii) Grants, prizes and awards. This paragraph (d) is effective for 
payments made for grants, prizes and awards, targeted grants, and 
achievement awards after September 25, 1995. However, the taxpayer may 
elect to apply the provisions of this paragraph (d) to payments made for 
grants, prizes and awards, targeted grants, and achievement awards after 
December 31, 1986, and before September 26, 1995.
    (e) Residual interest in a REMIC--(1) REMIC inducement fees. An 
inducement fee (as defined in Sec.  1.446-6(b)(2)) shall be treated as 
income from sources within the United States.
    (2) Excess inclusion income and net losses. An excess inclusion (as 
defined in section 860E(c)) shall be treated as income from sources 
within the United States. To the extent of excess inclusion income 
previously taken into account with respect to a residual interest 
(reduced by net losses previously taken into account under this 
paragraph), a net loss (described in section 860C(b)(2)) with respect to 
the residual interest shall be allocated to the class of gross income 
and apportioned to the statutory grouping(s) or residual grouping of 
gross income to which the excess inclusion income was assigned.
    (f) Applicability date. Paragraph (b) of this section applies to 
taxable years ending on or after December 23, 2019. However, a taxpayer 
may apply paragraph (b) of this section in its entirety

[[Page 317]]

for taxable years beginning after December 31, 2017, and ending before 
December 23, 2019, provided that the taxpayer and all persons related to 
the taxpayer (within the meaning of section 267 or 707) apply paragraph 
(b) of this section and Sec. Sec.  1.863-2(b), 1.863-3, 1.863-
8(b)(3)(ii), 1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in their 
entirety for the taxable year, and once applied, the taxpayer and all 
persons related to the taxpayer (within the meaning of section 267 or 
707) continue to apply these regulations in their entirety for all 
subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.863-1 as 
contained in 26 CFR part 1 revised as of April 1, 2020. Paragraph (e)(2) 
of this section applies for taxable years ending after August 1, 2006.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 8615, 60 FR 
44275, Aug. 25, 1995; T.D. 8687, 61 FR 60545, Nov. 29, 1996; 61 FR 
65323, Dec. 12, 1996; T.D. 9128, 69 FR 26041, May 11, 2004; T.D. 9272, 
71 FR 43366, Aug. 1, 2006; T.D. 9415, 73 FR 40172, July 14, 2008; T.D. 
9921, 85 FR 79845, Dec. 11, 2020]



Sec.  1.863-2  Allocation and apportionment of taxable income.

    (a) Determination of taxable income. Section 863(b) provides an 
alternate method for determining taxable income from sources within the 
United States in the case of gross income derived from sources partly 
within and partly without the United States. Under this method, taxable 
income is determined by deducting from such gross income the expenses, 
losses, or other deductions properly apportioned or allocated thereto 
and a ratable part of any other expenses, losses, or deductions that 
cannot definitely be allocated to some item or class of gross income. 
The income to which this section applies will consist of gains, profits, 
and income:
    (1) From certain transportation or other services rendered partly 
within and partly without the United States to the extent not within the 
scope of section 863(c) or other specific provisions of this title;
    (2) From the sale of inventory property (within the meaning of 
section 865(i)) produced (in whole or in part) by the taxpayer in the 
United States and sold outside the United States or produced (in whole 
or in part) by the taxpayer outside the United States and sold in the 
United States; or
    (3) Derived from the purchase of personal property within a 
possession of the United States and its sale within the United States, 
to the extent not excluded from the scope of these regulations under 
Sec.  1.936-6(a)(5), Q&A 7.
    (b) Determination of source of taxable income. Income treated as 
derived from sources partly within and partly without the United States 
under paragraph (a) of this section may be allocated or apportioned to 
sources within and without the United States pursuant to Sec. Sec.  
1.863-1, 1.863-3, 1.863-4, 1.863-8, and 1.863-9. To determine the source 
of certain types of income described in paragraph (a)(1) of this 
section, see Sec.  1.863-4. To determine the source of gross income 
described in paragraph (a)(2) of this section, see Sec.  1.863-1 for 
natural resources, Sec.  1.863-3 for other sales of inventory property, 
and Sec.  1.863-8 for source of gross income from space and ocean 
activity. Section 1.865-3 may apply instead of the provisions in this 
section to source gross income from sales of personal property 
(including inventory property) by nonresidents attributable to an office 
or other fixed place of business in the United States. To determine the 
source of income partly from sources within a possession of the United 
States, including income described in paragraph (a)(3) of this section, 
see Sec.  1.863-3(e).
    (c) Applicability date. Except as provided in this paragraph (c), 
this section applies to taxable years beginning after December 30, 1996. 
Paragraph (b) of this section applies to taxable years ending on or 
after December 23, 2019. However, a taxpayer may apply paragraph (b) of 
this section in its entirety for taxable years beginning after December 
31, 2017, and ending before December 23, 2019, provided that the 
taxpayer and all persons related to the taxpayer (within the meaning of 
section 267 or 707) apply paragraph (b) of this section and Sec. Sec.  
1.863-1(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-5(a) and (b), 1.864-
6(c)(2), and 1.865-3 in their entirety for the taxable year, and once 
applied, the taxpayer and all persons related to the taxpayer (within 
the meaning of section 267 or

[[Page 318]]

707) continue to apply these regulations in their entirety for all 
subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.863-2 as 
contained in 26 CFR part 1 revised as of April 1, 2020.

[T.D. 8687, 61 FR 60546, Nov. 29, 1996; 61 FR 65323, Dec. 12, 1996, as 
amended by T.D. 9921, 85 FR 79846, Dec. 11, 2020]



Sec.  1.863-3  Allocation and apportionment of income from certain 
sales of inventory.

    (a) In general--(1) Scope. Subject to the rules of Sec.  1.865-3, 
paragraphs (a) through (d) of this section apply to determine the source 
of income derived from the sale of inventory property (inventory) that a 
taxpayer produces (in whole or in part) within the United States and 
sells without the United States, or that a taxpayer produces (in whole 
or in part) without the United States and sells within the United States 
(collectively, Section 863(b)(2) Sales). See section 865(i)(1) for the 
definition of inventory. Paragraph (b) of this section provides that the 
source of gross income from Section 863(b)(2) Sales is based solely on 
the production activities with respect to the inventory. Paragraph (c) 
of this section describes how to determine source based on production 
activity, including when inventory is produced partly within the United 
States and partly without the United States. Paragraph (d) of this 
section determines taxable income from Section 863(b)(2) Sales. 
Paragraph (e) of this section applies to determine the source of certain 
income derived from a possession of the United States. Paragraph (f) of 
this section provides special rules for partnerships for all sales 
subject to Sec. Sec.  1.863-1 through 1.863-3. Paragraph (g) of this 
section provides applicability dates for the rules in this section.
    (2) Cross references. To determine the source of income derived from 
the sale of personal property (including inventory) by a nonresident 
that is attributable to the nonresident's office or other fixed place of 
business in the United States under section 865(e)(2) and Sec.  1.865-
3(c), the rules of Sec.  1.865-3 apply, and the rules of this section do 
not apply except to the extent provided in Sec.  1.865-3. To determine 
the source of income from sales of property produced by the taxpayer, 
when the property is either produced in whole or in part in space, as 
defined in Sec.  1.863-8(d)(1)(i), or international water, as defined in 
Sec.  1.863-8(d)(1)(ii), or is sold in space or international water, the 
rules of Sec.  1.863-8 apply, and the rules of this section do not apply 
except to the extent provided in Sec.  1.863-8.
    (b) Sourcing based solely on production activities. Subject to the 
rules of Sec.  1.865-3, all income, gain, or loss derived from Section 
863(b)(2) Sales is allocated and apportioned solely on the basis of the 
production activities with respect to the inventory.
    (c) Determination of the source of gross income from production 
activity--(1) Production only within the United States or only within 
foreign countries--(i) Source of income. For purposes of this section, 
production activity means an activity that creates, fabricates, 
manufactures, extracts, processes, cures, or ages inventory. See Sec.  
1.864-1. Whether a taxpayer's activities constitute production activity 
is determined under the principles of Sec.  1.954-3(a)(4) (except for 
Sec.  1.954-3(a)(4)(iv)). Subject to the provisions in Sec.  1.1502-13 
or paragraph (f)(2)(ii) of this section, the only production activities 
that are taken into account for purposes of Sec. Sec.  1.863-1, 1.863-2, 
and this section are those conducted directly by the taxpayer. Where the 
taxpayer's production assets are located only within the United States 
or only outside the United States, gross income is sourced where the 
taxpayer's production assets are located. For rules regarding the source 
of income when production assets are located both within the United 
States and without the United States, see paragraph (c)(2) of this 
section. For rules regarding the source of income when production takes 
place, in whole or in part, in space or international water, the rules 
of Sec.  1.863-8 apply, and the rules of this section do not apply 
except to the extent provided in Sec.  1.863-8.
    (ii) Definition of production assets. Subject to the provisions of 
Sec.  1.1502-13 and paragraph (f)(2)(ii) of this section, production 
assets include only tangible and intangible assets owned directly by the 
taxpayer that are directly used by

[[Page 319]]

the taxpayer to produce inventory described in paragraph (a) of this 
section. Production assets do not include assets that are not directly 
used to produce inventory described in paragraph (a) of this section. 
Thus, production assets do not include such assets as accounts 
receivables, intangibles not related to production of inventory (e.g., 
marketing intangibles, including trademarks and customer lists), 
transportation assets, warehouses, the inventory itself, raw materials, 
or work-in-process. In addition, production assets do not include cash 
or other liquid assets (including working capital), investment assets, 
prepaid expenses, or stock of a subsidiary.
    (iii) Location of production assets. For purposes of this section, a 
tangible production asset will be considered located where the asset is 
physically located. An intangible production asset will be considered 
located where the tangible production assets owned by the taxpayer to 
which it relates are located.
    (2) Production both within and without the United States--(i) Source 
of income. Where the taxpayer's production assets are located both 
within and without the United States, income from sources without the 
United States will be determined by multiplying the gross income by a 
fraction, the numerator of which is the average adjusted basis of 
production assets that are located outside the United States and the 
denominator of which is the average adjusted basis of all production 
assets within and without the United States. The remaining income is 
treated as from sources within the United States.
    (ii) Adjusted basis of production assets--(A) In general. For 
purposes of paragraph (c)(2)(i) of this section, the adjusted basis of 
an asset is determined by using the alternative depreciation system 
under section 168(g)(2). The adjusted basis of all production assets for 
purposes of paragraph (c)(2)(i) of this section is determined as though 
the production assets were subject to the alternative depreciation 
system set forth in section 168(g)(2) for the entire period that such 
property has been in service. The adjusted basis of the production 
assets is determined without regard to the election to expense certain 
depreciable assets under section 179 and without regard to any 
additional first-year depreciation provision (for example, section 
168(k), (l), and (m), and former sections 1400L(b) and 1400N(d)). The 
average adjusted basis of assets is computed by averaging the adjusted 
basis at the beginning and end of the taxable year, unless by reason of 
changes during the taxable year, as might be the case in the event of a 
major acquisition or disposition of assets, the average would materially 
distort the calculation in paragraph (c)(2)(i) of this section. In this 
event, the average adjusted basis is determined upon a more appropriate 
basis that is weighted to reasonably reflect the period for which the 
assets are held by the taxpayer during the taxable year.
    (B) Production assets used to produce other property. If a 
production asset is used to produce inventory sold in Section 863(b)(2) 
Sales and also used to produce other property during the taxable year, 
the portion of its adjusted basis that is included in the fraction 
described in paragraph (c)(2)(i) of this section will be determined 
under any method that reasonably reflects the portion of the asset that 
produces inventory sold in Section 863(b)(2) Sales. For example, the 
portion of such an asset that is included in the formula may be 
determined by multiplying the asset's average adjusted basis by a 
fraction, the numerator of which is the gross receipts from sales of 
inventory from Section 863(b)(2) Sales produced by the asset, and the 
denominator of which is the gross receipts from all property produced by 
that asset.
    (3) Anti-abuse rule. The purpose of paragraph (b) of this section 
and this paragraph (c) is to attribute the source of the taxpayer's 
gross income from certain sales of inventory property to the location of 
the taxpayer's production activity. Therefore, if the taxpayer has 
entered into or structured one or more transactions with a principal 
purpose of reducing its U.S. tax liability in a manner inconsistent with

[[Page 320]]

the purpose of paragraph (b) of this section or this paragraph (c), the 
Commissioner may make appropriate adjustments so that the source of the 
taxpayer's gross income more clearly reflects the location of production 
activity. For example, a taxpayer may be subject to the rule in this 
paragraph (c)(3) if domestic production assets are acquired by a related 
partnership (or a subsidiary of a related partnership) with a principal 
purpose of reducing its U.S. tax liability by claiming that the 
taxpayer's income from sales of inventory is subject to section 
862(a)(6) rather than section 863(b).
    (4) Examples. The following examples illustrate the rules of this 
paragraph (c):
    (i) Example 1. Source of gross income--(A) Facts. A, a U.S. 
corporation, produces widgets that are sold both within the United 
States and within a foreign country. The initial manufacture of all 
widgets occurs in the United States. The second stage of production of 
widgets that are sold within a foreign country is completed within the 
country of sale. A's U.S. plant and machinery which is involved in the 
initial manufacture of the widgets has an average adjusted basis of 
$200, as determined using the alternative depreciation system under 
section 168(g)(2). A also owns warehouses used to store work-in-process. 
A owns foreign equipment with an average adjusted basis of $25. A's 
gross receipts from all sales of widgets is $100, and its gross receipts 
from export sales of widgets is $25. Assume that apportioning average 
adjusted basis using gross receipts is reasonable. Assume A's cost of 
goods sold from the sale of widgets in the foreign countries is $13 and 
thus, its gross income from widgets sold in foreign countries is $12.
    (B) Analysis. A determines its gross income from sources without the 
United States by multiplying A's $12 of gross income from sales of 
widgets in foreign countries by a fraction, the numerator of which is 
all relevant foreign production assets, or $25, and the denominator of 
which is all relevant production assets, or $75 ($25 foreign assets + 
($200 U.S. assets x $25 gross receipts from export sales/$100 gross 
receipts from all sales)). Therefore, A's gross income from sources 
without the United States is $4 ($12 x ($25/$75)).
    (ii) Example 2. Location of intangible property. Assume the same 
facts as in paragraph (c)(4)(i)(A) of this section (the facts in Example 
1), except that A employs a patented process that applies only to the 
initial production of widgets. In computing the formula used to 
determine the source of gross income, A's patent, if it has an average 
adjusted basis, would be located in the United States.
    (iii) Example 3. Anti-abuse rule--(A) Facts. Assume the same facts 
as in paragraph (c)(4)(i)(A) of this section (the facts in Example 1). A 
sells its U.S. assets to B, an unrelated U.S. corporation, with a 
principal purpose of reducing its U.S. tax liability by manipulating the 
property fraction. A then leases these assets from B. After this 
transaction, under the general rule of paragraph (c)(2) of this section, 
all of A's gross income would be considered from sources without the 
United States, because all of A's relevant production assets are located 
within a foreign country. Since the leased property is not owned by the 
taxpayer, it is not included in the fraction.
    (B) Analysis. Because A has entered into a transaction with a 
principal purpose of reducing its U.S. tax liability by manipulating the 
formula described in paragraph (c)(2)(i) of this section, A's income 
must be adjusted to more clearly reflect the source of that income. In 
this case, the Commissioner may redetermine the source of A's gross 
income by ignoring the sale-leaseback transactions.
    (d) Determination of source of taxable income. Once the source of 
gross income has been determined under paragraph (c) of this section, 
the taxpayer must properly allocate and apportion its expenses, losses, 
and other deductions to its respective amounts of gross income from 
sources within and without the United States from its Section 863(b)(2) 
Sales. See Sec. Sec.  1.861-8 through 1.861-14T and 1.861-17.
    (e) Income partly from sources within a possession of the United 
States--(1) In general. This paragraph (e) relates to certain sales that 
give rise to income, gain, or loss that is treated as derived partly 
from sources within the United

[[Page 321]]

States and partly from sources within a possession of the United States 
(Section 863 Possession Sales). This paragraph (e) applies to determine 
the source of income derived from the sale of inventory produced (in 
whole or in part) by a taxpayer within the United States and sold within 
a possession of the United States, or produced (in whole or in part) by 
a taxpayer in a possession of the United States and sold within the 
United States (collectively, Possession Production Sales). It also 
applies to determine the source of income derived from the purchase of 
personal property within a possession of the United States and its sale 
within the United States (Possession Purchase Sales). A taxpayer subject 
to this paragraph (e) must apportion gross income from Section 863 
Possession Sales under paragraph (e)(2) of this section (in the case of 
Possession Production Sales) or under paragraph (e)(3) of this section 
(in the case of Possession Purchase Sales). The source of taxable income 
from Section 863 Possession Sales is determined under paragraph (d) of 
this section.
    (2) Allocation or apportionment for Possession Production Sales. The 
source of gross income from Possession Production Sales is determined 
under the rules of paragraph (c) of this section, except that the term 
possession of the United States is substituted for foreign country 
wherever it appears.
    (3) Allocation or apportionment for Possession Purchase Sales--(i) 
Determination of source of gross income from Possession Purchase Sales. 
Gross income from Possession Purchase Sales is allocated in its entirety 
to the taxpayer's business activity, and is then apportioned between 
sources within the United States and sources within a possession of the 
United States under paragraph (e)(3)(ii) of this section.
    (ii) Determination of source of gross income from business 
activity--(A) Source of gross income. Gross income from the taxpayer's 
business activity is sourced in the possession in the same proportion 
that the amount of the taxpayer's business activity for the taxable year 
within the possession bears to the amount of the taxpayer's business 
activity for the taxable year both within the possession and outside the 
possession, with respect to Possession Purchase Sales. The remaining 
income is sourced in the United States.
    (B) Business activity. For purposes of this paragraph (e)(3)(ii), 
the taxpayer's business activity is equal to the sum of--
    (1) The amounts for the taxable period paid for wages, salaries, and 
other compensation of employees, and other expenses attributable to 
Possession Purchase Sales (other than amounts that are nondeductible 
under section 263A, interest, and research and development);
    (2) Cost of goods sold attributable to Possession Purchase Sales 
during the taxable period; and
    (3) Possession Purchase Sales for the taxable period.
    (C) Location of business activity. For purposes of determining the 
location of the taxpayer's business activity within a possession, the 
following rules apply:
    (1) Sales activity. Receipts from gross sales will be attributed to 
a possession in accordance with the principles of Sec.  1.861-7(c).
    (2) Cost of goods sold. Payments for cost of goods sold will be 
properly attributable to gross receipts from sources within the 
possession only to the extent that the property purchased was 
manufactured, produced, grown, or extracted in the possession (within 
the meaning of section 954(d)(1)(A)).
    (3) Expenses. Expenses will be attributed to a possession under the 
rules of Sec. Sec.  1.861-8 through 1.861-14T.
    (4) Examples. The following examples illustrate the rules of 
paragraph (e)(3)(ii) of this section relating to the determination of 
source of gross income from business activity:
    (i) Example 1. Purchase of goods manufactured in possession--(A) 
Facts. U.S. Co. purchases in a possession product X for $80 from A. A 
manufactures X in the possession. Without further production, U.S. Co. 
sells X in the United States for $100. Assume U.S. Co. has sales and 
administrative expenses in the possession of $10.
    (B) Analysis. To determine the source of U.S. Co.'s gross income, 
the $100 gross income from sales of X is allocated entirely to U.S. 
Co.'s business activity. Forty-seven dollars of U.S. Co.'s

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gross income is sourced in the possession. [Possession expenses ($10) 
plus possession purchases (i.e., cost of goods sold) ($80) plus 
possessions sales ($0), divided by total expenses ($10) plus total 
purchases ($80) plus total sales ($100).] The remaining $53 is sourced 
in the United States.
    (ii) Example 2. Purchase of goods manufactured outside possession--
(A) Facts. Assume the same facts as in paragraph (e)(4)(i)(A) of this 
section (the facts in Example 1), except that A manufactures X outside 
the possession.
    (B) Analysis. To determine the source of U.S. Co.'s gross income, 
the $100 gross income is allocated entirely to U.S. Co.'s business 
activity. Five dollars of U.S. Co.'s gross income is sourced in the 
possession. [Possession expenses ($10) plus possession purchases ($0) 
plus possession sales ($0), divided by total expenses ($10) plus total 
purchases ($80) plus total sales ($100).] The $80 purchase is not 
included in the numerator used to determine U.S. Co.'s business activity 
in the possession, since product X was not manufactured in the 
possession. The remaining $95 is sourced in the United States.
    (5) Special rules for partnerships. In applying the rules of this 
paragraph (e) to transactions involving partners and partnerships, the 
rules of paragraph (f) of this section apply.
    (f) Special rules for partnerships--(1) General rule. For purposes 
of Sec.  1.863-1 and this section, a taxpayer's production activity does 
not include production activities conducted by a partnership of which 
the taxpayer is a partner either directly or through one or more 
partnerships, except as otherwise provided in paragraphs (c)(3) or 
(f)(2) of this section.
    (2) Exceptions--(i) In general. For purposes of determining the 
source of the partner's distributive share of partnership income or 
determining the source of the partner's income from the sale of 
inventory property which the partnership distributes to the partner in 
kind, the partner's production activity includes an activity conducted 
by the partnership. In addition, the production activity of a 
partnership includes the production activity of a taxpayer that is a 
partner either directly or through one or more partnerships, to the 
extent that the partner's production activity is related to inventory 
that the partner contributes to the partnership in a transaction 
described under section 721.
    (ii) Attribution of production assets to or from a partnership. A 
partner will be treated as owning its proportionate share of the 
partnership's production assets only to the extent that, under paragraph 
(f)(2)(i) of this section, the partner's activity includes production 
activity conducted through a partnership. A partner's share of 
partnership assets will be determined by reference to the partner's 
distributive share of partnership income for the year attributable to 
such production assets. Similarly, to the extent a partnership's 
activities include the production activities of a partner, the 
partnership will be treated as owning the partner's production assets 
related to the inventory that is contributed in kind to the partnership. 
See paragraph (c)(2)(ii) of this section for rules apportioning the 
basis of assets to Section 863 Sales.
    (iii) Basis. For purposes of this section, in those cases where the 
partner is treated as owning its proportionate share of the 
partnership's production assets, the partner's basis in production 
assets held through a partnership shall be determined by reference to 
the partnership's adjusted basis in its assets (including a partner's 
special basis adjustment, if any, under section 743). Similarly, a 
partnership's basis in a partner's production assets is determined with 
reference to the partner's adjusted basis in its assets.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (f):
    (i) Example 1. Distributive share of partnership income. A, a U.S. 
corporation, forms a partnership in the United States with B, a country 
X corporation. A and B each have a 50 percent interest in the income, 
gains, losses, deductions and credits of the partnership. The 
partnership is engaged in the manufacture and sale of widgets. The 
widgets are manufactured in the partnership's plant located in the 
United States and are sold by the partnership outside the United States. 
The partnership owns the manufacturing facility and all other production 
assets used to

[[Page 323]]

produce the widgets. A's distributive share of partnership income 
includes 50 percent of the sales income from these sales. In applying 
the rules of section 863 to determine the source of its distributive 
share of partnership income from the export sales of widgets, A is 
treated as carrying on the activity of the partnership related to 
production of these widgets and as owning a proportionate share of the 
partnership's assets related to production of the widgets, based upon 
its distributive share of partnership income.
    (ii) Example 2. Distribution in kind. Assume the same facts as in 
paragraph (f)(3)(i) of this section (the facts in Example 1) except that 
the partnership, instead of selling the widgets, distributes the widgets 
to A and B. A then further processes the widgets and then sells them 
outside the United States. In determining the source of the income 
earned by A on the sales outside the United States, A is treated as 
conducting the activities of the partnership related to production of 
the distributed widgets. Thus, the source of gross income on the sale of 
the widgets is determined under section 863 and this section. In 
applying paragraph (c) of this section, A is treated as owning its 
proportionate share of the partnership's production assets based upon 
its distributive share of partnership income.
    (g) Applicability dates. This section applies to taxable years 
ending on or after December 23, 2019. However, a taxpayer may apply this 
section in its entirety for taxable years beginning after December 31, 
2017, and ending before December 23, 2019, provided that the taxpayer 
and all persons related to the taxpayer (within the meaning of section 
267 or 707) apply this section and Sec. Sec.  1.863-1(b), 1.863-2(b), 
1.863-8(b)(3)(ii), 1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in 
their entirety for the taxable year, and once applied, the taxpayer and 
all persons related to the taxpayer (within the meaning of section 267 
or 707) continue to apply these regulations in their entirety for all 
subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.863-3 as 
contained in 26 CFR part 1 revised as of April 1, 2020.

[T.D. 9921, 85 FR 79846, Dec. 11, 2020]

   regulations applicable to taxable years prior to december 30, 1996



Sec.  1.863-3A  Income from the sale of personal property derived partly 
from within and partly from without the United States.

    (a) General--(1) Classes of income. Income from the sale of property 
to which paragraph (b)(2) and (3) of Sec.  1.863-2 applies is divided 
into two classes for purposes of this section, namely, income which is 
treated as derived partly from sources within the United States and 
partly from sources within a foreign country, and income which is 
treated as derived partly from sources within the United States and 
partly from sources within a possession of the United States.
    (2) Definition. For purposes of this section, the word ``produced'' 
includes created, fabricated, manufactured, extracted, processed, cured, 
or aged. For determining the time and place of sale of personal property 
for purposes of this section, see paragraph (c) of Sec.  1.861-7.
    (b) Income partly from sources within a foreign country--(1) 
General. This paragraph relates to gains, profits, and income derived 
from the sale of personal property produced (in whole or in part) by the 
taxpayer within the United States and sold within a foreign country, or 
produced (in whole or in part) by the taxpayer within a foreign country 
and sold within the United States. Pursuant to section 863(b) such items 
shall be treated as derived partly from sources within the United States 
and partly from sources within a foreign country.
    (2) Allocation or apportionment. The taxable income from sources 
within the United States, in the case of the items to which this 
paragraph applies, shall be determined according to the examples set 
forth in this subparagraph. For such purposes, the deductions for the 
personal exemptions shall not be taken into account, but the special 
deductions described in paragraph (c) of Sec.  1.861-8 shall be taken 
into account.


[[Page 324]]


    Example 1. Where the manufacturer or producer regularly sells part 
of his output to wholly independent distributors or other selling 
concerns in such a way as to establish fairly an independent factory or 
production price--or shows to the satisfaction of the district director 
(or, if applicable, the Director of International Operations) that such 
an independent factory or production price has been otherwise 
established--unaffected by considerations of tax liability and the 
selling or distributing branch or department of the business is located 
in a different country from that in which the factory is located or the 
production carried on, the taxable income attributable to sources within 
the United States shall be computed by an accounting which treats the 
products as sold by the factory or productive department of the business 
to the distributing or selling department at the independent factory 
price so established. In all such cases the basis of the accounting 
shall be fully explained in a statement attached to the return for the 
taxable year.
    Example 2. (i)-(ii) [Reserved]. For guidance, see Sec.  863-3T(b)(2) 
Example (2)(i) and (ii).
    (iii) The term ``gross sales'', as used in this example, refers only 
to the sales of personal property produced (in whole or in part) by the 
taxpayer within the United States and sold within a foreign country or 
produced (in whole or in part) by the taxpayer within a foreign country 
and sold within the United States.
    (iv) The term ``property'', as used in this example, includes only 
the property held or used to produce income which is derived from such 
sales. Such property should be taken at its actual value, which in the 
case of property valued or appraised for purposes of inventory, 
depreciation, depletion, or other purposes of taxation shall be the 
highest amount at which so valued or appraised, and which in other cases 
shall be deemed to be its book value in the absence of affirmative 
evidence showing such value to be greater or less than the actual value. 
The average value during the taxable year or period shall be employed. 
The average value of property as above prescribed at the beginning and 
end of the taxable year or period ordinarily may be used, unless by 
reason of material changes during the taxable year or period such 
average does not fairly represent the average for such year or period, 
in which event the average shall be determined upon a monthly or daily 
basis.
    (v) Bills and accounts receivable shall (unless satisfactory reason 
for a different treatment is shown) be assigned or allocated to the 
United States when the debtor resides in the United States, unless the 
taxpayer has no office, branch, or agent in the United States.
    Example 3. Application for permission to base the return upon the 
taxpayer's books of account will be considered by the district director 
(or, if applicable, the Director of International Operations) in the 
case of any taxpayer who, in good faith and unaffected by considerations 
of tax liability, regularly employs in his books of account a detailed 
allocation of receipts and expenditures which reflects more clearly than 
the processes or formulas herein prescribed the taxable income derived 
from sources within the United States.

    (c) Income partly from sources within a possession of the United 
States--(1) General. This paragraph relates to gains, profits, and 
income which, pursuant to section 863(b), are treated as derived partly 
from sources within the United States and partly from sources within a 
possession of the United States. The items so treated are described in 
subparagraphs (3) and (4) of this paragraph.
    (2) Allocation or apportionment. The taxable income from sources 
within the United States, in the case of the items to which this 
paragraph applies, shall be determined according to the examples set 
forth in subparagraphs (3) and (4) of this paragraph. For such purposes, 
the deductions for the personal exemptions shall not be taken into 
account, but the special deductions described in paragraph (c) of Sec.  
1.861-8 shall be taken into account.
    (3) Personal property produced and sold. This subparagraph relates 
to gross income derived from the sale of personal property produced (in 
whole or in part) by the taxpayer within the United States and sold 
within a possession of the United States, or produced (in whole or in 
part) by the taxpayer within a possession of the United States and sold 
within the United States.

    Example 1. Same as example 1 under paragraph (b)(2) of this section.
    Example 2. (i) Where an independent factory or production price has 
not been established as provided under example 1, the taxable income 
shall first be computed by deducting from the gross income derived from 
the sale of personal property produced (in whole or in part) by the 
taxpayer within the United States and sold within a possession of the 
United States, or produced (in whole or in part) by the taxpayer within 
a possession of the United States and sold within the United States, the 
expenses, losses, or other

[[Page 325]]

deductions properly allocated and apportioned thereto in accordance with 
the rules set forth in Sec.  1.861-8.
    (ii) Of the amount of taxable income so determined, one-half shall 
be apportioned in accordance with the value of the taxpayer's property 
within the United States and within the possession of the United States, 
the portion attributable to sources within the United States being 
determined by multiplying such one-half by a fraction the numerator of 
which consists of the value of the taxpayer's property within the United 
States, and the denominator of which consists of the value of the 
taxpayer's property both within the United States and within the 
possession of the United States. The remaining one-half of such taxable 
income shall be apportioned in accordance with the total business of the 
taxpayer within the United States and within the possession of the 
United States, the portion attributable to sources within the United 
States being determined by multiplying such one-half by a fraction the 
numerator of which consists of the amount of the taxpayer's business for 
the taxable year or period within the United States, and the denominator 
of which consists of the amount of the taxpayer's business for the 
taxable year or period both within the United States and within the 
possession of the United States.
    (iii) ``The business of the taxpayer'', as used in this example, 
shall be measured by the amounts which the taxpayer paid out during the 
taxable year or period for wages, salaries, and other compensation of 
employees and for the purchase of goods, materials, and supplies 
consumed in the regular course of business, plus the amounts received 
during the taxable year or period from gross sales, such expenses, 
purchases, and gross sales being limited to those attributable to the 
production (in whole or in part) of personal property within the United 
States and its sale within a possession of the United States or to the 
production (in whole or in part) of personal property within a 
possession of the United States and its sale within the United States. 
The term ``property'', as used in this example, includes only the 
property held or used to produce income which is derived from such 
sales.
    Example 3. Same as example 3 under paragraph (b)(2) of this section.

    (4) Personal property purchased and sold. This subparagraph relates 
to gross income derived from the purchase of personal property within a 
possession of the United States and its sale within the United States.

    Example 1. (i) The taxable income shall first be computed by 
deducting from such gross income the expenses, losses, or other 
deductions properly allocated or apportioned thereto in accordance with 
the rules set forth in Sec.  1.861-8.
    (ii) The amount of taxable income so determined shall be apportioned 
in accordance with the total business of the taxpayer within the United 
States and within the possession of the United States, the portion 
attributable to sources within the United States being that percentage 
of such taxable income which the amount of the taxpayer's business for 
the taxable year or period within the United States bears to the amount 
of the taxpayer's business for the taxable year or period both within 
the United States and within the possession of the United States.
    (iii) The ``business of the taxpayer'', as that term is used in this 
example, shall be measured by the amounts which the taxpayer paid out 
during the taxable year or period for wages, salaries, and other 
compensation of employees and for the purchase of goods, materials, and 
supplies sold or consumed in the regular course of business, plus the 
amount received during the taxable year or period from gross sales, such 
expenses, purchases, and gross sales being limited to those attributable 
to the purchase of personal property within a possession of the United 
States and its sale within the United States.
    Example 2. Same as example 3 under paragraph (b)(2) of this section.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7456, 42 FR 
1214, Jan. 6, 1977; T.D. 8228, 53 FR 35506, Sept. 14, 1988. Redesignated 
by T.D. 8687, 61 FR 60545, Nov. 29, 1996]



Sec.  1.863-3AT  Income from the sale of personal property derived partly 
from within and partly from without the United States (temporary regulations).

    (a) [Reserved]
    (b) Income partly from sources within a foreign country. (1) 
[Reserved]
    (2) Allocation or apportionment.

    Example 1. [Reserved]
    Example 2. (i) Where an independent factory or production price has 
not been established as provided under Example (1), the gross income 
derived from the sale of personal property produced (in whole or in 
part) by the taxpayer within the United States and sold within a foreign 
country or produced (in whole or in part) by the taxpayer within a 
foreign country and sold within the United States shall be computed.
    (ii) Of this gross amount, one-half shall be apportioned in 
accordance with the value of the taxpayer's property within the United 
States and within the foreign country, the portion attributable to 
sources within the United States being determined by multiplying such 
one-half by a fraction, the numerator of which consists of the value of 
the

[[Page 326]]

taxpayer's property within the United States and the denominator of 
which consists of the value of the taxpayer's property both within the 
United States and within the foreign country. The remaining one-half of 
such gross income shall be apportioned in accordance with the gross 
sales of the taxpayer within the United States and within the foreign 
country, the portion attributable to sources within the United States 
being determined by multiplying such one-half by a fraction the 
numerator of which consists of the taxpayer's gross sales for the 
taxable year or period within the United States, and the denominator of 
which consists of the taxpayer's gross sales for the taxable year or 
period both within the United States and within the foreign country. 
Deductions from gross income that are allocable and apportionable to 
gross income described in paragraph (i) of this Example 2 shall be 
apportioned between the United States and foreign source portions of 
such income, as determined under this paragraph (ii), on a pro rata 
basis, without regard to whether the deduction relates primarily or 
exclusively to the production of property or to the sale of property.

    (b)(2) Example (2)(iii) through (c)(4) [Reserved]

[T.D. 8228, 53 FR 35506, Sept. 14, 1988. Redesignated by T.D. 8687, 61 
FR 60545, Nov. 29, 1996]



Sec.  1.863-4  Certain transportation services.

    (a) General. A taxpayer carrying on the business of transportation 
service (other than an activity giving rise to transportation income 
described in section 863(c) or to income subject to other specific 
provisions of this title) between points in the United States and points 
outside the United States derives income partly from sources within and 
partly from sources without the United States.
    (b) Gross income. The gross income from sources within the United 
States derived from such services shall be determined by taking such a 
portion of the total gross revenues therefrom as (1) the sum of the 
costs or expenses of such transportation business carried on by the 
taxpayer within the United States and a reasonable return upon the 
property used in its transportation business while within the United 
States bears to (2) the sum of the total costs or expenses of such 
transportation business carried on by the taxpayer and a reasonable 
return upon the total property used in such transportation business. 
Revenues from operations incidental to transportation services, such as 
the sale of money orders, shall be apportioned on the same basis as 
direct revenues from transportation services.
    (c) Allocation of costs or expenses. In allocating the total costs 
or expenses incurred in such transportation business, costs or expenses 
incurred in connection with that part of the services which was wholly 
rendered in the United States shall be assigned to the cost of 
transportation business within the United States. For example, expenses 
of loading and unloading in the United States, rentals, office expenses, 
salaries, and wages wholly incurred for services rendered to the 
taxpayer in the United States belong to this class. Costs and expenses 
incurred in connection with services rendered partly within and partly 
without the United States may be prorated on a reasonable basis between 
such services. For example, ship wages, charter money, insurance, and 
supplies chargeable to voyage expenses shall ordinarily be prorated for 
each voyage on the basis of the proportion which the number of days the 
ship was within the territorial limits of the United States bears to the 
total number of days on the voyage; and fuel consumed on each voyage may 
be prorated on the basis of the proportion which the number of miles 
sailed within the territorial limits of the United States bears to the 
total number of miles sailed on the voyage. For other expenses entering 
into the cost of services, only such expenses as are allowable 
deductions under the internal revenue laws shall be taken into account.
    (d) Items not included as costs or expenses--(1) Taxes and interest. 
Income, war profits, and excess profits taxes shall not be regarded as 
costs or expenses for the purpose of determining the proportion of gross 
income from sources within the United States; and, for such purpose, 
interest and other expenses for the use of borrowed capital shall not be 
taken into the cost of services rendered, for the reason that the return 
upon the property used measures the extent to which such borrowed 
capital is the source of the income. See paragraph (f)(2) of this 
section.

[[Page 327]]

    (2) Other business activity and general expenses. If a taxpayer 
subject to this section is also engaged in a business other than that of 
providing transportation service between points in the United States and 
points outside the United States, the costs and expenses, including 
taxes, properly apportioned or allocated to such other business shall be 
excluded both from the deductions and from the apportionment process 
prescribed in paragraph (c) of this section; but, for the purpose of 
determining taxable income, a ratable part of any general expenses, 
losses, or deductions, which cannot definitely be allocated to some item 
or class of gross income, may be deducted from the gross income from 
sources within the United States after the amount of such gross income 
has been determined. Such ratable part shall ordinarily be based upon 
the ratio of gross income from sources within the United States to the 
total gross income. See paragraph (f)(3) of this section.
    (3) Personal exemptions and special deductions. The deductions for 
the personal exemptions, and the special deductions described in 
paragraph (c) of Sec.  1.861-8, shall not be taken into account for 
purposes of paragraph (c) of this section.
    (e) Property used while within the United States--(1) General. The 
value of the property used shall be determined upon the basis of cost 
less depreciation. Eight percent may ordinarily be taken as a reasonable 
rate of return to apply to such property. The property taken shall be 
the average property employed in the transportation service between 
points in the United States and points outside the United States during 
the taxable year.
    (2) Average property. For ships, the average shall be determined 
upon a daily basis for each ship, and the amount to be apportioned for 
each ship as assets employed within the United States shall be computed 
upon the proportion which the number of days the ship was within the 
territorial limits of the United States bears to the total number of 
days the ship was in service during the taxable period. For other assets 
employed in the transportation business, the average of the assets at 
the beginning and end of the taxable period ordinarily may be taken, but 
if the average so obtained does not, by reason of material changes 
during the taxable year, fairly represent the average for such year 
either for the assets employed in the transportation business in the 
United States or in total, the average must be determined upon a monthly 
or daily basis.
    (3) Current assets. Current assets shall be decreased by current 
liabilities and allocated to services between the United States and 
foreign countries and to other services. The part allocated to services 
between the United States and foreign countries shall be based on the 
proportion which the gross receipts from such services bear to the gross 
receipts from all services. The amount so allocated to services between 
the United States and foreign countries shall be further allocated to 
services rendered within the United States and to services rendered 
without the United States. The portion allocable to services rendered 
within the United States shall be based on the proportion which the 
expenses incurred within the territorial limits of the United States 
bear to the total expenses incurred in services between the United 
States and foreign countries.
    (f) Taxable income--(1) General. In computing taxable income from 
sources within the United States there shall be allowed as deductions 
from the gross income from such sources, determined in accordance with 
paragraph (b) of this section, (i) the expenses of the transportation 
business carried on within the United States (as determined under 
paragraphs (c) and (d) of this section) and (ii) the expenses and 
deductions determined in accordance with this paragraph.
    (2) Interest and taxes. Interest and income, war-profits, and excess 
profits taxes shall be excluded from the apportionment process, as 
indicated in paragraph (d) of this section; but, for the purpose of 
computing taxable income there may be deducted from the gross income 
from sources within the United States, after the amount of such gross 
income has been determined, a ratable part of all interest deductible 
under section 163 and of all income, war-profits, and excess profits 
taxes deductible

[[Page 328]]

under section 164, paid or accrued in respect of the business of 
transportation service between points in the United States and points 
outside the United States. The ratable part shall ordinarily be based 
upon the ratio of gross income from sources within the United States to 
the total gross income, from such transportation service.
    (3) General expenses. General expenses, losses, or deductions shall 
be deducted under this paragraph to the extent indicated in paragraph 
(d)(2) of this section.
    (4) Personal exemptions. The deductions for the personal exemptions 
shall be allowed under this paragraph to the same extent as provided by 
paragraph (b) of Sec.  1.861-8.
    (5) Special deductions. The special deductions allowed in the case 
of a corporation by sections 241, 922, and 941 shall be allowed under 
this paragraph to the same extent as provided by paragraph (c) of Sec.  
1.861-8.
    (g) Allocation based on books of account. Application for permission 
to base the return upon the taxpayer's books of account will be 
considered by the district director (or, if applicable, the Director of 
International Operations) in the case of any taxpayer subject to this 
section, who, in good faith and unaffected by considerations of tax 
liability, regularly employs in his books of account a detailed 
allocation of receipts and expenditures which more clearly reflects the 
income derived from sources within the United States than does the 
process prescribed by paragraphs (b) to (f), inclusive, of this section.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 8687, 61 FR 
60550, Nov. 29, 1996]



Sec.  1.863-6  Income from sources within a foreign country.

    The principles applied in sections 861 through 863 and section 865 
and the regulations thereunder for determining the gross and the taxable 
income from sources within and without the United States shall generally 
be applied in determining the gross and the taxable income from sources 
within and without a particular foreign country when such a 
determination must be made under any provision of Subtitle A of the 
Internal Revenue Code, including section 952(a)(5). This section shall 
not apply, however, to the extent it is determined by applying Sec.  
1.863-3 that a portion of the taxable income is from sources within the 
United States and the balance of the taxable income is from sources 
within a foreign country. In the application of this section, the name 
of the particular foreign country shall be used instead of the term 
United States, and the term domestic shall be construed to mean created 
or organized in such foreign country. In applying section 861 and the 
regulations thereunder for purposes of this section, references to 
sections 243 and 245 shall be excluded, and the exception in section 
861(a)(3) shall not apply. In the case of any item of income, the income 
from sources within a foreign country shall not exceed the amount which, 
by applying any provision of sections 861 through 863 and section 865 
and the regulations thereunder without reference to this section, is 
treated as income from sources without the United States. See Sec.  
1.937-2T for rules for determining income from sources within a 
possession of the United States.

[T.D. 9194, 70 FR 18928, Apr. 11, 2005]



Sec.  1.863-7  Allocation of income attributable to certain notional 
principal contracts under section 863(a).

    (a) Scope--(1) Introduction. This section provides rules relating to 
the source and, in certain cases, the character of notional principal 
contract income. However, this section does not apply to income from a 
section 988 transaction within the meaning of section 988 and the 
regulations thereunder, relating to the treatment of certain 
nonfunctional currency transactions. Further, this section does not 
apply to a dividend equivalent described in section 871(m) and the 
regulations thereunder. Notional principal contract income is income 
attributable to a notional principal contract as defined in Sec.  1.446-
3(c). An agreement between a taxpayer and a qualified business unit (as 
defined in section 989(a)) of the taxpayer, or among qualified business 
units of the same taxpayer, is not a notional principal contract, 
because a taxpayer cannot enter into a contract with itself.

[[Page 329]]

    (2) Effective/applicability date.This section applies to notional 
principal contract income includible in income on or after February 13, 
1991. However, any taxpayer desiring to apply paragraph (b)(2)(iv) of 
this section to notional principal contract income includible in income 
prior to February 13, 1991, in lieu of temporary Income Tax Regulations 
Sec.  1.863-7T(b)(2)(iv) may (on a consistent basis) so choose. See 
paragraph (c) of this section for an election to apply the rules of this 
section to notional principal contract income includible in income 
before December 24, 1986. With respect to a dividend equivalent 
described in section 871(m) and the regulations thereunder, this section 
applies to payments made on or after January 23, 2012.
    (b) Source of notional principal contract income--(1) General rule. 
Unless paragraph (b)(2) or (3) of this section applies, the source of 
notional principal contract income shall be determined by reference to 
the residence of the taxpayer as determined under section 
988(a)(3)(B)(i).
    (2) Qualified business unit exception. The source of notional 
principal contract income shall be determined by reference to the 
residence of a qualified business unit of a taxpayer if--
    (i) The taxpayer's residence, determined under section 
988(a)(3)(B)(i), is the United States;
    (ii) The qualified business unit's residence, determined under 
section 988(a)(3)(B)(ii), is outside the United States;
    (iii) The qualified business unit is engaged in the conduct of a 
trade or business where it is a resident as determined under section 
988(a)(3)(B)(ii); and
    (iv) The notional principal contract is properly reflected on the 
books of the qualified business unit. Whether a notional principal 
contract is properly reflected on the books of such qualified business 
unit is a question of fact. The degree of participation in the 
negotiation and acquisition of a notional principal contract shall be 
considered in this determination. Participation in connection with the 
negotiation or acquisition of a notional principal contract may be 
disregarded if the district director determines that a purpose for such 
participation was to affect the source of notional principal contract 
income.
    (3) Effectively connected notional principal contract income. 
Notional principal contract income that under principles similar to 
those set forth in Sec.  1.864-4(c) arises from the conduct of a United 
States trade or business shall be sourced in the United States and such 
income shall be treated as effectively connected to the conduct of a 
United States trade or business for purposes of sections 871(b) and 
882(a)(1).
    (c) Election--(1) Eligibility and effect. A taxpayer described in 
paragraph (b)(2)(i) of this section may make an election to apply the 
rules of this section to all, but not part, of the taxpayer's income 
attributable to notional principal contracts for all taxable years (or 
portion thereof) beginning before December 24, 1986, for which the 
period of limitations for filing a claim for refund under section 
6511(a) has not expired. A taxpayer not described in paragraph (b)(2)(i) 
of this section that is engaged in trade or business within the United 
States may make an election to apply the rules of this section to all, 
but not part, of the taxpayer's income described in paragraph (b)(3) of 
this section for all taxable years (or portion thereof) beginning before 
December 24, 1986, for which the period of limitations for filing a 
claim for refund under section 6511(a) has not expired. If a taxpayer 
makes an election pursuant to this paragraph (c)(1) in the time and 
manner provided in paragraph (c) (2) and (3) of this section, then, with 
respect to such taxable years (or portion thereof), no tax shall be 
deducted or withheld under sections 1441 and 1442 with respect to 
payments made by the taxpayer pursuant to a notional principal contract 
the income attributable to which is subject to such election. The 
election may be revoked only with the consent of the Commissioner.
    (2) Time for making election. The election specified in paragraph 
(c)(1) of this section shall be made by May 14, 1991.
    (3) Manner of making election. The election described in paragraph 
(c)(1) of this section shall be made by attaching a statement to the tax 
return or an amended tax return for each taxable year beginning before 
December 24, 1986, in which the taxpayer accrued or

[[Page 330]]

received notional principal contract income. The statement shall--
    (i) Contain the name, address, and taxpayer identifying number of 
the electing taxpayer;
    (ii) Identify the election as a ``Notional Principal Contract 
Election under Sec.  1.863-7''; and
    (iii) Specify each taxable year described in paragraph (c)(1) of 
this section in which payments were made.
    (d) Example. The operation of this section is illustrated by the 
following example:

    Example. (1) On January 1, 1990, X, a calendar year domestic 
corporation, entered into an interest rate swap contract with FZ, an 
unrelated foreign corporation. X does not have a qualified business unit 
outside the United States. Under the contract, X is required to pay FZ 
fixed rate dollar amounts, and FZ is required to pay X floating rate 
dollar amounts, each determined solely by reference to a notional dollar 
denominated principal amount specified under the contract. The contract 
is a notional principal contract under Sec.  1.863-7(a) because the 
contract provides for the payment of amounts at specified intervals 
calculated by reference to a specified index upon a notional principal 
amount in exchange for a promise to pay similar amounts.
    (2) Assume that during 1990 X had notional principal contract income 
of $100 in connection with the notional principal contract described in 
(1) above. Also assume that the contract provides that payments more 
than 30 days late give rise to a $5 fee, and that X receives such a fee 
in 1990. Under paragraph (b)(1) of this section, the source of X's $100 
of income attributable to the swap agreement is domestic. The $5 fee is 
not notional principal contract income.

    (e) Cross references. See Sec.  1.861-9T(b) for the allocation of 
expense to certain notional principal contracts. For rules relating to 
the source of income from nonfunctional currency notional principal 
contracts, see Sec.  1.9 88-4T. For rules relating to the taxable amount 
of notional principal contract income allocable under this section to 
sources inside or outside the United States, see Sec.  1.863-1(c).

[T.D. 8330, 56 FR 1362, Jan. 14, 1991, as amended by T.D. 9572, 77 FR 
3109, Jan. 23, 2012; T.D. 9648, 78 FR 73080, Dec. 5, 2013]



Sec.  1.863-8  Source of income derived from space and ocean activity 
under section 863(d).

    (a) In general. Income of a United States or a foreign person 
derived from space and ocean activity (space and ocean income) is 
sourced under the rules of this section, notwithstanding any other 
provision, including sections 861, 862, 863, and 865. A taxpayer will 
not be considered to derive income from space or ocean activity, as 
defined in paragraph (d) of this section, if such activity is performed 
by another person, subject to the rules for the treatment of 
consolidated groups in Sec.  1.1502-13.
    (b) Source of gross income from space and ocean activity--(1) Space 
and ocean income derived by a United States person. Space and ocean 
income derived by a United States person is income from sources within 
the United States. However, space and ocean income derived by a United 
States person is income from sources without the United States to the 
extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries.
    (2) Space and ocean income derived by a foreign person--(i) In 
general. Space and ocean income derived by a person other than a United 
States person is income from sources without the United States, except 
as otherwise provided in this paragraph (b)(2).
    (ii) Space and ocean income derived by a controlled foreign 
corporation. Space and ocean income derived by a controlled foreign 
corporation (CFC) is income from sources within the United States. 
However, space and ocean income derived by a CFC is income from sources 
without the United States to the extent the income, based on all the 
facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed in a foreign country or countries. 
For purposes of this section, a CFC has the meaning provided in section 
957, determined without applying section 318(a)(3)(A), (B), and (C) so 
as to consider a United States person as owning stock which is owned by 
a person who is not a United States person.

[[Page 331]]

    (iii) Space and ocean income derived by foreign persons engaged in a 
trade or business within the United States. Space and ocean income 
derived by a foreign person (other than a CFC) engaged in a trade or 
business within the United States is income from sources within the 
United States to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed within the United States.
    (3) Source rules for income from certain sales of property--(i) 
Sales of purchased property. When a taxpayer sells purchased property in 
space or international water, the source of gross income from the sale 
generally will be determined under paragraph (b)(1) or (2) of this 
section, as applicable. However, if such property is inventory property 
within the meaning of section 1221(a)(1) (inventory property) and is 
sold for use, consumption, or disposition outside space and 
international water, the source of income from the sale will be 
determined under Sec.  1.861-7(c).
    (ii) Sales of property produced by the taxpayer--(A) General. If the 
taxpayer both produces property and sells such property and either the 
production (in whole or in part) or the sale takes place in space or 
international water, the taxpayer must allocate and apportion all 
income, gain, or loss derived from sales of such property solely on the 
basis of the production activities with respect to such property, and 
the source of that income will be determined under paragraph 
(b)(3)(ii)(B) or (C) of this section. To determine the source of income 
derived from the sale of personal property (including inventory) by a 
nonresident that is attributable to the nonresident's office or other 
fixed place of business in the United States under section 865(e)(2), 
the rules of Sec.  1.865-3 apply, and the rules of this section do not 
apply.
    (B) Production only in space or international water, or only outside 
space and international water. When production occurs only in space or 
international water, gross income is sourced under paragraph (b)(1) or 
(2) of this section, as applicable. When production occurs only outside 
space and international water, gross income is sourced under Sec.  
1.863-3(c).
    (C) Production both in space or international water and outside 
space and international water. When property is produced both in space 
or international water and outside space and international water, gross 
income must be allocated to production occurring in space or 
international water and production occurring outside space and 
international water. Such gross income is allocated to production 
activity occurring in space or international water to the extent the 
income, based on all the facts and circumstances, is attributable to 
functions performed, resources employed, or risks assumed in space or 
international water. The balance of such gross income is allocated to 
production activity occurring outside space and international water. The 
source of gross income in space or international water is determined 
under paragraph (b)(1) or (2) of this section, as applicable. The source 
of gross income occurring outside space and international water is 
determined under Sec.  1.863-3(c).
    (4) Special rule for determining the source of gross income from 
services. To the extent a transaction characterized as the performance 
of a service constitutes a space or ocean activity, as determined under 
paragraph (d)(2)(ii) of this section, the source of gross income derived 
from such transaction is determined under paragraph (b)(1) or (2) of 
this section.
    (5) Special rule for determining source of income from 
communications activity (other than income from international 
communications activity). Space and ocean activity, as defined in 
paragraph (d) of this section, includes activity that occurs in space or 
international water that is characterized as a communications activity 
as defined in Sec.  1.863-9(h)(1) (other than international 
communications activity). The source of space and ocean income that is 
also communications income as defined in Sec.  1.863-9(h)(2) (but not 
space/ocean communications income as defined in Sec.  1.863-9(h)(3)(v)) 
is determined under the rules of Sec.  1.863-9(c), (d), and (f), as 
applicable, rather than under paragraph (b) of this section. The source 
of space and ocean income that is also

[[Page 332]]

space/ocean communications income as defined in Sec.  1.863-9(h)(3)(v) 
is determined under the rules of paragraph (b) of this section. See 
Sec.  1.863-9(e).
    (c) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(1), (b)(2), (b)(3)(ii), or (b)(4) of this section, the 
taxpayer must allocate expenses, losses, and other deductions as 
prescribed in Sec. Sec.  1.861-8 through 1.861-14T to the class or 
classes of gross income that include the income so allocated in each 
case. A taxpayer must then apply the rules of Sec. Sec.  1.861-8 through 
1.861-14T to apportion properly amounts of expenses, losses, and other 
deductions so allocated to such gross income between gross income from 
sources within the United States and gross income from sources without 
the United States.
    (d) Space and ocean activity--(1) Definition--(i) Space activity. In 
general, space activity is any activity conducted in space. For purposes 
of this section, space means any area not within the jurisdiction (as 
recognized by the United States) of a foreign country, possession of the 
United States, or the United States, and not in international water. For 
purposes of determining space activity, the Commissioner may separate 
parts of a single transaction into separate transactions or combine 
separate transactions as part of a single transaction. Paragraph (d)(3) 
of this section lists specific exceptions to the general definition of 
space activity. Activities that constitute space activity include but 
are not limited to--
    (A) Performance and provision of services in space, as defined in 
paragraph (d)(2)(ii) of this section;
    (B) Leasing of equipment located in space, including spacecraft (for 
example, satellites) or transponders located in space;
    (C) Licensing of technology or other intangibles for use in space;
    (D) Production, processing, or creation of property in space, as 
defined in paragraph (d)(2)(i) of this section;
    (E) Activity occurring in space that is characterized as 
communications activity (other than international communications 
activity) under Sec.  1.863-9(h)(1);
    (F) Underwriting income from the insurance of risks on activities 
that produce space income; and
    (G) Sales of property in space (see Sec.  1.861-7(c)).
    (ii) Ocean activity. In general, ocean activity is any activity 
conducted on or under water not within the jurisdiction (as recognized 
by the United States) of a foreign country, possession of the United 
States, or the United States (collectively, in international water). For 
purposes of determining ocean activity, the Commissioner may separate 
parts of a single transaction into separate transactions or combine 
separate transactions as part of a single transaction. Paragraph (d)(3) 
of this section lists specific exceptions to the general definition of 
ocean activity. Activities that constitute ocean activity include but 
are not limited to--
    (A) Performance and provision of services in international water, as 
defined in paragraph (d)(2)(ii) of this section;
    (B) Leasing of equipment located in international water, including 
underwater cables;
    (C) Licensing of technology or other intangibles for use in 
international water;
    (D) Production, processing, or creation of property in international 
water, as defined in paragraph (d)(2)(i) of this section;
    (E) Activity occurring in international water that is characterized 
as communications activity (other than international communications 
activity) under Sec.  1.863-9(h)(1);
    (F) Underwriting income from the insurance of risks on activities 
that produce ocean income;
    (G) Sales of property in international water (see Sec.  1.861-7(c));
    (H) Any activity performed in Antarctica;
    (I) The leasing of a vessel that does not transport cargo or persons 
for hire between ports-of-call (for example, the leasing of a vessel to 
engage in research activities in international water); and
    (J) The leasing of drilling rigs, extraction of minerals, and 
performance and provision of services related thereto, except as 
provided in paragraph (d)(3)(ii) of this section.

[[Page 333]]

    (2) Determining a space or ocean activity--(i) Production of 
property in space or international water. For purposes of this section, 
production activity means an activity that creates, fabricates, 
manufactures, extracts, processes, cures, or ages property within the 
meaning of section 864(a) and Sec.  1.864-1.
    (ii) Special rule for performance of services--(A) General. Except 
as provided in paragraph (d)(2)(ii)(B) of this section, if a transaction 
is characterized as the performance of a service, then such service will 
be treated as a space or ocean activity in its entirety when any part of 
the service is performed in space or international water. Services are 
performed in space or international water if functions are performed, 
resources are employed, or risks are assumed in space or international 
water, regardless of whether performed by personnel, equipment, or 
otherwise.
    (B) Exception to the general rule. If the taxpayer can demonstrate 
the value of the service attributable to performance occurring in space 
or international water, and the value of the service attributable to 
performance occurring outside space and international water, then such 
service will be treated as space or ocean activity only to the extent of 
the activity performed in space or international water. The value of the 
service is attributable to performance occurring in space or 
international water to the extent the performance of the service, based 
on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed in space or 
international water. In addition, if the taxpayer can demonstrate, based 
on all the facts and circumstances, that the value of the service 
attributable to performance in space and international water is de 
minimis, such service will not be treated as space or ocean activity.
    (3) Exceptions to space or ocean activity. Space or ocean activity 
does not include the following types of activities:
    (i) Any activity giving rise to transportation income as defined in 
section 863(c).
    (ii) Any activity with respect to mines, oil and gas wells, or other 
natural deposits, to the extent the mines, wells, or natural deposits 
are located within the jurisdiction (as recognized by the United States) 
of any country, including the United States and its possessions.
    (iii) Any activity giving rise to international communications 
income as defined in Sec.  1.863-9(h)(3)(ii).
    (e) Treatment of partnerships. This section is applied at the 
partner level.
    (f) Examples. The following examples illustrate the rules of this 
section:
    (1) Example 1. Space activity--activity occurring on land and in 
space--(i) Facts. S, a United States person, owns satellites in orbit. S 
leases one of its satellites to A. S, as lessor, will not operate the 
satellite. Part of S's performance as lessor in this transaction occurs 
on land. Assume that the combination of S's activities is characterized 
as the lease of equipment.
    (ii) Analysis. Because the leased equipment is located in space, the 
transaction is defined in its entirety as space activity under paragraph 
(d)(1)(i) of this section. Income derived from the lease will be sourced 
under paragraph (b)(1) of this section. Under paragraph (b)(1) of this 
section, S's space income is sourced outside the United States to the 
extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries.
    (2) Example 2. Space activity--(i) Facts. X is an Internet service 
provider. X offers a service that permits a customer (C) to connect to 
the Internet via a telephone call, initiated by the modem of C's 
personal computer, to a control center. X transmits information 
requested by C to C's personal computer, in part using satellite 
capacity leased by X from S. X performs the uplink and downlink 
functions. X charges its customers a flat monthly fee. Assume that 
neither X nor S derive international communications income within the 
meaning of Sec.  1.863-9(h)(3)(ii). In addition, assume that X is able 
to demonstrate, pursuant to paragraph (d)(2)(ii)(B) of this section, the 
extent to which the value of the service is attributable to functions 
performed, resources employed, and risks assumed in space.

[[Page 334]]

    (ii) Analysis. Under paragraph (d)(2)(ii) of this section, the 
service performed by X constitutes space activity to the extent the 
value of the service is attributable to functions performed, resources 
employed, and risks assumed in space. To the extent the service 
performed by X constitutes space activity, the source of X's income from 
the service transaction is determined under paragraph (b) of this 
section. To the extent the service performed by X does not constitute 
space or ocean activity, the source of X's income from the service is 
determined under sections 861, 862, and 863, as applicable. To the 
extent that X derives space and ocean income that is also communications 
income within the meaning of Sec.  1.863-9(h)(2), the source of X's 
income is determined under paragraph (b) of this section and Sec.  
1.863-9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) 
of this section. S derives space and ocean income that is also 
communications income within the meaning of Sec.  1.863-9(h)(2), and the 
source of S's income is therefore determined under paragraph (b) of this 
section and Sec.  1.863-9(c), (d), and (f), as applicable, as provided 
in paragraph (b)(5) of this section.
    (3) Example 3. Services as space activity--de minimis value 
attributable to performance occurring in space--(i) Facts. R owns a 
retail outlet in the United States. R engages S to provide a security 
system for R's premises. S operates its security system by transmitting 
images from R's premises directly to a satellite, and from the satellite 
to a group of S employees located in Country B, who monitor the premises 
by viewing the transmitted images. The satellite is used as a medium of 
delivery and not as a method of surveillance. O provides S with 
transponder capacity on O's satellite, which S uses to transmit those 
images. Assume that S's transaction with R is characterized as the 
performance of a service. Assume that O's provision of transponder 
capacity is also viewed as the provision of a service. Assume also that 
S is able to demonstrate, pursuant to Sec.  1.863-9(h)(1), that the 
value of the transaction with R attributable to communications 
activities is de minimis.
    (ii) Analysis. S derives income from providing monitoring services. 
S can demonstrate, pursuant to paragraph (d)(2)(ii) of this section, 
that based on all the facts and circumstances, the value of S's service 
transaction attributable to performance in space is de minimis. Thus, S 
is not treated as engaged in a space activity, and none of S's income 
from the service transaction is space income. In addition, because S 
demonstrates that the value of the transaction with R attributable to 
communications activities is de minimis, S is not required under Sec.  
1.863-9(h)(1)(ii) to treat the transaction as separate communications 
and non-communications transactions, and none of S's gross income from 
the transaction is treated as communications income within the meaning 
of Sec.  1.863-9(h)(2). O's provision of transponder capacity is viewed 
as the provision of a service. Based on all the facts and circumstances, 
the value of O's service transaction attributable to performance in 
space is not de minimis. Thus, O's activity will be considered space 
activity, pursuant to paragraph (d)(2)(ii) of this section, to the 
extent the value of the services transaction is attributable to 
performance in space (unless O's activity in space is international 
communications activity). To the extent that O derives communications 
income, the source of such income is determined under paragraph (b) of 
this section and Sec.  1.863-9(b), (c), (d), and (f), as applicable, as 
provided in paragraph (b)(5) of this section. R does not derive any 
income from space activity.
    (4) Example 4. Space activity--(i) Facts. L, a domestic corporation, 
offers programming and certain other services to customers located both 
in the United States and in foreign countries. Assume that L's provision 
of programming and other services in paragraph (f)(4)(i) (Example 4) is 
characterized as the provision of a service, and that no part of the 
service transaction occurs in space or international water. Assume that 
the delivery of the programming constitutes a separate transaction also 
characterized as the performance of a service. L uses satellite capacity 
acquired from S to deliver the

[[Page 335]]

programming service directly to customers' television sets. L performs 
the uplink and downlink functions, so that part of the value of the 
delivery transaction derives from functions performed and resources 
employed in space. Assume that these contributions to the value of the 
delivery transaction occurring in space are not considered de minimis 
under paragraph (d)(2)(ii)(B) of this section. Customer C pays L to 
provide and deliver programming to C's residence in the United States. 
Assume S's provision of satellite capacity in paragraph (f)(4)(i) 
(Example 4) is viewed as the provision of a service, and also that S 
does not derive international communications income within the meaning 
of Sec.  1.863-9(h)(3)(ii).
    (ii) Analysis. S's activity will be considered space activity. To 
the extent that S derives space and ocean income that is also 
communications income under Sec.  1.863-9(h)(2), the source of S's 
income is determined under paragraph (b) of this section and Sec.  
1.863-9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) 
of this section. On these facts, L's activities are treated as two 
separate service transactions: the provision of programming (and other 
services), and the delivery of programming. L's income derived from 
provision of programming and other services is not income derived from 
space activity. L's delivery of programming and other services is 
considered space activity, pursuant to paragraph (d)(2)(ii) of this 
section, to the extent the value of the delivery transaction is 
attributable to performance in space. To the extent that the delivery of 
programming is treated as a space activity, the source of L's income 
derived from the delivery transaction is determined under paragraph 
(b)(1) of this section, as provided in paragraph (b)(4) of this section. 
To the extent that L derives space and ocean income that is also 
communications income within the meaning of Sec.  1.863-9(h)(2), the 
source of such income is determined under paragraph (b) of this section 
and Sec.  1.863-9(b), (c), (d), (e), and (f), as applicable, as provided 
in paragraph (b)(5) of this section.
    (5) Example 5. Space activity--(i) Facts. The facts are the same as 
in paragraph (f)(4)(i) of this section (the facts in Example 4), except 
that L does not deliver the programming service directly but instead 
engages R, a domestic corporation specializing in content delivery, to 
deliver by transmission its programming. For all portions of a 
transmission which require satellite capacity, R, in turn, contracts out 
such functions to S. S performs the uplink and downlink functions, so 
that part of the value of the delivery transaction derives from 
functions performed and resources employed in space.
    (ii) Analysis. L's activity will not be considered space activity 
because none of L's activity occurs in space. Thus, L does not derive 
any space and ocean income. L does, however, derive communications 
income within the meaning of Sec.  1.863-9(h)(2). This is the case even 
though L does not perform the transmission function because L is paid by 
Customer C to transmit, and bears the risk of transmitting, the 
communications or data. To the extent that L's activity consists in part 
of non-de minimis communications and non-de minimis non-communications 
activity, each part of the transaction must be treated as a separate 
transaction and gross income is allocated accordingly under Sec.  1.863-
9(h)(1)(ii). In addition, L must also allocate expenses, losses, and 
other deductions, for example, payments to R, to the class or classes of 
gross income that include the income so allocated. R's activity will not 
be considered space activity. Since R contracts out all of the functions 
involving satellite capacity to S, no part of R's activity occurs in 
space. Thus, R does not derive any space and ocean income. R does, 
however, derive communications income within the meaning of Sec.  1.863-
9(h)(2). This is the case even though R does not perform the 
transmission function because R is paid by L to transmit, and bears the 
risk of transmitting, the communications or data. S's activity will be 
considered space activity. To the extent that S derives space and ocean 
income that is also communications income within the meaning of Sec.  
1.863-9(h)(2), the source of such income is determined under paragraph 
(b) of this section and

[[Page 336]]

Sec.  1.863-9(b), (c), (d), (e), and (f), as applicable, as provided in 
paragraph (b)(5) of this section.
    (6) Example 6. Space activity--treatment of land activity--(i) 
Facts. S, a United States person, offers remote imaging products and 
services to its customers. In year 1, S uses its satellite's remote 
sensors to gather data on certain geographical terrain. In year 3, C, a 
construction development company, contracts with S to obtain a satellite 
image of an area for site development work. S pulls data from its 
archives and transfers to C the images gathered in year 1, in a 
transaction that is characterized as a sale of the data. S's rights, 
title, and interest in the data pass to C in the United States. Before 
transferring the images to C, S uses computer software in its land-based 
office to enhance the images so that the images can be used.
    (ii) Analysis. The collection of data and creation of images in 
space is characterized as the creation of property in space. Because S 
both produces and sells the data, the source of the gross income from 
the sale of the data is determined under paragraph (b)(3)(ii) of this 
section solely on the basis of the production activities. The source of 
S's gross income is determined under paragraph (b)(3)(ii)(C) of this 
section because production activities occur both in space and on land.
    (7) Example 7. Use of intangible property in space--(i) Facts. X 
acquires a license to use a particular satellite slot or orbit, which X 
sublicenses to C. C pays X a royalty.
    (ii) Analysis. Because the royalty is paid for the right to use 
intangible property in space, the source of the royalty paid by C to X 
is determined under paragraph (b) of this section.
    (8) Example 8. Performance of services--(i) Facts. E, a domestic 
corporation, operates satellites with sensing equipment that can 
determine how much heat and light particular plants emit and reflect. 
Based on the data, E will provide F, a U.S. farmer, a report analyzing 
the data, which F will use in growing crops. E analyzes the data from 
offices located in the United States. Assume that E's combined 
activities are characterized as the performance of services.
    (ii) Analysis. Based on all the facts and circumstances, the value 
of E's service transaction attributable to performance in space is not 
de minimis. Thus, E's activities will be considered space activities, 
pursuant to paragraph (d)(2)(ii) of this section, to the extent the 
value of E's service transaction is attributable to performance in 
space. To the extent E's service transaction constitutes a space 
activity, the source of E's income derived from the service transaction 
will be determined under paragraph (b)(4) of this section, by reference 
to paragraph (b)(1) of this section. To the extent that E's service 
transaction does not constitute a space or ocean activity, the source of 
E's income derived from the service transaction is determined under 
sections 861, 862, and 863, as applicable.
    (9) Example 9. Separate transactions--(i) Facts. The same facts as 
in paragraph (f)(8)(i) of this section (the facts in Example 8), except 
that E provides the raw data to F in a transaction characterized as a 
sale of a copyrighted article. In addition, E provides an analysis in 
the form of a report to F. The price F pays E for the raw data is 
separately stated.
    (ii) Analysis. To the extent that the provision of raw data and the 
analysis of the data are each treated as separate transactions, the 
source of income from the production and sale of data is determined 
under paragraph (b)(3)(ii) of this section. The provision of services 
would be analyzed in the same manner as in paragraph (f)(8)(ii) of this 
section (the analysis in Example 8).
    (10) Example 10. Sale of property in international water--(i) Facts. 
T purchased and owns transatlantic cable that lies in international 
water. T sells the cable to B, with T's rights, title, and interest in 
the cable passing to B in international water. Assume that the 
transatlantic cable is not inventory property within the meaning of 
section 1221(a)(1).
    (ii) Analysis. Because T's rights, title, and interest in the 
property pass to B in international water, the sale takes place in 
international water under Sec.  1.861-7(c), and the sale transaction is 
ocean activity under paragraph (d)(1)(ii) of this section. The source of 
T's sales income is determined under

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paragraph (b)(3)(i) of this section, by reference to paragraph (b)(1) or 
(2) of this section.
    (11) Example 11. Sale of property in space--(i) Facts. S, a United 
States person, manufactures a satellite in the United States and sells 
it to a customer who is not a United States person. S's rights, title, 
and interest in the satellite pass to the customer in space.
    (ii) Analysis. Because S's rights, title, and interest in the 
satellite pass to the customer in space, the sale takes place in space 
under Sec.  1.861-7(c), and the sale transaction is space activity under 
paragraph (d)(1)(i) of this section. The source of income derived from 
the sale of the satellite manufactured in the United States and sold in 
space is determined under paragraph (b)(3)(ii) of this section solely on 
the basis of the production activities with respect to the satellite.
    (12) Example 12. Sale of property in space--(i) Facts. S has a right 
to operate from a particular position (satellite slot or orbit) in 
space. S sells the right to operate from that position to P. Assume that 
the sale of the satellite slot is characterized as a sale of property 
and that S's rights, title, and interest in the satellite slot pass to P 
in space.
    (ii) Analysis. The sale of the satellite slot takes place in space 
under Sec.  1.861-7(c) because S's rights, title, and interest in the 
satellite slot pass to P in space. The sale of the satellite slot is 
space activity under paragraph (d)(1)(i) of this section, and income or 
gain from the sale is sourced under paragraph (b)(3)(i) of this section, 
by reference to paragraph (b)(1) or (2) of this section.
    (13) Example 13. Source of income of a foreign person--(i) Facts. 
FP, a foreign corporation that is not a CFC, derives income from the 
operation of satellites. FP operates ground stations in the United 
States and in foreign Country FC. Assume that FP is considered engaged 
in a trade or business within the United States based on FP's operation 
of the ground station in the United States.
    (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's 
space income is sourced in the United States to the extent the income, 
based on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed within the United 
States.
    (14) Example 14. Source of income of a foreign person--(i) Facts. 
FP, a foreign corporation that is not a CFC, operates remote sensing 
satellites in space to collect data and images for its customers. FP 
uses an independent agent, A, in the United States who provides 
marketing, order-taking, and other customer service functions. Assume 
that FP is considered engaged in a trade or business within the United 
States based on A's activities on FP's behalf in the United States.
    (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's 
space income is sourced in the United States to the extent the income, 
based on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed within the United 
States.
    (g) Reporting and documentation requirements--(1) In general. A 
taxpayer making an allocation of gross income under paragraph (b)(1), 
(b)(2), (b)(3)(ii), or (b)(4) of this section must satisfy the 
requirements in paragraphs (g)(2), (3), and (4) of this section.
    (2) Required documentation. In all cases, a taxpayer must prepare 
and maintain documentation in existence when its return is filed 
regarding the allocation of gross income and allocation and 
apportionment of expenses, losses, and other deductions, the 
methodologies used, and the circumstances justifying use of those 
methodologies. The taxpayer must make available such documentation 
within 30 days upon request.
    (3) Access to software. If the taxpayer or any third party used any 
computer software, within the meaning of section 7612(d), to allocate 
gross income, or to allocate or apportion expenses, losses, and other 
deductions, the taxpayer must make available upon request--
    (i) Any computer software executable code, within the meaning of 
section 7612(d), used for such purposes, including an executable copy of 
the version of the software used in the preparation of the taxpayer's 
return (including any plug-ins, supplements, etc.) and a copy

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of all related electronic data files. Thus, if software subsequently is 
upgraded or supplemented, a separate executable copy of the version used 
in preparing the taxpayer's return must be retained;
    (ii) Any related computer software source code, within the meaning 
of section 7612(d), acquired or developed by the taxpayer or a related 
person, or primarily for internal use by the taxpayer or such person 
rather than for commercial distribution; and
    (iii) In the case of any spreadsheet software or similar software, 
any formulae or links to supporting worksheets.
    (4) Use of allocation methodology. In general, when a taxpayer 
allocates gross income under paragraph (b)(1), (b)(2), (b)(3)(ii), or 
(b)(4) of this section, it does so by making the allocation on a timely 
filed original return (including extensions). However, a taxpayer will 
be permitted to make changes to such allocations made on its original 
return with respect to any taxable year for which the statute of 
limitations has not closed as follows:
    (i) In the case of a taxpayer that has made a change to such 
allocations prior to the opening conference for the audit of the taxable 
year to which the allocation relates or who makes such a change within 
90 days of such opening conference, if the IRS issues a written 
information document request asking the taxpayer to provide the 
documents and such other information described in paragraphs (g)(2) and 
(3) of this section with respect to the changed allocations and the 
taxpayer complies with such request within 30 days of the request, then 
the IRS will complete its examination, if any, with respect to the 
allocations for that year as part of the current examination cycle. If 
the taxpayer does not provide the documents and information described in 
paragraphs (g)(2) and (3) of this section within 30 days of the request, 
then the procedures described in paragraph (g)(4)(ii) of this section 
shall apply.
    (ii) If the taxpayer changes such allocations more than 90 days 
after the opening conference for the audit of the taxable year to which 
the allocations relate or the taxpayer does not provide the documents 
and information with respect to the changed allocations as requested in 
accordance with paragraphs (g)(2) and (3) of this section, then the IRS 
will, in a separate cycle, determine whether an examination of the 
taxpayer's allocations is warranted and complete any such examination. 
The separate cycle will be worked as resources are available and may not 
have the same estimated completion date as the other issues under 
examination for the taxable year. The IRS may ask the taxpayer to extend 
the statute of limitations on assessment and collection for the taxable 
year to permit examination of the taxpayer's method of allocation, 
including an extension limited, where appropriate, to the taxpayer's 
method of allocation.
    (h) Applicability dates. Except as provided in this paragraph (h), 
this section applies to taxable years beginning on or after December 27, 
2006. The provisions in paragraph (b)(2)(ii) of this section relating to 
the meaning of a CFC apply to taxable years of foreign corporations 
ending on or after October 1, 2019. For taxable years of foreign 
corporations ending before October 1, 2019, 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, 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 provisions with respect to all foreign 
corporations. For taxable years of foreign corporations ending before 
October 1, 2019, where the taxpayer does not apply the provisions of 
paragraph (b)(2)(ii) of this section relating to the meaning of a CFC, 
see paragraph (b)(2)(ii) of this section as in effect and contained in 
26 CFR part 1, as revised April 1, 2020. Paragraph (b)(3)(ii) of this 
section applies to taxable years ending on or after December 23, 2019. 
However, a taxpayer may apply paragraph (b)(3)(ii) of this section in 
its entirety for taxable years beginning after December 31, 2017, and 
ending before December 23, 2019, provided that the taxpayer and all 
persons related to the taxpayer (within the meaning of section 267 or 
707) apply paragraph (b)(3)(ii) of this section and Sec. Sec.  1.863-
1(b),

[[Page 339]]

1.863-2(b), 1.863-3, 1.864-5(a) and (b), 1.864-6(c)(2), and 1.865-3 in 
their entirety for the taxable year, and once applied, the taxpayer and 
all persons related to the taxpayer (within the meaning of section 267 
or 707) continue to apply these regulations in their entirety for all 
subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.863-8 as 
contained in 26 CFR part 1 revised as of April 1, 2020.

[T.D. 9305, 71 FR 77603, Dec. 27, 2006, as amended by T.D. 9908, 85 FR 
59434, Sept. 22, 2020; T.D. 9921, 85 FR 79849, Dec. 11, 2020]



Sec.  1.863-9  Source of income derived from communications activity 
under section 863(a), (d), and (e).

    (a) In general. Income of a United States or a foreign person 
derived from each type of communications activity, as defined in 
paragraph (h)(3) of this section, is sourced under the rules of this 
section, notwithstanding any other provision including sections 861, 
862, 863, and 865. Notwithstanding that a communications activity would 
qualify as space or ocean activity under section 863(d) and the 
regulations thereunder, the source of income derived from such 
communications activity is determined under this section, and not under 
section 863(d) and the regulations thereunder, except to the extent 
provided in Sec.  1.863-8(b)(5).
    (b) Source of international communications income--(1) International 
communications income derived by a United States person. Income derived 
from international communications activity (international communications 
income) by a United States person is one-half from sources within the 
United States and one-half from sources without the United States.
    (2) International communications income derived by foreign persons--
(i) In general. International communications income derived by a person 
other than a United States person is, except as otherwise provided in 
this paragraph (b)(2), wholly from sources without the United States.
    (ii) International communications income derived by a controlled 
foreign corporation. International communications income derived by a 
controlled foreign corporation (CFC) is one-half from sources within the 
United States and one-half from sources without the United States. For 
purposes of this section, a CFC has the meaning provided in section 957, 
determined without applying section 318(a)(3)(A), (B), and (C) so as to 
consider a United States person as owning stock which is owned by a 
person who is not a United States person.
    (iii) International communications income derived by foreign persons 
with a fixed place of business in the United States. International 
communications income derived by a foreign person, other than a CFC, 
that is attributable to an office or other fixed place of business of 
the foreign person in the United States is from sources within the 
United States. The principles of section 864(c)(5) apply in determining 
whether a foreign person has an office or fixed place of business in the 
United States. See Sec.  1.864-7. International communications income is 
attributable to an office or other fixed place of business to the extent 
of functions performed, resources employed, or risks assumed by the 
office or other fixed place of business.
    (iv) International communications income derived by foreign persons 
engaged in a trade or business within the United States. International 
communications income derived by a foreign person (other than a CFC) 
engaged in a trade or business within the United States is income from 
sources within the United States to the extent the income, based on all 
the facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed within the United States.
    (c) Source of U.S. communications income. Income derived by a United 
States or foreign person from U.S. communications activity is from 
sources within the United States.
    (d) Source of foreign communications income. Income derived by a 
United States or foreign person from foreign communications activity is 
from sources without the United States.
    (e) Source of space/ocean communications income. The source of 
income derived by a United States or foreign person from space/ocean 
communications activity is determined under section 863(d) and the 
regulations thereunder.

[[Page 340]]

    (f) Source of communications income when taxpayer cannot establish 
the two points between which the taxpayer is paid to transmit the 
communication. Income derived by a United States or foreign person from 
communications activity, when the taxpayer cannot establish the two 
points between which the taxpayer is paid to transmit the communication 
as required in paragraph (h)(3)(i) of this section, is from sources 
within the United States.
    (g) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, the 
taxpayer must allocate expenses, losses, and other deductions as 
prescribed in Sec. Sec.  1.861-8 through 1.861-14T to the class or 
classes of gross income that include the income so allocated in each 
case. A taxpayer must then apply the rules of Sec. Sec.  1.861-8 through 
1.861-14T properly to apportion amounts of expenses, losses, and other 
deductions so allocated to such gross income between gross income from 
sources within the United States and gross income from sources without 
the United States. For amounts of expenses, losses, and other deductions 
allocated to gross income derived from international communications 
activity, when the source of income is determined under the 50/50 method 
of paragraph (b)(1) or (b)(2)(ii) of this section, taxpayers generally 
must apportion expenses, losses, and other deductions between sources 
within the United States and sources without the United States pro rata 
based on the relative amounts of gross income from sources within the 
United States and gross income from sources without the United States. 
However, the preceding sentence shall not apply to research and 
experimental expenditures qualifying under Sec.  1.861-17, which are to 
be allocated and apportioned under the rules of that section.
    (h) Communications activity and income derived from communications 
activity--(1) Communications activity--(i) General rule. For purposes of 
this part, communications activity consists solely of the delivery by 
transmission of communications or data (communications). Delivery of 
communications other than by transmission (for example, by delivery of 
physical packages and letters) is not communications activity within the 
meaning of this section. Communications activity also includes the 
provision of capacity to transmit communications. Provision of content 
or any other additional service provided along with, or in connection 
with, a non-de minimis communications activity must be treated as a 
separate non-communications activity unless de minimis. Communications 
activity or non-communications activity will be treated as de minimis to 
the extent, based on the facts and circumstances, the value attributable 
to such activity is de minimis.
    (ii) Separate transaction. To the extent that a taxpayer's 
transaction consists in part of non-de minimis communications activity 
and in part of non-de minimis non-communications activity, each such 
part of the transaction must be treated as a separate transaction. Gross 
income is allocated to each such communications activity transaction and 
non-communications activity transaction to the extent the income, based 
on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed in each such activity.
    (2) Income derived from communications activity. Income derived from 
communications activity (communications income) is income derived from 
the delivery by transmission of communications, including income derived 
from the provision of capacity to transmit communications. Income may be 
considered derived from a communications activity even if the taxpayer 
itself does not perform the transmission function, but in all cases, the 
taxpayer derives communications income only if the taxpayer is paid to 
transmit, and bears the risk of transmitting, the communications.
    (3) Determining the type of communications activity--(i) In general. 
Whether income is derived from international communications activity, 
U.S. communications activity, foreign communications activity, or space/
ocean communications activity is determined by identifying the two 
points between which the taxpayer is paid to transmit the communication. 
The taxpayer must establish the two points between which the taxpayer is 
paid to transmit,

[[Page 341]]

and bears the risk of transmitting, the communication. Whether the 
taxpayer contracts out part or all of the transmission function is not 
relevant. A taxpayer may satisfy the requirement that the taxpayer 
establish the two points between which the taxpayer is paid to transmit, 
and bears the risk of transmitting, the communication by using any 
consistently applied reasonable method to establish one or both 
endpoints. In evaluating the reasonableness of such method, 
consideration will be given to all the facts and circumstances, 
including whether the endpoints would otherwise be identifiable absent 
this reasonable method provision and the reliability of the data. 
Depending on the facts and circumstances, methods based on, for example, 
records of port or transport charges, customer billing records, a 
satellite footprint, or records of termination fees made pursuant to an 
international settlement agreement may be reasonable. In addition, 
practices used by taxpayers to classify or categorize certain 
communications activity in connection with preparation of statements and 
analyses for the use of management, creditors, minority shareholders, 
joint ventures, or other parties or governmental agencies in interest 
may be reliable indicators of the reasonableness of the method chosen, 
but need not be accorded conclusive weight by the Commissioner. In all 
cases, the method chosen to establish the two points between which the 
taxpayer is paid to transmit, and bears the risk of transmitting, the 
communication must be supported by sufficient documentation to permit 
verification by the Commissioner.
    (ii) Income derived from international communications activity. 
Income derived by a taxpayer from international communications activity 
(international communications income) is income derived from 
communications activity, as defined in paragraph (h)(2) of this section, 
when the taxpayer is paid to transmit--
    (A) Between a point in the United States and a point in a foreign 
country (or a possession of the United States); or
    (B) Foreign-originating communications (communications with a 
beginning point in a foreign country or a possession of the United 
States) from a point in space or international water to a point in the 
United States.
    (iii) Income derived from U.S. communications activity. Income 
derived by a taxpayer from U.S. communications activity (U.S. 
communications income) is income derived from communications activity, 
as defined in paragraph (h)(2) of this section, when the taxpayer is 
paid to transmit--
    (A) Between two points in the United States; or
    (B) Between the United States and a point in space or international 
water, except as provided in paragraph (h)(3)(ii)(B) of this section.
    (iv) Income derived from foreign communications activity. Income 
derived by a taxpayer from foreign communications activity (foreign 
communications income) is income derived from communications activity, 
as defined in paragraph (h)(2) of this section, when the taxpayer is 
paid to transmit--
    (A) Between two points in a foreign country or countries (or a 
possession or possessions of the United States);
    (B) Between a foreign country and a possession of the United States; 
or
    (C) Between a foreign country (or a possession of the United States) 
and a point in space or international water.
    (v) Income derived from space/ocean communications activity. Income 
derived by a taxpayer from space/ocean communications activity (space/
ocean communications income) is income derived from communications 
activity, as defined in paragraph (h)(2) of this section, when the 
taxpayer is paid to transmit between a point in space or international 
water and another point in space or international water.
    (i) Treatment of partnerships. This section is applied at the 
partner level.
    (j) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Income derived from non-communications activity--remote 
data base access. (i) Facts. D provides its customers in various foreign 
countries with access to its data base, which contains information on 
certain individuals' health care insurance coverage. Customer C obtains 
access to D's data base by placing a call to D's telephone number. 
Assume that C's telephone service, used to access D's data base, is 
provided by a third party, and that D assumes no responsibility

[[Page 342]]

for the transmission of the information via telephone.
    (ii) Analysis. D is not paid to transmit communications and does not 
derive income from communications activity within the meaning of 
paragraph (h)(2) of this section. Rather, D derives income from 
provision of content or provision of services to its customers. 
Therefore, the rules of this section do not apply to determine the 
source of D's income.
    Example 2. Income derived from U.S. communications activity--U.S. 
portion of international communication. (i) Facts. TC, a local telephone 
company, receives an access fee from an international carrier for 
picking up a call from a local telephone customer and delivering the 
call to a U.S. point of presence (POP) of the international carrier. The 
international carrier picks up the call from its U.S. POP and delivers 
the call to a foreign country.
    (ii) Analysis. TC is not paid to carry the transmission between the 
United States and a foreign country. TC is paid to transmit a 
communication between two points in the United States. TC derives U.S. 
communications income as defined in paragraph (h)(3)(iii) of this 
section, which is sourced under paragraph (c) of this section as U.S. 
source income.
    Example 3. Income derived from international communications 
activity--underwater cable. (i) Facts. TC, a domestic corporation, owns 
an underwater fiber optic cable. Pursuant to contracts, TC makes 
available to its customers capacity to transmit communications via the 
cable. TC's customers then solicit telephone customers and arrange to 
transmit the telephone customers' calls. The cable runs in part through 
U.S. waters, in part through international waters, and in part through 
foreign country waters.
    (ii) Analysis. TC derives international communications income as 
defined in paragraph (h)(3)(ii) of this section because TC is paid to 
make available capacity to transmit communications between the United 
States and a foreign country. Because TC is a United States person, TC's 
international communications income is sourced under paragraph (b)(1) of 
this section as one-half from sources within the United States and one-
half from sources without the United States.
    Example 4. Income derived from international communications 
activity--satellite. (i) Facts. S, a United States person, owns 
satellites in orbit and uplink facilities in Country X, a foreign 
country. B, a resident of Country X, pays S to deliver B's programming 
from S's uplink facility, located in Country X, to a downlink facility 
in the United States owned by C, a customer of B.
    (ii) Analysis. S derives international communications income under 
paragraph (h)(3)(ii) of this section because S is paid to transmit the 
communications between a beginning point in a foreign country and an 
endpoint in the United States. Because S is a United States person, the 
source of S's international communications income is determined under 
paragraph (b)(1) of this section as one-half from sources within the 
United States and one-half from sources without the United States.
    Example 5. The paid-to-do rule--foreign communications via domestic 
route. (i) Facts. TC is paid to transmit communications from Toronto, 
Canada, to Paris, France. TC transmits the communications from Toronto 
to New York. TC pays another communications company, IC, to transmit the 
communications from New York to Paris.
    (ii) Analysis. Under the paid-to-do rule of paragraph (h)(3)(i) of 
this section, TC derives foreign communications income under paragraph 
(h)(3)(iv) of this section because TC is paid to transmit communications 
between two points in foreign countries, Toronto and Paris. Under 
paragraph (h)(3)(i) of this section, the character of TC's 
communications activity is determined without regard to the fact that TC 
pays IC to transmit the communications for some portion of the delivery 
path. IC has international communications income under paragraph 
(h)(3)(ii) of this section because IC is paid to transmit the 
communications between a point in the United States and a point in a 
foreign country.
    Example 6. The paid-to-do rule--domestic communication via foreign 
route. (i) Facts. TC is paid to transmit a call between two points in 
the United States, but routes the call through Canada.
    (ii) Analysis. Under paragraph (h)(3)(i) of this section, the 
character of income derived from communications activity is determined 
by the two points between which the taxpayer is paid to transmit, and 
bears the risk of transmitting, the communications, without regard to 
the path of the transmission between those two points. Thus, under 
paragraph (h)(3)(iii) of this section, TC derives income from U.S. 
communications activity because it is paid to transmit the 
communications between two U.S. points.
    Example 7. The paid-to-do rule--foreign-originating communications. 
(i) Facts. Under an international settlement agreement, G, a Country X 
international carrier, pays T to receive all calls originating in 
Country X that are bound for the United States and to terminate such 
calls in the United States. Due to Country X legal restrictions, the 
international settlement agreement specifies that G carries the 
transmission to a point outside the territory of Country X and that T 
carries the foreign-originating transmission from such point to the 
destined point in the United States. T, in turn, contracts out with 
another communications company, S, to transmit the U.S. portion of

[[Page 343]]

the communications. Tracing and identifying the endpoints of each 
transmission is not possible or practical. T does, however, keep records 
of termination fees received from G for terminating the foreign-
originating calls.
    (ii) Analysis. T derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, T can establish that T is paid to transmit, and bears the 
risk of transmitting, foreign-originating calls from a point in space or 
international water to a point in the United States using a reasonable 
method to establish the endpoints, assuming that this method is 
consistently applied. In this case, T can reasonably establish that T is 
paid to receive foreign-originating calls and terminate such calls in 
the United States based on the records of termination fees pursuant to 
an international settlement agreement. Under paragraph (h)(3)(ii)(B) of 
this section, a taxpayer derives income from international 
communications activity when the taxpayer is paid to transmit foreign-
originating communications from space or international water to the 
United States. Thus, under paragraph (h)(3)(ii)(B) of this section, T 
derives income from international communications. If, based on all the 
facts and circumstances, T could reasonably trace and identify the 
endpoints, then T would have to directly establish that each call 
originated in a foreign country. Assuming T is able to do so, the rest 
of the analysis in this Example 7 remains the same. Under paragraph 
(h)(3)(iii) of this section, S derives income from U.S. communications 
activity because S is paid to transmit the communications between two 
U.S. points.
    Example 8. Indeterminate endpoints--prepaid telephone calling cards. 
(i) Facts. S purchases capacity from TC to transmit telephone calls. S 
sells prepaid telephone calling cards that give customers access to TC's 
telephone lines for a certain number of minutes. Assume that S cannot 
establish the endpoints of its customers' telephone calls, even under 
the reasonable method rule of paragraph (h)(3) of this section.
    (ii) Analysis. S derives communications income as defined in 
paragraph (h)(2) of this section because S makes capacity to transmit 
communications available to its customers. In this case, S cannot 
establish the two points between which the communications are 
transmitted. Therefore, S's communications income is U.S. source income, 
as provided by paragraph (f) of this section.
    Example 9. Reasonable methods--minutes of use data on long distance 
calling plans. (i)Facts. B provides both domestic and international long 
distance services in a calling plan for a limited number of minutes for 
a set amount each month. Tracing and identifying the endpoints of each 
transmission is not possible or practical. B is, however, able to 
establish that the calling plan generated $10,000 of revenue for 25,000 
minutes based on reports derived from customer billing records. Based on 
minutes of use data in these reports, B is able to establish that of the 
total 25,000 minutes, 60 percent or 15,000 minutes were for U.S. long 
distance calls and 40 percent or 10,000 minutes were for international 
calls.
    (ii) Analysis. B derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, B can establish the two points between which B is paid to 
transmit, and bears the risk of transmitting, the communications using a 
reasonable method to establish the endpoints, assuming that this method 
is consistently applied. In this case, B can reasonably establish that 
60 percent of the income derived from the long distance calling plan is 
U.S. communications income and 40 percent is international 
communications income based on the minutes of use data derived from 
customer billing records to establish the endpoints of the 
communications. If, based on all the facts and circumstances, B could 
reasonably trace and identify the endpoints, then B would have to 
directly identify the endpoints between which B is paid to transmit the 
communications.
    Example 10. Reasonable methods--system design. (i) Facts. D operates 
satellites which are designed to transmit signals through two separate 
ranges of signal frequencies (bands). Due to technological limitations, 
requirements, and practicalities, one band is designed to only transmit 
signals within the United States. The other band is designed to transmit 
signals between foreign countries and the United States. D cannot trace 
and identify the endpoints of each individual transmission. D does, 
however, track the total transmission through each band and the total 
income derived from transmitting signals through each band.
    (ii) Analysis. D derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, D can establish the two points between which D is paid to 
transmit, and bears the risk of transmitting, the communications using a 
reasonable method to establish endpoints, assuming that this method is 
consistently applied. In this case, D can reasonably establish that 
income derived from transmissions through the first band is U.S. 
communications income and income derived from transmissions through the 
second band is international communications income based on the design 
of the bands to establish the endpoints of the communications.
    Example 11. Reasonable methods--port locations. (i) Facts. X 
provides its customer, C, with a virtual private network (VPN) so that 
C's U.S. headquarter office can connect

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and communicate with offices in the United States, Country X, Country Y, 
and Country Z. Assume that the VPN is only for communications with the 
U.S. headquarter office. X cannot trace and identify the endpoints of 
each transmission. C pays X a set amount each month for the entire 
service, regardless of the magnitude of the usage or the geographic 
points between which C uses the service.
    (ii) Analysis. X derives communications income as defined in 
paragraph (h)(2) of this section. Based on the facts and circumstances, 
X can establish the two points between which X is paid to transmit, and 
bears the risk of transmitting, the communications using a reasonable 
method to establish endpoints, assuming that this method is consistently 
applied. In this case, X can reasonably establish that one-fourth of the 
income derived from the VPN service is U.S. communications income and 
three-fourths is international communications income based on the 
location of the VPN ports to establish the endpoints of the 
communications.
    Example 12. Indeterminate endpoints--Internet access. (i) Facts. B, 
a domestic corporation, is an Internet service provider. B charges its 
customer, C, a monthly lump sum for Internet access. C accesses the 
Internet via a telephone call, initiated by the modem of C's personal 
computer, to one of B's control centers, which serves as C's portal to 
the Internet. B transmits data sent by C from B's control center in 
France to a recipient in England, over the Internet. B does not maintain 
records as to the beginning and endpoints of the transmission.
    (ii) Analysis. B derives communications income as defined in 
paragraph (h)(2) of this section. The source of B's communications 
income is determined under paragraph (f) of this section as income from 
sources within the United States because B cannot establish the two 
points between which it is paid to transmit the communications.
    Example 13. De minimis non-communications activity. (i) Facts. The 
same facts as in Example 12.
    Assume in addition that B replicates frequently requested sites on 
B's own servers, solely to speed up response time. Assume that B's 
replication of frequently requested sites would be considered a de 
minimis non-communications activity under this section.
    (ii) Analysis. On these facts, because B's replication of frequently 
requested sites would be considered a de minimis non-communications 
activity, B is not required to treat the replication activity as a 
separate non-communications activity transaction under paragraph (h)(1) 
of this section. B derives communications income under paragraph (h)(2) 
of this section. The character and source of B's communications income 
are determined by demonstrating the points between which B is paid to 
transmit the communications, under paragraph (h)(3)(i) of this section.
    Example 14. Income derived from communications and non-
communications activity--bundled services. (i) Facts. A, a domestic 
corporation, offers customers local and long distance phone service, 
video, and Internet services. Customers pay a flat monthly fee plus 10 
cents a minute for all long-distance calls, including international 
calls.
    (ii) Analysis. Under paragraph (h)(1)(ii) of this section, to the 
extent that A's transaction with its customer consists in part of non-de 
minimis communications activity and in part of non-de minimis non-
communications activity, each such part of the transaction must be 
treated as a separate transaction. A's gross income from the transaction 
is allocated to each such communications activity transaction and non-
communications activity transaction in accordance with paragraph 
(h)(1)(ii) of this section. To the extent A can establish that it 
derives international communications income as defined in paragraph 
(h)(3)(ii) of this section, A would determine the source of such income 
under paragraph (b)(1) of this section. If A cannot establish the points 
between which it is paid to transmit communications, as required by 
paragraph (h)(3)(i) of this section, A's communications income is from 
sources within the United States, as provided by paragraph (f) of this 
section.
    Example 15. Income derived from communications and non-
communications activity. (i) Facts. B, a domestic corporation, is paid 
by D, a cable system operator in Foreign Country, to provide television 
programs and to transmit the television programs to Foreign Country. 
Using its own satellite transponder, B transmits the television programs 
from the United States to downlink facilities owned by D in Foreign 
Country. D receives the transmission, unscrambles the signals, and 
distributes the broadcast to D's customers in Foreign Country. Assume 
that B's provision of television programs is a non-de minimis non-
communications activity, and that B's transmission of television 
programs is a non-de minimis communications activity.
    (ii) Analysis. Under paragraph (h)(1)(ii) of this section, B must 
treat its communications and non-communications activities as separate 
transactions. B's gross income is allocated to each such separate 
communications and non-communications activity transaction in accordance 
with paragraph (h)(1)(ii) of this section. Income derived by B from the 
transmission of television programs to D's Foreign Country downlink 
facility is international communications income as defined in paragraph 
(h)(3)(ii) of this section because B is paid to transmit communications 
from the United States to a foreign country.

[[Page 345]]

    Example 16. Income derived from foreign communications activity. (i) 
Facts. STS provides satellite capacity to B, a broadcaster located in 
Australia. B beams programming from Australia to the satellite. S's 
satellite picks the communications up in space and beams the programming 
over a footprint covering Southeast Asia.
    (ii) Analysis. S derives communications income as defined in 
paragraph (h)(2) of this section. S's income is characterized as foreign 
communications income under paragraph (h)(3)(iv) of this section because 
S picks up the communication in space, and beams it to a footprint 
entirely covering a foreign area. Under paragraph (d) of this section, 
S's foreign communications income is from sources without the United 
States. If S were beaming the programming over a satellite footprint 
that covered area both in the United States and outside the United 
States, S would be required to allocate the income derived from the 
different types of communications activity.

    (k) Reporting and documentation requirements--(1) In general. A 
taxpayer making an allocation of gross income under paragraph 
(b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section must satisfy the 
requirements in paragraphs (k)(2), (3), and (4) of this section.
    (2) Required documentation. In all cases, a taxpayer must prepare 
and maintain documentation in existence when its return is filed 
regarding the allocation of gross income, and allocation and 
apportionment of expenses, losses, and other deductions, the 
methodologies used, and the circumstances justifying use of those 
methodologies. The taxpayer must make available such documentation 
within 30 days upon request.
    (3) Access to software. If the taxpayer or any third party used any 
computer software, within the meaning of section 7612(d), to allocate 
gross income, or to allocate or apportion expenses, losses, and other 
deductions, the taxpayer must make available upon request--
    (i) Any computer software executable code, within the meaning of 
section 7612(d), used for such purposes, including an executable copy of 
the version of the software used in the preparation of the taxpayer's 
return (including any plug-ins, supplements, etc.) and a copy of all 
related electronic data files. Thus, if software subsequently is 
upgraded or supplemented, a separate executable copy of the version used 
in preparing the taxpayer's return must be retained;
    (ii) Any related computer software source code, within the meaning 
of section 7612(d), acquired or developed by the taxpayer or a related 
person, or primarily for internal use by the taxpayer or such person 
rather than for commercial distribution; and
    (iii) In the case of any spreadsheet software or similar software, 
any formulae or links to supporting worksheets.
    (4) Use of allocation methodology. In general, when a taxpayer 
allocates gross income under paragraph (b)(2)(iii), (b)(2)(iv), or 
(h)(1)(ii) of this section, it does so by making the allocation on a 
timely filed original return (including extensions). However, a taxpayer 
will be permitted to make changes to such allocations made on its 
original return with respect to any taxable year for which the statute 
of limitations has not closed as follows:
    (i) In the case of a taxpayer that has made a change to such 
allocations prior to the opening conference for the audit of the taxable 
year to which the allocation relates or who makes such a change within 
90 days of such opening conference, if the IRS issues a written 
information document request asking the taxpayer to provide the 
documents and such other information described in paragraphs (k)(2) and 
(3) of this section with respect to the changed allocations and the 
taxpayer complies with such request within 30 days of the request, then 
the IRS will complete its examination, if any, with respect to the 
allocations for that year as part of the current examination cycle. If 
the taxpayer does not provide the documents and information described in 
paragraphs (k)(2) and (3) of this section within 30 days of the request, 
then the procedures described in paragraph (k)(4)(ii) of this section 
shall apply.
    (ii) If the taxpayer changes such allocations more than 90 days 
after the opening conference for the audit of the taxable year to which 
the allocations relate or the taxpayer does not provide the documents 
and information with respect to the changed allocations as requested in 
accordance with paragraphs (k)(2) and (3) of this section,

[[Page 346]]

then the IRS will, in a separate cycle, determine whether an examination 
of the taxpayer's allocations is warranted and complete any such 
examination. The separate cycle will be worked as resources are 
available and may not have the same estimated completion date as the 
other issues under examination for the taxable year. The IRS may ask the 
taxpayer to extend the statute of limitations on assessment and 
collection for the taxable year to permit examination of the taxpayer's 
method of allocation, including an extension limited, where appropriate, 
to the taxpayer's method of allocation.
    (l) Applicability dates. Except as otherwise provided in this 
paragraph (l), this section applies to taxable years beginning on or 
after December 27, 2006. The provisions in paragraph (b)(2)(ii) of this 
section relating to the meaning of a CFC apply to taxable years of 
foreign corporations ending on or after October 1, 2019. For taxable 
years of foreign corporations ending before October 1, 2019, 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, 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 provisions with 
respect to all foreign corporations. For taxable years of foreign 
corporations ending before October 1, 2019, where the taxpayer does not 
apply the provisions of paragraph (b)(2)(ii) of this section relating to 
the meaning of a CFC, see paragraph (b)(2)(ii) of this section as in 
effect and contained in 26 CFR part 1, as revised April 1, 2020.

[T.D. 9305, 71 FR 77603, Dec. 27, 2006; 72 FR 3490, Jan. 25, 2007, as 
amended by T.D. 9908, 85 FR 59434, Sept. 22, 2020]



Sec.  1.863-10  Source of income from a qualified fails charge.

    (a) In general. Except as provided in paragraphs (b) and (c) of this 
section, the source of income from a qualified fails charge shall be 
determined by reference to the residence of the taxpayer as determined 
under section 988(a)(3)(B)(i).
    (b) Qualified business unit exception. The source of income from a 
qualified fails charge shall be determined by reference to the residence 
of a qualified business unit (as defined in section 989) of a taxpayer 
if--
    (1) The taxpayer's residence, determined under section 
988(a)(3)(B)(i), is the United States;
    (2) The qualified business unit's residence, determined under 
section 988(a)(3)(B)(ii), is outside the United States;
    (3) The qualified business unit is engaged in the conduct of a trade 
or business in the country where it is a resident; and
    (4) The transaction to which the qualified fails charge relates is 
attributable to the qualified business unit. A transaction will be 
treated as attributable to a qualified business unit if it satisfies the 
principles of Sec.  1.864-4(c)(5)(iii) (substituting ``qualified 
business unit'' for ``U.S. office'').
    (c) Effectively connected income exception. Qualified fails charge 
income that arises from a transaction any income from which is (or would 
be if the transaction produced income) effectively connected with a 
United States trade or business pursuant to Sec.  1.864-4(c) is treated 
as from sources within the United States, and the income from the 
qualified fails charge is treated as effectively connected to the 
conduct of a United States trade or business.
    (d) Qualified fails charge. For purposes of this section, a 
qualified fails charge is a payment that--
    (1) Compensates a party to a transaction that provides for delivery 
of a designated security (as defined in paragraph (e) of this section) 
in exchange for the payment of cash (delivery-versus-payment settlement) 
for another party's failure to deliver the specified designated security 
on the settlement date specified in the relevant agreement; and
    (2) Is made pursuant to--
    (i) A trading practice or similar guidance approved or adopted by 
either an agency of the United States government or the Treasury Market 
Practices Group, or
    (ii) Any trading practice, program, policy or procedure approved by 
the

[[Page 347]]

Commissioner in guidance published in the Internal Revenue Bulletin.
    (e) Designated security. For purposes of this section, a designated 
security means any--
    (i) Debt instrument (as defined in Sec.  1.1275-1(d)) issued by the 
United States Treasury Department, the Federal National Mortgage 
Association, the Federal Home Loan Mortgage Corporation, or any Federal 
Home Loan Bank; or
    (ii) Pass-through mortgage-backed security guaranteed by the Federal 
National Mortgage Association, the Federal Home Loan Mortgage 
Corporation, or the Government National Mortgage Association.
    (g) Effective/applicability date. This section is effective on 
February 21, 2012. This section applies to a qualified fails charge paid 
or accrued on or after December 8, 2010.

[T.D. 9579, 77 FR 9847, Feb. 21, 2012]



Sec.  1.864-1  Meaning of sale, etc.

    For purposes of Sec. Sec.  1.861 through 1.864-7, the word ``sale'' 
includes ``exchange''; the word ``sold'' includes ``exchanged''; the 
word ``produced'' includes ``created'', ``fabricated'', 
``manufactured'', ``extracted'', ``processed'', ``cured'', and ``aged''.

[T.D. 6948, 33 FR 5090, Mar. 28, 1968]



Sec.  1.864-2  Trade or business within the United States.

    (a) In general. As used in part I (section 861 and following) and 
part II (section 871 and following), subchapter N, chapter 1 of the 
Code, and chapter 3 (section 1441 and following) of the Code, and the 
regulations thereunder, the term ``engaged in trade or business within 
the United States'' does not include the activities described in 
paragraphs (c) and (d) of this section, but includes the performance of 
personal services within the United States at any time within the 
taxable year except to the extent otherwise provided in this section.
    (b) Performance of personal services for foreign employer--(1) 
Excepted services. For purposes of paragraph (a) of this section, the 
term ``engaged in trade or business within the United States'' does not 
include the performance of personal services--
    (i) For a nonresident alien individual, foreign partnership, or 
foreign corporation, not engaged in trade or business within the United 
States at any time during the taxable year, or
    (ii) For an office or place of business maintained in a foreign 
country or in a possession of the United States by an individual who is 
a citizen or resident of the United States or by a domestic partnership 
or a domestic corporation, by a nonresident alien individual who is 
temporarily present in the United States for a period or periods not 
exceeding a total of 90 days during the taxable year and whose 
compensation for such services does not exceed in the aggregate gross 
amount of $3,000.
    (2) Rules of application. (i) As a general rule, the term ``day'', 
as used in subparagraph (1) of this paragraph, means a calendar day 
during any portion of which the nonresident alien individual is 
physically present in the United States.
    (ii) Solely for purposes of applying this paragraph, the nonresident 
alien individual, foreign partnership, or foreign corporation for which 
the nonresident alien individual is performing personal services in the 
United States shall not be considered to be engaged in trade or business 
in the United States by reason of the performance of such services by 
such individual.
    (iii) In applying subparagraph (1) of this paragraph it is 
immaterial whether the services performed by the nonresident alien 
individual are performed as an employee for his employer or under any 
form of contract with the person for whom the services are performed.
    (iv) In determining for purposes of subparagraph (1) of this 
paragraph whether compensation received by the nonresident alien 
individual exceeds in the aggregate a gross amount of $3,000, any 
amounts received by the individual from an employer as advances or 
reimbursements for travel expenses incurred on behalf of the employer 
shall be omitted from the compensation received by the individual, to 
the extent of expenses incurred, where he was required to account and 
did account to his employer for such expenses and has

[[Page 348]]

met the tests for such accounting provided in Sec.  1.162-17 and 
paragraph (e)(4) of Sec.  1.274-5. If advances or reimbursements exceed 
such expenses, the amount of the excess shall be included as 
compensation for personal services for purposes of such subparagraph. 
Pensions and retirement pay attributable to personal services performed 
in the United States are not to be taken into account for purposes of 
subparagraph (1) of this paragraph.
    (v) See section 7701(a)(5) and Sec.  301.7701-5 of this chapter 
(Procedure and Administration Regulations) for the meaning of 
``foreign'' when applied to a corporation or partnership.
    (vi) As to the source of compensation for personal services, see 
Sec. Sec.  1.861-4 and 1.862-1.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. During 1967, A, a nonresident alien individual, is 
employed by the London office of a domestic partnership. A, who uses the 
calendar year as his taxable year, is temporarily present in the United 
States during 1967 for 60 days performing personal service in the United 
States for the London office of the partnership and is paid by that 
office a total gross salary of $2,600 for such services. During 1967, A 
is not engaged in trade or business in the United States solely by 
reason of his performing such personal services for the London office of 
the domestic partnership.
    Example 2. The facts are the same as in example 1, except that A's 
total gross salary for the services performed in the United States 
during 1967 amounts to $3,500, of which $2,625 is received in 1967 and 
$875 is received in 1968. During 1967, is engaged in trade or business 
in the United States by reason of his performance of personal services 
in the United States.

    (c) Trading in stocks or securities. For purposes of paragraph (a) 
of this section--
    (1) In general. The term ``engaged in trade or business within the 
United States'' does not include the effecting of transactions in the 
United States in stocks or securities through a resident broker, 
commission agent, custodian, or other independent agent. This 
subparagraph shall apply to any taxpayer, including a broker or dealer 
in stocks or securities, except that it shall not apply if at any time 
during the taxable year the taxpayer has an office or other fixed place 
of business in the United States through which, or by the direction of 
which, the transactions in stocks or securities are effected. The volume 
of stock or security transactions effected during the taxable year shall 
not be taken into account in determining under this subparagraph whether 
the taxpayer is engaged in trade or business within the United States.
    (2) Trading for taxpayer's own account--(i) In general. The term 
``engaged in trade or business within the United States'' does not 
include the effecting of transactions in the United States in stocks or 
securities for the taxpayer's own account, irrespective of whether such 
transactions are effected by or through--
    (a) The taxpayer himself while present in the United States,
    (b) Employees of the taxpayer, whether or not such employees are 
present in the United States while effecting the transactions, or
    (c) A broker, commission agent, custodian, or other agent of the 
taxpayer, whether or not such agent while effecting the transactions is 
(1) dependent or independent, or (2) resident, nonresident, or present, 
in the United States, and irrespective of whether any such employee or 
agent has discretionary authority to make decisions in effecting such 
transactions. For purposes of this paragraph, the term ``securities'' 
means any note, bond, debenture, or other evidence of indebtedness, or 
any evidence of an interest in or right to subscribe to or purchase any 
of the foregoing; and the effecting of transactions in stocks or 
securities includes buying, selling (whether or not by entering into 
short sales), or trading in stocks, securities, or contracts or options 
to buy or sell stocks or securities, on margin or otherwise, for the 
account and risk of the taxpayer, and any other activity closely related 
thereto (such as obtaining credit for the purpose of effectuating such 
buying, selling, or trading). The volume of stock of security 
transactions effected during the taxable year shall not be taken into 
account in determining under this subparagraph whether the

[[Page 349]]

taxpayer is engaged in trade or business within the United States. The 
application of this subdivision may be illustrated by the following 
example:

    Example. A, a nonresident alien individual who is not a dealer in 
stocks or securities, authorizes B, an individual resident of the United 
States, as his agent to effect transactions in the United States in 
stocks and securities for the account of A. B is empowered with complete 
authority to trade in stocks and securities for the account of A and to 
use his own discretion as to when to buy or sell for A's account. This 
grant of discretionary authority from A to B is also communicated in 
writing by A to various domestic brokerage firms through which A 
ordinarily effects transactions in the United States in stocks or 
securities. Under the agency arrangement B has the authority to place 
orders with the brokers, and all confirmations are to be made by the 
brokers to B, subject to his approval. The brokers are authorized by A 
to make payments to B and to charge such payments to the account of A. 
In addition, B is authorized to obtain and advance the necessary funds, 
if any, to maintain credits with the brokerage firms. Pursuant to his 
authority B carries on extensive trading transactions in the United 
States during the taxable year through the various brokerage firms for 
the account of A. During the taxable year A makes several visits to the 
United States in order to discuss with B various aspects of his trading 
activities and to make necessary changes in his trading policy. A is not 
engaged in trade or business within the United States during the taxable 
year solely because of the effecting by B of transactions in the United 
States in stocks or securities during such year for the account of A.

    (ii) Partnerships. A nonresident alien individual, foreign 
partnership, foreign estate, foreign trust, or foreign corporation shall 
not be considered to be engaged in trade or business within the United 
States solely because such person is a member of a partnership (whether 
domestic or foreign) which, pursuant to discretionary authority granted 
to such partnership by such person, effects transactions in the United 
States in stocks or securities for the partnership's own account or 
solely because an employee of such partnership, or a broker, commission 
agent, custodian, or other agent, pursuant to discretionary authority 
granted by such partnership, effects transactions in the United States 
in stocks or securities for the account of such partnership. This 
subdivision shall not apply, however, to any member of (a) a partnership 
which is a dealer in stocks or securities or (b) a partnership (other 
than a partnership in which, at any time during the last half of its 
taxable year, more than 50 percent of either the capital interest or the 
profits interest is owned, directly or indirectly, by five or fewer 
partners who are individuals) the principal business of which is trading 
in stocks or securities for its own account, if the principal office of 
such partnership is in the United States at any time during the taxable 
year. The principles of subdivision (iii) of this subparagraph for 
determining whether a foreign corporation has its principal office in 
the United States shall apply in determining under this subdivision 
whether a partnership has its principal office in the United States. See 
section 707(b)(3) and paragraph (b)(3) of Sec.  1.707-1 for rules for 
determining the extent of the ownership by a partner of a capital 
interest or profits interest in a partnership. The application of this 
subdivision may be illustrated by the following examples:

    Example 1. B, a nonresident alien individual, is a member of 
partnership X, the members of which are U.S. citizens, nonresident alien 
individuals, and foreign corporations. The principal business of 
partnership X is trading in stocks or securities for its own account. 
Pursuant to discretionary authority granted by B, partnership X effects 
transactions in the United States in stocks or securities for its own 
account. Partnership X is not a dealer in stocks or securities, and more 
than 50 percent of either the capital interest or the profits interest 
in partnership X is owned throughout its taxable year by five or fewer 
partners who are individuals. B is not engaged in trade or business 
within the United States solely by reason of such effecting of 
transactions in the United States in stocks or securities by partnership 
X for its own account.
    Example 2. The facts are the same as in example 1, except that not 
more than 50 percent of either the capital interest or the profits 
interest in partnership X is owned throughout the taxable year by five 
or fewer partners who are individuals. However, partnership X does not 
maintain its principal office in the United States at any time during 
the taxable year. B is not engaged in trade or business within the 
United States solely by reason of the trading in stocks or securities by 
partnership X for its own account.

[[Page 350]]

    Example 3. The facts are the same as in example 1, except that, 
pursuant to discretionary authority granted by partnership X, domestic 
broker D effects transactions in the United States in stocks or 
securities for the account of partnership X. B is not engaged in trade 
or business in the United States solely by reason of such trading in 
stocks or securities for the account of partnership X.

    (iii) Dealers in stocks or securities and certain foreign 
corporations. This subparagraph shall not apply to the effecting of 
transactions in the United States for the account of (a) a dealer in 
stocks or securities or (b) a foreign corporation (other than a 
corporation which is, or but for section 542(c)(7) or 543(b)(1)(C) would 
be, a personal holding company) the principal business of which is 
trading in stocks or securities for its own account, if the principal 
office of such corporation is in the United States at any time during 
the taxable year. Whether a foreign corporation's principal office is in 
the United States for this purpose is to be determined by comparing the 
activities (other than trading in stocks or securities) which the 
corporation conducts from its office or other fixed place of business 
located in the United States with the activities it conducts from its 
offices or other fixed places of business located outside the United 
States. For purposes of this subdivision, a foreign corporation is 
considered to have only one principal office, and an office of such 
corporation will not be considered to be its principal office merely 
because it is a statutory office of such corporation. For example, a 
foreign corporation which carries on most or all of its investment 
activities in the United States but maintains a general business office 
or offices outside the United States in which its management is located 
will not be considered as having its principal office in the United 
States if all or a substantial portion of the following functions is 
carried on at or from an office or offices located outside the United 
States:
    (1) Communicating with its shareholders (including the furnishing of 
financial reports),
    (2) Communicating with the general public,
    (3) Soliciting sales of its own stock,
    (4) Accepting the subscriptions of new stockholders,
    (5) Maintaining its principal corporate records and books of 
account,
    (6) Auditing its books of account,
    (7) Disbursing payments of dividends, legal fees, accounting fees, 
and officers' and directors' salaries,
    (8) Publishing or furnishing the offering and redemption price of 
the shares of stock issued by it,
    (9) Conducting meetings of its shareholders and board of directors, 
and
    (10) Making redemptions of its own stock.

The application of this subdivision may be illustrated by the following 
examples:

    Example 1. (a) Foreign corporation X (not a corporation which is, or 
but for section 542(c)(7) or 543(b)(1)(C) would be, a personal holding 
company) was organized to sell its shares to nonresident alien 
individuals and foreign corporations and to invest the proceeds from the 
sale of such shares in stocks or securities in the United States. 
Foreign corporation X is engaged primarily in the business of investing, 
reinvesting, and trading in stocks or securities for its own account.
    (b) For a period of three years, foreign corporation X irrevocably 
authorizes domestic corporation Y to exercise its discretion in 
effecting transactions in the United States in stocks or securities for 
the account and risk of foreign corporation X. Foreign corporation X 
issues a prospectus in which it is stated that its funds will be 
invested pursuant to an investment advisory contract with domestic 
corporation Y and otherwise advertises its services. Shares of foreign 
corporation X are sold to nonresident aliens and foreign corporations 
who are customers of the United States brokerage firms unrelated to 
domestic corporation Y or foreign corporation X. The principal functions 
performed for foreign corporation X by domestic corporation Y are the 
rendering of investment advice and the effecting of transactions in the 
United States in stocks or securities for the account of foreign 
corporation X. Moreover, domestic corporation Y occasionally 
communicates with prospective foreign investors in foreign corporation X 
(through speaking engagements abroad by management of domestic 
corporation Y, and otherwise) for the purpose of explaining the 
investment techniques and policies used by domestic corporation Y in 
investing the funds of foreign corporation X. However, domestic 
corporation Y does not participate in the day-to-day conduct of other 
business activities of foreign corporation X.
    (c) Foreign corporation X maintains a general business office or 
offices outside the United States in which its management is

[[Page 351]]

permanently located and from which it carries on, except to the extent 
noted heretofore, the functions enumerated in (b)(1) through (10) of 
this subdivision. The management of foreign corporation X at all times 
retains the independent power to cancel the investment advisory contract 
with domestic corporation Y subject to the contractual limitations 
contained therein and is in all other respects independent of the 
management of domestic corporation Y. The managing personnel of foreign 
corporation X communicate on a regular basis with domestic corporation 
Y, and periodically visit the offices of domestic corporation Y, in 
connection with the business activities of foreign corporation X.
    (d) The principal office of foreign corporation X will not be 
considered to be in the United States; and, therefore, foreign 
corporation X is not engaged in trade or business within the United 
States solely by reason of its relationship with domestic corporation Y.
    Example 2. The facts are the same as in example 1 except that, in 
lieu of having the investment advisory contract with domestic 
corporation Y, foreign corporation X has an office in the United States 
in which its employees perform the same functions as are performed by 
domestic corporation Y in example 1. Foreign corporation X is not 
engaged in trade or business within the United States during the taxable 
year solely because the employees located in its United States office 
effect transactions in the United States in stocks or securities for the 
account of that corporation.

    (iv) Definition of dealer in stocks or securities--(a) In general. 
For purposes of this subparagraph, a dealer in stocks or securities is a 
merchant of stocks or securities, with an established place of business, 
regularly engaged as a merchant in purchasing stocks or securities and 
selling them to customers with a view to the gains and profits that may 
be derived therefrom. Persons who buy and sell, or hold, stocks or 
securities for investment or speculation, irrespective of whether such 
buying or selling constitutes the carrying on of a trade or business, 
and officers of corporations, members of partnerships, or fiduciaries, 
who in their individual capacities buy and sell, or hold, stocks or 
securities for investment or speculation are not dealers in stocks or 
securities within the meaning of this subparagraph solely by reason of 
that activity. In determining under this subdivision whether a person is 
a dealer in stocks or securities such person's transactions in stocks or 
securities effected both in and outside the United States shall be taken 
into account.
    (b) Underwriting syndicates and dealers trading for others. A 
foreign person who otherwise may be considered a dealer in stocks or 
securities under (a) of this subdivision shall not be considered a 
dealer in stocks or securities for purposes of this subparagraph--
    (1) Solely because he acts as an underwriter, or as a selling group 
member, for the purpose of making a distribution of stocks or securities 
of a domestic issuer to foreign purchasers of such stocks or securities, 
irrespective of whether other members of the selling group distribute 
the stocks or securities of the domestic issuer to domestic purchasers, 
or
    (2) Solely because of transactions effected in the United States in 
stocks or securities pursuant to his grant of discretionary authority to 
make decisions in effecting those transactions, if he can demonstrate to 
the satisfaction of the Commissioner that the broker, commission agent, 
custodian, or other agent through whom the transactions were effected 
acted pursuant to his written representation that the funds in respect 
of which such discretion was granted were the funds of a customer who is 
neither a dealer in stocks or securities, a partnership described in 
subdivision (ii)(b) of this subparagraph, or a foreign corporation 
described in subdivision (iii)(b) of this subparagraph.


For purposes of this (b), a foreign person includes a nonresident alien 
individual, a foreign corporation, or a partnership any member of which 
is a nonresident alien individual or a foreign corporation. This (b) 
shall apply only if the foreign person at no time during the taxable 
year has an office or other fixed place of business in the United States 
through which, or by the direction of which, the transactions in stocks 
or securities are effected.
    (c) Illustrations. The application of this subdivision may be 
illustrated by the following examples:

    Example 1. Foreign corporation X is a member of an underwriting 
syndicate organized to distribute stock issued by domestic corporation 
Y. Foreign corporation X distributes the stock of domestic corporation Y 
to

[[Page 352]]

foreign purchasers only. Domestic corporation M is syndicate manager of 
the underwriting syndicate and, pursuant to the terms of the 
underwriting agreement, reserves the right to sell certain quantities of 
the underwritten stock on behalf of all the members of the syndicate so 
as to engage in stabilizing transactions and to take certain other 
actions which may result in the realization of profit by all members of 
the underwriting syndicate. Foreign corporation X is not engaged in 
trade or business within the United States solely by reason of its 
participation as a member of such underwriting syndicate for the purpose 
of distributing the stock of domestic corporation Y to foreign 
purchasers or by reason of the exercise by M corporation of its 
discretionary authority as manager of such syndicate.
    Example 2. Foreign corporation Y, a calendar year taxpayer, is a 
bank which trades in stocks or securities both for its own account and 
for the account of others. During 1967 foreign corporation Y authorizes 
domestic corporation M, a broker, to exercise its discretion in 
effecting transactions in the United States in stocks or securities for 
the account of B, a nonresident alien individual who has a trading 
account with foreign corporation Y. Foreign corporation Y furnishes a 
written representation to domestic corporation M to the effect that the 
funds in respect of which foreign corporation Y has authorized domestic 
corporation M to use its discretion in trading in the United States in 
stocks or securities are not funds in respect of which foreign 
corporation Y is trading for its own account but are the funds of one of 
its customers who is neither a dealer in stocks or securities, a 
partnership described in subdivision (ii)(b) of this subparagraph, or a 
foreign corporation described in subdivision (iii)(b) of this 
subparagraph. Pursuant to the discretionary authority so granted, 
domestic corporation M effects transactions in the United States during 
1967 in stocks or securities for the account of the customer of foreign 
corporation Y. At no time during 1967 does foreign corporation Y have an 
office or other fixed place of business in the United States through 
which, or by the direction of which, such transactions in stocks or 
securities are effected by domestic corporation M. During 1967 foreign 
corporation Y is not engaged in trade or business within the United 
States solely by reason of such trading in stocks or securities during 
such year by domestic corporation M for the account of the customer of 
foreign corporation Y. Copies of the written representations furnished 
to domestic corporation M should be retained by foreign corporation Y 
for inspection by the Commissioner, if inspection is requested.

    (d) Trading in commodities. For purposes of paragraph (a) of this 
section--
    (1) In general. The term ``engaged in trade or business within the 
United States'' does not include the effecting of transactions in the 
United States in commodities (including hedging transactions) through a 
resident broker, commission agent, custodian, or other independent agent 
if (i) the commodities are of a kind customarily dealt in on an 
organized commodity exchange, such as a grain futures or a cotton 
futures market, (ii) the transaction is of a kind customarily 
consummated at such place, and (iii) the taxpayer at no time during the 
taxable year has an office or other fixed place of business in the 
United States through which, or by the direction of which, the 
transactions in commodities are effected. The volume of commodity 
transactions effected during the taxable year shall not be taken into 
account in determining under this subparagraph whether the taxpayer is 
engaged in trade or business in the United States.
    (2) Trading for taxpayer's own account--(i) In general. The term 
``engaged in trade or business within the United States'' does not 
include the effecting of transactions in the United States in 
commodities (including hedging transactions) for the taxpayer's own 
account if the commodities are of a kind customarily dealt in on an 
organized commodity exchange and if the transaction is of a kind 
customarily consummated at such place. This rule shall apply 
irrespective of whether such transactions are effected by or through--
    (a) The taxpayer himself while present in the United States,
    (b) Employees of the taxpayer, whether or not such employees are 
present in the United States while effecting the transactions, or
    (c) A broker, commission, agent, custodian, or other agent of the 
taxpayer, whether or not such agent while effecting the transactions is 
(1) dependent or independent, or (2) resident, nonresident, or present, 
in the United States, and irrespective of whether any such employee or 
agent has discretionary authority to make decisions in effecting such 
transactions. The volume of commodity transactions effected during the 
taxable year shall not be taken into account in determining

[[Page 353]]

under this subparagraph whether the taxpayer is engaged in trade or 
business within the United States. This subparagraph shall not apply to 
the effecting of transactions in the United States for the account of a 
dealer in commodities.
    (ii) Partnerships. A nonresident alien individual, foreign 
partnership, foreign estate, foreign trust, or foreign corporation shall 
not be considered to be engaged in trade or business within the United 
States solely because such person is a member of a partnership (whether 
domestic or foreign) which, pursuant to discretionary authority granted 
to such partnership by such person, effects transactions in the United 
States in commodities for the partnership's account or solely because an 
employee of such partnership, or a broker, commission agent, custodian, 
or other agent, pursuant to discretionary authority granted by such 
partnership, effects transactions in the United States in commodities 
for the account of such partnership. This subdivision shall not apply to 
any member of a partnership which is a dealer in commodities.
    (iii) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. Foreign corporation X, a calendar year taxpayer, is engaged 
as a merchant in the business of purchasing grain in South America and 
selling such cash grain outside the United States under long-term 
contracts for delivery in foreign countries. Foreign corporation X 
consummates a sale of 100,000 bushels of cash grain in February 1967 for 
July delivery to Sweden. Because foreign corporation X does not actually 
own such grain at the time of the sales transaction, such corporation 
buys as a hedge a July ``futures contract'' for delivery of 100,000 
bushels of grain, in order to protect itself from loss by reason of a 
possible rise in the price of grain between February and July. The 
``futures contract'' is ordered through domestic corporation Y, a 
futures commission merchant registered under the Commodity Exchange Act. 
Foreign corporation X is not engaged in trade or business within the 
United States during 1967 solely by reason of its effecting of such 
futures contract for its own account through domestic corporation Y.

    (3) Definition of commodity. For purposes of section 864(b)(2)(B) 
and this paragraph the term ``commodities'' does not include goods or 
merchandise in the ordinary channels of commerce.
    (e) Other rules. The fact that a person is not determined by reason 
of this section to be not engaged in trade or business with the United 
States is not to be considered a determination that such person is 
engaged in trade or business within the United States. Whether or not 
such person is engaged in trade or business within the United States 
shall be determined on the basis of the facts and circumstances in each 
case. For other rules relating to the determination of whether a 
taxpayer is engaged in trade or business in the United States see 
section 875 and the regulations thereunder.
    (f) Effective date. The provisions of this section shall apply only 
in the case of taxable years beginning after December 31, 1966.

[T.D. 6948, 33 FR 5090, Mar. 28, 1968, as amended by T.D. 7378, 40 FR 
45435, Oct. 2, 1975]



Sec.  1.864-3  Rules for determining income effectively connected with 
U.S. business of nonresident aliens or foreign corporations.

    (a) In general. For purposes of the Internal Revenue Code, in the 
case of a nonresident alien individual or a foreign corporation that is 
engaged in a trade or business in the United States at any time during 
the taxable year, the rules set forth in Sec. Sec.  1.864-4 through 
1.864-7 and this section shall apply in determining whether income, 
gain, or loss shall be treated as effectively connected for a taxable 
year beginning after December 31, 1966, with the conduct of a trade or 
business in the United States. Except as provided in sections 871 (c) 
and (d) and 882 (d) and (e), and the regulations thereunder, in the case 
of a nonresident alien individual or a foreign corporation that is at no 
time during the taxable year engaged in a trade or business in the 
United States, no income, gain, or loss shall be treated as effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States. The general rule prescribed by the preceding 
sentence shall apply even though the income, gain, or loss would have 
been treated as effectively connected with the conduct of a trade or 
business in the United States

[[Page 354]]

if such income or gain had been received or accrued, or such loss had 
been sustained, in an earlier taxable year when the taxpayer was engaged 
in a trade or business in the United States. In applying Sec. Sec.  
1.864-4 through 1.864-7 and this section, the determination whether an 
item of income, gain, or loss is effectively connected with the conduct 
of a trade or business in the United States shall not be controlled by 
any administrative, judicial, or other interpretation made under the 
laws of any foreign country.
    (b) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. During 1967 foreign corporation N, which uses the 
calendar year as the taxable year, is engaged in the business of 
purchasing and selling household equipment on the installment plan. 
During 1967 N is engaged in business in the United States by reason of 
the sales activities it carries on in the United States for the purpose 
of selling therein some of the equipment which it has purchased. During 
1967 N receives installment payments of $800,000 on sales it makes that 
year in the United States, and the income from sources within the United 
States for 1967 attributable to such payments is $200,000. By reason of 
section 864(c)(3) and paragraph (b) of Sec.  1.864-4 this income of 
$200,000 is effectively connected for 1967 with the conduct of a trade 
or business in the United States by N. In December of 1967, N 
discontinues its efforts to make any further sales of household 
equipment in the United States, and at no time during 1968 is N engaged 
in a trade or business in the United States. During 1968 N receives 
installment payments of $500,000 on the sales it made in the United 
States during 1967, and the income from sources within the United States 
for 1968 attributable to such payments is $125,000. By reason of section 
864(c)(1)(B) and this section, this income of $125,000 is not 
effectively connected for 1968 with the conduct of a trade or business 
in the United States by N, even though such amount, if it had been 
received by N during 1967, would have been effectively connected for 
1967 with the conduct of a trade or business in the United States by 
that corporation.
    Example 2. R, a foreign holding company, owns all of the voting 
stock in five corporations, two of which are domestic corporations. All 
of the subsidiary corporations are engaged in the active conduct of a 
trade or business. R has an office in the United States where its chief 
executive officer, who is also the chief executive officer of one of the 
domestic corporations, spends a substantial portion of the taxable year 
supervising R's investment in its operating subsidiaries and performing 
his function as chief executive officer of the domestic operating 
subsidiary. R is not considered to be engaged in a trade or business in 
the United States during the taxable year by reason of the activities 
carried on in the United States by its chief executive officer in the 
supervision of its investment in its operating subsidiary corporations. 
Accordingly, the dividends from sources within the United States 
received by R during the taxable year from its domestic subsidiary 
corporations are not effectively connected for that year with the 
conduct of a trade or business in the United States by R.
    Example 3. During the months of June through December 1971, B, a 
nonresident alien individual who uses the calendar year as the taxable 
year and the cash receipts and disbursements method of accounting, is 
employed in the United States by domestic corporation M for a salary of 
$2,000 per month, payable semimonthly. During 1971, B receives from M 
salary payments totaling $13,000, all of which income by reason of 
section 864(c)(2) and paragraph (c)(6)(ii) of Sec.  1.864-4, is 
effectively connected for 1971 with the conduct of a trade or business 
in the United States by B. On December 31, 1971, B terminates his 
employment with M and departs from the United States. At no time during 
1972 is B engaged in a trade or business in the United States. In 
January of 1972, B receives from M salary of $1,000 for the last half of 
December 1971, and a bonus of $1,000 in consideration of the services B 
performed in the United States during 1971 for that corporation. By 
reason of section 864(c)(1)(B) and this section, the $2,000 received by 
B during 1972 from sources within the United States is not effectively 
connected for that year with the conduct of a trade or business in the 
United States, even though such amount, if it had been received by B 
during 1971, would have been effectively connected for 1971 with the 
conduct of a trade or business in the United States by B.

[T.D. 7216, 37 FR 23424, Nov. 3, 1972]



Sec.  1.864-4  U.S. source income effectively connected with U.S. business.

    (a) In general. This section applies only to a nonresident alien 
individual or a foreign corporation that is engaged in a trade or 
business in the United States at some time during a taxable year 
beginning after December 31, 1966, and to the income, gain, or loss of 
such person from sources within the United States. If the income, gain, 
or loss of such person for the taxable year from sources within the 
United States consists of (1) gain or loss from the sale

[[Page 355]]

or exchange of capital assets or (2) fixed or determinable annual or 
periodical gains, profits, and income or certain other gains described 
in section 871(a)(1) or 881(a), certain factors must be taken into 
account, as prescribed by section 864(c)(2) and paragraph (c) of this 
section, in order to determine whether the income, gain, or loss is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that person. All other income, gain, 
or loss of such person for the taxable year from sources within the 
United States shall be treated as effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that person, as prescribed by section 864(c)(3) and paragraph (b) of 
this section.
    (b) Income other than fixed or determinable income and capital 
gains. All income, gain, or loss for the taxable year derived by a 
nonresident alien individual or foreign corporation engaged in a trade 
or business in the United States from sources within the United States 
which does not consist of income, gain, or loss described in section 
871(a)(1) or 881(a), or of gain or loss from the sale or exchange of 
capital assets, shall, for purposes of paragraph (a) of this section, be 
treated as effectively connected for the taxable year with the conduct 
of a trade or business in the United States. This income, gain, or loss 
shall be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States, whether or not the 
income, gain, or loss is derived from the trade or business being 
carried on in the United States during the taxable year. The application 
of this paragraph may be illustrated by the following examples:

    Example 1. M, a foreign corporation which uses the calendar year as 
the taxable year, is engaged in the business of manufacturing machine 
tools in a foreign country. It establishes a branch office in the United 
States during 1968 which solicits orders from customers in the United 
States for the machine tools manufactured by that corporation. All 
negotiations with respect to such sales are carried on in the United 
States. By reason of its activity in the United States M is engaged in 
business in the United States during 1968. The income or loss from 
sources within the United States from such sales during 1968 is treated 
as effectively connected for that year with the conduct of a business in 
the United States by M. Occasionally, during 1968 the customers in the 
United States write directly to the home office of M, and the home 
office makes sales directly to such customers without routing the 
transactions through its branch office in the United States. The income 
or loss from sources within the United States for 1968 from these 
occasional direct sales by the home office is also treated as 
effectively connected for that year with the conduct of a business in 
the United States by M.
    Example 2. The facts are the same as in example 1 except that during 
1967 M was also engaged in the business of purchasing and selling office 
machines and that it used the installment method of accounting for the 
sales made in this separate business. During 1967 M was engaged in 
business in the United States by reason of the sales activities it 
carried on in the United States for the purpose of selling therein a 
number of the office machines which it had purchased. Although M 
discontinued this business activity in the United States in December of 
1967, it received in 1968 some installment payments on the sales which 
it had made in the United States during 1967. The income of M for 1968 
from sources within the United States which is attributable to such 
installment payments is effectively connected for 1968 with the conduct 
of a business in the United States, even though such income is not 
connected with the business carried on in the United States during 1968 
through its sales office located in the United States for the 
solicitation of orders for the machine tools it manufactures.
    Example 3. Foreign corporation S, which uses the calendar year as 
the taxable year, is engaged in the business of purchasing and selling 
electronic equipment. The home office of such corporation is also 
engaged in the business of purchasing and selling vintage wines. During 
1968, S establishes a branch office in the United States to sell 
electronic equipment to customers, some of whom are located in the 
United States and the balance, in foreign countries. This branch office 
is not equipped to sell, and does not participate in sales of, wine 
purchased by the home office. Negotiations for the sales of the 
electronic equipment take place in the United States. By reason of the 
activity of its branch office in the United States, S is engaged in 
business in the United States during 1968. As a result of advertisements 
which the home office of S places in periodicals sold in the United 
States, customers in the United States frequently place orders for the 
purchase of wines with the home office in the foreign country, and the 
home office makes sales of wine in 1968 directly to such customers 
without routing the transactions through its branch office in the United

[[Page 356]]

States. The income or loss from sources within the United States for 
1968 from sales of electronic equipment by the branch office, together 
with the income or loss from sources within the United States for that 
year from sales of wine by the home office, is treated as effectively 
connected for that year with the conduct of a business in the United 
States by S.

    (c) Fixed or determinable income and capital gains--(1) Principal 
factors to be taken into account--(i) In general. In determining for 
purposes of paragraph (a) of this section whether any income for the 
taxable year from sources within the United States which is described in 
section 871(a)(1) or 881(a), relating to fixed or determinable annual or 
periodical gains, profits, and income and certain other gains, or 
whether gain or loss from sources within the United States for the 
taxable year from the sale or exchange of capital assets, is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States, the principal tests to be applied are (a) the 
asset-use test, that is, whether the income, gain, or loss is derived 
from assets used in, or held for use in, the conduct of the trade or 
business in the United States, and (b) the business-activities test, 
that is, whether the activities of the trade or business conducted in 
the United States were a material factor in the realization of the 
income, gain, or loss.
    (ii) Special rule relating to interest on certain deposits. For 
purposes of determining under section 861(a)(1)(A) (relating to interest 
on deposits with banks, savings and loan associations, and insurance 
companies paid or credited before January 1, 1976) whether the interest 
described therein is effectively connected for the taxable year with the 
conduct of a trade or business in the United States, such interest shall 
be treated as income from sources within the United States for purposes 
of applying this paragraph and Sec.  1.864-5. If by reason of the 
application of this paragraph such interest is determined to be income 
which is not effectively connected for the taxable year with the conduct 
of a trade or business in the United States, it shall then be treated as 
interest from sources without the United States which is not subject to 
the application of Sec.  1.864-5.
    (2) Application of the asset-use test--(i) In general. For purposes 
of subparagraph (1) of this paragraph, the asset-use test ordinarily 
shall apply in making a determination with respect to income, gain, or 
loss of a passive type where the trade or business activities as such do 
not give rise directly to the realization of the income, gain, or loss. 
However, even in the case of such income, gain, or loss, any activities 
of the trade or business which materially contribute to the realization 
of such income, gain, or loss shall also be taken into account as a 
factor in determining whether the income, gain, or loss is effectively 
connected with the conduct of a trade or business in the United States. 
The asset-use test is of primary significance where, for example, 
interest income is derived from sources within the United States by a 
nonresident alien individual or foreign corporation that is engaged in 
the business of manufacturing or selling goods in the United States. See 
also subparagraph (5) of this paragraph for rules applicable to 
taxpayers conducting a banking, financing, or similar business in the 
United States.
    (ii) Cases where applicable. Ordinarily, an asset shall be treated 
as used in, or held for use in, the conduct of a trade or business in 
the United States if the asset is--
    (a) Held for the principal purpose of promoting the present conduct 
of the trade or business in the United States; or
    (b) Acquired and held in the ordinary course of the trade or 
business conducted in the United States, as, for example, in the case of 
an account or note receivable arising from that trade or business; or
    (c) Otherwise held in a direct relationship to the trade or business 
conducted in the United States, as determined under paragraph (c)(2)(iv) 
of this section.
    (iii) Application of asset-use test to stock--(a) In general. Except 
as provided in paragraph (c)(2)(iii)(b) of this section, stock of a 
corporation (whether domestic or foreign) shall not be treated as an 
asset used in, or held for use in, the conduct of a trade or business in 
the United States.

[[Page 357]]

    (b) Stock held by foreign insurance companies. This paragraph 
(c)(2)(iii) shall not apply to stock of a corporation (whether domestic 
or foreign) held by a foreign insurance company unless the foreign 
insurance company owns 10 percent or more of the total voting power or 
value of all classes of stock of such corporation. For purposes of this 
section, section 318(a) shall be applied in determining ownership, 
except that in applying section 318(a)(2)(C), the phrase ``10 percent'' 
is used instead of the phrase ``50 percent.''
    (iv) Direct relationship between holding of asset and trade or 
business--(a) In general. In determining whether an asset is held in a 
direct relationship to the trade or business conducted in the United 
States, principal consideration shall be given to whether the asset is 
needed in that trade or business. An asset shall be considered needed in 
a trade or business, for this purpose, only if the asset is held to meet 
the present needs of that trade or business and not its anticipated 
future needs. An asset shall be considered as needed in the trade or 
business conducted in the United States if, for example, the asset is 
held to meet the operating expenses of that trade or business. 
Conversely, an asset shall be considered as not needed in the trade or 
business conducted in the United States if, for example, the asset is 
held for the purpose of providing for (1) future diversification into a 
new trade or business, (2) expansion of trade or business activities 
conducted outside of the United States, (3) future plant replacement, or 
(4) future business contingencies.
    (b) Presumption of direct relationship. Generally, an asset will be 
treated as held in a direct relationship to the trade or business if (1) 
the asset was acquired with funds generated by that trade or business, 
(2) the income from the asset is retained or reinvested in that trade or 
business, and (3) personnel who are present in the United States and 
actively involved in the conduct of that trade or business exercise 
significant management and control over the investment of such asset.
    (v) Illustration. The application of paragraph (iv) may be 
illustrated by the following examples:

    Example 1. M, a foreign corporation which uses the calendar year as 
the taxable year, is engaged in industrial manufacturing in a foreign 
country. M maintains a branch in the United States which acts as 
importer and distributor of the merchandise it manufactures abroad; by 
reason of these branch activities. M is engaged in business in the 
United States during 1968. The branch in the United States is required 
to hold a large current cash balance for business purposes, but the 
amount of the cash balance so required varies because of the fluctuating 
seasonal nature of the branch's business. During 1968 at a time when 
large cash balances are not required the branch invests the surplus 
amount in U.S. Treasury bills. Since these Treasury bills are held to 
meet the present needs of the business conducted in the United States 
they are held in a direct relationship to that business, and the 
interest for 1968 on these bills is effectively connected for that year 
with the conduct of the business in the United States by M.
    Example 2. Foreign corporation M, which uses the calendar year as 
the taxable year, has a branch office in the United States where it 
sells to customers located in the United States various products which 
are manufactured by that corporation in a foreign country. By reason of 
this activity M is engaged in business in the United States during 1997. 
The U.S. branch establishes in 1997 a fund to which are periodically 
credited various amounts which are derived from the business carried on 
at such branch. The amounts in this fund are invested in various 
securities issued by domestic corporations by the managing officers of 
the U.S. branch, who have the responsibility for maintaining proper 
investment diversification and investment of the fund. During 1997, the 
branch office derives from sources within the United States interest on 
these securities, and gains and losses resulting from the sale or 
exchange of such securities. Since the securities were acquired with 
amounts generated by the business conducted in the United States, the 
interest is retained in that business, and the portfolio is managed by 
personnel actively involved in the conduct of that business, the 
securities are presumed under paragraph (c)(2)(iv)(b) of this section to 
be held in a direct relationship to that business. However, M is able to 
rebut this presumption by demonstrating that the fund was established to 
carry out a program of future expansion and not to meet the present 
needs of the business conducted in the United States. Consequently, the 
income, gains, and losses from the securities for 1997 are not 
effectively connected for that year with the conduct of a trade or 
business in the United States by M.


[[Page 358]]


    (3) Application of the business-activities test--(i) In general. For 
purposes of subparagraph (1) of this paragraph, the business-activities 
test shall ordinarily apply in making a determination with respect to 
income, gain, or loss which, even though generally of the passive type, 
arises directly from the active conduct of the taxpayer's trade or 
business in the United States. The business-activities test is of 
primary significance, for example, where (a) dividends or interest are 
derived by a dealer in stocks or securities, (b) gain or loss is derived 
from the sale or exchange of capital assets in the active conduct of a 
trade or business by an investment company, (c) royalties are derived in 
the active conduct of a business consisting of the licensing of patents 
or similar intangible property, or (d) service fees are derived in the 
active conduct of a servicing business. In applying the business-
activities test, activities relating to the management of investment 
portfolios shall not be treated as activities of the trade or business 
conducted in the United States unless the maintenance of the investments 
constitutes the principal activity of that trade or business. See also 
subparagraph (5) of this paragraph for rules applicable to taxpayers 
conducting a banking, financing, or similar business in the United 
States.
    (ii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation S is a foreign investment company 
organized for the purpose of investing in stocks and securities. S is 
not a personal holding company or a corporation which would be a 
personal holding company but for section 542(c)(7) or 543(b)(1)(C). Its 
investment portfolios consist of common stocks issued by both foreign 
and domestic corporations and a substantial amount of high grade bonds. 
The business activity of S consists of the management of its portfolios 
for the purpose of investing, reinvesting, or trading in stocks and 
securities. During the taxable year 1968, S has its principal office in 
the United States within the meaning of paragraph (c)(2)(iii) of Sec.  
1.864-2 and, by reason of its trading in the United States in stocks and 
securities, is engaged in business in the United States. The dividends 
and interest derived by S during 1968 from sources within the United 
States, and the gains and losses from sources within the United States 
for such year from the sale of stocks and securities from its investment 
portfolios, are effectively connected for 1968 with the conduct of the 
business in the United States by that corporation, since its activities 
in connection with the management of its investment portfolios are 
activities of that business and such activities are a material factor in 
the realization of such income, gains, and losses.
    Example 2. N, a foreign corporation which uses the calendar year as 
the taxable year, has a branch in the United States which acts as an 
importer and distributor of merchandise; by reason of the activities of 
that branch, N is engaged in business in the United States during 1968. 
N also carries on a business in which it licenses patents to unrelated 
persons in the United States for use in the United States. The 
businesses of the licensees in which these patents are used have no 
direct relationship to the business carried on in N's branch in the 
United States, although the merchandise marketed by the branch is 
similar in type to that manufactured under the patents. The negotiations 
and other activities leading up to the consummation of these licenses 
are conducted by employees of N who are not connected with the U.S. 
branch of that corporation, and the U.S. branch does not otherwise 
participate in arranging for the licenses. Royalties received by N 
during 1968 from these licenses are not effectively connected for that 
year with the conduct of its business in the United States because the 
activities of that business are not a material factor in the realization 
of such income.

    (4) Method of accounting as a factor. In applying the asset-use test 
or the business-activities test described in subparagraph (1) of this 
paragraph, due regard shall be given to whether or not the asset, or the 
income, gain, or loss, is accounted for through the trade or business 
conducted in the United States, that is, whether or not the asset, or 
the income, gain, or loss, is carried on books of account separately 
kept for that trade or business, but this accounting test shall not by 
itself be controlling. In applying this subparagraph, consideration 
shall be given to whether the accounting treatment of an item reflects 
the consistent application of generally accepted accounting principles 
in a particular trade or business in accordance with accepted conditions 
or practices in that trade or business and whether there is a consistent 
accounting treatment of that item from year to year by the taxpayer.

[[Page 359]]

    (5) Special rules relating to banking, financing, or similar 
business activity--(i) Definition of banking, financing, or similar 
business. A nonresident alien individual or a foreign corporation shall 
be considered for purposes of this section and paragraph (b)(2) of Sec.  
1.864-5 to be engaged in the active conduct of a banking, financing, or 
similar business in the United States if at some time during the taxable 
year the taxpayer is engaged in business in the United States and the 
activities of such business consist of any one or more of the following 
activities carried on, in whole or in part, in the United States in 
transactions with persons situated within or without the United States:
    (a) Receiving deposits of funds from the public,
    (b) Making personal, mortgage, industrial, or other loans to the 
public,
    (c) Purchasing, selling, discounting, or negotiating for the public 
on a regular basis, notes, drafts, checks, bills of exchange, 
acceptances, or other evidences of indebtedness,
    (d) Issuing letters of credit to the public and negotiating drafts 
drawn thereunder,
    (e) Providing trust services for the public, or
    (f) Financing foreign exchange transactions for the public.


Although the fact that the taxpayer is subjected to the banking and 
credit laws of a foreign country shall be taken into account in 
determining whether he is engaged in the active conduct of a banking, 
financing, or similar business, the character of the business actually 
carried on during the taxable year in the United States shall determine 
whether the taxpayer is actively conducting a banking, financing, or 
similar business in the United States. A foreign corporation which acts 
merely as a financing vehicle for borrowing funds for its parent 
corporation or any other person who would be a related person within the 
meaning of section 954(d)(3) if such foreign corporation were a 
controlled foreign corporation shall not be considered to be engaged in 
the active conduct of a banking, financing, or similar business in the 
United States.
    (ii) Effective connection of income from stocks or securities with 
active conduct of a banking, financing, or similar business. 
Notwithstanding the rules in subparagraphs (2) and (3) of this paragraph 
with respect to the asset-use test and the business-activities test, any 
dividends or interest from stocks or securities, or any gain or loss 
from the sale or exchange of stocks or securities which are capital 
assets, which is from sources within the United States and derived by a 
nonresident alien individual or a foreign corporation in the active 
conduct during the taxable year of a banking, financing, or similar 
business in the United States shall be treated as effectively connected 
for such year with the conduct of that business only if the stocks or 
securities giving rise to such income, gain, or loss are attributable to 
the U.S. office through which such business is carried on and--
    (a) Were acquired--
    (1) As a result of, or in the course of making loans to the public,
    (2) In the course of distributing such stocks or securities to the 
public, or
    (3) For the purpose of being used to satisfy the reserve 
requirements, or other requirements similar to reserve requirements, 
established by a duly constituted banking authority in the United 
States, or
    (b) Consist of securities (as defined in subdivision (v) of this 
subparagraph) which are--
    (1) Payable on demand or at a fixed maturity date not exceeding 1 
year from the date of acquisition,
    (2) Issued by the United States, or any agency or instrumentality 
thereof, or
    (3) Not described in (a) or in (1) or (2) of this (b).


However, the amount of interest from securities described in (b)(3) of 
this subdivision (ii) which shall be treated as effectively connected 
for the taxable year with the active conduct of a banking, financing, or 
similar business in the United States shall be an amount (but not in 
excess of the entire interest for the taxable year from sources within 
the United States from such securities) determined by multiplying the 
entire interest for the taxable year from sources within the United 
States from such securities by a fraction the numerator of which is 10 
percent and the

[[Page 360]]

denominator of which is the same percentage, determined on the basis of 
a monthly average for the taxable year, as the book value of the total 
of such securities held by the U.S. office through which such business 
is carried on bears to the book value of the total assets of such 
office. The amount of gain or loss, if any, for the taxable year from 
the sale or exchange of such securities which shall be treated as 
effectively connected for the taxable year with the active conduct of a 
banking, financing, or similar business in the United States shall be an 
amount (but not in excess of the entire gain or loss for the taxable 
year from sources within the United States from the sale or exchange of 
such securities) determined by multiplying the entire gain or loss for 
the taxable year from sources within the United States from the sale or 
exchange of such securities by the fraction described in the immediately 
preceding sentence. The percentage of the denominator of the limiting 
fraction for such purposes shall be the percentage obtained by 
separately adding the book value of such securities and such total 
assets held at the close of each month in the taxable year, dividing 
each such sum by 12, and then dividing the amount of securities so 
obtained by the amount of assets so obtained. This subdivision does not 
apply to dividends from stock owned by a foreign corporation in a 
domestic corporation of which more than 50 percent of the total combined 
voting power of all classes of stock entitled to vote is owned by such 
foreign corporation and which is engaged in the active conduct of a 
banking business in the United States. The application of this 
subdivision may be illustrated by the following example:

    Example. Foreign corporation M, created under the laws of foreign 
country Y, has in the United States a branch, B, which during the 
taxable year is engaged in the active conduct of the banking business in 
the United States within the meaning of subdivision (i) of this 
subparagraph. During the taxable year M derives from sources within the 
United States through the activities carried on through B, $7,500,000 
interest from securities described in subdivision (b)(3) of this 
subdivision (ii) and $7,500,000 gain from the sale or exchange of such 
securities. The monthly average, determined as of the last day of each 
month in the taxable year, of such securities held by B divided by the 
monthly average, as so determined, of the total assets held by B equals 
15 percent. Under this subdivision, the amount of interest income from 
such securities that shall be treated as effectively connected for the 
taxable year with the active conduct by M of a banking business in the 
United States is $5 million ($7,500,000 interest x 10% / 15%), and the 
amount of gain from the sale or exchange of such securities that shall 
be treated as effectively connected for such year with the active 
conduct of such business is $5 million ($7,500,000 gain x 10% / 15%).

    (iii) Stocks or securities attributable to U.S. office--(a) In 
general. For purposes of paragraph (c)(5)(ii) of this section, a stock 
or security shall be deemed to be attributable to a U.S. office only if 
such office actively and materially participated in soliciting, 
negotiating, or performing other activities required to arrange the 
acquisition of the stock or security. The U.S. office need not have been 
the only active participant in arranging the acquisition of the stock or 
security.
    (b) Exceptions. A stock or security shall not be deemed to be 
attributable to a U.S. office merely because such office conducts one or 
more of the following activities:
    (1) Collects or accounts for the dividends, interest, gain, or loss 
from such stock or security,
    (2) Exercises general supervision over the activities of the persons 
directly responsible for carrying on the activities described in 
paragraph (c)(5)(iii)(a) of this section,
    (3) Performs merely clerical functions incident to the acquisition 
of such stock or security,
    (4) Exercises final approval over the execution of the acquisition 
of such stock or security, or
    (5) Holds such stock or security in the United States or records 
such stock or security on its books or records as having been acquired 
by such office or for its account.
    (c) Effective date. This paragraph (c)(5)(iii) shall be effective 
for income includible in taxable years beginning on or after June 18, 
1984, except that 26 CFR 1.864-4 (c)(5)(iii) as it appeared in the Code 
of Federal Regulations revised as of April 1, 1983, shall apply to 
income received or accrued under a

[[Page 361]]

loan made by the taxpayer on or before May 18, 1984, or pursuant to a 
written binding commitment entered into on or before May 18, 1984.
    (iv) Acquisitions in course of making loans to the public. For 
purposes of subdivision (ii) of this subparagraph--
    (a) A stock or security shall be considered to have been acquired in 
the course of making a loan to the public where, for example, such stock 
or security was acquired as additional consideration for the making of 
the loan,
    (b) A stock or security shall be considered to have been acquired as 
a result of making a loan to the public if, for example, such stock or 
security was acquired by foreclosure upon a bona fide default of the 
loan and is held as an ordinary and necessary incident to the active 
conduct of the banking, financing, or similar business in the United 
States, and
    (c) A stock or security acquired on a stock exchange or organized 
over-the-counter market shall be considered not to have been acquired as 
a result of, or in the course of, making loans to the public.
    (v) Security defined. For purposes of this subparagraph, a security 
is any bill, note, bond, debenture, or other evidence of indebtedness, 
or any evidence of an interest in, or right to subscribe to or purchase, 
any of the foregoing items.
    (vi) Limitations on application of subparagraph--(a) Other business 
activity. This subparagraph provides rules for determining when certain 
income from stocks or securities is effectively connected with the 
active conduct of a banking, financing, or similar business in the 
United States. Any dividends, interest, gain, or loss from sources 
within the United States which by reason of the application of 
subdivision (ii) of this subparagraph is not effectively connected with 
the active conduct by a nonresident alien individual or a foreign 
corporation of a banking, financing, or similar business in the United 
States may be effectively connected for the taxable year, under 
subparagraph (2) or (3) of this paragraph with the conduct by such 
taxpayer of another trade or business in the United States, such as, for 
example, the business of selling or manufacturing goods or merchandise 
or of trading in stocks or securities for the taxpayer's own account.
    (b) Other income. For rules relating to income, gain, or loss from 
sources within the United States (other than dividends or interest from, 
or gain or loss from the sale or exchange of, stocks or securities 
referred to in subdivision (ii) of this subparagraph) derived in the 
active conduct of a banking, financing, or similar business in the 
United States, see subparagraphs (2) and (3) of this paragraph and 
paragraph (b) of this section.
    (vii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation F, which is created under the laws of 
foreign country X and engaged in the active conduct of the banking 
business in country X and a number of other foreign countries, has in 
the United States a branch, B, which during the taxable year is engaged 
in the active conduct of the banking business in the United States 
within the meaning of subdivision (i) of this subparagraph. In the 
course of its banking business in foreign countries, F receives at its 
branches located in country X and other foreign countries substantial 
deposits in U.S. dollars which are transferred to the accounts of B in 
the United States. During the taxable year, B actively participates in 
negotiating loans to residents of the United States, such as call loans 
to U.S. brokers, which are financed from the U.S. dollar deposits 
transferred to B by F. In addition, B actively participates in 
purchasing on the New York Stock Exchange and over-the-counter markets 
long-term bonds and notes issued by the U.S. Government, U.S. Treasury 
bills, and long-term interest-bearing bonds issued by domestic 
corporations and having a maturity date of less than 1 year from the 
date of acquisition, all of which are purchased from the deposits 
transferred to B by F. All of the securities so acquired are held by B 
and recorded on its books in the United States. Pursuant to subdivision 
(ii) of this subparagraph, the interest received by F during the taxable 
year on these loans, bonds, notes, and bills is effectively connected 
for such year with the active conduct by F of a banking business in the 
United States.
    Example 2. The facts are the same as in example 1 except that B also 
actively participates in using part of the U.S. dollar deposits, which 
are transferred to it by F, to purchase on the New York Stock Exchange 
shares of common stock issued by various domestic corporations. All of 
the shares so purchased are considered to be capital assets within the 
meaning of section 1221 and are

[[Page 362]]

recorded on B's books in the United States. None of the shares so 
purchased were acquired for the purpose of meeting reserve or other 
similar requirements. During the taxable year some of the shares are 
sold by B on the stock exchange. Pursuant to subdivision (ii) of this 
subparagraph, the dividends and gains received by F during the taxable 
year on these shares of stock are not effectively connected with the 
active conduct by F of a banking, financing, or similar business in the 
United States.
    Example 3. The facts are the same as in example 1 except that B also 
uses part of the U.S. dollar deposits, which are transferred to it by F, 
to make a loan to domestic corporation M. As part of the consideration 
for the loan, M gives to B a number of shares of common stock issued by 
M. All of these shares of stock are considered to be capital assets 
within the meaning of section 1221 and are recorded on B's books in the 
United States. During the taxable year one-half of these shares of stock 
is sold by B on the New York Stock Exchange. Pursuant to subdivision 
(ii) of this subparagraph, the dividends and gains received by F during 
the taxable year on these shares of stock are effectively connected for 
such year with the active conduct by F of a banking business in the 
United States.
    Example 4. The facts are the same as in example 1 except that during 
the taxable year the home office of F in country X actively participates 
in negotiating loans to residents of the United States, such as call 
loans to U.S. brokers, which are financed by the U.S. dollar deposits 
received at the home office and are recorded on the books of the home 
office. B does not participate in negotiating these loans. Pursuant to 
subdivision (ii) of this subparagraph the interest received by F during 
the taxable year on these loans made by the home office in country X is 
not effectively connected with the active conduct by F of a banking, 
financing, or similar business in the United States.
    Example 5. Foreign corporation Y, which is created under the laws of 
foreign country X and is engaged in the active conduct of a banking 
business in country X and other foreign countries, has a branch, C, in 
the United States that is engaged in the active conduct of a banking 
business in the United States, within the meaning of paragraph (c)(5)(i) 
of this section, during the taxable year. C handles the negotiation and 
acquisition of securities involved in loans made by Y to U.S. persons. C 
also presents interest coupons with respect to such securities for 
payment, presents all such securities for payment at maturity, and 
maintains compete photocopy files with respect to such securities. The 
activities of the office of Y in country X with respect to these 
securities consist of giving pro forma approval of the loans, storing 
the original securities, and recording the securities on the books of 
the country X office. Pursuant to paragraphs (c)(5)(ii) and (c)(5)(iii) 
of this section, the U.S. source interest income received by Y during 
the taxable year on these securities is effectively connected for such 
year with the active conduct by Y of a banking business in the United 
States.

    (6) Income related to personal services of an individual--(i) 
Income, gain, or loss from assets. Income or gains from sources within 
the United States described in section 871(a)(1) and derived from an 
asset, and gain or loss from sources within the United States from the 
sale or exchange of capital assets, realized by a nonresident alien 
individual engaged in a trade or business in the United States during 
the taxable year solely by reason of his performing personal services in 
the United States shall not be treated as income, gain, or loss which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States, unless there is a direct economic 
relationship between his holding of the asset from which the income, 
gain, or loss results and his trade or business of performing the 
personal services.
    (ii) Wages, salaries, and pensions. Wages, salaries, fees, 
compensations, emoluments, or other remunerations, including bonuses, 
received by a nonresident alien individual for performing personal 
services in the United States which, under paragraph (a) of Sec.  1.864-
2, constitute engaging in a trade or business in the United States, and 
pensions and retirement pay attributable to such personal services, 
constitute income which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States by that 
individual if he is engaged in a trade or business in the United States 
at some time during the taxable year in which such income is received.
    (7) Effective date. Paragraphs (c)(2) and (c)(6)(i) of this section 
are effective for taxable years beginning on or after June 6, 1996.

[T.D. 7216, 37 FR 23425, Nov. 3, 1972, as amended by T.D. 7332, 39 FR 
44232, Dec. 23, 1974; T.D. 79-58, 49 FR 21052, May 18, 1984; T.D. 8657, 
61 FR 9337, Mar. 8, 1996; T.D. 9226, 70 FR 57510, Oct. 3, 2005]

[[Page 363]]



Sec.  1.864-5  Foreign source income effectively connected with U.S. business.

    (a) In general. This section applies only to a nonresident alien 
individual or a foreign corporation that is engaged in a trade or 
business in the United States at some time during a taxable year 
beginning after December 31, 1966, and to the income, gain, or loss of 
such person from sources without the United States. The income, gain, or 
loss of such person for the taxable year from sources without the United 
States which is specified in paragraph (b) of this section shall be 
treated as effectively connected for the taxable year with the conduct 
of a trade or business in the United States, only if he also has in the 
United States at some time during the taxable year, but not necessarily 
at the time the income, gain, or loss is realized, an office or other 
fixed place of business, as defined in Sec.  1.864-7, to which such 
income, gain, or loss is attributable in accordance with Sec.  1.864-6. 
The income of such person for the taxable year from sources without the 
United States which is specified in paragraph (c) of this section shall 
be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States when derived by a 
foreign corporation carrying on a life insurance business in the United 
States. Except as provided in paragraphs (b) and (c) of this section, no 
income, gain, or loss of a nonresident alien individual or a foreign 
corporation for the taxable year from sources without the United States 
shall be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that person. Any 
income, gain, or loss described in paragraph (b) or (c) of this section 
which, if it were derived by the taxpayer from sources within the United 
States for the taxable year, would not be treated under Sec.  1.864-4 as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States shall not be treated under this section 
as effectively connected for the taxable year with the conduct of a 
trade or business in the United States. To determine the source of 
income, gain or loss from the sale of personal property (including 
inventory property) attributable to an office or other fixed place of 
business in the United States by nonresidents, as defined in section 
865(g)(1)(B), see Sec.  1.865-3.
    (b) Income other than income attributable to U.S. life insurance 
business. Income, gain, or loss from sources without the United States 
other than income described in paragraph (c) of this section or income 
from section 865(e)(2) sales, as defined in Sec.  1.865-3(c), shall be 
taken into account pursuant to paragraph (a) of this section in applying 
Sec. Sec.  1.864-6 and 1.864-7 only if it consists of--
    (1) Rents, royalties, or gains on sales of intangible property. (i) 
Rents or royalties for the use of, or for the privilege of using, 
intangible personal property located outside the United States or from 
any interest in such property, including rents or royalties for the use, 
or for the privilege of using, outside the United States, patents, 
copyrights, secret processes and formulas, good will, trademarks, trade 
brands, franchises, and other like properties, if such rents or 
royalties are derived in the active conduct of the trade or business in 
the United States.
    (ii) Gains or losses on the sale or exchange of intangible personal 
property located outside the United States or from any interest in such 
property, including gains or losses on the sale or exchange of the 
privilege of using, outside the United States, patents, copyrights, 
secret processes and formulas, good will, trademarks, trade brands, 
franchises, and other like properties, if such gains or losses are 
derived in the active conduct of the trade or business in the United 
States.
    (iii) Whether or not such an item of income, gain, or loss is 
derived in the active conduct of a trade or business in the United 
States shall be determined from the facts and circumstances of each 
case. The frequency with which a nonresident alien individual or a 
foreign corporation enters into transactions of the type from which the 
income, gain, or loss is derived shall not of itself determine that the 
income, gain, or loss is derived in the active conduct of a trade or 
business.
    (iv) This subparagraph shall not apply to rents or royalties for the 
use of, or for the privilege of using, real

[[Page 364]]

property or tangible personal property, or to gain or loss from the sale 
or exchange of such property.
    (2) Dividends or interest, or gains or loss from sales of stocks or 
securities--(i) In general. Dividends or interests from any transaction, 
or gains or losses on the sale or exchange of stocks or securities, 
realized by (a) a nonresident alien individual or a foreign corporation 
in the active conduct of a banking, financing, or similar business in 
the United States or (b) a foreign corporation engaged in business in 
the United States whose principal business is trading in stocks or 
securities for its own account. Whether the taxpayer is engaged in the 
active conduct of a banking, financing, or similar business in the 
United States for purposes of this subparagraph shall be determined in 
accordance with the principles of paragraph (c)(5)(i) of Sec.  1.864-4.
    (ii) Substitute payments. For purposes of this paragraph (b)92), a 
substitute interest payment (as defined in Sec.  1.861-2(a)(7)) received 
by a foreign person subject to tax under this paragraph (b) pursuant to 
a securities lending transaction or a sale-repurchase transaction (as 
defined in Sec.  1.861-2(a)(7)) with respect to a security (as defined 
in Sec.  1.864-6(b)(2)(ii)(c)) shall have the same character as interest 
income paid or accrued with respect to the terms of the transferred 
security. Similarly, for purposes of this paragraph (b)(2), a substitute 
dividend payment (as defined in Sec.  1.861-3(a)(6)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec.  1.861-3(a)(6)) with respect 
to a stock shall have the same character as a distribution with respect 
to the transferred security. This paragraph (b)(2)(ii) is applicable to 
payments made after November 13, 1997.
    (iii) Incidental investment activity. This subparagraph shall not 
apply to income, gain, or loss realized by a nonresident alien 
individual or foreign corporation on stocks or securities held, sold, or 
exchanged in connection with incidental investment activities carried on 
by that person. Thus, a foreign corporation which is primarily a holding 
company owning significant percentages of the stocks or securities 
issued by other corporations shall not be treated under this 
subparagraph as a corporation the principal business of which is trading 
in stocks or securities for its own account, solely because it engages 
in sporadic purchases or sales of stocks or securities to adjust its 
portfolio. The application of this subdivision may be illustrated by the 
following example:

    Example. F, a foreign corporation, owns voting stock in foreign 
corporations M, N, and P, its holdings in such corporations constituting 
15, 20, and 100 percent, respectively, of all classes of their 
outstanding voting stock. Each of such stock holdings by F represents 
approximately 20 percent of its total assets. The remaining 40 percent 
of F's assets consist of other investments, 20 percent being invested in 
securities issued by foreign governments and in stocks and bonds issued 
by other corporations in which F does not own a significant percentage 
of their outstanding voting stock, and 20 percent being invested in 
bonds issued by N. None of the assets of F are held primarily for sale; 
but if the officers of that corporation were to decide that other 
investments would be preferable to its holding of such assets, F would 
sell the stocks and securities and reinvest the proceeds therefrom in 
other holdings. Any income, gain, or loss which F may derive from this 
investment activity is not considered to be realized by a foreign 
corporation described in subdivision (i) of this subparagraph.

    (3) Sale of goods or merchandise through U.S. office. (i) Income, 
gain, or loss from the sale of inventory items or of property held 
primarily for sale to customers in the ordinary course of business, as 
described in section 1221(1), where the sale is outside the United 
States but through the office or other fixed place of business which the 
nonresident alien or foreign corporation has in the United States, 
irrespective of the destination to which such property is sent for use, 
consumption, or disposition.
    (ii) This subparagraph shall not apply to income, gain, or loss 
resulting from a sales contract entered into on or before February 24, 
1966. See section 102(e)(1) of the Foreign Investors Tax Act of 1966 (80 
Stat. 1547). Thus, for example, the sales office in the United States of 
a foreign corporation enters into negotiations for the sale of 500,000 
industrial bearings which the corporation produces in a foreign country 
for

[[Page 365]]

consumption in the Western Hemisphere. These negotiations culminate in a 
binding agreement entered into on January 1, 1966. By its terms delivery 
under the contract is to be made over a period of 3 years beginning in 
March of 1966. Payment is due upon delivery. The income from sources 
without the United States resulting from this sale negotiated by the 
U.S. sales office of the foreign corporation shall not be taken into 
account under this subparagraph for any taxable year.
    (iii) This subparagraph shall not apply to gains or losses on the 
sale or exchange of intangible personal property to which subparagraph 
(1) of this paragraph applies or of stocks or securities to which 
subparagraph (2) of this paragraph applies.
    (c) Income attributable to U.S. life insurance business. (1) All of 
the income for the taxable year of a foreign corporation described in 
subparagraph (2) of this paragraph from sources without the United 
States, which is attributable to its U.S. life insurance business, shall 
be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that corporation. 
Thus, in determining its life insurance company taxable income from its 
U.S. business for purposes of section 802, the foreign corporation shall 
include all of its items of income from sources without the United 
States which would appropriately be taken into account in determining 
the life insurance company taxable income of a domestic corporation. The 
income to which this subparagraph applies shall be taken into account 
for purposes of paragraph (a) of this section without reference to 
Sec. Sec.  1.864-6 and 1.864-7.
    (2) A foreign corporation to which subparagraph (1) of this 
paragraph applies is a foreign corporation carrying on an insurance 
business in the United States during the taxable year which--
    (i) Without taking into account its income not effectively connected 
for that year with the conduct of any trade or business in the United 
States, would qualify as a life insurance company under part I (section 
801 and following) of subchapter L, chapter 1 of the Code, if it were a 
domestic corporation, and
    (ii) By reason of section 842 is taxable under that part on its 
income which is effectively connected for that year with its conduct of 
any trade or business in the United States.
    (d) Excluded foreign source income. Notwithstanding paragraphs (b) 
and (c) of this section, no income from sources without the United 
States shall be treated as effectively connected for any taxable year 
with the conduct of a trade or business in the United States by a 
nonresident alien individual or a foreign corporation if the income 
consists of--
    (1) Dividends, interest, or royalties paid by a related foreign 
corporation. Dividends, interest, or royalties paid by a foreign 
corporation in which the nonresident alien individual or the foreign 
corporation described in paragraph (a) of this section owns, within the 
meaning of section 958(a), or is considered as owning, by applying the 
ownership rules of section 958(b), at the time such items are paid more 
than 50 percent of the total combined voting power of all classes of 
stock entitled to vote.
    (2) Subpart F income of a controlled foreign corporation. Any income 
of the foreign corporation described in paragraph (a) of this section 
which is subpart F income for the taxable year, as determined under 
section 952(a), even though part of the income is attributable to 
amounts which, if distributed by the foreign corporation, would be 
distributed with respect to its stock which is owned by shareholders who 
are not U.S. shareholders within the meaning of section 951(b). This 
subparagraph shall not apply to any income of the foreign corporation 
which is excluded in determining its subpart F income for the taxable 
year for purposes of section 952(a). Thus, for example, this 
subparagraph shall not apply to--
    (i) Foreign base company shipping income which is excluded under 
section 954(b)(2),
    (ii) Foreign base company income amounting to less than 10 percent 
(30 percent in the case of taxable years of foreign corporations ending 
before January 1, 1976) of gross income which by reason of section 
954(b)(3)(A) does not become subpart F income for the taxable year,

[[Page 366]]

    (iii) Any income excluded from foreign base company income under 
section 954(b)(4), relating to exception for foreign corporations not 
availed of to reduce taxes,
    (iv) Any income derived in the active conduct of a trade or business 
which is excluded under section 954(c)(3), or
    (v) Any income received from related persons which is excluded under 
section 954(c)(4).


This subparagraph shall apply to the foreign corporation's entire 
subpart F income for the taxable year determined under section 952(a), 
even though no amount is included in the gross income of a U.S. 
shareholder under section 951(a) with respect to that subpart F income 
because of the minimum distribution provisions of section 963(a) or 
because of the reduction under section 970(a) with respect to an export 
trade corporation. This subparagraph shall apply only to a foreign 
corporation which is a controlled foreign corporation within the meaning 
of section 957 and the regulations thereunder. The application of this 
subparagraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporation M, incorporated under the 
laws of foreign country X, is engaged in the business of purchasing and 
selling merchandise manufactured in foreign country Y by an unrelated 
person. M negotiates sales, through its sales office in the United 
States, of its merchandise for use outside of country X. These sales are 
made outside the United States, and the merchandise is sold for use 
outside the United States. No office maintained by M outside the United 
States participates materially in the sales made through its U.S. sales 
office. These activities constitute the only activities of M. During the 
taxable year M derives $100,000 income from these sales made through its 
U.S. sales office, and all of such income is foreign base company sales 
income by reason of section 954(d)(2) and paragraph (b) of Sec.  1.954-
3. The entire $100,000 is also subpart F income, determined under 
section 952(a). In addition, all of this income would, without reference 
to section 864(c)(4)(D)(ii) and this subparagraph, be treated as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by M. Through its entire taxable year 
60 percent of the one class of stock of M is owned within the meaning of 
section 958(a) by U.S. shareholders, as defined in section 951(b), and 
40 percent of its one class of stock is owned within the meaning of 
section 958(a) by persons who are not U.S. shareholders, as defined in 
section 951(b). Although only $60,000 of the subpart F income of M for 
the taxable year is includible in the income of the U.S. shareholders 
under section 951(a), the entire subpart F income of $100,000 
constitutes income which, by reason of section 864(c)(4)(D)(ii) and this 
subparagraph, is not effectively connected for the taxable year with the 
conduct of a trade or business in the United States by M.
    Example 2. The facts are the same as in example 1 except that the 
foreign base company sales income amounts to $150,000 determined in 
accordance with paragraph (d)(3)(i) of Sec.  1.954-1, and that M also 
has gross income from sources without the United States of $50,000 from 
sales, through its sales office in the United States, of merchandise for 
use in country X. These sales are made outside the United States. All of 
this income would, without reference to section 864(c)(4)(D)(ii) and 
this subparagraph, be treated as effectively connected for the taxable 
year with the conduct of a trade or business in the United States by M. 
Since the foreign base company income of $150,000 amounts to 75 percent 
of the entire gross income of $200,000, determined as provided in 
paragraph (d)(3)(ii) of Sec.  1.954-1, the entire $200,000 constitutes 
foreign base company income under section 954(b)(3)(B). Assuming that M 
has no amounts to be taken into account under paragraphs (1), (2), (4), 
and (5) of section 954(b), the $200,000 is also subpart F income, 
determined under section 952(a). This subpart F income of $200,000 
constitutes income which, by reason of section 864(c)(4)(D)(ii) and this 
subparagraph, is not effectively connected for the taxable year with the 
conduct of a trade or business in the United States by M.

    (3) Interest on certain deposits. Interest which, by reason of 
section 861(a)(1)(A) (relating to interest on deposits with banks, 
savings and loan associations, and insurance companies paid or credited 
before January 1, 1976) and paragraph (c) of Sec.  1.864-4, is 
determined to be income from sources without the United States because 
it is not effectively connected for the taxable year with the conduct of 
a trade or business in the United States by the nonresident alien 
individual or foreign corporation.
    (e) Applicability dates. Paragraphs (a) and (b) of this section 
apply to taxable years ending on or after December 23, 2019. However, a 
taxpayer may apply paragraphs (a) and (b) of this section in

[[Page 367]]

their entirety for taxable years beginning after December 31, 2017, and 
ending before December 23, 2019, provided that the taxpayer and all 
persons related to the taxpayer (within the meaning of section 267 or 
707) apply paragraphs (a) and (b) of this section and Sec. Sec.  1.863-
1(b), 1.863-2(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-6(c)(2), and 1.865-3 
in their entirety for the taxable year, and once applied, the taxpayer 
and all persons related to the taxpayer (within the meaning of section 
267 or 707) continue to apply these regulations in their entirety for 
all subsequent taxable years. For regulations generally applicable to 
taxable years ending before December 23, 2019, see Sec.  1.864-5 as 
contained in 26 CFR part 1 revised as of April 1, 2020.

[T.D. 7216, 37 FR 23429, Nov. 3, 1972, as amended by T.D. 7893, 48 FR 
22507, May 19, 1983; T.D. 8735, 62 FR 53501, Oct. 14, 1997; T.D. 9921, 
85 FR 79850, Dec. 11, 2020]



Sec.  1.864-6  Income, gain, or loss attributable to an office or other 
fixed place of business in the United States.

    (a) In general. Income, gain, or loss from sources without the 
United States which is specified in paragraph (b) of Sec.  1.864-5 and 
received by a nonresident alien individual or a foreign corporation 
engaged in a trade or business in the United States at some time during 
a taxable year beginning after December 31, 1966, shall be treated as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States only if the income, gain, or loss is 
attributable under paragraphs (b) and (c) of this section to an office 
or other fixed place of business, as defined in Sec.  1.864-7, which the 
taxpayer has in the United States at some time during the taxable year.
    (b) Material factor test--(1) In general. For purposes of paragraph 
(a) of this section, income, gain, or loss is attributable to an office 
or other fixed place of business which a nonresident alien individual or 
a foreign corporation has in the United States only if such office or 
other fixed place of business is a material factor in the realization of 
the income, gain, or loss, and if the income, gain, or loss is realized 
in the ordinary course of the trade or business carried on through that 
office or other fixed place of business. For this purpose, the 
activities of the office or other fixed place of business shall not be 
considered to be a material factor in the realization of the income, 
gain, or loss unless they provide a significant contribution to, by 
being an essential economic element in, the realization of the income, 
gain, or loss. Thus, for example, meetings in the United States of the 
board of directors of a foreign corporation do not of themselves 
constitute a material factor in the realization of income, gain, or 
loss. It is not necessary that the activities of the office or other 
fixed place of business in the United States be a major factor in the 
realization of the income, gain, or loss. An office or other fixed place 
of business located in the United States at some time during a taxable 
year may be a material factor in the realization of an item of income, 
gain, or loss for that year even though the office or other fixed place 
of business is not present in the United States when the income, gain, 
or loss is realized.
    (2) Application of material factor test to specific classes of 
income. For purposes of paragraph (a) of this section, an office or 
other fixed place of business which a nonresident alien individual or a 
foreign corporation, engaged in a trade or business in the United States 
at some time during the taxable year, had in the United States, shall be 
considered a material factor in the realization of income, gain, or loss 
consisting of--
    (i) Rents, royalties, or gains on sales of intangible property. 
Rents, royalties, or gains or losses, from intangible personal property 
specified in paragraph (b)(1) of Sec.  1.864-5, if the office or other 
fixed place of business either actively participates in soliciting, 
negotiating, or performing other activities required to arrange, the 
lease, license, sale, or exchange from which such income, gain, or loss 
is derived or performs significant services incident to such lease, 
license, sale, or exchange. An office or other fixed place of business 
in the United States shall not be considered to be a material factor in 
the realization of income, gain, or loss for purposes of this 
subdivision merely because the office or other fixed place of

[[Page 368]]

business conducts one or more of the following activities: (a) Develops, 
creates, produces, or acquires and adds substantial value to, the 
property which is leased, licensed, or sold, or exchanged, (b) collects 
or accounts for the rents, royalties, gains, or losses, (c) exercises 
general supervision over the activities of the persons directly 
responsible for carrying on the activities or services described in the 
immediately preceding sentence, (d) performs merely clerical functions 
incident to the lease, license, sale, or exchange or (e) exercises final 
approval over the execution of the lease, license, sale, or exchange. 
The application of this subdivision may be illustrated by the following 
examples:

    Example 1. F, a foreign corporation, is engaged in the active 
conduct of the business of licensing patents which it has either 
purchased or developed in the United States. F has a business office in 
the United States. Licenses for the use of such patents outside the 
United States are negotiated by offices of F located outside the United 
States, subject to approval by an officer of such corporation located in 
the U.S. office. All services which are rendered to F's foreign 
licensees are performed by employees of F's offices located outside the 
United States. None of the income, gain, or loss resulting from the 
foreign licenses so negotiated by F is attributable to its business 
office in the United States.
    Example 2. N, a foreign corporation, is engaged in the active 
conduct of the business of distributing motion picture films and 
television programs. N does not distribute such films or programs in the 
United States. The foreign distribution rights to these films and 
programs are acquired by N's U.S. business office from the U.S. owners 
of these films and programs. Employees of N's offices located in various 
foreign countries carry on in such countries all the solicitations and 
negotiations for the licensing of these films and programs to licensees 
located in such countries and provide the necessary incidental services 
to the licensees. N's U.S. office collects the rentals from the foreign 
licensees and maintains the necessary records of income and expense. 
Officers of N located in the United States also maintain general 
supervision over the employees of the foreign offices, but the foreign 
employees conduct the day to day business of N outside the United States 
of soliciting, negotiating, or performing other activities required to 
arrange the foreign licenses. None of the income, gain, or loss 
resulting from the foreign licenses so negotiated by N is attributable 
to N's U.S. office.

    (ii) Dividends or interest, or gains or losses from sales of stock 
or securities--(a) In general. Dividends or interest from any 
transaction, or gains or losses on the sale or exchange of stocks or 
securities, specified in paragraph (b)(2) of Sec.  1.864-5, if the 
office or other fixed place of business either actively participates in 
soliciting, negotiating, or performing other activities required to 
arrange, the issue, acquisition, sale, or exchange, of the asset from 
which such income, gain, or loss is derived or performs significant 
services incident to such issue, acquisition, sale, or exchange. An 
office or other fixed place of business in the United States shall not 
be considered to be a material factor in the realization of income, 
gain, or loss for purposes of this subdivision merely because the office 
or other fixed place of business conducts one or more of the following 
activities: (1) Collects or accounts for the dividends, interest, gains, 
or losses, (2) exercises general supervision over the activities of the 
persons directly responsible for carrying on the activities or services 
described in the immediately preceding sentence, (3) performs merely 
clerical functions incident to the issue, acquisition, sale, or 
exchange, or (4) exercises final approval over the execution of the 
issue, acquisition, sale, or exchange.
    (b) Effective connection of income from stocks or securities with 
active conduct of a banking, financing, or similar business. 
Notwithstanding (a) of this subdivision (ii), the determination as to 
whether any dividends or interest from stocks or securities, or gain or 
loss from the sale or exchange of stocks or securities which are capital 
assets, which is from sources without the United States and derived by a 
nonresident alien individual or a foreign corporation in the active 
conduct during the taxable year of a banking, financing, or similar 
business in the United States, shall be treated as effectively connected 
for such year with the active conduct of that business shall be made by 
applying the principles of paragraph (c)(5)(ii) of Sec.  1.864-4 for 
determining whether income, gain, or loss of such type from sources 
within the United States is effectively connected for such year with the 
active conduct of that business.

[[Page 369]]

    (c) Security defined. For purposes of this subdivision (ii), a 
security is any bill, note, bond, debenture, or other evidence of 
indebtedness, or any evidence of an interest in, or right to subscribe 
or to purchase, any of the foregoing items.
    (d) Limitations on application of rules on banking, financing, or 
similar business--(1) Trading for taxpayer's own account. The provisions 
of (b) of this subdivision (ii) apply for purposes of determining when 
certain income, gain, or loss from stocks or securities is effectively 
connected with the active conduct of a banking, financing, or similar 
business in the United States. Any dividends, interest, gain, or loss 
from sources without the United States which by reason of the 
application of (b) of this subdivision (ii) is not effectively connected 
with the active conduct by a foreign corporation of a banking, 
financing, or similar business in the United States may be effectively 
connected for the taxable year, under (a) of this subdivision (ii), with 
the conduct by such taxpayer of a trade or business in the United States 
which consists of trading in stocks or securities for the taxpayer's own 
account.
    (2) Other income. For rules relating to dividends or interest from 
sources without the United States (other than dividends or interest 
from, or gain or loss from the sale or exchange of, stocks or securities 
referred to in (b) of this subdivision (ii)) derived in the active 
conduct of a banking, financing, or similar business in the United 
States, see (a) of this subdivision (ii).
    (iii) Sale of goods or merchandise through U.S. office. Income, 
gain, or loss from sales of goods or merchandise specified in paragraph 
(b)(3) of Sec.  1.864-5, if the office or other fixed place of business 
actively participates in soliciting the order, negotiating the contract 
of sale, or performing other significant services necessary for the 
consummation of the sale which are not the subject of a separate 
agreement between the seller and the buyer. The office or other fixed 
place of business in the United States shall be considered a material 
factor in the realization of income, gain, or loss from a sale made as a 
result of a sales order received in such office or other fixed place of 
business except where the sales order is received unsolicited and that 
office or other fixed place of business is not held out to potential 
customers as the place to which such sales orders should be sent. The 
income, gain, or loss must be realized in the ordinary course of the 
trade or business carried on through the office or other fixed place of 
business in the United States. Thus, if a foreign corporation is engaged 
solely in a manufacturing business in the United States, the income 
derived by its office in the United States as a result of an occasional 
sale outside the United States is not attributable to the U.S. office if 
the sales office of the manufacturing business is located outside the 
United States. On the other hand, if a foreign corporation establishes a 
sales office in the United States to sell for consumption in the Western 
Hemisphere merchandise which the corporation produces in Africa, the 
income derived by the sales office in the United States as a result of 
an occasional sale made by it in Europe shall be attributable to the 
U.S. sales office. An office or other fixed place of business in the 
United States shall not be considered to be a material factor in the 
realization of income, gain, or loss for purposes of this subdivision 
merely because of one or more of the following activities: (a) The sale 
is made subject to the final approval of such office or other fixed 
place of business, (b) the property sold is held in, and distributed 
from, such office or other fixed place of business, (c) samples of the 
property sold are displayed (but not otherwise promoted or sold) in such 
office or other fixed place of business, or (d) such office or other 
fixed place of business performs merely clerical functions incident to 
the sale. Activities carried on by employees of an office or other fixed 
place of business constitute activities of that office or other fixed 
place of business.
    (3) Limitation where foreign office is a material factor in 
realization of income--(i) Goods or merchandise destined for foreign 
use, consumption, or disposition. Notwithstanding subparagraphs (1) and 
(2) of this paragraph, an office or other fixed place of business which 
a nonresident alien individual or a foreign corporation has in the 
United States

[[Page 370]]

shall not be considered, for purposes of paragraph (a) of this section, 
to be a material factor in the realization of income, gain, or loss from 
sales of goods or merchandise specified in paragraph (b)(3) of Sec.  
1.864-5 if the property is sold for use, consumption, or disposition 
outside the United States and an office or other fixed place of 
business, as defined in Sec.  1.864-7, which such nonresident alien 
individual or foreign corporation has outside the United States 
participates materially in the sale. For this purpose an office or other 
fixed place of business which the taxpayer has outside the United States 
shall be considered to have participated materially in a sale made 
through the office or other fixed place of business in the United States 
if the office or other fixed place of business outside the United States 
actively participates in soliciting the order resulting in the sale, 
negotiating the contract of sale, or performing other significant 
services necessary for the consummation of the sale which are not the 
subject of a separate agreement between the seller and buyer. An office 
or other fixed place of business which the taxpayer has outside the 
United States shall not be considered to have participated materially in 
a sale merely because of one or more of the following activities: (a) 
The sale is made subject to the final approval of such office or other 
fixed place of business, (b) the property sold is held in, and 
distributed from, such office or other fixed place of business, (c) 
samples of the property sold are displayed (but not otherwise promoted 
or sold) in such office or other fixed place of business, (d) such 
office or other fixed place of business is used for purposes of having 
title to the property pass outside the United States, or (e) such office 
or other fixed place of business performs merely clerical functions 
incident to the sale.
    (ii) Rules for determining country of use, consumption, or 
disposition--(a) In general. As a general rule, personal property which 
is sold to an unrelated person shall be presumed for purposes of this 
subparagraph to have been sold for use, consumption, or disposition in 
the country of destination of the property sold; for such purpose, the 
occurrence in a country of a temporary interruption in shipment of 
property shall not cause that country to be considered the country of 
destination. However, if at the time of a sale of personal property to 
an unrelated person the taxpayer knew, or should have known from the 
facts and circumstances surrounding the transaction, that the property 
probably would not be used, consumed, or disposed of in the country of 
destination, the taxpayer must determine the country of ultimate use, 
consumption, or disposition of the property or the property shall be 
presumed to have been sold for use, consumption, or disposition in the 
United States. A taxpayer who sells personal property to a related 
person shall be presumed to have sold the property for use, consumption, 
or disposition in the United States unless the taxpayer establishes the 
use made of the property by the related person; once he has established 
that the related person has disposed of the property, the rules in the 
two immediately preceding sentences relating to sales to an unrelated 
person shall apply at the first stage in the chain of distribution at 
which a sale is made by a related person to an unrelated person. 
Notwithstanding the preceding provisions of this subdivision (a), a 
taxpayer who sells personal property to any person whose principal 
business consists of selling from inventory to retail customers at 
retail outlets outside the United States may assume at the time of the 
sale to that person that the property will be used, consumed, or 
disposed of outside the United States. For purposes of this (a), a 
person is related to another person if either person owns or controls 
directly or indirectly the other, or if any third person or persons own 
or control directly or indirectly both. For this purpose, the term 
``control'' includes any kind of control, whether or not legally 
enforceable, and however, exercised or exercisable. For illustrations of 
the principles of this subdivision, see paragraph (a)(3)(iv) of Sec.  
1.954-3.
    (b) Fungible goods. For purposes of this subparagraph, a taxpayer 
who sells to a purchaser personal property which because of its fungible 
nature cannot reasonably be specifically traced to other purchasers and 
to the countries

[[Page 371]]

of ultimate use, consumption, or disposition shall, unless the taxpayer 
establishes a different disposition as being proper, treat that property 
as being sold, for ultimate use, consumption, or disposition in those 
countries, and to those other purchasers, in the same proportions in 
which property from the fungible mass of the first purchaser is sold in 
the ordinary course of business by such first purchaser. No 
apportionment is required to be made, however, on the basis of sporadic 
sales by the first purchaser. This (b) shall apply only in a case where 
the taxpayer knew, or should have known from the facts and circumstances 
surrounding the transaction, the manner in which the first purchaser 
disposes of property from the fungible mass.
    (iii) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. Foreign corporation M has a sales office in the United 
States during the taxable year through which it sells outside the United 
States for use in foreign countries industrial electrical generators 
which such corporation manufactures in a foreign country. M is not a 
controlled foreign corporation within the meaning of section 957 and the 
regulations thereunder, and, by reason of its activities in the United 
States, is engaged in business in the United States during the taxable 
year. The generators require specialized installation and continuous 
adjustment and maintenance services. M has an office in foreign country 
X which is the only organization qualified to perform these 
installation, adjustment, and maintenance services. During the taxable 
year M sells several generators through its U.S. office for use in 
foreign country Y under sales contracts which also provide for 
installation, adjustment, and maintenance by its office in country X. 
The generators are installed in country Y by employees of M's office in 
country X, who also are responsible for the servicing of the equipment. 
Since the office of M in country X performs significant services 
incident to these sales which are necessary for their consummation and 
are not the subject of a separate agreement between M and the purchaser, 
the U.S. office of M is not considered to be a material factor in the 
realization of the income from the sales and, for purposes of paragraph 
(a) of this section, such income is not attributable to the U.S. office 
of that corporation.

    (c) Amount of income, gain, or loss allocable to U.S. office--(1) In 
general. If, in accordance with paragraph (b) of this section, an office 
or other fixed place of business which a nonresident alien individual or 
a foreign corporation has in the United States at some time during the 
taxable year is a material factor in the realization for that year of an 
item of income, gain, or loss specified in paragraph (b) of Sec.  1.864-
5, such item of income, gain, or loss shall be considered to be 
allocable in its entirety to that office or other fixed place of 
business. In no case may any income, gain, or loss for the taxable year 
from sources without the United States, or part thereof, be allocable 
under this paragraph to an office or other fixed place of business which 
a nonresident alien individual or a foreign corporation has in the 
United States if the taxpayer is at no time during the taxable year 
engaged in a trade or business in the United States.
    (2) Special limitation in case of sales of goods or merchandise 
through U.S. office. Notwithstanding paragraph (c)(1) of this section, 
the special rules described in this paragraph (c)(2) apply with respect 
to a sale of goods or merchandise specified in Sec.  1.864-5(b)(3), to 
which paragraph (b)(3)(i) of this section does not apply. In the case of 
a nonresident alien with a tax home within the United States, as defined 
in section 911(d)(3), the amount of income from the sale of goods or 
merchandise that is properly allocable to the individual's U.S. office 
is determined under Sec.  1.865-3(d).
    (3) Examples. The application of this paragraph (c) may be 
illustrated by the following examples--
    (i) Example 1. Sales of produced inventory through a U.S. sales 
office. Individual A, who is a nonresident alien within the meaning of 
section 7701(b)(1)(B) and has a tax home in the United States, 
manufactures machinery in a foreign country and sells the machinery 
outside the United States through A's sales office in the United States 
for use in foreign countries. A is not a nonresident within the meaning 
of section 865(g)(1)(B). Therefore, Sec.  1.865-3 does not apply to A's 
sale of the machinery, except to the extent provided in paragraph (c)(2) 
of this section. Title to the property sold is transferred to the 
foreign purchaser outside the United States, but no office

[[Page 372]]

or other fixed place of business of A in a foreign country materially 
participates in the sale made through A's U.S. office. By reason of its 
sales activities in the United States, A is engaged in business in the 
United States during the taxable year. During the taxable year, A 
derives a total income of $250,000x from these sales. Under paragraph 
(c)(2) of this section, the amount of income that is allocable to A's 
U.S. office is determined under Sec.  1.865-3(d)(2). The taxpayer does 
not allocate income from the sale under the books and records method 
described in Sec.  1.865-3(d)(2)(ii). Thus, 50 percent of A's foreign 
source income of $250,000x, plus any additional income allocable based 
on the location of production activities under Sec. Sec.  1.865-
3(d)(2)(i) and 1.863-3 (in this case, $0x), is effectively connected for 
the taxable year with the conduct of A's U.S. trade or business, or 
$125,000x.
    (ii) Example 2. Sales of inventory purchased and resold through a 
U.S. sales office by a nonresident alien with a tax home in the United 
States. Individual B, who is a nonresident alien within the meaning of 
section 7701(b)(1)(B) and has a tax home in the United States, has an 
office in a foreign country that purchases merchandise and sells it 
through B's sales office in the United States for use in various foreign 
countries, with title to the property passing outside the United States. 
B is not a nonresident within the meaning of section 865(g)(1)(B). 
Therefore, Sec.  1.865-3 does not apply to B's sale of the merchandise, 
except to the extent provided in paragraph (c)(2) of this section. No 
other office of B materially participates in these sales made through 
its U.S. office. By reason of its sales activities in the United States, 
B is engaged in business in the United States during the taxable year. 
During the taxable year, B derives income of $300,000x from these sales 
made through its U.S. sales office. All of B's income from these sales 
is foreign source as B purchases the merchandise outside the United 
States and title to the merchandise also passes outside the United 
States. The amount of income properly allocable to B's U.S. office 
determined under Sec.  1.865-3(d)(3) is $300,000x, and thus $300,000x is 
effectively connected for the taxable year with the conduct of B's U.S. 
trade or business.
    (iii) Example 3. Foreign sales office also materially participates 
in sale. The facts are the same as in paragraph (c)(3)(ii) of this 
section (the facts in Example 2), except that B also has an office in a 
foreign country that is a material factor in the realization of income 
from the sales made through B's U.S. office. No income from the sale of 
merchandise is allocable to B's U.S. sales office for the taxable year, 
by reason of paragraph (b)(3)(i) of this section, and thus none of the 
$300,000x is effectively connected for the taxable year with the conduct 
of B's U.S. trade or business.
    (iv) Example 4. Sales of inventory purchased and resold through a 
U.S. sales office by a foreign corporation. The facts are the same as in 
paragraph (c)(3)(ii) of this section (the facts in Example 2), except 
that B is a foreign corporation. B is a nonresident within the meaning 
of section 865(g)(1)(B). The income from such sales will be sourced in 
accordance with Sec.  1.865-3(a) and (d)(3).
    (4) Applicability date. Paragraph (c)(2) of this section applies to 
taxable years ending on or after December 23, 2019. However, a taxpayer 
may apply paragraph (c)(2) of this section in its entirety for taxable 
years beginning after December 31, 2017, and ending before December 23, 
2019, provided that the taxpayer and all persons related to the taxpayer 
(within the meaning of section 267 or 707) apply paragraph (c)(2) of 
this section and Sec. Sec.  1.863-1(b), 1.863-2(b), 1.863-3, 1.863-
8(b)(3)(ii), 1.864-5(a) and (b), and 1.865-3 in their entirety for the 
taxable year, and once applied, the taxpayer and all persons related to 
the taxpayer (within the meaning of section 267 or 707) continue to 
apply these regulations in their entirety for all subsequent taxable 
years. For regulations generally applicable to taxable years ending 
before December 23, 2019, see Sec.  1.864-6 as contained in 26 CFR part 
1 revised as of April 1, 2020.

[T.D. 7216, 37 FR 23431, Nov. 3, 1972, as amended by T.D. 9921, 85 FR 
79850, Dec. 11, 2020]



Sec.  1.864-7  Definition of office or other fixed place of business.

    (a) In general. (1) This section applies for purposes of determining 
whether a

[[Page 373]]

nonresident alien individual or a foreign corporation that is engaged in 
a trade or business in the United States at some time during a taxable 
year beginning after December 31, 1966, has an office or other fixed 
place of business in the United States for purposes of applying section 
864(c)(4)(B) and Sec.  1.864-6 to income, gain, or loss specified in 
paragraph (b) of Sec.  1.864-5 from sources without the United States or 
has an office or other fixed place of business outside the United States 
for purposes of applying section 864(c)(4)(B)(iii) and paragraph 
(b)(3)(i) of Sec.  1.864-6 to sales of goods or merchandise for use, 
consumption, or disposition outside the United States.
    (2) In making a determination under this section due regard shall be 
given to the facts and circumstances of each case, particularly to the 
nature of the taxpayer's trade or business and the physical facilities 
actually required by the taxpayer in the ordinary course of the conduct 
of his trade or business.
    (3) The law of a foreign country shall not be controlling in 
determining whether a nonresident alien individual or a foreign 
corporation has an office or other fixed place of business.
    (b) Fixed facilities--(1) In general. As a general rule, an office 
or other fixed place of business is a fixed facility, that is, a place, 
site, structure, or other similar facility, through which a nonresident 
alien individual or a foreign corporation engages in a trade or 
business. For this purpose an office or other fixed place of business 
shall include, but shall not be limited to, a factory; a store or other 
sales outlet; a workshop; or a mine, quarry, or other place of 
extraction of natural resources. A fixed facility may be considered an 
office or other fixed place of business whether or not the facility is 
continuously used by a nonresident alien individual or foreign 
corporation.
    (2) Use of another person's office or other fixed place of business. 
A nonresident alien individual or a foreign corporation shall not be 
considered to have an office or other fixed place of business merely 
because such alien individual or foreign corporation uses another 
person's office or other fixed place of business, whether or not the 
office or place of business of a related person, through which to 
transact a trade or business, if the trade or business activities of the 
alien individual or foreign corporation in that office or other fixed 
place of business are relatively sporadic or infrequent, taking into 
account the overall needs and conduct of that trade or business.
    (c) Management activity. A foreign corporation shall not be 
considered to have an office or other fixed place of business merely 
because a person controlling that corporation has an office or other 
fixed place of business from which general supervision and control over 
the policies of the foreign corporation are exercised. The fact that top 
management decisions affecting the foreign corporation are made in a 
country shall not of itself mean that the foreign corporation has an 
office or other fixed place of business in that country. For example, a 
foreign sales corporation which is a wholly owned subsidiary of a 
domestic corporation shall not be considered to have an office or other 
fixed place of business in the United States merely because of the 
presence in the United States of officers of the domestic parent 
corporation who are generally responsible only for the policy decisions 
affecting the foreign sales corporation, provided that the foreign 
corporation has a chief executive officer, whether or not he is also an 
officer of the domestic parent corporation, who conducts the day-to-day 
trade or business of the foreign corporation from a foreign office. The 
result in this example would be the same even if the executive officer 
should (1) regularly confer with the officers of the domestic parent 
corporation, (2) occasionally visit the U.S. office of the domestic 
parent corporation, and (3) during such visits to the United States 
temporarily conduct the business of the foreign subsidiary corporation 
out of the domestic parent corporation's office in the United States.
    (d) Agent activity--(1) Dependent agents--(i) In general. In 
determining whether a nonresident alien individual or a foreign 
corporation has an office or other fixed place of business, the office 
or other fixed place of business of an agent who is not an independent 
agent, as defined in subparagraph (3) of

[[Page 374]]

this paragraph, shall be disregarded unless such agent (a) has the 
authority to negotiate and conclude contracts in the name of the 
nonresident alien individual or foreign corporation, and regularly 
exercises that authority, or (b) has a stock of merchandise belonging to 
the nonresident alien individual or foreign corporation from which 
orders are regularly filed on behalf of such alien individual or foreign 
corporation. A person who purchases goods from a nonresident alien 
individual or a foreign corporation shall not be considered to be an 
agent for such alien individual or foreign corporation for purposes of 
this paragraph where such person is carrying on such purchasing 
activities in the ordinary course of its own business, even though such 
person is related in some manner to the nonresident alien individual or 
foreign corporation. For example, a wholly owned domestic subsidiary 
corporation of a foreign corporation shall not be treated as an agent of 
the foreign parent corporation merely because the subsidiary corporation 
purchases goods from the foreign parent corporation and resells them in 
its own name. However, if the domestic subsidiary corporation regularly 
negotiates and concludes contracts in the name of its foreign parent 
corporation or maintains a stock of merchandise from which it regularly 
fills orders on behalf of the foreign parent corporation, the office or 
other fixed place of business of the domestic subsidiary corporation 
shall be treated as the office or other fixed place of business of the 
foreign parent corporation unless the domestic subsidiary corporation is 
an independent agent within the meaning of subparagraph (3) of this 
paragraph.
    (ii) Authority to conclude contracts or fill orders. For purposes of 
subdivision (i) of this subparagraph, an agent shall be considered 
regularly to exercise authority to negotiate and conclude contracts or 
regularly to fill orders on behalf of his foreign principal only if the 
authority is exercised, or the orders are filled, with some frequency 
over a continuous period of time. This determination shall be made on 
the basis of the facts and circumstances in each case, taking into 
account the nature of the business of the principal; but, in all cases, 
the frequency and continuity tests are to be applied conjunctively. 
Regularity shall not be evidenced by occasional or incidental activity. 
An agent shall not be considered regularly to negotiate and conclude 
contracts on behalf of his foreign principal if the agent's authority to 
negotiate and conclude contracts is limited only to unusual cases or 
such authority must be separately secured by the agent from his 
principal with respect to each transaction effected.
    (2) Independent agents. The office or other fixed place of business 
of an independent agent, as defined in subparagraph (3) of this 
paragraph, shall not be treated as the office or other fixed place of 
business of his principal who is a nonresident alien individual or a 
foreign corporation, irrespective of whether such agent has authority to 
negotiate and conclude contracts in the name of his principal, and 
regularly exercises that authority, or maintains a stock of goods from 
which he regularly fills orders on behalf of his principal.
    (3) Definition of independent agent--(i) In general. For purposes of 
this paragraph, the term ``independent agent'' means a general 
commission agent, broker, or other agent of an independent status acting 
in the ordinary course of his business in that capacity. Thus, for 
example, an agent who, in pursuance of his usual trade or business, and 
for compensation, sells goods or merchandise consigned or entrusted to 
his possession, management, and control for that purpose by or for the 
owner of such goods or merchandise is an independent agent.
    (ii) Related persons. The determination of whether an agent is an 
independent agent for purposes of this paragraph shall be made without 
regard to facts indicating that either the agent or the principal owns 
or controls directly or indirectly the other or that a third person or 
persons own or control directly or indirectly both. For example, a 
wholly owned domestic subsidiary corporation of a foreign corporation 
which acts as an agent for the foreign parent corporation may be treated 
as acting in the capacity of

[[Page 375]]

independent agent for the foreign parent corporation. The facts and 
circumstances of a specific case shall determine whether the agent, 
while acting for his principal, is acting in pursuance of his usual 
trade or business and in such manner as to constitute him an independent 
agent in his relations with the nonresident alien individual or foreign 
corporation.
    (iii) Exclusive agents. Where an agent who is otherwise an 
independent agent within the meaning of subdivision (i) of this 
subparagraph acts in such capacity exclusively, or almost exclusively, 
for one principal who is a nonresident alien individual or a foreign 
corporation, the facts and circumstances of a particular case shall be 
taken into account in determining whether the agent, while acting in 
that capacity, may be classified as an independent agent.
    (e) Employee activity. Ordinarily, an employee of a nonresident 
alien individual or a foreign corporation shall be treated as a 
dependent agent to whom the rules of paragraph (d)(1) of this section 
apply if such employer does not in and of itself have a fixed facility 
(as defined in paragraph (b) of this section) in the United States or 
outside the United States, as the case may be. However, where the 
employee, in the ordinary course of his duties, carries on the trade or 
business of his employer in or through a fixed facility of such employer 
which is regularly used by the employee in the course of carrying out 
such duties, such fixed facility shall be considered the office or other 
fixed place of business of the employer, irrespective of the rules of 
paragraph (d)(1) of this section. The application of this paragraph may 
be illustrated by the following example:

    Example. M, a foreign corporation, opens a showroom office in the 
United States for the purpose of promoting its sales of merchandise 
which it purchases in foreign country X. The employees of the U.S. 
office, consisting of salesmen and general clerks, are empowered only to 
run the office, to arrange for the appointment of distributing agents 
for the merchandise offered by M, and to solicit orders generally. These 
employees do not have the authority to negotiate and conclude contracts 
in the name of M, nor do they have a stock of merchandise from which to 
fill orders on behalf of M. Any negotiations entered into by these 
employees are under M's instructions and subject to its approval as to 
any decision reached. The only independent authority which the employees 
have is in the appointment of distributors to whom M is to sell 
merchandise, but even this authority is subject to the right of M to 
approve or disapprove these buyers on receipt of information as to their 
business standing. Under the circumstances, this office used by a group 
of salesmen for sales promotion is a fixed place of business which M has 
in the United States.

    (f) Office or other fixed place of business of a related person. The 
fact that a nonresident alien individual or a foreign corporation is 
related in some manner to another person who has an office or other 
fixed place of business shall not of itself mean that such office or 
other fixed place of business of the other person is the office or other 
fixed place of business of the nonresident alien individual or foreign 
corporation. Thus, for example, the U.S. office of foreign corporation 
M, a wholly owned subsidiary corporation of foreign corporation N, shall 
not be considered the office or other fixed place of business of N 
unless the facts and circumstances show that N is engaged in trade or 
business in the United States through that office or other fixed place 
of business. However, see paragraph (b)(2) of this section.
    (g) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. S, a foreign corporation, is engaged in the business of 
buying and selling tangible personal property. S is a wholly owned 
subsidiary of P, a domestic corporation engaged in the business of 
buying and selling similar property, which has an office in the United 
States. Officers of P are generally responsible for the policies 
followed by S and are directors of S, but S has an independent group of 
officers, none of whom are regularly employed in the United States. In 
addition to this group of officers, S has a chief executive officer, D, 
who is also an officer of P but who is permanently stationed outside the 
United States. The day-to-day conduct of S's business is handled by D 
and the other officers of such corporation, but they regularly confer 
with the officers of P and on occasion temporarily visit P's offices in 
the United States, at which time they continue to conduct the business 
of S. S does not have an office or other fixed place of business in the 
United States for purposes of this section.

[[Page 376]]

    Example 2. The facts are the same as in example 1 except that, on 
rare occasions, an employee of P receives an order which he, after 
consultation with officials of S and because P cannot fill the order, 
accepts on behalf of S rather than on behalf of P. P does not hold 
itself out as a person which those wishing to do business with S should 
contact. Assuming that orders for S are seldom handled in this manner 
and that they do not constitute a significant part of that corporation's 
business, S shall not be considered to have an office or other fixed 
place of business in the United States because of these activities of an 
employee of P.
    Example 3. The facts are the same as in example 1 except that all 
orders received by S are subject to review by an officer of P before 
acceptance. S has a business office in the United States.
    Example 4. S, a foreign corporation organized under the laws of 
Puerto Rico, is engaged in the business of manufacturing dresses in 
Puerto Rico and is entitled to an income tax exemption under the Puerto 
Rico Industrial Incentive Act of 1963. S is a wholly owned subsidiary of 
P, a domestic corporation engaged in the business of buying and selling 
dresses to customers in the United States. S sells most of the dresses 
it produces to P, the assumption being made that the income from these 
sales is derived from sources without the United States. P in turn sells 
these dresses in the United States in its name and through the efforts 
of its own employees and of distributors appointed by it. S does not 
have a fixed facility in the United States, and none of its employees 
are stationed in the United States. On occasion, employees of S visit 
the office of P in the United States, and executives of P visit the 
office of S in Puerto Rico, to discuss with one another matters of 
mutual business interest involving both corporations, including the 
strategy for marketing the dresses produced by S. These matters are also 
regularly discussed by such persons by telephone calls between the 
United States and Puerto Rico. S's employees do not otherwise 
participate in P's marketing activities. Officers of P are generally 
responsible for the policies followed by S and are directors of S, but S 
has a chief executive officer in Puerto Rico who, from its office 
therein, handles the day-to-day conduct of S's business. Based upon the 
facts presented, and assuming there are no other facts which would lead 
to a different determination, S shall not be considered to have an 
office or other fixed place of business in the United States for 
purposes of this section.
    Example 5. The facts are the same as in example 4 except that the 
dresses are manufactured by S in styles and designs furnished by P and 
out of goods and raw materials purchased by P and sold to S. Based upon 
the facts presented, and assuming there are no other facts which would 
lead to a different determination, S shall not be considered to have an 
office or other fixed place of business in the United States for 
purposes of this section.
    Example 6. The facts are the same as in example 5 except that, 
pursuant to the instructions of P, the dresses sold by P are shipped by 
S directly to P's customers in the United States. Based upon the facts 
presented, and assuming there are no other facts which would lead to a 
different determination, S shall not be considered to have an office or 
other fixed place of business in the United States for purposes of this 
section.

[T.D. 7216, 37 FR 23433, Nov. 3, 1972]



Sec.  1.864-8T  Treatment of related person factoring income (temporary).

    (a) Applicability--(1) General rule. This section applies for 
purposes of determining the treatment of income derived by a person from 
a trade or service receivable acquired from a related person. Except as 
provided in paragraph (d) of this section, if a person acquires 
(directly or indirectly) a trade or service receivable from a related 
person, any income (including any stated interest, discount or service 
fee) derived from the trade or service receivable shall be treated as if 
it were interest received on a loan to the obligor under the receivable. 
The characterization of income as interest pursuant to this section 
shall apply only for purposes of sections 551-558 (relating to foreign 
personal holding companies), sections 951-964 (relating to controlled 
foreign corporations), and section 904 (relating to the limitation on 
the foreign tax credit) of the Code and the regulations thereunder. The 
principles of sections 861 through 863 and the regulations thereunder 
shall be applied to determine the source of such interest income for 
purposes of section 904.
    (2) Override. With respect to income characterized as interest under 
this section, the special rules of section 864(d) and this section 
override any conflicting provisions of the Code and regulations relating 
to foreign personal holding companies, controlled foreign corporations, 
and the foreign tax credit limitation. Thus, for example, pursuant to 
section 864(d)(5) and paragraph (e) of this section, stated interest 
derived from a factored trade or service receivable is not eligible for 
the subpart F de minimis rule of section

[[Page 377]]

954(b)(3), the same country exception of section 954(c)(3)(A)(i), or the 
special rules for export financing interest of sections 904(d)(2) and 
954(c)(2)(B), even if in the absence of this section the treatment of 
such stated interest would be governed by those sections.
    (3) Limitation. Section 864(d) and this section apply only with 
respect to the tax treatment of income derived from a trade or service 
receivable acquired from a related person. Therefore, neither section 
864(d) nor this section affects the characterization of an expense or 
loss of either the seller of a receivable or the obligor under a 
receivable. Accordingly, the obligor under a trade or service receivable 
shall not be allowed to treat any part of the purchase price of property 
or services as interest (other than amounts treated as interest under 
provisions other than section 864(d)).
    (b) Definitions. The following definitions apply for purposes of 
this section and Sec.  1.956-3T.
    (1) Trade or service receivable. The term ``trade or service 
receivable'' means any account receivable or evidence of indebtedness, 
whether or not issued at a discount and whether or not bearing stated 
interest, arising out of the disposition by a related person of property 
described in section 1221(l) (hereinafter referred to as ``inventory 
property'') or the performance of services by a related person.
    (2) Related person. A ``related person'' is:
    (i) A person who is a related person within the meaning of section 
267(b) and the regulations thereunder;
    (ii) A United States shareholder (as defined in section 951(b)); or
    (iii) A person who is related (within the meaning of section 267(b) 
and the regulations thereunder) to a United States shareholder.
    (c) Acquisition of a trade or service receivable--(1) General rule. 
A trade or service receivable is considered to be acquired by a person 
at the time when that person is entitled to receive all or a portion of 
the income from the trade or service receivable. A person who acquires a 
trade or service receivable (hereinafter referred to as the ``factor'') 
is considered to have acquired a trade or service receivable regardless 
of whether:
    (i) The acquisition is characterized for federal income tax purposes 
as a sale, a pledge of collateral for a loan, an assignment, a capital 
contribution, or otherwise;
    (ii) The factor takes title to or obtains physical possession of the 
trade or service receivable;
    (iii) The related person assigns the trade or service receivable 
with or without recourse:
    (iv) The factor or some other person is obligated to collect the 
payments due under the trade or service receivable;
    (v) The factor is liable for all property, excise, sales, or similar 
taxes due upon collection of the receivable;
    (vi) The factor advances the entire face amount of the trade or 
service receivable transferred;
    (vii) All trade or service receivables assigned by the related 
person are assigned to one factor; and
    (viii) The obligor under the trade or service receivable is notified 
of the assignment.
    (2) Example. The following example illustrates the application of 
paragraphs (a), (b), and (c)(1) of this section.

    Example. P, a domestic corporation, owns all of the outstanding 
stock of FS, a controlled foreign corporation. P manufactures and sells 
paper products to customers, including X, an unrelated domestic 
corporation. As part of a sales transaction, P takes back a trade 
receivable from X and sells the receivable to FS. Because FS has 
acquired a trade or service receivable from a related person, the income 
derived by FS from P's receivable is interest income described in 
paragraph (a)(1) of this section.

    (3) Indirect acquisitions--(i) Acquisition through unrelated person. 
A trade or service receivable will be considered to be acquired from a 
related person if it is acquired from an unrelated person who acquired 
(directly or indirectly) such receivable from a person who is a related 
person to the factor. The following example illustrates the application 
of this paragraph (c)(3)(i).

    Example. A, a United States citizen, owns all of the outstanding 
stock of FPHC, a foreign personal holding company. A performs 
engineering services within and without the United States for customers, 
including X, an

[[Page 378]]

unrelated corporation. A performs engineering services for X and takes 
back a service receivable. A sells the receivable to Y, an unrelated 
corporation engaged in the factoring business. Y resells the receivable 
to FPHC. Because FPHC has indirectly acquired a service receivable from 
a related person, the income derived by FPHC from A's receivable is 
interest income described in paragraph (a)(1) of this section.

    (ii) Acquisition by nominee or pass-through entity. A factor will be 
considered to have acquired a trade or service receivable held on its 
behalf by a nominee or by a partnership, simple trust, S corporation or 
other pass-through entity to the extent the factor owns (directly or 
indirectly) a beneficial interest in such partnership or other pass-
through entity. The rule of this paragraph (c)(3)(ii) does not limit the 
application of paragraph (c)(3)(iii) of this section regarding the 
characterization of trade or service receivables of unrelated persons 
acquired pursuant to certain swap or pooling arrangements. The following 
example illustrates the application of this paragraph (c)(3)(ii).

    Example. FS1, a controlled foreign corporation, acquires a 20 
percent limited partnership interest in PS, a partnership. PS purchases 
trade or service receivables resulting from the sale of inventory 
property by FS1's domestic parent, P. PS does not purchase receivables 
of any person who is related to any other partner in PS. FS1 is 
considered to have acquired a 20 percent interest in the receivables 
acquired by PS. Thus, FS1's distributive share of the income derived by 
PS from the receivables of P is considered to be interest income 
described in paragraph (a)(1) of this section.

    (iii) Swap or pooling arrangements. A trade or service receivable of 
a person unrelated to the factor will be considered to be a trade or 
service receivable acquired from a related person and subject to the 
rules of this section if it is acquired in accordance with an 
arrangement that involves two or more groups of related persons that are 
unrelated to each other and the effect of the arrangement is that one or 
more related persons in each group acquire (directly or indirectly) 
trade or service receivables of one or more unrelated persons who are 
also parties to the arrangement, in exchange for reciprocal purchases of 
the first group's receivables. The following example illustrates the 
application of this paragraph (c)(3)(iii).

    Example. Controlled foreign corporations A, B, C, and D are wholly-
owned subsidiaries of domestic corporations M, N, O, and P, 
respectively. M, N, O, and P are not related persons. According to a 
prearranged plan, A, B, C, and D each acquire trade or service 
receivables of M, N, O, and/or P, except that neither A, B, C nor D 
acquires receivables of its own parent corporation. Because the effect 
of this arrangement is that the unrelated groups acquire each other's 
trade or service receivables pursuant to the arrangement, income derived 
by A, B, C, and D from the receivables acquired from M, N, O, and P is 
interest income described in paragraph (a)(1) of this section.

    (iv) Financing arrangements. If a controlled foreign corporation (as 
defined in section 957(a)) participates (directly or indirectly) in a 
lending transaction that results in a loan to the purchaser of inventory 
property, services, or trade or service receivables of a related person 
(or a loan to a person who is related to the purchaser), and if the loan 
would not have been made or maintained on the same terms but for the 
corresponding purchase, then the controlled foreign corporation shall be 
considered to have indirectly acquired a trade or service receivable, 
and income derived by the controlled foreign corporation from such a 
loan shall be considered to be income described in paragraph (a)(1) of 
this section. For purposes of this paragraph (c)(3)(iv), it is 
immaterial that the sums lent are not, in fact, the sums used to finance 
the purchase of a related person's inventory property, services, or 
trade or service receivables. The amount of income derived by the 
controlled foreign corporation to be taken into account shall be the 
total amount of income derived from a lending transaction described in 
this paragraph (c)(3)(iv), if the amount lent is less than or equal to 
the purchase price of the inventory property, services, or trade or 
service receivables. If the amount lent is greater than the purchase 
price of the inventory property, services or receivables, the amount to 
be taken into account shall be the proportion of the interest charge 
(including original issue discount) that the purchase price bears to the 
total amount lent pursuant to the lending transaction. The following

[[Page 379]]

examples illustrate the application of this paragraph (c)(3)(iv).

    Example 1. P, a domestic corporation, owns all of the outstanding 
stock of FS1, a controlled foreign corporation engaged in the financing 
business in Country X. P manufactures and sells toys, including sales to 
C, an unrelated corporation. Prior to P's sale of toys to C for $2,000, 
D, a wholly-owned Country X subsidiary of C, borrows $3,000 from FS1. 
The loan from FS1 to D would not have been made or maintained on the 
same terms but for C's purchase of toys from P. Two-thirds of the income 
derived by FS1 from the loan to D is interest income described in 
paragraph (a)(1) of this section.
    Example 2. P, a domestic corporation, owns all of the outstanding 
stock of FS1, a controlled foreign corporation organized under the laws 
of Country X. FS1 has accumulated cash reserves. P has uncollected trade 
and service receivables of foreign obligors. FS1 makes a $1,000 loan to 
U, a foreign corporation that is unrelated to P or FS1. U purchases P's 
trade and service receivables for $2,000. The loan would not have been 
made or maintained on the same terms but for U's purchase of P's 
receivables. The income derived by U from the receivables is not 
interest income within the meaning of paragraph (a) of this section. 
However, the interest paid by U to FS1 is interest income described in 
paragraph (a)(1) of this section.
    Example 3. The facts are the same as in Example (2), except that U 
is a wholly-owned Country Y subsidiary of FS1. Because U is related to P 
within the meaning of paragraph (b)(2) of this section, under paragraph 
(c)(1) of this section, income derived by U from P's receivables is 
interest income described in paragraph (a)(1) of this section. In 
addition, the income derived by FS1 from the loan to U is interest 
income described in paragraph (a)(1) of this section.

    (d) Same country exception--(1) Income from trade or service 
receivables. Income derived from a trade or service receivable acquired 
from a related person shall not be treated as interest income described 
in paragraph (a)(1) of this section if:
    (i) The person acquiring the trade or service receivable and the 
related person are created or organized under the laws of the same 
foreign country;
    (ii) The related person has a substantial part of its assets used in 
its trade or business located in such foreign country; and
    (iii) The related person would not have derived foreign base company 
income, as defined in section 954(a) and the regulations thereunder, or 
income effectively connected with a United States trade or business from 
such receivable if the related person had collected the receivable.


For purposes of paragraph (d)(1)(ii) of this section, the standards 
contained in Sec.  1.954-2(e) shall apply in determining the location of 
a substantial part of the assets of a related person. For purposes of 
paragraph (d)(1)(iii) of this section, a determination of whether the 
related person would have derived foreign base company income shall be 
made without regard to the de minimis test described in section 
954(b)(3)(A). The following examples illustrate the application of this 
paragraph (d)(1).

    Example 1. FS1, a controlled foreign corporation incorporated under 
the laws of Country X, owns all of the outstanding stock of FS2, which 
is also incorporated under the laws of Country X. FS1 has a substantial 
part of its assets used in its business in Country X. FS1 manufactures 
and sells toys for use in Country Y. The toys sold are considered to be 
manufactured in Country X under Sec.  1.954-3(a)(2). FS1 is not 
considered to have a branch or similar establishment in Country Y that 
is treated as a separate corporation under section 954(d)(2) and Sec.  
1.954-3(b). Thus, gross income derived by FS1 from the toy sales is not 
foreign base company sales income. FS1 takes back receivables without 
stated interest from its customers. FS1 assigns those receivables to 
FS2. The income derived by FS2 from the receivables of FS1 is not 
interest income described in paragraph (a)(1) of this section, because 
it satisfies the same country exception under paragraph (d)(1) of this 
section.
    Example 2. The facts are the same as in Example 1, except that the 
toys sold by FS1 are purchased from FS1's U.S. parent and are sold for 
use outside of Country X. Thus, any income derived by FS1 from the sale 
of the toys would be foreign base company sales income. Therefore, 
income derived by FS2 from the receivables of FS1 is interest income 
described in paragraph (a)(1) of this section. FS2 is considered to 
derive interest income from the receivable even if, solely by reason of 
the de minimis rule of section 954(b)(3)(A), FS1 would not have derived 
foreign base company income if FS1 had collected the receivable.

    (2) Income from financing arrangements. Income derived by a 
controlled foreign corporation from a loan to a person that purchases 
inventory property or services of a person that is related to the 
controlled foreign corporation, or from other loans described in

[[Page 380]]

paragraph (c)(3)(iv) of this section, shall not be treated as interest 
income described in paragraph (a)(1) of this section if:
    (i) The person providing the financing and the related person are 
created or organized under the laws of the same foreign country;
    (ii) The related person has a substantial part of its assets used in 
its trade or business located in such foreign country; and
    (iii) The related person would not have derived foreign base company 
income or income effectively connected with a United States trade or 
business:
    (A) From the sale of inventory property or services to the borrower 
or from financing the borrower's purchase of inventory property or 
services, in the case of a loan to the purchaser of inventory property 
or services of a related person; or
    (B) From collecting amounts due under the receivable or from 
financing the purchase of the receivable, in the case of a loan to the 
purchaser of a trade or service receivable of a related person.


For purposes of paragraph (d)(2)(ii) of this section, the standards 
contained in Sec.  1.954-2(e) shall apply in determining the location of 
a substantial part of the assets of a related person. For purposes of 
paragraph (d)(2)(iii) of this section, a determination of whether the 
related person would have derived foreign base company income shall be 
made without regard to the de minimis test described in section 
954(b)(3)(A). The following examples illustrate the application of this 
paragraph (d)(2).

    Example 1. FS1, a controlled foreign corporation incorporated under 
the laws of Country X, owns all of the outstanding stock of FS2, which 
is also incorporated under the laws of Country X. FS1, which has a 
substantial part of its assets used in its business located in Country 
X, manufactures and sells toys for use in Country Y. The toys sold are 
considered to be manufactured in Country X under Sec.  1.954-3(a)(2). 
FS1 is not considered to have a branch or similar establishment in 
Country Y that is treated as a separate corporation under section 
954(d)(2) and Sec.  1.954-3(b). Thus, the gross income derived by FS1 
from the toy sales is not foreign base company sales income. FS2 makes a 
loan to FS3, a wholly-owned subsidiary of FS1 which is also incorporated 
under the laws of Country X, in connection with FS3's purchase of toys 
from FS1. FS3 does not earn any subpart F gross income. Thus, FS1 would 
not have derived foreign personal holding company interest income if FS1 
had made the loan to FS3, because the interest would be covered by the 
same country exception of section 954(c)(3). Therefore, the income 
derived by FS2 from its loan to FS3 is not treated as interest income 
described in paragraph (a)(1) of this section, because it satisfies the 
same country exception under paragraph (d)(2) of this section. Such 
income is also not treated as foreign personal holding company income 
described in section 954(c)(1)(A) because the same country exception of 
section 954(c)(3) also applies to the interest actually derived by FS2 
from its loan to FS3.
    Example 2. FS1, a controlled foreign corporation incorporated under 
the laws of Country X, owns all of the outstanding stock of FS2, which 
is also incorporated under the laws of Country X. FS1 purchases toys 
from its U.S. parent and resells them for use outside of Country X. As 
part of a sales transaction, FS1 takes back trade receivables. FS2 makes 
a loan to U, an unrelated corporation, to finance U's purchase of FS1's 
trade receivables. Because FS1 would have derived foreign base company 
income if FS1 had collected the receivables or made the loan itself, the 
same country exception of paragraph (d)(2) of this section does not 
apply. Accordingly, under paragraph (c)(3)(iv) of this section, the 
income derived by FS2 from its loan to U is treated as interest income 
described in paragraph (a)(1) of this section.

    (e) Special rules--(1) Foreign personal holding companies and 
controlled foreign corporations. For purposes of sections 551-558 
(relating to foreign personal holding companies), the exclusion provided 
by section 552(c) for interest described in section 954(c)(3)(A) shall 
not apply to income described in paragraph (a)(1) of this section. For 
purposes of the sections 951-964 (relating to controlled foreign 
corporations), income described in paragraph (a)(1) of this section 
shall be included in a United States shareholder's pro rata share of a 
controlled foreign corporation's subpart F income without regard to the 
de minimis rule under section 954(b)(3)(A). However, income described in 
paragraph (a)(1) of this section shall be included in the computation of 
a controlled foreign corporation's foreign base company income for 
purposes of applying the de minimis rule under section 954(b)(3)(A) and 
the more than 70 percent of gross income test under

[[Page 381]]

section 954(b)(3)(B). In addition, income described in paragraph (a)(1) 
of this section shall be considered to be subpart F income without 
regard to the exclusions from foreign base company income provided by 
section 954(c)(2)(B) (relating to export financing interest derived in 
the conduct of a banking business) and section 954(c)(3)(A)(i) (relating 
to certain interest income received from related persons).
    (2) Foreign tax credit. Income described in paragraph (a)(1) of this 
section shall be considered to be interest income for purposes of the 
section 904 foreign tax credit limitation and is not eligible for the 
exceptions for export financing interest provided in section 904(d)(2) 
(A)(iii)(II), (B)(ii), and (C)(iii). In addition, such income will be 
subject to the look-through rule for subpart F income set forth in 
section 904(d)(3) without regard to the de minimis exception provided in 
section 904(d)(3)(E).
    (3) Possessions corporations--(i) Limitation on credit. Income 
described in paragraph (a)(1) of this section shall not be treated as 
income described in section 936(a)(1) (A) or (B) unless the income is 
considered under the principles of Sec.  1.863-6 to be derived from 
sources within the possessions. Thus, the credit provided by section 936 
is not available for income described in paragraph (a)(1) of this 
section unless the obligor under the receivable is a resident of a 
possession. In the case of a loan described in section 864(d)(6), the 
credit provided by section 936 is not available for income described in 
paragraph (a)(1) of this section unless the purchaser of the inventory 
property or services is a resident of a possession.
    (ii) Eligibility determination. Notwithstanding the limitation on 
the availability of the section 936 credit for income described in 
paragraph (a)(1) of this section, if income treated as interest income 
under paragraph (a)(1) of this section is derived from sources within a 
possession (determined without regard to this section), such income 
shall be eligible for inclusion in a corporation's gross income for 
purposes of section 936(a)(2)(A). If such income is derived from the 
active conduct of a trade or business within a possession (determined 
without regard to this section), such income shall be eligible for 
inclusion in a corporation's gross income for purposes of section 
936(a)(2)(B). (These rules apply for purposes of determining whether a 
corporation is eligible to elect the credit provided under section 
936(a).)
    (iii) Example. The following example illustrates the application of 
paragraph (e)(3) of this section.

    Example. Corporation X is operating in a possession as a possessions 
corporation. In 1985, X earned $50,000 from the active conduct of a 
business in the possession, including $5,000 from trade or service 
receivables acquired from a related party. Obligors under the 
receivables acquired by X are not residents of the possession. 
Corporation X also earned $20,000 from activities other than its active 
conduct of business in the possession. The $5,000 derived by X from the 
receivables is not eligible for the section 936 credit. However, the 
$5,000 may be used by X to meet the percentage tests under section 
936(a)(2) to the extent that such income is considered to be derived 
from sources within the possession (for purposes of section 
936(a)(2)(A)) or is considered to be derived from the active conduct of 
a trade or business in the possession (for purposes of section 
936(a)(2)(B)), in either case determined without regard to the 
characterization of such income under this section.

    (f) Effective date. The provisions of this section shall apply with 
respect to accounts receivable and evidences of indebtedness transferred 
after March 1, 1984 and are effective June 14, 1988.

[T.D. 8209, 53 FR 22166, June 14, 1988]



Sec.  1.864(c)(8)-1  Gain or loss by foreign persons on the disposition 
of certain partnership interests.

    (a) Overview. This section provides rules and definitions under 
section 864(c)(8). Paragraph (b) of this section provides the general 
rule treating gain or loss recognized by a nonresident alien individual 
or foreign corporation from the sale or exchange of a partnership 
interest as effectively connected gain or effectively connected loss. 
Paragraph (c) of this section provides rules for determining the 
limitations on the amount of effectively connected gain or effectively 
connected loss under section 864(c)(8) and paragraph (b) of this 
section. Paragraph (d) of this section provides rules regarding 
coordination with section 897. Paragraph (e)

[[Page 382]]

of this section provides rules regarding certain tiered partnerships. 
Paragraph (f) of this section provides rules regarding U.S. income tax 
treaties. Paragraph (g) of this section provides definitions. Paragraph 
(h) of this section provides a rule regarding certain contributions of 
property to a partnership. Paragraph (i) of this section contains 
examples illustrating the rules set forth in this section. Paragraph (j) 
of this section provides the applicability date.
    (b) Gain or loss treated as effectively connected gain or loss--(1) 
In general. Notwithstanding any other provision of subtitle A of the 
Internal Revenue Code, if a foreign transferor owns, directly or 
indirectly, an interest in a partnership that is engaged in the conduct 
of a trade or business within the United States, outside capital gain, 
outside capital loss, outside ordinary gain, or outside ordinary loss 
(each as defined in paragraph (b)(2) of this section) recognized by the 
foreign transferor on the transfer of all (or any portion) of the 
interest is treated as effectively connected gain or effectively 
connected loss, subject to the limitations described in paragraph (b)(3) 
of this section. Except as provided in paragraph (d) of this section, 
this section does not apply to prevent any portion of the gain or loss 
that is otherwise treated as effectively connected gain or effectively 
connected loss under provisions of the Internal Revenue Code other than 
section 864(c)(8) from being so treated.
    (2) Determination of outside gain and loss--(i) In general. The 
amount of gain or loss recognized by the foreign transferor in 
connection with the transfer of its partnership interest is determined 
under all relevant provisions of the Internal Revenue Code and the 
regulations thereunder. See, e.g., Sec. Sec.  1.741-1(a) and 1.751-
1(a)(2). For purposes of this section, the amount of gain or loss that 
is treated as capital gain or capital loss under sections 741 and 751 is 
referred to as outside capital gain or outside capital loss, 
respectively. The amount of gain or loss that is treated as ordinary 
gain or ordinary loss under sections 741 and 751 is referred to as 
outside ordinary gain or outside ordinary loss, respectively.
    (ii) Nonrecognition provisions. A foreign transferor's gain or loss 
recognized in connection with the transfer of its partnership interest 
does not include gain or loss to the extent that the gain or loss is not 
recognized by reason of one or more nonrecognition provisions of the 
Internal Revenue Code.
    (3) Limitations. For purposes of applying this section, this 
paragraph (b)(3) limits the amount of gain or loss recognized by a 
foreign transferor that may be treated as effectively connected gain or 
effectively connected loss.
    (i) Capital gain limitation. Outside capital gain recognized by a 
foreign transferor is treated as effectively connected gain to the 
extent it does not exceed aggregate deemed sale EC capital gain 
determined under paragraph (c)(3)(ii)(B) of this section.
    (ii) Capital loss limitation. Outside capital loss recognized by a 
foreign transferor is treated as effectively connected loss to the 
extent it does not exceed aggregate deemed sale EC capital loss 
determined under paragraph (c)(3)(ii)(B) of this section.
    (iii) Ordinary gain limitation. Outside ordinary gain recognized by 
a foreign transferor is treated as effectively connected gain to the 
extent it does not exceed aggregate deemed sale EC ordinary gain 
determined under paragraph (c)(3)(ii)(A) of this section.
    (iv) Ordinary loss limitation. Outside ordinary loss recognized by a 
foreign transferor is treated as effectively connected loss to the 
extent it does not exceed aggregate deemed sale EC ordinary loss 
determined under paragraph (c)(3)(ii)(A) of this section.
    (c) Amount treated as effectively connected with the conduct of a 
trade or business within the United States. This paragraph (c) describes 
the steps to be followed in computing the limitations described in 
paragraph (b)(3) of this section.
    (1) Step 1: Determine deemed sale gain and loss. Determine the 
amount of gain or loss that the partnership would recognize with respect 
to each of its assets (other than interests in partnerships described in 
paragraph (e) of this section) upon a deemed sale of all of the 
partnership's assets on the date of the

[[Page 383]]

transfer of the partnership interest described in paragraph (b)(1) of 
this section (deemed sale). For this purpose, a deemed sale is treated 
as a sale by the partnership to an unrelated person of each of its 
assets (tangible and intangible) in a fully taxable transaction for cash 
in an amount equal to the fair market value of each asset (taking into 
account section 7701(g)) immediately before the partner's transfer of 
the interest in the partnership. For rules concerning the deemed sale of 
certain partnership interests, see paragraph (e) of this section.
    (2) Step 2: Determine deemed sale EC gain and loss--(i) In general--
(A) Effectively connected determination. With respect to each asset 
deemed sold in paragraph (c)(1) of this section, determine the amount of 
gain or loss from the deemed sale that would be treated as effectively 
connected gain or effectively connected loss (including by reason of 
section 897). Gain described in this paragraph (c)(2) is referred to as 
deemed sale EC gain, and loss described in this paragraph (c)(2) is 
referred to as deemed sale EC loss. Section 864 and the regulations 
thereunder apply for purposes of determining whether deemed sale gain or 
loss would be treated as effectively connected gain or loss. See 
paragraph (c)(2)(ii) of this section for sourcing rules that apply for 
purposes of determining deemed sale EC gain and deemed sale EC loss.
    (B) 10-year exception. For purposes of applying paragraph 
(c)(2)(i)(A) of this section, gain or loss from the deemed sale of an 
asset (other than a United States real property interest within the 
meaning of section 897(c)) will not be treated as deemed sale EC gain or 
deemed sale EC loss if--
    (1) No income or gain produced by the asset was taxable as income 
that was effectively connected with the conduct of a trade or business 
within the United States by the partnership (or the foreign transferor, 
a predecessor of the foreign transferor, or a predecessor of the 
partnership) during the lesser of the ten-year period ending on the date 
of the transfer or the period for which the partnership (and, if 
applicable, the foreign transferor, a predecessor of the foreign 
transferor, and a predecessor of the partnership) held the asset; and
    (2) The asset has not been used, or held for use, in the conduct of 
a trade or business within the United States by the partnership (or the 
foreign transferor, a predecessor of the foreign transferor, or a 
predecessor of the partnership) during that same period.
    (ii) Sourcing rules for determining deemed sale EC gain and deemed 
sale EC loss--(A) In general. For purposes of applying section 
865(e)(2)(A) in connection with the determination of deemed sale EC gain 
and deemed sale EC loss under this paragraph (c)(2)(ii)(A), except to 
the extent provided in paragraphs (c)(2)(ii)(B) through (E) of this 
section, the deemed sale of an asset will be treated as attributable to 
an office or other fixed place of business maintained by the partnership 
in the United States. However, if the partnership does not maintain an 
office or other fixed place of business in the United States (within the 
meaning of section 864(c)(5)(A) and Sec.  1.864-7), neither the office 
attribution described in this paragraph (c)(2)(ii)(A), nor the rules of 
paragraphs (c)(2)(ii)(B) through (E) of this section, will apply.
    (B) Look-back rule for sale of inventory property. The deemed sale 
of inventory property (as defined in section 865(i)(1)) will not be 
treated as attributable to an office or other fixed place of business 
maintained by the partnership in the United States to the extent of 
foreign source inventory gain or loss. Foreign source inventory gain or 
loss is determined by multiplying the deemed sale gain or deemed sale 
loss attributable to inventory property by the foreign source inventory 
ratio. The foreign source inventory ratio cannot exceed one. If the 
amount in paragraph (c)(2)(ii)(B)(1) of this section is not positive, 
the foreign source inventory ratio is zero. If the amount in paragraph 
(c)(2)(ii)(B)(1) of this section is positive, but the amount in 
paragraph (c)(2)(ii)(B)(2) of this section is not positive, the foreign 
source inventory ratio is one. The foreign source inventory ratio is--
    (1) The gross income of the partnership from sources without the 
United States (as determined under sections 865(b) and 865(e)(2)) that 
was attributable to inventory property sold during the lesser of--

[[Page 384]]

    (i) The period comprised of the partnership's three taxable years 
immediately preceding the date of the deemed sale, or
    (ii) The period beginning on the date the partnership (or any of its 
predecessors) was formed and ending on the last day of the partnership's 
taxable year immediately preceding the date of the deemed sale; over
    (2) The total gross income of the partnership that was attributable 
to inventory property sold during that same period.
    (C) Look-back rule for intangibles. The deemed sale of an intangible 
(as defined in section 865(d)(2), including going concern value) will 
not be treated as attributable to an office or other fixed place of 
business maintained by the partnership in the United States to the 
extent of foreign source intangible gain or loss. Foreign source 
intangible gain or loss is determined by multiplying the deemed sale 
gain or deemed sale loss from an intangible, without regard to any gain 
described in section 865(d)(4)(A), by the foreign source intangible 
ratio. The foreign source intangible ratio cannot exceed one. If the 
amount in paragraph (c)(2)(ii)(C)(1) of this section is not positive, 
the foreign source intangible ratio is zero. If the amount in paragraph 
(c)(2)(ii)(C)(1) of this section is positive, but the amount in 
paragraph (c)(2)(ii)(C)(2) of this section is not positive, the foreign 
source inventory ratio is one. The foreign source intangible ratio is--
    (1) The gross ordinary income (other than from dispositions of 
depreciable or amortizable property) of the partnership from sources 
without the United States that was not effectively connected with the 
conduct of a trade or business within the United States, during the 
lesser of--
    (i) The period comprised of the partnership's three taxable years 
immediately preceding the date of the deemed sale, or
    (ii) The period beginning on the date the partnership (or any of its 
predecessors) is formed and ending on the last day of the partnership's 
taxable year immediately preceding the year in which the deemed sale 
occurs; over
    (2) The total gross ordinary income (other than from dispositions of 
depreciable or amortizable property) of the partnership during that 
period.
    (D) Depreciable personal property--(1) Depreciation recapture. The 
deemed sale of depreciable personal property (as defined in section 
865(c)(4)(A)), including from the sale of an amortizable intangible (as 
defined in section 865(d)(2)), will not be treated as attributable to an 
office or other fixed place of business maintained by the partnership in 
the United States to the extent the deemed sale gain would be treated as 
from sources outside the United States after applying section 865(c)(1) 
at the time of the deemed sale.
    (2) Gain in excess of depreciation or loss with respect to 
depreciable personal property. For purposes of this section, if the 
deemed sale of depreciable personal property (other than an amortizable 
intangible) results in deemed sale gain in excess of the property's 
depreciation adjustments (as defined in section 865(c)(4)(B)), or 
results in deemed sale loss, attribution to an office or other fixed 
place of business maintained by the partnership in the United States 
with respect to the excess deemed sale gain, or deemed sale loss, will 
be determined based on where the property is located: If the property is 
located outside the United States, the excess deemed sale gain, or the 
deemed sale loss, will not be treated as attributable to an office or 
other fixed place of business maintained by the partnership in the 
United States; if the property is located within the United States, the 
excess deemed sale gain, or the deemed sale loss, will be treated as 
attributable to an office or other fixed place of business maintained by 
the partnership in the United States.
    (E) Material change in circumstances rule. If a material change in 
circumstances occurred that causes the applicable rule provided in 
paragraph (c)(2)(ii)(B) or (C) of this section to provide a sourcing 
result that is materially different from the sourcing result that would 
occur if the applicable period described in paragraph (c)(2)(ii)(B)(1) 
or (c)(2)(ii)(C)(1) of this section began on the date on which the 
material change in circumstance occurred and ended on the last day of 
the partnership's taxable year immediately preceding the year in which 
the deemed

[[Page 385]]

sale occurs (the modified look-back period), the applicable rule 
provided in paragraph (c)(2)(ii)(B) or (C) of this section may be 
applied by reference to the modified look-back period. The difference 
between the sourcing results is determined by comparing the foreign 
source inventory ratio (as described in paragraph (c)(2)(ii)(B) of this 
section) or the foreign source intangible ratio (as described in 
paragraph (c)(2)(ii)(C) of this section), as applicable, with the 
foreign source inventory ratio or foreign source intangible ratio, as 
applicable, if that ratio were determined by reference to the modified 
look-back period. For purposes of this paragraph (c)(2)(ii)(E), the 
sourcing results will not be materially different unless the percentage 
point difference between the ratios described in the preceding sentence 
is at least 30 percentage points.
    (iii) Examples. This paragraph (c)(2)(iii) provides examples that 
illustrate the rules of paragraph (c)(2)(ii) of this section. Except as 
otherwise provided, the following facts apply for purposes of this 
paragraph (c)(2)(iii). FP is a foreign corporation and a partner in PRS, 
a partnership that is engaged in the conduct of a trade or business 
within the United States (the U.S. Business) and a business in Country A 
(the Country A Business). Both businesses purchase inventory property 
and sell the purchased inventory property to unrelated customers; this 
is the only income-generating activity carried on by the businesses. PRS 
maintains an office or fixed place of business within the U.S. (within 
the meaning of section 864(c)(5)(A) and Sec.  1.864-7) and, for its U.S. 
business, PRS sells its inventory property through its U.S. office. For 
the Country A business, PRS sells its inventory property through its 
Country A office for consumption in Country A; PRS's Country A office 
materially participates in each sale. The gain or loss from the 
inventory sold through PRS's Country A office is treated as from sources 
without the United States and is not effectively connected with PRS's 
U.S. Business. In year 4, FP sells its entire interest in PRS, thereby 
triggering the deemed sale described in paragraph (c)(1) of this 
section. In the deemed sale, PRS recognizes $10x of gain on the sale of 
its inventory property (the only asset PRS holds other than goodwill and 
going concern value). The 10-year exception provided in paragraph 
(c)(2)(i)(B) of this section does not apply.
    (A) Example 1: Determining foreign source inventory gain--(1) Facts. 
Based on PRS's sales records for the three taxable years immediately 
preceding the date of the deemed sale, PRS's gross income from sources 
without the United States that is attributable to sales of inventory 
property is $12x and PRS's total gross income attributable to sales of 
inventory property during that period is $30x.
    (2) Analysis. To determine foreign source inventory gain or loss 
described in paragraph (c)(2)(ii)(B) of this section, the $10x deemed 
sale gain attributable to inventory property is multiplied by PRS's 
foreign source inventory ratio. PRS's foreign source inventory ratio is 
PRS's gross income from sources without the United States that are 
attributable to sales of inventory property within PRS's three taxable 
years preceding the date of the deemed sale, over PRS's total gross 
income attributable to sales of inventory property during the same 
period. Thus, based on PRS's sales records from the three taxable years 
preceding the date of the deemed sale, the foreign source inventory gain 
for PRS's inventory is $4x (the $10x deemed sale gain attributable to 
inventory multiplied by the foreign source inventory ratio of $12x over 
$30x).
    (B) Example 2: Determining deemed sale EC gain attributable to 
inventory property under the material change in circumstances rule--(1) 
Facts. The facts are the same as in paragraph (c)(2)(iii)(A)(1) of this 
section (the facts of Example 1 in this paragraph (c)(2)(iii)), except 
that at the beginning of year 3 (PRS's taxable year immediately 
preceding the date of the deemed sale), PRS started a new business in 
Country B (the Country B Business) to take advantage of favorable market 
prospects for its products in Country B. For the Country B Business, PRS 
sells its inventory property through its Country B office for 
consumption in Country B; PRS's Country B office materially participates 
in each

[[Page 386]]

such sale. The gain or loss from the inventory sold through PRS's 
Country B office is foreign source gain or loss. Also, at the beginning 
of year 3, PRS substantially reduced its U.S. Business as a result of 
market factors. As a result of these changes in year 3, 95% of PRS's 
inventory property is sold in its Country A Business and Country B 
Business (collectively, the Foreign Businesses) beginning on the date in 
which these changes occurred; accordingly, 5% of PRS' inventory property 
is sold in its U.S. Business after these changes. Based on PRS's sales 
records for the three taxable years preceding the date of the deemed 
sale, PRS's gross income from sources without the United States that are 
attributable to sales of inventory property is $15x and PRS's total 
gross income attributable to sales of inventory property during that 
period is $30x; for year 3, PRS's gross income from sources without the 
United States that are attributable to sales of inventory property is 
$9.5x, and PRS's total gross income attributable to sales of inventory 
property in Year 3 is $10x.
    (2) Analysis. The material change in circumstances rule described in 
paragraph (c)(2)(ii)(E) of this section applies if due to a material 
change in circumstances, the sourcing rule provided in paragraph 
(c)(2)(ii)(B) of this section provides a sourcing result that is 
materially different from the sourcing result that would occur if that 
sourcing rule was applied by reference to the modified look-back period; 
that is, the period beginning on the date in which a material chance in 
circumstances occurred and ending on the last day of the PRS's taxable 
year immediately preceding the date of the deemed sale. For this 
purpose, the reduction in PRS's U.S. business in year 3, coupled with 
the creation of the Country B Business in the same year, qualifies as a 
material change in circumstances. Thus, the modified look-back period 
consists of year 3; that is, the period starting at the beginning of 
year 3, the date in which the material change in circumstances occurred, 
and ending of the last day of year 3, the last day of PRS's taxable year 
immediately preceding the date of the deemed sale. Based on PRS's sales 
records for the three taxable years preceding the deemed sale, the 
foreign source inventory ratio, expressed as a percentage, is 50% ($15x 
attributable to PRS's gross income from sources without the United 
States with respect to sales of its inventory property, over $30x 
attributable to PRS's total gross income with respect to sales of its 
inventory property). Due to the material change in circumstances, 
however, 95% of PRS's inventory property is sold in its Foreign 
Businesses. ($9.5x attributable to PRS's gross income from sources 
without the United States with respect to sales of its inventory 
property, over $10x attributable to PRS's total gross income with 
respect to sales of its inventory property.) Accordingly, if PRS applied 
the sourcing rule provided in paragraph (c)(2)(ii)(B) of this section by 
reference to the modified look-back period, 95% ($9.5x/$10x), or $9.5x, 
of the gain would be attributable to sales for PRS's Foreign Businesses 
(gain from sources without the United States), and only 5% ($.5x/$10x), 
or $0.5x, of the gain would be attributable to sales for PRS's U.S. 
Business (gain from United States sources). The excess of the foreign 
source inventory ratio determined by reference to the modified look-back 
period (expressed as a percentage), over the foreign source inventory 
ratio (also expressed as a percentage) is 45%; that is 95% (as 
determined under the modified look-back period) minus 50% (as determined 
under the foreign source inventory ratio). Accordingly, the sourcing 
results are materially different because the 45 percentage point 
difference is greater than the 30 percentage point threshold provided in 
paragraph (c)(2)(ii)(E) of this section. Thus, the material change in 
circumstances rule of paragraph (c)(2)(ii)(E) of this section applies 
and the foreign source inventory gain determined under paragraph 
(c)(2)(ii)(B) of this section, determined by reference to the modified 
look-back period, is $9.5x; that is, the deemed sale gain attributable 
to inventory property ($10x), multiplied by the foreign source inventory 
ratio determined by reference to the modified look-back period ($9.5x/
$10x).
    (3) Step 3: Determine the foreign transferor's distributive share of 
deemed sale

[[Page 387]]

EC gain or deemed sale EC loss--(i) In general. A foreign transferor's 
distributive share of deemed sale EC gain or deemed sale EC loss with 
respect to each asset is the amount of the deemed sale EC gain and 
deemed sale EC loss determined under paragraph (c)(2) of this section 
that would have been allocated to the foreign transferor by the 
partnership under all applicable Internal Revenue Code sections 
(including section 704) upon the deemed sale described in paragraph 
(c)(1) of this section, taking into account allocations of tax items 
applying the principles of section 704(c), including any remedial 
allocations (see Sec.  1.704-3(d)), and any section 743(b) basis 
adjustments (see Sec.  1.743-1(j)(3)). For this purpose, a foreign 
transferor's distributive share of deemed sale EC gain or deemed sale EC 
loss does not include any amount that is excluded from the foreign 
transferor's gross income or otherwise exempt from U.S. Federal income 
tax by reason of an applicable provision of the Internal Revenue Code 
(including, for example, by reason of section 864(b)(2), 872(b), or 
883). Similarly, a foreign transferor's distributive share of deemed 
sale EC gain or deemed sale EC loss does not include any amount to which 
an exception under section 897 applies, such as section 897(k) or 
section 897(l), if that amount is not otherwise treated as effectively 
connected under a provision of the Code. For rules regarding the 
determination of a foreign transferor's distributive share of deemed 
sale EC gain and deemed sale EC loss under an applicable U.S. income tax 
treaty, see paragraph (f) of this section.
    (ii) Aggregate deemed sale EC items--(A) Ordinary gain or loss. A 
foreign transferor's aggregate deemed sale EC ordinary gain (if the net 
aggregate of the foreign transferor's distributive share of the deemed 
sale EC ordinary gain and loss is a gain) or aggregate deemed sale EC 
ordinary loss (if the net aggregate of the foreign transferor's 
distributive share of the deemed sale EC ordinary gain and loss is a 
loss) is determined by taking into account--
    (1) The portion of the foreign transferor's distributive share of 
deemed sale EC gain and deemed sale EC loss that is attributable to the 
deemed sale of the partnership's assets that are section 751(a) 
property; and
    (2) Deemed sale EC gain and deemed sale EC loss from the deemed sale 
of assets that are section 751(a) property that would be allocated to 
the foreign transferor with respect to interests in partnerships that 
are engaged in the conduct of a trade or business within the United 
States under paragraph (e)(1)(ii) of this section upon the deemed asset 
sales described in paragraph (e)(1)(i) of this section.
    (B) Capital gain or loss. A foreign transferor's aggregate deemed 
sale EC capital gain (if the net aggregate of the foreign transferor's 
distributive share of the deemed sale EC capital gain and loss is a 
gain) or aggregate deemed sale EC capital loss (if the net aggregate of 
the foreign transferor's distributive share of the deemed sale EC 
capital gain and loss is a loss) is determined by taking into account--
    (1) The portion of the foreign transferor's distributive share of 
deemed sale EC gain and deemed sale EC loss that is attributable to the 
deemed sale of assets that are not section 751(a) property; and
    (2) Deemed sale EC gain and deemed sale EC loss from the sale of 
assets that are not section 751(a) property and that would be allocated 
to the foreign transferor with respect to all interests in partnerships 
that are engaged in the conduct of a trade or business within the United 
States under paragraph (e)(1)(ii) of this section upon the deemed asset 
sales described in paragraph (e)(1)(i) of this section.
    (iii) Partial transfers. If a foreign transferor transfers less than 
all of its interest in a partnership, then for purposes of paragraph 
(c)(3)(i) of this section, the foreign transferor's distributive share 
of deemed sale EC gain and deemed sale EC loss is determined by 
reference to the amount of deemed sale EC gain or deemed sale EC loss 
determined under paragraph (c)(3)(i) of this section that is 
attributable to the portion of the foreign transferor's partnership 
interest that was transferred.
    (d) Coordination with section 897. If a foreign transferor transfers 
an interest in a partnership in a transfer that is subject to section 
864(c)(8) and the partnership owns one or more United

[[Page 388]]

States real property interests (as defined in section 897(c)), then the 
foreign transferor determines its effectively connected gain and 
effectively connected loss under this section, and not pursuant to 
section 897(g). Accordingly, with respect to a transfer that is subject 
to section 864(c)(8), section 864(c)(8)(C) does not reduce the amount of 
gain or loss treated as effectively connected gain or loss under this 
section. For rules regarding a transfer not subject to section 864(c)(8) 
of an interest in a partnership that owns one or more United States real 
property interests, see section 897(g) and the regulations thereunder. 
If a foreign transferor transfers an interest in a partnership in the 
manner described in paragraph (b)(2)(ii) of this section, the transfer 
is treated as not subject to section 864(c)(8) to the extent of the gain 
or loss that is not recognized; instead, if the partnership owns one or 
more United States real property interests at the time of transfer, the 
rules of section 897(g) and the regulations thereunder apply to the 
unrecognized gain or loss.
    (e) Tiered partnerships--(1) Transfers of upper-tier partnerships. 
Assets sold in a deemed sale described in paragraph (c)(1) of this 
section do not include interests in partnerships that are engaged in the 
conduct of a trade or business within the United States or interests in 
partnerships that hold, directly or indirectly, partnerships that are 
engaged in the conduct of a trade or business within the United States. 
Rather, if a foreign transferor transfers an interest in a partnership 
(upper-tier partnership) that owns, directly or indirectly, an interest 
in one or more partnerships that are engaged in the conduct of a trade 
or business within the United States, then--
    (i) Beginning with the lowest-tier partnership that is engaged in 
the conduct of a trade or business within the United States in a chain 
of partnerships and going up the chain, each partnership that is engaged 
in the conduct of a trade or business within the United States is 
treated as selling its assets in a deemed sale in accordance with the 
principles of paragraph (c)(1) of this section; and
    (ii) Each partnership must determine its deemed sale EC gain and 
deemed sale EC loss in accordance with the principles of paragraph 
(c)(2) of this section, and determine the distributive share of deemed 
sale EC gain and deemed sale EC loss for each partner that is either a 
partnership (in which the foreign transferor is a direct or indirect 
partner) or a foreign transferor, in accordance with the principles of 
paragraph (c)(3)(i) of this section.
    (2) Transfers by upper-tier partnerships. If a foreign transferor is 
a direct or indirect partner in an upper-tier partnership and the upper-
tier partnership transfers an interest in a partnership that is engaged 
in the conduct of a trade or business within the United States 
(including a partnership held indirectly through one or more 
partnerships), then the principles of this section (including paragraph 
(e)(1) of this section) apply with respect to the gain or loss on the 
transfer that is allocated to the foreign transferor by the upper-tier 
partnership.
    (3) Coordination with section 897. For purposes of this paragraph 
(e), a lower-tier partnership that holds one or more United States real 
property interests is treated as engaged in the conduct of a trade or 
business within the United States.
    (f) Treaty coordination. This paragraph (f) describes how paragraph 
(c)(3) of this section applies in the case of a transfer of an interest 
in a partnership by a foreign transferor that is eligible for benefits 
under an applicable U.S. income tax treaty. As a general matter, a 
foreign transferor must satisfy the requirements of the limitation on 
benefits article, if any, in the treaty between the jurisdiction in 
which the transferor is resident and the United States to be eligible 
for treaty benefits. In the case of a foreign transferor that is 
entitled to treaty benefits, in determining the foreign transferor's 
distributive share of deemed sale EC gain and deemed sale EC loss, gain 
or loss derived by the foreign transferor attributable to assets deemed 
sold that would be exempt from tax under an applicable U.S. income tax 
treaty if disposed of by the partnership are not taken into account 
under paragraph (c)(3) of this section. In general, gain or

[[Page 389]]

loss on the alienation of a partnership interest will be treated as 
effectively connected gain or loss under section 864(c)(8) to the extent 
that the gain or loss is either attributable to assets forming part of a 
U.S. permanent establishment or fixed place of business, or taxable 
under a provision governing the disposition of United States real 
property interests. Gain or loss from the alienation of a partnership 
interest will be considered gain or loss attributable to the alienation 
of assets forming part of a permanent establishment or fixed place of 
business in the United States to the extent the assets deemed sold under 
section 864(c)(8) form a part of the U.S. permanent establishment or 
fixed place of business of the partnership. If, however, after applying 
treaty benefits in paragraph (c)(3) of this section, the only gains or 
losses that would be taken into account are gains or losses attributable 
to United States real property interests, the foreign transferor 
determines its effectively connected gain and effectively connected loss 
pursuant to section 897 and not under this section.
    (g) Definitions. The following definitions apply for purposes of 
this section.
    (1) Effectively connected gain. The term effectively connected gain 
means gain that is treated as effectively connected with the conduct of 
a trade or business within the United States.
    (2) Effectively connected loss. The term effectively connected loss 
means loss treated as effectively connected with the conduct of a trade 
or business within the United States.
    (3) Foreign transferor. The term foreign transferor means a 
nonresident alien individual or foreign corporation.
    (4) Section 751(a) property. The term section 751(a) property means 
unrealized receivables described in section 751(c) and inventory items 
described in section 751(d).
    (5) Transfer. The term transfer means a sale, exchange, or other 
disposition, and includes a distribution from a partnership to a partner 
to the extent that gain or loss is recognized on the distribution, as 
well as a transfer treated as a sale or exchange under section 
707(a)(2)(B).
    (h) Anti-stuffing rule. If a foreign transferor (or a person that is 
related to a foreign transferor within the meaning of section 267(b) or 
707(b)) transfers property (including another partnership interest) to a 
partnership in a transaction with a principal purpose of reducing the 
amount of gain treated as effectively connected gain, or increasing the 
amount of loss treated as effectively connected loss, under section 
864(c)(8) or section 897, the transfer is disregarded for purposes of 
section 864(c)(8) or section 897, as appropriate.
    (i) Examples. This paragraph (i) provides examples that illustrate 
the rules of this section. Except as otherwise provided, the following 
facts are presumed for purposes of this paragraph (i). FP is a foreign 
corporation. USP is a domestic corporation. PRS is a partnership that 
was formed on January 1, 2018, when FP and USP each contributed $100x in 
cash. PRS has made no distributions and received no contributions other 
than those described in the preceding sentence. FP's adjusted basis in 
its interest in PRS is $100x. X is a foreign corporation that is 
unrelated to FP, USP, or PRS. Upon the formation of PRS, FP and USP 
entered into an agreement providing that all income, gain, loss, and 
deduction of PRS will be allocated equally between FP and USP. PRS is 
engaged in the conduct of a trade or business within the United States 
(the U.S. Business) and an unrelated business in Country A (the Country 
A Business). In a deemed sale described in paragraph (c)(1) of this 
section, gain or loss on assets of the U.S. Business would be treated as 
effectively connected gain or effectively connected loss, and gain or 
loss on assets of the Country A Business would not be so treated 
(including by reason of paragraph (c)(2)(i)(B) of this section). PRS has 
no liabilities.
    (1) Example 1. Deemed sale limitation--(i) Facts. On January 1, 
2019, FP sells its entire interest in PRS to X for $105x. FP does not 
qualify for the benefits of an income tax treaty between the United 
States and another country. Immediately before the sale, PRS's balance 
sheet appears as follows:

[[Page 390]]



----------------------------------------------------------------------------------------------------------------
                                                                                                   Fair market
                                                                               Adjusted basis         value
----------------------------------------------------------------------------------------------------------------
U.S. Business section 1231 asset............................................             $100x             $104x
Country A Business capital asset............................................              100x              106x
                                                                             -----------------------------------
    Total...................................................................              200x              210x
----------------------------------------------------------------------------------------------------------------

    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest in 
PRS to X. For purposes of this example, for simplicity, PRS is assumed 
to hold no section 751(a) property and depreciation recapture is assumed 
to be zero. FP recognizes a $5x capital gain under section 741, which is 
an outside capital gain within the meaning of paragraph (b)(2)(i) of 
this section. Under paragraph (b)(1) of this section, FP's $5x capital 
gain is treated as effectively connected gain to the extent that it does 
not exceed the limitation described in paragraph (b)(3)(i) of this 
section, which is FP's aggregate deemed sale EC capital gain.
    (B) Deemed sale. FP's aggregate deemed sale EC capital gain is 
determined according to the three-step process set forth in paragraph 
(c) of this section. First, the amount of gain or loss that PRS would 
recognize with respect to each of its assets upon a deemed sale 
described in paragraph (c)(1) of this section is a $4x gain with respect 
to the U.S. Business section 1231 asset and a $6x gain with respect to 
the Country A Business capital asset. Second, under paragraph (c)(2) of 
this section, PRS's deemed sale EC gain is $4x. Third, under paragraph 
(c)(3)(ii)(B) of this section, FP's aggregate deemed sale EC capital 
gain is $2x (that is, the aggregate of its distributive share of deemed 
sale EC gain attributable to the deemed sale of assets that are not 
section 751(a) property, which is 50% of $4x).
    (C) Limitation. Under paragraph (b)(3)(i) of this section, the $5x 
outside capital gain recognized by FP is treated as effectively 
connected gain to the extent that it does not exceed FP's $2x aggregate 
deemed sale EC capital gain. Accordingly, FP recognizes $2x of capital 
gain that is treated as effectively connected gain.
    (2) Example 2. Outside gain limitation--(i) Facts. On January 1, 
2019, FP sells its entire interest in PRS to X for $110x. FP does not 
qualify for the benefits of an income tax treaty between the United 
States and another country. Immediately before the sale, PRS's balance 
sheet appears as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   Fair market
                                                                               Adjusted basis         value
----------------------------------------------------------------------------------------------------------------
U.S. Business section 1231 asset............................................             $100x             $150x
Country A Business capital asset............................................              100x               70x
                                                                             -----------------------------------
    Total...................................................................              200x              220x
----------------------------------------------------------------------------------------------------------------

    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest in 
PRS to X. For purposes of this example, for simplicity, PRS is assumed 
to hold no section 751(a) property and depreciation recapture is assumed 
to be zero. FP recognizes a $10x capital gain under section 741, which 
is an outside capital gain within the meaning of paragraph (b)(2)(i) of 
this section. Under paragraph (b)(1) of this section, FP's $10x capital 
gain is treated as effectively connected gain to the extent that it does 
not exceed the limitation described in paragraph (b)(3)(i) of this 
section, which is FP's aggregate deemed sale EC capital gain.
    (B) Deemed sale. FP's aggregate deemed sale EC capital gain is 
determined according to the three-step process set forth in paragraph 
(c) of this section. First, the amount of gain or

[[Page 391]]

loss that PRS would recognize with respect to each of its assets upon a 
deemed sale described in paragraph (c)(1) of this section is a $50x gain 
with respect to the U.S. Business section 1231 asset and a $30x loss 
with respect to the Country A Business capital asset. Second, under 
paragraph (c)(2) of this section, PRS's deemed sale EC gain is $50x. 
Third, under paragraph (c)(3)(ii)(B) of this section, FP's aggregate 
deemed sale EC capital gain is $25x (that is, the aggregate of its 
distributive share of deemed sale EC gain attributable to the deemed 
sale of assets that are not section 751(a) property, which is 50% of 
$50x).
    (C) Limitation. Under paragraph (b)(3)(i) of this section, the $10x 
outside capital gain recognized by FP is treated as effectively 
connected gain to the extent that it does not exceed FP's $25x aggregate 
deemed sale EC capital gain. Accordingly, FP recognizes $10x of capital 
gain that is treated as effectively connected gain.
    (3) Example 3. Interaction with section 751(a)--(i) Facts. On 
January 1, 2019, FP sells its entire interest in PRS to X for $95x. FP 
does not qualify for the benefits of an income tax treaty between the 
United States and another country. Through both its U.S. Business and 
its Country A Business, PRS holds inventory items and receivables that 
are section 751 property (as defined in Sec.  1.751-1(a)). Immediately 
before the sale, PRS's balance sheet appears as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                   Fair market
                                                                               Adjusted basis         value
----------------------------------------------------------------------------------------------------------------
U.S. Business section 1231 asset............................................              $20x              $50x
U.S. Business inventory and receivables.....................................               30x               50x
Country A Business capital asset............................................              100x               80x
Country A Business inventory................................................               50x               10x
                                                                             -----------------------------------
    Total...................................................................              200x              190x
----------------------------------------------------------------------------------------------------------------

    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest in 
PRS to X. Under sections 741 and 751, FP recognizes a $10x ordinary loss 
and a $5x capital gain. See Sec.  1.751-1(a). Under paragraph (b)(2)(i) 
of this section, FP has outside ordinary loss equal to $10x and outside 
capital gain equal to $5x. Under paragraph (b)(1) of this section, FP's 
outside ordinary loss and outside capital gain are treated as 
effectively connected loss and effectively connected gain to the extent 
that each does not exceed the applicable limitation described in 
paragraph (b)(3) of this section. In the case of FP's outside ordinary 
loss, the applicable limitation is FP's aggregate deemed sale EC 
ordinary loss. In the case of FP's outside capital gain, the applicable 
limitation is FP's aggregate deemed sale EC capital gain.
    (B) Deemed sale. FP's aggregate deemed sale EC ordinary loss and 
aggregate deemed sale EC capital gain are determined according to the 
three-step process set forth in paragraph (c) of this section.
    (1) Step 1. The amount of gain or loss that PRS would recognize with 
respect to each of its assets upon a deemed sale described in paragraph 
(c)(1) of this section is as follows:

------------------------------------------------------------------------
                          Asset                             Gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................            $30x
U.S. Business inventory and receivables.................             20x
Country A Business capital asset........................           (20x)
Country A Business inventory............................           (40x)
------------------------------------------------------------------------

    (2) Step 2. Under paragraph (c)(2) of this section, PRS's deemed 
sale EC gain and deemed sale EC loss must be determined with respect to 
each asset. The amounts determined under paragraph (c)(2) of this 
section are as follows:

------------------------------------------------------------------------
                                                          Deemed sale EC
                          Asset                             gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................            $30x
U.S. Business inventory and receivables.................             20x
Country A Business capital asset........................               0
Country A Business inventory............................               0
------------------------------------------------------------------------

    (3) Step 3. Under paragraph (c)(3)(ii)(B) of this section, FP's 
aggregate deemed sale EC capital gain is

[[Page 392]]

$15x (that is, the aggregate of its distributive share of deemed sale EC 
gain that is attributable to the deemed sale of assets that are not 
section 751(a) property, which is 50% of $30x) and FP's aggregate deemed 
sale EC ordinary loss is $0 (that is, the aggregate of its distributive 
share of deemed sale EC loss that is attributable to the deemed sale of 
assets that are section 751(a) property).
    (C) Limitation--(i) Capital gain. Under paragraph (b)(3)(i) of this 
section, the $5x outside capital gain recognized by FP is treated as 
effectively connected gain to the extent that it does not exceed FP's 
$15x aggregate deemed sale EC capital gain. Accordingly, the amount of 
FP's capital gain that is treated as effectively connected gain is $5x.
    (ii) Ordinary loss. Under paragraph (b)(3)(iv) of this section, the 
$10x outside ordinary loss recognized by FP is treated as effectively 
connected loss to the extent that it does not exceed FP's $0 aggregate 
deemed sale EC ordinary loss. Accordingly, the amount of FP's ordinary 
loss that is treated as effectively connected loss is $0.
    (4) Example 4. Coordination with income tax treaties--(i) Facts--(A) 
Sale of interest. On January 1, 2019, FP sells its entire interest in 
PRS to X for $105x. Immediately before the sale, PRS's balance sheet 
appears as follows:

------------------------------------------------------------------------
                                                           Fair market
                                       Adjusted basis         value
------------------------------------------------------------------------
U.S. Business section 1231 asset....             $100x             $104x
Country A Business capital asset....              100x              106x
                                     -----------------------------------
    Total...........................              200x              210x
------------------------------------------------------------------------

    (B) Treaty benefits. FP is a qualified resident of Country A under a 
U.S. income tax treaty between the United States and Country A that is 
similar or identical in all material respects to the 2006 U.S. Model 
Income Tax Convention (the Treaty). PRS is treated as fiscally 
transparent for purposes of Country A tax law. PRS does not carry on its 
U.S. Business through a U.S. permanent establishment (PE).
    (ii) Analysis--(A) Outside gain or loss. FP is a foreign transferor 
(within the meaning of paragraph (g)(3) of this section) and transfers 
(within the meaning of paragraph (g)(5) of this section) its interest in 
PRS to X. For purposes of this example, for simplicity, PRS is assumed 
to hold no section 751(a) property and depreciation recapture is assumed 
to be zero. FP recognizes a $5x capital gain under section 741, which is 
an outside capital gain within the meaning of paragraph (b)(2)(i) of 
this section. Under paragraph (b)(1) of this section, FP's $5x capital 
gain is treated as effectively connected gain to the extent that it does 
not exceed the limitation described in paragraph (b)(3)(i) of this 
section, which is FP's aggregate deemed sale EC capital gain.
    (B) Deemed sale. FP's aggregate deemed sale EC capital gain is 
determined according to the three-step process set forth in paragraph 
(c) of this section by taking into account the treaty coordination rule 
under paragraph (f) of this section.
    (1) Step 1. The amount of gain or loss that PRS would recognize with 
respect to each of its assets upon a deemed sale described in paragraph 
(c)(1) of this section is as follows:

------------------------------------------------------------------------
                          Asset                             Gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................             $4x
Country A Business capital asset........................              6x
------------------------------------------------------------------------

    (2) Step 2. Under paragraph (c)(2) of this section, PRS's deemed 
sale EC gain is as follows:

------------------------------------------------------------------------
                          Asset                             Gain/(loss)
------------------------------------------------------------------------
U.S. Business section 1231 asset........................             $4x
Country A Business capital asset........................              0x
------------------------------------------------------------------------

    (3) Step 3. FP is eligible for benefits under the Treaty and derives 
the gain on the deemed sale of U.S. Business section 1231 asset. Under 
paragraph (c)(3)(i) and paragraph (f) of this section, because gain from 
the disposition of the U.S. Business section 1231 asset does not form 
part of a U.S. PE, the

[[Page 393]]

gain is exempt from U.S. tax under the Treaty, and is not taken into 
account in determining FP's distributive share of deemed sale EC gain 
under paragraphs (c)(3)(i) and paragraph (f) of this section. Therefore, 
FP's aggregate deemed sale EC capital gain is $0x under paragraph 
(c)(3)(ii)(B) of this section.
    (C) Limitation. Under paragraph (b)(3)(i) of this section, the $5x 
outside capital gain recognized by FP is not treated as effectively 
connected gain since all of it would exceed FP's $0x aggregate deemed 
sale EC capital gain.
    (j) Applicability date. This section applies to transfers occurring 
on or after December 26, 2018, and to amounts received on or after 
December 26, 2018, pursuant to an installment sale (as defined in 
section 453(b)) occurring on or after November 27, 2017.

[T.D. 9919, 85 FR 70965, Nov. 6, 2020]



Sec.  1.864(c)(8)-2  Notification and reporting requirements.

    (a) Notification by foreign transferor--(1) In general. Except as 
provided in paragraph (a)(2) of this section, a notifying transferor 
that transfers an interest in a specified partnership must notify the 
partnership of the transfer in writing within 30 days after the 
transfer. The notification must include--
    (i) The names and addresses of the notifying transferor and the 
transferee or transferees;
    (ii) The U.S. taxpayer identification number (TIN) of the notifying 
transferor and, if known, of the transferee or transferees; and
    (iii) The date of the transfer.
    (2) Exceptions--(i) Certain interests in publicly traded 
partnerships. Paragraph (a)(1) of this section does not apply to a 
notifying transferor that transfers an interest in a publicly traded 
partnership if the interest is publicly traded on an established 
securities market or is readily tradable on a secondary market (or the 
substantial equivalent thereof).
    (ii) Certain distributions. Paragraph (a)(1) of this section does 
not apply to a notifying transferor that is treated as transferring an 
interest in a specified partnership because it received a distribution 
from that specified partnership.
    (3) Section 6050K. The notification described in paragraph (a)(1) of 
this section may be combined with or provided at the same time as the 
notification described in Sec.  1.6050K-1(d), provided that it satisfies 
the requirements of both sections.
    (4) Other guidance. The notification described in paragraph (a)(1) 
of this section must also include any information prescribed by the 
Commissioner in forms or instructions or in publications or guidance 
published in the Internal Revenue Bulletin (see Sec. Sec.  601.601(d)(2) 
and 601.602 of this chapter).
    (b) Reporting by specified partnerships with notifying transferor--
(1) In general--(i) Requirement to provide statement. A specified 
partnership must provide to a notifying transferor the statement 
described in paragraph (b)(2) of this section if--
    (A) The partnership receives the notice described in paragraph (a) 
of this section, or otherwise has actual knowledge that there has been a 
transfer of an interest in the partnership by a notifying transferor; 
and
    (B) At the time of the transfer, the notifying transferor would have 
had a distributive share of deemed sale EC gain or deemed sale EC loss 
within the meaning of Sec.  1.864(c)(8)-1(c).
    (ii) Distributions. For purposes of paragraph (b)(1)(i)(B) of this 
section, a specified partnership that is a transferee because it makes a 
distribution is treated as having actual knowledge of that transfer.
    (2) Contents of statement. The statement required to be furnished by 
the specified partnership under paragraph (b)(1) of this section must 
include--
    (i) The items described in Sec.  1.864(c)(8)-1(c)(3)(ii) (foreign 
transferor's aggregate deemed sale EC items, which includes items 
derived from lower-tier partnerships);
    (ii) Whether the items described in paragraph (b)(2)(i) of this 
section were determined (in whole or in part) under Sec.  1.864(c)(8)-
1(c)(2)(ii)(E) (material change in circumstances rule for determining 
deemed sale EC gain or deemed sale EC loss from a deemed sale of the 
partnership's inventory property or intangibles); and

[[Page 394]]

    (iii) Any other information as may be prescribed by the Commissioner 
in forms, instructions, publications, or guidance published in the 
Internal Revenue Bulletin (see Sec. Sec.  601.601(d)(2) and 601.602 of 
this chapter).
    (3) Time for furnishing statement. The specified partnership must 
furnish the required information on or before the due date (with 
extensions) for issuing Schedule K-1 (Form 1065), Partner's Share of 
Income, Deductions, Credits, etc., or other statement required to be 
furnished under Sec.  1.6031(b)-1T, to the notifying transferor for the 
year of the transfer. See Sec.  1.6031(b)-1T(b).
    (4) Manner of furnishing statement. The statement required to be 
furnished under paragraph (b)(1) of this section must be provided on 
Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, 
Credits, etc., or other statement required to be furnished under Sec.  
1.6031(b)-1T.
    (5) Partnership notifying transferor. For purposes of this paragraph 
(b), a specified partnership must treat a notifying transferor that is a 
partnership as a nonresident alien individual.
    (c) Statement may be provided to agent. A specified partnership may 
provide a statement required under paragraph (b)(2) of this section to a 
person other than the notifying transferor if the person is described in 
Sec.  1.6031(b)-1T(c).
    (d) Definitions. The following definitions apply for purposes of 
this section.
    (1) Notifying transferor. The term notifying transferor means any 
foreign person, any domestic partnership that has a foreign person as a 
direct partner, and any domestic partnership that has actual knowledge 
that a foreign person indirectly holds, through one or more 
partnerships, an interest in the domestic partnership.
    (2) Specified partnership. The term specified partnership means a 
partnership that is engaged in a trade or business within the United 
States or that owns (directly or indirectly) an interest in a 
partnership that is engaged in a trade or business within the United 
States.
    (3) Transfer. The term transfer has the meaning provided in Sec.  
1.864(c)(8)-1(g)(5).
    (e) Applicability dates. Paragraph (a) of this section applies to 
transfers that occur on or after November 30, 2020. Paragraphs (b) and 
(c) of this section apply to returns filed on or after November 30, 
2020. Paragraph (d) of this section applies beginning on November 30, 
2020.

[T.D. 9926, 85 FR 76931, Nov. 30, 2020]



Sec.  1.865-1  Loss with respect to personal property other than stock.

    (a) General rules for allocation of loss--(1) Allocation against 
gain. Except as otherwise provided in Sec.  1.865-2 and paragraph (c) of 
this section, loss recognized with respect to personal property shall be 
allocated to the class of gross income and, if necessary, apportioned 
between the statutory grouping of gross income (or among the statutory 
groupings) and the residual grouping of gross income, with respect to 
which gain from a sale of such property would give rise in the hands of 
the seller. For purposes of this section, loss includes bad debt 
deductions under section 166 and loss on property that is marked-to-
market (such as under section 475) and subject to the rules of this 
section. Thus, for example, loss recognized by a United States resident 
on the sale or worthlessness of a bond generally is allocated to reduce 
United States source income.
    (2) Loss attributable to foreign office. Except as otherwise 
provided in Sec.  1.865-2 and paragraph (c) of this section, and except 
with respect to loss subject to paragraph (b) of this section, in the 
case of loss recognized by a United States resident with respect to 
property that is attributable to an office or other fixed place of 
business in a foreign country within the meaning of section 865(e)(3), 
the loss shall be allocated to reduce foreign source income if a gain on 
the sale of the property would have been taxable by the foreign country 
and the highest marginal rate of tax imposed on such gains in the 
foreign country is at least 10 percent. However, paragraph (a)(1) of 
this section and not this paragraph (a)(2) will apply if gain on the 
sale of such property would be sourced under section 865(c), (d)(1)(B), 
or (d)(3).
    (3) Loss recognized by United States citizen or resident alien with 
foreign tax home. Except as otherwise provided in Sec.  1.865-2 and 
paragraph (c) of this section, and except with respect to loss

[[Page 395]]

subject to paragraph (b) of this section, in the case of loss with 
respect to property recognized by a United States citizen or resident 
alien that has a tax home (as defined in section 911(d)(3)) in a foreign 
country, the loss shall be allocated to reduce foreign source income if 
a gain on the sale of such property would have been taxable by a foreign 
country and the highest marginal rate of tax imposed on such gains in 
the foreign country is at least 10 percent.
    (4) Allocation for purposes of section 904. For purposes of section 
904, loss recognized with respect to property that is allocated to 
foreign source income under this paragraph (a) shall be allocated to the 
separate category under section 904(d) to which gain on the sale of the 
property would have been assigned (without regard to section 
904(d)(2)(A)(iii)(III)). For purposes of Sec.  1.904-4(c)(2)(ii)(A), any 
such loss allocated to passive income shall be allocated (prior to the 
application of Sec.  1.904-4(c)(2)(ii)(B)) to the group of passive 
income to which gain on a sale of the property would have been assigned 
had a sale of the property resulted in the recognition of a gain under 
the law of the relevant foreign jurisdiction or jurisdictions.
    (5) Loss recognized by partnership. A partner's distributive share 
of loss recognized by a partnership with respect to personal property 
shall be allocated and apportioned in accordance with this section as if 
the partner had recognized the loss. If loss is attributable to an 
office or other fixed place of business of the partnership within the 
meaning of section 865(e)(3), such office or fixed place of business 
shall be considered to be an office of the partner for purposes of this 
section.
    (b) Special rules of application--(1) Depreciable property. In the 
case of a loss recognized with respect to depreciable personal property, 
the gain referred to in paragraph (a)(1) of this section is the gain 
that would be sourced under section 865(c)(1) (depreciation recapture).
    (2) Contingent payment debt instrument. Loss described in the last 
sentence of Sec.  1.1275-4(b)(9)(iv)(A) that is recognized with respect 
to a contingent payment debt instrument to which Sec.  1.1275-4(b) 
applies (instruments issued for money or publicly traded property) shall 
be allocated to the class of gross income and, if necessary, apportioned 
between the statutory grouping of gross income (or among the statutory 
groupings) and the residual grouping of gross income, with respect to 
which interest income from the instrument (in the amount of the loss 
subject to this paragraph (b)(2)) would give rise.
    (c) Exceptions--(1) Foreign currency and certain financial 
instruments. This section does not apply to loss governed by section 988 
and loss recognized with respect to options contracts or derivative 
financial instruments, including futures contracts, forward contracts, 
notional principal contracts, or evidence of an interest in any of the 
foregoing.
    (2) Inventory. This section does not apply to loss recognized with 
respect to property described in section 1221(a)(1).
    (3) Interest equivalents and trade receivables. Loss subject to 
Sec.  1.861-9T(b) (loss equivalent to interest expense and loss on trade 
receivables) shall be allocated and apportioned under the rules of Sec.  
1.861-9T and not under the rules of this section.
    (4) Unamortized bond premium. If a taxpayer recognizing loss with 
respect to a bond (within the meaning of Sec.  1.171-1(b)) did not 
amortize bond premium to the full extent permitted by section 171 and 
the regulations thereunder, then, to the extent of the amount of bond 
premium that could have been, but was not, amortized by the taxpayer, 
loss recognized with respect to the bond shall be allocated to the class 
of gross income and, if necessary, apportioned between the statutory 
grouping of gross income (or among the statutory groupings) and the 
residual grouping of gross income, with respect to which interest income 
from the bond was assigned.
    (5) Accrued interest. Loss attributable to accrued but unpaid 
interest on a debt obligation shall be allocated to the class of gross 
income and, if necessary, apportioned between the statutory grouping of 
gross income (or among the statutory groupings) and the residual 
grouping of gross income, with respect to which interest income from the 
obligation was assigned. For purposes of this section, whether loss is

[[Page 396]]

attributable to accrued but unpaid interest (rather than to principal) 
shall be determined under the principles of Sec. Sec.  1.61-7(d) and 
1.446-2(e).
    (6) Anti-abuse rules--(i) Transactions involving built-in losses. If 
one of the principal purposes of a transaction is to change the 
allocation of a built-in loss with respect to personal property by 
transferring the property to another person, qualified business unit, 
office or other fixed place of business, or branch that subsequently 
recognizes the loss, the loss shall be allocated by the transferee as if 
it were recognized by the transferor immediately prior to the 
transaction. If one of the principal purposes of a change of residence 
is to change the allocation of a built-in loss with respect to personal 
property, the loss shall be allocated as if the change of residence had 
not occurred. If one of the principal purposes of a transaction is to 
change the allocation of a built-in loss on the disposition of personal 
property by converting the original property into other property and 
subsequently recognizing loss with respect to such other property, the 
loss shall be allocated as if it were recognized with respect to the 
original property immediately prior to the transaction. Transactions 
subject to this paragraph shall include, without limitation, 
reorganizations within the meaning of section 368(a), liquidations under 
section 332, transfers to a corporation under section 351, transfers to 
a partnership under section 721, transfers to a trust, distributions by 
a partnership, distributions by a trust, transfers to or from a 
qualified business unit, office or other fixed place of business, or 
branch, or exchanges under section 1031. A person may have a principal 
purpose of affecting loss allocation even though this purpose is 
outweighed by other purposes (taken together or separately).
    (ii) Offsetting positions. If a taxpayer recognizes loss with 
respect to personal property and the taxpayer (or any person described 
in section 267(b) (after application of section 267(c)), 267(e), 318 or 
482 with respect to the taxpayer) holds (or held) offsetting positions 
with respect to such property with a principal purpose of recognizing 
foreign source income and United States source loss, the loss shall be 
allocated and apportioned against such foreign source income. For 
purposes of this paragraph (c)(6)(ii), positions are offsetting if the 
risk of loss of holding one or more positions is substantially 
diminished by holding one or more other positions.
    (iii) Matching rule. If a taxpayer (or a person described in section 
1059(c)(3)(C) with respect to the taxpayer) engages in a transaction or 
series of transactions with a principal purpose of recognizing foreign 
source income that results in the creation of a corresponding loss with 
respect to personal property (as a consequence of the rules regarding 
the timing of recognition of income, for example), the loss shall be 
allocated and apportioned against such income to the extent of the 
recognized foreign source income. For an example illustrating a similar 
rule with respect to stock loss, see Sec.  1.865-2(b)(4)(iv) Example 3.
    (d) Definitions--(1) Contingent payment debt instrument. A 
contingent payment debt instrument is any debt instrument that is 
subject to Sec.  1.1275-4.
    (2) Depreciable personal property. Depreciable personal property is 
any property described in section 865(c)(4)(A).
    (3) Terms defined in Sec.  1.861-8. See Sec.  1.861-8 for the 
meaning of class of gross income, statutory grouping of gross income, 
and residual grouping of gross income.
    (e) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. On January 1, 2000, A, a domestic corporation, purchases 
for $1,000 a machine that produces widgets, which A sells in the United 
States and throughout the world. Throughout A's holding period, the 
machine is located and used in Country X. During A's holding period, A 
incurs depreciation deductions of $400 with respect to the machine. 
Under Sec.  1.861-8, A allocates and apportions depreciation deductions 
of $250 against foreign source general limitation income and $150 
against U.S. source income. On December 12, 2002, A sells the machine 
for $100 and recognizes a loss of $500. Because the machine was used 
predominantly outside the United States, under sections 865(c)(1)(B) and 
865(c)(3)(B)(ii) gain on the disposition of the machine would be foreign 
source general limitation income to the extent of the depreciation 
adjustments. Therefore, under paragraph (b)(1) of this section, the 
entire $500

[[Page 397]]

loss is allocated against foreign source general limitation income.
    Example 2. On January 1, 2002, A, a domestic corporation, loans 
$2,000 to N, its wholly-owned controlled foreign corporation, in 
exchange for a contingent payment debt instrument subject to Sec.  
1.1275-4(b). During 2002 through 2004, A accrues and receives interest 
income of $630, $150 of which is foreign source general limitation 
income and $480 of which is foreign source passive income under section 
904(d)(3). Assume there are no positive or negative adjustments pursuant 
to Sec.  1.1275-4(b)(6) in 2002 through 2004. On January 1, 2005, A 
disposes of the debt instrument and recognizes a $770 loss. Under Sec.  
1.1275-4(b)(8)(ii), $630 of the loss is treated as ordinary loss and 
$140 is treated as capital loss. Assume that $140 of interest income 
earned in 2005 with respect to the debt instrument would be foreign 
source passive income under section 904(d)(3). Under Sec.  1.1275-
4(b)(9)(iv), $150 of the ordinary loss is allocated against foreign 
source general limitation income and $480 of the ordinary loss is 
allocated against foreign source passive income. Under paragraph (b)(2) 
of this section, the $140 capital loss is allocated against foreign 
source passive income.
    Example 3. (i) On January 1, 2003, A, a domestic corporation, 
purchases for $1,200 a taxable bond maturing on December 31, 2008, with 
a stated principal amount of $1,000, payable at maturity. The bond 
provides for unconditional payments of interest of $100, payable 
December 31 of each year. The issuer of the bond is a foreign 
corporation and interest on the bond is thus foreign source. Interest 
payments for 2003 and 2004 are timely made. A does not elect to amortize 
its bond premium under section 171 and the regulations thereunder, which 
would have permitted A to offset the $100 of interest income by $28.72 
of bond premium in 2003, and by $30.42 in 2004. On January 1, 2005, A 
sells the bond and recognizes a $100 loss. Under paragraph (c)(4) of 
this section, $59.14 of the loss is allocated against foreign source 
income. Under paragraph (a)(1) of this section, the remaining $40.86 of 
the loss is allocated against U.S. source income.
    (ii) The facts are the same as in paragraph (i) of this Example 3, 
except that A made the election to amortize its bond premium effective 
for taxable year 2004 (see Sec.  1.171-4(c)). Under paragraph (c)(4) of 
this section, $28.72 of the loss is allocated against foreign source 
income. Under paragraph (a)(1) of this section, the remaining $71.28 of 
the loss is allocated against U.S. source income.
    Example 4. On January 1, 2002, A, a domestic corporation, purchases 
for $1,000 a bond maturing December 31, 2014, with a stated principal 
amount of $1,000, payable at maturity. The bond provides for 
unconditional payments of interest of $100, payable December 31 of each 
year. The issuer of the bond is a foreign corporation and interest on 
the bond is thus foreign source. Between 2002 and 2006, A accrues and 
receives foreign source interest income of $500 with respect to the 
bond. On January 1, 2007, A sells the bond and recognizes a $500 loss. 
Under paragraph (a)(1) of this section, the $500 loss is allocated 
against U.S. source income.
    Example 5. On January 1, 2002, A, a domestic corporation on the 
accrual method of accounting, purchases for $1,000 a bond maturing 
December 31, 2012, with a stated principal amount of $1,000, payable at 
maturity. The bond provides for unconditional payments of interest of 
$100, payable December 31 of each year. The issuer of the bond is a 
foreign corporation and interest on the bond is thus foreign source. On 
June 10, 2002, after A has accrued $44 of interest income, but before 
any interest has been paid, the issuer suddenly becomes insolvent and 
declares bankruptcy. A sells the bond (including the accrued interest) 
for $20. Assuming that A properly accrued $44 of interest income, A 
treats the $20 proceeds from the sale of the bond as payment of interest 
previously accrued and recognizes a $1,000 loss with respect to the bond 
principal and a $24 loss with respect to the accrued interest. See Sec.  
1.61-7(d). Under paragraph (a)(1) of this section, the $1,000 loss with 
respect to the principal is allocated against U.S. source income. Under 
paragraph (c)(5) of this section, the $24 loss with respect to accrued 
but unpaid interest is allocated against foreign source interest income.

    (f) Effective date--(1) In general. Except as provided in paragraph 
(f)(2) of this section, this section is applicable to loss recognized on 
or after January 8, 2002. For purposes of this paragraph (f), loss that 
is recognized but deferred (for example, under section 267 or 1092) 
shall be treated as recognized at the time the loss is taken into 
account.
    (2) Application to prior periods. A taxpayer may apply the rules of 
this section to losses recognized in any taxable year beginning on or 
after January 1, 1987, and all subsequent years, provided that--
    (i) The taxpayer's tax liability as shown on an original or amended 
tax return is consistent with the rules of this section for each such 
year for which the statute of limitations does not preclude the filing 
of an amended return on June 30, 2002; and
    (ii) The taxpayer makes appropriate adjustments to eliminate any 
double benefit arising from the application of this section to years 
that are not open for assessment.

[[Page 398]]

    (3) Examples. See Sec.  1.865-2(e)(3) for examples illustrating an 
applicability date provision similar to the applicability date provided 
in this paragraph (f).

[T.D. 8973, 66 FR 67083, Dec. 28, 2001]



Sec.  1.865-2  Loss with respect to stock.

    (a) General rules for allocation of loss with respect to stock--(1) 
Allocation against gain. Except as otherwise provided in paragraph (b) 
of this section, loss recognized with respect to stock shall be 
allocated to the class of gross income and, if necessary, apportioned 
between the statutory grouping of gross income (or among the statutory 
groupings) and the residual grouping of gross income, with respect to 
which gain (other than gain treated as a dividend under section 
964(e)(1) or 1248) from a sale of such stock would give rise in the 
hands of the seller (without regard to section 865(f)). For purposes of 
this section, loss includes loss on property that is marked-to-market 
(such as under section 475) and subject to the rules of this section. 
Thus, for example, loss recognized by a United States resident on the 
sale of stock generally is allocated to reduce United States source 
income.
    (2) Stock attributable to foreign office. Except as otherwise 
provided in paragraph (b) of this section, in the case of loss 
recognized by a United States resident with respect to stock that is 
attributable to an office or other fixed place of business in a foreign 
country within the meaning of section 865(e)(3), the loss shall be 
allocated to reduce foreign source income if a gain on the sale of the 
stock would have been taxable by the foreign country and the highest 
marginal rate of tax imposed on such gains in the foreign country is at 
least 10 percent.
    (3) Loss recognized by United States citizen or resident alien with 
foreign tax home--(i) In general. Except as otherwise provided in 
paragraph (b) of this section, in the case of loss with respect to stock 
that is recognized by a United States citizen or resident alien that has 
a tax home (as defined in section 911(d)(3)) in a foreign country, the 
loss shall be allocated to reduce foreign source income if a gain on the 
sale of the stock would have been taxable by a foreign country and the 
highest marginal rate of tax imposed on such gains in the foreign 
country is at least 10 percent.
    (ii) Bona fide residents of Puerto Rico. Except as otherwise 
provided in paragraph (b) of this section, in the case of loss with 
respect to stock in a corporation described in section 865(g)(3) 
recognized by a United States citizen or resident alien that is a bona 
fide resident of Puerto Rico during the entire taxable year, the loss 
shall be allocated to reduce foreign source income. If gain from a sale 
of such stock would give rise to income exempt from tax under section 
933, the loss with respect to such stock shall be allocated to amounts 
that are excluded from gross income under section 933(1) and therefore 
shall not be allowed as a deduction from gross income. See section 
933(1) and Sec.  1.933-1(c).
    (4) Stock constituting a United States real property interest. Loss 
recognized by a nonresident alien individual or a foreign corporation 
with respect to stock that constitutes a United States real property 
interest shall be allocated to reduce United States source income. For 
additional rules governing the treatment of such loss, see section 897 
and the regulations thereunder.
    (5) Allocation for purposes of section 904. For purposes of section 
904, loss recognized with respect to stock that is allocated to foreign 
source income under this paragraph (a) shall be allocated to the 
separate category under section 904(d) to which gain on a sale of the 
stock would have been assigned (without regard to section 
904(d)(2)(A)(iii)(III)). For purposes of Sec.  1.904-4(c)(2)(ii)(A), any 
such loss allocated to passive income shall be allocated (prior to the 
application of Sec.  1.904-4(c)(2)(ii)(B)) to the group of passive 
income to which gain on a sale of the stock would have been assigned had 
a sale of the stock resulted in the recognition of a gain under the law 
of the relevant foreign jurisdiction or jurisdictions.
    (b) Exceptions--(1) Dividend recapture exception--(i) In general. If 
a taxpayer recognizes a loss with respect to shares of stock, and the 
taxpayer (or a person described in section 1059(c)(3)(C) with

[[Page 399]]

respect to such shares) included in income a dividend recapture amount 
(or amounts) with respect to such shares at any time during the 
recapture period, then, to the extent of the dividend recapture amount 
(or amounts), the loss shall be allocated and apportioned on a 
proportionate basis to the class or classes of gross income or the 
statutory or residual grouping or groupings of gross income to which the 
dividend recapture amount was assigned.
    (ii) Exception for de minimis amounts. Paragraph (b)(1)(i) of this 
section shall not apply to a loss recognized by a taxpayer on the 
disposition of stock if the sum of all dividend recapture amounts (other 
than dividend recapture amounts eligible for the exception described in 
paragraph (b)(1)(iii) of this section (passive limitation dividends)) 
included in income by the taxpayer (or a person described in section 
1059(c)(3)(C)) with respect to such stock during the recapture period is 
less than 10 percent of the recognized loss.
    (iii) Exception for passive limitation dividends. Paragraph 
(b)(1)(i) of this section shall not apply to the extent of a dividend 
recapture amount that is treated as income in the separate category for 
passive income described in section 904(d)(2)(A) (without regard to 
section 904(d)(2)(A)(iii)(III)). The exception provided for in this 
paragraph (b)(1)(iii) shall not apply to any dividend recapture amount 
that is treated as income in the separate category for financial 
services income described in section 904(d)(2)(C).
    (iv) Examples. The application of this paragraph (b)(1) may be 
illustrated by the following examples:

    Example 1. (i) P, a domestic corporation, is a United States 
shareholder of N, a controlled foreign corporation. N has never had any 
subpart F income and all of its earnings and profits are described in 
section 959(c)(3). On May 5, 1998, N distributes a dividend to P in the 
amount of $100. The dividend gives rise to a $5 foreign withholding tax, 
and P is deemed to have paid an additional $45 of foreign income tax 
with respect to the dividend under section 902. Under the look-through 
rules of section 904(d)(3) the dividend is general limitation income 
described in section 904(d)(1)(I).
    (ii) On February 6, 2000, P sells its shares of N and recognizes a 
$110 loss. In 2000, P has the following taxable income, excluding the 
loss on the sale of N:
    (A) $1,000 of foreign source income that is general limitation 
income described in section 904(d)(1)(I);
    (B) $1,000 of foreign source capital gain from the sale of stock in 
a foreign affiliate that is sourced under section 865(f) and is passive 
income described in section 904(d)(1)(A); and
    (C) $1,000 of U.S. source income.
    (iii) The $100 dividend paid in 1998 is a dividend recapture amount 
that was included in P's income within the recapture period preceding 
the disposition of the N stock. The de minimis exception of paragraph 
(b)(1)(ii) of this section does not apply because the $100 dividend 
recapture amount exceeds 10 percent of the $110 loss. Therefore, to the 
extent of the $100 dividend recapture amount, the loss must be allocated 
under paragraph (b)(1)(i) of this section to the separate limitation 
category to which the dividend was assigned (general limitation income).
    (iv) P's remaining $10 loss on the disposition of the N stock is 
allocated to U.S. source income under paragraph (a)(1) of this section.
    (v) After allocation of the stock loss, P's foreign source taxable 
income in 2000 consists of $900 of foreign source general limitation 
income and $1,000 of foreign source passive income.
    Example 2. (i) P, a domestic corporation, owns all of the stock of 
N1, which owns all of the stock of N2, which owns all of the stock of 
N3. N1, N2, and N3 are controlled foreign corporations. All of the 
corporations use the calendar year as their taxable year. On February 5, 
1997, N3 distributes a dividend to N2. The dividend is foreign personal 
holding company income of N2 under section 954(c)(1)(A) that results in 
an inclusion of $100 in P's income under section 951(a)(1)(A)(i) as of 
December 31, 1997. Under section 904(d)(3)(B) the inclusion is general 
limitation income described in section 904(d)(1)(I). The income 
inclusion to P results in a corresponding increase in P's basis in the 
stock of N1 under section 961(a).
    (ii) On March 5, 1999, P sells its shares of N1 and recognizes a 
$110 loss. The $100 1997 subpart F inclusion is a dividend recapture 
amount that was included in P's income within the recapture period 
preceding the disposition of the N1 stock. The de minimis exception of 
paragraph (b)(1)(ii) of this section does not apply because the $100 
dividend recapture amount exceeds 10 percent of the $110 loss. 
Therefore, to the extent of the $100 dividend recapture amount, the loss 
must be allocated under paragraph (b)(1)(i) of this section to the 
separate limitation category to which the dividend recapture amount was 
assigned (general limitation income). The remaining $10 loss is 
allocated to U.S. source income under paragraph (a)(1) of this section.

[[Page 400]]

    Example 3. (i) P, a domestic corporation, owns all of the stock of 
N1, which owns all of the stock of N2. N1 and N2 are controlled foreign 
corporations. All the corporations use the calendar year as their 
taxable year and the U.S. dollar as their functional currency. On May 5, 
1998, N2 pays a dividend of $100 to N1 out of general limitation 
earnings and profits.
    (ii) On February 5, 2000, N1 sells its N2 stock to an unrelated 
purchaser. The sale results in a loss to N1 of $110 for U.S. tax 
purposes. In 2000, N1 has the following current earnings and profits, 
excluding the loss on the sale of N2:
    (A) $1,000 of non-subpart F foreign source general limitation 
earnings and profits described in section 904(d)(1)(I);
    (B) $1,000 of foreign source gain from the sale of stock that is 
taken into account in determining foreign personal holding company 
income under section 954(c)(1)(B)(i) and which is passive limitation 
earnings and profits described in section 904(d)(1)(A);
    (C) $1,000 of foreign source interest income received from an 
unrelated person that is foreign personal holding company income under 
section 954(c)(1)(A) and which is passive limitation earnings and 
profits described in section 904(d)(1)(A).
    (iii) The $100 dividend paid in 1998 is a dividend recapture amount 
that was included in N1's income within the recapture period preceding 
the disposition of the N2 stock. The de minimis exception of paragraph 
(b)(1)(ii) of this section does not apply because the $100 dividend 
recapture amount exceeds 10 percent of the $110 loss. Therefore, to the 
extent of the $100 dividend recapture amount, the loss must be allocated 
under paragraph (b)(1)(i) of this section to the separate limitation 
category to which the dividend was assigned (general limitation earnings 
and profits).
    (iv) N1's remaining $10 loss on the disposition of the N2 stock is 
allocated to foreign source passive limitation earnings and profits 
under paragraph (a)(1) of this section.
    (v) After allocation of the stock loss, N1's current earnings and 
profits for 1998 consist of $900 of foreign source general limitation 
earnings and profits and $1,990 of foreign source passive limitation 
earnings and profits.
    (vi) After allocation of the stock loss, N1's subpart F income for 
2000 consists of $1,000 of foreign source interest income that is 
foreign personal holding company income under section 954(c)(1)(A) and 
$890 of foreign source net gain that is foreign personal holding company 
income under section 954(c)(1)(B)(i). P includes $1,890 in income under 
section 951(a)(1)(A)(i) as passive income under sections 904(d)(1)(A) 
and 904(d)(3)(B).
    Example 4. P, a foreign corporation, has two wholly-owned 
subsidiaries, S, a domestic corporation, and B, a foreign corporation. 
On January 1, 2000, S purchases a one-percent interest in N, a foreign 
corporation, for $100. On January 2, 2000, N distributes a $20 dividend 
to S. The $20 dividend is foreign source financial services income. On 
January 3, 2000, S sells its N stock to B for $80 and recognizes a $20 
loss that is deferred under section 267(f). On June 10, 2008, B sells 
its N stock to an unrelated person for $55. Under section 267(f) and 
Sec.  1.267(f)-1(c)(1), S's $20 loss is deferred until 2008. Under this 
paragraph (b)(1), the $20 loss is allocated to reduce foreign source 
financial services income in 2008 because the loss was recognized 
(albeit deferred) within the 24-month recapture period following the 
receipt of the dividend. See Sec. Sec.  1.267(f)-1(a)(2)(i)(B) and 
1.267(f)-1(c)(2).
    Example 5. The facts are the same as in Example 4, except P, S, and 
B are domestic corporations and members of the P consolidated group. 
Under the matching rule of Sec.  1.1502-13(c)(1), the separate entity 
attributes of S's intercompany items and B's corresponding items are 
redetermined to the extent necessary to produce the same effect on 
consolidated taxable income as if S and B were divisions of a single 
corporation and the intercompany transaction was a transaction between 
divisions. If S and B were divisions of a single corporation, the 
transfer of N stock on January 3, 2000 would be ignored for tax 
purposes, and the corporation would be treated as selling that stock 
only in 2008. Thus, the corporation's entire $45 loss would have been 
allocated against U.S. source income under paragraph (a)(1) of this 
section because a dividend recapture amount was not received during the 
corporation's recapture period. Accordingly, S's $20 loss and B's $25 
loss are allocated to reduce U.S. source income.
    Example 6. (i) On January 1, 1998, P, a domestic corporation, 
purchases N, a foreign corporation, for $1,000. On March 1, 1998, P 
causes N to sell its operating assets, distribute a $400 general 
limitation dividend to P, and invest its remaining $600 in short-term 
government securities. P converted the N assets into low-risk 
investments with a principal purpose of holding the N stock without 
significant risk of loss until the recapture period expired. N earns 
interest income from the securities. The income constitutes subpart F 
income that is included in P's income under section 951, increasing P's 
basis in the N stock under section 961(a). On March 1, 2002, P sells N 
and recognizes a $400 loss.
    (ii) Pursuant to paragraph (d)(3) of this section, the recapture 
period is increased by the period in which N's assets were held as low-
risk investments because P caused N's assets to be converted into and 
held as low-risk investments with a principal purpose of enabling P to 
hold the N stock without significant risk of loss. Accordingly, under 
paragraph (b)(1)(i) of this section the $400

[[Page 401]]

loss is allocated against foreign source general limitation income.

    (2) Exception for inventory. This section does not apply to loss 
recognized with respect to stock described in section 1221(1).
    (3) Exception for stock in an S corporation. This section does not 
apply to loss recognized with respect to stock in an S corporation (as 
defined in section 1361).
    (4) Anti-abuse rules--(i) Transactions involving built-in losses. If 
one of the principal purposes of a transaction is to change the 
allocation of a built-in loss with respect to stock by transferring the 
stock to another person, qualified business unit (within the meaning of 
section 989(a)), office or other fixed place of business, or branch that 
subsequently recognizes the loss, the loss shall be allocated by the 
transferee as if it were recognized with respect to the stock by the 
transferor immediately prior to the transaction. If one of the principal 
purposes of a change of residence is to change the allocation of a 
built-in loss with respect to stock, the loss shall be allocated as if 
the change of residence had not occurred. If one of the principal 
purposes of a transaction is to change the allocation of a built-in loss 
with respect to stock (or other personal property) by converting the 
original property into other property and subsequently recognizing loss 
with respect to such other property, the loss shall be allocated as if 
it were recognized with respect to the original property immediately 
prior to the transaction. Transactions subject to this paragraph shall 
include, without limitation, reorganizations within the meaning of 
section 368(a), liquidations under section 332, transfers to a 
corporation under section 351, transfers to a partnership under section 
721, transfers to a trust, distributions by a partnership, distributions 
by a trust, or transfers to or from a qualified business unit, office or 
other fixed place of business. A person may have a principal purpose of 
affecting loss allocation even though this purpose is outweighed by 
other purposes (taken together or separately).
    (ii) Offsetting positions. If a taxpayer recognizes loss with 
respect to stock and the taxpayer (or any person described in section 
267(b) (after application of section 267(c)), 267(e), 318 or 482 with 
respect to the taxpayer) holds (or held) offsetting positions with 
respect to such stock with a principal purpose of recognizing foreign 
source income and United States source loss, the loss will be allocated 
and apportioned against such foreign source income. For purposes of this 
paragraph (b)(4)(ii), positions are offsetting if the risk of loss of 
holding one or more positions is substantially diminished by holding one 
or more other positions.
    (iii) Matching rule. If a taxpayer (or a person described in section 
1059(c)(3)(C) with respect to the taxpayer) engages in a transaction or 
series of transactions with a principal purpose of recognizing foreign 
source income that results in the creation of a corresponding loss with 
respect to stock (as a consequence of the rules regarding the timing of 
recognition of income, for example), the loss shall be allocated and 
apportioned against such income to the extent of the recognized foreign 
source income. This paragraph (b)(4)(iii) applies to any portion of a 
loss that is not allocated under paragraph (b)(1)(i) of this section 
(dividend recapture rule), including a loss in excess of the dividend 
recapture amount and a loss that is related to a dividend recapture 
amount described in paragraph (b)(1)(ii) (de minimis exception) or 
(b)(1)(iii) (passive dividend exception) of this section.
    (iv) Examples. The application of this paragraph (b)(4) may be 
illustrated by the following examples. No inference is intended 
regarding the application of any other Internal Revenue Code section or 
judicial doctrine that may apply to disallow or defer the recognition of 
loss. The examples are as follows:

    Example 1. (i) Facts. On January 1, 2000, P, a domestic corporation, 
owns all of the stock of N1, a controlled foreign corporation, which 
owns all of the stock of N2, a controlled foreign corporation. N1's 
basis in the stock of N2 exceeds its fair market value, and any loss 
recognized by N1 on the sale of N2 would be allocated under paragraph 
(a)(1) of this section to reduce foreign source passive limitation 
earnings and profits of N1. In contemplation of the sale of N2 to an 
unrelated purchaser, P causes N1 to liquidate with principal purposes of 
recognizing the

[[Page 402]]

loss on the N2 stock and allocating the loss against U.S. source income. 
P sells the N2 stock and P recognizes a loss.
    (ii) Loss allocation. Because one of the principal purposes of the 
liquidation was to transfer the stock to P in order to change the 
allocation of the built-in loss on the N2 stock, under paragraph 
(b)(4)(i) of this section the loss is allocated against P's foreign 
source passive limitation income.
    Example 2. (i) Facts. On January 1, 2000, P, a domestic corporation, 
forms N and F, foreign corporations, and contributes $1,000 to the 
capital of each. N and F enter into offsetting positions in financial 
instruments that produce financial services income. Holding the N stock 
substantially diminishes P's risk of loss with respect to the F stock 
(and vice versa). P holds N and F with a principal purpose of 
recognizing foreign source income and U.S. source loss. On March 31, 
2000, when the financial instrument held by N is worth $1,200 and the 
financial instrument held by F is worth $800, P sells its F stock and 
recognizes a $200 loss.
    (ii) Loss allocation. Because P held an offsetting position with 
respect to the F stock with a principal purpose of recognizing foreign 
source income and U.S. source loss, the $200 loss is allocated against 
foreign source financial services income under paragraph (b)(4)(ii) of 
this section.
    Example 3. (i) Facts. On January 1, 2002, P and Q, domestic 
corporations, form R, a domestic partnership. The corporations and 
partnership use the calendar year as their taxable year. P contributes 
$900 to R in exchange for a 90-percent partnership interest and Q 
contributes $100 to R in exchange for a 10-percent partnership interest. 
R purchases a dance studio in Country X for $1,000. On January 2, 2002, 
R enters into contracts to provide dance lessons in Country X for a 5-
year period beginning January 1, 2003. These contracts are prepaid by 
the dance studio customers on December 31, 2002, and R recognizes 
foreign source taxable income of $500 from the prepayments (R's only 
income in 2002). P takes into income its $450 distributive share of 
partnership taxable income. On January 1, 2003, P's basis in its 
partnership interest is $1,350 ($900 from its contribution under section 
722, increased by its $450 distributive share of partnership income 
under section 705). On September 22, 2003, P contributes its R 
partnership interest to S, a newly-formed domestic corporation, in 
exchange for all the stock of S. Under section 358, P's basis in S is 
$1,350. On December 1, 2003, P sells S to an unrelated party for $1050 
and recognizes a $300 loss.
    (ii) Loss allocation. P recognized foreign source income for tax 
purposes before the income had economically accrued, and the accelerated 
recognition of income increased P's basis in R without increasing its 
value by a corresponding amount, which resulted in the creation of a 
built-in loss with respect to the S stock. Under paragraph (b)(4)(iii) 
of this section the $300 loss is allocated against foreign source income 
if P had a principal purpose of recognizing foreign source income and 
corresponding loss.

    (c) Loss recognized by partnership. A partner's distributive share 
of loss recognized by a partnership shall be allocated and apportioned 
in accordance with this section as if the partner had recognized the 
loss. If loss is attributable to an office or other fixed place of 
business of the partnership within the meaning of section 865(e)(3), 
such office or fixed place of business shall be considered to be an 
office of the partner for purposes of this section.
    (d) Definitions--(1) Terms defined in Sec.  1.861-8. See Sec.  
1.861-8 for the meaning of class of gross income, statutory grouping of 
gross income, and residual grouping of gross income.
    (2) Dividend recapture amount. A dividend recapture amount is a 
dividend (except for an amount treated as a dividend under section 78), 
an inclusion described in section 951(a)(1)(A)(i) (but only to the 
extent attributable to a dividend (including a dividend under section 
964(e)(1)) included in the earnings of a controlled foreign corporation 
(held directly or indirectly by the person recognizing the loss) that is 
included in foreign personal holding company income under section 
954(c)(1)(A)) and an inclusion described in section 951(a)(1)(B).
    (3) Recapture period. A recapture period is the 24-month period 
ending on the date on which a taxpayer recognized a loss with respect to 
stock. For example, if a taxpayer recognizes a loss on March 15, 2002, 
the recapture period begins on and includes March 16, 2000, and ends on 
and includes March 15, 2002. A recapture period is increased by any 
period of time in which the taxpayer has diminished its risk of loss in 
a manner described in section 246(c)(4) and the regulations thereunder 
and by any period in which the assets of the corporation are hedged 
against risk of loss (or are converted into and held as low-risk 
investments) with a principal purpose of enabling the taxpayer to hold 
the stock without significant risk of loss until the recapture period 
has expired. In the case of a loss recognized

[[Page 403]]

after a dividend is declared but before such dividend is paid, the 
recapture period is extended through the date on which the dividend is 
paid.
    (4) United States resident. See section 865(g) and the regulations 
thereunder for the definition of United States resident.
    (e) Effective date--(1) In general. This section is applicable to 
loss recognized on or after January 11, 1999, except that paragraphs 
(a)(3)(ii), (b)(1)(iv) Example 6, (b)(4)(iii), (b)(4)(iv) Example 3, and 
(d)(3) of this section are applicable to loss recognized on or after 
January 8, 2002. For purposes of this paragraph (e), loss that is 
recognized but deferred (for example, under section 267 or 1092) shall 
be treated as recognized at the time the loss is taken into account.
    (2) Application to prior periods. A taxpayer may apply the rules of 
this section to losses recognized in any taxable year beginning on or 
after January 1, 1987, and all subsequent years, provided that--
    (i) The taxpayer's tax liability as shown on an original or amended 
tax return is consistent with the rules of this section for each such 
year for which the statute of limitations does not preclude the filing 
of an amended return on June 30, 2002; and
    (ii) The taxpayer makes appropriate adjustments to eliminate any 
double benefit arising from the application of this section to years 
that are not open for assessment.
    (3) Examples. The rules of this paragraph (e) may be illustrated by 
the following examples:

    Example 1. (i) P, a domestic corporation, has a calendar taxable 
year. On March 10, 1985, P recognizes a $100 capital loss on the sale of 
N, a foreign corporation. Pursuant to sections 1211(a) and 1212(a), the 
loss is not allowed in 1985 and is carried over to the 1990 taxable 
year. The loss is allocated against foreign source income under Sec.  
1.861-8(e)(7). In 1999, P chooses to apply this section to all losses 
recognized in its 1987 taxable year and in all subsequent years.
    (ii) Allocation of the loss on the sale of N is not affected by the 
rules of this section because the loss was recognized in a taxable year 
that did not begin after December 31, 1986.
    Example 2. (i) P, a domestic corporation, has a calendar taxable 
year. On March 10, 1988, P recognizes a $100 capital loss on the sale of 
N, a foreign corporation. Pursuant to sections 1211(a) and 1212(a), the 
loss is not allowed in 1988 and is carried back to the 1985 taxable 
year. The loss is allocated against foreign source income under Sec.  
1.861-8(e)(7) on P's federal income tax return for 1985 and increases an 
overall foreign loss account under Sec.  1.904(f)-1.
    (ii) In 1999, P chooses to apply this section to all losses 
recognized in its 1987 taxable year and in all subsequent years. 
Consequently, the loss on the sale of N is allocated against U.S. source 
income under paragraph (a)(1) of this section. Allocation of the loss 
against U.S. source income reduces P's overall foreign loss account and 
increases P's tax liability in 2 years: 1990, a year that will not be 
open for assessment on June 30, 1999, and 1997, a year that will be open 
for assessment on June 30, 1999. Pursuant to paragraph (e)(2)(i) of this 
section, P must file an amended federal income tax return that reflects 
the rules of this section for 1997, but not for 1990.
    Example 3. (i) P, a domestic corporation, has a calendar taxable 
year. On March 10, 1989, P recognizes a $100 capital loss on the sale of 
N, a foreign corporation. The loss is allocated against foreign source 
income under Sec.  1.861-8(e)(7) on P's federal income tax return for 
1989 and results in excess foreign tax credits for that year. The excess 
credit is carried back to 1988, pursuant to section 904(c). In 1999, P 
chooses to apply this section to all losses recognized in its 1989 
taxable year and in all subsequent years. On June 30, 1999, P's 1988 
taxable year is closed for assessment, but P's 1989 taxable year is open 
with respect to claims for refund.
    (ii) Because P chooses to apply this section to its 1989 taxable 
year, the loss on the sale of N is allocated against U.S. source income 
under paragraph (a)(1) of this section. Allocation of the loss against 
U.S. source income would have permitted the foreign tax credit to be 
used in 1989, reducing P's tax liability in 1989. Nevertheless, under 
paragraph (e)(2)(ii) of this section, because the credit was carried 
back to 1988, P may not claim the foreign tax credit in 1989.

[T.D. 8805, 64 FR 1511, Jan. 11, 1999, as amended by T.D. 8973, 66 FR 
67085, Dec. 28, 2001; 67 FR 3812, Jan. 28, 2002]



Sec.  1.865-3  Source of gross income from sales of personal property 
(including inventory property) by a nonresident attributable to an office 
or other fixed place of business in the United States.

    (a) In general. Notwithstanding any provision of section 861 through 
865 or other regulations in this part, this section provides the sole 
sourcing rules for gross income, gain, or loss from section 865(e)(2) 
sales. Gross income, gain,

[[Page 404]]

or loss from a section 865(e)(2) sale is U.S. source income to the 
extent that the gross income, gain, or loss is properly allocable to an 
office or other fixed place of business in the United States under 
paragraph (d) of this section.
    (b) Exception for certain inventory sales for use, disposition or 
consumption outside the United States. A section 865(e)(2) sale does not 
include any sale of inventory property that is sold for use, 
disposition, or consumption outside the United States if an office or 
other fixed place of business of the nonresident in a foreign country 
materially participates in the sale. See Sec.  1.864-6(b)(3) to 
determine whether a foreign office materially participates in the sale 
and whether the property was destined for foreign use.
    (c) Section 865(e)(2) sales. For purposes of this section, a 
``section 865(e)(2) sale'' is a sale of personal property by a 
nonresident, including inventory property, other than a sale described 
in paragraph (b) of this section, that is attributable to an office or 
other fixed place of business in the United States under the principles 
of section 864(c)(5)(B) as prescribed in Sec.  1.864-6(b)(1) and (2). In 
determining whether a nonresident maintains an office or other fixed 
place of business in the United States, the principles of section 
864(c)(5)(A) as prescribed in Sec.  1.864-7 apply, including the rules 
of paragraph (d) of that section regarding the office or other fixed 
place of business of a dependent agent of the nonresident. For purposes 
of this section, ``inventory property'' has the meaning provided in 
section 865(i)(1), and ``nonresident'' has the meaning provided in 
section 865(g)(1)(B).
    (d) Amount of gross income, gain, or loss on sale of personal 
property properly allocable to a U.S. office--(1) In general. Except as 
otherwise provided in paragraphs (d)(2) through (4) of this section, the 
amount of gross income, gain, or loss from a section 865(e)(2) sale that 
is properly allocable to an office or other fixed place of business in 
the United States is determined under the principles of Sec.  1.864-
6(c)(1).
    (2) Produced inventory property. Gross income, gain, or loss from a 
section 865(e)(2) sale of inventory property that is produced by the 
nonresident seller is properly allocable to an office or other fixed 
place of business in the United States or to production activities in 
accordance with the ``50/50 method'' described in paragraph (d)(2)(i) of 
this section. However, in lieu of the 50/50 method, the nonresident 
seller may elect to allocate the gross income, gain, or loss under the 
``books and records method'' described in paragraph (d)(2)(ii)(A) of 
this section, provided that the nonresident satisfies all of the 
requirements described in paragraph (d)(2)(ii)(B) of this section to the 
satisfaction of the Commissioner. Gross income allocable to production 
activities under this paragraph (d)(2) is sourced in accordance with 
Sec.  1.863-3. For purposes of this paragraph (d)(2), the term 
``produced'' includes created, fabricated, manufactured, extracted, 
processed, cured, and aged, as determined under the principles of Sec.  
1.954-3(a)(4) (except for Sec.  1.954-3(a)(4)(iv)). See section 864(a) 
and Sec.  1.864-1.
    (i) The 50/50 method. Fifty percent of the gross income, gain, or 
loss from a section 865(e)(2) sale of inventory property that is 
produced by the nonresident seller is properly allocable to an office or 
other fixed place of business in the United States, and the remaining 50 
percent of the gross income, gain, or loss is properly allocable to 
production activities (the ``50/50 method'').
    (ii) Books and records method--(A) Method. Subject to paragraph 
(d)(2)(ii)(B) of this section, a nonresident may elect to determine the 
amount of its gross income, gain, or loss from the sale of inventory 
property produced by the nonresident seller that is properly allocable 
to production activities and sales activities for the taxable year based 
upon its books of account (the ``books and records method''). The gross 
income, gain, or loss allocable to sales activities under this method is 
treated as properly allocable to an office or other fixed place of 
business in the United States and the remaining gross income, gain, or 
loss is treated as properly allocable to production activities.
    (B) Election and reporting rules--(1) In general. A nonresident may 
not make the election described in paragraph

[[Page 405]]

(d)(2)(ii)(A) of this section unless the requirements of paragraphs 
(d)(2)(ii)(B)(2) through (4) of this section are satisfied. Once the 
election is made, the nonresident must continue to satisfy the 
requirements of paragraphs (d)(2)(ii)(B)(2) through (4) of this section 
until the election is revoked. If the nonresident fails to satisfy the 
requirements in paragraphs (d)(2)(ii)(B)(2) through (4) of this section 
to the satisfaction of the Commissioner, the Commissioner may, in its 
sole discretion, apply the 50/50 method described in paragraph (d)(2)(i) 
of this section.
    (2) Books of account. The nonresident must establish that it, in 
good faith and unaffected by considerations of tax liability, regularly 
employs in its books of account a detailed allocation of receipts and 
expenditures that, under the principles of section 482, clearly reflects 
both the amount of the nonresident's gross income, gain, or loss from 
its inventory sales that are attributable to its sales activities, and 
the amount of its gross income, gain, or loss from its inventory sales 
that are attributable to its production activities. For purposes of this 
paragraph (d)(2)(ii)(B)(2), section 482 principles apply as if the 
office or other fixed place of business in the United States were a 
separate organization, trade, or business (and, thus, a separate 
controlled taxpayer) from the nonresident (whether or not payments are 
made between the United States office or other fixed place of business 
and the nonresident's other offices, and whether or not the nonresident 
itself would otherwise constitute an organization, trade, or business).
    (3) Required records. The nonresident must prepare and maintain the 
records described in paragraph (d)(2)(ii)(B)(2) of this section, which 
must be in existence when its return is filed. The nonresident must also 
prepare an explanation of how the allocation clearly reflects the 
nonresident's gross income, gain, or loss from production and sales 
activities under the principles of section 482. The nonresident must 
make available the explanation and records of the nonresident (including 
for the office or other fixed place of business in the United States and 
the offices or branches that perform the production activities) upon 
request of the Commissioner, within 30 days, unless some other period is 
agreed upon between the Commissioner and the nonresident.
    (4) Making and revoking the books and records method election; 
disclosure of election. Except as otherwise provided in publications, 
forms, instructions, or other guidance, a nonresident makes or revokes 
the election to apply the books and records method by attaching a 
statement to its original timely filed Federal income tax return 
(including extensions) providing that it elects, or revokes the 
election, to apply the books and records method described in paragraph 
(d)(2)(ii)(A) of this section. For nonresidents making the election, the 
statement must provide that the nonresident has prepared the records 
described in paragraph (d)(2)(ii)(B)(2) and (3) of this section.
    (5) Limitation on revoking the books and records method election. 
Once made, the books and records method election continues until 
revoked. An election cannot be revoked, without the consent of the 
Commissioner, for any taxable year beginning within 48 months of the 
last day of the taxable year for which the election was made.
    (3) Purchased inventory property. All gross income, gain, or loss 
from a section 865(e)(2) sale of inventory property that is both 
purchased and sold by a nonresident is properly allocable to an office 
or other fixed place of business in the United States.
    (4) Depreciable personal property. Gain from a section 865(e)(2) 
sale of depreciable personal property (as defined in section 865(c)(4)) 
is allocated under paragraphs (d)(4)(i) and (ii) of this section.
    (i) The gain not in excess of the depreciation adjustments, if any, 
is properly allocable to an office or other fixed place of business in 
the United States to the same extent that the gain would be allocated to 
sources within the United States under the rules of section 865(c)(1). 
The remaining gain not in excess of the depreciation adjustments, if 
any, is allocated to sources without the United States in accordance 
with section 865(c)(1). However, notwithstanding the preceding

[[Page 406]]

sentences, if the property was predominantly used in the United States, 
within the meaning of section 865(c)(3)(B)(i), for a particular taxable 
year, all of the gain not in excess of depreciation for that year is 
properly allocable to the office or other fixed place of business in the 
United States.
    (ii) The gain in excess of the depreciation adjustments, if any, is 
treated as if such gain was from the sale of inventory and the amount 
allocable to an office or fixed place of business in the United States 
is determined under paragraph (d)(2) or (3) of this section, as 
applicable.
    (e) Determination of source of taxable income. For rules allocating 
and apportioning expenses to gross income effectively connected with the 
conduct of a trade or business of a foreign corporation in the United 
States (including gross income, gain, or loss sourced under this 
section), see section 882(c)(1). For rules allocating and apportioning 
expenses to gross income, gain, or loss effectively connected with the 
conduct of a trade or business of a nonresident alien in the United 
States (including gross income, gain, or loss sourced under this 
section), see section 873(a).
    (f) Export trade corporations. This section does not apply for 
purposes of defining an export trade corporation under section 971(a).
    (g) Applicability date. This section applies to taxable years ending 
on or after December 23, 2019. However, a nonresident may apply this 
section in its entirety for taxable years beginning after December 31, 
2017, and ending before December 23, 2019, provided that the nonresident 
and all persons related to the nonresident (within the meaning of 
section 267 or 707) apply this section and Sec. Sec.  1.863-1(b), 1.863-
2(b), 1.863-3, 1.863-8(b)(3)(ii), 1.864-5(a) and (b), and 1.864-6(c)(2) 
in their entirety for the taxable year, and once applied, the 
nonresident and all persons related to the nonresident (within the 
meaning of section 267 or 707) continue to apply these regulations in 
their entirety for all subsequent taxable years.

[T.D. 9921, 85 FR 79851, Dec. 11, 2020]

               Nonresident Aliens and Foreign Corporations

                      nonresident alien individuals



Sec.  1.871-1  Classification and manner of taxing alien individuals.

    (a) Classes of aliens. For purposes of the income tax, alien 
individuals are divided generally into two classes, namely, resident 
aliens and nonresident aliens. Resident alien individuals are, in 
general, taxable the same as citizens of the United States; that is, a 
resident alien is taxable on income derived from all sources, including 
sources without the United States. See Sec.  1.1-1(b). Nonresident alien 
individuals are taxable only on certain income from sources within the 
United States and on the income described in section 864(c)(4) from 
sources without the United States which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States. However, nonresident alien individuals may elect, under section 
6013 (g) or (h), to be treated as U.S. residents for purposes of 
determining their income tax liability under Chapters 1 and 24 of the 
code. Accordingly, any reference in Sec. Sec.  1.1-1 through 1.1388-1 to 
non-resident alien individuals does not include those with respect to 
whom an election under section 6013 (g) or (h) is in effect, unless 
otherwise specifically provided. Similarly, any reference to resident 
aliens or U.S. residents includes those with respect to whom an election 
is in effect, unless otherwise specifically provided.
    (b) Classes of nonresident aliens--(1) In general. For purposes of 
the income tax, nonresident alien individuals are divided into the 
following three classes:
    (i) Nonresident alien individuals who at no time during the taxable 
year are engaged in a trade or business in the United States,
    (ii) Nonresident alien individuals who at any time during the 
taxable year are, or are deemed under Sec.  1.871-9 to be, engaged in a 
trade or business in the United States, and
    (iii) Nonresident alien individuals who are bona fide residents of a 
section 931 possession (as defined in Sec.  1.931-1(c)(1) of this 
chapter) or Puerto Rico

[[Page 407]]

during the entire taxable year. An individual described in paragraph 
(b)(1)(i) or (ii) of this section is subject to tax pursuant to the 
provisions of subpart A (section 871 and following), part II, subchapter 
N, chapter 1 of the Code, and the regulations under those provisions. 
The provisions of subpart A do not apply to individuals described in 
this paragraph (b)(1)(iii), but such individuals, except as provided in 
section 931 or 933, are subject to the tax imposed by section 1 or 55. 
See Sec.  1.876-1.
    (2) Treaty income. If the gross income of a nonresident alien 
individual described in subparagraph (1) (i) or (ii) of this paragraph 
includes income on which the tax is limited by tax convention, see Sec.  
1.871-12.
    (3) Exclusions from gross income. For rules relating to the 
exclusion of certain items from the gross income of a nonresident alien 
individual, including annuities excluded under section 871(f), see 
Sec. Sec.  1.872-2 and 1.894-1.
    (4) Expatriation to avoid tax. For special rules applicable in 
determining the tax of a nonresident alien individual who has lost U.S. 
citizenship with a principal purpose of avoiding certain taxes, see 
section 877.
    (5) Adjustment of tax of certain nonresident aliens. For the 
application of pre-1967 income tax provisions to residents of a foreign 
country which imposes a more burdensome income tax than the United 
States, and for the adjustment of the income tax of a national or 
resident of a foreign country which imposes a discriminatory income tax 
on the income of citizens of the United States or domestic corporations, 
see section 896.
    (6) Conduit financing arrangements. For rules regarding conduit 
financing arrangements, see Sec. Sec.  1.881-3 and 1.881-4.
    (c) Effective/applicability date. This section shall apply for 
taxable years beginning after December 31, 1966. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.871-1 and 1.871-7(a) (Revised as of January 1, 1971). Paragraph 
(b)(1)(iii) of this section applies to taxable years ending after April 
9, 2008.

[T.D. 7332, 39 FR 44218, Dec. 23, 1974, as amended by T.D. 7670, 45 FR 
6928, Jan. 31, 1980; T.D. 8611, 60 FR 41004, Aug. 11, 1995; T.D. 9194, 
70 FR 18928, Apr. 11, 2005; T.D. 9391, 73 FR 19358, Apr. 9, 2008; T.D. 
9849, 84 FR 9236, Mar. 14, 2019]



Sec.  1.871-2  Determining residence of alien individuals.

    (a) General. The term nonresident alien individual means an 
individual whose residence is not within the United States, and who is 
not a citizen of the United States. The term includes a nonresident 
alien fiduciary. For such purpose the term fiduciary shall have the 
meaning assigned to it by section 7701(a)(6) and the regulations in part 
301 of this chapter (Regulations on Procedure and Administration). For 
presumption as to an alien's nonresidence, see paragraph (b) of Sec.  
1.871-4.
    (b) Residence defined. An alien actually present in the United 
States who is not a mere transient or sojourner is a resident of the 
United States for purposes of the income tax. Whether he is a transient 
is determined by his intentions with regard to the length and nature of 
his stay. A mere floating intention, indefinite as to time, to return to 
another country is not sufficient to constitute him a transient. If he 
lives in the United States and has no definite intention as to his stay, 
he is a resident. One who comes to the United States for a definite 
purpose which in its nature may be promptly accomplished is a transient; 
but, if his purpose is of such a nature that an extended stay may be 
necessary for its accomplishment, and to that end the alien makes his 
home temporarily in the United States, he becomes a resident, though it 
may be his intention at all times to return to his domicile abroad when 
the purpose for which he came has been consummated or abandoned. An 
alien whose stay in the United States is limited to a definite period by 
the immigration laws is not a resident of the United States within the 
meaning of this section, in the absence of exceptional circumstances.
    (c) Application and effective dates. Unless the context indicates 
otherwise,

[[Page 408]]

Sec. Sec.  1.871-2 through 1.871-5 apply to determine the residence of 
aliens for taxable years beginning before January 1, 1985. To determine 
the residence of aliens for taxable years beginning after December 31, 
1984, see section 7701(b) and Sec. Sec.  301.7701(b)-1 through 
301.7701(b)-9 of this chapter. However, for purposes of determining 
whether an individual is a qualified individual under section 
911(d)(1)(A), the rules of Sec. Sec.  1.871-2 and 1.871-5 shall continue 
to apply for taxable years beginning after December 31, 1984. For 
purposes of determining whether an individual is a resident of the 
United States for estate and gift tax purposes, see Sec.  20.0-1(b)(1) 
and (2) and Sec.  25.2501-1(b) of this chapter, respectively.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 8411, 57 FR 15241, Apr. 27, 1992]



Sec.  1.871-3  Residence of alien seamen.

    In order to determine whether an alien seaman is a resident of the 
United States for purposes of the income tax, it is necessary to decide 
whether the presumption of nonresidence (as prescribed by paragraph (b) 
of Sec.  1.871-4) is overcome by facts showing that he has established a 
residence in the United States. Residence may be established on a vessel 
regularly engaged in coastwise trade, but the mere fact that a sailor 
makes his home on a vessel which is flying the United States flag and is 
engaged in foreign trade is not sufficient to establish residence in the 
United States, even though the vessel, while carrying on foreign trade, 
touches at American ports. An alien seaman may acquire an actual 
residence in the United States within the rules laid down in Sec.  
1.871-4, although the nature of his calling requires him to be absent 
for a long period from the place where his residence is established. An 
alien seaman may acquire such a residence at a sailors' boarding house 
or hotel, but such a claim should be carefully scrutinized in order to 
make sure that such residence is bona fide. The filing of Form 1078 or 
taking out first citizenship papers is proof of residence in the United 
States from the time the form is filed or the papers taken out, unless 
rebutted by other evidence showing an intention to be a transient.



Sec.  1.871-4  Proof of residence of aliens.

    (a) Rules of evidence. The following rules of evidence shall govern 
in determining whether or not an alien within the United States has 
acquired residence therein for purposes of the income tax.
    (b) Nonresidence presumed. An alien by reason of his alienage, is 
presumed to be a nonresident alien.
    (c) Presumption rebutted--(1) Departing alien. In the case of an 
alien who presents himself for determination of tax liability before 
departure from the United States, the presumption as to the alien's 
nonresidence may be overcome by proof--
    (i) That the alien, at least six months before the date he so 
presents himself, has filed a declaration of his intention to become a 
citizen of the United States under the naturalization laws; or
    (ii) That the alien, at least six months before the date he so 
presents himself, has filed Form 1078 or its equivalent; or
    (iii) Of acts and statements of the alien showing a definite 
intention to acquire residence in the United States or showing that his 
stay in the United States has been of such an extended nature as to 
constitute him a resident.
    (2) Other aliens. In the case of other aliens, the presumption as to 
the alien's nonresidence may be overcome by proof--
    (i) That the alien has filed a declaration of his intention to 
become a citizen of the United States under the naturalization laws; or
    (ii) That the alien has filed Form 1078 or its equivalent; or
    (iii) Of acts and statements of the alien showing a definite 
intention to acquire residence in the United States or showing that his 
stay in the United States has been of such an extended nature as to 
constitute him a resident.
    (d) Certificate. If, in the application of paragraph (c)(1)(iii) or 
(2)(iii) of this section, the internal revenue officer or employee who 
examines the alien is in doubt as to the facts, such officer or employee 
may, to assist him in determining the facts, require a certificate

[[Page 409]]

or certificates setting forth the facts relied upon by the alien seeking 
to overcome the presumption. Each such certificate, which shall contain, 
or be verified by, a written declaration that it is made under the 
penalties of perjury, shall be executed by some credible person or 
persons, other than the alien and members of his family, who have known 
the alien at least six months before the date of execution of the 
certificate or certificates.



Sec.  1.871-5  Loss of residence by an alien.

    An alien who has acquired residence in the United States retains his 
status as a resident until he abandons the same and actually departs 
from the United States. An intention to change his residence does not 
change his status as a resident alien to that of a nonresident alien. 
Thus, an alien who has acquired a residence in the United States is 
taxable as a resident for the remainder of his stay in the United 
States.



Sec.  1.871-6  Duty of withholding agent to determine status 
of alien payees.

    For the obligation of a withholding agent to withhold the tax 
imposed by this section, see chapter 3 of the Internal Revenue Code and 
the regulations thereunder.

[T.D. 8734, 62 FR 53416, Oct. 14, 1997]



Sec.  1.871-7  Taxation of nonresident alien individuals not engaged 
in U.S. business.

    (a) Imposition of tax. (1) This section applies for purposes of 
determining the tax of a nonresident alien individual who at no time 
during the taxable year is engaged in trade or business in the United 
States. However, see also Sec.  1.871-8 where such individual is a 
student or trainee deemed to be engaged in trade or business in the 
United States or where he has an election in effect for the taxable year 
in respect to real property income. Except as otherwise provided in 
Sec.  1.871-12, a nonresident alien individual to whom this section 
applies is not subject to the tax imposed by section 1 or section 
1201(b) but, pursuant to the provision of section 871(a), is liable to a 
flat tax of 30 percent upon the aggregate of the amounts determined 
under paragraphs (b), (c), and (d) of this section which are received 
during the taxable year from sources within the United States. Except as 
specifically provided in such paragraphs, such amounts do not include 
gains from the sale or exchange of property. To determine the source of 
such amounts, see sections 861 through 863, and the regulations 
thereunder.
    (2) The tax of 30 percent is imposed by section 871(a) upon an 
amount only to the extent the amount constitutes gross income. Thus, for 
example, the amount of an annuity which is subject to such tax shall be 
determined in accordance with section 72.
    (3) Deductions shall not be allowed in determining the amount 
subject to tax under this section except that losses from sales or 
exchanges of capital assets shall be allowed to the extent provided in 
section 871(a)(2) and paragraph (d) of this section.
    (4) Except as provided in Sec. Sec.  1.871-9 and 1.871-10, a 
nonresident alien individual not engaged in trade or business in the 
United States during the taxable year has no income, gain, or loss for 
the taxable year which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States. See 
section 864(c)(1)(B) and Sec.  1.864-3.
    (5) Gains and losses which, by reason of section 871(d) and Sec.  
1.871-10, are treated as gains or losses which are effectively connected 
for the taxable year with the conduct of a trade or business in the 
United States by the nonresident alien individual shall not be taken 
into account in determining the tax under this section. See, for 
example, paragraph (c)(2) of Sec.  1.871-10.
    (6) For special rules applicable in determining the tax of certain 
nonresident alien individuals, see paragraph (b) of Sec.  1.871-1.
    (b) Fixed or determinable annual or periodical income--(1) General 
rule. The tax of 30 percent imposed by section 871(a)(1) applies to the 
gross amount received from sources within the United States as fixed or 
determinable annual or periodical gains, profits, or income. Specific 
items of fixed or determinable annual or periodical income are 
enumerated in section 871(a)(1)(A) as interest, dividends, rents, 
salaries, wages, premiums, annuities, compensations,

[[Page 410]]

remunerations, and emoluments, but other items of fixed or determinable 
annual or periodical gains, profits, or income are also subject to the 
tax, as, for instance, royalties, including royalties for the use of 
patents, copyrights, secret processes and formulas, and other like 
property. As to the determination of fixed or determinable annual or 
periodical income see Sec.  1.1441-2(b). For special rules treating gain 
on the disposition of section 306 stock as fixed or determinable annual 
or periodical income for purposes of section 871(a), see section 306(f) 
and paragraph (h) of Sec.  1.306-3.
    (2) Substitute payments. For purposes of this section, a substitute 
interest payment (as defined in Sec.  1.861-2(a)(7)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec.  1.861-2(a)(7)) shall have 
the same character as interest income paid or accrued with respect to 
the terms of the transferred security. Similarly, for purposes of this 
section, a substitute dividend payment (as defined in Sec.  1.861-
3(a)(6)) received by a foreign person pursuant to a securities lending 
transaction or a sale-repurchase transaction (as defined in Sec.  1.861-
3(a)(6)) shall have the same character as a distribution received with 
respect to the transferred security. Where, pursuant to a securities 
lending transaction or a sale-repurchase transaction, a foreign person 
transfers to another person a security the interest on which would 
qualify as portfolio interest under section 871(h) in the hands of the 
lender, substitute interest payments made with respect to the 
transferred security will be treated as portfolio interest, provided 
that in the case of interest on an obligation in registered form (as 
defined in Sec.  1.871-14(c)(1)(i)), the transferor complies with the 
documentation requirement described in Sec.  1.871-14(c)(1)(ii)(C) with 
respect to the payment of the substitute interest and none of the 
exceptions to the portfolio interest exemption in sections 871(h) (3) 
and (4) apply. See also Sec. Sec.  1.861-2(b)(2) and 1.894-1(c).
    (c) Other income and gains--(1) Items subject to tax. The tax of 30 
percent imposed by section 871(a)(1) also applies to the following gains 
received during the taxable year from sources within the United States:
    (i) Gains described in section 402(a)(2), relating to the treatment 
of total distributions from certain employees' trusts; section 
403(a)(2), relating to treatment of certain payments under certain 
employee annuity plans; and section 631 (b) or (c), relating to 
treatment of gain on the disposal of timber, coal, or iron ore with a 
retained economic interest;
    (ii) [Reserved]
    (iii) Gains on transfers described in section 1235, relating to 
certain transfers of patent rights, made on or before October 4, 1966; 
and
    (iv) Gains from the sale or exchange after October 4, 1966, of 
patents, copyrights, secret processes and formulas, good will, 
trademarks, trade brands, franchises, or other like property, or of any 
interest in any such property, to the extent the gains are from payments 
(whether in a lump sum or in installments) which are contingent on the 
productivity, use or disposition of the property or interest sold or 
exchanged, or from payments which are treated under section 871(e) and 
Sec.  1.871-11 as being so contingent.
    (2) Nonapplication of 183-day rule. The provisions of section 
871(a)(2), relating to gains from the sale or exchange of capital 
assets, and paragraph (d)(2) of this section do not apply to the gains 
described in this paragraph; as a consequence, the taxpayer receiving 
gains described in subparagraph (1) of this paragraph during a taxable 
year is subject to the tax of 30 percent thereon without regard to the 
183-day rule contained in such provisions.
    (3) Determination of amount of gain. The tax of 30 percent imposed 
upon the gains described in subparagraph (1) of this paragraph applies 
to the full amount of the gains and is determined (i) without regard to 
the alternative tax imposed by section 1201(b) upon the excess of the 
net long-term capital gain over the net short-term capital loss; (ii) 
without regard to the deduction allowed by section 1202 in respect of 
capital gains; (iii) without regard to section 1231, relating to 
property used in the trade or business and involuntary conversions; and 
(iv), except in

[[Page 411]]

the case of gains described in subparagraph (1)(ii) of this paragraph, 
whether or not the gains are considered to be gains from the sale or 
exchange of property which is a capital asset.
    (d) Gains from sale or exchange of capital assets--(1) Gains subject 
to tax. The tax of 30 percent imposed by section 871(a)(2) applies to 
the excess of gains derived from sources within the United States over 
losses allocable to sources within the United States, which are derived 
from the sale or exchange of capital assets, determined in accordance 
with the provisions of subparagraphs (2) through (4) of this paragraph.
    (2) Presence in the United States 183 days or more. (i) If the 
nonresident alien individual has been present in the United States for a 
period or periods aggregating 183 days or more during the taxable year, 
he is liable to a tax of 30 percent upon the amount by which his gains, 
derived from sources within the United States, from sales or exchanges 
of capital assets effected at any time during the year exceed his 
losses, allocable to sources within the United States, from sales or 
exchanges of capital assets effected at any time during that year. Gains 
and losses from sales or exchanges effected at any time during such 
taxable year are to be taken into account for this purpose even though 
the nonresident alien individual is not present in the United States at 
the time the sales or exchanges are effected. In addition, if the 
nonresident alien individual has been present in the United States for a 
period or periods aggregating 183 days or more during the taxable year, 
gains and losses for such taxable year from sales or exchanges of 
capital assets effected during a previous taxable year beginning after 
December 31, 1966, are to be taken into account, but only if he was also 
present in the United States during such previous taxable year for a 
period or periods aggregating 183 days or more.
    (ii) If the nonresident alien individual has not been present in the 
United States during the taxable year, or if he has been present in the 
United States for a period or periods aggregating less than 183 days 
during the taxable year, gains and losses from sales or exchanges of 
capital assets effected during the year are not to be taken into 
account, except as required by paragraph (c) of this section, in 
determining the tax of such individual even though the sales or 
exchanges are effected during his presence in the United States. 
Moreover, gains and losses for such taxable year from sales or exchanges 
of capital assets effected during a previous taxable year beginning 
after December 31, 1966, are not to be taken into account, even though 
the nonresident alien individual was present in the United States during 
such previous year for a period or periods aggregating 183 days or more.
    (iii) For purposes of this subparagraph, a nonresident alien 
individual is not considered to be present in the United States by 
reason of the presence in the United States of a person who is an agent 
or partner of such individual or who is a fiduciary of an estate or 
trust of which such individual is a beneficiary or a grantor-owner to 
whom section 671 applies.
    (iv) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. B, a nonresident alien individual not engaged in trade or 
business in the United States and using the calendar year as the taxable 
year, is present in the United States from May 1, 1971, to November 15, 
1971, a period of more than 182 days. While present in the United 
States, B effects for his own account on various dates a number of 
transactions in stocks and securities on the stock exchange, as a result 
of which he has recognized capital gains of $10,000. During the period 
from January 1, 1971, to April 30, 1971, he carries out similar 
transactions through an agent in the United States, as a result of which 
B has recognized capital gains of $5,000. On December 15, 1971, through 
an agent in the United States B sells a capital asset on the installment 
plan, no payments being made by the purchaser in 1971. During 1972, B 
receives installment payments of $50,000 on the installment sale made in 
1971, and the capital gain from sources within the United States for 
1972 attributable to such payments is $12,500. In addition, during the 
period from January 1, 1972, to May 31, 1972, B effects for his own 
account, through an agent in the United States, a number of transactions 
in stocks and securities on the stock exchange, as a result of which B 
has recognized capital gains of $20,000. At no time during 1972 is B 
present in the United States or engaged in trade or business in the 
United States. Accordingly,

[[Page 412]]

for 1971, B is subject to tax under section 871(a)(2) on his capital 
gains of $15,000 from the transactions in that year on the stock 
exchange. For 1972, B is not subject to tax on the capital gain of 
$12,500 from the installment sale in 1971 or on the capital gains of 
$20,000 from the transactions in 1972 on the stock exchange.
    Example 2. The facts are the same as in example 1 except that B is 
present in the United States from June 15, 1972, to December 31, 1972, a 
period of more than 182 days. Accordingly, B is subject to tax under 
section 871(a)(2) for 1971 on his capital gains of $15,000 from the 
transactions in that year on the stock exchange. He is also subject to 
tax under section 871(a)(2) for 1972 on his capital gains of $32,500 
($12,500 from the installment sale in 1971 plus $20,000 from the 
transactions in 1972 on the stock exchange).
    Example 3. D, a nonresident alien individual not engaged in trade or 
business in the United States and using the calendar year as the taxable 
year, is present in the United States from April 1, 1971, to August 31, 
1971, a period of less than 183 days. While present in the United 
States, D effects for his own account on various dates a number of 
transactions in stocks and securities on the stock exchange, as a result 
of which he has recognized capital gains of $15,000. During the period 
from January 1, 1971, to March 31, 1971, he carries out similar 
transactions through an agent in the United States, as a result of which 
D has recognized capital gains of $8,000. On December 20, 1971, through 
an agent in the United States D sells a capital asset on the installment 
plan, no payments being made by the purchaser in 1971. During 1972, D 
receives installment payments of $200,000 on the installment sale made 
in 1971, and the capital gain from sources within the United States for 
1972 attributable to such payments is $50,000. In addition, during the 
period from February 1, 1972, to August 15, 1972, a period of more than 
182 days. D effects for his own account, through an agent in the United 
States, a number of transactions in stocks and securities on the stock 
exchange, as a result of which D has recognized capital gains of 
$25,000. At no time during 1972 is D present in the United States or 
engaged in trade or business in the United States. Accordingly, D is not 
subject to tax for 1971 or 1972 on any of his recognized capital gains.
    Example 4. The facts are the same as in example 3 except that D is 
present in the United States from February 1, 1972, to August 15, 1972, 
a period of more than 182 days. Accordingly, D is not subject to tax for 
1971 on his capital gains of $23,000 from the transactions in that year 
on the stock exchange. For 1972 he is subject to tax under section 
871(a)(2) on his capital gains of $25,000 from the transactions in that 
year on the stock exchange, but he is not subject to the tax on the 
capital gain of $50,000 from the installment sale in 1971.

    (3) Determination of 183-day period--(i) In general. In determining 
the total period of presence in the United States for a taxable year for 
purposes of subparagraph (2) of this paragraph, all separate periods of 
presence in the United States during the taxable year are to be 
aggregated. If the nonresident alien individual has not previously 
established a taxable year, as defined in section 441(b), he shall be 
treated as having a taxable year which is the calendar year, as defined 
in section 441(d). Subsequent adoption by such individual of a fiscal 
year as the taxable year will be treated as a change in the taxpayer's 
annual accounting period to which section 442 applies, and the change 
must be authorized under this part (Income Tax Regulations) or prior 
approval must be obtained by filing an application on Form 1128 in 
accordance with paragraph (b) of Sec.  1.442-1. If in the course of his 
taxable year the nonresident alien individual changes his status from 
that of a citizen or resident of the United States to that of a 
nonresident alien individual, or vice versa, the determination of 
whether the individual has been present in the United States for 183 
days or more during the taxable year shall be made by taking into 
account the entire taxable year, and not just that part of the taxable 
year during which he has the status of a nonresident alien individual.
    (ii) Definition of ``day''. The term ``day'', as used in 
subparagraph (2) of this paragraph, means a calendar day during any 
portion of which the nonresident alien individual is physically present 
in the United States (within the meaning of sections 7701(a)(9) and 638) 
except that, in the case of an individual who is a resident of Canada or 
Mexico and, in the normal course of his employment in transportation 
service touching points within both Canada or Mexico and the United 
States, performs personal services in both the foreign country and the 
United States, the following rules shall apply:
    (a) The performance of labor or personal services during 8 hours or 
more in any 1 day within the United States shall be considered as 1 day 
in the United States, except that if a period

[[Page 413]]

of more or less than 8 hours is considered a full workday in the 
transportation job involved, such period shall be considered as 1 day 
within the United States.
    (b) The performance of labor or personal services during less than 8 
hours in any day in the United States shall, except as provided in (a) 
of this subdivision, be considered as a fractional part of a day in the 
United States. The total number of hours during which such services are 
performed in the United States during the taxable year, when divided by 
eight, shall be the number of days during which such individual shall be 
considered present in the United States during the taxable year.
    (c) The aggregate number of days determined under (a) and (b) of 
this subdivision shall be considered the total number of days during 
which such individual is present in the United States during the taxable 
year.
    (4) Determination of amount of excess gains--(i) In general. For the 
purpose of determining the excess of gains over losses subject to tax 
under this paragraph, gains and losses shall be taken into account only 
if, and to the extent that, they would be recognized and taken into 
account if the nonresident alien individual were engaged in trade or 
business in the United States during the taxable year and such gains and 
losses were effectively connected for such year with the conduct of a 
trade or business in the United States by such individual. However, in 
determining such excess of gains over losses no deduction may be taken 
under section 1202, relating to the deduction for capital gains, or 
section 1212, relating to the capital loss carryover. Thus, for example, 
in determining such excess gains all amounts considered under chapter 1 
of the Code as gains or losses from the sale or exchange of capital 
assets shall be taken into account, except those gains which are 
described in section 871(a)(1) (B) or (D) and taken into account under 
paragraph (c) of this section and are considered to be gains from the 
sale or exchange of capital assets. Also, for example, a loss described 
in section 631 (b) or (c) which is considered to be a loss from the sale 
of a capital asset shall be taken into account in determining the excess 
gains which are subject to tax under this paragraph. In further 
illustration, in determining such excess gains no deduction shall be 
allowed, pursuant to the provisions of section 267, for losses from 
sales or exchanges of property between related taxpayers. Any gains 
which are taken into account under section 871(a)(1) and paragraph (c) 
of this section shall not be taken into account in applying section 1231 
for purposes of this paragraph. Gains and losses are to be taken into 
account under this paragraph whether they are short-term or long-term 
capital gains or losses within the meaning of section 1222.
    (ii) Gains not included. The provisions of this paragraph do not 
apply to any gains described in section 871(a)(1) (B) or (D), and in 
subdivision (i), (iii), or (iv) of paragraph (c)(1) of this section, 
which are considered to be gains from the sale or exchange of capital 
assets.
    (iii) Allowance of losses. In determining the excess of gains over 
losses subject to tax under this paragraph losses shall be allowed only 
to the extent provided by section 165(c). Losses from sales or exchanges 
of capital assets in excess of gains from sales or exchanges of capital 
assets shall not be taken into account.
    (e) Credits against tax. The credits allowed by section 31 (relating 
to tax withheld on wages), by section 32 (relating to tax withheld at 
source on nonresident aliens), by section 39 (relating to certain uses 
of gasoline and lubricating oil), and by section 6402 (relating to 
overpayments of tax) shall be allowed against the tax of a nonresident 
alien individual determined in accordance with this section.
    (f) Effective date. Except as otherwise provided in this paragraph, 
this section shall apply for taxable years beginning after December 31, 
1966. Paragraph (b)(2) of this section is applicable to payments made 
after November 13, 1997. For corresponding rules applicable to taxable 
years beginning before January 1, 1967, see 26 CFR 1.871-7 (b) and (c) 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44219, Dec. 23, 1974, as amended by T.D. 8734, 62 FR 
53416, Oct. 14, 1997; T.D. 8735, 62 FR 53501, Oct. 14, 1997]

[[Page 414]]



Sec.  1.871-8  Taxation of nonresident alien individuals engaged 
in U.S. business or treated as having effectively connected income.

    (a) Segregation of income. This section applies for purposes of 
determining the tax of a nonresident alien individual who at any time 
during the taxable year is engaged in trade or business in the United 
States. It also applies for purposes of determining the tax of a 
nonresident alien student or trainee who is deemed under section 871(c) 
and Sec.  1.871-9 to be engaged in trade or business in the United 
States or of a nonresident alien individual who at no time during the 
taxable year is engaged in trade or business in the United States but 
has an election in effect for the taxable year under section 871(d) and 
Sec.  1.871-10 in respect to real property income. A nonresident alien 
individual to whom this section applies must segregate his gross income 
for the taxable year into two categories, namely (1) the income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual, and (2) the income 
which is not effectively connected for the taxable year with the conduct 
of a trade or business in the United States by that individual. A 
separate tax shall then be determined upon each such category of income, 
as provided in paragraph (b) of this section. The determination of 
whether income or gain is or is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by the nonresident alien individual shall be made in accordance 
with section 864(c) and Sec. Sec.  1.864-3 through 1.864-7. For purposes 
of this section income which is effectively connected for the taxable 
year with the conduct of a trade or business in the United States 
includes all income which is treated under section 871 (c) or (d) and 
Sec.  1.871-9 or Sec.  1.871-10 as income which is effectively connected 
for such year with the conduct of a trade or business in the United 
States by the nonresident alien individual.
    (b) Imposition of tax--(1) Income not effectively connected with the 
conduct of a trade or business in the United States. If a nonresident 
alien individual who is engaged in trade or business in the United 
States at any time during the taxable year derives during such year from 
sources within the United States income or gains described in section 
871(a)(1), and paragraph (b) or (c) of Sec.  1.871-7 or gains from the 
sale or exchange of capital assets determined as provided in section 
871(a)(2) and paragraph (d) of Sec.  1.871-7, which are not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that individual, such income or gains shall be 
subject to a flat tax of 30 percent of the aggregate amount of such 
items. This tax shall be determined in the manner, and subject to the 
same conditions, set forth in Sec.  1.871-7 as though the income or 
gains were derived by a nonresident alien individual not engaged in 
trade or business in the United States during the taxable year, except 
that (i) the rule in paragraph (d)(3) of such section for treating the 
calendar year as the taxable year shall not apply and (ii) in applying 
paragraph (c) and (d)(4) of such section, there shall not be taken into 
account any gains or losses which are taken into account in determining 
the tax under section 871(b) and subparagraph (2) of this paragraph. A 
nonresident alien individual who has an election in effect for the 
taxable year under section 871(d) and Sec.  1.871-10 and who at no time 
during the taxable year is engaged in trade or business in the United 
States must determine his tax under Sec.  1.871-7 on his income which is 
not treated as effectively connected with the conduct of a trade or 
business in the United States, subject to the exception contained in 
subdivision (ii) of this subparagraph.
    (2) Income effectively connected with the conduct of a trade or 
business in the United States--(i) In general. If a nonresident alien to 
whom this section applies derives income or gains which are effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that individual, the taxable income or gains 
shall, except as provided in Sec.  1.871-12, be taxed in accordance with 
section 1 or, in the alternative, section 1201(b). See section 
871(b)(1). Any income of the nonresident alien individual which is

[[Page 415]]

not effectively connected for the taxable year with the conduct of a 
trade or business in the United States by that individual shall not be 
taken into account in determining either the rate or amount of such tax. 
See paragraph (b) of Sec.  1.872-1.
    (ii) Determination of taxable income. The taxable income for any 
taxable year for purposes of this subparagraph consists only of the 
nonresident alien individual's taxable income which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that individual; and, for this purpose, it is 
immaterial that the trade or business with which that income is 
effectively connected is not the same as the trade or business carried 
on in the United States by that individual during the taxable year. See 
example 2 in Sec.  1.864-4(b). In determining such taxable income all 
amounts constituting, or considered to be, gains or losses for the 
taxable year from the sale or exchange of capital assets shall be taken 
into account if such gains or losses are effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by that individual, and, for such purpose, the 183-day rule set 
forth in section 871(a)(2) and paragraph (d)(2) of Sec.  1.871-7 shall 
not apply. Losses which are not effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that individual shall not be taken into account in determining taxable 
income under this subdivision, except as provided in section 873(b)(1).
    (iii) Cross references. For rules for determining the gross income 
and deductions for the taxable year, see sections 872 and 873, and the 
regulations thereunder.
    (c) Change in trade or business status--(1) In general. The 
determination as to whether a nonresident alien individual is engaged in 
trade or business within the United States during the taxable year is to 
be made for each taxable year. If at any time during the taxable year he 
is engaged in a trade or business in the United States, he is considered 
to be engaged in trade or business within the United States during the 
taxable year for purposes of sections 864(c)(1) and 871(b), and the 
regulations thereunder. Income, gain, or loss of a nonresident alien 
individual is not treated as being effectively connected for the taxable 
year with the conduct of a trade or business in the United States if he 
is not engaged in trade or business within the United States during such 
year, even though such income, gain, or loss may have been effectively 
connected for a previous taxable year with the conduct of a trade or 
business in the United States. See Sec.  1.864-3. However, income, gain, 
or loss which is treated as effectively connected for the taxable year 
with the conduct of a trade or business in the United States by a 
nonresident alien individual will generally be treated as effectively 
connected for a subsequent taxable year if he is engaged in a trade or 
business in the United States during such subsequent year, even though 
such income, gain, or loss is not effectively connected with the conduct 
of the trade or business carried on in the United States during such 
subsequent year. This subparagraph does not apply to income described in 
section 871 (c) or (d). It may not apply to a nonresident alien 
individual who for the taxable year uses an accrual method of accounting 
or to income which is constructively received in the taxable year within 
the meaning of Sec.  1.451-2.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. B, a nonresident alien individual using the calendar year 
as the taxable year and the cash receipts and disbursements method of 
accounting, is engaged in business (business R) in the United States 
from January 1, 1971, to August 31, 1971. During the period of September 
1, 1971, to December 31, 1971, B receives installment payments of 
$30,000 on sales made in the United States by business R during that 
year, and the income from sources within the United States for that year 
attributable to such payments is $7,509. On September 15, 1971, another 
business (business S), which is carried on by B only in a foreign 
country sells to U.S. customers on the installment plan several pieces 
of equipment from inventory. During the period of September 16, 1971, to 
December 31, 1971, B receives installment payments of $50,000 on these 
sales by business S, and the income from sources within the United 
States for that year attributable to such payments is $10,000. Under 
section 864(c)(3)

[[Page 416]]

and paragraph (b) of Sec.  1.864-4 the entire income of $17,500 is 
effectively connected for 1971 with the conduct of a business in the 
United States by B. Accordingly, such income is taxable to B under 
paragraph (b)(2) of this section.
    Example 2. Assume the same facts as in example 1, except that during 
1972 B receives installment payments of $20,000 from the sales made 
during 1971 in the United States by business R, and of $80,000 from the 
sales made in 1971 to U.S. customers by business S, the total income 
from sources within the United States for 1972 attributable to such 
payments being $13,000. At no time during 1972 is B engaged in a trade 
or business in the United States. Under section 864(c)(1)(B) the income 
of $13,000 for 1972 is not effectively connected with the conduct of a 
trade or business in the United States by B. Moreover, such income is 
not fixed or determinable annual or periodical income. Accordingly, no 
amount of such income is taxable to B under section 871.
    Example 3. Assume the same facts as in example 2, except that during 
1972 B is engaged in a new business (business T) in the United States 
from July 1, 1972, to December 31, 1972. Under section 864(c)(3) and 
paragraph (b) of Sec.  1.864-4, the income of $13,000 is effectively 
connected for 1972 with the conduct of a business in the United States 
by B. Accordingly, such income is taxable to B under paragraph (b)(2) of 
this section.
    Example 4. Assume the same facts as in example 2, except that the 
installment payments of $20,000 from the sales made during 1971 in the 
United States by business R and not received by B until 1972 could have 
been received by B in 1971 if he had so desired. Under Sec.  1.451-2, B 
is deemed to have constructively received the payments of $20,000 in 
1971. Accordingly, the income attributable to such payments is 
effectively connected for 1971 with the conduct of a business in the 
United States by B and is taxable to B in 1971 under paragraph (b)(2) of 
this section.

    (d) Credits against tax. The credits allowed by section 31 (relating 
to tax withheld on wages), section 32 (relating to tax withheld at 
source on nonresident aliens), section 33 (relating to the foreign tax 
credit), section 35 (relating to partially tax-exempt interest), section 
38 (relating to investment in certain depreciable property), section 39 
(relating to certain uses of gasoline and lubricating oil), section 40 
(relating to expenses of work incentive programs), and section 6402 
(relating to overpayments of tax) shall be allowed against the tax 
determined in accordance with this section. However, the credits allowed 
by sections 33, 38, and 40 shall not be allowed against the flat tax of 
30 percent imposed by section 871(a) and paragraph (b)(1) of this 
section. Moreover, no credit shall be allowed under section 35 to a non- 
resident alien individual with respect to whom a tax is imposed for the 
taxable year under section 871(a) and paragraph (b)(1) of this section, 
even though such individual has income for such year upon which tax is 
imposed under section 871(b) and paragraph (b)(2) of this section. For 
special rules applicable in determining the foreign tax credit, see 
section 906(b) and the regulations thereunder. For the disallowance of 
certain credits where a return is not filed for the taxable year, see 
section 874 and Sec.  1.874-1.
    (e) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.871-7(d) 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44221, Dec. 23, 1974]



Sec.  1.871-9  Nonresident alien students or trainees deemed 
to be engaged in U.S. business.

    (a) Participants in certain exchange or training programs. For 
purposes of Sec. Sec.  1.871-7 and 1.871-8 a nonresident alien 
individual who is temporarily present in the United States during the 
taxable year as a nonimmigrant under subparagraph (F) (relating to the 
admission of students into the United States) or subparagraph (J) 
(relating to the admission of teachers, trainees, specialists, etc., 
into the United States) of section 101(a)(15) of the Immigration and 
Nationality Act (8 U.S.C. 1101(a)(15) (F) or (J)), and who without 
regard to this paragraph is not engaged in trade or business in the 
United States during such year, shall be deemed to be engaged in trade 
or business in the United States during the taxable year. For purposes 
of determining whether an alien who is present in the United States on 
an F visa or a J visa is a resident of the United States, see Sec. Sec.  
301.7701(b)-1 through 301.7701(b)-9 of this chapter.
    (b) Income treated as effectively connected with U.S. business. Any 
income described in paragraph (1) (relating to

[[Page 417]]

the nonexcluded portion of certain scholarship or fellowship grants) or 
paragraph (2) (relating to certain nonexcluded expenses incident to such 
grants) of section 1441(b) which is received during the taxable year 
from sources within the United States by a nonresident alien individual 
described in paragraph (a) of this section is to be treated for purposes 
of Sec. Sec.  1.871-7, 1.871-8, 1.872-1, and 1.873-1 as income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual. However, such 
income is not to be treated as effectively connected for the taxable 
year with the conduct of a trade or business in the United States for 
purposes of section 1441(c)(1) and paragraph (a) of Sec.  1.1441-4. For 
exclusion relating to compensation paid to such individual by a foreign 
employer, see paragraph (b) of Sec.  1.872-2.
    (c) Exchange visitors. For purposes of paragraph (a) of this section 
a nonresident alien individual who is temporarily present in the United 
States during the taxable year as a nonimmigrant under subparagraph (J) 
of section 101(a)(15) of the Immigration and Nationality Act includes a 
nonresident alien individual admitted to the United States as an 
``exchange visitor'' under section 201 of the U.S. Information and 
Educational Exchange Act of 1948 (22 U.S.C. 1446), which section was 
repealed by section 111 of the Mutual Educational and Cultural Exchange 
Act of 1961 (75 Stat. 538).
    (d) Mandatory application of rule. The application of this section 
is mandatory and not subject to an election by the taxpayer.
    (e) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.871-7(a)(3) 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44222, Dec. 23, 1974, as amended by T.D. 8411, 57 FR 
15241, Apr. 27, 1992]



Sec.  1.871-10  Election to treat real property income as effectively 
connected with U.S. business.

    (a) When election may be made. A nonresident alien individual or 
foreign corporation which during the taxable year derives any income 
from real property which is located in the United States and, in the 
case of a nonresident alien individual, held for the production of 
income, or derives income from any interest in any such property, may 
elect, pursuant to section 871(d) or 882(d) and this section, to treat 
all such income as income which is effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that taxpayer. The election may be made whether or not the taxpayer is 
engaged in trade or business in the United States during the taxable 
year for which the election is made or whether or not the taxpayer has 
income from real property which for the taxable year is effectively 
connected with the conduct of a trade or business in the United States, 
but it may be made only with respect to that income from sources within 
the United States which, without regard to this section, is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by the taxpayer. If for the taxable 
year the taxpayer has no income from real property located in the United 
States, or from any interest in such property, which is subject to the 
tax imposed by section 871(a) or 881(a), the election may not be made. 
But if an election has been properly made under this section for a 
taxable year, the election remains in effect, unless properly revoked, 
for subsequent taxable years even though during any such subsequent 
taxable year there is no income from the real property, or interest 
therein, in respect of which the election applies.
    (b) Income to which the election applies--(1) Included income. An 
election under this section shall apply to all income from real property 
which is located in the United States and, in the case of a nonresident 
alien individual, held for the production of income, and to all income 
derived from any interest in such property, including (i) gains from the 
sale or exchange of such property or an interest therein, (ii) rents or 
royalties from mines, oil or gas wells, or other natural resources, and 
(iii) gains described in section 631 (b) or (c), relating to treatment 
of gain on the

[[Page 418]]

disposal of timber, coal, or iron ore with a retained economic interest. 
The election may not be made with respect to only one class of such 
income. For purposes of the election, income from real property, or from 
any interest in real property, includes any amount included under 
section 652 or 662 in the gross income of a nonresident alien individual 
or foreign corporation that is the beneficiary of an estate or trust if, 
by reason of the application of section 652(b) or 662(b), and the 
regulations thereunder, such amount has the character in the hands of 
that beneficiary of income from real property, or from any interest in 
real property. It is immaterial that no tax would be imposed on the 
income by section 871(a) and paragraph (a) of Sec.  1.871-7, or by 
section 881(a) and paragraph (a) of Sec.  1.881-2, if the election were 
not in effect. Thus, for example, if an election under this section has 
been made by a nonresident alien individual not engaged in trade or 
business in the United States during the taxable year, the tax imposed 
by section 871(b)(1) and paragraph (b)(2) of Sec.  1.871-8 applies to 
his gains derived from the sale of real property located in the United 
States and held for the production of income, even though such income 
would not be subject to tax under section 871(a) if the election had not 
been made. In further illustration, assume that a nonresident alien 
individual not engaged in trade or business, or present, in the United 
States during the taxable year has income from sources within the United 
States consisting of oil royalties, rentals from a former personal 
residence, and capital gain from the sale of another residence held for 
the production of income. If he makes an election under this section, it 
will apply with respect to his royalties, rentals, and capital gain, 
even though such capital gain would not be subject to tax under section 
871(a) if the election had not been made.
    (2) Income not included. For purposes of subparagraph (1) of this 
paragraph, income from real property, or from any interest in real 
property, does not include (i) interest on a debt obligation secured by 
a mortgage of real property, (ii) any portion of a dividend, within the 
meaning of section 316, which is paid by a corporation or a trust, such 
as a real estate investment trust described in section 857, which 
derives income from real property, (iii) in the case of a nonresident 
alien individual, income from real property, such as a personal 
residence, which is not held for the production of income or from any 
transaction in such property which was not entered into for profit, (iv) 
rentals from personal property, or royalties from intangible personal 
property, within the meaning of subparagraph (3) of this paragraph, or 
(v) income which, without regard to section 871(d) or 882(d) and this 
section, is treated as income which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States.
    (3) Rules applicable to personal property. For purposes of 
subparagraph (2) of this paragraph, in the case of a sales agreement, or 
rental or royalty agreement, affecting both real and personal property, 
the income from the transaction is to be allocated between the real 
property and the personal property in proportion to their respective 
fair market values unless the agreement specifically provides otherwise. 
In the case of such a rental or royalty agreement, the respective fair 
market values are to be determined as of the time the agreement is 
signed. In making determinations of this subparagraph, the principles of 
paragraph (c) of Sec.  1.48-1, relating to the definition of ``section 
38 property,'' apply for purposes of determining whether property is 
tangible or intangible personal property and of paragraph (a)(5) of 
Sec.  1.1245-1 apply for purposes of making the allocation of income 
between real and personal property.
    (c) Effect of the election--(1) Determination of tax. The income to 
which, in accordance with paragraph (b) of this section, an election 
under this section applies shall be subject to tax in the manner, and 
subject to the same conditions, provided by section 871(b)(1) and 
paragraph (b)(2) of Sec.  1.871-8, or by section 882(a)(1) and paragraph 
(b)(2) of Sec.  1.882-1. For purposes of determining such tax for the 
taxable year, income to which the election applies shall be aggregated 
with all other income of the nonresident alien individual or foreign

[[Page 419]]

corporation which is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that taxpayer. To 
the extent that deductions are connected with income from real property 
to which the election applies, they shall be treated for purposes of 
section 873(a) or section 882(c)(1) as connected with income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by the nonresident alien individual or 
foreign corporation. An election under this section does not cause a 
nonresident alien individual or foreign corporation, which is not 
engaged in trade or business in the United States during the taxable 
year, to be treated as though such taxpayer were engaged in trade or 
business in the United States during the taxable year. Thus, for 
example, the compensation received during the taxable year for services 
performed in the United States in a previous taxable year by a 
nonresident alien individual, who has an election in effect for the 
taxable year under this section but is engaged in trade or business in 
the United States at no time during the taxable year, is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States. In further illustration, gain for the taxable year 
from the casual sale of personal property described in section 1221(I) 
derived by a nonresident alien individual who is not engaged in trade or 
business in the United States during the taxable year but has an 
election in effect for such year under this section is not effectively 
connected with the conduct of a trade or business in the United States. 
See Sec.  1.864-3. If an election under this section is in effect for 
the taxable year, the income to which the election applies shall be 
treated, for purposes of section 871(b)(1) or section 882(a)(1), section 
1441(c)(1), and paragraph (a) of Sec.  1.1441-4, as income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by the taxpayer.
    (2) Treatment of property to which election applies. Any real 
property, or interest in real property, with respect to which an 
election under this section applies shall be treated as a capital asset 
which, if depreciable, is subject to the allowance for depreciation 
provided in section 167 and the regulations thereunder. Such property, 
or interest in property, shall be treated as property not used in a 
trade or business for purposes of applying any provisions of the Code, 
such as section 172(d)(4)(A), relating to gain or loss attributable to a 
trade or business for purposes of determining a net operating loss; 
section 1221(2), relating to property not constituting a capital asset; 
or section 1231(b), relating to special rules for treatment of gains and 
losses. For example, if a nonresident alien individual makes the 
election under this section and, while the election is in effect, sells 
unimproved land which is located in the United States and held for 
investment purposes, any gain or loss from the sale shall be considered 
gain or loss from the sale of a capital asset and shall be treated, for 
purposes of determining the tax under section 871(b)(1) and paragraph 
(b)(2) of Sec.  1.871-8, as a gain or loss which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States.
    (d) Manner of making or revoking an election--(1) Election, or 
revocation, without consent of Commissioner--(i) In general. A 
nonresident alien individual or foreign corporation may, for the first 
taxable year for which the election under this section is to apply, make 
the initial election at any time before the expiration of the period 
prescribed by section 6511(a), or by section 6511(c) if the period for 
assessment is extended by agreement, for filing a claim for credit or 
refund of the tax imposed by chapter 1 of the Code for such taxable 
year. This election may be made without the consent of the Commissioner. 
Having made the initial election, the taxpayer may, within the time 
prescribed for making the election for such taxable year, revoke the 
election without the consent of the Commissioner. If the revocation is 
timely and properly made, the taxpayer may make his initial election 
under this section for a later taxable year without the consent of the 
Commissioner. If the taxpayer revokes the initial election

[[Page 420]]

without the consent of the Commissioner he must file amended income tax 
returns, or claims for credit or refund, where applicable, for the 
taxable years to which the revocation applies.
    (ii) Statement to be filed with return. An election made under this 
section without the consent of the Commissioner shall be made for a 
taxable year by filing with the income tax return required under section 
6012 and the regulations thereunder for such taxable year a statement to 
the effect that the election is being made. This statement shall include 
(a) a complete schedule of all real property, or any interest in real 
property, of which the taxpayer is titular or beneficial owner, which is 
located in the United States, (b) an indication of the extent to which 
the taxpayer has direct or beneficial ownership in each such item of 
real property, or interest in real property, (c) the location of the 
real property or interest therein, (d) a description of any substantial 
improvements on any such property, and (e) an identification of any 
taxable year or years in respect of which a revocation or new election 
under this section has previously occurred. This statement may not be 
filed with any return under section 6851 and the regulations thereunder.
    (iii) Exemption from withholding of tax. For statement to be filed 
with a withholding agent at the beginning of a taxable year in respect 
of which an election under this section is to be made, see paragraph (a) 
of Sec.  1.1441-4.
    (2) Revocation, or election, with consent of Commissioner--(i) In 
general. If the nonresident alien individual or foreign corporation 
makes the initial election under this section for any taxable year and 
the period prescribed by subparagraph (1)(i) of this paragraph for 
making the election for such taxable year has expired, the election 
shall remain in effect for all subsequent taxable years, including 
taxable years for which the taxpayer realizes no income from real 
property, or from any interest therein, or for which he is not required 
under section 6012 and the regulations thereunder to file an income tax 
return. However, the election may be revoked in accordance with 
subdivision (iii) of this subparagraph for any subsequent taxable year 
with the consent of the Commissioner. If the election for any such 
taxable year is revoked with the consent of the Commissioner, the 
taxpayer may not make a new election before his fifth taxable year which 
begins after the first taxable year for which the revocation is 
effective unless consent is given to such new election by the 
Commissioner in accordance with subdivision (iii) of this subparagraph.
    (ii) Effect of new election. A new election made for the fifth 
taxable year, or taxable year thereafter, without the consent of the 
Commissioner, and a new election made with the consent of the 
Commissioner, shall be treated as an initial election to which 
subparagraph (1) of this paragraph applies.
    (iii) Written request required. A request to revoke an election made 
under this section when such revocation requires the consent of the 
Commissioner, or to make a new election when such election requires the 
consent of the Commissioner, shall be made in writing and shall be 
addressed to the Director of International Operations, Internal Revenue 
Service, Washington, DC 20225. The request shall include the name and 
address of the taxpayer and shall be signed by the taxpayer or his duly 
authorized representative. It must specify the taxable year for which 
the revocation or new election is to be effective and shall be filed 
within 75 days after the close of the first taxable year for which it is 
desired to make the change. The request must specify the grounds which 
are considered to justify the revocation or new election. The Director 
of International Operations may require such other information as may be 
necessary in order to determine whether the proposed change will be 
permitted. A copy of the consent by the Director of International 
Operations shall be attached to the taxpayer's return required under 
section 6012 and the regulations thereunder for the taxable year for 
which the revocation or new election is effective. A copy of such 
consent may not be filed with any return under section 6851 and the 
regulations thereunder.
    (3) Election by partnership. If a non-resident alien individual or 
foreign corporation is a member of a partnership

[[Page 421]]

which has income described in paragraph (b)(1) of this section from real 
property, any election to be made under this section in respect of such 
income shall be made by the partners and not by the partnership. A 
nonresident alien or foreign corporation that makes an election 
generally must provide the partnership a Form W-8ECI, ``Certificate of 
Foreign Person's Claim for Exemption from Withholding on Income 
Effectively Connected with the Conduct of a Trade or Business in the 
United States,'' and attach to such form a copy of the election (or a 
statement that indicates that the nonresident alien or foreign 
corporation will make the election). However, if the nonresident alien 
or foreign corporation has already submitted a valid form to the 
partnership that establishes such partner's foreign status, the partner 
shall furnish the partnership a copy of the election (or a statement 
that indicates that the nonresident alien or foreign corporation will 
make the election). To the extent the partnership has income to which 
the election pertains, the partnership shall treat such income as 
effectively connected income subject to withholding under section 1446. 
See also Sec.  1.1446-2.
    (e) Effective dates. This section shall apply for taxable years 
beginning after December 31, 1966, except the last four sentences of 
paragraph (d)(3) of this section shall apply to partnership taxable 
years beginning after May 18, 2005, or such earlier time as the 
regulations under Sec. Sec.  1.1446-1 through 1.1446-5 apply by reason 
of an election under Sec.  1.1446-7. There are no corresponding rules in 
this part for taxable years beginning before January 1, 1967.

[T.D. 7332, 39 FR 44222, Dec. 23, 1974, as amended by T.D. 9200, 70 FR 
28717, May 18, 2005]



Sec.  1.871-11  Gains from sale or exchange of patents, copyrights, 
or similar property.

    (a) Contingent payment defined. For purposes of section 
871(a)(1)(D), section 881(a)(4), Sec.  1.871-7(c)(1)(iv), Sec.  1.881-
2(c)(1)(iii), and this section, payments which are contingent on the 
productivity, use, or disposition of property or of an interest therein 
include continuing payments measured by a percentage of the selling 
price of the products marketed, or based on the number of units 
manufactured or sold, or based in a similar manner upon production, sale 
or use, or disposition of the property or interest transferred. A 
payment which is certain as to the amount to be received, but contingent 
as to the time of payment, or an installment payment of a principal sum 
agreed upon in a transfer agreement, shall not be treated as a 
contingent payment for purposes of this paragraph. For the inapplication 
of section 1253 to certain amounts described in this paragraph, see 
paragraph (a) of Sec.  1.1253-1.
    (b) Payments treated as contingent on use. Pursuant to section 
871(e), if more than 50 percent of the gain of a nonresident alien 
individual or foreign corporation for any taxable year from the sale or 
exchange after October 4, 1966, of any patent, copyright, secret process 
or formula, goodwill, trademark, trade brand, franchise, or other like 
property, or of any interest in any such property, is from payments 
which are contingent on the productivity, use, or disposition of such 
property or interest, all of the gain of such individual or corporation 
for the taxable year from the sale or exchange of such property or 
interest are, for purposes of section 871(a)(1)(D), section 881(a)(4), 
section 1441(b), or section 1442(a), and the regulations thereunder, to 
be treated as being from payments which are contingent on the 
productivity, use, or disposition of such property or interest. This 
paragraph does not apply for purposes of determining under section 
871(b)(1) or 882(a)(1) the tax of a nonresident alien individual or 
foreign corporation on income which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States.
    (c) Sale or exchange. A sale or exchange for purposes of this 
section includes, but is not limited to, a transfer by an individual 
which by reason of section 1235, relating to the sale or exchange of 
patents, is considered the sale or exchange of a capital asset. The 
provisions of section 1253, relating to transfers of franchises, 
trademarks, and trade names, do not apply in determining whether a 
transfer is a sale or exchange for purposes of this section.

[[Page 422]]

    (d) Recovery of adjusted basis. For purposes of determining for any 
taxable year the amount of gains which are subject to tax under section 
871(a)(1)(D) or 881(a)(4), payments received by the nonresident alien 
individual or foreign corporation during such year must be reduced by 
amounts representing recovery of the taxpayer's adjusted basis of the 
property or interest which is sold or exchanged. Where the taxpayer 
receives in the same taxable year payments which, without reference to 
section 871(e) and this section, are not contingent on the productivity, 
use, or disposition of the property or interest which is sold or 
exchanged and payments which are contingent on the productivity, use, or 
disposition of the property or interest which is sold or exchanged, the 
taxpayer's unrecovered adjusted basis in the property or interest which 
is sold or exchanged must be allocated for the taxable year between such 
payments on the basis of the gross amount of each such type of payments. 
Where the taxpayer receives in the taxable year only payments which are 
not so contingent or only payments which are so contingent, the 
taxpayer's unrecovered basis must be allocated in its entirety to such 
payments for the taxable year.
    (e) Source rule. In determining whether gains described in section 
871(a)(1)(D) or 881(a)(4) and paragraph (b) of this section are received 
from sources within the United States, such gains shall be treated, for 
purposes of section 871(a)(1)(D), section 881(a)(4), section 1441(b), 
and section 1442(a), as rentals or royalties for the use of, or 
privilege of using, property or an interest in property. See section 
861(a)(4), Sec.  1.861-5, and paragraph (a) of Sec.  1.862-1.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. (a) A, a nonresident alien individual who uses the cash 
receipts and disbursements method of accounting and the calendar year as 
the taxable year, holds a U.S. patent which he developed through his own 
effort. On December 15, 1967, A enters into an agreement of sale with M 
Corporation, a domestic corporation, whereby A assigns to M Corporation 
all of his U.S. rights in the patent. In consideration of the sale, M 
Corporation is obligated to pay a fixed sum of $60,000, $20,000 being 
payable on execution of the contract and the balance payable in four 
annual installments of $10,000 each. As additional consideration, M 
Corporation agrees to pay to A a royalty in the amount of 2 percent of 
the gross sales of the products manufactured by M Corporation under the 
patent. A is not engaged in trade or business in the United States at 
any time during 1967 and 1968. His adjusted basis in the patent at the 
time of sale is $28,800.
    (b) In 1967, A receives only the $20,000 paid by M Corporation on 
the execution of the contract of sale. No gain is realized by A upon 
receipt of this amount, and his unrecovered adjusted basis in the patent 
is reduced to $8,800 ($28,800 less $20,000).
    (c) In 1968, M Corporation has gross sales of $600,000 from products 
manufactured under the patent. Consequently, for 1968, M Corporation 
pays $22,000 to A, $10,000 being the annual installment on the fixed 
payment and $12,000 being payments under the terms of the royalty 
provision. A's recognized gain for 1968 is $13,200 ($22,000 reduced by 
the unrecovered adjusted basis of $8,800). Of the total gain of $13,200, 
gain in the amount of $6,000 ($10,000- [$8,800 x $10,000/$22,000]) is 
considered to be from the fixed installment payment and of $7,200 
($12,000-[$8,800 x $12,000/$22,000]) is considered to be from the 
royalty payment. Since 54.5 percent ($7,200/$13,200) of the gain 
recognized in 1968 from the sale of the patent is from payments which 
are contingent on the productivity, use, or disposition of the patent, 
all of the $13,200 gain recognized in 1968 is treated, for purposes of 
section 871(a)(1)(D) and section 1441(b), as being from payments which 
are contingent on the productivity, use, or disposition of the patent.
    Example 2. (a) F, a foreign corporation using the calendar year as 
the taxable year and not engaged in trade or business in the United 
States, holds a U.S. patent on certain property which it developed 
through its own efforts. Corporation F uses the cash receipts and 
disbursements method of accounting. On December 1, 1966, F Corporation 
enters into an agreement of sale with D Corporation, a domestic 
corporation, whereby D Corporation purchases the exclusive right and 
license, and the right to sublicense to others, to manufacture, use, 
and/or sell certain devices under the patent in the United States during 
the term of the patent. The agreement grants D Corporation the right to 
dispose, anywhere in the world, of machinery manufactured in the United 
States and equipped with such devices. Corporation D is granted the 
right, at its own expense, to prosecute infringers in its own name or in 
the name of F Corporation, or both, and to retain any damages recovered.
    (b) Corporation D agrees to pay to F Corporation annually $5 for 
each device manufactured under the patent during the year but in no case 
less than $5,000 per year. In

[[Page 423]]

1967, D Corporation manufactures 2,500 devices under the patent; and, in 
1968, 1,500 devices. Under the terms of the contract D Corporation pays 
to F Corporation in 1967 $12,500 with respect to production in that year 
and $7,500 in 1968 with respect to production in that year. F 
Corporation's basis in the patent at the time of the sale is $17,000.
    (c) With respect to the payments received by F Corporation in 1967, 
no gain is realized by that corporation and its unrecovered adjusted 
basis in the patent is reduced to $4,500 ($17,000 less $12,500).
    (d) With respect to the payments received by F Corporation in 1968, 
such corporation has recognized gain of $3,000 ($7,500 reduced by 
unrecovered adjusted basis of $4,500). Of the total gain of $3,000, gain 
in the amount of $2,000 ($5,000- [$4,500 x $5,000/$7,500]) is considered 
to be from the fixed installment payment and of $1,000 ($2,500-[$4,500 x 
$2,500/$7,500]) is considered to be from payments which are contingent 
on the productivity, use, or disposition of the patent. Since 33.3 
percent ($1,000/$3,000) of the gain recognized in 1968 from the sale of 
the patent is from payments which are contingent on the productivity, 
use, or disposition of the patent, only $1,000 of the $3,000 gain for 
that year constitutes gains which, for purposes of section 881(a)(4) and 
section 1442(a), are from payments which are contingent on the 
productivity, use, or disposition of the patent. The balance of $2,000 
is gain from the sale of property and is not subject to tax under 
section 881(a).

    (g) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966, but only in respect of gains from 
sales or exchanges occurring after October 4, 1966. There are no 
corresponding rules in this part for taxable years beginning before 
January 1, 1967.

[T.D. 7332, 39 FR 44224, Dec. 23, 1974]



Sec.  1.871-12  Determination of tax on treaty income.

    (a) In general. This section applies for purposes of determining 
under Sec.  1.871-7 or Sec.  1.871-8 the tax of a nonresident alien 
individual, or under Sec.  1.881-2 or Sec.  1.882-1 the tax of a foreign 
corporation, which for the taxable year has income described in section 
872(a) or 882(b) upon which the tax is limited by an income tax 
convention to which the United States is a party. Income for such 
purposes does not include income of any kind which is exempt from tax 
under the provisions of an income tax convention to which the United 
States is a party. See Sec. Sec.  1.872-2(c) and 1.883-1(b). This 
section shall not apply to a nonresident alien individual who is a bona 
fide resident of Puerto Rico during the entire taxable year.
    (b) Definition of treaty and nontreaty income--(1) In general. (i) 
For purposes of this section the term ``treaty income'' shall be 
construed to mean the gross income of a nonresident alien individual or 
foreign corporation, as the case may be, the tax on which is limited by 
a tax convention. The term ``non-treaty income'' shall be construed, for 
such purposes, to mean the gross income of the nonresident alien 
individual or foreign corporation other than the treaty income. Neither 
term includes income of any kind which is exempt from the tax imposed by 
chapter 1 of the Code.
    (ii) In determining either the treaty or nontreaty income the gross 
income shall be determined in accordance with Sec. Sec.  1.872-1 and 
1.872-2, or with Sec. Sec.  1.882-3 and 1.883-1, except that in 
determining the treaty income the exclusion granted by section 116(a) 
for dividends shall not be taken into account. Thus, for example, treaty 
income includes the total amount of dividends paid by a domestic 
corporation not disqualified by section 116(b) and received from sources 
within the United States if, in accordance with a tax convention, the 
dividends are subject to the income tax at a rate not to exceed 15 
percent but does not include interest which, in accordance with a tax 
convention, is exempt from the income tax. In further illustration, 
neither the treaty nor the nontreaty income includes interest on certain 
governmental obligations which by reason of section 103 is excluded from 
gross income, or interest which by reason of a tax convention is exempt 
from the tax imposed by chapter 1 of the Code.
    (iii) For purposes of applying any income tax convention to which 
the United States is a party, original issue discount which is subject 
to tax under section 871(a)(1)(C) or 881(a)(3) is to be treated as 
interest, and gains which are subject to tax under section 871(a)(1)(D) 
or 881(a)(4) are to be treated as royalty income. This subdivision shall 
not apply, however, where its application

[[Page 424]]

would be contrary to any treaty obligation of the United States.
    (2) Application of permanent establishment rule of treaties. In 
applying this section with respect to income which is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by a nonresident alien individual or foreign 
corporation, see section 894(b), which provides that with respect to 
such income the nonresident alien individual or foreign corporation 
shall be deemed not to have a permanent establishment in the United 
States at any time during the taxable year for purposes of applying any 
exemption from, or reduction in rate of, tax provided by any tax 
convention.
    (c) Determination of tax--(1) In general. If the gross income of a 
nonresident alien individual or foreign corporation, as the case may be, 
consists of both treaty and nontreaty income, the tax liability for the 
taxable year shall be the sum of the amounts determined in accordance 
with subparagraphs (2) and (3) of this paragraph. In no case, however, 
may the tax liability so determined exceed the tax liability (tax 
reduced by allowable credits) with respect to the taxpayer's entire 
income, determined in accordance with Sec.  1.871-7 or Sec.  1.871-8, or 
with Sec.  1.881-2 or Sec.  1.882-1, as though the tax convention had 
not come into effect and without reference to the provisions of this 
section. Determinations under this paragraph shall be made without 
taking into account any credits allowed by sections 31, 32, 39, and 
6402, but such credits shall be allowed against the tax liability 
determined in accordance with this subparagraph.
    (2) Tax on nontreaty income. For purposes of subparagraph (1) of 
this paragraph, compute a partial tax (determined without the allowance 
of any credit) upon only the nontreaty income in accordance with Sec.  
1.871-7 or Sec.  1.871-8, or with Sec.  1.881-2 or Sec.  1.882-1, 
whichever applies, as though the tax convention had not come into 
effect. To the extent allowed by paragraph (d) of Sec.  1.871-8, or 
paragraph (c) of Sec.  1.882-1, the credits allowed by sections 33, 35, 
38, and 40 shall then be allowed, without taking into account any item 
included in the treaty income, against the tax determined under this 
subparagraph.
    (3) Tax on treaty income. For purposes of subparagraph (1) of this 
paragraph, compute a tax upon the gross amount, determined without the 
allowance of any deduction, of each separate item of treaty income at 
the reduced rate applicable to that item under the tax convention. No 
credits shall be allowed against the tax determined under this 
subparagraph.
    (d) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) A nonresident alien individual who is a resident of a 
foreign country with which the United States has entered into a tax 
convention receives during the taxable year 1967 from sources within the 
United States total gross income of $22,000, consisting of the following 
items:

Compensation for personal services the tax on which is not       $20,000
 limited by the tax convention (effectively connected income
 under Sec.   1.864-4(c)(6)(ii))..............................
Oil royalties the tax on which is limited by the tax               2,000
 convention to 15 percent of the gross amount thereof
 (effectively connected income by reason of election under
 Sec.   1.871-10).............................................
                                                               ---------
   Total gross income.........................................    22,000
 

    (b) The taxpayer is engaged in business in the United States during 
the taxable year but does not have a permanent establishment therein. 
There are no allowable deductions, other than the deductions allowed by 
sections 613 and 873(b)(3).
    (c) The tax liability for the taxable year is $6,100, determined as 
follows:

Nontreaty gross income........................................   $20,000
Less: Deduction for personal exemption........................       600
                                                               ---------
   Nontreaty taxable income...................................    19,400
                                                               =========
Tax under section 1 of the Code on nontreaty taxable income        5,800
 ($5,170 plus 45 percent of $1,400)...........................
Plus: Tax on treaty income (Gross oil royalties) ($2,000 x 15        300
 percent).....................................................
                                                               ---------
    Total tax (determined as provided in paragraph (c) (2) and     6,100
     (3) of this section).....................................
                                                               =========
 

    (d) If the tax had been determined under paragraph (b)(2) of Sec.  
1.871-8 as though the tax liability would have been $6,478, determined 
as follows and by taking into account the election under Sec.  1.871-10:

Total gross income...................................  .......   $22,000
  Less: Deduction under section 613 for percentage        $550
   depletion ($2000 x 27\1/2\ percent)...............
  Deduction for personal exemption...................      600     1,150
                                                      ------------------
   Taxable income....................................   20,850
                                                               =========

[[Page 425]]

 
Tax under section 1 of the Code on taxable income ($6,070 plus     6,478
 48 percent of $850)..........................................
 

    (e) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.871-7(e) 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44225, Dec. 23, 1974, as amended at T.D. 8657, 61 FR 
9338, Mar. 8, 1996]



Sec.  1.871-13  Taxation of individuals for taxable year of change 
of U.S. citizenship or residence.

    (a) In general. (1) An individual who is a citizen or resident of 
the United States at the beginning of the taxable year but a nonresident 
alien at the end of the taxable year, or a nonresident alien at the 
beginning of the taxable year but a citizen or resident of the United 
States at the end of the taxable year, is taxable for such year as 
though his taxable year were comprised of two separate periods, one 
consisting of the time during which he is a citizen or resident of the 
United States and the other consisting of the time during which he is 
not a citizen or resident of the United States. Thus, for example, the 
income tax liability of an alien individual under chapter 1 of the Code 
for the taxable year in which he changes his residence will be computed 
under two different sets of rules, one relating to resident aliens for 
the period of residence and the other relating to nonresident aliens for 
the period of nonresidence. However, in determining the taxable income 
for such year which is subject to the graduated rate of tax imposed by 
section 1 or 1201 of the Code, all income for the period of U.S. 
citizenship or residence must be aggregated with the income for the 
period of nonresidence which is effectively connected for such year with 
the conduct of a trade or business in the United States. This section 
does not apply to alien individuals treated as residents for the entire 
taxable year under section 6013 (g) or (h). These individuals are taxed 
under the rules in Sec.  1.1-1(b).
    (2) For purposes of this section, an individual is deemed to be a 
citizen or resident of the United States for the day on which he becomes 
a citizen or resident of the United States, a nonresident of the United 
States for the day on which he abandons his U.S. residence, and an alien 
for the day on which he gives up his U.S. citizenship.
    (b) Acquisition of U.S. citizenship or residence. Income from 
sources without the United States which is not effectively connected 
with the conduct by the taxpayer of a trade or business in the United 
States is not taxable if received by an alien individual while he is not 
a resident of the United States even though he becomes a citizen or 
resident of the United States after its receipt and before the close of 
the taxable year. However, income from sources without the United States 
which is not effectively connected with the conduct by the taxpayer of a 
trade or business in the United States is taxable if received by an 
individual while he is a citizen or resident of the United States, even 
though he earns the income earlier in the taxable year while he is 
neither a citizen nor resident of the United States.
    (c) Abandonment of U.S. citizenship or residence. Income from 
sources without the United States which is not effectively connected 
with the conduct by the taxpayer of a trade or business in the United 
States is not taxable if received by an alien individual while he is not 
a resident of the United States, even though he earns the income earlier 
in the taxable year while he is a citizen or resident of the United 
States. However, income from sources without the United States which is 
not effectively connected with the conduct by the taxpayer of a trade or 
business in the United States is taxable if received by an individual 
while he is a citizen or resident of the United States, even though he 
abandons his U.S. citizenship or residence after its receipt and before 
the close of the taxable year.
    (d) Special rules--(1) Method of accounting. Paragraphs (b) and (c) 
of this section may not apply to an individual who for the taxable year 
uses an accrual method of accounting.
    (2) Deductions for personal exemptions. An alien individual to whom 
this section applies is entitled to deduct one personal exemption for 
the taxable year under section 151. In addition, he

[[Page 426]]

is entitled to such additional exemptions as are allowed as a deduction 
under section 151 but only to the extent the amount of such additional 
exemptions do not exceed his taxable income (determined without regard 
to any deduction for personal exemptions) for the period in the taxable 
year during which he is a citizen or resident of the United States. This 
subparagraph does not apply to the extent it is inconsistent with 
section 873, and the regulations thereunder, or with the provisions of 
an income tax convention to which the United States is a party.
    (3) Exclusion of dividends received. In determining the $100 
exclusion for the taxable year provided by section 116 in respect of 
certain dividends, only those dividends for the period during which the 
individual is neither a citizen nor resident of the United States may be 
taken into account as are effectively connected for the taxable year 
with the conduct of a trade or business in the United States. See Sec.  
1.116-1(e)(1).
    (e) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a married alien individual who uses the calendar year 
as the taxable year and the cash receipts and disbursements method of 
accounting, becomes a resident of the United States on June 1, 1971. 
During the period of nonresidence from January 1, 1971, to May 31, 1971, 
inclusive, A receives $15,000 income from sources without the United 
States which is not effectively connected with the conduct of a trade or 
business in the United States. During the period of residence from June 
1, 1971, to December 31, 1971, A receives wages of $10,000, dividends of 
$200 from a foreign corporation, and dividends of $75 from a domestic 
corporation qualifying under section 116(a). Of the amount of wages so 
received, $2,000 is for services performed by A outside the United 
States during the period of nonresidence. Total allowable deductions 
(other than for personal exemptions) amount to $700, none of which are 
deductible under section 62 in computing adjusted gross income. For 1971 
A's spouse has no gross income and is not the dependent of another 
taxpayer. For 1971, A's taxable income is $8,200, all of which is 
subject to tax under section 1, as follows:

Wages.........................................................   $10,000
Dividends from foreign corporation............................       200
Dividends from domestic corporation ($75 less $75 exclusion)..         0
                                                      ----------
Adjusted gross income.........................................    10,200
Less deductions:
  Personal exemptions (2 x $650).....................   $1,300
  Other allowable deductions.........................      700     2,000
                                                      ------------------
Taxable income.......................................  .......     8,200
                                                               =========
 

    Example 2. The facts are the same as in example 1 except that during 
the period of nonresidence from January 1, 1971, to May 31, 1971, A 
receives from sources within the United States income of $1,850 which is 
effectively connected with the conduct by A of a business in the United 
States and $350 in dividends from domestic corporations qualifying under 
section 116(a). Only $50 of these dividends are effectively connected 
with the conduct by A of a business in the United States. The assumption 
is made that there are no allowable deductions connected with such 
effectively connected income. For 1971, A has taxable income of $10,075 
subject to tax under section 1 and $300 income subject to tax under 
section 871(a)(1)(A), as follows:

Wages.........................................................   $10,000
Business income...............................................     1,850
Dividends from foreign corporation............................       200
Dividends from domestic corporation ($125 less $100 exclusion)        25
                                                      ----------
Adjusted gross income.........................................    12,075
Less deductions:
  Personal exemptions (2 x $650).....................   $1,300
  Other allowable deductions.........................      700     2,000
                                                      ------------------
Taxable income subject to tax under section 1.................    10,075
                                                      ==========
Income subject to tax under section 871(a)(1)(A)..............       300
                                                      ==========
 

    Example 3. A, a married alien individual with three children, uses 
the calendar year as the taxable year and the cash receipts and 
disbursements method of accounting. On October 1, 1971, A and his family 
become residents of the United States. During the period of nonresidence 
from January 1, 1971, to September 30, 1971, A receives income of 
$18,000 from sources without the United States which is not effectively 
connected with the conduct of a trade or business in the United States 
and of $2,500 from sources within the United States which is effectively 
connected with the conduct of a business in the United States. It is 
assumed there are no allowable deductions connected with such 
effectively connected income. During the period of residence from 
October 1, 1971, to December 31, 1971, A receives wages of $2,000, of 
which $400 is for services performed outside the United States during 
the period of nonresidence. Total allowable deductions (other than for 
personal exemptions) amount to $250, none of which are deductible under 
section 62 in computing adjusted gross income. Neither the spouse nor 
any of the children has any gross income for 1971, and the spouse is not 
the dependent of another taxpayer for such year. For 1971, A's taxable 
income is $1,850, all of which is subject to tax under section 1, as 
follows:

[[Page 427]]



Wages (residence period).............................   $2,000
Less: Allowable deductions...........................      250
                                                      ---------
Taxable income (without deduction for personal exemptions)        $1,750
 (residence period)...........................................
Business income (nonresidence period).........................     2,500
                                                      ----------
Total taxable income (without deduction for personal               4,250
 exemptions)..................................................
Less deduction for personal exemptions:
  Taxpayer...........................................      650
  Wife and 3 children (4 x $650, but not to exceed       1,750     2,400
   $1,750)...........................................
                                                      ------------------
Taxable income.......................................  .......     1,850
                                                               =========
 

    (f) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. There are no corresponding rules in 
this part for taxable years beginning before January 1, 1967.

[T.D. 7332, 39 FR 44226, Dec. 23, 1974, as amended by T.D. 7670, 45 FR 
6928, Jan. 31, 1980]



Sec.  1.871-14  Rules relating to repeal of tax on interest of nonresident 
alien individuals and foreign corporations received from certain portfolio 
debt investments.

    (a) General rule. No tax shall be imposed under section 
871(a)(1)(A), 871(a)(1)(C), 881(a)(1) or 881(a)(3) on any portfolio 
interest as defined in sections 871(h)(2) and 881(c)(2) received by a 
foreign person. But see section 871(b) or 882(a) if such interest is 
effectively connected with the conduct of a trade or business within the 
United States.
    (b) Rules concerning obligations in bearer form before March 19, 
2012--(1) In general. Interest (including original issue discount) with 
respect to an obligation in bearer form is portfolio interest within the 
meaning of section 871(h)(2)(A) or 881(c)(2)(A) only if it is paid with 
respect to an obligation issued after July 18, 1984, and issued before 
March 19, 2012, that is described in section 163(f)(2)(B), as in effect 
before the amendment by section 502 of the Hiring Incentives to Restore 
Employment Act of 2010 (HIRE Act), Public Law 111-147, and the 
regulations under that section and an exception under section 871(h) or 
881(c) does not apply. Any obligation that is not in registered form as 
defined in paragraph (c)(1)(i) of this section is an obligation in 
bearer form.
    (2) Coordination with withholding and reporting rules. For an 
exemption from withholding under section 1441 with respect to 
obligations described in this paragraph (b), see Sec.  1.1441-
1(b)(4)(i). See Sec.  1.1471-2 for rules relating to withholding under 
chapter 4 of the Code that may apply to withholdable payments (as 
defined in Sec.  1.1471-4(b)(145)) made on or after July 1, 2014, with 
respect to an agreement or instrument that is not treated as an 
obligation outstanding before March 19, 2012. For purposes of the 
preceding sentence, the terms obligation and outstanding are described 
in Sec.  1.1471-2(b)). See also Sec.  1.1471-4(d)(6) for the reporting 
requirements of participating foreign financial institutions (as defined 
in Sec.  1.1471-1(b)(91)) with respect to accounts held by recalcitrant 
account holders (as defined in Sec.  1.1471-5(g)). For rules relating to 
an exemption from Form 1099 reporting and backup withholding under 
section 3406, see section 6049 and Sec.  1.6049-5(b)(8) for the payment 
of interest and Sec.  1.6045-1(g)(1)(ii) for the redemption, retirement, 
or sale of an obligation in bearer form.
    (c) Rules concerning obligations in registered form--(1) In 
general--(i) Obligation in registered form. For purposes of this 
section, an obligation is in registered form only as provided in this 
paragraph (c)(1)(i). The conditions for an obligation to be considered 
in registered form are identical to the conditions described in Sec.  
5f.103-1 of this chapter. Therefore, an obligation that would be an 
obligation in registered form except for the fact that it can be 
converted at any time in the future into an obligation that is not in 
registered form shall not be an obligation in registered form. An 
obligation that is not in registered form by reason of the preceding 
sentence may nevertheless be in registered form, but only after the 
possibility of conversion is terminated. An obligation that is not in 
registered form and can be converted into an obligation that would meet 
the requirements of this paragraph (c)(1)(i) for being in registered 
form shall be considered in registered form only after the conversion is 
effected. For purposes of this section, an obligation is convertible if 
the obligation can be transferred by any means not described

[[Page 428]]

in Sec.  5f.103-1(c) of this chapter. An obligation is treated as an 
obligation in registered form if--
    (A) The obligation is registered as to both principal and any stated 
interest with the issuer (or its agent) and transfer of the obligation 
may be effected only by surrender of the old instrument, and either the 
reissuance by the issuer of the old instrument to the new holder or the 
issuance by the issuer of a new instrument to the new holder;
    (B) The right to the principal of, and stated interest on, the 
obligation may be transferred only through a book entry system 
maintained by the issuer (or its agent) described in this paragraph 
(c)(1)(i)(B). An obligation shall be considered transferable through a 
book entry system if the ownership of an interest in the obligation, is 
required to be reflected in a book entry, whether or not physical 
securities are issued. A book entry is a record of ownership that 
identifies the owner of an interest in the obligation; or
    (C) It is registered as to both principal and any stated interest 
with the issuer (or its agent) and may be transferred by way of either 
of the methods described in paragraph (c)(1)(i) (A) or (B) of this 
section.
    (ii) Requirements for portfolio interest qualification in the case 
of an obligation in registered form. Interest (including original issue 
discount) received on an obligation that is in registered form qualifies 
as portfolio interest only if--
    (A) The interest is paid on an obligation issued after July 18, 
1984;
    (B) The interest would be subject to tax under section 871(a)(1)(A), 
871(a)(1)(C), 881(a)(1) or 881(a)(3) but for section 871(h) or 881(c);
    (C) A United States (U.S.) person otherwise required to deduct and 
withhold tax under chapter 3 of the Internal Revenue Code (Code) 
receives a statement that meets the requirements of section 871(h)(5) 
that the beneficial owner of the obligation is not a U.S. person; and
    (D) An exception under section 871(h) or 881(c) does not apply.
    (2) Required statement. For purposes of paragraph (c)(1)(ii)(C) of 
this section, a U.S. person will be considered to have received a 
statement that meets the requirements of section 871(h)(5) if either it 
complies with one of the procedures described in this paragraph (c)(2) 
and does not have actual knowledge or reason to know that the beneficial 
owner is a U.S. person or it complies with the procedures described in 
paragraph (d) or (e) of this section (to the extent applicable).
    (i) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment with documentation 
upon which it can rely to treat the payment as made to a foreign 
beneficial owner in accordance with Sec.  1.1441-1(e)(1)(ii). See Sec.  
1.1441-1(b)(2)(vii) for rules regarding reliable association with 
documentation.
    (ii) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment with a withholding 
certificate described in Sec.  1.1441-5(c)(2)(iv) from a person claiming 
to be a withholding foreign partnership or Sec.  1.1441-5(e)(v) for a 
person claiming to be a withholding foreign trust.
    (iii) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment with a withholding 
certificate described in Sec.  1.1441-1(e)(3)(ii) from a person 
representing to be a qualified intermediary that has assumed primary 
withholding responsibility for the payment in accordance with Sec.  
1.1441-1(e)(5)(iv) or a qualified intermediary that has provided a 
withholding statement that meets the requirements of Sec.  1.1441-
1(e)(5)(v)(C) or that includes the payment in a withholding rate pool 
for payments excepted from withholding.
    (iv) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment with a withholding 
certificate described in Sec.  1.1441-1(e)(3)(v) from a person claiming 
to be a U.S. branch of a foreign bank or of a foreign insurance company 
that is described in Sec.  1.1441-1(b)(2)(iv)(A) or a U.S. branch 
designated in accordance with Sec.  1.1441-1(b)(2)(iv)(E).
    (v) The U.S. person receives a statement from a securities clearing 
organization, a bank, or another financial institution that holds 
customers' securities in the ordinary course of its trade or business. 
In such case the statement

[[Page 429]]

must be signed under penalties of perjury by an authorized 
representative of the financial institution and must state that the 
institution has received from the beneficial owner a withholding 
certificate described in Sec.  1.1441-1(e)(2)(i) (a Form W-8 or an 
acceptable substitute form as defined Sec.  1.1441-1(e)(4)(vi)) or that 
it has received from another financial institution a similar statement 
that it, or another financial institution acting on behalf of the 
beneficial owner, has received the Form W-8 from the beneficial owner. 
In the case of multiple financial institutions between the beneficial 
owner and the U.S. person, this statement must be given by each 
financial institution to the one above it in the chain. No particular 
form is required for the statement provided by the financial 
institutions. However, the statement must provide the name and address 
of the beneficial owner, and a copy of the Form W-8 provided by the 
beneficial owner must be attached. The statement is subject to the same 
rules described in Sec.  1.1441-1(e)(4) that apply to intermediary Forms 
W-8 described in Sec.  1.1441-1(e)(3)(iii). If the information on the 
Form W-8 changes, the beneficial owner must so notify the financial 
institution acting on its behalf within 30 days of such changes, and the 
financial institution must promptly so inform the U.S. person. This 
notice also must be given if the financial institution has actual 
knowledge that the information has changed but has not been so informed 
by the beneficial owner. In the case of multiple financial institutions 
between the beneficial owner and the U.S. person, this notice must be 
given by each financial institution to the institution above it in the 
chain.
    (vi) The U.S. person complies with procedures that the U.S. 
competent authority may agree to with the competent authority of a 
country with which the United States has an income tax treaty in effect.
    (3) Time for providing certificate or documentary evidence--(i) 
General rule. Interest on a registered obligation shall qualify as 
portfolio interest if the withholding certificate or documentary 
evidence that must be provided is furnished before expiration of the 
beneficial owner's period of limitation for claiming a refund of tax 
with respect to such interest. See, however, Sec.  1.1441-1(b)(7) for 
consequences to a withholding agent that makes a payment without 
withholding even though it cannot reliably associate the payment with 
the documentation prior to the payment. If a withholding agent withholds 
an amount under chapter 3 of the Code because it cannot reliably 
associate the payment with the documentation for the beneficial owner on 
the date of payment, the beneficial owner may nevertheless claim the 
benefit of an exemption from tax under this section by claiming a refund 
or credit for the amount withheld based upon the procedures described in 
Sec. Sec.  1.1464-1 and 301.6402-3(e) of this chapter. See Sec. Sec.  
1.1474-5 and 301.6402-3(e) of this chapter for the allowance and 
requirements for a refund with respect to an amount (including a payment 
of interest) that was withheld upon under chapter 4 of the Code. In the 
alternative, adjustments to any amount of overwithheld tax may be made 
under the procedures described in Sec.  1.1461-2(a) for a payment 
withheld upon under chapter 3 of the Code or in Sec.  1.1474-2 for a 
payment withheld upon under chapter 4 of the Code.
    (ii) Example. The following example illustrates the rules of this 
paragraph (c)(3) and their coordination with Sec.  1.1441-1(b)(7):

    Example. A is a withholding agent who, on October 12, 2001, pays 
interest on a registered obligation to B, a foreign corporation. B is a 
calendar year taxpayer, engaged in the conduct of a trade or business in 
the United States, and is, therefore, required to file an annual income 
tax return on Form 1120F. The interest, however, is not effectively 
connected with B's U.S. trade or business. On the date of payment, B has 
not furnished, and A cannot associate the payment with documentation for 
B. However, A does not withhold under section 1442, even though, under 
Sec.  1.1441-1(b)(3)(iii)(A), A should presume that B is a foreign 
person, because A's communications with B are mailed to an address in a 
foreign country. Assuming that B files a return for its taxable year 
ending December 31, 2001, and that its statute of limitations period 
with regard to that year expires on June 15, 2005, the interest paid on 
October 12, 2001, may qualify as portfolio interest only if B provides 
appropriate documentation to A on or before June 15, 2005. If B does not 
provide the documentation on or before June 15, 2005, and does not pay 
the

[[Page 430]]

tax, A is liable for the tax under section 1463, even if B provides the 
documentation to A after June 15, 2005. Therefore, the provisions in 
Sec.  1.1441-1(b)(7), regarding late-received documentation would not 
help A avoid liability for tax under section 1463 even if the 
documentation is furnished within the statute of limitations period of 
A. This is because, in a case involving interest, the documentation 
received within the limitations period of the beneficial owner serves as 
a condition for the interest to qualify as portfolio interest. When 
documentation is received after the expiration of the beneficial owner's 
limitations period, the interest can no longer qualify as portfolio 
interest. On the other hand, A could rely on documentation that it 
receives after the expiration of B's limitations period to establish B's 
right to a reduced rate of withholding under an applicable income tax 
treaty (since, in such a case, a claim of treaty benefits is not 
conditioned upon providing documentation prior to the expiration of the 
beneficial owner's limitations period).

    (4) Coordination with withholding and reporting rules. For an 
exemption from withholding under section 1441 with respect to 
obligations described in this paragraph (c)(4), see Sec.  1.1441-
1(b)(4)(i). For rules applicable to withholding certificates, see Sec.  
1.1441-1(e)(4). For rules regarding documentary evidence, see Sec.  
1.6049-5(c)(1). For application of presumptions when the U.S. person 
cannot reliably associate the payment with documentation, see Sec.  
1.1441-1(b)(3). For standards of knowledge applicable to withholding 
agents, see Sec.  1.1441-7(b). For rules relating to reporting on Forms 
1042 and 1042-S, see Sec.  1.1461-1(b) and (c). For rules relating to an 
exemption from Form 1099 reporting and backup withholding under section 
3406, see section 6049 and Sec.  1.6049-5(b)(8) for the payment of 
interest and Sec.  1.6045-1(g)(1)(i) for the redemption, retirement, or 
sale of an obligation in registered form. For rules relating to 
withholding under sections 1471 and 1472 that may apply notwithstanding 
the exemption for payments of portfolio interest under section 1441, see 
Sec. Sec.  1.1471-2(a), 1.1471-4(b), and 1.1472-1(b).
    (d) Application of repeal of 30-percent withholding to pass-through 
certificates--(1) In general. Interest received on a pass-through 
certificate qualifies as portfolio interest under section 871(h)(2) or 
881(c)(2) if the interest satisfies the conditions described in 
paragraph (b)(1), (c)(1), or (e) of this section without regard to 
whether any obligation held by the fund or trust to which the pass-
through certificate relates is described in paragraph (b)(1), 
(c)(1)(ii), or (e) of this section. This paragraph (d)(1) applies only 
to payments made to the holder of the pass-through certificate from the 
trustee of the pass-through trust and does not apply to payments made to 
the trustee of the pass-through trust. For example, a mortgage pass-
through certificate in bearer form must meet the requirements set forth 
in paragraph (b)(1) of this section, but the obligations held by the 
fund or trust to which the mortgage pass-through certificate relates 
need not meet the requirements set forth in paragraph (b)(1), 
(c)(1)(ii), or (e) of this section. However, for purposes of paragraphs 
(b)(1), (c)(1)(ii), and (e) of this section and section 127 of the Tax 
Reform Act of 1984, a pass-through certificate will be considered as 
issued after July 18, 1984, only to the extent that the obligations held 
by the fund or trust to which the pass-through certificate relates are 
issued after July 18, 1984.
    (2) Interest in REMICs. Interest received on a regular or residual 
interest in a REMIC qualifies as portfolio interest under section 
871(h)(2) or 881(c)(2) if the interest satisfies the conditions 
described in paragraph (b)(1), (c)(1)(ii), or (e) of this section. For 
purposes of paragraph (b)(1), (c)(1)(ii), or (e) of this section, 
interest on a regular interest in a REMIC is not considered interest on 
any mortgage obligations held by the REMIC. The foregoing rule, however, 
applies only to payments made to the holder of the regular interest from 
the REMIC and does not apply to payments made to the REMIC. For purposes 
of paragraph (b)(1), (c)(1)(ii), or (e) of this section, interest on a 
residual interest in a REMIC is considered to be interest on or with 
respect to the obligations held by the REMIC, and not on or with respect 
to the residual interest. For purposes of paragraphs (b)(1), (c)(1)(ii), 
and (e) of this section and section 127 of the Tax Reform Act of 1984, a 
residual interest in a REMIC will be considered as issued after July 18, 
1984, only to the extent that the obligations held by the REMIC are 
issued

[[Page 431]]

after July 18, 1984, but a regular interest in a REMIC will be 
considered as issued after July 18, 1984, if the regular interest was 
issued after July 18, 1984, without regard to the date on which the 
mortgage obligations held by the REMIC were issued.
    (3) Date of issuance. In general, a mortgage pass-through 
certificate will be considered to have been issued after July 18, 1984, 
if all of the mortgages held by the fund or trust were issued after July 
18, 1984. If some of the mortgages held by the fund or trust were issued 
before July 19, 1984, then the portion of any interest payment which 
represents interest on those mortgages shall not be considered to be 
portfolio interest. The preceding sentence shall not apply, however, if 
all of the following conditions are satisfied:
    (i) The mortgage pass-through certificate is issued after December 
31, 1986;
    (ii) Payment of the mortgage pass-through certificate is guaranteed 
by, and a guarantee commitment has been issued by, an entity that is 
independent from the issuer of the underlying obligation;
    (iii) The guarantee commitment with respect to the mortgage pass-
through certificate cannot have been issued more than 14 months prior to 
the date on which the mortgage pass-through certificate is issued; and
    (iv) The fund or trust to which the mortgage pass-through 
certificate relates cannot contain mortgage obligations on which the 
first scheduled monthly payment of principal and interest was made more 
than twelve months before the date on which the guarantee commitment was 
made.
    (e) Foreign-targeted registered obligations--(1) General rule. The 
statement described in paragraph (c)(1)(ii) of this section is not 
required with respect to interest paid on an obligation issued before 
January 1, 2016, that is a registered obligation targeting foreign 
markets in accordance with the provisions of paragraph (e)(2) of this 
section if the interest is paid by a U.S. person, a withholding foreign 
partnership, or a U.S. branch described in Sec.  1.1441-1(b)(2)(iv)(A) 
or (E) to a registered owner at an address outside the United States, 
provided that the registered owner is a financial institution described 
in section 871(h)(5)(B). In that case, the U.S. person otherwise 
required to deduct and withhold tax may treat the interest as portfolio 
interest if it does not have actual knowledge that the beneficial owner 
is a United States person and if it receives the certificate described 
in paragraph (e)(3)(i) of this section from a financial institution or 
member of a clearing organization, which member is the beneficial owner 
of the obligation, or the documentary evidence or statement described in 
paragraph (e)(3)(ii) of this section from the beneficial owner, in 
accordance with the procedures described in paragraph (e)(4) of this 
section.
    (2) Definition of a foreign-targeted registered obligation. An 
obligation is considered to be targeted to foreign markets for purposes 
of paragraph (e)(1) of this section if it is sold (or resold in 
connection with its original issuance) only to foreign persons (or to 
foreign branches of United States financial institutions described in 
section 871(h)(5)(B)) in accordance with procedures similar to those 
prescribed in Sec.  1.163-5(c)(2)(i) (A), (B), or (D). However, the 
provisions of that section that require an obligation to be offered for 
sale or resale in connection with its original issuance only outside the 
United States do not apply with respect to registered obligations 
offered for sale through a public auction. Similarly, the provisions of 
that section that require delivery to be made outside the United States 
do not apply to registered obligations offered for sale through a public 
auction if the obligations are considered to be in registered form by 
virtue of the fact that they may be transferred only through a book 
entry system. The obligation, if evidenced by a physical document other 
than a confirmation receipt, must contain on its face a legend 
indicating that it has been sold (or resold in connection with its 
original issuance) in accordance with those procedures.
    (3) Documentation. A certificate described in paragraph (e)(3)(i) of 
this section is required if the United States person otherwise required 
to deduct and withhold tax (the withholding

[[Page 432]]

agent) pays interest to a financial institution described in section 
871(h)(5)(B) or to a member of a clearing organization, which member is 
the beneficial owner of the obligation. The documentation described in 
paragraph (e)(3)(ii) of this section is required if a withholding agent 
pays interest to a beneficial owner that is neither a financial 
institution described in section 871(h)(5)(B) nor a member of a clearing 
organization.
    (i) Interest paid to a financial institution or a member of a 
clearing organization--(A) Requirement of a certificate. (1) If the 
withholding agent pays interest to a financial institution described in 
section 871(h)(5)(B) or to a member of a clearing organization, which 
member is the beneficial owner of the obligation, the withholding agent 
must receive a certificate which states that, beginning at the time the 
last preceding certificate under this paragraph (e)(3)(i) was provided 
and while the financial institution or clearing organization member has 
held the obligation, with respect to each foreign-targeted registered 
obligation which has been held by the person providing the certificate 
at any time since the provision of such last preceding certificate, 
either--
    (i) The beneficial owner of the obligation has not been a United 
States person on each interest payment date; or
    (ii) If the person providing the certificate is a financial 
institution which is holding or has held an obligation on behalf of the 
beneficial owner, the beneficial owner of the obligation has been a 
United States person on one or more interest payment dates (identifying 
such date or dates), and the person making the certification has 
forwarded or will forward the appropriate United States beneficial 
ownership notification to the withholding agent in accordance with the 
provisions of paragraph (e)(4) of this section.
    (2) The person providing the certificate need not state the 
foregoing where no previous certificate has been required to be provided 
by the payee to the withholding agent under this paragraph (e)(3)(i).
    (B) Additional representations. Whether or not a previous 
certificate has been required to be provided with respect to the 
obligation, each certificate furnished pursuant to the provisions in 
this paragraph (e)(3)(i) must further state that, for each foreign-
targeted registered obligation held and every other such obligation to 
be acquired and held by the person providing the certificate during the 
period beginning on the date of the certificate and ending on the date 
the next certificate is required to be provided, the beneficial owner of 
the obligation will not be a United States person on each interest 
payment date while the financial institution or clearing organization 
member holds the obligation and that, if the person providing the 
certificate is a financial institution which is holding or will be 
holding the obligation on behalf of a beneficial owner, such person will 
provide a United States beneficial ownership notification to the 
withholding agent (and a clearing organization that is not a withholding 
agent where a member organization is required by this paragraph (e)(3) 
to furnish the clearing organization with a statement) in accordance 
with paragraph (e)(4) of this section in the event such certificate (or 
statement in the case of a statement provided by a member organization 
to a clearing organization that is not a withholding agent) is or 
becomes untrue with respect to any obligation. A clearing organization 
is an entity which is in the business of holding obligations for member 
organizations and transferring obligations among such members by credit 
or debit to the account of a member without the necessity of physical 
delivery of the obligation.
    (C) Obligation must be identified. The certificate described in 
paragraph (e)(3)(ii)(A) of this section must identify the obligation or 
obligations with respect to which it is given, except where the 
certification is given with respect to an obligation that has not been 
acquired at the time the certification is made. An obligation is 
identified if it or the larger issuance of which it is a part is 
described on a list (e.g., $5 million principal amount of 12% debentures 
of ABC Savings and Loan Association due February 25, 1995, $3 million 
principal amount of 10% U.S. Treasury notes due May 28, 1990) of all 
registered obligations targeted to foreign markets held by or on behalf 
of

[[Page 433]]

the person providing the certificate and the list is attached to, and 
incorporated by reference into, the certificate. The certificate must 
identify and provide the address of the person furnishing the 
certificate.
    (D) Payment to a depository of a clearing organization. If the 
withholding agent pays interest to a depository of a clearing 
organization, then the clearing organization must provide the 
certificate described in this paragraph (e)(3)(i) to the withholding 
agent. Any certificate that is provided by a clearing organization must 
state that the clearing organization has received a statement from each 
member which complies with the provisions of this paragraph (e)(3)(i) 
and of paragraph (e)(4) of this section (as if the clearing organization 
were the withholding agent and regardless of whether the member is a 
financial institution described in section 871(h)(5)(B)).
    (E) Statement in lieu of Form W-8. Subject to the requirements set 
out in paragraph (e)(4) of this section, a certificate or statement in 
the form described in this paragraph (e)(3)(i), in conjunction with the 
next annual certificate or statement, will serve as the certificate that 
may be provided in lieu of a Form W-8 with respect to interest on all 
foreign-targeted registered obligations held by the person making the 
certification or statement and which is paid to such person within the 
period beginning on the date of the certificate and ending on the date 
the next certificate is required to be provided.
    (F) Electronic transmission. The certificate described in this 
paragraph (e)(3)(i) may be provided electronically under the terms and 
conditions of Sec.  1.163-5(c)(2)(i)(D)(3)(ii).
    (ii) Payment to a person other than a financial institution or 
member of a clearing organization. If the withholding agent pays 
interest to the beneficial owner of an obligation that is neither a 
financial institution described in section 871(h)(5)(B) nor a member of 
a clearing organization, then such owner must provide the withholding 
agent a statement described in paragraph (c)(1)(ii)(C) of this section.
    (4) Applicable procedures regarding documentation--(i) Procedures 
applicable to certificates required under paragraph (e)(3)(i) of this 
section--(A) Time for providing certificate. Where no previous 
certificate for foreign-targeted registered obligations has been 
provided to the withholding agent by the person providing the 
certificate under paragraph (e)(3)(i) of this section, such certificate 
must be provided within the period beginning 90 days prior to the first 
interest payment date on which the person holds a foreign-targeted 
registered obligation. The withholding agent may, in its discretion, 
withhold under section 1441(a), 1442(a), or 1443 if the certificate is 
not received by the date 30 days prior to the interest payment. 
Thereafter the certificate must be filed within the period beginning on 
January 15 and ending January 31 of each year. If a certificate provided 
pursuant to the first sentence of this paragraph (e)(4)(i)(A) is 
provided during the period beginning on January 15 and ending on January 
31 of any year, then no other certificate need be provided during such 
period in such year.
    (B) Change of status notification on Form W-9. If, on any interest 
payment date after the obligation was acquired by the person making the 
certification, the beneficial owner of the obligation is a U.S. person, 
then the person to whom the withholding agent pays interest must furnish 
the withholding agent with a U.S. beneficial ownership notification 
within 30 days after such interest payment date. A U.S. beneficial 
ownership notification must include a statement that the beneficial 
owner of the obligation has been a U.S. person on an interest payment 
date (identifying such date), that such owner has provided to the person 
providing the notification a Form W-9 (or a substitute form that is 
substantially similar to Form W-9 and completed under penalties of 
perjury), and that the person providing the notification has been and 
will be complying with the information reporting requirements of section 
6049, if applicable.
    (C) Alternative notification statement. Where the person providing 
the notification described in paragraph (e)(4)(i)(B) of this section is 
neither a controlled foreign corporation within the meaning of section 
957(a), nor a foreign corporation 50-percent or more of the gross income 
of which from all

[[Page 434]]

sources for the three-year period ending with the close of the taxable 
year preceding the date of the statement was effectively connected with 
the conduct of trade or business in the United States, such person must 
attach to the notification a copy of the Form W-9 (or substitute form 
that is substantially similar to Form W-9 and completed under penalties 
of perjury) provided by the beneficial owner. When a person that 
provides the U.S. beneficial ownership notification does not attach to 
it a copy of such Form W-9 (or substitute form that is substantially 
similar to Form W-9 and completed under penalties of perjury), such 
person must state that it is either a controlled foreign corporation 
within the meaning of section 957(a), or a foreign corporation 50-
percent or more of the gross income of which from all sources for the 
three-year period ending with the close of its taxable year preceding 
the date of the statement was effectively connected with the conduct of 
a trade or business in the United States. A withholding agent that 
receives a Form W-9 (or a substitute form that is substantially similar 
to Form W-9 and completed under penalties of perjury) must send a copy 
of such form to the IRS, at such address as the IRS shall indicate, 
within 30 days after receiving it and must attach a statement that the 
Form W-9 or substitute form was provided pursuant to this paragraph 
(e)(4) with respect to a U.S. person that has owned a foreign-targeted 
registered obligation on one or more interest payment dates.
    (D) Failure to provide notification. If either a Form W-9 (or a 
substitute form that is substantially similar to a Form W-9 and 
completed under penalties of perjury) or the statement described in 
paragraph (e)(4)(i)(C) of this section is not attached to the U.S. 
beneficial ownership notification provided pursuant to paragraph 
(e)(4)(i)(B) of this section, the withholding agent is required to 
withhold under section 1441, 1442, or 1443 on a payment of interest made 
after the withholding agent has received the notification unless such 
form or statement (or a statement that the beneficial owner of the 
obligation is no longer a U.S. person) is received before the interest 
payment date from the person who provided the notification (or 
transferee). If, during the period beginning on the next January 15 and 
ending on the next January 31, such person certifies as set out in 
paragraph (e)(3)(i) of this section (subject to paragraph 
(e)(3)(i)(A)(2) of this section) then the withholding agent is not 
required to withhold during the year following such certification 
(unless such person again provides a U.S. beneficial ownership 
notification without attaching a Form W-9 or substitute form that is 
substantially similar to Form W-9 and completed under penalties of 
perjury or the statement described in paragraph (e)(4)(i)(C) of this 
section).
    (E) Procedures for clearing organizations. Within the period 
beginning 10 days before the end of the calendar quarter and ending on 
the last day of each calendar quarter, any clearing organization 
(including a clearing organization that is a withholding agent) relying 
on annual certificates or statements from its member organizations, as 
set forth in paragraph (e)(3)(i) of this section, must send each member 
organization having submitted such certificate or statement a reminder 
that the member organization must give the clearing organization a U.S. 
beneficial ownership notification in the circumstances described in 
paragraph (e)(4)(i)(B) of this section.
    (F) Retention of certificates. The certificate described in 
paragraph (e)(3)(i) of this section must be retained in the records of 
the withholding agent for four years from the end of the calendar year 
in which it was received. The statement described in paragraph (e)(3)(i) 
of this section that is received by a clearing organization from a 
member organization must be retained in the records of the clearing 
organization for four years from the end of the calendar year in which 
it was received.
    (G) No reporting requirement. The withholding agent who receives the 
certificate described in paragraph (e)(3)(i) of this section is not 
required to file Form 1042S to report payments under Sec.  1.1461-1 (b) 
or (c) of interest that are made with respect to foreign-targeted 
registered obligations held by the person providing the certificate

[[Page 435]]

and are made within the period beginning with the certificate date and 
ending on the last date for filing the next certificate.
    (ii) Procedures regarding certificates required under paragraph 
(e)(3)(ii) of this section--(A) Time for providing certificate. The 
statement described in paragraph (e)(3)(ii) of this section must be 
provided to the withholding agent within the period beginning 90 days 
prior to and ending on the first interest payment date on which the 
withholding agent pays interest to the beneficial owner. The withholding 
agent may, in its discretion, withhold under section 1441(a), 1442(a), 
or 1443 if the statement is not received by the date 30 days prior to 
the interest payment. The beneficial owner must confirm to the 
withholding agent the continuing validity of the documentary evidence 
within the period beginning 90 days prior to the first day of the third 
calendar year following the provision of such evidence and during the 
same period every three years thereafter while the owner still owns the 
obligation. The withholding agent who receives the statement described 
in paragraph (e)(3)(ii) of this section is not required to report 
payments of interest under Sec.  1.1461-1(b) or (c) if the payments are 
made with respect to foreign-targeted registered obligations held by the 
person who provides the statement and are made within the period 
beginning with the date on which the statement is provided and ending on 
the last date for confirming the validity of the statement. The 
statement received for purposes of paragraph (e)(3)(ii) of this section 
is subject to the applicable procedures set forth in Sec.  1.1441-
1(e)(4).
    (B) Change of status notification on Form W-9. If on any interest 
payment date after the obligation was acquired by the person providing 
the statement described in paragraph (e)(3)(ii) of this section, the 
beneficial owner of the obligation is a U.S. person, then the beneficial 
owner must so inform the withholding agent within 30 days after such 
interest payment date and must provide a Form W-9 (or substitute form 
that is substantially similar completed under penalties of perjury) to 
the withholding agent. However, the beneficial owner is not required to 
provide another Form W-9 (or substitute form that is substantially 
similar and completed under penalties of perjury) if such person has 
already provided it to the withholding agent within the same calendar 
year.
    (iii) Disqualification of documentation. In accordance with the 
provisions of section 871(h)(4), the Secretary may make a determination 
in appropriate cases that a certificate or statement by any person, or 
class of persons, does not satisfy the requirements of that section. 
Should that determination be made, all payments of interest that 
otherwise qualify as portfolio interest to that person would become 
subject to 30-percent withholding under section 1441(a), 1442(a), or 
1443.
    (5) Information reporting. See Sec.  1.6049-5(b)(7) for special 
information reporting rules applicable to interest on foreign-targeted 
registered obligations. See Sec.  1.6045-1(g)(1)(ii) for information 
reporting rules applicable to the redemption, retirement, or sale of 
foreign-targeted registered obligations.
    (f) Securities lending transactions. For applicable rules regarding 
substitute interest payments received pursuant to a securities lending 
transaction or a sale-repurchase transaction, see Sec. Sec.  1.871-
7(b)(2) and 1.881-2(b)(2).
    (g) Portfolio interest not to include interest received by 10-
percent shareholders--(1) In general. For purposes of section 871(h), 
the term portfolio interest shall not include any interest received by a 
10-percent shareholder.
    (2) Ten-percent shareholder--(i) In general. The term 10-percent 
shareholder means--
    (A) In the case of an obligation issued by a corporation, any person 
who owns 10-percent or more of the total combined voting power of all 
classes of stock of such corporation entitled to vote; or
    (B) In the case of an obligation issued by a partnership, any person 
who owns 10-percent or more of the capital or profits interest in such 
partnership.
    (ii) Ownership--(A) Stock ownership. For purposes of paragraph 
(g)(2)(i)(A) of this section, stock owned means stock directly or 
indirectly owned and stock owned by reason of the attribution rules of 
section 318(a), as modified by section 871(h)(3)(C).

[[Page 436]]

    (B) Ownership of partnership interest. For purposes of paragraph 
(g)(2)(i)(B) of this section, rules similar to the rules in paragraph 
(g)(2)(ii)(A) of this section shall be applied in determining the 
ownership of a capital or profits interest in a partnership.
    (3) Application of 10-percent shareholder test to partners receiving 
interest through a partnership--(i) Partner level test. Whether interest 
paid to a partnership and included in the distributive share of a 
partner that is a nonresident alien individual or foreign corporation is 
received by a 10 percent shareholder shall be determined by applying the 
rules of this paragraph (g) only at the partner level.
    (ii) Time at which 10-percent shareholder test is applied. The 
determination of whether a nonresident alien individual or foreign 
corporation that is a partner in a partnership is a 10-percent 
shareholder under the rules of section 871(h)(3), section 881(c)(3), and 
this paragraph (g) with respect to interest paid to such partnership 
shall be made at the time that the withholding agent, absent the 
provisions of section 871(h), 881(c) and the rules of this paragraph, 
would otherwise be required to withhold under sections 1441 and 1442 
with respect to such interest. For example, in the case of U.S. source 
interest paid by a domestic corporation to a domestic partnership or 
withholding foreign partnership (as defined in Sec.  1.1441-5(c)(2)), 
the 10-percent shareholder test is applied when any distributions that 
include the interest are made to a foreign partner and, to the extent 
that a foreign partner's distributive share of the interest has not 
actually been distributed, on the earlier of the date that the statement 
required under section 6031(b) is mailed or otherwise provided to such 
partner, or the due date for furnishing such statement. See Sec.  
1.1441-5(b)(2) and (c)(2)(iii).
    (4) Application of 10-percent shareholder test to interest paid to a 
simple trust or grantor trust. Whether interest paid to a simple trust 
or grantor trust and distributed to or included in the gross income of a 
nonresident alien individual or foreign corporation that is a 
beneficiary or owner of such trust, as the case may be, is received by a 
10-percent shareholder shall be determined by applying the rules of this 
paragraph (g) only at the beneficiary or owner level. The 10-percent 
shareholder test is applied with respect to a nonresident alien 
individual or foreign corporation that is a beneficiary of a simple 
trust or an owner of a grantor trust at the time that a withholding 
agent, absent any exceptions, would otherwise be required to withhold 
under sections 1441 and 1442 with respect to such interest.
    (h) Portfolio interest not to include certain contingent interest--
(1) Dividend equivalents. Contingent interest does not qualify as 
portfolio interest to the extent that the interest is a dividend 
equivalent within the meaning of section 871(m).
    (2) Amount of dividend equivalent that is not portfolio interest. 
The amount that does not qualify as portfolio interest because it is a 
dividend equivalent equals the amount of the dividend equivalent 
determined pursuant to Sec.  1.871-15(j). Unless otherwise excluded 
pursuant to section 871(h), any other interest paid on an obligation 
that is not a dividend equivalent may qualify as portfolio interest.
    (i) Definitions. For purposes of this section, the terms U.S. person 
and foreign person have the meaning set forth in Sec.  1.1441-1(c)(2), 
the term beneficial owner has the meaning set forth in Sec.  1.1441-
1(c)(6), the term withholding agent has the meaning set forth in Sec.  
1.1441-7(a); the term payee has the meaning set forth in Sec.  1.1441-
1(b)(2); and the term payment has the meaning set forth in Sec.  1.1441-
2(e).
    (j) Effective/applicability date--(1) In general. Except as 
otherwise provided in paragraph (j)(2) and (3) of this section, this 
section applies to payments of interest made on or after January 6, 
2017. (For the rules that apply after June 30, 2014, and before January 
6, 2017, see this section as in effect and contained in 26 CFR part 1, 
as revised April 1, 2016. For payments of interest made after December 
31, 2000, and before July 1, 2014, see this section as in effect and 
contained in 26 CFR part 1, as revised April 1, 2013.)
    (2) Portfolio interest not to include interest received by 10-
percent shareholders. Paragraph (g) applies to interest paid after April 
12, 2007. Taxpayers may

[[Page 437]]

choose to apply the rules of paragraph (g) to interest paid in any 
taxable year not closed by the period of limitations as of April 12, 
2007, provided they do so consistently for all relevant partnerships 
during such years.
    (3) Portfolio interest not to include certain contingent interest. 
The rules of paragraph (h) of this section apply beginning September 18, 
2015.

[T.D. 8734, 62 FR 53416, Oct. 14, 1997, as amended by T.D. 8804, 63 FR 
72184, 72187, Dec. 31, 1998; T.D. 8856, 64 FR 73409, 73412, Dec. 30, 
1999; T.D. 9323, 72 FR 18387, Apr. 12, 2007; 72 FR 26543, May 10, 2007. 
T.D. 9658, 79 FR 12746, Mar. 6, 2013; 79 FR 37182, July 1, 2014; T.D. 
9734, 80 FR 56879, Sept. 18, 2015; T.D. 9808, 82 FR 2055, Jan. 6, 2017]



Sec.  1.871-15  Treatment of dividend equivalents.

    (a) Definitions. For purposes of this section, the following terms 
have the meanings described in this paragraph (a).
    (1) Broker. A broker is a broker within the meaning provided in 
section 6045(c), except that the term does not include any corporation 
that is a broker solely because it regularly redeems its own shares.
    (2) Dealer. A dealer is a dealer in securities within the meaning of 
section 475(c)(1).
    (3) Dividend. A dividend is a dividend as described in section 316 
(even if there is no actual distribution of cash or property).
    (4) Equity-linked instrument. An equity-linked instrument (ELI) is a 
financial transaction, other than a securities lending or sale-
repurchase transaction or an NPC, that references the value of one or 
more underlying securities. For example, a futures contract, forward 
contract, option, debt instrument, or other contractual arrangement that 
references the value of one or more underlying securities is an ELI.
    (5) Initial hedge. An initial hedge is the number of underlying 
security shares that a short party would need to fully hedge an NPC or 
ELI (whether the NPC or ELI is a complex contract or a simple contract 
benchmark (within the meaning of paragraph (h)(2) of this section), as 
appropriate) with respect to an underlying security at the calculation 
time for the NPC or ELI, even if the short party does not in fact fully 
hedge the NPC or ELI.
    (6) Issue. An NPC or ELI is treated as issued at inception, original 
issuance, or at the time of an issuance as a result of a deemed exchange 
pursuant to section 1001.
    (7) Notional principal contract. A notional principal contract (NPC) 
is a notional principal contract as defined in Sec.  1.446-3(c).
    (8) Option. An option includes an option embedded in any debt 
instrument, forward contract, NPC, or other potential section 871(m) 
transaction.
    (9) Parties to the transaction--(i) Long party. A long party is the 
party to a potential section 871(m) transaction with respect to an 
underlying security that would be entitled to receive a payment of a 
dividend equivalent (within the meaning of paragraph (i) of this 
section) described in paragraph (c) of this section.
    (ii) Short party. A short party is the party to a potential section 
871(m) transaction with respect to an underlying security that would be 
obligated to make a payment of a dividend equivalent (within the meaning 
of paragraph (i) of this section) described in paragraph (c) of this 
section.
    (iii) Party to the transaction. A party to the transaction is any 
person that is a long party or a short party to a potential section 
871(m) transaction, any agent acting on behalf of the long party or 
short party, or any person acting as an intermediary with respect to the 
potential section 871(m) transaction.
    (iv) Party to the transaction that is both a long party and a short 
party--(A) In general. If a potential section 871(m) transaction 
references more than one underlying security, the long party and short 
party are determined separately with respect to each underlying 
security. A party to a potential section 871(m) transaction is both a 
long party and a short party when the party is entitled to a payment 
that references a dividend payment on an underlying security and the 
same party is obligated to make a payment that references a dividend 
payment on another underlying security pursuant to the potential section 
871(m) transaction.

[[Page 438]]

    (B) Example. The following example illustrates the definitions in 
paragraph (a)(9) of this section:

    Example. (i) Stock X and Stock Y are underlying securities. A and B 
enter into an NPC that entitles A to receive payments from B based on 
any appreciation in the value of Stock X and dividends paid on Stock X 
during the term of the contract and obligates A to make payments to B 
based on any depreciation in the value of Stock X during the term of the 
contract. In return, the NPC entitles B to receive payments from A based 
on any appreciation in the value of Stock Y and dividends paid on Stock 
Y during the term of the contract and obligates B to make payments to A 
based on any depreciation in the value of Stock Y during the term of the 
contract.
    (ii) A is the long party with respect to Stock X, and the short 
party with respect to Stock Y. B is the long party with respect to Stock 
Y, and the short party with respect to Stock X.

    (10) Payment. A payment has the meaning provided in paragraph (i) of 
this section.
    (11) Reference. To reference means to be contingent upon or 
determined by reference to, directly or indirectly, whether in whole or 
in part.
    (12) Section 871(m) transaction and potential section 871(m) 
transaction. A section 871(m) transaction is any securities lending or 
sale-repurchase transaction, specified NPC, or specified ELI. A 
potential section 871(m) transaction is any securities lending or sale-
repurchase transaction, NPC, or ELI that references one or more 
underlying securities.
    (13) Securities lending or sale-repurchase transaction. A securities 
lending or sale-repurchase transaction is any securities lending 
transaction, sale-repurchase transaction, or substantially similar 
transaction that references an underlying security. Securities lending 
transaction and sale-repurchase transaction have the same meaning as 
provided in Sec.  1.861-3(a)(6).
    (14) Simple contracts and complex contracts-- (i) Simple contract. A 
simple contract is an NPC or ELI for which, with respect to each 
underlying security, all amounts to be paid or received on maturity, 
exercise, or any other payment determination date are calculated by 
reference to a single, fixed number of shares (as determined in 
paragraph (j)(3) of this section) of the underlying security, provided 
that the number of shares can be ascertained at the calculation time for 
the contract, and there is a single maturity or exercise date with 
respect to which all amounts (other than any upfront payment or any 
periodic payments) are required to be calculated with respect to the 
underlying security. For purposes of this section, a contract that 
provides an adjustment to the number of shares of the underlying 
security for a merger, stock split, cash dividend, or similar corporate 
action that affects all holders of the underlying securities 
proportionately will not cease to be treated as referencing a single, 
fixed number of shares solely as a result of that provision. A contract 
has a single exercise date even though it may be exercised by the holder 
at any time on or before the stated expiration of the contract. An NPC 
or ELI that includes a term that discontinuously increases or decreases 
the amount paid or received (such as a digital option), or that 
accelerates or extends the maturity is not a simple contract. A simple 
contract that is an NPC is a simple NPC. A simple contract that is an 
ELI is a simple ELI.
    (ii) Complex contract--(A) In general. A complex contract is any NPC 
or ELI that is not a simple contract. A complex contract that is an NPC 
is a complex NPC. A complex contract that is an ELI is a complex ELI.
    (B) Example. An ELI entitles the long party to a return equal to 200 
percent of the appreciation on 100 shares of Stock X, and obligates the 
long party to pay an amount equal to the actual depreciation on 100 
shares of Stock X. Pursuant to paragraph (j)(3) of the section, the ELI 
references 200 shares when Stock X appreciates, but only 100 shares when 
Stock X depreciates. Because the ELI does not provide the long party 
with an amount that is calculated by reference to a single, fixed number 
of shares of Stock X on the maturity date that can be ascertained at the 
calculation time, it is not a simple ELI. More specifically, upon 
maturity the ELI will either entitle the long party to receive a payment 
that is, in substance, measured by reference to 200 shares of stock or 
obligate the long party to make a payment measured by

[[Page 439]]

reference to 100 shares of stock. The ELI is a complex ELI because it is 
not a simple ELI.
    (15) Underlying security. An underlying security is any interest in 
an entity if that interest could give rise to a U.S. source dividend 
pursuant to Sec.  1.861-3, where applicable taking into account 
paragraph (m) of this section. Except as provided in paragraph (l) of 
this section, if a potential section 871(m) transaction references an 
interest in more than one entity described in the preceding sentence or 
different interests in the same entity, each referenced interest is a 
separate underlying security for purposes of applying the rules of this 
section.
    (b) Source of a dividend equivalent. A dividend equivalent is 
treated as a dividend from sources within the United States for purposes 
of sections 871(a), 881, 892, 894, and 4948(a), and chapters 3 and 4 of 
subtitle A of the Internal Revenue Code.
    (c) Dividend equivalent--(1) In general. Except as provided in 
paragraph (c)(2) of this section, dividend equivalent means--
    (i) Any payment that references a dividend from an underlying 
security pursuant to a securities lending or sale-repurchase 
transaction;
    (ii) Any payment that references a dividend from an underlying 
security pursuant to a specified NPC described in paragraph (d) of this 
section;
    (iii) Any payment that references a dividend from an underlying 
security pursuant to a specified ELI described in paragraph (e) of this 
section; and
    (iv) Any other substantially similar payment as described in 
paragraph (f) of this section.
    (2) Exceptions--(i) Not a dividend. A payment that references a 
distribution with respect to an underlying security is not a dividend 
equivalent to the extent that the distribution would not be subject to 
tax pursuant to section 871(a) or section 881 if the long party owned 
the underlying security. For example, if an NPC references stock in a 
regulated investment company that pays a dividend that includes a 
capital gains dividend described in section 852(b)(3)(C) that would not 
be subject to tax under section 871(a) or section 881 if paid directly 
to the long party, then an NPC payment is not a dividend equivalent to 
the extent that it is determined by reference to the capital gains 
dividend.
    (ii) Section 305 coordination. A dividend equivalent received by a 
long party, who is a shareholder as defined in Sec.  1.305-1(d) of an 
instrument that gives rise to a dividend pursuant to sections 305(b) and 
(c) (including a debt instrument that is convertible into shares of 
stock and stock that is convertible into shares of another class of 
stock) that is also a section 871(m) transaction, is reduced by any 
amount treated as a dividend by sections 305(b) and (c) to the long 
party. For other section 871(m) transactions that reference an 
underlying security that is an instrument treated as paying a dividend 
pursuant to sections 305(b) and (c) and for which the long party is not 
a shareholder as defined in Sec.  1.305-1(d), the dividend equivalent 
received by the long party with respect to the section 871(m) 
transaction includes (and is not reduced by) any amount treated as a 
dividend pursuant to sections 305(b) and (c).
    (iii) Due bills. A dividend equivalent does not include a payment 
made pursuant to a due bill arising from the actions of a securities 
exchange that apply to all transactions in the stock with respect to the 
dividend. For purposes of this section, a stock will be considered to 
trade with a due bill only when the relevant securities exchange has set 
an ex-dividend date with respect to a dividend that occurs after the 
record date.
    (iv) Payments made pursuant to annuity, endowment, and life 
insurance contracts--(A) Insurance contracts issued by domestic 
insurance companies. A payment made pursuant to a contract that is an 
annuity, endowment, or life insurance contract issued by a domestic 
corporation (including its foreign or U.S. possession branch) that is a 
life insurance company described in section 816(a) does not include a 
dividend equivalent if the payment is subject to tax under section 
871(a) or section 881.
    (B) Insurance contracts issued by foreign insurance companies. A 
payment does not include a dividend equivalent if it is made pursuant to 
a contract that is an annuity, endowment, or life

[[Page 440]]

insurance contract issued by a foreign corporation that would be subject 
to tax under subchapter L if it were a domestic corporation.
    (C) Insurance contracts held by foreign insurance companies. A 
payment made pursuant to a policy of insurance (including a policy of 
reinsurance) does not include a dividend equivalent if it is made to a 
foreign corporation that would be subject to tax under subchapter L if 
it were a domestic corporation.
    (v) Certain payments pursuant to employee compensation arrangements. 
A dividend equivalent does not include the portion of equity-based 
compensation for personal services of a nonresident alien individual 
that is--
    (A) Wages subject to withholding under section 3402 and the 
regulations under that section;
    (B) Excluded from the definition of wages under Sec.  31.3401(a)(6)-
1; or
    (C) Exempt from withholding under Sec.  1.1441-4(b).
    (d) Specified NPCs--(1) Specified NPCs entered into before January 
1, 2017--(i) In general. For payments made after March 18, 2012, and 
before January 1, 2017, a specified NPC is any NPC if--
    (A) In connection with entering into the contract, any long party to 
the contract transfers the underlying security to any short party to the 
contract;
    (B) In connection with the termination of the contract, any short 
party to the contract transfers the underlying security to any long 
party to the contract;
    (C) The underlying security is not readily tradable on an 
established securities market; or
    (D) In connection with entering into the contract, the underlying 
security is posted as collateral by any short party to the contract with 
any long party to the contract.
    (ii) Specified NPC status as of January 1, 2017. An NPC that is 
treated as a specified NPC pursuant to paragraph (d)(1)(i) of this 
section will remain a specified NPC on or after January 1, 2017.
    (2) Specified NPCs on or after January 1, 2017--(i) Simple NPCs. A 
simple NPC that has a delta of 0.8 or greater with respect to an 
underlying security at the calculation time for the NPC is a specified 
NPC.
    (ii) Complex NPCs. A complex NPC that meets the substantial 
equivalence test described in paragraph (h) of this section with respect 
to an underlying security at the calculation time for the NPC is a 
specified NPC.
    (e) Specified ELIs--(1) Simple ELIs. A simple ELI that has a delta 
of 0.8 or greater with respect to an underlying security at the 
calculation time for the ELI is a specified ELI.
    (2) Complex ELIs. A complex ELI that meets the substantial 
equivalence test described in paragraph (h) of this section with respect 
to an underlying security at the calculation time for the ELI is a 
specified ELI.
    (f) Other substantially similar payments. For purposes of this 
section, any payment made in satisfaction of a tax liability of the long 
party with respect to a dividend equivalent by a withholding agent is a 
dividend equivalent received by the long party. The amount of that 
dividend equivalent constitutes additional income to the payee to the 
extent provided in Sec.  1.1441-3(f)(1).
    (g) Delta--(1) In general. Delta is the ratio of the change in the 
fair market value of an NPC or ELI to a small change in the fair market 
value of the number of shares of the underlying security (as determined 
under paragraph (j)(3) of this section) referenced by the NPC or ELI. If 
an NPC or ELI contains more than one reference to a single underlying 
security, all references to that underlying security are taken into 
account in determining the delta with respect to that underlying 
security. If an NPC or ELI references more than one underlying security 
or other property, the delta with respect to each underlying security 
must be determined without taking into account any other underlying 
security or property. The delta of an equity derivative that is embedded 
in a debt instrument or other derivative is determined without taking 
into account changes in the market value of the debt instrument or other 
derivative that are not directly related to the equity element of the 
instrument. Thus, for example, the delta of an option embedded in a 
convertible note is determined without regard to the debt component of 
the convertible

[[Page 441]]

note. For purposes of this section, delta must be determined in a 
commercially reasonable manner. If a taxpayer calculates delta for non-
tax business purposes, that delta ordinarily is the delta used for 
purposes of this section.
    (2) Time for determining delta--(i) In general. Except as provided 
in paragraph (g)(4) of this section, the delta of a potential section 
871(m) transaction is determined at the calculation time for the 
potential section 871(m) transaction.
    (ii) Calculation time. The calculation time for a potential section 
871(m) transaction is the earlier of when the potential section 871(m) 
transaction is priced and when the potential section 871(m) transaction 
is issued. Notwithstanding the preceding sentence, if the pricing time 
is more than 14 calendar days before the potential section 871(m) 
transaction is issued, the calculation time is when the potential 
section 871(m) transaction is issued.
    (iii) Pricing time. A potential section 871(m) transaction is priced 
when all material economic terms for the transaction have been agreed 
upon, including the price at which the transaction is sold.
    (3) Simplified delta calculation for certain simple contracts that 
reference multiple underlying securities. If an NPC or ELI references 10 
or more underlying securities and an exchange-traded security (for 
example, an exchange-traded fund) is available that would fully hedge 
the NPC or ELI at the calculation time, the delta of the NPC or ELI may 
be calculated by determining the ratio of the change in the fair market 
value of the simple contract to a small change in the fair market value 
of the exchange-traded security. A delta determined under this paragraph 
(g)(3) must be used as the delta for each underlying security for 
purposes of calculating the amount of a dividend equivalent as provided 
in paragraph (j)(1)(ii) of this section.
    (4) Delta calculation for listed options--(i) In general. The delta 
of an option contract that is listed on a regulated exchange described 
in paragraph (g)(4)(ii) of this section is the delta of that option at 
the close of business on the business day before the date of issuance. 
On the date an option contract is listed for the first time, the delta 
is the delta of that option at the close of business on the date of 
issuance. Notwithstanding the preceding two sentences, the delta of a 
listed option that is also a customized option is determined under the 
rules of paragraphs (g)(2) and (g)(3) of this section.
    (ii) Regulated exchange. For purposes of paragraph (g)(4)(i) of this 
section, a regulated exchange is any exchange that is either:
    (A) Described in paragraph (l)(3)(vii) of this section; or
    (B) Foreign securities exchange--(1) In general. A foreign 
securities exchange that:
    (i) Is regulated or supervised by a governmental authority of the 
country in which the market is located;
    (ii) Has trading volume, listing, financial disclosure, 
surveillance, and other requirements designed to prevent fraudulent and 
manipulative acts and practices, to remove impediments to and perfect 
the mechanism of a free and open, fair and orderly market, and to 
protect investors, and the laws of the country in which the exchange is 
located and the rules of the exchange ensure that those requirements are 
actually enforced;
    (iii) Has rules that effectively promote active trading of listed 
options on the exchange; and
    (iv) Has an average daily trading volume on the exchange exceeding 
$10 billion notional amount during the immediately preceding calendar 
year.
    (2) Application to an exchange with more than one tier or market. If 
an exchange in a foreign country has more than one tier or market level 
on which listed options may be separately listed or traded, each tier or 
market level is treated as a separate exchange.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (g). For purposes of these examples, Stock X and Stock Y are 
common stock of domestic corporations X and Y. LP is the long party to 
the transaction.

    Example 1. Delta calculation for an NPC. The terms of an NPC require 
LP to pay the short party an amount equal to all of the depreciation in 
the value of 100 shares of Stock X and an interest-rate based return. In 
return, the

[[Page 442]]

NPC requires the short party to pay LP an amount equal to all of the 
appreciation in the value of 100 shares of Stock X and any dividends 
paid by X on those shares. The value of the NPC will change by $1 for 
each $0.01 change in the price of a share of Stock X. When LP entered 
into the NPC, Stock X had a fair market value of $50 per share. The NPC 
therefore has a delta of 1.0 ($1.00/($0.01 x 100)).
    Example 2. Delta calculation for an option. LP purchases a call 
option that references 100 shares of Stock Y. At the time LP purchases 
the call option, the value of the option is expected to change by $0.30 
for a $0.01 change in the price of a share of Stock Y. When LP purchases 
the option, Stock Y has a fair market value of $100 per share. The call 
option has a delta of 0.3 ($0.30/($0.01 x 100)).

    (h) Substantial equivalence test--(1) In general. The substantial 
equivalence test described in this paragraph (h) applies to determine 
whether a complex contract is a section 871(m) transaction. The 
substantial equivalence test assesses whether a complex contract 
substantially replicates the economic performance of the underlying 
security by comparing, at various testing prices for the underlying 
security, the differences between the expected changes in value of that 
complex contract and its initial hedge with the differences between the 
expected changes in value of a simple contract benchmark (as described 
in paragraph (h)(2) of this section) and its initial hedge. If the 
complex contract contains more than one reference to a single underlying 
security, all references to that underlying security are taken into 
account for purposes of applying the substantial equivalence test with 
respect to that underlying security. With respect to an equity 
derivative that is embedded in a debt instrument or other derivative, 
the substantial equivalence test is applied to the complex contract 
without taking into account changes in the market value of the debt 
instrument or other derivative that are not directly related to the 
equity element of the instrument. The complex contract is a section 
871(m) transaction with respect to an underlying security if, for that 
underlying security, the expected change in value of the complex 
contract and its initial hedge is equal to or less than the expected 
change in value of the simple contract benchmark and its initial hedge 
when the substantial equivalence test described in this paragraph (h) is 
calculated at the calculation time for the complex contract. To the 
extent that the steps of the substantial equivalence test set out in 
this paragraph (h) cannot be applied to a particular complex contract, a 
taxpayer must use the principles of the substantial equivalence test to 
reasonably determine whether the complex contract is a section 871(m) 
transaction with respect to each underlying security. For purposes of 
this section, the test must be applied and the inputs must be determined 
in a commercially reasonable manner. The term of the simple contract 
benchmark must be, and the inputs must use, a reasonable time period, 
consistently applied (for example, in determining the standard deviation 
and probability). If a taxpayer calculates any relevant input for non-
tax business purposes, that input ordinarily is the input used for 
purposes of this section.
    (2) Simple contract benchmark. The simple contract benchmark is an 
actual or hypothetical simple contract that, at the calculation time for 
the complex contract, has a delta of 0.8, references the applicable 
underlying security referenced by the complex contract, and has terms 
that are consistent with all the material terms of the complex contract, 
including the maturity date. If an actual simple contract does not 
exist, the taxpayer must create a hypothetical simple contract. 
Depending on the complex contract, the simple contract benchmark might 
be, for example, a call option, a put option, or a collar.
    (3) Substantial equivalence. A complex contract is a section 871(m) 
transaction with respect to an underlying security if the complex 
contract calculation described in paragraph (h)(4) of this section 
results in an amount that is equal to or less than the amount of the 
benchmark calculation described in paragraph (h)(5) of this section.
    (4) Complex contract calculation--(i) In general. The complex 
contract calculation for each underlying security referenced by a 
potential section 871(m) transaction that is a complex contract is 
computed by:

[[Page 443]]

    (A) Determining the change in value (as described in paragraph 
(h)(4)(ii) of this section) of the complex contract with respect to the 
underlying security at each testing price (as described in paragraph 
(h)(4)(iii) of this section);
    (B) Determining the change in value of the initial hedge for the 
complex contract at each testing price;
    (C) Determining the absolute value of the difference between the 
change in value of the complex contract determined in paragraph 
(h)(4)(i)(A) of this section and the change in value of the initial 
hedge determined in paragraph (h)(4)(i)(B) of this section at each 
testing price;
    (D) Determining the probability (as described in paragraph 
(h)(4)(iv) of this section) associated with each testing price;
    (E) Multiplying the absolute value for each testing price determined 
in paragraph (h)(4)(i)(C) of this section by the corresponding 
probability for that testing price determined in paragraph (h)(4)(i)(D) 
of this section;
    (F) Adding the product of each calculation determined in paragraph 
(h)(4)(i)(E) of this section; and
    (G) Dividing the sum determined in paragraph (h)(4)(i)(F) of this 
section by the initial hedge for the complex contract.
    (ii) Determining the change in value. The change in value of a 
complex contract is the difference between the value of the complex 
contract with respect to the underlying security at the calculation time 
for the complex contract and the value of the complex contract with 
respect to the underlying security if the price of the underlying 
security were equal to the testing price at the calculation time for the 
complex contract. The change in value of the initial hedge of a complex 
contract with respect to the underlying security is the difference 
between the value of the initial hedge at the calculation time for the 
complex contract and the value of the initial hedge if the price of the 
underlying security were equal to the testing price at the calculation 
time for the complex contract.
    (iii) Testing price. The testing prices must include the prices of 
the underlying security if the price of the underlying security at the 
calculation time for the complex contract were alternatively increased 
by one standard deviation and decreased by one standard deviation, each 
of which is a separate testing price. In circumstances where using only 
two testing prices is reasonably likely to provide an inaccurate measure 
of substantial equivalence, a taxpayer must use additional testing 
prices as necessary to determine whether a complex contract satisfies 
the substantial equivalence test. If additional testing prices are used 
for the substantial equivalence test, the probabilities as described in 
paragraph (h)(4)(iv) of this section must be adjusted accordingly.
    (iv) Probability. For purposes of paragraphs (h)(4)(i)(D) and (E) of 
this section, the probability of an increase by one standard deviation 
is the measure of the likelihood that the price of the underlying 
security will increase by any amount from its price at the calculation 
time for the complex contract. For purposes of paragraphs (h)(4)(i)(D) 
and (E) of this section, the probability of a decrease by one standard 
deviation is the measure of the likelihood that the price of the 
underlying security will decrease by any amount from its price at the 
calculation time for the complex contract.
    (5) Benchmark calculation. The benchmark calculation with respect to 
each underlying security referenced by the potential section 871(m) 
transaction is determined by using the computation methodology described 
in paragraph (h)(4) of this section with respect to a simple contract 
benchmark for the underlying security.
    (6) Substantial equivalence calculation for certain complex 
contracts that reference multiple underlying securities. If a complex 
contract references 10 or more underlying securities and an exchange-
traded security (for example, an exchange-traded fund) is available that 
would fully hedge the complex contract at its calculation time, the 
substantial equivalence calculations for the complex contract may be 
calculated by treating the exchange-traded security as the underlying 
security. When the exchange-traded security is used for the substantial 
equivalence calculation pursuant to this paragraph (h)(6), the initial 
hedge is the number of shares of

[[Page 444]]

the exchange-traded security for purposes of calculating the amount of a 
dividend equivalent as provided in paragraph (j)(1)(iii) of this 
section.
    (7) Example. The following example illustrates the rules of 
paragraph (h) of this section. For purposes of this example, Stock X is 
common stock of domestic corporation X. FI is the financial institution 
that structures the transaction described in the example, and is the 
short party to the transaction. Investor is a nonresident alien 
individual.

    Example. Complex contract that is not substantially equivalent. (i) 
FI issues an investment contract (the Contract) that has a stated 
maturity of one year, and Investor purchases the Contract from FI at 
issuance for $10,000. At maturity, the Contract entitles Investor to a 
return of $10,000 (i) plus 200 percent of any appreciation in Stock X 
above $100 per share, capped at $110, on 100 shares or (ii) minus 100 
percent of any depreciation in Stock X below $90 on 100 shares. At the 
calculation time for the Contract, the price of Stock X is $100 per 
share. Thus, for example, Investor will receive $11,000 if the price of 
Stock X is $105 per share at maturity of the Contract, but Investor will 
receive $9,000 if the price of Stock X is $80 per share when the 
Contract matures. At issuance, FI acquires 64 shares of Stock X to fully 
hedge the Contract issued to Investor. The calculation time for this 
example is the issuance.
    (ii) The Contract references an underlying security and is not an 
NPC, so it is classified as an ELI under paragraph (a)(4) of this 
section. At the calculation time for the Contract, the Contract does not 
provide for an amount paid at maturity that is calculated by reference 
to a single, fixed number of shares of Stock X. When the Contract 
matures, the amount paid is effectively calculated based on either 200 
shares of Stock X (if the price of Stock X has appreciated up to $110) 
or 100 shares of Stock X (if the price of Stock X has declined below 
$90). Consequently, the Contract is a complex contract described in 
paragraph (a)(14) of this section.
    (iii) Because it is a complex ELI, FI applies the substantial 
equivalence test described in paragraph (h) of this section to determine 
whether the Contract is a specified ELI. FI determines that the price of 
Stock X would be $120 if the price of Stock X were increased by one 
standard deviation, and $79 if the price of Stock X were decreased by 
one standard deviation. Based on these results, FI next determines the 
change in value of the Contract to be $2000 at the testing price that 
represents an increase by one standard deviation ($12,000 testing price 
minus $10,000 issue price) and a negative $1,100 at the testing price 
that represents a decrease by one standard deviation ($10,000 issue 
price minus $8,900 testing price). FI performs the same calculations for 
the 64 shares of Stock X that constitute the initial hedge, determining 
that the change in value of the initial hedge is $1,280 at the testing 
price that represents an increase by one standard deviation ($6,400 at 
issuance compared to $7,680 at the testing price) and negative $1,344 at 
the testing price that represents a decrease by one standard deviation 
($6,400 at issuance compared to $5,056 at the testing price).
    (iv) FI then determines the absolute value of the difference between 
the change in value of the initial hedge and the Contract at the testing 
price that represents an increase by one standard deviation and a 
decrease by one standard deviation. Increased by one standard deviation, 
the absolute value of the difference is $720 ($2,000-$1,280); decreased 
by one standard deviation, the absolute value of the difference is $244 
(negative $1,100 minus negative $1,344). FI determines that there is a 
52% chance that the price of Stock X will have increased in value when 
the Contract matures and a 48% chance that the price of Stock X will 
have decreased in value at that time. FI multiplies the absolute value 
of the difference between the change in value of the initial hedge and 
the Contract at the testing price that represents an increase by one 
standard deviation by 52%, which equals $374.40. FI multiplies the 
absolute value of the difference between the change in value of the 
initial hedge and the Contract at the testing price that represents a 
decrease by one standard deviation by 48%, which equals $117.12. FI adds 
these two numbers and divides by the number of shares that constitute 
the initial hedge to determine that the transaction calculation is 7.68 
((374.40 plus 117.12) divided by 64).
    (v) FI then performs the same calculation with respect to the simple 
contract benchmark, which is a one-year call option that references one 
share of Stock X, settles on the same date as the Contract, and has a 
delta of 0.8. The one-year call option has a strike price of $79 and has 
a cost (the purchase premium) of $22. The initial hedge for the one-year 
call option is 0.8 shares of Stock X.
    (vi) FI first determines that the change in value of the simple 
contract benchmark is $19.05 if the testing price is increased by one 
standard deviation ($22.00 at issuance to $41.05 at the testing price) 
and negative $20.95 if the testing price is decreased by one standard 
deviation ($22.00 at issuance to $1.05 at the testing price). Second, FI 
determines that the change in value of the initial hedge is $16.00 at 
the testing price that represents an increase by one standard deviation 
($80 at

[[Page 445]]

issuance to $96 at the testing price) and negative $16.80 at the testing 
price that represents a decrease by one standard deviation ($80.00 at 
issuance to $63.20 at the testing price).
    (vii) FI determines the absolute value of the difference between the 
change in value of the initial hedge and the one-year call option at the 
testing price that represents an increase by one standard deviation is 
$3.05 ($16.00 minus $19.05). FI next determines the absolute value of 
the difference between the change in value of the initial hedge and the 
option at the testing price that represents a decrease by one standard 
deviation is $4.15 (negative $16.80 minus negative $20.95). FI 
multiplies the absolute value of the difference between the change in 
value of the initial hedge and the option at the testing price that 
represents an increase by one standard deviation by 52%, which equals 
$1.586. FI multiplies the absolute value of the difference between the 
change in value of the initial hedge and the option at the testing price 
that represents a decrease by one standard deviation by 48%, which 
equals $1.992. FI adds these two numbers and divides by the number of 
shares that constitute the initial hedge to determine that the benchmark 
calculation is 4.473 ((1.586 plus 1.992) divided by .8).
    (viii) FI concludes that the Contract is not a section 871(m) 
transaction because the transaction calculation of 7.68 exceeds the 
benchmark calculation of 4.473.
    (i) Payment of a dividend equivalent--(1) Payments determined on 
gross basis. For purposes of this section, a payment includes any gross 
amount that references a dividend and that is used in computing any net 
amount transferred to or from the long party even if the long party 
makes a net payment to the short party or no amount is paid because the 
net amount is zero.
    (2) Actual and estimated dividends--(i) In general. A payment 
includes any amount that references an actual or estimated dividend, 
whether the reference is explicit or implicit. If a potential section 
871(m) transaction provides for a payment based on an estimated dividend 
that adjusts to account for the amount of an actual dividend paid, the 
payment is treated as referencing the actual dividend amount and not an 
estimated dividend amount.
    (ii) Implicit dividends. A payment includes an actual or estimated 
dividend that is implicitly taken into account in computing one or more 
of the terms of a potential section 871(m) transaction, including 
interest rate, notional amount, purchase price, premium, upfront 
payment, strike price, or any other amount paid or received pursuant to 
the potential section 871(m) transaction.
    (iii) Actual dividend presumption. A short party to a section 871(m) 
transaction is treated as paying a per-share dividend amount equal to 
the actual dividend amount unless the short party to the section 871(m) 
transaction identifies a reasonable estimated dividend amount in writing 
at the calculation time. For this purpose, a reasonable estimated 
dividend amount stated in an offering document or the documents 
governing the terms at the calculation time will establish the estimated 
dividend amount. To qualify as an estimated dividend amount, the written 
estimated dividend amount must separately state the amount estimated for 
each anticipated dividend or state a formula that allows each dividend 
to be determined. If an underlying security is not expected to have a 
dividend, a reasonable estimate of the dividend amount may be zero.
    (iv) Additions to estimated payments. If a section 871(m) 
transaction provides for any payment in addition to an estimated 
dividend and that additional payment is determined by reference to a 
dividend (for example, a special dividend), both the estimated dividend 
and the additional payment are used to determine the per-share dividend 
amount.
    (3) Dividends for certain baskets--(i) In general. If a section 
871(m) transaction references long positions in more than 25 underlying 
securities, the short party may treat the dividends with respect to the 
referenced underlying securities as paid at the end of the applicable 
calendar quarter to compute the per-share dividend amount.
    (ii) Publicly available dividend amount. For purposes of paragraph 
(i)(3)(i) of this section, if a section 871(m) transaction references 
the same underlying securities as a security (for example, stock in an 
exchange-traded fund) or index for which there is a publicly available 
quarterly dividend amount, the publicly available dividend amount may be 
used to determine the per-share dividend amount for the section 871(m)

[[Page 446]]

transaction with any adjustment for special dividends.
    (iii) Dividend amount for a section 871(m) transaction using the 
simplified delta calculation. When the delta of a section 871(m) 
transaction is determined under paragraph (g)(3) of this section, the 
per-share dividend amount for that section 871(m) transaction must be 
determined using the dividend amount for the exchange-traded security 
that would fully hedge the section 871(m) transaction (whether or not 
the exchange-traded security is actually acquired).
    (4) Examples. The following examples illustrate the rules of this 
paragraph (i). For purposes of these examples, Stock X is common stock 
of Corporation X, a domestic corporation, that historically pays 
quarterly dividends on Stock X. The parties anticipate that Corporation 
X will continue to pay quarterly dividends.

    Example 1. Forward contract to purchase domestic stock. (i) When 
Stock X is trading at $50 per share, Foreign Investor enters into a 
forward contract to purchase 100 shares of Stock X in one year. 
Reasonable estimates of the quarterly dividend are specified in the 
transaction documents. The price in the forward contract is determined 
by multiplying the number of shares referenced in the contract by the 
current price of the shares and an interest rate, and subtracting the 
value of any dividends expected to be paid during the term of the 
contract. Assuming that the forward contract is priced using an interest 
rate of 4 percent and total estimated dividends with a future value of 
$1 per share during the term of the forward contract, the purchase price 
set in the forward contract is $5,100 (100 shares x $50 per share x 1.04 
- ($1 x 100)).
    (ii) Subject to paragraph (i)(2)(iv) of this section, the estimated 
dividend amounts are the per-share dividend amounts because the 
estimates are reasonable and specified in accordance with paragraph 
(i)(2)(iii) of this section. The estimated per-share dividend amounts 
are dividend equivalents for purposes of this section.
    Example 2. Price return only swap contract. (i) Foreign Investor 
enters into a price return swap contract that entitles Foreign Investor 
to receive payments based on the appreciation in the value of 100 shares 
of Stock X and requires Foreign Investor to pay an amount based on LIBOR 
plus any depreciation in the value of Stock X. The swap contract neither 
explicitly entitles Foreign Investor to payments based on dividends paid 
on Stock X during the term of the contract nor references an estimated 
dividend amount. The LIBOR rate in the swap contract, however, is 
reduced to reflect expected annual dividends on Stock X.
    (ii) Because the LIBOR leg of the swap contract is reduced to 
reflect estimated dividends and the estimated dividend amounts are not 
specified, Foreign Investor is treated as receiving the actual dividend 
amounts are in accordance with paragraph (i)(2) of this section. The 
actual per-share dividend amounts are dividend equivalents for purposes 
of this section.

    (j) Amount of dividend equivalent-- (1) Calculation of the amount of 
a dividend equivalent. The long party is liable for tax on any dividend 
equivalents required to be determined pursuant to paragraph (j)(2) of 
this section only with respect to dividend equivalents that arise while 
the long party is a party to the transaction. The amount of any dividend 
equivalent is determined as follows:
    (i) Securities lending or sale-repurchase transactions. For a 
securities lending or sale-repurchase transaction, the amount of the 
dividend equivalent for each dividend on an underlying security equals 
the amount of the actual per-share dividend paid on the underlying 
security multiplied by the number of shares of the underlying security.
    (ii) Simple contracts. For a simple contract that is a section 
871(m) transaction, the amount of the dividend equivalent for each 
dividend on an underlying security equals:
    (A) The per-share dividend amount (as determined under either 
paragraph (i)(2) or (i)(3) of this section) with respect to the 
underlying security multiplied by;
    (B) The number of shares of the underlying security multiplied by;
    (C) The delta of the section 871(m) transaction with respect to the 
underlying security.
    (iii) Complex contracts. For a complex contract that is a section 
871(m) transaction, the amount of the dividend equivalent for each 
dividend on an underlying security equals:
    (A) The per-share dividend amount (as determined under paragraph 
(i)(2) or (i)(3) of this section) with respect to the underlying 
security multiplied by;
    (B) The initial hedge for the underlying security.

[[Page 447]]

    (iv) Other substantially similar payments. In addition to any amount 
determined pursuant to paragraph (j)(1)(i), (ii), or (iii), the amount 
of a dividend equivalent includes the amount of any payment described in 
paragraph (f) of this section.
    (2) Time for determining the amount of a dividend equivalent. The 
amount of a dividend equivalent is determined on the earlier of the date 
that is the record date of the dividend and the day prior to the ex-
dividend date with respect to the dividend. For example, if a specified 
NPC provides for a payment at settlement that takes into account an 
earlier dividend payment, the amount of the dividend equivalent is 
determined on the earlier of the record date or the day prior to the ex-
dividend date for that dividend.
    (3) Number of shares. The number of shares of an underlying security 
generally is the number of shares of the underlying security stated in 
the contract. If the transaction modifies that number by a factor or 
fraction or otherwise alters the amount of any payment, the number of 
shares is adjusted to take into account the factor, fraction, or other 
modification. For example, in a transaction in which the long party 
receives or makes payments based on 200 percent of the appreciation or 
depreciation (as applicable) of 100 shares of stock, the number of 
shares of the underlying security is 200 shares of the stock.
    (4) Taxable year of a dividend equivalent. A long party is liable 
for tax on a dividend equivalent in the year the dividend equivalent is 
subject to withholding pursuant to Sec.  1.1441-2(e)(7). Notwithstanding 
the preceding sentence, a long party that is a qualified derivatives 
dealer is liable for tax on a dividend equivalent when the applicable 
dividend on the underlying security would be subject to withholding 
pursuant to Sec.  1.1441-2(e)(4). The amount of the long party's tax 
liability, however, is determined by reference to the amount that would 
have been due at the time the dividend equivalent amount is determined 
pursuant to paragraph (j)(2) of this section based on the beneficial 
owners at that time (for example, based on the tax rate at that time, 
whether the long party qualified for a treaty benefit at that time, and 
in the case of a partnership, based on the partners at that time).
    (k) Limitation on the treatment of certain corporate acquisitions as 
section 871(m) transactions. A potential section 871(m) transaction is 
not a section 871(m) transaction with respect to an underlying security 
if the transaction obligates the long party to acquire ownership of the 
underlying security as part of a plan pursuant to which one or more 
persons (including the long party) are obligated to acquire underlying 
securities representing more than 50 percent of the value of the entity 
issuing the underlying securities.
    (l) Rules relating to indices--(1) Purpose. The purpose of this 
paragraph (l) is to provide a safe harbor for potential section 871(m) 
transactions that reference certain passive indices that are based on a 
diverse basket of publicly-traded securities and that are widely used by 
numerous market participants. Notwithstanding any other provision in 
this paragraph (l), an index is not a qualified index if treating the 
index as a qualified index would be contrary to the purpose described in 
this paragraph (l)(1).
    (2) Qualified index not treated as an underlying security--(i) In 
general. For purposes of this section, a qualified index is treated as a 
single security that is not an underlying security. The determination of 
whether an index referenced in a potential section 871(m) transaction is 
a qualified index is made at the calculation time for the transaction 
based on whether the index is a qualified index on the first business 
day of the calendar year containing the calculation time.
    (ii) Rule for the first year of an index. In the case of an index 
that was not in existence on the first business day of the calendar year 
containing the calculation time for the transaction, paragraph (l)(2) of 
this section is applied by testing the index on the first business day 
it is created, and the dividend yield calculation required by paragraph 
(l)(3)(vi) of this section is determined by using the dividend yield 
that the index would have had in the immediately preceding year if it 
had the same components throughout that year that it has on the day it 
is created.

[[Page 448]]

    (3) Qualified index. A qualified index means an index that--
    (i) References 25 or more component securities (whether or not the 
security is an underlying security);
    (ii) Except as provided in paragraph (l)(6)(ii) of this section, 
references only long positions in component securities;
    (iii) References no component underlying security that represents 
more than 15 percent of the weighting of the component securities in the 
index;
    (iv) References no five or fewer component underlying securities 
that together represent more than 40 percent of the weighting of the 
component securities in the index;
    (v) Is modified or rebalanced only according to publicly stated, 
predefined criteria, which may require interpretation by the index 
provider or a board or committee responsible for maintaining the index;
    (vi) Did not provide an annual dividend yield in the immediately 
preceding calendar year from component underlying securities that is 
greater than 1.5 times the annual dividend yield of the S&P 500 Index as 
reported for the immediately preceding calendar year; and
    (vii) Is traded through futures contracts or option contracts 
(regardless of whether the contracts provide price only or total return 
exposure to the index or provide for dividend reinvestment in the index) 
on--
    (A) A national securities exchange that is registered with the 
Securities and Exchange Commission or a domestic board of trade 
designated as a contract market by the Commodity Futures Trading 
Commission; or
    (B) A foreign exchange or board of trade that is a qualified board 
or exchange as determined by the Secretary pursuant to section 
1256(g)(7)(C) or that has a staff no action letter from the CFTC 
permitting direct access from the United States that is effective on the 
applicable testing date, provided that the referenced component 
underlying securities, in the aggregate, comprise less than 50 percent 
of the weighting of the component securities in the index.
    (4) Safe harbor for certain indices that reference assets other than 
underlying securities. Notwithstanding paragraph (l)(3) of this section, 
an index is a qualified index if the index is widely traded, the 
referenced component underlying securities in the aggregate comprise 10 
percent or less of the weighting of the component securities in the 
index, and the index was not formed or availed of with a principal 
purpose of avoiding U.S. withholding tax.
    (5) Weighting of component securities. For purposes of this 
paragraph (l), the weighting of a component security of an index is the 
percentage of the index's value represented, or accounted for, by the 
component security.
    (6) Transactions that reference a qualified index and one or more 
component securities or indices--(i) In general. When a potential 
section 871(m) transaction references a qualified index and one or more 
component securities or other indices, the qualified index remains a 
qualified index only if the potential section 871(m) transaction does 
not reference a short position in any referenced component security of 
the qualified index, other than a short position with respect to the 
entire qualified index (for example, a cap or floor) or a de minimis 
short position described in paragraph (l)(6)(ii) of this section. If, in 
connection with a potential section 871(m) transaction that references a 
qualified index, a taxpayer (or a related person within the meaning of 
section 267(b) or section 707(b)) enters into one or more transactions 
that reduce exposure to any referenced component security of the index, 
other than transactions that reduce exposure to the entire index, then 
the potential section 871(m) transaction is not treated as referencing a 
qualified index.
    (ii) Safe harbor for de minimis short positions. Notwithstanding 
paragraphs (l)(3)(ii) and (l)(6)(i) of this section, an index may be a 
qualified index if the short position (whether part of the index or 
entered into separately by the taxpayer or related person within the 
meaning of section 267(b) or section 707(b)) reduces exposure to 
referenced component securities of a qualified index (excluding any 
short positions with respect to the entire qualified index) by five 
percent or less of the value of the long positions in component 
securities in the qualified index.

[[Page 449]]

    (7) Transactions that indirectly reference a qualified index. If a 
potential section 871(m) transaction references an exchange-traded fund 
that tracks a qualified index, the potential section 871(m) transaction 
will be treated as referencing a qualified index.
    (m) Rules relating to derivatives that reference partnerships--(1) 
In general. When a potential section 871(m) transaction references a 
partnership interest, the assets of the partnership will be treated as 
referenced by the potential section 871(m) transaction only if the 
partnership carries on a trade or business of dealing or trading in 
securities, holds significant investments in securities (either of which 
is a covered partnership), or directly or indirectly holds an interest 
in a lower-tier partnership that is a covered partnership. For purposes 
of this section, if a covered partnership directly or indirectly holds 
assets that are underlying securities or potential section 871(m) 
transactions, any potential section 871(m) transaction that references 
an interest in the covered partnership is treated as referencing the 
shares of the underlying securities, including underlying securities of 
potential section 871(m) transactions, directly or indirectly allocable 
to that partnership interest. For purposes of this paragraph (m), a 
security is defined in section 475(c).
    (2) Significant investments in securities--(i) In general. For 
purposes of this paragraph (m), a partnership holds significant 
investments in securities if either--
    (A) 25 percent or more of the value of the partnership's assets 
consist of underlying securities or potential section 871(m) 
transactions; or
    (B) The value of the underlying securities or potential section 
871(m) transactions equals or exceeds $25 million.
    (ii) Determining the value of the partnership's assets. For purposes 
of this paragraph (m)(2)(i) of this section, the value of a 
partnership's assets is determined at the calculation time for the 
potential section 871(m) transaction referencing that partnership 
interest based on the value of the assets held by the partnership on the 
last day of the partnership's prior taxable year unless the long party 
or the short party has actual knowledge that a subsequent transaction 
has caused the partnership to cross either of the thresholds described 
in paragraph (m)(2)(i). The value of a partnership's assets is equal to 
their fair market value, except that the value of any NPC, futures 
contract, forward contract, option, and any similar financial instrument 
held by the partnership is deemed to be the value of the notional 
securities referenced by the transaction.
    (n) Combined transactions--(1) In general. For purposes of 
determining whether a potential section 871(m) transaction is a section 
871(m) transaction, two or more potential section 871(m) transactions 
are treated as a single transaction with respect to an underlying 
security when--
    (i) A person (or a related person within the meaning of section 
267(b) or section 707(b)) is the long party with respect to the 
underlying security for each potential section 871(m) transaction;
    (ii) The potential section 871(m) transactions reference the same 
underlying security;
    (iii) The potential section 871(m) transactions, when combined, 
replicate the economics of a transaction that would be a section 871(m) 
transaction if the transactions had been entered into as a single 
transaction; and
    (iv) The potential section 871(m) transactions are entered into in 
connection with each other (regardless of whether the transactions are 
entered into simultaneously or with the same counterparty).
    (2) Section 871(m) transactions. If a potential section 871(m) 
transaction is a section 871(m) transaction, either by itself or as a 
result of a combination with one or more other potential section 871(m) 
transactions, it does not cease to be a section 871(m) transaction as a 
result of applying paragraph (n) of this section or disposing of one or 
more of the potential section 871(m) transaction with which it is 
combined.
    (3) Short party presumptions regarding combined transactions--(i) In 
general. If a short party relies on the presumption provided in 
paragraph (n)(3)(ii) of this section or in paragraph (n)(3)(iii) of this 
section, the short party is not required to treat those potential 
section 871(m) transactions as part of a single

[[Page 450]]

transaction pursuant to paragraph (n)(1) of this section.
    (ii) Transactions in separate accounts. A short party that is a 
broker may presume that transactions are not entered into in connection 
with each other for purposes of paragraph (n)(1) of this section if a 
long party holds or reflects the transactions in separate accounts 
maintained by the short party, unless the short party has actual 
knowledge that the transactions held or reflected in separate accounts 
by the long party were entered into in connection with each other or 
that separate accounts were created or used to avoid section 871(m).
    (iii) Transactions separated by at least two business days. A short 
party that is a broker may presume that transactions entered into two or 
more business days apart are not entered into in connection with each 
other for purposes of paragraph (n)(1) of this section unless the short 
party has actual knowledge that the transactions were entered into in 
connection with each other.
    (4) Presumptions Commissioner will apply to long party--(i) 
Transactions in separate trading books. The Commissioner will presume 
that a long party did not enter into two or more transactions in 
connection with each other for purposes of paragraph (n)(1) of this 
section if the long party properly reflected those transactions on 
separate trading books. The Commissioner may rebut this presumption with 
facts and circumstances showing that transactions reflected on separate 
trading books were entered into in connection with each other or that 
separate trading books were created or used to avoid section 871(m).
    (ii) Transactions separated by at least two days. The Commissioner 
will presume that a long party did not enter into two or more 
transactions in connection with each other for purposes of paragraph 
(n)(1) of this section if the long party entered into the transactions 
two or more business days apart. The Commissioner may rebut this 
presumption with facts and circumstances showing that the transactions 
entered into two or more business days apart were entered into in 
connection with each other.
    (iii) Transactions separated by fewer than two days and reflected in 
the same trading book. The Commissioner will presume that transactions 
that are entered into fewer than two business days apart and reflected 
on the same trading book are entered into in connection with each other. 
A long party can rebut this presumption with facts and circumstances 
showing that the transactions were not entered into in connection with 
each other.
    (5) Rules of application--(i) Two business days rule. For the 
purpose of determining the number of business days between transactions, 
the short party may, and the Commissioner will, assume that all 
transactions are entered into at 4:00 p.m. on the date the transaction 
becomes effective in the jurisdiction of the long party.
    (ii) No long party presumptions. Notwithstanding the presumptions 
described in paragraphs (n)(3) and (n)(4) of this section, the long 
party must treat two or more transactions as combined transactions if 
the transactions are described in paragraph (n)(1) of section.
    (6) Ordering rule for transactions entered into in connection with 
each other. If a long party enters into more than two potential section 
871(m) transactions that could be combined under this paragraph (n), a 
short party is required to apply paragraph (n)(1) of this section by 
combining transactions in a manner that results in the most transactions 
with a delta of 0.8 or higher with respect to the referenced underlying 
security. Thus, for example, if a taxpayer has sold one at-the-money put 
and purchased two at-the-money calls, each with respect to 100 shares of 
the same underlying security, the put and one call are combined. 
Similarly, a purchased call on 100 shares and a sold put on 200 shares 
of the same underlying security can be combined for 100 shares with 100 
shares of the put remaining separate. The two calls are not combined 
because they do not provide the long party with economic exposure to 
depreciation in the underlying security. Similarly, if a long party 
enters into more than two potential section 871(m) transactions that 
could be combined under this paragraph (n), but have not been combined

[[Page 451]]

by a short party, the long party is required to apply paragraph (n)(1) 
of this section by combining transactions in a manner that results in 
the most transactions with a delta of 0.8 or higher with respect to the 
referenced underlying security.
    (7) More than one underlying security referenced. If potential 
section 871(m) transactions reference more than one underlying security, 
paragraph (n)(1) of this section applies separately with respect to each 
underlying security.
    (o) Anti-abuse rule. If a taxpayer (directly or through the use of a 
related person within the meaning of section 267(b) or section 707(b)) 
acquires (whether by entering into, purchasing, accepting by transfer, 
by exchange, or by conversion, or otherwise acquiring) or disposes of 
(whether by sale, offset, exercise, termination, expiration, maturity, 
or other means) a transaction or transactions with a principal purpose 
of avoiding the application of this section, the Commissioner may treat 
any payment (as described in paragraph (i) of this section) made with 
respect to that transaction or transactions as a dividend equivalent to 
the extent necessary to prevent the avoidance of this section. 
Therefore, notwithstanding any other provision of this section, the 
Commissioner may, for example, adjust the delta of a transaction, change 
the number of shares, adjust an estimated dividend amount, change the 
maturity, adjust the timing of payments, treat a transaction that 
references a partnership interest as referencing the assets of the 
partnership, combine, separate, or disregard transactions, indices, or 
components of indices to reflect the substance of the transaction or 
transactions, or otherwise depart from the rules of this section as 
necessary to determine whether the transaction includes a dividend 
equivalent or the amount or timing of a dividend equivalent. A purpose 
may be a principal purpose even though it is outweighed by other 
purposes (taken together or separately). When a withholding agent knows 
that the taxpayer acquired or disposed of a transaction or transactions 
with a principal purpose of avoiding the application of this section and 
the Commissioner treats a payment made with respect to any transaction 
as a dividend equivalent, the withholding agent may be liable for any 
tax pursuant to section 1461.
    (p) Information required to be reported regarding a potential 
section 871(m) transaction-- (1) Responsible party--(i) In general. If a 
broker or dealer is a party to a potential section 871(m) transaction 
with a counterparty or customer that is not a broker or dealer, the 
broker or dealer is required to determine whether the potential section 
871(m) transaction is a section 871(m) transaction. If both parties to a 
potential section 871(m) transaction are brokers or dealers, or neither 
party to a potential section 871(m) transaction is a broker or dealer, 
the short party must determine whether the potential section 871(m) 
transaction is a section 871(m) transaction.
    (ii) Transactions with multiple brokers. For a potential section 
871(m) transaction in which both the short party and an agent or 
intermediary acting on behalf of the short party are a broker or dealer, 
the short party must determine whether the potential section 871(m) 
transaction is a section 871(m) transaction. For a potential section 
871(m) transaction in which the short party is not a broker or dealer 
and more than one agent or intermediary acting on behalf of the short 
party is a broker or dealer, the broker or dealer that is a party to the 
transaction and closest to the short party in the payment chain must 
determine whether the potential section 871(m) transaction is a section 
871(m) transaction. For a potential section 871(m) transaction in which 
neither the short party nor any agent or intermediary acting on behalf 
of the short party is a broker or dealer, and the long party and an 
agent or intermediary acting on behalf of the long party are a broker or 
dealer, or more than one agent or intermediary acting on behalf of the 
long party is a broker or dealer, the broker or dealer that is a party 
to the transaction and closest to the long party in the payment chain 
must determine whether the potential section 871(m) transaction is a 
section 871(m) transaction.
    (iii) Responsible party for transactions traded on an exchange and 
cleared by a

[[Page 452]]

clearing organization. Except as provided in paragraph (p)(1)(iv) of 
this section, for a potential section 871(m) transaction that is traded 
on an exchange and cleared by a clearing organization, and for which 
more than one broker-dealer acts as an agent or intermediary between the 
short party and a foreign payee, the broker or dealer that has an 
ongoing customer relationship with the foreign payee with respect to 
that transaction (generally the clearing firm) must determine whether 
the potential section 871(m) transaction is a section 871(m) 
transaction.
    (iv) Responsible party for certain structured notes, warrants, and 
convertible instruments. When a potential section 871(m) transaction is 
a structured note, warrant, convertible stock, or convertible debt, the 
issuer is the party responsible for determining whether a potential 
section 871(m) transaction is a section 871(m) transaction.
    (v) Obligations of the responsible party. The party to the 
transaction that is required to determine whether a transaction is a 
section 871(m) transaction must also determine and report to the 
counterparty or customer the timing and amount of any dividend 
equivalent (as described in paragraphs (i) and (j) of this section). 
Except as otherwise provided in paragraph (n)(3) of this section, the 
party required to make the determinations described in this paragraph is 
required to exercise reasonable diligence to determine whether a 
transaction is a section 871(m) transaction, the amount of any dividend 
equivalents, and any other information necessary to apply the rules of 
this section. The information must be provided in the manner prescribed 
in paragraphs (p)(2) and (p)(3) of this section. The determinations 
required by paragraph (p) of this section are binding on the parties to 
the potential section 871(m) transaction and on any person who is a 
withholding agent with respect to the potential section 871(m) 
transaction unless the person knows or has reason to know that the 
information received is incorrect. The determinations are not binding on 
the Commissioner.
    (2) Reporting requirements. For rules regarding the reporting 
requirements of withholding agents with respect to dividend equivalents 
described in this section, see Sec. Sec.  1.1461-1(b) and (c) and 
1.1474-1(c) and (d).
    (3) Additional information available to a party to a potential 
section 871(m) transaction--(i) In general. Upon request by any person 
described in paragraph (p)(3)(ii) of this section, the party required to 
report information pursuant to paragraph (p)(1) of this section must 
provide the requester with information regarding the amount of each 
dividend equivalent, the delta of the potential section 871(m) 
transaction, the amount of any tax withheld and deposited, the estimated 
dividend amount if specified in accordance with paragraph (i)(2)(iii) of 
this section, the identity of any transactions combined pursuant to 
paragraph (n) of this section, and any other information necessary to 
apply the rules of this section. The information requested must be 
provided within a reasonable time, not to exceed 10 business days, and 
communicated in one or more of the following ways:
    (A) By telephone, and confirmed in writing;
    (B) By written statement sent by first class mail to the address 
provided by the requesting party;
    (C) By electronic publication available to all persons entitled to 
request information; or
    (D) By any other method agreed to by the parties, and confirmed in 
writing.
    (ii) Persons entitled to request information. Any party to the 
transaction described in paragraph (a)(9) of this section may request 
the information specified in paragraph (p) of this section with respect 
to a potential section 871(m) transaction from the party required by 
paragraph (p)(3)(i) of this section to provide the information.
    (iii) Reliance on information received. A person described in 
paragraph (p)(1) or (p)(3)(ii) of this section that receives information 
described in paragraph (p)(1) or (p)(3)(i) of this section may rely on 
that information to provide information to any other person unless the 
recipient knows or has reason to know that the information received is 
incorrect. When the recipient knows or has reason to know that the 
information received is incorrect, the recipient must make a reasonable 
effort to determine and provide the information

[[Page 453]]

described in paragraph (p)(1) or (p)(3)(i) of this section to any person 
described in paragraph (p)(1) or (p)(3)(ii) of this section that 
requests information from the recipient.
    (4) Recordkeeping rules--(i) In general. For rules regarding 
recordkeeping requirements sufficient to establish whether a transaction 
is a section 871(m) transaction and whether a payment is a dividend 
equivalent and the amount of gross income treated as a dividend 
equivalent, see Sec.  1.6001-1.
    (ii) Records sufficient to establish whether a transaction is a 
section 871(m) transaction and any dividend equivalent amount. Any 
person required to retain records must keep sufficient information to 
establish whether a transaction is a section 871(m) transaction and the 
amount of a dividend equivalent (if any), including documentation and 
work papers supporting the delta calculation or the substantial 
equivalence test (including the number of shares of the initial hedge), 
as applicable, and written estimated dividends (if any). The records and 
documentation must be created substantially contemporaneously. A record 
will be considered to have been created substantially contemporaneously 
if it was created within 10 business days of the date containing the 
calculation time for the potential section 871(m) transaction.
    (iii) Recordkeeping required for certain options. With respect to 
any option to which paragraph (g)(4) of this section applies, 
contemporaneous documentation is not required to be retained provided 
that there is a pre-existing documented methodology that is sufficient 
to permit the delta for the transaction to be verified at a later time.
    (5) Example. The following example illustrates the rules of 
paragraph (p) of this section.
    (i) Example 1: Responsible party for a transaction with multiple 
broker-dealers. (A) Facts. CO is a domestic clearing organization and is 
not a broker as defined in paragraph (a)(1) of this section. CO serves 
as a central counterparty clearing and settlement service provider for 
derivatives exchanges in the United States. EB and CB are brokers 
organized in the United States and members of CO. FC, a foreign 
corporation, instructs EB to execute the purchase of a call option that 
is a specified ELI (as described in paragraph (e) of this section). EB 
effects the trade for FC on the exchange and then, as instructed by FC, 
transfers the option to CB to be cleared with CO. The exchange matches 
FC's order with an order for a written call option with the same terms 
and then sends the matched trade to CO, which clears the trade. CB and 
the clearing member representing the person who sold the call option 
settle the trade with CO. Upon receiving the matched trade, the option 
contracts are novated and CO becomes the counterparty to CB and the 
counterparty to the clearing member representing the person who sold the 
call option.
    (B) Analysis. Both EB and CB are broker-dealers acting on behalf of 
FC for a potential section 871(m) transaction. Under paragraph 
(p)(1)(iii) of this section, however, only CB is required to make the 
determinations described in paragraph (p) of this section because CB has 
the ongoing customer relationship with FC with respect to the call 
option.
    (ii) [Reserved]
    (q) Dividend and dividend equivalent payments to a qualified 
derivatives dealer--(1) In general. Except as otherwise provided in this 
paragraph (q), a qualified derivatives dealer described in Sec.  1.1441-
1(e)(6) that receives a payment (within the meaning of paragraph (i) of 
this section) of a dividend equivalent in its equity derivatives dealer 
capacity will not be liable for tax under section 881 on that dividend 
equivalent, provided that the qualified derivatives dealer complies with 
its obligations under the qualified intermediary withholding agreement 
described in Sec. Sec.  1.1441-1(e)(5) and 1.1441-1(e)(6). A qualified 
derivatives dealer is liable for tax under section 881(a)(1) on its 
section 871(m) amount for each dividend on each underlying security. 
This tax liability is reduced (but not below zero) by the amount of tax 
paid by the qualified derivatives dealer under section 881(a)(1) on 
dividends it receives with respect to that underlying security on that 
same dividend in its capacity as an equity derivatives dealer. In 
addition, a qualified derivatives dealer is liable for tax under section 
881(a)(1) for

[[Page 454]]

all dividend equivalents it receives that are not received in its equity 
derivatives dealer capacity. A qualified derivatives dealer also is 
liable for tax under section 881(a)(1) for all dividends it receives, 
other than dividends received in 2017 in its equity derivatives dealer 
capacity. This paragraph does not apply for a qualified derivatives 
dealer that is a foreign branch of a United States financial institution 
(within the meaning of Sec.  1.1471-5(e)).
    (2) Transactions on the books of an equity derivatives dealer. 
Transactions properly reflected in a qualified derivatives dealer's 
equity derivatives dealer book are presumed to be held by the dealer in 
its equity derivatives dealer capacity for purposes of determining the 
qualified derivatives dealer's tax liability. For purposes of 
determining whether a dealer is acting in its equity derivatives dealer 
capacity, only the dealer's activities as an equity derivatives dealer 
are taken into account. Accordingly, for purposes of this paragraph (q), 
a dividend or dividend equivalent is treated as received by a qualified 
derivatives dealer acting in its non-equity derivatives dealer capacity 
if the dividend or dividend equivalent is received by a qualified 
derivatives dealer acting as a proprietary trader.
    (3) Section 871(m) amount. For each dividend on each underlying 
security, the section 871(m) amount is the product of:
    (i) The qualified derivatives dealer's net delta exposure to the 
underlying security for the applicable dividend, multiplied by;
    (ii) The applicable dividend amount per share.
    (4) Net delta exposure. The net delta exposure to an underlying 
security is the amount (measured in number of shares) by which (A) the 
aggregate number of shares of an underlying security that the qualified 
derivatives dealer has exposure to as a result of positions in the 
underlying security (including as a result of owning the underlying 
security) with values that move in the same direction as the underlying 
security (the long positions) exceeds (B) the aggregate number of shares 
of an underlying security that the qualified derivatives dealer has 
exposure to as a result of positions in the underlying security with 
values that move in the opposite direction from the underlying security 
(the short positions). The net delta exposure calculation only includes 
long positions and short positions that the qualified derivatives dealer 
holds in its equity derivatives dealer capacity (as described in 
paragraph (q)(2) of this section). Any long positions or short positions 
that are treated as effectively connected with the qualified derivatives 
dealer's conduct of a trade or business in the United States for U.S. 
federal income tax purposes are excluded from the net delta exposure 
computation. The net delta exposure to an underlying security is 
determined at the end of the day on the date provided in Sec.  1.871-
15(j)(2) for the applicable dividend. For purposes of this calculation, 
net delta must be determined in a commercially reasonable manner. If a 
qualified derivatives dealer calculates net delta for non-tax business 
purposes, the net delta ordinarily will be the delta used for that 
purpose, subject to the modifications required by this definition. Each 
qualified derivatives dealer must determine its net delta exposure 
separately only taking into account transactions that are recognized and 
are attributable to that qualified derivatives dealer for U.S. federal 
income tax purposes.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (q):

    Example 1. Forward contract entered into by a foreign equity 
derivatives dealer. (i) Facts. FB is a foreign bank that is a qualified 
intermediary that acts as a qualified derivatives dealer. On April 1, 
Year 1, FB enters into a cash settled forward contract initiated by a 
foreign customer (Customer) that entitles Customer to receive from FB 
all of the appreciation and dividends on 100 shares of Stock X, and 
obligates Customer to pay FB any depreciation on 100 shares of Stock X, 
at the end of three years. FB hedges the forward contract by entering 
into a total return swap contract with a domestic broker (U.S. Broker) 
and maintains the swap contract as a hedge for the duration of the 
forward contract. The swap contract entitles FB to receive an amount 
equal to all of the dividends on 100 shares of Stock X and obligates FB 
to pay an amount referenced to a floating interest rate each quarter, 
and also entitles FB to receive from or pay to U.S. Broker, as the case 
may be, the difference between the

[[Page 455]]

value of 100 shares of Stock X at the inception of the swap and the 
value of 100 shares of Stock X at the end of 3 years. Stock X pays a 
quarterly dividend of $0.25 per share. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB owns 
the forward contract and total return swap; FB does not own any shares 
of Stock X or any other transactions that reference Stock X. FB provides 
valid documentation to U.S. Broker that FB will receive payments under 
the swap contract in its capacity as a qualified derivatives dealer, and 
FB contemporaneously enters both the swap contract with U.S. Broker and 
the forward contract with Customer on its equity derivatives dealer 
books.
    (ii) Application of rules. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB is a 
long party on a delta one contract (the total return swap) and a short 
party on a delta one contract (the forward contract with Customer). 
Pursuant to Sec.  1.1441-1(b)(4)(xxii), U.S. Broker is not obligated to 
withhold on the dividend equivalent payments to FB on the swap contract 
that are referenced to Stock X dividends because U.S. Broker has 
received valid documentation that it may rely upon to treat the payment 
as made to FB acting as a qualified derivatives dealer. Pursuant to 
paragraph (q)(1) of this section, FB is not liable for tax under 
sections 871(m) and 881 on the payments it receives from U.S. Broker 
referenced to Stock X dividends because FB's net delta exposure with 
respect to 100 shares of Stock X is zero at the end of the day on the 
date provided in paragraph (j)(2) of this section for the dividend. The 
net delta exposure is zero because the taxpayer has 100 shares of Stock 
X long position exposure as a result of the total return swap that is 
reduced by 100 shares of Stock X short position exposure as a result of 
the forward contract. FB is required to withhold on dividend equivalent 
payments to Customer on the forward contract in accordance with Sec.  
1.1441-2(e)(7).
    Example 2. At-the-money option contract entered into by a foreign 
equity derivatives dealer. (i) Facts. The facts are the same as Example 
1, but Customer purchases from FB an at-the-money call option on 100 
shares of Stock X with a term of one year. The call option has a delta 
of 0.5, and FB hedges the call option by entering into a total return 
swap that references 50 shares of Stock X with U.S. Broker. At the end 
of the day on the date provided in paragraph (j)(2) of this section for 
the dividend, the call option has a delta of 0.6, FB hedges the call 
option with a total return swap that references 60 shares of Stock X 
with U.S. Broker, and FB has no shares of Stock X or other transactions 
that reference Stock X.
    (ii) Application of rules. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB is a 
long party on 60 shares of Stock X through the total return swap and a 
short party on an option. Because the option has a delta of less than 
0.8 at the calculation time, it is not a section 871(m) transaction. 
Therefore, there will be no dividend equivalent payments made by FB to 
Customer that are subject to withholding. Pursuant to Sec.  1.1441-
1(b)(4)(xxii), U.S. Broker is not obligated to withhold on the dividend 
equivalents with respect to Stock X paid to FB because U.S. Broker has 
received valid documentation that it may rely upon to treat the dividend 
equivalents as paid to FB acting as a qualified derivatives dealer. The 
net delta exposure is zero at the end of the day on the date provided in 
paragraph (j)(2) of this section for the dividend because FB has a long 
position of 60 shares as a result of the total return swap, which is 
reduced by FB's short position of 60 shares as a result of the option.
    Example 3. In-the-money option contract entered into by a foreign 
equity derivatives dealer. (i) Facts. The facts are the same as Example 
2, but Customer purchases from FB an in-the-money call option on 100 
shares of Stock X with a term of one year. The call option has a delta 
of 0.8 and FB hedges the call option by purchasing 80 shares of Stock X, 
which are held in an account with U.S. Broker, who also acts as paying 
agent. The price of Stock X declines substantially and the option lapses 
unexercised. At the end of the day on the date provided in paragraph 
(j)(2) of this section for the dividend, the call option has a delta of 
0.48 and FB has reduced its hedge to 50 shares of Stock X with U.S. 
Broker. In addition, on that date, FB owns no other shares of Stock X or 
any other transactions that reference Stock X in its equity derivatives 
dealer capacity.
    (ii) Application of rules. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB is a 
long party on 50 shares of Stock X and a short party on an option. 
Because the option has a delta of 0.8 at the calculation time, it is a 
section 871(m) transaction. Therefore, FB is required to withhold on 
dividend equivalent payments to Customer on the option contract in 
accordance with Sec.  1.1441-2(e)(7). U.S. Broker is required to 
withhold on the Stock X dividends paid to FB. Assuming that FB is a 
qualified resident of a country with a treaty that provides withholding 
on dividends at a 15 percent rate, U.S. Broker is required withhold on 
the dividends with respect to the 50 shares of stock held by FB. FB's 
net delta exposure is two shares of Stock X at the end of the day on the 
date provided in paragraph (j)(2) of this section because FB has a long 
position of 50 shares, reduced by FB's short position of 48 shares as a 
result of the option. FB's section 881 tax on the $0.50 (two shares 
multiplied by a dividend of $0.25 per share) is reduced (but not below 
zero) by

[[Page 456]]

the section 881 tax amount paid by the qualified derivatives dealer on 
the 50 shares. Therefore, FB's section 871(m) amount is zero.
    (r) Effective/applicability date--(1) In general. This section 
applies to payments made on or after January 19, 2017 except as provided 
in paragraphs (r)(2) and (3) of this section.
    (2) Effective/applicability date for paragraphs (d)(2) and (e). 
Paragraphs (d)(2) and (e) of this section apply to any payment made on 
or after January 1, 2017, with respect to any transaction with a delta 
of one issued on or after January 1, 2017. Paragraphs (d)(2) and (e) of 
this section apply to any payment made on or after January 1, 2018, with 
respect to any other transaction issued on or after January 1, 2018. 
Notwithstanding the prior sentence, paragraphs (d)(2) and (e) of this 
section will apply to any payments made on or after January 1, 2020, 
with respect to the exchange-traded notes issued on or after January 1, 
2017, that are identified in a separate notice, and not payments made 
before January 1, 2020, with respect to those notes. Notwithstanding the 
first sentence of this paragraph (r)(3), paragraphs (d)(2) and (e) of 
this section do not apply to payments made in 2017 to a qualified 
derivatives dealer in its equity derivatives dealer capacity to hedge 
transactions that have a delta of less than one.
    (3) Effective/applicability date for paragraphs (g)(4)(ii)(B), 
(p)(1)(ii) through (iv), and (p)(5) of this section. Paragraphs 
(c)(2)(iv), (h), and (q) of this section apply to payments made on or 
after January 1, 2017.

[T.D. 9648, 78 FR 73080, Dec. 5, 2013, as amended by T.D. 9734, 80 FR 
56879, Sept. 18, 2015; 80 FR 75946, Dec. 7, 2015; T.D. 9815, 82 FR 8155, 
8160, Jan. 24, 2017; T.D. 9815, 82 FR 49508, Oct. 26, 2017; T.D. 9887, 
84 FR 68793, Dec. 17, 2019]



Sec.  1.872-1  Gross income of nonresident alien individuals.

    (a) In general--(1) Inclusions. The gross income of a nonresident 
alien individual for any taxable year includes only (i) the gross income 
which is derived from sources within the United States and which is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual and (ii) the gross 
income, irrespective of whether such income is derived from sources 
within or without the United States, which is effectively connected for 
the taxable year with the conduct of a trade or business in the United 
States by that individual. For the determination of the sources of 
income, see sections 861 through 863 and the regulations thereunder. For 
the determination of whether income from sources within or without the 
United States is effectively connected for the taxable year with the 
conduct of a trade or business in the United States, see sections 864(c) 
and 871 (c) and (d), Sec. Sec.  1.864-3 through 1.864-7, and Sec. Sec.  
1.871-9 and 1.871-10. For special rules for determining the income of an 
alien individual who changes his residence during the taxable year, see 
Sec.  1.871-13.
    (2) Exchange transactions. Even though a nonresident alien 
individual who effects certain transactions in the United States in 
stocks, securities, or commodities during the taxable year may not, by 
reason of section 864(b)(2) and paragraph (c) or (d) of Sec.  1.864-2, 
be engaged in trade or business in the United States during the taxable 
year through the effecting of such transactions, nevertheless he shall 
be required to include in gross income for the taxable year the gains 
and profits from those transactions to the extent required by Sec.  
1.871-7 or Sec.  1.871-8.
    (3) Exclusions. For exclusions from gross income, see Sec.  1.872-2.
    (b) Individuals not engaged in U.S. business. In the case of a 
nonresident alien individual who at no time during the taxable year is 
engaged in trade or business in the United States, the gross income 
shall include only (1) the gross income from sources within the United 
States which is described in section 871(a) and paragraphs (b), (c), and 
(d) of Sec.  1.871-7, and (2) the gross income from sources within the 
United States which, by reason of section 871 (c) or (d) and Sec.  
1.871-9 or Sec.  1.871-10, is treated as effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by that individual.
    (c) Individuals engaged in U.S. business. In the case of a 
nonresident alien individual who is engaged in trade or business in the 
United States at any time during the taxable year, the gross

[[Page 457]]

income shall include (1) the gross income from sources within and 
without the United States which is effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that individual, (2) the gross income from sources within the United 
States which, by reason of the election provided in section 871(d) and 
Sec.  1.871-10, is treated as effectively connected for the taxable year 
with the conduct of a trade or business in the United States by that 
individual, and (3) the gross income from sources within the United 
States which is described in section 871(a) and paragraphs (b), (c), and 
(d) of Sec.  1.871-7 and is not effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that individual.
    (d) Special rules applicable to certain expatriates. For special 
rules for determining the gross income of a nonresident alien individual 
who has lost U.S. citizenship with a principal purpose of avoiding 
certain taxes, see section 877(b)(1).
    (e) Alien resident of Puerto Rico. This section shall not apply in 
the case of a nonresident alien individual who is a bona fide resident 
of Puerto Rico during the entire taxable year. See section 876 and Sec.  
1.876-1.
    (f) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.872-1 
(Revised as of January 1, 1971).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7332, 39 FR 
44228, Dec. 23, 1974]



Sec.  1.872-2  Exclusions from gross income of nonresident alien individuals.

    (a) Earnings of foreign ships or aircraft--(1) Basic rule. So much 
of the income from sources within the United States of a nonresident 
alien individual as consists of earnings derived from the operation of a 
ship or ships documented, or of aircraft registered, under the laws of a 
foreign country which grants an equivalent exemption to citizens of the 
United States nonresident in that foreign country and to corporations 
organized in the United States shall not be included in gross income.
    (2) Equivalent exemption--(i) Ships. A foreign country which either 
imposes no income tax, or, in imposing an income tax, exempts from 
taxation so much of the income of a citizen of the U.S. nonresident in 
that foreign country and of a corporation organized in the United States 
as consists of earnings derived from the operation of a ship or ships 
documented under the laws of the United States is considered as granting 
an equivalent exemption for purposes of the exclusion from gross income 
of the earnings of a foreign ship or ships.
    (ii) Aircraft. A foreign country which either imposes no income tax, 
or, in imposing an income tax, exempts from taxation so much of the 
income of a citizen of the U.S. nonresident in that foreign country and 
of a corporation organized in the United States as consists of earnings 
derived from the operation of aircraft registered under the laws of the 
United States is considered as granting an equivalent exemption for 
purposes of the exclusion from gross income of the earnings of foreign 
aircraft.
    (3) Definition of earnings. For purposes of subparagraphs (1) and 
(2) of this paragraph, compensation for personal services performed by 
an individual aboard a ship or aircraft does not constitute earnings 
derived by such individual from the operation of ships or aircraft.
    (b) Compensation paid by foreign employer to participants in certain 
exchange or training programs--(1) Exclusion from income. Compensation 
paid to a nonresident alien individual for the period that the 
nonresident alien individual is temporarily present in the United States 
as a nonimmigrant under subparagraph (F) (relating to the admission of 
students into the United States) or subparagraph (J) (relating to the 
admission of teachers, trainees, specialists, etc., into the United 
States) of section 101(a)(15) of the Immigration and Nationality Act (8 
U.S.C. 1101(a)(15) (F) or (J)) shall be excluded from gross income if 
the compensation is paid to such alien by his foreign employer. 
Compensation paid to a nonresident alien individual by the U.S. office 
of a domestic bank which is acting

[[Page 458]]

as paymaster on behalf of a foreign employer constitutes compensation 
paid by a foreign employer for purposes of this paragraph if the 
domestic bank is reimbursed by the foreign employer for such payment. A 
nonresident alien individual who is temporarily present in the United 
States as a nonimmigrant under such subparagraph (J) includes a 
nonresident alien individual admitted to the United States as an 
``exchange visitor'' under section 201 of the U.S. Information and 
Educational Exchange Act of 1948 (22 U.S.C. 1446), which section was 
repealed by section 111 of the Mutual Education and Cultural Exchange 
Act of 1961 (75 Stat. 538).
    (2) Definition of foreign employer. For purposes of this paragraph, 
the term ``foreign employer'' means a nonresident alien individual, a 
foreign partnership, a foreign corporation, or an office or place of 
business maintained in a foreign country or in a possession of the 
United States by a domestic corporation, a domestic partnership, or an 
individual who is a citizen or resident of the United States. The term 
does not include a foreign government. However, see section 893 and 
Sec.  1.893-1. Thus, if a French citizen employed in the Paris branch of 
a banking company incorporated in the State of New York were admitted to 
the United States under section 101(a)(15)(J) of the Immigration and 
Nationality Act to study monetary theory and continued to receive a 
salary from such foreign branch while studying in the United States, 
such salary would not be includable in his gross income.
    (c) Tax convention. Income of any kind which is exempt from tax 
under the provisions of a tax convention or treaty to which the United 
States is a party shall not be included in the gross income of a 
nonresident alien individual. Income on which the tax is limited by tax 
convention shall be included in the gross income of a nonresident alien 
individual if it is not otherwise excluded from gross income. See 
Sec. Sec.  1.871-12 and 1.894-1.
    (d) Certain bond income of residents of the Ryukyu Islands or the 
Trust Territory of the Pacific Islands. Income derived by a nonresident 
alien individual from a series E or series H U.S. savings bond shall not 
be included in gross income if such individual acquired the bond while 
he was a resident of the Ryukyu Islands or the Trust Territory of the 
Pacific Islands. It is not necessary that the individual continue to be 
a resident of such Islands or Trust Territory for the period when, 
without regard to section 872(b)(4) and this paragraph, the income from 
the bond would otherwise be includible in his gross income under the 
provisions of section 446 or 454.
    (e) Certain annuities received under qualified plans. Pursuant to 
section 871(f), income received by a nonresident alien individual as an 
annuity under a qualified annuity plan described in section 403(a)(1) 
(relating to taxation of employee annuities), or from a qualified trust 
described in section 401(a) (relating to qualified pension, profit-
sharing, and stock bonus plans) which is exempt from tax under section 
501(a) (relating to exemption from tax on corporations, certain trusts, 
etc.), shall not be included in gross income, and shall be exempt from 
tax, for purposes of section 871 and Sec. Sec.  1.871-7 and 1.871-8, 
if--
    (1) All of the personal services by reason of which the annuity is 
payable were either--
    (i) Personal services performed outside the United States by an 
individual (whether or not the annuitant) who, at the time of 
performance of the services, was a nonresident alien individual, or
    (ii) Personal services performed in the United States by a 
nonresident alien individual (whether or not the annuitant) which, by 
reason of section 864(b)(1) (or corresponding provision of any prior 
law), were not personal services causing such individual to be engaged 
in trade or business in the United States during the taxable year, and
    (2) At the time the first amount is paid (even though paid in a 
taxable year beginning before January 1, 1967) as such annuity under 
such annuity plan, or by such trust, to (i) the individual described in 
subparagraph (1) of this paragraph, or (ii) his nonresident alien 
beneficiary if such beneficiary is entitled to receive such first 
amount, 90 percent or more of the employees or annuitants for whom 
contributions or

[[Page 459]]

benefits are provided under the annuity plan, or under the plan or plans 
of which the trust is a part, are citizens or residents of the United 
States.


This paragraph shall apply whether or not the taxpayer is engaged in 
trade or business in the United States at any time during the taxable 
year in which the annuity is received. This paragraph shall not apply to 
distributions by an employees' trust or from an annuity plan which give 
rise to gains described in section 402(a)(2) or 403(a)(2), whichever 
applies. See section 871(a)(1)(B) and paragraph (c)(1)(i) of Sec.  
1.871-7. For exemption from withholding of tax at source on an annuity 
which is exempt from tax under section 871(f) and this paragraph, see 
paragraph (g) of Sec.  1.1441-4.
    (f) Other exclusions. Income which is from sources without the 
United States, as determined under the provisions of sections 861 
through 863, and the regulations thereunder, is not included in the 
gross income of a nonresident alien individual unless such income is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual. To determine 
specific exclusions in the case of other items which are from sources 
within the United States, see the applicable sections of the Code. For 
special rules under a tax convention for determining the sources of 
income and for excluding, from gross income, income from sources without 
the United States which is effectively connected with the conduct of a 
trade or business in the United States, see the applicable tax 
convention. For determining which income from sources without the United 
States is effectively connected with the conduct of a trade or business 
in the United States, see section 864(c)(4) and Sec.  1.864-5.
    (g) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 4, 1967 see 26 CFR 1.872-2 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44228, Dec. 23, 1974]



Sec.  1.873-1  Deductions allowed nonresident alien individuals.

    (a) General provisions--(1) Allocation of deductions. In computing 
the taxable income of a nonresident alien individual the deductions 
otherwise allowable shall be allowed only if, and to the extent that, 
they are connected with income from sources within the United States. No 
deduction shall be allowed in respect of any item, or portion thereof, 
which is not connected with income from such sources. For this purpose, 
the proper apportionment and allocation of the deductions with respect 
to sources of income within and without the United States shall be 
determined as provided in part I (section 861 and following), subchapter 
N, chapter 1 of the Code, and the regulations thereunder, except as may 
otherwise be provided by tax convention. Thus, from the items of gross 
income specifically from sources within the United States and from the 
items allocated thereto under the provisions of section 863(a), there 
shall be deducted (i) the expenses, losses, and other deductions which 
are connected with those items of income and are properly apportioned or 
allocated thereto, and (ii) a ratable part of any other expenses, 
losses, or deductions which are connected with those items of income but 
cannot definitely be allocated to some item or class of gross income. 
The ratable part shall be based upon the ratio of gross income from 
sources within the United States to the total gross income. See 
Sec. Sec.  1.861-8 and 1.863-1. In the case of income partly from within 
and partly from without the United States the expenses, losses, and 
other deductions connected with income from sources within the United 
States shall also be deducted in the manner prescribed by Sec. Sec.  
1.863-2 through 1.863-5 in order to ascertain under section 863 the 
portion of the taxable income attributable to sources within the United 
States.
    (2) Personal exemptions. The deductions for the personal exemptions 
allowed by section 151 or 642(b) shall not be taken into account for 
purposes of subparagraph (1) of this paragraph but shall be allowed to 
the extent provided by paragraphs (b) and (c) of this section.

[[Page 460]]

    (3) Adjusted gross income. The adjusted gross income of a 
nonresident alien individual shall be the gross income from sources 
within the United States, determined in accordance with Sec.  1.871-7, 
minus the deductions prescribed by section 62 to the extent such 
deductions are allowed under this section in computing taxable income.
    (4) Standard deduction. The standard deduction shall not be allowed 
in computing the taxable income of a nonresident alien individual. See 
section 142(b)(1) and the regulations thereunder.
    (5) Exempt income. No deduction shall be allowed under this section 
for the amount of any item or part thereof allocable to a class or 
classes of exempt income, including income exempt by tax convention. See 
section 265 and the regulations thereunder.
    (b) No United States business--(1) Income of not more than $15,400--
(i) Deduction for losses only. A nonresident alien individual within 
class 1 shall not be allowed any deductions other than the deduction for 
losses from sales or exchanges of capital assets determined in the 
manner prescribed by paragraph (b)(4)(vii) of Sec.  1.871-7. Thus, an 
individual within this class shall not be allowed any deductions for the 
personal exemptions otherwise allowed by section 151 or 642(b).
    (ii) Source of losses. Notwithstanding the provisions of section 
873(b)(1), losses from sales or exchanges of capital assets shall be 
allowed under this subparagraph only if allocable to sources within the 
United States. See paragraph (b)(4)(i) of Sec.  1.871-7.
    (2) Aggregate more than $15,400--(i) Deductions allowed. In 
computing the income subject to tax under section 1 or section 1201(b), 
a nonresident alien individual within class 2 shall be allowed 
deductions to the extent prescribed by paragraph (c)(3) of Sec.  1.871-
7, but subject to the limitations of this section. For this purpose, the 
deduction for the personal exemptions shall be allowed in accordance 
with subdivision (iii) of this subparagraph.
    (ii) Deductions disallowed. In computing the minimum tax prescribed 
by section 871(b)(3), that individual shall not be allowed any 
deductions other than the deduction for losses from sales or exchanges 
of capital assets determined in the manner prescribed by paragraph 
(b)(4)(vii) of Sec.  1.871-7. For this purpose, the deductions for the 
personal exemptions shall not be allowed. See paragraph (c)(4) of Sec.  
1.871-7.
    (iii) Personal exemptions. When the deductions for personal 
exemptions are allowed under this subparagraph, only one exemption under 
section 151 shall be allowed in the case of an individual who is not a 
resident of Canada or Mexico. A resident of either of those countries 
shall be allowed all the exemptions granted by section 151 to the extent 
prescribed therein. An estate or trust, whether or not a resident of 
Canada or Mexico, shall determine its deduction for the personal 
exemption in accordance with section 642(b) and the regulations 
thereunder.
    (iv) Source of losses. Notwithstanding the provisions of section 
873(b), losses from sales or exchanges of capital assets shall be 
allowed under this subparagraph only if allocable to sources within the 
United States. See paragraph (c)(3)(i) of Sec.  1.871-7.
    (3) Election to be taxed on a net basis. Notwithstanding the other 
provisions of this paragraph, a nonresident alien individual within 
class 1 or 2 shall be allowed the deductions allowed by paragraph (c) of 
this section, if pursuant to a tax convention he is entitled, and does 
elect, to be subject to United States tax on a net basis as though he 
were engaged in trade or business within the United States through a 
permanent establishment situated therein.
    (c) United States business--(1) Deductions in general. For purposes 
of computing the income subject to tax, a nonresident alien individual 
within class 3 shall be allowed deductions to the extent prescribed by 
paragraph (d) of Sec.  1.871-7, but subject to the limitations of this 
section. For this purpose, the deductions for the personal exemptions 
shall be allowed in accordance with subparagraph (3) of this paragraph.
    (2) Special deductions. Notwithstanding the rule of source 
prescribed in paragraph (a) of this section, an individual within class 
3 shall be allowed the following deductions whether or not they are 
connected with income from sources within the United States:

[[Page 461]]

    (i) Losses on transactions for profit. Any loss sustained during the 
taxable year and not compensated for by insurance or otherwise, if 
incurred in any transaction entered into for profit, though not 
connected with a trade or business, shall be allowed to the extent 
allowed by section 165(c)(2), but only if and to the extent that the 
profit, if the transaction had resulted in a profit, would be taxable to 
such individual. Losses allowed under this subdivision shall be deducted 
in full, as provided in Sec. Sec.  1.861-8 and 1.863-1, when the profit 
from the transaction, if it had resulted in a profit, would, under the 
provisions of section 861(a) or 863(a), have been taxable in full as 
income from sources within the United States; but shall be deducted 
under the provisions of Sec.  1.863-3 when the profit from the 
transaction, if it had resulted in profit, would have been taxable only 
in part.
    (ii) Casualty losses. Any loss of property not connected with a 
trade or business, sustained during the taxable year and not compensated 
for by insurance or otherwise, if the loss arises from fire, storm, 
shipwreck, or other casualty, or from theft, shall be allowed to the 
extent allowed by section 165(c)(3), but only if the loss is of property 
within the United States. Losses allowed under this subdivision shall be 
deducted in full, as provided in Sec. Sec.  1.861-8 and 1.863-1, from 
the items of gross income specified under sections 861(a) and 863(a) as 
being derived in full from sources within the United States; but, if 
greater than the sum of those items, the unabsorbed loss shall be 
deducted from the income apportioned under the provisions of Sec.  
1.863-3 to sources within the United States.
    (iii) Charitable contributions. The deduction for charitable 
contributions and gifts, to the extent allowed by section 170, shall be 
allowed under this subparagraph, but only as to contributions or gifts 
made to domestic corporations, or to community chests, funds, or 
foundations, created in the United States.
    (3) Personal exemptions. Only one exemption under section 151 shall 
be allowed in the case of an individual who is not a resident of Canada 
or Mexico. A resident of either of those countries shall be allowed all 
the exemptions granted by section 151 to the extent prescribed therein. 
An estate or trust, whether or not a resident of Canada or Mexico, shall 
determine its deduction for the personal exemption in accordance with 
section 642(b) and the regulations thereunder.



Sec.  1.874-1  Allowance of deductions and credits to nonresident 
alien individuals.

    (a) Return required. A nonresident alien individual shall receive 
the benefit of the deductions and credits otherwise allowable with 
respect to the income tax, only if the nonresident alien individual 
timely files or causes to be filed with the Philadelphia Service Center, 
in the manner prescribed in subtitle F, a true and accurate return of 
the income which is effectively connected, or treated as effectively 
connected, with the conduct of a trade or business within the United 
States by the nonresident alien individual. No provision of this section 
(other than paragraph (c)(2)) shall be construed, however, to deny the 
credits provided by sections 31, 32, 33, 34 and 852(b)(3)(D)(ii). In 
addition, notwithstanding the requirement that a nonresident alien must 
file a timely return in order to receive the benefit of the deductions 
and credits otherwise allowable with respect to the income tax, the 
nonresident alien individual may, for purposes of determining the amount 
of tax to be withheld under section 1441 from remuneration paid for 
labor or personal services performed within the United States, receive 
the benefit of the deduction for personal exemptions provided in section 
151, to the extent allowable under section 873(b)(3) and paragraph 
(c)(3) of Sec.  1.873-1, or in any applicable tax convention, by filing 
a claim therefore with the withholding agent. The amount of the 
deduction for the personal exemptions and the amount of the tax to be 
withheld under those circumstances shall be determined in accordance 
with paragraph (e)(2) of Sec.  1.1441-3. The deductions and credits 
allowed such a nonresident alien individual electing under a tax 
convention to be subject to tax on a net basis may be obtained by filing 
a return of income in the manner prescribed in the regulations (if any)

[[Page 462]]

under the tax convention or under any other guidance issued by the 
Commissioner.
    (b) Filing deadline for return--(1) General rule. As provided in 
paragraph (a) of this section, for purposes of computing the nonresident 
alien individual's taxable income for any taxable year, otherwise 
allowable deductions and credits will be allowed only if a true and 
accurate return for that taxable year is filed by the nonresident alien 
individual on a timely basis. For taxable years of a nonresident alien 
individual ending after July 31, 1990, whether a return for the current 
taxable year has been filed on a timely basis is dependent upon whether 
the nonresident alien individual filed a return for the taxable year 
immediately preceding the current taxable year. If a return was filed 
for that immediately preceding taxable year, or if the current taxable 
year is the first taxable year of the nonresident alien individual for 
which a return is required to be filed, the required return for the 
current taxable year must be filed within 16 months of the due date, as 
set forth in section 6072 and the regulations under that section, for 
filing the return for the current taxable year. If no return for the 
taxable year immediately preceding the current taxable year has been 
filed, the required return for the current taxable year (other than the 
first taxable year of the nonresident alien individual for which a 
return is required to be filed) must have been filed no later than the 
earlier of the date which is 16 months after the due date, as set forth 
in section 6072, for filing the return for the current taxable year or 
the date the Internal Revenue Service mails a notice to the nonresident 
alien individual advising the nonresident alien individual that the 
current year tax return has not been filed and that no deductions or 
credits (other than those provided in sections 31, 32, 33, 34 and 
852(b)(3)(D)(ii)) may be claimed by the nonresident alien individual.
    (2) Waiver. The filing deadlines set forth in paragraph (b)(1) of 
this section may be waived if the nonresident alien individual 
establishes to the satisfaction of the Commissioner or his or her 
delegate that the individual, based on the facts and circumstances, 
acted reasonably and in good faith in failing to file a U.S. income tax 
return (including a protective return (as described in paragraph (b)(6) 
of this section)). For this purpose, a nonresident alien individual 
shall not be considered to have acted reasonably and in good faith if 
the individual knew that he or she was required to file the return and 
chose not to do so. In addition, a nonresident alien individual shall 
not be granted a waiver unless the individual cooperates in determining 
his or her U.S. income tax liability for the taxable year for which the 
return was not filed. The Commissioner or his or her delegate shall 
consider the following factors in determining whether the nonresident 
alien individual, based on the facts and circumstances, acted reasonably 
and in good faith in failing to file a U.S. income tax return--
    (i) Whether the individual voluntarily identifies himself or herself 
to the Internal Revenue Service as having failed to file a U.S. income 
tax return before the Internal Revenue Service discovers the failure to 
file;
    (ii) Whether the individual did not become aware of his or her 
ability to file a protective return (as described in paragraph (b)(6) of 
this section) by the deadline for filing the protective return;
    (iii) Whether the individual had not previously filed a U.S. income 
tax return;
    (iv) Whether the individual failed to file a U.S. income tax return 
because, after exercising reasonable diligence (taking into account his 
or her relevant experience and level of sophistication), the individual 
was unaware of the necessity for filing the return;
    (v) Whether the individual failed to file a U.S. income tax return 
because of intervening events beyond the individual's control; and
    (vi) Whether other mitigating or exacerbating factors existed.
    (3) Examples. The following examples illustrate the provisions of 
paragraph (b). In all examples, A is a nonresident alien individual and 
uses the calendar year as A's taxable year. The examples are as follows:

    Example 1. Nonresident alien individual discloses own failure to 
file. In Year 1, A became

[[Page 463]]

a limited partner with a passive investment in a U.S. limited 
partnership that was engaged in a U.S. trade or business. During Year 1 
through Year 4, A incurred losses with respect to A's U.S. partnership 
interest. A's foreign tax advisor incorrectly concluded that because A 
was a limited partner and had only losses from A's partnership interest, 
A was not required to file a U.S. income tax return. A was aware neither 
of A's obligation to file a U.S. income tax return for those years nor 
of A's ability to file a protective return for those years. A had never 
filed a U.S. income tax return before. In Year 5, A began realizing a 
profit rather than a loss with respect to the partnership interest and, 
for this reason, engaged a U.S. tax advisor to handle A's responsibility 
to file U.S. income tax returns. In preparing A's U.S. income tax return 
for Year 5, A's U.S. tax advisor discovered that returns were not filed 
for Year 1 through Year 4. Therefore, with respect to those years for 
which applicable filing deadlines in paragraph (b)(1) of this section 
were not met, A would be barred by paragraph (a) of this section from 
claiming any deductions that otherwise would have given rise to net 
operating losses on returns for these years, and that would have been 
available as loss carryforwards in subsequent years. At A's direction, 
A's U.S. tax advisor promptly contacted the appropriate examining 
personnel and cooperated with the Internal Revenue Service in 
determining A's income tax liability, for example, by preparing and 
filing the appropriate income tax returns for Year 1 through Year 4 and 
by making A's books and records available to an Internal Revenue Service 
examiner. A has met the standard described in paragraph (b)(2) of this 
section for waiver of any applicable filing deadlines in paragraph 
(b)(1) of this section.
    Example 2. Nonresident alien individual refuses to cooperate. Same 
facts as in Example 1, except that while A's U.S. tax advisor contacted 
the appropriate examining personnel and filed the appropriate income tax 
returns for Year 1 through Year 4, A refused all requests by the 
Internal Revenue Service to provide supporting information (for example, 
books and records) with respect to those returns. Because A did not 
cooperate in determining A's U.S. tax liability for the taxable years 
for which an income tax return was not timely filed, A is not granted a 
waiver as described in paragraph (b)(2) of this section of any 
applicable filing deadlines in paragraph (b)(1) of this section.
    Example 3. Nonresident alien individual fails to file a protective 
return. Same facts as in Example 1, except that in Year 1 through Year 
4, A also consulted a U.S. tax advisor, who advised A that it was 
uncertain whether U.S. income tax returns were necessary for those years 
and that A could protect A's right subsequently to claim the loss 
carryforwards by filing protective returns under paragraph (b)(6) of 
this section. A did not file U.S. income tax returns or protective 
returns for those years. A did not present evidence that intervening 
events beyond A's control prevented A from filing an income tax return, 
and there were no other mitigating factors. A has not met the standard 
described in paragraph (b)(2) of this section for waiver of any 
applicable filing deadlines in paragraph (b)(1) of this section.
    Example 4. Nonresident alien with effectively connected income. In 
Year 1, A, a computer programmer, opened an office in the United States 
to market and sell a software program that A had developed outside the 
United States. A had minimal business or tax experience internationally, 
and no such experience in the United States. Through A's personal 
efforts, U.S. sales of the software produced income effectively 
connected with a U.S. trade or business. A, however, did not file U.S. 
income tax returns for Year 1 or Year 2. A was aware neither of A's 
obligation to file a U.S. income tax return for those years, nor of A's 
ability to file a protective return for those years. A had never filed a 
U.S. income tax return before. In November of Year 3, A engaged U.S. 
counsel in connection with licensing software to an unrelated U.S. 
company. U.S. counsel reviewed A's U.S. activities and advised A that A 
should have filed U.S. income tax returns for Year 1 and Year 2. A 
immediately engaged a U.S. tax advisor who, at A's direction, promptly 
contacted the appropriate examining personnel and cooperated with the 
Internal Revenue Service in determining A's income tax liability, for 
example, by preparing and filing the appropriate income tax returns for 
Year 1 and Year 2 and by making A's books and records available to an 
Internal Revenue Service examiner. A has met the standard described in 
paragraph (b)(2) of this section for waiver of any applicable filing 
deadlines in paragraph (b)(1) of this section.
    Example 5. IRS discovers nonresident alien's failure to file. In 
Year 1, A, a computer programmer, opened an office in the United States 
to market and sell a software program that A had developed outside the 
United States. Through A's personal efforts, U.S. sales of the software 
produced income effectively connected with a U.S. trade or business. A 
had extensive experience conducting similar business activities in other 
countries, including making the appropriate tax filings. A, however, was 
aware neither of A's obligation to file a U.S. income tax return for 
those years, nor of A's ability to file a protective return for those 
years. A had never filed a U.S. income tax return before. Despite A's 
extensive experience conducting similar business activities in other 
countries, A made no effort to seek advice in connection with A's U.S. 
tax obligations. A failed to file either U.S. income tax returns or 
protective returns for Year 1 and Year 2.

[[Page 464]]

In November of Year 3, an Internal Revenue Service examiner asked A for 
an explanation of A's failure to file U.S. income tax returns. A 
immediately engaged a U.S. tax advisor, and cooperated with the Internal 
Revenue Service in determining A's income tax liability, for example, by 
preparing and filing the appropriate income tax returns for Year 1 and 
Year 2 and by making A's books and records available to the examiner. A 
did not present evidence that intervening events beyond A's control 
prevented A from filing a return, and there were no other mitigating 
factors. A has not met the standard described in paragraph (b)(2) of 
this section for waiver of any applicable filing deadlines in paragraph 
(b)(1) of this section.
    Example 6. Nonresident alien with prior filing history. A began a 
U.S. trade or business in Year 1 as a sole proprietorship. A's tax 
advisor filed the appropriate U.S. income tax returns for Year 1 through 
Year 6, reporting income effectively connected with A's U.S. trade or 
business. In Year 7, A replaced this tax advisor with a tax advisor 
unfamiliar with U.S. tax law. A did not file a U.S. income tax return 
for any year from Year 7 through Year 10, although A had effectively 
connected income for those years. A was aware of A's ability to file a 
protective return for those years. In Year 11, an Internal Revenue 
Service examiner contacted A and asked for an explanation of A's failure 
to file income tax returns after Year 6. A immediately engaged a U.S. 
tax advisor and cooperated with the Internal Revenue Service in 
determining A's income tax liability, for example, by preparing and 
filing the appropriate income tax returns for Year 7 through Year 10 and 
by making A's books and records available to the examiner. A did not 
present evidence that intervening events beyond A's control prevented A 
from filing a return, and there were no other mitigating factors. A has 
not met the standard described in paragraph (b)(2) of this section for 
waiver of any applicable filing deadlines in paragraph (b)(1) of this 
section.

    (4) Effective date. Paragraphs (b)(2) and (3) of this section are 
applicable to open years for which a request for a waiver is filed on or 
after January 29, 2002.
    (5) Income tax treaties. A nonresident alien individual who has a 
permanent establishment or fixed base, as defined in an income tax 
treaty between the United States and the country of residence of the 
nonresident alien individual, in the United States is subject to the 
filing deadlines as set forth in paragraph (b)(1) of this section.
    (6) Protective return. If a nonresident alien individual conducts 
limited activities in the United States in a taxable year which the 
nonresident alien individual determines does not give rise to gross 
income which is effectively connected with the conduct of a trade or 
business within the United States as defined in sections 871(b) and 864 
(b) and (c) and the regulations under those sections, the nonresident 
alien individual may nonetheless file a return for that taxable year on 
a timely basis under paragraph (b)(1) of this section and thereby 
protect the right to receive the benefit of the deductions and credits 
attributable to that gross income if it is later determined, after the 
return was filed, that the original determination was incorrect. On that 
timely filed return, the nonresident alien individual is not required to 
report any gross income as effectively connected with a United States 
trade or business or any deductions or credits but should attach a 
statement indicating that the return is being filed for the reason set 
forth in this paragraph (b)(4). If the nonresident alien individual 
determines that part of the activities which he or she conducts in the 
United States in a taxable year gives rise to gross income which is 
effectively connected with the conduct of a trade or business and part 
does not, the nonresident alien individual must timely file a return for 
that taxable year to report the gross income determined to be 
effectively connected, or treated as effectively connected, with the 
conduct of that trade or business within the United States and the 
deductions and credits attributable to the gross income. In addition, 
the nonresident alien individual should attach to that return the 
statement described in this paragraph (b)(4) with regard to the other 
activities. The nonresident alien individual may follow the same 
procedure if the nonresident alien individual determines initially that 
he or she has no United States tax liability under the provisions of an 
applicable income tax treaty. In the event the nonresident alien 
individual relies on the provisions of an income tax treaty to reduce or 
eliminate the income subject to taxation, or to reduce the rate of tax 
to which that income is subject, disclosure may be required pursuant to 
section 6114.

[[Page 465]]

    (c) Allowed deductions and credits--(1) In general. Except for 
losses of property located within the United States, charitable 
contributions and personal exemptions (see section 873(b)), deductions 
are allowed to a nonresident alien individual only to the extent they 
are connected with gross income which is effectively connected, or 
treated as effectively connected, with the conduct of the nonresident 
alien individual's trade or business in the United States. Other than 
credits allowed by sections 31, 32, 33, 34, and 852(b)(3)(D)(ii), the 
nonresident alien individual is entitled to credits only if they are 
attributable to effectively connected income. See paragraph (a) of this 
section for the requirement that a return be timely filed. Except as 
provided by section 906, a nonresident alien individual shall not be 
allowed the credit against the tax for taxes of foreign countries and 
possessions of the United States allowed by section 901.
    (2) Verification. At the request of the Internal Revenue Service, a 
nonresident alien individual claiming deductions from gross income which 
is effectively connected or treated as effectively connected, with the 
conduct of a trade or business in the United States and credits 
attributable to that income must furnish at the place designated 
pursuant to Sec.  301.7605-1(a) information sufficient to establish that 
the nonresident alien individual is entitled to the deductions and 
credits in the amounts claimed. All information must be furnished in a 
form suitable to permit verification of the claimed deductions and 
credits. The Internal Revenue Service may require, as appropriate, that 
an English translation be provided with any information in a foreign 
language. If a nonresident alien individual fails to furnish sufficient 
information, the Internal Revenue Service may in its discretion disallow 
any claimed deductions and credits in full or in part.
    (d) Return by Internal Revenue Service. If a nonresident alien 
individual has various sources of income within the United States, so 
that from any one source, or from all sources combined, the amount of 
income shall call for the assessment of a tax greater than that withheld 
at the source in the case of that individual, and a return of income has 
not been filed in the manner prescribed by subtitle F, including the 
filing deadlines set forth in paragraph (b)(1) of this section, the 
Internal Revenue Service shall:
    (1) Cause a return of income to be made,
    (2) Include on the return the income described in Sec.  1.871-7 or 
Sec.  1.871-8 of that individual from all sources concerning which it 
has information, and
    (3) Assess the tax. If the nonresident alien individual is not 
engaged in, or does not receive income that is treated as being 
effectively connected with, a United States trade or business and Sec.  
1.871-7 is applicable, the tax shall be assessed on the basis of gross 
income without allowance for deductions or credits (other than the 
credits provided by sections 31, 32, 33, 34 and 852(b)(3)(D)(ii)) and 
collected from one or more sources of income within the United States. 
If the nonresident alien individual is engaged in a United States trade 
or business or is treated as having effectively connected income and 
Sec.  1.871-8 applies, the tax on the income of the nonresident alien 
individual that is not effectively connected, or treated as effectively 
connected with the conduct of a United States trade or business shall be 
assessed on the basis of gross income, determined in accordance with the 
rules of Sec.  1.871-7, without allowance for deductions or credits 
(other than the credits provided by sections 31, 32, 33, 34 and 
852(b)(3)(D)(ii)) and collected from one or more of the sources of 
income within the United States. Tax on income that is effectively 
connected, or treated as effectively connected, with the conduct of a 
United States trade or business shall be assessed in accordance with 
either section 1, 55 or 402(e)(1) without allowance for deductions or 
credits (other than the credits provided by sections 31, 32, 33, 34 and 
852(b)(3)(D)(ii)) and collected from one or more of the sources of 
income within the United States.
    (e) Alien resident of Puerto Rico, Guam, American Samoa, or the 
Commonwealth of the Northern Mariana Islands. This section shall not 
apply to a nonresident alien individual who is a bona fide resident of 
Puerto Rico, Guam, American

[[Page 466]]

Samoa, or the Commonwealth of the Northern Mariana Islands during the 
entire taxable year. See section 876 and Sec.  1.876-1.

[T.D. 8322, 55 FR 50828, Dec. 11, 1990; 56 FR 1361, Jan. 14, 1991, as 
amended by T.D. 8981, 67 FR 4174, Jan. 29, 2002; T.D. 9043, 68 FR 11313, 
Mar. 10, 2003]



Sec.  1.875-1  Partnerships.

    Whether a nonresident alien individual who is a member of a 
partnership is taxable in accordance with subsection (a), (b), or (c) of 
section 871 may depend on the status of the partnership. A nonresident 
alien individual who is a member of a partnership which is not engaged 
in trade or business within the United States is subject to the 
provisions of section 871 (a) or (b), as the case may be, depending on 
whether or not he receives during the taxable year an aggregate of more 
than $15,400 gross income described in section 871(a), if he is not 
otherwise engaged in trade or business within the United States. A 
nonresident alien individual who is a member of a partnership which at 
any time within the taxable year is engaged in trade or business within 
the United States is considered as being engaged in trade or business 
within the United States and is therefore taxable under section 871(c). 
For definition of what the term ``partnership'' includes, see section 
7701(a)(2) and the regulations in part 301 of this chapter (Regulations 
on Procedure and Administration). The test of whether a partnership is 
engaged in trade or business within the United States is the same as in 
the case of a nonresident alien individual. See Sec.  1.871-8.



Sec.  1.875-2  Beneficiaries of estates or trusts.

    (a) [Reserved]
    (b) Exception for certain taxable years. Notwithstanding paragraph 
(a) of this section, for any taxable year beginning before January 1, 
1975, the grantor of a trust, whether revocable or irrevocable, is not 
deemed to be engaged in trade or business within the United States 
merely because the trustee is engaged in trade or business within the 
United States.
    (c) [Reserved]

[T.D. 7332, 39 FR 44233, Dec. 23, 1974]



Sec.  1.876-1  Alien residents of Puerto Rico, Guam, American Samoa, 
or the Northern Mariana Islands.

    (a) Scope. Section 876 and this section apply to any nonresident 
alien individual who is a bona fide resident of Puerto Rico or of a 
section 931 possession during the entire taxable year.
    (b) In general. An individual to whom this section applies is, in 
accordance with the provisions of section 876, subject to tax under 
sections 1 and 55 in generally the same manner as an alien resident of 
the United States. See Sec. Sec.  1.1-1(b) and 1.871-1. The tax 
generally is imposed upon the taxable income of such individual, 
determined in accordance with section 63(a) and the regulations under 
that section, from sources both within and without the United States, 
except for amounts excluded from gross income under the provisions of 
section 931 or 933. For determining the form of return to be used by 
such an individual, see section 6012 and the regulations under that 
section.
    (c) Exceptions. Though subject to the tax imposed by section 1, an 
individual to whom this section applies will nevertheless be treated as 
a nonresident alien individual for the purpose of many provisions of the 
Internal Revenue Code (Code) relating to nonresident alien individuals. 
Thus, for example, such an individual is not allowed the standard 
deduction (section 63(c)(6)); is subject to withholding of tax at source 
under chapter 3 of the Code (for example, section 1441(e)); is generally 
excepted from the collection of income tax at source on wages for 
services performed in the possession (section 3401(a)(6)); is not 
allowed to make a joint return (section 6013(a)(1)); and, if described 
in section 6072(c), must pay his first installment of estimated income 
tax on or before the 15th day of the 6th month of the taxable year 
(section 6654(j) and (k)) and must pay his income tax on or before the 
15th day of the 6th month following the close of the taxable year 
(sections 6072(c) and 6151(a)). In addition, under section 152(b)(3), an 
individual is not allowed a deduction for a dependent

[[Page 467]]

who is a resident of the relevant possession unless the dependent is a 
citizen or national of the United States.
    (d) Credits against tax. (1) Certain credits under the Internal 
Revenue Code are available to any taxpayer subject to the tax imposed by 
section 1, including individuals to whom this section applies. For 
example, except as otherwise provided under section 931 or 933, the 
credits provided by the following sections are allowable to the extent 
provided under such sections against the tax determined in accordance 
with this section--
    (i) Section 23 (relating to the credit for adoption expenses);
    (ii) Section 31 (relating to the credit for tax withheld on wages);
    (iii) Section 33 (relating to the credit for tax withheld at source 
on nonresident aliens); and
    (iv) Section 34 (relating to the credit for certain uses of gasoline 
and special fuels).
    (2) Certain credits under the Internal Revenue Code are not 
available to nonresident aliens or are subject to limitations based on 
such factors as principal place of abode in the United States. For 
example, the credits provided by the following sections are not 
allowable against the tax determined in accordance with this section 
except to the extent otherwise provided under such sections--
    (i) Section 22 (relating to the credit for the elderly and 
disabled);
    (ii) Section 25A (relating to the Hope Scholarship and Lifetime 
Learning Credits); and
    (iii) Section 32 (relating to the earned income credit).
    (e) Definitions. For purposes of this section--
    (1) ``Bona fide resident'' is defined in Sec.  1.937-1; and
    (2) ``Section 931 possession'' is defined in Sec.  1.931-1(c)(1).
    (f) Effective/applicability date. This section applies to taxable 
years ending after April 9, 2008.

[T.D. 9391, 73 FR 19358, Apr. 9, 2008]



Sec.  1.879-1  Treatment of community income.

    (a) Treatment of community income--(1) In general. For taxable years 
beginning after December 31, 1976, community income of a citizen or 
resident of the United States who is married to a nonresident alien 
individual, and the deductions properly allocable to that income, shall 
be divided between the U.S. citizen or resident spouse in accordance 
with the rules in section 879 and paragraph (a)(2) through (a)(6) of 
this section. This section does not apply for any taxable year with 
respect to which an election under section 6013 (g) or (h) is in effect. 
Community income for this purpose includes all gross income, whether 
derived from sources within or without the United States, which is 
treated as community income of the spouses under the community property 
laws of the State, foreign country, or possession of the United States 
in which the recipient of the income is domiciled. Income from real 
property also may be community income if so treated under the laws of 
the jurisdiction in which the real property is located.
    (2) Earned income. Wages, salaries, or professional fees, and other 
amounts received as compensation for personal services actually 
performed, which are community income for the taxable year, shall be 
treated as the income of the spouse who actually performed the personal 
services. This paragraph (a)(2) does not apply, however, to the 
following items of community income:
    (i) Community income derived from any trade or business carried on 
by the husband or the wife.
    (ii) Community income attributable to a spouse's distributive share 
of the income of a partnership to which paragraph (a)(4) of this section 
applies.
    (iii) Community income consisting of compensation for personal 
services rendered to a corporation which represents a distribution of 
the earnings and profits of the corporation rather than a reasonable 
allowance as compensation for the personal services actually performed, 
but not including any income that would be treated as earned income 
under the second sentence of section 911(b).
    (iv) Community income derived from property which is acquired as 
consideration for personal services performed.


These items of community income are divided in accordance with the rules 
in

[[Page 468]]

paragraph (a)(3) through (a)(6) of this section.
    (3) Trade or business income. If any income derived from a trade or 
business carried on by the husband or wife is community income for the 
taxable year, all of the gross income, and the deductions attributable 
to that income, shall be treated as the gross income and deductions of 
the husband. However, if the wife exercises substantially all of the 
management and control of the trade or business, all of the gross income 
and deductions shall be treated as the gross income and deductions of 
the wife. This paragraph (a)(3) does not apply to any income derived 
from a trade or business carried on by a partnership of which both or 
one of the spouses is a member (see paragraph (a)(4) of this section). 
For purposes of this paragraph (a)(3), income derived from a trade or 
business includes any income derived from a trade or business in which 
both personal services and capital are material income producing 
factors. The term ``management and control'' means management and 
control in fact, not the management and control imputed to the husband 
under the community property laws of a State, foreign country or 
possession of the United States. For example, a wife who operates a 
pharmacy without any appreciable collaboration on the part of a husband 
is considered as having substantially all of the management and control 
of the business despite the provisions of any community property laws of 
a State, foreign country, or possession of the United States, vesting in 
the husband the right of management and control of community property. 
The income and deductions attributable to the operation of the pharmacy 
are considered the income and deductions of the wife.
    (4) Partnership income. If any portion of a spouse's distributive 
share of the income of a partnership, of which the spouse is a member, 
is community income for the taxable year, all of that distributive share 
shall be treated as the income of that spouse and shall not be taken 
into account in determining the income of the other spouse. If both 
spouses are members of the same partnership, the distributive share of 
the income of each spouse which is community income shall be treated as 
the income of that spouse. A spouse's distributive share of the income 
of a partnership that is community income shall be determined as 
provided in section 704 and the regulations thereunder.
    (5) Income from separate property. Any community income for the 
taxable year, other than income described in section 879(a) (1) or (2) 
and paragraph (a)(2), (3), or (4) of this section, which is derived from 
the separate property of one of the spouses shall be treated as the 
income of that spouse. The determination of what property is separate 
property for this purpose shall be made in accordance with the laws of 
the State, foreign country, or possession of the United States in which, 
in accordance with paragraph (a)(1) of this section, the recipient of 
the income is domiciled or, in the case of income from real property, in 
which the real property is located.
    (6) Other community income. Any community income for the taxable 
year, other than income described in section 879(a) (1), (2), or (3), 
and paragraph (a)(2), (3), (4), or (5) of this section, shall be treated 
as income of that spouse who has a proprietary vested interest in that 
income under the laws of the state, foreign country, or possession of 
the United States in which, in accordance with paragraph (a)(1) of this 
section, the recipient of the income is domiciled or, in the case of 
income from real property, in which the real property is located. Thus, 
for example, this paragraph (a)(6) applies to community income not 
described in paragraph (a)(2), (3), (4), or (5) of this section which 
consists of dividends, interest, rents, royalties, or gains, from 
community property or of the earnings of unemancipated minor children.
    (7) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. H, a U.S. citizen, and W, a nonresident alien individual, 
each of whose taxable years is the calendar year, were married 
throughout 1977. H and W were residents of, and domiciled in, foreign 
country Z during the entire taxable year. No election under section 6013 
(g) or (h) is in effect for 1977.

[[Page 469]]

During 1977, H earned $10,000 from the performance of personal services 
as an employee. H also received $500 in dividend income from stock which 
under the community property laws of country Z is considered to be the 
separate property of H. W had no separate income for 1977. Under the 
community property laws of country Z all income earned by either spouse 
is considered to be community income, and one-half of this income is 
considered to belong to the other spouse. In addition, the laws of 
country Z provide that all income derived from property held separately 
by either spouse is to be treated as community income and treated as 
belonging one-half to each spouse. Thus, under the community property 
laws of country Z, H and W are both considered to have realized income 
of $5,250 during 1977, even though Z's laws recognize the stock as the 
separate property of H. Under the rules of paragraph (a)(2) and (5) of 
this section all of the income of $10,500 derived during 1977 is 
treated, for U.S. income tax purposes, as the income of H.
    Example 2. (a) The facts are the same as in example 1, except that H 
is the sole proprietor of a retail merchandising company, which has a 
$10,000 profit during 1977. W exercises no management and control over 
the business. In addition, H is a partner in a wholesale distributing 
company, and his distributive share of the partnership profit is $5,000. 
Both of these amounts of income are treated as community income under 
the community property laws of country Z, and under these laws both H 
and W are treated as realizing $7,500 of the income. Under the rule of 
paragraph (a)(3) and (4) of this section all $15,000 of the income is 
treated as the income of H for U.S. income tax purposes.
    (b) If W exercises substantially all of the management and control 
over the retail merchandising company, then for U.S. income tax purposes 
the $10,000 profit is treated as the income of W.
    Example 3. The facts are the same as in example 1, except that H 
also received $1,000 in dividends on stock held separately in his name. 
Under the community property laws of country Z the stock is considered 
to be community property, the dividends to be community income, and one-
half of the income to be the income of each spouse. Under the rule of 
paragraph (a)(6) of this section, $500 of the dividend income is 
treated, for U.S. income tax purposes, as the income of each spouse.

    (b) Definitions and other special rules--(1) Spouses with different 
taxable years. A special rule applies if the nonresident alien and the 
United States citizen or resident spouse of the alien do not have the 
same taxable years, as defined in section 441(b) and the regulations 
thereunder. The special rule is as follows. With respect to the U.S. 
citizen or resident spouse, section 879 and this section shall apply to 
each taxable year of the U.S. citizen or resident spouse for which no 
election under section 6013 (g) or (h) is in effect. With respect to the 
nonresident alien spouse, section 879 and this section apply to each 
period falling within the consecutive taxable years of the nonresident 
alien spouse which coincides with a taxable year of the U.S. citizen or 
resident spouse to which section 879 and this section apply.
    (2) Determination of marital status. For purposes of this section, 
marital status shall be determined under section 143(a).

[T.D. 7670, 45 FR 6928, Jan. 31, 1980]

                          foreign corporations



Sec.  1.881-0  Table of contents.

    This section lists the major headings for Sec. Sec.  1.881-1 through 
1.881-4.

           Sec.  1.881-1 Manner of Taxing Foreign Corporations

    (a) Classes of foreign corporations.
    (b) Manner of taxing.
    (1) Foreign corporations not engaged in U.S. business.
    (2) Foreign corporations engaged in U.S. business.
    (c) Meaning of terms.
    (d) Rules applicable to foreign insurance companies.
    (1) Corporations qualifying under subchapter L.
    (2) Corporations not qualifying under subchapter L.
    (e) Other provisions applicable to foreign corporations.
    (1) Accumulated earnings tax.
    (2) Personal holding company tax.
    (3) Foreign personal holding companies.
    (4) Controlled foreign corporations.
    (i) Subpart F income and increase of earnings invested in U.S. 
property.
    (ii) Certain accumulations of earnings and profits.
    (5) Changes in tax rate.
    (6) Consolidated returns.
    (7) Adjustment of tax of certain foreign corporations.
    (f) Effective date.

   Sec.  1.881-2 Taxation of Foreign Corporations Not Engaged in U.S. 
                                Business

    (a) Imposition of tax.
    (b) Fixed or determinable annual or periodical income.

[[Page 470]]

    (c) Other income and gains.
    (1) Items subject to tax.
    (2) Determination of amount of gain.
    (d) Credits against tax.
    (e) Effective date.

              Sec.  1.881-3 Conduit Financing Arrangements

    (a) General rules and definitions.
    (1) Purpose and scope.
    (2) Definitions.
    (i) Financing arrangement.
    (A) In general.
    (B) Special rule for related parties.
    (ii) Financing transaction.
    (A) In general.
    (B) Limitation on inclusion of stock or similar interests.
    (iii) Conduit entity.
    (iv) Conduit financing arrangement.
    (v) Related.
    (3) Disregard of participation of conduit entity.
    (i) Authority of district director.
    (ii) Effect of disregarding conduit entity.
    (A) In general.
    (B) Character of payments made by the financed entity.
    (C) Effect of income tax treaties.
    (D) Effect on withholding tax.
    (E) Special rule for a financing entity that is unrelated to both 
intermediate entity and financed entity.
    (iii) Limitation on taxpayer's use of this section.
    (4) Standard for treatment as a conduit entity.
    (i) In general.
    (ii) Multiple intermediate entities.
    (A) In general.
    (B) Special rule for related persons.
    (b) Determination of whether participation of intermediate entity is 
pursuant to a tax avoidance plan.
    (1) In general.
    (2) Factors taken into account in determining the presence or 
absence of a tax avoidance purpose.
    (i) Significant reduction in tax.
    (ii) Ability to make the advance.
    (iii) Time period between financing transactions.
    (iv) Financing transactions in the ordinary course of business.
    (3) Presumption if significant financing activities performed by a 
related intermediate entity.
    (i) General rule.
    (ii) Significant financing activities.
    (A) Active rents or royalties.
    (B) Active risk management.
    (c) Determination of whether an unrelated intermediate entity would 
not have participated in financing arrangement on substantially same 
terms.
    (1) In general.
    (2) Effect of guarantee.
    (i) In general.
    (ii) Definition of guarantee.
    (d) Determination of amount of tax liability.
    (1) Amount of payment subject to recharacterization.
    (i) In general.
    (ii) Determination of principal amount.
    (A) In general.
    (B) Debt instruments and certain stock.
    (C) Partnership and trust interests.
    (D) Leases and licenses.
    (2) Rate of tax.
    (e) Examples.
    (f) Effective date.

 Sec.  1.881-4 Recordkeeping Requirements Concerning Conduit Financing 
                              Arrangements

    (a) Scope.
    (b) Recordkeeping requirements.
    (1) In general.
    (2) Application of sections 6038 and 6038A.
    (c) Records to be maintained.
    (1) In general.
    (2) Additional documents.
    (3) Effect of record maintenance requirement.
    (d) Effective date.

[T.D. 8611, 60 FR 41005, Aug. 11, 1995]



Sec.  1.881-1  Manner of taxing foreign corporations.

    (a) Classes of foreign corporations. For purposes of the income tax, 
foreign corporations are divided into two classes, namely, foreign 
corporations which at no time during the taxable year are engaged in 
trade or business in the United States and foreign corporations which, 
at any time during the taxable year, are engaged in trade or business in 
the United States.
    (b) Manner of taxing--(1) Foreign corporations not engaged in U.S. 
business. A foreign corporation which at no time during the taxable year 
is engaged in trade or business in the United States is taxable, as 
provided in Sec.  1.881-2, on all income received from sources within 
the United States which is fixed or determinable annual or periodical 
income and on other items of income enumerated under section 881(a). 
Such a foreign corporation is also taxable on certain income from 
sources within the United States which, pursuant to Sec.  1.882-2, is 
treated as effectively connected for the taxable year with the conduct 
of a trade or business in the United States.
    (2) Foreign corporations engaged in U.S. business. A foreign 
corporation which at any time during the taxable

[[Page 471]]

year is engaged in trade or business in the United States is taxable, as 
provided in Sec.  1.882-1, on all income from whatever source derived, 
whether or not fixed or determinable annual or periodical income, which 
is effectively connected for the taxable year with the conduct of a 
trade or business in the United States. Such a foreign corporation is 
also taxable, as provided in Sec.  1.882-1, on income received from 
sources within the United States which is not effectively connected for 
the taxable year with the conduct of a trade or business in the United 
States and consists of (i) fixed or determinable annual or periodical 
income, or (ii) other items of income enumerated in section 881(a). A 
foreign corporation which at any time during the taxable year is engaged 
in trade or business in the United States is also taxable on certain 
income from sources within the United States which, pursuant to Sec.  
1.882-2, is treated as effectively connected for the taxable year with 
the conduct of a trade or business in the United States.
    (c) Meaning of terms. For the meaning of the term ``engaged in trade 
or business within the United States'', as used in section 881 and this 
section, see section 864(b) and the regulations thereunder. For 
determining when income, gain, or loss of a foreign corporation for a 
taxable year is effectively connected for that year with the conduct of 
a trade or business in the United States, see section 864(c), the 
regulations thereunder, and Sec.  1.882-2. The term foreign corporation 
has the meaning assigned to it by section 7701(a)(3) and (5) and the 
regulations thereunder. However, for special rules relating to 
possessions of the United States, see Sec.  1.881-5.
    (d) Rules applicable to foreign insurance companies--(1) 
Corporations qualifying under subchapter L. A foreign corporation 
carrying on an insurance business in the United States at any time 
during the taxable year, which, without taking into account its income 
not effectively connected for the taxable year with the conduct of a 
trade or business in the United States, would qualify for the taxable 
year under part I, II, or III of subchapter L if it were a domestic 
corporation, shall be taxable for such year under that part on its 
entire taxable income (whether derived from sources within or without 
the United States) which is, or which pursuant to section 882 (d) or (e) 
and Sec.  1.882-2 is treated as, effectively connected for the taxable 
year with the conduct of a trade or business (whether or not its 
insurance business) in the United States. Any income derived by that 
foreign corporation from sources within the United States which is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States is taxable as provided in section 
881(a) and Sec.  1.882-1. See sections 842 and 861 through 864, and the 
regulations thereunder.
    (2) Corporations not qualifying under subchapter L. A foreign 
corporation which carries on an insurance business in the United States 
at any time during the taxable year, and which, without taking into 
account its income not effectively connected for the taxable year with 
the conduct of a trade or business in the United States, would not 
qualify for the taxable year under part I, II, or III of subchapter L if 
it were a domestic corporation, and a foreign insurance company which 
does not carry on an insurance business in the United States at any time 
during the taxable year, shall be taxable--
    (i) Under section 881(a) and Sec.  1.881-2 or Sec.  1.882-1 on its 
income from sources within the United States which is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States,
    (ii) Under section 882(a)(1) and Sec.  1.882-1 on its income 
(whether derived from sources within or without the United States) which 
is effectively connected for the taxable year with the conduct of a 
trade or business in the United States, and
    (iii) Under section 882(a)(1) and Sec.  1.882-1 on its income from 
sources within the United States which pursuant to section 882 (d) or 
(e) and Sec.  1.882-2, is treated as effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States.
    (e) Other provisions applicable to foreign corporations--(1) 
Accumulated earnings tax. For the imposition of the accumulated earnings 
tax upon the accumulated taxable income of a foreign

[[Page 472]]

corporation formed or availed of for tax avoidance purposes, whether or 
not such corporation is engaged in trade or business in the United 
States, see section 532 and the regulations thereunder.
    (2) Personal holding company tax. For the imposition of the personal 
holding company tax upon the undistributed personal holding company 
income of a foreign corporation which is a personal holding company, 
whether or not such corporation is engaged in trade or business in the 
United States, see sections 541 through 547, and the regulations 
thereunder. Except in the case of a foreign corporation having personal 
service contract income to which section 543(a)(7) applies, a foreign 
corporation is not a personal holding company if all of its stock 
outstanding during the last half of the taxable year is owned by 
nonresident alien individuals, whether directly or indirectly through 
foreign estates, foreign trusts, foreign partnerships, or other foreign 
corporations. See section 542(c)(7).
    (3) Foreign personal holding companies. For the mandatory inclusion 
in the gross income of the United States shareholders of the 
undistributed foreign personal holding company income of a foreign 
personal holding company, see section 551 and the regulations 
thereunder.
    (4) Controlled foreign corporations--(i) Subpart F income and 
increase of earnings invested in U.S. Property. For the mandatory 
inclusion in the gross income of the U.S. shareholders of the subpart F 
income, of the previously excluded subpart F income withdrawn from 
investment in less developed countries, of the previously excluded 
subpart F income withdrawn from investment in foreign base company 
shipping operations, and of the increase in earnings invested in U.S. 
property, of a controlled foreign corporation, see sections 951 through 
964, and the regulations thereunder.
    (ii) Certain accumulations of earnings and profits. For the 
inclusion in the gross income of U.S. persons as a dividend of the gain 
recognized on certain sales or exchanges of stock in a foreign 
corporation, to the extent of certain earnings and profits attributable 
to the stock which were accumulated while the corporation was a 
controlled foreign corporation, see section 1248 and the regulations 
thereunder.
    (5) Changes in tax rate. For provisions respecting the effect of any 
change in rate of tax during the taxable year on the income of a foreign 
corporation, see section 21 and the regulations thereunder.
    (6) Consolidated returns. Except in the case of certain corporations 
organized under the laws of Canada or Mexico and maintained solely for 
the purpose of complying with the laws of that country as to title and 
operation of property, a foreign corporation is not an includible 
corporation for purposes of the privilege of making a consolidated 
return by an affiliated group of corporations. See section 1504 and the 
regulations thereunder.
    (7) Adjustment of tax of certain foreign corporations. For the 
application of pre-1967 income tax provisions to corporations of a 
foreign country which imposes a more burdensome income tax than the 
United States, and for the adjustment of the income tax of a corporation 
of a foreign country which imposes a discriminatory income tax on the 
income of citizens of the United States or domestic corporations, see 
section 896.
    (f) Effective/applicability date. This section applies for taxable 
years beginning after December 31, 1966. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.881-1 (Revised as of January 1, 1971).

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

[T.D. 7293, 38 FR 32795, Nov. 28, 1973, as amended by T.D. 7385, 40 FR 
50260, Oct. 29, 1975; T.D. 7893, 48 FR 22507, May 19, 1983; T.D. 9194, 
70 FR 18929, Apr. 11, 2005; T.D. 9391, 73 FR 19359, Apr. 9, 2008]



Sec.  1.881-2  Taxation of foreign corporations not engaged in U.S. business.

    (a) Imposition of tax. (1) This section applies for purposes of 
determining the tax of a foreign corporation which at no time during the 
taxable year is engaged in trade or business in the United States. 
However, see also Sec.  1.882-2 where such corporation has an election 
in effect for the taxable year

[[Page 473]]

in respect to real property income or receives interest on obligations 
of the United States. Except as otherwise provided in Sec.  1.871-12, a 
foreign corporation to which this section applies is not subject to the 
tax imposed by section 11 or section 1201(a) but, pursuant to the 
provisions of section 881(a), is liable to a flat tax of 30 percent upon 
the aggregate of the amounts determined under paragraphs (b) and (c) of 
this section which are received during the taxable year from sources 
within the United States. Except as specifically provided in such 
paragraphs, such amounts do not include gains from the sale or exchange 
of property. To determine the source of such amounts, see sections 861 
through 863, and the regulations thereunder.
    (2) The tax of 30 percent is imposed by section 881(a) upon an 
amount only to the extent the amount constitutes gross income.
    (3) Deductions shall not be allowed in determining the amount 
subject to tax under this section.
    (4) Except as provided in Sec.  1.882-2, a foreign corporation which 
at no time during the taxable year is engaged in trade or business in 
the United States has no income, gain, or loss for the taxable year 
which is effectively connected for the taxable year with the conduct of 
a trade or business in the United States. See section 864(c)(1)(B) and 
Sec.  1.864-3.
    (5) Gains and losses which, by reason of section 882(d) and Sec.  
1.882-2, are treated as gains or losses which are effectively connected 
for the taxable year with the conduct of a trade or business in the 
United States by such a foreign corporation shall not be taken into 
account in determining the tax under this section. See, for example, 
paragraph (c)(2) of Sec.  1.871-10.
    (6) Interest received by a foreign corporation pursuant to certain 
portfolio debt instruments is not subject to the flat tax of 30 percent 
described in paragraph (a)(1) of this section. For rules applicable to a 
foreign corporation's receipt of interest on certain portfolio debt 
instruments, see sections 871(h), 881(c), and Sec.  1.871-14.
    (b) Fixed or determinable annual or periodical income--(1) General 
rule. The tax of 30 percent imposed by section 881(a) applies to the 
gross amount received from sources within the United States as fixed or 
determinable annual or periodical gains, profits, or income. Specific 
items of fixed or determinable annual or periodical income are 
enumerated in section 881(a)(1) as interest, dividends, rents, salaries, 
wages, premiums, annuities, compensations, remunerations, and 
emoluments, but other items of fixed or determinable annual or 
periodical gains, profits, or income are also subject to the tax as, for 
instance, royalties, including royalties for the use of patents, 
copyrights, secret processes and formulas, and other like property. As 
to the determination of fixed or determinable annual or periodical 
income, see paragraph (a) of Sec.  1.1441-2. For special rules treating 
gain on the disposition of section 306 stock as fixed or determinable 
annual or periodical income for purposes of section 881(a), see section 
306(f) and paragraph (h) of Sec.  1.306-3.
    (2) Substitute payments. For purposes of this section, a substitute 
interest payment (as defined in Sec.  1.861-2(a)(7)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec.  1.861-2(a)(7)) shall have 
the same character as interest income received pursuant to the terms of 
the transferred security. Similarly, for purposes of this section, a 
substitute dividend payment (as defined in Sec.  1.861-3(a)(6)) received 
by a foreign person pursuant to a securities lending transaction or a 
sale-repurchase transaction (as defined in Sec.  1.861-2(a)(7)) shall 
have the same character as a distribution received with respect to the 
transferred security. Where, pursuant to a securities lending 
transaction or a sale-repurchase transaction, a foreign person transfers 
to another person a security in the interest on which would qualify as 
portfolio interest under section 881(c) in the hands of the lender, 
substitute interest payments made with respect to the transferred 
security will be treated as portfolio interest, provided that in the 
case of interest on an obligation in registered form (as defined in 
Sec.  1.871-14(c)(1)(i)), the transferor complies with the documentation 
requirement described in Sec.  1.871-

[[Page 474]]

14(c)(1)(ii)(C) with respect to the payment of substitute interest and 
none of the exceptions to the portfolio interest exemption in sections 
881(c) (3) and (4) apply. See also Sec. Sec.  1.871-7(b)(2) and 1.894-
1(c).
    (3) Dividend Equivalents. For rules applicable to a foreign 
corporation's receipt of a dividend equivalent, see section 871(m) and 
the regulations thereunder.
    (c) Other income and gains--(1) Items subject to tax. The tax of 30 
percent imposed by section 881(a) also applies to the following gains 
received during the taxable year from sources within the United States:
    (i) Gains described in section 631 (b) or (c), relating to the 
treatment of gain on the disposal of timber, coal, or iron ore with a 
retained economic interest;
    (ii) [Reserved]
    (iii) Gains from the sale or exchange after October 4, 1966, of 
patents, copyrights, secret processes and formulas, goodwill, 
trademarks, trade brands, franchises, or other like property, or of any 
interest in any such property, to the extent the gains are from payments 
(whether in a lump sum or in installments) which are contingent on the 
productivity, use, or disposition of the property or interest sold or 
exchanged, or from payments which are treated under section 871(e) and 
Sec.  1.871-11 as being so contingent.
    (2) Determination of amount of gain. The tax of 30 percent imposed 
upon the gains described in subparagraph (1) of this paragraph applies 
to the full amount of the gains and is determined (i) without regard to 
the alternative tax imposed by section 1201(a) upon the excess of net 
long-term capital gain over the net short-term capital loss; (ii) 
without regard to section 1231, relating to property used in the trade 
or business and involuntary conversions; and (iii) except in the case of 
gains described in subparagraph (1)(ii) of this paragraph, whether or 
not the gains are considered to be gains from the sale or exchange of 
property which is a capital asset.
    (d) Credits against tax. The credits allowed by section 32 (relating 
to tax withheld at source on foreign corporations), by section 39 
(relating to certain uses of gasoline and lubricating oil), and by 
section 6402 (relating to overpayments of tax) shall be allowed against 
the tax of a foreign corporation determined in accordance with this 
section.
    (e) Effective/applicability date. Except as otherwise provided in 
this paragraph, this section applies for taxable years beginning after 
December 31, 1966. Paragraph (b)(2) of this section is applicable to 
payments made after November 13, 1997. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.881-2 (Revised as of January 1, 1971). Paragraph (b)(3) of this 
section applies to payments made on or after January 23, 2012.

[T.D. 7293, 38 FR 32796, Nov. 28, 1973, as amended by T.D. 8735, 62 FR 
53502, Oct. 14, 1997; T.D. 9323, 72 FR 18388, Apr. 12, 2007; T.D. 9572, 
77 FR 3109, Jan. 23, 2012; T.D. 9648, 78 FR 73080, Dec. 5, 2013]



Sec.  1.881-3  Conduit financing arrangements.

    (a) General rules and definitions--(1) Purpose and scope. Pursuant 
to the authority of section 7701(l), this section provides rules that 
permit the director of field operations to disregard, for purposes of 
section 881, the participation of one or more intermediate entities in a 
financing arrangement where such entities are acting as conduit 
entities. For purposes of this section, any reference to tax imposed 
under section 881 includes, except as otherwise provided and as the 
context may require, a reference to tax imposed under sections 871 or 
884(f)(1)(A) or required to be withheld under section 1441 or 1442. See 
Sec.  1.881-4 for recordkeeping requirements concerning financing 
arrangements. See Sec. Sec.  1.1441-3(g) and 1.1441-7(f) for withholding 
rules applicable to conduit financing arrangements. See Sec.  1.1471-
3(e)(5) for withholding rules applicable to conduit financing 
arrangements for purposes of sections 1471 and 1472. See also Sec. Sec.  
1.267A-1 and 1.267A-4 (disallowing a deduction for certain interest or 
royalty payments to the extent the income attributable to the payment is 
offset by a hybrid deduction).
    (2) Definitions. The following definitions apply for purposes of 
this section and Sec. Sec.  1.881-4, 1.1441-3(g) and 1.1441-7(f).

[[Page 475]]

    (i) Financing arrangement--(A) In general. Financing arrangement 
means a series of transactions by which one person (the financing 
entity) advances money or other property, or grants rights to use 
property, and another person (the financed entity) receives money or 
other property, or rights to use property, if the advance and receipt 
are effected through one or more other persons (intermediate entities) 
and, except in cases to which paragraph (a)(2)(i)(B) of this section 
applies, there are financing transactions linking the financing entity, 
each of the intermediate entities, and the financed entity. A transfer 
of money or other property in satisfaction of a repayment obligation is 
not an advance of money or other property. A financing arrangement 
exists regardless of the order in which the transactions are entered 
into, but only for the period during which all of the financing 
transactions coexist. See paragraphs (e)(1) through (5) of this section 
(Examples 1 through 5) for illustrations of the term financing 
arrangement.
    (B) Special rule for related parties. If two (or more) financing 
transactions involving two (or more) related persons would form part of 
a financing arrangement but for the absence of a financing transaction 
between the related persons, the director of field operations may treat 
the related persons as a single intermediate entity if he determines 
that one of the principal purposes for the structure of the financing 
transactions is to prevent the characterization of such arrangement as a 
financing arrangement. This determination shall be based upon all of the 
facts and circumstances, including, without limitation, the factors set 
forth in paragraph (b)(2) of this section. See paragraphs (e)(6) and (7) 
of this section (Examples 6 and 7) for illustrations of this paragraph 
(a)(2)(i)(B).
    (C) Treatment of disregarded entities. For purposes of this section, 
the term person includes a business entity that is disregarded as an 
entity separate from its single member owner under Sec. Sec.  301.7701-1 
through 301.7701-3 of this chapter and, therefore, such entity may, for 
example, be treated as a party to a financing transaction with its 
owner. See paragraph (e)(3) of this section (Example 3).
    (ii) Financing transaction--(A) In general. Financing transaction 
means--
    (1) Debt;
    (2) Stock in a corporation (or a similar interest in a partnership, 
trust, or other person) that meets the requirements of paragraph 
(a)(2)(ii)(B) of this section;
    (3) Any lease or license; or
    (4) Any other transaction (including an interest in a trust 
described in sections 671 through 679) pursuant to which a person makes 
an advance of money or other property or grants rights to use property 
to a transferee who is obligated to repay or return a substantial 
portion of the money or other property advanced, or the equivalent in 
value. This paragraph (a)(2)(ii)(A)(4) shall not apply to the posting of 
collateral unless the collateral consists of cash or the person holding 
the collateral is permitted to reduce the collateral to cash (through a 
transfer, grant of a security interest or similar transaction) prior to 
default on the financing transaction secured by the collateral.
    (B) Limitation on inclusion of stock or similar interests--(1) In 
general. Stock in a corporation (or a similar interest in a partnership, 
trust, or other person) will constitute a financing transaction only if 
one or more of the following conditions is satisfied--
    (i) The issuer is required to redeem the stock or similar interest 
at a specified time or the holder has the right to require the issuer to 
redeem the stock or similar interest or to make any other payment with 
respect to the stock or similar interest;
    (ii) The issuer has the right to redeem the stock or similar 
interest, but only if, based on all of the facts and circumstances as of 
the issue date, redemption pursuant to that right is more likely than 
not to occur;
    (iii) The owner of the stock or similar interest has the right to 
require a person related to the issuer (or any other person who is 
acting pursuant to a plan or arrangement with the issuer) to acquire the 
stock or similar interest or make a payment with respect to the stock or 
similar interest; or

[[Page 476]]

    (iv) The stock or similar interest is treated as debt under the tax 
law of the issuer's country of residence or, if the issuer is not a tax 
resident of any country, such as a partnership, the tax law of the 
country in which the issuer is created, organized, or otherwise 
established.
    (v) [Reserved]
    (2) Rules of special application--(i) Existence of a right. For 
purposes of this paragraph (a)(2)(ii)(B), a person will be considered to 
have a right to cause a redemption or payment if the person has the 
right (other than rights arising, in the ordinary course, between the 
date that a payment is declared and the date that a payment is made) to 
enforce the payment through a legal proceeding or to cause the issuer to 
be liquidated if it fails to redeem the interest or to make a payment. A 
person will not be considered to have a right to force a redemption or a 
payment if the right is derived solely from ownership of a controlling 
interest in the issuer in cases where the control does not arise from a 
default or similar contingency under the instrument. The person is 
considered to have such a right if the person has the right as of the 
issue date or, as of the issue date, it is more likely than not that the 
person will receive such a right, whether through the occurrence of a 
contingency or otherwise.
    (ii) Restrictions on payment. The fact that the issuer does not have 
the legally available funds to redeem the stock or similar interest, or 
that the payments are to be made in a blocked currency, will not affect 
the determinations made pursuant to this paragraph (a)(2)(ii)(B).
    (iii) Conduit entity means an intermediate entity whose 
participation in the financing arrangement may be disregarded in whole 
or in part pursuant to this section, whether or not the director of 
field operations has made a determination that the intermediate entity 
should be disregarded under paragraph (a)(3)(i) of this section.
    (iv) Conduit financing arrangement means a financing arrangement 
that is effected through one or more conduit entities.
    (v) Related means related within the meaning of sections 267(b) or 
707(b)(1), or controlled within the meaning of section 482, and the 
regulations under those sections. For purposes of determining whether a 
person is related to another person, the constructive ownership rules of 
section 318 shall apply, and the attribution rules of section 267(c) 
also shall apply to the extent they attribute ownership to persons to 
whom section 318 does not attribute ownership.
    (3) Disregard of participation of conduit entity--(i) Authority of 
director of field operations. The director of field operations may 
determine that the participation of a conduit entity in a conduit 
financing arrangement should be disregarded for purposes of section 881. 
For this purpose, an intermediate entity will constitute a conduit 
entity if it meets the standards of paragraph (a)(4) of this section. 
The director of field operations has discretion to determine the manner 
in which the standards of paragraph (a)(4) of this section apply, 
including the financing transactions and parties composing the financing 
arrangement.
    (ii) Effect of disregarding conduit entity--(A) In general. If the 
director of field operations determines that the participation of a 
conduit entity in a financing arrangement should be disregarded, the 
financing arrangement is recharacterized as a transaction directly 
between the remaining parties to the financing arrangement (in most 
cases, the financed entity and the financing entity) for purposes of 
section 881. To the extent that a disregarded conduit entity actually 
receives or makes payments pursuant to a conduit financing arrangement, 
it is treated as an agent of the financing entity. Except as otherwise 
provided, the recharacterization of the conduit financing arrangement 
also applies for purposes of sections 871, 884(f)(1)(A), 1441, and 1442 
and other procedural provisions relating to those sections. This 
recharacterization will not otherwise affect a taxpayer's Federal income 
tax liability under any substantive provisions of the Internal Revenue 
Code. Thus, for example, the recharacterization generally applies for 
purposes of section 1461, in order to impose liability on a withholding 
agent who fails to

[[Page 477]]

withhold as required under Sec.  1.1441-3(g), but not for purposes of 
Sec.  1.882-5.
    (B) Character of payments made by the financed entity. If the 
participation of a conduit financing arrangement is disregarded under 
this paragraph (a)(3), payments made by the financed entity generally 
shall be characterized by reference to the character (e.g., interest or 
rent) of the payments made to the financing entity. However, if the 
financing transaction to which the financing entity is a party is a 
transaction described in paragraph (a)(2)(ii)(A)(2) or (4) of this 
section that gives rise to payments that would not be deductible if paid 
by the financed entity, the character of the payments made by the 
financed entity will not be affected by the disregard of the 
participation of a conduit entity. The characterization provided by this 
paragraph (a)(3)(ii)(B) does not, however, extend to qualification of a 
payment for any exemption from withholding tax under the Internal 
Revenue Code or a provision of any applicable tax treaty if such 
qualification depends on the terms of, or other similar facts or 
circumstances relating to, the financing transaction to which the 
financing entity is a party that do not apply to the financing 
transaction to which the financed entity is a party. Thus, for example, 
payments made by a financed entity that is not a bank cannot qualify for 
the exemption provided by section 881(i) of the Code even if the loan 
between the financing entity and the conduit entity is a bank deposit.
    (C) Effect of income tax treaties. Where the participation of a 
conduit entity in a conduit financing arrangement is disregarded 
pursuant to this section, it is disregarded for all purposes of section 
881, including for purposes of applying any relevant income tax 
treaties. Accordingly, the conduit entity may not claim the benefits of 
a tax treaty between its country of residence and the United States to 
reduce the amount of tax due under section 881 with respect to payments 
made pursuant to the conduit financing arrangement. The financing entity 
may, however, claim the benefits of any income tax treaty under which it 
is entitled to benefits in order to reduce the rate of tax on payments 
made pursuant to the conduit financing arrangement that are 
recharacterized in accordance with paragraph (a)(3)(ii)(B) of this 
section.
    (D) Effect on withholding tax. For the effect of recharacterization 
on withholding obligations, see Sec. Sec.  1.1441-3(g) and 1.1441-7(f).
    (E) Special rule for a financing entity that is unrelated to both 
intermediate entity and financed entity--(1) Liability of financing 
entity. Notwithstanding the fact that a financing arrangement is a 
conduit financing arrangement, a financing entity that is unrelated to 
the financed entity and the conduit entity (or entities) shall not 
itself be liable for tax under section 881 unless the financing entity 
knows or has reason to know that the financing arrangement is a conduit 
financing arrangement. But see Sec.  1.1441-3(g) for the withholding 
agent's withholding obligations.
    (2) Financing entity's knowledge--(i) In general. A financing entity 
knows or has reason to know that the financing arrangement is a conduit 
financing arrangement only if the financing entity knows or has reason 
to know of facts sufficient to establish that the financing arrangement 
is a conduit financing arrangement, including facts sufficient to 
establish that the participation of the intermediate entity in the 
financing arrangement is pursuant to a tax avoidance plan. A person that 
knows only of the financing transactions that comprise the financing 
arrangement will not be considered to know or have reason to know of 
facts sufficient to establish that the financing arrangement is a 
conduit financing arrangement.
    (ii) Presumption regarding financing entity's knowledge. It shall be 
presumed that the financing entity does not know or have reason to know 
that the financing arrangement is a conduit financing arrangement if the 
financing entity is unrelated to all other parties to the financing 
arrangement and the financing entity establishes that the intermediate 
entity who is a party to the financing transaction with the financing 
entity is actively engaged in a substantial trade or business. An 
intermediate entity will not be considered to be engaged in a trade or 
business if its business is making or managing investments, unless the 
intermediate entity is actively engaged in a banking,

[[Page 478]]

insurance, financing or similar trade or business and such business 
consists predominantly of transactions with customers who are not 
related persons. An intermediate entity's trade or business is 
substantial if it is reasonable for the financing entity to expect that 
the intermediate entity will be able to make payments under the 
financing transaction out of the cash flow of that trade or business. 
This presumption may be rebutted if the director of field operations 
establishes that the financing entity knew or had reason to know that 
the financing arrangement is a conduit financing arrangement. See 
paragraph (e)(8) of this section (Example 8) for an illustration of the 
rules of this paragraph (a)(3)(ii)(E).
    (iii) Limitation on taxpayer's use of this section. A taxpayer may 
not apply this section to reduce the amount of its Federal income tax 
liability by disregarding the form of its financing transactions for 
Federal income tax purposes or by compelling the director of field 
operations to do so. See, however, paragraph (b)(2)(i) of this section 
for rules regarding the taxpayer's ability to show that the 
participation of one or more intermediate entities results in no 
significant reduction in tax.
    (4) Standard for treatment as a conduit entity--(i) In general. An 
intermediate entity is a conduit entity with respect to a financing 
arrangement if--
    (A) The participation of the intermediate entity (or entities) in 
the financing arrangement reduces the tax imposed by section 881 
(determined by comparing the aggregate tax imposed under section 881 on 
payments made on financing transactions making up the financing 
arrangement with the tax that would have been imposed under paragraph 
(d) of this section);
    (B) The participation of the intermediate entity in the financing 
arrangement is pursuant to a tax avoidance plan; and
    (C) Either--
    (1) The intermediate entity is related to the financing entity or 
the financed entity; or
    (2) The intermediate entity would not have participated in the 
financing arrangement on substantially the same terms but for the fact 
that the financing entity engaged in the financing transaction with the 
intermediate entity.
    (ii) Multiple intermediate entities--(A) In general. If a financing 
arrangement involves multiple intermediate entities, the director of 
field operations will determine whether each of the intermediate 
entities is a conduit entity. The director of field operations will make 
the determination by applying the special rules for multiple 
intermediate entities provided in this section or, if no special rules 
are provided, applying principles consistent with those of paragraph 
(a)(4)(i) of this section to each of the intermediate entities in the 
financing arrangement.
    (B) Special rule for related persons. The director of field 
operations may treat related intermediate entities as a single 
intermediate entity if he determines that one of the principal purposes 
for the involvement of multiple intermediate entities in the financing 
arrangement is to prevent the characterization of an intermediate entity 
as a conduit entity, to reduce the portion of a payment that is subject 
to withholding tax or otherwise to circumvent the provisions of this 
section. This determination shall be based upon all of the facts and 
circumstances, including, but not limited to, the factors set forth in 
paragraph (b)(2) of this section. If a director of field operations 
determines that related persons are to be treated as a single 
intermediate entity, financing transactions between such related parties 
that are part of the conduit financing arrangement shall be disregarded 
for purposes of applying this section. See paragraphs (e)(9) and (10) of 
this section (Examples 9 and 10) for illustrations of the rules of this 
paragraph (a)(4)(ii).
    (b) Determination of whether participation of intermediate entity is 
pursuant to a tax avoidance plan--(1) In general. A tax avoidance plan 
is a plan one of the principal purposes of which is the avoidance of tax 
imposed by section 881. Avoidance of the tax imposed by section 881 may 
be one of the principal purposes for such a plan even though it is 
outweighed by other purposes (taken together or separately). In this 
regard, the only relevant purposes are those pertaining to the 
participation of the intermediate entity in the financing

[[Page 479]]

arrangement and not those pertaining to the existence of a financing 
arrangement as a whole. The plan may be formal or informal, written or 
oral, and may involve any one or more of the parties to the financing 
arrangement. The plan must be in existence no later than the last date 
that any of the financing transactions comprising the financing 
arrangement is entered into. The director of field operations may infer 
the existence of a tax avoidance plan from the facts and circumstances. 
In determining whether there is a tax avoidance plan, the director of 
field operations will weigh all relevant evidence regarding the purposes 
for the intermediate entity's participation in the financing 
arrangement. See paragraphs (e)(13) and (14) of this section (Examples 
13 and 14) for illustrations of the rule of this paragraph (b)(1).
    (2) Factors taken into account in determining the presence or 
absence of a tax avoidance purpose. The factors described in paragraphs 
(b)(2)(i) through (iv) of this section are among the facts and 
circumstances taken into account in determining whether the 
participation of an intermediate entity in a financing arrangement has 
as one of its principal purposes the avoidance of tax imposed by section 
881.
    (i) Significant reduction in tax. The director of field operations 
will consider whether the participation of the intermediate entity (or 
entities) in the financing arrangement significantly reduces the tax 
that otherwise would have been imposed under section 881. The fact that 
an intermediate entity is a resident of a country that has an income tax 
treaty with the United States that significantly reduces the tax that 
otherwise would have been imposed under section 881 is not sufficient, 
by itself, to establish the existence of a tax avoidance plan. The 
determination of whether the participation of an intermediate entity 
significantly reduces the tax generally is made by comparing the 
aggregate tax imposed under section 881 on payments made on financing 
transactions making up the financing arrangement with the tax that would 
be imposed under paragraph (d) of this section. However, the taxpayer is 
not barred from presenting evidence that the financing entity, as 
determined by the director of field operations, was itself an 
intermediate entity and another entity should be treated as the 
financing entity for purposes of applying this test. A reduction in the 
absolute amount of tax may be significant even if the reduction in rate 
is not. A reduction in the amount of tax may be significant if the 
reduction is large in absolute terms or in relative terms. See 
paragraphs (e)(15) through (17) of this section (Examples 15 through 17) 
for illustrations of this factor.
    (ii) Ability to make the advance. The director of field operations 
will consider whether the intermediate entity had sufficient available 
money or other property of its own to have made the advance to the 
financed entity without the advance of money or other property to it by 
the financing entity (or in the case of multiple intermediate entities, 
whether each of the intermediate entities had sufficient available money 
or other property of its own to have made the advance to either the 
financed entity or another intermediate entity without the advance of 
money or other property to it by either the financing entity or another 
intermediate entity).
    (iii) Time period between financing transactions. The director of 
field operations will consider the length of the period of time that 
separates the advances of money or other property, or the grants of 
rights to use property, by the financing entity to the intermediate 
entity (in the case of multiple intermediate entities, from one 
intermediate entity to another), and ultimately by the intermediate 
entity to the financed entity. A short period of time is evidence of the 
existence of a tax avoidance plan while a long period of time is 
evidence that there is not a tax avoidance plan. See paragraph (e)(18) 
of this section (Example 18) for an illustration of this factor.
    (iv) Financing transactions in the ordinary course of business. If 
the parties to the financing transaction are related, the director of 
field operations will consider whether the financing transaction occurs 
in the ordinary course of the active conduct of complementary or 
integrated trades or businesses engaged in by these entities. The fact

[[Page 480]]

that a financing transaction is described in this paragraph (b)(2)(iv) 
is evidence that the participation of the parties to that transaction in 
the financing arrangement is not pursuant to a tax avoidance plan. A 
loan will not be considered to occur in the ordinary course of the 
active conduct of complementary or integrated trades or businesses 
unless the loan is a trade receivable or the parties to the transaction 
are actively engaged in a banking, insurance, financing or similar trade 
or business and such business consists predominantly of transactions 
with customers who are not related persons. See paragraph (e)(19) of 
this section (Example 19) for an illustration of this factor.
    (3) Presumption if significant financing activities performed by a 
related intermediate entity--(i) General rule. It shall be presumed that 
the participation of an intermediate entity (or entities) in a financing 
arrangement is not pursuant to a tax avoidance plan if the intermediate 
entity is related to either or both the financing entity or the financed 
entity and the intermediate entity performs significant financing 
activities with respect to the financing transactions forming part of 
the financing arrangement to which it is a party. This presumption may 
be rebutted if the director of field operations establishes that the 
participation of the intermediate entity in the financing arrangement is 
pursuant to a tax avoidance plan. See paragraphs (e)(23) through (25) of 
this section (Examples 23 through 25) for illustrations of this 
presumption.
    (ii) Significant financing activities. For purposes of this 
paragraph (b)(3), an intermediate entity performs significant financing 
activities with respect to such financing transactions only if the 
financing transactions satisfy the requirements of either paragraph 
(b)(3)(ii)(A) or (B) of this section.
    (A) Active rents or royalties. An intermediate entity performs 
significant financing activities with respect to leases or licenses if 
rents or royalties earned with respect to such leases or licenses are 
derived in the active conduct of a trade or business within the meaning 
of section 954(c)(2)(A), to be applied by substituting the term 
intermediate entity for the term controlled foreign corporation.
    (B) Active risk management--(1) In general. An intermediate entity 
is considered to perform significant financing activities with respect 
to financing transactions only if officers and employees of the 
intermediate entity participate actively and materially in arranging the 
intermediate entity's participation in such financing transactions 
(other than financing transactions described in paragraph 
(b)(3)(ii)(B)(3) of this section) and perform the business activity and 
risk management activities described in paragraph (b)(3)(ii)(B)(2) of 
this section with respect to such financing transactions, and the 
participation of the intermediate entity in the financing transactions 
produces (or reasonably can be expected to produce) efficiency savings 
by reducing transaction costs and overhead and other fixed costs.
    (2) Business activity and risk management requirements. An 
intermediate entity will be considered to perform significant financing 
activities only if, within the country in which the intermediate entity 
is organized (or, if different, within the country with respect to which 
the intermediate entity is claiming the benefits of a tax treaty), its 
officers and employees--
    (i) Exercise management over, and actively conduct, the day-to-day 
operations of the intermediate entity. Such operations must consist of a 
substantial trade or business or the supervision, administration and 
financing for a substantial group of related persons; and
    (ii) Actively manage, on an ongoing basis, material market risks 
arising from such financing transactions as an integral part of the 
management of the intermediate entity's financial and capital 
requirements (including management of risks of currency and interest 
rate fluctuations) and management of the intermediate entity's short-
term investments of working capital by entering into transactions with 
unrelated persons.
    (3) Special rule for trade receivables and payables entered into in 
the ordinary course of business. If the activities of the intermediate 
entity consist in whole or in part of cash management

[[Page 481]]

for a controlled group of which the intermediate entity is a member, 
then employees of the intermediate entity need not have participated in 
arranging any such financing transactions that arise in the ordinary 
course of a substantial trade or business of either the financed entity 
or the financing entity. Officers or employees of the financing entity 
or financed entity, however, must have participated actively and 
materially in arranging the transaction that gave rise to the trade 
receivable or trade payable. Cash management includes the operation of a 
sweep account whereby the intermediate entity nets intercompany trade 
payables and receivables arising from transactions among the other 
members of the controlled group and between members of the controlled 
group and unrelated persons.
    (4) Activities of officers and employees of related persons. Except 
as provided in paragraph (b)(3)(ii)(B)(3) of this section, in applying 
this paragraph (b)(3)(ii)(B), the activities of an officer or employee 
of an intermediate entity will not constitute significant financing 
activities if any officer or employee of a related person participated 
materially in any of the activities described in this paragraph, other 
than to approve any guarantee of a financing transaction or to exercise 
general supervision and control over the policies of the intermediate 
entity.
    (c) Determination of whether an unrelated intermediate entity would 
not have participated in financing arrangement on substantially the same 
terms--(1) In general. The determination of whether an intermediate 
entity would not have participated in a financing arrangement on 
substantially the same terms but for the financing transaction between 
the financing entity and the intermediate entity shall be based upon all 
of the facts and circumstances.
    (2) Effect of guarantee--(i) In general. The director of field 
operations may presume that the intermediate entity would not have 
participated in the financing arrangement on substantially the same 
terms if there is a guarantee of the financed entity's liability to the 
intermediate entity (or in the case of multiple intermediate entities, a 
guarantee of the intermediate entity's liability to the intermediate 
entity that advanced money or property, or granted rights to use other 
property). However, a guarantee that was neither in existence nor 
contemplated on the last date that any of the financing transactions 
comprising the financing arrangement is entered into does not give rise 
to this presumption. A taxpayer may rebut this presumption by producing 
clear and convincing evidence that the intermediate entity would have 
participated in the financing transaction with the financed entity on 
substantially the same terms even if the financing entity had not 
entered into a financing transaction with the intermediate entity.
    (ii) Definition of guarantee. For the purposes of this paragraph 
(c)(2), a guarantee is any arrangement under which a person, directly or 
indirectly, assures, on a conditional or unconditional basis, the 
payment of another person's obligation with respect to a financing 
transaction. The term shall be interpreted in accordance with the 
definition of the term in section 163(j)(6)(D)(iii) (as in effect for 
taxable years beginning before January 1, 2018).
    (d) Determination of amount of tax liability--(1) Amount of payment 
subject to recharacterization--(i) In general. If a financing 
arrangement is a conduit financing arrangement, a portion of each 
payment made by the financed entity with respect to the financing 
transactions that comprise the conduit financing arrangement shall be 
recharacterized as a transaction directly between the financed entity 
and the financing entity. If the aggregate principal amount of the 
financing transaction(s) to which the financed entity is a party is less 
than or equal to the aggregate principal amount of the financing 
transaction(s) linking any of the parties to the financing arrangement, 
the entire amount of the payment shall be so recharacterized. If the 
aggregate principal amount of the financing transaction(s) to which the 
financed entity is a party is greater than the aggregate principal 
amount of the financing transaction(s) linking any of the parties to the 
financing arrangement, then the recharacterized portion shall be 
determined by multiplying the payment by a fraction the numerator

[[Page 482]]

of which is equal to the lowest aggregate principal amount of the 
financing transaction(s) linking any of the parties to the financing 
arrangement (other than financing transactions that are disregarded 
pursuant to paragraphs (a)(2)(i)(B) and (a)(4)(ii)(B) of this section) 
and the denominator of which is the aggregate principal amount of the 
financing transaction(s) to which the financed entity is a party. In the 
case of financing transactions the principal amount of which is subject 
to adjustment, the fraction shall be determined using the average 
outstanding principal amounts for the period to which the payment 
relates. The average principal amount may be computed using any method 
applied consistently that reflects with reasonable accuracy the amount 
outstanding for the period. See paragraph (e)(26) of this section 
(Example 26) for an illustration of the calculation of the amount of tax 
liability.
    (ii) Determination of principal amount--(A) In general. Unless 
otherwise provided in this paragraph (d)(1)(ii), the principal amount 
equals the amount of money advanced, or the fair market value of other 
property advanced or subject to a lease or license, in the financing 
transaction. In general, fair market value is calculated in U.S. dollars 
as of the close of business on the day on which the financing 
transaction is entered into. However, if the property advanced, or the 
right to use property granted, by the financing entity is the same as 
the property or rights received by the financed entity, the fair market 
value of the property or right shall be determined as of the close of 
business on the last date that any of the financing transactions 
comprising the financing arrangement is entered into. In the case of 
fungible property, property of the same type shall be considered to be 
the same property. See paragraph (e)(27) of this section (Example 27) 
for an illustration of the calculation of the principal amount in the 
case of financing transactions involving fungible property. The 
principal amount of a financing transaction shall be subject to 
adjustments, as set forth in this paragraph (d)(1)(ii).
    (B) Debt instruments and certain stock. In the case of a debt 
instrument or of stock that is subject to the current inclusion rules of 
sections 305(c)(3) or (e), the principal amount generally will be equal 
to the issue price. However, if the fair market value on the issue date 
differs materially from the issue price, the fair market value of the 
debt instrument shall be used in lieu of the instrument's issue price. 
Appropriate adjustments will be made for accruals of original issue 
discount and repayments of principal (including accrued original issue 
discount).
    (C) Partnership and trust interests. In the case of a partnership 
interest or an interest in a trust, the principal amount is equal to the 
fair market value of the money or property contributed to the 
partnership or trust in return for that partnership or trust interest.
    (D) Leases or licenses. In the case of a lease or license, the 
principal amount is equal to the fair market value of the property 
subject to the lease or license on the date on which the lease or 
license is entered into. The principal amount shall be adjusted for 
depreciation or amortization, calculated on a basis that accurately 
reflects the anticipated decline in the value of the property over its 
life.
    (iii) [Reserved]
    (2) Rate of tax. The rate at which tax is imposed under section 881 
on the portion of the payment that is recharacterized pursuant to 
paragraph (d)(1) of this section is determined by reference to the 
nature of the recharacterized transaction, as determined under 
paragraphs (a)(3)(ii)(B) and (C) of this section.
    (e) Examples. The following examples illustrate this section. For 
purposes of these examples, unless otherwise indicated, it is assumed 
that FP, a corporation organized in country N, owns all of the stock of 
FS, a corporation organized in country T, and DS, a corporation 
organized in the United States. Country T, but not country N, has an 
income tax treaty with the United States. The treaty exempts interest, 
rents and royalties paid by a resident of one state (the source state) 
to a resident of the other state from tax in the

[[Page 483]]

source state. For purposes of the examples in this paragraph (e), unless 
otherwise indicated, it is assumed that no stock is of the type 
described in paragraph (a)(2)(ii)(B)(1)(iv) of this section.
    (1) Example 1. Financing arrangement. (i) On January 1, 1996, BK, a 
bank organized in country T, lends $1,000,000 to DS in exchange for a 
note issued by DS. FP guarantees to BK that DS will satisfy its 
repayment obligation on the loan. There are no other transactions 
between FP and BK.
    (ii) BK's loan to DS is a financing transaction within the meaning 
of paragraph (a)(2)(ii)(A)(1) of this section. FP's guarantee of DS's 
repayment obligation is not a financing transaction as described in 
paragraphs (a)(2)(ii)(A)(1) through (4) of this section. Therefore, 
these transactions do not constitute a financing arrangement as defined 
in paragraph (a)(2)(i) of this section.
    (2) Example 2. Financing arrangement. (i) On January 1, 1996, FP 
lends $1,000,000 to DS in exchange for a note issued by DS. On January 
1, 1997, FP assigns the DS note to FS in exchange for a note issued by 
FS. After receiving notice of the assignment, DS remits payments due 
under its note to FS.
    (ii) The DS note held by FS and the FS note held by FP are financing 
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of this 
section, and together constitute a financing arrangement within the 
meaning of paragraph (a)(2)(i) of this section.
    (3) Example 3. Participation of a disregarded intermediate entity. 
The facts are the same as in paragraph (e)(2) of this section (the facts 
in Example 2), except that FS is an entity that is disregarded as an 
entity separate from its owner, FP, under Sec.  301.7701-3 of this 
chapter. Under paragraph (a)(2)(i)(C) of this section, FS is a person 
and, therefore, may itself be an intermediate entity that is linked by 
financing transactions to other persons in a financing arrangement. The 
DS note held by FS and the FS note held by FP are financing transactions 
within the meaning of paragraph (a)(2)(ii) of this section, and together 
constitute a financing arrangement within the meaning of paragraph 
(a)(2)(i) of this section.
    (4) Example 4. Hybrid instrument as financing arrangement. The facts 
are the same as in paragraph (e)(2) of this section (the facts in 
Example 2), except that FP assigns the DS note to FS in exchange for 
stock issued by FS. The stock issued by FS is in form convertible debt 
with a 49-year term that is treated as debt under the tax law of Country 
T. The FS stock is not subject to any of the redemption, acquisition, or 
payment rights or requirements specified in paragraphs 
(a)(2)(ii)(B)(1)(i) through (iii) of this section. However, because the 
FS stock is treated as debt under the tax law of Country T, the FS stock 
is a financing transaction under paragraph (a)(2)(ii)(B)(1)(iv) of this 
section. Therefore, the DS note held by FS and the FS stock held by FP 
are financing transactions within the meaning of paragraphs 
(a)(2)(ii)(A)(1) and (2) of this section, respectively, and together 
constitute a financing arrangement within the meaning of paragraph 
(a)(2)(i) of this section. See also Sec.  1.267A-4 for rules applicable 
to disqualified imported mismatch amounts.
    (5) Example 5. Financing arrangement. (i) On December 1, 1994 FP 
creates a special purposes subsidiary, FS. On that date FP capitalizes 
FS with $1,000,000 in cash and $10,000,000 in debt from BK, a Country N 
bank. On January 1, 1995, C, a U.S. person, purchases an automobile from 
DS in return for an installment note. On August 1, 1995, DS sells a 
number of installment notes, including C's, to FS in exchange for 
$10,000,000. DS continues to service the installment notes for FS.
    (ii) The C installment note now held by FS (as well as all of the 
other installment notes now held by FS) and the FS note held by BK are 
financing transactions within the meaning of paragraph (a)(2)(ii)(A)(1) 
of this section, and together constitute a financing arrangement within 
the meaning of paragraph (a)(2)(i) of this section.
    (6) Example 6. Related persons treated as a single intermediate 
entity. (i) On January 1, 1996, FP deposits $1,000,000 with BK, a bank 
that is organized in country N and is unrelated to FP and its 
subsidiaries. M, a corporation also organized in country N, is wholly-
owned by the sole shareholder of BK but is not a bank within the meaning

[[Page 484]]

of section 881(c)(3)(A). On July 1, 1996, M lends $1,000,000 to DS in 
exchange for a note maturing on July 1, 2006. The note is in registered 
form within the meaning of section 881(c)(2)(B)(i) and DS has received 
from M the statement required by section 881(c)(2)(B)(ii). One of the 
principal purposes for the absence of a financing transaction between BK 
and M is the avoidance of the application of this section.
    (ii) The transactions described above would form a financing 
arrangement but for the absence of a financing transaction between BK 
and M. However, because one of the principal purposes for the 
structuring of these financing transactions is to prevent 
characterization of such arrangement as a financing arrangement, the 
director of field operations may treat the financing transactions 
between FP and BK, and between M and DS as a financing arrangement under 
paragraphs (a)(2)(i)(B) of this section. In such a case, BK and M would 
be considered a single intermediate entity for purposes of this section. 
See also paragraph (a)(4)(ii)(B) of this section for the authority to 
treat BK and M as a single intermediate entity.
    (7) Example 7. Related persons treated as a single intermediate 
entity. (i) On January 1, 1995, FP lends $10,000,000 to FS in exchange 
for a 10-year note that pays interest annually at a rate of 8 percent 
per annum. On January 2, 1995, FS contributes $10,000,000 to FS2, a 
wholly-owned subsidiary of FS organized in country T, in exchange for 
common stock of FS2. On January 1, 1996, FS2 lends $10,000,000 to DS in 
exchange for an 8-year note that pays interest annually at a rate of 10 
percent per annum. FS is a holding company whose most significant asset 
is the stock of FS2. Throughout the period that the FP-FS loan is 
outstanding, FS causes FS2 to make distributions to FS, most of which 
are used to make interest and principal payments on the FP-FS loan. 
Without the distributions from FS2, FS would not have had the funds with 
which to make payments on the FP-FS loan. One of the principal purposes 
for the absence of a financing transaction between FS and FS2 is the 
avoidance of the application of this section.
    (ii) The conditions of paragraph (a)(4)(i)(A) of this section would 
be satisfied with respect to the financing transactions between FP, FS, 
FS2 and DS but for the absence of a financing transaction between FS and 
FS2. However, because one of the principal purposes for the structuring 
of these financing transactions is to prevent characterization of an 
entity as a conduit, the director of field operations may treat the 
financing transactions between FP and FS, and between FS2 and DS as a 
financing arrangement. See paragraph (a)(4)(ii)(B) of this section. In 
such a case, FS and FS2 would be considered a single intermediate entity 
for purposes of this section. See also paragraph (a)(2)(i)(B) of this 
section for the authority to treat FS and FS2 as a single intermediate 
entity.
    (8) Example 8. Presumption with respect to unrelated financing 
entity. (i) FP is a corporation organized in country T that is actively 
engaged in a substantial manufacturing business. FP has a revolving 
credit facility with a syndicate of banks, none of which is related to 
FP and FP's subsidiaries, which provides that FP may borrow up to a 
maximum of $100,000,000 at a time. The revolving credit facility 
provides that DS and certain other subsidiaries of FP may borrow 
directly from the syndicate at the same interest rates as FP, but each 
subsidiary is required to indemnify the syndicate banks for any 
withholding taxes imposed on interest payments by the country in which 
the subsidiary is organized. BK, a bank that is organized in country N, 
is the agent for the syndicate. Some of the syndicate banks are 
organized in country N, but others are residents of country O, a country 
that has an income tax treaty with the United States which allows the 
United States to impose a tax on interest at a maximum rate of 10 
percent. It is reasonable for BK and the syndicate banks to have 
determined that FP will be able to meet its payment obligations on a 
maximum principal amount of $100,000,000 out of the cash flow of its 
manufacturing business. At various times throughout 1995, FP borrows 
under the revolving credit facility until the outstanding

[[Page 485]]

principal amount reaches the maximum amount of $100,000,000. On December 
31, 1995, FP receives $100,000,000 from a public offering of its equity. 
On January 1, 1996, FP pays BK $90,000,000 to reduce the outstanding 
principal amount under the revolving credit facility and lends 
$10,000,000 to DS. FP would have repaid the entire principal amount, and 
DS would have borrowed directly from the syndicate, but for the fact 
that DS did not want to incur the U.S. withholding tax that would have 
applied to payments made directly by DS to the syndicate banks.
    (ii) Pursuant to paragraph (a)(3)(ii)(E)(1) of this section, even 
though the financing arrangement is a conduit financing arrangement 
(because the financing arrangement meets the standards for 
recharacterization in paragraph (a)(4)(i) of this section), BK and the 
other syndicate banks have no section 881 liability unless they know or 
have reason to know that the financing arrangement is a conduit 
financing arrangement. Moreover, pursuant to paragraph 
(a)(3)(ii)(E)(2)(ii) of this section, BK and the syndicate banks are 
presumed not to know that the financing arrangement is a conduit 
financing arrangement. The syndicate banks are unrelated to both FP and 
DS, and FP is actively engaged in a substantial trade or business--that 
is, the cash flow from FP's manufacturing business is sufficient for the 
banks to expect that FP will be able to make the payments required under 
the financing transaction. See Sec.  1.1441-3(g) for the withholding 
obligations of the withholding agents.
    (9) Example 9. Multiple intermediate entities--special rule for 
related persons. (i) On January 1, 1995, FP lends $10,000,000 to FS in 
exchange for a 10-year note that pays interest annually at a rate of 8 
percent per annum. On January 2, 1995, FS contributes $9,900,000 to FS2, 
a wholly-owned subsidiary of FS organized in country T, in exchange for 
common stock and lends $100,000 to FS2. On January 1, 1996, FS2 lends 
$10,000,000 to DS in exchange for an 8-year note that pays interest 
annually at a rate of 10 percent per annum. FS is a holding company that 
has no significant assets other than the stock of FS2. Throughout the 
period that the FP-FS loan is outstanding, FS causes FS2 to make 
distributions to FS, most of which are used to make interest and 
principal payments on the FP-FS loan. Without the distributions from 
FS2, FS would not have had the funds with which to make payments on the 
FP-FS loan. One of the principal purposes for structuring the 
transactions between FS and FS2 as primarily a contribution of capital 
is to reduce the amount of the payment that would be recharacterized 
under paragraph (d) of this section.
    (ii) Pursuant to paragraph (a)(4)(ii)(B) of this section, the 
director of field operations may treat FS and FS2 as a single 
intermediate entity for purposes of this section since one of the 
principal purposes for the participation of multiple intermediate 
entities is to reduce the amount of the tax liability on any 
recharacterized payment by inserting a financing transaction with a low 
principal amount.
    (10) Example 10. Multiple intermediate entities. (i) On January 1, 
1995, FP deposits $1,000,000 with BK, a bank that is organized in 
country T and is unrelated to FP and its subsidiaries, FS and DS. On 
January 1, 1996, at a time when the FP-BK deposit is still outstanding, 
BK lends $500,000 to BK2, a bank that is wholly-owned by BK and is 
organized in country T. On the same date, BK2 lends $500,000 to FS. On 
July 1, 1996, FS lends $500,000 to DS. FP pledges its deposit with BK to 
BK2 in support of FS' obligation to repay the BK2 loan. FS', BK's and 
BK2's participation in the financing arrangement is pursuant to a tax 
avoidance plan.
    (ii) The conditions of paragraphs (a)(4)(i)(A) and (B) of this 
section are satisfied because the participation of BK, BK2 and FS in the 
financing arrangement reduces the tax imposed by section 881, and FS', 
BK's and BK2's participation in the financing arrangement is pursuant to 
a tax avoidance plan. However, since BK and BK2 are unrelated to FP and 
DS, under paragraph (a)(4)(i)(C)(2) of this section, BK and BK2 will be 
treated as conduit entities only if BK and BK2 would not have 
participated in the financing arrangement on substantially the same 
terms but for the financing transaction between FP and BK.

[[Page 486]]

    (iii) It is presumed that BK2 would not have participated in the 
financing arrangement on substantially the same terms but for the BK-BK2 
financing transaction because FP's pledge of an asset in support of FS' 
obligation to repay the BK2 loan is a guarantee within the meaning of 
paragraph (c)(2)(ii) of this section. If the taxpayer does not rebut 
this presumption by clear and convincing evidence, then BK2 will be a 
conduit entity.
    (iv) Because BK and BK2 are related intermediate entities, the 
director of field operations must determine whether one of the principal 
purposes for the involvement of multiple intermediate entities was to 
prevent characterization of an entity as a conduit entity. In making 
this determination, the director of field operations may consider the 
fact that the involvement of two related intermediate entities prevents 
the presumption regarding guarantees from applying to BK. In the absence 
of evidence showing a business purpose for the involvement of both BK 
and BK2, the director of field operations may treat BK and BK2 as a 
single intermediate entity for purposes of determining whether they 
would have participated in the financing arrangement on substantially 
the same terms but for the financing transaction between FP and BK. The 
presumption that applies to BK2 therefore will apply to BK. If the 
taxpayer does not rebut this presumption by clear and convincing 
evidence, then BK will be a conduit entity.
    (11) Example 11. Reduction of tax. (i) On February 1, 1995, FP 
issues debt to the public that would satisfy the requirements of section 
871(h)(2)(A) (relating to obligations that are not in registered form) 
if issued by a U.S. person. FP lends the proceeds of the debt offering 
to DS in exchange for a note.
    (ii) The debt issued by FP and the DS note are financing 
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of this 
section and together constitute a financing arrangement within the 
meaning of paragraph (a)(2)(i) of this section. The holders of the FP 
debt are the financing entities, FP is the intermediate entity and DS is 
the financed entity. Because interest payments on the debt issued by FP 
would not have been subject to withholding tax if the debt had been 
issued by DS, there is no reduction in tax under paragraph (a)(4)(i)(A) 
of this section. Accordingly, FP is not a conduit entity.
    (12) Example 12. Reduction of tax. (i) On January 1, 1995, FP 
licenses to FS the rights to use a patent in the United States to 
manufacture product A. FS agrees to pay FP a fixed amount in royalties 
each year under the license. On January 1, 1996, FS sublicenses to DS 
the rights to use the patent in the United States. Under the sublicense, 
DS agrees to pay FS royalties based upon the units of product A 
manufactured by DS each year. Although the formula for computing the 
amount of royalties paid by DS to FS differs from the formula for 
computing the amount of royalties paid by FS to FP, each represents an 
arm's length rate.
    (ii) Although the royalties paid by DS to FS are exempt from U.S. 
withholding tax, the royalty payments between FS and FP are income from 
U.S. sources under section 861(a)(4) subject to the 30 percent gross tax 
imposed by Sec.  1.881-2(b) and subject to withholding under Sec.  
1.1441-2(a). Because the rate of tax imposed on royalties paid by FS to 
FP is the same as the rate that would have been imposed on royalties 
paid by DS to FP, the participation of FS in the FP-FS-DS financing 
arrangement does not reduce the tax imposed by section 881 within the 
meaning of paragraph (a)(4)(i)(A) of this section. Accordingly, FP is 
not a conduit entity.
    (13) Example 13. A principal purpose. (i) On January 1, 1995, FS 
lends $10,000,000 to DS in exchange for a 10-year note that pays 
interest annually at a rate of 8 percent per annum. As was intended at 
the time of the loan from FS to DS, on July 1, 1995, FP makes an 
interest-free demand loan of $10,000,000 to FS. A principal purpose for 
FS' participation in the FP-FS-DS financing arrangement is that FS 
generally coordinates the financing for all of FP's subsidiaries 
(although FS does not engage in significant financing activities with 
respect to such financing transactions). However, another principal 
purpose for

[[Page 487]]

FS' participation is to allow the parties to benefit from the lower 
withholding tax rate provided under the income tax treaty between 
country T and the United States.
    (ii) The financing arrangement satisfies the tax avoidance purpose 
requirement of paragraph (a)(4)(i)(B) of this section because FS 
participated in the financing arrangement pursuant to a plan one of the 
principal purposes of which is to allow the parties to benefit from the 
country T-U.S. treaty.
    (14) Example 14. A principal purpose. (i) DX is a U.S. corporation 
that intends to purchase property to use in its manufacturing business. 
FX is a partnership organized in country N that is owned in equal parts 
by LC1 and LC2, leasing companies that are unrelated to DX. BK, a bank 
organized in country N and unrelated to DX, LC1 and LC2, lends 
$100,000,000 to FX to enable FX to purchase the property. On the same 
day, FX purchases the property and engages in a transaction with DX 
which is treated as a lease of the property for country N tax purposes 
but a loan for U.S. tax purposes. Accordingly, DX is treated as the 
owner of the property for U.S. tax purposes. The parties comply with the 
requirements of section 881(c) with respect to the debt obligation of DX 
to FX. FX and DX structured these transactions in this manner so that 
LC1 and LC2 would be entitled to accelerated depreciation deductions 
with respect to the property in country N and DX would be entitled to 
accelerated depreciation deductions in the United States. None of the 
parties would have participated in the transaction if the payments made 
by DX were subject to U.S. withholding tax.
    (ii) The loan from BK to FX and from FX to DX are financing 
transactions and, together constitute a financing arrangement. The 
participation of FX in the financing arrangement reduces the tax imposed 
by section 881 because payments made to FX, but not BK, qualify for the 
portfolio interest exemption of section 881(c) because BK is a bank 
making an extension of credit in the ordinary course of its trade or 
business within the meaning of section 881(c)(3)(A). Moreover, because 
DX borrowed the money from FX instead of borrowing the money directly 
from BK to avoid the tax imposed by section 881, one of the principal 
purposes of the participation of FX was to avoid that tax (even though 
another principal purpose of the participation of FX was to allow LC1 
and LC2 to take advantage of accelerated depreciation deductions in 
country N). Assuming that FX would not have participated in the 
financing arrangement on substantially the same terms but for the fact 
that BK loaned it $100,000,000, FX is a conduit entity and the financing 
arrangement is a conduit financing arrangement.
    (15) Example 15. Significant reduction of tax. (i) FS owns all of 
the stock of FS1, which also is a resident of country T. FS1 owns all of 
the stock of DS. On January 1, 1995, FP contributes $10,000,000 to the 
capital of FS in return for perpetual preferred stock. On July 1, 1995, 
FS lends $10,000,000 to FS1. On January 1, 1996, FS1 lends $10,000,000 
to DS. Under the terms of the country T-U.S. income tax treaty, a 
country T resident is not entitled to the reduced withholding rate on 
interest income provided by the treaty if the resident is entitled to 
specified tax benefits under country T law. Although FS1 may deduct 
interest paid on the loan from FS, these deductions are not pursuant to 
any special tax benefits provided by country T law. However, FS 
qualifies for one of the enumerated tax benefits pursuant to which it 
may deduct dividends paid with respect to the stock held by FP. 
Therefore, if FS had made a loan directly to DS, FS would not have been 
entitled to the benefits of the country T-U.S. tax treaty with respect 
to payments it received from DS, and such payments would have been 
subject to tax under section 881 at a 30 percent rate.
    (ii) The FS-FS1 loan and the FS1-DS loan are financing transactions 
within the meaning of paragraph (a)(2)(ii)(A)(1) of this section and 
together constitute a financing arrangement within the meaning of 
paragraph (a)(2)(i) of this section. Pursuant to paragraph (b)(2)(i) of 
this section, the significant reduction in tax resulting from the 
participation of FS1 in the financing arrangement is evidence that the 
participation of FS1 in the financing arrangement is pursuant to a tax 
avoidance plan. However, other facts

[[Page 488]]

relevant to the presence of such a plan must also be taken into account.
    (16) Example 16. Significant reduction of tax. (i) FP owns 90 
percent of the voting stock of FX, an unlimited liability company 
organized in country T. The other 10 percent of the common stock of FX 
is owned by FP1, a subsidiary of FP that is organized in country N. 
Although FX is a partnership for U.S. tax purposes, FX is entitled to 
the benefits of the U.S.-country T income tax treaty because FX is 
subject to tax in country T as a resident corporation. On January 1, 
1996, FP contributes $10,000,000 to FX in exchange for an instrument 
denominated as preferred stock that pays a dividend of 7 percent and 
that must be redeemed by FX in seven years. For U.S. tax purposes, the 
preferred stock is a partnership interest. On July 1, 1996, FX makes a 
loan of $10,000,000 to DS in exchange for a 7-year note paying interest 
at 6 percent.
    (ii) Because FX is required to redeem the partnership interest at a 
specified time, the partnership interest constitutes a financing 
transaction within the meaning of paragraph (a)(2)(ii)(A)(2) of this 
section. Moreover, because the FX-DS note is a financing transaction 
within the meaning of paragraph (a)(2)(ii)(A)(1) of this section, 
together the transactions constitute a financing arrangement within the 
meaning of (a)(2)(i) of this section. Payments of interest made directly 
by DS to FP and FP1 would not be eligible for the portfolio interest 
exemption and would not be entitled to a reduction in withholding tax 
pursuant to a tax treaty. Therefore, there is a significant reduction in 
tax resulting from the participation of FX in the financing arrangement, 
which is evidence that the participation of FX in the financing 
arrangement is pursuant to a tax avoidance plan. However, other facts 
relevant to the existence of such a plan must also be taken into 
account.
    (17) Example 17. Significant reduction of tax. (i) FP owns a 10 
percent interest in the profits and capital of FX, a partnership 
organized in country N. The other 90 percent interest in FX is owned by 
G, an unrelated corporation that is organized in country T. FX is not 
engaged in business in the United States. On January 1, 1996, FP 
contributes $10,000,000 to FX in exchange for an instrument documented 
as perpetual subordinated debt that provides for quarterly interest 
payments at 9 percent per annum. Under the terms of the instrument, 
payments on the perpetual subordinated debt do not otherwise affect the 
allocation of income between the partners. FP has the right to require 
the liquidation of FX if FX fails to make an interest payment. For U.S. 
tax purposes, the perpetual subordinated debt is treated as a 
partnership interest in FX and the payments on the perpetual 
subordinated debt constitute guaranteed payments within the meaning of 
section 707(c). On July 1, 1996, FX makes a loan of $10,000,000 to DS in 
exchange for a 7-year note paying interest at 8 percent per annum.
    (ii) Because FP has the effective right to force payment of the 
``interest'' on the perpetual subordinated debt, the instrument 
constitutes a financing transaction within the meaning of paragraph 
(a)(2)(ii)(A)(2) of this section. Moreover, because the note between FX 
and DS is a financing transaction within the meaning of paragraph 
(a)(2)(ii)(A)(1) of this section, together the transactions are a 
financing arrangement within the meaning of (a)(2)(i) of this section. 
Without regard to this section, 90 percent of each interest payment 
received by FX would be treated as exempt from U.S. withholding tax 
because it is beneficially owned by G, while 10 percent would be subject 
to a 30 percent withholding tax because beneficially owned by FP. If FP 
held directly the note issued by DS, 100 percent of the interest 
payments on the note would have been subject to the 30 percent 
withholding tax. The significant reduction in the tax imposed by section 
881 resulting from the participation of FX in the financing arrangement 
is evidence that the participation of FX in the financing arrangement is 
pursuant to a tax avoidance plan. However, other facts relevant to the 
presence of such a plan must also be taken into account.
    (18) Example 18. Time period between transactions. (i) On January 1, 
1995, FP lends $10,000,000 to FS in exchange for a 10-year note that 
pays no interest annually. When the note matures, FS is obligated to pay 
$24,000,000 to FP. On

[[Page 489]]

January 1, 1996, FS lends $10,000,000 to DS in exchange for a 10-year 
note that pays interest annually at a rate of 10 percent per annum.
    (ii) The FS note held by FP and the DS note held by FS are financing 
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of this 
section and together constitute a financing arrangement within the 
meaning of (a)(2)(i) of this section. Pursuant to paragraph (b)(2)(iii) 
of this section, the short period of time (twelve months) between the 
loan by FP to FS and the loan by FS to DS is evidence that the 
participation of FS in the financing arrangement is pursuant to a tax 
avoidance plan. However, other facts relevant to the presence of such a 
plan must also be taken into account.
    (19) Example 19. Financing transactions in the ordinary course of 
business. (i) FP is a holding company. FS is actively engaged in country 
T in the business of manufacturing and selling product A. DS 
manufactures product B, a principal component in which is product A. FS' 
business activity is substantial. On January 1, 1995, FP lends 
$100,000,000 to FS to finance FS' business operations. On January 1, 
1996, FS ships $30,000,000 of product A to DS. In return, FS creates an 
interest-bearing account receivable on its books. FS' shipment is in the 
ordinary course of the active conduct of its trade or business (which is 
complementary to DS' trade or business.)
    (ii) The loan from FP to FS and the accounts receivable opened by FS 
for a payment owed by DS are financing transactions within the meaning 
of paragraph (a)(2)(ii)(A)(1) of this section and together constitute a 
financing arrangement within the meaning of paragraph (a)(2)(i) of this 
section. Pursuant to paragraph (b)(2)(iv) of this section, the fact that 
DS' liability to FS is created in the ordinary course of the active 
conduct of DS' trade or business that is complementary to a business 
actively engaged in by DS is evidence that the participation of FS in 
the financing arrangement is not pursuant to a tax avoidance plan. 
However, other facts relevant to the presence of such a plan must also 
be taken into account.
    (20) Example 20. Tax avoidance plan--other factors. (i) On February 
1, 1995, FP issues debt in Country N that is in registered form within 
the meaning of section 881(c)(3)(A). The FP debt would satisfy the 
requirements of section 881(c) if the debt were issued by a U.S. person 
and the withholding agent received the certification required by section 
871(h)(2)(B)(ii). The purchasers of the debt are financial institutions 
and there is no reason to believe that they would not furnish Forms W-8. 
On March 1, 1995, FP lends a portion of the proceeds of the offering to 
DS.
    (ii) The FP debt and the loan to DS are financing transactions 
within the meaning of paragraph (a)(2)(ii)(A)(1) of this section and 
together constitute a financing arrangement within the meaning of 
paragraph (a)(2)(i) of this section. The owners of the FP debt are the 
financing entities, FP is the intermediate entity and DS is the financed 
entity. Interest payments on the debt issued by FP would be subject to 
withholding tax if the debt were issued by DS, unless DS received all 
necessary Forms W-8. Therefore, the participation of FP in the financing 
arrangement potentially reduces the tax imposed by section 881(a). 
However, because it is reasonable to assume that the purchasers of the 
FP debt would have provided certifications in order to avoid the 
withholding tax imposed by section 881, there is not a tax avoidance 
plan. Accordingly, FP is not a conduit entity.
    (21) Example 21. Tax avoidance plan--other factors. (i) Over a 
period of years, FP has maintained a deposit with BK, a bank organized 
in the United States, that is unrelated to FP and its subsidiaries. FP 
often sells goods and purchases raw materials in the United States. FP 
opened the bank account with BK in order to facilitate this business and 
the amounts it maintains in the account are reasonably related to its 
dollar-denominated working capital needs. On January 1, 1995, BK lends 
$5,000,000 to DS. After the loan is made, the balance in FP's bank 
account remains within a range appropriate to meet FP's working capital 
needs.
    (ii) FP's deposit with BK and BK's loan to DS are financing 
transactions within the meaning of paragraph

[[Page 490]]

(a)(2)(ii)(A)(1) of this section and together constitute a financing 
arrangement within the meaning of paragraph (a)(2)(i) of this section. 
Pursuant to section 881(i), interest paid by BK to FP with respect to 
the bank deposit is exempt from withholding tax. Interest paid directly 
by DS to FP would not be exempt from withholding tax under section 
881(i) and therefore would be subject to a 30% withholding tax. 
Accordingly, there is a significant reduction in the tax imposed by 
section 881, which is evidence of the existence of a tax avoidance plan. 
See paragraph (b)(2)(i) of this section. However, the director of field 
operations also will consider the fact that FP historically has 
maintained an account with BK to meet its working capital needs and 
that, prior to and after BK's loan to DS, the balance within the account 
remains within a range appropriate to meet those business needs as 
evidence that the participation of BK in the FP-BK-DS financing 
arrangement is not pursuant to a tax avoidance plan. In determining the 
presence or absence of a tax avoidance plan, all relevant facts will be 
taken into account.
    (22) Example 22. Tax avoidance plan--other factors. (i) Assume the 
same facts as in paragraph (e)(21) of this section (the facts in Example 
21), except that on January 1, 2000, FP's deposit with BK substantially 
exceeds FP's expected working capital needs and on January 2, 2000, BK 
lends additional funds to DS. Assume also that BK's loan to DS provides 
BK with a right of offset against FP's deposit. Finally, assume that FP 
would have lent the funds to DS directly but for the imposition of the 
withholding tax on payments made directly to FP by DS.
    (ii) As in paragraph (e)(20) of this section (Example 20), the 
transactions in paragraph (e)(22)(i) of this section (this Example 22) 
are a financing arrangement within the meaning of paragraph (a)(2)(i) 
and the participation of the BK reduces the section 881 tax. In this 
case, the presence of funds substantially in excess of FP's working 
capital needs and the fact that FP would have been willing to lend funds 
directly to DS if not for the withholding tax are evidence that the 
participation of BK in the FP-BK-FS financing arrangement is pursuant to 
a tax avoidance plan. However, other facts relevant to the presence of 
such a plan must also be taken into account. Even if the director of 
field operations determines that the participation of BK in the 
financing arrangement is pursuant to a tax avoidance plan, BK may not be 
treated as a conduit entity unless BK would not have participated in the 
financing arrangement on substantially the same terms in the absence of 
FP's deposit with BK. BK's right of offset against FP's deposit (a form 
of guarantee of BK's loan to DS) creates a presumption that BK would not 
have made the loan to DS on substantially the same terms in the absence 
of FP's deposit with BK. If the taxpayer overcomes the presumption by 
clear and convincing evidence, BK will not be a conduit entity.
    (23) Example 23. Significant financing activities. (i) FS is 
responsible for coordinating the financing of all of the subsidiaries of 
FP, which are engaged in substantial trades or businesses and are 
located in country T, country N, and the United States. FS maintains a 
centralized cash management accounting system for FP and its 
subsidiaries in which it records all intercompany payables and 
receivables; these payables and receivables ultimately are reduced to a 
single balance either due from or owing to FS and each of FP's 
subsidiaries. FS is responsible for disbursing or receiving any cash 
payments required by transactions between its affiliates and unrelated 
parties. FS must borrow any cash necessary to meet those external 
obligations and invests any excess cash for the benefit of the FP group. 
FS enters into interest rate and foreign exchange contracts as necessary 
to manage the risks arising from mismatches in incoming and outgoing 
cash flows. The activities of FS are intended (and reasonably can be 
expected) to reduce transaction costs and overhead and other fixed 
costs. FS has 50 employees, including clerical and other back office 
personnel, located in country T. At the request of DS, on January 1, 
1995, FS pays a supplier $1,000,000 for materials delivered to DS and 
charges DS an open account receivable for this

[[Page 491]]

amount. On February 3, 1995, FS reverses the account receivable from DS 
to FS when DS delivers to FP goods with a value of $1,000,000.
    (ii) The accounts payable from DS to FS and from FS to other 
subsidiaries of FP constitute financing transactions within the meaning 
of paragraph (a)(2)(ii)(A)(1) of this section, and the transactions 
together constitute a financing arrangement within the meaning of 
paragraph (a)(2)(i) of this section. FS's activities constitute 
significant financing activities with respect to the financing 
transactions even though FS did not actively and materially participate 
in arranging the financing transactions because the financing 
transactions consisted of trade receivables and trade payables that were 
ordinary and necessary to carry on the trades or businesses of DS and 
the other subsidiaries of FP. Accordingly, pursuant to paragraph 
(b)(3)(i) of this section, FS' participation in the financing 
arrangement is presumed not to be pursuant to a tax avoidance plan.
    (24) Example 24. Significant financing activities--active risk 
management. (i) The facts are the same as in paragraph (e)(23) of this 
section (the facts in Example 23), except that, in addition to its 
short-term funding needs, DS needs long-term financing to fund an 
acquisition of another U.S. company; the acquisition is scheduled to 
close on January 15, 1995. FS has a revolving credit agreement with a 
syndicate of banks located in Country N. On January 14, 1995, FS borrows 
[yen]10 billion for 10 years under the revolving credit agreement, 
paying yen LIBOR plus 50 basis points on a quarterly basis. FS enters 
into a currency swap with BK, an unrelated bank that is not a member of 
the syndicate, under which FS will pay BK [yen]10 billion and will 
receive $100 million on January 15, 1995; these payments will be 
reversed on January 15, 2004. FS will pay BK U.S. dollar LIBOR plus 50 
basis points on a notional principal amount of $100 million semi-
annually and will receive yen LIBOR plus 50 basis points on a notional 
principal amount of [yen]10 billion quarterly. Upon the closing of the 
acquisition on January 15, 1995, DS borrows $100 million from FS for 10 
years, paying U.S. dollar LIBOR plus 50 basis points semiannually.
    (ii) Although FS performs significant financing activities with 
respect to certain financing transactions to which it is a party, FS 
does not perform significant financing activities with respect to the 
financing transactions between FS and the syndicate of banks and between 
FS and DS because FS has eliminated all material market risks arising 
from those financing transactions through its currency swap with BK. 
Accordingly, the financing arrangement does not benefit from the 
presumption of paragraph (b)(3)(i) of this section and the director of 
field operations must determine whether the participation of FS in the 
financing arrangement is pursuant to a tax avoidance plan on the basis 
of all the facts and circumstances. However, if additional facts 
indicated that FS reviews its currency swaps daily to determine whether 
they are the most cost efficient way of managing their currency risk 
and, as a result, frequently terminates swaps in favor of entering into 
more cost efficient hedging arrangements with unrelated parties, FS 
would be considered to perform significant financing activities and FS' 
participation in the financing arrangements would not be pursuant to a 
tax avoidance plan.
    (25) Example 25. Significant financing activities--presumption 
rebutted. (i) The facts are the same as in paragraph (e)(23) of this 
section (the facts in Example 23), except that, on January 1, 1995, FP 
lends to FS DM 15,000,000 (worth $10,000,000) in exchange for a 10 year 
note that pays interest annually at a rate of 5 percent per annum. Also, 
on March 15, 1995, FS lends $10,000,000 to DS in exchange for a 10-year 
note that pays interest annually at a rate of 8 percent per annum. FS 
would not have had sufficient funds to make the loan to DS without the 
loan from FP. FS does not enter into any long-term hedging transaction 
with respect to these financing transactions, but manages the interest 
rate and currency risk arising from the transactions on a daily, weekly 
or quarterly basis by entering into forward currency contracts.
    (ii) Because FS performs significant financing activities with 
respect to the financing transactions between FS, DS and FP, the 
participation of FS in the

[[Page 492]]

financing arrangement is presumed not to be pursuant to a tax avoidance 
plan. The director of field operations may rebut this presumption by 
establishing that the participation of FS is pursuant to a tax avoidance 
plan, based on all the facts and circumstances. The mere fact that FS is 
a resident of country T is not sufficient to establish the existence of 
a tax avoidance plan. However, the existence of a plan can be inferred 
from other factors in addition to the fact that FS is a resident of 
country T. For example, the loans are made within a short time period 
and FS would not have been able to make the loan to DS without the loan 
from FP.
    (26) Example 26. Determination of amount of tax liability. (i) On 
January 1, 1996, FP makes two three-year installment loans of $250,000 
each to FS that pay interest at a rate of 9 percent per annum. The loans 
are self-amortizing with payments on each loan of $7,950 per month. On 
the same date, FS lends $1,000,000 to DS in exchange for a two-year note 
that pays interest semi-annually at a rate of 10 percent per annum, 
beginning on June 30, 1996. The FS-DS loan is not self-amortizing. 
Assume that for the period of January 1, 1996 through June 30, 1996, the 
average principal amount of the financing transactions between FP and FS 
that comprise the financing arrangement is $469,319. Further, assume 
that for the period of July 1, 1996 through December 31, 1996, the 
average principal amount of the financing transactions between FP and FS 
is $393,632. The average principal amount of the financing transaction 
between FS and DS for the same periods is $1,000,000. The director of 
field operations determines that the financing transactions between FP 
and FS, and FS and DS, are a conduit financing arrangement.
    (ii) Pursuant to paragraph (d)(1)(i) of this section, the portion of 
the $50,000 interest payment made by DS to FS on June 30, 1996, that is 
recharacterized as a payment to FP is $23,450 computed as follows: 
($50,000 x $469,319/$1,000,000) = $23,450. The portion of the interest 
payment made on December 31, 1996 that is recharacterized as a payment 
to FP is $19,650, computed as follows: ($50,000 x $393,632/$1,000,000) = 
$19,650. Furthermore, under Sec.  1.1441-3(g), DS is liable for 
withholding tax at a 30 percent rate on the portion of the $50,000 
payment to FS that is recharacterized as a payment to FP, i.e., $7,035 
with respect to the June 30, 1996 payment and $5,895 with respect to the 
December 31, 1996 payment.
    (27) Example 27. Determination of principal amount. (i) FP lends DM 
5,000,000 to FS in exchange for a ten year note that pays interest semi-
annually at a rate of 8 percent per annum. Six months later, pursuant to 
a tax avoidance plan, FS lends DM 10,000,000 to DS in exchange for a 10 
year note that pays interest semi-annually at a rate of 10 percent per 
annum. At the time FP make its loan to FS, the exchange rate is DM 1.5/
$1. At the time FS makes its loan to DS the exchange rate is DM 1.4/$1.
    (ii) FP's loan to FS and FS' loan to DS are financing transactions 
and together constitute a financing arrangement. Furthermore, because 
the participation of FS reduces the tax imposed under section 881 and 
FS' participation is pursuant to a tax avoidance plan, the financing 
arrangement is a conduit financing arrangement.
    (iii) Pursuant to paragraph (d)(1)(i) of this section, the amount 
subject to recharacterization is a fraction the numerator of which is 
the lowest aggregate principal amount advanced and the denominator of 
which is the principal amount advanced from FS to DS. Because the 
property advanced in these financing transactions is the same type of 
fungible property, under paragraph (d)(1)(ii)(A) of this section, both 
are valued on the date of the last financing transaction. Accordingly, 
the portion of the payments of interest that is recharacterized is ((DM 
5,000,000 x DM 1.4/$1)/(DM 10,000,000 x DM 1.4/$1) or 0.5.
    (f) Applicability date. This section is effective for payments made 
by financed entities on or after September 11, 1995. This section shall 
not apply to interest payments covered by section 127(g)(3) of the Tax 
Reform Act of 1984, and to interest payments with respect to other debt 
obligations issued prior to October 15, 1984 (whether or not such debt 
was issued by a Netherlands Antilles corporation). Paragraphs 
(a)(2)(i)(C) and (e)(3) (Example 3) of this section apply to payments 
made on or after

[[Page 493]]

December 9, 2011. Paragraph (a)(2)(ii)(B)(1)(iv) of this section applies 
to payments made on or after November 12, 2020.

[T.D. 8611, 60 FR 41005, Aug. 11, 1995; 60 FR 55312, Oct. 31, 1995; 63 
FR 67578, Dec. 8, 1998; T.D. 9562, 76 FR 76896, Dec. 9, 2011; 77 FR 
22480, Apr. 16, 2012; T.D. 9922, 85 FR 72055, Nov. 12, 2020; 86 FR 
54367, Oct. 1, 2021]



Sec.  1.881-4  Recordkeeping requirements concerning conduit 
financing arrangements.

    (a) Scope. This section provides rules for the maintenance of 
records concerning certain financing arrangements to which the 
provisions of Sec.  1.881-3 apply.
    (b) Recordkeeping requirements--(1) In general. Any person subject 
to the general recordkeeping requirements of section 6001 must keep the 
permanent books of account or records, as required by section 6001, that 
may be relevant to determining whether that person is a party to a 
financing arrangement and whether that financing arrangement is a 
conduit financing arrangement.
    (2) Application of Sections 6038 and 6038A. A financed entity that 
is a reporting corporation within the meaning of section 6038A(a) and 
the regulations under that section, and any other person that is subject 
to the recordkeeping requirements of Sec.  1.6038A-3, must comply with 
those recordkeeping requirements with respect to records that may be 
relevant to determining whether the financed entity is a party to a 
financing arrangement and whether that financing arrangement is a 
conduit financing arrangement. Such records, including records that a 
person is required to maintain pursuant to paragraph (c) of this 
section, shall be considered records that are required to be maintained 
pursuant to section 6038 or 6038A. Accordingly, the provisions of 
sections 6038 and 6038A (including, without limitation, the penalty 
provisions thereof), and the regulations under those sections, shall 
apply to any records required to be maintained pursuant to this section.
    (c) Records to be maintained--(1) In general. An entity described in 
paragraph (b) of this section shall be required to retain any records 
containing the following information concerning each financing 
transaction that the entity knows or has reason to know comprises the 
financing arrangement--
    (i) The nature (e.g., loan, stock, lease, license) of each financing 
transaction;
    (ii) The name, address, taxpayer identification number (if any) and 
country of residence of--
    (A) Each person that advanced money or other property, or granted 
rights to use property;
    (B) Each person that was the recipient of the advance or rights; and
    (C) Each person to whom a payment was made pursuant to the financing 
transaction (to the extent that person is a different person than the 
person who made the advance or granted the rights);
    (iii) The date and amount of--
    (A) Each advance of money or other property or grant of rights; and
    (B) Each payment made in return for the advance or grant of rights;
    (iv) The terms of any guarantee provided in conjunction with a 
financing transaction, including the name of the guarantor; and
    (v) In cases where one or both of the parties to a financing 
transaction are related to each other or another entity in the financing 
arrangement, the manner in which these persons are related.
    (2) Additional documents. An entity described in paragraph (b) of 
this section must also retain all records relating to the circumstances 
surrounding its participation in the financing transactions and 
financing arrangements. Such documents may include, but are not limited 
to--
    (i) Minutes of board of directors meetings;
    (ii) Board resolutions or other authorizations for the financing 
transactions;
    (iii) Private letter rulings;
    (iv) Financial reports (audited or unaudited);
    (v) Notes to financial statements;
    (vi) Bank statements;
    (vii) Copies of wire transfers;
    (viii) Offering documents;
    (ix) Materials from investment advisors, bankers and tax advisors; 
and
    (x) Evidences of indebtedness.

[[Page 494]]

    (3) Effect of record maintenance requirement. Record maintenance in 
accordance with paragraph (b) of this section generally does not require 
the original creation of records that are ordinarily not created by 
affected entities. If, however, a document that is actually created is 
described in this paragraph (c), it is to be retained even if the 
document is not of a type ordinarily created by the affected entity.
    (d) Effective date. This section is effective September 11, 1995. 
This section shall not apply to interest payments covered by section 
127(g)(3) of the Tax Reform Act of 1984, and to interest payments with 
respect to other debt obligations issued prior to October 15, 1984 
(whether or not such debt was issued by a Netherlands Antilles 
corporation).

[T.D. 8611, 60 FR 41014, Aug. 11, 1995]



Sec.  1.881-5  Exception for certain possessions corporations.

    (a) Scope. Section 881(b) and this section provide special rules for 
the application of sections 881 and 884 to certain corporations created 
or organized in possessions of the United States. Paragraph (g) of this 
section provides special rules for the application of sections 881 and 
884 to corporations created or organized in the United States for 
purposes of determining tax liability incurred to certain possessions 
that administer income tax laws that are identical (except for the 
substitution of the name of the possession for the term ``United 
States'' where appropriate) to those in force in the United States. See 
Sec.  1.884-0(b) for special rules relating to the application of 
section 884 with respect to possessions of the United States.
    (b) Operative rules. (1) Corporations described in paragraphs (c) 
and (d) of this section are not treated as foreign corporations for 
purposes of section 881. Accordingly, they are exempt from the tax 
imposed by section 881(a).
    (2) For corporations described in paragraph (e) of this section, the 
rate of tax imposed by section 881(a) on U.S. source dividends received 
is 10 percent (rather than the generally applicable 30 percent).
    (c) U.S. Virgin Islands and section 931 possessions. A corporation 
created or organized in, or under the law of, the U.S. Virgin Islands or 
a section 931 possession is described in this paragraph (c) for a 
taxable year when the following conditions are satisfied--
    (1) At all times during such taxable year, less than 25 percent in 
value of the stock of such corporation is beneficially owned (directly 
or indirectly) by foreign persons;
    (2) At least 65 percent of the gross income of such corporation is 
shown to the satisfaction of the Commissioner upon examination to be 
effectively connected with the conduct of a trade or business in such a 
possession or the United States for the 3-year period ending with the 
close of the taxable year of such corporation (or for such part of such 
period as the corporation or any predecessor has been in existence); and
    (3) No substantial part of the income of such corporation for the 
taxable year is used (directly or indirectly) to satisfy obligations to 
persons who are not bona fide residents of such a possession or the 
United States.
    (d) Section 935 possessions. A corporation created or organized in, 
or under the law of, a section 935 possession is described in this 
paragraph (d) for a taxable year when the following conditions are 
satisfied--
    (1) At all times during such taxable year, less than 25 percent in 
value of the stock of such corporation is owned (directly or indirectly) 
by foreign persons; and
    (2) At least 20 percent of the gross income of such corporation is 
shown to the satisfaction of the Commissioner upon examination to have 
been derived from sources within such possession for the 3-year period 
ending with the close of the preceding taxable year of such corporation 
(or for such part of such period as the corporation has been in 
existence).
    (e) Puerto Rico. A corporation created or organized in, or under the 
law of, Puerto Rico is described in this paragraph (e) for a taxable 
year when the conditions of paragraphs (c)(1) through (c)(3) of this 
section are satisfied (using the language ``Puerto Rico'' instead of 
``such a possession'').
    (f) Definitions and other rules. For purposes of this section--
    (1) ``Section 931 possession'' is defined in Sec.  1.931-1(c)(1);and

[[Page 495]]

    (2) ``Section 935 possession'' is defined in Sec.  1.935-1(a)(3)(i).
    (3) Foreign person means any person other than--
    (i) A United States person (as defined in section 7701(a)(30) and 
the regulations under that section); or
    (ii) A person who would be a United States person if references to 
the United States in section 7701 included references to a possession of 
the United States.
    (4) Bona fide resident--
    (i) With respect to a particular possession, means--
    (A) An individual who is a bona fide resident of the possession as 
defined in Sec.  1.937-1; or
    (B) A business entity organized under the laws of the possession and 
taxable as a corporation in the possession; and
    (ii) With respect to the United States, means--
    (A) An individual who is a citizen or resident of the United States 
(as defined under section 7701(b)(1)(A)); or
    (B) A business entity organized under the laws of the United States 
or any State that is classified as a corporation for Federal tax 
purposes under Sec.  301.7701-2(b) of this chapter.
    (5) Source. The rules of Sec.  1.937-2 will apply for determining 
whether income is from sources within a possession.
    (6) Effectively connected income. The rules of Sec.  1.937-3 (other 
than paragraph (c) of that section) will apply for determining whether 
income is effectively connected with the conduct of a trade or business 
in a possession.
    (7) Indirect ownership. The rules of section 318(a)(2) will apply 
except that the language ``5 percent'' will be used instead of ``50 
percent'' in section 318(a)(2)(C).
    (g) Mirror code jurisdictions. For purposes of applying mirrored 
section 881 to determine tax liability incurred to a section 935 
possession or the U.S. Virgin Islands--
    (1) The rules of paragraphs (b) through (d) of this section will not 
apply; and
    (2) A corporation created or organized in, or under the law of, such 
possession or the United States will not be considered a foreign 
corporation.
    (h) Example. The principles of this section are illustrated by the 
following example:

    Example. X is a corporation organized under the law of the U.S. 
Virgin Islands with a branch located in State F. At least 65 percent of 
the gross income of X is effectively connected with the conduct of a 
trade or business in the U.S. Virgin Islands and no substantial part of 
the income of X for the taxable year is used to satisfy obligations to 
persons who are not bona fide residents of the United States or the U.S. 
Virgin Islands. Seventy-four percent of the stock of X is owned by 
unrelated individuals who are residents of the United States or the U.S. 
Virgin Islands. Y, a corporation organized under the law of State D, and 
Z, a partnership organized under the law of State F, each own 13 percent 
of the stock of X. A, an unrelated foreign individual, owns 100 percent 
of the stock of corporation Y. B and C, unrelated foreign individuals, 
each own a 50 percent interest in partnership Z. Thus, the condition of 
paragraph (c)(1) of this section is not satisfied, because 26 percent of 
X is owned indirectly by foreign persons (A, B, and C). Accordingly, X 
is treated as a foreign corporation for purposes of section 881.

    (i) Effective/applicability dates. Except as otherwise provided in 
this paragraph (i), this section applies to payments made in taxable 
years ending after April 9, 2008. If, on or after April 9, 2008, there 
takes effect an increase in the Commonwealth of Puerto Rico's 
withholding tax generally applicable to dividends paid to United States 
corporations not engaged in a trade or business in the Commonwealth to a 
rate greater than 10 percent, the rules of paragraphs (b)(2) and (e) of 
this section will not apply to dividends received on or after the 
effective date of the increase. Paragraph (f)(4) of this section applies 
to payments made after January 31, 2006. Taxpayers may choose to apply 
paragraph (f)(4) of this section to payments made after October 22, 
2004.

[T.D. 9248, 71 FR 5001, Jan. 31, 2006, as amended by T.D. 9391, 73 FR 
19359, Apr. 9, 2008; 73 FR 27728, May 14, 2008]



Sec.  1.882-0  Table of contents.

    This section lists captions contained in Sec. Sec.  1.882-1, 1.882-
2, 1.882-3, 1.882-4 and 1.882-5.

[[Page 496]]

Sec.  1.882-1 Taxation of foreign corporations engaged in U.S. business 
   or of foreign corporations treated as having effectively connected 
                                 income.

    (a) Segregation of income.
    (b) Imposition of tax.
    (1) Income not effectively connected with the conduct of a trade or 
business in the United States.
    (2) Income effectively connected with the conduct of a trade or 
business in the United States.
    (i) In general.
    (ii) Determination of taxable income.
    (iii) Cross references.
    (c) Change in trade or business status.
    (d) Credits against tax.
    (e) Payment of estimated tax.
    (f) Effective date.

   Sec.  1.882-2 Income of foreign corporation treated as effectively 
                      connected with U.S. business.

    (a) Election as to real property income.
    (b) Interest on U.S. obligations received by banks organized in 
possessions.
    (c) Treatment of income.
    (d) Effective date.

          Sec.  1.882-3 Gross income of a foreign corporation.

    (a) In general.
    (1) Inclusions.
    (2) Exchange transactions.
    (3) Exclusions.
    (b) Foreign corporations not engaged in U.S. business.
    (c) Foreign corporations engaged in U.S. business.
    (d) Effective date.

      Sec.  1.882-4 Allowance of deductions and credits to foreign 
                              corporations.

    (a) Foreign corporations.
    (1) In general.
    (2) Return necessary.
    (3) Filing deadline for return.
    (4) Return by Internal Revenue Service.
    (b) Allowed deductions and credits.
    (1) In general.
    (2) Verification.

           Sec.  1.882-5 Determination of interest deduction.

    (a)(1) Overview.
    (i) In general.
    (ii) Direct allocations.
    (A) In general.
    (B) Partnership interests.
    (2) Coordination with tax treaties.
    (3) Limitation on interest expense.
    (4) Translation convention for foreign currency.
    (5) Coordination with other sections.
    (6) Special rule for foreign governments.
    (7) Elections under Sec.  1.882-5.
    (i) In general.
    (ii) Failure to make the proper election.
    (iii) Step 2 special election for banks.
    (8) Examples.
    (b) Step 1: Determination of total value of U.S. assets for the 
taxable year.
    (1) Classification of an asset as a U.S. asset.
    (i) General rule.
    (ii) Items excluded from the definition of U.S. asset.
    (iii) Items included in the definition of U.S. asset.
    (iv) Interbranch transactions.
    (v) Assets acquired to increase U.S. assets artificially.
    (2) Determination of the value of a U.S. asset.
    (i) General rule.
    (ii) Fair-market value election.
    (A) In general.
    (B) Adjustment to partnership basis.
    (iii) Reduction of total value of U.S. assets by amount of bad debt 
reserves under section 585.
    (A) In general.
    (B) Example.
    (3) Computation of total value of U.S. assets.
    (i) General rule.
    (ii) Adjustment to basis of financial instruments.
    (c) Step 2: Determination of total amount of U.S.-connected 
liabilities for the taxable year.
    (1) General rule.
    (2) Computation of the actual ratio.
    (i) In general.
    (ii) Classification of items.
    (iii) Determination of amount of worldwide liabilities.
    (iv) Determination of value of worldwide assets.
    (v) Hedging transactions.
    (vi) Treatment of partnership interests and liabilities.
    (vii) Computation of actual ratio of insurance companies.
    (viii) Interbranch transactions.
    (ix) Amounts must be expressed in a single currency.
    (3) Adjustments.
    (4) Elective fixed ratio method of determining U.S. liabilities.
    (5) Examples.
    (d) Step 3: Determination of amount of interest expense allocable to 
ECI under the adjusted U.S. booked liabilities method.
    (1) General rule.
    (2) U.S. booked liabilities.
    (i) In general.
    (ii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is not a bank.
    (A) In general.
    (B) Identified liabilities not properly reflected.

[[Page 497]]

    (iii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is a bank.
    (A) In general.
    (B) Inadvertent error.
    (iv) Liabilities of insurance companies.
    (v) Liabilities used to increase artificially interest expense on 
U.S. booked liabilities.
    (vi) Hedging transactions.
    (vii) Amount of U.S. booked liabilities of a partner.
    (viii) Interbranch transactions.
    (3) Average total amount of U.S. booked liabilities.
    (4) Interest expense where U.S. booked liabilities equal or exceed 
U.S. liabilities.
    (i) In general.
    (ii) Scaling ratio.
    (iii) Special rules for insurance companies.
    (5) U.S.-connected interest rate where U.S. booked liabilities are 
less than U.S.-connected liabilities.
    (i) In general.
    (ii) Interest rate on excess U.S.-connected liabilities.
    (A) General rule.
    (B) Annual published rate election.
    (6) Examples.
    (e) Separate currency pools method.
    (1) General rule.
    (i) Determine the value of U.S. assets in each currency pool.
    (ii) Determine the U.S.-connected liabilities in each currency pool.
    (iii) Determine the interest expense attributable to each currency 
pool.
    (2) Prescribed interest rate.
    (3) Hedging transactions.
    (4) Election not available if excessive hyperinflationary assets.
    (5) Examples.
    (f) Effective date.
    (1) General rule.
    (2) Special rules for financial products.

[T.D. 8658, 61 FR 9329, Mar. 8, 1996; 61 FR 15891, Apr. 10, 1996, as 
amended by T.D. 9281, 71 FR 47448, Aug. 17, 2006; T.D. 9465, 74 FR 
49317, Sept. 28, 2009]



Sec.  1.882-1  Taxation of foreign corporations engaged in U.S. business 
or of foreign corporations treated as having effectively connected income.

    (a) Segregation of income. This section applies for purposes of 
determining the tax of a foreign corporation which at any time during 
the taxable year is engaged in trade or business in the United States. 
It also applies for purposes of determining the tax of a foreign 
corporation which at no time during the taxable year is engaged in trade 
or business in the United States but has for the taxable year real 
property income or interest on obligations of the United States which, 
by reason of section 882 (d) or (e) and Sec.  1.882-2, is treated as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation. A foreign 
corporation to which this section applies must segregate its gross 
income for the taxable year into two categories, namely, the income 
which is effectively connected for the taxable year with the conduct of 
a trade or business in the United States by that corporation and the 
income which is not effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that corporation. 
A separate tax shall then be determined upon each such category of 
income, as provided in paragraph (b) of this section. The determination 
of whether income or gain is or is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by the foreign corporation shall be made in accordance with 
section 864(c) and Sec. Sec.  1.864-3 through 1.864-7. For purposes of 
this section income which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States includes 
all income which is treated under section 882 (d) or (e) and Sec.  
1.882-2 as income which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States by the 
foreign corporation.
    (b) Imposition of tax--(1) Income not effectively connected with the 
conduct of a trade or business in the United States. If a foreign 
corporation to which this section applies derives during the taxable 
year from sources within the United States income or gains described in 
section 881(a) and paragraph (b) or (c) of Sec.  1.881-2 which are not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation, such income or 
gains shall be subject to a flat tax of 30 percent of the aggregate 
amount of such items. This tax shall be determined in the manner, and 
subject to the same conditions, set forth in Sec.  1.881-2 as though the 
income or gains were derived by a foreign corporation not engaged in 
trade or business in the United States during the

[[Page 498]]

taxable year, except that in applying paragraph (c) of such section 
there shall not be taken into account any gains which are taken into 
account in determining the tax under section 882(a)(1) and subparagraph 
(2) of this paragraph.
    (2) Income effectively connected with the conduct of a trade or 
business in the United States--(i) In general. If a foreign corporation 
to which this section applies derives income or gains which are 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation, the taxable income 
or gains shall, except as provided in Sec.  1.871-12, be taxed in 
accordance with section 11 or, in the alternative, section 1201(a). See 
sections 11(f) and 882(a)(1). Any income of the foreign corporation 
which is not effectively connected for the taxable year with the conduct 
of a trade or business in the United States by that corporation shall 
not be taken into account in determining either the rate or amount of 
such tax.
    (ii) Determination of taxable income. The taxable income for any 
taxable year for purposes of this subparagraph consists only of the 
foreign corporation's taxable income which is effectively connected for 
the taxable year with the conduct of a trade or business in the United 
States by that corporation; and, for this purpose, it is immaterial that 
the trade or business with which that income is effectively connected is 
not the same as the trade or business carried on in the United States by 
that corporation during the taxable year. See example 2 in Sec.  1.864-
4(b). In determining such taxable income all amounts constituting, or 
considered to be, gains or losses for the taxable year from the sale or 
exchange of capital assets shall be taken into account if such gains or 
losses are effectively connected for the taxable year with the conduct 
of a trade or business in the United States by that corporation.
    (iii) Cross references. For rules for determining the gross income 
and deductions for the taxable year, see section 882 (b) and (c)(1) and 
the regulations thereunder.
    (c) Change in trade or business status. The principles of paragraph 
(c) of Sec.  1.871-8 shall apply to cases where there has been a change 
in the trade or business status of a foreign corporation.
    (d) Credits against tax. The credits allowed by section 32 (relating 
to tax withheld at source on foreign corporations), section 33 (relating 
to the foreign tax credit), section 38 (relating to investment in 
certain depreciable property), section 39 (relating to certain uses of 
gasoline and lubricating oil), section 40 (relating to expenses of work 
incentive programs), and section 6042 (relating to overpayments of a 
tax) shall be allowed against the tax determined in accordance with this 
section. However, the credits allowed by sections 33, 38, and 40 shall 
not be allowed against the flat tax of 30 percent imposed by section 
881(a) and paragraph (b)(1) of this section. For special rules 
applicable in determining the foreign tax credit, see section 906(b) and 
the regulations thereunder. For the disallowance of certain credits 
where a return is not filed for the taxable year see section 882(c)(2) 
and the regulations thereunder.
    (e) Payment of estimated tax. Every foreign corporation which for 
the taxable year is subject to tax under section 11 or 1201(a) and this 
section must make payment of its estimated tax in accordance with 
section 6154 and the regulations thereunder. In determining the amount 
of the estimated tax the foreign corporation must treat the tax imposed 
by section 881(a) and paragraph (b)(1) of this section as though it were 
a tax imposed by section 11.
    (f) Effective date. This section applies for taxable years beginning 
after December 31, 1966. For corresponding rules applicable to taxable 
years beginning before January 1, 1967, see 26 CFR 1.882-1 (Revised as 
of January 1, 1971).

[T.D. 7293, 38 FR 32797, Nov. 28, 1973]



Sec.  1.882-2  Income of foreign corporations treated as effectively connected 
with U.S. business.

    (a) Election as to real property income. A foreign corporation which 
during the taxable year derives any income from real property which is 
located in the United States, or derives income from

[[Page 499]]

any interest in any such real property, may elect, pursuant to section 
882(d) and Sec.  1.871-10, to treat all such income as income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation. The election may 
be made whether or not the foreign corporation is engaged in trade or 
business in the United States during the taxable year for which the 
election is made or whether or not the corporation has income from real 
property which for the taxable year is effectively connected with the 
conduct of a trade or business in the United States, but it may be made 
only with respect to income from sources within the United States which, 
without regard to section 882(d) and Sec.  1.871-10, is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that corporation. The income to which the 
election applies shall be determined as provided in paragraph (b) of 
Sec.  1.871-10 and shall be subject to tax in the manner, and subject to 
the same conditions, provided by section 882(a)(1) and paragraph (b)(2) 
of Sec.  1.882-1. Section 871(d) (2) and (3) and the provisions of Sec.  
1.871-10 thereunder shall apply in respect of an election under section 
882(d) in the same manner and to the same extent as they apply in 
respect of elections under section 871(d).
    (b) Interest on U.S. obligations received by banks organized in 
possessions. Interest received from sources within the United States 
during the taxable year on obligations of the United States by a foreign 
corporation created or organized in, or under the law of, a possession 
of the United States and carrying on the banking business in a 
possession of the United States during the taxable year shall be 
treated, pursuant to section 882(e) and this paragraph, as income which 
is effectively connected for the taxable year with the conduct of a 
trade or business in the United States by that corporation. This 
paragraph applies whether or not the foreign corporation is engaged in 
trade or business in the United States at any time during the taxable 
year but only with respect to income which, without regard to this 
paragraph, is not effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that corporation. 
Any interest to which this paragraph applies shall be subject to tax in 
the manner, and subject to the same conditions, provided by section 
882(a)(1) and paragraph (b)(2) of Sec.  1.882-1. To the extent that 
deductions are connected with interest to which this paragraph applies, 
they shall be treated for purposes of section 882(c)(1) and the 
regulations thereunder as connected with income which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by the foreign corporation. An election by the 
taxpayer is not required in respect of the income to which this 
paragraph applies. For purposes of this paragraph the term ``possession 
of the United States'' includes Guam, the Midway Islands, the Panama 
Canal Zone, the Commonwealth of Puerto Rico, American Samoa, the Virgin 
Islands, and Wake Island.
    (c) Treatment of income. Any income in respect of which an election 
described in paragraph (a) of this section is in effect, and any 
interest to which paragraph (b) of this section applies, shall be 
treated, for purposes of paragraph (b)(2) of Sec.  1.882-1 and paragraph 
(a) of Sec.  1.1441-4, as income which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by the foreign corporation. A foreign corporation shall not be 
treated as being engaged in trade or business in the United States 
merely by reason of having such income for the taxable year.
    (d) Effective date. This section applies for taxable years beginning 
after December 31, 1966. There are no corresponding rules in this part 
for taxable years beginning before January 1, 1967.

[T.D. 7293, 38 FR 32798, Nov. 28, 1973]



Sec.  1.882-3  Gross income of a foreign corporation.

    (a) In general--(1) Inclusions. The gross income of a foreign 
corporation for any taxable year includes only (i) the gross income 
which is derived from sources within the United States and which is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States

[[Page 500]]

by that corporation and (ii) the gross income, irrespective of whether 
such income is derived from sources within or without the United States, 
which is effectively connected for the taxable year with the conduct of 
a trade or business in the United States by that corporation. For the 
determination of the sources of income, see sections 861 through 863, 
and the regulations thereunder. For the determination of whether income 
from sources within or without the United States is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States, see sections 864(c) and 882 (d) and (e), 
Sec. Sec.  1.864-3 through 1.864-7, and Sec.  1.882-2.
    (2) Exchange transactions. Even though a foreign corporation which 
effects certain transactions in the United States in stocks, securities, 
or commodities during the taxable year may not, by reason of section 
864(b)(2) and paragraph (c) or (d) of Sec.  1.864-2, be engaged in trade 
or business in the United States during the taxable year through the 
effecting of such transactions, nevertheless it shall be required to 
include in gross income for the taxable year the gains and profits from 
those transactions to the extent required by paragraph (c) of Sec.  
1.881-2 or by paragraph (a) of Sec.  1.882-1.
    (3) Exclusions. For exclusions from gross income of a foreign 
corporation, see Sec.  1.883-1.
    (b) Foreign corporations not engaged in U.S. business. In the case 
of a foreign corporation which at no time during the taxable year is 
engaged in trade or business in the United States the gross income shall 
include only (1) the gross income from sources within the United States 
which is described in section 881(a) and paragraphs (b) and (c) of Sec.  
1.881-2, and (2) the gross income from sources within the United States 
which, by reason of section 882 (d) or (e) and Sec.  1.882-2, is treated 
as effectively connected for the taxable year with the conduct of a 
trade or business in the United States by that corporation.
    (c) Foreign corporations engaged in U.S. business. In the case of a 
foreign corporation which is engaged in trade or business in the United 
States at any time during the taxable year, the gross income shall 
include (1) the gross income from sources within and without the United 
States which is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that corporation, 
(2) the gross income from sources within the United States which, by 
reason of section 882 (d) or (e) and Sec.  1.882-2, is treated as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation, and (3) the gross 
income from sources within the United States which is described in 
section 881(a) and paragraphs (b) and (c) of Sec.  1.881-2 and is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation.
    (d) Effective date. This section applies for taxable years beginning 
after December 31, 1966. For corresponding rules applicable to taxable 
years beginning before January 1, 1967, see 26 CFR 1.882-2 (Revised as 
of January 1, 1971).

[T.D. 7293, 38 FR 32799, Nov. 28, 1973]



Sec.  1.882-4  Allowance of deductions and credits to foreign corporations.

    (a) Foreign corporations--(1) In general. A foreign corporation that 
is engaged in, or receives income treated as effectively connected with, 
a trade or business within the United States is allowed the deductions 
which are properly allocated and apportioned to the foreign 
corporation's gross income which is effectively connected, or treated as 
effectively connected, with its conduct of a trade or business within 
the United States. The foreign corporation is entitled to credits which 
are attributable to that effectively connected income. No provision of 
this section (other than paragraph (b)(2)) shall be construed to deny 
the credits provided by sections 33, 34 and 852(b)(3)(D)(ii) or the 
deduction allowed by section 170.
    (2) Return necessary. A foreign corporation shall receive the 
benefit of the deductions and credits otherwise allowed to it with 
respect to the income tax, only if it timely files or causes to be filed 
with the Philadelphia Service Center, in the manner prescribed in 
subtitle F, a true and accurate return of its taxable income which is 
effectively connected, or treated as

[[Page 501]]

effectively connected, for the taxable year with the conduct of a trade 
or business in the United States by that corporation. The deductions and 
credits allowed such a corporation electing under a tax convention to be 
subject to tax on a net basis may be obtained by filing a return of 
income in the manner prescribed in the regulations (if any) under the 
tax convention or under any other guidance issued by the Commissioner.
    (3) Filing deadline for return. (i) As provided in paragraph (a)(2) 
of this section, for purposes of computing the foreign corporation's 
taxable income for any taxable year, otherwise allowable deductions 
(other than that allowed by section 170) and credits (other than those 
allowed by sections 33, 34 and 852(b)(3)(D)(ii)) will be allowed only if 
a return for that taxable year is filed by the foreign corporation on a 
timely basis. For taxable years of a foreign corporation ending after 
July 31, 1990, whether a return for the current taxable year has been 
filed on a timely basis is dependent upon whether the foreign 
corporation filed a return for the taxable year immediately preceding 
the current taxable year. If a return was filed for that immediately 
preceding taxable year, or if the current taxable year is the first 
taxable year of the foreign corporation for which a return is required 
to be filed, the required return for the current taxable year must be 
filed within 18 months of the due date as set forth in section 6072 and 
the regulations under that section, for filing the return for the 
current taxable year. If no return for the taxable year immediately 
preceding the current taxable year has been filed, the required return 
for the current taxable year (other than the first taxable year of the 
foreign corporation for which a return is required to be filed) must 
have been filed no later than the earlier of the date which is 18 months 
after the due date, as set forth in section 6072, for filing the return 
for the current taxable year or the date the Internal Revenue Service 
mails a notice to the foreign corporation advising the corporation that 
the current year tax return has not been filed and that no deductions 
(other than that allowed under section 170) or credits (other than those 
allowed under sections 33, 34 and 852(b)(3)(D)(ii)) may be claimed by 
the taxpayer.
    (ii) The filing deadlines set forth in paragraph (a)(3)(i) of this 
section may be waived if the foreign corporation establishes to the 
satisfaction of the Commissioner or his or her delegate that the 
corporation, based on the facts and circumstances, acted reasonably and 
in good faith in failing to file a U.S. income tax return (including a 
protective return (as described in paragraph (a)(3)(vi) of this 
section)). For this purpose, a foreign corporation shall not be 
considered to have acted reasonably and in good faith if it knew that it 
was required to file the return and chose not to do so. In addition, a 
foreign corporation shall not be granted a waiver unless it cooperates 
in the process of determining its income tax liability for the taxable 
year for which the return was not filed. The Commissioner or his or her 
delegate shall consider the following factors in determining whether the 
foreign corporation, based on the facts and circumstances, acted 
reasonably and in good faith in failing to file a U.S. income tax 
return--
    (A) Whether the corporation voluntarily identifies itself to the 
Internal Revenue Service as having failed to file a U.S. income tax 
return before the Internal Revenue Service discovers the failure to 
file;
    (B) Whether the corporation did not become aware of its ability to 
file a protective return (as described in paragraph (a)(3)(vi) of this 
section) by the deadline for filing a protective return;
    (C) Whether the corporation had not previously filed a U.S. income 
tax return;
    (D) Whether the corporation failed to file a U.S. income tax return 
because, after exercising reasonable diligence (taking into account its 
relevant experience and level of sophistication), the corporation was 
unaware of the necessity for filing the return;
    (E) Whether the corporation failed to file a U.S. income tax return 
because of intervening events beyond its control; and
    (F) Whether other mitigating or exacerbating factors existed.

[[Page 502]]

    (iii) The following examples illustrate the provisions of this 
section. In all examples, FC is a foreign corporation and uses the 
calendar year as its taxable year. The examples are as follows:

    Example 1. Foreign corporation discloses own failure to file. In 
Year 1, FC became a limited partner with a passive investment in a U.S. 
limited partnership that was engaged in a U.S. trade or business. During 
Year 1 through Year 4, FC incurred losses with respect to its U.S. 
partnership interest. FC's foreign tax director incorrectly concluded 
that because it was a limited partner and had only losses from its 
partnership interest, FC was not required to file a U.S. income tax 
return. FC's management was aware neither of FC's obligation to file a 
U.S. income tax return for those years, nor of its ability to file a 
protective return for those years. FC had never filed a U.S. income tax 
return before. In Year 5, FC began realizing a profit rather than a loss 
with respect to its partnership interest and, for this reason, engaged a 
U.S. tax advisor to handle its responsibility to file U.S. income tax 
returns. In preparing FC's income tax return for Year 5, FC's U.S. tax 
advisor discovered that returns were not filed for Year 1 through Year 
4. Therefore, with respect to those years for which applicable filing 
deadlines in paragraph (a)(3)(i) of this section were not met, FC would 
be barred by paragraph (a)(2) of this section from claiming any 
deductions that otherwise would have given rise to net operating losses 
on returns for those years, and that would have been available as loss 
carryforwards in subsequent years. At FC's direction, its U.S. tax 
advisor promptly contacted the appropriate examining personnel and 
cooperated with the Internal Revenue Service in determining FC's income 
tax liability, for example, by preparing and filing the appropriate 
income tax returns for Year 1 through Year 4 and by making FC's books 
and records available to an Internal Revenue Service examiner. FC has 
met the standard described in paragraph (a)(3)(ii) of this section for 
waiver of any applicable filing deadlines in paragraph (a)(3)(i) of this 
section.
    Example 2. Foreign corporation refuses to cooperate. Same facts as 
in Example 1, except that while FC's U.S. tax advisor contacted the 
appropriate examining personnel and filed the appropriate income tax 
returns for Year 1 through Year 4, FC refused all requests by the 
Internal Revenue Service to provide supporting information (for example, 
books and records) with respect to those returns. Because FC did not 
cooperate in determining its U.S. tax liability for the taxable years 
for which an income tax return was not timely filed, FC is not granted a 
waiver as described in paragraph (a)(3)(ii) of this section of any 
applicable filing deadlines in paragraph (a)(3)(i) of this section.
    Example 3. Foreign corporation fails to file a protective return. 
Same facts as in Example 1, except that in Year 1 through Year 4, FC's 
tax director also consulted a U.S. tax advisor, who advised FC's tax 
director that it was uncertain whether U.S. income tax returns were 
necessary for those years and that FC could protect its right 
subsequently to claim the loss carryforwards by filing protective 
returns under paragraph (a)(3)(vi) of this section. FC did not file U.S. 
income tax returns or protective returns for those years. FC did not 
present evidence that intervening events beyond FC's control prevented 
it from filing an income tax return, and there were no other mitigating 
factors. FC has not met the standard described in paragraph (a)(3)(ii) 
of this section for waiver of any applicable filing deadlines in 
paragraph (a)(3)(i) of this section.
    Example 4. Foreign corporation with effectively connected income. In 
Year 1, FC, a technology company, opened an office in the United States 
to market and sell a software program that FC had developed outside the 
United States. FC had minimal business or tax experience 
internationally, and no such experience in the United States. Through 
FC's direct efforts, U.S. sales of the software produced income 
effectively connected with a U.S. trade or business. FC, however, did 
not file U.S. income tax returns for Year 1 or Year 2. FC's management 
was aware neither of FC's obligation to file a U.S. income tax return 
for those years, nor of its ability to file a protective return for 
those years. FC had never filed a U.S. income tax return before. In 
January of Year 4, FC engaged U.S. counsel in connection with licensing 
software to an unrelated U.S. company. U.S. counsel reviewed FC's U.S. 
activities and advised FC that it should have filed U.S. income tax 
returns for Year 1 and Year 2. FC immediately engaged a U.S. tax advisor 
who, at FC's direction, promptly contacted the appropriate examining 
personnel and cooperated with the Internal Revenue Service in 
determining FC's income tax liability, for example, by preparing and 
filing the appropriate income tax returns for Year 1 and Year 2 and by 
making FC's books and records available to an Internal Revenue Service 
examiner. FC has met the standard described in paragraph (a)(3)(ii) of 
this section for waiver of any applicable filing deadlines in paragraph 
(a)(3)(i) of this section.
    Example 5. IRS discovers foreign corporation's failure to file. In 
Year 1, FC, a technology company, opened an office in the United States 
to market and sell a software program that FC had developed outside the 
United States. Through FC's direct efforts, U.S. sales of the software 
produced income effectively connected with a U.S. trade or

[[Page 503]]

business. FC had extensive experience conducting similar business 
activities in other countries, including making the appropriate tax 
filings. However, FC's management was aware neither of FC's obligation 
to file a U.S. income tax return for those years, nor of its ability to 
file a protective return for those years. FC had never filed a U.S. 
income tax return before. Despite FC's extensive experience conducting 
similar business activities in other countries, it made no effort to 
seek advice in connection with its U.S. tax obligations. FC failed to 
file either U.S. income tax returns or protective returns for Year 1 and 
Year 2. In January of Year 4, an Internal Revenue Service examiner asked 
FC for an explanation of FC's failure to file U.S. income tax returns. 
FC immediately engaged a U.S. tax advisor, and cooperated with the 
Internal Revenue Service in determining FC's income tax liability, for 
example, by preparing and filing the appropriate income tax returns for 
Year 1 and Year 2 and by making FC's books and records available to the 
examiner. FC did not present evidence that intervening events beyond its 
control prevented it from filing a return, and there were no other 
mitigating factors. FC has not met the standard described in paragraph 
(a)(3)(ii) of this section for waiver of any applicable filing deadlines 
in paragraph (a)(3)(i) of this section.
    Example 6. Foreign corporation with prior filing history. FC began a 
U.S. trade or business in Year 1. FC's tax advisor filed the appropriate 
U.S. income tax returns for Year 1 through Year 6, reporting income 
effectively connected with FC's U.S. trade or business. In Year 7, FC 
replaced its tax advisor with a tax advisor unfamiliar with U.S. tax 
law. FC did not file a U.S. income tax return for any year from Year 7 
through Year 10, although it had effectively connected income for those 
years. FC's management was aware of FC's ability to file a protective 
return for those years. In Year 11, an Internal Revenue Service examiner 
contacted FC and asked its chief financial officer for an explanation of 
FC's failure to file U.S. income tax returns after Year 6. FC 
immediately engaged a U.S. tax advisor and cooperated with the Internal 
Revenue Service in determining FC's income tax liability, for example, 
by preparing and filing the appropriate income tax returns for Year 7 
through Year 10 and by making FC's books and records available to the 
examiner. FC did not present evidence that intervening events beyond its 
control prevented it from filing a return, and there were no other 
mitigating factors. FC has not met the standard described in paragraph 
(a)(3)(ii) of this section for waiver of any applicable filing deadlines 
in paragraph (a)(3)(i) of this section.

    (iv) Paragraphs (a)(3)(ii) and (iii) of this section are applicable 
to open years for which a request for a waiver is filed on or after 
January 29, 2002.
    (v) A foreign corporation which has a permanent establishment, as 
defined in an income tax treaty between the United States and the 
foreign corporation's country of residence, in the United States is 
subject to the filing deadlines set forth in paragraph (a)(3)(i) of this 
section.
    (vi) If a foreign corporation conducts limited activities in the 
United States in a taxable year which the foreign corporation determines 
does not give rise to gross income which is effectively connected with 
the conduct of a trade or business within the United States as defined 
in sections 882(b) and 864 (b) and (c) and the regulations under those 
sections, the foreign corporation may nonetheless file a return for that 
taxable year on a timely basis under paragraph (a)(3)(i) of this section 
and thereby protect the right to receive the benefit of the deductions 
and credits attributable to that gross income if it is later determined, 
after the return was filed, that the original determination was 
incorrect. On that timely filed return, the foreign corporation is not 
required to report any gross income as effectively connected with a 
United States trade or business or any deductions or credits but should 
attach a statement indicating that the return is being filed for the 
reason set forth in this paragraph (a)(3). If the foreign corporation 
determines that part of the activities which it conducts in the United 
States in a taxable year gives rise to gross income which is effectively 
connected with the conduct of a trade or business and part does not, the 
foreign corporation must timely file a return for that taxable year to 
report the gross income determined to be effectively connected, or 
treated as effectively connected, with the conduct of the trade or 
business within the United States and the deductions and credits 
attributable to the gross income. In addition, the foreign corporation 
should attach to that return the statement described in this paragraph 
(b)(3) with regard to the other activities. The foreign corporation may 
follow the same procedure if it determines initially

[[Page 504]]

that it has no United States tax liability under the provisions of an 
applicable income tax treaty. In the event the foreign corporation 
relies on the provisions of an income tax treaty to reduce or eliminate 
the income subject to taxation, or to reduce the rate of tax, disclosure 
may be required pursuant to section 6114.
    (vii) In order to be eligible for any deductions and credits for 
purposes of computing the accumulated earnings tax of section 531, a 
foreign corporation must file a true and accurate return; on a timely 
basis, in the manner as set forth in paragraph (a)(2) and (3) of this 
section.
    (4) Return by Internal Revenue Service. If a foreign corporation has 
various sources of income within the United States and a return of 
income has not been filed, in the manner prescribed by subtitle F, 
including the filing deadlines set forth in paragraph (a)(3) of this 
section, the Internal Revenue Service shall:
    (i) Cause a return of income to be made,
    (ii) Include on the return the income described in Sec.  1.882-1 of 
that corporation from all sources concerning which it has information, 
and
    (iii) Assess the tax and collect it from one or more of those 
sources of income within the United States, without allowance for any 
deductions (other than that allowed by section 170) or credits (other 
than those allowed by sections 33, 34 and 852(b)(3)(D)(ii)).
    If the income of the corporation is not effectively connected with, 
or if the corporation did not receive income that is treated as being 
effectively connected with, the conduct of a United States trade or 
business, the tax will be assessed under Sec.  1.882-1(b)(1) on a gross 
basis, without allowance for any deduction (other than that allowed by 
section 170) or credit (other than the credits allowed by sections 33, 
34 and 852(b)(3)(D)(ii)). If the income is effectively connected, or 
treated as effectively connected, with the conduct of a United States 
trade on business, tax will be assessed in accordance with either 
section 11, 55 or 1201(a) without allowance for any deduction (other 
than that allowed by section 170) or credit (other than the credits 
allowed by sections 33, 34 and 852(b)(3)(D)(ii)).
    (b) Allowed deductions and credits--(1) In general. Except for the 
deduction allowed under section 170 for charitable contributions and 
gifts (see section 882(c)(1)(B)), deductions are allowed to a foreign 
corporation only to the extent they are connected with gross income 
which is effectively connected, or treated as effectively connected, 
with the conduct of a trade or business in the United States. Deductible 
expenses (other than interest expense) are properly allocated and 
apportioned to effectively connected gross income in accordance with the 
rules of Sec.  1.861-8. For the method of determining the interest 
deduction allowed to a foreign corporation, see Sec.  1.882-5. Other 
than the credits allowed by sections 33, 34 and 852(b)(3)(D)(ii), the 
foreign corporation is entitled to credits only if they are attributable 
to effectively connected income. See paragraph (a)(2) of this section 
for the requirement that a return be filed. Except as provided by 
section 906, a foreign corporation shall not be allowed the credit 
against the tax for taxes of foreign countries and possessions of the 
United States allowed by section 901.
    (2) Verification. At the request of the Internal Revenue Service, a 
foreign corporation claiming deductions from gross income which is 
effectively connected, or treated as effectively connected, with the 
conduct of a trade or business in the United States or credits which are 
attributable to that income must furnish at the place designated 
pursuant to Sec.  301.7605-1(a) information sufficient to establish that 
the corporation is entitled to the deductions and credits in the amounts 
claimed. All information must be furnished in a form suitable to permit 
verification of claimed deductions and credits. The Internal Revenue 
Service may require, as appropriate, that an English translation be 
provided with any information in a foreign language. If a foreign 
corporation fails to furnish sufficient information, the Internal 
Revenue Service may in its discretion disallow any claimed deductions 
and credits in full or in part. For additional filing requirements and 
for penalties for failure

[[Page 505]]

to provide information, see also section 6038A.

[T.D. 8322, 55 FR 50830, Dec. 11, 1990, as amended by T.D. 8981, 67 FR 
4175, Jan. 29, 2002; T.D. 9043, 68 FR 11314, Mar. 10, 2003]



Sec.  1.882-5  Determination of interest deduction.

    (a)(1) Overview--(i) In general. The amount of interest expense of a 
foreign corporation that is allocable under section 882(c) to income 
which is (or is treated as) effectively connected with the conduct of a 
trade or business within the United States (ECI) is the sum of the 
interest allocable by the foreign corporation under the three-step 
process set forth in paragraphs (b), (c), and (d) of this section and 
the specially allocated interest expense determined under paragraph 
(a)(1)(ii) of this section. The provisions of this section provide the 
exclusive rules for allocating interest expense to the ECI of a foreign 
corporation under section 882(c). Under the three-step process, the 
total value of the U.S. assets of a foreign corporation is first 
determined under paragraph (b) of this section (Step 1). Next, the 
amount of U.S.-connected liabilities is determined under paragraph (c) 
of this section (Step 2). Finally, the amount of interest paid or 
accrued on U.S.-booked liabilities, as determined under paragraph (d)(2) 
of this section, is adjusted for interest expense attributable to the 
difference between U.S.-connected liabilities and U.S.-booked 
liabilities (Step 3). Alternatively, a foreign corporation may elect to 
determine its interest rate on U.S.-connected liabilities by reference 
to its U.S. assets, using the separate currency pools method described 
in paragraph (e) of this section.
    (ii) Direct allocations--(A) In general. A foreign corporation that 
has a U.S. asset and indebtedness that meet the requirements of Sec.  
1.861-10T (b) or (c), as limited by Sec.  1.861-10T(d)(1), shall 
directly allocate interest expense from such indebtedness to income from 
such asset in the manner and to the extent provided in Sec.  1.861-10T. 
For purposes of paragraph (b)(1) or (c)(2) of this section, a foreign 
corporation that allocates its interest expense under the direct 
allocation rule of this paragraph (a)(1)(ii)(A) shall reduce the basis 
of the asset that meets the requirements of Sec.  1.861-10T (b) or (c) 
by the principal amount of the indebtedness that meets the requirements 
of Sec.  1.861- 10T (b) or (c). The foreign corporation shall also 
disregard any indebtedness that meets the requirements of Sec.  1.861-
10T (b) or (c) in determining the amount of the foreign corporation's 
liabilities under paragraphs (c)(2) and (d)(2) of this section and shall 
not take into account any interest expense paid or accrued with respect 
to such a liability for purposes of paragraph (d) or (e) of this 
section.
    (B) Partnership interest. A foreign corporation that is a partner in 
a partnership that has a U.S. asset and indebtedness that meet the 
requirements of Sec.  1.861-10T (b) or (c), as limited by Sec.  1.861-
10T(d)(1), shall directly allocate its distributive share of interest 
expense from that indebtedness to its distributive share of income from 
that asset in the manner and to the extent provided in Sec.  1.861-10T. 
A foreign corporation that allocates its distributive share of interest 
expense under the direct allocation rule of this paragraph (a)(1)(ii)(B) 
shall disregard any partnership indebtedness that meets the requirements 
of Sec.  1.861-10T (b) or (c) in determining the amount of its 
distributive share of partnership liabilities for purposes of paragraphs 
(b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) of this section, and 
shall not take into account any partnership interest expense paid or 
accrued with respect to such a liability for purposes of paragraph (d) 
or (e) of this section. For purposes of paragraph (b)(1) of this 
section, a foreign corporation that directly allocates its distributive 
share of interest expense under this paragraph (a)(1)(ii)(B) shall--
    (1) Reduce the partnership's basis in such asset by the amount of 
such indebtedness in allocating its basis in the partnership under Sec.  
1.884-1(d)(3)(ii); or
    (2) Reduce the partnership's income from such asset by the 
partnership's interest expense from such indebtedness under Sec.  1.884-
1(d)(3)(iii).
    (2) Coordination with tax treaties. Except as expressly provided by 
or pursuant to a U.S. income tax treaty or accompanying documents (such 
as an exchange of notes), the provisions of this

[[Page 506]]

section provide the exclusive rules for determining the interest expense 
attributable to the business profits of a permanent establishment under 
a U.S. income tax treaty.
    (3) Limitation on interest expense. In no event may the amount of 
interest expense computed under this section exceed the amount of 
interest on indebtedness paid or accrued by the taxpayer within the 
taxable year (translated into U.S. dollars at the weighted average 
exchange rate for each currency prescribed by Sec.  1.989(b)-1 for the 
taxable year).
    (4) Translation convention for foreign currency. For each 
computation required by this section, the taxpayer shall translate 
values and amounts into the relevant currency at a spot rate or a 
weighted average exchange rate consistent with the method such taxpayer 
uses for financial reporting purposes, provided such method is applied 
consistently from year to year. Interest expense paid or accrued, 
however, shall be translated under the rules of Sec.  1.988-2. The 
director of field operations or the Assistant Commissioner 
(International) may require that any or all computations required by 
this section be made in U.S. dollars if the functional currency of the 
taxpayer's home office is a hyperinflationary currency, as defined in 
Sec.  1.985-1, and the computation in U.S. dollars is necessary to 
prevent distortions.
    (5) Coordination with other sections. Any provision that disallows, 
defers, or capitalizes interest expense applies after determining the 
amount of interest expense allocated to ECI under this section. For 
example, in determining the amount of interest expense that is 
disallowed as a deduction under section 265 or 163(j), deferred under 
section 163(e)(3) or 267(a)(3), or capitalized under section 263A with 
respect to a United States trade or business, a taxpayer takes into 
account only the amount of interest expense allocable to ECI under this 
section.
    (6) Special rule for foreign governments. The amount of interest 
expense of a foreign government, as defined in Sec.  1.892-2T(a), that 
is allocable to ECI is the total amount of interest paid or accrued 
within the taxable year by the United States trade or business on U.S. 
booked liabilities (as defined in paragraph (d)(2) of this section). 
Interest expense of a foreign government, however, is not allocable to 
ECI to the extent that it is incurred with respect to U.S. booked 
liabilities that exceed 80 percent of the total value of U.S. assets for 
the taxable year (determined under paragraph (b) of this section). This 
paragraph (a)(6) does not apply to controlled commercial entities within 
the meaning of Sec.  1.892-5T.
    (7) Elections under Sec.  1.882-5--(i) In general. A corporation 
must make each election provided in this section on the corporation's 
original timely filed Federal income tax return for the first taxable 
year it is subject to the rules of this section. An amended return does 
not qualify for this purpose, nor shall the provisions of Sec.  
301.9100-1 of this chapter and any guidance promulgated thereunder 
apply. Except as provided elsewhere in this section, each election under 
this section, whether an election for the first taxable year or a 
subsequent change of election, shall be made by indicating the method 
used on Schedule I (Form 1120-F) attached to the corporation's timely 
filed return. An elected method (other than the fair market value method 
under paragraph (b)(2)(ii) of this section, or the annual 30-day London 
Interbank Offered Rate (LIBOR) election in paragraph (d)(5)(ii) of this 
section) must be used for a minimum period of five years before the 
taxpayer may elect a different method. To change an election before the 
end of the requisite five-year period, a taxpayer must obtain the 
consent of the Commissioner or his delegate. The Commissioner or his 
delegate will generally consent to a taxpayer's request to change its 
election only in rare and unusual circumstances. After the five-year 
minimum period, an elected method may be changed for any subsequent year 
on the foreign corporation's original timely filed tax return for the 
first year to which the changed election applies.
    (ii) Failure to make the proper election. If a taxpayer, for any 
reason, fails to make an election provided in this section in a timely 
fashion, the Director of Field Operations may make any or

[[Page 507]]

all of the elections provided in this section on behalf of the taxpayer, 
and such elections shall be binding as if made by the taxpayer.
    (iii) Step 2 special election for banks. For the first taxable year 
for which an original income tax return is due (including extensions) 
after August 17, 2006, in which a taxpayer that is a bank as described 
in paragraph (c)(4) of this section is subject to the requirements of 
this section, a taxpayer may make a new election to use the fixed ratio 
on an original timely filed return. A new fixed ratio election may be 
made in any subsequent year subject to the timely filing and five-year 
minimum period requirements of paragraph (a)(7)(i) of this section. A 
new fixed ratio election under this paragraph (a)(7)(iii) is subject to 
the adjusted basis or fair market value conforming election requirements 
of paragraph (b)(2)(ii)(A)(2) of this section and may not be made if a 
taxpayer elects or maintains a fair market value election for purposes 
of paragraph (b) of this section. Taxpayers that already use the fixed 
ratio method under an existing election may continue to use the new 
fixed ratio at the higher percentage without having to make a new five-
year election in the first year that the higher percentage is effective.
    (8) Examples. The following examples illustrate the application of 
paragraph (a) of this section:

    Example 1. Direct allocations. (i) Facts: FC is a foreign 
corporation that conducts business through a branch, B, in the United 
States. Among B's U.S. assets is an interest in a partnership, P, that 
is engaged in airplane leasing solely in the U.S. FC contributes 200 x 
to P in exchange for its partnership interest. P incurs qualified 
nonrecourse indebtedness within the meaning of Sec.  1.861-10T to 
purchase an airplane. FC's share of the liability of P, as determined 
under section 752, is 800 x .
    (ii) Analysis: Pursuant to paragraph (a)(1)(ii)(B) of this section, 
FC is permitted to directly allocate its distributive share of the 
interest incurred with respect to the qualified nonrecourse indebtedness 
to FC's distributive share of the rental income generated by the 
airplane. A liability the interest on which is allocated directly to the 
income from a particular asset under paragraph (a)(1)(ii)(B) of this 
section is disregarded for purposes of paragraphs (b)(1), (c)(2)(vi), 
and (d)(2)(vii) or (e)(1)(ii) of this section. Consequently, for 
purposes of determining the value of FC's assets under paragraphs (b)(1) 
and (c)(2)(vi) of this section, FC's basis in P is reduced by the 800 x 
liability as determined under section 752, but is not increased by the 
800 x liability that is directly allocated under paragraph (a)(1)(ii)(B) 
of this section. Similarly, pursuant to paragraph (a)(1)(ii)(B) of this 
section, the 800 x liability is disregarded for purposes of determining 
FC's liabilities under paragraphs (c)(2)(vi) and (d)(2)(vii) of this 
section.
    Example 2. Limitation on interest expense. (i) FC is a foreign 
corporation that conducts a real estate business in the United States. 
In its 1997 tax year, FC has no outstanding indebtedness, and therefore 
incurs no interest expense. FC elects to use the 50% fixed ratio under 
paragraph (c)(4) of this section.
    (ii) Under paragraph (a)(3) of this section, FC is not allowed to 
deduct any interest expense that exceeds the amount of interest on 
indebtedness paid or accrued in that taxable year. Since FC incurred no 
interest expense in taxable year 1997, FC will not be entitled to any 
interest deduction for that year under Sec.  1.882-5, notwithstanding 
the fact that FC has elected to use the 50% fixed ratio.
    Example 3. Coordination with other sections. (i) FC is a foreign 
corporation that is a bank under section 585(a)(2) and a financial 
institution under section 265(b)(5). FC is a calendar year taxpayer, and 
operates a U.S. branch, B. Throughout its taxable year 1997, B holds 
only two assets that are U.S. assets within the meaning of paragraph 
(b)(1) of this section. FC does not make a fair-market value election 
under paragraph (b)(2)(ii) of this section, and, therefore, values its 
U.S. assets according to their bases under paragraph (b)(2)(i) of this 
section. The first asset is a taxable security with an adjusted basis of 
$100. The second asset is an obligation the interest on which is exempt 
from federal taxation under section 103, with an adjusted basis of $50. 
The tax-exempt obligation is not a qualified tax-exempt obligation as 
defined by section 265(b)(3)(B).
    (ii) FC calculates its interest expense under Sec.  1.882-5 to be 
$12. Under paragraph (a)(5) of this section, however, a portion of the 
interest expense that is allocated to FC's effectively connected income 
under Sec.  1.882-5 is disallowed in accordance with the provisions of 
section 265(b). Using the methodology prescribed under section 265, the 
amount of disallowed interest expense is $4, calculated as follows:
[GRAPHIC] [TIFF OMITTED] TR08MR96.000

    (iii) Therefore, FC deducts a total of $8 ($12-$4) of interest 
expense attributable to its effectively connected income in 1997.

[[Page 508]]

    Example 4. Treaty exempt asset. (i) FC is a foreign corporation, 
resident in Country X, that is actively engaged in the banking business 
in the United States through a permanent establishment, B. The income 
tax treaty in effect between Country X and the United States provides 
that FC is not taxable on foreign source income earned by its U.S. 
permanent establishment. In its 1997 tax year, B earns $90 of U.S. 
source income from U.S. assets with an adjusted tax basis of $900, and 
$12 of foreign source interest income from U.S. assets with an adjusted 
tax basis of $100. FC's U.S. interest expense deduction, computed in 
accordance with Sec.  1.882-5, is $500.
    (ii) Under paragraph (a)(5) of this section, FC is required to apply 
any provision that disallows, defers, or capitalizes interest expense 
after determining the interest expense allocated to ECI under Sec.  
1.882-5. Section 265(a)(2) disallows interest expense that is allocable 
to one or more classes of income that are wholly exempt from taxation 
under subtitle A of the Internal Revenue Code. Section 1.265-1(b) 
provides that income wholly exempt from taxes includes both income 
excluded from tax under any provision of subtitle A and income wholly 
exempt from taxes under any other law. Section 894 specifies that the 
provisions of subtitle A are applied with due regard to any relevant 
treaty obligation of the United States. Because the treaty between the 
United States and Country X exempts foreign source income earned by B 
from U.S. tax, FC has assets that produce income wholly exempt from 
taxes under subtitle A, and must therefore allocate a portion of its 
Sec.  1.882-5 interest expense to its exempt income. Using the 
methodology prescribed under section 265, the amount of disallowed 
interest expense is $50, calculated as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.029

    (iii) Therefore, FC deducts a total of $450 ($500-$50) of interest 
expense attributable to its effectively connected income in 1997.

    (b) Step 1: Determination of total value of U.S. assets for the 
taxable year--(1) Classification of an asset as a U.S. asset--(i) 
General rule. Except as otherwise provided in this paragraph (b)(1), an 
asset is a U.S. asset for purposes of this section to the extent that it 
is a U.S. asset under Sec.  1.884-1(d). For purposes of this section, 
the term determination date, as used in Sec.  1.884-1(d), means each day 
for which the total value of U.S. assets is computed under paragraph 
(b)(3) of this section.
    (ii) Items excluded from the definition of U.S. asset. For purposes 
of this section, the term U.S. asset excludes an asset to the extent it 
produces income or gain described in sections 883 (a)(3) and (b).
    (iii) Items included in the definition of U.S. asset. For purposes 
of this section, the term U.S. asset includes--
    (A) U.S. real property held in a wholly-owned domestic subsidiary of 
a foreign corporation that qualifies as a bank under section 
585(a)(2)(B) (without regard to the second sentence thereof), provided 
that the real property would qualify as used in the foreign 
corporation's trade or business within the meaning of Sec.  1.864-4(c) 
(2) or (3) if held directly by the foreign corporation and either was 
initially acquired through foreclosure or similar proceedings or is U.S. 
real property occupied by the foreign corporation (the value of which 
shall be adjusted by the amount of any indebtedness that is reflected in 
the value of the property);
    (B) An asset that produces income treated as ECI under section 
921(d) or 926(b) (relating to certain income of a FSC and certain 
dividends paid by a FSC to a foreign corporation);
    (C) An asset that produces income treated as ECI under section 
953(c)(3)(C) (relating to certain income of a captive insurance company 
that a corporation elects to treat as ECI) that is not otherwise ECI; 
and
    (D) An asset that produces income treated as ECI under section 
882(e) (relating to certain interest income of possessions banks).
    (iv) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not create a U.S. 
asset.
    (v) Assets acquired to increase U.S. assets artificially. An asset 
shall not be treated as a U.S. asset if one of the

[[Page 509]]

principal purposes for acquiring or using that asset is to increase 
artificially the U.S. assets of a foreign corporation on the 
determination date. Whether an asset is acquired or used for such 
purpose will depend upon all the facts and circumstances of each case. 
Factors to be considered in determining whether one of the principal 
purposes in acquiring or using an asset is to increase artificially the 
U.S. assets of a foreign corporation include the length of time during 
which the asset was used in a U.S. trade or business, whether the asset 
was acquired from a related person, and whether the aggregate value of 
the U.S. assets of the foreign corporation increased temporarily on or 
around the determination date. A purpose may be a principal purpose even 
though it is outweighed by other purposes (taken together or 
separately).
    (2) Determination of the value of a U.S. asset--(i) General rule. 
The value of a U.S. asset is the adjusted basis of the asset for 
determining gain or loss from the sale or other disposition of that 
item, further adjusted as provided in paragraph (b)(2)(iii) of this 
section.
    (ii) Fair-market value election--
    (A) In general--(1) Fair market value conformity requirement. A 
taxpayer may elect to value all of its U.S. assets on the basis of fair 
market value, subject to the requirements of Sec.  1.861-9T(g)(1)(iii), 
and provided the taxpayer is eligible and uses the actual ratio method 
under paragraph (c)(2) of this section and the methodology prescribed in 
Sec.  1.861-9T(h). Once elected, the fair market value must be used by 
the taxpayer for both Step 1 and Step 2 described in paragraphs (b) and 
(c) of this section, and must be used in all subsequent taxable years 
unless the Commissioner or his delegate consents to a change.
    (2) Conforming election requirement. Taxpayers that as of the 
effective date of this paragraph (b)(2)(ii)(A)(2) have elected and 
currently use both the fair market value method for purposes of 
paragraph (b) of this section and a fixed ratio for purposes of 
paragraph (c)(4) of this section must conform either the adjusted basis 
or fair market value methods in Step 1 and Step 2 of the allocation 
formula by making an adjusted basis election for paragraph (b) of this 
section purposes while continuing the fixed ratio for Step 2, or by 
making an actual ratio election under paragraph (c)(2) of this section 
while remaining on the fair market value method under paragraph (b) of 
this section. Taxpayers who elect to conform Step 1 and Step 2 of the 
formula to the adjusted basis method must remain on both methods for the 
minimum five-year period in accordance with the provisions of paragraph 
(a)(7) of this section. Taxpayers that elect to conform Step 1 and Step 
2 of the formula to the fair market value method must remain on the 
actual ratio method until the consent of the Commissioner or his 
delegate is obtained to switch to the adjusted basis method. If consent 
to use the adjusted basis method in Step 1 is granted in a later year, 
the taxpayer must remain on the actual ratio method for the minimum 
five-year period unless consent to use the fixed ratio is independently 
obtained under the requirements of paragraph (a)(7) of this section. For 
the first taxable year for which an original income tax return is due 
(including extensions) after August 17, 2006, taxpayers that are 
required to make a conforming election under this paragraph 
(b)(2)(ii)(A)(2), may do so on an original timely filed return. If a 
conforming election is not made within the timeframe provided in this 
paragraph, the Director of Field Operations or his delegate may make the 
conforming elections in accordance with the provisions of paragraph 
(a)(7)(ii) of this section.
    (B) Adjustment to partnership basis. If a partner makes a fair 
market value election under paragraph (b)(2)(ii) of this section, the 
value of the partner's interest in a partnership that is treated as an 
asset shall be the fair market value of his partnership interest, 
increased by the fair market value of the partner's share of the 
liabilities determined under paragraph (c)(2)(vi) of this section. See 
Sec.  1.884-1(d)(3).
    (iii) Reduction of total value of U.S. assets by amount of bad debt 
reserves under section 585--(A) In general. The total value of loans 
that qualify as U.S. assets shall be reduced by the amount of any 
reserve for bad debts additions to

[[Page 510]]

which are allowed as deductions under section 585.
    (B) Example. The following example illustrates the provisions of 
paragraph (b)(2)(iii)(A) of this section:

    Example. Foreign banks; bad debt reserves. FC is a foreign 
corporation that qualifies as a bank under section 585(a)(2)(B) (without 
regard to the second sentence thereof), but is not a large bank as 
defined in section 585(c)(2). FC conducts business through a branch, B, 
in the United States. Among B's U.S. assets are a portfolio of loans 
with an adjusted basis of $500. FC accounts for its bad debts for U.S. 
federal income tax purposes under the reserve method, and B maintains a 
deductible reserve for bad debts of $50. Under paragraph (b)(2)(iii) of 
this section, the total value of FC's portfolio of loans is $450 ($500-
$50).

    (3) Computation of total value of U.S. assets--(i) General rule. The 
total value of U.S. assets for the taxable year is the average of the 
sums of the values (determined under paragraph (b)(2) of this section) 
of U.S. assets. For each U.S. asset, value shall be computed at the most 
frequent regular intervals for which data are reasonably available. In 
no event shall the value of any U.S. asset be computed less frequently 
than monthly (beginning of taxable year and monthly thereafter) by a 
large bank (as defined in section 585(c)(2)) or a dealer in securities 
(within the meaning of section 475) and semi-annually (beginning, middle 
and end of taxable year) by any other taxpayer.
    (ii) Adjustment to basis of financial instruments. For purposes of 
determining the total average value of U.S. assets in this paragraph 
(b)(3), the value of a security or contract that is marked to market 
pursuant to section 475 or section 1256 shall be determined as if each 
determination date is the most frequent regular interval for which data 
are reasonably available that reflects the taxpayer's consistent 
business practices for reflecting mark-to-market valuations on its books 
and records.
    (c) Step 2: Determination of total amount of U.S.-connected 
liabilities for the taxable year--(1) General rule. The amount of U.S.-
connected liabilities for the taxable year equals the total value of 
U.S. assets for the taxable year (as determined under paragraph (b)(3) 
of this section) multiplied by the actual ratio for the taxable year (as 
determined under paragraph (c)(2) of this section) or, if the taxpayer 
has made an election in accordance with paragraph (c)(4) of this 
section, by the fixed ratio.
    (2) Computation of the actual ratio--(i) In general. A taxpayer's 
actual ratio for the taxable year is the total amount of its worldwide 
liabilities for the taxable year divided by the total value of its 
worldwide assets for the taxable year. The total amount of worldwide 
liabilities and the total value of worldwide assets for the taxable year 
is the average of the sums of the amounts of the taxpayer's worldwide 
liabilities and the values of its worldwide assets (determined under 
paragraphs (c)(2) (iii) and (iv) of this section). In each case, the 
sums must be computed semi-annually (beginning, middle and end of 
taxable year) by a large bank (as defined in section 585(c)(2)) and 
annually (beginning and end of taxable year) by any other taxpayer.
    (ii) Classification of items. The classification of an item as a 
liability or an asset must be consistent from year to year and in 
accordance with U.S. tax principles.
    (iii) Determination of amount of worldwide liabilities. The amount 
of a liability must be determined consistently from year to year and 
must be substantially in accordance with U.S. tax principles. To be 
substantially in accordance with U.S. tax principles, the principles 
used to determine the amount of a liability must not differ from U.S. 
tax principles to a degree that will materially affect the value of 
taxpayer's worldwide liabilities or the taxpayer's actual ratio.
    (iv) Determination of value of worldwide assets. The value of an 
asset must be determined consistently from year to year and must be 
substantially in accordance with U.S. tax principles. To be 
substantially in accordance with U.S. tax principles, the principles 
used to determine the value of an asset must not differ from U.S. tax 
principles to a degree that will materially affect the value of the 
taxpayer's worldwide assets or the taxpayer's actual ratio. The value of 
an asset is the adjusted basis of that asset for determining the

[[Page 511]]

gain or loss from the sale or other disposition of that asset, adjusted 
in the same manner as the basis of U.S. assets are adjusted under 
paragraphs (b)(2) (ii) through (iv) of this section. The rules of 
paragraph (b)(3) of this section apply in determining the total value of 
applicable worldwide assets for the taxable year, except that the 
minimum number of determination dates are those stated in paragraph 
(c)(2)(i) of this section.
    (v) Hedging transactions. [Reserved]
    (vi) Treatment of partnership interests and liabilities. For 
purposes of computing the actual ratio, the value of a partner's 
interest in a partnership that will be treated as an asset is the 
partner's adjusted basis in its partnership interest, reduced by the 
partner's share of liabilities of the partnership as determined under 
section 752 and increased by the partner's share of liabilities 
determined under this paragraph (c)(2)(vi). If the partner has made a 
fair market value election under paragraph (b)(2)(ii) of this section, 
the value of its interest in the partnership shall be increased by the 
fair market value of the partner's share of the liabilities determined 
under this paragraph (c)(2)(vi). For purposes of this section a partner 
shares in any liability of a partnership in the same proportion that it 
shares, for income tax purposes, in the expense attributable to that 
liability for the taxable year. A partner's adjusted basis in a 
partnership interest cannot be less than zero.
    (vii) Computation of actual ratio of insurance companies. [Reserved]
    (viii) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not create an 
asset or a liability.
    (ix) Amounts must be expressed in a single currency. The actual 
ratio must be computed in either U.S. dollars or the functional currency 
of the home office of the taxpayer, and that currency must be used 
consistently from year to year. For example, a taxpayer that determines 
the actual ratio annually using British pounds converted at the spot 
rate for financial reporting purposes must translate the U.S. dollar 
values of assets and amounts of liabilities of the U.S. trade or 
business into pounds using the spot rate on the last day of its taxable 
year. The director of field operations or the Assistant Commissioner 
(International) may require that the actual ratio be computed in dollars 
if the functional currency of the taxpayer's home office is a 
hyperinflationary currency, as defined in Sec.  1.985-1, that materially 
distorts the actual ratio.
    (3) Adjustments. The director of field operations or the Assistant 
Commissioner (International) may make appropriate adjustments to prevent 
a foreign corporation from intentionally and artificially increasing its 
actual ratio. For example, the director of field operations or the 
Assistant Commissioner (International) may offset a loan made from or to 
one person with a loan made to or from another person if any of the 
parties to the loans are related persons, within the meaning of section 
267(b) or 707(b)(1), and one of the principal purposes for entering into 
the loans was to increase artificially the actual ratio of a foreign 
corporation. A purpose may be a principal purpose even though it is 
outweighed by other purposes (taken together or separately).
    (4) Elective fixed ratio method of determining U.S. liabilities. A 
taxpayer that is a bank as defined in section 585(a)(2)(B) (without 
regard to the second sentence thereof or whether any such activities are 
effectively connected with a trade or business within the United States) 
may elect to use a fixed ratio of 95 percent in lieu of the actual 
ratio. A taxpayer that is neither a bank nor an insurance company may 
elect to use a fixed ratio of 50 percent in lieu of the actual ratio.
    (5) Examples. The following examples illustrate the application of 
paragraph (c) of this section:

    Example 1. Classification of item not in accordance with U.S. tax 
principles. Bank Z, a resident of country X, has a branch in the United 
States through which it conducts its banking business. In preparing its 
financial statements in country X, Z treats an instrument documented as 
perpetual subordinated debt as a liability. Under U.S. tax principles, 
however, this instrument is treated as equity. Consequently, the 
classification of this instrument as a liability for purposes of 
paragraph (c)(2)(iii) of this section is not in accordance with U.S. tax 
principles.

[[Page 512]]

    Example 2. Valuation of item not substantially in accordance with 
U.S. tax principles. Bank Z, a resident of country X, has a branch in 
the United States through which it conducts its banking business. Bank Z 
is a large bank as defined in section 585(c)(2). The tax rules of 
country X allow Bank Z to take deductions for additions to certain 
reserves. Bank Z decreases the value of the assets on its financial 
statements by the amounts of the reserves. The additions to the reserves 
under country X tax rules cause the value of Bank Z's assets to differ 
from the value of those assets determined under U.S. tax principles to a 
degree that materially affects the value of taxpayer's worldwide assets. 
Consequently, the valuation of Bank Z's worldwide assets under country X 
tax principles is not substantially in accordance with U.S. tax 
principles. Bank Z must increase the value of its worldwide assets under 
paragraph (c)(2)(iii) of this section by the amount of its country X 
reserves.
    Example 3. Valuation of item substantially in accordance with U.S. 
tax principles. Bank Z, a resident of country X, has a branch in the 
United States through which it conducts its banking business. In 
determining the value of its worldwide assets, Bank Z computes the 
adjusted basis of certain non-U.S. assets according to the depreciation 
methodology provided under country X tax laws, which is different than 
the depreciation methodology provided under U.S. tax law. If the 
depreciation methodology provided under country X tax laws does not 
differ from U.S. tax principles to a degree that materially affects the 
value of Bank Z's worldwide assets or Bank Z's actual ratio as computed 
under paragraph (c)(2) of this section, then the valuation of Bank Z's 
worldwide assets under paragraph (c)(2)(iv) of this section is 
substantially in accordance with U.S. tax principles.
    Example 4. [Reserved]
    Example 5. Adjustments. FC is a foreign corporation engaged in the 
active conduct of a banking business through a branch, B, in the United 
States. P, an unrelated foreign corporation, deposits $100,000 in the 
home office of FC. Shortly thereafter, in a transaction arranged by the 
home office of FC, B lends $80,000 bearing interest at an arm's length 
rate to S, a wholly owned U.S. subsidiary of P. The director of field 
operations or the Assistant Commissioner (International) determines that 
one of the principal purposes for making and incurring such loans is to 
increase FC's actual ratio. For purposes of this section, therefore, P 
is treated as having directly lent $80,000 to S. Thus, for purposes of 
paragraph (c) of this section (Step 2), the director of field operations 
or the Assistant Commissioner (International) may offset FC's liability 
and asset arising from this transaction, resulting in a net liability of 
$20,000 that is not a booked liability of B. Because the loan to S from 
B was initiated and arranged by the home office of FC, with no material 
participation by B, the loan to S will not be treated as a U.S. asset.

    (d) Step 3: Determination of amount of interest expense allocable to 
ECI under the adjusted U.S. booked liabilities method--(1) General rule. 
The adjustment to the amount of interest expense paid or accrued on U.S. 
booked liabilities is determined by comparing the amount of U.S.-
connected liabilities for the taxable year, as determined under 
paragraph (c) of this section, with the average total amount of U.S. 
booked liabilities, as determined under paragraphs (d)(2) and (3) of 
this section. If the average total amount of U.S. booked liabilities 
equals or exceeds the amount of U.S.-connected liabilities, the 
adjustment to the interest expense on U.S. booked liabilities is 
determined under paragraph (d)(4) of this section. If the amount of 
U.S.-connected liabilities exceeds the average total amount of U.S. 
booked liabilities, the adjustment to the amount of interest expense 
paid or accrued on U.S. booked liabilities is determined under paragraph 
(d)(5) of this section.
    (2) U.S. booked liabilities--(i) In general. A liability is a U.S. 
booked liability if it is properly reflected on the books of the U.S. 
trade or business, within the meaning of paragraph (d)(2)(ii) or (iii) 
of this section.
    (ii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is not a bank--(A) In general. A 
liability, whether interest bearing or non-interest bearing, is properly 
reflected on the books of the U.S. trade or business of a foreign 
corporation that is not a bank as described in section 585(a)(2)(B) 
(without regard to the second sentence thereof) if--
    (1) The liability is secured predominantly by a U.S. asset of the 
foreign corporation;
    (2) The foreign corporation enters the liability on a set of books 
reasonably contemporaneously with the time at which the liability is 
incurred and the liability relates to an activity that produces ECI.
    (3) The foreign corporation maintains a set of books and records 
relating to an activity that produces ECI and the Director of Field 
Operations determines that there is a direct connection

[[Page 513]]

or relationship between the liability and that activity. Whether there 
is a direct connection between the liability and an activity that 
produces ECI depends on the facts and circumstances of each case.
    (B) Identified liabilities not properly reflected. A liability is 
not properly reflected on the books of the U.S. trade or business merely 
because a foreign corporation identifies the liability pursuant to Sec.  
1.884-4(b)(1)(ii) and (b)(3).
    (iii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is a bank--
    (A) In general. A liability, whether interest bearing or non-
interest bearing, is properly reflected on the books of the U.S. trade 
or business of a foreign corporation that is a bank as described in 
section 585(a)(2)(B) (without regard to the second sentence thereof) 
if--
    (1) The bank enters the liability on a set of books before the close 
of the day on which the liability is incurred, and the liability relates 
to an activity that produces ECI; and
    (2) There is a direct connection or relationship between the 
liability and that activity. Whether there is a direct connection 
between the liability and an activity that produces ECI depends on the 
facts and circumstances of each case. For example, a liability that is 
used to fund an interbranch or other asset that produces non-ECI may 
have a direct connection to an ECI producing activity and may constitute 
a U.S.-booked liability if both the interbranch or non-ECI activity is 
the same type of activity in which ECI assets are also reflected on the 
set of books (for example, lending or money market interbank 
placements), and such ECI activities are not de minimis. Such U.S. 
booked liabilities may still be subject to paragraph (d)(2)(v) of this 
section.
    (B) Inadvertent error. If a bank fails to enter a liability in the 
books of the activity that produces ECI before the close of the day on 
which the liability was incurred, the liability may be treated as a U.S. 
booked liability only if, under the facts and circumstances, the 
taxpayer demonstrates a direct connection or relationship between the 
liability and the activity that produces ECI and the failure to enter 
the liability in those books was due to inadvertent error.
    (iv) Liabilities of insurance companies. [Reserved]
    (v) Liabilities used to increase artificially interest expense on 
U.S. booked liabilities. U.S. booked liabilities shall not include a 
liability if one of the principal purposes for incurring or holding the 
liability is to increase artificially the interest expense on the U.S. 
booked liabilities of a foreign corporation. Whether a liability is 
incurred or held for the purpose of artificially increasing interest 
expense will depend upon all the facts and circumstances of each case. 
Factors to be considered in determining whether one of the principal 
purposes for incurring or holding a liability is to increase 
artificially the interest expense on U.S. booked liabilities of a 
foreign corporation include whether the interest expense on the 
liability is excessive when compared to other liabilities of the foreign 
corporation denominated in the same currency and whether the currency 
denomination of the liabilities of the U.S. branch substantially matches 
the currency denomination of the U.S. branch's assets. A purpose may be 
a principal purpose even though it is outweighed by other purposes 
(taken together or separately).
    (vi) Hedging transactions. [Reserved]
    (vii) Amount of U.S. booked liabilities of a partner. A partner's 
share of liabilities of a partnership is considered a booked liability 
of the partner provided that it is properly reflected on the books 
(within the meaning of paragraph (d)(2)(ii) of this section) of the U.S. 
trade or business of the partnership.
    (viii) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not result in the 
creation of a liability.
    (3) Average total amount of U.S. booked liabilities. The average 
total amount of U.S. booked liabilities for the taxable year is the 
average of the sums of the amounts (determined under paragraph (d)(2) of 
this section) of U.S. booked liabilities. The amount of U.S. booked 
liabilities shall be computed at the most frequent, regular intervals 
for which data are reasonably available. In no

[[Page 514]]

event shall the amount of U.S. booked liabilities be computed less 
frequently than monthly by a large bank (as defined in section 
585(c)(2)) and semi-annually by any other taxpayer.
    (4) Interest expense where U.S. booked liabilities equal or exceed 
U.S. liabilities--(i) In general. If the average total amount of U.S. 
booked liabilities (as determined in paragraphs (d)(2) and (3) of this 
section) exceeds the amount of U.S.-connected liabilities (as determined 
under paragraph (c) of this section (Step 2)), the interest expense 
allocable to ECI is the product of the total amount of interest paid or 
accrued within the taxable year by the U.S. trade or business on U.S. 
booked liabilities and the scaling ratio set out in paragraph (d)(4)(ii) 
of this section. For purposes of this section, the reduction resulting 
from the application of the scaling ratio is applied pro-rata to all 
interest expense paid or accrued by the foreign corporation. A similar 
reduction in income, expense, gain, or loss from a hedging transaction 
(as described in paragraph (d)(2)(vi) of this section) must also be 
determined by multiplying such income, expense, gain, or loss by the 
scaling ratio. If the average total amount of U.S. booked liabilities 
(as determined in paragraph (d)(3) of this section) equals the amount of 
U.S.-connected liabilities (as determined under Step 2), the interest 
expense allocable to ECI is the total amount of interest paid or accrued 
within the taxable year by the U.S. trade or business on U.S. booked 
liabilities.
    (ii) Scaling ratio. For purposes of this section, the scaling ratio 
is a fraction the numerator of which is the amount of U.S.-connected 
liabilities and the denominator of which is the average total amount of 
U.S. booked liabilities.
    (iii) Special rules for insurance companies. [Reserved]
    (5) U.S.-connected interest rate where U.S. booked liabilities are 
less than U.S.-connected liabilities--(i) In general. If the amount of 
U.S.-connected liabilities (as determined under paragraph (c) of this 
section (Step 2)) exceeds the average total amount of U.S. booked 
liabilities, the interest expense allocable to ECI is the total amount 
of interest paid or accrued within the taxable year by the U.S. trade or 
business on U.S. booked liabilities, plus the excess of the amount of 
U.S.-connected liabilities over the average total amount of U.S. booked 
liabilities multiplied by the interest rate determined under paragraph 
(d)(5)(ii) of this section.
    (ii) Interest rate on excess U.S.-connected liabilities--(A) General 
rule. The applicable interest rate on excess U.S.-connected liabilities 
is determined by dividing the total interest expense paid or accrued for 
the taxable year on U.S.-dollar liabilities that are not U.S.-booked 
liabilities (as defined in paragraph (d)(2) of this section) and that 
are shown on the books of the offices or branches of the foreign 
corporation outside the United States by the average U.S.-dollar 
denominated liabilities (whether interest-bearing or not) that are not 
U.S.-booked liabilities and that are shown on the books of the offices 
or branches of the foreign corporation outside the United States for the 
taxable year.
    (B) Annual published rate election. For each taxable year beginning 
with the first year end for which the original tax return due date 
(including extensions) is after August 17, 2006, in which a taxpayer is 
a bank within the meaning of section 585(a)(2)(B) (without regard to the 
second sentence thereof or whether any such activities are effectively 
connected with a trade or business within the United States), such 
taxpayer may elect to compute its excess interest by reference to a 
published average 30-day London Interbank Offering Rate (LIBOR) for the 
year. The election may be made for any eligible year by indicating the 
rate used on Schedule I (Form 1120-F) attached to the timely filed 
return. Once selected, the rate may not be changed by the taxpayer. If a 
taxpayer that is eligible to make the 30-day LIBOR election either does 
not file a timely return or files a calculation that allocates interest 
expense under the scaling ratio in paragraph (d)(4) of this section and 
it is determined by the Director of Field Operations that the taxpayer's 
U.S.-connected liabilities exceed its U.S.-booked liabilities, then the 
Director of Field Operations, and not the taxpayer, may choose whether

[[Page 515]]

to determine the taxpayer's excess interest rate under paragraph 
(d)(5)(ii)(A) or (B) of this section and may select the published 30-day 
LIBOR rate.
    (6) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Computation of interest expense; actual ratio. (i) Facts. 
(A) FC is a foreign corporation that is not a bank and that actively 
conducts a real estate business through a branch, B, in the United 
States. For the taxable year, FC's balance sheet and income statement is 
as follows (assume amounts are in U.S. dollars and computed in 
accordance with paragraphs (b)(2) and (b)(3) of this section):

------------------------------------------------------------------------
                                                        Value
------------------------------------------------------------------------
Asset 1.............................................    $2,000
Asset 2.............................................     2,500
Asset 3.............................................     5,500
                                                       Amount   Interest
                                                                 Expense
Liability 1.........................................      $800        56
Liability 2.........................................     3,200       256
Capital.............................................     6,000         0
------------------------------------------------------------------------

    (B) Asset 1 is the stock of FC's wholly-owned domestic subsidiary 
that is also actively engaged in the real estate business. Asset 2 is a 
building in the United States producing rental income that is entirely 
ECI to FC. Asset 3 is a building in the home country of FC that produces 
rental income. Liabilities 1 and 2 are loans that bear interest at the 
rates of 7% and 8%, respectively. Liability 1 is a booked liability of 
B, and Liability 2 is booked in FC's home country. Assume that FC has 
not elected to use the fixed ratio in Step 2.
    (ii) Step 1. Under paragraph (b)(1) of this section, Assets 1 and 3 
are not U.S. assets, while Asset 2 qualifies as a U.S. asset. Thus, 
under paragraph (b)(3) of this section, the total value of U.S. assets 
for the taxable year is $2,500, the value of Asset 2.
    (iii) Step 2. Under paragraph (c)(1) of this section, the amount of 
FC's U.S.-connected liabilities for the taxable year is determined by 
multiplying $2,500 (the value of U.S. assets determined under Step 1) by 
the actual ratio for the taxable year. The actual ratio is the average 
amount of FC's worldwide liabilities divided by the average value of 
FC's worldwide assets. The amount of Liability 1 is $800, and the amount 
of Liability 2 is $3,200. Thus, the numerator of the actual ratio is 
$4,000. The average value of worldwide assets is $10,000 (Asset 1 + 
Asset 2 + Asset 3). The actual ratio, therefore, is 40% ($4,000/
$10,000), and the amount of U.S.-connected liabilities for the taxable 
year is $1,000 ($2,500 U.S. assets x 40%).
    (iv) Step 3. Because the amount of FC's U.S.-connected liabilities 
($1,000) exceeds the average total amount of U.S. booked liabilities of 
B ($800), FC determines its interest expense in accordance with 
paragraph (d)(5) of this section by adding the interest paid or accrued 
on U.S. booked liabilities, and the interest expense associated with the 
excess of its U.S.-connected liabilities over its average total amount 
of U.S. booked liabilities. Under paragraph (d)(5)(ii) of this section, 
FC determines the interest rate attributable to its excess U.S.-
connected liabilities by dividing the interest expense paid or accrued 
by the average amount of U.S.-dollar denominated liabilities, which 
produces an interest rate of 8% ($256/$3200). Therefore, FC's allocable 
interest expense is $72 ($56 of interest expense from U.S. booked 
liabilities plus $16 ($200 x 8%) of interest expense attributable to its 
excess U.S.-connected liabilities).
    Example 2. Computation of interest expense; fixed ratio. (i) The 
facts are the same as in Example 1, except that FC makes a fixed ratio 
election under paragraph (c)(4) of this section. The conclusions under 
Step 1 are the same as in Example 1.
    (ii) Step 2. Under paragraph (c)(1) of this section, the amount of 
U.S.-connected liabilities for the taxable year is determined by 
multiplying $2,500 (the value of U.S. assets determined under Step 1) by 
the fixed ratio for the taxable year, which, under paragraph (c)(4) of 
this section is 50 percent. Thus, the amount of U.S.-connected 
liabilities for the taxable year is $1,250 ($2,500 U.S. assets x 50%).
    (iii) Step 3. As in Example 1, the amount of FC's U.S.-connected 
liabilities exceed the average total amount of U.S. booked liabilities 
of B, requiring FC to determine its interest expense under paragraph 
(d)(5) of this section. In this case, however, FC has excess U.S.-
connected liabilities of $450 ($1,250 of U.S.-connected liabilities--
$800 U.S. booked liabilities). FC therefore has allocable interest 
expense of $92 ($56 of interest expense from U.S. booked liabilities 
plus $36 ($450 x 8%) of interest expense attributable to its excess 
U.S.-connected liabilities).
    Example 3. Scaling ratio. (i) Facts. Bank Z, a resident of country 
X, has a branch in the United States through which it conducts its 
banking business. For the taxable year, Z has U.S.-connected 
liabilities, determined under paragraph (c) of this section, equal to 
$300. Z, however, has U.S. booked liabilities of $300 and U500. 
Therefore, assuming an exchange rate of the U to the U.S. dollar of 5:1, 
Z has U.S. booked liabilities of $400 ($300 + (U500 / 5)).
    (ii) U.S.-connected liabilities. Because Z's U.S. booked liabilities 
of $400 exceed its U.S.-connected liabilities by $100, all of Z's 
interest expense allocable to its U.S. trade or business must be scaled 
back pro-rata. To determine the scaling ratio, Z divides its U.S.-
connected liabilities by its U.S. booked liabilities, as required by 
paragraph (d)(4) of this section. Z's interest expense is scaled

[[Page 516]]

back pro rata by the resulting ratio of \3/4\ ($300 / $400). Z's income, 
expense, gain or loss from hedging transactions described in paragraph 
(d)(2)(vi) of this section must be similarly reduced.
    Example 4. [Reserved]
    Example 5. U.S. booked liabilities--direct relationship. (i) Facts. 
Bank A, a resident of Country X maintains a banking office in the U.S. 
that records transactions on three sets of books for State A, an 
International Banking Facility (IBF) for its bank regulatory approved 
international transactions, and a shell branch licensed operation in 
Country C. Bank A records substantial ECI assets from its bank lending 
and placement activities and a mix of interbranch and non-ECI producing 
assets from the same or similar activities on the books of State A 
branch and on its IBF. Bank A's Country C branch borrows substantially 
from third parties, as well as from its home office, and lends all of 
its funding to its State A branch and IBF to fund the mix of ECI, 
interbranch and non-ECI activities on those two books. The consolidated 
books of State A branch and IBF indicate that a substantial amount of 
the total book assets constitute U.S. assets under paragraph (b) of this 
section. Some of the third-party borrowings on the books of the State A 
branch are used to lend directly to Bank A's home office in Country X. 
These borrowings reflect the average borrowing rate of the State A 
branch, IBF and Country C branches as a whole. All third-party 
borrowings reflected on the books of State A branch, the IBF and Country 
C branch were recorded on such books before the close of business on the 
day the liabilities were acquired by Bank A.
    (ii) U.S. booked liabilities. The facts demonstrate that the 
separate State A branch, IBF and Country C branch books taken together, 
constitute a set of books within the meaning of paragraph 
(d)(2)(iii)(A)(1) of this section. Such set of books as a whole has a 
direct relationship to an ECI activity under paragraph (d)(2)(iii)(A)(2) 
of this section even though the Country C branch books standing alone 
would not. The third-party liabilities recorded on the books of Country 
C constitute U.S. booked liabilities because they were timely recorded 
and the overall set of books on which they were reflected has a direct 
relationship to a bank lending and interbank placement ECI producing 
activity. The third-party liabilities that were recorded on the books of 
State A branch that were used to lend funds to Bank A's home office also 
constitute U.S. booked liabilities because the interbranch activity the 
funds were used for is a lending activity of a type that also gives rise 
to a substantial amount of ECI that is properly reflected on the same 
set of books as the interbranch loans. Accordingly, the liabilities are 
not traced to their specific interbranch use but to the overall activity 
of bank lending and interbank placements which gives rise to substantial 
ECI. The facts show that the liabilities were not acquired to increase 
artificially the interest expense of Bank A's U.S. booked liabilities as 
a whole under paragraph (d)(2)(v) of this section. The third-party 
liabilities also constitute U.S. booked liabilities for purposes of 
determining Bank A's branch interest under Sec.  1.884-4(b)(1)(i)(A) 
regardless of whether Bank A uses the Adjusted U.S. booked liability 
method, or the Separate Currency Pool method to allocate its interest 
expense under paragraph 5(e) of this section.

    (e) Separate currency pools method--(1) General rule. If a foreign 
corporation elects to use the method in this paragraph, its total 
interest expense allocable to ECI is the sum of the separate interest 
deductions for each of the currencies in which the foreign corporation 
has U.S. assets. The separate interest deductions are determined under 
the following three-step process.
    (i) Determine the value of U.S. assets in each currency pool. First, 
the foreign corporation must determine the amount of its U.S. assets, 
using the methodology in paragraph (b) of this section, in each currency 
pool. The foreign corporation may convert into U.S. dollars any currency 
pool in which the foreign corporation holds less than 3% of its U.S. 
assets. A transaction (or transactions) that hedges a U.S. asset shall 
be taken into account for purposes of determining the currency 
denomination and the value of the U.S. asset.
    (ii) Determine the U.S.-connected liabilities in each currency pool. 
Second, the foreign corporation must determine the amount of its U.S.-
connected liabilities in each currency pool by multiplying the amount of 
U.S. assets (as determined under paragraph (b)(3) of this section) in 
the currency pool by the foreign corporation's actual ratio (as 
determined under paragraph (c)(2) of this section) for the taxable year 
or, if the taxpayer has made an election in accordance with paragraph 
(c)(4) of this section, by the fixed ratio.
    (iii) Determine the interest expense attributable to each currency 
pool. Third, the foreign corporation must determine the interest expense 
attributable to each currency pool by multiplying the U.S.-connected 
liabilities in each

[[Page 517]]

currency pool by the prescribed interest rate as defined in paragraph 
(e)(2) of this section.
    (2) Prescribed interest rate. For each currency pool, the prescribed 
interest rate is determined by dividing the total interest expense that 
is paid or accrued for the taxable year with respect to the foreign 
corporation's worldwide liabilities denominated in that currency, by the 
foreign corporation's average worldwide liabilities (whether interest 
bearing or not) denominated in that currency. The interest expense and 
liabilities are to be stated in that currency.
    (3) Hedging transactions. [Reserved]
    (4) Election not available if excessive hyperinflationary assets. 
The election to use the separate currency pools method of this paragraph 
(e) is not available if the value of the foreign corporation's U.S. 
assets denominated in a hyperinflationary currency, as defined in Sec.  
1.985-1, exceeds ten percent of the value of the foreign corporation's 
total U.S. assets. If a foreign corporation made a valid election to use 
the separate currency pools method in a prior year but no longer 
qualifies to use such method pursuant to this paragraph (e)(4), the 
taxpayer must use the method provided by paragraphs (b) through (d) of 
this section.
    (5) Examples. The separate currency pools method of this paragraph 
(e) is illustrated by the following examples:

    Example 1. Separate currency pools method--(i) Facts. (A) Bank Z, a 
resident of country X, has a branch in the United States through which 
it conducts its banking business. For its 1997 taxable year, Z has U.S. 
assets, as defined in paragraph (b) of this section, that are 
denominated in U.S. dollars and in U, the country X currency. 
Accordingly, Z's U.S. assets are as follows:

------------------------------------------------------------------------
                                                                Average
                                                                 value
------------------------------------------------------------------------
U.S. Dollar Assets...........................................    $20,000
U Assets.....................................................    U 5,000
------------------------------------------------------------------------

    (B) Z's worldwide liabilities are also denominated in U.S. Dollars 
and in U. The average interest rates on Z's worldwide liabilities, 
including those in the United States, are 6% on its U.S. dollar 
liabilities, and 12% on its liabilities denominated in U. Assume that Z 
has properly elected to use its actual ratio of 95% to determine its 
U.S.-connected liabilities in Step 2, and has also properly elected to 
use the separate currency pools method provided in paragraph (e) of this 
section.
    (ii) Determination of interest expense. Z determines the interest 
expense attributable to its U.S.-connected liabilities according to the 
steps described below.
    (A) First, Z separates its U.S. assets into two currency pools, one 
denominated in U.S. dollars ($20,000) and the other denominated in U 
(U5,000).
    (B) Second, Z multiplies each pool of assets by the applicable ratio 
of worldwide liabilities to assets, which in this case is 95%. Thus, Z 
has U.S.-connected liabilities of $19,000 ($20,000 x 95%), and U4750 
(U5000 x 95%).
    (C) Third, Z calculates its interest expense by multiplying each 
pool of its U.S.-connected liabilities by the relevant interest rates. 
Accordingly, Z's allocable interest expense for the year is $1140 
($19,000 x 6%), the sum of the expense associated with its U.S. dollar 
liabilities, plus U570 (U4750 x 12%), the interest expense associated 
with its liabilities denominated in U. Z must translate its interest 
expense denominated in U in accordance with the rules provided in 
section 988, and then must determine whether it is subject to any other 
provision of the Code that would disallow or defer any portion of its 
interest expense so determined.
    Example 2. [Reserved]

    (f)(1) Effective/applicability date (1) This section is applicable 
for taxable years ending on or after August 15, 2009. A taxpayer, 
however, may choose to apply Sec.  1.882-5T, rather than applying the 
final regulations, for any taxable year beginning on or after August 16, 
2008 but before August 15, 2009.
    (2) Special rules for financial products. [Reserved]

[T.D. 8658, 61 FR 9329, Mar. 8, 1996; 61 FR 15891, Apr. 10, 1996, as 
amended by T.D. 9281, 71 FR 47448, Aug. 17, 2006; 71 FR 56868, Sept. 28, 
2006; T.D. 9465, 74 FR 49320, Sept. 28, 2009; 74 FR 57252, Nov. 5, 2009]



Sec.  1.883-0  Outline of major topics.

    This section lists the major paragraphs contained in Sec. Sec.  
1.883-1 through 1.883-5.

 Sec.  1.883-1 Exclusion of income from the international operation of 
                           ships or aircraft.

    (a) General rule.
    (b) Qualified income.
    (c) Qualified foreign corporation.
    (1) General rule.
    (2) Stock ownership test.
    (3) Substantiation and reporting requirements.

[[Page 518]]

    (i) General rule.
    (ii) Further documentation.
    (A) General rule.
    (B) Names and permanent addresses of certain shareholders.
    (4) Commissioner's discretion to cure defects in documentation.
    (d) Qualified foreign country.
    (e) Operation of ships or aircraft.
    (1) General rule.
    (2) Pool, partnership, strategic alliance, joint operating 
agreement, code-sharing arrangement or other joint venture.
    (3) Activities not considered operation of ships or aircraft.
    (4) Examples.
    (5) Definitions.
    (i) Bareboat charter.
    (ii) Code-sharing arrangement.
    (iii) Dry lease.
    (iv) Entity.
    (v) Fiscally transparent entity under the income tax laws of the 
United States.
    (vi) Full charter.
    (vii) Nonvessel operating common carrier.
    (viii) Space or slot charter.
    (ix) Time charter.
    (x) Voyage charter.
    (xi) Wet lease.
    (f) International operation of ships or aircraft.
    (1) General rule.
    (2) Determining whether income is derived from international 
operation of ships or aircraft.
    (i) International carriage of passengers.
    (A) General rule.
    (B) Round trip travel on ships.
    (ii) International carriage of cargo.
    (iii) Bareboat charter of ships or dry lease of aircraft used in 
international operation of ships or aircraft.
    (iv) Charter of ships or aircraft for hire.
    (g) Activities incidental to the international operation of ships or 
aircraft.
    (1) General rule.
    (2) Activities not considered incidental to the international 
operation of ships or aircraft.
    (3) Other Services. [Reserved]
    (4) Activities involved in a pool, partnership, strategic alliance, 
joint operating agreement, code-sharing arrangement or other joint 
venture.
    (h) Equivalent exemption.
    (1) General rule.
    (2) Determining equivalent exemptions for each category of income.
    (3) Special rules with respect to income tax conventions.
    (i) Countries with only an income tax convention.
    (ii) Countries with both an income tax convention and an equivalent 
exemption.
    (A) General rule.
    (B) Special rule for claiming simultaneous benefits under section 
883 and an income tax convention.
    (iii) Participation in certain joint ventures.
(iv) Independent interpretation of income tax conventions.
    (4) Exemptions not qualifying as equivalent exemptions.
    (i) General rule.
    (ii) Reduced tax rate or time limited exemption.
    (iii) Inbound or outbound freight tax.
    (iv) Exemptions for limited types of cargo.
    (v) Territorial tax systems.
    (vi) Countries that tax on a residence basis.
    (vii) Exemptions within categories of income.
    (i) Treatment of possessions.
    (j) Expenses related to qualified income.

        Sec.  1.883-2 Treatment of publicly-traded corporations.

    (a) General rule.
    (b) Established securities market.
    (1) General rule.
    (2) Exchanges with multiple tiers.
    (3) Computation of dollar value of stock traded.
    (4) Over-the-counter market.
    (5) Discretion to determine that an exchange does not qualify as an 
established securities market.
    (c) Primarily traded.
    (d) Regularly traded.
    (1) General rule.
    (2) Classes of stock traded on a domestic established securities 
market treated as meeting trading requirements.
    (3) Closely-held classes of stock not treated as meeting trading 
requirements.
    (i) General rule.
    (ii) Exception.
    (iii) Five-percent shareholders.
    (A) Related persons.
    (B) Investment companies.
    (4) Anti-abuse rule.
    (5) Example.
    (e) Substantiation that a foreign corporation is publicly traded.
    (1) General rule.
    (2) Availability and retention of documents for inspection.
    (f) Reporting requirements.

       Sec.  1.883-3 Treatment of controlled foreign corporations.

    (a) General rule.
    (b) Qualified U.S. person ownership test.
    (1) General rule.
    (2) Qualified U.S. person.
    (3) Treatment of bearer shares.
    (4) Ownership attribution through certain domestic entities.
    (5) Examples.

[[Page 519]]

    (c) Substantiation of CFC stock ownership.
    (1) In general.
    (2) Ownership statements from qualified U.S. persons.
    (3) Ownership statements from intermediaries.
    (4) Three-year period of validity.
    (5) Availability and retention of documents for inspection.
    (d) Reporting requirements.

        Sec.  1.883-4 Qualified shareholder stock ownership test.

    (a) General rule.
    (b) Qualified shareholder.
    (1) General rule.
    (2) Residence of individual shareholders.
    (i) General rule.
    (ii) Tax home.
    (3) Certain income tax convention restrictions applied to 
shareholders.
    (4) Not-for-profit organizations.
    (5) Pension funds.
    (i) Pension fund defined.
    (ii) Government pension funds.
    (iii) Nongovernment pension funds.
    (iv) Beneficiary of a pension fund.
    (c) Rules for determining constructive ownership.
    (1) General rules for attribution.
    (2) Partnerships.
    (i) General rule.
    (ii) Partners resident in the same country.
    (iii) Examples.
    (3) Trusts and estates.
    (i) Beneficiaries.
    (ii) Grantor trusts.
    (4) Corporations that issue stock.
    (5) Taxable nonstock corporations.
    (6) Mutual insurance companies and similar entities.
    (7) Computation of beneficial interests in nongovernment pension 
funds.
    (d) Substantiation of stock ownership.
    (1) General rule.
    (2) Application of general rule.
    (i) Ownership statements.
    (ii) Three-year period of validity.
    (3) Special rules.
    (i) Substantiating residence of certain shareholders.
    (ii) Special rule for registered shareholders owning less than one 
percent of widely-held corporations.
    (iii) Special rule for beneficiaries of pension funds.
    (A) Government pension fund.
    (B) Nongovernment pension fund.
    (iv) Special rule for stock owned by publicly-traded corporations.
    (v) Special rule for not-for-profit organizations.
    (vi) Special rule for a foreign airline covered by an air services 
agreement.
    (vii) Special rule for taxable nonstock corporations.
    (viii) Special rule for closely-held corporations traded in the 
United States.
    (4) Ownership statements from shareholders.
    (i) Ownership statements from individuals.
    (ii) Ownership statements from foreign governments.
    (iii) Ownership statements from publicly-traded corporate 
shareholders.
    (iv) Ownership statements from not-for-profit organizations.
    (v) Ownership statements from intermediaries.
    (A) General rule.
    (B) Ownership statements from widely-held intermediaries with 
registered shareholders owning less than one percent of such widely-held 
intermediary.
    (C) Ownership statements from pension funds.
    (1) Ownership statements from government pension funds.
    (2) Ownership statements from nongovernment pension funds.
    (3) Time for making determinations.
    (D) Ownership statements from taxable nonstock corporations.
    (5) Availability and retention of documents for inspection.
    (e) Reporting requirements.

                     Sec.  1.883-5 Effective dates.

    (a) General rule.
    (b) Election for retroactive application.
    (c) Transitional information reporting rule.
    (d) Effective/applicability dates.

[T.D. 9087, 68 FR 51399, Aug. 26, 2003, as amended by T.D. 9332, 72 FR 
34604, June 25, 2007; T.D. 9502, 75 FR 56861, Sept. 17, 2010]



Sec.  1.883-1  Exclusion of income from the international operation 
of ships or aircraft.

    (a) General rule. Qualified income derived by a qualified foreign 
corporation from its international operation of ships or aircraft is 
excluded from gross income and exempt from United States Federal income 
tax. Paragraph (b) of this section defines the term qualified income. 
Paragraph (c) of this section defines the term qualified foreign 
corporation. Paragraph (f) of this section defines the term 
international operation of ships or aircraft.
    (b) Qualified income. Qualified income is income derived from the 
international operation of ships or aircraft that--
    (1) Is properly includible in any of the income categories described 
in paragraph (h)(2) of this section; and

[[Page 520]]

    (2) Is the subject of an equivalent exemption, as defined in 
paragraph (h) of this section, granted by the qualified foreign country, 
as defined in paragraph (d) of this section, in which the foreign 
corporation seeking qualified foreign corporation status is organized.
    (c) Qualified foreign corporation--(1) General rule. A qualified 
foreign corporation is a corporation that is organized in a qualified 
foreign country and considered engaged in the international operation of 
ships or aircraft. The term corporation is defined in section 7701(a)(3) 
and the regulations thereunder. Paragraph (d) of this section defines 
the term qualified foreign country. Paragraph (e) of this section 
defines the term operation of ships or aircraft, and paragraph (f) of 
this section defines the term international operation of ships or 
aircraft. To be a qualified foreign corporation, the corporation must 
satisfy the stock ownership test of paragraph (c)(2) of this section and 
satisfy the substantiation and reporting requirements described in 
paragraph (c)(3) of this section. A corporation may be a qualified 
foreign corporation with respect to one category of qualified income but 
not with respect to another such category. See paragraph (h)(2) of this 
section for a discussion of the categories of qualified income.
    (2) Stock ownership test. To be a qualified foreign corporation, a 
foreign corporation must satisfy the publicly-traded test of Sec.  
1.883-2(a), the CFC stock ownership test of Sec.  1.883-3(a), or the 
qualified shareholder stock ownership test of Sec.  1.883-4(a).
    (3) Substantiation and reporting requirements--(i) General rule. To 
be a qualified foreign corporation, a foreign corporation must include 
the following information in its Form 1120-F, ``U.S. Income Tax Return 
of a Foreign Corporation,'' in the manner prescribed by such form and 
its accompanying instructions--
    (A) The corporation's name and address (including mailing code);
    (B) The corporation's U.S. taxpayer identification number;
    (C) The foreign country in which the corporation is organized;
    (D) The applicable authority for an equivalent exemption, for 
example, the citation of a statute in the country where the corporation 
is organized, a diplomatic note between the United States and such 
country, or an income tax convention between the United States and such 
country in the case of a corporation described in paragraphs (h)(3)(i), 
(ii) and (iii) of this section;
    (E) The category or categories of qualified income for which an 
exemption is being claimed;
    (F) A reasonable estimate of the gross amount of income in each 
category of qualified income for which the exemption is claimed, to the 
extent such amounts are readily determinable;
    (G) A statement as to whether any shares of the foreign corporation 
or of any intermediary corporation that are relied on to satisfy any 
stock ownership test described in paragraph (c)(2) of this section are 
issued in bearer form and whether the bearer shares are maintained in a 
dematerialized book-entry system in which the bearer shares are 
represented only by book entries and no physical certificates are issued 
or transferred, or in an immobilized book-entry system in which evidence 
of ownership is maintained on the books and records of the corporate 
issuer or by a broker or financial institution;
    (H) Any other information required under Sec.  1.883-2(f), Sec.  
1.883-3(d), or Sec.  1.883-4(e), as applicable; and
    (I) Any other relevant information specified in Form 1120-F, ``U.S. 
Income Tax Return of a Foreign Corporation,'' and its accompanying 
instructions.
    (ii) Further documentation--(A) General rule. Except as provided in 
paragraph (c)(3)(ii)(B) of this section, if the Commissioner requests in 
writing that the foreign corporation provide documentation or 
substantiate any representations made under paragraph (c)(3)(i) of this 
section, or under Sec.  1.883-2(f), Sec.  1.883-3(d), or Sec.  1.883-
4(e), as applicable, the foreign corporation must provide the requested 
documentation or substantiation within 60 days of receiving the written 
request. If the foreign corporation does not provide the requested 
documentation or substantiation within the 60-day period, but 
demonstrates that the failure was due

[[Page 521]]

to reasonable cause and not willful neglect, the Commissioner may grant 
the foreign corporation a 30-day extension to provide the requested 
documentation or substantiation. Whether a failure to provide the 
documentation or substantiation in a timely manner was due to reasonable 
cause and not willful neglect shall be determined by the Commissioner 
based on all the facts and circumstances.
    (B) Names and permanent addresses of certain shareholders. If the 
Commissioner requests the names and permanent addresses of individual 
qualified shareholders of a foreign corporation, as represented on each 
individual's ownership statement, to substantiate the requirements of 
the exception to the closely-held test in the publicly-traded test in 
Sec.  1.883-2(e), the qualified shareholder stock ownership test in 
Sec.  1.883-4(a), or the qualified U.S. person ownership test in Sec.  
1.883-3(b), the foreign corporation must provide the requested 
information within 30 days of receiving the written request. If the 
foreign corporation does not provide the requested information within 
the 30-day period, but demonstrates that the failure was due to 
reasonable cause and not willful neglect, the Commissioner may grant the 
foreign corporation a 30-day extension to provide the requested 
information. Whether a failure to provide the requested information was 
due to reasonable cause and not willful neglect shall be determined by 
the Commissioner based on all the facts and circumstances.
    (d) Qualified foreign country. A qualified foreign country is a 
foreign country that grants to corporations organized in the United 
States an equivalent exemption, as described in paragraph (h) of this 
section, for the category of qualified income, as described in paragraph 
(h)(2) of this section, derived by the foreign corporation seeking 
qualified foreign corporation status. A foreign country may be a 
qualified foreign country with respect to one category of qualified 
income but not with respect to another such category.
    (e) Operation of ships or aircraft--(1) General rule. Except as 
provided in paragraph (e)(2) of this section, a foreign corporation is 
considered engaged in the operation of ships or aircraft only during the 
time it is an owner or lessee of one or more entire ships or aircraft 
and uses such ships or aircraft in one or more of the following 
activities--
    (i) Carriage of passengers or cargo for hire;
    (ii) In the case of a ship, the leasing out of the ship under a time 
or voyage charter (full charter), space or slot charter, or bareboat 
charter, as those terms are defined in paragraph (e)(5) of this section, 
provided the ship is used to carry passengers or cargo for hire; and
    (iii) In the case of aircraft, the leasing out of the aircraft under 
a wet lease (full charter), space, slot, or block-seat charter, or dry 
lease, as those terms are defined in paragraph (e)(5) of this section, 
provided the aircraft is used to carry passengers or cargo for hire.
    (2) Pool, partnership, strategic alliance, joint operating 
agreement, code-sharing arrangement or other joint venture. A foreign 
corporation is considered engaged in the operation of ships or aircraft 
within the meaning of paragraph (e)(1) of this section with respect to 
its participation in a pool, partnership, strategic alliance, joint 
operating agreement, code-sharing arrangement or other joint venture if 
it directly, or indirectly through one or more fiscally transparent 
entities under the income tax laws of the United States, as defined in 
paragraph (e)(5)(v) of this section--
    (i) Owns an interest in a partnership, disregarded entity, or other 
fiscally transparent entity under the income tax laws of the United 
States that itself would be considered engaged in the operation of ships 
or aircraft under paragraph (e)(1) of this section if it were a foreign 
corporation; or
    (ii) Participates in a pool, strategic alliance, joint operating 
agreement, code-sharing arrangement, or other joint venture that is not 
an entity, as defined in paragraph (e)(5)(iv) of this section, involving 
one or more activities described in paragraphs (e)(1)(i) through (iii) 
of this section, but only if--

[[Page 522]]

    (A) In the case of a direct interest, the foreign corporation is 
otherwise engaged in the operation of ships or aircraft under paragraph 
(e)(1) of this section; or
    (B) In the case of an indirect interest, either the foreign 
corporation is otherwise engaged, or one of the fiscally transparent 
entities would be considered engaged if it were a foreign corporation, 
in the operation of ships or aircraft under paragraph (e)(1) of this 
section.
    (3) Activities not considered operation of ships or aircraft. 
Activities that do not constitute operation of ships or aircraft 
include, but are not limited to--
    (i) The activities of a nonvessel operating common carrier, as 
defined in paragraph (e)(5)(vii) of this section;
    (ii) Ship or aircraft management;
    (iii) Obtaining crews for ships or aircraft operated by another 
party;
    (iv) Acting as a ship's agent;
    (v) Ship or aircraft brokering;
    (vi) Freight forwarding;
    (vii) The activities of travel agents and tour operators;
    (viii) Rental by a container leasing company of containers and 
related equipment; and
    (ix) The activities of a concessionaire.
    (4) Examples. The rules of paragraphs (e)(1) through (3) of this 
section are illustrated by the following examples:

    Example 1. Three tiers of charters--(i) Facts. A, B, and C are 
foreign corporations. A purchases a ship. A and B enter into a bareboat 
charter of the ship for a term of 20 years, and B, in turn, enters into 
a time charter of the ship with C for a term of 5 years. Under the time 
charter, B is responsible for the complete operation of the ship, 
including providing the crew and maintenance. C uses the ship during the 
term of the time charter to carry its customers' freight between U.S. 
and foreign ports. C owns no ships.
    (ii) Analysis. Because A is the owner of the entire ship and leases 
out the ship under a bareboat charter to B, and because the sublessor, 
C, uses the ship to carry cargo for hire, A is considered engaged in the 
operation of a ship under paragraph (e)(1) of this section during the 
term of the time charter. B leases in the entire ship from A and leases 
out the ship under a time charter to C, who uses the ship to carry cargo 
for hire. Therefore, B is considered engaged in the operation of a ship 
under paragraph (e)(1) of this section during the term of the time 
charter. C time charters the entire ship from B and uses the ship to 
carry its customers' freight during the term of the charter. Therefore, 
C is also engaged in the operation of a ship under paragraph (e)(1) of 
this section during the term of the time charter.
    Example 2. Partnership with contributed shipping assets--(i) Facts. 
X, Y, and Z, each a foreign corporation, enter into a partnership, P. P 
is a fiscally transparent entity under the income tax laws of the United 
States, as defined in paragraph (e)(5)(v) of this section. Under the 
terms of the partnership agreement, each partner contributes all of the 
ships in its fleet to P in exchange for interests in the partnership and 
shares in the P profits from the international carriage of cargo. The 
partners share in the overall management of P, but each partner, acting 
in its capacity as partner, continues to crew and manage all ships 
previously in its fleet.
    (ii) Analysis. P owns the ships contributed by the partners and uses 
these ships to carry cargo for hire. Therefore, if P were a foreign 
corporation, it would be considered engaged in the operation of ships 
within the meaning of paragraph (e)(1) of this section. Accordingly, 
because P is a fiscally transparent entity under the income tax laws of 
the United States, as defined in paragraph (e)(5)(v) of this section, X, 
Y, and Z are each considered engaged in the operation of ships through 
P, within the meaning of paragraph (e)(2)(i) of this section, with 
respect to their distributive share of income from P's international 
carriage of cargo.
    Example 3. Joint venture with chartered in ships--(i) Facts. Foreign 
corporation A owns a number of foreign subsidiaries involved in various 
aspects of the shipping business, including S1, S2, S3, and S4. S4 is a 
foreign corporation that provides cruises but does not own any ships. 
S1, S2, and S3 are foreign corporations that own cruise ships. S1, S2, 
S3, and S4 form joint venture JV, in which they are all interest 
holders, to conduct cruises. JV is a fiscally transparent entity under 
the income tax laws of the United States, as defined in paragraph 
(e)(5)(v) of this section. Under the terms of the joint venture, S1, S2, 
and S3 each enter into time charter agreements with JV, pursuant to 
which S1, S2, and S3 retain control of the navigation and management of 
the individual ships, and JV will use the ships to carry passengers for 
hire. The overall management of the cruise line will be provided by S4.
    (ii) Analysis. S1, S2, and S3 each owns ships and time charters 
those ships to JV, which uses the ships to carry passengers for hire. 
Accordingly, S1, S2, and S3 are each considered engaged in the operation 
of ships under paragraph (e)(1) of this section. JV leases in entire 
ships by means of the time charters, and JV uses those ships to carry 
passengers on cruises. Thus, JV would be engaged in the operation of 
ships within the meaning of

[[Page 523]]

paragraph (e)(1) of this section if it were a foreign corporation. 
Therefore, although S4 does not directly own or lease in a ship, S4 also 
is engaged in the operation of ships, within the meaning of paragraph 
(e)(2)(i) of this section, with respect to its participation in JV.
    Example 4. Tiered partnerships--(i) Facts. Foreign corporations A, 
B, and C enter into a partnership, P1. P1 is one of several shareholders 
of Poolco, a foreign limited liability company that makes an election 
pursuant to Sec.  301.7701-3 of this chapter to be treated as a 
partnership for U.S. tax purposes. P1 acquires several ships and time 
charters them out to Poolco. Poolco slot or voyage charters such ships 
out to third parties for use in the carriage of cargo for hire. P1 and 
Poolco are fiscally transparent entities under the income tax laws of 
the United States, as defined in paragraph (e)(5)(v) of this section.
    (ii) Analysis. A, B, and C are considered engaged in the operation 
of ships under paragraph (e)(2)(i) of this section with respect to their 
direct interest in P1 and with respect to their indirect interest in 
Poolco because both P1 and Poolco are fiscally transparent entities 
under the income tax laws of the United States and would be considered 
engaged in the operation of ships under paragraph (e)(1) of this section 
if they were foreign corporations. The result would be the same if 
Poolco were a single-member disregarded entity owned solely by P1.

    (5) Definitions--(i) Bareboat charter. A bareboat charter is a 
contract for the use of a ship or aircraft whereby the lessee is in 
complete possession, control, and command of the ship or aircraft. For 
example, in a bareboat charter, the lessee is responsible for the 
navigation and management of the ship or aircraft, the crew, supplies, 
repairs and maintenance, fees, insurance, charges, commissions and other 
expenses connected with the use of the ship or aircraft. The lessor of 
the ship bears none of the expense or responsibility of operation of the 
ship or aircraft.
    (ii) Code-sharing arrangement. A code-sharing arrangement is an 
arrangement in which one air carrier puts its identification code on the 
flight of another carrier. This arrangement allows the first carrier to 
hold itself out as providing service in markets where it does not 
otherwise operate or where it operates infrequently. Code-sharing 
arrangements can range from a very limited agreement between two 
carriers involving only one market to agreements involving multiple 
markets and alliances between or among international carriers which also 
include joint marketing, baggage handling, one-stop check-in service, 
sharing of frequent flyer awards, and other services. For rules 
involving the sale of code-sharing tickets, see paragraph (g)(1)(vi) of 
this section.
    (iii) Dry lease. A dry lease is the bareboat charter of an aircraft.
    (iv) Entity. For purposes of this paragraph (e), an entity is any 
person that is treated by the United States as other than an individual 
for U.S. Federal income tax purposes. The term includes disregarded 
entities.
    (v) Fiscally transparent entity under the income tax laws of the 
United States. For purposes of this paragraph (e), an entity is fiscally 
transparent under the income tax laws of the United States if the entity 
would be considered fiscally transparent under the income tax laws of 
the United States under the principles of Sec.  1.894-1(d)(3).
    (vi) Full charter. Full charter (or full rental) means a time 
charter or a voyage charter of a ship or a wet lease of an aircraft but 
during which the full crew and management are provided by the lessor.
    (vii) Nonvessel operating common carrier. A nonvessel operating 
common carrier is an entity that does not exercise control over any part 
of a vessel, but holds itself out to the public as providing 
transportation for hire, issues bills of lading, assumes responsibility 
or is liable by law as a common carrier for safe transportation of 
shipments, and arranges in its own name with other common carriers, 
including those engaged in the operation of ships, for the performance 
of such transportation.
    (viii) Space or slot charter. A space or slot charter is a contract 
for use of a certain amount of space (but less than all of the space) on 
a ship or aircraft, and may be on a time or voyage basis. When used in 
connection with passenger aircraft this sort of charter may be referred 
to as the sale of block seats.
    (ix) Time charter. A time charter is a contract for the use of a 
ship or aircraft for a specific period of time, during which the lessor 
of the ship or aircraft retains control of the navigation and management 
of the ship or aircraft

[[Page 524]]

(i.e., the lessor continues to be responsible for the crew, supplies, 
repairs and maintenance, fees and insurance, charges, commissions and 
other expenses connected with the use of the ship or aircraft).
    (x) Voyage charter. A voyage charter is a contract similar to a time 
charter except that the ship or aircraft is chartered for a specific 
voyage or flight rather than for a specific period of time.
    (xi) Wet lease. A wet lease is the time or voyage charter of an 
aircraft.
    (f) International operation of ships or aircraft--(1) General rule. 
The term international operation of ships or aircraft means the 
operation of ships or aircraft, as defined in paragraph (e) of this 
section, with respect to the carriage of passengers or cargo on voyages 
or flights that begin or end in the United States, as determined under 
paragraph (f)(2) of this section. The term does not include the carriage 
of passengers or cargo on a voyage or flight that begins and ends in the 
United States, even if the voyage or flight contains a segment extending 
beyond the territorial limits of the United States, unless the passenger 
disembarks or the cargo is unloaded outside the United States. Operation 
of ships or aircraft beyond the territorial limits of the United States 
does not constitute in itself international operation of ships or 
aircraft.
    (2) Determining whether income is derived from international 
operation of ships or aircraft. Whether income is derived from 
international operation of ships or aircraft is determined on a 
passenger by passenger basis (as provided in paragraph (f)(2)(i) of this 
section) and on an item-of-cargo by item-of-cargo basis (as provided in 
paragraph (f)(2)(ii) of this section). In the case of the bareboat 
charter of a ship or the dry lease of an aircraft, whether the charter 
income for a particular period is derived from international operation 
of ships or aircraft is determined by reference to how the ship or 
aircraft is used by the lowest-tier lessee in the chain of lessees (as 
provided in paragraph (f)(2)(iii) of this section).
    (i) International carriage of passengers--(A) General rule. Except 
in the case of a round trip described in paragraph (f)(2)(i)(B) of this 
section, income derived from the carriage of a passenger will be income 
from international operation of ships or aircraft if the passenger is 
carried between a beginning point in the United States and an ending 
point outside the United States, or vice versa. Carriage of a passenger 
will be treated as ending at the passenger's final destination even if, 
en route to the passenger's final destination, a stop is made at an 
intermediate point for refueling, maintenance, or other business 
reasons, provided the passenger does not change ships or aircraft at the 
intermediate point. Similarly, carriage of a passenger will be treated 
as beginning at the passenger's point of origin even if, en route to the 
passenger's final destination, a stop is made at an intermediate point, 
provided the passenger does not change ships or aircraft at the 
intermediate point. Carriage of a passenger will be treated as beginning 
or ending at a U.S. or foreign intermediate point if the passenger 
changes ships or aircraft at that intermediate point. Income derived 
from the sale of a ticket for international carriage of a passenger will 
be treated as income derived from international operation of ships or 
aircraft even if the passenger does not begin or complete an 
international journey because of unanticipated circumstances.
    (B) Round trip travel on ships. In the case of income from the 
carriage of a passenger on a ship that begins its voyage in the United 
States, calls on one or more foreign intermediate ports, and returns to 
the same or another U.S. port, such income from carriage of a passenger 
on the entire voyage will be treated as income derived from 
international operation of ships or aircraft under paragraph 
(f)(2)(i)(A) of this section. This result obtains even if such carriage 
includes one or more intermediate stops at a U.S. port or ports and even 
if the passenger does not disembark at the foreign intermediate point.
    (ii) International carriage of cargo. Income from the carriage of 
cargo will be income derived from international operation of ships or 
aircraft if the cargo is carried between a beginning point in the United 
States and an ending point

[[Page 525]]

outside the United States, or vice versa. Carriage of cargo will be 
treated as ending at the final destination of the cargo even if, en 
route to that final destination, a stop is made at a U.S. intermediate 
point, provided the cargo is transported to its ultimate destination on 
the same ship or aircraft. If the cargo is transferred to another ship 
or aircraft, the carriage of the cargo may nevertheless be treated as 
ending at its final destination, if the same taxpayer transports the 
cargo to and from the U.S. intermediate point and the cargo does not 
pass through customs at the U.S. intermediate point. Similarly, carriage 
of cargo will be treated as beginning at the cargo's point of origin, 
even if en route to its final destination a stop is made at a U.S. 
intermediate point, provided the cargo is transported to its ultimate 
destination on the same ship or aircraft. If the cargo is transferred to 
another ship or aircraft at the U.S. intermediate point, the carriage of 
the cargo may nevertheless be treated as beginning at the point of 
origin, if the same taxpayer transports the cargo to and from the U.S. 
intermediate point and the cargo does not pass through customs at the 
U.S. intermediate point. Repackaging, recontainerization, or any other 
activity involving the unloading of the cargo at the U.S. intermediate 
point does not change these results, provided the same taxpayer 
transports the cargo to and from the U.S. intermediate point and the 
cargo does not pass through customs at the U.S. intermediate point. A 
lighter vessel that carries cargo to, or picks up cargo from, a vessel 
located beyond the territorial limits of the United States and 
correspondingly loads or unloads that cargo at a U.S. port, carries 
cargo between a point in the United States and a point outside the 
United States. However, a lighter vessel that carries cargo to, or picks 
up cargo from, a vessel located within the territorial limits of the 
United States, and correspondingly loads or unloads that cargo at a U.S. 
port, is not engaged in international operation of ships or aircraft. 
Income from the carriage of military cargo on a voyage that begins in 
the United States, stops at a foreign intermediate port or a military 
prepositioning location, and returns to the same or another U.S. port 
without unloading its cargo at the foreign intermediate point, will 
nevertheless be treated as derived from international operation of ships 
or aircraft.
    (iii) Bareboat charter of ships or dry lease of aircraft used in 
international operation of ships or aircraft. If a qualified foreign 
corporation bareboat charters a ship or dry leases an aircraft to a 
lessee, and the lowest tier lessee in the chain of ownership uses such 
ship or aircraft for the international carriage of passengers or cargo 
for hire, as described in paragraphs (f)(2)(i) and (ii) of this section, 
then the amount of charter income attributable to the period the ship or 
aircraft is used by the lowest tier lessee is income from international 
operation of ships or aircraft. The foreign corporation generally must 
determine the amount of the charter income that is attributable to such 
international operation of ships or aircraft by multiplying the amount 
of charter income by a fraction, the numerator of which is the total 
number of days of uninterrupted travel on voyages or flights of such 
ship or aircraft between the United States and the farthest point or 
points where cargo or passengers are loaded en route to, or discharged 
en route from, the United States during the smaller of the taxable year 
or the particular charter period, and the denominator of which is the 
total number of days in the smaller of the taxable year or the 
particular charter period. For this purpose, the number of days during 
which the ship or aircraft is not generating transportation income, 
within the meaning of section 863(c)(2), are not included in the 
numerator or denominator of the fraction. However, the foreign 
corporation may adopt an alternative method for determining the amount 
of the charter income that is attributable to the international 
operation of ships or aircraft if it can establish that the alternative 
method more accurately reflects the amount of such income.
    (iv) Charter of ships or aircraft for hire. For purposes of this 
section, if a foreign corporation time, voyage, or bareboat charters out 
a ship or aircraft, and the lowest-tier lessee uses the ship or aircraft 
to carry passengers

[[Page 526]]

or cargo on a fee basis, the ship or aircraft is considered used to 
carry passengers or cargo for hire, regardless of whether the ship or 
aircraft may be empty during a portion of the charter period due to a 
backhaul voyage or flight or for purposes of repositioning. If a foreign 
corporation time, voyage, or bareboat charters out a ship or aircraft, 
and the lowest-tier lessee uses the ship or aircraft for the carriage of 
proprietary goods, including an empty backhaul voyage or flight or 
repositioning related to such carriage of proprietary goods, the ship or 
aircraft similarly will be treated as used to carry cargo for hire.
    (g) Activities incidental to the international operation of ships or 
aircraft--(1) General rule. Certain activities of a foreign corporation 
engaged in the international operation of ships or aircraft are so 
closely related to the international operation of ships or aircraft that 
they are considered incidental to such operation, and income derived by 
the foreign corporation from its performance of these incidental 
activities is deemed to be income derived from the international 
operation of ships or aircraft. Examples of such activities include--
    (i) Temporary investment of working capital funds to be used in the 
international operation of ships or aircraft by the foreign corporation;
    (ii) Sale of tickets by the foreign corporation engaged in the 
international operation of ships for the international carriage of 
passengers by ship on behalf of another corporation engaged in the 
international operation of ships;
    (iii) Sale of tickets by the foreign corporation engaged in the 
international operation of aircraft for the international carriage of 
passengers by air on behalf of another corporation engaged in the 
international operation of aircraft;
    (iv) Contracting with concessionaires for performance of services 
onboard during the international operation of the foreign corporation's 
ships or aircraft;
    (v) Providing (either by subcontracting or otherwise) for the 
carriage of cargo preceding or following the international carriage of 
cargo under a through bill of lading, airway bill or similar document 
through a related corporation or through an unrelated person (and the 
rules of section 267(b) shall apply for purposes of determining whether 
a corporation or other person is related to the foreign corporation);
    (vi) To the extent not described in paragraph (g)(1)(iii) of this 
section, the sale or issuance by the foreign corporation engaged in the 
international operation of aircraft of intraline, interline, or code-
sharing tickets for the carriage of persons by air between a U.S. 
gateway and another U.S. city preceding or following international 
carriage of passengers, provided that all such flight segments are 
provided pursuant to the passenger's original invoice, ticket or 
itinerary and in the case of intraline tickets are a part of 
uninterrupted international air transportation (within the meaning of 
section 4262(c)(3));
    (vii) Arranging for port city hotel accommodations within the United 
States for a passenger for the one night before or after the 
international carriage of that passenger by the foreign corporation 
engaged in the international operation of ships;
    (viii) Bareboat charter of ships or dry lease of aircraft normally 
used by the foreign corporation in international operation of ships or 
aircraft but currently not needed, if the ship or aircraft is used by 
the lessee for international carriage of cargo or passengers;
    (ix) Arranging by means of a space or slot charter for the carriage 
of cargo listed on a bill of lading or airway bill or similar document 
issued by the foreign corporation on the ship or aircraft of another 
corporation engaged in the international operation of ships or aircraft;
    (x) The provision of containers and related equipment by the foreign 
corporation in connection with the international carriage of cargo for 
use by its customers, including short-term use within the United States 
immediately preceding or following the international carriage of cargo 
(for this purpose, a period of five days or less shall be presumed to be 
short-term); and
    (xi) The provision of goods and services by engineers, ground and 
equipment maintenance staff, cargo handlers, catering staff, and 
customer

[[Page 527]]

services personnel, and the provision of facilities such as passenger 
lounges, counter space, ground handling equipment, and hangars.
    (2) Activities not considered incidental to the international 
operation of ships or aircraft. Examples of activities that are not 
considered incidental to the international operation of ships or 
aircraft include--
    (i) The sale of or arranging for train travel, bus transfers, single 
day shore excursions, or land tour packages;
    (ii) Arranging for hotel accommodations within the United States 
other than as provided in paragraph (g)(1)(vii) of this section;
    (iii) The sale of airline tickets or cruise tickets other than as 
provided in paragraph (g)(1)(ii), (iii), or (vi) of this section;
    (iv) The sale or rental of real property;
    (v) Treasury activities involving the investment of excess funds or 
funds awaiting repatriation, even if derived from the international 
operation of ships or aircraft;
    (vi) The carriage of passengers or cargo on ships or aircraft on 
domestic legs of transportation not treated as either international 
operation of ships or aircraft under paragraph (f) of this section or as 
an activity that is incidental to such operation under paragraph (g)(1) 
of this section;
    (vii) The carriage of cargo by bus, truck or rail by a foreign 
corporation between a U.S. inland point and a U.S. gateway port or 
airport preceding or following the international carriage of such cargo 
by the foreign corporation; and
    (viii) The provision of containers or other related equipment by the 
foreign corporation within the United States other than as provided in 
paragraph (g)(1)(x) of this section, including warehousing.
    (3) Other services. [Reserved]
    (4) Activities involved in a pool, partnership, strategic alliance, 
joint operating agreement, code-sharing arrangement or other joint 
venture. Notwithstanding paragraph (g)(1) of this section, an activity 
is considered incidental to the international operation of ships or 
aircraft by a foreign corporation, and income derived by the foreign 
corporation with respect to such activity is deemed to be income derived 
from the international operation of ships or aircraft, if the activity 
is performed by or pursuant to a pool, partnership, strategic alliance, 
joint operating agreement, code-sharing arrangement or other joint 
venture in which such foreign corporation participates directly, or 
indirectly through a fiscally transparent entity under the income tax 
laws of the United States, provided that--
    (i) Such activity is incidental to the international operation of 
ships or aircraft by the pool, partnership, strategic alliance, joint 
operating agreement, code-sharing arrangement or other joint venture, 
and provided that it is described in paragraph (e)(2)(i) of this 
section; or
    (ii) Such activity would be incidental to the international 
operation of ships or aircraft by the foreign corporation, or fiscally 
transparent entity if it performed such activity itself, and provided 
the foreign corporation is engaged or the fiscally transparent entity 
would be considered engaged if it were a foreign corporation in the 
operation of ships or aircraft under paragraph (e)(1) of this section.
    (h) Equivalent exemption--(1) General rule. A foreign country grants 
an equivalent exemption when it exempts from taxation income from the 
international operation of ships or aircraft derived by corporations 
organized in the United States. Whether a foreign country provides an 
equivalent exemption must be determined separately with respect to each 
category of income, as provided in paragraph (h)(2) of this section. An 
equivalent exemption may be available for income derived from the 
international operation of ships even though income derived from the 
international operation of aircraft may not be exempt, and vice versa. 
For rules regarding foreign corporations organized in countries that 
provide exemptions only through an income tax convention, see paragraph 
(h)(3) of this section. An equivalent exemption may exist where the 
foreign country--
    (i) Generally imposes no tax on income, including income from the 
international operation of ships or aircraft;

[[Page 528]]

    (ii) Provides an exemption from tax for income derived from the 
international operation of ships or aircraft, either by statute, decree, 
income tax convention, or otherwise; or
    (iii) Exchanges diplomatic notes with the United States, or enters 
into an agreement with the United States, that provides for a reciprocal 
exemption for purposes of section 883.
    (2) Determining equivalent exemptions for each category of income. 
Whether a foreign country grants an equivalent exemption must be 
determined separately with respect to income from the international 
operation of ships and income from the international operation of 
aircraft for each category of income listed in paragraphs (h)(2)(i) 
through (v), (vii), and (viii) of this section. If an exemption is 
unavailable in the foreign country for a particular category of income, 
the foreign country is not considered to grant an equivalent exemption 
with respect to that category of income. Income in that category is not 
considered to be the subject of an equivalent exemption and, thus, is 
not eligible for exemption from income tax in the United States, even 
though the foreign country may grant an equivalent exemption for other 
categories of income. With respect to paragraph (h)(2)(vi) of this 
section, a foreign country may be considered to grant an equivalent 
exemption for one or more types of income described in paragraph (g)(1) 
of this section. The following categories of income derived from the 
international operation of ships or aircraft may be exempt from United 
States income tax if an equivalent exemption is available--
    (i) Income from the carriage of passengers and cargo;
    (ii) Time or voyage (full) charter income of a ship or wet lease 
income of an aircraft;
    (iii) Bareboat charter income of a ship or dry charter income of an 
aircraft;
    (iv) Incidental bareboat charter income or incidental dry lease 
income;
    (v) Incidental container-related income;
    (vi) Income incidental to the international operation of ships or 
aircraft other than incidental income described in paragraphs (h)(2)(iv) 
and (v) of this section;
    (vii) Capital gains derived by a qualified foreign corporation 
engaged in the international operation of ships or aircraft from the 
sale, exchange or other disposition of a ship, aircraft, container or 
related equipment or other moveable property used by that qualified 
foreign corporation in the international operation of ships or aircraft; 
and
    (viii) Income from participation in a pool, partnership, strategic 
alliance, joint operating agreement, code-sharing arrangement, 
international operating agency, or other joint venture described in 
paragraph (e)(2) of this section.
    (3) Special rules with respect to income tax conventions--(i) 
Countries with only an income tax convention. If a foreign country 
grants an exemption from tax for profits from the international 
operation of ships or aircraft only under an income tax convention with 
the United States, that exemption shall constitute an equivalent 
exemption with respect to a foreign corporation organized in that 
country only if--
    (A) The foreign corporation satisfies the conditions for claiming 
benefits with respect to such profits under the income tax convention; 
and
    (B) The profits that are exempt from tax pursuant to the shipping 
and air transport or gains article of the income tax convention and are 
described within a category of income included in paragraphs (h)(2)(i) 
through (viii) of this section.
    (ii) Countries with both an income tax convention and an equivalent 
exemption--(A) General rule. If a foreign country grants an exemption 
from tax for profits from the international operation of ships or 
aircraft under the shipping and air transport or gains article of an 
income tax convention with the United States and also by some other 
means (for example, by diplomatic note or domestic law of the foreign 
country), a foreign corporation may elect annually whether to claim an 
exemption from tax under section 883 or the income tax convention. 
Except as provided in paragraph (h)(3)(ii)(B) of this section, the 
foreign

[[Page 529]]

corporation must apply the elected exemption (section 883 or the income 
tax convention) to all categories of income described in paragraph 
(h)(2) of this section. If the foreign corporation elects to claim the 
exemption under section 883, it must satisfy all of the requirements for 
claiming the exemption under section 883. If the foreign corporation 
elects to claim the exemption under the income tax convention, it must 
satisfy all of the requirements and conditions for claiming benefits 
under the income tax convention. See Sec.  1.883-4(b)(3) for rules 
concerning relying on shareholders resident in a foreign country that 
grants an equivalent exemption under an income tax convention to satisfy 
the stock ownership test of paragraph (c)(2) of this section.
    (B) Special rule for claiming simultaneous benefits under section 
883 and an income tax convention. If a foreign corporation that is 
organized in a country that grants an exemption from tax under an income 
tax convention and also by some other means (such as by diplomatic note 
or domestic law of the foreign country) with respect to a specific 
category of income described in paragraph (h)(2) of this section, and 
the foreign corporation elects to claim the exemption under the income 
tax convention, the foreign corporation may nonetheless simultaneously 
claim an exemption under section 883 with respect to a category of 
income exempt from tax by such other means if the foreign corporation--
    (1) Satisfies the requirements of paragraphs (h)(3)(i)(A) and (B) of 
this section for each category of income;
    (2) Satisfies one of the stock ownership tests of paragraph (c)(2) 
of this section; and
    (3) Complies with the substantiation and reporting requirements in 
paragraph (c)(3) of this section.
    (iii) Participation in certain joint ventures. If a foreign country 
grants an exemption for a category of income only through an income tax 
convention, a foreign corporation that is organized in that country and 
that derives income, directly or indirectly, through a participation in 
a pool, partnership, strategic alliance, joint operating agreement, 
code-sharing arrangement, or other joint venture described in paragraph 
(e)(2) of this section, may treat that exemption as an equivalent 
exemption even if the foreign corporation would not be eligible to claim 
benefits under the income tax convention for that category of income 
solely because the joint venture was not fiscally transparent, within 
the meaning of Sec.  1.894-1(d)(3)(iii)(A), with respect to that 
category of income under the income tax laws of the foreign 
corporation's country of residence.
    (iv) Independent interpretation of income tax conventions. Nothing 
in this section nor Sec. Sec.  1.883-2 through 1.883-5 affects the 
rights or obligations under any income tax convention between the United 
States and a foreign country. The definitions provided in this section 
and Sec. Sec.  1.883-2 through 1.883-5 shall not give meaning to similar 
or identical terms used in an income tax convention, or provide guidance 
regarding the scope of any exemption provided by such convention, unless 
the income tax convention entered into force after August 26, 2003, and 
it, or its legislative history, explicitly refers to section 883 and 
guidance promulgated under that section for its meaning.
    (4) Exemptions not qualifying as equivalent exemptions--(i) General 
rule. Certain types of exemptions provided to corporations organized in 
the United States by foreign countries do not satisfy the equivalent 
exemption requirements of this section. Paragraphs (h)(4)(ii) through 
(vii) of this section provide descriptions of some of the types of 
exemptions that do not qualify as equivalent exemptions for purposes of 
this section.
    (ii) Reduced tax rate or time limited exemption. The exemption 
granted by the foreign country's law or income tax convention must be a 
complete exemption. The exemption may not constitute merely a reduction 
to a nonzero rate of tax levied against the income of corporations 
organized in the United States derived from the international operation 
of ships or aircraft or a temporary reduction to a zero rate of tax, 
such as in the case of a tax holiday.
    (iii) Inbound or outbound freight tax. With respect to the carriage 
of cargo, the foreign country must provide an exemption from tax for 
income from transporting freight both inbound and

[[Page 530]]

outbound. For example, a foreign country that imposes tax only on 
outbound freight will not be treated as granting an equivalent exemption 
for income from transporting freight inbound into that country.
    (iv) Exemptions for limited types of cargo. A foreign country must 
provide an exemption from tax for income from transporting all types of 
cargo. For example, if a foreign country were generally to impose tax on 
income from the international carriage of cargo but were to provide a 
statutory exemption for income from transporting agricultural products, 
the foreign country would not be considered to grant an equivalent 
exemption with respect to income from the international carriage of 
cargo, including agricultural products.
    (v) Territorial tax systems. A foreign country with a territorial 
tax system will be treated as granting an equivalent exemption if it 
treats all income derived from the international operation of ships or 
aircraft derived by a U.S. corporation as entirely foreign source and 
therefore not subject to tax, including income derived from a voyage or 
flight that begins or ends in that foreign country.
    (vi) Countries that tax on a residence basis. A foreign country that 
provides an equivalent exemption to corporations organized in the United 
States but also imposes a residence-based tax on certain corporations 
organized in the United States may nevertheless be considered to grant 
an equivalent exemption if the residence-based tax is imposed only on a 
corporation organized in the United States that maintains its center of 
management and control or other comparable attributes in that foreign 
country. If the residence-based tax is imposed on corporations organized 
in the United States and engaged in the international operation of ships 
or aircraft that are not managed and controlled in that foreign country, 
the foreign country shall not be treated as a qualified foreign country 
and shall not be considered to grant an equivalent exemption for 
purposes of this section.
    (vii) Exemptions within categories of income. With respect to 
paragraphs (h)(2)(i) through (v), (vii), and (viii) of this section, a 
foreign country must provide an exemption from tax for all income in a 
category of income, as defined in paragraph (h)(2) of this section. For 
example, a country that exempts income from the bareboat charter of 
passenger aircraft but not the bareboat charter of cargo aircraft does 
not provide an equivalent exemption. However, an equivalent exemption 
may be available for income derived from the international operation of 
ships even though income derived from the international operation of 
aircraft may not be exempt, and vice versa. With respect to paragraph 
(h)(2)(vi) of this section, a foreign country may be considered to grant 
an equivalent exemption for one or more types of income described in 
paragraph (g)(1) of this section.
    (i) Treatment of possessions. For purposes of this section, a 
possession of the United States will be treated as a foreign country. A 
possession of the United States will be considered to grant an 
equivalent exemption and will be treated as a qualified foreign country 
if it applies a mirror system of taxation. If a possession does not 
apply a mirror system of taxation, the possession may nevertheless be a 
qualified foreign country if, for example, it provides for an equivalent 
exemption through its internal law. A possession applies the mirror 
system of taxation if the U.S. Internal Revenue Code of 1986, as 
amended, applies in the possession with the name of the possession used 
instead of ``United States'' where appropriate.
    (j) Expenses related to qualified income. If a qualified foreign 
corporation derives qualified income from the international operation of 
ships or aircraft as well as income that is not qualified income, and 
the nonqualified income is effectively connected with the conduct of a 
trade or business within the United States, the foreign corporation may 
not deduct from such nonqualified income any amount otherwise allowable 
as a deduction from qualified income, if that qualified income is 
excluded under this section. See section 265(a)(1).

[T.D. 9087, 68 FR 51400, Aug. 26, 2003; 69 FR 7995, Feb. 20, 2004, as 
amended by T.D. 9332, 72 FR 34605, June 25, 2007; 72 FR 45159, Aug. 13, 
2007; T.D. 9502, 75 FR 56861, Sept. 17, 2010]

[[Page 531]]



Sec.  1.883-2  Treatment of publicly-traded corporations.

    (a) General rule. A foreign corporation satisfies the stock 
ownership test of Sec.  1.883-1(c)(2) if it is considered a publicly-
traded corporation and satisfies the substantiation and reporting 
requirements of paragraphs (e) and (f) of this section. To be considered 
a publicly-traded corporation, the stock of the foreign corporation must 
be primarily traded and regularly traded, as defined in paragraphs (c) 
and (d) of this section, respectively, on one or more established 
securities markets, as defined in paragraph (b) of this section, in 
either the United States or any qualified foreign country.
    (b) Established securities market--(1) General rule. For purposes of 
this section, the term established securities market means, for any 
taxable year--
    (i) A foreign securities exchange that is officially recognized, 
sanctioned, or supervised by a governmental authority of the qualified 
foreign country in which the market is located, and has an annual value 
of shares traded on the exchange exceeding $1 billion during each of the 
three calendar years immediately preceding the beginning of the taxable 
year;
    (ii) A national securities exchange that is registered under section 
6 of the Securities Act of 1934 (15 U.S.C. 78f);
    (iii) A United States over-the-counter market, as defined in 
paragraph (b)(4) of this section;
    (iv) Any exchange designated under a Limitation on Benefits article 
in a United States income tax convention; and
    (v) Any other exchange that the Secretary may designate by 
regulation or otherwise.
    (2) Exchanges with multiple tiers. If an exchange in a foreign 
country has more than one tier or market level on which stock may be 
separately listed or traded, each such tier shall be treated as a 
separate exchange.
    (3) Computation of dollar value of stock traded. For purposes of 
paragraph (b)(1)(i) of this section, the value in U.S. dollars of shares 
traded during a calendar year shall be determined on the basis of the 
dollar value of such shares traded as reported by the International 
Federation of Stock Exchanges located in Paris, or, if not so reported, 
then by converting into U.S. dollars the aggregate value in local 
currency of the shares traded using an exchange rate equal to the 
average of the spot rates on the last day of each month of the calendar 
year.
    (4) Over-the-counter market. An over-the-counter market is any 
market reflected by the existence of an interdealer quotation system. An 
interdealer quotation system is any system of general circulation to 
brokers and dealers that regularly disseminates quotations of stocks and 
securities by identified brokers or dealers, other than by quotation 
sheets that are prepared and distributed by a broker or dealer in the 
regular course of business and that contain only quotations of such 
broker or dealer.
    (5) Discretion to determine that an exchange does not qualify as an 
established securities market. The Commissioner may determine that a 
securities exchange that otherwise meets the requirements of paragraph 
(b) of this section does not qualify as an established securities 
market, if--
    (i) The exchange does not have adequate listing, financial 
disclosure, or trading requirements (or does not adequately enforce such 
requirements); or
    (ii) There is not clear and convincing evidence that the exchange 
ensures the active trading of listed stocks.
    (c) Primarily traded. For purposes of this section, stock of a 
corporation is primarily traded in a country on one or more established 
securities markets, as defined in paragraph (b) of this section, if, 
with respect to each class of stock described in paragraph (d)(1)(i) of 
this section (relating to classes of stock relied on to meet the 
regularly traded test)--
    (1) The number of shares in each such class that are traded during 
the taxable year on all established securities markets in that country 
exceeds
    (2) The number of shares in each such class that are traded during 
that year on established securities markets in any other single country.
    (d) Regularly traded--(1) General rule. For purposes of this 
section, stock of a corporation is regularly traded on one or more 
established securities markets,

[[Page 532]]

as defined in paragraph (b) of this section, if--
    (i) One or more classes of stock of the corporation that, in the 
aggregate, represent more than 50 percent of the total combined voting 
power of all classes of stock of such corporation entitled to vote and 
of the total value of the stock of such corporation are listed on such 
market or markets during the taxable year; and
    (ii) With respect to each class relied on to meet the more than 50 
percent requirement of paragraph (d)(1)(i) of this section--
    (A) Trades in each such class are effected, other than in de minimis 
quantities, on such market or markets on at least 60 days during the 
taxable year (or \1/6\ of the number of days in a short taxable year); 
and
    (B) The aggregate number of shares in each such class that are 
traded on such market or markets during the taxable year are at least 10 
percent of the average number of shares outstanding in that class during 
the taxable year (or, in the case of a short taxable year, a percentage 
that equals at least 10 percent of the average number of shares 
outstanding in that class during the taxable year multiplied by the 
number of days in the short taxable year, divided by 365).
    (2) Classes of stock traded on a domestic established securities 
market treated as meeting trading requirements. A class of stock that is 
traded during the taxable year on an established securities market 
located in the United States shall be considered to meet the trading 
requirements of paragraph (d)(1)(ii) of this section if the stock is 
regularly quoted by dealers making a market in the stock. A dealer makes 
a market in a stock only if the dealer regularly and actively offers to, 
and in fact does, purchase the stock from, and sell the stock to, 
customers who are not related persons (as defined in section 954(d)(3)) 
with respect to the dealer in the ordinary course of a trade or 
business.
    (3) Closely-held classes of stock not treated as meeting trading 
requirements--(i) General rule. Except as provided in paragraph 
(d)(3)(ii) of this section, a class of stock of a foreign corporation 
that otherwise meets the requirements of paragraph (d)(1) or (2) of this 
section shall not be treated as meeting such requirements for a taxable 
year if, for more than half the number of days during the taxable year, 
one or more persons who own at least 5 percent of the vote and value of 
the outstanding shares of the class of stock, as determined under 
paragraph (d)(3)(iii) of this section (each a 5-percent shareholder), 
own, in the aggregate, 50 percent or more of the vote and value of the 
outstanding shares of the class of stock. If one or more 5-percent 
shareholders own, in the aggregate, 50 percent or more of the vote and 
value of the outstanding shares of the class of stock, such shares held 
by the 5-percent shareholders will constitute a closely-held block of 
stock.
    (ii) Exception. Paragraph (d)(3)(i) of this section shall not apply 
to a class of stock if the foreign corporation can establish that 
qualified shareholders, as defined in Sec.  1.883-4(b), applying the 
attribution rules of Sec.  1.883-4(c), own sufficient shares in the 
closely-held block of stock to preclude nonqualified shareholders in the 
closely-held block of stock from owning 50 percent or more of the total 
value of the class of stock of which the closely-held block is a part 
for more than half the number of days during the taxable year. Any 
shares that are owned, after application of the attribution rules in 
Sec.  1.883-4(c), by a qualified shareholder shall not also be treated 
as owned by a nonqualified shareholder in the chain of ownership for 
purposes of the preceding sentence. A foreign corporation must obtain 
the documentation described in Sec.  1.883-4(d) from the qualified 
shareholders relied upon to satisfy this exception. However, no person 
otherwise treated as a qualified shareholder under Sec.  1.883-4(b) may 
be treated for purposes of this paragraph (d)(3) as a qualified 
shareholder if such person's interest in the foreign corporation, or in 
any intermediary corporation, is held through bearer shares that are not 
maintained during the relevant period in a dematerialized or immobilized 
book-entry system, as described in Sec.  1.883-1(c)(3)(i)(G).

[[Page 533]]

    (iii) Five-percent shareholders--(A) Related persons. Solely for 
purposes of determining whether a person is a 5-percent shareholder, 
persons related within the meaning of section 267(b) shall be treated as 
one person. In determining whether two or more corporations are members 
of the same controlled group under section 267(b)(3), a person is 
considered to own stock owned directly by such person, stock owned 
through the application of section 1563(e)(1), and stock owned through 
the application of section 267(c). In determining whether a corporation 
is related to a partnership under section 267(b)(10), a person is 
considered to own the partnership interest owned directly by such person 
and the partnership interest owned through the application of section 
267(e)(3).
    (B) Investment companies. For purposes of this paragraph (d)(3), an 
investment company registered under the Investment Company Act of 1940, 
as amended (54 Stat. 789), shall not be treated as a 5-percent 
shareholder.
    (4) Anti-abuse rule. Trades between or among related persons 
described in section 267(b), as modified by paragraph (d)(3)(iii) of 
this section, and trades conducted in order to meet the requirements of 
paragraph (d)(1) of this section shall be disregarded. A class of stock 
shall not be treated as meeting the trading requirements of paragraph 
(d)(1) of this section if there is a pattern of trades conducted to meet 
the requirements of that paragraph. For example, trades between two 
persons that occur several times during the taxable year may be treated 
as an arrangement or a pattern of trades conducted to meet the trading 
requirements of paragraph (d)(1)(ii) of this section.
    (5) Example. The closely-held test in paragraph (d)(3) of this 
section is illustrated by the following example:

    Example. Closely-held exception. (i) Facts. X is a foreign 
corporation organized in a qualified foreign country and engaged in the 
international operation of ships. X has one class of stock, which is 
primarily traded on an established securities market in the qualified 
foreign country. The stock of X meets the regularly traded requirements 
of paragraph (d)(1)(ii) of this section without regard to paragraph 
(d)(3)(i) of this section. A, B, C and D are four members of the 
corporation's founding family who each own, during the entire taxable 
year, 25 percent of the stock of Hold Co, a company that issues 
registered shares. Hold Co, in turn, owns 60 percent of the stock of X 
during the entire taxable year. The remaining 40 percent of the stock of 
X is not owned by any 5-percent shareholder, as determined under 
paragraph (d)(3)(iii) of this section. A, B, and C are not residents of 
a qualified foreign country, but D is a resident of a qualified foreign 
country.
    (ii) Analysis. Because Hold Co owns 60 percent of the stock of X for 
more than half the number of days during the taxable year, Hold Co is a 
5-percent shareholder that owns 50 percent or more of the value of the 
stock of X. Thus, the shares owned by Hold Co constitute a closely-held 
block of stock. Under paragraph (d)(3)(i) of this section, the stock of 
X will not be regularly traded within the meaning of paragraph (d)(1) of 
this section unless X can establish, under paragraph (d)(3)(ii) of this 
section, that qualified shareholders within the closely-held block of 
stock own sufficient shares in the closely-held block of stock to 
preclude nonqualified shareholders in the closely-held block of stock 
from owning 50 percent or more of the value of the outstanding shares in 
the class of stock for more than half the number of days during the 
taxable year. A, B, and C are not qualified shareholders within the 
meaning of Sec.  1.883-4(b) because they are not residents of a 
qualified foreign country, but D is a resident of a qualified foreign 
country and therefore is a qualified shareholder. D owns 15 percent of 
the outstanding shares of X through Hold Co (25 percent x 60 percent = 
15 percent) while A, B, and C in the aggregate own 45 percent of the 
outstanding shares of X through Hold Co. D, therefore, owns sufficient 
shares in the closely-held block of stock to preclude the nonqualified 
shareholders in the closely-held block of stock, A, B and C, from owning 
50 percent or more of the value of the class of stock (60 percent-15 
percent = 45 percent) of which the closely-held block is a part. 
Provided that X obtains from D the documentation described in Sec.  
1.883-4(d), X's sole class of stock meets the exception in paragraph 
(d)(3)(ii) of this section and will not be disqualified from the 
regularly traded test by virtue of paragraph (d)(3)(i) of this section.
    (e) Substantiation that a foreign corporation is publicly traded--
(1) General rule. A foreign corporation that relies on the publicly 
traded test of this section to meet the stock ownership test of Sec.  
1.883-1(c)(2) must substantiate that the stock of the foreign 
corporation is primarily and regularly traded on one or more established 
securities markets, as that term is defined in paragraph (b)

[[Page 534]]

of this section. If one of the classes of stock on which the foreign 
corporation relies to meet this test is closely-held within the meaning 
of paragraph (d)(3)(i) of this section, the foreign corporation must 
obtain an ownership statement described in Sec.  1.883-4(d) from each 
qualified shareholder and intermediary that it relies upon to satisfy 
the exception to the closely-held test, but only to the extent such 
statement would be required if the foreign corporation were relying on 
the qualified shareholder stock ownership test of Sec.  1.883-4 with 
respect to those shares of stock. The foreign corporation must also 
maintain and provide to the Commissioner upon request a list of its 
shareholders of record and any other relevant information known to the 
foreign corporation supporting its entitlement to an exemption under 
this section.
    (2) Availability and retention of documents for inspection. A 
foreign corporation seeking qualified foreign corporation status must 
retain the documentation described in paragraph (e)(1) of this section 
until the expiration of the statute of limitations for its taxable year 
to which the documentation relates. The foreign corporation must make 
such documentation available for inspection at such time and such place 
as the Commissioner requests in writing under Sec.  1.883-1(c)(3)(ii)(A) 
or (B).
    (f) Reporting requirements. A foreign corporation relying on this 
section to satisfy the stock ownership test of Sec.  1.883-1(c)(2) must 
provide the following information in addition to the information 
required in Sec.  1.883-1(c)(3) to be included in its Form 1120-F, 
``U.S. Income Tax Return of a Foreign Corporation,'' for the taxable 
year. The information must be current as of the end of the corporation's 
taxable year and must include the following--
    (1) The name of the country in which the stock is primarily traded;
    (2) The name of the established securities market or markets on 
which the stock is listed;
    (3) A description of each class of stock relied upon to meet the 
requirements of paragraph (d) of this section, including whether the 
class is issued in registered or bearer form and whether any such bearer 
shares are maintained in a dematerialized or immobilized book-entry 
system, as described in Sec.  1.883-1(c)(3)(i)(G), the number of shares 
issued and outstanding in that class as of the close of the taxable 
year, and the relative value of each class in relation to the total 
value of all shares of stock of the corporation that are outstanding as 
of the close of the taxable year;
    (4) For each class of stock relied upon to meet the requirements of 
paragraph (d) of this section, if one or more 5-percent shareholders, as 
defined in paragraph (d)(3)(i) of this section, own in the aggregate 50 
percent or more of the vote and value of the outstanding shares of that 
class of stock for more than half the number of days during the taxable 
year--
    (i) The days during the taxable year of the corporation in which the 
stock was closely-held without regard to the exception in paragraph 
(d)(3)(ii) of this section and the percentage of the vote and value of 
the class of stock that is owned by 5-percent shareholders during such 
days;
    (ii) With respect to all qualified shareholders that own directly, 
or by application of the attribution rules in Sec.  1.883-4(c), shares 
of the closely-held block of stock and that the foreign corporation 
relies on to satisfy the exception provided by paragraph (d)(3)(ii) of 
this section--
    (A) The number of such qualified shareholders;
    (B) The total percentage of the value of the shares owned, directly 
or indirectly, by such qualified shareholders by country of residence, 
determined under Sec.  1.883-4(b)(2) (residence of individual 
shareholders) or Sec.  1.883-4(d)(3) (special rules for residence of 
certain shareholders); and
    (C) The number of days during the taxable year of the foreign 
corporation that such qualified shareholders owned, directly or 
indirectly, their shares in the closely held block of stock.
    (5) Any other relevant information specified by Form 1120-F and its 
accompanying instructions.

[T.D. 9087, 68 FR 51406, Aug. 26, 2003, as amended by T.D. 9332, 72 FR 
34606, June 25, 2007; T.D. 9502, 75 FR 56862, Sept. 17, 2010; 75 FR 
63380, Oct. 15, 2010]

[[Page 535]]



Sec.  1.883-3  Treatment of controlled foreign corporations.

    (a) General rule. A foreign corporation satisfies the stock 
ownership test of Sec.  1.883-1(c)(2) if it satisfies the qualified U.S. 
person ownership test in paragraph (b) of this section and the 
substantiation and reporting requirements of paragraphs (c) and (d) of 
this section, respectively. A foreign corporation that fails the 
qualified U.S. person ownership test of paragraph (b) of this section 
can satisfy the stock ownership test of Sec.  1.883-1(c)(2) if it meets 
either the publicly-traded test of Sec.  1.883-2(a) or the qualified 
shareholder stock ownership test of Sec.  1.883-4(a).
    (b) Qualified U.S. person ownership test--(1) General rule. A 
foreign corporation satisfies the qualified U.S. person ownership test 
only if the following two conditions are satisfied concurrently during 
more than half the days in its taxable year:
    (i) The foreign corporation is a controlled foreign corporation 
(within the meaning of section 957(a)).
    (ii) One or more qualified U.S. persons own more than 50 percent of 
the total value of all the outstanding stock of the foreign corporation 
(within the meaning of section 958(a) and paragraph (b)(4) of this 
section).
    (2) Qualified U.S. person. For purposes of this section, a qualified 
U.S. person is a United States citizen or resident alien, a domestic 
corporation, or a domestic trust described in section 501(a), but only 
if the person provides the controlled foreign corporation an ownership 
statement described in paragraph (c)(2) of this section, and the 
controlled foreign corporation meets the reporting requirements of 
paragraph (d) of this section with respect to that person.
    (3) Treatment of bearer shares. For purposes of paragraph (b)(1)(ii) 
of this section, any shares of the foreign corporation or of any 
intermediary corporation that are issued in bearer form, shall be 
treated as not owned by qualified U.S. persons if the bearer shares are 
not maintained in a dematerialized or immobilized book-entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G).
    (4) Ownership attribution through certain domestic entities. For 
purposes of paragraph (b)(1)(ii) of this section, stock owned, directly 
or indirectly, by or for a domestic partnership, a domestic trust not 
described in section 501(a), or a domestic estate, shall be treated as 
owned proportionately by the partners, beneficiaries, grantors, or other 
interest holders, respectively, under the rules of section 958(a), which 
shall be applied by treating each domestic entity as a foreign entity. 
Stock that is considered owned by a person under this paragraph (b)(4) 
shall, for purposes of applying this paragraph (b)(4) to such person, be 
treated as actually owned by such person.
    (5) Examples. The following examples illustrate the qualified U.S. 
person ownership test of paragraph (b)(1) of this section:

    Example 1. Ship Co is a controlled foreign corporation (within the 
meaning of section 957(a)) for more than half the days of its taxable 
year and is organized in a qualified foreign country. A domestic 
partnership owns all of the outstanding stock of Ship Co for the entire 
taxable year. All of the partners in the domestic partnership are 
residents of foreign countries and not citizens of the United States. 
Ship Co does not satisfy the qualified U.S. person ownership test of 
paragraph (b)(1) of this section because qualified U.S. persons do not 
own shares of Ship Co stock with a value that is greater than 50 percent 
of the total value of the outstanding stock of the corporation for at 
least half the days of Ship Co's taxable year. Therefore, to satisfy the 
stock ownership test of Sec.  1.883-1(c)(2) and constitute a qualified 
foreign corporation, Ship Co must meet the qualified shareholder stock 
ownership test of Sec.  1.883-4(a).
    Example 2. Ship Co is a controlled foreign corporation (within the 
meaning of section 957(a)) for more than half the days of its taxable 
year and is organized in a qualified foreign country. Ship Co has a 
single class of stock outstanding. For Ship Co's entire taxable year, a 
foreign corporation (Corp A), that is wholly owned by a resident of a 
foreign country who is not a U.S. citizen, owns 40 percent of the 
outstanding Ship Co stock. During that same period, a domestic 
partnership owns the remaining 60 percent of the outstanding Ship Co 
stock. The domestic partnership is wholly owned by 20 United States 
citizens, each of whom owns a 5-percent partnership interest for Ship 
Co's entire taxable year. Ship Co meets the qualified U.S. person 
ownership test of paragraph (b)(1) of this section because during more 
than half the days in its taxable year it was a controlled foreign 
corporation within the meaning of section 957(a), and, applying the 
ownership attribution rules of paragraph

[[Page 536]]

(b)(4) of this section, qualified U.S. persons (the partners in the 
domestic partnership) owned Ship Co stock with a value that is greater 
than 50 percent of the total value of all the outstanding Ship Co 
shares. Therefore, Ship Co will meet the stock ownership test of Sec.  
1.883-1(c)(2) if it satisfies the substantiation and reporting 
requirements of paragraphs (c) and (d) of this section with respect to 
the partners in the domestic partnership. Alternatively, if four or more 
partners in the domestic partnership were not qualified U.S. persons, 
Ship Co would not meet the qualified U.S. person ownership test of 
paragraph (b)(1) of this section because, even though during more than 
half the days in its taxable year it would have been a controlled 
foreign corporation within the meaning of section 957(a), qualified U.S. 
persons would not have owned Ship Co stock with a value that is greater 
than 50 percent of the total value of all the outstanding Ship Co shares 
during that period.
    Example 3. Ship Co is a controlled foreign corporation (within the 
meaning of section 957(a)) and is organized in a qualified foreign 
country. Ship Co has two classes of stock outstanding, Class A 
representing 60 percent of the vote and value and Class B representing 
the remaining 40 percent of the vote and value of all the shares 
outstanding of Ship Co. The Class A stock is issued in bearer form and 
is maintained in a dematerialized book-entry system, as described in 
Sec.  1.883-1(c)(3)(i)(G). The Class B stock is also issued in bearer 
form, but is not maintained in a dematerialized or immobilized book-
entry system. For Ship Co's entire taxable year, a United States citizen 
A holds all the Class A stock and nonresident alien individual B owns 
all the Class B stock. Although the Class A stock is issued in bearer 
form, Ship Co will satisfy the qualified U.S. person ownership test of 
paragraph (b)(1) of this section because the Class A stock is maintained 
in a dematerialized book-entry system on behalf of A. The Class B stock 
is not owned by a qualified U.S. person but is taken into account in 
determining the total value of Ship Co's outstanding stock. 
Alternatively, if the Class B stock were owned by a qualified U.S. 
person, the results would be similar. Class B stock would not be taken 
into account in determining if the qualified U.S. person ownership test 
were satisfied, but would be taken into account in determining the total 
value of Ship Co's outstanding stock.

    (c) Substantiation of CFC stock ownership--(1) In general. A 
controlled foreign corporation must establish all of the facts necessary 
to demonstrate to the Commissioner that it satisfies the qualified U.S. 
person ownership test of paragraph (b)(1) of this section by obtaining a 
written ownership statement (described in paragraph (c)(2) or (3) of 
this section, as applicable), signed under penalties of perjury by an 
individual authorized to sign that person's Federal tax or information 
return, from--
    (i) Each qualified U.S. person whose ownership of stock of the 
controlled foreign corporation is taken into account for purposes of 
meeting the qualified U.S. person ownership test; and
    (ii) Each domestic intermediary described in paragraph (b)(4) of 
this section, each foreign intermediary (including a foreign 
corporation, partnership, trust, or estate), and mere legal owners or 
record holders acting as nominees in the chain of ownership between each 
such qualified U.S. person and the controlled foreign corporation, if 
any.
    (2) Ownership statements from qualified U.S. persons. An ownership 
statement from a qualified U.S. person must include--
    (i) The qualified U.S. person's name, permanent address, and 
taxpayer identification number;
    (ii) If the qualified U.S. person directly owns shares in the 
controlled foreign corporation, the number of shares of each class of 
stock of the controlled foreign corporation owned by the qualified U.S. 
person, whether any shares are issued in bearer form, whether any bearer 
shares are maintained in a dematerialized or immobilized book-entry 
system, as described in Sec.  1.883-1(c)(3)(i)(G), and the period (or 
periods) in the taxable year of the controlled foreign corporation 
during which the qualified U.S. person owned the shares;
    (iii) If the qualified U.S. person indirectly owns shares in the 
controlled foreign corporation through a foreign or domestic 
intermediary described in paragraph (c)(1)(ii) of this section, the name 
of each intermediary, the amount and nature of the qualified U.S. 
person's interest in each intermediary, the period (or periods) in the 
taxable year of the controlled foreign corporation during which the 
qualified U.S. person held such interest, and, with respect to any 
intermediary foreign corporation, whether any shares

[[Page 537]]

are issued in bearer form and whether any such bearer shares are 
maintained in a dematerialized or immobilized book-entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G); and
    (iv) Any other information specified in published guidance by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (3) Ownership statements from intermediaries. An ownership statement 
from a domestic or foreign intermediary must include:
    (i) The intermediary's name, permanent address, and taxpayer 
identification number, if any.
    (ii) If the intermediary directly owns stock in the controlled 
foreign corporation, the number of shares of each class of stock of the 
controlled foreign corporation owned by the intermediary, whether such 
shares are issued in bearer form and maintained in a dematerialized or 
immobilized book-entry system, as described in Sec.  1.883-
1(c)(3)(i)(G), and the period (or periods) in the taxable year of the 
controlled foreign corporation during which the intermediary owned the 
shares.
    (iii) If the intermediary indirectly owns the stock of the 
controlled foreign corporation, the name and address of each 
intermediary in the chain of ownership between it and the controlled 
foreign corporation, the period (or periods) in the taxable year of the 
controlled foreign corporation during which the intermediary owned the 
shares, the percentage of its indirect ownership interest in the 
controlled foreign corporation, and, if any intermediary in the chain of 
ownership is a foreign corporation, whether any shares of such 
intermediary are issued in bearer form and if any such bearer shares are 
maintained in a dematerialized or immobilized book- entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G).
    (iv) Any other information specified in published guidance by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (4) Three-year period of validity. The rules of Sec.  1.883-
4(d)(2)(ii) shall apply for determining the validity of the ownership 
statements required under paragraph (c)(2) of this section.
    (5) Availability and retention of documents for inspection. The 
foreign corporation seeking qualified foreign corporation status must 
retain the ownership statements described in this paragraph (c) until 
the expiration of the statute of limitations for its taxable year to 
which the ownership statements relate. The ownership statements must be 
made available for inspection at such time and place as the Commissioner 
may request in writing in accordance with Sec.  1.883-1(c)(3)(ii).
    (d) Reporting requirements. A controlled foreign corporation that 
relies on this section to satisfy the stock ownership test of Sec.  
1.883-1(c)(2) must include the following information (in addition to the 
information required by Sec.  1.883-1(c)(3)) with its Form 1120-F, 
``U.S. Income Tax Return of a Foreign Corporation'', filed for its 
taxable year. This information must be consistent with the ownership 
statements obtained by the controlled foreign corporation pursuant to 
paragraph (c) of this section and must be current as of the end of the 
corporation's taxable year--
    (1) The relative value of the shares of the controlled foreign 
corporation that are owned (directly, and indirectly applying the rules 
of paragraph (b)(4) of this section) by all qualified U.S. persons 
identified in paragraph (c)(2) of this section as compared to the value 
of all outstanding shares of the corporation;
    (2) The period (or periods) in the taxable year during which such 
qualified U.S. persons held such shares;
    (3) The period (or periods) in the taxable year during which the 
foreign corporation was a controlled foreign corporation;
    (4) A statement as to whether the controlled foreign corporation or 
any intermediary corporation had bearer shares outstanding during the 
taxable year, and whether any such bearer shares taken into account for 
purposes of satisfying the qualified U.S. person ownership test are 
maintained in a dematerialized or immobilized book-entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G); and
    (5) Any other information specified by Form 1120-F, and its 
accompanying instructions, or in published guidance

[[Page 538]]

by the Internal Revenue Service (see Sec.  601.601(d)(2) of this 
chapter).

[T.D. 9502, 75 FR 56863, Sept. 17, 2010]



Sec.  1.883-4  Qualified shareholder stock ownership test.

    (a) General rule. A foreign corporation satisfies the stock 
ownership test of Sec.  1.883-1(c)(2) if more than 50 percent of the 
value of its outstanding shares is owned, or treated as owned by 
applying the attribution rules of paragraph (c) of this section, for at 
least half of the number of days in the foreign corporation's taxable 
year by one or more qualified shareholders, as defined in paragraph (b) 
of this section. A shareholder may be a qualified shareholder with 
respect to one category of income while not being a qualified 
shareholder with respect to another. A foreign corporation will not be 
considered to satisfy the stock ownership test of Sec.  1.883-1(c)(2) 
pursuant to this section unless the foreign corporation meets the 
substantiation and reporting requirements of paragraphs (d) and (e) of 
this section.
    (b) Qualified shareholder--(1) General rule. A shareholder is a 
qualified shareholder only if the shareholder--
    (i) With respect to the category of income for which the foreign 
corporation is seeking an exemption, is--
    (A) An individual who is a resident, as described in paragraph 
(b)(2) of this section, of a qualified foreign country;
    (B) The government of a qualified foreign country (or a political 
subdivision or local authority of such country);
    (C) A foreign corporation that is organized in a qualified foreign 
country and meets the publicly traded test of Sec.  1.883-2(a);
    (D) A not-for-profit organization described in paragraph (b)(4) of 
this section that is not a pension fund as defined in paragraph (b)(5) 
of this section and that is organized in a qualified foreign country;
    (E) An individual beneficiary of a pension fund (as defined in 
paragraph (b)(5)(iv) of this section) that is administered in or by a 
qualified foreign country, who is treated as a resident under paragraph 
(d)(3)(iii) of this section, of a qualified foreign country; or
    (F) A shareholder of a foreign corporation that is an airline 
covered by a bilateral Air Services Agreement in force between the 
United States and the qualified foreign country in which the airline is 
organized, provided the United States has not waived the ownership 
requirement in the Air Services Agreement, or that the ownership 
requirement has not otherwise been made ineffective;
    (ii) Does not own its interest in the foreign corporation through 
bearer shares, either directly or by applying the attribution rules of 
paragraph (c) of this section, unless such bearer shares are maintained 
in a dematerialized or immobilized book-entry system, as described in 
Sec.  1.883-1(c)(3)(i)(G); and
    (iii) Provides to the foreign corporation the documentation required 
in paragraph (d) of this section and the foreign corporation meets the 
reporting requirements of paragraph (e) of this section with respect to 
such shareholder.
    (2) Residence of individual shareholders--(i) General rule. An 
individual described in paragraph (b)(1)(i)(A) of this section is a 
resident of a qualified foreign country only if the individual is fully 
liable to tax as a resident in such country (e.g., an individual who is 
liable to tax on a remittance basis in a foreign country will not be 
treated as a resident of that country unless all residents of that 
country are taxed on a remittance basis only) and, in addition--
    (A) The individual has a tax home, within the meaning of paragraph 
(b)(2)(ii) of this section, in that qualified foreign country for 183 
days or more of the taxable year; or
    (B) The individual is treated as a resident of a qualified foreign 
country based on special rules pursuant to paragraph (d)(3) of this 
section.
    (ii) Tax home. For purposes of this section, an individual's tax 
home is considered to be located at the individual's regular or 
principal (if more than one regular) place of business. If the 
individual has no regular or principal place of business because of the 
nature of his business (or lack of a business), then the individual's 
tax home is located at his regular place of abode in a real and 
substantial sense. If an individual has no regular or principal place

[[Page 539]]

of business and no regular place of abode in a real and substantial 
sense in a qualified foreign country for 183 days or more of the taxable 
year, that individual does not have a tax home for purposes of this 
section. A foreign estate or trust, as defined in section 7701(a)(31), 
does not have a tax home for purposes of this section. See paragraph 
(c)(3) of this section for alternative rules in the case of trusts or 
estates.
    (3) Certain income tax convention restrictions applied to 
shareholders. For purposes of paragraph (b)(1) of this section, a 
shareholder described in paragraph (b)(1) of this section may be 
considered a resident of, or organized in, a qualified foreign country 
if that foreign country provides an exemption by means of an income tax 
convention with the United States, but only if the shareholder 
demonstrates that it is treated as a resident of that country under the 
convention and qualifies for benefits under any Limitation on Benefits 
article, and that the convention provides an exemption for the relevant 
category of income. If the convention has a requirement in the shipping 
and air transport article other than residence, such as place of 
registration or documentation of the ship or aircraft, the shareholder 
is not required to demonstrate that the corporation seeking qualified 
foreign corporation status could satisfy any such additional 
requirement.
    (4) Not-for-profit organizations. The term not-for-profit 
organization means an organization that meets the following 
requirements--
    (i) It is a corporation, association taxable as a corporation, 
trust, fund, foundation, league or other entity operated exclusively for 
religious, charitable, educational, or recreational purposes, and not 
organized for profit;
    (ii) It is generally exempt from tax in its country of organization 
by virtue of its not-for-profit status; and
    (iii) Either--
    (A) More than 50 percent of its annual support is expended on behalf 
of individuals described in paragraph (b)(1)(i)(A) of this section (see 
paragraph (d)(3)(v) of this section for special rules to substantiate 
the residence of individual beneficiaries of not-for-profit 
organizations) and on behalf of U.S. exempt organizations that have 
received determination letters under section 501(c)(3); or
    (B) More than 50 percent of its annual support is derived from 
individuals described in paragraph (b)(1)(i)(A) of this section (see 
paragraph (d)(3)(v) of this section for special rules to substantiate 
the residence of individual supporters of not-for-profit organizations).
    (5) Pension funds--(i) Pension fund defined. The term pension fund 
shall mean a government pension fund or a nongovernment pension fund, as 
those terms are defined, respectively, in paragraphs (b)(5)(ii) and 
(iii) of this section, that is a trust, fund, foundation, or other 
entity that is established exclusively for the benefit of employees or 
former employees of one or more employers, the principal purpose of 
which is to provide retirement, disability, and death benefits to 
beneficiaries of such entity and persons designated by such 
beneficiaries in consideration for prior services rendered.
    (ii) Government pension funds. A government pension fund is a 
pension fund that is a controlled entity of a foreign sovereign within 
the principles of Sec.  1.892-2T(c)(1) (relating to pension funds 
established for the benefit of employees or former employees of a 
foreign government).
    (iii) Nongovernment pension funds. A nongovernment pension fund is a 
pension fund that--
    (A) Is administered in a foreign country and is subject to 
supervision or regulation by a governmental authority (or other 
authority delegated to perform such supervision or regulation by a 
governmental authority) in such country;
    (B) Is generally exempt from income taxation in its country of 
administration;
    (C) Has 100 or more beneficiaries; and
    (D) The trustees, directors or other administrators of which pension 
fund provide the documentation required in paragraph (d) of this 
section.
    (iv) Beneficiary of a pension fund. The term beneficiary of a 
pension fund shall mean any person who has made contributions to a 
pension fund, as that term is defined in paragraph (b)(5)(i) of

[[Page 540]]

this section, or on whose behalf contributions have been made, and who 
is currently receiving retirement, disability, or death benefits from 
the pension fund or can reasonably be expected to receive such benefits 
in the future, whether or not the person's right to receive benefits 
from the fund has vested. See paragraph (c)(7) of this section for rules 
regarding the computation of stock ownership through nongovernment 
pension funds.
    (c) Rules for determining constructive ownership (1) General rules 
for attribution. For purposes of applying paragraph (a) of this section 
and the exception to the closely-held test in Sec.  1.883-1(d)(3)(ii), 
stock owned by or for a corporation, partnership, trust, estate, or 
mutual insurance company or similar entity shall be treated as owned 
proportionately by its shareholders, partners, beneficiaries, grantors, 
or other interest holders, as provided in paragraphs (c)(2) through (7) 
of this section. The proportionate interest rules of this paragraph (c) 
shall apply successively upward through the chain of ownership, and a 
person's proportionate interest shall be computed for the relevant days 
or period taken into account in determining whether a foreign 
corporation satisfies the requirements of paragraph (a) of this section. 
Stock treated as owned by a person by reason of this paragraph (c) shall 
be treated as actually owned by such person for purposes of this 
section. An owner of an interest in an association taxable as a 
corporation shall be treated as a shareholder of such association for 
purposes of this paragraph (c). Stock issued in bearer form will not be 
treated as owned proportionately by its shareholders unless the shares 
are maintained in a dematerialized or immobilized book-entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G).
    (2) Partnerships--(i) General rule. A partner shall be treated as 
having an interest in stock of a foreign corporation owned by a 
partnership in proportion to the least of--
    (A) The partner's percentage distributive share of the partnership's 
dividend income from the stock;
    (B) The partner's percentage distributive share of gain from 
disposition of the stock by the partnership; or
    (C) The partner's percentage distributive share of the stock (or 
proceeds from the disposition of the stock) upon liquidation of the 
partnership.
    (ii) Partners resident in the same country. For purposes of this 
paragraph, all qualified shareholders that are partners in a partnership 
and that are residents of, or organized in, the same qualified foreign 
country shall be treated as one partner. Thus, the percentage 
distributive shares of dividend income, gain and liquidation rights of 
all qualified shareholders that are partners in a partnership and that 
are residents of, or organized in, the same qualified foreign country 
are aggregated prior to determining the least of the three percentages 
set out in paragraph (c)(2)(i) of this section. For the meaning of the 
term resident, see paragraph (b)(2) of this section.
    (iii) Examples. The rules of paragraph (c)(2)(ii) of this section 
are illustrated by the following examples:

    Example 1. Stock held solely by qualified shareholders through a 
partnership. Country X grants an equivalent exemption. A and B are 
individual residents of Country X and are qualified shareholders within 
the meaning of paragraph (b)(1) of this section. A and B are the sole 
partners of Partnership P. P's only asset is the stock of Corporation Z, 
a Country X corporation seeking a reciprocal exemption under this 
section. A's distributive share of P's income and gain on the 
disposition of P's assets is 80 percent, but A's distributive share of 
P's assets (or the proceeds therefrom) on P's liquidation is 20 percent. 
B's distributive share of P's income and gain is 20 percent and B is 
entitled to 80 percent of the assets (or proceeds therefrom) on P's 
liquidation. Under the attribution rules of paragraph (c)(2)(ii) of this 
section, A and B will be treated as a single partner owning in the 
aggregate 100 percent of the stock of Z owned by P.
    Example 2. Stock held by both qualified and nonqualified 
shareholders through a partnership. Assume the same facts as in Example 
1 except that C, an individual who is not a resident of a qualified 
foreign country, is also a partner in P and that C's distributive share 
of P's income is 60 percent. The distributive shares of A and B are the 
same as in Example 1, except that A's distributive share of income is 20 
percent. Under the attribution rules of paragraph (c)(2)(ii) of this 
section, qualified shareholders A and B will be treated as a single 
partner owning in the aggregate 40 percent of the stock of Z owned by P 
(i.e., the lowest aggregate percentage of

[[Page 541]]

A and B's distributive shares of dividend income (40 percent), gain (100 
percent), and liquidation rights (100 percent) with respect to the Z 
stock). Thus, only 40 percent of the Z stock is treated as owned by 
qualified shareholders.
    Example 3. Stock held through tiered partnerships. Country X grants 
an equivalent exemption. A and B are individual residents of Country X 
and are qualified shareholders within the meaning of paragraph (b)(1) of 
this section. A and B are the sole partners of Partnership P. P is a 
partner in Partnership P1, which owns the stock of Corporation Z, a 
Country X corporation seeking a reciprocal exemption under this section. 
Assume that P's distributive share of the dividend income, gain and 
liquidation rights with respect to the Z stock held by P1 is 40 percent. 
Assume that of the remaining partners of P1 only D is a qualified 
shareholder. D's distributive share of P1's dividend income and gain is 
15 percent; D's distributive share of P1's assets on liquidation is 25 
percent. Under the attribution rules of paragraph (c)(2)(ii) of this 
section, A and B, treated as a single partner, will own 40 percent of 
the Z stock owned by P1 (100 percent x 40 percent) and D will be treated 
as owning 15 percent of the Z stock owned by P1 (the least of D's 
dividend income (15 percent), gain (15 percent), and liquidation rights 
(25 percent) with respect to the Z stock). Thus, 55 percent of the Z 
stock owned by P1 is treated as owned by qualified shareholders.

    (3) Trusts and estates--(i) Beneficiaries. In general, an individual 
shall be treated as having an interest in stock of a foreign corporation 
owned by a trust or estate in proportion to the individual's actuarial 
interest in the trust or estate, as provided in section 318(a)(2)(B)(i), 
except that an income beneficiary's actuarial interest in the trust will 
be determined as if the trust's only asset were the stock. The interest 
of a remainder beneficiary in stock will be equal to 100 percent minus 
the sum of the percentages of any interest in the stock held by income 
beneficiaries. The ownership of an interest in stock owned by a trust 
shall not be attributed to any beneficiary whose interest cannot be 
determined under the preceding sentence, and any such interest, to the 
extent not attributed by reason of this paragraph (c)(3)(i), shall not 
be considered owned by a beneficiary unless all potential beneficiaries 
with respect to the stock are qualified shareholders. In addition, a 
beneficiary's actuarial interest will be treated as zero to the extent 
that someone other than the beneficiary is treated as owning the stock 
under paragraph (c)(3)(ii) of this section. A substantially separate and 
independent share of a trust, within the meaning of section 663(c), 
shall be treated as a separate trust for purposes of this paragraph 
(c)(3)(i), provided that payment of income, accumulated income or corpus 
of a share of one beneficiary (or group of beneficiaries) cannot affect 
the proportionate share of income, accumulated income or corpus of 
another beneficiary (or group of beneficiaries).
    (ii) Grantor trusts. A person is treated as the owner of stock of a 
foreign corporation owned by a trust to the extent that the stock is 
included in the portion of the trust that is treated as owned by the 
person under sections 671 through 679 (relating to grantors and others 
treated as substantial owners).
    (4) Corporations that issue stock. A shareholder of a corporation 
that issues stock shall be treated as owning stock of a foreign 
corporation that is owned by such corporation on any day in a proportion 
that equals the value of the stock owned by such shareholder to the 
value of all stock of such corporation. If, however, there is an 
agreement, express or implied, that a shareholder of a corporation will 
not receive distributions from the earnings of stock owned by the 
corporation, the shareholder will not be treated as owning that stock 
owned by the corporation.
    (5) Taxable nonstock corporations. A taxable nonstock corporation 
that is entitled in its country of organization to deduct from its 
taxable income amounts distributed for charitable purposes may deem a 
recipient of such charitable distributions to be a shareholder of such 
taxable nonstock corporation in the same proportion as the amount that 
such beneficiary receives in the taxable year bears to the total income 
of such taxable nonstock corporation in the taxable year. Whether each 
such recipient is a qualified shareholder may then be determined under 
paragraph (b) of this section or under the special rules of paragraph 
(d)(3)(vii) of this section.
    (6) Mutual insurance companies and similar entities. Stock held by a 
mutual

[[Page 542]]

insurance company, mutual savings bank, or similar entity (including an 
association taxable as a corporation that does not issue stock 
interests) shall be considered owned proportionately by the 
policyholders, depositors, or other owners in the same proportion that 
such persons share in the surplus of such entity upon liquidation or 
dissolution.
    (7) Computation of beneficial interests in nongovernment pension 
funds. Stock held by a pension fund shall be considered owned by the 
beneficiaries of the fund equally on a pro-rata basis if--
    (i) The pension fund meets the requirements of paragraph (b)(5)(iii) 
of this section;
    (ii) The trustees, directors or other administrators of the pension 
fund have no knowledge, and no reason to know, that a pro-rata 
allocation of interests of the fund to all beneficiaries would differ 
significantly from an actuarial allocation of interests in the fund (or, 
if the beneficiaries' actuarial interest in the stock held directly or 
indirectly by the pension fund differs from the beneficiaries' actuarial 
interest in the pension fund, the actuarial interests computed by 
reference to the beneficiaries' actuarial interest in the stock);
    (iii) Either--
    (A) Any overfunding of the pension fund would be payable, pursuant 
to the governing instrument or the laws of the foreign country in which 
the pension fund is administered, only to, or for the benefit of, one or 
more corporations that are organized in the country in which the pension 
fund is administered, individual beneficiaries of the pension fund or 
their designated beneficiaries, or social or charitable causes (the 
reduction of the obligation of the sponsoring company or companies to 
make future contributions to the pension fund by reason of overfunding 
shall not itself result in such overfunding being deemed to be payable 
to or for the benefit of such company or companies); or
    (B) The foreign country in which the pension fund is administered 
has laws that are designed to prevent overfunding of a pension fund and 
the funding of the pension fund is within the guidelines of such laws; 
or
    (C) The pension fund is maintained to provide benefits to employees 
in a particular industry, profession, or group of industries or 
professions and employees of at least 10 companies (other than companies 
that are owned or controlled, directly or indirectly, by the same 
interests) contribute to the pension fund or receive benefits from the 
pension fund; and
    (iv) The trustees, directors or other administrators provide the 
relevant documentation as required in paragraph (d) of this section.
    (d) Substantiation of stock ownership-- (1) General rule. A foreign 
corporation that relies on this section to satisfy the stock ownership 
test of Sec.  1.883-1(c)(2), must establish all the facts necessary to 
satisfy the Commissioner that more than 50 percent of the value of its 
shares is owned, or treated as owned applying paragraph (c) of this 
section, by qualified shareholders for the relevant period. If a foreign 
corporation relies upon bearer shares in the chain of ownership to 
satisfy one of the stock ownership tests, the foreign corporation must 
also establish all of the facts necessary to satisfy the Commissioner 
that such shares are maintained in a dematerialized book-entry system, 
as described in Sec.  1.883-1(c)(3)(i)(G), for the benefit of the 
relevant shareholder.
    (2) Application of general rule--(i) Ownership statements. Except as 
provided in paragraph (d)(3) of this section, a person shall only be 
treated as a qualified shareholder of a foreign corporation if--
    (A) For the relevant period, the person completes an ownership 
statement described in paragraph (d)(4) of this section or has a valid 
ownership statement in effect under paragraph (d)(2)(ii) of this 
section;
    (B) In the case of a person owning stock in the foreign corporation 
indirectly through one or more intermediaries (including mere legal 
owners or recordholders acting as nominees), each intermediary in the 
chain of ownership between that person and the foreign corporation 
seeking qualified foreign corporation status completes an intermediary 
ownership statement described in paragraph (d)(4)(v) of this section or 
has a valid intermediary

[[Page 543]]

ownership statement in effect under paragraph (d)(2)(ii) of this 
section; and
    (C) The foreign corporation seeking qualified foreign corporation 
status obtains the statements described in paragraphs (d)(2)(i)(A) and 
(B) of this section.
    (ii) Three-year period of validity. The ownership statements 
required in paragraph (d)(2)(i) of this section shall remain valid until 
the earlier of the last day of the third calendar year following the 
year in which the ownership statement is signed, or the day that a 
change of circumstance occurs that makes any information on the 
ownership statement incorrect. For example, an ownership statement 
signed on September 30, 2000, remains valid through December 31, 2003, 
unless a change of circumstance occurs that makes any information on the 
ownership statement incorrect.
    (3) Special rules--(i) Substantiating residence of certain 
shareholders. A foreign corporation seeking qualified foreign 
corporation status or an intermediary that is a direct or indirect 
shareholder of such foreign corporation may substantiate the residence 
of certain shareholders, for purposes of paragraph (b)(2)(i)(B) of this 
section, under one of the following special rules in paragraphs 
(d)(3)(ii) through (viii) of this section, in lieu of obtaining the 
ownership statements required in paragraph (d)(2)(i) of this section 
from such shareholders.
    (ii) Special rule for registered shareholders owning less than one 
percent of widely-held corporations. A foreign corporation with at least 
250 registered shareholders, that is not a publicly-traded corporation, 
as described in Sec.  1.883-2 (a widely-held corporation), is not 
required to obtain an ownership statement from an individual shareholder 
owning less than one percent of the widely-held corporation at all times 
during the taxable year if the requirements of paragraphs (d)(3)(ii)(A) 
and (B) of this section are satisfied. If the widely-held foreign 
corporation is the foreign corporation seeking qualified foreign 
corporation status, or an intermediary that meets the documentation 
requirements of paragraphs (d)(4)(v)(A) and (B) of this section, the 
widely-held foreign corporation may treat the address of record in its 
ownership records as the residence of any less than one percent 
individual shareholder if--
    (A) The individual's address of record is a specific street address 
and not a nonresidential address, such as a post office box or in care 
of a financial intermediary or stock transfer agent; and
    (B) The officers and directors of the widely-held corporation 
neither know nor have reason to know that the individual does not reside 
at that address.
    (iii) Special rule for beneficiaries of pension funds--(A) 
Government pension fund. An individual who is a beneficiary of a 
government pension fund, as defined in paragraph (b)(5)(ii) of this 
section, may be treated as a resident of the country in which the 
pension fund is administered if the pension fund satisfies the 
documentation requirements of paragraphs (d)(4)(v)(A) and (C)(1) of this 
section.
    (B) Nongovernment pension fund. An individual who is a beneficiary 
of a nongovernment pension fund, as described in paragraph (b)(5)(iii) 
of this section, may be treated as a resident of the country of the 
beneficiary's address as it appears on the records of the fund, provided 
it is not a nonresidential address, such as a post office box or an 
address in care of a financial intermediary, and provided none of the 
trustees, directors or other administrators of the pension fund know, or 
have reason to know, that the beneficiary is not an individual resident 
of such foreign country. The rules of this paragraph (d)(3)(iii)(B) 
shall apply only if the nongovernment pension fund satisfies the 
documentation requirements of paragraphs (d)(4)(v)(A) and (C)(2) of this 
section.
    (iv) Special rule for stock owned by publicly-traded corporations. 
Any stock in a foreign corporation seeking qualified foreign corporation 
status that is owned by a publicly-traded corporation will be treated as 
owned by an individual resident in the country where the publicly-traded 
corporation is organized if the foreign corporation receives the 
statement described in paragraph (d)(4)(iii) of this section from the 
publicly-traded corporation and copies of any relevant ownership 
statements

[[Page 544]]

from shareholders of the publicly-traded corporation relied on to 
satisfy the exception to the closely-held test of Sec.  1.883-
2(d)(3)(ii), as required in paragraph (d)(2)(i) of this section.
    (v) Special rule for not-for-profit organizations. For purposes of 
meeting the ownership requirements of paragraph (a) of this section, a 
not-for-profit organization may rely on the addresses of record of its 
individual beneficiaries and supporters to determine the residence of an 
individual beneficiary or supporter, within the meaning of paragraph 
(b)(2)(i)(B) of this section, to the extent required under paragraph 
(b)(4) of this section, provided that--
    (A) The addresses of record are not nonresidential addresses such as 
a post office box or in care of a financial intermediary;
    (B) The officers, directors or administrators of the organization do 
not know or have reason to know that the individual beneficiaries or 
supporters do not reside at that address; and
    (C) The foreign corporation seeking qualified foreign corporation 
status receives the statement required in paragraph (d)(4)(iv) of this 
section from the not-for-profit organization.
    (vi) Special rule for a foreign airline covered by an air services 
agreement. A foreign airline that is covered by a bilateral Air Services 
Agreement in force between the United States and the qualified foreign 
country in which the airline is organized may rely exclusively on the 
Air Services Agreement currently in effect and will not have to 
otherwise substantiate its ownership under this section, provided that 
the United States has not waived the ownership requirements in the 
agreement or that the ownership requirements have not otherwise been 
made ineffective. Such an airline will be treated as owned by qualified 
shareholders resident in the country where the foreign airline is 
organized.
    (vii) Special rule for taxable nonstock corporations. Any stock in a 
foreign corporation seeking qualified foreign corporation status that is 
owned by a taxable nonstock corporation will be treated as owned, in any 
taxable year, by the recipients of distributions made during that 
taxable year, as set out in paragraph (c)(5) of this section. The 
taxable nonstock corporation may treat the address of record in its 
distribution records as the residence of any recipient if--
    (A) An individual recipient's address is in a qualified foreign 
country and is a specific street address and not a nonresidential 
address, such as a post office box or in care of a financial 
intermediary or stock transfer agent;
    (B) The address of a nonindividual recipient's principal place of 
business is in a qualified foreign country;
    (C) The officers and directors of the taxable nonstock corporation 
neither know nor have reason to know that the recipients do not reside 
or have their principal place of business at such addresses; and
    (D) The foreign corporation receives the statement described in 
paragraph (d)(4)(v)(D) of this section from the taxable nonstock 
corporation intermediary.
    (viii) Special rule for closely-held corporations traded in the 
United States. To demonstrate that a class of stock is not closely-held 
for purposes of Sec.  1.883-2(d)(3)(i), a foreign corporation whose 
stock is traded on an established securities market in the United States 
may rely on current Schedule 13D and Schedule 13G filings with the 
Securities and Exchange Commission to identify its 5-percent 
shareholders in each class of stock relied upon to meet the regularly 
traded test, without having to make any independent investigation to 
determine the identity of the 5-percent shareholder. However, if any 
class of stock is determined to be closely-held within the meaning of 
Sec.  1.883-2(d)(3)(i), the publicly traded corporation cannot satisfy 
the requirements of Sec.  1.883-2(e) unless it obtains sufficient 
documentation described in this paragraph (d) to demonstrate that the 
requirements of Sec.  1.883-2(d)(3)(ii) are met with respect to the 5-
percent shareholders.
    (4) Ownership statements from shareholders--(i) Ownership statements 
from individuals. An ownership statement from an individual is a written 
statement signed by the individual under penalties of perjury stating--

[[Page 545]]

    (A) The individual's name, permanent address, and country where the 
individual is fully liable to tax as a resident, if any;
    (B) If the individual was not a resident of the country for the 
entire taxable year of the foreign corporation seeking qualified foreign 
corporation status, each of the foreign countries in which the 
individual resided and the dates of such residence during the taxable 
year of such foreign corporation;
    (C) If the individual directly owns shares of stock in the 
corporation seeking qualified foreign corporation status, the name of 
the corporation, the number of shares in each class of stock of the 
corporation owned by the individual, whether any such shares are issued 
in bearer form and maintained in a dematerialized or immobilized book-
entry system, as described in Sec.  1.883-1(c)(3)(i)(G), and the period 
(or periods) in the taxable year of the foreign corporation during which 
the individual owned the shares;
    (D) If the individual directly owns an interest in a corporation, 
partnership, trust, estate, or other intermediary that directly or 
indirectly owns stock in the corporation seeking qualified foreign 
corporation status, the name of the intermediary, the number and class 
of shares or the amount and nature of the interest that the individual 
holds in such intermediary, and, if the intermediary is a corporation, 
whether any such shares are issued in bearer form and maintained in a 
dematerialized or immobilized book-entry system, as described in Sec.  
1.883-1(c)(3)(i)(G), and the period (or periods) in the taxable year of 
the foreign corporation seeking qualified foreign corporation status 
during which the individual held such interest;
    (E) To the extent known by the individual, a description of the 
chain of ownership through which the individual owns stock in the 
corporation seeking qualified foreign corporation status, including the 
name and address of each intermediary standing between the intermediary 
described in paragraph (d)(4)(i)(D) of this section and the foreign 
corporation and whether this interest is owned either directly or 
indirectly through bearer shares; and
    (F) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (ii) Ownership statements from foreign governments. An ownership 
statement from a foreign government that is a qualified shareholder is a 
written statement--
    (A) Signed by any one of the following--
    (1) An official of the governmental authority, agency or office who 
has supervisory authority with respect to the government's ownership 
interest and who is authorized to sign such a statement on behalf of the 
authority, agency or office; or
    (2) The competent authority of the foreign country (as defined in 
the income tax convention between the United States and the foreign 
country); or
    (3) An income tax return preparer that, for purposes of this 
paragraph (d)(4)(ii) only, shall mean a firm of licensed or certified 
public accountants, a law firm whose principals or members are admitted 
to practice in one or more states, territories or possessions of the 
United States or the country of such government, or a bank or other 
financial institution licensed to do business in such foreign country 
and having assets at least equivalent to 50 million U.S. dollars and who 
is authorized to represent the government or governmental authority; and
    (B) That provides--
    (1) The title of the official or other person signing the statement;
    (2) The name and address of the government authority, agency or 
office that has supervisory authority and, if applicable, the income tax 
preparer which has prepared such ownership statement;
    (3) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``government'' instead of 
``individual'') with respect to the government's direct or indirect 
ownership of stock in the corporation seeking qualified resident status;
    (4) In the case of an ownership statement prepared by an income tax 
return preparer, a statement under penalties

[[Page 546]]

of perjury identifying the documentation relied upon in the conduct of 
due diligence for the taxable year to determine the aggregate government 
investment in the stock of the shipping or aircraft company in 
preparation of such ownership statement attached to a valid power of 
attorney to represent the taxpayer for the taxable year; and
    (5) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (iii) Ownership statements from publicly-traded corporate 
shareholders. An ownership statement from a publicly-traded corporation 
that is a direct or indirect owner of the corporation seeking qualified 
foreign corporation status is a written statement, signed under 
penalties of perjury by a person that would be authorized to sign a tax 
return on behalf of the shareholder corporation containing the following 
information--
    (A) The name of the country in which the stock is primarily traded;
    (B) The name of the established securities market or markets on 
which the stock is listed;
    (C) A description of each class of stock relied upon to meet the 
requirements of Sec.  1.883-2(d)(1), including the number of shares 
issued and outstanding as of the close of the taxable year;
    (D) For each class of stock relied upon to meet the requirements of 
Sec.  1.883-2(d)(1), if one or more 5-percent shareholders, as defined 
in Sec.  1.883-2(d)(3)(i), own in the aggregate 50 percent or more of 
the vote and value of the outstanding shares of that class of stock for 
more than half the number of days during the taxable year--
    (1) The days during the taxable year of the corporation in which the 
stock was closely-held without regard to the exception in paragraph 
(d)(3)(ii) of this section and the percentage of the vote and value of 
the class of stock that is owned by 5-percent shareholders during such 
days;
    (2) For each qualified shareholder who owns or is treated as owning 
stock in the closely-held block upon whom the corporation intends to 
rely to satisfy the exception to the closely-held test of Sec.  1.883-
2(d)(3)(ii)--
    (i) The name of each such shareholder;
    (ii) The percentage of the total value of the class of stock held by 
each such shareholder and the days during which the stock was held;
    (iii) The address of record of each such shareholder; and
    (iv) The country of residence of each such shareholder, determined 
under paragraph (b)(2) or (d)(3) of this section;
    (E) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``publicly-traded 
corporation'' instead of ``individual'') with respect to the publicly-
traded corporation's direct or indirect ownership of stock in the 
corporation seeking qualified resident status; and
    (F) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (iv) Ownership statements from not-for-profit organizations. An 
ownership statement from a not-for-profit organization (other than a 
pension fund as defined in paragraph (b)(5) of this section) is a 
written statement signed by a person authorized to sign a tax return on 
behalf of the organization under penalties of perjury stating--
    (A) The name, permanent address, and principal location of the 
activities of the organization (if different from its permanent 
address);
    (B) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``not-for-profit 
organization'' instead of ``individual'');
    (C) A representation that the not-for-profit organization satisfies 
the requirements of paragraph (b)(4) of this section; and
    (D) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (v) Ownership statements from intermediaries--(A) General rule. The 
foreign corporation seeking qualified foreign corporation status under 
the shareholder stock ownership test must obtain an intermediary 
ownership statement from each intermediary standing in the chain of 
ownership between it

[[Page 547]]

and the qualified shareholders on whom it relies to meet this test. An 
intermediary ownership statement is a written statement signed under 
penalties of perjury by the intermediary (if the intermediary is an 
individual) or a person who would be authorized to sign a tax return on 
behalf of the intermediary (if the intermediary is not an individual) 
containing the following information--
    (1) The name, address, country of residence, and principal place of 
business (in the case of a corporation or partnership) of the 
intermediary, and, if the intermediary is a trust or estate, the name 
and permanent address of all trustees or executors (or equivalent under 
foreign law), or if the intermediary is a pension fund, the name and 
permanent address of place of administration of the intermediary;
    (2) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``intermediary'' instead of 
``individual'');
    (3) If the intermediary is a nominee for a shareholder or another 
intermediary, the name and permanent address of the shareholder, or the 
name and principal place of business of such other intermediary;
    (4) If the intermediary is not a nominee for a shareholder or 
another intermediary, the name and country of residence (within the 
meaning of paragraph (b)(2) of this section) and the proportionate 
interest in the intermediary of each direct shareholder, partner, 
beneficiary, grantor, or other interest holder (or if the direct holder 
is a nominee, of its beneficial shareholder, partner, beneficiary, 
grantor, or other interest holder), on which the foreign corporation 
seeking qualified foreign corporation status intends to rely to satisfy 
the requirements of paragraph (a) of this section. In addition, such 
intermediary must obtain from all such persons an ownership statement 
that includes the period of time during the taxable year for which the 
interest in the intermediary was owned by the shareholder, partner, 
beneficiary, grantor or other interest holder. For purposes of this 
paragraph (d)(4)(v)(A), the proportionate interest of a person in an 
intermediary is the percentage interest (by value) held by such person, 
determined using the principles for attributing ownership in paragraph 
(c) of this section;
    (5) If the intermediary is a widely-held corporation with registered 
shareholders owning less than one percent of the stock of such widely-
held corporation, the statement set out in paragraph (d)(4)(v)(B) of 
this section, relating to ownership statements from widely-held 
intermediaries with registered shareholders owning less than one percent 
of such widely-held intermediaries;
    (6) If the intermediary is a pension fund, within the meaning of 
paragraph (b)(5) of this section, the statement set out in paragraph 
(d)(4)(v)(C) of this section, relating to ownership statements from 
pension funds;
    (7) If the intermediary is a taxable nonstock corporation, within 
the meaning of paragraph (c)(5) of this section, the statement set out 
in paragraph (d)(4)(v)(D) of this section, relating to ownership 
statements from intermediaries that are taxable nonstock corporations; 
and
    (8) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (B) Ownership statements from widely-held intermediaries with 
registered shareholders owning less than one percent of such widely-held 
intermediary. An ownership statement from an intermediary that is a 
corporation with at least 250 registered shareholders, but that is not a 
publicly-traded corporation within the meaning of Sec.  1.883-2, and 
that relies on paragraph (d)(3)(ii) of this section, relating to the 
special rule for registered shareholders owning less than one percent of 
widely-held corporations, must provide the following information in 
addition to the information required in paragraph (d)(4)(v)(A) of this 
section--
    (1) The aggregate proportionate interest by country of residence in 
the widely-held corporation of such registered shareholders or other 
interest holders whose address of record is a specific street address 
and not a nonresidential address, such as a post office box or in care 
of a financial intermediary or stock transfer agent; and

[[Page 548]]

    (2) A representation that the officers and directors of the widely-
held intermediary neither know nor have reason to know that the 
individual shareholder does not reside at his or her address of record 
in the corporate records; and
    (3) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (C) Ownership statements from pension funds--(1) Ownership 
statements from government pension funds. A government pension fund (as 
defined in paragraph (b)(5)(ii) of this section) that relies on 
paragraph (d)(3)(iii) of this section (relating to the special rules for 
pension funds) generally must provide the documentation required in 
paragraph (d)(4)(v)(A) of this section, and, in addition, the government 
pension fund must also provide the following information--
    (i) The name of the country in which the plan is administered;
    (ii) A representation that the fund is established exclusively for 
the benefit of employees or former employees of a foreign government, or 
employees or former employees of a foreign government and 
nongovernmental employees or former employees that perform or performed 
governmental or social services;
    (iii) A representation that the funds that comprise the trust are 
managed by trustees who are employees of, or persons appointed by, the 
foreign government;
    (iv) A representation that the trust forming part of the pension 
plan provides for retirement, disability, or death benefits in 
consideration for prior services rendered;
    (v) A representation that the income of the trust satisfies the 
obligations of the foreign government to the participants under the 
plan, rather than inuring to the benefit of a private person; and
    (vi) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (2) Ownership statements from nongovernment pension funds. The 
trustees, directors, or other administrators of the nongovernment 
pension fund, as defined in paragraph (b)(5)(iii) of this section, that 
rely on paragraph (d)(3)(iii) of this section, relating to the special 
rules for pension funds, generally must provide the pension fund's 
intermediary ownership statement described in paragraph (d)(4)(v)(A) of 
this section. In addition, the nongovernment pension fund must also 
provide the following information--
    (i) The name of the country in which the pension fund is 
administered;
    (ii) A representation that the pension fund is subject to 
supervision or regulation by a governmental authority (or other 
authority delegated to perform such supervision or regulation by a 
governmental authority) in such country, and, if so, the name of the 
governmental authority (or other authority delegated to perform such 
supervision or regulation);
    (iii) A representation that the pension fund is generally exempt 
from income taxation in its country of administration;
    (iv) The number of beneficiaries in the pension plan;
    (v) The aggregate percentage interest of beneficiaries by country of 
residence based on addresses shown on the books and records of the fund, 
provided the addresses are not nonresidential addresses, such as a post 
office box or an address in care of a financial intermediary, and 
provided none of the trustees, directors or other administrators of the 
pension fund know, or have reason to know, that the beneficiary is not a 
resident of such foreign country;
    (vi) A representation that the pension fund meets the requirements 
of paragraph (b)(5)(iii) of this section;
    (vii) A representation that the trustees, directors or other 
administrators of the pension fund have no knowledge, and no reason to 
know, that a pro-rata allocation of interests of the fund to all 
beneficiaries would differ significantly from an actuarial allocation of 
interests in the fund (or, if the beneficiaries' actuarial interest in 
the stock held directly or indirectly by the pension fund differs from 
the beneficiaries' actuarial interest in the pension fund, the actuarial 
interests computed by reference to the beneficiaries' actuarial interest 
in the stock);

[[Page 549]]

    (viii) A representation that any overfunding of the pension fund 
would be payable, pursuant to the governing instrument or the laws of 
the foreign country in which the pension fund is administered, only to, 
or for the benefit of, one or more corporations that are organized in 
the country in which the pension fund is administered, individual 
beneficiaries of the pension fund or their designated beneficiaries, or 
social or charitable causes (the reduction of the obligation of the 
sponsoring company or companies to make future contributions to the 
pension fund by reason of overfunding shall not itself result in such 
overfunding being deemed to be payable to or for the benefit of such 
company or companies); or that the foreign country in which the pension 
fund is administered has laws that are designed to prevent overfunding 
of a pension fund and the funding of the pension fund is within the 
guidelines of such laws; or that the pension fund is maintained to 
provide benefits to employees in a particular industry, profession, or 
group of industries or professions, and that employees of at least 10 
companies (other than companies that are owned or controlled, directly 
or indirectly, by the same interests) contribute to the pension fund or 
receive benefits from the pension fund; and
    (ix) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (3) Time for making determinations. The determinations required to 
be made under this paragraph (d)(4)(v)(C) shall be made using 
information shown on the records of the pension fund for a date during 
the foreign corporation's taxable year to which the determination is 
relevant.
    (D) Ownership statements from taxable nonstock corporations. An 
ownership statement from an intermediary that is a taxable nonstock 
corporation must provide the following information in addition to the 
information required in paragraph (d)(4)(v)(A) of this section--
    (1) With respect to paragraph (d)(4)(v)(A)(7) of this section, for 
each beneficiary that is treated as a qualified shareholder, the name, 
address of residence (in the case of an individual beneficiary, the 
address must be a specific street address and not a nonresidential 
address, such as a post office box or in care of a financial 
intermediary; in the case of a nonindividual beneficiary, the address of 
the principal place of business) and percentage that is the same 
proportion as the amount that the beneficiary receives in the tax year 
bears to the total net income of the taxable nonstock corporation in the 
tax year;
    (2) A representation that the officers and directors of the taxable 
nonstock corporation neither know nor have reason to know that the 
individual beneficiaries do not reside at the address listed in 
paragraph (d)(4)(v)(D)(1) of this section or that any other 
nonindividual beneficiary does not conduct its primary activities at 
such address or in such country of residence; and
    (3) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (5) Availability and retention of documents for inspection. The 
documentation described in paragraphs (d)(3) and (4) of this section 
must be retained by the corporation seeking qualified foreign 
corporation status (the foreign corporation) until the expiration of the 
statute of limitations for the taxable year of the foreign corporation 
to which the documentation relates. Such documentation must be made 
available for inspection by the Commissioner at such time and place as 
the Commissioner may request in writing.
    (e) Reporting requirements. A foreign corporation relying on the 
qualified shareholder stock ownership test of this section to meet the 
stock ownership test of Sec.  1.883-1(c)(2) must provide the following 
information in addition to the information required in Sec.  1.883-
1(c)(3) to be included in its Form 1120-F, ``U.S. Income Tax Return of a 
Foreign Corporation,'' for each taxable year. The information should be 
current as of the end of the corporation's taxable year. The information 
must include the following--
    (1) A representation that more than 50 percent of the value of the 
outstanding shares of the corporation is owned (or treated as owned by 
reason of paragraph (c) of this section) by

[[Page 550]]

qualified shareholders for each category of income for which the 
exemption is claimed;
    (2) With respect to all qualified shareholders relied upon to 
satisfy the 50 percent ownership test of paragraph (a) of this section, 
the total number of such qualified shareholders as defined in paragraph 
(b)(1) of this section; the total percentage of the value of the 
outstanding shares owned, applying the attribution rules of paragraph 
(c) of this section, by such qualified shareholders by country of 
residence or organization, whichever is applicable; and the period 
during the taxable year of the foreign corporation that such stock was 
held by qualified shareholders; and
    (3) Any other relevant information specified by the Form 1120-F, 
``U.S. Income Tax Return of a Foreign Corporation,'' and its 
accompanying instructions, or in published guidance by the Internal 
Revenue Service (see Sec.  601.601(d)(2) of this chapter).

[T.D. 9087, 68 FR 51406, Aug. 26, 2003; 69 FR 7995, Feb. 20, 2004, as 
amended by T.D. 9332, 72 FR 34608, June 25, 2007; T.D. 9502, 75 FR 
56865, Sept. 17, 2010]



Sec.  1.883-5  Effective/applicability dates.

    (a) General rule. Sections 1.883-1 through 1.883-4 apply to taxable 
years of a foreign corporation seeking qualified foreign corporation 
status beginning after September 24, 2004.
    (b) Election for retroactive application. Taxpayers may elect to 
apply Sec. Sec.  1.883-1 through 1.883-4 for any open taxable year of 
the foreign corporation beginning after December 31, 1986, except that 
the substantiation and reporting requirements of Sec.  1.883-1(c)(3) 
(relating to the substantiation and reporting required to be treated as 
a qualified foreign corporation) or Sec. Sec.  1.883-2(f), 1.883-3(d) 
and 1.883-4(e) (relating to additional information to be included in the 
return to demonstrate whether the foreign corporation satisfies the 
stock ownership test) will not apply to any year beginning before 
September 25, 2004. Such election shall apply to the taxable year of the 
election and to all subsequent taxable years beginning before September 
25, 2004.
    (c) Transitional information reporting rule. For taxable years of 
the foreign corporation beginning after September 24, 2004, and until 
such time as the Form 1120-F, ``U.S. Income Tax Return of a Foreign 
Corporation,'' or its instructions are revised to provide otherwise, the 
information required in Sec.  1.883-1(c)(3) and Sec.  1.883-2(f), Sec.  
1.883-3(d) or Sec.  1.883-4(e), as applicable, must be included on a 
written statement attached to the Form 1120-F and file with the return.
    (d) Effective/applicability dates. Except as otherwise provided in 
this paragraph (d), Sec. Sec.  1.883-1, 1.883-2, 1.883-3, and 1.883-4 
apply to taxable years of the foreign corporation beginning after June 
25, 2007, and may be applied to any open taxable years of the foreign 
corporation beginning on or after December 31, 2004. The portion of any 
provision concerning bearer shares maintained in a dematerialized or 
immobilized book-entry system, as described in Sec.  1.883-
1(c)(3)(i)(G), applies to taxable years of a foreign corporation 
beginning on or after September 17, 2010.

[T.D. 9218, 70 FR 45530, Aug. 8, 2005, as amended by T.D. 9332, 72 FR 
34609, June 25, 2007; T.D. 9502, 75 FR 56865, Sept. 17, 2010; 75 FR 
63380, Oct. 15, 2010]



Sec.  1.884-0  Overview of regulation provisions for section 884.

    (a) Introduction. Section 884 consists of three main parts: a branch 
profits tax on certain earnings of a foreign corporation's U.S. trade or 
business; a branch-level interest tax on interest paid, or deemed paid, 
by a foreign corporation's U.S. trade or business; and an anti-treaty 
shopping rule. A foreign corporation is subject to section 884 by virtue 
of owning an interest in a partnership, trust, or estate that is engaged 
in a U.S. trade or business or has income treated as effectively 
connected with the conduct of a trade or business in the United States. 
An international organization (as defined in section 7701(a)(18)) is not 
subject to the branch profits tax by reason of section 884(e)(5). A 
foreign government treated as a corporate resident of its country of 
residence under section 892(a)(3) shall be treated as a corporation for 
purposes of section 884. The preceding sentence shall be effective for 
taxable years ending on or after September 11, 1992, except that, for 
the

[[Page 551]]

first taxable year ending on or after that date, the branch profits tax 
shall not apply to effectively connected earnings and profits of the 
foreign government earned prior to that date nor to decreases in the 
U.S. net equity of a foreign government occurring after the close of the 
preceding taxable year and before that date. Similarly, Sec.  1.884-4 
shall apply, in the case of branch interest, only with respect to 
amounts of interest accrued and paid by a foreign government on or after 
that date, or, in the case of excess interest, only with respect to 
amounts attributable to interest accrued by a foreign government on or 
after that date and apportioned to ECI, as defined in Sec.  1.884-
1(d)(1)(iii). Except as otherwise provided, for purposes of the 
regulations under section 884, the term ``U.S. trade or business'' 
includes all the U.S. trades or businesses of a foreign corporation.
    (1) The branch profits tax. Section 1.884-1 provides rules for 
computing the branch profits tax and defines various terms that affect 
the computation of the tax. In general, section 884(a) imposes a 30-
percent branch profits tax on the after-tax earnings of a foreign 
corporation's U.S. trade or business that are not reinvested in a U.S. 
trade or business by the close of the taxable year, or are disinvested 
in a later taxable year. Changes in the value of the equity of the 
foreign corporation's U.S. trade or business are used as the measure of 
whether earnings have been reinvested in, or disinvested form, a U.S. 
trade or business. An increase in the equity during the taxable year is 
generally treated as a reinvestment of the earnings for the current 
taxable year; a decrease in the equity during the taxable year is 
generally treated as a disinvestment of prior years' earnings that have 
not previously been subject to the branch profits tax. The amount 
subject to the branch profits tax for the taxable year is the dividend 
equivalent amount. Section 1.884-2T contains special rules relating to 
the effect on the branch profits tax of the termination or incorporation 
of a U.S. trade or business or the liquidation or reorganization of a 
foreign corporation or its domestic subsidiary.
    (2) The branch-level interest tax. Section 1.884-4 provides rules 
for computing the branch-level interest tax. In general, interest paid 
by a U.S. trade or business of a foreign corporation (``branch 
interest'', as defined in Sec.  1.884-4(b)) is treated as if it were 
paid by a domestic corporation and may be subject to tax under section 
871(a) or 881, and to withholding under section 1441 or 1442. In 
addition, if the interest apportioned to ECI exceeds branch interest, 
the excess is treated as interest paid to the foreign corporation by a 
wholly-owned domestic corporation and is subject to tax under section 
881(a).
    (3) Qualified resident. Section 1.884-5 provides rules for 
determining whether a foreign corporation is a qualified resident of a 
foreign country. In general, a foreign corporation must be a qualified 
resident of a foreign country with which the United States has an income 
tax treaty in order to claim an exemption or rate reduction with respect 
to the branch profits tax, the branch-level interest tax, and the tax on 
dividends paid by the foreign corporation.
    (b) Special rules for U.S. possessions. (1) Section 884 does not 
apply to a corporation created or organized in, or under the law of, 
American Samoa, Guam, the Northern Mariana Islands, or the U.S. Virgin 
Islands, provided that the conditions of Sec.  1.881-5(c)(1) through 
(c)(3) are satisfied with respect to such corporation. The preceding 
sentence applies for taxable years ending after April 9, 2008.
    (2) Section 884 does not apply for purposes of determining tax 
liability incurred to a section 935 possession or the U.S. Virgin 
Islands by a corporation created or organized in, or under the law of, 
such possession or the United States. The preceding sentence applies for 
taxable years ending after April 9, 2008.
    (c) Outline of major topics in Sec. Sec.  1.884-1 through 1.884-5.

                    Sec.  1.884-1 Branch profits tax.

    (a) General rule.
    (b) Dividend equivalent amount.
    (1) Definition.
    (2) Adjustment for increase in U.S. net equity.
    (3) Adjustment for decrease in U.S. net equity.
    (4) Examples.

[[Page 552]]

    (c) U.S. net equity.
    (1) Definition.
    (2) Definition of amount of a U.S. asset.
    (3) Definition of determination date.
    (d) U.S. assets.
    (1) Definition of a U.S. asset.
    (2) Special rules for certain assets.
    (3) Interest in a partnership.
    (4) Interest in a trust or estate.
    (5) Property that is not a U.S. asset.
    (6) E&P basis of a U.S. asset.
    (e) U.S. liabilities.
    (1) Liabilities based on Sec.  1.882-5.
    (2) Insurance reserves.
    (3) Election to reduce liabilities.
    (4) Artificial decrease in U.S. liabilities.
    (5) Examples.
    (f) Effectively connected earnings and profits.
    (1) In general.
    (2) Income that does not produce ECEP.
    (3) Allocation of deductions attributable to income that does not 
produce ECEP.
    (4) Examples.
    (g) Corporations resident in countries with which the United States 
has an income tax treaty.
    (1) General rule.
    (2) Special rules for foreign corporations that are qualified 
residents on the basis of their ownership.
    (3) Exemptions for foreign corporations resident in certain 
countries with income tax treaties in effect on January 1, 1987.
    (4) Modifications with respect to other income tax treaties.
    (5) Benefits under treaties other than income tax treaties.
    (h) Stapled entities.
    (i) Effective date.
    (1) General rule.
    (2) Election to reduce liabilities.
    (3) Separate election for installment obligations.
    (4) Special rule for certain U.S. assets and liabilities.
    (j) Transition rules.
    (1) General rule.
    (2) Installment obligations.

Sec.  1.884-2T Special rules for termination or incorporation of a U.S. 
    trade or business or liquidation or reorganization of a foreign 
           corporation or its domestic subsidiary (temporary).

    (a) Complete termination of a U.S. trade or business.
    (1) General rule.
    (2) Operating rules.
    (3) Complete termination in the case of a section 338 election.
    (4) Complete termination in the case of a foreign corporation with 
income under section 864(c)(6) or 864(c)(7).
    (5) Special rule if a foreign corporation terminates an interest in 
a trust. [Reserved]
    (6) Coordination with second-level withholding tax.
    (b) Election to remain engaged in a U.S. trade or business.
    (1) General rule.
    (2) Marketable security.
    (3) Identification requirements.
    (4) Treatment of income from deemed U.S. assets.
    (5) Method of election.
    (6) Effective date.
    (c) Liquidation, reorganization, etc., of a foreign corporation.
    (1) Inapplicability of paragraph (a)(1) to section 381 (a) 
transactions.
    (2) Transferor's dividend equivalent amount for the taxable year in 
which a section 381 (a) transaction occurs.
    (3) Transferor's dividend equivalent amount for any taxable year 
succeeding the taxable year in which the section 381 (a) transaction 
occurs.
    (4) Earnings and profits of the transferor carried over to the 
transferee pursuant to the section 381 (a) transaction.
    (5) Determination of U.S. net equity of a transferee that is a 
foreign corporation.
    (6) Special rules in the case of the disposition of stock or 
securities in a domestic transferee or in the transferor.
    (d) Incorporation under section 351.
    (1) In general.
    (2) Inapplicability of paragraph (a)(1) of this section to section 
351 transactions.
    (3) Transferor's dividend equivalent amount for the taxable year in 
which a section 351 transaction occurs.
    (4) Election to increase earnings and profits.
    (5) Dispositions of stock or securities of the transferee by the 
transferor.
    (6) Example.
    (e) Certain transactions with respect to a domestic subsidiary.
    (f) Effective date.

   Sec.  1.884-3T Coordination of branch profits tax with second-tier 
                   withholding (temporary). [Reserved]

                Sec.  1.884-4 Branch-level interest tax.

    (a) General rule.
    (1) Tax on branch interest.
    (2) Tax on excess interest.
    (3) Original issue discount.
    (4) Examples.
    (b) Branch interest.
    (1) Definition of branch interest.
    (2) [Reserved]
    (3) Requirements relating to specifically identified liabilities.
    (4) [Reserved]
    (5) Increase in branch interest where U.S. assets constitute 80 
percent or more of a foreign corporation's assets.

[[Page 553]]

    (6) Special rule where branch interest exceeds interest apportioned 
to ECI of a foreign corporation.
    (7) Effect of election under paragraph (c)(1) of this section to 
treat interest as if paid in year of accrual.
    (8) Effect of treaties.
    (c) Rules relating to excess interest.
    (1) Election to compute excess interest by treating branch interest 
that is paid and accrued in different years as if paid in year of 
accrual.
    (2) Interest paid by a partnership.
    (3) Effect of treaties.
    (4) Examples.
    (d) Stapled entities.
    (e) Effective dates.
    (1) General rule.
    (2) Special rule.
    (f) Transition rules.
    (1) Election under paragraph (c)(1) of this section.
    (2) Waiver of notification requirement for non-banks under Notice 
89-80.
    (3) Waiver of legending requirement for certain debt issued prior to 
January 3, 1989.

                    Sec.  1.884-5 Qualified resident.

    (a) Definition of qualified resident.
    (b) Stock ownership requirement.
    (1) General rule.
    (2) Rules for determining constructive ownership.
    (3) Required documentation.
    (4) Ownership statements from qualifying shareholders.
    (5) Certificate of residency.
    (6) Intermediary ownership statement.
    (7) Intermediary verification statement.
    (8) Special rules for pension funds.
    (9) Availability of documents for inspection.
    (10) Examples.
    (c) Base erosion.
    (d) Publicly-traded corporations.
    (1) General rule.
    (2) Established securities market.
    (3) Primary traded.
    (4) Regularly traded.
    (5) Burden of proof for publicly-traded corporations.
    (e) Active trade or business.
    (1) General rule.
    (2) Active conduct of a trade or business.
    (3) Substantial presence test.
    (4) Integral part of an active trade or business in the foreign 
corporation's country of residence.
    (f) Qualified resident ruling.
    (1) Basis for ruling.
    (2) Factors.
    (3) Procedural requirements.
    (g) Effective dates.
    (h) Transition rule.

[T.D. 8432, 57 FR 41649, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9338, Mar. 8, 
1996; T.D. 9194, 70 FR 18930, Apr. 11, 2005; T.D. 9391, 73 FR 19360, 
Apr. 9, 2008; 73 FR 27728, May 14, 2008]



Sec.  1.884-1  Branch profits tax.

    (a) General rule. A foreign corporation shall be liable for a branch 
profits tax in an amount equal to 30 percent of the foreign 
corporation's dividend equivalent amount for the taxable year. The 
branch profits tax shall be in addition to the tax imposed by section 
882 and shall be reported on a foreign corporation's income tax return 
for the taxable year. The tax shall be due and payable as provided in 
section 6151 and such other provisions of Subtitle F of the Internal 
Revenue Code as apply to the income tax liability of corporations. 
However, no estimated tax payments shall be due with respect to a 
foreign corporation's liability for the branch profits tax. See 
paragraph (g) of this section for the application of the branch profits 
tax to corporations that are residents of countries with which the 
United States has an income tax treaty, and Sec.  1.884-2T for the 
effect on the branch profits tax of the termination or incorporation of 
a U.S. trade or business, or the liquidation or reorganization of a 
foreign corporation or its domestic subsidiary.
    (b) Dividend equivalent amount--(1) Definition. The term ``dividend 
equivalent amount'' means a foreign corporation's effectively connected 
earnings and profits (``ECEP'', as defined in paragraph (f)(1) of this 
section) for the taxable year, adjusted pursuant to paragraph (b)(2) or 
(3) of this section, as applicable. The dividend equivalent amount 
cannot be less than zero.
    (2) Adjustment for increase in U.S. net equity. If a foreign 
corporation's U.S. net equity (as defined in paragraph (c) of this 
section) as of the close of the taxable year exceeds the foreign 
corporation's U.S. net equity as of the close of the preceding taxable 
year, then, for purposes of computing the foreign corporation's dividend 
equivalent amount for the taxable year, the foreign corporation's ECEP 
for the taxable year shall be reduced (but not

[[Page 554]]

below zero) by the amount of such excess.
    (3) Adjustment for decrease in U.S. net equity--(i) In general. 
Except as provided in paragraph (b)(3)(ii) of this section, if a foreign 
corporation's U.S. net equity as of the close of the taxable year is 
less than the foreign corporation's U.S. net equity as of the close of 
the preceding taxable year, then, for purposes of computing the foreign 
corporation's dividend equivalent amount for the taxable year, the 
foreign corporation's ECEP for the taxable year shall be increased by 
the amount of such difference.
    (ii) Limitation based on accumulated ECEP. The increase of a foreign 
corporation's ECEP under paragraph (b)(3)(i) of this section shall not 
exceed the accumulated ECEP of the foreign corporation as of the 
beginning of the taxable year. The term ``accumulated ECEP'' means the 
aggregate amount of ECEP of a foreign corporation for preceding taxable 
years beginning after December 31, 1986, minus the aggregate dividend 
equivalent amounts for such preceding taxable years. Accumulated ECEP 
may be less than zero.
    (4) Examples. The principles of paragraph (b)(2) and (3) of this 
section are illustrated by the following examples.

    Example 1. Reinvestment of all ECEP. Foreign corporation A, a 
calendar year taxpayer, had $1,000 U.S. net equity as of the close of 
1986 and $100 of ECEP for 1987. A acquires $100 of additional U.S. 
assets during 1987 and its U.S. net equity as of the close of 1987 is 
$1,100. In computing A's dividend equivalent amount for 1987, A's ECEP 
of $100 is reduced under paragraph (b)(2) of this section by the $100 
increase in U.S. net equity between the close of 1986 and the close of 
1987. A has no dividend equivalent amount for 1987.
    Example 2. Partial reinvestment of ECEP. Assume the same facts as in 
Example 1 except that A acquires $40 (rather than $100) of U.S. assets 
during 1987 and its U.S. net equity as of the close of 1987 is $1,040. 
In computing A's dividend equivalent amount for 1987, A's ECEP of $100 
is reduced under paragraph (b)(2) of this section by the $40 increase in 
U.S. net equity between the close of 1986 and the close of 1987. A has a 
dividend equivalent amount of $60 for 1987.
    Example 3. Disinvestment of prior year's ECEP. Assume the same facts 
as in Example 1 for 1987. A has no ECEP for 1988. A's U.S. net equity 
decreases by $40 (to $1,060) as of the close of 1988. A has a dividend 
equivalent amount of $40 for 1988, even though it has no ECEP for 1988. 
A's ECEP of $0 for 1988 is increased under paragraph (b)(3)(i) of this 
section by the $40 reduction in U.S. net equity (subject to the 
limitation in paragraph (b)(3)(ii) of this section of $100 of 
accumulated ECEP).
    Example 4. Accumulated ECEP limitation. Assume the same facts as in 
Example 2 for 1987. For 1988, A has $125 of ECEP and its U.S. net equity 
decreases by $50. A's U.S. net equity as of the close of 1988 is $990 
($1,040-$50). In computing A's dividend equivalent amount for 1988, the 
$125 of ECEP for 1988 is not increased under paragraph (b)(3)(i) of this 
section by the full amount of the $50 decrease in U.S. net equity during 
1988. Rather, the increase in ECEP resulting from the decrease in U.S. 
net equity is limited to A's accumulated ECEP as of the beginning of 
1988. A had $100 of ECEP for 1987 and a dividend equivalent amount of 
$60 for that year, so A had $40 of accumulated ECEP as of the beginning 
of 1988. The increase in ECEP resulting from a decrease in U.S. net 
equity is thus limited to $40, and the dividend equivalent amount for 
1988 is $165 ($125 ECEP + $40 decrease in U.S. net equity).
    Example 5. Effect of deficits in ECEP. Foreign corporation A, a 
calendar year taxpayer, has $150 of accumulated ECEP as of the beginning 
of 1991 ($200 aggregate ECEP less $50 aggregate dividend equivalent 
amounts for years preceding 1991). A has U.S. net equity of $450 as of 
the close of 1990, U.S. net equity of $350 as of the close of 1991 
(i.e., a $100 decrease in U.S. net equity) and a $90 deficit in ECEP for 
1991. A's dividend equivalent amount is $10 for 1991, i.e., A's deficit 
of $90 in ECEP for 1991 increased by $100, the decrease in A's U.S. net 
equity during 1991. A portion of the reduction in U.S. net equity in 
1991 ($90) is attributable to A's deficit in ECEP for that year. The 
reduction in U.S. net equity in 1991 ($100) triggers a dividend 
equivalent amount only to the extent it exceeds the $90 current year 
deficit in ECEP for 1991. As of the beginning of 1992, A has $50 of 
accumulated ECEP (i.e., $110 aggregate ECEP less $60 aggregate dividend 
equivalent amounts for years preceding 1992).
    Example 6. Nimble dividend equivalent amount. Foreign corporation A, 
a calendar year taxpayer, had a deficit in ECEP of $100 for 1987 and 
$100 for 1988, and has $90 of ECEP for 1989. A had $2,000 U.S. net 
equity as of the close of 1988 and has $2,000 U.S. net equity as of the 
close of 1989. A has a dividend equivalent amount of $90 for 1989, its 
ECEP for the year, even though it has a net deficit of $110 in ECEP for 
the period 1987-1989.

    (c) U.S. net equity--(1) Definition. The term ``U.S. net equity'' 
means the aggregate amount of the U.S. assets (as defined in paragraphs 
(c)(2) and (d)(1) of this section) of a foreign corporation as

[[Page 555]]

of the determination date (as defined in paragraph (c)(3) of this 
section), reduced (including below zero) by the U.S. liabilities (as 
defined in paragraph (e) of this section) of the foreign corporation as 
of the determination date.
    (2) Definition of the amount of a U.S. asset--(i) In general. For 
purposes of this section, the term ``amount of a U.S. asset'' means the 
U.S. asset's adjusted basis for purposes of computing earnings and 
profits (``E&P basis'') multiplied by the proportion of the asset that 
is treated as a U.S. asset under paragraphs (d) (1) through (4) of this 
section. The amount of a U.S. asset that is money shall be its face 
value. See paragraph (d)(6) of this section for rules concerning the 
computation of the E&P basis of a U.S. asset.
    (ii) Bad debt reserves. A bank described in section 585(a)(2)(B) 
(without regard to the second sentence thereof) that uses the reserve 
method of accounting for bad debts for U.S. federal income tax purposes 
shall decrease the amount of loans that qualify as U.S. assets by any 
reserve that is permitted under section 585.
    (3) Definition of determination date. For purposes of this section, 
the term ``determination date'' means the close of the day on which the 
amount of U.S. net equity is required to be determined. Unless otherwise 
provided, the U.S. net equity of a foreign corporation is required to be 
determined as of the close of the foreign corporation's taxable year.
    (d) U.S. assets--(1) Definition of a U.S. asset--(i) General rule. 
Except as provided in paragraph (d)(5) of this section, the term ``U.S. 
asset'' means an asset of a foreign corporation (other than an interest 
in a partnership, trust, or estate) that is held by the corporation as 
of the determination date if--
    (A) All income produced by the asset on the determination date is 
ECI (as defined in paragraph (d)(1)(iii) of this section) (or would be 
ECI if the asset produced income on that date); and
    (B) All gain from the disposition of the asset would be ECI if the 
asset were disposed of on that date and the disposition produced gain.


For purposes of determining whether income or gain from an asset would 
be ECI under this paragraph (d)(1)(i), it is immaterial whether the 
asset is of a type that is unlikely to, or cannot, produce income or 
gain. For example, money may be a U.S. asset although it does not 
produce income or gain. In the case of an asset that does not produce 
income, however, the determination of whether income from the asset 
would be ECI shall be made under the principles of section 864 and the 
regulations thereunder, but without regard to Sec.  1.864-
4(c)(2)(iii)(b). For purposes of determining whether an asset is a U.S. 
asset under this paragraph (d)(1), a foreign corporation may presume, 
unless it has reason to know otherwise, that gain from the sale of 
personal property (including inventory property) would be U.S. source if 
gain from the sale of that type of property would ordinarily be 
attributable to an office or other fixed place of business of the 
foreign corporation within the United States (within the meaning of 
section 865(e)(2)).
    (ii) Special rules for assets not described in paragraph (d)(1)(i) 
of this section. An asset of a foreign corporation that is held by the 
corporation as of the determination date and is not described in 
paragraph (d)(1)(i) of this section shall be treated as a U.S. asset to 
the extent provided in paragraph (d)(2) of this section (relating to 
special rules for certain assets, including assets that produce income 
or gain at least a portion of which is ECI), and in paragraphs (d) (3) 
and (4) of this section (relating to special rules for interests in a 
partnership, trust, and estate).
    (iii) Definition of ECI. For purposes of the regulations under 
section 884, the term ``ECI'' means income that is effectively connected 
with the conduct of a trade or business in the United States and income 
that is treated as effectively connected with the conduct of a trade or 
business in the United States under any provision of the Code. The term 
``ECI'' also includes all income that is or is treated as effectively 
connected with the conduct of a U.S. trade or business whether or not 
the income is included in gross income (for example, interest income 
earned with respect to tax-exempt bonds).
    (2) Special rules for certain assets--(i) Depreciable and 
amortizable property. An

[[Page 556]]

item of depreciable personal property or an item of amortizable 
intangible property shall be treated as a U.S. asset of a foreign 
corporation in the same proportion that the amount of the depreciation 
or amortization with respect to the item of property that is allowable 
as a deduction, or is includible in cost of goods sold, for the taxable 
year in computing the effectively connected taxable income of the 
foreign corporation bears to the total amount of depreciation or 
amortization computed for the taxable year with respect to the item of 
property.
    (ii) Inventory. An item or pool of inventory property (as defined in 
section 865(i)(1)) shall be treated as a U.S. asset in the same 
proportion as the amount of gross receipts from the sale or exchange of 
such property for the three preceding taxable years (or for such part of 
the three-year period as the corporation has been in existence) that is 
effectively connected with the conduct of a U.S. trade or business bears 
to the total amount of gross receipts from the sale or exchange of such 
property during such period (or part thereof). If a foreign corporation 
has not sold or exchanged such property during such three-year period 
(or part thereof), then the property shall be treated as a U.S. asset in 
the same proportion that the anticipated amount of gross receipts from 
the sale or exchange of the property that is reasonably anticipated to 
be ECI bears to the anticipated total amount of gross receipts from the 
sale or exchange of the property.
    (iii) Installment obligations. An installment obligation received in 
connection with an installment sale (as defined in section 453(b)) for 
which an election under section 453(d) has not been made shall be 
treated as a U.S. asset to the extent that it is received in connection 
with the sale of a U.S. asset. If an obligation is received in 
connection with the sale of an asset that is wholly a U.S. asset, it 
shall be treated as a U.S. asset in its entirety. If a single obligation 
is received in connection with the sale of an asset that is in part a 
U.S. asset under the rules of paragraphs (d) (2) through (4) of this 
section, or in connection with the sale of several assets including one 
or more non-U.S. assets, the obligation shall be treated as a U.S. asset 
in the same proportion as--
    (A) The sum of the amount of gain from the installment sale that 
would be ECI if the obligation were satisfied in full on the 
determination date and the adjusted basis of the obligation on such date 
(as determined under section 453B) attributable to the amount of gain 
that would be ECI bears to
    (B) The sum of the total amount of gain from the sale if the 
obligation were satisfied in full and the adjusted basis of the 
obligation on such date (as determined under section 453B).


However, the obligation will only be treated as a U.S. asset if the 
interest income or original issue discount with respect to the 
obligation is ECI or the foreign corporation elects to treat the 
interest or original issue discount as ECI in the same proportion that 
the obligation is treated as a U.S. asset. A foreign corporation may 
elect to treat interest income or original issue discount as ECI by 
reporting such interest income or original issue discount as ECI on its 
income tax return or an amended return for the taxable year. See 
paragraph (d)(6)(ii) of this section to determine the E&P basis of an 
installment obligation for purposes of this paragraph (d)(2)(iii).
    (iv) Receivables--(A) Receivables arising from the sale or exchange 
of inventory property. An account or note receivable (whether or not 
bearing stated interest) with a maturity not exceeding six months that 
arises from the sale or exchange of inventory property (as defined in 
section 865(i)(1)) shall be treated as a U.S. asset in the proportion 
determined under paragraph (d)(2)(iii) of this section as if the 
receivable were an installment obligation.
    (B) Receivables arising from the performance of services or leasing 
of property. An account or note receivable (whether or not bearing 
stated interest) with a maturity not exceeding six months that arises 
from the performance of services or the leasing of property in the 
ordinary course of a foreign corporation's trade or business shall be 
treated as a U.S. asset in the same proportion that the amount of gross 
income represented by the receivable that is ECI bears to the total 
amount

[[Page 557]]

of gross income represented by the receivable. For purposes of this 
paragraph (d)(2)(iv)(B), the amount of income represented by a 
receivable shall not include interest income or original issue discount.
    (v) Bank and other deposits. A deposit or credit balance with a 
person described in section 871(i)(3) or a Federal Reserve Bank that is 
interest-bearing shall be treated as a U.S. asset if all income derived 
by the foreign corporation with respect to the deposit or credit balance 
during the taxable year is ECI. Any other deposit or credit balance 
shall only be treated as a U.S. asset if the deposit or credit balance 
is needed in a U.S. trade or business within the meaning of Sec.  1.864-
4(c)(2)(iii)(a).
    (vi) Debt instruments. A debt instrument, as defined in section 
1275(a)(1) (other than an asset treated as a U.S. asset under any other 
subdivision of this paragraph (d)) shall be treated as a U.S. asset, 
notwithstanding the fact that gain from the sale or exchange of the 
obligation on the determination date would not be ECI, if--
    (A) All income derived by the foreign corporation from such 
obligation during the taxable year is ECI; and
    (B) The yield for the period that the instrument was held during the 
taxable year equals or exceeds the Applicable Federal Rate for 
instruments of similar type and maturity.


Shares in a regulated investment company that purchases solely 
instruments that, under this paragraph (d)(2)(vi), would be U.S. assets 
if held directly by the foreign corporation shall also be treated as a 
U.S. asset.
    (vii) Securities held by a foreign corporation engaged in a banking, 
financing or similar business. Securities described in Sec.  1.864-
4(c)(5)(ii)(b)(3) held by a foreign corporation engaged in the active 
conduct of a banking, financing, or similar business in the United 
States during the taxable year shall be treated as U.S. assets in the 
same proportion that income, gain, or loss from such securities is ECI 
for the taxable year under Sec.  1.864-4(c)(5)(ii).
    (viii) Federal income taxes. An overpayment of Federal income taxes 
shall be treated as a U.S. asset to the extent that the tax would reduce 
a foreign corporation's ECEP for the taxable year but for the fact that 
the tax does not accrue during the taxable year.
    (ix) Losses involving U.S. assets. A foreign corporation that 
sustains, with respect to a U.S. asset, a loss for which a deduction is 
not allowed under section 165 (in whole or in part) because there exists 
a reasonable prospect of recovering compensation for the loss shall be 
treated as having a U.S. asset (``loss property'') from the date of the 
loss in the same proportion that the asset was treated as a U.S. asset 
immediately before the loss. See paragraph (d)(6)(iv) of this section to 
determine the E&P basis of the loss property.
    (x) Ruling for involuntary conversion. If property that is a U.S. 
asset of a foreign corporation is compulsorily or involuntarily 
converted into property not similar or related in service or use (within 
the meaning of section 1033), the foreign corporation may apply to the 
Commissioner for a ruling to determine its U.S. assets for the taxable 
year of the involuntary conversion.
    (xi) Examples. The principles of paragraphs (c) and (d) (1) and (2) 
of this section are illustrated by the following examples.

    Example 1. Depreciable property. Foreign corporation A, a calendar 
year taxpayer, is engaged in a trade or business in the United States. A 
owns equipment that is used in its manufacturing business in country X 
and in the United States. Under Sec.  1.861-8, A's depreciation 
deduction with respect to the equipment is allocated to sales income and 
is apportioned 70 percent to ECI and 30 percent to income that is not 
ECI. Under paragraph (d)(2)(ii) of this section, the equipment is 70 
percent a U.S. asset. The equipment has an E&P basis of $100 at the 
beginning of 1993. A's depreciation deduction (for purposes of computing 
earnings and profits) with respect to the equipment is $10 for 1993. To 
determine the amount of A's U.S. asset at the close of 1993, the 
equipment's $90 E&P basis at the close of 1993 is multiplied by 70 
percent (the proportion of the asset that is a U.S. asset). The amount 
of the U.S. asset as of the close of 1993 is $63.
    Example 2. U.S. real property interest connected to a U.S. business. 
FC is a foreign corporation that is a bank, within the meaning of 
section 585(a)(2)(B) (without regard to the second sentence thereof), 
and is engaged in the business of taking deposits and making loans 
through its branch in the United States. In 1996, FC makes a loan in the 
ordinary course of its lending business in the United States, securing 
the loan with a

[[Page 558]]

mortgage on the U.S. real property being financed by the borrower. In 
1997, after the borrower has defaulted on the loan, FC takes title to 
the real property that secures the loan. On December 31, 1997, FC 
continues to hold the property, classifying it on its financial 
statement as Other Real Estate Owned. Because all income and gain from 
the property would be ECI to FC under the principles of section 
864(c)(2), the U.S. real property constitutes a U.S. asset within the 
meaning of paragraph (d) of this section.
    Example 3. U.S. real property interest not connected to a U.S. 
business. Foreign corporation A owns a condominium apartment in the 
United States. Assume that holding the apartment does not constitute a 
U.S. trade or business and the foreign corporation has not made an 
election under section 882(d) to treat income with respect to the 
property as ECI. The condominium apartment is not a U.S. asset of A 
because the income, if any, from the asset would not be ECI. However, 
the disposition by A of the condominium apartment at a gain will give 
rise to ECEP.
    Example 4. Stock in a domestically-controlled REIT. As an 
investment, foreign corporation A owns stock in a domestically-
controlled REIT, within the meaning of section 897(h)(4)(B). Under 
section 897(h)(2), gain on disposition of stock in the REIT is not 
treated as ECI. For this reason the stock does not qualify as a U.S. 
asset under paragraph (d)(1) of this section even if dividend 
distributions from the REIT are treated as ECI. Thus, A will have a 
dividend equivalent amount based on the ECEP attributable to a 
distribution of ECI from the REIT, even if A invests the proceeds from 
the dividend in additional stock of the REIT. (Stock in a REIT that is 
not a domestically-controlled REIT is also not a U.S. asset. See Sec.  
1.884-1(d)(5)).
    Example 5. Section 864(c)(7) property. Foreign corporation A is 
engaged in the equipment leasing business in the United States and 
Canada. A transfers the equipment leased by its U.S. trade or business 
to its Canadian business after the equipment is fully depreciated in the 
United States. The Canadian business sells the equipment two years 
later. Section 864(c)(7) would treat the gain on the disposition of the 
equipment by A as taxable under section 882 as if the sale occurred 
immediately before the equipment was transferred to the Canadian 
business. The equipment would not be treated as a U.S. asset even if the 
gain was ECI because the income from the equipment in the year of the 
sale in Canada would not be ECI.

    (3) Interest in a partnership--(i) In general. A foreign corporation 
that is a partner in a partnership must take into account its interest 
in the partnership (and not the partnership assets) in determining its 
U.S. assets. For purposes of determining the proportion of the 
partnership interest that is a U.S. asset, a foreign corporation may 
elect to use either the asset method described in paragraph (d)(3)(ii) 
of this section or the income method described in paragraph (d)(3)(iii) 
of this section.
    (ii) Asset method--(A) In general. A partner's interest in a 
partnership shall be treated as a U.S. asset in the same proportion that 
the sum of the partner's proportionate share of the adjusted bases of 
all partnership assets as of the determination date, to the extent that 
the assets would be treated as U.S. assets if the partnership were a 
foreign corporation, bears to the sum of the partner's proportionate 
share of the adjusted bases of all partnership assets as of the 
determination date. Generally a partner's proportionate share of a 
partnership asset is the same as its proportionate share of all items of 
income, gain, loss, and deduction that may be generated by the asset.
    (B) Non-uniform proportionate shares. If a partner's proportionate 
share of all items of income, gain, loss, and deduction that may be 
generated by a single asset of the partnership throughout the period 
that includes the taxable year of the partner is not uniform, then, for 
purposes of determining the partner's proportionate share of the 
adjusted basis of that asset, a partner must take into account the 
portion of the adjusted basis of the asset that reflects the partner's 
economic interest in that asset. A partner's economic interest in an 
asset of the partnership must be determined by applying the following 
presumptions. These presumptions may, however, be rebutted if the 
partner or the Internal Revenue Service shows that the presumption is 
inconsistent with the partner's true economic interest in the asset 
during the corporation's taxable year.
    (1) If a partnership asset ordinarily generates directly 
identifiable income, a partner's economic interest in the asset is 
determined by reference to its proportionate share of income that may be 
generated by the asset for the partnership's taxable year ending with or 
within the partner's taxable year.

[[Page 559]]

    (2) If a partnership asset ordinarily generates current deductions 
and ordinarily generates no directly identifiable income, for example 
because the asset contributes equally to the generation of all the 
income of the partnership (such as an asset used in general and 
administrative functions), a partner's economic interest in the asset is 
determined by reference to its proportionate share of the total 
deductions that may be generated by the asset for the partnership's 
taxable year ending with or within the partner's taxable year.
    (3) For other partnership assets not described in paragraph 
(d)(3)(ii)(B) (1) or (2) of this section, a partner's economic interest 
in the asset is determined by reference to its proportionate share of 
the total gain or loss to which it would be entitled if the asset were 
sold at a gain or loss in the partnership's taxable year ending with or 
within the partner's taxable year.
    (C) Partnership election under section 754. If a partnership files 
an election in accordance with section 754, then for purposes of this 
paragraph (d)(3)(ii), the basis of partnership property shall reflect 
adjustments made pursuant to sections 734 (relating to distributions of 
property to a partner) and 743 (relating to the transfer of an interest 
in a partnership). However, adjustments made pursuant to section 743 may 
be made with respect to a transferee partner only.
    (iii) Income method. Under the income method, a partner's interest 
in a partnership shall be treated as a U.S. asset in the same proportion 
that its distributive share of partnership ECI for the partnership's 
taxable year that ends with or within the partner's taxable year bears 
to its distributive share of all partnership income for that taxable 
year.
    (iv) Manner of election--(A) In general. In determining the 
proportion of a foreign corporation's interest in a partnership that is 
a U.S. asset, a foreign corporation must elect one of the methods 
described in paragraph (d)(3) of this section on a timely filed return 
for the first taxable year beginning on or after the effective date of 
this section. An amended return does not qualify for this purpose, nor 
shall the provisions of Sec.  301.9100-1 of this chapter and any 
guidance promulgated thereunder apply. An election shall be made by the 
foreign corporation calculating its U.S. assets in accordance with the 
method elected. An elected method must be used for a minimum period of 
five years before the foreign corporation may elect a different method. 
To change an election before the end of the requisite five-year period, 
a foreign corporation must obtain the consent of the Commissioner or her 
delegate. The Commissioner or her delegate will generally consent to a 
foreign corporation's request to change its election only in rare and 
unusual circumstances. A foreign corporation that is a partner in more 
than one partnership is not required to elect to use the same method for 
each partnership interest.
    (B) Elections with tiered partnerships. If a foreign corporation 
elects to use the asset method with respect to an interest in a 
partnership, and that partnership is a partner in a lower-tier 
partnership, the foreign corporation may apply either the asset method 
or the income method to determine the proportion of the upper-tier 
partnership's interest in the lower-tier partnership that is a U.S. 
asset.
    (v) Failure to make proper election. If a foreign corporation, for 
any reason, fails to make an election to use one of the methods required 
by paragraph (d)(3) of this section in a timely fashion, the director of 
field operations or the Assistant Commissioner (International) may make 
the election on behalf of the foreign corporation and such election 
shall be binding as if made by that corporation.
    (vi) Special rule for determining a partner's adjusted basis in a 
partnership interest. For purposes of paragraphs (d)(3) and (6) of this 
section, a partner's adjusted basis in a partnership interest shall be 
the partner's basis in such interest (determined under section 705) 
reduced by the partner's share of the liabilities of the partnership 
determined under section 752 and increased by a proportionate share of 
each liability of the partnership equal to the partner's proportionate 
share of the expense, for income tax purposes, attributable to such 
liability for the taxable year. A

[[Page 560]]

partner's adjusted basis in a partnership interest cannot be less than 
zero.
    (vii) E&P basis of a partnership interest. See paragraph (d)(6)(iii) 
of this section for special rules governing the calculation of a foreign 
corporation's E&P basis in a partnership interest.
    (viii) The application of this paragraph (d)(3) is illustrated by 
the following examples:

    Example 1. General rule. (i) Facts. Foreign corporation, FC, is a 
partner in partnership ABC, which is engaged in a trade or business 
within the United States. FC and ABC are both calendar year taxpayers. 
ABC owns and manages two office buildings located in the United States, 
each with an adjusted basis of $50. ABC also owns a non-U.S. asset with 
an adjusted basis of $100. ABC has no liabilities. Under the partnership 
agreement, FC has a 50 percent interest in the capital of ABC and a 50 
percent interest in all items of income, gain, loss, and deduction that 
may be generated by the partnership's assets. FC's adjusted basis in ABC 
is $100. In determining the proportion of its interest in ABC that is a 
U.S. asset, FC elects to use the asset method described in paragraph 
(d)(3)(ii) of this section.
    (ii) Analysis. FC's interest in ABC is treated as a U.S. asset in 
the same proportion that the sum of FC's proportionate share of the 
adjusted bases of all ABC's U.S. assets (50% of $100), bears to the sum 
of FC's proportionate share of the adjusted bases of all of ABC's assets 
(50% of $200). Under the asset method, the amount of FC's interest in 
ABC that is a U.S. asset is $50 ($100 x $50/$100).
    Example 2. Special allocation of gain with respect to real property. 
(i) Facts. The facts are the same as in Example 1, except that under the 
partnership agreement, FC is allocated 20 percent of the income from the 
partnership property but 80 percent of the gain on disposition of the 
partnership property.
    (ii) Analysis. Assuming that the buildings ordinarily generate 
directly identifiable income, there is a rebuttable presumption under 
paragraph (d)(3)(ii)(B)(1) of this section that FC's proportionate share 
of the adjusted basis of the buildings is FC's proportionate share of 
the income generated by the buildings (20%) rather than the total gain 
that it would be entitled to under the partnership agreement (80%) if 
the buildings were sold at a gain on the determination date. Thus, the 
sum of FC's proportionate share of the adjusted bases in ABC's U.S. 
assets (the buildings) is presumed to be $20 [(20% of $50) + (20% of 
$50)]. Assuming that the non-U.S. asset is not income-producing and does 
not generate current deductions, there is a rebuttable presumption under 
paragraph (d)(3)(ii)(B)(3) of this section that FC's proportionate share 
of the adjusted basis of that asset is FC's interest in the gain on the 
disposition of the asset (80%) rather than its proportionate share of 
the income that may be generated by the asset (20%). Thus, FC's 
proportionate share of the adjusted basis of ABC's non-U.S. asset is 
presumed to be $80 (80% of $100). FC's proportionate share of the 
adjusted bases of all of the assets of ABC is $100 ($20 + $80). The 
amount of FC's interest in ABC that is a U.S. asset is $20 ($100 x $20/
$100).
    Example 3. Tiered partnerships (asset method). (i) Facts. The facts 
are the same as in Example 1, except that FC's adjusted basis in ABC is 
$175 and ABC also has a 50 percent interest in the capital of 
partnership DEF. DEF owns and operates a commercial shopping center in 
the United States with an adjusted basis of $200 and also owns non-U.S. 
assets with an adjusted basis of $100. DEF has no liabilities. ABC's 
adjusted basis in its interest in DEF is $150 and ABC has a 50 percent 
interest in all the items of income, gain, loss and deduction that may 
be generated by the assets of DEF.
    (ii) Analysis. Because FC has elected to use the asset method 
described in paragraph (d)(3)(ii) of this section, it must determine 
what proportion of ABC's partnership interest in DEF is a U.S. asset. As 
permitted by paragraph (d)(3)(iv)(B) of this section, FC also elects to 
use the asset method with respect to ABC's interest in DEF. ABC's 
interest in DEF is treated as a U.S. asset in the same proportion that 
the sum of ABC's proportionate share of the adjusted bases of all DEF's 
U.S. assets (50% of $200), bears to the sum of ABC's proportionate share 
of the adjusted bases of all of DEF's assets (50% of $300). Thus, the 
amount of ABC's interest in DEF that is a U.S. asset is $100 ($150 x 
$100/$150). FC must then apply the rules of paragraph (d)(3)(ii) of this 
section to all the assets of ABC, including ABC's interest in DEF that 
is treated in part as a U.S. asset ($100) and in part as a non-U.S. 
asset ($50). FC's interest in ABC is treated as a U.S. asset in the same 
proportion that the sum of FC's proportionate share of the adjusted 
bases of the U.S. assets of ABC (including ABC's interest in DEF), bears 
to the sum of FC's proportionate share of the adjusted bases of all 
ABC's assets (including ABC's interest in DEF). Thus, the amount of FC's 
interest in ABC that is a U.S. asset is $100 (FC's adjusted basis in ABC 
($175) multiplied by FC's proportionate share of the sum of the adjusted 
bases of ABC's U.S. assets ($100)) over FC's proportionate share of the 
sum of the adjusted bases of ABC's assets ($175)).
    Example 4. Tiered partnerships (income method). (i) Facts. The facts 
are the same as in Example 3, except that FC has elected to use the 
income method described in paragraph (d)(3)(iii) of this section to 
determine the proportion of its interest in ABC that is a U.S. asset. 
The two office buildings located

[[Page 561]]

in the United States generate $60 of income that is ECI for the taxable 
year. The non-U.S. asset is not-income producing. In addition ABC's 
distributive share of income from DEF consists of $40 of income that is 
ECI and $140 of income that is not ECI.
    (ii) Analysis. Because FC has elected to use the income method it 
does need to determine what proportion of ABC's partnership interest in 
DEF is a U.S. asset. FC's interest in ABC is treated as a U.S. asset in 
the same proportion that its distributive share of ABC's income for the 
taxable year that is ECI ($50) ($30 earned directly by ABC + $20 
distributive share from DEF) bears to its distributive share of all 
ABC's income for the taxable year ($55) ($30 earned directly by ABC + 
$25 distributive share from DEF). Thus, FC's interest in ABC that is a 
U.S. asset is $159 ($175 x $50/$55).

    (4) Interest in a trust or estate--(i) Estates and non-grantor 
trusts. A foreign corporation that is a beneficiary of a trust or estate 
shall not be treated as having a U.S. asset by virtue of its interest in 
the trust or estate.
    (ii) Grantor trusts. If, under sections 671 through 678, a foreign 
corporation is treated as owning a portion of a trust that includes all 
the income and gain that may be generated by a trust asset (or pro rata 
portion of a trust asset), the foreign corporation will be treated as 
owning the trust asset (or pro rata portion thereof) for purposes of 
determining its U.S. assets under this section.
    (5) Property that is not a U.S. asset--(i) Property that does not 
give rise to ECEP. Property described in paragraphs (d) (1) through (4) 
of this section shall not be treated as a U.S. asset of a foreign 
corporation if, on the determination date, income from the use of the 
property, or gain or loss from the disposition of the property, would be 
described in paragraph (f)(2) of this section (relating to certain 
income that does not produce ECEP).
    (ii) Assets acquired to increase U.S. net equity artificially. U.S. 
assets shall not include assets acquired or used by a foreign 
corporation if one of the principal purposes of such acquisition or use 
is to increase artificially the U.S. assets of a foreign corporation on 
the determination date. Whether assets are acquired or used for such 
purpose will depend upon all the facts and circumstances of each case. 
Factors to be considered in determining whether one of the principal 
purposes in acquiring or using an asset is to increase artificially the 
U.S. assets of a foreign corporation include the length of time during 
which the asset was used in a U.S. trade or business, whether the asset 
was acquired from, or disposed of to, a related person, and whether the 
aggregate value of the U.S. assets of the foreign corporation increased 
temporarily on the determination date. For purposes of this paragraph 
(d)(5)(ii), to be one of the principal purposes, a purpose must be 
important, but it is not necessary that it be the primary purpose.
    (iii) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not create a U.S. 
asset.
    (6) E&P basis of a U.S. asset--(i) General rule. The E&P basis of a 
U.S. asset for purposes of this section is its adjusted basis for 
purposes of computing the foreign corporation's earnings and profits. In 
determining the E&P basis of a U.S. asset, the adjusted basis of the 
asset (for purposes of computing taxable income) must be increased or 
decreased to take into account inclusions of income or gain, and 
deductions or similar charges, that affect the basis of the asset where 
such items are taken into account in a different manner for purposes of 
computing earnings and profits than for purposes of computing taxable 
income. For example, if section 312 (k) requires that depreciation with 
respect to a U.S. asset be determined using the straight line method for 
purposes of computing earnings and profits, but depreciation with 
respect to the asset is determined using a different method for purposes 
of computing taxable income, the E&P basis of the property for purposes 
of this section must be computed using the straight line method of 
depreciation.
    (ii) Installment obligations--(A) Sales in taxable year beginning on 
or after January 1, 1987. For purposes of this section, the E&P basis of 
an installment obligation described in paragraph (d)(2)(iii) of this 
section that arises in connection with an installment sale occurring in 
a taxable year beginning on or after January 1, 1987, shall equal the 
sum of the total amount of gain from the sale if the obligation were 
satisfied

[[Page 562]]

in full and the adjusted basis of the property sold as of the date of 
sale, reduced by payments received with respect to the obligation that 
are not interest or original issue discount. See paragraph (j)(2)(ii) of 
this section, however, for a special E&P basis rule for an installment 
obligation arising in connection with a sale of a U.S. asset by a 
foreign corporation described in section 312(k)(4), where such sale 
occurs in a taxable year beginning in 1987.
    (B) Sales in taxable year prior to January 1, 1987. For purposes of 
this section, the E&P basis of an installment obligation described in 
paragraph (d)(2)(iii) of this section that arises in connection with an 
installment sale occurring in a taxable year beginning before January 1, 
1987, shall equal zero.
    (iii) Computation of E&P basis in a partnership. For purposes of 
this section, a foreign corporation's E&P basis in a partnership 
interest shall be the foreign corporation's adjusted basis in such 
interest (as determined under paragraph (d)(3)(vi) of this section), 
further adjusted to take into account any differences between the 
foreign corporation's distributive share of items of partnership income, 
gain, loss, and deduction for purposes of computing the taxable income 
of the foreign corporation and the foreign corporation's distributive 
share of items of partnership income, gain, loss, and deductions for 
purposes of computing the earnings and profits of the foreign 
corporation.
    (iv) Computation of E&P basis of a loss property. The E&P basis of a 
loss property (as defined in paragraph (d)(2)(ix) of this section) shall 
equal the E&P basis, immediately before the loss, of the U.S. asset with 
respect to which the loss was sustained, reduced (but not below zero) 
by--
    (A) The amount of any deduction claimed under section 165 by the 
foreign corporation with respect to the loss for earnings and profits 
purposes; and
    (B) Any compensation received with respect to the loss.
    (v) Computation of E&P basis of financial instruments. [Reserved]
    (vi) Example. The application of paragraph (d)(6)(ii) of this 
section is illustrated by the following example.

    Example. Sale in taxable year beginning on or after January 1, 1987. 
Foreign corporation A, a calendar year taxpayer, sells a U.S. asset on 
the installment method in 1993. Under the terms of the sale, A is to 
receive $100, payable in ten annual installments of $10 beginning in 
1994, plus an arm's-length rate of interest on the unpaid balance of the 
sales price. A's adjusted basis in the property sold is $70. The 
obligation received in connection with the installment sale is treated 
as a U.S. asset with an E&P basis of $100 ($30 (the amount of gain from 
the sale if the obligation were satisfied in full) + $70 (the adjusted 
basis of the property sold)). If A receives a payment of $10 (not 
including interest) in 1994 with respect to the obligation, the 
obligation is treated as a U.S. asset with an E&P basis of $90 ($100-
$10) as of the close of 1994.

    (e) U.S. liabilities. The term U.S. liabilities means the amount of 
liabilities determined under paragraph (e)(1) of this section decreased 
by the amount of liabilities determined under paragraph (e)(3) of this 
section, and increased by the amount of liabilities determined under 
paragraph (e)(2) of this section.
    (1) Liabilities based on Sec.  1.882-5. The amount of liabilities 
determined under this paragraph (e)(1) is the amount of U.S.-connected 
liabilities of a foreign corporation under Sec.  1.882-5 if the U.S.-
connected liabilities were computed using the assets and liabilities of 
the foreign corporation as of the determination date (rather than the 
average of such assets and liabilities for the taxable year) and without 
regard to paragraph (e)(3) of this section.
    (2) Additional liabilities--(i) Insurance reserves. The amount of 
liabilities determined under this paragraph (e)(2)(i) is the amount (as 
of the determination date) of the total insurance liabilities on United 
States business (within the meaning of section 842(b)(2)(B)) of a 
foreign corporation described in section 842(a) (relating to foreign 
corporations carrying on an insurance business in the United States) to 
the extent that such liabilities are not otherwise treated as U.S. 
liabilities by reason of paragraph (e)(1) of this section.
    (ii) Liabilities described in Sec.  1.882-5(a)(1)(ii). The amount of 
liabilities determined under this paragraph (e)(2)(ii) is the amount (as 
of the determination date) of liabilities described in Sec.  1.882-
5(a)(1)(ii) (relating to liabilities giving

[[Page 563]]

rise to interest expense that is directly allocated to income from a 
U.S. asset).
    (3) Election to reduce liabilities--(i) General rule. The amount of 
liabilities determined under this paragraph (e)(3) is the amount by 
which a foreign corporation elects to reduce its liabilities under 
paragraph (e)(1) of this section.
    (ii) Limitation. For any taxable year, a foreign corporation may 
elect to reduce the amount of its liabilities determined under paragraph 
(e)(1) of this section by an amount that does not exceed the lesser of 
the amount of U.S. liabilities as of the determination date, or the 
amount of U.S. liability reduction needed to reduce a dividend 
equivalent amount as of the determination date to zero.
    (iii) Effect of election on interest deduction and branch-level 
interest tax. A foreign corporation that elects to reduce its 
liabilities under this paragraph (e)(3) must, for purposes of computing 
the amount of its interest apportioned to ECI under Sec.  1.882-5, 
reduce its U.S.-connected liabilities for the taxable year of the 
election by the amount of the reduction in liabilities under this 
paragraph (e)(3). The reduction of its U.S.-connected liabilities will 
also require a corresponding decrease in the amount of its interest 
apportioned to ECI under Sec.  1.882-5 for purposes of Sec.  1.884-4(a) 
and for all other Code sections for which the amount of interest 
apportioned under Sec.  1.882-5 is relevant.
    (iv) Method of election. A foreign corporation that elects the 
benefits of this paragraph (e)(3) for a taxable year shall attach a 
statement to its return for the taxable year that it has elected to 
reduce its liabilities for the taxable year under this paragraph (e)(3) 
and that it has reduced the amount of its U.S.-connected liabilities as 
provided in paragraph (e)(3)(iii) of this section and shall indicate the 
amount of such reductions on such attachment. The cumulative amount of 
all U.S. liability reductions is shown on Schedule I (Form 1120-F) in 
addition to the separate elections attached to the timely filed return. 
An election under this paragraph (e)(3) must be made before the due date 
(including extensions) for the foreign corporation's income tax return 
for the taxable year.
    (v) Effect of election on complete termination. If a foreign 
corporation completely terminates its U.S. trade or business (within the 
meaning of Sec.  1.884-2T (a)(2)), notwithstanding Sec.  1.884-2T(a), 
the foreign corporation will be subject to tax on a dividend equivalent 
amount that equals the lesser of--
    (A) The foreign corporation's accumulated ECEP that is attributable 
to an election to reduce liabilities; or
    (B) The amount by which the corporation elected to reduce 
liabilities at the end of the taxable year preceding the year of 
complete termination.


For purposes of the preceding sentence, accumulated ECEP is attributable 
to an election to reduce liabilities to the extent that the ECEP was 
accumulated because of such an election rather than because of an 
increase in U.S. assets. For example, if a foreign corporation did not 
have positive ECEP in any year for which an election was made, it would 
not be required to include an amount as a dividend equivalent amount 
under this paragraph (e)(3)(v) because any accumulated ECEP that it may 
have is not attributable to an election to reduce liabilities.
    (4) Artificial decrease in U.S. liabilities. If a foreign 
corporation repays or otherwise decreases its U.S. liabilities and one 
of the principal purposes of such decrease is to decrease artificially 
its U.S. liabilities on the determination date, then such decrease shall 
not be taken into account for purposes of computing the foreign 
corporation's U.S. net equity. Whether the U.S. liabilities of a foreign 
corporation are artificially decreased will depend on all the facts and 
circumstances of each case. Factors to be considered in determining 
whether one of the principal purposes for the repayment or decrease of 
the liabilities is to decrease artificially the U.S. liabilities of a 
foreign corporation shall include whether the aggregate liabilities are 
temporarily decreased on or before the determination date by, for 
example, the repayment of liabilities, or U.S. liabilities are 
temporarily decreased on or before the determination date by the 
acquisition with contributed funds of passive-type assets that are not 
U.S. assets. For purposes of this paragraph (e)(4), to

[[Page 564]]

be one of the principal purposes, a purpose must be important, but it is 
not necessary that it be the primary purpose.
    (5) Examples. The application of this paragraph (e) is illustrated 
by the following examples.

    Example 1. General rule for computation of U.S. liabilities. As of 
the close of 1997, foreign corporation A, a calendar year taxpayer 
computes its U.S.-connected liabilities under Sec.  1.882-5(c) using its 
actual ratio of liabilities to assets. For purposes of computing its 
U.S.- connected liabilities under Sec.  1.882-5(c), A must determine the 
average total value of its assets that are U.S. assets. Assume that the 
average value of such assets is $100, while the amount of such assets as 
of the close of 1997 is $125. For purposes of Sec.  1.882-5(c)(2), A 
must determine the ratio of the average of its worldwide liabilities for 
the year to the average total value of worldwide assets for the taxable 
year. Assume that A's average liabilities-to-assets ratio under Sec.  
1.882-5(c)(2) is 55 percent, while its liabilities-to-assets ratio at 
the close of 1997 is only 50 percent. Thus, assuming no further 
adjustments under paragraph (e)(3) of this section, A's U.S.-connected 
liabilities for purposes of Sec.  1.882-5 are $55 ($100 x 55%). However, 
A's U.S. liabilities are $62.50 for purposes of this section, the value 
of its assets determined under Sec.  1.882-5(b)(2) as of the close of 
December ($125) multiplied by the liabilities-to-assets ratio of (50%) 
as of such date.
    Example 2. Election made to reduce liabilities. (i) As of the close 
of 2007, foreign corporation A, a real estate company, owns U.S. assets 
with an E&P basis of $1000. A has $800 of liabilities under paragraph 
(e)(1) of this section. A has accumulated ECEP of $500 and in 2008, A 
has $60 of ECEP that it intends to retain for future expansion of its 
U.S. trade or business. A elects under paragraph (e)(3) of this section 
to reduce its liabilities by $60 from $800 to $740. As a result of the 
election, assuming A's U.S. assets and U.S. liabilities would otherwise 
have remained constant, A's U.S. net equity as of the close of 2007 will 
increase by the amount of the decrease in liabilities ($60) from $200 to 
$260 and its ECEP will be reduced to zero. Under paragraph (e)(3)(iii) 
of this section, A's interest expense for the taxable year is reduced by 
the amount of interest attributable to $60 of liabilities and A's excess 
interest is reduced by the same amount. A's taxable income and ECEP are 
increased by the amount of the reduction in interest expense 
attributable to the liabilities, and A may make an election under 
paragraph (e)(3) of this section to further reduce its liabilities, thus 
increasing its U.S. net equity and reducing the amount of additional 
ECEP created for the election.
    (ii) In 2009, assuming A again has $60 of ECEP, A may again make the 
election under paragraph (e)(3) to reduce its liabilities. However, 
assuming A's U.S. assets and liabilities under paragraph (e)(1) of this 
section remain constant, A will need to make an election to reduce its 
liabilities by $120 to reduce to zero its ECEP in 2009 and to continue 
to retain for expansion (without the payment of the branch profits tax) 
the $60 of ECEP earned in 2008. Without an election to reduce 
liabilities, A's dividend equivalent amount for 2009 would be $120 ($60 
of ECEP plus the $60 reduction in U.S. net equity from $260 to $200). If 
A makes the election to reduce liabilities by $120 (from $800 to $680), 
A's U.S. net equity will increase by $60 (from $260 at the end of the 
previous year to $320), the amount necessary to reduce its ECEP to $0. 
However, the reduction of liabilities will itself create additional ECEP 
subject to section 884 because of the reduction in interest expense 
attributable to the $120 of liabilities. A can make the election to 
reduce liabilities by $120 without exceeding the limitation on the 
election provided in paragraph (e)(3)(ii) of this section because the 
$120 reduction does not exceed the amount needed to treat the 2009 and 
2008 ECEP as reinvested in the net equity of the trade or business 
within the United States.
    (iii) If A terminates its U.S. trade or business in 2009 in 
accordance with the rules in Sec.  1.884-2T(a), A would not be subject 
to the branch profits tax on the $60 of ECEP earned in that year. Under 
paragraph (e)(3)(v) of this section, however, it would be subject to the 
branch profits tax on the portion of the $60 of ECEP that it earned in 
2008 that became accumulated ECEP because of an election to reduce 
liabilities.

    (f) Effectively connected earnings and profits--(1) In general. 
Except as provided in paragraph (f)(2) of this section and as modified 
by Sec.  1.884-2T (relating to the incorporation or complete termination 
of a U.S. trade or business or the reorganization or liquidation of a 
foreign corporation or its domestic subsidiary), the term ``effectively 
connected earnings and profits'' (``ECEP'') means the earnings and 
profits (or deficits therein) determined under section 312 and this 
paragraph (f) that are attributable to ECI (within the meaning of 
paragraph (d)(1)(iii) of this section). Because the term ``ECI'' 
includes income treated as effectively connected, income that is ECI 
under section 842(b) (relating to minimum net investment income of an 
insurance business) or 864(c)(7) (relating to gain from property 
formerly held for use in a U.S. trade or

[[Page 565]]

business) gives rise to ECEP. ECEP also includes earnings and profits 
attributable to ECI of a foreign corporation earned through a 
partnership, and through a trust or estate. For purposes of section 884, 
gain on the sale of a U.S. real property interest by a foreign 
corporation that has made an election to be treated as a domestic 
corporation under section 897(i) will also give rise to ECEP. ECEP is 
not reduced by distributions made by the foreign corporation during any 
taxable year or by the amount of branch profits tax or tax on excess 
interest (as defined in Sec.  1.884-4(a)(2)) paid by the foreign 
corporation. Earnings and profits are treated as attributable to ECI 
even if the earnings and profits are taken into account under section 
312 in an earlier or later taxable year than the taxable year in which 
the ECI is taken into account.
    (2) Income that does not produce ECEP. The term ``ECEP'' does not 
include any earnings and profits attributable to--
    (i) Income excluded from gross income under section 883(a)(1) or 
883(a)(2) (relating to certain income derived from the operation of 
ships or aircraft);
    (ii) Income that is ECI by reason of section 921(d) or 926(b) 
(relating to certain income of a FSC and certain dividends paid by a FSC 
to a foreign corporation or nonresident alien) that is not otherwise 
ECI;
    (iii) Gain on the disposition of a U.S. real property interest 
described in section 897(c)(1)(A)(ii) (relating to certain interests in 
a domestic corporation);
    (iv) Income that is ECI by reason of section 953(c)(3)(C) (relating 
to certain income of a captive insurance company that a corporation 
elects to treat as ECI) that is not otherwise ECI;
    (v) Income that is exempt from tax under section 892 (relating to 
certain income of foreign governments); and
    (vi) Income that is ECI by reason of section 882(e) (relating to 
certain interest income of banks organized under the laws of a 
possession of the United States) that is not otherwise ECI.
    (3) Allocation of deductions attributable to income that does not 
produce ECEP. In determining the amount of a foreign corporation's ECEP 
for the taxable year, deductions and other adjustments shall be 
allocated and apportioned under the principles of Sec.  1.861-8 between 
ECI that gives rise to ECEP and income described in paragraph (f)(2) of 
this section (relating to income that is ECI but does not give rise to 
ECEP).
    (4) Examples. The principles of paragraph (f) of this section are 
illustrated by the following examples.

    Example 1. Tax-exempt income. Foreign corporation A owns a tax-
exempt municipal bond that is a U.S. asset as of the close of its 1989 
taxable year. The municipal bond gives rise in 1989 to ECI (even though 
the income is excluded from gross income under section 103(a) and is not 
gross income of a foreign corporation by reason of section 882(b)), and 
therefore gives rise to ECEP in 1989.
    Example 2. Income exempt under a treaty. Foreign corporation A 
derives ECI that constitutes business profits that are not attributable 
to a permanent establishment maintained by A in the United States. The 
ECI is exempt from taxation under section 882(a) by reason of an income 
tax treaty and section 894(a). The income nevertheless gives rise to 
ECEP under this paragraph (f). However, a dividend equivalent amount 
attributable to such ECEP may be exempt from the branch profits tax by 
reason of paragraph (g) of this section (relating to the application of 
the branch profits tax to corporations that are residents of countries 
with which the United States has an income tax treaty).

    (g) Corporations resident in countries with which the United States 
has an income tax treaty--(1) General rule. Except as provided in 
paragraph (g)(2) of this section, a foreign corporation that is a 
resident of a country with which the United States has an income tax 
treaty in effect for a taxable year in which it has a dividend 
equivalent amount and that meets the requirements, if any, of the 
limitation on benefits provisions of such treaty with respect to the 
dividend equivalent amount shall not be subject to the branch profits 
tax on such amount (or will qualify for a reduction in the amount of tax 
with respect to such amount) only if--
    (i) The foreign corporation is a qualified resident of such country 
for the taxable year, within the meaning of Sec.  1.884-5(a); or
    (ii) The limitation on benefits provision, or an amendment to that 
provision, entered into force after December 31, 1986.


If, after application of Sec.  1.884-5(e)(4)(iv), a foreign corporation 
is a qualified resident under Sec.  1.884-5(e) (relating to the active 
trade or business test) only

[[Page 566]]

with respect to one of its trades or businesses in the United States, 
i.e., the trade or business that is an integral part of its business 
conducted in its country of residence, and not with respect to another, 
the rules of this paragraph shall apply only to that portion of its 
dividend equivalent amount attributable to the trade or business for 
which the foreign corporation is a qualified resident.
    (2) Special rules for foreign corporations that are qualified 
residents on the basis of their ownership--(i) General rule. A foreign 
corporation that, in any taxable year, is a qualified resident of a 
country with which the United States has an income tax treaty in effect 
solely by reason of meeting the requirements of Sec.  1.884-5 (b) and 
(c) (relating, respectively, to stock ownership and base erosion) shall 
be exempt from the branch profits tax or subject to a reduced rate of 
branch profits tax under paragraph (g)(1) of this section with respect 
to the portion of its dividend equivalent amount for the taxable year 
attributable to accumulated ECEP only if the foreign corporation is a 
qualified resident of such country within the meaning of Sec.  1.884-
5(a) for the taxable years includable, in whole or in part, in a 
consecutive 36-month period that includes the taxable year of the 
dividend equivalent amount. A foreign corporation that fails the 36-
month test described in the preceding sentence shall be exempt from the 
branch profits tax or subject to the branch profits tax at a reduced 
rate under paragraph (g)(1) of this section with respect to accumulated 
ECEP (determined on a last-in-first-out basis) accumulated only during 
prior years in which the foreign corporation was a qualified resident of 
such country within the meaning of Sec.  1.884-5(a).
    (ii) Rules of application. A foreign corporation that has not 
satisfied the 36-month test as of the close of the taxable year of the 
dividend equivalent amount but satisfies the test with respect to such 
dividend equivalent amount by meeting the 36-month test by the close of 
the second taxable year succeeding the taxable year of the dividend 
equivalent amount shall be subject to the branch profits tax for the 
year of the dividend equivalent amount without regard to paragraph 
(g)(1) of this section on the portion of the dividend equivalent amount 
attributable to accumulated ECEP derived in a taxable year in which the 
foreign corporation was not a qualified resident within the meaning of 
Sec.  1.884-5(a). Upon meeting the 36-month test, the foreign 
corporation shall be entitled to claim by amended return a refund of the 
tax paid with respect to the dividend equivalent amount in excess of the 
branch profits tax calculated by taking into account paragraph (g)(2)(i) 
of this section, provided the foreign corporation establishes in the 
amended return for the taxable year that it has met the requirements of 
such paragraph. For purposes of section 6611 (dealing with interest on 
overpayments), any overpayment of branch profits tax by reason of this 
paragraph (g)(2)(ii) shall be deemed not to have been made before the 
filing date for the taxable year in which the foreign corporation 
establishes that it has met the 36-month test.
    (iii) Example. The application of this paragraph (g)(2) is 
illustrated by the following example.

    Example. (i) Foreign corporation A, a calendar year taxpayer, is a 
resident of the United Kingdom. A has a dividend equivalent amount for 
its taxable year 1991 of $300, of which $100 is attributable to 1991 
ECEP and $200 to accumulated ECEP. A is a qualified resident for its 
taxable year 1991 because for that year it meets the requirements of 
Sec.  1.884-5 (b) and (c), relating, respectively, to stock ownership 
and base erosion. For 1991 A does not meet the requirements of Sec.  
1.884-5 (d), (e), or (f) for qualified residence. A is not a qualified 
resident of the United Kingdom for any taxable year prior to 1990 but is 
a qualified resident for its taxable years 1990 and 1992.
    (ii) Because A is a qualified resident for the 3-year period (1990, 
1991, and 1992) that includes the taxable year of the dividend 
equivalent amount (1991), A satisfies the 36-month test of this 
paragraph (g)(2) and no branch profits tax is imposed on the total $300 
dividend equivalent amount. However, since A was not a qualified 
resident for any taxable year prior to 1990 and therefore cannot 
establish that it has satisfied the 36-month test until the taxable year 
following the year of the dividend equivalent amount, A must pay the 
branch profits tax for its taxable year 1991 with respect to the portion 
of the dividend equivalent amount attributable to accumulated ECEP 
relating to years prior

[[Page 567]]

to 1990 without regard to paragraph (g)(1) of this section. A may file 
for a refund of the branch profits tax paid with respect to its 1991 
taxable year at any time after it establishes that it is a qualified 
resident for its 1992 taxable year.

    (3) Exemptions for foreign corporations resident in certain 
countries with income tax treaties in effect on January 1, 1987. The 
branch profits tax shall not be imposed on the portion of the dividend 
equivalent amount with respect to which a foreign corporation satisfies 
the requirements of paragraphs (g) (1) and (2) of this section for a 
country listed below, so long as the income tax treaty between the 
United States and that country, as in effect on January 1, 1987, remains 
in effect, except to the extent the treaty is modified on or after 
January 1, 1987, to expressly provide for the imposition of the branch 
profits tax:

Aruba
Austria
Belgium
People's Republic of China
Cyprus
Denmark
Egypt
Finland
Germany
Greece
Hungary
Iceland
Ireland
Italy
Jamaica
Japan
Korea
Luxembourg
Malta
Morocco
Netherlands
Netherlands Antilles
Norway
Pakistan
Philippines
Sweden
Switzerland
United Kingdom

    (4) Modifications with respect to other income tax treaties--(i) 
Limitation on rate of tax--(A) General rule. If, under paragraphs (g) 
(1) and (2) of this section, a corporation qualifies for a reduction in 
the amount of the branch profits tax and paragraph (g)(3) of this 
section does not apply, the rate of tax shall be the rate of tax on 
branch profits specified in the treaty between the United States and the 
corporation's country of residence or, if no rate of tax on branch 
profits is specified, the rate of tax that would apply under such treaty 
to dividends paid to the foreign corporation by a wholly-owned domestic 
corporation.
    (B) Certain treaties in effect on January 1, 1987. The branch 
profits tax shall generally be imposed at the following rates on the 
portion of the dividend equivalent amount with respect to which a 
foreign corporation satisfies the requirements of paragraphs (g) (1) and 
(2) of this section for a country listed below, for as long as the 
relevant provisions of those income tax treaties remain in effect and 
are not modified or superseded by subsequent agreement:

Australia (15%)
Barbados (5%)
Canada (10%)
France (5%)
New Zealand (5%)
Poland (5%)
Romania (10%)
South Africa (30%)
Trinidad & Tobago (10%)
U.S.S.R. (30%)


However, for special rates imposed on corporations resident in France 
and Trinidad & Tobago that have certain amounts of dividend and interest 
income, see the dividend articles of the income tax treaties with those 
countries.
    (ii) Limitations other than rate of tax. If, under paragraphs (g) 
(1) and (2) of this section, a foreign corporation qualifies for a 
reduction in the amount of branch profits tax and paragraph (g) (3) of 
this section does not apply, then--
    (A) The foreign corporation shall be entitled to the benefit of any 
limitations on imposition of a tax on branch profits (in addition to any 
limitations on the rate of tax) contained in the treaty; and
    (B) No branch profits tax shall be imposed with respect to a 
dividend equivalent amount out of ECEP or accumulated ECEP of the 
foreign corporation unless the ECEP or accumulated ECEP is attributable 
to a permanent establishment in the United States or, if not otherwise 
prohibited under the treaty, to gain from the disposition of a U.S. real 
property interest described in section 897(c)(1)(A)(i), except to the 
extent the treaty specifically permits the imposition of the branch 
profits tax on such earnings and profits.
    No article in such treaty shall be construed to provide any 
limitations on imposition of the branch profits tax other than as 
provided in this paragraph (g)(4).
    (iii) Computation of the dividend equivalent amount if a foreign 
corporation has both ECEP attributable to a permanent establishment and 
not attributable to a permanent establishment. To determine the dividend 
equivalent amount of a

[[Page 568]]

foreign corporation out of ECEP that is attributable to a permanent 
establishment, the foreign corporation may only take into account its 
U.S. assets, U.S. liabilities, U.S. net equity and ECEP attributable to 
its permanent establishment. Thus, a foreign corporation may not reduce 
the amount of its ECEP attributable to its permanent establishment by 
reinvesting all or a portion of that amount in U.S. assets not 
attributable to the permanent establishment.
    (iv) Limitations under the Canadian treaty. The limitations on the 
imposition of the branch profits tax under the Canadian treaty include, 
but are not limited to, those described in paragraphs (g)(4)(iv) (A) and 
(B).
    (A) Effect of deficits in earnings and profits. In the case of a 
foreign corporation that is a qualified resident of Canada, the dividend 
equivalent amount for any taxable year shall not exceed the foreign 
corporation's accumulated ECEP as of the beginning of the taxable year 
plus the corporation's ECEP for the taxable year. Thus, for example, if 
a foreign corporation that is a qualified resident of Canada has a 
deficit in accumulated ECEP of $200 as of the beginning of the taxable 
year and ECEP of $100 for the taxable year, it will have no dividend 
equivalent amount for the taxable year because it would have a 
cumulative deficit in ECEP of $100 as of the close of the taxable year. 
For purposes of this paragraph (g)(4)(iii)(A), any net deficit in 
accumulated earnings and profits attributable to taxable years beginning 
before January 1, 1987, shall be includible in determining accumulated 
ECEP.
    (B) One-time exemption of Canadian $500,000--(1) General rule. In 
the case of a foreign corporation that is a qualified resident of 
Canada, the branch profits tax shall be imposed only with respect to 
that portion of the dividend equivalent amount for the taxable year 
that, when translated into Canadian dollars and added to the dividend 
equivalent amounts for preceding taxable years translated into Canadian 
dollars, exceeds Canadian $500,000. The value of the dividend equivalent 
amount in Canadian currency shall be determined by translating the ECEP 
for each taxable year that is includible in the dividend equivalent 
amount (as determined in U.S. dollars under the currency translation 
method used in determining the foreign corporation's taxable income for 
U.S. tax purposes) by the weighted average exchange rate for the taxable 
year (determined under the rules of section 989(b)(3)) during which the 
earnings and profits were derived.
    (2) Reduction in amount of exemption in the case of related 
corporations. The amount of a foreign corporation's exemption under this 
paragraph (g)(4)(iii)(B) shall be reduced by the amount of any exemption 
that reduced the dividend equivalent amount of an associated foreign 
corporation with respect to the same or a similar business. For purposes 
of this paragraph (g)(4)(iii)(B), a foreign corporation is an associated 
foreign corporation if it is related to the foreign corporation for 
purposes of sectional 267(b) or it and the foreign corporation are 
stapled entities (within the meaning of section 269B(c)(2)) or are 
effectively stapled entities. A business is the same as or similar to 
another business if it involves the sale, lease, or manufacture of the 
same or a similar type of property or the provision of the same or a 
similar type of services. A U.S. real property interest described in 
section 897(c)(1)(A)(i) shall be treated as a business and all such U.S. 
real property interests shall be treated as businesses that are the same 
or similar.
    (3) Coordination with second-tier withholding tax. The value of the 
dividend equivalent amount that is exempt from the branch profits tax by 
reason of paragraph (g)(4)(iii)(B)(1) of this section shall not be 
subject to tax under section 871(a) or 881, or to withholding under 
section 1441 or 1442, when distributed by the foreign corporation.
    (5) Benefits under treaties other than income tax treaties. A treaty 
that is not an income tax treaty does not exempt a foreign corporation 
from the branch profits tax or reduce the amount of the tax.
    (h) Stapled entities. Any foreign corporation that is treated as a 
domestic corporation by reason of section 269B (relating to stapled 
entities) shall continue to be treated as a foreign corporation for 
purposes of section 884 and

[[Page 569]]

the regulations thereunder, notwithstanding section 269B or the 
regulations thereunder. Dividends paid by such foreign corporation shall 
be treated as paid by a domestic corporation and shall be subject to the 
tax imposed by section 871(a) or 881(a), and to withholding under 
section 1441 or 1442, as applicable, to the extent paid out of earnings 
and profits that are not subject to tax under section 884(a). Dividends 
paid by such foreign corporation out of earnings and profits subject to 
tax under section 884(a) shall be exempt from the tax imposed by 
sections 871(a) and 881(a) and shall not be subject to withholding under 
section 1441 or 1442. Whether dividends are paid out of earnings and 
profits that are subject to tax under section 884(a) shall be determined 
under section 884(e)(3)(A) and the regulations thereunder. The 
limitation on the application of treaty benefits in section 884(e)(3)(B) 
(relating to qualified residents) shall apply to a foreign corporation 
described in this paragraph (h).
    (i) Effective date--(1) General rule. This section is effective for 
taxable years beginning on or after October 13, 1992. With respect to a 
taxable year beginning before October 13, 1992 and after December 31, 
1986, a foreign corporation may elect to apply this section in lieu of 
Sec.  1.884-1T of the temporary regulations (as contained in the CFR 
edition revised as of April 1, 1992), but only if the foreign 
corporation also makes an election under Sec.  1.884-4 (e) to apply 
Sec.  1.884.4 in lieu of Sec.  1.884-4T (as contained in the CFR edition 
revised as of April 1, 1992) for that taxable year, and the statute of 
limitations for assessment of a deficiency has not expired for that 
taxable year. Once an election has been made, an election under this 
section shall apply to all subsequent taxable years. However, paragraph 
(f)(2)(vi) of this section (relating to certain interest income of 
Possessions banks) shall not apply for taxable years beginning before 
January 1, 1990.
    (2) Election to reduce liabilities. A foreign corporation may make 
an election to reduce its liabilities under paragraph (e)(3) of this 
section with respect to a taxable year for which an election under 
paragraph (i)(1) of this section is in effect by filing an amended 
return for the taxable year and recomputing its interest deduction and 
any other item affected by the election on an amended Form 1120F to take 
into account the reduction in liabilities for such year.
    (3) Separate election for installment obligations. A foreign 
corporation may make a separate election to apply paragraphs (d)(2)(iii) 
and (d)(6)(ii) of this section (relating to installment obligations 
treated as U.S. assets) to any prior taxable year without making an 
election under paragraph (i)(1) of this section, provided the statute of 
limitations for assessment of a deficiency has not expired for that 
taxable year and each succeeding taxable year. Once an election under 
this paragraph (i)(3) has been made, it shall apply to all subsequent 
taxable years.
    (4) Special rules for certain U.S. assets and liabilities. 
Paragraphs (c)(2) (i) and (ii), (d)(3), (d)(4), (d)(5)(iii), 
(d)(6)(iii), (d)(6)(vi), (e)(2), and (e)(3)(ii), of this section are 
effective for taxable years beginning on or after June 6, 1996.
    (j) Transition rules--(1) General rule. Except as provided in 
paragraph (j)(2) of this section, in order to compute its dividend 
equivalent amount in the first taxable year to which this section 
applies (whether or not such year begins before October 13, 1992, a 
foreign corporation must recompute its U.S. net equity as of close of 
the preceding taxable year using the rules of this section and use such 
recomputed amount, rather than the amount computed under Sec.  1.884-1T 
(as contained in the CFR edition revised as of April 1, 1992), to 
determine the amount of any increase or decrease in the U.S. net equity 
as of the close of that taxable year.
    (2) Installment obligations--(i) Interest election. In recomputing 
its U.S. net equity as of the close of the preceding taxable year, a 
foreign corporation that holds an installment obligation treated as a 
U.S. asset under Sec.  1.884-1T(d)(7) (as contained in the CFR edition 
revised as of April 1, 1992) as of such date may apply the rules of 
paragraph (d)(2)(iii) of this section without regard to the rule in that 
paragraph that requires interest or original issue

[[Page 570]]

discount on the obligation to be treated as ECI in order for such 
obligation to be treated as a U.S. asset.
    (ii) 1987 sales by certain foreign corporations. The E&P basis of an 
installment obligation arising in connection with a sale of property by 
a foreign corporation described in section 312(k)(4), where such sale 
occurs in a taxable year beginning in 1987, shall equal the E&P basis of 
the property sold as of the determination date reduced by payments 
received with respect to the obligation that do not represent gain for 
earnings and profits purposes, interest or original issue discount.

[T.D. 8432, 57 FR 41651, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992; 58 FR 17166, Apr. 1, 1993, as amended by T.D. 
8657, 61 FR 9338, Mar. 8, 1996; 61 FR 14247, Apr. 1, 1996; T.D. 9281, 71 
FR 47451, Aug. 17, 2006; T.D. 9465, 74 FR 49320, Sept. 28, 2009; 74 FR 
57252, Nov. 5, 2009]



Sec.  1.884-2  Special rules for termination or incorporation of a U.S. trade 
or business or liquidation or reorganization of a foreign corporation 
or its domestic subsidiary.

    (a)-(a)(2)(i) [Reserved]. For further information, see Sec.  1.884-
2T(a) through (a)(2)(ii).
    (a)(2)(ii) Waiver of period of limitations. The waiver referred to 
in Sec.  1.884-2T(a)(2)(i)(D) shall be executed on Form 8848, or 
substitute form, and shall extend the period for assessment of the 
branch profits tax for the year of complete termination to a date not 
earlier than the close of the sixth taxable year following that taxable 
year. This form shall include such information as is required by the 
form and accompanying instructions. The waiver must be signed by the 
person authorized to sign the income tax returns for the foreign 
corporation (including an agent authorized to do so under a general or 
specific power of attorney). The waiver must be filed on or before the 
date (including extensions) prescribed for filing the foreign 
corporation's income tax return for the year of complete termination. 
With respect to a complete termination occurring in a taxable year 
ending prior to June 6, 1996 a foreign corporation may also satisfy the 
requirements of this paragraph (a)(2)(ii) by applying Sec.  1.884-
2T(a)(2)(ii) of the temporary regulations (as contained in the CFR 
edition revised as of April 1, 1995). A properly executed Form 8848, 
substitute form, or other form of waiver authorized by this paragraph 
(a)(2)(ii) shall be deemed to be consented to and signed by a Service 
Center Director or the Assistant Commissioner (International) for 
purposes of Sec.  301.6501(c)-1(d) of this chapter.
    (a)(3)-(4) [Reserved]. For further information, see Sec.  1.884-
2T(a)(3) through (a)(4).
    (a)(5) Special rule if a foreign corporation terminates an interest 
in a trust. A foreign corporation whose beneficial interest in a trust 
terminates (by disposition or otherwise) in any taxable year shall be 
subject to the branch profits tax on ECEP attributable to amounts 
(including distributions of accumulated income or gain) treated as ECI 
to such beneficiary in such taxable year notwithstanding any other 
provision of Sec.  1.884-2T(a).
    (b) through (c)(2)(ii) [Reserved]. For further information, see 
Sec.  1.884-2T (b) through (c)(2)(ii).
    (c)(2)(iii) Waiver of period of limitations and transferee 
agreement. In the case of a transferee that is a domestic corporation, 
the provisions of Sec.  1.884-2T(c)(2)(i) shall not apply unless, as 
part of the section 381(a) transaction, the transferee executes a Form 
2045 (Transferee Agreement) and a waiver of period of limitations as 
described in this paragraph (c)(2)(iii), and files both documents with 
its timely filed (including extensions) income tax return for the 
taxable year in which the section 381(a) transaction occurs. The waiver 
shall be executed on Form 8848, or substitute form, and shall extend the 
period for assessment of any additional branch profits tax for the 
taxable year in which the section 381(a) transaction occurs to a date 
not earlier than the close of the sixth taxable year following the 
taxable year in which such transaction occurs. This form shall include 
such information as is required by the form and accompanying 
instructions. The waiver must be signed by the person authorized to sign 
Form

[[Page 571]]

2045. With respect to a complete termination occurring in a taxable year 
ending prior to June 6, 1996 a foreign corporation may also satisfy the 
requirements of this paragraph (c)(2)(iii) by applying Sec.  1.884-
2T(c)(2)(iii) of the temporary regulations (as contained in the CFR 
edition revised as of April 1, 1995). A properly executed Form 8848, 
substitute form, or other form of waiver authorized by this paragraph 
(c)(2)(iii) shall be deemed to be consented to and signed by a Service 
Center Director or the Assistant Commissioner (International) for 
purposes of Sec.  301.6501(c)-1(d) of this chapter.
    (c)(3) through (c)(6)(i)(A) [Reserved]. For further guidance, see 
Sec.  1.884-2T(c)(3) through (c)(6)(i)(A).
    (B) Shareholders of the transferee (or of the transferee's parent in 
the case of a triangular reorganization described in section 
368(a)(1)(C) or a reorganization described in sections 368(a)(1)(A) and 
368(a)(2)(D) or (E)) who in the aggregate owned more than 25 percent of 
the value of the stock of the transferor at any time within the 12-month 
period preceding the close of the year in which the section 381(a) 
transaction occurs sell, exchange or otherwise dispose of their stock or 
securities in the transferee at any time during a period of three years 
from the close of the taxable year in which the section 381(a) 
transaction occurs.
    (C) In the case of a triangular reorganization described in section 
368(a)(1)(C) or a reorganization described in sections 368(a)(1)(A) and 
368(a)(2)(D) or (E), the transferee's parent sells, exchanges, or 
otherwise disposes of its stock or securities in the transferee at any 
time during a period of three years from the close of the taxable year 
in which the section 381(a) transaction occurs.
    (D) A corporation related to any such shareholder or the shareholder 
itself if it is a corporation (subsequent to an event described in 
paragraph (c)(6)(i)(A) or (B) of this section) or the transferee's 
parent (subsequent to an event described in paragraph (c)(6)(i)(C) of 
this section), uses, directly or indirectly, the proceeds or property 
received in such sale, exchange or disposition, or property attributable 
thereto, in the conduct of a trade or business in the United States at 
any time during a period of three years from the date of sale in the 
case of a disposition of stock in the transferor, or from the close of 
the taxable year in which the section 381(a) transaction occurs in the 
case of a disposition of the stock or securities in the transferee (or 
the transferee's parent in the case of a triangular reorganization 
described in section 368(a)(1)(C) or a reorganization described in 
sections 368(a)(1)(A) and (a)(2)(D) or (E)). Where this paragraph 
(c)(6)(i) applies, the transferor's branch profits tax liability for the 
taxable year in which the section 381(a) transaction occurs shall be 
determined under Sec.  1.884-1, taking into account all the adjustments 
in U.S. net equity that result from the transfer of U.S. assets and 
liabilities to the transferee pursuant to the section 381(a) 
transaction, without regard to any provisions in this paragraph (c). If 
an event described in paragraph (c)(6)(i)(A), (B), or (C) of this 
section occurs after the close of the taxable year in which the section 
381(a) transaction occurs, and if additional branch profits tax is 
required to be paid by reason of the application of this paragraph 
(c)(6)(i), then interest must be paid on that amount at the underpayment 
rates determined under section 6621(a)(2), with respect to the period 
between the date that was prescribed for filing the transferor's income 
tax return for the year in which the section 381(a) transaction occurs 
and the date on which the additional tax for that year is paid. Any such 
additional tax liability together with interest thereon shall be the 
liability of the transferee within the meaning of section 6901 pursuant 
to section 6901 and the regulations thereunder.
    (c)(6)(ii)-(f) [Reserved]. For further guidance, see Sec.  1.884-
2T(c)(6)(ii) through (f).
    (g) Effective dates. Paragraphs (a)(2)(ii) and (c)(2)(iii) of this 
section are effective for taxable years beginning after December 31, 
1986. Paragraph (a)(5) of this section is effective for taxable years 
beginning on or after June 6, 1996. Paragraphs (c)(6)(i)(B), (C), and 
(D), are applicable for tax years beginning after December 31, 1986, 
except that such paragraphs are applicable to

[[Page 572]]

transactions occurring on or after January 23, 2006, in the case of 
reorganizations described in sections 368(a)(1)(A) and 368(a)(2)(D) or 
(E).

[T.D. 8657, 61 FR 9341, Mar. 8, 1996, as amended by T.D. 9243, 71 FR 
4292, Jan. 26, 2006]



Sec.  1.884-2T  Special rules for termination or incorporation of a U.S. trade 
or business or liquidation or reorganization of a foreign corporation 
or its domestic subsidiary (temporary).

    (a) Complete termination of a U.S. trade or business--(1) General 
rule. A foreign corporation shall not be subject to the branch profits 
tax for the taxable year in which it completely terminates all of its 
U.S. trade or business within the meaning of paragraph (a)(2) of this 
section. A foreign corporation's non-previously taxed accumulated 
effectively connected earnings and profits as of the close of the 
taxable year of complete termination shall be extinguished for purposes 
of section 884 and the regulations thereunder, but not for other 
purposes (for example, sections 312, 316 and 381).
    (2) Operating rules--(i) Definition of complete termination. A 
foreign corporation shall have completely terminated all of its U.S. 
trade or business for any taxable year (``the year of complete 
termination'') only if--
    (A) As of the close of that taxable year, the foreign corporation 
either has no U.S. assets, or its shareholders have adopted an 
irrevocable resolution in that taxable year to completely liquidate and 
dissolve the corporation and, before the close of the immediately 
succeeding taxable year (also a ``year of complete termination'' for 
purposes of applying this paragraph (a)(2)), all of its U.S. assets are 
either distributed, used to pay off liabilities, or cease to be U.S. 
assets;
    (B) Neither the foreign corporation nor a related corporation uses, 
directly or indirectly, any of the U.S. assets of the terminated U.S. 
trade or business, or property attributable thereto or to effectively 
connected earnings and profits earned by the foreign corporation in the 
year of complete termination, in the conduct of a trade or business in 
the United States at any time during a period of three years from the 
close of the year of complete termination;
    (C) The foreign corporation has no income that is, or is treated as, 
effectively connected with the conduct of a trade or business in the 
United States (other than solely by reason of section 864 (c)(6) or 
(c)(7)) during the period of three years from the close of the year of 
complete termination; and
    (D) The foreign corporation attaches to its income tax return for 
each year of complete termination a waiver of the period of limitations, 
as described in paragraph (a)(2)(ii) of this section.


If a foreign corporation fails to completely terminate all of its U.S. 
trade or business because of the failure to meet any of the requirements 
of this paragraph (a)(2), then its branch profits tax liability for the 
taxable year and all subsequent taxable years shall be determined under 
the provisions of Sec.  1.884-1, without regard to any provisions in 
this paragraph (a), taking into account any reduction in U.S. net equity 
that results from a U.S. trade or business of the foreign corporation 
ceasing to have U.S. assets. Any additional branch profits tax liability 
that may result, together with interest thereon (charged at the 
underpayment rates determined under section 6621(a)(2) with respect to 
the period between the date that was prescribed for filing the foreign 
corporation's income tax return for the taxable year with respect to 
which the branch profits tax liability arises and the date on which the 
additional tax for that year is paid), and applicable penalties, if any, 
shall be the liability of the foreign corporation (or of any person who 
is a transferee of the foreign corporation within the meaning of section 
6901).
    (ii) Waiver of period of limitations. [Reserved]. See Sec.  1.884-
2(a)(2)(ii) for rules relating to this paragraph.
    (iii) Property subject to reinvestment prohibition rule. For 
purposes of paragraph (a)(2)(i)(B) of this section--
    (A) The term U.S. assets of the terminated U.S. trade or business 
shall mean all the money and other property that qualified as U.S. 
assets of the foreign corporation as of the close of the taxable year 
immediately preceding the year of complete termination; and

[[Page 573]]

    (B) Property attributable to U.S. assets or to effectively connected 
earnings and profits earned by the foreign corporation in the year of 
complete termination shall mean money or other property into which any 
part or all of such assets or effectively connected earnings and profits 
are converted at any time before the expiration of the three-year period 
specified in paragraph (a)(2)(i)(B) of this section by way of sale, 
exchange, or other disposition, as well as any money or other property 
attributable to the sale by a shareholder of the foreign corporation of 
its interest in the foreign corporation (or a successor corporation) at 
any time after a date which is 12 months before the close of the year of 
complete termination (24 months in the case of a foreign corporation 
that makes an election under paragraph (b) of this section).
    (iv) Related corporation. For purposes of paragraph (a)(2)(i)(B) of 
this section, a corporation shall be related to a foreign corporation if 
either corporation is a 10-percent shareholder of the other corporation 
or, where the foreign corporation completely liquidates, if either 
corporation would have been a 10-percent shareholder of the other 
corporation had the foreign corporation remained in existence. For this 
purpose, the term 10-percent shareholder means any person described in 
section 871(h)(3)(B) as well as any person who owns 10 percent or more 
of the total value of the stock of the corporation, and stock ownership 
shall be determined on the basis of the attribution rules described in 
section 871(h)(3)(C).
    (v) Direct or indirect use of U.S. assets. The use of any part or 
all of the property referred to in paragraph (a)(2)(i)(B) of this 
section shall include the loan thereof to a related corporation or the 
use thereof as security (as a pledge, mortgage, or otherwise) for any 
indebtedness of a related corporation.
    (3) Complete termination in the case of a section 338 election. A 
foreign corporation whose stock is acquired by another corporation that 
makes (or is deemed to make) an election under section 338 with respect 
to the stock of the foreign corporation shall be treated as having 
completely liquidated as of the close of the acquisition date (as 
defined in section 338(h)(2)) and to have completely terminated all of 
its U.S. trade or business with respect to the taxable year ending on 
such acquisition date provided the foreign corporation that exists prior 
to the section 338 transaction complies with the requirements of 
paragraph (a)(2)(i) (B) and (D) of this section. For purposes of the 
preceding sentence, any of the money or other property paid as 
consideration for the acquisition of the stock in the foreign 
corporation (and for any debt claim against the foreign corporation) 
shall be treated as property attributable to the U.S. assets of the 
terminated U.S. trade or business and to the effectively connected 
earnings and profits of the foreign corporation earned in the year of 
complete termination.
    (4) Complete termination in the case of a foreign corporation with 
income under section 864(c)(6) or 864(c)(7). No branch profits tax shall 
be imposed on effectively connected earnings and profits attributable to 
income that is treated as effectively connected with the conduct of a 
trade or business in the United States solely by reason of section 
864(c)(6) or 864(c)(7) if--
    (i) No income of the foreign corporation for the taxable year is, or 
is treated as, effectively connected with the conduct of a trade or 
business in the United States, without regard to section 864(c)(6) or 
864(c)(7),
    (ii) The foreign corporation has no U.S. assets as of the close of 
the taxable year, and
    (iii) Such effectively connected earnings and profits would not have 
been subject to branch profits tax pursuant to the complete termination 
provisions of paragraph (a)(1) of this section if income or gain subject 
to section 864(c)(6) had not been deferred or if property subject to 
section 864(c)(7) had been sold immediately prior to the date the 
property ceased to have been used in the conduct of a trade or business 
in the United States.
    (5) Special rule if a foreign corporation terminates an interest in 
a trust. [Reserved]. See Sec.  1.884-2(a)(5) for rules relating to this 
paragraph.

[[Page 574]]

    (6) Coordination with second-level withholding tax. Effectively 
connected earnings and profits and non-previously taxed accumulated 
effectively connected earnings and profits of a foreign corporation that 
are exempt from branch profits tax by reason of the provisions of 
paragraph (a)(1) of this section shall not be subject to tax under 
section 871(a), 881(a), 1441 or 1442 when paid as a dividend by such 
foreign corporation (or a successor-in-interest).
    (b) Election to remain engaged in a U.S. trade or business--(1) 
General rule. A foreign corporation that would be considered to have 
completely terminated all of its U.S. trade or business for the taxable 
year under the provisions of paragraph (a)(2)(i) of this section, but 
for the provisions of paragraph (a)(2)(i)(B) of this section that 
prohibit reinvestment within a three-year period, may make an election 
under this paragraph (b) for the taxable year in which it completely 
terminates all its U.S. trade or business (as determined without regard 
to paragraph (a)(2)(i)(B) of this section) and, if it so chooses, for 
the following taxable year (but not for any succeeding taxable year). 
The election under this paragraph (b) is an election by the foreign 
corporation to designate an amount of marketable securities as U.S. 
assets for purposes of Sec.  1.884-1. The marketable securities 
identified pursuant to the election under paragraph (b)(3) of this 
section shall be treated as being U.S. assets in an amount equal, in the 
aggregate, to the lesser of the adjusted basis of the U.S. assets that 
ceased to be U.S. assets during the taxable year in which the election 
is made (determined on the date or dates the U.S. assets ceased to be 
U.S. assets) or the adjusted basis of the marketable securities as of 
the end of the taxable year. The securities must be held from the date 
that they are identified until the end of the taxable year for which the 
election is made, or if disposed of during the taxable year, must be 
replaced on the date of disposition with other marketable securities 
that are acquired on or before that date and that have a fair market 
value as of the date of substitution not less than their adjusted basis.
    (2) Marketable security. For purposes of this paragraph (b), the 
term marketable security means a security (including stock) that is part 
of an issue any portion of which is regularly traded on an established 
securities market (within the meaning of Sec.  1.884-5(d)(2) and (4)) 
and a deposit described in section 871(i)(3) (A) or (B).
    (3) Identification requirements. In order to qualify for this 
election--
    (i) The marketable securities must be identified on the books and 
records of the U.S. trade or business within 30 days of the date an 
equivalent amount of U.S. assets ceases to be U.S. assets; and
    (ii) On the date a marketable security is identified, its adjusted 
basis must not exceed its fair market value.
    (4) Treatment of income from deemed U.S. assets. The income or gain 
from the marketable securities (or replacement securities) subject to an 
election under this paragraph (b) that arises in a taxable year for 
which an election is made shall be treated as ECI (other than for 
purposes of section 864(c)(7)), and losses from the disposition of such 
marketable securities shall be allocated entirely to income that is ECI. 
In addition, all such securities shall be treated as if they had been 
sold for their fair market value on the earlier of the last business day 
of a taxable year for which an election is in effect or the day 
immediately prior to the date of substitution by the foreign corporation 
of a U.S. asset for the marketable security, and any gain (but not loss) 
and accrued interest on the securities shall also be treated as ECI. The 
adjusted basis of such property shall be increased by the amount of any 
gain recognized by reason of this paragraph (b).
    (5) Method of election. A foreign corporation may make an election 
under this paragraph (b) by attaching to its income tax return for the 
taxable year a statement--
    (i) Identifying the marketable securities treated as U.S. assets 
under this paragraph (b);
    (ii) Setting forth the E&P bases of such securities; and
    (iii) Agreeing to treat any income, gain or loss as provided in 
paragraph (b)(4) of this section.


Such statement must be filed on or before the due date (including 
extensions)

[[Page 575]]

of the foreign corporation's income tax return for the taxable year. A 
foreign corporation shall not be permitted to make an election under 
this paragraph (b) more than once.
    (6) Effective date. This paragraph (b) is effective for taxable 
years beginning on or after October 13, 1992. However, if a foreign 
corporation has made a valid election under Sec.  1.884-1(i) to apply 
that section with respect to a taxable year beginning before October 13, 
1992 and after December 31 1986, this paragraph (b) shall be effective 
beginning with such taxable year.
    (c) Liquidation, reorganization, etc. of a foreign corporation. The 
following rules apply to the transfer by a foreign corporation engaged 
(or deemed engaged) in the conduct of a U.S. trade or business (the 
``transferor'') of its U.S. assets to another corporation (the 
``transferee'') in a complete liquidation or reorganization described in 
section 381(a) (a ``section 381(a) transaction'') if the transferor is 
engaged (or deemed engaged) in the conduct of a U.S. trade or business 
immediately prior to the section 381(a) transaction. For purposes of 
this paragraph (c), a section 381(a) transaction is considered to occur 
in the taxable year that ends on the date of distribution or transfer 
(as defined in Sec.  1.381(b)-1(b)) pursuant to the section 381(a) 
transaction.
    (1) Inapplicability of paragraph (a)(1) of this section to section 
381(a) transactions. Paragraph (a)(1) of this section (relating to the 
complete termination of a U.S. trade or business of a foreign 
corporation) does not apply to exempt the transferor from branch profits 
tax liability for the taxable year in which the section 381(a) 
transaction occurs or in any succeeding taxable year.
    (2) Transferor's dividend equivalent amount for the taxable year in 
which a section 381(a) transaction occurs. The dividend equivalent 
amount for the taxable year, including a short taxable year, in which a 
section 381(a) transaction occurs shall be determined under the 
provisions of Sec.  1.884-1, as modified under the provisions of this 
paragraph (c)(2).
    (i) U.S. net equity. The transferor's U.S. net equity as of the 
close of the taxable year shall be determined without regard to any 
transfer in that taxable year of U.S. assets to or from the transferee 
pursuant to a section 381(a) transaction, and without regard to any U.S. 
liabilities assumed or acquired by the transferee from the transferor in 
that taxable year pursuant to a section 381(a) transaction. The 
transferor's adjusted basis (for earnings and profits purposes) in U.S. 
assets transferred to the transferee pursuant to a section 381(a) 
transaction shall be the adjusted basis of those assets (for earnings 
and profits purposes) immediately prior to the section 381(a) 
transaction, adjusted as provided under section 362(b), treating the 
transferor, for that purpose, as though it were the transferee and 
treating the gain taken into account for earnings and profits purposes 
as gain recognized.
    (ii) Effectively connected earnings and profits. The transferor's 
effectively connected earnings and profits for the taxable year in which 
the section 381(a) transaction occurs and its non-previously taxed 
accumulated effectively connected earnings and profits shall be 
determined without regard to the carryover to the transferee of the 
transferor's earnings and profits under section 381 (a) and (c)(2) and 
paragraph (c)(4) of this section. Effectively connected earnings and 
profits for the taxable year in which a section 381(a) transaction 
occurs shall be adjusted by the amount of any gain recognized to the 
transferor in that year pursuant to the section 381(a) transaction (to 
the extent taken into account for earnings and profits purposes).
    (iii) Waiver of period of limitations and transferee agreement. 
[Reserved]. See Sec.  1.884-2(c)(2)(iii) for rules relating to this 
paragraph.
    (3) Transferor's dividend equivalent amount for any taxable year 
succeeding the taxable year in which the section 381(a) transaction 
occurs. Any decrease in U.S. net equity in any taxable year succeeding 
the taxable year in which the section 381(a) transaction occurs shall 
increase the transferor's dividend equivalent amount for those years 
without regard to the limitation in Sec.  1.884-1(b)(3)(ii), to the 
extent such decrease in U.S. net equity does not exceed the balance of 
effectively connected earnings and profits and non-

[[Page 576]]

previously taxed accumulated effectively connected earnings and profits 
carried over to the transferee pursuant to section 381 (a) and (c)(2), 
as determined under paragraph (c)(4) of this section.
    (4) Earnings and profits of the transferor carried over to the 
transferee pursuant to the section 381(a) transaction--(i) Amount. The 
amount of effectively connected earnings and profits and non-previously 
taxed accumulated effectively connected earnings and profits of the 
transferor that carry over to the transferee under section 381 (a) and 
(c)(2) shall be the effectively connected earnings and profits and the 
non-previously taxed accumulated effectively connected earnings and 
profits of the transferor immediately before the close of the taxable 
year in which the section 381(a) transaction occurs. For this purpose, 
the provisions in Sec.  1.381(c)(2)-1 shall generally apply with proper 
adjustments to reflect the fact that effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits are not affected by distributions to shareholders 
but, rather, by dividend equivalent amounts. Therefore, the amounts of 
effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits that carry over 
to the transferee pursuant to those provisions are reduced by the 
transferor's dividend equivalent amount for the taxable year in which 
the section 381(a) transaction occurs. Such amounts are also reduced to 
the extent of any dividend equivalent amount determined for any 
succeeding taxable year solely as a result of the provisions of 
paragraph (c)(3) of this section. For purposes of this paragraph 
(c)(4)(i), if the transferor accumulates non-previously taxed 
effectively connected earnings and profits, or incurs a deficit in 
effectively connected earnings and profits, attributable to a period 
that is after the close of the taxable year in which the section 381(a) 
transaction occurs and before the liquidation of the transferor, then 
such effectively connected earnings and profits, or deficits therein, 
shall be deemed to have been accumulated or incurred on or before the 
close of the taxable year in which the section 381(a) transaction 
occurs.
    (ii) Retention of character. All of the transferor's effectively 
connected earnings and profits and non-previously taxed accumulated 
effectively connected earnings and profits that carry over to the 
transferee shall constitute non-previously taxed accumulated effectively 
connected earnings and profits of the transferee. In the case of a 
domestic transferee, such non-previously taxed accumulated effectively 
connected earnings and profits shall also constitute accumulated 
earnings and profits of the transferee for purposes of section 
316(a)(2).
    (iii) Treatment of distributions by a domestic transferee out of 
non-previously taxed accumulated effectively connected earnings and 
profits. In the event the transferee is a domestic corporation, 
distributions out of the transferee's non-previously taxed accumulated 
effectively connected earnings and profits that are received by a 
foreign distributee shall qualify for benefits under an applicable 
income tax treaty only (A) if the distributee qualifies for the benefits 
under such treaty and (B) to the extent that the transferor foreign 
corporation would have qualified under the principles of Sec.  1.884-
1(g) (1) and (2)(i) for an exemption or reduction in rate with respect 
to the branch profits tax if the non-previously taxed accumulated 
effectively connected earnings and profits had been reflected in a 
dividend equivalent amount for the taxable year in which the section 
381(a) transaction occurs. (The tax rate on dividends specified in the 
treaty between the distributee's country of residence and the United 
States shall apply to any dividends received by a distributee who 
qualifies for a treaty benefit under the preceding sentence.) In 
addition, distributions out of such non-previously taxed accumulated 
effectively connected earnings and profits shall retain their character 
in the hands of any domestic distributee up a chain of corporate 
shareholders for purposes of applying this paragraph (c)(4)(iii) to 
distributions made by any such person to a foreign distributee. If a 
domestic transferee has non-previously taxed accumulated effectively 
connected earnings and profits carried over from the

[[Page 577]]

transferor as well as accumulated earnings and profits, then each 
category of earnings and profits shall be accounted for in two separate 
pools, and any distribution of earnings and profits shall be treated as 
a distribution out of each pool in proportion to the respective amount 
of undistributed earnings and profits in each pool. Section 871(i) 
(relating, in part, to dividends paid by a domestic corporation meeting 
the 80-percent foreign business requirements of section 861(c)(1)) shall 
not apply to any dividends paid by a domestic transferee out of its non-
previously taxed accumulated effectively connected earnings and profits.
    (5) Determination of U.S. net equity of a transferee that is a 
foreign corporation. In the event the transferee is a foreign 
corporation, then for purposes of determining the transferee's increase 
or decrease in U.S. net equity under Sec.  1.884-1 for its taxable year 
during which the section 381(a) transaction occurs, its U.S. net equity 
as of the close of its immediately preceding taxable year shall be 
increased by the amount of U.S. net equity acquired by the transferee 
from the transferor pursuant to the section 381(a) transaction, taking 
into account the adjustments to the basis (for earnings and profits 
purposes) of U.S. assets under the principles of section 362(b).
    (6) Special rules in the case of the disposition of stock or 
securities in a domestic transferee or in the transferor--(i) General 
rule. This paragraph (c)(6)(i) shall apply where the transferee is a 
domestic corporation, subdivision (A), (B), or (C) of this paragraph 
applies and subdivision (D) of this paragraph applies.
    (A) Shareholders of the transferor sell, exchange or otherwise 
dispose of stock in the transferor at any time during a 12-month period 
before the date of distribution or transfer (as defined in Sec.  
1.381(b)-1(b)) and the aggregate amount of such stock sold, exchanged or 
otherwise disposed of exceeds 25 percent of the value of the stock of 
the transferor, determined on a date that is 12 months before the date 
of distribution or transfer.
    (B), (C), and (D) [Reserved]. For further guidance, see Sec.  1.884-
2(c)(6)(i)(B), (C), and (D).


Where this paragraph (c)(6)(i) applies, the transferor's branch profits 
tax liability for the taxable year in which the section 381(a) 
transaction occurs shall be determined under Sec.  1.884-1, taking into 
account all the adjustments in U.S. net equity that result from the 
transfer of U.S. assets and liabilities to the transferee pursuant to 
the section 381(a) transaction, without regard to any provisions in this 
paragraph (c). If an event described in paragraph (c)(6)(i) (A), (B), or 
(C) of this section occurs after the close of the taxable year in which 
the section 381(a) transaction occurs, and if additional branch profits 
tax is required to be paid by reason of the application of this 
paragraph (c)(6)(i), then interest must be paid on that amount at the 
underpayment rates determined under section 6621(a)(2), with respect to 
the period between the date that was prescribed for filing the 
transferor's income tax return for the year in which the section 381(a) 
transaction occurs and the date on which the additional tax for that 
year is paid. Any such additional tax liability together with interest 
thereon shall be the liability of the transferee within the meaning of 
section 6901 pursuant to section 6901 and the regulations thereunder.
    (ii) Operating rule. For purposes of paragraph (c)(6)(i) of this 
section paragraphs (a)(2) (iii)(B), (iv) and (v) of this section shall 
apply for purposes of making the determinations under paragraph 
(c)(6)(i)(D) of this section.
    (d) Incorporation under section 351--(1) In general. The following 
rules apply to the transfer by a foreign corporation engaged (or deemed 
engaged) in the conduct of a U.S. trade or business (the ``transferor'') 
of part or all of its U.S. assets to a U.S. corporation (the 
``transferee'') in exchange for stock or securities in the transferee in 
a transaction that qualifies under section 351(a) (a ``section 351 
transaction''), provided that immediately after the transaction, the 
transferor is in control (as defined in section 368(c)) of the 
transferee, without regard to other transferors.
    (2) Inapplicability of paragraph (a)(1) of this section to section 
351 transactions. Paragraph (a)(1) of this section does not apply to 
exempt the transferor

[[Page 578]]

from branch profits tax liability for the taxable year in which a 
section 351 transaction described in paragraph (d)(1) of this section 
occurs and shall not apply for any subsequent taxable year of the 
transferor in which it, or a successor-in-interest, owns stock or 
securities of a transferee as of the close of the transferor's taxable 
year.
    (3) Transferor's dividend equivalent amount for the taxable year in 
which a section 351 transaction occurs. The dividend equivalent amount 
of the transferor for the taxable year in which a section 351 
transaction described in paragraph (d)(1) of this section occurs shall 
be determined under the provisions of Sec.  1.884-1, as modified by the 
provisions of this paragraph (d)(3) provided that the transferee elects 
under paragraph (d)(4) of this section to be allocated a proportionate 
amount of the transferor's effectively connected earnings and profits 
and non-previously taxed accumulated effectively connected earnings and 
profits and the foreign corporation files a statement as provided in 
paragraph (d)(5)(i) of this section and complies with the agreement 
included in such statement with respect to a subsequent disposition of 
the transferee's stock.
    (i) U.S. net equity. The transferor's U.S. net equity as of the 
close of the taxable year shall be determined without regard to any 
transfer in that taxable year of U.S. assets to or from the transferee 
pursuant to a section 351 transaction, and without regard to any U.S. 
liabilities assumed or acquired by the transferee from the transferor in 
that taxable year pursuant to a section 351 transaction. The 
transferor's adjusted basis for earnings and profits purposes in U.S. 
assets transferred to the transferee pursuant to a section 351 
transaction shall be the adjusted basis of those assets for earnings and 
profits purposes immediately prior to the section 351 transaction, 
increased by the amount of any gain recognized by the transferor on the 
transfer of such assets in the section 351 transaction to the extent 
taken into account for earnings and profits purposes.
    (ii) Effectively connected earnings and profits. Subject to the 
limitation in paragraph (d)(3)(iii) of this section, the calculation of 
the transferor's dividend equivalent amount shall take into account the 
transferor's effectively connected earnings and profits for the taxable 
year in which a section 351 transaction occurs (including any amount of 
gain recognized to the transferor pursuant to the section 351 
transaction to the extent the gain is taken into account for earnings 
and profits purposes) and, for purposes of applying the limitation of 
Sec.  1.884-1(b)(3)(ii), its non-previously taxed accumulated 
effectively connected earnings and profits, determined without regard to 
the allocation to the transferee of the transferor's effectively 
connected earnings and profits and non-previously taxed accumulated 
effectively connected earnings and profits pursuant to the election 
under paragraph (d)(4)(i) of this section.
    (iii) Limitation on dividend equivalent amount. The dividend 
equivalent amount determined under this paragraph (d)(3) shall not 
exceed the sum of the transferor's effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits determined after taking into account the allocation 
to the transferee of the transferor's earnings pursuant to an election 
under paragraph (d)(4)(i) of this section.
    (4) Election to increase earnings and profits--(i) General rule. The 
election referred to in paragraph (d)(3) of this section is an election 
by the transferee to increase its earnings and profits by the amount 
determined under paragraph (d)(4)(ii) of this section. An election under 
this paragraph (d)(4)(i) shall be effective only if the transferee 
attaches a statement to its timely filed (including extensions) income 
tax return for the taxable year in which the section 351 transaction 
occurs, in which--
    (A) It agrees to be subject to the rules of paragraph (c)(4) (ii) 
and (iii) of this section with respect to the transferor's effectively 
connected earnings and profits and non-previously taxed accumulated 
effectively connected earnings and profits allocated to the transferee 
pursuant to the election under this paragraph (d)(4)(i) in the same 
manner as if such earnings and profits had been carried over to the

[[Page 579]]

transferee pursuant to section 381 (a) and (c)(2), and
    (B) It identifies the amount of effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits that are allocated from the transferor.


An election with respect to a taxable year ending on or before December 
1, 1988, may be made by filing an amended Form 1120F on or before 
January 3, 1988, to which the statement described in this paragraph 
(d)(4)(i) shall be attached.
    (ii) Amount of the transferor's effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits allocated to the transferee. The amount referred to 
in paragraph (d)(4)(i) of this section is equal to the same proportion 
of the transferor's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits 
(determined immediately prior to the section 351 transaction and without 
regard to this paragraph (d)(4) or any dividend equivalent amount for 
the taxable year) that the adjusted bases for purposes of computing 
earnings and profits in all the U.S. assets transferred to the 
transferee by the transferor pursuant to the section 351 transaction 
bear to the adjusted bases for purposes of computing earnings and 
profits in all the U.S. assets of the transferor, determined immediately 
prior to the section 351 transaction.
    (iii) Effect of election on transferor. For purposes of computing 
the transferor's dividend equivalent amount for the taxable year 
succeeding the taxable year in which a section 351 transaction occurs, 
the transferor's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits 
as of the close of the taxable year in which the section 351 transaction 
occurs shall be reduced by the amount of its effectively connected 
earnings and profits and non-previously taxed accumulated effectively 
connected earnings and profits allocated to the transferee pursuant to 
the election under paragraph (d)(4)(i) of this section (and by its 
dividend equivalent amount for the taxable year in which the section 351 
transaction occurs).
    (5) Dispositions of stock or securities of the transferee by the 
transferor--(i) General rule. The statement referred to in paragraph 
(d)(3) of this section is a statement executed by the transferor stating 
the transferor's agreement that, upon the disposition of part or all of 
the stock or securities it owns in the transferee (or a successor-in-
interest), it shall treat as a dividend equivalent amount for the 
taxable year in which the disposition occurs an amount equal to the 
lesser of (A) the amount realized upon such disposition or (B) the total 
amount of effectively connected earnings and profits and non-previously 
taxed accumulated effectively connected earnings and profits that was 
allocated from the transferor to that transferee pursuant to an election 
under paragraph (d)(4)(i) of this section, which amount shall be reduced 
to the extent previously taken into account by the transferor as 
dividends or dividend equivalent amounts for tax or branch profits, tax 
purposes. The extent and manner in which such dividend equivalent amount 
may be subject to the branch profits tax in the taxable year of 
disposition shall be determined under the provisions of section 884 and 
the regulations thereunder, including the provisions of paragraph (a) of 
this section (relating to complete terminations), as limited under 
paragraph (d)(2) of this section. Except as otherwise provided in 
paragraph (d)(5)(ii) of this section, the term disposition means any 
transfer that would constitute a disposition by the transferor for any 
purpose of the Internal Revenue Code and the regulations thereunder. 
This paragraph (d)(5)(i) shall apply regardless of whether the stock or 
securities of the transferee are U.S. assets in the hands of the 
transferor at the time of sale, exchange or disposition.
    (ii) Exception for certain tax-free dispositions. For purposes of 
paragraph (d)(5)(i) of this section, a disposition does not include a 
transfer of stock or securities of the transferee by the transferor in a 
transaction that qualifies as a transfer pursuant to a complete 
liquidation described in section

[[Page 580]]

332(b) or a transfer pursuant to a reorganization described in section 
368(a)(1)(F). Any other transfer that qualifies for non-recognition of 
gain or loss shall be treated as a disposition for purposes of paragraph 
(d)(5)(i) of this section, unless the Commissioner has, by published 
guidance or by prior ruling issued to the taxpayer upon its request, 
determined such transfer not to be a disposition for purposes of 
paragraph (d)(5)(i) of this section.
    (iii) Distributions governed by section 355. In the case of a 
distribution or exchange of stock or securities of a transferee to which 
section 355 applies (or so much of section 356 as relates to section 
355) and that is not in pursuance of a plan meeting the requirements of 
a reorganization as defined in section 368(a)(1)(D), Sec.  1.3l2-10(b) 
(relating to the allocation of earnings and profits in certain corporate 
separations) shall not apply to reduce the transferor's effectively 
connected earnings and profits or non-previously taxed accumulated 
effectively connected earnings and profits.
    (iv) Filing of statement. The statement referred to in paragraph 
(d)(5)(i) of this section shall be attached to a timely filed (including 
extensions) income tax return of the transferor for the taxable year in 
which the section 351 transaction occurs. An election with respect to a 
taxable year ending on or before December 1, 1988, may be made by filing 
an amended Form 1120F on or before January 3, 1988, to which the 
statement described in this paragraph (d)(5)(iv) shall be attached.
    (6) Example. The provisions of this paragraph (d) are illustrated by 
the following example.

    Example. Foreign corporation X has a calendar taxable year. X's only 
assets are U.S. assets and X computes its interest deduction using the 
actual ratio of liabilities to assets under Sec.  1.882-5(b)(2)(ii). X's 
U.S. net equity as of the close of its 1988 taxable year is $2,000, 
resulting from the following amounts of U.S. assets and liabilities:

------------------------------------------------------------------------
           U.S. assets                       U.S. liabilities
------------------------------------------------------------------------
U.S. building A.................    $l,000  Mortgage A........       800
U.S. building B.................     2,500  Mortgage B........     1,500
Other U.S. assets...............       800
                                 ----------                    ---------
    Total.......................     4,300                         2,300
------------------------------------------------------------------------

    Assume that X's adjusted basis in its assets is equal to X's 
adjusted basis in its assets for earnings and profits purposes. On 
September 30, 1989, X transfers building A, which has a fair market 
value of $1,800, to a newly created U.S. corporation Y under section 351 
in exchange for 100% of the stock of Y with a fair market value of $800, 
other property with a fair market value of $200, and the assumption of 
Mortgage A. Assume that under sections 11 and 351(b), tax of $30 is 
imposed with respect to the $200 of other property received by X. X's 
non-previously taxed accumulated effectively connected earnings and 
profits as of the close of its 1988 taxable year are $200 and its 
effectively connected earnings and profits for its 1989 taxable year are 
$330, including $170 of gain recognized to X on the transfer as adjusted 
for earnings and profits purposes (i.e., $200 of gain recognized minus 
$30 of tax paid with respect to the gain). Y takes a $1,200 basis in the 
building transferred from X, equal to the basis in the hands of X 
($1,000) increased by the amount of gain recognized to X in the section 
351 transaction ($200). Y makes an election in the manner described in 
paragraph (d)(4)(i) of this section to increase its earnings and profits 
by the amount described in paragraph (d)(4)(ii) of this section and X 
files a statement as provided in paragraph (d)(5)(i) of this section. 
The branch profits tax consequences to X and Y in the taxable year in 
which the section 351 transaction occurs and in subsequent taxable years 
are as follows:
    (i) X's dividend equivalent amount for 1989. The determination of 
X's dividend equivalent amount for 1989 is a three-step process: 
determining X's U.S. net equity as of the close of its 1989 taxable year 
under paragraph (d)(3)(i) of this section; determining the amount of X's 
effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits for its 1989 
taxable year under paragraph (d)(3)(ii) of this section; and applying 
the limitation in paragraph (d)(3)(iii) of this section.
    Step one: Pursuant to paragraph (d)(3)(i) of this section, X's U.S. 
net equity as of the close of its 1989 taxable year is calculated 
without regard to the section 351 transaction except that X's basis in 
its U.S. assets is increased by the $170 amount of gain it has 
recognized for earnings and profits purposes in connection with the 
section 351 transaction. Thus, X's U.S. net equity as of the close of 
its 1989 taxable year is $1,870, consisting of the following U.S. assets 
and liabilities, taking into account the fact that X's other U.S. assets 
have decreased to $500:

------------------------------------------------------------------------
           U.S. assets                       U.S. liabilities
------------------------------------------------------------------------
Building A......................    $l,170  Mortgage A........       800
Building B......................     2,500  Mortgage B........     1,500

[[Page 581]]

 
Other U.S. assets...............       500
                                 ----------                    ---------
    Total.......................     4,170                         2,300
------------------------------------------------------------------------

    Thus, X's U.S. net equity as of the close of its 1989 taxable year 
has decreased by $130 relative to its U.S. net equity as of the close of 
its 1988 taxable year.
    Step two: Pursuant to paragraph (d)(3)(ii) of this section, X's 
effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits for the taxable 
year are determined without taking into account the allocation to Y of 
X's effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits pursuant to the 
election under paragraph (d)(4)(i) of this section. Thus, X's 
effectively connected earnings and profits for its 1989 taxable year are 
$330 and X's non-previously taxed accumulated effectively connected 
earnings and profits are $200. Thus, but for the limitation in paragraph 
(d)(3)(iii) of this section, X's dividend equivalent amount for the 
taxable year would be $460, equal to X's effectively connected earnings 
and profits for the taxable year ($330), increased by the decrease in 
X's U.S. net equity ($130).
    Step three: Pursuant to paragraph (d)(3)(iii) of this section, X's 
dividend equivalent amount for its 1989 taxable year may not exceed the 
sum of the transferor's effectively connected earnings and profits and 
non-previously taxed accumulated effectively connected earnings and 
profits, determined as of the close of its 1989 taxable year, after 
taking into account the allocation of the transferor's earnings and 
profits pursuant to the election under paragraph (d)(4)(i) of this 
section. Based upon subdivision (ii) of this example, X's dividend 
equivalent amount for 1989 cannot exceed $423, which is equal to the 
total amount of X's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits, 
determined as of the close of its 1989 taxable year without regard to 
the allocation of earnings and profits to Y pursuant to Y's election 
under paragraph (d)(4)(i) of this section ($530), reduced by the amount 
of X's effectively connected earnings and profits and non-previously 
taxed accumulated effectively connected earnings and profits allocated 
to Y pursuant to Y's election under paragraph (d)(4)(i) of this section 
($107). Thus, X's dividend equivalent amount for its 1989 taxable year 
is limited to $423.
    (ii) Amount of X's effectively connected earnings and profits and 
non-previously taxed accumulated effectively connected earnings and 
profits transferred to Y. Pursuant to Y's election under paragraph 
(d)(4)(i) of this section, Y increases its earnings and profits by the 
amount prescribed in paragraph (d)(4)(ii) of this section. This amount 
is equal to the sum of X's effectively connected earnings and profits 
and non previously taxed accumulated effectively connected earnings and 
profits determined immediately before the section 351 transaction, 
without regard to X's dividend equivalent amount for the year, allocated 
in the same proportion that X's basis in the U.S. assets transferred to 
Y bears to the bases of all of X's U.S. assets, which bases are 
determined immediately prior to the section 351(a) transaction. The 
amount of X's effectively connected earnings and profits immediately 
before the section 351 transaction is assumed to be $260. The total 
amount of effectively connected earnings and profits ($260) and non-
previously taxed accumulated effectively connected earnings and profits 
($200) determined immediately before the section 351 transaction is, 
therefore, $460. The portion of $460 that is allocated to Y pursuant to 
Y's election under paragraph (d)(4)(i) of this section is $107, 
calculated as $46? multiplied by a fraction, the numerator of which is 
the basis of the U.S. assets transferred to Y pursuant to the section 
351 transaction ($1,000), and the denominator of which is the basis of 
X's U.S. assets determined immediately before the section 351 
transaction ($4,300). Pursuant to paragraph (d)(4)(i) of this section, 
the amount of $107 of X's effectively connected earnings and profits and 
non-previously taxed accumulated effectively connected earnings and 
profits allocated to Y pursuant to paragraph (d)(4)(i) of this section 
constitutes non-previously taxed accumulated effectively connected 
earnings and profits of Y.
    (iii) X's non-previously taxed accumulated effectively connected 
earnings and profits for 1990. Pursuant to paragraph (d)(4)(iii) of this 
section, X's non-previously taxed accumulated effectively connected 
earnings and profits as of the close of its 1989 taxable year for 
purposes of computing its dividend equivalent amount for its taxable 
year 1990 are zero, i.e., $530 of effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits reduced by $107 of effectively connected earnings 
and profits and non-previously taxed accumulated effectively connected 
earnings and profits allocated to Y, and further reduced by X's $423 
dividend equivalent amount for its 1989 taxable year.
    (iv) X's U.S. net equity for purposes of determining the dividend 
equivalent amount for succeeding taxable years. For 1990, X must 
determine its U.S. net equity as of December 31, 1989, in order to 
determine whether there has been an increase or decrease in its U.S. net 
equity as of December 31, 1990. For this purpose, X's U.S. net equity as 
of December 31, 1989 is determined under the provisions of Sec.  1.884-1 
without regard to the special rules in paragraph (d)(3)(i) of this 
section. Thus,

[[Page 582]]

X.'s U.S. net equity as of December 31, 1989 is $1,500, consisting of 
the following. U.S. assets and liabilities:

------------------------------------------------------------------------
           U.S. assets                       U.S. liabilities
------------------------------------------------------------------------
Building B......................    $2,500  Mortgage B........     1,500
Other U.S. assets...............       500
                                 ----------                    ---------
    Total.......................    $3,000                         1,500
------------------------------------------------------------------------

    (e) Certain transactions with respect to a domestic subsidiary. In 
the case of a section 381(a) transaction in which a domestic subsidiary 
of a foreign corporation transfers assets to that foreign corporation or 
to another foreign corporation with respect to which the first foreign 
corporation owns stock (directly or indirectly) meeting the requirements 
of section 1504(a)(2), the transferee's non-previously taxed accumulated 
effectively connected earnings and profits for the taxable year in which 
the section 381(a) transaction occurs shall be increased by all of the 
domestic subsidiary's current earnings and profits and earnings and 
profits accumulated after December 31, 1986, that carry over to the 
transferee under sections 381(a) and (c)(1) (including non-previously 
taxed accumulated effectively connected earnings and profits, if any, 
transferred to the domestic subsidiary under paragraphs (c)(4) and 
(d)(4) of this section and treated as earnings and profits under 
paragraphs (c)(4)(ii) and (d)(4)(ii) of this section). For purposes of 
determining the transferee's dividend equivalent amount for the taxable 
year in which the section 381(a) transaction occurs, the transferee's 
U.S. net equity as of the close of its taxable year immediately 
preceding the taxable year during which the section 381(a) transaction 
occurs shall be increased by the greater of
    (1) The amount by which the transferee's U.S. net equity computed 
immediately prior to the transfer would have increased due to the 
transfer of the subsidiary's assets and liabilities if U.S. net equity 
were computed immediately prior to the transfer and immediately after 
the transfer (taking into account in the earnings and profits basis of 
the assets transferred any gain recognized on the transfer to the extent 
reflected in earnings and profits), or
    (2) The total amount of U.S net equity transferred (directly or 
indirectly) by the foreign parent to the domestic subsidiary in one or 
more prior section 351 or 381(a) transactions.
    (f) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.

[T.D. 8223, 53 FR 34059, Sept. 2, 1988, as amended by T.D. 8432, 57 FR 
41659, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1993; 57 FR 60126, Dec. 18, 
1992; T.D. 8657, 61 FR 9341, Mar. 8, 1996; T.D. 9243, 71 FR 4293, Jan. 
26, 2006]



Sec.  1.884-3T  Coordination of branch profits tax with second-tier 
withholding (temporary). [Reserved]



Sec.  1.884-4  Branch-level interest tax.

    (a) General rule--(1) Tax on branch interest. In the case of a 
foreign corporation that, during the taxable year, is engaged in trade 
or business in the United States or has gross income that is ECI (as 
defined in Sec.  1.884-1(d)(1)(iii)), any interest paid by such trade or 
business (hereinafter ``branch interest,'' as defined in paragraph (b) 
of this section) shall, for purposes of subtitle A (Income Taxes), be 
treated as if it were paid by a domestic corporation (other than a 
corporation described in section 861(c)(1), relating to a domestic 
corporation that meets the 80 percent foreign business requirement). 
Thus, for example, whether such interest is treated as income from 
sources within the United States by the person who receives the interest 
shall be determined in the same manner as if such interest were paid by 
a domestic corporation (other than a corporation described in section 
861(c)(1)). Such interest shall be subject to tax under section 871(a) 
or 881, and to withholding under section 1441 or 1442, in the same 
manner as interest paid by a domestic corporation (other than a 
corporation described in section 861(c)(1)) if received by a foreign 
person and not effectively connected with the conduct by the foreign 
person of a trade or business in the United States, unless the interest, 
if paid by a domestic corporation, would be exempt under section 871(h) 
or 881(c) (relating to exemption for certain portfolio interest received 
by a foreign person), section 871(i) or 881(d) (relating, in part, to 
exemption

[[Page 583]]

for certain bank deposit interest received by a foreign person), or 
another provision of the Code. Such interest shall also be treated as 
interest paid by a domestic corporation (other than a corporation 
described in section 861(c)(1)) for purposes of sections 864(c), 871(b) 
and 882(a) (relating to income that is effectively connected with the 
conduct of a trade or business within the United States) and section 904 
(relating to the limitation on the foreign tax credit). For purposes of 
this section, a foreign corporation also shall be treated as engaged in 
trade or business in the United States if, at any time during the 
taxable year, it owns an asset taken into account under Sec.  1.882-
5(a)(1)(ii) or (b)(1) for purposes of determining the amount of the 
foreign corporation's interest expense allocated or apportioned to ECI. 
See paragraph (b)(8) of this section for the effect of income tax 
treaties on branch interest.
    (2) Tax on excess interest--(i) Definition of excess interest. For 
purposes of this section, the term ``excess interest'' means--
    (A) The amount of interest allocated or apportioned to ECI of the 
foreign corporation under Sec.  1.882-5 for the taxable year, after 
application of Sec.  1.884-1(e)(3); minus
    (B) The foreign corporation's branch interest (as defined in 
paragraph (b) of this section) for the taxable year, but not including 
interest accruing in a taxable year beginning before January 1, 1987; 
minus
    (C) The amount of interest determined under paragraph (c)(2) of this 
section (relating to interest paid by a partnership).
    (ii) Imposition of tax. A foreign corporation shall be liable for 
tax on excess interest under section 881(a) in the same manner as if 
such excess interest were interest paid to the foreign corporation by a 
wholly-owned domestic corporation (other than a corporation described in 
section 861(c)(1)) on the last day of the foreign corporation's taxable 
year. Excess interest shall be exempt from tax under section 881(a) only 
as provided in paragraph (a)(2)(iii) of this section (relating to 
treatment of certain excess interest of banks as interest on deposits) 
or paragraph (c)(3) of this section (relating to income tax treaties).
    (iii) Treatment of a portion of the excess interest of banks as 
interest on deposits. A portion of the excess interest of a foreign 
corporation that is a bank (as defined in section 585(a)(2)(B) without 
regard to the second sentence thereof) provided that a substantial part 
of its business in the United States, as well as all other countries in 
which it operates, consists of receiving deposits and making loans and 
discounts, shall be treated as interest on deposits (as described in 
section 871(i)(3)), and shall be exempt from the tax imposed by section 
881(a) as provided in such section. The portion of the excess interest 
of the foreign corporation that is treated as interest on deposits shall 
equal the product of the foreign corporation's excess interest and the 
greater of--
    (A) The ratio of the amount of interest bearing deposits, within the 
meaning of section 871(i)(3)(A), of the foreign corporation as of the 
close of the taxable year to the amount of all interest bearing 
liabilities of the foreign corporation on such date; or
    (B) 85 percent.
    (iv) Reporting and payment of tax on excess interest. The amount of 
tax due under section 884(f) and this section with respect to excess 
interest of a foreign corporation shall be reported on the foreign 
corporation's income tax return for the taxable year in which the excess 
interest is treated as paid to the foreign corporation under section 
884(f)(1)(B) and paragraph (a)(2) of this section, and shall not be 
subject to withholding under section 1441 or 1442. The tax shall be due 
and payable as provided in section 6151 and such other sections of 
Subtitle F of the Internal Revenue Code as apply, and estimated tax 
payments shall be due with respect to a foreign corporation's liability 
for the tax on excess interest as provided in section 6655.
    (3) Original issue discount. For purposes of this section, the term 
``interest'' includes original issue discount, as defined in section 
1273(a)(1).
    (4) Examples. The application of this paragraph (a) is illustrated 
by the following examples.


[[Page 584]]


    Example 1. Taxation of branch interest and excess interest. Foreign 
corporation A, a calendar year taxpayer that is not a corporation 
described in paragraph (a)(2)(iii) of this section (relating to banks), 
has $120 of interest allocated or apportioned to ECI under Sec.  1.882-5 
for 1997. A's branch interest (as defined in paragraph (b) of this 
section) for 1997 is as follows: $55 of portfolio interest (as defined 
in section 871(h)(2)) to B, a nonresident alien; $25 of interest to 
foreign corporation C, which owns 15 percent of the combined voting 
power of A's stock, with respect to bonds issued by A; and $20 to D, a 
domestic corporation. B and C are not engaged in the conduct of a trade 
or business in the United States. A, B and C are residents of countries 
with which the United States does not have an income tax treaty. The 
interest payments made to B and D are not subject to tax under section 
871(a) or 881 and are not subject to withholding under section 1441 or 
1442. The payment to C, which does not qualify as portfolio interest 
because C owns at least 10 percent of the combined voting power of A's 
stock, is subject to withholding of $7.50 ($25 x 30%). In addition, 
because A's interest allocated or apportioned to ECI under Sec.  1.882-5 
($120) exceeds its branch interest ($100), A has excess interest of $20, 
which is subject to a tax of $6 ($20 x 30%) under section 881. The tax 
on A's excess interest must be reported on A's income tax return for 
1997.
    Example 2. Taxation of excess interest of a bank. Foreign 
corporation A, a calendar year taxpayer, is a corporation described in 
paragraph (a)(2)(iii) of this section (relating to banks) and is a 
resident of a country with which the United States does not have an 
income tax treaty. A has excess interest of $100 for 1997. At the close 
of 1997, A has $10,000 of interest-bearing liabilities (including 
liabilities that give rise to branch interest), of which $8,700 are 
interest-bearing deposits. For purposes of computing the tax on A's 
excess interest, $87 of the excess interest ($100 excess interest x 
($8,700 interest-bearing deposits/$10,000 interest-bearing liabilities)) 
is treated as interest on deposits. Thus, $87 of A's excess interest is 
exempt from tax under section 881(a) and the remaining $13 of excess 
interest is subject to a tax of $3.90 ($13 x 30%) under section 881(a).

    (b) Branch interest--(1) Definition of branch interest. For purposes 
of this section, the term ``branch interest'' means interest that is--
    (i) Paid by a foreign corporation with respect to a liability that 
is--
    (A) A U.S. booked liability within the meaning of Sec.  1.882-
5(d)(2) (other than a U.S. booked liability of a partner within the 
meaning of Sec.  1.882-5(d)(2)(vii)); or
    (B) Described in Sec.  1.884-1(e)(2) (relating to insurance 
liabilities on U.S. business and liabilities giving rise to interest 
expense that is directly allocated to income from a U.S. asset); or
    (ii) In the case of a foreign corporation other than a corporation 
described in paragraph (a)(2)(iii) of this section, a liability 
specifically identified (as provided in paragraph (b)(3)(i) of this 
section) as a liability of a U.S. trade or business of the foreign 
corporation on or before the earlier of the date on which the first 
payment of interest is made with respect to the liability or the due 
date (including extensions) of the foreign corporation's income tax 
return for the taxable year, provided that--
    (A) The amount of such interest does not exceed 85 percent of the 
amount of interest of the foreign corporation that would be excess 
interest before taking into account interest treated as branch interest 
by reason of this paragraph (b)(1)(ii);
    (B) The requirements of paragraph (b)(3)(ii) of this section 
(relating to notification of recipient of interest) are satisfied; and
    (C) The liability is not described in paragraph (b)(3)(iii) of this 
section (relating to liabilities incurred in the ordinary course of a 
foreign business or secured by foreign assets) or paragraph (b)(1)(i) of 
this section.
    (2) [Reserved]
    (3) Requirements relating to specifically identified liabilities--
(i) Method of identification. A liability described in paragraph 
(b)(1)(ii) of this section is identified as a liability of a U.S. trade 
or business only if the liability is shown on the records of the U.S. 
trade or business, or is identified as a liability of the U.S. trade or 
business on other records of the foreign corporation or on a schedule 
established for the purpose of identifying the liabilities of the U.S. 
trade or business. Each such liability must be identified with 
sufficient specificity so that the amount of branch interest 
attributable to the liability, and the name and address of the 
recipient, can be readily identified from such records or schedule. 
However, with respect to liabilities that give rise to portfolio 
interest (as defined in sections 871(h) and 881(c)) or that are payable 
183 days or less from the date of original issue, and form part of a 
larger

[[Page 585]]

debt issue, such liabilities may be identified by reference to the issue 
and maturity date, principal amount and interest payable with respect to 
the entire debt issue. Records or schedules described in this paragraph 
that identify liabilities that give rise to branch interest must be 
maintained in the United States by the foreign corporation or an agent 
of the foreign corporation for the entire period commencing with the due 
date (including extensions) of the income tax return for the taxable 
year to which the records or schedules relate and ending with the 
expiration of the period of limitations for assessment of tax for such 
taxable year. A foreign corporation that is subject to this section may 
identify a liability under paragraph (b)(1)(ii) of this section whether 
or not it is actually engaged in the conduct of a trade or business in 
the United States.
    (ii) Notification to recipient. Interest with respect to a liability 
described in paragraph (b)(1)(ii) of this section shall not be treated 
as branch interest unless the foreign corporation paying the interest 
either--
    (A) Makes a return, pursuant to section 6049, with respect to the 
interest payment; or
    (B) Sends a notice to the person who receives such interest in a 
confirmation of the transaction, a statement of account, or a separate 
notice, within two months of the end of the calendar year in which the 
interest was paid, stating that the interest paid with respect to the 
liability is from sources within the United States.
    (iii) Liabilities that do not give rise to branch interest under 
paragraph (b)(1)(ii) of this section. A liability is described in this 
paragraph (b)(3)(iii) (and interest with respect to the liability may 
not be treated as branch interest of a foreign corporation by reason of 
paragraph (b)(1)(ii) of this section) if--
    (A) The liability is directly incurred in the ordinary course of the 
profit-making activities of a trade or business of the foreign 
corporation conducted outside the United States, as, for example, an 
account or note payable arising from the purchase of inventory or 
receipt of services by such trade or business; or
    (B) The liability is secured (during more than half the days during 
the portion of the taxable year in which the interest accrues) 
predominantly by property that is not a U.S. asset (as defined in Sec.  
1.884-1(d)) unless such liability is secured by substantially all the 
property of the foreign corporation.
    (4) [Reserved]
    (5) Increase in branch interest where U.S. assets constitute 80 
percent or more of a foreign corporation's assets--(i) General rule. If 
a foreign corporation would have excess interest before application of 
this paragraph (b)(5) and the amount of the foreign corporation's U.S. 
assets as of the close of the taxable year equals or exceeds 80 percent 
of all money and the aggregate E&P basis of all property of the foreign 
corporation on such date, then all interest paid and accrued by the 
foreign corporation during the taxable year that was not treated as 
branch interest before application of this paragraph (b)(5) and that is 
not paid with respect to a liability described in paragraph (b)(3)(iii) 
of this section (relating to liabilities incurred in the ordinary course 
of a foreign business or secured by non-U.S. assets) shall be treated as 
branch interest. However, if application of the preceding sentence would 
cause the amount of the foreign corporation's branch interest to exceed 
the amount permitted by paragraph (b)(6)(i) of this section (relating to 
branch interest in excess of a foreign corporation's interest allocated 
or apportioned to ECI under Sec.  1.882-5) the amount of branch interest 
arising by reason of this paragraph shall be reduced as provided in 
paragraphs (b)(6) (ii) and (iii) of this section, as applicable.
    (ii) Example. The application of this paragraph (b)(5) is 
illustrated by the following example.

    Example. Application of 80 percent test. Foreign corporation A, a 
calendar year taxpayer, has $90 of interest allocated or apportioned to 
ECI under Sec.  1.882-5 for 1993. Before application of this paragraph 
(b)(5), A has $40 of branch interest in 1993. A pays $60 of other 
interest during 1993, none of which is attributable to a liability 
described in paragraph (b)(3)(iii) of this section (relating to 
liabilities incurred in the ordinary course of a foreign business and 
liabilities predominantly secured by foreign assets). As of the close of

[[Page 586]]

1993, A has an amount of U.S. assets that exceeds 80 percent of the 
money and E&P bases of all A's property. Before application of this 
paragraph (b)(5), A would have $50 of excess interest (i.e., the $90 
interest allocated or apportioned to its ECI under Sec.  1.882-5 less 
$40 of branch interest). Under this paragraph (b)(5), the $60 of 
additional interest paid by A is also treated as branch interest. 
However, to the extent that treating the $60 of additional interest as 
branch interest would create an amount of branch interest that would 
exceed the amount of branch interest permitted under paragraph (b)(6) of 
this section (relating to branch interest that exceeds a foreign 
corporation's interest allocated or apportioned to ECI under Sec.  
1.882-5) the amount of the additional branch interest is reduced under 
paragraph (b)(6)(iii) of this section, which generally allows a foreign 
corporation to specify certain liabilities that do not give rise to 
branch interest or paragraph (b)(6)(ii) of this section, which generally 
specifies liabilities that do not give rise to branch interest beginning 
with the most-recently incurred liability.

    (6) Special rule where branch interest exceeds interest allocated or 
apportioned to ECI of a foreign corporation--(i) General rule. If the 
amount of branch interest that is both paid and accrued by a foreign 
corporation during the taxable year (including interest that the foreign 
corporation elects under paragraph (c)(1) of this section to treat as 
paid during the taxable year) exceeds the amount of interest allocated 
or apportioned to ECI of a foreign corporation under Sec.  1.882-5 for 
the taxable year, then the amount of the foreign corporation's branch 
interest shall be reduced by the amount of such excess as provided in 
paragraphs (b)(6)(ii) and (iii) of this section, as applicable. The 
rules of paragraphs (b)(6)(ii) and (iii) of this section shall also 
apply where the amount of branch interest with respect to liabilities 
identified under paragraph (b)(1)(ii) of this section exceeds the 
maximum amount that may be treated as branch interest under that 
paragraph. This paragraph (b)(6) shall apply whether or not a reduction 
in the amount of branch interest occurs as a result of adjustments made 
during the examination of the foreign corporation's income tax return, 
such as a reduction in the amount of interest allocated or apportioned 
to ECI of the foreign corporation under Sec.  1.882-5.
    (ii) Reduction of branch interest beginning with most-recently 
incurred liability. Except as provided in paragraph (b)(6)(iii) of this 
section (relating to an election to specify liabilities that do not give 
rise to branch interest), the amount of the excess in paragraph 
(b)(6)(i) of this section shall first reduce branch interest 
attributable to liabilities described in paragraph (b)(1)(ii) of this 
section (relating to liabilities identified as giving rise to branch 
interest) and then, if such excess has not been reduced to zero, branch 
interest attributable to the group of liabilities described in paragraph 
(b)(1)(i) of this section. The reduction of branch interest attributable 
to each group of liabilities (i.e., liabilities described in paragraph 
(b)(1)(ii) of this section and liabilities described in paragraph 
(b)(1)(i) of this section) shall be made beginning with interest 
attributable to the latest-incurred liability and continuing, in reverse 
chronological order, with branch interest attributable to the next-
latest incurred liability. The branch interest attributable to a 
liability must be reduced to zero before a reduction is made with 
respect to branch interest attributable to the next-latest incurred 
liability. Where only a portion of the branch interest attributable to a 
liability is reduced by reason of this paragraph (b)(6)(ii), the 
reduction shall be made beginning with the last interest payment made 
with respect to the liability during the taxable year and continuing, in 
reverse chronological order, with the next-latest payment until the 
amount of branch interest has been reduced by the amount specified in 
paragraph (b)(6)(i) of this section. The amount of interest that is not 
treated as branch interest by reason of this paragraph (b)(6)(ii) shall 
not be treated as paid by a domestic corporation and thus shall not be 
subject to tax under section 871(a) or 881(a).
    (iii) Election to specify liabilities that do not give rise to 
branch interest. For purposes of reducing the amount of branch interest 
under paragraph (b)(6)(i) of this section, a foreign corporation may, 
instead of using the method described in paragraph (b)(6)(ii) of this 
section, elect for any taxable year to specify which liabilities will 
not be treated as giving rise to branch interest or will be treated as 
giving

[[Page 587]]

rise only in part to branch interest. Branch interest paid during the 
taxable year with respect to a liability specified under this paragraph 
(b)(6)(iii) must be reduced to zero before a reduction is made with 
respect to branch interest attributable to the next-specified liability. 
If all interest payments with respect to a specified liability, when 
added to all interest payments with respect to other liabilities 
specified under this paragraph (b)(6)(iii), would exceed the amount of 
the reduction under paragraph (b)(6)(i) of this section, then only a 
portion of the branch interest attributable to that specified liability 
shall be reduced under this paragraph (b)(6)(iii), and the reduction 
shall be made beginning with the last interest payment made with respect 
to the liability during the taxable year and continuing, in reverse 
chronological order, with the next-latest payment until the amount of 
branch interest has been reduced by the amount of the reduction under 
paragraph (b)(6)(i) of this section. A foreign corporation that elects 
to have this paragraph (b)(6)(iii) apply shall note on its books and 
records maintained in the United States that the liability is not to be 
treated as giving rise to branch interest, or is to be treated as giving 
rise to branch interest only in part. Such notation must be made after 
the close of the taxable year in which the foreign corporation pays the 
interest and prior to the due date (with extensions) of the foreign 
corporation's income tax return for the taxable year. However, if the 
excess interest in paragraph (b)(6)(i) of this section occurs as a 
result of adjustments made during the examination of the foreign 
corporation's income tax return, the election and notation may be made 
at the time of examination. The amount of interest that is not treated 
as branch interest by reason of this paragraph (b)(6)(iii) shall not be 
treated as paid by a domestic corporation and thus shall not be subject 
to tax under section 871 (a) or 881 (a).

    (iv) Examples. The application of this paragraph (b)(6) is 
illustrated by the following examples.

    Example 1. Branch interest exceeds interest apportioned to ECI with 
no election in effect. Foreign corporation A, a calendar year, accrual 
method taxpayer, has interest expense apportioned to ECI under Sec.  
1.882-5 of $230 for 1997. A's branch interest for 1997 is as follows:
    (i) $130 paid to B, a domestic corporation, with respect to a note 
issued on March 10, 1997, and secured by real property located in the 
United States;
    (ii) $60 paid to C, an individual resident of country X who is 
entitled to a 10 percent rate of withholding on interest payments under 
the income tax treaty between the United States and X, with respect to a 
note issued on October 15, 1996, which gives rise to interest subject to 
tax under section 871(a);
    (iii) $80 paid to D, an individual resident of country Y who is 
entitled to a 15 percent rate of withholding on interest payments under 
the income tax treaty between the United States and Y, with respect to a 
note issued on February 15, 1997, which gives rise to interest subject 
to tax under section 871(a); and
    (iv) $70 of portfolio interest (as defined in section 871(h) (2)) 
paid to E, a nonresident alien, with respect to a bond issued on March 
1, 1997.


A's branch interest accrues during 1997 for purposes of calculating the 
amount of A's interest apportioned to ECI under Sec.  1.882-5. A has 
identified under paragraph (b)(1)(ii) of this section the liabilities 
described in paragraphs (ii), (iii) and (iv) of this example. A has not 
made an election under paragraph (b)(6)(iii) of this section to specify 
liabilities that do not give rise to branch interest. The amount of A's 
branch interest in 1997 is limited under paragraph (b)(6)(i) of this 
section to $230, the amount of the interest apportioned to A's ECI for 
1997. The amount of A's branch interest must thus be reduced by $110 
($340-$230) under paragraph (b)(6)(ii) of this section. The reduction is 
first made with respect to interest attributable to liabilities 
described in paragraph (b)(1)(ii) of this section (i.e., liabilities 
identified as giving rise to branch interest) and, within the group of 
liabilities described in paragraph (b)(1)(ii) of this section, is first 
made with respect to the latest-incurred liability. Thus, the $70 of 
interest paid to E with respect to the bond issued on March 1, 1997, and 
$40 of the $80 of interest paid to D with respect to the note issued on 
February 15, 1997, are not treated as branch interest. The interest paid 
to D is no longer subject to tax under section 871(a), and D may claim a 
refund of amounts withheld with respect to the interest payments. There 
is no change in the tax consequences to E because the interest received 
by E was portfolio interest and was not subject to tax when it was 
treated as branch interest.
    Example 2. Effect of election to specify liabilities. Assume the 
same facts as in Example 1 except that A makes an election under 
paragraph (b)(6)(iii) of this section to specify

[[Page 588]]

which liabilities are not to be treated as giving rise to branch 
interest. A specifies the liability to D, who would be taxable at a rate 
of 15 percent on interest paid with respect to the liability, as a 
liability that does not give rise to branch interest, and D is therefore 
not subject to tax under section 871 (a) and is entitled to a refund of 
amounts withheld with respect to the interest payments. A also specifies 
the liability to C as a liability that gives rise to branch interest 
only in part. As a result, $30 of the $60 of interest paid to C is not 
treated as branch interest, and C is entitled to a refund with respect 
to the $30 of interest that is not treated as branch interest.

    (7) Effect of election under paragraph (c)(1) of this section to 
treat interest as if paid in year of accrual. If a foreign corporation 
accrues an interest expense in a taxable year earlier than the taxable 
year of payment and elects under paragraph (c)(1) of this section to 
compute its excess interest as if the interest expense were branch 
interest paid in the year of accrual, the interest expense shall be 
treated as branch interest that is paid at the close of such year (and 
not in the actual year of payment) for all purposes of this section. 
Such interest shall thus be subject to tax under section 871(a) or 
881(a) and withholding under section 1441 or section 1442, as if paid on 
the last day of the taxable year of accrual. Interest that is treated 
under paragraph (c)(1) of this section as paid in a later year for 
purposes of computing excess interest shall be treated as paid only in 
the actual year of payment for all purposes of this section other than 
paragraphs (a)(2) and (c)(1) of this section (relating to excess 
interest).
    (8) Effect of treaties--(i) Payor's treaty. In the case of a foreign 
corporation's branch interest, relief shall be available under an 
article of an income tax treaty between the United States and the 
foreign corporation's country of residence relating to interest paid by 
the foreign corporation only if, for the taxable year in which the 
branch interest is paid (or if the branch interest is treated as paid in 
an earlier taxable year under paragraph (b)(7) of this section, for the 
earlier taxable year)--
    (A) The foreign corporation meets the requirements of the limitation 
on benefits provision, if any, in the treaty, and either--
    (1) The corporation is a qualified resident (as defined in Sec.  
1.884-5(a)) of that foreign country in such year; or
    (2) The corporation meets the requirements of paragraph (b)(8)(iii) 
of this section in such year; or
    (B) The limitation on benefits provision, or an amendment to that 
provision, entered into force after December 31, 1986.
    (ii) Recipient's treaty. A foreign person (other than a foreign 
corporation) that derives branch interest is entitled to claim benefits 
under provisions of an income tax treaty between the United States and 
its country of residence relating to interest derived by the foreign 
person. A foreign corporation may claim such benefits if it meets, with 
respect to the branch interest, the requirements of the limitation on 
benefits provision, if any, in the treaty and--
    (A) The foreign corporation meets the requirements of paragraphs 
(b)(8)(i)(A) or (B) of this section; and
    (B) In the case of interest paid in a taxable year beginning after 
December 31, 1988, with respect to an obligation with a maturity not 
exceeding one year, each foreign corporation that beneficially owned the 
obligation prior to maturity was a qualified resident (for the period 
specified in paragraph (b)(8)(i) of this section) of a foreign country 
with which the United States has an income tax treaty or met the 
requirements of the limitation on benefits provision in a treaty with 
respect to the interest payment and such provision entered into force 
after December 31, 1986.
    (iii) Presumption that a foreign corporation continues to be a 
qualified resident. For purposes of this paragraph (b)(8), a foreign 
corporation that was a qualified resident for the prior taxable year 
because it fulfills the requirements of Sec.  1.884-5 shall be 
considered a qualified resident with respect to branch interest that is 
paid or received during the current taxable year if--
    (A) In the case of a foreign corporation that met the stock 
ownership and base erosion tests in Sec.  1.884-5(b) and (c) for the 
preceding taxable year, the foreign corporation does not know, or have 
reason to know, that either 50 percent of its stock (by value) is not

[[Page 589]]

beneficially owned (or treated as beneficially owned by reason of Sec.  
1.884-5(b)(2)) by qualifying shareholders at any time during the portion 
of the taxable year that ends with the date on which the interest is 
paid, or that the base erosion test is not met during the portion of the 
taxable year that ends with the date on which the interest is paid;
    (B) In the case of a foreign corporation that met the requirements 
of Sec.  1.884-5(d) (relating to publicly-traded corporations) for the 
preceding taxable year, the foreign corporation is listed on an 
established securities exchange in the United States or its country of 
residence at all times during the portion of the taxable year that ends 
with the date on which the interest is paid and does not fail the 
requirements of Sec.  1.884-5(d)(4)(iii) (relating to certain closely-
held corporations) at any time during such period; or
    (C) In the case of a foreign corporation that met the requirements 
of Sec.  1.884-5(e) (relating to the active trade or business test) for 
the preceding taxable year, the foreign corporation continues to operate 
(other than in a nominal degree), at all times during the portion of the 
taxable year that ends with the date on which the interest is paid, the 
same business in the U.S. and its country of residence that caused it to 
meet such requirements for the preceding taxable year.
    (iv) Treaties other than income tax treaties. A treaty that is not 
an income tax treaty does not provide any benefits with respect to 
branch interest.
    (v) Effect of income tax treaties on interest paid by a partnership. 
If a foreign corporation is a partner (directly or indirectly) in a 
partnership that is engaged in a trade or business in the United States 
and owns an interest of 10 percent or more (as determined under the 
attribution rules of section 318) in the capital, profits, or losses of 
the partnership at any time during the partner's taxable year, the 
relief that may be claimed under an income tax treaty with respect to 
the foreign corporation distributive share of interest paid or treated 
as paid by the partnership shall not exceed the relief that would be 
available under paragraphs (b)(8) (i) and (ii) of this section if such 
interest were branch interest of the foreign corporation. See paragraph 
(c)(2) of this section for the effect on a foreign corporation's excess 
interest of interest paid by a partnership of which the foreign 
corporation is a partner.
    (vi) Examples. The following examples illustrate the application of 
this paragraph (b)(8).

    Example 1. Payor's treaty. The income tax treaty between the United 
States and country X provides that the United States may not impose a 
tax on interest paid by a corporation that is a resident of that country 
(and that is not a domestic corporation) if the recipient of the 
interest is a nonresident alien or a foreign corporation. Corp A is a 
qualified resident of country X and meets the limitation on benefits 
provision in the treaty. A's branch interest is not subject to tax under 
section 871(a) or 881(a) regardless of whether the recipient is entitled 
to benefits under an income tax treaty.
    Example 2. Recipient's treaty and interest received from a 
partnership. A, a foreign corporation, and B, a nonresident alien, are 
partners in a partnership that owns and operates U.S. real estate and 
each has a distributive share of partnership interest deductions equal 
to 50 percent of the interest deductions of the partnership. There is no 
income tax treaty between the United States and the countries of 
residence of A and B. The partnership pays $1,000 of interest to a bank 
that is a resident of a foreign country, Y, and that qualifies under an 
income tax treaty in effect with the United States for a 5 percent rate 
of tax on U.S. source interest paid to a resident of country Y. However, 
the bank is not a qualified resident of country Y and the limitation on 
benefits provision of the treaty has not been amended since December 31, 
1986. The partnership is required to withhold at a rate of 30 percent on 
$500 of the interest paid to the bank (i.e., A's 50 percent distributive 
share of interest paid by the partnership) because the bank cannot, 
under paragraph (b)(8)(iv) of this section, claim greater treaty 
benefits by lending money to the partnership than it could claim, if it 
lent money to A directly and the $500 were branch interest of A.

    (c) Rules relating to excess interest--(1) Election to compute 
excess interest by treating branch interest that is paid and accrued in 
different years as if paid in year of accrual--(i) General rule. If 
branch interest is paid in one or more taxable years before or after the 
year in which the interest accrues, a foreign corporation may elect to 
compute its excess interest as if such branch interest were paid on the 
last day of the

[[Page 590]]

taxable year in which it accrues, and not in the taxable year in which 
it is actually paid. The interest expense will thus reduce the amount of 
the foreign corporation's excess interest in the year of accrual rather 
than in the year of actual payment. Except as provided in paragraph 
(c)(1)(ii) of this section, if an election is made for a taxable year, 
this paragraph (c)(1)(i) shall apply to all branch interest that is paid 
or accrued during that year. See paragraph (b)(7) of this section for 
the effect of an election under this paragraph (c)(1) on branch interest 
that accrues in a taxable year after the year of payment.
    (ii) Election not to apply in certain cases. An election under this 
paragraph (c)(1) shall not apply to an interest expense that accrued in 
a taxable year beginning before January 1, 1987, and shall not apply to 
an interest expense that was paid in a taxable year beginning before 
such date unless the interest was income from sources within the United 
States. An election under this paragraph (c)(1) shall not apply to 
branch interest that accrues during the taxable year and is paid in an 
earlier taxable year if the branch interest reduced excess interest in 
such earlier year. However, a foreign corporation may amend its income 
tax return for such earlier taxable year so that the branch interest 
does not reduce excess interest in such year.
    (iii) Requirements for election. A foreign corporation that elects 
to apply this paragraph (c)(1) shall attach to its income tax return (or 
to an amended income tax return) a statement that it elects to have the 
provisions of this paragraph (c)(1) apply, or shall provide written 
notice to the Commissioner during an examination that it elects to apply 
this paragraph (c)(1). The election shall be effective for the taxable 
year to which the return relates and for all subsequent taxable years 
unless the Commissioner consents to revocation of the election.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(1).

    Example 1. Interest accrued before paid. Foreign corporation A, a 
calendar year, accrual method taxpayer, has $100 of interest allocated 
or apportioned to ECI under Sec.  1.882-5 for 1997. A has $60 of branch 
interest in 1997 before application of this paragraph (c)(1). A has an 
interest expense of $20 that properly accrues for tax purposes in 1997 
but is not paid until 1998. When the interest is paid in 1998 it will 
meet the requirements for branch interest under paragraph (b)(1) of this 
section. A makes a timely election under this paragraph (c)(1) to treat 
the accrued interest as if it were paid in 1997. A will be treated as 
having branch interest of $80 for 1997 and excess interest of $20 in 
1997. The $20 of interest treated as branch interest of A in 1997 will 
not again be treated as branch interest in 1998.
    Example 2. Interest paid before accrued. Foreign corporation A, a 
calendar year, accrual method taxpayer, has $60 of branch interest in 
1997. The interest expense does not accrue until 1994 and the amount of 
interest allocated or apportioned to A's ECI under Sec.  1.882-5 is zero 
for 1997 and $60 for 1998. A makes an election under this paragraph 
(c)(1) with respect to 1997. As a result of the election, A's $60 of 
branch interest in 1997 reduces the amount of A's excess interest for 
1994 rather than in 1998.

    (2) Interest paid by a partnership--(i) General rule. Except as 
otherwise provided in paragraphs (c)(2) (i) and (ii) of this section, if 
a foreign corporation is a partner in a partnership that is engaged in 
trade or business in the United States, the amount of the foreign 
corporation's distributive share of interest paid or accrued by the 
partnership shall reduce (but not below zero) the amount of the foreign 
corporation's excess interest for the year to the extent such interest 
is taken into account by the foreign corporation in that year for 
purposes of calculating the interest allocated or apportioned to the ECI 
of the foreign corporation under Sec.  1.882-5. A foreign corporation's 
excess interest shall not be reduced by its distributive share of 
partnership interest that is attributable to a liability described in 
paragraph (b)(3)(iii) of this section (relating to interest on 
liabilities incurred in the ordinary course of a foreign business or 
secured predominantly by assets that are not U.S. assets) or would be 
described in paragraph (b)(3)(iii) of this section if entered on the 
partner's books. See paragraph (b)(8)(v) of this section for the effect 
of income tax treaties on interest paid by a partnership.
    (ii) Special rule for interest that is paid and accrued in different 
years. Paragraph (c)(2)(i) of this section shall not

[[Page 591]]

apply to any portion of a foreign corporation's distributive share of 
partnership interest that is paid and accrued in different taxable years 
unless the foreign corporation has an election in effect under paragraph 
(c)(1) of this section that is effective with respect to such interest 
and any tax due under section 871(a) or 881(a) with respect to such 
interest has been deducted and withheld at source in the earlier of the 
taxable year of payment or accrual.
    (3) Effect of treaties--(i) General rule. The rate of tax imposed on 
the excess interest of a foreign corporation that is a resident of a 
country with which the United States has an income tax treaty shall not 
exceed the rate provided under such treaty that would apply with respect 
to interest paid by a domestic corporation to that foreign corporation 
if the foreign corporation meets, with respect to the excess interest, 
the requirements of the limitation on benefits provision, if any, in the 
treaty and either--
    (A) The corporation is a qualified resident (as defined in Sec.  
1.884-5(a)) of that foreign country for the taxable year in which the 
excess interest is subject to tax; or
    (B) The limitation on benefits provision, or an amendment to that 
provision, entered into force after December 31, 1986.
    (ii) Provisions relating to interest paid by a foreign corporation. 
Any provision in an income tax treaty that exempts or reduces the rate 
of tax on interest paid by a foreign corporation does not prevent 
imposition of the tax on excess interest or reduce the rate of such tax.
    (4) Example. The application of paragraphs (c)(2) and (3) of this 
section is illustrated by the following example.

    Example. Interest paid by a partnership. Foreign corporation A, a 
calendar year taxpayer, is not a resident of a foreign country with 
which the United States has an income tax treaty. A is engaged in the 
conduct of a trade or business both in the United States and in foreign 
countries, and owns a 50 percent interest in X, a calendar year 
partnership engaged in the conduct of a trade or business in the United 
States. For 1997, all of X's liabilities are of a type described in 
paragraph (b)(1) of this section (relating to liabilities on U.S. books) 
and none are described in paragraph (b)(3)(iii) of this section 
(relating to liabilities that may not give rise to branch interest). A's 
distributive share of interest paid by X in 1997 is $20. For 1997, A has 
$150 of interest allocated or apportioned to its ECI under Sec.  1.882-
5, $120 of which is attributable to branch interest. Thus, the amount of 
A's excess interest for 1997, before application of paragraph (c)(2)(i) 
of this section, is $30. Under paragraph (c)(2)(i) of this section, A's 
$30 of excess interest is reduced by $20, representing A's share of 
interest paid by X. Thus, the amount of A's excess interest for 1997 is 
reduced to $10. A is subject to a tax of 30 percent on its $10 of excess 
interest.

    (d) Stapled entities. A foreign corporation that is treated as a 
domestic corporation by reason of section 269B (relating to stapled 
entities) shall continue to be treated as a foreign corporation for 
purposes of section 884 (f) and this section, notwithstanding section 
269B and the regulations thereunder. Interest paid by such foreign 
corporation shall be treated as paid by a domestic corporation and shall 
be subject to the tax imposed by section 871 (a) or 881 (a), and to 
withholding under section 1441 and 1442, as applicable, to the extent 
such interest is not subject to tax by reason of section 884(f) and this 
section.
    (e) Effective dates--(1) General rule. Except as provided in 
paragraph (e)(2) of this section, this section is effective for taxable 
years beginning October 13, 1992, and for payments of interest described 
in section 884(f)(1)(A) made (or treated as made under paragraph (b)(7) 
of this section) during taxable years of the payor beginning after such 
date. With respect to taxable years beginning before October 13, 1992, 
and after December 31, 1986, a foreign corporation may elect to apply 
this section in lieu of Sec.  1.884-4T of the temporary regulations (as 
contained in the CFR edition revised as of April 1, 1992) as they 
applied to the foreign corporation after issuance of Notice 89-80, 1989-
2 C.B. 394, but only if the foreign corporation has made an election 
under Sec.  1.884-1 (i) to apply Sec.  1.884-1 in lieu of Sec.  1.884-1T 
(as contained in the CFR edition revised as of April 1, 1992) for that 
year, and the statute of limitations for assessment of a deficiency has 
not expired for that taxable year. Once an election has been made, an 
election under this section shall apply to all subsequent taxable years.

[[Page 592]]

    (2) Special rule. Paragraphs (a)(1), (a)(2)(i)(A), (a)(2)(iii), 
(b)(1), (b)(3), (b)(5)(i), (b)(6)(i), (b)(6)(ii), and (c)(2)(i) of this 
section are effective for taxable years beginning on or after June 6, 
1996.
    (f) Transition rules--(1) Election under paragraph (c)(1) of this 
section. If a foreign corporation has made an election described in 
Sec.  1.884-4T(b)(7) (as contained in the CFR edition revised as of 
April 1, 1992) with respect to interest that has accrued and been paid 
in different taxable years, such election shall be effective for 
purposes of paragraph (c)(1) of this section as if the corporation had 
made the election under paragraph (c)(1) of this section of these 
regulations.
    (2) Waiver of notification requirement for non-banks under Notice 
89-80. If a foreign corporation that is not a bank has made an election 
under Notice 89-80 to apply the rules in part 2 of section I of the 
Notice in lieu of the rules in Sec.  1.884-4T(b) (as contained in the 
CFR edition revised as of April 1, 1992) to determine the amount of its 
interest paid and excess interest in taxable years beginning prior to 
1990, the requirement that the foreign corporation satisfy the 
notification requirements described in paragraph (b)(3)(ii) of this 
section is waived with respect to interest paid in taxable years ending 
on or before the date the Notice was issued.
    (3) Waiver of legending requirement for certain debt issued prior to 
January 3, 1989. For purposes of sections 871(h), 881(c), and this 
section, branch interest of a foreign corporation that would be treated 
as portfolio interest under section 871(h) or 881(c) but for the fact 
that it fails to meet the requirements of section 163(f)(2)(B)(ii)(II) 
(relating to the legend requirement), shall nevertheless be treated as 
portfolio interest provided the interest arises with respect to a 
liability incurred by the foreign corporation before January 3, 1989, 
and interest with respect to the liability was treated as branch 
interest in a taxable year beginning before January 1, 1990.

[T.D. 8432, 57 FR 41660, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9341, Mar. 8, 
1996]



Sec.  1.884-5  Qualified resident.

    (a) Definition of qualified resident. A foreign corporation is a 
qualified resident of a foreign country with which the United States has 
an income tax treaty in effect if, for the taxable year, the foreign 
corporation is a resident of that country (within the meaning of such 
treaty) and either--
    (1) Meets the requirements of paragraphs (b) and (c) of this section 
(relating to stock ownership and base erosion);
    (2) Meets the requirements of paragraph (d) of this section 
(relating to publicly-traded corporations);
    (3) Meets the requirements of paragraph (e) of this section 
(relating to the conduct of an active trade or business); or
    (4) Obtains a ruling as provided in paragraph (f) of this section 
that it shall be treated as a qualified resident of its country of 
residence.
    (b) Stock ownership requirement--(1) General rule--(i) Ownership by 
qualifying shareholders. A foreign corporation satisfies the stock 
ownership requirement of this paragraph (b) for the taxable year if more 
than 50 percent of its stock (by value) is beneficially owned (or is 
treated as beneficially owned by reason of paragraph (b)(2) of this 
section) during at least half of the number of days in the foreign 
corporation's taxable year by one or more qualifying shareholders. A 
person shall be treated as a qualifying shareholder only if such person 
meets the requirements of paragraph (b)(3) of this section and is 
either--
    (A) An individual who is either a resident of the foreign country of 
which the foreign corporation is a resident or a citizen or resident of 
the United States;
    (B) The government of the country of which the foreign corporation 
is a resident (or a political subdivision or local authority of such 
country), or the United States, a State, the District of Columbia, or a 
political subdivision or local authority of a State;
    (C) A corporation that is a resident of the foreign country of which 
the foreign corporation is a resident and whose stock is primarily and 
regularly traded on an established securities

[[Page 593]]

market (within the meaning of paragraph (d) of this section) in that 
country or the United States or a domestic corporation whose stock is 
primarily and regularly traded on an established securities market 
(within the meaning of paragraph (d) of this section) in the United 
States;
    (D) A not-for profit organization described in paragraph (b)(1)(iv) 
of this section that is not a pension fund as defined in paragraph 
(b)(8)(i)(A) of this section and that is organized under the laws of the 
foreign country of which the foreign corporation is a resident or the 
United States; or
    (E) A beneficiary of certain pension funds (as defined in paragraph 
(b)(8)(i)(A) of this section) administered in or by the country in which 
the foreign corporation is a resident to the extent provided in 
paragraph (b)(8) of this section.


Beneficial owners of an association taxable as a corporation shall be 
treated as shareholders of such association for purposes of this 
paragraph (b)(1). If stock of a foreign corporation is owned by a 
corporation that is treated as a qualifying shareholder under paragraph 
(b)(1)(i)(C) of this section, such stock shall not also be treated as 
owned, directly or indirectly, by any qualifying shareholders of such 
corporation for purposes of this paragraph (b). Notwithstanding the 
above, a foreign corporation will not be treated as a qualified resident 
unless it obtains the documentation described in paragraph (b)(3) of 
this section to show that the requirements of this paragraph (b)(1)(i) 
have been met and maintains the documentation as provided in paragraph 
(b)(9) of this section. See also paragraph (b)(1)(iii) of this section, 
which treats certain publicly-traded classes of stock as owned by 
qualifying shareholders.
    (ii) Special rules relating to qualifying shareholders. For purposes 
of applying paragraph (b)(1)(i) of this section--
    (A) Stock owned on any day shall be taken into account only if the 
beneficial owner is a qualifying shareholder on that day or, in the case 
of a corporation or not-for-profit organization that is a qualifying 
shareholder under paragraph (b)(1)(i) (C) or (D) of this section, for a 
one-year period that includes such day; and
    (B) An individual, corporation or not-for-profit organization is a 
resident of a foreign country if it is a resident of that country for 
purposes of the income tax treaty between the United States and that 
country.
    (iii) Publicly-traded class of stock treated as owned by qualifying 
shareholders. A class of stock of a foreign corporation shall be treated 
as owned by qualifying shareholders if--
    (A) The class of stock is listed on an established securities market 
in the United States or in the country of residence of the foreign 
corporation seeking qualified resident status; and
    (B) The class of stock is primarily and regularly traded on such 
market (within the meaning of paragraphs (d) (3) and (4) of this 
section, applied as if the class of stock were the sole class of stock 
relied on to meet the requirements of paragraph (d)(4)(i)(A)).


For purposes of this paragraph (b), stock in such class shall not also 
be treated as owned by any qualifying shareholders who own such stock, 
either directly or indirectly.
    (iv) Special rule for not-for-profit organizations. A not-for-profit 
organization is described in paragraph (b)(1)(iv) of this section if it 
meets the following requirements--
    (A) It is a corporation, association taxable as a corporation, 
trust, fund, foundation, league or other entity operated exclusively for 
religious, charitable, educational, or recreational purposes, and it is 
not organized for profit;
    (B) It is generally exempt from tax in its country of organization 
by virtue of its not-for-profit status; and
    (C) Either--
    (1) More than 50 percent of its annual support is expended on behalf 
of persons described in paragraphs (b)(1)(i)(A) through (E) of this 
section or on qualified residents of the country in which the 
organization is organized; or
    (2) More than 50 percent of its annual support is derived from 
persons described in paragraphs (b)(1)(i) (A) through (E) of this 
section or from persons who are qualified residents of the country in 
which the organization is organized.


[[Page 594]]



For purposes of meeting the requirements of paragraph (b)(1)(iv)(C) of 
this section, a not-for-profit organization may rely on the addresses of 
record of its individual beneficiaries and supporters to determine if 
such persons are resident in the country in which the not-for-profit 
organization is organized, provided that the addresses of record are not 
nonresidential addresses such as a post office box or in care of a 
financial intermediary, and the officers, directors or administrators of 
the organization do not know or have reason to know that the individual 
beneficiaries or supporters do not reside at that address.
    (2) Rules for determining constructive ownership--(i) General rules 
for attribution. For purposes of this section, stock owned by a 
corporation, partnership, trust, estate, or mutual insurance company or 
similar entity shall be treated as owned proportionately by its 
shareholders, partners, beneficiaries, grantors or other interest 
holders as provided in paragraph (b)(2)(ii) through (v) of this section. 
The proportionate interest rules of this paragraph (b)(2) shall apply 
successively upward through a chain of ownership, and a person's 
proportionate interest shall be computed for the relevant days or period 
that is taken into account in determining whether a foreign corporation 
is a qualified resident. Except as otherwise provided, stock treated as 
owned by a person by reason of this paragraph (b)(2) shall, for purposes 
of applying this paragraph (b)(2), be treated as actually owned by such 
person.
    (ii) Partnerships. A partner shall be treated as having an interest 
in stock of a foreign corporation owned by a partnership in proportion 
to the least of--
    (A) The partner's percentage distributive share of the partnership's 
dividend income from the stock;
    (B) The partner's percentage distributive share of gain from 
disposition of the stock by the partnership;
    (C) The partner's percentage distributive share of the stock (or 
proceeds from the disposition of the stock) upon liquidation of the 
partnership.


For purposes of this paragraph (b)(2)(ii), however, all qualifying 
shareholders that are partners of a partnership shall be treated as one 
partner. Thus, the percentage distributive shares of dividend income, 
gain and liquidation rights of all qualifying shareholders that are 
partners in a partnership are aggregated prior to determining the least 
of the three percentages.
    (iii) Trusts and estates--(A) Beneficiaries. In general, a person 
shall be treated as having an interest in stock of a foreign corporation 
owned by a trust or estate in proportion to the person's actuarial 
interest in the trust or estate, as provided in section 318(a)(2)(B)(i), 
except that an income beneficiary's actuarial interest in the trust will 
be determined as if the trust's only asset were the stock. The interest 
of a remainder beneficiary in stock will be equal to 100 percent minus 
the sum of the percentages of any interest in the stock held by income 
beneficiaries. The ownership of an interest in stock owned by a trust 
shall not be attributed to any beneficiary whose interest cannot be 
determined under the preceding sentence, and any such interest, to the 
extent not attributed by reason of this paragraph (b)(2)(iii)(A), shall 
not be considered owned by a beneficiary unless all potential 
beneficiaries with respect to the stock are qualifying shareholders. In 
addition, a beneficiary's actuarial interest will be treated as zero to 
extent that a grantor is treated as owning the stock under paragraph 
(b)(2)(iii)(B) of this section. A substantially separate and independent 
share of a trust, within the meaning of section 663(c), shall be treated 
as a separate trust for purposes of this paragraph (b)(2)(iii)(A), 
provided that payment of income, accumulated income or corpus of a share 
of one beneficiary (or group of beneficiaries) cannot affect the 
proportionate share of income, accumulated income or corpus of another 
beneficiary (or group of beneficiaries).
    (B) Grantor trusts. A person is treated as the owner of stock of a 
foreign corporation owned by a trust to the extent that the stock is 
included in the portion of the trust that is treated as owned by the 
person under sections 671 to 679 (relating to grantors and others 
treated as substantial owners).

[[Page 595]]

    (iv) Corporations that issue stock. A shareholder of a corporation 
that issues stock shall be treated as owning stock of a foreign 
corporation that is owned by such corporation on any day in a proportion 
that equals the value of the stock owned by such shareholder to the 
value of all stock of such corporation. If there is an agreement, 
express or implied, that a shareholder of a corporation will not receive 
distributions from the earnings of stock owned by the corporation, the 
shareholder will not be treated as owning that stock owned by the 
corporation.
    (v) Mutual insurance companies and similar entities. Stock held by a 
mutual insurance company, mutual savings bank, or similar entity 
(including an association taxable as a corporation that does not issue 
stock interests) shall be considered owned proportionately by the policy 
holders, depositors, or other owners in the same proportion that such 
persons share in the surplus of such entity upon liquidation or 
dissolution.
    (vi) Pension funds. See paragraphs (b)(8) (ii) and (iii) of this 
section for the attribution of stock owned by a pension fund (as defined 
in paragraph (b)(8)(i)(A)) to beneficiaries of the fund.
    (vii) Examples. The rules of paragraph (b)(2)(ii) of this section 
are illustrated by the following examples.

    Example 1. Stock held solely by qualifying shareholders through a 
partnership. A and B, residents of country X, are qualifying 
shareholders, within the meaning of paragraphs (b)(1)(i) (A) through (E) 
of this section, and the sole partners of partnership P. P's only asset 
is the stock of foreign corporation Z, a country X corporation seeking 
qualified resident status under this section. A's distributive share of 
P's income and gain on the disposition of P's assets is 80 percent, but 
A's distributive share of P's assets (or the proceeds therefrom) on P's 
liquidation is 20 percent. B's distributive share of P's income and gain 
is 20 percent and B is entitled to 80 percent of the assets (or proceeds 
therefrom) on P's liquidation. Under the attribution rules of paragraph 
(b)(2)(ii) of this section, A and B will be treated as a single partner 
owning in the aggregate 100 percent of the stock of Z owned by P.
    Example 2. Stock held by both qualifying and non-qualifying 
shareholders through a partnership. Assume the same facts as in Example 
1 except that C, an individual who is not a qualifying shareholder, is 
also a partner in P and that C's distributive share of P's income is 60 
percent. The distributive shares of A and B are the same as in Example 1 
except that A's distributive share of income is 20 percent. Under the 
attribution rules of paragraph (b)(2)(ii) of this section, A and B will 
be treated as a single partner owning in the aggregate 40 percent of the 
stock of Z owned by P (i.e., the least of A and B's aggregate 
distributive shares of dividend income (40 percent), gain (100 percent), 
and liquidation rights (100 percent) with respect to the Z stock).
    Example 3. Stock held through tiered partnerships. Assume the same 
facts as in Example 1, except that P does not own the stock of Z 
directly, but rather is a partner in partnership P1, which owns the 
stock of Z. Assume that P's distributive share of the dividend income, 
gain and liquidation rights with respect to the Z stock held by P1 is 40 
percent. Assume that of the remaining partners of P1 only D is a 
qualifying shareholder. D's distributive share of P1's dividend income 
and gain is 15 percent; D's distributive share of P1's assets on 
liquidation is 25 percent. Under the attribution rules of paragraph 
(b)(2)(ii) of this section, A and B, treated as a single partner, will 
own 40 percent of the Z stock owned by P1 (100 percent X 40 percent) and 
D will be treated as owning 15 percent of the Z stock owned by P1 (the 
least of D's dividend income (15 percent), gain (15 percent), and 
liquidation rights (25 percent) with respect to the Z stock). Thus, 55 
percent of the Z stock owned by P1 is treated as owned by qualifying 
shareholders under paragraph (b)(2)(ii) of this section.

    (3) Required documentation--(i) Ownership statements, certificates 
of residency and intermediary ownership statements. Except as provided 
in paragraphs (b)(3)(ii), (iii) and (iv) and paragraph (b)(8) of this 
section, a person shall only be treated as a qualifying shareholder of a 
foreign corporation if--
    (A) For the relevant period, the person completes an ownership 
statement described in paragraph (b)(4) of this section and, in the case 
of an individual who is not a U.S. citizen or resident, also obtains a 
certificate of residency described in paragraph (b)(5) of this section;
    (B) In the case of a person owning stock in the foreign corporation 
indirectly through one or more intermediaries (including mere legal 
owners or recordholders acting as nominees), each intermediary completes 
an intermediary ownership statement described in paragraph (b)(6) of 
this section; and

[[Page 596]]

    (C) Such ownership statements and certificates of residency are 
received by the foreign corporation on or before the earlier of the date 
it files its income tax return for the taxable year to which the 
statements relate or the due date (including extensions) for filing such 
return or, in the case of a foreign corporation claiming treaty benefits 
under Sec.  1.884-4(b)(8) (i) or (ii) (relating to branch interest) on 
or before the date on which such interest is paid.
    (ii) Substitution of intermediary verification statement for 
ownership statements and certificates of residency. If a qualifying 
shareholder owns stock through an intermediary that is either a domestic 
corporation, a resident of the United States, or a resident (for treaty 
purposes) of a country with which the United States has an income tax 
treaty in effect, the intermediary may provide an intermediary 
verification statement (as described in paragraph (b)(7) of this 
section) in place of any relevant ownership statements and certificates 
of residency from qualifying shareholders, and in place of intermediary 
ownership statements (or, where applicable, intermediary verification 
statements) from all intermediaries standing in the chain of ownership 
between the qualifying shareholders and the intermediary issuing the 
intermediary verification statement. An intermediary verification 
statement generally certifies that the verifying intermediary holds the 
documentation described in the preceding sentence and agrees to make it 
available to the District Director on request. Such intermediary 
verification statements, along with an intermediary ownership statement 
from the verifying intermediary, must be received by the foreign 
corporation on or before the earlier of the date if files its income tax 
return for the taxable year to which the statements relate or the due 
date (including extensions) for filing such return. An indirect owner of 
a foreign corporation is thus treated as a qualifying shareholder of a 
foreign corporation if the foreign corporation receives, on or before 
the time specified above, an intermediary verification statement and an 
intermediary ownership statement from the verifying intermediary and an 
intermediary ownership statement from all intermediaries standing in the 
chain of the verifying intermediary's ownership of its interest in the 
foreign corporation.
    (iii) Special rule for registered shareholders of widely-held 
corporations. An ownership statement and a certificate of residency 
shall not be required in the case of an individual who is a shareholder 
of record of a corporation that has at least 250 shareholders if--
    (A) The individual owns less than one percent of the stock (by 
value) (applying the attribution rules of section 318) of the 
corporation at all times during the taxable year;
    (B) The individual's address of record is in the corporation's 
country of residence and is not a nonresidential address such as a post 
office box or in care of a financial intermediary or stock transfer 
agent; and
    (C) The officers and directors of the corporation do not know or 
have reason to know that the individual does not reside at that address.


The rule in this paragraph (b)(3)(iii) may also be applied with respect 
to individual owners of mutual insurance companies, mutual savings banks 
or similar entities, provided that the same conditions set forth in this 
paragraph (b)(3)(iii) are met with respect to such individuals.
    (iv) Special rule for pension funds. See paragraphs (b)(8) (ii) 
through (v) of this section for special documentation rules applicable 
to pension funds (as defined in paragraph (b)(8)(i)(A) of this section).
    (v) Reasonable cause exception. If a foreign corporation does not 
obtain the documentation described in this paragraph (b)(3) or (b)(8) of 
this section in a timely manner but is able to show prior to 
notification of an examination of the return for the taxable year that 
the failure was due to reasonable cause and not willful neglect, the 
foreign corporation may perfect the documentation after the deadlines 
specified in this paragraph (b)(3) or (b)(8) of this section. It may 
make such a showing by providing a written statement to the District 
Director having jurisdiction over the taxpayer's return or the Office of 
the Assistant Commissioner (International), as applicable, setting

[[Page 597]]

forth the reasons for the failure to obtain the documentation in a 
timely manner and describing the documentation that was received after 
the deadline had passed. Whether a failure to obtain the documentation 
in a timely manner was due to reasonable cause shall be determined by 
the District Director or the Office of the Assistant Commissioner 
(International), as applicable, under all the facts and circumstances.
    (4) Ownership statements from qualifying shareholders--(i) Ownership 
statements from individuals. An ownership statement from an individual 
is a written statement signed by the individual under penalties of 
perjury stating--
    (A) The name, permanent address, and country of residence of the 
individual and, if the individual was not a resident of the country for 
the entire taxable year of the foreign corporation seeking qualified 
resident status, the period during which it was a resident of the 
foreign corporation's country of residence;
    (B) If the individual is a direct beneficial owner of stock in the 
foreign corporation, the name of the corporation, the number of shares 
in each class of stock of the corporation that are so owned, and the 
period of time during the taxable year of the foreign corporation during 
which the individual owned the stock (or, in the case of an association 
taxable as a corporation, the amount and nature of the owner's interest 
in such association);
    (C) If the individual directly owns an interest in a corporation, 
partnership, trust, estate or other intermediary that owns (directly or 
indirectly) stock in the foreign corporation, the name of the 
intermediary, the number and class of shares or amount and nature of the 
interest of the individual in such intermediary (that is relevant for 
purposes of attributing ownership in paragraph (b)(2) of this section), 
and the period of time during the taxable year of the foreign 
corporation during which the individual held such interest; and
    (D) To the extent known by the individual, a description of the 
chain of ownership through which the individual owns stock in the 
foreign corporation, including the name and address of each intermediary 
standing between the intermediary described in paragraph (b)(4)(i)(C) of 
this section and the foreign corporation.
    (ii) Ownership statements from governments. An ownership statement 
from a government that is a qualifying shareholder is a written 
statement signed by either--
    (A) An official of the governmental authority, agency or office that 
has supervisory authority with respect to the government's ownership 
interest who is authorized to sign such a statement on behalf of the 
authority, agency or office; or
    (B) The competent authority of the foreign country (as defined in 
the income tax treaty between the United States and the foreign 
country).


Such statement shall provide the title of the official signing the 
statement and the name and address of the government agency, and shall 
provide the information described in paragraphs (b)(4)(i) (B) through 
(D) of this section (substituting ``government'' for ``individual'') 
with respect to the government's direct or indirect ownership of stock 
in the foreign corporation seeking qualified resident status.
    (iii) Ownership statements from publicly-traded corporations. An 
ownership statement from a corporation that is a qualifying shareholder 
under paragraph (b)(1)(i)(C) of this section is a written statement 
signed by a person authorized to sign a tax return on behalf of the 
corporation under penalties of perjury stating--
    (A) The name, permanent address, and principal place of business of 
the corporation (if different from its permanent address);
    (B) The information described in paragraphs (b)(4)(i) (B) through 
(D) of this section (substituting ``corporation'' for ``individual''); 
and
    (C) That the corporation's stock is primarily and regularly traded 
on an established securities exchange (within the meaning of paragraph 
(d) of this section) in the United States or its country of residence.
    (iv) Ownership statements from not-for-profit organizations. An 
ownership statement from a not-for-profit organization (other than a 
pension fund as defined in paragraph (b)(8)(i)(A) of this section) is a 
written statement signed

[[Page 598]]

by a person authorized to sign a tax return on behalf of the 
organization under penalties of perjury stating--
    (A) The name, permanent address, and principal location of the 
activities of the organization (if different from its permanent 
address);
    (B) The information described in paragraphs (b)(4)(i) (B) through 
(D) of this section (substituting ``not-for-profit organization'' for 
``individual'') with respect to the not-for-profit organization's direct 
or indirect ownership of stock in the foreign corporation seeking 
qualified resident status; and
    (C) That the not-for-profit organization satisfies the requirements 
of paragraph (b)(1)(iv) of this section.
    (v) Ownership through a nominee. For purposes of this paragraph 
(b)(4) and paragraph (b)(6) of this section, a person who owns either 
stock in a foreign corporation seeking qualified resident status or an 
interest in an intermediary described in paragraph (b)(4)(i)(C) of this 
section through a nominee shall be treated as owning such stock or 
interest directly and must, therefore, provide the information described 
in paragraphs (b)(4) (i) through (iv) of this section, as applicable. 
Such person must also provide the name and address of the nominee.
    (5) Certificate of residency. A certificate of residency must be 
signed by the relevant authorities (as described below) of the country 
of residence of the individual shareholder and must state that the 
individual is a resident of that country for purposes of its income tax 
laws or, if the authorities do not customarily make such a 
determination, that the individual has filed a tax return claiming 
resident status and subjecting the individual's income to tax on a 
resident basis for the taxable year or period that ends with or within 
the taxable year for which the corporation is seeking qualified resident 
status. In the case of an individual who is not legally required to file 
a tax return in his or her country of residence or in any other country, 
a certificate of residency of a parent or guardian residing at such 
individual's address shall be considered sufficient to meet that 
individual's obligation under this paragraph (b)(5). The relevant 
authorities shall be the competent authority of the foreign country of 
which the foreign corporation is a resident, as defined in the income 
tax treaty between the foreign country and the United States, or such 
other governmental office of the foreign country (or political 
subdivision thereof) that customarily provides statements of residence. 
Notwithstanding the foregoing, the Commissioner may consult with the 
competent authority of a country regarding the procedures set forth in 
this paragraph (b)(5) and if necessary agree on additional or 
alternative procedures under which these certificates may be issued.
    (6) Intermediary ownership statement. An intermediary ownership 
statement is a written statement signed under penalties of perjury by 
the intermediary (if the intermediary is an individual) or a person that 
would be authorized to sign a tax return on behalf of the intermediary 
(if the intermediary is not an individual) containing the following 
information:
    (i) The name, address, country of residence, and principal place of 
business (in the case of a corporation or partnership) of the 
intermediary and, if the intermediary is a trust or estate, the name and 
permanent address of all trustees or executors (or equivalent under 
foreign law);
    (ii) The information described in paragraphs (b)(4)(i) (B) through 
(D) (substituting ``intermediary making the ownership statement'' for 
``individual'') with respect to the intermediary's direct or indirect 
ownership in the stock in the foreign corporation seeking qualified 
resident status;
    (iii) If the intermediary is a nominee for a qualifying shareholder 
or another intermediary, the name and permanent address of the 
qualifying shareholder, or the name and principal place of business of 
such other intermediary;
    (iv) If the intermediary is not a nominee for a qualifying 
shareholder or another intermediary, the proportionate interest in the 
intermediary of each direct shareholder, partner, beneficiary, grantor, 
or other interest holder (or if the direct holder is a nominee, of its 
beneficial shareholder, partner, beneficiary, grantor, or other interest 
holder) from which the intermediary

[[Page 599]]

received an ownership statement and the period of time during the 
taxable year for which the interest in the intermediary was owned by 
such shareholder, partner, beneficiary, grantor or other interest 
holder. For purposes of this paragraph (b)(6)(iv), the proportionate 
interest of a person in an intermediary is the percentage interest (by 
value) held by such person, determined using the principles for 
attributing ownership in paragraph (b)(2) of this section. If an 
intermediary is not required to receive an ownership statement from its 
individual registered shareholders or other interest holders by reason 
of paragraph (b)(3)(iii) of this section, then it must provide a list of 
the names and addresses of such registered shareholders or other 
interest holders and the aggregate proportionate interest in the 
intermediary of such registered shareholders or other interest holders.
    (7) Intermediary verification statement. An intermediary 
verification statement that may be substituted for certain documentation 
under paragraph (b)(3)(ii) of this section is a written statement signed 
under penalties of perjury by the intermediary (if the intermediary is 
an individual) or by a person that would be authorized to sign a tax 
return on behalf of the intermediary (if the verifying intermediary is 
not an individual) containing the following information--
    (i) The name, principal place of business, and country of residence 
of the verifying intermediary;
    (ii) A statement that the verifying intermediary has obtained 
either--
    (A) An ownership statement and, if applicable, a certificate of 
residency from a qualifying shareholder with respect to the foreign 
corporation seeking qualified resident status, and an intermediary 
ownership statement from each intermediary standing in the chain of 
ownership between the verifying intermediary and the qualifying 
shareholder; or
    (B) An intermediary verification statement substituting for the 
documentation described in paragraph (b)(7)(ii)(A) and an intermediary 
ownership statement from such intermediary and each intermediary 
standing in the chain of ownership between such intermediary and the 
verifying intermediary;
    (iii) The proportionate interest (as computed using the 
documentation described in paragraph (b)(7)(ii) of this section) in the 
intermediary owned directly or indirectly by qualifying shareholders;
    (iv) An agreement to make available to the Commissioner at such time 
and place as the Commissioner may request the underlying documentation 
described in paragraph (b)(7)(ii) of this section; and
    (v) A specific and valid waiver of any right to bank secrecy or 
other secrecy under the laws of the country in which the verifying 
intermediary is located, with respect to any qualifying shareholder 
ownership statements, certificates of residency, intermediary ownership 
statements or intermediary verification statements that the verifying 
intermediary has obtained pursuant to paragraph (b)(7)(ii) of this 
section.


A foreign corporation may combine, in a single statement, the 
information in an intermediary ownership statement and the information 
in an intermediary verification statement.
    (8) Special rules for pension funds--(i) Definitions--(A) Pension 
fund. For purposes of this section, the term ``pension fund'' shall mean 
a trust, fund, foundation, or other entity that is established 
exclusively for the benefit of employees or former employees of one or 
more employers, the principal purpose of which is to provide retirement, 
disability, and death benefits to beneficiaries of such entity and 
persons designated by such beneficiaries in consideration for prior 
services rendered.
    (B) Beneficiary. For purposes of this section, the term 
``beneficiary'' of a pension fund shall mean any person who has made 
contributions to the pension fund, or on whose behalf contributions have 
been made, and who is currently receiving retirement, disability, or 
death benefits from the pension fund or can reasonably be expected to 
receive such benefits in the future, whether or not the person's right 
to receive benefits from the fund has vested.
    (ii) Government pension funds. An individual who is a beneficiary of 
a pension fund that would be a controlled

[[Page 600]]

entity of a foreign sovereign within the principles of Sec.  1.892-
2T(c)(1) of the regulations (relating to pension funds established for 
the benefit of employees or former employees of a foreign government) 
shall be treated as a qualifying shareholder of a foreign corporation in 
which the pension fund owns a direct or indirect interest without having 
to meet the documentation requirements under paragraph (b)(3)(i)(A) of 
this section, if the foreign corporation is resident in the country of 
the foreign sovereign and the trustees, directors, or other 
administrators of the pension fund provide, with the pension fund's 
intermediary ownership statement described in paragraph (b)(6) of this 
section, a written statement that the fund is a controlled entity 
described in this paragraphs (b)(8)(ii). See paragraph (b)(4)(ii) of 
this section regarding an ownership statement from a pension fund that 
is an integral part of a foreign government.
    (iii) Non-government pension funds. For purposes of this section, an 
individual who is a beneficiary of a pension fund not described in 
paragraph (b)(8)(ii) of this section shall be treated as a qualifying 
shareholder of a foreign corporation owned directly or indirectly by 
such pension fund without having to meet the documentation requirements 
under paragraph (b)(3)(i)(A) of this section, if--
    (A) The pension fund is administered in the foreign corporation's 
country of residence and is subject to supervision or regulation by a 
governmental authority (or other authority delegated to perform such 
supervision or regulation by a governmental authority) in such country;
    (B) The pension fund is generally exempt from income taxation in its 
country of administration;
    (C) The pension fund has 100 or more beneficiaries;
    (D) The beneficiary's address, as it appears on the records of the 
fund, is in the foreign corporation's country of residence or the United 
States and is not a nonresidential address, such as a post office box or 
in care of a financial intermediary, and none of the trustees, directors 
or other administrators of the pension fund know, or have reason to 
know, that the beneficiary is not an individual resident of such foreign 
country or the United States;
    (E) In the case of a pension fund that has fewer than 500 
beneficiaries, the beneficiary's employer provides (if the beneficiary 
is currently contributing to the fund) to the trustees, directors or 
other administrators a written statement that the beneficiary is 
currently employed in the country in which the fund is administered or 
is usually employed in such country but is temporarily employed by the 
company outside of the country; and
    (F) The trustees, directors or other administrators of the pension 
fund provide, with the pension fund's intermediary ownership statement 
described in paragraph (b)(6) of this section, a written statement 
signed under penalties of perjury declaring that the pension fund meets 
the requirements in paragraphs (b)(8)(iii) (A), (B), and (C) of this 
section and giving the number of beneficiaries who meet the requirements 
of paragraph (b)(8)(iii)(D) of this section, and, if applicable, 
paragraph (b)(8)(iii)(E) of this section.
    (iv) Computation of beneficial interests in non-government pension 
funds. The number of shares in a foreign corporation that are held 
indirectly by beneficiaries of a pension fund who are qualifying 
shareholders may be computed based on the ratio of the number of such 
beneficiaries to all beneficiaries of the pension fund (rather than on 
the basis of the rules in paragraph (b)(2) of this section) if--
    (A) The pension fund meets the requirements of paragraphs 
(b)(8)(iii) (A), (B), and (C) of this section;
    (B) The trustees, directors or other administrators of the pension 
fund have no knowledge, and no reason to know, that the ratio of the 
pension fund's beneficiaries who are residents of either the country in 
which the pension fund is administered or of the United States to all 
beneficiaries of the pension fund would differ significantly from the 
ratio of the sum of the actuarial interests of such residents in the 
pension fund to the actuarial interests of all beneficiaries in the 
pension fund (or, if the beneficiaries' actuarial interest in the stock 
held directly or indirectly by the pension fund differs from the 
beneficiaries' actuarial interest in

[[Page 601]]

the pension fund, the ratio of actuarial interests computed by reference 
to the beneficiaries' actuarial interest in the stock);
    (C) Either--
    (1) Any overfunding of the pension fund would be payable, pursuant 
to the governing instrument or the laws of the foreign country in which 
the pension fund is administered, only to, or for the benefit of, one or 
more corporations that are qualified residents of the country in which 
the pension fund is administered, individual beneficiaries of the 
pension fund or their designated beneficiaries, or social or charitable 
causes (the reduction of the obligation of the sponsoring company or 
companies to make future contributions to the pension fund by reason of 
overfunding shall not itself result in such overfunding being deemed to 
be payable to or for the benefit of such company or companies); or
    (2) The foreign country in which the pension fund is administered 
has laws that are designed to prevent overfunding of a pension fund and 
the funding of the pension fund is within the guidelines of such laws; 
or
    (3) The pension fund is maintained to provide benefits to employees 
in a particular industry, profession, or group of industries or 
professions and employees of at least 10 companies (other than companies 
that are owned or controlled, directly or indirectly, by the same 
interests) contribute to the pension fund or receive benefits from the 
pension fund; and
    (D) The trustees, directors or other administrators provide, with 
the pension fund's intermediary ownership statement described in 
paragraph (b)(6) of this section, a written statement signed under 
penalties of perjury certifying that the requirements in paragraphs 
(b)(8)(iv) (A), (B), and either (C)(1), (C)(2) or (C)(3) of this section 
have been met.


The statement described in paragraph (b)(8)(iv) (D) of this section may 
be combined, in a single statement, with the information required in 
paragraph (b)(8)(iv) (F) of this section.
    (v) Time for making determinations. The determinations required to 
be made under this paragraph (b)(8) shall be made using information 
shown on the records of the pension fund for a date on or after the 
beginning of the foreign corporation's taxable year to which the 
determination is relevant.
    (9) Availability of documents for inspection--(i) Retention of 
documents by the foreign corporation. The documentation described in 
paragraphs (b)(3) and (b)(8) of this section must be retained by the 
foreign corporation until expiration of the period of limitations for 
the taxable year to which the documentation relates and must be made 
available for inspection by the District Director at such time and place 
as the District Director may request.
    (ii) Retention of documents by an intermediary issuing an 
intermediary verification statement. The documentation upon which an 
intermediary relies to issue an intermediary verification statement 
under paragraph (b)(7) of this section must be retained by the 
intermediary for a period of six years from the date of issuance of the 
intermediary verification statement and must be made available for 
inspection by the District Director at such time and place as the 
District Director may request.
    (10) Examples. The application of this paragraph (b) is illustrated 
by the following examples.

    Example 1. Foreign corporation A is a resident of country L, which 
has an income tax treaty in effect with the United States. Foreign 
corporation A has one class of stock issued and outstanding consisting 
of 1,000 shares, which are beneficially owned by the following alien 
individuals, directly or by application of paragraph (b)(2) of this 
section:

------------------------------------------------------------------------
                                                    Shares
                                                    owned,
                                                 directly or
                                                  indirectly
                                                      by
                   Individual                    application  Percentage
                                                      of
                                                  paragraph
                                                  (b)(2) of
                                                     this
                                                   section
------------------------------------------------------------------------
T--resident of the U.S.........................         200           20
U--resident of country L.......................         400           40
V--resident of country M.......................         100           10
W--resident of country L.......................         210           21
X--resident of country N.......................          90            9
                                                ------------------------
    Total......................................       1,000          100
------------------------------------------------------------------------

    (i) T owns his 200 shares directly and is a beneficial owner.
    (ii) U and V own, respectively, an 80 percent and a 20 percent 
actuarial interest in

[[Page 602]]

foreign trust FT, (which interest does not differ from their respective 
interests in the stock owned by FT), which beneficially owns 100 percent 
of the stock of a foreign corporation B with bearer shares, which 
beneficially owns 500 shares of foreign corporation A. Foreign 
corporation B is incorporated in a country that does not have an income 
tax treaty with the United States. The foreign trust has deposited the 
bearer shares it owns in B with a bank in a foreign country that has an 
income tax treaty with the United States.
    (iii) W beneficially owns all the shares of foreign corporation C, 
which are registered in the name of individual Z, a nominee, who resides 
in country L; foreign corporation C beneficially owns a 70 percent 
interest in foreign corporation D, which beneficially owns 300 shares of 
A. D's shares are bearer shares that C (not a resident of a country with 
which the United States has an income tax treaty) has deposited with a 
bank in a foreign country that has an income tax treaty with the United 
States.
    (iv) X beneficially owns a 30 percent interest in foreign 
corporation D.
    (v) A is a qualified resident of country L if it obtains the 
applicable documentation described in paragraph (b)(3) of this section 
either with respect to ownership by individuals U and W or with respect 
to ownership by individuals T and U, since either combination of 
qualifying shareholders of foreign corporation A will exceed 50 percent.
    Example 2. Assume the same facts as in Example 1 and assume that 
foreign corporation A chooses to obtain documentation with respect to 
individuals T and U.
    (i) A must obtain, pursuant to paragraph (b)(3)(i) of this section, 
an ownership statement (as described in paragraph (b)(4)(i) of this 
section) signed by T. T is not required to furnish a certificate of 
residency because T is a U.S. resident.
    (ii) U must provide foreign trust FT with an ownership statement and 
certificate of residency, as described in paragraphs (b)(4) and (b)(5) 
of this section. The trustees of FT must provide the depository bank 
holding foreign corporation B's bearer shares with an intermediary 
ownership statement concerning its beneficial ownership of B's shares 
and must attach to it the documentation provided by U. The depository 
bank must provide B with an intermediary ownership statement regarding 
its holding of B shares on behalf of FT and has the choice of 
attaching--
    (A) The documentation from U and the intermediary ownership 
statement from FT; or
    (B) An intermediary verification statement described in paragraph 
(b)(7) of this section, in which case foreign corporation B would not be 
provided with U's individual documentation or FT's intermediary 
ownership statement, both of which are retained by the depository bank.
    (iii) In either case, B must then provide foreign corporation A with 
an intermediary ownership statement regarding its direct beneficial 
ownership of shares in A and, as the case may be, either--
    (A) U's documentation and the intermediary ownership statements by 
FT and the depository bank; or
    (B) The depository bank's intermediary ownership and verification 
statements.
    (iv) Thus, with respect to U, A must obtain under paragraph 
(b)(3)(i) of this section the individual documentation regarding U and 
an intermediary ownership statement from each intermediary standing in 
the chain of U's indirect beneficial ownership of shares in A, i.e., 
from FT, the depository bank and B. In the alternative, A must obtain 
under paragraph (b)(3)(ii) of this section an intermediary verification 
statement issued by the depository bank and an intermediary ownership 
statement from the bank and from B, which, in this example, are the only 
intermediaries standing in the chain of ownership of the verifying 
intermediary (i.e., the depository bank).
    Example 3. Assume the same facts as in Example 1. In addition, 
assume that foreign corporation A chooses to obtain documentation with 
respect to individuals U and W. With respect to U, A must obtain the 
same documentation that is described in Example 2. With respect to W, A 
must obtain, under paragraph (b)(3)(i) of this section, individual 
documentation regarding W and an intermediary ownership statement from 
each intermediary standing in the chain of W's indirect beneficial 
ownership of shares in A, i.e., from individual Z, foreign corporation 
C, the depository bank in the foreign treaty country, and foreign 
corporation D. In the alternative, A must obtain, under paragraph 
(b)(3)(ii) of this section, either--
    (i) An intermediary verification statement by the depository bank in 
the foreign treaty country and an intermediary ownership statement from 
the bank and from D; or
    (ii) An intermediary verification statement from Z and an 
intermediary ownership statement from Z and from each intermediary 
standing in the chain of ownership of shares in foreign corporation A, 
i.e., from C, the depository bank in the foreign treaty country and D. C 
may not issue an intermediary verification statement because it is not a 
resident of a country with which the United States has an income tax 
treaty.

    (c) Base erosion. A foreign corporation satisfies the requirement 
relating to base erosion for a taxable year if it establishes that less 
than 50 percent of its income for the taxable year is used

[[Page 603]]

(directly or indirectly) to make deductible payments in the current 
taxable year to persons who are not residents (or, in the case of 
foreign corporations, qualified residents) of the foreign country of 
which the foreign corporation is a resident and who are not citizens or 
residents (or, in the case of domestic corporations, qualified 
residents) of the United States. Whether a domestic corporation is a 
qualified resident of the United States shall be determined under the 
principles of this section. For purposes of this paragraph (c), the term 
``deductible payments'' includes payments that would be ordinarily 
deductible under U.S. income tax principles without regard to other 
provisions of the Code that may require the capitalization of the 
expense, or disallow or defer the deduction. Such payments include, for 
example, interest, rents, royalties and reinsurance premiums. For 
purposes of this paragraph (c), the income of a foreign corporation 
means the corporation's gross income for the taxable year (or, if the 
foreign corporation has no gross income for the taxable year, the 
average of its gross income for the three previous taxable years) under 
U.S. tax principles, but not excluding items of income otherwise 
excluded from gross income under U.S. tax principles.
    (d) Publicly-traded corporations--(1) General rule. A foreign 
corporation that is a resident of a foreign country shall be treated as 
a qualified resident of that country for any taxable year in which--
    (i) Its stock is primarily and regularly traded (as defined in 
paragraphs (d) (3) and (4) of this section) on one or more established 
securities markets (as defined in paragraph (d)(2) of this section) in 
that country, or in the United States, or both; or
    (ii) At least 90 percent of the total combined voting power of all 
classes of stock of such foreign corporation entitled to vote and at 
least 90 percent of the total value of the stock of such foreign 
corporation is owned, directly or by application of paragraph (b)(2) of 
this section, by a foreign corporation that is a resident of the same 
foreign country or a domestic corporation and the stock of such parent 
corporation is primarily and regularly traded on an established 
securities market in that foreign country or in the United States, or 
both.
    (2) Established securities market--(i) General rule. For purposes of 
section 884, the term ``established securities market'' means, for any 
taxable year--
    (A) A foreign securities exchange that is officially recognized, 
sanctioned, or supervised by a governmental authority of the country in 
which the market is located, is the principal exchange in that country, 
and has an annual value of shares traded on the exchange exceeding $1 
billion during each of the three calendar years immediately preceding 
the beginning of the taxable year;
    (B) A national securities exchange that is registered under section 
6 of the Securities Act of 1934 (15 U.S.C. 78f); and
    (C) A domestic over-the-counter market (as defined in paragraph 
(d)(2)(iv) of this section).
    (ii) Exchanges with multiple tiers. If a principal exchange in a 
foreign country has more than one tier or market level on which stock 
may be separately listed or traded, each such tier shall be treated as a 
separate exchange.
    (iii) Computation of dollar value of stock traded. For purposes of 
paragraph (d)(2)(i)(A) of this section, the value in U.S. dollars of 
shares traded during a calendar year shall be determined on the basis of 
the dollar value of such shares traded as reported by the International 
Federation of Stock Exchanges, located in Paris, or, if not so reported, 
then by converting into U.S. dollars the aggregate value in local 
currency of the shares traded using an exchange rate equal to the 
average of the spot rates on the last day of each month of the calendar 
year.
    (iv) Definition of over-the-counter market. An over-the-counter 
market is any market reflected by the existence of an interdealer 
quotation system. An interdealer quotation system is any system of 
general circulation to brokers and dealers that regularly disseminates 
quotations of stocks and securities by identified brokers or dealers, 
other than by quotation sheets that are prepared and distributed by a 
broker or dealer in the regular course of business

[[Page 604]]

and that contain only quotations of such broker or dealer.
    (v) Discretion to determine that an exchange qualifies as an 
established securities market. The Commissioner may, in his sole 
discretion, determine in a published document that a securities exchange 
that does not meet the requirements of paragraph (d)(2)(i)(A) of this 
section qualifies as an established securities market. Such a 
determination will be made only if it is established that--
    (A) The exchange, in substance, has the attributes of an established 
securities market (including adequate trading volume, and comparable 
listing and financial disclosure requirements);
    (B) The rules of the exchange ensure active trading of listed 
stocks; and
    (C) The exchange is a member of the International Federation of 
Stock Exchanges.
    (vi) Discretion to determine that an exchange does not qualify as an 
established securities market. The Commissioner may, in his sole 
discretion, determine in a published document that a securities exchange 
that meets the requirements of paragraph (d)(2)(i) of this section does 
not qualify as an established securities market. Such determination 
shall be made if, in the view of the Commissioner--
    (A) The exchange does not have adequate listing, financial 
disclosure, or trading requirements (or does not adequately enforce such 
requirements); or
    (B) There is not clear and convincing evidence that the exchange 
ensures the active trading of listed stocks.
    (3) Primarily traded. For purposes of this section, stock of a 
corporation is ``primarily traded'' on one or more established 
securities markets in the corporation's country of residence or in the 
United States in any taxable year if, with respect to each class 
described in paragraph (d)(4)(l)(i)(A) of this section (relating to 
classes of stock relied on to meet the regularly traded test)--
    (i) The number of shares in each class that are traded during the 
taxable year on all established securities markets in the corporation's 
country of residence or in the United States during the taxable year 
exceeds
    (ii) The number of shares in each such class that are traded during 
that year on established securities markets in any other single foreign 
country.
    (4) Regularly traded--(i) General rule. For purposes of this 
section, stock of a corporation is ``regularly traded'' on one or more 
established securities markets in the foreign corporation's country of 
residence or in the United States for the taxable year if--
    (A) One or more classes of stock of the corporation that, in the 
aggregate, represent 80 percent or more of the total combined voting 
power of all classes of stock of such corporation entitled to vote and 
of the total value of the stock of such corporation are listed on such 
market or markets during the taxable year;
    (B) With respect to each class relied on to meet the 80 percent 
requirement of paragraph (d)(4)(i)(A) of this section--
    (1) Trades in each such class are effected, other than in de minimis 
quantities, on such market or markets on at least 60 days during the 
taxable year (or \1/6\ of the number of days in a short taxable year); 
and
    (2) The aggregate number of shares in each such class that is traded 
on such market or markets during the taxable year is at least 10 percent 
of the average number of shares outstanding in that class during the 
taxable year (or, in the case of a short taxable year, a percentage that 
equals at least 10 percent of the number of days in the short taxable 
year divided by 365).


If stock of a foreign corporation fails the 80 percent requirement of 
paragraph (d)(4)(i)(A) of this section, but a class of such stock meets 
the trading requirements of paragraph (d)(4)(i)(B) of this section, such 
class of stock may be taken into account under paragraph (b)(1)(iii) of 
this section as owned by qualifying shareholders for purposes of meeting 
the ownership test of paragraph (b)(1) of this section.
    (ii) Classes of stock traded on a domestic established securities 
market treated as meeting trading requirements. A class of stock that is 
traded during the taxable year on an established securities market 
located in the United States shall be treated as meeting the trading 
requirements of paragraph (d)(4)(i)(B) of this section if the stock is 
regularly quoted by brokers or dealers making a

[[Page 605]]

market in the stock. A broker or dealer makes a market in a stock only 
if the broker or dealer holds himself out to buy or sell the stock at 
the quoted price.
    (iii) Closely-held classes of stock not treated as meeting trading 
requirement--(A) General rule. A class of stock shall not be treated as 
meeting the trading requirements of paragraph (d)(4)(i)(B) of this 
section (or the requirements of paragraph (d)(4)(ii) of this section) 
for a taxable year if, at any time during the taxable year, one or more 
persons who are not qualifying shareholders (as defined in paragraph 
(b)(1) of this section) and who each beneficially own 5 percent or more 
of the value of the outstanding shares of the class of stock own, in the 
aggregate, 50 percent or more of the outstanding shares of the class of 
stock for more than 30 days during the taxable year. For purposes of the 
preceding sentence, shares shall not be treated as owned by a qualifying 
shareholder unless such shareholder provides to the foreign corporation, 
by the time prescribed in paragraph (b)(3) of this section, the 
documentation described in paragraph (b)(3) of this section necessary to 
establish that it is a qualifying shareholder. For purposes of this 
paragraph (d)(4)(iii)(A), shares of stock owned by a pension fund, as 
defined in paragraph (b)(8)(i)(A) of this section, shall be treated as 
beneficially owned by the beneficiaries of such fund, as defined in 
paragraph (b)(8)(i)(B) of this section.
    (B) Treatment of related persons. Persons related within the meaning 
of section 267(b) shall be treated as one person for purposes of this 
paragraph (d)(4)(iii). In determining whether two or more corporations 
are members of the same controlled group under section 267(b)(3), a 
person is considered to own stock owned directly by such person, stock 
owned with the application of section 1563(e)(1), and stock owned with 
the application of section 267(c). Further, in determining whether a 
corporation is related to a partnership under section 267(b)(10), a 
person is considered to own the partnership interest owned directly by 
such person and the partnership interest owned with the application of 
section 267(e)(3).
    (iv) Anti-abuse rule. Trades between persons described in section 
267(b) (as modified in paragraph (d)(4)(iii)(B) of this section) and 
trades conducted in order to meet the requirements of paragraph 
(d)(4)(i)(B) of this section shall be disregarded. A class of stock 
shall not be treated as meeting the trading requirements of paragraph 
(d)(4)(i)(B) of this section if there is a pattern of trades conducted 
to meet the requirements of that paragraph. For example, trades between 
two persons that occur several times during the taxable year my be 
treated as an arrangement or a pattern of trades conducted to meet the 
trading requirements of paragraph (d)(4)(i)(B) of this section.
    (5) Burden of proof for publicly-traded corporations. A foreign 
corporation that relies on this paragraph (d) to establish that it is a 
qualified resident of a country with which the United States has an 
income tax treaty shall have the burden of proving all the facts 
necessary for the corporation to be treated as a qualified resident, 
except that with respect to paragraphs (d)(4) (iii) and (iv) of this 
section, a foreign corporation, with either registered or bearer shares, 
will meet the burden of proof if it has no reason to know and no actual 
knowledge of facts that would cause the corporation's stock not to be 
treated as regularly traded under such paragraphs. A foreign corporation 
that has shareholders of record must also maintain a list of such 
shareholders and, on request, make available to the District Director 
such list and any other relevant information known to the foreign 
corporation.
    (e) Active trade or business--(1) General rule. A foreign 
corporation that is a resident of a foreign country shall be treated as 
a qualified resident of that country with respect to any U.S. trade or 
business if, during the taxable year--
    (i) It is engaged in the active conduct of a trade or business (as 
defined in paragraph (e)(2) of this section) in its country of 
residence;
    (ii) It has a substantial presence (within the meaning of paragraph 
(e)(3) of this section) in its country of residence; and

[[Page 606]]

    (iii) Either--
    (A) Such U.S. trade or business is an integral part (as defined in 
paragraph (e)(4) of this section) of an active trade or business 
conducted by the foreign corporation in its country of residence; or
    (B) In the case of interest received by the foreign corporation for 
which a treaty exemption or rate reduction is claimed pursuant to Sec.  
1.884-4(b)(8)(ii), the interest is derived in connection with, or is 
incidental to, a trade or business described in paragraph (e)(1)(i) of 
this section.


A foreign corporation may determine whether it is a qualified resident 
under this paragraph (e) by applying the rules of this paragraph (e) to 
the entire affiliated group (as defined in section 1504 (a) without 
regard to section 1504(b)(2) or (3)) of which the foreign corporation is 
a member rather than to the foreign corporation separately. If a foreign 
corporation chooses to apply the rules of this paragraph (e) to its 
entire affiliated group as provided in the preceding sentence, then it 
must apply such rules consistently to all of its U.S. trades or 
businesses conducted during the taxable year.
    (2) Active conduct of a trade or business. A foreign corporation is 
engaged in the active conduct of a trade or business only if either--
    (i) It is engaged in the active conduct of a trade or business 
within the meaning of section 367(a)(3) and the regulations thereunder; 
or
    (ii) It qualifies as a banking or financing institution under the 
laws of the foreign country of which it is a resident, it is licensed to 
do business with residents of its country of residence, and it is 
engaged in the active conduct of a banking, financing, or similar 
business within the meaning of Sec.  1.864-4(c)(5)(i) in its country of 
residence.


A foreign corporation that is an insurance company within the meaning of 
Sec.  1.801-3 (a) or (b) is engaged in the active conduct of a trade or 
business only if it is predominantly engaged in the active conduct of an 
insurance business within the meaning of section 952(c)(1)(B)(v) and the 
regulations thereunder.
    (3) Substantial presence test--(i) General rule. Except as provided 
in paragraph (e)(3)(ii) of this section, a foreign corporation that is 
engaged in the active conduct of a trade or business in its country of 
residence has a substantial presence in that country if, for the taxable 
year, the average of the following three ratios exceeds 25 percent and 
each ratio is at least equal to 20 percent--
    (A) The ratio of the value of the assets of the foreign corporation 
used or held for use in the active conduct of a trade or business in its 
country of residence at the close of the taxable year to the value of 
all assets of the foreign corporation at the close of the taxable year;
    (B) The ratio of gross income from the active conduct of the foreign 
corporation's trade or business in its country of residence that is 
derived from sources within such country for the taxable year to the 
worldwide gross income of the foreign corporation for the taxable year; 
and
    (C) The ratio of the payroll expenses in the foreign corporation's 
country of residence for the taxable year to the foreign corporation's 
worldwide payroll expenses for the taxable year.
    (ii) Special rules--(A) Asset ratio. For purposes of paragraph 
(e)(3)(i)(A) of this section, the value of an asset shall be determined 
using the method used by the taxpayer in keeping its books for purposes 
of financial reporting in its country of residence. An asset shall be 
treated as used or held for use in a foreign corporation's trade or 
business if it meets the requirements of Sec.  1.367(a)-2(d)(5). Stock 
held by a foreign corporation shall not be treated as an asset of the 
foreign corporation for purposes of paragraph (e)(3)i)(A) of this 
section if the foreign corporation owns 10 percent or more of the total 
combined voting power of all classes of stock of such corporation 
entitled to vote. The rules of Sec.  1.954-2T(b)(3) (other than Sec.  
1.954-2T(b)(3)(x)) shall apply to determine the location of assets used 
or held for use in a trade or business. Loans originated or acquired in 
the course of the normal customer loan activities of a banking, 
financing or similar institution, and securities and derivative 
financial instruments held by

[[Page 607]]

dealers, traders and insurance companies for use in a trade or business 
shall be treated as located in the country in which an office or other 
fixed place of business is primarily responsible for the acquisition of 
the asset and the realization of income, gain or loss with respect to 
the asset.
    (B) Gross income ratio--(1) General rule. For purposes of paragraph 
(e)(3)(i)(B) of this section, the term ``gross income'' means the gross 
income of a foreign corporation for purposes of financial reporting in 
its country of residence. Gross income shall not include, however, 
dividends, interest, rent, or royalties unless such corporation derives 
such dividends, interest, rents, or royalties in the active conduct of 
its trade or business. Gross income shall also not include gain from the 
disposition of stock if the foreign corporation owns 10 percent or more 
of the total combined voting power of all classes of stock of such 
corporation entitled to vote. Except as provided in this paragraph 
(e)(3)(ii)(B), the principles of sections 861 through 865 shall apply to 
determine the amount of gross income of a foreign corporation derived 
within its country of residence.
    (2) Banks, dealers and traders. Dividend income and gain from the 
sale of securities, or from entering into or disposing of derivative 
financial instruments by dealers and traders in such securities or 
derivative financial instruments shall be treated as derived within the 
country where the assets are located under paragraph (e)(3)(ii)(A) of 
this section. Other income, including interest and fees, earned in the 
active conduct of a banking, financing or similar business shall be 
treated as derived within the country where the payor of such interest 
or other income resides. For purposes of the preceding sentence, if a 
branch or similar establishment outside the country in which the payor 
resides makes a payment of interest or other income, such amounts shall 
be treated as derived within the country in which the branch or similar 
establishment is located.
    (3) Insurance companies. The gross income of a foreign insurance 
company shall include only gross premiums received by the country.
    (4) Other corporations. Gross income from the performance of 
services, including transportation services, shall be treated as derived 
within the country of residence of the person for whom the services are 
performed. Gross income from the sale of property by a foreign 
corporation shall be treated as derived within the country in which the 
purchaser resides.
    (5) Anti-abuse rule. The Commissioner may disregard the source of 
income from a transaction determined under this paragraph (e)(3)(ii)(B) 
if it is determined that one of the principal purposes of the 
transaction was to increase the source of income derived within the 
country of residence of the foreign corporation for purposes of this 
section.
    (C) Payroll ratio. For purposes of paragraph (e)(3)(i)(C) of this 
section, the payroll expenses of a foreign corporation shall include 
expenses for ``leased employees'' (within the meaning of section 
414(n)(2) but without regard to subdivision (B) of that section) and 
commission expenses paid to employees and agents for services performed 
for or on behalf of the corporation. Payroll expense for an employee, 
agent or a ``leased employee'' shall be treated as incurred where the 
employee, agent or ``leased employee'' performs services on behalf of 
the corporation.
    (iii) Exception to gross income test for foreign corporations 
engaged in certain trades or businesses. In determining whether a 
foreign corporation engaged primarily in selling tangible property or in 
manufacturing, producing, growing, or extracting tangible property has a 
substantial presence in its country of residence for purposes of 
paragraph (e)(3)(i) of this section, the foreign corporation may apply 
the ratio provided in this paragraph (e)(3)(iii) instead of the ratio 
described in paragraph (e)(3)(i)(B) of this section (relating to the 
ratio of gross income derived from its country of residence). This ratio 
shall be the ratio of the direct material costs of the foreign 
corporation with respect to tangible property manufactured, produced, 
grown, or extracted in the foreign corporation's country of residence to 
the total direct

[[Page 608]]

material costs of the foreign corporation.
    (4) Integral part of an active trade or business in a foreign 
corporation's country of residence--(i) In general. A U.S. trade or 
business of a foreign corporation is an integral part of an active trade 
or business conducted by a foreign corporation in its country of 
residence if the active trade or business conducted by the foreign 
corporation in both its country of residence and in the United States 
comprise, in principal part, complementary and mutually interdependent 
steps in the United States and its country of residence in the 
production and sale or lease of goods or in the provision of services. 
Subject to the presumption and de minimis rule in paragraphs (e)(4) 
(iii) and (iv) of this section, if a U.S. trade or business of a foreign 
corporation sells goods that are not, in principal part, manufactured, 
produced, grown, or extracted by the foreign corporation in its country 
of residence, such business shall not be treated as an integral part of 
an active trade or business conducted in the foreign corporation's 
country of residence unless the foreign corporation takes physical 
possession of the goods in a warehouse or other storage facility that is 
located in its country of residence and in which goods of such type are 
normally stored prior to sale to customers in such country.
    (ii) Presumption for banks. A U.S. trade or business of a foreign 
corporation that is described in Sec.  1.884-4(a)(2)(iii) shall be 
presumed to be an integral part of an active banking business conducted 
by the foreign corporation in its country of residence provided that a 
substantial part of the business of the foreign corporation in both its 
country of residence and the United States consists of receiving 
deposits and making loans and discounts. This paragraph shall be 
effective for taxable years beginning on or after June 6, 1996.
    (iii) Presumption if business principally conducted in country of 
residence. A U.S. trade or business of a foreign corporation shall be 
treated as an integral part of an active trade or business of a foreign 
corporation in its country or residence with respect to the sale or 
lease of property (or the performance of services) if at least 50 
percent of the foreign corporation's worldwide gross income from the 
sale or lease of property of the type sold in the United States (or from 
the performance of services of the type performed in the United States) 
is derived from the sale or lease of such property for consumption, use, 
or disposition in the foreign corporation's country of residence (or 
from the performance of such services in the foreign corporation's 
country of residence). In determining whether property or services are 
of the same type, a foreign corporation shall follow recognized industry 
or trade usage or the three-digit major groups (or any narrower 
classification) of the Standard Industrial Classification as prepared by 
the Statistical Policy Division of the Office of Management and Budget, 
Executive Office of the President. The determination of whether income 
is of the same kind must be made in a consistent manner from year to 
year.
    (iv) De minimis rule. If a foreign corporation is engaged in more 
than one U.S. trade or business and if at least 80 percent of the sum of 
the ECEP from the current year and the preceding two years is 
attributable to one or more trades or businesses that meet the integral 
part test of this paragraph (e)(4), all of the U.S. trades or businesses 
of the foreign corporation shall be treated as an integral part of an 
active or business conducted by the foreign corporation. If a foreign 
corporation has more than one U.S. trade or business and does not meet 
the requirements of the preceding sentence but otherwise meets the 
requirements of this paragraph (e)(4) with regard to one or more trade 
or business, see Sec.  1.884-1(g)(1) to determine the extent to which 
treaty benefits apply to such corporation.
    (f) Qualified resident ruling--(1) Basis for ruling. In his or her 
sole discretion, the Commissioner may rule that a foreign corporation is 
a qualified resident of its country or residence if the Commissioner 
determines that individuals who are not residents of the foreign country 
of which the foreign corporation is a resident do not use the treaty 
between that country and the United States in a manner inconsistent with

[[Page 609]]

the purposes of section 884. The purposes of section 884 include, but 
are not limited to, the prevention of treaty shopping by an individual 
with respect to any article of an income tax treaty between the country 
of residence of the foreign corporation and the United States.
    (2) Factors. In order to make this determination, the Commissioner 
may take into account the following factors, including, but not limited 
to:
    (i) The business reasons for establishing and maintaining the 
foreign corporation in its country of residence;
    (ii) The date of incorporation of the foreign corporation in 
relation to the date that an income tax treaty between the United States 
and the foreign corporation's country of residence entered into force;
    (iii) The continuity of the historical business and ownership of the 
foreign corporation;
    (iv) The extent to which the foreign corporation meets the 
requirements of one or more of the tests described in paragraphs (b) 
through (e) of this section;
    (v) The extent to which the U.S. trade or business is dependent on 
capital, assets, or personnel of the foreign trade or business;
    (vi) The extent to which the foreign corporation receives special 
tax benefits in its country of residence;
    (vii) Whether the foreign corporation is a member of an affiliated 
group (as defined in section 1504(a) without regard to section 
1504(b)(2) or (3)), that has no members resident outside the country of 
residence of the foreign corporation; and
    (viii) The extent to which the foreign corporation would be entitled 
to comparable treaty benefits with respect to all articles of an income 
tax treaty that would apply to that corporation if it had been 
incorporated in the country or countries of residence of the majority of 
its shareholders. For purposes of the preceding sentence, shareholders 
taken into account shall generally be limited to persons described in 
paragraph (b)(1)(i) of this section but for the fact that they are not 
residents of the foreign corporation's country of residence.
    (3) Procedural requirements. A request for a ruling under this 
paragraph (f) must be submitted on or before the due date (including 
extensions) of the foreign corporation's income tax return for the 
taxable year for which the ruling is requested. A foreign corporation 
receiving a ruling will be treated as a qualified resident of its 
country of residence for the taxable year for which the ruling is 
requested and for the succeeding two taxable years. If there is a 
material change in any fact that formed the basis of the ruling, such as 
the ownership or the nature of the trade or business of the foreign 
corporation, the foreign corporation must notify the Secretary within 90 
days of such change and submit a new private letter ruling request. The 
Commissioner will then rule whether the change affects the foreign 
corporation's status as a qualified resident, and such ruling will be 
valid for the taxable year in which the material change occurred and the 
two succeeding taxable years, subject to the requirement in the 
preceding sentence to notify the Commissioner of a material change.
    (g) Effective dates. Except as provided in paragraph (e)(4)(ii) of 
this section, this section is effective for taxable years beginning on 
or after October 13, 1992. With respect to a taxable year beginning 
before October 13, 1992, and after December 31, 1986, a foreign 
corporation may elect to apply this section in lieu of the temporary 
regulations under 1.884-5T (as contained in the CFR edition revised as 
of April 1, 1992), but only if the statute of limitations for assessment 
of a deficiency has not expired for that taxable year. Once an election 
has been made, an election shall apply to all subsequent taxable years.
    (h) Transition rule. If a foreign corporation elects to apply this 
section in lieu of Sec.  1.884-5T (as contained in the CFR edition 
revised as of April 1, 1992) as provided in paragraph (g) of this 
section, and the application of paragraph (b) of this section results in 
additional documentation requirements in order for the foreign 
corporation to be treated as a qualified resident, the foreign

[[Page 610]]

corporation must obtain the documentation required under that paragraph 
on or before March 11, 1993.

[T.D. 8432, 57 FR 41666, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9343, Mar. 8, 
1996; 61 FR 14248, Apr. 1, 1996; T.D. 9803, 81 FR 91030, Dec. 16, 2016]

                        miscellaneous provisions



Sec.  1.891  Statutory provisions; doubling of rates of tax on citizens 
and corporations of certain foreign countries.

    Sec. 891. Doubling of rates of tax on citizens and corporations of 
certain foreign countries. Whenever the President finds that, under the 
laws of any foreign country, citizens or corporations of the United 
States are being subjected to discriminatory or extraterritorial taxes, 
the President shall so proclaim and the rates of tax imposed by sections 
1, 3, 11, 802, 821, 831, 852, 871, and 881 shall, for the taxable year 
during which such proclamation is made and for each taxable year 
thereafter, be doubled in the case of each citizen and corporation of 
such foreign country; but the tax at such doubled rate shall be 
considered as imposed by such sections as the case may be. In no case 
shall this section operate to increase the taxes imposed by such 
sections (computed without regard to this section) to an amount in 
excess of 80 percent of the taxable income of the taxpayer (computed 
without regard to the deductions allowable under section 151 and under 
part VIII of subchapter B). Whenever the President finds that the laws 
of any foreign country with respect to which the President has made a 
proclamation under the preceding provisions of this section have been 
modified so that discriminatory and extraterritorial taxes applicable to 
citizens and corporations of the United States have been removed, he 
shall so proclaim, and the provisions of this section providing for 
doubled rates of tax shall not apply to any citizen or corporation of 
such foreign country with respect to any taxable year beginning after 
such proclamation is made.

(Sec. 891 as amended by sec. 5(6), Life Insurance Company Tax Act 1955 
(70 Stat. 49); sec. 3(f)(1), Life Insurance Company Income Tax Act 1959 
(73 Stat. 140))

[T.D. 6610, 27 FR 8723, Aug. 31, 1962]



Sec.  1.892-1T  Purpose and scope of regulations (temporary regulations).

    (a) In general. These regulations provide guidance with respect to 
the taxation of income derived by foreign governments and international 
organizations from sources within the United States. Under section 892, 
certain specific types of income received by foreign governments are 
excluded from gross income and are exempt, unless derived from the 
conduct of a commercial activity or received from or by a controlled 
commercial entity. This section sets forth the effective date of the 
regulations. Section 1.892-2T defines a foreign government. In 
particular it describes the extent to which either an integral part of a 
foreign sovereign or an entity which is not an integral part of a 
foreign sovereign will be treated as a foreign government for purposes 
of section 892. Section 1.892-3T describes the types of income that 
generally qualify for exemption and certain limitations on the 
exemption. Section 1.892-4T provides rules concerning the 
characterization of activities as commercial activities. Section 1.892-
5T defines a controlled commercial entity. Section 1.892-6T sets forth 
the extent to which income of international organizations from sources 
within the United States is excluded from gross income and is exempt 
from taxation. Section 1.892-7T sets forth the relationship of section 
892 to other Internal Revenue Code sections.
    (b) Effective date. The regulations set forth in Sec. Sec.  1.892-1T 
through 1.892-7T apply to income received by a foreign government on or 
after July 1, 1986. No amount of income shall be required to be deducted 
and withheld, by reason of the amendment of section 892 by section 1247 
of the Tax Reform Act of 1986 (Pub. L. 99-514, 100 Stat. 2085, 2583) 
from any payment made before October 22, 1986.

[T.D. 8211, 53 FR 24061, June 27, 1988; 53 FR 27595, July 21, 1988]



Sec.  1.892-2T  Foreign government defined (temporary regulations).

    (a) Foreign government--(1) Definition. The term ``foreign 
government'' means only the integral parts or controlled entities of a 
foreign sovereign.
    (2) Integral part. An ``integral part'' of a foreign sovereign is 
any person, body of persons, organization, agency, bureau, fund, 
instrumentality, or other body, however designated, that constitutes a 
governing authority of a foreign country. The net earnings of the

[[Page 611]]

governing authority must be credited to its own account or to other 
accounts of the foreign sovereign, with no portion inuring to the 
benefit of any private person. An integral part does not include any 
individual who is a sovereign, official, or administrator acting in a 
private or personal capacity. Consideration of all the facts and 
circumstances will determine whether an individual is acting in a 
private or personal capacity.
    (3) Controlled entity. The term ``controlled entity'' means an 
entity that is separate in form from a foreign sovereign or otherwise 
constitute a separate juridical entity if it satisfies the following 
requirements:
    (i) It is wholly owned and controlled by a foreign sovereign 
directly or indirectly through one or more controlled entities;
    (ii) It is organized under the laws of the foreign sovereign by 
which owned;
    (iii) Its net earnings are credited to its own account or to other 
accounts of the foreign sovereign, with no portion of its income inuring 
to the benefit of any private person; and
    (iv) Its assets vest in the foreign sovereign upon dissolution.


A controlled entity does not include partnerships or any other entity 
owned and controlled by more than one foreign sovereign. Thus, a foreign 
financial organization organized and wholly owned and controlled by 
several foreign sovereigns to foster economic, financial, and technical 
cooperation between various foreign nations is not a controlled entity 
for purposes of this section.
    (b) Inurement to the benefit of private persons. For purposes of 
this section, income will be presumed not to inure to the benefit of 
private persons if such persons (within the meaning of section 
7701(a)(1)) are the intended beneficiaries of a governmental program 
which is carried on by the foreign sovereign and the activities of which 
constitute governmental functions (within the meaning of Sec.  1.892-
4T(c)(4)). Income will be considered to inure to the benefit of private 
persons if such income benefits:
    (1) Private persons through the use of a governmental entity as a 
conduit for personal investment; or
    (2) Private persons who divert such income from its intended use by 
the exertion of influence or control through means explicitly or 
implicitly approved of by the foreign sovereign.
    (c) Pension trusts--(1) In general. A controlled entity includes a 
separately organized pension trust if it meets the following 
requirements:
    (i) The trust is established exclusively for the benefit of (A) 
employees or former employees of a foreign government or (B) employees 
or former employees of a foreign government and non-governmental 
employees or former employees that perform or performed governmental or 
social services;
    (ii) The funds that comprise the trust are managed by trustees who 
are employees of, or persons appointed by, the foreign government;
    (iii) The trust forming a part of the pension plan provides for 
retirement, disability, or death benefits in consideration for prior 
services rendered; and
    (iv) Income of the trust satisfies the obligations of the foreign 
government to participants under the plan, rather than inuring to the 
benefit of a private person.


Income of a pension trust is subject to the rules of Sec.  1.892-
5T(b)(3) regarding the application of the rules for controlled 
commercial entities to pension trusts. Income of a superannuation or 
similar pension fund of an integral part or controlled entity (which is 
not a separate pension trust as defined in this paragraph (c)(1)) is 
subject to the rules that generally apply to a foreign sovereign. Such a 
pension fund may also benefit non-governmental employees or former 
employees that perform or performed governmental or social services.
    (2) Illustrations. The following examples illustrate the application 
of paragraph (c)(1).

    Example 1. The Ministry of Welfare (MW), an integral part of foreign 
sovereign FC, instituted a retirement plan for FC's employees and former 
employees. Retirement benefits under the plan are based on a percentage 
of the final year's salary paid to an individual, times the number of 
years of government service. Pursuant to the plan, contributions are 
made by MW to a pension trust managed by persons appointed by MW to the 
extent actuarially necessary to fund accrued pension liabilities. The 
pension trust

[[Page 612]]

in turn invests such contributions partially in United States Treasury 
obligations. The income of the trust is credited to the trust's account 
and subsequently used to satisfy the pension plan's obligations to 
retired employees. Under these circumstances, the income of the trust is 
not deemed to inure to the benefit of private persons. Accordingly, the 
trust is considered a controlled entity of FC.
    Example 2. The facts are the same as in Example 1, except that the 
retirement plan also benefits employees performing governmental or 
social services for the following non-government institutions: (i) A 
university in a local jurisdiction; (ii) a harbor commission; and (iii) 
a library system. The retirement benefits under the plan are based on 
the total amounts credited to an individual's account over the term of 
his or her employment. MW makes annual contributions to each covered 
employee's account equal to a percentage of annual compensation. In 
addition, the income derived from investment of the annual contributions 
is credited annually to individual accounts. The annual contributions do 
not exceed an amount that is determined to be actuarially necessary to 
provide the employee with reasonable retirement benefits. 
Notwithstanding that retirement benefits vary depending upon the 
investment experience of the trust, no portion of the income of the 
trust is deemed to inure to the benefit of private persons. Accordingly, 
the trust is considered a controlled entity of FC.
    Example 3. The facts are the same as in Example 1, except that 
employees are allowed to make unlimited contributions to the trust, and 
such contributions are credited to the employee's account as well as 
interest accrued on such contributions. Retirement benefits will reflect 
the amounts credited to the individual accounts in addition to the usual 
annuity computation based on the final year's salary and years of 
service. A pension plan established under these rules is in part acting 
as an investment conduit. As a result, the income of the trust is deemed 
to inure to the benefit of private persons. Accordingly, the trust is 
not considered a controlled entity of FC.
    Example 4. (a) The facts are the same as in Example 2, except that 
MW establishes a pension fund rather than a separate pension trust. A 
pension fund is merely assets of an integral part or controlled entity 
allocated to a separate account and held and invested for purposes of 
providing retirement benefits. Under these circumstances, the income of 
the pension fund is not deemed to inure to the benefit of private 
persons. Accordingly, income earned from the United States Treasury 
obligations by the pension fund is considered to be received by a 
foreign government and is exempt from taxation under section 892.
    (b) The facts are the same as in Example 4(a), except that MW is a 
controlled entity of foreign sovereign FC. The result is the same as in 
Example 4(a). However, should MW engage in commercial activities 
(whether within or outside the United States), the income from the 
Treasury obligations earned by the pension fund will not be exempt from 
taxation under section 892 since MW will be considered a controlled 
commercial entity within the meaning of Sec.  1.892-5T(a).

    (d) Political subdivision and transnational entity. The rules that 
apply to a foreign sovereign apply to political subdivisions of a 
foreign country and to transnational entities. A transnational entity is 
an organization created by more than one foreign sovereign that has 
broad powers over external and domestic affairs of all participating 
foreign countries stretching beyond economic subjects to those 
concerning legal relations and transcending state or political 
boundaries.

[T.D. 8211, 53 FR 24061, June 27, 1988; 53 FR 27595, July 21, 1988]



Sec.  1.892-3  Income of foreign governments.

    (a)(1)-(5) [Reserved] For further information, see Sec.  1.892-
3T(a)(1) through (a)(5).
    (6) Dividend equivalents. Income from investments in stocks includes 
the payment of a dividend equivalent described in section 871(m) and the 
regulations thereunder.
    (b) [Reserved] For further information, see Sec.  1.892-3T(b).
    (c) Effective/applicability date. Paragraph (a)(6) of this section 
applies to payments made on or after December 5, 2013.

[T.D. 9648, 78 FR 73080, Dec. 5, 2013]



Sec.  1.892-3T  Income of foreign governments (temporary regulations).

    (a) Types of income exempt--(1) In general. Subject to the 
exceptions contained in Sec. Sec.  1.892-4T and 1.892-5T for income 
derived from the conduct of a commercial activity or received from or by 
a controlled commercial entity, the following types of income derived by 
a foreign government (as defined in Sec.  1.892-2T) are not included in 
gross income and are exempt:

[[Page 613]]

    (i) Income from investments in the United States in stocks, bonds, 
or other securities;
    (ii) Income from investments in the United States in financial 
instruments held in the execution of governmental financial or monetary 
policy; and
    (iii) Interest on deposits in banks in the United States of moneys 
belonging to such foreign government.


Income derived from sources other than described in this paragraph (such 
as income earned from a U.S. real property interest described in section 
897(c)(1)(A)(i)) is not exempt from taxation under section 892. 
Furthermore, any gain derived from the disposition a U.S. real property 
interest defined in section 897(c)(1)(A)(i) shall in no event qualify 
for exemption under section 892.
    (2) Income from investments. For purposes of paragraph (a) of this 
section, income from investments in stocks, bonds or other securities 
includes gain from their disposition and income earned from engaging in 
section 1058 securities lending transactions. Gain on the disposition of 
an interest in a partnership or a trust is not exempt from taxation 
under section 892.
    (3) Securities. For purposes of paragraph (a) of this section, the 
term ``other securities'' includes any note or other evidence of 
indebtedness. Thus, an annuity contract, a mortgage, a banker's 
acceptance or a loan are securities for purposes of this section.
    However, the term ``other securities'' does not include partnership 
interests (with the exception of publicly traded partnerships within the 
meaning of section 7704) or trust interests. The term also does not 
include commodity forward or futures contracts and commodity options 
unless they constitute securities for purposes of section 864(b)(2)(A).
    (4) Financial instrument. For purposes of paragraph (a) of this 
section, the term ``financial instrument'' includes any forward, 
futures, options contract, swap agreement or similar instrument in a 
functional or nonfunctional currency (see section 985(b) for the 
definition of functional currency) or in precious metals when held by a 
foreign government or central bank of issue (as defined in Sec.  1.895-
1(b)). Nonfunctional currency or gold shall be considered a ``financial 
instrument'' also when physically held by a central bank of issue.
    (5) Execution of financial or monetary policy--(i) Rule. A financial 
instrument shall be deemed held in the execution of governmental 
financial or monetary policy if the primary purpose for holding the 
instrument is to implement or effectuate such policy.
    (ii) Illustration. The following example illustrates the application 
of this paragraph (a)(5).

    Example. In order to ensure sufficient currency reserves, the 
monetary authority of foreign country FC issues short-term government 
obligations. The amount received from the obligations is invested in 
U.S. financial instruments. Since the primary purpose for obtaining the 
U.S. financial instruments is to implement FC's monetary policy, the 
income received from the financial instruments is exempt from taxation 
under section 892.

    (b) Illustrations. The principles of paragraph (a) of this section 
may be illustrated by the following examples.

    Example 1. X, a foreign corporation not engaged in commercial 
activity anywhere in the world, is a controlled entity of a foreign 
sovereign within the meaning of Sec.  1.892-2T(a)(3). X is not a Central 
bank of issue as defined in Sec.  1.895-1(b). In 1987, X received the 
following items of income from investments in the United States: (i) 
Dividends from a portfolio of publicly traded stocks in U.S. 
corporations in which X owns less than 50 percent of the stock; (ii) 
dividends from BTB Corporation, an automobile manufacturer, in which X 
owns 50 percent of the stock; (iii) interest from bonds issued by 
noncontrolled entities and from interest-bearing bank deposits in 
noncontrolled entities; (iv) rents from a net lease on real property; 
(v) gains from silver futures contracts; (vi) gains from wheat futures 
contracts; (vii) gains from spot sales of nonfunctional foreign currency 
in X's possession; (viii) gains from the disposition of a publicly 
traded partnership interest, and (ix) gains from the disposition of the 
stock of Z Corporation, a United States real property holding company as 
defined in section 897, of which X owns 12 percent of the stock. Only 
income derived from sources described in paragraph (a)(1) of this 
section is treated as income of a foreign government eligible for 
exemption from taxation. Accordingly, only income received by X from 
items (i), (iii), (v) provided that the silver futures contracts are 
held in the execution of governmental financial or monetary policy,

[[Page 614]]

and (ix) is exempt from taxation under section 892.
    Example 2. The facts are the same as in Example 1, except that X is 
also a central bank of issue within the meaning of section 895. Since 
physical possession of nonfunctional foreign currency when held by a 
central bank of issue is considered a financial instrument, the item 
(vii) gains from spot sales of nonfunctional foreign currency are exempt 
from taxation under paragraph (a)(1) of this section, if physical 
possession of the currency was an essential part of X's reserve policy 
in the execution of its governmental financial or monetary policy.
    Example 3. State Concert Bureau, an integral part of a foreign 
sovereign within the meaning of Sec.  1.892-2T(a)(2), entered into an 
agreement with a U.S. corporation engaged in the business of promoting 
international cultural programs. Under the agreement the State Concert 
Bureau agreed to send a ballet troupe on tour for 5 weeks in the United 
States. The Bureau received approximately $60,000 from the performances. 
Regardless of whether the performances themselves constitute commercial 
activities under Sec.  1.892-4T, the income received by the Bureau is 
not exempt from taxation under section 892 since the income is from 
sources other than described in paragraph (a)(1) of this section.

[T.D. 8211, 53 FR 24062, June 27, 1988]



Sec.  1.892-4T  Commercial activities (temporary regulations).

    (a) Purpose. The exemption generally applicable to a foreign 
government (as defined in Sec.  1.892-2T) for income described in Sec.  
1.892-3T does not apply to income derived from the conduct of a 
commercial activity or income received by a controlled commercial entity 
or received (directly or indirectly) from a controlled commercial 
entity. This section provides rules for determining whether income is 
derived from the conduct of a commercial activity. These rules also 
apply in determining under Sec.  1.892-5T whether an entity is a 
controlled commercial entity.
    (b) In general. Except as provided in paragraph (c) of this section, 
all activities (whether conducted within or outside the United States) 
which are ordinarily conducted by the taxpayer or by other persons with 
a view towards the current or future production of income or gain are 
commercial activities. An activity may be considered a commercial 
activity even if such activity does not constitute the conduct of a 
trade or business in the United States under section 864(b).
    (c) Activities that are not commercial--(1) Investments--(i) In 
general. Subject to the provisions of paragraphs (ii) and (iii) of this 
paragraph (c)(1), the following are not commercial activities: 
Investments in stocks, bonds, and other securities; loans; investments 
in financial instruments held in the execution of governmental financial 
or monetary policy; the holding of net leases on real property or land 
which is not producing income (other than on its sale or from an 
investment in net leases on real property); and the holding of bank 
deposits in banks. Transferring securities under a loan agreement which 
meets the requirements of section 1058 is an investment for purposes of 
this paragraph (c)(1)(i). An activity will not cease to be an investment 
solely because of the volume of transactions of that activity or because 
of other unrelated activities.
    (ii) Trading. Effecting transactions in stocks, securities, or 
commodities for a foreign government's own account does not constitute a 
commercial activity regardless of whether such activities constitute a 
trade or business for purposes of section 162 or a U.S. trade or 
business for purposes of section 864. Such transactions are not 
commercial activities regardless of whether they are effected by the 
foreign government through its employees or through a broker, commission 
agent, custodian, or other independent agent and regardless of whether 
or not any such employee or agent has discretionary authority to make 
decisions in effecting the transactions. An activity undertaken as a 
dealer, however, as defined in Sec.  1.864-2(c)(2)(iv)(a) will not be an 
investment for purposes of this paragraph (c)(1)(i). For purposes of 
this paragraph (c)(1)(ii), the term ``commodities'' means commodities of 
a kind customarily dealt in on an organized commodity exchange but only 
if the transaction is of a kind customarily consummated at such place.
    (iii) Banking, financing, etc. Investments (including loans) made by 
a banking, financing, or similar business constitute commercial 
activities, even if the income derived from such investments is not 
considered to be income

[[Page 615]]

effectively connected to the active conduct of a banking, financing, or 
similar business in the U.S. by reason of the application of Sec.  
1.864-4(c)(5).
    (2) Cultural events. Performances and exhibitions within or outside 
the United States of amateur athletic events and events devoted to the 
promotion of the arts by cultural organizations are not commercial 
activities.
    (3) Non-profit activities. Activities that are not customarily 
attributable to or carried on by private enterprise for profit are not 
commercial activities. The fact that in some instances Federal, State, 
or local governments of the United States also are engaged in the same 
or similar activity does not mean necessarily that it is a non-profit 
activity. For example, even though the United States Government may be 
engaged in the activity of operating a railroad, operating a railroad is 
not a non-profit activity.
    (4) Governmental functions. Governmental functions are not 
commercial activities. The term ``governmental functions'' shall be 
determined under U.S. standards. In general, activities performed for 
the general public with respect to the common welfare or which relate to 
the administration of some phase of government will be considered 
governmental functions. For example, the operation of libraries, toll 
bridges, or local transportation services and activities substantially 
equivalent to the Federal Aviation Authority, Interstate Commerce 
Commission, or United States Postal Service will all be considered 
governmental functions for purposes of this section.
    (5) Purchasing. The mere purchasing of goods for the use of a 
foreign government is not a commercial activity.

[T.D. 8211, 53 FR 24063, June 27, 1988]



Sec.  1.892-5  Controlled commercial entity.

    (a)-(a)(2) [Reserved]. For further information, see Sec.  1.892-
5T(a) through (a)(2).
    (3) For purposes of section 892(a)(2)(B), the term entity means and 
includes a corporation, a partnership, a trust (including a pension 
trust described in Sec.  1.892-2T(c)) and an estate.
    (4) Effective date. This section applies on or after January 14, 
2002. See Sec.  1.892-5T(a) for the rules that apply before January 14, 
2002.
    (b)-(d) [Reserved]. For further information, see Sec. Sec.  1.892-
5T(b) through (d).

[T.D. 9012, 67 FR 49864, Aug. 1, 2002]



Sec.  1.892-5T  Controlled commercial entity (temporary regulations).

    (a) In general. The exemption generally applicable to a foreign 
government (as defined in Sec.  1.892-2T) for income described in Sec.  
1.892-3T does not apply to income received by a controlled commercial 
entity or received (directly or indirectly) from a controlled commercial 
entity. The term ``controlled commercial entity'' means any entity 
engaged in commercial activities as defined in Sec.  1.892-4T (whether 
conducted within or outside the United States) if the government--
    (1) Holds (directly or indirectly) any interest in such entity which 
(by value or voting power) is 50 percent or more of the total of such 
interests in such entity, or
    (2) Holds (directly or indirectly) a sufficient interest (by value 
or voting power) or any other interest in such entity which provides the 
foreign government with effective practical control of such entity.
    (3) [Reserved]. For further information, see Sec.  1.892-5(a)(3).
    (b) Entities treated as engaged in commercial activity--(1) U.S. 
real property holding corporations. A United States real property 
holding corporation, as defined in section 897(c)(2) or a foreign 
corporation that would be a United States real property holding 
corporation if it was a United States corporation, shall be treated as 
engaged in commercial activity and, therefore, is a controlled 
commercial entity if the requirements of paragraph (a)(1) or (a)(2) of 
this section are satisfied.
    (2) Central banks. Notwithstanding paragraph (a) of this section, a 
central bank of issue (as defined in Sec.  1.895-1(b)) shall be treated 
as a controlled commercial entity only if it engages in commercial 
activities within the United States.
    (3) Pension trusts. A pension trust, described in Sec.  1.892-2T(c), 
which engages in commercial activities within or outside the United 
States, shall be treated

[[Page 616]]

as a controlled commercial entity. Income derived by such a pension 
trust is not income of a foreign government for purposes of the 
exemption from taxation provided in section 892. A pension trust 
described in Sec.  1.892-2T(c) shall not be treated as a controlled 
commercial entity if such trust solely earns income which would not be 
unrelated business taxable income (as defined in section 512(a)(1)) if 
the trust were a qualified trust described in section 401(a). However, 
only income derived by a pension trust that is described in Sec.  1.892-
3T and which is not from commercial activities as defined in Sec.  
1.892-4T is exempt from taxation under section 892.
    (c) Control--(1) Attribution--(i) Rule. In determining for purposes 
of paragraph (a) of this section the interest held by a foreign 
government, any interest in an entity (whether or not engaged in 
commercial activity) owned directly or indirectly by an integral part or 
controlled entity of a foreign sovereign shall be treated as actually 
owned by such foreign sovereign.
    (ii) Illustration. The following example illustrates the application 
of paragraph (c)(1)(i) of this section.

    Example. FX, a controlled entity of foreign sovereign FC, owns 20 
percent of the stock of Corp 1. Neither FX nor Corp 1 is engaged in 
commercial activity anywhere in the world. Corp 1 owns 60 percent of the 
stock of Corp 2, which is engaged in commercial activity. The remaining 
40 percent of Corp 2's stock is owned by Bureau, an integral part of 
foreign sovereign FC. For purposes of determining whether Corp 2 is a 
controlled commercial entity of FC, Bureau will be treated as actually 
owning the 12 percent of Corp 2's stock indirectly owned by FX. 
Therefore, since Bureau directly and indirectly owns 52 percent of the 
stock of Corp 2, Corp 2 is a controlled commercial entity of FC within 
the meaning of paragraph (a) of this section. Accordingly, dividends or 
other income received, directly or indirectly, from Corp 2 by either 
Bureau or FX will not be exempt from taxation under section 892. 
Furthermore, dividends from Corp 1 to the extent attributable to 
dividends from Corp 2 will not be exempt from taxation. Thus, a 
distribution from Corp 1 to FX shall be exempt only to the extent such 
distribution exceeds Corp 1's earnings and profits attributable to the 
Corp 2 dividend amount received by Corp 1.

    (2) Effective practical control. An entity engaged in commercial 
activity may be treated as a controlled commercial entity if a foreign 
government holds sufficient interests in such entity to give it 
``effective practical control'' over the entity. Effective practical 
control may be achieved through a minority interest which is 
sufficiently large to achieve effective control, or through creditor, 
contractual, or regulatory relationships which, together with ownership 
interests held by the foreign government, achieve effective control. For 
example, an entity engaged in commercial activity may be treated as a 
controlled commercial entity if a foreign government, in addition to 
holding a small minority interest (by value or voting power), is also a 
substantial creditor of the entity or controls a strategic natural 
resource which such entity uses in the conduct of its trade or business, 
giving the foreign government effective practical control over the 
entity.
    (d) Related controlled entities--(1) Brother/sister entities. 
Commercial activities of a controlled entity are not attributed to such 
entity's other brother/sister related entities. Thus, investment income 
described in Sec.  1.892-2T that is derived by a controlled entity that 
is not itself engaged in commercial activity within or outside the 
United States is exempt from taxation notwithstanding the fact that such 
entity's brother/sister related entity is a controlled commercial 
entity.
    (2) Parent/subsidiary entities--(i) Subsidiary to parent 
attribution. Commercial activities of a subsidiary controlled entity are 
not attributed to its parent. Thus, investment income described in Sec.  
1.892-3T that is derived by a parent controlled entity that is not 
itself engaged in commercial activity within or outside the United 
States is exempt from taxation notwithstanding the fact that its 
subsidiary is a controlled commercial entity. Dividends or other 
payments of income received by the parent controlled entity from the 
subsidiary are not exempt under section 892, because it constitutes 
income received from a controlled commercial entity. Furthermore, 
dividends paid by the parent are not exempt to the extent attributable 
to the dividends received by the parent from the subsidiary. Thus, a 
distribution by the

[[Page 617]]

parent shall be exempt only to the extent such distribution exceeds 
earnings and profits attributable to the dividend received from its 
subsidiary.
    (ii) Parent to subsidiary attribution. Commercial activities of a 
parent controlled entity are attributed to its subsidiary. Thus, 
investment income described in Sec.  1.892-3T that is derived by a 
subsidiary controlled entity (not engaged in commercial activity within 
or outside the United States) is not exempt from taxation under section 
892 if its parent is a controlled commercial entity.
    (3) Partnerships. Except for partners of publicly traded 
partnerships, commercial activities of a partnership are attributable to 
its general and limited partners for purposes of section 892. For 
example, where a controlled entity is a general partner in a partnership 
engaged in commercial activities, the controlled entity's distributive 
share of partnership income (including income described in Sec.  1.892-
3T) will not be exempt from taxation under section 892.
    (4) Illustrations. The principles of this section may be illustrated 
by the following examples.

    Example 1. (a) The Ministry of Industry and Development is an 
integral part of a foreign sovereign under Sec.  1.892-2T(a)(2). The 
Ministry is engaged in commercial activity within the United States. In 
addition, the Ministry receives income from various publicly traded 
stocks and bonds, soybean futures contracts and net leases on U.S. real 
property. Since the Ministry is an integral part, and not a controlled 
entity, of a foreign sovereign, it is not a controlled commercial entity 
within the meaning of paragraph (a) of this section. Therefore, income 
described in Sec.  1.892-3T is ineligible for exemption under section 
892 only to the extent derived from the conduct of commercial 
activities. Accordingly, the Ministry's income from the stocks and bonds 
is exempt from U.S. tax.
    (b) The facts are the same as in Example (1)(a), except that the 
Ministry also owns 75 percent of the stock of R, a U.S. holding company 
that owns all the stock of S, a U.S. operating company engaged in 
commercial activity. Ministry's dividend income from R is income 
received indirectly from a controlled commercial entity. The Ministry's 
income from the stocks and bonds, with the exception of dividend income 
from R, is exempt from U.S. tax.
    (c) The facts are the same as in Example (1)(a), except that the 
Ministry is a controlled entity of a foreign sovereign. Since the 
Ministry is a controlled entity and is engaged in commercial activity, 
it is a controlled commercial entity within the meaning of paragraph (a) 
of this section, and none of its income is eligible for exemption.
    Example 2. (a) Z, a controlled entity of a foreign sovereign, has 
established a pension trust as part of a pension plan for the benefit of 
its employees and former employees. The pension trust (T), which meets 
the requirements of Sec.  1.892-2T(c), has investments in the U.S. in 
various stocks, bonds, annuity contracts, and a shopping center which is 
leased and managed by an independent real estate management firm. T also 
makes securities loans in transactions that qualify under section 1058. 
T's investment in the shopping center is not considered an unrelated 
trade or business within the meaning of section 513(b). Accordingly, T 
will not be treated as engaged in commercial activity. Since T is not a 
controlled commercial entity, its investment income described in Sec.  
1.892-3T, with the exception of income received from the operations of 
the shopping center, is exempt from taxation under section 892.
    (b) The facts are the same as Example (2)(a), except that T has an 
interest in a limited partnership which owns the shopping center. The 
shopping center is leased and managed by the partnership rather than by 
an independent management firm. Managing a shopping center, directly or 
indirectly through a partnership of which a trust is a member, would be 
considered an unrelated trade or business within the meaning of section 
513(b) giving rise to unrelated business taxable income. Since the 
commercial activities of a partnership are attributable to its partners, 
T will be treated as engaged in commercial activity and thus will be 
considered a controlled commercial entity. Accordingly, none of T's 
income will be exempt from taxation under section 892.
    (c) The facts are the same as Example (2)(a), except that Z is a 
controlled commercial entity. The result is the same as in Example 
(2)(a).
    Example 3. (a) The Department of Interior, an integral part of 
foreign sovereign FC, wholly owns corporations G and H. G, in turn, 
wholly owns S. G, H and S are each controlled entities. G, which is not 
engaged in commercial activity anywhere in the world, receives interest 
income from deposits in banks in the United States. Both H and S do not 
have any investments in the U.S. but are both engaged in commercial 
activities. However, only S is engaged in commercial activities within 
the United States. Because neither the commercial activities of H nor 
the commercial activities of S are attributable to the Department of 
Interior or G, G's interest income is exempt from taxation under section 
892.
    (b) The facts are the same as Example (3)(a), except that G rather 
than S is engaged

[[Page 618]]

in commercial activities and S rather than G receives the interest 
income from the United States. Since the commercial activities of G are 
attributable to S, S's interest income is not exempt from taxation.
    Example 4. (a) K, a controlled entity of a foreign sovereign, is a 
general partner in the Daj partnership. The Daj partnership has 
investments in the U.S. in various stocks and bonds and also owns and 
manages an office building in New York. K will be deemed to be engaged 
in commercial activity by being a general partner in Daj even if K does 
not actually make management decisions with regard to the partnership's 
commercial activity, the operation of the office building. Accordingly 
K's distributive share of partnership income (including income derived 
from stocks and bonds) will not be exempt from taxation under section 
892.
    (b) The facts are the same as in Example (4)(a), except that the Daj 
partnership has hired a real estate management firm to lease offices and 
manage the building. Notwithstanding the fact that an independent 
contractor is performing the activities, the partnership shall still be 
deemed to be engaged in commercial activity. Accordingly, K's 
distributive share of partnership income (including income derived from 
stocks and bonds) will not be exempt from taxation under section 892.
    (c) The facts are the same as in Example (4)(a), except that K is a 
partner whose partnership interest is considered a publicly traded 
partnership interest within the meaning of section 7704. Under paragraph 
(d)(3) of this section, the partnership's commercial activity will not 
be attributed to K. Since K will not be deemed to be engaged in 
commercial activity, K's distributive share of partnership income 
derived from stocks and bonds will be exempt from taxation under section 
892.

[T.D. 8211, 53 FR 24064, June 27, 1988, as amended by T.D. 9012, 67 FR 
49864, Aug. 1, 2002]



Sec.  1.892-6T  Income of international organizations (temporary regulations).

    (a) Exempt from tax. Subject to the provisions of section 1 of the 
International Organizations Immunities Act (22 U.S.C. 288) (the 
provisions of which are set forth in paragraph (b)(3) of Sec.  1.893-1), 
the income of an international organization (as defined in section 
7701(a)(18)) received from investments in the United States in stocks, 
bonds, or other domestic securities, owned by such international 
organization, or from interest on deposits in banks in the United States 
of moneys belonging to such international organization, or from any 
other source within the United States, is exempt from Federal income 
tax.
    (b) Income received prior to Presidential designation. An 
organization designated by the President through appropriate Executive 
order as entitled to enjoy the privileges, exemptions, and immunities 
provided in the International Organizations Immunities Act may enjoy the 
benefits of the exemption with respect to income of the prescribed 
character received by such organization prior to the date of the 
issuance of such Executive order, if (i) the Executive order does not 
provide otherwise and (ii) the organization is a public international 
organization in which the United States participates, pursuant to a 
treaty or under the authority of an act of Congress authorizing such 
participation or making an appropriation for such participation, at the 
time such income is received.

[T.D. 8211, 53 FR 24065, June 27, 1988]



Sec.  1.892-7T  Relationship to other Internal Revenue Code sections 
(temporary regulations).

    (a) Section 893. The term ``foreign government'' referred to in 
section 893 (relating to the exemption for compensation of employees of 
foreign governments) has the same meaning as given such term in Sec.  
1.892-2T.
    (b) Section 895. A foreign central bank of issue (as defined in 
Sec.  1.895-1(b)) that fails to qualify for the exemption from tax 
provided by this section (for example, it is not wholly owned by a 
foreign sovereign) may nevertheless be exempt from tax on the items of 
income described in section 895.
    (c) Section 883(b). Nothing in section 892 or these regulations 
shall limit the exemption provided under section 883(b) relating 
generally to the exemption of earnings derived by foreign participants 
from the ownership or operation of communications satellite systems.
    (d) Section 884. Earnings and profits attributable to income of a 
controlled entity of a foreign sovereign which is exempt from taxation 
under section 892 shall not be subject to the tax imposed by section 
884(a).

[[Page 619]]

    (e) Sections 1441 and 1442. No withholding is required under 
sections 1441 and 1442 in the case of income exempt from taxation under 
section 892.

[T.D. 8211, 53 FR 24066, June 27, 1988]



Sec.  1.893-1  Compensation of employees of foreign governments 
or international organizations.

    (a) Employees of foreign governments--(1) Exempt from tax. Except to 
the extent that the exemption is limited by the execution and filing of 
the waiver provided for in section 247(b) of the Immigration and 
Nationality Act (8 U.S.C. 1257(b)), all employees of a foreign 
government (including consular or other officers, or nondiplomatic 
representatives) who are not citizens of the United States, or are 
citizens of the Republic of the Philippines (whether or not citizens of 
the United States), are exempt from Federal income tax with respect to 
wages, fees, or salaries received by them as compensation for official 
services rendered to such foreign government, provided (i) the services 
are of a character similar to those performed by employees of the 
Government of the United States in that foreign country and (ii) the 
foreign government whose employees are claiming exemption grants an 
equivalent exemption to employees of the Government of the United States 
performing similar services in that foreign country.
    (2) Certificate by Secretary of State. Section 893(b) provides that 
the Secretary of State shall certify to the Secretary of the Treasury 
the names of the foreign countries which grant an equivalent exemption 
to the employees of the Government of the United States performing 
services in such foreign countries, and the character of the services 
performed by employees of the Government of the United States in foreign 
countries.
    (3) Items not exempt. The income received by employees of foreign 
governments from sources other than their salaries, fees, or wages, 
referred to in subparagraph (1) of this paragraph, is subject to Federal 
income tax.
    (4) Immigration and Nationality Act. Section 247(b) of the 
Immigration and Nationality Act provides as follows:

    Sec. 247. Adjustment of status of certain resident aliens.* * *
    (b) The adjustment of status required by subsection (a) [of section 
247 of the Immigration and Nationality Act] shall not be applicable in 
the case of any alien who requests that he be permitted to retain his 
status as an immigrant and who, in such form as the Attorney General may 
require, executes and files with the Attorney General a written waiver 
of all rights, privileges, exemptions, and immunities under any law or 
any executive order which would otherwise accrue to him because of the 
acquisition of an occupational status entitling him to a nonimmigrant 
status under paragraph (15)(A), (15)(E), or (15)(G) of section 101(a).

    (5) Effect of waiver. An employee of a foreign government who 
executes and files with the Attorney General the waiver provided for in 
section 247(b) of the Immigration and Nationality Act thereby waives the 
exemption conferred by section 893 of the Code. As a consequence, that 
exemption does not apply to income received by that alien after the date 
of filing of the waiver.
    (6) Citizens of the United States. The compensation of citizens of 
the United States (other than those who are also citizens of the 
Republic of the Philippines) who are officers or employees of a foreign 
government is not exempt from income tax pursuant to this paragraph. But 
see section 911 and the regulations thereunder.
    (b) Employees of international organizations--(1) Exempt from tax. 
Except to the extent that the exemption is limited by the execution and 
filing of the waiver provided for in section 247(b) of the Immigration 
and Nationality Act and subject to the provisions of sections 1, 8, and 
9 of the International Organizations Immunities Act (22 U.S.C. 288, 
288e, 288f), wages, fees, or salary of any officer or employee of an 
international organization (as defined in section 7701(a)(18)) received 
as compensation for official services to that international organization 
is exempt from Federal income tax, if that officer or employee (i) is 
not a citizen of the United States or (ii) is a citizen of the Republic 
of the Philippines (whether or not a citizen of the United States).
    (2) Income earned prior to executive action. An individual of the 
prescribed class who receives wages, fees, or salary as compensation for 
official services to an organization designated by

[[Page 620]]

the President through appropriate Executive order as entitled to enjoy 
the privileges, exemptions, and immunities provided in the International 
Organizations Immunities Act and who has been duly notified to, and 
accepted by, the Secretary of State as an officer or employee of that 
organization, or who has been designated by the Secretary of State, 
prior to formal notification and acceptance, as a prospective officer or 
employee of that organization, may enjoy the benefits of the exemption 
with respect to compensation of the prescribed character earned by that 
individual, either prior to the date of the Issuance of the Executive 
order, or prior to the date of the acceptance or designation by the 
Secretary of State, for official services to that organization, if (i) 
the Executive order does not provide otherwise, (ii) the organization is 
a public international organization in which the United States 
participates, pursuant to a treaty or under the authority of an act of 
Congress authorizing such participation or making an appropriation for 
such participation, at the time the compensation is earned, and (iii) 
the individual is an officer or employee of that organization at that 
time.
    (3) International Organizations Immunities Act. Sections 1, 8, and 9 
of the International Organizations Immunities Act (22 U.S.C. 288, 288e, 
288f) provide in part as follows:

    Section 1. For the purposes of this title [International 
Organizations Immunities Act], the term ``international organization'' 
means a public international organization in which the United States 
participates pursuant to any treaty or under the authority of any Act of 
Congress authorizing such participation or making an appropriation for 
such participation, and which shall have been designated by the 
President through appropriate Executive order as being entitled to enjoy 
the privileges, exemptions, and immunities herein provided. The 
President shall be authorized, in the light of the functions performed 
by any such international organization, by appropriate Executive order 
to withhold or withdraw from any such organization or its officers or 
employees any of the privileges, exemptions, and immunities provided for 
in this title (including the amendments made by this title) or to 
condition or limit the enjoyment by any such organization or its 
officers or employees of any such privilege, exemption, or immunity. The 
President shall be authorized, if in his judgment such action should be 
justified by reason of the abuse by an international organization or its 
officers and employees of the privileges, exemptions, and immunities 
herein provided or for any other reason, at any time to revoke the 
designation of any international organization under this section, 
whereupon the international organization in question shall cease to be 
classed as an international organization for the purposes of this title.

                                * * * * *

    Sec. 8. (a) No person shall be entitled to the benefits of this 
title [International Organizations Immunities Act] unless he (1) shall 
have been duly notified to and accepted by the Secretary of State as a * 
* * officer, or employee; or (2) shall have been designated by the 
Secretary of State, prior to formal notification and acceptance, as a 
prospective * * * officer, or employee; * * *.
    (b) Should the Secretary of State determine that the continued 
presence in the United States of any person entitled to the benefits of 
this title is not desirable, he shall so inform the * * * international 
organization concerned * * *, and after such person shall have had a 
reasonable length of time, to be determined by the Secretary of State, 
to depart from the United States, he shall cease to be entitled to such 
benefits.
    (c) No person shall, by reason of the provisions of this title, be 
considered as receiving diplomatic status or as receiving any of the 
privileges incident thereto other than such as are specifically set 
forth herein.
    Sec. 9. The privileges, exemptions, and immunities of international 
organizations and of their officers and employees * * * provided for in 
this title [International Organizations Immunities Act], shall be 
granted notwithstanding the fact that the similar privileges, 
exemptions, and immunities granted to a foreign government, its 
officers, or employees, may be conditioned upon the existence of 
reciprocity by that foreign government: Provided, That nothing contained 
in this title shall be construed as precluding the Secretary of State 
from withdrawing the privileges, exemptions, and immunities herein 
provided from persons who are nationals of any foreign country on the 
ground that such country is failing to accord corresponding privileges, 
exemptions, and immunities to citizens of the United States.

    (4) Effect of waiver. An officer or employee of an international 
organization who executes and files with the Attorney General the waiver 
provided for in section 247(b) of the Immigration and Nationality Act (8 
U.S.C. 1257(b)) thereby waives the exemption conferred by

[[Page 621]]

section 893 of the Code. As a consequence, that exemption does not apply 
to income received by that individual after the date of filing of the 
waiver.
    (5) Citizens of the United States. The compensation of citizens of 
the United States (other than those who are also citizens of the 
Republic of the Philippines) who are officers or employees of an 
international organization is not exempt from income tax pursuant to 
this paragraph. But see section 911 and the regulations thereunder.
    (c) Tax conventions, consular conventions, and international 
agreements--(1) Exemption dependent upon internal revenue laws. A tax 
convention or consular convention between the United States and a 
foreign country, which provides that the United States may include in 
the tax base of its residents all income taxable under the internal 
revenue laws, and which makes no specific exception for the income of 
the employees of that foreign government, does not provide any exemption 
(with respect to residents of the United States) beyond that which is 
provided by the internal revenue laws. Accordingly, the effect of the 
execution and filing of a waiver under section 247(b) of the Immigration 
and Nationality Act by an employee of a foreign government which is a 
party to such a convention is to subject the employee to tax to the same 
extent as provided in paragraph (a)(5) of this section with respect to 
the waiver of exemption under section 893.
    (2) Exemption not dependent upon internal revenue laws. If a tax 
convention, consular convention, or international agreement provides 
that compensation paid by the foreign government or international 
organization to its employees is exempt from Federal income tax, and the 
application of this exemption is not dependent upon the provisions of 
the internal revenue laws, the exemption so conferred is not affected by 
the execution and filing of a waiver under section 247(b) of the 
Immigration and Nationality Act. For examples of exemptions which are 
not affected by the Immigration and Nationality Act, see article X of 
the income tax convention between the United States and the United 
Kingdom (60 Stat. 1383); article IX, section 9(b), of the Articles of 
Agreement of the International Monetary Fund (60 Stat. 1414); and 
article VII, section 9(b), of the Articles of Agreement of the 
International Bank for Reconstruction and Development (60 Stat. 1458).



Sec.  1.894-1  Income affected by treaty.

    (a) Income exempt under treaty. Income of any kind is not included 
in gross income and is exempt from tax under Subtitle A (relating to 
income taxes), to the extent required by any income tax convention to 
which the United States is a party. However, unless otherwise provided 
by an income tax convention, the exclusion from gross income under 
section 894(a) and this paragraph does not apply in determining the 
accumulated taxable income of a foreign corporation under section 535 
and the regulations thereunder or the undistributed personal holding 
company income of a foreign corporation under section 545 and the 
regulations thereunder. Moreover, the distributable net income of a 
foreign trust is determined without regard to section 894 and this 
paragraph, to the extent provided by section 643(a)(6)(B). Further, the 
compensating tax adjustment required by section 819(a)(3) in the case of 
a foreign life insurance company is to be determined without regard to 
section 894 and this paragraph, to the extent required by section 
819(a)(3)(A). See Sec.  1.871-12 for the manner of determining the tax 
liability of a nonresident alien individual or foreign corporation whose 
gross income includes income on which the tax is reduced under a tax 
convention.
    (b) Taxpayer treated as having no permanent establishment in the 
United States--(1) In general. A nonresident alien individual or a 
foreign corporation, that is engaged in trade or business in the United 
States through a permanent establishment located therein at any time 
during a taxable year beginning after December 31, 1966, shall be deemed 
not to have a permanent establishment in the United States at any time 
during that year for purposes of applying any exemption from, or 
reduction in the rate of, any tax under Subtitle A of the Code which is 
provided by any income tax convention with respect to income which is

[[Page 622]]

not effectively connected for that year with the conduct of a trade or 
business in the United States by the taxpayer. This paragraph applies to 
all treaties or conventions entered into by the United States, whether 
entered into before, on, or after November 13, 1966, the date of 
enactment of the Foreign Investors Tax Act of 1966 (80 Stat. 1539). This 
paragraph is not considered to be contrary to any obligation of the 
United States under an income tax convention to which it is a party. The 
benefit granted under section 894(b) and this paragraph applies only to 
those items of income derived from sources within the United States 
which are subject to the tax imposed by section 871(a) or 881(a), and 
section 1441, 1442, or 1451, on the noneffectively connected income 
received from sources within the United States by a nonresident alien 
individual or a foreign corporation. The benefit does not apply to any 
income from real property in respect of which an election is in effect 
for the taxable year under Sec.  1.871-10 or in determining under 
section 877(b) the tax of a nonresident alien individual who has lost 
United States citizenship at any time after March 8, 1965. The benefit 
granted by section 894(b) and this paragraph is not elective.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. M, a corporation organized in foreign country X, uses the 
calendar year as the taxable year. The United States and country X are 
parties to an income tax convention which provides in part that 
dividends received from sources within the United States by a 
corporation of country X not having a permanent establishment in the 
United States are subject to tax under Chapter 1 of the Code at a rate 
not to exceed 15 percent. During 1967, M is engaged in business in the 
United States through a permanent establishment located therein and 
receives $100,000 in dividends from domestic corporation B, which under 
section 861(a)(2)(A) constitute income from sources within the United 
States. Under section 864(c)(2) and Sec.  1.864-4(c), the dividends 
received from B are not effectively connected for 1967 with the conduct 
of a trade or business in the United States by M. Although M has a 
permanent establishment in the United States during 1967, it is deemed, 
under section 894(b) and this paragraph, not to have a permanent 
establishment in the United States during that year with respect to the 
dividends. Accordingly, in accordance with paragraph (c)(3) of Sec.  
1.871-12 the tax on the dividends is $15,000, that is, 15 percent of 
$100,000, determined without the allowance of any deductions.
    Example 2. T, a corporation organized in foreign country X, uses the 
calendar year as the taxable year. The United States and country X are 
parties to an income tax convention which provides in part that an 
enterprise of country X is not subject to tax under chapter 1 of the 
Code in respect of its industrial or commercial profits unless it is 
engaged in trade or business in the United States during the taxable 
year through a permanent establishment located therein and that, if it 
is so engaged, the tax may be imposed upon the entire income of that 
enterprise from sources within the United States. The convention also 
provides that the tax imposed by Chapter 1 of the Code on dividends 
received from sources within the United States by a corporation of X 
which is not engaged in trade or business in the United States through a 
permanent establishment located therein shall not exceed 15 percent of 
the dividend. During 1967, T is engaged in a business (business A) in 
the United States which is carried on through a permanent establishment 
in the United States; in addition, T is engaged in a business (business 
B) in the United States which is not carried on through a permanent 
establishment. During 1967, T receives from sources within the United 
States $60,000 in service fees through the operation of business A and 
$10,000 in dividends through the operation of business B, both of which 
amounts are, under section 864(c)(2)(B) and Sec.  1.864-4(c)(3), 
effectively connected for that year with the conduct of a trade or 
business in the United States by that corporation. The service fees are 
considered to be industrial or commercial profits under the tax 
convention with country X. Since T has no income for 1967 which is not 
effectively connected for that year with the conduct of a trade or 
business in the United States by that corporation, section 894(b), this 
paragraph, and Sec.  1.871-12 do not apply. Accordingly, for 1967 T's 
entire income of $70,000 from sources within the United States is 
subject to tax, after allowance of deductions, in accordance with 
section 882(a)(1) and paragraph (b)(2) of Sec.  1.882-1.
    Example 3. S, a corporation organized in foreign country W, uses the 
calendar year as the taxable year. The United States and country W are 
parties to an income tax convention which provides in part that a 
corporation of country W is not subject to tax under Chapter 1 of the 
Code in respect of its industrial or commercial profits unless it is 
engaged in trade or business in the United States during the taxable 
year through a permanent establishment located therein and that, if it 
is so engaged, the tax may be

[[Page 623]]

imposed upon the entire income of that corporation from sources within 
the United States. The convention also provides that the tax imposed by 
Chapter 1 of the Code on dividends received from sources within the 
United States by a corporation of country W which is not engaged in 
trade or business in the United States through a permanent establishment 
located therein shall not exceed 15 percent of the dividend. During 
1967, S is engaged in business in the United States through a permanent 
establishment located therein and derives from sources within the United 
States $100,000 in service fees which, under section 864(c)(2)(B) and 
Sec.  1.864-4(c)(3), are effectively connected for that year with the 
conduct of a trade or business in the United States by S and which are 
considered to be industrial or commercial profits under the tax 
convention with country W. During 1967, S also derives from sources 
within the United States, through another business it carries on in 
foreign country X, $10,000 in sales income which, under section 
864(c)(3) and Sec.  1.864-4(b), is effectively connected for that year 
with the conduct of a trade or business in the United States by S and 
$5,000 in dividends which, under section 864(c)(2)(A) and Sec.  1.864-
4(c)(2), are not effectively connected for that year with the conduct of 
a trade or business in the United States by S. The sales income is 
considered to be industrial or commercial profits under the tax 
convention with country W. Although S is engaged in a trade or business 
in the United States during 1967 through a permanent establishment 
located therein, it is deemed, under section 894(b) and this paragraph, 
not to have a permanent establishment therein with respect to the $5,000 
in dividends. Accordingly, in accordance with paragraph (c) of Sec.  
1.871-12, for 1967 S is subject to a tax of $750 on the dividends 
($5,000 x .15) and a tax, determined under section 882(a) and Sec.  
1.882-1, on its $110,000 industrial or commercial profits.
    Example 4. (a) N, a corporation organized in foreign country Z, uses 
the calendar year as the taxable year. The United States and country Z 
are parties to an income tax convention which provides in part that the 
tax imposed by Chapter 1 of the Code on dividends received from sources 
within the United States by a corporation of country Z shall not exceed 
15 percent of the amount distributed if the recipient does not have a 
permanent establishment in the United States or, where the recipient 
does have a permanent establishment in the United States, if the shares 
giving rise to the dividends are not effectively connected with the 
permanent establishment. The tax convention also provides that if a 
corporation of country Z is engaged in industrial or commercial activity 
in the United States through a permanent establishment in the United 
States, income tax may be imposed by the United States on so much of the 
industrial or commercial profits of such corporation as are attributable 
to the permanent establishment in the United States.
    (b) During 1967, N is engaged in a business (business A) in the 
United States which is not carried on through a permanent establishment 
in the United States. In addition, N has a permanent establishment in 
the United States through which it carries on another business (business 
B) in the United States. During 1967, N holds shares of stock in 
domestic corporation D which are not effectively connected with N's 
permanent establishment in the United States. During 1967, N receives 
$100,000 in dividends from D which, pursuant to section 864(c)(2)(A) and 
Sec.  1.864-4(c)(2), are effectively connected for that year with the 
conduct of business A. Under section 861(a)(2)(A) these dividends are 
treated as income from sources within the United States. In addition, 
during 1967, N receives from sources within the United States $150,000 
in sales income which, pursuant to section 864(c)(3) and Sec.  1.864-
4(b), is effectively connected with the conduct of a trade or business 
in the United States and which is considered to be industrial or 
commercial profits under the tax convention with country Z. Of these 
total profits, $70,000 is from business A and $80,000 is from business 
B. Only the $80,000 of industrial or commercial profits is attributable 
to N's permanent establishment in the United States.
    (c) Since N has no income for 1967 which is not effectively 
connected for that year with the conduct of a trade or business in the 
United States by that corporation, section 894(b) and this paragraph do 
not apply. However, N is entitled to the reduced rate of tax under the 
tax convention with country Z with respect to the dividends because the 
shares of stock are not effectively connected with N's permanent 
establishment in the United States. Accordingly, assuming that there are 
no deductions connected with N's industrial or commercial profits, the 
tax for 1967, determined as provided in paragraph (c) of Sec.  1.871-12, 
is $46,900 as follows:

Tax on nontreaty income:
  $80,000 x .48...............................................   $38,400
  Less $25,000 x .26..........................................     6,500
                                                               ---------
                                                                  31,900
Tax on treaty income:
  $100,000 (gross dividends) x .15............................    15,000
                                                               =========
   Total tax..................................................    46,900
 

    Example 5. M, a corporation organized in foreign country Z, uses the 
calendar year as the taxable year. The United States and country Z are 
parties to an income tax convention which provides in part that a 
corporation of country Z is not subject to tax under Chapter 1 of the 
Code in respect of its commercial and industrial profits except such 
profits as are allocable to its permanent

[[Page 624]]

establishment in the United States. The regulations in this chapter 
under the tax convention with country Z provide that a corporation of 
country Z having a permanent establishment in the United States is 
subject to U.S. tax upon its industrial and commercial profits from 
sources within the United States and that its industrial and commercial 
profits from such sources are deemed to be allocable to the permanent 
establishment in the United States. During 1967, M is engaged in a 
business (business A) in the United States which is carried on through a 
permanent establishment in the United States; in addition, M is engaged 
in a business (business B) in foreign country X and none of such 
business is carried on in the United States. During 1967, M receives 
from sources within the United States $40,000 in sales income through 
the operation of business A and $10,000 in sales income through the 
operation of business B, both of which amounts are, under section 
864(c)(3) and Sec.  1.864-4(b), effectively connected for that year with 
the conduct of a trade or business in the United States by that 
corporation. The sales income is considered to be industrial and 
commercial profits under the tax convention with country Z. Since M has 
no income for 1967 which is not effectively connected for that year with 
the conduct of a trade or business in the United States by that 
corporation, section 894(b) and this paragraph do not apply. 
Accordingly, for 1967 M's entire income of $50,000 from sources within 
the United States is subject to tax, after allowance of deductions, in 
accordance with section 882(a)(1) and paragraph (b)(2) of Sec.  1.882-1.

    (c)(1) Substitute interest and dividend payments. The provisions of 
an income tax convention dealing with interest or dividends paid to or 
derived by a foreign person include substitute interest or dividend 
payments that have the same character as interest or dividends under 
Sec.  1.864-5(b)92)(ii), 1.871-7(b)(2) or 1.881-2(b)(2). The provisions 
of this paragraph (c) shall apply for purposes of securities lending 
transactions or sale-repurchase transactions as defined in Sec.  1.861-
2(a)(7) and Sec.  1.861-3(a)(6).
    (2) Dividend equivalents. The provisions of an income tax convention 
relating to dividends paid to or derived by a foreign person apply to 
the payment of a dividend equivalent described in section 871(m) and the 
regulations thereunder.
    (d) Special rule for items of income received by entities--(1) In 
general. The tax imposed by sections 871(a), 881(a), 1443, 1461, and 
4948(a) on an item of income received by an entity, wherever organized, 
that is fiscally transparent under the laws of the United States and/or 
any other jurisdiction with respect to an item of income shall be 
eligible for reduction under the terms of an income tax treaty to which 
the United States is a party only if the item of income is derived by a 
resident of the applicable treaty jurisdiction. For this purpose, an 
item of income may be derived by either the entity receiving the item of 
income or by the interest holders in the entity or, in certain 
circumstances, both. An item of income paid to an entity shall be 
considered to be derived by the entity only if the entity is not 
fiscally transparent under the laws of the entity's jurisdiction, as 
defined in paragraph (d)(3)(ii) of this section, with respect to the 
item of income. An item of income paid to an entity shall be considered 
to be derived by the interest holder in the entity only if the interest 
holder is not fiscally transparent in its jurisdiction with respect to 
the item of income and if the entity is considered to be fiscally 
transparent under the laws of the interest holder's jurisdiction with 
respect to the item of income, as defined in paragraph (d)(3)(iii) of 
this section. Notwithstanding the preceding two sentences, an item of 
income paid directly to a type of entity specifically identified in a 
treaty as a resident of a treaty jurisdiction shall be treated as 
derived by a resident of that treaty jurisdiction.
    (2) Application to domestic reverse hybrid entities--(i) In general. 
An income tax treaty may not apply to reduce the amount of federal 
income tax on U.S. source payments received by a domestic reverse hybrid 
entity. Further, notwithstanding paragraph (d)(1) of this section, the 
foreign interest holders of a domestic reverse hybrid entity are not 
entitled to the benefits of a reduction of U.S. income tax under an 
income tax treaty on items of income received from U.S. sources by such 
entity. A domestic reverse hybrid entity is a domestic entity that is 
treated as not fiscally transparent for U.S. tax purposes and as 
fiscally transparent under the laws of the interest holder's 
jurisdiction, with respect to the item of income received by the 
domestic entity.

[[Page 625]]

    (ii) Payments by domestic reverse hybrid entities--(A) General rule. 
Except as otherwise provided in paragraph (d)(2)(ii)(B) of this section, 
an item of income paid by a domestic reverse hybrid entity to an 
interest holder in such entity shall have the character of such item of 
income under U.S. law and shall be considered to be derived by the 
interest holder, provided the interest holder is not fiscally 
transparent in its jurisdiction, as defined in paragraph (d)(3)(iii) of 
this section, with respect to the item of income. In determining whether 
the interest holder is fiscally transparent with respect to the item of 
income under this paragraph (d)(2)(ii)(A), the determination under 
paragraph (d)(3)(ii) of this section shall be made based on the 
treatment that would have resulted had the item of income been paid by 
an entity that is not fiscally transparent under the laws of the 
interest holder's jurisdiction with respect to any item of income.
    (B) Payment made to related foreign interest holder--(1) General 
rule. If--
    (i) A domestic entity makes a payment to a related domestic reverse 
hybrid entity that is treated as a dividend under either the laws of the 
United States or the laws of the jurisdiction of a related foreign 
interest holder in the domestic reverse hybrid entity, and under the 
laws of the jurisdiction of the related foreign interest holder in the 
domestic reverse hybrid entity, the related foreign interest holder is 
treated as deriving its proportionate share of the payment under the 
principles of paragraph (d)(1) of this section; and
    (ii) The domestic reverse hybrid entity makes a payment of a type 
that is deductible for U.S. tax purposes to the related foreign interest 
holder or to a person, wherever organized, the income and losses of 
which are available, under the laws of the jurisdiction of the related 
foreign interest holder, to offset the income and losses of the related 
foreign interest holder, and for which a reduction in U.S. withholding 
tax would be allowed under an applicable income tax treaty; then
    (iii) To the extent the amount of the payment described in paragraph 
(d)(2)(ii)(B)(1)(ii) of this section does not exceed the sum of the 
portion of the payment described in paragraph (d)(2)(ii)(B)(1)(i) of 
this section treated as derived by the related foreign interest holder 
and the portion of any other prior payments described in paragraph 
(d)(2)(ii)(B)(1)(i) of this section treated as derived by the related 
foreign interest holder, the amount of the payment described in 
(d)(2)(ii)(B)(1)(ii) of this section will be treated for all purposes of 
the Internal Revenue Code and any applicable income tax treaty as a 
distribution within the meaning of section 301(a) of the Internal 
Revenue Code, and the tax to be withheld from the payment described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section (assuming the payment is 
a dividend under section 301(c)(1) of the Internal Revenue Code) shall 
be determined based on the appropriate rate of withholding that would be 
applicable to dividends paid from the domestic reverse hybrid entity to 
the related foreign interest holder in accordance with the principles of 
paragraph (d)(2)(ii)(A) of this section.
    (2) Determining amount to be recharacterized under paragraph 
(d)(2)(ii)(B)(1)(iii). For purposes of determining the amount to be 
recharacterized under paragraph (d)(2)(ii)(B)(1)(iii) of this section, 
the portion of the payment described in paragraph (d)(2)(ii)(B)(1)(i) of 
this section treated as derived by the related foreign interest holder 
shall be increased by the portion of the payment derived by any other 
person described in paragraph (d)(2)(ii)(B)(1)(ii), and shall be reduced 
by the amount of any prior section 301(c) distributions made by the 
domestic reverse hybrid entity to the related foreign interest holder or 
any other person described in paragraph (d)(2)(ii)(B)(1)(ii) and by the 
amount of any payments from the domestic reverse hybrid entity 
previously recharacterized under paragraph (d)(2)(ii)(B)(1)(iii) of this 
section.
    (3) Tiered entities. The principles of this paragraph (d)(2)(ii)(B) 
also shall apply to payments referred to in this paragraph (d)(2)(ii)(B) 
made among related entities when there is more than one domestic reverse 
hybrid entity or other fiscally transparent entity involved.

[[Page 626]]

    (4) Definition of related. For purposes of this section, a person 
shall be treated as related to a domestic reverse hybrid entity if it is 
related by reason of the ownership requirements of section 267(b) or 
707(b)(1), except that the language ``at least 80 percent'' applies 
instead of ``more than 50 percent,'' where applicable. For purposes of 
determining whether a person is related by reason of the ownership 
requirements of section 267(b) or 707(b)(1), the constructive ownership 
rules of section 318 shall apply, and the attribution rules of section 
267(c) also shall apply to the extent they attribute ownership to 
persons to whom section 318 does not attribute ownership.
    (C) Payments to persons not described in paragraph 
(d)(2)(ii)(B)(1)(ii)--(1) Related persons. The Commissioner may treat a 
payment by a domestic reverse hybrid entity to a related person (who is 
neither the related foreign interest holder nor otherwise described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section), in whole or in part, as 
being made to a related foreign interest holder for purposes of applying 
paragraph (d)(2)(ii)(B) of this section, if--
    (i) The payment to the related person is of a type that is 
deductible by the domestic reverse hybrid entity; and
    (ii) The payment is made in connection with one or more transactions 
the effect of which is to avoid the application of paragraph 
(d)(2)(ii)(B) of this section.
    (2) Unrelated persons. The Commissioner may treat a payment by a 
domestic reverse hybrid entity to an unrelated person, in whole or in 
part, as being made to a related foreign interest holder for purposes of 
applying paragraph (d)(2)(ii)(B) of this section, if--
    (i) The payment to the unrelated person is of a type that is 
deductible by the domestic reverse hybrid entity;
    (ii) The unrelated person (or other person (whether related or not) 
which receives a payment in a series of transactions that includes a 
transaction involving such unrelated person) makes a payment to the 
related foreign interest holder (or other person described in paragraph 
(d)(2)(ii)(B)(1)(ii));
    (iii) The foregoing payments are made in connection with a series of 
transactions which constitute a financing arrangement, as defined in 
Sec.  1.881-3(a)(2)(i); and
    (iv) The transactions have the effect of avoiding the application of 
paragraph (d)(2)(ii)(B) of this section.
    (iii) Examples. The rules of this paragraph (d)(2) are illustrated 
by the following examples:

    Example 1. Dividend paid by unrelated entity to domestic reverse 
hybrid entity. (i) Facts. Entity A is a domestic reverse hybrid entity, 
as defined in paragraph (d)(2)(i) of this section, with respect to the 
U.S. source dividends it receives from B, a domestic corporation to 
which A is not related within the meaning of paragraph (d)(2)(ii)(B)(4) 
of this section. A's 85-percent shareholder, FC, is a corporation 
organized under the laws of Country X, which has an income tax treaty in 
effect with the United States. A's remaining 15-percent shareholder is 
an unrelated domestic corporation. Under Country X law, FC is not 
fiscally transparent with respect to the dividend, as defined in 
paragraph (d)(3)(ii) of this section. In year 1, A receives $100 of 
dividend income from B. Under Country X law, FC is treated as deriving 
$85 of the $100 dividend payment received by A. The applicable rate of 
tax on dividends under the U.S.-Country X income tax treaty is 5 percent 
with respect to a 10-percent or more corporate shareholder.
    (ii) Analysis. Under paragraph (d)(2)(i) of this section, the U.S.-
Country X income tax treaty does not apply to the dividend income 
received by A because the payment is made by B, a domestic corporation, 
to A, another domestic corporation. A remains fully taxable under the 
U.S. tax laws as a domestic corporation with regard to that item of 
income. Further, pursuant to paragraph (d)(2)(i) of this section, 
notwithstanding the fact that A is treated as fiscally transparent with 
respect to the dividend income under the laws of Country X, FC may not 
claim a reduced rate of taxation on its share of the U.S. source 
dividend income received by A.
    Example 2. Interest paid by domestic reverse hybrid entity to 
related foreign interest holder where dividend is paid by unrelated 
entity. (i) Facts. The facts are the same as in Example 1. Both the 
United States and Country X characterize the payment by B in year 1 as a 
dividend. In addition, in year 2, A makes a payment of $25 to FC that is 
characterized under the Internal Revenue Code as interest on a loan from 
FC to A. Under the U.S.-Country X income tax treaty, the rate of tax on 
interest is zero. Under Country X laws, had the interest been paid by an 
entity that is not fiscally transparent under Country X's laws with 
respect to any item of income, FC would not be fiscally transparent as 
defined

[[Page 627]]

in paragraph (d)(2)(ii) of this section with respect to the interest.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 payment from B to A. With respect to the $25 payment from A 
to FC, paragraph (d)(2)(ii)(B) of this section will not apply because, 
although FC is a related foreign interest holder in A, A is not related 
to B, the payor of the dividend income it received. Under paragraph 
(d)(2)(ii)(A) of this section, the $25 of interest paid by A to FC in 
year 2 is characterized under U.S. law as interest. Accordingly, in year 
2, A is entitled to an interest deduction with respect to the $25 
interest payment from A to FC, and FC is entitled to the reduced rate of 
withholding applicable to interest under the U.S.-Country X income tax 
treaty, assuming all other requirements for claiming treaty benefits are 
met.
    Example 3. Interest paid by domestic reverse hybrid entity to 
related foreign interest holder where dividend is paid by a related 
entity. (i) Facts. The facts are the same as in Example 2, except the 
$100 dividend income received by A in year 1 is from A's wholly-owned 
subsidiary, S.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. However, the $25 interest 
payment in year 2 by A to FC will be treated as a dividend for all 
purposes of the Internal Revenue Code and the U.S.-Country X income tax 
treaty because $25 does not exceed FC's share of the $100 dividend 
payment made by S to A ($85). Since FC is not fiscally transparent with 
respect to the payment as determined under paragraph (d)(2)(ii)(A) of 
this section, FC is entitled to the reduced rate applicable to dividends 
under the U.S.-Country X income tax treaty with respect to the $25 
payment. Because the $25 payment in year 2 is recharacterized as a 
dividend for all purposes of the Internal Revenue Code and the U.S.-
Country X income tax treaty, A is not entitled to an interest deduction 
with respect to that payment and FC is not entitled to claim the reduced 
rate of withholding applicable to interest.
    Example 4. Definition of related foreign interest holder. (i) Facts. 
The facts are the same as in Example 3, except that A has two 50-percent 
shareholders, FC1 and FC2. In year 2, A makes an interest payment of $25 
to both FC1 and FC2. FC1 is a corporation organized under the laws of 
Country X, which has an income tax treaty in effect with the United 
States. FC2 is a corporation organized under the laws of Country Y, 
which also has an income tax treaty in effect with the United States. FP 
owns 100-percent of both FC1 and FC2, and is organized under the laws of 
Country X. Under Country X law, FC1 is not fiscally transparent with 
respect to the dividend, as defined in paragraph (d)(3)(ii) of this 
section. Under Country X law, FC1 is treated as deriving $50 of the $100 
dividend payment received by A because A is fiscally transparent under 
the laws of Country X, as determined under paragraph (d)(3)(iii) of this 
section. The applicable rate of tax on dividends under the U.S.-Country 
X income tax treaty is 5-percent with respect to a 10-percent or more 
corporate shareholder. Under Country Y law, FC2 is not treated as 
deriving any of the $100 dividend payment received by A because, under 
the laws of Country Y, A is not a fiscally transparent entity.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the $25 
payment in year 2 by A to FC1, the payment will be treated as a dividend 
for all purposes of the Internal Revenue Code and the U.S.-Country X 
income tax treaty because FC1 is a related foreign interest holder as 
determined under paragraph (d)(2)(ii)(B)(4) of this section, and because 
$25 does not exceed FC1's share of the dividend payment made by S to A 
($50). FC1 is a related foreign interest holder because FC1 is treated 
as owning the stock of A owned by FC2 under section 267(b)(3). Since FC1 
is not fiscally transparent with respect to the payment as determined 
under paragraph (d)(2)(ii)(A) of this section, FC1 is entitled to the 5-
percent reduced rate applicable to dividends under the U.S.-Country X 
income tax treaty with respect to the $25 payment. Because the $25 
payment in year 2 is recharacterized as a dividend for all purposes of 
the Internal Revenue Code and the U.S.-Country X income tax treaty, A is 
not entitled to an interest deduction with respect to that payment. Even 
though FC2 is also a related foreign interest holder, the $25 interest 
payment by A to FC2 in year 2 is not recharacterized because A is not 
fiscally transparent under the laws of Country Y, and FC2 is not treated 
as deriving any of the $100 dividend payment received by A. Thus, the 
U.S.-Country Y income tax treaty is not implicated.
    Example 5. Higher treaty withholding rate on dividends. (i) Facts. 
The facts are the same as in Example 3, except that under the U.S.-
Country X income tax treaty, the rate of tax on interest is 10-percent 
and the rate of tax on dividends is 5-percent.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. The analysis is the same as in 
Example 3 with respect to the $25 interest payment in year 2 from A to 
FC.
    Example 6. Foreign sister corporation the income and losses of which 
may offset the income and losses of related foreign interest holder. (i) 
Facts. The facts are the same as Example 3, except that in year 2, A 
makes the interest payment of $25 to FS, a subsidiary of FC also 
organized in Country X. Under the laws of Country X, FS is not fiscally 
transparent with respect to the interest payment, and the income and 
losses of FS may be used to offset the income and losses of FC.

[[Page 628]]

    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the $25 
interest payment from A to FS in year 2, FS is a person described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section because the income and 
losses of FS may be used under the laws of Country X to offset the 
income and losses of FC, the related foreign interest holder that 
derived its proportionate share of the payment from S to A. Therefore, 
paragraph (d)(2)(ii)(B) of this section applies, and the $25 interest 
payment in year 2 by A to FS is treated as a dividend for all purposes 
of the Internal Revenue Code and the U.S.-Country X income tax treaty 
because the $25 payment does not exceed FC's share of the $100 dividend 
payment made by S to A ($85). Since FS is not fiscally transparent with 
respect to the payment as determined under paragraph (d)(2)(ii)(A) of 
this section, FS is entitled to obtain the rate applicable to dividends 
under the U.S.-Country X income tax treaty with respect to the $25 
payment. Because the $25 payment in year 2 is recharacterized as a 
dividend for all purposes of the Internal Revenue Code and the U.S.-
Country X income tax treaty, A is not entitled to an interest deduction 
with respect to the payment and FS is not entitled to claim the reduced 
rate of withholding applicable to interest under the U.S.-Country X 
income tax treaty.
    Example 7. Interest paid by domestic reverse hybrid entity to 
unrelated foreign bank. (i) Facts. The facts are the same as in Example 
3, except that in year 2, A makes the interest payment of $25 to FB, a 
Country Y unrelated foreign bank, on a loan from FB to A.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the payment 
from A to FB, paragraph (d)(2)(ii)(B) of this section will not apply 
because, although A is related to S, the payor of the dividend income it 
received, A is not related to FB under paragraph (d)(2)(ii)(B)(4) of 
this section. Under paragraph (d)(2)(ii)(A) of this section, the $25 
interest payment made from A to FB in year 2 is characterized as 
interest under the Internal Revenue Code.
    Example 8. Interest paid by domestic reverse hybrid to an unrelated 
entity pursuant to a financing arrangement. (i) Facts. The facts are the 
same as in Example 7, except that in year 3, FB makes an interest 
payment of $25 to FC on a deposit made by FC with FB.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the $25 
payment from A to FB in year 2, because the payment is made in 
connection with a transaction that constitutes a financing arrangement 
within the meaning of paragraph (d)(2)(ii)(C)(2) of this section, the 
payment may be treated by the Commissioner as being made directly to FC. 
If the Commissioner disregards FB, then the analysis is the same as in 
Example 3 with respect to the $25 interest payment in year 2 from A to 
FC.
    Example 9. Royalty paid by related entity to domestic reverse hybrid 
entity. (i) Facts. The facts are the same as in Example 3, except the 
$100 income received by A from S in year 1 is a royalty payment under 
both the laws of the United States and the laws of Country X. The 
royalty rate under the treaty is 10 percent and the interest rate is 0 
percent.
    (ii) Analysis. The analysis as to the royalty payment from S to A is 
the same as in Example 1 with respect to the $100 dividend payment from 
S to A. With respect to the $25 payment from A to FC, paragraph 
(d)(2)(ii)(B) of this section will not apply because the payment from S 
to A is not treated as a dividend under the Internal Revenue Code or the 
laws of Country X. Under paragraph (d)(2)(ii)(A) of this section, the 
$25 of interest paid by A to FC in year 2 is characterized as interest 
under the Internal Revenue Code. Accordingly, in year 2, FC may obtain 
the reduced rate of withholding applicable to interest under the U.S.-
Country X income tax treaty, assuming all other requirements for 
claiming treaty benefits are met.

    (3) Definitions--(i) Entity. For purposes of this paragraph (d), the 
term entity shall mean any person that is treated by the United States 
or the applicable treaty jurisdiction as other than an individual. The 
term entity includes disregarded entities, including single member 
disregarded entities with individual owners.
    (ii) Fiscally transparent under the law of the entity's 
jurisdiction--(A) General rule. For purposes of this paragraph (d), an 
entity is fiscally transparent under the laws of the entity's 
jurisdiction with respect to an item of income to the extent that the 
laws of that jurisdiction require the interest holder in the entity, 
wherever resident, to separately take into account on a current basis 
the interest holder's respective share of the item of income paid to the 
entity, whether or not distributed to the interest holder, and the 
character and source of the item in the hands of the interest holder are 
determined as if such item were realized directly from the source from 
which realized by the entity. However, the entity will be fiscally 
transparent with respect to the item of income even if the item of 
income is not separately taken into account by the interest holder, 
provided the item of income, if separately taken

[[Page 629]]

into account by the interest holder, would not result in an income tax 
liability for that interest holder different from that which would 
result if the interest holder did not take the item into account 
separately, and provided the interest holder is required to take into 
account on a current basis the interest holder's share of all such 
nonseparately stated items of income paid to the entity, whether or not 
distributed to the interest holder. In determining whether an entity is 
fiscally transparent with respect to an item of income in the entity's 
jurisdiction, it is irrelevant that, under the laws of the entity's 
jurisdiction, the entity is permitted to exclude such item from gross 
income or that the entity is required to include such item in gross 
income but is entitled to a deduction for distributions to its interest 
holders.
    (B) Special definitions. For purposes of this paragraph (d)(3)(ii), 
an entity's jurisdiction is the jurisdiction where the entity is 
organized or incorporated or may otherwise be considered a resident 
under the laws of that jurisdiction. An interest holder will be treated 
as taking into account that person's share of income paid to an entity 
on a current basis even if such amount is taken into account by the 
interest holder in a taxable year other than the taxable year of the 
entity if the difference is due solely to differing taxable years.
    (iii) Fiscally transparent under the law of an interest holder's 
jurisdiction--(A) General rule. For purposes of this paragraph (d), an 
entity is treated as fiscally transparent under the law of an interest 
holder's jurisdiction with respect to an item of income to the extent 
that the laws of the interest holder's jurisdiction require the interest 
holder resident in that jurisdiction to separately take into account on 
a current basis the interest holder's respective share of the item of 
income paid to the entity, whether or not distributed to the interest 
holder, and the character and source of the item in the hands of the 
interest holder are determined as if such item were realized directly 
from the source from which realized by the entity. However, an entity 
will be fiscally transparent with respect to the item of income even if 
the item of income is not separately taken into account by the interest 
holder, provided the item of income, if separately taken into account by 
the interest holder, would not result in an income tax liability for 
that interest holder different from that which would result if the 
interest holder did not take the item into account separately, and 
provided the interest holder is required to take into account on a 
current basis the interest holder's share of all such nonseparately 
stated items of income paid to the entity, whether or not distributed to 
the interest holder. An entity will not be treated as fiscally 
transparent with respect to an item of income under the laws of the 
interest holder's jurisdiction, however, if, under the laws of the 
interest holder's jurisdiction, the interest holder in the entity is 
required to include in gross income a share of all or a part of the 
entity's income on a current basis year under any type of anti-deferral 
or comparable mechanism. In determining whether an entity is fiscally 
transparent with respect to an item of income under the laws of an 
interest holder's jurisdiction, it is irrelevant how the entity is 
treated under the laws of the entity's jurisdiction.
    (B) Special definitions. For purposes of this paragraph (d)(3)(iii), 
an interest holder's jurisdiction is the jurisdiction where the interest 
holder is organized or incorporated or may otherwise be considered a 
resident under the laws of that jurisdiction. An interest holder will be 
treated as taking into account that person's share of income paid to an 
entity on a current basis even if such amount is taken into account by 
such person in a taxable year other than the taxable year of the entity 
if the difference is due solely to differing taxable years.
    (iv) Applicable treaty jurisdiction. The term applicable treaty 
jurisdiction means the jurisdiction whose income tax treaty with the 
United States is invoked for purposes of reducing the rate of tax 
imposed under sections 871(a), 881(a), 1461, and 4948(a).
    (v) Resident. The term resident shall have the meaning assigned to 
such term in the applicable income tax treaty.
    (4) Application to all income tax treaties. Unless otherwise 
explicitly agreed

[[Page 630]]

upon in the text of an income tax treaty, the rules contained in this 
paragraph (d) shall apply in respect of all income tax treaties to which 
the United States is a party. Notwithstanding the foregoing sentence, 
the competent authorities may agree on a mutual basis to depart from the 
rules contained in this paragraph (d) in appropriate circumstances. 
However, a reduced rate under a tax treaty for an item of U.S. source 
income paid will not be available irrespective of the provisions in this 
paragraph (d) to the extent that the applicable treaty jurisdiction 
would not grant a reduced rate under the tax treaty to a U.S. resident 
in similar circumstances, as evidenced by a mutual agreement between the 
relevant competent authorities or by a public notice of the treaty 
jurisdiction. The Internal Revenue Service shall announce the terms of 
any such mutual agreement or public notice of the treaty jurisdiction. 
Any denial of tax treaty benefits as a consequence of such a mutual 
agreement or notice shall affect only payment of U.S. source items of 
income made after announcement of the terms of the agreement or of the 
notice.
    (5) Examples. This paragraph (d) is illustrated by the following 
examples:

    Example 1. Treatment of entity treated as partnership by U.S. and 
country of organization. (i) Facts. Entity A is a business organization 
formed under the laws of Country X that has an income tax treaty in 
effect with the United States. A is treated as a partnership for U.S. 
federal income tax purposes. A is also treated as a partnership under 
the laws of Country X, and therefore Country X requires the interest 
holders in A to separately take into account on a current basis their 
respective shares of the items of income paid to A, whether or not 
distributed to the interest holders, and the character and source of the 
items in the hands of the interest holders are determined as if such 
items were realized directly from the source from which realized by A. A 
receives royalty income from U.S. sources that is not effectively 
connected with the conduct of a trade or business in the United States.
    (ii) Analysis. A is fiscally transparent in its jurisdiction within 
the meaning of paragraph (d)(3)(ii) of this section with respect to the 
U.S. source royalty income in Country X and, thus, A does not derive 
such income for purposes of the U.S.-X income tax treaty.
    Example 2. Treatment of interest holders in entity treated as 
partnership by U.S. and country of organization. (i) Facts. The facts 
are the same as under Example 1. A's partners are M, a corporation 
organized under the laws of Country Y that has an income tax treaty in 
effect with the United States, and T, a corporation organized under the 
laws of Country Z that has an income tax treaty in effect with the 
United States. M and T are not fiscally transparent under the laws of 
their respective countries of incorporation. Country Y requires M to 
separately take into account on a current basis M's respective share of 
the items of income paid to A, whether or not distributed to M, and the 
character and source of the items of income in M's hands are determined 
as if such items were realized directly from the source from which 
realized by A. Country Z treats A as a corporation and does not require 
T to take its share of A's income into account on a current basis 
whether or not distributed.
    (ii) Analysis. M is treated as deriving its share of the U.S. source 
royalty income for purposes of the U.S.-Y income tax treaty because A is 
fiscally transparent under paragraph (d)(3)(iii) with respect to that 
income under the laws of Country Y. Under Country Z law, however, 
because T is not required to take into account its share of the U.S. 
source royalty income received by A on a current basis whether or not 
distributed, A is not treated as fiscally transparent. Accordingly, T is 
not treated as deriving its share of the U.S. source royalty income for 
purposes of the U.S.-Z income tax treaty.
    Example 3. Dual benefits to entity and interest holder. (i) Facts. 
The facts are the same as under Example 2, except that A is taxable as a 
corporation under the laws of Country X. Article 12 of the U.S.-X income 
tax treaty provides for a source country reduced rate of taxation on 
royalties of 5-percent. Article 12 of the U.S.-Y income tax treaty 
provides that royalty income may only be taxed by the beneficial owner's 
country of residence.
    (ii) Analysis. A is treated as deriving the U.S. source royalty 
income for purposes of the U.S.-X income tax treaty because it is not 
fiscally transparent with respect to the item of income within the 
meaning of paragraph (d)(3)(ii) of this section in Country X, its 
country of organization. M is also treated as deriving its share of the 
U.S. source royalty income for purposes of the U.S.-Y income tax treaty 
because A is fiscally transparent under paragraph (d)(3)(iii) of this 
section with respect to that income under the laws of Country Y. T is 
not treated as deriving the U.S. source royalty income for purposes of 
the U.S.-Z income tax treaty because under Country Z law A is not 
fiscally transparent. Assuming all other requirements for eligibility 
for treaty benefits have been satisfied, A is entitled to the 5-percent 
treaty reduced rate on royalties under the U.S.-X income tax treaty with 
respect to the entire royalty payment. Assuming all other

[[Page 631]]

requirements for treaty benefits have been satisfied, M is also entitled 
to a zero rate under the U.S.-Y income tax treaty with respect to its 
share of the royalty income.
    Example 4. Treatment of grantor trust. (i) Facts. Entity A is a 
trust organized under the laws of Country X, which does not have an 
income tax treaty in effect with the United States. M, the grantor and 
owner of A for U.S. income tax purposes, is a resident of Country Y, 
which has an income tax treaty in effect with the United States. M is 
also treated as the grantor and owner of the trust under the laws of 
Country Y. Thus, Country Y requires M to take into account all items of 
A's income in the taxable year, whether or not distributed to M, and 
determines the character of each item in M's hands as if such item was 
realized directly from the source from which realized by A. Country X 
does not treat M as the owner of A and does not require M to account for 
A's income on a current basis whether or not distributed to M. A 
receives interest income from U.S. sources that is neither portfolio 
interest nor effectively connected with the conduct of a trade or 
business in the United States.
    (ii) Analysis. A is not fiscally transparent under the laws of 
Country X within the meaning of paragraph (d)(3)(ii) of this section 
with respect to the U.S. source interest income, but A may not claim 
treaty benefits because there is no U.S.-X income tax treaty. M, 
however, does derive the income for purposes of the U.S.-Y income tax 
treaty because under the laws of Country Y, A is fiscally transparent.
    Example 5. Treatment of complex trust. (i) Facts. The facts are the 
same as in Example 4 except that M is treated as the owner of the trust 
only under U.S. tax law, after application of section 672(f), but not 
under the law of Country Y. Although the trust document governing A does 
not require that A distribute any of its income on a current basis, some 
distributions are made currently to M. There is no requirement under 
Country Y law that M take into account A's income on a current basis 
whether or not distributed to him in that year. Under the laws of 
Country Y, with respect to current distributions, the character of the 
item of income in the hands of the interest holder is determined as if 
such item were realized directly from the source from which realized by 
A. Accordingly, upon a current distribution of interest income to M, the 
interest income retains its source as U.S. source income.
    (ii) Analysis. M does not derive the U.S. source interest income 
because A is not fiscally transparent under paragraph (d)(3)(ii) of this 
section with respect to the U.S. source interest income under the laws 
of Country Y. Although the character of the interest in the hands of M 
is determined as if realized directly from the source from which 
realized by A, under the laws of Country Y, M is not required to take 
into account his share of A's interest income on a current basis whether 
or not distributed. Accordingly, neither A nor M is entitled to claim 
treaty benefits, since A is a resident of a non-treaty jurisdiction and 
M does not derive the U.S. source interest income for purposes of the 
U.S.-Y income tax treaty.
    Example 6. Treatment of interest holders required to include passive 
income under anti-deferral regime. (i) Facts. The facts are the same as 
under Example 2. However, Country Z does require T, who is treated as 
owning 60-percent of the stock of A, to take into account its respective 
share of the royalty income of A under an anti-deferral regime 
applicable to certain passive income of controlled foreign corporations.
    (ii) Analysis. T is still not eligible to claim treaty benefits with 
respect to the royalty income. T is not treated as deriving the U.S. 
source royalty income for purposes of the U.S.-Z income tax treaty under 
paragraph (d)(3)(iii) of this section because T is only required to take 
into account its pro rata share of the U.S. source royalty income by 
reason of Country Z's anti-deferral regime.
    Example 7. Treatment of contractual arrangements operating as 
collective investment vehicles. (i) Facts. A is a contractual 
arrangement without legal personality for all purposes under the laws of 
Country X providing for joint ownership of securities. Country X has an 
income tax treaty in effect with the United States. A is a collective 
investment fund which is of a type known as a Common Fund under Country 
X law. Because of the absence of legal personality in Country X of the 
arrangement, A is not liable to tax as a person at the entity level in 
Country X and is thus not a resident within the meaning of the Residence 
Article of the U.S.-X income tax treaty. A is treated as a partnership 
for U.S. income tax purposes and receives U.S. source dividend income. 
Under the laws of Country X, however, investors in A only take into 
account their respective share of A's income upon distribution from the 
Common Fund. Some of A's interest holders are residents of Country X and 
some of Country Y. Country Y has no income tax treaty in effect with the 
United States.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because the interest holders in A are not required to take into 
account their respective shares of such income in the taxable year 
whether or not distributed. Because A is an arrangement without a legal 
personality that is not considered a person in Country X and thus not a 
resident of Country X under the Residence Article of the U.S.-X income 
tax treaty, however, A does not derive the income as a resident of 
Country X for purposes of the U.S.-X income tax treaty. Further, because 
A is not fiscally transparent

[[Page 632]]

under paragraph (d)(3)(iii) of this section with respect to the U.S. 
source dividend income, A's interest holders that are residents of 
Country X do not derive the income as residents of Country X for 
purposes of the U.S.-X income tax treaty.
    Example 8. Treatment of person specifically listed as resident in 
applicable treaty. (i) Facts. The facts are the same as in Example 7 
except that A (the Common Fund) is organized in Country Z and the 
Residence Article of the U.S.-Z income tax treaty provides that ``the 
term 'resident of a Contracting State' includes, in the case of Country 
Z, Common Funds.* * *''
    (ii) Analysis. A is treated, for purposes of the U.S.-Z income tax 
treaty as deriving the dividend income as a resident of Country Z under 
paragraph (d)(1) of this section because the item of income is paid 
directly to A, A is a Common Fund under the laws of Country Z, and 
Common Funds are specifically identified as residents of Country Z in 
the U.S.-Z treaty. There is no need to determine whether A meets the 
definition of fiscally transparent under paragraph (d)(3)(ii) of this 
section.
    Example 9. Treatment of investment company when entity receives 
distribution deductions, and all distributions sourced by residence of 
entity. (i) Facts. Entity A is a business organization formed under the 
laws of Country X, which has an income tax treaty in effect with the 
United States. A is treated as a partnership for U.S. income tax 
purposes. Under the laws of Country X, A is an investment company 
taxable at the entity level and a resident of Country X. It is also 
entitled to a distribution deduction for amounts distributed to its 
interest holders on a current basis. A distributes all its net income on 
a current basis to its interest holders and, thus, in fact, has no 
income tax liability to Country X. A receives U.S. source dividend 
income. Under Country X law, all amounts distributed to interest holders 
of this type of business entity are treated as dividends from sources 
within Country X and Country X imposes a withholding tax on all payments 
by A to foreign persons. Under Country X laws, the interest holders in A 
do not have to separately take into account their respective shares of 
A's income on a current basis if such income is not, in fact, 
distributed.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividends 
because the interest holders in A do not have to take into account their 
respective share of the U.S. source dividends on a current basis whether 
or not distributed. A is also not fiscally transparent under paragraph 
(d)(3)(ii) of this section because there is a change in source of the 
income received by A when A distributes the income to its interest 
holders and, thus, the character and source of the income in the hands 
of A's interest holder are not determined as if such income were 
realized directly from the source from which realized by A. Accordingly, 
A is treated as deriving the U.S. source dividends for purposes of the 
U.S.-Country X treaty.
    Example 10. Item by item determination of fiscal transparency. (i) 
Facts. Entity A is a business organization formed under the laws of 
Country X, which has an income tax treaty in effect with the United 
States. A is treated as a partnership for U.S. income tax purposes. 
Under the laws of Country X, A is an investment company taxable at the 
entity level and a resident of Country X. It is also entitled to a 
distribution deduction for amounts distributed to its interest holders 
on a current basis. A receives both U.S. source dividend income and 
interest income from U.S. sources that is neither portfolio interest nor 
effectively connected with the conduct of a trade or business in the 
United States. Country X law sources all distributions attributable to 
dividend income based on the residence of the investment company. In 
contrast, Country X law sources all distributions attributable to 
interest income based on the residence of the payor of the interest. No 
withholding applies with respect to distributions attributable to U.S. 
source interest and the character of the distributions attributable to 
the interest income remains the same in the hands of A's interest 
holders as if such items were realized directly from the source from 
which realized by A. However, under Country X law the interest holders 
in A do not have to take into account their respective share of the 
interest income received by A on a current basis whether or not 
distributed.
    (ii) Analysis. An item by item analysis is required under paragraph 
(d) of this section. The analysis is the same as Example 9 with respect 
to the dividend income. A is also not fiscally transparent under 
paragraph (d)(3)(ii) of this section with respect to the interest income 
because, although the character of the distributions attributable to the 
interest income in the hands of A's interest holders is determined as if 
realized directly from the source from which realized by A, under 
Country X law the interest holders in A do not have to take into account 
their respective share of the interest income received by A on a current 
basis whether or not distributed. Accordingly, A derives the U.S. source 
interest income for purpose of the U.S.-X treaty.
    Example 11. Treatment of charitable organizations. (i) Facts. Entity 
A is a corporation organized under the laws of Country X that has an 
income tax treaty in effect with the United States. Entity A is 
established and operated exclusively for religious, charitable, 
scientific, artistic, cultural, or educational purposes. Entity A 
receives U.S. source dividend income from U.S. sources. A

[[Page 633]]

provision of Country X law generally exempts Entity A's income from 
Country X tax due to the fact that Entity A is established and operated 
exclusively for religious, charitable, scientific, artistic, cultural, 
or educational purposes. But for such provision, Entity A's income would 
be taxed by Country X.
    (ii) Analysis. Entity A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because, under Country X law, the dividend income is treated as 
an item of income of A and no other persons are required to take into 
account their respective share of the item of income on a current basis, 
whether or not distributed. Accordingly, Entity A is treated as deriving 
the U.S. source dividend income.
    Example 12. Treatment of pension trusts. (i) Facts. Entity A is a 
trust established and operated in Country X exclusively to provide 
pension or other similar benefits to employees pursuant to a plan. 
Entity A receives U.S. source dividend income. A provision of Country X 
law generally exempts Entity A's income from Country X tax due to the 
fact that Entity A is established and operated exclusively to provide 
pension or other similar benefits to employees pursuant to a plan. Under 
the laws of Country X, the beneficiaries of the trust are not required 
to take into account their respective share of A's income on a current 
basis, whether or not distributed and the character and source of the 
income in the hands of A's interest holders are not determined as if 
realized directly from the source from which realized by A.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because under the laws of Country X, the beneficiaries of A are 
not required to take into account their respective share of A's income 
on a current basis, whether or not distributed. A is also not fiscally 
transparent under paragraph (d)(3)(ii) of this section with respect to 
the U.S. source dividend income because under the laws of Country X, the 
character and source of the income in the hands of A's interest holders 
are not determined as if realized directly from the source from which 
realized by A. Accordingly, A derives the U.S. source dividend income 
for purposes of the U.S.-X income tax treaty.

    (6) Effective dates. This paragraph (d) applies to items of income 
paid on or after June 30, 2000, except paragraphs (d)(2)(ii) and 
(d)(2)(iii) of this section apply to items of income paid by a domestic 
reverse hybrid entity on or after June 12, 2002 with respect to amounts 
received by the domestic reverse hybrid entity on or after June 12, 
2002.
    (e) Effective/applicability date. Paragraphs (a) and (b) of this 
section apply for taxable years beginning after December 31, 1966. For 
corresponding rules applicable to taxable years beginning before January 
1, 1967, (see 26 CFR part 1 revised April 1, 1971). Paragraph (c)(1) of 
this section applies to payments made after November 13, 1997. Paragraph 
(c)(2) of this section applies to payments made on or after December 5, 
2013. See paragraph (d)(6) of this section for applicability dates for 
paragraph (d) of this section.

[T.D. 7293, 38 FR 32800, Nov. 28, 1973, as amended by T.D. 8735, 62 FR 
53502, Oct. 14, 1997; T.D. 8889, 65 FR 40997, July 3, 2000; 65 FR 76932, 
Dec. 8, 2000; T.D. 8999, 67 FR 40160, June 12, 2002; T.D. 9648, 78 FR 
73080, Dec. 5, 2013]



Sec.  1.895-1  Income derived by a foreign central bank of issue, or by 
Bank for International Settlements, from obligations of the United States 
or from bank deposits.

    (a) In general. Income derived by a foreign central bank of issue 
from obligations of the United States or of any agency or 
instrumentality thereof, or from interest on deposits with persons 
carrying on the banking business, is excluded from the gross income of 
such bank and is exempt from income tax if the bank is the owner of the 
obligations or deposits and does not hold the obligations or deposits 
for, or use them in connection with, the conduct of a commercial banking 
function or other commercial activity by such bank. For purposes of this 
section and paragraph (i) of Sec.  1.1441-4, obligations of the United 
States or of any agency or instrumentality thereof include beneficial 
interests, participations, and other instruments issued under section 
302(c) of the Federal National Mortgage Association Charter Act (12 
U.S.C. 1717). See 24 CFR part 1600 et seq.
    (b) Foreign central bank of issue. (1) A foreign central bank of 
issue is a bank which is by law or government sanction the principal 
authority, other than the government itself, issuing instruments 
intended to circulate as currency. Such a bank is generally the 
custodian of the banking reserves of the country under whose law it is 
organized. See also paragraph (b)(5) of Sec.  1.861-2.

[[Page 634]]

    (2) The exclusion granted by section 895 applies to an 
instrumentality that is separate from a foreign government, whether or 
not owned in whole or in part by a foreign government. For example, 
foreign banks organized along the lines of, and performing functions 
similar to, the Federal Reserve System qualify as foreign central banks 
of issue for purposes of this section.
    (3) The Bank for International Settlements shall be treated as 
though it were a foreign central bank of issue for purposes of obtaining 
the exclusion granted by section 895.
    (c) Ownership of United States obligations or bank deposits. The 
exclusion does not apply if the obligations or bank deposits from which 
the income is derived are not owned by the foreign central bank of 
issue. Obligations held, or deposits made, by a foreign central bank of 
issue as agent, custodian, trustee, or in any other fiduciary capacity, 
shall be considered as not owned by such bank for purposes of this 
section.
    (d) Commercial banking function or other commercial activity. The 
exclusion applies only to obligations of the United States or of any 
agency or instrumentality thereof, or to bank deposits, held for, or 
used in connection with, the conduct of a central banking function and 
not to obligations or deposits held for, or used in connection with, the 
conduct of commercial banking functions or other commercial activities 
by the foreign central bank.
    (e) Other exclusions. See section 861(a)(1) (A) and (E) and Sec.  
1.861-2(b)(1) and (4), for special rules relating to interest paid or 
credited before January 1, 1977, on deposits and on similar amounts and 
for rules on interest derived from bankers' acceptances. For exemption 
from withholding under Sec.  1.1441-1 on income derived by a foreign 
central bank of issue, or by the Bank of International Settlements, from 
obligations of the United States or of any agency or instrumentality 
thereof, or from bank deposits, see Sec.  1.1441-4(i).
    (f) Effective date. This section shall apply with respect to taxable 
years beginning after December 31, 1966. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.85-1 (Revised as of January 1, 1972).

[T.D. 7378, 40 FR 45435, Oct. 2, 1975; 40 FR 48508, Oct. 16, 1975]



Sec.  1.897-1  Taxation of foreign investment in United States real 
property interests, definition of terms.

    (a) In general--(1) Purpose and scope of regulations. These 
regulations provide guidance with respect to the taxation of foreign 
investments in U.S. real property interests and related matters. This 
section defines various terms for purposes of sections 897, 1445, and 
6039C and the regulations thereunder. Section 1.897-2 provides rules 
regarding the definition of, and consequences of, U.S. real property 
holding corporation status. Section 1.897-3 sets forth rules pursuant to 
which certain foreign corporations may elect under section 897(i) to be 
treated as domestic corporations for purposes of sections 897 and 6039C. 
Finally, Sec.  1.987-4 provides rules concerning the similar election 
under section 897(k) for certain foreign corporations in the process of 
liquidation.
    (2) Effective date. The regulations set forth in Sec. Sec.  1.897-1 
through 1.897-4 are effective for transactions occurring after June 18, 
1980. However, with respect to all transactions occurring after June 18, 
1980 and before January 30, 1985, taxpayers may at their option choose 
to apply the Temporary Regulations under section 897 (in their 
entirety). The Temporary Regulations are located at 26 CFR 6a.897-1 
through 6a.897-4 (Revised as of April 1, 1983), and were originally 
published in the Federal Register for September 21, 1982 (47 FR 41532) 
and amended by T.D. 7890, published in the Federal Register on April 28, 
1983 (48 FR 19163).
    (b) Real property--(1) In general. The term ``real property'' 
includes the following three categories of property: Land and unserved 
natural products of the land, improvements, and personal property 
associated with the use of real property. The three categories of real 
property are defined in subparagraphs (2), (3), and (4) of this 
paragraph (b). Local law definitions will not be controlling for 
purposes of determining the meaning of the term ``real property'' as it 
is used in sections 897, 1445,

[[Page 635]]

and 6039C and the regulations thereunder.
    (2) Land and unserved natural products of the land. The term ``real 
property'' includes land, growing crops and timber, and mines, wells, 
and other natural deposits. Crops and timber cease to be real property 
at the time that they are served from the land. Ores, minerals, and 
other natural deposits cease to be real property when they are extracted 
from the ground. The storage of severed or extracted crops, timber, or 
minerals in or upon real property will not cause such property to be 
recharacterized as real property.
    (3) Improvements--(i) In general. The term ``real property'' 
includes improvements on land. An improvement is a building, any other 
inherently permanent structure, or the structural components of either, 
as defined in subdivisions (ii) through (iv) of this paragraph (b)(3).
    (ii) Building. The term ``building'' generally means any structure 
or edifice enclosing a space within its walls, and usually covered by a 
roof, the purpose of which is, for example, to provide shelter or 
housing or to provide working, office, parking, display, or sales space. 
The term includes, for example, structures such as apartment houses, 
factory and office buildings, warehouses, barns, garages, railway or bus 
stations, and stores. Any structure that is classified as a building for 
purposes of section 48(a)(1)(B) and Sec.  1.48-1 shall be treated as 
such for purposes of this section.
    (iii) Inherently permanent structure--(A) In general. The term 
``inherently permanent structure'' means any property not otherwise 
described in this paragraph (b)(3) that is affixed to real property and 
that will ordinarily remain affixed for an indefinite period of time. 
Property that is not classified as a building for purposes of section 
48(a)(1)(B) and Sec.  1.48-1 may nevertheless constitute an inherently 
permanent structure. For purposes of this section, affixation to real 
property may be accomplished by weight alone.
    (B) Use of precedents under section 48. Any property not otherwise 
described in this paragraph (b)(3) that constitutes ``other tangible 
property'' under the principles of section 48(a)(1)(B) and Sec.  1.48-1 
(c) and (d) shall be treated for purposes of this section as an 
inherently permanent structure. Thus, for example, the term includes 
swimming pools, paved parking areas and other pavements, special 
foundations for heavy equipment, wharves and docks, bridges, fences, 
inherently permanent advertising displays, inherently permanent outdoor 
lighting facilities, railroad tracks and signals, telephone poles, 
permanently installed telephone and television cables, broadcasting 
towers, oil derricks, oil and gas pipelines, oil and gas storage tanks, 
grain storage bins, and silos. However, property that is determined to 
be either property in the nature of machinery under Sec.  1.48-1(c) or 
property which is essentially an item of machinery or equipment under 
Sec.  1.48-1(e)(1)(i) shall not be treated as an inherently permanent 
structure.
    (C) Absence of precedents under section 48. Where precedents 
developed under the principles of section 48 fail to provide adequate 
guidance with respect to the classification of particular property, the 
determination of whether such property constitutes an inherently 
permanent structure shall be made in view of all the facts and 
circumstances. In particular, the following factors must be taken into 
account:
    (1) The manner in which the property is affixed to real property;
    (2) Whether the property was designed to be easily removable or to 
remain in place indefinitely;
    (3) Whether the property has been moved since its initial 
installation;
    (4) Any circumstances that suggest the expected period of affixation 
(e.g., a lease that requires removal of the property upon its 
expiration);
    (5) The amount of damage that removal of the property would cause to 
the property itself or to the real property to which it is affixed; and
    (6) The extent of the effort that would be required to remove the 
property, in terms of time and expense.
    (iv) Structural components of buildings and other inherently 
permanent structures. Structural components of buildings and other 
inherently permanent structures, as defined in Sec.  1.48-1 (e)(2), 
themselves constitute improvements.

[[Page 636]]

Structural components include walls, partitions, floors, ceilings, 
windows, doors, wiring, plumbing, central heating and central air 
conditioning systems, lighting fixtures, pipes, ducts, elevators, 
escalators, sprinkler systems, fire escapes and other components 
relating to the operation or maintenance of a building. However, the 
term ``structural components'' does not include machinery the sole 
justification for the installation of which is the fact that such 
machinery is required to meet temperature or humidity requirements which 
are essential for the operation of other machinery or the processing of 
materials or foodstuffs. Machinery may meet the ``sole justification'' 
test provided by the preceding sentence even though it incidentally 
provides for the comfort of employees or serves to an insubstantial 
degree areas where such temperature or humidity requirements are not 
essential.
    (4) Personal property associated with the use of the real property--
(i) In general. The term ``real property'' includes movable walls, 
furnishings, and other personal property associated with the use of the 
real property. Personal property is associated with the use of real 
property only if it is described in one of the categories set forth in 
subdivisions (A) through (D) of this paragraph (b)(4)(i). ``Personal 
property'' for purposes of this section means any property that 
constitutes ``tangible personal property'' under the principles of Sec.  
1.48-1(c), without regard to whether such property qualifies as section 
38 property. Such property will be associated with the use of the real 
property only where both the personal property and the United States 
real property interest with which it is associated are held by the same 
person or by related persons within the meaning of Sec.  1.897-1(i). For 
purposes of this paragraph (b)(4)(i), property is used ``predominantly'' 
in a named activity if it is devoted to that activity during at least 
half of the time in which it is in use during a calendar year.
    (A) Property used in mining, farming, and forestry. Personal 
property is associated with the use of real property if it is 
predominantly used to exploit unsevered natural products in or upon the 
land. Such property includes mining equipment used to extract ores, 
minerals, and other natural deposits from the ground. It also includes 
any property used to cultivate the soil and harvest its products, such 
as farm machinery, draft animals, and equipment used in the growing and 
cutting of timber. However, personal property used to process or 
transport minerals, crops, or timber after they are severed from the 
land is not associated personal property.
    (B) Property used in the improvement of real property. Personal 
property is associated with the use of real property if it is 
predominantly used to construct or otherwise carry out improvements to 
real property. Such property includes equipment used to alter the 
natural contours of the land, equipment used to clear and prepare raw 
land for construction, and equipment used to carry out the construction 
of improvements.
    (C) Property used in the operation of a lodging facility. Personal 
property is associated with the use of real property if it is 
predominantly used in connection with the operation of a lodging 
facility. Property that is used in connection with the operation of a 
lodging facility includes property used in the living quarters of such 
facility, such as beds and other furniture, refrigerators, ranges and 
other equipment, as well as property used in the common areas of such 
facility, such as lobby furniture and laundry equipment. Such property 
constitutes personal property associated with the use of real property 
in the hands of the owner or operator of the facility, not of the tenant 
or guest. A lodging facility is an apartment house or apartment, hotel, 
motel, dormitory, residence, or any other facility (or part of a 
facility) predominantly used to provide, at a charge, living and/or 
sleeping accommodations, whether on daily, weekly, monthly, annual, or 
other basis. The term ``lodging facility'' does not include a personal 
residence occupied solely by its owner, or a facility used primarily as 
a means of transportation (such as an aircraft, vessel, or a railroad 
car) or used primarily to provide medical or convalescent services, even 
though sleeping accommodations are provided. Nor does

[[Page 637]]

the term include temporary living quarters provided by an employer due 
to the unavailability of lodgings within a reasonable distance of a 
work-site (such as a mine or construction project). The term ``lodging 
facility'' does not include any portion of a facility that constitutes a 
nonlodging commercial facility and that is available to persons not 
using the lodging facility on the same basis that it is available to 
tenants of the lodging facility. Examples of nonlodging commercial 
facilities include restaurants, drug stores, and grocery stores located 
in a lodging facility.
    (D) Property used in the rental of furnished office and other work 
space. Personal property is associated with the use of real property if 
it is predominantly used by a lessor to provide furnished office or 
other work space to lessees. Property that is so used includes office 
furniture and equipment included in the rental of furnished space. Such 
property constitutes personal property associated with the use of real 
property in the hands of the lessor, not of the lessee.
    (ii) Dispositions of associated personal property--(A) In general. 
Personal property that has become associated with the use of a real 
property interest shall itself be treated as a real property interest 
upon its disposition, unless either:
    (1) The personal property is disposed of more than one year before 
the disposition of any present right to use or occupy the real property 
with which it was associated (and subject to the provisions of 
subdivision (B) of this paragraph (b)(4)(ii));
    (2) The personal property is disposed of more than one year after 
the disposition of all present rights to use or occupy the real property 
with which it was associated (and subject to the provisions of 
subdivision (C) of this paragraph (b)(4)(ii)); or
    (3) The personal property and the real property with which it was 
associated are separately sold to persons that are related neither to 
the transferor nor to one another (and subject to the provisions of 
subdivision (D) of this paragraph (b)(4)(ii)).
    (B) Personalty property disposed of one year before realty. A 
transferor of personal property associated with the use of real property 
need not treat such property as a real property interest upon 
disposition if on the date of disposition the transferor does not expect 
or intend to dispose of the real property until more than one year 
later.


However, if the real property is in fact disposed of within the 
following year, the transferor must treat the personal property as 
having been a real property interest as of the date on which the 
personalty was disposed of. If the transferor had not previously filed 
an income tax return, a return must be filed and tax paid, together with 
any interest due thereon, by the later of the date on which a tax return 
or payment is actually due (with extensions), or the 60th day following 
the date of disposition. If the transferor had previously filed an 
income tax return, an amended return must be filed and tax paid, 
together with any interest due thereon, by the later of the dates 
specified above. Such a transferor may be liable to penalties for 
failure to file, for late payment of tax, or for understatement of 
liability, but only if the transferor knew or had reason to anticipate 
that the real property would be disposed of within one year of the 
disposition of the associated personal property.
    (C) Personalty disposed of one year after realty. A disposition of 
real property shall be disregarded for purposes of subdivision (A)(2) of 
this paragraph (b)(4)(ii) if any right to use or occupy the real 
property is reacquired within the one-year period referred to in that 
subdivision. However, the disposition shall not be disregarded if such 
reacquisition is made in foreclosure of a mortgage or other security 
interest, in the exercise of a contractual remedy, or in the enforcement 
of a judgment. If, however, the reacquisition of the property is made 
pursuant to a plan the principal purpose of which is the avoidance of 
the provisions of section 897, 1445, or 6039C and the regulations 
thereunder, then the initial disposition shall be disregarded for 
purposes of subdivision (A)(2) of this paragraph (b)(4)(ii).
    (D) Separate dispositions of personalty and realty. A transferor of 
personal property associated with the use of real property need not 
treat such property

[[Page 638]]

as a real property interest upon disposition if within 90 days before or 
after such disposition the transferor separately disposes of the real 
property interest to persons that are related neither to the transferor 
nor to the purchaser of the personal property. A transferor may rely 
upon this rule unless the transferor knows or has reason to know that 
the purchasers of the real property and the personal property--
    (1) Are related persons; or
    (2) Intend to reassociate the personal property with the use of the 
real property within one year of the date of disposition of the personal 
property.
    (E) Status of property in hands of transferee. Personal property 
that has been associated with the use of real property and that is sold 
to an unrelated party will be treated as real property in the hands of 
the transferee only if the personal property becomes associated with the 
use of real property held or acquired by the transferee, in the manner 
described in paragraph (b)(4)(i) of this section.
    (iii) Determination dates. The determination of whether personal 
property is personal property associated with the use of real property 
as defined in this paragraph (b)(4) is to be made on the date the 
personal property is disposed of and on each applicable determination 
date. See Sec.  1.897-2(c).
    (c) United States real property interest--(1) In general. The term 
``United States real property interest'' means any interest, other than 
an interest solely as a creditor, in either:
    (i) Real property located in the United States or the Virgin 
Islands, or
    (ii) A domestic corporation unless it is established that the 
corporation was not a U.S. real property holding corporation within the 
period described in section 897(c)(1)(A)(ii).
    In addition, for the limited purpose of determining whether any 
corporation is a U.S. real property holding corporation, the term 
``United States real property interest'' means an interest, other than 
an interest solely as a creditor, in a foreign corporation unless it is 
established that the foreign corporation is not a U.S. real property 
holding corporation within the period prescribed in section 
897(c)(1)(A)(ii). See Sec.  1.897-2 for rules regarding the manner of 
establishing that a corporation is not a United States real property 
holding corporation.
    (2) Exceptions and special rules--(i) Domestically-controlled REIT. 
An interest in a domestically-controlled real estate investment trust 
(REIT) is not a U.S. real property interest. A domestically-controlled 
REIT is one in which less than 50 percent of the fair market value of 
the outstanding stock was directly or indirectly held by foreign persons 
during the five-year period ending on the applicable determination date 
(or the period since June 18, 1980, if shorter). For purposes of this 
determination the actual owners of stock, as determined under Sec.  
1.857-8, must be taken into account.
    (ii) Corporation that has disposed of all U.S. real property 
interests. The term ``United States real property interest'' does not 
include an interest in a corporation which has disposed of all its U.S. 
real property interests in transactions in which the full amount of 
gain, if any, was recognized, as provided by section 897(c)(1)(B). See 
Sec.  1.897-2(f) for rules regarding the requirements of section 
897(c)(1)(B).
    (iii) Publicly-traded corporations. If, at any time during the 
calendar year, any class of stock of a domestic corporation is regularly 
traded on an established securities market, an interest in such 
corporation shall be treated as a U.S. real property interest only in 
the case of:
    (A) A regularly traded interest owned by a person who beneficially 
owned more than 5 percent of the total fair market value of that class 
of interests at any time during the five-year period ending either on 
the date of disposition of such interest or other applicable 
determination date (or the period since June 18, 1980, in shorter), or
    (B) [Reserved]


Separate non-regularly traded interests that were acquired in 
transactions more than three years apart shall not be cumulated pursuant 
to this rule. In determining whether a shareholder holds 5 percent of a 
class of stock in a corporation (or any other interest of an equivalent 
fair market value), section 318(a) shall apply (except that sections 
318(a) (2)(C) and (3)(C) are applied by

[[Page 639]]

substituting the phrase ``5 percent'' for ``50 percent'').
    (iv) Publicly traded partnerships and trusts. If any class of 
interests in a partnership or trust is, within the meaning of Sec.  
1.897-1(m) and (n), regularly traded on an established securities 
market, then for purposes of sections 897(g) and 1445 and Sec.  1.897-2 
(d) and (e) an interest in the entity shall not be treated as an 
interest in a partnership or trust. Instead, such an interest shall be 
subject to the rules applicable to interests in publicly traded 
corporations pursuant to paragraph (c)(2)(iii) of this section. Such 
interests can be real property interests in the hands of a person that 
holds a greater than 5 percent interest. Therefore, solely for purposes 
of determining whether greater than 5 percent interests in such an 
entity constitute U.S. real property interests the disposition of which 
is subject to tax, the entity is required to determine pursuant to the 
provisions of Sec.  1.897-2 whether the assets it holds would cause it 
to be classified as a U.S. real property holding corporation if it were 
a corporation. The treatment of dispositions of U.S. real property 
interests by publicly traded partnerships and trusts is not affected by 
the rules of this paragraph (c)(2)(iv); by reason of the operation of 
section 897(a), foreign partners or beneficiaries are subject to tax 
upon their distributive share of any gain recognized upon such 
dispositions by the partnership or trust. The rules of this paragraph 
(c)(2)(iv) are illustrated by the following example.

    Example. PTP is a partnership one class of interests in which is 
regularly traded on an established securities market. A is a nonresident 
alien individual who owns 1 percent of a class of limited partnership 
interests in PTP. B is a nonresident alien individual who owns 10 
percent of the same class of limited partnership interests in PTP. On 
July 1, 1986, A and B sell their interests in PTP. Pursuant to the rules 
of this paragraph (c)(2)(iv), neither disposition is treated as the 
disposition of a partnership interest subject to the provisions of 
section 897(g). Instead, A and B are treated as having disposed of 
interests in a publicly traded corporation. Therefore, pursuant to the 
rule of paragraph (c)(2)(iii) of this section, A's disposition of a 1 
percent interest has no consequences under section 897. However, B's 
disposition of a 10 percent interest will constitute the disposition of 
a U.S. real property interest subject to tax by reason of the operation 
of section 897 unless it is established pursuant to the rules of Sec.  
1.897-2 that the interest is not a U.S. real property interest.

    (d) Interest other than an interest solely as a creditor--(1) In 
general. This paragraph defines an interest other than an interest 
solely as a creditor, with respect to real property, and with respect to 
corporations, partnerships, trusts, and estates. An interest solely as a 
creditor either in real property or in a domestic corporation does not 
constitute a United States real property interest. Similarly, where one 
corporation holds an interest solely as a creditor in a second 
corporation or in a partnership, trust, or estate, that interest will be 
disregarded for purposes of determining whether the first corporation is 
a U.S. real property holding corporation (except to the extent that such 
interest constitutes an asset used or held for use in a trade or 
business, in accordance with rules of Sec.  1.897-1(f)). In addition, 
the disposition of an interest solely as a creditor in a partnership, 
trust, or estate is not subject to sections 897, 1445, and 6039C. 
Whether an interest is considered debt under any provisions of the Code 
is not determinative of whether it constitutes an interest solely as a 
creditor for purpose of sections 897, 1445, and 6039C and the 
regulations thereunder.
    (2) Interests in real property other than solely as creditor--(i) In 
general. An interest in real property other than an interest solely as a 
creditor includes a fee ownership, co-ownership, or leasehold interest 
in real property, a time sharing interest in real property, and a life 
estate, remainder, or reversionary interest in such property. The term 
also includes any direct or indirect right to share in the appreciation 
in the value, or in the gross or net proceeds or profits generated by, 
the real property.
    A loan to an individual or entity under the terms of which a holder 
of the indebtedness has any direct or indirect right to share in the 
appreciation in value of, or the gross or net proceeds or profits 
generated by, an interest in

[[Page 640]]

real property of the debtor or of a related person is, in its entirety, 
an interest in real property other than solely as a creditor. An 
interest in production payments described in section 636 does not 
generally constitute an interest in real property other than solely as a 
creditor. However, a right to production payments shall constitute an 
interest in real property other than solely as a creditor if it conveys 
a right to share in the appreciation in value of the mineral property. A 
production payment that is limited to a quantum of mineral (including a 
percentage of recoverable reserves produced) or a period of time will be 
considered to convey a right to share in the appreciation in value of 
the mineral property. The rules of this paragraph (d)(2)(i) are 
illustrated by the following example.

    Example. A, a U.S. citizen, purchases a condominium unit located in 
the United States for $500,000. A makes a $100,000 down payment and 
borrows $400,000 from B, a foreign person, to pay the balance of the 
purchase price. Under the terms of the loan. A is to pay B 13 percent 
annual interest each year for 10 years and 35 percent of the 
appreciation in the fair market value of the condominium at the end of 
the 10-year period. Because B has a right to share in the appreciation 
in value of the condominium, B has an interest other than solely as a 
creditor in the condominium. B's entire interest in the obligation from 
A, therefore, is a United States real property interest.

    (ii) Special rule--(A) Installment obligations. A right to 
installment or other deferred payments from the disposition of an 
interest in real property will constitute an interest solely as a 
creditor if the transferor elects not to have the installment method of 
section 453(a) apply, any gain or loss is recognized in the year of 
disposition, and all tax due is timely paid. See section 1445 and 
regulations thereunder for further guidance concerning the availability 
of installment sale treatment under section 453. If an agreement for the 
payment of tax with respect to an installment sale is entered into with 
the Internal Revenue Service pursuant to section 1445, that agreement 
may specify whether or not the installment obligation will constitute an 
interest solely as a creditor. If an installment obligation constitutes 
an interest other than solely as a creditor then the receipt of each 
payment shall be treated as the disposition of an interest in real 
property that is subject to section 897(a) to the extent of any gain 
required to be taken into account pursuant to section 453.
    If the original holder of an installment obligation that constitutes 
an interest other than solely as a creditor subsequently disposes of the 
obligation to an unrelated party and recognizes gain or loss pursuant to 
section 453B, the obligation will constitute an interest in real 
property solely as a creditor in the hands of the subsequent holder. 
However, if the obligation is disposed of to a related person and the 
full amount of gain realized upon the disposition of the real property 
has not been recognized upon such disposition of the installment 
obligation, then the obligation shall continue to be an interest in real 
property other than solely as a creditor in the hands of the subsequent 
holder subject to the rules of this paragraph (d)(2)(ii)(A).
    In addition, if the obligation is disposed of to any person for a 
principal purpose of avoiding the provisions of sections 897, 1445, or 
6039C, then the obligation shall continue to be an interest in real 
property other than solely as a creditor in the hands of the subsequent 
holder subject to the rules of this paragraph (d)(2)(ii)(A). However, 
rights to payments arising from dispositions that took place before June 
19, 1980, shall in no event constitute interests in real property other 
than solely as a creditor, even if such payments are received after June 
18, 1980. In addition, rights to payments arising from dispositions to 
unrelated parties that took place before January 1, 1985, and that were 
not subject to U.S. tax pursuant to the provisions of a U.S. income tax 
treaty, shall not constitute interests in real property other than 
solely as a creditor, even if such payments are received after December 
31, 1984.
    (B) Options. An option, a contract or a right of first refusal to 
acquire any interest in real property (other than an interest solely as 
a creditor) will itself constitute an interest in real property other 
than solely as a creditor.
    (C) Security interests. A right to repossess or foreclose on real 
property under

[[Page 641]]

a mortgage, security agreement, financing statement, or other collateral 
instrument securing a debt will not be considered a reversionary 
interest in, or a right to share in the appreciation in value of or 
gross or net proceeds or profits generated by, an interest in real 
property. Thus, no such right of repossession or foreclosure will of 
itself cause an interest in real property which is otherwise an interest 
solely as a creditor to become an interest other than solely as a 
creditor. In addition, a person acting as mortgagee in possession shall 
not be considered to hold an interest in real property other than solely 
as a creditor, if the mortgagee's interest in the property otherwise 
constitutes an interest solely as a creditor.
    (D) Indexed interest rates. An interest will not constitute a right 
to share in the appreciation in the value of, or gross or net proceeds 
or profits generated by, real property solely because it bears a rate of 
interest that is tied to an index of any kind that is intended to 
reflect general inflation or deflation of prices and interest rates 
(e.g., the Consumer Price Index). However, where an interest in real 
property bears a rate of interest that is tied to an index the principal 
purpose of which is to reflect changes in real property values, the real 
property interest will be considered an indirect right to share in the 
appreciation in value of, or gross or net proceeds or profits generated 
by, real property. Such an indirect right constitutes an interest in 
real property other than solely as a creditor.
    (E) Commissions. A right to payment of a commission, brokerage fee, 
or similar charge for professional services rendered in connection with 
the arrangement or financing of a purchase, sale, or lease of real 
property does not constitute a right to share in the appreciation in 
value of, or gross or net proceeds or profits of, real property solely 
because it is based upon a percentage of the purchase price or rent. 
Thus, a right to a commission earned by a real estate agent based on a 
percentage of the sales price does not constitute an interest in real 
property other than solely as a creditor.
    However, a right to a commission, brokerage fee, or similar charge 
will constitute an interest other than solely as a creditor if the total 
amount of the payment is contingent upon appreciation, proceeds, or 
profits of the real property occurring or arising after the date of the 
transaction with respect to which the professional services were 
rendered. For example, a commission earned in connection with the 
purchase of a real property interest that is contingent upon the amount 
of gain ultimately realized by the purchaser will constitute an interest 
in real property other than solely as a creditor.
    (F) Trustees' fees, etc. A right to payment of reasonable 
compensation for services rendered as a trustee, as an administrator of 
an estate, or in a similar capacity does not constitute a right to share 
in the appreciation in the value of, or gross or net proceeds or profits 
of, real property solely because the assets of the trust or estate 
include U.S. real property interests.
    (3) Interest in an entity other than solely as a creditor--(i) In 
general. For purposes of sections 897, 1445, and 6039C, an interest in 
an entity other than an interest solely as a creditor is--
    (A) Stock of a corporation;
    (B) An interest in a partnership as a partner within the meaning of 
section 761(b) and the regulations thereunder;
    (C) An interest in a trust or estate as a beneficiary within the 
meaning of section 643(c) and the regulations thereunder or an ownership 
interest in any portion of a trust as provided in sections 671 through 
679 and the regulations thereunder;
    (D) An interest which is, in whole or in part, a direct or indirect 
right to share in the appreciation in value of an interest in an entity 
described in subdivision (A), (B), or (C) of this paragraph (d)(3)(i) or 
a direct or indirect right to share in the appreciation in value of 
assets of, or gross or net proceeds or profits derived by, the entity; 
or
    (E) A right (whether or not presently exercisable) directly or 
indirectly to acquire, by purchase, conversion, exchange, or in any 
other manner, an interest described in subdivision (A), (B), (C), or (D) 
of this paragraph (d)(3) (i).
    (ii) Special rules--(A) Installment obligations. A right to 
installment or other deferred payments from the disposition

[[Page 642]]

of an interest in an entity will constitute an interest solely as a 
creditor if the transferor elects not to have the installment method of 
section 453(a) apply, any gain or loss is recognized in the year of 
disposition, and tax due is timely paid. See section 1445 and 
regulations thereunder for further guidance concerning the availability 
of installment sale treatment under section 453. If an agreement for the 
payment of tax with respect to an installment sale is entered into with 
the Internal Revenue Service pursuant to section 1445, that agreement 
may specify whether or not the installment obligation will constitute an 
interest solely as a creditor. If an installment obligation constitutes 
an interest other than solely as a creditor then the receipt of each 
payment shall be treated as the disposition of such an interest and 
shall be subject to section 897(a) to the extent that:
    (1) It constitutes the disposition of a U.S. real property interest 
and
    (2) Gain or loss is required to be taken into account pursuant to 
section 453. Such treatment shall apply to payments arising from 
dispositions of interests in a corporation any class of the stock of 
which is regularly traded on an established securities market, but only 
in the case of a disposition of any portion of an interest described in 
paragraph (c)(2)(iii)(A) or (B) of this section. If the original holder 
of an installment obligation that constitutes an interest other than 
solely as a creditor subsequently disposes of the obligation to an 
unrelated party and recognizes gain or loss pursuant to section 453B, 
the obligation will constitute an interest in the entity solely as a 
creditor in the hands of the subsequent holder. However, if the 
obligation is disposed of to a related person and the full amount of 
gain realized upon the disposition of the interest in the entity has not 
been recognized upon such disposition of the installment obligation, 
then the obligation shall continue to be an interest in the entity other 
than solely as a creditor in the hands of the subsequent holder subject 
to the rules of this paragraph (d)(3)(ii)(A). In addition, if the 
obligation is disposed of to any person for a principal purpose of 
avoiding the provisions of section 897, 1445, or 6039C, then the 
obligation shall continue to be an interest in the entity other than 
solely as a creditor in the hands of the subsequent holder subject to 
the rules of this paragraph (d)(3)(ii)(A). However, rights to payments 
arising from dispositions that took place before June 19, 1980, shall in 
no event constitute interests in an entity other than solely as a 
creditor, even if such payments are received after June 18, 1980. In 
addition, such treatment shall not apply to payments arising from 
dispositions to unrelated parties that took place before January 1, 
1985, and that were not subject to U.S. tax pursuant to the provisions 
of a U.S. income tax treaty, regardless of when such payments are 
received.
    (B) Contingent interests. The interests described in subdivision (D) 
of paragraph (d)(3)(i) of this section include any right to a payment 
from an entity the amount of which is contingent on the appreciation in 
value of an interest described in subdivision (A), (B), or (C) of 
paragraph (d)(3)(i) of this section or which is contingent on the 
appreciation in value of assets of, or the general gross or net proceeds 
or profits derived by, such entity. The right to such a payment is 
itself an interest in the entity other than solely as a creditor, 
regardless of whether the holder of such right actually holds an 
interest in the entity described in subdivision (A), (B), or (C) of 
paragraph (d)(3)(i) of this section. For example, a stock appreciation 
right constitutes an interest in a corporation other than solely as a 
creditor even if the holder of such right actually holds no stock in the 
corporation. However, the interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include any right to a 
payment that is (1) exclusively contingent upon and exclusively paid out 
of revenues from sales of personal property (whether tangible or 
intangible) or from services, or (2) exclusively contingent upon the 
resolution of a claim asserted against the entity by a person related 
neither to the entity nor to the holder of the interest.
    (C) Security interests. A right to repossess or foreclose on an 
interest in an entity under a mortgage, security agreement, financing 
statement, or other collateral instrument securing a

[[Page 643]]

debt will not of itself cause an interest in an entity which is 
otherwise an interest solely as a creditor to become an interest other 
than solely as a creditor.
    (D) Royalties. The interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include rights to payments 
representing royalties, license fees, or similar charges for the use of 
patents, inventions, formulas, copyrights, literary, musical or artistic 
compositions, trademarks, trade names, franchises, licenses, or similar 
intangible property.
    (E) Commissions. The interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include a right to a 
commission, brokerage fee or similar charge for professional services 
rendered in connection with the purchase or sale of an interest in an 
entity. However, a right to such a payment will constitute an interest 
other than solely as a creditor if the total amount of the payment is 
contingent upon appreciation in value of assets of, or proceeds or 
profits derived by, the entity after the date of the transaction with 
respect to which the payment was earned.
    (F) Trustee's fees. The interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include a right to payment 
representing reasonable compensation for services rendered as a trustee, 
as an administrator of an estate, or in a similar capacity.
    (4) Aggregation of interests. If a person holds both interests 
solely as a creditor and interests other than solely as a creditor in 
real property or in an entity, those interests will generally be treated 
as separate and distinct interests. However, such interests shall be 
aggregated and treated as interests other than solely as a creditor in 
their entirety if the interest solely as a creditor has been separated 
from, or acquired separately from, the interest other than solely as a 
creditor, for a principal purpose of avoiding the provisions of section 
897, 1445, or 6039C by causing one or more of such interests to be an 
interest solely as a creditor. The existence of such a purpose will be 
determined with reference to all the facts and circumstances. Where an 
interest solely as a creditor has arm's-length interest and repayment 
terms it shall in no event be aggregated with and treated as an interest 
other than solely as a creditor. For purposes of this paragraph (d)(4), 
an interest rate that does not exceed 120 percent of the applicable 
Federal rate (as defined in section 1274(d)) shall be presumed to be an 
arm's-length interest rate. For purposes of applying the rules of this 
paragraph (d)(4), a person shall be treated as holding any interests 
held by a related person within the meaning of Sec.  1.897-1(i).
    (5) ``Interest'' means ``interest other than solely as a creditor.'' 
Unless otherwise stated, the term ``interest'' as used with regard to 
real property or with regard to an entity hereafter in the regulations 
under sections 897, 1445, and 6039C, means an interest in such real 
property or entity other than an interest solely as a creditor.
    (e) Proportionate share of assets held by an entity--(1) In general. 
A person that holds an interest in an entity is for certain purposes 
treated as holding a proportionate or pro rata share of the assets held 
by the entity. Such proportionate share must be calculated, in 
accordance with the rules of this paragraph, for the following purposes.
    (i) In determining whether a corporation is a U.S. real property 
holding corporation--
    (A) A person holding an interest in a partnership, trust, or estate 
is treated as holding a proportionate share of the assets held by the 
partnership, trust, or estate (see section 897-2(e)(2)), and
    (B) A corporation that holds a controlling interest in a second 
corporation is treated as holding a proportionate share of the assets 
held by the second corporation (see Sec.  1.897-2(e)(3)).
    (ii) In determining reporting obligations that may be imposed under 
section 6039C, the holder of an interest in a partnership, trust, or 
estate is treated as owning a proportionate share of the U.S. real 
property interests held by the partnership, trust, or estate.
    (2) Proportionate share of assets held by a corporation or 
partnership--(i) In general. A person's proportionate or pro rata share 
of assets held by a corporation or partnership is determined by 
multiplying--
    (A) The person's percentage ownership interest in the entity, by

[[Page 644]]

    (B) The fair market value of the assets held by the entity (or the 
book value of such assets, in the case of a determination pursuant to 
Sec.  1.897-2(b)(2)).
    (ii) Percentage ownership interest. A person's percentage ownership 
interest in a corporation or partnership is the percentage equal to the 
ratio of (A) the sum of the liquidation values of all interests in the 
entity held by the person to (B) the sum of the liquidation values of 
all outstanding interest in the entity. The liquidation value of an 
interest in an entity is the amount of cash and the fair market value of 
any property that would be distributed with respect to such interest 
upon the liquidation of the entity after satisfaction of liabilities to 
persons having interests in the entity solely as creditors. With respect 
to an entity that has interests outstanding that grant a presently-
exercisable option to acquire or right to convert into or otherwise 
acquire an interest in the entity other than solely as a creditor, the 
liquidation value of all interests in such entity shall be calculated as 
though such option or right had been exercised, giving effect both to 
the payment of any consideration required to exercise the option or 
right and to the issuance of the additional interest.


The fair market value of the assets of the entity, the amount of cash 
held by the entity, and the amount of liabilities to persons having 
interests solely as creditors if determined for this purpose on the date 
with respect to which the percentage ownership interest is determined.
    (iii) Examples. The rules of this paragraph (e)(2) are illustrated 
by the following examples.

    Example 1. Corporation K's only assets are stock and securities with 
a fair market value as of the applicable determination date of 
$20,000,000 K's assets are subject to liabilities of $10,000,000. Among 
K's liabilities are a $1,000,000 loan from L, under the terms of which L 
is entitled, upon payment of the loan principal, to a profit share equal 
to 10 percent of the excess of the fair market value of K's assets over 
$18,000,000, but only if all other corporate liabilities have been paid. 
K has two classes of stock, common and preferred. PS1 and PS2 each own 
100 of the 200 outstanding shares of preferred stock. CS1 and CS2 each 
own 500 of the 1,000 outstanding shares of common stock. Each preferred 
shareholder is entitled to $10,000 per share of preferred stock upon 
liquidation, subject to payment of all corporate liabilities and to any 
amount owed to L, but before any common shareholder is paid. The 
liquidation value of L's interest in K, which constitutes an interest 
other than an interest solely as a creditor, is $1,200 ($1,000,000 
principal of the loan to K plus $200,000 (10 percent of the excess of 
$20,000,000 over $18,000,000). The liquidation value of each of PS1's 
and PS2's blocks of preferred stock is $1,000,000 ($10,000 times 100 
shares each). The liquidation value of each of CS1's and CS2's blocks of 
common stock is $3,900,000 [$20,000,000 (the total fair market value of 
K's assets)--$9,000,000 (liabilities to creditors other than L)--
$1,200,000 (L's liquidation value)--$2,000,000 (PS1's and PS2's 
liquidation value)) times 50 percent (the percentage of common stock 
owned by each)]. The sum of the liquidation values of all of the 
outstanding interests in K (i.e., interests other than solely as a 
creditor) is $11,000,000 [$1,200,000 (L's liquidation value) + 
$2,000,000 (PS1's and PS2's liquidation values) + $7,800,000 (CS1's and 
CS2's liquidation values)]. Each of CS1's and CS2's percentage ownership 
interests in K is 35.5 percent ($3,900,000 divided by $11,000,000). Each 
of PS1's and PS2's percentage ownership interests in K is 9 percent 
($1,000,000 divided by $11,000,000). L's percentage ownership interest 
in K is 11 percent ($1,200,000 divided by $11,000,000).
    Example 2. A, a U.S. person, and B, a foreign person are partners in 
a partnership the only asset of which is a parcel of undeveloped land 
located in the United States that was purchased by the partnership in 
1980 for $300,000. The partnership has no liabilities, and its capital 
is $300,000. A's and B's interests in the capital of the partnership are 
25 percent and 75 percent, respectively, and A and B each has a 50 
percent profit interest in the partnership. The partnership agreement 
provides that upon liquidation any unrealized gain will be distributed 
in accordance with the partners' profit interest. In 1984 the 
partnership has no items of income or deduction, and the fair market 
value of its parcel of undeveloped land is $500,000. In 1984 the 
percentage ownership interest of A in the partnership is 35 percent [the 
ratio of $100,000 (the liquidation value of A's profit interest in 1984) 
plus $75,000 (the liquidation value of A's 25 percent interest in the 
partnership's $300,000 capital) to $500,000 (the sum of the liquidation 
values of all outstanding interests in the partnership)]. The percentage 
ownership interest of B in the partnership in 1984 is 65 percent [the 
ratio of $325,000 (B's $100,000 profit interest plus his $225,000 
capital interest) to $500,000]


[[Page 645]]


    (3) Proportionate share of assets held by trusts and estates--(i) In 
general. A person's proportionate or pro rata share of assets held by a 
trust or estate is determined by multiplying--
    (A) The person's percentage ownership interest in the trust or 
estate, by
    (B) The fair market value of the assets held by the trust or estate 
(or the book value of such assets, in the case of a determination 
pursuant to Sec.  1.897-2(b)(2)).
    (ii) Percentage ownership interest--(A) General rule. A person's 
percentage ownership interest in a trust or an estate--is the percentage 
equal to the ratio of:
    (1) The sum of the actuarial values of such person's interests in 
the cash and other assets held by the trust or estate after satisfaction 
of the liabilities of the trust or estate to persons holding interests 
in the trust or estate solely as creditors, to (2) the entire amount of 
such cash and other assets after satisfaction of liabilities to persons 
holding interests in the trust or estate solely as creditors. For 
purposes of calculating this ratio, the fair market value of the trust's 
or estate's assets, the amount of cash held by the trust or estate, and 
the amount of the liabilities to persons having interests solely as 
creditors is determined on the date with respect to which the percentage 
ownership interest is determined. With respect to a trust or estate that 
has interests outstanding that grant a presently-exercisable option to 
acquire or right to convert into or otherwise acquire an interest in the 
trust or estate other than solely as a creditor, the liquidation value 
of all interests in such entity shall be calculated as though such 
option or right had been exercised, giving effect both to the payment of 
any consideration required to exercise the option or right and to the 
issuance of the additional interest. With respect to a trust or estate 
that has interests outstanding that entitle any person to a distribution 
of U.S. real property interests upon liquidation that is 
disproportionate to such person's interest in the total assets of the 
trust or estate, such disproportionate right shall be disregarded in the 
calculation of the interest-holders' proportionate share of the U.S. 
real property interests held by the entity. For purposes of determining 
his own percentage ownership interest in a trust, a grantor or other 
person will be treated as owning any portion of the trust's cash and 
other assets which such person is treated as owning under sections 671 
through 679.
    (B) Discretionary trusts and estates. In determining percentage 
ownership interest in a trust or an estate, the sum of the definitely 
ascertainable actuarial values of interests in the cash and the other 
assets of the trust or estate held by persons in existence on the date 
with respect to which such determination is made must equal the amount 
in paragraph (e)(3)(ii)(A)(2) of this section. If the amount in 
paragraph (e)(3)(ii)(A)(2) of this section exceeds the sum of the 
definitely ascertainable actuarial values of the interests held by 
persons in existence on the determination date, the excess will be 
considered to be owned in total by each beneficiary who is in existence 
on such date, whose interest in the excess is not definitely 
ascertainable and who is potentially entitled to such excess. However, 
such excess shall not be considered to be owned in total by each 
beneficiary if the discretionary terms of the trust or estate were 
included for a principal purpose of avoiding the provisions of section 
897, 1445, or 6039C by causing assets other than U.S. real property 
interests to be attributed in total to each beneficiary. The rules of 
this paragraph (e)(3) are illustrated by the following example.

    Example. A, a U.S. person, established a trust on December 31, 1984, 
and contributed real property with a fair market value of $10,000 to the 
trust. The terms of that trust provided that the trustee, a bank that is 
unrelated to A, at its discretion may retain trust income or may 
distribute it to X, a foreign person, or to the head of state of any 
country other than the United States. The remainder upon the death of X 
is to go in equal shares to such of Y and Z, both foreign persons, as 
survive X. On December 31, 1984, the total value of the trust's assets 
is $10,000. On the same date, the actuarial values of the remainder 
interests of Y and Z in the corpus of the trust are definitely 
ascertainable. They are $1,000 and $500, respectively. Neither the 
income interest of X nor of the head of state of any country other than 
the United States has a definitely ascertainable

[[Page 646]]

actuarial value on December 31, 1984. The interests of Y and Z in the 
income portion of the trust similarly have no definitely ascertainable 
actuarial values on such date since the income may be distributed rather 
than retained by the trust. Since the sum of the actuarial values of 
definitely ascertainable interests of persons in existence ($1,500) is 
less than $10,000, the difference ($8,500) is treated as owned by each 
beneficiary who is in existence on December 31, 1984, and who is 
potentially entitled to such excess. Therefore, X, Y, Z, and the head of 
state of any country other than the United States are each considered as 
owning the entire $8,500 income interest in the trust. On December 31, 
1984, the total actuarial value of X's interest is $8,500, and his 
percentage ownership interest is 85 percent. The total actuarial value 
of Y's interest in the trust is $9,500 ($1,000 plus $8,500), and his 
percentage ownership interest is 95 percent. The total actuarial value 
of Z's interest is $9,000 ($500 plus $8,500), and his percentage 
ownership interest is 90 percent. The actuarial value of the interest of 
the head of state of each country other than the United States is 
$8,500, and his percentage ownership interest is 85 percent.

    (4) Dates with respect to which percentage ownership interests are 
determined. The dates with respect to which percentage ownership 
interests are determined are the applicable determination dates outlined 
in Sec.  1.897-2 or in regulations under section 6039C.
    (f) Asset used or held for use in a trade or business--(1) In 
general. The term ``asset used or held for use in a trade or business'' 
means--
    (i) Property, other than a U.S. real property interest, that is--
    (A) Stock in trade of an entity or other property of a kind which 
would properly be included in the inventory of the entity if on hand at 
the close of the taxable year, or property held by the entity primarily 
for sale to customers in the ordinary course of its trade or business, 
or
    (B) Depreciable property used or held for use in the trade or 
business, as described in section 1231(b)(1) but without regard to the 
holding period limitations of section 1231(b), or
    (C) Livestock, including poultry, used or held for use in a trade or 
business for draft, breeding, dairy, or sporting purposes, and
    (ii) Goodwill and going concern value, patents, inventions, formulas 
copyrights, literary, musical, or artistic compositions, trademarks, 
trade names, franchises, licenses, customer lists, and similar 
intangible property, but only to the extent that such property is used 
or held for use in the entity's trade or business and subject to the 
valuation rules of Sec.  1.897-1(o)(4), and
    (iii) Cash, stock, securities, receivables of all kinds, options or 
contracts to acquire any of the foregoing, and options or contracts to 
acquire commodities, but only to the extent that such assets are used or 
held for use in the corporation's trade or business and do not 
constitute U.S. real property interests.
    (2) Used or held for use in a trade or business. An asset is used or 
held for use in an entity's trade or business if it is, under the 
principles of Sec.  1.864-4(c)(2)--
    (i) Held for the principal purpose of promoting the present conduct 
of the trade or business,
    (ii) Acquired and held in the ordinary course of the trade or 
business, as, for example, in the case of an account or note receivable 
arising from that trade or business (including the performance of 
services), or
    (iii) Otherwise held in a direct relationship to the trade or 
business.


In determining whether an asset is held in a direct relationship to the 
trade or business, consideration shall be given to whether the asset is 
needed in that trade or business. An asset shall be considered to be 
needed in a trade or business only if the asset is held to meet the 
present needs of that trade or business and not its anticipated future 
needs. An asset shall be considered as needed in the trade or business 
if, for example, the asset is held to meet the operating expenses of 
that trade or business. Conversely, an asset shall be considered as not 
needed in the trade or business if, for example, the asset is held for 
the purpose of providing for future diversification into a new trade or 
business, future expansion of trade or business activities, future plant 
replacement, or future business contingencies. An asset that is held to 
meet reserve or capitalization requirements imposed by applicable law 
shall be presumed to be held in a direct relationship to the trade or 
business.

[[Page 647]]

    (3) Special rules concerning liquid assets--(i) Safe harbor amount. 
Assets described in paragraph (f)(1)(iii) of this section shall be 
presumed to be used or held for use in a trade or business, in an amount 
up to 5 percent of the fair market value of other assets used or held 
for use in the trade or business. However, the rule of this paragraph 
(f)(3)(i) shall not apply with respect to any assets described in 
paragraph (f)(1)(iii) of this section that are held or acquired for the 
principal purpose of avoiding the provisions of section 897 or 1445.
    (ii) Investment companies. Assets described in paragraph (f)(1)(iii) 
of this section shall be presumed to be used or held for use in an 
entity's trade or business if the principal business of the entity is 
trading or investing in such assets for its own account. An entity's 
principal business shall be presumed to be trading or investing in 
assets described in paragraph (f)(1)(iii) of this section if the fair 
market value of such assets held by the entity equals or exceeds 90 
percent of the sum of the fair market values of the entity's U.S. real 
property interests, interests in real property located outside the 
United States, assets otherwise used or held for use in trade or 
business, and assets described in paragraph (f)(1)(iii) of this section.
    (4) Examples. The application of this paragraph (f) may be 
illustrated by the following examples:

    Example 1. M, a domestic corporation engaged in industrial 
manufacturing, is required to hold a large current cash balance for the 
purposes of purchasing materials and meeting its payroll. The amount of 
the cash balance so required varies because of the fluctuating seasonal 
nature of the corporation's business. In months when large cash balances 
are not required, the corporation invests the surplus amount in U.S. 
Treasury bills. Since both the cash and the Treasury bills are held to 
meet the present needs of the business, they are held in a direct 
relationship to that business, and, therefore, constitute assets used or 
held for use in the trade or business.
    Example 2. R, a domestic corporation engaged in the manufacture of 
goods, engages a stock brokerage firm to manage securities which were 
purchased with funds from R's general surplus reserves. The funds 
invested in these securities are intended to provide for the future 
expansion of R into a new trade or business. Thus, the funds are not 
necessary for the present needs of the business; they are accordingly 
not held in a direct relationship to the business and do not constitute 
assets used or held for use in the trade or business.
    Example 3. B, a federally chartered and regulated bank, is required 
by law to hold substantial reserves of cash, stock, and securities. 
Pursuant to the rule of paragraph (f)(2) of this section, such assets 
are presumed to be held in a direct relationship to B's business, and 
thus constitute assets used or held for use in the trade or business. In 
addition, B holds substantial loan receivables which are acquired and 
held in the ordinary course of its banking business. Pursuant to the 
rule of paragraph (f)(1)(iii) of this section, such receivables 
constitute assets used or held for use in the trade or business.

    (g) Disposition. For purposes of sections 897, 1445, and 6039C, the 
term ``disposition'' means any transfer that would constitute a 
disposition by the transferor for any purpose of the Internal Revenue 
Code and regulations thereunder. The severance of crops or timber and 
the extraction of minerals do not alone constitute the disposition of a 
U.S. real property interest.
    (h) Gain or loss. The amount of gain or loss arising from the 
disposition of the U.S. real property interest shall be determined as 
provided in section 1001 (a) and (b). Such gain or loss shall be subject 
to the provisions of section 897 (a) and (b), unless a nonrecognition 
provision is applicable pursuant to section 897 (d) or (e) and 
regulations thereunder. Amounts otherwise treated for Federal income tax 
purposes as principal and interest payments on debt obligations of all 
kinds (including obligations that are interests other than solely as a 
creditor) do not give rise to gain or loss that is subject to section 
897(a). However, principal payments on installment obligations described 
in Sec. Sec.  1.897-1(d)(2)(ii)(A) and 1.897-1(d)(3)(ii)(A) do give rise 
to gain or loss that is subject to section 897(a), to the extent such 
gain or loss is required to be recognized pursuant to section 453. The 
rules of paragraphs (g) and (h) are illustrated by the following 
examples.

    Example 1. Foreign individual C has an undivided fee interest in a 
parcel of real property located in the United States. The fair market 
value of C's interest is $70,000, and C's basis in such interest is 
$50,000. The only liability to which the real property is subject

[[Page 648]]

is the liability of $65,000 secured by a mortgage in the same amount. C 
transfers his fee interest in the property subject to the mortgage by 
gift to D. C realizes $15,000 of gain upon such transfer. As a transfer 
by gift constitutes a disposition for purposes of the Code, and as gain 
is realized upon that transfer, the gift is a disposition for purposes 
of sections 897, 1445, and 6039C and is subject to section 897(a) to the 
extent of the gain realized. However, section 897(a) would not be 
applicable to the transfer if the mortgage on the U.S. real property 
were equal to or less than C's $50,000 basis, since the transfer then 
would not give rise to the realization of gain or loss under the 
Internal Revenue Code.
    Example 2. Foreign corporation Y makes a loan of $1 million to 
domestic individual Z, secured by a mortgage on residential real 
property purchased with the loan proceeds. The loan agreement provides 
that Y is entitled to receive fixed monthly payments from Z, 
constituting repayment of principal plus interest at a fixed rate. In 
addition, the agreement provides that Y is entitled to receive a 
percentage of the appreciation value of the real property as of the time 
that the loan is retired. The obligation in its entirety is considered 
debt for Federal income tax purposes. However, because of Y's right to 
share in the appreciation in value of the real property, the debt 
obligation gives Y an interest in the real property other than solely as 
a creditor. Nevertheless, as principal and interest payments do not 
constitute gain under section 1001 and paragraph (h) of this section, 
and both the monthly and final payments received by Y are considered to 
consist solely of principal and interest for Federal income tax 
purposes, section 897(a) shall not apply to Y's receipt of such 
payments. However, Y's sale of the debt obligation to foreign 
corporation A would give rise to gain that is subject to section 897(a).

    (i) Related person. For purposes of sections 897, 1445, and 6039C, 
persons are considered to be related if they are partners or 
partnerships described in section 707(b)(1) of the Code or if they are 
related within the meaning of section 267 (b) and (c) of the Code 
(except that section 267(f) shall apply without regard to section 
1563(b)(2)).
    (j) Domestic corporation. The term ``domestic corporation'' has the 
same meaning as set forth in section 7701(a) (3) and (4) and Sec.  
301.7701-5. For purposes of sections 897 and 6039C, it also includes a 
foreign corporation with respect to which an election under section 
897(i) and Sec.  1.897-3 or section 897(k) and Sec.  1.897-4 to be 
treated as domestic corporation is in effect.
    (k) [Reserved]
    (l) Foreign corporation. The term ``foreign corporation'' has the 
meaning ascribed to such term in section 7701(a) (3) and (5) and Sec.  
301.7701-5. For purposes of sections 897 and 6039C, however, the term 
does not include a foreign corporation with respect to which there is in 
effect an election under section 897(i) and Sec.  1.897-3 or section 
897(k) and Sec.  1.897-4 to be treated as a domestic corporation.
    (m) Established securities market. For purposes of sections 897, 
1445, and 6039C, the term ``established securities market'' means--
    (1) A national securities exchange which is registered under section 
6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f),
    (2) A foreign national securities exchange which is officially 
recognized, sanctioned, or supervised by governmental authority, and
    (3) Any over-the-counter market. An over-the-counter market is any 
market reflected by the existence of an interdealer quotation system. An 
interdealer quotation system is any system of general circulation to 
brokers and dealers which regularly disseminates quotations of stocks 
and securities by identified brokers or dealers, other than by quotation 
sheets which are prepared and distributed by a broker or dealer in the 
regular course of business and which contain only quotations of such 
broker or dealer.
    (n) [Reserved]
    (o) Fair market value--(1) In general. For purposes of sections 897, 
1445, and 6039C only, the term ``fair market value'' means the value of 
the property determined in accordance with the rules, contained in this 
paragraph (o). The definition of fair market value provided herein is 
not to be used in the calculation of gain or loss from the disposition 
of a U.S. real property interest pursuant to section 1001. An 
independent professional appraisal of the value of property must be 
submitted only if such an appraisal is specifically requested in 
connection with the negotiation of a security agreement pursuant to 
section 1445.
    (2) Method of calculating fair market value--(i) In general. The 
fair market value of property is its gross value (as defined in 
paragraph (o)(2)(ii) of this

[[Page 649]]

section) reduced by the outstanding balance of any debts secured by the 
property which are described in paragraph (o)(2)(iii) of this section. 
See Sec.  1.897-2(b) for the alternative use of book values in certain 
limited circumstances.
    (ii) Gross value. Gross value is the price at which the property 
would change hands between an unrelated willing buyer and willing 
seller, neither being under any compulsion to buy or to sell and both 
having reasonable knowledge of all relevant facts. Generally, with 
respect to trade or business assets, going concern value should be used 
as it will provide the most accurate reflection of such a price. 
However, taxpayers may use other methods of valuation if they can 
establish that such method will provide a more accurate determination of 
gross value and if they consistently apply such method to all assets to 
be valued. See subdivisions (3) and (4) of this paragraph (o) for 
special rules with respect to the valuation of leases and of intangible 
assets.
    (iii) Debts secured by the property. The gross value of property 
shall be reduced by the outstanding balance of debts that are:
    (A) Secured by a mortgage or other security interest in the property 
that is valid and enforceable under the law of the jurisdiction in which 
the property is located, and
    (B) Either (1) Incurred to acquire the property (including long-term 
financing obtained in replacement of construction loans or other short-
term debt within one year of the acquisition or completion of the 
property), or (2) otherwise incurred in direct connection with the 
property, such as property tax liens upon real property or debts 
incurred to maintain or improve property.


In addition, if any debt described in this paragraph (o)(2)(iii) is 
refinanced for a valid business purpose (such as obtaining a more 
favorable rate of interest), the principal amount of the replacement 
debt does not exceed the outstanding balance of the original debt, and 
the replacement debt is secured by the property, then the gross value of 
the property shall be reduced by the replacement debt. Obligations to 
related persons shall not be taken into account for purposes of this 
paragraph (o)(2)(iii) unless such obligations constitute interests 
solely as a creditor pursuant to the provisions of paragraph (d)(4) of 
this section and unless the related person has made similar loans to 
unrelated persons on similar terms and conditions.
    (iv) Anti-abuse rule. The gross value of real property located 
outside the United States and of assets used or held for use in a trade 
or business shall be reduced by the outstanding balance of any debt that 
was entered into for the principal purpose of avoiding the provisions of 
section 897, 1445, or 6039C by enabling the corporation to acquire such 
assets. The existence of such a purpose shall be determined with 
reference to all the facts and circumstances. Debts that a particular 
corporation routinely enters into in the ordinary course of its 
acquisition of assets used or held for use in its trade or business will 
not be considered to be entered into for the principal purpose of 
avoiding the provisions of section 897, 1445, or 6039C.
    (3) Fair market value of leases and options. For purposes of 
sections 897, 1445, and 6039C, the fair market value of a leasehold 
interest in real property is the price at which the lease could be 
assigned or the property sublet, neither party to such transaction being 
under any compulsion to enter into the transaction and both having 
reasonable knowledge of all relevant facts. Thus, the value of a 
leasehold interest will generally consist of the present value, over the 
period of the lease remaining, of the difference between the rental 
provided for in the lease and the current rental value of the real 
property. A leasehold interest bearing restrictions on its assignment or 
sublease has a fair market value of zero, but only if those restrictions 
in practical effect preclude (rather than merely condition) the lessee's 
ability to transfer, at a gain, the benefits of a favorable lease. The 
normal commercial practice of lessors may be used to determine whether 
restrictions in a lease have the practical effect of precluding transfer 
at a gain. The fair market value of an option to purchase any property 
is, similarly, the price at which the option

[[Page 650]]

could be sold, consisting generally of the difference between the option 
price and the fair market value of the property, taking proper account 
of any restrictions upon the transfer of the option.
    (4) Fair market value of intangible assets. For purposes of 
determining whether a corporation is a U.S. real property holding 
corporation, the fair market value of intangible assets described in 
Sec.  1.897-1(f)(1)(ii) may be determined in accordance with the 
following rules.
    (i) Purchase price. Intangible assets described in Sec.  1.897-
1(f)(1)(ii) that were acquired by purchase from a person not related to 
the purchaser within the meaning of Sec.  1.897-1(i) may be valued at 
their purchase price. However, such purchase price must be adjusted to 
reflect any amortization required by generally accepted accounting 
principles applied in the United States. Intangible assets acquired by 
purchase shall include any amounts allocated to goodwill or going 
concern valued pursuant to section 338(b)(3) and regulations thereunder. 
Intangible assets acquired by purchase shall not include assets that 
were acquired indirectly through an acquisition of stock to which 
section 338 does not apply. Such assets must be value pursuant to a 
method described in subdivision (ii) or (iii) of this paragraph (o)(4).
    (ii) Book value. Intangible assets described in Sec.  1.897-
1(f)(1)(ii) (other than good will and going concern value) may be valued 
at the amount at which such assets are carried on the financial 
accounting records of the holder of such assets, provided that such 
amount is determined in accordance with generally accepted accounting 
principles applied in the United States. However, this method may not be 
used with respect to assets acquired by purchase from a related person 
within the meaning of Sec.  1.897-1(i).
    (iii) Other methods. Intangible assets described in Sec.  1.897-
1(f)(1)(ii) may be valued pursuant to any other reasonable method at an 
amount reflecting the price at which the asset would change hands 
between an unrelated willing buyer and willing seller, neither being 
under any compulsion to buy or to sell and both having reasonable 
knowledge of all relevant facts. However, a corporation that uses a 
method of valuation other than the purchase price or book value methods 
may be required to comply with the special notification requirements of 
Sec.  1.897-2(h)(1)(iii)(A).
    (p) Identifying number. The ``identifying number'' of an individual 
is the individual's United States social security number or the 
identification number assigned by the Internal Revenue Service (see 
Sec.  301.6109-1 of this chapter). The ``identifying number'' of any 
other person is its United States employer identification number.

(Approved by the Office of Management and Budget under control number 
l545-0123)

(Sec. 897 (94 Stat. 2683; 26 U.S.C. 897), sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the 
Internal Revenue Code of 1954)

[T.D. 7999, 49 FR 50693, Dec. 31, 1984; 50 FR 12530, Mar. 29, 1985, as 
amended by T.D. 8113, 51 FR 46626, Dec. 24, 1986; T.D. 8198, 53 FR 
16217, May 5, 1988; T.D. 8657, 61 FR 9343, Mar. 8, 1996; 61 FR 14248, 
Apr. 1, 1996; T.D. 9082, 68 FR 46082, Aug. 5, 2003]



Sec.  1.897-2  United States real property holding corporations.

    (a) Purpose and scope. This section provides rules regarding the 
definition and consequences of U.S. real property holding corporation 
status. U.S. real property holding corporation status is important for 
determining whether gain from the disposition by a foreign person of an 
interest in a domestic corporation is taxable. Such status is also 
important for purposes of the withholding and reporting requirements of 
sections 1445 and 6039C. For example, a person that buys stock of a U.S. 
real property holding corporation from a foreign person is required to 
withhold under section 1445. In addition, for purposes of determining 
whether another corporation is a U.S. real property holding corporation, 
an interest in a foreign corporation is a U.S. real property interest 
unless it is established that the foreign corporation is not a U.S. real 
property holding corporation. The general definition of a U.S. real 
property holding corporation is provided in paragraph (b) of this 
section. Paragraph (c) provides rules regarding the dates on which U.S. 
real property

[[Page 651]]

holding corporation status must be determined. The assets that must be 
included in making the determination of a corporation's status are set 
forth in paragraph (d), while paragraph (e) provides special rules 
regarding the treatment of interests held by a corporation in 
partnerships, trusts, estates, and other corporations. Rules regarding 
the termination of U.S. real property holding corporation status are set 
forth in paragraph (f). Paragraph (g) explains the manner in which an 
interest-holder can establish that a corporation is not a U.S. real 
property holding corporation, and paragraph (h) provides rules regarding 
certain notification requirements applicable to corporations.
    (b) U.S. real property holding corporation--(1) In general. A 
corporation is a U.S. real property holding corporation if the fair 
market value of the U.S. real property interests held by the corporation 
on any applicable determination date equals or exceeds 50 percent of the 
sum of the fair market values of its--
    (i) U.S. real property interests;
    (ii) Interests in real property located outside the United States; 
and
    (iii) Assets other than those described in subdivision (i) or (ii) 
of this paragraph (b)(1) that are used or held for use in its trade or 
business.


See paragraphs (d) and (e) of this section for rules regarding the 
directly and indirectly held assets that must be included in the 
determination of whether a corporation is a U.S. real property holding 
corporation. The term ``interest in real property located outside the 
United States'' means an interest other than solely as a creditor (as 
defined in Sec.  1.897-1(d)) in real property (as defined in Sec.  
1.897-(b)) that is located outside the United States or the Virgin 
Islands. If a corporation qualifies as a U.S. real property holding 
corporation on any applicable determination date after June 18, 1980, 
any interest in it shall be treated as a U.S. real property interest for 
a period of five years from that date, unless the provisions of 
paragraph (f)(2) of this section are applicable.
    (2) Alternative test--(i) In general. The fair market value of a 
corporation's U.S. real property interests shall be presumed to be less 
than 50 percent of the fair market value of the aggregate of its assets 
described in paragraphs (d) and (e) of this section if on an applicable 
determination date the total book value of the U.S. real property 
interests held by the corporation is 25 percent or less of the book 
value of the aggregate of the corporation's assets described in 
paragraphs (d) and (e) of this section.
    (ii) Definition of book value. For purposes of this section and 
Sec.  1.897-1(e) the term ``book value'' shall be defined as follows. In 
the case of assets that are held directly by the corporation, the term 
means the value at which an item is carried on the financial accounting 
records of the corporation, if such value is determined in accordance 
with generally accepted accounting principles applied in the United 
States. In the case of assets of which a corporation is treated as 
holding a pro rata share pursuant to paragraphs (e) (2) and (3) of this 
section and Sec.  1.897-1(e), the term ``book value'' means the 
corporation's share of the value at which the asset is carried on the 
financial accounting records of the entity that directly holds the 
asset, if such value is determined in accordance with generally accepted 
accounting principles applied in the United States. For purposes of this 
paragraph (b)(2)(ii), an entity need not keep all of its books in 
accordance with U.S. accounting principles, so long as the value of the 
relevant assets is determined in accordance therewith.
    (iii) Denial of presumption. If the Internal Revenue Service 
determines, on the basis of information as to the fair market values of 
a corporation's assets, that the presumption allowed by this paragraph 
(b)(2) may not accurately reflect the status of the corporation, the 
Service will notify the corporation that it may not rely upon the 
presumption. The Service will provide a written notice to the 
corporation that sets forth the general grounds for the Service's 
conclusion that the presumption may be inaccurate. By the 90th day 
following the date on which the corporation receives the Service's 
notification, the corporation must determine whether on its most recent 
determination date it was a U.S. real property holding corporation 
pursuant

[[Page 652]]

to the general rule set forth in paragraph (b)(1) of this section and 
must notify the Service of its determination. If the corporation 
determines that it was not a U.S. real property holding corporation 
pursuant to the general rule, then the corporation may upon future 
determination dates rely upon the presumption allowed by this paragraph 
(b)(2), unless on the basis of additional information the Service again 
requests that the determination be made pursuant to the general rule. If 
the corporation determines that it was a U.S. real property holding 
corporation on its most recent determination date, then by the 180th day 
following the date on which the corporation received the Service's 
notification the corporation (if a domestic corporation) must notify 
each holder of an interest in it that contrary to any prior 
representations it was a U.S. real property holding corporation as of 
its most recent determination date.
    (iv) Applicability of penalties. A corporation that had previously 
relied upon the presumption allowed by this paragraph (b)(2) but that is 
determined to be a U.S. real property holding corporation shall not be 
subject to penalties for any incorrect notice previously given pursuant 
to the requirements of paragraph (h) of this section, if:
    (A) The corporation in fact carried out the necessary calculations 
enabling it to rely upon the presumption allowed by this paragraph 
(b)(2); and
    (B) The corporation complies with the provisions of paragraph 
(b)(2)(iii) of this section. However, a corporation shall remain subject 
to any applicable penalties if at the time of its reliance on the 
presumption allowed by this paragraph (b)(2) the corporation knew that 
the book value of relevant assets was substantially higher or lower than 
the fair market value of those assets and therefore had reason to 
believe that under the general test of paragraph (b)(1) of this section 
the corporation would probably be a U.S. real property holding 
corporation. Information with respect to the fair market value of its 
assets is known by a corporation if such information is included on any 
books and records of the corporation or its agent, is known by its 
directors or officers, or is known by employees who in the course of 
their employment have reason to know such information. A corporation 
relying upon the presumption allowed by this paragraph (b)(2) has no 
affirmative duty to determine the fair market values of assets if such 
values are not otherwise known to it in accordance with the preceding 
sentence. The rules of this paragraph (b)(2)(iv) may be illustrated by 
the following examples.

    Example 1. DC is a domestic corporation engaged in light 
manufacturing that knows that it has foreign shareholders. On its 
December 31, 1985 determination date DC held assets used in its trade or 
business, consisting largely of recently-purchased equipment, with a 
book value of $500,000. DC's only real property interest was a factory 
that it had occupied for over 50 years, which had a book value of 
$200,000. The factory was located in a deteriorated downtown area, and 
DC had no knowledge of any facts indicating that the fair market value 
of the property was substantially higher than its book value. Therefore, 
DC was entitled to rely upon the presumption allowed by Sec.  1.897-
2(b)(2) and any incorrect statement pursuant to Sec.  1.897-2(h) that 
arose out of such reliance would not give rise to penalties.
    Example 2. The facts are the same as in Example 1, except as 
follows. By the time of DC's December 31, 1989 determination date, the 
downtown area in which DC's factory was located had become the subject 
of an extensive urban renewal program. On December 1, 1989, the 
president of DC was offered $750,000 for the factory by a developer who 
planned to convert the property into condominiums. Because DC thus had 
knowledge of the fair market value of its assets which made it clear 
that the corporation would probably be a U.S. real property holding 
corporation under the general rule of Sec.  1.897-2(b)(1), DC was not 
entitled to rely upon the presumption allowed by Sec.  1.897-2(b)(2) 
after December 1, 1989, and any false statements arising out of such 
reliance thereafter would give rise to penalties.

    (v) Effect on interest-holders and related persons. For the effect 
on interest holders and related persons of reliance on a statement 
issued by a corporation that made a determination as to whether it was a 
U.S. real property holding corporation under the provisions of Sec.  
1.897-2(b), see Sec. Sec.  1.897-2(g)(1)(ii)(A) and 1.897-2(g)(2)(ii).
    (c) Determination dates for applying U.S. real property holding 
corporation

[[Page 653]]

test--(1) In general. Whether a corporation is a U.S. real property 
holding corporation is to be determined as of the following dates:
    (i) The last day of the corporation's taxable year;
    (ii) The date on which the corporation acquires any U.S. real 
property interest;
    (iii) The date on which the corporation disposes of an interest in 
real property located outside the United States or disposes of other 
assets used or held for use in a trade or business during the calendar 
year, subject to the provisions of paragraph (c)(2)(i) of this section; 
and
    (iv) In the case of a corporation that is treated pursuant to 
paragraph (d)(4) or (5) of this section as owning a portion of the 
assets held by an entity in which the corporation directly or indirectly 
holds an interest, the date on which that entity either (A) acquires a 
U.S. real property interest, (B) disposes of an interest in real 
property located outside the United States or (C) disposes of other 
assets used or held for use in a trade or business during the calendar 
year, subject to the provisions of paragraph (c)(2)(ii) of this section. 
A determination that is triggered by a transaction described in 
subdivision (ii), (iii), or (iv) of this paragraph (c)(1) must take such 
transaction into account. However, the first determination of a 
corporation's status need not be made until the 120th day after the 
later of the date of incorporation or of the date on which the 
corporation first acquires a shareholder. In addition, no determination 
of a corporation's status need be made during the 12-month period 
beginning on the date on which a corporation adopts a plan of complete 
liquidation, provided that all the assets of the corporation (other than 
assets retained to meet claims) are distributed within such period.
    (2) Transactions not requiring a determination--(i) Transactions by 
corporation. Notwithstanding the provisions of paragraph (c)(1) of this 
section, a determination of U.S. real property holding corporation 
status need not be made on the date of:
    (A) A corporation's disposition of inventory or livestock (as 
described in Sec.  1.897-1(f)(1)(i) (A) and (C));
    (B) The satisfaction of accounts receivable arising from the 
disposition of inventory or livestock or from the performance of 
services;
    (C) The disbursement of cash to meet the regular operating needs of 
the business (e.g., to acquire inventory or to pay wages and salaries);
    (D) A corporation's disposition of assets used or held for use in a 
trade or business (other than inventory or livestock) not in excess of a 
limitation amount determined in accordance with the rules of subdivision 
(iii) of this paragraph (c)(2); or
    (E) A corporation's acquisition of U.S. real property interests not 
in excess of a limitation amount determined in accordance with the rules 
of subdivision (iii) of this paragraph (c)(2).
    (ii) Transactions by entity other than corporation. Notwithstanding 
the provisions of paragraph (c)(1)(iv) or (c)(2)(v) of this section, in 
the case of a corporation that is treated as owning a portion of the 
assets held by an entity in which the corporation directly or indirectly 
holds an interest, a determination of U.S. real property holding 
corporation status need not be made on the date of:
    (A) The entity's disposition of inventory or livestock (as described 
in Sec.  1.897-1(f)(1)(i) (A) and (C));
    (B) The satisfaction of accounts receivable arising from the 
entity's disposition of inventory or livestock or from the performance 
of personal services;
    (C) The entity's disbursement of cash to meet the regular operating 
needs of its business (e.g. to acquire inventory or to pay wages and 
salaries);
    (D) The entity's disposition of assets used or held for use in a 
trade or business (other than inventory or livestock) not in excess of a 
limitation amount determined in accordance with the rules of subdivision 
(iii) of this paragraph (c)(2); or
    (E) The entity's acquisition of U.S. real property interests not in 
excess of a limitation amount determined in accordance with the rules of 
subdivision (iii) of this paragraph (c)(2).
    (iii) Calculation of limitation amount. The amount of assets used or 
held for use in a trade or business that may be disposed of, and the 
amount of U.S.

[[Page 654]]

real property interests that may be acquired, by a corporation or other 
entity without triggering a determination date shall be calculated in 
accordance with the following rules:
    (A) If, in accordance with the provisions of paragraphs (d) and (e) 
of this section, a corporation on its most recent determination date was 
considered to hold U.S. real property interests having a fair market 
value that was less than 25 percent of the aggregate fair market value 
of all the assets it was considered to hold, then the applicable 
limitation amount shall be 10 percent of the fair market value of all 
trade or business assets or all U.S. real property interests (as 
applicable) held directly by the corporation or by another entity 
described in paragraph (c)(1)(iv) of this section on that determination 
date.
    (B) If, in accordance with the provisions of paragraphs (d) and (e) 
of this section, a corporation on its most recent determination date was 
considered to hold U.S. real property interests having a fair market 
value that was equal to or greater than 25 and less than 35 percent of 
the aggregate fair market value of all the assets it was considered to 
hold, then the applicable limitation amount shall be 5 percent of the 
fair market value of all trade or business assets or all U.S. real 
property interests (as applicable) held directly by the corporation or 
by another entity described in paragraph (c)(1)(iv) of this section on 
that determination date.
    (C) If, in accordance with the provisions of paragraphs (d) and (e) 
of this section, a corporation on its most recent determination date was 
considered to hold U.S. real property interests having a fair market 
value that


was equal to or greater than 35 percent of the aggregate fair market 
value of all the assets it was considered to hold, then the applicable 
limitation amount shall be 2 percent of the fair market value of all 
trade or business assets or all U.S. real property interests (as 
applicable) held directly by the corporation or by another entity 
described in paragraph (c)(1)(iv) of this section on that determination 
date.
    (D) If a corporation is not a U.S. real property holding corporation 
under the alternative test of paragraph (b)(2) of this section (relating 
to the book value of the corporation's assets), then the applicable 
limitation shall be 10 percent of the book value of all trade or 
business assets or all U.S. real property interests (as applicable) held 
directly by the corporation or by another entity described in paragraph 
(c)(1)(iv) of this section on the most recent determination date.
    Dispositions or acquisitions by the corporation or other entity of 
assets having a value less than the applicable limitation amount must be 
cumulated by the corporation or entity making such dispositions or 
acquisitions, and a determination must be made on the date of a 
transaction that causes the total of either type to exceed the 
applicable limitation. Once a determination is triggered by a 
transaction that causes the applicable limitation to be exceeded, the 
computation of the amount of trade or business assets disposed of or 
real property interests acquired after that date shall begin again at 
zero.
    The rules of this paragraph (c)(2) may be illustrated by the 
following examples.

    Example 1. DC is a domestic corporation, no class of stock of which 
is regularly traded on an established securities market, that knows that 
it has several foreign shareholders. As of December 31, 1984, DC holds 
U.S. real property interests with a fair market value of $500,000, no 
real property interests located outside the U.S. and other assets used 
in its trade or business with a fair market value of $1,600,000. Thus, 
the fair market value of DC's U.S. real property interests ($500,000) is 
less than 25% ($525,000) of the total ($2,100,000) of DC's U.S. real 
property interests ($500,000), interests in real property located 
outside the United States (zero), and assets used or held for use in a 
trade or business ($1,600,000). DC is not a U.S. real property holding 
corporation, and under the rule of paragraph (c)(2)(i) of this section 
it may dispose of trade or business assets with a fair market value 
equal to 10 percent ($160,000) of the total fair market value 
($1,600,000) of such assets held by it on its most recent determination 
date (December 31, 1984), without triggering a determination of its U.S. 
real property holding corporation status. Therefore, when DC disposes of 
$60,000 worth of trade or business assets (other than inventory or 
livestock) on March 1, 1985, and again on April 1, 1985, no 
determination of its status is required on either date. However, when

[[Page 655]]

DC disposes of a further $60,000 worth of such trade or business assets 
on May 1, its total dispositions of such assets ($180,000) exceeds its 
applicable limitation amount, and DC is therefore required to determine 
its U.S. real property holding corporation status. On May 1, 1985, the 
fair market value of DC's U.S. real property interests ($500,000) is 
greater than 25 percent ($480,000) and less than 35 percent ($672,000) 
of the total ($1,920,000) of DC's U.S. real property interests 
($500,000), interests in real property located outside the United States 
(zero), and assets used or held for use in a trade or business 
($1,420,000). DC is still not a U.S. real property holding corporation, 
but must now compute its applicable limitation amount as of the May 1 
determination date. Under the rule of paragraph (c)(2)(iii)(B) of this 
section. DC could now dispose of trade or business assets other than 
inventory or livestock with a total fair market value equal to 5 percent 
of the fair market value of all trade or business assets held by DC on 
the May 1 determination date. Therefore, disposition of such trade or 
business assets with a fair market value of more than $71,000 (5 percent 
of $1,420,000) will trigger a further determination date for DC.
    Example 2. DC is a domestic corporation, no class of stock of which 
is regularly traded on an established securities market, that knows that 
it has several foreign shareholders. As of December 31, 1986, DC's only 
assets are a U.S. real property interest with a fair market value of 
$300,000 other assets used or held for use in its trade or business with 
a fair market value of $600,000, and a 50 percent partnership interest 
in domestic partnership DP. DC's interest in DP constitutes a percentage 
ownership interest in the partnership of 50 percent, and pursuant to the 
rules of paragraph (e)(2) of this section DC is treated as owning a 
portion of the assets of DP determined by multiplying that percentage by 
the fair market value of DP's assets. As of December 31, 1986, DP's only 
assets are U.S. real property interests with a fair market value of 
$120,000 and other assets used in its trade or business with a fair 
market value of $380,000. As of its December 31, 1986, determination 
date, the fair market value ($360,000) of the U.S. real property 
interests DC holds ($300,000) and is treated as holding ($80,000 [The 
fair market value of DP's U.S. real property interest ($120,000) 
multiplied by DC's percentage ownership interest in DP (50 percent)]), 
is equal to 31 percent of the sum of the fair market values ($1,150,000) 
of the U.S. real property interests DC holds and is treated as holding 
($360,000) DC's interest in real property located outside the United 
States (zero), and assets used or held for use in a trade or business 
that DC holds or is treated as holding ($790,000 [$600,000 (held 
directly) plus $190,000 (DC's 50 percent share of assets used or held 
for use in a trade or business by DP)]). Thus, under the rules of 
paragraph (c)(2) (i) and (iii)(B) of this section DC may dispose of 
assets used or held for use in its trade or business with a fair market 
value equal to 5 percent ($30,000) of the total fair market value 
($600,000) of such assets held directly by it on its most recent 
determination date (December 31, 1986), without triggering a 
determination of its U.S. real property holding corporation status. In 
addition, under the rules of paragraph (c)(2) (ii) and (iii)(A) of this 
section, a determination date for DC would not be triggered by DP's 
disposition of trade or business assets (other than inventory or 
livestock) with a fair market value equal to 5 percent ($19,000) of the 
total fair market value ($380,000) of such assets held by it as of DC's 
most recent determination date (December 31, 1986). However, any 
disposition of such assets by DP exceeding that limitation would trigger 
a determination of DC's U.S. real property holding corporation status. 
In addition under the rule of paragraph (c)(1)(iv) of this section, any 
disposition of a U.S. real property interest by DP would trigger a 
determination date for DC, while under the rule of paragraph (c)(2)(ii) 
of this section no disposition of inventory or livestock by DP would 
trigger a determination for DC.

    (3) Alternative monthly determination dates--(i) In general. 
Notwithstanding the provisions of paragraphs (c) (1) and (2) of this 
section, a corporation may choose to determine its U.S. real property 
holding corporation status in accordance with the rules of this 
paragraph (c)(3). In the case of a corporation that has determined that 
it is not a U.S. real property holding corporation pursuant to the 
alternative test of paragraph (b)(2) of this section (relating to the 
book value of the corporation's assets), the rules of this paragraph 
(c)(3) may be applied by using book values rather than fair market 
values in all relevant calculations.
    (ii) Monthly determinations. A corporation that determines its U.S. 
real property holding corporation status in accordance with the rules of 
this paragraph (c)(3) must make a determination at the end of each 
calendar month.
    (iii) Transactional determinations. A corporation that determines 
its U.S. real property holding corporation status in accordance with the 
rules of this paragraph (c)(3) must make a determination as of the date 
on which, pursuant to a single transaction (consisting of one or more 
transfers):
    (A) U.S. real property interests are acquired, and/or

[[Page 656]]

    (B) Interests in real property located outside the U.S. and/or 
assets used or held for use in a trade or business are disposed of,


if the total fair market value of the assets acquired and/or disposed of 
exceeds 5 percent of the sum of the fair market values of the U.S. real 
property interests, interests in real property located outside the U.S., 
and assets used or held for use in a trade or business held by the 
corporation.
    (iv) Exceptions. Notwithstanding any other provision of this 
paragraph (c)(3), the first determination of a corporation's status need 
not be made until the 120th day after the later of the date of 
incorporation or the date on which the corporation first acquires a 
shareholder. In addition, no determination of a corporation's status 
need be made during the 12-month period beginning on the date on which a 
corporation adopts a plan of complete liquidation, if all the assets of 
the corporation (other than assets retained to meet claims) are 
distributed within such period.
    (4) Valuation date methods--(i) In general. For purposes of 
determining whether a corporation is a U.S. real property holding 
corporation on any applicable determination date, the fair market value 
of the assets held by the corporation (in accordance with Sec.  1.897-
2(d)) as of that determination date must be used.
    (ii) Alternative valuation date method for determination dates other 
than the last day of the taxable year. For purposes of paragraph 
(c)(4)(i) of this section, if an applicable determination date under 
paragraph (c) (1), (2), or (3) of this section is other than the last 
day of the taxable year, property may be valued as of the later of the 
last day of the previous taxable year or the date such property was 
acquired. For purposes of the determination date that falls on the last 
day of the taxable year, fair market value as of that date must always 
be used.
    (iii) Consistent methods. The valuation date method selected under 
this paragraph (c)(4) for the first determination date in a taxable year 
must be used for all subsequent determination dates for such year. In 
addition, the valuation date method selected must be used for all 
property with respect to which the determination is made. The use of one 
method for one taxable year does not preclude the use of the other 
method for any other taxable year.
    (5) Illustrations. The rules of this paragraph (c) are illustrated 
by the following examples:

    Example 1. Nonresident alien individual C purchased 100 shares of 
stock of domestic corporation K on July 26, 1985. Although K has 
additional shares of common stock outstanding, its stock has never been 
traded on an established securities market. At all times during calendar 
year 1985, K's only assets were a parcel of U.S. real estate (parcel A) 
and a parcel of country Z real estate (parcel B). On December 31, 1985, 
the fair market value of parcel A was $1,000,000 and the fair market 
value of parcel B was $2,000,000. For purposes of determining whether K 
was a U.S. real property holding corporation during 1985, the only 
applicable determination date was December 31, 1985, because K did not 
make any acquisitions or dispositions described in paragraph (c)(1) of 
this section during the year. The test of paragraph (b) of this section 
is applied using the fair market value of the property held on that 
date. K was not a U.S. real property holding corporation during 1985 
because as of December 31, 1985, the fair market value ($1,000,000) of 
the U.S. real property interests held by K did not equal or exceed 50 
percent ($1,500,000) of the sum ($3,000,000) of the fair market value of 
K's U.S. real property interest ($1,000,000), the interests in real 
property located outside the United States ($2,000,000), plus other 
assets used or held for use by K in a trade or business (zero).
    Example 2. The facts are the same as in example 1, except that on 
April 7, 1986, K purchased another parcel of U.S. real estate for 
$2,000,000. K's purchase of real property on April 7 triggered a 
determination on that date. As provided in paragraph (c)(3)(ii) of this 
section, K chooses to use the value of parcels A and B as of the 
previous December 31, while newly acquired parcel C must be valued as of 
its acquisition on April 7, 1986. On that date, K qualifies as a U.S. 
real property holding corporation, since the fair market value of its 
U.S. real property interests ($3,000,000) exceeds 50 percent 
($2,500,000) of the sum ($5,000,000) of the fair market value of K's 
U.S. real property interests ($3,000,000), its interests in real 
property located outside the U.S. ($2,000,000), and its other assets 
used or held for use in a trade or business (zero).

    (d) Assets held by a corporation. The assets that must be included 
in the determination of whether a corporation is a U.S. real property 
holding corporation are the following:

[[Page 657]]

    (1) U.S. real property interests that are held directly by the 
corporation (including directly-held interests in foreign corporations 
that are treated as U.S. real property interests pursuant to the rules 
of paragraph (e)(1) of this section);
    (2) Interests in real property located outside the United States 
that are held directly by the corporation;
    (3) Assets used or held for use in a trade or business that are held 
directly by the corporation;
    (4) A proportionate share of assets held through a partnership, 
trust, or estate pursuant to the rules of paragraph (e)(2) of this 
section; and
    (5) A proportionate share of assets held through a domestic or 
foreign corporation in which a corporation holds a controlling interest, 
pursuant to the rules of paragraph (e)(3) of this section.
    (e) Special rules regarding assets held by a corporation--(1) 
Interests in foreign corporations. For purposes only of determining 
whether any corporation is a U.S. real property holding corporation, an 
interest in a foreign corporation shall be treated as a U.S. real 
property interest unless it is established that the interest was not a 
U.S. real property interest under the rules of this section on the 
applicable determination date. The rules of paragraph (g)(2) of this 
section must be complied with to establish that the interest is not a 
U.S. real property interest. However, regardless of whether an interest 
in a foreign corporation is treated as a U.S. real property interest for 
this purpose, gain or loss from the disposition of an interest in such 
corporation will not be treated as effectively connected with the 
conduct of a U.S. trade or business by reason of section 897(a). The 
rules of this paragraph (e)(1) are illustrated by the following 
examples. In each example, fair market value is determined as of the 
applicable determination dates under paragraph (c)(4)(i) of this 
section.

    Example 1. Nonresident alien individual F holds all of the stock of 
domestic corporation DC. DC's only assets are 40 percent of the stock of 
foreign corporation FC, with a fair market value of $500,000, and a 
parcel of country W real estate, with a fair market value of $400,000. 
Foreign corporation FP, unrelated to DC, holds the other 60 percent of 
the stock of FC. FC's only asset is a parcel of U.S. real estate with a 
fair market value of $1,250,000. FC is a U.S. real property holding 
corporation because the fair market value of its U.S. real property 
interests ($1,250,000) exceeds 50 percent ($625,000) of the sum of the 
fair market values of its U.S. real property interests ($1,250,000), its 
interests in real property located outside the United States (zero), 
plus its other assets used or held for use in a trade or business 
(zero). Consequently DC's interest in FC is treated as a U.S. real 
property interest under the rules of this paragraph (e)(1). DC is a U.S. 
real property holding corporation because the fair market value 
($500,000) of its U.S. real property interest (the stock of FC) exceeds 
50 percent ($450,000) of the sum ($900,000) of the fair market value of 
its U.S. real property interests ($500,000), its interests in real 
property located outside the United States ($400,000), plus its other 
assets used or held for use in a trade or business (zero). If F disposes 
of her stock within 5 years of the current determination date, her gain 
or loss on the disposition of her stock in DC will be treated as 
effectively connected with a U.S. trade or business under section 
897(a). However, FP's gain on the disposition of its FC stock would not 
be subject to the provisions of section 897(a) because the stock of FC 
is a U.S. real property interest only for purposes of determining 
whether DC is a U.S. real property holding corporation.
    Example 2. Nonresident alien individual B holds all of the stock of 
domestic corporation US. US's only assets are 40 percent of the stock of 
foreign corporation FC1. Nonresident alien individual N, unrelated to 
US, holds the other 60 percent of FC1's stock. FC1's only assets are 40 
percent of the stock of foreign corporation FC2. The remaining 60 
percent of the stock of FC2 is owned by nonresident alien individual X, 
who is unrelated to FC1. FC2's only asset is a parcel of U.S. real 
estate with fair market value of $1,000,000. FC2, therefore, is a U.S. 
real property holding corporation, and the stock of FC2 held by FC1 is a 
U.S. real property interest for purposes of determining whether FC1 is a 
U.S. real property holding corporation (but not for purposes of treating 
FC1's gain from the disposition of FC2 stock as effectively connected 
with a U.S. trade or business under section 897(a)). As all of FC1's 
assets are U.S. real property interests, the stock of FC1 held by US is 
a U.S. real property interest for purposes of determining whether US is 
a U.S. real property holding corporation (but not for purposes of 
subjecting N's gain on the disposition of FC1 stock to the provisions of 
section 897(a)). As US is a domestic corporation and as all of its 
assets are U.S. real property interests, US is a U.S. real property 
holding corporation, and the stock of US held by B is a U.S. real 
property interest for purposes of section 897(a)).

[[Page 658]]

Therefore, B's gain or loss upon the disposition of the stock of US 
within 5 years of the most recent determination date is subject to the 
provisions of section 897(a).

    (2) Proportionate ownership of assets held by partnerships, trusts, 
and estates. For purposes of determining whether a corporation is a U.S. 
real property holding corporation, a holder of an interest in a 
partnership, a trust, or an estate (whether domestic or foreign) shall 
be treated pursuant to section 897(c)(4)(B) as holding a proportionate 
share of the assets held by the entity.


However, a holder of an interest shall not be treated as holding a 
proportionate share of assets that in the hands of the entity are 
subject to the rule of Sec.  1.897-1(f)(3)(ii) (concerning the trade or 
business assets of investment companies). Such proportionate share is to 
be determined in accordance with the rules of Sec.  1.897-1(e) on each 
applicable determination date. The interest in the entity shall itself 
be disregarded when a proportionate share of the entity's assets is 
attributed to the interest-holder pursuant to the rule of this paragraph 
(e)(2). Any asset treated as held by a holder of an interest by reason 
of this paragraph (e)(2) which is used or held for use in a trade or 
business by the partnership, trust, or estate shall be treated as so 
used or held for use by the holder of the interest. The proportionate 
ownership rule of this paragraph (e)(2) applies successively upward 
through a chain of ownership. The proportionate ownership rule of this 
paragraph (e)(2) is illustrated by the following examples. In each 
example fair market value is determined as of the applicable 
determination date under paragraph (c)(4)(i) of this section.

    Example 1. Nonresident alien individual F holds all of the stock of 
domestic corporation DC. DC is a partner in foreign partnership FP, and 
DC's percentage ownership interest in FP is 50 percent. DC's other 
assets are a parcel of country F real estate with a fair market value of 
$500,000 and other assets which it uses in its business with a fair 
market value of $100,000, FP's assets are a parcel of country Z real 
estate with a fair market value of $300,000 and a parcel of U.S. real 
estate with a fair market value of $2,000,000. For purposes of 
determining whether DC is a U.S. real property holding corporation, DC 
is treated as holding its pro rata share of the assets held by FP. DC's 
pro rata share of the U.S. real estate held by FP is $1,000,000, 
determined by multiplying the fair market value ($2,000,000) of the U.S. 
real property interests held by FP by DC's percentage ownership interest 
in FP (50 percent). DC's pro rata share of the country Z real estate 
held by FP is $150,000, determined in the same manner. DC is a U.S. real 
property holding corporation because the fair market value ($1,000,000) 
of its U.S. real property interests (the U.S. real estate it is treated 
as holding proportionately) exceeds 50 percent ($875,000) of the sum 
($1,750,000) of the fair market value of its U.S. real property 
interests ($1,000,000), its interests in real property located outside 
the United States [($650,000) (its country F real estate and its pro 
rata share of the country Z real estate)], plus its other assets which 
are used or held for use in a trade or business ($100,000). Because DC 
is a domestic U.S. real property holding corporation, the stock of DC is 
a U.S. real property interest and F's gain or loss on the disposition of 
this DC stock within 5 years of the current determination date will be 
treated as effectively connected with a U.S. trade or business under 
section 897(a).
    Example 2. Nonresident alien individual B holds all of the stock of 
domestic corporation US. US is a beneficiary of foreign trust FT. US's 
percentage ownership interest in FT is 90 percent. US has no other 
assets. FT is a partner in domestic partnership DP. FT's percentage 
ownership interest in DP is 30 percent. FT has no other assets. DP's 
only asset is a parcel of U.S. real estate with a fair market value of 
$1,000,000. FT is treated as holding U.S. real estate with a fair market 
value of $300,000 (30 percent of the U.S. real estate held by DP with a 
fair market value of $1,000,000). For purposes of determining whether US 
is a U.S. real property holding corporation, the proportionate ownership 
rule is applied successively upward through the chain of ownership. 
Thus, US is treated as holding 90 percent of FT's $300,000 pro rata 
share of the U.S. real estate held by DP. US is a U.S. real property 
holding corporation because the fair market value ($270,000) of its U.S. 
real property interests (its pro rata share of the U.S. real estate held 
by DP) exceeds 50 percent ($135,000) of the sum of the fair market 
values of its U.S. real property interests ($270,000), its interests in 
real property located outside the United States (zero), plus its other 
assets used or held for use in a trade or business (zero). Because US is 
a domestic U.S. real property holding corporation, the stock of US is a 
U.S. real property interest, and B's gain or loss from the disposition 
of US stock within 5 years of the current determination date will be 
treated as effectively connected with a U.S. trade or business under 
section 807(a).


[[Page 659]]


    (3) Controlling interests in corporations. For purposes only of 
determining whether a corporation is a U.S. real property holding 
corporation, if the corporation (the ``first corporation'') holds a 
controlling interest in a second corporation--
    (i) The first corporation is treated as holding a proportionate 
share of each asset (i.e., U.S. real property interests, interests in 
real property located outside the United States, and assets used or held 
for use in a trade or business) held by the second corporation, 
determined in accordance with the rules of Sec.  1.897-1(e);
    (ii) Any asset so treated as held proportionately by the first 
corporation which is used or held for use by the second corporation in a 
trade or business shall be treated as so used or held for use by the 
first corporation; and
    (iii) Interests in the second corporation held by the first 
corporation are not themselves taken into account as U.S. real property 
interests (regardless of whether the second corporation is a U.S. real 
property holding corporation) or as trade or business assets. However, 
the first corporation shall not be treated as holding a proportionate 
share of assets that in the hands of the second corporation are subject 
to the rules of Sec.  1.897-1(f)(3)(ii) (concerning the trade or 
business assets of investment companies). A determination of what 
portion of the assets of the second corporation are considered to be 
held by the first corporation shall be made as of the applicable dates 
for determining whether the first corporation is a U.S. real property 
holding corporation.


A ``controlling interest'' means 50 percent or more of the fair market 
value of all classes of stock of the corporation, determined as of the 
applicable determination date. In determining whether a corporation 
holds a controlling interest in another corporation, section 318(a) 
shall apply (except that sections 318(a)(2)(C) and (3)(C) are applied by 
substituting the phrase ``5 percent'' for ``50 percent''). However, a 
corporation that does not directly hold any interest in a second 
corporation shall not be treated as holding a controlling interest in 
the second corporation by reason of the application of section 
318(a)(3)(C). The rules of this paragraph (e)(3) apply successively 
upward through a chain of ownership. For example, if the second 
corporation owns a controlling interest in a third corporation, the 
rules of this paragraph shall be applied first to determine the portion 
of the assets of the third corporation that is considered to be held by 
the second corporation and then to determine the portion of the assets 
held and considered to be held by the second corporation that is 
considered to be held by the first corporation. The controlling interest 
rules of this paragraph (e)(3) apply, regardless of whether a 
corporation is domestic or foreign, whenever it is necessary to 
determine whether a corporation is a U.S. real property holding 
corporation. The rules of this paragraph (e)(3) are illustrated by the 
following examples. In each example fair market value is determined as 
of the applicable determination date under paragraph (c)(4)(i) of this 
section and no corporation holds constructively any interest not 
specified in the example.

    Example 1. Nonresident alien individual N owns all of the stock of 
domestic corporation DC. DC's only assets are 60 percent of the fair 
market value of all classes of stock of foreign corporation FS and 60 
percent of the fair market value of all classes of stock of domestic 
corporation DS. The percentage ownership interest of DC in each of FS 
and DS is 60 percent. The balance of the stock in FS and DS is held by 
nonresident alien individual B, who is unrelated to DC. FS's only asset 
is a parcel of country F real estate with a fair market value of 
$1,000,000. DS's only asset is a parcel of U.S. real estate with a fair 
market value of $2,000,000. The value of DC stock in FS and DS is not 
taken into account for purposes of determining whether DC is a U.S. real 
property holding corporation. Rather, because DC holds a controlling 
interest (60 percent) in each of FS and DS, DC is treated as holding a 
portion of each asset held by FS and DS. DC's portion of the country F 
real estate held by FS is $600,000, determined by multiplying the fair 
market value ($1,000,000) of the country F real estate by DC's 
percentage ownership interest (60 percent). Similarly, DC's portion of 
the U.S. real estate held by DS is $1,200,000 (60 percent of 
$2,000,000). DC is a U.S. real property holding corporation, because the 
fair market value ($1,200,000) of its U.S. real property interests (its 
portion of the U.S. real estate) exceeds 50 percent ($900,000) of the 
sum ($1,800,000) of the fair market values of its U.S. real property 
interests ($1,200,000), its interests in real property located outside 
the

[[Page 660]]

United States (the $600,000 portion of country F real estate), plus its 
other assets used or held for use in a trade or business (zero). Because 
DC is a domestic U.S. real property holding corporation, the stock of DC 
is a U.S. real property interest, and N's gain or loss on the 
disposition of DC stock within 5 years of the current determination date 
would be treated as effectively connected with a U.S. trade or business 
under section 897(a).
    Example 2. (i) Nonresident alien individual F owns all of the stock 
of domestic corporation US1. US1's only asset is 85 percent of the fair 
market value of all classes of stock of domestic corporation US2. US2's 
only assets are 60 percent of the fair market value of all classes of 
stock of domestic corporation US3, with a fair market value of $600,000, 
and a parcel of country D real estate with a fair market value of 
$800,000. US3's only asset is a parcel of U.S. real estate with a fair 
market value of $2,000,000. The percentage ownership interest of F in 
US1 is 100 percent.


Although US1 owns 85 percent of the stock of US2, US1's percentage 
ownership interest in US2 is 75 percent, because US2 has other interests 
other than solely as a creditor outstanding. US2's percentage ownership 
interest in US3 is 60 percent.
    (ii) US2 holds a controlling interest in US3, since it holds more 
than 50 percent of the fair market value of all classes of stock of US3. 
Consequently, the value of US2's stock in US3 is not taken into account 
in determining whether US2 is a U.S. real property holding corporation, 
even though US3 is a U.S. real property holding corporation. Instead, 
US2 is treated as holding a portion of the U.S. real estate held by US3. 
US2's portion of the U.S. real estate is $1,200,000, determined by 
multiplying US2's percentage ownership interest (60 percent) by the fair 
market value ($2,000,000) of the U.S. real estate. US1 holds a 
controlling interest in US2 (75 percent.). By reapplying the rules of 
paragraph (e)(3) of this section successively upward through the chain 
of ownership, US1's stock in US2 is not taken into account, and US1 is 
treated as holding a portion of the country D real estate held by US2 
and the U.S. real estate which US2 is treated as holding 
proportionately. US1's portion of the country D real estate is $600,000, 
determined by multiplying US1's percentage ownership interest (75 
percent) by the fair market value ($800,000) of the country D real 
estate. US1's portion of the U.S. real estate which US2 is treated as 
owning is $900,000, determined by multiplying US1's percentage ownership 
interest (75 percent) by the fair market value ($1,200,000) of US2's 
portion of U.S. real estate held by US3. US1 is a U.S. real property 
holding corporation, because the fair market value ($900,000) of its 
U.S. real property interests (its portion of US2's portion of U.S. real 
estate) is more than 50 percent ($750,000) of the sum ($1,500,000) of 
fair market values of its U.S. real property interests ($900,000), its 
interests in real property located outside the United States ($800,000), 
plus its other assets need or held for use in a trade or business 
(zero). Because US1 is a U.S. real property holding corporation and is a 
domestic corporation, the stock of US1 is a U.S. real property interest, 
and F's gain or loss on the disposition of US1 stock within 5 years of 
the current determination date will be treated as effectively connected 
with a U.S. trade or business under section 897(a).
    Example 3. Nonresident alien individual B holds all of the stock of 
domestic corporation DC. DC's only assets are 40 percent of the fair 
market value of all classes of stock of foreign corporation FC and a 
parcel of country R real estate with a fair market value of $100,000. 
FC's only asset is one parcel of U.S. real estate with a fair market 
value of $1,000,000. The fair market value of the FC stock held by DC is 
$200,000. FC is a U.S. real property holding corporation. Since DC does 
not hold a controlling interest in FC, the controlling interest rules of 
paragraph (e)(3) of this section do not apply to treat DC as holding a 
portion of the U.S. real estate held by FC. However, because FC is a 
U.S. real property holding corporation, the stock of FC is a U.S. real 
property interest for purposes of determining whether DC is a U.S. real 
property holding corporation. DC is a U.S. real property holding 
corporation because the fair market value ($200,000) of its U.S. real 
property interest (the stock of FC) exceeds 50 percent ($150,000) of the 
sum ($300,000) of the fair market values of its U.S. real property 
interest ($200,000), its interests in real property located outside the 
United States ($100,000), plus its other assets used or held for use in 
a trade or business (zero). Because DC is a U.S. real property holding 
corporation and is a domestic corporation, its stock is a U.S. real 
property interest, and B's gain or loss on the disposition of DC stock 
within 5 years of the current determination date would be subject to the 
provisions of section 897(a).
    Example 4. Nonresident alien individual C owns all of the stock of 
domestic corporation DC1. DC1's only assets are 25 percent of the fair 
market value of all classes of stock of domestic corporation DC2, and a 
parcel of U.S. real estate with a fair market value of $100,000. The 
stock of DC2 is not an asset used or held for use in DC1's trade or 
business. DC2's only assets are a building located in the U.S. with a 
fair market value of $100,000 and manufacturing equipment and inventory 
with a fair market value of $200,000, DC2 is not a U.S. real property 
holding corporation. Since DC1 does not hold a controlling interest in 
DC2, the rules of this paragraph (e)(3) do not apply to treat DC1 as

[[Page 661]]

holding a portion of the assets held by DC2. In addition, since DC2 is 
not a U.S. real property corporation, its stock does not constitute a 
U.S. real property interest. Therefore, for purposes of determining 
whether DC1 is a real property holding corporation, its interest in DC2 
is not taken into account. Since DC1's only other asset is a parcel of 
U.S. real estate, DC1 is a U.S. real property holding corporation, and 
C's gain or loss on the disposition of DC1 stock within 5 years of the 
current determination date would be subject to the provisions of section 
897(a).

    (4) Co-application of rules of this paragraph (e). The rules of this 
paragraph (e) apply in conjunction with one another for purposes of 
determining whether a corporation is a U.S. real property holding 
corporation. The rule of this paragraph (e)(4) is illustrated by the 
following example. In the example fair market value is determined as of 
the applicable determination date in accordance with paragraph (c)(4)(i) 
of this section.

    Example. Nonresident alien individual B holds 100 percent of the 
stock of domestic corporation US. US's only asset is 10 percent of the 
stock of foreign corporation FC1. FC1's only asset is 100 percent of the 
stock of foreign corporation FC2. FC2's only asset is a 50 percent 
interest in domestic partnership DP. FC2's percentage ownership interest 
in DP is 50 percent. DP's only asset is a parcel of U.S. real estate 
with a fair market value of $10,000,000. In determining whether US is a 
U.S. real property holding corporation, the rules of this paragraph (e) 
apply in conjunction with one another. Consequently, under paragraph 
(e)(2) of the section FC2 is treated as holding U.S. real estate with a 
fair market value of $5,000,000 (50 percent of $10,000,000, its pro rata 
share of real estate held by DP). Under paragraph (e)(3) of this 
section, FC1 is treated as holding 100 percent of the assets of FC2 
(U.S. real estate with a fair market value of $5,000,000). FC1, 
therefore, is a U.S. real property holding corporation. Under paragraph 
(e)(1) of this section, the stock of FC1 is treated as U.S. real 
property interest. US is a U.S. real property holding corporation 
because 100 percent of its assets (the stock of FC1) are U.S. real 
property interests. As US is a U.S. real property holding corporation 
and is a domestic corporation, the stock of US is a U.S. real property 
interest, and B's gain or loss from the disposition of stock of US 
within 5 years of the current determination date will be subject to the 
provisions of section 897(a).

    (f) Termination of U.S. real property holding corporation status--
(1) In general. A U.S. real property holding corporation may voluntarily 
determine its status as of the date of any acquisition or disposition of 
assets. If the fair market value of its U.S. real property interests on 
such date no longer equals or exceeds 50 percent of the fair market 
value of all assets described in paragraphs (d) and (e) of this section, 
such corporation shall cease to be U.S. real property holding 
corporation as of such date, and on the day that is five years after 
such date interests in such corporation shall cease to be treated as 
U.S. real property interests (unless subsequent transactions within the 
five-year period have caused the fair market value of the corporation's 
U.S. real property interests to equal or exceed 50 percent of the fair 
market value of assets described in paragraphs (d) and (e) of this 
section). A corporation that determines that interests in it have ceased 
to be U.S. real property interests pursuant to the rules of this 
paragraph (f) may so inform the Internal Revenue Service, as provided in 
paragraph (h) of this section.
    (2) Early termination. Interests in a U.S. real property holding 
corporation shall immediately cease to be U.S. real property interests 
as of the first date on which the following conditions are met--
    (i) The corporation does not hold any U.S. real property interests;
    (ii) All of the U.S. real property interests directly or indirectly 
held by such corporation at any time during the previous five years (but 
disregarding any disposed of before June 19, 1980) either (A) were 
directly of indirectly disposed of in transactions in which the full 
amount of the gain (if any) was recognized or (B) ceased to be U.S. real 
property interests by reason of the application of this paragraph (f) to 
one or more other corporations; and
    (iii) If the disposition occurs on or after December 18, 2015, 
neither the corporation nor any predecessor of the corporation was a 
regulated investment company or a real estate investment trust at any 
time during the shorter of the periods described in section 
897(c)(1)(A)(ii).


For purposes of this paragraph (f)(2), a corporation that disposes of 
all U.S. real property interests other than a lease that has a fair 
market value of

[[Page 662]]

zero will be considered to have disposed of all of its U.S. real 
property interests, provided that the leased property is used in the 
conduct by the corporation of a trade or business in the United States. 
Such a lease may include an option to renew, but only if such option is 
for a renewal at fair market rental rates prevailing at the time of 
renewal.
    (g) Establishing that a corporation is not a U.S. real property 
holding corporation--(1) Foreign persons disposing of interests--(i) In 
general. A foreign person disposing of an interest in a domestic 
corporation (other than an interest solely as a creditor) must establish 
that the interest was not a U.S. real property interest as of the date 
of disposition, either by:
    (A) Obtaining a statement from the corporation pursuant to the 
provisions of subdivision (ii) of this paragraph (g)(1), or
    (B) Obtaining a determination by the Commissioner, Small Business/
Self Employed Division (SB/SE) pursuant to the provisions of subdivision 
(iii) of this paragraph (g)(1).


If the foreign person does not establish by either method that the 
interest disposed of was not a U.S. real property interest then the 
interest shall be presumed to have been a U.S. real property interest 
the disposition of which is subject to section 897(a). See paragraph 
(g)(3) of this section for certain exceptions to this rule. It should be 
noted that the rules of this section relate solely to interests in a 
corporation that are interests other than solely as a creditor. 
Therefore, a statement by a corporation or a determination by the 
Commissioner (under paragraphs (g) or (h) of this section) that an 
interest is not a U.S. real property interest depends solely upon 
whether or not the corporation was a U.S. real property holding 
corporation during the period described in section 897(c)(1)(A)(ii) 
(subject to certain special rules). The determination of whether an 
interest is one solely as a creditor is made under the rules of Sec.  
1.897-1(d).
    (ii) Statement from corporation--(A) In general. A foreign person 
disposing of an interest in a domestic corporation may establish that 
the interest was not a U.S. real property interest as of the date of the 
disposition by requesting and obtaining from the corporation a statement 
that the interest was not a U.S. real property interest as of that date. 
However, a corporation's statement shall not be valid for purposes of 
this rule, and thus may not be relied upon for purposes of establishing 
that an interest was not a U.S. real property interest, unless the 
corporation complies with the notice requirements of paragraph (h) (2) 
or (h)(4) of this section.


A foreign person that requests and obtains such a statement is not 
required to forward the statement to the Internal Revenue Service and is 
not required to take any further action to establish that the interest 
disposed of was not a U.S. real property interest. To qualify under this 
rule, the foreign person must obtain the corporation's statement no 
later than the date, including any extensions, on which a tax return 
would otherwise be due with respect to a disposition. A foreign person 
that relies in good faith upon a statement from the corporation is not 
thereby excused from filing a return and paying any taxes and interest 
due thereon if the corporation's statement is later found to have been 
incorrect. However, such reliance shall be taken into account in 
determining whether the foreign person shall be subject to any penalty 
for the previous failure to file. However, a foreign person that knew or 
had reason to know that a corporation's statement was incorrect is not 
entitled to rely upon such statement and shall remain liable for all 
applicable penalties.
    (B) Coordination with section 1445. Pursuant to section 1445 and 
regulations thereunder, withholding of tax is not required with respect 
to a foreign person's disposition of an interest in a domestic 
corporation, if the transferee is furnished with a statement by the 
corporation under paragraph (h) of this section that the interest is not 
a U.S. real property interest. A foreign person that obtains a 
corporation's statement for that purpose prior to the date of 
disposition may also rely upon the statement for purposes of this 
paragraph (g)(1)(ii), unless the corporation informs the foreign person 
(pursuant to paragraph (h)(1)(iv)(C) of this section)

[[Page 663]]

that it became a U.S. real property holding corporation after the date 
of the notice but prior to the actual date of disposition.
    (iii) Determination by Commissioner--(A) In general. A foreign 
person disposing of an interest in a domestic corporation may establish 
that the interest was not a U.S. real property interest as of the date 
of disposition by requesting and obtaining a determination to that 
effect from the Commissioner. Such a determination may be requested 
pursuant to the provisions of subdivision (B) or (C) of this paragraph 
(g)(1)(iii). A request for a determination should be addressed to: 
Commissioner, Small Business/Self Employed Division (SB/SE); S C3-413 
NCFB, 500 Ellin Road, Lanham, MD 20706. A foreign transferor who has 
requested a determination by the Commissioner pursuant to the rules of 
this paragraph (g)(1)(iii) is not thereby excused from filing a return 
and paying any tax due by the date, including any extensions, on which 
such return and payment would otherwise be due with respect to a 
disposition. If the Commissioner subsequently determines and notifies 
the foreign transferor that the interest was not a U.S. real property 
interest, the foreign transferor shall be entitled to a refund of any 
taxes, penalties, and interest paid by reason of the application of 
section 897(a) pursuant to the rules of paragraph (g)(1)(i) of this 
section, together with any interest otherwise due on such refund, if a 
claim for refund is made within the applicable time limits.
    (B) Determination based on Commissioner's information. A foreign 
person may request that the Commissioner make a determination based on 
information contained in the Commissioner's records, if:
    (1) The foreign person made a request to the corporation for 
information as to the status of its interest no later than the 90th day 
before the date, including any extensions, on which a tax return would 
otherwise be due with respect to a disposition, and
    (2) The corporation failed to respond to such request by the 30th 
day following the date the request was delivered to the corporation.


If the Commissioner is unable to make a determination based on 
information available to him, he shall inform the foreign person that 
the interest must be treated as a U.S. real property interest unless the 
person subsequently obtains either the necessary statement from the 
corporation or a determination pursuant to subdivision (C) of this 
paragraph (g)(1)(iii).
    (C) Determination based on information supplied by foreign person. A 
foreign person may request that the Commissioner make a determination 
based on information supplied by the foreign person. Such information 
may be drawn, for example, from annual reports, financial statements, or 
records of the corporation, and must establish to the satisfaction of 
the Commissioner that the foreign person's interest was not a U.S. real 
property interest as of the date of disposition.
    (D) Determination by Commissioner on his own motion. Notwithstanding 
any other provision of this section, a foreign person shall not treat 
the disposition of an interest in a domestic corporation as a 
disposition of a U.S. real property interest if such person is notified 
that the Commissioner has upon his own motion determined that the 
interest was not a U.S. real property interest as of the date of 
disposition.
    (2) Corporations determining U.S. real property holding corporation 
status--(i) In general. A corporation that must determine whether it is 
a U.S. real property holding corporation, and that holds an interest in 
another corporation (other than a controlling interest as defined in 
paragraph (e)(3) of this section), must determine whether or not that 
interest was a U.S. real property interest as of its own determination 
date, by either:
    (A) Obtaining a statement from the second corporation pursuant to 
the provisions of subdivision (ii) of this paragraph (g)(2);
    (B) Obtaining a determination by the Commissioner pursuant to the 
provisions of subdivision (iii) of this paragraph (g)(2); or
    (C) Making an independent determination pursuant to the provisions 
of subdivision (iv) of this paragraph (g)(2).


A corporation that is unable to determine by any of the above methods

[[Page 664]]

whether its interest in a second corporation is a U.S. real property 
interest must presume that such interest is a U.S. real property 
interest.
    (ii) Statement from corporation. A corporation may determine whether 
or not an interest in a second corporation was a U.S. real property 
interest as of its own determination date by obtaining from the second 
corporation a statement that the interest was not a U.S. real property 
interest as of that date. However, the second corporation's statement 
shall not be valid for purposes of this rule, and thus may not be relied 
upon for purposes of establishing that an interest was not a U.S. real 
property interest, unless such corporation complies with the notice 
requirements of paragraph (h)(2) or (h)(4) of this section.


A corporation that requests and obtains such a statement is not required 
to forward the statement to the Internal Revenue Service and is not 
required to take any further action to establish that the interest in 
the second corporation was not a U.S. real property interest. If the 
second corporation's statement is later found to have been incorrect, 
the first corporation shall not be subject to penalties arising out of 
past failures to comply with the requirements of section 897 or 1445, if 
such failures were attributable to reliance upon the second 
corporation's statement. By the 90th day following receipt of a 
notification from the Service or from the second corporation that a 
prior statement was incorrect, the first corporation must redetermine 
its status (as of its most recent determination date) and if appropriate 
notify the Internal Revenue Service that it is a U.S. real property 
holding corporation in accordance with paragraph (h)(1)(ii)(C) of this 
section. However, a corporation that knew or had reason to know that a 
second corporation's statement was incorrect is not entitled to rely 
upon such statement and shall remain liable for all applicable taxes, 
penalties, and interest arising out of the second corporation's status 
as a U.S. real property holding corporation.
    (iii) Determination by Commissioner--(A) In general. A corporation 
may determine whether or not an interest in a second corporation was a 
U.S. real property interest as of its own determination date by 
requesting and obtaining a determination to that effect from the 
Commissioner. Such a determination may be requested pursuant to the 
provisions of subdivision (B) or (C) of this paragraph (g)(2)(iii). A 
request for a determination must be addressed to: Commissioner, Small 
Business/Self Employed Division (SB/SE); S C3-413 NCFB, 500 Ellin Road, 
Lanhan, MD 20706. A corporation that has requested a determination by 
the Commissioner pursuant to the provisions of this paragraph is not 
thereby excused from taking any action required by section 897 or 1445 
by the date on which such action would otherwise be due. However, the 
Commissioner may grant a reasonable extension of time for the 
satisfaction of any requirement if the Commissioner is satisfied that 
the corporation has not sought a determination pursuant to this 
paragraph (g)(2)(iii) for a principal purpose of delay.
    (B) Determination based on Commissioner's information. A corporation 
may request that the Commissioner make a determination based on 
information contained in the Commissioner's records, if:
    (1) The corporation made a request to the second corporation for 
information as to the status of its interest no later than the fifth day 
following the first corporation's determination date, and
    (2) The second corporation failed to respond to such request by the 
30th day following the date the request was delivered to the second 
corporation.


Pending his resolution of such a request, the Commissioner will 
generally grant an extension with respect to the change-of-status 
notification that may otherwise be required pursuant to paragraph 
(h)(1)(ii) of this section. If the Commissioner is unable to make a 
determination based on information available to him, he shall inform the 
corporation that the interest must be treated as a U.S. real property 
interest unless the corporation subsequently obtains either the 
necessary statement from the second corporation or a determination 
pursuant to paragraph (g)(2)(iii)(C) or (g)(2)(iv) of this section.
    (C) Determination based on information supplied by corporation. A 
corporation may request that the Commissioner

[[Page 665]]

make a determination based on information supplied by the corporation. 
Such information may be drawn, for example, from annual reports, 
financial statements, or records of the second corporation, and must 
establish to the satisfaction of the Commissioner that the interest in 
the second corporation was not a U.S. real property interest as of the 
first corporation's determination date.
    (D) Determination by Commissioner on his own motion. Notwithstanding 
any other provision of this section, a corporation shall not treat an 
interest in a second corporation as a U.S. real property interest if the 
corporation is notified that the Commissioner has upon his own motion 
determined that the interest in the second corporation is not a U.S. 
real property interest.
    (iv) Independent determination by corporation. A corporation may 
independently determine whether or not an interest in a second 
corporation was a U.S. real property interest as of the first 
corporation's own determination date. Such determination must be based 
upon the best evidence available, drawn from annual reports, financial 
statements, records of the second corporation, or from any other source, 
that demonstrates to a reasonable certainty that the interest in the 
second corporation was not a U.S. real property interest. A corporation 
that makes an independent determination pursuant to this paragraph 
(g)(2)(iv) shall be subject to the special notification rule of 
paragraph (h)(1)(iii)(D) of the section. If the Commissioner 
subsequently determines that the corporation's independent determination 
was incorrect, the corporation shall be subject to penalties for any 
past failure to comply with the requirements of section 897 or 1445 only 
if the corporation's determination was unreasonable in view of facts 
that the corporation knew or had reason to know.
    (3) Requirements not applicable. If at any time during the calendar 
year any class of stock of a corporation is regularly traded on an 
established securities market, the requirements of this paragraph (g) 
shall not apply with respect to any holder of an interest in such 
corporation other than a person who holds an interest described in Sec.  
1.897-1(c)(2)(iii) (A) or (B). For example, a corporation determining 
whether it is a U.S. real property holding corporation need not 
ascertain from a regularly traded corporation in which it neither holds, 
nor has held during the period described in section 897(c)(1)(A)(ii), 
more than a 5 percent interest whether that regularly traded corporation 
is itself a U.S. real property holding corporation.


In addition, the requirements of this paragraph (g) do not apply to any 
holder of an interest in a domestically-controlled RETT, as defined in 
section 897(h)(4)(B).
    (h) Notice requirements applicable to corporations--(1) Statement to 
foreign interest-holder--(i) In general. A domestic corporation must, 
within a reasonable period after receipt of a request from a foreign 
person holding an interest in it, inform that person whether the 
interest constitutes a U.S. real property interest. No particular form 
is required for this statement, which need only indicate the 
corporation's determination. The statement must be dated and signed by a 
responsible corporate officer who must verify under penalties of perjury 
that the statement is correct to his knowledge and belief.
    (ii) Required determination. For purposes of the statement required 
by paragraph (h)(1)(i) of this section, an interest in a corporation is 
a U.S. real property interest if the corporation was a U.S. real 
property holding corporation on any determination date during the 5-year 
period ending on the date specified in the interest-holder's request, or 
on the date such request was received if no date is specified (or during 
such shorter period ending on the date that is applicable pursuant to 
section 897(c)(1)(A)(ii). However, an interest in a corporation is not a 
U.S. real property interest if such interest is excluded under section 
897(c)(1)(B).
    (2) Notice to the Internal Revenue Service. If a foreign interest 
holder requests that a domestic corporation provide a statement 
described in paragraph (h)(1) of this section, then such corporation 
must provide a notice to the Internal Revenue Service in accordance with 
this paragraph (h)(2). No particular form is required for such notice, 
but the following must be provided:

[[Page 666]]

    (i) A statement that the notice is provided pursuant to the 
requirements of Sec.  1.897-2(h)(2);
    (ii) The name, address, and identifying number of the corporation 
providing the notice;
    (iii) The name, address, and identifying number (if any) of the 
foreign interest holder that requested the statement (this information 
may be omitted from the notice if fully set forth in the statement to 
the foreign interest holder attached to the notice).
    (iv) Whether the interest in question is a U.S. real property 
interest;
    (v) A statement signed by a responsible corporate officer verifying 
under penalties of perjury that the notice (including any attachments 
thereto) is correct to his knowledge and belief. A copy of any statement 
provided to the foreign interest holder must be attached to the notice. 
The notice must be mailed to the address specified in the Instructions 
for Form 8288 under the heading ``Where To File'' on or before the 30th 
day after the statement referred to in Sec.  1.897-2(h)(1) is mailed to 
the interest holder that requested it. Failure to mail such notice 
within the time period set forth in the preceding sentence will cause 
the statement provided pursuant to Sec.  1.897-2(h)(1) to become an 
invalid statement.
    (3) Requirements not applicable. The requirements of this paragraph 
(h) do not apply to domestically-controlled REITS, as defined in section 
897(h)(4)(B). These requirements also do not apply to a corporation any 
class of stock in which is regularly traded on an established securities 
market at any time during the calendar year. However, such a corporation 
may voluntarily choose to comply with the requirements of paragraph 
(h)(4) of this section.
    (4) Voluntary notice to Internal Revenue Service--(i) In general. A 
domestic corporation which determines that it is not a U.S. real 
property holding corporation--
    (A) On each of the applicable determination dates in a taxable year, 
or
    (B) Pursuant to section 897(c)(1)(B), may attach to its income tax 
return for that year a statement informing the Internal Revenue Service 
of its determination. A corporation that has provided a voluntary notice 
described in this Sec.  1.897-2(h)(4)(i) for the immediately preceding 
taxable year and that does not have an event described in Sec.  1.897-
2(c)(1) (ii), (iii) or (iv) prior to receiving a request from a foreign 
person under Sec.  1.897-2(h)(1), is exempt from the notice requirement 
of Sec.  1.897-2(h)(2).
    (ii) Early termination of real property holding corporation status. 
A corporation that determines during the course of its taxable year that 
interests in it have ceased to be U.S. real property interests pursuant 
to the rules of section 897(c)(1)(B) may, on the day of its 
determination or thereafter, provide a statement to the address 
specified in the Instructions for Form 8288 under the heading ``Where To 
File'', informing the Service of its determination. No particular form 
is required but the statement must set forth the corporation's name, 
address, identification number, a brief statement regarding its 
determination and the date such determination was made. Such statement 
will enable foreign interest-holders to dispose of their interests 
without being subject to section 897(a), as provided in paragraph (g) of 
this section.
    (5) Supplemental statements--(i) By corporations with substantial 
intangible assets. A corporation that is subject to the requirements of 
paragraph (h)(2) of this section (or that voluntarily complies with the 
requirements of paragraph (h)(4) of this section) must submit a 
supplemental statement to the Internal Revenue Service if--
    (A) Such corporation values any of the intangible assets described 
in Sec.  1.897-1(f)(1)(ii) (other than goodwill or going concern value) 
by a method other than the purchase price or book value methods 
described in Sec.  1.897-1(o)(4); and
    (B) The fair market value of such intangible assets equals or 
exceeds 25 percent of the total of the fair market values of the assets 
the corporation is considered to hold in accordance with the provisions 
of paragraphs (d) and (e) of this section.
    The supplemental statement must inform the Internal Revenue Service 
that the corporation meets the criteria of subdivisions (A) and (B) of 
this paragraph (h)(5)(i), and must summarize the methods and 
calculations upon which the corporation's determination of the

[[Page 667]]

fair market value of its intangible assets is based. In addition, the 
supplemental statement must list any intangible assets that were 
purchased from any person that have been valued by the corporation at an 
amount other than their purchase price, and must provide a justification 
for such a departure from the purchase price. The supplemental statement 
must be attached to or incorporated in the statement provided under 
paragraph (h)(2) or (h)(4) of this section.
    (ii) Corporation not valuing goodwill or going concern value at 
purchase price. A corporation that is subject to the requirements of 
paragraph (h)(2) of this section (or that voluntarily complies with the 
requirements of paragraph (h)(4) of this section) must submit a 
supplemental statement to the Internal Revenue Service if such 
corporation values goodwill or going concern value pursuant to Sec.  
1.897-1(o)(4)(iii). The supplemental statement must set forth that it is 
made pursuant to this paragraph (h)(5)(ii), and must summarize the 
methods and calculations upon which the corporation's determination of 
the fair market value of such intangible assets is based. In addition, 
the supplemental statement must list any such assets that were purchased 
from any person that have been valued by the corporation at an amount 
other than their purchase price, and must provide a justification for 
such a departure from the purchase price. The supplemental statement 
must be attached to or incorporated in the statement provided under 
paragraph (h)(2) or (h)(4) of this section.
    (iii) Corporation using alternative U.S. real property holding 
corporation test. A corporation that is subject to the requirements of 
paragraph (h)(2) of this section (or that voluntarily complies with the 
requirements of paragraph (h)(4) of this section) must submit a 
supplemental statement to the Internal Revenue Service if--
    (A) Such corporation utilizes the rule of paragraph (b)(2) of this 
section (regarding the book values of assets held by the corporation) to 
presume that it is not a U.S. real property holding corporation; and
    (B) Such corporation is engaged in or is planning to engage in a 
trade or business of mining, farming, or forestry, or of buying and 
selling or developing real property, or of leasing real property to 
tenants.
    The supplemental statement must inform the Internal Revenue Service 
that the corporation meets the criteria of subdivisions (A) and (B) of 
this paragraph (h)(5)(iii), and must be attached to or incorporated in 
the statement provided under paragraph (h)(2) or (h)(4) of this section.
    (iv) Corporation determining real property holding corporation 
status of second corporation. A corporation that is subject to the 
requirements of paragraph (h)(2) of this section (or that voluntarily 
complies with the requirements of paragraph (h)(4) of this section) must 
submit a supplemental statement to the Internal Revenue Service if such 
corporation independently determines whether or not an interest in a 
second corporation is a U.S. real property interest, pursuant to 
paragraph (g)(2)(iv) of this section. The supplemental statement must 
set forth that it is made pursuant to this paragraph (h)(5)(iv) and must 
briefly summarize the facts upon which the corporation's determination 
is based and the sources of the information relied upon by the 
corporation. The supplemental statement must be attached to or 
incorporated in the statement provided under paragraph (h)(2) or (h)(4) 
of this section.
    (i) Transition Rules--(1) General waiver of penalties for failure to 
file. If a foreign person disposed of an interest in a domestic 
corporation between June 18, 1980 and January 23, 1987, and such person 
establishes under the rules of paragraph (g) of this section at any time 
that the interest disposed of was not a U.S. real property interest, 
then such person shall not be subject to tax under section 897 and shall 
not be subject to penalties (or interest) for failure to file an income 
tax return with respect to such disposition.
    (2) Foreign persons that met the requirements of prior regulations. 
A foreign person that disposed of an interest in a domestic corporation 
between June 18, 1980 and January 23, 1987, shall be deemed to have 
satisfied the requirements of paragraph (g) of this section with respect 
to such disposition if such

[[Page 668]]

person established under prior temporary or prior final regulations 
issued under section 897 that the interest disposed of was not a U.S. 
real property interest.

(Sec. 897 (94 Stat. 2683; 26 U.S.C. 897), sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the 
Internal Revenue Code of 1954)

[T.D. 7999, 49 FR 50702, Dec. 31, 1984; 50 FR 12531, Mar. 29, 1985; T.D. 
8113, 51 FR 46627, Dec. 24, 1986; 52 FR 3796, 3916, Feb. 6, 1987; T.D. 
9082, 68 FR 46083, Aug. 5, 2003; T.D. 9751, Feb. 19, 2016]



Sec.  1.897-3  Election by foreign corporation to be treated as a domestic 
corporation under section 897(i).

    (a) Purpose and scope. This section provides rules pursuant to which 
a foreign corporation may elect under section 897(i) to be treated as a 
domestic corporation for purposes of sections 897, 1445, and 6039C and 
the regulations thereunder. A foreign corporation with respect to which 
an election under section 897(i) is in effect is subject to all rules 
under sections 897 and 1445 that apply to domestic corporations. Thus, 
for example, if a foreign corporation that has made an election under 
section 897(i) is a U.S. real property holding corporation, interests in 
it are U.S. real property interests that are subject to withholding 
under section 1445, and any gain or loss from the disposition of such 
interests by a foreign person will be treated as effectively connected 
with a U.S. trade or business under section 897(a). Similarly, if a 
foreign corporation makes an election under section 897(i), its 
distribution of a U.S. real property interest pursuant to section 301 
will be subject to the carryover basis rule of section 897(f). However, 
an interest in an electing corporation is not a U.S. real property 
interest if following the election the interest is described in section 
897(c)(1)(B) or Sec.  1.897-1(c)(2) (subject to the exceptions of 
subdivisions (i) and (ii) of that section). In addition, section 897(d) 
will not apply to any distribution of a U.S. real property interest by 
such corporation or to any sale or exchange of such interest pursuant to 
a plan of complete liquidation under section 337. A foreign corporation 
that makes an election under section 897(i) shall not be treated as a 
domestic corporation for purposes of any other provision of the Code or 
regulations, except to the extent that it is required to consent to such 
treatment as a condition to making the election. For further information 
concerning the effect of an election under section 897(i) upon the 
withholding requirements of section 1445, see Sec.  1.1445-7. An 
election under section 897(i) is the exclusive remedy of any foreign 
person claiming discriminatory treatment under any treaty with respect 
to the application of sections 897, 1445, and 6039C to a foreign 
corporation. Therefore, if a corporation does not make an effective 
election, relief under a nondiscrimination article of any treaty shall 
not be otherwise available with respect to the application of sections 
897, 1445, and 6039C to such corporation.
    (b) General conditions. A foreign corporation may make an election 
under section 897(i) only if it meets all three of the following 
conditions.
    (1) Holding a U.S. real property interest. The foreign corporation 
must hold a U.S. real property interest at the time of the election. 
This condition is satisfied when a U.S. real property interest is 
acquired simultaneously with the effective date of an election. For 
example, this condition is satisfied when real property is acquired in 
an exchange described in section 351 that is carried out simultaneously 
with the effective date of the election. This condition is also 
satisfied by a corporation that indirectly holds a U.S. real property 
interest through a partnership, trust, or estate.
    (2) Entitlement to nondiscriminatory treatment. The foreign 
corporation must be entitled to nondiscriminatory treatment with respect 
to its U.S. real property interest under any treaty to which the United 
States is a party. Where the corporation indirectly holds a U.S. real 
property interest through a partnership, trust, or estate, the 
corporation itself must be entitled to nondiscriminatory treatment with 
respect to such property interest.
    (3) Submission of election in proper form. The foreign corporation 
must comply with the requirements of paragraph (c) of this section 
respecting the manner and form in which an election must be submitted.

[[Page 669]]

    (c) Manner and form of election. An election under section 897(i) is 
made by filing the materials described in subparagraphs (1) through (5) 
of this paragraph (c) at the address specified in the Instructions for 
Form 8288 under the heading ``Where To File''. The required items may be 
incorporated in a single document.
    (1) General statement. The foreign corporation must supply a general 
statement indicating that an election under section 897(i) is being 
made. The general statement must be signed by a responsible corporate 
officer, who must verify under penalty of perjury that the statement and 
all other documents submitted pursuant to the requirements of this 
paragraph (c) are true and correct to his knowledge and belief. No 
particular form is required for the statement, which must contain all 
the following information--
    (i) The name, address, identifying number, and place and date of 
incorporation of the foreign corporation;
    (ii) The treaty and article under which the foreign corporation is 
seeking nondiscriminatory treatment;
    (iii) A description of the U.S. real property interests held by the 
corporation, either directly or through a partnership, trust, or estate, 
including the dates such interests were acquired, the corporation's 
adjusted bases in such interests, and their fair market values as of the 
date of the election (or book values if the corporation is not a U.S. 
real property holding corporation under the alternative test of Sec.  
1.897-2(b)(2)); and
    (iv) A list of all dispositions of any interests in the foreign 
corporation after December 31, 1979, and before June 19, 1980, between 
related persons (as defined in section 453(f)(1)), giving the type and 
the amount of any interest transferred, the name and address of the 
related person to whom the interest was transferred, the transferor's 
basis in the interest transferred, and the amount of any nontaxed gain 
as defined in section 1125(d) of Pub. L. 96-499.
    (2) Waiver of treaty benefits. The foreign corporation must submit a 
binding waiver of the benefits of any U.S. treaty with respect to any 
gain or loss from the disposition of a U.S. real property interest 
during the period in which the election is in effect.
    (3) Consent to be taxed. The foreign corporation must submit a 
binding agreement to treat as though it were a domestic corporation any 
gain or loss that is recognized upon--
    (i) The disposition of any U.S. real property interest during the 
period in which the election is in effect, and
    (ii) The disposition of any property that it acquired in exchange 
for a U.S. real property interest in a nonrecognition transaction (as 
defined under section 897(e)) during the period in which the election is 
in effect.
    (4) Interest-holders' consent to election--(i) In general. The 
foreign corporation must submit both a signed consent to the making of 
the election and a waiver of U.S. treaty benefits with respect to any 
gain or loss from the disposition of an interest in the corporation from 
each person who holds an interest in the corporation on the date the 
election is made. In the case of a corporation any class of stock of 
which is regularly traded on an established securities market at any 
time during the calendar year, the signed consent and waiver need only 
be provided by a person who holds an interest described in Sec.  1.897-
1(c)(2)(iii)(A) or (B) (determined after application of the constructive 
ownership rules of section 897(c)(6)(C). The foreign corporation must 
also include with the signed consents and waivers a list that identifies 
and describes the interest in the corporation held by each interest 
holder, including the type and amount of such interest and its fair 
market value as of the date of the election.
    (ii) Corporation's retention of interest-holders' consents. A 
corporation need not file the consents and waivers of its interest-
holders as required by paragraph (c)(4)(i) of this section, if it 
instead complies with the requirements of subdivisions (A) through (D) 
of this paragraph (c)(4)(ii).
    (A) The corporation must place a legend on each outstanding 
certificate for shares of its stock that reads substantially as follows: 
``(Name of corporation) has made an election under section 897(i) of the 
United States Internal Revenue Code to be treated as a U.S. corporation 
for certain tax purposes,

[[Page 670]]

and any purchaser of this interest may therefore be required to withhold 
tax at the time of the purchase.'' The corporation must certify that the 
foregoing requirement has been met and that it will place an equivalent 
legend on every stock certificate that is issued while the election 
under section 897(i) is in effect and the corporation retains the 
consents and waivers of its interest-holders under the rules of this 
paragraph (c)(4)(ii). However, with respect to any registered 
certificate issued prior to January 30, 1985, in lieu of placing a 
legend on the certificate the corporation may certify that it will 
provide the purchaser of the interest with a copy of the legend at the 
time the certificate is surrendered for issuance of a new certificate.
    (B) The corporation must include with its election a statement that 
the corporation has received both a signed consent to the making of the 
election and a waiver of U.S. treaty benefits with respect to any gain 
or loss from the disposition of an interest in the corporation from each 
person who holds an interest in the corporation on the date the election 
is made. In the case of a corporation any class of stock of which is 
regularly traded on an established securities market at any time during 
the calendar year, the signed consent and waiver need only be provided 
by a person who holds or has held an interest described in Sec.  1.897-
1(c)(2)(iii) (A) or (B) (determined after application of the 
constructive ownership rules of section 897(c)(6)(C).
    (C) The corporation must include with its election a list that 
describes the interests in the corporation held by each interest-holder. 
The list need not identify the interest-holders by name, but must set 
forth the type, amount, and fair market value of the interests held by 
each.
    (D) The corporation must include with its election an agreement that 
the corporation will retain all signed consents and waivers for a period 
of three years from the date of the election and supply such documents 
to the Director within 30 days of his request for production thereof. 
The Director's review of the signed consents and waivers pursuant to 
this provision shall not constitute an examination for purposes of 
section 7605(b).
    (5) Statement regarding prior dispositions. The foreign corporation 
must state that no interest in the corporation was disposed of during 
the shortest of (A) the period from June 19, 1980, through the date of 
the election, (B) the period from the date on which the corporation 
first holds a U.S. real property interest through the date of the 
election or (C) the five-year period ending on the date of the election. 
If the corporation cannot state that no such dispositions have been 
made, it may make the section 897(i) election only if it states that it 
has complied with the requirements of paragraph (d)(2) of this section.
    (d) Time and duration of election--(1) In general. A foreign 
corporation that meets the conditions of paragraph (b) of this section 
may make an election under section 897(i) at any time before the first 
disposition of an interest in the corporation which would be subject to 
section 897(a) if the election had been made before that disposition, 
except as otherwise provided in paragraph (d)(2) of this section. The 
period to which the election applies begins on the date on which the 
election is made, or such earlier date as is specified in the election, 
but not earlier than June 19, 1980. Unless revoked, an election applies 
for the duration of the time for which the corporation remains in 
existence. An election is made on the date that the statements described 
in paragraph (c) of this section are delivered to the address specified 
in the Instructions for Form 8288 under the heading ``Where To File''. 
If the election is delivered by United States mail, the provisions of 
section 7502 and the regulations thereunder shall apply in determining 
the date of delivery.
    (2) Election after disposition of stock. An election under section 
897(i) may be made after any disposition of an interest in the 
corporation which would have been subject to section 897(a) if the 
election had been made before that disposition, but only if the 
requirements of either subdivision (i) or (ii) of this paragraph (d)(2) 
are met with respect to all dispositions of interests during the period 
described in paragraph (c)(5) of this section.

[[Page 671]]

    (i) There is a payment of an amount equal to any taxes which would 
have been imposed by reason of the application of section 897 upon all 
persons who had disposed of interests in the corporation during the 
period described in paragraph (c)(5) of this section had the corporation 
made the election prior to such dispositions. Such payment must be made 
by the later of the date the election is made, or the date on which 
payment of such taxes would otherwise have been due, and must include 
any interest that would have accrued had tax actually been due with 
respect to the disposition. As an election made prior to any disposition 
of interests in the corporation would have been conditioned on a waiver 
of treaty benefits by the interest-holders, payment of an amount equal 
to tax and any interest with respect to such prior disposition is 
required as a condition to making a subsequent election under this 
subdivision (i) irrespective of the application of any treaty provision. 
For this purpose, it is not necessary that the payment be made by the 
person who would have owed the tax if the election under this section 
had been made prior to the disposition, and that person is under no 
obligation to supply any information to the present holders of interests 
in the electing corporation. The payment shall be made to the U.S. 
Treasury. Where the payment is made by a present holder of an interest, 
the basis of the person's interest in the corporation shall be increased 
to the extent of the amount paid.
    (ii) Each person that acquired an interest in the electing 
corporation took a basis in the interest that was equal to the basis of 
the interest in the hands of the person from which the interest was 
acquired, increased by the sum of any gain recognized by the transferor 
of the interest and any tax paid under chapter 1 by the person that 
acquired the interest, if such interest was acquired after June 18, 
1980.
    (3) Adequate proof of basis. For purposes of meeting the conditions 
of paragraph (d)(2) (i) or (ii) of this section, a corporation must 
establish the bases of and amount of gain realized by all persons who 
disposed of interests in the corporation during the period described in 
paragraph (c)(5) of this section. See paragraph (g)(3) of this section 
for an exception to this rule.
    (4) Acknowledgement of receipt. Within 60 days after its receipt of 
an election under section 897(i), the Internal Revenue Service will 
acknowledge receipt of the election. Such acknowledgement either will 
indicate that the information submitted with the election is complete or 
will specify any documents that remain to be submitted pursuant to the 
requirements of paragraph (c) of this section respecting the manner and 
form in which an election must be made.
    (e) Anti-abuse rule--(1) In general. A corporation that is otherwise 
eligible to make an election under section 897(i) may do so only by 
complying with the requirements of subdivision (2) of this paragraph, if 
during the period described in paragraph (c)(5) of this section--
    (i) Prior to receipt of a U.S. real property interest by the 
corporation seeking to make the election, stock in such corporation (or 
in any corporation controlled by such corporation) was acquired in a 
transaction in which the person acquiring such stock obtained an 
increase in basis in the stock over the adjusted basis of the stock in 
the hands of the person from whom it was acquired;
    (ii) The full amount of gain realized by the person from whom the 
stock was acquired was not subject to U.S. tax; and
    (iii) The corporation seeking to make the election received the U.S. 
real property interest in a transaction or series of transactions to 
which section 897 (d)(1)(B) or (e)(1) applies to allow for 
nonrecognition of gain.
    (2) Recognition of gain. A corporation described in subparagraph (1) 
of this paragraph (e) may make an election under section 897(i) only if 
it pays an amount equal to the tax on the full amount of gain realized 
by the transferors of the stock of such corporation (or of any 
corporation controlled by it) in the transaction described in paragraph 
(e)(1)(i) of this section. However, such amount must be paid only if the 
stock of the corporation seeking to make the election (or the stock of a 
corporation controlled by it) would have constituted a U.S. real 
property

[[Page 672]]

interest had it (or a corporation controlled by it) made the election 
before that acquisition. Such amount must be paid by the later of the 
date of the election or the date on which such tax would otherwise be 
due, and must include any interest that would have accrued had tax 
actually been due with respect to the disposition.
    (3) Definition of control. For purposes of this paragraph, a 
corporation controls a second corporation if it holds 80 percent or more 
of the total combined voting power of all classes of stock entitled to 
vote, and 80 percent or more of the total number of shares of all other 
classes of stock of the second corporation. In a chain of corporations 
where each succeeding corporation is controlled within the meaning of 
this subparagraph (3) by the corporation immediately above it in the 
chain, each corporation in the chain shall be considered to be 
controlled by all corporations that preceded it in the chain.
    (4) Examples. The rules of this paragraph (e) are illustrated by the 
following examples.

    Example 1. Nonresident alien individual X owns 100 percent of the 
stock of foreign corporation L which was organized in 1981. L's only 
asset is a parcel of U.S. real property which it has held since 1981. 
The fair market value of the U.S. real property held by L on January 1, 
1984, is $1,000,000. L's basis in the property is $200,000. X's basis in 
the L stock is $500,000. On June 1, 1984, M corporation, a foreign 
corporation owned by foreign persons who are unrelated to X, purchases 
the stock of L from X for $1,000,000 with title passing outside of the 
United States. Since the stock of L is not a U.S. real property 
interest, X's gain from the disposition of the L stock ($500,000) is not 
treated as effectively connected with a U.S. trade or business under 
section 897(a). In addition, since X was neither engaged in a U.S. trade 
or business nor present in the U.S. at any time during 1984, such gain 
is not subject to U.S. tax under section 871. On January 1, 1987, M 
liquidates L under a plan of liquidation adopted on that same date. 
Under section 332 of the Code M recognizes no gain on receipt of the 
parcel of U.S. real property distributed by L in liquidation. Under 
section 334(b)(1) M takes $200,000 as its basis in the U.S. real 
property received from L. Under section 897(d)(1)(B) no gain would be 
recognized to L under section 897(d)(1)(A) on the liquidating 
distribution. As a consequence, no gain is recognized to L under section 
336 of the Code. After its receipt of the U.S. real property from L, M 
seeks to make an election to be treated as a domestic corporation. Thus, 
M acquired the L stock in a transaction in which it obtained a basis in 
such stock in excess of the adjusted basis of X in the stock, U.S. tax 
was not paid on the full amount of the gain realized by X, and M has 
received the property in a distribution to which section 897(d)(1)(B) 
applied to provide for nonrecognition of gain to L. Therefore, M may 
make the election only if it pays an amount equal to the tax on the full 
amount of X's gain, pursuant to the rule of subparagraph (e)(2) of this 
section.
    Example 2. Nonresident alien individual X owns 100 percent of the 
stock of foreign corporation A which owns 100 percent of the stock of 
foreign corporation B. X's basis in the A stock is $500,000. A's basis 
in the B stock is $500,000. B owns U.S. real property with a fair market 
value of $1,000,000. B's basis in the U.S. real property is $500,000. On 
January 1, 1985, X sells the stock of A to Y, an unrelated individual, 
for $1,000,000 with title passing outside of the United States. In 
addition, X was neither engaged in a U.S. trade or business nor present 
in the U.S. at any time during 1985. Since the A stock is not a U.S. 
real property interest, X's gain on such disposition is not treated as 
effectively connected with a U.S. trade or business under section 897(a) 
and is therefore not subject to U.S. tax under section 871. On July 1, 
1987, a plan of liquidation is adopted, and B is liquidated into A. 
Under sections 332, 334(b)(1), 336, and 897(d)(1)(B), there is no tax to 
A on receipt of U.S. real property from B and no tax to B on the 
distribution of the U.S. real property interest to A. After receipt of 
the property A seeks to make an election under section 897(i). Under the 
rules of paragraph (e) of this section, A may make the election only if 
it pays an amount equal to the tax on the full amount of X's gain. 
(Assuming that A is a U.S. real property holding corporation, the same 
result would be required by the rule of paragraph (d)(2) of this 
section.)

    (f) Revocation of election--(1) In general. An election under 
section 897(i) may be revoked only with the consent of the Commissioner. 
A request for revocation shall be in writing and shall be delivered to 
the address specified in the Instructions for Form 8288 under the 
heading ``Where To File''. The request shall include the name, address, 
and identifying number of the corporation seeking to revoke the 
election, and a description of all U.S. real property interests held by 
the corporation on the date of the request for revocation, including the 
dates such interests were acquired, the corporation's adjusted bases in 
such interests, and their fair

[[Page 673]]

market values as of the date of the request (or book value if the 
corporation is not a U.S. real property holding corporation under the 
alternative test of Sec.  1.897-2(b)(2)). The request shall be signed by 
a responsible officer of the corporation under penalty of perjury and 
shall contain a statement either that the corporation has made no 
distributions described in subparagraph (2) of this paragraph (f) or 
that the conditions of that subparagraph have been satisfied. A 
revocation will be effective as of the date the request is delivered to 
the address specified in the Instructions for Form 8288 under the 
heading ``Where To File'', unless the Commissioner provides otherwise in 
his consent to the revocation. If the request is delivered by United 
States mail, the provisions of section 7502 and the regulations 
thereunder shall apply in determining the date of delivery. The 
Commissioner will generally consent to a revocation, provided either 
that there have been no distributions described in subparagraph (2) of 
this paragraph (f), or that the conditions of that subparagraph have 
been satisfied. Within 90 days after its receipt of a request to revoke 
an election under section 897(i), the Internal Revenue Service will 
acknowledge receipt of the request. Such acknowledgement either will 
indicate that the information submitted with the request is complete or 
will specify any information that remains to be submitted pursuant to 
the requirements of this paragraph (f).
    (2) Revocation after distribution. If there have been any 
distributions of U.S. real property interests by the corporation during 
the period to which an election made under section 897(i) applies, the 
Commissioner shall consent to the revocation of such election only if 
one of the following conditions is met.
    (i) The full amount of gain realized by the corporation upon the 
distribution was subject to U.S. income tax.
    (ii) There is a payment of an amount equal to the taxes that would 
have been imposed upon the corporation by reason of the application of 
section 897 if the election had not been in effect on the date of the 
distribution. Such payment must be made by the later of the date of the 
request for revocation or the date on which payment of such tax would 
otherwise have been due, and must include any interest that would have 
accrued had tax actually been due with respect to the distribution. If 
under the terms of any treaty to which the United States is a party such 
distribution would not have been subject to U.S. income tax 
notwithstanding the provisions of section 897, then this condition may 
be satisfied by providing a statement with the request for revocation 
setting forth the treaty and article which would have exempted the 
distribution from U.S. tax had the election under section 897(i) not 
been in effect on the date thereof.
    (iii) At the time of the receipt of the distributed property, the 
distributee would be subject to taxation under chapter 1 of the Code on 
a subsequent disposition of the distributed property, and the basis of 
the distributed property in the hands of the distributee is no greater 
than the adjusted basis of such property before the distribution, 
increased by the amount of gain (if any) recognized by the distributing 
corporation. For purposes of this paragraph (f)(2)(i)(C), a distributee 
shall be considered to be subject to taxation upon a subsequent 
disposition of distributed property only if such distributee waives the 
benefits of any U.S. treaty that would otherwise render such disposition 
not taxable by the United States. Such waiver must be attached to the 
corporation's request for revocation.
    (g) Transitional rules--(1) In general. An election under section 
897(i) that was made at any time after June 18, 1980, must be amended to 
comply with the requirements of paragraphs (b), (c), and (d) of this 
section. Such amendment must be delivered in writing to the Director, 
Philadelphia Service Center by April 1, 1985. If the amendment is 
delivered by United States mail, the provisions of section 7502 and the 
regulations thereunder shall apply in determining the date of delivery. 
An election that is properly amended pursuant to the requirements of 
this section shall be effective as of the date of the original election.
    (2) Corporations previously entitled to make election. A foreign 
corporation that would have been entitled under

[[Page 674]]

the rules of this section to make a section 897(i) election at any time 
between June 19, 1980, and January 30, 1985, may retroactively make such 
an election pursuant to the requirements of this section. Such election 
must be delivered to the Director, Foreign Operations District, by March 
1, 1985.
    (3) Interests in corporation disposed of prior to publication. Where 
interests in a corporation were disposed of before January 3, 1984, the 
requirement of paragraph (d)(2) of this section may be met, 
notwithstanding the requirement of paragraph (d)(3), by paying a tax 
that is based upon a reasonable estimate of the gain upon the prior 
dispositions. Such estimate must be based on all facts and circumstances 
known to, and ascertainable through the exercise of reasonable diligence 
by, the corporation seeking to make the election.
    (h) Effective date. The requirement in paragraph (c)(1)(i) of this 
section that the statement making the section 897(i) election contain 
the identifying number of the foreign corporation (in all cases) is 
applicable November 3, 2003.

(Sec. 897 (94 Stat. 2683; 26 U.S.C. 897), sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the 
Internal Revenue Code of 1954)

[T.D. 7999, 49 FR 50713, Dec. 31, 1984; 50 FR 12531, Mar. 29, 1985; T.D. 
8113, 51 FR 46629, Dec. 24, 1986; T.D. 9082, 68 FR 46083, Aug. 5, 2003; 
T.D. 9751, 81 FR 8400, Feb. 19, 2016]



Sec.  1.897-4AT  Table of contents (temporary).

           Sec.  1.897-5T Corporate distributions (temporary).

    (a) Purpose and scope.
    (b) Distributions by domestic corporations.
    (1) Limitation of basis upon dividend distribution of U.S. real 
property interest.
    (2) Distributions by U.S. real property holding corporation under 
generally applicable rules.
    (3) Section 332 liquidations of U.S. real property holding 
corporations.
    (i) General rules.
    (ii) Distribution to a foreign corporation under section 332 after 
June 18, 1980, and before the repeal of the General Utilities doctrine.
    (iii) Distribution to a foreign corporation under section 332 and 
former section 334(b)(2) after June 18, 1980.
    (iv) Distribution to a foreign corporation under section 332(a) 
after July 31, 1986 and after the repeal of the General Utilities 
doctrine.
    (A) Liquidation of domestic corporation.
    (B) Liquidation of certain foreign corporations making a section 
897(i) election.
    (v) Transfer of foreign corporation stock followed by a section 332 
liquidation treated as a reorganization.
    (4) Section 897(i) companies.
    (5) Examples.
    (6) Section 333 elections.
    (i) General rule.
    (ii) Example.
    (c) Distributions of U.S. real property interests by foreign 
corporations.
    (1) Recognition of gain required.
    (2) Recognition of gain not required.
    (i) Statutory exception.
    (ii) Section 332 liquidations.
    (A) In general.
    (B) Recognition of gain required in certain section 332 
liquidations.
    (iii) Examples.
    (3) Limitation of gain recognized under paragraph (c)(1) of this 
section for certain section 355 distributions.
    (i) In general.
    (ii) Example.
    (4) Distribution by a foreign corporation in certain 
reorganizations.
    (i) In general.
    (ii) Statutory exception.
    (iii) Regulatory limitation on gain recognized.
    (iv) Examples.
    (5) Sales of U.S. real property interests by foreign corporations 
under section 337.
    (6) Section 897(l) credit.
    (7) Other applicable rules.
    (d) Rules of general application.
    (1) Interests subject to taxation upon later dispositions.
    (i) In general.
    (ii) Effects of income tax treaties.
    (A) Effect of treaty exemption from tax.
    (B) Effect of treaty reduction of tax.
    (C) Waiver of treaty benefits to preserve nonrecognition.
    (iii) Procedural requirements.
    (2) Treaty exception to imposition of tax.
    (3) Withholding.
    (4) Effect on earnings and profits.
    (e) Effective date.

Sec.  1.897-6T Nonrecognition exchanges applicable to corporations their 
shareholders, and other taxpayers, and certain transfers of property in 
                 corporate reorganizations (temporary).

    (a) Nonrecognition exchanges.
    (1) In general.
    (2) Definition of nonrecognition provision.
    (3) Consequence of nonapplication of nonrecognition provisions.
    (4) Section 355 distributions treated as exchanges.
    (5) Section 1034 rollover of gain.
    (i) Purchase of foreign principal residence.

[[Page 675]]

    (ii) Purchase of U.S. principal residence.
    (6) Determination of basis.
    (7) Examples.
    (8) Treatment of nonqualifying property.
    (i) In general.
    (ii) Treatment of mixed exchanges.
    (A) Allocation of nonqualifying property.
    (B) Recognition of gain.
    (C) Treatment of other amounts.
    (iii) Example.
    (9) Treaty exception to imposition of tax.
    (b) Certain foreign to foreign exchanges.
    (1) Exceptions to the general rule.
    (2) Applicability of exception.
    (3) No exceptions.
    (4) Examples.
    (5) Contribution of property.
    (c) Denial of nonrecognition with respect to certain tax avoidance 
transfers.
    (1) In general.
    (2) Certain transfers to domestic corporations.
    (i) General rule.
    (ii) Example.
    (3) Basis adjustment for certain related person transactions.
    (4) Rearrangement of ownership to gain treaty benefit.
    (d) Effective date.

 Sec.  1.897-7T Treatment of certain partnership interests as entirely 
     U.S. real property interests under section 897(g) (temporary).

    (a) Rule.
    (b) Effective date.

 Sec.  1.897-8T Status as a U.S. real property holding corporation as a 
    condition for electing section 897(i) pursuant to Sec.  1.897-3 
                              (temporary).

    (a) Purpose and scope.
    (b) General conditions.
    (c) Effective date.

    Sec.  1.897-9T Treatment of certain interests in publicly traded 
corporations, definition of foreign person, and foreign governments and 
                international organizations (temporary).

    (a) Purpose and scope.
    (b)
    (c) Foreign person.
    (d) Regularly traded.
    (e) Foreign governments and international organizations.
    (f) Effective date.

[T.D. 8198, 53 FR 16217, May 5, 1988]



Sec.  1.897-5  Corporate distributions.

    (a)-(d)(1)(iii)(E) [Reserved]. For further guidance, see Sec.  
1.897-5T(a) through (d)(1)(iii)(E).
    (d)(1)(iii)(F) Identification by name and address of the distributee 
or transferee, including the distributee's or transferee's taxpayer 
identification number;
    (d)(1)(iii)(G) through (d)(4) [Reserved]. For further guidance, see 
Sec.  1.897-5T(d)(1)(iii)(G) through (d)(4).
    (e) Effective date. This section is applicable to transfers and 
distributions after November 3, 2003.

[T.D. 9082, 68 FR 46083, Aug. 5, 2003]



Sec.  1.897-5T  Corporate distributions (temporary).

    (a) Purpose and scope. This section provides rules concerning the 
recognition of gain or loss and adjustments to basis required with 
respect to certain corporate distributions that are subject to section 
897. Paragraph (b) of this section provides rules concerning such 
distributions by domestic corporations, including distributions under 
section 301, distributions in redemption of stock, and distributions in 
liquidation. Paragraph (c) sets forth rules concerning distributions by 
foreign corporations, including distributions under sections 301 and 
355, distributions in redemption of stock, and distributions in 
liquidation. Finally, various rules generally applicable to 
distributions subject to this section, as well as to transfers subject 
to Sec.  1.897-6T, are set forth in paragraph (d). The rules contained 
in this section are also subject to the tax avoidance rules of Sec.  
1.897-6T(c).
    (b) Distributions by domestic corporations--(1) Limitation of basis 
upon dividend distribution of U.S. real property interest. Under section 
897(f), if any domestic corporation (distributing corporation) 
distributes a U.S. real property interest to a shareholder that is a 
foreign person (distributee) in a distribution to which section 301 
applies, then the basis of the distributed U.S. real property interest 
in the hands of the foreign distributee shall be determined in 
accordance with the provisions of section 301(d), and shall not exceed--
    (i) The adjusted basis of the property before the distribution in 
the hands of the distributing corporation, increased by
    (ii) The sum of--
    (A) Any gain recognized by the distributing corporation on the 
distribution, and

[[Page 676]]

    (B) Any U.S. tax paid by or on behalf of the distributee with 
respect to the distribution.
    (2) Distributions by U.S. real property holding corporations which 
are taxable exchanges of stock under generally applicable rules. If a 
domestic corporation, stock in which is treated as a U.S. real property 
interest, distributes property with respect to such stock to a foreign 
shareholder, the distributee shall be treated as having disposed of a 
U.S. real property interest, and shall recognize gain or loss on the 
stock of such domestic corporation to the extent that, with respect to 
the distributees--
    (i) Part of all of the distribution is treated pursuant to section 
301(c)(3)(A) as a sale or exchange of stock;
    (ii) Part or all of the distribution is treated pursuant to section 
302(a) as made in part or full payment in exchange for stock; or
    (iii) Part or all of the distribution is treated pursuant to section 
331(a) as made in full payment in exchange for stock.


Stock in a domestic corporation shall not be considered a U.S. real 
property interest pursuant to the provisions of Sec.  1.897-2(f)(2) if 
the corporation does not hold any U.S. real property interests and has 
disposed of all of its U.S. real property interests owned within the 
previous five years in transactions in which the full amount of gain was 
recognized under the rules of Sec.  1.897-2(f)(2). If gain is recognized 
at the corporate level on either a distribution of a U.S. real property 
interest or a sale of a U.S. real property interest in a liquidation, 
such distribution or sale shall be considered a disposition for purposes 
of Sec.  1.897-2(f)(2). With regard to the consequences of a 
distribution from a U.S. real property holding corporation under section 
355(a), see Sec.  1.897-6T(a)(1) and (4).
    (3) Section 332 liquidations of U.S. real property holding 
corporations--(i) General rules. Exchanges that are subject to section 
897(e) are normally covered by Sec.  1.897-6T(a)(1), (2) and (3). This 
paragraph (b)(3) provides rules concerning the application of section 
897(e) and the general principles of Sec.  1.897-6T(a)(1), (2) and (3) 
to section 332 liquidations of U.S real property holding corporations.
    (ii) Distribution to a foreign corporation under section 332 after 
June 18, 1980, and before the repeal of the General Utilities doctrine. 
Except for distributions under paragraph (b)(3)(iii) of this section 
(relating to section 332 and former section 334(b)(2)), the rules of 
this paragraph (b)(3)(ii) shall apply to section 332 distributions after 
June 18, 1980, and before January 1, 1990, pursuant to section 336(a) as 
in effect prior to the effective dates of the amendments made by section 
631 of the Tax Reform Act of 1986. A foreign corporation that meets the 
stock ownership requirements of section 332(b) with respect to stock in 
a domestic corporation that is a U.S. real property interest shall not, 
after December 31, 1984, be subject to taxation by reason of section 
367(a). The foreign corporation shall recognize gain pursuant to section 
897(e)(1) on such stock upon the receipt of property in a section 332(a) 
liquidation from such domestic corporation, but only to the extent that 
the property received constitutes property other than a U.S. real 
property interest. The gain on the stock in the domestic corporation to 
be recognized by the foreign corporation pursuant to section 897(e)(1) 
shall be determined by multiplying the gain realized on the distribution 
by a fraction. The numerator of the fraction shall be the fair market 
value of the property other than U.S. real property interests received 
by the foreign corporation on the distribution, and the denominator 
shall be the fair market value of all property received by the foreign 
corporation on the distribution. The bases of the distributed U.S. real 
property interests in the hands of the foreign corporation shall be the 
same as the bases in the hands of the domestic corporation. The bases of 
the property other than U.S. real property interests in the hands of the 
foreign corporation shall be the same as the bases in the hands of the 
domestic corporation, plus any gain recognized by the foreign 
corporation on the distribution allocated among such assets in 
proportion to the potential gain inherent in each such asset at the time 
of distribution. However, the basis of each asset is limited to its fair 
market value. Property, other than a U.S. real property interest

[[Page 677]]

that is distributed by the domestic corporation, shall not be considered 
to be distributed by the domestic corporation pursuant to a section 332 
liquidation (that is, the foreign corporation shall not be considered to 
be a corporation for purposes of section 332) if the requirements of 
section 367(a) are not satisfied. See, for example, sections 1245(b)(3) 
and 1250(d)(3) regarding the consequences to the distributing domestic 
corporation if the requirements of section 367(a) are not satisfied.
    (iii) Distribution to a foreign corporation under section 332 and 
former section 334(b)(2) after June 18, 1980. The rules of this 
paragraph (b)(2)(iii) shall apply to section 332 distributions after 
June 18, 1980 where the basis of the distributed property in the hands 
of the foreign corporation is determined under section 334(b)(2) as in 
effect prior to the Tax Equity and Fiscal Responsibility Act of 1982. A 
foreign corporation that meets the stock ownership requirements of 
section 332(b) with respect to stock in a domestic corporation that is a 
U.S. real property interest shall recognize gain on the receipt of 
property in a section 332(a) liquidation where section 334(b)(2) applies 
to the extent that the fair market value of the distributed assets that 
are not U.S real property interests exceeds the basis of such assets 
determined under section 334(b)(2) (for example, if the liquidation does 
not occur immediately upon the purchase of stock in the domestic 
corporation). The gain recognized shall not exceed the excess of the 
fair market value of the stock of the domestic corporation in the hands 
of the foreign corporation at the time of the distribution over the 
shareholder's adjusted basis in such stock. The basis of the distributed 
U.S. real property interests in the hands of the foreign corporation 
shall be determined under section 334(b)(2), by reference to the 
adjusted basis of the stock with respect to which the distribution was 
made. The basis of such property other than U.S. real property interests 
shall be tentatively determined under section 334(b)(2), and then 
increased by any gain recognized by the foreign corporation on the 
distribution allocated among such assets in proportion to the potential 
gain inherent in each such asset at the time of distribution (computed 
using the tentative basis as determined under section 334(b)(2)). The 
basis of each asset is limited, however, to its fair market value.
    (iv) Distribution to a foreign corporation under section 332 after 
July 31, 1986 and after the repeal of the General Utilities doctrine. 
The rules of this subdivision (iv) shall apply to section 332 
distributions after July 31, 1986, pursuant to section 337(a) as in 
effect after the effective dates of the amendments of section 631 of the 
Tax Reform Act of 1986.
    (A) Liquidation of domestic corporation. A foreign corporation that 
meets the stock ownership requirements of section 332(b) with respect to 
stock in a domestic corporation that is a U.S. real property interest 
(except a foreign corporation that has made an effective election under 
section 897(i) and the stock of which is treated as a U.S. real property 
interest) shall not recognize any gain under sections 367(a) or 
897(e)(1) on the receipt of property in a section 332(a) liquidation. 
The domestic corporation shall not recognize gain under section 
367(e)(2) on the distribution of U.S. real property interests (other 
than stock in a former U.S. real property holding corporation which is 
treated as a U.S. real property interest) to the foreign corporation. 
The domestic corporation shall recognize gain under section 367(e)(2) on 
the distribution of stock in a former U.S. real property holding 
corporation which is treated as a U.S. real property interest. With 
respect to the recognition of gain or loss by the domestic corporation 
under section 367(e)(2) on the distribution of property other than U.S. 
real property interests, see the regulations under section 367(e)(2). 
The basis of the distributed U.S. real property interests (other than 
stock in a former U.S. real property holding corporation) in the hands 
of the foreign corporation shall be the same as it was in the hands of 
the domestic corporation. The basis of any property (other than U.S. 
real property interests) and stock in a former U.S. real property 
holding corporation that is a U.S. real property interest in the hands 
of the foreign corporation shall be the same as it was in the hands of 
the domestic corporation

[[Page 678]]

increased by any gain recognized by the distributing corporation on the 
distribution that was subject to U.S. taxation.
    (B) Liquidation of certain foreign corporations making a section 
897(i) election. A foreign corporation that meets the stock ownership 
requirements of section 332(b) with respect to stock in another foreign 
corporation, that has made an effective election under section 897(i) 
and the stock of which is treated as a U.S. real property interest, 
shall recognize gain pursuant to section 897(e)(1) on such stock upon 
the receipt from the distributing foreign corporation of property that 
is not a U.S. real property interest, and that is not used by the 
distributee foreign corporation in the conduct of a trade or business 
within the United States (if the distributee foreign corporation is not 
a resident of a country with which the United States maintains an income 
tax treaty) or in a permanent establishment within the United States (if 
the distributee foreign corporation is a resident of a country with 
which the United States maintains an income tax treaty). The gain on the 
stock in the foreign corporation (making an effective election under 
section 897(i)) to be recognized by the distributee foreign corporation 
pursuant to section 897(e)(1) shall be determined by multiplying the 
gain realized on the distribution by a fraction. The numerator of the 
fraction shall be the fair market value of the property received by the 
distributee foreign corporation upon which it must recognize gain, and 
the denominator of the fraction shall be the fair market value of all 
property received by the distributee foreign corporation on the 
distribution. The distributing foreign corporation shall not recognize 
gain under section 367(e)(2) on the distribution of U.S. real property 
interests to the distributee foreign corporation. With respect to the 
recognition of gain or loss under section 367(e)(2) on the distribution 
of property other than U.S. real property interests, see the regulations 
under section 367(e)(2). The basis of the distributed U.S. real property 
interests in the hands of the distributee foreign corporation shall be 
the same as it was in the hands of the distributing foreign corporation. 
The basis of the property upon which the distributee foreign corporation 
recognized gain in the hands of the distributee foreign corporation 
shall be the same as the basis in the hands of the distributing foreign 
corporation, plus any gain recognized by the distributee foreign 
corporation on the receipt of such property allocated among such 
property in proportion to the potential gain inherent in each such 
property at the time of the distribution. In regard to the basis of any 
other property received by the distributee foreign corporation in the 
liquidation, see the regulations under section 367(e)(2). However, the 
basis of each asset is limited to its fair market value.
    (v) Transfer of foreign corporation stock followed by a section 332 
liquidation treated as a reorganization. If a nonresident alien or 
foreign corporation transfers the stock of a foreign-corporation that 
owns a U.S. real property interest to a domestic corporation in exchange 
for stock of the domestic corporation (or its domestic or foreign parent 
corporation) in a reorganization under section 368(a)(1)(B) or in an 
exchange under section 351(a), and if the foreign corporation then 
distributes the U.S. real property interest to the domestic corporation 
in a liquidation described in section 332(a) within five years of the 
transfer of the stock of the foreign corporation to the domestic 
corporation, then the transfer of the foreign corporation stock and the 
liquidation shall be treated as a reorganization described in section 
368(a)(1) (C) or (D). The rules of Sec.  1.897-6T(a)(1) shall apply to 
the transfer of the U.S. real property interest to the domestic 
corporation in exchange for domestic corporation stock, and the rules of 
Sec.  1.897-5T(c)(4) shall apply to the distribution of domestic 
corporation stock by the foreign corporation. However, the rules of this 
paragraph (b)(3)(v) shall not apply if the transfer of the foreign 
corporation stock and the liquidation under section 332(a) are separate 
and independent transactions justified by substantial and verifiable 
business purposes.
    (4) Section 897(i) companies. Except as otherwise provided herein 
for purposes of this section and Sec.  1.897-6T, a foreign

[[Page 679]]

corporation that has made a valid election under section 897(i) shall be 
treated as a domestic corporation and not as a foreign corporation in 
determining the application of section 897. For rules concerning the 
making of a section 897(i) election, see Sec. Sec.  1.897-3 and 1.897-
8T. In regard to section 367(e)(2) and foreign corporations that have 
made an effective election under section 897(i), see paragraph 
(b)(3)(iv) of this section.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (b). In each example there is no applicable income tax treaty 
to which the United States is a party.

    Example 1. (i) A is a nonresident alien who owns 100 percent of the 
stock of DC, a U.S. real property holding corporation. DC's only asset 
is Parcel P, a U.S. real property interest, with a fair market value of 
$500,000 and an adjusted basis of $300,000. DC completely liquidates in 
1987 and distributes Parcel P to A in exchange for the DC stock held by 
A.
    (ii) Under section 336(a), DC must recognize gain to the extent of 
the excess of the fair market value ($500,000) over the adjusted basis 
($300,000), or $200,000.
    (iii) A does not recognize any gain under section 897(a) because the 
DC stock in the hands of A is no longer a U.S. real property interest 
under paragraph (b)(2) of this section and paragraph 2(f) of Sec.  
1.897-2. A does recognize gain (if any) under section 331(a); however, 
the gain is not subject to taxation under section 871(a). A's adjusted 
basis in Parcel P is $500,000.
    (iv) If DC did not recognize all of the gain on the disposition 
under a transitional rule to section 631 of the Tax Reform Act of 1986, 
then paragraph (b)(2) of this section and paragraph 2(f) of Sec.  1.897-
2 would not apply to A. A would recognize gain (if any) under paragraph 
(b)(2) because the distribution is treated as in full payment in 
exchange for the DC stock under section 897(a).
    Example 2. (i) FC, a Country F corporation, owns 100 percent of the 
stock of DC, a U.S. real property holding corporation. FC's basis in the 
stock of DC is $400,000, and the fair market value of the DC stock is 
$800,000. DC owns a U.S. real property interest with an adjusted basis 
of $350,000 and a fair market value of $600,000. DC also owns other 
assets that are not U.S. real property interests that have an adjusted 
basis of $125,000 and a fair market value of $200,000. DC completely 
liquidates in 1985 and distributes all of its property to FC in exchange 
for the DC stock held by FC.
    (ii) Under paragraph (b)(3)(ii) of this section, FC recognizes 
$100,000 of gain under section 897(a) on the disposition of the DC 
stock. This is determined by multiplying FC's gain realized ($400,000) 
by a fraction. The numerator of the fraction is the fair market value of 
the property other than U.S. real property interests ($200,000), and the 
denominator of the fraction is the fair market value of all property 
received ($800,000). FC takes a carryover adjusted basis in the U.S. 
real property interest ($350,000). FC's adjusted basis in the assets 
that are not U.S. real property interests ($200,000) is the basis of 
those assets in the hands of DC ($125,000) plus the gain recognized by 
FC on the distribution ($100,000) not to exceed the fair market value 
($200,000).
    Example 3. (i) FC, a Country F corporation, owns 100 percent of the 
stock of DC, a U.S. real property holding corporation. FC's basis in the 
stock of DC is $300,000, and the fair market value of the DC stock is 
$500,000. DC owns Parcel P, a U.S. real property interest, with an 
adjusted basis of $250,000 and a fair market value of $400,000. DC also 
owns all of the stock of DX, a former U.S. real property holding 
corporation whose stock is a U.S. real property interest, with an 
adjusted basis of $50,000 and a fair market value of $100,000. DC 
completely liquidates in 1987 and distributes all of its property to FC 
in exchange for the DC stock held by FC.
    (ii) Under paragraph (b)(3)(iv)(A) of this section, DC recognizes 
$50,000 of gain on the distribution to FC of the DX stock. DC does not 
recognize any gain for purposes of section 367(e)(2) on the distribution 
to FC of Parcel P.
    (iii) Under paragraph (b)(3)(iv)(A) of this section, FC's 
disposition of its DC stock is not treated as a disposition of a U.S. 
real property interest. Under section 334(b)(1), FC takes a carryover 
adjusted basis of $250,000 in Parcel P. FC takes an increased basis of 
$100,000 in the DX stock which is equal to DC's basis ($50,000) 
increased by the gain recognized by DC ($50,000).
    (iv) The result would be the same if FC had made an effective 
election under section 897(i).

    (6) Section 333 elections--(i) General rule. A foreign shareholder 
that elects section 333 as in effect prior to its repeal by the Tax 
Reform Act of 1986 upon the distribution of property in a liquidation by 
a domestic corporation whose stock is treated as a U.S. real property 
interest shall recognize gain on such stock to the extent that--
    (A) The property received by the foreign shareholder constitutes 
property other than U.S. real property interests subject to U.S. 
taxation upon its disposition as specified by paragraph (a)(1) of this 
section, or
    (B) The basis of a U.S. real property interest subject to U.S. 
taxation upon

[[Page 680]]

its disposition in the hands of the recipient foreign shareholder 
exceeds the basis of the U.S. real property interest in the hands of the 
liquidating domestic corporation.


In determining the amount of gain recognized by the foreign shareholder, 
the foreign shareholder shall be considered to have exchanged the 
domestic corporation stock for all the property distributed on a 
proportionate fair market value basis. The gain recognized on a 
respective portion of domestic corporation stock shall not exceed the 
gain realized on that portion. Property other than U.S. real property 
interests subject to U.S. taxation upon disposition shall have a fair 
market value basis in the hands of the foreign shareholder. The basis of 
U.S. real property interests subject to U.S. taxation upon disposition 
shall be the basis of the proportionate part of the domestic corporation 
stock cancelled or redeemed in the liquidation, increased in the amount 
of gain recognized (other than gain recognized under this section) by 
the shareholder in respect to that proportionate part of the domestic 
corporation stock.
    (ii) Example. The rules of paragraph (b)(6)(i) of this section may 
be illustrated by the following example.

    Example. (i) A is a citizen and resident of Country F with which the 
U.S. does not have an income tax treaty. A owns all of the stock of DC, 
a U.S. real property holding corporation. The DC stock has a fair market 
value of $1,000,000. A acquired the DC stock in two purchases. The basis 
of one lot of the DC stock is $150,000, and the basis of the other lot 
is $650,000.
    (ii) DC owns Parcel P, a U.S. real property interest, with a fair 
market value of $750,000 and an adjusted basis of $400,000. DC's only 
other property is equipment with a fair market value of $250,000 and an 
adjusted basis of $100,000. DC does not have any earnings and profits.
    (iii) DC completely liquidates in 1985 in accordance with section 
333 by distributing Parcel P and the equipment to A. A elects section 
333 treatment.
    (iv) A is considered as having exchanged 75 percent (fair market 
value of Parcel P/fair market value of all property distributed) of the 
DC stock for Parcel P. A realized gain of $150,000 on that portion of 
the DC stock ($750,000-$600,000). All of the gain of $150,000 is 
recognized under section 897 (a) because A's basis in Parcel P under 
section 334 (c) ($600,000) would exceed DC's basis in Parcel P 
($400,000) by at least the amount of realized gain. A takes a basis of 
$750,000 in Parcel P.
    (v) A is considered as having exchanged 25 percent (fair market 
value of equipment/fair market value of all property distributed) of the 
DC stock for the equipment. A realized gain of $50,000 on that portion 
of the DC stock ($250,000-$200,000). All of the gain of $50,000 is 
recognized under section 897 (a). A takes a basis of $250,000 in the 
equipment.

    (c) Distributions of U.S. real property interests by foreign 
corporations--(1) Recognition of gain required. If a foreign corporation 
makes a distribution (including a distribution in liquidation or 
redemption) of a U.S. real property interest to a shareholder (whether 
foreign or domestic), then, except as provided in paragraph (c) (2), 
(3), or (4) of this section, the distributing corporation shall 
recognize gain (but not loss) on the distribution under section 897 (d) 
(1). The gain recognized shall be equal to the excess of the fair market 
value of the U.S. real property interest (as of the time of the 
distribution) over its adjusted basis. Except as otherwise provided, the 
distributee's basis in the distributed U.S. real property interest shall 
be determined under the otherwise applicable sections of the Code. The 
distributee (whether domestic or foreign) of a foreign corporation in a 
liquidation under section 332 shall take the foreign corporation's basis 
in the distributed U.S. real property interest increased by any gain 
recognized (and subject to U.S. income taxation) by the foreign 
corporation on the distribution of such U.S. real property interest.
    (2) Recognition of gain not required--(i) Statutory exception rule. 
Under section 897(d)(2)(A), gain shall not be recognized by a 
distributing foreign corporation if--
    (A) At the time of the receipt of the distributed U.S. real property 
interest, the distributee would be subject to U.S. income taxation on a 
subsequent disposition of the U.S. real property interest, determined in 
accordance with the rules of paragraph (d)(1) of this section;
    (B) The basis of the distributed U.S. real property interest in the 
hands of the distributee is no greater than the adjusted basis of such 
property before the distribution, increased by the amount of gain (if 
any) recognized by the distributing corporation upon the

[[Page 681]]

distribution and added to the adjusted basis under the otherwise 
applicable provisions; and
    (C) The distributing corporation complies with the filing 
requirements of paragraph (d)(1)(iii) of this section.
    (ii) Section 332 liquidations--(A) In general. A distributing 
foreign corporation that meets the requirements of paragraph (c)(2)(i) 
in a section 332(a) liquidation shall not recognize gain on the 
distribution of U.S. real property interests to a foreign corporation 
meeting the stock ownership requirements of section 332(b) if the 
distributing corporation complies with the procedural requirements of 
paragraph (d)(1)(iii). Whether a foreign corporation recognizes gain on 
the distribution of U.S. real property interests to a U.S. corporation 
meeting the stock ownership requirements of section 332(b) depends upon 
whether the U.S. corporation satisfies the subject to tax requirement 
provided in paragraph (d)(1)(i) (in addition to the procedural 
requirements of paragraph (d)(1)(iii)). With respect to section 332 
distributions by a foreign corporation occurring after July 31, 1986, 
section 367(e)(2) shall not affect the application of section 337(a) (as 
in effect after the Tax Reform Act of 1986) and paragraph (c)(2)(i) of 
this section to the distribution of a U.S. real property interest.
    (B) Recognition of gain required in certain section 332 
liquidations. Notwithstanding the other rules of this paragraph (c), a 
foreign corporation shall, pursuant to the authority conferred by 
section 897(e)(2), recognize gain on its distribution after May 5, 1988 
of a U.S. real property interest to a domestic corporation meeting the 
stock ownership requirements of section 332(b) if--
    (1) The foreign corporation has not made an election under section 
897(i), and any gain on the stock in the foreign corporation would be 
subject to U.S. taxation if an election were made on the date of the 
liquidation; and
    (2) The distribution of the U.S. real property interest by the 
foreign corporation to the domestic corporation pursuant to section 
332(a) occurs less than five years after the date of the last gain from 
the disposition of stock of the foreign corporation that would be 
subject to payment of tax under Sec.  1.897-3(d)(2)(i) if an election 
under section 897(i) were made by the foreign corporation on the date of 
its liquidation.


With regard to the treatment of certain foreign corporations as domestic 
corporations under section 897(i), however, see Sec. Sec.  1.897-3 and 
1.897-8T.
    (iii) Examples. The rules of this paragraph (c)(2) may be 
illustrated by the following examples.

    Example 1. (i) DC, a domestic corporation, owns 100 percent of the 
stock of FC, a Country F corporation, FC's only asset is Parcel P, a 
U.S. real property interest, with a fair market value of $500x and an 
adjusted basis of $100x. In September 1987, FC liquidates under section 
332(a) and transfers Parcel P to DC. The transitional rules contained in 
section 633 of the Tax Reform Act of 1986 concerning the repeal of the 
General Utilities doctrine would not be applicable to a subsequent 
distribution or disposition of assets by DC.
    (ii) Assume that FC complies with the filing requirements of 
paragraph (d)(1)(iii). DC will be subject to U.S. income taxation on a 
subsequent disposition of Parcel P under the rules of paragraph (d)(1). 
The basis of Parcel P in the hands of DC will be $100x under section 
334(b)(1), and thus no greater than the basis of Parcel P in the hands 
of FC. FC does not recognize any gain under the rules of paragraph 
(c)(1) of this section on the distribution because the exception of 
paragraph (d)(2)(i) applies.
    Example 2. If in Example (1) the distribution by FC to DC occurred 
in September 1985, and DC sold or exchanged Parcel P under sections 
336(a) or 337(a) as in effect prior to the Tax Reform Act of 1986, then 
FC must recognize gain of $400x on the distribution of Parcel P. The 
gain must be recognized because Parcel P in the hands of DC is not 
considered subject to U.S. income taxation on a subsequent disposition 
under the rules of paragraph (d)(1) of this section.

    (3) Limitation of gain recognized under paragraph (c)(1) of this 
section for certain section 355 distributions--(i) In general. Under 
paragraph (c)(1) of this section, a foreign corporation that distributes 
stock in a domestic corporation that constitutes a U.S. real property 
interest in a distribution to which section 355 applies shall recognize 
gain on the distribution to the extent that the fair market value of the 
distributed stock exceeds its adjusted basis in the hands of the 
distributing foreign corporation. The gain recognized shall be limited 
under this paragraph (c)(3), however, to the amount by which the 
aggregate

[[Page 682]]

basis of the distributed stock in the hands of the distributees exceeds 
the aggregate adjusted basis of the distributed stock in the hands of 
the distributing corporation. The distributees' basis in the distributed 
U.S. real property interest shall be determined under the otherwise 
applicable provisions of section 358. (Thus, the distributees' basis in 
the distributed U.S. real property interest shall be determined without 
any increase for any gain recognized by the foreign corporation).
    (ii) Example. The rules of paragraph (c)(3)(i) of this section may 
be illustrated by the following example.

    Example. (i) C is a citizen and resident of Country F. C owns all of 
the stock of FC, a Country F corporation. The fair market value of the 
FC stock is 1000x, and C has a basis of 600x in the FC stock. Country F 
does not have an income tax treaty with the United States.
    (ii) In a transaction qualifying as a distribution of stock of a 
controlled corporation under section 355(a), FC distributes to C all of 
the stock of DC, a U.S. real property holding corporation. C does not 
surrender any of the FC stock. The DC stock has a fair market value of 
600x, and FC has an adjusted basis of 200x in the DC stock. After the 
distribution, the FC stock has a fair market value of 400x.
    (iii) Under paragraph (c)(3)(i) of this section, FC must recognize 
gain on the distribution of the DC stock to C equal to the difference 
between the fair market value of the DC stock (600x) and FC's adjusted 
basis in the DC stock (200x). This results in a potential gain of 400x. 
Under section 358, C takes a 360x adjusted basis in the DC stock. 
Provided that FC complies with the filing requirements of paragraph 
(d)(1)(iii) of this section, the gain recognized by FC is limited under 
paragraph (c)(3)(i) to 160x because (A) this is the amount by which the 
basis of the DC stock in the hands of C (360x) exceeds the adjusted 
basis of the DC stock in the hands of FC (200x), and (B) at the time of 
receipt of the DC stock, C would be subject to U.S. taxation on a 
subsequent disposition of the stock.
    (iv) C's adjusted basis in the DC stock is not increased by the 160x 
recognized by FC.

    (4) Distribution by a foreign corporation in certain 
reorganizations--(i) In general. Under paragraph (c)(1) of this section, 
a foreign corporation that transfers property to another corporation in 
an exchange under section 361(a) for stock of a domestic corporation 
which is a United States real property holding corporation immediately 
after the transfer in a reorganization under section 368(a)(1) (C), (D), 
or (F) shall recognize gain under section 897(d)(1) on the distribution 
(whether actual or deemed) of the stock of the domestic corporation 
received by the foreign corporation to its shareholders (whether 
domestic or foreign). See Sec.  1.897-6T(a) of the regulations for the 
consequences to the foreign corporation of the exchange of its property 
for the domestic corporation stock.
    (ii) Statutory exception. Pursuant to the exception provided in 
section 897(d)(2)(A), no gain shall be recognized by the foreign 
corporation on its distribution of the domestic corporation stock if--
    (A) At the time of the distribution, the distributee (i.e., the 
exchanging shareholder in the section 354 exchange) would be subject to 
U.S. taxation on a subsequent disposition of the stock of the domestic 
corporation, determined in accordance with the rules of paragraph (d)(1) 
of this section;
    (B) The distributee's adjusted basis in the stock of the foreign 
corporation immediately before the distribution was no greater than the 
foreign corporation's basis in the stock of the domestic corporation 
determined under section 358; and
    (C) The distributing corporation complies with the filing 
requirements of paragraph (d)(1)(iii) of this section.
    (iii) Regulatory limitation on gain recognized. If the requirements 
of subdivisions (A) and (C) of paragraph (c)(4)(ii) are met, the amount 
of any gain recognized by the foreign corporation shall not exceed the 
excess of the distributee's adjusted basis in the stock of the foreign 
corporation immediately before the distribution over the foreign 
corporation's basis in the stock of the domestic corporation immediately 
before the distribution as determined under section 358.
    (iv) Examples. The rules of paragraph (c)(4) of this section may be 
illustrated by the following examples.

    Example 1. (i) A, a nonresident alien, organized FC, a Country W 
corporation, in September 1980 to invest in U.S. real estate. In 1986, 
FC's only asset is Parcel P, a U.S. real property interest with a fair 
market value of $600,000 and an adjusted basis to FC of

[[Page 683]]

$200,000. Parcel P is subject to a mortgage with an outstanding balance 
of $100,000. The fair market value of the FC stock is $500,000, and A's 
adjusted basis in the stock is $100,000. FC does not have liabilities in 
excess of the adjusted basis in Parcel P. The United States does not 
have a treaty with Country W that entitles FC to nondiscriminatory 
treatment as described in section 1.897-3(b)(2) of the regulations.
    (ii) Pursuant to a plan of reorganization under section 
368(a)(1)(D), FC transfers Parcel P to DC, a newly formed domestic 
corporation, in exchange for DC stock. FC distributes the DC stock to A 
in exchange for A's FC stock.
    (iii) FC's exchange of Parcel P for the DC stock is a disposition of 
a U.S. real property interest. Under Sec.  1.897-6T(a)(1), there is an 
exchange of a U.S. real property interest (Parcel P) for another U.S. 
real property interest (DC stock) so that no gain is recognized on the 
exchange under section 897(e). DC takes FC's basis of $200,000 in Parcel 
P under section 362(b). Under section 358(a)(1), FC takes a $100,000 
basis in the DC stock because FC's substituted basis of $200,000 in the 
DC stock is reduced by the $100,000 of liabilities to which Parcel P is 
subject.
    (iv) Under section 897(d)(1) and paragraph (c)(4)(i) of this 
section, FC generally must recognize gain on the distribution of the DC 
stock received in exchange for FC's assets equal to the difference 
between the fair market value of the DC stock ($500,000) and FC's 
adjusted basis in the DC stock prior to the distribution ($100,000). 
This results in a potential gain of $400,000. Under section 358(a)(1), A 
takes a basis in the DC stock equal to its basis in the FC stock of 
$100,000. Provided that FC complies with the filing requirements of 
paragraph (d)(1)(iii) of this section, no gain is recognized by FC on 
the distribution of the DC stock under the statutory exception to the 
general rule of section 897(d)(1) provided in section 897(d)(2)(A) and 
paragraph (c)(4)(ii) of this section because (1) A's basis in the DC 
stock ($100,000) does not exceed FC's adjusted basis in the DC stock 
($100,000) immediately prior to the distribution and (2) A, at the time 
of receipt of the DC stock, would be subject to U.S. taxation on a 
subsequent disposition of the stock.
    (v) The FC stock in the hands of A is not a U.S. real property 
interest because FC is a foreign corporation that has not elected to be 
treated as a domestic corporation under section 897(i). Accordingly, the 
exchange of the FC stock by A for DC stock is not a disposition of a 
U.S. real property interest under section 897(a).
    Example 2. The facts are the same as in Example 1, except that A 
purchased the FC stock in September 1983 for $100,000 from S, a 
nonresident alien, and that S had a basis of $40,000 in the FC stock at 
the time of the sale to A. The results are the same as in Example 1.
    Example 3. (i) The facts are the same as in Example 1, except that 
A's adjusted basis in the FC stock prior to the reorganization is 
$300,000. Following the distribution, A takes its basis of $300,000 in 
the FC stock as its basis in the DC stock pursuant to section 358(a)(1).
    (ii) FC does not qualify under the statutory exception of paragraph 
(c)(4)(ii) to the general recognition rule of section 897(d)(1) and 
paragraph (c)(4)(i) of this section because A's basis in the DC stock 
($300,000) exceeds FC's adjusted basis in the DC stock ($100,000) 
immediately prior to the distribution. However, provided that FC 
complies with the filing requirements of paragraph (d)(1)(iii) of this 
section, the gain recognized by FC is limited to $200,000 under the 
regulatory limitation of gain provided by paragraph (c)(4)(iii). This is 
the excess of A's basis in the FC stock immediately before the 
distribution ($300,000) over A's adjusted basis in the DC stock 
immediately before the distribution ($100,000).
    (iii) A takes a basis of $300,000 in the DC stock under section 
358(a)(1). A's basis in the DC stock is not increased by the gain 
recognized by FC. DC takes a basis of $200,000 in Parcel P under section 
362(b).
    Example 4. (i) The facts are the same as in Example 3, except that 
the United States has an income tax treaty with Country W entitling FC 
to nondiscriminatory treatment under section 1.897-3(b)(2) of the 
regulations. A valid election under section 897(i) is made to treat FC 
as a U.S. corporation.
    (ii) FC is treated as a domestic corporation for purposes of section 
897 and is not required to recognize gain under section 897(d)(1) and 
paragraph (c)(4)(i) of this section on the distribution of the DC stock 
as described in Example 3. (If a valid section 897(i) election were not 
made, the result would be same as in Example 3.)
    (iii) The FC stock in the hands of A is a U.S. real property 
interest because an election was made under section 897(i) to treat FC 
as a U.S. corporation. The exchange of the FC stock for DC stock by A is 
a disposition of a U.S. real property interest. Under section 897(e)(1) 
and paragraph (a) of Sec.  1.897-6T, A does not recognize gain on the 
exchange because there is an exchange of a U.S. real property interest 
(the FC stock) for another U.S. real property interest (the DC stock). 
Under section 358(a)(1), A takes as its basis in the DC stock A's basis 
in the FC stock ($300,000).

    (5) Sales of U.S. real property interests by foreign corporations 
under section 337. Section 337 as in effect prior to the Tax Reform Act 
of 1986 shall not apply to any sale or exchange (including a deemed 
section 337 sale pursuant to an

[[Page 684]]

election under section 338(a) to treat a stock purchase as an asset 
acquisition) of a U.S. real property interest by a foreign corporation.
    (6) Section 897(l) credit. If a foreign corporation adopts a plan of 
complete liquidation and if, solely by reason of section 897(d) and this 
section, section 337(a) (as in effect before the Tax Reform Act of 1986) 
does not apply to sales or exchanges of, or section 336 (as in effect 
before the Tax Reform Act of 1986) does not apply to distributions of, 
United States real property interests by the liquidating corporation, 
then--
    (i) The amount realized by the shareholder on the distribution shall 
be increased by its proportionate share of the amount by which the tax 
imposed by chapter 1 of the Code, as modified by the provisions of any 
applicable U.S. income tax treaty, on the liquidating corporation would 
have been reduced if section 897(d) and this section had not been 
applicable, and
    (ii) For purposes of the Code, the shareholder shall be deemed to 
have paid, on the last day prescribed by law for the payment of the tax 
imposed by subtitle A of the Code on the shareholder for the taxable 
year, an amount of tax equal to the amount of increase in the amount 
realized described in subdivison (i) of this paragraph (c).


The special rule provided by this paragraph (c)(5) applies only to 
shareholders who are United States citizens or residents, and who have 
held stock in the liquidating corporation continuously since June 18, 
1980. This special rule also only applies for the first taxable year of 
any such shareholder in which the shareholder receives a distribution in 
complete liquidation from the foreign corporation.
    (7) Other applicable rules. For rules concerning exemption of gain 
pursuant to a U.S. income tax treaty, withholding of tax from 
distributions, and other applicable rules, see paragraph (d) of this 
section. For the treatment of liquidations described in section 
334(b)(2)(A) of certain foreign corporations acquired before November 6, 
1980, see Sec.  1.897-4.
    (d) Rules of general application--(1) Interests subject to taxation 
upon later disposition--(i) In general. Pursuant to the otherwise 
applicable rules of this section and Sec.  1.897-6T, nonrecognition of 
gain or loss may apply with respect to certain distribution or exchanges 
of U.S. real property interests if any gain from a subsequent 
disposition of the interests that are distributed or received by the 
transferor in the exchange would be included in the gross income of the 
distributee or transferor and be subject to U.S. taxation. Gain is 
considered subject to U.S. taxation if the gain is included on the 
income tax return of a U.S. tax paying entity even if there is no U.S. 
tax liability (for example, because of net operating losses or an 
investment tax credit). Gain is not considered subject to U.S. taxation 
if the gain is derived by a tax exempt entity. A real estate investment 
trust is considered to be a pass-through entity for purposes of the rule 
of taxability of this paragraph (d)(1)(i). Thus, for example, a tax 
exempt entity holding an interest in a real estate investment trust is 
not subject to tax. A domestic corporation (including a foreign 
corporation that makes an effective section 897(i) election after 
receipt of the U.S. real property interest) shall not be considered 
subject to U.S. taxation on a subsequent disposition of a U.S. real 
property interest if it received the U.S. real property interest prior 
to the effective date of the repeal of section 336(a) or 337(a) as in 
effect prior to the Tax Reform Act of 1986, unless the U.S. real 
property interest has not been sold or exchanged by the domestic 
corporation prior to such effective date in a transaction to which 
either section 336(a) or section 337(a) (as in effect prior to such 
effective date) applied. In addition, an interest shall be considered to 
be subject to U.S. taxation upon its subsequent disposition only if the 
requirements set forth in subdivision (iii) of this paragraph (d)(1) are 
met.
    (ii) Effects of income tax treaties--(A) Effect of treaty exemption 
from tax. Except as otherwise provided in subdivision (C) of this 
paragraph (d)(1)(ii), a U.S. real property interest shall not be 
considered to be subject to U.S. taxation upon a subsequent disposition 
if, at the time of its distribution or exchange, the recipient is 
entitled pursuant to the provisions of a U.S. income tax treaty to an 
exemption from U.S.

[[Page 685]]

taxation upon a disposition of the interest.
    (B) Effect of treaty reduction of tax. If, at the time of a 
distribution or exchange, a distributee of a U.S. real property interest 
in a distribution or a transferor who receives a U.S. real property 
interest in an exchange would be entitled pursuant to the provisions of 
a U.S. income tax treaty to reduced U.S. taxation upon the disposition 
of the interest, then a portion of the interest received shall be 
treated as an interest subject to U.S. taxation upon its disposition, 
and, therefore, that portion shall be entitled to nonrecognition 
treatment under the rules of this section or Sec.  1.897-6T. The portion 
of the interest that is treated as subject to U.S. taxation is 
determined by multiplying the fair market value of the interest by a 
fraction. The numerator of the fraction is the amount of tax that would 
be due pursuant to the provisions of the applicable U.S. income tax 
treaty upon the recipient's disposition of the interest, determined as 
of the date of the distribution or transfer. The denominator of the 
fraction is the amount of tax that would be due upon such disposition 
but for the provisions of the treaty. However, nonrecognition treatment 
may be preserved in accordance with the provisions of subdivision (C) of 
this paragraph (d)(1)(ii). With regard to the provisions of this 
paragraph, see Article XIII (9) of the United States-Canada Income Tax 
Convention.
    (C) Waiver of treaty benefits to preserve nonrecognition. 
Notwithstanding the provisions of subdivisions (A) and (B) of this 
paragraph (d)(1)(ii), an interest shall be considered to be subject to 
U.S. taxation upon its subsequent disposition if, in accordance with 
paragraph (d)(1)(iii)(F) of this section, the recipient waives the 
benefits of a U.S. income tax treaty that would otherwise entitle the 
recipient to an exemption from (or reduction of) U.S. tax upon a 
disposition of the interest.
    (iii) Procedural requirements. If a U.S. real property interest is 
distributed or transferred after December 31, 1987, the transferor or 
distributor (that is a nonresident alien individual or a foreign 
corporation) shall file an income tax return for the taxable year of the 
distribution or transfer. Also, if a U.S. real property interest is 
distributed or transferred in a transaction before January 1, 1988, with 
respect to which nonrecognition treatment would not have been available 
under the express provisions of section 897 (d) or (e) of the Code but 
is available under the provisions of this section or Sec.  1.897-6T, 
then the person that would otherwise be subject to tax by reason of the 
operation of section 897 must file an income tax return for the taxable 
year of the distribution or transfer. This requirement is satisfied by 
filing a tax return or an amended tax return for the year of the 
distribution or transfer by May 5, 1989, or by the date that the filing 
of the return is otherwise required. The person filing the return must 
attach thereto a document setting forth the following:
    (A) A statement that the distribution or transfer is one to which 
section 897 applies;
    (B) A description of the U.S. real property interest distributed or 
transferred, including its location, its adjusted basis in the hands of 
the distributor or tranferor immediately before the distribution or 
transfer, and the date of the distribution or transfer;
    (C) A description of the U.S. real property interest received in an 
exchange;
    (D) A declaration signed by an officer of the corporation that the 
distributing foreign corporation has substantiated the adjusted basis of 
the shareholder in its stock if the distributing corporation has 
nonrecognition or recognition limitation under paragraph (c) (3) or (4) 
of this section;
    (E) The amount of any gain recognized and tax withheld by any person 
with respect to the distribution or transfer;
    (F) [Reserved]. For further guidance, see Sec.  1.897-
5(d)(1)(iii)(F).
    (G) The treaty and article (if any) under which the distributee or 
transferor would be exempt from U.S. taxation on a sale of the 
distributed U.S. real property interest or the U.S. real property 
interest received in the transfer; and
    (H) A declaration, signed by the distributee or transferor or its 
authorized legal representative, that the distributee or transferor 
shall treat any

[[Page 686]]

subsequent sale, exchange, or other disposition of the U.S. real 
property interest as a disposition that is subject to U.S. taxation, 
notwithstanding the provisions of any U.S. income tax treaty or 
intervening change in circumstances.


A person who has provided or filed a notice described in Sec.  1.1445-
2(d)(2)(iii) or Sec.  1.1445-5(b)(2)(ii) in connection with a 
transaction may satisfy the requirement of this paragraph (d)(1)(iii) by 
attaching to his return a copy of that notice together with any 
information or declaration required by this subdivision not contained in 
that notice.
    (2) Treaty exception to imposition of tax. If gain that would be 
currently recognized pursuant to the provisions of this section or Sec.  
1.897-6T is subject to an exemption from (or reduction of) U.S. tax 
pursuant to a U.S. income tax treaty, then gain shall be recognized only 
as provided by that treaty, for dispositions occurring before January 1, 
1985. For dispositions occurring after December 31, 1984, all gain shall 
be recognized as provided in section 897 and the regulations thereunder, 
except as provided by Articles XIII (9) and XXX (5) of the United 
States-Canada Income Tax Convention or other income tax treaty entered 
into force after June 6, 1988.
    With regard to Article XXX (5) of the Income Tax Treaty with Canada, 
see, Rev. Rul. 85-76, 1985-1 C.B. 409. With regard to basis adjustments 
for certain related person transactions, see, Sec.  1.897-6T(c)(3).
    (3) Withholding. Under sections 1441 and 1442, as modified by the 
provisions of any applicable U.S. income tax treaty, a corporation must 
withhold tax from a dividend distribution to which section 301 applies 
to a shareholder that is a foreign person, if the dividend is considered 
to be from sources inside the United States. For a description of 
dividends that are considered to be from sources inside the United 
States, see section 861(a)(2). Under section 1445, withholding is 
required with respect to certain dispositions and distributions of U.S. 
real property interests.
    (4) Effect on earnings and profits. With respect to adjustments to 
earnings and profits for gain recognized to a distributing corporation 
on a distribution, see section 312 and the regulations thereunder.
    (e) Effective date. Except as otherwise specifically provided in the 
text of these regulations, this section shall be effective for 
transfers, exchanges, distributions and other dispositions occurring 
after June 18, 1980.

[T.D. 8198, 53 FR 16217, May 5, 1988; 53 FR 18022, May 19, 1988; T.D. 
9082, 68 FR 46084, Aug. 5, 2003]



Sec.  1.897-6T  Nonrecognition exchanges applicable to corporations, 
their shareholders, and other taxpayers, and certain transfers of property 
in corporate reorganizations (temporary).

    (a) Nonrecognition exchanges--(1) In general. Except as otherwise 
provided in this section and in Sec.  1.897-5T, for purposes of section 
897(e) any nonrecognition provision shall apply to a transfer by a 
foreign person of a U.S. real property interest on which gain is 
realized only to the extent that the transferred U.S. real property 
interest is exchanged for a U.S. real property interest which, 
immediately following the exchange, would be subject to U.S. taxation 
upon its disposition, and the transferor complies with the filing 
requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T. No loss shall 
be recognized pursuant to section 897(e) or the rules of this section 
unless such loss is otherwise permitted to be recognized. In the case of 
an exchange of a U.S. real property interest for stock in a domestic 
corporation (that is otherwise treated as a U.S. real property 
interest), such stock shall not be considered a U.S. real property 
interest unless the domestic corporation is a U.S. real property holding 
corporation immediately after the exchange. Whether an interest would be 
subject to U.S. taxation in the hands of the transferor upon its 
disposition shall be determined in accordance with the rules of Sec.  
1.897-5T(d)(1).
    (2) Definition of ``nonrecognition'' provision. A ``nonrecognition 
provision'' is any provision of the Code which provides that gain or 
loss shall not be recognized if the requirements of that provision are 
met. Nonrecognition provisions relevant to this section include, but are 
not limited to, sections 332, 351,

[[Page 687]]

354, 355, 361, 721, 731, 1031, 1033, and 1036. For purposes of section 
897(e), sections 121 and 453 are not nonrecognition provisions.
    (3) Consequence of nonapplication of nonrecognition provisions. If a 
nonrecognition provision does not apply to a transaction, then the U.S. 
real property interest transferred shall be considered exchanged 
pursuant to a transaction that is subject to U.S. taxation by reason of 
the operation of section 897. See, however, Sec.  1.897-5T (d)(2) with 
respect to the treaty exceptions to the imposition of tax. If a U.S. 
real property interest is exchanged for an interest the disposition of 
which is only partially subject to taxation under chapter 1 of the Code 
(as modified by the provisions of any applicable U.S. income tax 
treaty), then any nonrecognition provision shall apply only to the 
extent that the interest received in the exchange would be subject to 
taxation under chapter 1 of the Code, as modified. For example, the 
exchange of a U.S. real property interest for an interest in a 
partnership will receive nonrecognition treatment pursuant to section 
721 only to the extent that a disposition of the partnership interest 
will be subject to U.S. taxation by reason of the operation of section 
897(g).
    (4) Section 355 distributions treated as exchanges. If a domestic 
corporation, stock in which is treated as a U.S. real property interest, 
distributes stock in a foreign corporation or stock in a domestic 
corporation that is not a U.S. real property holding corporation to a 
foreign person under section 355(a), then the foreign person shall be 
considered as having exchanged a proportionate part of the stock in the 
domestic corporation that is treated as a U.S. real property interest 
for stock that is not treated as a U.S. real property interest.
    (5) [Reserved]
    (6) Determination of basis. If a nonrecognition provision applies to 
the transfer of a U.S. real property interest pursuant to the provisions 
of this section, then the basis of the property received in the exchange 
shall be determined in accordance with the rules generally applicable 
with respect to such nonrecognition provision. Similarly, the basis of 
the exchanged property in the hands of the transferee shall be 
determined in accordance with the rules that generally apply to such 
transfer.
    (7) Examples. The rules of paragraphs (a)(1) through (6) of this 
section may be illustrated by the following examples. In each instance, 
the filing requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T have 
been satisfied.

    Example 1. (i) A is a citizen and resident of Country F with which 
the U.S. does not have an income tax treaty. A owns Parcel P, a U.S. 
real property interest, with a fair market value of $500,000 and an 
adjusted basis of $300,000. A transfers Parcel P to DC, a newly formed 
U.S. real property holding corporation wholly owned by A, in exchange 
for DC stock.
    (ii) Under paragraph (a)(1) of this section, A has exchanged a U.S. 
real property interest (Parcel P) for another U.S. real property 
interest (DC stock) which is subject to U.S. taxation upon its 
disposition. The nonrecognition provisions of section 351(a) apply to 
A's transfer of Parcel P.
    (iii) Under paragraph (a)(6) of this section, the basis of the DC 
stock received by A is determined in accordance with the rules generally 
applicable to the transfer. A takes a $300,000 adjusted basis in the DC 
stock under the rules of section 358(a)(1).
    Examples 2-3. [Reserved]
    Example 4. (i) B is a citizen and resident of Country F with which 
the U.S. does not have an income tax treaty. B owns stock in DC1, a U.S. 
real property holding corporation. In a reorganization qualifying for 
nonrecognition under section 368(a)(1)(B), B exchanges the DC1 stock 
under section 354(a) for stock in DC2, a U.S. real property holding 
corporation.
    (ii) A does not recognize any gain under paragraph (a)(1) of this 
section on the exchange of the DC1 stock for DC2 stock because there is 
an exchange of a U.S. real property interest (the DC1 stock) for another 
U.S. real property interest (the DC2 stock) which is subject to U.S. 
taxation upon its disposition.
    Example 5. (i) C is a citizen and resident of Country F with which 
the U.S. does not have an income tax treaty. C owns all of the stock of 
DC, a U.S. real property holding corporation. The fair market value of 
the DC stock is 500x, and C has a basis of 100x in the DC stock.
    (ii) In a transaction qualifying as a distribution of stock of a 
controlled corporation under section 355(a), DC distributes to C all of 
the stock of FC, a foreign corporation that has not made a section 
897(i) election. C does not surrender any of the DC stock. The FC stock 
has a fair market value of 200x. After

[[Page 688]]

the distribution, the DC stock has a fair market value of 300x.
    (iii) Under the rules of paragraph (a)(4) of this section, C is 
considered to have exchanged DC stock with a fair market value of 200x 
and an adjusted basis of 40x for FC stock with a fair market value of 
200x. Because the FC stock is not a U.S. real property interest, C must 
recognize gain of 160x under section 897(a) on the distribution. C takes 
a basis of 200x in the FC stock. C's basis in the DC stock is reduced to 
60x pursuant to section 358(c).
    Example. (i) A is an individual citizen and resident of Country F. F 
has an income tax treaty with the United States that exempts gain from 
the sale of stock, but not real property, by a resident of F from U.S. 
taxation. In 1981, A transferred Parcel P, an appreciated U.S. real 
property interest, to DC, a U.S. real property holding corporation, in 
exchange for DC stock. A owned all of the stock of DC.
    (ii) Under the rules of paragraph (a)(1) of this section, A must 
recognize gain on the transfer of Parcel P. Even though there is an 
exchange of a U.S. real property interest for another U.S. real property 
interest, there is gain recognition because the U.S. real property 
interest received (the DC stock) would not have been subject to U.S. 
taxation upon a disposition immediately following the exchange. A may 
not convert a U.S. real property interest that was subject to taxation 
under section 897 into a U.S. real property interest that could be sold 
without taxation under section 897 due to a treaty exemption.
    Example 7. (i) A, a nonresident alien, organized FC1, a Country W 
corporation in September 1980 to invest in U.S. real property. FC1's 
only asset is Parcel P, a U.S. real property interest with a fair market 
value of $500,000 and an adjusted basis of $200,000. The FCI stock has a 
fair market value of $500,000 and A's basis in the FC1 stock is 
$100,000. The United States does not have a treaty with Country W.
    (ii) A, organized FC2, a Country W corporation in July 1987. FC2 
organized DC in August 1987. Pursuant to a plan of reorganization under 
section 368 (a)(1)(C), FC1 transfers Parcel P to DC in exchange for FC2 
voting stock. As a result of the transfer, DC is a U.S. real property 
holding corporation wholly owned by FC2. The FC2 stock used by DC in the 
acquisition had been transferred by FC2 to DC as part of the plan of 
reorganization. FC1 distributes the FC2 stock to A in exchange for A's 
FC1 stock.
    (iii) FC1's exchange of Parcel P for the FC2 stock under section 
361(a) is a disposition of a U.S. real property interest. FC1 must 
recognize gain of $300,000 under section 897(e) and paragraph (a)(1) of 
this section on the exchange because the FC2 stock received in exchange 
for Parcel P is not a U.S. real property interest.
    (iv) Under section 362(b), DC takes a basis of $500,000 in Parcel P. 
FC2 takes a basis of $500,000 in the DC stock. A takes a basis of 
$100,000 in the FC2 stock under section 358(a)(1). Section 897(d) and 
paragraph (c)(1) of Sec.  1.897-5T do not apply to FC1's distribution of 
the FC2 stock because the FC2 stock is not a U.S. real property 
interest.
    Example 8. (i) The facts are the same as in Example 7, except that 
the United States has a treaty with Country W that entitles FC1 and FC2 
to nondiscriminatory treatment as described in Sec.  1.897-3(b)(2). FC1, 
but not FC2, makes a valid section 897(i) election prior to the 
transaction.
    (ii) FC1's transfer of Parcel P to DC in exchange for FC2 stock is 
not subject to section 897(e) and paragraph (a)(1) of this section 
because FC1 made an election under section 897(i). DC takes a basis of 
$200,000 in Parcel P under section 362(b).
    (iii) FC1's distribution of the FC2 stock to A in exchange for the 
FC1 stock is not subject to the section 897(d) and paragraph (c)(1) of 
Sec.  1.897-5T because FC1 made an election under section 897(i).
    (iv) A must recognize gain on the exchange under section 354(a) of 
the FC1 stock for the FC2 stock. A exchanged a U.S. real property 
interest (the FC1 stock) for an interest which is not a U.S. real 
property interest (the FC2 stock). A recognizes gain of $400,000. Under 
section 1012, A takes a $500,000 basis in the FC2 stock.
    Example 9. (i) The facts are the same as in Example 7 except that 
the United States has a treaty with Country W that entitles FC1 and FC2 
to nondiscriminatory treatment as described in Sec.  1.897-3(b)(2). FC2, 
but not FC1, makes a valid section 897(i) election prior to the 
transaction.
    (ii) FC1's exchange of Parcel P for the FC2 stock under section 
361(a) is a disposition of a U.S. real property interest. FC1 does not 
recognize any gain under section 897(e) and paragraph (a)(1) of this 
section because there is an exchange of a U.S. real property interest 
(Parcel P) for another U.S. real property interest (the FC2 stock). DC 
takes a basis of $200,000 in Parcel P under section 362(b). FC2 takes a 
basis of $200,000 in the DC stock.
    (iii) FC1's distribution of the FC2 stock to A in exchange for the 
FC1 stock is subject to section 897(d) and paragraph (c)(1) of Sec.  
1.897-5T. Because A takes a basis of $100,000 in the FC2 stock under 
section 358(a) (which is less than the $200,000 basis of the FC2 stock 
in the hands of FC1), and A would be subject to U.S. taxation under 
section 897(a) on a subsequent disposition of the FC2 stock, FC1 does 
not recognize any gain under paragraph (c)(1) of Sec.  1.897-5T due to 
the statutory exception of paragraph (c)(2)(i) of that section, provided 
that FC1 complies with the filing requirements of paragraph (d)(1)(C) of 
Sec.  1.897-5T.
    (iv) Since, the FC1 stock was not a U.S. real property interest, its 
disposition by A in

[[Page 689]]

the section 354(a) exchange for FC2 stock is not subject to section 
897(e) and paragraph (a)(1) of this section.
    Example 10. (i) The facts are the same as in Example 7, except that 
the United States has a treaty with Country W that entitles FC1 and FC2 
to nondiscriminatory treatment as described in Sec.  1.897-3(b)(2). FC1 
and FC2 made valid section 897(i) elections prior to the transactions.
    (ii) FC1's transfer of Parcel P to DC in exchange for FC2 stock is 
not subject to section 897(e) and paragraph (a)(1) of this section 
because FC1 made an election under section 897(i). DC takes a basis of 
$200,000 in Parcel P under section 362(a). FC2 takes a basis of $200,000 
in the DC stock.
    (iii) FC1's distribution of the FC2 stock to A in exchange for the 
FC1 stock is not subject to section 897(d) and paragraph (c)(1) of Sec.  
1.897-5T because FC1 made an election under section 897(i).
    (iv) A does not recognize any gain on the exchange of the FC1 stock 
for the FC2 stock under section 354(a). Under paragraph (a)(1) of this 
section, there is an exchange of a U.S. real property interest (FC1 
stock) for another U.S. real property interest (FC2 stock). A takes a 
basis of $100,000 in the FC2 stock under section 358(a).

    (8) Treatment of nonqualifying property--(i) In general. If, under 
paragraph (a)(1) of this section, a nonrecognition provision would apply 
to an exchange but for the fact that nonqualifying property (cash or 
property other than U.S. real property interests) is received in 
addition to property (U.S. real property interests) that is permitted to 
be received under paragraph (a)(1) of this section, then the transferor 
shall recognize gain under this section equal to the lesser of--
    (A) The sum of the cash received plus the fair market value of the 
nonqualifying property received, or
    (B) The gain realized with respect to the U.S. real property 
interest transferred. However, no loss shall be recognized pursuant to 
this paragraph (a)(8) unless such loss is otherwise permitted to be 
recognized.
    (ii) Treatment of mixed exchanges. In a mixed exchange where both a 
U.S. real property interest and other property (including cash) is 
transferred in exchange both for property the receipt of which would 
qualify for nonrecognition treatment pursuant to paragraph (a)(1) of 
this section and for other property (including cash) which would not so 
qualify, the transferor will recognize gain in accordance with the rules 
set forth in subdivisions (A) through (C) of this paragraph (a)(8)(ii).
    (A) Allocation of nonqualifying property. The amount of 
nonqualifying property (including cash) considered to be received in 
exchange for U.S. real property interests shall be determined by 
multiplying the fair market value of the nonqualifying property received 
by a fraction (``real property fraction''). The numerator of the 
fraction is the fair market value of the U.S. real property interest 
transferred in the exchange. The denominator of the fraction is the fair 
market value of all property transferred in the exchange.
    (B) Recognition of gain. The amount of gain that must be recognized, 
and that shall be subject to U.S. taxation by reason of the operation of 
section 897, shall be equal to the lesser of:
    (1) The amount determined under subdivision (A) of this paragraph 
(a)(8)(ii), or
    (2) The gain or loss realized with respect to the U.S. real property 
interest exchanged.
    (C) Treatment of other amounts. The treatment of other amounts 
received in a mixed exchange shall be determined as follows:
    (1) The amount of nonqualifying property (including cash) considered 
to be received in exchange for property (including cash) other than U.S. 
real property interests shall be treated in the manner provided in the 
relevant nonrecognition provision. Such amounts shall be determined by 
subtracting the amount determined under subdivision (A) of this 
paragraph (a)(8)(ii) from the total amount of nonqualifying property 
received in the exchange.
    (2) The amount of qualifying property considered to be received in 
exchange for U.S. real property interests shall be treated in the manner 
provided in paragraph (a)(1) of this section. Such amount shall be 
determined by multiplying the total fair market value of qualifying 
property received in the exchange by the real property fraction 
described in subdivision (A) of this paragraph (a)(8)(ii).
    (3) The amount of qualifying property considered to be received in 
exchange for property other than U.S.

[[Page 690]]

real property interests shall be treated in the manner provided in the 
relevant nonrecognition provision. Such amount shall be determined by 
subtracting the amount determined under subdivision (2) of this 
paragraph (a)(8)(ii)(C) from the total fair market value of qualifying 
property received in the exchange.
    (iii) Example. The rules of paragraph (a)(8)(ii) of this section may 
be illustrated by the following example.

    Example. (i) A is an individual citizen and resident of country F. 
Country F does not have an income tax treaty with the United States. A 
is the sole proprietor of a business located in the United States, the 
assets of which consist of a U.S. real property interest with a fair 
market value of $1,000,000 and an adjusted basis of $700,000, and 
equipment used in the business with a fair market value of $500,000 and 
an adjusted basis of $250,000. A decides to incorporate the business, 
and on January 1, 1987, A transfers his assets to domestic corporation 
DC in exchange for 100 percent of the stock of DC, with a fair market 
value of $900,000. In addition, A receives a long term note 
(constituting a security) from DC for $600,000, bearing arm's length 
interest and repayment terms. DC has no assets other than those received 
in the exchange with A. Pursuant to section 897(c)(2) and Sec.  1.897-2, 
DC is a U.S. real property holding corporation. Therefore, the stock of 
DC is a U.S. real property interest. Assume that the note from DC 
constitutes an interest in the corporation solely as a creditor as 
provided by Sec.  1.897-1(d)(4) of the regulation. A complies with the 
filing requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T.
    (ii) Because the note from DC would not be subject to U.S. taxation 
upon its disposition, it is nonqualifying property for purposes of 
determining whether A is entitled to receive nonrecognition treatment 
pursuant to section 351 with respect to his exchange of the U.S. real 
property interest. Thus, A must recognize gain in the manner provided in 
paragraph (a)(8)(ii) of this section. Pursuant to paragraph 
(a)(8)(ii)(A), the amount of nonqualifying property received in exchange 
for the real property interests is determined by multiplying the fair 
market value of such property ($600,000) by the real property fraction. 
The numerator of the fraction is $1,000,000, the fair market value of 
the real property transferred by A. The denominator is $1,500,000, the 
fair market value of all property transferred by A. Thus, A is 
considered to have received $400,000 of the note in exchange for the 
real property ($600,000 x $1,000,000/$1,500,000). Pursuant to paragraph 
(a)(8)(ii)(B), A must recognize the lesser of the amount initially 
determined or the gain realized with respect to the U.S. real property 
interest. Therefore, A must recognize the $300,000 gain realized with 
respect to the real property.
    (iii) Pursuant to paragraph (a)(8)(ii)(C) of this section, A is 
considered to have received $200,000 of the note in exchange for 
equipment ($600,000 [total value of note received] minus $400,000 
[portion of note received in exchange for real property]), $600,000 of 
the stock in exchange for real property ($900,000 [total value of stock 
received] times $1,000,000/1,500,000) [proportion of property exchanged 
consisting of real property]), and $300,000 of the stock in exchange for 
equipment ($900,000 [total value of stock received] minus $600,000 
[portion of stock received in exchange for real property]). All three 
amounts are entitled to nonrecognition treatment pursuant to section 
351.
    (iv) Pursuant to paragraph (a)(2) of this section, A's basis in the 
stock and note received and DC's basis in the U.S. real property 
interest and equipment will be determined in accordance with the 
generally applicable rules. The $400,000 portion of the note received in 
exchange for the real property interest is other property. Pursuant to 
section 358(a)(2), A takes a fair market value ($400,000) basis for that 
portion of the note. Pursuant to section 358(a)(1), A's basis in the 
property received without the recognition of gain (the DC stock and the 
other portion of the note) will be equal to the basis of the property 
transferred ($950,000 [$700,000 basis of U.S. real property interest 
plus $250,000 basis of equipment]), decreased by the fair market value 
of the other property received ($400,000 portion of the note), and 
increased by the amount of gain recognized to A on the transaction 
($300,000). Thus, A's basis in the stock and the nonrecognition portion 
of the note is $850,000 ($950,000-$400,000 + $300,000). Under Sec.  
1.358-2(b)(2) of the regulations, the $850,000 is allocated between the 
stock and the nonrecognition portion of the note in proportion to their 
fair market values. A takes a basis of $697,000 in the DC stock 
($850,000 x 900,000/1,100,000). A takes a basis of $153,000 in the 
nonrecognition portion of the note ($850,000 x 200,000/1,100,000). A's 
basis in the note is $553,000 ($400,000 + $153,000). DC's basis in the 
property received from A will be determined under section 362(a). DC 
takes a basis of $1,000,000 in the real property interest (A's basis of 
$700,000 increased by the $300,000 of gain recognized by A on it). DC 
takes a basis of $250,000 in the equipment (A's basis of $250,000).

    (9) Treaty exception to imposition of tax. If gain that would be 
currently recognized pursuant to the provisions of this section is 
subject to an exemption from, or reduction of, U.S. tax pursuant to a 
U.S. income tax treaty, then

[[Page 691]]

gain shall be recognized only as provided by that treaty for 
dispositions occurring before January 1, 1985. For dispositions 
occurring after December 31, 1984, all gain shall be recognized as 
provided in section 897 and the regulations thereunder, except as 
provided by Articles XII (9) and XXX (5) of the United States-Canada 
Income Tax Convention or other income tax treaty entered into after June 
6, 1988. In regard to Article XXX (5) the Income Tax Treaty with Canada, 
see, Rev. Rul. 85-76, 1985-1 C.B. 409.
    (b) Certain foreign to foreign exchanges--(1) Exceptions to the 
general rule. Notwithstanding the provisions of paragraph (a)(1) of this 
section and pursuant to authority conferred by section 897(e)(2), a 
foreign person shall not recognize gain, in the instances described in 
paragraph (b)(2) of this section, on the transfer of a U.S. real 
property interest to a foreign corporation in exchange for stock in a 
foreign corporation, but only if the transferee's subsequent disposition 
of the transferred U.S. real property interest would be subject to U.S. 
taxation, as determined in accordance with the provisions of Sec.  
1.897-5T(d)(1), if the filing requirements of paragraph (d)(1)(iii) of 
Sec.  1.897-5T have been satisfied, if one of the five conditions set 
forth in paragraph (b)(2) exists, and if one of the following three 
forms of exchange takes place.
    (i) The exchange is made by a foreign corporation pursuant to 
section 361(a) in a reorganization described in section 368(a)(1) (D) or 
(F) and there is an exchange of the transferor corporation stock for the 
transferee corporation stock under section 354(a); or
    (ii) The exchange is made by a foreign corporation pursuant to 
section 361(a) in a reorganization described in section 368(a)(1)(C); 
there is an exchange of the transferor corporation stock for the 
transferee corporation stock (or stock of the transferee corporation's 
parent in the case of a parenthetical C reorganization) under section 
354(a); and the transferor corporation's shareholders own more than 
fifty percent of the voting stock of the transferee corporation (or 
stock of the transferee corporation's parent in the case of a 
parenthetical C reorganization) immediately after the reorganization; or
    (iii) The U.S. real property interest exchanged is stock in a U.S. 
real property holding corporation; the exchange qualifies under section 
351(a) of section 354(a) in a reorganization described in section 
368(a)(1)(B); and immediately after the exchange, all of the outstanding 
stock of the transferee corporation (or stock of the transferee 
corporation's parent in the case of a parenthetical B reorganization) is 
owned in the same proportions by the same nonresident alien individuals 
and foreign corporations that, immediately before the exchange, owned 
the stock of the U.S. real property holding corporation.


If, however, a nonresident alien individual or foreign corporation which 
received stock in an exchange described in subdivision (iii) of this 
paragraph (b)(1) (or the transferee corporation's parent) disposes of 
any of such foreign stock within three years from the date of its 
receipt, then that individual or corporation shall recognize that 
portion of the gain realized with respect to the stock in the U.S. real 
property holding corporation for which foreign stock disposed of was 
received.
    (2) Applicability of exception. The exception to the provisions of 
paragraph (a)(1) provided by paragraph (b)(1) shall apply only if one of 
the following five conditions exists.
    (i) Each of the interests exchanged or received in a transferor 
corporation or transferee corporation would not be a U.S. real property 
interest as defined in Sec.  1.897-1(c)(1) if such corporations were 
domestic corporations; or
    (ii) The transferee corporation (and the transferee corporation's 
parent in the case of a parenthetical B or C reorganization) is 
incorporated in a foreign country that maintains an income tax treaty 
with the United States that contains an information exchange provision; 
the transfer occurs after May 5, 1988; and the transferee corporation 
(and the transferee corporation's parent in the case of a parenthetical 
B or C reorganization) submit a binding waiver of all benefits of the 
respective income tax treaty (including the opportunity to make an 
election under section 897 (i)), which must be attached to

[[Page 692]]

each of the transferor and transferee corporation's income tax returns 
for the year of the transfer; or
    (iii) The transferee foreign corporation (and the transferee 
corporation's parent in the case of a parenthetical B or C 
reorganization) is a qualified resident as defined in section 884(e) and 
any regulations thereunder of the foreign country in which it is 
incorporated; or
    (iv) The transferee foreign corporation (and the transferee 
corporation's parent in the case of a parenthetical B or C 
reorganization) is incorporated in the same foreign country as the 
transferor foreign corporation; and there is an income tax treaty in 
force between that foreign country and the United States at the time of 
the transfer that contains an exchange of information provision; or
    (v) The transferee foreign corporation is incorporated in the same 
foreign country as the transferor foreign corporation; and the transfer 
is incident to a mere change in identity, form, or place of organization 
of one corporation under section 368(a)(1)(F).


For purposes of any election by a transferee foreign corporation (or the 
transferee corporation's parent in the case of a parenthetical C 
reorganization) to be treated as a domestic corporation under section 
897(i) and Sec.  1.897-3 where the exchange was described in 
subdivisions (i) or (ii) of paragraph (b)(1) of this section, any prior 
dispositions of the transferor foreign corporation stock will be subject 
to the requirements of Sec.  1.897-3(d)(2) upon an election under 
section 897(i) by the transferee foreign corporation (or the transferee 
corporation's parent in the case of a parenthetical C reorganization).
    (3) No exceptions. No exception to recognition of gain under 
paragraph (a)(1) of this section is provided for the transfer of a U.S. 
real property interest by a foreign person to a foreign corporation in 
exchange for stock in a foreign corporation other than as provided in 
this paragraph (b). Thus, no exception is provided where--
    (i) Such exchange is made pursuant to section 351 and the U.S. real 
property interest transferred is not stock in a U.S. real property 
holding corporation; or
    (ii) Such exchange is made pursuant to section 361(a) in a 
reorganization described in section 368(a)(1) that does not qualify for 
nonrecognition of gain under this paragraph (b). With regard to the 
treatment of certain foreign corporations as domestic corporations under 
section 897(i), see Sec. Sec.  1.897-3 and 1.897-8T.
    (4) Examples. The rules of paragraph (b)(1) and (2) of this section 
may be illustrated by the following examples. In each instance, the 
filing requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T have been 
satisfied.

    Example 1. (i) FC is a Country F corporation that has not made a 
section 897 (i) election. FC owns Parcel P, a U.S. real property 
interest, with a fair market value of $450x and an adjusted basis of 
100x.
    (ii) FC transfers Parcel P to FS, its wholly owned Country F 
subsidiary, in exchange for FS stock under section 351 (a). FS has not 
made a section 897(i) election. Under the rules of paragraph (a)(1) of 
this section, FC must recognize gain of 350x under section 897 (a) 
because the FS stock received in the exchange is not a U.S. real 
property interest. No exception to the recognition rule of paragraph 
(a)(1) is provided under this paragraph (b) for a transfer under section 
351 (a) of a U.S. real property interest (that is not stock in a U.S. 
real property holding corporation) by a foreign corporation to another 
foreign corporation in exchange for stock to the transferee corporation.
    Example 2. (i) FC is a Country F corporation that has not made a 
section 897(i) election. FC owns several U.S. real property interests 
that have appreciated in value since FC purchased the interests. FP, a 
Country F corporation, owns all of the outstanding stock of FC. Country 
F maintains an income tax treaty with the United States.
    (ii) For valid business purposes, FC transferred substantially all 
of its assets including all of its U.S. real property interests to FS in 
1989 under section 361(a) in a reorganization in exchange for FS stock. 
FS is a newly formed Country F corporation that is owned by FC. The 
transfer qualifies as a reorganization under section 368(a)(1)(D). FC 
immediately distributes the FS stock to FP in exchange for the FC stock 
and FC dissolves. FP has no gain or loss on the exchange of the FC stock 
for the FS stock under section 354(a).
    (iii) Under the rules of paragraph (b)(1)(i) of this section, FC 
does not recognize any gain on the transfer of the U.S. real property

[[Page 693]]

interests to FS under section 361(a) in the reorganization under section 
368(a)(1)(D) because FS would be subject to U.S. taxation on a 
subsequent disposition of the interests, as required by paragraph (b)(1) 
of this section; there is an exchange of stock under section 354(a), as 
required by paragraph (b)(1)(i); and FC and FS are incorporated in 
Country F which maintains an income tax treaty with the United States, 
as required by paragraph (b)(2)(iv).

    (5) Contributions of property. A foreign person that contributes a 
U.S. real property interest to a foreign corporation as paid in surplus 
or as a contribution to capital (including a contribution provided in 
section 304(a)) shall be treated, for purposes of section 897(j) and 
this section, as exchanging the U.S. real property interest for stock in 
the foreign corporation.
    (c) Denial of nonrecognition with respect to certain tax avoidance 
transfers--(1) In general. The provisions of Sec.  1.897-5T and 
paragraphs (a) and (b) of this section are subject to the rules of this 
paragraph (c).
    (2) Certain transfers to domestic corporations--(i) General rule. If 
a foreign person transfers property, that is not a U.S. real property 
interest, to a domestic corporation in a nonrecognition exchange, 
where--
    (A) The adjusted basis of such property transferred exceeded its 
fair market value on the date of the transfer to the domestic 
corporation;
    (B) The property transferred will not immediately be used in, or 
held by the domestic corporation for use in, the conduct of a trade or 
business as defined in Sec.  1.897-1(f); and
    (C) Within two years of the transfer to the domestic corporation, 
the property transferred is sold at a loss;


then, it will be presumed, absent clear and convincing evidence to the 
contrary, that the purpose for transferring the loss property was the 
avoidance of taxation on the disposition of U.S. real property interests 
by the domestic corporation. Any loss recognized by the domestic 
corporation on the sale or exchange of such property shall not be used 
by the domestic corporation, either by direct offset or as part of a net 
operating loss or capital loss carryback or carryover to offset any gain 
recognized from the sale or exchange of a U.S. real property interest by 
the domestic corporation.
    (ii) Example. The rules of paragraph (c)(2)(i) of this section may 
be illustrated by the following example.

    Example. A is an individual citizen and resident of country F, which 
does not have an income tax treaty with the U.S. On January 1, 1987, A 
transfers a U.S. real property interest with a basis of $100,000 and a 
fair market value of $600,000 to domestic corporation DC in exchange for 
all of the stock of DC. On October 20, 1987, A transfers stock of a 
publicly traded domestic corporation with a basis in his hands of 
$900,000 and a fair market value of $500,000, in exchange for additional 
stock of DC. The stock of the publicly traded domestic corporation does 
not constitute an asset used or held for use in DC's trade or business. 
If DC sells the stock of the publicly traded domestic corporation before 
October 20, 1989 and recognizes a loss, the loss may not be used to 
offset any gain recognized on the sale of the U.S. real property 
interests by DC.

    (3) Basis adjustment for certain related person transactions. In the 
case of any disposition after December 31, 1979, of a U.S. real property 
interest to a related person (within the meaning of section 453(f)(1)), 
the basis of the interest in the hands of the person acquiring such 
interest shall be reduced by the amount of any gain which is not subject 
to taxation under section 871(b)(1) or 882(a)(1) because the disposition 
occurred before June 19, 1980 or because of any treaty obligation of the 
United States. If a foreign corporation makes an election under section 
897(i), and the stock of such corporation was transferred between 
related persons after December 31, 1979 and before June 19, 1980, then 
such stock shall be treated as a U.S. real property interest solely for 
purposes of this paragraph (c)(3).
    (4) Rearrangement of ownership to gain treaty benefit. A foreign 
person who directly or indirectly owns a U.S. real property interest may 
not directly or indirectly rearrange the incidents of ownership of the 
U.S. real property interest through the use of nonrecognition provisions 
in order to gain the benefit of a treaty exemption from taxation. Such 
nonrecognition will not apply to the foreign transferor. The transferor 
will recognize gain but not loss on the transfer under section 897(a).

[[Page 694]]

    (d) Effective date. Except as specifically provided otherwise in the 
text of the regulations, paragraphs (a) through (c) shall be effective 
for transfers, exchanges and other dispositions occurring after June 18, 
1980. Paragraph (a)(5)(ii) of this section shall be effective for 
exchanges and elections occurring after June 6, 1988.

[T.D. 8198, 53 FR 16224, May 5, 1988; 53 FR 18022, May 19, 1988; T.D. 
9082, 68 FR 46084, Aug. 5, 2003]



Sec.  1.897-7  Treatment of certain partnership interests, trusts and estates 
under section 897(g).

    (a)-(b) [Reserved]. For further guidance, see Sec.  1.897-7T(a) 
through (b).
    (c) Coordination with section 864(c)(8). Except as provided in Sec.  
1.864(c)(8)-1, the amount of any money, and the fair market value of any 
property, received by a nonresident alien individual or foreign 
corporation in exchange for all or part of its interest in a 
partnership, trust, or estate will, to the extent attributable to United 
States real property interests, be considered as an amount received from 
the sale or exchange in the United States of such property. See also 
Sec.  1.864(c)(8)-1(h) for an anti-stuffing rule that may apply to 
transactions subject to section 897. This paragraph applies to transfers 
occurring on or after December 26, 2018, and to amounts received on or 
after December 26, 2018, pursuant to an installment sale (as defined in 
section 453(b)) occurring on or after November 27, 2017.

[T.D. 9919, 85 FR 70971, Nov. 6, 2020]



Sec.  1.897-7T  Treatment of certain partnership interests as entirely U.S. 
real property interests under sections 897(g) and 1445(e) (temporary).

    (a) Rule. Pursuant to section 897(g), an interest in a partnership 
in which, directly or indirectly, fifty percent or more of the value of 
the gross assets consist of U.S. real property interests, and ninety 
percent or more of the value of the gross assets consist of U.S. real 
property interests plus any cash or cash equivalents shall, for purposes 
of section 1445, be treated as entirely a U.S. real property interest. 
For purposes of section 897(g), such interest shall be treated as a U.S. 
real property interest only to the extent that the gain on the 
disposition is attributable to U.S. real property interests (and not 
cash, cash equivalents or other property). Consequently, a disposition 
of any portion of such partnership interest shall be subject to partial 
taxation under section 897(a) and full withholding under section 
1445(a). For purposes of this paragraph, cash equivalent means any asset 
readily convertible into cash (whether or not denominated in U.S. 
dollars) including, but not limited to, bank accounts, certificates of 
deposit, money market accounts, commercial paper, U.S. and foreign 
treasury obligations and bonds, corporate obligations and bonds, 
precious metals or commodities, and publicly traded instruments.
    (b) Effective date. Section 1.897-7T shall be effective for 
transfers, exchanges, distributions and other dispositions occurring 
after June 6, 1988.
    (c) Coordination with section 864(c)(8). [Reserved]. For further 
guidance, see Sec.  1.897-7(c).

[T.D. 8198, 53 FR 16228, May 5, 1988, as amended by T.D. 9919, 85 FR 
70971, Nov. 6, 2020]



Sec.  1.897-8T  Status as a U.S. real property holding corporation 
as a condition for electing section 897(i) pursuant to Sec.  1.897-3 
(temporary).

    (a) Purpose and scope. This section provides a temporary regulation 
that if and when adopted as a final regulation, will be added to 
paragraph (b) of Sec.  1.897-3. Paragraph (b) of this section would then 
appear as paragraph (b)(4) of Sec.  1.897-3.
    (b) General conditions. The foreign corporation upon making an 
election under section 897(i) (including any retroactive election) must 
qualify as a U.S. real property holding corporation as defined in 
paragraph (b)(1) of Sec.  1.897-2.
    (c) Effective Date. Section 1.897-8T shall be effective as of June 
6, 1988, with respect to foreign corporations making an election under 
section 897(i) after May 5, 1988.

[T.D. 8198, 53 FR 16229, May 5, 1988]

[[Page 695]]



Sec.  1.897-9T  Treatment of certain interest in publicly traded corporations, 
definition of foreign person, and foreign governments and international 
organizations (temporary).

    (a) Purpose and scope. This section provides a temporary regulation 
that, if and when adopted as a final regulation will be added as new 
paragraphs (c)(2)(iii)(B), (k), (n) and (q) of Sec.  1.897-1. Paragraph 
(b) of this section would then appear as paragraph (c)(2)(iii)(B) of 
Sec.  1.897-1. Paragraph (c) of this section would then appear as 
paragraph (k) of Sec.  1.897-1. Paragraph (d) of this section would then 
appear as paragraph (n) of Sec.  1.897-1. Paragraph (e) of this section 
would then appear as paragraph (q) of Sec.  1.897-1.
    (b) Any other interest in the corporation (other than an interest 
solely as a creditor) if on the date such interest was acquired by its 
present holder it had a fair market value greater than the fair market 
value on that date of 5 percent of the regularly traded class of the 
corporation's stock with the lowest fair market value. However, if a 
non-regularly traded class of interests in the corporation is 
convertible into a regularly traded class of interests in the 
corporation, an interest in such non-regularly traded class shall be 
treated as a U.S. real property interest if on the date it was acquired 
by its present holder it had a fair market value greater than the fair 
market value on that date of 5 percent of the regularly traded class of 
the corporation's stock into which it is convertible. If a person holds 
interests in a corporation of a class that is not regularly traded, and 
subsequently acquires additional interests of the same class, then all 
such interests must be aggregated and valued as of the date of the 
subsequent acquisition. If the subsequent acquisition causes that 
person's interests to exceed the applicable limitation, then all such 
interests shall be treated as U.S. real property interests, regardless 
of when acquired. In addition, if a person holds interests in a 
corporation of separate classes that are not regularly traded, and if 
such interests were separately acquired for a principal purpose of 
avoiding the applicable 5 percent limitation of this paragraph, then 
such interests shall be aggregated for purposes of applying that 
limitation. This rule shall not apply to interests of separate classes 
acquired in transactions more than three years apart. For purposes of 
paragraph (c)(2)(iii) of Sec.  1.897-1, section 318(a) shall apply 
(except that section 318(a)(2)(C) and (3)(C) shall each be applied by 
substituting ``5 percent'' for ``50 percent'').
    (c) Foreign person. The term ``foreign person'' means a nonresident 
alien individual (including an individual subject to the provisions of 
section 877), a foreign corporation as defined in paragraph (1) of this 
section, a foreign partnership, a foreign trust or a foreign estate, as 
such persons are defined respectively by Sec.  1.871-2 and by 7701 and 
the regulations thereunder. A resident alien individual, including a 
nonresident alien with respect to whom there is in effect an election 
under section 6013(g) or (h) to be treated as United States resident, is 
not a foreign person. With respect to the status of foreign governments 
and international organizations, see paragraph (e) of this section.
    (d) Regularly traded--(1) General rule--(i) Trading requirements. A 
class of interests that is traded on one or more established securities 
markets is considered to be regularly traded on such market or markets 
for any calendar quarter during which--
    (A) Trades in such class are effected, other than in de minimis 
quantities, on at least 15 days during the calendar quarter;
    (B) The aggregate number of the interests in such class traded is at 
least 7.5 percent or more of the average number of interests in such 
class outstanding during the calendar quarter; and
    (C) The requirements of paragraph (d)(3) of this section are met.
    (ii) Exceptions--(A) in the case of the class of interests which is 
held by 2,500 or more record shareholders, the requirements of paragraph 
(d)(1)(i)(B) of this section shall be applied by substituting ``2.5 
percent'' for ``7.5 percent''.
    (B) If at any time during the calendar quarter 100 or fewer persons 
own 50 percent or more of the outstanding shares of a class of 
interests, such class shall

[[Page 696]]

not be considered to be regularly traded for purposes of sections 897, 
1445 and 6039C. Related persons shall be treated as one person for 
purposes of this paragraph (d)(1)(ii)(B).
    (iii) Anti-abuse rule. Trades between related persons shall be 
disregarded. In addition, a class of interests shall not be treated as 
regularly traded if there is an arrangement or a pattern of trades 
designed to meet the requirements of this paragraph (d)(1). For example, 
trades between two persons that occur several times during the calendar 
quarter may be treated as an arrangement or a pattern of trades designed 
to meet the requirements of this paragraph (d)(1).
    (2) Interests traded on domestic established securities markets. For 
purposes of sections 897, 1445 and 6039C, a class of interests that is 
traded on an established securities market located in the United States 
is considered to be regularly traded for any calendar quarter during 
which it is regularly quoted by brokers or dealers making a market in 
such interests. A broker or dealer makes a market in a class of 
interests only if the broker or dealer holds himself out to buy or sell 
interests in such class at the quoted price. Stock of a corporation that 
is described in section 851(a)(1) and units of a unit investment trust 
registered under the Investment Company Act of 1940 (15 U.S.C. sections 
80a-1 to 80a-2) shall be treated as regularly traded within the meaning 
of this paragraph.
    (3) Reporting requirement for interests traded on foreign securities 
markets. A class of interests in a domestic corporation that is traded 
on one or more established securities markets located outside the United 
States shall not be considered to be regularly traded on such market or 
markets unless such class is traded in registered form, and--
    (i) The corporation registers such class of interests pursuant to 
section 12 of the Securities Exchange Act of 1934, 15 U.S.C. section 78, 
or
    (ii) The corporation attaches to its Federal income tax return a 
statement providing the following:
    (A) A caption which states ``The following information concerning 
certain shareholders of this corporation is provided in accordance with 
the requirements of Sec.  1.897-9T.''
    (B) The name under which the corporation is incorporated, the state 
in which such corporation is incorporated, the principal place of 
business of the corporation, and its employer identification number, if 
any;
    (C) The identity of each person who, at any time during the 
corporation's taxable year, was the beneficial owner of more than 5 
percent of any class of interests of the corporation to which this 
paragraph (d)(3) applies;
    (D) The title, and the total number of shares issued, of any class 
of interests so owned; and
    (E) With respect to each beneficial owner of more than 5 percent of 
any class of interests of the corporation, the number of shares owned, 
the percentage of the class represented thereby, and the nature of the 
beneficial ownership of each class of shares so owned.


Interests in a domestic corporation which has filed a report pursuant to 
this paragraph (d)(3)(ii) shall be considered to be regularly traded on 
an established securities market only for the taxable year of the 
corporation with respect to which such a report is filed.
    (4) Coordination with section 1445. For purposes of section 1445, a 
class of interests in a corporation shall be presumed to be regularly 
traded during a calendar quarter if such interests were regularly traded 
within the meaning of this paragraph during the previous calendar 
quarter.
    (e) Foreign governments and international organizations. A foreign 
government shall be treated as a foreign person with respect to U.S. 
real property interests, and shall be subject to sections 897, 1445, and 
6039C on the disposition of a U.S. real property interest except to the 
extent specifically otherwise provided in the regulations issued under 
section 892. An international organization (as defined in section 
7701(a)(18)) is not a foreign person with respect to U.S. real property 
interests, and is not subject to sections 897, 1445, and 6039C on the 
disposition of a U.S. real property interest. Buildings or parts of 
buildings and the land ancillary thereto (including the residence of the 
head of the diplomatic mission)

[[Page 697]]

used by the foreign government for a diplomatic mission shall not be a 
U.S. real property interest in the hands of the respective foreign 
government.
    (f) Effective date. Section 1.897-9T with the exception of paragraph 
(e) shall be effective for transfers, exchanges, distributions and other 
dispositions occurring on or after June 6, 1988. Paragraph (e) of this 
section shall be effective for transfers, exchanges, distributions and 
other dispositions occurring on or after July 1, 1986.

[T.D. 8198, 53 FR 16229, May 5, 1988]



Sec.  1.897(l)-1  Exception for interests held by foreign pension funds.

    (a) Scope and overview. This section provides rules regarding the 
exception from section 897 for qualified holders. The definitions and 
requirements in this section apply only for purposes of this section 
(including as applicable by cross-reference from other sections), and no 
inference is to be drawn with respect to the definitions and 
requirements in this section, including with respect to the meaning of a 
pension fund, for any other purpose. Paragraph (b) of this section 
provides the general rule excepting qualified holders from section 897. 
Paragraph (c) of this section provides the requirements that an eligible 
fund must satisfy to be treated as a qualified foreign pension fund. 
Paragraph (d) of this section provides the requirements that a qualified 
foreign pension fund or a qualified controlled entity must satisfy to be 
treated as a qualified holder. Paragraph (e) of this section provides 
definitions. Paragraph (f) of this section provides examples 
illustrating the application of the rules of this section. Paragraph (g) 
of this section provides applicability dates. For rules applicable to a 
qualified foreign pension fund or qualified controlled entity claiming 
an exemption from withholding under chapter 3, see generally Sec. Sec.  
1.1441-3, 1.1445-2, 1.1445-5, 1.1445-8, 1.1446-1, and 1.1446-2.
    (b) Exception from section 897--(1) In general. Gain or loss of a 
qualified holder from the disposition of a United States real property 
interest, including gain from a distribution described in section 
897(h), is not subject to section 897(a).
    (2) Limitation. Paragraph (b)(1) of this section applies solely with 
respect to gain or loss that is attributable to one or more qualified 
segregated accounts maintained by a qualified holder.
    (c) Qualified foreign pension fund requirements--(1) In general. An 
eligible fund is a qualified foreign pension fund if it satisfies the 
requirements of this paragraph (c). Paragraph (c)(2) of this section 
provides rules regarding the application of the requirements of section 
897(l)(2) to an eligible fund. Paragraph (c)(3) of this section provides 
rules on the application of the requirements in paragraph (c)(2) of this 
section, including rules regarding the application of those requirements 
to an eligible fund that is an organization or arrangement and rules 
regarding recordkeeping.
    (2) Applicable requirements--(i) Created or organized. An eligible 
fund must be created, organized, or established under the laws of a 
foreign jurisdiction. For purposes of this paragraph (c)(2)(i), a 
governmental unit is treated as created or organized in the foreign 
jurisdiction with respect to which it is, or is a part of, the foreign 
government.
    (ii) Establishment of eligible fund--(A) General requirement--(1) 
Purpose of and parties establishing eligible fund. An eligible fund must 
be established--
    (i) By, or at the direction of, the foreign jurisdiction in which it 
is created or organized to provide retirement and pension benefits to 
participants or beneficiaries that are current or former employees or 
persons designated by such employees as a result of services rendered by 
such employees to their employers; or
    (ii) By one or more employers (including a governmental unit in its 
capacity as an employer) to provide retirement and pension benefits to 
participants or beneficiaries that are current or former employees or 
persons designated by such employees in consideration for services 
rendered by such employees to such employers.
    (2) Identification of type of eligible fund. An eligible fund that 
is described in both paragraphs (c)(2)(ii)(A)(1)(i) and (ii) of this 
section shall be treated solely as described in the latter paragraph.

[[Page 698]]

    (3) Role of parties other than the foreign jurisdiction or employer. 
For purposes of paragraph (c)(2)(ii)(A)(1) of this section, the 
determination of whether an eligible fund is established by, or at the 
direction of, a foreign jurisdiction or established by an employer is 
made without regard to whether one or more persons that are not the 
foreign jurisdiction or employer administer or otherwise provide 
services with regard to the eligible fund (including holding assets in a 
qualified segregated account as part of or on behalf of the eligible 
fund).
    (B) Established to provide retirement or pension benefits. An 
eligible fund is established to provide retirement or pension benefits 
for purposes of the general requirement in paragraph (c)(2)(ii)(A) of 
this section if--
    (1) All of the benefits that an eligible fund provides are qualified 
benefits provided to qualified recipients;
    (2) At least 85 percent of the present value of the qualified 
benefits that the eligible fund reasonably expects to provide to 
qualified recipients in the future are retirement and pension benefits; 
and
    (3) No more than five percent of the present value of the qualified 
benefits the eligible fund reasonably expects to provide to qualified 
recipients in the future are non-ancillary benefits.
    (C) Present valuation--(1) In general. For purposes of satisfying 
the requirements in paragraphs (c)(2)(ii)(B)(2) and (3) of this section, 
an eligible fund must determine, on at least an annual basis, the 
present value of the qualified benefits that the eligible fund 
reasonably expects to provide to qualified recipients during the entire 
period during which the eligible fund is expected to be in existence. An 
eligible fund may utilize any reasonable method for performing the 
present valuation.
    (2) 48-month average alternative calculation. An eligible fund that 
does not satisfy the requirements of paragraph (c)(2)(ii)(B)(2) or (3) 
of this section based on the present value determination under paragraph 
(c)(2)(ii)(C)(1) of this section may satisfy the requirements of 
paragraph (c)(2)(ii)(B)(2) or (3) of this section based on the 
alternative calculation in this paragraph (c)(2)(ii)(C)(2). The 
alternative calculation in this paragraph is satisfied if the average of 
the present values of the future qualified benefits that the eligible 
fund reasonably expected to provide, as determined during the 48-month 
period preceding (and including) the most recent present valuation 
determination, satisfies the requirements of paragraph (c)(2)(ii)(B)(2) 
or (3) of this section, respectively. The determination of such average 
must be based on the valuations described in paragraph (c)(2)(ii)(C)(1) 
of this section that were carried out during the 48-month period 
preceding (and including) the most recent present value determination, 
and must use the values (not percentages) of the qualified benefits the 
eligible fund reasonably expected to provide. The determination 
described in this paragraph must be calculated using a weighted average 
whereby values are adjusted if the relevant valuations are applicable 
for different periods (as described in paragraph (c)(2)(ii)(C)(3) of 
this section) because an eligible fund performs valulations more 
frequently than on an annual basis. If an eligible fund has been in 
existence for less than 48 months, this paragraph (c)(2)(ii)(C)(2) is 
applied to the period that the eligible fund has been in existence. The 
alternative calculation in this paragraph (c)(2)(ii)(C)(2) may be 
satisfied based on any reasonable determination of the present valuation 
described in paragraph (c)(2)(ii)(C)(1) of this section for any period 
that starts before the date that the requirements of paragraph 
(c)(2)(ii)(C) of this section first apply to an organization or 
arrangement and ends on or before December 29, 2022.
    (3) Application of present valuation. An eligible fund must use the 
present value determination made as of the most recent valuation under 
paragraph (c)(2)(ii)(C)(1) of this section or the alternative 
calculation provided in paragraph (c)(2)(ii)(C)(2) of this section (to 
the extent the eligible fund did not satisfy the requirements of 
paragraphs (c)(2)(ii)(B)(2) and (3) of this section in the most recent 
valuation) for purposes of meeting the requirements in paragraphs 
(c)(2)(ii)(B)(2) and (3) of this section with respect to dispositions of 
United States real property interests or distributions described in 
section

[[Page 699]]

897(h) occurring in the twelve months succeeding the most recent 
valuation, or until a new present value determination is made, whichever 
occurs first.
    (D) Certain distributions from eligible funds. The following 
distributions are not taken into account for purposes of determining 
whether an eligible fund satisfies the requirements of paragraph 
(c)(2)(ii)(B) of this section--
    (1) A loan to a qualified recipient pursuant to terms set by the 
eligible fund (other than a loan with respect to which a qualified 
recipient defaults and is not required to repay in whole or part, unless 
the default is subject to tax and penalty in such foreign jurisdiction);
    (2) A distribution (as permitted by the laws of the foreign 
jurisdiction in which the eligible fund is established or operates) made 
before the participant or beneficiary reaches the retirement age (as 
determined under the relevant foreign laws), provided that the 
distribution is to a designee that is a qualified holder or to another 
arrangement subject to similar distribution or tax rules under the laws 
of the foreign jurisdiction; and
    (3) A withdrawal of funds before the participant or beneficiary 
reaches the retirement age (as determined under the relevant foreign 
laws) to satisfy a financial need (under principles similar to the U.S. 
hardship distribution rules, see Sec.  1.401(k)-1(d)(3)) as permitted 
under the laws of the foreign jurisdiction in which the eligible fund is 
established or operates, provided the distribution (or at least the 
portion of the distribution exceeding basis) is subject to tax and 
penalty in such foreign jurisdiction.
    (E) Certain employers and employees. For purposes of this section, 
the following rules apply--
    (1) A self-employed individual is treated as both an employer and an 
employee;
    (2) Employees of an individual, trust, corporation, or partnership 
that is a member of an employer group are treated as employees of each 
member of the employer group that includes the individual, trust, 
corporation, or partnership; and
    (3) An eligible fund established by a trade union, professional 
association, or similar group, either alone or in combination with the 
employer or group of employers, is treated as established by any 
employer that funds, in whole or in part, the eligible fund.
    (iii) Single participant or beneficiary--(A) In general. An eligible 
fund may not have a single qualified recipient that has a right to more 
than five percent of the assets or income of the eligible fund.
    (B) Constructive ownership. For purposes of paragraph (c)(2)(iii)(A) 
of this section, an individual is considered to have a right to the 
assets or income of an eligible fund to which any person who bears a 
relationship to the individual described in section 267(b) or 707(b) has 
a right.
    (iv) Regulation and information reporting--(A) In general. The 
eligible fund must be subject to government regulation and annually 
provide to the relevant tax authorities (or other relevant governmental 
units) in the foreign jurisdiction in which the eligible fund is 
established or operates information about the amount of qualified 
benefits (if any) provided to each qualified recipient by the eligible 
fund, or such information must otherwise be available to the relevant 
tax authorities (or other relevant governmental units). An eligible fund 
is not treated as failing to satisfy the requirement of this paragraph 
(c)(2)(iv)(A) as a result of the eligible fund not being required to 
provide information to the relevant tax authorities (or other relevant 
governmental units) in a year in which no qualified benefits are 
provided to qualified recipients.
    (B) Treatment of certain eligible funds established by foreign 
jurisdictions. An eligible fund that is described in paragraph 
(c)(2)(ii)(A)(1)(i) of this section is deemed to satisfy the 
requirements of paragraph (c)(2)(iv)(A) of this section.
    (v) Tax treatment--(A) In general. The tax laws of the foreign 
jurisdiction in which the eligible fund is established or operates must 
provide that, due to the status of the eligible fund as a retirement or 
pension fund, either--
    (1) Contributions to the eligible fund that would otherwise be 
subject to tax

[[Page 700]]

under such laws are deductible or excluded from the gross income of the 
eligible fund or taxed at a reduced rate; or
    (2) Taxation of any investment income of the eligible fund is 
deferred or excluded from the gross income of the eligible fund or such 
income is taxed at a reduced rate.
    (B) Income subject to preferential tax treatment. An eligible fund 
is treated as satisfying the requirement of paragraph (c)(2)(v)(A) of 
this section in a taxable year if, under the tax laws of the foreign 
jurisdiction in which the eligible fund is established or operates--
    (1) At least 85 percent of the contributions to the eligible fund 
are subject to the tax treatment described in paragraph (c)(2)(v)(A)(1) 
of this section, or
    (2) At least 85 percent of the investment income of the eligible 
fund is subject to the tax treatment described in paragraph 
(c)(2)(v)(A)(2) of this section.
    (C) Income not subject to tax. An eligible fund is treated as 
satisfying the requirement of paragraph (c)(2)(v)(A) of this section if 
the eligible fund is exempt from the income tax of the foreign 
jurisdiction in which it is established or operates or the foreign 
jurisdiction in which it is established or operates has no income tax.
    (D) Other preferential tax regimes. An eligible fund that does not 
receive the tax treatment described in either paragraph (c)(2)(v)(A)(1) 
or (2) of this section is nonetheless treated as satisfying the 
requirement of paragraph (c)(2)(v)(A) of this section if the eligible 
fund establishes that each of the conditions described in paragraphs 
(c)(2)(v)(D)(1) and (2) of this section is satisfied:
    (1) Under the tax laws of the foreign jurisdiction in which the 
eligible fund is established or operates, the eligible fund is subject 
to a preferential tax regime due to its status as a retirement or 
pension fund; and
    (2) The preferential tax regime described in paragraph 
(c)(2)(v)(D)(1) of this section has a substantially similar effect as 
the tax treatment described in paragraphs (c)(2)(v)(A)(1) or (2) of this 
section.
    (E) Tax law of subnational jurisdictions. Solely for purposes of 
this paragraph (c)(2)(v), a reference to the tax law of a foreign 
jurisdiction includes the tax law of a political subdivision or other 
local authority of a foreign jurisdiction, provided that income taxes 
imposed under the subnational tax law are treated as covered taxes under 
an income tax treaty between that foreign jurisdiction and the United 
States.
    (3) Operating rules--(i) Rules on the application of the 
requirements in paragraph (c)(2) of this section--(A) Organizations or 
arrangements. An organization or arrangement is treated as a single 
entity for purposes of determining whether the requirements of paragraph 
(c)(2) of this section are satisfied, except that each person or 
governmental unit that is part of or party to an organization or 
arrangement must satisfy the requirement of paragraph (c)(2)(i) of this 
section.
    (B) Relevant income, assets, and functions. The determination of 
whether an eligible fund satisfies the requirements of paragraph (c)(2) 
of this section is made solely with respect to the assets and income of 
the eligible fund held in one or more qualified segregated accounts, the 
qualified benefits funded by the qualified segregated accounts, the 
information reporting and regulation related to the qualified segregated 
accounts, and the qualified recipients whose benefits are funded by the 
qualified segregated accounts. For this purpose, all assets held by an 
eligible fund in qualified segregated accounts (within the meaning of 
paragraph (e)(13)(ii) of this section) are treated as a single qualified 
segregated account.
    (ii) Aggregate approach to partnerships. For purposes of this 
section, assets held by a partnership shall be treated as held 
proportionately by its partners, and activities conducted by a 
partnership shall be treated as conducted by its partners.
    (iii) Recordkeeping. An eligible fund that claims the exemption 
under section 897(l) must have records sufficient to establish that it 
satisfies the requirements of paragraph (c)(2) of this section. See 
section 6001 and Sec.  1.6001-1, requiring records to be maintained.
    (d) Qualified holder requirements--(1) In general. With respect to a 
disposition

[[Page 701]]

described in section 897(a) or a distribution described in section 
897(h), a qualified foreign pension fund (including a part of a 
qualified foreign pension fund) or a qualified controlled entity is a 
qualified holder only if it satisfies the requirement of paragraph 
(d)(2) or (3) of this section.
    (2) Qualified holders that did not hold U.S. real property 
interests. The requirement of this paragraph (d)(2) is satisfied if the 
qualified foreign pension fund or qualified controlled entity owned no 
United States real property interests as of the earliest date during an 
uninterrupted period, ending on the date of the disposition or 
distribution, in which the qualified foreign pension fund or qualified 
controlled entity satisfied the requirements of paragraph (c)(2) of this 
section or paragraph (e)(9) of this section, as applicable.
    (3) Qualified holders that satisfy the testing period--(i) In 
general. The requirement of this paragraph (d)(3) is satisfied if the 
qualified foreign pension fund or qualified controlled entity 
continuously satisfies the requirements of paragraph (c)(2) of this 
section or paragraph (e)(9) of this section, as applicable, for the 
duration of the testing period.
    (ii) Testing Period. The term testing period means whichever of the 
following periods is the shortest:
    (A) The period beginning on December 18, 2015, and ending on the 
date of the disposition or the distribution;
    (B) The ten-year period ending on the date of the disposition or the 
distribution; and,
    (C) The period beginning on the date the entity (or its predecessor) 
was created or organized and ending on the date of the disposition or 
the distribution.
    (4) Transition Rules--(i) Qualified foreign pension fund or 
qualified controlled entity requirements. With respect to any period 
from December 18, 2015, to the date when the requirements of paragraph 
(c)(2) or (e)(9) of this section first apply to a qualified foreign 
pension fund or qualified controlled entity under paragraph (g) of this 
section, as applicable (but in any event no later than December 29, 
2022, in the case of paragraph (c)(2) of this section, and no later than 
June 6, 2019, in the case of paragraph (e)(9) of this section), the 
qualified foreign pension fund or qualified controlled entity is deemed 
to satisfy the requirements of paragraphs (c)(2) and (e)(9) of this 
section, as applicable, for purposes of paragraphs (d)(2) and (3) of 
this section if the qualified foreign pension fund or qualified 
controlled entity satisfies the requirements of section 897(l)(2) based 
on a reasonable interpretation of those requirements (including 
determining any applicable valuations using a consistent method).
    (ii) Ownership of qualified controlled entity by service providers. 
Solely for purposes of paragraphs (d)(2) and (3) of this section, the 
determination of whether a corporation or trust is a qualified 
controlled entity will not include stock or interests held directly or 
indirectly by any person that provides services to such corporation or 
trust, provided that such stock or interests are, in the aggregate, no 
more than five percent (by vote or value) of the stock or interests of 
such corporation or trust. This paragraph (d)(4)(ii) applies to 
interests held from December 18, 2015 until February 27, 2023.
    (e) Definitions. The following definitions apply for purposes of 
this section.
    (1) Ancillary benefits--(i) In general. The term ancillary benefits 
means--
    (A) Benefits payable upon the diagnosis of a terminal illness, 
incidental death benefits (for example, funeral expenses), short-term 
disability benefits, life insurance benefits, and medical benefits;
    (B) Unemployment, shutdown, or layoff benefits that do not continue 
past retirement age and do not affect the payment of accrued retirement 
and pension benefits; and
    (C) Other health-related or unemployment benefits that are similar 
to the benefits described in paragraphs (e)(1)(i) and (ii) of this 
section.
    (ii) Overlap with retirement and pension benefits. Ancillary 
benefits do not include any benefits that could also be defined as 
retirement and pension benefits within the meaning of paragraph (e)(14) 
of this section.
    (2) Eligible fund. The term eligible fund means a trust, 
corporation, or other organization or arrangement

[[Page 702]]

that maintains one or more qualified segregated accounts.
    (3) Employer group. The term employer group means all individuals, 
trusts, partnerships, and corporations with a relationship to each other 
specified in section 267(b) or section 707(b).
    (4) Foreign jurisdiction. The term foreign jurisdiction means a 
jurisdiction other than the United States, including a country, a state, 
province, or political subdivision of a foreign country, and a territory 
of the United States.
    (5) Governmental unit. The term governmental unit means any foreign 
government or part thereof, including any person, body, group of 
persons, organization, agency, bureau, fund, or instrumentality, however 
designated, of a foreign government.
    (6) Non-ancillary benefits. The term non-ancillary benefits means 
benefits that are neither ancillary benefits (within the meaning of 
paragraph (e)(1) of this section) nor retirement and pension benefits 
(within the meaning of paragraph (e)(14) of this section), and are 
provided by the eligible fund as permitted or required under the laws of 
the foreign jurisdiction in which the eligible fund is established or 
operates.
    (7) Organization or arrangement. The term organization or 
arrangement means one or more trusts, corporations, governmental units, 
or employers.
    (8) Qualified benefits. The term qualified benefits means retirement 
and pension benefits, ancillary benefits and non-ancillary benefits. 
However, the portions of qualified benefits consisting of ancillary 
benefits and non-ancillary benefits provided by a qualified foreign 
pension fund are limited as provided in paragraph (c)(2)(ii)(B) of this 
section.
    (9) Qualified controlled entity. The term qualified controlled 
entity means a trust or corporation created or organized under the laws 
of a foreign jurisdiction all of the interests of which are held by one 
or more qualified foreign pension funds directly or indirectly through 
one or more qualified controlled entities.
    (10) Qualified foreign pension fund. The term qualified foreign 
pension fund means an eligible fund that satisfies the requirements of 
paragraph (c) of this section.
    (11) Qualified holder. The term qualified holder means a qualified 
foreign pension fund or qualified controlled entity that satisfies the 
requirements of paragraph (d) of this section.
    (12) Qualified recipient--(i) In general. The term qualified 
recipient means--
    (A) With respect to an eligible fund described in paragraph 
(c)(2)(ii)(A)(1)(i) of this section, any person eligible to be treated 
as a participant or beneficiary of such eligible fund and any person 
designated by such participant or beneficiary to receive qualified 
benefits, and
    (B) With respect to an eligible fund described in paragraph 
(c)(2)(ii)(A)(1)(ii) of this section, a current or former employee, a 
spouse of a current or former employee, and any person designated by 
such participants or beneficiaries to receive qualified benefits.
    (C) To the extent not already described in paragraph (e)(12)(i)(B) 
of this section, with respect to an eligible fund described in paragraph 
(c)(2)(ii)(A)(1)(ii) of this section, any person eligible to be treated 
as a participant or beneficiary of such fund and any person designated 
by such participant or beneficiary to receive qualified benefits, so 
long as such recipients do not exceed five percent of the eligible 
fund's total qualified recipients or have a right to more than five 
percent of the assets or income of the eligible fund. An eligible fund 
must make a determination for purposes of this paragraph (e)(12)(i)(C) 
on at least an annual basis and may utilize any reasonable method in 
doing so. An eligible fund must use its most recent determination under 
this paragraph with respect to dispositions of United States real 
property interests or distributions described in section 897(h) 
occurring in the twelve months succeeding such determination, or until a 
new determination is made, whichever occurs first.
    (ii) Special rule regarding automatic designation. For purposes of 
paragraph (e)(12)(i) of this section, a person is treated as designating 
another person to receive qualified benefits if the other person is, by 
reason of such person's relationship or other status with respect to the 
first person, entitled to receive benefits pursuant to the terms

[[Page 703]]

applicable to the eligible fund or pursuant to the laws of the foreign 
jurisdiction in which the eligible fund is created or organized, whether 
or not the first person expressly designated such person as a 
beneficiary.
    (13) Qualified segregated account--(i) In general. The term 
qualified segregated account means an identifiable pool of assets 
maintained by an eligible fund or a qualified controlled entity for the 
sole purpose of funding and providing qualified benefits to qualified 
recipients.
    (ii) Assets held by eligible funds. For purposes of paragraph 
(e)(13)(i) of this section, an identifiable pool of assets of an 
eligible fund is treated as maintained for the sole purpose of funding 
qualified benefits to qualified recipients, and hence as a qualified 
segregated account, only if the terms applicable to the eligible fund or 
the laws of the foreign jurisdiction in which the eligible fund is 
established or operates require that all the assets in the pool, and all 
the income earned with respect to such assets, be used exclusively to 
fund the provision of qualified benefits to qualified recipients or to 
satisfy necessary reasonable expenses of the eligible fund, and that 
such assets or income may not inure to the benefit of a person other 
than a qualified recipient. For purposes of this paragraph (e)(13)(ii), 
the fact that assets or income may inure to the benefit of a 
governmental unit by operation of escheat or similar laws, or may revert 
(such as upon plan termination or dissolution (after all obligations to 
qualified recipients and creditors have been satisfied) or the qualified 
recipients' benefits failing to vest) to the governmental unit or 
employer in accordance with applicable foreign law is ignored, so long 
as contributions to the plan are not more than reasonably necessary to 
fund the qualified benefits to be provided to qualified recipients.
    (iii) Assets held by qualified controlled entities. For purposes of 
paragraph (e)(13)(i) of this section, the assets of a qualified 
controlled entity are treated as an identifiable pool of assets 
maintained for the sole purpose of funding qualified benefits to 
qualified recipients only if both of the following requirements are 
satisfied:
    (A) All of the net earnings of the qualified controlled entity are 
credited to its own account or to the qualified segregated account of a 
qualified foreign pension fund or another qualified controlled entity, 
with no portion of the net earnings of the qualified controlled entity 
inuring to the benefit of a person other than a qualified recipient; and
    (B) Upon dissolution, all of the assets of the qualified controlled 
entity, after satisfaction of liabilities to persons having interests in 
the entity solely as creditors, vest in a qualified segregated account 
of a qualified foreign pension fund or another qualified controlled 
entity.
    (14) Retirement and pension benefits. The term retirement and 
pension benefits means distributions to qualified recipients that are 
made after the qualified recipient reaches retirement age as determined 
under or in accordance with the laws in the foreign jurisdiction in 
which the eligible fund is established or operates (including a benefit 
paid to a qualified recipient who retires on or after a stated early 
retirement age), or after a specified event that results in a qualified 
recipient being permanently unable to work, and includes any such 
distribution made to a surviving beneficiary of the qualifying 
recipient. Retirement and pension benefits may be based on one or more 
of the following factors: contributions, investment performance, years 
of service with an employer, or compensation received by the qualified 
recipient.
    (f) Examples. This paragraph (f) provides examples that illustrate 
the rules of this section. The examples do not illustrate the 
application of the applicable withholding rules, including sections 1445 
and 1446 and the regulations thereunder. It is assumed that no person is 
entitled to more than five percent of any eligible fund's assets or 
income, taking into account the constructive ownership rules in 
paragraph (c)(2)(iii)(B) of this section, and that the eligible fund 
owns no United States real property interests other than as described.
    (1) Example 1: No legal entity--(i) Facts. On January 1, 2023, 
Country A establishes Retirement Plan for the sole purpose of providing 
retirement and

[[Page 704]]

pension benefits to citizens of Country A aged 65 or older. Retirement 
Plan is composed of Asset Pool and Agency. Asset Pool is a group of 
accounts maintained on the balance sheet of the government of Country A. 
Pursuant to the laws of Country A, income and gain earned by Asset Pool 
is used solely to support the provision of retirement and pension 
benefits by Retirement Plan. Agency is a Country A agency that 
administers the provision of benefits by Retirement Plan and manages 
Asset Pool's investments. Under the laws of Country A, investment income 
earned by Retirement Plan is not subject to Country A's income tax. At 
the end of each calendar year, Retirement Plan performs a present 
valuation of the retirement and pension benefits it reasonably expects 
to provide in the future, and all of the benefits that Retirement Plan 
reasonably expects to provide are retirement and pension benefits. On 
January 1, 2024, Agency purchases Property, which is an interest in real 
property located in the United States owned by Asset Pool. On June 1, 
2026, Agency sells Property, realizing $100x of gain with respect to 
Property that would be subject to tax under section 897(a) unless 
paragraph (b) of this section applies with respect to the gain.
    (ii) Analysis. (A) Retirement Plan, which is composed of Asset Pool 
and Agency, includes one or more governmental units described in 
paragraph (e)(5) of this section. Accordingly, Retirement Plan is an 
organization or arrangement described in paragraph (e)(7) of this 
section. Furthermore, Retirement Plan maintains a qualified segregated 
account in the form of Asset Pool, an identifiable pool of assets 
maintained for the sole purpose of funding retirement and pension 
benefits to beneficiaries of the Retirement Fund (qualified recipients 
as defined in paragraph (e)(12)(i)(A) of this section). Therefore, 
Retirement Plan is an eligible fund within the meaning of paragraph 
(e)(2) of this section.
    (B) Paragraph (c)(3)(i) of this section applies for purposes of 
determining whether Retirement Plan is an eligible fund that satisfies 
the requirements of paragraph (c)(2) of this section and would therefore 
be treated as a qualified foreign pension fund. Accordingly, the 
activities of Asset Pool and Agency are integrated and treated as 
undertaken by a single entity to determine whether the requirements of 
paragraph (c)(2) of this section are met. However, Asset Pool and Agency 
must independently satisfy the requirement of paragraph (c)(2)(i) of 
this section.
    (C) Retirement Plan is composed of Asset Pool and Agency, each of 
which is a governmental unit and treated as created or organized under 
the laws of Country A for purposes of paragraph (c)(2)(i) of this 
section. Accordingly, Retirement Plan satisfies the requirement of 
paragraph (c)(2)(i) of this section.
    (D) Retirement Plan is established by Country A as an eligible fund 
described in paragraph (c)(2)(ii)(A)(1)(i) of this section to provide 
retirement and pension benefits, which are qualified benefits described 
in paragraph (e)(8) of this section, to citizens of Country A, who are 
qualified recipients described in paragraph (e)(12)(i)(A) of this 
section because they are eligible to be participants or beneficiaries of 
Retirement Plan. Accordingly, all of the benefits that Retirement Plan 
provides are qualified benefits provided to qualified recipients. In 
addition, Retirement Plan satisfies the requirements of the present 
valuation test as described in paragraphs (c)(2)(ii)(B) and (C) of this 
section. Accordingly, Retirement Plan satisfies the requirement of 
paragraph (c)(2)(ii) of this section.
    (E) Retirement Plan provides retirement and pension benefits to 
citizens of Country A aged 65 or older, with no citizen entitled to more 
than five percent of Retirement Fund's assets or to more than five 
percent of the income of the eligible fund. Accordingly, Retirement Plan 
satisfies the requirement of paragraph (c)(2)(iii) of this section.
    (F) Retirement Plan is composed solely of governmental units within 
the meaning of paragraph (e)(5) of this section. Accordingly, under 
paragraph (c)(2)(iv)(B) of this section, Retirement Plan is treated as 
satisfying the requirements of paragraph (c)(2)(iv)(A) of this section.
    (G) Investment income earned by Retirement Plan is not subject to 
income

[[Page 705]]

tax in Country A. Accordingly, Retirement Plan satisfies the requirement 
of paragraph (c)(2)(v) of this section.
    (H) Because Retirement Plan satisfies the requirements of paragraph 
(c)(2) of this section, Retirement Plan is a qualified foreign pension 
fund. Because Retirement Plan held no United States real property 
interests as of January 1, 2023, the earliest date during an 
uninterrupted period ending on June 1, 2026, the date of the 
disposition, in which it satisfied the requirements of paragraph (c)(2) 
of this section, Retirement Plan is a qualified holder under paragraph 
(d)(2) of this section. Retirement Plan's gain with respect to Property 
is attributable solely to Asset Pool, a qualified segregated account 
maintained by Retirement Plan. Accordingly, under paragraph (b) of this 
section, the $100x gain realized by Retirement Plan attributable to the 
disposition of Property is not subject to section 897(a).
    (2) Example 2: Fund established by an employer--(i) Facts. Employer, 
a corporation organized in Country B, establishes Fund to provide 
retirement and pension benefits to current and former employees of 
Employer and S1, a Country B corporation that is wholly owned by 
Employer. On January 1, 2023, Fund is established as a trust under the 
laws of Country B, and Employer retains discretion to invest assets and 
to administer benefits on Fund's behalf. Fund receives contributions 
from Employer and S1 and contributions from employees of Employer and S1 
who are beneficiaries of Fund. All contributions to Fund and all of 
Fund's earnings are separately accounted for on Fund's books and records 
and are required by Fund's organizational documents to exclusively fund 
the provision of benefits to Fund's beneficiaries, except as necessary 
to satisfy reasonable expenses of Fund. Fund currently has over 100 
beneficiaries, a number that is reasonably expected to grow as Employer 
expands. Fund will pay benefits to employees upon retirement based on 
years of service and employee contributions, but, if a beneficiary dies 
before retirement, Fund will pay an incidental death benefit in addition 
to payment of any accrued retirement and pension benefits to the 
beneficiary's designee (or deemed designee under local laws if the 
beneficiary fails to identify a designee). Fund annually performs a 
present valuation of the benefits it reasonably expects to provide to 
Fund's beneficiaries, and the valuation concludes that more than 85 
percent of the present value of the total benefits it reasonably expects 
to pay to its beneficiaries in the future are retirement and pension 
benefits. In addition, it is reasonably expected that the incidental 
death benefits paid by Fund will account for less than fifteen percent 
of the present value of the total benefits that Fund expects to provide 
in the future, and Fund does not reasonably expect to pay any other 
types of benefits to its beneficiaries in the future. Fund annually 
provides to the tax authorities of Country B the amount of benefits 
distributed to each participant (or designee). Country B's tax 
authorities prescribe rules and regulations governing Fund's operations. 
Under the laws of Country B, Fund is not taxed on its investment income. 
On January 1, 2024, Fund purchases Property, which is an interest in 
real property located in the United States. On June 1, 2026, Fund sells 
Property, realizing $100x of gain with respect to Property that would be 
subject to tax under section 897(a) unless paragraph (b) of this section 
applies with respect to the gain.
    (ii) Analysis. (A) Fund is a trust that maintains an identifiable 
pool of assets for the sole purpose of funding retirement and pension 
benefits and ancillary benefits to current and former employees of the 
employer group (within the meaning of paragraph (e)(3) of this section) 
that includes Employer and S1 (current and former employees of Employer 
and S1 constitute qualified recipients, as defined in paragraph 
(e)(12)(i)(B) of this section). All assets held by Fund and all income 
earned by Fund are used to provide such benefits. Therefore, Fund is a 
trust that maintains a qualified segregated account within the meaning 
of paragraph (e)(13) of this section. Accordingly, Fund is an eligible 
fund within the meaning of paragraph (e)(2) of this section.
    (B) Because Fund is created or organized under the laws of Country 
B, Fund satisfies the requirement of paragraph (c)(2)(i) of this 
section.

[[Page 706]]

    (C) The only benefits that Fund provides are retirement and pension 
benefits described in paragraph (e)(14) of this section and ancillary 
benefits (that is, the incidental death benefits) described in paragraph 
(e)(1) of this section, both of which constitute qualified benefits 
described in paragraph (e)(8) of this section, to qualified recipients, 
described in paragraph (e)(12)(i)(B) of this section. Furthermore, Fund 
satisfies the requirements of the present valuation test as described in 
paragraphs (c)(2)(ii)(B) and (C) of this section. Accordingly, Fund is 
established by Employer to provide retirement and pension benefits to 
qualified recipients in consideration for services rendered by such 
qualified recipients to Employer and S1, and Fund satisfies the 
requirement of paragraph (c)(2)(ii) of this section.
    (D) No single qualified recipient has a right to more than five 
percent of the assets or income of the eligible fund. Accordingly, Fund 
satisfies the requirement of paragraph (c)(2)(iii) of this section.
    (E) Fund is regulated and annually provides to the relevant tax 
authorities in the foreign jurisdiction in which it is established or 
operates the amount of qualified benefits provided to each qualified 
recipient by the eligible fund. Accordingly, Fund satisfies the 
requirements of paragraph (c)(2)(iv) of this section.
    (F) Fund is not subject to income tax on its investment income. 
Accordingly, Fund satisfies the requirement of paragraph (c)(2)(v) of 
this section.
    (G) Because Fund meets the requirements of paragraph (c)(2) of this 
section, Fund is treated as a qualified foreign pension fund. 
Furthermore, because Fund held no United States real property interests 
as of January 1, 2023, the earliest date during an uninterrupted period 
ending on June 1, 2026, the date of the disposition, in which it 
satisfied the requirements of paragraph (c)(2) of this section, Fund is 
a qualified holder under paragraph (d)(2) of this section. All of Fund's 
assets are held in a qualified segregated account within the meaning of 
paragraph (e)(13) of this section. Accordingly, under paragraph (b) of 
this section, the $100x gain attributable to the disposition of Property 
is not subject to section 897(a).
    (3) Example 3: Fund established by an employer at the direction of a 
foreign jurisdiction--(i) Facts. The facts are the same as in paragraph 
(f)(2) of this section (Example 2), except that Fund was established by 
Employer at the direction of Country B and, in addition to being 
established to provide retirement and pension benefits to current and 
former employees of Employer and S1, Fund was also established to 
provide retirement and pension benefits to other employees. All 
employees that are beneficiaries provide contributions to Fund. Fund 
makes a determination on at least an annual basis using a reasonable 
method to measure the number of participants in the Fund who are not 
current and former employees of Employer and S1. Each time such a 
determination is made, Fund finds that such employees constitute less 
than five percent of Fund's total qualified recipients and do not have a 
right to more than five percent of the assets or income of Fund.
    (ii) Analysis. Fund satisfies the requirements of paragraph 
(c)(2)(ii)(A)(1)(i) of this section because it was established by, or at 
the direction of, Country B to provide retirement and pension benefits 
to participants or beneficiaries that are current or former employees or 
persons designated by such employees as a result of services rendered by 
such employees to their employers. Fund also satisfies the requirements 
of paragraph (c)(2)(ii)(A)(1)(ii) of this section because it was 
established by Employer to provide retirement and pension benefits to 
participants or beneficiaries that are current or former employees or 
persons designated by such employees in consideration for services 
rendered by such employees to Employer and S1. Because it satisfies the 
requirements of both such provisions, under paragraph (c)(2)(ii)(A)(2) 
of this section, Fund will be treated solely as an eligible fund under 
paragraph (c)(2)(ii)(A)(1)(ii) of this section. As a result, Fund must 
meet the reporting requirements described in paragraph (c)(2)(iv)(A) of 
this section and must apply the definition

[[Page 707]]

of qualified recipient described in paragraphs (e)(12)(i)(B) and (C) of 
this section. Because Fund makes a determination on at least an annual 
basis using a reasonable method to measure the number of participants in 
the Fund who are not current and former employees of Employer and S1, 
finding that such employees constitute less than five percent of Fund's 
total qualified recipients and do not have a right to more than five 
percent of the assets or income of Fund, the requirement of paragraph 
(c)(2)(ii)(B)(1) of this section, requiring that all of the benefits 
that an eligible fund provides are provided to qualified recipients, is 
considered satisfied. Because Fund meets the requirements of paragraph 
(c)(2) of this section, Fund is treated as a qualified foreign pension 
fund under paragraph (b) of this section. Accordingly, the $100x gain 
attributable to the disposition of Property is not subject to section 
897(a).
    (4) Example 4: Employer controlled organization or arrangement--(i) 
Facts. The facts are the same as in paragraph (f)(2) of this section 
(Example 2), except that S2, a Country B corporation that is wholly 
owned by Employer, performs all tax compliance functions for Employer, 
S1, and S2, including information reporting with respect to Fund 
participants.
    (ii) Analysis. For purposes of the requirements of paragraph (c)(2) 
of this section, Fund and S2 are an organization or arrangement that is 
treated as a single entity under paragraph (c)(3)(i)(A) of this section 
and an eligible fund under paragraph (e)(2) of this section with respect 
to the qualified segregated account held by Fund. Because the eligible 
fund composed of Fund and S2 satisfies the requirements of paragraph 
(c)(2) of this section (including the rule under paragraph (c)(3)(i)(A) 
of this section that each entity satisfy the foreign organization 
requirement of paragraph (c)(2)(i) of this section) with respect to the 
qualified benefits provided to the qualified recipients out of the 
eligible fund's qualified segregated account (determined in accordance 
with paragraph (c)(3)(i)(B) of this section), the eligible fund that is 
composed of Fund and S2 constitutes a qualified foreign pension fund. 
Furthermore, the requirements for qualified holder status are satisfied, 
as described in paragraph (f)(2) of this section. Thus, under paragraph 
(b) of this section, the $100x gain attributable to the disposition of 
Property is not subject to section 897(a).
    (5) Example 5: Third-party assumption of pension liabilities--(i) 
Facts. The facts are the same as in paragraph (f)(2) of this section 
(Example 2), except that Fund does not purchase Property on January 1, 
2024. In addition, Fund anticipates $100x of qualified benefits will be 
paid each year beginning on January 1, 2028. Fund enters into an 
agreement with Guarantor, a privately held Country B corporation, which 
provides that Fund will, on January 30, 2023, cede a portion of its 
assets to Guarantor in exchange for annual payments of $100x beginning 
on January 1, 2028 and continuing until one or more previously 
identified participants (and their designees) ceases to be eligible to 
receive benefits. Guarantor has discretion to invest the ceded assets as 
it chooses, subject to certain agreed upon investment restrictions. 
Pursuant to its agreement with Fund, Guarantor must maintain Segregated 
Pool, a pool of assets securing its obligations under its agreement with 
Fund. The value of Segregated Pool must exceed a specified amount 
(determined based on an agreed upon formula) until Guarantor's payment 
obligations are completed, and any remaining assets in Segregated Pool 
(that is, assets exceeding the required payments to Fund) are retained 
by Guarantor. Guarantor bears all investment risk with respect to 
Segregated Pool. Accordingly, Guarantor is required to make annual 
payments of $100x to Fund regardless of the performance of Segregated 
Pool. On January 1, 2024, Guarantor purchases stock in Company A, a 
United States real property holding company that is a United States real 
property interest, and holds the Company A stock in Segregated Pool. On 
June 1, 2027, Guarantor sells the stock in Company A, realizing a gain 
of $100x.
    (ii) Analysis. The Segregated Pool is not a qualified segregated 
account, because it is not maintained for the sole purpose of funding 
qualified benefits to

[[Page 708]]

qualified recipients, and because income attributable to assets in the 
Segregated Pool (including the Company A stock) may inure to Guarantor, 
which is not a qualified recipient. Accordingly, Fund and Guarantor do 
not qualify as an organization or arrangement that is an eligible fund 
with respect to the Company A stock. Therefore, Guarantor is not exempt 
under paragraph (b) of this section with respect to the $100x of gain 
realized in connection with the sale of its shares in Company A.
    (6) Example 6: Asset manager--(i) Facts. The facts are the same as 
in paragraph (f)(5) of this section (Example 5) except that instead of 
ceding legal ownership of a portion of its assets to Guarantor, Fund 
transfers the assets into Trust with respect to which Fund is the sole 
beneficiary on January 30, 2023, and Trust purchases stock in Company A 
on January 1, 2024. Guarantor has exclusive management authority over 
the Trust assets and is entitled to a reasonable fixed management fee 
which it withdraws annually from Trust's assets. On June 1, 2027, Trust 
sells the stock in Company A, realizing a gain of $100x.
    (ii) Analysis. For purposes of testing the requirements of paragraph 
(c)(2) of this section, Fund and Trust are an organization or 
arrangement that is treated as a single entity under paragraph 
(c)(3)(i)(A) of this section and an eligible fund under paragraph (e)(2) 
of this section. Assets held by Trust are held in a qualified segregated 
account, and those assets are the assets that are relevant for purposes 
of determining whether the eligible fund composed of Fund and Trust 
meets the requirements of paragraph (c)(2) of this section. The eligible 
fund that is composed of Fund and Trust is treated as established by 
Employer notwithstanding that Guarantor provides management services. 
See paragraph (c)(2)(ii)(A)(3) of this section. Paragraph (e)(13)(ii) of 
this section provides that the assets held by an eligible fund in a 
qualified segregated account may be used to satisfy reasonable expenses 
of the eligible fund, such that the reasonable fixed management fee paid 
to Guarantor does not cause the assets held in Trust to fail to be 
treated as held in a qualified segregated account. All of the other 
requirements for qualified foreign pension fund status are satisfied by 
the eligible fund that is composed of Fund and Trust, as described in 
paragraph (f)(2) of this section. The eligible fund that is composed of 
Fund and Trust is a qualified holder under paragraph (d)(2) of this 
section because it held no United States real property interests on 
January 1, 2023, the earliest date during an uninterrupted period ending 
on June 1, 2027, the date of the disposition of Company A stock, in 
which it satisfied the requirements of paragraph (c)(2) of this section. 
The eligible fund that is composed of Fund and Trust is therefore exempt 
under paragraph (b) of this section with respect to the $100x of gain 
realized in connection with the sale by Trust of the shares in Company 
A.
    (7) Example 7: Partnership--(i) Facts. The facts are the same as in 
paragraph (f)(5) of this section (Example 5) except that instead of 
ceding legal ownership of the assets to Guarantor, Fund contributes the 
assets to a partnership (PRS) formed with Guarantor and PRS purchases 
stock in Company A on January 30, 2023. Guarantor receives a profits 
interest in the partnership that is reasonable in light of Guarantor's 
management activity. Guarantor has no direct or indirect ownership in 
PRS assets, and the partnership agreement provides that upon 
dissolution, PRS assets would be distributed to Fund. Guarantor serves 
as the general partner of PRS and has discretionary authority to buy and 
sell PRS assets without approval from Fund. On June 1, 2027, PRS sells 
the stock in Company A, realizing a gain of $100x.
    (ii) Analysis. All of Fund's assets, including the assets held by 
PRS that are treated as held proportionately by Fund under paragraph 
(c)(3)(ii) of this section, are held in a qualified segregated account 
within the meaning of paragraph (e)(13) of this section. See paragraph 
(f)(2)(ii)(A) of this section (Example 2). The eligible fund that is 
composed of Fund is treated as established by Employer notwithstanding 
that Guarantor provides management services to PRS. See paragraphs 
(c)(2)(ii)(A)(3) and (c)(3)(ii) of this section. All of the other 
requirements for

[[Page 709]]

qualified foreign pension fund status are satisfied by Fund as described 
in paragraphs (f)(2)(ii)(B) through (F) of this section, and Fund is a 
qualified holder as described in paragraph (f)(2)(ii)(G) of this 
section. Accordingly, Fund is exempt under paragraph (b) of this section 
with respect to its allocable share of the $100x of gain realized in 
connection with the sale by PRS of the shares in Company A. Guarantor is 
not exempt under paragraph (b) of this section with respect to its 
allocable share of the $100x of gain realized in connection with the 
sale by PRS of the shares in Company A because Guarantor is neither part 
of the organization or arrangement that forms Fund nor a qualified 
holder under paragraph (d) of this section that maintains qualified 
segregated accounts.
    (8) Example 8: Not a qualified holder--(i) Facts. Fund is a 
qualified foreign pension fund organized in Country C that meets the 
requirements of paragraph (c)(2) of this section. Fund owns all the 
outstanding stock of OpCo, a manufacturing corporation organized in 
Country C, in a qualified segregated account maintained by Fund. OpCo 
was originally formed by a person other than Fund on January 1, 2023. 
Fund purchased all of the stock of OpCo on November 1, 2023 for the 
purpose of conducting the manufacturing business and utilizing the 
business profits to fund pension liabilities. During the period from 
January 1, 2023, through October 31, 2023, OpCo was not a qualified 
foreign pension fund, a part of a qualified foreign pension fund, or a 
qualified controlled entity. On January 30, 2023, OpCo purchased 
Property A, a United States real property interest, from a third party. 
For all periods after Fund acquired OpCo, OpCo must either retain or 
distribute to Fund all of its net earnings, and upon dissolution, must 
distribute all of its assets to its stockholder (that is, Fund) after 
satisfaction of liabilities to its creditors. On June 1, 2024, OpCo 
realizes $100x of gain on the disposition of Property A.
    (ii) Analysis. (A) A qualified controlled entity described in 
paragraph (e)(9) of this section includes any corporation organized 
under the laws of a foreign jurisdiction all the interests of which are 
owned by one or more qualified foreign pension funds directly or 
indirectly through one or more qualified controlled entities. Fund is a 
qualified foreign pension fund that wholly owns OpCo. Accordingly, OpCo 
is a qualified controlled entity for the period when it is owned by Fund 
beginning on November 1, 2023.
    (B) Under paragraph (d)(1) of this section, a qualified controlled 
entity is a qualified holder only if either, under paragraph (d)(2) of 
this section, the qualified controlled entity owned no United States 
real property interests as of the earliest date during an uninterrupted 
period ending on the date of the disposition or distribution in which 
the qualified controlled entity satisfied the requirements of paragraph 
(e)(9) of this section, or, under paragraph (d)(3) of this section, the 
qualified controlled entity satisfies the requirements of paragraph 
(e)(9) of this section throughout the entire testing period. Because 
OpCo owned a United States real property interest as of November 1, 
2023, the earliest date during an uninterrupted period ending on the 
date of the disposition during which it satisfied the requirements of 
paragraph (e)(9) of this section, OpCo cannot satisfy the requirements 
of paragraph (d)(2) of this section and must instead satisfy the 
requirements of paragraph (d)(3) of this section to be a qualified 
holder. Under paragraph (d)(3) of this section, a qualified holder does 
not include any entity that was not a qualified foreign pension fund, a 
part of a qualified foreign pension fund, or a qualified controlled 
entity at any time during the testing period. The testing period with 
respect to OpCo is the period from January 1, 2023 (the date of OpCo's 
formation), to June 1, 2024 (the date of the disposition). Because OpCo 
was not a qualified foreign pension fund, a part of a qualified foreign 
pension fund, or a qualified controlled entity from January 1, 2023, to 
October 31, 2023, OpCo was not a qualified foreign pension fund, a part 
of a qualified foreign pension fund, or a qualified controlled entity at 
all times during the testing period. Accordingly, OpCo is not a 
qualified holder with respect to the disposition of Property A, and the 
$100x of gain recognized by OpCo is not exempt from tax under section 
897(l),

[[Page 710]]

regardless of the amount of unrealized gain in Property A as of November 
1, 2023.
    (9) Example 9: 48-month alternative test--(i) Facts. Fund is a 
qualified foreign pension fund organized in Country C that, except as 
otherwise noted, meets the requirements of paragraph (c)(2) of this 
section. Fund owns all the outstanding stock of OpCo, a manufacturing 
corporation organized in Country C and formed by Fund on January 1, 
2023, in a qualified segregated account maintained by Fund. On January 
30, 2023, OpCo purchased Property A, a United States real property 
interest, from a third party. OpCo either retains or distributes to Fund 
all of its net earnings, and upon dissolution, must distribute all of 
its assets to its stockholder (that is, Fund) after satisfaction of 
liabilities to its creditors. On June 1, 2027, OpCo realizes $100x of 
gain on the disposition of Property A. Fund reasonably expected to 
provide $90x of retirement and pension benefits and $100x of qualified 
benefits for the valuations that it performed pursuant to paragraph 
(c)(2)(ii)(C)(1) of this section on December 31, 2023, December 31, 
2024, and December 31, 2025. Fund reasonably expected to provide $160x 
of retirement and pension benefits and $200x of qualified benefits for 
the valuation that it performed pursuant to paragraph (c)(2)(ii)(C)(1) 
of this section on December 31, 2026.
    (ii) Analysis. In each of the years ending on December 31, 2023, 
December 31, 2024, and December 31, 2025, the valuation performed 
pursuant to paragraph (c)(2)(ii)(C)(1) of this section demonstrates that 
that the requirements of paragraph (c)(2)(ii)(B)(2) of this section have 
been met because $90x of retirement and pension benefits constitutes 90 
percent of the total $100x of qualified benefits. For the year ending on 
December 31, 2026, the valuation performed pursuant to paragraph 
(c)(2)(ii)(C)(1) of this section does not demonstrate that that the 
requirements of paragraph (c)(2)(ii)(B)(2) of this section have been met 
because $160x of retirement and pension benefits constitutes only 80 
percent of the total $200x of qualified benefits. Thus, Fund does not 
meet the requirements of paragraph (c)(2)(ii)(C)(1) of this section for 
the year ending on December 31, 2026. However, under the 48-month 
alternative calculation in paragraph (c)(2)(ii)(C)(2) of this section, 
Fund satisfies the requirement that it reasonably expects to provide 85 
percent retirement and pension benefits to qualified recipients as of 
December 31, 2026. This is because when averaging the values (not 
percentages) of the qualified benefits and retirement and pension 
benefits that Fund reasonably expected to provide from the valuations 
performed over the preceding 48 months (including the most recent 
valuation), Fund divides the total retirement and pension benefits of 
$430x ($90x + $90x + $90x + $160x) by the total qualified benefits that 
it reasonably expected to provide of $500x ($100x + $100x + $100x + 
$200x) for an average of 86 percent. Under paragraph (c)(2)(ii)(C)(3) of 
this section, Fund may rely on either the most recent present valuation 
described in paragraph (c)(2)(ii)(C)(1) of this section or the 
alternative calculation in paragraph (c)(2)(ii)(C)(2) of this section, 
both of which are determined as of December 31, 2026. Because Fund 
satisfies the requirements of paragraph (c)(2)(ii)(B)(2) of this section 
under the test in paragraph (c)(2)(ii)(C)(2) of this section, even 
though it does not do so under the test in paragraph (c)(2)(ii)(C)(1) of 
this section, Fund is a qualified foreign pension fund with respect to 
the disposition on June 1, 2027. Because OpCo is held by a qualified 
foreign pension fund as of the date of the disposition, OpCo is a 
qualified controlled entity within the meaning of paragraph (e)(9) of 
this section. Accordingly, the $100x of gain realized by OpCo is exempt 
from tax under section 897(l).
    (10) Example 10: 48-month alternative test with multiple valuations 
in the same year--(i) Facts. The facts are the same as in paragraph 
(f)(9) of this section (Example 9), except that in the year ending 
December 31, 2023, Fund carried out two valuations pursuant to paragraph 
(c)(2)(ii)(C)(1) of this section, one on June 30, 2023 and the second on 
December 31, 2023. For each valuation, Fund reasonably expected to 
provide $90x of retirement and pension benefits and $100x of qualified 
benefits. In addition, in the year ending on December

[[Page 711]]

31, 2026, pursuant to a valuation carried out under paragraph 
(c)(2)(ii)(C)(1) of this section, Fund reasonably expected to provide 
$150x retirement and pension benefits and $200x of qualified benefits.
    (ii) Analysis. In each of the years ending on December 31, 2023, 
December 31, 2024, and December 31, 2025 (including the two valuations 
performed in 2023), the valuation performed pursuant to paragraph 
(c)(2)(ii)(C)(1) of this section demonstrates that the requirements of 
paragraph (c)(2)(ii)(B)(2) of this section have been met because $90x of 
retirement and pension benefits constitutes 90 percent of the total 
$100x of qualified benefits. For the year ending on December 31, 2026, 
the valuation performed pursuant to paragraph (c)(2)(ii)(C)(1) of this 
section does not demonstrate that the requirements of paragraph 
(c)(2)(ii)(B)(2) of this section have been met because $150x of 
retirement and pension benefits constitutes 75 percent of the total 
$200x of qualified benefits. Thus, Fund does not meet the requirements 
of paragraph (c)(2)(ii)(C)(1) of this section for the year ending on 
December 31, 2026. Under the 48-month alternative calculation in 
paragraph (c)(2)(ii)(C)(2) of this section, Fund also does not satisfy 
the requirement that it reasonably expects to provide 85 percent 
retirement and pension benefits to qualified recipients as of December 
31, 2026. This is because when averaging the values (not percentages) of 
the qualified benefits and retirement and pension benefits that Fund 
reasonably expected to provide from the valuations performed over the 
preceding 48 months (including the most recent valuation), Fund must use 
a weighted average whereby values are adjusted when the length of 
valuation periods differs. In this case, each of the two valuations in 
2023 must be divided by two for a total weighted average for each 
valuation of $45x retirement and pension benefits and $50x of qualified 
benefits. When Fund then divides the total retirement and pension 
benefits that it reasonably expected to provide of $420x ($45x + $45x + 
$90x + $90x + $150x) by the total qualified benefits that it reasonably 
expected to provide of $500x ($50x + $50x + $100x + $100x + $200x), the 
average is 84 percent. Because Fund does not satisfy the requirements of 
paragraph (c)(2)(ii)(B)(2) of this section under the test in paragraph 
(c)(2)(ii)(C)(2) of this section or the test in paragraph 
(c)(2)(ii)(C)(1) of this section, Fund is not a qualified foreign 
pension fund with respect to the disposition on June 1, 2027. Because 
OpCo is not held by a qualified foreign pension fund as of the date of 
the disposition, OpCo is not a qualified controlled entity within the 
meaning of paragraph (e)(9) of this section. Accordingly, the $100x of 
gain realized by OpCo is not exempt from tax under section 897(l).
    (11) Example 11: Qualified foreign pension fund as qualified 
holder--(i) Facts. The facts are the same as in paragraph (f)(10) of 
this section (Example 10), except that OpCo does not dispose of Property 
A on June 1, 2027 and Fund reasonably expects to provide 85 percent of 
retirement and pension benefits to qualified recipients in the future in 
each of the annual present valuations it performs as of December 31, 
2027 through December 31, 2033. Fund also satisfies the other 
requirements of paragraph (c)(2) of this section during this period. On 
April 1, 2029, Fund purchases Property B, a United States real property 
interest, and holds it in a qualified segregated account. On June 1, 
2034, Fund realizes $100x of gain on the disposition of Property B and 
OpCo realizes $100x of gain on the disposition of Property A. At least 
85 percent and no more than five percent of the actual value of the 
aggregate benefits provided by Fund before December 31, 2033, the most 
recent present value determination, were retirement and pension benefits 
and non-ancillary benefits, respectively.
    (ii) Analysis. (A) Because Fund reasonably expected to provide 85 
percent of retirement and pension benefits to qualified recipients as of 
the valuation performed on December 31, 2033, and it met the other 
requirements of paragraph (c)(2) of this section, Fund is a qualified 
foreign pension fund under paragraph (c)(2)(ii)(C)(3) of this section 
for the twelve months succeeding the most recent valuation, which 
includes June 1, 2034, the date of the disposition of Property A and 
Property B.
    (B) Fund is a qualified holder under paragraph (d)(2) of this 
section because

[[Page 712]]

Fund did not own any United States real property interests as of 
December 31, 2027, the earliest date during the uninterrupted period 
ending on the date of the disposition, June 1, 2034, during which it 
satisfied the requirements of paragraph (c)(2) of this section and 
therefore qualified as a qualified foreign pension fund. Fund is 
eligible for the exemption under section 897(l) with respect to the 
disposition of Property B because it held Property B in a qualified 
segregated account. Thus, the $100x of gain realized by Fund on the 
disposition of Property B is exempt from tax under section 897(l).
    (C) Because OpCo owned Property A, a United States real property 
interest, as of December 31, 2027, the earliest date during an 
uninterrupted period ending on the date of the disposition, June 1, 
2034, during which it was a qualified controlled entity, OpCo cannot 
satisfy the requirements of paragraph (d)(2) of this section and must 
instead satisfy the requirements of paragraph (d)(3) of this section to 
be a qualified holder. The testing period with respect to OpCo, 
determined under paragraph (d)(3)(ii) of this section, ends on June 1, 
2034 (the date of the disposition) and begins on June 1, 2024 (the date 
that is ten years before the disposition date). Because Fund failed to 
qualify as a qualified foreign pension fund as of December 31, 2026, 
OpCo was not continuously owned by a qualified foreign pension fund for 
the duration of the testing period, and thus did not qualify as a 
qualified foreign pension fund, part of a qualified foreign pension 
fund, or a qualified controlled entity for the duration of the testing 
period. As a result, OpCo is not a qualified holder under paragraph 
(d)(3) of this section. Accordingly, the $100x of gain recognized by 
OpCo on the disposition of Property A is not exempt from tax under 
section 897(l).
    (12) Example 12: Qualified controlled entity as qualified holder--
(i) Facts. Fund is a qualified foreign pension fund organized in Country 
C that meets the requirements of paragraph (c)(2) of this section as of 
December 31, 2022 and December 31, 2023. Fund purchases an interest in 
Company A, a United States real property holding company, on June 1, 
2024. As of December 31, 2024, Fund fails to satisfy the present 
valuation requirement of paragraph (c)(2)(ii)(B)(2) of this section and 
does not satisfy the alternative calculation under paragraph 
(c)(2)(ii)(C)(2) of this section. From December 31, 2025, through 
December 31, 2030, Fund satisfies the present valuation requirement of 
paragraph (c)(2)(ii)(B)(2) of this section and meets all other 
requirements in paragraph (c)(2) of this section to be treated as a 
qualified foreign pension fund. On June 1, 2026, Fund purchases all of 
the stock of Company B, a Country C corporation that owns no United 
States real property interests and is not a qualified foreign pension 
fund, a part of a qualified foreign pension fund, or a qualified 
controlled entity. On January 1, 2027, Company B purchases Property D, a 
United States real property interest. Company B retains or distributes 
to Fund all of its net earnings, and upon dissolution, must distribute 
all of its assets to its stockholders (that is, Fund) after satisfaction 
of liabilities to its creditors. On June 1, 2031, Fund realizes $100x of 
gain on the disposition of stock in Company A, and Company B realizes 
$100x of gain on the disposition of Property D.
    (ii) Analysis. (A) Fund owned Company A, a United States real 
property holding company, as of December 31, 2025, the earliest date 
during an uninterrupted period ending on the date of the disposition, 
June 1, 2031, during which Fund satisfied the requirements of paragraph 
(c)(2) of this section. Accordingly, to be a qualified holder, Fund must 
satisfy the requirements of paragraph (d)(3) of this section. The 
testing period with respect to Fund, determined under paragraph (d)(3) 
of this section, ends on June 1, 2031 (the date of disposition) and 
begins on June 1, 2021 (the date that is ten years before the 
disposition date). Fund is not a qualified holder because it failed to 
satisfy the requirements of paragraph (c)(2) of this section as of 
December 31, 2024 and, thus, has not satisfied the requirements of 
paragraph (c)(2) of this section continuously for the duration of the 
testing period. Accordingly, the $100x of gain realized by Fund on the 
disposition of the stock of Company A is not exempt from tax under 
section 897(l).

[[Page 713]]

    (B) Although Fund is not a qualified holder as of June 1, 2031, the 
date of Company B's disposition of Property D, Fund is still a qualified 
foreign pension fund because it satisfies the requirements of paragraph 
(c)(2) of this section. Company B is therefore a qualified controlled 
entity within the meaning of paragraph (e)(9) of this section as of June 
1, 2031, because it is wholly owned by Fund, a qualified foreign pension 
fund. Notwithstanding that Fund is not a qualified holder under either 
paragraph (d)(2) or (3) of this section, Company B is a qualified holder 
under paragraph (d)(2) of this section because Company B did not own a 
United States real property interest as of June 1, 2026, the earliest 
date during an uninterrupted period ending on June 1, 2031 (the date of 
the disposition) during which Company B was a qualified controlled 
entity. Lastly, all of Company B's assets constitute a qualified 
segregated account. Accordingly, the $100x of gain realized by Company B 
on the disposition of Property D is exempt from tax under section 
897(l).
    (g) Applicability date--(1) In general. Except as otherwise provided 
in paragraph (g)(2) of this section, this section applies to 
dispositions of United States real property interests and distributions 
described in section 897(h) occurring on or after December 29, 2022.
    (2) Certain provisions. Paragraphs (b)(1), (d), (e)(5) and (e)(9) of 
this section apply with respect to dispositions of United States real 
property interests and distributions described in section 897(h) 
occurring on or after June 6, 2019.
    (3) Early application. An eligible fund may choose to apply this 
section with respect to dispositions and distributions occurring on or 
after December 18, 2015, and before December 29, 2022, provided that the 
eligible fund, and all persons bearing a relationship to the eligible 
fund described in section 267(b) or 707(b), consistently apply the rules 
in this section for all relevant years. An eligible fund that chooses to 
apply this section pursuant to this paragraph (g)(3) must apply the 
principles of paragraph (d)(4)(i) of this section to any valuation 
requirements with respect to dates preceding December 18, 2015.

[T.D. 9971, 87 FR 80055, Dec. 29, 2022]

              Income From Sources Without the United States

                           foreign tax credit



Sec.  1.901-1  Allowance of credit for foreign income taxes.

    (a) In general. Citizens of the United States, domestic 
corporations, certain aliens resident in the United States or Puerto 
Rico, and certain estates and trusts may choose to claim a credit, as 
provided in section 901, against the tax imposed by chapter 1 of the 
Internal Revenue Code (Code) for certain taxes paid or accrued to 
foreign countries and possessions of the United States, subject to the 
conditions prescribed in this section.
    (1) Citizen of the United States. An individual who is a citizen of 
the United States, whether resident or nonresident, may claim a credit 
for--
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the 
individual's method of accounting for such taxes) during the taxable 
year;
    (ii) The individual's share of any such taxes of a partnership of 
which the individual is a member, or of an estate or trust of which the 
individual is a beneficiary; and
    (iii) In the case of an individual who has made an election under 
section 962, the taxes deemed to have been paid under section 960 (see 
Sec.  1.962-1(b)(2)).
    (2) Domestic corporation. A domestic corporation may claim a credit 
for--
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the 
corporation's method of accounting for such taxes) during the taxable 
year;
    (ii) The corporation's share of any such taxes of a partnership of 
which the corporation is a member, or of an estate or trust of which the 
corporation is a beneficiary; and
    (iii) The taxes deemed to have been paid under section 960.
    (3) Alien resident of the United States or Puerto Rico. Except as 
provided in a Presidential proclamation described in section 901(c), an 
individual who is a resident alien of the United States (as

[[Page 714]]

defined in section 7701(b)), or an individual who is a bona fide 
resident of Puerto Rico (as defined in section 937(a)) during the entire 
taxable year, may claim a credit for--
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the 
individual's method of accounting for such taxes) during the taxable 
year;
    (ii) The individual's share of any such taxes of a partnership of 
which the individual is a member, or of an estate or trust of which the 
individual is a beneficiary; and
    (iii) In the case of an individual who has made an election under 
section 962, the taxes deemed to have been paid under section 960 (see 
Sec.  1.962-1(b)(2)).
    (4) Estates and trusts. An estate or trust may claim a credit for--
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the estate 
or trust's method of accounting for such taxes) during the taxable year 
to the extent not allocable to and taken into account by its 
beneficiaries under paragraph (a)(1)(ii), (a)(2)(ii), or (a)(3)(ii) of 
this section (see section 642(a)); and
    (ii) In the case of an estate or trust that has made an election 
under section 962, the taxes deemed to have been paid under section 960 
(see Sec.  1.962-1(b)(2)).
    (b) Limitations. Certain Code sections, including sections 245A(d) 
and (e)(3), 814, 901(e) through (m), 904, 906, 907, 908, 909, 911, 
965(g), 999, and 6038, reduce, defer, or otherwise limit the credit 
against the tax imposed by chapter 1 of the Code for certain amounts of 
foreign income taxes.
    (c) Deduction denied if credit claimed--(1) In general. Except as 
provided in paragraphs (c)(2) and (3) of this section, if a taxpayer 
chooses with respect to any taxable year to claim a credit under section 
901 to any extent, such choice will apply to all of the foreign income 
taxes paid or accrued (as the case may be, depending on the taxpayer's 
method of accounting for such taxes) by the taxpayer in such taxable 
year, and no deduction from gross income is allowed for any portion of 
such taxes in any taxable year. See section 275(a)(4).
    (2) Exception for taxes not subject to section 275. A deduction may 
be allowed under section 164(a)(3) for foreign income tax for which a 
credit is disallowed under any Code section and to which section 275 
does not apply. See, for example, sections 901(f), 901(j)(3), 901(k)(7), 
901(l)(4), 901(m)(6), and 908(b). For rules on the taxable year in which 
a deduction for foreign income taxes is allowed under section 164(a)(3), 
see Sec. Sec.  1.446-1(c)(1)(ii), 1.461-2(a)(2), and 1.461-
4(g)(6)(iii)(B).
    (3) Exception for taxes paid by an accrual basis taxpayer that 
relate to a prior year in which the taxpayer deducted foreign income 
taxes. If a taxpayer claims a credit for foreign income taxes accrued in 
a taxable year (including a cash method taxpayer that elects under 
section 905(a) to claim a credit in the year the taxes accrue), a 
deduction may be claimed in that taxable year for additional foreign 
income taxes that are finally determined and paid as a result of a 
foreign tax redetermination in that taxable year if the additional 
foreign income taxes relate to a prior taxable year in which the 
taxpayer claimed a deduction, rather than a credit, for foreign income 
taxes paid or accrued (as the case may be, depending on the taxpayer's 
overall method of accounting) in that prior year.
    (4) Example. The following example illustrates the application of 
paragraph (c)(3) of this section.
    (i) Facts. U.S.C. is a domestic corporation that is engaged in a 
trade or business in Country X through a branch. U.S.C. uses the accrual 
method of accounting and a calendar year for U.S. and Country X tax 
purposes. For taxable Years 1 through 3, U.S.C. deducted foreign income 
taxes accrued in those years. In Years 4 through 6, U.S.C. claimed a 
credit for foreign income taxes accrued in those years. In Year 6, 
U.S.C. paid an additional $50x tax to Country X that relates to Year 1 
because of the close of a Country X tax audit.
    (ii) Analysis. The additional $50x Country X tax paid by U.S.C. in 
Year 6 that relates to Year 1 cannot be claimed by U.S.C. as a deduction 
on an amended return for Year 1 because the

[[Page 715]]

additional tax accrued in Year 6. See section 461(f) (flush language); 
Sec. Sec.  1.461-1(a)(2)(i) and 1.461-2(a)(2). In addition, because the 
additional $50x Country X tax relates to and is considered to accrue in 
Year 1 for foreign tax credit purposes, U.S.C. cannot claim a credit for 
the additional $50x Country X tax on its Federal income tax return for 
Year 6. See Sec.  1.905-1(d)(1). However, pursuant to paragraph (c)(3) 
of this section, U.S.C. can claim a deduction for the additional $50x 
Country X tax that relates to Year 1 on its Federal income tax return 
for Year 6, even though it claims a credit for foreign income taxes that 
accrue in Year 6 and that relate to Year 6.
    (d) Period during which election can be made or changed--(1) In 
general. The taxpayer may, for a particular taxable year, elect to claim 
a credit under section 901 (or claim a deduction in lieu of electing to 
claim a credit) at any time before the expiration of the period within 
which a claim for credit or refund of Federal income tax for such 
taxable year that is attributable to such credit or deduction, as the 
case may be, may be made (or, if longer, the period prescribed by 
section 6511(c) if the refund period for that taxable year is extended 
by an agreement to extend the assessment period under section 
6501(c)(4)). Thus, an election to claim a credit for foreign income 
taxes paid or accrued (as the case may be, depending on the taxpayer's 
method of accounting for such taxes) in a particular taxable year can be 
made within the period prescribed by section 6511(d)(3)(A) for claiming 
a credit or refund of Federal income tax for that taxable year that is 
attributable to a credit for the foreign income taxes paid or accrued in 
that particular taxable year or, if longer, the period prescribed by 
section 6511(c) with respect to that particular taxable year. A choice 
to claim a deduction under section 164(a)(3), rather than a credit under 
section 901, for foreign income taxes paid or accrued in a particular 
taxable year can be made within the period prescribed by section 6511(a) 
or 6511(c), as applicable, for claiming a credit or refund of Federal 
income tax for that particular taxable year.
    (2) Manner in which election is made or changed. A taxpayer claims a 
deduction or a credit for foreign income taxes paid or accrued in a 
particular taxable year by filing an original or amended return for that 
taxable year within the relevant period specified in paragraph (d)(1) of 
this section. A claim for a credit shall be accompanied by Form 1116 in 
the case of an individual, estate or trust, and by Form 1118 in the case 
of a corporation (and an individual, estate or trust making an election 
under section 962). See Sec. Sec.  1.905-3 and 1.905-4 for rules 
requiring the filing of amended returns for all affected years when a 
timely change in the taxpayer's election to claim a deduction or credit 
results in U.S. tax deficiencies.
    (e) Joint return. In the case of spouses making a joint return, 
credit for taxes paid or accrued to any foreign country or to any 
possession of the United States shall be computed upon the basis of the 
total taxes so paid by or accrued against the spouses.
    (f) Taxes against which credit is allowed. The credit for foreign 
income taxes is allowed only against the tax imposed by chapter 1 of the 
Code. The credit is not allowed against a tax that, under section 
26(b)(2), is not treated as a tax imposed by such chapter.
    (g) Taxpayers to whom credit not allowed. Among those to whom the 
credit for taxes is not allowed are the following:
    (1) Except as provided in section 906, a foreign corporation.
    (2) Except as provided in section 906, a nonresident alien 
individual who is not described in section 876 (see sections 874(c) and 
901(b)(4)).
    (3) A nonresident alien individual described in section 876 other 
than a bona fide resident (as defined in section 937(a) and the 
regulations under that section) of Puerto Rico during the entire taxable 
year (see sections 901(b)(3) and (4)).
    (4) A U.S. citizen or resident alien individual who is a bona fide 
resident of a section 931 possession (as defined in Sec.  1.931-
1(c)(1)), the U.S. Virgin Islands, or Puerto Rico, and who excludes 
certain income from U.S. gross income to

[[Page 716]]

the extent of taxes allocable to the income so excluded (see sections 
931(b)(2), 933(1), and 932(c)(4)).
    (h) Taxpayers denied credit in a particular taxable year. Taxpayers 
who are denied the credit for taxes for particular taxable years are the 
following:
    (1) Except as provided in paragraphs (c)(2) and (3) of this section, 
a taxpayer that claims a deduction for foreign income taxes paid or 
accrued (as the case may be, depending on the taxpayer's method of 
accounting for such taxes) for that taxable year (see sections 164 and 
275); and
    (2) A regulated investment company which has exercised the election 
under section 853.
    (i) Dividends from a DISC treated as foreign. For purposes of 
sections 901 through 906 and the regulations thereunder, any amount 
treated as a dividend from a corporation which is a DISC or former DISC 
(as defined in section 992(a) (1) or (3) as the case may be) will be 
treated as a dividend from a foreign corporation to the extent such 
dividend is treated under section 861(a)(2)(D) as income from sources 
without the United States.
    (j) Applicability date. Paragraph (g) of this section applies to 
taxable years ending after April 9, 2008. This section applies to 
foreign taxes paid or accrued in taxable years beginning on or after 
December 28, 2021.

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

    Editorial Note: For Federal Register citations affecting Sec.  
1.901-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.901-2  Income, war profits, or excess profits tax paid or accrued.

    (a) Definition of foreign income tax--(1) Overview and scope. 
Paragraphs (a) and (b) of this section define a foreign income tax for 
purposes of section 901. Paragraph (c) of this section is reserved. 
Paragraph (d) of this section contains rules describing what constitutes 
a separate levy. Paragraph (e) of this section provides rules for 
determining the amount of foreign income tax paid by a taxpayer. 
Paragraph (f) of this section contains rules for determining by whom 
foreign income tax is paid. Paragraph (g) of this section defines the 
terms used in this section, and in particular provides that the term 
``paid'' means ``paid'' or ``accrued,'' depending on the taxpayer's 
method of accounting for foreign income taxes. Paragraph (h) of this 
section provides the applicability date for this section.
    (i) In general. Section 901 allows a credit for the amount of 
income, war profits, and excess profits taxes paid during the taxable 
year to any foreign country, and section 903 provides that for purposes 
of Part III of subchapter N of the Code and sections 164(a) and 275(a), 
such taxes include a tax paid in lieu of a tax on income, war profits or 
excess profits that is otherwise generally imposed by a foreign country 
(collectively, for purposes of this section, a ``foreign income tax''). 
Whether a foreign levy is a foreign income tax is determined 
independently for each separate levy. A foreign tax either is or is not 
a foreign income tax, in its entirety, for all persons subject to the 
foreign tax.
    (ii) Requirements. A foreign levy is a foreign income tax only if--
    (A) It is a foreign tax; and
    (B) Either:
    (1) The foreign tax is a net income tax, as defined in paragraph 
(a)(3) of this section; or
    (2) The foreign tax is a tax in lieu of an income tax, as defined in 
Sec.  1.903-1(b).
    (iii) Coordination with treaties. A foreign levy that is treated as 
an income tax under the relief from double taxation article of an income 
tax treaty entered into by the United States and the foreign country 
imposing the levy is a foreign income tax if the levy is, as determined 
under such income tax treaty, paid by a citizen or resident of the 
United States that elects benefits under the treaty. In addition, a 
foreign levy (including a foreign levy paid by a controlled foreign 
corporation) that is modified by an applicable income tax treaty to 
which the foreign country imposing the levy is a party may qualify as a 
foreign income tax notwithstanding that the unmodified foreign levy does 
not satisfy the requirements in paragraph (b) of this section or the 
requirements of Sec.  1.903-1(b) if the levy, as modified by such 
treaty, satisfies the requirements of paragraph (b) of

[[Page 717]]

this section or the requirements of Sec.  1.903-1(b). See paragraph 
(d)(1)(iv) of this section for rules treating as a separate levy a 
foreign tax that is limited in its application or otherwise modified by 
the terms of an income tax treaty to which the foreign country imposing 
the tax is a party.
    (2) Tax--(i) In general. A foreign levy is a tax if it requires a 
compulsory payment pursuant to the authority of a foreign country to 
levy taxes. A penalty, fine, interest, or similar obligation is not a 
tax, nor is a customs duty a tax. Whether a foreign levy requires a 
compulsory payment pursuant to a foreign country's authority to levy 
taxes is determined by principles of U.S. law and not by principles of 
law of the foreign country. Therefore, the assertion by a foreign 
country that a levy is pursuant to the foreign country's authority to 
levy taxes is not determinative that, under U.S. principles, it is 
pursuant thereto. Notwithstanding any assertion of a foreign country to 
the contrary, a foreign levy is not pursuant to a foreign country's 
authority to levy taxes, and thus is not a tax, to the extent a person 
subject to the levy receives (or will receive), directly or indirectly, 
a specific economic benefit (as defined in paragraph (a)(2)(ii)(B) of 
this section) from the foreign country in exchange for payment pursuant 
to the levy. Rather, to that extent, such levy requires a compulsory 
payment in exchange for such specific economic benefit. If, applying 
U.S. principles, a foreign levy requires a compulsory payment pursuant 
to the authority of a foreign country to levy taxes and also requires a 
compulsory payment in exchange for a specific economic benefit, the levy 
is considered to have two distinct elements: A tax and a requirement of 
compulsory payment in exchange for such specific economic benefit. In 
such a situation, these two distinct elements of the foreign levy (and 
the amount paid pursuant to each such element) must be separated. No 
credit is allowable for a payment pursuant to a foreign levy by a dual 
capacity taxpayer (as defined in paragraph (a)(2)(ii)(A) of this 
section) unless the person claiming such credit establishes the amount 
that is paid pursuant to the distinct element of the foreign levy that 
is a tax. See paragraph (a)(2)(ii) of this section and Sec.  1.901-2A.
    (ii) Dual capacity taxpayers--(A) In general. For purposes of this 
section and Sec. Sec.  1.901-2A and 1.903-1, a person who is subject to 
a levy of a foreign state or of a possession of the United States or of 
a political subdivision of such a state or possession and who also, 
directly or indirectly (within the meaning of paragraph (a)(2)(ii)(E) of 
this section) receives (or will receive) a specific economic benefit 
from the state or possession or from a political subdivision of such 
state or possession or from an agency or instrumentality of any of the 
foregoing is referred to as a ``dual capacity taxpayer.'' Dual capacity 
taxpayers are subject to the special rules of Sec.  1.901-2A.
    (B) Specific economic benefit. For purposes of this section and 
Sec. Sec.  1.901-2A and 1.903-1, the term ``specific economic benefit'' 
means an economic benefit that is not made available on substantially 
the same terms to substantially all persons who are subject to the 
income tax that is generally imposed by the foreign country, or, if 
there is no such generally imposed income tax, an economic benefit that 
is not made available on substantially the same terms to the population 
of the country in general. Thus, a concession to extract government-
owned petroleum is a specific economic benefit, but the right to travel 
or to ship freight on a government-owned airline is not, because the 
latter, but not the former, is made generally available on substantially 
the same terms. An economic benefit includes property; a service; a fee 
or other payment; a right to use, acquire or extract resources, patents 
or other property that a foreign country owns or controls (within the 
meaning of paragraph (a)(2)(ii)(D) of this section); or a reduction or 
discharge of a contractual obligation. It does not include the right or 
privilege merely to engage in business generally or to engage in 
business in a particular form.
    (C) Pension, unemployment, and disability fund payments. A foreign 
levy imposed on individuals to finance retirement, old-age, death, 
survivor, unemployment, illness, or disability benefits, or for some 
substantially similar

[[Page 718]]

purpose, is not a requirement of compulsory payment in exchange for a 
specific economic benefit, as long as the amounts required to be paid by 
the individuals subject to the levy are not computed on a basis 
reflecting the respective ages, life expectancies or similar 
characteristics of such individuals.
    (D) Control of property. A foreign country controls property that it 
does not own if the country exhibits substantial indicia of ownership 
with respect to the property, for example, by both regulating the 
quantity of property that may be extracted and establishing the minimum 
price at which it may be disposed of.
    (E) Indirect receipt of a benefit. A person is considered to receive 
a specific economic benefit indirectly if another person receives a 
specific economic benefit and that other person--
    (1) Owns or controls, directly or indirectly, the first person or is 
owned or controlled, directly or indirectly, by the first person or by 
the same persons that own or control, directly or indirectly, the first 
person; or
    (2) Engages in a transaction with the first person under terms and 
conditions such that the first person receives, directly or indirectly, 
all or part of the value of the specific economic benefit.
    (3) Net income tax. A foreign tax is a net income tax only if the 
foreign tax meets the net gain requirement in paragraph (b) of this 
section.
    (b) Net gain requirement--(1) In general. A foreign tax satisfies 
the net gain requirement only if the tax satisfies the realization, 
gross receipts, cost recovery, and attribution requirements in 
paragraphs (b)(2), (3), (4), and (5) of this section, respectively, or 
if the foreign tax is a surtax described in paragraph (b)(6) of this 
section. Paragraphs (b)(2) through (6) of this section are applied with 
respect to a foreign tax solely on the basis of the foreign tax law 
governing the calculation of the foreign taxable base, unless otherwise 
provided, and without any consideration of the rate of tax imposed on 
the foreign taxable base.
    (2) Realization requirement--(i) In general. A foreign tax satisfies 
the realization requirement if it is imposed upon one or more of the 
events described in paragraphs (b)(2)(i)(A) through (C) of this section. 
If a foreign tax meets the realization requirement in paragraphs 
(b)(2)(i)(A) through (C) of this section except with respect to one or 
more specific and defined classes of nonrealization events (such as, for 
example, imputed rental income from a personal residence used by the 
owner), and as judged based on the application of the foreign tax to all 
taxpayers subject to the foreign tax, the incidence and amounts of gross 
receipts attributable to such nonrealization events is insignificant 
relative to the incidence and amounts of gross receipts attributable to 
events covered by the foreign tax that do meet the realization 
requirement, then the foreign tax is treated as meeting the realization 
requirement in paragraph (b)(2) of this section (despite the fact that 
the foreign tax is also imposed on the basis of some nonrealization 
events, and that some persons subject to the foreign tax may only be 
taxed on nonrealization events).
    (A) Realization events. The foreign tax is imposed upon or after the 
occurrence of events (``realization events'') that result in the 
realization of income under the income tax provisions of the Internal 
Revenue Code.
    (B) Pre-realization recapture events. The foreign tax is imposed 
upon the occurrence of an event before a realization event (a ``pre-
realization event'') that results in the recapture (in whole or part) of 
a tax deduction, tax credit, or other tax allowance previously accorded 
to the taxpayer (for example, the recapture of an incentive tax credit 
if required investments are not completed within a specified period).
    (C) Pre-realization timing difference events. The foreign tax is 
imposed upon the occurrence of a pre-realization event, other than one 
described in paragraph (b)(2)(i)(B) of this section, but only if the 
foreign country does not, upon the occurrence of a later event, impose 
tax under the same or a separate levy (a ``second tax'') on the same 
taxpayer (for purposes of this paragraph (b)(2)(i)(C), treating a 
disregarded entity as defined in Sec.  301.7701-3(b)(2)(i)(C) of this 
chapter as a taxpayer separate from its owner), with respect to the 
income on which tax is

[[Page 719]]

imposed by reason of such pre-realization event (or, if it does impose a 
second tax, a credit or other comparable relief is available against the 
liability for such a second tax for tax paid on the occurrence of the 
pre-realization event) and--
    (1) The imposition of the tax upon such pre-realization event is 
based on the difference in the fair market value of property at the 
beginning and end of a period;
    (2) The pre-realization event is the physical transfer, processing, 
or export of readily marketable property (as defined in paragraph 
(b)(2)(ii) of this section) and the imposition of the tax upon the pre-
realization event is based on the fair market value of such property; or
    (3) The pre-realization event relates to a deemed distribution (for 
example, by a corporation to a shareholder) or inclusion (for example, 
under a controlled foreign corporation inclusion regime) of amounts 
(such as earnings and profits) that meet the realization requirement in 
paragraph (b)(2) of this section in the hands of the person that, under 
foreign tax law, is deemed to distribute such amounts.
    (ii) Readily marketable property. Property is readily marketable 
if--
    (A) It is stock in trade or other property of a kind that properly 
would be included in inventory if on hand at the close of the taxable 
year or if it is held primarily for sale to customers in the ordinary 
course of business, and
    (B) It can be sold on the open market without further processing or 
it is exported from the foreign country.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (b)(2) of this section:
    (A) Example 1. Residents of Country X are subject to a tax of 10 
percent on the aggregate net appreciation in fair market value during 
the calendar year of all shares of stock held by them at the end of the 
year. In addition, all such residents are subject to a Country X tax 
that qualifies as a net income tax within the meaning of paragraph 
(a)(3) of this section. Included in the base of the net income tax are 
gains and losses realized on the sale of stock, and the basis of stock 
for purposes of determining such gain or loss is its cost. The operation 
of the stock appreciation tax and the net income tax as applied to sales 
of stock is exemplified as follows: A, a resident of Country X, 
purchases stock in June of Year 1 for 100u (units of Country X currency) 
and sells it in May of Year 3 for 160u. On December 31, Year 1, the 
stock is worth 120u and on December 31, Year 2, it is worth 155u. 
Pursuant to the stock appreciation tax, A pays 2u for Year 1 (10 percent 
of (120u-100u)), 3.5u for Year 2 (10 percent of (155u-120u)), and 
nothing for Year 3 because no stock was held at the end of that year. 
For purposes of the net income tax, A must include 60u (160u-100u) in 
his income for Year 3, the year of sale. Pursuant to paragraph 
(b)(2)(i)(C) of this section, the stock appreciation tax does not 
satisfy the realization requirement because Country X imposes a second 
tax upon the occurrence of a later event (that is, the sale of stock) 
with respect to the income that was taxed by the stock appreciation tax 
and no credit or comparable relief is available against such second tax 
for the stock appreciation tax paid.
    (B) Example 2. The facts are the same as those in paragraph 
(b)(2)(iii)(A) of this section (the facts in Example 1), except that if 
stock was held on the December 31 last preceding the date of its sale, 
the basis of such stock for purposes of computing gain or loss under the 
net income tax is the value of the stock on such December 31. Thus, in 
Year 3, A includes only 5u (160u-155u) as income from the sale for 
purposes of the net income tax. Because the net income tax imposed upon 
the occurrence of a later event (the sale) does not impose a tax with 
respect to the income that was taxed by the stock appreciation tax, 
under paragraph (b)(2)(i)(C) of this section, the stock appreciation tax 
satisfies the realization requirement. The result would be the same if, 
instead of a basis adjustment to reflect taxation pursuant to the stock 
appreciation tax, the Country X net income tax allowed a credit (or 
other comparable relief) to take account of the stock appreciation tax. 
If a credit mechanism is used, see also paragraph (e)(4)(i) of this 
section.
    (C) Example 3. Country X imposes a tax on the realized net income of 
corporations that do business in Country

[[Page 720]]

X. Country X also imposes a branch profits tax on corporations organized 
under the law of a country other than Country X that do business in 
Country X. The branch profits tax is imposed when realized net income is 
remitted or deemed to be remitted by branches in Country X to home 
offices outside of Country X. Because the branch profits tax is imposed 
subsequent to the occurrence of events that would result in realization 
of income by corporations subject to such tax under the income tax 
provisions of the Internal Revenue Code, under paragraph (b)(2)(i)(A) of 
this section the branch profits tax satisfies the realization 
requirement.
    (D) Example 4. Country X imposes a tax on the realized net income of 
corporations that do business in Country X (the ``Country X corporate 
tax''). Country X also imposes a separate tax on shareholders of such 
corporations (the ``Country X shareholder tax''). The Country X 
shareholder tax is imposed on the sum of the actual distributions 
received during the taxable year by such a shareholder from the 
corporation's realized net income for that year (that is, income from 
past years is not taxed in a later year when it is actually distributed) 
plus the distributions deemed to be received by such a shareholder. 
Deemed distributions are defined as a shareholder's pro rata share of 
the corporation's realized net income for the taxable year, less such 
shareholder's pro rata share of the corporation's Country X corporate 
tax for that year, less actual distributions made by such corporation to 
such shareholder from such net income. A shareholder's receipt of actual 
distributions is a realization event within the meaning of paragraph 
(b)(2)(i)(A) of this section. The deemed distributions are not 
realization events, but they are described in paragraph (b)(2)(i)(C)(3) 
of this section. Accordingly, the Country X shareholder tax satisfies 
the realization requirement.
    (3) Gross receipts requirement--(i) Rule. A foreign tax satisfies 
the gross receipts requirement if it is imposed on the basis of the 
amounts described in paragraphs (b)(3)(i)(A) through (D) of this 
section.
    (A) Actual gross receipts.
    (B) In the case of either an insignificant nonrealization event 
described in the second sentence of paragraph (b)(2)(i) of this section 
or a realization event described in paragraph (b)(2)(i)(A) of this 
section that does not result in actual gross receipts, deemed gross 
receipts in an amount that is reasonably calculated to produce an amount 
that is not greater than fair market value.
    (C) Deemed gross receipts in the amount of a tax deduction that is 
recaptured by reason of a pre-realization recapture event described in 
paragraph (b)(2)(i)(B) of this section.
    (D) The amount of deemed gross receipts arising from pre-realization 
timing difference events described in paragraph (b)(2)(i)(C) of this 
section.
    (ii) Examples. The following examples illustrate the rules of 
paragraph (b)(3)(i) of this section.
    (A) Example 1: Cost-plus tax--(1) Facts. Country X imposes a ``cost-
plus tax'' on Country X corporations that serve as regional headquarters 
companies for affiliated nonresident corporations, and this tax is a 
separate levy (within the meaning of paragraph (d)(1) of this section). 
A headquarters company for purposes of this tax is a corporation that 
performs administrative, management or coordination functions solely for 
nonresident affiliated entities. Due to the difficulty of determining on 
a case-by-case basis the arm's length gross receipts that headquarters 
companies would charge affiliates for such services, gross receipts of a 
headquarters company are deemed, for purposes of this tax, to equal 110 
percent of the business expenses incurred by the headquarters company.
    (2) Analysis. Because the cost-plus tax is based on costs and not on 
actual gross receipts, the cost-plus tax does not satisfy the gross 
receipts requirement of paragraph (b)(3)(i) of this section.
    (B) Example 2: Actual gross receipts determined under appropriate 
transfer pricing methodology--(1) Facts. Country X imposes a tax on 
resident corporations that meets the attribution requirement of 
paragraph (b)(5)(ii) of this section. The Country X tax is based on 
actual gross receipts, including gross receipts recorded on the 
taxpayer's books and

[[Page 721]]

records as due from related and unrelated persons. Corporation A, a 
resident of Country X, properly determines the arm's length transfer 
price for services provided to related persons using a cost-plus 
methodology, recording on its books and records receivables for the 
arm's length amounts due from those related persons and using those 
amounts to determine the realized gross receipts included in the base of 
the Country X tax.
    (2) Analysis. Because the Country X tax is based on actual gross 
receipts, it satisfies the gross receipts requirement of paragraph 
(b)(3)(i) of this section.
    (C) Example 3: Petroleum taxed on extraction--(1) Facts. Country X 
imposes a tax that is a separate levy (within the meaning of paragraph 
(d)(1) of this section) on income from the extraction of petroleum. 
Under the terms of that tax, gross receipts from extraction income are 
deemed to equal 105 percent of the fair market value of petroleum 
extracted.
    (2) Analysis. Because it is imposed on deemed gross receipts that 
exceed the fair market value of the petroleum extracted, the tax on 
extraction income does not satisfy the gross receipts requirement of 
paragraph (b)(3)(i) of this section.
    (4) Cost recovery requirement--(i) Costs and expenses that must be 
recovered--(A) In general. A foreign tax satisfies the cost recovery 
requirement if the base of the tax is computed by reducing gross 
receipts (as described in paragraph (b)(3) of this section) to permit 
recovery of the significant costs and expenses (including capital 
expenditures) described in paragraph (b)(4)(i)(C) of this section 
attributable, under reasonable principles, to such gross receipts. A 
foreign tax need not permit recovery of significant costs and expenses, 
such as certain personal expenses, that are not attributable, under 
reasonable principles, to gross receipts included in the foreign taxable 
base. A foreign tax whose base is gross receipts, with no reduction for 
costs and expenses, satisfies the cost recovery requirement only if 
there are no significant costs and expenses attributable to the gross 
receipts included in the foreign tax base that must be recovered under 
the rules of paragraph (b)(4)(i)(C)(1) of this section. See paragraph 
(b)(4)(iv)(A) of this section (Example 1). A foreign tax that provides 
an alternative cost allowance satisfies the cost recovery requirement 
only as provided in paragraph (b)(4)(i)(B) of this section. See 
paragraph (b)(4)(i)(D) of this section for rules regarding principles 
for attributing costs and expenses to gross receipts.
    (B) Alternative cost allowances--(1) In general. Except as provided 
in paragraph (b)(4)(i)(B)(2) of this section, if foreign tax law does 
not permit recovery of one or more significant costs and expenses in 
computing the base of the foreign tax but provides an alternative cost 
allowance, the foreign tax satisfies the cost recovery requirement only 
if the alternative allowance permits recovery of an amount that by its 
terms may be greater, but can never be less, than the actual amounts of 
such significant costs and expenses (for example, under a provision 
identical to percentage depletion allowed under section 613). If foreign 
tax law provides an optional alternative cost allowance or an election 
to recover costs and expenses under an alternative method, the foreign 
tax satisfies the cost recovery requirement if the foreign tax law also 
expressly provides an option to recover actual costs and expenses. See 
Sec.  1.901-2(e)(5) for rules limiting the amount of foreign income tax 
paid to the amount due under the option that minimizes the taxpayer's 
liability for foreign income tax over time. If foreign tax law provides 
an alternative cost allowance that does not by its terms permit recovery 
of an amount equal to or greater than the actual amounts of significant 
costs and expenses, the foreign tax does not satisfy the cost recovery 
requirement, even if, in practice, the amounts recovered under the 
alternative allowance equal or exceed the amount of actual costs and 
expenses.
    (2) Small business exception. If foreign tax law provides an 
alternative method for determining the amount of costs and expenses 
allowed in computing the taxable base of small business enterprises, the 
foreign tax satisfies the cost recovery requirement if the foreign tax 
law contains reasonable limits on the maximum size of business 
enterprises to which the alternative cost allowance

[[Page 722]]

applies (for example, business enterprises having asset values or annual 
gross revenues below specified thresholds). See paragraph (b)(4)(iv)(B) 
of this section (Example 2).
    (C) Significant costs and expenses--(1) Amounts that must be 
recovered. Whether a cost or expense is significant for purposes of this 
paragraph (b)(4)(i) is determined based on whether, for all taxpayers in 
the aggregate to which the foreign tax applies, the item of cost or 
expense constitutes a significant portion of the taxpayers' total costs 
and expenses. Costs and expenses (as characterized under foreign law) 
related to capital expenditures, interest, rents, royalties, wages or 
other payments for services, and research and experimentation are always 
treated as significant costs or expenses for purposes of this paragraph 
(b)(4)(i). Significant costs and expenses (such as interest expense) are 
not considered to be recovered by reason of the time value of money 
attributable to the acceleration of a tax benefit or other economic 
benefit attributable to the timing of the recovery of other costs and 
expenses (such as the current expensing of debt-financed capital 
expenditures). Foreign tax law is considered to permit recovery of 
significant costs and expenses even if recovery of all or a portion of 
certain costs or expenses is disallowed, if such disallowance is 
consistent with any principle underlying the disallowances required 
under the Internal Revenue Code, including the principles of limiting 
base erosion or profit shifting and public policy concerns. For example, 
a foreign tax is considered to permit recovery of significant costs and 
expenses if the foreign tax law limits interest deductions based on a 
measure of taxable income (determined either before or after 
depreciation and amortization), disallows deductions in connection with 
hybrid transactions, disallows deductions attributable to gross receipts 
that in whole or in part are excluded, exempt or eliminated from taxable 
income, or disallows certain deductions based on public policy 
considerations similar to those underlying the disallowances contained 
in section 162. See paragraph (b)(4)(iv)(C) of this section (Example 3).
    (2) Amounts that need not be recovered. A foreign tax is considered 
to permit recovery of significant costs and expenses even if the foreign 
tax law does not permit recovery of any costs and expenses attributable 
to wage income or to investment income that is not derived from a trade 
or business. In addition, in determining whether a foreign tax (the 
``tested foreign tax'') meets the cost recovery requirement, it is 
immaterial whether the tested foreign tax allows a deduction for other 
taxes that would qualify as foreign income taxes (determined without 
regard to whether such other tax allows a deduction for the tested 
foreign tax). See paragraph (b)(4)(iv)(D) and (E) of this section 
(Examples 4 and 5).
    (3) Timing of recovery. A foreign tax law permits recovery of 
significant costs and expenses even if such costs and expenses are 
recovered earlier or later than they are recovered under the Internal 
Revenue Code unless the time of recovery is so much later as effectively 
to constitute a denial of such recovery. The amount of costs and 
expenses that is recovered under the foreign tax law is neither 
discounted nor augmented by taking into account the time value of money 
attributable to any acceleration or deferral of a tax benefit resulting 
from the foreign law cost recovery method compared to when tax would be 
paid under the Internal Revenue Code. Therefore, a foreign tax satisfies 
the cost recovery requirement if items deductible under the Internal 
Revenue Code are capitalized under the foreign tax law and recovered 
either immediately, on a recurring basis over time, or upon the 
occurrence of some future event (for example, upon the property becoming 
worthless or being disposed of), or if the recovery of items capitalized 
under the Internal Revenue Code occurs more or less rapidly than under 
the foreign tax law.
    (D) Attribution of costs and expenses to gross receipts. Principles 
used in the foreign tax law to attribute costs and expenses to gross 
receipts may be reasonable even if they differ from principles that 
apply under the Internal Revenue Code (for example, principles that 
apply under section 265, 465 or 861(b) of the Internal Revenue Code). 
See also

[[Page 723]]

paragraph (b)(5) of this section for additional requirements relating to 
foreign tax law rules for attributing costs and expenses to gross 
receipts.
    (ii) Consolidation of profits and losses. In determining whether a 
foreign tax satisfies the cost recovery requirement, one of the factors 
to be taken into account is whether, in computing the base of the tax, a 
loss incurred in one activity (for example, a contract area in the case 
of oil and gas exploration) in a trade or business is allowed to offset 
profit earned by the same person in another activity (for example, a 
separate contract area) in the same trade or business. If such an offset 
is allowed, it is immaterial whether the offset may be made in the 
taxable period in which the loss is incurred or only in a different 
taxable period, unless the period is such that under the circumstances 
there is effectively a denial of the ability to offset the loss against 
profit. In determining whether a foreign tax satisfies the cost recovery 
requirement, it is immaterial that no such offset is allowed if a loss 
incurred in one such activity may be applied to offset profit earned in 
that activity in a different taxable period, unless the period is such 
that under the circumstances there is effectively a denial of the 
ability to offset such loss against profit. In determining whether a 
foreign tax satisfies the cost recovery requirement, it is immaterial 
whether a person's profits and losses from one trade or business (for 
example, oil and gas extraction) are allowed to offset its profits and 
losses from another trade or business (for example, oil and gas refining 
and processing), or whether a person's business profits and losses and 
its passive investment profits and losses are allowed to offset each 
other in computing the base of the foreign tax. Moreover, it is 
immaterial whether foreign tax law permits or prohibits consolidation of 
profits and losses of related persons, unless foreign tax law requires 
separate entities to be used to carry on separate activities in the same 
trade or business. If foreign tax law requires that separate entities 
carry on such separate activities, the determination whether the cost 
recovery requirement is satisfied is made by applying the same 
considerations as if such separate activities were carried on by a 
single entity.
    (iii) Carryovers. In determining whether a foreign tax satisfies the 
cost recovery requirement, it is immaterial, except as otherwise 
provided in paragraph (b)(4)(ii) of this section, whether losses 
incurred during one taxable period may be carried over to offset profits 
incurred in different taxable periods.
    (iv) Examples. The following examples illustrate the rules of 
paragraph (b)(4) of this section.
    (A) Example 1: Tax on gross interest income of certain residents; no 
deductions allowed--(1) Facts. Country X imposes a net income tax on 
corporations resident in Country X. Country X imposes a second tax (the 
``bank tax'') of 1 percent on the gross amount of interest income 
derived by banks resident in Country X; no deductions are allowed in 
determining the base of the bank tax. Banks resident in Country X incur 
substantial costs and expenses, including interest expense, attributable 
to their interest income.
    (2) Analysis. Because the terms of the bank tax do not permit 
recovery of significant costs and expenses attributable to the gross 
receipts included in the tax base, the bank tax does not satisfy the 
cost recovery requirement of paragraph (b)(4)(i) of this section.
    (B) Example 2: Small business alternative allowance--(1) Facts. 
Country X imposes a tax on the income of corporations resident in 
Country X. Under Country X tax law, corporations are generally allowed 
to deduct actual costs and expenses attributable to the realized gross 
receipts included in the Country X tax base. However, in lieu of 
deductions for actual costs and expenses, businesses with gross revenues 
of less than the Country X currency equivalent of $500,000 are allowed a 
flat cost allowance of 50 percent of gross revenues.
    (2) Analysis. Under paragraph (b)(4)(i)(B)(2) of this section, the 
alternative cost allowance for small businesses provided under Country X 
tax law satisfies the cost recovery requirement.

[[Page 724]]

    (C) Example 3: Permissible deduction disallowance--(1) Facts. 
Country X imposes a tax on the income of corporations resident in 
Country X. Under Country X tax law, deductions for the significant costs 
and expenses attributable to the gross receipts included in the Country 
X tax base are allowed, except that deductions for interest expense 
incurred by corporations are limited to 30 percent of the corporation's 
earnings before income taxes, depreciation, and amortization, and unused 
interest expense may be carried forward for a period of 5 years. In 
addition, Country X tax law contains anti-hybrid rules that deny 
deductions for interest, royalties, rents, and services payments made by 
a Country X resident to a related entity outside Country X that is 
treated as a transparent entity in the jurisdiction in which it is 
organized but as a separate entity in the jurisdiction of the entity's 
owners (a ``reverse hybrid entity'') to the extent that the payment is 
not included in the income of the reverse hybrid entity or its owners.
    (2) Analysis. Under paragraph (b)(4)(i)(C)(1) of this section, costs 
and expenses related to interest, rents, royalties, and payments for 
services are treated as significant costs or expenses that must be 
recoverable under Country X tax law. However, because the interest 
expense limitation rule and the anti-hybrid rules in Country X tax law 
are consistent with the principles underlying the disallowances required 
under the Internal Revenue Code (namely, section 163(j) and section 
267A), the Country X tax satisfies the cost recovery requirement.
    (D) Example 4: Gross basis tax on wages--(1) Facts. A foreign 
country imposes payroll tax on resident employees at the rate of 10 
percent of the amount of gross wages; no deductions are allowed in 
computing the base of the payroll tax.
    (2) Analysis. Although the foreign tax law does not allow for the 
recovery of any costs and expenses attributable to gross receipts 
included in the taxable base, under paragraph (b)(4)(i)(C)(2) of this 
section, because the only gross receipts included in the taxable base 
are from wages, the payroll tax satisfies the cost recovery requirement.
    (E) Example 5: No deduction for another net income tax--(1) Facts. 
Each of Country X and Province Y (a political subdivision of Country X) 
imposes a tax on resident corporations, called the ``Country X income 
tax'' and the ``Province Y income tax,'' respectively. Each tax has an 
identical base, which is computed by reducing a corporation's realized 
gross receipts by deductions that, based on the laws of Country X and 
Province Y, generally permit recovery of the significant costs and 
expenses (including significant capital expenditures) that are 
attributable under reasonable principles to such gross receipts. 
However, the Country X income tax does not allow a deduction for the 
Province Y income tax for which a taxpayer is liable, nor does the 
Province Y income tax allow a deduction for the Country X income tax for 
which a taxpayer is liable.
    (2) Analysis. Under paragraph (d)(1)(i) of this section, each of the 
Country X income tax and the Province Y income tax is a separate levy. 
Without regard to whether the Province Y income tax may allow a 
deduction for the Country X income tax, and without regard to whether 
the Country X income tax may allow a deduction for the Province Y income 
tax, both taxes would qualify as net income taxes under paragraph (a)(3) 
of this section. Therefore, under paragraph (b)(4)(i)(C)(2) of this 
section the fact that neither levy's base allows a deduction for the 
other levy is immaterial, and both levies satisfy the cost recovery 
requirement.
    (5) Attribution requirement. A foreign tax satisfies the attribution 
requirement if the amount of gross receipts and costs that are included 
in the base of the foreign tax are determined based on rules described 
in paragraph (b)(5)(i) of this section (with respect to a separate levy 
imposed on nonresidents of the foreign country) or paragraph (b)(5)(ii) 
of this section (with respect to a separate levy imposed on residents of 
the foreign country).
    (i) Tax on nonresidents. The gross receipts and costs attributable 
to each of the items of income of nonresidents of a foreign country that 
is included in the base of the foreign tax must satisfy the requirements 
of paragraph (b)(5)(i)(A), (B), or (C) of this section.

[[Page 725]]

    (A) Income attribution based on activities. The gross receipts and 
costs that are included in the base of the foreign tax are limited to 
gross receipts and costs that are attributable, under reasonable 
principles, to the nonresident's activities within the foreign country 
imposing the foreign tax (including the nonresident's functions, assets, 
and risks located in the foreign country). For purposes of the preceding 
sentence, attribution of gross receipts under reasonable principles 
includes rules similar to those for determining effectively connected 
income under section 864(c) but does not include rules that take into 
account as a significant factor the mere location of customers, users, 
or any other similar destination-based criterion, or the mere location 
of persons from whom the nonresident makes purchases in the foreign 
country. In addition, for purposes of the first sentence of this 
paragraph (b)(5)(i)(A), reasonable principles do not include rules that 
deem the existence of a trade or business or permanent establishment 
based on the activities of another person (other than an agent or other 
person acting on behalf of the nonresident or a pass-through entity of 
which the nonresident is an owner), or that attribute gross receipts or 
costs to a nonresident based upon the activities of another person 
(other than an agent or other person acting on behalf of the nonresident 
or a pass-through entity of which the nonresident is an owner).
    (B) Income attribution based on source. The amount of gross income 
arising from gross receipts (other than gross receipts from sales or 
other dispositions of property) that is included in the base of the 
foreign tax on the basis of source (instead of on the basis of 
activities or the situs of property as described in paragraphs 
(b)(5)(i)(A) and (C) of this section) is limited to gross income arising 
from sources within the foreign country that imposes the tax, and the 
sourcing rules of the foreign tax law are reasonably similar to the 
sourcing rules that apply under the Internal Revenue Code. A foreign tax 
law's application of such sourcing rules need not conform in all 
respects to the application of those sourcing rules for Federal income 
tax purposes. For purposes of determining whether the sourcing rules of 
the foreign tax law are reasonably similar to the sourcing rules that 
apply under the Internal Revenue Code, the character of gross income 
arising from gross receipts is determined under the foreign tax law 
(except as provided in paragraph (b)(5)(i)(B)(3) of this section), and 
the following rules apply:
    (1) Services. Under the foreign tax law, gross income from services 
must be sourced based on where the services are performed, as determined 
under reasonable principles (which do not include determining the place 
of performance of the services based on the location of the service 
recipient).
    (2) Royalties. A foreign tax on gross income from royalties must be 
sourced based on the place of use of, or the right to use, the 
intangible property.
    (3) Sales of property. Gross income arising from gross receipts from 
sales or other dispositions of property (including copyrighted articles 
sold through an electronic medium) must be included in the foreign tax 
base on the basis of the rules in paragraph (b)(5)(i)(A) or (C) of this 
section, and not on the basis of source. In the case of sales of 
copyrighted articles (as determined under rules similar to Sec.  1.861-
18), a foreign tax satisfies the attribution requirement of paragraph 
(b)(5) of this section only if the transaction is treated as a sale of 
tangible property and not as a license of intangible property.
    (C) Attribution based on situs of property. A foreign tax on gains 
of nonresidents from the sale or disposition of property, including 
shares in a corporation or an interest in a partnership or other pass-
through entity, based on the situs of property satisfies the attribution 
requirement only as provided in this paragraph (b)(5)(i)(C). The amount 
of gross receipts from the sale or disposition of property that is 
included in the base of the foreign tax on the basis of the situs of 
real property (instead of on the basis of activities as described in 
paragraph (b)(5)(i)(A) of this section) may only include gross receipts 
that are attributable to the disposition of real property situated in 
the foreign country imposing the foreign tax (or an interest in a 
resident corporation or

[[Page 726]]

other entity that owns such real property) under rules reasonably 
similar to the rules in section 897. The amount of gross receipts from 
the sale or disposition of property other than shares in a corporation, 
including an interest in a partnership or other pass-through entity, 
that is included in the base of the foreign tax on the basis of the 
situs of property other than real property may only include gross 
receipts that are attributable to property forming part of the business 
property of a taxable presence in the foreign country imposing the 
foreign tax under rules that are reasonably similar to the rules in 
section 864(c).
    (ii) Tax on residents. The base of a foreign tax imposed on 
residents of the foreign country imposing the foreign tax may include 
all of the worldwide gross receipts of the resident. The foreign tax law 
must provide that any allocation to or from the resident of income, 
gain, deduction, or loss with respect to transactions between such 
resident and organizations, trades, or businesses owned or controlled 
directly or indirectly by the same interests (that is, any allocation 
made pursuant to the foreign country's transfer pricing rules) is 
determined under arm's length principles, without taking into account as 
a significant factor the location of customers, users, or any other 
similar destination-based criterion.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (b)(5) of this section.
    (A) Example 1--(1) Facts. Country X imposes a separate levy on 
nonresident companies that furnish, from a location outside of Country 
X, specified types of electronically supplied services to users located 
in Country X (the ``ESS tax''). The base of the ESS tax is computed by 
taking the nonresident company's overall net income related to supplying 
electronically supplied services, and deeming a portion of such net 
income to be attributable to a deemed permanent establishment of the 
nonresident company in Country X. The amount of the nonresident 
company's net income attributable to the deemed permanent establishment 
is determined on a formulary basis based on the percentage of the 
nonresident company's total users that are located in Country X.
    (2) Analysis. The taxable base of the ESS tax is not computed based 
on a nonresident company's activities located in Country X, but instead 
takes into account the location of the nonresident company's users. 
Therefore, the ESS tax does not meet the requirement in paragraph 
(b)(5)(i)(A) of this section. The ESS tax also does not meet the 
requirement in paragraph (b)(5)(i)(B) of this section because it is not 
imposed on the basis of source, and it does not meet the requirement in 
paragraph (b)(5)(i)(C) of this section because it is not imposed on the 
sale or other disposition of property.
    (B) Example 2--(1) Facts. The facts are the same as those in 
paragraph (b)(5)(iii)(A)(1) of this section (the facts in Example 1), 
except that instead of imposing the ESS tax by deeming nonresident 
companies to have a permanent establishment in Country X, Country X 
treats gross income from electronically supplied services provided to 
users located in Country X as sourced in Country X. The gross income 
sourced to Country X is reduced by costs that are reasonably attributed 
to such gross income, to arrive at the taxable base of the ESS tax. The 
amount of the nonresident's gross income and costs that are sourced to 
Country X is determined by multiplying the nonresident's total gross 
income and costs by the percentage of its total users that are located 
in Country X.
    (2) Analysis. Country X tax law's rule for sourcing electronically 
supplied services is not based on where the services are performed and 
is instead based on the location of the service recipient. Therefore, 
the ESS tax, which is imposed on the basis of source, does not meet the 
requirement in paragraph (b)(5)(i)(B) of this section. The ESS tax also 
does not meet the requirement in paragraph (b)(5)(i)(A) of this section 
because it is not imposed on the basis of a nonresident's activities 
located in Country X, and it does not meet the requirement in paragraph 
(b)(5)(i)(C) of this section because it is not imposed on the sale or 
other disposition of property.

[[Page 727]]

    (6) Surtax on net income tax. A foreign tax satisfies the net gain 
requirement in this paragraph (b) if the base of the foreign tax is the 
amount of a net income tax. For example, if a tax (surtax) is computed 
as a percentage of a separate levy that is itself a net income tax, then 
such surtax is considered to satisfy the net gain requirement.
    (c) [Reserved]
    (d) Separate levies--(1) In general. Each foreign levy must be 
analyzed separately to determine whether it is a net income tax within 
the meaning of paragraph (a)(3) of this section and whether it is a tax 
in lieu of an income tax within the meaning of Sec.  1.903-1(b)(2). 
Whether a single levy or separate levies are imposed by a foreign 
country depends on U.S. principles and not on whether foreign tax law 
imposes the levy or levies pursuant to a single or separate statutes. A 
foreign levy is a separate levy described in this paragraph (d)(1) if it 
is described in paragraph (d)(1)(i), (ii), (iii), or (iv) of this 
section. In the case of levies that apply to dual capacity taxpayers, 
see also Sec.  1.901-2A(a).
    (i) Taxing authority. A levy imposed by one taxing authority (for 
example, the national government of a foreign country) is always 
separate from a levy imposed by another taxing authority (for example, a 
political subdivision of that foreign country), even if the base of the 
levy is the same.
    (ii) Different taxable base. Where the base of a foreign levy is 
computed differently for different classes of persons subject to the 
levy, the levy is considered to impose separate levies with respect to 
each such class of persons. For example, foreign levies identical to the 
taxes imposed by sections 1, 11, 541, 871(a), 871(b), 881, 882, 3101 and 
3111 of the Internal Revenue Code are each separate levies, because the 
levies are imposed on different classes of taxpayers, and the base of 
each of those levies contains different items than the base of each of 
the others. A taxable base of a separate levy may consist of a 
particular type of income (for example, wage income, investment income, 
or income from self-employment). The taxable base of a separate levy may 
also consist of an amount unrelated to income (for example, wage expense 
or assets). A separate levy may provide that items included in the base 
of the tax are computed separately merely for purposes of a preliminary 
computation and are then combined as a single taxable base. Income 
included in the taxable base of a separate levy may also be included in 
the taxable base of another levy (which may or may not also include 
other items of income); separate levies are considered to be imposed if 
the taxable bases are not combined as a single taxable base, even if the 
taxable bases are determined using the same computational rules. For 
example, a foreign levy identical to the tax imposed by section 1 is a 
separate levy from a foreign levy identical to the tax imposed by 
section 1411, because tax is imposed under each levy on a separate 
taxable base that is not combined with the other as a single taxable 
base. Where foreign tax law imposes a levy that is the sum of two or 
more separately computed amounts of tax, and each such amount is 
computed by reference to a different base, separate levies are 
considered to be imposed. Levies are not separate merely because 
different rates apply to different classes of taxpayers that are subject 
to the same provisions in computing the base of the tax. For example, a 
foreign levy identical to the tax imposed on U.S. citizens and resident 
alien individuals by section 1 of the Internal Revenue Code is a single 
levy notwithstanding that the levy has graduated rates and applies 
different rate schedules to unmarried individuals, married individuals 
who file separate returns, and married individuals who file joint 
returns. In addition, in general, levies are not separate merely because 
some provisions determining the base of the levy apply, by their terms 
or in practice, to some, but not all, persons subject to the levy. For 
example, a foreign levy identical to the tax imposed by section 11 of 
the Internal Revenue Code is a single levy even though some provisions 
apply by their terms to some but not all corporations

[[Page 728]]

subject to the section 11 tax (for example, section 465 is by its terms 
applicable to corporations described in sections 465(a)(1)(B), but not 
to other corporations), and even though some provisions apply in 
practice to some but not all corporations subject to the section 11 tax 
(for example, section 611 does not, in practice, apply to any 
corporation that does not have a qualifying interest in the type of 
property described in section 611(a)).
    (iii) Tax imposed on nonresidents. A foreign levy imposed on 
nonresidents is always treated as a separate levy from that imposed on 
residents, even if the base of the tax as applied to residents and 
nonresidents is the same, and even if the levies are treated as a single 
levy under foreign tax law. In addition, a withholding tax (as defined 
in section 901(k)(1)(B)) that is imposed on gross income of nonresidents 
is treated as a separate levy as to each separate class of income 
described in section 61 (for example, interest, dividends, rents, or 
royalties) subject to the withholding tax. If two or more subsets of a 
separate class of income are subject to a withholding tax based on 
different income attribution rules (for example, if technical services 
are subject to tax based on the residence of the payor and other 
services are subject to tax based on where the services are performed), 
separate levies are considered to be imposed with respect to each subset 
of that separate class of income.
    (iv) Foreign levy modified by an applicable income tax treaty. A 
foreign levy that is limited in its application by, or is otherwise 
modified by, an income tax treaty to which the foreign country imposing 
the levy is a party is a separate levy from the levy imposed under the 
domestic law (without regard to the treaty) of the foreign country, and 
is also a separate levy from the foreign levy as modified by a different 
income tax treaty to which the foreign country imposing the levy is a 
party, even if the two treaties modify the foreign levy in exactly the 
same manner. Accordingly, a foreign levy paid by taxpayers that qualify 
for and claim benefits under an income tax treaty is a separate levy 
from the levy as applied to taxpayers that are ineligible for, or that 
do not claim, benefits under that treaty, even if the two foreign levies 
would apply in the same manner to a particular taxpayer, and regardless 
of whether the unmodified foreign levy is a foreign income tax within 
the meaning of paragraph (a)(1)(ii) of this section.
    (2) Contractual modifications. Notwithstanding paragraph (d)(1) of 
this section, if foreign tax law imposing a levy is modified for one or 
more persons subject to the levy by a contract entered into by such 
person or persons and the foreign country, then the foreign tax law is 
considered for purposes of sections 901 and 903 to impose a separate 
levy for all persons to whom such contractual modification of the levy 
applies, as contrasted to the levy as applied to all persons to whom 
such contractual modification does not apply.
    (3) Examples. The following examples illustrate the rules of 
paragraph (d)(1) of this section.
    (i) Example 1: Separate taxable bases--(A) Facts. A foreign statute 
imposes a levy on corporations equal to the sum of 15% of the 
corporation's realized net income plus 3% of its net worth.
    (B) Analysis. As the levy is the sum of two separately computed 
amounts, each of which is computed by reference to a separate base, 
under paragraph (d)(1)(ii) of this section each of the portion of the 
levy based on income and the portion of the levy based on net worth is 
considered, for purposes of sections 901 and 903, to be a separate levy.
    (ii) Example 2: Separate taxable bases--(A) Facts. A foreign statute 
imposes a levy on nonresident alien individuals analogous to the taxes 
imposed by section 871 of the Internal Revenue Code.
    (B) Analysis. As the levy is imposed on separately computed amounts, 
each of which is computed by reference to a separate taxable base and 
portions of which comprise withholding tax on gross income of 
nonresidents, under paragraphs (d)(1)(ii) and (iii) of this section, 
each of the portions of the foreign levy imposed on each separate class 
of gross income analogous to the tax imposed by section 871(a) and the 
portion of the foreign levy analogous to the tax imposed by sections 
871(b) and 1 is considered, for purposes of sections 901 and 903, to be 
a separate levy.

[[Page 729]]

    (iii) Example 3: Separate taxable bases--(A) Facts. (1) A single 
foreign statute or separate foreign statutes impose a foreign levy that 
is the sum of the products of specified rates applied to specified 
bases, as follows:

                 Table 1 to paragraph (d)(3)(iii)(A)(1)
------------------------------------------------------------------------
                                                                 Rate
                            Base                               (percent)
------------------------------------------------------------------------
Net income from mining......................................          45
Net income from manufacturing...............................          50
Net income from technical services..........................          50
Net income from other services..............................          45
Net income from investments.................................          15
All other net income........................................          50
------------------------------------------------------------------------

    (2) In computing each such base, deductible expenditures are 
allocated to the type of income they generate. If allocated deductible 
expenditures exceed the gross amount of a specified type of income, the 
excess may not be applied against income of a different specified type.
    (B) Analysis. The levy is the sum of several separately computed 
amounts, each of which is computed by reference to a separate base. 
Accordingly, under paragraph (d)(1)(ii) of this section, each of the 
levies on mining net income, manufacturing net income, technical 
services net income, other services net income, investment net income 
and other net income is considered, for purposes of sections 901 and 
903, to be a separate levy.
    (iv) Example 4: Combined taxable base after preliminary separate 
computation--(A) Facts. The facts are the same as those in paragraph 
(d)(3)(iii)(A) of this section (the facts in Example 3), except that 
excess deductible expenditures allocated to one type of income are 
applied against other types of income to which the same rate applies.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the levies 
on mining net income and other services net income together are 
considered, for purposes of sections 901 and 903, to be a single levy 
since, despite a separate preliminary computation of the bases, by 
reason of the permitted application of excess allocated deductible 
expenditures the bases are not separately computed. For the same reason, 
the levies on manufacturing net income, technical services net income 
and other net income together are considered, for purposes of sections 
901 and 903, to be a single levy. The levy on investment net income is 
considered, for purposes of sections 901 and 903, to be a separate levy. 
These results are not dependent on whether the application of excess 
allocated deductible expenditures to a different type of income is 
permitted in the same taxable period in which the expenditures are taken 
into account for purposes of the preliminary computation, or only in a 
different (for example, later) taxable period.
    (v) Example 5: Combined taxable base with income subject to 
different rates--(A) Facts. The facts are the same as those in paragraph 
(d)(3)(iii)(A) of this section (the facts in Example 3), except that 
excess deductible expenditures allocated to any type of income other 
than investment income are applied against the other types of income 
(including investment income) according to a specified set of priorities 
of application. Excess deductible expenditures allocated to investment 
income are not applied against any other type of income.
    (B) Analysis. For the same reasons as those set forth in paragraph 
(d)(3)(iv)(B) of this section (the analysis in Example 4), all of the 
levies are together considered, for purposes of sections 901 and 903, to 
be a single levy.
    (vi) Example 6: Minimum Tax--(A) Facts. Country X imposes a net 
income tax (``Income Tax'') and a minimum tax (``Minimum Tax'') on its 
residents. Under Country X tax law, alternative minimum taxable income 
for purposes of the Minimum Tax equals the taxable income under the 
Income Tax increased by certain disallowed deductions. The Minimum Tax 
equals the excess, if any, of the alternative minimum taxable income 
times the Minimum Tax rate over the amount of the Income Tax.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the 
Minimum Tax is a separate levy from the Income Tax, because the taxable 
base of each levy is separately computed and not combined as a single 
taxable base. The result would be the same if under Country X tax law 
the Minimum Tax equaled the alternative minimum taxable income times the 
Minimum Tax rate, and residents of Country X were

[[Page 730]]

required to pay the greater of the Income Tax or the Minimum Tax (rather 
than the Income Tax plus the excess, if any, of the Minimum Tax over the 
Income Tax).
    (vii) Example 7: Diverted Profits Tax--(A) Facts. Country X imposes 
a 20% net income tax (``Income Tax'') and a 25% ``Diverted Profits Tax'' 
on nonresident corporations. Under Country X tax law, taxable income 
under the Diverted Profits Tax is determined first by attributing gross 
receipts of the nonresident corporation to a hypothetical permanent 
establishment in Country X. Country X applies the same computational 
rules that apply under the Income Tax to determine the taxable income 
attributable to a hypothetical permanent establishment under the 
Diverted Profits Tax.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the 
Diverted Profits Tax is a separate levy from the Income Tax, because the 
taxable income under the Diverted Profits Tax is not combined with the 
taxable income under the Income Tax as a single taxable base.
    (viii) Example 8: Modified Income Tax--(A) Facts. Country X imposes 
a net income tax (``Income Tax'') on nonresident corporations that carry 
on a trade or business in Country X through a permanent establishment. 
Under Country X tax law, the taxable base of the Income Tax as initially 
enacted is determined by attributing profits of the nonresident 
corporation to its permanent establishment in Country X based upon rules 
similar to Articles 5 and 7 of the 2016 U.S. Model Income Tax 
Convention. However, Country X later amends the Income Tax to provide 
that nonresident corporations that are engaged in certain digital 
transactions in Country X and earning revenues above certain thresholds 
are deemed to have a permanent establishment; under the Income Tax as 
originally enacted, such activities would not have created a permanent 
establishment in Country X.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the Income 
Tax as applied to nonresident corporations engaged in digital 
transactions and deemed to have a permanent establishment under the 
modified Income Tax is not a separate levy from the Income Tax as 
applied to the same or other nonresident corporations that would have 
permanent establishments under the Income Tax as originally enacted, 
because income attributable to both actual and deemed permanent 
establishments is combined as a single taxable base.
    (ix) Example 9: Disallowed deductions--(A) Facts. Country X imposes 
a net income tax (``Income Tax'') on resident corporations. In 
determining the taxable base for the Income Tax, Country X tax law has a 
cap on allowed interest deductions for companies engaged in the 
extraction, production, or refinement of oil or natural gas.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the Income 
Tax as applied to corporations engaged in the extraction, production, or 
refinement of oil or natural gas is not a separate levy from the Income 
Tax as applied to other corporations subject to the levy. The Income Tax 
is a single levy even though the cap on allowed interest expense 
deductions applies by its terms to some, but not all, corporations 
subject to the Income Tax.
    (x) Example 10: Different taxable base for class of taxpayers--(A) 
Facts. Country X imposes a net income tax (``Income Tax'') and an oil 
tax. The oil tax applies only to resident corporations engaged in the 
extraction, production, or refinement of oil, and resident corporations 
subject to the oil tax are not subject to the Income Tax. The taxable 
base under the oil tax is the taxable income under the Income Tax 
increased by disallowed interest expense.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the oil 
tax is a separate levy from the Income Tax, because the taxable income 
under the oil tax is not combined with the taxable income under the 
Income Tax as a single taxable base. The levies are imposed on different 
classes of taxpayers (resident taxpayers engaged in the extraction, 
production, or refinement of oil, in the case of the oil tax, and all 
other resident corporations, in the case of the Income Tax), and the 
base of each of those levies contains different items.

[[Page 731]]

    (e) Amount of foreign income tax that is creditable--(1) In general. 
Credit is allowed under section 901 for the amount of foreign income tax 
that is paid by the taxpayer. Under paragraph (g) of this section, the 
term ``paid'' means ``paid'' or ``accrued,'' depending on the taxpayer's 
method of accounting for such taxes. The amount of foreign income tax 
paid by the taxpayer is determined separately for each taxpayer under 
the rules in this paragraph (e).
    (2) Refunds and credits--(i) Refundable amounts. An amount remitted 
to a foreign country is not an amount of foreign income tax paid to the 
extent that it is reasonably certain that the amount will be refunded, 
rebated, abated, or forgiven. It is reasonably certain that an amount 
will be refunded, rebated, abated, or forgiven to the extent the amount 
exceeds a reasonable approximation of final foreign income tax liability 
to the foreign country. See section 905(c) and Sec.  1.905-3 for the 
required redeterminations if amounts claimed as a credit (on either the 
cash or accrual basis) exceed the amount of the final foreign income tax 
liability.
    (ii) Credits. Except as provided in paragraph (e)(2)(iii) of this 
section, an amount of foreign income tax liability is not an amount of 
foreign income tax paid to the extent the foreign income tax liability 
is reduced, satisfied, or otherwise offset by a tax credit, including a 
tax credit that under the foreign tax law is payable in cash only to the 
extent it exceeds the taxpayer's liability for foreign income tax or a 
tax credit acquired from another taxpayer.
    (iii) Exception for overpayments and other fully refundable credits. 
An amount of foreign income tax paid is not reduced (or treated as 
constructively refunded) solely by reason of the fact that a credit is 
allowed (or may be allowed) for the amount paid to reduce the amount of 
a different separate levy owed by the taxpayer. See paragraphs 
(e)(2)(ii) and (e)(4) of this section. However, under paragraph 
(e)(2)(i) of this section (and taking into account any redetermination 
required under section 905(c) and Sec.  1.905-3), an amount remitted 
with respect to a separate levy for a foreign taxable period that 
constitutes an overpayment of the taxpayer's final liability for that 
levy for that period, and that is refundable in cash at the taxpayer's 
option, is not an amount of tax paid. Therefore, if such an overpayment 
of one tax is applied as a credit against a different foreign income tax 
liability of the taxpayer for the same or a different taxable period, 
the credited amount of the overpayment may qualify as an amount paid of 
that different foreign income tax, if the credited amount does not 
exceed a reasonable approximation of the taxpayer's final foreign income 
tax liability for the taxable period to which the overpayment is 
applied. Similarly, if under the foreign tax law, the full amount of a 
tax credit is payable in cash at the taxpayer's option, the taxpayer's 
choice to apply all or a portion of the tax credit in satisfaction of a 
foreign income tax liability of the taxpayer is treated as a 
constructive payment of cash to the taxpayer in the amount so applied, 
followed by a constructive payment of the foreign income tax liability 
against which the credit is applied. An overpayment or other tax credit 
that under the foreign tax law is otherwise fully payable in cash at the 
taxpayer's option and that is applied in part in satisfaction of a 
foreign income tax liability is treated as an amount of foreign income 
tax paid notwithstanding that a portion of the amount otherwise payable 
in cash to the taxpayer is subject to a lien or otherwise seized in 
order to satisfy a different, pre-existing liability of the taxpayer to 
the foreign government or to a third party.
    (iv) Examples. The following examples illustrate the rules of 
paragraph (e)(2) of this section.
    (A) Example 1. The domestic law of Country X imposes a 25 percent 
tax described in Sec.  1.903-1(b) on the gross amount of interest from 
sources in Country X that is received by a nonresident of Country X. 
Country X imposes the tax on the nonresident recipient and requires any 
resident of Country X that pays such interest to a nonresident to 
withhold and pay over to Country X 25 percent of such interest, which is 
applied to offset the recipient's liability for the 25 percent tax. A 
tax treaty between the United States and Country X modifies domestic law

[[Page 732]]

of Country X and provides that Country X may not tax interest received 
by a resident of the United States from a resident of Country X at a 
rate in excess of 10 percent of the gross amount of such interest. A 
resident of the United States may claim the benefit of the treaty only 
by applying for a refund of the excess withheld amount (15 percent of 
the gross amount of interest income) after the end of the taxable year. 
A, a resident of the United States, receives a gross amount of 100u 
(units of Country X currency) of interest income from a resident of 
Country X from sources in Country X in Year 1, from which 25u of Country 
X tax is withheld. A files a timely claim for refund of the 15u excess 
withheld amount. 15u of the amount withheld (25u - 10u) is reasonably 
certain to be refunded; therefore, under paragraph (e)(2)(i) of this 
section 15u is not considered an amount of foreign income tax paid to 
Country X.
    (B) Example 2. A's initial foreign income tax liability under 
Country X tax law is 100u (units of Country X currency). However, under 
Country X tax law A's initial income tax liability is reduced in order 
to compute A's final tax liability by an investment credit of 15u and a 
credit for charitable contributions of 5u. Under paragraph (e)(2)(ii) of 
this section, the amount of foreign income tax paid by A is 80u.
    (C) Example 3. A computes foreign income tax liability in Country X 
for Year 1 of 100u (units of Country X currency), files a tax return on 
that basis, and remits 100u of tax. The day after A files that return, A 
files a claim for refund of 90u. The difference between the 100u of 
liability reflected in A's original return and the 10u of liability 
reflected in A's refund claim depends on whether a particular 
expenditure made by A is nondeductible or deductible, respectively. 
Based on an analysis of the Country X tax law, A's Country X tax 
advisors have advised A that it is not clear whether or not that 
expenditure is deductible. In view of the uncertainty as to the proper 
treatment of the item in question under Country X tax law, no portion of 
the 100u paid by A is reasonably certain to be refunded. If A receives a 
refund, A must treat the refund as required by section 905(c) of the 
Internal Revenue Code.
    (D) Example 4. A levy of Country X, which qualifies as a foreign 
income tax within the meaning of paragraph (a)(1)(ii) of this section, 
provides that each person who makes payment to Country X pursuant to the 
levy will receive a bond to be issued by Country X with an amount 
payable at maturity equal to 10 percent of the amount paid pursuant to 
the levy. A remits 38,000u (units of Country X currency) to Country X 
and is entitled to receive a bond with an amount payable at maturity of 
3,800u. It is reasonably certain that a refund in the form of property 
(the bond) will be made. The amount of that refund is equal to the fair 
market value of the bond. Therefore, only the portion of the 38,000u 
payment in excess of the fair market value of the bond is an amount of 
foreign income tax paid.
    (3) Subsidies--(i) General rule. An amount of foreign income tax is 
not an amount of foreign income tax paid by a taxpayer to a foreign 
country to the extent that--
    (A) The amount is used, directly or indirectly, by the foreign 
country imposing the tax to provide a subsidy by any means (including, 
but not limited to, a rebate, a refund, a credit, a deduction, a 
payment, a discharge of an obligation, or any other method) to the 
taxpayer, to a related person (within the meaning of section 482), to 
any party to the transaction, or to any party to a related transaction; 
and
    (B) The subsidy is determined, directly or indirectly, by reference 
to the amount of the tax or by reference to the base used to compute the 
amount of the tax.
    (ii) Subsidy. The term ``subsidy'' includes any benefit conferred, 
directly or indirectly, by a foreign country to one of the parties 
enumerated in paragraph (e)(3)(i)(A) of this section. Substance and not 
form shall govern in determining whether a subsidy exists. The fact that 
the U.S. taxpayer may derive no demonstrable benefit from the subsidy is 
irrelevant in determining whether a subsidy exists.
    (iii) Official exchange rate. A subsidy described in paragraph 
(e)(3)(i)(B) of this section does not include the actual use of an 
official foreign government

[[Page 733]]

exchange rate converting foreign currency into dollars where a free 
exchange rate also exists if--
    (A) The economic benefit represented by the use of the official 
exchange rate is not targeted to or tied to transactions that give rise 
to a claim for a foreign tax credit;
    (B) The economic benefit of the official exchange rate applies to a 
broad range of international transactions, in all cases based on the 
total payment to be made without regard to whether the payment is a 
return of principal, gross income, or net income, and without regard to 
whether it is subject to tax; and
    (C) Any reduction in the overall cost of the transaction is merely 
coincidental to the broad structure and operation of the official 
exchange rate.
    (iv) Examples. The following examples illustrate the rules of 
paragraph (e)(3) of this section.
    (A) Example 1--(1) Facts. Country X imposes a 30 percent tax on 
nonresident lenders with respect to interest which the nonresident 
lenders receive from borrowers who are residents of Country X, and it is 
established that this tax is a tax in lieu of an income tax within the 
meaning of Sec.  1.903-1(b). Country X provides the nonresident lenders 
with receipts upon their payment of the 30 percent tax. Country X remits 
to resident borrowers an incentive payment for engaging in foreign 
loans, which payment is an amount equal to 20 percent of the interest 
paid to nonresident lenders.
    (2) Analysis. Because the incentive payment is based on the interest 
paid, it is determined by reference to the base used to compute the tax 
that is imposed on the nonresident lender. The incentive payment is a 
subsidy under paragraph (e)(3)(i) of this section since it is provided 
to a party (the borrower) to the transaction and is based on the amount 
of tax that is imposed on the lender with respect to the transaction. 
Therefore, two-thirds (20 percent/30 percent) of the amount withheld by 
the resident borrower from interest payments to the nonresident lender 
is not an amount of foreign income tax paid.
    (B) Example 2--(1) Facts. A U.S. bank lends money to a development 
bank in Country X. The development bank relends the money to companies 
resident in Country X. A withholding tax is imposed by Country X on the 
U.S. bank with respect to the interest that the development bank pays to 
the U.S. bank, and appropriate receipts are provided. On the date that 
the tax is withheld, fifty percent of the tax is credited by Country X 
to an account of the development bank. Country X requires the 
development bank to transfer the amount credited to the borrowing 
companies.
    (2) Analysis. The amount successively credited to the account of the 
development bank and then to the account of the borrowing companies is 
determined by reference to the amount of the tax and the tax base. Since 
the amount credited to the borrowing companies is a subsidy provided to 
a party (the borrowing companies) to a related transaction and is based 
on the amount of tax and the tax base, under paragraph (e)(3)(i) of this 
section it is not an amount of foreign income tax paid.
    (C) Example 3--(1) Facts. A U.S. bank lends dollars to a Country X 
borrower. Country X imposes a withholding tax on the lender with respect 
to the interest. The tax is to be paid in Country X currency, although 
the interest is payable in dollars. Country X has a dual exchange rate 
system, comprised of a controlled official exchange rate and a free 
exchange rate. Priority transactions such as exports of merchandise, 
imports of merchandise, and payments of principal and interest on 
foreign currency loans payable abroad to foreign lenders are governed by 
the official exchange rate which yields more dollars per unit of Country 
X currency than the free exchange rate. The Country X borrower remits 
the net amount of dollar interest due to the U.S. bank (interest due 
less withholding tax), pays the tax withheld in Country X currency to 
the Country X government, and provides to the U.S. bank a receipt for 
payment of the Country X taxes.
    (2) Analysis. Under paragraph (e)(3)(iii) of this section, the use 
of the official exchange rate by the U.S. bank to determine foreign 
taxes with respect to interest is not a subsidy described in paragraph 
(e)(3)(i)(B) of this section. The official exchange rate is not targeted 
to or tied to transactions that

[[Page 734]]

give rise to a claim for a foreign tax credit. The use of the official 
exchange rate applies to the interest paid and to the principal paid. 
Any benefit derived by the U.S. bank through the use of the official 
exchange rate is merely coincidental to the broad structure and 
operation of the official exchange rate.
    (D) Example 4--(1) Facts. B, a U.S. corporation, is engaged in the 
production of oil and gas in Country X pursuant to a production sharing 
agreement among B, Country X, and the state petroleum authority of 
Country X. The agreement is approved and enacted into law by the 
Legislature of Country X. Both B and the petroleum authority are subject 
to the Country X income tax. Each entity files an annual income tax 
return and pays, to the tax authority of Country X, the amount of income 
tax due on its annual income. B is a dual capacity taxpayer as defined 
in Sec.  1.901-2(a)(2)(ii)(A). Country X has agreed to return to the 
petroleum authority one-half of the income taxes paid by B by allowing 
it a credit in calculating its own tax liability to Country X.
    (2) Analysis. The petroleum authority is a party to a transaction 
with B and the amount returned by Country X to the petroleum authority 
is determined by reference to the amount of the tax imposed on B. 
Therefore, under paragraph (e)(3)(i) of this section the amount returned 
is a subsidy, and one-half of the tax imposed on B is not an amount of 
foreign income tax paid.
    (E) Example 5--(1) Facts. The facts are the same as those in 
paragraph (e)(3)(iv)(D)(1) of this section (the facts in Example 4), 
except that the state petroleum authority of Country X does not receive 
amounts from Country X related to tax paid by B. Instead, the authority 
of Country X receives a general appropriation from Country X which is 
not calculated with reference to the amount of tax paid by B.
    (2) Analysis. Because the general appropriation is not calculated 
with reference to the amount of tax paid by B, it is not a subsidy 
described in paragraph (e)(3)(i) of this section.
    (4) Multiple levies--(i) In general. If, under foreign law, a 
taxpayer's tentative liability for one levy (the ``reduced levy'') is or 
can be reduced by the amount of the taxpayer's liability for a different 
levy (the ``applied levy''), then the amount considered paid by the 
taxpayer to the foreign country pursuant to the applied levy is an 
amount equal to its entire liability for that applied levy (which is not 
considered to be reduced by the amount applied against the reduced 
levy), and the remainder of the total amount paid, if any, is considered 
paid pursuant to the reduced levy. See also paragraphs (e)(2)(ii) and 
(iii) of this section.
    (ii) Examples. The following examples illustrate the rules of 
paragraphs (e)(2)(ii) and (iii) and (e)(4)(i) of this section.
    (A) Example 1: Tax reduced by credits--(1) Facts. A's tentative 
liability for foreign income tax imposed by Country X is 100u (units of 
Country X currency). However, under Country X tax law, in determining 
A's final foreign income tax liability, its tentative liability is 
reduced by a 15u credit for a separate Country X levy that does not 
qualify as a foreign income tax and that A accrued and paid on its gross 
services income and is also reduced by a 5u credit for charitable 
contributions. Under Country X tax law, the amount of the charitable 
contributions credit is refundable in cash to the extent the credit 
exceeds the taxpayer's Country X income tax liability after applying the 
credit for the tax on gross services income. A timely remits the 80u due 
to Country X.
    (2) Analysis. Under paragraphs (e)(2)(ii) and (e)(4) of this 
section, the amount of Country X income tax paid by A is 80u (100u 
tentative liability - 20u tax credits), and the amount of Country X tax 
on gross services income paid by A is 15u.
    (B) Example 2: Tax paid by credit for overpayment--(1) Facts. The 
facts are the same as those in paragraph (e)(4)(ii)(A)(1) of this 
section (the facts in Example 1), except that A's final Country X income 
tax liability of 80u is satisfied by applying a credit for an otherwise 
refundable 60u overpayment from the previous taxable year of A's 
liability for a separate levy imposed by Country X that is also a 
foreign income tax and remitting the balance due of 20u.

[[Page 735]]

    (2) Analysis. The result is the same as in paragraph 
(e)(4)(ii)(A)(2) of this section (the analysis in Example 1). Under 
paragraph (e)(2)(iii) of this section, the portion of A's Country X 
income tax liability that was satisfied by applying the 60u overpayment 
of A's different foreign income tax liability for the previous taxable 
year qualifies as an amount of Country X income tax paid, because that 
refundable overpayment exceeded (and so is not treated as a payment of) 
A's different foreign income tax liability for the previous taxable 
year.
    (5) Noncompulsory amounts--(i) In general. An amount remitted to a 
foreign country (a ``foreign payment'') is not a compulsory payment, and 
thus is not an amount of foreign income tax paid, to the extent that the 
foreign payment exceeds the amount of liability for foreign income tax 
under the foreign tax law (as defined in paragraph (g) of this section). 
A foreign payment does not exceed the amount of such liability if the 
foreign payment is determined by the taxpayer in a manner that is 
consistent with a reasonable interpretation and application of the 
substantive and procedural provisions of foreign tax law (including 
applicable tax treaties) in such a way as to reduce, over time, the 
taxpayer's reasonably expected liability under foreign tax law for 
foreign income tax, and if the taxpayer exhausts all effective and 
practical remedies, including invocation of competent authority 
procedures available under applicable tax treaties, to reduce, over 
time, the taxpayer's liability for foreign income tax (including 
liability pursuant to a foreign tax audit adjustment). See paragraphs 
(e)(5)(ii) through (v) of this section. Whether a taxpayer has satisfied 
its obligation to minimize the aggregate amount of its liability for 
foreign income taxes over time is determined without regard to the 
present value of a deferred tax liability or other time value of money 
considerations. However, a taxpayer is not required to reduce its 
foreign income tax liability to the extent the reasonably expected, 
arm's length costs of reducing the liability would exceed the amount by 
which the liability could be reduced. For this purpose, such costs may 
include an additional liability for a different foreign tax (but not 
U.S. taxes) that is not a foreign income tax only to the extent the 
amount of the additional liability is determined in a manner consistent 
with the rules of this paragraph (e)(5). A taxpayer is not required to 
alter its form of doing business, its business conduct, or the form of 
any business transaction in order to reduce its liability under foreign 
law for foreign income tax.
    (ii) Reasonable application of foreign tax law. An interpretation or 
application of foreign tax law is not reasonable if there is actual 
notice or constructive notice (for example, a published court decision) 
to the taxpayer that the interpretation or application is likely to be 
erroneous. In interpreting foreign tax law, a taxpayer may generally 
rely on advice obtained in good faith from competent foreign tax 
advisors to whom the taxpayer has disclosed the relevant facts. Except 
as provided in paragraphs (e)(5)(i) and (e)(5)(iv) of this section, 
voluntarily forgoing a tax benefit to which a taxpayer is entitled under 
the foreign tax law results in a foreign payment in excess of the 
taxpayer's liability for foreign income tax.
    (iii) Effect of foreign tax law elections--(A) In general. Where 
foreign tax law includes options or elections whereby a taxpayer's 
foreign income tax liability may be shifted, in whole or part, to a 
different year or years, the taxpayer's use or failure to use such 
options or elections does not result in a foreign payment in excess of 
the taxpayer's liability for foreign income tax. Except as provided in 
paragraph (e)(5)(iii)(B) of this section, where foreign tax law provides 
a taxpayer with options or elections in computing its liability for 
foreign income tax whereby a taxpayer's foreign income tax liability may 
be permanently decreased in the aggregate over time, the taxpayer's 
failure to use such options or elections results in a foreign payment in 
excess of the taxpayer's liability for foreign income tax.
    (B) Exception for certain options or elections--(1) Entity 
classification elections. If foreign tax law provides an option or 
election to treat an entity as fiscally transparent or non-fiscally

[[Page 736]]

transparent, a taxpayer's decision to use or not use such option or 
election is not considered to increase the taxpayer's liability for 
foreign income tax over time for purposes of this paragraph (e)(5).
    (2) Foreign consolidation, group relief, or other loss sharing 
regime. If foreign tax law provides an option or election for one 
foreign entity to join in the filing of a consolidated return with 
another foreign entity, or to surrender its loss in order to offset the 
income of another foreign entity pursuant to a foreign group relief or 
other loss-sharing regime, a taxpayer's decision whether to file a 
consolidated return, whether to surrender a loss, or whether to use a 
surrendered loss, is not considered to increase the taxpayer's liability 
for foreign income tax over time for purposes of this paragraph (e)(5).
    (C) Alternative creditable levies. If under foreign tax law a 
taxpayer has the option to determine its foreign income tax liability 
under only one of multiple separate levies, each of which qualifies as a 
foreign income tax, then the amount of foreign income tax paid equals 
the smallest liability of the amounts that would be due under each of 
the alternative levies, regardless of which levy the taxpayer uses to 
determine its foreign income tax liability.
    (iv) Exception for increase in liability in connection with anti-
hybrid rules--(A) In general. If a taxpayer (the ``first taxpayer'') 
that makes a payment to another taxpayer (the ``second taxpayer'') is 
permitted to increase the first taxpayer's liability for foreign income 
tax (for example, by waiving an otherwise allowable deduction), and 
doing so results in a greater decrease in the amount of liability for 
foreign income tax of the second taxpayer by reason of the deactivation 
of a hybrid mismatch rule that would otherwise apply to the second 
taxpayer, then the increase in the first taxpayer's liability is not 
considered to result in a foreign payment in excess of the first 
taxpayer's liability for foreign income tax for purposes of this 
paragraph (e)(5).
    (B) Definition of hybrid mismatch rule. The term hybrid mismatch 
rule means foreign tax law rules substantially similar to sections 
245A(e) and 267A and includes rules the purpose of which is to eliminate 
the deduction/no-inclusion outcome of hybrid and branch mismatch 
arrangements. Examples of such rules include rules based on, or 
substantially similar to, the recommendations contained in OECD/G-20, 
Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 2015 
Final Report (October 2015), and OECD/G-20, Neutralising the Effects of 
Branch Mismatch Arrangements, Action 2: Inclusive Framework on BEPS 
(July 2017).
    (v) Exhaustion of remedies. In determining whether a taxpayer has 
exhausted all effective and practical remedies, a remedy is effective 
and practical only if the cost of pursuing it (including the reasonably 
expected risk of incurring an offsetting or additional foreign income 
tax or other tax liability) is reasonable considering the amount at 
issue and the likelihood of success. An available remedy is considered 
effective and practical if an economically rational taxpayer would 
pursue it whether or not a compulsory payment of the amount at issue 
would be eligible for a U.S. foreign tax credit. A settlement by a 
taxpayer of two or more issues will be evaluated on an overall basis, 
not on an issue-by-issue basis, in determining whether an amount is a 
compulsory payment.
    (vi) Examples. The following examples illustrate the rules of 
paragraph (e)(5) of this section.
    (A) Example 1. A, a corporation organized and doing business solely 
in the United States, owns all of the stock of B, a corporation 
organized in Country X. In Year 1, A buys merchandise from unrelated 
persons for $1,000,000, and shortly thereafter resells that merchandise 
to B for $600,000. Later in Year 1, B resells the merchandise to 
unrelated persons for $1,200,000. Under the Country X income tax, which 
is a net income tax within the meaning of paragraph (a)(3) of this 
section, all corporations organized in Country X are subject to a tax 
equal to 3 percent of their net income. In computing its Year 1 Country 
X income tax liability, B reports $600,000 ($1,200,000 - $600,000) of 
profit from the purchase and resale of merchandise. The Country X tax 
law requires that transactions between related persons be reported at 
arm's

[[Page 737]]

length prices, and a reasonable interpretation of this requirement, as 
it has been applied in Country X, would consider B's arm's length 
purchase price of the merchandise purchased from A to be $1,050,000. 
When it computes its Country X tax liability B is aware that $600,000 is 
not an arm's length price (by Country X standards). B's knowing use of a 
non-arm's length price (by Country X standards) of $600,000, instead of 
a price of $1,050,000 (an arm's length price under Country X's law), is 
not consistent with a reasonable interpretation and application of 
Country X tax law, determined in such a way as to reduce over time B's 
reasonably expected liability for Country X income tax. Accordingly, 
$13,500 (3 percent of $450,000 ($1,050,000 - $600,000)), the amount of 
Country X income tax remitted by B to Country X that is attributable to 
the purchase of the merchandise from B's parent at less than an arm's 
length price, is in excess of the amount of B's liability for Country X 
income tax, and thus is not an amount of foreign income tax paid.
    (B) Example 2. A, a corporation organized and doing business solely 
in the United States, owns all of the stock of B, a corporation 
organized in Country X. Country X has in force an income tax treaty with 
the United States. The tax treaty provides that the profits of related 
persons shall be determined as if the persons were not related. A and B 
deal extensively with each other. A and B, with respect to a series of 
transactions involving both of them, treat A as having $300,000 of 
income and B as having $700,000 of income for purposes of A's United 
States income tax and B's Country X income tax, respectively. B has no 
actual or constructive notice that its treatment of these transactions 
under Country X tax law is likely to be erroneous. Subsequently, the 
Internal Revenue Service reallocates $200,000 of this income from B to A 
under the authority of section 482 and the tax treaty. This reallocation 
constitutes actual notice to A and constructive notice to B that B's 
interpretation and application of Country X's tax law and the tax treaty 
is likely to be erroneous. B does not exhaust all effective and 
practical remedies to obtain a refund of the amount remitted by B to 
Country X that is attributable to the reallocated $200,000 of income. 
Under paragraph (e)(5)(i) of this section, this amount is in excess of 
the amount of B's liability for Country X income tax and thus is not an 
amount of foreign income tax paid.
    (C) Example 3. The facts are the same as those in paragraph 
(e)(5)(vi)(B) of this section (the facts in Example 2), except that B 
files a claim for refund (an administrative proceeding) of Country X tax 
and A or B invokes the competent authority procedures of the tax treaty, 
the cost of which is reasonable in view of the amount at issue and the 
likelihood of success. Nevertheless, B does not obtain any refund of 
Country X income tax. The cost of pursuing any judicial remedy in 
Country X would be unreasonable in light of the amount at issue and the 
likelihood of B's success, and B does not pursue any such remedy. Under 
paragraph (e)(5)(i) of this section, the entire amount paid by B to 
Country X is a compulsory payment and thus is an amount of foreign 
income tax paid by B.
    (D) Example 4. The facts are the same as those in paragraph 
(e)(5)(vi)(B) of this section (the facts in Example 2), except that, 
when the Internal Revenue Service makes the reallocation, the Country X 
statute of limitations on refunds has expired, and neither the internal 
law of Country X nor the tax treaty authorizes the Country X tax 
authorities to pay a refund that is barred by the statute of 
limitations. B does not file a claim for refund, and neither A nor B 
invokes the competent authority procedures of the tax treaty. Because 
the Country X tax authorities would be barred by the statute of 
limitations from paying a refund, B has no effective and practical 
remedies. Under paragraph (e)(5)(i) of this section, the entire amount 
paid by B to Country X is a compulsory payment and thus is an amount of 
foreign income tax paid by B.
    (E) Example 5. A is a U.S. person doing business in Country X. In 
computing its income tax liability to Country X, A is permitted, at its 
election, to recover the cost of machinery used in its business either 
by deducting that cost in the year of acquisition or by depreciating 
that cost on the straight-

[[Page 738]]

line method over a period of 2, 4, 6 or 10 years. A elects to depreciate 
machinery over 10 years. This election merely shifts A's tax liability 
to different years (compared to the timing of A's tax liability under a 
different depreciation period); it does not result in a payment in 
excess of the amount of A's liability for Country X income tax in any 
year since the amount of Country X income tax paid by A is consistent 
with a reasonable interpretation of Country X tax law in such a way as 
to reduce over time A's reasonably expected liability for Country X 
income tax. Because the standard of paragraph (e)(5)(i) of this section 
refers to A's reasonably expected liability, not its actual liability, 
events actually occurring in subsequent years (for example, whether A 
has sufficient profit in such years so that such depreciation deductions 
actually reduce A's Country X tax liability or whether the Country X tax 
rates change) are immaterial.
    (F) Example 6. The domestic law of Country X imposes a 25 percent 
tax described in Sec.  1.903-1(b) on the gross amount of interest from 
sources in Country X that is received by a nonresident of Country X. 
Country X tax law imposes the tax on the nonresident recipient and 
requires any resident of Country X that pays such interest to a 
nonresident to withhold and pay over to Country X 25 percent of such 
interest, which is applied to offset the recipient's liability for the 
25 percent tax. A tax treaty between the United States and Country X 
overrides domestic law of Country X and provides that Country X may not 
tax interest received by a resident of the United States from a resident 
of Country X at a rate in excess of 10 percent of the gross amount of 
such interest. A resident of the United States may claim the benefit of 
the tax treaty only by applying for a refund of the excess withheld 
amount (15 percent of the gross amount of interest income) after the end 
of the taxable year. A, a resident of the United States, receives a 
gross amount of 100u (units of Country X currency) of interest income 
from a resident of Country X from sources in Country X in Year 1, from 
which 25u of Country X tax is withheld. A does not file a timely claim 
for refund. Under paragraph (e)(5)(i) of this section, 15u of the amount 
withheld (25u - 10u) is not a compulsory payment and thus is not an 
amount of foreign income tax paid.
    (G) Example 7: Reasonable steps to minimize creditable tax--larger 
noncreditable tax cost--(1) Facts. Corporations resident in Country X 
are subject to a 20% generally applicable net income tax, which 
qualifies as a foreign income tax under paragraph (a)(1)(ii) of this 
section (``Income Tax''), and a separate levy equal to 25% of certain 
deductible payments above a specified threshold made to related parties 
that are not residents of Country X, which does not qualify as a foreign 
income tax under paragraph (a)(1)(ii) of this section (``Base Erosion 
Tax''). CFC, a Country X corporation, makes payments to nonresident 
related parties that exceed the specified threshold of the Base Erosion 
Tax by 100u (units of Country X currency), which if claimed as 
deductions would result in a Base Erosion Tax of 25u (.25 x 100u), and 
would also result in 300u of taxable income for purposes of the Income 
Tax, thus resulting in Income Tax of 60u (.20 x 300u). If in computing 
its liability for Income Tax CFC does not claim deductions for the 100u 
of excess related party payments, its liability for the Base Erosion Tax 
would be zero, and its liability for Income Tax would be 80u (.20 x 
400u).
    (2) Analysis. If CFC chooses not to deduct the 100u of excess 
related party payments that would subject it to the Base Erosion Tax and 
pays 80u of Income Tax, the amount of foreign income tax paid under 
paragraph (e)(5) of this section is 80u. Under paragraph (e)(5)(i) of 
this section, although CFC could reduce its liability for Income Tax 
from 80u to 60u by claiming the deductions, no portion of the Income Tax 
remitted is a noncompulsory payment because reducing the Income Tax by 
20u would incur a Base Erosion Tax of 25u, which exceeds the amount of 
the potential reduction.
    (H) Example 8: Reasonable steps to minimize creditable tax--smaller 
noncreditable tax cost--(1) Facts. The facts are the same as those in 
paragraph (e)(5)(vi)(G)(1) of this section (the facts in Example 7) 
except that the rate of

[[Page 739]]

the Base Erosion Tax is 20% and the rate of the Income Tax is 25%. 
Accordingly, if CFC claims the 100u of excess deductions its liability 
for Base Erosion Tax would be 20u (.20 x 100u), and its liability for 
Income Tax would be 75u (.25 x 300u). If CFC chooses not to claim the 
100u of excess deductions its liability for Base Erosion Tax would be 
zero, and its liability for Income Tax would be 100u (.25 x 400u).
    (2) Analysis. If CFC chooses not to claim the 100u of excess 
deductions in computing its liability for Income Tax and pays 100u of 
Income Tax, the amount of foreign income tax paid under paragraph (e)(5) 
of this section is 75u. CFC's additional payment of 25u is not an amount 
of Income Tax paid, because CFC could have reduced its Income Tax 
liability by 25u by claiming the excess deductions and paying 20u of 
Base Erosion Tax.
    (I) Example 9: Alternative creditable taxes--(1) Facts. The facts 
are the same as those in paragraph (e)(5)(vi)(G)(1) of this section (the 
facts in Example 7), except that Country X does not have a Base Erosion 
Tax, and it allows resident corporations to elect to pay either the 
Income Tax or a separate levy using an alternative cost allowance (the 
``Alternative Tax''), which qualifies as a tax in lieu of an income tax 
under Sec.  1.903-1(b)(2). CFC's liability under the Income Tax is 80u, 
and its liability under the Alternative Tax is 100u. CFC chooses to pay 
the 100u of Alternative Tax rather than the 80u of Income Tax.
    (2) Analysis. Under paragraph (e)(5)(iii)(C) of this section, the 
amount of foreign income tax paid by CFC is 80u, the smaller of the 
amounts due under the two alternative foreign income taxes.
    (vii) Structured passive investment arrangements--(A) In general. 
Notwithstanding paragraph (e)(5)(i) of this section, an amount paid to a 
foreign country (a ``foreign payment'') is not a compulsory payment, and 
thus is not an amount of foreign income tax paid, if the foreign payment 
is attributable (within the meaning of paragraph (e)(5)(vii)(B)(1)(ii) 
of this section) to a structured passive investment arrangement (as 
described in paragraph (e)(5)(vii)(B) of this section).
    (B) Conditions. An arrangement is a structured passive investment 
arrangement if all of the following conditions are satisfied:
    (1) Special purpose vehicle (SPV). An entity that is part of the 
arrangement meets the following requirements:
    (i) Substantially all of the gross income (for U.S. tax purposes) of 
the entity, if any, is passive investment income, and substantially all 
of the assets of the entity are assets held to produce such passive 
investment income.
    (ii) There is a foreign payment attributable to income of the entity 
(as determined under the laws of the foreign country to which such 
foreign payment is made), including the entity's share of income of a 
lower-tier entity that is a branch or pass-through entity under the laws 
of such foreign country, that, if the foreign payment were an amount of 
foreign income tax paid, would be paid in a U.S. taxable year in which 
the entity meets the requirements of paragraph (e)(5)(vii)(B)(1)(i) of 
this section. A foreign payment attributable to income of an entity 
includes a foreign payment attributable to income that is required to be 
taken into account by an owner of the entity, if the entity is a branch 
or pass-through entity under the laws of such foreign country. A foreign 
payment attributable to income of the entity also includes a withholding 
tax (within the meaning of section 901(k)(1)(B)) imposed on a dividend 
or other distribution (including distributions made by a pass-through 
entity or an entity that is disregarded as an entity separate from its 
owner for U.S. tax purposes) with respect to the equity of the entity.
    (2) U.S. party. A person would be eligible to claim a credit under 
section 901(a) (including a credit for foreign taxes deemed paid under 
section 960) for all or a portion of the foreign payment described in 
paragraph (e)(5)(vii)(B)(1)(ii) of this section if the foreign payment 
were an amount of foreign income tax paid.
    (3) Direct investment. The U.S. party's proportionate share of the 
foreign payment or payments described in paragraph (e)(5)(vii)(B)(1)(ii) 
of this section is (or is expected to be) substantially greater than the 
amount of credits, if

[[Page 740]]

any, that the U.S. party reasonably would expect to be eligible to claim 
under section 901(a) for foreign income taxes attributable to income 
generated by the U.S. party's proportionate share of the assets owned by 
the SPV if the U.S. party directly owned such assets. For this purpose, 
direct ownership shall not include ownership through a branch, a 
permanent establishment or any other arrangement (such as an agency 
arrangement or dual resident status) that would result in the income 
generated by the U.S. party's proportionate share of the assets being 
subject to tax on a net basis in the foreign country to which the 
payment is made. A U.S. party's proportionate share of the assets of the 
SPV shall be determined by reference to such U.S. party's proportionate 
share of the total value of all of the outstanding interests in the SPV 
that are held by its equity owners and creditors. A U.S. party's 
proportionate share of the assets of the SPV, however, shall not include 
any assets that produce income subject to gross basis withholding tax.
    (4) Foreign tax benefit. The arrangement is reasonably expected to 
result in a credit, deduction, loss, exemption, exclusion or other tax 
benefit under the laws of a foreign country that is available to a 
counterparty or to a person that is related to the counterparty 
(determined under the principles of paragraph (e)(5)(vii)(C)(7) of this 
section by applying the tax laws of a foreign country in which the 
counterparty is subject to tax on a net basis). However, a foreign tax 
benefit in the form of a credit is described in this paragraph 
(e)(5)(vii)(B)(4) only if the amount of any such credit corresponds to 
10 percent or more of the amount of the U.S. party's share (for U.S. tax 
purposes) of the foreign payment referred to in paragraph 
(e)(5)(vii)(B)(1)(ii) of this section. In addition, a foreign tax 
benefit in the form of a deduction, loss, exemption, exclusion or other 
tax benefit is described in this paragraph (e)(5)(vii)(B)(4) only if 
such amount corresponds to 10 percent or more of the foreign base with 
respect to which the U.S. party's share (for U.S. tax purposes) of the 
foreign payment is imposed. For purposes of the preceding two sentences, 
if an arrangement involves more than one U.S. party or more than one 
counterparty or both, the aggregate amount of foreign tax benefits 
available to all of the counterparties and persons related to such 
counterparties is compared to the aggregate amount of all of the U.S. 
parties' shares of the foreign payment or foreign base, as the case may 
be. Where a U.S. party indirectly owns interests in an SPV that are 
treated as equity interests for both U.S. and foreign tax purposes, a 
foreign tax benefit available to a foreign entity in the chain of 
ownership that begins with the SPV and ends with the first-tier entity 
in the chain does not correspond to the U.S. party's share of the 
foreign payment attributable to income of the SPV to the extent that 
such benefit relates to earnings of the SPV that are distributed with 
respect to equity interests in the SPV that are owned directly or 
indirectly by the U.S. party for purposes of both U.S. and foreign tax 
law.
    (5) Counterparty. The arrangement involves a counterparty. A 
counterparty is a person that, under the tax laws of a foreign country 
in which the person is subject to tax on the basis of place of 
management, place of incorporation or similar criterion or otherwise 
subject to a net basis tax, directly or indirectly owns or acquires 
equity interests in, or assets of, the SPV. However, a counterparty does 
not include the SPV or a person with respect to which for U.S. tax 
purposes the same domestic corporation, U.S. citizen or resident alien 
individual directly or indirectly owns more than 80 percent of the total 
value of the stock (or equity interests) of each of the U.S. party and 
such person. A counterparty also does not include a person with respect 
to which for U.S. tax purposes the U.S. party directly or indirectly 
owns more than 80 percent of the total value of the stock (or equity 
interests), but only if the U.S. party is a domestic corporation, a U.S. 
citizen or a resident alien individual. In addition, a counterparty does 
not include an individual who is a U.S. citizen or resident alien.
    (6) Inconsistent treatment. The United States and an applicable 
foreign country treat one or more of the aspects of the arrangement 
listed in paragraph

[[Page 741]]

(e)(5)(vii)(B)(6)(i) through (iv) of this section differently under 
their respective tax systems, and for one or more tax years when the 
arrangement is in effect one or both of the following two conditions 
applies; either the amount of income attributable to the SPV that is 
recognized for U.S. tax purposes by the SPV, the U.S. party or parties, 
and persons related to a U.S. party or parties is materially less than 
the amount of income that would be recognized if the foreign tax 
treatment controlled for U.S. tax purposes; or the amount of credits 
claimed by the U.S. party or parties (if the foreign payment described 
in paragraph (e)(5)(vii)(B)(1)(ii) of this section were an amount of 
foreign income tax paid) is materially greater than it would be if the 
foreign tax treatment controlled for U.S. tax purposes:
    (i) The classification of the SPV (or an entity that has a direct or 
indirect ownership interest in the SPV) as a corporation or other entity 
subject to an entity-level tax, a partnership or other flow-through 
entity or an entity that is disregarded for tax purposes.
    (ii) The characterization as debt, equity or an instrument that is 
disregarded for tax purposes of an instrument issued by the SPV (or an 
entity that has a direct or indirect ownership interest in the SPV) to a 
U.S. party, a counterparty or a person related to a U.S. party or a 
counterparty.
    (iii) The proportion of the equity of the SPV (or an entity that 
directly or indirectly owns the SPV) that is considered to be owned 
directly or indirectly by a U.S. party and a counterparty.
    (iv) The amount of taxable income that is attributable to the SPV 
for one or more tax years during which the arrangement is in effect.
    (C) Definitions. The following definitions apply for purposes of 
paragraph (e)(5)(vii) of this section.
    (1) Applicable foreign country. An applicable foreign country means 
each foreign country to which a foreign payment described in paragraph 
(e)(5)(vii)(B)(1)(ii) of this section is made or which confers a foreign 
tax benefit described in paragraph (e)(5)(vii)(B)(4) of this section.
    (2) Counterparty. The term counterparty means a person described in 
paragraph (e)(5)(vii)(B)(5) of this section.
    (3) Entity. The term entity includes a corporation, trust, 
partnership or disregarded entity described in Sec.  301.7701-
2(c)(2)(i).
    (4) Indirect ownership. Indirect ownership of stock or another 
equity interest (such as an interest in a partnership) shall be 
determined in accordance with the principles of section 958(a)(2), 
regardless of whether the interest is owned by a U.S. or foreign entity.
    (5) Passive investment income--(i) In general. The term passive 
investment income means income described in section 954(c), as modified 
by this paragraph (e)(5)(vii)(C)(5)(i) and paragraph 
(e)(5)(vii)(C)(5)(ii) of this section. In determining whether income is 
described in section 954(c), paragraphs (c)(1)(H), (c)(3), and (c)(6) of 
section 954 shall be disregarded. Sections 954(c), 954(h), and 954(i) 
shall be applied at the entity level as if the entity (as defined in 
paragraph (e)(5)(vii)(C)(3) of this section) were a controlled foreign 
corporation (as defined in section 957(a)). For purposes of determining 
if sections 954(h) and 954(i) apply for purposes of this paragraph 
(e)(5)(vii)(C)(5)(i) and paragraph (e)(5)(vii)(C)(5)(ii) of this 
section, any income of an entity attributable to transactions that, 
assuming the entity is an SPV, are with a person that is a counterparty, 
or with persons that are related to a counterparty within the meaning of 
paragraph (e)(5)(vii)(B)(4) of this section, shall not be treated as 
qualified banking or financing income or as qualified insurance income, 
and shall not be taken into account in applying sections 954(h) and 
954(i) for purposes of determining whether other income of the entity is 
excluded from section 954(c)(1) under section 954(h) or 954(i), but only 
if any such person (or a person that is related to such person within 
the meaning of paragraph (e)(5)(vii)(B)(4) of this section) is eligible 
for a foreign tax benefit described in paragraph (e)(5)(vii)(B)(4) of 
this section. In addition, in applying section 954(h) for purposes of 
this paragraph (e)(5)(vii)(C)(5)(i) and paragraph

[[Page 742]]

(e)(5)(vii)(C)(5)(ii) of this section, section 954(h)(3)(E) shall not 
apply, section 954(h)(2)(A)(ii) shall be satisfied only if the entity 
conducts substantial activity with respect to its business through its 
own employees, and the term ``any foreign country'' shall be substituted 
for ``home country'' wherever it appears in section 954(h).
    (ii) Income attributable to lower-tier entities; holding company 
exception. Income of an upper-tier entity that is attributable to an 
equity interest in a lower-tier entity, including dividends, an 
allocable share of partnership income, and income attributable to the 
ownership of an interest in an entity that is disregarded as an entity 
separate from its owner is passive investment income unless 
substantially all of the upper-tier entity's assets consist of qualified 
equity interests in one or more lower-tier entities, each of which is 
engaged in the active conduct of a trade or business and derives more 
than 50 percent of its gross income from such trade or business, and 
substantially all of the upper-tier entity's opportunity for gain and 
risk of loss with respect to each such interest in a lower-tier entity 
is shared by the U.S. party (or persons that are related to a U.S. 
party) and, assuming the entity is an SPV, a counterparty (or persons 
that are related to a counterparty) (``holding company exception''). If 
an arrangement involves more than one U.S. party or more than one 
counterparty or both, then substantially all of the upper-tier entity's 
opportunity for gain and risk of loss with respect to its interest in 
any lower-tier entity must be shared (directly or indirectly) by one or 
more U.S. parties (or persons related to such U.S. parties) and, 
assuming the upper-tier entity is an SPV, one or more counterparties (or 
persons related to such counterparties). Substantially all of the upper-
tier entity's opportunity for gain and risk of loss with respect to its 
interest in any lower-tier entity is not shared if the opportunity for 
gain and risk of loss is borne (directly or indirectly) by one or more 
U.S. parties (or persons related to such U.S. party or parties) or, 
assuming the upper-tier entity is an SPV, by one or more counterparties 
(or persons related to such counterparty or counterparties). Whether and 
the extent to which a person is considered to share in an upper-tier 
entity's opportunity for gain and risk of loss is determined based on 
all the facts and circumstances, provided, however, that a person does 
not share in an upper-tier entity's opportunity for gain and risk of 
loss if its equity interest in the upper-tier entity was acquired in a 
sale-repurchase transaction or if its interest is treated as debt for 
U.S. tax purposes. If a U.S. party owns an interest in an entity 
indirectly through a chain of entities, the application of the holding 
company exception begins with the lowest-tier entity in the chain that 
may satisfy the holding company exception and proceeds upward; provided, 
however, that the opportunity for gain and risk of loss borne by any 
upper-tier entity in the chain that is a counterparty shall be 
disregarded to the extent borne indirectly by a U.S. party. An upper-
tier entity that satisfies the holding company exception is itself 
considered to be engaged in the active conduct of a trade or business 
and to derive more than 50 percent of its gross income from such trade 
or business for purposes of applying the holding company exception to 
the owners of such entity. A lower-tier entity that is engaged in a 
banking, financing, or similar business shall not be considered to be 
engaged in the active conduct of a trade or business unless the income 
derived by such entity would be excluded from section 954(c)(1) under 
section 954(h) or 954(i) as modified by paragraph (e)(5)(vii)(C)(5)(i) 
of this section.
    (6) Qualified equity interest. With respect to an interest in a 
corporation, the term qualified equity interest means stock representing 
10 percent or more of the total combined voting power of all classes of 
stock entitled to vote and 10 percent or more of the total value of the 
stock of the corporation or disregarded entity, but does not include any 
preferred stock (as defined in section 351(g)(3)). Similar rules shall 
apply to determine whether an interest in an entity other than a 
corporation is a qualified equity interest.
    (7) Related person. Two persons are related if--

[[Page 743]]

    (i) One person directly or indirectly owns stock (or an equity 
interest) possessing more than 50 percent of the total value of the 
other person; or
    (ii) The same person directly or indirectly owns stock (or an equity 
interest) possessing more than 50 percent of the total value of both 
persons.
    (8) Special purpose vehicle (SPV). The term SPV means the entity 
described in paragraph (e)(5)(vii)(B)(1) of this section.
    (9) U.S. party. The term U.S. party means a person described in 
paragraph (e)(5)(vii)(B)(2) of this section.
    (D) Examples. The following examples illustrate the rules of 
paragraph (e)(5)(vii) of this section. No inference is intended as to 
whether a taxpayer would be eligible to claim a credit under section 
901(a) if a foreign payment were an amount of foreign income tax paid. 
The examples set forth below do not limit the application of other 
principles of existing law to determine the proper tax consequences of 
the structures or transactions addressed in the regulations.
    (1) Example 1: U.S. borrower transaction--(i) Facts. A domestic 
corporation (USP) forms a Country M corporation (Newco), contributing 
$1.5 billion in exchange for 100% of the stock of Newco. Newco, in turn, 
loans the $1.5 billion to a second Country M corporation (FSub) wholly 
owned by USP. USP then sells its entire interest in Newco to a Country M 
corporation (FP) for the original purchase price of $1.5 billion, 
subject to an obligation to repurchase the interest in five years for 
$1.5 billion. The sale has the effect of transferring ownership of the 
Newco stock to FP for Country M tax purposes. Assume the sale-repurchase 
transaction is structured in a way that qualifies as a collateralized 
loan for U.S. tax purposes. Therefore, USP remains the owner of the 
Newco stock for U.S. tax purposes. All of FSub's income is subpart F 
income. In Year 1, FSub pays Newco $120 million of interest. Newco pays 
$36 million to Country M with respect to such interest income and 
distributes the remaining $84 million to FP. Under Country M law, the 
$84 million distribution is excluded from FP's income. None of FP's 
stock is owned, directly or indirectly, by USP or any shareholders of 
USP that are domestic corporations, U.S. citizens, or resident alien 
individuals. Under an income tax treaty between Country M and the United 
States, Country M does not impose Country M tax on interest received by 
U.S. residents from sources in Country M.
    (ii) Result. The $36 million payment by Newco to Country M is not a 
compulsory payment, and thus is not an amount of foreign income tax paid 
because the foreign payment is attributable to a structured passive 
investment arrangement. First, Newco is an SPV because all of Newco's 
income is passive investment income described in paragraph 
(e)(5)(iv)(C)(5) of this section; Newco's only asset, a note, is held to 
produce such income; the payment to Country M is attributable to such 
income; and if the payment were an amount of foreign income tax paid it 
would be paid in a U.S. taxable year in which Newco meets the 
requirements of paragraph (e)(5)(vii)(B)(1)(i) of this section. Second, 
if the foreign payment were treated as an amount of foreign income tax 
paid, USP would be deemed to pay the foreign payment under section 
960(a) and, therefore, would be eligible to claim a credit for such 
payment under section 901(a). Third, USP would not pay any Country M tax 
if it directly owned Newco's loan receivable. Fourth, the distribution 
from Newco to FP is exempt from tax under Country M law, and the exempt 
amount corresponds to more than 10% of the foreign base with respect to 
which USP's share (which is 100% under U.S. tax law) of the foreign 
payment was imposed. Fifth, FP is a counterparty because FP owns stock 
of Newco under Country M law and none of FP's stock is owned by USP or 
shareholders of USP that are domestic corporations, U.S. citizens, or 
resident alien individuals. Sixth, FP is the owner of 100% of Newco's 
stock for Country M tax purposes, while USP is the owner of 100% of 
Newco's stock for U.S. tax purposes, and the amount of credits claimed 
by USP if the payment to Country M were an amount of foreign income tax 
paid is materially greater than it would be if Country M tax treatment 
controlled for U.S. tax purposes such that FP, rather than

[[Page 744]]

USP, owned 100% of Newco's stock. Because the payment to Country M is 
not an amount of foreign income tax paid, USP is not deemed to pay any 
Country M tax under section 960(a). USP includes $84 million in income 
under subpart F with respect to Newco and also has interest expense of 
$84 million. FSub's income and earnings and profits are reduced by $120 
million of interest expense.
    (2) Example 2: U.S. borrower transaction--(i) Facts. The facts are 
the same as those in paragraph (e)(5)(vii)(D)(1)(i) of this section (the 
facts in Example 1), except that FSub is a wholly-owned subsidiary of 
Newco. In addition, assume FSub is engaged in the active conduct of 
manufacturing and selling widgets and derives more than 50% of its gross 
income from such business.
    (ii) Result. The result is the same as in paragraph 
(e)(5)(vii)(D)(1)(ii) of this section (the result in Example 1), except 
that Newco's income is tested income rather than subpart F income, and 
if the $36 million foreign payment were an amount of foreign income tax 
paid USP would be deemed to pay a portion of the foreign payment under 
section 960(d), rather than 960(a). Although Newco wholly owns FSub, 
which is engaged in the active conduct of manufacturing and selling 
widgets and derives more than 50% of its income from such business, 
Newco's income that is attributable to Newco's equity interest in FSub 
is passive investment income because the sale-repurchase transaction 
limits FP's interest in Newco and its assets to that of a creditor, so 
that substantially all of Newco's opportunity for gain and risk of loss 
with respect to its stock in FSub is borne by USP. See paragraph 
(e)(5)(vii)(C)(5)(ii) of this section. Accordingly, Newco's stock in 
FSub is held to produce passive investment income. Thus, Newco is an SPV 
because all of Newco's income is passive investment income described in 
paragraph (e)(5)(vii)(C)(5) of this section, Newco's assets are held to 
produce such income, the payment to Country M is attributable to such 
income, and if the payment were an amount of foreign income tax paid it 
would be paid in a U.S. taxable year in which Newco meets the 
requirements of paragraph (e)(5)(vii)(B)(1)(i) of this section.
    (3) Example 3: U.S. borrower transaction--(i) Facts. A domestic 
corporation (USP) loans $750 million to its wholly-owned domestic 
subsidiary (Sub). USP and Sub form a Country M partnership (Partnership) 
to which each contributes $750 million. Partnership loans all of its 
$1.5 billion of capital to Issuer, a wholly-owned Country M affiliate of 
USP, in exchange for a note and coupons providing for the payment of 
interest at a fixed rate over a five-year term. Partnership sells all of 
the coupons to Coupon Purchaser, a Country N partnership owned by a 
Country M corporation (Foreign Bank) and a wholly-owned Country M 
subsidiary of Foreign Bank, for $300 million. At the time of the coupon 
sale, the fair market value of the coupons sold is $290 million and, 
pursuant to section 1286(b)(3), Partnership's basis allocated to the 
coupons sold is $290 million. Several months later and prior to any 
interest payments on the note, Foreign Bank and its subsidiary sell all 
of their interests in Coupon Purchaser to an unrelated Country O 
corporation for $280 million. None of Foreign Bank's stock or its 
subsidiary's stock is owned, directly or indirectly, by USP or Sub or by 
any shareholders of USP or Sub that are domestic corporations, U.S. 
citizens, or resident alien individuals. Assume that both the United 
States and Country M respect the sale of the coupons for tax law 
purposes. In the year of the coupon sale, for Country M tax purposes 
USP's and Sub's shares of Partnership's profits total $300 million, a 
payment of $60 million to Country M is made with respect to those 
profits, and Foreign Bank and its subsidiary, as partners of Coupon 
Purchaser, are entitled to deduct the $300 million purchase price of the 
coupons from their taxable income. For U.S. tax purposes, USP and Sub 
recognize their distributive shares of the $10 million premium income 
and claim a direct foreign tax credit for their shares of the $60 
million payment to Country M. Country M imposes no additional tax when 
Foreign Bank and its subsidiary sell their interests in Coupon 
Purchaser. Country M also

[[Page 745]]

does not impose Country M tax on interest received by U.S. residents 
from sources in Country M.
    (ii) Result. The payment to Country M is not a compulsory payment, 
and thus is not an amount of foreign income tax paid, because the 
foreign payment is attributable to a structured passive investment 
arrangement. First, Partnership is an SPV because all of Partnership's 
income is passive investment income described in paragraph 
(e)(5)(vii)(C)(5) of this section; Partnership's only asset, Issuer's 
note, is held to produce such income; the payment to Country M is 
attributable to such income; and if the payment were an amount of 
foreign income tax paid, it would be paid in a U.S. taxable year in 
which Partnership meets the requirements of paragraph 
(e)(5)(vii)(B)(1)(i) of this section. Second, if the foreign payment 
were an amount of tax paid, USP and Sub would be eligible to claim a 
credit for such payment under section 901(a). Third, USP and Sub would 
not pay any Country M tax if they directly owned Issuer's note. Fourth, 
for Country M tax purposes, Foreign Bank and its subsidiary deduct the 
$300 million purchase price of the coupons and are exempt from Country M 
tax on the $280 million received upon the sale of Coupon Purchaser, and 
the deduction and exemption correspond to more than 10% of the $300 
million base with respect to which USP's and Sub's 100% share of the 
foreign payments was imposed. Fifth, Foreign Bank and its subsidiary are 
counterparties because they indirectly acquired assets of Partnership, 
the interest coupons on Issuer's note, and are not directly or 
indirectly owned by USP or Sub or shareholders of USP or Sub that are 
domestic corporations, U.S. citizens, or resident alien individuals. 
Sixth, the amount of taxable income of Partnership for one or more years 
is different for U.S. and Country M tax purposes, and the amount of 
income attributable to USP and Sub for U.S. tax purposes is materially 
less than the amount of income they would recognize if the Country M tax 
treatment of the coupon sale controlled for U.S. tax purposes. Because 
the payment to Country M is not an amount of foreign income tax paid, 
USP and Sub are not considered to pay tax under section 901. USP and Sub 
have income of $10 million in the year of the coupon sale.
    (4) Example 4: Active business; no SPV--(i) Facts. A, a domestic 
corporation, wholly owns B, a Country X corporation engaged in the 
manufacture and sale of widgets. On January 1, Year 1, C, also a Country 
X corporation, loans $400 million to B in exchange for an instrument 
that is debt for U.S. tax purposes and equity in B for Country X tax 
purposes. As a result, C is considered to own stock of B for Country X 
tax purposes. B loans $55 million to D, a Country Y corporation wholly 
owned by A. In year 1, B has $166 million of net income attributable to 
its sales of widgets and $3.3 million of interest income attributable to 
the loan to D. Substantially all of B's assets are used in its widget 
business. Country Y does not impose tax on interest paid to 
nonresidents. B makes a payment of $50.8 million to Country X with 
respect to B's net income. Country X does not impose tax on dividend 
payments between Country X corporations. None of C's stock is owned, 
directly or indirectly, by A or by any shareholders of A that are 
domestic corporations, U.S. citizens, or resident alien individuals.
    (ii) Result. B is not an SPV within the meaning of paragraph 
(e)(5)(vii)(B)(1) of this section because the amount of interest income 
received from D does not constitute substantially all of B's income and 
the $55 million note from D does not constitute substantially all of B's 
assets. Accordingly, the $50.8 million payment to Country X is not 
attributable to a structured passive investment arrangement.
    (5) Example 5: U.S. lender transaction--(i) Facts. A Country X 
corporation (Foreign Bank) contributes $2 billion to a newly-formed 
Country X company (Newco) in exchange for 90% of the common stock of 
Newco and securities that are treated as debt of Newco for U.S. tax 
purposes and preferred stock of Newco for Country X tax purposes. A 
domestic corporation (USP) contributes $1 billion to Newco in exchange 
for 10% of Newco's common stock and securities that are treated as 
preferred stock of Newco for U.S. tax purposes and debt of Newco for 
Country X tax purposes. Newco loans the $3 billion to

[[Page 746]]

a wholly-owned, Country X subsidiary of Foreign Bank (FSub) in return 
for a $3 billion, seven-year note paying interest currently. The Newco 
securities held by USP represent more than 50% of the voting power in 
Newco and more than 50% of the value of the securities in Newco that are 
treated as equity for U.S. tax purposes. The Newco securities held by 
USP entitle the holder to fixed distributions of $4 million per year, 
and the Newco securities held by Foreign Bank entitle the holder to 
receive $82 million per year, payable only on maturity of the $3 billion 
FSub note in Year 7. At the end of Year 5, pursuant to a prearranged 
plan, Foreign Bank acquires USP's Newco stock and securities for a 
prearranged price of $1 billion. Country X does not impose tax on 
dividends received by one Country X corporation from a second Country X 
corporation. Under an income tax treaty between Country X and the United 
States, Country X does not impose Country X tax on interest received by 
U.S. residents from sources in Country X. None of Foreign Bank's stock 
is owned, directly or indirectly, by USP or any shareholders of USP that 
are domestic corporations, U.S. citizens, or resident alien individuals. 
In each of Years 1 through 7, FSub pays Newco $124 million of interest 
on the $3 billion note. Newco distributes $4 million to USP in each of 
Years 1 through 5. The distributions are deductible for Country X tax 
purposes, and Newco pays Country X $36 million with respect to $120 
million of taxable income from the FSub note in each year. For U.S. tax 
purposes, in each year Newco's subpart F income and earnings and profits 
are increased by $124 million of interest income and reduced by accrued 
interest expense with respect to the Newco securities held by Foreign 
Bank.
    (ii) Result. The $36 million payment to Country X is not a 
compulsory payment, and thus is not an amount of foreign income tax 
paid, because the foreign payment is attributable to a structured 
passive investment arrangement. First, Newco is an SPV because all of 
Newco's income is passive investment income described in paragraph 
(e)(5)(vii)(C)(5) of this section; Newco's only asset, a note of FSub, 
is held to produce such income; the payment to Country X is attributable 
to such income; and if the payment were an amount of foreign income tax 
paid it would be paid in a U.S. taxable year in which Newco meets the 
requirements of paragraph (e)(5)(vii)(B)(1)(i) of this section. Second, 
if the foreign payment were an amount of foreign income tax paid, USP 
would be deemed to pay its pro rata share of the foreign payment under 
section 960(a) in each of Years 1 through 5 and, therefore, would be 
eligible to claim a credit under section 901(a). Third, USP would not 
pay any Country X tax if it directly owned its proportionate share of 
Newco's assets, a note of FSub. Fourth, for Country X tax purposes, 
Foreign Bank is eligible to receive a tax-free distribution of $82 
million attributable to each of Years 1 through 5, and that amount 
corresponds to more than 10% of the foreign base with respect to which 
USP's share of the foreign payment was imposed. Fifth, Foreign Bank is a 
counterparty because it owns stock of Newco for Country X tax purposes 
and none of Foreign Bank's stock is owned, directly or indirectly, by 
USP or shareholders of USP that are domestic corporations, U.S. 
citizens, or resident alien individuals. Sixth, the United States and 
Country X treat various aspects of the arrangement differently, 
including whether the Newco securities held by Foreign Bank and USP are 
debt or equity. The amount of credits claimed by USP if the payment to 
Country X were an amount of foreign income tax paid is materially 
greater than it would be if the Country X tax treatment controlled for 
U.S. tax purposes such that the securities held by USP were treated as 
debt or the securities held by Foreign Bank were treated as equity, and 
the amount of income recognized by Newco for U.S. tax purposes is 
materially less than the amount of income recognized for Country X tax 
purposes. Because the payment to Country X is not an amount of foreign 
income tax paid, USP is not deemed to pay any Country X tax under 
section 960(a). USP has a subpart F inclusion of $4 million in each of 
Years 1 through 5.
    (6) Example 6: Holding company; no SPV--(i) Facts. A, a Country X 
corporation, and B, a domestic corporation,

[[Page 747]]

each contribute $1 billion to a newly-formed Country X entity (C) in 
exchange for 50% of the common stock of C. C is treated as a corporation 
for Country X purposes and a partnership for U.S. tax purposes. C 
contributes $1.95 billion to a newly-formed Country X corporation (D) in 
exchange for 100% of D's common stock. C loans its remaining $50 million 
to D. Accordingly, C's sole assets are stock and debt of D. D uses the 
entire $2 billion to engage in the business of manufacturing and selling 
widgets. In Year 1, D derives $300 million of income from its widget 
business and derives $2 million of interest income. Also in Year 1, C 
has dividend income of $200 million and interest income of $3.2 million 
with respect to its investment in D. Country X does not impose tax on 
dividends received by one Country X corporation from a second Country X 
corporation. C makes a payment of $960,000 to Country X with respect to 
C's net income.
    (ii) Result. C qualifies for the holding company exception described 
in paragraph (e)(5)(vii)(C)(5)(ii) of this section because C holds a 
qualified equity interest in D, D is engaged in an active trade or 
business and derives more than 50% of its gross income from such trade 
or business, C's interest in D constitutes substantially all of C's 
assets, and A and B share in substantially all of C's opportunity for 
gain and risk of loss with respect to D. As a result, C's dividend 
income from D is not passive investment income and C's stock in D is not 
held to produce such income. Accordingly, C is not an SPV within the 
meaning of paragraph (e)(5)(vii)(B)(1) of this section, and the $960,000 
payment to Country X is not attributable to a structured passive 
investment arrangement.
    (7) Example 7: Holding company; no SPV--(i) Facts. The facts are the 
same as those in paragraph (e)(5)(vii)(D)(6)(i) of this section (the 
facts in Example 6), except that instead of loaning $50 million to D, C 
contributes the $50 million to E in exchange for 10% of the stock of E. 
E is a Country Y corporation that is not engaged in the active conduct 
of a trade or business. Also in Year 1, D pays no dividends to C, E pays 
$3.2 million in dividends to C, and C makes a payment of $960,000 to 
Country X with respect to C's net income.
    (ii) Result. C qualifies for the holding company exception described 
in paragraph (e)(5)(vii)(C)(5)(ii) of this section because C holds a 
qualified equity interest in D, D is engaged in an active trade or 
business and derives more than 50% of its gross income from such trade 
or business, C's interest in D constitutes substantially all of C's 
assets, and A and B share in substantially all of C's opportunity for 
gain and risk of loss with respect to D. As a result, less than 
substantially all of C's assets are held to produce passive investment 
income. Accordingly, C is not an SPV because it does not meet the 
requirements of paragraph (e)(5)(vii)(B)(1) of this section, and the 
$960,000 payment to Country X is not attributable to a structured 
passive investment arrangement.
    (8) Example 8: Holding company; no SPV--(i) Facts. The facts are the 
same as those in paragraph (e)(5)(vii)(D)(6)(i) of this section (the 
facts in Example 6), except that B's $1 billion investment in C consists 
of 30% of C's common stock and 100% of C's preferred stock. A's $1 
billion investment in C consists of 70% of C's common stock. B sells its 
preferred stock to F, a Country X corporation, subject to a repurchase 
obligation. Assume that under Country X tax law, but not U.S. tax law, F 
is treated as the owner of the preferred shares and receives a 
distribution in Year 1 of $50 million. The remaining earnings are 
distributed 70% to A and 30% to B.
    (ii) Result. C qualifies for the holding company exception described 
in paragraph (e)(5)(vii)(C)(5)(ii) of this section because C holds a 
qualified equity interest in D, D is engaged in an active trade or 
business and derives more than 50% of its gross income from such trade 
or business, and C's interest in D constitutes substantially all of C's 
assets. Additionally, although F does not share in C's opportunity for 
gain and risk of loss with respect to C's interest in D because F 
acquired its interest in C in a sale-repurchase transaction, B (the U.S. 
party) and in the aggregate A and F (who would be counterparties 
assuming C were an SPV) share in substantially all of C's opportunity 
for gain and risk of loss with respect to D

[[Page 748]]

and such opportunity for gain and risk of loss is not borne exclusively 
either by B or by A and F in the aggregate. Accordingly, C's shares in D 
are not held to produce passive investment income and the $200 million 
dividend from D is not passive investment income. C is not an SPV within 
the meaning of paragraph (e)(5)(vii)(B)(1) of this section, and the 
$960,000 payment to Country X is not attributable to a structured 
passive investment arrangement.
    (9) Example 9: Asset holding transaction--(i) Facts. A domestic 
corporation (USP) contributes $6 billion of Country Z debt obligations 
to a Country Z entity (DE) in exchange for all of the class A and class 
B stock of DE. DE is a disregarded entity for U.S. tax purposes and a 
corporation for Country Z tax purposes. A corporation unrelated to USP 
and organized in Country Z (FC) contributes $1.5 billion to DE in 
exchange for all of the class C stock of DE. DE uses the $1.5 billion 
contributed by FC to redeem USP's class B stock. The terms of the class 
C stock entitle its holder to all income from DE, but FC is obligated 
immediately to contribute back to DE all distributions on the class C 
stock. USP and FC enter into a contract under which USP agrees to buy 
after five years the class C stock for $1.5 billion and an agreement 
under which USP agrees to pay FC periodic payments on $1.5 billion. The 
transaction is structured in such a way that, for U.S. tax purposes, 
there is a loan of $1.5 billion from FC to USP, and USP is the owner of 
the class C stock and the class A stock. In Year 1, DE earns $400 
million of interest income on the Country Z debt obligations. DE makes a 
payment to Country Z of $100 million with respect to such income and 
distributes the remaining $300 million to FC. FC contributes the $300 
million back to DE. None of FC's stock is owned, directly or indirectly, 
by USP or shareholders of USP that are domestic corporations, U.S. 
citizens, or resident alien individuals. Assume that Country Z imposes a 
withholding tax on interest income derived by U.S. residents. Country Z 
treats FC as the owner of the class C stock. Pursuant to Country Z tax 
law, FC is required to report the $400 million of income with respect to 
the $300 million distribution from DE, but is allowed to claim credits 
for DE's $100 million payment to Country Z. For Country Z tax purposes, 
FC is entitled to current deductions equal to the $300 million 
contributed back to DE.
    (ii) Result. The payment to Country Z is not a compulsory payment, 
and thus is not an amount of foreign income tax paid, because the 
payment is attributable to a structured passive investment arrangement. 
First, DE is an SPV because all of DE's income is passive investment 
income described in paragraph (e)(5)(vii)(C)(5) of this section; all of 
DE's assets are held to produce such income; the payment to Country Z is 
attributable to such income; and if the payment were an amount of tax 
paid it would be paid in a U.S. taxable year in which DE meets the 
requirements of paragraph (e)(5)(vii)(B)(1)(i) of this section. Second, 
if the payment were an amount of foreign income tax paid, USP would be 
eligible to claim a credit for such amount under section 901(a). Third, 
USP's proportionate share of DE's foreign payment of $100 million is 
substantially greater than the amount of credits USP would be eligible 
to claim if it directly held its proportionate share of DE's assets, 
excluding any assets that would produce income subject to gross basis 
withholding tax if directly held by USP. Fourth, FC is entitled to claim 
a credit under Country Z tax law for the payment and recognizes a 
deduction for the $300 million contributed to DE under Country Z law. 
The credit claimed by FC corresponds to more than 10% of USP's share 
(for U.S. tax purposes) of the foreign payment and the deductions 
claimed by FC correspond to more than 10% of the base with respect to 
which USP's share of the foreign payment was imposed. Fifth, FC is a 
counterparty because FC is considered to own equity of DE under Country 
Z law and none of FC's stock is owned, directly or indirectly, by USP or 
shareholders of USP that are domestic corporations, U.S. citizens, or 
resident alien individuals. Sixth, the United States and Country Z treat 
certain aspects of the transaction differently, including the proportion 
of equity owned in DE by USP and FC,

[[Page 749]]

and the amount of credits claimed by USP if the Country Z payment were 
an amount of tax paid is materially greater than it would be if the 
Country Z tax treatment controlled for U.S. tax purposes such that FC, 
rather than USP, owned the class C stock. Because the payment to Country 
Z is not an amount of foreign income tax paid, USP is not considered to 
pay tax under section 901. USP has $400 million of interest income.
    (10) Example 10: Loss surrender--(i) Facts. The facts are the same 
as those in paragraph (e)(5)(vii)(D)(9)(i) of this section (the facts in 
Example 9), except that the deductions attributable to the arrangement 
contribute to a loss recognized by FC for Country Z tax purposes, and 
pursuant to a group relief regime in Country Z FC elects to surrender 
the loss to its Country Z subsidiary.
    (ii) Result. The results are the same as in paragraph 
(e)(5)(vii)(D)(9)(ii) of this section (the results in Example 9). The 
surrender of the loss to a related party is a foreign tax benefit that 
corresponds to the base with respect to which USP's share of the foreign 
payment was imposed.
    (11) Example 11: Joint venture; no foreign tax benefit--(i) Facts. 
FC, a Country X corporation, and USC, a domestic corporation, each 
contribute $1 billion to a newly-formed Country X entity (C) in exchange 
for stock of C. FC and USC are entitled to equal 50% shares of all of 
C's income, gain, expense and loss. C is treated as a corporation for 
Country X purposes and a partnership for U.S. tax purposes. In Year 1, C 
earns $200 million of net passive investment income, makes a payment to 
Country X of $60 million with respect to that income, and distributes 
$70 million to each of FC and USC. Country X does not impose tax on 
dividends received by one Country X corporation from a second Country X 
corporation.
    (ii) Result. FC's tax-exempt receipt of $70 million, or its 50% 
share of C's profits, is not a foreign tax benefit within the meaning of 
paragraph (e)(5)(vii)(B)(4) of this section because it does not 
correspond to any part of the foreign base with respect to which USC's 
share of the foreign payment was imposed. Accordingly, the $60 million 
payment to Country X is not attributable to a structured passive 
investment arrangement.
    (12) Example 12: Joint venture; no foreign tax benefit--(i) Facts. 
The facts are the same as those in paragraph (e)(5)(vii)(D)(11)(i) of 
this section (the facts in Example 11), except that C in turn 
contributes $2 billion to a wholly-owned and newly-formed Country X 
entity (D) in exchange for stock of D. D is treated as a corporation for 
Country X purposes and disregarded as an entity separate from its owner 
for U.S. tax purposes. C has no other assets and earns no other income. 
In Year 1, D earns $200 million of passive investment income, makes a 
payment to Country X of $60 million with respect to that income, and 
distributes $140 million to C.
    (ii) Result. C's tax-exempt receipt of $140 million is not a foreign 
tax benefit within the meaning of paragraph (e)(5)(vii)(B)(4) of this 
section because it does not correspond to any part of the foreign base 
with respect to which USC's share of the foreign payment was imposed. 
Fifty percent of C's foreign tax exemption is not a foreign tax benefit 
within the meaning of paragraph (e)(5)(vii)(B)(4) of this section 
because it relates to earnings of D that are distributed with respect to 
an equity interest in D that is owned indirectly by USC under both U.S. 
and foreign tax law. The remaining 50% of C's foreign tax exemption, as 
well as FC's tax-exempt receipt of $70 million from C, is also not a 
foreign tax benefit because it does not correspond to any part of the 
foreign base with respect to which USC's share of the foreign payment 
was imposed. Accordingly, the $60 million payment to Country X is not 
attributable to a structured passive investment arrangement.
    (6) Soak-up taxes--(i) In general. An amount remitted to a foreign 
country is not an amount of foreign income tax paid to the extent that 
liability for the foreign income tax is dependent (by its terms or 
otherwise) on the availability of a credit for the tax against income 
tax liability to another country. Liability for foreign income tax is 
dependent on the availability of a credit for the foreign income tax 
against income tax liability to another country

[[Page 750]]

only if and to the extent that the foreign income tax would not be 
imposed but for the availability of such a credit.
    (ii) Examples. The following examples illustrate the application of 
paragraph (e)(6)(i) of this section.
    (A) Example 1: Tax rates dependent on availability of credit--(1) 
Facts. Country X imposes a tax on the receipt of royalties from sources 
in Country X by nonresidents of Country X. The tax is 15% of the gross 
amount of such royalties unless the recipient is a resident of the 
United States or of country A, B, C, or D, in which case the tax is 20% 
of the gross amount of such royalties. Like the United States, each of 
countries A, B, C, and D allows its residents a credit against the 
income tax otherwise payable to it for income taxes paid to other 
countries.
    (2) Analysis. Because the 20% rate applies only to residents of 
countries that allow a credit for taxes paid to other countries and the 
15% rate applies to residents of countries that do not allow such a 
credit, one-fourth of the Country X tax would not be imposed on 
residents of the United States but for the availability of such a 
credit. One-fourth of the Country X tax imposed on residents of the 
United States who receive royalties from sources in Country X is 
dependent on the availability of a credit for the Country X tax against 
income tax liability to another country and, accordingly, under 
paragraph (e)(6)(i) of this section that amount is not an amount of 
foreign income tax paid.
    (B) Example 2: Tax not dependent on availability of credit--(1) 
Facts. Country X imposes a net income tax on the realized net income of 
nonresidents of Country X from carrying on a trade or business in 
Country X. Although Country X tax law does not prohibit other 
nonresidents from carrying on business in Country X, United States 
persons are the only nonresidents of Country X that carry on business in 
Country X. The Country X tax would be imposed in its entirety on a 
nonresident of Country X irrespective of the availability of a credit 
for the Country X tax against income tax liability to another country.
    (2) Analysis. Because no portion of the Country X tax liability is 
dependent on the availability of a credit for such tax in another 
country, under paragraph (e)(6)(i) of this section no portion of the 
Country X tax is a soak-up tax.
    (C) Example 3: Tax holiday denied to corporations with shareholders 
eligible for credit--(1) Facts. Country X imposes a net income tax on 
the realized net income of all corporations incorporated in Country X. 
Country X allows a tax holiday to qualifying corporations incorporated 
in Country X that are owned by nonresidents of Country X, pursuant to 
which no Country X tax is imposed on the net income of a qualifying 
corporation for the first 10 years of its operations in Country X. A 
corporation qualifies for the tax holiday if it meets certain minimum 
investment criteria and if the development office of Country X certifies 
that in its opinion the operations of the corporation will be consistent 
with specified development goals of Country X. The development office 
will not issue this certification to any corporation owned by persons 
resident in countries that allow a credit to shareholders (such as a 
deemed paid credit under section 960) for Country X tax paid by a 
corporation incorporated in Country X. In practice, tax holidays are 
granted to a large number of corporations, but the Country X net income 
tax is imposed on a significant number of other corporations 
incorporated in Country X (for example, those owned by Country X persons 
and those which have had operations for more than 10 years) in addition 
to corporations denied a tax holiday because their shareholders qualify 
for a credit for the Country X tax against income tax liability to 
another country.
    (2) Analysis. Under paragraph (e)(6)(i) of this section, no portion 
of the Country X tax paid by Country X corporations denied a tax holiday 
because they have U.S. shareholders is dependent on the availability of 
a credit for the Country X tax against income tax liability to another 
country, because a significant number of other Country X corporations 
pay the Country X tax irrespective of the availability of a credit to 
their shareholders.

[[Page 751]]

    (D) Example 4: Tax deferral allowed for corporations with 
shareholders eligible for credit--(1) Facts. The facts are the same as 
those in paragraph (e)(6)(ii)(C)(1) of this section (the facts of 
Example 3), except that Country X corporations owned by persons resident 
in countries that allow a credit for Country X tax when dividends are 
distributed by the corporations are granted a provisional tax holiday. 
Under the provisional tax holiday, instead of relieving such a 
corporation from Country X tax for 10 years, liability for such tax is 
deferred until the Country X corporation distributes dividends.
    (2) Analysis. Because a significant number of other Country X 
corporations pay the Country X tax irrespective of the availability of a 
credit to their shareholders, the result is the same as in paragraph 
(e)(6)(ii)(C)(2) of this section.
    (E) Example 5: Tax based on greater of tax in lieu of income tax or 
amount eligible for credit--(1) Facts. Pursuant to a contract with 
Country X, A, a domestic corporation engaged in manufacturing activities 
in Country X, must pay tax to Country X equal to the greater of 5u 
(units of Country X currency) per item produced, or the maximum amount 
creditable by A against its U.S. income tax liability for that year with 
respect to income from its Country X operations. Also pursuant to the 
contract, A is exempted from Country X's otherwise generally-imposed net 
income tax. The contractual tax is a tax in lieu of income tax as 
defined in Sec.  1.903-1(b). In Year 1, A produces 16 items, which would 
result in Country X tax of 16 x 5u = 80u, and taking into account the 
section 904 limitation, the maximum amount of Country X tax that A can 
claim as a credit against its U.S. income tax liability is 125u. 
Accordingly, A's contractual liability for Country X tax in lieu of 
income tax is 125u, the greater of the two amounts.
    (2) Analysis. Under paragraph (e)(6)(i) of this section, the amount 
of tax paid by A that is dependent on the availability of a credit 
against income tax of another country is 125u-80u = 45u, the amount that 
would not be imposed but for the availability of a credit.
    (f) Taxpayer--(1) In general. The person by whom tax is considered 
paid for purposes of sections 901 and 903 is the person on whom foreign 
law imposes legal liability for such tax, even if another person (e.g., 
a withholding agent) remits such tax. For purposes of this section, 
Sec.  1.901-2A and Sec.  1.903-1, the person on whom foreign law imposes 
such liability is referred to as the ``taxpayer.'' A foreign tax of a 
type described in paragraph (a)(2)(ii)(C) of this section is considered 
to be imposed on the recipients of wages if such tax is deducted from 
such wages under provisions that are comparable to section 3102 (a) and 
(b) of the Internal Revenue Code.
    (2) Party undertaking tax obligation as part of transaction--(i) In 
general. Tax is considered paid by the taxpayer even if another party to 
a direct or indirect transaction with the taxpayer agrees, as a part of 
the transaction, to assume the taxpayer's foreign tax liability. The 
rules of the foregoing sentence apply notwithstanding anything to the 
contrary in paragraph (e)(3) of this section. See Sec.  1.901-2A for 
additional rules regarding dual capacity taxpayers.
    (ii) Examples. The following examples illustrate the rules of 
paragraphs (f)(1) and (2)(i) of this section.
    (A) Example 1. Under a loan agreement between A, a resident of 
Country X, and B, a United States person, A agrees to pay B a certain 
amount of interest net of any tax that Country X may impose on B with 
respect to its interest income. Country X imposes a 10 percent tax on 
the gross amount of interest income received by nonresidents of Country 
X from sources in Country X, and it is established that this tax is a 
tax in lieu of an income tax within the meaning of Sec.  1.903-1(b). 
Under the law of Country X this tax is imposed on the nonresident 
recipient, and any resident of Country X that pays such interest to a 
nonresident is required to withhold and pay over to Country X 10 percent 
of the amount of such interest, which is applied to offset the 
recipient's liability for the tax. Because legal liability for the tax 
is imposed on the recipient of such interest income, B is the taxpayer 
with respect to the Country X tax imposed on B's interest income from 
B's loan to A. Accordingly, B's interest income for Federal income tax 
purposes includes the

[[Page 752]]

amount of Country X tax that is imposed on B with respect to such 
interest income and that is paid on B's behalf by A pursuant to the loan 
agreement, and, under paragraph (f)(2)(i) of this section, such tax is 
considered for purposes of section 903 to be paid by B.
    (B) Example 2. The facts are the same as those in paragraph 
(f)(2)(ii)(A) of this section (the facts in Example 1), except that in 
collecting and receiving the interest B is acting as a nominee for, or 
agent of, C, who is a United States person. Because C (not B) is the 
beneficial owner of the interest, legal liability for the tax is imposed 
on C, not B (C's nominee or agent). Thus, C is the taxpayer with respect 
to the Country X tax imposed on C's interest income from C's loan to A. 
Accordingly, C's interest income for Federal income tax purposes 
includes the amount of Country X tax that is imposed on C with respect 
to such interest income and that is paid on C's behalf by A pursuant to 
the loan agreement. Under paragraph (f)(2)(i) of this section, such tax 
is considered for purposes of section 903 to be paid by C. No such tax 
is considered paid by B.
    (C) Example 3. Country X imposes a tax called the ``Country X income 
tax.'' A, a United States person engaged in construction activities in 
Country X, is subject to that tax. Country X has contracted with A for A 
to construct a naval base. A is a dual capacity taxpayer (as defined in 
paragraph (a)(2)(ii)(A) of this section) and, in accordance with 
paragraphs (a)(1) and (c)(1) of Sec.  1.901-2A, A has established that 
the Country X income tax as applied to dual capacity persons and the 
Country X income tax as applied to persons other than dual capacity 
persons together constitute a single levy. A has also established that 
that levy is a net income tax within the meaning of paragraph (a)(3) of 
this section. Pursuant to the terms of the contract, Country X has 
agreed to assume any Country X tax liability that A may incur with 
respect to A's income from the contract. For Federal income tax 
purposes, A's income from the contract includes the amount of tax 
liability that is imposed by Country X on A with respect to its income 
from the contract and that is assumed by Country X; and for purposes of 
section 901 the amount of such tax liability assumed by Country X is 
considered to be paid by A. By reason of paragraph (f)(2)(i) of this 
section, Country X is not considered to provide a subsidy, within the 
meaning of paragraph (e)(3) of this section, to A.
    (3) Taxes imposed on combined income of two or more persons--(i) In 
general. If foreign tax is imposed on the combined income of two or more 
persons (for example, a husband and wife or a corporation and one or 
more of its subsidiaries), foreign law is considered to impose legal 
liability on each such person for the amount of the tax that is 
attributable to such person's portion of the base of the tax. Therefore, 
if foreign tax is imposed on the combined income of two or more persons, 
such tax is allocated among, and considered paid by, such persons on a 
pro rata basis in proportion to each person's portion of the combined 
income, as determined under foreign law and paragraph (f)(3)(iii) of 
this section. Combined income with respect to each foreign tax that is 
imposed on a combined basis is computed separately, and the tax on that 
combined income is allocated separately under this paragraph (f)(3)(i). 
If foreign law exempts from tax, or provides for specific rates of tax 
with respect to, certain types of income, or if certain expenses, 
deductions or credits are taken into account only with respect to a 
particular type of income, combined income with respect to such portions 
of the combined income is also computed separately, and the tax on that 
combined income is allocated separately under this paragraph (f)(3)(i). 
The rules of this paragraph (f)(3) apply regardless of which person is 
obligated to remit the tax, which person actually remits the tax, or 
which person the foreign country could proceed against to collect the 
tax in the event all or a portion of the tax is not paid. For purposes 
of this paragraph (f)(3), the term person means an individual or an 
entity (including a disregarded entity described in Sec.  301.7701-
2(c)(2)(i) of this chapter) that is subject to tax in a foreign country 
as a corporation (or otherwise at the entity level). In determining the 
amount of tax paid by an owner of a partnership or a disregarded entity, 
this paragraph

[[Page 753]]

(f)(3) first applies to determine the amount of tax paid by the 
partnership or disregarded entity, and then paragraph (f)(4) of this 
section applies to allocate the amount of such tax to the owner.
    (ii) Combined income. For purposes of this paragraph (f)(3), foreign 
tax is imposed on the combined income of two or more persons if such 
persons compute their taxable income on a combined basis under foreign 
law and foreign tax would otherwise be imposed on each such person on 
its separate taxable income. For example, income is computed on a 
combined basis if two or more persons add their items of income, gain, 
deduction, and loss to compute a single consolidated taxable income 
amount for foreign tax purposes. Foreign tax is considered to be imposed 
on the combined income of two or more persons even if the combined 
income is computed under foreign law by attributing to one such person 
(for example, the foreign parent of a foreign consolidated group) the 
income of other such persons or by treating persons that would otherwise 
be subject to tax as separate entities as unincorporated branches of a 
single corporation for purposes of computing the foreign tax on the 
combined income of the group. However, foreign tax is not considered to 
be imposed on the combined income of two or more persons if, because one 
or more persons is a fiscally transparent entity (under the principles 
of Sec.  1.894-1(d)(3)) under foreign law, only one of such persons is 
subject to tax under foreign law (even if two or more of such persons 
are corporations for U.S. Federal income tax purposes). Therefore, 
foreign tax is not considered to be imposed on the combined income of 
two or more persons solely because foreign law:
    (A) Permits one person to surrender a loss to another person 
pursuant to a group relief or other loss-sharing regime described in 
Sec.  1.909-2(b)(2)(vi);
    (B) Requires a shareholder of a corporation to include in income 
amounts attributable to taxes imposed on the corporation with respect to 
distributed earnings, pursuant to an integrated tax system that allows 
the shareholder a credit for such taxes;
    (C) Requires a shareholder to include, pursuant to an anti-deferral 
regime (similar to subpart F of the Internal Revenue Code (sections 951 
through 965)), income attributable to the shareholder's interest in the 
corporation;
    (D) Reallocates income from one person to a related person under 
foreign transfer pricing rules;
    (E) Requires a person to take into account a distributive share of 
income of an entity that is a partnership or other fiscally transparent 
entity for foreign tax law purposes; or
    (F) Requires a person to take all or part of the income of an entity 
that is a corporation for U.S. Federal income tax purposes into account 
because foreign law treats the entity as a branch or fiscally 
transparent entity (a reverse hybrid). A reverse hybrid does not include 
an entity that is treated under foreign law as a branch or fiscally 
transparent entity solely for purposes of calculating combined income of 
a foreign consolidated group.
    (iii) Portion of combined income--(A) In general. Each person's 
portion of the combined income is determined by reference to any return, 
schedule or other document that must be filed or maintained with respect 
to a person showing such person's income for foreign tax purposes, as 
properly amended or adjusted for foreign tax purposes. If no such 
return, schedule or other document must be filed or maintained with 
respect to a person for foreign tax purposes, then, for purposes of this 
paragraph (f)(3), such person's income is determined from the books of 
account regularly maintained by or on behalf of the person for purposes 
of computing its income for foreign tax purposes. Each person's portion 
of the combined income is determined by adjusting such person's income 
determined under this paragraph (f)(3)(iii)(A) as provided in paragraph 
(f)(3)(iii)(B) and (f)(3)(iii)(C) of this section.
    (B) Effect of certain payments. (1) Each person's portion of the 
combined income is determined by giving effect to payments and accrued 
amounts of interest, rents, royalties, and other amounts between persons 
whose income is included in the combined base to the extent such amounts 
would be taken into account in computing the

[[Page 754]]

separate taxable incomes of such persons under foreign law if they did 
not compute their income on a combined basis. Each person's portion of 
the combined income is determined without taking into account any 
payments from other persons whose income is included in the combined 
base that are treated as dividends or other non-deductible distributions 
with respect to equity under foreign law, and without taking into 
account deemed dividends or any similar attribution of income made for 
purposes of computing the combined income under foreign law, regardless 
of whether any such deemed dividend or attribution of income results in 
a deduction or inclusion under foreign law.
    (2) For purposes of determining each person's portion of the 
combined income, the treatment of a payment is determined under foreign 
law. Thus, for example, interest accrued by one group member with 
respect to an instrument held by another member that is treated as debt 
for foreign tax purposes but as equity for U.S. Federal income tax 
purposes would be considered income of the holder and would reduce the 
income of the issuer. See also Sec.  1.909-2(b)(3)(i) for rules 
requiring suspension of foreign income taxes paid by the owner of a U.S. 
equity hybrid instrument.
    (C) Net losses. If tax is considered to be imposed on the combined 
income of three or more persons and one or more of such persons has a 
net loss for the taxable year for foreign tax purposes, the following 
rules apply. If foreign law provides mandatory rules for allocating the 
net loss among the other persons, then the rules that apply for foreign 
tax purposes apply for purposes of this paragraph (f)(3). If foreign law 
does not provide mandatory rules for allocating the net loss, the net 
loss is allocated among all other such persons on a pro rata basis in 
proportion to the amount of each person's income, as determined under 
paragraphs (f)(3)(iii)(A) and (f)(3)(iii)(B) of this section. For 
purposes of this paragraph (f)(3)(iii)(C), foreign law is not considered 
to provide mandatory rules for allocating a net loss solely because such 
loss is attributed from one person to a second person for purposes of 
computing combined income, as described in paragraph (f)(3)(ii) of this 
section.
    (iv) Collateral consequences. U.S. tax principles apply to determine 
the tax consequences if one person remits a tax that is the legal 
liability of, and thus is considered paid by, another person.
    (4) Taxes imposed on partnerships and disregarded entities--(i) 
Partnerships. If foreign law imposes tax at the entity level on the 
income of a partnership, the partnership is considered to be legally 
liable for such tax under foreign law and therefore is considered to pay 
the tax for Federal income tax purposes. The rules of this paragraph 
(f)(4)(i) apply regardless of which person is obligated to remit the 
tax, which person actually remits the tax, or which person the foreign 
country could proceed against to collect the tax in the event all or a 
portion of the tax is not paid. See Sec. Sec.  1.702-1(a)(6) and 1.704-
1(b)(4)(viii) for rules relating to the determination of a partner's 
distributive share of such tax.
    (ii) Disregarded entities. If foreign law imposes tax at the entity 
level on the income of an entity described in Sec.  301.7701-2(c)(2)(i) 
of this chapter (a disregarded entity), the person (as defined in 
section 7701(a)(1)) who is treated as owning the assets of the 
disregarded entity for Federal income tax purposes is considered to be 
legally liable for such tax under foreign law. Such person is considered 
to pay the tax for Federal income tax purposes. The rules of this 
paragraph (f)(4)(ii) apply regardless of which person is obligated to 
remit the tax, which person actually remits the tax, or which person the 
foreign country could proceed against to collect the tax in the event 
all or a portion of the tax is not paid.
    (5) Allocation of taxes in the case of certain ownership or 
classification changes--(i) In general. If a partnership, disregarded 
entity, or corporation undergoes one or more covered events during its 
foreign taxable year that do not result in a closing of the foreign 
taxable year, then a portion of the foreign income tax (other than a 
withholding tax described in section 901(k)(1)(B)) paid by a person 
under paragraphs (f)(1) through (4) of this section with respect to the 
continuing foreign taxable year in which such covered event or events

[[Page 755]]

occur is allocated to and among all persons that were predecessor 
entities or prior owners during such foreign taxable year. The 
allocation is made based on the respective portions of the taxable 
income (as determined under foreign law) for the continuing foreign 
taxable year that are attributable under the principles of Sec.  1.1502-
76(b) to the period of existence or ownership of each predecessor entity 
or prior owner during the continuing foreign taxable year. Foreign 
income tax allocated to a person that is a predecessor entity is treated 
(other than for purposes of section 986) as paid by the person as of the 
close of the last day of its last U.S. taxable year. Foreign income tax 
allocated to a person that is a prior owner, for example a transferor of 
a disregarded entity, is treated (other than for purposes of section 
986) as paid by the person as of the close of the last day of its U.S. 
taxable year in which the covered event occurred.
    (ii) Covered event. For purposes of this paragraph (f)(5), a covered 
event is a partnership termination under section 708(b)(1), a transfer 
of a disregarded entity, or a change in the entity classification of a 
disregarded entity or a corporation.
    (iii) Predecessor entity and prior owner. For purposes of this 
paragraph (f)(5), a predecessor entity is a partnership or a corporation 
that undergoes a covered event as described in paragraph (f)(5)(ii) of 
this section. A prior owner is a person that either transfers a 
disregarded entity or owns a disregarded entity immediately before a 
change in the entity classification of the disregarded entity as 
described in paragraph (f)(5)(ii) of this section.
    (iv) Partnership variances. In the case of a change in any partner's 
interest in the partnership (a variance), except as otherwise provided 
in section 706(d)(2) (relating to certain cash basis items) or 706(d)(3) 
(relating to tiered partnerships), foreign tax paid by the partnership 
during its U.S. taxable year in which the variance occurs is allocated 
between the portion of the U.S. taxable year ending on, and the portion 
of the U.S. taxable year beginning on the day after, the day of the 
variance. The allocation is made under the principles of this paragraph 
(f)(5) as if the variance were a covered event.
    (6) Allocation of foreign taxes in connection with elections under 
section 336(e) or 338 or Sec.  1.245A-5(e). For rules relating to the 
allocation of foreign taxes in connection with elections made pursuant 
to section 336(e), see Sec.  1.336-2(g)(3)(ii). For rules relating to 
the allocation of foreign taxes in connection with elections made 
pursuant to section 338, see Sec.  1.338-9(d). For rules relating to the 
allocation of foreign taxes in connection with elections made pursuant 
to Sec.  1.245A-5(e)(3)(i), see Sec.  1.245A-5(e)(3)(i)(B).
    (7) Examples. The following examples illustrate the rules of 
paragraphs (f)(3) through (6) of this section.
    (i) Example 1--(A) Facts. A, a United States person, owns 100 
percent of B, an entity organized in Country X. B owns 100 percent of C, 
also an entity organized in Country X. B and C are corporations for U.S. 
and foreign tax purposes that use the ``u'' as their functional 
currency. Pursuant to a consolidation regime, Country X imposes a net 
income tax described in paragraph (a)(3) of this section on the combined 
income of B and C within the meaning of paragraph (f)(3)(ii) of this 
section. In year 1, C pays 25u of interest to B. If B and C did not 
report their income on a combined basis for Country X tax purposes, the 
interest paid from C to B would result in 25u of interest income to B 
and 25u of deductible interest expense to C. For purposes of reporting 
the combined income of B and C, Country X first requires B and C to 
determine their own income (or loss) on a separate schedule. For this 
purpose, however, neither B nor C takes into account the 25u of interest 
paid from C to B because the income of B and C is included in the same 
combined base. The separate income of B and C reported on their Country 
X schedules for year 1, which do not reflect the 25u intercompany 
payment, is 100u and 200u, respectively. The combined income reported 
for Country X purposes is 300u (the sum of the 100u separate income of B 
and 200u separate income of C).
    (B) Result. On the separate schedules described in paragraph 
(f)(3)(iii)(A) of this section, B's separate income is 100u and C's 
separate income is 200u.

[[Page 756]]

Under paragraph (f)(3)(iii)(B)(1) of this section, the 25u interest 
payment from C to B is taken into account for purposes of determining 
B's and C's portions of the combined income under paragraph (f)(3)(iii) 
of this section, because B and C would have taken the items into account 
if they did not compute their income on a combined basis. Thus, B's 
portion of the combined income is 125u (100u plus 25u) and C's portion 
of the combined income is 175u (200u less 25u). The result is the same 
regardless of whether the 25u interest payment from C to B is deductible 
for U.S. Federal income tax purposes. See paragraph (f)(3)(iii)(B)(2) of 
this section.
    (ii) Example 2--(A) Facts. A, a United States person, owns 100 
percent of B, an entity organized in Country X. B is a corporation for 
Country X tax purposes, and a disregarded entity for U.S. income tax 
purposes. B owns 100 percent of C and D, entities organized in country X 
that are corporations for both U.S. and Country X tax purposes. B, C, 
and D use the ``u'' as their functional currency and file on a combined 
basis for Country X income tax purposes. Country X imposes a net income 
tax described in paragraph (a)(3) of this section at the rate of 30 
percent on the taxable income of corporations organized in Country X. 
Under the Country X combined reporting regime, income (or loss) of C and 
D is attributed to, and treated as income (or loss) of, B. B has the 
sole obligation to pay Country X income tax imposed with respect to 
income of B and income of C and D that is attributed to, and treated as 
income of, B. Under Country X tax law, Country X may proceed against B, 
but not C or D, if B fails to pay over to Country X all or any portion 
of the Country X income tax imposed with respect to such income. In year 
1, B has income of 100u, C has income of 200u, and D has a net loss of 
(60u). Under Country X tax law, B is considered to have 240u of taxable 
income with respect to which 72u of Country X income tax is imposed. 
Country X does not provide mandatory rules for allocating D's loss.
    (B) Result. Under paragraph (f)(3)(ii) of this section, the 72u of 
Country X tax is considered to be imposed on the combined income of B, 
C, and D. Because Country X tax law does not provide mandatory rules for 
allocating D's loss between B and C, under paragraph (f)(3)(iii)(C) of 
this section D's (60u) loss is allocated pro rata: 20u to B ((100u/300u) 
x 60u) and 40u to C ((200u/300u) x 60u). Under paragraph (f)(3)(i) of 
this section, the 72u of Country X tax must be allocated pro rata among 
B, C, and D. Because D has no income for Country X tax purposes, no 
Country X tax is allocated to D. Accordingly, 24u (72u x (80u/240u)) of 
the Country X tax is allocated to B, and 48u (72u x (160u/240u)) of such 
tax is allocated to C. Under paragraph (f)(4)(ii) of this section, A is 
considered to have legal liability for the 24u of Country X tax 
allocated to B under paragraph (f)(3) of this section.
    (g) Definitions. For purposes of this section and Sec. Sec.  1.901-
2A and 1.903-1, the following definitions apply.
    (1) Foreign country and possession (territory) of the United States. 
The term foreign country means any foreign state, any possession 
(territory) of the United States, and any political subdivision of any 
foreign state or of any possession (territory) of the United States. The 
term possession (or territory) of the United States means American 
Samoa, Guam, the Commonwealth of the Northern Mariana Islands, the 
Commonwealth of Puerto Rico, and the U.S. Virgin Islands.
    (2) Foreign levy. The term foreign levy means a levy imposed by a 
foreign country.
    (3) Foreign tax. The term foreign tax means a foreign levy that is a 
tax as defined in paragraph (a)(2) of this section.
    (4) Foreign tax law. The term foreign tax law means the laws of the 
foreign country imposing a foreign tax, including a separate levy that 
is modified by an applicable income tax treaty. The foreign tax law is 
construed on the basis of the foreign country's statutes, regulations, 
case law, and administrative rulings or other official pronouncements, 
as modified by an applicable income tax treaty.
    (5) Paid, payment, and paid by. The term paid means ``paid'' or 
``accrued''; the term payment means ``payment'' or ``accrual''; and the 
term paid by means ``paid by'' or ``accrued by or on behalf

[[Page 757]]

of,'' depending on the taxpayer's method of accounting for foreign 
income taxes. In the case of a taxpayer that claims a foreign tax 
credit, the taxpayer's method of accounting for foreign income taxes 
refers to whether the taxpayer claims the foreign tax credit for taxes 
paid (that is, remitted) or taxes accrued (as determined under Sec.  
1.905-1(d)) during the taxable year. The term paid does not include 
foreign taxes deemed paid under section 904(c) or section 960.
    (6) Resident and nonresident. The terms resident and nonresident, 
when used in the context of the foreign tax law of a foreign country, 
have the meaning provided in paragraphs (g)(6)(i) and (ii) of this 
section.
    (i) Resident. An individual is a resident of a foreign country if 
the individual is liable to income tax in such country by reason of the 
individual's residence, domicile, citizenship, or similar criterion 
under such country's foreign tax law. An entity (including a 
corporation, partnership, trust, estate, or an entity that is 
disregarded as an entity separate from its owner for Federal income tax 
purposes) is a resident of a foreign country if the entity is liable to 
tax on its income (regardless of whether tax is actually imposed) under 
the laws of the foreign country by reason of the entity's place of 
incorporation or place of management in that country (or in a political 
subdivision or local authority thereof), or by reason of a criterion of 
similar nature, or if the entity is of a type that is specifically 
identified as a resident in an income tax treaty with the United States 
to which the foreign country is a party.
    (ii) Nonresident. A nonresident with respect to a foreign country is 
any individual or entity that is not a resident of such foreign country.
    (7) Taxpayer. The term taxpayer has the meaning set forth in 
paragraph (f)(1) of this section.
    (h) Applicability dates. Except as otherwise provided in this 
paragraph (h), this section applies to foreign taxes paid (within the 
meaning of paragraph (g) of this section) in taxable years beginning on 
or after December 28, 2021. For foreign taxes that relate to (and if 
creditable are considered to accrue in) taxable years beginning before 
December 28, 2021, and that are remitted in taxable years beginning on 
or after December 28, 2021, by a taxpayer that accounts for foreign 
income taxes on the accrual basis, see Sec.  1.901-2 as contained in 26 
CFR part 1 revised as of April 1, 2021. For foreign taxes paid to Puerto 
Rico by reason of section 1035.05 of the Puerto Rico Internal Revenue 
Code of 2011, as amended (13 L.P.R.A. Sec.  30155) (treating certain 
income, gain or loss as effectively connected with the active conduct of 
a trade or business with Puerto Rico), this section applies to foreign 
taxes paid (within the meaning of paragraph (g) of this section) in 
taxable years beginning on or after January 1, 2023. For foreign taxes 
described in the preceding sentence that are paid in taxable years 
beginning before January 1, 2023, see Sec.  1.901-2 as contained in 26 
CFR part 1 revised as of April 1, 2021.

(Approved by the Office of Management and Budget under control number 
1545-0746)

[T.D. 7918, 48 FR 46276, Oct. 12, 1983, as amended by T.D. 8372, 56 FR 
56008, Oct. 31, 1991; T.D. 9416, 73 FR 40733, July 16, 2008; T.D. 9536, 
76 FR 42037, July 18, 2011, T.D. 9535, 76 FR 42043, July 18, 2011; T.D. 
9536, 76 FR 53819, Aug. 30, 2011; T.D. 9576, 77 FR 8125, Feb. 14, 2012; 
T.D. 9619, 78 FR 28489, May 15, 2013; T.D. 9634, 78 FR 54391, Sept. 4, 
2013; T.D. 9959, 87 FR 335, Jan. 4, 2022; 87 FR 45019, July 27, 2022]



Sec.  1.901-2A  Dual capacity taxpayers.

    (a) Application of separate levy rules as applied to dual capacity 
taxpayers--(1) In general. If the application of a foreign levy (as 
defined in Sec.  1.901-2(g)(3)) is different, either by the terms of the 
levy or in practice, for dual capacity taxpayers (as defined in Sec.  
1.901-2(a)(2)(ii)(A)) from its application to other persons, then, 
unless the only such difference is that a lower rate (but the same base) 
applies to dual capacity taxpayers, such difference is considered to be 
related to the fact that dual capacity taxpayers receive, directly or 
indirectly, a specific economic benefit (as defined in Sec.  1.901-
2(a)(2)(ii)(B)) from the foreign country and thus to be a difference in 
kind, and not merely of degree. In such a case, notwithstanding any 
contrary provision of Sec.  1.901-2(d), the levy as applicable to such 
dual capacity taxpayers is a separate levy (within the meaning of Sec.  
1.901-2(d)) from the levy as applicable to such

[[Page 758]]

other persons, regardless of whether such difference is in the base of 
the levy, in the rate of the levy, or both. In such a case, each of the 
levy as applied to dual capacity taxpayers and the levy as applied to 
other persons must be analyzed separately to determine whether it is an 
income tax within the meaning of Sec.  1.901-2(a)(1) and whether it is a 
tax in lieu of an income tax within the meaning of Sec.  1.903-1(a). 
However, if the application of the levy is neither different by its 
terms nor different in practice for dual capacity taxpayers from its 
application to other persons, or if the only difference is that a lower 
rate (but the same base) applies to dual capacity taxpayers, then, in 
accordance with Sec.  1.901-2(d), such foreign levy as applicable to 
dual capacity taxpayers and such levy as applicable to other persons 
together constitute a single levy. In such a case, no amount paid (as 
defined in Sec.  1.901-2(g)(1)) pursuant to such levy by any such dual 
capacity taxpayer is considered to be paid in exchange for a specific 
economic benefit, and such levy, as applicable in the aggregate to such 
dual capacity taxpayers and to such other persons, is analyzed to 
determine whether it is an income tax within the meaning of Sec.  1.901-
2(a)(1) or a tax in lieu of an income tax within the meaning of Sec.  
1.903-1(a). Application of a foreign levy to dual capacity taxpayers 
will be considered to be different in practice from application of that 
levy to other persons, even if no such difference is apparent from the 
terms of the levy, unless it is established that application of that 
levy to dual capacity taxpayers does not differ in practice from its 
application to other persons.
    (2) Examples. The provisions of paragraph (a)(1) of this section may 
be illustrated by the following examples:

    Example 1. Under a levy of country X called the country X income 
tax, every corporation that does business in country X is required to 
pay to country X 40 percent of its income from its business in country 
X. Income for purposes of the country X income tax is computed by 
subtracting specified deductions from the corporation's gross income 
derived from its business in country X. The specified deductions include 
the corporation's expenses attributable to such gross income and 
allowances for recovery of the cost of capital expenditures attributable 
to such gross income, except that under the terms of the country X 
income tax a corporation engaged in the exploitation of minerals K, L or 
M in country X is not permitted to recover, currently or in the future, 
expenditures it incurs in exploring for those minerals. In practice, the 
only corporations that engage in exploitation of the specified minerals 
in country X are dual capacity taxpayers. Thus, the application of the 
country X income tax to dual capacity taxpayers is different from its 
application to other corporations. The country X income tax as applied 
to corporations that engage in the exploitation of minerals K, L or M 
(dual capacity taxpayers) is, therefore, a separate levy from the 
country X income tax as applied to other corporations. Accordingly, each 
of (i) the country X income tax as applied to such dual capacity 
taxpayers and (ii) the country X income tax as applied to such other 
persons, must be analyzed separately to determine whether it is an 
income tax within the meaning of Sec.  1.901-2(a)(1) and whether it is a 
tax in lieu of an income tax within the meaning of Sec.  1.903-1(a).
    Example 2. The facts are the same as in example 1, except that it is 
demonstrated that corporations that engage in exploitation of the 
specified minerals in country X and that are subject to the levy include 
both dual capacity taxpayers and other persons. The country X income tax 
as applied to all corporations is, therefore, a single levy. 
Accordingly, no amount paid pursuant to the country X income tax by a 
dual capacity taxpayer is considered to be paid in exchange for a 
specific economic benefit; and, if the country X income tax is an income 
tax within the meaning of Sec.  1.901-2(a)(1) or a tax in lieu of an 
income tax within the meaning of Sec.  1.903-1(a), it will be so 
considered in its entirety for all corporations subject to it.
    Example 3. Under a levy of country Y called the country Y income 
tax, each corporation incorporated in country Y is required to pay to 
country Y a percentage of its worldwide income. The applicable 
percentage is greater for such corporations that earn more than a 
specified amount of income than for such corporations that earn less 
than that amount. Income for purposes of the levy is computed by 
deducting from gross income specified types of expenses and specified 
allowances for capital expenditures. The expenses for which deductions 
are permitted differ depending on the type of business in which the 
corporation subject to the levy is engaged, e.g., a deduction for 
interest paid to a related party is not allowed for corporations engaged 
in enumerated types of activities. In addition, carryover of losses from 
one taxable period to another is permitted for corporations engaged in 
specified types of activities, but not for corporations engaged in other 
activities. By its terms, the foreign

[[Page 759]]

levy makes no distinction between dual capacity taxpayers and other 
persons. It is established that in practice the higher rate of the 
country Y income tax applies to both dual capacity taxpayers and other 
persons and that in practice the differences in the base of the country 
Y income tax (e.g., the lack of a deduction for interest paid to related 
parties for some corporations subject to the levy and the lack of a 
carryover provision for some corporations subject to the levy) apply to 
both dual capacity taxpayers and other persons. The country Y income tax 
as applied to all corporations incorporated in country Y is therefore a 
single levy. Accordingly, no amount paid pursuant to the country Y 
income tax by a dual capacity taxpayer is considered to be paid in 
exchange for a specific economic benefit; and if the country Y income 
tax is an income tax within the meaning of Sec.  1.901-2(a)(1) or a tax 
in lieu of an income tax within the meaning of Sec.  1.903-1(a), it will 
be so considered in its entirety for all persons subject to it.
    Example 4. The facts are the same as in example 3, except that it is 
not established that in practice the higher rate does not apply only to 
dual capacity taxpayers. By reason of such higher rate, application of 
the country Y income tax to dual capacity taxpayers is different in 
practice from application of the country Y income tax to other persons 
subject to it. The country Y income tax as applied to dual capacity 
taxpayers is therefore a separate levy from the country Y income tax as 
applied to other corporations incorporated in country Y. Accordingly, 
each of (i) the country Y income tax as applied to dual capacity 
taxpayers and (ii) the country Y income tax as applied to other 
corporations incorporated in country Y, must be analyzed separately to 
determine whether it is an income tax within the meaning of Sec.  1.901-
2(a)(1) and whether it is a tax in lieu of an income tax within the 
meaning of Sec.  1.903-1(a).
    Example 5. Under a levy of country X called the country X tax, all 
persons who do not engage in business in country X and who receive 
interest income from residents of country X are required to pay to 
country X 25 percent of the gross amount of such interest income. It is 
established that the country X tax applies by its terms and in practice 
to certain banks that are dual capacity taxpayers and to persons who are 
not dual capacity taxpayers and that application to such dual capacity 
taxpayers does not differ by its terms or in practice from application 
to such other persons. The country X tax as applied to all such persons 
(both the dual capacity taxpayers and the other persons) is, therefore, 
a single levy. Accordingly, no amount paid pursuant to the country X tax 
by such a dual capacity taxpayer is considered to be paid in exchange 
for a specific economic benefit; and, if the country X tax is a tax in 
lieu of an income tax within the meaning of Sec.  1.903-1(a), it will be 
so considered in its entirety for all persons subject to it.
    Example 6. Under a levy of country X called the country X tax, every 
corporation incorporated outside of country X (``foreign corporation'') 
that maintains a branch in country X is required annually to pay to 
country X 52 percent of its net income attributable to that branch. It 
is established that the application of the country X tax is neither 
different by its terms nor different in practice for certain banks that 
are dual capacity taxpayers from its application to persons (which may, 
but do not necessarily, include other banks) that are not dual capacity 
taxpayers. The country X tax as applied to all foreign corporations with 
branches in country X (i.e., both those banks that are dual capacity 
taxpayers and the foreign corporations that are not dual capacity 
taxpayers) is, therefore, a single levy. Accordingly, no amount paid 
pursuant to the country X tax by a bank that is a dual capacity taxpayer 
is considered to be paid in exchange for a specific economic benefit; 
and, if the country X tax is an income tax within the meaning of Sec.  
1.901-2(a)(1) or a tax in lieu of an income tax within the meaning of 
Sec.  1.903-1(a), it will be so considered in its entirety for all 
persons subject to it.
    Example 7. Under a levy of country H called the country H tax, all 
corporations that are organized outside country H and that do not engage 
in business in country H are required to pay to country H a percentage 
of the gross amount of interest income derived from residents of country 
H. The percentage is 30 percent, except that it is 15 percent for a 
specified category of corporations. All corporations in that category 
are dual capacity taxpayers. It is established that the country H tax 
applies by its terms and in practice to dual capacity taxpayers and to 
persons that are not dual capacity taxpayers and that the only 
difference in application between such dual capacity taxpayers and such 
other persons is that a lower rate (but the same base) applies to such 
dual capacity taxpayers. The country H tax as applied to all such 
persons (both the dual capacity taxpayers and the other persons) is, 
therefore, a single levy. Accordingly, no amount paid pursuant to the 
country H tax by such a dual capacity taxpayer is considered to be paid 
in exchange for a specific economic benefit, and if the country H tax is 
a tax in lieu of an income tax within the meaning of Sec.  1.903-1(a), 
it will be so considered in its entirety for all persons subject to it.

    (b) Burden of proof for dual capacity taxpayers--(1) In general. For 
credit to be allowable under section 901 or 903, the person claiming 
credit must establish that the foreign levy with respect

[[Page 760]]

to which credit is claimed is an income tax within the meaning of Sec.  
1.901-2(a)(1) or a tax in lieu of an income tax within the meaning of 
Sec.  1.903-1(a), respectively. Thus, such person must establish, among 
other things, that such levy is a tax. See Sec.  1.901-2(a)(2)(i) and 
Sec.  1.903-1(a). Where a person claims credit under section 901 or 903 
for an amount paid by a dual capacity taxpayer pursuant to a foreign 
levy, Sec.  1.901-2(a)(2)(i) and Sec.  1.903-1(a), respectively, require 
such person to establish the amount, if any, that is paid pursuant to 
the distinct element of the levy that is a tax. If, pursuant to 
paragraph (a)(1) of this section and Sec.  1.901-2(d), such levy as 
applicable to dual capacity taxpayers and such levy as applicable to 
other persons together constitute a single levy, then no amount paid 
pursuant to that levy by any such dual capacity taxpayer is considered 
to be paid in exchange for a specific economic benefit. Accordingly, 
such levy has only one distinct element, and the levy either is or is 
not, in its entirety, a tax. If, however, such levy as applicable to 
dual capacity taxpayers is a separate levy from such levy as applicable 
to other persons, then a person claiming credit under section 901 or 903 
for an amount paid by a dual capacity taxpayer pursuant to such separate 
levy may establish the amount, if any, that is paid pursuant to the 
distinct element of the levy that is a tax only by the facts and 
circumstances method or the safe harbor method described in paragraph 
(c) of this section. If such person fails to so establish such amount, 
no portion of the amount that is paid pursuant to the separate levy by 
the dual capacity taxpayer to such foreign country shall be treated as 
an amount of tax. Any amount that, either by reason of application of 
the methods of paragraph (c) of this section or by reason of the 
immediately preceding sentence, is not treated as an amount of tax shall 
(i) be considered to have been paid in exchange for a specific economic 
benefit; (ii) be characterized (e.g., as royalty, purchase price, cost 
of sales, reduction of the proceeds of a sale, or reduction of interest 
income) according to the nature of the transaction and of the specific 
economic benefit received; and (iii) be treated according to such 
characterization for all purposes of chapter 1 of the Internal Revenue 
Code, except that any determination that an amount is not tax for 
purposes of section 901 or 903 by reason of application of the safe 
harbor method shall not be taken into account in determining whether or 
not such an amount is to be characterized and treated as tax for 
purposes of computing an allowance for percentage depletion under 
sections 611 and 613.
    (2) Effect of certain treaties. If, irrespective of whether such 
credit would be allowable under section 901 or 903 in the absence of a 
treaty, the United States has in force a treaty with a foreign country 
that treats a foreign levy as an income tax for purposes of allowing 
credit for United States tax and if the person claiming credit is 
entitled to the benefit of such treaty, then, unless such person claims 
credit not under the treaty but under section 901 or 903, and except to 
the extent the treaty provides otherwise and subject to all terms, 
conditions and limitations provided in the treaty, no portion of an 
amount paid with respect to such levy by a dual capacity taxpayer shall 
be considered to be paid in exchange for a specific economic benefit. 
If, however, such person claims credit not under such treaty but rather 
under section 901 or 903 (e.g., so as not to be subject to a limitation 
contained in such treaty), the provisions of this section apply to such 
levy.
    (c) Satisfaction of burden of proof--(1) In general. This paragraph 
(c) sets out the methods by which a person who claims credit under 
section 901 or 903 for an amount paid by a dual capacity taxpayer 
pursuant to a foreign levy that satisfies all of the criteria of section 
901 or 903 other than the determination of the distinct element of the 
levy that is a tax and of the amount that is paid pursuant to that 
distinct element (a ``qualifying levy'') may establish such distinct 
element and amount. Such person must establish the amount paid pursuant 
to a qualifying levy that is paid pursuant to the distinct element of 
the levy that is a tax (which amount therefore is an amount of income 
tax within the meaning of Sec.  1.901-2(a)(1) or an amount of tax in 
lieu of income tax within the

[[Page 761]]

meaning of Sec.  1.903-1(a) (a ``qualifying amount'')) only by the facts 
and circumstances method set forth in paragraph (c)(2) of this section 
or the safe harbor method set forth in paragraph (c)(3) of this section. 
A levy is not a qualifying levy, and neither the facts and circumstances 
method nor the safe harbor method applies to an amount paid by a dual 
capacity taxpayer pursuant to a foreign levy, if it has been established 
pursuant to Sec.  1.901-2(d) and paragraph (a)(1) of this section that 
that levy as applied to that dual capacity taxpayer and that levy as 
applied to persons other than dual capacity taxpayers together 
constitute a single levy, or if it has been established in accordance 
with the first sentence of paragraph (b)(2) of this section that credit 
is allowable by reason of a treaty for an amount paid with respect to 
such levy.
    (2) Facts and circumstances method--(i) In general. If the person 
claiming credit establishes, based on all of the relevant facts and 
circumstances, the amount, if any, paid by the dual capacity taxpayer 
pursuant to the qualifying levy that is not paid in exchange for a 
specific economic benefit, such amount is the qualifying amount with 
respect to such qualifying levy. In determining the qualifying amount 
with respect to a qualifying levy under the facts and circumstances 
method, neither the methodology nor the results that would have obtained 
if a person had elected to apply the safe harbor method to such 
qualifying levy is a relevant fact or circumstance. Accordingly, neither 
such methodology nor such results shall be taken into account in 
applying the facts and circumstances method.
    (ii) Examples. The application of the facts and circumstances method 
is illustrated by the following examples:

    Example 1. Country A, which does not have a generally imposed income 
tax, imposes a levy, called the country A income tax, on corporations 
that carry on the banking business through a branch in country A. All 
such corporations lend money to the government of country A, and the 
consideration (interest) paid by the government of country A for the 
loans is not made available by the government on substantially the same 
terms to the population of country A in general. Thus, the country A 
income tax is imposed only on dual capacity taxpayers. L, a corporation 
that carries on the banking business through a branch in country A and 
that is a dual capacity taxpayer, establishes that all of the criteria 
of section 901 are satisfied by the country A income tax, except for the 
determination of the distinct element of the levy that is a tax and of 
L's qualifying amount with respect thereto. The country A income tax is, 
therefore, a qualifying levy. L establishes that, although all persons 
subject to the country A income tax are dual capacity taxpayers, the 
country A income tax applies in the same manner to income from such 
persons' transactions with the government of country A as it does to 
income from their transactions with private persons; that there are 
significant transactions (either in volume or in amount) with private 
persons; and that the portion of such persons' income that is derived 
from transactions with the government of country A on the one hand or 
private persons on the other varies greatly among persons subject to the 
country A income tax. By making this showing, L has demonstrated that no 
portion of the amount paid by it to country A pursuant to the levy is 
paid in exchange for a specific economic benefit (the interest income). 
Accordingly, L has demonstrated under the facts and circumstances method 
that the entire amount it has paid pursuant to the country A income tax 
is a qualifying amount.
    Example 2. A, a domestic corporation that is a dual capacity 
taxpayer subject to a qualifying levy of country X, pays 1000u (units of 
country X currency) to country X in 1986 pursuant to the qualifying 
levy. A does not elect to apply the safe harbor method to country X, but 
if it had so elected, 800u would have been A's qualifying amount with 
respect to the levy. Based on all of the relevant facts and 
circumstances (which do not include either the methodology of the safe 
harbor method or the qualifying amount that would have obtained under 
that method), A establishes that 628u of such 1000u is not paid in 
exchange for a specific economic benefit. A has demonstrated under the 
facts and circumstances method that 628u is a qualifying amount. 
Pursuant to paragraph (b)(1) of this section, 372u (1000u-628u) is 
considered to have been paid by A in exchange for a specific economic 
benefit. That amount is characterized and treated as provided in 
paragraph (b)(1) of this section.
    Example 3. The facts are the same as in example 2 except that under 
the safe harbor method 580u would have been A's qualifying amount with 
respect to the levy. That amount is not a relevant fact or circumstance 
and the result is the same as in example 2.

    (3) Safe harbor method. Under the safe harbor method, the person 
claiming credit makes an election as provided in

[[Page 762]]

paragraph (d) of this section and, pursuant to such election, applies 
the safe harbor formula described in paragraph (e) of this section to 
the qualifying levy or levies to which the election applies.
    (d) Election to use the safe harbor method--(1) Scope of election. 
An election to use the safe harbor method is made with respect to one or 
more foreign states and possessions of the United States with respect to 
a taxable year of the person making the election (the ``electing 
person''). Such election applies to such taxable year and to all 
subsequent taxable years of the electing person (``election years''), 
unless the election is revoked in accordance with paragraph (d)(4) of 
this section. If an election applies to a foreign state or possession of 
the United States (``elected country''), it applies to all qualifying 
levies of the elected country and to all qualifying levies of all 
political subdivisions of the elected country with respect to which the 
electing person claims credit for amounts paid (or deemed to be paid) by 
any dual capacity taxpayer. A member of an affiliated group that files a 
consolidated United States income tax return may use the safe harbor 
method for a foreign state or U.S. possession only if an election to use 
the safe harbor method for that state or possession has been made by the 
common parent of such affiliated group on behalf of all members of the 
group. Similarly, a member of an affiliated group that does not file a 
consolidated United States income tax return may elect to use the safe 
harbor method for a foreign state or U.S. possession only if an election 
to use the safe harbor method for that state or possession is made by 
each member of the affiliated group which claims credit for taxes paid 
to such state or possession or to any political subdivision thereof. An 
election to use the safe harbor method for an elected country does not 
apply to foreign taxes carried back or forward to any election year from 
any taxable year to which the election does not apply. Such election 
does apply to foreign taxes carried back or forward from any election 
year to any taxable year. A person who elects to use the safe harbor 
method for one or more foreign countries may, in a later taxable year, 
also elect to use that method for other foreign countries.
    (2) Effect of election. An election to use the safe harbor method 
described in paragraph (c)(3) of this section requires the electing 
person to apply the safe harbor formula of paragraph (e) of this section 
to all qualifying levies of all elected countries and their political 
subdivisions, and constitutes a specific waiver by such person of the 
right to use the facts and circumstances method described in paragraph 
(c)(2) of this section with respect to any levy of any elected country 
or any political subdivision thereof.
    (3) Time and manner of making election--(i) In general. To elect to 
use the safe harbor method, an electing person must attach a statement 
to its United States income tax return for the taxable year for which 
the election is made and must file such return by the due date 
(including extensions) for the filing thereof. Such statement shall 
state--
    (A) That the electing person elects to use the safe harbor method 
for the foreign states and the possessions of the United States 
designated in the statement and their political subdivisions, and
    (B) That the electing person waives the right, for any election 
year, to use the facts and circumstances method for any levy of the 
designated states, possessions and political subdivisions. 
Notwithstanding the foregoing, a person may, with the consent of the 
Commissioner, elect to use the safe harbor method for a taxable year for 
one or more foreign states or possessions of the United States, at a 
date later than that specified in the first sentence of this paragraph 
(d)(3)(i), e.g., upon audit of such person's United States income tax 
return for such taxable year. The Commissioner will normally consent to 
such a later election if such person demonstrates that it failed to make 
a timely election for such a foreign state or possession for such 
taxable year because such person reasonably believed either that it was 
not a dual capacity taxpayer with respect to such state or possession or 
that no levy that it paid

[[Page 763]]

to such state or possession or any political subdivision thereof was a 
qualifying levy (for example, because it reasonably, but incorrectly, 
believed that the levy it paid was not a separate levy from that 
applicable to persons other than dual capacity taxpayers). The 
Commissioner will not, however, consent to such a later election with 
respect to any state or possession for a taxable year if such person (or 
any other member of an affiliated group of which such person is a 
member) applied the facts and circumstances method to any levy of such 
state or possession or any political subdivision thereof for such 
taxable year.
    (ii) Certain retroactive elections. Notwithstanding the requirements 
of paragraph (d)(3)(i) of this section relating to the time and manner 
of making an election, an election may be made for a taxable year 
beginning on or before November 14, 1983, provided the electing person 
elects in accordance with Sec.  1.901-2(h) to apply all of the 
provisions of this section, Sec.  1.901-2 and Sec.  1.903-1 to such 
taxable year and provided all of the requirements set forth in this 
paragraph (d)(3)(ii) are satisfied. Such an election shall be made by 
timely (including extensions) filing a federal income tax return or an 
amended federal income tax return for such taxable year; by attaching to 
such return a statement containing the statements and information set 
forth in paragraph (d)(3)(i) of this section; and by filing amended 
income tax returns for all subsequent election years for which income 
tax returns have previously been filed in which credit is claimed under 
section 901 or 903 and applying the safe harbor method in such amended 
returns. All amended returns referred to in the immediately preceding 
sentence must be filed on or before October 12, 1984, (unless the 
Commissioner consents to a later filing in circumstances similar to 
those provided in paragraph (d)(3)(i)) and at a time when neither 
assessment of a deficiency for any of such election years nor the filing 
of a claim for any refund claimed in any such amended return is barred.
    (iii) Election to credit taxes made in amended return. If a person 
has filed a United States income tax return for a taxable year to which 
this Sec.  1.901-2A applies (including application by reason of the 
election provided in Sec.  1.901-2(h)(2)) in which such person has 
deducted (instead of credited) qualifying foreign taxes and such person 
validly makes an election to credit (instead of deduct) such taxes in a 
timely filed amended return for such taxable year, an election to use 
the safe harbor method may be made in such amended return provided all 
of the requirements of paragraph (d)(3)(ii) of this section are 
satisfied other than the requirement that such amended return and the 
other amended returns referred to in that paragraph be filed on or 
before October 12, 1984.
    (4) Revocation of election. An election to use the safe harbor 
method described in paragraph (c)(3) of this section may not be revoked 
without the consent of the Commissioner. An application for consent to 
revoke such election with respect to one or more elected countries shall 
be made to the Commissioner of Internal Revenue, Washington, DC 20224. 
Such application shall be made not later than the 30th day before the 
due date (including extensions) for the filing of the income tax return 
for the first taxable year for which the revocation is sought to be 
effective, except in the case of an event described in (i), (ii), (iii) 
or (iv) below, in which case an application for revocation with 
retroactive effect may be made within a reasonable time after such 
event. The Commissioner may make his consent to any revocation 
conditioned upon adjustments being made in one or more taxable years so 
as to prevent the revocation from resulting in a distortion of the 
amount of any item relating to tax liability in any taxable year. The 
Commissioner will normally consent to a revocation (including, in the 
case of (i), (ii), (iii) or (iv) below, one with retroactive effect), 
if--
    (i) An amendment to the Internal Revenue Code or the regulations 
thereunder is made which applies to the taxable year for which the 
revocation is to be effective and the amendment substantially affects 
the taxation of income from sources outside the United States under 
subchapter N of chapter 1 of the Internal Revenue Code; or

[[Page 764]]

    (ii) After a safe harbor election is made with respect to a foreign 
state, a tax treaty between the United States and that state enters into 
force; that treaty covers a foreign tax to which the safe harbor 
election applies; and that treaty applies to the taxable year for which 
the revocation is to be effective; or
    (iii) After a safe harbor election is made with respect to a foreign 
state or possession of the United States, a material change is made in 
the tax law of that state or possession or of a political subdivision of 
that state or possession; and the changed law applies to the taxable 
year for which the revocation is to be effective and has a material 
effect on the taxpayer; or
    (iv) With respect to a foreign country to which a safe harbor 
election applies, the Internal Revenue Service issues a letter ruling to 
the electing person and that letter ruling (A) relates to the 
availability or application of the safe harbor method to one or more 
levies of such foreign country; (B) does not relate to the facts and 
circumstances method described in paragraph (c)(2) of this section; and 
(C) fails to include a ruling requested by the electing person or 
includes a ruling contrary to one requested by such person (in either 
case, other than one relating to the facts and circumstances method) and 
such failure or inclusion has a material adverse effect on the amount of 
such electing person's credit for taxes paid to such foreign country for 
the taxable year for which the revocation is to be effective; or
    (v) A corporation (``new member'') becomes a member of an affiliated 
group; the new member and one or more pre-existing members of such group 
are dual capacity taxpayers with respect to the same foreign country; 
and, with respect to such country, either the new member or the pre-
existing members (but not both) have made a safe harbor election; and 
the Commissioner in his discretion determines that obtaining the benefit 
of the right to revoke the safe harbor election with respect to such 
foreign country was not the principal purpose of the affiliation between 
such new member and such group; or
    (vi) The election has been in effect with respect to at least three 
taxable years prior to the taxable year for which the revocation is to 
be effective.


The Commissioner may, in his discretion, consent to a revocation even if 
none of the foregoing subdivisions (i) through (vi) is applicable. If an 
election has been revoked with respect to an elected country, a 
subsequent election to apply the safe harbor method with respect to such 
elected country may be made only with the consent of the Commissioner 
and upon such terms and conditions as the Commissioner in his discretion 
may require.
    (e) Safe harbor formula--(1) In general. The safe harbor formula 
applies to determine the distinct element of a qualifying levy that is a 
tax and the amount paid by a dual capacity taxpayer pursuant to such 
qualifying levy that is the qualifying amount with respect to such levy. 
Under the safe harbor formula the amount paid in a taxable year pursuant 
to a qualifying levy that is the qualifying amount with respect to such 
levy is an amount equal to:

(A - B - C) x D / (1 - D)

where (except as otherwise provided in paragraph (e)(5) of this 
section):
A = the amount of gross receipts as determined under paragraph (e)(2) of 
          this section
B = the amount of costs and expenses as determined under paragraph 
          (e)(2) of this section
C = the total amount paid in the taxable year by the dual capacity 
          taxpayer pursuant to the qualifying levy (the ``actual payment 
          amount'')
D = the tax rate as determined under paragraph (e)(3) of this section


In no case, however, shall the qualifying amount exceed the actual 
payment amount; and the qualifying amount is zero if the safe harbor 
formula yields a qualifying amount less than zero. The safe harbor 
formula is intended to yield a qualifying amount that is approximately 
equal to the amount of generally imposed income tax within the meaning 
of paragraphs (a) and (b)(1) of Sec.  1.903-1 (``general tax'') of the 
foreign country that would have been required to be paid in the taxable 
year by the dual capacity taxpayer if it had not been a dual capacity 
taxpayer

[[Page 765]]

and if the base of the general tax had allowed a deduction in such year 
for the amount (``specific economic benefit amount'') by which the 
actual payment amount exceeds the qualifying amount. See, however, 
paragraph (e)(5) of this section if an elected country has no general 
tax. The specific economic benefit amount is considered to be the 
portion of the actual payment amount that is paid pursuant to the 
distinct portion of the qualifying levy that imposes an obligation in 
exchange for a specific economic benefit. The specific economic benefit 
amount is therefore considered to be an amount paid by the dual capacity 
taxpayer in exchange for such specific economic benefit, which amount 
must be treated for purposes of chapter 1 of the Internal Revenue Code 
as provided in paragraph (b)(1) of this section.
    (2) Determination of gross receipts and costs and expenses. For 
purposes of the safe harbor formula, gross receipts and costs and 
expenses are, except as otherwise provided in this paragraph (e), the 
gross receipts and the deductions for costs and expenses, respectively, 
as determined under the foreign law applicable in computing the actual 
payment amount of the qualifying levy to which the safe harbor formula 
applies. However, except as otherwise provided in this paragraph (e), if 
provisions of the qualifying levy increase or decrease the liability 
imposed on dual capacity taxpayers compared to the general tax liability 
of persons other than dual capacity taxpayers by reason of the 
determination or treatment of gross receipts or of costs or expenses, 
the provisions generally applicable in computing such other persons' tax 
base under the general tax shall apply to determine gross receipts and 
costs and expenses for purposes of computing the qualifying amount. If 
provisions of the qualifying levy relating to gross receipts meet the 
requirements of Sec.  1.901-2(b)(3)(i), such provisions shall apply to 
determine gross receipts for purposes of computing the qualifying 
amount. If neither the general tax nor the qualifying levy permits 
recovery of one or more costs or expenses, and by reason of the failure 
to permit such recovery the qualifying levy does not satisfy the net 
income requirement of Sec.  1.901-2(b)(4) (even though the general tax 
does satisfy that requirement), then such cost or expense shall be 
considered a cost or expense for purposes of computing the qualifying 
amount. If the qualifying levy does not permit recovery of one or more 
significant costs or expenses, but provides allowances that effectively 
compensate for nonrecovery of such significant costs or expenses, then, 
for purposes of computing the qualifying amount, costs and expenses 
shall not include the costs and expenses under the general tax whose 
nonrecovery under the qualifying levy is compensated for by such 
allowances but shall instead include such allowances. In determining 
costs and expenses for purposes of computing the qualifying amount with 
respect to a qualifying levy, the actual payment amount with respect to 
such levy shall not be considered a cost or expense. For purposes of 
this paragraph, the following differences in gross receipts and costs 
and expenses between the qualifying levy and the general tax shall not 
be considered to increase the liability imposed on dual capacity 
taxpayers compared to the general tax liability of persons other than 
dual capacity taxpayers, but only if the general tax would be an income 
tax within the meaning of Sec.  1.901-2(a)(1) if such different 
treatment under the qualifying levy had also applied under the general 
tax:
    (i) Differences in the time of realization or recognition of one or 
more items of income or in the time when recovery of one or more costs 
and expenses is allowed (unless the period of recovery of such costs and 
expenses pursuant to the qualifying levy is such that it effectively is 
a denial of recovery of such costs and expenses, as described in Sec.  
1.901-2(b)(4)(i)); and
    (ii) Differences in consolidation or carryover provisions of the 
types described in paragraphs (b)(4)(ii) and (b)(4)(iii) of Sec.  1.901-
2.
    (3) Determination of tax rate. The tax rate for purposes of the safe 
harbor formula is the tax rate (expressed as a decimal) that is 
applicable in computing tax liability under the general tax. If the rate 
of the general tax varies according to the amount of the base of that 
tax, the rate to be applied in

[[Page 766]]

computing the qualifying amount is the rate that applies under the 
general tax to a person whose base is, using the terminology of 
paragraph (e)(1) of this section, ``A'' minus ``B'' minus the specific 
economic benefit amount paid by the dual capacity taxpayer pursuant to 
the qualifying levy, provided such rate applies in practice to persons 
other than dual capacity taxpayers, or, if such rate does not so apply 
in practice, the next lowest rate of the general tax that does so apply 
in practice.
    (4) Determination of applicable provisions of general tax--(i) In 
general. If the general tax is a series of income taxes (e.g., on 
different types of income), or if the application of the general tax 
differs by its terms for different classes of persons subject to the 
general tax (e.g., for persons in different industries), then, except as 
otherwise provided in this paragraph (e), the qualifying amount small be 
computed by reference to the income tax contained in such series of 
income taxes, or in the case of such different applications the 
application of the general tax, that by its terms and in practice 
imposes the highest tax burden on persons other than dual capacity 
taxpayers. Notwithstanding the preceding sentence, the general tax 
amount shall be computed by reference to the application of the general 
tax to entities of the same type (as determined under the general tax) 
as the dual capacity taxpayer and to persons of the same resident or 
nonresident status (as determined under the general tax) as the dual 
capacity taxpayer; and, if the general tax treats business income 
differently from non-business (e.g., investment) income (as determined 
under the general tax), the dual capacity taxpayer's business and non-
business income shall be treated as the general tax treats such income. 
If, for example, the dual capacity taxpayer would, under the general 
tax, be treated as a resident (e.g., because the general tax treats an 
entity that is organized in the foreign country or managed or controlled 
there as a resident) and as a corporation (i.e., because the rules of 
the general tax treat an entity like the dual capacity taxpayer as a 
corporation), and if some of the dual capacity taxpayer's income would, 
under the general tax, be treated as business income and some as non-
business income, the dual capacity taxpayer and its income shall be so 
treated in computing the qualifying amount.
    (ii) Establishing that provisions apply in practice. For purposes of 
the safe harbor formula a provision (including tax rate) shall be 
considered a provision of the general tax only if it is reasonably 
likely that that provision applies by its terms and in practice to 
persons other than dual capacity taxpayers. In general, it will be 
assumed that a provision (including tax rate) that by its terms applies 
to persons other than dual capacity taxpayers is reasonably likely to 
apply in practice to such other persons, unless the person claiming 
credit knows or has reason to know otherwise. However, in cases of 
doubt, the person claiming credit may be required to demonstrate that 
such provision is reasonably likely so to apply in practice.
    (5) No general tax. If a foreign country does not impose a general 
tax (and thus a levy, in order to be a qualifying levy must satisfy all 
of the criteria of section 901 (because section 903 cannot apply), other 
than the determination of the distinct element of the levy that is a tax 
and of the amount that is paid pursuant to that distinct element), 
paragraphs (e)(2), (3) and (4) of this section do not apply to a 
qualifying levy of such country, and the terms of the safe harbor 
formula set forth in paragraph (e)(1) of this section are defined with 
respect to such levy as follows:

A = the amount of gross receipts as determined under the qualifying 
          levy;
B = the amount of deductions for costs and expenses as determined under 
          the qualifying levy;
C = the actual payment amount; and
D = the lower of the rate of the qualifying levy, or the rate of tax 
          specified in section 11(b)(5) (or predecessor or successor 
          section, as the case may be) of the Internal Revenue Code as 
          applicable to the taxable year in which the actual payment 
          amount is paid.

    (6) Certain taxes in lieu of an income tax. To the extent a tax in 
lieu of an income tax (within the meaning of Sec.  1.903-1(a)) that 
applies in practice to persons other than dual capacity taxpayers would 
actually have been required to be paid in the taxable year by

[[Page 767]]

a dual capacity taxpayer if it had not been a dual capacity taxpayer 
(e.g., in substitution for the general tax with respect to a type of 
income, such as interest income, dividend income, royalty income, 
insurance income), such tax in lieu of an income tax shall be treated as 
if it were an application of the general tax for purposes of applying 
the safe harbor formula of this paragraph (e) to such dual capacity 
taxpayer, and such formula shall be applied to yield a qualifying amount 
that is approximately equal to the general tax (so defined) that would 
have been required to be paid in the taxable year by such dual capacity 
taxpayer if the base of such general tax had allowed a deduction in such 
year for the specific economic benefit amount.
    (7) Multiple levies. If, in any election year of an electing person, 
with respect to any elected country and all of its political 
subdivisions,
    (i) Amounts are paid by a dual capacity taxpayer pursuant to more 
than one qualifying levy or pursuant to one or more levies that are 
qualifying levies and one or more levies that are not qualifying levies 
by reason of the last sentence of paragraph (c)(1) of this section but 
with respect to which credit is allowable, or
    (ii) More than one general tax (including a tax treated as if it 
were an application of the general tax under paragraph (e)(6)) would 
have been required to be paid by a dual capacity taxpayer (or taxpayers) 
if it (or they) had not been a dual capacity taxpayer (or taxpayers), or
    (iii) Credit is claimed with respect to amounts paid by more than 
one dual capacity taxpayer, the provisions of this paragraph (e) shall 
be applied such that the aggregate qualifying amount with respect to 
such qualifying levy or levies plus the aggregate amount paid with 
respect to levies referred to in (e)(7)(i) that are not qualifying 
levies shall be the aggregate amount that would have been required to be 
paid in the taxable year by such dual capacity taxpayer (or taxpayers) 
pursuant to such general tax or taxes if it (or they) had not been a 
dual capacity taxpayer (or taxpayers) and if the base of such general 
tax or taxes had allowed a deduction in such year for the aggregate 
specific economic benefit amount (except that, if paragraph (e)(5) 
applies to any levy of such elected country or any political subdivision 
thereof, the aggregate qualifying amount for qualifying levies of such 
elected country and all of its political subdivisions plus the aggregate 
amount paid with respect to levies referred to in paragraph (e)(7)(i) 
that are not qualifying levies shall not exceed the greater of the 
aggregate amount paid with respect to levies referred to in paragraph 
(e)(7)(i) that are not qualifying levies and the amount determined in 
accordance with paragraph (e)(5) where ``D'' is the rate of tax 
specified in section 11(b)(5) (or predecessor or successor section, as 
the case may be) of the Internal Revenue Code as applicable to the 
taxable year in which the actual payment amount is paid). However, in no 
event shall such aggregate amount exceed the aggregate actual payment 
amount plus the aggregate amount paid with respect to levies referred to 
in (e)(7)(i) that are not qualifying levies, nor be less than the 
aggregate amount paid with respect to levies referred to in (e)(7)(i) 
that are not qualifying levies. In applying (e)(7)(ii) a person who is 
not subject to a levy but who is considered to receive a specific 
economic benefit by reason of Sec.  1.901-2(a)(2)(ii)(E) shall be 
treated as a dual capacity taxpayer. See example 12 in paragraph (e)(8) 
of this section.
    (8) Examples. The provisions of this paragraph (e) may be 
illustrated by the following examples:

    Example 1. Under a levy of country X called the country X income 
tax, every corporation that does business in country X is required to 
pay to country X 40% of its income from its business in country X. 
Income for purposes of the country X income tax is computed by 
subtracting specified deductions from the corporation's gross income 
derived from its business in country X. The specified deductions include 
the corporation's expenses attributable to such gross income and 
allowances for recovery of the cost of capital expenditures attributable 
to such gross income, except that under the terms of the country X 
income tax a corporation engaged in the exploitation of minerals K, L or 
M in country X is not permitted to recover, currently or in the future, 
expenditures it incurs in exploring for those minerals. Under the terms 
of the country X income tax interest is not deductible to the extent it 
exceeds

[[Page 768]]

an arm's length amount (e.g., if the loan to which the interest relates 
is not in accordance with normal commercial practice or to the extent 
the interest rate exceeds an arm's length rate). In practice, the only 
corporations that engage in exploitation of the specified minerals in 
country X are dual capacity taxpayers. Because no other persons subject 
to the levy engage in exploitation of minerals K, L or M in country X, 
the application of the country X income tax to dual capacity taxpayers 
is different from its application to other corporations. The country X 
income tax as applied to corporations that engage in the exploitation of 
minerals K, L or M (dual capacity taxpayers) is, therefore, a separate 
levy from the country X income tax as applied to other corporations.
    A is a U.S. corporation that is engaged in country X in exploitation 
of mineral K. Natural deposits of mineral K in country X are owned by 
country X, and A has been allowed to extract mineral K in consideration 
of payment of a bonus and of royalties to an instrumentality of country 
X. Therefore, A is a dual capacity taxpayer. In 1984, A does business in 
country X within the meaning of the levy. A has validly elected the safe 
harbor method for country X for 1984. In 1984, as determined in 
accordance with the country X income tax as applied to A, A has gross 
receipts of 120u (units of country X currency), deducts 20u of costs and 
expenses, and pays 40u (40% of (120u-20u)) to country X pursuant to the 
levy. A also incurs in 1984 10u of nondeductible expenditures for 
exploration for mineral K and 2u of nondeductible interest costs 
attributable to an advance of funds from a related party to finance an 
undertaking relating to the exploration for mineral K for which normal 
commercial financing was unavailable because of the substantial risk 
inherent in the undertaking. A establishes that the country X income tax 
as applied to persons other than dual capacity taxpayers is an income 
tax within the meaning of Sec.  1.901-2(a)(1), that it is the generally 
imposed income tax of country X and hence the general tax, and that all 
of the criteria of section 903 are satisfied with respect to the country 
X income tax as applied to dual capacity taxpayers, except for the 
determination of the distinct element of the levy that is a tax and of 
A's qualifying amount with respect thereto. (No conclusion is reached 
whether the country X income tax as applied to dual capacity taxpayers 
is an income tax within the meaning of Sec.  1.901-2(a)(1). Such a 
determination would require, among other things, that the country X 
income tax as so applied, judged on the basis of its predominant 
character, meets the net income requirement of Sec.  1.901-2(b)(4) 
notwithstanding its failure to permit recovery of exploration expenses.) 
A has therefore demonstrated that the country X income tax as applied to 
dual capacity taxpayers is a qualifying levy.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(2), the amount of A's costs and expenses includes the 10u of 
nondeductible exploration expenses. The failure to permit recovery of 
interest in excess of arm's length amounts, a provision of both the 
general tax and the qualifying levy, does not cause the qualifying levy 
to fail to satisfy the net income requirement of Sec.  1.901-2(b)(4); 
therefore, the amount of A's costs and expenses does not include the 2u 
of nondeductible interest costs. Thus, under the safe harbor method, A's 
qualifying amount with respect to the levy is 33.33u ((120u-30u-40u) x 
.40/(1-.40)). A's specific economic benefit amount is 6.67u (A's actual 
payment amount (40u) less A's qualifying amount (33.33u)). Under 
paragraph (a) of this section, this 6.67u is considered to be 
consideration paid by A for the right to extract mineral K. Pursuant to 
paragraph (b) of this section, this amount is characterized according to 
the nature of A's transactions with country X and its instrumentality 
and of the specific economic benefit received (the right to extract 
mineral K), as an additional royalty or other business expense paid or 
accrued by A and is so treated for all purposes of chapter 1 of the 
Internal Revenue Code, except that if an allowance for percentage 
depletion is allowable to A under sections 611 and 613 with respect to 
A's interest in mineral K, the determination whether this 6.67u is tax 
or royalty for purposes of computing the amount of such allowance shall 
be made under sections 611 and 613 without regard to the determination 
that under the safe harbor formula such 6.67u is not tax for purposes of 
section 901 or 903.
    Example 2. Under a levy of country Y called the country Y income 
tax, each corporation incorporated in country Y is required to pay to 
country Y a percentage of its worldwide income. The applicable 
percentage is 40 percent of the first 1,000u (units of country Y 
currency) of income and 50 percent of income in excess of 1,000u. Income 
for purposes of the levy is computed by deducting from gross income 
specified types of expenses and specified allowances for capital 
expenditures. The expenses for which deductions are permitted differ 
depending on the type of business in which the corporation subject to 
the levy is engaged, e.g., a deduction for interest paid to a related 
party is not allowed for corporations engaged in enumerated types of 
activities. In addition, carryover of losses from one taxable period to 
another is permitted for corporations engaged in specified types of 
activities, but not for corporations engaged in other activities. By its 
terms, the foreign

[[Page 769]]

levy makes no distinction between dual capacity taxpayers and other 
persons. In practice the differences in the base of the country Y income 
tax (e.g., the lack of a deduction for interest paid to related parties 
for some corporations subject to the levy and the lack of a carryover 
provision for some corporations subject to the levy) apply to both dual 
capacity taxpayers and other persons, but the 50 percent rate applies 
only to dual capacity taxpayers. By reason of such higher rate, 
application of the country Y income tax to dual capacity taxpayers is 
different in practice from application of the country Y income tax to 
other persons subject to it. The country Y income tax as applied to dual 
capacity taxpayers is therefore a separate levy from the country Y 
income tax as applied to other corporations incorporated in country Y.
    B is a corporation incorporated in country Y that is engaged in 
construction activities in country Y. B has a contract with the 
government of country Y to build a hospital in country Y for a fee that 
is not made available on substantially the same terms to substantially 
all persons who are subject to the general tax of country X. 
Accordingly, B is a dual capacity taxpayer. B has validly elected the 
safe harbor method for country Y for 1985. In 1985, as determined in 
accordance with the country Y income tax as applied to B, B has gross 
receipts of 10,000u, deducts 6,000u of costs and expenses, and pays 
1900u ((1,000u x 40%) + (3,000u x 50%)) to country Y pursuant to the 
levy.
    It is assumed that B has established that the country Y income tax 
as applied to persons other than dual capacity taxpayers is an income 
tax within the meaning of Sec.  1.901-2(a)(1) and is the general tax. It 
is further assumed that B has demonstrated that all of the criteria of 
section 901 are satisfied with respect to the country Y income tax as 
applied to dual capacity taxpayers, except for the determination of the 
distinct element of such levy that is a tax and of B's qualifying amount 
with respect to that levy, and therefore that the country Y income tax 
as applied to dual capacity taxpayers is a qualifying levy.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(3), the 50 percent rate is not used because it does not apply in 
practice to persons other than dual capacity taxpayers. The next lowest 
rate of the general tax that does apply in practice to such persons, 40 
percent, is used. Accordingly, under the safe harbor formula, B's 
qualifying amount with respect to the levy is 1400u ((10,000u-6000u-
1900u) x .40/(1-.40)). B's specific economic benefit amount is 500u (B's 
actual payment amount (1900u) less B's qualifying amount (1400u)). 
Pursuant to paragraph (b) of this section, B's specific economic benefit 
amount is characterized according to the nature of B's transactions with 
country Y and of the specific economic benefit received, as a reduction 
of B's proceeds of its contract with country Y; and this amount is so 
treated for all purposes of chapter 1 of the Code, including the 
computation of B's accumulated profits for purposes of section 902.
    Example 3. The facts are the same as in example 2, with the 
following additional facts: The contract between B and country Y is a 
cost plus contract. One of the costs of the contract which country Y is 
required to pay or for which it is required to reimburse B is any tax of 
country Y on B's income or receipts from the contract. Instead of 
reimbursing B therefor, country Y agrees with B to assume any such tax 
liability. Under country Y tax law, B is not considered to have 
additional income or receipts by reason of country Y's assumption of B's 
country Y tax liability. In 1985, B's gross receipts of 10,000u include 
3000u from the contract, and its costs and expenses of 6000u include 
2000u attributable to the contract. B's other gross receipts and 
expenses do not relate to any transaction in which B receives a specific 
economic benefit. In accordance with the contract, country Y, and not B, 
is required to bear the amount of B's country Y income tax liability on 
B's 1000u (3000u-2000u) income from the contract. In accordance with the 
contract B computes its country Y income tax without taking this 1000u 
into account and therefore pays 1400u ((1000u x 40%) + (2000u x 50%)) to 
country Y pursuant to the levy.
    In accordance with Sec.  1.901-2(f)(2)(i), the country Y income tax 
which country Y is, under the contract, required to bear is considered 
to be paid by country Y on behalf of B. B's proceeds of its contract, 
for all purposes of chapter 1 of the Code (including the computation of 
B's accumulated profits for purposes of section 902), therefore, are 
increased by the additional 500u (1900u computed as in example 2 less 
1400u as computed above) of B's liability under the country Y income tax 
that is assumed by country Y and such 500u is considered to be paid 
pursuant to the levy by country Y on behalf of B. In applying the safe 
harbor formula, therefore, the computation is exactly as in example 2 
and the results are the same as in example 2.
    Example 4. Country L issues a decree (the ``April 11 decree''), in 
which it states it is exercising its tax authority to impose a tax on 
all corporations on their ``net income'' from country L. ``Net income'' 
is defined as actual gross receipts less all expenses attributable 
thereto, except that in the case of income from extraction of petroleum, 
gross receipts are defined as 105 percent of actual gross receipts, and 
no deduction is allowed for interest incurred on loans whose proceeds 
are used for exploration for petroleum. Under the April 11 decree, wages 
paid by corporations subject to the decree are deductible in

[[Page 770]]

the year of payment, except that corporations engaged in the extraction 
of petroleum may deduct such wages only by amortization over a 5-year 
period and, to the extent such wages are paid to officers, they may be 
deducted only by amortization over a period of 50 years. The April 11 
decree permits related corporations subject to the decree to file 
consolidated returns in which net income and net losses of related 
corporations offset each other in computing net income for purposes of 
the April 11 decree, except that corporations engaged in petroleum 
exploration or extraction activities are not eligible for inclusion in 
such a consolidated return. The law of country L does not require 
separate entities to carry on separate activities in connection with 
exploring for or extracting petroleum. Net losses of a taxable year may 
be carried over for 10 years to offset income, except that no more than 
25% of net income (before deducting the loss carryover) in any such 
future year may be offset by a carryover of net loss, and, in the case 
of any corporation engaged in exploration or extraction of petroleum, 
losses incurred prior to such a corporation's having net income from 
production may be carried forward for only 8 years and no more than 15% 
of net income in any such future year may be offset by such a net loss. 
The rate to be paid under the April 11 decree is 50% of net income (as 
defined in the levy), except that if net income exceeds 10,000u (units 
of country L currency), the rate is 75% of the corporation's net income 
(including the first 10,000u thereof). In practice, no corporations 
other than corporations engaged in extraction of petroleum have net 
income in excess of 10,000u. All petroleum resources of country L are 
owned by the government of country L, whose petroleum ministry licenses 
corporations to explore for and extract petroleum in consideration for 
payment of royalties as petroleum is produced.
    J is a U.S. corporation that is engaged in country L in the 
exploration and extraction of petroleum and therefore is a dual capacity 
taxpayer. J has validly elected the safe harbor method for country L for 
the year 1983, the year that J commenced activities in country L, and 
has not revoked such election. For the years 1983 through 1986, J's 
gross receipts, deductions and net income before application of the 
carryover provisions, determined in accordance with the April 11 decree, 
are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Net income
                                  Gross                                                             (loss) (B-C-
                                 receipts                 Wages paid    Wages paid                  amortization
                                   (105      Deductions   other than    to officers  Nondeductible       of
             Year               percent of   other than   to officers  (amortizable   exploration   cumulative D-
                                  actual       wages     (amortizable      at 2         interest    amortization
                                  gross                      at 20       percent)       expense          of
                                receipts)                  percent)                                  cumulative
                                                                                                         E)
----------------------------------------------------------------------------------------------------------------
A.                                      B.           C.            D.            E.            F.             G.
----------------------------------------------------------------------------------------------------------------
1983.........................            0      13,000u          100u           50u        1,000u      (13,021u)
1984.........................            0      17,000u          100u           50u        2,800u      (17,042u)
1985.........................      42,000u      15,000u          100u           50u        2,800u        26,937u
1986.........................     105,000u      20,000u          100u           50u        2,800u        84,916u
----------------------------------------------------------------------------------------------------------------

    After application of the carryover provisions, J's net income and 
actual payment amounts pursuant to the April 11 levy are as follows:

------------------------------------------------------------------------
                                                                Actual
                                                 Net income    payment
                     Year                          (loss)    amount (I x
                                                             75 percent)
------------------------------------------------------------------------
H.                                                       I.           J.
------------------------------------------------------------------------
1983..........................................    (13,021u)            0
1984..........................................    (17,042u)            0
1985..........................................      22,896u      17,172u
1986..........................................      72,179u      54,134u
------------------------------------------------------------------------

    Pursuant to paragraph (a)(1) of this section, the April 11 decree as 
applied to corporations engaged in the exploration or extraction of 
petroleum in country L is a separate levy from the April 11 decree as 
applied to all other corporations. J establishes that the April 11 
decree, as applied to such other corporations, is an income tax within 
the meaning of Sec.  1.901-2(a)(1) and that the decree as so applied is 
the general tax.
    The April 11 decree as applied to corporations engaged in the 
exploration or extraction of petroleum in country L does not meet the 
gross receipts requirement of Sec.  1.901-2(b)(3); therefore, 
irrespective of whether it meets the other requirements of Sec.  1.901-
2(b)(1), it is not an income tax within the meaning of Sec.  1.901-
2(a)(1). However, the April 11 decree as applied to such corporations is 
a qualifying levy because J has demonstrated that all of the criteria of 
section 903 are satisfied with respect to the April 11 decree as applied 
to such corporations, except for the determination of the distinct 
element of such levy that imposes a tax and of J's qualifying amount 
with respect thereto.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(2), gross receipts are computed by reference to the general

[[Page 771]]

levy, and thus are 100%, not 105%, of actual gross receipts. Similarly, 
costs and expenses include exploration interest expense. In accordance 
with paragraph (e)(2)(i) of this section the difference between the 
general tax and the qualifying levy in the timing of the deduction for 
wages, other than wages of officers, is not considered to increase the 
liability of dual capacity taxpayers because the general tax would not 
have failed to be an income tax within the meaning of Sec.  1.901-
2(a)(1) if it had provided for 5-year amortization of such wages instead 
of for current deduction. See Sec.  1.901-2(b)(4)(i). However, 
amortization of wages paid to officers over a 50-year period is such a 
deferred recovery of such wages that it effectively is a denial of the 
deduction of the excess of such wages paid in any year over the 
amortization of such cumulative wages permitted in such year. See Sec.  
1.901-2(b)(4)(i). The different treatment of wages paid to officers 
under the general tax and the qualifying levy is thus not merely a 
difference in timing within the meaning of paragraph (e)(2)(i) of this 
section. Accordingly, the difference between the amount of wages paid by 
J to officers in any year and J's deduction (in computing the actual 
payment amount) for amortization of such cumulative wages allowed in 
such year is, pursuant to paragraph (e)(2) of this section, treated as a 
cost and expense in computing J's qualifying amount for such year with 
respect to the April 11 decree. The differences in the consolidation and 
carryover provisions between the general tax and the qualifying levy are 
of the types described in paragraph (e)(2)(ii) of this section and, 
pursuant to paragraphs (b)(4)(ii) and (b)(4)(iii) of Sec.  1.901-2, the 
general tax would not fail to be an income tax within the meaning of 
Sec.  1.901-2(a)(i) even if it contained the consolidation and carryover 
provisions of the qualifying levy. Thus, such differences are not 
considered to increase the liability of dual capacity taxpayers pursuant 
to the qualifying levy as compared to the general tax liability of 
persons other than dual capacity taxpayers.
    Accordingly, in applying the safe harbor formula to the qualifying 
levy for 1985 and 1986, gross receipts and costs and expenses are 
computed as follows:

                             Gross receipts

1985: 42,000u x (100/105) - 40,000u
1986: 105,000u x (100/105) - 100,000u

                           costs and expenses
------------------------------------------------------------------------
                     Item                           1985         1986
------------------------------------------------------------------------
1. Deductions other than wages (column C in         15,000u      20,000u
 the preceding chart).........................
2. Amortization of cumulative wages paid in             60u          80u
 1983 and thereafter other than to officers...
3. Deduction of wages to officers paid in               50u          50u
 current year, instead of amortization allowed
 in current year of such cumulative wages paid
 in 1983 and thereafter.......................
4. Deduction of exploration interest expense..       2,800u       2,800u
                                               -------------------------
5. Costs and expenses before carryover of net       17,910u      22,930u
 loss (sum of lines 1 through 4)..............
                                               =========================
6. Recalculation of loss carryover by
 recalculating 1983 and 1984 net income (loss)
 to reflect current deduction of wages to
 officers and exploration interest expense:
 1983 adjusted net loss carryover: (13,021u) +
 (49u) + (1000u) = (14,070u); 1984 adjusted
 net loss carryover: (17,042u) + (48u) +
 (2800u) = (19,890u)..........................
7. Recalculation of limitation on use of net
 loss carryover deduction:
  Gross receipts..............................      40,000u     100,000u
  Less costs and expenses.....................    (17,910u)     (22,930)
                                               -------------------------
   Total......................................      22,090u      77,070u
  Times 15 percent limitation.................       3,314u      11,561u
                                               -------------------------
8. Costs and expenses including net loss            21,224u      34,491u
 carryover deduction (line 5 plus line 7).....
------------------------------------------------------------------------

    In years after 1986, costs and expenses for purposes of determining 
the qualifying amount would reflect net loss carryforward deductions 
based on the recomputed losses carried forward from 1983 and 1984 
(14,070u and 19,890u, respectively) less the amounts thereof that were 
utilized in determining costs and expenses for 1985 and 1986 (3,314u and 
11,561u, respectively). The 1983 and 1984 loss carryforwards would be 
considered utilized in accordance with the order of priority in which 
such losses are utilized under the terms of the qualifying levy.
    In applying the safe harbor formula, the tax rate to be used, in 
accordance with paragraph (e)(3) of this section, is .50.
    Accordingly, under the safe harbor method, J's qualifying amounts 
with respect to the April 11 decree for 1985 and 1986 are computed as 
follows:

1985: (40,000u - 21,224u - 17,172u) x .50 / (1 - .50) = 1604u

1986: (100,000u - 34,491u - 54,134u) x .50 / (1 - .50) = 11,375u

    Under the safe harbor method J's qualifying amounts with respect to 
the April 11

[[Page 772]]

decree for 1985 and 1986 are thus 1604u and 11,375u, respectively; and 
its specific economic benefit amounts are 15,568u (17,172u-1604u) and 
42,759u, (54,134u-11,375u), respectively. Pursuant to paragraph (b) of 
this section, J's specific economic benefit amounts are characterized 
according to the nature of J's transactions with country L and of the 
specific economic benefit received by J as additional royalties paid to 
country L with respect to the petroleum extracted by J in country L in 
1985 and 1986, and these amounts are so treated for all purposes of 
chapter 1 of the Code.
    Example 5. Country E, which has no generally imposed income tax, 
imposes a levy called the country E income tax only on corporations 
carrying on the banking business through a branch in country E and on 
corporations engaged in the extraction of petroleum in country E. All of 
the petroleum resources of country E are owned by the government of 
country E, whose petroleum ministry licenses corporations to explore for 
and extract petroleum in consideration of payment of royalties as 
petroleum is extracted. The base of the country E income tax is a 
corporation's actual gross receipts from sources in country E less all 
expenses attributable, on reasonable principles, to such gross receipts; 
the rate of tax is 29 percent.
    A is a U.S corporation that carries on the banking business through 
a branch in country E. B is a U.S. corporation (unrelated to A) that is 
engaged in the extraction of petroleum in country E. In 1984 A receives 
interest on loans it has made to 160 borrowers in country E, seven of 
which are agencies and instrumentalities of the government of country E. 
The economic benefits received by A and B (i.e., the interest received 
by A from the government and B's license to extract petroleum owned by 
the government) are not made available on substantially the same terms 
to the population of country E in general.
    A and B are dual capacity taxpayers. Each of them has validly 
elected the safe harbor method for country E for 1984. A demonstrates 
that the country E income tax as applied to it (a dual capacity 
taxpayer) is not different by its terms or in practice from the country 
E income tax as applied to persons (in this case other banks) that are 
not dual capacity taxpayers. A has therefore established pursuant to 
paragraph (a)(1) of this section and Sec.  1.901-2(d) that the country E 
income tax as applied to it and the country E income tax as applied to 
persons other than dual capacity taxpayers are together a single levy. A 
establishes that such levy is an income tax within the meaning of Sec.  
1.901-2(a)(1). In accordance with paragraph (a)(1) of this section, no 
portion of the amount paid by A pursuant to such levy is considered to 
be paid in exchange for a specific economic benefit. Thus, the entire 
amount paid by A pursuant to this levy is an amount of income tax paid.
    B does not demonstrate that the country E income tax as applied to 
corporations engaged in the extraction of petroleum in country E (dual 
capacity taxpayers) is not different by its terms or in practice from 
the country E income tax as applied to persons other than dual capacity 
taxpayers (i.e., banks that are not dual capacity taxpayers). 
Accordingly, pursuant to paragraph (a)(1) of this section and Sec.  
1.901-2(d), the country E income tax as applied to corporations engaged 
in the extraction of petroleum in country E is a separate levy from the 
country E income tax as applied to other persons.
    B demonstrates that all of the criteria of section 901 are satisfied 
with respect to the country E income tax as applied to corporations 
engaged in the exploration of petroleum in country E, except for the 
determination of the distinct element of such levy that imposes a tax 
and of B's qualifying amount with respect to the levy. Pursuant to 
paragraph (e)(5) of this section, in applying the safe harbor formula to 
B, ``A'' is the amount of B's gross receipts as determined under the 
country E income tax as applied to B; ``B'' is the amount of B's costs 
and expenses as determined thereunder; ``C'' is B's actual payment 
amount; and ``D'' is .29, the lower of the rate (29 percent) of the 
qualifying levy (the country E income tax as applied to corporations 
engaged in the extraction of petroleum in country E) or the rate (46 
percent) of tax specified for 1984 in section 11(b)(5) of the Internal 
Revenue Code. Thus, B's qualifying amount is equal to its actual payment 
amount.
    Example 6. The facts are the same as in example 5, except that the 
rate of the country E income tax is 55 percent. For the reasons stated 
in example 5, the results with respect to A are the same as in example 
5. In applying the safe harbor formula to B, ``A,'' ``B,'' and ``C'' are 
the same as in example 5, but ``D'' is .46, as that rate is less than 
.55. Thus, B's qualifying amount is less than B's actual payment amount, 
and the difference is B's specific economic benefit amount.
    Example 7. Country E imposes a tax (called the country E income tax) 
on the realized net income derived by corporations from sources in 
country E, except that, with respect to interest income received from 
sources in country E and certain insurance income, nonresident 
corporations are instead subject to other levies. With respect to such 
interest income a levy (called the country E interest tax) requires 
nonresident corporations to pay to country E 20 percent of such gross 
interest income unless the nonresident corporation falls within a 
specified category of corporations (``special corporations''), all of 
which are dual capacity taxpayers, in which case the rate is instead 25 
percent.

[[Page 773]]

With respect to such insurance income nonresident corporations are 
subject to a levy (called the country E insurance tax), which is not an 
income tax within the meaning of Sec.  1.901-2(a)(1).
    The country E interest tax applies at the 20 percent rate by its 
terms and in practice to persons other than dual capacity taxpayers. The 
country E interest tax as applied at the 25 percent rate to special 
corporations applies only to dual capacity taxpayers; therefore, the 
country E interest tax as applied to special corporations is a separate 
levy from the country E interest tax as applied at the 20 percent rate.
    A is a U.S. corporation which is a special corporation subject to 
the 25 percent rate of the country E interest tax. A does not have any 
insurance income that is subject to the country E insurance tax. A, a 
dual capacity taxpayer, has validly elected the safe harbor formula for 
1984. In 1984 A receives 100u (units of country E currency) of gross 
interest income subject to the country E interest tax and pays 25u to 
country E.
    A establishes that the country E income tax is the generally imposed 
income tax of country E; that all of the criteria of section 903 are 
satisfied with respect to the country E interest tax as applied to 
special corporations except for the determination of the distinct 
element of the levy that is a tax and of A's qualifying amount with 
respect thereto. A has therefore demonstrated that the country E 
interest tax as applied to special corporations is a qualifying levy. A 
establishes that the country E interest tax at the 20 percent rate is a 
tax in lieu of an income tax within the meaning of Sec.  1.903-1(a). 
Pursuant to paragraph (e)(6) of this section the country E interest tax 
at the 20 percent rate is treated as if it were an application of the 
general tax for purposes of the safe harbor formula of this paragraph 
(e), since that tax would actually have been required to have been paid 
by A with respect to its interest income had A not been a dual capacity 
taxpayer (special corporation) instead subject to the qualifying levy 
(the country E interest tax at the 25 percent rate).
    Even if the country E insurance tax is a tax in lieu of an income 
tax within the meaning of Sec.  1.903-1(a), that tax is not treated as 
if it were an application of the general tax for purposes of applying 
the safe harbor formula to A since A had no insurance income in 1984 and 
hence such tax would not actually have been required to be paid by A had 
A not been a dual capacity taxpayer.
    Example 8. Under a levy of country S called the country S income 
tax, each corporation operating in country S is required to pay country 
S 50 percent of its income from operations in country S. Income for 
purposes of the country S income tax is computed by subtracting all 
attributable costs and expenses from a corporation's gross receipts 
derived from its business in country S. Among corporations on which the 
country S income tax is imposed are corporations engaged in the 
exploitation of mineral K in country S. Natural deposits of mineral K in 
country S are owned by country S, and all corporations engaged in the 
exploitation thereof do so under concession agreement with an 
instrumentality of country S. Such corporations, in addition to the 50 
percent country S income tax, are also subject to a levy called a 
surtax, which is equal to 60 percent of posted price net income less the 
amount of the country S income tax. The surtax is not deductible in 
computing the country S income tax of corporations engaged in the 
exploitation of mineral K in country S.
    A is a U.S. corporation engaged in country S in the exploitation of 
mineral K, and A has been allowed to extract mineral K under a 
concession agreement with an instrumentality of country S. Therefore, A 
is a dual capacity taxpayer. In accordance with a term of the concession 
agreement, certain of A's income (net of expenses attributable thereto) 
is exempted from the income tax and surtax.
    The results for A in 1984 are as follows:

------------------------------------------------------------------------
                                                    Income Tax   Surtax
------------------------------------------------------------------------
Gross Receipts:
  Realized--Taxable..............................         120u        --
  Realized--Exempt...............................          15u        --
  Posted Price-Taxable...........................           --      145u
Costs:
  Attributable to Taxable Receipts...............          20u       20u
  Attributable to Exempt Receipts................           5u        --
Taxable Income...................................         100u      125u
Tentative Surtax (60 percent)....................           --       75u
Petroleum Levy at 50 percent.....................          50u       50u
Surtax...........................................           --       25u
------------------------------------------------------------------------

    Because of the difference (nondeductibility of the surtax) in the 
country S income tax as applied to dual capacity taxpayers from its 
application to other persons, the country S income tax as applied to 
dual capacity taxpayers and the country S income tax as applied to 
persons other than dual capacity taxpayers are separate levies. 
Moreover, because A's concession agreement provides for a modification 
(exemption of certain income) of the country S income tax and surtax as 
they otherwise apply to other persons engaged in the exploitation of 
mineral K in country S, those levies (contractual levies) as applied to 
A are separate levies from those levies as applied to other persons 
engaged in the exploitation of mineral K in country S.
    A establishes that the country S income tax as applied to persons 
other than dual capacity taxpayers is an income tax within the meaning 
of Sec.  1.901-2(a)(1) and is the general tax. A demonstrates that all 
the criteria of section 903 are satisfied with respect to the country S 
income tax as applied to A and with respect to the surtax as applied to 
A,

[[Page 774]]

except for the determination of the distinct elements of such levies 
that are taxes and of A's qualifying amounts with respect to such 
levies. Therefore, both the country S income tax as applied to A and the 
surtax as applied to A are qualifying levies.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(2), the amount of A's gross receipts includes the exempt realized 
income, and the amount of A's costs and expenses includes the costs 
attributable to such exempt income. In accordance with paragraph 
(e)(7)(i), the amount of the qualifying levy for purposes of the formula 
is the sum of A's liability for the country S income tax and A's 
liability for the surtax. Accordingly, under the safe harbor formula, 
A's qualifying amount with respect to the country S income tax and the 
surtax is 35u ((135u-25u-75u) x .50/(1-.50)). A's specific economic 
benefit amount is 40u (A's actual payment amount (75u) less A's 
qualifying amount (35u)).
    Example 9. Country T imposes a levy on corporations, called the 
country T income tax. The country T income tax is imposed at a rate of 
50 percent on gross receipts less all costs and expenses, and affiliated 
corporations are allowed to consolidate their results in applying the 
country T income tax. Corporations engaged in the exploitation of 
mineral L in country T are subject to a levy that is identical to the 
country T income tax except that no consolidation among affiliated 
corporations is allowed. The levy allows unlimited loss carryforwards.
    C and D are affiliated U.S. corporations engaged in country T in the 
exploitation of mineral L. Natural deposits of mineral L in country T 
are owned by country T, and C and D have been allowed to extract mineral 
L in consideration of certain payments to an instrumentality of country 
T. Therefore, C and D are dual capacity taxpayers.
    The results for C and D in 1984 and 1985 are as follows:

------------------------------------------------------------------------
                                            1984              1985
                                     -----------------------------------
                                         C        D        C        D
------------------------------------------------------------------------
Gross Receipts......................     120u        0     120u     120u
Costs...............................      20u      50u      20u      20u
Loss Carryforward...................  .......  .......  .......      50u
Net Income (Loss)...................     100u    (50u)     100u      50u
Income Tax..........................      50u  .......      50u      25u
------------------------------------------------------------------------

    C and D establish that the country T income tax as applied to 
persons other than dual capacity taxpayers is an income tax within the 
meaning of Sec.  1.901-2(a)(1) and is the general tax. C and D 
demonstrate that all of the criteria of section 901 are satisfied with 
respect to the country T income tax as applied to dual capacity 
taxpayers, except for the determination of the distinct element of such 
levy that is a tax and of C and D's qualifying amounts with respect to 
that levy. Therefore, the country T income tax as applied to dual 
capacity taxpayers is a qualifying levy.
    In applying the safe harbor formula, in accordance with paragraphs 
(e)(2)(ii) and (e)(7)(iii), the gross receipts, costs and expenses, and 
actual payment amounts of C and D are aggregated, except that in D's 
loss year (1984) its gross receipts and costs and expenses are 
disregarded. The results of any loss year are disregarded since the 
country T income tax as applied to dual capacity taxpayers does not 
allow consolidation, and, pursuant to paragraph (e)(2)(ii), differences 
in consolidation provisions between such levy and the country T income 
tax as applied to persons that are not dual capacity taxpayers are not 
considered. Accordingly, in 1984 the qualifying amount with respect to 
the country T income tax is 50u ((120u-20u-50u) x .50/(1-.50)), all of 
which is considered paid by C. In 1985 the qualifying amount is 75u 
((120u + 120u-20u-20u-50u (loss carry forward)--50u--25u) x .50/
(1-.50)), of which 50u is considered to be paid by C and 25u by D.
    Example 10. Country W imposes a levy called the country W income tax 
on corporations doing business in country W. The country W income tax is 
imposed at a 50 percent rate on gross receipts less all costs and 
expenses. Corporations engaged in the exploitation of mineral M in 
country W are subject to a levy that is identical in all respects to the 
country W income tax except that it is imposed at a rate of 80 percent 
(the ``80 percent levy'').
    A is a U.S. corporation engaged in country W in exploitation of 
mineral M and is subject to the 80 percent levy. Natural deposits of 
mineral M in country W are owned by country W, and A has been allowed to 
extract mineral M in consideration of certain payments to an 
instrumentality of country W. Therefore, A is a dual capacity taxpayer. 
B, a U.S. corporation affiliated with A, also is engaged in business in 
country W, but has no transactions with country W. B is subject to the 
country W income tax. B is a dual capacity taxpayer within the meaning 
of Sec.  1.901-2(a)(2)(ii)(A) by virtue of its affiliation with A.
    The results for A and B in 1984 are as follows:

------------------------------------------------------------------------
                                                        A          B
------------------------------------------------------------------------
Gross Receipts....................................       120u       100u
Costs.............................................        20u        40u
Net Income........................................       100u        60u
Tax Rate..........................................        .80        .50
Tax...............................................        80u        30u
------------------------------------------------------------------------

    A and B establish that the country W income tax as applied to 
persons other than dual capacity taxpayers is an income tax within the 
meaning of Sec.  1.901-2(a)(1) and is the general tax. It is assumed 
that B has

[[Page 775]]

demonstrated that the country W income tax as applied to B does not 
differ by its terms or in practice from the country W income tax as 
applied to persons other than dual capacity taxpayers and hence that the 
country W income tax as applied to B, a dual capacity taxpayer, and the 
country W income tax as applied to such other persons is a single levy. 
Thus, with respect to B, the country W income tax is not a qualifying 
levy by reason of the last sentence of paragraph (c)(1) of this section. 
A demonstrates that all the criteria of section 901 are satisfied with 
respect to the 80 percent levy, except for the determination of the 
distinct element of such levy that is a tax and of A's qualifying amount 
with respect thereto. Accordingly, the 80 percent levy as applied to A 
is a qualifying levy.
    In applying the safe harbor formula in accordance with paragraphs 
(e)(7)(i) and (e)(7)(iii) in the instant case, it is not necessary to 
incorporate B's results in the safe harbor formula because B's taxation 
in country W is identical to the taxation of persons other than dual 
capacity taxpayers and because neither A's and B's results nor their 
taxation in country W interact in any way to change A's taxation. All of 
the amount paid by B, 30u, is an amount of income tax paid by B within 
the meaning of Sec.  1.901-2(a)(1). Accordingly, under the safe harbor 
formula, the qualifying amount for A with respect to the 80 percent levy 
is 20u ((120u-20u-80u) x .50/(1-.50)). The remaining 60u paid by A (80u 
- 20u) is A's specific economic benefit amount.
    Example 11. The facts are the same as in example 10, except that it 
is assumed that B has not demonstrated that the country W income tax as 
applied to B does not differ by its terms or in practice from the 
country W income tax as applied to persons other than dual capacity 
taxpayers. In addition, A and B demonstrate that all the criteria of 
section 901 are satisfied with respect to each of the country W income 
tax and the 80 percent levy as applied to dual capacity taxpayers, 
except for the determination of the distinct elements of such levies 
that are taxes of A and B's qualifying amounts with respect to such 
levies. Therefore, the country W income tax and 80 percent levy as 
applied to dual capacity taxpayers are qualifying levies.
    In applying the safe harbor formula in accordance with paragraphs 
(e)(7)(i) and (e)(7)(iii), the results of A and B are aggregated. 
Accordingly, under the safe harbor formula, the aggregate qualifying 
amount for A and B with respect to the country W income tax and 80 
percent levy is 50u ([(120u + 100u)-(20u + 40u)-(80u + 30u)] x .50/
(1-.50)).
    Example 12. Country Y imposes a levy on corporations operating in 
country Y, called the country Y income tax. Income for purposes of the 
country Y income tax is computed by subtracting all costs and expenses 
from a corporation's gross receipts derived from its business in country 
Y. The rate of the country Y income tax is 50 percent. Country Y also 
imposes a 20 percent tax (the ``withholding tax'') on the gross amount 
of certain income, including dividends, received by persons who are not 
residents of country Y from persons who are residents of country Y and 
from corporations that operate there. Corporations engaged in the 
exploitation of mineral K in country Y are subject to a levy (the ``75 
percent levy'') that is identical in all respects to the country Y 
income tax except that it is imposed at a rate of 75 percent. Dividends 
received from such corporations are not subject to the withholding tax.
    C, a wholly-owned country Y subsidiary of D, a U.S. corporation, is 
engaged in country Y in the exploitation of mineral K. Natural deposits 
of mineral K in country Y are owned by country Y, and C has been allowed 
to extract mineral K in consideration of certain payments to an 
instrumentality of country Y. Therefore, C is a dual capacity taxpayer. 
D has elected the safe harbor method for country Y for 1984. In 1984, 
C's gross receipts are 120u (units of country Y currency), its costs and 
expenses are 20u, and its liability under the 75 percent levy is 75u. C 
distributes the amount that remains, 25u, as a dividend to D.
    D establishes that the country Y income tax as applied to persons 
other than dual capacity taxpayers is an income tax within the meaning 
of Sec.  1.901-2(a)(1) and the general tax, and that all the criteria of 
section 901 are satisfied with respect to the 75 percent levy, except 
for the determination of the distinct element of such levy that is tax 
and of C's qualifying amount with respect thereto. Accordingly, the 75 
percent levy is a qualifying levy.
    Pursuant to paragraph (e)(7), D (which is not subject to a levy of 
country Y but is considered to receive a specific economic benefit by 
reason of Sec.  1.901-2(a)(2)(ii)(E)) is treated as a dual capacity 
taxpayer in applying paragraph (e)(7)(ii). D demonstrates that the 
withholding tax is a tax in lieu of an income tax within the meaning of 
Sec.  1.903-1, which tax applies in practice to persons other than dual 
capacity taxpayers, and that such tax actually would have applied to D 
had D not been a dual capacity taxpayer (i.e., had C not been a dual 
capacity taxpayer, in which case D also would not have been one). 
Accordingly, the withholding tax is treated for purposes of the safe 
harbor formula as if it were an application of the general tax.
    In applying the safe harbor formula to this situation in accordance 
with paragraph (e)(7)(ii), the rates of the country Y income tax and the 
withholding tax are aggregated into a single effective general tax rate. 
In this case, the rate is .60 (.50 + [(1-.50) x .20]). Accordingly, 
under the safe harbor formula, C's qualifying amount with respect to the 
75 percent levy is 37.5u [(120u-20u-75u) x .60/(1-.60)], the aggregate 
amount that C and D

[[Page 776]]

would have paid if C had been subject to the country Y income tax and 
had distributed to D as a dividend subject to the withholding tax the 
entire amount that remained for the year after payment of the country Y 
income tax. Because C is in fact the only taxpayer, the entire 
qualifying amount is paid by C.
    Example 13. The facts are the same as in example 12, except that 
dividends received from corporations engaged in the exploitation of 
mineral K in country Y are subject to the withholding tax. Thus, C's 
liability under the 75 percent levy is 75u, and D's liability under the 
withholding tax on the 25u distribution is 5u.
    D, which is a dual capacity taxpayer, demonstrates that the 
withholding tax as applied to D does not differ by its terms or in 
practice from the withholding tax as applied to persons other than dual 
capacity taxpayers and hence that the withholding tax as applied to D 
and that levy as applied to such other persons is a single levy. D 
demonstrates that all of the criteria of section 903 are satisfied with 
respect to the withholding tax. The withholding tax is not a qualifying 
levy by reason of the last sentence of paragraph (c)(1) of this section.
    Paragraphs (e)(7)(i), (e)(7)(ii) and (e)(7)(iii) all apply in this 
situation. As in example 10, it is not necessary to incorporate the 
withholding tax into the safe harbor formula. All of the amount paid by 
D, 5u, is an amount of tax paid by D in lieu of an income tax. In 
applying the safe harbor formula to C, therefore, with respect to the 75 
percent levy, ``A'' is 120, ``B'' is ``20'', ``C'' is 75 and ``D'' is 
.50. Accordingly, C's qualifying amount with respect to the 75 percent 
levy is 25u; the remaining 50u that it paid is its specific economic 
benefit amount.
    Example 14. The facts are the same as in example 12, except that 
dividends received from corporations engaged in the exploitation of 
mineral K in country Y are subject to a 10 percent withholding tax (the 
``10 percent withholding tax''). Thus, C's liability under the 75 
percent levy is 75u, and D's liability under the 10 percent withholding 
tax on the 25u distribution is 2.5u.
    The only difference between the withholding tax and the 10 percent 
withholding tax applicable only to dual capacity taxpayers (including D) 
is that a lower rate (but the same base) applies to dual capacity 
taxpayers. Although the withholding tax and the 10 percent withholding 
tax are together a single levy, this difference makes it necessary, when 
dealing with multiple levies, to incorporate the withholding tax and D's 
payment pursuant to the 10 percent withholding tax in the safe harbor 
formula. Accordingly, as in example 12, the safe harbor formula is 
applied by aggregation.
    The aggregate effective rate of the general taxes for purposes of 
the safe harbor formula is .60 (.50 + [(1-.50) x .20]). Pursuant to 
paragraph (e)(7), the aggregate actual payment amount of the qualifying 
levies for purposes of the formula is the sum of C and D's liability for 
the 75 percent levy and the 10 percent withholding tax. Accordingly, 
under the safe harbor formula, the aggregate qualifying amount with 
respect to the 75 percent levy on C and the 10 percent withholding tax 
on D is 33.75u ((120u-20u-[75u + 2.5u]) x .60/(1-.60)), which is the 
aggregate amount of tax that C and D would have paid if C had been 
subject to the country Y income tax and had paid out its entire amount 
remaining after payment of that tax to D as a dividend subject to the 
withholding tax.
    Example 15. The facts are the same as in example 5, except that the 
rate of the country E income tax is 45 percent and a political 
subdivision of country E also imposes a levy, called the ``local tax,'' 
on all corporations subject to the country E income tax. The base of the 
local tax is the same as the base of the country E income tax; the rate 
is 10 percent.
    The reasoning of example 5 with regard to the country E income tax 
as applied to A and B, respectively, applies equally with regard to the 
local tax as applied to A and B, respectively. Accordingly, the entire 
amount paid by A pursuant to each of the country E income tax and the 
local tax is an amount of income tax paid, and both the country E income 
tax as applied to B and the local tax as applied to B are qualifying 
levies.
    Pursuant to paragraph (e)(7), in applying the safe harbor formula to 
B, ``A'' is the amount of B's gross receipts as determined under the 
(identical) country E income tax and local tax as applied to B; ``B'' is 
the amount of B's costs and expenses thereunder; and ``C'' is the sum of 
B's actual payment amounts with respect to the two levies. Pursuant to 
paragraph (e)(7), in applying the safe harbor formula to B, B's 
aggregate qualifying amount with respect to the two levies is limited to 
the amount determined in accordance with paragraph (e)(5) where ``D'' is 
the rate of tax specified in section 11(b)(5) of the Internal Revenue 
Code. Accordingly, ``D'' is .46, which is the lower of the aggregate 
rate (55 percent) of the qualifying levies or the section 11(b)(5) rate 
(46 percent). B's aggregate qualifying amount is, therefore, identical 
to B's qualifying amount in example 6, which is less than its aggregate 
actual payment amount, and the difference is B's specific economic 
benefit amount.

    (f) Effective date. The effective date of this section is as 
provided in Sec.  1.901-2(h).

(Approved by the Office of Management and Budget under control number 
1545-0746)

[T.D. 7918, 48 FR 46284, Oct. 12, 1983]

[[Page 777]]



Sec.  1.901-3  Reduction in amount of foreign taxes on foreign mineral 
income allowed as a credit.

    (a) Determination of amount of reduction--(1) In general. For 
purposes of determining the amount of taxes which are allowed as a 
credit under section 901(a) for taxable years beginning after December 
31, 1969, the amount of any income, war profits, and excess profits 
taxes paid or accrued, or deemed to be paid under section 902, during 
the taxable year to any foreign country or possession of the United 
States with respect to foreign mineral income (as defined in paragraph 
(b) of this section) from sources within such country or possession 
shall be reduced by the amount, if any, by which--
    (i) The smaller of--
    (a) The amount of such foreign income, war profits, and excess 
profits taxes, or
    (b) The amount of the tax which would be computed under chapter 1 of 
the Code for such year with respect to such foreign mineral income if 
the deduction for depletion were determined under section 611 without 
regard to the deduction for percentage depletion under section 613, 
exceeds
    (ii) The amount of the tax computed under chapter 1 of the Code for 
such year with respect to such foreign mineral income.


The reduction required by this subparagraph must be made on a country-
by-country basis whether the taxpayer uses for the taxable year the per-
country limitation under section 904(a)(1), or the overall limitation 
under section 904(a)(2), on the amount of taxes allowed as credit under 
section 901(a).
    (2) Determination of amount of tax on foreign mineral income--(i) 
Foreign tax. For purposes of subparagraph (1)(i)(a) of this paragraph, 
the amount of the income, war profits, and excess profits taxes paid or 
accrued during the taxable year to a foreign country or possession of 
the United States with respect to foreign mineral income from sources 
within such country or possession is an amount which is the greater of--
    (a) The amount by which the total amount of the income, war profits, 
and excess profits taxes paid or accrued during the taxable year to such 
country or possession exceeds the amount of such taxes that would be 
paid or accrued for such year to such country or possession without 
taking into account such foreign mineral income, or
    (b) The amount of the income, war profits, and excess profits taxes 
that would be paid or accrued to such country or possession if such 
foreign mineral income were the taxpayer's only income for the taxable 
year, except that in no case shall the amount so determined exceed the 
total of all income, war profits, and excess profits taxes paid or 
accrued during the taxable year to such country or possession. For such 
purposes taxes which are paid or accrued also include taxes which are 
deemed paid under section 902. In the case of a dividend described in 
paragraph (b)(2)(i) (a) of this section which is from sources within a 
foreign country or possession of the United States and is attributable 
in whole or in part to foreign mineral income, the amount of the income, 
war profits, and excess profits taxes deemed paid under section 902 
during the taxable year to such country or possession with respect to 
foreign mineral income from sources within such country or possession is 
an amount which bears the same ratio to the amount of the income, war 
profits, and excess profits taxes deemed paid under section 902 during 
such year to such country or possession with respect to such dividend as 
the portion of the dividend which is attributable to foreign mineral 
income bears to the total dividend. For purposes of (a) and (b) of this 
subdivision, foreign mineral income is to be reduced by any credits, 
expenses, losses, and other deductions which are properly allocable to 
such income under the law of the foreign country or possession of the 
United States from which such income is derived.
    (ii) U.S. tax. For purposes of subparagraph (1)(ii) of this 
paragraph, the amount of the tax computed under chapter 1 of the Code 
for the taxable year with respect to foreign mineral income from sources 
within a foreign country or possession of the United States is the 
greater of--
    (a) The amount by which the tax under chapter 1 of the Code on the 
taxpayer's taxable income for the taxable

[[Page 778]]

year exceeds a tax determined under such chapter on the taxable income 
for such year determined without regard to such foreign mineral income, 
or
    (b) The amount of tax that would be determined under chapter 1 of 
the Code if such foreign mineral income were the taxpayer's only income 
for the taxable year.


For purposes of this subdivision the tax is to be determined without 
regard to any credits against the tax and without taking into account 
any tax against which a credit is not allowed under section 901(a). For 
purposes of (b) of this subdivision, the foreign mineral income is to be 
reduced only by expenses, losses, and other deductions properly 
allocable under chapter 1 of the Code to such income and is to be 
computed without any deduction for personal exemptions under section 151 
or 642(b).
    (iii) U.S. income tax computed without deduction allowed by section 
613. For purposes of subparagraph (1)(i)(b) of this paragraph, the 
amount of the tax which would be computed under chapter 1 of the Code 
(without regard to section 613) for the taxable year with respect to 
foreign mineral income from sources within a foreign country or 
possession of the United States is the amount of the tax on such income 
that would be computed under such chapter by using as the allowance for 
depletion cost depletion computed upon the adjusted depletion basis of 
the property. For purposes of this subdivision the tax is to be 
determined without regard to any credits against the tax and without 
taking into account any tax against which credit is not allowed under 
section 901(a). If the greater tax with respect to the foreign mineral 
income under subdivision (ii) of this subparagraph is the tax determined 
under (a) of such subdivision, the tax determined for purposes of 
subparagraph (1)(i)(b) of this paragraph is to be determined by applying 
the principles of (a) (rather than of (b)) of subdivision (ii) of this 
subparagraph. On the other hand, if the greater tax with respect to the 
foreign mineral income under subdivision (ii) of this subparagraph is 
the tax determined under (b) of such subdivision, the tax determined for 
purposes of subparagraph (1)(i)(b) of this paragraph is to be determined 
by applying the principles of (b) (rather than of (a)) of subdivision 
(ii) of this subparagraph.
    (3) Special rules. (i) The reduction required by this paragraph in 
the amount of taxes paid, accrued, or deemed to be paid to a foreign 
country or possession of the United States applies only where the 
taxpayer is allowed a deduction for percentage depletion under section 
613 with respect to any part of his foreign mineral income for the 
taxable year from sources within such country or possession, whether or 
not such deduction is allowed with respect to the entire foreign mineral 
income from sources within such country or possession for such year.
    (ii) For purposes of this section, the term ``foreign country'' or 
``possession of the United States'' includes the adjacent continental 
shelf areas to the extent, and in the manner, provided by section 638(2) 
and the regulations thereunder.
    (iii) The provisions of this section are to be applied before making 
any reduction required by section 1503(b) in the amount of income, war 
profits, and excess profits taxes paid or accrued to foreign countries 
or possessions of the United States by a Western Hemisphere trade 
corporation.
    (iv) If a taxpayer chooses with respect to any taxable year to claim 
a credit under section 901 and has any foreign mineral income from 
sources within a foreign country or possession of the United States with 
respect to which the deduction under section 613 is allowed, he must 
attach to his return a schedule showing the computations required by 
subdivisions (i), (ii), and (iii) of subparagraph (2) of this paragraph.
    (v) A taxpayer who has elected to use the overall limitation under 
section 904(a)(2) on the amount of the foreign tax credit for any 
taxable year beginning before January 1, 1970, may, for his first 
taxable year beginning after December 31, 1969, revoke his election 
without first securing the consent of the Commissioner. See paragraph 
(d) of Sec.  1.904-1.
    (b) Foreign mineral income defined--(1) In general. The term 
``foreign mineral income'' means income (determined under chapter 1 of 
the Code) from

[[Page 779]]

sources within a foreign country or possession of the United States 
derived from--
    (i) The extraction of minerals from mines, wells, or other natural 
deposits,
    (ii) The processing of minerals into their primary products, or
    (iii) The transportation, distribution, or sale of minerals or of 
the primary products derived from minerals.


Any income of the taxpayer derived from an activity described in either 
subdivision (i), (ii), or (iii) of this subparagraph is foreign mineral 
income, since it is not necessary that the taxpayer extract, process, 
and transport, distribute, or sell minerals or their primary products 
for the income derived from any such activity to be foreign mineral 
income. Thus, for example, an integrated oil company must treat as 
foreign mineral income from sources within a foreign country or 
possession of the United States all income from such sources derived 
from the production of oil, the refining of crude oil into gasoline, the 
distribution of gasoline to marketing outlets, and the retail sale of 
gasoline. Similarly, income from such sources from the refining, 
distribution, or marketing of fuel oil by the taxpayer is foreign 
mineral income, whether or not the crude oil was extracted by the 
taxpayer. In further illustration, income from sources within a foreign 
country or possession of the United States derived from the processing 
of minerals into their primary products by the taxpayer is foreign 
mineral income, whether or not the minerals were extracted, or the 
primary products were sold, by the taxpayer. Section 901(e) and this 
section apply whether or not the extraction, processing, transportation, 
distribution, or selling of the minerals or primary products is done by 
the taxpayer. Thus, for example, an individual who derives royalty 
income from the extraction of oil from an oil well in a foreign country 
has foreign mineral income for purposes of this paragraph. Income from 
the manufacture, distribution, and marketing of petrochemicals is not 
foreign mineral income. Foreign mineral income is not limited to gross 
income from the property within the meaning of section 613(c) and Sec.  
1.613-3.
    (2) Income included in foreign mineral income--(i) In general. 
Foreign mineral income from sources within a foreign country or 
possession of the United States includes, but is not limited to--
    (a) Dividends from such sources, as determined under Sec.  1.902-
1(h)(1), received from a foreign corporation in respect of which taxes 
are deemed paid by the taxpayer under section 902, to the extent such 
dividends are attributable to foreign mineral income described in 
subparagraph (1) of this paragraph. The portion of such a dividend which 
is attributable to such income is that amount which bears the same ratio 
to the total dividend received as the earnings and profits out of which 
such dividend is paid that are attributable to foreign mineral income 
bear to the total earnings and profits out of which such dividend is 
paid. For such purposes, the foreign mineral income of a foreign 
corporation is its foreign mineral income described in this paragraph 
(including any dividends described in this (a) which are received from 
another foreign corporation), whether or not such income is derived from 
sources within the foreign country or possession of the United States in 
which, or under the laws of which, the former corporation is created or 
organized. A foreign corporation is considered to have no foreign 
mineral income for any taxable year beginning before January 1, 1970.
    (b) Any section 78 dividend to which a dividend described in (a) of 
this subdivision gives rise, but only to the extent such section 78 
dividend is deemed paid under paragraph (a)(2)(i) of this section with 
respect to foreign mineral income from sources within such country or 
possession and to the extent it is treated under of Sec.  1.902-1(h)(1) 
as income from sources within such country or possession.
    (c) Any amounts includible in income of the taxpayer under section 
702(a) as his distributive share of the income of a partnership 
consisting of income described in subparagraph (1) of this paragraph.
    (d) Any amounts includible in income of the taxpayer by virtue of 
section 652(a), 662(a), 671, 682(a), or 691(a), to

[[Page 780]]

the extent such amounts consist of income described in subparagraph (1) 
of this paragraph.
    (ii) Illustration. The provisions of this subparagraph may be 
illustrated by the following example:

    Example. (a) Throughout 1974, M, a domestic corporation, owns all 
the one class of stock of N, a foreign corporation which is not a less 
developed country corporation within the meaning of section 902(d). Both 
corporations use the calendar year as the taxable year. N is 
incorporated in foreign country Y. During 1974, N has income from 
sources within foreign country X, all of which is foreign mineral 
income. During 1974, N also has income from sources within country Y, 
none of which is foreign mineral income. N is taxed in each foreign 
country only on income derived from sources within that country. Neither 
country X nor country Y allows a credit against its tax for foreign 
income taxes. N pays a dividend of $40,000 to M for 1974. For purposes 
of section 902, the dividend is paid from earnings and profits for 1974.
    (b) N's earnings and profits and taxes for 1974 are determined as 
follows:

Foreign mineral income from country X........................   $100,000
Less:
  Intangible drilling and development costs........   $21,000
  Cost depletion...................................     3,000     24,000
                                                    --------------------
Taxable income from country X................................     76,000
Income tax rate of country X.................................      x 50%
                                                    -----------
Tax paid to country X........................................     38,000
                                                    ===========
Income from country Y........................................    100,000
Less deductions..............................................     25,000
                                                    -----------
Taxable income from country Y................................     75,000
Income tax rate of country Y.................................      x 60%
                                                    -----------
Tax paid to country Y........................................     45,000
                                                    ===========
Total taxable income.........................................    151,000
Less total foreign income taxes..............................     83,000
                                                    -----------
Total earnings and profits...................................     68,000
                                                    ===========
Taxable income from foreign mineral income...................     76,000
Less: Tax paid on foreign mineral income.....................     38,000
                                                    -----------
Earnings and profits from foreign mineral income.............     38,000
 

    (c) For 1974, M has foreign mineral income from country Y of 
$49,636.68, determined in the following manner and by applying this 
section, Sec.  1.78-1, and Sec.  1.902-1(h)(1):

Portion of dividend from country Y attributable to foreign    $22,352.94
 mineral income (subdivision (i)(a) of this subparagraph)
 ($40,000 x $38,000/$68,000)................................
Foreign income tax deemed paid by M to country Y under         48,823.53
 section 902(a)(1) ($83,000 x $40,000/$68,000)..............
Foreign income tax deemed paid by M to country Y with          27,283.74
 respect to foreign mineral income from country Y (paragraph
 (a)(2)(i) of this section) ($48,823.53 x $22,352.94/
 $40,000)...................................................
                                                             -----------
Foreign mineral income from country Y:
  Dividend attributable to foreign mineral income from         22,352.94
   country Y................................................
  Sec. 78 dividend deemed paid with respect to foreign         27,283.74
   mineral income (subdivision (i)(b) of this subparagraph).
  Total foreign mineral income..............................   49,636.68
                                                             ===========
 

    (c) Limitations on foreign tax credit--(1) In general. The reduction 
under section 901(e) and paragraph (a)(1) of this section in the amount 
of foreign taxes allowed as a credit under section 901(a) is to be made 
whether the per-country limitation under section 904(a)(1) or the 
overall limitation under section 904(a)(2) is used for the taxable year, 
but the reduction in the amount of foreign taxes allowed as a credit 
under section 901(a) must be made on a country-by-country basis before 
applying the limitation under section 904(a) to the reduced amount of 
taxes. If for the taxable year the separate limitation under section 
904(f) applies to any foreign mineral income, that limitation must also 
be applied after making the reduction under section 901(e) and paragraph 
(a)(1) of this section.
    (2) Carrybacks and carryovers of excess tax paid--(i) In general. 
Any amount by which (a) any income, war profits, and excess profits 
taxes paid or accrued, or deemed to be paid under section 902, during 
the taxable year to any foreign country or possession of the United 
States with respect to foreign mineral income from sources within such 
country or possession exceed (b) the reduced amount of such taxes as 
determined under paragraph (a)(1) of this section may not be deemed paid 
or accrued under section 904(d) in any other taxable year. See Sec.  
1.904-2(b)(2)(iii). However, to the extent such reduced amount of taxes 
exceeds the applicable limitation under section 904(a) for the taxable 
year it shall be deemed paid or accrued under section 904(d) in another 
taxable year as a carryback or carryover of an unused foreign tax. The 
amount so deemed paid or accrued in another taxable year is not, 
however, deemed paid or accrued with respect to foreign mineral income 
in such other taxable year. See Sec.  1.904-2(c)(3).

[[Page 781]]

    (ii) Carryovers to taxable years beginning after December 31, 1969. 
Where, under the provisions of section 904(d), taxes paid or accrued, or 
deemed to be paid under section 902, to any foreign country or 
possession of the United States in any taxable year beginning before 
January 1, 1970, are deemed paid or accrued in one or more taxable years 
beginning after December 31, 1969, the amount of such taxes so deemed 
paid or accrued shall not be deemed paid or accrued with respect to 
foreign mineral income and shall not be reduced under section 901(e) and 
paragraph (a)(1) of this section.
    (iii) Carrybacks to taxable years beginning before January 1, 1970. 
Where income, war profits, and excess profits taxes are paid or accrued, 
or deemed to be paid under section 902, to any foreign country or 
possession of the United States in any taxable year beginning after 
December 31, 1969, with respect to foreign mineral income from sources 
within such country or possession, they must first be reduced under 
section 901(e) and paragraph (a)(1) of this section before they may be 
deemed paid or accrued under section 904(d) in one or more taxable years 
beginning before January 1, 1970.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples, in which the surtax exemption 
provided by section 11(d) and the tax surcharge provided by section 
51(a) are disregarded for purposes of simplification:

    Example 1. (a) M, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country W. 
For 1971, M's gross income under chapter 1 of the Code is $100,000, all 
of which is foreign mineral income from a property in country W and is 
subject to the allowance for depletion. During 1971, M incurs intangible 
drilling and development costs of $15,000, which are currently 
deductible for purposes of the tax of both countries. Cost depletion 
amounts to $2,000 for purposes of the tax of both countries, and only 
cost depletion is allowed as a deduction under the law of country W. It 
is assumed that no other deductions are allowable under the law of 
either country. Based upon the facts assumed, the income tax paid to 
country W on such foreign mineral income is $41,500, and the U.S. tax on 
such income before allowance of the foreign tax credit is $30,240, 
determined as follows:

------------------------------------------------------------------------
                                                     U.S. tax    W tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     15,000     15,000
  Cost depletion..................................  .........      2,000
  Percentage depletion (22% of $100,000, but not       22,000  .........
   to exceed 50% of $85,000)......................
Taxable income....................................     63,000     83,000
Income tax rate...................................        48%        50%
Tax...............................................     30,240     41,500
------------------------------------------------------------------------

    (b) Without taking this section into account, M would be allowed a 
foreign tax credit for 1971 of $30,240 ($30,240 x $63,000/$63,000), and 
foreign income tax in the amount of $11,260 ($41,500 less $30,240) would 
first be carried back to 1969 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $31,900, determined as follows:

Foreign income tax paid on foreign mineral income.............   $41,500
Less reduction under sec. 901(e):
  Smaller of $41,500 (tax paid to country W on          39,840
   foreign mineral income) or $39,840 (U.S. tax on
   foreign mineral income of $83,000 ($83,000 x
   48%), determined by deducting cost depletion of
   $2,000 in lieu of percentage depletion of
   $22,000).........................................
  Less: U.S. tax on foreign mineral income (before     $30,240     9,600
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    31,900
 

    (d) After taking this section into account, M is allowed a foreign 
tax credit for 1971 of $30,240 ($30,240 x $63,000/$63,000). The amount 
of foreign income tax which may be first carried back to 1969 under 
section 904(d) is reduced from $11,260 to $1,660 ($31,900 less $30,240).
    Example 2. (a) M, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country X. 
For 1972, M has gross income under chapter 1 of the Code of $100,000, 
all of which is foreign mineral income from a property in country X and 
is subject to the allowance for depletion. During 1972, M incurs 
intangible drilling and development costs of $50,000 which are currently 
deductible for purposes of the U.S. tax but which must be amortized for 
purposes of the tax of country X. Percentage depletion of $22,000 is 
allowed as a deduction by both countries. For purposes of the U.S. tax, 
cost depletion for 1972 amounts to $15,000. It is assumed that no other 
deductions are allowable under the law of either country. Based upon 
these facts, the income tax paid to country X on such foreign mineral 
income is $27,200, and the U.S. tax on such income before allowance of 
the foreign tax credit is $13,440, determined as follows:

[[Page 782]]



------------------------------------------------------------------------
                                                     U.S. tax    X tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     50,000     10,000
  Percentage depletion............................     22,000     22,000
Taxable income....................................     28,000     68,000
Income tax rate...................................        48%        40%
Tax...............................................     13,440     27,200
------------------------------------------------------------------------

    (b) Without taking this section into account, M would be allowed a 
foreign tax credit for 1972 of $13,440 ($13,440 x $28,000/$28,000), and 
foreign income tax in the amount of $13,760 ($27,200 less $13,440) would 
first be carried back to 1970 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $23,840, determined as follows:

Foreign income tax paid on foreign mineral income.............  $27,200
Less reduction under sec. 901(e):
  Smaller of $27,200 (tax paid to country X on         $16,800
   foreign mineral income) or $16,800 (U.S. tax on
   foreign mineral income of $35,000 ($35,000 x
   48%), determined by deducting cost depletion of
   $15,000 in lieu of percentage depletion of
   $22,000).........................................
  Less: U.S. tax on foreign mineral income (before      13,440     3,360
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    23,840
 

    (d) After taking this section into account, M is allowed a foreign 
tax credit of $13,440 ($13,440 x $28,000/$28,000). The amount of foreign 
income tax which may be first carried back to 1970 under section 904(d) 
is reduced from $13,760 to $10,400 ($23,840 less $13,440).
    Example 3. (a) N, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country Y. 
For 1972, N's gross income under chapter 1 of the Code is $100,000, all 
of which is foreign mineral income from a property in country Y and is 
subject to the allowance for depletion. During 1972, N incurs intangible 
drilling and development costs of $15,000, which are currently 
deductible for purposes of the U.S. tax but are not deductible under the 
law of country Y. Depreciation of $40,000 is allowed as a deduction for 
purposes of the U.S. tax; and of $20,000, for purposes of the Y tax. 
Cost depletion amounts to $10,000 for purposes of the tax of both 
countries, and only cost depletion is allowed as a deduction under the 
law of country Y. It is assumed that no other deductions are allowable 
under the law of either country. Based upon the facts assumed, the 
income tax paid to country Y on such foreign mineral income is $14,000, 
and the U.S. tax on such income before allowance of the foreign tax 
credit is $11,040, determined as follows:

------------------------------------------------------------------------
                                                     U.S. tax    Y tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     15,000  .........
  Depreciation....................................     40,000     20,000
  Cost depletion..................................  .........     10,000
  Percentage depletion (22% of $100,000, but not       22,000  .........
   to exceed 50% of $45,000)......................
  Taxable income..................................     23,000     70,000
  Income tax rate.................................        48%        20%
  Tax.............................................     11,040     14,000
------------------------------------------------------------------------

    (b) Without taking this section into account, N would be allowed a 
foreign tax credit for 1972 of $11,040 ($11,040 x $23,000/$23,000), and 
foreign income tax in the amount of $2,960 ($14,000 less $11,040) would 
first be carried back to 1970 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $11,040, determined as follows:

Foreign income tax paid on foreign mineral income.............   $14,000
Less reduction under sec. 901(e):
  Smaller of $14,000 (tax paid to country Y on         $14,000
   foreign mineral income) or $16,800 (U.S. tax on
   foreign mineral income of $35,000 ($35,000 x
   48%), determined by deducting cost depletion of
   $10,000 in lieu of percentage depletion of
   $22,000).........................................
  Less: U.S. tax on foreign mineral income (before      11,040     2,960
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    11,040
 

    (d) After taking this section into account, N is allowed a foreign 
tax credit for 1972 of $11,040 ($11,040 x $23,000/$23,000), but no 
foreign income tax is carried back to 1970 under section 904(d) since 
the allowable credit of $11,040 does not exceed the limitation of 
$11,040.
    Example 4. (a) D, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country Z. 
For 1971, D's gross income under chapter 1 of the Code is $100,000, all 
of which is foreign mineral income from a property in country Z and is 
subject to the allowance for depletion. During 1971, D incurs intangible 
drilling and development costs of $85,000, which are currently 
deductible for purposes of the U.S. Tax but are not deductible under the 
law of country Z. Cost depletion in the amount of $10,000 is allowed as 
a deduction for purposes of both the U.S. tax and the tax of country Z. 
Percentage depletion is not allowed as a deduction under the law of 
country Z and is not taken as a deduction for purposes of the U.S. tax. 
It is assumed that no other deductions are allowable under the law of 
either country. Based upon the facts assumed, the income tax paid to 
country Z on such foreign mineral income is $27,000, and the U.S. tax on 
such income before allowance

[[Page 783]]

of the foreign tax credit is $2,400, determined as follows:

------------------------------------------------------------------------
                                                     U.S. tax    Z tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     85,000  .........
  Cost depletion..................................     10,000     10,000
Taxable income....................................      5,000     90,000
Income tax rate...................................        48%        30%
Tax...............................................      2,400     27,000
------------------------------------------------------------------------

    (b) Section 901(e) and this section do not apply to reduce the 
amount of the foreign income tax paid to country Z with respect to the 
foreign mineral income since for 1971 D is not allowed the deduction for 
percentage depletion with respect to any foreign mineral income from 
sources within country Z. Accordingly, D is allowed a foreign tax credit 
of $2,400 ($2,400 x $5,000/$5,000), and foreign income tax in the amount 
of $24,600 ($27,000 less $2,400) is first carried back to 1969 under 
section 904(d).
    Example 5. (a) R, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in the United States 
and in foreign country Z. For 1971, R's gross income under chapter 1 of 
the Code is $250,000, of which $100,000 is foreign mineral income from a 
property in foreign country Z and $150,000 is from a property in the 
United States, all being subject to the allowance for depletion. During 
1971, R incurs intangible drilling and development costs of $125,000 in 
the United States and of $25,000 in country Z, all of which are 
currently deductible for purposes of the U.S. tax. Of these costs of 
$25,000 incurred in country Z, only $2,500 is currently deductible under 
the law of country Z. Cost depletion in the case of the U.S. property 
amounts to $60,000; and in the case of the property in country Z, to 
$5,000, which is allowed as a deduction under the laws of such country. 
Percentage depletion is not allowed as a deduction under the law of 
country Z. In computing the U.S. tax for 1971, R is required to use cost 
depletion with respect to the mineral income from the U.S. property and 
percentage depletion with respect to the foreign mineral income from the 
property in country Z. It is assumed that no other deductions are 
allowed under the law of either country. Based upon the facts assumed, 
the income tax paid to country Z on the foreign mineral income from 
sources therein is $37,000, and the U.S. tax on the entire mineral 
income before allowance of the foreign tax credit is $8,640, determined 
as follows:

------------------------------------------------------------------------
                                                     U.S. tax    Z tax
------------------------------------------------------------------------
Gross income (including foreign mineral income)...   $250,000   $100,000
Less:
  Intangible drilling and development costs.......    150,000      2,500
  Cost depletion..................................     60,000      5,000
  Percentage depletion on foreign mineral income       22,000  .........
   (22% of $100,000, but not to exceed 50% of
   [$100,000-$25,000])............................
Taxable income....................................     18,000     92,500
Income tax rate...................................        48%        40%
Tax...............................................      8,640     37,000
------------------------------------------------------------------------

    (b) Without taking this section into account, R would be allowed a 
foreign tax credit for 1971 of $8,640 ($8,640 x $18,000/$18,000), and 
foreign income tax in the amount of $28,360 ($37,000 less $8,640) would 
first be carried back to 1969 under section 904(d).
    (c) Under paragraph (a)(2)(ii) of this section, the amount of the 
U.S. tax for 1971 with respect to foreign mineral income from country Z 
is $25,440, which is the greater of the amounts of tax determined under 
subparagraphs (1) and (2):
    (1) U.S. tax on total taxable income in excess of U.S. tax on 
taxable income excluding foreign mineral income from country Z 
(determined under paragraph (a)(2)(ii)(a) of this section):

U.S. tax on total taxable income..................  .........     $8,640
Less U.S. tax on taxable income other than foreign
 mineral income from country Z:
  Income from U.S. property.......................   $150,000
  Intangible drilling and development costs.......    125,000
  Cost depletion..................................     60,000
  Taxable income..................................          0
  Income tax rate.................................        48%
  U.S. tax........................................          0          0
                                                   ---------------------
Excess tax........................................  .........      8,640
 

    (2) U.S. tax on foreign mineral income from country Z (determined 
under paragraph (a)(2)(ii) (b) of this section):

Foreign mineral income.......................................   $100,000
Intangible drilling and development costs....................     25,000
Percentage depletion (22% of $100,000, but not to exceed 50%      22,000
 of $75,000).................................................
Taxable income...............................................     53,000
Income tax rate..............................................        48%
U.S. tax.....................................................     25,440
 

    (d) Under paragraph (a)(2)(iii) of this section, the amount of the 
U.S. tax which would be computed for 1971 (without regard to section 
613) with respect to foreign mineral income from sources within country 
Z is $33,600, computed by applying the principles of paragraph 
(a)(2)(ii)(b) of this section:

Foreign mineral income.......................................   $100,000
Intangible drilling and development costs....................     25,000
Cost depletion...............................................      5,000
Taxable income...............................................     70,000
Income tax rate..............................................        48%
U.S. tax.....................................................     33,600
 

    (e) Pursuant to paragraph (a)(1) of this section, the foreign income 
tax allowable as a

[[Page 784]]

credit against the U.S. tax for 1971 is reduced to $28,840, determined 
as follows:

Foreign income tax paid on foreign mineral income.............   $37,000
Less reduction under sec. 901(e):
  Smaller of $37,000 (tax paid to country Z on         $33,600
   foreign mineral income) or $33,600 (U.S. tax on
   foreign mineral income of $70,000, as determined
   under paragraph (d) of this example..............
  Less: U.S. tax on foreign mineral income of           25,440     8,160
   $53,000, as determined under paragraph (c) of
   this example.....................................
                                                     -------------------
Foreign income tax allowable as a credit......................   $28,840
 

    (f) After taking this section into account, R is allowed a foreign 
tax credit for 1971 of $8,640 ($8,640 x $18,000/$18,000). The amount of 
foreign income tax which may be first carried back to 1969 under section 
904(d) is reduced from $28,360 to $20,200 ($28,840 less $8,640).
    Example 6. (a) B, a single individual using the calendar year as the 
taxable year, is an operator drilling for oil in foreign countries X and 
Y. For 1972, B's gross income under chapter 1 of the Code is $250,000, 
of which $150,000 is foreign mineral income from a property in country X 
and $100,000 is foreign mineral income from a property in country Y, all 
being subject to the allowance for depletion. The assumption is made 
that B's earned taxable income for 1972 is insufficient to cause section 
1348 to apply. During 1972, B incurs intangible drilling and development 
costs of $16,000 in country X and of $9,000 in country Y, which are 
currently deductible for purposes of both the U.S. tax and the tax of 
countries X and Y, respectively. For purposes of both the U.S. tax and 
the tax of countries X and Y, respectively, cost depletion in the case 
of the X property amounts to $8,000, and in the case of Y property, to 
$7,000; and only cost depletion is allowed as a deduction under the law 
of countries X and Y. For 1972, B uses the overall limitation under 
section 904(a)(2) on the foreign tax credit. Percentage depletion is not 
allowed as a deduction under the law of countries X and Y. It is assumed 
that the only other allowable deductions amount to $2,250. None of these 
deductions is attributable to the income from the properties in 
countries X and Y, and none is deductible under the laws of country X or 
country Y. Based upon the facts assumed, the income tax paid to 
countries X and Y on the foreign mineral income from each such country 
is $71,820 and $25,200, respectively, and the U.S. tax on B's total 
taxable income before allowance of the foreign tax credit is $99,990, 
determined as follows:

------------------------------------------------------------------------
                                          U.S. Tax    X tax      Y tax
------------------------------------------------------------------------
Total income (including foreign mineral   $250,000   $150,000   $100,000
 income from countries X and Y)........
Intangible drilling and development         25,000     16,000      9,000
 costs.................................
Cost depletion.........................  .........      8,000      7,000
Percentage depletion (22% of $150,000,      55,000  .........  .........
 but not to exceed 50% of $134,000;
 plus 22% of $100,000, but not to
 exceed 50% of $91,000)................
Adjusted gross income..................    170,000  .........  .........
Other deductions.......................      2,250  .........  .........
Personal exemption.....................        750  .........  .........
Taxable income.........................    167,000    126,000     84,000
Income tax rate........................  .........        57%        30%
Foreign tax............................  .........     71,820     25,200
U.S. tax ($53,090 plus 70% of $67,000).     99,990  .........  .........
------------------------------------------------------------------------

    (b) Without taking this section into account, B would be allowed a 
foreign tax credit for 1972 of $97,020 ($71,820 + $25,200), but not to 
exceed the overall limitation under section 904(a)(2) of $99,990 
($99,990 x $167,750/$167,750). There would be no foreign income tax 
carried back to 1970 under section 904(d) since the allowable credit of 
$97,020 does not exceed the limitation of $99,990.
    (c) Under paragraph (a)(2)(ii) of this section, the amount of the 
U.S. tax for 1972 with respect to foreign mineral income from sources 
within country X is $69,760, which is the greater of the amounts of tax 
determined under subparagraphs (1) and (2):
    (1) U.S. tax on total taxable income in excess of U.S. tax on 
taxable income excluding foreign mineral income from country X 
(determined under paragraph (a)(2)(ii)(a) of this section):

U.S. tax on total taxable income..................  .........    $99,990
Less U.S. tax on taxable income other than foreign
 mineral income from country X:
  Foreign mineral income from country Y...........   $100,000
  Intangible drilling and development costs.......      9,000
  Percentage depletion (22% of $100,000, but not       22,000
   to exceed 50% of $91,000)......................
  Adjusted gross income...........................     69,000
  Other deductions................................      2,250
  Personal exemption..............................        750
  Taxable income..................................     66,000
U.S. tax ($26,390 plus 64% of $6,000).............  .........     30,230
                                                              ----------
Excess tax........................................  .........     69,760
 

    (2) U.S. tax on foreign mineral income from country X (determined 
under paragraph (a)(2)(ii)(b) of this section):

Foreign mineral income from country X......................  $150,000.00
Intangible drilling and development costs..................    16,000.00
Percentage depletion (22% of $150,000, but not to exceed       33,000.00
 50% of $134,000)..........................................
Adjusted gross income......................................   101,000.00

[[Page 785]]

 
Other deductions...........................................
Taxable income.............................................   101,000.00
U.S. tax ($53,090 plus 70% of excess over $100,000)........    53,790.00
 

    (d) Under paragraph (a)(2)(iii) of this section, and by applying the 
principles of paragraph (a)(2)(ii)(a) of this section, the amount of the 
U.S. tax which would be computed for 1972 (without regard to section 
613) with respect to foreign mineral income from sources within country 
X is $87,920, which is the excess of the U.S. tax ($127,990) determined 
under subparagraph (1) over the U.S. tax ($40,070) determined under 
subparagraph (2):
    (1) U.S. tax on total taxable income determined without regard to 
section 613:

Total income.................................................   $250,000
Intangible drilling and development costs....................     25,000
Cost depletion...............................................     15,000
Adjusted gross income........................................    210,000
Other deductions.............................................      2,250
Personal exemption...........................................        750
Taxable income...............................................    207,000
U.S. tax ($53,090 plus 70% of $107,000)......................    127,990
 

    (2) U.S. tax on total taxable income other than foreign mineral 
income from country X, determined without regard to section 613:

Foreign mineral income from country Y........................   $100,000
Intangible drilling and development costs....................      9,000
Cost depletion...............................................      7,000
Adjusted gross income........................................     84,000
Other deductions.............................................      2,250
Personal exemption...........................................        750
Taxable income...............................................     81,000
U.S. tax ($39,390 plus 68% of $1,000)........................     40,070
 

    (e) Under paragraph (a)(2)(i) of this section, the amount of income 
tax paid to country X for 1972 with respect to foreign mineral income 
from sources within such country is $71,820. This is the amount 
determined under both (a) and (b) of paragraph (a)(2)(i) of this 
section, since, in this case, there is no income from sources within 
country X other than foreign mineral income, and there are no deductions 
allowed under the law of country X which are not allocable to such 
foreign mineral income.
    (f) Pursuant to paragraph (a)(1) of this section, the foreign income 
tax with respect to foreign mineral income from sources within country X 
which is allowable as a credit against the U.S. tax for 1972 is reduced 
to $69,760, determined as follows:

Foreign income tax paid to country X on foreign mineral income   $71,820
Less reduction under sec. 901(e):
  Smaller of $71,820 (tax paid to country X on         $71,820
   foreign mineral income) or $87,920 (U.S. tax on
   foreign mineral income from sources within
   country X, as determined under paragraph (d) of
   this example)....................................
  Less: U.S. tax on foreign mineral income from         69,760     2,060
   sources within country X, determined under
   paragraph (c) of this example....................
                                                     -------------------
Foreign income tax of country X allowable as a        ........    69,760
 credit.............................................
 

    (g) Under paragraph (a)(2)(ii) of this section, the amount of the 
U.S. tax for 1972 with respect to foreign mineral income from sources 
within country Y is $48,280, which is the greater of the amounts of tax 
determined under subparagraphs (1) and (2):
    (1) U.S. tax on total taxable income in excess of U.S. tax on 
taxable income excluding foreign mineral income from country Y 
(determined under paragraph (a)(2)(ii)(a) of this section):

U.S. tax on total taxable income..............................   $99,990
  Less U.S. tax on taxable income other than foreign mineral
   income from country Y:
  Foreign mineral income from country X............   $150,000
  Intangible drilling and development costs........     16,000
  Percentage depletion (22% of $150,000, but not to     33,000
   exceed 50% of $134,000).........................
  Adjusted gross income............................    101,000
  Other deductions.................................      2,250
  Personal exemption...............................        750
  Taxable income...................................     98,000
  U.S. tax ($46,190 plus 69% of $8,000)............  .........    51,710
                                                               ---------
Excess tax.........................................  .........    48,280
 

    (2) U.S. tax on foreign mineral income from country Y (determined 
under paragraph (a)(2)(ii)(b) of this section):

Foreign mineral income from country Y........................   $100,000
Intangible drilling and development costs....................      9,000
Percentage depletion (22% of $100,000, but not to exceed 50%      22,000
 of $91,000).................................................
Adjusted gross income........................................     69,000
Other deductions.............................................  .........
Taxable income...............................................     69,000
U.S. tax ($26,390 plus 64% of $9,000)........................     32,150
 

    (h) Under paragraph (a)(2)(iii) of this section, and by applying the 
principles of paragraph (a)(2)(ii)(a) of this section, the amount of the 
U.S. tax which would be computed for 1972 (without regard to section 
613) with respect to foreign mineral income from sources within country 
Y is $58,800, which is the excess of the U.S. tax ($127,990) determined 
under paragraph (d)(1) of this example over the U.S. tax ($69,190) on 
total taxable income other than foreign mineral income from country Y, 
determined without regard to section 613, as follows:

Foreign mineral income from country X........................   $150,000
Intangible drilling and development costs....................     16,000
Cost depletion...............................................      8,000
Adjusted gross income........................................    126,000
Other deductions.............................................      2,250
Personal exemption...........................................        750
Taxable income...............................................    123,000
U.S. tax ($53,090 plus 70% of $23,000).......................     69,190
 

    (i) Under paragraph (a)(2)(i) of this section, the amount of income 
tax paid to country Y for 1972 with respect to foreign mineral income 
from sources within such country is $25,200. This is the amount 
determined under both (a) and (b) of paragraph (a)(2)(i) of this

[[Page 786]]

section, since, in this case, there is no income from sources within 
country Y other than foreign mineral income, and there are no deductions 
allowed under the law of country Y which are not allocable to such 
foreign mineral income.
    (j) Pursuant to paragraph (a)(1) of this section, the foreign income 
tax with respect to foreign mineral income from sources within country Y 
which is allowable as a credit against the U.S. tax for 1972 is not 
reduced from $25,200, as follows:

Foreign income tax paid to country Y on foreign       ........   $25,200
 mineral income.....................................
Less reduction under sec. 901(e):
  Smaller of $25,200 (tax paid to country Y on         $25,200
   foreign mineral income) or $58,800 (U.S. tax on
   foreign mineral income from sources within
   country Y, as determined under paragraph (h) of
   this example)....................................
  Less: U.S. tax on foreign mineral income from         48,280
   sources within country Y, as determined under
   paragraph (g) of this example....................
                                                     -------------------
Foreign income tax of country Y allowable as a        ........    25,200
 credit.............................................
 

    (k) After taking this section into account, B is allowed a foreign 
tax credit for 1972 of $94,960 ($69,760 + $25,200), but not to exceed 
the overall limitation under section 904 (a)(2) of $99,990 ($99,990 x 
$167,750/$167,750). There would be no foreign income tax carried back to 
1970 under section 904(d) since the allowable credit of $94,960 does not 
exceed the limitation of $99,990.
    Example 7. (a) P, a domestic corporation using the calendar year as 
the taxable year, is an operator mining for iron ore in foreign country 
X. For 1971, P's gross income under chapter 1 of the Code is $100,000, 
all of which is foreign mineral income from a property in country X and 
is subject to the allowance for depletion. For 1971, cost depletion 
amounts to $5,000 for purposes of the tax of both countries, and only 
cost depletion is allowed as a deduction under the law of country X. It 
is assumed that deductions (other than for depletion) attributable to 
the mineral property in country X amount to $8,000, and these deductions 
are allowable under the law of both countries. Based upon the facts 
assumed, the income tax paid to country X on such foreign mineral income 
is $39,150, and the U.S. tax on such income before allowance of the 
foreign tax credit is $37,440 determined as follows:

------------------------------------------------------------------------
                                                     U.S. tax    X tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Percentage depletion (14% of $100,000, but not       14,000  .........
   to exceed 50% of $92,000)......................
  Cost depletion..................................  .........      5,000
  Other deductions................................      8,000      8,000
Taxable income....................................     78,000     87,000
Income tax rate...................................        48%        45%
Tax...............................................     37,440     39,150
------------------------------------------------------------------------

    (b) Without taking this section into account, P would be allowed a 
foreign tax credit for 1971 of $37,440 ($37,440 x $78,000/ $78,000), and 
foreign income tax in the amount of $1,710 ($39,150 less $37,440) would 
first be carried back to 1969 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $37,440, determined as follows:

Foreign income tax paid on foreign mineral income.............   $39,150
Less reduction under sec. 901(e):
  Smaller of $39,150 (tax paid to country X on         $39,150
   foreign mineral income) or $41,760 (U.S. tax on
   foreign mineral income of $87,000 ($87,000 x
   48%), determined by deducting cost depletion of
   $5,000 in lieu of percentage depletion of
   $14,000).........................................
  Less: U.S. tax on foreign mineral income (before      37,440     1,710
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    37,440
 

    (d) After taking this section into account, P is allowed a foreign 
tax credit for 1971 of $37,440 ($37,440 x $78,000/$78,000), but no 
foreign income tax is carried back to 1969 under section 904(d) since 
the allowable credit of $37,440 does not exceed the limitation of 
$37,440.
    Example 8. (a) The facts are the same as in example 7, except that P 
is assumed to have received dividends for 1971 of $25,000 from R, a 
foreign corporation incorporated in country X which is not a less 
developed country corporation within the meaning of section 902(d). 
Income tax of $2,500 ($25,000 x 10%) on such dividends is withheld at 
the source in country X. It is assumed that P is deemed under section 
902(a)(1) and Sec.  1.902-1(h) to have paid income tax of $22,500 to 
country X in respect of such dividends and that under paragraphs 
(a)(2)(i) and (b)(2)(i) of this section such dividends are deemed to be 
attributable to foreign mineral income from sources in country X and 
that such tax is deemed to be paid with respect to such foreign mineral 
income. Based upon the facts assumed, the U.S. tax on the foreign 
mineral income from sources in country X is $60,240 before allowance of 
the foreign tax credit, determined as follows:

Foreign mineral income from country X:
  Income from mining property.....................   $100,000
  Dividends from R................................     25,000
  Sec. 78 dividend................................     22,500   $147,500
                                                   -----------
Less:
  Percentage depletion (14% of $100,000, but not to exceed       $14,000
   50% of $92,000)...........................................
  Other deductions...........................................      8,000
Taxable income...............................................    125,500

[[Page 787]]

 
Income tax rate..............................................        48%
U.S. tax.....................................................     60,240
 

    (b) Without taking this section into account, P would be allowed a 
foreign tax credit for 1971 of $60,240 ($60,240 x $125,500/$125,500), 
and foreign income tax in the amount of $3,910 ([$39,150 + $22,500 + 
$2,500] less $60,240) would first be carried back to 1969 under section 
904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
from $64,150 to $60,240, determined as follows:

Foreign income tax paid, and deemed to be paid, to country X     $64,150
 on foreign mineral income ($39,150 + $22,500 + $2,500)......
Less reduction under sec. 901(e):
  Smaller of $64,150 (tax paid and deemed paid to     $64,150
   country X on foreign mineral income) or $64,560
   (U.S. tax on foreign mineral income of $134,500
   ($134,500 x 48%), determined by deducting cost
   depletion of $5,000 in lieu of percentage
   depletion of $14,000)..........................
  Less: U.S. tax on foreign mineral income (before    $60,240     $3,910
   credit)........................................
                                                   ---------------------
Foreign income tax allowable as a credit.....................     60,240
 

    (d) After taking this section into account, P is allowed a foreign 
tax credit for 1971 of $60,240 ($60,240 x $125,500/$125,500), but no 
foreign income tax is carried back to 1969 under section 904(d) since 
the allowable credit of $60,240 does not exceed the limitation of 
$60,240.

[T.D. 7294, 38 FR 33074, Nov. 30, 1973, as amended by T.D. 7481, 42 FR 
20130, Apr. 18, 1977]



Sec.  1.901(j)-1  Denial of foreign tax credit with respect to 
certain foreign countries.

    (a) Sourcing rule for certain payments and inclusions. Any income 
paid or accrued through one or more entities is treated as income from 
sources within a country described in section 901(j)(2) if the income 
was, without regard to such entities, from sources within that country.
    (b) Applicability date. This section applies to taxable years that 
end on or after December 4, 2018.

[T.D. 9882, 84 FR 69075, Dec. 17, 2019]



Sec.  1.901(m)-1  Definitions.

    (a) Definitions. For purposes of section 901(m), this section, and 
Sec. Sec.  1.901(m)-2 through 1.901(m)-8, the following definitions 
apply:
    (1) The term aggregate basis difference means, with respect to a 
foreign income tax and a foreign payor, the sum of the allocated basis 
differences and the allocated basis difference adjustments for a U.S. 
taxable year of a section 901(m) payor, plus any aggregate basis 
difference carryover from the immediately preceding U.S. taxable year of 
the section 901(m) payor with respect to the foreign income tax and 
foreign payor, as adjusted under Sec.  1.901(m)-6(c). For purposes of 
this definition, if foreign law imposes tax on the combined income 
(within the meaning of Sec.  1.901-2(f)(3)(ii)) of two or more foreign 
payors, all foreign payors whose items of income, deduction, gain, or 
loss are included in the U.S. taxable income or earnings and profits of 
the section 901(m) payor are treated as a single foreign payor. 
Aggregate basis difference is determined with respect to each separate 
category.
    (2) The term aggregate basis difference carryover has the meaning 
provided in Sec.  1.901(m)-3(c).
    (3) The term aggregated CAA transaction means a series of related 
CAAs occurring as part of a plan.
    (4) The term allocable foreign income means the portion of foreign 
income of a foreign payor that relates to the foreign income tax amount 
of the foreign payor that is paid or accrued by, or considered paid or 
accrued by, a section 901(m) payor.
    (5) The term allocated basis difference means, with respect to an 
RFA and a foreign income tax, the sum of the cost recovery amounts and 
disposition amounts assigned to a U.S. taxable year of the section 
901(m) payor under Sec.  1.901(m)-5.
    (6) The term allocated basis difference adjustment means an 
adjustment to a section 901(m) payor's allocated basis difference with 
respect to an RFA and a foreign income tax for a U.S. taxable year. If 
the RFA has a positive basis difference, the allocated basis difference 
adjustment is equal to the lesser of the allocated basis difference or 
the portion of any unallocated CAA gain that corresponds to the CAA gain 
recognized by the section 901(m) payor or a member of the section 901(m) 
payor's consolidated group. If the RFA

[[Page 788]]

has a negative basis difference, the allocated basis difference 
adjustment is equal to the greater of the allocated basis difference or 
the portion of any unallocated CAA loss that corresponds to the CAA loss 
recognized by the section 901(m) payor or a member of the section 901(m) 
payor's consolidated group. For purposes of this paragraph, CAA gain or 
CAA loss recognized by the section 901(m) payor or a member of the 
section 901(m) payor's consolidated group includes their distributive 
share of CAA gain or CAA loss recognized by a partnership.
    (7) The term applicable foreign corporation means--
    (i) For taxable years of foreign corporations beginning before 
January 1, 2018, a section 902 corporation (as defined in section 
909(d)(5) (as in effect on December 21, 2017)), and
    (ii) For taxable years of foreign corporations beginning after 
December 31, 2017, a controlled foreign corporation (as defined in 
section 957).
    (8) The term basis difference has the meaning provided in Sec.  
1.901(m)-4.
    (9) The term CAA gain means the amount of gain recognized with 
respect to an RFA for U.S. tax purposes as a result of a CAA.
    (10) The term CAA loss means the amount of loss recognized with 
respect to an RFA for U.S. tax purposes as a result of a CAA.
    (11) The term consolidated group has the meaning provided in Sec.  
1.1502-1(h).
    (12) The term cost recovery amount has the meaning provided in Sec.  
1.901(m)-5(b)(2).
    (13) The term covered asset acquisition (or CAA) has the meaning 
provided in Sec.  1.901(m)-2.
    (14) The term cumulative basis difference exemption has the meaning 
provided in Sec.  1.901(m)-7(b)(2).
    (15) The term disposition means an event (for example, a sale, 
abandonment, or mark-to-market event) that results in gain or loss being 
recognized with respect to an RFA for purposes of U.S. income tax or a 
foreign income tax, or both.
    (16) The term disposition amount has the meaning provided in Sec.  
1.901(m)-5(c)(2).
    (17) The term disqualified tax amount has the meaning provided in 
Sec.  1.901(m)-3(b).
    (18) The term disregarded entity means an entity that is disregarded 
as an entity separate from its owner, as described in Sec.  301.7701-
2(c)(2)(i) of this chapter.
    (19) The term fiscally transparent entity means an entity, including 
a disregarded entity, that is fiscally transparent under the principles 
of Sec.  1.894-1(d)(3) for purposes of U.S. income tax or a foreign 
income tax (or both).
    (20) The term foreign basis means the adjusted basis of an asset 
determined for purposes of a foreign income tax.
    (21) The term foreign basis election has the meaning provided in 
Sec.  1.901(m)-4(c).
    (22) The term foreign country creditable tax (or FCCT) means, with 
respect to a foreign income tax amount, the amount of income, war 
profits, or excess profits tax paid or accrued to a foreign country or 
possession of the United States and claimed as a foreign tax credit for 
purposes of determining the foreign income tax amount. To qualify as a 
FCCT, the tax imposed by the foreign country or possession must be a 
foreign income tax or a withholding tax determined on a gross basis as 
described in section 901(k)(1)(B).
    (23) The term foreign disposition gain means, with respect to a 
foreign income tax, the amount of gain recognized on a disposition of an 
RFA in determining foreign income, regardless of whether the gain is 
deferred or otherwise not taken into account currently. Notwithstanding 
the foregoing, if after a section 743(b) CAA there is a disposition of 
an asset that is an RFA with respect to that section 743(b) CAA, foreign 
disposition gain has the meaning provided in Sec.  1.901(m)-
5(c)(2)(iii).
    (24) The term foreign disposition loss means, with respect to a 
foreign income tax, the amount of loss recognized on a disposition of an 
RFA in determining foreign income, regardless of whether the loss is 
deferred or disallowed or otherwise not taken into account currently. 
Notwithstanding the foregoing, if after a section 743(b) CAA there is a 
disposition of an asset that is an RFA with respect to that section 
743(b) CAA, foreign disposition loss has

[[Page 789]]

the meaning provided in Sec.  1.901(m)-5(c)(2)(iii).
    (25) The term foreign income means, with respect to a foreign income 
tax, the taxable income (or loss) reflected on a foreign tax return (as 
properly amended or adjusted), even if the taxable income (or loss) is 
reported by an entity that is a fiscally transparent entity for purposes 
of the foreign income tax. If, however, foreign law imposes tax on the 
combined income (within the meaning of Sec.  1.901-2(f)(3)(ii)) of two 
or more foreign payors, foreign income means the combined taxable income 
(or loss) of such foreign payors, regardless of whether such income (or 
loss) is reflected on a single foreign tax return.
    (26) The term foreign income tax means an income, war profits, or 
excess profits tax for which a credit is allowable under section 901 or 
section 903, except that it does not include any withholding tax 
determined on a gross basis as described in section 901(k)(1)(B).
    (27) The term foreign income tax amount means, with respect to a 
foreign income tax, the amount of tax (including an amount of tax that 
is zero) reflected on a foreign tax return (as properly amended or 
adjusted). If foreign law imposes tax on the combined income (within the 
meaning of Sec.  1.901-2(f)(3)(ii)) of two or more foreign payors, 
however, a foreign income tax amount means the amount of tax imposed on 
the combined income, regardless of whether the tax is reflected on a 
single foreign tax return.
    (28) The term foreign payor means an individual or entity (including 
a disregarded entity) subject to a foreign income tax. If foreign law 
imposes tax on the combined income (within the meaning of Sec.  1.901-
2(f)(3)(ii)) of two or more individuals or entities, each such 
individual or entity is a foreign payor. An individual or entity may be 
a foreign payor with respect to more than one foreign income tax for 
purposes of applying section 901(m).
    (29) The term foreign taxable year means a taxable year for purposes 
of a foreign income tax.
    (30) The term mid-year transaction means a transaction in which a 
foreign payor that is a corporation or a disregarded entity has a change 
in ownership or makes an election pursuant to Sec.  301.7701-3 to change 
its entity classification, or a transaction in which a foreign payor 
that is a partnership terminates under section 708(b)(1), provided in 
each case that the foreign payor's foreign taxable year does not close 
as a result of the transaction, and, if the foreign payor is a 
corporation or a partnership, the foreign payor's U.S. taxable year 
closes.
    (31) The term prior CAA has the meaning provided in Sec.  1.901(m)-
6(b)(2).
    (32) The term prior section 743(b) CAA has the meaning provided in 
Sec.  1.901(m)-6(b)(4)(iii).
    (33) The term relevant foreign asset (or RFA) has the meaning 
provided in Sec.  1.901(m)-2.
    (34) The term reverse hybrid has the meaning provided in Sec.  
1.909-2(b)(1)(iv).
    (35) The term RFA class exemption has the meaning provided in Sec.  
1.901(m)-7(b)(3).
    (36) The term RFA exemption has the meaning provided in Sec.  
1.901(m)-7(b)(4).
    (37) The term RFA owner (U.S.) means a person that owns an RFA for 
U.S. income tax purposes.
    (38) The term RFA owner (foreign) means an individual or entity 
(including a disregarded entity) that owns an RFA for purposes of a 
foreign income tax.
    (39) The term section 338 CAA has the meaning provided in Sec.  
1.901(m)-2(b)(1).
    (40) The term section 743(b) CAA has the meaning provided in Sec.  
1.901(m)-2(b)(3).
    (41) The term section 901(m) payor means a person eligible to claim 
the foreign tax credit allowed under section 901(a), regardless of 
whether the person chooses to claim the foreign tax credit, as well as 
an applicable foreign corporation. Each member of a consolidated group 
is a separate section 901(m) payor. If individuals file a joint return, 
those individuals are treated as a single section 901(m) payor.
    (42) The term separate category means each separate category 
described in Sec.  1.904-5(a)(4)(v), and in the case of an applicable 
foreign corporation described in paragraph (a)(7)(ii) of this section, 
each income group described in Sec.  1.960-1(d)(2)(ii).

[[Page 790]]

    (43) The term subsequent CAA has the meaning provided in Sec.  
1.901(m)-6(b)(4)(i).
    (44) The term subsequent section 743(b) CAA has the meaning provided 
in Sec.  1.901(m)-6(b)(4)(iii).
    (45) The term successor transaction has the meaning provided in 
Sec.  1.901(m)-6(b)(2).
    (46) The term tentative disqualified tax amount has the meaning 
provided in Sec.  1.901(m)-3(b)(2)(ii).
    (47) The term unallocated basis difference means, with respect to an 
RFA and a foreign income tax, the basis difference reduced by the sum of 
the cost recovery amounts and the disposition amounts that have been 
computed under Sec.  1.901(m)-5.
    (48) The term unallocated CAA gain means, with respect to an RFA, 
the CAA gain reduced by the sum of the allocated basis difference 
adjustments that have been computed with respect to the RFA.
    (49) The term unallocated CAA loss means, with respect to an RFA, 
the CAA loss reduced by the sum of the allocated basis difference 
adjustments that have been computed with respect to the RFA.
    (50) The term U.S. basis means the adjusted basis of an asset 
determined for U.S. income tax purposes.
    (51) The term U.S. basis deduction has the meaning provided in Sec.  
1.901(m)-5(b)(3).
    (52) The term U.S. disposition gain means the amount of gain 
recognized for U.S. income tax purposes on a disposition of an RFA, 
regardless of whether the gain is deferred or otherwise not taken into 
account currently. Notwithstanding the foregoing, if after a section 
743(b) CAA there is a disposition of an asset that is an RFA with 
respect to that section 743(b) CAA, U.S. disposition gain has the 
meaning provided in Sec.  1.901(m)-5(c)(2)(iii).
    (53) The term U.S. disposition loss means the amount of loss 
recognized for U.S. income tax purposes on a disposition of an RFA, 
regardless of whether the loss is deferred or disallowed or otherwise 
not taken into account currently. Notwithstanding the foregoing, if 
after a section 743(b) CAA there is a disposition of an asset that is an 
RFA with respect to that section 743(b) CAA, U.S. disposition loss has 
the meaning provided in Sec.  1.901(m)-5(c)(2)(iii).
    (54) The term U.S. taxable year means a taxable year as defined in 
section 7701(a)(23).
    (b) Applicability dates. (1) Except as provided in paragraph (b)(2) 
of this section, this section applies to CAAs occurring on or after 
March 23, 2020.
    (2) Paragraphs (a)(8), (12), (13), (15), (16), (18), (19), (23) 
through (26), (31) through (33), (39), (40), (43) through (45), (47), 
(50), and (52) through (54) of this section apply to CAAs occurring on 
or after July 21, 2014, and to CAAs occurring before that date resulting 
from an entity classification election made under Sec.  301.7701-3 that 
is filed on or after July 29, 2014, and that is effective on or before 
July 21, 2014. Paragraphs (a)(8), (12), (13), (15), (16), (18), (19), 
(23) through (26) through (33), (39), (40), (43) through (45), (47), 
(50), and (52) through (54) of this section also apply to CAAs occurring 
on or after January 1, 2011, and before July 21, 2014, other than CAAs 
occurring before July 21, 2014, resulting from an entity classification 
election made under Sec.  301.7701-3 that is filed on or after July 29, 
2014, and that is effective on or before July 21, 2014, but only if the 
basis difference (within the meaning of section 901(m)(3)(C)(i)) in one 
or more RFAs with respect to the CAA had not been fully taken into 
account under section 901(m)(3)(B) either as of July 21, 2014, or, in 
the case of an entity classification election made under Sec.  301.7701-
3 that is filed on or after July 29, 2014, and that is effective on or 
before July 21, 2014, before the transactions that are deemed to occur 
under Sec.  301.7701-3(g) as a result of the change in classification.
    (3) Taxpayers may, however, choose to apply provisions in this 
section before the date such provisions are applicable pursuant to 
paragraph (b)(1) or (2) of this section, provided that they (along with 
any persons that are related (within the meaning of section 267(b) or 
707(b)) to the taxpayer)--
    (i) Consistently apply this section, Sec.  1.704-
1(b)(4)(viii)(c)(4)(v) through (vii), and Sec. Sec.  1.901(m)-3 through 
1.901(m)-8 (excluding Sec.  1.901(m)-4(e)) to all CAAs occurring on or 
after January 1, 2011, and

[[Page 791]]

consistently apply Sec.  1.901(m)-2 (excluding Sec.  1.901(m)-2(d)) to 
all CAAs occurring on or after December 7, 2016, on any original or 
amended tax return for each taxable year for which the application of 
the provisions listed in this paragraph (b)(3)(i) affects the tax 
liability and for which the statute of limitations does not preclude 
assessment or the filing of a claim for refund, as applicable;
    (ii) File all tax returns described in paragraph (b)(3)(i) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (iii) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(b)(3)(i) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16249, Mar. 23, 2020]



Sec.  1.901(m)-2  Covered asset acquisitions and relevant foreign assets.

    (a) In general. Paragraph (b) of this section sets forth the 
transactions that are covered asset acquisitions (or CAAs). Paragraph 
(c) of this section provides rules for identifying assets that are 
relevant foreign assets (or RFAs) with respect to a CAA. Paragraph (d) 
of this section provides special rules for identifying CAAs and RFAs 
with respect to transactions to which paragraphs (b) and (c) of this 
section do not apply. Paragraph (e) of this section provides examples 
illustrating the rules of this section, and paragraph (f) of this 
section provides applicability dates.
    (b) Covered asset acquisitions. Except as provided in paragraph (d) 
of this section, the transactions set forth in this paragraph (b) are 
CAAs.
    (1) A qualified stock purchase (as defined in section 338(d)(3)) to 
which section 338(a) applies (section 338 CAA);
    (2) Any transaction that is treated as an acquisition of assets for 
U.S. income tax purposes and treated as an acquisition of stock of a 
corporation (or disregarded) for foreign income tax purposes;
    (3) Any acquisition of an interest in a partnership that has an 
election in effect under section 754 (section 743(b) CAA);
    (4) Any transaction (or series of transactions occurring pursuant to 
a plan) to the extent it is treated as an acquisition of assets for 
purposes of U.S. income tax and as the acquisition of an interest in a 
fiscally transparent entity for purposes of a foreign income tax;
    (5) Any transaction (or series of transactions occurring pursuant to 
a plan) to the extent it is treated as a partnership distribution of one 
or more assets the U.S. basis of which is determined by section 732(b) 
or 732(d) or to the extent it causes the U.S. basis of the partnership's 
remaining assets to be adjusted under section 734(b), provided the 
transaction results in an increase in the U.S. basis of one or more of 
the assets distributed by the partnership or retained by the partnership 
without a corresponding increase in the foreign basis of such assets; 
and
    (6) Any transaction (or series of transactions occurring pursuant to 
a plan) to the extent it is treated as an acquisition of assets for 
purposes of both U.S. income tax and a foreign income tax, provided the 
transaction results in an increase in the U.S. basis without a 
corresponding increase in the foreign basis of one or more assets.
    (c) Relevant foreign asset--(1) In general. Except as provided in 
paragraph (d) of this section, an RFA means, with respect to a foreign 
income tax and a CAA, any asset (including goodwill, going concern 
value, or other intangible) subject to the CAA that is relevant in 
determining foreign income for purposes of the foreign income tax.
    (2) RFA status with respect to a foreign income tax. An asset is 
relevant in determining foreign income if income, deduction, gain, or 
loss attributable to the asset is taken into account in determining 
foreign income immediately after the CAA, or would be taken into account 
in determining foreign income immediately after the CAA if the asset 
were to give rise to income, deduction, gain, or loss at such time.
    (3) Subsequent RFA status with respect to another foreign income 
tax. After a CAA, an asset will become an RFA with respect to another 
foreign income tax if, pursuant to a plan or series of

[[Page 792]]

related transactions that have a principal purpose of avoiding the 
application of section 901(m), an asset that was not relevant in 
determining foreign income for purposes of that foreign income tax 
immediately after the CAA becomes relevant in determining such foreign 
income. A principal purpose of avoiding section 901(m) will be deemed to 
exist if income, deduction, gain, or loss attributable to the asset is 
taken into account in determining such foreign income within the one-
year period following the CAA, or would be taken into account in 
determining such foreign income during such time if the asset were to 
give rise to income, deduction, gain, or loss within the one-year 
period.
    (d) Identifying covered asset acquisitions and relevant foreign 
assets to which paragraphs (b) and (c) of this section do not apply. For 
transactions occurring on or after January 1, 2011, and before July 21, 
2014, other than transactions occurring before July 21, 2014, resulting 
from an entity classification election made under Sec.  301.7701-3 of 
this chapter that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014, the transactions set forth under 
section 901(m)(2) are CAAs and the assets that are relevant foreign 
assets with respect to the CAA under section 901(m)(4) are RFAs.
    (e) Examples. The following examples illustrate the rules of this 
section:
    (1) Example 1: CAA involving an acquisition of a partnership 
interest for foreign income tax purposes--(i) Facts. (A) FPS is an 
entity organized in Country F that is treated as a partnership for both 
U.S. and Country F income tax purposes. FPS is owned equally by FC1 and 
FC2, each of which is a corporation organized in Country F and treated 
as a corporation for both U.S. and Country F income tax purposes. FPS 
has a single asset, Asset A. USP, a domestic corporation, owns all the 
interests in DE, a disregarded entity.
    (B) Pursuant to the same transaction, USP acquires FC1's interest in 
FPS, and DE acquires FC2's interest in FPS. For U.S. income tax 
purposes, with respect to USP, the acquisition of the interests in FPS 
is treated as the acquisition of Asset A by USP. See Rev. Rul. 99-6, 
1999-1 C.B. 432. For Country F tax purposes, the acquisitions of the 
interests of FPS by USP and DE are treated as acquisitions of 
partnership interests.
    (ii) Result. The transaction is a CAA under paragraph (b)(4) of this 
section because it is treated as the acquisition of Asset A for U.S. 
income tax purposes and the acquisition of interests in a fiscally 
transparent entity for Country F tax purposes.
    (2) Example 2: CAA involving an asset acquisition for purposes of 
both U.S. income tax and a foreign income tax--(i) Facts. (A) USP, a 
domestic corporation, wholly owns CFC1, a foreign corporation, and CFC1 
wholly owns CFC2, also a foreign corporation. CFC1 and CFC2 are 
organized in Country F. CFC1 owns Asset A.
    (B) In an exchange described in section 351, CFC1 transfers Asset A 
to CFC2 in exchange for CFC2 common stock and cash. CFC1 recognizes gain 
on the exchange under section 351(b). Under section 362(a), CFC2's U.S. 
basis in Asset A is increased by the gain recognized by CFC1. For 
Country F tax purposes, gain or loss is not recognized on the transfer 
of Asset A to CFC2, and therefore there is no increase in the foreign 
basis in Asset A.
    (ii) Result. The transaction is a CAA under paragraph (b)(6) of this 
section because it is treated as an acquisition of Asset A by CFC2 for 
both U.S. and Country F income tax purposes, and it results in an 
increase in the U.S. basis of Asset A without a corresponding increase 
in the foreign basis of Asset A.
    (3) Example 3: RFA status determined immediately after CAA; 
application of principal purpose rule--(i) Facts. (A) USP1 and USP2 are 
unrelated domestic corporations. USP1 wholly owns USSub, also a domestic 
corporation. On January 1 of Year 1, USP2 acquires all of the stock of 
USSub from USP1 in a qualified stock purchase (as defined in section 
338(d)(3)) to which section 338(a) applies. Immediately after the 
acquisition, none of the income, deduction, gain, or loss attributable 
to any of the assets of USSub is taken into account in determining 
foreign income for purposes of a foreign income tax nor would such items 
be taken into account in determining foreign income for purposes of a 
foreign income tax

[[Page 793]]

immediately after the acquisition if such assets were to give rise to 
income, deduction, gain, or loss immediately after the acquisition.
    (B) On December 1 of Year 1, USSub contributes all its assets to 
FSub, its wholly owned subsidiary, which is a corporation for both U.S. 
and Country X income tax purposes, in a transfer described in section 
351 (subsequent transfer). USSub recognizes no gain or loss for U.S. or 
Country X income tax purposes as a result of the subsequent transfer. As 
a result of the subsequent transfer, income, deduction, gain, or loss 
attributable to the assets of USSub that were transferred to FSub is 
taken into account in determining foreign income of FSub for Country X 
tax purposes.
    (ii) Result. (A) Under paragraph (b)(1) of this section, the 
acquisition by USP2 of the stock of USSub is a section 338 CAA. Under 
paragraph (c)(1) of this section, none of the assets of USSub are RFAs 
immediately after the CAA, because none of the income, deduction, gain, 
or loss attributable to such assets is taken into account for purposes 
of determining foreign income with respect to any foreign income tax 
immediately after the CAA (nor would such items be taken into account 
for purposes of determining foreign income immediately after the CAA if 
such assets were to give rise to income, deduction, gain, or loss at 
such time).
    (B) Although the subsequent transfer is not a CAA under paragraph 
(b) of this section, the subsequent transfer causes the assets of USSub 
to become relevant in the hands of FSub in determining foreign income 
for Country X tax purposes. Because the subsequent transfer occurred 
within the one-year period following the CAA, it is presumed to have a 
principal purpose of avoiding section 901(m) under paragraph (c)(3) of 
this section. Accordingly, the assets of USSub with respect to the CAA 
occurring on January 1 of Year 1 become RFAs with respect to Country X 
tax as a result of the subsequent transfer. Thus, a basis difference 
with respect to Country X tax must be computed for the RFAs and taken 
into account under section 901(m).
    (f) Applicability dates. (1) Except as provided in paragraph (f)(2) 
of this section, this section applies to CAAs occurring on or after 
March 23, 2020.
    (2) Paragraphs (a), (b)(1) through (3), and (c)(1) of this section 
apply to transactions occurring on or after July 21, 2014, and to 
transactions occurring before that date resulting from an entity 
classification election made under Sec.  301.7701-3 of this chapter that 
is filed on or after July 29, 2014, and that is effective on or before 
July 21, 2014. Paragraph (d) of this section applies to transactions 
occurring on or after January 1, 2011, and before July 21, 2014, other 
than transactions occurring before July 21, 2014, resulting from an 
entity classification election made under Sec.  301.7701-3 of this 
chapter that is filed on or after July 29, 2014, and that is effective 
on or before July 21, 2014.
    (3) Taxpayers may, however, choose to apply provisions in this 
section before the date such provisions are applicable pursuant to 
paragraph (f)(1) or (2) of this section, provided that they (along with 
any persons that are related (within the meaning of section 267(b) or 
707(b)) to the taxpayer)--
    (i) Consistently apply this section (excluding paragraph (d) of this 
section) to all CAAs occurring on or after December 7, 2016 and 
consistently apply Sec.  1.704-1(b)(4)(viii)(c)(4)(v) through (vii), 
Sec.  1.901(m)-1, and Sec. Sec.  1.901(m)-3 through 1.901(m)-8 
(excluding Sec.  1.901(m)-4(e)) to all CAAs occurring on or after 
January 1, 2011, on any original or amended tax return for each taxable 
year for which the application of the provisions listed in this 
paragraph (f)(3)(i) affects the tax liability and for which the statute 
of limitations does not preclude assessment or the filing of a claim for 
refund, as applicable;
    (ii) File all tax returns described in paragraph (f)(3)(i) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (iii) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(f)(3)(i) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16251, Mar. 23, 2020]

[[Page 794]]



Sec.  1.901(m)-3  Disqualified tax amount and aggregate basis 
difference carryover.

    (a) In general. If a section 901(m) payor has an aggregate basis 
difference, with respect to a foreign income tax and a foreign payor, 
for a U.S. taxable year, the section 901(m) payor must determine the 
portion of a foreign income tax amount that is disqualified under 
section 901(m) (disqualified tax amount). Paragraph (b) of this section 
provides rules for determining the disqualified tax amount. Paragraph 
(c) of this section provides rules for determining what portion, if any, 
of aggregate basis difference will be carried forward to the next U.S. 
taxable year (aggregate basis difference carryover). Paragraph (d) of 
this section provides applicability dates.
    (b) Disqualified tax amount--(1) In general. A section 901(m) 
payor's disqualified tax amount is not taken into account in determining 
the credit allowed under section 901(a). If the section 901(m) payor is 
an applicable foreign corporation, the disqualified tax amount is not 
taken into account for purposes of section 902 (for tax years of foreign 
corporations beginning before January 1, 2018) or 960. Sections 78 and 
275 do not apply to the disqualified tax amount. The disqualified tax 
amount is allowed as a deduction to the extent otherwise deductible. See 
sections 164, 212, and 964 and the regulations under those sections.
    (2) Determination of disqualified tax amount--(i) In general. Except 
as provided in paragraph (b)(2)(iv) of this section, the disqualified 
tax amount is equal to the lesser of the foreign income tax amount that 
is paid or accrued by, or considered paid or accrued by, the section 
901(m) payor for the U.S. taxable year or the tentative disqualified tax 
amount. All calculations are determined with respect to each separate 
category.
    (ii) Tentative disqualified tax amount. The tentative disqualified 
tax amount is equal to the amount determined under paragraph 
(b)(2)(ii)(A) of this section reduced (but not below zero) by the amount 
described in paragraph (b)(2)(ii)(B) of this section.
    (A) The product of--
    (1) The sum of the foreign income tax amount and the FCCTs that are 
paid or accrued by, or considered paid or accrued by, the section 901(m) 
payor, and
    (2) A fraction, the numerator of which is the aggregate basis 
difference, but not in excess of the allocable foreign income, and the 
denominator of which is the allocable foreign income.
    (B) The amount of the FCCT that is a disqualified tax amount of the 
section 901(m) payor with respect to another foreign income tax.
    (iii) Allocable foreign income--(A) No allocation required. Except 
as provided in paragraph (b)(2)(iii)(D) of this section, if the entire 
foreign income tax amount is paid or accrued by, or considered paid or 
accrued by, a single section 901(m) payor, then the allocable foreign 
income is equal to the entire foreign income, determined with respect to 
each separate category.
    (B) Allocation required. Except as provided in paragraph 
(b)(2)(iii)(D) of this section, if the foreign income tax amount is 
allocated to, and considered paid or accrued by, more than one person, a 
section 901(m) payor's allocable foreign income is equal to the portion 
of the foreign income that relates to the foreign income tax amount 
allocated to that section 901(m) payor, determined with respect to each 
separate category.
    (C) Rules for allocations. This paragraph (b)(2)(iii)(C) provides 
allocation rules that apply to determine allocable foreign income in 
certain cases.
    (1) If the foreign payor is involved in a mid-year transaction and 
the foreign income tax amount is allocated under Sec.  1.336-
2(g)(3)(ii), Sec.  1.338-9(d), or Sec.  1.901-2(f)(4), then, to the 
extent any portion of the foreign income tax amount is allocated to, and 
considered paid or accrued by, a section 901(m) payor, the allocable 
foreign income of the section 901(m) payor is determined in accordance 
with the principles of Sec.  1.1502-76(b). To the extent the foreign 
income tax amount is allocated to an entity that is a partnership for 
U.S. income tax purposes, a portion of the foreign income is first 
allocated to the partnership in accordance with the principles of Sec.  
1.1502-76(b), which is then allocated under the rules of paragraph

[[Page 795]]

(b)(2)(iii)(C)(2) of this section to determine the allocable foreign 
income of a section 901(m) payor that owns an interest in the 
partnership directly or indirectly through one or more other 
partnerships for U.S. income tax purposes.
    (2) If the foreign income tax amount is considered paid or accrued 
by a section 901(m) payor for a U.S. taxable year under Sec.  1.702-
1(a)(6), the determination of the allocable foreign income must be 
consistent with the allocation of the foreign income tax amount that 
relates to the foreign income. See Sec.  1.704-1(b)(4)(viii).
    (3) If the foreign income tax amount that is allocated to, and 
considered paid or accrued by, a section 901(m) payor for a U.S. taxable 
year is determined under Sec.  1.901-2(f)(3)(i), the allocable foreign 
income is determined in accordance with Sec.  1.901-2(f)(3)(iii).
    (D) Failure to substantiate allocable foreign income. If, pursuant 
to section 901(m)(3)(A), a section 901(m) payor fails to substantiate 
its allocable foreign income to the satisfaction of the Secretary, then 
allocable foreign income will equal the amount determined by dividing 
the sum of the foreign income tax amount and the FCCTs that are paid or 
accrued by, or considered paid or accrued by, the section 901(m) payor, 
by the highest marginal tax rate applicable to income of the foreign 
payor under foreign tax law.
    (iv) Special rule. A section 901(m) payor's disqualified tax amount 
is zero for a U.S. taxable year if:
    (A) The section 901(m) payor's aggregate basis difference for the 
U.S. taxable year is a negative amount;
    (B) Foreign income is less than or equal to zero for the foreign 
taxable year of the foreign payor; or
    (C) The foreign income tax amount that is paid or accrued by, or 
considered paid or accrued by, the section 901(m) payor for the U.S. 
taxable year is zero.
    (3) Examples. The following examples illustrate the rules of 
paragraph (b)(2) of this section. For purposes of all the examples, 
unless otherwise specified: USP is a domestic corporation. CFC1, CFC2, 
DE1, and DE2 are organized in Country F and are treated as corporations 
for Country F tax purposes. CFC1 and CFC2 are applicable foreign 
corporations. DE1 and DE2 are disregarded entities. USP, CFC1, and CFC2 
each have a calendar year for both U.S. and Country F income tax 
purposes, and DE1 and DE2 each have a calendar year for Country F tax 
purposes. Country F and Country G each impose a single tax that is a 
foreign income tax. CFC1, CFC2, DE1, and DE2 each have a functional 
currency of the u with respect to all activities. At all relevant times, 
1u equals $1. All amounts are stated in millions. The examples assume 
that the applicable cost recovery method for property results in basis 
being recovered ratably over the life of the property beginning on the 
first day of the U.S. taxable year in which the property is acquired or 
placed into service; there is a single separate category with respect to 
a foreign income and foreign income tax amount; and a section 901(m) 
payor properly substantiates its allocable foreign income to the 
satisfaction of the Secretary.
    (i) Example 1: Determining aggregate basis difference; multiple 
foreign payors--(A) Facts. CFC1 wholly owns CFC2 and DE1. DE1 wholly 
owns DE2. Assume that the tax laws of Country F do not allow combined 
income reporting or the filing of consolidated income tax returns. 
Accordingly, CFC1, CFC2, DE1, and DE2 file separate tax returns for 
Country F tax purposes. USP acquires all of the stock of CFC1 in a 
qualified stock purchase (as defined in section 338(d)(3)) to which 
section 338(a) applies for both CFC1 and CFC2.
    (B) Result. (1) The acquisition of CFC1 gives rise to four separate 
CAAs under Sec.  1.901(m)-2(b). The acquisition of the stock of CFC1 and 
the deemed purchase of the stock of CFC2 under section 338(h)(3)(B) are 
each a section 338 CAA under Sec.  1.901(m)-2(b)(1). Furthermore, 
because the deemed purchase of the assets of DE1 and DE2 for U.S. income 
tax purposes is disregarded for Country F tax purposes, each acquisition 
is a CAA under Sec.  1.901(m)-2(b)(2). Because these four CAAs occur 
pursuant to a plan, under Sec.  1.901(m)-1(a)(3) they are part of an 
aggregated CAA transaction. Under Sec.  1.901(m)-1(a)(37), CFC1 is the 
RFA owner (U.S.) with respect to its assets and those of DE1 and DE2. 
CFC2 is the RFA owner (U.S.) with respect to

[[Page 796]]

its assets. Under Sec.  1.901(m)-1(a)(28), CFC1, CFC2, DE1, and DE2 are 
each a foreign payor for Country F tax purposes. Under Sec.  1.901(m)-
1(a)(41), CFC1 is the section 901(m) payor with respect to foreign 
income tax amounts for which CFC1, DE1, and DE2 are the foreign payors 
(see Sec.  1.901-2(f)(1) and (f)(4)(ii)). CFC2 is the section 901(m) 
payor with respect to foreign income tax amounts for which CFC2 is the 
foreign payor (see Sec.  1.901-2(f)(1)).
    (2) In determining aggregate basis difference under Sec.  1.901(m)-
1(a)(1) for a U.S. taxable year of CFC1, CFC1 has three computations 
with respect to Country F tax, because there are three foreign payors 
for Country F tax purposes whose foreign income tax amount, if any, is 
considered paid or accrued by CFC1 as the section 901(m) payor. 
Furthermore, for each U.S. taxable year, CFC1 will compute a separate 
disqualified tax amount and aggregate basis difference carryover (if 
any) under paragraph (b)(2) of this section, with respect to each 
foreign payor.
    (3) In determining aggregate basis difference for a U.S. taxable 
year of CFC2 under Sec.  1.901(m)-1(a)(1), CFC2 has a single computation 
with respect to Country F tax, because there is a single foreign payor 
(CFC2) for Country F tax purposes whose foreign income tax amount, if 
any, is considered paid or accrued by CFC2 as the section 901(m) payor. 
Furthermore, for each U.S. taxable year, CFC2 will compute a 
disqualified tax amount and aggregate basis difference carryover (if 
any) under paragraph (b)(2) of this section.
    (C) Alternative facts. Assume the same facts as in paragraph 
(b)(3)(i)(A) of this section (paragraph (A) of this Example 1), except 
that foreign income for Country F tax purposes is based on combined 
income (within the meaning of Sec.  1.901-2(f)(3)(ii)) of CFC1, CFC2, 
DE1, and DE2. For purposes of determining an aggregate basis difference 
for a U.S. taxable year of CFC1 under Sec.  1.901(m)-1(a)(1), CFC1, DE1, 
and DE2 are treated as a single foreign payor because all of the items 
of income, deduction, gain, or loss with respect to CFC1, DE1, and DE2 
are included in the earnings and profits of CFC1 for U.S. income tax 
purposes. For each U.S. taxable year, CFC1 will therefore compute a 
single aggregate basis difference, disqualified tax amount, and 
aggregate basis difference carryover. The result for CFC2 under the 
alternative facts is the same as in paragraph (b)(3)(i)(B)(3) (paragraph 
(B)(3) of this Example 1).
    (ii) Example 2: Computation of disqualified tax amount--(A) Facts. 
On December 31 of Year 0, USP acquires all of the stock of CFC1 in a 
qualified stock purchase (as defined in section 338(d)(3)) to which 
section 338(a) applies (Acquisition). CFC1 owns four assets (Asset A, 
Asset B, Asset C, and Asset D, and collectively, Assets) and conducts 
activities in Country F and in a Country G branch. The activities 
conducted by CFC1 in Country G are not subject to tax in Country F. The 
tax rate is 25% in Country F and 30% in Country G. For Country F tax 
purposes, CFC1's foreign income and foreign income tax amount for each 
foreign taxable year 1 through 15 is 100u and $25 (25u translated at the 
exchange rate of $1 = 1u), respectively. For Country G tax purposes, 
CFC1's foreign income and foreign income tax amount for each foreign 
taxable year 1 through 5 is 400u and $120 (120u translated at the 
exchange rate of $1 = 1u), respectively. No dispositions occur for any 
of the Assets during the applicable cost recovery period. Additional 
facts relevant to each of the Assets are summarized below.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                      Applicable cost
                Assets                   Relevant foreign income   Basis difference   recovery period                 Cost recovery amount
                                                   tax                                    (years)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Asset A...............................  Country F tax............              150u                15  10u (150u/15).
Asset B...............................  Country F tax............               50u                 5  10u (50u/5).
Asset C...............................  Country G tax............              300u                 5  60u (300u/5).
Asset D...............................  Country G tax............            (100u)                 5  negative 20u (negative 100/5).
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (B) Result. (1) Under Sec.  1.901(m)-2(b)(1), the acquisition of the 
stock of CFC1 is a section 338 CAA. Under Sec.  1.901(m)-2(c)(1), Assets 
A and B are RFAs with

[[Page 797]]

respect to Country F tax, because they are relevant in determining 
foreign income of CFC1 for Country F tax purposes and were owned by CFC1 
when the Acquisition occurred. Assets C and D are RFAs with respect to 
Country G tax, because they are relevant in determining foreign income 
of CFC1 for Country G tax purposes and were owned by CFC1 when the 
Acquisition occurred. Under Sec.  1.901(m)-1(a)(37), CFC1 is the RFA 
owner (U.S.) with respect to all of the RFAs. Under Sec.  1.901(m)-
1(a)(41) and (28), CFC1 is the section 901(m) payor and the foreign 
payor for Country F and Country G tax purposes.
    (2) In determining aggregate basis difference for a U.S. taxable 
year of CFC1, CFC1 has two computations, one with respect to Country F 
tax and one with respect to Country G tax. Under Sec.  1.901(m)-1(a)(1), 
the aggregate basis difference for a U.S. taxable year with respect to 
Country F tax is equal to the sum of the allocated basis differences and 
allocated basis difference adjustments with respect to Assets A and B 
for the U.S. taxable year. Under Sec.  1.901(m)-1(a)(5), allocated basis 
differences are the sum of cost recovery amounts and disposition 
amounts. Because there are no dispositions, the only allocated basis 
differences taken into account in determining an aggregate basis 
difference are cost recovery amounts. Under Sec.  1.901(m)-5(b), any 
cost recovery amounts are attributed to CFC1, because CFC1 is the 
section 901(m) payor and RFA owner (U.S.) with respect to all of the 
Assets. For each U.S. taxable year, CFC1 will compute a separate 
disqualified tax amount and aggregate basis difference carryover (if 
any) with respect to Country F tax and Country G tax under paragraph 
(b)(2) of this section. For purposes of both disqualified tax amount 
computations, because CFC1 is the section 901(m) payor and foreign 
payor, the foreign income tax amount paid or accrued by CFC1 with 
respect to Country F tax and Country G tax, respectively, will be the 
entire foreign income tax amount and CFC1's allocable foreign income 
will be the entire foreign income.
    (3) With respect to Country F tax, in U.S. taxable years 1 through 
5, CFC1 has an aggregate basis difference of 20u each year (10u cost 
recovery amount with respect to Asset A plus 10u cost recovery amount 
with respect to Asset B). For U.S. taxable years 1 through 5, under 
paragraph (b)(2) of this section, the disqualified tax amount each year 
is $5, the lesser of two amounts: the tentative disqualified tax amount, 
in this case, $5 ($25 foreign income tax amount x (20u aggregate basis 
difference/100u allocable foreign income)), or the foreign income tax 
amount paid or accrued by CFC1, in this case, $25. After U.S. taxable 
year 5, Asset B has no unallocated basis difference with respect to 
Country F tax. Accordingly, in U.S. taxable years 6 through 15, CFC1 has 
an aggregate basis difference of 10u each year. Accordingly, for U.S. 
taxable years 6 through 15, the disqualified tax amount each year is 
$2.50, the lesser of two amounts: the tentative disqualified tax amount, 
in this case, $2.50 ($25 foreign income tax amount x (10u aggregate 
basis difference/100u allocable foreign income)), or the foreign income 
tax amount paid or accrued by CFC1, in this case, $25. After U.S. 
taxable year 15, Asset A has no unallocated basis difference with 
respect to Country F tax and, therefore, CFC1 has no disqualified tax 
amount with respect to Country F Tax.
    (4) With respect to Country G tax, in U.S. taxable years 1 through 
5, CFC1 has an aggregate basis difference of 40u each year (60u cost 
recovery amount with respect to Asset C + (20u) cost recovery amount 
with respect to Asset D). For U.S. taxable years 1 through 5, under 
paragraph (b)(2) of this section, the disqualified tax amount each year 
is $12, the lesser of two amounts: the tentative disqualified tax 
amount, in this case, $12 ($120 foreign income tax amount x (40u 
aggregate basis difference/400u allocable foreign income)), or the 
foreign income tax amount paid or accrued by CFC1, in this case, $120. 
After U.S. taxable year 5, Asset C and Asset D have no unallocated basis 
difference with respect to Country G tax. Accordingly, in U.S. taxable 
years 6 through 15, CFC1 has no disqualified tax amount with respect to 
Country G Tax.
    (iii) Example 3: FCCT--(A) Facts. In U.S. taxable year 1, USP 
acquires all of

[[Page 798]]

the interests in DE1 in a transaction (Transaction) that is treated as a 
stock acquisition for Country F tax purposes. Immediately after the 
Transaction, DE1 owns assets (Pre-Transaction Assets), all of which are 
used in a Country G branch and give rise to income that is taken into 
account for Country F tax and Country G tax purposes. After the 
Transaction, DE1 acquires additional assets (Post-Transaction Assets), 
which are not used by the Country G branch. Both Country F and Country G 
have a tax rate of 30%. Country F imposes worldwide tax on its residents 
and provides a foreign tax credit for taxes paid to other jurisdictions. 
In foreign taxable year 3, 100u of income is attributable to DE1's Post-
Transaction Assets and 100u of income is attributable to DE1's Pre-
Transaction Assets. For Country G tax purposes, the foreign income is 
100u and foreign income tax amount is 30u (30% x 100u). For Country F 
tax purposes, the foreign income is 200u and the pre-foreign tax credit 
tax is 60u (30% x 200u). The 60u of Country F pre-foreign tax credit tax 
is reduced by the 30u foreign income tax amount imposed for Country G 
tax purposes. Thus, the foreign income tax amount for Country F tax 
purposes is $30 (30u translated into dollars at the exchange rate of $1 
= 1u). Assume that for U.S. taxable year 3 USP has 100u aggregate basis 
difference with respect to Country F tax and 100u aggregate basis 
difference with respect to Country G tax. USP does not dispose of DE1 or 
any assets of DE1 in U.S. taxable year 3.
    (B) Result. (1) Under Sec.  1.901(m)-2(b)(2), the Transaction is a 
CAA. Under Sec.  1.901(m)-2(c)(1), the Pre-Transaction Assets are RFAs 
with respect to both Country F tax and Country G tax, because they are 
relevant in determining the foreign income of DE1 for Country F tax and 
Country G tax purposes and were owned by DE1 when the Transaction 
occurred. Under Sec.  1.901(m)-1(a)(37), USP is the RFA owner (U.S.) 
with respect to the RFAs. Under Sec.  1.901(m)-1(a)(28), DE1 is a 
foreign payor for Country F tax and Country G tax purposes. Under Sec.  
1.901(m)-1(a)(41), USP is the section 901(m) payor with respect to 
foreign income tax amounts for which DE1 is the foreign payor (see Sec.  
1.901-2(f)(4)(ii)). Because the Country G foreign income tax amount is 
claimed as a credit for purposes of determining the Country F foreign 
income tax amount, the Country G foreign income tax amount is an FCCT 
under Sec.  1.901(m)-1(a)(22).
    (2) Under Sec.  1.901(m)-1(a)(1), for each U.S. taxable year, USP 
will separately compute the aggregate basis difference with respect to 
Country F tax and with respect to Country G tax and will use those 
amounts to separately compute a disqualified tax amount and aggregate 
basis difference carryover (if any) with respect to each foreign income 
tax. Because DE1 is a disregarded entity owned by USP during the entire 
U.S. taxable year 3, the foreign income tax amount paid or accrued by 
DE1 is not subject to allocation. Accordingly, for purposes of each of 
the disqualified tax amount computations, the foreign income tax amount 
paid or accrued by USP with respect to Country F tax and Country G tax, 
respectively, is the entire foreign income tax amount paid or accrued by 
DE1, and, under paragraph (b)(2)(iii)(A) of this section, USP's 
allocable foreign income will be equal to DE1's entire foreign income.
    (3) As stated in paragraph (b)(3)(iii)(A) of this section (paragraph 
(A) of this Example 3), for U.S. taxable year 3 USP has 100u aggregate 
basis difference with respect to Country F tax and 100u aggregate basis 
difference with respect to Country G tax. With respect to Country G tax, 
in U.S. taxable year 3, under paragraph (b)(2) of this section, the 
disqualified tax amount is $30, the lesser of the two amounts: the 
tentative disqualified tax amount, in this case, $30 ($30 foreign income 
tax amount x (100u aggregate basis difference/100u allocable foreign 
income)), or the foreign income tax amount considered paid or accrued by 
USP, in this case, $30.
    (4) With respect to Country F tax, in U.S. taxable year 3, under 
paragraph (b)(2) of this section, the disqualified tax amount is $0, the 
lesser of two amounts: the tentative disqualified tax amount, in this 
case $0 (($30 foreign income tax amount + $30 Country G FCCT) x (100u 
aggregate basis difference/200u foreign income) = $30 reduced by $30 
Country G FCCT that is a

[[Page 799]]

disqualified tax amount of USP), or the foreign income tax amount 
considered paid or accrued by USP, in this case, $30.
    (c) Aggregate basis difference carryover--(1) In general. If a 
section 901(m) payor has an aggregate basis difference carryover for a 
U.S. taxable year, as determined under this paragraph (c), the aggregate 
basis difference carryover is taken into account in computing the 
section 901(m) payor's aggregate basis difference for the next U.S. 
taxable year. For successor rules that apply to an aggregate basis 
difference carryover, see Sec.  1.901(m)-6(c).
    (2) Amount of aggregate basis difference carryover. (i) If a section 
901(m) payor's disqualified tax amount is zero, all of the section 
901(m) payor's aggregate basis difference (positive or negative) for the 
U.S. taxable year gives rise to an aggregate basis difference carryover 
to the next U.S. taxable year.
    (ii) If a section 901(m) payor's disqualified tax amount is not 
zero, then aggregate basis difference carryover can arise in either or 
both of the following two situations:
    (A) If a section 901(m) payor's aggregate basis difference for the 
U.S. taxable year exceeds its allocable foreign income, the excess gives 
rise to an aggregate basis difference carryover.
    (B) If the tentative disqualified tax amount exceeds the 
disqualified tax amount, the excess tentative disqualified tax amount is 
converted into aggregate basis difference carryover by multiplying such 
excess by a fraction, the numerator of which is the allocable foreign 
income, and the denominator of which is the sum of the foreign income 
tax amount and the FCCTs that are paid or accrued by, or considered paid 
or accrued by, the section 901(m) payor.
    (3) Example. The following example illustrates the rules of 
paragraph (c) of this section.
    (i) Facts. (A) On July 1 of Year 1, CFC1 acquires all of the 
interests of DE1 in a transaction (Transaction) that is treated as a 
stock acquisition for Country F tax purposes. CFC1 and DE1 are organized 
in Country F and are treated as corporations for Country F tax purposes. 
CFC1 is an applicable foreign corporation, and DE1 is a disregarded 
entity. CFC1 has a calendar year for U.S. income tax purposes, and DE1 
has a June 30 year-end for Country F tax purposes. Country F imposes a 
single tax that is a foreign income tax. CFC1 and DE1 each have a 
functional currency of the u with respect to all activities. Immediately 
after the Transaction, DE1 owns one asset, Asset A, that gives rise to 
income that is taken into account for Country F tax purposes. For the 
first U.S. taxable year (U.S. taxable year 1) there is a cost recovery 
amount with respect to Asset A of 9u, and for each subsequent U.S. 
taxable year until the U.S. basis is fully recovered, there is a cost 
recovery amount with respect to Asset A of 18u. There is no disposition 
of Asset A.
    (ii) Result. (A) Under Sec.  1.901(m)-2(b)(2), the Transaction is a 
CAA. Under Sec.  1.901(m)-2(c)(1), Asset A is an RFA with respect to 
Country F tax because it is relevant in determining the foreign income 
of DE1 for Country F tax purposes and was owned by DE1 when the 
Transaction occurred. Under Sec.  1.901(m)-1(a)(37), CFC1 is the RFA 
owner (U.S.) with respect to Asset A. Under Sec.  1.901(m)-1(a)(28), DE1 
is a foreign payor for Country F tax purposes. Under Sec.  1.901(m)-
1(a)(41), CFC1 is the section 901(m) payor with respect to foreign 
income tax amounts for which DE1 is the foreign payor (see Sec.  1.901-
2(f)(4)(ii)).
    (B) Under Sec.  1.901(m)-1(a)(1), in determining the aggregate basis 
difference for U.S. taxable year 1, CFC1 has one computation with 
respect to Country F tax. Under Sec.  1.901(m)-1(a)(1), aggregate basis 
difference with respect to Country F tax is equal to the sum of 
allocated basis differences and allocated basis difference adjustments 
with respect to all RFAs, which, in this case, is only Asset A. Under 
Sec.  1.901(m)-1(a)(5), allocated basis differences are the sum of cost 
recovery amounts and disposition amounts. Because there is no 
disposition of Asset A, the only allocated basis difference taken into 
account in determining an aggregate basis difference are cost recovery 
amounts with respect to Asset A. Under Sec.  1.901(m)-5(b), any cost 
recovery amounts are assigned to a U.S taxable year of CFC1, because 
CFC1 is the section 901(m) payor and RFA owner (U.S.) with respect to 
Asset A. Under paragraph

[[Page 800]]

(b)(2) of this section, for each U.S. taxable year, CFC1 will compute a 
disqualified tax amount and aggregate basis difference carryover with 
respect to the aggregate basis difference. Because DE1 is a disregarded 
entity owned by CFC1, the foreign income tax amount paid or accrued by 
DE1 is not subject to allocation. Accordingly, for purposes of the 
disqualified tax amount computation, the foreign income tax amount paid 
or accrued by CFC1 with respect to Country F tax is the entire foreign 
income tax amount paid or accrued by DE1, and under paragraph 
(b)(2)(iii)(A) of this section, CFC1's allocable foreign income will be 
equal to DE1's entire foreign income.
    (C) In U.S. taxable year 1, CFC1 has an aggregate basis difference 
of 9u (the 9u cost recovery amount with respect to Asset A for U.S. 
taxable year 1). However, because the foreign taxable year of DE1, the 
foreign payor, will not end between July 1 and December 31, there will 
not be a foreign income tax amount for U.S. taxable year 1. Because the 
foreign income tax amount considered paid or accrued by CFC1 for U.S. 
taxable year 1 is zero, under paragraph (b)(2)(iv) of this section, the 
disqualified tax amount for U.S. taxable year 1 of CFC1 is also zero. 
Furthermore, because the disqualified tax amount is zero, under 
paragraph (c)(2)(i) of this section, CFC1 has an aggregate basis 
difference carryover equal to 9u, the entire amount of the aggregate 
basis difference for U.S. taxable year 1. Under paragraph (c)(1) of this 
section, the 9u aggregate basis difference carryover is taken into 
account in computing CFC1's aggregate basis difference for U.S. taxable 
year 2. Accordingly, in U.S. taxable year 2, CFC1 has an aggregate basis 
difference of 27u (18u cost recovery amount for U.S. taxable year 2, 
plus 9u aggregate basis difference carryover from U.S. taxable year 1).
    (d) Applicability dates. This section applies to CAAs occurring on 
or after March 23, 2020. Taxpayers may, however, choose to apply this 
section before the date this section is applicable provided that they 
(along with any persons that are related (within the meaning of section 
267(b) or 707(b)) to the taxpayer)--
    (1) Consistently apply this section, Sec.  1.704-
1(b)(4)(viii)(c)(4)(v) through (vii), Sec.  1.901(m)-1, and Sec. Sec.  
1.901(m)-4 through 1.901(m)-8 (excluding Sec.  1.901(m)-4(e)) to all 
CAAs occurring on or after January 1, 2011, and consistently apply Sec.  
1.901(m)-2 (excluding Sec.  1.901(m)-2(d)) to all CAAs occurring on or 
after December 7, 2016, on any original or amended tax return for each 
taxable year for which the application of the provisions listed in this 
paragraph (d)(1) affects the tax liability and for which the statute of 
limitations does not preclude assessment or the filing of a claim for 
refund, as applicable
    (2) File all tax returns described in paragraph (d)(1) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (3) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(d)(1) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16252, Mar. 23, 2020]



Sec.  1.901(m)-4  Determination of basis difference.

    (a) In general. This section provides rules for determining for each 
RFA the basis difference that arises as a result of a CAA. A basis 
difference is computed separately with respect to each foreign income 
tax for which an asset subject to a CAA is an RFA. Paragraph (b) of this 
section provides the general rule for determining basis difference that 
references only U.S. basis in the RFA. Paragraph (c) of this section 
provides for an election to determine basis difference by reference to 
foreign basis and sets forth the procedures for making the election. 
Paragraph (d) of this section provides special rules for determining 
basis difference in the case of a section 743(b) CAA. Paragraph (e) of 
this section provides a special rule for determining basis difference in 
an RFA with respect to a CAA to which paragraphs (b) through (d) of this 
section do not apply. Paragraph (f) of this section provides examples 
illustrating the rules of this section, and paragraph (g) of this 
section provides applicability dates.

[[Page 801]]

    (b) General rule. Except as otherwise provided in paragraphs (c), 
(d), and (e) of this section, basis difference is the U.S. basis in the 
RFA immediately after the CAA, less the U.S. basis in the RFA 
immediately before the CAA. Basis difference is an attribute that 
attaches to an RFA.
    (c) Foreign basis election. (1) An election (foreign basis election) 
may be made to apply section 901(m)(3)(C)(i)(II) by reference to the 
foreign basis immediately after the CAA instead of the U.S. basis 
immediately before the CAA. Accordingly, if a foreign basis election is 
made, basis difference is the U.S. basis in the RFA immediately after 
the CAA, less the foreign basis in the RFA immediately after the CAA. 
For this purpose, the foreign basis immediately after the CAA takes into 
account any adjustment to that foreign basis resulting from the CAA for 
purposes of the foreign income tax.
    (2) Except as otherwise provided in this paragraph (c), a foreign 
basis election is made by the RFA owner (U.S.). If, however, the RFA 
owner (U.S.) is a partnership, each partner in the partnership (and not 
the partnership) may independently make a foreign basis election. In the 
case of one or more tiered partnerships, the foreign basis election is 
made at the level at which a partner is not also a partnership.
    (3) The foreign basis election may be made separately for each CAA, 
and with respect to each foreign income tax and each foreign payor. For 
purposes of making the foreign basis election, all CAAs that are part of 
an aggregated CAA transaction are treated as a single CAA. Furthermore, 
for purposes of making the foreign basis election, if foreign law 
imposes tax on the combined income (within the meaning of Sec.  1.901-
2(f)(3)(ii)) of two or more foreign payors, all foreign payors whose 
items of income, deduction, gain, or loss for U.S. income tax purposes 
are included in the U.S. taxable income or earnings and profits of a 
single section 901(m) payor are treated as a single foreign payor.
    (4) A foreign basis election is made by using foreign basis to 
determine basis difference for purposes of computing a disqualified tax 
amount and an aggregate basis difference carryover for the U.S. taxable 
year, as provided under Sec.  1.901(m)-3. A separate statement or form 
evidencing the foreign basis election need not be filed. Except as 
provided in paragraphs (c)(5) and (6) of this section, in order for a 
foreign basis election to be effective, the election must be reflected 
on a timely filed original federal income tax return (taking into 
account extensions) for the first U.S. taxable year that the foreign 
basis election is relevant to the computation of any amounts reported on 
such return, including on any required schedules.
    (5) If the RFA owner (U.S.) is a partnership, a foreign basis 
election reflected on a partner's timely filed amended federal income 
tax return is also effective if all of the following conditions are 
satisfied:
    (i) The partner's timely filed original federal income tax return 
(taking into account extensions) for the first U.S. taxable year of the 
partner in which a foreign basis election is relevant to the computation 
of any amounts reported on such return, including on any required 
schedules, does not reflect the application of section 901(m);
    (ii) The information provided by the partnership to the partner for 
purposes of applying section 901(m) and any information required to be 
reported by the partnership is based solely on computations that use 
foreign basis to determine basis difference; and
    (iii) Before the due date of the original federal income tax return 
described in paragraph (c)(5)(i) of this section, the partner delegated 
the authority to the partnership to choose whether to provide the 
partner with information to apply section 901(m) using foreign basis, 
either pursuant to a written partnership agreement (within the meaning 
of Sec.  1.704-1(b)(2)(ii)(h)) or written notice provided by the partner 
to the partnership.
    (6) If, pursuant to paragraph (g)(3) of this section, a taxpayer 
chooses to have this section apply to CAAs occurring on or after January 
1, 2011, a foreign basis election will be effective if the election is 
reflected on a timely filed amended federal income tax return (or tax 
returns, as applicable) filed no later than March 23, 2021.

[[Page 802]]

    (7) The foreign basis election is irrevocable. Relief under Sec.  
301.9100-1 is not available for the foreign basis election.
    (d) Determination of basis difference in a section 743(b) CAA--(1) 
In general. Except as provided in paragraphs (d)(2) and (e) of this 
section, if there is a section 743(b) CAA, basis difference is the 
resulting basis adjustment under section 743(b) that is allocated to the 
RFA under section 755.
    (2) Foreign basis election. If a foreign basis election is made with 
respect to a section 743(b) CAA, then, for purposes of paragraph (d)(1) 
of this section, the section 743(b) adjustment is determined by 
reference to the foreign basis of the RFA, determined immediately after 
the CAA.
    (e) Determination of basis difference in an RFA with respect to a 
CAA with respect to which paragraphs (b), (c), and (d) of this section 
do not apply. For CAAs occurring on or after January 1, 2011, and before 
July 21, 2014, other than CAAs occurring before July 21, 2014, resulting 
from an entity classification election made under Sec.  301.7701-3 of 
this chapter that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014, basis difference in an RFA with 
respect to the CAA is the amount of any basis difference (within the 
meaning of section 901(m)(3)(C)(i)) that had not been taken into account 
under section 901(m)(3)(B) either as of July 21, 2014, or, in the case 
of an entity classification election made under Sec.  301.7701-3 of this 
chapter that is filed on or after July 29, 2014, and that is effective 
on or before July 21, 2014, before the transactions that are deemed to 
occur under Sec.  301.7701-3(g) as a result of the change in 
classification.
    (f) Examples. The following examples illustrate the rules of this 
section:
    (1) Example 1: Scope of basis choice; identifying separate CAAs, RFA 
owners (U.S.), and foreign payors in an aggregated CAA transaction--(i) 
Facts. CFC1 wholly owns CFC2, both of which are applicable foreign 
corporations, organized in Country F, and treated as corporations for 
Country F tax purposes. CFC1 also wholly owns DE1, and DE1 wholly owns 
DE2. DE1 and DE2 are entities organized in Country F treated as 
corporations for Country F tax purposes and as disregarded entities for 
U.S. income tax purposes. Country F imposes a single tax that is a 
foreign income tax. All of the stock of CFC1 is acquired in a qualified 
stock purchase (within the meaning of section 338(d)(3)) to which 
section 338(a) applies for both CFC1 and CFC2. For Country F tax 
purposes, the transaction is treated as an acquisition of the stock of 
CFC1.
    (ii) Result. (A) The acquisition of CFC1 gives rise to four separate 
CAAs described in Sec.  1.901(m)-2. Under Sec.  1.901(m)-2(b)(1), the 
acquisition of the stock of CFC1 and the deemed acquisition of the stock 
of CFC2 under section 338(h)(3)(B) are each a section 338 CAA. 
Furthermore, because the deemed acquisition of the assets of each of DE1 
and DE2 for U.S. income tax purposes is disregarded for Country F tax 
purposes, the deemed acquisitions are CAAs under Sec.  1.901(m)-2(b)(2). 
Because the four CAAs occurred pursuant to a plan, under Sec.  1.901(m)-
1(a)(3), all of the CAAs are part of an aggregated CAA transaction. 
Under Sec.  1.901(m)-1(a)(37), CFC1 is the RFA owner (U.S.) with respect 
to its assets and the assets of DE1 and DE2 that are RFAs. CFC2 is the 
RFA owner (U.S.) with respect to its assets that are RFAs. Under Sec.  
1.901(m)-1(a)(28), CFC1, CFC2, DE1, and DE2 are each a foreign payor for 
Country F tax purposes.
    (B) Under paragraph (c) of this section, a foreign basis election 
may be made by the RFA owner (U.S.). The election is made separately 
with respect to each CAA (for this purpose, treating all CAAs that are 
part of an aggregated CAA transaction as a single CAA) and with respect 
to each foreign income tax and foreign payor. Thus, in this case, CFC1 
can make a separate foreign basis election for one or more of the 
following three groups of RFAs: RFAs that are relevant in determining 
foreign income of CFC1; RFAs that are relevant in determining foreign 
income of DE1; and RFAs that are relevant in determining foreign income 
of DE2. Furthermore, CFC2 can make a foreign basis election for all of 
its RFAs that are relevant in determining its foreign income.
    (2) Example 2: Scope of basis choice; RFA owner (U.S.) is a 
partnership--(i) Facts. USPS is a domestic partnership

[[Page 803]]

for which a section 754 election is in effect. USPS owns two assets, the 
stock of DE1 and DE2. DE1 is an entity organized in Country X and 
treated as a corporation for Country X tax purposes. DE2 is an entity 
organized in Country Y and treated as a corporation for Country Y tax 
purposes. DE1 and DE2 are disregarded entities. Country X and Country Y 
each impose a single tax that is a foreign income tax. US1 and US2, 
unrelated domestic corporations, and FP, a foreign person unrelated to 
US1 and US2, acquire partnership interests in USPS from existing 
partners of USPS pursuant to the same plan.
    (ii) Result. Under Sec.  1.901(m)-2(b)(3), the acquisitions of the 
partnership interests in USPS by US1, US2, and FP each give rise to 
separate section 743(b) CAAs, but under Sec.  1.901(m)-1(a)(3), they are 
treated as an aggregated CAA transaction because they occur as part of a 
plan. Under Sec.  1.901(m)-1(a)(37), USPS is the RFA owner (U.S.) with 
respect to the assets of DE1 and DE2 that are RFAs. Under Sec.  
1.901(m)-1(a)(28), DE1 is a foreign payor for Country X tax purposes, 
and DE2 is a foreign payor for Country Y tax purposes. Because the RFA 
owner (U.S.) is a partnership, paragraph (c)(2) of this section provides 
that US1, US2, and FP (the relevant partners in USPS) separately choose 
whether to make a foreign basis election for purposes of determining 
basis difference. Furthermore, under paragraph (c)(3) of this section, 
the choice to make the election is made separately by each partner with 
respect to each foreign payor. Thus, in this case, each partner may make 
separate elections for the RFAs that are relevant in determining foreign 
income of DE1 for Country X tax purposes and the RFAs that are relevant 
in determining foreign income of DE2 for Country Y tax purposes.
    (g) Applicability dates. (1) Except as provided in paragraph (g)(2) 
of this section, this section applies to CAAs occurring on or after 
March 23, 2020.
    (2) Paragraphs (a), (b), and (d)(1) of this section apply to CAAs 
occurring on or after July 21, 2014, and to CAAs occurring before that 
date resulting from an entity classification election made under Sec.  
301.7701-3 that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014. Paragraph (e) of this section 
applies to CAAs occurring on or after January 1, 2011, and before July 
21, 2014, other than CAAs occurring before July 21, 2014, resulting from 
an entity classification election made under Sec.  301.7701-3 of this 
chapter that is filed on or after July 29, 2014, and that is effective 
on or before July 21, 2014. Taxpayers may, however, consistently apply 
paragraph (d)(1) of this section to all section 743(b) CAAs occurring on 
or after January 1, 2011. For this purpose, persons that are related 
(within the meaning of section 267(b) or 707(b)) will be treated as a 
single taxpayer.
    (3) Taxpayers may, however, choose to apply provisions in this 
section before the date such provisions are applicable pursuant to 
paragraph (g)(1) or (2) of this section, provided that they (along with 
any persons that are related (within the meaning of section 267(b) or 
707(b)) to the taxpayer)--
    (i) Consistently apply this section (excluding paragraph (e) of this 
section), Sec.  1.704-1(b)(4)(viii)(c)(4)(v) through (vii), Sec.  
1.901(m)-1, Sec.  1.901(m)-3, and Sec. Sec.  1.901(m)-5 through 
1.901(m)-8 to all CAAs occurring on or after January 1, 2011, and 
consistently apply Sec.  1.901(m)-2 (excluding Sec.  1.901(m)-2(d)) to 
all CAAs occurring on or after December 7, 2016, on any original or 
amended tax return for each taxable year for which the application of 
the provisions listed in this paragraph (g)(3)(i) affects the tax 
liability and for which the statute of limitations does not preclude 
assessment or the filing of a claim for refund, as applicable;
    (ii) File all tax returns described in paragraph (g)(3)(i) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (iii) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(g)(3)(i) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16256, Mar. 23, 2020]

[[Page 804]]



Sec.  1.901(m)-5  Basis difference taken into account.

    (a) In general. This section provides rules for determining the 
amount of basis difference with respect to an RFA that is taken into 
account in a U.S. taxable year for purposes of determining the 
disqualified portion of a foreign income tax amount. Paragraph (b) of 
this section provides rules for determining a cost recovery amount and 
assigning that amount to a U.S. taxable year of a single section 901(m) 
payor when the RFA owner (U.S.) is the section 901(m) payor. Paragraph 
(c) of this section provides rules for determining a disposition amount 
and assigning that amount to a U.S. taxable year of a single section 
901(m) payor when the RFA owner (U.S.) is the section 901(m) payor. 
Paragraph (d) of this section provides rules for allocating cost 
recovery amounts and disposition amounts when the RFA owner (U.S.) is a 
fiscally transparent entity for U.S. income tax purposes. Paragraph (e) 
of this section provides special rules for allocating cost recovery 
amounts and disposition amounts with respect to certain section 743(b) 
CAAs. Paragraph (f) of this section provides special rules for 
allocating certain disposition amounts when a foreign payor is 
transferred in a mid-year transaction. Paragraph (g) of this section 
provides special rules for allocating both cost recovery amounts and 
disposition amounts in certain cases in which the RFA owner (U.S.) 
either is a reverse hybrid or a fiscally transparent entity for both 
U.S. and foreign income tax purposes that is directly or indirectly 
owned by a reverse hybrid. Paragraph (h) of this section provides 
examples illustrating the application of this section. Paragraph (i) of 
this section provides the applicability dates.
    (b) Basis difference taken into account under applicable cost 
recovery method--(1) In general. When the RFA owner (U.S.) is a section 
901(m) payor, all of a cost recovery amount is attributed to the section 
901(m) payor and assigned to the U.S. taxable year of the section 901(m) 
payor in which the corresponding U.S. basis deduction is taken into 
account under the applicable cost recovery method. This is the case 
regardless of whether the deduction is deferred or disallowed for U.S. 
income tax purposes. If instead the RFA owner (U.S.) is a fiscally 
transparent entity for U.S. income tax purposes, a cost recovery amount 
is allocated to one or more section 901(m) payors under paragraph (d) of 
this section, except as provided in paragraphs (e) and (g) of this 
section. If a cost recovery amount arises from an RFA with respect to a 
section 743(b) CAA, in certain cases the cost recovery amount is 
allocated to a section 901(m) payor under paragraph (e) of this section. 
In certain cases in which the RFA owner (U.S.) either is a reverse 
hybrid or a fiscally transparent entity for both U.S. and foreign income 
tax purposes that is directly or indirectly owned by a reverse hybrid, a 
cost recovery amount is allocated to one or more section 901(m) payors 
under paragraph (g) of this section.
    (2) Determining a cost recovery amount--(i) General rule. A cost 
recovery amount for an RFA is determined by applying the applicable cost 
recovery method to the basis difference rather than to the U.S. basis.
    (ii) U.S. basis subject to multiple cost recovery methods. If the 
entire U.S. basis is not subject to the same cost recovery method, the 
applicable cost recovery method for determining the cost recovery amount 
is the cost recovery method that applies to the portion of the U.S. 
basis that corresponds to the basis difference.
    (3) Applicable cost recovery method. For purposes of section 901(m), 
an applicable cost recovery method includes any method for recovering 
the cost of property over time for U.S. income tax purposes (each 
application of a method giving rise to a U.S. basis deduction). Such 
methods include depreciation, amortization, or depletion, as well as a 
method that allows the cost (or a portion of the cost) of property to be 
expensed in the year of acquisition or in the placed-in-service year, 
such as under section 179. Applicable cost recovery methods do not 
include any provision allowing the U.S. basis to be recovered upon a 
disposition of an RFA.
    (c) Basis difference taken into account as a result of a 
disposition--(1) In general. Except as provided in paragraph (f) of this 
section, when the RFA owner

[[Page 805]]

(U.S.) is a section 901(m) payor, all of a disposition amount is 
attributed to the section 901(m) payor and assigned to the U.S. taxable 
year of the section 901(m) payor in which the disposition occurs. If 
instead the RFA owner (U.S.) is a fiscally transparent entity for U.S. 
income tax purposes, except as provided in paragraphs (e), (f), and (g) 
of this section, a disposition amount is allocated to one or more 
section 901(m) payors under paragraph (d) of this section. If a 
disposition amount arises from an RFA with respect to a section 743(b) 
CAA, in certain cases the disposition amount is allocated to a section 
901(m) payor under paragraph (e) of this section. If there is a 
disposition of an RFA in a foreign taxable year of a foreign payor 
during which there is a mid-year transaction, in certain cases a 
disposition amount is allocated under paragraph (f) of this section. In 
certain cases in which the RFA owner (U.S.) either is a reverse hybrid 
or a fiscally transparent entity for both U.S. and foreign income tax 
purposes that is directly or indirectly owned by a reverse hybrid, a 
disposition amount is allocated to one or more section 901(m) payors 
under paragraph (g) of this section.
    (2) Determining a disposition amount--(i) Disposition is fully 
taxable for purposes of both U.S. income tax and the foreign income tax. 
If a disposition of an RFA is fully taxable (that is, results in all 
gain or loss, if any, being recognized with respect to the RFA) for 
purposes of both U.S. income tax and the foreign income tax, the 
disposition amount is equal to the unallocated basis difference with 
respect to the RFA.
    (ii) Disposition is not fully taxable for purposes of U.S. income 
tax or the foreign income tax (or both). If the disposition of an RFA is 
not fully taxable for purposes of both U.S. income tax and the foreign 
income tax, the disposition amount is determined under this paragraph 
(c)(2)(ii). See Sec.  1.901(m)-6 for rules regarding the continued 
application of section 901(m) if the RFA has any unallocated basis 
difference after determining the disposition amount under paragraph 
(c)(2)(ii)(A) or (B) of this section, as applicable.
    (A) Positive basis difference. If the disposition of an RFA is not 
fully taxable for purposes of both U.S. income tax and the foreign 
income tax, and the RFA has a positive basis difference, the disposition 
amount equals the lesser of:
    (1) Any foreign disposition gain plus any U.S. disposition loss (for 
this purpose, expressed as a positive amount), or
    (2) Unallocated basis difference with respect to the RFA.
    (B) Negative basis difference. If the disposition of an RFA is not 
fully taxable for purposes of both U.S. income tax and the foreign 
income tax, and the RFA has a negative basis difference, the disposition 
amount equals the greater of:
    (1) Any U.S. disposition gain (for this purpose, expressed as a 
negative amount) plus any foreign disposition loss, or
    (2) Unallocated basis difference with respect to the RFA.
    (iii) Disposition of an RFA after a section 743(b) CAA. If an RFA 
was subject to a section 743(b) CAA and subsequently there is a 
disposition of the RFA, then, for purposes of determining the 
disposition amount, foreign disposition gain or foreign disposition loss 
are specially defined to mean the amount of gain or loss recognized for 
purposes of the foreign income tax on the disposition of the RFA that is 
allocable to the partnership interest that was transferred in the 
section 743(b) CAA. In addition, U.S. disposition gain or U.S. 
disposition loss are specially defined to mean the amount of gain or 
loss recognized for U.S. income tax purposes on the disposition of the 
RFA that is allocable to the partnership interest that was transferred 
in the section 743(b) CAA, taking into account the basis adjustment 
under section 743(b) that was allocated to the RFA under section 755.
    (d) General rules for allocating and assigning a cost recovery 
amount or a disposition amount when the RFA owner (U.S.) is a fiscally 
transparent entity--(1) In general. Except as provided in paragraphs 
(e), (f), and (g) of this section, this paragraph (d) provides rules for 
allocating a cost recovery amount or a disposition amount when the RFA 
owner (U.S.) is a fiscally transparent entity for U.S. income tax 
purposes in which a section 901(m) payor directly

[[Page 806]]

or indirectly owns an interest, as well as for assigning the allocated 
amount to a U.S. taxable year of the section 901(m) payor. For purposes 
of this paragraph (d), unless otherwise indicated, a reference to direct 
or indirect ownership in an entity means for U.S. income tax purposes. 
For purposes of this paragraph (d), a person indirectly owns an interest 
in an entity for U.S. income tax purposes if the person owns the 
interest through one or more fiscally transparent entities for U.S. 
income tax purposes, and at least one of the fiscally transparent 
entities is not a disregarded entity. For purposes of this paragraph 
(d), a person indirectly owns an interest in an entity for foreign 
income tax purposes if the person owns the interest through one or more 
fiscally transparent entities for foreign income tax purposes. If the 
RFA owner (U.S.) is a lower-tier fiscally transparent entity for U.S. 
income tax purposes in which the section 901(m) payor indirectly owns an 
interest, the rules of this section apply in a manner consistent with 
the application of these rules when the section 901(m) payor directly 
owns an interest in the RFA owner (U.S.).
    (2) Allocation of a cost recovery amount. A cost recovery amount is 
allocated to a section 901(m) payor that directly or indirectly owns an 
interest in the RFA owner (U.S.) to the extent the U.S. basis deduction 
that corresponds to the cost recovery amount is (or will be) included in 
the section 901(m) payor's distributive share of the income of the RFA 
owner (U.S.) for U.S. income tax purposes.
    (3) Allocation of a disposition amount attributable to foreign 
disposition gain or foreign disposition loss--(i) In general. Except as 
provided in paragraph (f) of this section, a disposition amount 
attributable to foreign disposition gain or foreign disposition loss (as 
determined under paragraph (d)(5) of this section) is allocated under 
paragraph (d)(3)(ii) or (d)(3)(iii) of this section to a section 901(m) 
payor that directly or indirectly owns an interest in the RFA owner 
(U.S.).
    (ii) First allocation rule. This paragraph (d)(3)(ii) applies when a 
section 901(m) payor, or a disregarded entity directly owned by a 
section 901(m) payor, is the foreign payor whose foreign income includes 
a distributive share of the foreign income of the RFA owner (foreign) 
and, therefore, all of the foreign income tax amount of the foreign 
payor is paid or accrued by, or considered paid by, the section 901(m) 
payor. Thus, this paragraph (d)(3)(ii) applies when the RFA owner (U.S.) 
is a fiscally transparent entity for both U.S. and foreign income tax 
purposes and a section 901(m) payor either directly owns an interest in 
the RFA owner (U.S.) or directly owns an interest in another fiscally 
transparent entity for U.S. and foreign income tax purposes, which, in 
turn, directly or indirectly owns an interest in the RFA owner (U.S.) 
for both U.S. and foreign income tax purposes. In these cases, the 
section 901(m) payor is allocated the portion of a disposition amount 
that is equal to the product of the disposition amount attributable to 
foreign disposition gain or foreign disposition loss, as applicable, and 
a fraction, the numerator of which is the portion of the foreign 
disposition gain or foreign disposition loss recognized by the RFA owner 
(foreign) for foreign income tax purposes that is (or will be) included 
in the foreign payor's distributive share of the foreign income of the 
RFA owner (foreign), and the denominator of which is the foreign 
disposition gain or foreign disposition loss.
    (iii) Second allocation rule. This paragraph (d)(3)(iii) applies 
when neither a section 901(m) payor nor a disregarded entity directly 
owned by a section 901(m) payor is the foreign payor with respect to the 
foreign income of the RFA owner (foreign). Instead, a section 901(m) 
payor directly or indirectly owns an interest in the foreign payor, 
which is a fiscally transparent entity for U.S. income tax purposes 
(other than a disregarded entity directly owned by the section 901(m) 
payor), and, therefore, the section 901(m) payor is considered to pay or 
accrue only its allocated portion of the foreign income tax amount of 
the foreign payor. This will be the case when the foreign payor is 
either the RFA owner (U.S.), another fiscally transparent entity for 
U.S. income tax purposes (other than a disregarded entity directly owned 
by a section 901(m) payor) that directly or

[[Page 807]]

indirectly owns an interest in the RFA owner (U.S.) for both U.S. and 
foreign income tax purposes, or a disregarded entity directly owned by 
the RFA owner (U.S.). In these cases, the section 901(m) payor is 
allocated the portion of a disposition amount that is equal to the 
product of the disposition amount attributable to foreign disposition 
gain or foreign disposition loss, as applicable, and a fraction, the 
numerator of which is the portion of the foreign disposition gain or 
foreign disposition loss that is included in the allocable foreign 
income of the section 901(m) payor, and the denominator of which is the 
foreign disposition gain or foreign disposition loss. If allocable 
foreign income is not otherwise required to be determined because there 
is no foreign income tax amount, the numerator is the portion of the 
foreign disposition gain or foreign disposition loss that would be 
included in the allocable foreign income of the section 901(m) payor if 
there were a foreign income tax amount.
    (4) Allocation of a disposition amount attributable to U.S. 
disposition gain or U.S. disposition loss. A section 901(m) payor that 
directly or indirectly owns an interest in the RFA owner (U.S.) is 
allocated the portion of a disposition amount that is equal to the 
product of the disposition amount attributable to U.S. disposition gain 
or U.S. disposition loss (as determined under paragraph (d)(5) of this 
section), as applicable, and a fraction, the numerator of which is the 
portion of the U.S. disposition gain or U.S. disposition loss that is 
(or will be) included in the section 901(m) payor's distributive share 
of income of the RFA owner (U.S.) for U.S. income tax purposes, and the 
denominator of which is the U.S. disposition gain or U.S. disposition 
loss.
    (5) Determining the extent to which a disposition amount is 
attributable to foreign or U.S. disposition gain or loss--(i) RFA with a 
positive basis difference. When there is a disposition of an RFA with a 
positive basis difference and the disposition results in either a 
foreign disposition gain or a U.S. disposition loss, but not both, the 
entire disposition amount is attributable to foreign disposition gain or 
U.S. disposition loss, as applicable, even if the disposition amount 
exceeds the foreign disposition gain or the absolute value of the U.S. 
disposition loss. If the disposition results in both a foreign 
disposition gain and a U.S. disposition loss, the disposition amount is 
attributable first to foreign disposition gain to the extent thereof, 
and the excess disposition amount, if any, is attributable to the U.S. 
disposition loss, even if the excess disposition amount exceeds the 
absolute value of the U.S. disposition loss.
    (ii) RFA with a negative basis difference. When there is a 
disposition of an RFA with a negative basis difference and the 
disposition results in either a foreign disposition loss or a U.S. 
disposition gain, but not both, the entire disposition amount is 
attributable to foreign disposition loss or U.S. disposition gain, as 
applicable, even if the absolute value of the disposition amount exceeds 
the absolute value of the foreign disposition loss or the U.S. 
disposition gain. If the disposition results in both a foreign 
disposition loss and a U.S. disposition gain, the disposition amount is 
attributable first to foreign disposition loss to the extent thereof, 
and the excess disposition amount, if any, is attributable to the U.S. 
disposition gain, even if the absolute value of the excess disposition 
amount exceeds the U.S. disposition gain.
    (6) U.S. taxable year of a section 901(m) payor to which an 
allocated cost recovery amount or disposition amount is assigned. A cost 
recovery amount or a disposition amount allocated to a section 901(m) 
payor under paragraph (d) of this section is assigned to the U.S. 
taxable year of the section 901(m) payor that includes the last day of 
the U.S. taxable year of the RFA owner (U.S.) in which, in the case of a 
cost recovery amount, the RFA owner (U.S.) takes into account the 
corresponding U.S. basis deduction (without regard to whether the 
deduction is deferred or disallowed for U.S. income tax purposes), or in 
the case of a disposition amount, the disposition occurs.
    (e) Special rules for certain section 743(b) CAAs. If a section 
901(m) payor acquires a partnership interest in a section 743(b) CAA, 
including a section 743(b) CAA with respect to a lower-tier

[[Page 808]]

partnership that results from a direct acquisition by the section 901(m) 
payor of an interest in an upper-tier partnership, and subsequently 
there is a cost recovery amount or a disposition amount that arises from 
an RFA with respect to that section 743(b) CAA, all of the cost recovery 
amount or the disposition amount is allocated to that section 901(m) 
payor. The U.S. taxable year of the section 901(m) payor to which the 
cost recovery amount or the disposition amount is assigned is the U.S. 
taxable year in which, in the case of a cost recovery amount, the 
section 901(m) payor takes into account the corresponding U.S. basis 
deduction (without regard to whether the deduction is deferred or 
disallowed for U.S. income tax purposes), or in the case of a 
disposition amount, the disposition occurs.
    (f) Mid-year transactions--(1) In general. When a disposition of an 
RFA occurs in the same foreign taxable year that a foreign payor is 
involved in a mid-year transaction, the portion of the disposition 
amount that is attributable to foreign disposition gain or foreign 
disposition loss (as determined under paragraph (d)(5) of this section) 
is allocated to a section 901(m) payor and assigned to a U.S. taxable 
year of the section 901(m) payor under this paragraph (f). To the extent 
the disposition amount is attributable to U.S. disposition gain or U.S. 
disposition loss (as determined under paragraph (d)(5) of this section), 
see paragraph (c)(1) or (d) of this section, as applicable.
    (2) Allocation rule. To the extent a disposition amount is 
attributable to foreign disposition gain or foreign disposition loss, a 
section 901(m) payor is allocated the portion of the disposition amount 
equal to the product of the disposition amount attributable to foreign 
disposition gain or foreign disposition loss, as applicable, and a 
fraction, the numerator of which is the portion of the foreign 
disposition gain or foreign disposition loss that is included in the 
allocable foreign income of the section 901(m) payor, and the 
denominator of which is the foreign disposition gain or foreign 
disposition loss. If allocable foreign income is not otherwise required 
to be determined because there is no foreign income tax amount, the 
numerator is the portion of the foreign disposition gain or foreign 
disposition loss that would be included in the allocable foreign income 
of the section 901(m) payor if there were a foreign income tax amount.
    (3) Assignment to a U.S. taxable year of a section 901(m) payor. A 
disposition amount allocated to a section 901(m) payor under paragraph 
(f)(2) of this section is assigned to the U.S. taxable year of the 
section 901(m) payor in which the foreign disposition gain or foreign 
disposition loss (or portion thereof) is included in allocable foreign 
income of the section 901(m) payor or, if allocable foreign income is 
not otherwise required to be determined because there is no foreign 
income tax amount, the U.S. taxable year in which the foreign 
disposition gain or foreign disposition loss would be included in 
allocable foreign income if there were a foreign income tax amount.
    (g) Reverse hybrids--(1) In general. This paragraph (g) provides 
rules for allocating a cost recovery amount or a disposition amount when 
the RFA owner (U.S.) is either a reverse hybrid or a fiscally 
transparent entity for U.S. and foreign income tax purposes that is 
directly or indirectly owned by a reverse hybrid for U.S. and foreign 
income tax purposes, and in each case, the foreign payor whose foreign 
income includes a distributive share of the foreign income of the RFA 
owner (foreign) directly or indirectly owns an interest in the reverse 
hybrid for foreign income tax purposes. Application of the allocation 
rules under paragraphs (g)(2) and (g)(3) of this section depend upon 
whether a section 901(m) payor or a disregarded entity directly owned by 
a section 901(m) payor is the foreign payor, or, instead, a section 
901(m) payor directly or indirectly owns an interest in the foreign 
payor. For purposes of this paragraph (g), unless otherwise indicated, a 
reference to direct or indirect ownership in an entity means for U.S. 
income tax purposes. For purposes of this paragraph (g), a person 
indirectly owns an interest in an entity for U.S. income tax purposes if 
the person owns the interest through one or more fiscally transparent 
entities for U.S. income tax purposes, and at least one of the fiscally 
transparent

[[Page 809]]

entities is not a disregarded entity. For purposes of this paragraph 
(g), a person indirectly owns an interest in an entity for foreign 
income tax purposes if the person owns the interest through one or more 
fiscally transparent entities for foreign income tax purposes. If the 
RFA owner (U.S.) is a lower-tier fiscally transparent entity for U.S. 
income tax purposes in which the reverse hybrid indirectly owns an 
interest, the rules of this section apply in a manner consistent with 
the application of these rules when the reverse hybrid directly owns an 
interest in the RFA owner (U.S.).
    (2) First allocation rule--(i) Allocation to a section 901(m) payor. 
This paragraph (g)(2)(i) applies when a section 901(m) payor, or a 
disregarded entity directly owned by a section 901(m) payor, is the 
foreign payor whose foreign income includes a distributive share of the 
foreign income of the RFA owner (foreign), and, therefore, all of the 
foreign income tax amount of the foreign payor is paid or accrued by, or 
considered paid or accrued by, the section 901(m) payor. Thus, this 
paragraph (g)(2)(i) applies when a section 901(m) payor either directly 
owns an interest in the reverse hybrid or directly owns an interest in a 
fiscally transparent entity for U.S. and foreign income tax purposes, 
which, in turn, directly or indirectly owns an interest in the reverse 
hybrid for both U.S. and foreign income tax purposes. In these cases, 
the section 901(m) payor is allocated the portions of cost recovery 
amounts or disposition amounts (or both) with respect to RFAs that are 
equal to the product of the sum of the cost recovery amounts and the 
disposition amounts and a fraction, the numerator of which is the 
portion of the foreign income of the RFA owner (foreign) that is 
included in the foreign income of the foreign payor, and the denominator 
of which is the foreign income of the RFA owner (foreign).
    (ii) Assignment to a U.S. taxable year of a section 901(m) payor. 
This paragraph (g)(2)(ii) applies when a cost recovery amount or a 
disposition amount, or portion thereof, is allocated to a section 901(m) 
payor under paragraph (g)(2)(i) of this section. If the reverse hybrid 
is the RFA owner (U.S.), a cost recovery amount or disposition amount, 
or portion thereof, is assigned to the U.S. taxable year of the section 
901(m) payor that includes the last day of the U.S. taxable year of the 
reverse hybrid in which, in the case of a cost recovery amount, the 
reverse hybrid takes into account the corresponding U.S. basis deduction 
(without regard to whether the deduction is deferred or disallowed for 
U.S. income tax purposes), or, in the case of a disposition amount, the 
disposition occurs. If the reverse hybrid is not the RFA owner (U.S.) 
but instead the reverse hybrid directly or indirectly owns an interest 
in the RFA owner (U.S.) for both U.S. and foreign income tax purposes, a 
cost recovery amount or disposition amount, or portion thereof, is 
assigned to the U.S. taxable year of the section 901(m) payor that 
includes the last day of the U.S. taxable year of the reverse hybrid, 
which, in turn, includes the last day of the U.S. taxable year of the 
RFA owner (U.S.) in which, in the case of a cost recovery amount, the 
RFA owner (U.S.) takes into account the corresponding U.S. basis 
deduction (without regard to whether the deduction is deferred or 
disallowed for U.S. income tax purposes), or, in the case of a 
disposition amount, the disposition occurs.
    (3) Second allocation rule--(i) Allocation to a section 901(m) 
payor. This paragraph (g)(3)(i) applies when neither a section 901(m) 
payor nor a disregarded entity directly owned by a section 901(m) payor 
is the foreign payor with respect to the foreign income of the RFA owner 
(foreign). Instead, a section 901(m) payor directly or indirectly owns 
an interest in the foreign payor, which is a fiscally transparent entity 
for U.S. income tax purposes (other than a disregarded entity directly 
owned by the section 901(m) payor), and, therefore, the section 901(m) 
payor is considered to pay or accrue only its allocated portion of the 
foreign income tax amount of the foreign payor. In these cases, the 
section 901(m) payor is allocated the portions of cost recovery amounts 
or disposition amounts (or both) with respect to RFAs that are equal to 
the product of the sum of the

[[Page 810]]

cost recovery amounts and the disposition amounts and a fraction, the 
numerator of which is the portion of the foreign income of the RFA owner 
(foreign) that is included in the foreign income of the foreign payor 
and included in the allocable foreign income of the section 901(m) 
payor, and the denominator of which is the foreign income of the RFA 
owner (foreign). If allocable foreign income is not otherwise required 
to be determined for a section 901(m) payor because there is no foreign 
income tax amount, the numerator is the foreign income of the RFA owner 
(foreign) that is included in the foreign income of the foreign payor 
and that would be included in allocable foreign income of the section 
901(m) payor if there were a foreign income tax amount.
    (ii) Assignment to a U.S. taxable year of a section 901(m) payor. A 
cost recovery amount or a disposition amount, or portion thereof, that 
is allocated to a section 901(m) payor under paragraph (g)(3)(i) of this 
section is assigned to the U.S. taxable year of the section 901(m) payor 
in which the foreign income of the RFA owner (foreign) described in 
paragraph (g)(3)(i) of this section is included in the allocable foreign 
income of the section 901(m) payor, or, if there is no foreign income 
tax amount, the U.S. taxable year of the section 901(m) payor in which 
the foreign income of the RFA owner (foreign) described in paragraph 
(g)(3)(i) of this section would be included in allocable foreign income 
if there were a foreign income tax amount.
    (h) Examples. The following examples illustrate the rules of this 
section. In addition to any facts described in a particular example, the 
following facts apply to all the examples unless otherwise specified: 
CFC1, CFC2, and DE are organized in Country F and treated as 
corporations for Country F tax purposes. CFC1 and CFC2 are each an 
applicable foreign corporation that is wholly owned by the same U.S. 
corporation, and DE is a disregarded entity. CFC1 and CFC2 each have a 
U.S. taxable year that is a calendar year, and CFC1, CFC2, and DE each 
have a foreign taxable year that is a calendar year. Country F imposes a 
single tax that is a foreign income tax. CFC1, CFC2, and DE each have a 
functional currency of the u with respect to all activities. At all 
relevant times, 1u equals $1. All amounts are stated in millions. The 
examples assume that the applicable cost recovery method for property 
results in basis being recovered ratably over the life of the property 
beginning on the first day of the U.S. taxable year in which the 
property is acquired or placed into service.
    (1) Example 1: CAA followed by disposition: Fully taxable for both 
U.S. income tax and foreign income tax purposes--(i) Facts. (A) On 
January 1, Year 1, USP acquires all of the stock of CFC1 in a qualified 
stock purchase (as defined in section 338(d)(3)) to which section 338(a) 
applies (Section 338 Acquisition). At the time of the Section 338 
Acquisition, CFC1 owns a single asset (Asset A) that is located in 
Country F. Asset A gives rise to income that is taken into account for 
Country F tax purposes. Asset A is tangible personal property that, 
under the applicable cost recovery method in the hands of CFC1, is 
depreciable over 5 years. There are no cost recovery deductions 
available for Country F tax purposes with respect to Asset A. 
Immediately before the Section 338 Acquisition, Asset A has a U.S. basis 
of 10u and a foreign basis of 40u. Immediately after the Section 338 
Acquisition, Asset A has a U.S. basis of 100u and foreign basis of 40u.
    (B) On July 1, Year 2, Asset A is transferred to an unrelated 
thirdparty in exchange for 120u in a transaction in which all realized 
gainis recognized for both U.S. income tax and Country F tax 
purposes(subsequent transaction). For U.S. income tax purposes, 
CFC1recognizes U.S. disposition gain of 50u (amount realized of 120u, 
lessU.S. basis of 70u (100u cost basis, less 30u of 
accumulateddepreciation)) with respect to Asset A. The 30u of 
accumulateddepreciation is the sum of 20u of depreciation in Year 1 
(100u costbasis/5 years) and 10u of depreciation in Year 2 ((100u cost 
basis/5years) x 6/12). For Country F tax purposes, CFC1 recognizes 
foreigndisposition gain of 80u (amount realized of 120u, less foreign 
basisof 40u) with respect to Asset A. Immediately after the

[[Page 811]]

subsequenttransaction, Asset A has a U.S. basis and a foreign basis of 
120u.
    (ii) Result. (A) Under Sec.  1.901(m)-2(b)(1), USP's acquisition of 
the stock of CFC1 in the Section 338 Acquisition is a section 338 CAA. 
Under Sec.  1.901(m)-2(c)(i), Asset A is an RFA with respect to Country 
F tax because it is relevant in determining the foreign income of CFC1 
for Country F tax purposes. Under Sec.  1.901(m)-4(b), the basis 
difference with respect to Asset A is 90u (100u-10u). Under Sec.  
1.901(m)-1(a)(37), CFC1 is the RFA owner (U.S.) with respect to Asset A. 
Under Sec.  1.901(m)-1(a)(28), CFC1 is a foreign payor for Country F tax 
purposes. Under Sec.  1.901(m)-1(a)(41), CFC1 is the section 901(m) 
payor with respect to a foreign income tax amount for which CFC1 is the 
foreign payor (see Sec.  1.901-2(f)(1)).
    (B) Under Sec.  1.901(m)-1(a)(5), allocated basis differences are 
the sum of cost recovery amounts and disposition amounts. In Year 1, 
Asset A has an allocated basis difference that includes only a cost 
recovery amount. Under paragraph (b)(2) of this section, the cost 
recovery amount for Year 1 is determined by applying the applicable cost 
recovery method of Asset A in the hands of CFC1 to the basis difference 
with respect to Asset A. Accordingly, the cost recovery amount is 18u 
(90u basis difference/5 years). Under paragraph (b)(1) of this section, 
all of the 18u cost recovery amount is attributed to CFC1 and assigned 
to Year 1, because CFC1 is a section 901(m) payor and RFA owner (U.S.) 
with respect to Asset A and Year 1 is the U.S. taxable year of CFC1 in 
which it takes into account the corresponding 20u of depreciation. 
Immediately after Year 1, under Sec.  1.901(m)-1(a)(47), unallocated 
basis difference is 72u with respect to Asset A (90u-18u).
    (C) In Year 2, Asset A has an allocated basis difference that 
includes both a cost recovery amount and a disposition amount. Under 
paragraph (b)(2) of this section, the cost recovery amount for Year 2, 
as of the date of the subsequent transaction, is 9u ((90u basis 
difference/5 years) x 6/12). Under Sec.  1.901(m)-1(a)(15), the 
subsequent transaction is a disposition of Asset A, because the 
subsequent transaction is an event that results in an amount of gain 
being recognized for U.S. income tax and Country F tax purposes. Because 
all realized gain in Asset A is recognized for U.S. income tax and 
Country F tax purposes, the rule in paragraph (c)(2)(i) of this section 
applies to determine the disposition amount. Under that rule, the 
disposition amount for Year 2 is the unallocated basis difference of 63u 
(90u basis difference, less total 27u taken into account as cost 
recovery amounts in Year 1 and Year 2). Accordingly, the allocated basis 
difference for Year 2 is 72u (9u of cost recovery amount, plus 63u of 
disposition amount). Under paragraphs (b)(1) and (c)(1) of this section, 
all of the 72u of allocated basis difference is attributed to CFC1 and 
assigned to Year 2, because CFC1 is a section 901(m) payor and the RFA 
owner (U.S.) with respect to Asset A and Year 2 is the U.S. taxable year 
of CFC1 in which it takes into account the corresponding 10u of 
depreciation and in which the disposition occurred.
    (D) Unallocated basis difference with respect to Asset A, as 
determined immediately after the subsequent transaction, is 0u (90u 
basis difference less 90u basis difference taken into account as 27u 
total cost recovery amount in Year 1 and Year 2 and as a 63u disposition 
amount in Year 2). Accordingly, because there is no unallocated basis 
difference with respect to Asset A attributable to the Section 338 
Acquisition, the subsequent transaction is not a successor transaction 
as defined in Sec.  1.901(m)-6(b)(2). Furthermore, the subsequent 
transaction is not a CAA under Sec.  1.901(m)-2(b). For these reasons, 
section 901(m) no longer applies to Asset A.
    (2) Example 2: CAA followed by disposition: nontaxable for U.S. 
income tax purposes and taxable for foreign income tax purposes--(i) 
Facts. The facts are the same as in paragraph (h)(1)(i)(A) of this 
section (paragraph (i)(A) of Example 1) but the facts in paragraph 
(h)(1)(i)(B) of this section (paragraph (i)(B) of Example 1) are instead 
that on July 1, Year 2, Asset A is transferred to CFC2, in exchange for 
100u of stock of CFC2 (subsequent transaction). For U.S. income tax 
purposes, CFC1 does not recognize any U.S. disposition gain or U.S. 
disposition loss with respect to Asset A.

[[Page 812]]

For Country F tax purposes, CFC1 recognizes foreign disposition gain of 
60u (amount realized of 100u, less foreign basis of 40u) with respect to 
Asset A. Immediately after the subsequent transaction, Asset A has a 
U.S. basis of 70u (100u cost basis less 30u accumulated depreciation) 
and a foreign basis of 100u. The 30u of accumulated depreciation is the 
sum of 20u of depreciation in Year 1 (100u cost basis/5 years) and 10u 
in Year 2 ((100u cost basis/5 years) x 6/12).
    (ii) Result. (A) The results described in paragraph (h)(1)(ii)(A) of 
this section (paragraph (ii)(A) of Example 1) also apply to this 
paragraph (h)(2)(ii) (the results of this Example 2).
    (B) The result for Year 1 is the same as in paragraph (h)(1)(ii)(B) 
of this section (paragraph (ii)(B) of Example 1).
    (C) In Year 2, Asset A has an allocated basis difference that 
includes both a cost recovery amount and a disposition amount. Under 
paragraph (b)(2) of this section, the cost recovery amount for Year 2, 
as of the date of the subsequent transaction, is 9u ((90u basis 
difference/5 years) x 6/12). Under Sec.  1.901(m)-1(a)(15), the 
subsequent transaction is a disposition of Asset A, because the 
subsequent transaction is an event that results in an amount of gain 
being recognized for Country F tax purposes. Because the disposition is 
not also fully taxable for U.S. income tax purposes, the rule in 
paragraph (c)(2)(ii) of this section applies to determine the 
disposition amount. Under that rule, the disposition amount is 60u, the 
lesser of (i) 60u (60u foreign disposition gain plus absolute value of 
0u U.S. disposition loss), and (ii) 63u unallocated basis difference (90 
basis difference less total 27u taken into account as cost recovery 
amounts, 18u in Year 1 and 9u in Year 2). Accordingly, the allocated 
basis difference for the first half of Year 2 is 69u (9u of cost 
recovery amount, plus 60u of disposition amount). Under paragraphs 
(b)(1) and (c)(1) of this section, all of the 69u of allocated basis 
difference is attributed to CFC1 and assigned to Year 2, because CFC1 is 
a section 901(m) payor and the RFA owner (U.S.) with respect to Asset A 
and Year 2 is the U.S. taxable year of CFC1 in which it takes into 
account the corresponding 10u of depreciation and in which the 
disposition occurred.
    (D) Unallocated basis difference with respect to Asset A immediately 
after the subsequent transaction is 3u (90u basis difference less 87u 
basis difference taken into account as a 27u total cost recovery amount 
in Year 1 and Year 2 and as a 60u disposition amount in Year 2). 
Accordingly, because there is unallocated basis difference of 3u with 
respect to Asset A attributable to the Section 338 Acquisition, as 
determined immediately after the subsequent transaction, the subsequent 
transaction is a successor transaction as defined in Sec.  1.901(m)-
6(b)(2). Following the subsequent transaction, the unallocated basis 
difference of 3u must be taken into account as cost recovery amounts or 
disposition amounts (or both) by CFC2, the new section 901(m) payor and 
RFA owner (U.S.) of Asset A. See Sec.  1.901(m)-6(b)(3)(ii). Because the 
subsequent transaction is not a CAA under Sec.  1.901(m)-2(b), there is 
no additional basis difference with respect to Asset A as a result of 
the subsequent transaction.
    (3) Example 3: CAA followed by disposition: nontaxable for both U.S. 
income tax and foreign income tax purposes--(i) Facts. The facts are the 
same as in paragraph (h)(1)(i)(A) of this section (paragraph (i)(A) of 
Example 1) but the facts in paragraph (h)(1)(i)(B) of this section 
(paragraph (i)(B) of Example 1) are instead that on July 1, Year 2, CFC1 
transfers Asset A to CFC2, in exchange for 110u of stock of CFC2 
(subsequent transaction). For U.S. income tax purposes, CFC1 does not 
recognize any U.S. disposition gain or U.S. disposition loss with 
respect to Asset A as a result of the subsequent transaction. 
Furthermore, for Country F tax purposes, CFC1 recognizes no foreign 
disposition gain or foreign disposition loss with respect to Asset A as 
a result of the subsequent transaction. Immediately after the subsequent 
transaction, Asset A has a U.S. basis of 70u (100u cost basis less 30u 
accumulated depreciation) and a foreign basis of 40u. The 30u of 
accumulated depreciation is the sum of 20u of depreciation in Year 1 
(100u cost basis/5 years) and 10u in Year 2 ((100u cost basis/5 years) x 
6/12).

[[Page 813]]

    (ii) Result. (A) The result for Year 1 is the same as in paragraph 
(h)(1)(ii)(A) of this section (paragraph (ii)(A) of Example 1).
    (B) The result for Year 1 is the same as in paragraph (h)(1)(ii)(B) 
of this section (paragraph (ii)(B) of Example 1).
    (C) In Year 2, Asset A has an allocated basis difference that 
includes only a cost recovery amount. Under paragraph (b)(2) of this 
section, the cost recovery amount for Year 2, as of the date of the 
subsequent transaction, is 9u ((90u basis difference/5 years) x 6/12). 
Under Sec.  1.901(m)-1(a)(15), the subsequent transaction does not 
constitute a disposition of Asset A, because the subsequent transaction 
is not an event that results in an amount of gain or loss being 
recognized for U.S. income tax or for Country F tax purposes. Therefore, 
no disposition amount is taken into account for Asset A in Year 2. Under 
paragraph (b)(1) of this section, all of the 9u of allocated basis 
difference is attributed to CFC1 and assigned to Year 2, because CFC1 is 
a section 901(m) payor and RFA owner (U.S.) with respect to Asset A and 
Year 2 is the U.S. taxable year of CFC1 in which it takes into account 
the corresponding 10u of depreciation.
    (D) Unallocated basis difference with respect to Asset A immediately 
after the subsequent transaction is 63u (90u basis difference, less 27u 
total cost recovery amounts, 18u in Year 1 and 9u in Year 2). 
Accordingly, because there is unallocated basis difference of 63u with 
respect to Asset A attributable to the CAA, as determined immediately 
after the subsequent transaction, the subsequent transaction is a 
successor transaction as defined in Sec.  1.901(m)-6(b)(2). Following 
the subsequent transaction, the unallocated basis difference of 63u must 
be taken into account as cost recovery amounts or disposition amounts 
(or both) by CFC2, the new section 901(m) payor and RFA owner (U.S.) of 
Asset A. See Sec.  1.901(m)-6(b)(3)(ii). Because the subsequent 
transaction is not a CAA under Sec.  1.901(m)-2(b), there is no 
additional basis difference with respect to Asset A as a result of the 
subsequent transaction.
    (i) Applicability dates. (1) Except as provided in paragraph (i)(2) 
of this section, this section applies to CAAs occurring on or after 
March 23, 2020.
    (2) Paragraphs (b)(2)(i) and (c)(2) of this section apply to CAAs 
occurring on or after July 21, 2014, and to CAAs occurring before that 
date resulting from an entity classification election made under Sec.  
301.7701-3 of this chapter that is filed on or after July 29, 2014, and 
that is effective on or before July 21, 2014. Paragraphs (b)(2)(i) and 
(c)(2) of this section also apply to CAAs occurring on or after January 
1, 2011, and before July 21, 2014, other than CAAs occurring before July 
21, 2014, resulting from an entity classification election made under 
Sec.  301.7701-3 that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014, but only with respect to basis 
difference determined under Sec.  1.901(m)-4T(e) with respect to the 
CAA.
    (3) Taxpayers may, however, choose to apply provisions in this 
section before the date such provisions are applicable pursuant to 
paragraphs (i)(1) and (2) of this section, provided that they (along 
with any persons that are related (within the meaning of section 267(b) 
or 707(b)) to the taxpayer)--
    (i) Consistently apply this section, Sec.  1.704-
1(b)(4)(viii)(c)(4)(v) through (vii), Sec.  1.901(m)-1, Sec.  1.901(m)-
3, Sec.  1.901(m)-4 (excluding Sec.  1.901(m)-4(e)), Sec.  1.901(m)-6, 
Sec.  1.901(m)-7, and Sec.  1.901(m)-8 to all CAAs occurring on or after 
January 1, 2011, and consistently apply Sec.  1.901(m)-2 (excluding 
Sec.  1.901(m)-2(d)) to all CAAs occurring on or after December 7, 2016, 
on any original or amended tax return for each taxable year for which 
the application of the provisions listed in this paragraph (i)(3)(i) 
affects the tax liability and for which the statute of limitations does 
not preclude assessment or the filing of a claim for refund, as 
applicable;
    (ii) File all tax returns described in paragraph (i)(3)(i) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (ii) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(i)(3)(i) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16258, Mar. 23, 2020]

[[Page 814]]



Sec.  1.901(m)-6  Successor rules.

    (a) In general. This section provides successor rules applicable to 
section 901(m). Paragraph (b) of this section provides rules for the 
continued application of section 901(m) after an RFA that has 
unallocated basis difference has been transferred, including special 
rules applicable to successor transactions that are also CAAs or that 
involve partnerships. Paragraph (c) of this section provides rules for 
determining when an aggregate basis difference carryover of a section 
901(m) payor either becomes an aggregate basis difference carryover of 
the section 901(m) payor with respect to another foreign payor or is 
transferred to another section 901(m) payor, and paragraph (d) of this 
section provides applicability dates.
    (b) Successor rules for unallocated basis difference--(1) In 
general. Except as provided in paragraph (b)(4) of this section, section 
901(m) continues to apply after a successor transaction to any 
unallocated basis difference attached to a transferred RFA until the 
entire basis difference has been taken into account as a cost recovery 
amount or a disposition amount (or both) under Sec.  1.901(m)-5.
    (2) Definition of a successor transaction. A successor transaction 
occurs with respect to an RFA if, after a CAA (prior CAA), there is a 
transfer of the RFA for U.S. income tax purposes and the RFA has 
unallocated basis difference with respect to the prior CAA, determined 
immediately after the transfer. A successor transaction may occur 
regardless of whether the transfer of the RFA is a disposition, a CAA, 
or a non-taxable transaction for purposes of U.S. income tax. If the RFA 
was subject to multiple prior CAAs, a separate determination must be 
made with respect to each prior CAA as to whether the transfer is a 
successor transaction.
    (3) Special considerations. (i) If an asset is an RFA with respect 
to more than one foreign income tax, this paragraph (b) applies 
separately with respect to each foreign income tax.
    (ii) Any subsequent cost recovery amount for an RFA transferred in a 
successor transaction is determined based on the post-transaction 
applicable cost recovery method, as described in Sec.  1.901(m)-5(b)(3), 
that applies to the U.S. basis (or portion thereof) that corresponds to 
the unallocated basis difference.
    (4) Successor transaction is a CAA--(i) In general. An asset may be 
an RFA with respect to multiple CAAs if a successor transaction is also 
a CAA (subsequent CAA). Except as otherwise provided in this paragraph 
(b)(4), if there is a subsequent CAA, unallocated basis difference with 
respect to any prior CAAs will continue to be taken into account under 
section 901(m) after the subsequent CAA. Furthermore, the subsequent CAA 
may give rise to additional basis difference subject to section 901(m).
    (ii) Foreign basis election. If a foreign basis election is made 
under Sec.  1.901(m)-4(c) with respect to a foreign income tax in a 
subsequent CAA, any unallocated basis difference with respect to one or 
more prior CAAs will not be taken into account under section 901(m). The 
only basis difference that will be taken into account after the 
subsequent CAA with respect to that foreign income tax is the basis 
difference with respect to the subsequent CAA.
    (iii) Multiple section 743(b) CAAs. If an RFA is subject to two 
section 743(b) CAAs (prior section 743(b) CAA and subsequent section 
743(b) CAA) and the same partnership interest is acquired in both the 
CAAs, the RFA will be treated as having no unallocated basis difference 
with respect to the prior section 743(b) CAA if the basis difference for 
the section 743(b) CAA is determined independently from the prior 
section 743(b) CAA. In this regard, see generally Sec.  1.743-1(f). If 
the subsequent section 743(b) CAA results from the acquisition of only a 
portion of the partnership interest acquired in the prior section 743(b) 
CAA, then the transferor will be required to equitably apportion the 
unallocated basis difference attributable to the prior section 743(b) 
CAA between the portion retained by the transferor and the portion 
transferred. In this case, with respect to the portion transferred, the 
RFAs will be treated as having no unallocated basis difference with 
respect to the prior section 743(b) CAA if basis difference for

[[Page 815]]

the subsequent section 743(b) CAA is determined independently from the 
prior section 743(b) CAA.
    (5) Example. The following example illustrates the rules of 
paragraph (b) of this section.
    (i) Facts. USP, a domestic corporation, wholly owns CFC, a foreign 
corporation organized in Country A and treated as a corporation for both 
U.S. and Country A tax purposes. FT is an unrelated foreign corporation 
organized in Country A and treated as a corporation for both U.S. and 
Country A tax purposes. FT owns one asset, a parcel of land (Asset). 
Country A imposes a single tax that is a foreign income tax. On January 
1, Year 1, CFC acquires all of the stock of FT in exchange for 300u in a 
qualified stock purchase (as defined in section 338(d)(3)) to which 
section 338(a) applies (Acquisition). Immediately before the 
Acquisition, Asset had a U.S. basis of 100u, and immediately after the 
Acquisition, Asset had a U.S. basis of 300u. Effective on February 1, 
Year 1, FT elects to be a disregarded entity pursuant to Sec.  301.7701-
3. As a result of the election, FT is deemed, for U.S. income tax 
purposes, to distribute Asset to CFC in liquidation (Deemed Liquidation) 
immediately before the closing of the day before the election is 
effective pursuant to Sec.  301.7701-3(g)(1)(iii) and (3)(ii). The 
Deemed Liquidation is disregarded for Country A tax purposes. No gain or 
loss is recognized on the Deemed Liquidation for either U.S. or Country 
A tax purposes.
    (ii) Result. Under Sec.  1.901(m)-2(b)(1), the acquisition by CFC of 
the stock of FT is a section 338 CAA. Under Sec.  1.901(m)-2(c)(1), 
Asset is an RFA with respect to Country A tax and the Acquisition, 
because immediately after the Acquisition, Asset is relevant in 
determining foreign income of FT for Country A tax purposes, and FT 
owned Asset when the Acquisition occurred. Under Sec.  1.901(m)-4(b), 
the basis difference with respect to Asset is 200u (300u--100u). Under 
Sec.  1.901(m)-2(b)(2), the Deemed Liquidation is a CAA (subsequent CAA) 
because the Deemed Liquidation is treated as an acquisition of assets 
for U.S. income tax purposes and is disregarded for Country A tax 
purposes. Because the U.S. basis in Asset is 300u immediately before and 
after the Deemed Liquidation, the subsequent CAA does not give rise to 
any additional basis difference. The Deemed Liquidation is not a 
disposition under Sec.  1.901(m)-1(a)(15) because it did not result in 
gain or loss being recognized with respect to Asset for U.S. or Country 
A tax purposes. Accordingly, no basis difference with respect to Asset 
is taken into account under Sec.  1.901(m)-5 as a result of the Deemed 
Liquidation, and the unallocated basis difference with respect to Asset 
immediately after the Deemed Liquidation is 200u (200u--0u). Under 
paragraph (b)(2) of this section, the Deemed Liquidation is a successor 
transaction because there is a transfer of Asset for U.S. income tax 
purposes from FT to CFC and Asset has unallocated basis difference with 
respect to the Acquisition immediately after the Deemed Liquidation. 
Accordingly, under paragraph (b)(1) of this section, section 901(m) will 
continue to apply to the unallocated basis difference with respect to 
Asset until the entire 200u basis difference has been taken into account 
under Sec.  1.901(m)-5.
    (c) Successor rules for aggregate basis difference carryover--(1) 
Transfers of a section 901(m) payor's aggregate basis difference 
carryover to another person. If a corporation acquires the assets of a 
section 901(m) payor in a transaction to which section 381 applies, that 
corporation succeeds to any aggregate basis difference carryovers of the 
section 901(m) payor.
    (2) Transfers of a section 901(m) payor's aggregate basis difference 
carryover with respect to a foreign payor to another foreign payor. If a 
section 901(m) payor has an aggregate basis difference carryover, with 
respect to a foreign income tax and a foreign payor, and substantially 
all of the assets of the foreign payor are transferred to another 
foreign payor in which the section 901(m) payor owns an interest, the 
section 901(m) payor's aggregate basis difference carryover with respect 
to the first foreign payor is transferred to the section 901(m) payor's 
aggregate basis difference carryover with respect to the other foreign 
payor. In such a case, the section 901(m) payor's aggregate basis 
difference carryover with respect

[[Page 816]]

to the first foreign payor is reduced to zero.
    (3) Anti-abuse rule. If a section 901(m) payor has an aggregate 
basis difference carryover with respect to a foreign income tax and a 
foreign payor and, with a principal purpose of avoiding the application 
of section 901(m), assets of the foreign payor are transferred to 
another foreign payor in a transaction not described in paragraph (c)(1) 
or (2) of this section, then a portion of the aggregate basis difference 
carryover of the section 901(m) payor is transferred either to the 
aggregate basis difference carryover of the section 901(m) payor with 
respect to the other foreign payor or to another section 901(m) payor, 
as appropriate. The portion of the aggregate basis difference carryover 
transferred is determined based on the ratio of fair market value of the 
assets transferred to the fair market value of all of the assets of the 
foreign payor that transferred the assets. Similar principles apply 
when, with a principal purpose of avoiding the application of section 
901(m), there is a change in the allocation of foreign income for 
foreign income tax purposes or the allocation of foreign income tax 
amounts for U.S. income tax purposes that would otherwise separate 
foreign income tax amounts from the related aggregate basis difference 
carryover.
    (4) Ownership. For purposes of this paragraph (c), a section 901(m) 
payor owns an interest in a foreign payor if the section 901(m) payor 
owns the interest directly or indirectly through one or more fiscally 
transparent entities for U.S. income tax purposes.
    (d) Applicability dates. (1) Except as provided in paragraph (d)(2) 
of this section, this section applies to CAAs occurring on or after 
March 23, 2020.
    (2) Paragraphs (a), (b)(1) and (2), (b)(4)(i) and (iii), and (b)(5) 
of this section apply to CAAs occurring on or after July 21, 2014, and 
to CAAs occurring before that date resulting from an entity 
classification election made under Sec.  301.7701-3 of this chapter that 
is filed on or after July 29, 2014, and that is effective on or before 
July 21, 2014. Paragraphs (a), (b)(1) and (2), (b)(4)(i) and (iii), and 
(b)(5) of this section also apply to CAAs occurring on or after January 
1, 2011, and before July 21, 2014, other than CAAs occurring before July 
21, 2014, resulting from an entity classification election made under 
Sec.  301.7701-3 that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014, but only with respect to basis 
difference determined under Sec.  1.901(m)-4T(e) with respect to the 
CAA.
    (3) Taxpayers may, however, choose to apply provisions in this 
section before the date such provisions are applicable pursuant to 
paragraphs (d)(1) and (2) of this section, provided that they (along 
with any persons that are related (within the meaning of section 267(b) 
or 707(b)) to the taxpayer)--
    (i) Consistently apply this section, Sec.  1.704-
1(b)(4)(viii)(c)(4)(v) through (vii), Sec.  1.901(m)-1, Sec. Sec.  
1.901(m)-3 through 1.901(m)-5 (excluding Sec.  1.901(m)-4(e)), Sec.  
1.901(m)-7, and Sec.  1.901(m)-8 to all CAAs occurring on or after 
January 1, 2011, and consistently apply Sec.  1.901(m)-2 (excluding 
Sec.  1.901(m)-2(d)) to all CAAs occurring on or after December 7, 2016, 
on any original or amended tax return for each taxable year for which 
the application of the provisions listed in this paragraph (d)(3)(i) 
affects the tax liability and for which the statute of limitations does 
not preclude assessment or the filing of a claim for refund, as 
applicable;
    (ii) File all tax returns described in paragraph (d)(3)(i) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (iii) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(d)(3)(i) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16263, Mar. 23, 2020]



Sec.  1.901(m)-7  De minimis rules.

    (a) In general. This section provides rules describing basis 
difference that is not taken into account under section 901(m) because a 
CAA results in a de minimis amount of basis difference. Paragraph (b) of 
this section sets forth the general rule for determining whether the de 
minimis threshold is met. Paragraph (c) of this section modifies the 
general rule in the case of CAAs that are part of an aggregated

[[Page 817]]

CAA transaction. Paragraph (d) of this section provides rules for 
applying this section, and paragraph (e) of this section provides an 
anti-abuse rule applicable to related persons. Paragraph (f) of this 
section provides examples that illustrate the application of this 
section. Paragraph (g) of this section provides applicability dates.
    (b) General rule--(1) In general. A basis difference with respect to 
an RFA and a foreign income tax is not taken into account under section 
901(m) if the requirements under the cumulative basis difference 
exemption, the RFA class exemption, or the RFA exemption are satisfied.
    (2) Cumulative basis difference exemption. Except as provided in 
paragraph (c) of this section, a basis difference, with respect to an 
RFA and a foreign income tax, is not taken into account under section 
901(m) (cumulative basis difference exemption) if the sum of that basis 
difference and all other basis differences (including negative basis 
differences), with respect to a single CAA and a single RFA owner 
(U.S.), is less than the greater of:
    (i) $10 million, or
    (ii) 10 percent of the total U.S. basis of all the RFAs immediately 
after the CAA.
    (3) RFA class exemption--(i) Except as provided in paragraph (c) of 
this section, a basis difference, with respect to an RFA and a foreign 
income tax, is not taken into account under section 901(m) (RFA class 
exemption) if the RFA is part of a class of RFAs and the absolute value 
of the sum of the basis differences (including negative basis 
differences), with respect to a single CAA and a single RFA owner, for 
all the RFAs in that class is less than the greater of:
    (A) $2 million, or
    (B) 10 percent of the total U.S. basis of all the RFAs in that class 
of RFAs immediately after the CAA.
    (ii) For purposes of this paragraph (b)(3), the classes of RFAs are 
the seven asset classes defined in Sec.  1.338-6(b), regardless of 
whether the CAA is a section 338 CAA.
    (4) RFA exemption. A basis difference, with respect to an RFA and a 
foreign income tax, is not taken into account under section 901(m) (RFA 
exemption) if the absolute value of the basis difference with respect to 
the RFA is less than $20,000.
    (c) Special rule if a CAA is part of an aggregated CAA transaction. 
If a CAA is part of an aggregated CAA transaction and a single RFA owner 
(U.S.) does not own all the RFAs attributable to the CAAs that are part 
of the aggregated CAA transaction, the cumulative basis difference 
exemption and the RFA class exemption apply to such CAA only if, in 
addition to satisfying the requirements of paragraph (b)(2) or (b)(3) of 
this section, respectively, determined without regard to this paragraph 
(c), the cumulative basis difference exemption or the RFA class 
exemption, as modified by this paragraph (c), is satisfied. Solely for 
purposes of this paragraph (c), the cumulative basis difference 
exemption and the RFA class exemption are applied taking into account 
all the basis differences with respect to all the RFAs owned by all the 
RFA owners (U.S.) that are attributable to the CAAs that are part of the 
aggregated CAA transaction.
    (d) Rules of application. The following rules apply for purposes of 
this section.
    (1) Whether a basis difference qualifies for the cumulative basis 
difference exemption, the RFA class exemption, or the RFA exemption is 
determined when an asset first becomes an RFA with respect to a CAA. In 
the case of a subsequent CAA described in Sec.  1.901(m)-6(b)(4), the 
application of the cumulative basis difference exemption, the RFA class 
exemption, and the RFA exemption is based on basis difference, if any, 
that results from the subsequent CAA.
    (2) If there is an aggregated CAA transaction, the cumulative basis 
difference exemption and each RFA class exemption are applied by 
treating all CAAs that are part of the aggregated CAA transaction as a 
single CAA.
    (3) Basis difference is computed in accordance with Sec.  1.901(m)-4 
except that a foreign basis election need not be evidenced if the 
cumulative basis difference exemption, an RFA class exemption, or the 
RFA exemption apply to all RFAs with respect to the CAA.
    (4) Basis difference is translated into U.S. dollars (if necessary) 
using the

[[Page 818]]

spot rate determined under the principles of Sec.  1.988-1(d) on the 
date of the CAA.
    (e) Anti-abuse rule. The cumulative basis difference exemption, an 
RFA class exemption, and the RFA exemption are not available if the 
transferor and transferee in the CAA are related persons (as described 
in section 267(b) or 707(b)) and the CAA was entered into, or 
structured, with a principal purpose of avoiding the application of 
section 901(m). See also Sec.  1.901(m)-8(c), which provides that 
certain built-in loss assets are not taken into account for purposes of 
applying this section.
    (f) Examples. The following examples illustrate the rules of this 
section:
    (1) Example 1: De minimis; cumulative basis difference exemption--
(i) Facts. USP, a domestic corporation, as part of a plan, purchases all 
of the stock of CFC1 and CFC2 from a single seller. CFC1 and CFC2 are 
applicable foreign corporations, organized in Country F, and treated as 
corporations for Country F tax purposes. Country F imposes a single tax 
that is a foreign income tax. Each acquisition is a qualified stock 
purchase (as defined in section 338(d)(3)) to which section 338(a) 
applies. A foreign basis election is not made under Sec.  1.901(m)-4(c). 
Immediately after the acquisition of the stock of CFC1 and CFC2, the 
assets of CFC1 and CFC2 give rise to income that is taken into account 
for Country F tax purposes, and those assets are in a single class, as 
defined in Sec.  1.338-6(b). Assume that the absolute value of the basis 
difference with respect to any single RFA is greater than $20,000. At 
all relevant times, 1u equals $1. All amounts are stated in millions. 
The additional facts are summarized below.

----------------------------------------------------------------------------------------------------------------
                                                          Total U.S. basis
                Relevant foreign assets                     immediately      Total U.S. basis     Total basis
                                                               before       immediately after      difference
----------------------------------------------------------------------------------------------------------------
Assets of CFC1.........................................                48u                60u                12u
Assets of CFC2.........................................               100u                96u               (4)u
                                                        --------------------------------------------------------
    Total..............................................               148u               156u                 8u
----------------------------------------------------------------------------------------------------------------

    (ii) Result. (A) Under Sec.  1.901(m)-2(b)(1), USP's acquisitions of 
the stock of CFC1 and CFC2 are each a section 338 CAA. Under 1.901(m)-
1(a)(3), the two section 338 CAAs constitute an aggregated CAA 
transaction because the acquisitions occur as part of a plan. Under 
Sec.  1.901(m)-2(c)(1), the assets of CFC1 and CFC2 are RFAs for Country 
F tax purposes because they are relevant in determining foreign income 
of CFC1 and CFC 2, respectively, for Country F tax purposes. Under Sec.  
1.901(m)-1(a)(37), CFC1 is the RFA owner (U.S.) with respect to its 
assets, and CFC2 is the RFA owner (U.S.) with respect to its assets.
    (B) Under paragraph (b)(2) of this section, the application of the 
cumulative basis difference exemption is based on a single CAA and a 
single RFA owner (U.S.), subject to the requirements under paragraph (c) 
of this section that apply when there is an aggregated CAA transaction. 
In the case of the section 338 CAA with respect to CFC1, without regard 
to paragraph (c) of this section, the requirements of the cumulative 
basis difference exemption are satisfied if the sum of the basis 
differences is less than the threshold of $10 million, the greater of 
$10 million or $6 million (10% of the total U.S. basis of $60 million 
(60 million u translated into dollars at the exchange rate of $1 = 1u)). 
In this case, the sum of the basis differences is $12 million (12 
million u translated into dollars at the exchange rate of $1 = 1 u). 
Because the sum of the basis differences of $12 million is not less than 
the threshold of $10 million, the requirements of the cumulative basis 
difference exemption are not satisfied. Because the requirements of the 
cumulative basis difference exemption are not satisfied, without regard 
to paragraph (c) of this section, paragraph (c) of this section is not 
applicable. The RFA class exemption is not relevant because all of the 
RFAs of CFC1 are in a single class. Finally, because the absolute value 
with respect to each RFA is greater than $20,000, the RFA exemption does 
not apply. Accordingly, the

[[Page 819]]

basis differences with respect to all of the RFAs of CFC1 must be taken 
into account under section 901(m).
    (C) In the case of the section 338 CAA with respect to CFC2, without 
regard to paragraph (c) of this section, the requirements of the 
cumulative basis difference exemption are satisfied if the sum of the 
basis differences is less than the threshold of $10 million, the greater 
of $10 million or $ 9.6 million (10% of the total U.S. basis of $96 
million (96 million u translated into dollars at the exchange rate of $1 
= 1u)) In this case, the sum of the basis differences is ($4) million 
((4) million u translated into dollars at the exchange rate of $1 = 1 
u). Because the sum of the basis differences of ($4) million is less 
than the threshold of $10 million, the requirements of the cumulative 
basis difference exemption are satisfied. However, because the section 
338 CAA with respect to CFC2 is part of an aggregated CAA transaction 
that includes the section 338 CAA with respect to CFC1, paragraph (c) of 
this section is applicable. Under paragraph (c) of this section, the 
requirements of the cumulative basis difference exemption must also be 
satisfied taking into account all of the RFAs of both CFC2 and CFC1. In 
this case, the requirements of the cumulative basis difference exemption 
for purposes of paragraph (c) of this section are satisfied if the sum 
of the basis differences with respect to all of the RFAs of CFC2 and 
CFC1 is less than the threshold of $15.6 million, the greater of $10 
million or $15.6 million (10% of the total U.S. basis of $156 million 
(156 million u translated into dollars at the exchange rate of $1 = 
1u)). In this case, the sum of the basis differences is $8 million (8 
million u translated into dollars at the exchange rate of $1 = 1 u). 
Because the sum of the basis differences of $8 million is less than the 
threshold of $15.6 million, the requirements of the cumulative basis 
difference exemption are satisfied in the case of the section 338 CAA 
with respect to CFC2. Accordingly, none of the basis differences with 
respect to the RFAs of CFC2 are taken into account under section 901(m).
    (2) Example 2: De minimis; RFA Class Exemption--(i) Facts. USP, a 
domestic corporation, acquires all the stock of CFC, an applicable 
foreign corporation organized in Country F and treated as a corporation 
for Country F tax purposes, in a qualified stock purchase (as defined in 
section 338(d)(3)) to which section 338(a) applies. Country F imposes a 
single tax that is a foreign income tax. A foreign basis election is not 
made under Sec.  1.901(m)-4(c). Immediately after the acquisition of 
CFC, the assets of CFC give rise to income that is taken into account 
for Country F tax purposes. Assume that the absolute value of the basis 
difference with respect to any single RFA is greater than $20,000. At 
all relevant times, 1u equals $1. All amounts are stated in millions. 
The additional facts are summarized below.

----------------------------------------------------------------------------------------------------------------
                                                          Total U.S. basis
                Relevant foreign assets                     immediately      Total U.S. basis     Total basis
                                                               before       immediately after      difference
----------------------------------------------------------------------------------------------------------------
Cash (Class I).........................................                10u                10u                 0u
Inventory (Class IV)...................................                14u                15u                 1u
Buildings (Class V)....................................                19u                30u                11u
                                                        --------------------------------------------------------
    Total..............................................                43u                55u                12u
----------------------------------------------------------------------------------------------------------------

    (ii) Result. (A) Under Sec.  1.901(m)-2(b)(1), USP's acquisition of 
the stock of CFC is a section 338 CAA. Under Sec.  1.901(m)-2(c)(1), the 
assets of CFC are RFAs for Country F tax purposes because they are 
relevant in determining foreign income of CFC for Country F tax 
purposes.
    (B) Under paragraph (b)(2) of this section, the requirements of the 
cumulative basis difference exemption are satisfied if the sum of the 
basis differences is less than the threshold of $10 million, the greater 
of $10 million or $5.5 million (10% of the total U.S. basis of $55 
million (55 million u translated into dollars at the exchange rate of $1 
= 1u)). In this case, the sum of the

[[Page 820]]

basis differences is $12 million (12 million u translated into dollars 
at the exchange rate of $1 = 1 u). Because the sum of the basis 
differences of $12 million is not less than the threshold of $10 
million, the requirements of the cumulative basis difference exemption 
are not satisfied.
    (C) Under paragraph (b)(3) of this section, each of CFC's assets is 
allocated to its class under Sec.  1.338-6(b) for purposes of the RFA 
class exemption. The requirements of the RFA class exemption with 
respect to the Class IV RFAs (in this case, inventory) are satisfied if 
the absolute value of the sum of the basis differences with respect to 
the Class IV RFAs is less than the threshold of $2 million, the greater 
of $2 million or $1.5 million (10% of the total U.S. basis of Class IV 
RFAs of $15 million (15 million u translated into dollars at the 
exchange rate of $1 = 1u)). In this case, the absolute value of the sum 
of the basis differences is $1 million (1 million u translated into 
dollars at the exchange rate of $1 = 1 u). Because the sum of the basis 
differences of $1 million is less than the threshold of $2 million, the 
requirements of the RFA class exemption are satisfied. Accordingly, the 
basis differences with respect to the Class IV RFAs are not taken into 
account under section 901(m).
    (D) The requirements of the RFA class exemption with respect to the 
Class V RFAs (in this case, buildings) is satisfied if the absolute 
value of the sum of the basis differences with respect to the Class V 
RFAs is less than the threshold of $3 million, the greater of $2 million 
or $3 million (10% of the total U.S. basis of Class V RFAs of $30 
million (30 million u translated into dollars at the exchange rate of $1 
= 1u)). In this case, the absolute value of the sum of the basis 
differences is $11 million (11 million u translated into dollars at the 
exchange rate of $1 = 1 u). Because the sum of the basis differences of 
$11 million is not less than the threshold of $3 million, the 
requirements of the RFA class exemption are not satisfied. Finally, 
because the absolute value with respect to each RFA is greater than 
$20,000, the RFA exemption does not apply. Accordingly, the basis 
differences with respect to the Class V RFAs are taken into account 
under section 901(m).
    (E) The Class I RFAs (in this case, cash) are irrelevant because 
there are no basis differences with respect to those RFAs.
    (g) Applicability dates. This section applies to CAAs occurring on 
or after March 23, 2020. Taxpayers may, however, choose to apply this 
section before the date this section is applicable provided that they 
(along with any persons that are related (within the meaning of section 
267(b) or 707(b)) to the taxpayer)--
    (1) Consistently apply this section, Sec.  1.704-
1(b)(4)(viii)(c)(4)(v) through (vii), Sec.  1.901(m)-1, Sec. Sec.  
1.901(m)-3 through 1.901(m)-6 (excluding Sec.  1.901(m)-4(e)), and Sec.  
1.901(m)-8 to all CAAs occurring on or after January 1, 2011, and 
consistently apply Sec.  1.901(m)-2 (excluding Sec.  1.901(m)-2(d)) to 
all CAAs occurring on or after December 7, 2016, on any original or 
amended tax return for each taxable year for which the application of 
the provisions listed in this paragraph (g)(1) affects the tax liability 
and for which the statute of limitations does not preclude assessment or 
the filing of a claim for refund, as applicable;
    (2) File all tax returns described in paragraph (g)(1) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (3) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(g)(1) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16265, Mar. 23, 2020]



Sec.  1.901(m)-8  Miscellaneous.

    (a) In general. This section provides guidance on other matters 
under section 901(m). Paragraph (b) of this section provides guidance on 
the application of section 901(m) to pre-1987 foreign income taxes. 
Paragraph (c) of this section provides anti-abuse rules relating to 
built-in loss assets. Paragraph (d) of this section provides guidance on 
the interaction of section 901(m) and section 909. Paragraph (e) of this 
section provides applicability dates.

[[Page 821]]

    (b) Application of section 901(m) to pre-1987 foreign income taxes. 
Section 901(m) and Sec. Sec.  1.901(m)-1 through 1.901-8 apply to pre-
1987 foreign income taxes (as defined in Sec.  1.902-1(a)(10)(iii)) of 
an applicable foreign corporation.
    (c) Anti-abuse rule for built-in loss RFAs. A basis difference with 
respect to an RFA described in section 901(m)(3)(C)(ii) (built-in loss 
RFA) will not be taken into account for purposes of computing an 
allocated basis difference for a U.S. taxable year of a section 901(m) 
payor if any RFA, including an RFA other than built-in loss RFAs, is 
acquired with a principal purpose of using one or more built-in loss 
RFAs to avoid the application of section 901(m). Furthermore, a basis 
difference with respect to a built-in loss RFA will not be taken into 
account for purposes of the cumulative basis difference exemption or the 
RFA class exemption under Sec.  1.901(m)-7 if any RFAs, including RFAs 
other than built-in loss RFAs, are acquired with a principal purpose of 
avoiding the application of section 901(m).
    (d) Interaction with section 909. The amount of a foreign income tax 
that is disqualified under section 901(m) is determined before applying 
section 909. However, section 909 may apply to suspend a deduction for 
the amount of a foreign income tax that is disqualified under section 
901(m).
    (e) Applicability dates. This section applies to CAAs occurring on 
or after March 23, 2020. Taxpayers may, however, choose to apply this 
section before the date this section is applicable provided that they 
(along with any persons that are related (within the meaning of section 
267(b) or 707(b)) to the taxpayer)--
    (1) Consistently apply this section, Sec.  1.704-
1(b)(4)(viii)(c)(4)(v) through (vii), Sec.  1.901(m)-1, and Sec. Sec.  
1.901(m)-3 through 1.901(m)-7 (excluding Sec.  1.901(m)-4(e)) to all 
CAAs occurring on or after January 1, 2011, and consistently apply Sec.  
1.901(m)-2 (excluding Sec.  1.901(m)-2(d)) to all CAAs occurring on or 
after December 7, 2016, on any original or amended tax return for each 
taxable year for which the application of the provisions listed in this 
paragraph (e)(1) affects the tax liability and for which the statute of 
limitations does not preclude assessment or the filing of a claim for 
refund, as applicable;
    (2) File all tax returns described in paragraph (e)(1) of this 
section for any taxable year ending on or before March 23, 2020, no 
later than March 23, 2021; and
    (3) Make appropriate adjustments to take into account deficiencies 
that would have resulted from the consistent application under paragraph 
(e)(2) of this section for taxable years that are not open for 
assessment.

[T.D. 9895, 85 FR 16267, Mar. 23, 2020]



Sec.  1.902-0  Outline of regulations provisions for section 902.

    This section lists the provisions under section 902.

  Sec.  1.902-1 Credit for domestic corporate shareholder of a foreign 
  corporation for foreign income taxes paid by the foreign corporation.

    (a) Definitions and special effective date.
    (1) Domestic shareholder.
    (2) First-tier corporation.
    (3) Second-tier corporation.
    (4) Third- or lower-tier corporation.
    (i) Third-tier corporation.
    (ii) Fourth-, fifth-, or sixth-tier corporation.
    (5) Example.
    (6) Upper- and lower-tier corporations.
    (7) Foreign income taxes.
    (8) Post-1986 foreign income taxes.
    (i) In general.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986.
    (iii) Foreign income taxes paid or accrued with respect to high 
withholding tax interest.
    (9) Post-1986 undistributed earnings.
    (i) In general.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986.
    (iii) Reduction for foreign income taxes paid or accrued.
    (iv) Special allocations.
    (10) Pre-1987 accumulated profits.
    (i) Definition.
    (ii) Computation of pre-1987 accumulated profits.
    (iii) Foreign income taxes attributable to pre-1987 accumulated 
profits.
    (11) Dividend.
    (12) Dividend received.

[[Page 822]]

    (13) Special effective date.
    (i) Rule.
    (ii) Example.
    (b) Computation of foreign income taxes deemed paid by a domestic 
shareholder, first-tier corporation, or lower-tier corporation.
    (1) General rule.
    (2) Allocation rule for dividends attributable to post-1986 
undistributed earnings and pre-1987 accumulated profits.
    (i) Portion of dividend out of post-1986 undistributed earnings.
    (ii) Portion of dividend out of pre-1987 accumulated profits.
    (3) Dividends paid out of pre-1987 accumulated profits.
    (4) Deficits in accumulated earnings and profits.
    (5) Examples.
    (c) Special rules.
    (1) Separate computations required for dividends from each first-
tier and lower-tier corporation.
    (i) Rule.
    (ii) Example.
    (2) Section 78 gross-up.
    (i) Foreign income taxes deemed paid by a domestic shareholder.
    (ii) Foreign income taxes deemed paid by an upper-tier corporation.
    (iii) Example.
    (3) Creditable foreign income taxes.
    (4) Foreign mineral income.
    (5) Foreign taxes paid or accrued in connection with the purchase or 
sale of certain oil and gas.
    (6) Foreign oil and gas extraction income.
    (7) United States shareholders of controlled foreign corporations.
    (8) Effect of certain liquidations, reorganizations, or similar 
transactions on certain foreign taxes paid or accrued in taxable years 
beginning on or before August 5, 1997.
    (i) General rule.
    (ii) Example.
    (d) Dividends from controlled foreign corporations and noncontrolled 
section 902 corporations.
    (1) General rule.
    (2) Look-through.
    (i) Dividends.
    (ii) Coordination with section 960.
    (e) Information to be furnished.
    (f) Examples.
    (g) Effective date.

Sec.  1.902-2 Treatment of deficits in post-1986 undistributed earnings 
 and pre-1987 accumulated profits of a first- or lower-tier corporation 
 for purposes of computing an amount of foreign taxes deemed paid under 
                             Sec.  1.902-1.

    (a) Carryback of deficits in post-1986 undistributed earnings of a 
first- or lower-tier corporation to pre-effective date taxable years.
    (1) Rule.
    (2) Examples.
    (b) Carryforward of deficit in pre-1987 accumulated profits of a 
first- or lower-tier corporation to post-1986 undistributed earnings for 
purposes of section 902.
    (1) General rule.
    (2) Effect of pre-effective date deficit.
    (3) Examples.

  Sec.  1.902-3 Credit for domestic corporate shareholder of a foreign 
 corporation for foreign income taxes paid with respect to accumulated 
  profits of taxable years of the foreign corporation beginning before 
                            January 1, 1987.

    (a) Definitions.
    (1) Domestic shareholder.
    (2) First-tier corporation.
    (3) Second-tier corporation.
    (4) Third-tier corporation.
    (5) Foreign income taxes.
    (6) Dividend.
    (7) Dividend received.
    (b) Domestic shareholder owning stock in a first-tier corporation.
    (1) In general.
    (2) Amount of foreign taxes deemed paid by a domestic shareholder.
    (c) First-tier corporation owning stock in a second-tier 
corporation.
    (1) In general.
    (2) Amount of foreign taxes deemed paid by a first-tier corporation.
    (d) Second-tier corporation owning stock in a third-tier 
corporation.
    (1) In general.
    (2) Amount of foreign taxes deemed paid by a second-tier 
corporation.
    (e) Determination of accumulated profits of a foreign corporation.
    (f) Taxes paid on or with respect to accumulated profits of a 
foreign corporation.
    (g) Determination of earnings and profits of a foreign corporation.
    (1) Taxable year to which section 963 does not apply.
    (2) Taxable year to which section 963 applies.
    (3) Time and manner of making choice.
    (4) Determination by district director.
    (h) Source of income from first-tier corporation and country to 
which tax is deemed paid.
    (1) Source of income.
    (2) Country to which taxes deemed paid.
    (i) United Kingdom income taxes paid with respect to royalties.
    (j) Information to be furnished.
    (k) Illustrations.
    (l) Effective date.

   Sec.  1.902-4 Rules for distributions attributable to accumulated 
 profits for taxable years in which a first-tier corporation was a less 
                     developed country corporation.

    (a) In general.
    (b) Combined distributions.

[[Page 823]]

    (c) Distributions of a first-tier corporation attributable to 
certain distributions from second- or third-tier corporations.
    (d) Illustrations.

[T.D. 8708, 62 FR 927, Jan. 7, 1997, as amended by T.D. 9260, Apr. 25, 
2006]



Sec.  1.902-1  Credit for domestic corporate shareholder of a foreign 
corporation for foreign income taxes paid by the foreign corporation.

    (a) Definitions and special effective date. For purposes of section 
902, this section, and Sec.  1.902-2, the definitions provided in 
paragraphs (a)(1) through (12) of this section and the special effective 
date of paragraph (a)(13) of this section apply.
    (1) Domestic shareholder. In the case of dividends received by a 
domestic corporation from a foreign corporation after December 31, 1986, 
the term domestic shareholder means a domestic corporation, other than 
an S corporation as defined in section 1361(a), that owns at least 10 
percent of the voting stock of the foreign corporation at the time the 
domestic corporation receives a dividend from that foreign corporation.
    (2) First-tier corporation. In the case of dividends received by a 
domestic shareholder from a foreign corporation in a taxable year 
beginning after December 31, 1986, the term first-tier corporation means 
a foreign corporation, at least 10 percent of the voting stock of which 
is owned by a domestic shareholder at the time the domestic shareholder 
receives a dividend from that foreign corporation. The term first-tier 
corporation also includes a DISC or former DISC, but only with respect 
to dividends from the DISC or former DISC that are treated under 
sections 861(a)(2)(D) and 862(a)(2) as income from sources without the 
United States.
    (3) Second-tier corporation. In the case of dividends paid to a 
first-tier corporation by a foreign corporation in a taxable year 
beginning after December 31, 1986, the foreign corporation is a second-
tier corporation if, at the time a first-tier corporation receives a 
dividend from that foreign corporation, the first-tier corporation owns 
at least 10 percent of the foreign corporation's voting stock and the 
product of the following equals at least 5 percent--
    (i) The percentage of voting stock owned by the domestic shareholder 
in the first-tier corporation; multiplied by
    (ii) The percentage of voting stock owned by the first-tier 
corporation in the second-tier corporation.
    (4) Third- or lower-tier corporation.-- (i) Third-tier corporation. 
In the case of dividends paid to a second-tier corporation by a foreign 
corporation in a taxable year beginning after December 31, 1986, a 
foreign corporation is a third-tier corporation if, at the time a 
second-tier corporation receives a dividend from that foreign 
corporation, the second-tier corporation owns at least 10 percent of the 
foreign corporation's voting stock and the product of the following 
equals at least 5 percent--
    (A) The percentage of voting stock owned by the domestic shareholder 
in the first-tier corporation; multiplied by
    (B) The percentage of voting stock owned by the first-tier 
corporation in the second-tier corporation; multiplied by
    (C) The percentage of voting stock owned by the second-tier 
corporation in the third-tier corporation.
    (ii) Fourth-, fifth-, or sixth-tier corporation. In the case of 
dividends paid to a third-, fourth-, or fifth-tier corporation by a 
foreign corporation in a taxable year beginning after August 5, 1997, 
the foreign corporation is a fourth-, fifth-, or sixth-tier corporation, 
respectively, if at the time the dividend is paid, the corporation 
receiving the dividend owns at least 10 percent of the foreign 
corporation's voting stock, the chain of foreign corporations that 
includes the foreign corporation is connected through stock ownership of 
at least 10 percent of their voting stock, the domestic shareholder in 
the first-tier corporation in such chain indirectly owns at least 5 
percent of the voting stock of the foreign corporation through such 
chain, such corporation is a controlled foreign corporation (as defined 
in section 957) and the domestic shareholder is a United States 
shareholder (as defined in section 951(b)) in the foreign corporation. 
Taxes paid by a fourth-, fifth-, or sixth-tier corporation shall be 
taken into account in determining post-1986 foreign income taxes only if

[[Page 824]]

such taxes are paid with respect to taxable years beginning after August 
5, 1997, in which the corporation was a controlled foreign corporation.
    (5) Example. The following example illustrates the ownership 
requirements of paragraphs (a)(1) through (4) of this section:

    Example. (i) Domestic corporation M owns 30 percent of the voting 
stock of foreign corporation A on January 1, 1991, and for all periods 
thereafter. Corporation A owns 40 percent of the voting stock of foreign 
corporation B on January 1, 1991, and continues to own that stock until 
June 1, 1991, when Corporation A sells its stock in Corporation B. Both 
Corporation A and Corporation B use the calendar year as the taxable 
year. Corporation B pays a dividend out of its post-1986 undistributed 
earnings to Corporation A, which Corporation A receives on February 16, 
1991. Corporation A pays a dividend out of its post-1986 undistributed 
earnings to Corporation M, which Corporation M receives on January 20, 
1992. Corporation M uses a fiscal year ending on June 30 as the taxable 
year.
    (ii) On February 16, 1991, when Corporation B pays a dividend to 
Corporation A, Corporation M satisfies the 10 percent stock ownership 
requirement of paragraphs (a)(1) and (2) of this section with respect to 
Corporation A. Therefore, Corporation A is a first-tier corporation 
within the meaning of paragraph (a)(2) of this section and Corporation M 
is a domestic shareholder of Corporation A within the meaning of 
paragraph (a)(1) of this section. Also on February 16, 1991, Corporation 
B is a second-tier corporation within the meaning of paragraph (a)(3) of 
this section because Corporation A owns at least 10 percent of its 
voting stock, and the percentage of voting stock owned by Corporation M 
in Corporation A on February 16, 1991 (30 percent) multiplied by the 
percentage of voting stock owned by Corporation A in Corporation B on 
February 16, 1991 (40 percent) equals 12 percent. Corporation A shall be 
deemed to have paid foreign income taxes of Corporation B with respect 
to the dividend received from Corporation B on February 16, 1991.
    (iii) On January 20, 1992, Corporation M satisfies the 10-percent 
stock ownership requirement of paragraphs (a)(1) and (2) of this section 
with respect to Corporation A. Therefore, Corporation A is a first-tier 
corporation within the meaning of paragraph (a)(2) of this section and 
Corporation M is a domestic shareholder within the meaning of paragraph 
(a)(1) of this section. Accordingly, for its taxable year ending on June 
30, 1992, Corporation M is deemed to have paid a portion of the post-
1986 foreign income taxes paid, accrued, or deemed to be paid, by 
Corporation A. Those taxes will include taxes paid by Corporation B that 
were deemed paid by Corporation A with respect to the dividend paid by 
Corporation B to Corporation A on February 16, 1991, even though 
Corporation B is no longer a second-tier corporation with respect to 
Corporations A and M on January 20, 1992, and has not been a second-tier 
corporation with respect to Corporations A and M at any time during the 
taxable years of Corporations A and M that include January 20, 1992.

    (6) Upper- and lower-tier corporations. In the case of a sixth-tier 
corporation, the term upper-tier corporation means a first-, second-, 
third-, fourth-, or fifth-tier corporation. In the case of a fifth-tier 
corporation, the term upper-tier corporation means a first-, second-, 
third-, or fourth-tier corporation. In the case of a fourth-tier 
corporation, the term upper-tier corporation means a first-, second-, or 
third-tier corporation. In the case of a third-tier corporation, the 
term upper-tier corporation means a first- or second-tier corporation. 
In the case of a second-tier corporation, the term upper-tier 
corporation means a first-tier corporation. In the case of a first-tier 
corporation, the term lower-tier corporation means a second-, third-, 
fourth-, fifth-, or sixth-tier corporation. In the case of a second-tier 
corporation, the term lower-tier corporation means a third-, fourth-, 
fifth-, or sixth-tier corporation. In the case of a third-tier 
corporation, the term lower-tier corporation means a fourth-, fifth-, or 
sixth-tier corporation. In the case of a fourth-tier corporation, the 
term lower-tier corporation means a fifth- or sixth-tier corporation. In 
the case of a fifth-tier corporation, the term lower-tier corporation 
means a sixth-tier corporation.
    (7) Foreign income taxes. The term foreign income taxes means 
income, war profits, and excess profits taxes as defined in Sec.  1.901-
2(a), and taxes included in the term income, war profits, and excess 
profits taxes by reason of section 903, that are imposed by a foreign 
country or a possession of the United States, including any such taxes 
deemed paid by a foreign corporation under this section. Foreign income, 
war profits, and excess profits taxes shall not include amounts excluded 
from the definition of those taxes pursuant to section 901 and the 
regulations under that section. See section

[[Page 825]]

901(f) and (i) and paragraph (c)(5) of this section. Foreign income, war 
profits, and excess profits taxes also shall not include taxes for which 
a credit is disallowed under section 901 and the regulations under 
section 901. See section 901(j), (k), and (l), and paragraphs (c)(4) and 
(8) of this section.
    (8) Post-1986 foreign income taxes--(i) In general. Except as 
provided in paragraphs (a)(10) and (13) of this section, the term post-
1986 foreign income taxes of a foreign corporation means the sum of the 
foreign income taxes paid, accrued, or deemed paid in the taxable year 
of the foreign corporation in which it distributes a dividend plus the 
foreign income taxes paid, accrued, or deemed paid in the foreign 
corporation's prior taxable years beginning after December 31, 1986, to 
the extent the foreign taxes were not attributable to dividends 
distributed to, or earnings otherwise included (for example, under 
section 304, 367(b), 551, 951(a), 1248, or 1293) in the income of, a 
foreign or domestic shareholder in prior taxable years. Except as 
provided in paragraph (b)(4) of this section, foreign taxes paid or 
deemed paid by the foreign corporation on or with respect to earnings 
that were distributed or otherwise removed from post-1986 undistributed 
earnings in prior post-1986 taxable years shall be removed from post-
1986 foreign income taxes regardless of whether the shareholder is 
eligible to compute an amount of foreign taxes deemed paid under section 
902, and regardless of whether the shareholder in fact chose to credit 
foreign income taxes under section 901 for the year of the distribution 
or inclusion. Thus, if an amount is distributed or deemed distributed by 
a foreign corporation to a United States person that is not a domestic 
shareholder within the meaning of paragraph (a)(1) of this section (for 
example, an individual or a corporation that owns less than 10% of the 
foreign corporation's voting stock), or to a foreign person that does 
not meet the definition of an upper-tier corporation under paragraph 
(a)(6) of this section, then although no foreign income taxes shall be 
deemed paid under section 902, foreign income taxes attributable to the 
distribution or deemed distribution that would have been deemed paid had 
the shareholder met the ownership requirements of paragraphs (a)(1) 
through (4) of this section shall be removed from post-1986 foreign 
income taxes. Further, if a domestic shareholder chooses to deduct 
foreign taxes paid or accrued for the taxable year of the distribution 
or inclusion, it shall nonetheless be deemed to have paid a 
proportionate share of the foreign corporation's post-1986 foreign 
income taxes under section 902(a), and the foreign income taxes deemed 
paid must be removed from post-1986 foreign income taxes. In the case of 
a foreign corporation the foreign income taxes of which are determined 
based on an accounting period of less than one year, the term year means 
that accounting period. See sections 441(b)(3) and 443.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986. Post-1986 foreign 
income taxes shall include foreign income taxes that are deemed paid by 
an upper-tier corporation with respect to distributions from a lower-
tier corporation out of nonpreviously taxed pre-1987 accumulated 
profits, as defined in paragraph (a)(10) of this section, that are 
received by an upper-tier corporation in any taxable year of the upper-
tier corporation beginning after December 31, 1986, provided the upper-
tier corporation's earnings and profits in that year are included in its 
post-1986 undistributed earnings under paragraph (a)(9) of this section. 
Foreign income taxes deemed paid with respect to a distribution of pre-
1987 accumulated profits shall be translated from the functional 
currency of the lower-tier corporation into dollars at the spot exchange 
rate in effect on the date of the distribution. To determine the 
character of the earnings and profits and associated taxes for foreign 
tax credit limitation purposes, see section 904 and Sec.  1.904-7(a).
    (iii) Foreign income taxes paid or accrued with respect to high 
withholding tax interest. Post-1986 foreign income taxes shall not 
include foreign income

[[Page 826]]

taxes paid or accrued by a noncontrolled section 902 corporation (as 
defined in section 904(d)(2)(E)(i)) in a taxable year beginning on or 
before December 31, 2002 with respect to high withholding tax interest 
(as defined in section 904(d)(2)(B)) to the extent the foreign tax rate 
imposed on such interest exceeds 5 percent. See section 904(d)(2)(E)(ii) 
and Sec.  1.904-4(g)(2)(iii) (26 CFR revised as of April 1, 2006). The 
reduction in foreign income taxes paid or accrued by the amount of tax 
in excess of 5 percent imposed on high withholding tax interest income 
must be computed in functional currency before foreign income taxes are 
translated into U.S. dollars and included in post-1986 foreign income 
taxes.
    (9) Post-1986 undistributed earnings--(i) In general. Except as 
provided in paragraphs (a)(10) and (13) of this section, the term post-
1986 undistributed earnings means the amount of the earnings and profits 
of a foreign corporation (computed in accordance with sections 964(a) 
and 986) accumulated in taxable years of the foreign corporation 
beginning after December 31, 1986, determined as of the close of the 
taxable year of the foreign corporation in which it distributes a 
dividend. Post-1986 undistributed earnings shall not be reduced by 
reason of any earnings distributed or otherwise included in income, for 
example under section 304, 367(b), 551, 951(a), 1248 or 1293, during the 
taxable year. Post-1986 undistributed earnings shall be reduced to 
account for distributions or deemed distributions that reduced earnings 
and profits and inclusions that resulted in previously-taxed amounts 
described in section 959(c) (1) and (2) or section 1293(c) in prior 
taxable years beginning after December 31, 1986. Thus, post-1986 
undistributed earnings shall not be reduced to the extent of the ratable 
share of a controlled foreign corporation's subpart F income, as defined 
in section 952, attributable to a shareholder that is not a United 
States shareholder within the meaning of section 951(b) or section 
953(c)(1)(A), because that amount has not been included in a 
shareholder's gross income. Post-1986 undistributed earnings shall be 
reduced as provided herein regardless of whether any shareholder is 
deemed to have paid any foreign taxes, and regardless of whether any 
domestic shareholder chose to claim a foreign tax credit under section 
901(a) for the year of the distribution. For rules on carrybacks and 
carryforwards of deficits and their effect on post-1986 undistributed 
earnings, see Sec.  1.902-2. In the case of a foreign corporation the 
foreign income taxes of which are computed based on an accounting period 
of less than one year, the term year means that accounting period. See 
sections 441(b)(3) and 443.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986. Distributions by a 
lower-tier corporation out of non-previously taxed pre-1987 accumulated 
profits, as defined in paragraph (a)(10) of this section, that are 
received by an upper-tier corporation in any taxable year of the upper-
tier corporation beginning after December 31, 1986, shall be treated as 
post-1986 undistributed earnings of the upper-tier corporation, provided 
the upper-tier corporation's earnings and profits for that year are 
included in its post-1986 undistributed earnings under paragraph 
(a)(9)(i) of this section. To determine the character of the earnings 
and profits and associated taxes for foreign tax credit limitation 
purposes, see section 904 and Sec.  1.904-7(a).
    (iii) Reduction for foreign income taxes paid or accrued. In 
computing post-1986 undistributed earnings, earnings and profits shall 
be reduced by foreign income taxes paid or accrued regardless of whether 
the taxes are creditable. Thus, earnings and profits shall be reduced by 
foreign income taxes paid with respect to high withholding tax interest 
even though a portion of the taxes is not creditable pursuant to section 
904(d)(2)(E)(ii) and is not included in post-1986 foreign income taxes 
under paragraph (a)(8)(iii) of this section. Earnings and profits of an 
upper-tier corporation, however, shall not be reduced by foreign income 
taxes paid by a lower-tier corporation and deemed to have been paid by 
the upper-tier corporation.

[[Page 827]]

    (iv) Special allocations. The term post-1986 undistributed earnings 
means the total amount of the earnings of the corporation determined at 
the corporate level. Special allocations of earnings and taxes to 
particular shareholders, whether required or permitted by foreign law or 
a shareholder agreement, shall be disregarded. If, however, the 
Commissioner establishes that there is an agreement to pay dividends 
only out of earnings in the separate categories for passive or high 
withholding tax interest income, then only taxes imposed on passive or 
high withholding tax interest earnings shall be treated as related to 
the dividend. See Sec.  1.904-6(a)(2).
    (10) Pre-1987 accumulated profits--(i) Definition. The term pre-1987 
accumulated profits means the amount of the earnings and profits of a 
foreign corporation computed in accordance with section 902 and 
attributable to its taxable years beginning before January 1, 1987. If 
the special effective date of paragraph (a)(13) of this section applies, 
pre-1987 accumulated profits also includes any earnings and profits 
(computed in accordance with sections 964(a) and 986) attributable to 
the foreign corporation's taxable years beginning after December 31, 
1986, but before the first day of the first taxable year of the foreign 
corporation in which the ownership requirements of section 902(c)(3)(B) 
and paragraphs (a)(1) through (4) of this section are met with respect 
to that corporation.
    (ii) Computation of pre-1987 accumulated profits. Pre-1987 
accumulated profits must be computed under United States principles 
governing the computation of earnings and profits. Pre-1987 accumulated 
profits are determined at the corporate level. Special allocations of 
accumulated profits and taxes to particular shareholders with respect to 
distributions of pre-1987 accumulated profits in taxable years beginning 
after December 31, 1986, whether required or permitted by foreign law or 
a shareholder agreement, shall be disregarded. Pre-1987 accumulated 
profits of a particular year shall be reduced by amounts distributed 
from those accumulated profits or otherwise included in income from 
those accumulated profits, for example under sections 304, 367(b), 551, 
951(a), 1248 or 1293. If a deficit in post-1986 undistributed earnings 
is carried back to offset pre-1987 accumulated profits, pre-1987 
accumulated profits of a particular taxable year shall be reduced by the 
amount of the deficit carried back to that year. See Sec.  1.902-2. The 
amount of a distribution out of pre-1987 accumulated profits, and the 
amount of foreign income taxes deemed paid under section 902, shall be 
determined and translated into United States dollars by applying the law 
as in effect prior to the effective date of the Tax Reform Act of 1986. 
See Sec. Sec.  1.902-3, 1.902-4 and 1.964-1.
    (iii) Foreign income taxes attributable to pre-1987 accumulated 
profits. The term pre-1987 foreign income taxes means any foreign income 
taxes paid, accrued, or deemed paid by a foreign corporation on or with 
respect to its pre-1987 accumulated profits. Pre-1987 foreign income 
taxes of a particular year shall be reduced by the amount of taxes paid 
or deemed paid by the foreign corporation on or with respect to amounts 
distributed or otherwise included in income from pre-1987 accumulated 
profits of that year. Thus, pre-1987 foreign income taxes shall be 
reduced by the amount of taxes deemed paid by a domestic shareholder 
(regardless of whether the shareholder chose to credit foreign income 
taxes under section 901 for the year of the distribution or inclusion) 
or a first-tier or second-tier corporation, and by the amount of taxes 
that would have been deemed paid had any other shareholder been eligible 
to compute an amount of foreign taxes deemed paid under section 902. 
Foreign income taxes deemed paid with respect to a distribution of pre-
1987 accumulated profits shall be translated from the functional 
currency of the distributing corporation into United States dollars at 
the spot exchange rate in effect on the date of the distribution.
    (11) Dividend. For purposes of section 902, the definition of the 
term dividend in section 316 and the regulations under that section 
applies. Thus, for example, distributions and deemed distributions under 
sections 302, 304, 305(b) and 367(b) that are treated as dividends 
within the meaning of section 301(c)(1)

[[Page 828]]

also are dividends for purposes of section 902. In addition, the term 
dividend includes deemed dividends under sections 551 and 1248, but not 
deemed inclusions under sections 951(a) and 1293. For rules concerning 
excess distributions from section 1291 funds that are treated as 
dividends solely for foreign tax credit purposes, (see Regulation 
Project INTL-656-87 published in 1992-1 C.B. 1124; see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (12) Dividend received. A dividend shall be considered received for 
purposes of section 902 when the cash or other property is unqualifiedly 
made subject to the demands of the distributee. See Sec.  1.301-1(c). A 
dividend also is considered received for purposes of section 902 when it 
is deemed received under section 304, 367(b), 551, or 1248.
    (13) Special effective date--(i) Rule. If the first day on which the 
ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) 
through (4) of this section are met with respect to a foreign 
corporation, without regard to whether a dividend is distributed, is in 
a taxable year of the foreign corporation beginning after December 31, 
1986, then--
    (A) The post-1986 undistributed earnings and post-1986 foreign 
income taxes of the foreign corporation shall be determined by taking 
into account only taxable years beginning on and after the first day of 
the first taxable year of the foreign corporation in which the ownership 
requirements are met, including subsequent taxable years in which the 
ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) 
through (4) of this section are not met; and
    (B) Earnings and profits accumulated prior to the first day of the 
first taxable year of the foreign corporation in which the ownership 
requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) 
of this section are met shall be considered pre-1987 accumulated 
profits.
    (ii) Example. The following example illustrates the special 
effective date rules of this paragraph (a)(13):

    Example. As of December 31, 1991, and since its incorporation, 
foreign corporation A has owned 100 percent of the stock of foreign 
corporation B. Corporation B is not a controlled foreign corporation. 
Corporation B uses the calendar year as its taxable year, and its 
functional currency is the u. Assume 1u equals $1 at all relevant times. 
On April 1, 1992, Corporation B pays a 200u dividend to Corporation A 
and the ownership requirements of section 902(c)(3)(B) and paragraphs 
(a)(1) through (4) of this section are not met at that time. On July 1, 
1992, domestic corporation M purchases 10 percent of the Corporation B 
stock from Corporation A and, for the first time, Corporation B meets 
the ownership requirements of section 902(c)(3)(B) and paragraph (a)(2) 
of this section. Corporation M uses the calendar year as its taxable 
year. Corporation B does not distribute any dividends to Corporation M 
during 1992. For its taxable year ending December 31, 1992, Corporation 
B has 500u of earnings and profits (after foreign taxes but before 
taking into account the 200u distribution to Corporation A) and pays 
100u of foreign income taxes that is equal to $100. Pursuant to 
paragraph (a)(13)(i) of this section, Corporation B's post-1986 
undistributed earnings and post-1986 foreign income taxes will include 
earnings and profits and foreign income taxes attributable to 
Corporation B's entire 1992 taxable year and all taxable years 
thereafter. Thus, the April 1, 1992, dividend to Corporation A will 
reduce post-1986 undistributed earnings to 300u (500u-200u) under 
paragraph (a)(9)(i) of this section. The foreign income taxes 
attributable to the amount distributed as a dividend to Corporation A 
will not be creditable because Corporation A is not a domestic 
shareholder. Post-1986 foreign income taxes, however, will be reduced by 
the amount of foreign taxes attributable to the dividend. Thus, as of 
the beginning of 1993, Corporation B has $60 ($100-[$100 x 40% (200u/
500u)]) of post-1986 foreign income taxes. See paragraphs (a)(8)(i) and 
(b)(1) of this section.

    (b) Computation of foreign income taxes deemed paid by a domestic 
shareholder, first-tier corporation, or lower-tier corporation--(1) 
General rule. If a foreign corporation pays a dividend in any taxable 
year out of post-1986 undistributed earnings to a shareholder that is a 
domestic shareholder or an upper-tier corporation at the time it 
receives the dividend, the recipient shall be deemed to have paid the 
same proportion of any post-1986 foreign income taxes paid, accrued or 
deemed paid by the distributing corporation on or with respect to post-
1986 undistributed earnings which the amount of the dividend out of 
post-1986 undistributed earnings (determined without regard to the 
gross-up under section 78) bears to the

[[Page 829]]

amount of the distributing corporation's post-1986 undistributed 
earnings. An upper-tier corporation shall not be entitled to compute an 
amount of foreign taxes deemed paid on a dividend from a lower-tier 
corporation, however, unless the ownership requirements of paragraphs 
(a)(1) through (4) of this section are met at each tier at the time the 
upper-tier corporation receives the dividend. Foreign income taxes 
deemed paid by a domestic shareholder or an upper-tier corporation must 
be computed under the following formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.030

    (2) Allocation rule for dividends attributable to post-1986 
undistributed earnings and pre-1987 accumulated profits--(i) Portion of 
dividend out of post-1986 undistributed earnings. Dividends will be 
deemed to be paid first out of post-1986 undistributed earnings to the 
extent thereof. If dividends exceed post-1986 undistributed earnings and 
dividends are paid to more than one shareholder, then the dividend to 
each shareholder shall be deemed to be paid pro rata out of post-1986 
undistributed earnings, computed as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.031

    (ii) Portion of dividend out of pre-1987 accumulated profits. After 
the portion of the dividend attributable to post-1986 undistributed 
earnings is determined under paragraph (b)(2)(i) of this section, the 
remainder of the dividend received by a shareholder is attributable to 
pre-1987 accumulated profits to the extent thereof. That part of the 
dividend attributable to pre-1987 accumulated profits will be treated as 
paid first from the most recently accumulated earnings and profits. See 
Sec.  1.902-3. If dividends paid out of pre-1987 accumulated profits are 
attributable to more than one pre-1987 taxable year and are paid to more 
than one shareholder, then the dividend to each shareholder attributable 
to earnings and profits accumulated in a particular pre-1987 taxable 
year shall be deemed to be paid pro rata out of accumulated profits of 
that taxable year, computed as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.032


[[Page 830]]


    (3) Dividends paid out of pre-1987 accumulated profits. If dividends 
are paid by a first-tier corporation or a lower-tier corporation out of 
pre-1987 accumulated profits, the domestic shareholder or upper-tier 
corporation that receives the dividends shall be deemed to have paid 
foreign income taxes to the extent provided under section 902 and the 
regulations thereunder as in effect prior to the effective date of the 
Tax Reform Act of 1986. See paragraphs (a) (10) and (13) of this section 
and Sec. Sec.  1.902-3 and 1.902-4.
    (4) Deficits in accumulated earnings and profits. No foreign income 
taxes shall be deemed paid with respect to a distribution from a foreign 
corporation out of current earnings and profits that is treated as a 
dividend under section 316(a)(2), and post-1986 foreign income taxes 
shall not be reduced, if as of the end of the taxable year in which the 
dividend is paid or accrued, the corporation has zero or a deficit in 
post-1986 undistributed earnings and the sum of current plus accumulated 
earnings and profits is zero or less than zero. The dividend shall 
reduce post- 1986 undistributed earnings and accumulated earnings and 
profits.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. Domestic corporation M owns 100 percent of foreign 
corporation A. Both Corporation M and Corporation A use the calendar 
year as the taxable year, and Corporation A uses the u as its functional 
currency. Assume that 1u equals $1 at all relevant times. All of 
Corporation A's pre-1987 accumulated profits and post-1986 undistributed 
earnings are non-subpart F general limitation earnings and profits under 
section 904(d)(1)(I). As of December 31, 1992, Corporation A has 100u of 
post-1986 undistributed earnings and $40 of post-1986 foreign income 
taxes. For its 1986 taxable year, Corporation A has accumulated profits 
of 200u (net of foreign taxes) and paid 60u of foreign income taxes on 
those earnings. In 1992, Corporation A distributes 150u to Corporation 
M. Corporation A has 100u of post-1986 undistributed earnings and the 
dividend, therefore, is treated as paid out of post-1986 undistributed 
earnings to the extent of 100u. The first 100u distribution is from 
post-1986 undistributed earnings, and, because the distribution exhausts 
those earnings, Corporation M is deemed to have paid the entire amount 
of post-1986 foreign income taxes of Corporation A ($40). The remaining 
50u dividend is treated as a dividend out of 1986 accumulated profits 
under paragraph (b)(2) of this section. Corporation M is deemed to have 
paid $15 (60u x 50u/200u, translated at the appropriate exchange rates) 
of Corporation A's foreign income taxes for 1986. As of January 1, 1993, 
Corporation A's post-1986 undistributed earnings and post-1986 foreign 
income taxes are 0. Corporation A has 150u of accumulated profits and 
45u of foreign income taxes remaining in 1986.
    Example 2. Domestic corporation M (incorporated on January 1, 1987) 
owns 100 percent of foreign corporation A (incorporated on January 1, 
1987). Both Corporation M and Corporation A use the calendar year as the 
taxable year, and Corporation A uses the u as its functional currency. 
Assume that 1u equals $1 at all relevant times. Corporation A has no 
pre-1987 accumulated profits. All of Corporation A's post-1986 
undistributed earnings are non-subpart F general limitation earnings and 
profits under section 904(d)(1)(I). On January 1, 1992, Corporation A 
has a deficit in accumulated earnings and profits and a deficit in post-
1986 undistributed earnings of (200u). No foreign taxes have been paid 
with respect to post-1986 undistributed earnings. During 1992, 
Corporation A earns 100u (net of foreign taxes), pays $40 of foreign 
taxes on those earnings and distributes 50u to Corporation M. As of the 
end of 1992, Corporation A has a deficit of (100u) ((200u) post1986 
undistributed earnings + 100u current earnings and profits) in post-1986 
undistributed earnings. Corporation A, however, has current earnings and 
profits of 100u. Therefore, the 50u distribution is treated as a 
dividend in its entirety under section 316(a)(2). Under paragraph (b)(4) 
of this section, Corporation M is not deemed to have paid any of the 
foreign taxes paid by Corporation A because post-1986 undistributed 
earnings and the sum of current plus accumulated earnings and profits 
are (100u). The dividend reduces both post-1986 undistributed earnings 
and accumulated earnings and profits. Therefore, as of January 1, 1993, 
Corporation A's post-1986 undistributed earnings are (150u) and its 
accumulated earnings and profits are (150u). Corporation A's post-1986 
foreign income taxes at the start of 1993 are $40.

    (c) Special rules--(1) Separate computations required for dividends 
from each first-tier and lower-tier corporation--(i) Rule. If in a 
taxable year dividends are received by a domestic shareholder or an 
upper-tier corporation from two or more first-tier corporations or two 
or more lower-tier corporations, the foreign income taxes deemed paid by 
the domestic shareholder or the upper-tier corporation under sections 
902 (a) and (b) and paragraph (b) of this section

[[Page 831]]

shall be computed separately with respect to the dividends received from 
each first-tier corporation or lower-tier corporation. If a domestic 
shareholder receives dividend distributions from one or more first-tier 
corporations and in the same taxable year the first-tier corporation 
receives dividends from one or more lower-tier corporations, then the 
amount of foreign income taxes deemed paid shall be computed by starting 
with the lowest-tier corporation and working upward.
    (ii) Example. The following example illustrates the application of 
this paragraph (c)(1):

    Example. P, a domestic corporation, owns 40 percent of the voting 
stock of foreign corporation S. S owns 30 percent of the voting stock of 
foreign corporation T, and 30 percent of the voting stock of foreign 
corporation U. Neither S, T, nor U is a controlled foreign corporation. 
P, S, T and U all use the calendar year as their taxable year. In 1993, 
T and U both pay dividends to S and S pays a dividend to P. To compute 
foreign taxes deemed paid, paragraph (c)(1) of this section requires P 
to start with the lowest tier corporations and to compute foreign taxes 
deemed paid separately for dividends from each first-tier and lower-tier 
corporation. Thus, S first will compute foreign taxes deemed paid 
separately on its dividends from T and U. The deemed paid taxes will be 
added to S's post-1986 foreign income taxes, and the dividends will be 
added to S's post-1986 undistributed earnings. Next, P will compute 
foreign taxes deemed paid with respect to the dividend from S. This 
computation will take into account the taxes paid by T and U and deemed 
paid by S.

    (2) Section 78 gross-up--(i) Foreign income taxes deemed paid by a 
domestic shareholder. Except as provided in section 960(b) and the 
regulations under that section (relating to amounts excluded from gross 
income under section 959(b)), any foreign income taxes deemed paid by a 
domestic shareholder in any taxable year under section 902(a) and 
paragraph (b) of this section shall be included in the gross income of 
the domestic shareholder for the year as a dividend under section 78. 
Amounts included in gross income under section 78 shall, for purposes of 
section 904, be deemed to be derived from sources within the United 
States to the extent the earnings and profits on which the taxes were 
paid are treated under section 904(g) as United States source earnings 
and profits. Section 1.904-5(m)(6). Amounts included in gross income 
under section 78 shall be treated for purposes of section 904 as income 
in a separate category to the extent that the foreign income taxes were 
allocated and apportioned to income in that separate category. See 
section 904(d)(3)(G) and Sec.  1.904-6(b)(3).
    (ii) Foreign income taxes deemed paid by an upper-tier corporation. 
Foreign income taxes deemed paid by an upper-tier corporation on a 
distribution from a lower-tier corporation are not included in the 
earnings and profits of the upper-tier corporation. For purposes of 
section 904, foreign income taxes shall be allocated and apportioned to 
income in a separate category to the extent those taxes were allocated 
to the earnings and profits of the lower-tier corporation in that 
separate category. See section 904(d)(3)(G) and Sec.  1.904-6(b)(3). To 
the extent that section 904(g) treats the earnings of the lower-tier 
corporation on which those foreign income taxes were paid as United 
States source earnings and profits, the foreign income taxes deemed paid 
by the upper-tier corporation on the distribution from the lower-tier 
corporation shall be treated as attributable to United States source 
earnings and profits. See section 904(g) and Sec.  1.904-5(m)(6).
    (iii) Example. The following example illustrates the rules of this 
paragraph (c)(2):

    Example. P, a domestic corporation, owns 100 percent of the voting 
stock of controlled foreign corporation S. Corporations P and S use the 
calendar year as their taxable year, and S uses the u as its functional 
currency. Assume that 1u equals $1 at all relevant times. As of January 
1, 1992, S has -0- post-1986 undistributed earnings and -0- post-1986 
foreign income taxes. In 1992, S earns 150u of non-subpart F general 
limitation income net of foreign taxes and pays 60u of foreign income 
taxes. As of the end of 1992, but before dividend payments, S has 150u 
of post-1986 undistributed earnings and $60 of post-1986 foreign income 
taxes. Assume that 50u of S's earnings for 1992 are from United States 
sources. S pays P a dividend of 75u which P receives in 1992. Under 
Sec.  1.904-5(m)(4), one-third of the dividend, or 25u (75u x 50u/150u), 
is United States source income to P. P computes foreign taxes deemed 
paid on the dividend under paragraph (b)(1) of this section of $30 ($60 
x 50%[75u/150u]) and includes that

[[Page 832]]

amount in gross income under section 78 as a dividend. Because 25u of 
the 75u dividend is United States source income to P, $10 ($30 x 
33.33%[25u/75u]) of the section 78 dividend will be treated as United 
States source income to P under this paragraph (c)(2).

    (3) Creditable foreign income taxes. The amount of creditable 
foreign income taxes under section 901 shall include, subject to the 
limitations and conditions of sections 902 and 904, foreign income taxes 
actually paid and deemed paid by a domestic shareholder that receives a 
dividend from a first-tier corporation. Foreign income taxes deemed paid 
by a domestic shareholder under paragraph (b) of this section shall be 
deemed paid by the domestic shareholder only for purposes of computing 
the foreign tax credit allowed under section 901.
    (4) Foreign mineral income. Certain foreign income, war profits and 
excess profits taxes paid or accrued with respect to foreign mineral 
income will not be considered foreign income taxes for purposes of 
section 902. See section 901(e) and Sec.  1.901-3.
    (5) Foreign taxes paid or accrued in connection with the purchase or 
sale of certain oil and gas. Certain income, war profits, or excess 
profits taxes paid or accrued to a foreign country in connection with 
the purchase and sale of oil or gas extracted in that country will not 
be considered foreign income taxes for purposes of section 902. See 
section 901(f).
    (6) Foreign oil and gas extraction income. For rules relating to 
reduction of the amount of foreign income taxes deemed paid with respect 
to foreign oil and gas extraction income, see section 907(a) and the 
regulations under that section.
    (7) United States shareholders of controlled foreign corporations. 
See paragraph (d) of this section and sections 960 and 962 and the 
regulations under those sections for special rules relating to the 
application of section 902 in computing foreign income taxes deemed paid 
by United States shareholders of controlled foreign corporations.
    (8) Effect of certain liquidations, reorganizations, or similar 
transactions on certain foreign taxes paid or accrued in taxable years 
beginning on or before August 5, 1997--(i) General rule. Notwithstanding 
the effect of any liquidation, reorganization, or similar transaction, 
foreign taxes paid or accrued by a member of a qualified group (as 
defined in section 902(b)(2)) shall not be eligible to be deemed paid if 
they were paid or accrued in a taxable year beginning on or before 
August 5, 1997, by a corporation that was a fourth-, fifth- or sixth-
tier corporation with respect to the taxpayer on the first day of the 
corporation's first taxable year beginning after August 5, 1997.
    (ii) Example. The following examples illustrate the application of 
this paragraph (c)(8):

    Example. P, a domestic corporation, has owned 100 percent of the 
voting stock of foreign corporation S at all times since January 1, 
1987. Until June 30, 2002, S owned 100 percent of the voting stock of 
foreign corporation T, T owned 100 percent of the voting stock of 
foreign corporation U, and U owned 100 percent of the voting stock of 
foreign corporation V. P, S, T, U, and V each use the calendar year as 
their U.S. taxable year. Thus, beginning in 1998 V was a fourth-tier 
controlled foreign corporation, and its foreign taxes paid or accrued in 
1998 and later taxable years were eligible to be deemed paid. On June 
30, 2002, T was liquidated, causing S to acquire 100 percent of the 
stock of U. As a result, V became a third-tier controlled foreign 
corporation. In 2003, V paid a dividend to U. Under paragraph (c)(8) of 
this section, foreign taxes paid by V in taxable years beginning before 
1998 are not taken into account in computing the foreign taxes deemed 
paid with respect to the dividend paid by V to U.

    (d) Dividends from controlled foreign corporations and noncontrolled 
section 902 corporations--(1) General rule. If a dividend is described 
in paragraphs (d)(1)(i) through (iv) of this section, the following 
rules apply. If a dividend is paid out of post-1986 undistributed 
earnings or pre-1987 accumulated profits of a foreign corporation 
attributable to more than one separate category, the amount of foreign 
income taxes deemed paid by the domestic shareholder or the upper-tier 
corporation under section 902 and paragraph (b) of this section shall be 
computed separately with respect to the post-1986 undistributed earnings 
or pre-1987 accumulated profits in each separate category out of which 
the dividend is paid. See Sec.  1.904-5(c)(4) and (i), and paragraph

[[Page 833]]

(d)(2) of this section. The separately computed deemed-paid taxes shall 
be added to other taxes paid by the domestic shareholder or upper-tier 
corporation with respect to income in the appropriate separate category. 
The rules of this paragraph (d)(1) apply to dividends received by --
    (i) A domestic shareholder that is a United States shareholder (as 
defined in section 951(b) or section 953(c)) from a first-tier 
corporation that is a controlled foreign corporation;
    (ii) A domestic shareholder from a first-tier corporation that is a 
noncontrolled section 902 corporation;
    (iii) An upper-tier controlled foreign corporation from a lower-tier 
controlled foreign corporation if the corporations are related look-
through entities within the meaning of Sec.  1.904-5(i) (see Sec.  
1.904-5(i)(3)); or
    (iv) A foreign corporation that is eligible to compute an amount of 
foreign taxes deemed paid under section 902(b)(1), from a controlled 
foreign corporation or a noncontrolled section 902 corporation (that is, 
both the payor and payee corporations are members of the same qualified 
group as defined in section 902(b)(2) (see Sec.  1.904-5 (i)(4)).
    (2) Look-through--(i) Dividends. Any dividend distribution by a 
controlled foreign corporation or noncontrolled section 902 corporation 
to a domestic shareholder or a foreign corporation that is eligible to 
compute an amount of foreign taxes deemed paid under section 902(b)(1) 
shall be deemed paid pro rata out of each separate category of income. 
Any dividend distribution by a controlled foreign corporation to a 
controlled foreign corporation that is a related look-through entity 
within the meaning of Sec.  1.904-5(i)(3) shall also be deemed to be 
paid pro rata out of each separate category of income. See Sec. Sec.  
1.904-5(c)(4) and (i), and 1.904-7. The portion of the foreign income 
taxes attributable to a particular separate category that shall be 
deemed paid by the domestic shareholder or upper-tier corporation must 
be computed under the following formula:
[GRAPHIC] [TIFF OMITTED] TR11JN09.004

    (ii) Coordination with section 960. For rules coordinating the 
computation of foreign taxes deemed paid with respect to amounts 
included in gross income under section 951(a) and dividends distributed 
by a controlled foreign corporation, see section 960 and the regulations 
under that section.
    (e) Information to be furnished. If the credit for foreign income 
taxes claimed under section 901 includes foreign income taxes deemed 
paid under section 902 and paragraph (b) of this section, the domestic 
shareholder must furnish the same information with respect to the 
foreign income taxes deemed paid as it is required to furnish with 
respect to the foreign income taxes it directly paid or accrued and for 
which the credit is claimed. See Sec.  1.905-2. For other information 
required to be furnished by the domestic shareholder for the annual 
accounting period of certain foreign corporations ending with or within 
the shareholder's taxable year, and for reduction in the amount of 
foreign income taxes paid, accrued, or deemed paid for failure to 
furnish the required information, see section 6038 and the regulations 
under that section.
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. Since 1987, domestic corporation M has owned 10 percent 
of the one class of stock of foreign corporation A. The remaining 90 
percent of Corporation A's stock is owned by Z, a foreign corporation. 
Corporation A is not a controlled foreign corporation. Corporation A 
uses the u as its functional currency, and 1u equals $1 at all relevant 
times. Both Corporation A and Corporation M use the calendar year as the 
taxable year. In 1992, Corporation A pays a 30u dividend out of post-
1986 undistributed earnings, 3u to Corporation M and 27u to Corporation 
Z. Corporation M is deemed, under

[[Page 834]]

paragraph (b) of this section, to have paid a portion of the post-1986 
foreign income taxes paid by Corporation A and includes the amount of 
foreign taxes deemed paid in gross income under section 78 as a 
dividend. Both the foreign taxes deemed paid and the dividend would be 
subject to a separate limitation for dividends from Corporation A, a 
noncontrolled section 902 corporation. Under paragraph (a)(9)(i) of this 
section, Corporation A must reduce its post-1986 undistributed earnings 
as of January 1, 1993, by the total amount of dividends paid to 
Corporation M and Corporation Z in 1992. Under paragraph (a)(8)(i) of 
this section, Corporation A must reduce its post-1986 foreign income 
taxes as of January 1, 1993, by the amount of foreign income taxes that 
were deemed paid by Corporation M and by the amount of foreign income 
taxes that would have been deemed paid by Corporation Z had Corporation 
Z been eligible to compute an amount of foreign income taxes deemed paid 
with respect to the dividend received from Corporation A. Foreign income 
taxes deemed paid by Corporation M and Corporation A's opening balances 
in post-1986 undistributed earnings and post-1986 foreign income taxes 
for 1993 are computed as follows:

1. Assumed post-1986 undistributed earnings of     25u
 Corporation A at start of 1992.
2. Assumed post-1986 foreign income taxes of       $25
 Corporation A at start of 1992.
3. Assumed pre-tax earnings and profits of         50u
 Corporation A for 1992.
4. Assumed foreign income taxes paid or accrued    15u
 by Corporation A in 1992.
5. Post-1986 undistributed earnings in             60u
 Corporation A for 1992 (pre-dividend) (Line 1
 plus Line 3 minus Line 4).
6. Post-1986 foreign income taxes in Corporation   $40
 A for 1992 (pre-dividend) (Line 2 plus Line 4
 translated at the appropriate exchange rates).
7. Dividends paid out of post-1986 undistributed   3u
 earnings of Corporation A to Corporation M in
 1992.
8. Percentage of Corporation A's post-1986         5%
 undistributed earnings paid to Corporation M
 (Line 7 divided by Line 5).
9. Foreign income taxes of Corporation A deemed    $2
 paid by Corporation M under section 902(a) (Line
 6 multiplied by Line 8).
10. Total dividends paid out of post-1986          30u
 undistributed earnings of Corporation A to all
 shareholders in 1992.
11. Percentage of Corporation A's post-1986        50%
 undistributed earnings paid to all shareholders
 in 1992 (Line 10 divided by Line 5).
12. Post-1986 foreign income taxes paid with       $20
 respect to post-1986 undistributed earnings
 distributed to all shareholders in 1992 (Line 6
 multiplied by Line 11).
13. Corporation A's post-1986 undistributed        30u
 earnings at the start of 1993 (Line 5 minus Line
 10).
14. Corporation A's post-1986 foreign income       $20
 taxes at the start of 1993 (Line 6 minus Line
 12).
 

    Example 2. (i) The facts are the same as in Example 1, except that 
Corporation M has also owned 10 percent of the one class of stock of 
foreign corporation B since 1987. Corporation B uses the calendar year 
as the taxable year. The remaining 90 percent of Corporation B's stock 
is owned by Corporation Z. Corporation B is not a controlled foreign 
corporation. Corporation B uses the u as its functional currency, and 1u 
equals $1 at all relevant times. In 1992, Corporation B has earnings and 
profits and pays foreign income taxes, a portion of which are 
attributable to high withholding tax interest, as defined in section 
904(d)(2)(B)(i). Corporation B must reduce its pool of post-1986 foreign 
income taxes by the amount of tax imposed on high withholding tax 
interest in excess of 5 percent because that amount is not treated as a 
tax for purposes of section 902. See section 904(d)(2)(E)(ii) and 
paragraph (a)(8)(iii) of this section. Corporation B pays 50u in 
dividends in 1992, 5u to Corporation M and 45u to Corporation Z. 
Corporation M must compute its section 902(a) deemed paid taxes 
separately for the dividends it receives in 1992 from Corporation A (as 
computed in Example 1) and from Corporation B. Foreign income taxes of 
Corporation B deemed paid by Corporation M, and Corporation B's opening 
balances in post-1986 undistributed earnings and post-1986 foreign 
income taxes for 1993 are computed as follows:

1. Assumed post-1986 undistributed earnings of     (100u)
 Corporation B at start of 1992.
2. Assumed post-1986 foreign income taxes of       $0
 Corporation B at start of 1992.
3. Assumed pre-tax earnings and profits of         302.50u
 Corporation B for 1992 (including 50u of high
 withholding tax interest on which 5u of tax is
 withheld).
4. Assumed foreign income taxes paid or accrued    102.50u
 by Corporation B in 1992.
5. Post-1986 undistributed earnings in             100u
 Corporation B for 1992 (pre-dividend) (Line 1
 plus Line 3 minus Line 4).
6. Amount of foreign income tax of Corporation B   2.50u
 imposed on high withholding tax interest in
 excess of 5% (5u withholding tax--[5% x 50u high
 withholding tax interest]).
7. Post-1986 foreign income taxes in Corporation   $100
 B for 1992 (pre-dividend) (Line 2 plus [Line 4
 minus Line 6 translated at the appropriate
 exchange rate]).
8. Dividends paid out of post-1986 undistributed   5u
 earnings to Corporation M in 1992.
9. Percentage of Corporation B's post-1986         5%
 undistributed earnings paid to Corporation M
 (Line 8 divided by Line 5).
10. Foreign income taxes of Corporation B deemed   $5
 paid by Corporation M under section 902(a) (Line
 7 multiplied by Line 9).
11. Total dividends paid out of post-1986          50u
 undistributed earnings of Corporation B to all
 shareholders in 1992.

[[Page 835]]

 
12. Percentage of Corporation B's post-1986        50%
 undistributed earnings paid to all shareholders
 in 1992 (Line 11 divided by Line 5).
13. Post-1986 foreign income taxes of Corporation  $50
 B paid on or with respect to post-1986
 undistributed earnings distributed to all
 shareholders in 1992 (Line 7 multiplied by Line
 12).
14. Corporation B's post-1986 undistributed        50u
 earnings at start of 1993 (Line 5 minus Line 11).
15. Corporation B's post-1986 foreign income       $50
 taxes at start of 1993 (Line 7 minus Line 13).
 

    (ii) For 1992, as computed in Example 1, Corporation M is deemed to 
have paid $2 of the post-1986 foreign income taxes paid by Corporation A 
and includes $2 in gross income as a dividend under section 78. Both the 
income inclusion and the credit are subject to a separate limitation for 
dividends from Corporation A, a noncontrolled section 902 corporation. 
Corporation M also is deemed to have paid $5 of the post-1986 foreign 
income taxes paid by Corporation B and includes $5 in gross income as a 
deemed dividend under section 78. Both the income inclusion and the 
foreign taxes deemed paid are subject to a separate limitation for 
dividends from Corporation B, a noncontrolled section 902 corporation.
    Example 3. (i) Since 1987, domestic corporation M has owned 50 
percent of the one class of stock of foreign corporation A. The 
remaining 50 percent of Corporation A is owned by foreign corporation Z. 
For the same time period, Corporation A has owned 40 percent of the one 
class of stock of foreign corporation B, and Corporation B has owned 30 
percent of the one class of stock of foreign corporation C. The 
remaining 60 percent of Corporation B is owned by foreign corporation Y, 
and the remaining 70 percent of Corporation C is owned by foreign 
corporation X. Corporations A, B, and C are not controlled foreign 
corporations. Corporations A, B, and C use the u as their functional 
currency, and 1u equals $1 at all relevant times. Corporation B uses a 
fiscal year ending June 30 as its taxable year; all other corporations 
use the calendar year as the taxable year. On February 1, 1992, 
Corporation C pays a 500u dividend out of post-1986 undistributed 
earnings, 150u to Corporation B and 350u to Corporation X. On February 
15, 1992, Corporation B pays a 300u dividend out of post-1986 
undistributed earnings computed as of the close of Corporation B's 
fiscal year ended June 30, 1992, 120u to Corporation A and 180u to 
Corporation Y. On August 15, 1992, Corporation A pays a 200u dividend 
out of post-1986 undistributed earnings, 100u to Corporation M and 100u 
to Corporation Z. In computing foreign taxes deemed paid by Corporations 
B and A, section 78 does not apply and Corporations B and A thus do not 
have to include the foreign taxes deemed paid in earnings and profits. 
See paragraph (c)(2)(ii) of this section. Foreign income taxes deemed 
paid by Corporations B, A and M, and the foreign corporations' opening 
balances in post-1986 undistributed earnings and post-1986 foreign 
income taxes for Corporation B's fiscal year beginning July 1, 1992, and 
Corporation C's and Corporation A's 1993 calendar years are computed as 
follows:

A. Corporation C (third-tier corporation):
    1. Assumed post-1986 undistributed earnings    1300u
     in Corporation C at start of 1992.
    2. Assumed post-1986 foreign income taxes in   $500
     Corporation C at start of 1992.
    3. Assumed pre-tax earnings and profits of     500u
     Corporation C for 1992.
    4. Assumed foreign income taxes paid or        300u
     accrued in 1992.
    5. Post-1986 undistributed earnings in         1500u
     Corporation C for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    6. Post-1986 foreign income taxes in           $800
     Corporation C for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates).
    7. Dividends paid out of post-1986             150u
     undistributed earnings of Corporation C to
     Corporation B in 1992.
    8. Percentage of Corporation C's post-1986     10%
     undistributed earnings paid to Corporation B
     (Line 7 divided by Line 5).
    9. Foreign income taxes of Corporation C       $80
     deemed paid by Corporation B under section
     902(b)(2) (Line 6 multiplied by Line 8).
    10. Total dividends paid out of post-1986      500u
     undistributed earnings of Corporation C to
     all shareholders in 1992.
    11. Percentage of Corporation C's post-1986    33.33%
     undistributed earnings paid to all
     shareholders in 1992 (Line 10 divided by
     Line 5).
    12. Post-1986 foreign income taxes paid with   $266.66
     respect to post-1986 undistributed earnings
     distributed to all shareholders in 1992
     (Line 6 multiplied by Line 11).
    13. Post-1986 undistributed earnings in        1000u
     Corporation C at start of 1993 (Line 5 minus
     Line 10).
    14. Post-1986 foreign income taxes in          $533.34
     Corporation C at start of 1993 (Line 6 minus
     Line 12).
B. Corporation B (second-tier corporation):
    1. Assumed post-1986 undistributed earnings    0
     in Corporation B as of July 1, 1991.
    2. Assumed post-1986 foreign income taxes in   0
     Corporation B as of July 1, 1991.
    3. Assumed pre-tax earnings and profits of     1000u
     Corporation B for fiscal year ended June 30,
     1992, (including 150u dividend from
     Corporation B).
    4. Assumed foreign income taxes paid or        200u
     accrued by Corporation B in fiscal year
     ended June 30, 1992.
    5. Foreign income taxes of Corporation C       $80
     deemed paid by Corporation B in its fiscal
     year ended June 30, 1992 (Part A, Line 9 of
     paragraph (i) of this Example 3).

[[Page 836]]

 
    6. Post-1986 undistributed earnings in         800u
     Corporation B for fiscal year ended June 30,
     1992 (pre-dividend) (Line 1 plus Line 3
     minus Line 4).
    7. Post-1986 foreign income taxes in           $280
     Corporation B for fiscal year ended June 30,
     1992 (pre-dividend) (Line 2 plus Line 4
     translated at the appropriate exchange rates
     plus Line 5).
    8. Dividends paid out of post-1986             120u
     undistributed earnings of Corporation B to
     Corporation A on February 15, 1992.
    9. Percentage of Corporation B's post-1986     15%
     undistributed earnings for fiscal year ended
     June 30, 1992, paid to Corporation A (Line 8
     divided by Line 6).
    10. Foreign income taxes paid and deemed paid  $42
     by Corporation B as of June 30, 1992, deemed
     paid by Corporation A under section
     902(b)(1) (Line 7 multiplied by Line 9).
    11. Total dividends paid out of post-1986      300u
     undistributed earnings of Corporation B for
     fiscal year ended June 30, 1992.
    12. Percentage of Corporation B's post-1986    37.5%
     undistributed earnings for fiscal year ended
     June 30, 1992, paid to all shareholders
     (Line 11 divided by Line 6).
    13. Post-1986 foreign income taxes paid and    $105
     deemed paid with respect to post-1986
     undistributed earnings distributed to all
     shareholders during Corporation B's fiscal
     year ended June 30, 1992 (Line 7 multiplied
     by Line 12).
    14. Post-1986 undistributed earnings in        500u
     Corporation B as of July 1, 1992 (Line 6
     minus Line 11).
    15. Post-1986 foreign income taxes in          $175
     Corporation B as of July 1, 1992 (Line 7
     minus Line 13).
C. Corporation A (first-tier corporation):
    1. Assumed post-1986 undistributed earnings    250u
     in Corporation A at start of 1992.
    2. Assumed post-1986 foreign income taxes in   $100
     Corporation A at start of 1992.
    3. Assumed pre-tax earnings and profits of     250u
     Corporation A for 1992 (including 120u
     dividend from Corporation B).
    4. Assumed foreign income taxes paid or        100u
     accrued by Corporation A in 1992.
    5. Foreign income taxes paid or deemed paid    $42
     by Corporation B as of June 30, 1992, that
     are deemed paid by Corporation A in 1992
     (Part B, Line 10 of paragraph (i) of this
     Example 3).
    6. Post-1986 undistributed earnings in         400u
     Corporation A for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    7. Post-1986 foreign income taxes in           $242
     Corporation A for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates plus Line 5).
    8. Dividends paid out of post-1986             100u
     undistributed earnings of Corporation A to
     Corporation M on August 15, 1992.
    9. Percentage of Corporation A's post-1986     25%
     undistributed earnings paid to Corporation M
     in 1992 (Line 8 divided by Line 6).
    10. Foreign income taxes paid and deemed paid  $60.50
     by Corporation A in 1992 that are deemed
     paid by Corporation M under section 902(a)
     (Line 7 multiplied by Line 9).
    11. Total dividends paid out of post-1986      200u
     undistributed earnings of Corporation A to
     all shareholders in 1992.
    12. Percentage of Corporation A's post-1986    50%
     undistributed earnings paid to all
     shareholders in 1992 (Line 11 divided by
     Line 6).
    13. Post-1986 foreign income taxes paid and    $121
     deemed paid by Corporation A with respect to
     post-1986 undistributed earnings distributed
     to all shareholders in 1992 (Line 7
     multiplied by Line 12).
    14. Post-1986 undistributed earnings in        200u
     Corporation A at start of 1993 (Line 6 minus
     Line 11).
    15. Post-1986 foreign income taxes in          $121
     Corporation A at start of 1993 (Line 7 minus
     Line 13).
 

    (ii) Corporation M is deemed, under section 902(a) and paragraph (b) 
of this section, to have paid $60.50 of post-1986 foreign income taxes 
paid, or deemed paid, by Corporation A on or with respect to its post-
1986 undistributed earnings (Part C, Line 10) and Corporation M includes 
that amount in gross income as a dividend under section 78. Both the 
income inclusion and the credit are subject to a separate limitation for 
dividends from Corporation A, a noncontrolled section 902 corporation.
    Example 4. (i) Since 1987, domestic corporation M has owned 100 
percent of the voting stock of controlled foreign corporation A, and 
Corporation A has owned 100 percent of the voting stock of controlled 
foreign corporation B. Corporations M, A and B use the calendar year as 
the taxable year. Corporations A and B are organized in the same foreign 
country and use the u as their functional currency. 1u equals $1 at all 
relevant times. Assume that all of the earnings of Corporations A and B 
are general limitation earnings and profits within the meaning of 
section 904(d)(2)(I), and that neither Corporation A nor Corporation B 
has any previously taxed income accounts. In 1992, Corporation B pays a 
dividend of 150u to Corporation A out of post-1986 undistributed 
earnings, and Corporation A computes an amount of foreign taxes deemed 
paid under section 902(b)(1). The dividend is not subpart F income to 
Corporation A because section 954(c)(3)(B)(i) (the same country dividend 
exception) applies. Pursuant to paragraph (c)(2)(ii) of this section, 
Corporation A is not required to include the deemed paid taxes in 
earnings and profits. Corporation A has no pre-1987 accumulated profits 
and a deficit in post-1986 undistributed earnings for 1992. In 1992, 
Corporation A pays a dividend of 100u to Corporation M out of its 
earnings and profits for 1992 (current earnings and profits). Under 
paragraph (b)(4) of this section, Corporation M is not deemed to have 
paid any of the foreign income taxes paid or deemed paid by Corporation 
A because Corporation A has a deficit in post-1986 undistributed 
earnings as

[[Page 837]]

of December 31, 1992, and the sum of its current plus accumulated 
profits is less than zero. Note that if instead of paying a dividend to 
Corporation A in 1992, Corporation B had made an additional investment 
of $150 in United States property under section 956, that amount would 
have been included in gross income by Corporation M under section 
951(a)(1)(B) and Corporation M would have been deemed to have paid $50 
of foreign income taxes paid by Corporation B. See sections 951(a)(1)(B) 
and 960. Foreign income taxes of Corporation B deemed paid by 
Corporation A and the opening balances in post-1986 undistributed 
earnings and post-1986 foreign income taxes for Corporation A and 
Corporation B for 1993 are computed as follows:

A. Corporation B (second-tier corporation):
    1. Assumed post-1986 undistributed earnings    200u
     in Corporation B at start of 1992.
    2. Assumed post-1986 foreign income taxes in   $50
     Corporation B at start of 1992.
    3. Assumed pre-tax earnings and profits of     150u
     Corporation B for 1992.
    4. Assumed foreign income taxes paid or        50u
     accrued in 1992.
    5. Post-1986 undistributed earnings in         300u
     Corporation B for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    6. Post-1986 foreign income taxes in           $100
     Corporation B for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates).
    7. Dividends paid out of post-1986             150u
     undistributed earnings of Corporation B to
     Corporation A in 1992.
    8. Percentage of Corporation B's post-1986     50%
     undistributed earnings paid to Corporation A
     (Line 7 divided by Line 5).
    9. Foreign income taxes of Corporation B       $50
     deemed paid by Corporation A under section
     902(b)(1) (Line 6 multiplied by Line 8).
    10. Post-1986 undistributed earnings in        150u
     Corporation B at start of 1993 (Line 5 minus
     Line 7).
    11. Post-1986 foreign income taxes in          $50
     Corporation B at start of 1993 (Line 6 minus
     Line 9).
B. Corporation A (first-tier corporation):
    1. Assumed post-1986 undistributed earnings    (200u)
     in Corporation A at start of 1992.
    2. Assumed post-1986 foreign income taxes in   0
     Corporation A at start of 1992.
    3. Assumed pre-tax earnings and profits of     200u
     Corporation A for 1992 (including 150u
     dividend from Corporation B).
    4. Assumed foreign income taxes paid or        40u
     accrued by Corporation A in 1992.
    5. Foreign income taxes paid by Corporation B  $50
     in 1992 that are deemed paid by Corporation
     A (Part A, Line 9 of paragraph (i) of this
     Example 4).
    6. Post-1986 undistributed earnings in         (40u)
     Corporation A for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    7. Post-1986 foreign income taxes in           $90
     Corporation A for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates plus Line 5).
    8. Dividends paid out of current earnings and  100u
     profits of Corporation A for 1992.
    9. Percentage of post-1986 undistributed       0
     earnings of Corporation A paid to
     Corporation M in 1992 (Line 8 divided by the
     greater of Line 6 or zero).
    10. Foreign income taxes paid and deemed paid  0
     by Corporation A in 1992 that are deemed
     paid by Corporation M under section 902(a)
     (Line 7 multiplied by Line 9).
    11. Post-1986 undistributed earnings in        (140u)
     Corporation A at start of 1993 (line 6 minus
     line 8).
    12. Post-1986 foreign income taxes in          $90
     Corporation A at start of 1993 (Line 7 minus
     Line 10).
 

    (ii) For 1993, Corporation A has 500u of earnings and profits on 
which it pays 160u of foreign income taxes. Corporation A receives no 
dividends from Corporation B, and pays a 100u dividend to Corporation M. 
The 100u dividend to Corporation M carries with it some of the foreign 
income taxes paid and deemed paid by Corporation A in 1992, which were 
not deemed paid by Corporation M in 1992 because Corporation A had no 
post-1986 undistributed earnings. Thus, for 1993, Corporation M is 
deemed to have paid $125 of post-1986 foreign income taxes paid and 
deemed paid by Corporation A and includes that amount in gross income as 
a dividend under section 78, determined as follows:

1. Post-1986 undistributed earnings in             (140u)
 Corporation A at start of 1993.
2. Post-1986 foreign income taxes in Corporation   $90
 A at start of 1993.
3. Pre-tax earnings and profits of Corporation A   500u
 for 1993.
4. Foreign income taxes paid or accrued by         160u
 Corporation A in 1993.
5. Post-1986 undistributed earnings in             200u
 Corporation A for 1993 (pre-dividend) (Line 1
 plus Line 3 minus Line 4).
6. Post-1986 foreign income taxes in Corporation   $250
 A for 1993 (pre-dividend) (Line 2 plus Line 4
 translated at the appropriate exchange rates).
7. Dividends paid out of post-1986 undistributed   100u
 earnings of Corporation A to Corporation M in
 1993.
8. Percentage of post-1986 undistributed earnings  50%
 of Corporation A paid to Corporation M in 1993
 (Line 7 divided by Line 5).
9. Foreign income taxes paid and deemed paid by    $125
 Corporation A that are deemed paid by
 Corporation M in 1993 (Line 6 multiplied by Line
 8).
10. Post-1986 undistributed earnings in            100u
 Corporation A at start of 1994 (Line 5 minus
 Line 7).
11. Post-1986 foreign income taxes in Corporation  $125
 A at start of 1994 (Line 6 minus Line 9).
 


[[Page 838]]

    Example 5. (i) Since 1987, domestic corporation M has owned 100 
percent of the voting stock of controlled foreign corporation A. 
Corporation M also conducts operations through a foreign branch. Both 
Corporation A and Corporation M use the calendar year as the taxable 
year. Corporation A uses the u as its functional currency and 1u equals 
$1 at all relevant times. Corporation A has no subpart F income, as 
defined in section 952, and no increase in earnings invested in United 
States property under section 956 for 1992. Corporation A also has no 
previously taxed income accounts. Corporation A has general limitation 
income and high withholding tax interest income that, by operation of 
section 954(b)(4), does not constitute foreign base company income under 
section 954(a). Because Corporation A is a controlled foreign 
corporation, it is not required to reduce post-1986 foreign income taxes 
by foreign taxes paid or accrued with respect to high withholding tax 
interest in excess of 5 percent. See Sec.  1.902-1(a)(8)(iii). 
Corporation A pays a 60u dividend to Corporation M in 1992. For 1992, 
Corporation M is deemed, under paragraph (b) of this section, to have 
paid $24 of the post-1986 foreign income taxes paid by Corporation A and 
includes that amount in gross income under section 78 as a dividend, 
determined as follows:

1. Assumed post-1986 undistributed earnings in
 Corporation A at start of 1992 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  20u
     interest.
    (b) Section 904(d)(1)(I) general limitation    55u
     income.
2. Assumed post-1986 foreign income taxes in
 Corporation A at start of 1992 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  $5
     interest.
    (b) Section 904(d)(1)(I) general limitation    $20
     income.
3. Assumed pre-tax earnings and profits of
 Corporation A for 1992 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  20u
     interest.
    (b) Section 904(d)(1)(I) general limitation    20u
     income.
4. Assumed foreign income taxes paid or accrued
 in 1992 on or with respect to:
    (a) Section 904(d)(1)(B) high withholding tax  10u
     interest.
    (b) Section 904(d)(1)(I) general limitation    5u
     income.
5. Post-1986 undistributed earnings in
 Corporation A for 1992 (pre-dividend)
 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  30u
     interest (Line 1(a) + Line 3(a) minus Line
     4(a)).
    (b) Section 904(d)(1)(I) general limitation    70u
     income (Line 1(b) + Line 3(b) minus Line
     4(b)).
                                                  ----------------------
    (c) Total....................................  100u
6. Post-1986 foreign income taxes in Corporation
 A for 1992 (pre-dividend) attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  $15
     interest (Line 2(a) + Line 4(a) translated
     at the appropriate exchange rates).
    (b) Section 904(d)(1)(I) general limitation    $25
     income (Line 2(b) + Line 4(b) translated at
     the appropriate exchange rates).
7. Dividends paid to Corporation M in 1992.......  60u
8. Dividends paid to Corporation M in 1992
 attributable to section 904(d) separate
 categories pursuant to Sec.   1.904-5(d):
    (a) Dividends paid to Corporation M in 1992    18u
     attributable to section 904(d)(1)(B) high
     withholding tax interest (Line 7 multiplied
     by Line 5(a) divided by Line 5(c)).
    (b) Dividends paid to Corporation M in 1992    42u
     attributable to section 904(d)(1)(I) general
     limitation income (Line 7 multiplied by Line
     5(b) divided by Line 5(c)).
9. Percentage of Corporation A's post-1986
 undistributed earnings for 1992 paid to
 Corporation M attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  60%
     interest (Line 8(a) divided by Line 5(a)).
    (b) Section 904(d)(1)(I) general limitation    60%
     income (Line 8(b) divided by Line 5(b)).
10. Foreign income taxes of Corporation A deemed
 paid by Corporation M under section 902(a)
 attributable to:
    (a) Foreign income taxes of Corporation A      $9
     deemed paid by Corporation M under section
     902(a) with respect to section 904(d)(1)(B)
     high withholding tax interest (Line 6(a)
     multiplied by Line 9(a)).
    (b) Foreign income taxes of Corporation A      $15
     deemed paid by Corporation M under section
     902(a) with respect to section 904(d)(1)(I)
     general limitation income (Line 6(b)
     multiplied by Line 9(b)).
11. Post-1986 undistributed earnings in
 Corporation A at start of 1993 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  12u
     interest (Line 5(a) minus Line 8(a)).
    (b) Section 904(d)(1)(I) general limitation    28u
     income (Line 5(b) minus Line 8(b)).
12. Post-1986 foreign income taxes in Corporation
 A at start of 1989 allocable to:
    (a) Section 904(d)(1)(B) high withholding tax  $6
     interest (Line 6(a) minus Line 10(a)).
    (b) Section 904(d)(1)(I) general limitation    $10
     income (Line 6(b) minus Line 10(b)).
 

    (ii) For purposes of computing Corporation M's foreign tax credit 
limitation, the post-1986 foreign income taxes of Corporation A deemed 
paid by Corporation M with respect to income in separate categories will 
be added to the foreign income taxes paid or accrued by Corporation M 
associated with income derived from Corporation M's branch operation in 
the same separate categories. The dividend (and the section 78 inclusion 
with respect to the dividend) will be treated as income in separate 
categories and added to Corporation M's other income, if any, 
attributable to the same separate categories. See section 904(d) and 
Sec.  1.904-6.

    (g) Effective/applicability dates. This section applies to any 
distribution

[[Page 839]]

made in and after a foreign corporation's first taxable year beginning 
on or after January 1, 1987, except that the provisions of paragraphs 
(a)(4)(ii), (a)(6), (a)(7), (a)(8)(i), and (c)(8) of this section and, 
except as provided in Sec.  1.904-7(f)(9), the provisions of paragraph 
(d) of this section apply to distributions made in taxable years of 
foreign corporations ending on or after April 20, 2009. See 26 CFR 
1.902-1T(a)(4)(ii), (a)(6), (a)(7), (a)(8)(i), and (c)(8) (revised as of 
April 1, 2009) for rules applicable to distributions made in taxable 
years of foreign corporations beginning after April 25, 2006, and ending 
before April 20, 2009, and 26 CFR 1.902-1T(d), except as provided in 26 
CFR 1.904-7T(f)(9) (revised as of April 1, 2009), for rules applicable 
to distributions made in taxable years of foreign corporations beginning 
after December 31, 2002, and ending before April 20, 2009.

[T.D. 8708, 62 FR 928, Jan. 7, 1997, as amended by T.D. 8916, 66 FR 274, 
Jan. 3, 2001; T.D. 9260, 71 FR 24526, Apr. 25, 2006; 71 FR 77264, Dec. 
26, 2006; T.D. 9452, 74 FR 27875, June 11, 2009; T.D. 9954, 86 FR 52614, 
Sept. 22, 2021]



Sec.  1.902-2  Treatment of deficits in post-1986 undistributed earnings 
and pre-1987 accumulated profits of a first- or lower-tier corporation 
for purposes of computing an amount of foreign taxes deemed paid 
under Sec.  1.902-1.

    (a) Carryback of deficits in post-1986 undistributed earnings of a 
first- or lower-tier corporation to pre-effective date taxable years--
(1) Rule. For purposes of computing foreign income taxes deemed paid 
under Sec.  1.902-1(b) with respect to dividends paid by a first- or 
lower-tier corporation, when there is a deficit in the post-1986 
undistributed earnings of that corporation and the corporation makes a 
distribution to shareholders that is a dividend or would be a dividend 
if there were current or accumulated earnings and profits, then the 
post-1986 deficit shall be carried back to the most recent pre-effective 
date taxable year of the first- or lower-tier corporation with positive 
accumulated profits computed under section 902. See Sec.  1.902-3(e). 
For purposes of this Sec.  1.902-2, a pre-effective date taxable year is 
a taxable year beginning before January 1, 1987, or a taxable year 
beginning after December 31, 1986, if the special effective date of 
Sec.  1.902-1(a)(13) applies. The deficit shall reduce the section 902 
accumulated profits in the most recent pre-effective date year to the 
extent thereof, and any remaining deficit shall be carried back to the 
next preceding year or years until the deficit is completely allocated. 
The amount carried back shall reduce the deficit in post-1986 
undistributed earnings. Any foreign income taxes paid in a post-
effective date year will not be carried back to pre-effective date 
taxable years or removed from post-1986 foreign income taxes. See 
section 960 and the regulations under that section for rules governing 
the carryback of deficits and the computation of foreign income taxes 
deemed paid with respect to deemed income inclusions from controlled 
foreign corporations.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (a):

    Example 1. (i) From 1985 through 1990, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Z, a foreign 
corporation. Corporation A is not a controlled foreign corporation and 
uses the u as its functional currency. 1u equals $1 at all relevant 
times. Both Corporation A and Corporation M use the calendar year as the 
taxable year. Corporation A has pre-1987 accumulated profits and post-
1986 undistributed earnings or deficits in post-1986 undistributed 
earnings, pays pre-1987 and post-1986 foreign income taxes, and pays 
dividends as summarized below:

Taxable year................  1985........  1986........  1987........  1988........  1989........  1990
Current E & P (Deficits) of   150u........  150u........  (100u)......  100u........  0...........  0
 Corp. A.
Current Plus Accumulated E &  150u........  300u........  200u........  250u........  250u........  200u
 P of Corp. A.
Post-'86 Undistributed        ............  ............  (100u)......  100u........  100u........  50u
 Earnings of Corp. A.

[[Page 840]]

 
Post-'86 Undistributed        ............  ............  0...........  100u........  50u.........  50u
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (increased by
 deficit carryback).
Foreign Income Taxes of       120u........  120u........  $10.........  $50.........  0...........  0
 Corp. A (Annual).
Post-'86 Foreign Income       ............  ............  $10.........  $60.........  $60.........  $30
 Taxes of Corp. A.
12/31 Distributions to Corp.  0...........  0...........  5u..........  0...........  5u..........  0
 M.
12/31 Distributions to Corp.  0...........  0...........  45u.........  0...........  45u.........  0
 Z.
 

    (ii) On December 31, 1987, Corporation A distributes a 5u dividend 
to Corporation M and a 45u dividend to Corporation Z. At that time 
Corporation A has a deficit of (100u) in post-1986 undistributed 
earnings and $10 of post-1986 foreign income taxes. The (100u) deficit 
(but not the post-1986 foreign income taxes) is carried back to offset 
the accumulated profits of 1986 and removed from post-1986 undistributed 
earnings. The accumulated profits for 1986 are reduced to 50u (150u-
100u). The dividend is paid out of the reduced 1986 accumulated profits. 
Foreign taxes deemed paid by Corporation M with respect to the 5u 
dividend are 12u (120u x (5u / 50u)). See Sec.  1.902-1(b)(3). 
Corporation M must include 12u in gross income (translated under the 
rule applicable to foreign income taxes paid on earnings accumulated in 
pre-effective date years) under section 78 as a dividend. Both the 
income inclusion and the foreign taxes deemed paid are subject to a 
separate limitation for dividends from Corporation A, a noncontrolled 
section 902 corporation. No accumulated profits remain in Corporation A 
with respect to 1986 after the carryback of the 1987 deficit and the 
December 31, 1987, dividend distributions to Corporations M and Z.
    (iii) On December 31, 1989, Corporation A distributes a 5u dividend 
to Corporation M and a 45u dividend to Corporation Z. At that time 
Corporation A has 100u of post-1986 undistributed earnings and $60 of 
post-1986 foreign income taxes. Therefore, the dividend is considered 
paid out of Corporation A's post-1986 undistributed earnings. Foreign 
taxes deemed paid by Corporation M with respect to the 5u dividend are 
$3 ($60 x 5%[5u / 100u]). Corporation M must include $3 in gross income 
under section 78 as a dividend. Both the income inclusion and the 
foreign taxes deemed paid are subject to a separate limitation for 
dividends from noncontrolled section 902 corporation A. Corporation A's 
post-1986 undistributed earnings as of January 1, 1990, are 50u (100u-
50u). Corporation A's post-1986 foreign income taxes must be reduced by 
the amount of foreign taxes that would have been deemed paid if both 
Corporations M and Z were eligible to compute an amount of deemed paid 
taxes. Section 1.902-1(a)(8)(i). The amount of foreign income taxes that 
would have been deemed paid if both Corporations M and Z were eligible 
to compute an amount of deemed paid taxes on the 50u dividend 
distributed by Corporation A is $30 ($60 x 50%[50u / 100u]). Thus, post-
1986 foreign income taxes as of January 1, 1990, are $30 ($60-$30).
    Example 2. The facts are the same as in Example 1, except that 
Corporation A has a deficit in its post-1986 undistributed earnings of 
(150u) on December 31, 1987. The deficit is carried back to 1986 and 
reduces accumulated profits for that year to -0-. Thus, the foreign 
income taxes paid with respect to the 1986 accumulated profits will 
never be deemed paid. The 1987 dividend is deemed to be out of 
Corporation A's 1985 accumulated profits. Foreign taxes deemed paid by 
Corporation M under section 902 with respect to the 5u dividend paid on 
December 31, 1987, are 4u (120u x 5u / 150u). See Sec.  1.902-1(b)(3). 
As a result of the December 31, 1987, dividend distributions, 100u 
(150u-50u) of accumulated profits and 80u (120u reduced by 40u[120u x 
50u / 150u] of foreign taxes that would have been deemed paid had all of 
Corporation A's shareholders been eligible to compute an amount of 
foreign taxes deemed paid with respect to the dividend paid out of 1985 
accumulated profits) remain in Corporation A with respect to 1985.
    Example 3. (i) From 1986 through 1991, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Corporation Z, 
a foreign corporation. Corporation A is not a controlled foreign 
corporation and uses the u as its functional currency. 1u equals $1 at 
all relevant times. Both Corporation A and Corporation M use the 
calendar year as the taxable year. Corporation A has pre-1987 
accumulated profits and post-1986 undistributed earnings or deficits in 
post-1986 undistributed earnings, pays pre-1987 and post-1986 foreign 
income taxes, and pays dividends as summarized below:

Taxable year................  1986........  1987........  1988........  1989........  1990........  1991
Current E & P (Deficits) of   100u........  (50u).......  150u........  75u.........  25u.........  0
 Corp. A.
Current Plus Accumulated E &  100u........  50u.........  200u........  175u........  200u........  80u
 P of Corp. A.

[[Page 841]]

 
Post-'86 Undistributed        ............  (50u).......  100u........  75u.........  100u........  0
 Earnings of Corp. A.
Post-'86 Undistributed        ............  (50u).......  0...........  75u.........  0...........  0
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (increased by
 deficit carryback).
Foreign Income Taxes          80u.........  0...........  $120........  $20.........  $20.........  0
 (Annual) of Corp. A.
Post-'86 Foreign Income       ............  0...........  $120........  $20.........  $40.........  0
 Taxes of Corp. A.
12/31 Distributions to Corp.  0...........  0...........  10u.........  0...........  12u.........  0
 M.
12/31 Distributions to Corp.  0...........  0...........  90u.........  0...........  108u........  0
 Z.
 

    (ii) On December 31, 1988, Corporation A distributes a 10u dividend 
to Corporation M and a 90u dividend to Corporation Z. At that time 
Corporation A has 100u in its post-1986 undistributed earnings and $120 
in its post-1986 foreign income taxes. Corporation M is deemed, under 
Sec.  1.902-1(b)(1), to have paid $12 ($120 x 10%[10u / 100u]) of the 
post-1986 foreign income taxes paid by Corporation A and includes that 
amount in gross income under section 78 as a dividend. Both the income 
inclusion and the foreign taxes deemed paid are subject to a separate 
limitation for dividends from noncontrolled section 902 corporation A. 
Corporation A's post-1986 undistributed earnings as of January 1, 1989, 
are 0 (100u-100u). Its post-1986 foreign taxes as of January 1, 1989, 
also are 0, $120 reduced by $120 of foreign income taxes paid that would 
have been deemed paid if both Corporations M and Z were eligible to 
compute an amount of foreign taxes deemed paid on the dividend from 
Corporation A ($120 x 100%[100u / 100u]).
    (iii) On December 31, 1990, Corporation A distributes a 12u dividend 
to Corporation M and a 108u dividend to Corporation Z. At that time 
Corporation A has 100u in its post-1986 undistributed earnings and $40 
in its post-1986 foreign income taxes. The dividend is paid out of post-
1986 undistributed earnings to the extent thereof (100u), and the 
remainder of 20u is paid out of 1986 accumulated profits. Under Sec.  
1.902-1(b)(2), the 12u dividend to Corporation M is deemed to be paid 
out of post-1986 undistributed earnings to the extent of 10u (100u x 12u 
/ 120u) and the remaining 2u is deemed to be paid out of Corporation A's 
1986 accumulated profits. Similarly, the 108u dividend to Corporation Z 
is deemed to be paid out of post-1986 undistributed earnings to the 
extent of 90u (100u x 108u / 120u) and the remaining 18u is deemed to be 
paid out of Corporation A's 1986 accumulated profits. Foreign income 
taxes deemed paid by Corporation M under section 902 with respect to the 
portion of the dividend paid out of post-1986 undistributed earnings are 
$4 ($40 x 10%[10u / 100u]), and foreign taxes deemed paid by Corporation 
M with respect to the portion of the dividend deemed paid out of 1986 
accumulated profits are 1.6u (80u x 2u / 100u). Corporation M must 
include $4 plus 1.6u translated under the rule applicable to foreign 
income taxes paid on earnings accumulated in taxable years prior to the 
effective date of the Tax Reform Act of 1986 in gross income as a 
dividend under section 78. The income inclusion and the foreign income 
taxes deemed paid are subject to a separate limitation for dividends 
from noncontrolled section 902 Corporation A. As of January 1, 1991, 
Corporation A's post-1986 undistributed earnings are 0 (100u-100u). 80u 
(100u-20u) of accumulated profits remain with respect to 1986. Post-1986 
foreign income taxes as of January 1, 1991, are 0, $40 reduced by $40 of 
foreign income taxes paid that would have been deemed paid if both 
Corporations M and Z were eligible to compute an amount of deemed paid 
taxes on the 100u dividend distributed by Corporation A out of post-1986 
undistributed earnings ($40 x 100%[100u / 100u]). Corporation A has 64u 
of foreign income taxes remaining with respect to 1986, 80u reduced by 
16u [80u x 20u / 100u] of foreign income taxes that would have been 
deemed paid if Corporations M and Z both were eligible to compute an 
amount of deemed paid taxes on the 20u dividend distributed by 
Corporation A out of 1986 accumulated profits.

    (b) Carryforward of deficit in pre-1987 accumulated profits of a 
first- or lower-tier corporation to post-1986 undistributed earnings for 
purposes of section 902--(1) General rule. For purposes of computing 
foreign income taxes deemed paid under Sec.  1.902-1(b) with respect to 
dividends paid by a first- or lower-tier corporation out of post-1986 
undistributed earnings, the amount of a deficit in accumulated profits 
of the foreign corporation determined under section 902 as of the end of 
its last pre-effective date taxable year is carried forward and reduces 
post-1986 undistributed earnings on the first day of the foreign 
corporation's first taxable year beginning after December 31, 1986, or 
on the first day of the first taxable year in which the ownership 
requirements of section 902(c)(3)(B) and Sec.  1.902-1(a)(1) through (4) 
are met if the special effective date of Sec.  1.902-1(a)(13) applies. 
Any foreign income taxes paid with respect

[[Page 842]]

to a pre-effective date year shall not be carried forward and included 
in post-1986 foreign income taxes. Post-1986 undistributed earnings may 
not be reduced by the amount of a pre-1987 deficit in earnings and 
profits computed under section 964(a). See section 960 and the 
regulations under that section for rules governing the carryforward of 
deficits and the computation of foreign income taxes deemed paid with 
respect to deemed income inclusions from controlled foreign 
corporations. For translation rules governing carryforwards of deficits 
in pre-1987 accumulated profits to post-1986 taxable years of a foreign 
corporation with a dollar functional currency, see Sec.  1.985-6(d)(2).
    (2) Effect of pre-effective date deficit. If a foreign corporation 
has a deficit in accumulated profits as of the end of its last pre-
effective date taxable year, then the foreign corporation cannot pay a 
dividend out of pre-effective date years unless there is an adjustment 
made (for example, a refund of foreign taxes paid) that restores section 
902 accumulated profits to a pre-effective date taxable year or years. 
Moreover, if a foreign corporation has a deficit in section 902 
accumulated profits as of the end of its last pre-effective date taxable 
year, then no deficit in post-1986 undistributed earnings will be 
carried back under paragraph (a) of this section. For rules concerning 
carrybacks of eligible deficits from post-1986 undistributed earnings to 
reduce pre-1987 earnings and profits computed under section 964(a), see 
section 960 and the regulations under that section.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. (i) From 1984 through 1988, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Corporation Z, 
a foreign corporation. Corporation A is not a controlled foreign 
corporation and uses the u as its functional currency. 1u equals $1 at 
all relevant times. Both Corporation A and Corporation M use the 
calendar year as the taxable year. Corporation A has pre-1987 
accumulated profits or deficits in accumulated profits and post-1986 
undistributed earnings, pays pre-1987 and post-1986 foreign income 
taxes, and pays dividends as summarized below:

Taxable year..................  1984...........  1985...........  1986..........  1987..........  1988
Current E & P (Deficits) of     25u............  (100u).........  (25u).........  200u..........  100u
 Corp. A.
Current Plus Accumulated E & P  25u............  (75u)..........  (100u)........  100u..........  50u
 (Deficits) of Corp. A.
Post-'86 Undistributed          ...............  ...............  ..............  100u..........  50u
 Earnings of Corp. A.
Post-'86 Undistributed          ...............  ...............  ..............  (50u).........  50u
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (reduced by
 deficit carryforward).
Foreign Income Taxes (Annual)   20u............  5u.............  0.............  $100..........  $50
 of Corp. A.
Post-'86 Foreign Income Taxes   ...............  ...............  ..............  $100..........  $50
 of Corp. A.
12/31 Distributions to Corp. M  0..............  0..............  0.............  15u...........  0
12/31 Distributions to Corp. Z  0..............  0..............  0.............  135u..........  0
 

    (ii) On December 31, 1987, Corporation A distributes a 150u 
dividend, 15u to Corporation M and 135u to Corporation Z. Corporation A 
has 200u of current earnings and profits for 1987, but its post-1986 
undistributed earnings are only 100u as a result of the reduction for 
pre-1987 accumulated deficits required under paragraph (b)(1) of this 
section. Corporation A has $100 of post-1986 foreign income taxes. Only 
100u of the 150u distribution is a dividend out of post-1986 
undistributed earnings. Foreign income taxes deemed paid by Corporation 
M in 1987 with respect to the 10u dividend attributable to post-1986 
undistributed earnings, computed under Sec.  1.902-1(b), are $10 ($100 x 
10%[10u/100u]). Corporation M includes this amount in gross income under 
section 78 as a dividend. Both the income inclusion and the foreign 
taxes deemed paid are subject to a separate limitation for dividends 
from noncontrolled section 902 corporation A. After the distribution, 
Corporation A has (50u) of post-1986 undistributed earnings (100u -150u) 
and -0- post-1986 foreign income taxes, $100 reduced by $100 of foreign 
income taxes paid that would have been deemed paid if both Corporations 
M and Z were eligible to compute an amount of deemed paid taxes on the 
100u dividend distributed by Corporation A out of post-1986 
undistributed earnings ($100 x 100%[100u / 100u]).
    (iii) The remaining 50u of the 150u distribution cannot be deemed 
paid out of accumulated profits of a pre-1987 year because Corporation A 
has an accumulated deficit as of

[[Page 843]]

the end of 1986 that eliminated all pre-1987 accumulated profits. See 
paragraph (b)(2) of this section. The 50u is a dividend out of current 
earnings and profits under section 316(a)(2), but Corporation M is not 
deemed to have paid any additional foreign income taxes paid by 
Corporation A with respect to that 50u dividend out of current earnings 
and profits. See Sec.  1.902-1(b)(4).
    Example 2. (i) From 1986 through 1991, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Corporation Z, 
a foreign corporation. Corporation A is not a controlled foreign 
corporation and uses the u as its functional currency. 1u equals $1 at 
all relevant times. Both Corporation A and Corporation M use the 
calendar year as the taxable year. Corporation A has pre-1987 
accumulated profits or deficits in accumulated profits and post-1986 
undistributed earnings, pays post-1986 foreign income taxes, and pays 
dividends as summarized below:

Taxable year..................  1986...........  1987...........  1988..........  1989..........  1990
Current E & P (Deficits) of     (100u).........  150u...........  (150u)........  100u..........  250u
 Corp. A.
Current Plus Accumulated E & P  (100u).........  50u............  (200u)........  (100u)........  50u
 (Deficits) of Corp. A.
Post-'86 Undistributed          ...............  50u............  (200u)........  (100u)........  50u
 Earnings of Corp. A.
Post-'86 Undistributed          ...............  (50u)..........  (200u)........  (200u)........  0
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (reduced by
 deficit carryforward).
Foreign Income Taxes (Annual)   0..............  $120...........  0.............  $50...........  $100
 of Corp. A.
Post-'86 Foreign Income Taxes   ...............  $120...........  0.............  $50...........  $150
 of Corp. A.
12/31 Distributions to Corp. M  0..............  10u............  0.............  10u...........  5u
12/31 Distributions to Corp. Z  0..............  90u............  0.............  90u...........  45u
 

    (ii) On December 31, 1987, Corporation A distributes a 10u dividend 
to Corporation M and a 90u dividend to Corporation Z. At the time of the 
distribution, Corporation A has 50u of post-1986 undistributed earnings 
and 150u of current earnings and profits. Thus, 50u of the dividend 
distribution (5u to Corporation M and 45u to Corporation Z) is a 
dividend out of post-1986 undistributed earnings. The remaining 50u is a 
dividend out of current earnings and profits under section 316(a)(2), 
but Corporation M is not deemed to have paid any additional foreign 
income taxes paid by Corporation A with respect to that 50u dividend out 
of current earnings and profits. See Sec.  1.902-1(b)(4). Note that even 
if there were no current earnings and profits in Corporation A, the 
remaining 50u of the 100u distribution cannot be deemed paid out of 
accumulated profits of a pre1987 year because Corporation A has an 
accumulated deficit as of the end of 1986 that eliminated all pre-1987 
accumulated profits. See paragraph (b)(2) of this section. Corporation A 
has $120 of post-1986 foreign income taxes. Foreign taxes deemed paid by 
Corporation M under section 902 with respect to the 5u dividend out of 
post-1986 undistributed earnings are $12 ($120 x 10%[5u/50u]). 
Corporation M includes this amount in gross income as a dividend under 
section 78. Both the foreign taxes deemed paid and the deemed dividend 
are subject to a separate limitation for dividends from noncontrolled 
section 902 corporation A. As of January 1, 1988, Corporation A has 
(50u) in its post-1986 undistributed earnings (50u-100u) and -0- in its 
post-1986 foreign income taxes, $120 reduced by $120 of foreign taxes 
that would have been deemed paid if both Corporations M and Z were 
eligible to compute an amount of deemed paid taxes on the dividend 
distributed by Corporation A out of post-1986 undistributed earnings 
($120 x 100%[50u / 50u]).
    (iii) On December 31, 1989, Corporation A distributes a 10u dividend 
to Corporation M and a 90u dividend to Corporation Z. Although the 
distribution is considered a dividend in its entirety out of 1989 
earnings and profits pursuant to section 316(a)(2), post-1986 
undistributed earnings are (100u). Accordingly, for purposes of section 
902, Corporation M is deemed to have paid no post-1986 foreign income 
taxes. See Sec.  1.902-1(b)(4). Corporation A's post-1986 undistributed 
earnings as of January 1, 1990, are (200u) ((100u) - 100u). Corporation 
A's post-1986 foreign income taxes are not reduced because no taxes were 
deemed paid.
    (iv) On December 31, 1990, Corporation A distributes a 5u dividend 
to Corporation M and a 45u dividend to Corporation Z. At that time 
Corporation A has 50u of post-1986 undistributed earnings, and $150 of 
post-1986 foreign income taxes. Foreign taxes deemed paid by Corporation 
M under section 902 with respect to the 5u dividend are $15 ($150 x 
10%[5u / 50u]). Post-1986 undistributed earnings as of January 1, 1991, 
are -0- (50u - 50u). Post-1986 foreign income taxes as of January 1, 
1991, also are -0-, $150 reduced by $150 ($150 x 100%[50u / 50u]) of 
foreign income taxes that would have been deemed paid if both 
Corporations M and Z were eligible to compute an amount of deemed paid 
taxes on the 50u dividend.

[T.D. 8708, 62 FR 937, Jan. 7, 1997, as amended by T.D. 9260, 71 FR 
24526, Apr. 25, 2006; 71 FR 77265, Dec. 26, 2006]

[[Page 844]]



Sec.  1.902-3  Credit for domestic corporate shareholder of a foreign 
corporation for foreign income taxes paid with respect to accumulated profits 
of taxable years of the foreign corporation beginning before January 1, 1987.

    (a) Definitions. For purposes of section 902 and Sec. Sec.  1.902-3 
and 1.902-4:
    (1) Domestic shareholder. In the case of dividends received by a 
domestic corporation after December 31, 1964, from a foreign 
corporation, the term ``domestic shareholder'' means a domestic 
corporation which owns at least 10 percent of the voting stock of the 
foreign corporation at the time it receives a dividend from such foreign 
corporation.
    (2) First-tier corporation. In the case of dividends received by a 
domestic shareholder after December 31, 1964, from a foreign 
corporation, the term ``first-tier corporation'' means a foreign 
corporation at least 10 percent of the voting stock of which is owned by 
a domestic shareholder at the time it receives a dividend from such 
foreign corporation. The term ``first-tier corporation'' also means a 
DISC or former DISC, but only with respect to dividends from the DISC or 
former DISC to the extent they are treated under sections 861(a)(2)(D) 
and 862(a)(2) as income from sources without the United States.
    (3) Second-tier corporation. (i) In the case of dividends paid to a 
first-tier corporation by a foreign corporation after January 12, 1971 
(i.e., the date of enactment of Pub. L. 91-684, 84 Stat. 2068), but only 
for purposes of applying this section for a taxable year of a domestic 
shareholder ending after that date, the foreign corporation is a 
``second-tier corporation'' if at least 10 percent of its voting stock 
is owned by the first-tier corporation at the time the first-tier 
corporation receives the dividend.
    (ii) In the case of dividends paid to a first-tier corporation by a 
foreign corporation after January 12, 1971, but only for purposes of 
applying this section for a taxable year of a domestic shareholder 
ending before January 13, 1971, or in the case of any dividend paid to a 
first-tier corporation by a foreign corporation before January 13, 1971, 
the foreign corporation is a ``second-tier corporation'' if at least 50 
percent of its voting stock is owned by the first-tier corporation at 
the time the first-tier corporation receives the dividend.
    (4) Third-tier corporation. In the case of dividends paid to a 
second-tier corporation (as defined in paragraph (a)(3) (i) or (ii) of 
this section) by a foreign corporation after January 12, 1971, but only 
for purposes of applying this section for a taxable year of a domestic 
shareholder ending after that date, the foreign corporation is a 
``third-tier corporation'' if at least 10 percent of its voting stock is 
owned by the second-tier corporation at the time the second-tier 
corporation receives the dividend.
    (5) Foreign income taxes. The term ``foreign income taxes'' means 
income, war profits, and excess profits taxes, and taxes included in the 
term ``income, war profits, and excess profits taxes'' by reason of 
section 903, imposed by a foreign country or a possession of the United 
States.
    (6) Dividend. For the definition of the term ``dividend'' for 
purposes of applying section 902 and this section, see section 316 and 
the regulations thereunder.
    (7) Dividend received. A dividend shall be considered received for 
purposes of section 902 and this section when the cash or other property 
is unqualifiedly made subject to the demands of the distributee. See 
Sec.  1.301-1(c).
    (b) Domestic shareholder owning stock in a first-tier corporation--
(1) In general. (i) If a domestic shareholder receives dividends in any 
taxable year from its first-tier corporation, the credit for foreign 
income taxes allowed by section 901 includes, subject to the conditions 
and limitations of this section, the foreign income taxes deemed, in 
accordance with paragraph (b)(2) of this section, to be paid by such 
domestic shareholder for such year.
    (ii) If dividends are received by a domestic shareholder from more 
than one first-tier corporation, the taxes deemed to be paid by such 
shareholder under section 902(a) and this paragraph (b) shall be 
computed separately with respect to the dividends received from each of 
such first-tier corporations.
    (iii) Any taxes deemed paid by a domestic shareholder for the 
taxable year

[[Page 845]]

pursuant to section 902(a) and paragraph (b)(2) of this section shall, 
except as provided in Sec.  1.960-3(b), be included in the gross income 
of such shareholder for such year as a dividend pursuant to section 78 
and Sec.  1.78-1. For the source of such a section 78 dividend, see 
paragraph (h)(1) of this section.
    (iv) Any taxes deemed, under paragraph (b)(2) of this section, to be 
paid by the domestic shareholder shall be deemed to be paid by such 
shareholder only for purposes of the foreign tax credit allowed under 
section 901. See section 904 for other limitations on the amount of the 
credit.
    (v) For rules relating to reduction of the amount of foreign income 
taxes deemed paid or accrued with respect to foreign mineral income, see 
section 901(e) and Sec.  1.901-3.
    (vi) For the nonrecognition as a foreign income tax for purposes of 
this section of certain income, profits, or excess profits taxes paid or 
accrued to a foreign country in connection with the purchase and sale of 
oil or gas extracted in such country, see section 901(f) and the 
regulations thereunder.
    (vii) For rules relating to reduction of the amount of foreign 
income taxes deemed paid with respect to foreign oil and gas extraction 
income, see section 907(a) and the regulations thereunder.
    (viii) See the regulations under sections 960, 962, and 963 for 
special rules relating to the application of section 902 in computing 
the foreign tax credit of United States shareholders of controlled 
foreign corporations.
    (2) Amount of foreign taxes deemed paid by a domestic shareholder. 
To the extent dividends are paid by a first-tier corporation to its 
domestic shareholder out of accumulated profits, as defined in paragraph 
(e) of this section, for any taxable year, the domestic shareholder 
shall be deemed to have paid the same proportion of any foreign income 
taxes paid, accrued or deemed, in accordance with paragraph (c)(2) of 
this section, to be paid by such first-tier corporation on or with 
respect to such accumulated profits for such year which the amount of 
such dividends (determined without regard to the gross-up under section 
78) bears to the amount by which such accumulated profits exceed the 
amount of such taxes (other than those deemed, under paragraph (c)(2) of 
this section, to be paid). For determining the amount of foreign income 
taxes paid or accrued by such first-tier corporation on or with respect 
to the accumulated profits for the taxable year of such first-tier 
corporation, see paragraph (f) of this section.
    (c) First-tier corporation owning stock in a second-tier 
corporation--(1) In general. For purposes of applying section 902(a) and 
paragraph (b)(2) of this section, if a first-tier corporation receives 
dividends in any taxable year from its second-tier corporation, the 
foreign income taxes deemed to be paid by the first-tier corporation on 
or with respect to its own accumulated profits for such year shall be 
the amount determined in accordance with paragraph (c)(2) of this 
section. This paragraph (c) shall not apply unless the product of--
    (i) The percentage of voting stock owned by the domestic shareholder 
in the first-tier corporation at the time that the domestic shareholder 
receives dividends from the first-tier corporation in respect of which 
foreign income taxes are deemed to be paid by the domestic shareholder 
under paragraph (b)(1) of this section, and
    (ii) The percentage of voting stock owned by the first-tier 
corporation in the second-tier corporation equals at least 5 percent. 
The percentage under paragraph (c)(1)(ii) of this section of voting 
stock owned by the first-tier corporation in the second-tier corporation 
is determined as of the time that the dividend distributed by the 
second-tier corporation is received by the first-tier corporation and 
thus included in accumulated profits of the first-tier corporation out 
of which dividends referred to in paragraph (c)(1)(i) of this section 
are distributed by the first-tier corporation to the domestic 
shareholder.

    Example. On February 10, 1976, foreign corporation B pays a dividend 
out of its accumulated profits for 1975 to foreign corporation A. On 
February 16, 1976, the date on which it receives the dividend, A 
Corporation owns 40 percent of the voting stock of B Corporation. Both 
corporations use the calendar year as the taxable year. On June 1, 1976, 
A Corporation sells its stock in B Corporation. On January 17, 1977, A 
Corporation pays a dividend out of its accumulated profits for

[[Page 846]]

1976 to domestic corporation M. M Corporation owns 30 percent of the 
voting stock of A Corporation on January 20, 1977, the date on which it 
receives the dividend. M Corporation uses a fiscal year ending on April 
30 as the taxable year. On February 16, 1976, A Corporation satisfies 
the 10-percent stock ownership requirement referred to in paragraph 
(a)(3) of this section with respect to B Corporation, and on January 20, 
1977, M Corporation satisfies the 10-percent stock-ownership requirement 
referred to in paragraph (a)(2) of this section with respect to A 
Corporation. The 5-percent requirement of this paragraph (c)(1) is also 
satisfied since 30 percent (the percentage of voting stock owned by M 
Corporation in A Corporation on January 20, 1977), when multiplied by 40 
percent (the percentage of voting stock owned by A Corporation in B 
Corporation on February 16, 1976), equals 12 percent. Accordingly, for 
its taxable year ending on April 30, 1977, M Corporation is entitled to 
a credit for a portion of the foreign income taxes paid, accrued, or 
deemed to be paid, by A Corporation for 1976; and for 1976 A Corporation 
is deemed to have paid a portion of the foreign income taxes paid or 
accrued by B Corporation for 1975.
    (2) Amount of foreign taxes deemed paid by a first-tier corporation. 
A first-tier corporation which receives dividends in any taxable year 
from its second-tier corporation shall be deemed to have paid for such 
year the same proportion of any foreign income taxes paid, accrued, or 
deemed, in accordance with paragraph (d)(2) of this section, to be paid 
by its second-tier corporation on or with respect to the accumulated 
profits, as defined in paragraph (e) of this section, for the taxable 
year of the second-tier corporation from which such dividends are paid 
which the amount of such dividends bears to the amount by which such 
accumulated profits of the second-tier corporation exceed the taxes so 
paid or accrued. For determining the amount of the foreign income taxes 
paid or accrued by such second-tier corporation on or with respect to 
the accumulated profits for the taxable year of such second-tier 
corporation, see paragraph (f) of this section.
    (d) Second-tier corporation owning stock in a third-tier 
corporation--(1) In general. For purposes of applying section 902(b)(1) 
and paragraph (c)(2) of this section, if a second-tier corporation 
receives dividends in any taxable year from its third-tier corporation, 
the foreign income taxes deemed to be paid by the second-tier 
corporation on or with respect to its own accumulated profits for such 
year shall be the amount determined in accordance with paragraph (d)(2) 
of this section. This paragraph (d) shall not apply unless the product 
of--
    (i) The percentage of voting stock arrived at in applying the 5-
percent requirement of paragraph (c)(1) of this section with respect to 
dividends received by the first-tier corporation from the second-tier 
corporation, and
    (ii) the percentage of voting stock owned by the second-tier 
corporation in the third-tier corporation equals at least 5 percent. The 
percentage under paragraph (d)(1)(ii) of this section of voting stock 
owned by the second-tier corporation in the third-tier corporation is 
determined as of the time that the dividend distributed by the third-
tier corporation is received by the second-tier corporation and thus 
included in accumulated profits of the second-tier corporation out of 
which dividends referred to in paragraph (d)(1)(i) of this section are 
distributed by the second-tier corporation to the first-tier 
corporation.

    Example. On February 27, 1975, foreign corporation C pays a dividend 
out of its accumulated profits for 1974 to foreign corporation B. On 
March 3, 1975, the date on which it receives the dividend, B Corporation 
owns 50 percent of the voting stock of C Corporation. On February 10, 
1976, B Corporation pays a dividend out of its accumulated profits for 
1975 to foreign corporation A. On February 16, 1976, the date on which 
it receives the dividend, A Corporation owns 40 percent of the voting 
stock of B Corporation. All three corporations use the calendar year as 
the taxable year. On January 17, 1977, A Corporation pays a dividend out 
of its accumulated profits for 1976 to domestic corporation M. M 
Corporation owns 30 percent of the voting stock of A Corporation on 
January 20, 1977, the date on which it receives the dividend. M 
Corporation uses a fiscal year ending on April 30 as the taxable year. 
On February 16, 1976, A Corporation satisfies the 10-percent stock 
ownership requirement referred to in paragraph (a)(3) of this section 
with respect to B Corporation, and on January 20, 1977, M Corporation 
satisfies the 10-percent stock-ownership requirement referred to in 
paragraph (a)(2) of this section with respect to A Corporation. The 5-
percent requirement of paragraph (c)(1) of this section is also 
satisfied since 30 percent (the

[[Page 847]]

percentage of voting stock owned by M Corporation in A Corporation on 
January 20, 1977), when multiplied by 40 percent (the percentage of 
voting stock owned by A Corporation in B Corporation on February 16, 
1976), equals 12 percent. On March 3, 1975, B Corporation satisfies the 
10 percent stock ownership requirement referred to in paragraph (a)(4) 
of this section with respect to C Corporation. The 5-percent requirement 
of this paragraph (d)(1) is also satisfied since 12 percent (the 
percentage of voting stock arrived at in applying the 5-percent 
requirement of paragraph (c)(1) of this section with respect to the 
dividends received by A Corporation from B Corporation on February 16, 
1976), when multiplied by 50 percent (the percentage of voting stock 
owned by B Corporation in C Corporation on March 3, 1975), equals 6 
percent. Accordingly, for its taxable year ending on April 30, 1977, M 
Corporation is entitled to a credit for a portion of the foreign income 
taxes paid, accrued, or deemed to be paid, by A Corporation for 1976; 
for 1976 A Corporation is deemed to have paid a portion of the foreign 
income taxes paid, accrued, or deemed to be paid, by B Corporation for 
1975; and for 1975 B Corporation is deemed to have paid a portion of the 
foreign income taxes paid or accrued by C Corporation for 1974.

    (2) Amount of foreign taxes deemed paid by a second-tier 
corporation. For purposes of applying paragraph (c)(2) of this section 
to a first-tier corporation, a second-tier corporation which receives 
dividends in its taxable year from its third-tier corporation shall be 
deemed to have paid for such year the same proportion of any foreign 
income taxes paid or accrued by its third-tier corporation on or with 
respect to the accumulated profits, as defined in paragraph (e) of this 
section, for the taxable year of the third-tier corporation from which 
such dividends are paid which the amount of such dividends bears to the 
amount by which such accumulated profits of the third-tier corporation 
exceed the taxes so paid or accrued. For determining the amount of the 
foreign income taxes paid or accrued by such third-tier corporation on 
or with respect to the accumulated profits for the taxable year of such 
third-tier corporation, see paragraph (f) of this section.
    (e) Determination of accumulated profits of a foreign corporation. 
The accumulated profits for any taxable year of a first-tier corporation 
and the accumulated profits for any taxable year of a second-tier or 
third-tier corporation, which are taken into account in applying 
paragraph (c)(2) or (d)(2) of this section with respect to such first-
tier corporation, shall be the sum of--
    (1) The earnings and profits of such corporation for such year, and
    (2) The foreign income taxes imposed on or with respect to the 
gains, profits, and income to which such earnings and profits are 
attributable.
    (f) Taxes paid on or with respect to accumulated profits of a 
foreign corporation. For purposes of this section, the amount of foreign 
income taxes paid or accrued on or with respect to the accumulated 
profits of a foreign corporation for any taxable year shall be the 
entire amount of the foreign income taxes paid or accrued for such year 
on or with respect to such gains, profits, and income. For purposes of 
this paragraph (f), the gains, profits, and income of a foreign 
corporation for any taxable year shall be determined after reduction by 
any income, war profits, or excess profits taxes imposed on or with 
respect to such gains, profits, and income by the United States.
    (g) Determination of earning and profits of a foreign corporation--
(1) Taxable year to which section 963 does not apply. For purposes of 
this section, the earnings and profits of a foreign corporation for any 
taxable year beginning after December 31, 1962, other than a taxable 
year to which paragraph (g)(2) of this section applies, may, if the 
domestic shareholder chooses, be determined under the rules provided by 
Sec.  1.964-1 exclusive of paragraphs (d) and (e) of such section. The 
translation of amounts so determined into United States dollars or other 
foreign currency shall be made at the proper exchange rate for the date 
of distribution with respect to which the determination is made.
    (2) [Reserved]
    (3) Time and manner of making choice. The controlling United States 
shareholders (as defined in Sec.  1.964-1(c)(5)) of a foreign 
corporation shall make the choice referred to in paragraph (g)(1) of 
this section (including the elections permitted by Sec.  1.964-1 (b) and 
(c)) by filing a written statement to such effect with the Director of 
the Internal Revenue Service Center, 11601 Roosevelt Boulevard, 
Philadelphia, Pennsylvania 19155, within 180 days after the close of

[[Page 848]]

the first taxable year of the foreign corporation during which such 
shareholders receive a distribution of earnings and profits with respect 
to which the benefits of this section are claimed or on or before 
November 15, 1965, whichever is later. For purposes of this paragraph 
(g)(3), the 180-day period shall commence on the date of receipt of any 
distribution which is considered paid from the accumulated profits of a 
preceding year or years under paragraph (g)(4) of this section. See 
Sec.  1.964-1(c)(3) (ii) and (iii) for procedures requiring notification 
of the Director of the Internal Revenue Service Center and 
noncontrolling shareholders of action taken.
    (4) Determination by district director. The district director in 
whose district is filed the income tax return of the domestic 
shareholder claiming a credit under section 901 for foreign income taxes 
deemed, under section 902 and this section, to be paid by such 
shareholder shall have the power to determine, with respect to a foreign 
corporation, from the accumulated profits of what taxable year or years 
the dividends were paid. In making such determination the district 
director shall, unless it is otherwise established to his satisfaction, 
treat any dividends which are paid in the first 60 days of any taxable 
year of such a corporation as having been paid from the accumulated 
profits of the preceding taxable year or years of such corporation and 
shall, in other respects, treat any dividends as having been paid from 
the most recently accumulated profits. For purposes of this paragraph 
(g)(4), in the case of a foreign corporation the foreign income taxes of 
which are determined on the basis of an accounting period of less than 1 
year, the term ``year'' shall mean such accounting period. See sections 
441 (b)(3) and 443.
    (h) Source of income from first-tier corporation and country to 
which tax is deemed paid--(1) Source of income. For purposes of section 
904(a)(1) (relating to the per-country limitation), in the case of a 
dividend received by a domestic shareholder from a first-tier 
corporation there shall be deemed to be derived from sources within the 
foreign country or possession of the United States under the laws of 
which the first-tier corporation is created or organized the sum of the 
amounts which under paragraph (a)(3)(ii) of Sec.  1.861-3 are treated, 
with respect to such dividend, as income from sources without the United 
States.
    (2) Country to which taxes deemed paid. For purposes of section 904, 
all foreign income taxes paid, or deemed under paragraph (c) of this 
section to be paid, by a first-tier corporation shall be deemed to be 
paid to the foreign country or possession of the United States under the 
laws of which such first-tier corporation is created or organized.
    (i) United Kingdom income taxes paid with respect to royalties. A 
taxpayer shall not be deemed under section 902 and this section to have 
paid any taxes with respect to which a credit is allowable to such 
taxpayer or any other taxpayer by virtue of section 905(b).
    (j) Information to be furnished. If the credit for foreign income 
taxes claimed under section 901 includes taxes deemed, under paragraph 
(b)(2) of this section, to be paid, the domestic shareholder must 
furnish the same information with respect to such taxes as it is 
required to furnish with respect to the taxes actually paid or accrued 
by it and for which credit is claimed. See Sec.  1.905-2. For other 
information required to be furnished by the domestic shareholder for the 
annual accounting period of certain foreign corporations ending with or 
within such shareholder's taxable year, and for reduction in the amount 
of foreign income taxes paid or deemed to be paid for failure to furnish 
such information, see section 6038 and the regulations thereunder.
    (k) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Throughout 1978, domestic corporation M owns all the one 
class of stock of foreign corporation A. Both corporations use the 
calendar year as the taxable year. Corporation A has accumulated 
profits, pays foreign income taxes, and pays dividends for 1978 as 
summarized below. For 1978, M Corporation is deemed, under paragraph 
(b)(2) of this section, to have paid $20 of the foreign income taxes 
paid by A Corporation for 1978 and includes such amount in gross income 
under section 78 as a dividend, determined as follows:

Gains, profits, and income of A Corp..........................      $100
Foreign income taxes imposed on or with respect to gains,             40
 profits, and income..........................................

[[Page 849]]

 
Accumulated profits...........................................       100
Foreign income taxes paid on or with respect to accumulated           40
 profits (total foreign income taxes).........................
Accumulated profits in excess of foreign income taxes.........        60
Dividends paid to M Corp......................................        30
Foreign income taxes of A Corp. deemed paid by M Corp. under          20
 section 902(a) ($40 x $30/$60)...............................
 

    Example 2. The facts are the same as in example 1, except that M 
Corporation also owns all the one class of stock of foreign corporation 
B which also uses the calendar year as the taxable year. Corporation B 
has accumulated profits, pays foreign income taxes, and pays dividends 
for 1978 as summarized below. For 1978, M Corporation is deemed under 
paragraph (b)(2) of this section, to have paid $20 of the foreign income 
taxes paid by A Corporation for 1978 and to have paid $50 of the foreign 
income taxes paid by B Corporation for 1978, and includes $70 in gross 
income as a dividend under section 78, determined as follows:

                              B Corporation
  Gains, profits and income...................................      $200
  Foreign income taxes imposed on or with respect to gains,          100
   profits, and income........................................
  Accumulated profits.........................................       200
  Foreign income taxes paid by B Corp. on or with respect to         100
   accumulated profits........................................
  Accumulated profits in excess of foreign income taxes.......       100
  Dividends paid to M Corp....................................        50
  Foreign income taxes of B Corporation deemed paid by M              50
   Corporation under section 902(a) ($100 x $50/$100).........
 


                              M Corporation
Foreign income taxes deemed paid under section 902(a):........
  Taxes of A Corp. (from example 1)...........................       $20
  Taxes of B Corp. (as determined above)......................        50
                                                               ---------
     Total....................................................        70
                                                               =========
Foreign income taxes included in gross income under section 78
 as a dividend:
  Taxes of A Corp. (from example 1)...........................        20
  Taxes of B Corp.............................................        50
                                                               ---------
     Total....................................................        70
 

    Example 3. For 1978, domestic corporation M owns all the one class 
of stock of foreign corporation A, which in turn owns all the one class 
of stock of foreign corporation B. All corporations use the calendar 
year as the taxable year. For 1978, M Corporation is deemed under 
paragraph (b)(2) of this section to have paid $50 of the foreign income 
taxes paid, or deemed under paragraph (c)(2) of this section to be paid, 
by A Corporation for such year and includes such amount in gross income 
as a dividend under section 78, determined as follows upon the basis of 
the facts assumed:

B Corp. (second-tier corporation):
  Gains, profits, and income..................................      $300
  Foreign income taxes imposed on or with respect to gains,          120
   profits, and income........................................
  Accumulated profits.........................................       300
  Foreign income taxes paid by B Corp. on or with respect to         120
   its accumulated profits (total foreign income taxes).......
  Accumulated profits in excess of foreign income taxes.......       180
  Dividends paid on December 31, 1978 to A Corp...............        90
  Foreign income taxes of B Corp. deemed paid by A Corp. for          60
   1978 under section 902(b)(1) ($120 x $90/$180).............
A Corp. (first-tier corporation):
  Gains, profits, and income:
    Business operations.......................................       200
    Dividends from B Corp.....................................        90
                                                               ---------
     Total....................................................       290
Foreign income taxes imposed on or with respect to gains,             40
 profits, and income..........................................
Accumulated profits...........................................      $290
Foreign income taxes paid by A Corp. on or with respect to its        40
 accumulated profits (total foreign income taxes).............
Accumulated profits in excess of foreign income taxes.........       250
Foreign income taxes paid, and deemed to be paid, by A Corp.         100
 for 1978 on or with respect to its accumulated profits for
 such year ($60 + $40)........................................
Dividends paid on December. 31, 1978, to M Corp...............       125
M Corp. (domestic shareholder):
  Foreign income taxes of A Corp. deemed paid by M Corp. for          50
   1978 under section 902(a) ($100 x $125/$250)...............
  Foreign income taxes included in gross income of M Corp.            50
   under section 78 as a dividend received from A Corp........
 

    Example 4. Throughout 1978, domestic corporation M owns 50 percent 
of the voting stock of foreign corporation A, not a less developed 
country corporation. A Corporation has owned 40 percent of the voting 
stock of foreign corporation B, since 1970; B Corporation has owned 30 
percent of the voting stock of foreign corporation C, since 1972. B 
Corporation, uses a fiscal year ending on June 30 as its taxable year; 
all other corporations use the calendar year as the taxable year. On 
February 1, 1977, B Corporation receives a dividend from C Corporation 
out of C Corporation's accumulated profits for 1976. On February 15, 
1977, A Corporation receives a dividend from B Corporation out of B 
Corporation's accumulated profits for its fiscal year ending in 1977. On 
February 15, 1978, M Corporation receives a dividend from A Corporation 
out of A Corporation's accumulated profits for 1977. For 1978, M 
Corporation is deemed under paragraph (b)(2) of this section to have 
paid $81.67 of the foreign income taxes paid, or deemed under paragraph 
(c)(2) of this section to be paid, by A Corporation on or with respect 
to its accumulated profits for 1977, and M Corporation includes that 
amount in gross income as a dividend under section 78, determined as 
follows upon the basis of the facts assumed:

C Corp. (third-tier corporation):
  Gains, profits, and income for 1976.......................   $2,000.00
  Foreign income taxes imposed on or with respect to such         800.00
   gains, profits, and income...............................
  Accumulated profits.......................................    2,000.00

[[Page 850]]

 
  Foreign income taxes paid by C Corp. on or with respect to      800.00
   its accumulated profits (total foreign income taxes).....
  Accumulated profits in excess of foreign income taxes.....    1,200.00
  Dividends paid on Feb. 1, 1977 to B Corp..................      150.00
  Foreign income taxes of C Corp. for 1976 deemed paid by B       100.00
   Corp. for its fiscal year ending in 1977 ($800 x $150/
   $1,200)..................................................
B Corp. (second-tier corporation):
  Gains, profits, and income for fiscal year ending in 1977:
    Business operations.....................................      850.00
    Dividends from C Corp...................................      150.00
                                                             -----------
     Total..................................................    1,000.00
Foreign income taxes imposed on or with respect to gains,         200.00
 profits, and income........................................
Accumulated profits.........................................    1,000.00
Foreign income taxes paid by B Corp. on or with respect to       $200.00
 its accumulated profits (total foreign income taxes).......
Accumulated profits in excess of foreign income taxes.......      800.00
Foreign income taxes paid, and deemed to be paid, by B Corp.      300.00
 for its fiscal year on or with respect to its accumulated
 profits for such year ($100 + $200)........................
Dividends paid on February 15, 1977 to A Corp...............      120.00
Foreign income taxes of B Corp. for its fiscal year deemed         45.00
 paid by A Corp. for 1977 ($300 x $120/$800)................
A Corp. (first-tier corporation):
  Gains, profits, and income for 1977:
    Business operations.....................................      380.00
    Dividends from B Corp...................................      120.00
                                                             -----------
     Total..................................................      500.00
Foreign income taxes imposed on or with respect to gains,         200.00
 profits, and income........................................
Accumulated profits.........................................      500.00
Foreign income taxes paid by A Corp. on or with respect to        200.00
 its accumulated profits (total foreign income taxes).......
Accumulated profits in excess of foreign taxes..............      300.00
Foreign income taxes paid, and deemed to be paid, by A Corp.      245.00
 for 1977 on or with respect to its accumulated profits for
 such year ($45 + $200).....................................
Dividends paid on Feb. 15, 1978 to M Corp...................      100.00
M Corp. (domestic shareholder):
  Foreign income taxes of A Corp. for 1977 deemed paid by M        81.67
   Corp. for 1978 under section 902(a)(1) ($245 x $100/$300)
  Foreign income taxes included in gross income of M Corp.         81.67
   under section 78 as a dividend received from A Corp......
 


    (l) Effective date. Except as provided in Sec.  1.902-4, this 
section applies to any distribution received from a first-tier 
corporation by its domestic shareholder after December 31, 1964, and 
before the beginning of the foreign corporation's first taxable year 
beginning after December 31, 1986. If, however, the first day on which 
the ownership requirements of section 902(c)(3)(B) and Sec.  1.902-
1(a)(1) through (4) are met with respect to the foreign corporation is 
in a taxable year of the foreign corporation beginning after December 
31, 1986, then this section shall apply to all taxable years beginning 
after December 31, 1964, and before the year in which the ownership 
requirements are first met. See Sec.  1.902-1(a)(13)(i). For 
corresponding rules applicable to distributions received by the domestic 
shareholder prior to January 1, 1965, see Sec.  1.902-5 as contained in 
the 26 CFR part 1 edition revised April 1, 1976.

[T.D. 7481, 42 FR 20125, Apr. 18, 1977, as amended by T.D. 7490, 42 FR 
30497, June 15, 1977; T.D. 7649, 44 FR 60086, Oct. 18, 1979. 
Redesignated and amended by T.D. 8708, 62 FR 927, 940, Jan. 7, 1997; 62 
FR 7155, Feb. 18, 1997; T.D. 9849, 84 FR 9236, Mar. 14, 2019; T.D. 9954, 
86 FR 52614, Sept. 22, 2021]



Sec.  1.902-4  Rules for distributions attributable to accumulated profits 
for taxable years in which a first-tier corporation was a less developed 
country corporation.

    (a) In general. If a domestic shareholder receives a distribution 
from a first-tier corporation before January 1, 1978, in a taxable year 
of the domestic shareholder beginning after December 31, 1964, which is 
attributable to accumulated profits of the first-tier corporation for a 
taxable year beginning before January 1, 1976, in which the first-tier 
corporation was a less developed country corporation (as defined in 26 
CFR Sec.  1.902-2 revised as of April 1, 1978), then the amount of the 
credit deemed paid by the domestic shareholder with respect to such 
distribution shall be calculated under the rules relating to less 
developed country corporations contained in (26 CFR Sec.  1.902-1 
revised as of April 1, 1978).
    (b) Combined distributions. If a domestic shareholder receives a 
distribution before January 1, 1978, from a first-tier corporation, a 
portion of which is described in paragraph (a) of this section, and a 
portion of which is attributable to accumulated profits of the first-
tier corporation for a year in which the first-tier corporation was not 
a less developed country corporation, then the amount of taxes deemed 
paid by the domestic shareholder shall be computed separately on each 
portion of the dividend. The taxes deemed paid on that portion of the 
dividend described in paragraph (a) shall be computed as specified in 
paragraph (a). The taxes

[[Page 851]]

deemed paid on that portion of the dividend described in this paragraph 
(b), shall be computed as specified in Sec.  1.902-3.
    (c) Distributions of a first-tier corporation attributable to 
certain distributions from second- or third-tier corporations. Paragraph 
(a) shall apply to a distribution received by a domestic shareholder 
before January 1, 1978, from a first-tier corporation out of accumulated 
profits for a taxable year beginning after December 31, 1975, if:
    (1) The distribution is attributable to a distribution received by 
the first-tier corporation from a second- or third-tier corporation in a 
taxable year beginning after December 31, 1975.
    (2) The distribution from the second- or third-tier corporation is 
made out of accumulated profits of the second- or third-tier corporation 
for a taxable year beginning before January 1, 1976, and
    (3) The first-tier corporation would have qualified as a less 
developed country corporation under section 902(d) (as in effect on 
December 31, 1975), in the taxable year in which it received the 
distribution.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. M, a domestic corporation owns all of the one class of 
stock of foreign corporation A. Both corporations use the calendar year 
as the taxable year. A Corporation pays a dividend to M Corporation on 
January 1, 1977, partly out of its accumulated profits for calendar year 
1976 and partly out of its accumulated profits for calendar year 1975. 
For 1975 A Corporation qualified as a less developed country corporation 
under the former section 902(d) (as in effect on December 31, 1975). M 
Corporation is deemed under paragraphs (a) and (b) of this section to 
have paid $63 of foreign income taxes paid by A Corporation on or with 
respect to its accumulated profits for 1976 and 1975 and M Corporation 
includes $36 of that amount in gross income as a dividend under section 
78, determined as follows upon the basis of the facts assumed:

                                  1976
Gains, profits, and income of A Corp. for 1976...............    $120.00
Foreign income taxes imposed on or with respect to such            36.00
 gains, profits, and income..................................
Accumulated profits..........................................     120.00
Foreign income taxes paid by A Corp. on or with respect to         36.00
 its accumulated profits (total foreign income taxes)........
Accumulated profits in excess of foreign income taxes........      84.00
Dividend to M Corp. out of 1976 accumulated profits..........      84.00
Foreign income taxes of A for 1976 deemed paid by M Corp.          36.00
 ($84/$84 x $36).............................................
Foreign income taxes included in gross income of M Corp.           36.00
 under section 78 as a dividend from A Corp..................
 


                                  1975
Gains, profits, and income of A Corp. for 1975...............    $257.14
Foreign income taxes imposed on or with respect to such            77.14
 gains, profits, and income..................................
Accumulated profits (under section 902(c)(1)(B) as in effect      180.00
 prior to amendment by the Tax Reform Act of 1976)...........
Foreign income taxes paid by A Corp. on or with respect to         54.00
 its accumulated profits ($77.14 x $180/$257.14).............
Dividend to M Corp. out of accumulated profits of A Corp. for      90.00
 1975........................................................
Foreign income taxes of A Corp. for 1975 deemed paid by M          27.00
 Corp. (under section 902(a)(2) as in effect prior to
 amendment by the Tax Reform Act of 1976) ($54 x $90/$180)...
Foreign income taxes included in gross income of M Corp.               0
 under section 78 as a dividend from A Corp..................
 

    Example 2. The facts are the same as in example 1, except that the 
distribution from A Corporation to M Corporation on January 1, 1977, was 
from accumulated profits of A Corporation for 1976. A Corporation's 
accumulated profits for 1976 were made up of income from its trade or 
business, and a dividend paid by B, a second-tier corporation in 1976. 
The dividend from B Corporation to A Corporation was from accumulated 
profits of B Corporation for 1975. A Corporation would have qualified as 
a less developed country corporation for 1976 under the former section 
902(d) (as in effect on December 31, 1975). M Corporation is deemed 
under paragraphs (b) and (c) of this section to have paid $543 of the 
foreign taxes paid or deemed paid by A Corporation on or with respect to 
its accumulated profits for 1976, and M Corporation includes $360 of 
that amount in gross income as a dividend under section 78, determined 
as follows upon the basis of the facts assumed:

Total gains, profits, and income of A Corp. for 1976..........    $1,500
                                                               ---------
  Gains and profits from business operations..................     1,200
  Gains and profits from dividend A Corp. received in 1976           300
   from B Corp. out of accumulated profits of B Corp. for 1975
                                                               ---------
Foreign taxes imposed on or with respect to such profits and         450
 income.......................................................
                                                               ---------
  Foreign taxes paid by A Corp. attributable to gains and            360
   profits from A Corp.'s business operations.................
  Foreign taxes paid by A Corp. attributable to dividend from         90
   B Corp. in 1976............................................
                                                               ---------
Dividends from A Corp. to M Corp. on Jan. 1, 1977.............     1,050
                                                               ---------

[[Page 852]]

 
  Portion of dividend attributable to gains and profits of A         840
   Corp. from business operations. ($1,200/$1,500 x $1,050)...
  Portion of dividends attributable to gains on profits of A         210
   Corp. from dividend from B Corp. ($300/$1,500 x $1,050)....
 

    (a) Amount of foreign taxes of A Corp. deemed paid by M Corp. on A 
Corp.'s gains and profits for 1976 from business operations.

Gains, profits, and income of A Corp. from business operations    $1,200
Foreign income taxes imposed on or with respect to gains,            360
 profits, and income..........................................
Accumulated profits...........................................     1,200
Foreign income taxes paid by A Corp. on or with respect to its       360
 accumulated profits (total foreign income taxes).............
Accumulated profits in excess of foreign income taxes.........       840
Dividend to M Corp............................................       840
Foreign taxes of A Corp. deemed paid by M Corp. ($360 x $840/        360
 $840)........................................................
Foreign taxes included in gross income of M Corp. under              360
 section 78 as a dividend.....................................
 

    (b) Amount of foreign taxes of A Corp. deemed paid by M Corp. on 
portion of the dividend attributable to B Corp.'s accumulated profits 
for 1975.

B Corp. (second-tier corporation):
  Gains, profits, and income for calendar year 1975...........    $1,000
  Foreign income taxes imposed on or with respect to gains,          400
   profits, and income........................................
  Accumulated profits (under section 902(c)(1)(B) as in effect       600
   prior to amendment by the Tax Reform Act of 1976)..........
  Foreign income taxes paid by B Corp. on or with respect to         240
   its accumulated profits ($400 x $600/$1,000)...............
  Dividend to A Corp. in 1976.................................       300
  Foreign taxes of B Corp. for 1975 deemed paid by A Corp.           120
   (under section 902(b)(1)(B) as in effect prior to amendment
   by the Tax Reform Act of 1976) ($240 x $300/$600)..........
A Corp. (first-tier corporation):
  Gains, profits, and income for 1976 attributable to dividend       300
   from B Corp.'s accumulated profits for 1975................
  Foreign income taxes imposed on or with respect to such             90
   gains, profits, and income.................................
  Accumulated profits (under section 902(c)(1)(B) as in effect       210
   prior to amendment by the Tax Reform Act of 1976)..........
  Foreign taxes paid by A Corp. on or with respect to such            63
   accumulated profits ($90 x $210/$300)......................
  Foreign income taxes paid and deemed to be paid by A Corp.         183
   for 1976 on or with respect to such accumulated profits
   ($120 + $63)...............................................
  Dividend paid to M Corp. attributable to dividend from B           210
   Corp. out of accumulated profits for 1975).................
  Foreign taxes of A Corp. deemed paid by M Corp. (under             183
   section 902(a)(2) as in effect prior to amendment by the
   Tax Reform Act of 1976) ($183 x $210/$210).................
  Amount included in gross income of M Corp. under section 78.         0
 


[T.D. 7649, 44 FR 60087, Oct. 18, 1979. Redesignated and amended by T.D. 
8708, 62 FR 927, 940, Jan. 7, 1997]



Sec.  1.903-1  Taxes in lieu of income taxes.

    (a) Overview. Section 903 provides that the term ``income, war 
profits, and excess profits taxes'' includes a tax paid in lieu of a tax 
on income, war profits, or excess profits that is otherwise generally 
imposed by any foreign country. Paragraphs (b) and (c) of this section 
define a tax described in section 903. Paragraph (d) of this section 
provides examples illustrating the application of this section. 
Paragraph (e) of this section sets forth the applicability date of this 
section. For purposes of this section and Sec. Sec.  1.901-2 and 1.901-
2A, a tax described in section 903 is referred to as a ``tax in lieu of 
an income tax'' or an ``in lieu of tax'' and the definitions in Sec.  
1.901-2(g) apply for purposes of this section. Determinations of the 
amount of a tax in lieu of an income tax that is paid by a person and 
determinations of the person by whom such tax is paid are made under 
Sec.  1.901-2(e) and (f), respectively. Section 1.901-2A contains 
additional rules applicable to dual capacity taxpayers (as defined in 
Sec.  1.901-2(a)(2)(ii)(A)).
    (b) Definition of tax in lieu of an income tax--(1) In general. 
Paragraphs (b)(2) and (c) of this section provide the requirements for a 
foreign levy to qualify as a tax in lieu of an income tax. The rules of 
this section are applied independently to each separate levy (within the 
meaning of Sec. Sec.  1.901-2(d) and 1.901-2A(a)). A foreign tax either 
is or is not a tax in lieu of an income tax in its entirety for all 
persons subject to the tax. It is immaterial whether the base of the in 
lieu of tax bears any relation to realized net gain. The base of the 
foreign tax may, for example, be gross income, gross receipts or sales, 
or the number of units produced or exported. The foreign country's 
reason for imposing a foreign tax on a base other than net income (for 
example, because of administrative difficulty in determining the amount 
of income that would otherwise be subject to a net income tax) is 
immaterial, although paragraph (c)(1) of this section generally requires 
a showing that the foreign country made a deliberate and cognizant 
choice to impose the in lieu of tax instead of a net income tax (see 
paragraph (c)(1)(iii) of this section).

[[Page 853]]

    (2) Requirements. A foreign levy is a tax in lieu of an income tax 
only if--
    (i) It is a foreign tax; and
    (ii) It satisfies the substitution requirement of paragraph (c) of 
this section.
    (c) Substitution requirement--(1) In general. A foreign tax (the 
``tested foreign tax'') satisfies the substitution requirement if, based 
on the foreign tax law, the requirements in paragraphs (c)(1)(i) through 
(iv) of this section are satisfied with respect to the tested foreign 
tax, or the tested foreign tax is a covered withholding tax described in 
paragraph (c)(2) of this section.
    (i) Existence of generally-imposed net income tax. A separate levy 
that is a net income tax (as described in Sec.  1.901-2(a)(3)) is 
generally imposed by the same foreign country (the ``generally-imposed 
net income tax'') that imposes the tested foreign tax.
    (ii) Non-duplication. Neither the generally-imposed net income tax 
nor any other separate levy that is a net income tax is also imposed, in 
addition to the tested foreign tax, by the same foreign country on any 
persons with respect to any portion of the income to which the amounts 
(such as sales or units of production) that form the base of the tested 
foreign tax relate (the ``excluded income''). Therefore, a tested 
foreign tax does not meet the requirement of this paragraph (c)(1)(ii) 
if a net income tax imposed by the same foreign country applies to the 
excluded income of any persons that are subject to the tested foreign 
tax, even if not all persons subject to the tested foreign tax are 
subject to the net income tax.
    (iii) Close connection to excluded income. But for the existence of 
the tested foreign tax, the generally-imposed net income tax would 
otherwise have been imposed on the excluded income. The requirement in 
the preceding sentence is met only if the imposition of such tested 
foreign tax bears a close connection to the failure to impose the 
generally-imposed net income tax on the excluded income; the 
relationship cannot be merely incidental, tangential, or minor. A close 
connection must be established with proof that the foreign country made 
a cognizant and deliberate choice to impose the tested foreign tax 
instead of the generally-imposed net income tax. Such proof must be 
based on foreign tax law, or the legislative history of either the 
tested foreign tax or the generally-imposed net income tax that 
describes the provisions excluding taxpayers subject to the tested 
foreign tax from the generally-imposed net income tax. Thus, a close 
connection exists if the generally-imposed net income tax would apply by 
its terms to the excluded income, but for the fact that the excluded 
income is expressly excluded, and the tested foreign tax is enacted 
contemporaneously with the generally-imposed net income tax. A close 
connection also exists if the generally-imposed net income tax by its 
terms does not apply to, but does not expressly exclude, the excluded 
income, and the tested foreign tax is enacted contemporaneously with the 
generally-imposed net income tax. Where the tested foreign tax is not 
enacted contemporaneously with the generally-imposed net income tax and 
the generally-imposed net income tax is not amended contemporaneously 
with the enactment of the tested foreign tax to exclude the excluded 
income or to narrow the scope of the generally-imposed net income tax so 
as not to apply to the excluded income, a close connection can be 
established only by reference to the legislative history of the tested 
foreign tax (or a predecessor in lieu of tax). Not all income derived by 
persons subject to the tested foreign tax need be excluded income, 
provided the tested foreign tax applies only to amounts that relate to 
the excluded income.
    (iv) Jurisdiction to tax excluded income. If the generally-imposed 
net income tax, or a hypothetical new tax that is a separate levy with 
respect to the generally-imposed net income tax, were applied to the 
excluded income, such generally-imposed net income tax or separate levy 
would meet the attribution requirement described in Sec.  1.901-2(b)(5).
    (2) Covered withholding tax. A tested foreign tax is a covered 
withholding tax if, based on the foreign tax law, the requirements in 
paragraphs (c)(1)(i) and (c)(2)(i) through (iii) of this section are met 
with respect to the tested foreign tax. See also Sec.  1.901-
2(d)(1)(iii) for

[[Page 854]]

rules treating withholding taxes as separate levies with respect to each 
class of income subject to the tax or with respect to each subset of a 
class of income that is subject to different income attribution rules.
    (i) Withholding tax on nonresidents. The tested foreign tax is a 
withholding tax (as defined in section 901(k)(1)(B)) that is imposed on 
gross income of persons who are nonresidents of the foreign country 
imposing the tested foreign tax. It is immaterial whether the tested 
foreign tax is withheld by the payor or is imposed directly on the 
nonresident taxpayer.
    (ii) Non-duplication. The tested foreign tax is not in addition to 
any net income tax that is imposed by the foreign country on any portion 
of the net income attributable to the gross income that is subject to 
the tested foreign tax. Therefore, a tested foreign tax does not meet 
the requirement of this paragraph (c)(2)(ii) if by its terms it applies 
to gross income of nonresidents that are also subject to a net income 
tax imposed by the same foreign country on the same income, even if not 
all nonresidents subject to the tested foreign tax are also subject to 
the net income tax.
    (iii) Source-based attribution requirement. The income subject to 
the tested foreign tax satisfies the attribution requirement described 
in Sec.  1.901-2(b)(5)(i)(B).
    (d) Examples. The following examples illustrate the rules of this 
section.
    (1) Example 1: Tax on gross income from services; non-duplication 
requirement--(i) Facts. Country X imposes a tax at the rate of 3 percent 
on the gross receipts of companies, wherever resident, from furnishing 
specified types of electronically supplied services to customers located 
in Country X (the ``ESS tax''). No deductions are allowed in determining 
the taxable base of the ESS tax. In addition to the ESS tax, Country X 
imposes a net income tax within the meaning of Sec.  1.901-2(a)(3) on 
resident companies (the ``resident income tax'') and also imposes a net 
income tax within the meaning of Sec.  1.901-2(a)(3) on the income of 
nonresident companies that is attributable, under reasonable principles, 
to the nonresident's permanent establishment within Country X (the 
``nonresident income tax''). Under Country X tax law, a permanent 
establishment is defined in the same manner as under the 2016 U.S. Model 
Income Tax Convention. Both the resident income tax and the nonresident 
income tax, which are separate levies under Sec.  1.901-2(d)(1)(iii), 
qualify as generally-imposed net income taxes. Under Country X tax law, 
the ESS tax applies to both resident and nonresident companies 
regardless of whether the company is also subject to the resident income 
tax or the nonresident income tax, respectively.
    (ii) Analysis. Under Sec.  1.901-2(d)(1)(iii), the ESS tax comprises 
two separate levies, one imposed on resident companies (the ``resident 
ESS tax''), and one imposed on nonresident companies (the ``nonresident 
ESS tax''). Under paragraph (c)(1)(ii) of this section, neither the 
resident ESS tax nor the nonresident ESS tax satisfies the substitution 
requirement, because by its terms the income to which the gross receipts 
subject to the ESS tax relate is also subject to one of the two 
generally-imposed net income taxes imposed by Country X. Similarly, 
under paragraph (c)(2)(ii) of this section, the nonresident ESS tax is 
not a covered withholding tax because by its terms it is imposed in 
addition to the nonresident income tax. The fact that nonresident 
taxpayers that do not have a permanent establishment in Country X are in 
practice subject to the nonresident ESS tax but not to the nonresident 
income tax on the gross receipts included in the base of the nonresident 
ESS tax is not relevant to the determination of whether the ESS tax 
meets the substitution requirement under paragraph (c)(1) of this 
section. Therefore, neither the resident ESS tax nor the nonresident ESS 
tax is a tax in lieu of an income tax.
    (2) Example 2: Tax on gross income from services; attribution of 
income--(i) Facts. The facts are the same as those in paragraph 
(d)(1)(i) of this section (the facts in Example 1), except that under 
Country X tax law, the nonresident ESS tax is imposed only if the 
nonresident company does not have a permanent establishment in Country 
X. If the nonresident company has a Country X permanent establishment, 
the

[[Page 855]]

nonresident income tax applies to the profits attributable to that 
permanent establishment. In addition, the statutory language and 
legislative history to the nonresident ESS tax demonstrate that Country 
X made a cognizant and deliberate choice to impose the nonresident ESS 
tax instead of the nonresident income tax with respect to the gross 
receipts that are subject to the nonresident ESS tax.
    (ii) Analysis--(A) General application of substitution requirement. 
The nonresident ESS tax meets the requirements in paragraphs (c)(1)(i) 
and (ii) of this section because Country X has two generally-imposed net 
income taxes and neither generally-imposed net income tax nor any other 
separate levy that is a net income tax is imposed by Country X on a 
nonresident's income to which gross receipts that form the base of the 
nonresident ESS tax relate (which is the excluded income). The statutory 
language and legislative history to the nonresident ESS tax demonstrate 
that Country X made a cognizant and deliberate choice not to impose the 
nonresident income tax on the excluded income. Therefore, the 
nonresident ESS tax meets the requirement in paragraph (c)(1)(iii) of 
this section because, but for the existence of the tested foreign tax, 
the nonresident income tax would otherwise have been imposed on the 
excluded income. However, the nonresident ESS tax does not meet the 
requirement in paragraph (c)(1)(iv) of this section, because if Country 
X had chosen to apply the nonresident income tax (rather than the 
nonresident ESS tax) to the excluded income, the modified nonresident 
income tax would fail the attribution requirement in Sec.  1.901-
2(b)(5). First, the modified tax would not satisfy the requirement in 
Sec.  1.901-2(b)(5)(i)(A) because the modified tax would not apply to 
income attributable under reasonable principles to the nonresident's 
activities within the foreign country, since the modified tax is 
determined by taking into account the location of customers. Second, the 
modified tax would not satisfy the requirement in Sec.  1.901-
2(b)(5)(i)(B) because the excluded income is from services performed 
outside of Country X. Third, the modified tax would not satisfy the 
requirement in Sec.  1.901-2(b)(5)(i)(C) because the excluded income is 
not from sales or dispositions of real property located in Country X or 
from property forming part of the business property of a taxable 
presence in Country X. Because the Country X nonresident income tax as 
applied to the excluded income would fail to meet the attribution 
requirement in Sec.  1.901-2(b)(5), as required by paragraph (c)(1)(iv) 
of this section, the nonresident ESS tax does not satisfy the 
substitution requirement in paragraph (c)(1) of this section.
    (B) Covered withholding tax analysis. The nonresident ESS tax meets 
the requirement in paragraph (c)(1)(i) of this section because there 
exists a generally-imposed net income tax. It also meets the 
requirements in paragraphs (c)(2)(i) and (ii) of this section because it 
is a withholding tax on gross receipts of nonresidents and the income 
attributable to those gross receipts is not subject to a net income tax. 
However, the nonresident ESS tax does not meet the requirement in 
paragraph (c)(2)(iii) of this section because the services income 
subject to the nonresident ESS tax is from electronically supplied 
services performed outside of Country X. See Sec.  1.901-2(b)(5)(i)(B). 
Therefore, the nonresident ESS tax is not a covered withholding tax 
under paragraph (c)(2) of this section. Because the nonresident ESS tax 
does not satisfy the substitution requirement of paragraph (c) of this 
section, it is not a tax in lieu of an income tax.
    (3) Example 3: Withholding tax on royalties; attribution 
requirement--(i) Facts. YCo, a resident of Country Y, is a controlled 
foreign corporation wholly-owned by USP, a domestic corporation. In Year 
1, YCo grants a license to XCo, a resident of Country X unrelated to YCo 
or USP, for the right to use YCo's intangible property (IP) throughout 
the world, including in Country X. Under Country X's domestic tax law, 
all royalties paid by a resident of Country X to a nonresident are 
sourced in Country X and are subject to a 30% withholding tax on the 
gross income, regardless of whether the nonresident payee has a taxable 
presence in Country X. Country X's withholding tax on royalties is a 
separate levy under

[[Page 856]]

Sec.  1.901-2(d)(1)(iii). In Year 1, XCo withholds 30u (units of Country 
X currency) tax from 100u of royalties owed and paid to YCo under the 
licensing arrangement, of which 50u is attributable to XCo's use of the 
YCo IP in Country X and 50u is attributable to use of the YCo IP outside 
Country X. The United States and Country X have an income tax treaty 
(U.S.-Country X treaty); under the royalties article of the treaty, 
Country X agreed to impose its withholding tax on royalties paid to a 
U.S. resident only on royalties paid for IP used in Country X. Country X 
and Country Y do not have an income tax treaty.
    (ii) Analysis. Under Sec.  1.901-2(d)(1)(iv), the Country X 
withholding tax on royalties, as modified by the U.S.-Country X treaty, 
is a separate levy from the unmodified Country X withholding tax to 
which YCo was subject (because YCo is not a U.S. resident eligible for 
benefits under the U.S.-Country X treaty). The Country X withholding tax 
on royalties, unmodified by the U.S.-Country X treaty, does not meet the 
attribution requirement in Sec.  1.901-2(b)(5)(i)(B) because Country X's 
source rule for royalties (based upon residence of the payor) is not 
reasonably similar to the sourcing rules that apply under the Internal 
Revenue Code. Thus, under paragraph (c)(2)(iii) of this section, the 
Country X withholding tax paid by YCo is not a covered withholding tax, 
and none of the 30u of Country X withholding tax paid by YCo with 
respect to the 100u of royalties for the use of the IP is a payment of 
foreign income tax.
    (4) Example 4: Withholding tax on royalties; attribution 
requirement--(i) Facts. The facts are the same as in paragraph (d)(3)(i) 
of this section (the facts of Example 3), except that XCo only uses the 
IP in Country X and the 100u of royalties paid to YCo in Year 1 is all 
attributable to XCo's use of the IP in Country X.
    (ii) Analysis. The result is the same as in paragraph (d)(3) of this 
section (the analysis of Example 3). Because Country X's source rule for 
royalties (based upon residence of the payor) is not reasonably similar 
to the sourcing rules that apply under the Internal Revenue Code, the 
withholding tax paid by YCo does not meet the attribution requirement in 
Sec.  1.901-2(b)(5)(i)(B). Under paragraph (c)(2)(iii) of this section, 
the Country X withholding tax paid by YCo is not a covered withholding 
tax, and none of the 30u of Country X withholding tax paid by YCo with 
respect to the 100u of royalties for IP used in Country X is a payment 
of foreign income tax.
    (5) Example 5: Multiple in-lieu-of taxes--(i) Facts. Country X 
imposes a net income tax within the meaning of Sec.  1.901-2(a)(3) on 
the income of nonresident companies that is attributable, under 
reasonable principles, to the nonresident's activities within Country X 
(the ``trade or business tax''). The trade or business tax applies to 
all nonresident corporations that engage in business in Country X except 
for nonresident corporations that engage in insurance activities, which 
are instead subject to two different taxes (``insurance taxes''). The 
insurance taxes apply to nonresident corporations that engage in 
insurance activities that are attributable, under reasonable principles, 
to the nonresident's activities within Country X. The insurance taxes do 
not satisfy the cost recovery requirement in Sec.  1.901-2(b)(4). The 
trade or business tax and the two insurance taxes were enacted 
contemporaneously, and the statutory language of the trade or business 
tax expressly excludes gross income derived by nonresident corporations 
engaged in insurance activities from the trade or business tax.
    (ii) Analysis. The insurance taxes meet the requirements in 
paragraphs (c)(1)(i) and (ii) of this section because Country X has a 
generally-imposed net income tax, the trade or business tax, and neither 
the trade or business tax nor any other separate levy that is a net 
income tax is imposed by Country X on a nonresident's gross income to 
which the amounts that form the base of the insurance taxes (the 
``excluded income'') relate. The Country X tax law expressly provides 
that the trade or business tax does not apply to nonresident 
corporations engaged in insurance activities. In addition, the two 
insurance taxes were enacted contemporaneously with the trade or 
business tax. Therefore, it is demonstrated that

[[Page 857]]

Country X made a cognizant and deliberate choice to impose the insurance 
taxes in lieu of the generally-imposed trade or business tax, and the 
insurance taxes meet the requirement in paragraph (c)(1)(iii) of this 
section. If the trade or business tax also applied to the excluded 
income, the trade or business tax would meet the requirement in Sec.  
1.901-2(b)(5)(i)(A), because it would apply only to income attributable, 
under reasonable principles, to the nonresident's activities within the 
foreign country. Thus, the insurance taxes meet the requirement in 
paragraph (c)(1)(iv) of this section. Therefore, the insurance taxes 
satisfy the substitution requirement in paragraph (c)(1) of this 
section.
    (6) Example 6: Later-enacted in-lieu-of tax; close connection 
requirement--(i) Facts. The facts are the same as those in paragraph 
(d)(5)(i) of this section (the facts in Example 5), except that one of 
the two insurance taxes applies only to nonresident corporations engaged 
in the life insurance business in Country X and was enacted five years 
after the enactment of the trade or business tax and the other insurance 
tax enacted contemporaneously with the trade or business tax. The 
legislative history to the later-enacted insurance tax shows that 
Country X intended to increase the tax imposed on nonresident 
corporations engaged in life insurance activities and, instead of 
amending the first insurance tax to increase the rate applicable to life 
insurance companies, it enacted the second insurance tax that only 
applies to life insurance corporations.
    (ii) Analysis. The later-enacted insurance tax meets the 
requirements in paragraphs (c)(1)(i) and (ii) of this section because 
Country X has a generally-imposed net income tax, the trade or business 
tax, and neither the trade or business tax nor any other separate levy 
that is a net income tax is imposed by Country X on the income 
attributable to the activities that form the base of the later-enacted 
insurance tax. The later-enacted insurance tax meets the requirement in 
paragraph (c)(1)(iii) of this section because the legislative history to 
the later-enacted insurance tax demonstrates that Country X made a 
cognizant and deliberate choice to impose the later-enacted insurance 
tax on life insurance companies instead of the trade or business tax. 
The later-enacted insurance tax also meets the requirement of paragraph 
(c)(1)(iv) of this section for the reasons set forth in paragraph 
(d)(5)(ii) of this section. Therefore, the later-enacted insurance tax 
satisfies the substitution requirement in paragraph (c)(1) of this 
section.
    (7) Example 7: Excise tax creditable against net income tax--(i) 
Facts. Country X imposes an excise tax that does not satisfy the cost 
recovery requirement in Sec.  1.901-2(b)(4), and a net income tax within 
the meaning of Sec.  1.901-2(a)(3). The excise tax, which is payable 
independently of the net income tax, is allowed as a credit against the 
net income tax. In Year 1, A has a tentative net income tax liability of 
100u (units of Country X currency) but is allowed a credit for 30u of 
excise tax that it paid that year.
    (ii) Analysis. Pursuant to Sec.  1.901-2(e)(4), the amount of excise 
tax A has paid to Country X is 30u and the amount of net income tax A 
has paid to Country X is 70u. The excise tax paid by A does not satisfy 
the substitution requirement set forth in paragraph (c)(1) of this 
section because the excise tax is imposed in addition to, and not in 
substitution for, the generally-imposed net income tax.
    (e) Applicability dates. Except as otherwise provided in this 
paragraph (e), this section applies to foreign taxes paid (within the 
meaning of Sec.  1.901-2(g)(5)) in taxable years beginning on or after 
December 28, 2021. For foreign taxes paid to Puerto Rico under section 
3070.01 of the Puerto Rico Internal Revenue Code of 2011, as amended (13 
L.P.R.A. Sec.  31771) (imposing an excise tax on a controlled group 
member's acquisition from another group member of certain personal 
property manufactured or produced in Puerto Rico and certain services 
performed in Puerto Rico), this section applies to foreign taxes paid 
(within the meaning of Sec.  1.901-2(g)(5)) in taxable years beginning 
on or after January 1, 2023. For foreign taxes described in the 
preceding sentence that are paid in taxable years beginning before 
January 1,

[[Page 858]]

2023, see Sec.  1.903-1 as contained in 26 CFR part 1 revised as of 
April 1, 2021.

[T.D. 9959, 87 FR 357, Jan. 4, 2022]



Sec.  1.904-1  Limitation on credit for foreign income taxes.

    (a) In general. For each separate category described in Sec.  1.904-
5(a)(4)(v), the total credit for foreign income taxes (as defined in 
Sec.  1.901-2(a)) paid or accrued (including those deemed to have been 
paid or accrued other than by reason of section 904(c)) to any foreign 
country (as defined in Sec.  1.901-2(g)) does not exceed that proportion 
of the tax against which such credit is taken which the taxpayer's 
taxable income from foreign sources (but not in excess of the taxpayer's 
entire taxable income) in such separate category bears to the taxpayer's 
entire taxable income for the same taxable year.
    (b) Special computation of taxable income. For purposes of computing 
the limitation under paragraph (a) of this section, the taxable income 
in the case of an individual, estate, or trust is computed without any 
deduction for personal exemptions under section 151 or 642(b).
    (c) Joint return. In the case of spouses making a joint return, the 
applicable limitation prescribed by section 904(a) on the credit for 
taxes paid or accrued to foreign countries and possessions of the United 
States is applied with respect to the aggregate taxable income in each 
separate category from sources without the United States, and the 
aggregate taxable income from all sources, of the spouses.
    (d) Consolidated group. For rules relating to the computation of the 
foreign tax credit limitation for a consolidated group, see Sec.  
1.1502-4.
    (e) Applicability dates. This section applies to taxable years that 
both begin after December 31, 2017, and end on or after December 4, 
2018.

[T.D. 9882, 84 FR 69075, Dec. 17, 2019, as amended by T.D. 9922, 85 FR 
72056, Nov. 12, 2020]



Sec.  1.904-2  Carryback and carryover of unused foreign tax.

    (a) Credit for foreign tax carryback or carryover. A taxpayer who 
chooses to claim a credit under section 901 for a taxable year is 
allowed a credit under that section not only for taxes otherwise 
allowable as a credit but also for taxes deemed paid or accrued in that 
year as a result of a carryback or carryover of an unused foreign tax 
under section 904(c). However, the taxes so deemed paid or accrued are 
not allowed as a deduction under section 164(a). Foreign tax paid, 
accrued, or deemed paid under section 960 with respect to section 951A 
category income, including section 951A category income that is 
reassigned to a separate category for income resourced under a treaty, 
may not be carried back or carried forward or deemed paid or accrued 
under section 904(c). See Sec.  1.904-6 for rules for allocating and 
apportioning taxes to separate categories. For special rules regarding 
these computations in case of taxes paid, accrued, or deemed paid with 
respect to foreign oil and gas extraction income or foreign oil related 
income, see section 907(f).
    (b) Years to which foreign taxes are carried. If the taxpayer 
chooses the benefits of section 901 for a taxable year, any unused 
foreign tax paid or accrued in that year is carried first to the 
immediately preceding taxable year and then, as applicable, to each of 
the ten succeeding taxable years, in chronological order, but only to 
the extent not absorbed as taxes deemed paid or accrued under paragraphs 
(a) and (d) of this section in a prior taxable year.
    (c) Definitions. This paragraph (c) provides definitions that apply 
for purposes of this section.
    (1) Unused foreign tax. The term unused foreign tax means, with 
respect to each separate category for any taxable year, the excess of 
the amount of creditable foreign tax paid or accrued, or deemed paid 
under section 902 (as in effect on December 21, 2017) or section 960, in 
such year, over the applicable foreign tax credit limitation under 
section 904 for the separate category in such year. Unused foreign tax 
does not include any amount for which a credit is disallowed, including 
foreign income taxes for which a credit is disallowed or reduced when 
the tax is paid, accrued, or deemed paid.
    (2) Separate category. The term separate category has the same 
meaning as provided in Sec.  1.904-5(a)(4)(v).

[[Page 859]]

    (3) Excess limitation--(i) In general. The term excess limitation 
means, with respect to a separate category for any taxable year (the 
excess limitation year) and an unused foreign tax carried from another 
taxable year (the excess credit year), the amount (if any) by which the 
limitation for that separate category with respect to that excess 
limitation year exceeds the sum of--
    (A) The creditable foreign tax actually paid or accrued or deemed 
paid under section 902 (as in effect on December 21, 2017) or section 
960 with respect to the separate category in the excess limitation year; 
and
    (B) The portion of any unused foreign tax for a taxable year 
preceding the excess credit year that is absorbed as taxes deemed paid 
or accrued in the excess limitation year under paragraphs (a) and (d) of 
this section.
    (ii) Deduction years. Excess limitation for a taxable year absorbs 
unused foreign tax, regardless of whether the taxpayer chooses to claim 
a credit under section 901 for the year. In such case, the amount of the 
excess limitation, if any, for the year is determined in the same manner 
as though the taxpayer had chosen to claim a credit under section 901 
for that year. For purposes of this determination, if the taxpayer has 
an overall foreign loss account, the excess limitation in a deduction 
year is determined based on the amount of the overall foreign loss the 
taxpayer would have recaptured if the taxpayer had chosen to claim a 
credit under section 901 for that year and had not made an election 
under Sec.  1.904(f)-2(c)(2) to recapture more of the overall foreign 
loss account than is required under Sec.  1.904(f)-2(c)(1).
    (d) Taxes deemed paid or accrued--(1) Amount deemed paid or accrued. 
The amount of unused foreign tax with respect to a separate category 
that is deemed paid or accrued in any taxable year to which such unused 
foreign tax may be carried under paragraph (b) of this section is equal 
to the smaller of--
    (i) The portion of the unused foreign tax that may be carried to the 
taxable year under paragraph (b) of this section; or
    (ii) The amount, if any, of the excess limitation for such taxable 
year with respect to the separate category of such unused foreign tax.
    (2) Carryback or carryover tax deemed paid or accrued in the same 
separate category. Any unused foreign tax, which is deemed to be paid or 
accrued under section 904(c) in the year to which it is carried, is 
deemed to be paid or accrued with respect to the same separate category 
as the category to which it was assigned in the year in which it was 
actually paid or accrued. However, see paragraphs (h) through (j) of 
this section for transition rules in the case of certain carrybacks and 
carryovers.
    (3) No duplicate disallowance of creditable foreign tax. Foreign 
income taxes for which a credit is partially disallowed, including when 
the tax is paid, accrued, or deemed paid, are not reduced again by 
reason of the unused foreign tax being deemed to be paid or accrued in 
the year to which it is carried under section 904(c).
    (e) Periods of less than 12 months. A fractional part of a year 
which is a taxable year under sections 441(b) and 7701(a)(23) is a 
preceding or a succeeding taxable year for the purpose of determining 
under section 904(c) the years to which the unused foreign tax may be 
carried, and any unused foreign tax or excess limitation for such 
fractional part of a year is the unused foreign tax or excess limitation 
for a taxable year.
    (f) Statement with tax return. Every taxpayer claiming the benefit 
of a carryback or carryover of the unused foreign tax to any taxable 
year for which he chooses to claim a credit under section 901 shall file 
with his return (or with his claim for refund, if appropriate) for that 
year as an attachment to his Form 1116 or 1118, as the case may be, a 
statement setting forth the unused foreign tax deemed paid or accrued 
under this section and all material and pertinent facts relative 
thereto, including a detailed schedule showing the computation of the 
unused foreign tax so carried back or over.
    (g) [Reserved]
    (h) Transition rules for carryovers of pre-2003 unused foreign tax 
and carrybacks of post-2002 unused foreign tax paid or accrued with 
respect to dividends from noncontrolled section 902 corporations. For 
transition rules for

[[Page 860]]

carryovers of pre-2003 unused foreign tax, and carrybacks of post-2002 
unused foreign tax, paid or accrued with respect to dividends from 
noncontrolled section 902 corporations, see 26 CFR 1.904-2(h) (revised 
as of April 1, 2018).
    (i) Transition rules for carryovers of pre-2007 unused foreign tax 
and carrybacks of post-2006 unused foreign tax. For transition rules for 
carryovers of pre-2007 unused foreign tax, and carrybacks of post-2006 
unused foreign tax, see 26 CFR 1.904-2(i) (revised as of April 1, 2018).
    (j) Transition rules for carryovers and carrybacks of pre-2018 and 
post-2017 unused foreign tax--(1) Carryover of unused foreign tax--(i) 
In general. For purposes of this paragraph (j), the terms post-2017 
separate category, pre-2018 separate category, and specified separate 
category have the meanings set forth in Sec.  1.904(f)-12(j)(1). The 
rules of this paragraph (j)(1) apply to reallocate to the taxpayer's 
post-2017 separate categories for foreign branch category income, 
general category income, passive category income, and specified separate 
categories of income, any unused foreign taxes (as defined in paragraph 
(c)(1) of this section) that were paid or accrued or deemed paid under 
sections 902 and 960 with respect to income in a pre-2018 separate 
category.
    (ii) Allocation to the same separate category. Except as provided in 
paragraph (j)(1)(iii) of this section, to the extent any unused foreign 
taxes paid or accrued or deemed paid with respect to a separate category 
of income are carried forward to a taxable year beginning after December 
31, 2017, such taxes are allocated to the same post-2017 separate 
category as the pre-2018 separate category from which the unused foreign 
taxes are carried.
    (iii) Exception for certain general category unused foreign taxes--
(A) In general. To the extent any unused foreign taxes with respect to 
general category income are carried forward to a taxable year beginning 
after December 31, 2017, a taxpayer may choose to allocate those taxes 
to the taxpayer's post-2017 separate category for foreign branch 
category income to the extent the unused foreign taxes would have been 
allocated to the taxpayer's post-2017 separate category for foreign 
branch category income, and would have been unused foreign taxes with 
respect to foreign branch category income if that separate category had 
applied in the year or years the unused foreign taxes arose. Any 
remaining unused foreign taxes paid or accrued or deemed paid with 
respect to general category income carried forward to a taxable year 
beginning after December 31, 2017, are allocated to the taxpayer's post-
2017 separate category for general category income.
    (B) Safe harbor. In lieu of applying paragraph (j)(1)(iii)(A) of 
this section, the taxpayer may choose to allocate the unused foreign 
taxes with respect to general category income in a taxable year 
beginning before January 1, 2018, to the taxpayer's post-2017 separate 
category for foreign branch category income based on a ratio equal to 
the amount of foreign income taxes assigned to the general category that 
were paid or accrued by the taxpayer's foreign branches (as defined in 
Sec.  1.904-4(f)(3)(vii)) bears to all foreign income taxes assigned to 
the general category that were paid or accrued, or deemed paid by the 
taxpayer with respect to such taxable year. The amount of taxes paid or 
accrued by a foreign branch in a taxable year beginning before January1, 
2018, means all foreign income taxes properly reflected on the separate 
set of books and records (as defined in Sec.  1.989(a)-1(d)(1) and (2)) 
of the foreign branch as an expense (which does not include any taxes 
deemed paid under section 902 or 960).
    (C) Rules regarding the exception. A taxpayer applying the exception 
described in this paragraph (j)(1)(iii) (the branch carryover exception) 
must apply the exception to all of its unused foreign taxes paid or 
accrued with respect to general category income that are carried forward 
to all taxable years beginning after December 31, 2017. A taxpayer may 
apply the branch carryover exception on a timely filed original return 
(including extensions) or an amended return. A taxpayer that applies the 
exception on an amended return must make appropriate adjustments to 
eliminate any double benefit arising from application of the exception 
to years that are not open for assessment.

[[Page 861]]

    (D) Coordination rule. See Sec.  1.904(f)-12(j)(6) for coordination 
rule with respect to the exception described in paragraph (j)(1)(iii) of 
this section and the exceptions described in Sec.  1.904(f)-12(j)(2) 
through (4).
    (2) Carryback of unused foreign tax--(i) In general. The rules of 
this paragraph (j)(2) apply to any unused foreign taxes that were paid 
or accrued, or deemed paid under section 960, with respect to income in 
a post-2017 separate category.
    (ii) Passive category income and specified separate categories of 
income described in Sec.  1.904-4(m). Any unused foreign taxes paid or 
accrued or deemed paid with respect to passive category income or a 
specified separate category of income in a taxable year beginning after 
December 31, 2017, that are carried back to a taxable year beginning 
before January 1, 2018, are allocated to the same pre-2018 separate 
category as the post-2017 separate category from which the unused 
foreign taxes are carried.
    (iii) General category income and foreign branch category income. 
Any unused foreign taxes paid or accrued or deemed paid with respect to 
general category income or foreign branch category income in a taxable 
year beginning after December 31, 2017, that are carried back to a 
taxable year beginning before January 1, 2018, are allocated to the 
taxpayer's pre-2018 separate category for general category income.
    (k) Applicability date. Paragraphs (a) through (i) of this section 
apply to taxable years that both begin after December 31, 2017, and end 
on or after December 4, 2018. Paragraph (j) of this section applies to 
taxable years beginning after December 31, 2017. Paragraph (j)(2) of 
this section also applies to the last taxable year beginning before 
January 1, 2018.

[T.D. 6789, 29 FR 19244, Dec. 31, 1964]

    Editorial Note: For Federal Register citations affecting Sec.  
1.904-2, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.fdsys.gov.



Sec.  1.904-3  Carryback and carryover of unused foreign tax by spouses 
making a joint return.

    (a) In General. This section provides rules, in addition to those 
prescribed in Sec.  1.904-2, for the carryback and carryover of the 
unused foreign tax paid or accrued to a foreign country or possession by 
spouses making a joint return for one or more of the taxable years 
involved in the computation of the carryback or carryover. The rules in 
this section apply separately with respect to each separate category as 
defined in Sec.  1.904-5(a)(4)(v).
    (b) Joint unused foreign tax and joint excess limitation. In the 
case of spouses the joint unused foreign tax or the joint excess 
limitation for a taxable year for which a joint return is made shall be 
computed on the basis of the combined income, deductions, taxes, and 
credit of both spouses as if the combined income, deductions, taxes, and 
credit were those of one individual.
    (c) Continuous use of joint return. If spouses make a joint return 
for the current taxable year, and also make joint returns for each of 
the other taxable years involved in the computation of the carryback or 
carryover of the unused foreign tax to the current taxable year, the 
joint carryback or the joint carryover to the current taxable year shall 
be computed on the basis of the joint unused foreign tax and the joint 
excess limitations.
    (d) From separate to joint return. If spouses make a joint return 
for the current taxable year, but make separate returns for all of the 
other taxable years involved in the computation of the carryback or 
carryover of the unused foreign tax to the current taxable year, the 
separate carrybacks or separate carryovers shall be a joint carryback or 
a joint carryover to the current taxable year.
    (e) Amounts carried from or through a joint return year to or 
through a separate return year--(1) In general. It is necessary to 
allocate to each spouse the spouse's share of an unused foreign tax or 
excess limitation for any taxable year for which the spouses filed a 
joint return if--
    (i) The spouses file separate returns for the current taxable year 
and an unused foreign tax is carried thereto from

[[Page 862]]

a taxable year for which they filed a joint return;
    (ii) The spouses file separate returns for the current taxable year 
and an unused foreign tax is carried to such taxable year from a year 
for which they filed separate returns but is first carried through a 
year for which they filed a joint return; or
    (iii) The spouses file a joint return for the current taxable year 
and an unused foreign tax is carried from a taxable year for which they 
filed joint returns but is first carried through a year for which they 
filed separate returns.
    (2) Computation and adjustments. In the cases described in paragraph 
(e)(1) of this section, the separate carryback or carryover of each 
spouse to the current taxable year shall be computed in the manner 
described in Sec.  1.904-2 but with the modifications set forth in 
paragraph (f) of this section. Where applicable, appropriate adjustments 
are made to take into account the fact that, for any taxable year 
involved in the computation of the carryback or the carryover, either 
spouse has combined foreign oil and gas income described in section 
907(b) with respect to which the limitation in section 907(a) applies.
    (f) Allocation of unused foreign tax and excess limitation--(1) 
Separate category limitation. The limitation in a separate category of a 
particular spouse for a taxable year for which a joint return is made 
shall be the portion of the limitation on the joint return which bears 
the same ratio to such limitation as such spouse's foreign source 
taxable income (with gross income and deductions taken into account to 
the same extent as taken into account on the joint return) in such 
separate category (but not in excess of the joint foreign source taxable 
income) bears to the joint foreign source taxable income in such 
separate category.
    (2) Unused foreign tax. For purposes of this section, the term 
unused foreign tax means, with respect to a particular spouse and 
separate category for a taxable year for which a joint return is made, 
the excess of the foreign tax paid or accrued by that spouse with 
respect to that separate category over that spouse's separate category 
limitation.
    (3) Excess limitation. For purposes of this section, the term excess 
limitation means, with respect to a particular spouse and separate 
category for a taxable year for which a joint return is made, the excess 
of that spouse's separate category limitation over the foreign taxes 
paid or accrued by such spouse with respect to such separate category 
for such taxable year.
    (4) Excess limitation to be applied. The excess limitation of the 
particular spouse for any taxable year which is applied against the 
unused foreign tax of that spouse for another taxable year in order to 
determine the amount of the unused foreign tax which shall be carried 
back or over to a third taxable year shall be, in a case in which the 
excess limitation is determined on a joint return, the sum of the 
following amounts:
    (i) Such spouse's excess limitation determined under subparagraph 
(3) of this paragraph reduced as provided in subparagraph (5)(i) of this 
paragraph, and
    (ii) The excess limitation of the other spouse determined under 
subparagraph (3) of this paragraph for that taxable year reduced as 
provided in subparagraphs (5) (i) and (ii) of this paragraph.
    (5) Reduction of excess limitation. (i) The part of the excess 
limitation which is attributable to each spouse for the taxable year, as 
determined under subparagraph (3) of this paragraph, shall be reduced by 
absorbing as taxes deemed paid or accrued under section 904(c) in that 
year the unabsorbed separate unused foreign tax of such spouse, and the 
unabsorbed unused foreign tax determined under subparagraph (2) of this 
paragraph of such spouse, for taxable years which begin before the 
beginning of the year of origin of the unused foreign tax of the 
particular spouse against which the excess limitation so determined is 
being applied.
    (ii) In addition, the part of the excess limitation which is 
attributable to the other spouse for the taxable year, as determined 
under subparagraph (3) of this paragraph, shall be reduced by absorbing 
as taxes deemed paid or accrued under section 904(c) in that year the 
unabsorbed unused foreign tax, if any, of such other spouse for the 
taxable year which begins on the same

[[Page 863]]

date as the beginning of the year of origin of the unused foreign tax of 
the particular spouse against which the excess limitation so determined 
is being applied.
    (g) [Reserved]
    (h) Applicability date. This section is applicable for taxable years 
that both begin after December 31, 2017, and end on or after December 4, 
2018.

[T.D. 6789, 29 FR 19246, Dec. 31, 1964, as amended by T.D. 7292, 38 FR 
33292, Dec. 3, 1973; T.D. 7490, 42 FR 30497, June 15, 1977; T.D. 7961, 
49 FR 26225, June 27, 1984; T.D. 9882, 84 FR 69076, Dec. 17, 2019]




Sec.  1.904-4  Separate application of section 904 with respect to 
certain categories of income.

    (a) In general. A taxpayer is required to compute a separate foreign 
tax credit limitation for income received or accrued in a taxable year 
that is described in section 904(d)(1)(A) (section 951A category 
income), 904(d)(1)(B) (foreign branch category income), 904(d)(1)(C) 
(passive category income), 904(d)(1)(D) (general category income), or 
paragraph (m) of this section (specified separate categories). For 
purposes of this section, the definitions in Sec.  1.904-5(a)(4) apply.
    (b) Passive category income--(1) In general. The term passive 
category income means passive income and specified passive category 
income.
    (2) Passive income--(i) In general. The term passive income means 
any--
    (A) Income received or accrued by any person that is of a kind that 
would be foreign personal holding company income (as defined in section 
954(c), taking into account any exceptions or exclusions to section 
954(c), including, for example, section 954(c)(3), (c)(6), (h), or (i)) 
if the taxpayer were a controlled foreign corporation, including any 
amount of gain on the sale or exchange of stock in excess of the amount 
treated as a dividend under section 1248;
    (B) Amount includible in gross income under section 1293;
    (C) Distributive shares of partnership income treated as passive 
category income under paragraph (n)(1) of this section, and income from 
the sale of a partnership interest treated as passive category income 
under paragraph (n)(2) of this section; or
    (D) Income treated as passive category income under the look-through 
rules in Sec.  1.904-5.
    (ii) Exceptions. Passive income does not include any export 
financing interest (as defined in paragraph (h) of this section), any 
high-taxed income (as defined in paragraph (c) of this section), 
financial services income (as defined in paragraph (e)(1)(ii) of this 
section), or any active rents and royalties (as defined in paragraph 
(b)(2)(iii) of this section). In addition, passive income does not 
include any income that would otherwise be passive but is excluded from 
passive category income under Sec.  1.904-5(b)(1) or that is assigned to 
a separate category other than passive category income under Sec.  
1.904-5(c)(4)(iii). See also paragraph (k) of this section for rules 
relating to income resourced under a tax treaty. In determining whether 
any income is of a kind that would be foreign personal holding company 
income, the rules of section 864(d)(5)(A)(i) and (6) (treating related 
person factoring income of a controlled foreign corporation as foreign 
personal holding company income that is not eligible for the export 
financing income exception to the separate limitation for passive 
income) shall apply only in the case of income of a controlled foreign 
corporation (as defined in section 957). Thus, income earned directly by 
a United States person that is related person factoring income may be 
eligible for the exception for export financing interest.
    (iii) Active rents or royalties--(A) In general. For rents and 
royalties paid or accrued after September 20, 2004, passive income does 
not include any rents or royalties that are derived in the active 
conduct of a trade or business, regardless of whether such rents or 
royalties are received from a related or an unrelated person. Except as 
provided in paragraph (b)(2)(iii)(B) of this section, the principles of 
section 954(c)(2)(A) and the regulations under that section shall apply 
in determining whether rents or royalties are derived in the active 
conduct of a trade or business. For this purpose, the term taxpayer 
shall be substituted for the term controlled foreign corporation if the 
recipient of

[[Page 864]]

the rents or royalties is not a controlled foreign corporation.
    (B) Active conduct of trade or business. Rents and royalties are 
considered derived in the active conduct of a trade or business by a 
United States person or by a controlled foreign corporation (or other 
entity to which the look-through rules apply) for purposes of section 
904 (but not for purposes of section 954) if the requirements of section 
954(c)(2)(A) are satisfied by one or more corporations that are members 
of an affiliated group of corporations (within the meaning of section 
1504(a), determined without regard to section 1504(b)(3)) of which the 
recipient is a member. For purposes of this paragraph (b)(2)(iii)(B), an 
affiliated group includes only domestic corporations and foreign 
corporations that are controlled foreign corporations in which domestic 
members of the affiliated group own, directly or indirectly, at least 80 
percent of the total voting power and value of the stock. For purposes 
of this paragraph (b)(2)(iii)(B), indirect ownership shall be determined 
under section 318 and the regulations under that section.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (b)(2).
    (A) Example 1. For Year 1, USP, a domestic corporation, has a net 
foreign currency gain that would not constitute foreign personal holding 
company income if USP were a controlled foreign corporation because the 
gain is directly related to the business needs of USP. See section 
954(c)(1)(D). Under paragraph (b)(2)(i)(A) of this section, the foreign 
currency gain is, therefore, not passive category income to USP because 
it is not income of a kind that would be foreign personal holding 
company income.
    (B) Example 2. Controlled foreign corporation, CFC, is a wholly-
owned subsidiary of USP, a domestic corporation. CFC is regularly 
engaged in the restaurant franchise business. USP licenses trademarks, 
tradenames, certain know-how, related services, and certain restaurant 
designs for which CFC pays USP an arm's length royalty. USP is regularly 
engaged in the development and licensing of such property. Some of the 
franchisees are unrelated to CFC and USP. Other franchisees are related 
to CFC or USP and use the licensed property outside of CFC's country of 
incorporation. CFC does not satisfy, but USP does satisfy, the active 
trade or business requirements of section 954(c)(2)(A). The royalty 
income earned by CFC from both its related and unrelated franchisees is 
foreign personal holding company income because CFC does not satisfy the 
active trade or business requirements of section 954(c)(2)(A) and, in 
addition, the royalty income from the related franchisees does not 
qualify for the same country exception of section 954(c)(3) or the look-
through exception in section 954(c)(6). However, all of the royalty 
income earned by CFC is general category income to CFC under Sec.  
1.904-4(b)(2)(iii) because USP, a member of CFC's affiliated group, 
satisfies the active trade or business test (which is applied without 
regard to whether the royalties are paid by a related person). USP's 
inclusion under section 951(a)(1)(A) of CFC's royalty income is general 
category income to USP under Sec.  1.904-5(c)(5) and paragraph (d) of 
this section. The royalties received by USP are general category income 
to USP under Sec.  1.904-5(b)(1) and paragraph (d) of this section.
    (3) Specified passive category income means--
    (i) Dividends from a DISC or former DISC (as defined in section 
992(a)) to the extent such dividends are treated as income from sources 
without the United States;
    (ii) Taxable income attributable to foreign trade income (within the 
meaning of section 923(b)); or
    (iii) Distributions from a FSC (or a former FSC) out of earnings and 
profits attributable to foreign trade income (within the meaning of 
section 923(b)) or interest or carrying charges (as defined in section 
927(d)(1)) derived from a transaction which results in foreign trade 
income (as defined in section 923(b)).
    (c) High-taxed income--(1) In general. Income received or accrued by 
a United States person that would otherwise be passive income is not 
treated as passive income if the income is determined to be high-taxed 
income. Income is considered to be high-taxed income

[[Page 865]]

if, after allocating expenses, losses, and other deductions of the 
United States person to that income under paragraph (c)(2) of this 
section, the sum of the foreign income taxes paid or accrued, and deemed 
paid under section 960, by the United States person with respect to such 
income (reduced by any portion of such taxes for which a credit is not 
allowed) exceeds the highest rate of tax specified in section 1 or 11, 
whichever applies (and with reference to section 15 if applicable), 
multiplied by the amount of such income (including the amount treated as 
a dividend under section 78). If, after application of this paragraph 
(c), income that would otherwise be passive income is determined to be 
high-taxed income, the income is treated as general category income, 
foreign branch category income, section 951A category income, or income 
in a specified separate category, as determined under the rules of this 
section, and any taxes imposed on that income are considered related to 
the same separate category of income under Sec.  1.904-6. If, after 
application of this paragraph (c), passive income is zero or less than 
zero, any taxes imposed on the passive income are considered related to 
the same separate category of income to which the passive income (if not 
reduced to zero or less than zero) would have been assigned had the 
income been treated as high-taxed income (general category, foreign 
branch category, section 951A category, or a specified separate 
category). For additional rules regarding losses related to passive 
income, see paragraph (c)(2) of this section. Income and taxes shall be 
translated at the appropriate rates, as determined under sections 986, 
987 and 989 and the regulations under those sections, before application 
of this paragraph (c). For purposes of allocating taxes to groups of 
income, United States source passive income is treated as any other 
passive income. In making the determination whether income is high-
taxed, however, only foreign source income, as determined under United 
States tax principles, is relevant.
    (2) Grouping of items of income in order to determine whether 
passive income is high-taxed income
    (i) Grouping rules--Initial allocation and apportionment of 
deductions and taxes. For purposes of determining whether passive income 
is high-taxed, expenses, losses and other deductions shall be allocated 
and apportioned initially to each of the groups of passive income 
(described in paragraphs (c)(3), (4), and (5) of this section) under the 
rules of Sec. Sec.  1.861-8 through 1.861-17 and 1.865-1 through 1.865-
2. Taxpayers that allocate and apportion interest expense on an asset 
basis may nevertheless apportion passive interest expense among the 
groups of passive income on a gross income basis. Foreign taxes are 
allocated to groups under the rules of Sec.  1.904-6(a)(1)(iii). If a 
loss on a disposition of property gives rise to foreign tax (i.e., the 
transaction giving rise to the loss is treated under foreign law as 
having given rise to a gain), the foreign tax shall be allocated to the 
group of passive income to which gain on the sale would have been 
assigned under paragraph (c)(3) or (4) of this section. A determination 
of whether passive income is high-taxed shall be made only after 
application of paragraph (c)(2)(ii) of this section (if applicable).
    (ii) Reallocation of loss groups. If, after allocation and 
apportionment of expenses, losses and other deductions under paragraph 
(c)(2)(i) of this section, the sum of the allocable deductions exceeds 
the gross income in one or more groups, the excess deductions shall 
proportionately reduce income in the other groups (but not below zero).
    (iii) Coordination with section 904(b), (f) and (g). The 
determination of whether foreign source passive income is high-taxed is 
made before taking into account any adjustments under section 904(b) or 
any allocation or recapture of a separate limitation loss, overall 
foreign loss, or overall domestic loss under section 904(f) and (g).
    (3) Amounts received or accrued by United States persons. Except as 
otherwise provided in paragraph (c)(5) of this section, all passive 
income received by a United States person are subject to the rules of 
this paragraph (c)(3). Paragraph (c)(4) of this section provides 
additional rules for inclusions under section 951(a)(1) or 951A(a) that 
are passive income, dividends from a controlled foreign corporation or 
noncontrolled

[[Page 866]]

10-percent owned foreign corporation that are passive income, and income 
that is received or accrued by a United States person through a foreign 
QBU that is passive income. For purposes of this paragraph (c), a 
foreign QBU is a qualified business unit (as defined in section 989(a)), 
other than a controlled foreign corporation or noncontrolled 10-percent 
owned foreign corporation, that has its principal place of business 
outside the United States. The rules in this paragraph (c)(3) apply 
whether the income is received from a controlled foreign corporation of 
which the United States person is a United States shareholder, from a 
noncontrolled 10-percent owned foreign corporation of which the United 
States person is a United States shareholder that is a domestic 
corporation, or from any other person. In applying the rules in this 
paragraph (c)(3), passive income is not treated as subject to a 
withholding tax or other foreign tax when a credit is disallowed in full 
for such foreign tax, for example, under section 901(k). For purposes of 
determining whether passive income is high-taxed income, the following 
rules apply:
    (i) All passive income received during the taxable year that is 
subject to a withholding tax of fifteen percent or greater shall be 
treated as one item of income.
    (ii) All passive income received during the taxable year that is 
subject to a withholding tax of less than fifteen percent (but greater 
than zero) shall be treated as one item of income.
    (iii) All passive income received during the taxable year that is 
subject to no withholding tax or other foreign tax shall be treated as 
one item of income.
    (iv) All passive income received during the taxable year that is 
subject to no withholding tax but is subject to a foreign tax other than 
a withholding tax shall be treated as one item of income.
    (4) Dividends and inclusions from controlled foreign corporations, 
dividends from noncontrolled 10-percent owned foreign corporations, and 
income attributable to foreign QBUs. Except as provided in paragraph 
(c)(5) of this section, the rules of this paragraph (c)(4) apply to all 
dividends and all amounts included in gross income of a United States 
shareholder under section 951(a)(1) or 951A(a) with respect to the 
foreign corporation that (after application of the look-through rules of 
section 904(d)(3) and Sec.  1.904-5) are attributable to passive income 
received or accrued by a controlled foreign corporation, all dividends 
from a noncontrolled 10-percent owned foreign corporation that are 
received or accrued by a United States shareholder that (after 
application of the look-through rules of section 904(d)(4) and Sec.  
1.904-5) are treated as passive income, and all amounts of passive 
income received or accrued by a United States person through a foreign 
QBU. The grouping rules of paragraphs (c)(3)(i) through (iv) of this 
section apply separately to dividends, to inclusions under section 
951(a)(1) and to inclusions under section 951A(a) with respect to each 
controlled foreign corporation of which the taxpayer is a United States 
shareholder, and to dividends with respect to each noncontrolled 10-
percent owned foreign corporation of which the taxpayer is a United 
States shareholder that is a domestic corporation. The grouping rules of 
paragraphs (c)(3)(i) through (iv) of this section also apply separately 
to income attributable to each tested unit, as defined in Sec.  1.951A-
2(c)(7)(iv), of a controlled foreign corporation, and to each foreign 
QBU of a noncontrolled 10-percent owned foreign corporation or any other 
look-through entity defined in Sec.  1.904-5(i), or of any United States 
person.
    (5) Special rules--(i) Certain rents and royalties. All items of 
rent or royalty income to which an item of rent or royalty expense is 
directly allocable shall be treated as a single item of income and shall 
not be grouped with other amounts.
    (ii) Treatment of partnership income. A partner's distributive share 
of income from a foreign or domestic partnership that is treated as 
passive income under paragraph (n)(1)(ii) of this section (generally 
providing that a less than 10 percent partner's distributive share of 
partnership income is passive income) is treated as a single item of 
income and is not grouped with other amounts. A distributive share of 
income from a partnership that is treated as passive income under 
paragraph (n)(1)(i) of this

[[Page 867]]

section is grouped according to the rules in paragraph (c)(3) of this 
section, except that the portion, if any, of the distributive share of 
income attributable to income earned by a domestic partnership through a 
foreign QBU is separately grouped under the rules of paragraph (c)(4) of 
this section.
    (iii) Currency gain or loss--(A) Section 986(c). Any currency gain 
or loss with respect to a distribution received by a United States 
shareholder (other than a foreign QBU of that shareholder) of previously 
taxed earnings and profits that is recognized under section 986(c) and 
that is treated as an item of passive income shall be subject to the 
rules provided in paragraph (c)(3)(iii) of this section.
    (B) Section 987(3). Any currency gain or loss with respect to 
remittances or transfers of property between QBUs of a United States 
shareholder that is recognized under section 987(3)(B) and that is 
treated as an item of passive income shall be subject to the rules 
provided in paragraph (c)(3)(iii) of this section.
    (C) Example. The following example illustrates the application of 
this paragraph (c)(5)(iii).
    (1) Facts. USP, a domestic corporation, owns all of the stock of 
CFC, a controlled foreign corporation organized and operating in Country 
X that uses the ``u'' as its functional currency. In Year 1, when the 
highest rate of U.S. tax in section 11 is 21%, CFC earns 100u of passive 
category foreign personal holding company income subject to no foreign 
tax. When included in USP's income under section 951(a), the applicable 
exchange rate is 1u=$1x. Therefore, USP's section 951(a) inclusion is 
$100x and no foreign taxes are deemed paid by USP with respect to the 
inclusion. At the end of Year 1, CFC has previously taxed earnings and 
profits of 100u and USP's basis in those earnings is $100x. In Year 2, 
CFC has no earnings and profits and distributes 100u to USP. The value 
of the earnings when distributed is $150x. Assume that under section 
986(c), USP must recognize $50x of passive category income attributable 
to the appreciation of the previously taxed earnings and profits. 
Country X does not recognize any gain or loss on the distribution, but 
imposes a 10u withholding tax on USP with respect to the distribution.
    (2) Analysis. Because the section 986(c) gain is not subject to any 
foreign withholding tax or other foreign tax, under paragraph 
(c)(3)(iii) of this section the section 986(c) gain is grouped with 
other items of USP's income that are subject to no withholding tax or 
other foreign tax. Under paragraph (c)(6)(iii) of this section, the 10u 
withholding tax is related to passive category income. See section 
960(c) and Sec.  1.960-4 for rules relating to the increase in 
limitation in the year of distribution of previously taxed earnings and 
profits.
    (iv) Coordination with section 954(b)(4). For rules relating to 
passive income of a controlled foreign corporation that is exempt from 
subpart F treatment because the income is subject to high foreign tax, 
see section 904(d)(3)(E), Sec.  1.904-4(c)(7)(iii), and Sec.  1.904-
5(d)(2).
    (6) Application of this paragraph to additional taxes paid or deemed 
paid in the year of receipt of previously taxed income--(i) 
Determination made in year of inclusion. The determination of whether an 
amount included in gross income under section 951(a)(1) or 951A(a) is 
high-taxed income is made in the taxable year the income is included in 
the gross income of the United States shareholder under section 951(a) 
or 951A(a) (for purposes of this paragraph (c), the year of inclusion). 
Any increase in foreign taxes paid or accrued, or deemed paid, when the 
taxpayer receives an amount that is excluded from gross income under 
section 959(a) and that is attributable to a controlled foreign 
corporation's earnings and profits relating to the amount previously 
included in gross income will not be considered in determining whether 
the amount included in income in the year of inclusion is high-taxed 
income.
    (ii) Exception. Paragraph (c)(6)(i) of this section shall not apply 
to an increase in tax in a case in which the taxpayer is required to 
adjust its foreign taxes in the year of inclusion under section 905(c).
    (iii) Allocation of foreign taxes imposed on distributions of 
previously taxed income. If an item of income is considered

[[Page 868]]

high-taxed income in the year of inclusion and paragraph (c)(6)(i) of 
this section applies, then any increase in foreign income taxes imposed 
with respect to that item are considered to be related to the same 
separate category to which the income was assigned in the taxable year 
of inclusion. If an item of income is not considered to be high-taxed 
income in the year of inclusion and paragraph (c)(6)(i) of this section 
applies, the following rules shall apply. The taxpayer shall treat an 
increase in taxes paid or accrued, or deemed paid, on any distribution 
of the earnings and profits attributable to the amount included in gross 
income in the year of inclusion as taxes related to passive income to 
the extent of the excess of the product of the highest rate of tax in 
section 11 (determined with regard to section 15 and determined as of 
the year of inclusion) and the amount of the inclusion (after allocation 
of parent expenses) over the taxes paid or accrued, or deemed paid, in 
the year of inclusion. The taxpayer shall treat any taxes paid or 
accrued, or deemed paid, on the distribution in excess of this amount as 
taxes related to the same category of income to which such inclusion 
would have been assigned had the income been treated as high-taxed 
income in the year of inclusion (general category income, section 951A 
category income, or income in a specified separate category). If these 
additional taxes are not creditable in the year of distribution, the 
carryover rules of section 904(c) apply (see section 904(c) and Sec.  
1.904-2(a) for rules disallowing carryovers in the section 951A 
category). For purposes of this paragraph (c)(6), the foreign tax on an 
inclusion under section 951(a)(1) or 951A(a) is considered increased on 
distribution of the earnings and profits associated with that inclusion 
if the total of taxes paid and deemed paid on the inclusion and the 
distribution (taking into account any reductions in tax and any 
withholding taxes) exceeds the total taxes deemed paid in the year of 
inclusion. Any foreign currency loss associated with the earnings and 
profits that are distributed with respect to the inclusion is not to be 
considered as giving rise to an increase in tax.
    (iv) Increase in taxes paid by successors. If passive earnings and 
profits previously included in income of a United States shareholder are 
distributed to a person that was not a United States shareholder of the 
distributing corporation in the year the earnings were included, any 
increase in foreign taxes paid or accrued, or deemed paid, on that 
distribution is treated as taxes related to general category income (or 
income in a specified separate category, if applicable) in the case of 
earnings and profits previously included under section 951(a)(1), and is 
treated as taxes related to section 951A category income (or income in a 
specified separate category, if applicable) in the case of earnings and 
profits previously included under section 951A(a), regardless of whether 
the previously-taxed income was considered high-taxed income under 
section 904(d)(2)(F) in the year of inclusion.
    (7) Application of this paragraph to certain reductions of tax on 
distributions of income--(i) In general. If the effective rate of tax 
imposed by a foreign country on income of a foreign corporation that is 
included in a taxpayer's gross income is reduced under foreign law on 
distribution of such income, the rules of this paragraph (c) apply at 
the time that the income is included in the taxpayer's gross income, 
without regard to the possibility of a subsequent reduction of foreign 
tax on the distribution. If the inclusion is considered to be high-taxed 
income, then the taxpayer must initially treat the inclusion as general 
category income, section 951A category income, or income in a specified 
separate category as provided in paragraph (c)(1) of this section. When 
the foreign corporation distributes the earnings and profits to which 
the inclusion was attributable and the foreign tax on the inclusion is 
reduced, then if a redetermination of U.S. tax liability is required 
under Sec.  1.905-3(b)(2), the taxpayer must redetermine whether the 
revised inclusion (if any) is considered to be high-taxed income. See 
Sec.  1.905-3(b)(2)(ii) (requiring a redetermination of the amount of 
the inclusion, the application of the high-tax exception under section 
954(b)(4), and the amount of foreign taxes deemed paid). If, taking into 
account the reduction in

[[Page 869]]

foreign tax, the inclusion is not considered high-taxed income, then the 
taxpayer, in redetermining its U.S. tax liability for the year or years 
affected, must treat the inclusion and the associated taxes (as reduced 
on the distribution) as passive category income and taxes. For purposes 
of this paragraph (c), the foreign tax on an inclusion under section 
951(a)(1) or 951A(a) is considered reduced on distribution of the 
earnings and profits associated with the inclusion if the total taxes 
paid and deemed paid on the inclusion and the distribution (taking into 
account any reductions in tax and any withholding taxes) is less than 
the total taxes deemed paid in the year of inclusion. Therefore, any 
foreign currency gain associated with the earnings and profits that are 
distributed with respect to the inclusion is not taken into account in 
determining whether there is a reduction of tax requiring a 
redetermination of whether the inclusion is high-taxed income.
    (ii) Allocation of reductions of foreign tax. For purposes of 
paragraph (c)(7)(i) of this section, reductions in foreign tax shall be 
allocated among the separate categories under the same principles as 
those of Sec.  1.904-6 for allocating taxes among the separate 
categories. Thus, for purposes of determining to which year's taxes the 
reduction in taxes relates, foreign law shall apply. If, however, 
foreign law does not attribute a reduction in taxes to a particular year 
or years, then the reduction in taxes shall be attributable, on an 
annual last in-first out (LIFO) basis, to foreign taxes potentially 
subject to reduction that are associated with previously taxed income, 
then on a LIFO basis to foreign taxes associated with income that under 
paragraph (c)(7)(iii) of this section remains as passive income but that 
was excluded from subpart F income or tested income under section 
954(b)(4) or section 951A(c)(2)(A)(i)(III), and finally on a LIFO basis 
to foreign taxes associated with other earnings and profits. 
Furthermore, in applying the ordering rules of section 959(c), 
distributions shall be considered made on a LIFO basis first out of 
earnings described in section 959(c)(1) and (2), then on a LIFO basis 
out of earnings and profits associated with income that remains passive 
income under paragraph (c)(7)(iii) of this section but that was excluded 
from subpart F income or tested income under section 954(b)(4) or 
section 951A(c)(2)(A)(i)(III), and finally on a LIFO basis out of other 
earnings and profits. For purposes of this paragraph (c)(7)(ii), foreign 
law is not considered to attribute a reduction in tax to a particular 
year or years if foreign law attributes the tax reduction to a pool or 
group containing income from more than one taxable year and such pool or 
group is defined based on a characteristic of the income (for example, 
the rate of tax paid with respect to the income) rather than on the 
taxable year in which the income is derived.
    (iii) Treatment of income excluded under section 954(b)(4) or 
section 951A(c)(2)(A)(i)(III). If the effective rate of tax imposed by a 
foreign country on income of a foreign corporation is reduced under 
foreign law on distribution of that income, the rules of section 
954(b)(4) (including for purposes of determining tested income under 
section 951A(c)(2)(A)(i)(III)) are applied in the year of inclusion 
without regard to the possibility of a subsequent reduction of foreign 
tax. See Sec. Sec.  1.954-1(d)(3)(iii) and 1.951A-2(c)(6)(iv). If a 
taxpayer excludes passive income from a controlled foreign corporation's 
foreign personal holding company income or tested income under section 
954(b)(4) or section 951A(c)(2)(A)(i)(III), then, notwithstanding the 
general rule of Sec.  1.904-5(d)(2), the income is considered to be 
passive category income until distribution of that income. At that time, 
if after the redetermination of U.S. tax liability required under Sec.  
1.905-3(b)(2) the taxpayer still elects to exclude the passive income 
under section 954(b)(4) or section 951A(c)(2)(A)(i)(III), the rules of 
this paragraph (c)(7)(iii) apply to determine whether the income is 
high-taxed income upon distribution and, therefore, income in another 
separate category. For purposes of determining whether a reduction in 
tax is attributable to taxes on income excluded under section 954(b)(4) 
or section 951A(c)(2)(A)(i)(III), the rules of paragraph (c)(7)(ii) of 
this section apply. The rules of paragraph (c)(7)(ii) of this

[[Page 870]]

section also apply for purposes of ordering distributions to determine 
whether such distributions are out of earnings and profits associated 
with such excluded income. For an example illustrating the operation of 
this paragraph (c)(7)(iii), see paragraph (c)(8)(vi) of this section 
(Example 6).
    (8) Examples. The following examples illustrate the application of 
this paragraph (c). All of the examples assume that the highest tax rate 
under section 11 is 21%, unless otherwise noted.
    (i) Example 1. CFC, a controlled foreign corporation, is a wholly-
owned subsidiary of domestic corporation USP. CFC is a single qualified 
business unit (QBU) operating in foreign Country X. In Year 1, CFC earns 
$130x of gross royalty income that is passive income from Country X 
sources, and incurs $30x of expenses that do not include any payments to 
USP. CFC's $100x of pre-tax passive income from the royalty is subject 
to $30x of foreign tax, and is included under section 951(a)(1) in USP's 
gross income for the taxable year. USP allocates $50x of expenses to the 
$100x (consisting of the $70x section 951(a)(1) inclusion and $30x 
section 78 amount), resulting in net passive income of $50x. USP does 
not elect to exclude from subpart F under section 954(b)(4) the $70x of 
CFC's net passive income. After application of the high-tax kick-out 
rules of paragraph (c) of this section, the $50x of USP's net passive 
income is treated as general category income, and the $30x of taxes 
deemed paid are treated as taxes imposed on general category income, 
because the foreign taxes paid and deemed paid on the income exceed the 
highest U.S. tax rate multiplied by the $50x of net passive income ($30x 
 $10.5x (21% x $50x)).
    (ii) Example 2. CFC, a controlled foreign corporation, is a wholly-
owned subsidiary of domestic corporation USP. CFC is incorporated and 
operating in Country Y and has a branch in Country Z. CFC has two QBUs 
(QBU Y and QBU Z). In Year 1, CFC earns $65x of gross royalty income 
that is passive income in Country Y through QBU Y and $65x of gross 
royalty income that is passive income in Country Z through QBU Z. CFC 
allocates $15x of expenses to the gross royalty income earned by each 
QBU, resulting in pre-tax passive income of $50x in each QBU. Country Y 
imposes $5x of foreign tax on the royalty income earned in Y, and 
Country Z imposes $10x of tax on royalty income earned in Z. All of 
CFC's income constitutes foreign personal holding company income that is 
passive income and is included under section 951(a)(1) in USP's gross 
income for the taxable year. USP allocates $50x of expenses pro rata to 
the $100x section 951(a)(1) inclusion attributable to the QBUs 
(consisting of the $45x section 951(a)(1) inclusion derived through QBU 
Y, the $5x section 78 amount attributable to QBU Y, the $40x section 
951(a)(1) inclusion derived through QBU Z, and the $10x section 78 
amount attributable to QBU Z), resulting in net passive income of $50x. 
Pursuant to paragraph (c)(4) of this section, the high-tax kickout rules 
must be applied separately to the subpart F inclusion attributable to 
the income earned by QBU Y and the income earned by QBU Z. After 
application of the high-tax kickout rules, the $25x of net passive 
income attributable to QBU Y will be treated as passive category income 
because the foreign taxes paid and deemed paid on the income do not 
exceed the highest U.S. tax rate multiplied by the $25x of net passive 
income ($5x < $5.25x (21% x $25x)). The $25x of net passive income 
attributable to QBU Z will be treated as general category income because 
the foreign taxes paid and deemed paid on the income exceed the highest 
U.S. tax rate multiplied by the $25x of net passive income ($10x 
 $5.25x (21% x $25x)).
    (iii) Example 3. Domestic corporation USP operates in branch form in 
foreign countries X and Y. The branches are qualified business units 
(QBUs), within the meaning of section 989(a). In Year 1, QBU X earns 
passive royalty income, interest income, and rental income. All of the 
QBU X passive income is from Country Z sources. The royalty income is 
not subject to a withholding tax, and is not taxed by Country X, and the 
interest and the rental income are subject to a 4% and 10% withholding 
tax, respectively. QBU Y earns interest income in Country Y that is not 
subject to foreign tax. For purposes of determining whether USP's 
foreign source

[[Page 871]]

passive income is high-taxed income, the rental income and the interest 
income earned in QBU X are treated as one item of income pursuant to 
paragraph (c)(3)(ii) of this section. The interest income earned in QBU 
Y and the royalty income earned in QBU X are each treated as a separate 
item of income under paragraphs (c)(4) and (c)(3)(iii) of this section. 
If, after allocation of expenses, QBU X's items of income composed of 
rental income and interest income are high-taxed income, the income may 
be treated as foreign branch category income.
    (iv) Example 4. CFC, a controlled foreign corporation incorporated 
in foreign Country R, is a wholly-owned subsidiary of USP, a domestic 
corporation. USP and CFC have calendar year taxable years for both U.S. 
and Country R tax purposes. The highest tax rate under section 11 is 34% 
and 21% in Year 1 and Year 2, respectively. For Year 1, USP is required 
under section 951(a)(1) to include in gross income $80x (not including 
the section 78 amount) attributable to the earnings and profits of CFC 
for such year, all of which is foreign personal holding company income 
that is passive rent or royalty income. CFC does not make any 
distributions in Year 1. Foreign income taxes paid by CFC for Year 1 
that are deemed paid by USP for such year under section 960(a) with 
respect to the section 951(a)(1) inclusion equal $20x. USP properly 
allocates $30x of expenses to the section 951(a)(1) inclusion. The 
foreign income tax paid with respect to the section 951(a)(1) inclusion 
does not exceed the highest U.S. tax rate multiplied by the amount of 
income after allocation of USP's expenses ($20x < $23.80x (34% x $70x)). 
Thus, USP's section 951(a)(1) inclusion for Year 1 is included in USP's 
passive category income and the $20x of taxes attributable to that 
inclusion are treated as taxes related to passive category income. In 
Year 2, CFC distributes $70x to USP, and under section 959 that 
distribution is treated as attributable to the earnings and profits with 
respect to the amount included in income by USP in Year 1 and is 
excluded from USP's gross income. Foreign Country R imposes a 
withholding tax of $14x on the distribution in Year 2. Under paragraph 
(c)(6)(i) of this section, the withholding tax in Year 2 does not affect 
the characterization of the Year 1 inclusion as passive category income, 
nor does it affect the characterization of the $20x of taxes paid in 
Year 1 as taxes paid with respect to passive category income. No further 
expenses of USP are allocable to the receipt of that distribution. In 
Year 2, the foreign taxes paid ($14x) exceed the product of the highest 
U.S. tax rate and the amount of the inclusion reduced by taxes deemed 
paid in the year of inclusion ($14x  $3.80x ((34% x $70x) - 
$20x)). Thus, under paragraph (c)(6)(iii) of this section, $3.80x ((34% 
x $70x) - $20x) of the $14x withholding tax paid in Year 2 is treated as 
taxes related to passive category income and the remaining $10.20x ($14x 
- $3.80x) of the withholding tax is treated as related to general 
category income.
    (v) Example 5. CFC, a controlled foreign corporation, is a wholly-
owned subsidiary of USP, a domestic corporation. USP and CFC are 
calendar year taxpayers. In Year 1, CFC's only earnings consist of $200x 
of pre-tax passive income that is foreign personal holding company 
income that is earned in foreign Country X. Under Country X's tax 
system, the corporate tax on particular earnings is reduced on 
distribution of those earnings and no withholding tax is imposed. In 
Year 1, CFC pays $100x of foreign tax with respect to its passive 
income. USP does not elect to exclude this income from subpart F under 
section 954(b)(4) and includes $200x in gross income ($100x of net 
foreign personal holding company income and $100x of the amount under 
section 78 (the ``section 78 dividend'')). At the time of the inclusion, 
the income is considered to be high-taxed income under paragraphs (c)(1) 
and (c)(6)(i) of this section and is general category income to USP 
($100x  $42x (21% x $200x)). CFC does not distribute any of 
its earnings in Year 1. In Year 2, CFC has no additional earnings. On 
December 31, Year 2, CFC distributes the $100x of earnings from Year 1. 
At that time, CFC receives a $60x refund from Country X attributable to 
the reduction of the Country X corporate tax imposed on the Year 1 
earnings. The refund is a foreign tax redetermination under

[[Page 872]]

Sec.  1.905-3(a) that under Sec. Sec.  1.905-3(b)(2) and 1.954-
1(d)(3)(iii) requires a redetermination of CFC's Year 1 subpart F income 
and the application of section 954(b)(4), as well as a redetermination 
of USP's Year 1 inclusion under section 951(a)(1), its deemed paid taxes 
under section 960(a), and its Year 1 U.S. tax liability. As recomputed 
taking into account the $60x refund, CFC's Year 1 passive category net 
foreign personal holding company income is increased by $60x to $160x, 
CFC's foreign income taxes attributable to that income are reduced from 
$100x to $40x, and the income still qualifies to be excluded from CFC's 
subpart F income under section 954(b)(4) ($40x  $37.80x (90% 
x 21% x $200x)). Assuming USP does not change its Year 1 election, USP's 
Year 1 inclusion under section 951(a)(1) is increased by $60x to $160x, 
and the associated deemed paid tax and section 78 dividend are reduced 
by $60x to $40x. Under paragraph (c)(7)(i) of this section, in 
connection with the adjustments required under section 905(c), USP must 
redetermine whether the adjusted Year 1 inclusion is high-taxed income 
of USP. Taking into account the $60x refund, the inclusion is not 
considered high-taxed income of USP ($40x < $42x (21% x $200x)). 
Therefore, USP must treat the $200x of income ($160x inclusion plus $40x 
section 78 amount) and the $40x of taxes associated with the inclusion 
in Year 1 as passive category income and taxes. USP must also follow the 
appropriate procedures under Sec.  1.905-4.
    (vi) Example 6. The facts are the same as in paragraph (c)(8)(v) of 
this section (the facts in Example 5), except that in Year 1, USP elects 
to apply section 954(b)(4) to exclude CFC's passive income from its 
subpart F income, both before and after the recomputation of CFC's Year 
1 subpart F income and USP's Year 1 U.S. tax liability that is required 
by reason of the Year 2 $60x foreign tax redetermination. Although the 
income is not considered to be subpart F income, under paragraph 
(c)(7)(iii) of this section it remains passive category income until 
distribution. In Year 2, the $100x distribution is a dividend to USP, 
because CFC has $160x of accumulated earnings and profits described in 
section 959(c)(3) (the $100x of earnings in Year 1 increased by the $60x 
refund received in Year 2 that under Sec.  1.905-3(b)(2) is taken into 
account in Year 1). Under paragraph (c)(7)(iii) of this section, USP 
must determine whether the dividend income is high-taxed income to USP 
in Year 2. The treatment of the dividend as passive category income may 
be relevant in determining deductions allocable or apportioned to such 
dividend income or related stock that are excluded in the computation of 
USP's foreign tax credit limitation under section 904(a) in Year 2. See 
section 904(b)(4). Under paragraph (c)(1) of this section, the dividend 
income is passive category income to USP because the foreign taxes paid 
and deemed paid by USP ($0x) with respect to the dividend income do not 
exceed the highest U.S. tax rate on that income.
    (vii) Example 7. The facts are the same as in paragraph (c)(8)(v) of 
this section (the facts in Example 5), except that the distribution in 
Year 2 is subject to a withholding tax of $25x. Under paragraph 
(c)(7)(i) of this section, USP must redetermine whether its Year 1 
inclusion should be considered high-taxed income of USP because there is 
a net $35x reduction ($60x refund of foreign corporate tax--$25x 
withholding tax) of foreign tax. By taking into account both the 
reduction in foreign corporate tax and the additional withholding tax, 
the inclusion continues to be considered high-taxed income of USP in 
Year 1 ($65x  $42x (21% x $200)). USP must follow the 
appropriate section 905(c) procedures. USP must redetermine its U.S. tax 
liability for Year 1, but the Year 1 inclusion and the $65x taxes ($40x 
of deemed paid tax in Year 1 and $25x withholding tax in Year 2) will 
continue to be treated as general category income and taxes.
    (viii) Example 8. (A) CFC, a controlled foreign corporation 
operating in Country G, is a wholly-owned subsidiary of USP, a domestic 
corporation. USP and CFC are calendar year taxpayers. Country G imposes 
a tax of 50% on CFC's earnings. Under Country G's system, the foreign 
corporate tax on particular earnings is reduced on distribution of those 
earnings to 30% and no withholding tax is imposed. Under Country G's 
law, distributions are

[[Page 873]]

treated as made out of a pool of undistributed earnings subject to the 
50% tax rate. For Year 1, CFC's only earnings consist of passive income 
that is foreign personal holding company income that is earned in 
foreign Country G. CFC has taxable income of $110x for Federal income 
tax purposes and $100x for Country G purposes. Country G, therefore, 
imposes a tax of $50x on the Year 1 earnings of CFC. USP does not elect 
to exclude this income from subpart F under section 954(b)(4) and 
includes $110x in gross income ($60x of net foreign personal holding 
company income under section 951(a) and $50x of the section 78 
dividend). The highest rate of tax under section 11 in Year 1 is 34%. 
Therefore, at the time of the section 951(a) inclusion, the income is 
considered to be high-taxed income under paragraph (c) of this section 
($50x  $37.4x (34% x $110x)) and is general category income 
to USP. CFC does not distribute any of its earnings in Year 1.
    (B) In Year 2, CFC earns general category income that is not subpart 
F income or tested income. CFC again has $110x in taxable income for 
Federal income tax purposes and $100x in taxable income for Country G 
purposes, and CFC pays $50x of tax to foreign Country G. In Year 3, CFC 
has no taxable income or earnings. On December 31, Year 3, CFC 
distributes $60x of its total $120x of earnings and receives a refund of 
foreign tax of $24x. The $24x refund is a foreign tax redetermination 
under Sec.  1.905-3(a) that under Sec.  1.905-3(b)(2) requires a 
redetermination of CFC's Year 1 subpart F income and USP's deemed paid 
taxes and Year 1 U.S. tax liability. Country G treats the distribution 
of earnings as out of the 50% tax rate pool of $200x of earnings 
accumulated in Year 1 and Year 2, as calculated for Country G tax 
purposes. However, under paragraph (c)(7)(ii) of this section, the 
distribution, and, therefore, the reduction of tax is treated as first 
attributable to the $60x of passive category earnings attributable to 
income previously taxed in Year 1, and none of the distribution is 
treated as made out of the $60x of earnings accumulated in Year 2 (which 
is not previously taxed). Because 40 percent (the reduction in tax rates 
from 50 percent to 30 percent is a 40 percent reduction in the tax) of 
the $50x of foreign taxes attributable to the $60x of Year 1 passive 
income as calculated for Federal income tax purposes is refunded, $20x 
of the $24x foreign tax refund reduces foreign taxes on CFC's Year 1 
passive income from $50x to $30x. The other $4x of the tax refund 
reduces the taxes imposed in Year 2 on CFC's general category income 
from $50x to $46x.
    (C) Under paragraph (c)(7) of this section, in connection with the 
section 905(c) adjustment USP must redetermine whether its Year 1 
subpart F inclusion is considered high-taxed income. By taking into 
account the reduction in foreign tax, the inclusion is increased by $20x 
to $80x, the deemed paid taxes are reduced by $20x to $30x, and the 
inclusion is not considered high-taxed income ($30x < 34% x $110x). 
Therefore, USP must treat the revised section 951(a) inclusion and the 
taxes associated with the section 951(a) inclusion as passive category 
income and taxes in Year 1. USP must follow the appropriate procedures 
under Sec.  1.905-4.
    (ix) Example 9. USP, a domestic corporation, earns $100x of passive 
royalty income from sources within the United States. Under the laws of 
Country X, however, that royalty is considered to be from sources within 
Country X, and Country X imposes a 5% withholding tax on the payment of 
the royalty. USP also earns $100x of foreign source passive dividend 
income from Country Y subject to a 10% withholding tax to which $15x of 
expenses are allocated. In determining whether USP's passive income is 
high-taxed, the $5x withholding tax on USP's royalty income is allocated 
to passive income, and to the group of passive income described in 
paragraph (c)(3)(ii) of this section (passive income subject to a 
withholding tax of less than 15% (but greater than zero)). For purposes 
of determining whether the income is high-taxed, however, only the $85x 
of foreign source dividend income (and not the $100x of U.S. source 
royalty income) is taken into account. The foreign source dividend 
income is treated as passive category income because the foreign taxes 
paid on the passive income in the group ($15x) do not exceed the highest 
U.S. tax rate multiplied by the $85x of net

[[Page 874]]

foreign source income in the group ($15x < $17.85x ($100x - $15x) x 
21%).
    (x) Example 10. In Year 1, P, a U.S. citizen with a tax home in 
Country X, earns the following items of gross income: $400x of foreign 
source, passive interest income not subject to foreign withholding tax 
but subject to Country X income tax of $100x, $200x of foreign source, 
passive royalty income subject to a 5% foreign withholding tax (foreign 
tax paid is $10x), $1,300x of foreign source, passive rental income 
subject to a 25% foreign withholding tax (foreign tax paid is $325x), 
$500x of foreign source, general category loss, and $2,000x of U.S. 
source capital gain that is not subject to any foreign tax. P has a 
$900x deduction allocable to its passive rental income. P's only other 
deduction is a $700x capital loss on the sale of stock that is allocated 
to foreign source passive category income under Sec.  1.865-2(a)(3)(i). 
The $700x capital loss is initially allocated to the group of passive 
income described in paragraph (c)(3)(iv) of this section (passive income 
subject to no withholding tax but subject to foreign tax other than 
withholding tax). This group comprises the $400x of interest income not 
subject to foreign withholding tax but subject to Country X income tax. 
Under paragraph (c)(2)(ii) of this section, the $300x amount by which 
the capital loss exceeds the income in the group must be reallocated to 
the net income in the other groups described in paragraph (c)(3) of this 
section, but the $500x general category separate limitation loss is not 
allocated until the high-tax kickout rules are applied to determine 
whether the passive income is high-taxed income. P's $200x of royalty 
income subject to a 5% withholding tax is described in paragraph 
(c)(3)(i) of this section (passive income that is subject to a 
withholding tax of less than 15%, but greater than zero). P's $1,300x of 
rental income subject to a 25% withholding tax is described in paragraph 
(c)(3)(ii) of this section (passive income that is subject to a 
withholding tax of 15% or greater). The $1,300x of rental income is 
reduced by the $900x deduction allocable to such income. Therefore, the 
total net income in the other groups under paragraph (c)(3) is $600x, 
the $200x of royalty income and the $400x of rental income. The ($300x) 
net loss in the net basis tax group thus reduces the royalty income by 
$100x to $100x ($200x - ($300x x (200x/600x))) and the rental income by 
$200x to $200x ($400x - ($300x x (400x/600x))). The $100x of net royalty 
income is not high-taxed and remains passive category income because the 
foreign taxes of $10x do not exceed the highest U.S. rate of tax on that 
income, which is 37% for individuals ($10x < $37x (37% x $100x)). Under 
the high-tax kickout, the $200x of rental income and the $325x of 
associated foreign tax are assigned to the general category.
    (xi) Example 11. The facts are the same as in paragraph (c)(8)(x) of 
this section (the facts in Example 10), except the amount of the capital 
loss that is allocated under Sec.  1.865-2(a)(3)(i) and paragraph (c)(2) 
of this section to the group of foreign source passive income subject to 
no withholding tax but subject to foreign tax other than withholding tax 
is $1,200x. Under paragraph (c)(2)(ii) of this section, the excess 
deductions of $800x must be reallocated to the $200x of net royalty 
income subject to a 5% withholding tax and the $400x of net rental 
income subject to a 15% or greater withholding tax. The income in each 
of these groups is reduced to zero, and the foreign taxes imposed on the 
rental and royalty income are considered related to general category 
income. The remaining loss of $200x constitutes a separate limitation 
loss with respect to passive category income.
    (xii) Example 12. In Year 1, USP, a domestic corporation, earns a 
$100x dividend that is foreign source passive income subject to a 30% 
withholding tax. The dividend is not paid by a specified 10-percent 
owned foreign corporation (as defined in section 245A(b)(1)). A foreign 
tax credit for the withholding tax on the dividend is disallowed under 
section 901(k). A deduction for the tax is allowed, however, under 
sections 164 and 901(k)(7). In determining whether USP's passive income 
is high-taxed, under paragraph (c)(3) of this section the $100x dividend 
and the $30x deduction are allocated to the group of income described in 
paragraph (c)(3)(iv) of this section (passive income subject

[[Page 875]]

to no withholding tax or other foreign tax).
    (d) General category income. The term general category income means 
all income other than passive category income, foreign branch category 
income, section 951A category income, and income in a specified separate 
category. Any item that is excluded from the passive category under 
paragraph (c) or (h) of this section or Sec.  1.904-5(b)(1) is included 
in general category income only to the extent that such item does not 
meet the definition of another separate category. General category 
income also includes income treated as general category income under the 
look-through rules referenced in Sec.  1.904-5(a)(2).
    (e) Financial services income--(1) In general--(i) Treatment of 
financial services income. Passive income that is characterized as 
financial services income is not assigned to the passive category but is 
assigned in accordance with this paragraph (e)(1)(i). Financial services 
income that meets the definition of foreign branch category income (see 
paragraph (f)(1) of this section) is treated as income in that category. 
Financial services income of a controlled foreign corporation that is 
included in gross income of a United States shareholder under section 
951A(a) is treated as section 951A category income in the hands of the 
United States shareholder. Financial services income that is neither 
treated as foreign branch category income nor treated as section 951A 
category income is treated as general category income. Distributions, 
interest, rents, or royalties received from a related person that is a 
financial services entity that would be assigned to the passive category 
under the look-through rules in Sec.  1.904-5, but for the fact such 
amounts are paid by a financial services entity (and, therefore, not 
attributable to passive category income of the payor), are assigned to 
separate categories (other than the passive category) under the rules in 
this section.
    (ii) Definition of financial services income. The term financial 
services income means income derived by a financial services entity, as 
defined in paragraph (e)(3) of this section, that is:
    (A) Income derived in the active conduct of a banking, insurance, 
financing, or similar business (active financing income as defined in 
paragraph (e)(2) of this section);
    (B) Passive income as defined in section 904(d)(2)(B) and paragraph 
(b) of this section as determined before the application of the 
exception for high-taxed income but after the application of the 
exception for export financing interest; or
    (C) Incidental income as defined in paragraph (e)(4) of this 
section.
    (2) Active financing income--(i) Income included. For purposes of 
paragraph (e)(1) and (e)(3) of this section, income is active financing 
income only if it is described in any of the following subdivisions.
    (A) Income that is of a kind that would be insurance income as 
defined in section 953(a) (including related party insurance income as 
defined in section 953(c)(2)) and determined without regard to those 
provisions of section 953(a)(1)(A) that limit insurance income to income 
from countries other than the country in which the corporation was 
created or organized.
    (B) Income from the investment by an insurance company of its 
unearned premiums or reserves ordinary and necessary to the proper 
conduct of the insurance business, income from providing services as an 
insurance underwriter, income from insurance brokerage or agency 
services, and income from loss adjuster and surveyor services.
    (C) Income from investing funds in circumstances in which the 
taxpayer holds itself out as providing a financial service by the 
acceptance or the investment of such funds, including income from 
investing deposits of money and income earned investing funds received 
for the purchase of traveler's checks or face amount certificates.
    (D) Income from making personal, mortgage, industrial, or other 
loans.
    (E) Income from purchasing, selling, discounting, or negotiating on 
a regular basis, notes, drafts, checks, bills of exchange, acceptances, 
or other evidences of indebtedness.
    (F) Income from issuing letters of credit and negotiating drafts 
drawn thereunder.
    (G) Income from providing trust services.

[[Page 876]]

    (H) Income from arranging foreign exchange transactions, or engaging 
in foreign exchange transactions.
    (I) Income from purchasing stock, debt obligations, or other 
securities from an issuer or holder with a view to the public 
distribution thereof or offering or selling stock, debt obligations, or 
other securities for an issuer or holder in connection with the public 
distribution thereof, or participating in any such undertaking.
    (J) Income earned by broker-dealers in the ordinary course of 
business (such as commissions) from the purchase or sale of stock, debt 
obligations, commodities futures, or other securities or financial 
instruments and dividend and interest income earned by broker dealers on 
stock, debt obligations, or other financial instruments that are held 
for sale.
    (K) Service fee income from investment and correspondent banking.
    (L) Income from interest rate and currency swaps.
    (M) Income from providing fiduciary services.
    (N) Income from services with respect to the management of funds.
    (O) Bank-to-bank participation income.
    (P) Income from providing charge and credit card services or for 
factoring receivables obtained in the course of providing such services.
    (Q) Income from financing purchases from third parties.
    (R) Income from gains on the disposition of tangible or intangible 
personal property or real property that was used in the active financing 
business (as defined in paragraph (e)(3)(i) of this section) but only to 
the extent that the property was held to generate or generated active 
financing income prior to its disposition.
    (S) Income from hedging gain with respect to other active financing 
income.
    (T) Income from providing traveller's check services.
    (U) Income from servicing mortgages.
    (V) Income from a finance lease. For this purpose, a finance lease 
is any lease that is a direct financing lease or a leveraged lease for 
accounting purposes and is also a lease for tax purposes.
    (W) [Reserved]
    (X) Income from providing investment advisory services, custodial 
services, agency paying services, collection agency services, and stock 
transfer agency services.
    (Y) Any similar item of income that is disclosed in the manner 
provided in the instructions to the Form 1118 or 1116 or that is 
designated as a similar item of income in guidance published by the 
Internal Revenue Service.
    (3) Financial services entities--(i) In general. The term 
``financial services entity'' means an individual or entity that is 
predominantly engaged in the active conduct of a banking, insurance, 
financing, or similar business (active financing business) for any 
taxable Year. Except as provided in paragraph (e)(3)(ii) of this 
section, a determination of whether an entity is a financial services 
entity shall be done on an entity-by-entity basis. An individual or 
entity is predominantly engaged in the active financing business for any 
year if for that year at least 80 percent of its gross income is income 
described in paragraph (e)(2)(i) of this section. For this purpose, 
gross income includes all income realized by an individual or entity, 
whether includible or excludible from gross income under other operative 
provisions of the Code, but excludes gain from the disposition of stock 
of a corporation that prior to the disposition of its stock is related 
to the transferor within the meaning of section 267(b). For this 
purpose, income received from a related person that is a financial 
services entity shall be excluded if such income is characterized under 
the look-through rules of section 904(d)(3) and Sec.  1.904-5. In 
addition, income received from a related person that is not a financial 
services entity but that is characterized as financial services income 
under the look-through rules shall be excluded. Any income received from 
a related person that is characterized under the look-through rules and 
that is not otherwise excluded by this paragraph will retain its 
character either as active financing income or other income in the hands 
of the recipient for purposes of determining if the recipient is a 
financial

[[Page 877]]

services entity and if the income is financial services income to the 
recipient. For purposes of this paragraph, related person is defined in 
Sec.  1.904-5(i)(1).
    (ii) Special rule for affiliated groups. In the case of any 
corporation that is not a financial services entity under paragraph 
(e)(3)(i) of this section, but is a member of an affiliated group, such 
corporation will be deemed to be a financial services entity if the 
affiliated group as a whole meets the requirements of paragraph 
(e)(3)(i) of this section. For purposes of this paragraph (e)(3)(ii), 
affiliated group means an affiliated group as defined in section 
1504(a), determined without regard to section 1504(b)(3). In counting 
the income of the group for purposes of determining whether the group 
meets the requirements of paragraph (e)(3)(i) of this section, the 
following rules apply. Only the income of group members that are United 
States corporations or foreign corporations that are controlled foreign 
corporations in which United States members of the affiliated group own, 
directly or indirectly, at least 80 percent of the total voting power 
and value of the stock shall be included. For purposes of this paragraph 
(e)(3)(ii), indirect ownership shall be determined under section 318 and 
the regulations under that section. The income of the group will not 
include any income from transactions with other members of the group. 
Passive income will not be considered to be active financing income 
merely because that income is earned by a member of the group that is a 
financial services entity without regard to the rule of this paragraph 
(e)(3)(ii).
    (iii) Treatment of partnerships and other pass-through entities For 
purposes of determining whether a partner (including a partnership that 
is a partner in a second partnership) is a financial services entity, 
all of the partner's income shall be taken into account, except that 
income that is excluded under paragraph (e)(3)(i) of this section shall 
not be taken into account. Thus, if a partnership is determined to be a 
financial services entity none of the income of the partner received 
from the partnership that is characterized under the look-through rules 
shall be included for purpose of determining if the partner is a 
financial services entity. If a partnership is determined not to be a 
financial services entity, then income of the partner from the 
partnership that is characterized under the look-through rules will be 
taken into account (unless such income is financial services income) and 
such income will retain its character either as active financing income 
or as other income in the hands of the partner for purposes of 
determining if the partner is a financial service entity and if the 
income is financial services income to the partner. If a partnership is 
a financial services entity and the partner's income from the 
partnership is characterized as financial services income under the 
look-through rules, then, for purposes of determining a partner's 
foreign tax credit limitation, the income from the partnership shall be 
considered to be financial services income to the partner regardless of 
whether the partner is itself a financial services entity. The rules of 
this paragraph (e)(3)(iii) will apply for purposes of determining 
whether an owner of an interest in any other pass-through entity the 
character of the income of which is preserved when such income is 
included in the income of the owner of the interest is a financial 
services entity.
    (iv) [Reserved]
    (4) Definition of incidental income--(i) In general--(A) Rule. 
Incidental income is income that is integrally related to active 
financing income of a financial services entity. Such income includes, 
for example, income from precious metals trading and commodity trading 
that is integrally related to futures income. If securities, shares of 
stock, or other types of property are acquired by a financial services 
entity as an ordinary and necessary incident to the conduct of an active 
financing business, the income from such property will be considered to 
be financial services income but only so long as the retention of such 
property remains an ordinary or necessary incident to the conduct of 
such business. Thus property, including stock, acquired as the result 
of, or in order to prevent, a loss in an active financing business upon 
a loan held by the taxpayer in the ordinary course of

[[Page 878]]

such business will be considered ordinary and necessary to the conduct 
of such business, but income from such property will be considered 
financial services income only so long as the holding of such property 
remains an ordinary and necessary incident to the conduct of such 
business. If an entity holds such property for five years or less then 
the property is considered held incident to the financial services 
business. If an entity holds such property for more than five years, a 
presumption will be established that the entity is not holding such 
property incident to its financial services business. An entity will be 
able to rebut the presumption by demonstrating that under the facts and 
circumstances it is not holding the property as an investment. However, 
the fact that an entity holds the property for more than five years and 
is not able to rebut the presumption that it is not holding the property 
incident to its financial services business will not affect the 
characterization of any income received from the property during the 
first five years as financial services income.
    (B) [Reserved]
    (ii) Income that is not incidental income. Income that is 
attributable to non-financial activity is not incidental income within 
the meaning of paragraph (e)(4) (i) and (ii) of this section solely 
because such income represents a relatively small proportion of the 
taxpayer's total income or that the taxpayer engages in non-financial 
activity on a sporadic basis. Thus, for example, income from data 
processing services provided to related or unrelated parties or income 
from the sale of goods or non-financial services (for example travel 
services) is not financial services income, even if the recipient is a 
financial services entity.
    (f) Foreign branch category income--(1) Foreign branch category 
income--(i) In general. Except as provided in paragraph (f)(1)(ii), 
(iii), or (iv) of this section, the term foreign branch category income 
means income of a United States person, other than a pass-through 
entity, that is--
    (A) Income attributable to foreign branches of the United States 
person held directly or indirectly through disregarded entities;
    (B) A distributive share of partnership income that is attributable 
to foreign branches held by the partnership directly or indirectly 
through disregarded entities, or held indirectly by the partnership 
through another partnership or other pass-through entity that holds the 
foreign branch directly or indirectly through disregarded entities; and
    (C) Income from other pass-through entities determined under 
principles similar to those described in paragraph (f)(1)(i)(B) of this 
section.
    (ii) Passive category income excluded from foreign branch category 
income. Income assigned to the passive category under paragraph (b) of 
this section is not foreign branch category income, regardless of 
whether the income is described in paragraph (f)(1)(i) of this section. 
Income that is treated as passive category income under the look-through 
rules in Sec.  1.904-5 is also excluded from foreign branch category 
income, regardless of whether the income is attributable to a foreign 
branch. However, income that would be passive category income but for 
the application of section 904(d)(2)(B)(iii) (export financing interest 
and high-taxed income) or 904(d)(2)(C) (financial services income) and 
also meets the definition of foreign branch category income is foreign 
branch category income.
    (iii) Income arising from U.S. activities excluded from foreign 
branch category income. Gross income that is attributable to a foreign 
branch and that arises from activities carried out in the United States 
by any foreign branch, including income that is reflected on a foreign 
branch's separate books and records, is not assigned to the foreign 
branch category. Instead, such income is assigned to the general 
category or a specified separate category under the rules of this 
section. However, under paragraph (f)(2)(vi) of this section, gross 
income (including U.S. source gross income) attributable to activities 
carried on outside the United States by the foreign branch may be 
assigned to the foreign branch category by reason of a disregarded 
payment to a foreign branch from a foreign branch owner or

[[Page 879]]

another foreign branch that is allocable to income recorded on the books 
and records of the payor foreign branch or foreign branch owner.
    (iv) Income arising from stock excluded from foreign branch category 
income--(A) In general. Except as provided in paragraph (f)(1)(iv)(B) of 
this section, gross income that is attributable to a foreign branch and 
that comprises items of income arising from stock of a corporation 
(whether foreign or domestic), including gain from the disposition of 
such stock or any inclusion under section 951(a), 951A(a), 1248, or 
1293(a), is not assigned to the foreign branch category. Instead, such 
income is assigned to the general category or a specified separate 
category under the rules of this section.
    (B) Exception for dealer property. Paragraph (f)(1)(iv)(A) of this 
section does not apply to gain recognized from dispositions of stock of 
a corporation, if the stock would be dealer property (as defined in 
Sec.  1.954-2(a)(4)(v)) if the foreign branch were a controlled foreign 
corporation.
    (2) Gross income attributable to a foreign branch--(i) In general. 
Except as provided in this paragraph (f)(2), gross income is 
attributable to a foreign branch to the extent the gross income (as 
adjusted to conform to Federal income tax principles) is reflected on 
the separate set of books and records (as defined in Sec.  1.989(a)-
1(d)(1) and (2)) of the foreign branch. Gross income that is not 
attributable to the foreign branch and is therefore attributable to the 
foreign branch owner is income in a separate category (other than the 
foreign branch category) under the other rules of this section.
    (ii)-(iii) [Reserved]
    (iv) Disposition of interests in certain entities--(A) In general. 
Except as provided in paragraph (f)(2)(iv)(B) of this section, gross 
income attributable to a foreign branch does not include gain from the 
disposition of an interest in a partnership or other pass-through entity 
or an interest in a disregarded entity. See also paragraph (n)(2) of 
this section for general rules relating to the sale of a partnership 
interest.
    (B) Exception for sales by a foreign branch in the ordinary course 
of business. The rule in paragraph (f)(2)(iv)(A) of this section does 
not apply to gain from the sale or exchange of an interest in a 
partnership or other pass-through entity or an interest in a disregarded 
entity if the gain is reflected on the books and records of a foreign 
branch and the interest is held by the foreign branch in the ordinary 
course of its active trade or business. An interest is considered to be 
held in the ordinary course of the foreign branch's active trade or 
business only if the foreign branch--
    (1) Directly engages in the same, or a related, trade or business as 
that partnership, other pass-through entity, or disregarded entity; and
    (2) In the case of a partnership or other pass-through entity, the 
foreign branch owns 10 percent or more of the capital or profits 
interests in the partnership or other pass-through entity.
    (v) Adjustments to items of gross income reflected on the books and 
records. If a principal purpose of recording or failing to record an 
item of gross income on the books and records of a foreign branch, or of 
making or not making a disregarded payment described in paragraph 
(f)(2)(vi) of this section, is the avoidance of Federal income tax, the 
purposes of section 904, or the purposes of section 250 (in connection 
with section 250(b)(3)(A)(i)(VI)), the item must be attributed to one or 
more foreign branches or the foreign branch owner in a manner that 
reflects the substance of the transaction. For purposes of this 
paragraph (f)(2)(v), interest received by a foreign branch from a 
related person is presumed to be attributable to the foreign branch 
owner (and not to the foreign branch) unless the interest income meets 
the definition of financial services income under paragraph (e)(1)(ii) 
of this section. For purposes of this paragraph (f)(2)(v), a related 
person is any person that bears a relationship to the foreign branch 
owner described in section 267(b) or 707.
    (vi) Attribution of gross income to which disregarded payments are 
allocable--(A) In general. If a foreign branch makes a disregarded 
payment to its foreign branch owner or a second foreign branch, and the 
disregarded payment is allocable to gross income

[[Page 880]]

that would be attributable to the foreign branch under the rules in 
paragraphs (f)(2)(i) through (v) of this section, the gross income 
attributable to the foreign branch is adjusted downward (but not below 
zero) to reflect the allocable amount of the disregarded payment, and 
the gross income attributable to the foreign branch owner or the second 
foreign branch is adjusted upward by the same amount as the downward 
adjustment, translated (if necessary) from the foreign branch's 
functional currency to U.S. dollars (or the second foreign branch's 
functional currency, as applicable) at the spot rate (as defined in 
Sec.  1.988-1(d)) on the date of the disregarded payment. For rules 
addressing multiple disregarded payments in a taxable year, see 
paragraph (f)(2)(vi)(F) of this section. Similarly, if a foreign branch 
owner makes a disregarded payment to its foreign branch and the 
disregarded payment is allocable to gross income attributable to the 
foreign branch owner, the gross income attributable to the foreign 
branch owner is adjusted downward (but not below zero) to reflect the 
allocable amount of the disregarded payment, and the gross income 
attributable to the foreign branch is adjusted upward by the same amount 
as the downward adjustment, translated (if necessary) from U.S. dollars 
to the foreign branch's functional currency at the spot rate on the date 
of the disregarded payment. An adjustment to the amount of attributable 
gross income under this paragraph (f)(2)(vi) does not change the total 
amount, character, or source of the United States person's gross income; 
does not change the amount of a United States person's income in any 
separate category other than the foreign branch and general categories 
(or a specified separate category associated with the foreign branch and 
general categories); and has no bearing on the analysis of whether an 
item of gross income is eligible to be resourced under an income tax 
treaty.
    (B) Allocation of disregarded payments--(1) In general. Except as 
provided in paragraph (f)(2)(vi)(B)(2) of this section, whether a 
disregarded payment is allocable to gross income attributable to a 
foreign branch or gross income attributable to its foreign branch owner, 
and the source and separate category of the gross income to which the 
disregarded payment is allocable, is determined under the following 
rules:
    (i) Disregarded payments from a foreign branch owner to its foreign 
branch are allocable to gross income attributable to the foreign branch 
owner to the extent a deduction for that payment or any disregarded cost 
recovery deduction relating to that payment, if regarded, would be 
allocated and apportioned to gross income attributable to the foreign 
branch owner under the principles of Sec. Sec.  1.861-8 through 1.861-
14T and 1.861-17 (without regard to exclusive apportionment) by treating 
foreign source gross income and U.S. source gross income in each 
separate category (determined prior to the application of this paragraph 
(f)(2)(vi) to the disregarded payment at issue) each as a statutory 
grouping; and
    (ii) Disregarded payments from a foreign branch to its foreign 
branch owner or to another foreign branch are allocable to gross income 
attributable to the payor foreign branch to the extent a deduction for 
that payment or any disregarded cost recovery deduction relating to that 
payment, if regarded, would be allocated and apportioned to gross income 
attributable to the payor foreign branch under the principles of 
Sec. Sec.  1.861-8 through 1.861-14T and 1.861-17 (without regard to 
exclusive apportionment) by treating foreign source gross income and 
U.S. source gross income in each separate category (determined before 
the application of this paragraph (f)(2)(vi) to the disregarded payment 
at issue) each as a statutory grouping.
    (2) Special rule for certain disregarded payments. Whether a 
disregarded payment made in connection with a sale or exchange of 
property is allocable to gross income attributable to a foreign branch 
or its foreign branch owner, and the source and separate category of the 
gross income to which the disregarded payment is allocable, is 
determined under the following rules:
    (i) Except as provided in paragraph (f)(2)(vi)(D) of this section, 
disregarded payments from a foreign branch owner to its foreign branch 
in respect of non-inventory property are allocable to the

[[Page 881]]

gross income attributable to the foreign branch owner, if any, that is 
recognized with respect to a regarded sale or exchange of that property 
(including gross income arising in a later taxable year) to the extent 
of the adjusted disregarded gain with respect to the transferred 
property, and in the same proportions as the source and separate 
category of the gain recognized on the regarded sale or exchange of the 
transferred property;
    (ii) Except as provided in paragraph (f)(2)(vi)(D) of this section, 
disregarded payments from a foreign branch to its foreign branch owner 
or to another foreign branch in respect of non-inventory property are 
allocable to the gross income attributable to the foreign branch, if 
any, that is recognized with respect to a regarded sale or exchange of 
that property (including gross income arising in a later taxable year) 
to the extent of the adjusted disregarded gain with respect to the 
transferred property, and in the same proportions as the source and 
separate category of the gain recognized on the regarded sale or 
exchange of the transferred property; and
    (iii) The principles of paragraphs (f)(2)(vi)(B)(2)(i) and (ii) of 
this section apply in the case of disregarded payments in respect of 
inventory property between a foreign branch and its foreign branch owner 
or between foreign branches to the extent the disregarded payment, if 
regarded, would, for purposes of determining gross income, be subtracted 
from gross receipts that are regarded for Federal income tax purposes.
    (3) Timing of reattribution--(i) In general. The gross income 
attributable to the foreign branch is adjusted under paragraph 
(f)(2)(vi)(B)(1) of this section only in the taxable year that a 
disregarded payment, if regarded, would be allowed as a deduction 
(including by giving rise to disregarded cost recovery deductions), or 
otherwise would be taken into account as an increase to cost of goods 
sold.
    (ii) Disregarded sales of property. The gross income attributable to 
a foreign branch is adjusted under paragraph (f)(2)(vi)(B)(2) of this 
section only in the taxable year or years in which gain is recognized by 
reason of the disposition of property with an adjusted disregarded basis 
in a transaction that is regarded for Federal income tax purposes.
    (C) Exclusion of certain disregarded payments. Paragraph 
(f)(2)(vi)(A) of this section does not apply to the following payments, 
accruals, or other transfers between a foreign branch and its foreign 
branch owner, or between foreign branches, that are disregarded for 
Federal income tax purposes:
    (1) Interest, and interest equivalents that, if regarded, would be 
described in Sec. Sec.  1.861-9(b) and 1.861-9T(b);
    (2) Remittances from the foreign branch to its foreign branch owner, 
except as provided in paragraph (f)(2)(vi)(D) of this section;
    (3) Contributions of money, securities, and other property from the 
foreign branch owner to its foreign branch, except as provided in 
paragraph (f)(2)(vi)(D) of this section; or
    (4) Any disregarded payment that, if made to a foreign branch and 
regarded for Federal income tax purposes, could not result in the 
attribution of gross income to a foreign branch (for example, the sale 
of an interest in a partnership by a foreign branch to its foreign 
branch owner, unless the sale or exchange occurred in the ordinary 
course of business within the meaning of paragraph (f)(2)(iv)(B) of this 
section).
    (D) Certain transfers of intangible property--(1) In general. For 
purposes of applying this paragraph (f)(2)(vi), the amount of gross 
income attributable to a foreign branch (and the amount of gross income 
attributable to its foreign branch owner) must be adjusted under the 
principles of paragraph (f)(2)(vi)(B) of this section to reflect all 
transactions that are disregarded for Federal income tax purposes in 
which property described in section 367(d)(4) is transferred to or from 
a foreign branch or between foreign branches, whether or not a 
disregarded payment is made in connection with the transfer. In 
determining the amount of gross income that is attributable to a foreign 
branch that must be adjusted by reason of this paragraph (f)(2)(vi)(D), 
the principles of sections 367(d) and 482 apply. For example, if a 
foreign branch owner transfers property described in section

[[Page 882]]

367(d)(4) to a foreign branch, the principles of section 367(d) are 
applied by treating the foreign branch as a separate foreign corporation 
to which the property is transferred in exchange for stock of the 
corporation in a transaction described in section 351. Similarly, if a 
foreign branch remits property described in section 367(d)(4) to its 
foreign branch owner, the foreign branch is treated as having sold the 
transferred property to the foreign branch owner in exchange for annual 
payments contingent on the productivity or use of the property, the 
amounts of which are determined under the principles of section 367(d).
    (2) Transactions occurring before December 7, 2018. Paragraph 
(f)(2)(vi)(D)(1) of this section does not apply to a disregarded 
transfer of property that occurred before December 7, 2018.
    (3) Transitory ownership--(i) In general. Paragraph (f)(2)(vi)(D)(1) 
of this section does not apply to disregarded transfers of property by a 
foreign branch or a foreign branch owner (such foreign branch or foreign 
branch owner, the limited transferor), if the conditions in paragraphs 
(f)(2)(vi)(D)(3)(ii) and (iii) of this section are met.
    (ii) Transitory ownership period. The limited transferor's ownership 
of the property is transitory.
    (iii) Use of property. The limited transferor does not develop, 
exploit, or otherwise employ the property in a trade or business, other 
than in the ordinary course of the limited transferor's business during 
the period of transitory ownership.
    (iv) Predecessors. For purposes of paragraphs (f)(2)(vi)(D)(3)(ii) 
and (iii) of this section, a reference to a limited transferor that is a 
foreign branch owner includes any predecessor to the foreign branch 
owner. No person is a predecessor with respect to a foreign branch under 
this paragraph (f)(2)(vi)(D)(3)(iv).
    (E) Amount of disregarded payments. The amount of each disregarded 
payment used to make an adjustment under this paragraph (f)(2)(vi) (or 
the absence of any adjustment) must be determined in a manner that 
results in the attribution of the proper amount of gross income to each 
of a foreign branch and its foreign branch owner under the principles of 
section 482, applied as if the foreign branch were a corporation.
    (F) Multiple disregarded payments. In the case of multiple 
disregarded payments, this paragraph (f)(2)(vi) is applied with respect 
to each disregarded payment, and under the ordering rules specified in 
paragraphs (f)(2)(vi)(F)(1) and (2) of this section. For purposes of 
this paragraph (f)(2)(vi), paragraph (f)(2)(vi)(F)(1) of this section 
applies before paragraph (f)(2)(vi)(F)(2) of this section.
    (1) Income initially attributable to a foreign branch. In applying 
this paragraph (f)(2)(vi) to gross income that would, but for this 
paragraph (f)(2)(vi), be attributable to a foreign branch, adjustments 
related to disregarded payments from a foreign branch to another foreign 
branch are computed first, followed by adjustments related to 
disregarded payments from a foreign branch to its foreign branch owner, 
followed by adjustments related to disregarded payments from a foreign 
branch owner to its foreign branch.
    (2) Income initially attributable to a foreign branch owner. In 
applying this paragraph (f)(2)(vi) to gross income that would, but for 
this paragraph (f)(2)(vi), be attributable to a foreign branch owner, 
adjustments related to disregarded payments from a foreign branch owner 
to a foreign branch are computed first, followed by adjustments related 
to disregarded payments from a foreign branch to another foreign branch, 
followed by adjustments related to disregarded payments from a foreign 
branch to its foreign branch owner.
    (G) Effect of disregarded payments made and received by non-branch 
taxable units--(1) In general. For purposes of determining the amount, 
source, and character of gross income attributable to a foreign branch 
and its foreign branch owner under paragraph (f)(2) of this section, the 
rules of paragraph (f)(2) of this section apply to a non-branch taxable 
unit as though the non-branch taxable unit were a foreign branch or a 
foreign branch owner, as appropriate, to attribute gross income to the 
non-branch taxable unit and to further attribute, under this paragraph 
(f)(2)(vi)(G), the income of a non-

[[Page 883]]

branch taxable unit to one or more foreign branches or to a foreign 
branch owner. See paragraph (f)(4)(xvi) of this section (Example 16).
    (2) Foreign branch group income. The income of a foreign branch 
group is attributed to the foreign branch that owns the group. The 
income of a foreign branch group is the aggregate of the U.S. gross 
income that is attributed, under the rules of this paragraph (f)(2), to 
each member of the foreign branch group, determined after accounting for 
all disregarded payments made and received by each member of the foreign 
branch group.
    (3) Foreign branch owner group income. The income of a foreign 
branch owner group is attributed to the foreign branch owner that owns 
the group. The income of a foreign branch owner group income is the 
aggregate of the U.S. gross income that is attributed, under the rules 
of this paragraph (f)(2), to each member of the foreign branch owner 
group, determined after accounting for all disregarded payments made and 
received by each member of the foreign branch owner group.
    (3) Definitions. The following definitions apply for purposes of 
this paragraph (f).
    (i) Adjusted disregarded basis. The term adjusted disregarded basis 
means, with respect to property transferred in a transaction that is 
disregarded for Federal income tax purposes, the tentative disregarded 
basis of the property--
    (A) Reduced by any disregarded cost recovery deductions with respect 
to the property; and
    (B) Increased by any disregarded section 1016(a)(1) expenditures 
with respect to the property.
    (ii) Adjusted disregarded gain--(A) In general. The term adjusted 
disregarded gain means, with respect to property transferred in a 
transaction that is disregarded for Federal income tax purposes, the 
lesser of--
    (1) The adjusted disregarded basis of the property, reduced by the 
adjusted basis of the property at the time the property was transferred 
in a transaction that is disregarded for Federal income tax purposes; 
and
    (2) The gain (if any) attributable to a regarded sale or exchange of 
the transferred property.
    (B) Limitation. Adjusted disregarded gain may not be less than zero.
    (iii) Disregarded cost recovery deduction. For a taxable year, the 
term disregarded cost recovery deduction means, with respect to property 
transferred in a transaction that is disregarded for Federal income tax 
purposes--
    (A) The amounts that would be allowed as a deduction, and that would 
give rise to an adjustment described in section 1016(a)(2), with respect 
to the transferred property if the transfer (and the foreign branch) 
were regarded for Federal income tax purposes, to the extent that, under 
paragraph (f)(2)(vi)(B)(1) of this section, the deduction would be 
allocable to--
    (1) Gross income attributable to a foreign branch owner, in the case 
of property transferred to a foreign branch owner; or
    (2) Gross income attributable to a foreign branch, in the case of 
property transferred to a foreign branch; reduced by
    (B) The amounts that are allowed as a deduction, and that give rise 
to an adjustment described in section 1016(a)(2), with respect to the 
transferred property to the extent that, under the principles of 
paragraph (f)(2)(vi)(B)(1) of this section, the deduction would be 
allocable to--
    (1) Gross income attributable to a foreign branch owner, in the case 
of property transferred to a foreign branch owner; or
    (2) Gross income attributable to a foreign branch, in the case of 
property transferred to a foreign branch.
    (iv) Disregarded entity. The term disregarded entity means an entity 
described in Sec.  301.7701-2(c)(2) of this chapter that is disregarded 
as an entity separate from its owner for Federal income tax purposes.
    (v) Disregarded payment. A disregarded payment includes an amount of 
property (within the meaning of section 317(a)) that is transferred to 
or from a non-branch taxable unit, foreign branch, or foreign branch 
owner, including a payment in exchange for

[[Page 884]]

property or in satisfaction of an account payable, or a remittance or 
contribution, in connection with a transaction that is disregarded for 
Federal income tax purposes and that is reflected on the separate set of 
books and records of a non-branch taxable unit (other than an individual 
or domestic corporation) or a foreign branch. A disregarded payment also 
includes any other amount that is reflected on the separate set of books 
and records of a non-branch taxable unit (other than an individual or a 
domestic corporation) or a foreign branch in connection with a 
transaction that is disregarded for Federal income tax purposes and that 
would constitute an item of accrued income, gain, deduction, or loss of 
the non-branch taxable unit (other than an individual or a domestic 
corporation) or the foreign branch if the transaction to which the 
amount is attributable were regarded for Federal income tax purposes.
    (vi) Disregarded section 1016(a)(1) expenditure. The term 
disregarded section 1016(a)(1) expenditure means a disregarded payment 
that, if regarded for Federal income tax purposes, would be described in 
section 1016(a)(1) and that, under the principles of paragraph 
(f)(2)(vi)(B)(1) of this section, would be allocable to--
    (A) General category gross income, in the case of property held by a 
foreign branch owner; or
    (B) Foreign branch category income, in the case of property held by 
a foreign branch.
    (vii) Foreign branch--(A) In general. The term foreign branch means 
a qualified business unit (QBU), as defined in Sec.  1.989(a)-
1(b)(2)(ii) and (b)(3), that conducts a trade or business outside the 
United States. For an illustration of the principles of this paragraph 
(f)(3)(vii), see paragraph (f)(4)(i) of this section (Example 1).
    (B) Trade or business outside the United States. Activities carried 
out in the United States, whether or not such activities are described 
in Sec.  1.989(a)-1(b)(3), do not constitute the conduct of a trade or 
business outside the United States. Activities carried out outside the 
United States that constitute a permanent establishment under the terms 
of an income tax treaty between the United States and the country in 
which the activities are carried out constitute a trade or business 
conducted outside the United States for purposes of this paragraph 
(f)(3)(vii)(B). In determining whether activities constitute a trade or 
business under Sec.  1.989(a)-1(c), disregarded payments are taken into 
account and may give rise to a trade or business, provided that the 
activities (together with any other activities of the QBU) would 
otherwise satisfy the rule in Sec.  1.989(a)-1(c).
    (C) Activities of a partnership, estate, trust, or corporation--(1) 
Treatment as a foreign branch. For purposes of this paragraph 
(f)(3)(vii), the activities of a partnership, estate, trust, or 
corporation that conducts a trade or business that satisfies the 
requirements of Sec.  1.989(a)-1(b)(2)(ii)(A) (as modified by paragraph 
(f)(3)(vii)(B) of this section) are--
    (i) Deemed to satisfy the requirements of Sec.  1.989(a)-
1(b)(2)(ii)(B); and
    (ii) Comprise a foreign branch.
    (2) Separate set of books and records. A foreign branch described in 
this paragraph (f)(3)(vii)(C) is treated as maintaining a separate set 
of books and records with respect to the activities described in 
paragraph (f)(3)(vii)(C)(1) of this section, and must determine, as the 
context requires, the items of gross income, disregarded payments, and 
any other items that would be reflected on those books and records in 
applying this paragraph (f) with respect to the foreign branch. The 
principles of Sec.  1.1503(d)-5(c) apply for purposes of determining 
which items would be reflected on such books and records.
    (viii) Foreign branch group. The term foreign branch group means a 
foreign branch and any non-branch taxable units (other than an 
individual or a domestic corporation), to the extent that the foreign 
branch owns the non-branch taxable unit (if any) directly or indirectly 
through one or more other non-branch taxable units.
    (ix) Foreign branch owner. The term foreign branch owner means, with 
respect to a foreign branch, the person (including a foreign or domestic 
partnership or other pass-through entity) that owns the foreign branch, 
either directly or indirectly through one or more disregarded entities. 
For purposes

[[Page 885]]

of this paragraph (f)(3)(ix), the foreign branch owner does not include 
the foreign branch or another foreign branch of the person that owns the 
foreign branch.
    (x) Foreign branch owner group. The term foreign branch owner group 
means a foreign branch owner and any non-branch taxable units (other 
than an individual or a domestic corporation), to the extent that the 
foreign branch owner owns the non-branch taxable unit (if any) directly 
or indirectly through one or more other non-branch taxable units.
    (xi) Non-branch taxable unit. The term non-branch taxable unit has 
the meaning provided in Sec.  1.904-6(b)(2)(i)(B).
    (xii) Remittance. The term remittance means a transfer of property 
(within the meaning of section 317(a)) by a foreign branch that would be 
treated as a distribution if the foreign branch were treated as a 
separate corporation.
    (xiii) Tentative disregarded basis. The term tentative disregarded 
basis means, in connection with the transfer of property in a 
transaction that is disregarded for Federal income tax purposes, the 
basis that property would have if the disregarded payment made in 
exchange for the transferred property were treated as the cost of such 
property under section 1012(a).
    (4) Examples. The following examples illustrate the application of 
this paragraph (f).
    (i) Example 1: Determination of foreign branches and foreign branch 
owner--(A) Facts. (1) P, a domestic corporation, is a partner in PRS, a 
domestic partnership. All other partners in PRS are unrelated to P. PRS 
conducts activities solely in Country A (the Country A Business), and 
those activities constitute a trade or business outside the United 
States within the meaning of paragraph (f)(3)(vii)(B) of this section. 
PRS reflects items of income, gain, loss, and expense of the Country A 
Business on the books and records of PRS's home office. PRS is in the 
business of manufacturing bicycles.
    (2) PRS owns FDE1, a disregarded entity organized in Country B. FDE1 
conducts activities in Country B (the Country B Business), and those 
activities constitute a trade or business outside the United States 
within the meaning of paragraph (f)(3)(vii)(B) of this section. FDE1 
maintains a set of books and records that are separate from those of 
PRS, and the separate set of books and records reflects items of income, 
gain, loss, and expense with respect to the Country B Business. FDE1 is 
in the business of selling bicycles manufactured by PRS.
    (3) FDE1 owns FDE2, a disregarded entity organized in Country C. 
FDE2 conducts activities in Country C (the Country C Business), and 
those activities constitute a trade or business outside the United 
States within the meaning of paragraph (f)(3)(vii)(B) of this section. 
FDE2 maintains a set of books and records that are separate from those 
of PRS and FDE1, and the separate set of books and records reflects 
items of income, gain, loss, and expense with respect to the Country C 
Business. FDE2's paper business is not related to FDE1's bicycle sales 
business, and FDE1 does not hold its interest in FDE2 in the ordinary 
course of its trade or business.
    (B) Analysis. (1) Country A Business's activities comprise a trade 
or business conducted outside the United States within the meaning of 
Sec.  1.989(a)-1(b)(2)(ii)(A) and (b)(3) (in each case, as modified by 
paragraph (f)(3)(vii) of this section). PRS does not maintain a separate 
set of books and records with respect to the Country A Business. 
However, under paragraph (f)(3)(vii)(C) of this section, the Country A 
Business's activities are deemed to satisfy the requirement of Sec.  
1.989(a)-1(b)(2)(ii)(B) that a QBU maintain a separate set of books and 
records with respect to the relevant activities. Thus, for purposes of 
this paragraph (f), the activities of the Country A Business constitute 
a QBU as defined in Sec.  1.989-1(b)(2)(ii) and (b)(3), as modified by 
paragraph (f)(3)(vii) of this section, that conducts a trade or business 
outside the United States. Accordingly, the activities of the Country A 
Business constitute a foreign branch within the meaning of paragraph 
(f)(3)(vii) of this section. PRS, the person that owns the Country A 
Business, is the foreign branch owner, within the meaning of paragraph 
(f)(3)(ix) of this section, with respect to the Country A Business.

[[Page 886]]

    (2) Country B Business's activities comprise a trade or business 
outside the United States within the meaning of Sec.  1.989(a)-
1(b)(2)(ii)(A) and (b)(3) (in each case, as modified by paragraph 
(f)(3)(vii) of this section). PRS maintains a separate set of books and 
records with respect to the Country B Business, as described in Sec.  
1.989(a)-1(b)(2)(ii)(B). Thus, for purposes of this section, the 
activities of the Country B Business constitute a QBU as defined in 
Sec.  1.989-1(b)(2)(ii) and (b)(3), as modified by paragraph (f)(3)(vii) 
of this section, that conducts a trade or business outside the United 
States. Accordingly, the activities of the Country B Business constitute 
a foreign branch within the meaning of paragraph (f)(3)(vii) of this 
section. Under paragraph (f)(3)(ix) of this section, PRS, the person 
that owns the Country B Business indirectly through FDE1 (a disregarded 
entity), is the foreign branch owner with respect to the Country B 
Business.
    (3) The same analysis that applies to the Country B Business applies 
to the Country C Business. Accordingly, the activities of the Country C 
Business constitute a foreign branch within the meaning of paragraph 
(f)(3)(vii) of this section. PRS, the person that owns the Country C 
Business indirectly through FDE1 and FDE2 (disregarded entities), is the 
foreign branch owner with respect to the Country C Business.
    (ii) Example 2: Sale of foreign branch--(A) Facts. The facts are the 
same as in paragraph (f)(4)(i)(A) of this section (the facts in Example 
1), except that in Year 1, FDE1 sells FDE2 to an unrelated person, 
recording gain from the sale on its books and records. In Year 2, PRS 
sells FDE1 to another unrelated person, recording gain from the sale on 
its books and records. In each year, PRS allocates a portion of the gain 
to P.
    (B) Analysis--(1) Sale of FDE2. Under paragraph (f)(1)(i)(B) of this 
section, P's distributive share of gain recognized by PRS in connection 
with the sales of FDE1 and FDE2 constitutes foreign branch category 
income if it is attributable to a foreign branch held by PRS directly or 
indirectly through one or more disregarded entities. PRS's gross income 
from the Year 1 sale of FDE2 is reflected on the separate set of books 
and records maintained with respect to the Country B Business (a foreign 
branch) operated by FDE1. Therefore, absent an exception, under 
paragraph (f)(2)(i) of this section PRS's gross income from the sale of 
FDE2 would be attributable to the Country B Business, and would 
constitute foreign branch category income. However, under paragraph 
(f)(2)(iv) of this section, gross income attributable to the Country B 
Business does not include gain from the sale or exchange of an interest 
in FDE2, a disregarded entity, unless the interest in FDE2 is held by 
the Country B Business in the ordinary course of its active trade or 
business (within the meaning of paragraph (f)(2)(iv)(B) of this 
section). In this case, the Country B Business does not hold FDE2 in the 
ordinary course of its active trade or business within the meaning of 
paragraph (f)(2)(iv)(B) of this section. As a result, P's distributive 
share of gain from the sale of FDE2 is not attributable to a foreign 
branch, and is not foreign branch category income.
    (2) Sale of FDE1. The analysis of PRS's sale of FDE1 in Year 2 is 
the same as the analysis for the sale of FDE2, except that PRS, through 
its Country A Business, holds FDE1 in the ordinary course of its active 
trade or business within the meaning of paragraph (f)(2)(iv)(B) of this 
section because the Country A Business engages in a trade or business 
that is related to the trade or business of FDE1. Therefore, P's 
distributive share of gain from the sale of FDE1 is attributable to a 
foreign branch, and is foreign branch category income.
    (iii) Example 3: Disregarded payment for services--(A) Facts. P, a 
domestic corporation, owns FDE, a disregarded entity that is a foreign 
branch within the meaning of paragraph (f)(3)(vii) of this section. 
FDE's functional currency is the U.S. dollar. In Year 1, P accrues and 
records on its books and records (and not FDE's books and records) 
$1,000x of gross income from the performance of services to unrelated 
parties that is not passive category income, $400x of which is foreign 
source income in respect of services performed outside the United States 
by employees of FDE and $600x of which is U.S.

[[Page 887]]

source income in respect of services performed in the United States. 
Absent the application of paragraph (f)(2)(vi) of this section, the 
$1,000x of gross income earned by P would be general category income 
that would not be attributable to FDE. FDE provides services in support 
of P's gross income from services. P compensates FDE for its services 
with an arm's length payment of $400x, which is disregarded for Federal 
income tax purposes. The deduction for the payment of $400x from P to 
FDE would be allocated to P's $1,000x of general category gross services 
income and apportioned entirely to the $400x of foreign source services 
income under Sec. Sec.  1.861-8 and 1.861-8T principles (treating 
foreign source general category gross income and U.S. source general 
category gross income each as a statutory grouping) if the payment were 
regarded for Federal income tax purposes.
    (B) Analysis. The disregarded payment from P, a United States 
person, to FDE, its foreign branch, is not recorded on FDE's separate 
books and records (as adjusted to conform to Federal income tax 
principles) within the meaning of paragraph (f)(2)(i) of this section 
because it is disregarded for Federal income tax purposes. However, the 
disregarded payment is allocable to gross income attributable to P 
because a deduction for the payment, if it were regarded, would be 
allocated and apportioned to the $400x of P's foreign source services 
income. Accordingly, under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) 
of this section, the amount of gross income attributable to the FDE 
foreign branch (and the gross income attributable to P) is adjusted in 
Year 1 to take the disregarded payment into account. As such, $400x of 
P's foreign source gross income from the performance of services is 
attributable to the FDE foreign branch for purposes of this section. 
Therefore, $400x of the foreign source gross income that P earned with 
respect to its services in Year 1 constitutes gross income that is 
assigned to the foreign branch category.
    (iv) Example 4: Disregarded payment for non-inventory property--(A) 
Facts. P, a domestic corporation, owns FDE, a disregarded entity that is 
a foreign branch within the meaning of paragraph (f)(3)(vii) of this 
section. FDE's functional currency is the U.S. dollar. P holds Asset A, 
a non-depreciable asset, with an adjusted basis of $200x. In Year 1, P 
sells Asset A, which will be used in FDE's manufacturing business, to 
FDE for $500x. FDE makes no other disregarded payments with respect to 
Asset A. No adjustments described in section 1016(a) apply with respect 
to Asset A while FDE holds Asset A. In Year 3, FDE sells Asset A to a 
third party for $600x and reflects $400x of gross income on its separate 
set of books and records (that is, $600x amount realized less Asset A's 
$200x adjusted basis). Under sections 865(e)(1) and 904(d)(2)(B)(i), the 
income arising from the sale of Asset A is foreign source income that is 
not treated as passive category income. Asset A is not inventory 
property. Absent the application of paragraph (f)(2)(vi) of this 
section, the entire $400x of gross income earned by P by reason of FDE's 
sale of Asset A would be attributable to FDE and be treated as foreign 
branch category income.
    (B) Analysis--(1) Disregarded basis determinations. If regarded, the 
$500x payment from FDE to P would result in FDE holding Asset A with a 
basis of $500x under section 1012. Accordingly, the tentative 
disregarded basis (within the meaning of paragraph (f)(3)(xiii) of this 
section) with respect to Asset A is $500x. Because there are no 
adjustments described in section 1016 with respect to Asset A (including 
any adjustments resulting from any disregarded payments made with 
respect to the transferred property), the adjusted disregarded basis 
(within the meaning of paragraph (f)(3)(i) of this section) with respect 
to Asset A is $500x.
    (2) Adjusted disregarded gain. Under paragraph (f)(3)(ii) of this 
section, the adjusted disregarded gain with respect to Asset A is $300x, 
which is equal to the lesser of $300x (FDE's adjusted disregarded basis 
in Asset A ($500x) less the adjusted basis of Asset A at the time that 
Asset A was transferred to FDE ($200x)) and $400x (the gain (if any) 
attributable to the regarded sale or exchange of Asset A).
    (3) Attribution of gross income. Under paragraph (f)(2)(vi)(A) of 
this section, the gross income attributable to FDE

[[Page 888]]

($400x) is adjusted downward to the extent that the $500x disregarded 
payment from FDE to P is allocable to gross income of FDE that is 
reflected on FDE's separate set of books and records. Under paragraph 
(f)(2)(vi)(B)(2)(ii) of this section, the $500x payment from FDE to P is 
allocable to gross income attributable to FDE to the extent of FDE's 
adjusted disregarded gain ($300x) with respect to Asset A. The source 
and separate category of the gross income of FDE to which the payment is 
allocable is proportionate to the source and separate category of the 
gain recognized by FDE with respect to Asset A. Accordingly, $300x of 
the payment is allocable to foreign source income that would be foreign 
branch category income. Thus, under paragraphs (f)(2)(vi)(A) and 
(f)(2)(vi)(B)(3) of this section, foreign source gross income 
attributable to P is adjusted upward by $300x (increasing foreign source 
general category income by $300x) and foreign source gross income 
attributable to FDE is adjusted downward by $300x (decreasing foreign 
source foreign branch category income by $300x) in Year 3.
    (v) Example 5: Disregarded payment for depreciable non-inventory 
property--(A) Facts. The facts are the same as in paragraph 
(f)(4)(iv)(A) of this section (the facts in Example 4), except as set 
forth in this paragraph (f)(4)(v)(A). Asset A is depreciable property. 
In Year 2, P is entitled to a $20x depreciation deduction with respect 
to Asset A, $18x of which is allocated and apportioned to non-passive 
category gross income attributable to FDE under Sec. Sec.  1.861-8 
through 1.861-14T and $2x of which is allocated and apportioned to 
passive category gross income under Sec. Sec.  1.861-8 through 1.861-
14T. If the transfer of Asset A were regarded for Federal income tax 
purposes, FDE would be entitled to a $50x depreciation deduction, 90% of 
which would be allocated and apportioned to non-passive category gross 
income attributable to FDE under Sec. Sec.  1.861-8 through 1.861-14T 
and 10% of which would be allocated and apportioned to passive category 
gross income under Sec. Sec.  1.861-8 through 1.861-14T. In Year 2, FDE 
earns $315x of gross income that it reflects on its books and records 
that, in the absence of paragraph (f)(2)(vi) of this section, would be 
foreign branch category income. FDE also earns $35x of passive category 
income in Year 2 from the non-active rental of a portion of Asset A. In 
Year 3, FDE reflects $420x of gross income on its separate set of books 
and records by reason of the sale of Asset A (that is, $600x amount 
realized less Asset A's $180x adjusted basis), $42x of which is passive 
category income under paragraph (b) of this section.
    (B) Analysis--(1) Attribution of gross income in Year 2. The 
disregarded payment from FDE to P in Year 1 is disregarded for Federal 
income tax purposes, and does not generate gross income. However, under 
paragraph (f)(2)(vi)(B)(1)(ii) of this section, the disregarded payment 
is allocable to gross income attributable to FDE to the extent of any 
disregarded cost recovery deduction relating to that payment in Year 2. 
Under paragraph (f)(3)(iii) of this section, the disregarded cost 
recovery deduction with respect to Asset A is $30x, which is $50x (the 
amount that would be allowed as a deduction, and that would give rise to 
an adjustment described in section 1016(a)(2), with respect to Asset A 
if the transfer of Asset A to FDE were regarded for Federal income tax 
purposes, to the extent that the deduction would be allocable to income 
attributable to a foreign branch), reduced by $20x (the amount allowed 
as a deduction, and that gives rise to an adjustment described in 
section 1016(a)(2), with respect to Asset A, to the extent allocable to 
income attributable to a foreign branch). If regarded, $27x (90% of 
$30x) of the disregarded cost recovery deduction would be allocated and 
apportioned to non-passive category gross income attributable to FDE 
under Sec. Sec.  1.861-8 through 1.861-14T and $3x (10% of $30x) would 
be allocated and apportioned to passive category gross income under 
Sec. Sec.  1.861-8 through 1.861-14T. Accordingly, under paragraphs 
(f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, the $315x of non-
passive category gross income that would otherwise be attributed to FDE 
is reduced to $288x ($315x less $27x), and the non-passive category 
gross income attributable to P is increased by $27x in Year 2. As a 
result, in Year 2, P's foreign

[[Page 889]]

branch category gross income is $288x, and its general category gross 
income is increased by $27x. P's passive category gross income is $35x. 
See paragraphs (f)(1)(ii) and (f)(2)(vi)(A) of this section.
    (2) Attribution of gross income in Year 3--(i) Adjusted disregarded 
basis. If regarded, the $500x payment from FDE to P would result in FDE 
holding Asset A with a basis of $500x under section 1012. Accordingly, 
the tentative disregarded basis (within the meaning of paragraph 
(f)(3)(xiii) of this section) with respect to Asset A is $500x. To 
determine FDE's adjusted disregarded basis with respect to Asset A under 
paragraph (f)(3)(i) of this section, FDE's tentative disregarded basis 
is reduced by $30x (the disregarded cost recovery deduction with respect 
to Asset A), resulting in an adjusted disregarded basis of $470x.
    (ii) Adjusted disregarded gain. Under paragraph (f)(3)(ii) of this 
section, the adjusted disregarded gain with respect to Asset A is $270x, 
which is equal to the lesser of $270x (FDE's adjusted disregarded basis 
in Asset A ($470x) less the adjusted basis of Asset A at the time that 
Asset A was transferred to FDE ($200x)), and $420x (the gain 
attributable to the regarded sale or exchange of Asset A).
    (iii) Sale of Asset A. Under paragraph (f)(2)(vi)(A) of this 
section, the gross income attributable to FDE ($420x) by reason of the 
sale of Asset A is adjusted downward to the extent that the $500x 
disregarded payment from FDE to P is allocable to gross income that 
would be attributable to FDE under paragraphs (f)(2)(i) through (v) of 
this section. Under paragraph (f)(2)(vi)(B)(2)(ii) of this section, the 
$500x payment from FDE to P is allocable to gross income attributable to 
FDE to the extent of the adjusted disregarded gain with respect to Asset 
A, which is $270x. The source and separate category of the gross income 
of FDE to which that amount is allocable is proportionate to the source 
and separate category of the $420x of gain recognized on the regarded 
sale of Asset A ($378x of foreign source non-passive category income and 
$42x of foreign source passive category income). Consequently, under 
paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, in Year 
3, gross income attributable to P is adjusted upward by $270x 
(increasing P's foreign source general category gross income by $243x, 
which bears the same proportion to $270x as the foreign source non-
passive gain ($378x) bears to P's overall gain with respect to Asset A 
($420x)), and the foreign source gross income attributable to FDE is 
adjusted downward by $270x (with foreign source foreign branch category 
gross income reduced by $243x). P also has $42x of foreign source 
passive category income from the sale of Asset A. See paragraphs 
(f)(1)(ii) and (f)(2)(vi)(A) of this section.
    (vi) Example 6: Disregarded payment for non-depreciable non-
inventory property--regarded gain limitation--(A) Facts. The facts are 
the same as in paragraph (f)(4)(iv)(A) of this section (the facts in 
Example 4), except that in Year 3, FDE sells Asset A to a third party 
for $340x and reflects $140x of gross income on its separate set of 
books and records (that is, $340x amount realized less Asset A's $200x 
adjusted basis), none of which is passive category income.
    (B) Analysis. The analysis is the same as the analysis in paragraph 
(f)(4)(iv)(B) of this section (the analysis in Example 4), except that 
in Year 3, the adjusted disregarded gain with respect to Asset A is 
$140x, which is equal to the lesser of $300x (FDE's adjusted disregarded 
basis in Asset A ($500x) less the adjusted basis of Asset A at the time 
that Asset A was transferred to FDE ($200x)), and $140x (the gain 
attributable to the regarded sale or exchange of Asset A). Accordingly, 
under paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, 
gross income attributable to P is adjusted upward by $140x (increasing 
P's foreign source general category gross income by $140x) and gross 
income attributable to FDE is adjusted downward by $140x (decreasing P's 
foreign source foreign branch category gross income by $140x) in Year 3.
    (vii) Example 7: Disregarded payment for non-depreciable non-
inventory property--loss--(A) Facts. The facts are the same as in 
paragraph (f)(4)(iv)(A) of this section (the facts in Example 4), except 
that in Year 3, FDE sells Asset A to a third party for $175x and 
reflects a $25x loss on its separate set of books

[[Page 890]]

and records (that is, $175x amount realized less Asset A's $200x 
adjusted basis).
    (B) Analysis. The analysis is the same as the analysis in paragraph 
(f)(4)(iv)(B) of this section (the analysis in Example 4), except that 
in Year 3, the adjusted disregarded gain with respect to Asset A is $0x, 
which is equal to the lesser of $300x (FDE's adjusted disregarded basis 
in Asset A ($500x) less the adjusted basis of Asset A at the time that 
Asset A was transferred to FDE ($200x)), and $0x (the gain attributable 
to the regarded sale or exchange of Asset A). Accordingly, gross income 
amounts attributable to P and FDE are not adjusted under paragraph 
(f)(2)(vi)(A) of this section by reason of the transfer of Asset A from 
P to FDE.
    (viii) Example 8: Disregarded payment for non-depreciable non-
inventory property--disregarded gain limitation--(A) Facts. The facts 
are the same as in paragraph (f)(4)(iv)(A) of this section (the facts in 
Example 4), except that in Year 1, P sells Asset A to FDE for $65x.
    (B) Analysis. The analysis is the same as the analysis in paragraph 
(f)(4)(iv)(B) of this section (the analysis in Example 4), except that 
in Year 3, the tentative disregarded basis and the adjusted disregarded 
basis with respect to Asset A are $65x. Under paragraph (f)(3)(ii)(B) of 
this section, the adjusted disregarded gain with respect to Asset A is 
$0x. Accordingly, under paragraph (f)(2)(vi)(A) of this section, gross 
income amounts attributable to P and FDE are not adjusted under 
paragraph (f)(2)(vi)(A) of this section by reason of the transfer of 
Asset A from P to FDE.
    (ix) Example 9: Application of the rules to the sale of inventory 
from a foreign branch owner to a foreign branch for distribution--(A) 
Facts. P, a domestic corporation, owns FDE, a disregarded entity that is 
a foreign branch within the meaning of paragraph (f)(3)(vii) of this 
section. FDE's functional currency is the U.S. dollar. P manufactures 
portable electronic devices, which it sells to FDE for $1,500x during a 
taxable year in a transaction that is disregarded for Federal income tax 
purposes. In the same taxable year, FDE sells the portable electronic 
devices to its customers for $1,750x. P uses an overall accrual method 
of accounting and has $1,300x of cost of goods sold for the taxable 
year, $1,200x of which were incurred prior to the disregarded sale to 
FDE and recorded on P's separate set of books and records and $100x of 
which were incurred after the disregarded sale and recorded on the books 
and records of FDE. P reports $450x of gross income for the taxable 
year: $1,750x of gross receipts less cost of goods sold of $1,300x. The 
$450x of gross income from the sale of portable electronic devices is 
U.S. source income under section 863(b).
    (B) Analysis--(1) In general. The gross receipts from the sale of 
portable electronic devices ($1,750x), which results in U.S. source 
gross income of $450x, is recorded on FDE's separate books and records 
(as adjusted to conform to Federal income tax principles). Therefore, 
the gross income ($450x) generally would be foreign branch category 
income under paragraph (f)(2)(i) of this section. However, under 
paragraph (f)(2)(vi)(A) of this section, the amount of gross income 
attributable to FDE (and the gross income attributable to P) is adjusted 
to take the disregarded payment for the portable electronic devices from 
FDE to P into account. If both FDE and the disregarded payment from FDE 
to P were recognized for Federal income tax purposes, the amount of the 
payment ($1,500x) would reduce FDE's gross income. Therefore, under 
paragraph (f)(2)(vi)(B)(2)(iii) of this section, the principles of 
paragraph (f)(2)(vi)(B)(2)(ii) of this section apply for purposes of 
determining whether, and to what extent, the disregarded payment is 
allocable to non-passive category income attributable to FDE for 
purposes of determining the extent of any adjustment.
    (2) Applying the principles of the tangible property rules to sales 
of inventory. The principles of paragraph (f)(2)(vi)(B)(2)(ii) of this 
section are applied by treating the cost of goods sold with respect to 
expenses recorded on P's separate set of books and records ($1,200x) 
similarly to the adjusted basis at the time of the disregarded sale; the 
gross income ($450x) similarly to gain from the disposition of non-
inventory property; and the lesser of the recognized gross income 
($450x) and the disregarded payment less the cost of

[[Page 891]]

goods sold attributable to expenses reflected on P's separate set of 
books and records ($1,500x less $1,200x) similarly to disregarded gain 
($300x). Accordingly, under paragraph (f)(2)(vi)(A) of this section, 
general category U.S. source gross income attributable to P is adjusted 
upward by $300x and the non-passive category U.S. source gross income 
attributable to FDE is adjusted downward by $300x.
    (x) Example 10: Gross income initially attributable to a foreign 
branch--(A) Facts--(1) Overview. P, a domestic corporation, owns FDE, 
which is a disregarded entity that is a foreign branch within the 
meaning of paragraph (f)(3)(vii) of this section that has the U.S. 
dollar as its functional currency. P, which is a foreign branch owner 
with respect to FDE, also conducts a trade or business in the United 
States. During a single taxable year, P and FDE engage in the 
transactions described in paragraphs (f)(4)(x)(A)(2) and (3) of this 
section.
    (2) Unrelated party transactions. P, through its U.S. office, 
accrues and records on its books and records $5,000x of gross income 
from the performance of accounting services for Customer A, an unrelated 
party (the Customer A services). The gross income from the Customer A 
services performed by P is non-passive category income and, under 
section 861(a)(3), is U.S. source income. Absent the application of 
paragraph (f)(2)(vi) of this section, the gross income earned by P 
through its U.S. office would be general category income. FDE accrues 
and records on its books and records $3,400x of gross income from the 
performance of web design services for Customer B, an unrelated party 
(the Customer B services). The gross income from the Customer B services 
performed by FDE is non-passive category income and, under section 
862(a)(3), is foreign source income. Absent the application of paragraph 
(f)(2)(vi) of this section, the $3,400x of gross income earned by FDE 
would be foreign branch category income.
    (3) Disregarded payments. FDE provides web design services to P. As 
compensation for those services, P pays $300x to FDE. The deduction for 
P's payment to FDE (if regarded) would be allocable to the $5,000x of 
general category U.S. source gross income earned from P's performance of 
the Customer A services. P provides accounting services to FDE from P's 
U.S. office. As compensation for those services, FDE pays $300x to P. 
The deduction for FDE's payment to P (if regarded) would be allocable to 
the $3,400x of non-passive category foreign source gross income earned 
from FDE's performance of the Customer B services.
    (B) Analysis--(1) Application of multiple disregarded payments rule. 
Under paragraph (f)(2)(vi)(F) of this section, paragraph (f)(2)(vi) of 
this section applies to determine the effects of the disregarded 
payments described in paragraph (f)(4)(x)(A)(3) of this section on gross 
income initially attributable to FDE before paragraph (f)(2)(vi) of this 
section is applied to gross income initially attributable to P.
    (2) Disregarded payment from FDE to P. The disregarded payment from 
FDE to P is disregarded for Federal income tax purposes, and does not 
generate gross income. However, the disregarded payment is allocable to 
non-passive category gross income attributable to FDE because a 
deduction for the payment, if it were regarded, would be allocated to 
FDE's $3,400x of non-passive category foreign source gross services 
income under Sec.  1.861-8. Under paragraph (f)(2)(vi)(A) of this 
section, the amount of non-passive category foreign source gross income 
attributable to FDE is adjusted downward, and the amount of general 
category foreign source gross income attributable to P (in its capacity 
as a foreign branch owner) is adjusted upward, to take the disregarded 
payment into account. Thus, $300x of FDE's foreign source gross income 
relating to the Customer B services is attributable to P for purposes of 
this section, and $3,100x of that income is attributable to FDE.
    (3) Disregarded payment from P to FDE. The disregarded payment from 
P to FDE is not recorded on FDE's separate books and records (as 
adjusted to conform to Federal income tax principles) within the meaning 
of paragraph (f)(2)(i) of this section because it is disregarded for 
Federal income tax purposes. However, the disregarded payment is 
allocable to general category U.S. source gross income attributable

[[Page 892]]

to P because a deduction for the payment, if it were regarded, would be 
allocated to P's $5,000x of general category U.S. source gross services 
income under Sec.  1.861-8. Accordingly, under paragraph (f)(2)(vi)(A) 
of this section, the amount of general category U.S. source gross income 
attributable to P is adjusted downward, and the amount of non-passive 
category U.S. source gross income attributable to FDE is adjusted 
upward, to take the disregarded payment into account. Thus, $300x of P's 
U.S. source gross income from the performance of Customer A services is 
attributable to FDE for purposes of this section, and $4,700x of that 
income is attributable to P.
    (xi) Example 11: Ordering rule--(A) Facts--(1) Overview. P, a 
domestic corporation, owns FDE1 and FDE2, each of which is a disregarded 
entity that is a foreign branch within the meaning of paragraph 
(f)(3)(vii) of this section that has the U.S. dollar as its functional 
currency. P, which is a foreign branch owner with respect to FDE1 and 
FDE2, also conducts a trade or business in the United States. During a 
single taxable year, P, FDE1, and FDE2 engage in the transactions 
described in paragraphs (f)(4)(xi)(A)(2) and (3) of this section.
    (2) Unrelated party transactions. FDE1 accrues and records on its 
books and records $1,000x of gross income from the performance of 
services for Customer A, an unrelated party (the Customer A services). 
The gross income from the Customer A services performed by FDE is non-
passive category income and, under section 862(a)(3), is foreign source 
income. Absent the application of paragraph (f)(2)(vi) of this section, 
the $1,000x of non-passive foreign source gross income earned by FDE1 
would be foreign branch category income. FDE2 accrues and records on its 
books and records $1,100x of gross income from royalties received from 
Customer B, an unrelated party (the Customer B royalties) on licensed 
intangible property developed by FDE2 and used by Customer B in the 
United States. The gross income from the Customer B royalties is non-
passive category income and under section 861(a)(4) is U.S. source 
income. Absent the application of paragraph (f)(2)(vi) of this section, 
the $1,100x of non-passive category U.S. source gross income earned by 
FDE2 would be foreign branch category income.
    (3) Disregarded payments. FDE2 provides services to FDE1. As 
compensation for those services, FDE1 pays $200x to FDE2. The deduction 
for FDE1's payment to FDE2 (if regarded) would be allocable to the 
$1,000x of non-passive category foreign source gross income earned from 
the Customer A services. P provides services to FDE2 from P's U.S. 
office. As compensation for those services, FDE2 pays $50x to P. The 
deduction for FDE2's payment to P (if regarded) would be allocable to 
the non-passive category foreign source gross income attributable to 
FDE2 (see paragraph (f)(4)(xi)(B)(1) of this section) relating to gross 
income from the Customer A services.
    (B) Analysis--(1) Disregarded payment from FDE1 to FDE2. The $1,000x 
of gross income earned by FDE1 from the Customer A services would, but 
for paragraph (f)(2)(vi) of this section, be attributable to FDE1 (a 
foreign branch). Accordingly, under paragraph (f)(2)(vi)(F)(1) of this 
section, adjustments related to disregarded payments from FDE1 to FDE2 
are computed before adjustments related to disregarded payments from 
FDE2 to P (in its capacity as a foreign branch owner). The disregarded 
payment from FDE1 to FDE2 is not recorded on FDE2's separate books and 
records (as adjusted to conform to Federal income tax principles) within 
the meaning of paragraph (f)(2)(i) of this section because it is 
disregarded for Federal income tax purposes. However, the disregarded 
payment is allocable to gross income attributable to FDE1 because a 
deduction for the payment, if it were regarded, would be allocated to 
FDE1's $1,000x of non-passive category foreign source gross services 
income under Sec.  1.861-8. Accordingly, under paragraph (f)(2)(vi)(A) 
of this section, the amount of non-passive category foreign source gross 
income attributable to FDE1 is adjusted downward, and the amount of non-
passive category foreign source gross income attributable to FDE2 is 
adjusted upward, to take the disregarded payment into account. Thus, 
$200x of FDE1's non-passive category foreign source gross income from 
the

[[Page 893]]

performance of Customer A services is attributable to FDE2 for purposes 
of this section, and $800x of that income is attributable to FDE1.
    (2) Disregarded payment from FDE2 to P. The disregarded payment from 
FDE2 to P is disregarded for Federal income tax purposes, and does not 
generate gross income. However, the disregarded payment is allocable to 
gross income attributable to FDE2 because a deduction for the payment, 
if it were regarded, would be allocated to FDE2's $200x of non-passive 
category foreign source gross services income under Sec.  1.861-8. Under 
paragraph (f)(2)(vi)(A) of this section, the amount of non-passive 
category foreign source gross income attributable to FDE2 is adjusted 
downward, and the amount of general category foreign source gross income 
attributable to P is adjusted upward, to take the $50x disregarded 
payment into account. Thus, $50x of non-passive category foreign source 
gross income relating to the Customer A services is attributable to P 
for purposes of this section, $150x of that income is attributable to 
FDE2, and $800x of that income remains attributable to FDE1. FDE2's 
$1,100x of U.S. source royalty income is not adjusted under paragraph 
(f)(2)(vi) of this section and remains foreign branch category income.
    (xii) Example 12: Application of intangible property rules--(A) 
Facts. P, a domestic corporation that has a calendar taxable year, owns 
FDE, a disregarded entity that is a foreign branch within the meaning of 
paragraph (f)(3)(vii) of this section. FDE's functional currency is the 
U.S. dollar. Asset A, a patent with a useful life ending on December 31, 
Year 2, was obtained with respect to a discovery that was made by FDE in 
the course of its trade or business and was used in that trade or 
business until December 31, Year 1. On December 31, Year 1, FDE remits 
Asset A to P and receives no consideration. Asset A has an adjusted 
basis of $0. In Year 2, P uses Asset A to generate general category 
gross income. P earns $1,000x of general category U.S. source gross 
income in Year 2, including the income generated by its use of Asset A. 
If FDE were a domestic corporation, P were a foreign corporation, and 
Asset A had been transferred in exchange for stock in a transaction 
described in section 351, such that section 367(d) applied by its terms 
(but all other facts remained the same), the payment determined under 
section 367(d) for Year 2 would be $300x. A disregarded payment for the 
use of Asset A, if it were regarded, would be allocated to FDE's $1,000x 
of general category U.S. source gross income under Sec.  1.861-8.
    (B) Analysis. The remittance of Asset A by FDE to P is a transfer of 
intangible property described in section 367(d)(4) from a foreign branch 
to its foreign branch owner. The facts in paragraph (f)(4)(xii)(A) of 
this section do not implicate an exception in paragraph (f)(2)(vi)(D)(2) 
or (3) of this section. Therefore, this is a transaction to which 
paragraph (f)(2)(vi)(D)(1) of this section applies. The foreign branch 
is treated as having sold the transferred property to the foreign branch 
owner in exchange for annual payments contingent on the productivity or 
use of the property, the amount of which for Year 2 is determined under 
the principles of section 367(d) to be $300x. Thus, in Year 2, P is 
treated as making a $300x disregarded payment to FDE. The payment would 
be allocable to general category U.S. source income under paragraph 
(f)(2)(vi)(B)(1)(i) of this section. Therefore, $300x of P's non-passive 
category U.S. source gross income is attributable to FDE under 
paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section. P has 
$700x of general category U.S. source gross income and $300x of foreign 
branch category U.S. source gross income in Year 2.
    (xiii) Example 13: Disregarded payment from domestic corporation to 
foreign branch--(A) Facts. P, a domestic corporation, owns FDE, a 
disregarded entity that is a foreign branch. FDE's functional currency 
is the U.S. dollar. In Year 1, P accrues and records on its books and 
records for Federal income tax purposes $400x of gross income from the 
license of intellectual property to unrelated parties that is not 
passive category income, all of which is U.S. source income. P also 
accrues $600x of foreign source passive category interest income. P 
compensates FDE for services that FDE performs in a foreign country with 
an arm's length payment

[[Page 894]]

of $350x, which FDE records on its books and records; the transaction is 
disregarded for Federal income tax purposes. Absent the application of 
paragraph (f)(2)(vi) of this section, the $400x of gross income earned 
by P from the license would be general category income that would not be 
attributable to FDE. If the $350x disregarded payment from P to FDE were 
regarded for Federal income tax purposes, the deduction for the payment 
would be allocated and apportioned entirely to P's $400x of general 
category gross licensing income under the principles of Sec. Sec.  
1.861-8 and 1.861-8T (treating U.S. source general category gross income 
and foreign source passive category gross income each as a statutory 
grouping). P and FDE incur no other expenses.
    (B) Analysis. The $350x disregarded payment from P, a United States 
person, to FDE, its foreign branch, is not recorded on FDE's separate 
books and records (as adjusted to conform to Federal income tax 
principles) under paragraph (f)(2)(i) of this section because it is 
disregarded for Federal income tax purposes. The disregarded payment is 
allocable to gross income attributable to P because a deduction for the 
payment, if it were regarded, would be allocated and apportioned to the 
$400x of P's U.S. source licensing income. Accordingly, under paragraphs 
(f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, the amount of gross 
income attributable to the FDE foreign branch (and the gross income 
attributable to P) is adjusted in Year 1 to take the disregarded payment 
into account. Accordingly, $350x of P's $400x U.S. source general 
category gross income from the license is attributable to the FDE 
foreign branch for purposes of this section. Therefore, $350x of the 
U.S. source gross income that P earned with respect to its license in 
Year 1 constitutes U.S. source gross income that is assigned to the 
foreign branch category and $50x remains U.S. source general category 
income. P's $600x of foreign source passive category interest income is 
unchanged.
    (xiv) Example 14: Regarded payment from non-consolidated domestic 
corporation to a foreign branch--(A) Facts. The facts are the same as 
those in paragraph (f)(4)(xiii)(A) of this section (the facts in Example 
13), except P wholly owns USS, and USS (rather than P) owns FDE. P and 
USS do not file a consolidated return. USS has no gross income other 
than the $350x foreign source services income from the $350x payment it 
receives from P, through FDE.
    (B) Analysis. The $350x services payment from P, a United States 
person, to FDE, a foreign branch of USS, is not a disregarded payment 
because the transaction is regarded for Federal income tax purposes. 
Under Sec. Sec.  1.861-8 and 1.861-8T, P's $350x deduction for the 
services payment is allocated and apportioned to its U.S. source general 
category gross income. The payment of $350x from P to USS is services 
income attributable to FDE, and foreign branch category income of USS 
under paragraph (f)(2)(i) of this section. Accordingly, USS has $350x of 
foreign source foreign branch category gross income. P has $600x of 
foreign source passive category income and $400x of U.S. source general 
category gross income and a $350x deduction for the services payment, 
resulting in $50x of U.S. source general category taxable income to P.
    (xv) Example 15: Regarded payment from a member of a consolidated 
group to a foreign branch of another member of the consolidated group--
(A) Facts. The facts are the same as those in paragraph (f)(4)(xiv)(A) 
of this section (the facts in Example 14), except that P and USS are 
members of an affiliated group that files a consolidated return pursuant 
to section 1502 (P group).
    (B) Analysis--(1) Definitions under Sec.  1.1502-13. Under Sec.  
1.1502-13(b)(1), the $350x services payment from P to FDE, a foreign 
branch of USS, is an intercompany transaction between P and USS; USS is 
the selling member, P is the buying member, P has a deduction of $350x 
for the services payment that is a corresponding item, and USS has $350x 
of income that is an intercompany item. The payment is not a disregarded 
payment because the transaction is regarded for Federal income tax 
purposes.
    (2) Timing and attributes under Sec.  1.1502-13--(i) Separate entity 
versus single entity

[[Page 895]]

analysis. Under a separate entity analysis, the result is the same as in 
paragraph (f)(4)(xiv)(B) of this section (the analysis in Example 14), 
whereby P has $600x of foreign source passive category income and $50x 
of U.S. source general category income, and USS has $350x of foreign 
source foreign branch category income. In contrast, under a single 
entity analysis, the result is the same as in paragraph (f)(4)(xiii)(B) 
of this section (the analysis in Example 13), whereby P has $600x of 
foreign source passive category income, $50x of U.S. source general 
category income, and $350x of U.S. source foreign branch category 
income.
    (ii) Application of the matching rule. Under the matching rule in 
Sec.  1.1502-13(c), the timing, character, source, and other attributes 
of USS's $350x intercompany item and P's $350x corresponding item are 
redetermined to produce the effect of transactions between divisions of 
a single corporation, as if the services payment had been made to a 
foreign branch of that corporation. Accordingly, all of USS's foreign 
source income of $350x is redetermined to be U.S. source, rather than 
foreign source, income. Therefore, for purposes of Sec.  1.1502-4(c)(1), 
the P group has $600x of foreign passive category income, $50x of U.S. 
source general category income, and $350x of U.S. source foreign branch 
category income.
    (xvi) Example 16: Disregarded payment made from non-branch taxable 
unit--(A) Facts. The facts are the same as those in paragraph 
(f)(4)(xiii)(A) of this section (the facts in Example 13), except that P 
also wholly owns FDE1, a disregarded entity that is a non-branch taxable 
unit. In addition, FDE1 (rather than P) is the entity that properly 
accrues and records on its books and records the $400x of U.S. source 
general category income from the license of intellectual property and 
the $600x of foreign source passive category interest income, and FDE1 
(rather than P) is the entity that makes the $350x payment, which is 
disregarded for Federal income tax purposes, to FDE in compensation for 
services.
    (B) Analysis. Under paragraph (f)(2)(vi)(G) of this section, the 
rules of paragraph (f)(2) of this section apply to attribute gross 
income to FDE1, a non-branch taxable unit, as though FDE1 were a foreign 
branch. Under these rules, the $400x of licensing income and the $600 of 
interest income are initially attributable to FDE1. This income is 
adjusted in Year 1 to account for the $350x disregarded payment, which 
is allocable to the $400x of licensing income of FDE1. Accordingly, $50x 
of the $400x of U.S. source general category licensing income is 
attributable to FDE1 and $350x of this income is attributable to the FDE 
foreign branch. To determine the income that is attributable to P, the 
foreign branch owner, and FDE, the foreign branch, the income that is 
attributed to FDE1, after taking into account all of the disregarded 
payments that it makes and receives, must be further attributed to one 
or more foreign branches or a foreign branch owner under paragraph 
(f)(2)(vi)(G) of this section. Under paragraph (f)(2)(vi)(G) of this 
section, the income of FDE1 is attributed to the foreign branch group or 
foreign branch owner group of which it is a member. Because FDE1 is 
wholly owned by P, FDE is a member solely of the foreign branch owner 
group that is owned by P. See definition of ``foreign branch owner 
group'' in Sec.  1.904-4(f)(3). All the income that is attributed to 
FDE1 under paragraph (f)(2) of this section, namely, the $50x of U.S. 
source general category licensing income and the $600x of foreign source 
passive category interest income, is further attributed to P. See Sec.  
1.904-4(f)(2)(vi)(G)(3). Therefore, the result is the same as in 
paragraph (f)(4)(xiii)(B) of this section (the analysis in Example 13).
    (g) Section 951A category income--(1) In general. Except as provided 
in paragraph (g)(2) of this section, the term section 951A category 
income means amounts included (directly or indirectly through a pass-
through entity) in gross income of a United States person under section 
951A(a).
    (2) Exceptions for passive category income. Section 951A category 
income does not include any amounts included under section 951A(a) that 
are allocable to passive category income under Sec.  1.904-5(c)(6).
    (h) Export financing interest--(1) Definitions--(i) Export financing 
interest. The term ``export financing interest''

[[Page 896]]

means any interest derived from financing the sale (or other 
disposition) for use or consumption outside the United States of any 
property that is manufactured, produced, grown, or extracted in the 
United States by the taxpayer or a related person, and not more than 50 
percent of the fair market value of which is attributable to products 
imported into the United States. For purposes of this paragraph, the 
term ``United States'' includes the fifty States, the District of 
Columbia, and the Commonwealth of Puerto Rico.
    (ii) Fair market value. For purposes of this paragraph, the fair 
market value of any property imported into the United States shall be 
its appraised value, as determined by the Secretary under section 402 of 
the Tariff Act of 1930 (19 U.S.C. 1401a) in connection with its 
importation. For purposes of determining the foreign content of an item 
of property imported into the United States, see section 927 and the 
regulations thereunder.
    (iii) Related person. For purposes of this paragraph, the term 
``related person'' has the meaning given it by section 954(d)(3) except 
that such section shall be applied by substituting ``the person with 
respect to whom the determination is being made'' for ``controlled 
foreign corporation'' each place it applies.
    (2) Treatment of export financing interest. Except as provided in 
paragraph (h)(3) of this section, if a taxpayer (including a financial 
services entity) receives or accrues export financing interest from an 
unrelated person, then that interest is not treated as passive category 
income. Instead, the interest income is treated as foreign branch 
category income, section 951A category income, general category income, 
or income in a specified separate category under the rules of this 
section.
    (3) Exception. Unless it is received or accrued by a financial 
services entity, export financing interest shall be treated as passive 
category income if that income is also related person factoring income. 
For this purpose, related person factoring income is--
    (i) Income received or accrued by a controlled foreign corporation 
that is income described in section 864(d)(6) (income of a controlled 
foreign corporation from a loan for the purpose of financing the 
purchase of inventory property of a related person); or
    (ii) Income received or accrued by any person that is income 
described in section 864(d)(1) (income from a trade receivable acquired 
from a related person).
    (4) Examples. The following examples illustrate the application of 
paragraph (h)(3) of this section.
    (i) Example 1. Controlled foreign corporation CFC is a wholly-owned 
subsidiary of domestic corporation USP. CFC is not a financial services 
entity and has accumulated cash reserves. USP has uncollected trade and 
service receivables of foreign obligors. USP sells the receivables at a 
discount (``factors'') to CFC. The income derived by CFC on the 
receivables is related person factoring income. The income is also 
export financing interest. Because the income is related person 
factoring income, the income is passive category income to CFC.
    (ii) Example 2. Domestic corporation USS is a wholly-owned 
subsidiary of domestic corporation USP. USS is not a financial services 
entity, does not have any foreign qualified business entities, and has 
accumulated cash reserves. USP has uncollected trade and service 
receivables of foreign obligors. USP factors the receivables to USS. The 
income derived by USS on the receivables is related person factoring 
income. The income is also export financing interest. The income will be 
passive category income to USS.
    (iii) Example 3. The facts are the same as in paragraph (h)(4)(ii) 
of this section (the facts in Example 2), except that instead of 
factoring USP's receivables, USS finances the sales of USP's goods by 
making loans to the purchasers of USP's goods. The interest derived by 
USS on these loans is export financing interest and is not related 
person factoring income. The income will be general category income to 
USS.
    (5) Income eligible for section 864(d)(7) exception (same country 
exception) from related person factoring treatment--(i) Income other 
than interest. If any foreign person receives or accrues income that is 
described in section 864(d)(7) (income on a trade or service receivable 
acquired from a related person in the

[[Page 897]]

same foreign country as the recipient) and such income would also meet 
the definition of export financing interest if section 864(d)(1) applied 
to such income (income on a trade or service receivable acquired from a 
related person treated as interest), then the income is considered to be 
export financing interest and is not treated as passive category income. 
The income is treated as foreign branch category income, section 951A 
category income, general category income, or income in a specified 
separate category under the rules of this section.
    (ii) Interest income. If export financing interest is received or 
accrued by any foreign person and that income would otherwise be treated 
as related person factoring income of a controlled foreign corporation 
under section 864(d)(6) if section 864(d)(7) did not apply, section 
904(d)(2)(B)(iii)(I) applies and the interest is not treated as passive 
category income. The income is treated as general category income in the 
hands of the controlled foreign corporation.
    (iii) Examples. The following examples illustrate the application of 
this paragraph (h)(5):
    (A) Example 1. CFC1, a controlled foreign corporation, is a wholly-
owned subsidiary of domestic corporation USP. CFC2, a controlled foreign 
corporation, is a wholly-owned subsidiary of CFC1. CFC1 and CFC2 are 
incorporated in Country M. In Year 1, USP sells tractors to CFC2, which 
CFC2 sells to X, an unrelated foreign corporation organized in Country 
M. The tractors are to be used in Country M. CFC2 uses a substantial 
part of its assets in its trade or business located in Country M. CFC2 
has uncollected trade receivables from X that it factors to CFC1. The 
income is not related person factoring income because it is described in 
section 864(d)(7) (income eligible for the same country exception) and 
is tested income. If section 864(d)(1) applied, the income CFC1 derived 
from the receivables would meet the definition of export financing 
interest. The income, therefore, is considered to be export financing 
interest and is general category income to CFC1 and may be section 951A 
category income to USP.
    (B) Example 2. CFC1, a controlled foreign corporation, is a wholly-
owned subsidiary of domestic corporation, USP. CFC2, a controlled 
foreign corporation, is a wholly-owned subsidiary of CFC1. CFC1 and CFC2 
are incorporated in Country M. In Year 1, USP sells tractors to CFC2, 
which CFC2 sells to X, a foreign partnership that is organized in 
Country M and is related to CFC1 and CFC2. CFC1 makes a loan to X to 
finance the tractor sales. The interest earned by CFC1 from financing 
the sales is described in section 864(d)(7) and is export financing 
interest and is tested income. Therefore, the income is general category 
income to CFC1 and may be section 951A category income to USP.
    (i) Interaction of section 907(c) and income described in this 
section. If a person receives or accrues income that is income described 
in section 907(c) (relating to oil and gas income), the rules of section 
907(c) and the regulations thereunder, as well as the rules of this 
section, shall apply to the income. The reduction in amount allowed as 
foreign tax provided by section 907(a) shall therefore be calculated 
separately for income in each separate category.
    (j) Special rule for DASTM gain or loss. Any DASTM gain or loss 
computed under Sec.  1.985-3(d) must be allocated among the categories 
of income under the rules of Sec.  1.985-3 (e)(2)(iv) or (e)(3). The 
rules of Sec.  1.985-3(e) apply before the rules of section 
904(d)(2)(B)(iii)(II) (the exception from passive income for high-taxed 
income).
    (k) Separate category under section 904(d)(6) or 865(h) for items 
resourced under treaties--(1) Section 904(d)(6)--(i) In general. Except 
as provided in paragraph (k)(1)(iv)(A) of this section, sections 904(a), 
(b), (c), (d), (f), and (g) and sections 907 and 960 are applied 
separately to any item of income that, without regard to a treaty 
obligation of the United States, would be treated as derived from 
sources within the United States, but under a treaty obligation of the 
United States such item of income would be treated as arising from 
sources outside the United States, and the taxpayer chooses the benefits 
of such treaty obligation.
    (ii) Aggregation of items of income in each other separate category. 
For purposes of applying the general rule of paragraph (k)(1) of this 
section, items

[[Page 898]]

of income in each other separate category of income that are resourced 
under each applicable treaty are aggregated in a single separate 
category for income in that separate category that is resourced under 
that treaty. For example, all items of passive category income that 
would otherwise be treated as derived from sources within the United 
States but which the taxpayer chooses to treat as arising from sources 
outside the United States pursuant to a provision of a bilateral U.S. 
income tax treaty are treated as income in a separate category for 
passive category income resourced under the particular treaty, and the 
high-tax kickout grouping rules of paragraph (c) of this section are 
applied separately to the groups of passive income included in that 
separate category. Any items of resourced high-taxed passive income are 
assigned to a separate category for general (or other) category income 
resourced under a tax treaty. Items of income described in paragraph 
(k)(1) of this section are not combined with other income that is 
foreign source income under the Code, even if the other income arises 
from sources within the jurisdiction with which the United States has a 
bilateral income tax treaty (``treaty jurisdiction'') and is included in 
the same separate category to which the resourced income would be 
assigned without regard to section 904(d)(6). Items of income described 
in paragraph (k)(1) of this section are also not combined with other 
items of resourced income that are subject to a separate limitation by 
reason of a Code provision other than section 904(d)(6).
    (iii) Related taxes. Foreign taxes, including foreign taxes paid to 
a foreign jurisdiction other than the treaty jurisdiction on an item of 
resourced income, are allocated to each separate category described in 
paragraph (k)(1)(ii) of this section in accordance with Sec.  1.904-6.
    (iv) Coordination with certain income tax treaty provisions--(A) 
Exception for special relief from double taxation for individual 
residents of treaty jurisdictions. Section 904(d)(6)(A) and paragraph 
(k)(1) of this section do not apply to any item of income deemed to be 
from foreign sources by reason of the relief from double taxation rules 
in any U.S. income tax treaty that is solely applicable to U.S. citizens 
who are residents of the other Contracting State.
    (B) U.S. competent authority assistance. For purposes of applying 
paragraph (k)(1) of this section, if, under the mutual agreement 
procedure provisions of an applicable income tax treaty, the U.S. 
competent authority agrees to allow a taxpayer to treat an item of 
income as foreign source income, where such item of income would 
otherwise be treated as derived from sources within the United States, 
then the taxpayer is considered to have chosen the benefits of such 
treaty obligation to treat the item as foreign source income.
    (v) Coordination with other Code provisions. Section 904(d)(6)(A) 
and paragraph (k)(1) of this section do not apply to any item of income 
to which any of section 245(a)(10), 865(h), or 904(h)(10) applies. See 
also paragraph (l) of this section.
    (2) Section 865(h). If any gain, as defined in section 
865(h)(2)(A)(i), would be treated as derived from sources within the 
United States under section 865, but pursuant to a treaty obligation of 
the United States such gain would be treated as arising from sources 
outside the United States, and the taxpayer chooses the benefits of such 
treaty obligation, then that gain will be treated as foreign source 
income. However, sections 904(a), (b), (c), (d), (f), and (g) and 
sections 907 and 960 are applied separately to amounts described in the 
preceding sentence with respect to each treaty under which the taxpayer 
has claimed benefits and, within each treaty, to each separate category 
of income. The principles of the rules in paragraphs (k)(1)(ii) through 
(iv) of this section apply to gains, and foreign taxes on gains, that 
are subject to a separate limitation under section 865(h).
    (l) Priority rule. Income that meets the definitions of a specified 
separate category and another category of income described in section 
904(d)(1) is subject to the separate limitation described in paragraph 
(m) of this section and is not treated as general category income, 
foreign branch category income, passive category income, or section 951A 
category income.

[[Page 899]]

    (m) Income treated as allocable to a specified separate category. If 
section 904(a), (b), and (c) are applied separately to any category of 
income under the Internal Revenue Code (for example, under section 
245(a)(10), 865(h), 901(j), 904(d)(6), or 904(h)(10)), that category of 
income is treated for all purposes of the Internal Revenue Code as if it 
were a separate category listed in section 904(d)(1). For purposes of 
this section, a separate category that is treated as if it were listed 
in section 904(d)(1) by reason of the first sentence in this paragraph 
(m) is referred to as a specified separate category.
    (n) Income from partnerships and other pass-through entities--(1) 
Distributive shares of partnership income--(i) In general. Except as 
provided in paragraph (n)(1)(ii) of this section, a partner's 
distributive share of partnership income is characterized as passive 
category income to the extent that the distributive share is a share of 
income earned or accrued by the partnership in the passive category. A 
partner's distributive share of partnership income that is not described 
in the first sentence of this paragraph (n) is treated as foreign branch 
category income, general category income, or income in a specified 
separate category under the rules of this section. The principles of the 
rules in this paragraph (n)(1)(i) also apply to characterize a person's 
share of income from any other pass-through entity.
    (ii) Less than 10 percent partners partnership interests--(A) In 
general. Except as provided in paragraph (n)(1)(ii)(B) of this section, 
if any limited partner owns less than 10 percent of the value in a 
partnership, the partner's distributive share of partnership income from 
the partnership is passive income to the partner (subject to the 
exception for high-taxed income under section 904(d)(2)(B)(iii)(II) and 
paragraph (c) of this section), and the partner's distributive share of 
partnership deductions from the partnership is allocated and apportioned 
under the principles of Sec.  1.861-8 only to the partner's passive 
income from that partnership. See also Sec.  1.861-9(e)(4) for rules for 
apportioning partnership interest expense.
    (B) Exception for partnership interest held in the ordinary course 
of business. If a partnership interest described in paragraph 
(n)(1)(ii)(A) of this section is held in the ordinary course of a 
partner's active trade or business, the rules of paragraph (n)(1)(i) of 
this section apply for purposes of characterizing the partner's 
distributive share of the partnership income. A partnership interest is 
considered to be held in the ordinary course of a partner's active trade 
or business if the partner (or a member of the partner's affiliated 
group of corporations (within the meaning of section 1504(a) and without 
regard to section 1504(b)(3))) engages (other than through a less than 
10 percent interest in a partnership) in the same or a related trade or 
business as the partnership.
    (2) Income from the sale of a partnership interest--(i) In general. 
To the extent a partner recognizes gain on the sale of a partnership 
interest, that income shall be treated as passive income to the partner, 
subject to the exception for high-taxed income under section 
904(d)(2)(B)(iii)(II) and paragraph (c) of this section.
    (ii) Exception for sale by 25-percent owner. Except as provided in 
paragraph (f)(2)(iv) of this section, in the case of a sale of an 
interest in a partnership by a partner that is a 25-percent owner of the 
partnership, determined by applying section 954(c)(4)(B) and 
substituting ``partner'' for ``controlled foreign corporation'' every 
place it appears, for purposes of determining the separate category to 
which the income recognized on the sale of the partnership interest is 
assigned such partner is treated as selling the proportionate share of 
the assets of the partnership attributable to such interest.
    (3) Value of a partnership interest. For purposes of paragraphs 
(n)(1) and (2) of this section, a partner will be considered as owning 
10 percent of the value of a partnership for a particular year if the 
partner, together with any person that bears a relationship to the 
partner described in section 267(b) or 707, owns 10 percent of the 
capital and profits interest of the partnership. For purposes of this 
paragraph (n)(3), value will be determined at the end of the 
partnership's taxable year.
    (4) Example. The following example illustrates the application of 
this paragraph (n).

[[Page 900]]

    (i) Facts. PRS is a domestic partnership. PRS has two general 
partners, A and B. A and B each have a greater than 10% interest in PRS. 
PRS also has two limited partners, C and D. C has a 50% interest in the 
partnership and D has a 9% interest. D's partnership interest is not 
held in the ordinary course of business. A, B, C and D are all United 
States persons. In Year 1, PRS has $100x of general category non-subpart 
F income on which it pays no foreign tax.
    (ii) Analysis. Under paragraph (n)(1)(i) of this section, A's, B's, 
and C's distributive shares of PRS's income are not passive category 
income. Under paragraph (n)(1)(ii)(A) of this section, because D is a 
limited partner with a less than 10% interest in PRS, D's distributive 
share of PRS's income is passive category income.
    (o) Separate category of section 78 gross up. The amount included in 
income under section 78 by reason of taxes deemed paid under section 960 
is assigned to the separate category to which the taxes are allocated 
under 1.904-6(e).
    (p) Separate category of foreign currency gain or loss. Foreign 
currency gain or loss recognized under section 986(c) with respect to a 
distribution of previously taxed earnings and profits (as described in 
section 959 or 1293(c)) is assigned to the separate category or 
categories of the previously taxed earnings and profits from which the 
distribution is made. See Sec.  1.987-6(b) for rules on assigning 
section 987 gain or loss on a remittance from a section 987 QBU to a 
separate category or categories.
    (q) Applicability date. (1) Except as provided in paragraphs (q)(2) 
and (3) of this section, this section applies for taxable years that 
both begin after December 31, 2017, and end on or after December 4, 
2018.
    (2) Paragraphs (c)(7)(i) and (iii) and (c)(8)(v) through (viii) 
apply to taxable years ending on or after December 16, 2019. For taxable 
years that both begin after December 31, 2017, and end on or after 
December 4, 2018, and also end before December 16, 2019, see Sec.  
1.904-4(c)(7)(i) and (iii) as in effect on December 17, 2019.
    (3) Paragraphs (b)(2)(i)(A), (c)(4), and (f) of this section apply 
to taxable years that begin after December 31, 2019, and end on or after 
November 2, 2020.

[T.D. 8214, 53 FR 27011, July 18, 1988]

    Editorial Note: For Federal Register citations affecting Sec.  
1.904-4, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.904-5  Look-through rules as applied to controlled foreign 
corporations and other entities.

    (a) Scope and definitions--(1) Look-through rules under section 
904(d)(3) to passive category income. Paragraph (c) of this section 
provides rules for determining the extent to which dividends, interest, 
rents, and royalties received or accrued by certain eligible persons, 
and inclusions under sections 951(a)(1) and 951A(a), are treated as 
passive category income. Paragraph (g) of this section provides rules 
applying the principles of paragraph (c) of this section to foreign 
source interest, rents, and royalties paid by a domestic corporation to 
a related corporation. Paragraph (h) of this section provides rules for 
assigning a partnership payment to a partner described in section 707 to 
the passive category. Paragraph (i) of this section provides rules 
applying the principles of this section to assign distributions and 
payments from certain related entities to the passive category or to 
treat the distributions and payments as not in the passive category.
    (2) Other look-through rules under section 904(d). Under section 
904(d)(4) and paragraph (c)(4)(iii) of this section, certain dividends 
from noncontrolled 10-percent owned foreign corporations are treated as 
income in a separate category. Under section 904(d)(3)(H) and paragraph 
(j) of this section, certain inclusions under section 1293 are treated 
as income in a separate category. Paragraph (i) of this section provides 
rules applying the principles of this section to assign distributions 
from certain related entities to separate categories.
    (3) Other rules provided in this section. Paragraph (b) of this 
section provides operative rules for this section. Paragraph (d) of this 
section provides rules

[[Page 901]]

addressing exceptions to passive category income for certain purposes in 
the case of controlled foreign corporations that meet the requirements 
of section 954(b)(3)(A) (de minimis rule) or section 954(b)(4) (high-tax 
exception). Paragraph (e) of this section provides rules for 
characterizing a controlled foreign corporation's foreign base company 
income and gross insurance income when section 954(b)(3)(B) (full 
inclusion rule) applies. Paragraph (f) of this section modifies the 
look-through rules for certain types of income. Paragraph (k) of this 
section provides ordering rules for applying the look-through rules. 
Paragraph (l) of this section provides examples illustrating the 
application of certain rules in this section. Paragraphs (m) and (n) of 
this section provide rules related to the resourcing rules described in 
section 904(h).
    (4) Definitions. For purposes of this section, the following 
definitions apply:
    (i) The term controlled foreign corporation has the meaning given 
such term by section 957 (taking into account the special rule for 
certain captive insurance companies contained in section 953(c)), 
determined without applying section 318(a)(3)(A), (B), and (C) so as to 
consider a United States person as owning stock which is owned by a 
person who is not a United States person.
    (ii) The term look-through rules means the rules described in this 
section that assign income to a separate category based on the separate 
category of the income to which it is allocable.
    (iii) The term noncontrolled 10-percent owned foreign corporation 
has the meaning provided in section 904(d)(2)(E)(i).
    (iv) 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 income and its 
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.
    (v) The term separate category means, as the context requires, any 
category of income described in section 904(d)(1)(A), (B), (C), or (D), 
any specified separate category of income as defined in Sec.  1.904-
4(m), or any category of earnings and profits to which income described 
in such provisions is attributable.
    (vi) The term United States shareholder has the meaning given such 
term by section 951(b) (taking into account the special rule for certain 
captive insurance companies contained in section 953(c)), determined 
without applying section 318(a)(3)(A), (B), and (C) so as to consider a 
United States person as owning stock which is owned by a person who is 
not a United States person, except that for purposes of this section, a 
United States shareholder includes any member of the controlled group of 
the United States shareholder. For purposes of this paragraph 
(a)(4)(vi), the controlled group is any member of the affiliated group 
within the meaning of section 1504(a)(1) except that ``more than 50 
percent'' is substituted for ``at least 80 percent'' wherever it appears 
in section 1504(a)(2). When used in reference to a noncontrolled 10-
percent owned foreign corporation described in section 
904(d)(2)(E)(i)(II), the term United States shareholder also means a 
taxpayer that meets the stock ownership requirements described in 
section 904(d)(2)(E)(i)(II).
    (b) Operative rules--(1) Assignment of income not assigned under the 
look-through rules. Except as provided by the look-through rules, 
dividends, interest, rents, and royalties received or accrued by a 
taxpayer from a controlled foreign corporation in which the taxpayer is 
a United States shareholder are excluded from passive category income. 
Income excluded from the passive category under this paragraph (b)(1) is 
assigned to another separate category (other than the passive category) 
under the rules in Sec.  1.904-4.
    (2) Priority and ordering of look-through rules. Except as provided 
in this paragraph (b)(2), to the extent the look-through rules assign 
income to a separate category, the income is assigned to that separate 
category rather than the separate category to which

[[Page 902]]

the income would have been assigned under Sec.  1.904-4 (not taking into 
account Sec.  1.904-4(l)). See paragraph (k) of this section for 
ordering rules for applying the look-through rules. However, passive 
income that is financial services income is assigned to a separate 
category under the rules in Sec.  1.904-4(e)(1), (f)(1), and (l), 
regardless of whether the look-through rules otherwise would have 
assigned such income to the passive category.
    (c) Rules for specific types of inclusions and payments--(1) Scope. 
Subject to the exceptions in paragraph (f) of this section, paragraphs 
(c)(2) through (6) (other than paragraph (c)(4)(iii) of this section) of 
this section provide look-through rules with respect to interest, rents, 
royalties, dividends, and inclusions under sections 951(a)(1) and 
951A(a) that are received or accrued from a controlled foreign 
corporation in which the taxpayer is a United States shareholder. 
Paragraph (c)(4)(iii) of this section provides a look-through rule for 
dividends received from a noncontrolled 10-percent owned foreign 
corporation by a domestic corporation that is a United States 
shareholder in the foreign corporation.
    (2) Interest--(i) In general. For purposes of this paragraph, 
related person interest is any interest paid or accrued by a controlled 
foreign corporation to any United States shareholder in that corporation 
(or to any other related person) to which the look-through rules of 
section 904(d)(3) and this section apply. Unrelated person interest is 
all interest other than related person interest. Related person interest 
is treated as passive category income to the extent it is allocable to 
passive category income of the controlled foreign corporation. If 
related person interest is received or accrued from a controlled foreign 
corporation by two or more persons, the amount of interest received or 
accrued by each person that is allocable to passive category income is 
determined by multiplying the amount of related person interest 
allocable to passive category income by a fraction. The numerator of the 
fraction is the amount of related person interest received or accrued by 
that person and the denominator is the total amount of related person 
interest paid or accrued by the controlled foreign corporation. Solely 
for purposes of assigning interest income to a separate category under 
section 904(d)(3) and the look-through rule in this paragraph (c)(2), 
the rules in paragraph (c)(2)(ii) of this section for allocating and 
apportioning interest expense of a controlled foreign corporation apply 
for purposes of characterizing interest income in the hands of the 
recipient, even if a deduction for the interest expense is deferred or 
disallowed to the controlled foreign corporation.
    (ii) Allocating and apportioning expenses of a controlled foreign 
corporation including interest paid to a related person. Related person 
interest and other expenses of a controlled foreign corporation shall be 
allocated and apportioned in the following manner:
    (A) Gross income in each separate category shall be determined;
    (B) Any expenses that are definitely related to less than all of 
gross income as a class, including unrelated person interest that is 
directly allocated to income from a specific property, shall be 
allocated and apportioned under the principles of Sec. Sec.  1.861-8 or 
1.861-10T, as applicable, to income in each separate category;
    (C) Related person interest shall be allocated to and shall reduce 
(but not below zero) the amount of passive foreign personal holding 
company income as determined after the application of paragraph 
(c)(2)(ii)(B) of this section;
    (D) To the extent that related person interest exceeds passive 
foreign personal holding company income as determined after the 
application of paragraphs (c)(2)(ii) (B) and (C) of this section, the 
related person interest shall be apportioned under the rules of this 
paragraph to separate categories other than passive income.
    (1) If under Sec.  1.861-9T, the modified gross income method of 
apportioning interest expense is elected, related person interest shall 
be apportioned as follows:

[[Page 903]]

[GRAPHIC] [TIFF OMITTED] TC07OC91.034

    (2) If under Sec.  1.861-9T, the asset method of apportioning 
interest expense is elected, related person interest shall be 
apportioned according to the following formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.035

    (E) Any other expenses (including unrelated person interest that is 
not directly allocated to income from a specific property) that are not 
definitely related expenses or that are definitely related to all of 
gross income as a class shall be apportioned under the rules of this 
paragraph to reduce income in each separate category.
    (1) If under Sec.  1.861-9T, the modified gross income method of 
apportioning interest expense is elected, the interest expense shall be 
apportioned as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.036

    (2) If under Sec.  1.861-9T, the asset method of apportioning 
interest expense is elected, then the expense shall be apportioned as 
follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.037

    (3) Expenses other than interest shall be apportioned in a similar 
manner depending on the apportionment method used. See Sec.  1.861-
8T(c)(1) (i)-(vi).

[[Page 904]]

    (iii) Allocating and apportioning expenses of a noncontrolled 10-
percent owned foreign corporation. Expenses of a noncontrolled 10-
percent owned foreign corporation shall be allocated and apportioned in 
the same manner as expenses of a controlled foreign corporation under 
paragraph (c)(2)(ii) of this section, except that the related person 
interest rule of paragraphs (c)(2)(ii)(C) and (D) of this section shall 
not apply.
    (iv) Definitions--(A) Value of assets and reduction in value of 
assets and gross income. For purposes of paragraph (c)(2)(ii) (D) and 
(E) of this section, the value of total assets is the value of assets in 
all categories (determined under the principles of Sec.  1.861-9T(g)). 
See Sec.  1.861-10T(d)(2) to determine the reduction in value of assets 
and gross income for purposes of apportioning additional third person 
interest expense that is not directly allocated when some interest 
expense has been directly allocated. For purposes of this paragraph and 
paragraph (c)(2)(ii)(E) of this section, any reduction in the value of 
assets for indebtedness that relates to interest allocated under 
paragraph (c)(2)(ii)(C) of this section is made before determining the 
average of asset values. For rules relating to the averaging of reduced 
asset values see Sec.  1.861-9T(g)(2).
    (B) Related person debt allocated to passive assets. For purposes of 
paragraph (c)(2)(ii)(E) of this section, related person debt allocated 
to passive assets is determined as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.038


For this purpose, the term total related person debt means the sum of 
the principal amounts of obligations of a controlled foreign corporation 
owed to any United States shareholder of such corporation or to any 
related entity (within the meaning of paragraph (g) of this section) 
determined at the end of the taxable year.
    (v) Examples. The following examples illustrate the application of 
this paragraph (c)(2).
    (A) Example 1. (1) CFC, a controlled foreign corporation, is a 
wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC 
earns $200x of foreign personal holding company income that is passive 
category income. CFC also earns $100x of foreign base company sales 
income that is general category income. CFC has $2,000x of passive 
category assets and $2,000x of general category assets. In Year 1, CFC 
makes a $150x interest payment to USP with respect to a $1,500x loan 
from USP. CFC also pays $100x of interest to an unrelated person on a 
$1,000x loan from that person. CFC has no other expenses. CFC uses the 
asset method to apportion interest expense.
    (2) Under paragraph (c)(2)(ii)(C) of this section, the $150x related 
person interest payment is allocable to CFC's passive category foreign 
personal holding company income. Therefore, the $150x interest payment 
is passive category income to USP. Because the entire related person 
interest payment is allocated to passive category income under paragraph 
(c)(2)(ii)(C) of this section, none of the related person interest 
payment is apportioned to general category income under paragraph 
(c)(2)(ii)(D) of this section. Under paragraph (c)(2)(iv)(B) of this 
section, the entire amount of the related person debt is allocable to 
passive category assets ($1,500x = $1,500x x $150x/$150x). Under 
paragraph (c)(2)(ii)(E) of this section, $20x of the interest expense 
paid to an unrelated person is apportioned to passive category income 
($20x = $100x x ($2,000x - $1,500x)/($4,000x - $1,500x)), and $80x of 
the interest expense paid to an unrelated person is apportioned to 
general category income

[[Page 905]]

($80x = $100x x $2,000x/($4,000x - $1,500x)).
    (B) Example 2. The facts are the same as in paragraph (c)(2)(v)(A) 
of this section (the facts in Example 1), except that CFC uses the 
modified gross income method to apportion interest expense. Under 
paragraph (c)(2)(ii)(E) of this section, the unrelated person interest 
expense is apportioned based on gross income. Therefore, $33x of 
interest expense paid to an unrelated person is apportioned to CFC's 
passive category income ($33x = $100x x ($200x - $150x)/($300x - $150x)) 
and $67x of interest expense paid to an unrelated person is apportioned 
to CFC's general category income ($67x = $100x x $100x/($300x - $150x)).
    (C) Example 3. (1) The facts are the same as in paragraph 
(c)(2)(v)(A) of this section (the facts in Example 1), except that CFC 
has an additional $50x of third person interest expense that is directly 
allocated to income from a specific property that produces only passive 
category income. The principal amount of indebtedness to which the 
interest relates is $500x. CFC also has $50x of additional non-interest 
expenses that are not definitely related expenses and that are 
apportioned on an asset basis.
    (2) Under paragraph (c)(2)(ii)(B) of this section, the $50x of 
directly allocated third person interest is first allocated to reduce 
the passive category income of CFC. Under paragraph (c)(2)(ii)(C) of 
this section, the $150x of related person interest is allocated to the 
remaining $150x of passive category income. Under paragraph 
(c)(2)(iv)(B) of this section, all of the related person debt is 
allocated to passive category assets ($1,500x = $1,500x x $150x/$150x).
    (3) Under paragraph (c)(2)(ii)(E) of this section, the non-interest 
expenses that are not definitely related are apportioned on the basis of 
the asset values reduced by the allocated related person debt. 
Therefore, $10x of these expenses are apportioned to the passive 
category ($50x x ($2,000x - $1,500x)/($4,000x - $1,500x)) and $40x are 
apportioned to the general category ($50x x $2,000x/($4,000x - 
$1,500x)).
    (4) In order to apportion third person interest (that was not 
directly allocated third person interest) between the categories of 
assets, the value of assets in a separate category must also be reduced 
under the principles of Sec.  1.861-8 by the indebtedness relating to 
the specifically allocated interest. Therefore, under paragraph 
(c)(2)(iv)(B) of this section, the value of assets in the passive 
category for purposes of apportioning the additional third person 
interest = 0 ($2,000x minus $500x (the principal amount of the debt, the 
interest payment on which is directly allocated to specific interest-
producing properties) minus $1,500x (the related person debt allocated 
to passive category assets)). Under paragraph (c)(2)(ii)(E) of this 
section, all $100x of the non-definitely related third person interest 
expense is apportioned to the general category ($100x = $100x x $2,000x/
($4,000x - $500x - $1,500x)).
    (D) Example 4. (1) CFC, a controlled foreign corporation, is a 
wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC 
earns $100x of foreign personal holding company income that is passive 
category income. CFC also earns $100x of foreign base company sales 
income that is general category income. CFC has $1,000x of general 
category assets and $1,000x of passive category assets. In Year 1, CFC 
makes a $150x interest payment to USP on a $1,500x loan from USP and has 
$20x of general and administrative expenses (G & A) that under the 
principles of Sec. Sec.  1.861-8 through 1.861-14T is treated as 
directly allocable to all of CFC's gross income. CFC also makes a $25x 
interest payment to an unrelated person on a $250x loan from the 
unrelated person. CFC has no other expenses. CFC uses the asset method 
to apportion interest expense. CFC uses the modified gross income method 
to apportion G & A.
    (2) Under paragraph (c)(2)(iv)(B) of this section, related person 
debt allocated to passive category assets equals $1,000x ($1,000x = 
$1,500x x $100x/$150x).Under paragraph (c)(2)(ii)(C) of this section, 
$100x of the interest payment to USP is allocable to CFC's passive 
category foreign personal holding company income. Under paragraph 
(c)(2)(ii)(D) of this section, the additional $50x of related person 
interest expense is apportioned to CFC's general category income ($50x = 
$50x x $1,000x/$1,000x).

[[Page 906]]

    (3) Under paragraph (c)(2)(ii)(E) of this section, none of the $25x 
of interest expense paid to an unrelated person is apportioned to 
passive category income ($0 = $25x x ($1,000x - $1,000x)/($2,000x - 
$1,000x)). All $25x of the interest expense paid to an unrelated person 
is apportioned to general category income ($25x = $25x x $1,000x/
($2,000x - $1,000x)). Under paragraph (c)(2)(ii)(E) of this section, 
none of the G & A is allocable to CFC's passive category foreign 
personal holding company income ($0 = $20x x ($100x - $100x)/($200x - 
$100x)). All $20x of the G & A is apportioned to CFC's general category 
income ($20x = $20x x $100x/($200x - $100x)).
    (E) Example 5. The facts are the same as in paragraph (c)(2)(v)(D) 
of this section (the facts in Example 4), except that CFC uses the 
modified gross income method to apportion interest expense. As in 
paragraph (c)(2)(v)(D) of this section (Example 4), $100x of the 
interest payment to USP is allocated to passive category income under 
paragraph (c)(2)(ii)(C) of this section. Under paragraph (c)(2)(ii)(D) 
of this section, the additional $50x of related person interest expense 
is apportioned to general category income ($150x--100x x $100x/$100x). 
Under paragraph (c)(2)(ii)(E) of this section, none of the unrelated 
person interest expense and none of the G & A is apportioned to passive 
category income, because after the application of paragraph 
(c)(2)(ii)(C) of this section, no income remains in the passive 
category.
    (F) Example 6. CFC2, a controlled foreign corporation, is a wholly-
owned subsidiary of CFC1, a controlled foreign corporation. CFC1 is a 
wholly-owned subsidiary of USP, a domestic corporation. CFC1 and CFC2 
are incorporated in the same country. In Year 1, USP sells tractors to 
CFC2, which CFC2 sells to X, a foreign corporation that is related to 
both CFC1 and CFC2 and is organized in the same country as CFC1 and 
CFC2. CFC1 makes a loan to x to finance the tractor sales. Assume that 
the interest earned by CFC1 from financing the sales is export financing 
interest that is neither related person factoring income nor foreign 
personal holding company income. Under Sec.  1.904-4(h), the export 
financing interest earned by CFC1 is, therefore, general category 
income. CFC1 earns no other income. CFC1 makes a $100x interest payment 
to USP. The $100x of interest paid is not allocable under the look-
through rules and paragraph (c)(2)(ii) of this section to passive 
category income of CFC1. The income is general category income to USP.
    (3) Rents and royalties. Any rents or royalties received or accrued 
from a controlled foreign corporation in which the taxpayer is a United 
States shareholder are treated as passive category income to the extent 
they are allocable to passive category income of the controlled foreign 
corporation under the principles of Sec. Sec.  1.861-8 through 1.861-
14T.
    (4) Dividends--(i) Look-through rule for controlled foreign 
corporations. Except as provided in paragraph (d)(2) of this section, 
any dividend paid or accrued out of the earnings and profits of any 
controlled foreign corporation is treated as passive category income in 
proportion to the ratio of the portion of earnings and profits 
attributable to passive category income to the total amount of earnings 
and profits of the controlled foreign corporation. For purposes of this 
paragraph (c)(4), the term ``dividend'' includes any amount included in 
gross income under section 951(a)(1)(B) as a pro rata share of a 
controlled foreign corporation's increase in earnings invested in United 
States property.
    (ii) Special rule for dividends attributable to certain loans. If a 
dividend is distributed to a taxpayer by a controlled foreign 
corporation, that controlled foreign corporation is the recipient of 
loan proceeds from a related look-through entity (within the meaning of 
Sec.  1.904-5(i)), and the purpose of such loan is to alter the 
characterization of the dividend for purposes of this section, then, to 
the extent of the principal amount of the loan, the dividend shall be 
characterized with respect to the earnings and profits of the related 
person lender rather than with respect to the earnings and profits of 
the dividend payor. A loan will not be considered made for the purpose 
of altering the characterization of a dividend if the loan would have 
been made or maintained on substantially the same terms irrespective of 
the dividend. The

[[Page 907]]

determination of whether a loan would have been made or maintained on 
substantially the same terms irrespective of the dividend will be made 
taking into account all the facts and circumstances of the relationship 
between the lender and the borrower. Thus, for example, a loan by a 
related party lender to a controlled foreign corporation that arises 
from the sale of inventory in the ordinary course of business will not 
be considered a loan made for the purpose of altering the character of 
any dividend paid by the borrower.
    (iii) Look-through rule for dividends from noncontrolled 10-percent 
owned foreign corporations--(A) In general. Except as provided in 
paragraph (c)(4)(iii)(B) of this section, any dividend that is 
distributed by a noncontrolled 10-percent owned foreign corporation and 
received or accrued by a domestic corporation that is a United States 
shareholder of such foreign corporation is treated as income in a 
separate category in proportion to the ratio of the portion of earnings 
and profits attributable to income in such category to the total amount 
of earnings and profits of the noncontrolled 10-percent owned foreign 
corporation.
    (B) Inadequate substantiation. A dividend distributed by a 
noncontrolled 10-percent owned foreign corporation is treated as income 
in the separate category described in section 904(d)(4)(C)(ii) if the 
Commissioner determines that the look-through characterization of the 
dividend cannot reasonably be determined based on the available 
information.
    (5) Inclusions under section 951(a)(1)(A). Any amount included in 
gross income under section 951(a)(1)(A) is treated as passive category 
income to the extent the amount included is attributable to income 
received or accrued by the controlled foreign corporation that is 
passive category income. All other amounts included in gross income 
under section 951(a)(1)(A) are treated as general category income or 
income in a specified separate category under the rules in Sec.  1.904-
4. For rules concerning a distributive share of partnership income, see 
Sec.  1.904-4(n). For rules concerning the gross up under section 78, 
see Sec.  1.904-4(o). For rules concerning inclusions under section 
951(a)(1)(B), see paragraph (c)(4)(i) of this section.
    (6) Inclusions under section 951A(a). Any amount included in gross 
income under section 951A(a) is treated as passive category income to 
the extent the amount included is attributable to income received or 
accrued by the controlled foreign corporation that is passive category 
income. All other amounts included in gross income under section 951A(a) 
are treated as section 951A category income or income in a specified 
separate category under the rules in Sec.  1.904-4. For rules concerning 
a distributive share of partnership income, see Sec.  1.904-4(n). For 
rules concerning the gross up under section 78, see Sec.  1.904-4(o).
    (7) Examples. The following examples illustrate the application of 
paragraph (c) of this section.
    (i) Example 1--(A) Facts. CFC, a controlled foreign corporation, is 
a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC 
earns $100x of net income, $85x of which is general category foreign 
base company sales income and $15x of which is passive category foreign 
personal holding company income. No foreign tax is imposed on the 
income. CFC's income of $100x is subpart F income taxed currently to USP 
under section 951(a)(1)(A).
    (B) Analysis. Because $15x of the subpart F inclusion is 
attributable to passive category income of CFC, under section 
904(d)(3)(B) and paragraph (c)(5) of this section $15x of the subpart F 
inclusion is passive category income to USP. The remaining $85x subpart 
F inclusion is general category income to USP.
    (ii) Example 2--(A) Facts. CFC1, a controlled foreign corporation, 
is a wholly-owned subsidiary of USP, a domestic corporation. CFC2 is a 
controlled foreign corporation wholly owned by CFC1 and is incorporated 
and operates all of its business in the same country as CFC1. All of 
CFC2's earnings and profits are attributable to passive category foreign 
personal holding company income. USP elects to exclude CFC2's income 
from subpart F income under section 954(b)(4). In Year 1, CFC2 makes a 
distribution to CFC1 and CFC1 makes a

[[Page 908]]

distribution to USP, all of which is attributable to Year 1 earnings and 
profits. CFC1 has no earnings and profits in Year 1 other than those 
received from CFC2.
    (B) Analysis. (1) With respect to the dividend from CFC2 to CFC1, 
such amount is not subpart F income. See section 954(c)(3). Under 
section 904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this 
section the dividend income is not passive category income and therefore 
under Sec.  1.904-4 it is general category income to CFC1. Under section 
951A(c)(2)(A)(i)(IV), such dividend income is not tested income.
    (2) With respect to the dividend from CFC1 to USP, under section 
904(d)(3)(D) and (E) and paragraphs (c)(4) and (d)(2) of this section, 
such dividend income is not passive category income and therefore under 
Sec.  1.904-4 is general category income to USP.
    (iii) Example 3--(A) Facts. The facts are the same as in paragraph 
(c)(7)(ii)(A) of this section (the facts in Example 2), except that CFC1 
receives interest income from CFC2 instead of dividend income.
    (B) Analysis. Under section 904(d)(3)(C) and paragraph (c)(2)(i) of 
this section, the interest income is passive category income to CFC1 
because such interest is properly allocable to the passive category 
income of CFC2. The interest income from CFC2 is subpart F income of 
CFC1 taxable to USP because such income reduces the subpart F income of 
CFC2 or such interest is properly allocable to the subpart F income of 
CFC2. See section 954(c)(3) and (6). Under section 904(d)(3)(B) and 
paragraph (c)(5) of this section, the subpart F inclusion is passive 
category income to USP. Under section 959(a), the distribution from CFC1 
to USP is excluded from USP's gross income.
    (iv) Example 4--(A) Facts. The facts are the same as in paragraph 
(c)(7)(iii)(A) of this section (the facts in Example 3), except that USP 
elects to exclude CFC1's interest income from subpart F income under 
section 954(b)(4).
    (B) Analysis. Under section 904(d)(3)(D) and (E) and paragraphs 
(c)(4) and (d)(2) of this section, the distribution from CFC1 to USP is 
not a passive category dividend and therefore under Sec.  1.904-4 is 
general category income to USP.
    (v) Example 5--(A) Facts. The facts are the same as in paragraph 
(c)(7)(iv)(A) of this section (the facts in Example 4), except that USP 
receives interest income from CFC1 instead of dividend income.
    (B) Analysis. Under section 904(d)(3)(C) and paragraph (c)(2)(i) of 
this section, the interest income is passive category income to USP 
because such interest is properly allocable to passive category income 
of CFC1.
    (d) Effect of exclusions from subpart F income--(1) De minimis 
amount of subpart F income. If the sum of a controlled foreign 
corporation's gross foreign base company income (determined under 
section 954(a) without regard to section 954(b)(5)) and gross insurance 
income (determined under section 953(a)) for the taxable year is less 
than the lesser of 5 percent of gross income or $1,000,000, then none of 
that income is treated as passive category income. In addition, if the 
test in the first sentence of this paragraph (d)(1) is satisfied, for 
purposes of paragraphs (c)(2)(ii)(D) and (E) of this section 
(apportionment of interest expense to passive income using the asset 
method), any passive assets are not treated as passive category assets 
but are treated as assets in the general category or a specified 
separate category. The determination in the first sentence of this 
paragraph (d)(1) is made before the application of the exception for 
certain income subject to a high rate of foreign tax described in 
paragraph (d)(2) of this section.
    (2) Exception for certain income subject to high foreign tax. Except 
as provided in Sec.  1.904-4(c)(7)(iii) (relating to reductions in tax 
upon distribution), for purposes of the dividend look-through rule of 
paragraph (c)(4)(i) of this section, an item of net income that would 
otherwise be passive category income (after application of the priority 
rules of Sec.  1.904-4(l)) and that is received or accrued by a 
controlled foreign corporation is not treated as passive category 
income, and the earnings and profits attributable to such income is not 
treated as passive category earnings and profits, if the taxpayer 
establishes to the satisfaction of the Secretary

[[Page 909]]

under section 954(b)(4) that the income was subject to an effective rate 
of income tax imposed by a foreign country greater than 90 percent of 
the maximum rate of tax specified in section 11 (with reference to 
section 15, if applicable). Such income is treated as general category 
income or income in a specified separate category under the rules in 
Sec.  1.904-4. The first sentence of this paragraph (d)(2) has no effect 
on amounts (other than dividends) paid or accrued by a controlled 
foreign corporation to a United States shareholder of such controlled 
foreign corporation to the extent those amounts are allocable to passive 
category income of the controlled foreign corporation.
    (3) Example. The following example illustrates the application of 
this paragraph (d).
    (i) Facts. CFC, a controlled foreign corporation, is a wholly-owned 
subsidiary of USP, a domestic corporation. In Year 1, CFC earns $100x of 
gross income, $4x of which is interest that is foreign personal holding 
company income and $96x of which is gross manufacturing income that is 
not subpart F income. CFC has no other earnings for Year 1. CFC has no 
expenses and pays no foreign taxes.
    (ii) Analysis. Under the de minimis rule of section 954(b)(3)(A) and 
Sec.  1.954-1(b)(1)(i), none of CFC's income is treated as foreign base 
company income. All of CFC's income, therefore, is treated as general 
category income and tested income. In Year 1, USP has a GILTI inclusion 
amount with respect to CFC. Such amount is section 951A category income 
to USP.
    (e) Treatment of subpart F income in excess of 70 percent of gross 
income--(1) Rule. If the sum of a controlled foreign corporation's gross 
foreign base company income (determined without regard to section 
954(b)(5)) and gross insurance income for the taxable year exceeds 70 
percent of the gross income, then all of the controlled foreign 
corporation's gross income shall be treated as foreign base company 
income (whichever is appropriate) and, thus, included in a United States 
shareholder's gross income. However, the inclusion in gross income of an 
amount that would not otherwise be subpart F income does not affect its 
character for purposes of determining whether the income is within a 
separate category. The determination of whether the controlled foreign 
corporation's gross foreign base company income and gross insurance 
income exceeds 70 percent of gross income is made before the exception 
for certain income subject to a high rate of foreign tax.
    (2) Example. The following example illustrates the application of 
this paragraph (e).
    (i) Facts. Controlled foreign corporation CFC is a wholly-owned 
subsidiary of USP, a domestic corporation. CFC earns $100x, $75x of 
which is foreign personal holding company income and $25x of which is 
non-subpart F services income. CFC's gross and net income are equal.
    (ii) Analysis. Under the 70 percent full inclusion rule of section 
954(b)(3)(B), the entire $100x is foreign base company income currently 
taxable to USP under section 951. Because $75x of the $100x section 951 
inclusion is attributable to CFC's passive category income, $75x of the 
inclusion is passive category income to USP. The remaining $25x of the 
inclusion is treated as general category income to USP.
    (f) Modification of look-through rules for certain income.
    (1) [Reserved]
    (2) Distributions from a FSC. Income received or accrued by a 
taxpayer that, under the rules of paragraph (c)(4) of this section 
(look-through rules for dividends), would be treated as foreign trade 
income or as passive income that is interest and carrying charges (as 
defined in section 927(d)(1)), and that is also a distribution from a 
FSC (or a former FSC), shall be treated as a distribution from a FSC (or 
a former FSC).
    (g) Application of look-through rules to certain domestic 
corporations. The principles of paragraph (c) of this section shall 
apply to any foreign source interest, rents and royalties paid by a 
domestic corporation to a related corporation. For this purpose, a 
domestic corporation and another corporation are considered to be 
related if one owns, directly or indirectly, stock possessing more than 
50 percent of the total voting power of all classes of

[[Page 910]]

stock of the other corporation or more than 50 percent of the total 
value of the other corporation. In addition, a domestic corporation and 
another corporation shall be considered to be related if the same United 
States shareholders own, directly or indirectly, stock possessing more 
than 50 percent of the total voting power of all classes of stock or 
more than 50 percent of the total value of each corporation. For 
purposes of this paragraph, the constructive stock ownership rules of 
section 318 and the regulations under that section apply.
    (h) Application of look-through rules to payments from a partnership 
or other pass-through entity. Payments to a partner described in section 
707 (e.g., payments to a partner not acting in capacity as a partner) 
are characterized as passive category income to the extent that the 
payment is attributable under the principles of Sec.  1.861-8 and this 
section to passive category income of the partnership, if the payments 
are interest, rents, or royalties that would be characterized under the 
controlled foreign corporation look-through rules of paragraph (c) of 
this section if the partnership were a foreign corporation, and the 
partner who receives the payment owns 10 percent or more of the value of 
the partnership (as determined under Sec.  1.904-4(n)(3)). A payment by 
a partnership to a member of the controlled group (as defined in 
paragraph (a)(4)(vi) of this section) of the partner is characterized 
under the look-through rules of this paragraph (h) if the payment would 
be a section 707 payment entitled to look-through treatment if it were 
made to the partner. The rules in this paragraph (h) do not apply with 
respect to interest to the extent the interest income is assigned to a 
separate category under the downstream partnership loan rules described 
in Sec.  1.861-9(e)(8). The principles of the rules in this paragraph 
(h) apply to characterize a payment from any other pass-through entity.
    (i) Application of look-through rules to related entities--(1) In 
general. Except as provided in paragraphs (i)(2) and (3) of this 
section, the principles of this section shall apply to distributions and 
payments that are subject to the look-through rules of section 904(d)(3) 
and this section from a controlled foreign corporation or other entity 
otherwise entitled to look-through treatment (a ``look-through entity'') 
under this section to a related look-through entity. A noncontrolled 10-
percent owned foreign corporation shall be considered a look-through 
entity only to the extent provided in paragraph (i)(3) of this section. 
Two look-through entities shall be considered to be related to each 
other if one owns, directly or indirectly, stock possessing more than 50 
percent of the total voting power of all classes of voting stock of the 
other entity or more than 50 percent of the total value of such entity. 
In addition, two look-through entities are related if the same United 
States shareholders own, directly or indirectly, stock possessing more 
than 50 percent of the total voting power of all voting classes of stock 
(in the case of a corporation) or more than 50 percent of the total 
value of each look-through entity. In the case of a corporation, value 
shall be determined by taking into account all classes of stock. For 
purposes of this paragraph (i)(1), indirect ownership of stock is 
determined under section 318. In the case of a partnership or other 
pass-through entity, indirect ownership and value is determined under 
the rules in paragraph (i)(2) of this section.
    (2) Indirect ownership and value of a partnership interest. A person 
is considered as owning, directly or indirectly, more than 50 percent of 
the value of a partnership if the person, together with any other person 
that bears a relationship to the first person that is described in 
section 267(b) or 707, owns more than 50 percent of the capital and 
profits interests of the partnership. For purposes of this paragraph 
(i)(2), value will be determined at the end of the partnership's taxable 
year. The principles of this paragraph (i)(2) apply with respect to a 
person that owns a pass-through entity other than a partnership.
    (3) Special rule for dividends between certain foreign corporations. 
Solely for purposes of dividend payments between controlled foreign 
corporations, noncontrolled 10-percent owned foreign corporations, or a 
controlled foreign

[[Page 911]]

corporation and a noncontrolled 10-percent owned foreign corporation, 
the two foreign corporations are considered related look-through 
entities if the same person is a United States shareholder of both 
foreign corporations.
    (4) [Reserved]
    (5) Examples. The following examples illustrate the application of 
this paragraph (i):
    (i) Example 1. USP, a domestic corporation, owns all of the stock of 
CFC1, a controlled foreign corporation. CFC1 owns 40% of the stock of 
CFC2, a Country X corporation that is a controlled foreign corporation. 
The remaining 60% of the stock of CFC2 is owned by V, a domestic 
corporation, unrelated to USP. The percentages of value and voting power 
of CFC2 owned by CFC1 and V correspond to their percentages of stock 
ownership. CFC2 owns 40% (by vote and value) of the stock of CFC3, a 
Country Z corporation that is a controlled foreign corporation. The 
remaining 60% of CFC3 is owned by unrelated United States persons. CFC3 
earns exclusively general category income that is neither subpart F 
income nor tested income. In Year 1, CFC3 makes an interest payment of 
$100x to CFC2. Look-through principles do not apply because CFC2 and 
CFC3 are not related look-through entities under paragraph (i)(1) of 
this section (because CFC2 does not own more than 50% of the voting 
power or value of CFC3). The interest is passive category income to CFC2 
and is subpart F income of CFC2 that is taxable to USP and V. Under 
paragraph (c)(5) of this section, USP and V's subpart F inclusion with 
respect to CFC2 is passive category income.
    (ii) Example 2. The facts are the same as in paragraph (i)(5)(i) of 
this section (the facts in Example 1), except that instead of a $100x 
interest payment, CFC3 pays a $50x dividend to CFC2 in Year 1. USP and V 
each own, directly or indirectly, more than 10% of the voting power of 
all classes of stock of both CFC2 and CFC3, and, therefore, CFC2 and 
CFC3 have the same United States shareholders. Pursuant to paragraph 
(i)(3) of this section, because CFC2 and CFC3 have a common United 
States shareholder, for purposes of applying this section to the 
dividend from CFC2 to CFC3, CFC2 and CFC3 are treated as related look-
through entities. Therefore, look-through principles apply. Because CFC3 
has no passive category income or earnings and profits, the dividend 
income is characterized as general category income to CFC2. The dividend 
is subpart F income of CFC2 that is taxable to USP and V. Under 
paragraph (c)(5) of this section, the subpart F inclusions of USP and V 
are not passive category income to USP and V and therefore under Sec.  
1.904-4 the subpart F inclusions are general category income to USP and 
V.
    (iii) Example 3. The facts are the same as in paragraph (i)(5)(i) of 
this section (the facts in Example 1), except that CFC3 pays both a 
$100x interest payment and a $50x dividend to CFC2, and CFC2 owns 80% 
(by vote and value) of CFC3. Under paragraph (i)(1) of this section, 
CFC2 and CFC3 are related look-through entities, because CFC2 owns more 
than 50% (by vote and value) of CFC3. Therefore, look-through principles 
apply to both the interest and dividend income paid or accrued by CFC3 
to CFC2, and CFC2 treats both types of income as general category income 
because CFC3 does not have any passive category earnings. Under 
paragraph (c)(5) of this section and Sec.  1.904-4, the resulting 
subpart F inclusions are general category income to USP and V.
    (iv) Example 4. USP, a domestic corporation, owns 50% of the voting 
stock of CFC1, a controlled foreign corporation. CFC1 owns 10% of the 
voting stock of CFC2, a controlled foreign corporation. The remaining 
50% of the stock of CFC1 is owned by X. The remaining 90% of the stock 
of CFC2 is owned by Y. X and Y are each United States shareholders of 
CFC2 but are not related to USP, CFC1, or each other. In Year 1, CFC2 
pays a $100x dividend to CFC1. Under paragraph (i)(3) of this section 
because no person is a United States shareholder of both CFC1 and CFC2 
(USP and X each own only 5% of CFC2), CFC1 and CFC2 are not related 
look-through entities. Because CFC2 is not a related person to CFC1 
within the meaning of section 954(d)(3), section 954(c)(3) and (c)(6) 
are inapplicable, and the dividend is subpart F income of CFC1 that is 
taxable to USP

[[Page 912]]

and X. Therefore, under section 904(d)(2)(B)(i) and Sec.  1.904-
4(b)(2)(i)(A), because the dividend income is foreign personal holding 
company income, it is passive category income to CFC1.
    (v) Example 5. The facts are the same as in paragraph (i)(5)(iv) of 
this section (the facts in Example 4), except that X owns 10% of the 
voting stock of CFC2 and Y owns only 80% of the voting stock of CFC2. 
Because CFC2 is not a related person to CFC1 within the meaning of 
section 954(d)(3), the dividend is subpart F income of CFC1 that is 
taxable to USP and X. In addition, because X is a United States 
shareholder of both CFC1 and CFC2, CFC2 and CFC1 are related look-
through entities under paragraph (i)(3) of this section, the dividend 
income is general category income to CFC1 and the subpart F inclusion is 
general category income to USP and X.
    (j) Look-through rules applied to passive foreign investment company 
inclusions. If a passive foreign investment company is a controlled 
foreign corporation and the taxpayer is a United States shareholder in 
that passive foreign investment company, any amount included in gross 
income under section 1293 shall be treated as income in a separate 
category to the extent the amount so included is attributable to income 
received or accrued by that controlled foreign corporation that is 
described as income in the separate category.
    (k) Ordering rules--(1) In general. Income received or accrued by a 
related person to which the look-through rules apply is characterized 
under Sec.  1.904-4 before amounts included from, or paid or distributed 
by that person and received or accrued by a related person. For purposes 
of determining the character of income received or accrued by a person 
from a related person if the payor or another related person also 
receives or accrues income from the recipient and the look-through rules 
apply to the income in all cases, the rules of paragraph (k)(2) of this 
section apply.
    (2) Specific rules. For purposes of characterizing income under this 
paragraph, the following types of income are characterized in the order 
stated:
    (i) Rents and royalties;
    (ii) Interest;
    (iii) Inclusions under sections 951(a)(1)(A) and 951A(a) and 
distributive shares of partnership income;
    (iv) Dividend distributions.


If an entity is both a recipient and a payor of income described in any 
one of the categories described in (k)(2) (i) through (iv) of this 
section, the income received will be characterized before the income 
that is paid. In addition, the amount of interest paid or accrued, 
directly or indirectly, by a person to a related person shall be offset 
against and eliminate any interest received or accrued, directly or 
indirectly, by a person from that related person before application of 
the ordering rules of this paragraph. In a case in which a person pays 
or accrues interest to a related person, and also receives or accrues 
interest indirectly from the related person, the smallest interest 
payment is eliminated and the amount of all other interest payments are 
reduced by the amount of the smallest interest payment.
    (l) Examples. The following examples illustrate the application of 
this section.
    (1) Example 1--(i) Facts. CFC1 and CFC2, controlled foreign 
corporations, are wholly-owned subsidiaries of USP, a domestic 
corporation. CFC1 and CFC2 are incorporated in two different foreign 
countries and CFC2 is a financial services entity. In Year 1, CFC1 earns 
$100x of gross income that is passive category foreign personal holding 
company income. CFC1's only expense is a $50x interest payment to CFC2. 
CFC1's $50x of pre-tax income is subject to $20x of foreign income tax, 
and USP elects to exclude CFC1's $30x of net income from subpart F 
income under section 954(b)(4).
    (ii) Analysis. The $50x of interest is foreign personal holding 
company income in CFC2's hands because section 954(c)(3)(A)(i) (same 
country exception for interest payments) and section 954(c)(6) do not 
apply, because the interest payment is allocable to and reduces CFC1's 
subpart F income. The $50x of interest income is also passive category 
income to CFC2 because CFC1 and CFC2 are related look-through entities 
within the meaning of paragraph (i)(1) of this section and, therefore 
the

[[Page 913]]

look-through rules of paragraph (c)(2)(i) of this section apply to 
characterize the interest payment. However, because CFC2 is a financial 
services entity, under Sec.  1.904-4(e)(1) and paragraph (b)(2) of this 
section, the income is treated as financial services income and 
therefore as general category income in CFC2's hands. Thus, with respect 
to CFC2, under Sec.  1.904-4(d) and paragraph (c)(5) of this section, 
USP includes in its gross income a $50x general category inclusion under 
section 951(a)(1)(A) attributable to the general category foreign 
personal holding company income.
    (2) Example 2--(i) Facts. USP, a domestic corporation, owns 75% of 
USS, a domestic corporation. USP and USS are not financial services 
entities. In Year 1, USS's earnings consist of $100x of foreign source 
passive income. USS makes a $100x foreign source royalty payment to USP.
    (ii) Analysis. Under paragraph (g) of this section, the royalty 
payment to USP is subject to the look-through rules of paragraph (c)(3) 
of this section and is characterized as passive category income the 
extent that it is allocable to such income in USS's hands.
    (3) Example 3--(i) Facts. USP, a domestic corporation, owns 100% of 
the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% 
of the stock of CFC2, a controlled foreign corporation. CFC1 has $100x 
of passive foreign personal holding company income from unrelated 
persons and $100x of general category income. CFC1 also has $50x of 
interest income from CFC2. CFC1 pays CFC2 $100x of interest.
    (ii) Analysis. Under paragraph (k)(2) of this section, the $100x 
interest payment from CFC1 to CFC2 is reduced for limitation purposes to 
the extent of the $50x interest payment from CFC2 to CFC1 before 
application of the rules in paragraph (c)(2)(ii) of this section. 
Therefore, the interest payment from CFC2 to CFC1 is disregarded. CFC1 
is treated as if it paid $50x of interest to CFC2, all of which is 
allocable to CFC1's passive category foreign personal holding company 
income under paragraph (c)(2)(ii)(C) of this section. Therefore, under 
paragraph (c)(2)(i) of this section, the $50x interest payment from CFC1 
to CFC2 is passive category income.
    (4) Example 4--(i) Facts. USP, a domestic corporation, owns 100% of 
the stock of CFC1, a controlled foreign corporation. CFC1 owns 100% of 
the stock of CFC2, a controlled foreign corporation, and 100% of the 
stock of CFC3, a controlled foreign corporation. In Year 1, CFC2 pays 
CFC1 $5x of interest, CFC1 pays CFC3 $10x of interest, and CFC3 pays 
CFC2 $20x of interest.
    (ii) Analysis. Under paragraph (k)(2) of this section, the interest 
payments from CFC1 to CFC3 must be offset by the amount of interest that 
CFC1 is considered as receiving indirectly from CFC3 and the interest 
payment from CFC3 to CFC2 is offset by the amount of the interest 
payment that CFC3 is considered as receiving indirectly from CFC2. The 
$10x payment by CFC1 to CFC3 is reduced by $5x, the amount of the 
interest payment from CFC2 to CFC1 that is treated as being paid 
indirectly by CFC3 to CFC1. Similarly, the $20x interest payment from 
CFC3 to CFC2 is reduced by $5x, the amount of the interest payment from 
CFC1 to CFC3 that is treated as being paid indirectly by CFC2 to CFC3. 
Therefore, under paragraph (k)(2) of this section, CFC2 is treated as 
having made no interest payment to CFC1, CFC1 is treated as having paid 
$5x of interest to CFC3, and CFC3 is treated as having paid $15x to 
CFC2.
    (5) Example 5--(i) Facts. USP, a domestic corporation, owns 100% of 
the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% 
of the stock of CFC2, a controlled foreign corporation. In Year 1, CFC1 
earns $100x of passive category foreign personal holding company income 
and $100x of general category non-subpart F sales income from unrelated 
persons and $100x of general category non-subpart F interest income from 
a related person. CFC1 pays $150x of interest to CFC2. CFC2 earns $200x 
of general category sales income from unrelated persons and the $150x 
interest payment from CFC1. CFC2 pays CFC1 $100x of interest. USP does 
not have an inclusion under section 951A.
    (ii) Analysis--(A) Under paragraph (k)(2) of this section, the $100x 
interest payment from CFC2 to CFC1 reduces

[[Page 914]]

the $150x interest payment from CFC1 to CFC2. CFC1 is treated as though 
it paid $50x of interest to CFC2. CFC2 is treated as though it made no 
interest payment to CFC1.
    (B) Under paragraph (k)(2)(ii) of this section, the remaining $50x 
interest payment from CFC1 to CFC2 is then characterized. The interest 
payment is first allocable under the rules of paragraph (c)(2)(ii)(C) of 
this section to CFC1's passive category income. Therefore, under 
paragraph (c)(2)(i) of this section, the $50x interest payment to CFC2 
is passive category income. The interest income is foreign personal 
holding company income in CFC2's hands. CFC2, therefore, has $50x of 
passive category subpart F income and $200x of general category non-
subpart F income.
    (C) Under paragraph (k)(2)(iii) of this section, inclusions under 
section 951(a)(1)(A) are characterized next. USP has an inclusion under 
section 951(a)(1)(A) with respect to CFC1 of $50x that is attributable 
to passive category income of CFC1 and is treated as passive category 
income to USP. USP has an inclusion under section 951(a)(1)(A) with 
respect to CFC2 of $50x that is attributable to passive category income 
of CFC2 and is treated as passive category income to USP.
    (6) Example 6--(i) Facts. USP, a domestic corporation, owns 100% of 
the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% 
of the stock of CFC2, a controlled foreign corporation. USP also owns 
100% of the stock of CFC3, a controlled foreign corporation. CFC1, CFC2, 
and CFC3 are all incorporated in different foreign countries. In Year 1, 
CFC1 earns $100x of passive category foreign personal holding company 
income and $200x of general category non-subpart F income from unrelated 
persons. CFC1 also receives a $150x distribution from CFC2. CFC1 pays 
$100x of interest to CFC2 and $100x of interest to CFC3. CFC3 earns 
$300x of general category non-subpart F income and the $100x of interest 
received from CFC1. CFC3 pays a $100x royalty to CFC2. The royalty is 
directly allocable to CFC3's general category income and the royalty is 
not subpart F income to CFC2. CFC2 earns the $100x interest payment 
received from CFC1 and the $100x royalty received from CFC3. USP does 
not have an inclusion under section 951A.
    (ii) Analysis--(A) Under paragraph (k)(2)(i) of this section, the 
royalty paid by CFC3 to CFC2 is characterized first. With respect to 
CFC2, the royalty is general category non-subpart F income.
    (B) Under paragraph (k)(2)(ii) of this section, the interest 
payments from CFC1 to CFC2 and CFC3 are characterized next. Under 
paragraph (c)(2)(ii)(C) of this section, the interest payments are first 
allocable to CFC1's passive category income. Therefore, under paragraph 
(c)(2)(i) of this section, $50x of the interest payment to CFC2 is 
passive category income and $50x of the interest payment to CFC3 is 
passive category income. The remaining $50x paid to CFC2 is general 
category income and the remaining $50x paid to CFC3 is general category 
income. Because $100x of the interest income received or accrued from 
CFC1 is properly allocable to income of CFC1 which is not subpart F 
income, under section 954(c)(6) the general category interest income is 
not treated as foreign personal holding company income to CFC2 and CFC3. 
The remaining $100x of interest income received or accrued from CFC1 is 
passive category subpart F foreign personal holding company income to 
both recipients. Therefore, CFC3 and CFC2 each have $50x of passive 
category subpart F foreign personal holding company income related to 
the interest received from CFC1.
    (C) Under paragraph (k)(2)(iii) of this section, USP's $50x 
inclusion under section 951(a)(1)(A) with respect to CFC2 is 
characterized next. Under paragraph (c)(5) of this section, USP's 
inclusion under section 951(a)(1)(A) is attributable to the passive 
category portion of the interest income received by CFC2 from CFC1 and 
is passive category income to USP. Under paragraph (k)(2)(iii) of this 
section, USP's $50x inclusion under section 951(a)(1)(A) with respect to 
CFC3 is also characterized next. Under paragraph (c)(5) of this section, 
USP's inclusion under section 951(a)(1)(A) is attributable to the 
passive category portion of the interest income received by CFC3 from 
CFC2 and is passive category income to USP.

[[Page 915]]

    (D) Under paragraph (k)(2)(iv) of this section, the $150x 
distribution from CFC2 to CFC1 is characterized next. The first $50x of 
the distribution is out of passive category earnings and profits 
described in section 959(c)(2). The remaining $100x of the distribution 
is a dividend that is not attributable to CFC2's passive category 
income, so under paragraph (c)(4)(i) of this section it is general 
category income to CFC1 in its entirety. Because $100x of the dividend 
received or accrued from CFC2 is attributable to income of CFC2 which is 
not subpart F income, under section 954(c)(6) such dividend income is 
not treated as foreign personal holding company income of CFC1.
    (7) Example 7--(i) Facts. USP, a domestic corporation, owns 100% of 
the stock of CFC1, a controlled foreign corporation, and CFC1 owns 100% 
of the stock of CFC2, a controlled foreign corporation. USP also owns 
100% of the stock of CFC3, a controlled foreign corporation. CFC1, CFC2, 
and CFC3 are all incorporated in different foreign countries. In Year 1, 
CFC2 earns $100x of general category income that is not subpart F income 
and distributes the entire amount to CFC1 as a dividend. CFC1 earns 
$100x of passive category foreign personal holding company income and 
the $100x dividend from CFC2. CFC1 pays $100x of interest to CFC3. CFC3 
earns $200x of general category income that is foreign base company 
income and the $100x of interest income from CFC1. USP does not have an 
inclusion under section 951A.
    (ii) Analysis. This transaction does not involve circular payments 
and, therefore, the ordering rules of paragraph (k)(2) of this section 
do not apply. Instead, pursuant to paragraph (k)(1) of this section, 
income received is characterized first. CFC2's earnings and, thus, the 
dividend from CFC2 to CFC1 are characterized first. Under paragraph 
(c)(4)(i) of this section, CFC1 includes the $100x dividend from CFC2 in 
gross income as general category income because none of CFC2's earnings 
are passive category income. CFC1 thus has $100x of passive category 
foreign personal holding company income and $100x of general category 
income that is excluded from subpart F income under section 
954(c)(6)(A). The interest payment from CFC1 to CFC3 is then 
characterized as $100x passive category income under paragraph 
(c)(2)(ii)(C) of this section because it is allocable to passive foreign 
personal holding company income of CFC1. For Year 1, CFC3 thus has $200x 
of general category income that is subpart F income, and $100x of 
passive category foreign personal holding company income. For Year 1, 
under Sec.  1.904-4(d) and paragraph (c)(5) of this section, USP 
includes in its gross income an inclusion under section 951(a)(1)(A) 
with respect to CFC3, $200x of which is general category income and 
$100x of which is passive category income.
    (m) Application of section 904(h)--(1) In general. This paragraph 
(m) applies to certain amounts derived from controlled foreign 
corporations and noncontrolled 10-percent owned foreign corporations 
that are treated as United States-owned foreign corporations as defined 
in section 904(h)(6). For purposes of determining the portion of an 
interest payment that is allocable to income earned or accrued by a 
controlled foreign corporation or noncontrolled 10-percent owned foreign 
corporations from sources within the United States under section 
904(h)(3), the rules in paragraph (m)(2) of this section apply. For 
purposes of determining the portion of a dividend (which, for purposes 
of this paragraph (m), includes amounts described in section 
951(a)(1)(B)) paid or accrued by a controlled foreign corporation or 
noncontrolled 10-percent owned foreign corporations that is treated as 
from sources within the United States under section 904(h)(4), the rules 
in paragraph (m)(4) of this section apply. For purposes of determining 
the portion of an amount included in gross income under section 
951(a)(1)(A), 951A(a), or 1293 that is attributable to income of the 
controlled foreign corporation or noncontrolled 10-percent owned foreign 
corporations from sources within the United States under section 
904(h)(2), the rules in paragraph (m)(5) of this section apply. In order 
to determine whether section 904(h) applies, section 904(h)(5) 
(exception if a United States-owned foreign corporation has a de minimis 
amount of United States source income) shall be applied to the total

[[Page 916]]

amount of earnings and profits of a controlled foreign corporation or 
noncontrolled 10-percent owned foreign corporations for a taxable year 
without regard to the characterization of those earnings under section 
904(d).
    (2) Treatment of interest payments--(i) Interest payments from 
controlled foreign corporations. If interest is received or accrued by a 
United States shareholder or a person related to a United States 
shareholder (within the meaning of paragraph (c)(2)(ii) of this section) 
from a controlled foreign corporation, the interest shall be considered 
to be allocable to income of the controlled foreign corporation from 
sources within the United States for purposes of section 904(d) to the 
extent that the interest is allocable under paragraph (c)(2)(ii)(C) of 
this section to passive income that is from sources within the United 
States. If related person interest is less than or equal to passive 
income, the related person interest will be allocable to United States 
source passive income based on the ratio of United States source passive 
income to total passive income. To the extent that related person 
interest exceeds passive income, and, therefore, is allocated under 
paragraph (c)(2)(ii)(D) of this section to income in a separate category 
other than passive, the following formulas apply in determining the 
portion of the interest payment that is from sources within the United 
States. If the taxpayer uses the gross income method to allocate 
interest, the portion of the interest payment from sources within the 
United States is determined as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.118

    (ii) Interest payments from noncontrolled 10-percent owned foreign 
corporations. If interest is received or accrued by a shareholder from a 
noncontrolled 10-percent owned foreign corporation (where the 
shareholder is a domestic corporation that is a United States 
shareholder of such noncontrolled 10-percent owned foreign corporation), 
the rules of paragraph (m)(2)(i) of this section apply in determining 
the portion of the interest payment that is from sources within the 
United States, except that the related party interest rules of paragraph 
(c)(2)(ii)(C) of this section do not apply.
    (3) Examples. The following examples illustrate the application of 
this paragraph (m).
    (i) Example 1--(A) Facts. Controlled foreign corporation CFC is a 
wholly-owned subsidiary of USP, a domestic corporation. In Year 1, CFC 
pays USP $300x of interest. CFC has no other expenses. In Year 1, CFC 
has $3,000x of assets that generate $650x of foreign source general 
category income and a $1,000x loan to an unrelated foreign person that 
generates $20x of foreign source passive category interest income. CFC 
also has a $4,000x loan to an unrelated United States person that 
generates $70x of U.S. source passive category interest income and 
$4,000x of assets that generate $100x of U.S. source general category 
income. CFC uses the asset method to allocate interest expense. The 
following chart summarizes CFC's assets and income:

                    Table 1 to Paragraph (m)(3)(i)(A)
------------------------------------------------------------------------
                                             Foreign    U.S.     Totals
------------------------------------------------------------------------
Assets:
    Passive...............................    1,000x    4,000x    5,000x
    General...............................    3,000x    4,000x    7,000x
                                           -----------------------------
        Total.............................    4,000x    8,000x   12,000x
Income:
    Passive...............................       20x       70x       90x
    General...............................      650x      100x      750x
                                           -----------------------------
        Total.............................      670x      170x      840x
------------------------------------------------------------------------

    (B) Analysis. Under paragraph (c)(2)(ii)(C) of this section, $90x of 
the

[[Page 917]]

related person interest payment is allocable to CFC's passive category 
income. Under paragraph (m)(2) of this section, $70x of USP's $90x of 
passive category interest income is from sources within the United 
States and $20x is from foreign sources. Under paragraph (c)(2)(ii)(D) 
of this section, the remaining $210x of the related person interest 
payment is allocated to general category income. Under paragraph (m)(2) 
of this section, $120x of the remaining $210x of USP's interest income 
is treated as general category income from sources within the United 
States ($120x = $210x x $4,000x/$7,000x) and $90x is treated as general 
category income from foreign sources ($90x = $210x x $3,000x/$7,000x).
    (ii) Example 2. The facts are the same as in paragraph (m)(3)(i) of 
this section (the facts in Example 1), except that CFC uses the modified 
gross income method to allocate interest expense. The first $90x of 
related person interest expense is allocated to passive category income 
in the same manner as in paragraph (m)(3)(i) of this section (Example 
1), $70x to U.S. sources and $20x to foreign sources. Under paragraph 
(c)(2)(ii)(D) of this section, the remaining $210x of the related person 
interest expense is allocated to CFC's general category income. Under 
paragraph (m)(2) of this section, $28x of the remaining $210x of USP's 
interest income is treated as general category income from U.S. sources 
($28x = $210x x $100x/$750x) and $182x is treated as general category 
income from foreign sources ($182x = $210x x $650x/$750x).
    (4) Treatment of dividend payments--(i) Rule. Any dividend or 
distribution treated as a dividend under this paragraph (m) (including 
an amount included in gross income under section 951(a)(1)(B)) that is 
received or accrued by a United States shareholder from a controlled 
foreign corporation, or any dividend that is received or accrued by a 
domestic corporation from a noncontrolled 10-percent owned foreign 
corporation with respect to which the shareholder is a United States 
shareholder, are treated as income in a separate category derived from 
sources within the United States in proportion to the ratio of the 
portion of the earnings and profits of the controlled foreign 
corporation or noncontrolled 10-percent owned foreign corporation in the 
corresponding separate category from U.S. sources to the total amount of 
earnings and profits of the controlled foreign corporation or 
noncontrolled 10-percent owned foreign corporation in that separate 
category.
    (ii) Determination of earnings and profits from United States 
sources. In order to determine the portions of earnings and profits from 
United States sources and from foreign sources within each separate 
category, related person interest shall be allocated to the United 
States source portion of income in a separate category by applying the 
rules of paragraph (m)(2) of this section. Other expenses shall be 
allocated by applying the rules of paragraph (c)(2)(ii) of this section 
separately to the United States source income and the foreign source 
income in each category. For example, unrelated person interest expense 
that is allocated among categories of income based upon the relative 
amounts of assets in a category must be allocated between United States 
and foreign source income within each category by applying the rules of 
paragraph (c)(2)(ii)(E) of this section separately to United States 
source and foreign source assets in the separate category
    (5) Treatment of inclusions under sections 951(a)(1)(A), 951A and 
1293--(i) Rule. Any amount included in the gross income of a United 
States shareholder of a controlled foreign corporation under section 
951(a)(1)(A), 951A, or in the gross income of a domestic corporation 
that is a United States shareholder of a noncontrolled 10-percent owned 
foreign corporation described in section 904(d)(2)(E)(i)(II) that is a 
qualified electing fund under section 1293 is treated as income subject 
to a separate category that is derived from sources within the United 
States to the extent the amount is attributable to income of the 
controlled foreign corporation or qualified electing fund, respectively, 
in the corresponding category of income from sources within the United 
States. In order to determine a controlled foreign corporation's taxable 
income and earnings and profits from sources within the United States in 
each separate category, the principles of paragraph

[[Page 918]]

(m)(4)(ii) of this section shall apply. In order to determine a 
qualified electing fund's earnings and profits from sources within the 
United States in each separate category, the principles of paragraph 
(m)(4)(ii) of this section shall apply, except that the related person 
interest rule of paragraph (m)(2) of this section shall not apply.
    (ii) Example. The following example illustrates the application of 
this paragraph (m)(5).
    (A) Facts. Controlled foreign corporation CFC is a wholly-owned 
subsidiary of domestic corporation, USP. In Year 1, CFC earns $100x of 
subpart F foreign personal holding company income that is passive 
category income. Of this amount, $40x is derived from sources within the 
United States. CFC also earns $50x of subpart F general category income. 
None of this income is from sources within the United States. Assume 
that CFC pays no foreign taxes and has no expenses.
    (B) Analysis. USP must include $150x in gross income under section 
951(a). Of this amount, $60x is foreign source passive category income 
to USP, $40x is U.S. source passive category income to USP, and $50x is 
foreign source general category income to USP.
    (6) Treatment of section 78 amount. For purposes of treating taxes 
deemed paid by a taxpayer under section 960 as a dividend under section 
78, taxes that are paid or accrued with respect to United States source 
income in a separate category shall be treated as United States source 
income in that separate category.
    (7) Coordination with treaties--(i) Rule. If any amount of income 
derived from a United States-owned foreign corporation, as defined in 
section 904(h)(6), would be treated as derived from sources within the 
United States under section 904(h) and this paragraph (m) and, pursuant 
to an income tax convention with the United States, the taxpayer chooses 
to avail itself of benefits of the convention that treat that amount as 
arising from sources outside the United States under a rule explicitly 
treating the income as foreign source, then that amount will be treated 
as foreign source income. However, sections 904 (a), (b), (c), (d), (f), 
and (g), 907, and 960 shall be applied separately to amounts described 
in the preceding sentence with respect to each treaty under which the 
taxpayer has claimed benefits and, within each treaty, to each separate 
category of income.
    (ii) Example. The following example illustrates the application of 
this paragraph (m)(7).
    (A) Facts. Controlled foreign corporation CFC is incorporated in 
Country A and is a wholly-owned subsidiary of USP, a domestic 
corporation. In Year 1, CFC earns $80x of general category foreign base 
company sales income in Country A and $40x of passive category U.S. 
source interest income. CFC incurs $20x of expenses attributable to its 
sales business. CFC pays USP $40x of interest that is allocated to CFC's 
U.S. source passive category income under paragraph (c)(2)(ii)(C) of 
this section and so is U.S. source passive category income to USP under 
paragraphs (c)(2)(i) and (m)(2) of this section. Assume that earnings 
and profits equal net income. All of CFC's net income of $60x is subpart 
F income includible in USP's gross income under section 951(a)(1). For 
Year 1, USP also has $100x of foreign source passive category income 
derived from investments in Country B. Pursuant to section 904(h)(3) and 
paragraph (m)(2) of this section, the $40x interest payment from CFC is 
U.S. source income to USP because it is attributable to U.S. source 
interest income of CFC. The United States-Country A income tax treaty, 
however, treats all interest payments by residents of Country A as 
Country A sourced and USP elects to apply the treaty.
    (B) Analysis. Pursuant to section 904(h)(10) and this paragraph 
(m)(7), the entire interest payment will be treated as foreign source 
income to USP. USP thus has $60x of foreign source general category 
income, $40x of foreign source Country A treaty category passive income 
from CFC, and $100x of foreign source passive category income.
    (n) Order of application of section 904(d) and (h). In order to 
apply the rules of this section, Sec.  1.904-4 shall first be applied to 
the controlled foreign corporation or noncontrolled 10-percent owned 
foreign corporation to determine the amount of income and earnings and 
profits derived by the

[[Page 919]]

controlled foreign corporation or noncontrolled 10-percent owned foreign 
corporation in each separate category. The income and earnings and 
profits in each separate category that are from United States sources 
shall then be determined. Section 904(d)(3), (d)(4), and (h) and this 
section are then applied for purposes of characterizing and sourcing 
income received, accrued, or included by a United States shareholder of 
the foreign corporation that is attributable or allocable to income or 
earnings and profits of the foreign corporation.
    (o) Applicability dates. Except as otherwise provided in this 
paragraph (o), this section is applicable for taxable years that both 
begin after December 31, 2017, and end on or after December 4, 2018. 
Paragraphs (a)(4)(i) and (vi) of this section are applicable for taxable 
years of foreign corporations ending on or after October 1, 2019, and 
taxable years of United States persons ending on or after October 1, 
2019. For taxable years of foreign corporations ending before October 1, 
2019, and taxable years of United States persons ending before October 
1, 2019, 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 provisions with respect to 
all foreign corporations. For taxable years of foreign corporations 
ending before October 1, 2019, and taxable years of United States 
persons ending before October 1, 2019, where the taxpayer does not apply 
the provisions of paragraphs (a)(4)(i) and (vi) of this section, see 
paragraphs (a)(4)(i) and (vi) of this section as in effect and contained 
in 26 CFR part 1, as revised April 1, 2020.

[T.D. 8214, 53 FR 27020, July 18, 1988]

    Editorial Note: For Federal Register citations affecting Sec.  
1.904-5, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.904-6  Allocation and apportionment of foreign income taxes.

    (a) In general. The amount of foreign income taxes paid or accrued 
with respect to a separate category (as defined in Sec.  1.904-
5(a)(4)(v)) of income (including U.S. source income assigned to the 
separate category) includes only those foreign income taxes that are 
allocated and apportioned to the separate category under the rules of 
Sec.  1.861-20 (as modified by this section). In applying the foreign 
tax credit limitation under sections 904(a) and (d) to general category 
income described in section 904(d)(2)(A)(ii) and Sec.  1.904-4(d), 
foreign source income in the general category is a statutory grouping. 
However, general category income is the residual grouping of income for 
purposes of assigning foreign income taxes to separate categories. In 
addition, in determining the numerator of the foreign tax credit 
limitation under sections 904(a) and (d), where U.S. source income is 
the residual grouping, the amount of foreign income taxes paid or 
accrued for which a deduction is allowed, for example, under section 
901(k)(7), with respect to foreign source income in a separate category 
includes only those foreign income taxes that are allocated and 
apportioned to foreign source income in the separate category under the 
rules of Sec.  1.861-20 (as modified by this section). For purposes of 
this section, unless otherwise stated, terms have the same meaning as 
provided in Sec.  1.861-20(b). For examples illustrating the application 
of this section, see Sec.  1.861-20(g).
    (b) Assigning an item of foreign gross income to a separate 
category. For purposes of assigning an item of foreign gross income to a 
separate category or categories (or foreign source income in a separate 
category) under Sec.  1.861-20, the rules of this paragraph (b) apply.
    (1) Base differences. Any item of foreign gross income that is 
attributable to a base difference described in Sec.  1.861-
20(d)(2)(ii)(B) is assigned to the separate category described in 
section 904(d)(2)(H)(i), and to foreign source income in that category.
    (2) Disregarded payments--(i) In general--(A) Assignment of foreign 
gross income. Except as provided in paragraph (b)(2)(ii) of this 
section, if a taxpayer

[[Page 920]]

that is an individual or a domestic corporation includes an item of 
foreign gross income by reason of the receipt of a disregarded payment 
by a foreign branch or foreign branch owner (as those terms are defined 
in Sec.  1.904-4(f)(3)), or a non-branch taxable unit, the foreign gross 
income item is assigned to a separate category under Sec.  1.861-
20(d)(3)(v).
    (B) Definition of non-branch taxable unit. The term non-branch 
taxable unit means a person or interest that is described in paragraph 
(b)(2)(i)(B)(1) or (2) of this section, respectively.
    (1) Persons. A non-branch taxable unit described in this paragraph 
(b)(2)(i)(B)(1) means a person that is not otherwise a foreign branch 
owner and that is a U.S. individual, a domestic corporation, or a 
foreign or domestic partnership (or other pass-through entity, as 
defined in Sec.  1.904-5(a)(4)) an interest in which is owned, directly 
or indirectly through one or more other partnerships (or other pass-
through entities), by a U.S. individual or a domestic corporation.
    (2) Interests. A non-branch taxable unit described in this paragraph 
(b)(2)(i)(B)(2) means an interest of a foreign branch owner or an 
interest of a person described in paragraph (b)(2)(i)(B)(1) of this 
section that is not otherwise a foreign branch, and that is either a 
disregarded entity or a branch, as defined in Sec.  1.267A-5(a)(2), 
including a branch described in Sec.  1.951A-2(c)(7)(iv)(A)(3) (modified 
by substituting the term ``person'' for ``controlled foreign 
corporation'').
    (ii) Foreign branch group contributions--(A) In general. If a 
taxpayer includes an item of foreign gross income by reason of a foreign 
branch group contribution, the foreign gross income is assigned to the 
foreign branch category, or, in the case of a foreign branch owner that 
is a partnership, to the partnership's general category income that is 
attributable to the foreign branch. See, however, Sec. Sec.  1.861-
20(d)(3)(v)(C)(2), 1.960-1(d)(3)(ii)(A), and 1.960-1(e) for rules 
providing that foreign income tax on a disregarded payment that is a 
contribution from a controlled foreign corporation to a taxable unit is 
assigned to the residual grouping and cannot be deemed paid under 
section 960.
    (B) Foreign branch group contribution. A foreign branch group 
contribution is a contribution (as defined in Sec.  1.861-
20(d)(3)(v)(E)) made by a member of a foreign branch owner group to a 
member of a foreign branch group that the payor owns, made by a member 
of a foreign branch group to another member of that group that the payor 
owns, or made by a member of a foreign branch group to a member of a 
different foreign branch group that the payor owns. For purposes of this 
paragraph (b)(2)(ii)(B), the terms foreign branch group and foreign 
branch owner group have the meanings provided in Sec.  1.904-4(f)(3).
    (c) Allocating and apportioning deductions. For purposes of applying 
Sec.  1.861-20(e) to allocate and apportion deductions allowed under 
foreign law to foreign gross income in the separate categories, before 
undertaking the steps outlined in Sec.  1.861-20(e), foreign gross 
income in the passive category is first reduced by any related person 
interest expense that is allocated to the income under the principles of 
section 954(b)(5) and Sec.  1.904-5(c)(2)(ii)(C). In allocating and 
apportioning expenses not specifically allocated under foreign law, the 
principles of foreign law are applied only after taking into account the 
reduction of passive income by the application of section 954(b)(5). In 
allocating and apportioning expenses when foreign law does not provide 
rules for the allocation or apportionment of expenses, losses or other 
deductions to particular items of foreign gross income, then the 
principles of section 954(b)(5), in addition to the principles of the 
section 861 regulations (as defined in Sec.  1.861-8(a)(1)), apply to 
allocate and apportion expenses, losses or other foreign law deductions 
to foreign gross income after reduction of passive income by the amount 
of related person interest expense allocated to passive income under 
section 954(b)(5) and Sec.  1.904-5(c)(2)(ii)(C).
    (d) Apportionment of taxes for purposes of applying the high-tax 
income tests. If taxes have been allocated and apportioned to passive 
income under the rules of paragraph (a) this section, the taxes must 
further be apportioned to

[[Page 921]]

the groups of income described in Sec.  1.904-4(c)(3) through (5) for 
purposes of determining if the group is high-taxed income that is 
recharacterized as income in another separate category under the rules 
of Sec.  1.904-4(c). See also Sec.  1.954-1(c)(1)(iii)(B) (defining a 
single item of passive category foreign personal holding company income 
by reference to the grouping rules under Sec.  1.904-4(c)(3) through 
(5)). Taxes are related to income in a particular group under the same 
rules as those in paragraph (a) of this section except that those rules 
are applied by apportioning foreign income taxes to the groups described 
in Sec.  1.904-4(c)(3) through (5) instead of separate categories.
    (e) Allocation and apportionment of deemed paid taxes and certain 
creditable foreign tax expenditures--(1) Taxes deemed paid under section 
960(a) or (d). If a domestic corporation that is a United States 
shareholder includes any amount in gross income under section 
951(a)(1)(A) or 951A(a), any foreign tax deemed paid with respect to 
such amount under section 960(a) or (d) is allocated to the separate 
category to which the inclusion is assigned.
    (2) Taxes deemed paid under section 960(b)(1). If a domestic 
corporation that is a United States shareholder receives a distribution 
of previously taxed earnings and profits from a first-tier corporation 
that is excluded from the domestic corporation's income under section 
959(a) and Sec.  1.959-1, any foreign tax deemed paid under section 
960(b)(1) with respect to such distribution is allocated to the same 
separate category as the annual PTEP account and PTEP group (as defined 
in Sec.  1.960-3(c)) from which the distribution is made.
    (3) Taxes deemed paid under section 960(b)(2). If a controlled 
foreign corporation receives a distribution of previously taxed earnings 
and profits from an immediately lower-tier corporation that is excluded 
from such controlled foreign corporation's gross income under section 
959(b) and Sec.  1.959-2, any foreign tax deemed paid under section 
960(b)(2) with respect to such distribution is allocated to the same 
separate category as the annual PTEP account and PTEP group (as defined 
in Sec.  1.960-3(c)) from which the distribution is made. See also Sec.  
1.960-3(c)(2).
    (4) Creditable foreign tax expenditures--(i) In general. Except as 
provided in paragraph (e)(4)(ii) of this section, creditable foreign tax 
expenditures (CFTEs) allocated to a partner under Sec.  1.704-
1(b)(4)(viii)(a) are allocated for purposes of this section to the same 
separate category as the separate category to which the taxes were 
allocated in the hands of the partnership under the rules of paragraph 
(a) of this section.
    (ii) Foreign branch category. CFTEs allocated to a partner in a 
partnership under Sec.  1.704-1(b)(4)(viii)(a) are allocated and 
apportioned to the foreign branch category of the partner to the extent 
that:
    (A) The CFTEs are allocated and apportioned by the partnership under 
the rules of paragraph (a) of this section to the general category;
    (B) In the hands of the partnership, the CFTEs are related to 
general category income attributable to a foreign branch (as described 
in Sec.  1.904-4(f)(2)) under the principles of paragraph (a) of this 
section; and
    (C) The partner's distributive share of the income described in 
paragraph (e)(4)(ii)(B) of this section is foreign branch category 
income of the partner under Sec.  1.904-4(f)(1)(i)(B).
    (f) Treatment of certain foreign income taxes paid or accrued by 
United States shareholders. Some or all of the foreign gross income of a 
United States shareholder of a controlled foreign corporation, or of a 
U.S. person that owns the United States shareholder (the ``U.S. 
owner''), that is attributable to foreign law inclusion regime income 
with respect to a foreign law CFC described in Sec.  1.861-20(d)(3)(iii) 
or foreign law pass-through income from a reverse hybrid described in 
Sec.  1.861-20(d)(3)(i)(C) is assigned to the section 951A category if, 
were the controlled foreign corporation the taxpayer that recognizes the 
foreign gross income, the foreign gross income would be assigned to the 
controlled foreign corporation's tested income group (as defined in 
Sec.  1.960-1(b)(33)) within the general category to which an inclusion 
under section 951A is attributable. The amount of the United States 
shareholder's, or the U.S. owner's, foreign gross income that is 
assigned to the section 951A category

[[Page 922]]

(or a specified separate category associated with the section 951A 
category) is based on the inclusion percentage (as defined in Sec.  
1.960-2(c)(2)) of the United States shareholder. For example, if a 
United States shareholder has an inclusion percentage of 60 percent, 
then 60 percent of the foreign gross income of a United States 
shareholder that would be assigned (under Sec.  1.861-20(d)(3)(iii)) to 
the tested income group within the general category income of a reverse 
hybrid that is a controlled foreign corporation to which an inclusion 
under section 951A is attributable is assigned to the section 951A 
category or the specified separate category for income resourced under a 
tax treaty, and not to the general category.
    (g) Applicability dates. Except as otherwise provided in this 
paragraph (g), this section applies to taxable years that begin after 
December 31, 2019. Paragraph (b)(2) of this section applies to taxable 
years that begin after December 31, 2019, and end on or after November 
2, 2020.

[T.D. 8214, 53 FR 27029, July 18, 1988, as amended by T.D. 8412, 57 FR 
20652, May 14, 1992; T.D. 9141, 69 FR 43308, July 20, 2004; T.D. 9260, 
71 FR 24533, Apr. 25, 2006; T.D. 9882, 84 FR 69098, Dec. 17, 2019; T.D. 
9922, 85 FR 72059, Nov. 12, 2020; 86 FR 54368, Oct. 1, 2021; T.D. 9959, 
87 FR 363, Jan. 4, 2022]



Sec.  1.904-7  Transition rules.

    (a) Characterization of distributions and section 951(a)(1) (A) (ii) 
and (iii) and (B) inclusions of earnings of a controlled foreign 
corporation accumulated in taxable years beginning before January 1, 
1987, during taxable years of both the payor controlled foreign 
corporation and the recipient which begin after December 31, 1986--(1) 
Distributions and section 951(a)(1) (A) (ii) and (iii) and (B) 
inclusions. Earnings accumulated in taxable years beginning before 
January 1, 1987, by a foreign corporation that was a controlled foreign 
corporation when such earnings were accumulated are characterized in 
that foreign corporation's hands under section 904(d)(1)(A) (separate 
limitation interest income) or section 904(d)(1)(E) (general limitation 
income) (prior to their amendment by the Tax Reform Act of 1986 (the 
Act)) after application of the de minimis rule of former section 
904(d)(3)(C) (prior to its amendment by the Act). When, in a taxable 
year after the effective date of the Act, earnings and profits 
attributable to such income are distributed to, or included in the gross 
income of, a United States shareholder under section 951(a)(1) (A) (ii) 
or (iii) or (B) (hereinafter in this section ``inclusions''), the 
ordering rules of section 904(d)(3)(D) and Sec.  1.904-5(c)(4) shall be 
applied in determining initially the character of the income of the 
distributee or United States shareholder. Thus, a proportionate amount 
of a distribution described in this paragraph initially will be 
characterized as separate limitation interest income in the hands of the 
distributee based on the ratio of the separate limitation interest 
earnings and profits out of which the dividend was paid to the total 
earnings and profits out of which the dividend was paid. The 
distribution or inclusions must then be recharacterized in the hands of 
the distributee or United States shareholder on the basis of the 
following principles:
    (i) Distributions and inclusions that initially are characterized as 
separate limitation interest income shall be treated as passive income;
    (ii) Distributions and inclusions that initially are characterized 
as old general limitation income shall be treated as general limitation 
income, unless the taxpayer establishes to the satisfaction of the 
Commissioner that the distribution or inclusion is attributable to:
    (A) Earnings and profits accumulated with respect to shipping 
income, as defined in section 904(d)(2)(D) and Sec.  1.904-4(f); or
    (B) In the case of a financial services entity, earnings and profits 
accumulated with respect to financial services income, as defined in 
section 904(d)(2)(C)(ii) and Sec.  1.904-4(e)(1); or
    (C) Earnings and profits accumulated with respect to high 
withholding tax interest, as defined in section 904(d)(2)(B) and Sec.  
1.904-4(d).
    (2) Limitation on establishing the character of earnings and 
profits. In order for a taxpayer to establish that distributions or 
inclusions that are attributable to general limitation earnings and 
profits of a particular taxable year beginning before January 1, 1987, 
are

[[Page 923]]

attributable to shipping, financial services or high withholding tax 
interest earnings and profits, the taxpayer must establish the amounts 
of foreign taxes paid or accrued with respect to income attributable to 
those earnings and profits that are to be treated as taxes paid or 
accrued with respect to shipping, financial services or high withholding 
tax interest income, as the case may be, under section 904(d)(2)(I). 
Conversely, in order for a taxpayer to establish the amounts of general 
limitation taxes paid or accrued in a taxable year beginning before 
January 1, 1987, that are to be treated as taxes paid or accrued with 
respect to shipping, financial services or high withholding tax interest 
income, as the case may be, the taxpayer must establish the amount of 
any distributions or inclusions that are attributable to shipping, 
financial services or high withholding tax interest earnings and 
profits. For purposes of establishing the amounts of general limitation 
taxes that are to be treated as taxes paid or accrued with respect to 
shipping, financial services or high withholding tax interest income, 
the principles of Sec.  1.904-6 shall be applied.
    (b) Application of look-through rules to distributions (including 
deemed distributions) and payments by an entity to a recipient when 
one's taxable year begins before January 1, 1987 and the other's taxable 
year begins after December 31, 1986--(1) In general. This paragraph 
provides rules relating to the application of section 904(d)(3) to 
payments made by a controlled foreign corporation or other entity to 
which the look-through rules apply during its taxable year beginning 
after December 31, 1986, but received in a taxable year of the recipient 
beginning before January 1, 1987. The paragraph also provides rules 
relating to distributions (including deemed distributions) or payments 
made by a controlled foreign corporation to which section 904(d)(3) (as 
in effect before the Act) applies during its taxable year beginning 
before January 1, 1987, and received in a taxable year of the recipient 
beginning after December 31, 1986.
    (2) Payor of interest, rents, or royalties is subject to the Act and 
recipient is not subject to the Act. If interest, rents, or royalties 
are paid or accrued on or after the start of the payor's first taxable 
year beginning on or after January 1, 1987, but prior to the start of 
the recipient's first taxable year beginning on or after January 1, 
1987, such interest, rents, or royalties shall initially be 
characterized in accordance with section 904(d)(3) and Sec.  1.904-5. To 
the extent that interest payments in the hands of the recipient are 
initially characterized as passive income under these rules, they will 
be treated as separate limitation interest in the hands of the 
recipient. To the extent that rents or royalties in the hands of the 
recipient are initially characterized as passive income under these 
rules, they will be recharacterized as general limitation income in the 
hands of the recipient.
    (3) Recipient of interest, rents, or royalties is subject to the Act 
and payor is not subject to the Act. If interest, rents, or royalties 
are paid or accrued before the start of the payor's first taxable year 
beginning on or after January 1, 1987, but on or after the start of the 
recipient's first taxable year beginning after January 1, 1987, the 
income in the recipient's hands shall be initially characterized in 
accordance with former section 904(d)(3) (prior to its amendment by the 
Act). To the extent interest income is characterized as separate 
limitation interest income under these rules, that income shall be 
recharacterized as passive income in the hands of the recipient. Rents 
or royalties will be characterized as general limitation income.
    (4) Recipient of dividends and subpart F inclusions is subject to 
the Act and payor is not subject to the Act. If dividends are paid or 
accrued or section 951(a)(1) inclusions occur before the start of the 
first taxable year of a controlled foreign corporation beginning on or 
after January 1, 1987, but on or after the start of the first taxable 
year of the distributee or United States shareholder beginning on or 
after January 1, 1987, the dividends or section 951(a)(1) inclusions in 
the hands of the distributee or United States shareholder shall be 
initially characterized in accordance with former section 904(d)(3) 
(including the ordering rules of section 904(d)(3)(A). Therefore, under 
former

[[Page 924]]

section 904(d)(3)(A), dividends are considered to be paid or derived 
first from earnings attributable to separate limitation interest income. 
To the extent the dividend or section 951(a)(1) inclusion is initially 
characterized under these rules as separate limitation interest income 
in the hands of the distributee or United States shareholder, the 
dividend or section 951(a)(1) inclusion shall be recharacterized as 
passive income in the hands of the distributee or United States 
shareholder. The portion, if any, of the dividend or section 951(a)(1) 
inclusion that is not characterized as passive income shall be 
characterized according to the rules in paragraph (a) of this section. 
Therefore, a taxpayer may establish that income that would otherwise be 
characterized as general limitation income is shipping or financial 
services income. Rules comparable to the rules contained in section 
904(d)(2)(I) shall be applied for purposes of characterizing foreign 
taxes deemed paid with respect to distributions and section 951(a)(1) 
inclusions covered by this paragraph (b)(4).
    (5) Examples. The following examples illustrate the application of 
this paragraph (b).

    Example 1. P is a domestic corporation that is a fiscal year 
taxpayer (July 1-June 30). S, a controlled foreign corporation, is a 
wholly-owned subsidiary of P and has a calendar taxable year. On June l, 
1987, S makes a $100 interest payment to P. Because the payment is made 
after January 1, 1987 (the first day of S's first taxable year beginning 
after December 31, 1986), the look-through rules of section 904(d)(3) 
apply to characterize the payment made by S. To the extent, however, 
that the interest payment to P is allocable to passive income earned by 
S, the payment will be included in P's separate limitation for interest 
as provided in former section 904(d)(1)(A).
    Example 2. P is a domestic corporation that is a calendar year 
taxpayer. S, a controlled foreign corporation, is a wholly-owned 
subsidiary of P and has a July 1-June 30 taxable year. On June 1, 1987, 
S makes a $100 interest payment to P. Because the payment is made prior 
to July l, 1987 (the first day of S's first taxable year beginning after 
December 31, 1986), the look-through rules of section 904(d)(3) do not 
apply. Assume that, under former section 904(d)(3), the interest payment 
would be characterized as separate limitation interest income. For 
purposes of determining P's foreign tax credit limitation, the interest 
payment will be passive income as provided in section 904(d)(1)(A).
    Example 3. The facts are the same as in Example 2 except that on 
June 1, 1987, S makes a $100 dividend distribution to P. Because the 
dividend is paid prior to July l, 1987 (the first day of S's first 
taxable year beginning after December 31, 1986), the look-through rules 
of section 904(d)(3) do not apply. Assume that, under former section 
904(d)(3), S's earnings and profits for the taxable year ending June 30, 
1987, consist of $200 of earnings attributable to general limitation 
income and $75 of earnings attributable to separate limitation interest 
income. The portion of the dividend that is attributable to S's separate 
limitation interest and is treated as separate limitation interest 
income under former section 904(d)(3) is $75. The remaining $25 of the 
dividend is treated as general limitation income under former section 
904(d)(3). For purposes of determining P's foreign tax credit 
limitation, $75 of the dividend will be recharacterized as passive 
income. The remaining $25 of the dividend will be characterized as 
general limitation income, unless P can establish that the general 
limitation portion is attributable to shipping or financial services 
income.

    (c) Installment sales. If income is received or accrued by any 
person on or after the effective date of the Act (as applied to such 
person) that is attributable to a disposition of property by such person 
with regard to which section 453 or section 453A applies (installment 
sale treatment), and the disposition occurred prior to the effective 
date of the Act, that income shall be characterized according to the 
rules of Sec. Sec.  1.904-4 through 1.904-7.
    (d) Special effective date for high withholding tax interest earned 
by persons with respect to qualified loans described in section 
1201(e)(2) of the Act. For purposes of characterizing interest received 
or accrued by any person, the definition of high withholding tax 
interest in Sec.  1.904-4(d) shall apply to taxable years beginning 
after December 31, 1986, except as provided in section 1201(e)(2) of the 
Act.
    (e) Treatment of certain recapture income. Except as otherwise 
provided, if income is subject to recapture under section 585(c), the 
income shall be general limitation income. If the income is recaptured 
by a taxpayer that is a financial services entity, the entity may treat 
the income as financial services income if the taxpayer establishes to 
the satisfaction of the Secretary that

[[Page 925]]

the deduction to which the recapture amount is attributable is allocable 
to financial services income. If the taxpayer establishes to the 
satisfaction of the Secretary that the deduction to which the recapture 
amount is attributable is allocable to high-withholding tax interest 
income, the taxpayer may treat the income as high-withholding tax 
interest.
    (f) Treatment of non-look-through pools of a noncontrolled section 
902 corporation or a controlled foreign corporation in post-2002 taxable 
years--(1) Definition of non-look-through pools. The term non-look-
through pools means the pools of post-1986 undistributed earnings (as 
defined in Sec.  1.902-1(a)(9)) that were accumulated, and post-1986 
foreign income taxes (as defined in Sec.  1.902-1(a)(8)) paid, accrued, 
or deemed paid, in and after the first taxable year in which the foreign 
corporation had a domestic shareholder (as defined in Sec.  1.902-
1(a)(1)) but before any such shareholder was eligible for look-through 
treatment with respect to dividends from the foreign corporation.
    (2) Treatment of non-look-through pools of a noncontrolled section 
902 corporation. Any undistributed earnings in the non-look-through pool 
that were accumulated in taxable years beginning before January 1, 2003, 
by a noncontrolled section 902 corporation as of the last day of the 
corporation's last taxable year beginning before January 1, 2003, shall 
be treated in taxable years beginning after December 31, 2002, as if 
they were accumulated during a period when a dividend paid by the 
noncontrolled section 902 corporation to a domestic shareholder would 
have been eligible for look-through treatment under section 904(d)(4) 
and Sec.  1.904-5. Post-1986 foreign income taxes paid, accrued or 
deemed paid with respect to such earnings shall be treated as if they 
were paid, accrued or deemed paid during a period when the related 
earnings were eligible for look-through treatment. Any such earnings and 
taxes in the non-look-through pools shall constitute the opening balance 
of the noncontrolled section 902 corporation's pools of post-1986 
undistributed earnings and post-1986 foreign income taxes on the first 
day of the foreign corporation's first taxable year beginning after 
December 31, 2002, in accordance with the rules of paragraph (f)(4) of 
this section.
    (3) Treatment of non-look-through pools of a controlled foreign 
corporation. A controlled foreign corporation may have non-look-through 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes that were accumulated and paid in a taxable year beginning before 
January 1, 2003, in which it was a noncontrolled section 902 
corporation. Any such undistributed earnings in the non-look-through 
pool as of the last day of the controlled foreign corporation's last 
taxable year beginning before January 1, 2003, shall be treated in 
taxable years beginning on or after January 1, 2003, as if they were 
accumulated during a period when a dividend paid by the controlled 
foreign corporation out of such earnings, or an amount included in the 
gross income of a United States shareholder under section 951 that is 
attributable to such earnings, would have been eligible for look-through 
treatment. Any post-1986 foreign income taxes paid, accrued, or deemed 
paid with respect to such earnings shall be treated in taxable years 
beginning on or after January 1, 2003, as if they were paid, accrued, or 
deemed paid during a period when a dividend or inclusion out of such 
earnings would have been eligible for look-through treatment. Any such 
undistributed earnings and taxes in the non-look-through pools shall be 
added to the pools of post-1986 undistributed earnings and post-1986 
foreign income taxes of the controlled foreign corporation in the 
appropriate separate categories on the first day of the controlled 
foreign corporation's first taxable year beginning after December 31, 
2002, in accordance with the rules of paragraph (f)(4) of this section. 
Similar rules shall apply to characterize any previously-taxed earnings 
and profits described in section 959(c)(1)(A) that are attributable to 
earnings in the non-look-through pool.
    (4) Substantiation of look-through character of undistributed 
earnings and taxes in a non-look-through pool--(i) Reconstruction of 
earnings and taxes pools. In order to substantiate the look-through 
characterization of undistributed earnings and taxes in a non-look-
through

[[Page 926]]

pool under section 904(d)(4) and Sec.  1.904-5, the taxpayer shall make 
a reasonable, good-faith effort to reconstruct the non-look-through 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes (and previously-taxed earnings and profits, if any) on a look-
through basis for each year in the non-look-through period, beginning 
with the first taxable year in which post-1986 undistributed earnings 
were accumulated in the non-look-through pool. Reconstruction shall be 
based on reasonably available books and records and other relevant 
information, and it must account for earnings distributed and taxes 
deemed paid in these years as if they were distributed and deemed paid 
pro rata from the amounts that were added to the non-look-through pools 
during the non-look-through period.
    (ii) Safe harbor method. A taxpayer that was eligible for look-
through treatment with respect to a distribution from the foreign 
corporation in the taxpayer's first taxable year ending after the first 
day of the foreign corporation's first taxable year beginning after 
December 31, 2002, may allocate the undistributed earnings and taxes in 
the non-look-through pools to the foreign corporation's look-through 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes in other separate categories on the first day of the foreign 
corporation's first taxable year beginning after December 31, 2002, in 
the same percentages as the taxpayer properly characterizes the stock of 
the foreign corporation in the separate categories for purposes of 
apportioning the taxpayer's interest expense in its first taxable year 
ending after the first day of the foreign corporation's first taxable 
year beginning after December 31, 2002, under Sec.  1.861-12T(c)(3) or 
Sec.  1.861-12(c)(4), as the case may be. If the modified gross income 
method described in Sec.  1.861-9T(j) is used to apportion interest 
expense of the foreign corporation in its first taxable year beginning 
after December 31, 2002, the taxpayer must allocate the undistributed 
earnings and taxes in the non-look-through pools to the foreign 
corporation's look-through pools of post-1986 undistributed earnings and 
post-1986 foreign income taxes based on an average of the foreign 
corporation's modified gross income ratios for the foreign corporation's 
taxable years beginning in 2003 and 2004. A taxpayer may also use the 
safe harbor method described in this paragraph (f)(4)(ii) to allocate to 
separate categories any previously-taxed earnings and profits described 
in section 959(c)(1)(A) that are attributable to the non-look-through 
pool. A taxpayer may choose to use the safe harbor method on either a 
timely filed or amended tax return or during an audit. However, a 
taxpayer that uses the safe harbor method on an amended return or in the 
course of an audit must make appropriate adjustments to eliminate any 
duplicate benefits arising from application of the safe harbor method to 
taxable years that are not open for assessment. A taxpayer's choice to 
use the safe harbor method is evidenced by employing the method. The 
taxpayer need not file any separate statement.
    (iii) Inadequate substantiation. If a taxpayer does not use, or is 
ineligible to use, the safe harbor method described in paragraph 
(f)(4)(ii) of this section and the Commissioner determines that the 
look-through characterization of earnings and taxes in the non-look-
through pools cannot reasonably be determined based on the available 
information, the Commissioner shall allocate the undistributed earnings 
and taxes in the non-look-through pools to the foreign corporation's 
passive category.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (f)(4):

    Example 1. P, a domestic corporation, has owned 50 percent of the 
voting stock of S, a foreign corporation, at all times since January 1, 
1987, and S has been a noncontrolled section 902 corporation with 
respect to P since that date. P and S use the calendar year as their 
U.S. taxable year. The first year in which post-1986 undistributed 
earnings were accumulated in the non-look-through pool of S was 1987. As 
of December 31, 2002, S had 200u of post-1986 undistributed earnings and 
$100 of post-1986 foreign income taxes in its non-look-through pools. P 
does not use the safe harbor method under paragraph (f)(4)(ii) of this 
section to allocate the earnings and taxes in the non-look-through pools 
to S's other separate categories and does not attempt to substantiate 
the look-through characterization of S's non-look-

[[Page 927]]

through pools. The Commissioner, however, reasonably determines, based 
on information used to characterize S's stock for purposes of 
apportioning P's interest expense in P's 2003 and 2004 taxable years, 
that 100u of the earnings and all $100 of the taxes in the non-look-
through pools are properly assigned on a look-through basis to the 
general limitation category, and 100u of earnings and no taxes are 
properly assigned on a look-through basis to the passive category. 
Therefore, in accordance with the Commissioner's look-through 
characterization of the earnings and taxes in S's non-look-through 
pools, on January 1, 2003, S has 100u of post-1986 undistributed 
earnings and $100 of post-1986 foreign income taxes in the general 
limitation category and 100u of post-1986 undistributed earnings and no 
post-1986 foreign income taxes in the passive category.
    Example 2. The facts are the same as in Example 1, except that the 
Commissioner cannot reasonably determine, based on the available 
information, the proper look-through characterization of the 200u of 
undistributed earnings and $100 of taxes in S's non-look-through pools. 
Accordingly, the Commissioner will assign such earnings and taxes to the 
passive category, so that as of January 1, 2003, S has 200u of post-1986 
undistributed earnings and $100 of post-1986 foreign income taxes in the 
passive category, and the Commissioner will treat S as a passive 
category asset for purposes of apportioning P's interest expense.

    (5) Treatment of a deficit accumulated in a non-look-through pool. 
Any deficit in the non-look-through pool of a noncontrolled section 902 
corporation or a controlled foreign corporation as of the end of its 
last taxable year beginning before January 1, 2003, shall be treated in 
taxable years beginning after December 31, 2002, as if the deficit had 
been accumulated during a period in which a dividend paid by the foreign 
corporation would have been eligible for look-through treatment. In the 
case of a noncontrolled section 902 corporation, the deficit and taxes, 
if any, in the non-look-through pools shall constitute the opening 
balance of the look-through pools of post-1986 undistributed earnings 
and post-1986 foreign income taxes of the noncontrolled section 902 
corporation in the appropriate separate categories on the first day of 
its first taxable year beginning after December 31, 2002. In the case of 
a controlled foreign corporation, the deficit and taxes, if any, in the 
non-look-through pools shall be added to the balance of the look-through 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes of the controlled foreign corporation in the appropriate separate 
categories on the first day of its first taxable year beginning after 
December 31, 2002. The taxpayer must substantiate the look-through 
characterization of the deficit and taxes in accordance with the rules 
of paragraph (f)(4) of this section. If a taxpayer does not use the safe 
harbor method described in paragraph (f)(4)(ii) of this section and the 
Commissioner determines that the look-through characterization of the 
deficit and taxes cannot reasonably be determined based on the available 
information, the Commissioner shall allocate the deficit and taxes, if 
any, in the non-look-through pools to the foreign corporation's passive 
category. If, as of the end of a taxable year beginning after December 
31, 2002, in which it pays a dividend, the foreign corporation has zero 
or a deficit in post-1986 undistributed earnings (taking into account 
any earnings or a deficit accumulated in taxable years beginning before 
January 1, 2003), the deficit in post-1986 undistributed earnings shall 
be carried back to reduce pre-1987 accumulated profits, if any, on a 
last-in first-out basis. See Sec.  1.902-2(a)(1). If, as of the end of a 
taxable year beginning after December 31, 2002, in which the foreign 
corporation pays a dividend out of current earnings and profits, it has 
zero or a deficit in post-1986 undistributed earnings (taking into 
account any earnings or a deficit accumulated in taxable years beginning 
before January 1, 2003), and the sum of current plus accumulated 
earnings and profits is zero or less than zero, no foreign taxes shall 
be deemed paid with respect to the dividend. See Sec.  1.902-1(b)(4).
    (6) Treatment of pre-1987 accumulated profits. Any pre-1987 
accumulated profits (as defined in Sec.  1.902-1(a)(10)) of a controlled 
foreign corporation or noncontrolled section 902 corporation shall be 
treated in taxable years beginning after December 31, 2002, as if they 
were accumulated during a period in which a dividend paid by the foreign 
corporation would have been eligible for look-through treatment. Any 
pre-1987 foreign income taxes (as defined in Sec.  1.902-1(a)(10)(iii)) 
shall be treated as if they

[[Page 928]]

were paid, accrued or deemed paid during a year when a dividend out of 
the related pre-1987 accumulated profits would have been eligible for 
look-through treatment. The taxpayer must substantiate the look-through 
characterization of the pre-1987 accumulated profits and pre-1987 
foreign income taxes in accordance with the rules of paragraph (f)(4) of 
this section. If a taxpayer does not use, or is ineligible to use, the 
safe harbor method described in paragraph (f)(4)(ii) of this section and 
the Commissioner determines that the look-through characterization of 
the pre-1987 accumulated profits and pre-1987 foreign income taxes 
cannot reasonably be determined based on the available information, the 
pre-1987 accumulated profits and pre-1987 foreign income taxes shall be 
allocated to the foreign corporation's passive category.
    (7) Treatment of post-1986 undistributed earnings or a deficit of a 
controlled foreign corporation attributable to dividends from a 
noncontrolled section 902 corporation paid in taxable years beginning 
before January 1, 2003--(i) Look-through treatment of post-1986 
undistributed earnings at controlled foreign corporation level. 
Dividends paid by a noncontrolled section 902 corporation to a 
controlled foreign corporation in post-1986 taxable years of the 
noncontrolled section 902 corporation beginning before January 1, 2003, 
were assigned to a separate category for dividends from that 
noncontrolled section 902 corporation. Beginning on the first day of the 
controlled foreign corporation's first taxable year beginning on or 
after the first day of the lower-tier corporation's first taxable year 
beginning after December 31, 2002, any post-1986 undistributed earnings, 
or previously-taxed earnings and profits described in section 959(c)(1) 
or (2), of the controlled foreign corporation in such a separate 
category shall be treated as if they were accumulated during a period 
when a dividend paid by the noncontrolled section 902 corporation would 
have been eligible for look-through treatment. Any post-1986 foreign 
income taxes in such a separate category shall also be treated as if 
they were paid, accrued or deemed paid during a period when such a 
dividend would have been eligible for look-through treatment. Any such 
post-1986 undistributed earnings and post-1986 foreign income taxes in a 
separate category for dividends from a noncontrolled section 902 
corporation shall be added to the opening balance of the controlled 
foreign corporation's look-through pools of post-1986 undistributed 
earnings and post-1986 foreign income taxes in the appropriate separate 
categories on the first day of the controlled foreign corporation's 
first taxable year beginning on or after the first day of the lower-tier 
corporation's first taxable year beginning after December 31, 2002. Any 
section 952(c)(2) recapture account with respect to such a separate 
category shall be allocated in the same manner as the associated post-
1986 undistributed earnings. The taxpayer must substantiate the look-
through characterization of such earnings and taxes in accordance with 
the rules of paragraph (f)(7)(iii) of this section.
    (ii) Look-through treatment of deficit in post-1986 undistributed 
earnings at controlled foreign corporation level. If a controlled 
foreign corporation has a deficit in a separate category for dividends 
from a lower-tier noncontrolled section 902 corporation that is a member 
of the controlled foreign corporation's qualified group as defined in 
section 902(b)(2), such deficit shall be treated in taxable years of the 
upper-tier corporation beginning on or after the first day of the lower-
tier corporation's first taxable year beginning after December 31, 2002, 
as if the deficit had been accumulated during a period in which a 
dividend from the lower-tier corporation would have been eligible for 
look-through treatment. Any post-1986 foreign income taxes in the 
separate category for dividends from the noncontrolled section 902 
corporation shall also be treated as if they were paid, accrued or 
deemed paid during a period when the dividends were eligible for look-
through treatment. The deficit and related post-1986 foreign income 
taxes, if any, shall be added to the opening balance of the controlled 
foreign corporation's look-through pools of post-1986 undistributed 
earnings and post-1986 foreign income taxes in the appropriate separate 
categories on the first day of the controlled foreign corporation's 
first taxable year beginning

[[Page 929]]

on or after the first day of the lower-tier corporation's first taxable 
year beginning after December 31, 2002. The taxpayer must substantiate 
the look-through characterization of the deficit and taxes in accordance 
with the rules of paragraph (f)(7)(iii) of this section.
    (iii) Substantiation required for look-through treatment. The 
taxpayer must substantiate the look-through characterization of post-
1986 undistributed earnings, previously-taxed earnings and profits, or a 
deficit in post-1986 undistributed earnings in a separate category for 
dividends paid by a noncontrolled section 902 corporation in taxable 
years beginning before January 1, 2003, by making a reasonable, good-
faith effort to reconstruct the earnings (or deficit) and taxes in the 
separate category at the level of the controlled foreign corporation on 
a look-through basis, in accordance with the principles of paragraph 
(f)(4)(i) of this section. Alternatively, the taxpayer may allocate the 
earnings (or deficit) and taxes to the controlled foreign corporation's 
look-through pools under the safe harbor method described in paragraph 
(f)(4)(ii) of this section at the level of the controlled foreign 
corporation. If the taxpayer uses the safe harbor method, the earnings 
(or deficit) and taxes shall be allocated to the controlled foreign 
corporation's look-through pools in the appropriate separate categories 
on the first day of the controlled foreign corporation's first taxable 
year beginning on or after the first day of the lower-tier corporation's 
first taxable year beginning after December 31, 2002. The allocation 
shall be made in the same percentages as the controlled foreign 
corporation would properly characterize the stock of the lower-tier 
noncontrolled section 902 corporation in the separate categories for 
purposes of apportioning the controlled foreign corporation's interest 
expense in its first taxable year ending after the first day of the 
noncontrolled section 902 corporation's first taxable year beginning 
after December 31, 2002. Under Sec.  1.861-12T(c)(3), the apportionment 
ratios properly used by the controlled foreign corporation are in turn 
based on the apportionment ratios properly used by the noncontrolled 
section 902 corporation to apportion its interest expense in its first 
taxable year beginning after December 31, 2002. In the case of a 
taxpayer that uses the safe harbor method where the lower-tier 
noncontrolled section 902 corporation uses the modified gross income 
method described in Sec.  1.861-9T(j) to apportion interest expense for 
its first taxable year beginning after December 31, 2002, earnings (or a 
deficit) and taxes in the separate category for dividends from the 
noncontrolled section 902 corporation shall be allocated to the look-
through pools based on the average of the noncontrolled section 902 
corporation's modified gross income ratios for its taxable years 
beginning in 2003 and 2004. In the case of a controlled foreign 
corporation that has in its qualified group a chain of lower-tier 
noncontrolled section 902 corporations, the safe harbor applies first to 
characterize the stock of the third-tier corporation and then to 
characterize the stock of the second-tier corporation. Where a taxpayer 
uses the safe harbor method with respect to a lower-tier noncontrolled 
section 902 corporation with respect to which the taxpayer did not meet 
the requirements of section 902(a) as of the end of the upper-tier 
controlled foreign corporation's last taxable year beginning before 
January 1, 2003, the earnings (or deficit) and taxes in the separate 
category for dividends from the lower-tier corporation shall be 
allocated to the upper-tier corporation's look-through pools in the 
separate categories in the same percentages as the stock of the lower-
tier corporation would have been characterized for purposes of 
apportioning the upper-tier corporation's interest expense in the last 
year the taxpayer met the ownership requirements of section 902(a) with 
respect to the lower-tier corporation if the look-through rules had 
applied in that year. If a taxpayer does not use the safe harbor method 
described in this paragraph (f)(7)(iii), and the Commissioner determines 
that the look-through characterization of the earnings (or deficit) and 
taxes cannot reasonably be determined based on the available 
information, the Commissioner shall allocate the earnings (or deficit) 
and associated foreign income taxes to the controlled foreign 
corporation's passive category.

[[Page 930]]

    (8) Treatment of distributions received by an upper-tier corporation 
from a lower-tier noncontrolled section 902 corporation, including when 
the corporations do not have the same taxable years--(i) Rule. In the 
case of dividends paid by a lower-tier noncontrolled section 902 
corporation to an upper-tier corporation where both are members of the 
same qualified group as defined in section 902(b)(2), the following 
rules apply. Dividends paid by the lower-tier corporation in taxable 
years beginning before January 1, 2003, are assigned to a separate 
category for dividends from that corporation, regardless of whether the 
corresponding taxable year of the recipient corporation began after 
December 31, 2002. Post-1986 undistributed earnings, previously-taxed 
earnings and profits, and post-1986 foreign income taxes in such a 
separate category shall be treated, beginning on the first day of the 
upper-tier corporation's first taxable year beginning on or after the 
first day of the lower-tier corporation's first taxable year beginning 
after December 31, 2002, as if they were accumulated during a period 
when a dividend paid by the lower-tier corporation would have been 
eligible for look-through treatment under section 904(d)(4) and Sec.  
1.904-5. Dividends paid by a lower-tier corporation in taxable years 
beginning after December 31, 2002, are eligible for look-through 
treatment when paid, without regard to whether the corresponding taxable 
year of the recipient upper-tier corporation began after December 31, 
2002.
    (ii) Example. The following example illustrates the application of 
paragraph (f) of this section:

    Example. M, a domestic corporation, has directly owned 50 percent of 
the stock of foreign corporation X, and X has directly owned 50 percent 
of the stock of foreign corporation Y, at all times since X and Y were 
organized on January 1, 1990. Accordingly, X and Y are noncontrolled 
section 902 corporations with respect to M, and X and Y are members of 
the same qualified group. M and Y use the calendar year as their U.S. 
taxable year, and X uses a taxable year beginning on July 1. Under Sec.  
1.904-4(g) and paragraph (f)(10) of this section, a dividend paid to M 
by X on January 15, 2003 (during X's last pre-2003 taxable year) is not 
eligible for look-through treatment in 2003. However, under Sec.  1.861-
12(c)(4), M will characterize the stock of X on a look-through basis for 
purposes of interest expense apportionment in its 2003 taxable year. 
Under Sec.  1.904-2(h)(1), any unused foreign taxes in M's separate 
category for dividends from X will be carried over to M's other separate 
categories on a look-through basis for M's taxable years beginning on 
and after January 1, 2004. Under paragraph (f)(2) of this section, any 
undistributed earnings and taxes in X's non-look-through pools will be 
allocated to X's other separate categories on July 1, 2003. Under Sec.  
1.904-5(i)(4) and paragraphs (f)(8)(i) and (f)(10) of this section, a 
dividend paid to X by Y on January 15, 2003 (during Y's first post-2002 
taxable year) is eligible for look-through treatment when paid, 
notwithstanding that it is received in a pre-2003 taxable year of X.

    (9) Election to apply pre-AJCA rules to 2003 and 2004 taxable 
years--(i) Definition. The term single category for dividends from all 
noncontrolled section 902 corporations means the separate category 
described in section 904(d)(1)(E) as in effect for taxable years 
beginning after December 31, 2002, and prior to its repeal by the 
American Jobs Creation Act (AJCA), Public Law 108-357, 118 Stat. 1418 
(October 22, 2004).
    (ii) Time, manner, and form of election. A taxpayer may elect not to 
apply the provisions of section 403 of the AJCA and to apply the rules 
of this paragraph (f)(9) to taxable years of noncontrolled section 902 
corporations beginning after December 31, 2002, and before January 1, 
2005, without regard to whether the corresponding taxable years of the 
taxpayer or any upper-tier corporation begin before or after such dates. 
A taxpayer shall be eligible to make such an election provided that--
    (A) The taxpayer's tax liability as shown on an original or amended 
tax return for each of its affected taxable years is consistent with the 
rules of this paragraph (f)(9), the guidance set forth in Notice 2003-5 
(2003-1 CB 294) (see Sec.  601.601(d)(2) of this chapter), and the 
principles of Sec.  1.861-12(c)(4) for each such year for which the 
statute of limitations does not preclude the filing of an amended 
return;
    (B) The taxpayer makes appropriate adjustments to eliminate any 
duplicate benefits arising from the application of this paragraph (f)(9) 
to taxable years that are not open for assessment; and
    (C) The taxpayer attaches a statement to its next tax return for 
which the due date (with extensions) is more

[[Page 931]]

than 90 days after April 25, 2006, indicating that the taxpayer elects 
not to apply the provisions of section 403 of the AJCA to taxable years 
of its noncontrolled section 902 corporations beginning in 2003 and 
2004, and that the taxpayer has filed original returns or will file 
amended returns reflecting tax liabilities for each affected year that 
satisfy the requirements described in this paragraph (f)(9)(ii).
    (iii) Treatment of non-look-through pools in taxable years beginning 
after December 31, 2004. Undistributed earnings (or a deficit) and taxes 
in the non-look-through pools of a controlled foreign corporation or a 
noncontrolled section 902 corporation as of the end of its last taxable 
year beginning before January 1, 2005, shall be treated in taxable years 
beginning after December 31, 2004, as if they were accumulated and paid 
during a period in which a distribution out of earnings in the non-look-
through pool would have been eligible for look-through treatment. Such 
earnings (or deficit) and taxes shall be added to the foreign 
corporation's pools of post-1986 undistributed earnings and post-1986 
foreign income taxes in the appropriate separate categories on the first 
day of the foreign corporation's first taxable year beginning after 
December 31, 2004. In accordance with the principles of paragraph (f)(4) 
of this section, the taxpayer must reconstruct the non-look-through 
pools or, if the taxpayer chooses to use the safe harbor method, 
allocate the earnings and taxes in the non-look-through pools to the 
foreign corporation's look-through pools in the appropriate separate 
categories on the first day of the foreign corporation's first taxable 
year beginning after December 31, 2004. Under the safe harbor method, 
this allocation is made in the same percentages as the taxpayer properly 
characterized the stock of the foreign corporation for purposes of 
apportioning the taxpayer's interest expense in the taxpayer's first 
taxable year ending after the first day of the foreign corporation's 
first taxable year beginning after December 31, 2002. See Sec.  1.861-
12T(c)(3) and Sec.  1.861-12(c)(4). If a taxpayer does not use the safe 
harbor method described in paragraph (f)(4)(ii) of this section and the 
Commissioner determines that the look-through characterization of the 
earnings (or deficit) and taxes cannot reasonably be determined based on 
the available information, the earnings (or deficit) and taxes shall be 
allocated to the foreign corporation's passive category.
    (iv) Carryover of unused foreign tax. To the extent that a taxpayer 
has unused foreign taxes in the single category for dividends from all 
noncontrolled section 902 corporations, such taxes shall be carried 
forward to the appropriate separate categories in the taxpayer's taxable 
years beginning on or after the first day of the relevant noncontrolled 
section 902 corporation's first taxable year beginning after December 
31, 2004. Such unused taxes shall be carried forward in the same manner 
as Sec.  1.904-2(h)(1) provides that unused foreign taxes in the 
separate categories for dividends from each noncontrolled section 902 
corporation are carried over to taxable years beginning on or after the 
first day of the noncontrolled section 902 corporation's first taxable 
year beginning after December 31, 2002, in the case of a taxpayer that 
does not make the election under this paragraph (f)(9). The electing 
taxpayer shall determine which noncontrolled section 902 corporations 
paid the dividends to which the unused foreign taxes are attributable 
and assign the taxes to the appropriate separate categories as if such 
dividends had been eligible for look-through treatment when paid. 
Accordingly, the taxpayer must substantiate the look-through 
characterization of the unused foreign taxes in accordance with 
paragraph (f)(4) of this section by reconstructing the non-look-through 
pools or, if the taxpayer uses the safe harbor method, by allocating the 
unused foreign taxes to other separate categories in the same 
percentages as the taxpayer properly characterized the stock of the 
noncontrolled section 902 corporation for purposes of apportioning the 
taxpayer's interest expense for its first taxable year ending after the 
first day of the noncontrolled section 902 corporation's first taxable 
year beginning after December 31, 2002. The rule described in this 
paragraph (f)(9)(iv) shall apply only to unused foreign taxes 
attributable to dividends out of earnings that were accumulated

[[Page 932]]

by noncontrolled section 902 corporations in taxable years of such 
corporations beginning before January 1, 2003, because only unused 
foreign taxes attributable to distributions out of pre-2003 earnings are 
included in the single category for dividends from all noncontrolled 
section 902 corporations. To the extent that unused foreign taxes 
carried forward to the single category for dividends from all 
noncontrolled section 902 corporations under the rules of Notice 2003-5 
were either absorbed by low-taxed dividends paid by noncontrolled 
section 902 corporations out of the non-look-through pool in taxable 
years of such corporations beginning in 2003 or 2004, or expired unused, 
the amount of taxes carried forward to the separate categories on a 
look-through basis will be smaller than the aggregate amount of taxes 
initially carried forward to the single category for dividends from all 
noncontrolled section 902 corporations. In this case, the unused foreign 
taxes arising in each taxable year shall be deemed attributable to each 
noncontrolled section 902 corporation in the same ratio as the dividends 
included in the separate category that were paid by such corporation in 
such year bears to all such dividends paid by all noncontrolled section 
902 corporations in such year. Unused foreign taxes carried forward from 
the separate categories for dividends from each noncontrolled section 
902 corporation to the single category for dividends from all 
noncontrolled section 902 corporations will similarly be deemed to have 
been utilized on a pro rata basis. The remaining unused foreign taxes 
are then assigned to the appropriate separate categories under the rules 
of paragraph (f)(4) of this section. Unused foreign taxes shall be 
treated as allocable to general category income to the extent that such 
taxes would otherwise have been allocable to passive income (based on 
reconstructed pools or the safe harbor method), or to the extent that, 
under paragraph (f)(4)(iii) of this section, the Commissioner determines 
that the look-through characterization cannot reasonably be determined 
based on the available information.
    (v) Carryback of unused foreign tax. To the extent that a taxpayer 
has unused foreign taxes attributable to a dividend paid by a 
noncontrolled section 902 corporation that was eligible for look-through 
treatment under section 904(d)(4) and Sec.  1.904-5, any such unused 
foreign taxes shall be carried back to prior taxable years within the 
same separate category and not to the single category for dividends from 
all noncontrolled section 902 corporations or any separate category for 
dividends from a noncontrolled section 902 corporation. See Notice 2003-
5 for rules relating to the carryback of unused foreign taxes in the 
single category for dividends from all noncontrolled section 902 
corporations.
    (vi) Recapture of overall foreign loss or separate limitation loss 
in the single category for dividends from all noncontrolled section 902 
corporations. To the extent that a taxpayer has a balance in a separate 
limitation loss or overall foreign loss account in the single category 
for dividends from all noncontrolled section 902 corporations under 
section 904(d)(1)(E) (prior to its repeal by the AJCA), at the end of 
the taxpayer's last taxable year beginning before January 1, 2005 (or a 
later taxable year in which the taxpayer received a dividend subject to 
the separate limitation for dividends from all noncontrolled section 902 
corporations), the amount of such balance shall be allocated on the 
first day of the taxpayer's next taxable year to the taxpayer's other 
separate categories. The amount of such balance that is attributable to 
each noncontrolled section 902 corporation shall be allocated in the 
same percentages as the taxpayer properly characterized the stock of 
such corporation for purposes of apportioning the taxpayer's interest 
expense for its first taxable year ending after the first day of such 
corporation's first taxable year beginning after December 31, 2002, 
under Sec.  1.861-12T(c)(3) or Sec.  1.861-12(c)(4), as the case may be. 
To the extent that a taxpayer has a balance in a separate limitation 
loss account for the single category for dividends from all 
noncontrolled section 902 corporations with respect to another separate 
category, and the separate limitation loss account would otherwise be 
assigned to that other category under this paragraph (f)(9)(vi), such 
balance shall be eliminated.

[[Page 933]]

    (vii) Recapture of separate limitation losses in other separate 
categories. To the extent that a taxpayer has a balance in any separate 
limitation loss account in a separate category with respect to the 
single category for dividends from all noncontrolled section 902 
corporations at the end of the taxpayer's last taxable year with or 
within which ends the last taxable year of the relevant noncontrolled 
section 902 corporation beginning before January 1, 2005, such loss 
shall be recaptured in subsequent taxable years as income in the 
appropriate separate category. The separate limitation loss account 
shall be deemed attributable on a pro rata basis to those noncontrolled 
section 902 corporations that paid dividends out of earnings accumulated 
in taxable years beginning before January 1, 2003, in the years in which 
the separate limitation loss in the other separate category arose. The 
ratable portions of the separate limitation loss account shall be 
recaptured as income in the taxpayer's separate categories in the same 
percentages as the taxpayer properly characterized the stock of the 
relevant noncontrolled section 902 corporation for purposes of 
apportioning the taxpayer's interest expense in its first taxable year 
ending after the first day of such corporation's first taxable year 
beginning after December 31, 2002, under Sec.  1.861-12T(c)(3) or Sec.  
1.861-12(c)(4), as the case may be. To the extent that a taxpayer has a 
balance in any separate limitation loss account in any separate category 
that would have been recaptured as income in that same category under 
this paragraph (f)(9)(vii), such balance shall be eliminated.
    (viii) Treatment of undistributed earnings in an upper-tier 
corporation-level single category for dividends from lower-tier 
noncontrolled section 902 corporations. Where a controlled foreign 
corporation or noncontrolled section 902 corporation has a single 
category for dividends from all noncontrolled section 902 corporations 
containing earnings attributable to dividends paid by one or more lower-
tier corporations, the following rules apply. The post-1986 
undistributed earnings, previously-taxed earnings and profits described 
in section 959(c)(1) or (2), if any, and associated post-1986 foreign 
income taxes shall be allocated to the upper-tier corporation's other 
separate categories in the same manner as earnings and taxes in a 
separate category for dividends from each noncontrolled section 902 
corporation maintained by the upper-tier corporation are allocated under 
paragraph (f)(7) of this section. Accordingly, post-1986 undistributed 
earnings, previously-taxed earnings and profits, if any, and post-1986 
foreign income taxes in the single category for dividends from all 
noncontrolled section 902 corporations shall be treated as if they were 
accumulated and paid, accrued or deemed paid during a period when a 
dividend paid by each lower-tier corporation that paid dividends 
included in the single category would have been eligible for look-
through treatment. If the taxpayer uses the safe harbor method described 
in paragraph (f)(7)(iii) of this section, the earnings and taxes shall 
be allocated based on the apportionment ratios properly used by the 
lower-tier corporation to apportion its interest expense for its first 
taxable year beginning after December 31, 2002. Any section 952(c)(2) 
recapture account with respect to the single category shall be allocated 
in the same manner as the associated post-1986 undistributed earnings. 
The taxpayer must substantiate the look-through characterization of the 
earnings and taxes in accordance with the rules of paragraph (f)(7)(iii) 
of this section. If the taxpayer does not use the safe harbor method and 
the Commissioner determines that the look-through characterization of 
the earnings cannot reasonably be determined based on the available 
information, the earnings and taxes shall be assigned to the upper-tier 
corporation's passive category.
    (ix) Treatment of a deficit in the single category for dividends 
from lower-tier noncontrolled section 902 corporations. Where a 
controlled foreign corporation or noncontrolled section 902 corporation 
had an aggregate deficit in the single category for dividends from all 
noncontrolled section 902 corporations as of the end of the upper-tier 
corporation's last taxable year beginning before January 1, 2005, such 
deficit and the associated post-1986 foreign income taxes, if any, shall 
be allocated to the

[[Page 934]]

upper-tier corporation's other separate categories in the same 
percentages in which the non-look-through pools of each lower-tier 
corporation to which the deficit is attributable were assigned to such 
corporation's other separate categories in its first taxable year 
beginning after December 31, 2002. If the taxpayer uses the safe harbor 
method described in paragraph (f)(7)(iii) of this section, the deficit 
and taxes shall be allocated based on how the taxpayer properly 
characterized the stock of the lower-tier noncontrolled section 902 
corporation for purposes of apportioning the upper-tier corporation's 
interest expense for the upper-tier corporation's first taxable year 
ending after the first day of the lower-tier corporation's first taxable 
year beginning after December 31, 2002. The taxpayer must substantiate 
the look-through characterization of the deficit and taxes in accordance 
with the rules of paragraph (f)(7)(iii) of this section. If the taxpayer 
does not use the safe harbor method and the Commissioner determines that 
the look-through characterization of the deficit cannot reasonably be 
determined based on the available information, the deficit and taxes 
shall be assigned to the upper-tier corporation's passive category.
    (10) Effective/applicability date. This paragraph (f) shall apply to 
dividends from a noncontrolled section 902 corporation that are paid in 
taxable years of the noncontrolled section 902 corporation ending on or 
after April 20, 2009. See 26 CFR Sec.  1.904-7T(f) (revised as of April 
1, 2009) for rules applicable, except in the case of a taxpayer that 
makes the election under paragraph (f)(9) of that section, to dividends 
from a noncontrolled section 902 corporation that are paid in taxable 
years of the noncontrolled section 902 corporation beginning after 
December 31, 2002, and ending before April 20, 2009. See 26 CFR 1.904-
7T(f) (revised as of April 1, 2009) for rules applicable, in the case of 
a taxpayer that makes the election under paragraph (f)(9) of that 
section, to dividends from a noncontrolled section 902 corporation that 
are paid in taxable years of the noncontrolled section 902 corporation 
beginning after December 31, 2004, and ending before April 20, 2009. 
However, taxpayers may choose to apply paragraph (f) of this section in 
its entirety in lieu of 26 CFR 1.904-7T(f) to all dividends paid in 
periods covered by the temporary regulations, provided that appropriate 
adjustments are made to eliminate duplicate benefits arising from 
application of paragraph (f) to taxable years that are not open for 
assessment.
    (g) Treatment of earnings and foreign taxes of a controlled foreign 
corporation or a noncontrolled section 902 corporation accumulated in 
taxable years beginning before January 1, 2007--(1) Definitions--(i) 
Pre-2007 pools means the pools in each separate category of post-1986 
undistributed earnings (as defined in Sec.  1.902-1(a)(9)) that were 
accumulated, and post-1986 foreign income taxes (as defined in Sec.  
1.902-1(a)(8)) paid, accrued, or deemed paid, in taxable years beginning 
before January 1, 2007.
    (ii) Pre-2007 separate categories means the separate categories of 
income described in section 904(d) as applicable to taxable years 
beginning before January 1, 2007, and any other separate category of 
income described in Sec.  1.904-4(m).
    (iii) Post-2006 separate categories means the separate categories of 
income described in section 904(d) as applicable to taxable years 
beginning after December 31, 2006, and any other separate category of 
income described in Sec.  1.904-4(m).
    (2) Treatment of pre-2007 pools of a controlled foreign corporation 
or a noncontrolled section 902 corporation. Any post-1986 undistributed 
earnings in a pre-2007 pool of a controlled foreign corporation or a 
noncontrolled section 902 corporation shall be treated in taxable years 
beginning after December 31, 2006, as if they were accumulated during a 
period in which the rules governing the determination of post-2006 
separate categories applied. Post-1986 foreign income taxes paid, 
accrued, or deemed paid with respect to such earnings shall be treated 
as if they were paid, accrued, or deemed paid during a period in which 
the rules governing the determination of post-2006 separate categories 
(including the rules of section 904(d)(3)(E)) applied as well. Any such 
earnings and taxes in pre-2007

[[Page 935]]

pools shall constitute the opening balance of the foreign corporation's 
post-1986 undistributed earnings and post-1986 foreign income taxes on 
the first day of the foreign corporation's first taxable year beginning 
after December 31, 2006, in accordance with the rules of paragraph 
(g)(3) of this section. Similar rules shall apply to characterize any 
deficits in the pre-2007 pools and previously-taxed earnings and profits 
described in section 959(c)(1) and (2) that are attributable to earnings 
in the pre-2007 pools. Any section 952(c)(2) recapture account with 
respect to a separate category shall be allocated in the same manner as 
the post-1986 undistributed earnings in the associated pre-2007 pool.
    (3) Substantiation of post-2006 character of earnings and taxes in a 
pre-2007 pool--(i) Reconstruction of earnings and taxes pools. In order 
to substantiate the post-2006 characterization of post-1986 
undistributed earnings (as well as deficits and previously-taxed 
earnings, if any) and post-1986 foreign income taxes in pre-2007 pools 
of a controlled foreign corporation or a noncontrolled section 902 
corporation, the taxpayer shall make a reasonable, good-faith effort to 
reconstruct the pre-2007 pools of post-1986 undistributed earnings (as 
well as deficits and previously-taxed earnings, if any) and post-1986 
foreign income taxes following the rules governing the determination of 
post-2006 separate categories for each taxable year beginning before 
January 1, 2007, beginning with the first year in which post-1986 
undistributed earnings were accumulated in the pre-2007 pool. 
Reconstruction shall be based on reasonably available books and records 
and other relevant information. To the extent any pre-2007 separate 
category includes earnings that would be allocated to more than one 
post-2006 separate category, the taxpayer must account for earnings 
distributed and taxes deemed paid in these years for such category as if 
they were distributed and deemed paid pro rata from the amounts that 
were added to that category during each taxable year beginning before 
January 1, 2007.
    (ii) Safe harbor method--(A) In general. Subject to the rules of 
paragraph (g)(3)(iii) of this section, a taxpayer may allocate the post-
1986 undistributed earnings and post-1986 foreign income taxes in pre-
2007 pools of a controlled foreign corporation or a noncontrolled 
section 902 corporation (as well as deficits and previously-taxed 
earnings, if any) under one of the safe harbor methods described in 
paragraphs (g)(3)(ii)(B) and (g)(3)(ii)(C) of this section. A taxpayer 
may choose to use the safe harbor method on a timely filed (original or 
amended) tax return or during an audit. A taxpayer that uses the safe 
harbor method on an amended return or in the course of an audit must 
make appropriate adjustments to eliminate any double benefit arising 
from application of the safe harbor method to years that are not open 
for assessment. A taxpayer's choice to use the safe harbor method is 
evidenced by employing the method. The taxpayer need not file any 
separate statement.
    (B) General safe harbor method. (1) Any post-1986 undistributed 
earnings (as well as deficits and previously-taxed earnings, if any) and 
post-1986 foreign income taxes of a noncontrolled section 902 
corporation or a controlled foreign corporation in a pre-2007 separate 
category for passive income, certain dividends from a DISC or former 
DISC, taxable income attributable to certain foreign trade income, or 
certain distributions from a FSC or former FSC shall be allocated to the 
post-2006 separate category for passive category income.
    (2) Any post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes of 
a noncontrolled section 902 corporation or a controlled foreign 
corporation in a pre-2007 separate category for financial services 
income, shipping income or general limitation income shall be allocated 
to the post-2006 separate category for general category income.
    (3) Except as provided in paragraph (g)(3)(ii)(B)(4) of this 
section, any post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes of 
a noncontrolled section 902 corporation or a controlled foreign 
corporation in a pre-2007 separate category for high withholding tax 
interest

[[Page 936]]

shall be allocated to the post-2006 separate category for passive 
category income.
    (4) If a controlled foreign corporation has positive post-1986 
undistributed earnings and post-1986 foreign income taxes in a pre-2007 
separate category for high withholding tax interest, such earnings and 
taxes shall be allocated to the post-2006 separate category for general 
category income if the earnings would qualify as income subject to high 
foreign taxes under section 954(b)(4) if the entire amount of post-1986 
undistributed earnings were treated as a net item of income subject to 
the rules of Sec.  1.954-1(d). If the high withholding tax interest 
earnings would not qualify as income subject to high foreign taxes under 
section 954(b)(4), then the earnings and taxes shall be allocated to the 
post-2006 separate category for passive category income.
    (C) Interest apportionment safe harbor. A taxpayer may allocate the 
post-1986 undistributed earnings (as well as deficits and previously-
taxed earnings, if any) and post-1986 foreign income taxes in pre-2007 
pools of a controlled foreign corporation or a noncontrolled section 902 
corporation following the principles of paragraph (f)(4)(ii) of this 
section.
    (iii) Consistency rule. The election to apply a safe harbor method 
under paragraph (g)(3)(ii) of this section in lieu of the rules 
described in paragraph (g)(3)(i) of this section may be made on a 
separate category by separate category basis. However, if a taxpayer 
elects to apply a safe harbor to allocate pre-2007 pools of more than 
one pre-2007 separate category of a controlled foreign corporation or a 
noncontrolled section 902 corporation, such safe harbor (the general 
safe harbor described in paragraph (g)(3)(ii)(B) of this section or the 
interest apportionment safe harbor described in paragraph (g)(3)(ii)(C) 
of this section) shall apply to allocate post-1986 undistributed 
earnings (as well as deficits and previously-taxed earnings, if any) and 
post-1986 foreign income taxes for the pre-2007 pools in each pre-2007 
separate category of the foreign corporation for which the taxpayer 
elected to apply a safe harbor method in lieu of reconstructing the pre-
2007 pools.
    (4) Treatment of pre-1987 accumulated profits. Any pre-1987 
accumulated profits (as defined in Sec.  1.902-1(a)(10)) of a 
noncontrolled section 902 corporation or a controlled foreign 
corporation shall be treated in taxable years beginning after December 
31, 2006, as if they had been accumulated during a period in which the 
rules governing the determination of post-2006 separate categories 
applied. Foreign income taxes paid, accrued, or deemed paid with respect 
to such earnings shall be treated as if they were paid, accrued, or 
deemed paid during a period in which the rules governing the 
determination of post-2006 separate categories applied as well. The 
taxpayer must substantiate the post-2006 characterization of the pre-
1987 accumulated profits and pre-1987 foreign income taxes in accordance 
with the rules of paragraph (g)(3) of this section, including the safe 
harbor provisions. Similar rules shall apply to characterize any 
deficits or previously-taxed earnings and profits described in section 
959(c)(1) and (2) that are attributable to pre-1987 accumulated profits.
    (5) Treatment of earnings and foreign taxes in pre-2007 pools of a 
lower-tier controlled foreign corporation or noncontrolled section 902 
corporation. The rules of paragraphs (g)(1) through (4) of this section 
apply to post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes in 
pre-2007 pools, and pre-1987 accumulated profits and pre-1987 foreign 
income taxes, of a lower-tier controlled foreign corporation or 
noncontrolled section 902 corporation.
    (6) Effective/applicability date. This paragraph (g) shall apply to 
taxable years of United States persons and, for purposes of section 906, 
foreign persons beginning after December 31, 2006 and ending on or after 
December 21, 2007, and to taxable years of a foreign corporation which 
end with or within taxable years of its domestic corporate shareholder 
beginning after December

[[Page 937]]

31, 2006 and ending on or after December 21, 2007.

[T.D. 8214, 53 FR 27034, July 18, 1988, as amended by T.D. 8412, 57 FR 
20653, May 14, 1992; T.D. 9260, 71 FR 24533, Apr. 25, 2006; T.D. 9368, 
72 FR 72590, Dec. 21, 2007; T.D. 9452, 74 FR 27881, June 11, 2009; T.D. 
9521, 76 FR 19272, Apr. 7, 2011]



Sec.  1.904(b)-0  Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(b)-1 and 
1.904(b)-2.

      Sec.  1.904(b)-1 Special rules for capital gains and losses.

    (a) Capital gains and losses included in taxable income from sources 
outside the United States.
    (1) Limitation on capital gain from sources outside the United 
States when the taxpayer has net capital losses from sources within the 
United States.
    (i) In general.
    (ii) Allocation of reduction to separate categories or rate groups.
    (A) In general.
    (B) Taxpayer with capital gain rate differential.
    (2) Exclusivity of rules; no reduction by reason of net capital loss 
from sources outside the United States in a different separate category.
    (3) Capital losses from sources outside the United States in the 
same separate category.
    (4) Examples.
    (b) Capital gain rate differential.
    (1) Application of adjustments only if capital gain rate 
differential exists.
    (2) Determination of whether capital gain rate differential exists.
    (3) Special rule for certain noncorporate taxpayers.
    (c) Rate differential adjustment of capital gains.
    (1) Rate differential adjustment of capital gains in foreign source 
taxable income.
    (i) In general.
    (ii) Special rule for taxpayers with a net long-term capital loss 
from sources within the United States.
    (iii) Examples.
    (2) Rate differential adjustment of capital gains in entire taxable 
income.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States.
    (1) In general.
    (2) Determination of which capital gains are offset by net capital 
losses from sources outside the United States.
    (e) Qualified dividend income.
    (1) In general.
    (2) Exception.
    (f) Definitions.
    (1) Alternative tax rate.
    (2) Net capital gain.
    (3) Rate differential portion.
    (4) Rate group.
    (i) Short-term capital gains or losses.
    (ii) Long-term capital gains.
    (iii) Long-term capital losses.
    (5) Terms used in sections 1(h), 904(b) or 1222.
    (g) Examples.
    (h) Coordination with section 904(f).
    (1) In general.
    (2) Examples.
    (i) Effective date.

  Sec.  1.904(b)-2 Special rules for application of section 904(b) to 
               alternative minimum tax foreign tax credit.

    (a) Application of section 904(b)(2)(B) adjustments.
    (b) Use of alternative minimum tax rates.
    (1) Taxpayers other than corporations.
    (2) Corporate taxpayers.
    (c) Effective date.

[T.D. 9371, 72 FR 72596, Dec. 21, 2007]



Sec.  1.904(b)-1  Special rules for capital gains and losses.

    (a) Capital gains and losses included in taxable income from sources 
outside the United States--(1) Limitation on capital gain from sources 
outside the United States when the taxpayer has net capital losses from 
sources within the United States--(i) In general. Except as otherwise 
provided in this section, for purposes of section 904 and this section, 
taxable income from sources outside the United States (in all of the 
taxpayer's separate categories in the aggregate) shall include capital 
gain net income from sources outside the United States (determined by 
considering all of the capital gain and loss items in all of the 
taxpayer's separate categories in the aggregate) only to the extent of 
capital gain net income from all sources. Thus, capital gain net income 
from sources outside the United States (determined by considering all of 
the capital gain and loss items in all of the taxpayer's separate 
categories in the aggregate) shall be reduced to the extent such amount 
exceeds capital gain net income from all sources.
    (ii) Allocation of reduction to separate categories or rate groups--
(A) In general. If capital gain net income from sources outside the 
United States exceeds capital gain net income from all sources, and the 
taxpayer has capital gain net income from sources outside the

[[Page 938]]

United States in only one separate category, such excess is allocated as 
a reduction to that separate category. If a taxpayer has capital gain 
net income from foreign sources in two or more separate categories, such 
excess must be apportioned on a pro rata basis as a reduction to each 
such separate category. For purposes of the preceding sentence, pro rata 
means based on the relative amounts of the capital gain net income from 
sources outside the United States in each separate category.
    (B) Taxpayer with capital gain rate differential. If a taxpayer with 
a capital gain rate differential for the year (within the meaning of 
paragraph (b) of this section) has capital gain net income from foreign 
sources in only one rate group within a separate category, any reduction 
to such separate category pursuant to paragraph (a)(1)(ii)(A) of this 
section must be allocated to such rate group. If a taxpayer with a 
capital gain rate differential for the year (within the meaning of 
paragraph (b) of this section) has capital gain net income from foreign 
sources in two or more rate groups within a separate category, any 
reduction to such separate category pursuant to paragraph (a)(1)(ii)(A) 
of this section must be apportioned on a pro rata basis among such rate 
groups. For purposes of the preceding sentence, pro rata means based on 
the relative amounts of the capital gain net income from sources outside 
the United States in each rate group within the applicable separate 
category.
    (2) Exclusivity of rules; no reduction by reason of net capital 
losses from sources outside the United States in a different separate 
category. Capital gains from sources outside the United States in any 
separate category shall be limited by reason of section 904(b)(2)(A) and 
the comparable limitation of section 904(b)(2)(B)(i) only to the extent 
provided in paragraph (a)(1) of this section (relating to limitation on 
capital gain from sources outside the United States when taxpayer has 
net capital losses from sources within the United States).
    (3) Capital losses from sources outside the United States in the 
same separate category. Except as otherwise provided in paragraph (d) of 
this section, taxable income from sources outside the United States in 
each separate category shall be reduced by any capital loss that is 
allocable or apportionable to income from sources outside the United 
States in such separate category to the extent such loss is allowable in 
determining taxable income for the taxable year.
    (4) Examples. The following examples illustrate the application of 
this paragraph (a) to taxpayers that do not have a capital gain rate 
differential for the taxable year. See paragraph (g) of this section for 
examples that illustrate the application of this paragraph (a) to 
taxpayers that have a capital gain rate differential for the year. The 
examples are as follows:

    Example 1. Taxpayer A, a corporation, has a $3,000 capital loss from 
sources outside the United States in the general limitation category, a 
$6,000 capital gain from sources outside the United States in the 
passive category, and a $2,000 capital loss from sources within the 
United States. A's capital gain net income from sources outside the 
United States in the aggregate, from all separate categories, is $3,000 
($6,000 - $3,000). A's capital gain net income from all sources is 
$1,000 ($6,000 - $3,000 - $2,000). Thus, for purposes of section 904, 
A's taxable income from sources outside the United States in all of A's 
separate categories in the aggregate includes only $1,000 of capital 
gain net income from sources outside the United States. See paragraph 
(a)(1)(i) of this section. Pursuant to paragraphs (a)(1)(i) and 
(a)(1)(ii)(A) of this section, A must reduce the $6,000 of capital gain 
net income from sources outside the United States in the passive 
category by $2,000 ($3,000 of capital gain net income from sources 
outside the United States - $1,000 of capital gain net income from all 
sources). After the adjustment, A has $4,000 of capital gain from 
sources outside the United States in the passive category and $3,000 of 
capital loss from sources outside the United States in the general 
limitation category.
    Example 2. Taxpayer B, a corporation, has a $300 capital gain from 
sources outside the United States in the general limitation category and 
a $200 capital gain from sources outside the United States in the 
passive category. B's capital gain net income from sources outside the 
United States is $500 ($300 + $200). B also has a $150 capital loss from 
sources within the United States and a $50 capital gain from sources 
within the United States. Thus, B's capital gain net income from all 
sources is $400 ($300 + $200 - $150 + $50). Pursuant to paragraph 
(a)(1)(ii)(A) of this section, the $100 excess of capital gain net 
income from sources outside

[[Page 939]]

the United States over capital gain net income from all sources ($500 - 
$400) must be apportioned, as a reduction, three-fifths ($300/$500 of 
$100, or $60) to the general limitation category and two-fifths ($200/
$500 of $100, or $40) to the passive category. Therefore, for purposes 
of section 904, the general limitation category includes $240 ($300 - 
$60) of capital gain net income from sources outside the United States 
and the passive category includes $160 ($200 - $40) of capital gain net 
income from sources outside the United States.
    Example 3. Taxpayer C, a corporation, has a $10,000 capital loss 
from sources outside the United States in the general limitation 
category, a $4,000 capital gain from sources outside the United States 
in the passive category, and a $2,000 capital gain from sources within 
the United States. C's capital gain net income from sources outside the 
United States is zero, since losses exceed gains. C's capital gain net 
income from all sources is also zero. C's capital gain net income from 
sources outside the United States does not exceed its capital gain net 
income from all sources, and therefore paragraph (a)(1) of this section 
does not require any reduction of C's passive category capital gain. For 
purposes of section 904, C's passive category includes $4,000 of capital 
gain net income. C's general limitation category includes a capital loss 
of $6,000 because only $6,000 of capital loss is allowable as a 
deduction in the current year. The entire $4,000 of capital loss in 
excess of the $6,000 of capital loss that offsets capital gain in the 
taxable year is carried back or forward under section 1212(a), and none 
of such $4,000 is taken into account under section 904(a) or (b) for the 
current taxable year.

    (b) Capital gain rate differential--(1) Application of adjustments 
only if capital gain rate differential exists. Section 904(b)(2)(B) and 
paragraphs (c) and (d) of this section apply only for taxable years in 
which the taxpayer has a capital gain rate differential.
    (2) Determination of whether capital gain rate differential exists. 
For purposes of section 904(b) and this section, a capital gain rate 
differential is considered to exist for the taxable year only if the 
taxpayer has taxable income (excluding net capital gain and qualified 
dividend income) for the taxable year, a net capital gain for the 
taxable year and--
    (i) In the case of a taxpayer other than a corporation, tax is 
imposed on the net capital gain at a reduced rate under section 1(h) for 
the taxable year; or
    (ii) In the case of a corporation, tax is imposed under section 
1201(a) on the taxpayer at a rate less than any rate of tax imposed on 
the taxpayer by section 11, 511, or 831(a) or (b), whichever applies 
(determined without regard to the last sentence of section 11(b)(1)), 
for the taxable year.
    (3) Special rule for certain noncorporate taxpayers. A taxpayer that 
has a capital gain rate differential for the taxable year under 
paragraph (b)(2)(i) of this section and is not subject to alternative 
minimum tax under section 55 for the taxable year may elect not to apply 
the rate differential adjustments contained in section 904(b)(2)(B) and 
paragraphs (c) and (d) of this section if the highest rate of tax 
imposed on such taxpayer's taxable income (excluding net capital gain 
and any qualified dividend income) for the taxable year under section 1 
does not exceed the highest rate of tax in effect under section 1(h) for 
the taxable year and the amount of the taxpayer's net capital gain from 
sources outside the United States, plus the amount of the taxpayer's 
qualified dividend income from sources outside the United States, is 
less than $20,000. A taxpayer that has a capital gain rate differential 
for the taxable year under paragraph (b)(2)(i) of this section and is 
subject to alternative minimum tax under section 55 for the taxable year 
may make such election if the rate of tax imposed on such taxpayer's 
alternative minimum taxable income (excluding net capital gain and any 
qualified dividend income) under section 55 does not exceed 26 percent, 
the highest rate of tax imposed on such taxpayer's taxable income 
(excluding net capital gain and any qualified dividend income) for the 
taxable year under section 1 does not exceed the highest rate of tax in 
effect under section 1(h) for the taxable year and the amount of the 
taxpayer's net capital gain from sources outside the United States, plus 
the amount of the taxpayer's qualified dividend income from sources 
outside the United States, is less than $20,000. A taxpayer who makes 
this election shall apply paragraph (a) of this section as if such 
taxpayer does not have a capital gain rate differential for the taxable 
year. An eligible taxpayer shall be presumed to

[[Page 940]]

have elected not to apply the rate differential adjustments, unless such 
taxpayer applies the rate differential adjustments contained in section 
904(b)(2)(B) and paragraphs (c) and (d) of this section in determining 
its foreign tax credit limitation for the taxable year.
    (c) Rate differential adjustment of capital gains--(1) Rate 
differential adjustment of capital gains in foreign source taxable 
income--(i) In general. Subject to paragraph (c)(1)(ii) of this section, 
in determining taxable income from sources outside the United States for 
purposes of section 904 and this section, capital gain net income from 
sources outside the United States in each long-term rate group in each 
separate category (separate category long-term rate group), shall be 
reduced by the rate differential portion of such capital gain net 
income. For purposes of paragraph (c)(1) of this section, references to 
capital gain net income are references to capital gain net income 
remaining after any reduction to such income pursuant to paragraph 
(a)(1) of this section (i.e., paragraph (a)(1) of this section applies 
before paragraphs (c) and (d) of this section).
    (ii) Special rule for taxpayers with a net long-term capital loss 
from sources within the United States. If a taxpayer has a net long-term 
capital loss from sources within the United States (i.e., the taxpayer's 
long-term capital losses from sources within the United States exceed 
the taxpayer's long-term capital gains from sources within the United 
States) and also has any short-term capital gains from sources within or 
without the United States, then capital gain net income from sources 
outside the United States in each separate category long-term rate group 
shall be reduced by the rate differential portion of the applicable rate 
differential amount. The applicable rate differential amount is 
determined as follows:
    (A) Step 1: Determine the U.S. long-term capital loss adjustment 
amount. The U.S. long-term capital loss adjustment amount is the excess, 
if any, of the net long-term capital loss from sources within the United 
States over the amount, if any, by which the taxpayer reduced long-term 
capital gains from sources without the United States pursuant to 
paragraph (a)(1) of this section.
    (B) Step 2: Determine the applicable rate differential amount. If a 
taxpayer has capital gain net income from sources outside the United 
States in only one separate category long-term rate group, the 
applicable rate differential amount is the excess of such capital gain 
net income over the U.S. long-term capital loss adjustment amount. If a 
taxpayer has capital gain net income from sources outside the United 
States in more than one separate category long-term rate group, the U.S. 
long-term capital loss adjustment amount shall be apportioned on a pro 
rata basis to each separate category long-term rate group with capital 
gain net income. For purposes of the preceding sentence, pro rata means 
based on the relative amounts of capital gain net income from sources 
outside the United States in each separate category long-term rate 
group. The applicable rate differential amount for each separate 
category long-term rate group with capital gain net income is the excess 
of such capital gain net income over the portion of the U.S. long-term 
capital loss adjustment amount apportioned to the separate category 
long-term rate group pursuant to this Step 2.
    (iii) Examples. The following examples illustrate the provisions of 
paragraph (c)(1)(ii) of this section. The taxpayers in the examples are 
assumed to have taxable income (excluding net capital gain and qualified 
dividend income) subject to a rate of tax under section 1 greater than 
the highest rate of tax in effect under section 1(h) for the applicable 
taxable year. The examples are as follows:

    Example 1. (i) M, an individual, has $300 of long-term capital gain 
from foreign sources in the passive category, $200 of which is subject 
to tax at a rate of 15 percent under section 1(h) and $100 of which is 
subject to tax at a rate of 28% under section 1(h). M has $150 of short-
term capital gain from sources within the United States. M has a $100 
long-term capital loss from sources within the United States.
    (ii) M's capital gain net income from sources outside the United 
States ($300) does not exceed M's capital gain net income from all 
sources ($350). Therefore, paragraph (a)(1)

[[Page 941]]

of this section does not require any reduction of M's capital gain net 
income in the passive category.
    (iii) Because M has a net long-term capital loss from sources within 
the United States ($100) and also has a short-term capital gain from 
U.S. sources ($150), M must apply the provisions of paragraph (c)(1)(ii) 
of this section to determine the amount of the $300 of capital gain net 
income in the passive category that is subject to a rate differential 
adjustment. Under Step 1, the U.S. long-term capital loss adjustment 
amount is $100 ($100 - $0). Under Step 2, M must apportion this amount 
to each rate group in the passive category pro rata based on the amount 
of capital gain net income in each rate group. Thus, $66.67 ($200/$300 
of $100) is apportioned to the 15 percent rate group and $33.33 ($100/
$300 of $100) is apportioned to the 28 percent rate group. The 
applicable rate differential amount for the 15 percent rate group is 
$133.33 ($200 - $66.67). Thus, $133.33 of the $200 of capital gain net 
income in the 15 percent rate group is subject to a rate differential 
adjustment pursuant to paragraph (c)(1) of this section. The remaining 
$66.67 is not subject to a rate differential adjustment. The applicable 
rate differential amount for the 28 percent rate group is $66.67 ($100 - 
$33.33). Thus, $66.67 of the $100 of capital gain net income in the 28 
percent rate group is subject to a rate differential adjustment pursuant 
to paragraph (c)(1) of this section. The remaining $33.33 is not subject 
to a rate differential adjustment.
    Example 2. (i) N, an individual, has $300 of long-term capital gain 
from foreign sources in the passive category, all of which is subject to 
tax at a rate of 15 percent under section 1(h). N has $50 of short-term 
capital gain from sources within the United States. N has a $100 long-
term capital loss from sources within the United States.
    (ii) N's capital gain net income from sources outside the United 
States ($300) exceeds N's capital gain net income from all sources 
($250). Pursuant to paragraph (a)(1) of this section, N must reduce the 
$300 capital gain in the passive category by $50. N has $250 of capital 
gain remaining in the passive category.
    (iii) Because N has a net long-term capital loss from sources within 
the United States ($100) and also has a short-term capital gain from 
U.S. sources ($50), N must apply the provisions of paragraph (c)(1)(ii) 
of this section to determine the amount of the $250 of capital gain in 
the passive category that is subject to a rate differential adjustment. 
Under Step 1, the U.S. long-term capital loss adjustment amount is $50 
($100 - $50). Under Step 2, the applicable rate differential amount is 
$200 ($250 - $50). Thus, $200 of the capital gain in the passive 
category is subject to a rate differential adjustment under paragraph 
(c)(1) of this section. The remaining $50 is not subject to a rate 
differential adjustment.
    Example 3. (i) O, an individual, has a $100 short-term capital gain 
from foreign sources in the passive category. O has $300 of long-term 
capital gain from foreign sources in the passive category, all of which 
is subject to tax at a rate of 15 percent under section 1(h). O has a 
$100 long-term capital loss from sources within the United States.
    (ii) O's capital gain net income from sources outside the United 
States ($400) exceeds O's capital gain net income from all sources 
($300). Pursuant to paragraph (a)(1) of this section, O must reduce the 
$400 capital gain net income in the passive category by $100. Because C 
has capital gain net income in two or more rate groups in the passive 
category, O must apportion such amount, as a reduction, to each rate 
group on a pro rata basis pursuant to paragraph (a)(1)(ii)(B) of this 
section. Thus, $25 ($100/$400 of $100) is apportioned to the short-term 
capital gain and $75 ($300/$400 of $100) is apportioned to the long-term 
capital gain in the 15 percent rate group. After application of 
paragraph (a)(1) of this section, O has $75 of short-term capital gain 
in the passive category and $225 of long-term capital gain in the 15 
percent rate group in the passive category.
    (iii) Because O has a net long-term capital loss from sources within 
the United States ($100) and also has a short-term capital gain from 
foreign sources ($100), O must apply the provisions of paragraph 
(c)(1)(ii) of this section to determine the amount of the $225 of long-
term capital gain in the 15 percent rate group that is subject to a rate 
differential adjustment. Under Step 1, the U.S. long-term capital loss 
adjustment amount is $25 ($100 - $75). Under Step 2, the applicable rate 
differential amount is $200 ($225 - $25). Thus, $200 of the long-term 
capital gain is subject to a rate differential adjustment under 
paragraph (c)(1) of this section. The remaining $25 of long-term capital 
gain is not subject to a rate differential adjustment.

    (2) Rate differential adjustment of capital gains in entire taxable 
income. For purposes of section 904 and this section, entire taxable 
income shall include gains from the sale or exchange of capital assets 
only to the extent of capital gain net income reduced by the sum of the 
rate differential portions of each rate group of net capital gain.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States--(1) In general. In determining taxable income 
from sources outside the United States for purposes of section 904 and 
this section, a taxpayer with a net capital loss in a separate

[[Page 942]]

category rate group shall reduce such net capital loss by the sum of the 
rate differential portions of the capital gain net income in each long-
term rate group offset by such net capital loss. A net capital loss in a 
separate category rate group is the amount, if any, by which capital 
losses in a rate group from sources outside the United States included 
in a separate category exceed capital gains from sources outside the 
United States in the same rate group and the same separate category.
    (2) Determination of which capital gains are offset by net capital 
losses from sources outside the United States. For purposes of paragraph 
(d)(1) of this section, in order to determine the capital gain net 
income offset by net capital losses from sources outside the United 
States, the following rules shall apply in the following order:
    (i) Net capital losses from sources outside the United States in 
each separate category rate group shall be netted against capital gain 
net income from sources outside the United States from the same rate 
group in other separate categories.
    (ii) Capital losses from sources within the United States shall be 
netted against capital gains from sources within the United States in 
the same rate group.
    (iii) Net capital losses from sources outside the United States in 
excess of the amounts netted against capital gains under paragraph 
(d)(2)(i) of this section shall be netted against the taxpayer's 
remaining capital gains from sources within and outside the United 
States in the following order, and without regard to any net capital 
losses, from any rate group, from sources within the United States--
    (A) First against capital gain net income from sources within the 
United States in the same rate group;
    (B) Next, against capital gain net income in other rate groups, in 
the order in which capital losses offset capital gains for purposes of 
determining the taxpayer's taxable income and without regard to whether 
such capital gain net income derives from sources within or outside the 
United States, as follows:
    (1) A net capital loss in the short-term rate group is used first to 
offset any capital gain net income in the 28 percent rate group, then to 
offset capital gain net income in the 25 percent rate group, then to 
offset capital gain net income in the 15 percent rate group, and finally 
to offset capital gain net income in the 5 percent rate group.
    (2) A net capital loss in the 28 percent rate group is used first to 
offset capital gain net income in the 25 percent rate group, then to 
offset capital gain net income in the 15 percent rate group, and finally 
to offset capital gain net income in the 5 percent rate group.
    (3) A net capital loss in the 15 percent rate group is used first to 
offset capital gain net income in the 5 percent rate group, and then to 
offset capital gain net income in the 28 percent rate group, and finally 
to offset capital gain net income in the 25 percent rate group.
    (iv) Net capital losses from sources outside the United States in 
any rate group, to the extent netted against capital gains in any other 
separate category under paragraph (d)(2)(i) of this section or against 
capital gains in the same or any other rate group under paragraph 
(d)(2)(iii) of this section, shall be treated as coming pro rata from 
each separate category that contains a net capital loss from sources 
outside the United States in that rate group. For example, assume that 
the taxpayer has $20 of net capital losses in the 15 percent rate group 
in the passive category and $40 of net capital losses in the 15 percent 
rate group in the general limitation category, both from sources outside 
the United States. Further assume that $50 of the total $60 net capital 
losses from sources outside the United States are netted against capital 
gain net income in the 28 percent rate group (from other separate 
categories or from sources within the United States). One-third of the 
$50 of such capital losses would be treated as coming from the passive 
category, and two-thirds of such $50 would be treated as coming from the 
general limitation category.
    (v) In determining the capital gain net income offset by a net 
capital loss from sources outside the United States pursuant to this 
paragraph (d)(2), a taxpayer shall take into account any reduction to 
capital gain net income from sources outside the United States

[[Page 943]]

pursuant to paragraph (a) of this section and shall disregard any 
adjustments to such capital gain net income pursuant to paragraph (c)(1) 
of this section.
    (vi) If at any time during a taxable year, tax is imposed under 
section 1(h) at a rate other than a rate of tax specified in this 
paragraph (d)(2), the principles of this paragraph (d)(2) shall apply to 
determine the capital gain net income offset by any net capital loss in 
a separate category rate group.
    (vii) The determination of which capital gains are offset by capital 
losses from sources outside the United States under this paragraph 
(d)(2) is made solely in order to determine the appropriate rate-
differential-based adjustments to such capital losses under this section 
and section 904(b), and does not change the source, allocation, or 
separate category of any such capital gain or loss for purposes of 
computing taxable income from sources within or outside the United 
States or for any other purpose.
    (e) Qualified dividend income--(1) In general. A taxpayer that has 
taxable income (excluding net capital gain and qualified dividend 
income) for the taxable year and that qualifies for a reduced rate of 
tax under section 1(h) on its qualified dividend income (as defined in 
section 1(h)(11)) for the taxable year shall adjust the amount of such 
qualified dividend income in a manner consistent with the rules of 
paragraphs (c)(1)(i) (first sentence) and (c)(2) of this section 
irrespective of whether such taxpayer has a net capital gain for the 
taxable year. For purposes of making adjustments pursuant to this 
paragraph (e), the special rule in paragraph (c)(1)(ii) of this section 
for taxpayers with a net long-term capital loss from sources within the 
United States shall be disregarded.
    (2) Exception. A taxpayer that makes the election provided for in 
paragraph (b)(3) of this section shall not make adjustments pursuant to 
paragraph (e)(1) of this section. Additionally, a taxpayer other than a 
corporation that does not have a capital gain rate differential for the 
taxable year within the meaning of paragraph (b)(2) of this section may 
elect not to apply paragraph (e)(1) of this section if such taxpayer 
would have qualified for the election provided for in paragraph (b)(3) 
of this section had such taxpayer had a capital gain rate differential 
for the taxable year. Such a taxpayer shall be presumed to make the 
election provided for in the preceding sentence unless such taxpayer 
applies the rate differential adjustments provided for in paragraph 
(e)(1) of this section to the qualified dividend income in determining 
its foreign tax credit limitation for the taxable year.
    (f) Definitions. For purposes of section 904(b) and this section, 
the following definitions apply:
    (1) Alternative tax rate. The term alternative tax rate means, with 
respect to any rate group, the rate applicable to that rate group under 
section 1(h) (for taxpayers other than corporations) or section 1201(a) 
(for corporations). For example, the alternative tax rate for 
unrecaptured section 1250 gain is 25 percent.
    (2) Net capital gain. For purposes of this section, net capital gain 
shall not include any qualified dividend income (as defined in section 
1(h)(11)). See paragraph (e) of this section for rules relating to 
qualified dividend income.
    (3) Rate differential portion. The term rate differential portion 
with respect to capital gain net income from sources outside the United 
States in a separate category long-term rate group (or the applicable 
portion of such amount), net capital gain in a rate group, or capital 
gain net income in a long-term rate group, as the case may be, means the 
same proportion of such amount as--
    (i) The excess of the highest applicable tax rate (as defined in 
section 904(b)(3)(E)(ii)) over the alternative tax rate; bears to
    (ii) The highest applicable tax rate (as defined in section 
904(b)(3)(E)(ii)).
    (4) Rate group. For purposes of this section, the term rate group 
means:
    (i) Short-term capital gains or losses. With respect to a short-term 
capital gain or loss, the rate group is the short-term rate group.
    (ii) Long-term capital gains. With respect to a long-term capital 
gain, the rate group is the particular rate of tax to which such gain is 
subject under section 1(h). Such a rate group is a long-term rate group. 
For example, the 28

[[Page 944]]

percent rate group of capital gain net income from sources outside the 
United States consists of the capital gain net income from sources 
outside the United States that is subject to tax at a rate of 28 percent 
under section 1(h). Such 28 percent rate group is a long-term rate 
group. If a taxpayer has long-term capital gains that may be subject to 
tax at more than one rate under section 1(h) and the taxpayer's net 
capital gain attributable to such long-term capital gains and any 
qualified dividend income are taxed at one rate of tax under section 
1(h), then all of such long-term capital gains shall be treated as long-
term capital gains in that one rate group. If a taxpayer has long-term 
capital gains that may be subject to tax at more than one rate of tax 
under section 1(h) and the taxpayer's net capital gain attributable to 
such long-term capital gains and any qualified dividend income are taxed 
at more than one rate pursuant to section 1(h), the taxpayer shall 
determine the rate group for such long-term capital gains from sources 
within or outside the United States (and, to the extent from sources 
outside the United States, from each separate category) ratably based on 
the proportions of net capital gain and any qualified dividend income 
taxed at each applicable rate. For example, under the section 1(h) rates 
in effect for tax years beginning in 2004, a long-term capital gain 
(other than a long-term capital gain described in section 1(h)(4)(A) or 
(h)(6)) may be subject to tax at 5 percent or 15 percent.
    (iii) Long-term capital losses. With respect to a long-term capital 
loss, a loss described in section 1(h)(4)(B)(i) (collectibles loss) or 
(iii) (long-term capital loss carryover) is a loss in the 28 percent 
rate group. All other long-term capital losses shall be treated as 
losses in the highest rate group in effect under section 1(h) for the 
tax year with respect to long-term capital gains other than long-term 
capital gains described in section 1(h)(4)(A) or (h)(6). For example, 
under the section 1(h) rates in effect for tax years beginning in 2004, 
a long-term capital loss not described in section 1(h)(4)(B)(i) or (iii) 
shall be treated as a loss in the 15 percent rate group.
    (5) Terms used in sections 1(h), 904(b) or 1222. For purposes of 
this section, any term used in this section and also used in section 
1(h), section 904(b) or section 1222 shall have the same meaning given 
such term by section 1(h), 904(b) or 1222, respectively, except as 
otherwise provided in this section.
    (g) Examples. The following examples illustrate the provisions of 
this section. In these examples, the rate differential adjustment is 
shown as a fraction, the numerator of which is the alternative tax rate 
percentage and the denominator of which is 35 percent (assumed to be the 
highest applicable tax rate for individuals under section 1). Finally, 
all dollar amounts in the examples are abbreviated from amounts in the 
thousands (for example, $50 represents $50,000). The examples are as 
follows:

    Example 1. (i) AA, an individual, has items from sources outside the 
United States only in the passive category for the taxable year. AA has 
$1000 of long-term capital gains from sources outside the United States 
that are subject to tax at a rate of 15 percent under section 1(h). AA 
has $700 of long-term capital losses from sources outside the United 
States, which are not described in section 1(h)(4)(B)(i) or (iii). For 
the same taxable year, AA has $800 of long-term capital gains from 
sources within the United States that are taxed at a rate of 28 percent 
under section 1(h). AA also has $100 of long-term capital losses from 
sources within the United States, which are not described in section 
1(h)(4)(B)(i) or (iii). AA also has $500 of ordinary income from sources 
within the United States. The highest tax rate in effect under section 
1(h) for the taxable year with respect to long-term capital gains other 
than long-term capital gains described in section 1(h)(4)(A) or (h)(6) 
is 15 percent. Accordingly, AA's long-term capital losses are in the 15 
percent rate group.
    (ii) AA's items of ordinary income, capital gain and capital loss 
for the taxable year are summarized in the following table:

------------------------------------------------------------------------
                                                                Foreign
                                                      U.S.      source:
                                                     source     passive
------------------------------------------------------------------------
15% rate group...................................     ($100)     $1,000
                                                                   (700)
28% rate group...................................        800
Ordinary income..................................        500
------------------------------------------------------------------------

    (iii) AA's capital gain net income from sources outside the United 
States ($300) does not exceed AA's capital gain net income from all 
sources ($1,000). Therefore, paragraph (a)(1) of this section does not 
require

[[Page 945]]

any reduction of AA's capital gain net income in the passive category.
    (iv) In computing AA's taxable income from sources outside the 
United States in the numerator of the section 904(a) foreign tax credit 
limitation fraction for the passive category, AA's $300 of capital gain 
net income in the 15 rate group in the passive category must be adjusted 
as required under paragraph (c)(1) of this section. AA adjusts the $300 
of capital gain net income using 15 percent as the alternative tax rate, 
as follows: $300 (15%/35%).
    (v) In computing AA's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fraction, AA combines 
the $300 of capital gain net income from sources outside the United 
States and the $100 net capital loss from sources within the United 
States in the same rate group (15 percent). AA must adjust the resulting 
$200 ($300 - $100) of net capital gain in the 15 percent rate group as 
required under paragraph (c)(2) of this section, using 15 percent as the 
alternative tax rate, as follows: $200 (15%/35%). AA must also adjust 
the $800 of net capital gain in the 28 percent rate group, using 28 
percent as the alternative tax rate, as follows: $800 (28%/35%). AA must 
also include ordinary income from sources outside the United States in 
the numerator, and ordinary income from all sources in the denominator, 
of the foreign tax credit limitation fraction.
    (vi) AA's passive category foreign tax credit limitation fraction is 
$128.58/$1225.72, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.001

    Example 2. (i) BB, an individual, has the following items of 
ordinary income, capital gain, and capital loss for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group..................         $300        ($500)         $100
25% rate group..................          200  ............  ...........
28% rate group..................          500         (300)  ...........
Ordinary income.................        1,000          500           500
------------------------------------------------------------------------

    (ii) BB's capital gain net income from sources outside the United 
States in the aggregate (zero, since losses exceed gains) does not 
exceed BB's capital gain net income from all sources ($300). Therefore, 
paragraph (a)(1) of this section does not require any reduction of BB's 
capital gain net income in the passive category.
    (iii) In computing BB's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax credit 
limitation fractions for the passive and general limitation categories, 
BB must adjust capital gain net income from sources outside the United 
States in each separate category long-tem rate group and net capital 
losses from sources outside the United States in each separate category 
rate group as provided in paragraphs (c)(1) and (d) of this section.
    (A) The $100 of capital gain net income in the 15 percent rate group 
in the passive category is adjusted under paragraph (c)(1) of this 
section as follows: $100 (15%/35%).
    (B) BB must adjust the net capital losses in the 15 percent and 28 
percent rate groups in the general limitation category in accordance 
with the ordering rules contained in paragraph (d)(2) of this section. 
Under paragraph (d)(2)(i) of this section, BB's net capital loss in the 
15 percent rate group is netted against capital gain net income from 
sources outside the United States in other separate categories in the 
same rate group. Thus, $100 of the $500 net capital loss in the 15 
percent rate group in the general limitation category offsets $100 of 
capital gain net income in the 15 percent rate group in the passive 
category. Accordingly, $100 of the $500 net capital loss is adjusted 
under paragraph (d)(1) of this section as follows: $100 (15%/35%).
    (C) Next, under paragraph (d)(2)(iii)(A) of this section, BB's net 
capital losses from sources outside the United States in any separate 
category rate group are netted against capital gain net income in the 
same rate group from sources within the United States. Thus, $300 of the 
$500 net capital loss in the 15 percent rate group in the general 
limitation category offsets $300 of capital gain net income in the 15 
percent rate group from

[[Page 946]]

sources within the United States. Accordingly, $300 of the $500 net 
capital loss is adjusted under paragraph (d)(1) of this section as 
follows: $300 (15%/35%). Similarly, the $300 of net capital loss in the 
28 percent rate group in the general limitation category offsets $300 of 
capital gain net income in the 28 percent rate group from sources within 
the United States. The $300 net capital loss is adjusted under paragraph 
(d)(1) of this section as follows: $300 (28%/35%).
    (D) Finally, under paragraph (d)(2)(iii)(B) of this section, the 
remaining net capital losses in a separate category rate group are 
netted against capital gain net income from other rate groups from 
sources within and outside the United States. Thus, the remaining $100 
of the $500 net capital loss in the 15 percent rate group in the general 
limitation category offsets $100 of the remaining capital gain net 
income in the 28 percent rate group from sources within the United 
States. Accordingly, the remaining $100 of net capital loss is adjusted 
under paragraph (d)(1) of this section as follows: $100 (28%/35%).
    (iv) In computing BB's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, BB must 
adjust net capital gain by netting all of BB's capital gains and losses, 
from sources within and outside the United States, and adjusting any 
remaining net capital gains, based on rate group, under paragraph (c)(2) 
of this section. BB must also include foreign source ordinary income in 
the numerators, and ordinary income from all sources in the denominator, 
of the foreign tax credit limitation fractions. The denominator of BB's 
foreign tax credit limitation fractions reflects $2,000 of ordinary 
income from all sources, $100 of net capital gain taxed at the 28% rate 
and adjusted as follows: $100 (28%/35%), and $200 of net capital gain 
taxed at the 25% rate and adjusted as follows: $200 (25%/35%).
    (v) BB's foreign tax credit limitation fraction for the general 
limitation category is $8.56/$2222.86, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.002

    (vi) BB's foreign tax credit limitation fraction for the passive 
category is $542.86/$2222.86, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.003

    Example 3. (i) CC, an individual, has the following items of 
ordinary income, capital gain, and capital loss for the taxable year:

------------------------------------------------------------------------
                                                    Foreign source
                                 U.S. source ---------------------------
                                                 General       Passive
------------------------------------------------------------------------
15% rate group.................         $300        ($720)         ($80)
25% rate group.................          200  ............  ............
28% rate group.................          500         (150)           50
Ordinary income................        1,000        1,000           500
------------------------------------------------------------------------

    (ii) CC's capital gain net income from sources outside the United 
States (zero, since losses exceed gains) does not exceed CC's capital 
gain net income from all sources ($100). Therefore, paragraph (a)(1) of 
this section does not require any adjustment.
    (iii) In computing CC's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax credit 
limitation fractions for the passive and general limitation categories, 
CC must adjust capital gain net income from sources outside the United 
States in each separate category long-tem rate group and net capital 
losses from sources outside the United States in each separate category 
rate

[[Page 947]]

group as provided in paragraphs (c)(1) and (d) of this section.
    (A) CC must adjust the $50 of capital gain net income in the 28 
percent rate group in the passive category pursuant to paragraph (c)(1) 
of this section as follows: $50 (28%/35%).
    (B) Under paragraph (d)(2)(i) of this section, $50 of CC's $150 net 
capital loss in the 28 percent rate group in the general limitation 
category offsets $50 of capital gain net income in the 28 percent rate 
group in the passive category. Thus, $50 of the $150 net capital loss is 
adjusted as follows: $50 (28%/35%). Next, under paragraph (d)(2)(iii)(A) 
of this section, the remaining $100 of net capital loss in the 28 
percent rate group in the general limitation category offsets $100 of 
capital gain net income in the 28 percent rate group from sources within 
the United States. Thus, the remaining $100 of net capital loss is 
adjusted as follows: $100 (28%/35%).
    (C) Under paragraphs (d)(2)(iii)(A) and (d)(2)(iv) of this section, 
the net capital losses in the 15 percent rate group in the passive and 
general limitation categories offset on a pro rata basis the $300 of 
capital gain net income in the 15 percent rate group from sources within 
the United States. The proportionate amount of the $720 net capital loss 
($720/$800 of $300, or $270) is adjusted as follows: $270 (15%/35%). The 
proportionate amount of the $80 net capital loss ($80/$800 of $300, or 
$30) is adjusted as follows $30 (15%/35%).
    (D) Of the remaining $500 of net capital loss in the 15 percent rate 
group in the general limitation and passive categories, $400 offsets the 
remaining $400 of capital gain net income in the 28 percent rate group 
from sources within the United States under paragraph (d)(2)(iii)(B)(3) 
of this section. The proportionate amount of the $720 net capital loss 
($720/$800 of $400, or $360) is adjusted as follows: $360 (28%/35%). The 
proportionate amount of the $80 net capital loss ($80/$800 of $400, or 
$40) is adjusted as follows: $40 (28%/35%).
    (E) Under paragraph (d)(2)(iii)(B)(3) of this section, the remaining 
$100 of net capital loss in the 15 percent rate group in the general 
limitation and passive limitation categories offsets $100 of capital 
gain net income in the 25 percent rate group from sources within the 
United States. The proportionate amount of the $720 net capital loss 
($720/$800 of $100, or $90) is adjusted as follows: $90 (25%/35%). The 
proportionate amount of the $80 net capital loss ($80/$800 of $100 of 
$10) is adjusted as follows: $10 (25%/35%).
    (iv) In computing CC's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, CC must 
adjust capital gain net income by netting all of CC's capital gains and 
losses, from sources within and outside the United States, and adjusting 
any remaining net capital gains, based on rate group, under paragraph 
(c)(2) of this section. The denominator of CC's foreign tax credit 
limitation fractions reflects $2,500 of ordinary income from all sources 
and $100 of net capital gain taxed at the 25% rate and adjusted as 
follows: $100 (25%/35%).
    (v) CC's foreign tax credit limitation fraction for the general 
limitation category is $412/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.004

    (vi) CC's foreign tax credit limitation fraction for the passive 
category is $488.00/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.005

    Example 4. (i) DD, an individual, has the following items of 
ordinary income, capital gain and capital loss for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group.................         ($80)        ($100)         $300
Short-term.....................  ............          500           100

[[Page 948]]

 
Ordinary income................          500   ............  ...........
------------------------------------------------------------------------

    (ii) DD's capital gain net income from outside the United States 
($800) exceeds DD's capital gain net income from all sources ($720). 
Pursuant to paragraph (a)(1)(ii)(A) of this section, DD must apportion 
the $80 of excess of capital gain net income from sources outside the 
United States between the general limitation and passive categories 
based on the amount of capital gain net income in each separate 
category. Thus, one-half ($400/$800 of $100, or $40) is apportioned to 
the general limitation category and one-half ($400/$800 of $80, or $40) 
is apportioned to the passive category. The $40 apportioned to the 
general limitation category reduces DD's $500 short-term capital gain in 
the general limitation category to $460. Pursuant to paragraph 
(a)(1)(ii)(B) of this section, the $40 apportioned to the passive 
category must be apportioned further between the capital gain net income 
in the short-term rate group and the 15 percent rate group based on the 
relative amounts of capital gain net income in each rate group. Thus, 
one-fourth ($100/$400 of $40 or $10) is apportioned to the short-term 
rate group and three-fourths ($300/$400 of $40 or $30) is apportioned to 
the 15 percent rate group. DD's passive category includes $90 of short-
term capital gain and $270 of capital gain net income in the 15% rate 
group.
    (iii) Because DD has a net long-term capital loss from sources 
within the United States ($80) and also has short-term capital gains, DD 
must apply the provisions of paragraph (c)(1)(ii) of this section to 
determine the amount of DD's $270 of capital gain net income in the 15% 
rate group that is subject to a rate differential adjustment under 
paragraph (c)(1) of this section. Under Step 1, the U.S. long-term 
capital loss adjustment amount is $50 ($80-$30). Under Step 2, the 
applicable rate differential amount is the excess of the remaining 
capital gain net income over the U.S. long-term adjustment amount. Thus, 
the applicable rate differential amount is $220 ($270 - $50). In 
computing DD's taxable income from sources outside the United States in 
the numerator of the section 904(a) foreign tax credit limitation 
fraction for the passive category, DD must adjust this amount as 
follows: $220 (15%/35%). DD does not adjust the remaining $50 of capital 
gain net income in the 15% rate group.
    (iv) The amount of capital gain net income in the 15% rate group in 
the passive category, taking into account the adjustment pursuant to 
paragraph (a)(1) of this section and disregarding the adjustment 
pursuant to paragraph (c)(1) of this section, is $270. Under paragraphs 
(d)(2)(i) and (d)(2)(v) of this section, DD's $100 net capital loss in 
the 15% rate group in the general limitation category offsets capital 
gain net income in the 15% rate group in the passive category. 
Accordingly, the $100 of net capital loss is adjusted as follows: $100 
(15%/35%).
    (v) In computing DD's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, DD must 
adjust capital gain net income by netting all of DD's capital gains and 
losses from sources within and outside the United States, and adjusting 
the remaining net capital gain in each rate group pursuant to paragraph 
(c)(2) of this section. The denominator of DD's foreign tax credit 
limitation fraction reflects $500 of ordinary income from all sources, 
$600 of short-term capital gain and $120 of net capital gain in the 15 
percent rate group adjusted as follows: $120 (15%/35%).
    (vi) DD's foreign tax credit limitation fraction for the general 
limitation category is $417.14/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.006

    (vii) DD's foreign tax credit limitation fraction for the passive 
category is $234.29/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.007

    Example 5. (i) EE, an individual, has the following items of 
ordinary income, capital gain and capital loss for the taxable year:

------------------------------------------------------------------------
                                                                Foreign
                                                      U.S.       source
                                                     source   ----------
                                                                Passive
------------------------------------------------------------------------
15% rate group...................................      ($150)       $300
28% rate group...................................  ..........        200
Short-term.......................................         30         100
Ordinary income..................................        500   .........
------------------------------------------------------------------------

    (ii) EE's capital gain net income from sources outside the United 
States ($600) exceeds EE's capital gain net income from all sources 
($480). Pursuant to paragraph (a)(1)(ii) of this section, the $120 of 
excess capital gain net income from sources outside the United States is 
allocated as a reduction to the passive category and must be apportioned 
pro rata to each rate group within the passive category with capital 
gain net income. Thus, $20 ($100/$600 of $120) is apportioned to the 
short-term rate group, $60 ($300/

[[Page 949]]

$600 of $120) is apportioned to the 15 percent rate group and $40 ($200/
$600 of $120) is apportioned to the 28 percent rate group. After 
application of paragraph (a)(1) of this section, EE has $80 of capital 
gain net income in the short-term rate group, $240 of capital gain net 
income in the 15 percent rate group and $160 of capital gain net income 
in the 28 percent rate group.
    (iii) Because EE has a net long-term capital loss from sources 
within the United States ($150) and also has short-term capital gains, 
EE must apply the provisions of paragraph (c)(1)(ii) of this section to 
determine the amount of EE's remaining $400 ($240 + $160) of capital 
gain net income in long-term rate groups in the passive category that is 
subject to a rate differential adjustment to a rate differential 
adjustment. Under Step 1, the U.S. long-term capital loss adjustment 
amount is $50 ($150-$100). Under Step 2, EE must apportion this amount 
pro rata to each long-term rate group within the passive category with 
capital gain net income. Thus, $30 ($240/$400 of $50) is apportioned to 
the 15 percent rate group and $20 ($160/$400 of $50) is apportioned to 
the 28 percent rate group. The applicable rate differential amount for 
the 15 percent rate group is $210 ($240 - $30). The applicable rate 
differential amount for the 28 percent rate group is $140 ($160 - $20).
    (iv) Pursuant to paragraph (c)(1)(ii) of this section, EE must 
adjust $210 of the $240 capital gain in the 15 percent rate group as 
follows: $210 (15%/35%). EE does not adjust the remaining $30. Pursuant 
to paragraph (c)(1)(ii) of this section, EE must adjust $140 of the $160 
capital gain in the 28 percent rate group as follows: $140 (28%/35%). EE 
does not adjust the remaining $20.
    (v) In computing EE's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, EE must 
adjust capital gain net income by netting all of EE's capital gains and 
losses from sources within and outside the United States, and adjusting 
the remaining net capital gain in each rate group pursuant to paragraph 
(c)(2) of this section. The denominator of EE's foreign tax credit 
limitation fraction reflects $500 of ordinary income from all sources, 
$130 of short-term capital gain, $150 of net capital gain in the 15 
percent rate group adjusted as follows: $150 (15%/35%), and $200 of net 
capital gain in the 28 percent rate group adjusted as follows: $200 
(28%/35%).
    (vi) EE's foreign tax credit limitation fraction for the passive 
category is $332/$854.29, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.008

    (h) Coordination with section 904(f)--(1) In general. Section 904(b) 
and this section shall apply before the provisions of section 904(f) as 
follows:
    (i) The amount of a taxpayer's separate limitation income or loss in 
each separate category, the amount of overall foreign loss, and the 
amount of any additions to or recapture of separate limitation loss or 
overall foreign loss accounts pursuant to section 904(f) shall be 
determined after applying paragraphs (a), (c)(1), (d) and (e) of this 
section to adjust capital gains and losses and qualified dividend income 
from sources outside the United States in each separate category.
    (ii) To the extent a capital loss from sources within the United 
States reduces a taxpayer's foreign source taxable income under 
paragraph (a)(1) of this section, such capital loss shall be disregarded 
in determining the amount of a taxpayer's taxable income from sources 
within the United States for purposes of computing the amount of any 
additions to the taxpayer's overall foreign loss accounts.
    (iii) In determining the amount of a taxpayer's loss from sources in 
the United States under section 904(f)(5)(D) (section 904(f)(5)(D) 
amount), the taxpayer shall make appropriate adjustments to capital 
gains and losses from sources within the United States to reflect 
adjustments pursuant to section 904(b)(2) and this section. Therefore, 
for purposes of section 904, a taxpayer's section 904(f)(5)(D) amount 
shall be equal to the excess of the taxpayer's foreign source taxable 
income in all separate categories in the aggregate for the taxable year 
(taking into account any adjustments pursuant to paragraphs (a)(1), 
(c)(1), (d) and (e) of this section) over the taxpayer's entire taxable 
income for the taxable year (taking into account any adjustments

[[Page 950]]

pursuant to paragraphs (c)(2) and (e) of this section).
    (2) Examples. The following examples illustrate the application of 
paragraph (h) of this section:

    Example 1. (i) W, an individual, has the following items of ordinary 
income, capital gain, and capital loss for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                   U.S. source -------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group...................         $500         $100       ($400)
Ordinary income..................          900          100  ...........
------------------------------------------------------------------------

    (ii) In computing W's taxable income from sources outside the United 
States for purposes of section 904 and this section, W must adjust the 
capital gain net income and net capital loss in each separate category 
as provided in paragraphs (c)(1) and (d) of this section. Thus, W must 
adjust the $100 of capital gain net income in the general limitation 
category and the $400 of net capital loss in the passive category as 
follows: $100 (15%/35%) and $400 (15%/35%).
    (iii) After the adjustment to W's net capital loss in the passive 
category, W has a $171.43 separate limitation loss in the passive 
category. After the adjustment to W's capital gain in the general 
limitation category, W has $142.86 of foreign source taxable income in 
the general limitation category. Thus, $142.86 of the separate 
limitation loss reduces foreign source taxable income in the general 
limitation category. See section 904(f)(5)(B). W adds $142.86 to the 
separate limitation loss account for the passive category. The remaining 
$28.57 of the separate limitation loss reduces income from sources 
within the United States. See section 904(f)(5)(A). Thus, W adds $28.57 
to the overall foreign loss account for the passive category.
    Example 2. (i) X, a corporation, has the following items of ordinary 
income, ordinary loss, capital gain and capital loss for the taxable 
year: foreign source:

------------------------------------------------------------------------
                                                                Foreign
                                                     U.S.       source:
                                                    source      general
------------------------------------------------------------------------
Capital gain....................................      ($500)       $700
Ordinary income.................................       1100       (1000)
------------------------------------------------------------------------

    (ii) X's capital gain net income from sources outside the United 
States ($700) exceeds X's capital gain net income from all sources 
($200). Pursuant to paragraph (a)(1) of this section, X must reduce the 
$700 capital gain in the general limitation category by $500. After the 
adjustment, X has $200 of capital gain net income remaining in the 
general limitation category. Thus, X has an overall foreign loss 
attributable to the general limitation category of $800.
    (iii) For purposes of computing the amount of the addition to X's 
overall foreign loss account for the general limitation category, the 
$500 capital loss from sources within the United States is disregarded 
and X's taxable income from sources within the United States is $1100. 
Accordingly, X must increase its overall foreign loss account for the 
general limitation category by $800.
    Example 3. (i) Y, a corporation, has the following items of ordinary 
income, ordinary loss, capital gain and capital loss for the taxable 
year:

------------------------------------------------------------------------
                                                                Foreign
                                                       U.S.     source:
                                                      source    passive
------------------------------------------------------------------------
Capital gain......................................     ($100)       $200
Ordinary income...................................      (200)        500
------------------------------------------------------------------------

    (ii) Y's capital gain net income from sources outside the United 
States ($200) exceeds Y's capital gain net income from all sources 
($100). Pursuant to paragraph (a)(1) of this section, Y must reduce the 
$200 capital gain in the passive category by $100. Y has $100 of capital 
gain net income remaining in the passive category.
    (iii) Y is not required to make adjustments pursuant to paragraph 
(c), (d) or (e) of this section. See paragraphs (b) and (e) of this 
section. Y's foreign source taxable income in the passive category after 
the adjustment pursuant to paragraph (a)(1) of this section is $600. Y's 
entire taxable income for the taxable year is $400.
    (iv) Y's section 904(f)(5)(D) amount is the excess of Y's foreign 
source taxable income in all separate categories in the aggregate for 
the taxable year after taking into account the adjustment pursuant to 
paragraph (a)(1) of this section ($600) over Y's entire taxable income 
for the taxable year ($400). Therefore, Y's section 904(f)(5)(D) amount 
is $200 and Y's foreign source taxable income in the passive category is 
reduced to $400. See section 904(f)(5)(D).
    Example 4. (i) Z, an individual, has the following items of ordinary 
income, ordinary loss and capital gain for the taxable year:

[[Page 951]]



------------------------------------------------------------------------
                                                     Foreign source:
                                   U.S. source -------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group..................         $100   ...........  ...........
Ordinary income.................         (200)         $300         $300
------------------------------------------------------------------------

    (ii) Z's foreign source taxable income in all of Z's separate 
categories in the aggregate for the taxable year is $600. (There are no 
adjustments to Z's foreign source taxable income pursuant to paragraph 
(a)(1), (c)(1), (d) or (e) of this section.)
    (iii) In computing Z's entire taxable income in the denominator of 
the section 904(d) foreign tax credit limitation fractions, Z must 
adjust the $100 of net capital gain in the 15 percent rate group 
pursuant to paragraph (c)(2) of this section as follows: $100 (15%/35%). 
Thus, Z's entire taxable income for the taxable year, taking into 
account the adjustment pursuant to paragraph (c)(2) of this section, is 
$442.86.
    (iv) Z's section 904(f)(5)(D) amount is the excess of Z's foreign 
source taxable income in all separate categories in the aggregate for 
the taxable year ($600) over Z's entire taxable income for the taxable 
year after the adjustment pursuant to paragraph (c)(2) of this section 
($442.86). Therefore, Z's section 904(f)(5)(D) amount is $157.32. This 
amount must be allocated pro rata to the passive and general limitation 
categories in accordance with section 904(f)(5)(D).
    Example 5. (i) O, an individual, has the following items of ordinary 
income, ordinary loss and capital gain for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group.................        $1100         ($500)  ...........
Ordinary income................        (1000)         1000          $500
------------------------------------------------------------------------

    (ii) In determining O's taxable income from sources outside the 
United States, O must reduce the $500 capital loss in the general 
limitation category to $214.29 ($500 x 15%/35%) pursuant to paragraph 
(d) of this section. Taking this adjustment into account, O's foreign 
source taxable income in all of O's separate categories in the aggregate 
is $1285.71 ($1000 - $214.29 + $500).
    (iii) In computing O's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fraction, O must reduce 
the $600 of net capital gain for the year to $257.14 ($600 x 15%/35%) 
pursuant to paragraph (c)(2) of this section. Taking this adjustment 
into account, O's entire taxable income for the year is $757.14 ($500 + 
$257.14).
    (iv) Therefore, O's section 904(f)(5)(D) amount is $528.57 ($1285.71 
- $757.14). This amount must be allocated pro rata to O's $500 of income 
in the passive category and O's $785.71 of adjusted income in the 
general limitation category in accordance with section 904(f)(5)(D).

    (i) Effective date. This section shall apply to taxable years 
beginning after July 20, 2004. Taxpayers may choose to apply this 
section and Sec.  1.904(b)-2 to taxable years ending after July 20, 
2004.

[T.D. 9141, 69 FR 43308, July 20, 2004; 69 FR 61761, Oct. 21, 2004]



Sec.  1.904(b)-2  Special rules for application of section 904(b) 
to alternative minimum tax foreign tax credit.

    (a) Application of section 904(b)(2)(B) adjustments. Section 
904(b)(2)(B) shall apply for purposes of determining the alternative 
minimum tax foreign tax credit under section 59 (regardless of whether 
or not the taxpayer has made an election under section 59(a)(4)).
    (b) Use of alternative minimum tax rates--(1) Taxpayers other than 
corporations. In the case of a taxpayer other than a corporation, for 
purposes of determining the alternative minimum tax foreign tax credit 
under section 59--
    (i) Section 904(b)(3)(D)(i) shall be applied by using the language 
``section 55(b)(3)'' instead of ``subsection (h) of section 1'';
    (ii) Section 904(b)(3)(E)(ii)(I) shall be applied by using the 
language ``section 55(b)(1)(A)(i)'' instead of ``subsection (a), (b), 
(c), (d), or (e) of section 1 (whichever applies)''; and
    (iii) Section 904(b)(3)(E)(iii)(I) shall be applied by using the 
language ``the alternative rate of tax determined under section 
55(b)(3)'' instead of ``the

[[Page 952]]

alternative rate of tax determined under section 1(h)''.
    (2) Corporate taxpayers. In the case of a corporation, for purposes 
of determining the alternative minimum tax foreign tax credit under 
section 59, section 904(b)(3)(E)(ii)(II) shall be applied by using the 
language ``section 55(b)(1)(B)'' instead of ``section 11(b)''.
    (c) Effective date. This section shall apply to taxable years 
beginning after July 20, 2004. See Sec.  1.904(b)-1(i) for a rule 
permitting taxpayers to choose to apply Sec.  1.904(b)-1 and this Sec.  
1.904(b)-2 to taxable years ending after July 20, 2004.

[T.D. 9141, 69 FR 43316, July 20, 2004; 69 FR 61761, Oct. 21, 2004]



Sec.  1.904(b)-3  Disregard of certain dividends and deductions 
under section 904(b)(4).

    (a) Disregard of certain dividends and deductions--(1) In general. 
For purposes of section 904(a), in the case of a domestic corporation 
which is a United States shareholder with respect to a specified 10-
percent owned foreign corporation (as defined in section 245A(b)), the 
domestic corporation's foreign source taxable income in a separate 
category and entire taxable income is determined without regard to the 
following items:
    (i) Any dividend for which a deduction is allowed under section 
245A;
    (ii) Deductions properly allocable or apportioned to gross income in 
the section 245A subgroup as determined under paragraphs (b) and (c)(1) 
of this section; and
    (iii) Deductions properly allocable or apportioned to stock of 
specified 10-percent owned foreign corporations in the section 245A 
subgroup as determined under paragraphs (b) and (c) of this section.
    (2) Deductions properly allocable or apportioned to the residual 
grouping. Deductions that are properly allocable or apportioned to gross 
income or stock in the section 245A subgroup of the residual grouping 
(consisting of U.S. source income) are disregarded solely for purposes 
of determining entire taxable income under section 904(a).
    (b) Determining properly allocable or apportioned deductions. The 
amount of deductions properly allocable or apportioned to gross income 
or stock described in paragraphs (a)(1)(ii) and (iii) of this section is 
determined by subdividing the United States shareholder's gross income 
and assets in each separate category described in Sec.  1.904-5(a)(4)(v) 
into a section 245A subgroup and a non-section 245A subgroup. Gross 
income and assets in the residual grouping for U.S. source income are 
also subdivided into a section 245A subgroup and a non-section 245A 
subgroup. Each section 245A subgroup is treated as a statutory grouping 
under Sec.  1.861-8(a)(4). Deductions properly allocable or apportioned 
to dividends or stock described in paragraphs (a)(1)(ii) and (iii) of 
this section only include those deductions that are allocated and 
apportioned under Sec. Sec.  1.861-8 through 1.861-14T and 1.861-17 to 
the section 245A subgroups. The deduction allowed under section 245A(a) 
for dividends is allocated and apportioned solely among the section 245A 
subgroups on the basis of the relative amounts of gross income from such 
dividends in each section 245A subgroup.
    (c) Income and assets in the 245A subgroups--(1) In general. For 
purposes of applying the section 861 regulations (as defined in Sec.  
1.861-8(a)) to the deductions of a United States shareholder, the only 
gross income included in a section 245A subgroup is dividend income for 
which a deduction is allowed under section 245A. The only asset included 
in a section 245A subgroup is the portion of the value of stock of each 
specified 10-percent owned foreign corporation that is assigned to the 
section 245A subgroup determined under paragraph (c)(2) of this section.
    (2) Assigning stock to a subgroup. The value of stock of a specified 
10-percent owned foreign corporation is characterized as an asset in a 
separate category described in Sec.  1.904-5(a)(4)(v) or the residual 
grouping for U.S. source income under the rules of Sec.  1.861-12(c). If 
the specified 10-percent owned foreign corporation is not a controlled 
foreign corporation, all of the value of its stock (other than the 
portion of stock assigned to the statutory groupings for gross section 
245(a)(5) income under Sec. Sec.  1.861-12(c)(4) and 1.861-13) in each 
separate category and in the residual grouping for U.S. source income is 
assigned to the section 245A subgroup in

[[Page 953]]

such separate category or residual grouping. If the specified 10-percent 
owned foreign corporation is a controlled foreign corporation, a portion 
of the value of stock in each separate category and in the residual 
grouping for U.S. source income is subdivided between a section 245A and 
non-section 245A subgroup under Sec.  1.861-13(a)(5).
    (d) Coordination with OFL and ODL rules--(1) In general. Section 
904(b)(4) and this section apply before the operation of the overall 
foreign loss rules in section 904(f) and the overall domestic loss rules 
in section 904(g). See Sec.  1.904(g)-3(c).
    (2) Net operating losses. If the taxpayer has a net operating loss 
in the current taxable year, then solely for purposes of determining the 
source and separate category of the net operating loss, the overall 
foreign loss rules in section 904(f) and the overall domestic loss rules 
in section 904(g) are applied without taking into account the 
adjustments required under section 904(b) and this section.
    (e) Example. The following example illustrates the application of 
this section.
    (1) Facts--(i) Income and assets of USP. USP is a domestic 
corporation. USP owns a factory in the United States with a tax book 
value of $27,000x. USP also directly owns all of the stock of each of 
the following three controlled foreign corporations: CFC1, CFC2, and 
CFC3. USP's tax book value in each of CFC1, CFC2, and CFC3 is $10,000x. 
USP incurs $1,500x of interest expense and earns $1,600x of U.S. source 
gross income. Under section 951A and the section 951A regulations (as 
defined in Sec.  1.951A-1(a)(1)), USP's GILTI inclusion amount is 
$2,200x. USP's deduction under section 250 is $1,100x (``section 250 
deduction''), all of which is by reason of section 250(a)(1)(B)(i). No 
portion of USP's section 250 deduction is reduced by reason of section 
250(a)(2)(B). None of the CFCs makes any distributions.
    (ii) Characterization of CFC stock. After application of Sec.  
1.861-13(a), USP determined that $8,000x of the stock of each of CFC1, 
CFC2, and CFC3 is assigned to the section 951A category (``section 951A 
category stock'') in the non-section 245A subgroup and the remaining 
$2,000x of the stock of each of CFC1, CFC2, and CFC3 is assigned to the 
general category (``general category stock'') in the section 245A 
subgroup. Additionally, under Sec.  1.861-8(d)(2)(ii)(C)(2), $4,000x of 
the stock of each of CFC1, CFC2, and CFC3 that is section 951A category 
stock is an exempt asset. Accordingly, with respect to the stock of its 
controlled foreign corporations in the aggregate, USP has $12,000x of 
section 951A category stock in a non-section 245A subgroup; $6,000x of 
general category stock in a section 245A subgroup; and $12,000x of stock 
that is an exempt asset.
    (iii) Apportioning of expenses. Taking into account USP's factory 
and its stock in CFC1, CFC2, and CFC3, the tax book value of USP's 
assets for purposes of apportioning expenses is $45,000x (excluding the 
$12,000x of exempt assets). Under Sec.  1.861-9T(g), USP's $1,500 of 
interest expense is apportioned as follows: $400x ($1,500x x $12,000x/
$45,000x) to section 951A category income, $200x ($1,500x x $6,000x/
$45,000x) to general category income, and the remaining $900x ($1,500 x 
$27,000x/$45,000x) to the residual U.S. source grouping. Under Sec.  
1.861-8(e)(14), all of USP's section 250 deduction is allocated and 
apportioned to section 951A category income.
    (2) Analysis--(i) USP's pre-credit U.S. tax. USP's worldwide taxable 
income is $1,200x, which equals its GILTI inclusion amount of $2,200x 
plus its U.S. source gross income of $1,600x, less its deduction under 
section 250 of $1,100 and its interest expense of $1,500x. For purposes 
of applying section 904(a), before taking into account any foreign tax 
credit under section 901, USP's Federal income tax liability is 21% of 
$1,200x, or $252x.
    (ii) Application of section 904(b)(4). Under section 904(d)(1), USP 
applies section 904(a) separately to each separate category of income.
    (A) General category income. Before application of section 904(b)(4) 
and the rules in this section, USP's foreign source taxable income in 
the general category is a loss of $200x, which equals $0 (USP's foreign 
source general category income) less $200x (interest expense apportioned 
to general category income), and USP's worldwide taxable income is 
$1,200. Under paragraph (d) of this section, the rules in section 904(f)

[[Page 954]]

and (g) apply after section 904(b)(4) and the rules in this section. 
Under paragraphs (b) and (c)(1) of this section, USP has no deductions 
properly allocable or apportioned to gross income in the section 245A 
subgroup because USP has no dividend income in the general category for 
which a deduction is allowed under section 245A. Under paragraphs (b) 
and (c) of this section, USP has $200x of deductions for interest 
expense that are properly allocable or apportioned to stock of specified 
10-percent owned foreign corporations in the section 245A subgroup 
because USP's only general category assets are the general category 
stock of CFC1, CFC2, and CFC3, all of which are in the section 245A 
subgroup. Therefore, under paragraph (a) of this section, USP's foreign 
source taxable income in the general category and its worldwide taxable 
income are determined without regard to the $200x of deductions for 
interest expense. Accordingly, USP's foreign source taxable income in 
the general category is $0 and its worldwide taxable income is $1,400x, 
and therefore, there is no separate limitation loss for purposes of 
section 904(f). Under section 904(a) and (d)(1) USP's foreign tax credit 
limitation for the general category is $0.
    (B) Section 951A category income. Before application of section 
904(b)(4) and the rules in this section, USP's foreign source taxable 
income in the section 951A category is $700x, which equals $2,200x 
(USP's GILTI inclusion amount) less $1,100x (USP's section 250 
deduction) less $400x (interest apportioned to section 951A category 
income). Under paragraphs (b) and (c)(1) of this section, USP has no 
deductions properly allocable and apportioned to gross income in a 
section 245A subgroup of the section 951A category. Under paragraphs (b) 
and (c) of this section, USP has no deductions properly allocable and 
apportioned to stock of specified 10-percent owned foreign corporations 
in a section 245A subgroup of section 951A category stock because no 
portion of section 951A category stock is assigned to a section 245A 
subgroup. See Sec.  1.861-13(a)(5)(v). Therefore, under paragraph (a) of 
this section no adjustment is made to USP's foreign source taxable 
income in the section 951A category. However, the adjustments to USP's 
worldwide taxable income described in paragraph (e)(2)(ii)(A) of this 
section apply for purposes of calculating USP's foreign tax credit 
limitation for the section 951A category. Accordingly, USP's foreign 
source taxable income in the section 951A category is $700x and its 
worldwide taxable income is $1,400x. Under section 904(a) and (d)(1), 
USP's foreign tax credit limitation for the section 951A category is 
$126x ($252x x $700x/$1,400x).
    (f) Applicability dates. (1) Except as provided in paragraph (f)(2) 
of this section, this section applies to taxable years beginning after 
December 31, 2017.
    (2) Paragraph (d)(2) of this section applies to taxable years ending 
on or after December 16, 2019.

[T.D. 9882, 84 FR 69099, Dec. 17, 2019, as amended by T.D. 9922, 85 FR 
72060, Nov. 12, 2020]



Sec.  1.904(f)-0  Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(f)-1 through 
1.904(f)-8 and 1.904(f)-12.

           Sec.  1.904(f)-0 Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(f)-1 through 
1.904(f)-8 and 1.904(f)-12.

   Sec.  1.904(f)-1 Overall foreign loss and the overall foreign loss 
                                account.

    (a)(1) Overview of regulations.
    (2) Application to post-1986 taxable years.
    (b) Overall foreign loss accounts.
    (c) Determination of a taxpayer's overall foreign loss.
    (1) Overall foreign loss defined.
    (2) Separate limitation defined.
    (3) Method of allocation and apportionment of deductions.
    (d) Additions to the overall foreign loss account.
    (1) General rule.
    (2) Overall foreign losses of another taxpayer.
    (3) Additions to overall foreign loss account created by loss 
carryovers.
    (4) Adjustments for capital gains and losses.
    (e) Reductions of overall foreign loss accounts.
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers.
    (2) Reduction for amounts recaptured.
    (f) Illustrations.
    (g) Effective/applicability date.

[[Page 955]]

          Sec.  1.904(f)-2 Recapture of overall foreign losses.

    (a) In general.
    (b) Determination of taxable income from sources without the United 
States for purposes of recapture.
    (1) In general.
    (c) Section 904(f)(1) recapture.
    (1) In general.
    (2) Election to recapture more of the overall foreign loss than is 
required under paragraph (c)(1).
    (3) Special rule for recapture of losses incurred prior to section 
936 election.
    (4) Recapture of pre-1983 overall foreign losses determined on a 
combined basis.
    (5) Illustrations.
    (d) Recapture of overall foreign losses from dispositions under 
section 904(f)(3).
    (1) In general.
    (2) Treatment of net capital gain.
    (3) Dispositions where gain is recognized irrespective of section 
904(f)(3).
    (i) Foreign source gain.
    (ii) U.S. source gain.
    (4) Dispositions in which gain would not otherwise be recognized.
    (i) Recognition of gain to the extent of the overall foreign loss 
account.
    (ii) Basis adjustment.
    (iii) Recapture of overall foreign loss to the extent of amount 
recognized.
    (iv) Priorities among dispositions in which gain is deemed to be 
recognized.
    (5) Definitions.
    (i) Disposition.
    (ii) Property used in a trade or business.
    (iii) Property used predominantly outside the United States.
    (iv) Property which is a material factor in the realization of 
income.
    (6) Carryover of overall foreign loss accounts in a corporate 
acquisition to which section 381(a) applies.
    (7) Illustrations.
    (e) Effective/applicability.

    Sec.  1.904(f)-4 Recapture of foreign losses out of accumulation 
                   distributions from a foreign trust.

    (a) In general.
    (b) Effect of recapture on foreign tax credit limitation under 
section 667(d).
    (c) Recapture if taxpayer deducts foreign taxes deemed distributed.
    (d) Illustrations.

 Sec.  1.904(f)-5 Special rules for recapture of overall foreign losses 
                          of a domestic trust.

    (a) In general.
    (b) Recapture of trust's overall foreign loss.
    (1) Trust accumulates income.
    (2) Trust distributes income.
    (3) Trust accumulates and distributes income.
    (c) Amounts allocated to beneficiaries.
    (d) Section 904(f)(3) dispositions to which Sec.  1.904(f)-
2(d)(4)(i) is applicable.
    (e) Illustrations.

  Sec.  1.904(f)-6 Transitional rule for recapture of FORI and general 
  limitation overall foreign losses incurred in taxable year beginning 
 before January 1, 1983, from foreign source taxable income subject to 
  the general limitation in taxable years beginning after December 31, 
                                  1982.

    (a) General Rule.
    (b) Recapture of pre-1983 FORI and general limitation overall 
foreign losses from post-1982 income.
    (1) Recapture from income subject to the same limitation.
    (2) Recapture from income subject to the other limitation.
    (c) Coordination of recapture of pre-1983 and post-1982 overall 
foreign losses.
    (d) Illustrations.

 Sec.  1.904(f)-7 Separate limitation loss and the separate limitation 
                              loss account.

    (a) Overview of regulations.
    (b) Definitions.
    (1) Separate category.
    (2) Separate limitation income.
    (3) Separate limitation loss.
    (c) Separate limitation loss account.
    (d) Additions to separate limitation loss accounts.
    (1) General rule.
    (2) Separate limitation losses of another taxpayer.
    (3) Additions to separate limitation loss account created by loss 
carryovers.
    (e) Reductions of separate limitation loss accounts.
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers.
    (2) Reduction for offsetting loss accounts.
    (3) Reduction for amounts recaptured.
    (f) Effective/applicability date.

    Sec.  1.904(f)-8 Recapture of separate limitation loss accounts.

    (a) In general.
    (b) Effect of recharacterization of separate limitation income on 
associated taxes.
    (c) Effective/applicability date.

                   Sec.  1.904(f)-12 Transition rules.

    (a) Recapture in years beginning after December 31, 1986, of overall 
foreign losses incurred in taxable years beginning before January 1, 
1987.
    (1) In general.
    (2) Rule for general limitation losses.
    (i) In general.
    (ii) Exception.
    (3) Priority of recapture of overall foreign losses incurred in pre-
effective date taxable years.
    (4) Examples.

[[Page 956]]

    (b) Treatment of overall foreign losses that are part of net 
operating losses incurred in pre-effective date taxable years which are 
carried forward to post-effective date taxable years.
    (1) Rule.
    (2) Example.
    (c) Treatment of overall foreign losses that are part of net 
operating losses incurred in post-effective date taxable years which are 
carried back to pre-effective date taxable years.
    (1) Allocation to analogous income category.
    (2) Allocation to U.S. source income.
    (3) Allocation to other separate limitation categories.
    (4) Examples.
    (d) Recapture of FORI and general limitation overall foreign losses 
incurred in taxable years beginning before January 1, 1983.
    (e) Recapture of pre-1983 overall foreign losses determined on a 
combined basis.
    (f) Transition rules for taxable years beginning before December 31, 
1990.
    (g) Recapture in years beginning after December 31, 2002, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2003, with respect to the separate category 
for dividends from a noncontrolled section 902 corporation.
    (1) Recapture of separate limitation loss or overall foreign loss in 
a separate category for dividends from a noncontrolled section 902 
corporation.
    (2) Recapture of separate limitation loss in another separate 
category.
    (3) Exception.
    (4) Examples.
    (5) Effective/applicability date.
    (h) Recapture in years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2007.
    (1) Losses related to pre-2007 separate categories for passive 
income, certain dividends from a DISC or former DISC, taxable income 
attributable to certain foreign trade income or certain distributions 
from a FSC or former FSC.
    (i) Recapture of separate limitation loss or overall foreign loss 
incurred in a pre-2007 separate category for passive income, certain 
dividends from a DISC or former DISC, taxable income attributable to 
certain foreign trade income or certain distributions from a FSC or 
former FSC.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for passive income, certain dividends from a DISC 
or former DISC, taxable income attributable to certain foreign trade 
income or certain distributions from a FSC or former FSC.
    (2) Losses related to pre-2007 separate categories for shipping, 
financial services income or general limitation income.
    (i) Recapture of separate limitation loss or overall foreign loss 
incurred in a pre-2007 separate category for shipping income, financial 
services income or general limitation income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for shipping income, financial services income or 
general limitation income.
    (3) Losses related to a pre-2007 separate category for high 
withholding tax interest.
    (i) Recapture of separate limitation loss or overall foreign loss 
incurred in a pre-2007 separate category for high withholding tax 
interest.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for high withholding tax interest.
    (4) Elimination of certain separate limitation loss accounts.
    (5) Alternative method.
    (6) Effective/applicability date.

[T.D. 9371, 72 FR 72596, Dec. 21, 2007; T.D. 9452, 74 FR 27886, June 11, 
2009, T.D. 9521, 76 FR 19273, Apr. 7, 2011; T.D. 9595, 77 FR 37578, June 
22, 2012]



Sec.  1.904(f)-1  Overall foreign loss and the overall foreign loss account.

    (a)(1) Overview of regulations. In general, section 904(f) and these 
regulations apply to any taxpayer that sustains an overall foreign loss 
(as defined in paragraph (c)(1) of this section) in a taxable year 
beginning after December 31, 1975. For taxable years ending after 
December 31, 1984, and beginning before January 1, 1987, there can be 
five types of overall foreign losses: a loss under each of the five 
separate limitations contained in former section 904(d)(1)(A) (passive 
interest limitation), (d)(1)(B) (DISC dividend limitation), (d)(1)(C) 
(foreign trade income limitation), (d)(1)(D) (foreign sales corporation 
(FSC) distributions limitation), and (d)(1)(E) (general limitation). For 
taxable years beginning after December 31, 1982, and ending before 
January 1, 1985, there can be three types of overall foreign losses 
under former section 904(d)(1)(A) (passive interest limitation), former 
section 904(d)(1)(B) (DISC dividend limitation) and former section 
904(d)(1)(C) (general limitation). For taxpayers subject to section 907, 
the post-1982 general limitation overall foreign loss account may be 
further subdivided, as provided in Sec.  1.904(f)-6. For taxable years 
beginning after December 31, 1975, and before January 1, 1983,

[[Page 957]]

taxpayers should have computed overall foreign losses separately under 
the passive interest limitation, the DISC dividend limitation, the 
general limitation, and the section 907(b) (FORI) limitation. However, 
for taxable years beginning after December 31, 1975, and before January 
1, 1983, taxpayers may have computed only two types of overall foreign 
losses: A foreign oil related loss under the FORI limitation and an 
overall foreign loss computed on a combined basis for the passive 
interest limitation, the DISC dividend limitation, and the general 
limitation. A taxpayer that computed overall foreign losses for these 
years on a combined basis will not be required to amend its return to 
recompute such losses on a separate basis. If a taxpayer computed its 
overall foreign losses for these years separately under the passive 
interest limitation, the DISC dividend limitation, and the general 
limitation, on returns previously filed, a taxpayer may not amend those 
returns to compute such overall foreign losses on a combined basis. 
Section 1.904(f)-1 provides rules for determining a taxpayer's overall 
foreign losses, for establishing overall foreign loss accounts, and for 
making additions to and reductions of such accounts for purposes of 
section 904(f). Section 1.904(f)-2 provides rules for recapturing the 
balance in any overall foreign loss account under the general recapture 
rule of section 904(f)(1) and under the special recapture rule of 
section 904(f)(3) when the taxpayer disposes of property used 
predominantly outside the United States in a trade or business. Section 
1.904(f)-3 provides rules for allocating overall foreign losses that are 
part of net operating losses or net capital losses to foreign source 
income in years to which such losses are carried. In addition, Sec.  
1.904(f)-3 provides transition rules for the treatment of net operating 
losses incurred in taxable years beginning after December 31, 1982, and 
carried back to taxable years beginning before January 1, 1983, and of 
net operating losses incurred in taxable years beginning before January 
1, 1983, and carried forward to taxable years beginning after December 
31, 1982. Section 1.904(f)-4 provides rules for recapture out of an 
accumulation distribution of a foreign trust. Section 1.904(f)-5 
provides rules for recapture of overall foreign losses of domestic 
trusts. Section 1.904(f)-6 provides a transition rule for recapturing a 
taxpayer's pre-1983 overall foreign losses under the general limitation 
and the FORI limitation out of taxable income subject to the general 
limitation in taxable years beginning after December 31, 1982. Section 
Sec.  1.1502-9 provides rules concerning the application of these 
regulations to corporations filing consolidated returns.
    (2) Application to post-1986 taxable years. The principles of 
Sec. Sec.  1.904(f)-1 through 1.904(f)-5 shall apply to any overall 
foreign loss sustained in taxable years beginning after December 31, 
1986, modified so as to take into account the effect of statutory 
amendments.
    (b) Overall foreign loss accounts. Any taxpayer that sustains an 
overall foreign loss under paragraph (c) of this section must establish 
an account for such loss. Separate types of overall foreign losses must 
be kept in separate accounts. For taxable years beginning prior to 
January 1, 1983, taxpayers that computed losses on a combined basis in 
accordance with Sec.  1.904(f)-1(c)(1) will keep one overall foreign 
loss account for such overall foreign loss. The balance in each overall 
foreign loss account represents the amount of such overall foreign loss 
subject to recapture by the taxpayer in a given year. From year to year, 
amounts may be added to or subtracted from the balances in such accounts 
as provided in paragraphs (d) and (e) of this section. The taxpayer must 
report the balances (if any) in its overall foreign loss accounts 
annually on a Form 1116 or 1118. Such forms must be filed for each 
taxable year ending after September 24, 1987. The balance in each 
account does not have to be attributed to the year or years in which the 
loss was incurred.
    (c) Determination of a taxpayer's overall foreign loss--(1) Overall 
foreign loss defined. For taxable years beginning after December 31, 
1982, and before January 1, 1987, a taxpayer sustains an overall foreign 
loss in any taxable year in which its gross income from sources without 
the United States subject to a separate limitation (as defined in 
paragraph (c)(2) of this section) is exceeded

[[Page 958]]

by the sum of the deductions properly allocated and apportioned thereto. 
Such losses are to be determined separately in accordance with the 
principles of the separate limitations. Accordingly, income and 
deductions subject to a separate limitation are not to be netted with 
income and deductions subject to another separate limitation for 
purposes of determining the amount of an overall foreign loss. A 
taxpayer may, for example, have an overall foreign loss under the 
general limitation in the same taxable year in which it has taxable 
income under the DISC dividend limitation. The same principles of 
calculating overall foreign losses on a separate limitation basis apply 
for taxable years beginning before January 1, 1983, except that a 
taxpayer shall determine its overall foreign losses on a combined basis, 
except for income subject to the FORI limitation, if the taxpayer filed 
its pre-1983 returns on such basis. Thus, for taxable years beginning 
prior to January 1, 1983, a taxpayer can net income and losses among the 
passive interest limitation, the DISC dividend limitation, and the 
general limitation if the taxpayer calculated its overall foreign losses 
that way at the time. Taxpayers that computed overall foreign losses 
separately under each of the separate limitations on their returns filed 
for taxable years beginning prior to January 1, 1983, may not amend such 
returns to compute their overall foreign losses for pre-1983 years on a 
combined basis.
    (2) Separate limitation defined. For purposes of paragraph (c)(1) of 
this section and these regulations, the term separate limitation means 
any of the separate limitations under former section 904(d)(1)(A) 
(passive interest limitation), (B) (DISC dividend limitation), (C) 
(foreign trade income limitation), (D) (FSC distributions limitation), 
and (E) (general limitation) and the separate limitation under section 
907(b) (FORI limitation) (for taxable years ending after December 31, 
1975, and beginning before January 1, 1983).
    (3) Method of allocation and apportionment of deductions. In 
determining its overall foreign loss, a taxpayer shall allocate and 
apportion expenses, losses, and other deductions to the appropriate 
category of gross income in accordance with section 862(b) and Sec.  
1.861-8 of the regulations. However, the following deductions shall not 
be taken into account:
    (i) The amount of any net operating loss deduction for such year 
under section 172(a); and
    (ii) To the extent such losses are not compensated for by insurance 
or otherwise, the amount of any--
    (A) Expropriation losses for such year (as defined in section 
172(h)), or
    (B) Losses for such year which arise from fire, storm, shipwreck, or 
other casualty, or from theft.
    (d) Additions to the overall foreign loss account--(1) General rule. 
A taxpayer's overall foreign loss as determined under paragraph (c) of 
this section shall be added to the applicable overall foreign loss 
account at the end of its taxable year to the extent that the overall 
foreign loss has reduced United States source income during the taxable 
year or during a year to which the loss has been carried back. For rules 
with respect to carryovers see paragraph (d)(3) of this section and 
Sec.  1.904(f)-3.
    (2) Overall foreign losses of another taxpayer. If any portion of 
any overall foreign loss of another taxpayer is allocated to the 
taxpayer in accordance with Sec.  1.904(f)-5 (relating to overall 
foreign losses of domestic trusts) or Sec.  1.1502-9 (relating to 
consolidated overall foreign losses), the taxpayer shall add such amount 
to its applicable overall foreign loss account.
    (3) Additions to overall foreign loss account created by loss 
carryovers. Subject to the adjustments under Sec.  1.904(f)-1(d)(4), the 
taxpayer shall add to each overall foreign loss account--
    (i) All net operating loss carryovers to the current taxable year 
attributable to the same limitation to the extent that overall foreign 
losses included in the net operating loss carryovers reduced United 
States source income for the taxable year, and
    (ii) All capital loss carryovers to the current taxable year 
attributable to the same limitation to the extent that foreign source 
capital loss carryovers reduced United States source capital gain net 
income for the taxable year.

[[Page 959]]

    (4) Adjustments for capital gains and losses and qualified dividend 
income. If a taxpayer has capital gains or losses or qualified dividend 
income, as defined in section 1(h)(11), the taxpayer shall make 
adjustments to such capital gains and losses and qualified dividend 
income to the extent required under section 904(b)(2) and Sec.  
1.904(b)-1 before applying the provisions of Sec.  1.904(f)-1. See Sec.  
1.904(b)-1(h).
    (e) Reductions of overall foreign loss accounts. The taxpayer shall 
subtract the following amounts from its overall foreign loss accounts at 
the end of its taxable year in the following order, if applicable:
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers. An overall foreign loss account is reduced by the amount of 
any overall foreign loss which is allocated to another taxpayer in 
accordance with Sec.  1.904(f)-5 (relating to overall foreign losses of 
domestic trusts) or Sec.  1.1502-9 (relating to consolidated overall 
foreign losses).
    (2) Reduction for amounts recaptured. An overall foreign loss 
account is reduced by the amount of any foreign source income that is 
subject to the same limitation as the loss that resulted in the account 
and that is recaptured in accordance with Sec.  1.904(f)-2 (c) (relating 
to recapture under section 904(f)(1)); Sec.  1.904(f)-2 (d) (relating to 
recapture when the taxpayer disposes of certain properties under section 
904(f)(3)); and Sec.  1.904(f)-4 (relating to recapture when the 
taxpayer receives an accumulation distribution from a foreign trust 
under section 904(f)(4)).
    (f) Illustrations. The rules of this section are illustrated by the 
following examples.

    Example 1. X Corporation is a domestic corporation with foreign 
branch operations in country C. X's taxable income and losses for its 
taxable year 1983 are as follows:

U.S. Source taxable income........................................$1,000
Foreign source taxable income (loss) subject to the general limitation 
                                                                  ($500)
Foreign source taxable income subject to the passive interest limitation
                                                                    $200

    X has a general limitation overall foreign loss of $500 for 1983 in 
accordance with paragraph (c) (1) of this section. Since the general 
limitation overall foreign loss is not considered to offset income under 
the separate limitation for passive interest income, it therefore 
offsets $500 of United States source taxable income. This amount is 
added to X's general limitation overall foreign loss account at the end 
of 1983 in accordance with paragraphs (c) (1) and (d) (1) of this 
section.
    Example 2. Y Corporation is a domestic corporation with foreign 
branch operations in Country C. Y's taxable income and losses for its 
taxable year 1982 are as follows:

U.S. source taxable income........................................$1,000
Foreign source taxable income (loss) subject to the general limitation 
                                                                  ($500)
Foreign source taxable income subject to the passive interest limitation
                                                                    $250

    For its pre-1983 taxable years, Y filed its returns determining its 
overall foreign losses on a combined basis. In accordance with 
paragraphs (a) and (c) (1) of this section, Y may net the foreign source 
income and loss before offsetting the United States source income. Y 
therefore has a section 904(d)(1)(A-C) overall foreign loss account of 
$250 at the end of 1982.
    Example 3. X Corporation is a domestic corporation with foreign 
branch operations in country C. For its taxable year 1985, X has taxable 
income (loss) determined as follows:

U.S. source taxable income..........................................$200
Foreign source taxable income (loss) subject to the general limitation 
                                                                ($1,000)
Foreign source taxable income (loss) subject to the passive limitation 
                                                                  $1,800

    X has a general limitation overall foreign loss of $1,000 in 
accordance with paragraph (c)(1) of this section. The overall foreign 
loss offsets $200 of United States source taxable income in 1985 and, 
therefore, X has a $200 general limitation overall foreign loss account 
at the end of 1985. The remaining $800 general limitation loss is offset 
by the passive interest limitation income in 1985 so that X has no net 
operating loss carryover that is attributable to the general limitation 
loss and no additional amount attributable to that loss will be added to 
the overall foreign loss account in 1985 or in any other year.
    (g) Effective/applicability date. Paragraphs (a)(2) and (d)(4) of 
this section shall apply to taxable years beginning on or after January 
1, 2012. Taxpayers may choose to apply paragraphs (a)(2) and (d)(4) of 
this section to other taxable years beginning after December 21, 2007, 
including periods covered by 26

[[Page 960]]

CFR 1.904(f)-1T (revised as of April 1, 2010).

[T.D. 8153, 52 FR 31994, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987, as 
amended by T.D. 9371, 72 FR 72597, Dec. 21, 2007; T.D. 9595, 77 FR 
37578, June 22, 2012]



Sec.  1.904(f)-2  Recapture of overall foreign losses.

    (a) In general. A taxpayer shall be required to recapture an overall 
foreign loss as provided in this section. Recapture is accomplished by 
treating as United States source income a portion of the taxpayer's 
foreign source taxable income of the same limitation as the foreign 
source loss that resulted in an overall foreign loss account. As a 
result, if the taxpayer elects the benefits of section 901 or section 
936, the taxpayer's foreign tax credit limitation with respect to such 
income is decreased. As provided in Sec.  1.904 (f)-1(e)(2), the balance 
in a taxpayer's overall foreign loss account is reduced by the amount of 
loss recaptured. Recapture continues until such time as the amount of 
foreign source taxable income recharacterized as United States source 
income equals the amount in the overall foreign loss account. As 
provided in Sec.  1.904 (f)-1(e)(2), the balance in an overall foreign 
loss account is reduced at the end of each taxable year by the amount of 
the loss recaptured during that taxable year. Regardless of whether 
recapture occurs in a year in which a taxpayer elects the benefits of 
section 901 or in a year in which a taxpayer deducts its foreign taxes 
under section 164, the overall foreign loss account is recaptured only 
to the extent of foreign source taxable income remaining after applying 
the appropriate section 904(b) adjustments, if any, as provided in 
paragraph (b) of this section.
    (b) Determination of taxable income from sources without the United 
States for purposes of recapture--(1) In general. For purposes of 
determining the amount of an overall foreign loss subject to recapture, 
the taxpayer's taxable income from sources without the United States 
shall be computed with respect to each of the separate limitations 
described in Sec.  1.904 (f)-1(c)(2) in accordance with the rules set 
forth in Sec.  1.904 (f)-1(c) (1) and (3). This computation is made 
without taking into account foreign source taxable income (and 
deductions properly allocated and apportioned thereto) subject to other 
separate limitations. Before applying the recapture rules to foreign 
source taxable income, the following provisions shall be applied to such 
income in the following order:
    (i) Former section 904(b)(3)(C) (prior to its removal by the Tax 
Reform Act of 1986) and the regulations thereunder shall be applied to 
treat certain foreign source gain as United States source gain; and
    (ii) Section 904(b)(2) and the regulations thereunder shall be 
applied to make adjustments in the foreign tax credit limitation 
fraction for certain capital gains and losses.
    (c) Section 904(f)(1) recapture--(1) In general. In a taxable year 
in which a taxpayer elects the benefits of section 901 or section 30A, 
the section 904(f)(1) recapture amount is the amount of foreign source 
taxable income subject to recharacterization in a taxable year in which 
recapture of an overall foreign loss is required under paragraph (a) of 
this section. The section 904(f)(1) recapture amount equals the lesser 
of the aggregate amount of maximum potential recapture in all overall 
foreign loss accounts or fifty percent of the taxpayer's total foreign 
source taxable income. If the aggregate amount of maximum potential 
recapture in all overall foreign loss accounts exceeds fifty percent of 
the taxpayer's total foreign source taxable income, foreign source 
taxable income in each separate category with an overall foreign loss 
account is recharacterized in an amount equal to the section 904(f)(1) 
recapture amount, multiplied by the maximum potential recapture in the 
overall foreign loss account, divided by the aggregate amount of maximum 
potential recapture in all overall foreign loss accounts. The maximum 
potential recapture in an overall foreign loss account in a separate 
category is the lesser of the balance in that overall foreign loss 
account or the foreign source taxable income for the year in the same 
separate category as the loss account. If, in any taxable year, in 
accordance with sections 164(a) and 275(a)(4)(A), a taxpayer deducts 
rather than credits its

[[Page 961]]

foreign taxes, recapture is applied to the extent of the lesser of--
    (i) The balance in the overall foreign loss account in each separate 
category; or
    (ii) Foreign source taxable income (net of foreign taxes) in each 
separate category.
    (2) Election to recapture more of the overall foreign loss than is 
required under paragraph (c)(1). In a year in which a taxpayer elects 
the benefits of sections 901 or 936, a taxpayer may make an annual 
revocable election to recapture a greater portion of the balance in an 
overall foreign loss account than is required to be recaptured under 
paragraph (c)(1) of this section. A taxpayer may make such an election 
or amend a prior election by attaching a statement to its annual Form 
1116 or 1118. If an amendment is made to a prior year's election, an 
amended tax return should be filed. The statement attached to the Form 
1116 or 1118 must indicate the percentage and dollar amount of the 
taxpayer's foreign source taxable income that is being recharacterized 
as United States source income and the percentage and dollar amount of 
the balance (both before and after recapture) in the overall foreign 
loss account that is being recaptured. Except for the special recapture 
rules for section 936 corporations and for recapture of pre-1983 overall 
foreign losses determined on a combined basis, the taxpayer that elects 
to credit its foreign taxes may not elect to recapture an amount in 
excess of the taxpayer's foreign source taxable income subject to the 
same limitation as the loss that resulted in the overall foreign loss 
account.
    (3) Special rule for recapture of losses incurred prior to section 
936 election. If a corporation elects the application of section 936 and 
at the time of the election has a balance in any overall foreign loss 
account, such losses will be recaptured from the possessions source 
income of the electing section 936 corporation that qualifies for the 
section 936 credit, including qualified possession source investment 
income as defined in section 936(d)(2), even though the overall foreign 
loss to be recaptured may not be attributable to a loss in an income 
category of a type that would meet the definition of qualified 
possession source investment income. For purposes of recapturing an 
overall foreign loss incurred by a consolidated group including a 
corporation that subsequently elects to use section 936, the electing 
section 936 corporation's possession source income that qualifies for 
the section 936 credit, including qualified possession source investment 
income, shall be used to recapture the section 936 corporation's share 
of previously incurred overall foreign loss accounts. Rules for 
determining the section 936 corporation's share of the consolidated 
groups overall foreign loss accounts are provided in Sec.  1.1502-9(c).
    (4) Recapture of pre-1983 overall foreign losses determined on a 
combined basis. If a taxpayer computed its overall foreign losses on a 
combined basis in accordance with Sec.  1.904(f)-1(c)(1) for taxable 
years beginning before January 1, 1983, any losses recaptured in taxable 
years beginning after December 31, 1982, shall be recaptured from income 
subject to the general limitation, subject to the rules in Sec.  
1.904(f)-6 (a) and (b). Ordering rules for recapture of these losses are 
provided in Sec.  1.904(f)-6(c).
    (5) Illustrations. The rules of this paragraph (c) are illustrated 
by the following examples, all of which assume a United States corporate 
tax rate of 50 percent unless otherwise stated.

    Example 1. X Corporation is a domestic corporation that does 
business in the United States and abroad. On December 31, 1983, the 
balance in X's general limitation overall foreign loss account is $600, 
all of which is attributable to a loss incurred in 1983. For 1984, X has 
United States source taxable income of $500 and foreign source taxable 
income subject to the general limitation of $500. For 1984, X pays $200 
in foreign taxes and elects section 901. Under paragraph (c)(1) of this 
section, X is required to recapture $250 (the lesser of $600 or 50 
percent of $500) of its overall foreign loss. As a consequence, X's 
foreign tax credit limitation under the general limitation is $250/
$1,000 x $500, or $125, instead of $500/$1,000 x $500, or $250. The 
balance in X's general limitation overall foreign loss account is 
reduced by $250 in accordance with Sec.  1.904(f)-1(e)(2).
    Example 2. The facts are the same as in example 1 except that X 
makes an election to recapture its overall foreign loss to the extent of 
80 percent of its foreign source taxable income subject to the general 
limitation (or $400) in accordance with paragraph (c)(2) of this 
section. As a result of recapture,

[[Page 962]]

X's 1984 foreign tax credit limitation for income subject to the general 
limitation is $100/$1,000 x $500, or $50, instead of $500/$1,000 x $500, 
or $250. X's general limitation overall foreign loss account is reduced 
by $400 in accordance with Sec.  1.904(f)-1(e)(2).
    Example 3. The facts are the same as in example 1 except that X does 
not elect the benefits of section 901 in 1984 and instead deducts its 
foreign taxes paid. In 1984, X recaptures $300 of its overall foreign 
loss, the difference between X's foreign source taxable income of $500 
and $200 of foreign taxes paid. The balance in X's general limitation 
overall foreign loss account is reduced by $300 in accordance with Sec.  
1.904(f)-1(e)(2).
    Example 4. Y Corporation is a domestic corporation that does 
business in the United States and abroad. On December 31, 2007, the 
balance in Y's general category overall foreign loss account is $500, 
all of which is attributable to a loss incurred in 2007. Y has no other 
loss accounts subject to recapture. For 2008, Y has U.S. source taxable 
income of $400 and foreign source taxable income of $300 in the general 
category and $900 in the passive category. Under paragraph (c)(1) of 
this section, the amount of Y's general category income subject to 
recharacterization is the lesser of the aggregate maximum potential 
recapture or 50% of the total foreign source taxable income. In this 
case, Y's aggregate maximum potential recapture is $300 (the lesser of 
the $500 balance in the general category overall foreign loss account or 
$300 foreign source income in the general category for the year), which 
is less than 50% of Y's total foreign source taxable income ($1200 x 50% 
= $600). Therefore, pursuant to paragraph (c) of this section, $300 of 
foreign source income in the general category is recharacterized as U.S. 
source income. The balance in Y's general category overall foreign loss 
account is reduced to $200 in accordance with Sec.  1.904(f)-1(e)(2).
    Example 5. On December 31, 1980, V, a domestic corporation that does 
business in the United States and abroad, has a balance in its section 
904(d)(1)(A-C) overall foreign loss account of $600. V also has a 
balance in its FORI limitation overall foreign loss account of $900. For 
1981, V has foreign source taxable income subject to the general 
limitation of $500 and $500 of United States source income. V also has 
foreign source taxable income subject to the FORI limitation of $800. V 
is required to recapture $250 of its section 904(d)(1)(A-C) overall 
foreign loss account (the lesser of $600 or 50% of $500) and its general 
limitation foreign tax credit limitation is $250/$1,800 x $900, or $125 
instead of $500/$1,800 x $900, or $250. V is also required to recapture 
$400 of its FORI limitation overall foreign loss account (the lesser of 
$900 or 50% of $800). V's foreign tax credit limitation for FORI is 
$400/$1,800 x $900, or $200, instead of $800/$1,800 x $900, or $400. The 
balance in V's FORI limitation overall foreign loss account is reduced 
to $500 and the balance in V's section 904(d)(1)(A-C) account is reduced 
to $350, in accordance with Sec.  1.904(f)-1(e)(2).
    Example 6. This example assumes a United States corporate tax rate 
of 46 percent (under section 11(b)) and an alternative rate of tax under 
section 1201(a) of 28 percent. W is a domestic corporation that does 
business in the United States and abroad. On December 31, 1984, W has 
$350 in its general limitation overall foreign loss account. For 1985, W 
has $500 of United States source taxable income, and has foreign source 
income subject to the general limitation as follows:

Foreign source taxable income other than net capital gain........   $720
Foreign source net capital gain..................................   $460
 

    Under paragraph (b)(2) of this section, foreign source taxable 
income for purposes of recapture includes foreign source capital gain 
net income, reduced, under section 904(b)(2), by the rate differential 
portion of foreign source net capital gain, which adjusts for the 
reduced tax rate for net capital gain under section 1201(a):

Foreign source capital gain net income.........................     $460
Rate differential portion of foreign source net capital gain        -180
 (18/46 of $460)...............................................
                                                                --------
Foreign source capital gain included in foreign source taxable      $280
 income........................................................
 

    The total foreign source taxable income of W for purposes of 
recapture in 1985 is $1,000 ($720 + $280). Under paragraph (c)(1) of 
this section, W is required to recapture $350 (the lesser of $350 or 50 
percent of $1,000), and W's general limitation overall foreign loss 
account is reduced to zero. W's foreign tax credit limitation for income 
subject to the general limitation is $650/$1,500 x $690 ((.46) (500 + 
720) + (.28) (460)), or $299, instead of $1,000/$1,500 x $690, or $460.
    (d) Recapture of overall foreign losses from dispositions under 
section 904(f)(3)-- (1) In general. If a taxpayer disposes of property 
used or held for use predominantly without the United States in a trade 
or business during a taxable year and that property generates foreign 
source taxable income subject to a separate limitation to which 
paragraph (a) of this section applies, the applicable overall foreign 
loss account shall be recaptured as provided in paragraphs (d)(2), 
(d)(3), and (d)(4) of this section. See paragraph (d)(5) of this section 
for definitions. See the ordering rules under Sec.  1.904(g)-3(f) and 
(i) for coordination with other loss recapture under section 904(f) and 
(g).
    (2) Treatment of net capital gain. If the gain from a disposition of 
property to which this paragraph (d) applies is

[[Page 963]]

treated as net capital gain, all references to such gain in paragraphs 
(d)(3) and (d)(4) of this section shall mean such gain as adjusted under 
paragraph (b) of this section. The amount by which the overall foreign 
loss account shall be reduced shall be determined from such adjusted 
gain.
    (3) Dispositions where gain is recognized irrespective of section 
904 (f)(3)--(i) Foreign source gain. If a taxpayer recognizes foreign 
source gain in a separate category on the disposition of property 
described in paragraph (d)(1) of this section, and there is a balance in 
a taxpayer's overall foreign loss account that is attributable to a loss 
in such separate category after applying paragraph (c) of this section, 
an additional portion of such balance shall be recaptured in accordance 
with paragraphs (a) and (b) of this section. The amount recaptured shall 
be the lesser of such balance or the full amount of the foreign source 
gain recognized on the disposition that was not previously 
recharacterized.
    (ii) U.S. source gain. If a taxpayer recognizes U.S. source gain on 
the disposition of property described in paragraph (d)(1) of this 
section, and there is a balance in a taxpayer's overall foreign loss 
account that is attributable to a loss in the separate category to which 
the income generated by such property is assigned after applying 
paragraph (c) of this section, an amount of the gain shall be treated as 
foreign source and an additional portion of such balance equal to that 
amount shall be recaptured in accordance with paragraphs (a) and (b) of 
this section. The amount of gain treated as foreign source and the 
amount of overall foreign loss recaptured shall be the lesser of the 
balance in the overall foreign loss account or the full amount of the 
gain recognized on the disposition.
    (4) Dispositions in which gain would not otherwise be recognized--
(1) Recognition of gain to the extent of the overall foreign loss 
account. If a taxpayer makes a disposition of property described in 
paragraph (d)(1) of this section in which any amount of gain otherwise 
would not be recognized in the year of the disposition, and such 
property was used or held for use to generate foreign source taxable 
income subject to a separate limitation under which the taxpayer had a 
balance in its overall foreign loss account (including a balance that 
arose in the year of the disposition), the taxpayer shall recognize 
foreign source taxable income in an amount equal to the lesser of:
    (A) The sum of the balance in the applicable overall foreign loss 
account (but only after such balance has been increased by amounts added 
to the account for the year of the disposition or has been reduced by 
amounts recaptured for the year of the disposition under paragraph (c) 
and paragraph (d)(3) of this section) plus the amount of any overall 
foreign loss that would be part of a net operating loss for the year of 
the disposition if gain from the disposition were not recognized under 
section 904(f)(3), plus the amount of any overall foreign loss that is 
part of a net operating loss carryover from a prior year, or
    (B) The excess of the fair market value of such property over the 
taxpayer's adjusted basis in such property.


The excess of the fair market value of such property over its adjusted 
basis shall be determined on an asset by asset basis. Losses from the 
disposition of an asset shall not be recognized. Any foreign source 
taxable income deemed received and recognized under this paragraph 
(d)(4)(i) will have the same character as if the property had been sold 
or exchanged in a taxable transaction and will constitute gain for all 
purposes.
    (ii) Basis adjustment. The basis of the property received in an 
exchange to which this paragraph (d)(4) applies shall be increased by 
the amount of gain deemed recognized, in accordance with applicable 
sections of subchapters C (relating to corporate distributions and 
adjustments), K (relating to partners and partnerships), O (relating to 
gain or loss on the disposition of property), and P (relating to capital 
gains and losses). If the property to which this paragraph (d)(4) 
applies was transferred by gift, the basis of such property in the hands 
of the donor immediately preceding such gift shall be increased by the 
amount of the gain deemed recognized.

[[Page 964]]

    (iii) Recapture of overall foreign loss to the extent of amount 
recognized. The provisions of paragraphs (a) and (b) of this section 
shall be applied to the extent of 100 percent of the foreign source 
taxable income which is recognized under paragraph (d)(4)(i) of this 
section. However, amounts of foreign source gain that would not be 
recognized except by application of section 904(f)(3) and paragraph 
(d)(4)(i) of this section, and which are treated as United States source 
gain by application of section 904(b)(3)(C) (prior to its removal by the 
Tax Reform Act of 1986) and paragraph (b)(1) of this section, shall 
reduce the overall foreign loss account (subject to the adjustments 
described in paragraph (d)(2) of this section) if such gain is net 
capital gain, notwithstanding the fact that such amounts would otherwise 
not be recaptured under the ordering rules in paragraph (b) of this 
section.
    (iv) Priorities among dispositions in which gain is deemed to be 
recognized. If, in a single taxable year, a taxpayer makes more than one 
disposition to which this paragraph (d)(4) is applicable, the rules of 
this paragraph (d)(4) shall be applied to each disposition in succession 
starting with the disposition which occurred earliest, until the balance 
in the applicable overall foreign loss account is reduced to zero. If 
the taxpayer simultaneously makes more than one disposition to which 
this paragraph (d)(4) is applicable, the rules of paragraph (d)(4) shall 
be applied so that the balance in the applicable overall foreign loss 
account to be recaptured will be allocated pro rata among the assets in 
proportion to the excess of the fair market value of each asset over the 
adjusted basis of each asset.
    (5) Definitions--(i) Disposition. A disposition to which this 
paragraph (d) applies includes a sale; exchange; distribution; gift; 
transfer upon the foreclosure of a security interest (but not a mere 
transfer of title to a creditor upon creation of a security interest or 
to a debtor upon termination of a security interest); involuntary 
conversion; contribution to a partnership, trust, or corporation; 
transfer at death; or any other transfer of property whether or not gain 
or loss is recognized under other provisions of the Code. However, a 
disposition to which this paragraph (d) applies does not include:
    (A) A distribution or transfer of property to a domestic corporation 
described in section 381 (a) (provided that paragraph (d)(6) of this 
section applies);
    (B) A disposition of property which is not a material factor in the 
realization of income by the taxpayer (as defined in paragraph 
(d)(5)(iv) of this section);
    (C) A transaction in which gross income is not realized; or
    (D) The entering into of a unitization or pooling agreement (as 
defined in Sec.  1.614-8(b)(6) of the regulations) containing a valid 
election under section 761(a)(2), and in which the source of the entire 
gain from any disposition of the interest created by the agreement would 
be determined to be foreign source under section 862(a)(5) if the 
disposition occurred presently.
    (ii) Property used in a trade or business. Property is used in a 
trade or business if it is held for the principal purpose of promoting 
the present or future conduct of the trade or business. This generally 
includes property acquired and held in the ordinary course of a trade or 
business or otherwise held in a direct relationship to a trade or 
business. In determining whether an asset is held in a direct 
relationship to a trade or business, principal consideration shall be 
given to whether the asset is used in the trade or business. Property 
will be treated as held in a direct relationship to a trade or business 
if the property was acquired with funds generated by that trade or 
business or if income generated from the asset is available for use in 
that trade or business. Property used in a trade or business may be 
tangible or intangible, real or personal property. It includes property, 
such as equipment, which is subject to an allowance for depreciation 
under section 167 or cost recovery under section 168. Property may be 
considered used in a trade or business even if it is a capital asset in 
the hands of the taxpayer. However, stock of another corporation shall 
not be considered property used in a trade or business if a substantial 
investment motive exists for acquiring and holding the stock. On the 
other hand, stock acquired or held to assure a source of

[[Page 965]]

supply for a trade or business shall be considered property used in that 
trade or business. Inventory is generally not considered property used 
in a trade or business. However, when disposed of in a manner not in the 
ordinary course of a trade or business, inventory will be considered 
property used in the trade or business. A partnership interest will be 
treated as property used in a trade or business if the underlying assets 
of the partnership would be property used in a trade or business. For 
purposes of section 904(f) (3) and Sec.  1.904(f)-2 (d) (1) and (5), a 
disposition of a partnership interest to which this section applies will 
be treated as a disposition of a proportionate share of each of the 
assets of the partnership. For purposes of allocating the purchase price 
of the interest and the seller's basis in the interest to those assets, 
the principles of Sec.  1.751-1(a) will apply.
    (iii) Property used predominantly outside the United States. 
Property will be considered used predominantly outside the United States 
if for a 3-year period ending on the date of the disposition (or, if 
shorter, the period during which the property has been used in the trade 
or business) such property was located outside the United States more 
than 50 percent of the time. An aircraft, railroad rolling stock, 
vessel, motor vehicle, container, or other property used for 
transportation purposes is deemed to be used predominantly outside the 
United States if, during the 3-year (or shorter) period, either such 
property is located outside the United States more than 50 percent of 
the time or more than 50 percent of the miles traversed in the use of 
such property are traversed outside the United States.
    (iv) Property which is a material factor in the realization of 
income. For purposes of this section, property used in a trade or 
business will be considered a material factor in the realization of 
income unless the taxpayer establishes that it is not (or, if the 
taxpayer did not realize income from the trade or business in the 
taxable year, would not be expected to be) necessary to the realization 
of income by the taxpayer.
    (6) Carryover of overall foreign loss accounts in a corporate 
acquisition to which section 381(a) applies. In the case of a 
distribution or transfer described in section 381(a), an overall foreign 
loss account of the distributing or transferor corporation shall be 
treated as an overall foreign loss account of the acquiring or 
transferee corporation as of the close of the date of the distribution 
or transfer. If the transferee corporation had an overall foreign loss 
account under the same separate limitation prior to the distribution or 
transfer, the balance in the transferor's account must be added to the 
transferee's account. If not, the transferee must adopt the transferor's 
overall foreign loss account. An overall foreign loss of the transferor 
will be treated as incurred by the transferee in the year prior to the 
year of the transfer.
    (7) Illustrations. The rules of this paragraph (d) are illustrated 
by the following examples which assume that the United States corporate 
tax rate is 50 percent (unless otherwise stated). For purposes of these 
examples, none of the foreign source gains are treated as net capital 
gains (unless so stated).

    Example 1. X Corporation has a balance in its general limitation 
overall foreign loss account of $600 at the close of its taxable year 
ending December 31, 1984. In 1985, X sells assets used predominantly 
outside the United States in a trade or business and recognizes $1,000 
of gain on the sale under section 1001. This gain is subject to the 
general limitation. This sale is a disposition within the meaning of 
paragraph (d)(5)(i) of this section, and to which this paragraph (d) 
applies. X has no other foreign source taxable income in 1985 and has 
$1,000 of United States source taxable income. Under paragraph (c), X is 
required to recapture $500 (the lesser of the balance in X's general 
limitation overall foreign loss account ($600) or 50 percent of $1,000) 
of its overall foreign loss account. The balance in X's general 
limitation overall foreign loss account is reduced to $100 in accordance 
with Sec.  1.904(f)-1(e)(2). In addition, under paragraph (d)(3) of this 
section, X is required to recapture $100 (the lesser of the remaining 
balance in its general limitation overall foreign loss account ($100) or 
100 percent of its foreign source taxable income recognized on such 
disposition that has not been previously recharacterized ($500)). The 
total amount recaptured is $600. X's foreign tax credit limitation for 
income subject to the general limitation in 1985 is $200 ($400/$2,000 x 
$1,000) instead of $500 ($1,000/$2,000 x $1,000). The balance in X's 
general limitation overall foreign loss account is reduced to zero in 
accordance with Sec.  1.904(f)-1(e)(2).

[[Page 966]]

    Example 2. On December 31, 1984, Y Corporation has a balance in its 
general limitation overall foreign loss account of $1,500. In 1985, Y 
has $500 of United States source taxable income and $200 of foreign 
source taxable income subject to the general limitation. Y's foreign 
source taxable income is from the sale of property used predominantly 
outside of the United States in a trade or business. This sale is a 
disposition to which this paragraph (d) is applicable. In 1985, Y also 
transferred property used predominantly outside of the United States in 
a trade or business to another corporation. Under section 351, no gain 
was recognized on this transfer. Such property had been used to generate 
foreign source taxable income subject to the general limitation. The 
excess of the fair market value of the property transferred over Y's 
adjusted basis in such property was $2,000. In accordance with paragraph 
(c) of this section, Y is required to recapture $100 (the lesser of 
$1,500, the amount in Y's general limitation overall foreign loss 
account, or 50 percent of $200, the amount of general limitation foreign 
source taxable income for the current year) of its general limitation 
overall foreign loss. Y is then required to recapture an additional $100 
of its general limitation overall foreign loss account under paragraph 
(d)(3) of this section out of the remaining gain recognized on the sale 
of assets, because 100 percent of such gain is subject to recapture. The 
balance in Y's general limitation overall foreign loss account is 
reduced to $1,300 in accordance with Sec.  1.904(f)-1(e)(2). Y 
corporation is then required to recognize $1,300 of foreign source 
taxable income on its section 351 transfer under paragraph (d)(4) of 
this section. The remaining $700 of potential gain associated with the 
section 351 transfer is not recognized. Under paragraph (d)(4), 100 
percent of the $1,300 is recharacterized as United States source taxable 
income, and Y's general limitation overall foreign loss account is 
reduced to zero. Y's entire taxable income for 1985 is:

U.S. source taxable income.................................         $500
Foreign source taxable income subject to the general                 200
 limitation that is recharacterized as U.S. source income
 by paragraphs (c) and (d)(3) of this section..............
Gain recognized under section 904(f)(3) and paragraph              1,300
 (d)(4) of this section, and recharacterized as U.S. source
 income....................................................
                                                            ------------
    Total..................................................       $2,000
 


Y's foreign tax credit limitation for 1985 for income subject to the 
general limitation is $0 ($0/$2,000 x $1,000) instead of $100 ($200/$700 
x $350).
    Example 3. W Corporation is a calendar year domestic corporation 
with foreign branch operations in country C. As of December 31, 1984, W 
has no overall foreign loss accounts and has no net operating loss 
carryovers. W's entire taxable income in 1985 is:

U.S. source taxable income.................................         $800
Foreign source taxable income (loss) subject to the general     ($1,000)
 limitation................................................
 


W cannot carry back its 1985 NOL to any earlier year. As of December 31, 
1985, W therefore has $800 in its general limitation overall foreign 
loss account. In 1986, W earns $400 United States source taxable income 
and has an additional $1,000 loss from the operations of the foreign 
branch. Income in the loss category would be subject to the general 
limitation. Also in 1986, W disposes of property used predominately 
outside the United States in a trade or business. Such property 
generated income subject to the general limitation. The excess of the 
property's fair market value over its adjusted basis is $3,000. The 
disposition is of a type described in Sec.  1.904 (f)-2(d)(4)(i). W has 
no other income in 1986. Under Sec.  1.904 (f)-2(d)(4)(i), W is required 
to recognize foreign source taxable income on the disposition in an 
amount equal to the lesser of $2,000 ($800 (the balance in the general 
limitation overall foreign loss account as of 1985) + $400 (the increase 
in the general limitation overall foreign loss account attributable to 
the disposition year) + $600 (the general limitation overall foreign 
loss that is part of the NOL from 1986) + $200 (the general limitation 
overall foreign loss that is part of the NOL from 1985)) or $3,000. The 
$2,000 foreign source income required to be recognized under section 
904(f)(3) is reduced to $1,200 by the remaining $600 loss in 1986 and 
the $200 net operating loss carried forward from 1985. This $1,200 of 
income is subject to the general limitation. In computing foreign tax 
credit limitation for general limitation income, the $1,200 of foreign 
source income is treated as United States source income and, therefore, 
W's foreign tax credit limitation for income subject to the general 
limitation is zero. W's overall foreign loss account is reduced to zero.
    Example 4. Z Corporation has a balance in its FORI overall foreign 
loss account of $1,500 at the end of its taxable year 1980. In 1981, Z 
has $1,600 of foreign oil related income subject to the separate 
limitation for FORI income and no United States source income. In 
addition, in 1981, Z makes two dispositions of property used 
predominantly outside the United States in a trade or business on which 
no gain was recognized. Such property generated foreign oil related 
income. The excess of the fair market value of the property transferred 
in the first disposition over Z's adjusted basis in such property is 
$575. The excess of the fair market value of

[[Page 967]]

the property transferred in the second disposition over Z's adjusted 
basis in such property is $1,000. Under paragraph (c) of this section, Z 
is required to recapture $800 (the lesser of 50 percent of its foreign 
oil related income of $1,600 or the balance ($1,500) in its FORI overall 
foreign loss account) of its foreign oil related loss. In accordance 
with paragraphs (d)(4) (i) and (iv) of this section, Z is required to 
recognize foreign oil related income in the amount of $575 on the first 
disposition and, since the foreign oil related loss account is now 
reduced by $1,375 (the $800 and $575 amounts previously recaptured), Z 
is required to recognize foreign oil related income in the amount of 
$125 on the second disposition. In accordance with paragraph (d)(4)(iii) 
of this section, the entire amount recognized is treated as United 
States source income and the balance in the FORI overall foreign loss 
account is reduced to zero under Sec.  1.904 (f)-1 (e)(2). Z's foreign 
tax credit limitation for FORI is $400 ($800/$2,300 x $1,150) instead of 
$800 ($1,600/$1,600 x $800).
    Example 5. The facts are the same as in example 4, except that the 
gain from the two dispositions of property is treated as net capital 
gain and the United States corporate tax rate is assumed to be 46 
percent. As in example 4, Z is required to recapture $800 of its foreign 
oil related loss from its 1981 ordinary foreign oil related income. In 
accordance with paragraph (d)(4) (i) and (iv) of this section, Z is 
first required to recognize foreign oil related income (which is net 
capital gain) on the first disposition in the amount of $575. Under 
paragraphs (b) and (d) (2) of this section, this net capital gain is 
adjusted by subtracting the rate differential portion of such gain from 
the total amount of such gain to determine the amount by which the 
foreign oil related loss account is reduced, which is $350 ($575- ($575 
x 18/46)). The balance remaining in Z's foreign oil related loss account 
after this step is $350. Therefore, this process will be repeated, in 
accordance with paragraph (d)(4)(iv) of this section, to recapture that 
remaining balance out of the gain deemed recognized on the second 
disposition, resulting in reduction of the foreign oil related loss 
account to zero and net capital gain required to be recognized from the 
second disposition in the amount of $575, which must also be adjusted by 
subtracting the rate differential portion to determine the amount by 
which the foreign oil related loss account is reduced (which is $350). 
The $575 of net capital gain from each disposition is recharacterized as 
United States source net capital gain. Z's section 907 (b) foreign tax 
credit limitation is the same as in example 4, and Z has $1,150 ($575 + 
$575) of United States source net capital gain.
    (e) Effective/applicability date. Paragraphs (c)(1), (c)(5) Example 
4, (d)(1), and (d)(3) of this section shall apply to taxable years 
beginning on or after January 1, 2012. Taxpayers may choose to apply 
paragraphs (c)(1), (c)(5) Example 4, (d)(1), and (d)(3) of this section 
to other taxable years beginning after December 21, 2007, including 
periods covered by 26 CFR 1.904(f)-2T (revised as of April 1, 2010).

[T.D. 8153, 52 FR 31997, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987, as 
amended by T.D. 9371, 72 FR 72597, Dec. 21, 2007; T.D. 9595, 77 FR 
37578, June 22, 2012]



Sec.  1.904(f)-3  Allocation of net operating losses and net capital losses.

    For rules relating to the allocation of net operating losses and net 
capital losses, see Sec.  1.904(g)-3T.

[T.D. 9371, 72 FR 72598, Dec. 21, 2007]



Sec.  1.904(f)-4  Recapture of foreign losses out of accumulation 
distributions from a foreign trust.

    (a) In general. If a taxpayer receives a distribution of foreign 
source taxable income subject to a separate limitation in which the 
taxpayer had a balance in an overall foreign loss account and that 
income is treated under section 666 as having been distributed by a 
foreign trust in a preceding taxable year, a portion of the balance in 
the taxpayer's applicable overall foreign loss account shall be subject 
to recapture under this section. The amount subject to recapture shall 
be the lesser of the balance in the taxpayer's overall foreign loss 
account (after applying Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 
and 1.904(f)-6 to the taxpayer's other income or loss in the current 
taxable year) or the entire amount of foreign source taxable income 
deemed distributed in a preceding year or years under section 666.
    (b) Effect of recapture on foreign tax credit limitation under 
section 667(d). If paragraph (a) of this section is applicable, then in 
applying the separate limitation (in accordance with section 667(d)(1) 
(A) and (C)) to determine the amount of foreign taxes deemed distributed 
under section 666 (b) and (c) that can be credited against the increase 
in tax in a computation year, a portion of the foreign source taxable 
income deemed distributed in such computation year shall be treated as

[[Page 968]]

United States source income. Such portion shall be determined by 
multiplying the amount of foreign source taxable income deemed 
distributed in the computation year by a fraction. The numerator of this 
fraction is the balance in the taxpayer's overall foreign loss account 
(after application of Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, and 
1.904(f)-6), and the denominator of the fraction is the entire amount of 
foreign source taxable income deemed distributed under section 666. 
However, the numerator of this fraction shall not exceed the denominator 
of the fraction.
    (c) Recapture if taxpayer deducts foreign taxes deemed distributed. 
If paragraph (a) of this section is applicable and if, in accordance 
with section 667(d)(1)(B), the beneficiary deducted rather than credited 
its taxes in the computation year, the beneficiary shall reduce its 
overall foreign loss account (but not below zero) by an amount equal to 
the lesser of the balance in the applicable overall foreign loss account 
or the amount of the actual distribution deemed distributed in the 
computation year (without regard to the foreign taxes deemed 
distributed).
    (d) Illustrations. The provisions of this section are illustrated by 
the following examples:

    Example 1. X Corporation is a domestic corporation that has a 
balance of $10,000 in its general limitation overall foreign loss 
account on December 31, 1980. For its taxable year beginning January 1, 
1981, X's only income is an accumulation distribution from a foreign 
trust of $20,000 of general limitation foreign source taxable income. 
Under section 666, the amount distributed and the foreign taxes paid on 
such amount ($4,000) are deemed distributed in two prior taxable years. 
In determining the partial tax on such distribution under section 
667(b), the amount added to each computation year is $12,000 (the sum of 
the actual distribution plus the taxes deemed distributed ($24,000) 
divided by the number of accumulation years (2)). Of that amount, $5,000 
($10,000/$24,000 x $12,000) is treated as United States source taxable 
income in accordance with paragraph (b) of this section. Assuming the 
United States tax rate is 50 percent, X's separate foreign tax credit 
limitation against the increase in tax in each computation year is 
$3,500 ($7,000/$12,000 x $6,000) instead of $6,000 ($12,000/$12,000 x 
$6,000). X's overall foreign loss account is reduced to zero in 
accordance with paragraph (a) of this section.
    Example 2. Assume the same facts as in Example 1, except that X 
deducted rather than credited its foreign taxes in the computation 
years. In 1979, the amount added to X's income is $12,000 under section 
667(b), $2,000 of which is deductible under section 667(d)(1)(B). X must 
reduce its overall foreign loss account by $10,000, the amount of the 
actual distribution that is deemed distributed in 1979 (without regard 
to the $2,000 foreign taxes also deemed distributed). The entire overall 
foreign loss account is therefore reduced to $0 in 1979.

[T.D. 8153, 52 FR 32002, Aug. 25, 1987]



Sec.  1.904(f)-5  Special rules for recapture of overall foreign losses 
of a domestic trust.

    (a) In general. Except as provided in this section, the rules 
contained in Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-4, 
and 1.904(f)-6 apply to domestic trusts.
    (b) Recapture of trust's overall foreign loss. In taxable years in 
which a trust has foreign source taxable income subject to a separate 
limitation in which the trust has a balance in its overall foreign loss 
account, the balance in the trust's overall foreign loss account shall 
be recaptured as follows:
    (1) Trust accumulates income. If the trust accumulates all of its 
foreign source taxable income subject to the same limitation as the loss 
that created the balance in the overall foreign loss account, its 
overall foreign loss shall be recaptured out of such income in 
accordance with Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-
4, and 1.904(f)-6.
    (2) Trust distributes income. If the trust distributes all of its 
foreign source taxable income subject to the same limitation as the loss 
that created the overall foreign loss account, the amount of the overall 
foreign loss that would be subject to recapture by the trust under 
paragraph (b)(1) of this section shall be allocated to the beneficiaries 
in proportion to the amount of such income which is distributed to each 
beneficiary in that year.
    (3) Trust accumulates and distributes income. If the trust 
accumulates part of its foreign source taxable income subject to the 
same limitation as the loss that created the overall foreign loss 
account and distributes part of such income, the portion of the overall 
foreign loss that would be subject to recapture

[[Page 969]]

by the trust under paragraph (b)(1) of this section if the distributed 
income were accumulated shall be allocated to the beneficiaries 
receiving income distributions. The amount of overall foreign loss to be 
allocated to such beneficiaries shall be the same portion of the total 
amount of such overall foreign loss that would be recaptured as the 
amount of such income which is distributed to each beneficiary bears to 
the total amount of such income of the trust for such year. That portion 
of the overall foreign loss subject to recapture in such year that is 
not allocated to the beneficiaries in accordance with this paragraph 
(b)(3) shall be recaptured by the trust in accordance with paragraph 
(b)(1).
    (c) Amounts allocated to beneficiaries. Amounts of a trust's overall 
foreign loss allocated to any beneficiary in accordance with paragraph 
(b)(2) or (3) of this section shall be added to the beneficiary's 
applicable overall foreign loss account and treated as an overall 
foreign loss of the beneficiary incurred in the taxable year preceding 
the year of such allocation. Such amounts shall be recaptured in 
accordance with Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-
4, and 1.904(f)-6 out of foreign source taxable income distributed by 
the trust which is subject to the same separate limitation.
    (d) Section 904(f)(3) dispositions to which Sec.  1.904(f)-
2(d)(4)(i) is applicable. Foreign source taxable income recognized by a 
trust under Sec.  1.904(f)-2(d)(4) on a disposition of property used in 
a trade or business outside the United States shall be deemed to be 
accumulated by the trust. All such income shall be used to recapture the 
trust's overall foreign loss in accordance with Sec.  1.904(f)-2(d)(4).
    (e) Illustrations. The provisions of this section are illustrated by 
the following examples:

    Example 1. T, a domestic trust, has a balance of $2,000 in a general 
limitation overall foreign loss account on December 31, 1983. For its 
taxable year ending on December 31, 1984, T has foreign source taxable 
income subject to the general limitation of $1,600, all of which it 
accumulates. Under paragraph (b)(1) of this section, T is required to 
recapture $800 in 1984 (the lesser of the overall foreign loss or 50 
percent of the foreign source taxable income). This amount is treated as 
United States source income for purposes of taxing T in 1984 and upon 
subsequent distribution to T's beneficiaries. At the end of its 1984 
taxable year, T has a balance of $1,200 in its overall foreign loss 
account.
    Example 2. The facts are the same as in example 1. In 1985, T has 
general limitation foreign source taxable income of $1,000, which it 
distributes to its beneficiaries as follows: $500 to A, $250 to B, and 
$250 to C. Under paragraph (b)(1) of this section, T would have been 
required to recapture $500 of its overall foreign loss if it had 
accumulated all of such income. Therefore, under paragraph (b)(2) of 
this section, T must allocate $500 of its overall foreign loss to A, B, 
and C as follows: $250 to A ($500 x $500/$1,000), $125 to B ($500 x 
$250/$1,000), and $125 to C ($500 x $250/$1,000). Under paragraph (c) of 
this section and Sec.  1.904(f)-1(d)(4), A, B, and C must add the 
amounts of general limitation overall foreign loss allocated to them 
from T to their overall foreign loss accounts and treat such amounts as 
overall foreign losses incurred in 1984. A, B, and C must then apply the 
rules of Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-4, and 
1.904(f)-6 to recapture their overall foreign losses. T's overall 
foreign loss account is reduced in accordance with Sec.  1.904(f)-
1(e)(1) by the $500 that is allocated to A, B, and C. At the end of 
1985, T's general limitation overall foreign loss account has a balance 
of $700.
    Example 3. The facts are the same as in example 2, including an 
overall foreign loss account at the end of 1984 of $1,200, except that 
in 1985 T's general limitation foreign source taxable income is $1,500 
instead of $1,000, and T accumulates the additional $500. Under 
paragraph (b)(1) of this section, T would be required to recapture $750 
of its overall foreign loss if it accumulated all of the $1,500. Under 
paragraph (b)(3) of this section, T must allocate $500 of its overall 
foreign loss to A, B, and C as follows: $250 to A ($750 x $500/$1,500) 
and $125 each to B and C (750 x $250/$1,500). T must also recapture $250 
of its overall foreign loss, which is the amount subject to recapture in 
1985 that is not allocated to the beneficiaries ($750-$500 = $250). 
Under Sec.  1.904(f)-1(e)(1), T reduces its general limitation overall 
foreign loss account by $500. Under Sec.  1.904(f)-1(e)(2), T reduces 
its general limitation overall foreign loss account by $250. At the end 
of 1985 there is a balance in the general limitation overall foreign 
loss account of $450 (($1,200-$500)-$250).

[T.D. 8153, 52 FR 32002, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987]

[[Page 970]]



Sec.  1.904(f)-6  Transitional rule for recapture of FORI and general 
limitation overall foreign losses incurred in taxable years beginning 
before January 1, 1983, from foreign source taxable income subject to 
the general limitation in taxable years beginning after December 31, 1982.

    (a) General rule. For taxable years beginning after December 31, 
1982, foreign source taxable income subject to the general limitation 
includes foreign oil related income (as defined in section 907(c)(2) 
prior to its amendment by section 211 of the Tax Equity and Fiscal 
Responsibility Act of 1982). However, for purposes of recapturing 
general limitation overall foreign losses incurred in taxable years 
beginning before January 1, 1983 (pre-1983) out of foreign source 
taxable income subject to the general limitation in taxable years 
beginning after December 31, 1982 (post-1982), the taxpayer shall make 
separate determinations of foreign oil related income and other general 
limitation income (as if the FORI limitation under ``old section 
907(b)'' (prior to its amendment by section 211 of the Tax Equity and 
Fiscal Responsibility Act of 1982) were still in effect), and shall 
apply the rules set forth in this section. The taxpayer shall maintain 
separate accounts for its pre-1983 FORI limitation overall foreign 
losses, its pre-1983 general limitation overall foreign losses (or its 
pre-1983 section 904(d)(1)(A-C) overall foreign losses if such losses 
were computed on a combined basis), and its post-1982 general limitation 
overall foreign losses. The taxpayer shall continue to maintain such 
separate accounts, make such separate determinations, and apply the 
rules of this section separately to each account until the earlier of--
    (1) Such time as the taxpayer's entire pre-1983 FORI limitation 
overall foreign loss account and pre-1983 general limitation overall 
foreign loss account (or, if the taxpayer determined pre-1983 overall 
foreign losses on a combined basis, the section 904(d)(1)(A-C) account) 
have been recaptured, or
    (2) The end of the taxpayer's 8th post-1982 taxable year, at which 
time the taxpayer shall add any remaining balance in its pre-1983 FORI 
limitation account and pre-1983 general limitation overall foreign loss 
account (or the section 904(d)(1)(A-C) account) to its post-1982 general 
limitation overall foreign loss account.
    (b) Recapture of pre-1983 FORI and general limitation overall 
foreign losses from post-1982 income. A taxpayer having a balance in its 
pre-1983 FORI limitation overall foreign loss account or its pre-1983 
general limitation overall foreign loss account (or its pre-1983 section 
904(d)(1)(A-C) account) in a post-1982 taxable year shall recapture such 
overall foreign loss as follows:
    (1) Recapture from income subject to the same limitation. The 
taxpayer shall first apply the rules of Sec. Sec.  1.904(f)-1 through 
1.904(f)-5 to the taxpayer's separately determined foreign oil related 
income to recapture the pre-1983 FORI limitation overall foreign loss 
account, and shall apply such rules to the taxpayer's separately 
determined general limitation income (exclusive of foreign oil related 
income) to recapture the pre-1983 general limitation overall foreign 
loss account (or the section 904(d)(1)(A-C) overall foreign loss 
account. Rules for determining the recapture of the pre-1983 section 904 
(d)(1)(A-C) losses are contained in Sec.  1.904(f)-2(c)(4).
    (2) Recapture from income subject to the other limitation. The 
taxpayer shall next apply the rules of Sec. Sec.  1.904(f)-1 through 
1.904(f)-5 to the taxpayer's separately determined foreign oil related 
income to recapture the pre-1983 general limitation overall foreign loss 
account (or the section 904(d)(1)(A-C) overall foreign loss account) and 
shall apply such rules to the taxpayer's separately determined general 
limitation income to recapture foreign oil related losses to the extent 
that--
    (i) The amount recaptured from such separately determined income 
under paragraph (b)(1) of this section is less than 50 percent (or such 
larger percentage as the taxpayer elects) of such separately determined 
income, and
    (ii) The amount recaptured from such separately determined income 
under this paragraph (b)(2) does not exceed an amount equal to 12\1/2\ 
percent of the balance in the taxpayer's pre-1983 FORI limitation 
overall foreign loss account or the pre-1983 general limitation overall 
foreign loss account (or the section

[[Page 971]]

904(d)(1)(A-C) overall foreign loss account) at the beginning of the 
taxpayer's first post-1982 taxable year, multiplied by the number of 
post-1982 taxable years (including the year to which this rule is being 
applied) which have elapsed, less the amount (if any) recaptured in 
prior post-1982 taxable years under this paragraph (b)(2) from such 
separately determined income.
    The taxpayer may elect to recapture a pre-1983 overall foreign loss 
from post-1982 income subject to the general limitation at a faster rate 
than is required by this paragraph (b)(2). This election shall be made 
in the same manner as an election to recapture more than 50 percent of 
the income subject to recapture under section 904(f)(1), as provided in 
Sec.  1.904(f)-2(c)(2).
    (c) Coordination of recapture of pre-1983 and post-1982 overall 
foreign losses. A taxpayer incurring a general limitation overall 
foreign loss in any post-1982 taxable year in which the taxpayer has a 
balance in a pre-1983 FORI limitation or its pre-1983 general limitation 
overall foreign loss account (or the section 904(d)(1)(A-C) overall 
foreign loss account) shall establish a separate overall foreign loss 
account for such loss. The taxpayer shall recapture its overall foreign 
losses in succeeding taxable years by first applying the rules of this 
section to recapture its pre-1983 overall foreign losses, and then 
applying the rules of Sec. Sec.  1.904(f)-1 through 1.904(f)-5 to 
recapture its post-1982 general limitation overall foreign loss. A post-
1982 general limitation overall foreign loss is required to be 
recaptured only to the extent that the amount of foreign source taxable 
income recharacterized under paragraph (b) of this section is less than 
50 percent of the taxpayer's total general limitation foreign source 
taxable income (including foreign oil related income)) for such taxable 
year (except as required by section 904(f)(3)). However, a taxpayer may 
elect to recapture at a faster rate.
    (d) Illustrations. The provisions of this section are illustrated by 
the following examples:

    Example 1. X Corporation is a domestic corporation which has the 
calendar year as its taxable year. On December 31, 1982, X has a balance 
of $1,000 in its section 904(d)(1)(A-C) overall foreign loss account. X 
does not have a balance in a FORI limitation overall foreign loss 
account. For 1983, X has income of $1,200, which was subject to the 
general limitation and includes foreign oil related income of $1,000 and 
other general limitation income of $200. In 1983, X is required to 
recapture $225 of its pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account computed as follows:

Amount recaptured under paragraph (b)(1) of this section............$100

    The amount recaptured from general limitation income exclusive of 
foreign oil related income is the lesser of $1,000 (the pre-1983 loss 
reflected in the section 904(d)(1)(A-C) overall foreign loss account) or 
50 percent of $200 (the separately determined general limitation income 
(exclusive of foreign oil related income).

Amount recaptured under paragraph (b)(2) of this section............$125

    The amount recaptured from foreign oil related income is the lesser 
of $900 (the remaining pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account after recapture under paragraph (b)(1) of this section) or 
50 percent of $1,000 (the separately determined foreign oil related 
income), but as limited by paragraph (b)(2)(ii) of this section to 
(12\1/2\ percent of $1,000 x 1)-$0, which is $125.

Total amount recaptured in 1983.....................................$225
    Example 2. The facts are the same as in example 1, except that X has 
general limitation income of $50 for 1984 and $600 for 1985, all of 
which is foreign oil related income. X is required to recapture $25 in 
1984 and $225 in 1985 of its pre-1983 section 904(d)(1)(A-C) overall 
foreign loss account computed as follows:

Amount recaptured under paragraph (b)(2) of this section in 1984.....$25

    The amount recaptured from foreign oil related income is the lesser 
of $775 (the remaining pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account or 50 percent of $50 (the separately determined foreign oil 
related income).This amount is within the limitation of paragraph 
(b)(2)(ii) of this section, (12\1/2\ percent of $1,000 x 2)-$125, which 
is $125.

Amount recaptured under paragraph (b)(2) of this section in 1985....$225

    The amount recaptured from foreign oil related income is the lesser 
of $750 (the remaining pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account) or 50 percent of $600 (the separately determined foreign 
oil related income), but as limited by paragraph (b)(2)(ii) of this 
section to (12\1/2\ percent of $1,000 x 3)-($125 + $25), which is $225. 
($125 is the amount recaptured in 1983 under paragraph (b)(2) of this 
section, and $25 is the amount recaptured in 1984 under paragraph (b)(2) 
of this section.)
    Example 3. Y Corporation is a domestic corporation which has the 
calendar year as its

[[Page 972]]

taxable year. On December 31, 1982, Y has a balance of $400 in its 
section 904(d)(1)(A-C) overall foreign loss account. Y does not have a 
balance in a FORI overall foreign loss account. For 1983, Y has a 
general limitation overall foreign loss of $200. For 1984, Y has general 
limitation income of $1,200, all of which is foreign oil related income. 
In 1984, Y is required to recapture a total of $300 computed as follows:

Amount of pre-1983 overall foreign loss recaptured under paragraph 
(b)(2) of this section..............................................$100

    The amount of the pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account attributable to a general limitation loss recaptured from 
foreign oil related income is the lesser of $400 (the loss) or 50 
percent of $1,200 (the separately determined foreign oil related 
income), but as limited by paragraph (b)(2)(ii) of this section to 
(12\1/2\ percent of $400 x 2) - $0, which is $100.

Amount of post-1982 overall foreign loss recaptured under paragraph (c) 
of this section.....................................................$200

    The amount of post-1982 general limitation overall foreign loss 
recaptured is the amount computed under Sec.  1.904 (f)-2(c)(1), which 
is the lesser of $200 (the post-1982 loss) or 50 percent of $1,200 (the 
income), but only to the extent that the amount of pre-1983 loss 
recaptured under paragraph (b) of this section is less than 50 percent 
of such income ((50 percent of $1,200)--$100 recaptured under paragraph 
(b) = $500).

Total amount recaptured in 1984.....................................$300

    At the end of 1984, Y has a balance in its pre-1983 section 
904(d)(1)(A-C) overall foreign loss account of $300, and has reduced its 
post-1982 general limitation overall foreign loss account to zero.
    Example 4. Z is a domestic corporation which has the calendar year 
as its taxable year. On December 31, 1982, Z has a balance of $400 in 
its section 904 (d)(1)(A-C) overall foreign loss account, and a balance 
of $1,000 in its FORI limitation overall foreign loss account. For 1983, 
Z has general limitation income of $2,000, which includes foreign oil 
related income of $1,000 and other general limitation income of $1,000. 
Keeping these amounts separate for purposes of this section, Z is 
required to recapture a total of $1,000 in 1983, computed as follows:

Amount recaptured under paragraph (b)(1) of this section............$900

    The amount of pre-1983 section 904(d)(1)(A-C) overall foreign loss 
account recaptured from general limitation income exclusive of foreign 
oil related income, in accordance with Sec.  1.904 (f)-2(c)(1), is the 
lesser of $400 (the section 904(d)(1)(A-C) overall foreign loss) or 50 
percent of $1,000, the general limitation income exclusive of foreign 
oil related income), which is $400.
    The amount of pre-1983 FORI overall foreign loss recaptured from 
foreign oil related income, in accordance with Sec.  1.904(f)-2(c)(1), 
is the lesser of $1,000 (the FORI overall foreign loss) or 50 percent of 
$1,000 (the foreign oil related income), which is $500.

Amount recaptured under paragraph (b)(2) of this section............$100

    The amount of pre-1983 FORI 907(b) overall foreign loss recaptured 
from section general limitation income exclusive of foreign oil related 
income is the lesser of $500 (the remaining balance in that loss 
account) or 50 percent of $1,000 (the general limitation income 
exclusive of foreign oil related income), but only to the extent that 
the amount recaptured from such income under paragraph (b)(1) of this 
section is less than 50 percent of such income, or $100 (50 percent of 
$1,000)--$400 recaptured due to section 904(d)(1)(A-C) overall foreign 
loss account, and only up to the amount permitted by paragraph 
(b)(2)(ii) of this section, which is (12\1/2\ percent of $1,000 x 1)-$0, 
or $125.

Total amount recaptured in 1983...................................$1,000

    At the end of 1983, Z has reduced its pre-1983 section 904(d)(1)(A-
C) overall foreign loss account to zero, and has a balance in its pre-
1983 FORI overall foreign loss account of $400.

[T.D. 8153, 52 FR 32003, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987]



Sec.  1.904(f)-7  Separate limitation loss and the separate limitation 
loss account.

    (a) Overview of regulations. This section provides rules for 
determining a taxpayer's separate limitation losses, for establishing 
separate limitation loss accounts, and for making additions to and 
reducing such accounts for purposes of section 904(f). Section 1.904(f)-
8 provides rules for recharacterizing the balance in any separate 
limitation loss account under the general recharacterization rule of 
section 904(f)(5)(C).
    (b) Definitions. The definitions in paragraphs (b)(1) through (b)(4) 
of this section apply for purposes of this section and Sec. Sec.  
1.904(f)-8 and 1.904(g)-3.
    (1) Separate category means each separate category of income 
described in section 904(d) and any other category of income described 
in Sec.  1.904-4(m). For example, income subject to section 901(j) or 
section 904(h)(10) is income in a separate category.
    (2) Separate limitation income means, with respect to any separate 
category,

[[Page 973]]

the taxable income from sources outside the United States, separately 
computed for that category for the taxable year. Separate limitation 
income shall be determined by taking into account any adjustments for 
capital gains and losses and qualified dividend income, as defined in 
section 1(h)(11), under section 904(b)(2) and Sec.  1.904(b)-1. See 
Sec.  1.904(b)-1(h)(1)(i).
    (3) Separate limitation loss means, with respect to any separate 
category, the amount by which the foreign source gross income in that 
category is exceeded by the sum of expenses, losses and other deductions 
(not including any net operating loss deduction under section 172(a) or 
any expropriation loss or casualty loss described in section 
907(c)(4)(D)(iii)) properly apportioned or allocated to that separate 
category for the taxable year. Separate limitation losses shall be 
determined by taking into account any adjustments for capital gains and 
losses and qualified dividend income under section 904(b)(2) and Sec.  
1.904(b)-1. See Sec.  1.904(b)-1(h)(1)(i).
    (c) Separate limitation loss account. Any taxpayer that sustains a 
separate limitation loss that is allocated to reduce separate limitation 
income in one or more other separate categories of the taxpayer under 
the rules of Sec.  1.904(g)-3 must establish a separate limitation loss 
account for the loss with respect to each such other separate category. 
The balance in any separate limitation loss account represents the 
amount of such separate limitation loss that is subject to recapture in 
a given taxable year pursuant to Sec.  1.904(f)-8 and section 
904(f)(5)(F). From year to year, amounts may be added to or subtracted 
from the balance in such loss accounts, as provided in paragraphs (d) 
and (e) of this section.
    (d) Additions to separate limitation loss accounts--(1) General 
rule. A taxpayer's separate limitation loss as defined in paragraph 
(b)(3) of this section shall be added to the applicable separate 
limitation loss accounts at the end of its taxable year to the extent 
that the separate limitation loss reduces separate limitation income in 
one or more other separate categories in that taxable year or in a year 
to which the loss has been carried back. For rules with respect to net 
operating loss carryovers, see paragraph (d)(3) of this section and 
Sec.  1.904(g)-3.
    (2) Separate limitation losses of another taxpayer. If any portion 
of any separate limitation loss account of another taxpayer is allocated 
to the taxpayer in accordance with Sec.  1.1502-9 (relating to 
consolidated separate limitation losses) the taxpayer shall add such 
amount to its applicable separate limitation loss account.
    (3) Additions to separate limitation loss account created by loss 
carryovers. The taxpayer shall add to each separate limitation loss 
account all net operating loss carryovers to the current taxable year to 
the extent that separate limitation losses included in the net operating 
loss carryovers reduced foreign source income in one or more other 
separate categories for the taxable year.
    (e) Reductions of separate limitation loss accounts. The taxpayer 
shall subtract the following amounts from its separate limitation loss 
accounts at the end of its taxable year in the following order as 
applicable:
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers. A separate limitation loss account is reduced by the amount 
of any separate limitation loss account that is allocated to another 
taxpayer in accordance with Sec.  1.1502-9 (relating to consolidated 
separate limitation losses).
    (2) Reduction for offsetting loss accounts. A separate limitation 
loss account is reduced to take into account any netting of separate 
limitation loss accounts under Sec.  1.904(g)-3(d)(1).
    (3) Reduction for amounts recaptured. A separate limitation loss 
account is reduced by the amount of any separate limitation income that 
is earned in the same separate category as the separate limitation loss 
and that is recharacterized in accordance with Sec.  1.904(f)-8 
(relating to recapture of separate limitation losses) or section 
904(f)(5)(F) (relating to recapture of separate limitation loss accounts 
out of gain realized from certain dispositions).
    (f) Effective/applicability date. This section applies to taxpayers 
that sustain separate limitation losses in taxable years beginning on or 
after January 1, 2012. Taxpayers may choose to

[[Page 974]]

apply this section to separate limitation losses sustained in other 
taxable years beginning after December 21, 2007, including periods 
covered by 26 CFR 1.904(f)-7T (revised as of April 1, 2010). For rules 
relating to taxable years beginning after December 31, 1986, and on or 
before December 21, 2007, see section 904(f)(5).

[T.D. 9595, 77 FR 37579, June 22, 2012]



Sec.  1.904(f)-8  Recapture of separate limitation loss accounts.

    (a) In general. A taxpayer shall recapture a separate limitation 
loss account as provided in this section. If the taxpayer has a separate 
limitation loss account or accounts in any separate category (the ``loss 
category'') and the loss category has income in a subsequent taxable 
year, the income shall be recharacterized as income in that other 
category or categories. The amount of income recharacterized shall not 
exceed the aggregate balance in all separate limitation loss accounts 
for the loss category as determined under Sec.  1.904(f)-7. If the 
taxpayer has more than one separate limitation loss account in a loss 
category, and there is not enough income in the loss category to 
recapture all of the loss accounts, then separate limitation income in 
the loss category shall be recharacterized as separate limitation income 
in the other separate categories on a proportionate basis. This is 
determined by multiplying the total separate limitation income subject 
to recharacterization by a fraction, the numerator of which is the 
amount in a particular separate limitation loss account and the 
denominator of which is the total amount in all separate limitation loss 
accounts for the loss category.
    (b) Effect of recharacterization of separate limitation income on 
associated taxes. Recharacterization of income under paragraph (a) of 
this section shall not result in the recharacterization of any tax. The 
rules of Sec.  1.904-6, including the rules that the taxes are allocated 
on an annual basis and that foreign taxes paid on U.S. source income 
shall be allocated to the separate category that includes that U.S. 
source income (see Sec.  1.904-6(a)), shall apply for purposes of 
allocating taxes to separate categories. Allocation of taxes pursuant to 
Sec.  1.904-6 shall be made before the recapture of any separate 
limitation loss accounts of the taxpayer pursuant to the rules of this 
section.
    (c) Effective/applicability date. This section applies to taxpayers 
that sustain separate limitation losses in taxable years beginning on or 
after January 1, 2012. Taxpayers may choose to apply this section to 
separate limitation losses sustained in other taxable years beginning 
after December 21, 2007, including periods covered by 26 CFR Sec.  
1.904(f)-8T (revised as of April 1, 2010). For rules relating to taxable 
years beginning after December 31, 1986, and on or before December 21, 
2007, see section 904(f)(5).

[T.D. 9595, 77 FR 37580, June 22, 2012]



Sec. Sec.  1.904(f)-9--1.904(f)-11  [Reserved]



Sec.  1.904(f)-12  Transition rules.

    (a) Recapture in years beginning after December 31, 1986, of overall 
foreign losses incurred in taxable years beginning before January 1, 
1987--(1) In general. If a taxpayer has a balance in an overall foreign 
loss account at the end of its last taxable year beginning before 
January 1, 1987 (pre-effective date years), the amount of that balance 
shall be recaptured in subsequent years by recharacterizing income 
received in the income category described in section 904(d) as in effect 
for taxable years beginning after December 31, 1986 (post-effective date 
years), that is analogous to the income category for which the overall 
foreign loss account was established, as follows:
    (i) Interest income as defined in section 904(d)(1)(A) as in effect 
for pre-effective date taxable years is analogous to passive income as 
defined in section 904(d)(1)(A) as in effect for post-effective date 
years;
    (ii) Dividends from a DISC or former DISC as defined in section 
904(d)(1)(B) as in effect for pre-effective date taxable years is 
analogous to dividends from a DISC or former DISC as defined in section 
904(d)(1)(F) as in effect for post-effective date taxable years;
    (iii) Taxable income attributable to foreign trade income as defined 
in section 904(d)(1)(C) as in effect for pre-effective date taxable 
years is analogous

[[Page 975]]

to taxable income attributable to foreign trade income as defined in 
section 904(d)(1)(G) as in effect for post-effective date years;
    (iv) Distributions from a FSC (or former FSC) as defined in section 
904(d)(1)(D) as in effect for pre-effective date taxable years is 
analogous to distributions from a FSC (or former FSC) as defined in 
section 904(d)(1)(H) as in effect for post-effective date taxable years;
    (v) For general limitation income as described in section 
904(d)(1)(E) as in effect for pre-effective date taxable years, see the 
special rule in paragraph (a)(2) of this section.
    (2) Rule for general limitation losses--(i) In general. Overall 
foreign losses incurred in the general limitation category of section 
904(d)(1)(E), as in effect for pre-effective date taxable years, that 
are recaptured in post-effective date taxable years shall be recaptured 
from the taxpayer's general limitation income, financial services 
income, shipping income, and dividends from each noncontrolled section 
902 corporation. If the sum of the taxpayer's general limitation income, 
financial services income, shipping income and dividends from each 
noncontrolled section 902 corporation for a taxable year subject to 
recapture exceeds the overall foreign loss to be recaptured, then the 
amount of each type of separate limitation income that will be treated 
as U.S. source income shall be determined as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.043


This recapture shall be made after the allocation of separate limitation 
losses pursuant to section 904(f)(5)(B) and before the 
recharacterization of post-effective date separate limitation income 
pursuant to section 904(f)(5)(C).
    (ii) Exception. If a taxpayer can demonstrate to the satisfaction of 
the district director that an overall foreign loss in the general 
limitation category of section 904(d)(1)(E), as in effect for pre-
effective date taxable years, is attributable, in sums certain, to 
losses in one or more separate categories of section 904(d)(1) 
(including for this purpose the passive income category and the high 
withholding tax interest category), as in effect for post-effective date 
taxable years, then the taxpayer may recapture the loss (in the amounts 
demonstrated) from those separate categories only.
    (3) Priority of recapture of overall foreign losses incurred in pre-
effective date taxable years. An overall foreign loss incurred by a 
taxpayer in pre-effective date taxable years shall be recaptured to the 
extent thereof before the taxpayer recaptures an overall foreign loss 
incurred in a post-effective date taxable year.
    (4) Examples. The following examples illustrate the application of 
this paragraph (a).

    Example 1. X corporation is a domestic corporation which operates a 
branch in Country Y. For its taxable year ending December 31, 1988, X 
has $800 of financial services income, $100 of general limitation income 
and $100 of shipping income. X has a balance of $100 in its general 
limitation overall foreign loss account which resulted from an overall 
foreign loss incurred during its 1986 taxable year. X is unable to 
demonstrate to which of the income categories set forth in section 
904(d)(1) as in effect for post-effective date taxable years the loss is 
attributable. In addition, X has a balance of $100 in its shipping 
overall foreign loss account attributable to a shipping loss incurred 
during its 1987 taxable year. X has no other overall foreign loss 
accounts. Pursuant to section 904(f)(1), the full amount in each of X 
corporation's overall foreign loss accounts is subject to recapture 
since $200 (the sum of those amounts) is less than 50% of X's foreign 
source taxable income for its 1988 taxable year, or $500. X's overall 
foreign loss incurred during its 1986 taxable year is recaptured before 
the overall foreign loss incurred during its 1987 taxable

[[Page 976]]

year, as follows: $80 ($100 x 800/1000) of X's financial services 
income, $10 ($100 x 100/1000) of X's general limitation income, and $10 
(100 x 100/1000) of X's shipping income will be treated as U.S. source 
income. The remaining $90 of X corporation's 1988 shipping income will 
be treated as U.S. source income for the purpose of recapturing X's 100 
overall foreign loss attributable to the shipping loss incurred in 1987. 
$10 remains in X's shipping overall foreign loss account for recapture 
in subsequent taxable years.
    Example 2. The facts are the same as in Example 1 except that X has 
$800 of financial services income, $100 of general limitation income, a 
$100 dividend from a noncontrolled section 902 corporation and a ($100) 
shipping loss for its taxable year ending December 31, 1988. Separate 
limitation losses are allocated pursuant to the rules of section 
904(f)(5) before the recapture of overall foreign losses. Therefore, the 
($100) shipping loss incurred by X will be allocated to its separate 
limitation income as follows: $80 ($100 x 800/1000) will be allocated to 
X's financial services income, $10 ($100 x 100/1000) will be allocated 
to its general limitation income and $10 ($100 x 100/1000) will be 
allocated to X's dividend from the noncontrolled section 902 
corporation. Accordingly, after allocation of the 1988 shipping loss, X 
has $720 of financial services income, $90 of general limitation income, 
and a $90 dividend from the noncontrolled section 902 corporation. 
Pursuant to section 904(f)(1), the full amount in each of X 
corporation's overall foreign loss accounts is subject to recapture 
since $200 (the sum of those amounts) is less than 50% of X's net 
foreign source taxable income for its 1988 taxable year, or $450. X's 
overall foreign loss incurred during its 1986 taxable year is recaptured 
as follows: $80 ($100 x 720/900) of X's financial services income, $10 
($100 x 90/900) of its general limitation income and $10 ($100 x 90/900) 
of its dividend from the noncontrolled section 902 corporation will be 
treated as U.S. source income. Accordingly, after application of section 
904(f), X has $100 of U.S. source income, $640 of financial services 
income, $80 of general limitation income and a $80 dividend from the 
noncontrolled section 902 corporation for its 1988 taxable year. X must 
establish a separate limitation loss account for each portion of the 
1988 shipping loss that was allocated to its financial services income, 
general limitation income and dividends from the noncontrolled section 
902 corporation. X's overall foreign loss account for the 1986 general 
limitation loss is reduced to zero. X still has a $100 balance in its 
overall foreign loss account that resulted from the 1987 shipping loss.
    Example 3. Y is a domestic corporation which has a branch operation 
in Country Z. For its 1988 taxable year, Y has $5 of shipping income, 
$15 of general limitation income and $100 of financial services income. 
Y has a balance of $100 in its general limitation overall foreign loss 
account attributable to its 1986 taxable year. Y has no other overall 
foreign loss accounts. Pursuant to section 904(f)(1), $60 of the overall 
foreign loss is subject to recapture since 50% of Y's foreign source 
income for 1988 is less than the balance in its overall foreign loss 
account. Y can demonstrate that the entire $100 overall foreign loss was 
attributable to a shipping limitation loss incurred in 1986. 
Accordingly, only Y's $5 of shipping limitation income received in 1988 
will be treated as U.S. source income, Because Y can demonstrate that 
the 1986 loss was entirely attributable to a shipping loss, none of Y's 
general limitation income or financial services income received in 1988 
will be treated as U.S. source income.
    Example 4. The facts are the same as in Example 3 except that Y can 
only demonstrate that $50 of the 1986 overall foreign loss account was 
attributable to a shipping loss incurred in 1986. Accordingly, Y's $5 of 
shipping limitation income received in 1988 will be treated as U.S. 
source income. The remaining $50 of the 1986 overall foreign loss that Y 
cannot trace to a particular separate limitation will be recaptured and 
treated as U.S. source income as follows: $43 ($50 x 100/115) of Y's 
financial services income will be treated as U.S. source income and $7 
($50 x 15/115) of Y's general limitation income will be treated as U.S. 
source income. Y has $45 remaining in its overall foreign loss account 
to be recaptured from shipping income in a future year.

    (b) Treatment of overall foreign losses that are part of net 
operating losses incurred in pre-effective date taxable years which are 
carried forward to post-effective date taxable years--(1) Rule. An 
overall foreign loss that is part of a net operating loss incurred in a 
pre-effective date taxable year which is carried forward, pursuant to 
section 172, to a post-effective date taxable year will be carried 
forward under the rules of section 904(f)(5) and the regulations under 
that section. See also Notice 89-3, 1989-1 C.B. 623. For this purpose 
the loss must be allocated to income in the category analogous to the 
income category set forth in section 904(d) as in effect for pre-
effective date taxable years in which the loss occurred. The analogous 
category shall be determined under the rules of paragraph (a) of this 
section.
    (2) Example. The following example illustrates the rule of paragraph 
(b)(1) of this section.


[[Page 977]]


    Example. Z is a domestic corporation which has a branch operation in 
Country D. For its taxable year ending December 31, 1988, Z has $100 of 
passive income and $200 of general limitation income. Z also has a $60 
net operating loss which was carried forward pursuant to section 172 
from its 1986 taxable year. The net operating loss resulted from an 
overall foreign loss attributable to the general limitation income 
category. Z can demonstrate that the loss is a shipping loss. Therefore, 
the net operating loss will be treated as a shipping loss for Z's 1988 
taxable year. Pursuant to section 904(f)(5), the shipping loss will be 
allocated as follows: $20 ($60 x 100/300) will be allocated to Z's 
passive income and $40 ($60 x 200/300) will be allocated to Z's general 
limitation income. Accordingly, after application of section 904(f), Z 
has $80 of passive income and $160 of general limitation income for its 
1988 taxable year. Although no addition to Z's overall foreign loss 
account for shipping income will result from the NOL carry forward, 
shipping income earned by Z in subsequent taxable years, will be subject 
to recharacterization as a passive income and general limitation income 
pursuant to the rules set forth in section 904(f)(5).

    (c) Treatment of overall foreign losses that are part of net 
operating losses incurred in post-effective date taxable years which are 
carried back to pre-effective date taxable years--(1) Allocation to 
analogous income category. An overall foreign loss that is part of a net 
operating loss incurred by the taxpayer in a post-effective date taxable 
year which is carried back, pursuant to section 172, to a pre-effective 
date taxable year shall be allocated first to income in the pre-
effective date income category analogous to the income category set 
forth in section 904(d) as in effect for post-effective date taxable 
years in which the loss occurred. Except for the general limitation 
income category, the pre-effective date income category that is 
analogous to a post-effective date income category shall be determined 
under paragraphs (a)(1) (i) through (iv) of this section. The general 
limitation income category for pre-effective date years shall be treated 
as the income category that is analogous to the post-effective date 
categories for general limitation income, financial services income, 
shipping income, dividends from each noncontrolled section 902 
corporation and high withholding tax interest income. If the net 
operating loss resulted from separate limitation losses in more than one 
post-effective date income category and more than one loss is carried 
back to pre-effective date general limitation income, then the losses 
shall be allocated to the pre-effective date general limitation income 
based on the following formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.044

    (2) Allocation to U.S. source income. If an overall foreign loss is 
carried back to a pre-effective date taxable year and the loss exceeds 
the foreign source income in the analogous category for the carry back 
year, the remaining loss shall be allocated against U.S. source income 
as set forth in Sec.  1.904(f)-3. The amount of the loss that offsets 
U.S. source income must be added to the taxpayer's overall foreign loss 
account. An addition to an overall foreign loss account resulting from 
the carry back of a net operating loss incurred by a taxpayer in a post-
effective date taxable year shall be treated as having been incurred by 
the taxpayer in the year in which the loss arose and shall be subject to 
recapture pursuant to section 904(f) as in effect for post-effective 
date taxable years.
    (3) Allocation to other separate limitation categories. To the 
extent that an overall foreign loss that is carried back as part of a 
net operating loss exceeds the separate limitation income to

[[Page 978]]

which it is allocated and the U.S. source income of the taxpayer for the 
taxable year to which the loss is carried, the loss shall be allocated 
pro rata to other separate limitation income of the taxpayer for the 
taxable year. However, there shall be no recharacterization of separate 
limitation income pursuant to section 904(f)(5) as a result of the 
allocation of such a net operating loss to other separate limitation 
income of the taxpayer.
    (4) Examples. The following examples illustrate the rules of 
paragraph (c) of this section.

    Example 1. X is a domestic corporation which has a branch operation 
in Country A. For its taxable year ending December 31, 1987, X has a $60 
net operating loss which is carried back pursuant to section 172 to its 
taxable year ending December 31, 1985. The net operating loss resulted 
from a shipping loss; X had no U.S. source income in 1987. X had $20 of 
general limitation income, $40 of DISC limitation income and $10 of U.S. 
source income for its 1985 taxable year. The $60 NOL is allocated first 
to X's 1985 general limitation income to the extent thereof ($20) since 
the general limitation income category of section 904(d) as in effect 
for pre-effective date taxable years is the income category that is 
analogous to shipping income for post-effective date taxable years. 
Therefore, X has no general limitation income for its 1985 taxable year. 
Next, pursuant to section 904(f) as in effect for pre-effective date 
taxable years, the remaining $40 of the NOL is allocated first to X's 
$10 of U.S. source income and then to $30 of X's DISC limitation income 
for its 1985 taxable year. Accordingly, X has no U.S. source income and 
$10 of DISC limitation income for its 1985 taxable year after allocation 
of the NOL. X has a $10 balance in its shipping overall foreign loss 
account which is subject to recapture pursuant to section 904(f) as in 
effect for post-effective date taxable years. X will not be required to 
recharacterize, pursuant to section 904(f)(5), subsequent shipping 
income as DISC limitation income.
    Example 2. Y is a domestic corporation which has a branch operation 
in Country B. For its taxable year ending December 31, 1987, X has a 
$200 net operating loss which is carried back pursuant to section 172 to 
its taxable year ending December 31, 1986. The net operating loss 
resulted from a ($100) general limitation loss and a ($100) shipping 
loss. Y had $100 of general limitation income and $200 of U.S. source 
income for its taxable year ending December 31, 1986. The separate 
limitation losses for 1987 are allocated pro rata to Y's 1986 general 
limitation income as follows: $50 of the ($100) general limitation loss 
($100 x 100/200) and $50 of the ($100) shipping loss ($100 x 100/200) is 
allocated to Y's $100 of 1986 general limitation income. The remaining 
$50 of Y's general limitation loss and the remaining $50 of Y's shipping 
loss are allocated to Y's 1986 U.S. source income. Accordingly, Y has no 
foreign source income and $100 of U.S. source income for its 1986 
taxable year. Y has a $50 balance in its general limitation overall 
foreign loss account and a $50 balance in its shipping overall foreign 
loss account, both of which will be subject to recapture pursuant to 
section 904(f) as in effect for post-effective date taxable years.

    (d) Recapture of FORI and general limitation overall foreign losses 
incurred in taxable years beginning before January 1, 1983. For taxable 
years beginning after December 31, 1986, and before January 1, 1991, the 
rules set forth in Sec.  1.904 (f)-6 shall apply for purposes of 
recapturing general limitation and foreign oil related income (FORI) 
overall foreign losses incurred in taxable years beginning before 
January 1, 1983 (pre-1983). For taxable years beginning after December 
31, 1990, the rules set forth in this section shall apply for purposes 
of recapturing pre-1983 general limitation and FORI overall foreign 
losses.
    (e) Recapture of pre-1983 overall foreign losses determined on a 
combined basis. The rules set forth in paragraph (a)(2) of this section 
shall apply for purposes of recapturing overall foreign losses incurred 
in taxable years beginning before January 1, 1983, that were computed on 
a combined basis in accordance with Sec.  1.904 (f)-1(c) (1).
    (f) Transition rules for taxable years beginning before December 31, 
1990. For transition rules for taxable years beginning before January 1, 
1990, see 26 CFR 1.904 (f)-13T as it appeared in the Code of Federal 
Regulations revised as of April 1, 1990.
    (g) Recapture in years beginning after December 31, 2002, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2003, with respect to the separate category 
for dividends from a noncontrolled section 902 corporation--(1) 
Recapture of separate limitation loss or overall foreign loss in a 
separate category for dividends from a noncontrolled section 902 
corporation. To the extent that a taxpayer has a balance in any separate 
limitation loss or

[[Page 979]]

overall foreign loss account in a separate category for dividends from a 
noncontrolled section 902 corporation under section 904(d)(1)(E) (prior 
to its repeal by Public Law 108-357, 118 Stat. 1418 (October 22, 2004)) 
at the end of the taxpayer's last taxable year beginning before January 
1, 2003 (or a later taxable year in which the taxpayer received a 
dividend subject to a separate limitation for dividends from that 
noncontrolled section 902 corporation), the amount of such balance shall 
be allocated on the first day of the taxpayer's next taxable year to the 
taxpayer's other separate categories. The amount of such balance shall 
be allocated in the same percentages as the taxpayer properly 
characterized the stock of the noncontrolled section 902 corporation for 
purposes of apportioning the taxpayer's interest expense for its first 
taxable year ending after the first day of such corporation's first 
taxable year beginning after December 31, 2002, under Sec.  1.861-
12T(c)(3) or Sec.  1.861-12(c)(4), as the case may be. To the extent a 
taxpayer has a balance in any separate limitation loss account in a 
separate category for dividends from a noncontrolled section 902 
corporation with respect to another separate category, and the separate 
limitation loss would otherwise be assigned to that other category under 
this paragraph (g)(1), such balance shall be eliminated.
    (2) Recapture of separate limitation loss in another separate 
category. To the extent that a taxpayer has a balance in any separate 
limitation loss account in a separate category with respect to a 
separate category for dividends from a noncontrolled section 902 
corporation under section 904(d)(1)(E) (prior to its repeal by Public 
Law 108-357, 118 Stat. 1418 (October 22, 2004)) at the end of the 
taxpayer's last taxable year with or within which ends the last taxable 
year of the noncontrolled section 902 corporation beginning before 
January 1, 2003, such loss shall be recaptured in subsequent taxable 
years as income in the appropriate separate categories. The separate 
limitation loss shall be recaptured as income in other separate 
categories in the same percentages as the taxpayer properly 
characterizes the stock of the noncontrolled section 902 corporation for 
purposes of apportioning the taxpayer's interest expense in its first 
taxable year ending after the first day of the foreign corporation's 
first taxable year beginning after December 31, 2002, under Sec.  1.861-
12T(c)(3) or Sec.  1.861-12(c)(4), as the case may be. To the extent a 
taxpayer has a balance in a separate limitation loss account in a 
separate category that would have been recaptured as income in that same 
category under this paragraph (g)(2), such balance shall be eliminated.
    (3) Exception. Where a taxpayer formerly met the stock ownership 
requirements of section 902(a) with respect to a foreign corporation, 
but did not meet the requirements of section 902(a) on December 20, 2002 
(or on the first day of the taxpayer's first taxable year beginning 
after December 31, 2002, in the case of a transaction that was the 
subject of a binding contract in effect on December 20, 2002), if the 
taxpayer has a balance in any separate limitation loss or overall 
foreign loss account for a separate category for dividends from that 
foreign corporation under section 904(d)(1)(E) (prior to its repeal by 
Public Law 108-357, 118 Stat. 1418 (October 22, 2004)) at the end of the 
taxpayer's last taxable year beginning before January 1, 2003, then the 
amount of such balance shall not be subject to recapture under section 
904(f) and this section. If a separate limitation loss or overall 
foreign loss account for such category is not subject to recapture under 
this paragraph (g)(3), the taxpayer cannot carry over any unused foreign 
taxes in such separate category to any other limitation category. 
However, a taxpayer may elect to recapture the balances of all separate 
limitation loss and overall foreign loss accounts for all separate 
categories for dividends from such formerly-owned noncontrolled section 
902 corporations under the rules of paragraphs (g)(1) and (2) of this 
section. If a taxpayer so elects, it may carry over any unused foreign 
taxes in these separate categories to the appropriate separate 
categories as provided in Sec.  1.904-2(h).
    (4) Examples. The following examples illustrate the application of 
this paragraph (g):


[[Page 980]]


    Example 1. X is a domestic corporation that meets the ownership 
requirements of section 902(a) with respect to Y, a foreign corporation 
the stock of which X owns 50 percent. Therefore, Y is a noncontrolled 
section 902 corporation with respect to X. Both X and Y use the calendar 
year as their taxable year. As of December 31, 2002, X had a $100 
balance in its separate limitation loss account for the separate 
category for dividends from Y, of which $60 offset general limitation 
income and $40 offset passive income. For purposes of apportioning X's 
interest expense for its 2003 taxable year, X properly characterized the 
stock of Y as a multiple category asset (80% general and 20% passive). 
Under paragraph (g)(1) of this section, on January 1, 2003, $80 ($100 x 
80/100) of the $100 balance in the separate limitation loss account is 
assigned to the general limitation category. Of this $80 balance, $32 
($80 x 40/100) is with respect to the passive category, and $48 ($80 x 
60/100) is with respect to the general limitation category and therefore 
is eliminated. The remaining $20 balance ($100 x 20/100) of the $100 
balance is assigned to the passive category. Of this $20 balance, $12 
($20 x 60/100) is with respect to the general limitation category, and 
$8 ($20 x 40/100) is with respect to the passive category and therefore 
is eliminated.
    Example 2. The facts are the same as in Example 1, except that as of 
December 31, 2002, X had a $30 balance in its separate limitation loss 
account in the general limitation category, and a $20 balance in its 
separate limitation loss account in the passive category, both of which 
offset income in the separate category for dividends from Y. Under 
paragraph (g)(2) of this section, the separate limitation loss accounts 
in the general limitation and passive categories with respect to the 
separate category for dividends from Y will be recaptured on and after 
January 1, 2003, from income in other separate categories, as follows. 
Of the $30 balance in X's separate limitation loss account in the 
general category with respect to the separate category for dividends 
from Y, $6 ($30 x 20/100) is with respect to the passive category, and 
$24 ($30 x 80/100) is with respect to the general limitation category 
and therefore is eliminated. Of the $20 balance in X's separate 
limitation loss account in the passive category with respect to the 
separate category for dividends from Y, $16 ($20 x 80/100) will be 
recaptured out of general limitation income, and $4 ($20 x 20/100) would 
otherwise be recaptured out of passive income and therefore is 
eliminated.

    (5) Effective/applicability date. This paragraph (g) applies to 
taxable years ending on or after April 20, 2009. See 26 CFR 1.904(f)-
12T(g) (revised as of April 1, 2009) for rules applicable to taxable 
years beginning after December 31, 2002, and ending before April 20, 
2009.
    (h) Recapture in years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2007--(1) Losses related to pre-2007 
separate categories for passive income, certain dividends from a DISC or 
former DISC, taxable income attributable to certain foreign trade income 
or certain distributions from a FSC or former FSC--(i) Recapture of 
separate limitation loss or overall foreign loss incurred in a pre-2007 
separate category for passive income, certain dividends from a DISC or 
former DISC, taxable income attributable to certain foreign trade income 
or certain distributions from a FSC or former FSC. To the extent that a 
taxpayer has a balance in any separate limitation loss or overall 
foreign loss account in a pre-2007 separate category (as defined in 
Sec.  1.904-7(g)(1)(ii)) for passive income, certain dividends from a 
DISC or former DISC, taxable income attributable to certain foreign 
trade income or certain distributions from a FSC or former FSC, at the 
end of the taxpayer's last taxable year beginning before January 1, 
2007, the amount of such balance, or balances, shall be allocated on the 
first day of the taxpayer's next taxable year to the taxpayer's post-
2006 separate category (as defined in Sec.  1.904-7(g)(1)(iii)) for 
passive category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for passive income, certain dividends from a DISC 
or former DISC, taxable income attributable to certain foreign trade 
income or certain distributions from a FSC or former FSC. To the extent 
that a taxpayer has a balance in any separate limitation loss account in 
any pre-2007 separate category with respect to a pre-2007 separate 
category for passive income, certain dividends from a DISC or former 
DISC, taxable income attributable to certain foreign trade income or 
certain distributions from a FSC or former FSC at the end of the 
taxpayer's last taxable year beginning before January 1, 2007, such loss 
shall be recaptured in subsequent taxable years as income in the post-
2006 separate category for passive category income.
    (2) Losses related to pre-2007 separate categories for shipping, 
financial services

[[Page 981]]

income or general limitation income--(i) Recapture of separate 
limitation loss or overall foreign loss incurred in a pre-2007 separate 
category for shipping income, financial services income or general 
limitation income. To the extent that a taxpayer has a balance in any 
separate limitation loss or overall foreign loss account in a pre-2007 
separate category for shipping income, financial services income or 
general limitation income at the end of the taxpayer's last taxable year 
beginning before January 1, 2007, the amount of such balance, or 
balances, shall be allocated on the first day of the taxpayer's next 
taxable year to the taxpayer's post-2006 separate category for general 
category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for shipping income, financial services income or 
general limitation income. To the extent that a taxpayer has a balance 
in any separate limitation loss account in any pre-2007 separate 
category with respect to a pre-2007 separate category for shipping 
income, financial services income or general limitation income at the 
end of the taxpayer's last taxable year beginning before January 1, 
2007, such loss shall be recaptured in subsequent taxable years as 
income in the post-2006 separate category for general category income.
    (3) Losses related to a pre-2007 separate category for high 
withholding tax interest--(i) Recapture of separate limitation loss or 
overall foreign loss incurred in a pre-2007 separate category for high 
withholding tax interest. To the extent that a taxpayer has a balance in 
any separate limitation loss or overall foreign loss account in a pre-
2007 separate category for high withholding tax interest at the end of 
the taxpayer's last taxable year beginning before January 1, 2007, the 
amount of such balance shall be allocated on the first day of the 
taxpayer's next taxable year on a pro rata basis to the taxpayer's post-
2006 separate categories for general category and passive category 
income, based on the proportion in which any unused foreign taxes in the 
same pre-2007 separate category for high withholding tax interest are 
allocated under Sec.  1.904-2(i)(1). If the taxpayer, other than a 
financial services entity as defined in Sec.  1.904-4(e)(3), has no 
unused foreign taxes in the pre-2007 separate category for high 
withholding tax interest, then any loss account balance in that category 
shall be allocated to the post-2006 separate category for passive 
category income. If the taxpayer is a financial services entity, as 
defined in Sec.  1.904-4(e)(3), and has no unused foreign taxes in the 
pre-2007 separate category for high withholding tax interest, then any 
loss account balance in that category shall be allocated to the post-
2006 separate category for general category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for high withholding tax interest. To the extent 
that a taxpayer has a balance in a separate limitation loss account in 
any pre-2007 separate category with respect to a pre-2007 separate 
category for high withholding tax interest at the end of the taxpayer's 
last taxable year beginning before January 1, 2007, such loss shall be 
recaptured in subsequent taxable years on a pro rata basis as income in 
the post-2006 separate categories for general category and passive 
category income, based on the proportion in which any unused foreign 
taxes in the pre-2007 separate category for high withholding tax 
interest are allocated under Sec.  1.904-2(i)(1). If the taxpayer, other 
than a financial services entity as defined in Sec.  1.904-4(e)(3), has 
no unused foreign taxes in the pre-2007 separate category for high 
withholding tax interest, then the loss account balance shall be 
recaptured in subsequent taxable years solely as income in the post-2006 
separate category for passive category income. If the taxpayer is a 
financial services entity, as defined in Sec.  1.904-4(e)(3), and has no 
unused foreign taxes in the pre-2007 separate category for high 
withholding tax interest, then the loss account balance shall be 
recaptured in subsequent taxable years solely as income in the post-2006 
separate category for general category income.
    (4) Elimination of certain separate limitation loss accounts. After 
application of paragraphs (h)(1) through (h)(3) of this section, any 
separate limitation loss account allocated to the post-2006 separate 
category for passive category income for which income is to be 
recaptured as passive category income, as

[[Page 982]]

determined under those same provisions, shall be eliminated. Similarly, 
after application of paragraphs (h)(1) through (h)(3) of this section, 
any separate limitation loss account allocated to the post-2006 separate 
category for general category income for which income is to be 
recaptured as general category income, as determined under those same 
provisions, shall be eliminated.
    (5) Alternative method. In lieu of applying the rules of paragraphs 
(h)(1) through (h)(3) of this section, a taxpayer may apply the 
principles of paragraphs (g)(1) and (g)(2) of this section to determine 
recapture in taxable years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in 
taxable years beginning before January 1, 2007. A taxpayer may choose to 
use the alternative method on a timely filed (original or amended) tax 
return or during an audit. A taxpayer that uses the alternative method 
on an amended return or in the course of an audit must make appropriate 
adjustments to eliminate any double benefit arising from application of 
the alternative method to years that are not open for assessment. A 
taxpayer's choice to use the alternative method is evidenced by 
employing the method. The taxpayer need not file any separate statement.
    (6) Effective/applicability date. This paragraph (h) shall apply to 
taxable years beginning after December 31, 2006, and ending on or after 
December 21, 2007. However, taxpayers may choose to apply 26 CFR 
1.904(f)-12T(h) as it appeared in the Code of Federal Regulations as of 
April 1, 2010, in lieu of this paragraph (h) to taxable years beginning 
after December 31, 2006 and ending on or after December 21, 2007, but 
ending before April 7, 2011 provided that appropriate adjustments are 
made to eliminate duplicate benefits arising from application of 26 CFR 
1.904(f)-12T(h) to taxable years that are not open for assessment. In 
addition, if a taxpayer that is a financial services entity (as defined 
in Sec.  1.904-4(e)(3)) chooses to apply 26 CFR 1.904(f)-12T(h) to 
taxable years ending before April 7, 2011, then as of the beginning of 
the taxpayer's first taxable year ending on or after April 7, 2011 any 
remaining balance in a passive category loss account that is 
attributable to a loss account in a pre-2007 separate category for high 
withholding tax interest shall be allocated to the general category or 
eliminated pursuant to Sec.  1.904(f)-12(h)(4), and any remaining 
balance in a separate limitation loss account with respect to passive 
category income that is attributable to a loss account with respect to a 
pre-2007 separate category for high withholding tax interest will be 
recaptured in such year and subsequent taxable years as general category 
income or eliminated pursuant to Sec.  1.904(f)-12(h)(4).
    (i) [Reserved]
    (j) Recapture in years beginning after December 31, 2017, of 
separate limitation losses, overall foreign losses, and overall domestic 
losses incurred in years beginning before January 1, 2018--(1) 
Definitions--(i) The term pre-2018 separate categories means the 
separate categories of income described in section 904(d) and any 
specified separate categories of income, as applicable to taxable years 
beginning before January 1, 2018.
    (ii) The term post-2017 separate categories means the separate 
categories of income described in section 904(d) and any specified 
separate categories of income, as applicable to taxable years beginning 
after December 31, 2017.
    (iii) The term specified separate category has the meaning set forth 
in Sec.  1.904-4(m)).
    (2) Allocation of separate limitation loss or overall foreign loss 
account incurred in a pre-2018 separate category--(i) Allocation to the 
same category. To the extent that a taxpayer has a balance in any 
separate limitation loss or overall foreign loss account in a pre-2018 
separate category at the end of the taxpayer's last taxable year 
beginning before January 1, 2018, the amount of such balance is 
allocated on the first day of the taxpayer's next taxable year to the 
same post-2017 separate category as the pre-2018 separate category of 
the separate limitation loss or overall foreign loss account.
    (ii) Exception for general category separate limitation loss or 
overall foreign loss account--(A) In general. To the extent a taxpayer 
has a balance in any separate limitation loss or overall foreign loss

[[Page 983]]

account in the pre-2018 separate category for general category income at 
the end of the taxpayer's last taxable year beginning before January 1, 
2018, a taxpayer may choose to allocate any such balance to the 
taxpayer's post-2017 separate category for foreign branch category 
income to the extent the balance in the loss account would have been 
allocated to the taxpayer's post-2017 separate category for foreign 
branch category income if that separate category applied in the year or 
years the losses giving rise to the account were incurred. Any remaining 
portion of the balance in the separate limitation loss or overall 
foreign loss account is allocated to the taxpayer's post-2017 separate 
category for general category income.
    (B) Safe harbor. In lieu of applying paragraph (j)(2)(ii)(A) of this 
section, the taxpayer may choose to recapture the balance in any loss 
account described in paragraph (j)(2)(ii)(A) of this section from the 
first available income in the taxpayer's post-2017 separate category for 
general category income or foreign branch category income. If the sum of 
taxpayer's general category income and foreign branch category income 
for a taxable year subject to recharacterization exceeds the amount of 
the loss account described in paragraph (j)(2)(ii)(A) of this section 
that is to be recaptured, then the amount of general category income and 
foreign branch category income that will be recharacterized under the 
relevant recapture provisions is determined on a proportionate basis. 
The recapture under this paragraph (j)(2)(ii)(B) of any loss account 
described in paragraph (j)(2)(ii)(A) of this section is made before the 
recapture of any amount by which the balance of the loss account is 
increased after the end of the taxpayer's last taxable year beginning 
before January 1, 2018.
    (C) Rules regarding the exception. A taxpayer applying the exception 
described in paragraph (j)(2)(ii)(A) or (B) of this section must apply 
the exception to all balances in any separate limitation loss or overall 
foreign loss account in a pre-2018 separate category for general 
category income at the end of the taxpayer's last taxable year beginning 
before January 1, 2018. A taxpayer may apply the exception on a timely 
filed original return (including extensions) or an amended return. A 
taxpayer that applies the exception on an amended return must make 
appropriate adjustments to eliminate any double benefit arising from 
application of the exception to years that are not open for assessment.
    (3) Recapture of separate limitation loss or overall domestic loss 
that reduced pre-2018 separate category income--(i) Recapture as income 
in the same separate category. To the extent that at the end of the 
taxpayer's last taxable year beginning before January 1, 2018, a 
taxpayer has a balance in any separate limitation loss or overall 
domestic loss account which offset pre-2018 separate category income, 
such loss is recaptured in subsequent taxable years as income in the 
same post-2017 separate category as the pre-2018 separate category of 
income that was offset by the loss.
    (ii) Exception for separate limitation loss or overall domestic loss 
that reduced general category income--(A) In general. To the extent that 
a taxpayer's separate limitation loss or overall domestic loss account 
offset pre-2018 separate category income that was general category 
income, a taxpayer may choose to recapture the balance in the loss 
account at the end of the taxpayer's last taxable year beginning before 
January 1, 2018, in subsequent taxable years as income in the post-2017 
separate category for foreign branch category income to the extent the 
balance in the loss account would have offset foreign branch category 
income had that separate category applied in the year or years the 
losses were incurred. Any remaining portion of the balance in the loss 
account is recaptured as income in the taxpayer's post-2017 separate 
category for general category income.
    (B) Safe harbor. In lieu of applying paragraph (j)(3)(ii)(A) of this 
section, a taxpayer that had unused foreign income taxes in a pre-2018 
taxable year that were allocated to the foreign branch category under 
Sec.  1.904-2(j)(1)(iii)(A) or (B) may choose to recapture the balance 
in any loss account described in paragraph (j)(3)(ii)(A) of this section 
in subsequent taxable

[[Page 984]]

years ratably as income in the taxpayer's post-2017 separate categories 
for general category and foreign branch category income, based on the 
proportion in which any unused foreign taxes in the pre-2018 separate 
category for general category income are allocated under Sec.  1.904-
2(j)(1)(iii)(A) or (B).
    (C) Rules regarding the exception. A taxpayer applying the exception 
described in paragraph (j)(2)(ii)(A) or (B) of this section must apply 
the exception to the recapture of all balances at the end of the 
taxpayer's last taxable year beginning before January 1, 2018 in any 
separate limitation loss or overall domestic loss account which offset 
pre-2018 separate category income that was general category income. A 
taxpayer may apply the exception on a timely filed original return 
(including extensions) or an amended return. A taxpayer that applies the 
exception on an amended return must make appropriate adjustments to 
eliminate any double benefit arising from application of the exception 
to years that are not open for assessment.
    (4) Treatment of foreign losses that are part of net operating 
losses incurred in pre-2018 taxable years which are carried forward to 
post-2017 taxable years--(i) Treatment as a loss in the same separate 
category. A foreign loss that is part of a net operating loss incurred 
in a taxable year beginning before January 1, 2018, which is carried 
forward, pursuant to section 172, to a taxable year beginning after 
December 31, 2017, will be carried forward under the rules of Sec.  
1.904(g)-3(b)(2). For purposes of applying the rules of Sec.  1.904(g)-
3(b)(2), the portion of a net operating loss carryforward that is 
attributable to a foreign loss from a pre-2018 separate category will be 
treated as a loss attributable to the same post-2017 separate category 
as the pre-2018 separate category.
    (ii) Exception for general category foreign losses that are part of 
net operating losses--(A) In general. A taxpayer may choose to treat the 
portion of a net operating loss carryforward that is attributable to a 
foreign loss from the pre-2018 separate category for general category 
income as attributable to the post-2017 separate category for foreign 
branch category income to the extent the net operating loss would have 
been attributable to the taxpayer's post-2017 separate category for 
foreign branch category income had that separate category applied in the 
year or years the net operating loss arose. Any remaining portion of the 
net operating loss carryforward is treated as attributable to the 
taxpayer's post-2017 separate category for general category income.
    (B) Safe harbor. In lieu of applying paragraph (j)(4)(ii)(A) of this 
section, for the post-2017 taxable year in which a net operating loss 
carryforward described in paragraph (j)(4)(ii)(A) of this section is 
used, the taxpayer may choose to treat the net operating loss 
carryforward as attributable to the taxpayer's post-2017 separate 
categories for general category income and foreign branch category 
income to the extent of any general category income and foreign branch 
category income, respectively, that is available in the carryforward 
year to be offset by the net operating loss carryforward. To the extent 
the net operating loss carryforward offsets any other income in the 
carryforward year, it is treated as attributable to the taxpayer's post-
2017 separate category for general category income. If the sum of 
taxpayer's general category income and foreign branch income in the 
carryforward year exceeds the amount of the net operating loss 
carryforward, then the amount of each type of separate income that is 
offset by the net operating loss carryforward, and therefore the 
separate category treatment of the net operating loss carryforward, is 
be determined on a proportionate basis. A general category net operating 
loss to which the exception is applied is absorbed before any general 
category net operating loss that is incurred after the end of the 
taxpayer's last taxable year beginning before January 1, 2018.
    (C) Rules regarding the exception. A taxpayer applying the exception 
described in paragraph (j)(4)(ii)(A) or (B) of this section must apply 
the exception to all of its net operating losses that are attributable 
to a foreign loss from the pre-2018 separate category for general 
category income. A taxpayer may apply the exception on a timely

[[Page 985]]

filed original return (including extensions) or an amended return. A 
taxpayer that applies the exception on an amended return must make 
appropriate adjustments to eliminate any double benefit arising from 
application of the exception to years that are not open for assessment.
    (5) Treatment of net operating losses incurred in post-2017 taxable 
years that are carried back to pre-2018 taxable years--(i) In general. 
Except as provided in paragraph (j)(5)(ii) of this section, a net 
operating loss incurred in a taxable year beginning after December 31, 
2017 (a ``post-2017 taxable year''), which is carried back, pursuant to 
section 172, to a taxable year beginning before January 1, 2018 (a 
``pre-2018 carryback year''), will be carried back under the rules of 
Sec.  1.904(g)-3(b). For purposes of applying the rules of Sec.  
1.904(g)-3(b), income in a pre-2018 separate category in the taxable 
year to which the net operating loss is carried back is treated as if it 
included only income that would be assigned to the post-2017 general 
category. Therefore, any separate limitation loss created by reason of a 
passive category component of a net operating loss from a post-2017 
taxable year that is carried back to offset general category income in a 
pre-2018 carryback year will be recaptured in post-2017 taxable years as 
general category income, and not as a combination of general, foreign 
branch, and section 951A category income.
    (ii) Foreign source losses in the post-2017 separate categories for 
foreign branch category income and section 951A category income. Net 
operating losses attributable to a foreign source loss in the post-2017 
separate categories for foreign branch category income and section 951A 
category income are treated as first offsetting general category income 
in a pre-2018 carryback year to the extent available to be offset by the 
net operating loss carryback. If the sum of foreign source losses in the 
taxpayer's separate categories for foreign branch category income and 
section 951A category income in the year the net operating loss is 
incurred exceeds the amount of general category income that is available 
to be offset in the carryback year, then the amount of foreign source 
loss in each of the foreign branch and section 951A categories that is 
treated as offsetting general category income under this paragraph 
(j)(5)(ii), is determined on a proportionate basis. General category 
income in the pre-2018 carryback year is first offset by foreign source 
loss in the taxpayer's post-2017 separate category for general category 
income in the year the net operating loss is incurred before any foreign 
source loss in that year in the separate categories for foreign branch 
category income and section 951A category income is carried back to 
reduce general category income. To the extent a foreign source loss in a 
post-2017 separate category for foreign branch category income or 
section 951A category income offsets general category income in a pre-
2018 taxable year under the rules of this paragraph (j)(5)(ii), no 
separate limitation loss account is created.
    (6) Coordination rule with respect to exceptions. A taxpayer that 
applies any exception described in Sec.  1.904-2(j)(1)(iii) or paragraph 
(j)(2)(ii), (j)(3)(ii), or (j)(4)(ii) of this section must apply all 
such exceptions and cannot apply any of the general rules described in 
Sec.  1.904-2(j)(1)(ii) or paragraph (j)(2)(i), (j)(3)(i), or (j)(4)(i) 
of this section. However, in applying each such exception, the taxpayer 
may choose to apply the safe harbor provision regardless of whether the 
safe harbor is applied for purposes of any other exception.
    (7) Applicability date. Except as otherwise provided in this 
paragraph (j)(7), this paragraph (j) applies to taxable years ending on 
or after December 31, 2017. Paragraph (j)(5) of this section applies to 
carrybacks of net operating losses incurred in taxable years beginning 
on or after January 1, 2018.

[T.D. 8306, 55 FR 31381, Aug. 2, 1990, as amended by T.D. 9260, 71 FR 
24539, Apr. 25, 2006; T.D. 9368, 72 FR 72591, Dec. 21, 2007; T.D. 9452, 
74 FR 27886, June 11, 2009; T.D. 9521, 76 FR 19273, Apr. 7, 2011; T.D 
9882, 84 FR 69100, Dec. 17, 2019; T.D. 9956, 86 FR 52972, Sept. 24, 
2021]



Sec.  1.904(g)-0  Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(g)-1 through 
1.904(g)-3.

  Sec.  1.904(g)-1 Overall domestic loss and the overall domestic loss 
                                account.

    (a) Overview of regulations.

[[Page 986]]

    (b) Overall domestic loss accounts.
    (1) In general.
    (2) Taxable year in which overall domestic loss is sustained.
    (c) Determination of a taxpayer's overall domestic loss.
    (1) Overall domestic loss defined.
    (2) Domestic loss defined.
    (3) Qualified taxable year defined.
    (4) Method of allocation and apportionment of deductions.
    (d) Additions to overall domestic loss accounts.
    (1) General rule.
    (2) Overall domestic loss of another taxpayer.
    (3) Adjustments for capital gains and losses.
    (e) Reductions of overall domestic loss accounts.
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers.
    (2) Reduction for amounts recaptured.
    (f) Effective/applicability date.

         Sec.  1.904(g)-2 Recapture of overall domestic losses.

    (a) In general.
    (b) Determination of U.S. source taxable income for purposes of 
recapture.
    (c) Section 904(g)(1) recapture.
    (d) Effective/applicability date.

  Sec.  1.904(g)-3 Ordering rules for the allocation of net operating 
losses, net capital losses, U.S. source losses, and separate limitation 
  losses, and for the recapture of separate limitation losses, overall 
              foreign losses, and overall domestic losses.

    (a) In general.
    (b) Step One: Allocation of net operating loss and net capital loss 
carryovers.
    (1) In general.
    (2) Full net operating loss carryover.
    (3) Partial net operating loss carryover.
    (4) Net capital loss carryovers.
    (c) Step Two: Section 904(b) adjustments.
    (d) Step Three: Allocation of separate limitation losses.
    (e) Step Four: Allocation of U.S. source losses.
    (f) Step Five: Recapture of overall foreign loss accounts.
    (g) Step Six: Recapture of separate limitation loss accounts.
    (h) Step Seven: Recapture of overall domestic loss accounts.
    (i) Step Eight: Dispositions under section 904(f)(3) in which gain 
would not otherwise be recognized.
    (j) [Reserved]
    (k) Examples.
    (l) Applicability date.

[T.D. 9371, 72 FR 72599, Dec. 21, 2007, as amended by T.D. 9595, 77 FR 
37580, June 22, 2012; T.D 9882, 84 FR 69102, Dec. 17, 2019; T.D. 9882, 
85 FR 29323, May 15, 2020]



Sec.  1.904(g)-1  Overall domestic loss and the overall domestic loss account.

    (a) Overview of regulations. This section provides rules for 
determining a taxpayer's overall domestic losses, for establishing 
overall domestic loss accounts, and for making additions to and reducing 
such accounts for purposes of section 904(g). Section 1.904(g)-2 
provides rules for recapturing the balance in any overall domestic loss 
account under the general recharacterization rule of section 904(g)(1). 
Section 1.904(g)-3 provides ordering rules for the allocation of net 
operating losses, net capital losses, U.S. source losses, and separate 
limitation losses, and the recapture of separate limitation losses, 
overall foreign losses and overall domestic losses.
    (b) Overall domestic loss accounts--(1) In general. Any taxpayer 
that sustains an overall domestic loss under paragraph (c) of this 
section must establish an overall domestic loss account for such loss 
with respect to each separate category, as defined in Sec.  1.904(f)-
7(b)(1), of the taxpayer in which foreign source income is offset by the 
domestic loss. The balance in each overall domestic loss account 
represents the amount of such overall domestic loss subject to recapture 
in a given taxable year. From year to year, amounts may be added to or 
subtracted from the balances in such loss accounts as provided in 
paragraphs (d) and (e) of this section.
    (2) Taxable year in which overall domestic loss is sustained. When a 
domestic loss is carried back or carried forward as part of a net 
operating loss, and offsets foreign source income in a carryover year, 
the resulting overall domestic loss is treated as sustained in the later 
of the year in which the domestic loss was incurred or the year to which 
the loss was carried. Accordingly, when a taxpayer incurs a domestic 
loss that is carried back as part of a net operating loss to offset 
foreign source income in a qualified taxable year, as defined in 
paragraph (c)(3) of this section,

[[Page 987]]

the resulting overall domestic loss is treated as sustained in the later 
year in which the domestic loss was incurred and not in the earlier year 
in which the loss offset foreign source income. In addition, when a 
taxpayer incurs a domestic loss that is carried forward as part of a net 
operating loss and applied to offset foreign source income in a later 
taxable year, the resulting overall domestic loss is treated as 
sustained in the later year in which the domestic loss offsets foreign 
source income and not in the earlier year in which the loss was 
incurred. For example, if a taxpayer incurs a domestic loss in the 2007 
taxable year that is carried back to the 2006 qualified taxable year and 
offsets foreign source income in 2006, the resulting overall domestic 
loss is treated as sustained in the 2007 taxable year. If a taxpayer 
incurs a domestic loss in a pre-2007 taxable year that is carried 
forward to a post-2006 qualified taxable year and offsets foreign source 
income in the post-2006 year, the resulting overall domestic loss is 
treated as sustained in the post-2006 year. An overall domestic loss 
account is established, or increased under paragraph (d) of this 
section, at the end of the taxable year in which the overall domestic 
loss is treated as sustained and will be recaptured from U.S. source 
income arising in subsequent taxable years.
    (c) Determination of a taxpayer's overall domestic loss--(1) Overall 
domestic loss defined. For taxable years beginning after December 31, 
2006, a taxpayer sustains an overall domestic loss--
    (i) In any qualified taxable year in which its domestic loss for 
such taxable year offsets foreign source taxable income for the taxable 
year or for any preceding qualified taxable year by reason of a 
carryback; and
    (ii) In any other taxable year in which the domestic loss for such 
taxable year offsets foreign source taxable income for any preceding 
qualified taxable year by reason of a carryback.
    (2) Domestic loss defined. For purposes of this section and 
Sec. Sec.  1.904(g)-2 and 1.904(g)-3, the term domestic loss means the 
amount by which the U.S. source gross income for the taxable year is 
exceeded by the sum of the expenses, losses, and other deductions 
properly apportioned or allocated to such income, taking into account 
any net operating loss carried forward from a prior taxable year, but 
not any loss carried back. If a taxpayer has any capital gains or losses 
or qualified dividend income, as defined in section 1(h)(11), the amount 
of the taxpayer's domestic loss that offsets foreign source income must 
be determined taking into account adjustments under section 904(b)(2). 
See Sec.  1.904(g)-1(d)(3) for further guidance.
    (3) Qualified taxable year defined. For purposes of this section and 
Sec. Sec.  1.904(g)-2 and 1.904(g)-3, the term qualified taxable year 
means any taxable year for which the taxpayer chooses the benefits of 
section 901.
    (4) Method of allocation and apportionment of deductions. In 
determining its overall domestic loss, a taxpayer shall allocate and 
apportion expenses, losses, and other deductions to U.S. source gross 
income in accordance with sections 861(b) and 865 and the regulations 
thereunder, including Sec. Sec.  1.861-8 through 1.861-14T.
    (d) Additions to overall domestic loss accounts--(1) General rule. A 
taxpayer's overall domestic loss as determined under paragraph (c) of 
this section shall be added to the applicable overall domestic loss 
account at the end of its taxable year to the extent that the overall 
domestic loss either reduces foreign source income for the year (but 
only if such year is a qualified taxable year) or reduces foreign source 
income for a qualified taxable year to which the loss has been carried 
back.
    (2) Overall domestic loss of another taxpayer. If any portion of any 
overall domestic loss of another taxpayer is allocated to the taxpayer 
in accordance with Sec.  1.1502-9 (relating to consolidated overall 
domestic losses) the taxpayer shall add such amount to its applicable 
overall domestic loss account.
    (3) Adjustments for capital gains and losses. If the taxpayer has 
capital gains or losses or qualified dividend income, the amount by 
which a domestic loss is considered to reduce foreign source income in a 
taxable year shall equal the section 904(f)(5)(D) amount determined 
under Sec.  1.904(b)-1(h)(1)(iii), regardless of the amount of domestic 
loss that was

[[Page 988]]

determined before taking any section 904(b)(2) adjustments into account.
    (e) Reductions of overall domestic loss accounts. The taxpayer shall 
subtract the following amounts from its overall domestic loss accounts 
at the end of its taxable year in the following order, as applicable:
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers. An overall domestic loss account is reduced by the amount of 
any overall domestic loss which is allocated to another taxpayer in 
accordance with Sec.  1.1502-9 (relating to consolidated overall 
domestic losses).
    (2) Reduction for amounts recaptured. An overall domestic loss 
account is reduced by the amount of any U.S. source income that is 
recharacterized in accordance with Sec.  1.904(g)-2(c) (relating to 
recapture under section 904(g)(1)).
    (f) Effective/applicability date. This section applies to taxpayers 
that sustain an overall domestic loss for a taxable year beginning on or 
after January 1, 2012. Taxpayers may choose to apply this section to 
overall domestic losses sustained in other taxable years beginning after 
December 31, 2006, including periods covered by 26 CFR Sec.  1.904(g)-1T 
(revised as of April 1, 2010).

[T.D. 9595, 77 FR 37580, June 22, 2012]



Sec.  1.904(g)-2  Recapture of overall domestic losses.

    (a) In general. A taxpayer shall recapture an overall domestic loss 
as provided in this section. Recapture is accomplished by treating a 
portion of the taxpayer's U.S. source taxable income as foreign source 
income. The recharacterized income is allocated among and increases 
foreign source income in separate categories in proportion to the 
balances of the overall domestic loss accounts with respect to those 
separate categories. As a result, if the taxpayer chooses the benefits 
of section 901, the taxpayer's foreign tax credit limitation is 
increased. As provided in Sec.  1.904(g)-1(e)(2), the balance in a 
taxpayer's overall domestic loss account with respect to a separate 
category is reduced at the end of each taxable year by the amount of 
loss recaptured during that taxable year. Recapture continues until the 
amount of U.S. source income recharacterized as foreign source income 
equals the amount in the overall domestic loss account.
    (b) Determination of U.S. source taxable income for purposes of 
recapture. For purposes of determining the amount of an overall domestic 
loss subject to recapture, the taxpayer's taxable income from U.S. 
sources shall be computed in accordance with the rules set forth in 
Sec.  1.904(g)-1(c)(4). U.S. source taxable income shall be determined 
by taking into account adjustments for capital gains and losses and 
qualified dividend income in a similar manner to the adjustments made to 
foreign source taxable income under section 904(b)(2) and Sec.  
1.904(b)-1, following the principles of Sec.  1.904(b)-1(h)(1)(i).
    (c) Section 904(g)(1) recapture. The amount of any U.S. source 
taxable income subject to recharacterization in a taxable year in which 
paragraph (a) of this section applies is the lesser of the aggregate 
balance of the taxpayer's overall domestic loss accounts or 50 percent 
of the taxpayer's U.S. source taxable income (as determined under 
paragraph (b) of this section).
    (d) Effective/applicability date. This section applies to taxpayers 
that sustain an overall domestic loss for a taxable year beginning on or 
after January 1, 2012. Taxpayers may choose to apply this section to 
overall domestic losses sustained in other taxable years beginning after 
December 31, 2006, including periods covered by 26 CFR 1.904(g)-2T 
(revised as of April 1, 2010).

[T.D. 9595, 77 FR 37581, June 22, 2012]



Sec.  1.904(g)-3  Ordering rules for the allocation of net operating losses, 
net capital losses, U.S. source losses, and separate limitation losses, 
and for the recapture of separate limitation losses, overall foreign losses, 
and overall domestic losses.

    (a) In general. This section provides ordering rules for the 
allocation of net operating losses, net capital losses, U.S. source 
losses, and separate limitation losses, and for the recapture of 
separate limitation losses, overall foreign losses, and overall domestic 
losses. The rules must be applied in the order set forth in paragraphs 
(b) through (j) of this section.

[[Page 989]]

    (b) Step One: Allocation of net operating loss and net capital loss 
carryovers--(1) In general. Net operating losses from a current taxable 
year are carried forward or back to a taxable year in the following 
manner. Net operating losses that are carried forward pursuant to 
section 172 are combined with income or loss in the carryover year in 
the manner described in this paragraph (b). The combined amounts are 
then subject to the ordering rules provided in paragraphs (c) through 
(i) of this section. Net operating losses that are carried back to a 
prior taxable year pursuant to section 172 are allocated to income in 
the carryback year in the manner set forth in paragraphs (b)(2), (b)(3), 
(c), (d), and (e) of this section. The income in the carryback year to 
which the net operating loss is allocated is the foreign source income 
in each separate category and the U.S. source income after the 
application of sections 904(f) and 904(g) to income and loss in that 
previous year, including as a result of net operating loss carryovers or 
carrybacks from taxable years prior to the current taxable year. See 
Sec. Sec.  1.861-8(e)(8), 1.904(b)-3(d)(2), and 1.1502-4(c)(1)(iii) for 
rules to determine the source and separate category components of a net 
operating loss.
    (2) Full net operating loss deduction. If the full net operating 
loss (that remains after carryovers to other taxable years) is deducted 
in computing the taxable income in a particular year (carryover year), 
so that there is no remaining net operating loss that can be carried to 
other taxable years, U.S. source losses and foreign source losses in 
separate categories that comprise the net operating loss shall be 
combined with the U.S. source income or loss and the foreign source 
income or loss in the same separate categories in the carryover year.
    (3) Partial net operating loss deduction. If the full net operating 
loss (that remains after carryovers to other taxable years) is not 
deducted in computing the taxable income in a carryover year, so that 
there is remaining loss that can be carried to other taxable years, the 
following rules apply:
    (i) Any U.S. source loss (not to exceed the amount of the net 
operating loss carryover deducted in computing the taxable income in the 
carryover year (the net operating loss deduction)) shall be carried over 
to the extent of any U.S. source income in the carryover year.
    (ii) If the net operating loss deduction exceeds the U.S. source 
loss carryover determined under paragraph (b)(3)(i) of this section, 
then separate limitation losses that are part of the net operating loss 
shall be tentatively carried over to the extent of separate limitation 
income in the same separate category in the carryover year. If the sum 
of the potential separate limitation loss carryovers determined under 
the preceding sentence exceeds the amount of the net operating loss 
deduction reduced by any U.S. source loss carried over under paragraph 
(b)(3)(i) of this section, then the potential separate limitation loss 
carryovers shall be reduced pro rata so that their sum equals such 
amount.
    (iii) If the net operating loss deduction exceeds the sum of the 
U.S. and separate limitation loss carryovers determined under paragraphs 
(b)(3)(i) and (ii) of this section, then a proportionate part of the 
remaining loss from each separate category shall be carried over to the 
extent of such excess and combined with the foreign source loss, if any, 
in the same separate categories in the carryover year.
    (iv) If the net operating loss deduction exceeds the sum of all the 
loss carryovers determined under paragraphs (b)(3)(i), (ii), and (iii) 
of this section, then any U.S. source loss not carried over under 
paragraph (b)(3)(i) of this section shall be carried over to the extent 
of such excess and combined with the U.S. source loss, if any, in the 
carryover year.
    (4) Net capital loss carryovers. Rules similar to the rules of 
paragraphs (b)(1) through (3) of this section apply for purposes of 
determining the components of a net capital loss carryover to a taxable 
year.
    (c) Step Two: Section 904(b) adjustments. The taxpayer shall make 
any required adjustments to capital gains and losses and qualified 
dividend income under section 904(b)(2). The taxpayer also takes into 
account any adjustments required under section 904(b)(4) and Sec.  
1.904(b)-3.

[[Page 990]]

    (d) Step Three: Allocation of separate limitation losses. The 
taxpayer shall allocate separate limitation losses sustained during the 
taxable year (increased, if appropriate, by any losses carried over 
under paragraph (b) of this section), in the following manner--
    (1) The taxpayer shall allocate its separate limitation losses for 
the taxable year to reduce its separate limitation income in other 
separate categories on a proportionate basis, and increase its separate 
limitation loss accounts appropriately. To the extent a separate 
limitation loss in one separate category is allocated to reduce separate 
limitation income in a second separate category, and the second category 
has a separate limitation loss account from a prior taxable year with 
respect to the first category, the two separate limitation loss accounts 
shall be netted against each other.
    (2) If the taxpayer's separate limitation losses for the taxable 
year exceed the taxpayer's separate limitation income for the year, so 
that the taxpayer has separate limitation losses remaining after the 
application of paragraph (d)(1) of this section, the taxpayer shall 
allocate those losses to its U.S. source income for the taxable year, to 
the extent thereof, and shall increase its overall foreign loss accounts 
to that extent in accordance with Sec.  1.904(f)-1.
    (e) Step Four: Allocation of U.S. source losses. The taxpayer shall 
allocate U.S. source losses sustained during the taxable year 
(increased, if appropriate, by any losses carried over under paragraph 
(b) of this section) to separate limitation income on a proportionate 
basis, and shall increase its overall domestic loss accounts to the 
extent of such allocation in accordance with Sec.  1.904(g)-1.
    (f) Step Five: Recapture of overall foreign loss accounts. If the 
taxpayer's separate limitation income for the taxable year (reduced by 
any losses carried over under paragraph (b) of this section) exceeds the 
sum of the taxpayer's U.S. source loss and separate limitation losses 
for the year, so that the taxpayer has separate limitation income 
remaining after the application of paragraphs (d)(1) and (e) of this 
section, then the taxpayer recaptures prior year overall foreign losses, 
if any, in accordance with Sec.  1.904(f)-2, and reduces overall foreign 
loss accounts in accordance with Sec.  1.904(f)-2. The recapture in this 
paragraph (f) includes amounts determined under Sec.  1.904(f)-2(c) and 
(d)(3) but not Sec.  1.904(f)-2(d)(4), which is covered in paragraph (i) 
of this section.
    (g) Step Six: Recapture of separate limitation loss accounts. To the 
extent the taxpayer has remaining separate limitation income for the 
year after the application of paragraph (f) of this section, then the 
taxpayer shall recapture prior year separate limitation losses, if any, 
in accordance with Sec.  1.904(f)-8 and reduce separate limitation loss 
accounts in accordance with Sec.  1.904(f)-7.
    (h) Step Seven: Recapture of overall domestic loss accounts. If the 
taxpayer's U.S. source income for the year (reduced by any losses 
carried over under paragraph (b) of this section or allocated under 
paragraph (d) of this section, but not increased by any recapture of 
overall foreign loss accounts under paragraph (f) of this section) 
exceeds the taxpayer's separate limitation losses for the year, so that 
the taxpayer has U.S. source income remaining after the application of 
paragraph (d)(2) of this section, then the taxpayer shall recapture its 
prior year overall domestic losses, if any, and reduce overall domestic 
loss accounts in accordance with Sec.  1.904(g)-2.
    (i) Step Eight: Dispositions under section 904(f)(3) in which gain 
would not otherwise be recognized. The taxpayer determines the amount of 
gain that would otherwise not be recognized but that must be recognized 
in accordance with Sec.  1.904(f)-2(d)(4) (not exceeding the taxpayer's 
applicable overall foreign loss account) and then applies Sec.  
1.904(f)-2(a) and (b) to recapture and reduce its overall foreign loss 
accounts in an amount equal to the gain recognized. To the extent this 
recognition of gain in a taxable year reduces the amount of a current 
year net operating loss or increases the amount of a net operating loss 
carryover to that taxable year, paragraphs (b) through (e) of this

[[Page 991]]

section are applied to determine the allocation of any additional net 
operating loss deduction and other deductions or losses and the 
applicable increases in the taxpayer's overall foreign loss, separate 
limitation loss, and overall domestic loss accounts, but only after the 
applicable overall foreign loss account has been recaptured as provided 
in this paragraph (i).
    (j) Step Nine: Dispositions that result in additional income 
recognition under the branch loss recapture and dual consolidated loss 
recapture rules--(1) In general. If, after any gain is required to be 
recognized under section 904(f)(3) on a transaction that is otherwise a 
nonrecognition transaction, an additional amount of income is recognized 
under section 91(d), section 367(a)(3)(C) (as applicable to losses 
incurred before January 1, 2018), or Sec.  1.1503(d)-6, and that 
additional income amount is determined by taking into account an offset 
for the amount of gain recognized under section 904(f)(3) and so is not 
initially taken into account in applying paragraph (b) of this section, 
then paragraphs (b) through (h) of this section are applied to determine 
the allocation of any additional net operating loss deduction and other 
deductions or losses and the applicable increases in the taxpayer's 
overall foreign loss, separate limitation loss, and overall domestic 
loss accounts, as well as any additional recapture and reduction of the 
taxpayer's separate limitation loss, overall foreign loss, and overall 
domestic loss accounts.
    (2) Rules for additional recapture of loss accounts. For the purpose 
of recapturing and reducing loss accounts under paragraph (j)(1) of this 
section, the taxpayer also takes into account any creation of or 
addition to loss accounts that result from the application of paragraphs 
(b) through (i) of this section in the current tax year. If any of the 
additional income described in paragraph (j)(1) of this section is 
foreign source income in a separate category for which there is a 
remaining balance in an overall foreign loss account after applying 
paragraph (i) of this section, the section 904(f)(1) recapture amount 
under Sec.  1.904(f)-2(c) for that additional income is determined by 
first computing a hypothetical recapture amount as it would have been 
determined prior to the application of paragraph (i) of this section but 
taking into account the additional foreign source income described in 
this paragraph (j)(2) and then subtracting the actual overall foreign 
loss recapture determined prior to the application of paragraph (i) of 
this section (that did not take into account the additional foreign 
source income). The remainder is the overall foreign loss recapture 
amount with respect to the additional foreign source income described in 
this paragraph (j)(2).
    (k) Examples. The following examples illustrate the rules of this 
section. Unless otherwise noted, all corporations use the calendar year 
as the U.S. taxable year.
    (1) Example 1--(i) Facts--(A) USC is a domestic corporation with 
foreign branch operations in Country X. For Year 1, USC had the 
following taxable income and losses after application of section 904(f) 
and (g) to income and loss in Year 1:

                    Table 1 to Paragraph (k)(1)(i)(A)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$400x...........................................      $200x       $110x
------------------------------------------------------------------------

    (B) For Year 2, USC has a net operating loss of ($500x), determined 
as follows:

                    Table 2 to Paragraph (k)(1)(i)(B)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
($300x).........................................         $0     ($200x)
------------------------------------------------------------------------

    (ii) Analysis--(A) Net operating loss allocation. Because USC's 
taxable income for Year 1 exceeds its total net operating loss for Year 
2, the full net operating loss is carried back. Under paragraph (b) of 
this section (Step 1), each component of the net operating loss is 
carried back and combined with its same category in Year 1. See 
paragraph (b)(2) of this section. After allocation of the net operating 
loss, USC has the following taxable income and losses for Year 1:

[[Page 992]]



                   Table 3 to Paragraph (k)(1)(ii)(A)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$100x...........................................      $200x      ($90x)
------------------------------------------------------------------------

    (B) Loss allocation. Under paragraph (e) of this section (Step 4), 
the ($90x) of U.S. loss is allocated proportionately to reduce the 
foreign branch category and passive category income. Accordingly, $30x 
($90x x $100x/$300x) of the U.S. loss is allocated to foreign branch 
category income and $60x ($90x x $200x/$300x) of the U.S. loss is 
allocated to passive category income, with a corresponding creation or 
increase to USC's overall domestic loss accounts.
    (2) Example 2--(i) Facts--(A) USC is a domestic corporation with 
foreign branch operations in Country X. As of January 1, Year 1, USC has 
no loss accounts subject to recapture. For Year 1, USC has a net 
operating loss of ($1,400x), determined as follows:

                    Table 4 to Paragraph (k)(2)(i)(A)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
($400x).........................................    ($200x)     ($800x)
------------------------------------------------------------------------

    (B) For Year 2, USC has the following taxable income and losses:

                    Table 5 to Paragraph (k)(2)(i)(B)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$500x...........................................    ($100x)      $1200x
------------------------------------------------------------------------

    (ii) Analysis--(A) Net operating loss allocation. Under paragraph 
(b) of this section (Step 1), because USC's total taxable income for 
Year 2 of $1600x ($1,200x + $500x - $100x) exceeds the total Year 1 net 
operating loss, the full $1,400x net operating loss is carried forward. 
Under paragraph (b)(2) of this section, each component of the net 
operating loss is carried forward and combined with its same category in 
Year 2. After allocation of the net operating loss, USC has the 
following taxable income and losses:

                   Table 6 to Paragraph (k)(2)(ii)(A)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$100x...........................................    ($300x)       $400x
------------------------------------------------------------------------

    (B) Loss allocation. Under paragraph (d) of this section (Step 3), 
$100x of the passive category loss offsets the $100x of foreign branch 
category income, resulting in a passive category separate limitation 
loss account with respect to foreign branch category income, and the 
other $200x of passive category loss offsets $200x of the U.S. source 
taxable income, resulting in the creation of an overall foreign loss 
account in the passive category.
    (3) Example 3--(i) Facts. Assume the same facts as in paragraph 
(k)(2)(i) of this section (the facts in Example 2), except that in Year 
2, USC had the following taxable income and losses:

                     Table 7 to Paragraph (k)(3)(i)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$200x...........................................    ($100x)      $1200x
------------------------------------------------------------------------

    (ii) Analysis--(A) Net operating loss allocation. Under paragraph 
(b) of this section (Step 1), because the total net operating loss for 
Year 1 of ($1,400x) exceeds total taxable income for Year 2 of $1,300x 
($1,200x + $200x - $100x), USC has a partial net operating loss 
carryover to Year 2 of $1,300x. Under paragraph (b)(3)(i) of this 
section, first, the $800x U.S. source component of the net operating 
loss is allocated to U.S. income for Year 2. The tentative foreign 
branch category carryover under paragraph (b)(3)(ii) of this section 
($200x) does not exceed the remaining net operating loss carryover 
amount ($500x). Therefore, $200x of the foreign branch category 
component of the net operating loss is next allocated to the foreign 
branch category income for Year 2. Under paragraph (b)(3)(iii) of this 
section, the remaining $300x of net operating loss carryover ($1300x - 
$800x - $200x) is carried over proportionally from the remaining net 
operating loss components in the foreign branch category ($200x, or 
$400x total foreign branch category loss - $200x foreign branch category 
loss already allocated) and passive category ($200x). Therefore, $150x 
($300x x $200x/$400x) of the remaining net operating loss carryover is 
carried over from the foreign branch category for Year 1 and combined 
with the foreign branch category income for Year 2, and $150x ($300x x 
$200x/$400x) of the remaining net operating loss carryover is carried 
over from the passive

[[Page 993]]

category for Year 1 and combined with the passive category loss for Year 
2. After allocation of the net operating loss carryover from Year 1 to 
the appropriate categories for Year 2, USC has the following taxable 
income and losses:

                   Table 8 to Paragraph (k)(3)(ii)(A)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
($150x).........................................    ($250x)       $400x
------------------------------------------------------------------------

    (B) Loss allocation. Under paragraph (d) of this section (Step 3), 
the losses in the foreign branch and passive categories fully offset the 
U.S. source income, resulting in the creation of foreign branch category 
and passive category overall foreign loss accounts.
    (4) Example 4--(i) Facts. Assume the same facts as in paragraph 
(k)(2)(i) of this section (the facts in Example 2), except that in Year 
2, USC has the following taxable income and losses:

                     Table 9 to Paragraph (k)(4)(i)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$200x...........................................      $200x     ($200x)
------------------------------------------------------------------------

    (ii) Analysis--(A) Net operating loss allocation. Under paragraph 
(b) of this section (Step 1), because the total net operating loss of 
($1400x) exceeds total taxable income for Year 2 of $200x ($200x + $200x 
- $200x), USC has a partial net operating loss carryover to Year 2 of 
$200x. Because USC has no U.S. source income in Year 2, under paragraph 
(b)(3)(i) of this section no portion of the U.S. source component of the 
net operating loss is initially carried into Year 2. Because the total 
tentative carryover under paragraph (b)(3)(ii) of this section of $400x 
($200x in each of the foreign branch and passive categories) exceeds the 
net operating loss carryover amount, the tentative carryover from each 
separate category is reduced proportionately by $100x ($200x x $200x/
$400x). Accordingly, $100x ($200x - $100x) of the foreign branch 
category component of the net operating loss is carried forward and 
$100x ($200x - $100x) of the passive category component of the net 
operating loss is carried forward and combined with income in the same 
respective categories for Year 2. After allocation of the net operating 
loss carryover from Year 1, USC has the following taxable income and 
losses:

                   Table 10 to Paragraph (k)(4)(ii)(A)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$100x...........................................      $100x     ($200x)
------------------------------------------------------------------------

    (B) Loss allocation. Under paragraph (e) of this section (Step 4), 
the $200x U.S. source loss offsets the remaining $100x of foreign branch 
category income and $100x of passive category income, resulting in the 
creation of overall domestic loss accounts with respect to the foreign 
branch and passive categories.
    (5) Example 5--(i) Facts. Assume the same facts as in paragraph 
(k)(2)(i) of this section (the facts in Example 2), except that in Year 
2, USC has the following taxable income and losses:

                     Table 11 to Paragraph (k)(5)(i)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$800x...........................................    ($100x)       $100x
------------------------------------------------------------------------

    (ii) Analysis--(A) Net operating loss allocation. Under paragraph 
(b) of this section (Step 1), because USC's total net operating loss in 
Year 1 of ($1,400x) exceeds its total taxable income for Year 2 of $800x 
($100x + $800x - $100x), USC has a partial net operating loss carryover 
to Year 2 of $800x. Under paragraph (b)(3)(i) of this section, $100x of 
the U.S. source component of the net operating loss is allocated to U.S. 
income for Year 2. The tentative foreign branch category carryover under 
paragraph (b)(3)(ii) of this section does not exceed the remaining net 
operating loss carryover amount. Therefore, $400x of the foreign branch 
category component of the net operating loss is allocated to reduce 
foreign branch category income in Year 2. Under paragraph (b)(3)(iii) of 
this section, of the remaining $300x of net operating loss carryover 
($800x - $100x - $400x), $200x is carried forward from the passive 
category component of the net operating loss and combined with the 
passive category loss for Year 2. Under paragraph (b)(3)(iv) of this 
section, the remaining $100x ($300x - $200x) of net operating loss 
carryover is carried forward from the U.S. source component of the net

[[Page 994]]

operating loss and combined with the U.S. source income (and the 
previously allocated U.S. source component of the net operating loss) 
for Year 2. After allocation of the net operating loss carryover from 
Year 1, USC has the following taxable income and losses:

                   Table 12 to Paragraph (k)(5)(ii)(A)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$400x...........................................    ($300x)     ($100x)
------------------------------------------------------------------------

    (B) Loss allocation. (1) Under paragraph (d) of this section (Step 
3), the $300x passive category loss offsets the $300x of income in the 
foreign branch category, resulting in the creation of a passive category 
separate limitation loss account with respect to the foreign branch 
category.
    (2) Under paragraph (e) of this section (Step 4), the $100x U.S. 
source loss offsets the remaining $100x of the foreign branch category 
income, resulting in the creation of an overall domestic loss account 
with respect to the foreign branch category.
    (6) Example 6--(i) Facts--(A) USC is a domestic corporation with 
foreign branch operations in Country X. USC has no net operating losses 
and does not make an election to recapture more than the required amount 
of overall foreign losses. As of January 1, Year 1, USC has a ($200x) 
foreign branch category overall foreign loss (OFL) account and a ($200x) 
foreign branch category separate limitation loss (SLL) account with 
respect to the passive category. For Year 1, USC has $400x of passive 
category income that is fully offset by a ($400x) domestic loss in that 
taxable year, giving rise to the creation of an overall domestic loss 
(ODL) account with respect to the passive category. As of January 1, 
Year 2, USC has the following balances in its OFL, SLL, and ODL 
accounts:

                   Table 13 to Paragraph (k)(6)(i)(A)
------------------------------------------------------------------------
                       Foreign branch                             US
------------------------------------------------------------------------
                                                      SLL         ODL
                       OFL                         (passive)   (passive)
------------------------------------------------------------------------
$200x...........................................      $200x       $400x
------------------------------------------------------------------------

    (B) In Year 2, USC has the following taxable income and losses:

                   Table 14 to Paragraph (k)(6)(i)(B)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$400x...........................................    ($100x)       $600x
------------------------------------------------------------------------

    (ii) Analysis--(A) Loss allocation. Under paragraph (d) of this 
section (Step 3), the $100x of passive category loss offsets $100x of 
the foreign branch category income, creating a passive category SLL 
account of $100x with respect to the foreign branch category. Because 
there is an offsetting foreign branch category SLL account of $200x with 
respect to the passive category from a prior taxable year, the two 
accounts are netted against each other so that all that remains is a 
$100x foreign branch category SLL account with respect to the passive 
category.
    (B) OFL account recapture. Under paragraph (f) of this section (Step 
5), 50% of the remaining $300x, or $150x, of income in the foreign 
branch category is subject to recharacterization as U.S. source income 
as a recapture of part of the OFL account in the foreign branch 
category.
    (C) SLL account recapture. Under paragraph (g) of this section (Step 
6), $100x of the remaining $150x of income in the foreign branch 
category is recharacterized as passive category income as a recapture of 
the foreign branch category SLL account with respect to the passive 
category.
    (D) ODL account recapture. Under paragraph (h) of this section (Step 
7), 50% of the $600, or $300, of U.S. source income is subject to 
recharacterization as foreign source passive category income as a 
recapture of a part of the ODL account with respect to the passive 
category. None of the $150x of foreign branch category income that was 
recharacterized as U.S. source income under paragraph (f) of this 
section (Step 5) is included here as income subject to 
recharacterization in connection with recapture of the ODL account.
    (E) Results. (1) After the allocation of loss and recapture of loss 
accounts, USC has the following taxable income and losses for Year 2:

[[Page 995]]



                 Table 15 to Paragraph (k)(6)(ii)(E)(1)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
$50x............................................      $400x       $450x
------------------------------------------------------------------------

    (2) As of January 1, Year 3, USC has the following balances in its 
OFL, SLL and ODL accounts:

                 Table 16 to Paragraph (k)(6)(ii)(E)(2)
------------------------------------------------------------------------
                 Foreign branch                     Passive       US
------------------------------------------------------------------------
                                                      SLL
                 OFL                      SLL      (foreign       ODL
                                       (passive)    branch)    (passive)
------------------------------------------------------------------------
$50x................................         $0          $0       $100x
------------------------------------------------------------------------

    (l) Applicability date. This section applies to taxable years ending 
on or after November 2, 2020.

[T.D. 9595, 77 FR 37582, June 22, 2012, as amended by T.D. 9882, 84 FR 
69102, Dec. 17, 2019; T.D. 9922, 85 FR 72060, Nov. 12, 2020; 86 FR 
54368, Oct. 1, 2021]



Sec.  1.904(i)-0  Outline of regulation provisions.

    This section lists the headings for Sec.  1.904(i)-1.

 Sec.  1.904(i)-1 Limitation on use of deconsolidation to avoid foreign 
                         tax credit limitations.

    (a) General rule.
    (1) Determination of taxable income.
    (2) Allocation.
    (b) Definitions and special rules.
    (1) Affiliate.
    (i) Generally.
    (ii) Rules for consolidated groups.
    (iii) Exception for newly acquired affiliates.
    (2) Includible corporation.
    (c) Taxable years.
    (d) Consistent treatment of foreign taxes paid.
    (e) Effective date.

[T.D. 9371, 72 FR 72603, Dec. 21, 2007]



Sec.  1.904(i)-1  Limitation on use of deconsolidation to avoid 
foreign tax credit limitations.

    (a) General rule. If two or more includible corporations are 
affiliates, within the meaning of paragraph (b)(1) of this section, at 
any time during their taxable years, then, solely for purposes of 
applying the foreign tax credit provisions of section 59(a), sections 
901 through 908, and section 960, the rules of this section will apply.
    (1) Determination of taxable income--(i) Each affiliate must compute 
its net taxable income or loss in each separate category (as defined in 
Sec.  1.904-5(a)(4)(v), and treating U.S. source income or loss as a 
separate category) without regard to sections 904(f) and 907(c)(4). Only 
affiliates that are members of the same consolidated group use the 
consolidated return regulations (other than those under sections 904(f) 
and 907(c)(4)) in computing such net taxable income or loss. To the 
extent otherwise applicable, other provisions of the Code and 
regulations must be used in the determination of an affiliate's net 
taxable income or loss in a separate category.
    (ii) The net taxable income amounts in each separate category 
determined under paragraph (a)(1)(i) of this section are combined for 
all affiliates to determine one amount for the group of affiliates in 
each separate category. However, a net loss of an affiliate (first 
affiliate) in a separate category determined under paragraph (a)(1)(i) 
of this section will be combined under this paragraph (a) with net 
income or loss amounts of other affiliates in the same category only if, 
and to the extent that, the net loss offsets taxable income, whether 
U.S. or foreign source, of the first affiliate. The consolidated return 
regulations that apply the principles of sections 904(f) and 907(c)(4) 
to consolidated groups will then be applied to the combined amounts in 
each separate category as if all affiliates were members of a single 
consolidated group.
    (2) Allocation. Any net taxable income in a separate category 
calculated under paragraph (a)(1)(ii) of this section for purposes of 
the foreign tax credit provisions must then be allocated among the 
affiliates under any consistently applied reasonable method, taking into 
account all of the facts and circumstances. A method is consistently 
applied if used by all affiliates from year to year. Once chosen, an 
allocation method may be changed only with the consent of the 
Commissioner. This allocation will only affect the source and foreign 
tax credit separate limitation character of the income for purposes of 
the foreign tax credit separate limitation of each affiliate, and will 
not otherwise affect an affiliate's total

[[Page 996]]

net income or loss. This section applies whether the federal income tax 
consequences of its application favor, or are adverse to, the taxpayer.
    (b) Definitions and special rules For purposes of this section only, 
the following terms will have the meanings specified.
    (1) Affiliate--(i) Generally. Affiliates are includible 
corporations--
    (A) That are members of the same affiliated group, as defined in 
section 1504(a); or
    (B) That would be members of the same affiliated group, as defined 
in section 1504(a) if--
    (1) Any non-includible corporation meeting the ownership test of 
section 1504(a)(2) with respect to any such includible corporation was 
itself an includible corporation; or
    (2) The constructive ownership rules of section 1563(e) were applied 
for purposes of section 1504(a).
    (ii) Rules for consolidated groups. Affiliates that are members of 
the same consolidated group are treated as a single affiliate for 
purposes of this section. The provisions of paragraph (a) of this 
section shall not apply if the only affiliates under this definition are 
already members of the same consolidated group without operation of this 
section.
    (iii) Exception for newly acquired affiliates--(A) With respect to 
acquisitions after December 7, 1995, an includible corporation acquired 
from unrelated third parties (First Corporation) will not be considered 
an affiliate of another includible corporation (Second Corporation) 
during the taxable year of the First Corporation beginning before the 
date on which the First Corporation originally becomes an affiliate with 
respect to the Second Corporation.
    (B) With respect to acquisitions on or before December 7, 1995, an 
includible corporation acquired from unrelated third parties will not be 
considered an affiliate of another includible corporation during its 
taxable year beginning before the date on which the first includible 
corporation first becomes an affiliate with respect to that other 
includible corporation.
    (C) This exception does not apply where the acquisition of an 
includible corporation is used to avoid the application of this section.
    (2) Includible corporation. The term includible corporation has the 
same meaning it has in section 1504(b).
    (c) Taxable years. If all of the affiliates use the same U.S. 
taxable year, then that taxable year must be used for purposes of 
applying this section. If, however, the affiliates use more than one 
U.S. taxable year, then an appropriate taxable year must be used for 
applying this section. The determination whether a taxable year is 
appropriate must take into account all of the relevant facts and 
circumstances, including the U.S. taxable years used by the affiliates 
for general U.S. income tax purposes. The taxable year chosen by the 
affiliates for purposes of applying this section must be used 
consistently from year to year. The taxable year may be changed only 
with the prior consent of the Commissioner. Those affiliates that do not 
use the year determined under this paragraph (c) as their U.S. taxable 
year for general U.S. income tax purposes must, for purposes of this 
section, use their U.S. taxable year or years ending within the taxable 
year determined under this paragraph (c). If, however, the stock of an 
affiliate is disposed of so that it ceases to be an affiliate, then the 
taxable year of that affiliate will be considered to end on the 
disposition date for purposes of this section.
    (d) Consistent treatment of foreign taxes paid. All affiliates must 
consistently either elect under section 901(a) to claim a credit for 
foreign income taxes paid or accrued, or deemed paid or accrued, or 
deduct foreign taxes paid or accrued under section 164. See also Sec.  
1.1502-4(a); Sec.  1.905-1(a).
    (e) Effective date. Except as provided in paragraph (b)(1)(iii) of 
this section (relating to newly acquired affiliates), this section is 
effective for taxable years of affiliates beginning after December 31, 
1993.

[T.D. 8627, 60 FR 56119, Nov. 7, 1995, as amended by T.D. 9882, 84 FR 
69104, Dec. 17, 2019]



Sec.  1.904(j)-0  Outline of regulation provisions.

    This section lists the headings for Sec.  1.904(j)-1.

[[Page 997]]

  Sec.  1.904(j)-1 Certain individuals exempt from foreign tax credit 
                               limitation.

    (a) Election available only if all foreign taxes are creditable 
foreign taxes.
    (b) Coordination with carryover rules.
    (1) No carryovers to or from election year.
    (2) Carryovers to and from other years determined without regard to 
election years.
    (3) Determination of amount of creditable foreign taxes.
    (c) Examples.
    (d) Effective date.

[T.D. 9371, 72 FR 72603, Dec. 21, 2007]



Sec.  1.904(j)-1  Certain individuals exempt from foreign 
tax credit limitation.

    (a) Election available only if all foreign taxes are creditable 
foreign taxes. A taxpayer may elect to apply section 904(j) for a 
taxable year only if all of the taxes for which a credit is allowable to 
the taxpayer under section 901 for the taxable year (without regard to 
carryovers) are creditable foreign taxes (as defined in section 
904(j)(3)(B)).
    (b) Coordination with carryover rules--(1) No carryovers to or from 
election year. If the taxpayer elects to apply section 904(j) for any 
taxable year, then no taxes paid or accrued by the taxpayer during such 
taxable year may be deemed paid or accrued under section 904(c) in any 
other taxable year, and no taxes paid or accrued in any other taxable 
year may be deemed paid or accrued under section 904(c) in such taxable 
year.
    (2) Carryovers to and from other years determined without regard to 
election years. The amount of the foreign taxes paid or accrued, and the 
amount of the foreign source taxable income, in any year for which the 
taxpayer elects to apply section 904(j) shall not be taken into account 
in determining the amount of any carryover to or from any other taxable 
year. However, an election to apply section 904(j) to any year does not 
extend the number of taxable years to which unused foreign taxes may be 
carried under section 904(c) and Sec.  1.904-2(b). Therefore, in 
determining the number of such carryover years, the taxpayer must take 
into account years to which a section 904(j) election applies.
    (3) Determination of amount of creditable foreign taxes. Otherwise 
allowable carryovers of foreign tax credits from other taxable years 
shall not be taken into account in determining whether the amount of 
creditable foreign taxes paid or accrued by an individual during a 
taxable year exceeds $300 ($600 in the case of a joint return) for 
purposes of section 904(j)(2)(B).
    (c) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. In 2006, X, a single individual using the cash basis 
method of accounting for income and foreign tax credits, pays $100 of 
foreign taxes with respect to general limitation income that was earned 
and included in income for United States tax purposes in 2005. The 
foreign taxes would be creditable under section 901 but are not shown on 
a payee statement furnished to X. X's only income for 2006 from sources 
outside the United States is qualified passive income, with respect to 
which X pays $200 of creditable foreign taxes shown on a payee 
statement. X may not elect to apply section 904(j) for 2006 because some 
of X's foreign taxes are not creditable foreign taxes within the meaning 
of section 904(j)(3)(B).
    Example 2. (i) In 2009, A, a single individual using the cash basis 
method of accounting for income and foreign tax credits, pays creditable 
foreign taxes of $250 attributable to passive income. Under section 
904(c), A may also carry forward to 2009 $100 of unused foreign taxes 
paid in 2005 with respect to passive income, $300 of unused foreign 
taxes paid in 2005 with respect to general limitation income, $400 of 
unused foreign taxes paid in 2006 with respect to passive income, and 
$200 of unused foreign taxes paid in 2006 with respect to general 
limitation income. In 2009, A's only foreign source income is passive 
income described in section 904(j)(3)(A)(i), and this income is reported 
to A on a payee statement (within the meaning of section 6724(d)(2)). If 
A elects to apply section 904(j) for the 2009 taxable year, the unused 
foreign taxes paid in 2005 and 2006 are not deemed paid in 2009, and A 
therefore cannot claim a foreign tax credit for those taxes in 2009.
    (ii) In 2010, A again is eligible for and elects the application of 
section 904(j). The carryforwards from 2005 expire in 2010. The 
carryforward period established under section 904(c) is not extended by 
A's election under section 904(j). In 2011, A does not elect the 
application of section 904(j). The $600 of unused foreign taxes paid in 
2006 on passive and general limitation income are deemed paid in 2011, 
under section 904(c), without any adjustment for any portion of those 
taxes that might have been used as a foreign tax credit in 2009 or 2010 
if A had not elected to apply section 904(j) to those years.


[[Page 998]]


    (d) Effective date. Section 1.904(j)-1 applies to taxable years 
beginning after July 20, 2004.

[T.D. 9141, 69 FR 43316, July 20, 2004]



Sec.  1.905-1  When credit for foreign income taxes may be taken.

    (a) Scope. This section provides rules regarding when the credit for 
foreign income taxes (as defined in Sec.  1.901-2(a)) may be taken, 
based on a taxpayer's method of accounting for such taxes. Paragraph (b) 
of this section provides the general rule. Paragraph (c) of this section 
sets forth rules for determining the taxable year in which taxpayers 
using the cash receipts and disbursement method of accounting for income 
(``cash method'') may claim a foreign tax credit. Paragraph (d) of this 
section sets forth rules for determining the taxable year in which 
taxpayers using the accrual method of accounting for income (``accrual 
method'') may claim a foreign tax credit. Paragraph (e) of this section 
provides rules for taxpayers using the cash method to claim foreign tax 
credits on the accrual basis pursuant to the election provided under 
section 905(a). Paragraph (f) of this section provides rules for when 
foreign income tax expenditures of a pass-through entity can be taken as 
a credit by the entity's partners, shareholders, or owners. Paragraph 
(g) of this section provides rules for when a foreign tax credit can be 
taken with respect to blocked income. Paragraph (h) provides the 
applicability dates for this section.
    (b) General rule. The credit for foreign income taxes provided in 
subpart A, part III, subchapter N, chapter 1 of the Code (the ``foreign 
tax credit'') may be taken either on the return for the year in which 
the foreign income taxes accrued or on the return for the year in which 
the foreign income taxes were paid (that is, remitted), depending on 
whether the taxpayer uses the accrual or the cash receipts and 
disbursements method of accounting for purposes of computing taxable 
income and filing returns. However, regardless of the year in which the 
credit is claimed under the taxpayer's method of accounting for foreign 
income taxes, the foreign tax credit is allowed only to the extent the 
foreign income taxes are ultimately both owed and remitted to the 
foreign country (in the case of a taxpayer claiming the foreign tax 
credit on the accrual basis, within the time prescribed by section 
905(c)(2)). See section 905(b) and Sec. Sec.  1.901-1(a) and 1.901-2(e). 
Because the taxpayer's liability for foreign income tax may accrue (that 
is, become fixed and determinable) in a different taxable year than that 
in which the tax is paid (that is, remitted), the taxpayer's entitlement 
to the credit may be perfected, or become subject to adjustment, by 
reason of events that occur in a taxable year after the taxable year in 
which the credit is allowed. See section 905(c) and Sec.  1.905-3(a) for 
rules relating to changes to the taxpayer's foreign income tax liability 
that require a redetermination of the allowable foreign tax credit and 
the taxpayer's U.S. tax liability.
    (c) Rules for cash method taxpayers--(1) Credit allowed in year 
paid. Except as provided in paragraph (e) of this section, a taxpayer 
who uses the cash method of accounting may claim a foreign tax credit 
only in the taxable year in which the foreign income taxes are paid. 
Generally, foreign income taxes are considered paid in the taxable year 
in which the taxes are remitted to the foreign country. However, foreign 
withholding taxes described in section 901(k)(1)(B), as well as foreign 
net income taxes described in Sec.  1.901-2(a)(3) that are withheld from 
the taxpayer's gross income by the payor, are treated as paid in the 
year in which they are withheld. Foreign income taxes that have been 
withheld or remitted but which are not considered an amount of tax paid 
for purposes of section 901 under the rules of Sec.  1.901-2(e) (for 
example, because the amount withheld or remitted was not a compulsory 
payment), however, are not eligible for a foreign tax credit. See 
Sec. Sec.  1.901-2(e) and 1.905-3(b)(1)(ii)(B) (Example 2).
    (2) Payment of contested foreign tax liability. Under Sec.  1.901-
2(e)(2)(i), a foreign income tax liability that is contested by the 
taxpayer is not a reasonable approximation of the taxpayer's final 
foreign income tax liability and, therefore, is not considered an amount 
of tax paid for purposes of section 901

[[Page 999]]

until the contest is resolved. Thus, except as provided in paragraph 
(c)(3) of this section, a foreign tax credit for a contested foreign 
income tax liability (or portion thereof) that has been remitted to the 
foreign country cannot be claimed until such time as the contest is 
resolved and the tax is considered paid. Once the contest is resolved 
and the foreign income tax liability is finally determined, the tax 
liability is treated as paid in the taxable year in which the foreign 
tax was remitted. See paragraph (c)(1) of this section; see also section 
6511(d)(3) and Sec.  301.6511(d)-3 of this chapter for a special 10-year 
period of limitations for claiming a credit or refund of U.S. tax that 
is attributable to foreign income taxes for which a credit is allowed 
under section 901, which for taxpayers claiming credits on the cash 
basis runs from the unextended due date of the return for the taxable 
year in which the foreign income taxes are paid (within the meaning of 
paragraph (c) of this section).
    (3) Election to claim a provisional credit for contested taxes 
remitted before contest is resolved. A taxpayer claiming foreign tax 
credits on the cash basis may, under the conditions provided in this 
paragraph (c)(3), elect to claim a foreign tax credit for a contested 
foreign income tax liability (or a portion thereof) in the year the 
contested amount (or a portion thereof) is remitted to the foreign 
country, notwithstanding that the liability is not finally determined 
and so is not considered an amount of tax paid. Such election applies 
only for contested foreign income taxes that are remitted in a taxable 
year in which the taxpayer elects under section 901(a) to claim a 
credit, instead of a deduction under section 164(a)(3), for taxes paid 
in such year. To make the election, a taxpayer must file a Form 1116 
(Foreign Tax Credit (Individual, Estate, or Trust)) or Form 1118 
(Foreign Tax Credit--Corporations), and the agreement described in 
paragraphs (d)(4)(ii) and (iii) of this section. In addition, the 
taxpayer must, for each subsequent taxable year up to and including the 
taxable year in which the contest is resolved, file the annual notice 
described in paragraph (d)(4)(iv) of this section. Any portion of a 
contested foreign income tax liability for which a provisional credit is 
claimed under this paragraph (c)(3) that is subsequently refunded by the 
foreign country results in a foreign tax redetermination under Sec.  
1.905-3(a).
    (4) Adjustments to taxes claimed as a credit in the year paid. A 
refund of foreign income taxes for which a foreign tax credit has been 
claimed on the cash basis, or a subsequent determination that the amount 
paid exceeds the taxpayer's liability for foreign income tax, requires a 
redetermination of foreign income taxes paid and the taxpayer's U.S. tax 
liability pursuant to section 905(c) and Sec.  1.905-3. See Sec.  1.905-
3(a) and 1.905-3(b)(1)(ii)(G) (Example 7). Additional foreign income 
taxes paid that relate back to a prior year in which foreign income 
taxes were claimed as a credit on the cash basis, including by reason of 
the settlement of a dispute with the foreign tax authority, may be 
claimed as a credit only in the year the additional taxes are paid 
(within the meaning of paragraph (c) of this section). The payment of 
such additional taxes does not result in a redetermination pursuant to 
section 905(c) or Sec.  1.905-3 of the foreign income taxes paid in any 
prior year, although a redetermination of U.S. tax liability may be 
required due, for example, to a carryback of unused foreign tax under 
section 904(c) and Sec.  1.904-2.
    (d) Rules for accrual method taxpayers--(1) Credit allowed in year 
accrued--(i) In general. A taxpayer who uses the accrual method of 
accounting may claim a foreign tax credit only in the taxable year in 
which the foreign income taxes are considered to accrue for foreign tax 
credit purposes under the rules of this paragraph (d). Foreign income 
taxes accrue in the taxable year in which 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). For purposes of the preceding 
sentence, a foreign income tax that is contingent on a future 
distribution of earnings does not meet the all events test until the 
earnings are distributed. A foreign income tax liability determined on 
the basis of a

[[Page 1000]]

foreign taxable year becomes fixed and determinable at the close of the 
taxpayer's foreign taxable year. Therefore, foreign income taxes that 
are computed based on items of income, deduction, and loss that arise in 
a foreign taxable year accrue in the United States taxable year with or 
within which the taxpayer's foreign taxable year ends. Foreign 
withholding taxes that are paid with respect to a foreign taxable year 
and that represent advance payments of a foreign net income tax 
liability determined on the basis of that foreign taxable year accrue at 
the close of the foreign taxable year. Foreign withholding taxes imposed 
on a payment giving rise to an item of foreign gross income accrue on 
the date the payment from which the tax is withheld is made (or treated 
as made under foreign tax law).
    (ii) Relation-back rule for adjustments to taxes claimed as a credit 
in year accrued. Additional tax paid as a result of a change in the 
foreign tax liability, including additional tax paid when a contest with 
a foreign tax authority is resolved, relates back and is considered to 
accrue at the end of the foreign taxable year with respect to which the 
tax is imposed (the ``relation-back year''). Additional withholding tax 
paid as a result of a change in the amount of an item of foreign gross 
income (such as pursuant to a foreign transfer pricing adjustment) also 
relates back and is considered to accrue in the year in which the 
payment from which the additional tax is withheld is made (or considered 
to have been made under foreign tax law). Foreign income taxes that are 
not paid within 24 months after the close of the taxable year in which 
they were accrued are treated as refunded pursuant to Sec.  1.905-3(a); 
when subsequently paid, the foreign income taxes are allowed as a credit 
in the relation-back year. See Sec.  1.905-3(b)(1)(ii)(E) (Example 5). 
For special rules that apply to determine when foreign income tax is 
considered to accrue in the case of certain ownership and entity 
classification changes, see Sec. Sec.  1.336-2(g)(3)(ii), 1.338-9(d), 
1.901-2(f)(5), and 1.1502-76.
    (2) Special rule for 52-53 week U.S. taxable years. If a taxpayer 
has elected pursuant to section 441(f) to use a U.S. taxable year 
consisting of 52-53 weeks, and such U.S. taxable year closes within six 
calendar days of the end of the taxpayer's foreign taxable year, the 
determination of when foreign income taxes accrue under paragraph (d)(1) 
of this section is made by deeming the taxpayer's U.S. taxable year to 
end on the last day of its foreign taxable year.
    (3) Accrual of contested foreign tax liability. A contested foreign 
income tax liability is finally determined and accrues for purposes of 
paragraph (d)(1) of this section when the contest is resolved. However, 
pursuant to section 905(c)(2), no credit is allowed for any accrued tax 
that is not paid within 24 months of the close of the relation-back year 
until the tax is actually remitted and considered paid. Thus, except as 
provided in paragraph (d)(4) of this section, a foreign tax credit for a 
contested foreign income tax liability cannot be claimed until such time 
as both the contest is resolved and the tax is considered paid, even if 
the contested liability (or portion thereof) has previously been 
remitted to the foreign country. Once the contest is resolved and the 
foreign income tax liability is finally determined and paid, the tax 
liability accrues, and is considered to accrue in the relation-back year 
for purposes of the foreign tax credit. See paragraph (d)(1) of this 
section; see also section 6511(d)(3) and Sec.  301.6511(d)-3 of this 
chapter for a special 10-year period of limitations for claiming a 
credit or refund of U.S. tax that is attributable to foreign income 
taxes for which a credit is allowed under section 901, which for 
taxpayers claiming credits on the accrual basis runs from the unextended 
due date of the return for the taxable year in which the foreign income 
taxes accrued (within the meaning of this paragraph (d)).
    (4) Election to claim a provisional credit for contested taxes 
remitted before accrual--(i) Conditions of election. A taxpayer may, 
under the conditions provided in this paragraph (d)(4), elect to claim a 
foreign tax credit for a contested foreign income tax liability (or a 
portion thereof) in the relation-back year when the contested amount (or 
a portion thereof) is remitted to the foreign country, notwithstanding 
that the liability is not finally determined and

[[Page 1001]]

so has not accrued. This election is available only for contested 
foreign income taxes that relate to a taxable year in which the taxpayer 
has elected under section 901(a) to claim a credit, instead of a 
deduction under section 164(a)(3), for foreign income taxes that accrue 
in such year. If the election is made by a taxpayer with respect to 
contested foreign income taxes of a controlled foreign corporation, such 
taxes are treated as deemed paid in the relation-back year and the 
controlled foreign corporation may deduct the taxes in computing its 
taxable income in the relation-back year. To make the election, a 
taxpayer must file an amended return for the taxable year to which the 
contested tax relates, together with a Form 1116 (Foreign Tax Credit 
(Individual, Estate, or Trust)) or Form 1118 (Foreign Tax Credit--
Corporations), and the agreement described in paragraph (d)(4)(ii) of 
this section. In addition, the taxpayer must, for each subsequent 
taxable year up to and including the taxable year in which the contest 
is resolved, file the annual notice described in paragraph (d)(4)(iii) 
of this section. Any portion of a contested foreign income tax liability 
for which a provisional credit is claimed under this paragraph (d)(4) 
that is subsequently refunded by the foreign country results in a 
foreign tax redetermination under Sec.  1.905-3(a).
    (ii) Contents of provisional foreign tax credit agreement. The 
provisional foreign tax credit agreement must contain the following:
    (A) A statement that the document is an election and an agreement 
under the provisions of paragraph (d)(4) of this section;
    (B) A description of the contested foreign income tax liability, 
including the name (or other identifier) of the foreign tax or taxes 
being contested, the name of the country imposing the tax, the name and 
identifying number of the payor of the contested tax, the amount of the 
contested tax, and the U.S. taxable year(s) and the income to which the 
contested foreign income tax liability relates;
    (C) The amount of the contested foreign income tax liability in 
paragraph (d)(4)(ii)(B) of this section that has been remitted to the 
foreign country and the date of the remittance(s);
    (D) An agreement by the taxpayer, for a period of three years from 
the later of the filing or the due date (with extensions) of the return 
for the taxable year in which the taxpayer notifies the Internal Revenue 
Service of the resolution of the contest, not to assert the statute of 
limitations on assessment as a defense to the assessment of additional 
taxes or interest related to the contested foreign income tax liability 
described in paragraph (d)(4)(ii)(B) of this section that may arise from 
a determination that the taxpayer failed to exhaust all effective and 
practical remedies to minimize its foreign income tax liability, so that 
the amount of the contested foreign income tax is not a compulsory 
payment and is not considered paid within the meaning of Sec.  1.901-
2(e)(5);
    (E) A statement that the taxpayer agrees to comply with all the 
conditions and requirements of paragraph (d)(4) of this section, 
including to provide notice to the Internal Revenue Service upon the 
resolution of the contest; and
    (F) Any additional information as may be prescribed by the 
Commissioner of Internal Revenue in Internal Revenue Service forms or 
instructions.
    (iii) Signatory. The provisional foreign tax credit agreement must 
be signed under penalties of perjury by a person authorized to sign the 
return of the taxpayer.
    (iv) Annual notice. For each taxable year following the year in 
which an election pursuant to paragraph (d)(4) of this section is made 
up to and including the taxable year in which the contest is resolved, 
the taxpayer must include with its timely-filed return the information 
described in paragraphs (d)(4)(iii)(A) through (C) of this section on 
Form 1116 or Form 1118 or in such other form or manner prescribed by the 
Commissioner of Internal Revenue in Internal Revenue Service forms or 
instructions.
    (A) A description of the contested foreign income tax liability, 
including the name (or other identifier) of the foreign tax or taxes, 
the name of the country imposing the tax, the name and identifying 
number of the payor of

[[Page 1002]]

the contested tax, the amount of the contested tax, and a description of 
the status of the contest.
    (B) With the return for the taxable year in which the contest is 
resolved, notification that the contest has been resolved. Such 
notification must include the date of final resolution and the amount of 
the finally determined foreign income tax liability.
    (C) Any additional information, which may include a copy of the 
final judgment, order, settlement, or other documentation of the contest 
resolution, as may be prescribed by the Commissioner of Internal Revenue 
in Internal Revenue Service forms or instructions.
    (5) Correction of improper accruals--(i) In general. The accrual of 
a foreign income tax expense generally involves the determination of the 
proper timing for recognizing the expense for Federal income tax 
purposes. Thus, foreign income tax expense is a material item within the 
meaning of section 446. See Sec.  1.446-1(e)(2)(ii). As a material item, 
a change in the timing of accruing a foreign income tax expense is 
generally a change in method of accounting. See section 446(e). A change 
from an improper method of accruing foreign income taxes to the proper 
method of accrual described in this paragraph (d) is treated as a change 
in a method of accounting, regardless of whether the taxpayer (or a 
partner or beneficiary taking into account a distributive share of 
foreign income taxes paid by a partnership or other pass-through entity) 
chooses to claim a deduction or a credit for such taxes in any taxable 
year. For purposes of this paragraph (d)(5), an improper method of 
accruing foreign income taxes includes a method under which foreign 
income tax is accrued in a taxable year other than the taxable year in 
which the requirements of the all events test in Sec. Sec.  1.446-
1(c)(1)(ii)(A) and 1.461-4(g)(6)(iii)(B) are met, or which fails to 
apply the relation-back rule in paragraph (d)(1) of this section that 
applies for purposes of the foreign tax credit, but does not include 
corrections to estimated accruals or errors in computing the amount of 
foreign income tax that is allowed as a deduction or credit in any 
taxable year. Taxpayers must file a Form 3115, Application for Change in 
Accounting Method, in accordance with Revenue Procedure 2015-13 (or any 
successor administrative procedure prescribed by the Commissioner) to 
obtain the Commissioner's permission to change from an improper method 
of accruing foreign income taxes to the proper method described in this 
paragraph (d). In order to prevent a duplication or omission of a 
benefit for foreign income taxes that accrue in any taxable year 
(whether through the double allowance or double disallowance of either a 
deduction or a credit, the allowance of both a deduction and a credit, 
or the disallowance of either a deduction or a credit, for the same 
amount of foreign income tax), the rules in paragraphs (d)(5)(ii) 
through (iv) of this section, describing a modified cut-off approach, 
apply if the Commissioner grants permission for the taxpayer to change 
to the proper method of accrual. Under the modified cut-off approach, a 
section 481(a) adjustment is neither required nor permitted with respect 
to the amounts of foreign income tax that were improperly accrued (or 
improperly not accrued) under the taxpayer's improper method in taxable 
years before the taxable year of change.
    (ii) Adjustments required to implement a change in method of 
accounting for accruing foreign income taxes. A change from an improper 
method of accruing foreign income taxes to the proper method described 
in this paragraph (d) is made under the modified cut-off approach 
described in this paragraph (d)(5)(ii). Under the modified cut-off 
approach, the amount of foreign income tax in a statutory or residual 
grouping (such as a separate category as defined in Sec.  1.904-5(a)(4)) 
that properly accrues in the taxable year of change (accounted for in 
the currency in which the foreign tax liability is denominated) is first 
adjusted upward by the amount of foreign income tax in the same grouping 
that properly accrued in a taxable year before the taxable year of 
change but which, under the taxpayer's improper method of accounting, 
the taxpayer failed to accrue and claim as either a credit or a 
deduction in any taxable year before the taxable year of change, and 
next, adjusted downward (but not below zero) by the

[[Page 1003]]

amount of foreign income tax in the same grouping that the taxpayer 
improperly accrued in a taxable year before the year of change and for 
which the taxpayer claimed a credit or a deduction in such prior taxable 
year, but only if the improperly-accrued amount of foreign income tax 
did not properly accrue in a taxable year before the taxable year of 
change. The modified cut-off approach is applied separately with respect 
to amounts of foreign income tax for which the foreign tax credit is 
disallowed and to which section 275 does not apply. See, for example, 
section 901(m)(6). For purposes of the foreign tax credit, the adjusted 
amounts of accrued foreign income taxes, including any upward 
adjustment, are translated into U.S. dollars under Sec.  1.986(a)-1 as 
if those amounts properly accrued in the taxable year of change. To the 
extent that the downward adjustment in any grouping required under this 
modified cut-off approach exceeds the amount of foreign income tax 
properly accruing in that grouping in the year of change, as increased 
by the upward adjustment, if any, such excess will carry forward to each 
subsequent taxable year and reduce properly-accrued amounts of foreign 
income tax in the same grouping to the extent of those properly-accrued 
amounts, until all improperly-accrued amounts included in the downward 
adjustment are accounted for. See Sec.  1.861-20 for rules that apply to 
assign foreign income taxes to statutory and residual groupings. See 
paragraphs (d)(6)(v) through (d)(6)(ix) of this section for examples 
illustrating the application of the modified cut-off approach.
    (iii) Application of section 905(c)--(A) Two-year rule. Except as 
otherwise provided in this paragraph (d)(5)(iii), if the taxpayer 
claimed a credit for improperly-accrued amounts in a taxable year before 
the taxable year of change, no adjustment is required under section 
905(c)(2) and Sec.  1.905-3(a) solely by reason of the improper accrual. 
For purposes of applying section 905(c)(2) and Sec.  1.905-3(a) to 
improperly-accrued amounts of foreign income tax that were claimed as a 
credit in any taxable year before the taxable year of change, the 24-
month period runs from the close of the U.S. taxable year(s) in which 
those amounts were accrued under the taxpayer's improper method and 
claimed as a credit. To the extent any improperly-accrued amounts remain 
unpaid as of the date 24 months after the close of the taxable year in 
which the amounts were improperly accrued and claimed as a credit, an 
adjustment is required under section 905(c)(2) and Sec.  1.905-3(a) as 
if the improperly-accrued amounts were refunded as of the date 24 months 
after the close of such taxable year. See Sec.  1.986(a)-1(c) (a refund 
or other downward adjustment to foreign income taxes paid or accrued on 
more than one date reduces the foreign income taxes paid or accrued on a 
last-in, first-out basis, starting with the amounts most recently paid 
or accrued).
    (B) Application of payments. Amounts of foreign income tax that a 
taxpayer accrued and claimed as a credit or a deduction in a taxable 
year before the taxable year of change under the taxpayer's improper 
method, but that had properly accrued either in the taxable year the 
credit or deduction was claimed or in a different taxable year before 
the taxable year of change, are not included in the downward adjustment 
required by paragraph (d)(5)(ii) of this section. Remittances to the 
foreign country of such amounts (accounted for in the currency in which 
the foreign tax liability is denominated) are treated first as payments 
of the amounts of tax that had properly accrued in the taxable year 
claimed as a credit or deduction to the extent thereof, and then as 
payments of the amounts of tax that were improperly accrued in a 
different taxable year, on a last-in, first-out basis, starting with the 
most recent improperly-accrued amounts. Remittances to the foreign 
country of amounts of foreign income tax that properly accrue in or 
after the taxable year of change (accounted for in the foreign currency 
in which the foreign tax liability is denominated) but that are offset 
by the amounts included in the downward adjustment required by paragraph 
(d)(5)(ii) of this section are treated as payments of the amounts of tax 
that were improperly accrued before the taxable year of change and 
included in the downward adjustment on a last-in, first-out basis,

[[Page 1004]]

starting with the most recent improperly-accrued amounts. Additional 
amounts of foreign income tax that first accrue in or after the taxable 
year of change but that relate to a taxable year before the taxable year 
of change are taken into account in the earlier of the taxable year of 
change or the taxable year or years in which they would have been 
considered to accrue based upon the taxpayer's improper method. 
Additional amounts of foreign income tax that first accrue in or after 
the taxable year of change and that relate to the taxable year of change 
or a taxable year after the year of change are taken into account in the 
proper relation-back year, but may then be subject to the downward 
adjustment required by paragraph (d)(5)(ii) of this section.
    (iv) Foreign income tax expense improperly accrued by a foreign 
corporation, partnership, or other pass-through entity. Foreign income 
tax expense of a foreign corporation reduces both the corporation's 
taxable income and its earnings and profits, and may give rise to an 
amount of foreign taxes deemed paid under section 960 that may be 
claimed as a credit by a United States shareholder that is a domestic 
corporation or that is a person that makes an election under section 
962. If the Commissioner grants permission for a foreign corporation to 
change its method of accounting for foreign income tax expense, the 
duplication or omission of those expenses (accounted for in the 
functional currency of the foreign corporation) and the associated 
foreign income taxes (translated into dollars in accordance with Sec.  
1.986(a)-1) are accounted for by applying the rules in paragraph 
(d)(5)(ii) of this section as if the foreign corporation were itself 
eligible to, and did, claim a credit under section 901 for such amounts. 
In the case of a partnership or other pass-through entity that is 
granted permission to change its method of accounting for accruing 
foreign income taxes to a proper method as described in this paragraph 
(d), such partnership or other pass-through entity must provide its 
partners or other owners with the information needed for the partners or 
other owners to properly account for the improperly-accrued or unaccrued 
amounts under the rules in paragraph (d)(5)(ii) of this section as if 
their proportionate shares of foreign income tax expense were directly 
paid or accrued by them.
    (6) Examples. The following examples illustrate the application of 
paragraph (d) of this section. Unless otherwise stated, the local 
currency of Country X and Country Y, and the functional currency of any 
foreign branch, is the Euro ([euro]), and at all relevant times the 
exchange rate is $1:[euro]1.
    (i) Example 1: Accrual of foreign income tax--(A) Facts. A, a U.S. 
citizen, resides and works in Country X. A uses the calendar year as the 
U.S. taxable year and has made an election under paragraph (e) of this 
section to claim foreign tax credits on an accrual basis. Country X has 
a tax year that begins on April 1 and ends on March 31. A's wages are 
subject to net income tax, at graduated rates, under Country X tax law 
and are subject to withholding on a monthly basis by A's employer in 
Country X. In the period between April 1, Year 1, and March 31, Year 2, 
A earns $50,000x in Country X wages, from which A's employer withholds 
$10,000x in tax. On December 1, Year 1, A receives a dividend 
distribution from a Country Y corporation, from which the corporation 
withheld $500x of tax. Country Y imposes withholding tax on dividends 
paid to nonresidents solely based on the gross amount of the dividend 
payment; A is not required to file a tax return in Country Y.
    (B) Analysis. Under paragraph (d)(1) of this section, A's liability 
for Country X net income tax accrues on March 31, Year 2, the last day 
of the Country X taxable year. The Country X net income tax withheld by 
A's employer from A's wages is a reasonable approximation of, and 
represents an advance payment of, A's final net income tax liability for 
the year, which becomes fixed and determinable only at the close of the 
Country X taxable year. Thus, A cannot claim a credit for any portion of 
the Country X net income tax on A's Federal income tax return for Year 
1, and may claim a credit for the entire Country X net income tax that 
accrues on March 31, Year 2, on A's Federal income tax return for Year 
2. A may claim a credit for the Country

[[Page 1005]]

Y withholding tax on A's Federal income tax return for Year 1, because 
the withholding tax accrued on December 1, Year 1.
    (ii) Example 2: 52-53 week taxable year--(A) Facts. U.S.C., an 
accrual method taxpayer, is a domestic corporation that operates in 
branch form in Country X. U.S.C. uses the calendar year for Country X 
tax purposes. For Federal income tax purposes, U.S.C. elects pursuant to 
Sec.  1.441-2(a) to use a 52-53 week taxable year that ends on the last 
Friday of December. In Year 1, U.S.C.'s U.S. taxable year ends on 
Friday, December 25; in Year 2, U.S.C.'s U.S. taxable year ends Friday, 
December 31. For its foreign taxable year ending December 31, Year 1, 
U.S.C. earns $10,000x of foreign source income through its Country X 
branch and incurs Country X foreign income tax of $500x; for Year 2, 
U.S.C. earns $12,000x and incurs Country X foreign income tax of $600x.
    (B) Analysis. Under paragraph (d)(1) of this section, the $500x of 
Country X foreign income tax becomes fixed and determinable at the close 
of U.S.C.'s foreign taxable year, on December 31, Year 1, which is after 
the close of its U.S. taxable year (December 25, Year 1). The $600x of 
Country X foreign income tax becomes fixed and determinable on December 
31, Year 2. Thus, both the Year 1 and Year 2 Country X foreign income 
taxes accrue in U.S.C.'s U.S. taxable year ending December 31, Year 2. 
However, pursuant to paragraph (d)(2) of this section, for purposes of 
determining the amount of foreign income taxes accrued in each taxable 
year for foreign tax credit purposes, U.S.C.'s U.S. taxable year is 
deemed to end on December 31, the end of U.S.C.'s Country X taxable 
year. U.S.C. may therefore claim a foreign tax credit for $500x of 
Country X foreign income tax on its Federal income tax return for Year 1 
and a credit for $600x of Country X foreign income tax on its Federal 
income tax return for Year 2.
    (iii) Example 3: Contested tax--(A) Facts. U.S.C. is a domestic 
corporation that operates in branch form in Country X. U.S.C. uses an 
accrual method of accounting and uses the calendar year as its U.S. and 
Country X taxable year. In Year 1, when the average exchange rate 
described in Sec.  1.986(a)-1(a)(1) is $1:[euro]1, U.S.C. earns 
[euro]20,000x = $20,000x through its Country X branch for U.S. and 
Country X tax purposes and accrues Country X foreign income taxes of 
[euro]500x = $500x, which U.S.C. claims as a credit on its Federal 
income tax return for Year 1. In Year 3, when the average exchange rate 
is $1:[euro]1.2, Country X asserts that U.S.C. owes additional foreign 
income taxes of [euro]100x with respect to U.S.C.'s Year 1 income. 
U.S.C. contests the liability but remits [euro]40x to Country X with 
respect to the contested liability in Year 3. U.S.C. does not make an 
election under paragraph (d)(4) of this section to claim a provisional 
credit with respect to the [euro]40x. In Year 6, after exhausting all 
effective and practical remedies, it is finally determined that U.S.C. 
is liable for [euro]50x of additional Country X foreign income taxes 
with respect to its Year 1 income. U.S.C. pays an additional [euro]10x 
to Country X on September 15, Year 6, when the spot rate described in 
Sec.  1.986(a)-1(a)(2)(i) is $1:[euro]2.
    (B) Analysis. Pursuant to paragraph (d)(3) of this section, the 
additional liability asserted by Country X with respect to U.S.C.'s Year 
1 income does not accrue until the contest is resolved in Year 6. 
U.S.C.'s remittance of [euro]40x of contested tax in Year 3 is not a 
payment of accrued tax, and so is not a foreign tax redetermination. 
Both the [euro]40x of Country X taxes paid in Year 3 and the [euro]10x 
of Country X taxes paid in Year 6 accrue in Year 6, when the contest is 
resolved. Once accrued and paid, the [euro]50x relates back for foreign 
tax credit purposes to Year 1, and can be claimed as a credit by U.S.C. 
on a timely-filed amended return for Year 1. Under Sec.  1.986(a)-1(a), 
for foreign tax credit purposes the [euro]40x paid in Year 3 is 
translated into dollars at the average exchange rate for Year 1 
([euro]40x x $1/[euro]1 = $40x), and the [euro]10x paid in Year 6 is 
translated into dollars at the spot rate on the date paid ([euro]10x x 
$1/[euro]2 = $5x). Accordingly, after the [euro]50x of Country X income 
tax is paid in Year 6 U.S.C. may claim an additional foreign tax credit 
of $45x for Year 1.
    (iv) Example 4: Provisional credit for contested tax--(A) Facts. The 
facts are the same as those in paragraph (d)(6)(iii)(A) of this section 
(the facts in

[[Page 1006]]

Example 3), except that U.S.C. pays the entire contested tax liability 
of [euro]100x to Country X in Year 3 and elects under paragraph (d)(4) 
of this section to claim a provisional foreign tax credit on an amended 
return for Year 1. In Year 6, upon resolution of the contest, U.S.C. 
receives a refund of [euro]50x from Country X.
    (B) Analysis. In Year 3, U.S.C. may claim a provisional foreign tax 
credit for $100x ([euro]100x translated at the average exchange rate for 
Year 1) of contested foreign tax paid to Country X by filing an amended 
return for Year 1, with Form 1118 attached, and a provisional foreign 
tax credit agreement described in paragraph (d)(4)(ii) of this section. 
In each year for Years 4 through 6, U.S.C. must attach the certification 
described in paragraph (d)(4)(iii) of this section to its timely-filed 
Federal income tax return. In Year 6, as a result of the [euro]50x 
refund, U.S.C. must redetermine its U.S. tax liability for Year 1 and 
for any other affected year pursuant to Sec.  1.905-3, reducing the Year 
1 foreign tax credit by $50x (from $600x to $550x), and comply with the 
notification requirements in Sec.  1.905-4. See Sec.  1.986(a)-1(c) 
(refunds of foreign income tax translated into U.S. dollars at the rate 
used to claim the credit).
    (v) Example 5: Improperly accelerated accrual--(A) Facts--(1) 
Foreign income tax accrued and paid. U.S.C. is a domestic corporation 
that operates a foreign branch in Country X. All of U.S.C.'s gross and 
taxable income is foreign source foreign branch category income, and all 
of its foreign income taxes are properly allocated and apportioned under 
Sec.  1.861-20 to the foreign branch category. U.S.C. uses the accrual 
method of accounting and uses the calendar year as its U.S. taxable 
year. For Country X tax purposes, U.S.C. uses a fiscal year that ends on 
March 31. U.S.C. accrued [euro]200x of Country X net income tax (as 
defined in Sec.  1.901-2(a)(3)) for its foreign taxable year ending 
March 31, Year 2, for which the average exchange rate was $1:[euro]1. It 
timely filed its Country X tax return and paid the [euro]200x on January 
15, Year 3. U.S.C. accrued and paid with its timely filed Country X tax 
returns [euro]280x and [euro]240x of Country X net income tax for its 
foreign taxable years ending on March 31 of Year 3 and Year 4, 
respectively, on January 15 of Year 4 and Year 5, respectively.
    (2) Improper accrual. On its Federal income tax return for Year 1, 
U.S.C. improperly pro-rated and accelerated the accrual of Country X net 
income tax and claimed a credit for $150x, equal to three-fourths of the 
Country X net income tax of $200x that relates to U.S.C.'s foreign 
taxable year ending March 31, Year 2. Continuing with this improper 
method of accruing foreign income taxes, U.S.C. claimed a foreign tax 
credit of $260x on its U.S. tax return for Year 2, comprising $50x (one-
fourth of the $200x of net income tax relating to its foreign taxable 
year ending March 31, Year 2) plus $210x (three-fourths of the $280x of 
net income tax relating to its foreign taxable year ending March 31, 
Year 3). Similarly, U.S.C. improperly accrued and claimed a foreign tax 
credit on its U.S. tax return for Year 3 for $250x of Country X net 
income tax, comprising $70x (one-fourth of the $280x that properly 
accrued in Year 3) plus $180x (three-fourths of the $240x that properly 
accrued in Year 4). In Year 4, U.S.C. realizes its mistake and, as 
provided in paragraph (d)(5)(i) of this section, files Form 3115 with 
the IRS to seek permission to change from an improper method to a proper 
method of accruing foreign income taxes.

                  Table 1 to Paragraph (d)(6)(v)(A)(2)
------------------------------------------------------------------------
                                    Net income tax     Net income tax
 Country X taxable year ending in      properly         accrued under
    U.S. calendar taxable year       accrued ($1 =   improper method ($1
                                       [euro]1))         = [euro]1))
------------------------------------------------------------------------
3/31/Y1 ends in Year 1............               0  \3/4\ (200x) = 150x.
3/31/Y2 ends in Year 2............            200x  \1/4\ (200x) + \3/4\
                                                     (280x) = 260x.
3/31/Y3 ends in Year 3............            280x  \1/4\ (280x) + \3/4\
                                                     (240x) = 250x.
3/31/Y4 ends in Year 4............            240x  [year of change].
------------------------------------------------------------------------

    (B) Analysis--(1) Downward adjustment. Under paragraph (d)(5)(ii) of 
this section, in Year 4, the year of change, U.S.C. must reduce (but not 
below zero) the amount (in Euros) of Country X net income tax in the 
foreign branch category that properly accrues in Year 4, [euro]240x, by 
the amount of foreign income tax that was accrued and claimed as either 
a deduction or a credit in a year before the year of change, and that 
had

[[Page 1007]]

not properly accrued in either the year in which the tax was accrued 
under U.S.C.'s improper method or in any other taxable year before the 
taxable year of change. For all taxable years before the taxable year of 
change, under its improper method U.S.C. had accrued and claimed as a 
credit a total of [euro]660x = $660x of foreign income tax, of which 
only [euro]480x = $480x had properly accrued. Therefore, the downward 
adjustment required by paragraph (d)(5)(ii) of this section is 
[euro]180x ([euro]660x - [euro]480x = [euro]180x). In Year 4, U.S.C.'s 
foreign tax credit in the foreign branch category is reduced by $180x 
([euro]180x downward adjustment translated into dollars at $1:[euro]1, 
the average exchange rate for Year 4), from $240x to $60x.
    (2) Application of section 905(c)--(i) Year 1. Under paragraph 
(d)(5)(iii) of this section, the [euro]200x U.S.C. paid on January 15, 
Year 3, that relates to its Country X taxable year ending on March 31, 
Year 2, is first treated as a payment of the [euro]50x of that Country X 
net income tax liability that properly accrued and was claimed as a 
credit by U.S.C. in Year 2, and next as a payment of the [euro]150x of 
that Country X net income tax liability that U.S.C. improperly accrued 
and claimed as a credit in Year 1. Because all [euro]150x of the Country 
X net income tax that was improperly accrued and claimed as a credit in 
Year 1 was paid within 24 months of December 31, Year 1, no foreign tax 
redetermination occurs, and no redetermination of U.S. tax liability is 
required, for Year 1.
    (ii) Year 2. Under paragraph (d)(5)(iii) of this section, the 
[euro]280x U.S.C. paid on January 15, Year 4, that relates to its 
Country X taxable year ending on March 31, Year 3, is first treated as a 
payment of the [euro]70x = $70x of that Country X net income tax 
liability that properly accrued and was claimed as a credit by U.S.C. in 
Year 3, and next as a payment of the [euro]210x = $210x of that Country 
X net income tax liability that U.S.C. improperly accrued and claimed as 
a credit in Year 2. Together with the [euro]50x = $50x of U.S.C.'s 
Country X net income tax liability that properly accrued and was claimed 
as a credit in Year 2, all [euro]260x of the Country X net income tax 
that was accrued and claimed as a credit in Year 2 under U.S.C.'s 
improper method was paid within 24 months of December 31, Year 2. 
Accordingly, no foreign tax redetermination occurs, and no 
redetermination of U.S. tax liability is required, for Year 2.
    (iii) Year 3. Under paragraph (d)(5)(iii) of this section, the 
[euro]240x U.S.C. paid on January 15, Year 5, that relates to its 
Country X taxable year ending on March 31, Year 4, is first treated as a 
payment of the [euro]60x = $60x of that Country X net income tax 
liability that properly accrued and was claimed as a credit by U.S.C. in 
Year 4, and next as a payment of the [euro]180x = $180x of that Country 
X net income tax liability that U.S.C. improperly accrued and claimed as 
a credit in Year 3. Together with the [euro]70x = $70x of U.S.C.'s 
Country X net income tax liability that properly accrued and was claimed 
as a credit by U.S.C. in Year 3, all [euro]250x of the Country X net 
income tax that was accrued and claimed as a credit in Year 3 under 
U.S.C.'s improper method was paid within 24 months of December 31, Year 
3. Accordingly, no foreign tax redetermination occurs, and no 
redetermination of U.S. tax liability is required, for Year 3.
    (iv) Year 4. Under paragraph (d)(5)(iii) of this section, [euro]60x 
= $60x of U.S.C.'s January 15, Year 5 payment of [euro]240x with respect 
to its Country X net income tax liability for Year 4 is treated as a 
payment of [euro]60x = $60x of Country X net income tax that, after 
application of the downward adjustment required by paragraph (d)(5)(ii) 
of this section, was accrued and claimed as a credit in Year 4, the year 
of change.
    (vi) Example 6: Failure to pay improperly-accrued tax within 24 
months--(A) Facts. The facts are the same as those in paragraph 
(d)(6)(v) of this section (the facts in Example 5), except that U.S.C. 
does not pay its [euro]240x tax liability for its Country X taxable year 
ending on March 31, Year 4, until January 15 of Year 6, when the spot 
rate described in Sec.  1.986(a)-1(a)(2)(i) is $1:[euro]1.5.
    (B) Analysis. The results are the same as in paragraphs 
(d)(6)(v)(B)(2)(i) and (ii) of this section (the analysis in Example 5 
for Year 1 and Year 2). With respect to Year 3, because the [euro]180x = 
$180x of Year 4 foreign income tax that was improperly accrued and 
credited in

[[Page 1008]]

Year 3 was not paid within 24 months of the end of Year 3, under section 
905(c)(2) and Sec.  1.905-3(a) that [euro]180x = $180x is treated as 
refunded on December 31, Year 5, requiring a redetermination of U.S.C.'s 
Federal income tax liability for Year 3 (to reverse out the credit 
claimed). In Year 6, when U.S.C. pays the [euro]240x of Country X income 
tax liability for Year 4, under paragraph (d)(5)(iii) of this section 
that payment is first treated as a payment of the [euro]60x = $60x that 
was properly accrued and claimed as a credit in Year 4, and then as a 
payment of the [euro]180x that was improperly accrued and claimed as a 
credit in Year 3 and that was treated as refunded in Year 5. Under 
section 905(c)(2)(B) and Sec.  1.905-3(a), that Year 6 payment of 
accrued but unpaid tax is a second foreign tax redetermination for Year 
3 that also requires a redetermination of U.S.C.'s U.S. tax liability. 
Under Sec.  1.986(a)-1(a)(2), the [euro]180x of redetermined tax for 
Year 3 is translated into dollars at the spot rate on January 15, Year 
6, when the tax is paid ([euro]180x x $1/[euro]1.5 = $120x). Under Sec.  
1.905-4(b)(1)(iv), U.S.C. may file one amended return accounting for 
both foreign tax redeterminations (which occur in two consecutive 
taxable years) with respect to Year 3, which taken together result in a 
reduction in U.S.C.'s foreign tax credit for Year 3 from $250x to $190x 
($250x originally accrued - $180x unpaid after 24 months + $120x paid in 
Year 6).
    (vii) Example 7: Additional payment of improperly-accrued tax--(A) 
Facts. The facts are the same as those in paragraph (d)(6)(v)(A) of this 
section (the facts in Example 5), except that in Year 6, Country X 
assessed additional net income tax of [euro]100x with respect to 
U.S.C.'s Country X taxable year ending March 31, Year 3, and after 
exhausting all effective and practical remedies to reduce its liability 
for Country X income tax, U.S.C. pays the additional assessed tax on 
September 15, Year 7, when the spot rate described in Sec.  1.986(a)-
1(a)(2)(i) is $1:[euro]0.5.
    (B) Analysis. Under paragraph (d)(3) of this section, the additional 
[euro]100x of Country X income tax U.S.C. paid in Year 7 with respect to 
its foreign taxable year that ended March 31, Year 3, relates back and 
is considered to accrue in Year 3. However, under its improper method of 
accounting U.S.C. had accrued and claimed foreign tax credits for 
Country X net income tax that related to Year 3 on its Federal income 
tax returns for both Year 2 and Year 3. Accordingly, under paragraph 
(d)(5)(iii)(B) of this section U.S.C. must redetermine its U.S. tax 
liability for both Year 2 and Year 3 (and any other affected years) to 
account for the additional [euro]100x of Country X net income tax 
liability, using the improper method it used to accrue foreign income 
taxes before the year of change. Therefore, three-fourths of the 
[euro]100x of additional tax, or [euro]75x, is treated as if it accrued 
in Year 2, and one-fourth of the additional tax, or [euro]25x, is 
treated as if it accrued in Year 3. Pursuant to Sec.  1.986(a)-
1(a)(2)(i), the [euro]75x of tax treated as if it accrued in Year 2 and 
the [euro]25x of tax treated as if it accrued in Year 3 are converted 
into dollars using the September 15, Year 7, spot rate of $1:[euro]0.5, 
to $150x and $50x, respectively. Under Sec.  1.905-4(b)(1)(iii), U.S.C. 
may claim a refund for any resulting overpayment of U.S. tax for Year 2 
or Year 3 or any other affected year by filing an amended return within 
the period provided in section 6511.
    (viii) Example 8: Tax improperly accrued before year of change 
exceeds tax properly accrued in year of change--(A) Facts. U.S.C. owns 
all of the stock in CFC, a controlled foreign corporation organized in 
Country X. Country X imposes net income tax on Country X corporations at 
a rate of 10% only in the year its earnings are distributed to its 
shareholders, rather than in the year the income is earned. Both U.S.C. 
and CFC use the calendar year as their taxable year for both Federal and 
Country X income tax purposes and CFC uses the Euro as its functional 
currency. In each of Years 1-3, CFC earns [euro]1,000x for both Federal 
and Country X income tax purposes of general category foreign base 
company sales income (before reduction for foreign income taxes). CFC 
improperly accrues [euro]100x of Country X net income tax with respect 
to [euro]1,000x of income at the end of each of Years 1 and 2, even 
though no distribution is made in those years. In Year 1, for which the 
average exchange rate is $1:[euro]1, U.S.C. computes and includes in

[[Page 1009]]

income with respect to CFC $900x of subpart F income, claims a deemed 
paid foreign tax credit of $100x under section 960(a), and has a section 
78 dividend of $100x. In Year 2, for which the average exchange rate is 
$1:[euro]0.5, U.S.C. computes and includes in income with respect to CFC 
$1,800x of subpart F income, claims a deemed paid foreign tax credit of 
$200x under section 960(a), and has a section 78 dividend of $200x. In 
Year 2, CFC makes a distribution to U.S.C. of [euro]400x of earnings and 
pays [euro]40x of net income tax to Country X. In Year 3, for which the 
average exchange rate is $1:[euro]1, CFC makes another distribution to 
U.S.C. of [euro]500x of earnings and pays [euro]50x in net income tax to 
Country X. In Year 3, U.S.C. realizes its mistake and seeks permission 
from the IRS for CFC to change to a proper method of accruing foreign 
income taxes. In Year 4, for which the average exchange rate is 
$1:[euro]2, CFC makes a distribution of [euro]700x of earnings and pays 
[euro]70x of net income tax to Country X.

                  Table 2 to Paragraph (d)(6)(viii)(A)
------------------------------------------------------------------------
                                    Foreign income   Foreign income tax
        Taxable year ending          tax properly       accrued under
                                        accrued        improper method
------------------------------------------------------------------------
12/31/Y1 ($1:[euro]1).............               0  [euro]100x = $100x.
12/31/Y2 ($1:[euro]0.5)...........     [euro]40x =  [euro]100x = $200x.
                                              $80x
12/31/Y3 ($1:[euro]1).............     [euro]50x =  [year of change].
                                              $50x
12/31/Y4 ($1:[euro]2).............     [euro]70x =  ....................
                                              $35x
------------------------------------------------------------------------

    (B) Analysis--(1) Downward adjustment. Under paragraph (d)(5)(iv) of 
this section, CFC applies the rules of paragraph (d)(5) of this section 
as if it claimed a foreign tax credit under section 901 for Country X 
taxes. Under paragraph (d)(5)(ii) of this section, in Year 3, the year 
of change, CFC must reduce (but not below zero) the amount (in Euros) of 
Country X net income tax allocated and apportioned to its general 
category foreign base company sales income group that properly accrues 
in Year 3, [euro]50x, by the amount of foreign income tax (in Euros) 
that was improperly accrued in that statutory grouping in a year before 
the year of change, and that had not properly accrued in either the year 
accrued or in another taxable year before the year of change. For all 
taxable years before the year of change, under its improper method CFC 
had accrued a total of [euro]200x of foreign income tax with respect to 
its general category foreign base company sales income group, of which 
only [euro]40x had properly accrued. Therefore, the downward adjustment 
required by paragraph (d)(5)(ii) of this section is [euro]160x 
([euro]200x--[euro]40x = [euro]160x). In Year 3, CFC's [euro]50x of 
eligible foreign income taxes in the general category foreign base 
company sales income group is reduced by [euro]50x to zero. The 
[euro]110x balance of the downward adjustment carries forward to Year 4, 
and reduces CFC's [euro]70x of eligible foreign income taxes in the 
general category foreign base company sales income group by [euro]70x to 
zero. The remaining [euro]40x balance of the downward adjustment carries 
forward to later years and will reduce CFC's eligible foreign income 
taxes in the general category foreign base company sales income group 
until all improperly-accrued amounts are accounted for.
    (2) Application of section 905(c)--(i) Year 2. Under paragraph 
(d)(5)(iii) of this section, CFC's payment in Year 2 of the [euro]40x of 
Country X net income tax that properly accrued in Year 2, before the 
year of change, is treated as a payment of [euro]40x of foreign income 
tax that CFC properly accrued in Year 2. The [euro]60x of foreign income 
tax that CFC improperly accrued in Year 2 that remains unpaid at the end 
of Year 2 is not adjusted in Year 2. Under paragraph (d)(5)(iii) of this 
section, CFC's payment in Year 3 of [euro]50x of Country X net income 
tax that properly accrued but was offset by the downward adjustment in 
Year 3 is treated as a payment of [euro]50x of the remaining [euro]60x 
of Country X net income tax that CFC improperly accrued in Year 2, the 
most recent improper accrual. In addition, CFC's payment in Year 4 of 
[euro]70x of Country X net income tax that properly accrued but was 
offset by the downward adjustment in Year 4 is treated first as a 
payment of the remaining [euro]10x of Country X net income tax that CFC 
improperly accrued in Year 2. Because all [euro]100x of foreign income 
tax accrued in Year 2 under CFC's improper method of accounting is 
treated as paid within 24 months of December 31, Year 2, no foreign tax 
redetermination occurs, and no redetermination of CFC's foreign

[[Page 1010]]

base company sales income, earnings and profits, and eligible foreign 
income taxes or of U.S.C.'s $1,800x subpart F inclusion, $200x deemed 
paid credit, $200x section 78 dividend and U.S. tax liability is 
required, for Year 2.
    (ii) Year 1. Because all [euro]100x of the tax CFC improperly 
accrued in Year 1 remained unpaid as of December 31, Year 3, the date 24 
months after the end of Year 1, under section 905(c)(2) and Sec.  1.905-
3(a) that [euro]100x is treated as refunded on December 31, Year 3. 
Under Sec.  1.905-3(b)(2)(ii), U.S.C. must redetermine its Federal 
income tax liability for Year 1 to account for the foreign tax 
redetermination, increasing CFC's foreign base company sales income and 
earnings and profits by [euro]100x, and decreasing its eligible foreign 
income taxes by $100x. However, under paragraph (d)(5)(iii)(B) of this 
section [euro]60x of CFC's payment in Year 4 of [euro]70x of Country X 
net income tax that properly accrued but was offset by the downward 
adjustment in Year 4 is treated as a payment of [euro]60x of the 
[euro]100x of Country X net income tax that was improperly accrued in 
Year 1 and treated as refunded in Year 3. Under Sec.  1.905-4(b)(1)(iv), 
U.S.C. may account for the two foreign tax redeterminations that 
occurred in Years 3 and 4 on a single amended Federal income tax return 
for Year 1. CFC's foreign base company sales income (taking into account 
the reduction for foreign income taxes) and earnings and profits for 
Year 1 are recomputed as [euro]1,000x of foreign base company sales 
income--[euro]100x foreign income tax improperly accrued in Year 1 + 
[euro]100x improperly accrued foreign income tax treated as refunded on 
December 31, Year 3--[euro]60x improperly accrued foreign income tax 
treated as paid in Year 4 = [euro]940x. CFC's eligible foreign income 
taxes for Year 1 are translated into dollars at the applicable exchange 
rate and recomputed as $100x foreign income tax improperly accrued in 
Year 1--$100x improperly accrued foreign income tax treated as refunded 
on December 31, Year 3 + $30x improperly accrued foreign income tax 
treated as paid in Year 4 = $30x. U.S.C.'s subpart F inclusion with 
respect to CFC for Year 1 (translated at the average exchange rate for 
Year 1 of $1:[euro]1) is increased from $900x to $940x ([euro]940x x $1/
[euro]1), and the amount of foreign taxes deemed paid under section 
960(a) and the amount of the section 78 dividend are reduced from $100x 
to $30x.
    (iii) Summary. As of the end of Year 4, CFC and U.S.C. have been 
allowed a $30x foreign tax credit for Year 1, and a $200x foreign tax 
credit for Year 2. If in a later taxable year CFC distributes additional 
earnings to U.S.C. and accrues [euro]40x of additional Country X net 
income tax that is offset by the balance of the [euro]40x downward 
adjustment, CFC's payment of that [euro]40x Country X net income tax 
liability will be treated as a payment of the remaining [euro]40x of 
Country X net income tax that was improperly accrued in Year 1 and 
treated as refunded as of the end of Year 3.
    (ix) Example 9: Improperly deferred accrual--(A) Facts--(1) Foreign 
income tax accrued and paid. U.S.C. is a domestic corporation that 
operates a foreign branch in Country X. All of U.S.C.'s gross and 
taxable income is foreign source foreign branch category income, and all 
of its foreign income taxes are properly allocated and apportioned under 
Sec.  1.861-20 to the foreign branch category. U.S.C. uses the accrual 
method of accounting and uses the calendar year as its taxable year for 
both Federal and Country X income tax purposes. U.S.C. accrued 
[euro]160x of Country X net income tax (as defined in Sec.  1.901-
2(a)(3)) with respect to Year 1. U.S.C. filed its Country X tax return 
and paid the [euro]160x on June 30, Year 2. U.S.C. accrued [euro]180x, 
[euro]240x, and [euro]150x of Country X tax for Years 2, 3, and 4, 
respectively, and paid with its timely filed Country X tax returns these 
tax liabilities on June 30 of Years 3, 4, and 5, respectively. The 
average exchange rate described in Sec.  1.986(a)-1(a)(1) is 
$1:[euro]0.5 in Year 1, $1:[euro]1 in Year 2, $1:[euro]1.25 in Year 3, 
and $1:[euro]1.5 in Year 4.
    (2) Improper accrual. On its Federal income tax return for Year 1, 
U.S.C. claimed no foreign tax credit. On its Federal income tax return 
for Year 2, U.S.C. improperly accrued and claimed a credit for $160x 
([euro]160x of Country X tax for Year 1 that it paid in Year 2, 
translated into dollars at the average exchange rate for Year 2). 
Continuing with this improper method of accounting, U.S.C. improperly 
accrued and claimed a credit in Year 3 for $144x

[[Page 1011]]

([euro]180x of Country X tax for Year 2 that it paid in Year 3, 
translated into dollars at the average exchange rate for Year 3). In 
Year 4, U.S.C. realizes its mistake and seeks permission from the IRS to 
change to a proper method of accruing foreign income taxes.

                  Table 3 to Paragraph (d)(6)(ix)(A)(2)
------------------------------------------------------------------------
                                                      Foreign income tax
       Taxable year ending        Foreign income tax     accrued under
                                   properly accrued     improper method
------------------------------------------------------------------------
12/31/Y1 ($1:[euro]0.5).........  [euro]160x = $320x  0.
12/31/Y2 ($1:[euro]1)...........  [euro]180x = $180x  [euro]160x =
                                                       $160x.
12/31/Y3 ($1:[euro]1.25)........  [euro]240x = $192x  [euro]180x =
                                                       $144x.
12/31/Y4 ($1:[euro]1.5).........  [euro]150x = $100x  [year of change].
------------------------------------------------------------------------

    (B) Analysis--(1) Upward adjustment. Under paragraph (d)(5)(ii) of 
this section, in Year 4, the year of change, U.S.C. increases the amount 
of Country X net income tax allocated and apportioned to its foreign 
branch category that properly accrues in Year 4, [euro]150x, by the 
amount of foreign income tax in that same grouping that properly accrued 
in a taxable year before the taxable year of change, but which, under 
its improper method of accounting, U.S.C. failed to accrue and claim as 
either a credit or deduction before the taxable year of change. For all 
taxable years before the taxable year of change, under a proper method, 
U.S.C. would have accrued a total of [euro]580x of foreign income tax, 
of which it accrued and claimed a credit for only [euro]340x under its 
improper method. Thus, in Year 4, U.S.C. increases its [euro]150x of 
properly accrued foreign income taxes in the foreign branch category by 
[euro]240x ([euro]580x - [euro]340x), and may claim a credit in that 
year for the total, [euro]390x, or $260x (translated into dollars at the 
average exchange rate for Year 4, as if the total amount properly 
accrued in Year 4).
    (2) Application of section 905(c). Under paragraph (d)(5)(iii) of 
this section, U.S.C.'s payment in Year 2 of [euro]160x of Country X net 
income tax that properly accrued in Year 1 but that U.S.C. accrued and 
claimed as a credit in Year 2 under its improper method of accounting is 
first treated as a payment of the amount of the Year 1 tax liability 
that properly accrued in Year 2. Since none of the [euro]160x properly 
accrued in Year 2, the [euro]160x is treated as a payment of the Year 1 
tax liability that U.S.C. improperly accrued and claimed as a credit in 
Year 2, [euro]160x. Because all [euro]160x of the Country X net income 
tax that was improperly accrued and claimed as a credit in Year 2 was 
paid within 24 months of the end of Year 2, no foreign tax 
redetermination occurs, and no redetermination of U.S.C.'s $160x foreign 
tax credit and U.S. tax liability is required, for Year 2. Similarly, 
because all [euro]180x of the Year 2 Country X net income tax that was 
improperly accrued and claimed as a credit in Year 3 was paid within 24 
months of the end of Year 3, no foreign tax redetermination occurs, and 
no redetermination of U.S.C.'s $144x foreign tax credit and U.S. tax 
liability is required, for Year 3.
    (e) Election by cash method taxpayer to take credit on the accrual 
basis--(1) In general. A taxpayer who uses the cash method of accounting 
for income may elect to take the foreign tax credit in the taxable year 
in which the taxes accrue in accordance with the rules in paragraph (d) 
of this section. Except as provided in paragraph (e)(2) of this section, 
an election pursuant to this paragraph (e)(1) must be made on a timely-
filed original return, by checking the appropriate box on Form 1116 
(Foreign Tax Credit (Individual, Estate, or Trust)) or Form 1118 
(Foreign Tax Credit--Corporations) indicating the cash method taxpayer's 
choice to claim the foreign tax credit in the year the foreign income 
taxes accrue. Once made, the election is irrevocable and must be 
followed for purposes of claiming a foreign tax credit for all 
subsequent years. See section 905(a).
    (2) Exception for cash method taxpayers claiming a foreign tax 
credit for the first time. If the year with respect to which an election 
pursuant to paragraph (e)(1) of this section to claim the foreign tax 
credit on an accrual basis is made (the ``election year'') is the first 
year for which a taxpayer has ever claimed a foreign tax credit, the 
election to claim the foreign tax credit on an accrual basis can also be 
made on an amended return filed within the period permitted under Sec.  
1.901-1(d)(1). The election is binding in the election year and all 
subsequent taxable years in

[[Page 1012]]

which the taxpayer claims a foreign tax credit.
    (3) Treatment of taxes that accrued in a prior year. In the election 
year and subsequent taxable years, a cash method taxpayer that claimed 
foreign tax credits on the cash basis in a prior taxable year may claim 
a foreign tax credit not only for foreign income taxes that accrue in 
the election year, but also for foreign income taxes that accrued (or 
are considered to accrue) in a taxable year preceding the election year 
but that are paid in the election year or a subsequent taxable year, as 
applicable. Under paragraph (c) of this section, foreign income taxes 
paid with respect to a taxable year that precedes the election year may 
be claimed as a credit only in the year the taxes are paid and do not 
require a redetermination under section 905(c) or Sec.  1.905-3 of U.S. 
tax liability in any prior year.
    (4) Examples. The following examples illustrate the application of 
paragraph (e) of this section.
    (i) Example 1--(A) Facts. A, a U.S. citizen who is a resident of 
Country X, is a cash method taxpayer who uses the calendar year as the 
taxable year for both U.S. and Country X tax purposes. In Year 1 through 
Year 5, A claims foreign tax credits for Country X foreign income taxes 
on the cash method, in the year the taxes are paid. For Year 6, A makes 
a timely election to claim foreign tax credits on the accrual basis. In 
Year 6, A accrues $100x of Country X foreign income taxes with respect 
to Year 6. Also in Year 6, A pays $80x in foreign income taxes that had 
accrued in Year 5.
    (B) Analysis. Pursuant to paragraph (e)(3) of this section, A can 
claim a foreign tax credit in Year 6 for the $100x of Country X taxes 
that accrued in Year 6 and for the $80x of Country X taxes that accrued 
in Year 5 but that are paid in Year 6.
    (ii) Example 2--(A) Facts. The facts are the same as those in 
paragraph (e)(4)(i)(A) of this section (the facts in Example 1), except 
that in Year 7, A is assessed an additional $10x of foreign income tax 
by Country X with respect to A's income in Year 3. After exhausting all 
effective and practical remedies, A pays the additional $10x to Country 
X in Year 8.
    (B) Analysis. Pursuant to paragraph (e)(3) of this section, A can 
claim a foreign tax credit in Year 8 for the additional $10x of foreign 
income tax paid to Country X in Year 8 with respect to Year 3.
    (f) Rules for creditable foreign tax expenditures of partners, 
shareholders, or beneficiaries of a pass-through entity--(1) Effect of 
pass-through entity's method of accounting on when foreign tax credit or 
deduction can be claimed. Each partner that elects to claim the foreign 
tax credit for a particular taxable year may treat its distributive 
share of the creditable foreign tax expenditures (as defined in Sec.  
1.704-1(b)(4)(viii)(b)) of the partnership that are paid or accrued by 
the partnership, under the partnership's method of accounting, during 
the partnership's taxable year ending with or within the partner's 
taxable year, as foreign income taxes paid or accrued (as the case may 
be, according to the partner's method of accounting for such taxes) by 
the partner in that particular taxable year. See Sec. Sec.  1.702-
1(a)(6) and 1.703-1(b)(2). Under Sec. Sec.  1.905-3(a) and 1.905-
4(b)(2), additional creditable foreign tax expenditures of the 
partnership that result from a change in the partnership's foreign tax 
liability for a prior taxable year, including additional taxes paid when 
a contest with a foreign tax authority is resolved, must be identified 
by the partnership as a prior year creditable foreign tax expenditure in 
the information reported to its partners for its taxable year in which 
the additional tax is actually paid. Subject to the rules in paragraphs 
(c) and (e) of this section, a partner using the cash method of 
accounting for foreign income taxes may claim a credit (or a deduction) 
for its distributive share of such additional taxes in the partner's 
taxable year with or within which the partnership's taxable year ends. 
Subject to the rules in paragraph (d) of this section, a partner using 
the accrual method of accounting for foreign income taxes may claim a 
credit for the partner's distributive share of such additional taxes in 
the relation-back year, or may claim a deduction in its taxable year 
with or within which the partnership's taxable year ends. The principles 
of this paragraph (f)(1) apply to determine

[[Page 1013]]

the year in which a shareholder of a S corporation, or the grantor or 
beneficiary of an estate or trust, may claim a foreign tax credit (or a 
deduction) for its proportionate share of foreign income taxes paid or 
accrued by the S corporation, estate or trust. See sections 642(a), 671, 
901(b)(5), and 1373(a) and Sec. Sec.  1.1363-1(c)(2)(iii) and 1.1366-
1(a)(2)(iv). See Sec. Sec.  1.905-3 and 1.905-4 for notifications and 
adjustments of U.S. tax liability that are required if creditable 
foreign tax expenditures of a partnership or S corporation, or foreign 
income taxes paid or accrued by a trust or estate, are refunded or 
otherwise reduced.
    (2) Provisional credit for contested taxes. Under paragraph (d)(3) 
of this section, a contested foreign tax liability does not accrue until 
the contest is resolved and the amount of the liability has been finally 
determined. In addition, under section 905(c)(2), a foreign income tax 
that is not paid within 24 months of the close of the taxable year to 
which the tax relates may not be claimed as a credit until the tax is 
actually paid. Thus, a partnership or other pass-through entity cannot 
take the contested tax into account as a creditable foreign tax 
expenditure until both the contest is resolved and the tax is actually 
paid. However, to the extent that a partnership or other pass-through 
entity remits a contested foreign tax liability to a foreign country, a 
partner or other owner of such pass-through entity that claims foreign 
tax credits may, by complying with the rules in paragraph (c)(3) or 
(d)(4) of this section, as applicable, elect to claim a provisional 
credit for its distributive share of such contested tax liability in the 
year the pass-through entity remits the tax (for owners claiming foreign 
tax credits on the cash basis) or in the relation-back year (for owners 
claiming foreign tax credits on the accrual basis).
    (3) Example. The following example illustrates the application of 
paragraph (f) of this section.
    (i) Facts. ABC is a U.S. partnership that is engaged in a trade or 
business in Country X. ABC has two U.S. partners, A and B. For Federal 
income tax purposes, ABC and partner A both use the accrual method of 
accounting and utilize a taxable year ending on September 30. ABC uses a 
taxable year ending on September 30 for Country X tax purposes. B is a 
calendar year taxpayer that uses the cash method of accounting. For its 
taxable year ending September 30, Year 1, ABC accrues $500x in foreign 
income tax to Country X; each partner's distributive share of the 
foreign income tax is $250x. In its taxable year ending September 30, 
Year 5, ABC settles a contest with Country X with respect to its Year 1 
tax liability and, as a result of such settlement, accrues an additional 
$100x in foreign income tax for Year 1. ABC remits the additional tax to 
Country X in January of Year 6. A and B both elect to claim foreign tax 
credits for their respective taxable Years 1 through 6.
    (ii) Analysis. For its taxable year ending September 30, Year 1, A 
can claim a credit for its $250x distributive share of foreign income 
taxes paid by ABC with respect to ABC's taxable year ending September 
30, Year 1. Pursuant to paragraph (f)(1) of this section, B can claim 
its distributive share of $250x of foreign income tax for its taxable 
year ending December 31, Year 1, even if ABC does not remit the Year 1 
taxes to Country X until Year 2. Although the additional $100x of 
Country X foreign income tax owed by ABC with respect to Year 1 accrued 
in its taxable year ending September 30, Year 5, upon conclusion of the 
contest, because ABC uses the accrual method of accounting, it does not 
take the additional tax into account until the tax is actually paid, in 
its taxable year ending September 30, Year 6. See section 905(c)(2)(B) 
and paragraph (f)(1) of this section. Pursuant to Sec.  1.905-4(b)(2), 
ABC is required to notify the IRS and its partners of the foreign tax 
redetermination. A's distributive share of the additional tax relates 
back, is considered to accrue, and may be claimed as a credit for Year 
1; however, A cannot claim a credit for the additional tax until Year 6, 
when ABC remits the tax to Country X. See Sec.  1.905-3(a). B's 
distributive share of the additional tax does not relate back to Year 1 
and is creditable in B's taxable year ending December 31, Year 6.
    (g) Blocked income. If, under the provisions of the regulations 
under section 461, an amount otherwise constituting

[[Page 1014]]

gross income for the taxable year from sources without the United States 
is, owing to monetary, exchange, or other restrictions imposed by a 
foreign country, not includible in gross income of the taxpayer for such 
year, the credit for foreign income taxes imposed by such foreign 
country with respect to such amount shall be taken proportionately in 
any subsequent taxable year in which such amount or portion thereof is 
includible in gross income.
    (h) Applicability dates. This section applies to foreign income 
taxes paid or accrued in taxable years beginning on or after December 
28, 2021. In addition, the election described in paragraphs (c)(3) and 
(d)(4) of this section may be made (including by a partner or other 
owner of a pass-through entity described in paragraph (f)(2) of this 
section) with respect to amounts of contested tax that are remitted in 
taxable years beginning on or after December 28, 2021 and that relate to 
a taxable year beginning before December 28, 2021.

[T.D. 9959, 87 FR 363, Jan. 4, 2022; 87 FR 45020, July 27, 2022]



Sec.  1.905-2  Conditions of allowance of credit.

    (a) Forms and information. (1) Whenever the taxpayer chooses, in 
accordance with paragraph (d) of Sec.  1.901-1, to claim the benefits of 
the foreign tax credit, the claim for credit shall be accompanied by 
Form 1116 in the case of an individual or by Form 1118 in the case of a 
corporation.
    (2) The form must be carefully filled in with all the information 
called for and with the calculations of credits indicated. Except where 
it is established to the satisfaction of the district director that it 
is impossible for the taxpayer to furnish such evidence, the taxpayer 
must provide upon request the receipt for each such tax payment if 
credit is sought for taxes already paid or the return on which each such 
accrued tax was based if credit is sought for taxes accrued. The receipt 
or return must be either the original, a duplicate original, or a duly 
certified or authenticated copy. The preceding two sentences are 
applicable for returns whose original due date falls on or after January 
1, 1988. If the receipt or the return is in a foreign language, a 
certified translation thereof must be furnished by the taxpayer. Any 
additional information necessary for the determination under part I 
(section 861 and following), subchapter N, chapter 1 of the Code, of the 
amount of income derived from sources without the United States and from 
each foreign country shall, upon the request of the district director, 
be furnished by the taxpayer. If the taxpayer upon request fails without 
justification to furnish any such additional information which is 
significant, including any significant information which he is requested 
to furnish pursuant to Sec.  1.861-8(f)(5) as proposed in the Federal 
Register for November 8, 1976, the District Director may disallow the 
claim of the taxpayer to the benefits of the foreign tax credit.
    (b) Secondary evidence. Where it has been established to the 
satisfaction of the District Director that it is impossible to furnish a 
receipt for such foreign tax payment, the foreign tax return, or direct 
evidence of the amount of tax withheld at the source, the District 
Director, may, in his discretion, accept secondary evidence thereof as 
follows:
    (1) Receipt for payment. In the absence of a receipt for payment of 
foreign taxes there shall be submitted a photostatic copy of the check, 
draft, or other medium of payment showing the amount and date thereof, 
with certification identifying it with the tax claimed to have been 
paid, together with evidence establishing that the tax was paid for 
taxpayer's account as his own tax on his own income. If credit is 
claimed on an accrual method, it must be shown that the tax accrued in 
the taxable year.
    (2) Foreign tax return. If the foreign tax return is not available, 
the foreign tax has not been paid, and credit is claimed on an accrual 
method, there shall be submitted--
    (i) A certified statement of the amount shall be submitted--
    (ii) Excerpts from the taxpayer's accounts showing amounts of 
foreign income and tax thereon accrued on its books.

[[Page 1015]]

    (iii) A computation of the foreign tax based on income from the 
foreign country carried on the books and at current rates of tax to be 
established by data such as excerpts from the foreign law, assessment 
notices, or other documentary evidence thereof.
    (iv) A bond, if deemed necessary by the District Director, filed in 
the manner provided in cases where the foreign return is available, and
    (v) In case a bond is not required, a specific agreement wherein the 
taxpayer shall recognize its liability to report the correct amount of 
tax when ascertained, as required by the provisions of section 905 (c).


If at any time the foreign tax receipts or foreign tax returns become 
available to the taxpayer, they shall be promptly submitted to the 
district director.
    (3) Tax withheld at source. In the case of taxes withheld at the 
source from dividends, interest, royalties, compensation, or other form 
of income, where evidence of withholding and of the amount withheld 
cannot be secured from those who have made the payments, the district 
director may, in his discretion, accept secondary evidence of such 
withholding and of the amount of the tax so withheld, having due regard 
to the taxpayer's books of account and to the rates of taxation 
prevailing in the particular foreign country during the period involved.
    (c) Credit for taxes accrued but not paid. In the case of a credit 
sought for a tax accrued but not paid, the district director may, as a 
condition precedent to the allowance of a credit, require a bond from 
the taxpayer, in addition to Form 1116 or 1118. If such a bond is 
required, Form 1117 shall be used by an individual or by a corporation. 
It shall be in such sum as the Commissioner may prescribe, and shall be 
conditioned for the payment by the taxpayer of any amount of tax found 
due upon any redetermination of the tax made necessary by such credit 
proving incorrect, with such further conditions as the district director 
may require. This bond shall be executed by the taxpayer, or the agent 
or representative of the taxpayer, as principal, and by sureties 
satisfactory to and approved by the Commissioner. See also 6 U.S.C. 15.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7292, 38 FR 
33300, Dec. 3, 1973; 38 FR 34802, Dec. 19, 1973; T.D. 7456, 42 FR 1214, 
Jan. 6, 1977; T.D. 8210, 53 FR 23613, June 23, 1988; T.D. 8412, 57 FR 
20653, May 14, 1992; T.D. 8759, 63 FR 3813, Jan. 27, 1998; T.D. 9882, 84 
FR 69104, Dec. 17, 2019]



Sec.  1.905-3  Adjustments to U.S. tax liability and to current earnings 
and profits as a result of a foreign tax redetermination.

    (a) Foreign tax redetermination. For purposes of this section and 
Sec.  1.905-4, the term foreign tax redetermination means a change in 
the liability for foreign income taxes (as defined in Sec.  1.901-2(a)) 
or certain other changes described in this paragraph (a) that may affect 
a taxpayer's U.S. tax liability, including by reason of a change in the 
amount of its foreign tax credit, a change to claim a foreign tax credit 
for foreign income taxes that it previously deducted, a change to claim 
a deduction for foreign income taxes that it previously credited, a 
change in the amount of its distributions or inclusions under sections 
951, 951A, or 1293, a change in the application of the high-tax 
exception described in section 954(b)(4) (including for purposes of 
determining amounts excluded from gross tested income under section 
951A(c)(2)(A)(i)(III) and Sec.  1.951A-2(c)(1)(iii)), or a change in the 
amount of tax determined under sections 1291(c)(2) and 
1291(g)(1)(C)(ii). In the case of a taxpayer that claims the credit in 
the year the taxes are paid, a foreign tax redetermination occurs if any 
portion of the tax paid is subsequently refunded, or if the taxpayer's 
liability is subsequently determined to be less than the amount paid and 
claimed as a credit. In the case of a taxpayer that claims the credit in 
the year the taxes accrue, a foreign tax redetermination occurs if taxes 
that when paid or later adjusted differ from amounts accrued by the 
taxpayer and claimed as a credit or added to PTEP group taxes (as 
defined in Sec.  1.960-3(d)(1)). A foreign tax redetermination includes 
corrections and other adjustments to accrued amounts to reflect the 
final foreign tax liability, including additional payments of tax

[[Page 1016]]

that accrue after the close of the taxable year to which the tax relates 
and, for foreign income taxes taken into account when accrued but 
translated into dollars on the date of payment, a payment of accrued tax 
if the value of the foreign currency relative to the dollar has changed 
between the date or taxable year of accrual and the date of payment. A 
foreign tax redetermination occurs if any tax claimed as a credit or 
added to PTEP group taxes is refunded in whole or in part, regardless of 
whether such tax was paid within the meaning of Sec.  1.901-2(e) at the 
time the tax was claimed as a credit or added to PTEP group taxes. A 
foreign tax redetermination also includes accrued foreign income taxes 
that are not paid on or before the date that is 24 months after the 
close of the taxable year of the section 901 taxpayer (as defined in 
Sec.  1.986(a)-1(a)(1)) to which such taxes relate, as well as a 
subsequent payment of any such accrued but unpaid taxes. If accrued 
foreign income taxes are not paid on or before the date that is 24 
months after the close of the taxable year to which they relate, the 
resulting foreign tax redetermination is accounted for as if the unpaid 
portion of the foreign income taxes were refunded on such date. Foreign 
income taxes that first accrue after the date 24 months after the close 
of the taxable year to which such taxes relate may not be claimed as a 
credit or added to PTEP group taxes until paid. See section 905(b) and 
Sec.  1.461-4(g)(6)(iii)(B), which require the taxpayer to establish the 
amount of tax that was properly accrued.
    (b) Redetermination of U.S. tax liability--(1) Foreign income taxes 
other than taxes deemed paid under section 960--(i) In general. This 
paragraph (b)(1) applies to foreign income taxes claimed as a credit 
under section 901 other than foreign income taxes deemed paid under 
section 960. If a foreign tax redetermination occurs with respect to 
foreign income tax claimed as a credit under section 901 (other than a 
tax deemed paid under section 960), then a redetermination of U.S. tax 
liability is required for the taxable year in which the tax was claimed 
as a credit and any year to which unused foreign taxes from such year 
were carried under section 904(c). In the case of a taxpayer that claims 
the credit in the year the taxes are paid, the redetermination of U.S. 
tax liability is made by reducing the tax paid in such year by the 
amount refunded. In the case of a taxpayer that claims the credit in the 
year the taxes accrue, the redetermination of U.S. tax liability is made 
by treating the redetermined amount of foreign tax as the amount of tax 
that accrued in the year to which the redetermined tax relates. However, 
a redetermination of U.S. tax liability is not required (and a taxpayer 
need not notify the IRS) if the foreign income taxes are taken into 
account when accrued but translated into dollars on the date of payment, 
the difference between the dollar value of the accrued foreign income 
tax and the dollar value of the foreign income tax paid is solely 
attributable to fluctuations in the value of the foreign currency 
relative to the dollar between the date or taxable year of accrual and 
the date of payment, and the net dollar amount of the currency 
fluctuations attributable to the foreign tax redeterminations with 
respect to each and every foreign country is less than the lesser of 
$10,000 or two percent of the total dollar amount of the foreign income 
tax initially accrued with respect to that foreign country for the 
taxable year. In such case, if no redetermination of U.S. tax liability 
is made, an appropriate adjustment is made to the taxpayer's U.S. tax 
liability in the taxable year during which the foreign tax 
redeterminations occur.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (b)(1) and Sec.  1.986(a)-1. In all examples, assume that 
USC is a domestic corporation that uses the calendar year as its taxable 
year both for Federal income tax purposes and for foreign tax purposes 
and that it is doing business through a foreign branch operating in 
Country X, which is a qualified business unit (within the meaning of 
section 989 and Sec.  1.989(a)-1) (QBU) the functional currency of which 
is the ``u.'' Except as otherwise provided, the ``u'' is not an 
inflationary currency within the meaning of Sec.  1.986(a)-1(a)(2)(iii). 
USC is an accrual basis taxpayer.

[[Page 1017]]

    (A) Example 1: Contested tax--(1) Facts. In Year 1, USC earned 500u 
of foreign source foreign branch category income through its foreign 
branch in Country X and accrued and paid 50u of Country X foreign income 
tax on its earnings. The average exchange rate for Year 1 used to 
translate the foreign income taxes into dollars was $1x:1u. See Sec.  
1.986(a)-1(a)(1). On its Year 1 income tax return, USC claimed a foreign 
tax credit under section 901 of $50x (50u translated at the average 
exchange rate for Year 1, that is, $1x:1u). In Year 4, Country X 
assessed an additional 20u of tax with respect to USC's Year 1 earnings. 
USC did not pay or accrue the additional 20u of tax and contested the 
assessment. After exhausting all effective and practical remedies to 
reduce, over time, its liability for foreign tax, USC settled the 
contest with Country X in Year 6, paying 10u of additional tax on 
September 1, Year 6, when the spot rate was $1.10x:1u.
    (2) Analysis. USC's payment in Year 6 of the 10u of additional tax 
accrued with respect to Year 1 is a foreign tax redetermination under 
paragraph (a) of this section. Under paragraph (b)(1)(i) of this 
section, the additional tax is taken into account in Year 1, the year to 
which the redetermined tax relates, irrespective of when the tax is 
paid. Under Sec.  1.986(a)-1(a)(2)(i), because the tax was paid more 
than 24 months after the close of the year to which the redetermined tax 
relates, the 10u of tax is translated into dollars at the spot rate on 
the date of payment in Year 6 (10u at $1.10x:1u = $11x). If USC timely 
notifies the IRS, it may claim an increased foreign tax credit for Year 
1. USC must also make corresponding adjustments in determining its 
taxable income and net unrecognized section 987 gain or loss in Year 1. 
See Sec. Sec.  1.987-3(c)(2)(v) and 1.987-4(d)(7).
    (B) Example 2: Refund of tax improperly claimed as a credit--(1) 
Facts. USC holds a note issued by FC, an unrelated foreign corporation 
in Country Y. In Year 1, FC owed USC 500u of interest on the loan. The 
statutory rate of withholding on interest paid to a nonresident of 
Country Y is 20%. On December 1, Year 1, when the spot rate was $1x:1u, 
FC withheld and remitted to Country Y 100u of tax and paid 400u to USC. 
Effective for Year 1, USC elected under Sec.  1.986(a)-1(a)(2)(iv) to 
translate its taxes denominated in nonfunctional currency into dollars 
at the spot rate on the date the taxes are paid. Under the United 
States--Country Y Income Tax Treaty (Treaty), USC was entitled to a 
reduced 15% rate of withholding that would result in a withholding tax 
of 75u. However, USC improperly claimed a foreign tax credit under 
section 901 for 100u = $100x on its Year 1 Federal income tax return. 
(See Sec.  1.901-2(e)(2)(i) and (e)(5), providing that an amount is not 
tax paid to the extent it exceeds the taxpayer's liability for tax or is 
reasonably certain to be refunded.) In Year 4, USC filed a refund claim 
with Country Y for 25u, the difference between the amount actually 
withheld at the 20% statutory rate of tax and the amount owed by USC at 
the 15% Treaty rate. On March 15, Year 6, when the spot rate was 
$1.10x:1u, USC received a refund from Country Y of 25u. USC converted 
the 25u into dollars on the same day.
    (2) Analysis. Notwithstanding that the 25u of refundable tax did not 
constitute an amount of tax paid within the meaning of Sec.  1.901-2(e) 
at the time USC improperly claimed it as a credit, the 25u refund in 
Year 6 is a foreign tax redetermination under paragraph (a) of this 
section. Under paragraph (b)(1)(i) of this section, USC must redetermine 
its U.S. tax liability for Year 1, the taxable year to which the 
redetermined tax relates. Under Sec.  1.986(a)-1(c), the refund is 
translated at the exchange rate that was used to translate such amount 
when originally claimed as a credit. Accordingly, if not previously 
adjusted by USC or the Internal Revenue Service, USC must file an 
amended return for Year 1, reducing the amount of foreign tax credit 
claimed for Year 1 by $25x (25u translated at the spot rate on December 
1, Year 1; that is, $1x:1u). Under Sec.  1.986(a)-1(e)(1), USC's basis 
in the 25u is the same dollar value of the refund as determined under 
Sec.  1.986(a)-1(c), or $25x. When USC converted the 25u to $27.50x 
(translated at the spot rate on March 15, Year 6, that is, $1.10x:1u), 
it realized an exchange gain (within the meaning of Sec.  1.988-1(e)) 
equal to $2.50x ($27.50x-$25x basis).

[[Page 1018]]

    (C) Example 3: Change in functional currency--(1) Facts. In Year 1, 
USC earned 500u of foreign source foreign branch category income through 
its foreign branch in Country X and accrued 100u of Country X foreign 
income tax on its earnings. The average exchange rate for Year 1 used to 
translate the foreign income taxes into dollars was $1x:1u. See Sec.  
1.986(a)-1(a)(1). On its Federal income tax return for Year 1, USC 
claimed a foreign tax credit under section 901 of $100x (100u translated 
at the average exchange rate for Year 1, that is, $1x:1u). As of Year 2, 
the foreign branch changed its functional currency from the ``u'' to the 
dollar, and pursuant to Sec.  1.985-5(d)(2), USC's foreign branch 
terminated and USC recognized section 987 gain or loss on December 31, 
Year 1 (the date of change). The rate of exchange, as determined under 
Sec.  1.985-5(c), used to calculate the U.S. dollar basis in the foreign 
branch's property on the date of the change was $1.10x:1u, the spot rate 
on December 31, Year 1. On June 15, Year 3, when the spot rate was 
$1.30x:1u, USC's foreign branch received a refund from Country X of 10u. 
The foreign branch converted the 10u into $13x on the same day.
    (2) Analysis. The 10u refund in Year 3 is a foreign tax 
redetermination under paragraph (a) of this section. Under paragraph 
(b)(1)(i) of this section, USC must redetermine its U.S. tax liability 
for Year 1, the taxable year to which the redetermined tax relates. 
Under Sec.  1.986(a)-1(c), the refund is translated at the exchange rate 
that was used to translate such amount when originally claimed as a 
credit. Accordingly, USC must file an amended return, reducing the 
amount of foreign tax credit claimed for Year 1 by $10x (10u translated 
at the average exchange rate for Year 1, that is $1x:1u). USC must also 
make corresponding adjustments in determining its taxable income and net 
unrecognized section 987 gain or loss in Year 1. See Sec. Sec.  1.987-
3(c)(2)(v) and 1.987-4(d)(8). Because the foreign branch changed its 
functional currency to the dollar in Year 2, the 10u it receives is a 
refund of nonfunctional currency tax that is denominated in a currency 
that was the functional currency of the foreign branch at the time USC 
originally claimed a credit for that foreign income tax. Under 
Sec. Sec.  1.985-5(d)(2) and 1.987-4(d), in Year 1 USC must recognize an 
additional $1x of section 987 gain (or $1x less of section 987 loss) by 
reason of the 10u being treated as an asset of the foreign branch at the 
time of the foreign branch's termination. Under Sec.  1.986(a)-1(e)(2), 
USC's basis in the 10u refund is $11x, which is determined by using the 
exchange rate used under Sec.  1.985-5(c) when the foreign branch 
changed its functional currency in Year 2 ($1.10x:1u). When the foreign 
branch converted the 10u to $13x (translated at the spot rate on June 
15, Year 3, which is $1.30x:1u), it realized an exchange gain (within 
the meaning of Sec.  1.988-1(e)) equal to $2x ($13x-$11x (10u translated 
at $1.10x:1u)).
    (D) Example 4: Inflationary currency--(1) Facts. In Year 1, USC 
earned 500u of foreign source foreign branch category income through its 
foreign branch in Country X and accrued 100u of Country X foreign income 
tax on its earnings. The average exchange rate for Year 1 used to 
translate the foreign income taxes into dollars was $1x:1u. See Sec.  
1.986(a)-1(a)(1). On its Federal income tax return for Year 1, USC 
claimed a foreign tax credit under section 901 of $100x (100u translated 
at the average exchange rate for Year 1, that is, $1x:1u). USC paid the 
100u of tax on April 15, Year 3, when the spot rate was $1x:2u. In Year 
3, but not in Year 1, the u was an inflationary currency within the 
meaning of Sec.  1.986(a)-1(a)(2)(iii).
    (2) Analysis. Under Sec.  1.986(a)-1(a)(2)(iii), because the u was 
an inflationary currency in the year the taxes were paid, USC must 
translate the 100u of Year 1 tax into dollars using the spot rate on the 
date of payment of the foreign taxes. Under paragraph (a) of this 
section, because the translated value of USC's Year 1 taxes when paid, 
that is, $50x (100u translated at the spot rate on April 15, Year 3, 
that is, $1x:2u), differs from the amount claimed as credits, that is, 
$100x (100u translated at the average exchange rate for Year 1, that is, 
$1x:1u), a foreign tax redetermination has occurred. Under paragraph 
(b)(1)(i) of this section, because the $50x foreign tax redetermination 
resulting from the currency fluctuation exceeds 2% of the

[[Page 1019]]

$100x initially accrued, USC must redetermine its U.S. tax liability for 
Year 1, the taxable year to which the redetermined tax relates. 
Accordingly, USC must notify the IRS, reducing the amount of foreign tax 
credit claimed for Year 1 by $50x (the excess of the translated value of 
the Year 1 taxes when accrued, that is, $100x, over the translated value 
of the Year 1 taxes when paid, that is, $50x).
    (E) Example 5: Two-year rule--(1) Facts. In Year 1, USC earned 500u 
of foreign source foreign branch category income through its foreign 
branch in Country X and accrued 100u of Country X foreign income tax on 
its earnings. The average exchange rate used to translate the foreign 
income taxes into dollars for Year 1 was $1x:1u. See Sec.  1.986(a)-
1(a)(1). On its Federal income tax return for Year 1, USC claimed a 
foreign tax credit under section 901 of $100x (100u translated at the 
average exchange rate for Year 1, that is, $1x:1u). USC did not pay the 
Year 1 foreign income taxes until March 15, Year 6, when the spot rate 
was $0.8x:1u.
    (2) Analysis--(i) Result in Year 3. USC's failure to pay the tax by 
the end of Year 3 results in a foreign tax redetermination under 
paragraph (a) of this section. Because the taxes were not paid on or 
before the date 24 months after the close of the taxable year to which 
the tax relates, USC must account for the redetermination as if the 
unpaid 100u of accrued taxes were refunded on the last day of Year 3. 
Under paragraph (b)(1)(i) of this section, USC must redetermine its U.S. 
tax liability for Year 1, the taxable year to which the redetermined tax 
relates. Under Sec.  1.986(a)-1(c), the deemed refund is translated at 
the exchange rate that was used to translate such amount when originally 
claimed as a credit. Accordingly, USC must notify the IRS, reducing the 
amount of foreign tax credit claimed for Year 1 by $100x (100u 
translated at the average exchange rate for Year 1, that is, $1x:1u). 
USC must also make corresponding adjustments in determining its taxable 
income and net unrecognized section 987 gain or loss in Year 1. See 
Sec. Sec.  1.987-3(c)(2)(v) and 1.987-4(d)(8).
    (ii) Result in Year 6. USC's payment of the Year 1 tax liability of 
100u on March 15, Year 6, results in a second foreign tax 
redetermination under paragraph (a) of this section. Under paragraph 
(b)(1)(i) of this section, the additional tax is taken into account in 
Year 1, the year to which the redetermined tax relates, irrespective of 
when the tax is paid. Under Sec.  1.986(a)-1(a)(2)(i), because the tax 
was paid more than 24 months after the close of the year to which the 
tax relates, USC must translate the 100u of tax at the spot rate on the 
date of payment of the foreign taxes in Year 6. If USC timely notifies 
the IRS, it may claim an increased foreign tax credit for Year 1. USC 
must also make corresponding adjustments in determining its taxable 
income and net unrecognized section 987 gain or loss in Year 1. See 
Sec. Sec.  1.987-3(c)(2)(v) and 1.987-4(d)(7).
    (F) Example 6: Cash basis taxpayer that pays additional foreign 
tax--(1) Facts. Individual A, a U.S. citizen resident in Country X, is a 
cash basis taxpayer who has not made an election under section 905(a) to 
claim the foreign tax credit in the year the taxes accrue. A uses the 
calendar year as the taxable year for both U.S. and Country X tax 
purposes. In Year 2, A pays 100u of foreign income taxes to Country X 
with respect to Year 1. The exchange rate used to translate the foreign 
income taxes into dollars was $1x:1u, the spot rate on the date A paid 
the taxes in Year 2. See section 986(a)(2)(A) and Sec.  1.986(a)-1(b). 
On A's Year 2 Federal income tax return, A claims a foreign tax credit 
under section 901 of $100x. In Year 4, Country X assesses an additional 
20u of tax with respect to A's Year 1 income. A does not pay the 
additional 20u of tax and contests the assessment. After exhausting all 
effective and practical remedies to reduce, over time, A's liability for 
foreign tax, A settles the contest with Country X in Year 6, paying 10u 
of additional tax on September 1, Year 6, when the spot rate is 
$1.10x:1u.
    (2) Analysis. Because A is a cash basis taxpayer that claims the 
foreign tax credit in the year the taxes are paid, A's payment in Year 6 
of 10u of additional tax owed with respect to Year 1 is not a foreign 
tax redetermination requiring a redetermination of U.S. tax liability 
under paragraph (b)(1) of this

[[Page 1020]]

section. Rather, A is eligible to claim the additional tax as a credit 
in Year 6, the year in which the tax is paid. Under Sec.  1.986(a)-1(b), 
the 10u of tax is translated into dollars at the spot rate on the date 
of payment in Year 6 (10u at $1.10x:1u = $11x).
    (G) Example 7: Cash basis taxpayer that receives a refund of foreign 
tax--(1) Facts. The facts are the same as paragraph (b)(1)(ii)(F) of 
this section (the facts in Example 6) except that instead of being 
assessed additional tax in Year 4, A receives a refund in Year 4 of 10u 
with respect to A's Year 1 tax that was claimed as a credit in Year 2.
    (2) Analysis. Under paragraphs (a) and (b)(1) of this section, A 
must redetermine its U.S. tax liability for Year 2 and any year to which 
unused foreign taxes were carried from Year 2. Under Sec.  1.986(a)-
1(c), the amount of A's foreign tax credit for Year 2 is reduced by 
$10x, the 10u refund translated at the exchange rate used to translate 
the tax when claimed as a credit. Under Sec.  1.986(a)-1(e)(1), A's 
basis in the 10u is $10x.
    (2) Foreign income taxes paid or accrued by foreign corporations--
(i) In general. A redetermination of U.S. tax liability is required to 
account for the effect of a redetermination of foreign income taxes 
taken into account by a foreign corporation in the year accrued, or a 
refund of foreign income taxes taken into account by the foreign 
corporation in the year paid.
    (ii) Required adjustments. If a redetermination of U.S. tax 
liability is required for any taxable year under paragraph (b)(2)(i) of 
this section, the foreign corporation's taxable income, earnings and 
profits, and current year taxes (as defined in Sec.  1.960-1(b)(4)) must 
be adjusted in the year to which the redetermined tax relates (or, in 
the case of a foreign corporation that receives a refund of foreign 
income tax and uses the cash basis of accounting, in the year the tax 
was paid). The redetermination of U.S. tax liability is made by treating 
the redetermined amount of foreign tax as the amount of tax paid or 
accrued by the foreign corporation in such year. For example, in the 
case of a refund of foreign income taxes taken into account in the year 
accrued, the foreign corporation's subpart F income, tested income, and 
current earnings and profits are increased, as appropriate, in the year 
to which the foreign tax relates to reflect the functional currency 
amount of the foreign income tax refund. The required redetermination of 
U.S. tax liability must account for the effect of the foreign tax 
redetermination on the characterization and amount of distributions or 
inclusions under section 951, 951A, or 1293 taken into account by each 
of the foreign corporation's United States shareholders, on the 
application of the high-tax exception described in section 954(b)(4) 
(including for purposes of determining the exclusions from gross tested 
income under section 951A(c)(2)(A)(i)(III) and Sec.  1.951A-
2(c)(1)(iii)), and the amount of tax determined under sections 
1291(c)(2) and 1291(g)(1)(C)(ii), as well as on the amount of foreign 
taxes deemed paid under section 960 in such year, regardless of whether 
any such shareholder chooses to deduct or credit its foreign income 
taxes in any taxable year. In addition, a redetermination of U.S. tax 
liability is required for any subsequent taxable year in which the 
characterization or amount of a United States shareholder's distribution 
or inclusion from the foreign corporation is affected by the foreign tax 
redetermination, up to and including the taxable year in which the 
foreign tax redetermination occurs, as well as any year to which unused 
foreign taxes from such year were carried under section 904(c).
    (iii) Reduction of corporate level tax on distribution of earnings 
and profits. If a United States shareholder of a controlled foreign 
corporation receives a distribution out of previously taxed earnings and 
profits described in section 959(c)(1) and (2) and a foreign country has 
imposed tax on the income of the controlled foreign corporation, which 
tax is reduced on distribution of the earnings and profits of the 
corporation (resulting in a foreign tax redetermination), then the 
United States shareholder must redetermine its U.S. tax liability for 
the year or years affected. See also Sec.  1.904-4(c)(7)(i).
    (iv) Foreign tax redeterminations relating to taxable years 
beginning before January 1, 2018. In the case of a foreign tax

[[Page 1021]]

redetermination of a foreign corporation that relates to a taxable year 
of the foreign corporation beginning before January 1, 2018, a 
redetermination of U.S. tax liability is required under the rules of 
Sec.  1.905-5.
    (v) Examples. The following examples illustrate the application of 
this paragraph (b)(2).
    (A) Presumed Facts. Except as otherwise provided in this paragraph 
(b)(2)(v), the following facts are assumed for purposes of the examples 
in paragraphs (b)(2)(v)(B) through (E) of this section:
    (1) All parties are accrual basis taxpayers that use the calendar 
year as their taxable year both for Federal income tax purposes and for 
foreign tax purposes and use the average exchange rate to translate 
accrued foreign income taxes;
    (2) CFC, CFC1, and CFC2 are controlled foreign corporations 
organized in Country X that use the ``u'' as their functional currency;
    (3) No income adjustment is required to reflect exchange gain or 
loss (within the meaning of Sec.  1.988-1(e)) with respect to the 
disposition of nonfunctional currency attributable to a refund of 
foreign income taxes received by any CFC, because all foreign income 
taxes are denominated and paid in the CFC's functional currency;
    (4) The highest rate of U.S. tax in section 11 and the rate 
applicable to USP in all years is 21 percent;
    (5) No election to exclude high-taxed income under section 954(b)(4) 
or Sec.  1.951A-2(c)(7) is made with respect to CFC, CFC1, or CFC2; and
    (6) USP's foreign tax credit limitation under section 904(a) exceeds 
the amount of foreign income taxes it is deemed to pay.
    (B) Example 1: Refund of tested foreign income taxes--(1) Facts. CFC 
is a wholly-owned subsidiary of USP, a domestic corporation. In Year 1, 
CFC earns 3,660u of general category gross tested income and accrues and 
pays 300u of foreign income taxes with respect to that income. CFC has 
no allowable deductions other than the foreign income tax expense. 
Accordingly, CFC has tested income of 3,360u in Year 1. CFC has no 
qualified business asset investment (within the meaning of section 
951A(d) and Sec.  1.951A-3(b)). In Year 1, no portion of USP's deduction 
under section 250 (``section 250 deduction'') is reduced by reason of 
section 250(a)(2)(B)(ii). USP's inclusion percentage (as defined in 
Sec.  1.960-2(c)(2)) is 100%. In Year 1, USP earns no other income and 
has no other expenses. The average exchange rate used to translate USP's 
inclusion under section 951A and CFC's foreign income taxes into dollars 
for Year 1 is $1x:1u. See section 989(b)(3) and Sec. Sec.  1.951A-
1(d)(1) and 1.986(a)-1(a)(1). Accordingly, for Year 1, USP's tested 
foreign income taxes (as defined in Sec.  1.960-2(c)(3)) with respect to 
CFC are $300x. In Year 3, CFC carries back a loss for foreign tax 
purposes and receives a refund of foreign tax of 100u that relates to 
Year 1.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has tested income 
of 3,360u and tested foreign income taxes of $300x. Under section 
951A(a) and Sec.  1.951A-1(c)(1), USP has a GILTI inclusion amount of 
$3,360x (3,360u translated at $1x:1u). Under section 960(d) and Sec.  
1.960-2(c), USP is deemed to have paid $240x (80% x 100% x $300x) of 
foreign income taxes. Under section 78 and Sec.  1.78-1(a), USP is 
treated as receiving a dividend of $300x (a ``section 78 dividend''). 
USP's section 250 deduction is $1,830x (50% x ($3,360x + $300x)). 
Accordingly, for Year 1, USP has taxable income of $1,830x ($3,360x + 
$300x-$1,830x) and pre-credit U.S. tax liability of $384.30x (21% x 
$1,830x). Accordingly, USP pays U.S. tax of $144.30x ($384.30x-$240x).
    (ii) Result in Year 3. The refund of 100u to CFC in Year 3 is a 
foreign tax redetermination under paragraph (a) of this section. Under 
paragraph (b)(2)(ii) of this section, USP must account for the effect of 
the foreign tax redetermination on its GILTI inclusion amount and 
foreign taxes deemed paid in Year 1. In redetermining USP's U.S. tax 
liability for Year 1, USP must increase CFC's tested income and its 
earnings and profits in Year 1 by the refunded tax amount of 100u, must 
determine the effect of that increase on its GILTI inclusion amount, and 
must adjust the amount of foreign taxes deemed paid and the section 78 
dividend to account for CFC's refund of foreign tax. Under Sec.  
1.986(a)-1(c), the refund is translated

[[Page 1022]]

into dollars at the exchange rate that was used to translate such amount 
when initially accrued. As a result of the foreign tax redetermination, 
for Year 1, CFC has tested income of 3,460u (3,360u + 100u) and tested 
foreign income taxes of $200x ($300x-$100x). Under section 951A(a) and 
Sec.  1.951A-1(c)(1), USP has a redetermined GILTI inclusion amount of 
$3,460x (3,460u translated at $1x:1u). Under section 960(d) and Sec.  
1.960-2(c), USP is deemed to have paid $160x (80% x 100% x $200x) of 
foreign income taxes. Under section 78 and Sec.  1.78-1(a), USP's 
section 78 dividend is $200x. USP's redetermined section 250 deduction 
is $1,830x (50% x ($3,460x + $200x)). Accordingly, USP's redetermined 
taxable income is $1,830x ($3,460x + $200x-$1,830x) and its pre-credit 
U.S. tax liability is $384.30x (21% x $1,830x). Therefore, USP's 
redetermined U.S. tax liability is $224.3x ($384.30x-$160x), an increase 
of $80x ($224.30x-$144.30x).
    (C) Example 2: Additional payment of foreign income taxes--(1) 
Facts. CFC is a wholly-owned subsidiary of USP, a domestic corporation. 
In Year 1, CFC earns 1,000u of general category gross foreign base 
company sales income and accrues and pays 100u of foreign income taxes 
with respect to that income. CFC has no allowable deductions other than 
the foreign income tax expense. The average exchange rate used to 
translate USP's subpart F inclusion and CFC's foreign income taxes into 
dollars for Year 1 is $1x:1u. See section 989(b)(3) and Sec.  1.986(a)-
1(a)(1). In Year 1, USP earns no other income and has no other expenses. 
In Year 5, pursuant to a Country X audit CFC accrues and pays additional 
foreign income tax of 80u with respect to its 1,000u of general category 
foreign base company sales income earned in Year 1. The spot rate (as 
defined in Sec.  1.988-1(d)) on the date of payment of the tax in Year 5 
is $1x:0.8u. The foreign income taxes accrued and paid in Year 1 and 
Year 5 are properly attributable to CFC's foreign base company sales 
income that is included in income by USP under section 951(a)(1)(A) 
(``subpart F inclusion'') in Year 1 with respect to CFC.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has subpart F 
income of 900u (1,000u-100u). Accordingly, USP has a $900x (900u 
translated at $1x:1u) subpart F inclusion. Under section 960(a) and 
Sec.  1.960-2(b), USP is deemed to have paid $100x (100u translated at 
$1x:1u) of foreign income taxes. Under section 78 and Sec.  1.78-1(a), 
USP's section 78 dividend is $100x. Accordingly, for Year 1, USP has 
taxable income of $1,000x ($900x + $100x) and pre-credit U.S. tax 
liability of $210x (21% x $1,000x). Accordingly, USP's U.S. tax 
liability is $110x ($210x-$100x).
    (ii) Result in Year 5. CFC's payment of 80u of additional foreign 
income tax in Year 5 with respect to Year 1 is a foreign tax 
redetermination as defined in paragraph (a) of this section. Under 
paragraph (b)(2)(ii) of this section, USP must reduce CFC's subpart F 
income and its earnings and profits in Year 1 by the additional tax 
amount of 80u. Further, USP must reduce its subpart F inclusion, adjust 
the amount of foreign taxes deemed paid, and adjust the amount of the 
section 78 dividend to account for CFC's additional payment of foreign 
tax. Under section 986(a)(1)(B)(i) and Sec.  1.986(a)-1(a)(2)(i), 
because CFC's payment of additional tax occurs more than 24 months after 
the close of the taxable year to which it relates, the additional tax is 
translated into dollars at the spot rate on the date of payment 
($1x:0.8u). Therefore, CFC has foreign income taxes of $200x (100u 
translated at $1x:1u plus 80u translated at $1x:0.8u) that are properly 
attributable to CFC's foreign base company sales income that gives rise 
to USP's subpart F inclusion in Year 1. As a result of the foreign tax 
redetermination, for Year 1, USP has a subpart F inclusion of $820x 
(1,000u-180u = 820u translated at $1x:1u). Under section 960(a) and 
Sec.  1.960-2(b), USP is deemed to have paid $200x of foreign income 
taxes. Under section 78 and Sec.  1.78-1(a), USP's section 78 dividend 
is $200x. USP's redetermined U.S. taxable income is $1,020x ($820x + 
$200x) and its pre-credit U.S. tax liability is $214.20x (21% x 
$1,020x). Therefore, USP's redetermined U.S. tax liability is $14.20x 
($214.20x-$200x), a decrease of $95.80x ($110x-$14.20x). If USP makes a 
timely refund claim within the period allowed by section 6511, USP will 
be entitled to a refund of any overpayment resulting

[[Page 1023]]

from the redetermination of its U.S. tax liability.
    (D) Example 3: Two-year rule--(1) Facts. CFC is a wholly-owned 
subsidiary of USP, a domestic corporation. In Year 1, CFC earns 1,000u 
of general category gross foreign base company sales income and accrues 
210u of foreign income taxes with respect to that income. In Year 1, USP 
earns no other income and has no other expenses. The average exchange 
rate used to translate USP's subpart F inclusion and CFC's foreign 
income taxes into dollars for Year 1 is $1x:1u. See sections 989(b)(3) 
and 986(a)(1)(A) and Sec.  1.986(a)-1(a)(1). CFC does not pay its 
foreign income taxes for Year 1 until September 1, Year 5, when the spot 
rate is $0.8x:1u. The foreign income taxes accrued and paid in Year 1 
and Year 5, respectively, are properly attributable to CFC's foreign 
base company sales income that gives rise to USP's subpart F inclusion 
in Year 1 with respect to CFC.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has subpart F 
income of 790u (1,000u-210u). Accordingly, USP has a $790x (790u 
translated at $1x:1u) subpart F inclusion. Under section 960(a) and 
Sec.  1.960-2(b), USP is deemed to have paid $210x (210u translated at 
$1x:1u) of foreign income taxes. Under section 78 and Sec.  1.78-1(a), 
USP's section 78 dividend is $210x. Accordingly, for Year 1, USP has 
taxable income of $1,000x ($790x + $210x) and pre-credit U.S. tax 
liability of $210x (21% x $1,000x). Accordingly, USP owes no U.S. tax 
($210x-$210x = 0).
    (ii) Result in Year 3. CFC's failure to pay the tax by the end of 
Year 3 results in a foreign tax redetermination under paragraph (a) of 
this section. Because the taxes are not paid on or before the date 24 
months after the close of the taxable year to which the tax relates, 
under paragraph (a) of this section CFC must account for the 
redetermination as if the unpaid 210u of taxes were refunded on the last 
day of Year 3. Under paragraph (b)(2)(ii) of this section, USP must 
increase CFC's subpart F income and its earnings and profits in Year 1 
by the unpaid tax amount of 210u. Further, USP must increase its subpart 
F inclusion, and decrease the amount of foreign taxes deemed paid and 
the amount of the section 78 dividend to account for the unpaid taxes. 
As a result of the foreign tax redetermination, for Year 1, USP has a 
subpart F inclusion of $1,000x (1,000u translated at $1x:1u). Under 
section 960(a) and Sec.  1.960-2(b), USP is deemed to have paid no 
foreign income taxes. Under section 78 and Sec.  1.78-1(a), USP has no 
section 78 dividend. Accordingly, USP's redetermined taxable income is 
$1,000x and its pre-credit U.S. tax liability is unchanged at $210x (21% 
x $1,000x). However, USP has no foreign tax credits. Therefore, USP's 
redetermined U.S. tax liability for Year 1 is $210x, an increase of 
$210x.
    (iii) Result in Year 5. CFC's payment of the Year 1 tax liability of 
210u on September 1, Year 5, results in a second foreign tax 
redetermination under paragraph (a) of this section. Under paragraph 
(b)(2)(ii) of this section, USP must decrease CFC's subpart F income and 
its earnings and profits in Year 1 by the tax paid amount of 210u. 
Further, USP must reduce its subpart F inclusion, and adjust the amount 
of foreign taxes deemed paid and the amount of the section 78 dividend 
to account for CFC's payment of foreign tax. Under section 
986(a)(1)(B)(i) and Sec.  1.986(a)-1(a)(2)(i), because the tax was paid 
more than 24 months after the close of the year to which the tax 
relates, CFC must translate the 210u of tax at the spot rate on the date 
of payment of the foreign taxes in Year 5. Therefore, CFC has foreign 
income taxes of $168x (210u translated at $0.8x:1u) that are properly 
attributable to CFC's foreign base company sales income that gives rise 
to USP's subpart F inclusion in Year 1. As a result of the foreign tax 
redetermination, for Year 1, USP has a subpart F inclusion of $790x 
(1,000u-210u = 790u translated at $1x:1u). Under section 960(a) and 
Sec.  1.960-2(b), USP is deemed to have paid $168x of foreign income 
taxes. Under section 78 and Sec.  1.78-1(a), USP's section 78 dividend 
is $168x. Accordingly, USP's redetermined taxable income is $958x ($790x 
+ $168x), its pre-credit U.S. tax liability is $201.18x (21% x $958x), 
and its redetermined U.S. tax liability is $33.18 ($201.18x-$168x), a 
decrease of $176.82x ($210x-$33.18x). If USP makes a timely refund claim 
within the period allowed by section 6511, USP will be entitled to

[[Page 1024]]

a refund of any overpayment resulting from the redetermination of its 
U.S. tax liability.
    (E) Example 4: Contested tax--(1) Facts. CFC is a wholly-owned 
subsidiary of USP, a domestic corporation. In Year 1, CFC earns 360u of 
general category gross tested income and accrues and pays 160u of 
current year taxes with respect to that income. CFC has no allowable 
deductions other than the foreign income tax expense. Accordingly, CFC 
has tested income of 200u in Year 1. CFC has no qualified business asset 
investment (within the meaning of section 951A(d) and Sec.  1.951A-
3(b)). In Year 1, no portion of USP's section 250 deduction is reduced 
by reason of section 250(a)(2)(B)(ii). USP's inclusion percentage (as 
defined in Sec.  1.960-2(c)(2)) is 100%. In Year 1, USP earns no other 
income and has no other expenses. The average exchange rate used to 
translate USP's section 951A inclusion and CFC's foreign income taxes 
into dollars for Year 1 is $1x:1u. See section 989(b)(3) and Sec. Sec.  
1.951A-1(d)(1) and 1.986(a)-1(a)(1). Accordingly, for Year 1, CFC's 
tested foreign income taxes (as defined in Sec.  1.960-2(c)(3)) with 
respect to USP are $160x. In Year 3, Country X assessed an additional 
30u of tax with respect to CFC's Year 1 income. CFC did not pay the 
additional 30u of tax and contested the assessment. After exhausting all 
effective and practical remedies to reduce, over time, its liability for 
foreign income tax, CFC settled the contest with Country X in Year 4 for 
20u, which CFC did not pay until January 15, Year 5, when the spot rate 
was $1.1x:1u. CFC did not earn any other income or accrue any other 
foreign income taxes in Years 2 through 6 and made no distributions to 
USP. The additional taxes paid in Year 5 are also tested foreign income 
taxes of CFC with respect to USP.
    (2) Analysis--(i) Result in Year 1. In Year 1, CFC has tested income 
of 200u and tested foreign income taxes of $160x. Under section 951A(a) 
and Sec.  1.951A-1(c)(1), USP has a GILTI inclusion amount of $200x 
(200u translated at $1x:1u). Under section 960(d) and Sec.  1.960-2(c), 
USP is deemed to have paid $128x (80% x 100% x $160x) of foreign income 
taxes. Under section 78 and Sec.  1.78-1(a), USP's section 78 dividend 
is $160x. USP's section 250 deduction is $180x (50% x ($200x + $160x)). 
Accordingly, for Year 1, USP has taxable income of $180x ($200x + $160x-
$180x) and a pre-credit U.S. tax liability of $37.80x (21% x $180x). 
Under section 904(a), because all of USP's income is section 951A 
category income (see Sec.  1.904-4(g)), USP's foreign tax credit 
limitation is $37.80x ($37.80x x $180x/$180x), which is less than the 
$128x of foreign income tax that USP is deemed to have paid. 
Accordingly, USP owes no U.S. tax ($37.80x-$37.80x = 0).
    (ii) Result in Year 5. CFC's accrual and payment of the additional 
20u of foreign income tax with respect to Year 1 is a foreign tax 
redetermination under paragraph (a) of this section. Under Sec.  1.461-
4(g)(6)(iii)(B), the additional taxes accrue when the tax contest is 
resolved, that is, in Year 4. However, because the taxes, which relate 
to Year 1, were not paid on or before the date 24 months after close of 
CFC's taxable year to which the tax relates, that is, Year 1, under 
section 905(c)(2) and paragraph (a) of this section CFC cannot take 
these taxes into account when they accrue in Year 4. Instead, the taxes 
are taken into account when they are paid in Year 5. Under paragraph 
(b)(2)(ii) of this section, USP must decrease CFC's tested income and 
its earnings and profits in Year 1 by the additional tax amount of 20u. 
Further, USP must adjust its GILTI inclusion amount, the amount of 
foreign taxes deemed paid, and the amount of the section 78 dividend to 
account for CFC's additional payment of tax. Under section 
986(a)(1)(B)(i) and Sec.  1.986(a)-1(a)(2)(i), because CFC's payment of 
additional tax occurs more than 24 months after the close of the taxable 
year to which it relates, the additional tax is translated into dollars 
at the spot rate on the date of payment ($1.1x:1u). Therefore, CFC has 
tested foreign income taxes of $182x (160u translated at $1x:1u plus 20u 
translated at $1.1x:1u). As a result of the foreign tax redetermination, 
for Year 1, CFC has tested income of 180u (200u-20u). Under section 
951A(a) and Sec.  1.951A-1(c)(1), USP has a redetermined GILTI inclusion 
amount of $180x (180u, translated at $1x:1u). Under section 960(d) and 
Sec.  1.960-2(c), USP is deemed to have

[[Page 1025]]

paid $145.60x (80% x 100% x $182x) of foreign income taxes. Under 
section 78 and Sec.  1.78-1(a), USP's section 78 dividend is $182x. 
USP's redetermined section 250 deduction is $181x (50% x ($180x + 
$182x)). Accordingly, USP's redetermined taxable income is $181x ($180x 
+ $182x-$181x), its pre-credit U.S. tax liability is $38.01x (21% x 
$181x), and its redetermined U.S. tax liability is zero ($38.01x-
$38.01x).
    (3) Foreign tax redeterminations of successors or transferees. If at 
the time of a foreign tax redetermination the person with legal 
liability for the tax (or in the case of a refund, the legal right to 
such refund) (the ``successor'') is a different person than the person 
that had legal liability for the tax in the year to which the 
redetermined tax relates (the ``original taxpayer''), the required 
redetermination of U.S. tax liability is made as if the foreign tax 
redetermination occurred in the hands of the original taxpayer. Federal 
income tax principles apply to determine the tax consequences if the 
successor remits (or receives a refund of) a tax that in the year to 
which the redetermined tax relates was the legal liability of, and thus 
under Sec.  1.901-2(f) is considered paid by, the original taxpayer.
    (4) Change in election to claim a foreign tax credit. A 
redetermination of U.S. tax liability is required to account for the 
effect of a timely change by the taxpayer to claim a foreign tax credit 
or a deduction for foreign income taxes paid or accrued in any taxable 
year as permitted under Sec.  1.901-1(d).
    (c) Foreign income tax imposed on foreign refund. If a 
redetermination of foreign income tax for a taxable year or years 
results from a refund to the section 901 taxpayer of foreign income 
taxes paid to a foreign country or possession of the United States and 
the foreign country or possession imposed foreign income tax on such 
refund, then, in accordance with section 905(c)(5), the amount of the 
refund is considered to be reduced by the amount of any foreign income 
tax described in section 901 imposed by the foreign country or 
possession of the United States with respect to such refund. In such 
case, no other credit under section 901, and no deduction under section 
164, is allowed for any taxable year with respect to such tax imposed on 
such refund.
    (d) Applicability dates. Except as provided in this paragraph (d), 
this section applies to foreign tax redeterminations occurring in 
taxable years ending on or after December 16, 2019, and to foreign tax 
redeterminations of foreign corporations occurring in taxable years that 
end with or within a taxable year of a United States shareholder ending 
on or after December 16, 2019 and that relate to taxable years of 
foreign corporations beginning after December 31, 2017. The first two 
sentences of paragraph (a) of this section, and paragraph (b)(4) of this 
section, apply to foreign tax redeterminations occurring in taxable 
years beginning on or after December 28, 2021.

[T.D. 9882, 84 FR 69104, Dec. 17, 2019, as amended by T.D. 9922, 85 FR 
72060, Nov. 12, 2020; T.D. 9959, 87 FR 373, Jan. 4, 2022]



Sec.  1.905-4  Notification of foreign tax redetermination.

    (a) Application of this section. The rules of this section apply if, 
as a result of a foreign tax redetermination (as defined in Sec.  1.905-
3(a)), a redetermination of U.S. tax liability is required under section 
905(c) and Sec.  1.905-3(b).
    (b) Time and manner of notification--(1) Redetermination of U.S. tax 
liability--(i) In general. Except as provided in paragraphs (b)(1)(v) 
and (b)(2) through (4) of this section, any taxpayer for which a 
redetermination of U.S. tax liability is required must notify the 
Internal Revenue Service (IRS) of the foreign tax redetermination by 
filing an amended return, Form 1118 (Foreign Tax Credit--Corporations) 
or Form 1116 (Foreign Tax Credit (Individual, Estate, or Trust)), and 
the statement described in paragraph (c) of this section for the taxable 
year with respect to which a redetermination of U.S. tax liability is 
required. Such notification must be filed within the time prescribed by 
this paragraph (b) and contain the information described in paragraph 
(c) of this section. If a foreign tax redetermination requires an 
individual to redetermine the individual's U.S. tax liability, and if, 
after taking

[[Page 1026]]

into account such foreign tax redetermination, the amount of creditable 
foreign taxes (as defined in section 904(j)(3)(B)) that are paid or 
accrued by such individual during the taxable year does not exceed the 
applicable dollar limitation in section 904(j), the individual is not 
required to file Form 1116 with the amended return for such taxable year 
if the individual satisfies the requirements of section 904(j).
    (ii) Increase in amount of U.S. tax liability. Except as provided in 
paragraphs (b)(1)(iv) and (v) and (b)(2) through (4) of this section, 
for each taxable year of the taxpayer with respect to which a 
redetermination of U.S. tax liability is required by reason of a foreign 
tax redetermination that increases the amount of U.S. tax liability, for 
example, by reason of a downward adjustment to the amount of foreign 
income taxes paid or accrued by the taxpayer or a foreign corporation 
with respect to which the taxpayer computes an amount of foreign taxes 
deemed paid, the taxpayer must file a separate notification by the due 
date (with extensions) of the original return for the taxpayer's taxable 
year in which the foreign tax redetermination occurs.
    (iii) Decrease in amount of U.S. tax liability. Except as provided 
in paragraphs (b)(1)(iv) and (v) and (b)(2) through (4) of this section, 
for each taxable year of the taxpayer with respect to which a 
redetermination of U.S. tax liability is required by reason of a foreign 
tax redetermination that decreases the amount of U.S. tax liability and 
results in an overpayment, for example, by reason of an increase in the 
amount of foreign income taxes paid or accrued by the taxpayer or a 
foreign corporation with respect to which the taxpayer computes an 
amount of foreign taxes deemed paid, the taxpayer must file a claim for 
refund with the IRS within the period provided in section 6511. See 
section 6511(d)(3)(A) for the special refund period for refunds 
attributable to an increase in foreign tax credits.
    (iv) Multiple redeterminations of U.S. tax liability for same 
taxable year. The rules of this paragraph (b)(1)(iv) apply except as 
provided in paragraphs (b)(1)(v) and (b)(2) through (4) of this section. 
If more than one foreign tax redetermination requires a redetermination 
of U.S. tax liability for the same affected taxable year of the taxpayer 
and those foreign tax redeterminations occur within the same taxable 
year or within two consecutive taxable years of the taxpayer, the 
taxpayer may file for the affected taxable year one amended return, Form 
1118 or Form 1116, and the statement described in paragraph (c) of this 
section that reflects all such foreign tax redeterminations. If the 
taxpayer chooses to file one notification for such redeterminations, one 
or more of such redeterminations would increase the U.S. tax liability, 
and the net effect of all such redeterminations is to increase the U.S. 
tax liability for the affected taxable year, the taxpayer must file such 
notification by the due date (with extensions) of the original return 
for the taxpayer's taxable year in which the first foreign tax 
redetermination that would result in an increased U.S. tax liability 
occurred. If the taxpayer chooses to file one notification for such 
redeterminations, one or more of such redeterminations would decrease 
the U.S. tax liability, and the net effect of all such redeterminations 
is to decrease the total amount of U.S. tax liability for the affected 
taxable year, the taxpayer must file such notification as provided in 
paragraph (b)(1)(iii) of this section, within the period provided by 
section 6511. If a foreign tax redetermination with respect to the 
taxable year for which a redetermination of U.S. tax liability is 
required occurs after the date for providing such notification, more 
than one amended return may be required with respect to that taxable 
year.
    (v) Amended return required only if there is a change in amount of 
U.S. tax due. If a redetermination of U.S. tax liability is required by 
reason of a foreign tax redetermination (or multiple foreign tax 
redeterminations, in the case of redeterminations described in paragraph 
(b)(1)(iv) of this section), but does not change the amount of U.S. tax 
due for any taxable year, the taxpayer may, in lieu of applying the 
applicable rules of paragraphs (b)(1)(i) through (iv) of this section, 
notify the IRS of such redetermination by attaching a

[[Page 1027]]

statement to the original return for the taxpayer's taxable year in 
which the foreign tax redetermination occurs. The statement must be 
filed by the due date (with extensions) of the original return for the 
taxpayer's taxable year in which the foreign tax redetermination occurs 
and contain the information described in Sec.  1.904-2(f). If a 
redetermination of U.S. tax liability is required by reason of a foreign 
tax redetermination (either alone, or if the taxpayer chooses to apply 
paragraph (b)(1)(iv) of this section, in combination with other foreign 
tax redeterminations, as provided therein) and the redetermination of 
U.S. tax liability results in a change to the amount of U.S. tax due for 
a taxable year, but does not change the amount of U.S. tax due for other 
taxable years, for example, because of a carryback or carryover of an 
unused foreign tax under section 904(c), the notification requirements 
for such other taxable years are deemed to be satisfied if the taxpayer 
complies with the applicable rules of paragraphs (b)(1)(i) through (iv) 
of this section with respect to each taxable year for which the foreign 
tax redetermination changes the amount of U.S. tax due.
    (2) Notification with respect to a change in the amount of foreign 
tax reported to an owner by a pass-through entity--(i) In general. If a 
partnership, trust, or other pass-through entity that reports to its 
beneficial owners (or to any intermediary on behalf of its beneficial 
owners), including partners, shareholders, beneficiaries, or similar 
persons, an amount of creditable foreign tax expenditures, such pass-
through entity must notify both the IRS and its owners of any foreign 
tax redetermination described in Sec.  1.905-3(a) with respect to the 
foreign tax so reported. For purposes of this paragraph (b)(2), whether 
or not a redetermination has occurred within the meaning of Sec.  1.905-
3(a) is determined as if the pass-through entity were a domestic 
corporation which had elected to and claimed foreign tax credits in the 
amount reported for the year to which such foreign taxes relate. The 
notification required under this paragraph (b)(2) must include the 
statement described in paragraph (c) of this section along with any 
information necessary for the owners to redetermine their U.S. tax 
liability.
    (ii) Partnerships subject to subchapter C of chapter 63 of the Code. 
Except as provided in paragraph (b)(4) of this section, if a 
redetermination of U.S. tax liability that is required under Sec.  
1.905-3(b) by reason of a foreign tax redetermination described in Sec.  
1.905-3(a) would require a partnership adjustment as defined in Sec.  
301.6241-1(a)(6) of this chapter, the partnership must file an 
administrative adjustment request under section 6227 and make any 
adjustments required under section 6227. See Sec. Sec.  301.6227-2 and 
301.6227-3 of this chapter for procedures for making adjustments with 
respect to an administrative adjustment request. An administrative 
adjustment request required under this paragraph (b)(2)(ii) must be 
filed by the due date (with extensions) of the original return for the 
partnership's taxable year in which the foreign tax redetermination 
occurs, and the restrictions in section 6227(c) do not apply to such 
filing. However, unless the administrative adjustment request may 
otherwise be filed after applying the limitations contained in section 
6227(c), such a request is limited to adjustments that are required to 
be made under section 905(c). The requirements of paragraph (b)(2)(i) of 
this section are deemed to be satisfied with respect to any item taken 
into account in an administrative adjustment request filed under this 
paragraph (b)(2)(ii).
    (3) Alternative notification requirements. An amended return and 
Form 1118 (Foreign Tax Credit--Corporations) or Form 1116 (Foreign Tax 
Credit (Individual, Estate, or Trust)), is not required to notify the 
IRS of the foreign tax redetermination and redetermination of U.S. tax 
liability if the taxpayer satisfies alternative notification 
requirements that may be prescribed by the IRS through forms, 
instructions, publications, or other guidance.
    (4) Taxpayers under examination within the jurisdiction of the Large 
Business and International Division--(i) In general. The alternative 
notification requirements of this paragraph (b)(4) apply if all of the 
conditions described in paragraphs (b)(4)(i)(A) through (E) of this 
section are satisfied.

[[Page 1028]]

    (A) A foreign tax redetermination occurs while the taxpayer is under 
examination within the jurisdiction of the Large Business and 
International Division.
    (B) The foreign tax redetermination results in an adjustment to the 
amount of foreign income taxes paid or accrued by the taxpayer or a 
foreign corporation with respect to which the taxpayer computes an 
amount of foreign income taxes deemed paid.
    (C) The foreign tax redetermination requires a redetermination of 
U.S. tax liability that increases the amount of U.S. tax liability, and 
accordingly, but for this paragraph (b)(4), the taxpayer would be 
required to notify the IRS of such foreign tax redetermination under 
paragraph (b)(1)(ii) of this section (determined without regard to 
paragraphs (b)(1)(iv) and (v) of this section) or paragraph (b)(2)(ii) 
of this section. See paragraph (b)(4)(v) of this section regarding 
foreign tax redeterminations that decrease the amount of U.S. tax 
liability.
    (D) The return for the taxable year for which a redetermination of 
U.S. tax liability is required is under examination.
    (E) The due date specified in paragraph (b)(1)(ii) or (b)(2)(ii) of 
this section for providing notice of such foreign tax redetermination is 
not before the later of the opening conference or the hand-delivery or 
postmark date of the opening letter concerning an examination of the 
return for the taxable year for which a redetermination of U.S. tax 
liability is required by reason of such foreign tax redetermination.
    (ii) Notification requirements--(A) Foreign tax redetermination 
occurring before commencement of the examination. If a foreign tax 
redetermination described in paragraphs (b)(4)(i)(B) and (C) of this 
section occurs before the later of the opening conference or the hand-
delivery or postmark date of the opening letter and if the condition 
provided in paragraph (b)(4)(i)(E) of this section with respect to such 
foreign tax redetermination is met, the taxpayer, in lieu of applying 
the rules of paragraphs (b)(1)(i) and (ii) of this section (requiring 
the filing of an amended return, Form 1116 or 1118, and the statement 
described in paragraph (c) of this section) or paragraph (b)(2)(ii) of 
this section (requiring the filing of an administrative adjustment 
request), must notify the IRS of such redetermination by providing the 
statement described in paragraph (b)(4)(iii) of this section to the 
examiner no later than 120 days after the later of the date of the 
opening conference of the examination, or the hand-delivery or postmark 
date of the opening letter concerning the examination.
    (B) Foreign tax redetermination occurring within 180 days after 
commencement of the examination. If a foreign tax redetermination 
described in paragraphs (b)(4)(i)(B) and (C) of this section occurs on 
or after the latest of the opening conference or the hand-delivery or 
postmark date of the opening letter and on or before the date that is 
180 days after the later of the opening conference or the hand-delivery 
or postmark date of the opening letter, the taxpayer, in lieu of 
applying the rules of paragraph (b)(1)(i) and (ii) of this section or 
paragraph (b)(2) of this section, must notify the IRS of such 
redetermination by providing the statement described in paragraph 
(b)(4)(iii) of this section to the examiner no later than 120 days after 
the date the foreign tax redetermination occurs.
    (C) Foreign tax redetermination occurring more than 180 days after 
commencement of the examination. If a foreign tax redetermination 
described in paragraphs (b)(4)(i)(B) and (C) of this section occurs 
after the date that is 180 days after the later of the opening 
conference or the hand-delivery or postmark date of the opening letter, 
the taxpayer must either apply the rules of paragraphs (b)(1)(i) and 
(ii) of this section or paragraph (b)(2) of this section, or, in lieu of 
applying paragraphs (b)(1)(i) and (ii) of this section or paragraph 
(b)(2) of this section, provide the statement described in paragraph 
(b)(4)(iii) of this section to the examiner within 120 days after the 
date the foreign tax redetermination occurs. However, the IRS, in its 
discretion, may either accept such statement or require the taxpayer to 
comply with the rules of paragraphs (b)(1)(i) and (ii) of this section 
or paragraph (b)(2) of this section, as applicable.

[[Page 1029]]

    (iii) Statement. The statement required by paragraphs (b)(4)(ii)(A) 
and (B) of this section must provide the original amount of foreign 
income taxes paid or accrued, the revised amount of foreign income taxes 
paid or accrued, and documentation with respect to the revisions, 
including exchange rates and dates of accrual or payment, and, if 
applicable, the information described in paragraph (c)(8) of this 
section. The statement must include the following declaration signed by 
a person authorized to sign the return of the taxpayer: ``Under 
penalties of perjury, I declare that I have examined this written 
statement, and to the best of my knowledge and belief, this written 
statement is true, correct, and complete.''
    (iv) Penalty for failure to file notice of a foreign tax 
redetermination. A taxpayer subject to the rules of this paragraph 
(b)(4) must satisfy the rules of paragraph (b)(4)(ii) of this section in 
order not to be subject to the penalty relating to the failure to file 
notice of a foreign tax redetermination under section 6689 and Sec.  
301.6689-1 of this chapter.
    (v) Notification of foreign tax redetermination that decreases U.S. 
tax liability in an affected year under audit. A taxpayer may (but is 
not required to) notify the IRS as provided in this paragraph (b)(4)(v) 
if the taxpayer has a foreign tax redetermination that meets the 
conditions in paragraphs (b)(4)(i)(A), (B), and (D) of this section and 
results in a decrease in the amount of U.S. tax liability that, but for 
this paragraph (b)(4), would require the taxpayer to notify the IRS of 
such foreign tax redetermination under paragraph (b)(1)(iii) or 
(b)(2)(ii) of this section (determined without regard to paragraphs 
(b)(1)(iv) and (v) of this section). The notification should be made in 
the time and manner specified in paragraph (b)(4)(ii) of this section. 
The IRS, in its discretion, may either accept such alternate 
notification or require the taxpayer to comply with the rules of 
paragraphs (b)(1)(i) and (iii) or paragraphs (b)(2) of this section, as 
applicable.
    (5) Examples. The following examples illustrate the application of 
paragraph (b) of this section.
    (i) Example 1. (A) X, a domestic corporation, is an accrual basis 
taxpayer and uses the calendar year as its U.S. taxable year. X conducts 
business through a branch in Country M, the currency of which is the m, 
and also conducts business through a branch in Country N, the currency 
of which is the n. X uses the average exchange rate to translate foreign 
income taxes. X is able to claim a credit under section 901 for all 
foreign income taxes paid or accrued.
    (B) In Year 1, X accrued and paid 100m of Country M income taxes 
with respect to 400m of foreign source foreign branch category income. 
The average exchange rate for Year 1 was $1:1m. Also in Year 1, X 
accrued and paid 50n of Country N income taxes with respect to 150n of 
foreign source foreign branch category income. The average exchange rate 
for Year 1 was $1:1n. On its Year 1 Federal income tax return, X claimed 
a foreign tax credit under section 901 of $150 ($100 (100m translated at 
$1:1m) + $50 (50n translated at $1:1n)) with respect to its foreign 
source foreign branch category income. See Sec.  1.986(a)-1(a)(1).
    (C) In Year 2, X accrued and paid 100n of Country N income taxes 
with respect to 300n of foreign source foreign branch category income. 
The average exchange rate for Year 2 was $1.50:1n. On its Year 2 Federal 
income tax return, X claimed a foreign tax credit under section 901 of 
$150 (100n translated at $1.5:1n). See Sec.  1.986(a)-1(a)(1).
    (D) On June 15, Year 5, when the spot rate was $1.40:1n, X received 
a refund of 10n from Country N, and, on March 15, Year 6, when the spot 
rate was $1.20:1m, X was assessed by and paid Country M an additional 
20m of tax. Both payments were with respect to X's foreign source 
foreign branch category income in Year 1. On May 15, Year 6, when the 
spot rate was $1.45:1n, X received a refund of 5n from Country N with 
respect to its foreign source foreign branch category income in Year 2.
    (E) Both of the refunds and the assessment are foreign tax 
redeterminations under Sec.  1.905-3(a). Under Sec.  1.905-3(b)(1), X 
must redetermine its U.S. tax liability for both Year 1 and Year 2. With 
respect to Year 1, under paragraph (b)(1)(ii) of this section X must

[[Page 1030]]

notify the IRS of the June 15, Year 5, refund of 10n from Country N that 
increased X's U.S. tax liability by filing an amended return, Form 1118, 
and the statement required by paragraph (c) of this section for Year 1 
by the due date of the original return (with extensions) for Year 5. The 
amended return and Form 1118 would reflect the reduced amount of foreign 
income taxes claimed as a credit under section 901 and the increase in 
X's U.S. tax liability of $10 (10n refund translated at the average 
exchange rate for Year 1, or $1:1n (see Sec.  1.986(a)-1(c)). With 
respect to the March 15, Year 6, additional assessment of 20m by Country 
M, under paragraph (b)(1)(iii) of this section X must notify the IRS 
within the time period provided by section 6511, increasing the foreign 
income taxes available as a credit and reducing X's U.S. tax liability 
by $24 (20m translated at the spot rate on the date of payment, or 
$1.20:1m). See sections 986(a)(1)(B)(i) and 986(a)(2)(A) and Sec.  
1.986(a)-1(a)(2)(i). X may so notify the IRS by filing a second amended 
return, Form 1118, and the statement described in paragraph (c) of this 
section for Year 1, within the time period provided by section 6511. 
Alternatively, under paragraph (b)(1)(iv) of this section, when X 
redetermines its U.S. tax liability for Year 1 to take into account the 
10n refund from Country N that occurred in Year 5, X may also take into 
account the 20m additional assessment by Country M that occurred on 
March 15, Year 6. If X reflects both foreign tax redeterminations on the 
same amended return, Form 1118, and in the statement described in 
paragraph (c) of this section for Year 1, the amount of X's foreign 
income taxes available as a credit would be reduced by $10 (10n refund 
translated at $1:1n), and increased by $24 (20m additional assessment 
translated at the spot rate on the date of payment, March 15, Year 6, or 
$1.20:1m). The foreign income taxes available as a credit therefore 
would be increased by $14 ($24 (additional assessment)-$10 (refund)). 
Because the net effect of the foreign tax redeterminations is to 
increase the amount of foreign taxes paid or accrued and decrease X's 
U.S. tax liability for Year 1, under paragraph (b)(1)(iv) of this 
section the Year 1 amended return, Form 1118, and the statement required 
in paragraph (c) of this section reflecting foreign tax redeterminations 
in both years must be filed within the period provided by section 6511.
    (F) With respect to Year 2, under paragraph (b)(1)(ii) of this 
section X must notify the IRS by filing an amended return, Form 1118, 
and the statement required by paragraph (c) of this section for Year 2, 
in addition to the amended return, Form 1118, and statement that are 
required by reason of the separate foreign tax redeterminations that 
affect Year 1. The amended return, Form 1118, and the statement required 
by paragraph (c) of this section for Year 2 must be filed by the due 
date (with extensions) of X's original return for Year 6. The amended 
return and Form 1118 must reflect the reduced amount of foreign income 
taxes claimed as a credit under section 901 and the increase in X's U.S. 
tax liability of $7.50 (5n refund translated at the average exchange 
rate for Year 2, or $1.50:1n).
    (ii) Example 2. X, a taxpayer within the jurisdiction of the Large 
Business and International Division, uses the calendar year as its U.S. 
taxable year. On November 15, Year 2, X receives a refund of foreign 
income taxes that constitutes a foreign tax redetermination and 
necessitates a redetermination of U.S. tax liability for X's Year 1 
taxable year. Under paragraph (b)(1)(ii) of this section, X is required 
to notify the IRS of the foreign tax redetermination that increased its 
U.S. tax liability by filing an amended return, Form 1118, and the 
statement described in paragraph (c) of this section for its Year 1 
taxable year by October 15, Year 3 (the due date (with extensions) of 
the original return for X's Year 2 taxable year). On December 15, Year 
3, the IRS hand delivers an opening letter concerning the examination of 
the return for X's Year 1 taxable year, and the opening conference for 
such examination is scheduled for January 15, Year 4. Because the date 
for notifying the IRS of the foreign tax redetermination under paragraph 
(b)(1)(ii) of this section (October 15, Year 3) is before the date of 
the opening conference concerning the examination of the return

[[Page 1031]]

for X's Year 1 taxable year (January 15, Year 4), the condition of 
paragraph (b)(4)(i)(E) of this section is not met, and so paragraph 
(b)(4)(i) of this section does not apply. Accordingly, X must notify the 
IRS of the foreign tax redetermination by filing an amended return, Form 
1118, and the statement described in paragraph (c) of this section for 
the Year 1 taxable year by October 15, Year 3.
    (6) Transition rule for certain foreign tax redeterminations. In the 
case of foreign tax redeterminations occurring in taxable years ending 
on or after December 16, 2019, and before November 12, 2020, and foreign 
tax redeterminations of foreign corporations occurring in taxable years 
that end with or within a taxable year of a United States shareholder 
ending on or after December 16, 2019, and before November 12, 2020, any 
amended return or other notification that under paragraph (b)(1)(ii), 
(iv), or (v) or (b)(2)(ii) of this section must be filed by the due date 
(with extensions) of, or attached to, the original return for the 
taxpayer's taxable year in which the foreign tax redetermination occurs 
must instead be filed by the due date (with extensions) of, or attached 
to, the original return for the taxpayer's first taxable year ending on 
or after November 12, 2020. For purposes of paragraph (b)(4)(i)(E) of 
this section, the relevant due date is the due date specified in this 
paragraph (b)(6).
    (c) Notification contents. The statement required by paragraphs 
(b)(1)(i) through (iv) and (b)(2) of this section must contain 
information sufficient for the IRS to redetermine U.S. tax liability if 
such a redetermination is required under section 905(c). The information 
must be in a form that enables the IRS to verify and compare the 
original computation of U.S. tax liability, the revised computation 
resulting from the foreign tax redetermination, and the net changes 
resulting therefrom. The statement must include the following:
    (1) The taxpayer's name, address, identifying number, the taxable 
year or years of the taxpayer that are affected by the foreign tax 
redetermination, and, in the case of foreign taxes deemed paid, the name 
and identifying number, if any, of the foreign corporation;
    (2) The date or dates the foreign income taxes were accrued, if 
applicable; the date or dates the foreign income taxes were paid; the 
amount of foreign income taxes paid or accrued on each date (in foreign 
currency) and the exchange rate used to translate each such amount, as 
provided in Sec.  1.986(a)-1(a) or (b);
    (3) Information sufficient to determine any change to the 
characterization of a distribution, the amount of any inclusion under 
section 951(a), 951A, or 1293, or the deferred tax amount under section 
1291;
    (4) Information sufficient to determine any interest due from or 
owing to the taxpayer, including the amount of any interest paid by the 
foreign government to the taxpayer and the dates received;
    (5) In the case of any foreign income tax that is refunded in whole 
or in part, the taxpayer must provide the date of each such refund; the 
amount of such refund (in foreign currency); and the exchange rate that 
was used to translate such amount when originally claimed as a credit 
(as provided in Sec.  1.986(a)-1(c)) and the spot rate (as defined in 
Sec.  1.988-1(d)) for the date the refund was received (for purposes of 
computing foreign currency gain or loss under section 988);
    (6) In the case of any foreign income taxes that are not paid on or 
before the date that is 24 months after the close of the taxable year to 
which such taxes relate, the amount of such taxes in foreign currency, 
and the exchange rate that was used to translate such amount when 
originally claimed as a credit or added to PTEP group taxes (as defined 
in Sec.  1.960-3(d)(1));
    (7) If a redetermination of U.S. tax liability results in an amount 
of additional tax due, and the carryback or carryover of an unused 
foreign income tax under section 904(c) only partially eliminates such 
amount, the information required in Sec.  1.904-2(f); and
    (8) In the case of a pass-through entity, the name, address, and 
identifying number of each beneficial owner to which foreign taxes were 
reported for the taxable year or years to which the foreign tax 
redetermination relates,

[[Page 1032]]

and the amount of foreign tax initially reported to each beneficial 
owner for each such year and the amount of foreign tax allocable to each 
beneficial owner for each such year after the foreign tax 
redetermination is taken into account.
    (d) Payment or refund of U.S. tax. The amount of tax, if any, due 
upon a redetermination of U.S. tax liability is paid by the taxpayer 
after notice and demand has been made by the IRS. Subchapter B of 
chapter 63 of the Internal Revenue Code (relating to deficiency 
procedures) does not apply with respect to the assessment of the amount 
due upon such redetermination. In accordance with sections 905(c) and 
6501(c)(5), the amount of additional tax due is assessed and collected 
without regard to the provisions of section 6501(a) (relating to 
limitations on assessment and collection). The amount of tax, if any, 
shown by a redetermination of U.S. tax liability to have been overpaid 
is credited or refunded to the taxpayer in accordance with subchapter B 
of chapter 66 (sections 6511 through 6515).
    (e) Interest and penalties--(1) In general. If a redetermination of 
U.S. tax liability is required by reason of a foreign tax 
redetermination, interest is computed on the underpayment or overpayment 
in accordance with sections 6601 and 6611. No interest is assessed or 
collected on any underpayment resulting from a refund of foreign income 
taxes for any period before the receipt of the refund, except to the 
extent interest was paid by the foreign country or possession of the 
United States on the refund for the period before the receipt of the 
refund. See section 905(c)(5). In no case, however, will interest 
assessed and collected pursuant to the preceding sentence for any period 
before receipt of the refund exceed the amount that otherwise would have 
been assessed and collected under section 6601 for that period. Interest 
is assessed from the time the taxpayer (or the foreign corporation, 
partnership, trust, or other pass-through entity of which the taxpayer 
is a shareholder, partner, or beneficiary) receives a refund until the 
taxpayer pays the additional tax due the United States.
    (2) Imposition of penalty. Failure to comply with the provisions of 
this section subjects the taxpayer to the penalty provisions of section 
6689 and Sec.  301.6689-1 of this chapter.
    (f) Applicability date. This section applies to foreign tax 
redeterminations (as defined in Sec.  1.905-3(a)) occurring in taxable 
years ending on or after December 16, 2019, and to foreign tax 
redeterminations of foreign corporations occurring in taxable years that 
end with or within a taxable year of a United States shareholder ending 
on or after December 16, 2019.

[T.D. 9922, 85 FR 72063, Nov. 12, 2020]



Sec.  1.905-5  Foreign tax redeterminations of foreign corporations 
that relate to taxable years of the foreign corporation beginning 
before January 1, 2018.

    (a) In general--(1) Effect of foreign tax redetermination of a 
foreign corporation. Except as provided in paragraph (e) of this 
section, a foreign tax redetermination (as defined in Sec.  1.905-3(a)) 
of a foreign corporation that relates to a taxable year of the foreign 
corporation beginning before January 1, 2018, and that may affect a 
taxpayer's foreign tax credit in any taxable year, must be accounted for 
by adjusting the foreign corporation's taxable income and earnings and 
profits, post-1986 undistributed earnings as defined in Sec.  1.902-
1(a)(9), and post-1986 foreign income taxes as defined in Sec.  1.902-
1(a)(8) (or its 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), as applicable) in the taxable year of the foreign 
corporation to which the foreign taxes relate.
    (2) Required redetermination of U.S. tax liability. Except as 
provided in paragraph (e) of this section, a redetermination of U.S. tax 
liability is required to account for the effect of the foreign tax 
redetermination on the earnings and profits and taxable income of the 
foreign corporation, the taxable income of a United States shareholder, 
and the amount of foreign taxes deemed paid by the United States 
shareholder under section 902 or 960 (as in effect before December 22, 
2017), in the year to which the redetermined foreign taxes relate. For 
example, in the case of a refund of foreign income taxes, the subpart F 
income, earnings

[[Page 1033]]

and profits, and post-1986 undistributed earnings (or pre-1987 
accumulated profits, as applicable) of the foreign corporation are 
increased in the year to which the foreign tax relates to reflect the 
functional currency amount of the foreign income tax refund. The 
required redetermination of U.S. tax liability must account for the 
effect of the foreign tax redetermination on the characterization and 
amount of distributions or inclusions under section 951 or 1293 taken 
into account by each of the foreign corporation's United States 
shareholders and on the application of the high-tax exception described 
in section 954(b)(4), as well as on the amount of foreign income taxes 
deemed paid in such year. In addition, a redetermination of U.S. tax 
liability is required for any subsequent taxable year in which the 
United States shareholder received or accrued a distribution or 
inclusion from the foreign corporation, up to and including the taxable 
year in which the foreign tax redetermination occurs, as well as any 
year to which unused foreign taxes from such year were carried under 
section 904(c).
    (b) Notification requirements--(1) In general. The notification 
requirements of Sec.  1.905-4, as modified by paragraphs (b)(2) and (3) 
of this section, apply if a redetermination of U.S. tax liability is 
required under paragraph (a) or (e) of this section.
    (2) Notification relating to post-1986 undistributed earnings and 
post-1986 foreign income taxes. In the case of foreign tax 
redeterminations with respect to taxes included in post-1986 foreign 
income taxes, in addition to the information required by Sec.  1.905-
4(c), the taxpayer must provide the balances of the pools of post-1986 
undistributed earnings and post-1986 foreign income taxes before and 
after adjusting the pools, the dates and amounts of any dividend 
distributions or other inclusions made out of earnings and profits for 
the affected year or years, and the amount of earnings and profits from 
which such dividends were paid or such inclusions were made for the 
affected year or years.
    (3) Notification relating to pre-1987 accumulated profits and pre-
1987 foreign income taxes. In the case of foreign tax redeterminations 
with respect to pre-1987 accumulated profits, in addition to the 
information required by Sec.  1.905-4(c), the taxpayer must provide the 
following: The dates and amounts of any dividend distributions made out 
of earnings and profits for the affected year or years; the rate of 
exchange on the date of any such distribution; and the amount of 
earnings and profits from which such dividends were paid for the 
affected year or years.
    (c) Currency translation rules for adjustments to pre-1987 foreign 
income taxes. Foreign income taxes paid with respect to pre-1987 
accumulated profits that are deemed paid under section 960 (or under 
section 902 in the case of an amount treated as a dividend under section 
1248) are translated into dollars at the spot rate for the date of the 
payment of the foreign income taxes, and refunds of such taxes are 
translated into dollars at the spot rate for the date of the refund. 
Foreign income taxes deemed paid by a taxpayer under section 902 with 
respect to an actual distribution of pre-1987 accumulated profits and 
refunds of such taxes are translated into dollars at the spot rate for 
the date of the distribution of the earnings to which the foreign income 
taxes relate. See section 902(c)(6) (as in effect before December 22, 
2017) and Sec.  1.902-1(a)(10)(iii). For purposes of this section, the 
term spot rate has the meaning provided in Sec.  1.988-1(d).
    (d) Timing and effect of pooling adjustments. The redetermination of 
U.S. tax liability required by paragraphs (a) and (e) of this section is 
made in accordance with section 905(c) as in effect for those taxable 
years, without regard (except as provided in paragraph (e) of this 
section) to rules that required adjustments to a foreign corporation's 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes in the year of the foreign tax redetermination rather than in the 
year to which the redetermined foreign tax relates. No underpayment or 
overpayment of U.S. tax liability results from a foreign tax 
redetermination unless the required adjustments change the U.S. tax 
liability. Consequently, no interest is paid by or to a taxpayer as a 
result of adjustments, required by reason of a foreign tax 
redetermination, to a foreign corporation's pools of post-

[[Page 1034]]

1986 undistributed earnings and post-1986 foreign income taxes in the 
year to which the redetermined foreign tax relates (or a subsequent 
year) that did not result in a change to U.S. tax liability, for 
example, because no foreign taxes were deemed paid in that year.
    (e) Election to account for certain foreign tax redeterminations 
with respect to pre-2018 taxable years in the foreign corporation's last 
pooling year--(1) In general. A taxpayer may elect under the rules in 
paragraph (e)(2) of this section to account for foreign tax 
redeterminations of a foreign corporation that occur in the foreign 
corporation's taxable years ending with or within a taxable year of a 
United States shareholder of the foreign corporation ending on or after 
November 2, 2020, and that relate to taxable years of the foreign 
corporation beginning before January 1, 2018, by treating such foreign 
tax redeterminations as if they occurred in the foreign corporation's 
last taxable year beginning before January 1, 2018 (the ``last pooling 
year''), and applying the rules in Sec. Sec.  1.905-3T(d) and 1.905-5T 
for purposes of determining whether the foreign tax redetermination is 
accounted for in the foreign corporation's last pooling year or must be 
accounted for in the year to which the redetermined foreign tax relates. 
Except with respect to determining under the preceding sentence whether 
the foreign tax redetermination is accounted for in the foreign 
corporation's last pooling year or in the year to which the redetermined 
foreign tax relates, the rules of this section apply to foreign tax 
redeterminations covered by an election under this paragraph (e). 
Therefore, unless an exception in Sec.  1.905-3T(d)(3) applies, a 
foreign tax redetermination to which an election under this paragraph 
(e) applies is accounted for under paragraph (a)(2) of this section by 
adjusting the foreign corporation's pools of post-1986 undistributed 
earnings and post-1986 foreign income taxes in the last pooling year, 
rather than in the year to which the redetermined foreign tax relates. 
For purposes of this paragraph (e), references to Sec. Sec.  1.905-3T 
and 1.905-5T are to such provisions as contained in 26 CFR part 1, 
revised as of April 1, 2019.
    (2) Rules regarding the election--(i) Time and manner of election. 
For a foreign corporation's first taxable year that ends with or within 
a taxable year of a United States shareholder of the foreign corporation 
ending on or after November 2, 2020 in which the foreign corporation has 
a foreign tax redetermination (the ``first redetermination year''), the 
controlling domestic shareholders (as defined in Sec.  1.964-1(c)(5)) of 
the foreign corporation make the election described in paragraph (e)(1) 
of this section by--
    (A) Filing the statement required under Sec.  1.964-1(c)(3)(ii) with 
a timely filed original income tax return for the taxable year of each 
controlling domestic shareholder of the foreign corporation in which or 
with which the foreign corporation's first redetermination year ends;
    (B) Providing any notices required under Sec.  1.964-1(c)(3)(iii);
    (C) Filing amended returns as required under Sec.  1.905-4 and this 
section for each controlling domestic shareholder's taxable year with or 
within which ends the foreign corporation's last pooling year and each 
other affected year before the controlling domestic shareholder's 
taxable year with or within which ends the foreign corporation's first 
redetermination year reflecting a redetermination of the controlling 
domestic shareholder's U.S. tax liability for each such taxable year, in 
cases where a redetermination of the shareholder's U.S. tax liability 
for taxable years ending before the foreign corporation's last pooling 
year ends is not required under the rules in Sec. Sec.  1.905-3T(d) and 
1.905-5T;
    (D) Filing amended returns as required under Sec.  1.905-4 and this 
section with respect to each affected year before the controlling 
domestic shareholder's taxable year with or within which ends the 
foreign corporation's first redetermination year reflecting a 
redetermination of the controlling domestic shareholder's U.S. tax 
liability for each such taxable year, in cases where a redetermination 
of the shareholder's U.S. tax liability for taxable years ending before 
the foreign corporation's last pooling year ends is required under the 
rules in Sec. Sec.  1.905-3T(d) and 1.905-5T and this section; and

[[Page 1035]]

    (E) Providing any additional information required by applicable 
administrative pronouncements.
    (ii) Scope, duration, and effect of election. An election under 
paragraph (e)(1) of this section with respect to the first 
redetermination year of a foreign corporation is binding on all persons 
who are, or were in a prior year to which the election applies, United 
States shareholders of the foreign corporation. In addition, such 
election applies to all foreign tax redeterminations in the first 
redetermination year and all subsequent taxable years of such foreign 
corporation and cannot be revoked. For foreign tax redeterminations that 
occur in taxable years after the first redetermination year, all United 
States shareholders of such foreign corporation must account for the 
foreign tax redeterminations under the rules in paragraph (e)(1) of this 
section by filing amended returns and providing other information as 
required by Sec.  1.905-4 and paragraphs (e)(2)(i)(C) through (E) of 
this section.
    (iii) Requirements for valid election. An election under paragraph 
(e)(1) of this section is valid only if all of the requirements in 
paragraph (e)(2)(i) of this section, including the requirement to 
provide notice under paragraph (e)(2)(i)(B) of this section, are 
satisfied by each of the controlling domestic shareholders with respect 
to the first redetermination year.
    (iv) CFC group conformity requirement--(A) In general. An election 
made under paragraph (e)(1) of this section applies to all controlled 
foreign corporations that are members of the same CFC group, and the 
rules in paragraphs (e)(1) and (e)(2)(i) through (iii) of this section 
apply by reference to the CFC group. Therefore, an election by the 
controlling domestic shareholders of any controlled foreign corporation 
with respect to that controlled foreign corporation's first 
redetermination year also applies to foreign tax redeterminations of all 
members of the CFC group that includes that controlled foreign 
corporation, determined as of the close of that controlled foreign 
corporation's first redetermination year. The election is binding on all 
persons who are, or were in a prior year to which the election applies, 
United States shareholders of any member of the CFC group, applies with 
respect to foreign tax redeterminations of each member that occur in and 
after that member's first taxable year with or within which ends such 
controlled foreign corporation's first redetermination year, and cannot 
be revoked.
    (B) Determination of the CFC group--(1) Definition. Subject to the 
rules in paragraphs (b)(2)(iv)(B)(2) and (3) 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 (e)(2)(iv)(B)(1), 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.''
    (2) 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 first redetermination year of any controlled foreign corporation 
for which an election is made under paragraph (e)(1) of this section. 
One or more controlled foreign corporations are members of a CFC group 
if the requirements of paragraph (e)(2)(iv)(B)(2) of this section are 
satisfied as of the end of the first redetermination year of at least 
one of the controlled foreign corporations, even if the requirements are 
not satisfied as of the end of the first redetermination 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 first redetermination year that ends with or 
within the taxable year of the majority of the controlling domestic 
shareholders (determined based on voting power) or, if

[[Page 1036]]

no such majority taxable year exists, the calendar year.
    (3) 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 (e)(2)(iv)(B)(2) of this section, 
then ownership of stock of the controlled foreign corporation is 
determined by applying paragraph (e)(2)(iv)(B)(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 redetermination 
year of a controlled foreign corporation that would cause a CFC group to 
exist.
    (3) Rules for successor entities. All of the United States persons 
that own equity interests in a successor entity to a foreign corporation 
(``U.S. owners'') may elect under the principles of paragraph (e)(2) of 
this section to apply the rules in paragraph (e)(1) to foreign tax 
redeterminations of such foreign corporation that occur in taxable years 
of the successor entity that end with or within taxable years of its 
U.S. owners ending on or after November 2, 2020.
    (f) Applicability date. This section applies to foreign tax 
redeterminations (as defined in Sec.  1.905-3(a)) of foreign corporation 
and successor entities that occur in taxable years that end with or 
within taxable years of a United States shareholder or other United 
States persons ending on or after November 2, 2020, and that relate to 
taxable years of such foreign corporations beginning before January 1, 
2018.

[T.D. 9922, 85 FR 72067, Nov. 12, 2020]



Sec.  1.907-0  Outline of regulation provisions for section 907.

    This section lists the paragraphs contained in Sec. Sec.  1.907(a)-0 
through 1.907(f)-1.

    Sec.  1.907(a)-0 Introduction (for taxable years beginning after 
                           December 31, 1982).

    (a) Effective dates.
    (b) Key terms.
    (c) FOGEI tax limitation.
    (d) Reduction of creditable FORI taxes.
    (e) FOGEI and FORI.
    (f) Posted prices.
    (g) Transitional rules.
    (h) Section 907(f) carrybacks and carryovers.
    (i) Statutes covered.

  Sec.  1.907(a)-1 Reduction in taxes paid on FOGEI (for taxable years 
                   beginning after December 31, 1982).

    (a) Amount of reduction.
    (b) Foreign taxes paid or accrued.
    (1) Foreign taxes.
    (2) Foreign taxes paid or accrued.
    (c) Limitation level.
    (1) In general.
    (2) Limitation percentage of corporations.
    (3) Limitation percentage of individuals.
    (4) Losses.
    (5) Priority.
    (d) Illustrations.
    (e) Effect on other provisions.
    (1) Deduction denied.
    (2) Reduction inapplicable.
    (3) Section 78 dividend.
    (f) Section 904 limitation.

 Sec.  1.907(b)-1 Reduction of creditable FORI taxes (for taxable years 
                   beginning after December 31, 1982).

  Sec.  1.907(c)-1 Definitions relating to FOGEI and FORI (for taxable 
                years beginning after December 31, 1982).

    (a) Scope.
    (b) FOGEI.
    (1) General rule.
    (2) Amount.
    (3) Other circumstances.
    (4) Income directly related to extraction.
    (5) Income not included.
    (6) Fair market value.
    (7) Economic interest.
    (c) Carryover of foreign oil extraction losses.
    (1) In general.
    (2) Reduction.
    (3) Foreign oil extraction loss defined.
    (4) Affiliated groups.
    (5) FOGEI taxes.
    (6) Examples.
    (d) FORI.
    (1) In general.
    (2) Transportation.
    (3) Distribution or sale.
    (4) Processing.
    (5) Primary product from oil.
    (6) Primary product from gas.
    (7) Directly related income.
    (e) Assets used in a trade or business.
    (1) In general.
    (2) Section 907(c) activities.
    (3) Stock.
    (4) Losses on sale of stock.
    (5) Character of gain or loss.
    (6) Allocation of amount realized.
    (7) Interest.
    (f) Terms and items common to FORI and FOGEI.
    (1) Minerals
    (2) Taxable income.
    (3) Interest on working capital.

[[Page 1037]]

    (4) Exchange gain or loss.
    (5) Allocation.
    (6) Facts and circumstances.
    (g) Directly related income.
    (1) In general.
    (2) Directly related services.
    (3) Leases and licenses.
    (4) Related person.
    (5) Gross income.
    (h) Coordination with other provisions.
    (1) Certain adjustments.
    (2) Section 901(f).

 Sec.  1.907(c)-2 Section 907(c)(3) items (for taxable years beginning 
                        after December 31, 1982).

    (a) Scope.
    (b) Dividend.
    (1) Section 1248.
    (2) Section 78 dividend.
    (c) Taxes deemed paid.
    (1) Voting stock test.
    (2) Dividends and interest.
    (3) Amounts included under section 951(a).
    (d) Amount attributable to certain items.
    (1) Certain dividends.
    (2) Interest received from certain foreign corporations.
    (3) Dividends from domestic corporation.
    (4) Amounts with respect to which taxes are deemed paid under 
section 960(a).
    (5) Section 78 dividend.
    (6) Special rule.
    (7) Deficits.
    (8) Illustrations.
    (e) Dividends, interest, and other amounts from sources within a 
possession.
    (f) Income from partnerships, trusts, etc.

Sec.  1.907(c)-3 FOGEI and FORI taxes (for taxable years beginning after 
                           December 31, 1982).

    (a) Tax characterization, allocation and apportionment.
    (1) Scope.
    (2) Three classes of income.
    (3) More than one class in a foreign tax base.
    (4) Allocation of tax within a base.
    (5) Modified gross income.
    (6) Allocation of tax credits.
    (7) Withholding taxes.
    (b) Dividends.
    (1) In general.
    (2) Section 78 dividend.
    (c) Includable amounts under section 951(a).
    (d) Partnerships.
    (e) Illustrations.

Sec.  1.907(d)-1 Disregard of posted prices for purposes of chapter 1 of 
     the Code (for taxable years beginning after December 31, 1982).

    (a) In general.
    (1) Scope.
    (2) Initial computation requirement.
    (3) Burden of proof.
    (4) Related parties.
    (b) Adjustments.
    (c) Definitions.
    (1) Foreign government.
    (2) Minerals.
    (3) Posted price.
    (4) Other pricing arrangement.
    (5) Fair market value.

   Sec.  1.907(f)-1 Carryback and carryover of credits disallowed by 
  section 907(a) (for amounts carried between taxable years that each 
                     begin after December 31, 1982).

    (a) In general.
    (b) Unused FOGEI.
    (1) In general.
    (2) Year of origin.
    (c) Tax deemed paid or accrued.
    (d) Excess extraction limitation.
    (e) Excess general section 904 limitation.
    (f) Section 907(f) priority.
    (g) Cross-reference.
    (h) Example.

[T.D. 8338, 56 FR 11063, Mar. 15, 1991; 56 FR 21926, May 13, 1991; T.D. 
8655, 61 FR 516, Jan. 8, 1996]



Sec.  1.907(a)-0  Introduction (for taxable years beginning 
after December 31, 1982).

    (a) Effective dates. The provisions of Sec. Sec.  1.907(a)-0 through 
1.907(f)-1 apply to taxable years beginning after December 31, 1982. For 
provisions that apply to taxable years beginning before January 1, 1983, 
see Sec. Sec.  1.907(a)-0A through 1.907(f)-1A.
    (b) Key terms. For purposes of the regulations under section 907--
    (1) FOGEI means foreign oil and gas extraction income.
    (2) FORI means foreign oil related income.
    (3) FOGEI taxes mean foreign oil and gas extraction taxes as defined 
in section 907(c)(5).
    (4) FORI taxes means foreign taxes on foreign oil related income. 
See Sec.  1.907(c)-3.
    (c) FOGEI tax limitation. Section 907(a) limits the foreign tax 
credit for taxes paid or accrued on FOGEI. See Sec.  1.907(a)-1.
    (d) Reduction of creditable FORI taxes. Section 907(b) 
recharacterizes FORI taxes as non-creditable deductible expenses to the 
extent that the foreign law imposing the FORI taxes is structured, or in 
fact operates, so that the amount of tax imposed with respect to FORI 
will be materially greater, over a reasonable period of time, than the

[[Page 1038]]

amount generally imposed on income that is neither FOGEI nor FORI. See 
Sec.  1.907(b)-1.
    (e) FOGEI and FORI. FOGEI includes the taxable income from the 
extraction of minerals from oil or gas wells by a taxpayer (or another 
person) and from the sale or exchange of assets used in the extraction 
business. FORI includes taxable income from the activities of processing 
oil and gas into their primary products, transporting or distributing 
oil and gas and their primary products, and from the disposition of 
assets used in these activities. For this purpose, a disposition 
includes only a sale or exchange. FOGEI and FORI may also include 
taxable income from the performance of related services or from the 
lease of related property and certain dividends, interest, or amounts 
described in section 951(a). See Sec. Sec.  1.907(c)-1 through 1.907(c)-
3.
    (f) Posted prices. Certain sales prices are disregarded when 
computing FOGEI for purposes of chapter 1 of the Code. See Sec.  
1.907(d)-1.
    (g) Transitional rules. Section 907(e) provides rules for the 
carryover of unused FOGEI taxes from taxable years beginning before 
January 1, 1983, and carryback of FOGEI taxes arising in taxable years 
beginning after December 31, 1982. See Sec.  1.907(e)-1.
    (h) Section 907(f) carrybacks and carryovers. FOGEI taxes disallowed 
under section 907(a) may be carried back or forward to other taxable 
years. These FOGEI taxes may be absorbed in another taxable year to the 
extent of the lesser of the separate excess extraction limitation or the 
excess limitation in the general limitation category (section 
904(d)(1)(I)) for the carryback or carryover year. See Sec.  1.907(f)-1.
    (i) Statutes covered. The regulations under section 907 are issued 
as a result of the enactment of section 601 of the Tax Reduction Act of 
1975, of section 1035 of the Tax Reform Act of 1976, of section 
301(b)(14) of the Revenue Act of 1978, of section 211 of the Tax Equity 
and Fiscal Responsibility Act of 1982 and of section 1012(g)(6) (A)-(B) 
of the Technical and Miscellaneous Revenue Act of 1988.

[T.D. 8338, 56 FR 11065, Mar. 15, 1991]



Sec.  1.907(a)-1  Reduction in taxes paid on FOGEI 
(for taxable years beginning after December 31, 1982).

    (a) Amount of reduction. FOGEI taxes are reduced by the amount by 
which they exceed a limitation level (as defined in paragraph (c) of 
this section).
    (b) Foreign taxes paid or accrued. For purposes of the regulations 
under section 907--
    (1) Foreign taxes. The term ``foreign taxes'' means income, war 
profits, or excess profits taxes of foreign countries or possessions of 
the United States otherwise creditable under section 901 (including 
those creditable by reason of section 903).
    (2) Foreign taxes paid or accrued. The terms ``foreign taxes paid or 
accrued,'' ``FOGEI taxes paid or accrued,'' and ``FORI taxes paid or 
accrued'' include foreign taxes deemed paid under sections 902 and 960. 
Unless otherwise expressly provided, these terms do not include foreign 
taxes deemed paid by reason of sections 904(c) and 907(f).
    (c) Limitation level--(1) In general. The limitation level is FOGEI 
for the taxable year multiplied by the limitation percentage for that 
year.
    (2) Limitation percentage for corporations. A corporation's 
limitation percentage is the highest rate of tax specified in section 
11(b) for the particular year.
    (3) Limitation percentage for individuals. Section 907(a)(2)(B) 
provides that the limitation percentage for individual taxpayers is the 
effective rate of tax for those taxpayers. The effective rate of tax is 
computed by dividing the entire tax, before the credit under section 
901(a) is taken, by the taxpayer's entire taxable income.
    (4) Losses. (i) For purposes of determining whether income is FOGEI, 
a taxpayer's FOGEI will be recharacterized as foreign source non-FOGEI 
to the extent that FOGEI losses for preceding taxable years beginning 
after December 31, 1982, exceed the amount of FOGEI already 
recharacterized. See Sec.  1.907(c)-1(c). However, taxes that were paid 
or accrued on the recharacterized FOGEI will remain FOGEI taxes.
    (ii) Taxes paid or accrued by a person to a foreign country may be 
FOGEI taxes even though that person has

[[Page 1039]]

under U.S. law a net operating loss from sources within that country.
    (iii) For purposes of determining whether income is FOGEI, a 
taxpayer's income will be treated as income from sources outside the 
United States even though all or a portion of that income may be 
resourced as income from sources within the United States under section 
904(f) (1) and (4).
    (5) Priority. (i) Section 907(a) applies before section 908, 
relating to reduction of credit for participation in or cooperation with 
an international boycott.
    (ii) Section 901(f) (relating to certain payments with respect to 
oil and gas not considered as taxes) applies before section 907.
    (d) Illustrations. Paragraphs (a) through (c) of this section are 
illustrated by the following examples.

    Example 1. M, a U.S. corporation, uses the accrual method of 
accounting and the calendar year as its taxable year. For 1984, M has 
$20,000 of FOGEI, derived from operations in foreign countries X and Y, 
and has accrued $11,500 of foreign taxes with respect to FOGEI. The 
highest tax rate specified in section 11(b) for M's 1984 taxable year is 
46 percent. Pursuant to section 907(a), M's FOGEI taxes limitation level 
for 1984 is $9,200 (46% x $20,000). The foreign taxes in excess of this 
limitation level ($2,300) may be carried back or forward. See section 
907(f) and Sec.  1.907(f)-1 and section 907(e) and Sec.  1.907(e)-1.
    Example 2. The facts are the same as in Example 1 except that M is a 
partnership owned equally by U.S. citizens A and B who each file as 
unmarried individuals and do not itemize deductions. Pursuant to section 
905(a), A and B have elected to credit foreign taxes in the year 
accrued. The total amount of foreign taxes accrued by A and B with 
respect to their distributive shares of M's FOGEI is $11,500 ($5,750 
accrued by A and $5,750 accrued by B). A and B have no other FOGEI. A's 
only taxable income for 1984 is his 50% distributive share ($10,000) of 
M's FOGEI and A has a preliminary U.S. tax liability of $1,079. B has 
$112,130 of taxable income for 1984 (including his 50% distributive 
share ($10,000) of M's FOGEI) and has a preliminary U.S. tax liability 
of $44,000. Pursuant to section 907(a), A's FOGEI taxes limitation level 
for 1984 is $1,079 (($1,079/$10,000) x $10,000) and B's FOGEI taxes 
limitation level for 1984 is $3,924 (($44,000/$112,130) x $10,000).

    (e) Effect on other provisions--(1) Deduction denied. If a credit is 
claimed under section 901, no deduction under section 164(a)(3) is 
allowed for the amount of the FOGEI taxes that exceed a taxpayer's 
limitation level for the taxable year. See section 275(a)(4)(A). Thus, 
FOGEI taxes disallowed under section 907(a) are not added to the cost or 
inventory amount of oil or gas.
    (2) Reduction inapplicable. The reduction under section 907(a) does 
not apply to a taxpayer that deducts foreign taxes and does not claim 
the benefits of section 901 for a taxable year.
    (3) Section 78 dividend. The reduction under section 907(a) has no 
effect on the amount of foreign taxes that are treated as dividends 
under section 78.
    (f) Section 904 limitation. FOGEI taxes as reduced under section 
907(a) are creditable only to the extent permitted by the general 
limitation of section 904(d)(1)(I).

[T.D. 8338, 56 FR 11066, Mar. 15, 1991]



Sec.  1.907(b)-1  Reduction of creditable FORI taxes 
(for taxable years beginning after December 31, 1982).

    If the foreign law imposing a FORI tax (as defined in Sec.  
1.907(c)-3) is either structured in a manner, or operates in a manner, 
so that the amount of tax imposed on FORI is generally materially 
greater than the tax imposed by the foreign law on income that is 
neither FORI nor FOGEI (``described manner''), section 907(b) provides a 
special rule which limits the amount of FORI taxes paid or accrued by a 
person to a foreign country which will be considered income, war 
profits, or excess profits taxes. Section 907(b) will apply to a person 
regardless of whether that person is a dual capacity taxpayer as defined 
in Sec.  1.901-2(a)(2)(ii)(A). (In general, a dual capacity taxpayer is 
a person who pays an amount to a foreign country part of which is 
attributable to an income tax and the remainder of which is a payment 
for a specific economic benefit derived from that country.) Foreign law 
imposing a tax on FORI will be considered either to be structured in or 
to operate in the described manner only if, under the facts and 
circumstances, there has been a shifting of tax by the foreign country 
from a tax on FOGEI to a tax on FORI.

[T.D. 8338, 56 FR 11066, Mar. 15, 1991]

[[Page 1040]]



Sec.  1.907(c)-1  Definitions relating to FOGEI and FORI 
(for taxable years beginning after December 31, 1982).

    (a) Scope. This section explains the meaning to be given certain 
terms and items in section 907(c) (1), (2), and (4). See also Sec. Sec.  
1.907(a)-0(b) and 1.907(c)-2 for further definitions.
    (b) FOGEI--(1) General rule. Under section 907(c)(1), FOGEI means 
taxable income (or loss) derived from sources outside the United States 
and its possessions from the extraction (by the taxpayer or any other 
person) of minerals from oil or gas wells located outside the United 
States and its possessions or from the sale or exchange of assets used 
by the taxpayer in the trade or business of extracting those minerals. 
Extraction of minerals from oil or gas wells will result in gross income 
from extraction in every case in which that person has an economic 
interest in the minerals in place. For other circumstances in which 
gross income from extraction may arise, see paragraph (b)(3) of this 
section. For determination of the amount of gross income from 
extraction, see paragraph (b)(2) of this section. For definition of the 
phrase ``assets used by the taxpayer in the trade or business'' and for 
rules relating to that type of FOGEI, see paragraph (e)(1) of this 
section. The term ``minerals'' is defined in paragraph (f)(1) of this 
section. For determination of taxable income, see paragraph (f)(2) of 
this section. FOGEI includes, in addition, items listed in section 
907(c)(3) (relating to dividends, interest, partnership distributions, 
etc.) and explained in Sec.  1.907(c)-2. For the reduction of what would 
otherwise be FOGEI by losses incurred in a prior year, see section 
907(c)(4) and paragraph (c) of this section.
    (2) Amount. The gross income from extraction is determined by 
reference to the fair market value of the minerals in the immediate 
vicinity of the well. Fair market value is determined under paragraph 
(b)(6) of this section.
    (3) Other circumstances. Gross income from extraction or the sale or 
exchange of assets described in section 907(c)(1)(B) includes income 
from any arrangement, or a combination of arrangements or transactions, 
to the extent the income is in substance attributable to the extraction 
of minerals or such a sale or exchange. For instance, a person may have 
gross income from such a sale or exchange if the person purchased 
minerals from a foreign government at a discount and the discount 
reflects an arm's-length amount in consideration for the government's 
nationalization of assets that person owned and used in the extraction 
of minerals.
    (4) Income directly related to extraction. Gross income from 
extraction includes directly related income under paragraph (g) of this 
section.
    (5) Income not included. FOGEI as otherwise determined under this 
paragraph (b), nevertheless, does not include income to the extent 
attributable to marketing, distributing, processing or transporting 
minerals or primary products. Income from the purchase and sale of 
minerals is not ordinarily FOGEI. If the foreign taxes paid or accrued 
in connection with income from a purchase and sale are not creditable by 
reason of section 901(f), that income is not FOGEI. A taxpayer to whom 
section 901(f) applies is not a producer.
    (6) Fair market value. For purposes of this paragraph (b), the fair 
market value of oil or gas in the immediate vicinity of the well depends 
on all of the facts and circumstances as they exist relative to a party 
in any particular case. The facts and circumstances that may be taken 
into account include, but are not limited to, the following--
    (i) The facts and circumstances pertaining to an independent market 
value (if any) in the immediate vicinity of the well,
    (ii) The facts and circumstances pertaining to the relationships 
between the taxpayer and the foreign government. If an independent fair 
market value in the immediate vicinity of the well cannot be determined 
but fair market value at the port, or a similar point, in the foreign 
country can be determined (port price), an analysis of the arrangement 
between the taxpayer and the foreign government that retains a share of 
production could be evidence of the appropriate, arm's-length difference 
between the port price and the field price, and

[[Page 1041]]

    (iii) The other facts and circumstances pertaining to any difference 
in the producing country between the field and port prices.
    (7) Economic interest. For purposes of this paragraph (b), the term 
``economic interest'' means an economic interest as defined in Sec.  
1.611-1(b)(1), whether or not a deduction for depletion is allowable 
under section 611.
    (c) Carryover of foreign oil extraction losses--(1) In general. 
Pursuant to section 907(c)(4), the determination of FOGEI for a 
particular taxable year takes into account a foreign oil extraction loss 
incurred in prior taxable years beginning after December 31, 1982. There 
is no time limitation on this carryover of foreign oil extraction 
losses. Section 907(c)(4) does not provide for any carryback of these 
losses. Section 907(c)(4) operates solely for purposes of determining 
FOGEI and thus operates independently of section 904(f).
    (2) Reduction. That portion of the income of the taxpayer for the 
taxable year which but for this paragraph (c) would be treated as FOGEI 
is reduced (but not below zero) by the excess of--
    (i) The aggregate amount of foreign oil extraction losses for 
preceding taxable years beginning after December 31, 1982, over
    (ii) The aggregate amount of reductions under this paragraph (c) for 
preceding taxable years beginning after December 31, 1982.
    (3) Foreign oil extraction loss defined--(i) In general. For 
purposes of this paragraph (c), the term ``foreign oil extraction loss'' 
means the amount by which the gross income for the taxable year that is 
taken into account in determining FOGEI for that year is exceeded by the 
sum of the deductions properly allocated and apportioned to that gross 
income as determined under paragraph (f)(2) of this section). A person 
can have a foreign oil extraction loss for a taxable year even if the 
person has not chosen the benefits of section 901 for that year.
    (ii) Items not taken into account. For purposes of paragraph 
(c)(3)(i) of this section, the following items are not taken into 
account--
    (A) The net operating loss deduction allowable for the taxable year 
under section 172(a),
    (B) Any foreign expropriation loss (as defined in section 172(h)) 
for the taxable year, and
    (C) Any loss for the taxable year which arises from fire, storm, 
shipwreck, or other casualty, or from theft.


A loss mentioned in paragraph (c)(3)(ii) (B) or (C) of this section is 
taken into account, however, to the extent compensation (for instance by 
insurance) for the loss is included in gross income.
    (4) Affiliated groups. The foreign oil extraction loss of an 
affiliated group of corporations (within the meaning of section 1504(a)) 
that files a consolidated return is determined on a group basis. If the 
group does not have a foreign oil extraction loss, the foreign oil 
extraction loss of a member of that group will not reduce on a separate 
basis that member's FOGEI for a later taxable year. For special rules 
affecting the foreign oil extraction loss in the case of certain related 
domestic corporations that are not members of the same affiliated group, 
see section 904(i).
    (5) FOGEI taxes. If FOGEI is reduced pursuant to this paragraph (c) 
(and thereby recharacterized as non-FOGEI income), any foreign taxes 
imposed on the FOGEI that is recharacterized as other income retain 
their character as FOGEI taxes. See section 907(c)(5).
    (6) Examples. The provisions of this paragraph (c) may be 
illustrated by the following examples.

    Example 1. (i) Facts. X, a U.S. corporation using the accrual method 
of accounting and the calendar year as its taxable year, is engaged in 
extraction activities in three foreign countries. X has only the 
following combined foreign tax items for the three countries (prior to 
the application of this paragraph (c)) for 1983, 1984, and 1985:

------------------------------------------------------------------------
                                                  1983     1984    1985
------------------------------------------------------------------------
FOGEI.........................................    $(700)    $100    $450
FOGEI taxes...................................       10       60     200
Net operating loss deduction..................     (200)       0       0
Foreign oil extraction loss allowable after        (500)       0       0
 adjustment for paragraph (c)(3)(ii) amounts..
General limitation taxes other than FOGEI            30       90     230
 taxes........................................
------------------------------------------------------------------------

    (ii) 1983. Because X's FOGEI for 1983 is a loss of $(700), X's 
section 907(a) limitation for

[[Page 1042]]

1983 is $0 (.46 x $0). Thus, none of the FOGEI taxes paid or accrued in 
1983 ($10) can be credited in 1983. They can, however, be carried back 
to 1981 or 1982 pursuant to the provisions of section 907(e)(2) and 
Sec.  1.907(e)-1 and carried forward pursuant to the provisions of 
section 907(f) and Sec.  1.907(f)-1.
    (iii) 1984. X's FOGEI for 1984, prior to the application of this 
paragraph (c), is $100. X has a foreign oil extraction loss for 1983 of 
$(500). This loss must be applied against X's preliminary FOGEI of $100 
for 1984. Thus, X's FOGEI for 1984 is $0 and X has $(400) ($500-$100) of 
foreign oil extraction loss from 1983 to be carried to 1985. Since X's 
FOGEI for 1984 is $0, its section 907(a) limitation is $0 (.46 x $0). 
Therefore, none of the FOGEI taxes paid or accrued in 1984 ($60) can be 
credited in 1984. They can, however, be carried back pursuant to the 
provisions of section 907(e)(2) and Sec.  1.907(e)-1 and carried forward 
pursuant to the provisions of section 907(f) and Sec.  1.907(f)-1.
    (iv) 1985. X's FOGEI for 1985, prior to the application of this 
paragraph (c), is $450. X's remaining foreign oil extraction loss 
carryover from 1983 is $(400) and this must be applied against X's 
preliminary FOGEI of $450 for 1985. Thus, X's FOGEI for 1984 is $50 
($450-$400). X's section 907 (a) limitation is $23 (.46 x $50). 
Therefore, $23 of the FOGEI taxes paid or accrued in 1985, together with 
the other $230 of general limitation taxes, can be credited in 1985, 
subject to the general limitation of section 904(d)(1)(E) (as in effect 
prior to 1987). The excess of FOGEI taxes, $177 ($200-$23), can be 
carried back pursuant to the provisions of section 907(e)(2) and Sec.  
1.907(e)-1 and carried forward pursuant to the provisions of section 
907(f) and Sec.  1.907(f)-1.
    Example 2. (i) Facts. The facts are the same as in Example 1 except 
that X's paragraph (c)(3)(ii) items for 1983 allocable to FOGEI are 
$(800) instead of $(200). FOGEI remains a loss of $(700). Thus, X does 
not have a foreign oil extraction loss for 1983 because it has $100 of 
FOGEI when its paragraph (c)(3)(ii) items are not taken into account 
($(700) + $800).
    (ii) 1983. The results are the same as in Example 1.
    (iii) 1984. Although X had FOGEI loss of $(700) in 1983, there is 
not a loss that can be carried forward after adjustment for paragraph 
(c)(3)(ii) items. Thus, X's FOGEI for 1984 is not reduced by the 1983 
loss. X's section 907(a) limitation for 1984 is $46 (.46 x $100). 
Therefore, $46 of the FOGEI taxes paid or accrued in 1984, together with 
the other $90 of general limitation taxes, can be credited in 1984, 
subject to the general limitation of section 904(d)(1)(E) (as in effect 
prior to 1987). The excess of $14 ($60-$46) can be carried back to 1982 
pursuant to the provisions of section 907(e)(2) and Sec.  1.907(e)-1 and 
carried forward pursuant to the provisions of section 907(f) and Sec.  
1.907(f)-1.
    (iv) 1985. Since there is no foreign oil extraction loss for either 
1983 or 1984 to be applied in 1985, X's FOGEI for 1985 is $450. Thus, 
its section 907(a) limitation for 1985 is $207 (.46 x $450) and all of 
its FOGEI taxes paid or accrued in 1985 ($200), together with the other 
$230 of general limitation taxes, can be credited in 1985, subject to 
the general limitation of section 904(d)(1)(E) (as in effect prior to 
1987). FOGEI taxes in the amount of $10 from 1983 and $14 from 1984 may 
be carried forward to 1985 if they have not been used in carryback 
years. However, because the excess section 907(a) limitation for 1985 is 
only $7, that is the maximum potential FOGEI taxes from 1983 or 1984 
that may be used in 1985.
    Example 3. (i) Facts. Y, a U.S. corporation using the accrual method 
of accounting and the calendar year as its taxable year, is engaged in 
extraction activities in three foreign countries. Y's only foreign 
taxable income is income subject to the general limitation of section 
904(d)(1)(E) (as in effect prior to 1987). Y has no paragraph (c)(3)(ii) 
items. Y has the following foreign tax items for 1983 and 1984:

------------------------------------------------------------------------
                                                        1983      1984
------------------------------------------------------------------------
FOGEI...............................................    $(400)      $300
Other foreign taxable income........................      250        200
U.S. taxable income.................................    1,000      1,100
Worldwide taxable income............................      850      1,600
FOGEI taxes.........................................       10        180
Other general limitation taxes......................       50         40
Foreign oil extraction loss.........................     (400)         0
------------------------------------------------------------------------

    (ii) 1983--(A) Section 907(a) limitation. Because Y's FOGEI for 1983 
is a loss of $(400), Y's section 907(a) limitation for 1983 is $0. Thus, 
none of the FOGEI taxes paid or accrued in 1983 ($10) can be credited in 
1983. They can, however, be carried back to 1981 or 1982 pursuant to the 
provisions of section 907(e)(2) and Sec.  1.907(e)-1 and carried forward 
pursuant to the provisions of section 907(f) and Sec.  1.907(f)-1.
    (B) Section 904(d) fraction. Y has a foreign loss of $(150) ($(400 + 
$250) for 1983. Thus, its fraction for purposes of determining its 
general limitation of section 904(d)(1)(E) is $0/$850.
    (iii) 1984--(A) Section 907(a) limitation. Y's foreign oil 
extraction loss for 1983 is $(400). Applying this loss to its 
preliminary FOGEI for 1984 ($300) eliminates all of Y's FOGEI for 1984. 
Because Y's FOGEI for 1984 is $0, its section 907(a) limitation is also 
$0. Thus, none of the FOGEI taxes paid or accrued in 1984 ($180) can be 
credited in 1984. They can, however, be carried back to 1982 pursuant to 
the provisions of section 907(e)(2) and Sec.  1.907(e)-1 and carried 
forward pursuant to the provisions of section 907(f) and Sec.  1.907(f)-
1. Y has a remaining foreign oil extraction loss of $(100) from 1983 to 
be carried to 1985.

[[Page 1043]]

    (B) Section 904(d) fraction. Y's preliminary foreign taxable income 
for purposes of determining its general limitation of section 
904(d)(1)(E) is $500 ($300 + $200). However, Y has an overall foreign 
loss from 1983 of $(150) ($(400) + $250) and thus, pursuant to section 
904(f), Y must recharacterize $150 (lesser of $150 or 50% of $500) of 
its 1984 foreign taxable income as U.S. taxable income. Thus, Y's 
fraction for purposes of determining its general limitation of section 
904(d)(1)(E) for 1984 is $350/$1,600.
    Example 4. (i) Facts. Assume the same facts as in Example 3 except 
that Y has the following foreign tax items:

------------------------------------------------------------------------
                                                 1983     1984     1985
------------------------------------------------------------------------
FOGEI........................................  .......    $(100)    $225
Other foreign source taxable income subject      $(50)
 to the general limitation of section
 904(d)(1)(E)................................
U.S. source taxable income...................      50
Worldwide taxable income.....................  .......     (100)     225
FOGEI taxes..................................  .......       10      125
Foreign oil extraction loss..................  .......     (100)  ......
------------------------------------------------------------------------

    (ii) 1983. For 1983, Y has a section 904(d)(1)(E) overall foreign 
loss account of $50; see section 904(f) and Sec.  1.904(f)-1(b).
    (iii) 1984. Because Y's FOGEI for 1984 is a loss of $(100), Y's 
section 907(a) limitation for 1984 is $0. Thus, none of the FOGEI taxes 
paid or accrued in 1984 ($10) can be credited in 1984. They can, 
however, be carried back under the provisions of section 907(e)(2) and 
Sec.  1.907(e)-1 and carried forward under the provisions of section 
907(f) and Sec.  1.907(f)-1.
    (iv) 1985. Y's FOGEI loss of $(100) for 1984 is carried forward to 
1985 and offsets FOGEI income in that amount in 1985. The entire section 
904(d)(1)(E) overall foreign loss account of $50 is recaptured in 1985; 
therefore, Y has $75 of foreign source income and $50 of U.S. source 
income. However, Y has $125 of FOGEI since, for purposes of section 
907(a), the $50 resourced by section 904(f) will be treated as income 
from sources outside the United States; see Sec.  1.907(a)-1(c)(4)(iii). 
Accordingly, Y's section 907(a) limitation is $57.50 (.46 x $125). Y's 
section 904(d)(1)(E) limitation is, however, only $34.50 (.46 x $75). 
Thus, Y may claim a foreign tax credit of $34.50 in 1985. Y may carry 
back or carry forward $23 ($57.50-$34.50) and that amount is not subject 
to the section 907(a) limitation in the carry to year. In addition, 
$67.50 ($125-$57.50) may be carried back pursuant to the provisions of 
section 907(e)(2) and Sec.  1.907(e)-1 and carried forward pursuant to 
the provisions of section 907(f) and Sec.  1.907(f)-1. This amount is 
subject to the section 907(a) limitation in the carry to year.

    (d) FORI--(1) In general. Section 907(c)(2) defines FORI to include 
taxable income from the processing of oil and gas into their primary 
products, from the transportation or distribution and sale of oil and 
gas and their primary products, from the disposition of assets used in 
these activities and from the performance of any other related service. 
FORI may also include, under section 907(c)(3), certain dividends, 
interest, or amounts described in section 951(a). This paragraph (d) 
defines certain terms and items applicable to FORI.
    (2) Transportation. Gross income from transportation of minerals or 
primary products (``gross transportation income'') is gross income 
arising from carrying minerals or primary products between two places 
(including time or voyage charter hires) by any means of transportation, 
such as a vessel, pipeline, truck, railroad, or aircraft. Except for 
directly related income under paragraphs (d)(7) and (g) of this section, 
gross transportation income does not include gross income received by a 
lessor from a bareboat charter hire of a means of transportation, 
certain other rental income, or income from the performance of certain 
services.
    (3) Distribution or sale. The term ``distribution or sale'' means 
the sale or exchange of minerals or primary products to processors, 
users who purchase, store, or use in bulk quantities, other persons for 
further distribution, retailers, or consumers. Gross income from 
distribution or sale includes interest income attributable to the 
distribution of minerals or primary products on credit.
    (4) Processing. The term ``processing'' means the destructive 
distillation, or a process similar in effect to destructive 
distillation, of crude oil and the processing of natural gas into their 
primary products including processes used to remove pollutants from 
crude oil or natural gas.
    (5) Primary product from oil. The term ``primary product'' (in the 
case of oil) means all products derived from the processing of crude 
oil, including volatile products, light oils (such as motor fuel and 
kerosene), distillates (such as naphtha), lubricating oils, greases and 
waxes, and residues (such as fuel oil).
    (6) Primary product from gas. The term ``primary product'' (in the 
case of gas)

[[Page 1044]]

means all gas and associated hydrocarbon components from gas wells or 
oil wells, whether recovered at the lease or upon further processing, 
including natural gas, condensates, liquefiable petroleum gases (such as 
ethane, propane, and butane), and liquid products (such as natural 
gasoline).
    (7) Directly related income. FORI also includes directly related 
income under paragraph (g) of this section.
    (e) Assets used in a trade or business--(1) In general. The term 
``assets used by the taxpayer in the trade or business'' in section 
907(c) (1)(B) and (2)(D) means property primarily used in one or more of 
the trades or businesses that are section 907(c) activities. For 
purposes of this paragraph (e), assets used in a trade or business are 
assets described in section 1231(b) (applied without regard to any 
holding period or the character of the asset as being subject to the 
allowance for depreciation under section 167).
    (2) Section 907(c) activities. Section 907(c) activities are those 
described in section 907(c)(1)(A) (for FOGEI) or (c)(2) (A) through (C) 
(for FORI). If an asset is used primarily in one or more section 907(c) 
activities, then the entire gain (or loss) will be considered 
attributable to those activities. For example, if a person uses a 
service station primarily to distribute primary products from oil, then 
all of the gain (or loss) on the sale of the station is FORI even though 
the person uses the station to distribute products that are not primary 
products (such as tires or batteries). If an asset is not primarily used 
in one or more section 907(c) activities, then the entire gain or loss 
will not be FOGEI or FORI.
    (3) Stock. Stock of any corporation (whether foreign or domestic) 
will not be treated as an asset used by a person in section 907(c) 
activities.
    (4) Losses on sale of stock. If, under Sec.  1.861-8(e)(7), a loss 
on the sale, exchange, or disposition of stock is considered a deduction 
which is definitely related and allocable to FOGEI or FORI, then 
notwithstanding Sec.  1.861-8 (e)(7) and paragraph (f)(2) of this 
section, this loss shall be allocated and apportioned to the same class 
of income that would have been produced if there were capital gain from 
the sale, exchange or disposition.
    (5) Character of gain or loss. Except in the case of stock, gain or 
loss from the sale, exchange or disposition of assets used in the trade 
or business may be FORI or FOGEI to the extent taken into account in 
computing taxable income for the taxable year, whether or not the gain 
or loss is ordinary income or ordinary loss.
    (6) Allocation of amount realized. The amount realized from the 
sale, exchange or disposition of several assets in one transaction is 
allocated among them in proportion to their respective fair market 
values. This allocation is made under the principles set forth in Sec.  
1.1245-1(a)(5) (relating to allocation between section 1245 property and 
non-section 1245 property).
    (7) Interest. Gross income from the sale, exchange or disposition of 
an asset used in a section 907(c) activity includes interest income from 
such a sale, exchange or disposition.
    (f) Terms and items common to FORI and FOGEI--(1) Minerals. The term 
``minerals'' means hydrocarbon minerals extracted from oil and gas 
wells, including crude oil or natural gas (as defined in section 
613A(e)). The term includes incidental impurities from these wells, such 
as sulphur, nitrogen, or helium. The term does not include hydrocarbon 
minerals derived from shale oil or tar sands.
    (2) Taxable income. Deductions to be taken into account in computing 
taxable income or net operating loss attributable to FOGEI or FORI are 
determined under the principles of Sec.  1.861-8. For an exception with 
regard to losses, see paragraph (e)(4) of this section.
    (3) Interest on working capital. FORI and FOGEI may include interest 
on bank deposits or on any other temporary investment which is not in 
excess of funds reasonably necessary to meet the working capital 
requirements and the specifically anticipated business needs of the 
person that is engaged in the conduct of the activities described in 
section 907(c) (1) or (2).
    (4) Exchange gain or loss. Exchange gain (and loss) may be FORI and 
FOGEI. For taxable years beginning after 1986, exchange gain or loss 
from a section 988 transaction may be FORI or

[[Page 1045]]

FOGEI only if directly related to the business needs (under the 
principles of section 954(c)(1)(D)) attributable to the conduct of the 
section 907(c) activity.
    (5) Allocation. Interest income and exchange gain (or loss) 
described, respectively, in paragraph (f) (3) and (4) of this section 
are allocated among FORI, FOGEI, and any other class of income relevant 
for purposes of the foreign tax credit limitations under any reasonable 
method which is consistently applied from year-to-year.
    (6) Facts and circumstances. Income not described elsewhere in this 
section may be FOGEI or FORI if, under the facts and circumstances in 
the particular case, the income is in substance directly attributable to 
the activities described in section 907(c) (1) or (2). For example, 
assume that a producer in the North Sea suffers a casualty caused by an 
explosion, fire, and resulting destruction of a drilling platform. 
Insurance proceeds received for the platform's destruction in excess of 
the producer's basis is extraction income if the excess constitutes 
income from sources outside the United States. In addition, income from 
an insurance policy for business interruption may be extraction income 
to the extent the payments under the policy are geared directly to the 
loss of income from production and are treated as income from sources 
outside the United States. Also, if an oil company's oil concession or 
assets used in extraction activities described in section 907(c)(1)(A) 
and located outside the United States are nationalized or expropriated 
by a foreign government, or instrumentality thereof, income derived from 
that nationalization or expropriation (including interest on the income 
paid pursuant to the nationalization or expropriation) is FOGEI. 
Likewise, if a company's assets used in the activities described in 
section 907(c)(2) (A) through (C) and located outside the United States 
are nationalized or expropriated by a foreign government, or 
instrumentality thereof, income (including interest on the income paid 
pursuant to the nationalization or expropriation) derived from the 
nationalization or expropriation will be FORI. Nationalization or 
expropriation is deemed to be a sale or exchange for purposes of section 
907(c)(1)(B) and a disposition for purposes of section 907(c)(2)(D). In 
further example, assume that an oil company has an exclusive right to 
buy all the oil in country X from Y, an instrumentality of the foreign 
sovereign which owns all of the oil in X. The oil company does not have 
an economic interest in any oil in country X. Y has a temporary cash-
flow problem and demands that the oil company make advance deposits for 
the purchase of oil not yet delivered. In return, Y grants the oil 
company a discount on the price of the oil when delivered. Income 
represented by the discount on the later disposition of the oil is FORI 
described in section 907(c)(2)(C). The result would be the same if Y 
credited the oil company with interest on the advance deposits, which 
had to be used to purchase oil (the interest income would be FORI).
    (g) Directly related income--(1) In general. Section 907(c)(2)(E) 
and this paragraph (g) include in FORI, and this paragraph (g) includes 
in FOGEI, income from the performance of directly related services (as 
defined in paragraph (g)(2) of this section). This paragraph (g) also 
includes in FORI and FOGEI income from the lease or license of related 
property (as defined in paragraph (g)(3) of this section). Section 
907(c)(2)(E) with regard to FORI and this paragraph (g) with regard to 
both FORI and FOGEI do not apply to a person if--
    (i) Neither that person nor a related person (as defined in 
paragraph (g)(4) of this section) has FOGEI described in paragraph (b) 
of this section (other than paragraph (b)(4) of this section relating to 
directly related income) or FORI described in paragraph (d) of this 
section (other than paragraph (d)(7) of this section relating to 
directly related income), or
    (ii) Less than 50 percent of that person's gross income from sources 
outside the United States which is related exclusively to the 
performance of services and from the lease or license of property 
described in paragraph (g) (2) and (3) of this section, respectively, is 
attributable to services performed for (or on behalf of), leases to, or 
licenses with, related persons, but

[[Page 1046]]

    (iii) Paragraph (g)(1)(ii) of this section will not apply to a 
person if 50 percent or more of that person's total gross income from 
sources outside the United States is FOGEI and FORI (as both are 
described in paragraph (g)(1)(i) of this section).


A person described in paragraph (g)(1) (i) or (ii) of this section will, 
however, have directly related services income which is FOGEI if the 
income is so classified by reason of the income based on output test set 
forth in paragraph (g)(2)(i)(B) of this section.
    (2) Directly related services--(i) FOGEI. (A) Income from directly 
related services will be FOGEI, as that term is defined in paragraph 
(b)(1) and (3) of this section, if those services are directly related 
to the active conduct of extraction (including exploration) of minerals 
from oil and gas wells. Paragraph (b)(1) of this section provides that, 
in order to have extraction income, a person must have an economic 
interest in the minerals in place. However, paragraph (b)(3) of this 
section recognizes that income arising from ``other circumstances'' is 
extraction income if that income is in substance attributable to the 
extraction of minerals.
    (B) An example of ``other circumstances'' under paragraph (b)(3) of 
this section is the ``income based on output test.'' This income based 
on output test provides that, if the amount of compensation paid or 
credited to a person for services is dependent on the amount of minerals 
discovered or extracted, the income of the person from the performance 
of the services will be directly related services income which is FOGEI. 
This test will apply whether or not the person performing the services 
has, or had, an economic interest in the minerals discovered or 
extracted.
    (ii) FORI. With regard to the determination of directly related 
services income which is FORI, directly related services are those 
services directly related to the active conduct of the operations 
described in section 907(c)(2) (A) through (C). Those services include, 
for example, services performed in relation to the distribution of 
minerals or primary products or in connection with the operation of a 
refinery, or the types of services described in Sec.  1.954-6(d) (other 
than Sec.  1.954-6(d)(4) which relate to foreign base company shipping 
income.
    (iii) Recipient of the services. Directly related services described 
in paragraph (g)(2) (i) and (ii) of this section may be performed for 
any person without regard to whether that person is a related person.
    (iv) Excluded services--(A) FOGEI. Directly related services which 
produce FOGEI do not include insurance, accounting or managerial 
services.
    (B) FORI. Directly related services which produce FORI do not, 
generally, include insurance, accounting or managerial services. These 
services will, however, produce FORI if they are performed by the person 
performing the operations described in section 907(c)(2) (A) through 
(C). For these purposes, insurance income which is FORI means taxable 
income as defined in section 832(a).
    (3) Leases and licenses. A lease or license of related property is 
the lease or license of assets used (or held for use) by the lessor, 
licensor, or another person (including the lessee or a sublessee) in the 
active conduct of the activities described in section 907 (c)(1)(A) or 
(c)(2) (A) through (C). The leases or licenses described in this 
paragraph (g)(3) include, for example, a lease of a means of 
transportation under a bareboat charter hire, of drilling equipment used 
in extraction operations, or the license of a patent, know-how, or 
similar intangible property used in extracting, transporting, 
distributing or processing minerals or primary products. This paragraph 
(g)(3) applies without regard to whether the parties are related 
persons.
    (4) Related person. A person will be treated as a related person for 
purposes of this paragraph (g) if that person would be so treated within 
the meaning of section 954(d)(3) (as applied by substituting the word 
``corporation'' for the word ``controlled foreign corporation'') or that 
person is a partnership or partner described in section 707(b)(1).
    (5) Gross income. A foreign corporation shall be treated as a 
domestic corporation for the purpose of applying the gross-income rules 
in paragraph (g)(1) (ii) and (iii) of this section.

[[Page 1047]]

    (h) Coordination with other provisions--(1) Certain adjustments. The 
character of income as FOGEI or FORI is determined before making any 
adjustment under section 482 or section 907(d). For example, assume that 
X and Y are related parties, Y's only income is from the sale of oil 
that Y purchased from X, and FOGEI from X is diverted to Y through an 
arrangement described in paragraph (b)(3) of this section. Accordingly, 
Y has FOGEI. If under section 482 the Commissioner reallocates the FOGEI 
from Y to X, then Y's remaining income represents only a profit from 
distributing the oil, and thus is FORI. If the foreign taxes paid by Y 
on this income are otherwise creditable under section 901, the foreign 
taxes that are not refunded to Y retain their characterization as FOGEI 
taxes.
    (2) Section 901(f). Section 901(f) (relating to certain payments 
with respect to oil and gas not considered as taxes) applies before 
section 907. Taxes disallowed by section 901(f) are added to the cost or 
inventory amount of oil or gas.

[T.D. 8338, 56 FR 11067, Mar. 15, 1991]



Sec.  1.907(c)-2  Section 907(c)(3) items 
(for taxable years beginning after December 31, 1982).

    (a) Scope. This section provides rules relating to certain items 
listed in section 907(c)(3). The rules of this section are expressed in 
terms of FORI but apply for determining FOGEI by substituting ``FOGEI'' 
for ``FORI'' whenever appropriate. FOGEI does not include interest 
described in section 907(c)(3)(A). Dividends paid prior to January 1, 
1987, and described in section 907(c)(3)(B), as in effect prior to 
amendment by the Technical and Miscellaneous Revenue Act of 1988, are 
included in FORI and not FOGEI.
    (b) Dividend--(1) Section 1248 dividend. A section 1248 dividend is 
a dividend described in section 907(c)(3)(A). Except as otherwise 
provided in this paragraph (b)(1), gain (or loss) from the disposition 
of stock in any corporation is not FOGEI or FORI. See Sec.  1.907(c)-
1(e) (3) and (4).
    (2) Section 78 dividend. A section 78 dividend is FORI to the extent 
it arises from a dividend described in section 907(c)(3)(A), or an 
amount described in section 907(c)(3)(C).
    (c) Taxes deemed paid--(1) Voting stock test. Items described in 
section 907(c)(3) (A) or (C) are FORI only if a deemed-paid-tax test is 
met under the criteria of section 902 or 960. The purpose of this test 
is to require minimum direct or indirect ownership by a domestic 
corporation in the voting stock of a foreign corporation as a 
prerequisite for the item to qualify as FORI in the hands of the 
domestic corporation. The test is whether a domestic corporation would 
be deemed to pay any taxes of a foreign corporation when a dividend or 
an amount described in section 907(c)(3) (A) or (C), respectively, is 
included in the domestic corporation's gross income. In the case of 
interest described in section 907(c)(3)(A), the test is whether any 
taxes would be deemed paid if there were a hypothetical dividend.
    (2) Dividends and interest. For purposes of section 907(c)(3)(A), a 
domestic corporation is deemed under section 902 to pay taxes in respect 
of dividends and interest received from a foreign corporation whether or 
not the foreign corporation:
    (i) Actually pays or is deemed to pay taxes, or
    (ii) In the case of interest, actually pays dividends.


This paragraph (c)(2) also applies to dividends received by a foreign 
corporation from a second-tier or third-tier foreign corporation (as 
defined in Sec.  1.902-1(a)(3)(i) and (4), respectively). In the case of 
interest received by a foreign corporation from another foreign 
corporation, this paragraph (c)(2) applies if the taxes of both foreign 
corporations would be deemed paid under section 902 (a) or (b) for 
purposes of applying section 902(a) to the same taxpayer which is a 
domestic corporation. In the case of interest received by any 
corporation (whether foreign or domestic), all members of an affiliated 
group filing a consolidated return will be treated as the same taxpayer 
under section 907(c)(3)(A) if the foreign taxes of the payor and (if the 
recipient is a foreign corporation) the foreign taxes of the recipient 
would be deemed paid under section 902 by at least one member. The term 
``member'' is defined in

[[Page 1048]]

Sec.  1.1502-1(b). Thus, for example, assume that P owns all of the 
stock of D1 and D2 and P. D1, and D2 are members of an affiliated group 
filing a consolidated return. Assume further that D1 owns all of the 
stock of F1 and D2 owns all of the stock of F2, where F1 and F2 are 
foreign corporations. Interest paid by F1 to P, D2, or F2 may be FORI.
    (3) Amounts included under section 951(a). For purposes of section 
907(c)(3)(C), a domestic corporation is deemed under section 960 to pay 
taxes in respect of a foreign corporation, whether or not the foreign 
corporation actually pays taxes on the amounts included in gross income 
under section 951(a).
    (d) Amount attributable to certain items--(1) Certain dividends--(i) 
General rule. The portion of a dividend described in section 
907(c)(3)(A) that is FORI equals--

Amount of dividend x a/b

a = FORI accumulated profits in excess of FORI taxes paid or accrued, 
          and
b = Total accumulated profits in excess of total foreign taxes paid or 
          accrued.


This paragraph (d)(1)(i) applies even though the FORI accumulated 
profits arose in a taxable year of a foreign corporation beginning 
before January 1, 1983. Determination of the FORI amount of dividends 
under this paragraph (d)(1)(i) must be made separately for FORI 
accumulated profits and total accumulated profits that arose in taxable 
years beginning before January 1, 1987, and for FORI accumulated profits 
and total accumulated profits that arose in taxable years beginning 
after December 31, 1986. Dividends are deemed to be paid first out of 
FORI and total accumulated profits that arose in table years beginning 
after December 31, 1986. With regard to FORI accumulated profits and 
total accumulated profits that arose in taxable years beginning after 
December 31, 1986, the portion of a dividend that is FORI equals--

Amount of dividend x a/b

a = Post-1986 undistributed FORI earnings determined under the 
          principles of section 902(c)(1), and
b = Post-1986 undistributed earnings determined under the principles of 
          section 902(c)(1).

    (ii) Cross-references. See Sec.  1.902-1(g) for the determination of 
a foreign corporation's earnings and profits and of those out of which a 
dividend is paid. See Sec.  1.1248-2 or 1.1248-3 for the determination 
of the earnings and profits attributable to the sale or exchange of 
stock in certain foreign corporations.
    (2) Interest received from certain foreign corporations. Interest 
described in section 907(c)(3)(A) is FORI to the extent the 
corresponding interest expense of the paying corporation is properly 
allocable and apportionable to the gross income of the paying 
corporation that would be FORI were that corporation a domestic 
corporation. This allocation and apportionment is made in a manner 
consistent with the rules of section 954(b)(5) and Sec.  1.861-8(e)(2).
    (3) Dividends from domestic corporation. The amount of a dividend 
from a corporation described in section 907(c)(3)(B), as in effect prior 
to amendment by the Technical and Miscellaneous Revenue Act of 1988, 
paid in a taxable year of that corporation beginning before December 31, 
1986, that is FORI is determined under the principles of paragraph 
(d)(1)(i) of this section with respect to its current earnings and 
profits under section 316(a)(2) or its accumulated earnings and profits 
under section 316(a)(1), as the case may be.
    (4) Amounts with respect to which taxes are deemed paid under 
section 906(a)--(i) Portion attributable to FORI. The portion of an 
amount described in section 907(c)(3)(C) that is FORI equals:
[GRAPHIC] [TIFF OMITTED] TC07OC91.045

A = Amount described in section 907(c)(3)(C)
B = FORI earnings and profits
C = Total earnings and profits


For taxable years ending after January 23, 1989, the facts and 
circumstances will be used to determined what part of the amount of the 
section 907(c)(3)(C) amount is directly attributable to FOGEI, FORI and 
other income.
    (ii) Earnings and profits. Total earnings and profits are those of 
the foreign corporation for a taxable year under section 964 and the 
regulations under that section.

[[Page 1049]]

    (5) Section 78 dividend. The portion of a section 78 dividend that 
will be considered FORI will equal the amount of taxes deemed paid under 
either section 902(a) or section 960(a)(1) with respect to the dividend 
to the extent the taxes deemed paid are FORI taxes under Sec.  1.907(c)-
3 (b) or (c). See Sec.  1.907(c)-3(a)(1).
    (6) Special rule. (i) No item in the formula described in paragraph 
(d)(1)(i) of this section includes amounts excluded from the gross 
income of a United States shareholder under section 959(a)(1).
    (ii) With respect to a foreign corporation, earnings and profits in 
the formula described in paragraph (d)(4)(i) of this section do not 
include amounts excluded under section 959(b) from its gross income.
    (7) Deficits--(i) Allocation of deficits within a separate category. 
In a taxable year in which a foreign corporation described in section 
907(c)(3)(A) pays a dividend or has income that is subject to inclusion 
under section 951, if the foreign corporation has positive post--1986 
undistributed earnings in a separate category but within that separate 
category there is a deficit in post-1986 undistributed earnings 
attributable to earnings other than FOGEI and FORI, that deficit shall 
be allocated ratably between the FOGEI and FORI post-1986 undistributed 
earnings within that separate category. Any deficit in post-1986 
undistributed earnings attributable to either FOGEI or FORI shall be 
allocated first to FOGEI or FORI post-1986 undistributed earnings (as 
the case may be) to the extent thereof. Post-1986 undistributed FORI 
earnings are the post-1986 undistributed earnings (as defined in section 
902 and the regulations under that section) attributable to FORI as 
defined in section 907(c) (2) and (3). Post-1986 undistributed FOGEI 
earnings are the post-1986 undistributed earnings (as defined in section 
902 and the regulations under that section) attributable to FOGEI as 
defined in section 907(c) (1) and (3).

    Example. Foreign corporation X for years 1987 and 1988 had the 
following undistributed earnings (none of which is income that is 
subject to inclusion under section 951) and foreign taxes:

------------------------------------------------------------------------
                                                        Earnings   Taxes
------------------------------------------------------------------------
FOGEI.................................................     $800     $400
FORI..................................................     (750)  ......
Other.................................................      700      250
                                                       -----------------
  Total...............................................     $750     $650
                                                       -----------------
------------------------------------------------------------------------



On December 31, 1988, X paid a dividend of all of its post-1986 
undistributed earnings to its sole shareholder Y. Under paragraph (d)(5) 
and (7)(i) of this section and Sec.  1.907 (c)-2 (d)(5), $450 of Y's 
dividend is attributable to FOGEI ($50 from undistributed earnings plus 
a $400 section 78 dividend) and $950 is attributable to other earnings 
($700 from undistributed earnings plus a $250 section 78 dividend).

    (ii) Deficits allocated among separate categories. If a deficit in a 
separate category (``first separate category'') is allocated to another 
separate category (``second separate category'') under sections 902 and 
960 pursuant to notice 88-71, 1988-2 CB 374 and the regulations under 
those sections, the following rules shall apply. Any deficit in post-
1986 undistributed earnings attributable to either FOGEI (or FORI) from 
the first separate category shall be allocated to post-1986 
undistributed earnings in the second separate category to the extent 
thereof in the following order:
    (A) FOGEI (or FORI),
    (B) FORI (or FOGEI), and
    (C) Other income.


Any deficit in post-1986 undistributed earnings attributable to other 
income from the first separate category shall be allocated first to 
other post-1986 undistributed earnings and then ratably to FOGEI and 
FORI post--1986 undistributed earnings in the second separate category.
    (iii) Pre-1987 deficits. The amount of a dividend paid by a foreign 
corporation described in section 907(c)(3)(A) out of positive pre-1987 
earnings that is attributable to FOGEI and FORI shall be determined in a 
manner similar to that used in paragraph (d)(7) (i) and (ii) of this 
section except that the determinations shall be made on an annual basis.
    (8) Illustrations. The application of this paragraph (d) is 
illustrated by the following examples.

    Example 1. X, a domestic corporation, owns all of the stock of Y, a 
foreign corporation organized in country S. Y owns all of the

[[Page 1050]]

stock of Z, a foreign corporation also organized in country S. Each 
corporation uses the calendar year as its taxable year. In 1983, Z has 
$150 of FOGEI earnings and profits and $250 of earnings and profits 
other than FOGEI or FORI. Assume that Z paid no taxes to S and X must 
include $100 in its gross income under section 951(a) with respect to Z. 
Under paragraph (d)(4)(i) of this section, $37.50 of the amount 
described in section 951(a) is FOGEI ($100 x $150/$400). the remaining 
$62.50 of the section 951(a) amount represents other income.
    Example 2. Assume the same facts as in Example 1 except that the 
taxable year in question is 1988. In addition, under the facts and 
circumstances, it is determined that of the $100 section 951(a) amount 
included in X's gross income, $30 is directly attributable to Z's FOGEI 
activity, $60 is directly attributable to Z's FORI activity and $10 is 
directly attributable to Z's other activity. Accordingly, under 
paragraph (d)(4)(i), $30 will be FOGEI and $60 will be FORI to X.
    Example 3. (i) Assume the same facts as in Example 1. Assume further 
that, in 1983, Z distributes its entire earnings and profits ($400) to Y 
which consists of a dividend of $300 and a section 959(a)(1) 
distribution of $100. Y has no other earnings and profits during 1983. 
Assume that the dividend and distribution are not foreign personal 
holding company income under section 954(c). Y pays no taxes to S. In 
1983, Y distributes its entire earnings and profits to X.
    (ii) Under paragraphs (c)(2) and (d)(1)(i) of this section, Y has 
FOGEI of $112.50, i.e., the amount of the dividend received by Y ($300) 
multiplied by the fraction described in paragraph (d)(1)(i). The 
numerator of the fraction is Z's FOGEI accumulated profits in excess of 
the FOGEI taxes paid ($112.50) and the denominator is Z's total 
accumulated profits in excess of total foreign taxes paid ($400) minus 
the amount excluded from Y's gross income under section 959(a)(1) 
($100). The rule of paragraph (d)(6)(ii) of this section does not apply 
since X does not include any amount in its gross income under section 
951(a) with respect to Y. If Y paid taxes to S, this paragraph (d) would 
apply to characterize those taxes as FOGEI taxes or other taxes. See 
Sec.  1.907(c)-3(a)(8) and Example 2 (iii) under Sec.  1.907(c)-3(e).
    (iii) The distribution from Y to X is a dividend to the extent of 
$300, i.e., the amount of the distribution ($400) minus the amount 
excluded from X's gross income under section 959(a)(1) ($100). Under 
paragraphs (d) (1)(i) and (6)(i) of this section, $112.50 of the 
dividend is FOGEI, i.e., the amount of the dividend ($300) multiplied by 
a fraction. The numerator of the fraction is $112.50, i.e., the FOGEI 
accumulated profits of Y in excess of FOGEI taxes paid ($150) minus the 
FOGEI accumulated profits of Y in excess of FOGEI taxes paid excluded 
from X's gross income under section 959(a)(1) ($37.50). The denominator 
of the fraction is $300, i.e., the total accumulated profits of Y in 
excess of taxes paid ($400) minus the amount excluded from X's gross 
income under section 959(a)(1) ($100).
    Example 4. Assume the same facts as in Example 1 with the following 
modifications: In 1983, Z's only earnings and profits are FORI earnings 
and profits which are included in X's gross income under section 951(a). 
Z distributes its entire earnings and profits to Y. In 1983, Y has total 
earnings and profits of $100 without regard to the dividend from Z, $60 
of which are FORI earnings and profits. Y also has $40 which is included 
in X's gross income under section 951(a). Under paragraph (d)(6)(ii) of 
this section, the dividend from Z is disregarded for purposes of 
applying paragraph (d)(4)(i) of this section to the $40 included in X's 
gross income under section 951(a) with respect to Y. Accordingly, $24 of 
the amount described in section 951(a) is FORI ($40 x $60/$100). Had 
these circumstances existed in 1988, and if the $40 included in X's 
gross income under section 951(a) was directly attributable to FORI 
activity, all of that income would be FORI to X.

    (e) Dividends, interest, and other amounts from sources within a 
possession. FORI includes the items listed in (A) and (C) to the extent 
attributable to FORI of a corporation that is created or organized in or 
under the laws of a possession of the United States.
    (f) Income from partnerships, trusts, etc. FORI and FOGEI include a 
person's distributive share (determined under the principles of section 
704) of the income of any partnership and amounts included in income 
under subchapter J of chapter 1 of the Code (relating to the taxation of 
trusts, estates, and beneficiaries) to the extent the income and amounts 
are attributable to FORI and FOGEI. For taxable years beginning after 
1986, the principles of Sec.  1.904-5 (h) and (i) shall be applied to 
determine whether (and to what extent) a person's distributive share is 
FORI and FOGEI. Thus, for example, a less-than-10 percent corporate 
partner's share of income of the partnership would generally be treated 
as passive income to the partner, and not as FORI or FOGEI, unless an 
exception under Sec.  1.904-5 (h) and (i) applies.

[T.D. 8338, 56 FR 11071, Mar. 15, 1991]

[[Page 1051]]



Sec.  1.907(c)-3  FOGEI and FORI taxes 
(for taxable years beginning after December 31, 1982).

    (a) Tax characterization, allocation and apportionment--(1) Scope. 
Paragraphs (a)(2) through (6) of this section provides rules for the 
characterization, allocation, and apportionment of the income taxes 
(other than withholding taxes) paid or accrued to a foreign country 
among FOGEI, FORI, and other income relevant for purposes of sections 
907 and 904. Some of the rules in this section are expressed in terms of 
FOGEI taxes but they apply to FORI taxes by substituting ``FORI taxes'' 
for ``FOGEI taxes'' whenever appropriate. For the treatment of 
withholding taxes, see paragraph (a)(8) of this section. FOGEI taxes are 
determined without any reduction under section 907(a). In addition, 
determination of FOGEI taxes will not be affected by recharacterization 
of FOGEI by section 907(c)(4). See Sec.  1.907(c)-1(c)(5). Foreign taxes 
will not be characterized as creditable FORI taxes if section 907(b) and 
Sec.  1.907(b)-1 apply.
    (2) Three classes of income. There are three classes of income: 
FOGEI, FORI, and other income.
    (3) More than one class in a foreign tax base. If more than one 
class of income is taxed under one tax base under the law of a foreign 
country, the amount of pre-credit foreign tax for each base must be 
determined. This amount is the foreign taxes paid or accrued to that 
country for the base as increased by the tax credits (if any) which 
reduced those taxes and were allowed in the country for that tax. More 
than one class of income is taxed under the same base, if, under a 
foreign country's law, deductions from one class of income may reduce 
the income of any other class and the classes are subject to foreign tax 
at the same rates.
    (4) Allocation of tax within a base. If more than one class of 
income is taxed under the same base under a foreign country's law, the 
pre-credit foreign tax for the base is apportioned to each class of 
income in proportion to the income of each class. Tax credits are than 
allocated (under paragraph (a)(6) of this section) to the apportioned 
pre-credit tax. Income of a class over the deductions allowed under 
foreign law for, and which are attributable to, that class.
    (5) Modified gross income. Modified gross income is not necessarily 
the same as gross income as defined for purposes of chapter 1 of the 
Internal Revenue Code. Modified gross income is determined with 
reference to the foreign tax base for gross income (or its equivalent). 
However, the characterization of the base as a particular class of 
income is governed by general principles of U.S. tax law. Thus, for 
example--
    (i) Gross income from extraction is the fair market value of oil or 
gas in the immediate vicinity of the well (as determined under Sec.  
1.907(c)-1(b)(6) (without any deductions)).
    (ii) Whether cost of goods sold (or any other deduction) is a 
deduction from modified gross income and the amount of such a deduction 
is determined under foreign law.
    (iii) Modified gross income includes items that are part of the 
foreign tax base even though they are not gross income under U.S. law so 
long as the foreign taxes paid on the base constitute creditable taxes 
under section 901 (including taxes described in section 903). For 
example, if a foreign country imposes a tax (creditable under section 
901) on a tax base that includes in small part a percentage of the value 
of a company's oil reserves in place, modified gross income from 
extraction includes such a percentage of value solely for purposes of 
making the tax allocation in paragraph (a)(4) of this section.
    (iv) Modified gross income from extraction is increased for purposes 
of this paragraph (a)(5) by the entire excess of the posted price over 
fair market value if the foreign country uses a posted price system or 
other pricing arrangement described in section 907(d) in imposing its 
income tax.
    (v) Modified gross income from FORI is that income attributable to 
the activities in sections 907(c)(2) (A) through (C) and (E).
    (vi) Modified gross income for any class may not include gross 
income that is not subject to taxation by the foreign country.

[[Page 1052]]

    (6) Allocation of tax credits. The foreign taxes paid or accrued on 
a particular class of income equals the precredit tax on the class 
reduced (but not below zero) by the credits allowed under foreign law 
against the foreign tax on the particular class. Any tax credit 
attributable to a class that is not allocated to that class is allocated 
to the other class in the base or, if there are three classes in the 
base, is apportioned ratably among the taxes paid or accrued on the 
other two classes (as reduced in accordance with the preceding 
sentence).
    (7) Withholding taxes. Paragraph (a)(2) through (6) of this section 
does not apply to withholding taxes imposed by a foreign country. FOGEI 
taxes may include withholding taxes imposed with respect to a 
distribution from a corporation. The portion of the total withholding 
taxes on a distribution that constitutes FOGEI taxes is determined by 
the portion of the distribution that is FOGEI. In addition, FOGEI taxes 
may include taxes imposed on a distribution described in section 
959(a)(1) or on amounts described in section 959(b). The portion of the 
total withholding taxes imposed on a distribution described in section 
959(a)(1) or on amounts described in section 959(b) is determined by 
reference to the portion of the amount included in gross income under 
section 951(a) that was FOGEI.
    (b) Dividends--In general. (i) FOGEI taxes deemed paid with respect 
to a dividend equal the total taxes deemed paid with respect to the 
dividend multiplied by the fraction:

FOGEI taxes paid or accrued by the payor/Total foreign taxes paid or 
accrued by the payor.

    (ii) With regard to dividends received in taxable years beginning 
after December 31, 1986, FOGEI taxes deemed paid with respect to a 
dividend equal the total taxes deemed paid with respect to the portion 
of the dividend within a separate category multiplied by the fraction:
[GRAPHIC] [TIFF OMITTED] TC07OC91.046

    (iii) This paragraph (b) applies to a dividend described in section 
907(c)(3)(A) (including a section 1248 dividend) with reference to the 
particular taxable year or years of those accumulated profits out of 
which a dividend is paid. Determination of FOGEI taxes under this 
paragraph (b) must be made separately.
    (A) For FOGEI taxes paid on FOGEI accumulated profits and total 
taxes paid on accumulated profits that arose in taxable years beginning 
before January 1, 1987, to which paragraph (b)(1)(i) of this section 
applies, and
    (B) For FOGEI taxes paid on FOGEI accumulated profits and total 
taxes paid on accumulated profits that arose in taxable years beginning 
after December 31, 1986, to which paragraph (b)(1)(ii) of this section 
applies.


For purposes of these determinations, dividends are deemed to be paid 
first out of FOGEI and total accumulated profits that arose in taxable 
years beginning after December 31, 1986. See Sec.  1.907(c)-2(d)(1)(i). 
See section 960(a)(3) and Sec.  1.960-2 relating to distributions that 
are treated as dividends for purposes of section 902.
    (2) Section 78 dividend. There are no FOGEI taxes with respect to 
section 78 dividends.
    (c) Includable amounts under section 951(a). (1) FOGEI taxes deemed 
paid with respect to an amount includable in gross income under section 
951(a) equal the total taxes deemed paid with respect to that amount 
multiplied by the fraction:

[[Page 1053]]

[GRAPHIC] [TIFF OMITTED] TC07OC91.047

    (2) With regard to an amount includable in gross income under 
section 951(a) in taxable years beginning after December 31, 1986, FOGEI 
taxes deemed paid with respect to that amount equal the total taxes 
deemed paid with respect to that amount within a separate category 
multiplied by the fraction:
[GRAPHIC] [TIFF OMITTED] TC07OC91.048


Taxes in the fraction in this paragraph (c)(2) include only those 
foreign taxes that may be deemed paid under section 960(a) by reason of 
such inclusion. See Sec. Sec.  1.960-1(c)(3) and 1.960-2(c).
    (d) Partnerships. A partner's distributive share of the 
partnership's FOGEI taxes is determined under the principles of section 
704.
    (e) Illustrations. The application of this section may be 
illustrated by the following examples.

    Example 1. X, a domestic corporation, owns all of the stock of Y, a 
foreign corporation organized in country S. Y owns all of the stock of 
Z, a foreign corporation organized in country T. Each corporation used 
the calendar year as its taxable year. In 1983, X includes in its gross 
income an amount described in section 951(a) with respect to Z. Assume 
that the taxes deemed paid under section 902(a) by X by reason of such 
an inclusion is $70. Assume further that Z paid total taxes of $120, $80 
of which is FOGEI tax. Under paragraph (c) of this section, the FOGEI 
tax deemed paid is $46.67 (i.e., $70 x $80/$120). This $46.67 is also 
FOGEI under Sec.  1.907(c)-2(d)(5) because it must be included in X's 
gross income under section 78.
    Example 2. (i) Assume the same facts as in Example 1. Assume further 
that in 1983, Z distributes its entire earnings and profits to Y. Y has 
no earnings and profits during 1983 other than this dividend. Y paid a 
tax of $50 to S. Assume that Y is deemed under section 902(b)(1) to pay 
$50 of the tax paid by Z which was not deemed paid by X under section 
960(a)(1) in 1983. In 1983, Y distributes its entire earnings and 
profits to X. Assume that X is deemed under section 902(a) to pay $100 
of the taxes actually paid, and deemed paid, by Y.
    (ii) Paragraph (b)(1) of this section applies to characterize the 
$50 tax of Z that Y is deemed to pay under section 902(b)(1). Y is 
deemed to pay $33.33 of FOGEI tax, i.e., the amount of the tax deemed 
paid by Y ($50) multiplied by a fraction. The numerator of the fraction 
is the amount of Z's FOGEI tax ($80) and the denominator is the total 
taxes paid by Z ($120).
    (iii) Under paragraph (a)(8) of this section, a portion of the $50 
tax actually paid by Y on the earnings and profits received from Z is 
FOGEI tax. The amount of tax actually paid by Y that is FOGEI tax 
depends on the amount of the distribution from Z that is FOGEI (see 
Sec.  1.907(c)-2(d)(1) (i) and Example 2 (ii) under Sec.  1.907(c)-
2(d)(8)). This result does not depend upon whether a portion of the 
distribution from Z is described in section 959(b) and it follows even 
though a portion of Y's earnings and profits will be excluded from X's 
gross income under section 959(a)(1) when distributed by Y. Assume that 
$12.50 of the $50 tax actually paid by Y is FOGEI tax.
    (iv) Under paragraph (b)(1) of this section, X is deemed to pay 
$45.83 of FOGEI tax by reason of the distribution from Y. This amount is 
determined by multiplying the total taxes deemed paid by X by reason of 
such distribution ($100) by a fraction. The numerator of the fraction is 
the FOGEI tax paid, and deemed paid, by Y ($45.83, i.e., $33.33 under 
paragraph (ii) of this example plus $12.50 under paragraph (iii) of this 
example). The denominator of the fraction is the total taxes paid, and 
deemed paid, by Y ($100). This $45.83 is FOGEI under Sec.  1.907(c)-
2(d)(5) because it is included in X's gross income as a section 78 
dividend.
    Example 3. (i) X, a domestic corporation, has a concession with 
foreign country Y that gives it the exclusive right to extract and 
export the crude oil and natural gas owned by Y. The concession 
agreement and location of

[[Page 1054]]

the oil and gas wells mandate that X construct a system of pipelines to 
transport the minerals that are extracted to a port where they are 
loaded onto tankers for export. X owns the transportation facilities. Y 
has an income tax system under which income from mineral operations is 
subject to a 50 percent tax rate. The taxation by Y of the mineral 
operations is a separate tax base under paragraph (a)(3) of this 
section. Under this system, Y imposes the tax at the port prior to 
export and it establishes a posted price of $12 per barrel. Y also 
collects royalties of $1.44 per barrel (i.e., 12 percent of this posted 
price) which is deductible in computing the petroleum tax. Y also allows 
X deductible lifting costs of $.20 per barrel and deductible 
transporting costs of $.80 per barrel. Y does not allow any credits 
against the mineral tax. Assume that X does not have any income in Y 
other than the mineral income. (In 1983, X extracts, transports, and 
exports 10,000,000 barrels of crude oil, but for convenience, all 
computations are in terms of one barrel). X pays foreign taxes of $4.78 
per barrel, computed as follows:

Sales.................................................  .......   $12.00
Royalties.............................................    $1.44  .......
Lifting...............................................      .20  .......
Transporting..........................................      .80  .......
                                                       ---------
                                                           2.44   (2.44)
                                                                --------
Income base...........................................  .......     9.56
Tax rate (percent)....................................  .......      .50
Tax...................................................  .......     4.78
 


Assume that these taxes are creditable taxes under section 901, that the 
fair market value of the oil at the port is $10 per barrel, and that 
under Sec.  1.907(c)-1(b)(6) fair market value in the immediate vicinity 
of the oil wells is $9 per barrel. Thus, at the port, the excess of 
posted price ($12) over fair market value ($10) is $2.
    (ii) The $4.78 foreign tax paid to Y is allocated to FOGEI and FORI 
in accordance with the rules in paragraph (a)(2) through (5) of this 
section.
    (iii) Under paragraph (a)(3) of this section, FOGEI and FORI are 
subject to foreign taxation under one tax base. This foreign tax is 
allocated between FOGEI tax and FORI tax in accordance with paragraph 
(a)(4) and (5) of this section.
    (iv) The modified gross income for FOGEI is $11, i.e., fair market 
value in the immediate vicinity of the well ($9) plus the excess at the 
port of posted price over fair market value ($2). The modified gross 
income for FORI is $1, i.e., value added to the oil beyond the well-head 
which is part of Y's tax base ($10-$9).
    (v) The royalty deductions are all directly attributable to FOGEI.
    (vi) Under paragraph (a)(4) of this section, the income of each 
class is determined as follows:

------------------------------------------------------------------------
                                                        FOGEI     FORI
------------------------------------------------------------------------
Modified gross income...............................    $11.00     $1.00
Deductions:
    Royalties.......................................      1.44         0
    Lifting.........................................       .20         0
    Transporting....................................         0       .80
    Total...........................................      1.64       .80
Net Income..........................................      9.36       .20
------------------------------------------------------------------------

    (vii) Under paragraph (a)(4) of this section, the total tax paid to 
Y is allocated to FOGEI and FORI in proportion to the income in each 
class. The calculation is as follows:

FOGEI tax = $4.78 x $9.36/$9.56 = $4.68
FORI tax = $4.78 x $0.20/$9.56 = $0.10

Thus, for the 10,000,000 barrels, the FOGEI tax is $46,800,000 and the 
FORI tax is $1,000,000.

    (viii) The allocation under paragraph (a)(4) of this section, rather 
than the direct application of stated foreign tax rates to foreign-law 
taxable income in each class of income (which would produce the same 
results in the facts of this example), is necessary when a foreign 
country taxes more than one class of income under a progressive rate 
structure. See Example 4 in this paragraph (e).
    Example 4. Assume the same facts as in Example 3 except that Y's tax 
is imposed at 40 percent for the first $20,000,000 of income and at 60 
percent for all other income. The foreign taxes are allocated under 
paragraph (a)(4) of this section between FOGEI and FORI in the same 
manner as in paragraphs (vi) and (vii) of Example 3, as follows:

(1) Taxable income........................................   $95,600,000
(2) Tax:
    (a) 40% of $20,000,000................................     8,000,000
    (b) 60% of $75,600,000................................    45,360,000
    (c) Total tax.........................................    53,360,000
(3) FOGEI tax (line 2(c) x $9.36/$9.56)...................    52,243,680
(4) FORI tax (line 2(c) x $0.20/$9.56)....................     1,116,320
 

    Example 5. Assume the same facts as in Example 3. Assume further 
that X refines the crude oil into primary products prior to export and Y 
imposes its tax on the basis of crude oil equivalences of $12 per 
barrel, rather than the value of the primary products, to establish port 
prices. Assume that this arrangement is a pricing arrangement described 
in section 907(d). Thus, Y does not tax the refinery income. The results 
are the same as in Example 3 even if $12 per barrel is equal to, more 
than, or less than, the value of the primary products at the port. See 
paragraph (a)(5)(vi) of this section.

[T.D. 8338, 56 FR 11073, Mar. 15, 1991]



Sec.  1.907(d)-1  Disregard of posted prices for purposes of chapter 1 
of the Code (for taxable years beginning after December 31, 1982).

    (a) In general--(1) Scope. Section 907(d) applies if a person has 
FOGEI from the--

[[Page 1055]]

    (i) Acquisition (other than from a foreign government) or
    (ii) Disposition of minerals at a posted price that differs from the 
fair market value at the time of the transaction. Also, if a seller 
(other than a foreign government) derives FOGEI upon a disposition 
described in the preceding sentence, section 907(d) applies to the 
acquisition by the purchaser whether or not the purchaser has FOGEI. 
Thus, section 907(d) may apply in determining a person's FORI.
    (2) Initial computation requirement. If section 907(d) applies to 
any person, income on the transaction as initially reflected on the 
person's return shall be computed as if the transaction were effected at 
fair market value. This requirement applies the first time a person has 
taxable income derived from either the transaction or an item (such as a 
dividend described in section 907(c)(3)(A)) determined with reference to 
that income.
    (3) Burden of proof. The taxpayer must be able to demonstrate the 
transaction as it actually occurred and the basis for reporting the 
transaction under the principles of paragraph (a)(2) of this section.
    (4) Related parties. Section 907(d) (as a rule of characterization) 
applies whether or not the parties to the transaction are related. Thus, 
the excess of the posted price over the fair market value may never be 
taken into account in determining a person's FOGEI under section 907(a) 
but may be taken into account in determining a person's FORI.
    (b) Adjustments. If a taxpayer does not comply with the initial 
requirement of paragraph (a)(2) of this section, adjustments under 
section 907(d) may be made only by the Commissioner in the same manner 
that section 482 is administered. Correlative and similar adjustments 
consistent with the substantive and procedural principles of section 482 
and Sec.  1.482-1(d) apply. However, section 907(d) is not a limitation 
on section 482. If a taxpayer disposing of minerals at a posted price 
does comply with the initial computation requirement of this section, 
adjustments and correlative and similar adjustments consistent with the 
substantive and procedural aspects of section 482 and Sec.  1.482-1(d) 
shall apply, whether made on the return by the taxpayer or on a later 
audit. This paragraph (b) does not apply to an actual sale or exchange 
of minerals made between persons with respect to whom adjustments under 
section 482 would never apply (but see paragraph (a)(4) of this 
section).
    (c) Definitions. For purposes of this section--
    (1) Foreign government. The term foreign government means only the 
integral parts or controlled entities of a foreign sovereign and 
political subdivisions of a foreign country.
    (2) Minerals. The term minerals has the same meaning as in Sec.  
1.907(c)-1(f)(1).
    (3) Posted price. The term posted price means the price set by, or 
at the direction of, a foreign government to calculate income for 
purposes of its tax or at which minerals must be sold.
    (4) Other pricing arrangement. The term other pricing arrangement in 
section 907(d) means a pricing arrangement having the effect of a posted 
price.
    (5) Fair market value. The term fair market value, whether or not at 
the port prior to export, is determined in the same way that the 
wellhead price is determined under Sec.  1.907(c)-1(b)(6).

[T.D. 8338, 56 FR 11075, Mar. 15, 1991]



Sec.  1.907(e)-1  [Reserved]



Sec.  1.907(f)-1  Carryback and carryover of credits disallowed 
by section 907(a) (for amounts carried between taxable years that each begin 
after December 31, 1982).

    (a) In general. If a taxpayer chooses the benefits of section 901, 
any unused FOGEI tax paid or accrued in a taxable year beginning after 
December 31, 1982, may be carried to the taxable years specified in 
section 907(f) under the carryback and carryover principles of this 
section Sec.  1.904-2(b). See section 907(e) and Sec.  1.907(e)-1 for 
transitional rules that apply to unused FOGEI taxes carried back or 
forward between a taxable year beginning before January 1, 1983, and a 
taxable year beginning after December 31, 1982.
    (b) Unused FOGEI tax--(1) In general. The ``unused FOGEI tax'' for 
purposes of this section is the excess of the FOGEI taxes for a taxable 
year (year of

[[Page 1056]]

origin) over that year's limitation level (as defined in Sec.  1.907(a)-
1(b)).
    (2) Year of origin. The term ``year of origin'' in the regulations 
under section 904 corresponds to the term ``unused credit year'' under 
section 907(f).
    (c) Tax deemed paid or accrued. The unused FOGEI tax from a year of 
origin that may be deemed paid or accrued under section 907(f) in any 
preceding or succeeding taxable year (``excess limitation year'') may 
not exceed the lesser of--
    (1) The excess extraction limitation for the excess limitation year, 
or
    (2) The excess general section 904 limitation for the excess 
limitation year.
    (d) Excess extraction limitation. Under section 907(f)(2)(A), the 
``excess extraction limitation'' for an excess limitation year is the 
amount by which that year's section 907(a) extraction limitation exceeds 
the sum of--
    (1) The FOGEI taxes paid or accrued, and
    (2) The FOGEI taxes deemed paid or accrued in that year by reason of 
a section 907(f) carryback or carryover from preceding years of origin.
    (e) Excess general section 904 limitation. Under section 
907(f)(2)(B), the ``excess general section 904 limitation'' for an 
excess limitation year is the amount by which that year's section 904 
general limitation exceeds the sum of--
    (1) The general limitation taxes paid or accrued (or deemed to have 
been paid under section 902 or 960) to all foreign countries and 
possessions of the United States during the taxable year,
    (2) The general limitation taxes deemed paid or accrued in such 
taxable year under section 904(c) and which are attributable to taxable 
years preceding the unused credit year, plus
    (3) The FOGEI taxes deemed paid or accrued in that year by reason of 
a section 907(f) carryover (or carryback) from preceding years of 
origin.
    (f) Section 907(f) priority. If a taxable year is a year of origin 
under both section 907(f) and section 904(c), section 907(f) applies 
first. See section 907(f)(3)(A).
    (g) Cross-reference. In computing the carryback and carryover of 
disallowed credits under section 907(f), the principles of Sec.  1.904-2 
(d), (e), and (f) apply.
    (h) Example. The following example illustrates the application of 
section 907(f).

    Example. X, a U.S. corporation organized on January 1, 1983, uses 
the accrual method of accounting and the calendar year as its taxable 
year. X's only income is income which is not subject to a separate tax 
limitation under section 904(d). X's preliminary U.S. tax liability 
indicates an effective rate of 46% for taxable years 1983-1985. X has 
the following foreign tax items for 1983-1985:

------------------------------------------------------------------------
                                            1983       1984       1985
------------------------------------------------------------------------
1. FOGEI...............................    $15,000    $20,000    $10,000
2. FOGEI taxes.........................      7,500      9,200      4,200
3. Other foreign taxable income........      8,000      5,000     10,000
4. Other foreign taxes.................      3,200      2,000      3,000
5. (a) Section 907(a) limitation (.46 x      6,900      9,200      4,600
 Line 1)...............................
  (b) General section 904 limitation        10,580     11,500      9,200
   (.46 x (line 1 plus line 3))........
6. (a) Unused FOGEI taxes (excess of           600          0          0
 line 2 over line 5(a))................
  (b) Unused general limitation taxes            0          0          0
   (excess of line 4 plus lesser of
   line 2 or line 5(a) over line 5(b)).
7. (a) FOGEI taxes from years preceding          0          0          0
 1983 deemed accrued under section
 907(f)................................
  (b) Section 904 general limitation             0          0          0
   taxes from years preceding 1983
   deemed accrued under section 904(c).
8. (a) Excess section 907(a) limitation          0          0        400
 (excess of line 5(a) over sum of line
 2 and line 7(a))......................
  (b) Excess section 904 general               480        300      2,000
   limitation (excess of line 5(b) over
   sum of line 4, lesser of line 2 and
   line 5(a) and line 7(b))............
9. Limit on FOGEI taxes that will be             0          0        400
 deemed accrued under section 907(f)
 (lesser of line 8(a) and line 8(b)....
------------------------------------------------------------------------


X has unused 1983 FOGEI taxes of $600. Since the excess section 907(a) 
limitation for 1984 is zero, the unused FOGEI taxes are carried to 1985. 
Of the $600 carryover, $400 is deemed accrued in 1985 and the balance of 
$200 is carried to following years (but not to a year after 1988). After 
the carryover from 1983 to 1985, the excess section 904 general 
limitation for 1985 (line 8(b)) is reduced by $400 to $1,600 to reflect 
the amount of 1983 FOGEI taxes deemed accrued in 1985 under section 
907(f).

[T.D. 8338, 56 FR 11079, Mar. 15, 1991]

[[Page 1057]]



                              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 1059]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2023)

                      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 1060]]

     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)
        LX  Federal Communications Commission (Parts 6000--6099)

                        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)

[[Page 1061]]

      XXVI  Department of Defense (Parts 3600--3699)
    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)

[[Page 1062]]

    LXXIII  Department of Agriculture (Parts 8300--8399)
     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 (Parts 10100--10199)
       CII  U.S. Office of Special Counsel (Parts 10200--10299)
       CIV  Office of the Intellectual Property Enforcement 
                Coordinator (Part 10400--10499)

                      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)

[[Page 1063]]

      VIII  Agricultural Marketing Service (Federal Grain 
                Inspection Service, Fair Trade Practices Program), 
                Department of Agriculture (Parts 800--899)
        IX  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Fruits, Vegetables, Nuts), Department 
                of Agriculture (Parts 900--999)
         X  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Milk), Department of Agriculture 
                (Parts 1000--1199)
        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  [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  [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]

[[Page 1064]]

      XLII  Rural Business-Cooperative Service and Rural Utilities 
                Service, Department of Agriculture (Parts 4200--
                4299)
         L  Rural Business-Cooperative Service, and Rural 
                Utilities Service, Department of Agriculture 
                (Parts 5000--5099)

                    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  [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]

[[Page 1065]]

         X  Consumer Financial Protection Bureau (Parts 1000--
                1099)
        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XII  Federal Housing Finance Agency (Parts 1200--1299)
      XIII  Financial Stability Oversight Council (Parts 1300--
                1399)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        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 1066]]

      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)
        XV  Office of the Under-Secretary for Economic Affairs, 
                Department of Commerce (Parts 1500--1599)
            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 1067]]

                     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 1068]]

                          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) (Parts 1700--1799) 
                [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]

[[Page 1069]]

        XX  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 3200--3899)
      XXIV  Board of Directors of the HOPE for Homeowners Program 
                (Parts 4000--4099) [Reserved]
       XXV  Neighborhood Reinvestment Corporation (Parts 4100--
                4199)

                           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)

[[Page 1070]]

        XI  Department of Justice and Department of State (Parts 
                1100--1199)

                            Title 29--Labor

            Subtitle A--Office of the Secretary of Labor (Parts 
                0--99)
            Subtitle B--Regulations Relating to Labor
         I  National Labor Relations Board (Parts 100--199)
        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

[[Page 1071]]

         I  Monetary Offices, Department of the Treasury (Parts 
                51--199)
        II  Fiscal Service, Department of the Treasury (Parts 
                200--399)
        IV  Secret Service, Department of the Treasury (Parts 
                400--499)
         V  Office of Foreign Assets Control, Department of the 
                Treasury (Parts 500--599)
        VI  Bureau of Engraving and Printing, Department of the 
                Treasury (Parts 600--699)
       VII  Federal Law Enforcement Training Center, Department of 
                the Treasury (Parts 700--799)
      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)

[[Page 1072]]

                          Title 34--Education

            Subtitle A--Office of the Secretary, Department of 
                Education (Parts 1--99)
            Subtitle B--Regulations of the Offices of the 
                Department of Education
         I  Office for Civil Rights, Department of Education 
                (Parts 100--199)
        II  Office of Elementary and Secondary Education, 
                Department of Education (Parts 200--299)
       III  Office of Special Education and Rehabilitative 
                Services, Department of Education (Parts 300--399)
        IV  Office of Career, Technical, and Adult Education, 
                Department of Education (Parts 400--499)
         V  Office of Bilingual Education and Minority Languages 
                Affairs, Department of Education (Parts 500--599) 
                [Reserved]
        VI  Office of Postsecondary Education, Department of 
                Education (Parts 600--699)
       VII  Office of Educational Research and Improvement, 
                Department of Education (Parts 700--799) 
                [Reserved]
            Subtitle C--Regulations Relating to Education
        XI  [Reserved]
       XII  National Council on Disability (Parts 1200--1299)

                          Title 35 [Reserved]

             Title 36--Parks, Forests, and Public Property

         I  National Park Service, Department of the Interior 
                (Parts 1--199)
        II  Forest Service, Department of Agriculture (Parts 200--
                299)
       III  Corps of Engineers, Department of the Army (Parts 
                300--399)
        IV  American Battle Monuments Commission (Parts 400--499)
         V  Smithsonian Institution (Parts 500--599)
        VI  [Reserved]
       VII  Library of Congress (Parts 700--799)
      VIII  Advisory Council on Historic Preservation (Parts 800--
                899)
        IX  Pennsylvania Avenue Development Corporation (Parts 
                900--999)
         X  Presidio Trust (Parts 1000--1099)
        XI  Architectural and Transportation Barriers Compliance 
                Board (Parts 1100--1199)
       XII  National Archives and Records Administration (Parts 
                1200--1299)
        XV  Oklahoma City National Memorial Trust (Parts 1500--
                1599)
       XVI  Morris K. Udall Scholarship and Excellence in National 
                Environmental Policy Foundation (Parts 1600--1699)

             Title 37--Patents, Trademarks, and Copyrights

         I  United States Patent and Trademark Office, Department 
                of Commerce (Parts 1--199)
        II  U.S. Copyright Office, Library of Congress (Parts 
                200--299)

[[Page 1073]]

       III  Copyright Royalty Board, Library of Congress (Parts 
                300--399)
        IV  National Institute of Standards and Technology, 
                Department of Commerce (Parts 400--599)

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--199)
        II  Armed Forces Retirement Home (Parts 200--299)

                       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  [Reserved]
       105  General Services Administration (Parts 105-1--105-999)

[[Page 1074]]

       109  Department of Energy Property Management Regulations 
                (Parts 109-1--109-99)
       114  Department of the Interior (Parts 114-1--114-99)
       115  Environmental Protection Agency (Parts 115-1--115-99)
       128  Department of Justice (Parts 128-1--128-99)
  129--200  [Reserved]
            Subtitle D--Federal Acquisition Supply Chain Security
       201  Federal Acquisition Security Council (Parts 201-1--
                201-99).
            Subtitle E [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)

[[Page 1075]]

                       Title 45--Public Welfare

            Subtitle A--Department of Health and Human Services 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Welfare
        II  Office of Family Assistance (Assistance Programs), 
                Administration for Children and Families, 
                Department of Health and Human Services (Parts 
                200--299)
       III  Office of Child Support Enforcement (Child Support 
                Enforcement Program), Administration for Children 
                and Families, Department of Health and Human 
                Services (Parts 300--399)
        IV  Office of Refugee Resettlement, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 400--499)
         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)
        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)

[[Page 1076]]

                      Title 47--Telecommunication

         I  Federal Communications Commission (Parts 0--199)
        II  Office of Science and Technology Policy and National 
                Security Council (Parts 200--299)
       III  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                300--399)
        IV  National Telecommunications and Information 
                Administration, Department of Commerce, and 
                National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 400--499)
         V  The First Responder Network Authority (Parts 500--599)

           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)

[[Page 1077]]

        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199) [Reserved]
        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)
        53  Department of the Air Force Federal Acquisition 
                Regulation Supplement (Parts 5300--5399) 
                [Reserved]
        54  Defense Logistics Agency, Department of Defense (Parts 
                5400--5499)
        57  African Development Foundation (Parts 5700--5799)
        61  Civilian Board of Contract Appeals, General Services 
                Administration (Parts 6100--6199)
        99  Cost Accounting Standards Board, Office of Federal 
                Procurement Policy, Office of Management and 
                Budget (Parts 9900--9999)

                       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)

[[Page 1078]]

        IV  Joint Regulations (United States Fish and Wildlife 
                Service, Department of the Interior and National 
                Marine Fisheries Service, National Oceanic and 
                Atmospheric Administration, Department of 
                Commerce); Endangered Species Committee 
                Regulations (Parts 400--499)
         V  Marine Mammal Commission (Parts 500--599)
        VI  Fishery Conservation and Management, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 600--699)

[[Page 1079]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2023)

                                                  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 1080]]

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 Affairs, Office of the Under-          15, XV
       Secretary for
  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

[[Page 1081]]

  Defense Logistics Agency                        32, I, XII; 48, 54
  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 Affairs, Office of the Under-Secretary   15, XV
     for
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
[[Page 1082]]

Export-Import Bank of the United States           2, XXXV; 5, LII; 12, IV
Family Assistance, Office of                      45, II
Farm Credit Administration                        5, XXXI; 12, VI
Farm Credit System Insurance Corporation          5, XXX; 12, XIV
Farm Service Agency                               7, VII, XVIII
Federal Acquisition Regulation                    48, 1
Federal Acquisition Security Council              41, 201
Federal Aviation Administration                   14, I
  Commercial Space Transportation                 14, III
Federal Claims Collection Standards               31, IX
Federal Communications Commission                 2, LX; 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

[[Page 1083]]

  Federal Management Regulation                   41, 102
  Federal Property Management Regulations         41, 101
  Federal Travel Regulation System                41, Subtitle F
  General                                         41, 300
  Payment From a Non-Federal Source for Travel    41, 304
       Expenses
  Payment of Expenses Connected With the Death    41, 303
       of Certain Employees
  Relocation Allowances                           41, 302
  Temporary Duty (TDY) Travel Allowances          41, 301
Geological Survey                                 30, IV
Government Accountability Office                  4, I
Government Ethics, Office of                      5, XVI
Government National Mortgage Association          24, III
Grain Inspection, Packers and Stockyards          7, VIII; 9, II
     Administration
Great Lakes St. Lawrence Seaway Development       33, IV
     Corporation
Gulf Coast Ecosystem Restoration Council          2, LIX; 40, VIII
Harry S. Truman Scholarship Foundation            45, XVIII
Health and Human Services, Department of          2, III; 5, XLV; 45, 
                                                  Subtitle A
  Centers for Medicare & Medicaid Services        42, IV
  Child Support Enforcement, Office of            45, III
  Children and Families, Administration for       45, II, III, IV, X, XIII
  Community Services, Office of                   45, X
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  Indian Health Service                           25, V
  Inspector General (Health Care), Office of      42, V
  Public Health Service                           42, I
  Refugee Resettlement, Office of                 45, IV
Homeland Security, Department of                  2, XXX; 5, XXXVI; 6, I; 8, 
                                                  I
  Coast Guard                                     33, I; 46, I; 49, IV
  Coast Guard (Great Lakes Pilotage)              46, III
  Customs and Border Protection                   19, I
  Federal Emergency Management Agency             44, I
  Human Resources Management and Labor Relations  5, XCVII
       Systems
  Immigration and Customs Enforcement Bureau      19, IV
  Transportation Security Administration          49, XII
HOPE for Homeowners Program, Board of Directors   24, XXIV
     of
Housing and Urban Development, Department of      2, XXIV; 5, LXV; 24, 
                                                  Subtitle B
  Community Planning and Development, Office of   24, V, VI
       Assistant Secretary for
  Equal Opportunity, Office of Assistant          24, I
       Secretary for
  Federal Acquisition Regulation                  48, 24
  Federal Housing Enterprise Oversight, Office    12, XVII
       of
  Government National Mortgage Association        24, III
  Housing--Federal Housing Commissioner, Office   24, II, VIII, X, XX
       of Assistant Secretary for
  Housing, Office of, and Multifamily Housing     24, IV
       Assistance Restructuring, Office of
  Inspector General, Office of                    24, XII
  Public and Indian Housing, Office of Assistant  24, IX
       Secretary for
  Secretary, Office of                            24, Subtitle A, VII
Housing--Federal Housing Commissioner, Office of  24, II, VIII, X, XX
     Assistant Secretary for
Housing, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office of
Immigration and Customs Enforcement Bureau        19, IV
Immigration Review, Executive Office for          8, V
Independent Counsel, Office of                    28, VII
Independent Counsel, Offices of                   28, VI
Indian Affairs, Bureau of                         25, I, V
Indian Affairs, Office of the Assistant           25, VI
     Secretary
Indian Arts and Crafts Board                      25, II

[[Page 1084]]

Indian Health Service                             25, V
Industry and Security, Bureau of                  15, VII
Information Resources Management, Office of       7, XXVII
Information Security Oversight Office, National   32, XX
     Archives and Records Administration
Inspector General
  Agriculture Department                          7, XXVI
  Health and Human Services Department            42, V
  Housing and Urban Development Department        24, XII, XV
Institute of Peace, United States                 22, XVII
Intellectual Property Enforcement Coordinator,    5, CIV
     Office of
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 Environmental Enforcement, Bureau    30, II
       of
  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

[[Page 1085]]

  Federal Contract Compliance Programs, Office    41, 60
       of
  Federal Procurement Regulations System          41, 50
  Labor-Management Standards, Office of           29, II, IV
  Mine Safety and Health Administration           30, I
  Occupational Safety and Health Administration   29, XVII
  Public Contracts                                41, 50
  Secretary of Labor, Office of                   29, Subtitle A
  Veterans' Employment and Training Service,      41, 61; 20, IX
       Office of the Assistant Secretary for
  Wage and Hour Division                          29, V
  Workers' Compensation Programs, Office of       20, I, 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

[[Page 1086]]

National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
     Administration
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, L
Rural Development Administration                  7, XLII
Rural Housing Service                             7, XVIII, XXXV, L
Rural Utilities Service                           7, XVII, XVIII, XLII, L
Safety and Environmental Enforcement, Bureau of   30, II
Science and Technology Policy, Office of          32, XXIV; 47, II
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

[[Page 1087]]

  Federal Acquisition Regulation                  48, 6
Surface Mining Reclamation and Enforcement,       30, VII
     Office of
Surface Transportation Board                      49, X
Susquehanna River Basin Commission                18, VIII
Tennessee Valley Authority                        5, LXIX; 18, XIII
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     2, XII; 5, L
  Commercial Space Transportation                 14, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 12
  Federal Aviation Administration                 14, I
  Federal Highway Administration                  23, I, II
  Federal Motor Carrier Safety Administration     49, III
  Federal Railroad Administration                 49, II
  Federal Transit Administration                  49, VI
  Great Lakes St. Lawrence Seaway Development     33, IV
       Corporation
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 47, IV; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  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
U.S. Office of Special Counsel                    5, CII
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 1089]]







                      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



    Authority: 26 U.S.C. 7805.



Sec.  602.101  OMB Control numbers.

    (a) Purpose. This part collects and displays the control numbers 
assigned to collections of information in Internal Revenue Service 
regulations by the Office of Management and Budget (OMB) under the 
Paperwork Reduction Act of 1980. The Internal Revenue Service intends 
that this part comply with the requirements of Sec. Sec.  1320.7(f), 
1320.12, 1320.13, and 1320.14 of 5 CFR part 1320 (OMB regulations 
implementing the Paperwork Reduction Act), for the display of control 
numbers assigned by OMB to collections of information in Internal 
Revenue Service regulations. This part does not display control numbers 
assigned by the Office of Management and Budget to collections of 
information of the Bureau of Alcohol, Tobacco, and Firearms.
    (b) Display.

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
1.1(h)-1(e)................................................    1545-1654
1.25-1T....................................................    1545-0922
                                                               1545-0930
1.25-2T....................................................    1545-0922
                                                               1545-0930
1.25-3T....................................................    1545-0922
                                                               1545-0930
1.25-4T....................................................    1545-0922
1.25-5T....................................................    1545-0922
1.25-6T....................................................    1545-0922
1.25-7T....................................................    1545-0922
1.25-8T....................................................    1545-0922
1.25A-1....................................................    1545-1630
1.28-1.....................................................    1545-0619
1.31-2.....................................................    1545-0074
1.32-2.....................................................    1545-0074
1.32-3.....................................................    1545-1575
1.36B-5....................................................    1545-2232
1.37-1.....................................................    1545-0074
1.37-3.....................................................    1545-0074
1.41-2.....................................................    1545-0619
1.41-3.....................................................    1545-0619
1.41-4A....................................................    1545-0074
1.41-4 (b) and (c).........................................    1545-0074
1.41-8(b)..................................................    1545-1625
1.41-8(d)..................................................    1545-0732
1.41-9.....................................................    1545-0619
1.42-1T....................................................    1545-0984
                                                               1545-0988
1.42-5.....................................................    1545-1357
1.42-6.....................................................    1545-1102
1.42-8.....................................................    1545-1102
1.42-10....................................................    1545-1102
1.42-13....................................................    1545-1357
1.42-14....................................................    1545-1423
1.42-17....................................................    1545-1357
1.42-18....................................................    1545-2088
1.43-3(a)(3)...............................................    1545-1292
1.43-3(b)(3)...............................................    1545-1292
1.44B-1....................................................    1545-0219
1.45D-1....................................................    1545-1765
1.45G-1....................................................    1545-2031
1.46-1.....................................................    1545-0123
                                                               1545-0155
1.46-3.....................................................    1545-0155
1.46-4.....................................................    1545-0155
1.46-5.....................................................    1545-0155
1.46-6.....................................................    1545-0155
1.46-8.....................................................    1545-0155
1.46-9.....................................................    1545-0155
1.46-10....................................................    1545-0118
1.47-1.....................................................    1545-0155
                                                               1545-0166
1.47-3.....................................................    1545-0155
                                                               1545-0166
1.47-4.....................................................    1545-0123
1.47-5.....................................................    1545-0092
1.47-6.....................................................    1545-0099
1.48-3.....................................................    1545-0155
1.48-4.....................................................    1545-0155
                                                               1545-0808
1.48-5.....................................................    1545-0155
1.48-6.....................................................    1545-0155
1.48-12....................................................    1545-0155
                                                               1545-1783
1.50A-1....................................................    1545-0895
1.50A-2....................................................    1545-0895
1.50A-3....................................................    1545-0895
1.50A-4....................................................    1545-0895
1.50A-5....................................................    1545-0895
1.50A-6....................................................    1545-0895
1.50A-7....................................................    1545-0895
1.50B-1....................................................    1545-0895
1.50B-2....................................................    1545-0895
1.50B-3....................................................    1545-0895
1.50B-4....................................................    1545-0895

[[Page 1090]]

 
1.50B-5....................................................    1545-0895
1.51-1.....................................................    1545-0219
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219
1.52-3.....................................................    1545-0219
1.56(g)-1..................................................    1545-1233
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.59-1.....................................................    1545-1903
1.61-2.....................................................    1545-0771
1.61-4.....................................................    1545-0187
1.61-15....................................................    1545-0074
1.62-2.....................................................    1545-1148
1.63-1.....................................................    1545-0074
1.66-4.....................................................    1545-1770
1.67-2T....................................................    1545-0110
1.67-3.....................................................    1545-1018
1.67-3T....................................................    1545-0118
1.71-1T....................................................    1545-0074
1.72-4.....................................................    1545-0074
1.72-6.....................................................    1545-0074
1.72-9.....................................................    1545-0074
1.72-17....................................................    1545-0074
1.72-17A...................................................    1545-0074
1.72-18....................................................    1545-0074
1.74-1.....................................................    1545-1100
1.79-2.....................................................    1545-0074
1.79-3.....................................................    1545-0074
1.83-2.....................................................    1545-0074
1.83-5.....................................................    1545-0074
1.83-6.....................................................    1545-1448
1.103-10...................................................    1545-0123
                                                               1545-0940
1.103A-2...................................................    1545-0720
1.105-4....................................................    1545-0074
1.105-5....................................................    1545-0074
1.105-6....................................................    1545-0074
1.108-4....................................................    1545-1539
1.108-5....................................................    1545-1421
1.108-7....................................................    1545-2155
1.108(i)-1.................................................    1545-2147
1.108(i)-2.................................................    1545-2147
1.110-1....................................................    1545-1661
1.117-5....................................................    1545-0869
1.118-2....................................................    1545-1639
1.119-1....................................................    1545-0067
1.120-3....................................................    1545-0057
1.121-1....................................................    1545-0072
1.121-2....................................................    1545-0072
1.121-3....................................................    1545-0072
1.121-4....................................................    1545-0072
                                                               1545-0091
1.121-5....................................................    1545-0072
1.127-2....................................................    1545-0768
1.132-2....................................................    1545-0771
1.132-5....................................................    1545-0771
1.132-9(b).................................................    1545-1676
1.141-1....................................................    1545-1451
1.141-12...................................................    1545-1451
1.142-2....................................................    1545-1451
1.142(f)(4)-1..............................................    1545-1730
1.148-0....................................................    1545-1098
1.148-1....................................................    1545-1098
1.148-2....................................................    1545-1098
                                                               1545-1347
1.148-3....................................................    1545-1098
                                                               1545-1347
1.148-4....................................................    1545-1098
                                                               1545-1347
1.148-5....................................................    1545-1098
                                                               1545-1490
1.148-6....................................................    1545-1098
                                                               1545-1451
1.148-7....................................................    1545-1098
                                                               1545-1347
1.148-8....................................................    1545-1098
1.148-11...................................................    1545-1098
                                                               1545-1347
1.149(e)-1.................................................    1545-0720
1.150-1....................................................    1545-1347
1.151-1....................................................    1545-0074
1.152-3....................................................    1545-0071
                                                               1545-1783
1.152-4....................................................    1545-0074
1.152-4T...................................................    1545-0074
1.162-1....................................................    1545-0139
1.162-2....................................................    1545-0139
1.162-3....................................................    1545-0139
1.162-4....................................................    1545-0139
1.162-5....................................................    1545-0139
1.162-6....................................................    1545-0139
1.162-7....................................................    1545-0139
1.162-8....................................................    1545-0139
1.162-9....................................................    1545-0139
1.162-10...................................................    1545-0139
1.162-11...................................................    1545-0139
1.162-12...................................................    1545-0139
1.162-13...................................................    1545-0139
1.162-14...................................................    1545-0139
1.162-15...................................................    1545-0139
1.162-16...................................................    1545-0139
1.162-17...................................................    1545-0139
1.162-18...................................................    1545-0139
1.162-19...................................................    1545-0139
1.162-20...................................................    1545-0139
1.162-24...................................................    1545-2115
1.162-27...................................................    1545-1466
1.163-5....................................................    1545-0786
                                                               1545-1132
1.163-8T...................................................    1545-0995
1.163-10T..................................................    1545-0074
1.163-13...................................................    1545-1491
1.163(d)-1.................................................    1545-1421
1.165-1....................................................    1545-0177
1.165-2....................................................    1545-0177
1.165-3....................................................    1545-0177
1.165-4....................................................    1545-0177
1.165-5....................................................    1545-0177
1.165-6....................................................    1545-0177
1.165-7....................................................    1545-0177
1.165-8....................................................    1545-0177
1.165-9....................................................    1545-0177
1.165-10...................................................    1545-0177
1.165-11...................................................    1545-0074
                                                               1545-0177
                                                               1545-0786
1.165-12...................................................    1545-0786
1.166-1....................................................    1545-0123
1.166-2....................................................    1545-1254
1.166-4....................................................    1545-0123
1.166-10...................................................    1545-0123
1.167(a)-5T................................................    1545-1021
1.167(a)-7.................................................    1545-0172
1.167(a)-11................................................    1545-0152
                                                               1545-0172
1.167(a)-12................................................    1545-0172
1.167(d)-1.................................................    1545-0172
1.167(e)-1.................................................    1545-0172
1.167(f)-11................................................    1545-0172
1.167(l)-1.................................................    1545-0172
1.168(d)-1.................................................    1545-1146
1.168(i)-1.................................................    1545-1331

[[Page 1091]]

 
1.168-5....................................................    1545-0172
1.169-4....................................................    1545-0172
1.170-1....................................................    1545-0074
1.170-2....................................................    1545-0074
1.170-3....................................................    1545-0123
1.170A-1...................................................    1545-0074
1.170A-2...................................................    1545-0074
1.170A-4(A)(b).............................................    1545-0123
1.170A-8...................................................    1545-0074
1.170A-9...................................................    1545-0052
                                                               1545-0074
1.170A-11..................................................    1545-0074
                                                               1545-0123
                                                               1545-1868
1.170A-12..................................................    1545-0020
                                                               1545-0074
1.170A-13..................................................    1545-0074
                                                               1545-0754
                                                               1545-0908
                                                               1545-1431
1.170A-13(f)...............................................    1545-1464
1.170A-14..................................................    1545-0763
1.170A-15..................................................    1545-1953
1.170A-16..................................................    1545-1953
1.170A-17..................................................    1545-1953
1.170A-18..................................................    1545-1953
1.171-4....................................................    1545-1491
1.171-5....................................................    1545-1491
1.172-1....................................................    1545-0172
1.172-13...................................................    1545-0863
1.173-1....................................................    1545-0172
1.174-3....................................................    1545-0152
1.174-4....................................................    1545-0152
1.175-3....................................................    1545-0187
1.175-6....................................................    1545-0152
1.179-2....................................................    1545-1201
1.179-3....................................................    1545-1201
1.179-5....................................................    1545-0172
                                                               1545-1201
1.179B-1T..................................................    1545-2076
1.179C-1...................................................    1545-2103
1.179C-1T..................................................    1545-2103
1.180-2....................................................    1545-0074
1.181-1....................................................    1545-2059
1.181-2....................................................    1545-2059
1.181-3....................................................    1545-2059
1.182-6....................................................    1545-0074
1.183-1....................................................    1545-0195
1.183-2....................................................    1545-0195
1.183-3....................................................    1545-0195
1.183-4....................................................    1545-0195
1.190-3....................................................    1545-0074
1.194-2....................................................    1545-0735
1.194-4....................................................    1545-0735
1.195-1....................................................    1545-1582
1.197-1T...................................................    1545-1425
1.197-2....................................................    1545-1671
1.199-6....................................................    1545-1966
1.213-1....................................................    1545-0074
1.215-1T...................................................    1545-0074
1.217-2....................................................    1545-0182
1.243-3....................................................    1545-0123
1.243-4....................................................    1545-0123
1.243-5....................................................    1545-0123
1.248-1....................................................    1545-0172
1.261-1....................................................    1545-1041
1.263(a)-1.................................................    1545-2248
1.263(a)-3.................................................    1545-2248
1.263(a)-5.................................................    1545-1870
1.263(e)-1.................................................    1545-0123
1.263A-1...................................................    1545-0987
1.263A-1T..................................................    1545-0187
1.263A-2...................................................    1545-0987
1.263A-3...................................................    1545-0987
1.263A-8(b)(2)(iii)........................................    1545-1265
1.263A-9(d)(1).............................................    1545-1265
1.263A-9(f)(1)(ii).........................................    1545-1265
1.263A-9(f)(2)(iv).........................................    1545-1265
1.263A-9(g)(2)(iv)(C)......................................    1545-1265
1.263A-9(g)(3)(iv).........................................    1545-1265
1.265-1....................................................    1545-0074
1.265-2....................................................    1545-0123
1.266-1....................................................    1545-0123
1.267(f)-1.................................................    1545-0885
1.268-1....................................................    1545-0184
1.274-1....................................................    1545-0139
1.274-2....................................................    1545-0139
1.274-3....................................................    1545-0139
1.274-4....................................................    1545-0139
1.274-5....................................................    1545-0771
1.274-5A...................................................    1545-0139
                                                               1545-0771
1.274-5T...................................................    1545-0074
                                                               1545-0172
                                                               1545-0771
1.274-6....................................................    1545-0139
                                                               1545-0771
1.274-6T...................................................    1545-0074
                                                               1545-0771
1.274-7....................................................    1545-0139
1.274-8....................................................    1545-0139
1.279-6....................................................    1545-0123
1.280C-4...................................................    1545-1155
1.280F-3T..................................................    1545-0074
1.280G-1...................................................    1545-1851
1.281-4....................................................    1545-0123
1.302-4....................................................    1545-0074
1.305-3....................................................    1545-0123
1.305-5....................................................    1545-1438
1.307-2....................................................    1545-0074
1.312-15...................................................    1545-0172
1.316-1....................................................    1545-0123
1.331-1....................................................    1545-0074
1.332-4....................................................    1545-0123
1.332-6....................................................    1545-2019
1.336-2....................................................    1545-2125
1.336-4....................................................    1545-2125
1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
                                                               1545-1774
1.337(d)-4.................................................    1545-1633
1.337(d)-5.................................................    1545-1672
1.337(d)-6.................................................    1545-1672
1.337(d)-7.................................................    1545-1672
1.338-2....................................................    1545-1658
1.338-5....................................................    1545-1658
1.338-10...................................................    1545-1658
1.338-11...................................................    1545-1990
1.338(h)(10)-1.............................................    1545-1658
1.338(i)-1.................................................    1545-1990
1.351-3....................................................    1545-2019
1.355-5....................................................    1545-2019
1.362-2....................................................    1545-0123
1.362-4....................................................    1545-2247
1.367(a)-1T................................................    1545-0026
1.367(a)-2T................................................    1545-0026
1.367(a)-3.................................................    1545-0026
                                                               1545-1478
1.367(a)-3T................................................    1545-2183
1.367(a)-6T................................................    1545-0026
1.367(a)-7.................................................    1545-2183
1.367(a)-7T................................................    1545-2183
1.367(a)-8.................................................    1545-1271
                                                               1545-2056

[[Page 1092]]

 
                                                               1545-2183
1.367(b)-1.................................................    1545-1271
1.367(b)-3T................................................    1545-1666
1.367(d)-1T................................................    1545-0026
1.367(e)-1.................................................    1545-1487
1.367(e)-2.................................................    1545-1487
1.368-1....................................................    1545-1691
1.368-3....................................................    1545-2019
1.371-1....................................................    1545-0123
1.371-2....................................................    1545-0123
1.374-3....................................................    1545-0123
1.381(b)-1.................................................    1545-0123
1.381(c)(4)-1..............................................    1545-0123
                                                               1545-0152
                                                               1545-0879
1.381(c)(5)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(6)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(8)-1..............................................    1545-0123
1.381(c)(10)-1.............................................    1545-0123
1.381(c)(11)-1(k)..........................................    1545-0123
1.381(c)(13)-1.............................................    1545-0123
1.381(c)(17)-1.............................................    1545-0045
1.381(c)(22)-1.............................................    1545-1990
1.381(c)(25)-1.............................................    1545-0045
1.382-1T...................................................    1545-0123
1.382-2....................................................    1545-0123
1.382-2T...................................................    1545-0123
1.382-3....................................................    1545-1281
                                                               1545-1345
1.382-4....................................................    1545-1120
1.382-6....................................................    1545-1381
1.382-8....................................................    1545-1434
1.382-9....................................................    1545-1120
                                                               1545-1260
                                                               1545-1275
                                                               1545-1324
1.382-11...................................................    1545-2019
1.382-91...................................................    1545-1260
                                                               1545-1324
1.383-1....................................................    1545-0074
                                                               1545-1120
1.401-1....................................................    1545-0020
                                                               1545-0197
                                                               1545-0200
                                                               1545-0534
                                                               1545-0710
1.401(a)-11................................................    1545-0710
1.401(a)-20................................................    1545-0928
1.401(a)-31................................................    1545-1341
1.401(a)-50................................................    1545-0710
1.401(a)(9)-1..............................................    1545-1573
1.401(a)(9)-3..............................................    1545-1466
1.401(a)(9)-4..............................................    1545-1573
1.401(a)(9)-6..............................................    1545-2234
1.401(a)(31)-1.............................................    1545-1341
1.401(b)-1.................................................    1545-0197
1.401(f)-1.................................................    1545-0710
1.401(k)-1.................................................    1545-1039
                                                               1545-1069
                                                               1545-1669
                                                               1545-1930
1.401(k)-2.................................................    1545-1669
1.401(k)-3.................................................    1545-1669
1.401(k)-4.................................................    1545-1669
1.401(m)-3.................................................    1545-1699
1.401-14...................................................    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

[[Page 1093]]

 
1.455-2....................................................    1545-0152
1.455-6....................................................    1545-0123
1.456-2....................................................    1545-0123
1.456-6....................................................    1545-0123
1.456-7....................................................    1545-0123
1.457-8....................................................    1545-1580
1.458-1....................................................    1545-0879
1.458-2....................................................    1545-0152
1.460-1....................................................    1545-1650
1.460-6....................................................    1545-1031
                                                               1545-1572
                                                               1545-1732
1.461-1....................................................    1545-0074
1.461-2....................................................    1545-0096
1.461-4....................................................    1545-0917
1.461-5....................................................    1545-0917
1.463-1T...................................................    1545-0916
1.465-1T...................................................    1545-0712
1.466-1T...................................................    1545-0152
1.466-4....................................................    1545-0152
1.468A-3...................................................    1545-1269
                                                               1545-1378
                                                               1545-1511
1.468A-3(h), 1.468A-7, and 1.468A-8(d).....................    1545-2091
1.468A-4...................................................    1545-0954
1.468A-7...................................................    1545-0954
                                                               1545-1511
1.468A-8...................................................    1545-1269
1.468B-1...................................................    1545-1631
1.468B-1(j)................................................    1545-1299
1.468B-2(k)................................................    1545-1299
1.468B-2(l)................................................    1545-1299
1.468B-3(b)................................................    1545-1299
1.468B-3(e)................................................    1545-1299
1.468B-5(b)................................................    1545-1299
1.468B-9...................................................    1545-1631
1.469-1....................................................    1545-1008
1.469-2T...................................................    1545-0712
                                                               1545-1091
1.469-4T...................................................    1545-0985
                                                               1545-1037
1.469-7....................................................    1545-1244
1.471-2....................................................    1545-0123
1.471-5....................................................    1545-0123
1.471-6....................................................    1545-0123
1.471-8....................................................    1545-0123
1.471-11...................................................    1545-0123
                                                               1545-0152
1.472-1....................................................    1545-0042
                                                               1545-0152
1.472-2....................................................    1545-0152
1.472-3....................................................    1545-0042
1.472-5....................................................    1545-0152
1.472-8....................................................    1545-0028
                                                               1545-0042
                                                               1545-1767
1.475(a)-4.................................................    1545-1945
1.481-4....................................................    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

[[Page 1094]]

 
1.614-8....................................................    1545-0099
1.617-1....................................................    1545-0099
1.617-3....................................................    1545-0099
1.617-4....................................................    1545-0099
1.631-1....................................................    1545-0007
1.631-2....................................................    1545-0007
1.641(b)-2.................................................    1545-0092
1.642(c)-1.................................................    1545-0092
1.642(c)-2.................................................    1545-0092
1.642(c)-5.................................................    1545-0074
1.642(c)-6.................................................    1545-0020
                                                               1545-0074
                                                               1545-0092
1.642(g)-1.................................................    1545-0092
1.642(i)-1.................................................    1545-0092
1.645-1....................................................    1545-1578
1.663(b)-2.................................................    1545-0092
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-1(c).................................................    1545-2101
1.664-2....................................................    1545-0196
1.664-3....................................................    1545-0196
1.664-4....................................................    1545-0020
                                                               1545-0196
1.665(a)-0A through
1.665(g)-2A................................................    1545-0192
1.666(d)-1A................................................    1545-0092
1.671-4....................................................    1545-1442
1.671-5....................................................    1545-1540
1.701-1....................................................    1545-0099
1.702-1....................................................    1545-0074
1.703-1....................................................    1545-0099
1.704-2....................................................    1545-1090
1.706-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.706-4(f).................................................    1545-0123
1.707-3(c)(2)..............................................    1545-1243
1.707-5(a)(7)(ii)..........................................    1545-1243
1.707-6(c).................................................    1545-1243
1.707-8....................................................    1545-1243
1.708-1....................................................    1545-0099
1.732-1....................................................    1545-0099
                                                               1545-1588
1.736-1....................................................    1545-0074
1.743-1....................................................    1545-0074
                                                               1545-1588
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1.848-2(h)(3)..............................................    1545-1287
1.848-2(i)(4)..............................................    1545-1287
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1.860E-2(b)(2).............................................    1545-1276
1.860G-2...................................................    1545-2110
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1.861-4....................................................    1545-1900
1.861-8....................................................    1545-0126
1.861-8(e)(6) and (g)......................................    1545-1224
1.861-9T...................................................    1545-0121
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1.921-2....................................................    1545-0884
1.927(a)-1T................................................    1545-0935
1.927(d)-2T................................................    1545-0935
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1.1042-1T..................................................    1545-0916
1.1044(a)-1................................................    1545-1421
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1.1092(b)-1T...............................................    1545-0644
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1.1092(b)-3T...............................................    1545-0644
1.1092(b)-4T...............................................    1545-0644
1.1092(b)-5T...............................................    1545-0644
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1.1244(e)-1................................................    1545-0123
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1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
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1.1252-2...................................................    1545-0184
1.1254-1(c)(3).............................................    1545-1352
1.1254-4...................................................    1545-1493
1.1254-5(d)(2).............................................    1545-1352
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1.1272-3...................................................    1545-1353
1.1273-2(f)(9).............................................    1545-1353
1.1273-2(h)(2).............................................    1545-1353
1.1274-3(d)................................................    1545-1353
1.1274-5(b)................................................    1545-1353
1.1274A-1(c)...............................................    1545-1353
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1.1294-1T..................................................    1545-1002
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1.1311(a)-1................................................    1545-0074
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1.1366-1...................................................    1545-1613
1.1367-1(f)................................................    1545-1139
1.1368-1(f)(2).............................................    1545-1139
1.1368-1(f)(3).............................................    1545-1139
1.1368-1(f)(4).............................................    1545-1139
1.1368-1(g)(2).............................................    1545-1139
1.1374-1A..................................................    1545-0130
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1.1397E-1..................................................    1545-1908
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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
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1.1502-9A..................................................    1545-0121
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1.1502.21T.................................................    1545-0123
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1.1502-76..................................................    1545-1344
1.1502-76T.................................................    1545-2019
1.1502-77..................................................    1545-1699
1.1502-77A.................................................    1545-0123
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1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
1.1502-95..................................................    1545-1218
1.1502-95A.................................................    1545-1218
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
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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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1.6011-3...................................................    1545-0238
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                                                               1545-0967
                                                               1545-0970
                                                               1545-0991
                                                               1545-1023
                                                               1545-1033
                                                               1545-1079
1.6012-6...................................................    1545-0067
                                                               1545-0089
                                                               1545-0129
1.6013-1...................................................    1545-0074
1.6013-2...................................................    1545-0091
1.6013-6...................................................    1545-0074
1.6013-7...................................................    1545-0074
1.6015-5...................................................    1545-1719
1.6015(a)-1................................................    1545-0087
1.6015(b)-1................................................    1545-0087
1.6015(d)-1................................................    1545-0087
1.6015(e)-1................................................    1545-0087
1.6015(f)-1................................................    1545-0087
1.6015(g)-1................................................    1545-0087
1.6015(h)-1................................................    1545-0087
1.6015(i)-1................................................    1545-0087
1.6017-1...................................................    1545-0074
                                                               1545-0087
                                                               1545-0090
1.6031(a)-1................................................    1545-1583
1.6031(b)-1T...............................................    1545-0099
1.6031(c)-1T...............................................    1545-0099
1.6032-1...................................................    1545-0099
1.6033-2...................................................    1545-0047
                                                               1545-0049
                                                               1545-0052
                                                               1545-0092
                                                               1545-0687
                                                               1545-1150
                                                               1545-2117
1.6033-3...................................................    1545-0052
1.6034-1...................................................    1545-0092
                                                               1545-0094
1.6035-2...................................................    1545-0704
1.6037-1...................................................    1545-0130
                                                               1545-1023
1.6038-2...................................................    1545-1617
                                                               1545-2020
1.6038-3...................................................    1545-1617
1.6038A-2..................................................    1545-1191
1.6038A-3..................................................    1545-1191
                                                               1545-1440
1.6038B-1..................................................    1545-1617
                                                               1545-2183
1.6038B-1T.................................................    1545-0026
                                                               1545-2183
1.6038B-2..................................................    1545-1617
1.6039-2...................................................    1545-0820
1.6041-1...................................................    1545-0008
                                                               1545-0108
                                                               1545-0112
                                                               1545-0115
                                                               1545-0120
                                                               1545-0295
                                                               1545-0350
                                                               1545-0367
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
                                                               1545-1705
1.6041-2...................................................    1545-0008
                                                               1545-0119
                                                               1545-0350
                                                               1545-0441
                                                               1545-1729
1.6041-3...................................................    1545-1148
1.6041-4...................................................    1545-0115
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6041-5...................................................    1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6041-6...................................................    1545-0008
                                                               1545-0115
1.6041-7...................................................    1545-0112
                                                               1545-0295
                                                               1545-0350
                                                               1545-0367
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
1.6042-1...................................................    1545-0110
1.6042-2...................................................    1545-0110
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6042-3...................................................    1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6042-4...................................................    1545-0110
1.6043-1...................................................    1545-0041
1.6043-2...................................................    1545-0041
                                                               1545-0110
                                                               1545-0295
                                                               1545-0387
1.6043-3...................................................    1545-0047
1.6044-1...................................................    1545-0118
1.6044-2...................................................    1545-0118
1.6044-3...................................................    1545-0118
1.6044-4...................................................    1545-0118
1.6044-5...................................................    1545-0118
1.6045-1...................................................    1545-0715
                                                               1545-1705
1.6045-1(c)(3)(xi)(C)......................................    1545-2186
1.6045-1(n)(5).............................................    1545-2186
1.6045A-1..................................................    1545-2186
1.6045-2...................................................    1545-0115
1.6045-4...................................................    1545-1085
1.6046-1...................................................    1545-0704
                                                               1545-0794
                                                               1545-1317
1.6046-2...................................................    1545-0704
1.6046-3...................................................    1545-0704
1.6046A....................................................    1545-1646
1.6047-1...................................................    1545-0119
                                                               1545-0295
                                                               1545-0387
1.6047-2...................................................    1545-2234
1.6049-1...................................................    1545-0112
                                                               1545-0117
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0597
                                                               1545-0957
1.6049-2...................................................    1545-0117
1.6049-3...................................................    1545-0117
1.6049-4...................................................    1545-0096
                                                               1545-0112
                                                               1545-0117
                                                               1545-1018
                                                               1545-1050

[[Page 1099]]

 
1.6049-5...................................................    1545-0096
                                                               1545-0112
                                                               1545-0117
1.6049-6...................................................    1545-0096
1.6049-7...................................................    1545-1018
1.6050A-1..................................................    1545-0115
1.6050B-1..................................................    1545-0120
1.6050D-1..................................................    1545-0120
                                                               1545-0232
1.6050E-1..................................................    1545-0120
1.6050H-1..................................................    1545-0901
                                                               1545-1380
1.6050H-2..................................................    1545-0901
                                                               1545-1339
                                                               1545-1380
1.6050I-2..................................................    1545-1449
1.6050J-1T.................................................    1545-0877
1.6050K-1..................................................    1545-0941
1.6050S-1..................................................    1545-1678
1.6050S-2..................................................    1545-1729
1.6050S-3..................................................    1545-1678
1.6050S-4..................................................    1545-1729
1.6052-1...................................................    1545-0008
1.6052-2...................................................    1545-0008
1.6055-1...................................................    1545-2252
1.6055-2...................................................    1545-2252
1.6060-1...................................................    1545-0074
1.6060-1(a)(1).............................................    1545-1231
1.6061-1...................................................    1545-0123
1.6062-1...................................................    1545-0123
1.6063-1...................................................    1545-0123
1.6065-1...................................................    1545-0123
1.6071-1...................................................    1545-0123
                                                               1545-0810
1.6072-1...................................................    1545-0074
1.6072-2...................................................    1545-0123
                                                               1545-0807
1.6073-1...................................................    1545-0087
1.6073-2...................................................    1545-0087
1.6073-3...................................................    1545-0087
1.6073-4...................................................    1545-0087
1.6074-1...................................................    1545-0123
1.6074-2...................................................    1545-0123
1.6081-1...................................................    1545-0066
                                                               1545-0148
                                                               1545-0233
                                                               1545-1057
                                                               1545-1081
1.6081-2...................................................    1545-0148
                                                               1545-1036
                                                               1545-1054
1.6081-3...................................................    1545-0233
1.6081-4...................................................    1545-0188
                                                               1545-1479
1.6081-6...................................................    1545-0148
                                                               1545-1054
1.6081-7...................................................    1545-0148
                                                               1545-1054
1.6091-3...................................................    1545-0089
1.6107-1...................................................    1545-0074
                                                               1545-1231
1.6109-1...................................................    1545-0074
1.6109-2...................................................    1545-2176
1.6115-1...................................................    1545-1464
1.6151-1...................................................    1545-0074
1.6153-1...................................................    1545-0087
1.6153-4...................................................    1545-0087
1.6161-1...................................................    1545-0087
1.6162-1...................................................    1545-0087
1.6164-1...................................................    1545-0135
1.6164-2...................................................    1545-0135
1.6164-3...................................................    1545-0135
1.6164-5...................................................    1545-0135
1.6164-6...................................................    1545-0135
1.6164-7...................................................    1545-0135
1.6164-8...................................................    1545-0135
1.6164-9...................................................    1545-0135
1.6302-1...................................................    1545-0257
1.6302-2...................................................    1545-0098
                                                               1545-0257
1.6411-1...................................................    1545-0098
                                                               1545-0135
                                                               1545-0582
1.6411-2...................................................    1545-0098
                                                               1545-0582
1.6411-3...................................................    1545-0098
                                                               1545-0582
1.6411-4...................................................    1545-0582
1.6414-1...................................................    1545-0096
1.6425-1...................................................    1545-0170
1.6425-2...................................................    1545-0170
1.6425-3...................................................    1545-0170
1.6654-1...................................................    1545-0087
                                                               1545-0140
1.6654-2...................................................    1545-0087
1.6654-3...................................................    1545-0087
1.6655(e)-1................................................    1545-1421
1.6662-3(c)................................................    1545-0889
1.6662-4(e) and (f)........................................    1545-0889
1.6662-6...................................................    1545-1426
1.6694-1...................................................    1545-0074
1.6694-2...................................................    1545-0074
1.6694-2(c)................................................    1545-1231
1.6694-2(c)(3).............................................    1545-1231
1.6694-3(e)................................................    1545-1231
1.6695-1...................................................    1545-0074
                                                               1545-1385
1.6696-1...................................................    1545-0074
                                                               1545-0240
1.6851-1...................................................    1545-0086
                                                               1545-0138
1.6851-2...................................................    1545-0086
                                                               1545-0138
1.7476-1...................................................    1545-0197
1.7476-2...................................................    1545-0197
1.7519-2T..................................................    1545-1036
1.7520-1...................................................    1545-1343
1.7520-2...................................................    1545-1343
1.7520-3...................................................    1545-1343
1.7520-4...................................................    1545-1343
1.7701(l)-3................................................    1545-1642
1.7872-15..................................................    1545-1792
1.9100-1...................................................    1545-0074
1.9101-1...................................................    1545-0008
2.1-4......................................................    1545-0123
2.1-5......................................................    1545-0123
2.1-6......................................................    1545-0123
2.1-10.....................................................    1545-0123
2.1-11.....................................................    1545-0123
2.1-12.....................................................    1545-0123
2.1-13.....................................................    1545-0123
2.1-20.....................................................    1545-0123
2.1-22.....................................................    1545-0123
2.1-26.....................................................    1545-0123
3.2........................................................    1545-0123
4.954-1....................................................    1545-1068
4.954-2....................................................    1545-1068
5.6411-1...................................................    1545-0042
                                                               1545-0074
                                                               1545-0098
                                                               1545-0129
                                                               1545-0172
                                                               1545-0582
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[[Page 1100]]

 
5c.44F-1...................................................    1545-0619
5c.128-1...................................................    1545-0123
5c.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    1545-0720
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

[[Page 1101]]

 
26.2632-1..................................................    1545-0985
                                                               1545-1892
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985
26.2642-4..................................................    1545-0985
26.2642-6..................................................    1545-1902
26.2652-2..................................................    1545-0985
26.2654-1..................................................    1545-1902
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
26.6060-1(a)(1)............................................    1545-1231
26.6107-1..................................................    1545-1231
31.3102-3..................................................    1545-0029
                                                               1545-0059
                                                               1545-0065
31.3121(b)(19)-1...........................................    1545-0029
31.3121(d)-1...............................................    1545-0004
31.3121(i)-1...............................................    1545-0034
31.3121(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
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31.6011(a)-2...............................................    1545-0001
                                                               1545-0002
31.6011(a)-3...............................................    1545-0028
31.6011(a)-3A..............................................    1545-0955
31.6011(a)-4...............................................    1545-0034
                                                               1545-0035
                                                               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
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31.6051-2..................................................    1545-0008
31.6051-3..................................................    1545-0008
31.6053-1..................................................    1545-0029
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31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
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31.6053-4..................................................    1545-0065
                                                               1545-1603
31.6060-1(a)(1)............................................    1545-1231
31.6065(a)-1...............................................    1545-0029
31.6071(a)-1...............................................    1545-0001
                                                               1545-0028
                                                               1545-0029
31.6071(a)-1A..............................................    1545-0955
31.6081(a)-1...............................................    1545-0008
                                                               1545-0028
31.6091-1..................................................    1545-0028
                                                               1545-0029
31.6107-1..................................................    1545-1231
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
                                                               1545-2097
31.6301(c)-1AT.............................................    1545-0035
                                                               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
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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
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48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
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48.4081-2..................................................    1545-1270
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48.4081-3..................................................    1545-1270
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48.4081-4(b)(2)(ii)........................................    1545-1270
48.4081-4(b)(3)(i).........................................    1545-1270
48.4081-4(c)...............................................    1545-1270
48.4081-6(c)(1)(ii)........................................    1545-1270
48.4081-7..................................................    1545-1270
                                                               1545-1418
48.4082-1T.................................................    1545-1418
48.4082-2..................................................    1545-1418
48.4082-6..................................................    1545-1418
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48.4161(a)-1...............................................    1545-0723
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    1545-0723
48.4216(a)-2...............................................    1545-0023
48.4216(a)-3...............................................    1545-0023
48.4216(c)-1...............................................    1545-0023
48.4221-1..................................................    1545-0023
48.4221-2..................................................    1545-0023
48.4221-3..................................................    1545-0023
48.4221-4..................................................    1545-0023
48.4221-5..................................................    1545-0023
48.4221-6..................................................    1545-0023
48.4221-7..................................................    1545-0023
48.4222(a)-1...............................................    1545-0014
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48.4223-1..................................................    1545-0023
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48.6302(c)-1...............................................    1545-0023
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48.6412-1..................................................    1545-0723
48.6416(a)-1...............................................    1545-0023
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48.6416(a)-2...............................................    1545-0723
48.6416(a)-3...............................................    1545-0723
48.6416(b)(1)-1............................................    1545-0723
48.6416(b)(1)-2............................................    1545-0723
48.6416(b)(1)-3............................................    1545-0723
48.6416(b)(1)-4............................................    1545-0723
48.6416(b)(2)-1............................................    1545-0723
48.6416(b)(2)-2............................................    1545-0723
48.6416(b)(2)-3............................................    1545-0723
                                                               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
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48.6416(f)-1...............................................    1545-0023
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48.6416(g)-1...............................................    1545-0723
48.6416(h)-1...............................................    1545-0723
48.6420(c)-2...............................................    1545-0023
48.6420(f)-1...............................................    1545-0023
48.6420-1..................................................    1545-0162
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48.6420-2..................................................    1545-0162
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48.6420-3..................................................    1545-0162
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48.6420-4..................................................    1545-0162
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48.6420-5..................................................    1545-0162
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48.6420-6..................................................    1545-0162
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48.6421-0..................................................    1545-0162
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48.6421-1..................................................    1545-0162
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48.6421-2..................................................    1545-0162
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48.6421-3..................................................    1545-0162
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48.6421-4..................................................    1545-0162
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48.6421-5..................................................    1545-0162
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48.6421-6..................................................    1545-0162
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48.6421-7..................................................    1545-0162
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48.6424-0..................................................    1545-0723
48.6424-1..................................................    1545-0723
48.6424-2..................................................    1545-0723
48.6424-3..................................................    1545-0723
48.6424-4..................................................    1545-0723
48.6424-5..................................................    1545-0723
48.6424-6..................................................    1545-0723
48.6427-0..................................................    1545-0723
48.6427-1..................................................    1545-0023
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48.6427-2..................................................    1545-0162
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48.6427-3..................................................    1545-0723
48.6427-4..................................................    1545-0723
48.6427-5..................................................    1545-0723
48.6427-8..................................................    1545-1418
48.6427-9..................................................    1545-1418
48.6427-10.................................................    1545-1418
48.6427-11.................................................    1545-1418
49.4251-1..................................................    1545-1075
49.4251-2..................................................    1545-1075
49.4251-4(d)(2)............................................    1545-1628
49.4253-3..................................................    1545-0023
49.4253-4..................................................    1545-0023
49.4264(b)-1...............................................    1545-0023
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49.4271-1(d)...............................................    1545-0685
49.5000B-1.................................................    1545-2177
51.2(f)(2)(ii).............................................    1545-2209
51.7.......................................................    1545-2209
52.4682-1(b)(2)(iii).......................................    1545-1153
52.4682-2(b)...............................................    1545-1153
                                                               1545-1361
52.4682-2(d)...............................................    1545-1153
                                                               1545-1361
52.4682-3(c)(2)............................................    1545-1153
52.4682-3(g)...............................................    1545-1153
52.4682-4(f)...............................................    1545-0257
                                                               1545-1153
52.4682-5(d)...............................................    1545-1361
52.4682-5(f)...............................................    1545-1361
53.4940-1..................................................    1545-0052
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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
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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
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                                                               1545-0957
                                                               1545-1461
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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
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301.6112-1T................................................    1545-0865
                                                               1545-1686
301.6114-1.................................................    1545-1126
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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
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301.6316-7.................................................    1545-0029
301.6324A-1................................................    1545-0015
301.6361-1.................................................    1545-0024
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301.6361-2.................................................    1545-0024
301.6361-3.................................................    1545-0074
301.6402-2.................................................    1545-0024
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301.6402-3.................................................    1545-0055
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301.6402-5.................................................    1545-0928
301.6404-1.................................................    1545-0024
301.6404-2T................................................    1545-0024
301.6404-3.................................................    1545-0024
301.6405-1.................................................    1545-0024
301.6501(c)-1..............................................    1545-1241
                                                               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 1107]]



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, 2018 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.

                                  2018

                       (No regulations published)

                                  2019

26 CFR
                                                                   84 FR
                                                                    Page
Chapter I
1 Authority citation amended................................29334, 69058
1.851-2 (b)(1) and (b)(2)(i) revised; (b)(2)(iii) and (d) added.....9961
1.851-2 Correction; (b)(1)(i)(F) revised; (b)(2)(iii) amended......17082
1.861-8 (a)(1), (4), (e)(1), and (6)(i) amended; (a)(5), 
        (e)(6)(iii), (10), (12)(iv), and (f)(1)(i) removed; 
        (c)(2), (d)(2), (f)(4)(ii), and (g) revised; (c)(4), 
        (e)(13), (14), (15), (f)(1)(ii), and (h) added.............69058
1.861-8T (c)(2), (d)(2)(ii)(A), (iii)(C), and (iv) revised; 
        (d)(2)(ii)(B)(1) and (2) redesignated as 
        (d)(2)(ii)(B)(1)(i) and (ii); (d)(2)(ii)(B) introductory 
        text and undesignated text following new (1)(ii) 
        redesignated as new (d)(2)(ii)(B)(1) and (2); 
        (d)(2)(ii)(C), (e)(3), and (f) added; (d)(2)(iii)(B) 
        amended; (d)(2)(iii)(D), (e)(3) through (f)(1)(i), (ii), 
        and (iii) through (g) removed..............................69063
1.861-9 Heading, (f)(4) heading, (iii), (h)(5), (j), and (k) 
        revised; (a) through (e)(1), (e)(4) through (f)(3)(i), and 
        (f)(5) through (h)(3) removed; new (a), new (c), new (d), 
        new (e)(1), new (4) through (10), new (f) heading, new 
        (1), new (2), new (3) heading, new (f)(3)(i), (5), (g), 
        (h) introductory text, and (1) added; (e)(2), (3), 
        (f)(4)(i), (ii), and (i)(2)(i) amended.....................69064
1.861-9T (b)(3)(ii) amended; (b)(3)(ii) redesignated as 
        (b)(3)(ii)(A); new (b)(3)(ii)(A) Example redesignated as 
        (b)(3)(ii)(B)...............................................9236
1.861-9T (c)(5) and (e)(8) added; (e)(4)(i), (f)(4), (g)(1)(ii), 
        (2)(ii)(A)(2), (h) introductory text, and (j)(2)(ii) 
        revised; undesignated text and examples following, 
        (f)(2)(ii), (3)(i), (g)(1)(iii), (iv), (v), (g)(2)(i), 
        (v), and undesignated text following (j)(2)(ii)(B) removed
                                                                   69068
1.861-10 (e)(8)(vi) revised; (e)(10) removed; (f) added............69068
1.861-10T (e) revised..............................................69068

[[Page 1108]]

1.861-11 (a), (b), (c), and (d)(2) removed; new (a), new (b), new 
        (c), and (h) added; (d)(1) amended.........................69068
1.861-11T (b)(1) revised...........................................69069
1.861-12 (c)(2) revised; (k) added.................................29335
1.861-12 (a) through (c)(1), (5), and (d) through (j) removed; new 
        (a), (b), (c)(1), (d), and (e) added; (c)(3) and (4) 
        revised....................................................69069
1.861-12T (a), (c)(3)(i), (iii), and (d)(2) revised; (c)(2)(vi), 
        undesignated text following (3)(i)(B), (5), and (j) 
        removed....................................................69070
1.861-12T (c)(2)(i) revised........................................29336
1.861-13 Added.....................................................69070
1.861-14 (d)(1) amended; (d)(2) removed............................69074
1.861-17 (e)(3) and (i) added; (g) removed.........................69074
1.861-18 (i)(4) Example 2 removed; Examples 1 and 3 redesignated 
        as (i)(4)(i) and (ii); new (i)(4)(ii) heading amended......33692
1.871-1 (a) amended.................................................9236
1.871-15 (a)(1), (g)(4)(ii)(B), (p)(1)(ii), (iii), (iv), and (5) 
        revised; (r)(1) amended; (r)(4) removed....................68793
1.871-15T Removed..................................................68793
1.901 (j)-1 added..................................................69075
1.902-3 (g)(2) removed..............................................9236
1.904-0 Removed....................................................69075
1.904-1 Revised....................................................69075
1.904-2 (a) through (d), (h), and (i) revised; (e) amended; (g) 
        removed, (j) and (k) added.................................69075
1.904-3 Heading (e), (f)(1), (2), and (3) revised; (a) through 
        (d), (f)(5)(i), and (ii) amended; (f)(6), undesignated 
        text following (ii), and (g) removed; (h) added............69076
1.904-4 (a), (b)(2)(iv), (c)(4), (5)(ii), (iii)(C), (6)(iv), (8), 
        (e)(1), (h)(2), (4), (5), and (k) through (n) revised; 
        (b)(2)(i)(A), (B), (ii), (c)(1), (2)(i), (3) introductory 
        text, (5)(iii)(A), (6)(i), (iii), (7)(i), (iii), 
        (e)(3)(i), and (ii) amended; (b)(2)(i)(C), (D), 
        (c)(2)(iii), (d), (f), (g), (o), (p), and (q) added; 
        (e)(2)(i)(W), (3)(iv), (4)(i)(B), and (5) removed..........69077
1.904-5 (a), (b), (c)(1), (2)(v), (3), (4)(iii), (d)(1), (2), (3), 
        (e)(2), (h), (i)(2), (3), (5), (k)(2)(iii), (l), 
        (m)(2)(ii), (3), (4)(i), (5) heading, (ii), (7)(ii), and 
        (o) revised; (c)(2)(i), (iii), (4)(i), (g), (i)(1), (j), 
        (k)(1), (m)(1), (5)(i), (6), (7)(i), and (n) amended; 
        (c)(4)(iv), (f)(1), (3), and (i)(4) removed; (c)(5), (6), 
        and (7) added..............................................69091
1.904-6 (a)(1)(i) amended; (a)(1)(iv) and (b) revised; (a)(2), 
        (3), and (d) added; (c) removed............................69098
1.904(b)-3 Added...................................................69099
1.904(f)-12 (i) and (j) added......................................69100
1.904(g)-0 Amended.................................................69102
1.904(g)-3 (a) and (c) amended; (f) and (k) revised; (i) and (l) 
        added; (j) removed.........................................69102
1.904(i)-1 (a)(1)(i) amended.......................................69104
1.905-2 (a)(2) amended.............................................69104
1.905-3 Added......................................................69104
1.905-3T Removed...................................................69107

                                  2020

26 CFR
                                                                   85 FR
                                                                    Page
Chapter I
1 Authority citation amended.......................................16248
1 Authority citation amended..................70964, 72031, 76931, 79843
1.860C-2 (b)(2) revised............................................56842
1.861-8 Correction: (c)(4) and (e)(6)(i) amended...................29323
1.861-8 (a)(1), (d)(1), and (e)(6)(i) amended; (d)(2)(ii)(B), 
        (e)(4)(ii), (7), (8), and (h) revised; (e)(5) redesignated 
        as (e)(5)(i); (d)(2)(v), (e)(5) heading, (ii), (iii), 
        (16), and (g)(15) through (18) added.......................72033
1.861-8 (d)(2)(ii)(C)(1) amended; (f)(1)(vi)(N) added..............43109
1.861-8 (h) revised................................................68250
1.861-8T (d)(2)(ii)(B) revised.....................................72038
1.861-9 (a), (e)(8)(vi)(C), (D), and (k) revised; (b) and (e)(9) 
        added......................................................72038
1.861-9T (b)(1)(i) revising; (b)(8) added..........................72040
1.861-12 (e) and (k) revised; (f) and (g) added....................72040
1.861-12T (f) revised..............................................72041
1.861-13T Removed..................................................72041

[[Page 1109]]

1.861-14 (d)(1) amended; (d)(3) through (5), (e)(6), (ii), (f) 
        through (j) heading removed; (d)(3), (e) heading, (1) 
        through (5), (f), (h), and (k) added; (e)(6)(i) 
        redesignated as (e)(6); new (e)(6) revised.................72041
1.861-14T (e)(1)(i), (2)(i), (4), (5), and (h) revised; (e)(2)(ii) 
        removed; (j) footnote 1 added..............................72042
1.861-17 Correction: (e)(3) amended................................29323
1.861-17 Revised...................................................72042
1.861-20 Added.....................................................72049
1.863-0 Revised....................................................79843
1.863-0A Added.....................................................79845
1.863-1 (b)(7) Examples 1, 2, 3, 4, and 5 redesignated as 
        (b)(7)(i) through (v); (a), (b)(2), (3)(i), (ii), (6), and 
        (f) amended; (b)(1), (7)(i) through (v), and(f) heading 
        revised; (b)(3)(iii) removed...............................79845
1.863-2 (a) introductory text amended; (b) and (c) revised.........79846
1.863-3 Revised....................................................79846
1.863-8 (b)(2)(ii) amended; (h) revised............................59434
1.863-8 (f) Examples 1 through 14 redesignated as (f)(1) through 
        (14); (b)(3)(ii)(B), (ii)(C), (c), (f)(1) through (14), 
        (4)(i), (5)(i), (9)(i), (ii), (11)(ii), (g)(1), (4) 
        introductory text, and (h) amended; (b)(3)(ii)(A), 
        (f)(6)(ii) revised; (b)(3)(ii)(D) removed..................79849
1.863-9 (b)(2)(ii) and (l) revised.................................59434
1.864-5 (a) and (b) introductory text amended; (e) added...........79850
1.864-6 (c)(2) and (3) revised; (c)(4) added.......................79850
1.864(c)(8)-1 Added................................................70965
1.864(c)(8)-2 Added................................................76931
1.865-3 Added......................................................79851
1.881-3 (e) Examples 1 through 26 redesignated (e)(1) through 
        (26); (e)(4) through (26) further redesignated as (e)(5) 
        through (27); (a)(2)(ii)(B)(1)(iv), new (e)(4) added; 
        (a)(1), (2)(i)(A), (i)(B), (ii)(B)(1) introductory text, 
        (ii), (iii), (3)(ii)(E)(2)(ii), (4)(ii)(B), (b)(1), 
        (2)(i), (iii), (iv), (3)(i), (c)(2)(ii), (d)(1)(i), 
        (ii)(A), (e) introductory text, new (3), new (8)(ii), new 
        (22)(i), (ii), new (24)(i), new (25)(i), and (f) amended; 
        (a)(2)(i)(C) revised.......................................72055
1.881-3 (f) heading revised; (f) amended...........................72056
1.897-7 Added......................................................70971
1.897-7T (c) added.................................................70971
1.901(m)-1 Added...................................................16249
1.901(m)-1T Removed................................................16251
1.901(m)-2 Added...................................................16251
1.901(m)-2T Removed................................................16252
1.901(m)-3 Added...................................................16252
1.901(m)-3T Removed................................................16256
1.901(m)-4 Added...................................................16256
1.901(m)-4T Removed................................................16258
1.901(m)-5 Added...................................................16258
1.901(m)-5T Removed................................................16263
1.901(m)-6 Added...................................................16263
1.901(m)-6T Removed................................................16265
1.901(m)-7 Added...................................................16265
1.901(m)-7T Removed................................................16267
1.901(m)-8 Added...................................................16267
1.901(m)-8T Removed................................................16267
1.904-1 Heading and (a) revised....................................72057
1.904-4 Correction: (c)(6)(iii) amended............................29323
1.904-4 (c)(7)(i), (iii), and (q) revised; (c)(7)(ii) and (o) 
        amended; (c)(8)(v) through (viii) added....................72057
1.904-4T Removed...................................................72067
1.904-5 Correction: (c)(1)(ii) removed.............................29323
1.904-5 (a)(4)(i) and (o) revised; (a)(4)(vi) amended..............59435
1.904-6 Heading, (a), and (d) revised; (b) redesignated as (e); 
        new (b), (c), (f), and (g) added; new (e)(4)(i) and new 
        (ii)(C) amended............................................72059
1.904(b)-3 (c)(1) amended; (d)(2) added; (f) revised...............72060
1.904(g)-0 Correction: Amended.....................................29323
1.904(g)-3 (b)(1) amended; (j) added; (l) revised..................72060

[[Page 1110]]

1.905-3 Heading and (d) revised; (a) amended; (b)(2) and (3) added
                                                                   72060
1.905-4 Added......................................................72063
1.905-5 Added......................................................72067
1.905-5T Removed...................................................72069

                                  2021

26 CFR
                                                                   86 FR
                                                                    Page
Chapter I
1.861-8 Correction: (e)(5)(ii) and (8)(ii) amended.................54367
1.861-17 Correction: (d)(4)(iv) amended............................54367
1.861-20 Correction: (d)(3)(i)(B)(2) amended.......................54367
1.881-3 Correction: (e)(5) through (27) headings amended...........54367
1.902-1 (a)(12) amended............................................52614
1.902-3 (a)(7) amended.............................................52614
1.904-2 (j)(1)(iii)(D) amended.....................................52972
1.904-4 Correction: (q)(1) amended.................................54368
1.904-6 Correction: (f) amended....................................54368
1.904(f)-12 (j)(6) removed; (j)(5) redesignated as (j)(6); (j)(5) 
        and (7) added..............................................52972
1.904(g)-3 Correction: (b)(2) and (3) revised......................54368
1.905-4T Correction: Removed.......................................54368

                                  2022

26 CFR
                                                                   87 FR
                                                                    Page
Chapter I
1 Authority citation amended..................................175, 80055
1 Technical correction.............................................45021
1.860A-0 Amended.....................................................175
1.860A-1 (b)(7) added................................................175
1.860G-1 (a)(5) amended; (e) added...................................175
1.861 Technical correction.........................................45018
1.861-3 (d) redesignated as (e); new (d) added; heading and new 
        (e) heading revised; new (e) amended.........................325
1.861-8 (b)(2) amended; (e)(4)(i) revised; (h)(4) added..............326
1.861-8 Correction: (b)(2) amended.................................45019
1.861-9 (g)(3) amended; (k) revised..................................326
1.861-10 (a), (g), and (h) added; (e)(8)(v) and (f) revised..........326
1.861-13 (a) amended.................................................326
1.861-13(a) Correction: Instruction amended........................45018
1.861-14 (h) and (k) revised.........................................326
1.861-20 (b)(4), (c) introductory text, (d)(2)(ii)(B), (3)(i)(A), 
        (B)(2), and (ii)(B) amended; (b)(17) through (24) 
        redesignated as (b)(18) through (21) and (23) through 
        (26); (b)(7), new (20), new (25), and (i) revised; new 
        (b)(17), (22), (d)(2)(ii)(D), (3)(i)(D), (ii), (v), (vi), 
        (g)(10) through (14), and (h) added..........................327
1.861-20 Correction: Table revised.................................21743
1.861-20 Technical correction......................................45018
1.861-20 Correction: (d)(3)(v)(A) and (g)(14)(i) amended; 
        (d)(3)(v)(D), (E)(2), and (8) revised......................45019
1.897(l)-1 Added...................................................80055
1.901-1 Heading, (a) through (d), (f), (h)(1), and (j) heading 
        revised; (e) and (j) amended; (h)(2) removed; (h)(3) 
        redesignated as new (h)(2)...................................334
1.901-2 (a) heading, (1), (3), (b), (d), (e), (f)(2)(ii), (4) 
        through (6), (g), and (h) revised; (c) removed; 
        (f)(3)(ii)(A) and (iii)(B)(2) amended; (f)(7) added..........335
1.901-2 Correction: (a)(1)(iii) and (b)(4)(i)(C)(3) revised; 
        (b)(4)(i)(A), (C)(1), (5)(ii), and (h) amended.............45019
1.903-1 Revised......................................................357
1.904-4 (b)(2)(i)(A), (f)(2)(vi)(A), (B)(1)(ii), (3)(v) revised; 
        (f)(2)(ii) and (iii) removed; (f)(3)(viii), (ix), and (x) 
        redesignated as (f)(3)(ix), (xii), and (xiii); (c)(4), 
        (f)(1)(i) introductory text, (3)(vii)(B), new (ix), 
        (4)(i)(B)(1), (2), (iv)(B)(1), and (v)(B)(2) amended; 
        (f)(1)(iii), (iv), (2)(vi)(G), new (3)(viii), new (x), 
        (xi), (4)(xiii) through (xvi), and (q)(3) added..............360
1.904-4 Correction: (f)(3)(viii), (x), and (q)(1) revised; (q)(3) 
        amended....................................................45020
1.904-6 (b)(2) added; (g) revised....................................363
1.905-1 Revised......................................................363

[[Page 1111]]

1.905-1 Correction: (c)(1) amended.................................45020
1.905-3 (a) and (b)(1)(ii)(B)(1) amended; (b)(4) added; (d) 
        revised......................................................373
1.905-3 Correction: (a) and (b)(1)(ii)(B)(1) amended; (b)(4) 
        added; (d) revised.........................................21743

                                  2023

 (No regulations published from January 1, 2023, through April 1, 2023)


                                  [all]