[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2025 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, 2025
Containing a codification of documents of general
applicability and future effect
As of April 1, 2025
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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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........................ 1087
Alphabetical List of Agencies Appearing in the CFR...... 1107
Table of OMB Control Numbers............................ 1117
List of CFR Sections Affected........................... 1135
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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.
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[[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
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To determine whether a Code volume has been amended since its
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EFFECTIVE AND EXPIRATION DATES
Each volume of the Code contains amendments published in the Federal
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OMB CONTROL NUMBERS
The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires
Federal agencies to display an OMB control number with their information
collection request.
[[Page vi]]
Many agencies have begun publishing numerous OMB control numbers as
amendments to existing regulations in the CFR. These OMB numbers are
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PAST PROVISIONS OF THE CODE
Provisions of the Code that are no longer in force and effect as of
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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
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INCORPORATION BY REFERENCE
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This material, like any other properly issued regulation, has the force
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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
approval is based are:
(a) The incorporation will substantially reduce the volume of
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(b) The matter incorporated is adequately summarized in the preamble
of the final rule and is available to the extent necessary to afford
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(c) The incorporating document is drafted and submitted for
publication in accordance with 1 CFR part 51.
What if the material incorporated by reference cannot be found? If
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CFR INDEXES AND TABULAR GUIDES
A subject index to the Code of Federal Regulations is contained in a
separate volume, revised annually as of January 1, entitled CFR Index
and Finding Aids. This volume contains the Parallel Table of Authorities
and Rules. A list of CFR titles, chapters, subchapters, and parts and an
alphabetical list of agencies publishing in the CFR are also included in
this volume.
[[Page vii]]
An index to the text of ``Title 3--The President'' is carried within
that volume.
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the revision dates of the 50 CFR titles.
REPUBLICATION OF MATERIAL
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INQUIRIES
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The eCFR is a regularly updated, unofficial editorial compilation of
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available at www.ecfr.gov.
Oliver A. Potts,
Director,
Office of the Federal Register
April 1, 2025
[[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, 2025. 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)
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Part
chapter i--Internal Revenue Service, Department of the
Treasury (Continued)...................................... 1
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CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
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SUBCHAPTER A--INCOME TAX (CONTINUED)
Part Page
1 Income taxes (Continued).................... 5
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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.
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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, and source of gross income from, digital
content transactions.
1.861-19 Classification of cloud transactions.
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.
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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, unless otherwise noted.
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).
Section 1.861-8T also issued under 26 U.S.C. 863(a), 864(e), 865(i),
and 7701(f).
Section 1.861-9 also issued under 26 U.S.C. 861, 863(a), 864(e),
864(e)(7), 865(i), 987, and 989(c), and 7701(f).
Section 1.861-9T also issued under 26 U.S.C. 861, 863(a), 864(e),
864(e)(7), 865(i), and 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 1.861-10T also issued under 26 U.S.C. 863(a), 864(e),
865(i), and 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 1.861-11T also issued under 26 U.S.C. 863(a), 864(e),
865(i), and 7701(f).
Section 1.861-12 also issued under 26 U.S.C. 864(e)(7).
Section 1.861-12T also issued under 26 U.S.C. 863(a), 864(e),
865(i), and 7701(f).
Section 1.861-13 also issued under 26 U.S.C. 864(e)(7).
Section 1.861-13T also issued under 26 U.S.C. 863(a), 864(e),
865(i), and 7701(f).
Section 1.861-14 also issued under 26 U.S.C. 864(e)(7).
[[Page 10]]
Section 1.861-14T also issued under 26 U.S.C. 863(a), 864(e),
865(i), and 7701(f).
Section 1.861-17 also issued under 26 U.S.C. 864(e)(7).
Section 1.863-1 also issued under 26 U.S.C. 863(a).
Section 1.863-2 also issued under 26 U.S.C. 863.
Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and 26
U.S.C. 936(h).
Section 1.863-4 also issued under 26 U.S.C. 863.
Section 1.863-6 also issued under 26 U.S.C. 863.
Section 1.863-7 also issued under 26 U.S.C. 863(a) and 871(m).
Section 1.863-8 also issued under 26 U.S.C. 863(a), (b) and (d).
Section 1.863-9 also issued under 26 U.S.C. 863(a), (d) and (e).
Section 1.864-5 also issued under 26 U.S.C. 7701(l).
Section 1.864-8T also issued under 26 U.S.C. 864(d)(8).
Section 1.864(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(c), 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).
Section 1.897-1 also issued under 26 U.S.C. 897 and 897(l)(3).
Section 1.897-2 also issued under 26 U.S.C. 897.
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).
[[Page 11]]
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).
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.
[[Page 12]]
(ii) Income from a publicly traded partnership. Income is described
in this paragraph (b)(1)(ii) if it is net income derived from an
interest in a qualified publicly traded partnership (as defined in
section 851(h)).
(2) Special rules. (i) For purposes of section 851(b)(2)(A) and
paragraph (b)(1)(i)(A) of this section, amounts included in gross income
for the taxable year under section 951(a)(1)(A) or 1293(a) are treated
as dividends only to the extent that, under section 959(a)(1) or 1293(c)
(as the case may be), there is a distribution out of the earnings and
profits of the taxable year that are attributable to the amounts
included in gross income for the taxable year under section 951(a)(1)(A)
or 1293(a). For allocation of distributions to earnings and profits of
foreign corporations, see Sec. 1.959-3.
(ii) For purposes of subdivision (i) of this subparagraph, if by
reason of section 959(a)(1) a distribution of a foreign corporation's
earnings and profits for a taxable year described in section 959(c)(2)
is not included in a shareholder's gross income, then such distribution
shall be allocated proportionately between amounts attributable to
amounts included under each clause of section 951(a)(1)(A). Thus, for
example, M is a United States shareholder in X Corporation, a controlled
foreign corporation. M and X each use the calendar year as the taxable
year. For 1977, M is required by section 951(a)(1)(a) to include $3,000
in its gross income, $1,000 of which is included under clause (i)
thereof. In 1977, M received a distribution described in section
959(c)(2) of $2,700 out of X's earnings and profits for 1977, which is,
by reason of section 959(a)(1), excluded from M's gross income. The
amount of the distribution attributable to the amount included under
section 951(a)(1)(A)(i) is $900, i.e., $2,700 multiplied by ($1,000/
$3,000).
(iii) If an amount is included in gross income 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
[[Page 13]]
value of the total assets of the corporation (including the 50 percent
or more mentioned in subparagraph (A) of section 851(b)(4)) in the
securities (other than Government securities or the securities of other
regulated investment companies) of any one issuer, or of two or more
issuers which the taxpayer company controls and which are engaged in the
same or similar trades or businesses or related trades or businesses,
including such issuers as are merely a part of a unit contributing to
the completion and sale of a product or the rendering of a particular
service. Two or more issuers are not considered as being in the same or
similar trades or businesses merely because they are engaged in the
broad field of manufacturing or of any other general classification of
industry, but issuers shall be construed to be engaged in the same or
similar trades or businesses if they are engaged in a distinct branch of
business, trade, or manufacture in which they render the same kind of
service or produce or deal in the same kind of product, and such service
or products fulfill the same economic need. If two or more issuers
produce more than one product or render more than one type of service,
then the chief product or service of each shall be the basis for
determining whether they are in the same trade or business.
(d) Applicability date. The rules in paragraphs (b)(1) and (b)(2)(i)
and (iii) of this section apply to taxable years that begin after June
17, 2019.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6598, 27 FR
4090, Apr. 28, 1962; T.D. 7555, 43 FR 32753, July 28, 1978; T.D. 9851,
84 FR 9961, Mar. 19, 2019; 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)...........................
----------
[[Page 14]]
Total...................................................... 100
------------------------------------------------------------------------
(ii) Investment Company W owns all of the voting stock of
Corporations A and B, 15 percent of the voting stock of Corporation C,
and less than 10 percent of the voting stock of regulated investment
companies and various other corporations. Neither Corporation A nor
Corporation B owns:
(A) 20 percent or more of the voting stock of any other corporation;
(B) Securities issued by Corporation C; or
(C) Securities issued by any of the regulated investment companies
or various corporations whose securities are owned by Investment Company
W. Except for Corporation A and Corporation B, none of the corporations
(including the regulated investment companies) is a member of a
controlled group with Investment Company W.
(iii) Investment Company W meets the requirements under section
851(b)(3) at the end of its first quarter. It complies with subparagraph
(A) of section 851(b)(3) because it has 55 percent of its assets
invested as provided in that subparagraph. It complies with subparagraph
(B) of section 851(b)(3) because it does not have more than 25 percent
of its assets invested in the securities of any one issuer, of two or
more issuers that it controls, or of one or more qualified publicly
traded partnerships (as defined in section 851(h)).
Example 2. (i) Investment Company V at the close of a particular
quarter of the taxable year has its assets invested as follows:
------------------------------------------------------------------------
Percent
------------------------------------------------------------------------
Cash......................................................... 10
Government securities........................................ 35
Securities of Corporation A.................................. 7
Securities of Corporation B.................................. 12
Securities of Corporation C.................................. 15
Securities of Corporation D.................................. 21
----------
Total...................................................... 100
------------------------------------------------------------------------
(ii) Investment Company V fails to meet the requirements of
subparagraph (A) of section 851(b)(3) since its assets invested in
Corporations A, B, C, and D exceed in each case 5 percent of the value
of the total assets of the company at the close of the particular
quarter.
Example 3. (i) Investment Company X at the close of a particular
quarter of the taxable year has its assets invested as follows:
------------------------------------------------------------------------
Percent
------------------------------------------------------------------------
Cash and Government securities............................... 20
Securities of Corporation A.................................. 5
Securities of Corporation B.................................. 10
Securities of Corporation C.................................. 25
Securities of various corporations (not exceeding 5 percent 40
of its assets in any one company)...........................
----------
Total...................................................... 100
------------------------------------------------------------------------
(ii) Investment Company X owns more than 20 percent of the voting
power of Corporations B and C and less than 10 percent of the voting
power of all of the other corporations. Corporation B manufactures
radios 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
[[Page 15]]
assets invested in Corporation A. Later during the taxable year it makes
distributions to its shareholders and because of such distributions, it
finds at the close of the taxable year that it has more than 25 percent
of its remaining assets invested in Corporation A. Investment Company Z
does not lose its status as a regulated investment company for the
taxable year 2016 because of such distributions, nor will it lose its
status as a regulated investment company for any subsequent year solely
as a result of such distributions. See section 851(d)(1).
Example 6. Investment Company Q, which keeps its books and makes its
returns on the basis of the calendar year, at the close of the first
quarter of 2016 meets the requirements of section 851(b)(3) and has 20
percent of its assets invested in Corporation P. At the close of the
taxable year 2016, it finds that it has more than 25 percent of its
assets invested in Corporation P. This situation results entirely from
fluctuations in the market values of the securities in Investment
Company Q's portfolio and is not due in whole or in part to the
acquisition of any security or other property. Investment Company Q does
not lose its status as a regulated investment company for the taxable
year 2016 because of such fluctuations in the market values of the
securities in its portfolio, nor will it lose its status as a regulated
investment company for any subsequent year solely as a result of such
market value fluctuations. See section 851(d)(1).
Example 7. (i) Investment Company T at the close of a particular
quarter of its taxable year has its assets invested as follows:
------------------------------------------------------------------------
Percent
------------------------------------------------------------------------
Cash and Government securities............................... 40
Securities of Corporation A.................................. 20
Securities of various qualified publicly traded partnerships 15
(within the meaning of sections 851(b)(3) and 851(h)).......
Securities of various corporations (not exceeding 5 percent 25
of its assets in any one company)...........................
----------
Total...................................................... 100
------------------------------------------------------------------------
(ii) Investment Company T owns more than 20 percent of the voting
power of Corporation A and less than 10 percent of the voting power of
all of the other corporations. Corporation A has 80 percent of its
assets invested in qualified publicly traded partnerships.
(iii) Investment Company T is disqualified under subparagraph
(B)(iii) of section 851(b)(3), because, after applying section
851(c)(1), more than 25 percent of the value of Investment Company T's
total assets is invested in the securities of one or more qualified
publicly traded partnerships. This result is shown by the following
calculation:
------------------------------------------------------------------------
Percent
------------------------------------------------------------------------
Percentage of assets invested directly in qualified publicly 15.0
traded partnerships.........................................
Percentage invested in qualified publicly traded partnerships 16.0
indirectly through A (20% x 80%)............................
----------
Total percentage of assets of Investment Company T invested 31.0
in qualified publicly traded partnerships.................
------------------------------------------------------------------------
(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
[[Page 16]]
date of the first acquisition of any security in such corporation or any
predecessor thereof by such investment company if at the date of such
acquisition the corporation or its predecessor was principally so
engaged, and an investment company shall be considered at any date to be
furnishing capital to any company whose securities it holds if within 10
years before such date it had acquired any of such securities, or any
securities surrendered in exchange therefor, from such other company or
its predecessor.
(b) Exception to general rule. (1) The registered management
investment company, which for the taxable year meets the requirements of
paragraph (a) of this section, may (subject to the limitations of
section 851(e)(2) and paragraph (c) of this section) in the computation
of 50 percent of the value of its assets under section 851(b)(4)(A) and
paragraph (c)(1) of Sec. 1.851-2 for any quarter of such taxable year,
include the value of any securities of an issuer (whether or not the
investment company owns more than 10 percent of the outstanding voting
securities of such issuer) if at the time of the latest acquisition of
any securities of such issuer the basis of all such securities in the
hands of the investment company does not exceed 5 percent of the value
of the total assets of the investment company at that time. The
exception provided by section 851(e)(1) and this subparagraph is not
applicable to the securities of an issuer if the investment company has
continuously held any security of such issuer or of any predecessor
company (as defined in paragraph (d) of this section) for 10 or more
years preceding such quarter of the taxable year. The rule of section
851(e)(1) with respect to the relationship of the basis of the
securities of an issuer to the value of the total assets of the
investment company is, in substance, a qualification of the 5-percent
limitation in section 851(b)(4)(A)(ii) and paragraph (c)(1)(iv) of Sec.
1.851-2. All other provisions and requirements of section 851 and
Sec. Sec. 1.851-1 through 1.851-6 are applicable in determining whether
such registered management investment company qualifies as a regulated
investment company.
(2) The application of subparagraph (1) of this paragraph may be
illustrated by the following examples:
Example 1. (i) The XYZ Corporation, a regulated investment company,
qualified under section 851(e) as an investment company furnishing
capital to development corporations. On June 30, 1954, the XYZ
Corporation purchased 1,000 shares of the stock of the A Corporation at
a cost of $30,000. On June 30, 1954, 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...............
[[Page 17]]
Basis of the 1,000 shares of the A Corporation's stock 60,000
acquired on June 30, 1955...................................
----------
Total....................................................... 90,000
Basis of stock of A Corporation ($90,000)/Value of XYZ Corporation's
total assets at June 30, 1955, time of the latest acquisition
($1,500,000)= 6 percent
Example 3. The same facts existed as in example 2 and on June 30,
1956, the XYZ Corporation increased its investment in the stock of the A
Corporation by the purchase of an additional 100 shares of that stock at
a total cost of $6,000. On June 30, 1956, the value of the total assets
of the XYZ Corporation was $2,000,000 and on that date the investment in
the A Corporation qualified under section 851(b)(4)(A) as modified by
section 851(e)(1) illustrated as follows:
Basis to the XYZ Corporation of investments in the A
Corporation's stock:
1,000 shares acquired June 30, 1954........................ $30,000
1,000 shares acquired June 30, 1955........................ 60,000
100 shares acquired June 30, 1956.......................... 6,000
----------
Total....................................................... 96,000
Basis of stock of A Corporation ($96,000)/Value of XYZ Corporation's
total assets at June 30, 1956, time of the latest acquisition
($2,000,000) = 4.8 percent
(c) Limitation. Section 851(e) and this section do not apply in the
quarterly computation of 50 percent of the value of the assets of an
investment company under subparagraph (A) of section 851(b)(4) and
paragraph (c)(1) of Sec. 1.851-2 for any taxable year if at the close
of any quarter of such taxable year more than 25 percent of the value of
its total assets (including the 50 percent or more mentioned in such
subparagraph (A)) is represented by securities (other than Government
securities or the securities of other regulated investment companies) of
issuers as to each of which such investment company (1) holds more than
10 percent of the outstanding voting securities of such issuer, and (2)
has continuously held any security of such issuer (or any security of a
predecessor of such issuer) for 10 or more years preceding such quarter,
unless the value of its total assets so represented is reduced to 25
percent or less within 30 days after the close of such quarter.
(d) Definition of predecessor company. As used in section 851(e) and
this section, the term ``predecessor company'' means any corporation the
basis of whose securities in the hands of the investment company was,
under the provisions of section 358 or corresponding provisions of prior
law, the same in whole or in part as the basis of any of the securities
of the issuer and any corporation with respect to whose securities any
of the securities of the issuer were received directly or indirectly by
the investment company in a transaction or series of transactions
involving nonrecognition of gain or loss in whole or in part. The other
terms used in this section have the same meaning 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
[[Page 18]]
in exchange for his interest in the trust, no gain or loss shall be
recognized by such holder (or by any other holder of an interest in such
trust). For purposes of this paragraph, each purchase of an interest in
the trust by the holder will be considered a separate interest in the
trust. Items of income, gain, loss, deduction, or credit received by the
trust or a custodian thereof shall be taxed to the holders of interests
in the trust (and not to the trust) as though they had received their
proportionate share of the items directly on the date such items were
received by the trust or custodian.
(2) The basis of the assets of such trust which are treated under
subparagraph (1) of this paragraph as being owned by the holder of an
interest in such trust shall be the same as the basis of his interest in
such trust. Accordingly, the amount of the gain or loss recognized by
the holder upon the sale by the unit investment trust of the holder's
pro rata share of the trust assets shall be determined with reference
the basis, of his interest in the trust. Also, the basis of the assets
received by the holder, if the trust distributes a holder's pro rata
share of the trust assets in exchange for his interest in the trust,
will be the same as the basis of his interest in the trust. If the unit
investment trust sells less than all of the holder's pro rata share of
the trust assets and the holder retains an interest in the trust, the
amount of the gain or loss recognized by the holder upon the sale shall
be determined with reference to the basis of his interest in the assets
sold by the trust, and the basis of his interest in the trust shall be
reduced accordingly. If the trust distributes a portion of the holder's
pro rata share of the trust assets in exchange for a portion of his
interest in the trust, the basis of the assets received by the holder
shall be determined with reference to the basis of his interest in the
assets distributed by the trust, and the basis of his interest in the
trust shall be reduced accordingly. For purposes of this subparagraph
the basis of the holder's interest in assets sold by the trust or
distributed to him shall be an amount which bears the same relationship
to the basis of his total interest in the trust that the fair market
value of the assets so sold or distributed bears to the fair market
value of such total interest in the trust, such fair market value to be
determined on the date of such sale or distribution.
(3) The period for which the holder of an interest in such trust has
held the assets of the trust which are treated under subparagraph (1) of
this paragraph as being owned by him is the 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.
[[Page 19]]
(a) On April 4, 1970, at B's request, X sells the shares of Y
credited to B's account (315 shares) for $10 per share and distributes
the proceeds ($3,150) to B together with the remaining balance of $26.50
in B's account. The receipt of the $26.50 does not result in any tax
consequences to B. B recognizes a long-term capital gain of $100 and a
short- term capital gain of $50, computed as follows:
(1) B is treated as owning 110 shares of Y as of October 1, 1969.
The basis of these shares is $1,000, and they were sold for $1,100 (110
shares at $10 per share). Therefore, B recognizes a gain from the sale
or exchange of a capital asset held for more than 6 months in the amount
of $100.
(2) B is treated as owning 105 shares of Y as of January 1, 1970,
and 100 shares as of April 1, 1970. With respect to the shares acquired
on April 1, 1970, there is no gain recognized as the shares were sold
for $1,000, which is B's basis of the shares. The shares acquired on
January 1, 1970, were sold for $1,050 (105 shares at $10 per share), and
B's basis of these shares is $1,000. Therefore, B recognizes a gain of
$50 from the sale or exchange of a capital asset held for not more than
6 months.
(b) On April 4, 1970, at B's request, X distributes to B the shares
of Y credited to his account and $26.50 in cash. The receipt of the
$26.50 does not result in any tax consequences to B. B does not
recognize gain or loss on the distribution of the shares of Y to him.
The bases and holding periods of B's interests in Y are as follows:
------------------------------------------------------------------------
Date
Number of shares acquired Basis
------------------------------------------------------------------------
110................................................ 10-1-69 $9.09
105................................................ 1-1-70 9.52
100................................................ 4-1-70 10.00
------------------------------------------------------------------------
(d) Definition. A unit investment trust to which this section refers
is a business arrangement (other than a segregated asset account,
whether or not it holds assets pursuant to a variable annuity contract,
under the insurance laws or regulations of a State) which (except for
taxable years ending before Jan. 1, 1969)--
(1) Is a unit investment trust (as defined in the Investment Company
Act of 1940);
(2) Is registered under such Act;
(3) Issues periodic payment plan certificates (as defined in such
Act) in one or more series;
(4) Possesses, as substantially all of its assets, as to all such
series, securities issued by--
(i) A single management company (as defined in such Act), and
securities acquired pursuant to subparagraph (5) of this paragraph, or
(ii) A single other corporation; and
(5) Has no power to invest in any other securities except securities
issued by a single other management company, when permitted by such Act
or the rules and regulations of the Securities and Exchange Commission.
(e) Investment in two single management companies. (1) A unit
investment trust may possess securities issued by 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.
[[Page 20]]
(iii) The period for which the holder has held his interest in the
series so acquired shall be measured from the date of his acquisition of
his interest in that series.
(f) Cross references. (1) For reporting requirements imposed on
custodians of unit investment trusts described in this section, see
Sec. Sec. 1.852-4, 1.852-9, 1.853-3, 1.854-2, and 1.6042-2.
(2) For rules relating to redemptions of certain unit investment
trusts not described in this section, see Sec. 1.852-10.
[T.D. 7187, 37 FR 13254, July 6, 1972, as amended by T.D. 7187, 37 FR
20688, Oct. 3, 1972]
Sec. 1.852-1 Taxation of regulated investment companies.
(a) Requirements applicable thereto--(1) In general. Section 852(a)
denies the application of the provisions of part I, subchapter M,
chapter 1 of the Code (other than section 852(c), relating to earnings
and profits), to a regulated investment company for a taxable year
beginning after February 28, 1958, unless--
(i) The deduction for dividends paid for such taxable year as
defined in section 561 (computed without regard to capital gain
dividends) is equal to at least 90 percent of its investment company
taxable income for such taxable year (determined without regard to the
provisions of section 852(b)(2)(D) and paragraph (d) of Sec. 1.852-3);
and
(ii) The company complies for such taxable year with the provisions
of Sec. 1.852-6 (relating to records required to be maintained by a
regulated investment company).
See section 853(b)(1)(B) and paragraph (a) of Sec. 1.853-2 for amounts
to be added to the dividends paid deduction, and section 855 and Sec.
1.855-1, relating to dividends paid after the close of the taxable year.
(2) Special rule for taxable years of regulated investment companies
beginning before March 1, 1958. The provisions of part I of subchapter M
(including section 852(c)) are not applicable to a regulated investment
company for a taxable year beginning before March 1, 1958, unless such
company meets the requirements of section 852(a) and subparagraph (1)
(i) and (ii) of this paragraph.
(b) Failure to qualify. If a regulated investment company does not
meet the requirements of section 852(a) and paragraph (a)(1) (i) and
(ii) of this section for the taxable year, it will, even though it may
otherwise be classified as a regulated investment company, be taxed in
such year as an ordinary corporation and not as a regulated investment
company. In such case, none of 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
[[Page 21]]
Sec. 1.852-4. In the case of a taxable year ending after December 31,
1969, and beginning before January 1, 1975, such deduction for dividends
paid shall first be made from the amount subject to tax in accordance
with section 1201(a)(1)(B), to the extent thereof, and then from the
amount subject to tax in accordance with section 1201(a)(1)(A). See
Sec. 1.852-10, relating to certain distributions in redemption of
interests in unit investment trusts which, for purposes of the deduction
for dividends paid with reference to capital gain dividends only, are
not considered preferential dividends under section 562(c). See section
855 and Sec. 1.855-1, relating to dividends paid after the close of the
taxable year.
(2) Undistributed capital gains--(i) In general. A regulated
investment company (subject to tax under part I of subchapter M) may,
for taxable years beginning after December 31, 1956, designate under
section 852(b)(3)(D) an amount of undistributed capital gains to each
shareholder of the company. For the definition of the term
``undistributed capital gains'' and for the treatment of such amounts by
a shareholder, see paragraph (b)(2) of Sec. 1.852-4. For the rules
relating to the method of making such designation, the returns to be
filed, and the payment of the tax in such cases, see paragraph (a) of
Sec. 1.852-9.
(ii) Effect on earnings and profits of a regulated investment
company. If a regulated investment company designates an amount as
undistributed capital gains for a taxable year, the earnings and profits
of such regulated investment company for such taxable year shall be
reduced by the total amount of the undistributed capital gains so
designated. In such case, its capital account shall be increased--
(a) In the case of a taxable year ending before January 1, 1970, by
75 percent of the total amount designated,
(b) In the case of a taxable year ending after December 31, 1969,
and beginning before January 1, 1975, by the total amount designated
decreased by the amount of tax imposed by section 852(b)(3)(A) with
respect to such amount, or
(c) In the case of a taxable year beginning after December 31, 1974,
by 70 percent of the total amount designated. The earnings and profits
of a regulated investment company shall not be reduced by the amount of
tax which is imposed by section 852(b)(3)(A) on an amount designated as
undistributed capital gains and which is paid by 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
[[Page 22]]
placed on an annual basis even though such short taxable year results
from a change of accounting period.
Sec. 1.852-4 Method of taxation of shareholders of regulated investment
companies.
(a) Ordinary income. (1) Except as otherwise provided in paragraph
(b) of this section (relating to capital gains), a shareholder receiving
dividends from a regulated investment company shall include such
dividends in gross income for the taxable year in which they are
received.
(2) See section 853 (b)(2) and (c) and paragraph (b) of Sec. 1.853-
2 and Sec. 1.853-3 for the treatment by shareholders of dividends
received from a regulated investment company which has made an election
under section 853(a) with respect to the foreign tax credit. See section
854 and Sec. Sec. 1.854-1 through 1.854-3 for limitations applicable to
dividends received from regulated investment companies for the purpose
of the credit under section 34 (for dividends received on or before
December 31, 1964), the exclusion from gross income under section 116,
and the deduction under section 243. See section 855 (b) and (d) and
paragraphs (c) and (f) of Sec. 1.855-1 for treatment by shareholders of
dividends paid by a regulated investment company after the close of the
taxable year in the case of an election under section 855(a).
(b) Capital gains--(1) In general. Under section 852(b)(3)(B),
shareholders of a regulated investment company who receive capital gain
dividends (as defined in paragraph (c) of this section), in respect of
the capital gains of an investment company for a taxable year for which
it is taxable under part I, subchapter M, chapter 1 of the Code, as a
regulated investment company, shall treat such capital gain dividends as
gains from the sale or exchange of capital assets held for more than 1
year (6 months for taxable years beginning before 1977; 9 months for
taxable years beginning in 1977) and realized in the taxable year of the
shareholder in which the dividend was received. In the case of dividends
with respect to any taxable year of a regulated investment company
ending after December 31, 1969, and beginning before January 1, 1975,
the portion of a shareholder's capital gain dividend to which section
1201(d) (1) or (2) applies is the portion 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
[[Page 23]]
gains tax paid with respect to such amount, or
(c) In the case of an amount designated with respect to a taxable
year of the company beginning after December 31, 1974, a tax equal to 30
percent of such amount.
Such shareholder is entitled to a credit or refund of the tax so deemed
paid in accordance with the rules provided in paragraph (c)(2) of Sec.
1.852-9.
(iii) Any shareholder required to include an amount of undistributed
capital gains in gross income under section 852(b)(3)(D)(i) and
subdivision (i) of this subparagraph shall increase the adjusted basis
of the shares of stock with respect to which such amount is so
includible--
(a) In the case of an amount designated with respect to a taxable
year of the company ending before January 1, 1970, by 75 percent of such
amount.
(b) In the case of an amount designated with respect to a taxable
year of the company ending after December 31, 1969, and beginning before
January 1, 1975, by the amount designated under paragraph (a)(1)(iv) of
Sec. 1.852-9 by the regulated investment company, or
(c) In the case of an amount designated with respect to a taxable
year of the company beginning after December 31, 1974, by 70 percent of
such amount.
(iv) For purposes of determining whether the purchaser or seller of
a share or regulated investment company stock is the shareholder at the
close of such company's taxable year who is required to include an
amount of undistributed capital gains in gross income, the amount of the
undistributed capital gains shall be treated in the same manner as a
cash dividend payable to shareholders of record at the close of the
company's taxable year. Thus, if a cash dividend paid to shareholders of
record as of the close of the regulated investment company's taxable
year would be considered income to the purchaser, then the purchaser is
also considered to be the shareholder of such company at the close of
its taxable year for purposes of including an amount of undistributed
capital gains in gross income. If, in such a case, notice on Form 2439
is, pursuant to paragraph (a)(1) of Sec. 1.852-9, mailed by the
regulated investment company to the seller, then the seller 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
[[Page 24]]
regulations thereunder, as having realized a long-term capital gain in
such amount on the last day of the taxable year of the regulated
investment company in respect of which the undistributed capital gains
were designated.
(5) Effect on earnings and profits of corporate shareholders of a
regulated investment company. If a shareholder required to include an
amount of undistributed capital gains in gross income under section
852(b)(3)(D) and subparagraph (2) of this paragraph is a corporation,
such corporation, in computing its earnings and profits for the taxable
year for which such amount is so includible, shall treat such amount as
if it had actually been received and the taxes paid shall include any
amount of tax liability satisfied by a credit under section 852(b)(3)(D)
and subparagraph (2) of this paragraph.
(c) Definition of capital gain dividend--(1) General rule. A capital
gain dividend, as defined in section 852(b)(3)(C), is any dividend or
part thereof which is designated by a regulated investment company as a
capital gain dividend in a written notice mailed to its shareholders
within the period specified in paragraph (c)(4) of this section. If the
aggregate amount so designated with respect to the taxable year
(including capital gain dividends paid after the close of the taxable
year pursuant to an election under section 855) is greater than the
excess of the net long-term capital gain over the net short-term capital
loss of the taxable year, the portion of each distribution which shall
be a capital gain dividend shall be only that proportion of the amount
so designated which such excess of the net long-term capital gain over
the net short-term capital loss bears to the aggregate amount so
designated. For example, a regulated investment company making its
return on the calendar year basis advised its shareholders by written
notice mailed December 30, 1955, that of a distribution of $500,000 made
December 15, 1955, $200,000 constituted a capital gain dividend,
amounting to $2 per share. It was later discovered that an error had
been made in determining the excess of the net long-term capital gain
over the net short-term capital loss of the taxable year, and that such
excess was $100,000 instead of $200,000. In such case each 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
[[Page 25]]
trust, it shall so notify the Internal Revenue Service within 45 days
following the close of its taxable year. The custodian shall, upon
notice by the Internal Revenue Service that the regulated investment
company has failed to comply with the agreement, satisfy the
requirements of this subparagraph within 30 days of such notice. If a
notice under paragraph (c)(1) of this section is mailed within the 120-
day period following the date of a determination pursuant to paragraph
(c)(4)(ii) of this section, the 120-day period and the 130-day period
following the date of the determination shall be substituted for the 45-
day period and the 55-day period following the close of the regulated
investment company's taxable year prescribed by this subparagraph (2).
(3) Subsection (d) gain for certain taxable years. In the case of
capital gain dividends with respect to any taxable year of a regulated
investment company ending after December 31, 1969, and beginning before
January 1, 1975 (including capital gain dividends paid after the close
of the taxable year pursuant to an election under section 855), the
company must include in its written notice under paragraph (c)(1) of
this section a statement showing the shareholder's proportionate share
of the capital gain dividend which is gain described in section
1201(d)(1) and his proportionate share of such dividend which is gain
described in section 1201(d)(2). In determining the portion of the
capital gain dividend which, in the hands of a shareholder, is gain
described in section 1201(d) (1) or (2), the regulated investment
company shall consider that capital gain dividends for a taxable year
are first made from its long-term capital gains for such year which are
not described in section 1201(d) (1) or (2), to the extent thereof, and
then from its long-term capital gains for such year which are described
in section 1201(d) (1) or (2). A shareholder's proportionate share of
gains which are described in section 1201(d)(1) is the amount which
bears the same ratio to the amount paid to him as a capital gain
dividend in respect of such year as (i) the aggregate amount of the
company's gains which are described in section 1201(d)(1) and paid to
all shareholders bears to (ii) the aggregate amount of the capital gain
dividend 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
[[Page 26]]
which section 381(c)(25) applies. The date of a determination is
established under Sec. 1.860-2(b)(1).
(d) Special treatment of loss on the sale or exchange of regulated
investment company stock held less than 31 days--(1) In general. Under
section 852(b)(4), if any person, with respect to a share of regulated
investment company stock acquired by such person after December 31,
1957, and held for a period of less than 31 days, is required by section
852(b)(3) (B) or (D) to include in gross income as a gain from the sale
or exchange of a capital asset held for more than six months--
(i) The amount of a capital gain dividend, or
(ii) An amount of undistributed capital gains,
then such person shall, to the extent of such amount, treat any loss on
the sale or exchange of such share of stock as a loss from the sale or
exchange of a capital asset held for more than 1 year (6 months for
taxable years beginning before 1977; 9 months for taxable years
beginning in 1977). Such special treatment with respect to the sale of
regulated investment company stock held for a period of less than 31
days is applicable to losses for taxable years ending after December 31,
1957.
(2) Determination of holding period. The rules contained in section
246(c)(3) (relating to the determination of holding periods for purposes
of the deduction for dividends received) shall be applied in determining
whether, for purposes of section 852(b)(4) and this paragraph, a share
of regulated investment company stock has been held for a period of less
than 31 days. In applying those rules, however, ``30 days'' shall be
substituted for the number of days specified in subparagraph (B) of
section 246(c)(3).
(3) Example. The application of section 852(b)(4) and this paragraph
may be illustrated by the following example:
Example. On December 15, 1958, A purchased a share of stock in the X
regulated investment company for $20. The X regulated investment company
declared a capital gain dividend of $2 per share to shareholders of
record on December 31, 1958. A, therefore, received a capital gain
dividend of $2 which, pursuant to section 852(b)(3)(B), he must treat as
a gain from the sale or exchange of 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
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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
[[Page 124]]
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
[[Page 132]]
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
[[Page 133]]
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
[[Page 135]]
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 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. For determining
the place of sale of copyrighted articles transferred through an
electronic medium, see Sec. 1.861-18(f)(2)(ii).
(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.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as
amended by T.D. 10022, 90 FR 2988, Jan. 14, 2025]
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
[[Page 158]]
sources within the United States has been determined. Sections 862(b)
and 863(a) state in general terms how to determine taxable income of a
taxpayer from sources without the United States after gross income from
sources without the United States has been determined. This section
provides specific guidance for applying the cited Code 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
[[Page 159]]
gross income in a class or less gross income than deductions allocated
to the class, and paragraph (d)(2) of this section which provides that a
class of gross income may include excluded income. Allocation is
accomplished by determining, with respect to each deduction, the class
of gross income to which the deduction is definitely related and then
allocating the deduction to such class of gross income (without regard
to the taxpayable year in which such gross income is received or accrued
or is expected to be received or accrued). The classes of gross income
are not predetermined but must be determined on the basis of the
deductions to be allocated. Although most deductions will be definitely
related to some class of a taxpayer's total gross income, some
deductions are related to all gross income. In addition, some deductions
are treated as not definitely related to any gross income and are
ratably apportioned to all gross income. (See paragraph (e)(9) of this
section.) In allocating deductions it is not necessary to differentiate
between deductions related to one item of gross income and deductions
related to another item of gross income where both items of gross income
are exclusively within the same statutory grouping or exclusively within
the residual grouping.
(2) Relationship to activity or property. A deduction shall be
considered definitely related to a class of gross income and therefore
allocable to such class if it is incurred as a result of, or incident
to, an activity or in connection with property from which such class of
gross income is derived. Where a deduction is incurred as a result of,
or incident to, an activity or in connection with property, which
activity or property generates, has generated, or could reasonably have
been expected to generate gross income, such deduction shall be
considered definitely related to such gross income as a class whether or
not there is any item of gross income in such class which is received or
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
[[Page 160]]
definite relationship to a class of gross income constituting less than
all of gross income, it shall ordinarily be treated as definitely
related and allocable to all of the taxpayer's gross income except where
provided to the contrary under paragraph (e) of this section. Paragraph
(e)(9) of this section lists various deductions which generally are not
definitely related to any gross income and are ratably apportioned to
all gross income.
(c) Apportionment of deductions--(1) Deductions definitely related
to a class of gross income. [Reserved]. For guidance, see Sec. 1.861-
8T(c)(1).
(2) Apportionment based on assets. 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
[[Page 161]]
amount of deductions allocated and apportioned to a statutory grouping
exceeds the amount of gross income in the statutory grouping, the
effects are determined under the operative section. If the taxpayer is a
member of a group filing a consolidated return, such excess of
deductions allocated or apportioned to a statutory grouping of income of
such member is taken into account in determining the consolidated
taxable income from such statutory grouping, and such excess of
deductions allocated or apportioned to the residual grouping of income
is taken into account in determining the consolidated taxable income
from the residual grouping. See Sec. 1.1502-12.
(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
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equals the amount of the domestic corporation's deduction allowed under
section 250(a)(1)(A) (taking into account the reduction under section
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
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the operative section, under paragraph (d)(2)(ii)(C)(1) of this section,
$305x of USP's gross income attributable to its 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.
[[Page 164]]
(B) Examples. The following examples illustrate the application of
paragraph (d)(2)(v)(A) of this section.
(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
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and apportioned to U.S. source dividend income. Under paragraph (b)(5)
of this section, the remaining portion of 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
[[Page 166]]
the investor. If an investor has a foreign or international department
which exercises oversight functions 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
[[Page 167]]
(or which could reasonably have been expected to be derived from) that
specific product. The taxpayer is not relieved from his responsibility
to make a proper allocation and apportionment of fees on the grounds
that the statement of services rendered does not identify the services
performed beyond a generalized designation such as ``professional,'' or
does not provide any type of allocation, or does not properly allocate
the fees involved.
(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
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the corporate taxpayer includes foreign source income, then, in
computing the taxpayer's foreign tax credit limitation under section
904, for example, the taxpayer's deduction for state income tax will be
considered definitely related and allocable to a class of gross income
that includes the statutory grouping of foreign source income. When the
law of the state includes dividends that are treated under section
862(a)(2) as income from sources without the United States in taxable
income apportionable to the state, but 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
[[Page 169]]
state which does not impose a corporate income tax. The specific
allocation of state income tax illustrated in Example 28 follows the
rule in paragraph (e)(6)(i) of this section, and must be applied
whenever a taxpayer's state taxable income includes dividends
apportioned to the state under a formula that does not take into account
the factors of the corporations paying those dividends, regardless of
whether the taxpayer uses the methodology of Example 25 with respect to
the remainder of the deduction for state income taxes.
(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
[[Page 170]]
treated under section 862(a)(2) as income from sources without the
United States, but does not include factors of the corporations paying
the portfolio dividends in the apportionment formula used to determine
state taxable income, the taxpayer shall allocate an appropriate portion
of the deduction to a class of gross income consisting solely of foreign
source portfolio dividends. The portion of the deduction so allocated,
and the amount of foreign source portfolio dividends included in such
class, shall be determined in accordance with the methodology
illustrated in paragraph (ii) of Example 28 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).
[[Page 171]]
(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 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
[[Page 172]]
(e)(8)(i) of this section) that is deducted in the taxable year. Except
as provided 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
[[Page 173]]
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 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
[[Page 174]]
income shall be reduced by the deductions of the controlled foreign
corporation ``properly allocable to such income''. This section provides
rules for identifying which deductions are properly allocable to foreign
base company income.
(vi) Other operative sections. The rules provided in this section
also apply in determining--
(A) The amount of foreign source items of tax preference under
section 58(g) determined for purposes of the minimum tax;
(B) The amount of foreign mineral income under section 901(e);
(C) [Reserved]
(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
[[Page 175]]
925(a)(3) transfer pricing method. See Example (23) of paragraph (g) of
this section.
(3) Special rules of section 863(b)--(i) In general. Special rules
under section 863(b) provide for the application of rules of general
apportionment provided in Sec. Sec. 1.863-3 to 1.863-5, to worldwide
taxable income in order to attribute part of such worldwide taxable
income to U.S. sources and the remainder of such worldwide taxable
income to foreign sources. The activities specified in section 863(b)
are--
(A) Transportation or other services rendered partly within and
partly without the United States,
(B) Sales of personal property produced by the taxpayer within and
sold without the United States, or produced by the taxpayer without and
sold within the United States, and
(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.
[[Page 176]]
(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 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
[[Page 177]]
which deductions relate. See section 7602 and the regulations thereunder
which generally provide for the examination of books and witnesses. See
also section 905(b) and the regulations thereunder which require proof
of foreign tax credits to the satisfaction of the Secretary or his
delegate.
(g) 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
[[Page 178]]
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 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,
[[Page 179]]
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
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
[[Page 180]]
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 (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
[[Page 181]]
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 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..........................................
[[Page 182]]
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..........................................
------------
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
[[Page 183]]
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 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
[[Page 184]]
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 $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
[[Page 185]]
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 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.
[[Page 186]]
(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]
(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,
[[Page 187]]
(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 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).
[[Page 188]]
(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.
(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
[[Page 189]]
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
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
[[Page 190]]
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 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
[[Page 191]]
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 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
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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 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).
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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 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).
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(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 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
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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.
(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
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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 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
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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 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. In the case of taxpayers using the tax book value
method of apportionment, the following rules apply to determine the
value of the assets of a qualified business unit (QBU) (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)(3)), the tax book value is determined by applying the
rules of paragraph (g)(2)(i) of this section and Sec. 1.861-9T(g)(3) to
the beginning-of-year and end-of-year owner functional currency amount
of assets. The beginning-of-year owner functional currency amount of
assets is determined by reference to the owner 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 owner functional
currency amount of assets is determined by reference to the owner
functional currency amount of assets computed under Sec. 1.987-
4(d)(1)(i)(A) and (e) on the last day of the current taxable year. The
beginning-of-year and end-of-year owner functional currency amount of
assets, as so determined within each grouping, are then averaged as
provided in paragraph (g)(2)(i) of this section.
(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. 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 are
computed in dollars and averaged as provided in this paragraph (g)(2)
and Sec. 1.861-9T(g)(2).
(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).
(v) Applicability date. Generally, paragraph (g)(2)(ii)(A)(1) of
this section applies to taxable years beginning after December 31, 2024.
However, if pursuant to Sec. 1.987-15(b), a taxpayer chooses to apply
Sec. Sec. 1.987-1 through 1.987-15 to a taxable year before the first
taxable year described in Sec. 1.987-15(a)(1), then paragraph
(g)(2)(ii)(A)(1) of this section applies to that taxable year and
subsequent years.
(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
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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).
(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
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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
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
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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 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.
[[Page 201]]
(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; T.D. 10016, 89 FR 100164, Dec.
11, 2024]
Sec. 1.861-9T Allocation and apportionment of interest expense (temporary).
(a) In general. Any expense that is deductible under section 163
(including original issue discount) constitutes interest expense for
purposes of this section, as well as for purposes of Sec. Sec. 1.861-
10T, 1.861-11T, 1.861-12T, and 1.861-13T. The term interest refers to
the gross 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
[[Page 202]]
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 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
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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 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
[[Page 204]]
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.
(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
[[Page 205]]
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 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
[[Page 206]]
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 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.
[[Page 207]]
(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, 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
[[Page 208]]
(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 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
[[Page 209]]
(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, $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
[[Page 210]]
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 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
[[Page 211]]
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)-(ii) [Reserved]
(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]
(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
[[Page 212]]
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 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
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is determined on the basis of the taxpayer's percentage ownership
interest in the second related person) shall be increased to reflect the
first related person's percentage ownership interest in the second
related person to the extent it is larger.
Example. Assume that a taxpayer owns 80 percent of CFC1, which owns
100 percent of CFC2. The value of CFC1 is determined generally under
paragraph (h)(4) on the basis of the taxpayer's 80 percent indirect
interest in CFC2. For purposes of apportioning expenses of CFC1, 100
percent of the stock of CFC1 must be taken into account. Therefore, the
value of CFC2 stock in the hands of CFC1 shall equal the value of CFC2
stock in the hands of CFC1 as determined under paragraph (h)(4) of this
section, increased by 25 percent of such amount to reflect the fact that
CFC1 owns 100 percent and not 80 percent of CFC2.
(i) [Reserved]. For further guidance, see Sec. 1.861-9(i).
(j) Modified gross income method. Subject to rules set forth in
paragraph (f)(3) of this section, the interest expense of a controlled
foreign corporation may be allocated according to the following rules.
(1) Single-tier controlled foreign corporation. In the case of a
controlled foreign corporation that does not hold stock in any lower-
tier controlled foreign corporation, the interest expense of the
controlled foreign corporation shall be apportioned based on its gross
income.
(2) Multiple vertically owned controlled foreign corporations. In
the case of a controlled foreign corporation that holds stock in any
lower-tier controlled foreign corporation, the interest expense of that
controlled foreign corporation and such upper-tier controlled foreign
corporation shall be apportioned based on the following methodology:
(i) Step 1. Commencing with the lowest-tier controlled foreign
corporation in the chain, allocate and apportion its interest expense
based on its gross income as provided in paragraph (j)(1) of this
section, yielding gross income in each grouping net of interest expense.
(ii) Step 2. 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
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(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--
(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;
[[Page 215]]
(3) For the third effective taxable year, the 1984, 1985 and 1986
taxable years and the first and second effective taxable years;
(4) For the fourth effective taxable year, the 1985 and 1986 taxable
years and the first, second and third effective taxable years; and
(5) For the fifth effective taxable year, the 1986 taxable year and
the first, second, third and fourth effective taxable years.
(C) If, however, the U.S. shareholder does not choose, under
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to
one or more taxable years beginning before January 1, 1992, the U.S.
shareholder may not include within any foreign base period the taxable
year immediately preceding the first effective taxable year. Thus, for
example, a U.S. shareholder for which the first effective taxable year
is the taxable year beginning on October 1, 1992, may not include the
taxable year beginning on October 1, 1991, in any foreign base period.
Assuming that the U.S. shareholder does not elect the alternative base
periods described in paragraph (e)(2)(v)(B) of this section, the initial
foreign base period for the U.S. shareholder will consist of the taxable
years beginning on October 1 of 1986, 1987, 1988, 1989, and 1990. The
foreign base period for the U.S. shareholder for the following taxable
year, beginning on October 1, 1993, will consist of the taxable years
beginning on October 1 of 1987, 1988, 1989, 1990, and 1992.
(D) If the U.S. shareholder chooses the base periods described in
paragraph (e)(2)(v)(B) of this section as foreign base periods, it must
make a similar election under paragraph (e)(3)(v)(B) of this section
with respect to its U.S. base periods.
(vi) The ``related group debt-to-asset ratio'' of a U.S. shareholder
for a year is the ratio between--
(A) The related group indebtedness of the U.S. shareholder for the
year (as determined under paragraph (e)(2)(ii) of this section); and
(B) The average of the aggregate values at the beginning and end of
the year of the assets (including stock holdings in and obligations of
related persons, other than related controlled foreign corporations) of
each related controlled foreign corporation.
(vii) Notwithstanding paragraph (e)(2)(i) of this section, a U.S.
shareholder is considered to have no excess related group indebtedness
for the year if--
(A) Its related group indebtedness for the year does not exceed its
allowable related group indebtedness for the immediately preceding year
(as determined under paragraph (e)(2)(iii) of this section); or
(B) Its related group debt-to-asset ratio (as determined under
paragraph (e)(2)(vi) of this section) for the year does not exceed 0.10.
(3) Step Two: Excess U.S. shareholder indebtedness. (i) The excess
indebtedness of a U.S. shareholder for the year equals the amount by
which its unaffiliated indebtedness for the year exceeds its allowable
indebtedness for the year.
(ii) The ``unaffiliated indebtedness'' of the U.S. shareholder is
the average of the aggregate amounts at the beginning and end of the
year of indebtedness owed by the U.S. shareholder to any obligee, other
than a member of the affiliated group (as defined in Sec. 1.861-11T(d))
of the U.S shareholder.
(iii) The ``allowable indebtedness'' of a U.S. shareholder for the
year equals--
(A) The average of the aggregate values at the beginning and end of
the 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
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debt-to-asset ratio of the U.S. shareholder for any base year may not
exceed 110 percent of the U.S. base period ratio for that base year.
This limitation shall not apply with respect to any of the five taxable
years chosen as initial base years by the U.S. shareholder under
paragraph (e)(3)(v) of this section or with respect to any base year for
which of the debt-to-asset ratio does not exceed 0.10.
(v)(A) The U.S. base period for any current taxable year (except as
described in paragraphs (e)(3)(v) (B) and (C) of this section) shall
consist of the five taxable years immediately preceding the current
year.
(B) The U.S. shareholder may choose as U.S. base periods for all of
its first five taxable years for which this paragraph (e) is effective
the following alternative base periods:
(1) For the first effective taxable year, the 1982, 1983, 1984, 1985
and 1986 taxable years;
(2) For the second effective taxable year, the 1983, 1984, 1985 and
1986 taxable years and the first effective taxable year;
(3) For the third effective taxable year, the 1984, 1985 and 1986
taxable years and the first and second effective taxable years;
(4) For the fourth effective taxable year, the 1985 and 1986 taxable
years and the first, second and third effective taxable years; and
(5) For the fifth effective taxable year, the 1986 taxable year and
the first, second, third and fourth effective taxable years.
(C) If, however, the U.S. shareholder does not choose, under
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to
one or more taxable years beginning before January 1, 1992, the U.S.
shareholder may not include within any U.S. base period the taxable year
immediately preceding the first effective taxable year. Thus, for
example, a U.S. shareholder for which the first effective taxable year
is the taxable year beginning on October 1, 1992, may not include the
taxable year beginning on October 1, 1991, in any U.S. base period.
Assuming that the U.S. shareholder does not elect the alternative base
periods described in paragraph (e)(3)(v)(B) of this section, the initial
U.S. base period for the U.S. shareholder will consist of the taxable
years beginning on October 1, of 1986, 1987, 1988, 1989, and 1990. The
U.S. base period for the U.S. shareholder for the following taxable
year, beginning on October 1, 1993, will consist of the taxable years
beginning on October 1, 1987, 1988, 1989, 1990, and 1992.
(D) If the U.S. shareholder chooses the base periods described in
paragraph (e)(3)(v)(B) of this section as U.S. base periods, it must
make a similar election under paragraph (e)(2)(v)(B) of this section
with respect to its foreign base periods.
(vi) The ``debt-to-asset ratio'' of a U.S. shareholder for a year is
the ratio between--
(A) The unaffiliated indebtedness of the U.S. shareholder for the
year (as determined under paragraph (e)(3)(ii) of this section); and
(B) The average of the aggregate values at the beginning and end of
the year of the assets of the U.S. shareholder. For this purpose, the
assets of the U.S. shareholder include stock holdings in and obligations
of related controlled foreign corporations but do not include stock
holdings in and obligations of members of the affiliated group (as
defined in Sec. 1.861-11T(d)).
(vii) A U.S. shareholder is considered to have no excess
indebtedness for the year if its debt-to-asset ratio (as determined
under paragraph (e)(3)(vi) of this 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
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under Step Two in paragraph (e)(3) of this section).
(iii) The amount of interest income derived by a U.S. shareholder
from allocable related group indebtedness during the year equals the
total amount of interest income derived by the U.S. shareholder during
the year with respect to related group indebtedness, multiplied by the
ratio of allocable related group indebtedness for the year to the
aggregate amount of related group indebtedness for the year.
(iv) The portion of third party interest expense described in
paragraph (e)(4)(i) of this section shall be allocated in proportion to
the relative average amounts of related group indebtedness held by the
U.S. shareholder in each separate limitation category during the year.
The remaining portion of third party interest expense of the U.S.
shareholder for the year shall be apportioned as provided in Sec. Sec.
1.861-8T through 1.861-13T, excluding paragraph (e) of Sec. 1.861-10T
and this paragraph (e).
(v) The average amount of related group indebtedness held by the
U.S. shareholder in each separate limitation category during the year
equals the average of the aggregate amounts of such indebtedness in each
separate limitation category at the beginning and end of the year.
Solely for purposes of this paragraph (e)(4), each debt obligation of a
related controlled foreign corporation held by the U.S. shareholder at
the beginning or end of the year is attributed to separate limitation
categories in the same manner as the stock of the obligor would be
attributed under the rules of Sec. 1.861-12T(c)(3), whether or not such
stock is held directly by the U.S. shareholder.
(vi) The amount of third party interest expense of a U.S.
shareholder allocated pursuant to this paragraph (e)(4) shall not exceed
the total amount of the third party interest expense of the U.S.
shareholder for the year (excluding any third party interest expense
allocated under paragraphs (b) and (c) of Sec. 1.861-10T).
(5) Definitions. For purposes of this paragraph (e), the following
terms shall have the following meanings.
(i) U.S. shareholder. The term ``U.S. shareholder'' has the same
meaning as the term ``United States shareholder'' when used in section
957, except that, in the case of a United States shareholder that is a
member of an affiliated group (as defined in Sec. 1.861-11T(d)), the
entire affiliated group is considered to constitute a single U.S.
shareholder.
(ii) Related person. For the definition of the term ``related
person'', see Sec. 1.861-8T(c)(2). A controlled foreign corporation is
considered ``related'' to a U.S. shareholder if it is a related person
with respect to the U.S. shareholder.
(6) Determination of asset values. A U.S. shareholder shall
determine the values of the assets of each related controlled foreign
corporation (for purposes of Step One in paragraph (e)(2) of this
section) and the assets of the U.S. shareholder (for purposes of Step
Two in paragraph (e)(3) of this section) for any year in accordance with
the valuation method (tax book value or fair market value) elected for
that year pursuant to Sec. 1.861-9T(g). However, solely for purposes of
this paragraph (e), a U.S. shareholder may instead choose to determine
the values of the assets of all related controlled foreign corporations
by reference to their values as reflected on Forms 5471 (the annual
information return with respect to each related controlled foreign
corporation), subject to the translation rules of paragraph (e)(8)(i) of
this section. This method of valuation may be used only 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
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indebtedness held by the U.S. shareholder in each separate limitation
category during the year (as determined under Step Three in paragraph
(e)(4)(v) of this section).
(8) Special rules--(i) Exchange rates. All indebtedness amounts and
asset values (including current year and base year amounts and values)
denominated in a foreign currency shall be translated into U.S. dollars
at the exchange rate for the current year. The exchange rate for the
current year may be determined under any reasonable method (e.g.,
average of month-end exchange rates for each month in the current year)
if it is consistently applied to the current year and all base years.
Once chosen for a taxable year, a method for determining an exchange
rate must be used in each subsequent taxable year and will be treated as
a method of accounting for purposes of section 446. A taxpayer may apply
a different translation rule only with the prior consent of the
Commissioner. In this regard, the Commissioner will be guided by the
extent to which a different rule would reduce the comparability of
dollar amounts of indebtedness and dollar asset values for the base
years and the current year.
(ii) Exempt assets. Solely for purposes of this paragraph (e), any
exempt assets otherwise excluded under section 864(e)(3) and Sec.
1.861-8T(d) shall be included as assets of the U.S. shareholder or
related controlled foreign corporation.
(iii) Exclusion of certain directly allocated indebtedness and
assets. Qualified nonrecourse indebtedness (as defined in Sec. 1.861-
10T(b)(2)) and indebtedness incurred in connection with an integrated
financial transaction (as defined in Sec. 1.861-10T(c)(2)) shall be
excluded from U.S. shareholder indebtedness and related group
indebtedness. In addition, assets which are the subject of qualified
nonrecourse indebtedness or integrated financial transactions shall be
excluded from the assets of the U.S. shareholder and each related
controlled foreign corporation.
(iv) Exclusion of certain receivables. Receivables between related
controlled foreign corporations (or between members of the affiliated
group constituting the U.S. shareholder) shall be excluded from the
assets of the related controlled foreign corporation (or affiliated
group member) holding such receivables. See also Sec. 1.861-11T(e)(1).
(v) Classification of 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
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paragraph (e) does apply to all following years, including years in
which later members of the affiliated group may be incorporated.
(B) Foreign and U.S. base period ratios. In computing the foreign
and U.S. base period ratios, the foreign and U.S. base periods of the
U.S. shareholder shall be considered to be only the period prior to the
current year that the U.S. shareholder was in existence if this prior
period is less than five taxable years.
(iii) Acquisition of additional corporations. (A) If a U.S.
shareholder acquires (directly or indirectly) stock of a foreign or
domestic corporation which, by reason of the acquisition, then becomes a
related controlled foreign corporation or a member of the affiliated
group, then in determining excess related group indebtedness or excess
U.S. shareholder indebtedness, the indebtedness and assets of the
acquired corporation shall be taken into account only at the end of the
acquisition year and in following years. Thus, amounts of indebtedness
and assets and the various debt-to-asset ratios of the U.S. shareholder
existing at the beginning of the acquisition year or relating to
preceding years are not recalculated to take account of indebtedness and
assets of the acquired corporation existing as of dates before the end
of the year. If, however, a major acquisition is made within the last
three months of the year and a substantial distortion of values for the
year would otherwise result, the taxpaper must take into account the
average values of the acquired indebtedness and assets weighted to
reflect the time such indebtedness is owed and such assets are held by
the taxpayer during the year.
(B) In the case of a reverse acquisition subject to this paragraph
(e)(9), the rules of Sec. 1.1502-75(d)(3) apply in determining which
corporations are the acquiring and acquired corporations. For this
purpose, whether corporations are affiliated is determined under Sec.
1.861-11T(d).
(C) If the stock of a U.S. shareholder is acquired by (and, by
reason of such acquisition, the U.S. shareholder becomes affiliated
with) a corporation described below, then such U.S. shareholder shall be
considered to have acquired such corporation for purposes of the
application of the rules of this paragraph (e). A corporation to which
this paragraph (e)(9)(iii)(C) applies is--
(1) A corporation which is not affiliated with any other corporation
(other than other similarly described corporation); and
(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
[[Page 220]]
such indebtedness is owed and such assets are held by the taxpayer
during the year.
(vi) Election to compute base period ratios by excluding divested
corporations. A U.S. shareholder may choose, solely for purposes of
paragraph (e) (9) (v) and (vii) of this section, to compute its foreign
and U.S. base period ratios for the disposition year and all subsequent
years without taking into account the indebtedness and asset values of
the divested corporation or corporations at the beginning of the
disposition year and in each of the five base years preceding the
disposition year. This election, if made for a disposition, must be made
for all other dispositions occurring during the same taxable year or
initiated in that year and concluded in the following year.
(vii) Section 355 transactions. A U.S. corporation which becomes a
separate U.S. shareholder as a result of a distribution of its stock to
which section 355 applies shall be considered--
(A) As disposed of by the U.S. shareholder of the affiliated group
of which the distributing corporation is a member, with this disposition
subject to the rules of paragraphs (e) (9) (v) and (vi) of this section;
and
(B) As having the same related group debt-to-asset ratio and debt-
to-asset ratio as the distributing U.S. shareholder in each year
preceding the year of distribution for purposes of applying this
paragraph (e) to the year of 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
[[Page 221]]
group indebtedness of $24,000 for 1989 (assuming a foreign base period
ratio in 1989 of .12), and X's related group debt-to-asset ratio for
1990 is .20, which is greater than the ratio of .10 described in
paragraph (e)(2)(vii)(B) of this section. Therefore, X's excess related
group indebtedness for 1990 remains at $20,000.
(iii) Step 2: Using a beginning and end of year average, X has the
following average amounts of U.S. and foreign indebtedness and average
asset values:
--------------------------------------------------------------------------------------------------------------------------------------------------------
1985 1986 1987 1988 1989 1990
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1)..................................................... $231,400 225,000 225,000 225,000 220,800 249,600
(2)..................................................... 445,000 450,000 450,000 450,000 460,000 480,000
.............. .............. .............. .............. .............. (a)
(3)..................................................... .52 .50 .50 .50 .48 .52
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) U.S. and foreign indebtedness
(2) Average value of assets of U.S. shareholder
(3) Debt-to-Asset ratio of U.S. shareholder
(a) [500,000-20,000 (excess related group indebtedness determined in
Step 1)]
X's ``U.S. base period ratio'' for 1990 is:
(.52 + .50 + .50 + .50 + .48) / 5 = .50
X's ``allowable indebtedness'' for 1990 is:
$480,000 x .50 = $240,000
X's ``excess U.S. shareholder indebtedness'' for 1990 is:
$249,000 - $240,000 = $9,600
X's debt-to-asset ratio for 1990 is .52, which is greater than the
ratio of .10 described in paragraph (e)(3)(vii) of this section.
Therefore, X's excess U.S. shareholder indebtedness for 1990 remains at
$9,600.
(iv) Step 3: (a) Since X's excess U.S. shareholder indebtedness of
$9,600 is less than its excess related group indebtedness of $20,000,
X's allocable related group indebtedness for 1990 is $9,600. The amount
of interest received by X during 1990 on allocable related group
indebtedness is:
$5,000 x $9,600 / $50,000 = $960
(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
[[Page 222]]
Reduction of X's assets generating foreign source high withholding
tax interest income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.003
(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
[[Page 223]]
lease or other interest therein) as security for payment of the
principal and interest on the loan and, thus, cannot look to any other
property, the borrower, or any third party with respect to repayment of
principal or interest on the loan;
(iv) The cash flow from the property, as defined in paragraph (b)(3)
of this section, is reasonably expected to be sufficient in the first
year of ownership as well as in each subsequent year of ownership to
fulfill the terms and conditions of the loan agreement with respect to
the amount and timing of payments of interest and original issue
discount and periodic payments of principal in each such year; and
(v) There are restrictions in the loan agreement on the disposal or
use of the property consistent with the assumptions described in
subdivisions (iii) and (iv) of this paragraph (b)(2).
(3) Cash flow defined--(i) In general. The term ``cash flow from the
property'' as used in paragraph (b)(2)(iv) of this section means a
stream of revenue (as computed under paragraph (b)(3)(ii) of this
section) substantially all of which derives directly from the property.
The phrase ``cash flow from the property'' does not include revenue if a
significant portion thereof is derived from activities such as sales,
labor, services, or the use of other property. Thus, revenue derived
from the sale or lease of inventory or of similar property does not
constitute cash flow from the property, including plant or equipment
used in the manufacture and sale or lease, or purchase and sale or
lease, of such inventory or similar property. In addition, revenue
derived in part from the performance of services that are not ancillary
and subsidiary to the use of property does not constitute cash flow from
the property.
(ii) Self-constructed assets. The activities associated with self-
construction of assets shall be considered to constitute labor or
services for purposes of paragraph (b)(3)(i) only if the self-
constructed asset--
(A) Is constructed for the purpose of resale, or
(B) Without regard to purpose, is sold to an unrelated person within
one year from the date that the property is placed in service for
purposes of section 167.
(iii) Computation of cash flow. Cash flow is computed by subtracting
cash disbursements excluding debt service from cash receipts.
(iv) Analysis of operating costs. [Reserved]
(v) Examples. The principles of this paragraph may be demonstrated
by the following examples.
Example 1. In 1987, X borrows $100,000 in order to purchase an
apartment building, which X then purchases. The loan is secured only by
the building and the leases thereon. Annual debt service on the loan is
$12,000. Annual gross rents from the building are $20,000. Annual taxes
on the building are $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.
[[Page 224]]
(4) Exclusions. The term ``qualified nonrecourse indebtedness''
shall not include any transaction that--
(i) Lacks economic significance within the meaning of paragraph
(b)(5) of this section;
(ii) Involves cross collateralization within the meaning of
paragraph (b)(6) of this section;
(iii) Except in the case of a leveraged lease described in paragraph
(b)(7)(ii) of this section, involves credit enhancement within the
meaning of paragraph (b)(7) of this section or, with respect to loans
made on or after October 14, 1988, does not under the terms of the loan
documents, prohibit the acquisition by the holder of bond insurance or
similar forms of credit enhancement;
(iv) Involves the purchase of inventory;
(v) Involves the purchase of any financial asset, including stock in
a corporation, an interest in a partnership or a trust, or the debt
obligation of any obligor (although interest incurred in order to
purchase certain financial instruments may qualify for direct allocation
under paragraph (c) of this section);
(vi) Involves interest expense that constitutes qualified residence
interest as defined in section 163(h)(3); or
(vii) [Reserved]
(5) Economic significance. Indebtedness that otherwise qualifies
under paragraph (b)(2) shall nonetheless be subject to apportionment
under Sec. 1.861-9T if, taking into account all the facts and
circumstances, the transaction (including the security arrangement)
lacks economic significance.
(6) Cross collateralization. The term ``cross collateralization''
refers to the pledge as security for a loan of--
(i) Any asset of the borrower other than the identified property
described in paragraph (b)(2) of this section, or
(ii) Any asset belonging to any related person, as defined in Sec.
1.861-8T(c)(2).
(7) Credit enhancement--(i) In general. Except as provided in
paragraph (b)(7)(ii) of this section, the term ``credit enhancement''
refers to any device, including a contract, letter of credit, or
guaranty, that expands the creditor's rights, directly or indirectly,
beyond the identified property purchased, constructed, or improved with
the funds advanced and, thus effectively provides as security for a loan
the assets of any person other than the borrower. The acquisition of
bond insurance or any other contract of suretyship by an initial or
subsequent holder of an obligation shall constitute credit enhancement.
(ii) Special rule for leveraged leases. For purposes of this
paragraph (b), the term ``credit enhancement'' shall not include any
device under which any person that is not a related person within the
meaning of Sec. 1.861-8T(c)(2) agrees to guarantee, without recourse to
the lessor or any person related to the lessor, a lessor's payment of
principal and interest on indebtedness that 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.
[[Page 225]]
(8) Other arrangements that do not constitute cross
collateralization or credit enhancement. For purposes of paragraphs
(b)(6) and (7) of this section, the following arrangements do not
constitute cross collateralization or credit enhancement:
(i) Integrated projects. A taxpayer's pledge of multiple assets of
an integrated project, provided that the integrated project. An
integrated project consists of functionally related and geographically
contiguous assets that, as to the taxpayer, are used in the same trade
or business.
(ii) Insurance. A taxpayer's purchase of third-party casualty and
liability insurance on the collateral or, by contract, bearing the risk
of loss associated with destruction of the collateral or with respect to
the attachment of third party liability claims.
(iii) After-acquired property. Extension of a creditor's security
interest to improvements made to the collateral, provided that the
extension does not constitute excess collateralization under paragraph
(b)(6), determined by taking into account the value of improvements at
the time the improvements are made and the value of the original
property at the time the loan was made.
(iv) Warranties of completion and maintenance. A taxpayer's warranty
to a creditor that it will complete construction or manufacture of the
collateral or that it will maintain the collateral in good condition.
(v) Substitution of collateral. A taxpayer's right to substitute
collateral under any loan contract. However, after the right is
exercised, the loan shall no longer constitute qualified nonrecourse
indebtedness.
(9) Refinancings. If a taxpayer refinances qualified nonrecourse
indebtedness (as defined in paragraph (b)(2) of this section) with new
indebtedness, such new indebtedness shall continue to qualify only if--
(i) The principal amount of the new indebtedness does not exceed by
more than five percent the remaining principal amount of the original
indebtedness,
(ii) The term of the new indebtedness does not exceed by more than
six months the remaining term of the original indebtedness, and
(iii) The requirements of this paragraph (other than those of
paragraph (b)(2) (i) and (ii) of this section) are satisfied at the time
of the refinancing, and the exclusions contained in this paragraph
(b)(4) do not apply.
(10) Post-construction permanent financing. Financing that is
obtained after the completion of constructed property will be deemed to
satisfy the requirements of paragraph (b)(2) (i) and (ii) of this
section if--
(i) The financing is obtained within one year after the constructed
property or substantially all of a constructed integrated project (as
defined in paragraph (b)(9)(i) of this section) is placed in service for
purposes of section 167; and
(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
[[Page 226]]
to fulfill the terms and conditions of the loan agreement with respect
to the amount and timing of payments of principal and interest or
original issue discount;
(iii) The income constitutes interest or original issue discount or
would constitute income equivalent to interest if earned by a controlled
foreign corporation (as described in Sec. 1.954-2T(h));
(iv) The debt incurred and the investment mature within ten business
days of each other;
(v) The investment does not relate in any way to the operation of,
and is not made in the normal course of, the trade or business of the
taxpayer or any related person, including the financing of the sale of
goods or the performance of services by the taxpayer or any related
person, or the compensation of the taxpayer's employees (including any
contribution or loan to an employee stock ownership plan (as defined in
section 4975(e)(7)) or other plan that is qualified under section
401(a)); and
(vi) The borrower does not constitute a financial services entity
(as defined in section 904 and the regulations thereunder).
(3) Rollovers. In the event that a taxpayer sells of otherwise
liquidates an investment described in paragraph (c)(2) of this section,
the interest expense incurred on the borrowing shall, subsequent to that
liquidation, no longer qualify for direct allocation under this
paragraph (c).
(4) Examples. The principles of this paragraph (c) may be
demonstrated by the following examples.
Example 1. X is a manufacturer and does not constitute a financial
services entity as defined in the regulations under section 904. On
January 1, 1988, X borrows $100 for 6 months at an annual interest rate
of 10 percent. X identifies on its books and records by the close of
that day that the indebtedness is being incurred for the purpose of
making an investment that is intended to qualify as an integrated
financial transaction. On January 5, 1988, X uses the proceeds to
purchase a portfolio of stock that approximates the composition of the
Standard & Poor's 500 Index. On that day, X also enters into a forward
sale contract that requires X to sell the stock on June 1, 1988 for
$110. X identifies on its books and records by the close of January 5,
1988, that the portfolio stock purchases and the forward sale contract
constitute part of the integrated financial transaction with respect to
which the identified borrowing was incurred. Under Sec. 1.954-2T(h),
the income derived from the transaction would constitute income
equivalent to interest. Assuming that the return on the investment to be
derived on June 1, 1988, will be sufficient to pay the interest due on
June 1, 1988, the interest on the borrowing is directly allocated to the
gain from the investment.
Example 2. X does not constitute a financial services entity as
defined in the regulations under section 904. X is in the business of,
among other things, issuing credit cards to consumers and purchasing
from merchants who accept the X card the receivables of consumers who
make purchases with the X card. X borrows from Y in order to purchase X
credit card receivables from Z, a merchant. Assuming that the Y
borrowing satisfies the other requirements of paragraph (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.
[[Page 227]]
(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).
(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
[[Page 228]]
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) 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
[[Page 229]]
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, 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.
[[Page 230]]
(iii) Treatment of bank holding companies. The total aggregate
interest expense of any member of an affiliated group that constitutes a
bank holding company subject to regulation under the Bank Holding
Company Act of 1956 shall be prorated between the financial group and
the nonfinancial group on the basis of the assets in the financial and
nonfinancial groups. For purposes of making this proration, the assets
of each member of each group, and not the stock basis in each member,
shall be taken into account. Any direct or indirect subsidiary of a bank
holding company that is predominantly engaged in the active conduct of a
banking, financing, or similar business shall be considered to be a
financial corporation for purposes of this paragraph (d)(4). The
interest expense of the bank holding company must be further apportioned
in accordance with Sec. 1.861-9T(f) to the various section 904(d)
categories of income contained in both the financial group and the
nonfinancial group on the basis of the assets owned by each group. For
purposes of computing the apportionment fractions for each group, the
assets owned directly by a bank holding company within each limitation
category described in section 904(d)(1) (other than stock in affiliates
or assets described in Sec. 1.861-9T(f)) shall be treated as owned pro
rata by the nonfinancial group and the financial group based on the
relative amounts of investments of the bank holding company in the
nonfinancial group and financial group.
(iv) Consideration of stock of the members of one group held by
members of the other group. In apportioning interest expense, the
nonfinancial group shall not take into account the stock of any lower-
tier corporation that is treated as a member of the financial group
under paragraph (d)(4)(i) of this section. Conversely, in apportioning
interest expense, the financial group shall not take into account the
stock of any lower-tier corporation that is treated as a member of the
nonfinancial group under paragraph (d)(4)(i) of this section. For the
treatment of loans between members of the financial group and members of
the nonfinancial group, see paragraph (e)(1) of this section.
(5) Example. (i) Facts. X, a domestic corporation which is not a
bank holding company, is the parent of domestic corporations Y and Z. Z
owns 100 percent of the stock Z1, which is also a domestic corporation.
X, Y, Z, and Z1 were organized after January 1, 1987, and constitute an
affiliated group within the meaning of paragraph (d)(1) of this section.
Y and Z are financial corporations described in paragraph (d)(4) of this
section. X also owns 25 percent of the stock of A, a domestic
corporation. Y owns 25 percent of the voting stock of B, a foreign
corporation that is not a controlled foreign corporation. 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................
[[Page 231]]
X's basis in the A stock adjusted by the allocable amount $100,000
of A's earnings and profits...............................
------------
Total domestic assets................................ $2,000,000
------------
Total assets......................................... $2,500,000
(ii) Allocation. No portion of the $50,000 deduction of the YZ group
is definitely related solely to specific property within the meaning of
Sec. 1.861-10T. Thus, the YZ group's deduction for interest is related
to all its activities and properties. Similarly, no portion of the
$50,000 deduction of the XZ1 group is definitely related solely to
specific property within the meaning of Sec. 1.861-10T. Thus, the XZ1
group's deduction for interest is related to all its activities and
properties.
(iii) Apportionment. The YZ group would apportion its interest
expense as follows:
To gross financial services income from sources outside the United
States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.004
To gross income subject to a separate limitation for dividends from B:
[GRAPHIC] [TIFF OMITTED] TC07OC91.005
To gross income from sources inside the United States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.006
The XZ1 group would apportion its interest expense as follows:
To gross general limitation income from sources outside the United
States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.007
To gross income from sources inside the United States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.008
(6) Certain unaffiliated corporations. Certain corporations that are
not described in paragraph (d)(1) of this section will nonetheless be
considered to constitute affiliated corporations for purposes of
Sec. Sec. 1.861-9T through 1.861-13T. These corporations include:
(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
[[Page 232]]
two affiliated corporations only one of which constitutes a financial
corporation under paragraph (d)(4) of this section, the member borrower
shall allocate and apportion related person interest payments in the
same manner as unrelated person interest expense using group
apportionment fractions computed under Sec. 1.861-9T(f). The source of
the related person interest income to the member lender shall be
determined under section 861(a)(1).
(iii) Special rule for high withholding tax interest. In the case of
an affiliated corporation that pays interest that is high withholding
tax interest under Sec. 1.904-5(f)(1) to another affiliated
corporation, the interest expense of the payor shall be allocated to
high withholding tax interest.
(3) Back-to-back loans. If a member of the affiliated group makes a
loan to a nonmember who makes a loan to a member borrower, the rule of
paragraphs (e) (1) and (2) of this section shall apply, in the
Commissioner's discretion, as if the member lender made the loan
directly to the member borrower, provided that the loans constitute a
back-to-back loan transaction. Such loans will constitute a back-to-back
loan for purposes of this paragraph (e) if the loan by the nonmember
would not have been made or maintained on substantially the same terms
irrespective of the loan of funds by the lending member to the nonmember
or other intermediary party.
(4) Examples. The rules of this paragraph (e) may be illustrated by
the following examples.
Example 1. X, a domestic corporation, is the parent of Y, a domestic
corporation. X and Y were organized after January 1, 1987, and
constitute an affiliated group within the meaning of paragraph (d)(1) of
this section. Among X's assets is the note of Y for the amount of
$100,000. Because X and Y are members of an affiliated group, Y's note
does not constitute an asset for purposes of apportionment. The
apportionment fractions for the relevant tax year of the XY group are 50
percent domestic, 40 percent foreign general, and 10 percent foreign
passive. Y deducts its related person interest payment using those
apportionment fractions. Of the $10,000 in related person interest
income received by X, $5,000 consists of domestic source income, $4,000
consists of foreign general limitation income, and $1,000 consists of
foreign passive income.
Example 2. X is a domestic corporation organized after January 1,
1987. X owns all the stock of Y, a domestic corporation. On June 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
[[Page 233]]
and in the case of any corporation described in paragraph (d)(6) of this
section, the foreign tax credits in any separate limitation category are
limited to the credits computed under the rules of this paragraph (g).
As a consequence of the affiliated group allocation and apportionment of
interest expense required by section 864(e)(1) and this section,
interest expense of a group member may be apportioned for section 904
purposes to a limitation category in which that member has no gross
income, resulting in a loss in that limitation category. The same is
true in connection with any expense other than interest that is subject
to apportionment under the rules of section 864(e)(6) of the Code. Any
reference to ``interest expense'' in this paragraph (g) shall be treated
as including such expenses. For purposes of this paragraph, the term
``limitation category'' includes domestic source income, as well as the
types of income described in section 904(d)(1) (A) through (I). A loss
of one affiliate in a limitation category will reduce the income of
another member in the same limitation category if a consolidated return
is filed. (See Sec. 1.1502-4.) If a consolidated return is not filed,
this netting does not occur. Accordingly, in such a case, the following
adjustments among members are required in order to give effect to the
group allocation of interest expense:
(i) Losses created through group apportionment of interest expense
in one or more limitation categories within a given member must be
eliminated; and
(ii) A corresponding amount of income of other members in the same
limitation category must be recharacterized.
Such adjustments shall be accomplished, in accordance with paragraph
(g)(2) of this section, without changing the total taxable income of any
member and before the application of section 904(f). Section 904(f)
(including section 904(f)(5)) does not apply to a loss created through
the apportionment of interest expense to the extent that the loss is
eliminated pursuant to paragraph (g)(2)(ii) of this section. For
purposes of this section, the terms ``limitation adjustment'' and
``recharacterization'' mean the recharacterization of income in one
limitation category as income in another limitation category.
(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.
[[Page 234]]
(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 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.
[[Page 235]]
(v) Step 4: Recharacterization. The loss offset adjustments yield a
positive change in the foreign passive and the foreign general
limitation categories. Y and Z both have income in these limitation
categories. Accordingly, the income of Y and Z in each of these
limitation categories must be reduced on a pro rata basis (by reference
to the adjusted taxable income figures) to the extent of the positive
change in each limitation category. The total positive change in the
foreign passive limitation category is $0.52. The adjusted taxable
income of Y in the foreign passive limitation category is $4.02 and the
adjusted taxable income of Z in the foreign passive limitation category
is $3. Therefore, $0.30 is drawn from Y and $0.22 is drawn from Z. The
total positive change in the foreign general limitation category is
$2.48. The adjusted taxable income of Y in the foreign general
limitation category is $48.98, and the adjusted taxable income of Z in
the foreign general limitation category is $17. Therefore, $1.84 is
drawn from Y and $.64 is drawn from Z.
The members must then separately compute the sum of the limitation
reductions. Y has limitation reductions of $0.30 in the foreign passive
limitation category and $1.84 in the foreign general limitation
category, yielding total limitation reduction of $2.14. Under these
facts, domestic income is the only limitation category requiring a
positive adjustment. Accordingly, Y's domestic income is increased by
$2.14. Z has limitation reductions of $0.22 in the foreign passive
limitation category and $0.64 in the foreign general limitation
category, yielding total limitation reductions of $0.86. Under these
facts, domestic income is the only limitation category of Z requiring a
positive adjustment. Accordingly, Z's domestic income is increased by
$0.86.
------------------------------------------------------------------------
Recharacterization adjustments X Y Z Total
------------------------------------------------------------------------
Domestic............................ 0 + 2.14 + 0.86 + 3.00
Foreign Passive..................... 0 -0.30 -0.22 -0.52
Foreign General..................... 0 -1.84 -0.64 -2.48
------------------------------------------------------------------------
These recharacterization adjustments yield the following final
taxable income figures:
------------------------------------------------------------------------
Final taxable income X Y Z Total
------------------------------------------------------------------------
Domestic............................. 52.00 2.14 3.86 58.00
Foreign Passive...................... 0 3.72 2.78 6.50
Foreign General...................... 0 47.14 16.36 63.50
----------------------------------
Total............................ 52.00 53.00 23.00 128.00
------------------------------------------------------------------------
Example 2. (i) Facts. X, a domestic corporation, is the parent of
domestic corporations Y and Z. X, Y, and Z were organized after January
1, 1987, constitute an affiliated group within the meaning of paragraph
(d)(1) of this section, but do not file a consolidated return. Moreover,
X has served as the sole borrower in the group and, as a result, has
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
------------------------------------------------------------------------
[[Page 236]]
These adjustments yield the following adjusted taxable income
figures:
------------------------------------------------------------------------
Adjusted taxable income X Y Z Total
------------------------------------------------------------------------
Domestic........................ -40 0 100 60
Foreign Passive................. 0 5 5 10
Foreign General................. 0 70 35 105
---------------------------------------
Total....................... -40 75 140 175
------------------------------------------------------------------------
(iv) Step 3: Determination of amount subject to recharacterization.
The adjustments performed under Step 2 led to a change in the group's
taxable income within each limitation category. The total loss offset
adjustment column shown in paragraph (iii) above shows the net
deviations between Steps 1 and 2.
(v) Step 4: Recharacterization. The loss offset adjustments yield a
positive change in the foreign passive and the foreign general
limitation categories. Y and Z both have income in these limitation
categories. Accordingly, the income of Y and Z in each of these
limitation categories must be reduced on a pro rata basis (by reference
to the adjusted taxable income figures) to the extent of the positive
change in each limitation category. The total positive change in the
foreign passive limitation category is $3.50. The adjusted taxable
income of Y in the foreign passive limitation category is $5, and the
adjusted taxable income of Z in the foreign passive limitation category
is $5. Therefore, $1.75 is drawn from Y and $1.75 is drawn from Z. The
total positive change in the foreign general limitation category is
$31.50. The adjusted taxable income of Y in the foreign general
limitation category is $70, and the adjusted taxable income of Z in the
foreign general limitation category is $35. Therefore, $21 is drawn from
Y and $10.50 is drawn from Z.
The members must then separately compute the sum of the limitation
reductions. Y has limitation reductions of $1.75 in the foreign passive
limitation category and $21 in the foreign general limitation category,
yielding total limitation reductions of $22.75. Under these facts,
domestic income is the only limitation category requiring a positive
adjustment. Accordingly, Y's domestic income is increased by $22.75. Z
has limitation reductions of $1.75 in the foreign passive limitation
category and $10.50 in the foreign general limitation category, yielding
total limitation reductions of $12.25. Under these facts, domestic
income is the only limitation category requiring a positive adjustment.
Accordingly, Z's domestic income is increased by $12.25.
------------------------------------------------------------------------
Recharacterization adjustments X Y Z Total
------------------------------------------------------------------------
Domestic........................ 0 + 22.75 + 12.25 + 35.00
Foreign Passive................. 0 -1.75 -1.75 -3.50
Foreign General................. 0 -21.00 -10.50 -31.50
------------------------------------------------------------------------
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
[[Page 237]]
(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 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
[[Page 238]]
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 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
[[Page 239]]
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 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
[[Page 240]]
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 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
[[Page 241]]
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 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,
[[Page 242]]
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).
(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
[[Page 243]]
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 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
[[Page 244]]
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 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]
[[Page 245]]
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 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
[[Page 246]]
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 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
[[Page 247]]
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 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.
[[Page 248]]
(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 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
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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.
(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,
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$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
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
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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 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
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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 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
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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 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
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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 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
[[Page 255]]
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) 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
[[Page 256]]
the application of a method of apportionment based on units sold or
sales receipts, interaffiliate sales shall be eliminated.
(ii) Except as otherwise provided in this section, the rules of
Sec. 1.861-8T apply to the allocation and apportionment of the expenses
described in paragraph (e) of this section. Thus, allocation under this
paragraph (c) is accomplished by determining, with respect to each
expense described in paragraph (e), the class of gross income to which
the expense is definitely related and then allocating the deduction to
such class of gross income. For this purpose, the gross income of all
members of the affiliated group must be taken in account. Then, the
expense is apportioned by attributing the expense to gross income
(within the class to which the expense has been allocated) which is in
the statutory grouping and to gross income (within the class) which is
in the residual grouping. Section 1.861-8T(c)(1) identifies a number of
factors upon which apportionment may be based, such as comparison of
units sold, gross sales or receipts, assets used, or gross income. The
apportionment method chosen must be applied consistently by each member
of the affiliated group in apportioning the expense when more than one
member incurred the expense or when members incurred separate portions
of the expense. The apportionment fraction must take into account the
apportionment factors contributed by all members of the affiliated
group. In the case of an affiliated group of corporations that files a
consolidated return, consolidated foreign tax credit limitations are
computed for the group in accordance with the rules of Sec. 1.1502-4.
For purposes of this section the term ``taxpayer'' refers to the
affiliated group (regardless of whether the group files a consolidated
return), rather than to the separate members thereof.
(2) Expenses relating to fewer than all members. An expense relates
to fewer than all members of an affiliated group if the expense is
allocable under paragraph (e)(1) of this section to gross income of at
least one member other than the member that incurred the expense but
fewer than all members of the affiliated group. The taxable income of
the member that incurred the expense shall be determined by apportioning
that expense under the rules of paragraph (c)(1) of this section as if
the members of the affiliated group that derive gross income to which
such expense is allocable under paragraph (e)(1) were treated as a
single corporation.
(3) Prior application of section 482. The rules of this section do
not supersede the application of section 482 and the regulations
thereunder. Section 482 may be applied effectively to deny a deduction
for an expense to one member of an affiliated group and to allow a
deduction for that expense to another member of the affiliated group. In
cases to which section 482 is applied, expenses shall be reallocated and
reapportioned under section 864(e)(6) and this section after taking into
account the application of section 482.
(d)(1)-(2) [Reserved]. For further guidance, see Sec. 1.861-
14(d)(1) and (2).
(e) Expenses to be allocated and apportioned under this section. (1)
Expenses 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
[[Page 257]]
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 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
[[Page 258]]
factor chosen, apportionment is based on a fraction, the numerator of
which is export related combined gross income of the FSC or DISC and
related supplier and the denominator of which is the total gross income
of the affiliated group. Similarly, if units sold or sales receipts is
the apportionment factor chosen, the fraction is the units sold or sales
receipts that generated export income of the FSC or DISC and related
supplier over the total units sold or sales receipts of the affiliated
group. Under this rule, expenses of other group members may be
attributed to the combined gross income of a FSC of DISC and its related
supplier without affecting the amount of expenses (other than any
commission payable by the related supplier to the FSC or DISC) otherwise
deductible by the FSC or DISC, the related supplier, or other members of
the affiliated group. The FSC or DISC must calculate combined taxable
income, taking into account any reduction by expenses attributed from
other members of the affiliated group to determine the commission
derived by the FSC or DISC or the transfer price of qualifying export
property sold to the FSC or DISC.
(g) Losses created through apportionment. In the case of an
affiliated group that does not file a consolidated return, the taxable
income in any separate limitation category must be adjusted under this
paragraph (g) for purposes of computing the separate foreign tax credit
limitations under section 904(d). As a consequence of the affiliated
group allocation and apportionment of expenses required by section
864(e)(6) and this section, expenses of a group member may be
apportioned for section 904 purposes to a limitation category with a
consequent loss in that limitation category. For purposes of this
paragraph, the term ``limitation category'' includes domestic source
income, as well as the types of income described in section 904(d)(1)
(A) through (I). A loss of one affiliate in a limitation category will
reduce the income of another member in the same limitation category if a
consolidated return is filed. (See Sec. 1.1502-4.) If a consolidated
return is not filed, this netting does not occur. Accordingly, in such a
case, the following adjustments among members are required, in order to
give effect to the group allocation of expense:
(1) Losses created through group apportionment of expense in one or
more limitation categories within a given member must be eliminated; and
(2) A corresponding amount of income of other members in the same
limitation category must be recharacterized.
Such adjustments shall be accomplished in accordance with the rules of
Sec. 1.861-11T(g).
(h) Special rule for 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
[[Page 259]]
................................................................$100,000
Exclusive apportionment to United States source gross income.....$30,000
Research expense to be apportioned on the basis of sales.........$70,000
Apportionment of research expense to foreign source general limitation
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.018
Apportionment of research expense to United States source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.019
Total apportioned deduction for research........................$100,000
Of which--
Apportioned to foreign source gross income.......................$28,000
Apportioned to U.S. source gross income ($30,000 + $42,000)......$72,000
Tentative Apportionment on the Basis of Gross Income
Research expense apportioned to foreign source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.020
Research expense apportioned to United States income:
[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:
[[Page 260]]
[GRAPHIC] [TIFF OMITTED] TC07OC91.022
Apportionment of $100,000 expense to United States source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.023
Total apportioned expense.......................................$100,000
Example 3: (i) Facts. The facts are the same as in Example (2)
above, except that only employees of P and X participate in the training
program.
(ii) Analysis. Because only the employees of P and X participate in
the training program and they perform no services for Y, the expense
relates only to gross income generated by P and X. Accordingly, the
$100,000 expense must be allocated and apportioned as if P and X were a
single corporation. The apportionment of the $100,000 expense is as
follows:
Apportionment of $100,000 expense to foreign source general limitation
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.024
Apportionment of $100,000 expense to U.S. source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.025
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
[[Page 261]]
Apportionment of legal expenses to U.S. source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.027
Example 6: (i) Facts. P owns all of the stock of R, which owns all
of the stock of F. P and R are domestic corporations, and F is a foreign
sales corporation under section 922 of the Code. R and F have entered
into an agreement whereby F is paid a commission with respect to sales
of product A. In 1987, P had gross receipts of $1,000,000 from domestic
sales of product A, and gross receipts of $1,000,000 from foreign sales
of product A. R had gross receipts of $1,000,000 from domestic sales of
product A, and $1,000,000 from export sales of product A. R's cost of
goods sold attributable to export sales is $500,000. R has deductible
expenses of $100,000 directly related to its export sales, and F has
such deductible expenses of $100,000. During 1987, P incurred an expense
of $100,000 for marketing studies involving the worldwide market for
product A.
(ii) Analysis. P and R are an affiliated group of corporations
within the meaning of section 864(e)(5) and this section. The expense
incurred by P for marketing studies regarding the worldwide market for
product A is an expense that is not directly related solely to the
activities of P, but also to the activities of R. This expense must be
allocated and apportioned under the rules of paragraph (c)(1) of this
section, as if P and R were a single corporation. The expense is
allocable to the class of gross income that includes all gross income
generated by sales of product A. Apportionment on the basis of gross
receipts is reasonable under these facts. F, a foreign corporation, is
not a member of the affiliated group. However, for purposes of
determining F's commission on its sales, the combined gross income of F
and R must be reduced by the portion of the marketing studies expense of
P that is incurred in connection with export sales involving F under the
rules of paragraph (f) of this section. The computation of the combined
taxable income of R and F is as follows:
Combined Taxable Income of R and F
R's gross receipts from export sales....................... $1,000,000
R's cost of goods sold................................... $500,000
------------
Combined Gross Income...................................... $500,000
------------
Less:
R's other deductible expenses............................ $100,000
F's other deductible expenses............................ 100,000
Apportionment of P's expense:
[GRAPHIC] [TIFF OMITTED] TC07OC91.028
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
[[Page 262]]
this section has the meaning assigned to it by section 7701(a)(30).
(b) Property to which the election applies--(1) Section 38 property.
An election made under this section may be made only if the aircraft or
vessel is section 38 property, or property which would be section 38
property but for section 48(a)(5) (relating to property used by
governmental units), at the time the election is made and for all
taxable years to which the election applies. The aircraft or vessel must
be property which qualifies for the investment credit under section 38
unless the property does not qualify because it is described in section
48(a)(5). If an aircraft is used predominantly outside the United States
(determined under Sec. 1.48-1(g)(1)), it must qualify under the
provisions of section 48(a)(2)(B)(i) and Sec. 1.48-1(g)(2)(i). If a
vessel is used predominantly outside the United States, it must qualify
under the provisions of section 48(a)(2)(B)(iii) and Sec. 1.48-
1(g)(2)(iii). The aircraft or vessel may not be suspension or
termination period property described in section 48(h) or section 49(a)
(as in effect before the enactment of the Revenue Act of 1978). See
paragraph (g) (3) and (4) of this section for rules which apply if the
property ceases to be section 38 property.
(2) United States manufacture or construction. An election under
this section may be made only if the aircraft or vessel is manufactured
or constructed in the United States. The aircraft or vessel will be
considered to be manufactured or constructed in the United States if 50
percent or more of the basis of the aircraft or vessel is attributable
to value added within the United States.
(3) Exclusion of certain property used outside the United States.
The term ``aircraft or vessel'' as used in this paragraph (b) does not
include any property which is used predominantly outside the United
States and which qualifies as section 38 property under--
(i) Section 48(a)(2)(B)(v), relating to containers used in the
transportation of property to and from the United States,
(ii) Section 48(a)(2)(B)(vi), relating to certain property used for
the purpose of exploring for, developing, removing, or transporting
resources from the Outer Continental Shelf, or
(iii) Section 48(a)(2)(B)(x), relating to certain property used in
international or territorial waters.
(c) Leases or subleases to which the election applies. At the time
the election under this section is made and for all taxable years for
which the election applies, the lessee of the aircraft or 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
[[Page 263]]
which amounts in respect of the aircraft or vessel to which the election
relates are includible in gross income. However, the election may be
revoked under paragraph (g) (1) or (2) of this section or terminated
under paragraph (g)(3) of this section.
(2) Certain transfers involving carryover of basis. (i) If an
electing taxpayer transfers or distributes an aircraft or vessel which
is subject to the election under this section, the transferee or
distributee will be treated as having made an election under this
section with respect to the aircraft or vessel if the basis of the
aircraft or vessel in the hands of the transferee or distributee is
determined by reference to its basis in the hands of the transferor or
distributor. This paragraph (e)(2)(i) applies even though the transferor
or distributor recognizes an amount of gain which increases basis in the
hands of the transferee or distributee and even though the transferee of
distributee is a nonresident alien individual or foreign corporation.
For example, if a corporation distributes a vessel which is subject to
an election under this section to its parent corporation in a complete
liquidation described in section 332(b), the parent corporation will be
required to treat all amounts includible in its gross income with
respect to the vessel as income from source within the United States if,
unless the election is revoked or terminated under paragraph (g) of this
section, the basis of the property in the hands of the parent is
determined under section 334(b)(1) (relating to the general rule on
carryover of basis). In further illustration, if a corporation
distributes a vessel (subject to an election) in a distribution to which
section 301(a) applies, the distributee will be treated as having made
the election with respect to the vessel if its basis is determined under
section 301(d)(2) (relating to basis of corporate distributees) even
though the basis is the fair market value of the vessel under section
301(d)(2)(A).
(ii) If a member of an affiliated group which files a consolidated
return transfers an aircraft or vessel subject to an election to another
member of that group, the transferee will be treated as having made the
election with respect to the aircraft or vessel. In addition, if a
partnership distributes an aircraft or vessel subject to an election to
a partner, the partner will be treated as having made the election with
respect to the aircraft or vessel.
(iii) If paragraph (e)(2) (i) and (ii) of this section do not apply,
the election under this section with respect to an aircraft or vessel
will not be considered as made by a transferee or distributee.
(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.
[[Page 264]]
(3) Election by partnership. Any election under this section with
respect to an aircraft or vessel owned by a partnership shall be made by
the partnership. Any partnership election is applicable to each
partner's partnership interest in the aircraft or vessel. However, an
election made by a partner before August 8, 1979 will be recognized
where the partnership made no election and the election can no longer be
revoked without the consent of the Commissioner under paragraph (g)(1)
of this section.
(g) Termination of election--(1) Revocation without consent. A
taxpayer may revoke an election within the time prescribed in paragraph
(f)(1) of this section without the consent of the Commissioner. In such
a case, the taxpayer must file an amended income tax return for any
taxable year to which the election applied.
(2) Revocation with consent. Except as provided in paragraph (g) (1)
or (3) of this section, an election made under this section is binding
unless consent to revoke is obtained from the Commissioner. A request to
revoke the election must be made in writing and addressed to the
Assistant Commissioner of Internal Revenue (Technical), Attention:
T:C:C:3, Washington, DC 20224. The request must include the name and
address of the taxpayer and be signed by the taxpayer or his duly
authorized representative. It must specify the taxable year or years for
which the revocation is to be effective and must be filed at least 90
days prior to the time (not including extensions) prescribed by law for
filing the income tax return for the first taxable year for which the
revocation of the election is to be effective or by November 6, 1979
whichever is later. The request must specify the grounds which are
considered to justify the revocation. The Commissioner may require such
additional information as may be necessary in order to determine whether
the proposed revocation will be permitted. Consent will generally not be
given to revoke an election where the revocation would result in
treating gross income with respect to the aircraft or vessel (including
any gain from the sale, exchange, or other disposition of such aircraft
or vessel) as income from sources without the United States where,
during the period the election was in effect, there were losses from
sources within the United States. A copy of the consent of the
Commissioner to revoke must be attached to the taxpayer's income tax
return (or amended return) for each taxable year affected by the
revocation.
(3) Automatic termination. If an aircraft or vessel subject to an
election 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
[[Page 265]]
time the tax was paid for that year where the period set forth in
section 6511(a) has not been extended by agreement.
(5) Effect of revocation or termination. If an election is revoked
or terminated under this paragraph (g), the taxpayer is required to
recompute the tax for the appropriate taxable years without reference to
section 861(e)(1).
(6) Revocation or termination after December 28, 1980. The rules in
paragraph (g)(1) through (g)(5) continue to apply with respect to any
election made pursuant to this section even though the revocation or
termination may occur after December 28, 1980.
[T.D. 7635, 44 FR 46457, Aug. 8, 1979, as amended by T.D. 7928, 48 FR
55846, Dec. 16, 1983. Redesignated at 53 FR 35477, Sept. 14, 1988]
Sec. 1.861-16 Income from certain craft first leased after December 28, 1980.
(a) General rule. If a taxpayer--
(1) Owns a qualified craft (as defined in paragraph (b) of this
section).
(2) Leases such qualified craft after December 28, 1980, to a United
States person that is not a member of the same controlled group of
corporations as the taxpayer, and
(3) The lease is the taxpayer's first lease of the craft and the
taxpayer is not considered to have made an election with respect to the
craft under Sec. 1.861-9(e)(2),
then the taxpayer shall treat all amounts includible in gross income
with respect to the qualified craft as income from sources within the
United States for each taxable year ending after commencement of the
lease. If this section applies to income with respect to a craft, it
applies to all such amounts that are includible in the taxpayer's gross
income, whether or not includible during or after the period of a lease
to a United States person. Amounts derived by the taxpayer with respect
to the qualified craft include any gain from the sale, exchange, or
other disposition of the qualified craft. If this section applies to
income with respect to a craft and there is a loss with respect to that
craft (either due to the allowance of expenses and other deductions or
due to a sale, exchange, or other disposition of the qualified craft),
such loss is treated as allocable or apportionable to sources within the
United States. The fact that a craft ceases to be section 38 property,
ceases to be leased by the taxpayer to a United States person, or is
leased or subleased for any period of time to a person who is not a
United States person will not terminate the application of this section.
(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
[[Page 266]]
described in section 7701(a)(30) and individuals with respect to whom an
election under section 6013 (g) or (h) (relating to nonresident alien
individuals married to United States citizens or residents) is in
effect.
(d) Controlled group. For purposes of paragraph (a)(2) of this
section, whether a taxpayer and a United States person are members of
the same controlled group of corporations is determined under section
1563. Solely for purposes of this section, if at least 80% of the
capital interest, or the profits interest, in a partnership is owned,
directly or indirectly, by a member or members of a controlled group of
corporations, then the partnership shall be considered a member of that
controlled group of corporations. In addition, if at least 80% of the
capital interest, or the profits interest, in a partnership is owned,
directly or indirectly, by a corporation, then the partnership and that
corporation shall be considered members of a controlled group of
corporations.
(e) Certain transfers and distributions--(1) Transfers and
distributions involving carryover of basis. If--
(i) The income with respect to a craft is subject to this section,
(ii) The taxpayer transfers or distributes such craft, and
(iii) The basis of such craft in the hands of the transferee or
distributee is determined by reference to its basis in the hands of the
transferor or distributor,
then this section will apply to the income with respect to the craft
includible in the gross income of the transferee or distributee. This
paragraph (e)(1) applies even though the transferor or distributor
recognizes an amount of gain that increases basis in the hands of the
transferee or distributee and even though the transferee or distributee
is a nonresident alien or foreign corporation. For example, if a
corporation distributes a craft the income of which is subject to this
section to its parent corporation in a complete liquidation described in
section 332(b), the parent corporation will be treated as if it
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
[[Page 267]]
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 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
[[Page 268]]
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 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
[[Page 269]]
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, 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
[[Page 270]]
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
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
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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.
(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
[[Page 272]]
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 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)
[[Page 273]]
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 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.
[[Page 274]]
(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. 1.482-7(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
[[Page 275]]
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.
(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.
[[Page 276]]
(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 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.
[[Page 277]]
(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 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
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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.
(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
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$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 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, and source of gross income from, digital content transactions.
(a) General--(1) Scope. This section provides rules for classifying
digital content transactions (as defined in paragraph (b)(1) of this
section) for purposes of subchapter N of chapter 1 of the Internal
Revenue Code, sections 59A, 245A, 250, 267A, 367, 404A, 482, 679, 1059A,
chapters 3 and 4, sections 842 and 845 (to the extent involving a
foreign person), and transfers to foreign trusts not covered by section
679.
(2) Digital content--(i) Digital content defined. For purposes of
this section, digital content means a computer program or any other
content, such as books, movies, and music, in digital format that is--
(A) Protected by copyright law; or
(B) Not protected by copyright law solely--
(1) Due to the passage of time; or
(2) Because the creator dedicated the content to the public domain.
(ii) Computer program defined. 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 and includes any media, user manuals, documentation, data base,
or similar item if the media, user manuals, documentation, data
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base, or other similar item is incidental to the operation of the
computer program.
(b) Categories of transactions--(1) General. A transaction that
constitutes a transfer of digital content, or the provision of services
or of know-how with respect to digital content (each a digital content
transaction), is treated as being solely one of the following--
(i) A transfer of a copyright right in the digital content;
(ii) A transfer of a copy of the digital content (a copyrighted
article);
(iii) The provision of services for the development or modification
of the digital content; or
(iv) The provision of know-how relating to development of digital
content.
(2) Transaction with multiple elements. Taking into account the
overall transaction and the surrounding facts and circumstances, a
transaction that has multiple elements, one or more of which would be a
digital content transaction if considered separately, is classified in
its entirety as a digital content transaction under one of the
categories described in paragraph (b)(1) of this section if the
predominant character of the transaction is described in one of the
categories in that paragraph.
(3) Determination of predominant character--(i) General rule. For
purposes of paragraph (b)(2) of this section and Sec. 1.861-19(c)(2),
the predominant character of a transaction is determined by ascertaining
the primary benefit or value received by the customer in the
transaction.
(ii) Special rule. If the primary benefit or value received by the
customer in the transaction is not reasonably ascertainable, the
predominant character of a transaction is instead determined by
ascertaining the primary benefit or value received by a typical customer
in a substantially similar transaction as determined under paragraphs
(b)(3)(ii)(A) and (B) of this section.
(A) The primary benefit or value received by a typical customer is
determined by data on how a typical customer uses or accesses the
digital content. See paragraph (h)(17) of this section (Example 17).
(B) If data described in paragraph (b)(3)(ii)(A) of this section is
not available, then the predominant character of a transaction subject
to the special rule in paragraph (b)(3)(ii) of this section is
determined by examining other factors that are indicative of the primary
benefit or value received by a typical customer, including the
following--
(1) How the transferor or provider markets the transaction;
(2) The relative development costs to the transferor or provider of
each element of the transaction; and
(3) The relative price paid in an uncontrolled transaction for one
or more elements compared to the total contract price of the transaction
in question.
(iii) Identification and development of data. A transferor or
provider must use reasonable efforts to identify the data specified in
paragraphs (b)(3)(i) and (ii)(A) of this section, or if necessary, to
apply the factors relevant to paragraph (b)(3)(ii)(B) of this section.
However, a transferor or provider is not required to develop any of the
data specified in those paragraphs that it does not develop in the
course of business.
(c) Transfers involving copyright rights and copyrighted articles--
(1) Transfers involving transfers of copyright rights. A digital content
transaction involves a transfer of a copyright right if, as a result of
the transaction, a person acquires one or more of the rights described
in paragraphs (c)(2)(i) through (iv) of this section.
(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 digital content 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 digital content based upon the
digital content;
(iii) The right to make a public performance of digital content,
other than a right to publicly perform digital content for the purpose
of advertising the sale of the digital content performed; or
(iv) The right to publicly display digital content, other than a
right to publicly display digital content for the
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purpose of advertising the sale of the digital content displayed.
(3) Copyrighted articles. A copyrighted article includes a copy of
digital content 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 digital content may be fixed in any medium.
(d) Provision of services. The determination of whether a
transaction involving newly developed or modified digital content
involves the provision of services 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 digital content and how the risks of loss are allocated
between the parties. See paragraph (h)(15) of this section (Example 15).
(e) Provision of know-how. The provision of information with respect
to digital content involves the provision of know-how for purposes of
this section only if the information is--
(1) Information relating to the development of digital content;
(2) Furnished under conditions preventing unauthorized disclosure,
specifically contracted for between the parties; and
(3) Considered property subject to trade secret protection.
(f) Further classification of transfers involving copyright rights
and copyrighted articles--(1) Transfers of copyright rights. The
determination of whether a transfer of a copyright right is a sale or
exchange of property is made on the basis of whether, taking into
account all facts and circumstances, there has been a transfer of all
substantial rights in the copyright. A transfer of a copyright right
that does not constitute a sale or exchange because not all substantial
rights have been transferred will be classified as a license. For this
purpose, the principles of sections 1222 and 1235 apply. 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--(i) Classification. 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 transfer of a copyrighted article 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.
(ii) Source. Income from transactions that are classified as sales
or exchanges of copyrighted articles will be sourced under section
861(a)(6), 862(a)(6), 863, or 865(a), (b), (c), or (e), as appropriate.
When a copyrighted article is sold and transferred through an electronic
medium, the sale is deemed to have occurred at the location of the
billing address of the purchaser for purposes of Sec. 1.861-7(c).
However, in any case in which the sales transaction is arranged in a
particular manner for a principal purpose of tax avoidance, the
foregoing rules will not be applied. In such a case, all of the facts
and circumstances relevant to the transaction, such as the place where
the copyrighted article will be used, the place where negotiations and
the execution of the agreement occurred, and the terms of the agreement,
will be considered, and the sale will be treated as having occurred
where the substance of the sale occurred. Income derived from leasing a
copyrighted article will be sourced under section 861(a)(4) or
862(a)(4), as appropriate.
(3) Special circumstances of digital content. In connection with
determinations under this paragraph (f), consideration must be given as
appropriate to the special characteristics of digital content 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 digital content on a
disk subject to a requirement that the disk be destroyed after a
specified period is
[[Page 282]]
generally the equivalent of a transaction subject to a requirement that
the disk be returned after such period. Similarly, a transaction in
which the digital content deactivates itself after a specified period is
generally the equivalent of a transaction subject to a requirement that
the disk be returned after a specified period.
(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 digital content transaction.
(3) To the public--(i) In general. For purposes of paragraph
(c)(2)(i) of this section, a transferee of digital content shall not be
considered to have the right to distribute copies of the digital content
to the public if it is permitted to distribute copies of the digital
content 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
digital content who are permitted to use the digital content 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 digital
content who are permitted to use the digital content in connection with
the performance of those services is not relevant for purposes of this
paragraph (g)(3).
(h) Examples. The examples in this paragraph (h) illustrate the
provisions of this section. Unless otherwise specified, assume that Corp
A is a domestic corporation, the digital content described in each
example does not contain any online functionality, and all facts in each
example occur as part of a single transaction.
(1) Example 1: Sale of a computer program on a disk--(i) Facts. Corp
A 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 (b)(1) of this section, the
transfer of a disk containing a copy of Program X from Corp A to P is a
digital content transaction with one element, which is the transfer of a
copy of Program X. Therefore, the transaction is treated solely as a
transfer of a copyrighted article under paragraph (b)(1)(ii) of this
section. Under paragraph (g)(1) of this section, the label license is
not determinative.
[[Page 283]]
(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.
(2) Example 2: Sale of a computer program via download from the
internet--(i) Facts. The facts are the same as those in paragraph (h)(1)
of this section (Example 1), except that instead of selling disks, Corp
A 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) Under paragraph (b)(1) of this section, the
digital transfer of a copy of Program X from Corp A to P is a digital
content transaction with one element, which is the transfer of a copy of
Program X. Therefore, the transaction is treated solely as a transfer of
a copyrighted article under paragraph (b)(1)(ii) of this section.
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.
(B) As in paragraph (h)(1) of this section (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.
(3) Example 3: Lease of a computer program with requirement to
return disk--(i) Facts. The facts are the same as those in paragraph
(h)(1) of this section (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 (b)(1) of this section, the
transfer of a disk with a copy of Program X from Corp A to P is a
digital content transaction with one element, which is the transfer of a
copy of Program X. Therefore, the transaction is treated solely as a
transfer of a copyrighted article under paragraph (b)(1)(ii) of this
section.
(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 digital content 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.
(4) Example 4: Lease of a computer program with electronic lock--(i)
Facts. * * *
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the
digital transfer of a copy of Program X from Corp A to P is a digital
content transaction with one element, which is the transfer of a copy of
Program X. Therefore, the transaction is treated solely as a transfer of
a copyrighted article under paragraph (b)(1)(ii) of this section.
(B) As in paragraph (h)(3) of this section (Example 3), P is not
properly treated as the owner of a copyrighted article. Therefore, under
paragraph (f)(2) of this section, there has been a lease of a
copyrighted article rather than a sale. While P does retain Program X on
its computer at the end of the one-week period, as a legal matter P no
longer has the right to use the program (without further payment) and,
indeed, cannot use the program without the electronic key. Functionally,
Program X is no longer on the hard drive of P's computer. Instead, the
hard drive contains only a series of numbers which no longer perform the
function of Program X. Although in Example 3, P was required to
physically return the disk, taking into account the special
characteristics of digital
[[Page 284]]
content as provided in paragraph (f)(3) of this section, the result in
this paragraph (h)(4) (Example 4) is the same as in Example 3.
(5) Example 5: Sale of copyright rights to a computer program--(i)
Facts. Corp A 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 (a
period shorter than the copyright term). Corp A has ascertained that the
primary benefit or value from the transaction to Corp B is derived from
the four legal rights obtained in Program X from Corp A and not from the
receipt of a copy of Program X. The transfer of a copy of Program X is
merely the means by which Corp A provides Corp B access to Program X in
order to exercise its copyright rights.
(ii) Analysis. (A) The transaction between Corp A and Corp B has
multiple elements. One element is the transfer of a disk with a copy of
Program X, which would be a digital content transaction described under
paragraph (b)(1)(ii) of this section (transfer of a copyrighted article)
if considered separately. Another element is the grant of the right to
make an unlimited number of copies of Program X and distribute those
copies to the public, the right to prepare derivative works based upon
Program X, the right to make public performances of Program X, and the
right to publicly display Program X, which would be described under
paragraphs (b)(1)(i) and (c)(2) of this section (transfer of a copyright
right) if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under paragraph (b)(1) of this
section if its predominant character is described in that paragraph.
Pursuant to paragraph (b)(3)(i) of this section, the predominant
character of the transaction is based on the primary benefit or value of
the transaction to the customer, if it is reasonably ascertainable. The
predominant character of this transaction is therefore the transfer of
copyright rights because the primary benefit or value received by Corp B
from the transaction is the ability to exercise the copyright rights
described in paragraph (c)(2) of this section. Therefore, this
transaction is classified solely as a transfer of copyright rights
described in paragraph (b)(1)(i) of this section.
(C) 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.)
(6) Example 6: License of copyright right to make copies of a
computer program and distribute to the public--(i) Facts. Corp A
transfers a disk containing Program X to Corp B, a Country Z
corporation, and grants Corp B the non-exclusive right to reproduce and
distribute for sale to the public an unlimited number of disks
containing Program X 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. Corp A has ascertained that the primary benefit or value from
the transaction to Corp B is derived
[[Page 285]]
from the right to reproduce and distribute Program X and not from the
receipt of a copy of Program X. The transfer of a copy of Program X is
merely the means by which Corp A provides Corp B access to Program X in
order to exercise its copyright rights.
(ii) Analysis. (A) The transaction between Corp A and Corp B has
multiple elements. One element is the transfer of a disk with a copy of
Program X, which would be described under paragraph (b)(1)(ii) of this
section (transfer of a copyrighted article) if considered separately.
Another element is the grant of the right to reproduce and distribute
for sale to the public an unlimited number of disks containing Program
X, which would be described under paragraphs (b)(1)(i) and (c)(2)(i) of
this section (transfer of a copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under paragraph (b)(1) of this
section if its predominant character is described in that paragraph.
Pursuant to paragraph (b)(3) of this section, the predominant character
of the transaction is based on the primary benefit or value of the
transaction to the customer, if it is reasonably ascertainable. The
predominant character of this transaction is therefore the transfer of a
copyright right because the primary benefit or value received by Corp B
is the right to reproduce and distribute for sale to the public copies
of Program X. Therefore, this transaction is classified solely as a
transfer of copyright rights described in paragraph (b)(1)(i) of this
section.
(C) Taking into account all of the facts and circumstances, there
has been a license of Program X to Corp B. 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.
(7) Example 7: Sale of disks containing copies of a computer program
to a distributor--(i) Facts. Corp C, a distributor, enters into an
agreement with Corp A 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 paragraph (h)(1) of this
section (Example 1)).
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the
transfers of disks with copies of Program X from Corp A to Corp C are
digital content transactions with one element, which is the transfer of
copies of Program X. Therefore, the transactions are classified solely
as the transfer of copyrighted articles under paragraph (b)(1)(ii) of
this section. The use of the term license is not dispositive under
paragraph (g)(1) of this section.
(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.
(8) Example 8: License to a computer manufacturer of copyright
rights to make and load copies of a computer program onto the hard drive
of computers--(i) Facts. Corp A 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. Corp A has ascertained that the primary
benefit or value from the transaction to Corp D is the ability to copy
and distribute Program X onto computers manufactured by Corp D, not from
the receipt of a copy of Program X. The transfer of a
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copy of Program X is merely the means by which Corp A provides Corp D
access to Program X in order to exercise its right to make and
distribute copies.
(ii) Analysis. (A) The transaction between Corp A and Corp D has
multiple elements. One element is the transfer of a disk with a copy of
Program X, which would be described in paragraph (b)(1)(ii) of this
section (transfer of a copyrighted article) if considered separately.
Another element is the grant of the non-exclusive right to copy Program
X onto the hard drive of an unlimited number of computers and distribute
those copies (on the hard drive) to the public, which would be described
in paragraphs (b)(1)(i) and (c)(2)(i) of this section (transfer of a
copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under paragraph (b)(1) of this
section if its predominant character is described in that paragraph.
Pursuant to paragraph (b)(3) of this section, the predominant character
of the transaction is based on the primary benefit or value of the
transaction to the customer, if it is reasonably ascertainable. The
predominant character of this transaction is therefore the transfer of
copyright rights because the primary benefit or value received by Corp D
is the right to copy Program X onto the hard drive of an unlimited
number of computers and sell those copies (on the hard drive) to the
public. Therefore, this transaction is classified solely as a transfer
of copyright rights described in paragraph (b)(1)(i) of this section.
(C) Taking into account all of the facts and circumstances, there
has been a license of Program X to Corp D. 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
D's interest). Corp D 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. The result
would be the same if Corp D included with the computers it sells a copy
of Program X on a disk.
(9) Example 9: Sale of disks containing a copy of computer program
to a computer manufacturer--(i) Facts. The facts are the same as those
in paragraph (h)(8) of this section (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 paragraph (h)(1) of this section (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) Under paragraph (b)(1) of this section, the
transfers of disks with copies of Program X from Corp A to Corp D are
digital content transactions with one element, which is the transfer of
copies of Program X. Therefore, the transaction is classified solely as
the transfer of copyrighted articles under paragraph (b)(1)(ii) of this
section. Corp D acquires the disks without the right to reproduce and
distribute publicly further copies of Program X.
(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.
(10) Example 10: Sale of a computer program with right to load onto
multiple employee workstations--(i) Facts. Corp A transfers a disk
containing Program X to Corp E 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
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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) It must be determined whether the transfer from
Corp A to Corp E of a disk containing a copy of Program X and the right
to load Program X onto 50 individual workstations is a transaction with
multiple elements. There is at least one element, which is the transfer
of a disk containing a copy of Program X, which either is a digital
content transaction under paragraph (b)(1) of this section or would be a
digital content transaction if considered separately. If there is no
additional element, then the transaction is classified as a transfer of
a copyrighted article pursuant to paragraph (b)(1)(ii) of this section.
If there is a second element, then paragraph (b)(2) of this section
applies and the transaction is classified within a single category under
paragraph (b)(1) of this section if its predominant character is
described in that paragraph. 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 described in paragraph (c)(2) of this
section. Therefore, there is no second element in this transaction and
it is classified solely as the transfer of copyrighted articles (50
copies of Program X).
(B) Taking into account all of the facts and circumstances, Corp E
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 other persons that had a relationship to Corp E
specified in paragraph (g)(3) of this section.
(11) Example 11: Sale of a computer program with right to make
available to multiple employees via local area network--(i) Facts. The
facts are the same as those in paragraph (h)(10) of this section
(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 paragraph (h)(10) of this
section (Example 10), this is a digital content transaction with a
single element that is classified as the transfer of a copyrighted
article pursuant to paragraph (b)(1)(ii) of this section. 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 persons that had a relationship to Corp E specified
in paragraph (g)(3) of this section.
(12) Example 12: Lease of a computer program with right to receive
upgrades and technical support services--(i) Facts. The facts are the
same as in paragraph (h)(11) of this section (Example 11), except that
instead of paying a one-time fee, Corp E pays a monthly fee to Corp A
calculated with reference to the permitted maximum number of users
(which can be changed) and the computing power of Corp E's server. In
return for this monthly fee, Corp E receives the right to receive
upgrades of Program X when they become available. The agreement may be
terminated by either party at the end of any month. When the disk
containing the
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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 in the form of troubleshooting and configuration
assistance to Corp E, but the agreement does not allocate the monthly
fee between the right to use Program X, 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 when the
contract is entered into but is expected to be minimal. Corp A has
ascertained that the primary benefit or value to Corp E from the
transaction is the right to use Program X on the LAN (without the
ability to exercise any of the rights described in paragraphs (c)(2)(i)
through (iv) of this section), not the receipt of technical support
services with respect to Program X.
(ii) Analysis. (A) The transaction between Corp A and Corp E has
multiple elements. One element is the transfer of a disk with a copy of
Program X, which would be described in paragraph (b)(1)(ii) of this
section (transfer of a copyrighted article) if considered separately.
Another element is the provision of technical support services, which
are not services for the development or modification of Program X
described in paragraph (d) of this section because Corp E has received
no copyright rights with respect to Program X. Thus, the technical
support services would not be described in any of the categories in
paragraph (b)(1) of this section if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under paragraph (b)(1) of this
section if its predominant character is described in that paragraph.
Pursuant to paragraph (b)(3) of this section, the predominant character
of the transaction is based on the primary benefit or value of the
transaction to the customer. The predominant character of this
transaction is therefore the transfer of a copyrighted article because
the primary benefit or value received by Corp E is the right to use
Program X. Accordingly, this transaction is classified solely as a
transfer of a copyrighted article described in paragraph (b)(1)(ii) of
this section.
(C) 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 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.
(13) Example 13: Sale of a computer program along with right to
receive upgrades--(i) Facts. The facts are the same as those in
paragraph (h)(12) of this section (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 paragraph (h)(10)(ii)(B) of
this section (Example 10), the transfer of the program will be treated
as a sale of a copyrighted article rather than as a lease.
(14) Example 14: Sale of a modified computer program--(i) Facts.
Corp G enters into a contract with Corp A 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
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X. The agreement between Corp A and Corp G is otherwise identical as to
rights and payment terms as the agreement described in paragraph (h)(10)
of this section (Example 10).
(ii) Analysis. (A) It must be determined whether the transfer of
disks with modified copies of Program X from Corp A to Corp G is a
transaction with multiple elements. There is at least one element, the
transfer of copies of Program X, which either is a digital content
transaction under paragraph (b)(1) of this section or would be a digital
content transaction if considered separately. If there is no additional
element, then the transaction is classified as a transfer of a
copyrighted article pursuant to paragraph (b)(1)(ii) of this section. If
there is a second element, then paragraph (b)(2) of this section applies
and the transaction is classified within a single category under
paragraph (b)(1) of this section if its predominant character is
described in that paragraph. Pursuant to paragraph (d) of this section,
the modifications made by Corp A before transferring Program X to Corp G
do not constitute the provision of services for the development or
modification of digital content because Corp A retains all copyright
rights with respect to the modified software. Therefore, there is no
second element in this transaction and it is classified solely as the
transfer of copyrighted articles.
(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.
(15) Example 15: Provision of services for development of a computer
program--(i) Facts. Corp H enters into a license agreement for a new
computer program. Program Q is to be written by Corp A. 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. Under paragraph (b)(1) of this section, the provision
of computer program development services by Corp A to Corp H is a
digital content transaction with one element, which is the provision of
services for the development or modification of digital content. Under
paragraph (d) of this section, the transaction between Corp A and Corp H
involves the provision of services for the development of a computer
program 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. Taking into account all of the facts and circumstances, Corp
A is treated as providing services to Corp H described in paragraph
(b)(1)(iii) of this section. 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).
(16) Example 16: Provision of know-how by computer programmers--(i)
Facts. Corp A and Corp I, a Country Z corporation, agree that a
development engineer employed by Corp A will travel to Country Z to
provide know-how relating to certain techniques not generally known to
computer programmers, which will enable Corp I to more efficiently
create computer programs. These techniques represent the product of
experience gained by Corp A from working on many computer programming
projects, and are furnished to Corp I under nondisclosure conditions.
Such information is property subject to trade secret protection.
(ii) Analysis. The provision of know-how with respect to computer
programming techniques by Corp A's development engineer to Corp I is
described in
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paragraph (e) of this section. Therefore, the transaction is a digital
content transaction with one element, which is the provision of know-
how. The transaction is classified solely as the provision of know-how
pursuant to paragraph (b)(1)(iv) of this section.
(17) Example 17: Sale of development program in transaction with
multiple elements--(i) Facts. Corp A transfers a disk containing Program
Y to Corp E 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. 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 paragraph (h)(1) of this section (Example 1). Corp A cannot
reasonably ascertain the primary benefit or value of the transaction to
Corp E. A customer like Corp E derives two benefits from this or a
substantially similar transaction, the first of which is the ability to
use Program Y to develop new software and the second of which is the
right to utilize the libraries and reusable software components in
Program Y in distributed programs. Corp A possesses data arising from
market research and customer surveys indicating that customers utilize
Program Y primarily for its computer program development features and do
not make significant use of the libraries of reusable software
components. The libraries and reusable software components are not
significant components of any overall new program created by using
Program Y.
(ii) Analysis. (A) The transaction between Corp A and Corp E has
multiple elements. One element is the transfer of a disk with a copy of
Program Y, which would be described in paragraph (b)(1)(ii) of this
section (transfer of a copyrighted article) if considered separately.
Another element is the grant of the right to distribute copies of the
libraries of reusable software components with any program developed
using Program Y, which would be described in paragraphs (b)(1)(i) and
(c)(2)(i) of this section (transfer of a copyright right) if considered
separately.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under paragraph (b)(1) of this
section if its predominant character is described in that paragraph.
Pursuant to paragraph (b)(3)(i) of this section, the predominant
character of a transaction is generally based on the primary benefit or
value of the transaction to the customer. If the primary benefit or
value is not reasonably ascertainable, paragraph (b)(3)(ii) of this
section provides that the predominant character of a transaction may be
determined based on the primary benefit or value to a typical customer
of a substantially similar transaction. This primary benefit or value to
a typical customer can be identified through actual data about use or
access pursuant to paragraph (b)(3)(ii)(A) of this section, or if that
data is not available, by other evidence indicative of the primary
benefit or value to a typical customer pursuant to paragraph
(b)(3)(ii)(B) of this section. Although there are two benefits in this
type of transaction, Corp A possesses data indicating that a typical
customer primarily uses Program Y because of its computer program
development features, rather than the right to distribute reusable
components. This is reinforced by the fact that programs created using
Program Y do not contain libraries of reusable software components as
significant components. These facts indicate that the primary benefit or
value to a typical customer arises from the ability to use Program Y,
rather than the right to distribute reusable components. Therefore, the
predominant character of this transaction is the transfer of a copy of
Program Y, and this transaction is thus classified solely as the
transfer of a copyrighted article described in paragraph (b)(1)(ii) of
this section.
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(C) 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.
(18) Example 18: Sale of a computer program with right to make
modifications--(i) Facts. Corp A transfers a disk containing Program X
to Corp E. The disk contains both the object code and the source code to
Program X, and the license agreement grants Corp E the right to modify
the source code to correct minor errors and make minor adaptations to
Program X so it will function on Corp E's computer; as well as the right
to recompile the modified source code. 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 paragraph
(h)(1) of this section (Example 1). Corp A has ascertained that the
primary benefit or value received by Corp E from the transaction is the
core functionality of Program X rather than the limited rights to modify
the source code.
(ii) Analysis. (A) The transaction between Corp A and Corp E has
multiple elements. One element is the transfer of a disk with a copy of
Program X, which would be described in paragraph (b)(1)(ii) of this
section (transfer of a copyrighted article) if considered separately.
Another element is the grant of the right to modify the source code to
Program X and recompile the modified source code to create new code to
correct minor errors, and to make minor adaptations to Program X, which
would be described in paragraphs (b)(1)(i) and (c)(2)(ii) of this
section (transfer of a copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under the categories described under
paragraph (b)(1) of this section if its predominant character is
described in that paragraph. Pursuant to paragraph (b)(3) of this
section, the predominant character of the transaction is based on the
primary benefit or value of the transaction to the customer, if it is
reasonably ascertainable. Since the primary benefit or value received by
Corp E is the core functionality of Program X, rather than the limited
rights to modify the source code, the predominant character of this
transaction is the transfer of a copyrighted article. Therefore, this
transaction is classified solely as a transfer of a copyrighted article
under paragraph (b)(1)(ii) of this section.
(C) 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.
(19) Example 19: License to website operator to make and sell copies
of electronic books via download--(i) Facts. Corp A operates a website
that offers electronic books for download onto customers' computers or
other electronic devices. The books offered are protected by copyright
law. In a transaction between Corp A and a content owner, Corp A
receives from the content owner a digital master copy of a book, which
Corp A downloads onto its server. Corp A receives the non-exclusive
right to reproduce an unlimited number of copies of the book for
purposes of distribution and sale to the public. Corp A pays the content
owner a specified amount for each copy sold to a customer. Corp A may
not transfer any of the rights it receives from the content owner. The
term of the agreement Corp A has with the content owner is shorter than
the remaining life of the copyright. The content owner has ascertained
that the primary benefit or value Corp A receives in the transaction is
the right to reproduce and distribute an unlimited number of copies of
the book and not the transfer of a copy of the book. In a separate
transaction, Corp A charges a customer a fixed fee for each book
purchased. When purchasing a book from Corp A on Corp A's website, the
customer must acknowledge the terms of a license agreement with the
content owner that states that the customer may download and view the
electronic
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book in perpetuity but may not reproduce, distribute, or sell copies of
it. Once the customer downloads the book from Corp A's server onto a
device, the customer may access and view the book from that device,
which does not need to be connected to the internet for the customer to
view the book. The customer owes no additional payment to Corp A for the
ability to view the book in the future.
(ii) Analysis. (A) Notwithstanding the license agreement between
each customer and the content owner granting the customer rights to use
the book, the relevant transactions are the transfer of a master copy of
the book along with the grant from the content owners to Corp A of the
right to reproduce and sell to the public copies of the books, and the
transfers of copies of the books by Corp A to customers. Although the
content owner is identified as a party to the license agreement
memorializing the customer's rights with respect to the book, each
customer obtains those rights directly from Corp A, not from the content
owner. Under paragraph (b)(1) of this section, the download of a copy of
a book by a customer is a digital content transaction with one element,
which is the transfer of a digital copy of a book. Therefore, the
transaction is treated solely as a transfer of a copyrighted article
under paragraph (b)(1)(ii) of this section. Under the benefits and
burdens test of paragraph (f)(2) of this section, the transaction is
classified as a sale and not a lease, because the customer receives the
right to view the book in perpetuity on its device.
(B) The transaction between the content owner and Corp A has
multiple elements. One element is the transfer of a master copy of the
book, which would be described in paragraph (b)(1)(ii) of this section
(transfer of a copyrighted article) if considered separately. Another
element is the grant of the right to reproduce and sell an unlimited
number of copies to customers, which would be described in paragraphs
(b)(1)(i) and (c)(2)(i) of this section (transfer of a copyright right)
if considered separately. Because the transaction has multiple elements,
one or more of which would be a digital content transaction if
considered separately, paragraph (b)(2) of this section provides that
the transaction is classified within a single category under the
categories described under paragraph (b)(1) of this section if its
predominant character is described in that paragraph. Pursuant to
paragraph (b)(3) of this section, the predominant character of the
transaction is based on the primary benefit or value of the transaction
to the customer, if it is reasonably ascertainable. Since the primary
benefit or value Corp A receives in the transaction is the right to
reproduce and distribute an unlimited number of copies, the predominant
character of this transaction is the transfer of a copyright right.
Therefore, this transaction is classified solely as a transfer of
copyright rights described in paragraph (b)(1)(i) of this section.
(C) Taking into account all of the facts and circumstances, there
has been a license of books to Corp A. Under paragraph (f)(1) of this
section, there has not been a transfer of all substantial rights in the
copyright rights to the books because each content owner has the right
to enter into other licenses with respect to the copyright of their
book. Corp A has acquired no right itself to license the copyrights in
the books. Finally, the terms of the licenses are for less than the
remaining lives of the copyrights in the books.
(20) Example 20: Internet platform operator as agent for application
developers--(i) Facts. Corp A operates a platform on the internet that
offers applications for download onto a customer's mobile phone. Under
general tax principles, Corp A and an application developer establish an
agency relationship whereby Corp A acts as the agent to offer the
application for sale to customers on behalf of the application
developer. The applications are protected by copyright law. Under the
agreement between Corp A and the application developer, Corp A agrees to
provide the application developer with platform and agency services to
facilitate the sale of the application to customers. Corp A also
provides the application developer with hosting services to host the
application on Corp A's servers for download by the customers. Corp A
receives a digital master copy of the application along with a non-
exclusive right to make
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copies of the application and allow customers to download copies of the
application from Corp A's platform. Corp A has ascertained that the
primary benefit or value from the transaction received by the
application developer is the platform and agency services that Corp A
provides. Corp A receives the right to make copies of the application
merely to perform its activities as an agent on behalf of the
application developer. When purchasing an application on Corp A's
platform, the customer must acknowledge the terms of a license agreement
with the application developer that states that the customer may use the
application but may not reproduce or distribute copies of it. In
addition, the agreement provides that the customer may download the
application onto only one mobile phone at a time. A customer does not
need to be connected to the internet to access the application. The
customer owes no additional payment to Corp A or the application
developer for the ability to use the application in perpetuity. Corp A
retains a fixed percentage of each purchase price of the application and
remits the remaining balance to the application developer.
(ii) Analysis. (A) The transaction between Corp A and the
application developer has multiple elements. One element is the transfer
of a master copy of an application by the application developer to Corp
A, which would be described in paragraph (b)(1)(ii) of this section
(transfer of a copyrighted article) if considered separately. Another
element is the transfer of the right to make and distribute copies of
the application by the application developer to Corp A, which would be
described in paragraphs (b)(1)(i) and (c)(2) of this section (transfer
of a copyright right) if considered separately. A third element is the
platform and agency services provided by Corp A to the application
developer, which would not be described in this section if considered
separately. A fourth element is the hosting services provided by Corp A
to the application developer, which would be described in Sec. 1.861-19
if considered separately. Under the facts and circumstances, although
Corp A receives a copy of the application and the right to make and
distribute copies of the application, Corp A receives this copy and
right merely to facilitate the sale of applications on behalf of the
application developer.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under the categories described under
paragraph (b)(1) of this section if its predominant character is
described in that paragraph. Pursuant to paragraph (b)(3) of this
section, the predominant character of the transaction is based on the
primary benefit or value of the transaction to the customer, if it is
reasonably ascertainable. Since the primary benefit or value the
application developer receives in the transaction is the platform and
agency services, the predominant character of this transaction is the
platform and agency services and not a digital content transaction nor a
cloud transaction.
(C) The transfer of a copy of an application from the application
developer to a customer is a digital content transaction with one
element, which is the transfer of a copy of a digital program.
Therefore, the transaction is treated solely as a transfer of a
copyrighted article under paragraph (b)(1)(ii) of this section. Under
the benefits and burdens test of paragraph (f)(2) of this section, this
transaction is a sale of a copyrighted article because a customer has
the right to use the application in perpetuity.
(21) Example 21: Movies and TV shows available for stream, rent, or
purchase--(i) Facts. Corp A offers a catalog of movies and TV shows, all
of which are subject to copyright protection. Corp A gives customers
several options for viewing the content, each of which has a separate
price. A ``streaming'' option allows a customer to view the video, which
is hosted on Corp A's servers, while connected to the internet for as
many times as the customer wants during a limited period. A ``rent''
option allows a customer to download the video to its computer or other
electronic device (which does not need to be connected to the internet
for viewing) and watch the video as many
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times as the customer wants for a limited period, after which an
electronic lock is activated and the customer may no longer view the
content. A ``purchase'' option allows a customer to download the video
and view it as many times as the customer chooses with no end date.
Under all three options, the customer may view the video but may not
reproduce or distribute copies of it, prepare derivative works based on
it, or publicly display it.
(ii) Analysis. (A) With respect to the ``rent'' option, under
paragraph (b)(1) of this section the download of a video by a customer
is a digital content transaction with one element, which is the transfer
of a copy of the video. Therefore, the transaction is treated solely as
the transfer of a copyrighted article under paragraph (b)(1)(ii) of this
section. Although a customer will retain a copy of the content at the
end of the payment term, the customer cannot access the content after
the electronic lock is activated. The activation of the electronic lock
is the equivalent of having to return the copy. Therefore, the
transaction is classified as a lease of a copyrighted article under
paragraph (f)(2) of this section because the customer's right to view
the videos is for a limited period.
(B) With respect to the ``purchase'' option, under paragraph (b)(1)
of this section the download of a video by a customer is a digital
content transaction with one element, which is the transfer of a copy of
the video. Therefore, the transaction is treated solely as the transfer
of a copyrighted article under paragraph (b)(1)(ii) of this section. The
transaction is classified as a sale of a copyrighted article under
paragraph (f)(2) of this section because the customer receives the right
to view the videos in perpetuity.
(C) With respect to the ``streaming'' option, the transaction is
Corp A's grant of the right to its customers to view the movies or shows
while connected to the internet for a limited period. There is no
transfer of any copyright rights described in paragraph (c)(2) of this
section. There is also no transfer of a copyrighted article because the
content is not downloaded by a customer, but rather, is accessed through
an on-demand network. The transaction also does not constitute the
provision of services for the development of digital content or the
provision of know-how under paragraph (b)(1) of this section. Therefore,
the transaction is not a digital content transaction described in
paragraph (b)(1) of this section. Instead, the transaction is a cloud
transaction that is classified under Sec. 1.861-19. See Sec. 1.861-
19(b).
(22) Example 22: Website offering third-party videos via stream--(i)
Facts. Corp A operates a website that allows customers to stream videos
that third-party content creators upload to Corp A's website. Corp A has
advertising contracts with third-party advertisers pursuant to which
Corp A earns advertising revenue when a customer views a video.
Customers can either stream videos for free with advertisements or can
pay a subscription fee to stream videos without advertisements. Under
the contract between Corp A and content creators, content creators
retain all ownership rights in their videos and must own or have the
necessary rights to publish their videos. The contract also states that
content creators grant Corp A a non-exclusive license to use, reproduce,
distribute, and display their videos in connection with Corp A's
website, and grant customers a non-exclusive license to view the videos.
These licenses terminate within a commercially reasonable time after a
content creator removes or deletes a video from Corp A's website.
Content creators have ascertained that the primary benefit or value Corp
A receives from transactions with content creators is the right to use,
reproduce, distribute, and display their videos. Corp A pays content
creators a percentage of advertising revenue generated from the videos
and a percentage of subscription fees.
(ii) Analysis. (A) The transaction between Corp A and the content
creators has multiple elements. One element is the uploading of a video
by a content creator, which would be described in paragraph (b)(1)(ii)
of this section (transfer of a copyrighted article) if considered
separately. Another element is the grant by content creators
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to Corp A of the right to use, reproduce, distribute, and display their
videos, which would be described in paragraph (b)(1)(i) of this section
(transfer of a copyright right) if considered separately. Content
creators are not providing content development services to Corp A under
paragraph (d) of this section because content creators own the copyright
rights in the videos.
(B) Because the transaction has multiple elements, one or more of
which would be a digital content transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under the categories described under
paragraph (b)(1) of this section if its predominant character is
described in that paragraph. Pursuant to paragraph (b)(3) of this
section, the predominant character of the transaction is based on the
primary benefit or value of the transaction to the customer. The
predominant character of the transaction is therefore the transfer of
copyright rights because the primary benefit or value received by Corp A
is the right to use, reproduce, distribute, and display videos.
Accordingly, this transaction is characterized solely as a transfer of a
copyright right as described in paragraphs (b)(1)(i) of this section.
(C) Taking into account all of the facts and circumstances, there
has been a license of videos to Corp A. Under paragraph (f)(1) of this
section, there has not been a transfer of all substantial rights in the
copyright rights to the videos because each content owner has the right
to enter into other licenses with respect to the copyright of their
videos. Corp A has acquired no right itself to license the copyrights in
the videos. Finally, the terms of the licenses are for less than the
remaining lives of the copyrights in the videos.
(D) For both the free streaming and subscription streaming
transactions between Corp A and customers, there is no transfer of any
copyright rights described in paragraph (c)(2) of this section. There is
also no transfer of a copyrighted article, because the content is not
downloaded by a customer, but rather is accessed through an on-demand
network. The transactions also do not constitute the provision of
services for the development of digital content or the provision of
know-how under paragraph (b)(1) of this section. Therefore, paragraph
(b)(1) of this section does not apply to such transactions. Instead,
both transactions are cloud transactions that are classified under Sec.
1.861-19. See Sec. 1.861-19(b).
(23) Example 23: Sale of computer programs electronically through a
reseller--(i) Facts. Corp A owns the copyright to software (Program S).
Corp A hosts Program S on its servers. Corp A grants Corp B, a foreign
corporation wholly owned by Corp A, the right to distribute copies of
Program S (without the right to reproduce copies of Program S) to Corp
B's customers that are located in Corp B's country. Under the agreement
between Corp A and Corp B, Corp B pays Corp A a fixed fee for each copy
of Program S that Corp A delivers to a customer. In separate
transactions, customers pay Corp B for the right to receive digital
copies of Program S that they may then use in perpetuity without further
payment. Corp B is responsible for managing the purchase/sale
interaction with Corp B's customers, including invoicing and
collections. Corp A is responsible for creating and delivering the
digital copies of Program S to Corp B's customers from Corp A's servers.
Corp B does not perform any functions to provide access to Program S.
(ii) Analysis. (A) Although there is a single contract between Corp
A and Corp B that grants a legal right to Corp B with respect to Program
S, that right (the right to distribute) is not a copyright right
described in paragraphs (b)(1)(i) and (c)(2) of this section. Instead,
the transactions between Corp A and Corp B and then Corp B and its
customers are functionally and economically equivalent to back-to-back
transfers of copyrighted articles. The transfers are only superficially
different from those described in paragraph (h)(24) of this section
(Example 24) where the reseller acquires product keys and sells them on
to customers. Therefore, each sale of a copy of Program S by Corp B to a
customer should be viewed as a transfer of a copyrighted article from
Corp A to Corp B and then from Corp B to the customer.
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(B) The transaction between Corp A and Corp B is a digital content
transaction with a single element that is classified as a transfer of a
copyrighted article described in paragraph (b)(1)(ii) of this section.
There are no additional elements because Corp B's receipt of the right
to distribute copies of Program S (without the right to make copies) is
not a copyright right described in paragraph (c)(2) of this section.
Under the benefits and burdens test of paragraph (f)(2) of this section,
the transfer is classified as the sale of a copyrighted article.
(C) The transaction between Corp B and a customer is a digital
content transaction with a single element that is classified as a
transfer of a copyrighted article described in paragraph (b)(1)(ii) of
this section. Under the benefits and burdens test of paragraph (f)(2) of
this section, this transaction is a sale of a copyrighted article
because the customer has the right to use the application in perpetuity.
(24) Example 24: Sale of video games with online and offline
functionality through retailers using digital keys--(i) Facts. Corp A
owns the copyright in a computer program (Program Y). Corp A creates
digital keys that allow for the download of one copy of Program Y from
Corp A's website. Corp A sells these digital keys to retailers for a
one-time fee per key, and the retailers do not use Program Y, but
instead sell them in separate transactions to customers for a one-time
fee per key. Corp A ascertains that the primary benefit or value to
retailers from the purchase of digital keys from Corp A is the right to
further transfer the digital keys to customers. The retailers cannot
reasonably ascertain the primary benefit or value that their specific
customers derive from Program Y, nor is there data available to the
retailers about how their customers typically use Program Y. Program Y
is a video game that contains online and offline features, both of which
can be played without paying an additional game-specific cost after
paying the one-time fee to purchase a key. The offline feature is
comprised of a single-player story that does not require any internet
connection to play. The online feature is comprised of the ability to
play competitive matches against other players that are hosted on
servers owned by Corp A. The competitive matches require an ongoing
connection to the internet to play. Neither the customers nor the
retailer receives any copyright rights described in paragraph (c)(2) of
this section with respect to Program Y. Customers can use Program Y in
perpetuity. Program Y is primarily marketed as a single-player game in
television and online advertising, with only brief mentions of the
multiplayer mode in print advertising. The development cost for Program
Y was allocated 40% to developing the single-player content, 20% to
developing the multiplayer content, and 40% to developing content that
is used by both types of content (e.g., cost of developing the game
engine).
(ii) Analysis. (A) The transaction between Corp A and a retailer has
multiple elements. One element is the transfer of a key with the right
to download a copy of Program Y for use to play the offline story, which
would be a digital content transaction described in paragraph (b)(1)(ii)
of this section (transfer of a copyrighted article) if considered
separately. Another element is the transfer of the same key with a copy
of Program Y providing on-demand network access to digital content in
the form of competitive multiplayer functionality, which would be a
cloud transaction described in Sec. 1.861-19(b) if considered
separately.
(B) Because the transaction has multiple elements, one of which
would be a digital content transaction if considered separately and one
of which would be a cloud transaction if considered separately,
paragraph (b)(2) of this section provides that the transaction is
classified within a single category under paragraph (b)(1) of this
section if its predominant character is described in that paragraph, or
the transaction is classified solely as a cloud transaction if its
predominant character is a cloud transaction pursuant to Sec. 1.861-
19(c)(2). Pursuant to paragraph (b)(3)(i) of this section, the
predominant character of the transaction is based on the primary benefit
or value of the transaction to the customer, if it is reasonably
ascertainable. The predominant character of
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this transaction is therefore the transfer of copyrighted articles
because the primary benefit or value received by a retailer is the right
to further transfer the same copyrighted articles to customers in the
form of digital keys. The retailers do not have any intent to utilize
the cloud functionality of the digital keys, although they do have the
right to do so. Therefore, this transaction is classified solely as a
transfer of copyrighted articles described in paragraph (b)(1)(ii) of
this section.
(C) Under the benefits and burdens test of paragraph (f)(2) of this
section, the transfer between Corp A and a retailer is classified as the
sale of a copyrighted article because the retailer has the right to use,
or sell, Program Y in perpetuity without further payment.
(D) The transfer of a key (with the right to download a copy of
Program Y) by a retailer to a customer also contains the same two
elements as each transaction between Corp A and a retailer. However, a
retailer cannot reasonably ascertain the primary benefit or value
derived by a specific customer from Program Y. In such situations,
paragraph (b)(3)(ii) of this section provides that the predominant
character of a transaction may be determined based on the primary
benefit or value to a typical customer of a substantially similar
transaction. This primary benefit or value to a typical customer can be
identified through actual data about use or access pursuant to paragraph
(b)(3)(ii)(A) of this section, or if that data is not available, by
using other evidence indicative of the primary benefit or value to a
typical customer pursuant to paragraph (b)(3)(ii)(B) of this section.
Because the retailers do not have available data about how customers use
Program Y, they may use the marketing with respect to Program Y to
determine that its predominant character is that of a transfer of a
copyrighted article described in paragraph (b)(1)(ii) of this section.
The relative development costs of the offline and online components of
the game could also be used if they are known to a retailer. Therefore,
the transfer between a retailer and a customer of a digital key
containing the right to download a copy of Program Y is classified
solely as a transfer of a copyrighted article.
(E) Under the benefits and burdens test of paragraph (f)(2) of this
section, the transfer between a retailer and a customer is classified as
the sale of a copyrighted article because the customer has the right to
use Program Y in perpetuity without further payment.
(25) Example 25: Source of income from the sale of a copyrighted
article transferred through an electronic medium--(i) Facts. Corp A is
the parent company of a world-wide group of affiliated companies. Corp B
is a foreign corporation wholly owned by Corp A. In the ordinary course
of business, Corp B acts as a procurement hub for Corp A's affiliated
companies. In this role, Corp B regularly purchases products that will
be distributed amongst Corp A's affiliated companies to be used by them
in their respective businesses. Corp B purchases digital copies of a
computer program (Program Y) from Corp C, an unrelated company. Corp B
may use Program Y in perpetuity without further payment. Corp B receives
no copyright rights in Program Y. Corp B does not use Program Y, and
instead distributes all of its copies of Program Y to various
affiliates. Corp C sources income from the sale of Program Y using
sections 861(a)(6) and 862(a)(6).
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the
transfer of Program Y from Corp C to Corp B is a digital content
transaction with one element, which is the transfer of a copy of Program
Y. Therefore, the transaction is treated solely as transfers of a
copyrighted articles under paragraph (b)(1)(ii) of this section. Taking
into account all of the facts and circumstances, there have been sales
of copies of Program Y to Corp B under paragraph (f)(2) of this section.
(B) Income from the sale of Program Y by Corp C is sourced pursuant
to sections 861(a)(6) and 862(a)(6) to the place where the sale
occurred. Pursuant to paragraph (f)(2)(ii) of this section, a transfer
of a copyrighted article through an electronic medium is treated as
occurring at the billing address of the purchaser, in this case Corp B,
unless the sales transaction is arranged for a principal purpose of tax
avoidance. In this case, the sale is treated as
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occurring at the billing address of Corp B, and Corp C's income is
foreign source, even though Corp B will not use Program Y, because Corp
B regularly purchases products that will be distributed amongst its
affiliates to be used in their respective businesses, and therefore
there is no evidence that Corp B was used by Corp A to purchase Program
Y with a principal purpose of tax avoidance.
(26) Example 26: Application of anti-abuse rule for sale of a
copyrighted article transferred through an electronic medium--(i) Facts.
Corp A is the parent company of a world-wide group of affiliated
companies. Corp B is a foreign affiliate of Corp A. In the ordinary
course of business, Corp B does not act as a procurement hub regularly
purchasing products for use by Corp A's affiliated companies. Corp A
negotiates an agreement with Corp C, an unrelated company, to purchase
digital copies of a computer program (Program Y) for use in Corp A's
business. The agreement grants Corp A the right to use Program Y in
perpetuity for a one-time payment. Corp C requests that Corp B be the
purchaser of the copies of Program Y even though Corp B will not use
Program Y and is not otherwise involved in the transaction between Corp
A and Corp C for a principal purpose of tax avoidance. Corp A agrees,
and Corp B purchases the copies of Program Y and subsequently
distributes them to Corp A. Corp C sources income from the sale of
Program Y using sections 861(a)(6) and 862(a)(6).
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the
transfer of Program Y from Corp C to Corp B is a digital content
transaction with one element, which is the transfer of a copy of Program
Y. Therefore, the transaction is classified solely as a transfer of a
copyrighted article under paragraph (b)(1)(ii) of this section. Taking
into account all of the facts and circumstances, there have been sales
of copies of Program Y to Corp B under paragraph (f)(2) of this section.
(B) Income from the sale of Program Y by Corp C is sourced pursuant
to sections 861(a)(6) and 862(a)(6) to the place where the sale
occurred. Pursuant to paragraph (f)(2)(ii) of this section, a transfer
of a copyrighted article through an electronic medium is treated as
occurring at the billing address of the purchaser, in this case Corp B,
unless the sales transaction is arranged for a principal purpose of tax
avoidance. In this case, Corp B does not regularly purchase products
that will be used by other companies within Corp A's group of affiliated
companies, and Corp B was instead used as the purchaser of Program Y on
behalf of Corp A with a principal purpose of tax avoidance. Therefore,
the place where the sale occurred must be determined based on all
relevant facts and circumstances. Corp A negotiated the purchase, and
the software will be used by Corp A in its business. As a result, under
paragraph (f)(2)(ii) of this section, the sale is treated as occurring
at the location of Corp A and the income derived by Corp C from the sale
is U.S. source.
(C) The same result would apply if, instead of using Corp B for the
purchase, Corp A made the purchase but rented a P.O. Box outside the
United States to serve as the billing address for the transaction with a
principal purpose of tax avoidance.
(i) Applicability date--(1) In general. This section applies to
taxable years beginning on or after January 14, 2025.
(2) Early application. A taxpayer can apply this section to taxable
years beginning on or after August 14, 2019 and all subsequent taxable
years not described in paragraph (i)(1) of this section (early
application years) if--
(i) The taxpayer also applies Sec. 1.861-19 to the early
application years;
(ii) This section and Sec. 1.861-19 are applied to the early
application years by all persons related to the taxpayer (within the
meaning of sections 267(b) and 707(b));
(iii) The period of limitations on assessment for each early
application year of the taxpayer and all related parties (within the
meaning of sections 267(b) and 707(b)) is open under section 6501; and
(iv) The taxpayer would not be required under this section to change
its method of accounting as a result of such election.
(j) Change in method of accounting required by this section. In
order to comply with this section, a taxpayer may
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be required to change its method of accounting. If so required, the
taxpayer must secure the consent of the Commissioner in accordance with
the requirements of Sec. 1.446-1(e) and the applicable administrative
procedures for obtaining the Commissioner's consent under section 446(e)
for voluntary changes in methods of accounting.
[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; T.D. 10022, 90 FR
2988, Jan. 14, 2025]
Sec. 1.861-19 Classification of cloud transactions.
(a) In general. This section provides rules for classifying cloud
transactions (as defined in paragraph (b) of this section). The rules of
this section apply for purposes of Internal Revenue Code sections 59A,
245A, 250, 267A, 367, 404A, 482, 679, and 1059A; subchapter N of chapter
1; chapters 3 and 4; and sections 842 and 845 (to the extent involving a
foreign person), and apply with respect to transfers to foreign trusts
not covered by section 679.
(b) Cloud transaction defined. A cloud transaction is a transaction
through which a person obtains on-demand network access to computer
hardware, digital content (as defined in Sec. 1.861-18(a)(2)), or other
similar resources. A cloud transaction does not include network access
to download digital content for storage and use on a person's computer
or other electronic device.
(c) Classification of cloud transactions--(1) In general. A cloud
transaction is classified as the provision of services.
(2) Transaction with multiple elements. Taking into account the
overall transaction and the surrounding facts and circumstances, a
transaction that has multiple elements, one or more of which would be a
cloud transaction if considered separately, is classified in its
entirety as a cloud transaction if the predominant character of the
transaction as determined under Sec. 1.861-18(b)(3) is a cloud
transaction.
(d) Examples. The examples in this paragraph (d) illustrate the
provisions of this section. Unless otherwise specified, assume that Corp
A is a domestic corporation, no rights described in Sec. 1.861-18(c)(2)
(copyright rights) are transferred as part of the transactions
described, and all facts in each example occur as part of a single
transaction.
(1) Example 1: Computing capacity--(i) Facts. Corp A operates data
centers on its premises in various locations. Corp A provides Corp B
computing capacity on Corp A's servers in exchange for a monthly fee
based on the amount of computing power made available to Corp B. Corp B
provides its own software to run on Corp A's servers.
(ii) Analysis. The provision of on-demand network computing capacity
by Corp A to Corp B is a cloud transaction with one element. Therefore,
the transaction is treated solely as a cloud transaction under paragraph
(b) of this section and is classified as the provision of services under
paragraph (c)(1) of this section.
(2) Example 2: Computing capacity on dedicated on-premises servers--
(i) Facts. The facts are the same as in paragraph (d)(1)(i) of this
section (the facts in Example 1), except that, in order to offer more
security to Corp B, Corp A provides Corp B computing capacity
exclusively through designated servers, which are owned and operated by
Corp A and located at Corp B's facilities. Corp A agrees not to use the
designated server for any other customer for the duration of its
arrangement with Corp B. Although the server is located at Corp B's
facilities, Corp B accesses the server through Corp A's network and the
monthly fee is based on the amount of computing power made available to
Corp B.
(ii) Analysis. As in paragraph (d)(1) of this section (Example 1),
the transaction between Corp A and Corp B is the provision of on-demand
network computing capacity and is therefore a cloud transaction with one
element. Therefore, the transaction is treated solely as a cloud
transaction under paragraph (b) of this section and is classified as the
provision of services under paragraph (c)(1) of this section. If the
transaction between Corp A and Corp B involved only the provision of a
server by Corp A for use by Corp B, and not on-demand network access to
computing capacity, the transaction would not be a cloud transaction and
this section would not apply.
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(3) Example 3: Access to software development platform and website
hosting--(i) Facts. Corp A provides Corp B a software platform that Corp
B uses to develop and deploy websites with a range of features,
including blogs, message boards, and other collaborative knowledge
bases. The software development platform consists of an operating
system, web server software, scripting languages, libraries, tools, and
back-end relational database software and allows Corp B to use in its
websites certain visual elements subject to copyrights held by Corp A.
The software development platform is hosted on servers owned by Corp A
and located at Corp A's facilities. Corp B's finished websites are also
hosted on Corp A's servers. Corp B accesses the software development
platform via a standard web browser. Corp B has no ability to alter the
software code. A small amount of copyrighted scripting code is
downloaded onto Corp B's computers to facilitate secure logins and
access to the software development platform. All other functions of the
software development platform execute on Corp A's servers, and no
portion of the core software code is ever downloaded by Corp B or Corp
B's customers. Corp A has ascertained that the primary benefit or value
to Corp B from the transaction is the right to use the software
development platform. Corp B pays Corp A a monthly fee for the platform
and website hosting.
(ii) Analysis. (A) There is one transaction with multiple elements
between Corp A and Corp B. One element is Corp A's provision to Corp B
of on-demand network access to the software platform, which would be a
cloud transaction described in paragraph (b) of this section if
considered separately. Another element is Corp A's hosting of Corp B's
finished websites, which would be a cloud transaction described in
paragraph (b) of this section if considered separately. A third element
is the grant by Corp A to Corp B of the right to use in Corp B's
websites certain visual elements subject to copyrights held by Corp A,
which would be a transfer of copyright rights under Sec. 1.861-
18(b)(1)(i) if considered separately. A fourth element is the download
of scripting code by Corp B, which would be a transfer of a copyrighted
article under Sec. 1.861-18(b)(1)(ii) if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a cloud transaction if considered separately, paragraph
(c)(2) of this section provides that the transaction is classified as a
cloud transaction if its predominant character is a cloud transaction.
Pursuant to Sec. 1.861-18(b)(3), the predominant character of the
transaction is based on the primary benefit or value of the transaction
to the customer, if it is reasonably ascertainable. The predominant
character of this transaction is therefore a cloud transaction because
the primary benefit or value received by Corp B is the right to use the
software development platform. Accordingly, this transaction is
classified solely as a cloud transaction described in paragraph (b) of
this section and is classified as the provision of services under
paragraph (c)(1) of this section.
(4) Example 4: Access to online software via an application--(i)
Facts. Corp A provides Corp B word processing, spreadsheet, and
presentation software and allows employees of Corp B to access the
software over the internet through a web browser or an application
(``app'') that can be downloaded from Corp A's servers onto a computer
or mobile device. Corp B's employees usually download Corp A's app onto
their mobile devices. To access the full functionality of the app, the
device must be connected to the internet. Only a limited number of
features on the app are available without an internet connection. Corp B
has no ability to alter the software code. The software is hosted on
servers owned by Corp A and located at Corp A's facilities and is used
concurrently by other Corp A customers in addition to Corp B. Corp B
pays a monthly fee based on the number of employees with access to the
software. Users have the option to save files either online using the
storage provided by Corp B, or offline on their own hard drives. Corp
B's employees can also download updates to the app as part of the
monthly fee arrangement. Upon termination of the arrangement, Corp A
activates an electronic lock preventing Corp B's employees from further
utilizing the app,
[[Page 301]]
and Corp B's employees are no longer able to access the software via a
web browser. Corp A has ascertained that the primary benefit or value to
Corp B from the transaction is the right to access Corp A's software
over the internet, whether via web browser or after downloading the app.
(ii) Analysis. (A) There is one transaction with multiple elements
between Corp A and Corp B. One element is Corp A's provision to Corp B
of on-demand network access to Corp A's computer hardware and software
resources for the purpose of fully utilizing Corp A's software, which
would be a cloud transaction described in paragraph (b) of this section
if considered separately. Another element is the download of Corp A's
app by Corp B employees, which would be a transfer of a copyrighted
article under Sec. 1.861-18(b)(1)(ii) if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a cloud transaction if considered separately, paragraph
(c)(2) of this section provides that the transaction is classified as a
cloud transaction if its predominant character is a cloud transaction.
Pursuant to Sec. 1.861-18(b)(3), the predominant character of the
transaction is based on the primary benefit or value of the transaction
to the customer, if it is reasonably ascertainable. The predominant
character of this transaction is therefore a cloud transaction because
the primary benefit or value received by Corp B is the right to access
Corp A's software over the internet. Accordingly, this transaction is
classified solely as a cloud transaction described in paragraph (b) of
this section and is classified as the provision of services under
paragraph (c)(1) of this section.
(5) Example 5: Access to offline software with limited online
functions--(i) Facts. Corp A provides Corp B word processing,
spreadsheet, and presentation software that is functionally similar to
the software in paragraph (d)(4) of this section (Example 4). The
software is made available for access over the internet but only to
download the software from servers owned by Corp A onto a computer or
mobile device in the form of an app. The downloaded software contains
all the core functions of the software. Employees of Corp B can use the
software on their computers or mobile devices regardless of whether
their computer or mobile device is online. When online, the software
provides a few ancillary functions that are not available offline, such
as access to document templates and data collection for diagnosing
problems with the software. Whether working online or offline, Corp B
employees can store their files only on their own computer or mobile
device, and not on Corp A's data storage servers. Corp B's employees can
also download updates to the software as part of the monthly fee
arrangement. Upon termination of the arrangement, an electronic lock is
activated so that the software can no longer be accessed. Corp A has
ascertained that the primary benefit or value to Corp B from the
transaction is the right to download and use Corp A's software offline.
(ii) Analysis. (A) The transaction between Corp A and Corp B
contains multiple elements. One element is the transfer of a copy of
Corp A's software via download, which would be a transfer of a
copyrighted article described under Sec. 1.861-18(b)(1)(ii) if
considered separately. Another element is the provision of online
ancillary functionality of the software, which would be a cloud
transaction described in paragraph (b) of this section if considered
separately.
(B) Because the transaction has multiple elements, one or more of
which would be a cloud transaction if considered separately, paragraph
(c)(2) of this section provides that the transaction is classified as a
cloud transaction if its predominant character is a cloud transaction.
Pursuant to Sec. 1.861-18(b)(3), the predominant character of the
transaction is based on the primary benefit or value of the transaction
to the customer, if it is reasonably ascertainable. The predominant
character of this transaction is therefore the transfer of a copyrighted
article because the primary benefit or value received by Corp B is the
right to download and use Corp A's software offline. Accordingly, this
transaction is classified solely as a transfer of a copyrighted article
described in Sec. 1.861-18(b)(1)(ii). The provision of the software
constitutes a lease of a copyrighted article under Sec. 1.861-18
[[Page 302]]
because access to the app is terminated when the monthly fee is no
longer paid, even though Corp B employees retain the locked files on
their devices. See Sec. 1.861-18(h)(4).
(6) Example 6: Data storage, separate from access to offline
software--(i) Facts. The facts are the same as in paragraph (d)(5)(i) of
this section (the facts in Example 5), except that Corp A also provides
on-demand network data storage to Corp B on Corp A's servers in exchange
for a monthly fee based on the amount of data storage used by Corp B.
Under the data storage terms, Corp B employees may store files created
by Corp B employees using Corp A's software or other software. Although
Corp A's word processing software is compatible with Corp A's data
storage systems, the core functionality of Corp A's software is not
dependent on Corp B's purchase of the storage plan. Corp A's provision
of software and data storage capacity constitute separate transactions.
(ii) Analysis. (A) As explained in paragraph (d)(5)(ii) of this
section, Corp B's download of fully functional software, along with on-
demand network access to certain limited online features, does not
constitute a cloud transaction, but rather constitutes a lease of a
copyrighted article under Sec. 1.861-18.
(B) The provision of on-demand network data storage by Corp A to
Corp B is a cloud transaction with one element. Therefore, the
transaction is treated solely as a cloud transaction under paragraph (b)
of this section and is classified as the provision of services under
paragraph (c)(1) of this section.
(7) Example 7: Streaming and temporary download of digital content
using third-party servers--(i) Facts. Corp A offers via stream or
temporary download digital content in the form of videos and music to
customers from servers located in data centers owned and operated by
Data Center Operator. Each customer uses a computer or other electronic
device to access unlimited streaming or temporary downloads of video and
music in exchange for payment of a flat monthly fee to Corp A. The
customer may select from among the available content the particular
video or song to be streamed or downloaded. Corp A continually updates
its content catalog, replacing content with higher quality versions and
adding new content at no additional charge to the customer. It also
provides additional functionality such as various methods of filtering
and sorting the library, a watchlist, and recommendations based on a
customer's preferences. Content that is streamed to the customer is not
stored locally on the customer's computer or other electronic device and
therefore can be played only while the customer's computer or other
electronic device is connected to the internet. Content that is
temporarily downloaded is stored on the customer's computer or other
electronic device for 1 week and therefore can be played while the
customer's computer or other electronic device is not connected to the
internet. Corp A cannot reasonably ascertain the primary benefit or
value that its specific customers derive from accessing Corp A's catalog
of digital content. Data collected by Corp A indicates that the vast
majority of customers stream digital content rather than temporarily
download the content. Corp A pays Data Center Operator a fee based on
the amount of data storage used and computing power made available in
connection with Corp A's content offerings.
(ii) Analysis. (A) The provision of data storage and computing power
by Data Center Operator to Corp A is a cloud transaction with one
element. Therefore, the transaction is treated solely as a cloud
transaction under paragraph (b) of this section, and is classified as
the provision of services under paragraph (c)(1) of this section.
(B) A transaction between Corp A and a customer has two elements.
One element is streaming access to a curated and routinely updated
library of digital content, which would be a cloud transaction described
in paragraph (b) of this section if considered separately. Another
element is the transfer of a copy of digital content via temporary
download, which would be a transfer of a copyrighted article under Sec.
1.861-18(b)(1)(ii) if considered separately.
(C) Because the transaction has multiple elements, one or more of
which
[[Page 303]]
would be a cloud transaction if considered separately, paragraph (c)(2)
of this section provides that the transaction is classified as a cloud
transaction if its predominant character is a cloud transaction.
Pursuant to Sec. 1.861-18(b)(3), the predominant character of the
transaction is based on the primary benefit or value of the transaction
to the customer if it is reasonably ascertainable. However, Corp A
cannot reasonably ascertain the primary benefit or value derived by a
specific customer from Corp A's offering. In such situations, Sec.
1.861-18(b)(3)(ii) provides that the predominant character of a
transaction may be determined based on the primary benefit or value to a
typical customer of a substantially similar transaction. This primary
benefit or value to a typical customer can be identified through actual
data about use or access pursuant to Sec. 1.861-18(b)(3)(ii)(A), or if
that data is not available, by using other evidence indicative of the
primary benefit or value to a typical customer pursuant to Sec. 1.861-
18(b)(3)(ii)(B). Because Corp A has data that shows the typical customer
streams digital content rather than temporarily downloading it, the
primary benefit or value received by a typical customer is streaming
access to digital content. Therefore, the predominant character of the
transaction is a cloud transaction. Under paragraph (c)(1) of this
section, the cloud transaction is classified as the provision of
services.
(8) Example 8: Access to online database--(i) Facts. Corp A offers
an online database of industry-specific materials. Customers access the
materials through Corp A's website, which aggregates and organizes
information topically and hosts a proprietary search engine. Corp A
hosts the website and database on its own servers and provides multiple
customers access to the website and database concurrently. Most
materials in Corp A's database are publicly available by other means,
but Corp A's website offers an efficient way to locate and obtain the
information on demand. Certain materials in Corp A's database constitute
digital content within the meaning of Sec. 1.861-18(a)(2), and Corp A
pays the copyright owners a license fee for using them. Each customer
may download any of the materials to its own computer and keep such
materials without further payment. The customer pays Corp A a fee based
on the number of searches or the amount of time spent on the website,
and such fee is not dependent on the amount of materials the customer
downloads. The fee that the customer pays is substantially higher than
the stand-alone charge for accessing the same digital content outside of
Corp A's system. Corp A cannot reasonably ascertain the primary benefit
or value that a specific customer derives from accessing Corp A's
database. Corp A does not have data indicating whether the typical
customer downloads materials from the database. Corp A markets its
website and online database as user-friendly and an efficient way to
find relevant materials because of its proprietary search engine.
Developing the proprietary search engine was the largest cost Corp A
incurred in creating its website and online database.
(ii) Analysis. (A) The transaction between Corp A and a customer has
multiple elements. One element is Corp A's provision to a customer of
access to Corp A's website and online database, which is a cloud
transaction described in paragraph (b) of this section if considered
separately. Another element is the transfer of digital content via
download, which is the transfer of a copyrighted article under Sec.
1.861-18 if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a cloud transaction if considered separately, paragraph
(c)(2) of this section provides that the transaction is classified as a
cloud transaction if its predominant character is a cloud transaction.
Pursuant to Sec. 1.861-18(b)(3), the predominant character of the
transaction is based on the primary benefit or value of the transaction
to the customer, if it is reasonably ascertainable. However, Corp A
cannot reasonably ascertain the primary benefit or value derived by a
specific customer from access to Corp A's database. In such situations,
Sec. 1.861-18(b)(3)(ii) provides that the predominant character of a
transaction may be determined based on the primary benefit or value
[[Page 304]]
to a typical customer of a substantially similar transaction. This
primary benefit or value to a typical customer can be identified through
actual data about use or access pursuant to Sec. 1.861-18(b)(3)(ii)(A),
or if that data is not available, by using other evidence indicative of
the primary benefit or value to a typical customer pursuant to Sec.
1.861-18(b)(3)(ii)(B). That Corp A focuses on its proprietary search
engine when marketing its website and database, as well as the facts
that the search engine was the most expensive cost incurred by Corp A in
creating its website and database, and that customers pay a
substantially higher fee to access Corp A's system than they would
otherwise pay to access the content outside of Corp A's system,
indicates that the primary benefit or value received by a typical
customer is the right to use the search engine. Therefore, under
paragraph (c)(2) of this section, the predominant character of the
transaction between Corp A and a customer is a cloud transaction. Under
paragraph (c)(1) of this section the cloud transaction is classified as
the provision of services.
(9) Example 9: Temporary or perpetual access to a single movie via
stream or download--(i) Facts. Corp A hosts movies on its website and
allows customers to view a single movie for a limited period or
perpetually for a one-time fee, with perpetual viewing rights costing a
higher fee. Corp A does not charge customers a separate fee for access
to the website. In addition, Corp A's website provides recommendations
for movies based on a customer's search for a particular title and/or
the customer's purchase history. Customers have no ability to alter the
servers, website, or movies available on the website. The movies in Corp
A's database constitute digital content within the meaning of Sec.
1.861-18(a)(2), and Corp A pays the copyright owners a license fee for
using them. Corp A allows customers to view the movies by either
streaming the movies from Corp A's servers, or by downloading the movies
onto the customer's computer or other electronic device. The file size
of movies offered by Corp A is generally large and so customers may be
expected to download movies only in certain situations such as when
traveling without internet access. Upon the expiration of the rental
period, customers will no longer have access to stream the movies, and
any movie that was downloaded onto a customer's computer or other
electronic device will auto-delete from the customer's computer or other
electronic device. Whether a customer chooses to view the movie via
stream or download, Corp A charges the same one-time fee. Corp A cannot
reasonably ascertain the primary benefit or value that a specific
customer derives from accessing Corp A's website. Corp A maintains
aggregate data on whether a given movie is viewed via stream or
download, and this data shows that most movies are viewed by streaming,
even in the case where a customer pays for the right to view a movie in
perpetuity.
(ii) Analysis. (A) A transaction between Corp A and a customer
contains multiple elements. One element is Corp A's provision to a
customer of access to Corp A's website in order to view a movie via
stream, which is a cloud transaction described in paragraph (b) of this
section if considered separately. Another element is Corp A's provision
to a customer of access to Corp A's website in order to download a
movie, which is the transfer of a copyrighted article under Sec. 1.861-
18 if considered separately.
(B) Because the transaction has multiple elements, one or more of
which would be a cloud transaction if considered separately, paragraph
(c)(2) of this section provides that the transaction is classified as a
cloud transaction if its predominant character is a cloud transaction.
Pursuant to Sec. 1.861-18(b)(3), the predominant character of the
transaction is based on the primary benefit or value of the transaction
to the customer, if it is reasonably ascertainable. However, Corp A
cannot reasonably ascertain the primary benefit or value derived by a
specific customer from access to Corp A's database. In such situations,
Sec. 1.861-18(b)(3)(ii) provides that the predominant character of a
transaction may be determined based on the primary benefit or value
[[Page 305]]
to a typical customer of a substantially similar transaction. This
primary benefit or value to a typical customer can be identified through
actual data about use or access pursuant to Sec. 1.861-18(b)(3)(ii)(A),
or if that data is not available, by using other evidence indicative of
the primary benefit or value to a typical customer pursuant to Sec.
1.861-18(b)(3)(ii)(B). Corp A has data that shows that the typical
customer views movies by streaming rather than download. Accordingly,
under paragraph (c)(2) of this section, the predominant character of the
transaction is a cloud transaction because the primary benefit or value
a typical customer receives is access to stream movies on Corp A's
website. Under paragraph (c)(1) of this section, the cloud transaction
is classified as the provision of services.
(10) Example 10: Reseller of software as a service--(i) Facts. Corp
A owns the copyright to software (Program S). Corp A hosts Program S on
its servers. Customers access Program S only through an internet
connection. Corp A grants Corp B, a foreign corporation wholly owned by
Corp A, the right to sell access to Program S to Corp B's customers that
are located in Corp B's country. Corp B is responsible for managing the
purchase/sale interaction with Corp B's customers, including invoicing
and collections. Corp A is responsible for providing customers with
access to Program S. Corp B does not perform any functions to provide
access to Program S.
(ii) Analysis. (A) The transaction between Corp A and Corp B is
treated as Corp A providing on-demand access to Program S to Corp B even
though Corp B resells that access. This transaction is a cloud
transaction with one element. Under paragraph (c)(1) of this section,
the cloud transaction is classified as the provision of services. The
transaction does not involve the transfer of any copyright rights
described in Sec. 1.861-18(c)(2), and therefore is governed solely by
this section.
(B) The transaction between Corp B and its customers is the
provision of on-demand access to Program S by Corp B, which is a cloud
transaction with one element. Under paragraph (c)(1) of this section,
the cloud transaction is classified as the provision of services. The
transaction does not involve the transfer of any copyright rights
described in Sec. 1.861-18(c)(2), and therefore is governed solely by
this section.
(11) Example 11: Computer game with online functionality and in-game
purchases--(i) Facts. Corp A owns the copyright to a computer game (Game
X). Customers can purchase Game X for a one-time fee and download it
onto their computers. A customer may play certain aspects of Game X
while not connected to the internet, but most of the core functionality
of Game X is available only when the customer is connected to the
internet, including the ability to play with other customers. In order
to access the additional online functionality specific to Game X,
customers must pay a monthly fee to Corp A. The additional functionality
of Game X is hosted on servers owned by Corp A. Customers may also pay a
one-time fee to access an in-game item that can be utilized only when
playing Game X online.
(ii) Analysis. (A) There are three transactions between Corp A and a
customer. The first transaction is the transfer of a copy of Game X,
which is a digital content transaction with one element because a
customer receives from Corp A access only to offline content in exchange
for purchasing a copy of the game. Therefore, this transaction is
treated solely as a transfer of a copyrighted article under Sec. 1.861-
18.
(B) The second transaction between Corp A and a customer is the
payment of a monthly fee to play Game X online on Corp A's servers,
which is a cloud transaction with one element. Therefore, this
transaction is treated solely as a cloud transaction, and is classified
as the provision of services under paragraph (c)(1) of this section.
(C) The third transaction between Corp A and a customer is the
payment of a one-time fee in exchange for an in-game item. Because a
customer can utilize the item only when playing Game X through an
internet connection, the transaction is a cloud transaction with one
element. Therefore, this transaction is treated solely as a cloud
transaction, and is classified as
[[Page 306]]
the provision of services under paragraph (c)(1) of this section.
(e) Applicability date--(1) In general. This section applies to
taxable years beginning on or after January 14, 2025.
(2) Early application. A taxpayer can apply this section to taxable
years beginning on or after August 14, 2019 and all subsequent taxable
years not described in paragraph (e)(1) (early application years) if--
(i) The taxpayer also applies Sec. 1.861-18 to the early
application years;
(ii) This section and Sec. 1.861-18 are applied to the early
application years by all persons related to the taxpayer (within the
meaning of sections 267(b) and 707(b));
(iii) The period of limitations on assessment for each early
application year of the taxpayer and all related parties (within the
meaning of sections 267(b) and 707(b)) is open under section 6501; and
(iv) The taxpayer would not be required under this section to change
its method of accounting as a result of such election.
(f) Change in method of accounting required by this section. In
order to comply with this section, a taxpayer may be required to change
its method of accounting. If so required, the taxpayer must secure the
consent of the Commissioner in accordance with the requirements of Sec.
1.446-1(e) and the applicable administrative procedures for obtaining
the Commissioner's consent under section 446(e) for voluntary changes in
methods of accounting.
[T.D. 10022, 90 FR 2999, Jan. 14, 2025]
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
[[Page 307]]
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 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
[[Page 308]]
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 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
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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 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
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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 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
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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 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
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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 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
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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 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
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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 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
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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 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
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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 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
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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 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.
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(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, 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.
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(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 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
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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 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
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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 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
[[Page 322]]
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 (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.
[[Page 323]]
(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 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
[[Page 324]]
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 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-
[[Page 325]]
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, 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
[[Page 326]]
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 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
[[Page 327]]
(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 (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
[[Page 328]]
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
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
[[Page 329]]
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.
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.
[[Page 330]]
(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.
(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.
[[Page 331]]
(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.
(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
[[Page 332]]
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 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
[[Page 333]]
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
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
[[Page 334]]
or agency thereof), a State (or any political subdivision thereof), or
the District of Columbia shall be treated as income from sources within
the United States.
(ii) Foreign source income. Scholarships, fellowship grants, grants,
prizes and awards made by a foreign government (or an instrumentality,
agency, or any political subdivision thereof), an international
organization (as defined in section 7701(a)(18)), or a person other than
a U.S. person (as defined in section 7701(a)(30)) shall be treated as
income from sources without the United States.
(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
[[Page 335]]
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 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,
[[Page 336]]
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 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
[[Page 337]]
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 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
[[Page 338]]
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 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.
[[Page 339]]
(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 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.
[[Page 340]]
(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 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.
[[Page 341]]
The partnership is engaged in the manufacture and sale of widgets. The
widgets are manufactured in the partnership's plant located in the
United States and are sold by the partnership outside the United States.
The partnership owns the manufacturing facility and all other production
assets used to produce the widgets. A's distributive share of
partnership income includes 50 percent of the sales income from these
sales. In applying the rules of section 863 to determine the source of
its distributive share of partnership income from the export sales of
widgets, A is treated as carrying on the activity of the partnership
related to production of these widgets and as owning a proportionate
share of the partnership's assets related to production of the widgets,
based upon its distributive share of partnership income.
(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
[[Page 342]]
such purposes, the deductions for the personal exemptions shall not be
taken into account, but the special deductions described in paragraph
(c) of Sec. 1.861-8 shall be taken into account.
Example 1. Where the manufacturer or producer regularly sells part
of his output to wholly independent distributors or other selling
concerns in such a way as to establish fairly an independent factory or
production price--or shows to the satisfaction of the district director
(or, if applicable, the Director of International Operations) that such
an independent factory or production price has been otherwise
established--unaffected by considerations of tax liability and the
selling or distributing branch or department of the business is located
in a different country from that in which the factory is located or the
production carried on, the taxable income attributable to sources within
the United States shall be computed by an accounting which treats the
products as sold by the factory or productive department of the business
to the distributing or selling department at the independent factory
price so established. In all such cases the basis of the accounting
shall be fully explained in a statement attached to the return for the
taxable year.
Example 2. (i)-(ii) [Reserved]. For guidance, see Sec. 863-3T(b)(2)
Example (2)(i) and (ii).
(iii) The term ``gross sales'', as used in this example, refers only
to the sales of personal property produced (in whole or in part) by the
taxpayer within the United States and sold within a foreign country or
produced (in whole or in part) by the taxpayer within a foreign country
and sold within the United States.
(iv) The term ``property'', as used in this example, includes only
the property held or used to produce income which is derived from such
sales. Such property should be taken at its actual value, which in the
case of property valued or appraised for purposes of inventory,
depreciation, depletion, or other purposes of taxation shall be the
highest amount at which so valued or appraised, and which in other cases
shall be deemed to be its book value in the absence of affirmative
evidence showing such value to be greater or less than the actual value.
The average value during the taxable year or period shall be employed.
The average value of property as above prescribed at the beginning and
end of the taxable year or period ordinarily may be used, unless by
reason of material changes during the taxable year or period such
average does not fairly represent the average for such year or period,
in which event the average shall be determined upon a monthly or daily
basis.
(v) Bills and accounts receivable shall (unless satisfactory reason
for a different treatment is shown) be assigned or allocated to the
United States when the debtor resides in the United States, unless the
taxpayer has 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
[[Page 343]]
the United States, or produced (in whole or in part) by the taxpayer
within a possession of the United States and sold within the United
States, the expenses, losses, or other deductions properly allocated and
apportioned thereto in accordance with the rules set forth in Sec.
1.861-8.
(ii) Of the amount of taxable income so determined, one-half shall
be apportioned in accordance with the value of the taxpayer's property
within the United States and within the possession of the United States,
the portion attributable to sources within the United States being
determined by multiplying such one-half by a fraction the numerator of
which consists of the value of the taxpayer's property within the United
States, and the denominator of which consists of the value of the
taxpayer's property both within the United States and within the
possession of the United States. The remaining one-half of such taxable
income shall be apportioned in accordance with the total business of the
taxpayer within the United States and within the possession of the
United States, the portion attributable to sources within the United
States being determined by multiplying such one-half by a fraction the
numerator of which consists of the amount of the taxpayer's business for
the taxable year or period within the United States, and the denominator
of which consists of the amount of the taxpayer's business for the
taxable year or period both within the United States and within the
possession of the United States.
(iii) ``The business of the taxpayer'', as used in this example,
shall be measured by the amounts which the taxpayer paid out during the
taxable year or period for wages, salaries, and other compensation of
employees and for the purchase of goods, materials, and supplies
consumed in the regular course of business, plus the amounts received
during the taxable year or period from gross sales, such expenses,
purchases, and gross sales being limited to those attributable to the
production (in whole or in part) of personal property within the United
States and its sale within a possession of the United States or to the
production (in whole or in part) of personal property within a
possession of the United States and its sale within the United States.
The term ``property'', as used in this example, includes only the
property held or used to produce income which is derived from such
sales.
Example 3. Same as example 3 under paragraph (b)(2) of this section.
(4) Personal property purchased and sold. This subparagraph relates
to gross income derived from the purchase of personal property within a
possession of the United States and its sale within the United States.
Example 1. (i) The taxable income shall first be computed by
deducting from such 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
[[Page 344]]
portion attributable to sources within the United States being
determined by multiplying such one-half by a fraction, the numerator of
which consists of the value of the taxpayer's property within the United
States and the denominator of which consists of the value of the
taxpayer's property both within the United States and within the foreign
country. The remaining one-half of such gross income shall be
apportioned in accordance with the gross sales of the taxpayer within
the United States and within the foreign country, the portion
attributable to sources within the United States being determined by
multiplying such one-half by a fraction the numerator of which consists
of the taxpayer's gross sales for the taxable year or period within the
United States, and the denominator of which consists of the taxpayer's
gross sales for the taxable year or period both within the United States
and within the foreign country. Deductions from gross income that are
allocable and apportionable to gross income described in paragraph (i)
of this Example 2 shall be apportioned between the United States and
foreign source portions of such income, as determined under this
paragraph (ii), on a pro rata basis, without regard to whether the
deduction relates primarily or exclusively to the production of property
or to the sale of property.
(b)(2) Example (2)(iii) through (c)(4) [Reserved]
[T.D. 8228, 53 FR 35506, Sept. 14, 1988. Redesignated by T.D. 8687, 61
FR 60545, Nov. 29, 1996]
Sec. 1.863-4 Certain transportation services.
(a) General. A taxpayer carrying on the business of transportation
service (other than an activity giving rise to transportation income
described in section 863(c) or to income subject to other specific
provisions of this title) between points in the United States and points
outside the United States derives income partly from sources within and
partly from sources without the United States.
(b) Gross income. The gross income from sources within the United
States derived from such services shall be determined by taking such a
portion of the total gross revenues therefrom as (1) the sum of the
costs or expenses of such transportation business carried on by the
taxpayer within the United States and a reasonable return upon the
property used in its transportation business while within the United
States bears to (2) the sum of the total 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
[[Page 345]]
return upon the property used measures the extent to which such borrowed
capital is the source of the income. See paragraph (f)(2) of this
section.
(2) Other business activity and general expenses. If a taxpayer
subject to this section is also engaged in a business other than that of
providing transportation service between points in the United States and
points outside the United States, the costs and expenses, including
taxes, properly apportioned or allocated to such other business shall be
excluded both from the deductions and from the apportionment process
prescribed in paragraph (c) of this section; but, for the purpose of
determining taxable income, a ratable part of any general expenses,
losses, or deductions, which cannot definitely be allocated to some item
or class of gross income, may be deducted from the gross income from
sources within the United States after the amount of such gross income
has been determined. Such ratable part shall ordinarily be based upon
the ratio of gross income from sources within the United States to the
total gross income. See paragraph (f)(3) of this section.
(3) Personal exemptions and special deductions. The deductions for
the personal exemptions, and the special deductions described in
paragraph (c) of Sec. 1.861-8, shall not be taken into account for
purposes of paragraph (c) of this section.
(e) Property used while within the United States--(1) General. The
value of the property used shall be determined upon the basis of cost
less depreciation. Eight percent may ordinarily be taken as a reasonable
rate of return to apply to such property. The property taken shall be
the average property employed in the transportation service between
points in the United States and points outside the United States during
the taxable year.
(2) Average property. For ships, the average shall be determined
upon a daily basis for each ship, and the amount to be apportioned for
each ship as assets employed within the United States shall be computed
upon the proportion which the number of days the ship was within the
territorial limits of the United States bears to the total number of
days the ship was in service 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
[[Page 346]]
part of all interest deductible under section 163 and of all income,
war-profits, and excess profits taxes deductible under section 164, paid
or accrued in respect of the business of transportation service between
points in the United States and points outside the United States. The
ratable part shall ordinarily be based upon the ratio of gross income
from sources within the United States to the total gross income, from
such transportation service.
(3) General expenses. General expenses, losses, or deductions shall
be deducted under this paragraph to the extent indicated in paragraph
(d)(2) of this section.
(4) Personal exemptions. The deductions for the personal exemptions
shall be allowed under this paragraph to the same extent as provided by
paragraph (b) of Sec. 1.861-8.
(5) Special deductions. The special deductions allowed in the case
of a corporation by sections 241, 922, and 941 shall be allowed under
this paragraph to the same extent as provided by paragraph (c) of Sec.
1.861-8.
(g) Allocation based on books of account. Application for permission
to base the return upon the taxpayer's books of account will be
considered by the district director (or, if applicable, the Director of
International Operations) in the case of any taxpayer subject to this
section, who, in good faith and unaffected by considerations of tax
liability, regularly employs in his books of account a detailed
allocation of receipts and expenditures which more clearly reflects the
income derived from sources within the United States than does the
process prescribed by paragraphs (b) to (f), inclusive, of this section.
[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 8687, 61 FR
60550, Nov. 29, 1996]
Sec. 1.863-6 Income from sources within a foreign country.
The principles applied in sections 861 through 863 and section 865
and the regulations thereunder for determining the gross and the taxable
income from sources within and without the United States shall generally
be applied in determining the gross and the taxable income from sources
within and without 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
[[Page 347]]
not a notional principal contract, because a taxpayer cannot enter into
a contract with itself.
(2) Effective/applicability date.This section applies to notional
principal contract income includible in income on or after February 13,
1991. However, any taxpayer desiring to apply paragraph (b)(2)(iv) of
this section to notional principal contract income includible in income
prior to February 13, 1991, in lieu of temporary Income Tax Regulations
Sec. 1.863-7T(b)(2)(iv) may (on a consistent basis) so choose. See
paragraph (c) of this section for an election to apply the rules of this
section to notional principal contract income includible in income
before December 24, 1986. With respect to a dividend equivalent
described in section 871(m) and the regulations thereunder, this section
applies to payments made on or after January 23, 2012.
(b) Source of notional principal contract income--(1) General rule.
Unless paragraph (b)(2) or (3) of this section applies, the source of
notional principal contract income shall be determined by reference to
the residence of the taxpayer as determined under section
988(a)(3)(B)(i).
(2) Qualified business unit exception. The source of notional
principal contract income shall be determined by reference to the
residence of a qualified business unit of a taxpayer if--
(i) The taxpayer's residence, determined under section
988(a)(3)(B)(i), is the United States;
(ii) The qualified business unit's residence, determined under
section 988(a)(3)(B)(ii), is outside the United States;
(iii) The qualified business unit is engaged in the conduct of a
trade or business where it is a resident as determined under section
988(a)(3)(B)(ii); and
(iv) The notional principal contract is properly reflected on the
books of the qualified business unit. Whether a notional principal
contract is properly reflected on the books of such qualified business
unit is a question of fact. The degree of participation in the
negotiation and acquisition of a notional principal contract shall be
considered in this determination. Participation in 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
[[Page 348]]
amended tax return for each taxable year beginning before December 24,
1986, in which the taxpayer accrued or received notional principal
contract income. The statement shall--
(i) Contain the name, address, and taxpayer identifying number of
the electing taxpayer;
(ii) Identify the election as a ``Notional Principal Contract
Election under Sec. 1.863-7''; and
(iii) Specify each taxable year described in paragraph (c)(1) of
this section in which payments were made.
(d) Example. The operation of this section is illustrated by the
following example:
Example. (1) On January 1, 1990, X, a calendar year domestic
corporation, entered into an interest rate swap contract with FZ, an
unrelated foreign corporation. X does not have a qualified business unit
outside the United States. Under the contract, X is required to pay FZ
fixed rate dollar amounts, and FZ is required to pay X floating rate
dollar amounts, each determined solely by reference to a notional dollar
denominated principal amount specified under the contract. The contract
is a notional principal contract under Sec. 1.863-7(a) because the
contract provides for the payment of amounts at specified intervals
calculated by reference to a specified index upon a notional principal
amount in exchange for a promise to pay similar amounts.
(2) Assume that during 1990 X had notional principal contract income
of $100 in connection with the notional principal contract described in
(1) above. Also assume that the contract provides that payments more
than 30 days late give rise to a $5 fee, and that X receives such a fee
in 1990. Under paragraph (b)(1) of this section, the source of X's $100
of income attributable to the swap agreement is domestic. The $5 fee is
not notional principal contract income.
(e) Cross references. See Sec. 1.861-9T(b) for the allocation of
expense to certain notional principal contracts. For rules relating to
the source of income from nonfunctional currency notional principal
contracts, see Sec. 1.9 88-4T. For rules relating to the taxable amount
of notional principal contract income allocable under this section to
sources 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 349]]
(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 350]]
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 351]]
(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 352]]
(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 353]]
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 354]]
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
[[Page 355]]
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
[[Page 356]]
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 357]]
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 358]]
(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 359]]
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
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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
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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 and
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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 363]]
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 364]]
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 365]]
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 366]]
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 367]]
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 368]]
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 369]]
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 370]]
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 371]]
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 372]]
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 373]]
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
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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 375]]
(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 376]]
(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 377]]
(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 378]]
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 379]]
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 380]]
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 381]]
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 382]]
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 383]]
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 384]]
(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 385]]
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 386]]
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 387]]
(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 388]]
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 389]]
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 390]]
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 391]]
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 392]]
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 393]]
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 394]]
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 395]]
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 396]]
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 397]]
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 398]]
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 399]]
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 400]]
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 401]]
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 402]]
(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 403]]
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 404]]
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 405]]
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 406]]
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 407]]
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 408]]
----------------------------------------------------------------------------------------------------------------
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 409]]
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 410]]
$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 411]]
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 412]]
(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 413]]
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 414]]
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 415]]
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 416]]
(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 417]]
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 418]]
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 419]]
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 420]]
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 421]]
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 422]]
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 423]]
(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 424]]
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 425]]
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 426]]
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 427]]
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 428]]
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 429]]
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 430]]
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 431]]
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 432]]
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 433]]
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 434]]
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 435]]
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 436]]
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 437]]
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 438]]
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 439]]
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 440]]
(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 441]]
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 442]]
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 443]]
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 444]]
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 445]]
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 446]]
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 447]]
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 448]]
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 449]]
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 450]]
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 451]]
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 452]]
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 453]]
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 454]]
(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 455]]
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 456]]
(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 457]]
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 458]]
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 459]]
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
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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:
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(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
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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 463]]
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 464]]
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 465]]
(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 466]]
(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 467]]
(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 468]]
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 469]]
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 470]]
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 471]]
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 472]]
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 473]]
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 474]]
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 475]]
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 476]]
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 477]]
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 478]]
(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 479]]
(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 480]]
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 481]]
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 482]]
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 483]]
(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 484]]
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 485]]
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 486]]
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 487]]
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 488]]
(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 489]]
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 490]]
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 491]]
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 492]]
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 493]]
(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 494]]
(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 495]]
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 496]]
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 497]]
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 498]]
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 499]]
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 500]]
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 501]]
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 502]]
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 503]]
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 504]]
(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 505]]
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 506]]
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 507]]
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 508]]
(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 509]]
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 510]]
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 511]]
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 512]]
(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 513]]
(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 514]]
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 515]]
(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 516]]
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 517]]
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 518]]
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 519]]
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 520]]
(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 521]]
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 522]]
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 523]]
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 524]]
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 published rate
election in paragraph (d)(5)(ii) of this section) must be used for a
minimum period of five years before the taxpayer may elect a different
method. To change an election before the end of the requisite five-year
period, a taxpayer must obtain the consent of the Commissioner or his
delegate. The Commissioner or his delegate will generally consent to a
taxpayer's request to change its election only in rare and unusual
circumstances. After the five-year minimum period, an elected method may
be changed for any subsequent year on the foreign corporation's original
timely filed tax return for the first year to which the changed election
applies.
(ii) Failure to make the proper election. If a taxpayer, for any
reason, fails to make an election provided in this section in a timely
fashion, the Director of Field Operations may make any or all of the
elections provided in this section on behalf of the taxpayer, and
[[Page 525]]
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.
Example 4. Treaty exempt asset. (i) FC is a foreign corporation,
resident in Country X,
[[Page 526]]
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 principal purposes
for acquiring or
[[Page 527]]
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 which are allowed as deductions under
section 585.
[[Page 528]]
(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 gain or
loss from the sale or other disposition of that asset, adjusted in the
same manner as the basis of U.S. assets
[[Page 529]]
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.
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
[[Page 530]]
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 or relationship
between the liability and that activity. Whether there is a direct
connection between the liability
[[Page 531]]
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 event shall the amount of
U.S. booked liabilities be computed less frequently
[[Page 532]]
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--(1) In general. For each taxable
year in which a taxpayer is a bank within the meaning of section
585(a)(2)(B) (without regard to the second sentence of section
585(a)(2)(B) or whether any such activities are effectively connected
with a trade or business within the United States), the taxpayer may
elect to compute the interest expense attributable to excess U.S.-
connected liabilities by using the average published one-month Term
Secured Overnight Financing Rate published by the Chicago Mercantile
Exchange Group Benchmark Administration, Ltd. (or any successor
administrator) (``Term SOFR'') for the taxable year, plus a static
spread adjustment of 0.11448%, rather than the interest rate provided in
paragraph (d)(5)(ii)(A) of this section. A taxpayer may elect to apply
the rate provided in this paragraph (d)(5)(ii)(B) on an annual basis and
does not require the consent of the Commissioner to change this election
in a subsequent taxable year. If a taxpayer that is eligible to make the
published rate election either does not file a timely return or files a
calculation with no excess U.S.-connected liabilities and it is later
determined by the Director of Field Operations that the taxpayer has
excess U.S.-connected liabilities, then the Director of Field Operations
will apply
[[Page 533]]
the interest rate provided under this paragraph (d)(5)(ii)(B) to the
taxpayer's excess U.S.-connected liabilities in determining interest
expense.
(2) Transitional rule for taxable years including June 30, 2023. For
a taxable year that includes June 30, 2023, a taxpayer that makes the
annual published rate election must compute the interest expense
attributable to excess U.S.-connected liabilities by ratably using the
average 30-day U.S. dollar London Interbank Offered Rate for the portion
of its taxable year ending on June 30, 2023, and the average one-month
Term SOFR, plus a static spread adjustment of 0.11448%, for the portion
of its taxable year beginning on July 1, 2023.
(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
[[Page 534]]
has U.S.-connected liabilities, determined under paragraph (c) of this
section, equal to $300. Z, however, has U.S. booked liabilities of $300
and U500. Therefore, assuming an exchange rate of the U to the U.S.
dollar of 5:1, Z has U.S. booked liabilities of $400 ($300 + (U500 /
5)).
(ii) U.S.-connected liabilities. Because Z's U.S. booked liabilities
of $400 exceed its U.S.-connected liabilities by $100, all of Z's
interest expense allocable to its U.S. trade or business must be scaled
back pro-rata. To determine the scaling ratio, Z divides its U.S.-
connected liabilities by its U.S. booked liabilities, as required by
paragraph (d)(4) of this section. Z's interest expense is scaled back
pro rata by the resulting ratio of \3/4\ ($300 / $400). Z's income,
expense, gain or loss from hedging transactions described in paragraph
(d)(2)(vi) of this section must be similarly reduced.
Example 4. [Reserved]
Example 5. U.S. booked liabilities--direct relationship. (i) Facts.
Bank A, a resident of Country X maintains a banking office in the U.S.
that records transactions on three sets of books for State A, an
International Banking Facility (IBF) for its bank regulatory approved
international transactions, and a shell branch licensed operation in
Country C. Bank A records substantial ECI assets from its bank lending
and placement activities and a mix of interbranch and non-ECI producing
assets from the same or similar activities on the books of State A
branch and on its IBF. Bank A's Country C branch borrows substantially
from third parties, as well as from its home office, and lends all of
its funding to its State A branch and IBF to fund the mix of ECI,
interbranch and non-ECI activities on those two books. The consolidated
books of State A branch and IBF indicate that a substantial amount of
the total book assets constitute U.S. assets under paragraph (b) of this
section. Some of the third-party borrowings on the books of the State A
branch are used to lend directly to Bank A's home office in Country X.
These borrowings reflect the average borrowing rate of the State A
branch, IBF and Country C branches as a whole. All third-party
borrowings reflected on the books of State A branch, the IBF and Country
C branch were recorded on such books before the close of business on the
day the liabilities were acquired by Bank A.
(ii) U.S. booked liabilities. The facts demonstrate that the
separate State A branch, IBF and Country C branch books taken together,
constitute a set of books within the meaning of paragraph
(d)(2)(iii)(A)(1) of this section. Such set of books as a whole has a
direct relationship to an ECI activity under paragraph (d)(2)(iii)(A)(2)
of this section even though the Country C branch books standing alone
would not. The third-party liabilities recorded on the books of Country
C constitute U.S. booked liabilities because they were timely recorded
and the overall set of books on which they were reflected has a direct
relationship to a bank lending and interbank placement ECI producing
activity. The third-party liabilities that were recorded on the books of
State A branch that were used to lend funds to Bank A's home office also
constitute U.S. booked liabilities because the interbranch activity the
funds were used for is a lending activity of a type that also gives rise
to a substantial amount of ECI that is properly reflected on the same
set of books as the interbranch loans. Accordingly, the liabilities are
not traced to their specific interbranch use but to the 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
[[Page 535]]
determined under paragraph (b)(3) of this section) in the currency pool
by the foreign corporation's actual ratio (as determined under paragraph
(c)(2) of this section) for the taxable year or, if the taxpayer has
made an election in accordance with paragraph (c)(4) of this section, by
the fixed ratio.
(iii) Determine the interest expense attributable to each currency
pool. Third, the foreign corporation must determine the interest expense
attributable to each currency pool by multiplying the U.S.-connected
liabilities in each currency pool by the prescribed interest rate as
defined in paragraph (e)(2) of this section.
(2) Prescribed interest rate. For each currency pool, the prescribed
interest rate is determined by dividing the total interest expense that
is paid or accrued for the taxable year with respect to the foreign
corporation's worldwide liabilities denominated in that currency, by the
foreign corporation's average worldwide liabilities (whether interest
bearing or not) denominated in that currency. The interest expense and
liabilities are to be stated in that currency.
(3) Hedging transactions. [Reserved]
(4) Election not available if excessive hyperinflationary assets.
The election to use the separate currency pools method of this paragraph
(e) is not available if the value of the foreign corporation's U.S.
assets denominated in a hyperinflationary currency, as defined in Sec.
1.985-1, exceeds ten percent of the value of the foreign corporation's
total U.S. assets. If a foreign corporation made a valid election to use
the separate currency pools method in a prior year but no longer
qualifies to use such method pursuant to this paragraph (e)(4), the
taxpayer must use the method provided by paragraphs (b) through (d) of
this section.
(5) Examples. The separate currency pools method of this paragraph
(e) is illustrated by the following examples:
Example 1. Separate currency pools method--(i) Facts. (A) Bank Z, a
resident of country X, has a branch in the United States through which
it conducts its banking business. For its 1997 taxable year, Z has U.S.
assets, as defined in paragraph (b) of this section, that are
denominated in U.S. dollars and in U, the country X currency.
Accordingly, Z's U.S. assets are as follows:
------------------------------------------------------------------------
Average
value
------------------------------------------------------------------------
U.S. Dollar Assets........................................... $20,000
U Assets..................................................... U 5,000
------------------------------------------------------------------------
(B) Z's worldwide liabilities are also denominated in U.S. Dollars
and in U. The average interest rates on Z's worldwide liabilities,
including those in the United States, are 6% on its U.S. dollar
liabilities, and 12% on its liabilities denominated in U. Assume that Z
has properly elected to use its actual ratio of 95% to determine its
U.S.-connected liabilities in Step 2, and has also properly 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) Applicability date--(1) General rule. Except as provided in
paragraph (f)(3) of this section, this section is applicable for tax
years ending on or after August 15, 2009. A taxpayer, however, may
choose to apply Sec. 1.882-5T, rather than applying the regulations in
this section, for any taxable year beginning on or after August 16,
2008, but before August 15, 2009.
(2) [Reserved]
(3) Applicability date for published rate election. Paragraphs
(a)(7)(i) and (d)(5)(ii)(B) of this section apply to taxable years
ending after June 30, 2023. For taxable years ending before July 1,
[[Page 536]]
2023, see Sec. 1.882-5(d)(5)(ii)(B) (as contained in 26 CFR part 1,
revised as of April 1, 2023).
[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;
T.D. 9976, 88 FR 42234, June 30, 2023]
Sec. 1.883-0 Outline of major topics.
This section lists the major paragraphs contained in Sec. Sec.
1.883-1 through 1.883-5.
Sec. 1.883-1 Exclusion of income from the international operation of
ships or aircraft.
(a) General rule.
(b) Qualified income.
(c) Qualified foreign corporation.
(1) General rule.
(2) Stock ownership test.
(3) Substantiation and reporting requirements.
(i) General rule.
(ii) Further documentation.
(A) General rule.
(B) Names and permanent addresses of certain shareholders.
(4) Commissioner's discretion to cure defects in documentation.
(d) Qualified foreign country.
(e) Operation of ships or aircraft.
(1) General rule.
(2) Pool, partnership, strategic alliance, joint operating
agreement, code-sharing arrangement or other joint venture.
(3) Activities not considered operation of ships or aircraft.
(4) Examples.
(5) Definitions.
(i) Bareboat charter.
(ii) Code-sharing arrangement.
(iii) Dry lease.
(iv) Entity.
(v) Fiscally transparent entity under the income tax laws of the
United States.
(vi) Full charter.
(vii) Nonvessel operating common carrier.
(viii) Space or slot charter.
(ix) Time charter.
(x) Voyage charter.
(xi) Wet lease.
(f) International operation of ships or aircraft.
(1) General rule.
(2) Determining whether income is derived from international
operation of ships or aircraft.
(i) International carriage of passengers.
(A) General rule.
(B) Round trip travel on ships.
(ii) International carriage of cargo.
(iii) Bareboat charter of ships or dry lease of aircraft used in
international operation of ships or aircraft.
(iv) Charter of ships or aircraft for hire.
(g) Activities incidental to the international operation of ships or
aircraft.
(1) General rule.
(2) Activities not considered incidental to the international
operation of ships or aircraft.
(3) Other Services. [Reserved]
(4) Activities involved in a pool, partnership, strategic alliance,
joint operating agreement, code-sharing arrangement or other joint
venture.
(h) Equivalent exemption.
(1) General rule.
(2) Determining equivalent exemptions for each category of income.
(3) Special rules with respect to income tax conventions.
(i) Countries with only an income tax convention.
(ii) Countries with both an income tax convention and an equivalent
exemption.
(A) General rule.
(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.
[[Page 537]]
(3) Closely-held classes of stock not treated as meeting trading
requirements.
(i) General rule.
(ii) Exception.
(iii) Five-percent shareholders.
(A) Related persons.
(B) Investment companies.
(4) Anti-abuse rule.
(5) Example.
(e) Substantiation that a foreign corporation is publicly traded.
(1) General rule.
(2) Availability and retention of documents for inspection.
(f) Reporting requirements.
Sec. 1.883-3 Treatment of controlled foreign corporations.
(a) General rule.
(b) Qualified U.S. person ownership test.
(1) General rule.
(2) Qualified U.S. person.
(3) Treatment of bearer shares.
(4) Ownership attribution through certain domestic entities.
(5) Examples.
(c) Substantiation of CFC stock ownership.
(1) In general.
(2) Ownership statements from qualified U.S. persons.
(3) Ownership statements from intermediaries.
(4) Three-year period of validity.
(5) Availability and retention of documents for inspection.
(d) Reporting requirements.
Sec. 1.883-4 Qualified shareholder stock ownership test.
(a) General rule.
(b) Qualified shareholder.
(1) General rule.
(2) Residence of individual shareholders.
(i) General rule.
(ii) Tax home.
(3) Certain income tax convention restrictions applied to
shareholders.
(4) Not-for-profit organizations.
(5) Pension funds.
(i) Pension fund defined.
(ii) Government pension funds.
(iii) Nongovernment pension funds.
(iv) Beneficiary of a pension fund.
(c) Rules for determining constructive ownership.
(1) General rules for attribution.
(2) Partnerships.
(i) General rule.
(ii) Partners resident in the same country.
(iii) Examples.
(3) Trusts and estates.
(i) Beneficiaries.
(ii) Grantor trusts.
(4) Corporations that issue stock.
(5) Taxable nonstock corporations.
(6) Mutual insurance companies and similar entities.
(7) Computation of beneficial interests in nongovernment pension
funds.
(d) Substantiation of stock ownership.
(1) General rule.
(2) Application of general rule.
(i) Ownership statements.
(ii) Three-year period of validity.
(3) Special rules.
(i) Substantiating residence of certain shareholders.
(ii) Special rule for registered shareholders owning less than one
percent of widely-held corporations.
(iii) Special rule for beneficiaries of pension funds.
(A) Government pension fund.
(B) Nongovernment pension fund.
(iv) Special rule for stock owned by publicly-traded corporations.
(v) Special rule for not-for-profit organizations.
(vi) Special rule for a foreign airline covered by an air services
agreement.
(vii) Special rule for taxable nonstock corporations.
(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]
[[Page 538]]
Sec. 1.883-1 Exclusion of income from the international operation of ships or aircraft.
(a) General rule. Qualified income derived by a qualified foreign
corporation from its international operation of ships or aircraft is
excluded from gross income and exempt from United States Federal income
tax. Paragraph (b) of this section defines the term qualified income.
Paragraph (c) of this section defines the term qualified foreign
corporation. Paragraph (f) of this section defines the term
international operation of ships or aircraft.
(b) Qualified income. Qualified income is income derived from the
international operation of ships or aircraft that--
(1) Is properly includible in any of the income categories described
in paragraph (h)(2) of this section; and
(2) Is the subject of an equivalent exemption, as defined in
paragraph (h) of this section, granted by the qualified foreign country,
as defined in paragraph (d) of this section, in which the foreign
corporation seeking qualified foreign corporation status is organized.
(c) Qualified foreign corporation--(1) General rule. A qualified
foreign corporation is a corporation that is organized in a qualified
foreign country and considered engaged in the international operation of
ships or aircraft. The term corporation is defined in section 7701(a)(3)
and the regulations thereunder. Paragraph (d) of this section defines
the term qualified foreign country. Paragraph (e) of this section
defines the term operation of ships or aircraft, and paragraph (f) of
this section defines the term international operation of ships or
aircraft. To be a qualified foreign corporation, the corporation must
satisfy the stock ownership test of paragraph (c)(2) of this section and
satisfy the substantiation and reporting requirements described in
paragraph (c)(3) of this section. A corporation may be a qualified
foreign corporation with respect to one category of qualified income but
not with respect to another such category. See paragraph (h)(2) of this
section for a discussion of the categories of qualified income.
(2) Stock ownership test. To be a qualified foreign corporation, a
foreign corporation must satisfy the publicly-traded test of Sec.
1.883-2(a), the CFC stock ownership test of Sec. 1.883-3(a), or the
qualified shareholder stock ownership test of Sec. 1.883-4(a).
(3) Substantiation and reporting requirements--(i) General rule. To
be a qualified foreign corporation, a foreign corporation must include
the following information in its Form 1120-F, ``U.S. Income Tax Return
of a Foreign Corporation,'' in the manner prescribed by such form and
its accompanying instructions--
(A) The corporation's name and address (including mailing code);
(B) The corporation's U.S. taxpayer identification number;
(C) The foreign country in which the corporation is organized;
(D) The applicable authority for an equivalent exemption, for
example, the 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
[[Page 539]]
(I) Any other relevant information specified in Form 1120-F, ``U.S.
Income Tax Return of a Foreign Corporation,'' and its accompanying
instructions.
(ii) Further documentation--(A) General rule. Except as provided in
paragraph (c)(3)(ii)(B) of this section, if the Commissioner requests in
writing that the foreign corporation provide documentation or
substantiate any representations made under paragraph (c)(3)(i) of this
section, or under Sec. 1.883-2(f), Sec. 1.883-3(d), or Sec. 1.883-
4(e), as applicable, the foreign corporation must provide the requested
documentation or substantiation within 60 days of receiving the written
request. If the foreign corporation does not provide the requested
documentation or substantiation within the 60-day period, but
demonstrates that the failure was due to reasonable cause and not
willful neglect, the Commissioner may grant the foreign corporation a
30-day extension to provide the requested documentation or
substantiation. Whether a failure to provide the documentation or
substantiation in a timely manner was due to reasonable cause and not
willful neglect shall be determined by the Commissioner based on all the
facts and circumstances.
(B) Names and permanent addresses of certain shareholders. If the
Commissioner requests the names and permanent addresses of individual
qualified shareholders of a foreign corporation, as represented on each
individual's ownership statement, to substantiate the requirements of
the exception to the closely-held test in the publicly-traded test in
Sec. 1.883-2(e), the qualified shareholder stock ownership test in
Sec. 1.883-4(a), or the qualified U.S. person ownership test in Sec.
1.883-3(b), the foreign corporation must provide the requested
information within 30 days of receiving the written request. If the
foreign corporation does not provide the requested information within
the 30-day period, but demonstrates that the failure was due to
reasonable cause and not willful neglect, the Commissioner may grant the
foreign corporation a 30-day extension to provide the requested
information. Whether a failure to provide the requested information was
due to reasonable cause and not willful neglect shall be determined by
the Commissioner based on all the facts and circumstances.
(d) Qualified foreign country. A qualified foreign country is a
foreign country that grants to corporations organized in the United
States an equivalent exemption, as described in paragraph (h) of this
section, for the category of qualified income, as described in paragraph
(h)(2) of this section, derived by the foreign corporation seeking
qualified foreign corporation status. A foreign country may be a
qualified foreign country with respect to one category of qualified
income but not with respect to another such category.
(e) Operation of ships or aircraft--(1) General rule. Except as
provided in paragraph (e)(2) of this section, a foreign corporation is
considered engaged in the operation of ships or aircraft 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
[[Page 540]]
tax laws of the United States, as defined in paragraph (e)(5)(v) of this
section--
(i) Owns an interest in a partnership, disregarded entity, or other
fiscally transparent entity under the income tax laws of the United
States that itself would be considered engaged in the operation of ships
or aircraft under paragraph (e)(1) of this section if it were a foreign
corporation; or
(ii) Participates in a pool, strategic alliance, joint operating
agreement, code-sharing arrangement, or other joint venture that is not
an entity, as defined in paragraph (e)(5)(iv) of this section, involving
one or more activities described in paragraphs (e)(1)(i) through (iii)
of this section, but only if--
(A) In the case of a direct interest, the foreign corporation is
otherwise engaged in the operation of ships or aircraft under paragraph
(e)(1) of this section; or
(B) In the case of an indirect interest, either the foreign
corporation is otherwise engaged, or one of the fiscally transparent
entities would be considered engaged if it were a foreign corporation,
in the operation of ships or aircraft under paragraph (e)(1) of this
section.
(3) Activities not considered operation of ships or aircraft.
Activities that do not constitute operation of ships or aircraft
include, but are not limited to--
(i) The activities of a nonvessel operating common carrier, as
defined in paragraph (e)(5)(vii) of this section;
(ii) Ship or aircraft management;
(iii) Obtaining crews for ships or aircraft operated by another
party;
(iv) Acting as a ship's agent;
(v) Ship or aircraft brokering;
(vi) Freight forwarding;
(vii) The activities of travel agents and tour operators;
(viii) Rental by a container leasing company of containers and
related equipment; and
(ix) The activities of a concessionaire.
(4) Examples. The rules of paragraphs (e)(1) through (3) of this
section are illustrated by the following examples:
Example 1. Three tiers of charters--(i) Facts. A, B, and C are
foreign corporations. A purchases a ship. A and B enter into a bareboat
charter of the ship for a term of 20 years, and B, in turn, enters into
a time charter of the ship with C for a term of 5 years. Under the time
charter, B is responsible for the complete operation of the ship,
including providing the crew and maintenance. C uses the ship during the
term of the time charter to carry its customers' freight between U.S.
and foreign ports. C owns no ships.
(ii) Analysis. Because A is the owner of the entire ship and leases
out the ship under a bareboat charter to B, and because the sublessor,
C, uses the ship to carry cargo for hire, A is considered engaged in the
operation of a ship under paragraph (e)(1) of this section during the
term of the time charter. B leases in the entire ship from A and leases
out the ship under a time charter to C, who uses the ship to carry cargo
for hire. Therefore, B is considered engaged in the operation of a ship
under paragraph (e)(1) of this section during the term of the time
charter. C time charters the entire ship from B and uses the ship to
carry its customers' freight during the term of the charter. Therefore,
C 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,
[[Page 541]]
and S4 form joint venture JV, in which they are all interest holders, to
conduct cruises. JV is a fiscally transparent entity under the income
tax laws of the United States, as defined in paragraph (e)(5)(v) of this
section. Under the terms of the joint venture, S1, S2, and S3 each enter
into time charter agreements with JV, pursuant to which S1, S2, and S3
retain control of the navigation and management of the individual ships,
and JV will use the ships to carry passengers for hire. The overall
management of the cruise line will be provided by S4.
(ii) Analysis. S1, S2, and S3 each owns ships and time charters
those ships to JV, which uses the ships to carry passengers for hire.
Accordingly, S1, S2, and S3 are each considered engaged in the operation
of ships under paragraph (e)(1) of this section. JV leases in entire
ships by means of the time charters, and JV uses those ships to carry
passengers on cruises. Thus, JV would be engaged in the operation of
ships within the meaning of paragraph (e)(1) of this section if it were
a foreign corporation. Therefore, although S4 does not directly own or
lease in a ship, S4 also is engaged in the operation of ships, within
the meaning of paragraph (e)(2)(i) of this section, with respect to its
participation in JV.
Example 4. Tiered partnerships--(i) Facts. Foreign corporations A,
B, and C enter into a partnership, P1. P1 is one of several shareholders
of Poolco, a foreign limited liability company that makes an election
pursuant to Sec. 301.7701-3 of this chapter to be treated as a
partnership for U.S. tax purposes. P1 acquires several ships and time
charters them out to Poolco. Poolco slot or voyage charters such ships
out to third parties for use in the carriage of cargo for hire. P1 and
Poolco are fiscally transparent entities under the income tax laws of
the United States, as defined in paragraph (e)(5)(v) of this section.
(ii) Analysis. A, B, and C are considered engaged in the operation
of ships under paragraph (e)(2)(i) of this section with respect to their
direct interest in P1 and with respect to their indirect interest in
Poolco because both P1 and Poolco are fiscally transparent entities
under the income tax laws of the United States and would be considered
engaged in the operation of ships under paragraph (e)(1) of this section
if they were foreign corporations. The result would be the same if
Poolco were a single-member disregarded entity owned solely by P1.
(5) Definitions--(i) Bareboat charter. A bareboat charter is a
contract for the use of a ship or aircraft whereby the lessee is in
complete possession, control, and command of the ship or aircraft. For
example, in a bareboat charter, the lessee is responsible for the
navigation and management of the ship or aircraft, the crew, supplies,
repairs and maintenance, fees, insurance, charges, commissions and other
expenses connected with the use of the ship or aircraft. The lessor of
the ship bears none of the expense or responsibility of operation of the
ship or aircraft.
(ii) Code-sharing arrangement. A code-sharing arrangement is an
arrangement in which one air carrier puts its identification code on the
flight of another carrier. This arrangement allows the first carrier to
hold itself out as providing service in markets where it does not
otherwise operate or where it operates infrequently. Code-sharing
arrangements can range from a very limited agreement between two
carriers involving only one market to agreements involving multiple
markets and alliances between or among international carriers which also
include 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,
[[Page 542]]
issues bills of lading, assumes responsibility or is liable by law as a
common carrier for safe transportation of shipments, and arranges in its
own name with other common carriers, including those engaged in the
operation of ships, for the performance of such transportation.
(viii) Space or slot charter. A space or slot charter is a contract
for use of a certain amount of space (but less than all of the space) on
a ship or aircraft, and may be on a time or voyage basis. When used in
connection with passenger aircraft this sort of charter may be referred
to as the sale of block seats.
(ix) Time charter. A time charter is a contract for the use of a
ship or aircraft for a specific period of time, during which the lessor
of the ship or aircraft retains control of the navigation and management
of the ship or aircraft (i.e., the lessor continues to be responsible
for the crew, supplies, repairs and maintenance, fees and insurance,
charges, commissions and other expenses connected with the use of the
ship or aircraft).
(x) Voyage charter. A voyage charter is a contract similar to a time
charter except that the ship or aircraft is chartered for a specific
voyage or flight rather than for a specific period of time.
(xi) Wet lease. A wet lease is the time or voyage charter of an
aircraft.
(f) International operation of ships or aircraft--(1) General rule.
The term international operation of ships or aircraft means the
operation of ships or aircraft, as defined in paragraph (e) of this
section, with respect to the carriage of passengers or cargo on voyages
or flights that begin or end in the United States, as determined under
paragraph (f)(2) of this section. The term does not include the carriage
of passengers or cargo on a voyage or flight that begins and ends in the
United States, even if the voyage or flight contains a segment extending
beyond the territorial limits of the United States, unless the passenger
disembarks or the cargo is unloaded outside the United States. Operation
of ships or aircraft beyond the territorial limits of the United States
does not constitute in itself international operation of ships or
aircraft.
(2) Determining whether income is derived from international
operation of ships or aircraft. Whether income is derived from
international operation of ships or aircraft is determined on a
passenger by passenger basis (as provided in paragraph (f)(2)(i) of this
section) and on an item-of-cargo by item-of-cargo basis (as provided in
paragraph (f)(2)(ii) of this section). In the case of the bareboat
charter of a ship or the dry lease of an aircraft, whether the charter
income for a particular period is derived from international operation
of ships or aircraft is determined by reference to how the ship or
aircraft is used by the lowest-tier lessee in the chain of lessees (as
provided in paragraph (f)(2)(iii) of this section).
(i) International carriage of passengers--(A) General rule. Except
in the case of a round trip described in paragraph (f)(2)(i)(B) of this
section, income 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.
[[Page 543]]
(B) Round trip travel on ships. In the case of income from the
carriage of a passenger on a ship that begins its voyage in the United
States, calls on one or more foreign intermediate ports, and returns to
the same or another U.S. port, such income from carriage of a passenger
on the entire voyage will be treated as income derived from
international operation of ships or aircraft under paragraph
(f)(2)(i)(A) of this section. This result obtains even if such carriage
includes one or more intermediate stops at a U.S. port or ports and even
if the passenger does not disembark at the foreign intermediate point.
(ii) International carriage of cargo. Income from the carriage of
cargo will be income derived from international operation of ships or
aircraft if the cargo is carried between a beginning point in the United
States and an ending point outside the United States, or vice versa.
Carriage of cargo will be treated as ending at the final destination of
the cargo even if, en route to that final destination, a stop is made at
a U.S. intermediate point, provided the cargo is transported to its
ultimate destination on the same ship or aircraft. If the cargo is
transferred to another ship or aircraft, the carriage of the cargo may
nevertheless be treated as ending at its final destination, if the same
taxpayer transports the cargo to and from the U.S. intermediate point
and the cargo does not pass through customs at the U.S. intermediate
point. Similarly, carriage of cargo will be treated as beginning at the
cargo's point of origin, even if en route to its final destination a
stop is made at a U.S. intermediate point, provided the cargo is
transported to its ultimate destination on the same ship or aircraft. If
the cargo is transferred to another ship or aircraft at the U.S.
intermediate point, the carriage of the cargo may nevertheless be
treated as beginning at the point of origin, if the same taxpayer
transports the cargo to and from the U.S. intermediate point and the
cargo does not pass through customs at the U.S. intermediate point.
Repackaging, recontainerization, or any other activity involving the
unloading of the cargo at the U.S. intermediate point does not change
these results, provided the same taxpayer transports the cargo to and
from the U.S. intermediate point and the cargo does not pass through
customs at the U.S. intermediate point. A lighter vessel that carries
cargo to, or picks up cargo from, a vessel located beyond the
territorial limits of the United States and correspondingly loads or
unloads that cargo at a U.S. port, carries cargo between a point in the
United States and a point outside the United States. However, a lighter
vessel that carries cargo to, or picks up cargo from, a vessel located
within the territorial limits of the United States, and correspondingly
loads or unloads that cargo at a U.S. port, is not engaged in
international operation of ships or aircraft. Income from the carriage
of military cargo on a voyage that begins in the United States, stops at
a foreign intermediate 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
[[Page 544]]
States during the smaller of the taxable year or the particular charter
period, and the denominator of which is the total number of days in the
smaller of the taxable year or the particular charter period. For this
purpose, the number of days during which the ship or aircraft is not
generating transportation income, within the meaning of section
863(c)(2), are not included in the numerator or denominator of the
fraction. However, the foreign corporation may adopt an alternative
method for determining the amount of the charter income that is
attributable to the international operation of ships or aircraft if it
can establish that the alternative method more accurately reflects the
amount of such income.
(iv) Charter of ships or aircraft for hire. For purposes of this
section, if a foreign corporation time, voyage, or bareboat charters out
a ship or aircraft, and the lowest-tier lessee uses the ship or aircraft
to carry passengers or cargo on a fee basis, the ship or aircraft is
considered used to carry passengers or cargo for hire, regardless of
whether the ship or aircraft may be empty during a portion of the
charter period due to a backhaul voyage or flight or for purposes of
repositioning. If a foreign corporation time, voyage, or bareboat
charters out a ship or aircraft, and the lowest-tier lessee uses the
ship or aircraft for the carriage of proprietary goods, including an
empty backhaul voyage or flight or repositioning related to such
carriage of proprietary goods, the ship or aircraft similarly will be
treated as used to carry cargo for hire.
(g) Activities incidental to the international operation of ships or
aircraft--(1) General rule. Certain activities of a foreign corporation
engaged in the international operation of ships or aircraft are so
closely related to the international operation of ships or aircraft that
they are considered incidental to such operation, and income derived by
the foreign corporation from its performance of these incidental
activities is deemed to be income derived from the international
operation of ships or aircraft. Examples of such activities include--
(i) Temporary investment of working capital funds to be used in the
international operation of ships or aircraft by the foreign corporation;
(ii) Sale of tickets by the foreign corporation engaged in the
international operation of ships for the international carriage of
passengers by ship on behalf of another corporation engaged in the
international operation of ships;
(iii) Sale of tickets by the foreign corporation engaged in the
international operation of aircraft for the international carriage of
passengers by air on behalf of another corporation engaged in the
international operation of aircraft;
(iv) Contracting with concessionaires for performance of services
onboard during the international operation of the foreign corporation's
ships or aircraft;
(v) Providing (either by subcontracting or otherwise) for the
carriage of cargo preceding or following the international carriage of
cargo under a 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
[[Page 545]]
operation of ships or aircraft but currently not needed, if the ship or
aircraft is used by the lessee for international carriage of cargo or
passengers;
(ix) Arranging by means of a space or slot charter for the carriage
of cargo listed on a bill of lading or airway bill or similar document
issued by the foreign corporation on the ship or aircraft of another
corporation engaged in the international operation of ships or aircraft;
(x) The provision of containers and related equipment by the foreign
corporation in connection with the international carriage of cargo for
use by its customers, including short-term use within the United States
immediately preceding or following the international carriage of cargo
(for this purpose, a period of five days or less shall be presumed to be
short-term); and
(xi) The provision of goods and services by engineers, ground and
equipment maintenance staff, cargo handlers, catering staff, and
customer services personnel, and the provision of facilities such as
passenger lounges, counter space, ground handling equipment, and
hangars.
(2) Activities not considered incidental to the international
operation of ships or aircraft. Examples of activities that are not
considered incidental to the international operation of ships or
aircraft include--
(i) The sale of or arranging for train travel, bus transfers, single
day shore excursions, or land tour packages;
(ii) Arranging for hotel accommodations within the United States
other than as provided in paragraph (g)(1)(vii) of this section;
(iii) The sale of airline tickets or cruise tickets other than as
provided in paragraph (g)(1)(ii), (iii), or (vi) of this section;
(iv) The sale or rental of real property;
(v) Treasury activities involving the investment of excess funds or
funds awaiting repatriation, even if derived from the international
operation of ships or aircraft;
(vi) The carriage of passengers or cargo on ships or aircraft on
domestic legs of transportation not treated as either international
operation of ships or aircraft under paragraph (f) of this section or as
an activity that is incidental to such operation under paragraph (g)(1)
of this section;
(vii) The carriage of cargo by bus, truck or rail by a foreign
corporation between a U.S. inland point and a U.S. gateway port or
airport preceding or following the international carriage of such cargo
by the foreign corporation; and
(viii) The provision of containers or other related equipment by the
foreign corporation within the United States other than as provided in
paragraph (g)(1)(x) of this section, including warehousing.
(3) Other services. [Reserved]
(4) Activities involved in a pool, partnership, strategic alliance,
joint operating agreement, code-sharing arrangement or other joint
venture. Notwithstanding paragraph (g)(1) of this section, an activity
is considered incidental to the 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.
[[Page 546]]
(h) Equivalent exemption--(1) General rule. A foreign country grants
an equivalent exemption when it exempts from taxation income from the
international operation of ships or aircraft derived by corporations
organized in the United States. Whether a foreign country provides an
equivalent exemption must be determined separately with respect to each
category of income, as provided in paragraph (h)(2) of this section. An
equivalent exemption may be available for income derived from the
international operation of ships even though income derived from the
international operation of aircraft may not be exempt, and vice versa.
For rules regarding foreign corporations organized in countries that
provide exemptions only through an income tax convention, see paragraph
(h)(3) of this section. An equivalent exemption may exist where the
foreign country--
(i) Generally imposes no tax on income, including income from the
international operation of ships or aircraft;
(ii) Provides an exemption from tax for income derived from the
international operation of ships or aircraft, either by statute, decree,
income tax convention, or otherwise; or
(iii) Exchanges diplomatic notes with the United States, or enters
into an agreement with the United States, that provides for a reciprocal
exemption for purposes of section 883.
(2) Determining equivalent exemptions for each category of income.
Whether a foreign country grants an equivalent exemption must be
determined separately with respect to income from the international
operation of ships and income from the international operation of
aircraft for each category of income listed in paragraphs (h)(2)(i)
through (v), (vii), and (viii) of this section. If an exemption is
unavailable in the foreign country for a particular category of income,
the foreign country is not considered to grant an equivalent exemption
with respect to that category of income. Income in that category is not
considered to be the subject of an equivalent exemption and, thus, is
not eligible for exemption from income tax in the United States, even
though the foreign country may grant an equivalent exemption for other
categories of income. With respect to paragraph (h)(2)(vi) of this
section, a foreign country may be considered to grant an equivalent
exemption for one or more types of income described in paragraph (g)(1)
of this section. The following categories of income derived from the
international operation of ships or aircraft may be exempt from United
States income tax if an equivalent exemption is available--
(i) Income from the carriage of passengers and cargo;
(ii) Time or voyage (full) charter income of a ship or wet lease
income of an aircraft;
(iii) Bareboat charter income of a ship or dry charter income of an
aircraft;
(iv) Incidental bareboat charter income or incidental dry lease
income;
(v) Incidental container-related income;
(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
[[Page 547]]
(B) The profits that are exempt from tax pursuant to the shipping
and air transport or gains article of the income tax convention and are
described within a category of income included in paragraphs (h)(2)(i)
through (viii) of this section.
(ii) Countries with both an income tax convention and an equivalent
exemption--(A) General rule. If a foreign country grants an exemption
from tax for profits from the international operation of ships or
aircraft under the shipping and air transport or gains article of an
income tax convention with the United States and also by some other
means (for example, by diplomatic note or domestic law of the foreign
country), a foreign corporation may elect annually whether to claim an
exemption from tax under section 883 or the income tax convention.
Except as provided in paragraph (h)(3)(ii)(B) of this section, the
foreign corporation must apply the elected exemption (section 883 or the
income tax convention) to all categories of income described in
paragraph (h)(2) of this section. If the foreign corporation elects to
claim the exemption under section 883, it must satisfy all of the
requirements for claiming the exemption under section 883. If the
foreign corporation elects to claim the exemption under the income tax
convention, it must satisfy all of the requirements and conditions for
claiming benefits under the income tax convention. See Sec. 1.883-
4(b)(3) for rules concerning relying on shareholders resident in a
foreign country that grants an equivalent exemption under an income tax
convention to satisfy the stock ownership test of paragraph (c)(2) of
this section.
(B) Special rule for claiming simultaneous benefits under section
883 and an income tax convention. If a foreign corporation that is
organized in a country that grants an exemption from tax under an income
tax convention and also by some other means (such as by diplomatic note
or domestic law of the foreign country) with respect to a specific
category of income described in paragraph (h)(2) of this section, and
the foreign corporation elects to claim the exemption under the income
tax convention, the foreign corporation may nonetheless simultaneously
claim an exemption under section 883 with respect to a category of
income exempt from tax by such other means if the foreign corporation--
(1) Satisfies the requirements of paragraphs (h)(3)(i)(A) and (B) of
this section for each category of income;
(2) Satisfies one of the stock ownership tests of paragraph (c)(2)
of this section; and
(3) Complies with the substantiation and reporting requirements in
paragraph (c)(3) of this section.
(iii) Participation in certain joint ventures. If a foreign country
grants an exemption for a category of income only through an income tax
convention, a foreign corporation that is organized in that country and
that derives income, 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
[[Page 548]]
States by foreign countries do not satisfy the equivalent exemption
requirements of this section. Paragraphs (h)(4)(ii) through (vii) of
this section provide descriptions of some of the types of exemptions
that do not qualify as equivalent exemptions for purposes of this
section.
(ii) Reduced tax rate or time limited exemption. The exemption
granted by the foreign country's law or income tax convention must be a
complete exemption. The exemption may not constitute merely a reduction
to a nonzero rate of tax levied against the income of corporations
organized in the United States derived from the international operation
of ships or aircraft or a temporary reduction to a zero rate of tax,
such as in the case of a tax holiday.
(iii) Inbound or outbound freight tax. With respect to the carriage
of cargo, the foreign country must provide an exemption from tax for
income from transporting freight both inbound and outbound. For example,
a foreign country that imposes tax only on outbound freight will not be
treated as granting an equivalent exemption for income from transporting
freight inbound into that country.
(iv) Exemptions for limited types of cargo. A foreign country must
provide an exemption from tax for income from transporting all types of
cargo. For example, if a foreign country were generally to impose tax on
income from the international carriage of cargo but were to provide a
statutory exemption for income from transporting agricultural products,
the foreign country would not be considered to grant an equivalent
exemption with respect to income from the international carriage of
cargo, including agricultural products.
(v) Territorial tax systems. A foreign country with a territorial
tax system will be treated as granting an equivalent exemption if it
treats all income derived from the international operation of ships or
aircraft derived by a U.S. corporation as entirely foreign source and
therefore not subject to tax, including income derived from a voyage or
flight that begins or ends in that foreign country.
(vi) Countries that tax on a residence basis. A foreign country that
provides an equivalent exemption to corporations organized in the United
States but also imposes a residence-based tax on certain corporations
organized in the United States may nevertheless be considered to grant
an equivalent exemption if the residence-based tax is imposed only on a
corporation organized in the United States that maintains its center of
management and control or other comparable attributes in that foreign
country. If the residence-based tax is imposed on corporations organized
in the United States and engaged in the international operation of ships
or aircraft that are not managed and controlled in that foreign country,
the foreign country shall not be treated as a qualified foreign country
and shall not be considered to 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
[[Page 549]]
applies the mirror system of taxation if the U.S. Internal Revenue Code
of 1986, as amended, applies in the possession with the name of the
possession used instead of ``United States'' where appropriate.
(j) Expenses related to qualified income. If a qualified foreign
corporation derives qualified income from the international operation of
ships or aircraft as well as income that is not qualified income, and
the nonqualified income is effectively connected with the conduct of a
trade or business within the United States, the foreign corporation may
not deduct from such nonqualified income any amount otherwise allowable
as a deduction from qualified income, if that qualified income is
excluded under this section. See section 265(a)(1).
[T.D. 9087, 68 FR 51400, Aug. 26, 2003; 69 FR 7995, Feb. 20, 2004, as
amended by T.D. 9332, 72 FR 34605, June 25, 2007; 72 FR 45159, Aug. 13,
2007; T.D. 9502, 75 FR 56861, Sept. 17, 2010]
Sec. 1.883-2 Treatment of publicly-traded corporations.
(a) General rule. A foreign corporation satisfies the stock
ownership test of Sec. 1.883-1(c)(2) if it is considered a publicly-
traded corporation and satisfies the substantiation and reporting
requirements of paragraphs (e) and (f) of this section. To be considered
a publicly-traded corporation, the stock of the foreign corporation must
be primarily traded and regularly traded, as defined in paragraphs (c)
and (d) of this section, respectively, on one or more established
securities markets, as defined in paragraph (b) of this section, in
either the United States or any qualified foreign country.
(b) Established securities market--(1) General rule. For purposes of
this section, the term established securities market means, for any
taxable year--
(i) A foreign securities exchange that is officially recognized,
sanctioned, or supervised by a governmental authority of the qualified
foreign country in which the market is located, and has an annual value
of shares traded on the exchange exceeding $1 billion during each of the
three calendar years immediately preceding the beginning of the taxable
year;
(ii) A national securities exchange that is registered under section
6 of the Securities Act of 1934 (15 U.S.C. 78f);
(iii) A United States over-the-counter market, as defined in
paragraph (b)(4) of this section;
(iv) Any exchange designated under a Limitation on Benefits article
in a United States income tax convention; and
(v) Any other exchange that the Secretary may designate by
regulation or otherwise.
(2) Exchanges with multiple tiers. If an exchange in a foreign
country has more than one tier or market level on which stock may be
separately listed or traded, each such tier shall be treated as a
separate exchange.
(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
[[Page 550]]
trading requirements (or does not adequately enforce such requirements);
or
(ii) There is not clear and convincing evidence that the exchange
ensures the active trading of listed stocks.
(c) Primarily traded. For purposes of this section, stock of a
corporation is primarily traded in a country on one or more established
securities markets, as defined in paragraph (b) of this section, if,
with respect to each class of stock described in paragraph (d)(1)(i) of
this section (relating to classes of stock relied on to meet the
regularly traded test)--
(1) The number of shares in each such class that are traded during
the taxable year on all established securities markets in that country
exceeds
(2) The number of shares in each such class that are traded during
that year on established securities markets in any other single country.
(d) Regularly traded--(1) General rule. For purposes of this
section, stock of a corporation is regularly traded on one or more
established securities markets, as defined in paragraph (b) of this
section, if--
(i) One or more classes of stock of the corporation that, in the
aggregate, represent more than 50 percent of the total combined voting
power of all classes of stock of such corporation entitled to vote and
of the total value of the stock of such corporation are listed on such
market or markets during the taxable year; and
(ii) With respect to each class relied on to meet the more than 50
percent requirement of paragraph (d)(1)(i) of this section--
(A) Trades in each such class are effected, other than in de minimis
quantities, on such market or markets on at least 60 days during the
taxable year (or \1/6\ of the number of days in a short taxable year);
and
(B) The aggregate number of shares in each such class that are
traded on such market or markets during the taxable year are at least 10
percent of the average number of shares outstanding in that class during
the taxable year (or, in the case of a short taxable year, a percentage
that equals at least 10 percent of the average number of shares
outstanding in that class during the taxable year multiplied by the
number of days in the short taxable year, divided by 365).
(2) Classes of stock traded on a domestic established securities
market treated as meeting trading requirements. A class of stock that is
traded during the taxable year on an established securities market
located in the United States shall be considered to meet the trading
requirements of paragraph (d)(1)(ii) of this section if the stock is
regularly quoted by dealers making a market in the stock. A dealer makes
a market in a stock only if the dealer regularly and actively offers to,
and in fact does, purchase the stock from, and sell the stock to,
customers who are not related persons (as defined in section 954(d)(3))
with respect to the dealer in 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
[[Page 551]]
a part for more than half the number of days during the taxable year.
Any shares that are owned, after application of the attribution rules in
Sec. 1.883-4(c), by a qualified shareholder shall not also be treated
as owned by a nonqualified shareholder in the chain of ownership for
purposes of the preceding sentence. A foreign corporation must obtain
the documentation described in Sec. 1.883-4(d) from the qualified
shareholders relied upon to satisfy this exception. However, no person
otherwise treated as a qualified shareholder under Sec. 1.883-4(b) may
be treated for purposes of this paragraph (d)(3) as a qualified
shareholder if such person's interest in the foreign corporation, or in
any intermediary corporation, is held through bearer shares that are not
maintained during the relevant period in a dematerialized or immobilized
book-entry system, as described in Sec. 1.883-1(c)(3)(i)(G).
(iii) Five-percent shareholders--(A) Related persons. Solely for
purposes of determining whether a person is a 5-percent shareholder,
persons related within the meaning of section 267(b) shall be treated as
one person. In determining whether two or more corporations are members
of the same controlled group under section 267(b)(3), a person is
considered to own stock owned directly by such person, stock owned
through the application of section 1563(e)(1), and stock owned through
the application of section 267(c). In determining whether a corporation
is related to a partnership under section 267(b)(10), a person is
considered to own the partnership interest owned directly by such person
and the partnership interest owned through the application of section
267(e)(3).
(B) Investment companies. For purposes of this paragraph (d)(3), an
investment company registered under the Investment Company Act of 1940,
as amended (54 Stat. 789), shall not be treated as a 5-percent
shareholder.
(4) Anti-abuse rule. Trades between or among related persons
described in section 267(b), as modified by paragraph (d)(3)(iii) of
this section, and trades conducted in order to meet the requirements of
paragraph (d)(1) of this section shall be disregarded. A class of stock
shall not be treated as meeting the trading requirements of paragraph
(d)(1) of this section if there is a pattern of trades conducted to meet
the requirements of that paragraph. For example, trades between two
persons that occur several times during the taxable year may be treated
as an arrangement or a pattern of trades conducted to meet the trading
requirements of paragraph (d)(1)(ii) of this section.
(5) Example. The closely-held test in paragraph (d)(3) of this
section is illustrated by the following example:
Example. Closely-held exception. (i) Facts. X is a foreign
corporation organized in a qualified foreign country and engaged in the
international operation of ships. X has one 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
[[Page 552]]
percent) while A, B, and C in the aggregate own 45 percent of the
outstanding shares of X through Hold Co. D, therefore, owns sufficient
shares in the closely-held block of stock to preclude the nonqualified
shareholders in the closely-held block of stock, A, B and C, from owning
50 percent or more of the value of the class of stock (60 percent-15
percent = 45 percent) of which the closely-held block is a part.
Provided that X obtains from D the documentation described in Sec.
1.883-4(d), X's sole class of stock meets the exception in paragraph
(d)(3)(ii) of this section and will not be disqualified from the
regularly traded test by virtue of paragraph (d)(3)(i) of this section.
(e) Substantiation that a foreign corporation is publicly traded--
(1) General rule. A foreign corporation that relies on the publicly
traded test of this section to meet the stock ownership test of Sec.
1.883-1(c)(2) must substantiate that the stock of the foreign
corporation is primarily and regularly traded on one or more established
securities markets, as that term is defined in paragraph (b) of this
section. If one of the classes of stock on which the foreign corporation
relies to meet this test is closely-held within the meaning of paragraph
(d)(3)(i) of this section, the foreign corporation must obtain an
ownership statement described in Sec. 1.883-4(d) from each qualified
shareholder and intermediary that it relies upon to satisfy the
exception to the closely-held test, but only to the extent such
statement would be required if the foreign corporation were relying on
the qualified shareholder stock ownership test of Sec. 1.883-4 with
respect to those shares of stock. The foreign corporation must also
maintain and provide to the Commissioner upon request a list of its
shareholders of record and any other relevant information known to the
foreign corporation supporting its entitlement to an exemption under
this section.
(2) Availability and retention of documents for inspection. A
foreign corporation seeking qualified foreign corporation status must
retain the documentation described in paragraph (e)(1) of this section
until the expiration of the statute of limitations for its taxable year
to which the documentation relates. The foreign corporation must make
such documentation available for inspection at such time and such place
as the Commissioner requests in writing under Sec. 1.883-1(c)(3)(ii)(A)
or (B).
(f) Reporting requirements. A foreign corporation relying on this
section to satisfy the stock ownership test of Sec. 1.883-1(c)(2) must
provide the following information in addition to the information
required in Sec. 1.883-1(c)(3) to be included in its Form 1120-F,
``U.S. Income Tax Return of a Foreign Corporation,'' for the taxable
year. The information must be current as of the end of the corporation's
taxable year and must include the following--
(1) The name of the country in which the stock is primarily traded;
(2) The name of the established securities market or markets on
which the stock is listed;
(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
[[Page 553]]
block of stock and that the foreign corporation relies on to satisfy the
exception provided by paragraph (d)(3)(ii) of this section--
(A) The number of such qualified shareholders;
(B) The total percentage of the value of the shares owned, directly
or indirectly, by such qualified shareholders by country of residence,
determined under Sec. 1.883-4(b)(2) (residence of individual
shareholders) or Sec. 1.883-4(d)(3) (special rules for residence of
certain shareholders); and
(C) The number of days during the taxable year of the foreign
corporation that such qualified shareholders owned, directly or
indirectly, their shares in the closely held block of stock.
(5) Any other relevant information specified by Form 1120-F and its
accompanying instructions.
[T.D. 9087, 68 FR 51406, Aug. 26, 2003, as amended by T.D. 9332, 72 FR
34606, June 25, 2007; T.D. 9502, 75 FR 56862, Sept. 17, 2010; 75 FR
63380, Oct. 15, 2010]
Sec. 1.883-3 Treatment of controlled foreign corporations.
(a) General rule. A foreign corporation satisfies the stock
ownership test of Sec. 1.883-1(c)(2) if it satisfies the qualified U.S.
person ownership test in paragraph (b) of this section and the
substantiation and reporting requirements of paragraphs (c) and (d) of
this section, respectively. A foreign corporation that fails the
qualified U.S. person ownership test of paragraph (b) of this section
can satisfy the stock ownership test of Sec. 1.883-1(c)(2) if it meets
either the publicly-traded test of Sec. 1.883-2(a) or the qualified
shareholder stock ownership test of Sec. 1.883-4(a).
(b) Qualified U.S. person ownership test--(1) General rule. A
foreign corporation satisfies the qualified U.S. person ownership test
only if the following two conditions are satisfied concurrently during
more than half the days in its taxable year:
(i) The foreign corporation is a controlled foreign corporation
(within the meaning of section 957(a)).
(ii) One or more qualified U.S. persons own more than 50 percent of
the total value of all the outstanding stock of the foreign corporation
(within the meaning of section 958(a) and paragraph (b)(4) of this
section).
(2) Qualified U.S. person. For purposes of this section, a qualified
U.S. person is a United States citizen or resident alien, a domestic
corporation, or a domestic trust described in section 501(a), but only
if the person provides the controlled foreign corporation an ownership
statement described in paragraph (c)(2) of this section, and the
controlled foreign corporation meets the reporting requirements of
paragraph (d) of this section with respect to that person.
(3) Treatment of bearer shares. For purposes of paragraph (b)(1)(ii)
of this section, any shares of the foreign corporation or of any
intermediary corporation that are issued in bearer form, 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
[[Page 554]]
stock with a value that is greater than 50 percent of the total value of
the outstanding stock of the corporation for at least half the days of
Ship Co's taxable year. Therefore, to satisfy the stock ownership test
of Sec. 1.883-1(c)(2) and constitute a qualified foreign corporation,
Ship Co must meet the qualified shareholder stock ownership test of
Sec. 1.883-4(a).
Example 2. Ship Co is a controlled foreign corporation (within the
meaning of section 957(a)) for more than half the days of its taxable
year and is organized in a qualified foreign country. Ship Co has a
single class of stock outstanding. For Ship Co's entire taxable year, a
foreign corporation (Corp A), that is wholly owned by a resident of a
foreign country who is not a U.S. citizen, owns 40 percent of the
outstanding Ship Co stock. During that same period, a domestic
partnership owns the remaining 60 percent of the outstanding Ship Co
stock. The domestic partnership is wholly owned by 20 United States
citizens, each of whom owns a 5-percent partnership interest for Ship
Co's entire taxable year. Ship Co meets the qualified U.S. person
ownership test of paragraph (b)(1) of this section because during more
than half the days in its taxable year it was a controlled foreign
corporation within the meaning of section 957(a), and, applying the
ownership attribution rules of paragraph (b)(4) of this section,
qualified U.S. persons (the partners in the domestic partnership) owned
Ship Co stock with a value that is greater than 50 percent of the total
value of all the outstanding Ship Co shares. Therefore, Ship Co will
meet the stock ownership test of Sec. 1.883-1(c)(2) if it satisfies the
substantiation and reporting requirements of paragraphs (c) and (d) of
this section with respect to the partners in the domestic partnership.
Alternatively, if four or more partners in the domestic partnership were
not qualified U.S. persons, Ship Co would not meet the qualified U.S.
person ownership test of paragraph (b)(1) of this section because, even
though during more than half the days in its taxable year it would have
been a controlled foreign corporation within the meaning of section
957(a), qualified U.S. persons would not have owned Ship Co stock with a
value that is greater than 50 percent of the total value of all the
outstanding Ship Co shares during that period.
Example 3. Ship Co is a controlled foreign corporation (within the
meaning of section 957(a)) and is organized in a qualified foreign
country. Ship Co has two classes of stock outstanding, Class A
representing 60 percent of the vote and value and Class B representing
the remaining 40 percent of the vote and value of all the shares
outstanding of Ship Co. The Class A stock is issued in bearer form and
is maintained in a dematerialized book-entry system, as described in
Sec. 1.883-1(c)(3)(i)(G). The Class B stock is also issued in bearer
form, but is not maintained in a dematerialized or immobilized book-
entry system. For Ship Co's entire taxable year, a United States citizen
A holds all the Class A stock and nonresident alien individual B owns
all the Class B stock. Although the Class A stock is issued in bearer
form, Ship Co will satisfy the qualified U.S. person ownership test of
paragraph (b)(1) of this section because the Class A stock is maintained
in a dematerialized book-entry system on behalf of A. The Class B stock
is not owned by a qualified U.S. person but is taken into account in
determining the total value of Ship Co's outstanding stock.
Alternatively, if the Class B stock were owned by a qualified U.S.
person, the results would be similar. Class B stock would not be taken
into account in determining if the qualified U.S. person ownership test
were satisfied, but would be taken into account in determining the total
value of Ship Co's outstanding stock.
(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;
[[Page 555]]
(ii) If the qualified U.S. person directly owns shares in the
controlled foreign corporation, the number of shares of each class of
stock of the controlled foreign corporation owned by the qualified U.S.
person, whether any shares are issued in bearer form, whether any bearer
shares are maintained in a dematerialized or immobilized book-entry
system, as described in Sec. 1.883-1(c)(3)(i)(G), and the period (or
periods) in the taxable year of the controlled foreign corporation
during which the qualified U.S. person owned the shares;
(iii) If the qualified U.S. person indirectly owns shares in the
controlled foreign corporation through a foreign or domestic
intermediary described in paragraph (c)(1)(ii) of this section, the name
of each intermediary, the amount and nature of the qualified U.S.
person's interest in each intermediary, the period (or periods) in the
taxable year of the controlled foreign corporation during which the
qualified U.S. person held such interest, and, with respect to any
intermediary foreign corporation, whether any shares are issued in
bearer form and whether any such bearer shares are maintained in a
dematerialized or immobilized book-entry system, as described in Sec.
1.883-1(c)(3)(i)(G); and
(iv) Any other information specified in published guidance by the
Internal Revenue Service (see Sec. 601.601(d)(2) of this chapter).
(3) Ownership statements from intermediaries. An ownership statement
from a domestic or foreign intermediary must include:
(i) The intermediary's name, permanent address, and taxpayer
identification number, if any.
(ii) If the intermediary directly owns stock in the controlled
foreign corporation, the number of shares of each class of stock of the
controlled foreign corporation owned by the intermediary, whether such
shares are issued in bearer form and maintained in a dematerialized or
immobilized book-entry system, as described in Sec. 1.883-
1(c)(3)(i)(G), and the period (or periods) in the taxable year of the
controlled foreign corporation during which the intermediary owned the
shares.
(iii) If the intermediary indirectly owns the stock of the
controlled foreign corporation, the name and address of each
intermediary in the chain of ownership between it and the controlled
foreign corporation, the period (or periods) in the taxable year of the
controlled foreign corporation during which the intermediary owned the
shares, the percentage of its indirect ownership interest in the
controlled foreign corporation, and, if any intermediary in the chain of
ownership is a foreign corporation, whether any shares of such
intermediary are issued in bearer form and if any such bearer shares are
maintained in a dematerialized or immobilized book- entry system, as
described in Sec. 1.883-1(c)(3)(i)(G).
(iv) Any other information specified in published guidance by the
Internal Revenue Service (see Sec. 601.601(d)(2) of this chapter).
(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
[[Page 556]]
are owned (directly, and indirectly applying the rules of paragraph
(b)(4) of this section) by all qualified U.S. persons identified in
paragraph (c)(2) of this section as compared to the value of all
outstanding shares of the corporation;
(2) The period (or periods) in the taxable year during which such
qualified U.S. persons held such shares;
(3) The period (or periods) in the taxable year during which the
foreign corporation was a controlled foreign corporation;
(4) A statement as to whether the controlled foreign corporation or
any intermediary corporation had bearer shares outstanding during the
taxable year, and whether any such bearer shares taken into account for
purposes of satisfying the qualified U.S. person ownership test are
maintained in a dematerialized or immobilized book-entry system, as
described in Sec. 1.883-1(c)(3)(i)(G); and
(5) Any other information specified by Form 1120-F, and its
accompanying instructions, or in published guidance by the Internal
Revenue Service (see Sec. 601.601(d)(2) of this chapter).
[T.D. 9502, 75 FR 56863, Sept. 17, 2010]
Sec. 1.883-4 Qualified shareholder stock ownership test.
(a) General rule. A foreign corporation satisfies the stock
ownership test of Sec. 1.883-1(c)(2) if more than 50 percent of the
value of its outstanding shares is owned, or treated as owned by
applying the attribution rules of paragraph (c) of this section, for at
least half of the number of days in the foreign corporation's taxable
year by one or more qualified shareholders, as defined in paragraph (b)
of this section. A shareholder may be a qualified shareholder with
respect to one category of income while not being a qualified
shareholder with respect to another. A foreign corporation will not be
considered to satisfy the stock ownership test of Sec. 1.883-1(c)(2)
pursuant to this section unless the foreign corporation meets the
substantiation and reporting requirements of paragraphs (d) and (e) of
this section.
(b) Qualified shareholder--(1) General rule. A shareholder is a
qualified shareholder only if the shareholder--
(i) With respect to the category of income for which the foreign
corporation is seeking an exemption, is--
(A) An individual who is a resident, as described in paragraph
(b)(2) of this section, of a qualified foreign country;
(B) The government of a qualified foreign country (or a political
subdivision or local authority of such country);
(C) A foreign corporation that is organized in a qualified foreign
country and meets the publicly traded test of Sec. 1.883-2(a);
(D) A not-for-profit organization described in paragraph (b)(4) of
this section that is not a pension fund as defined in paragraph (b)(5)
of this section and that is organized in a qualified foreign country;
(E) An individual beneficiary of a pension fund (as defined in
paragraph (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
[[Page 557]]
such country (e.g., an individual who is liable to tax on a remittance
basis in a foreign country will not be treated as a resident of that
country unless all residents of that country are taxed on a remittance
basis only) and, in addition--
(A) The individual has a tax home, within the meaning of paragraph
(b)(2)(ii) of this section, in that qualified foreign country for 183
days or more of the taxable year; or
(B) The individual is treated as a resident of a qualified foreign
country based on special rules pursuant to paragraph (d)(3) of this
section.
(ii) Tax home. For purposes of this section, an individual's tax
home is considered to be located at the individual's regular or
principal (if more than one regular) place of business. If the
individual has no regular or principal place of business because of the
nature of his business (or lack of a business), then the individual's
tax home is located at his regular place of abode in a real and
substantial sense. If an individual has no regular or principal place of
business and no regular place of abode in a real and substantial sense
in a qualified foreign country for 183 days or more of the taxable year,
that individual does not have a tax home for purposes of this section. A
foreign estate or trust, as defined in section 7701(a)(31), does not
have a tax home for purposes of this section. See paragraph (c)(3) of
this section for alternative rules in the case of trusts or estates.
(3) Certain income tax convention restrictions applied to
shareholders. For purposes of paragraph (b)(1) of this section, a
shareholder described in paragraph (b)(1) of this section may be
considered a resident of, or organized in, a qualified foreign country
if that foreign country provides an exemption by means of an income tax
convention with the United States, but only if the shareholder
demonstrates that it is treated as a resident of that country under the
convention and qualifies for benefits under any Limitation on Benefits
article, and that the convention provides an exemption for the relevant
category of income. If the convention has a requirement in the shipping
and air transport article other than residence, such as place of
registration or documentation of the ship or aircraft, the shareholder
is not required to demonstrate that the corporation seeking qualified
foreign corporation status could satisfy any such additional
requirement.
(4) Not-for-profit organizations. The term not-for-profit
organization means an organization that meets the following
requirements--
(i) It is a corporation, association taxable as a corporation,
trust, fund, foundation, league or other entity operated exclusively for
religious, charitable, educational, or recreational purposes, and not
organized for profit;
(ii) It is generally exempt from tax in its country of organization
by virtue of its not-for-profit status; and
(iii) Either--
(A) More than 50 percent of its annual support is expended on behalf
of 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
[[Page 558]]
Sec. 1.892-2T(c)(1) (relating to pension funds established for the
benefit of employees or former employees of a foreign government).
(iii) Nongovernment pension funds. A nongovernment pension fund is a
pension fund that--
(A) Is administered in a foreign country and is subject to
supervision or regulation by a governmental authority (or other
authority delegated to perform such supervision or regulation by a
governmental authority) in such country;
(B) Is generally exempt from income taxation in its country of
administration;
(C) Has 100 or more beneficiaries; and
(D) The trustees, directors or other administrators of which pension
fund provide the documentation required in paragraph (d) of this
section.
(iv) Beneficiary of a pension fund. The term beneficiary of a
pension fund shall mean any person who has made contributions to a
pension fund, as that term is defined in paragraph (b)(5)(i) of this
section, or on whose behalf contributions have been made, and who is
currently receiving retirement, disability, or death benefits from the
pension fund or can reasonably be expected to receive such benefits in
the future, whether or not the person's right to receive benefits from
the fund has vested. See paragraph (c)(7) of this section for rules
regarding the computation of stock ownership through nongovernment
pension funds.
(c) Rules for determining constructive ownership (1) General rules
for attribution. For purposes of applying paragraph (a) of this section
and the exception to the closely-held test in Sec. 1.883-1(d)(3)(ii),
stock owned by or for a corporation, partnership, trust, estate, or
mutual insurance company or similar entity shall be treated as owned
proportionately by its shareholders, partners, beneficiaries, grantors,
or other interest holders, as provided in paragraphs (c)(2) through (7)
of this section. The proportionate interest rules of this paragraph (c)
shall apply successively upward through the chain of ownership, and a
person's proportionate interest shall be computed for the relevant days
or period taken into account in determining whether a foreign
corporation satisfies the requirements of paragraph (a) of this section.
Stock treated as owned by a person by reason of this paragraph (c) shall
be treated as actually owned by such person for purposes of this
section. An owner of an interest in an association taxable as a
corporation shall be treated as a shareholder of such association for
purposes of this paragraph (c). Stock issued in bearer form will not be
treated as owned proportionately by its shareholders unless the shares
are maintained in a dematerialized or immobilized book-entry system, as
described in Sec. 1.883-1(c)(3)(i)(G).
(2) Partnerships--(i) General rule. A partner shall be treated as
having an interest in stock of a foreign corporation owned by a
partnership in proportion to the least of--
(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
[[Page 559]]
asset is the stock of Corporation Z, a Country X corporation seeking a
reciprocal exemption under this section. A's distributive share of P's
income and gain on the disposition of P's assets is 80 percent, but A's
distributive share of P's assets (or the proceeds therefrom) on P's
liquidation is 20 percent. B's distributive share of P's income and gain
is 20 percent and B is entitled to 80 percent of the assets (or proceeds
therefrom) on P's liquidation. Under the attribution rules of paragraph
(c)(2)(ii) of this section, A and B will be treated as a single partner
owning in the aggregate 100 percent of the stock of Z owned by P.
Example 2. Stock held by both qualified and nonqualified
shareholders through a partnership. Assume the same facts as in Example
1 except that C, an individual who is not a resident of a qualified
foreign country, is also a partner in P and that C's distributive share
of P's income is 60 percent. The distributive shares of A and B are the
same as in Example 1, except that A's distributive share of income is 20
percent. Under the attribution rules of paragraph (c)(2)(ii) of this
section, qualified shareholders A and B will be treated as a single
partner owning in the aggregate 40 percent of the stock of Z owned by P
(i.e., the lowest aggregate percentage of A and B's distributive shares
of dividend income (40 percent), gain (100 percent), and liquidation
rights (100 percent) with respect to the Z stock). Thus, only 40 percent
of the Z stock is treated as owned by qualified shareholders.
Example 3. Stock held through tiered partnerships. Country X grants
an equivalent exemption. A and B are individual residents of Country X
and are qualified shareholders within the meaning of paragraph (b)(1) of
this section. A and B are the sole partners of Partnership P. P is a
partner in Partnership P1, which owns the stock of Corporation Z, a
Country X corporation seeking a reciprocal exemption under this section.
Assume that P's distributive share of the dividend income, gain and
liquidation rights with respect to the Z stock held by P1 is 40 percent.
Assume that of the remaining partners of P1 only D is a qualified
shareholder. D's distributive share of P1's dividend income and gain is
15 percent; D's distributive share of P1's assets on liquidation is 25
percent. Under the attribution rules of paragraph (c)(2)(ii) of this
section, A and B, treated as a single partner, will own 40 percent of
the Z stock owned by P1 (100 percent x 40 percent) and D will be treated
as owning 15 percent of the Z stock owned by P1 (the least of D's
dividend income (15 percent), gain (15 percent), and liquidation rights
(25 percent) with respect to the Z stock). Thus, 55 percent of the Z
stock owned by P1 is treated as owned by qualified shareholders.
(3) Trusts and estates--(i) Beneficiaries. In general, an individual
shall be treated as having an interest in stock of a foreign corporation
owned by a trust or estate in proportion to the individual's actuarial
interest in the trust or estate, as provided in section 318(a)(2)(B)(i),
except that an income beneficiary's actuarial interest in the trust will
be determined as if the trust's only asset were the stock. The interest
of a remainder beneficiary in stock will be equal to 100 percent minus
the sum of the percentages of any interest in the stock held by income
beneficiaries. The ownership of an interest in stock owned by a trust
shall not be attributed to any beneficiary whose interest cannot be
determined under the preceding sentence, and any such interest, to the
extent 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
[[Page 560]]
the value of all stock of such corporation. If, however, there is an
agreement, express or implied, that a shareholder of a corporation will
not receive distributions from the earnings of stock owned by the
corporation, the shareholder will not be treated as owning that stock
owned by the corporation.
(5) Taxable nonstock corporations. A taxable nonstock corporation
that is entitled in its country of organization to deduct from its
taxable income amounts distributed for charitable purposes may deem a
recipient of such charitable distributions to be a shareholder of such
taxable nonstock corporation in the same proportion as the amount that
such beneficiary receives in the taxable year bears to the total income
of such taxable nonstock corporation in the taxable year. Whether each
such recipient is a qualified shareholder may then be determined under
paragraph (b) of this section or under the special rules of paragraph
(d)(3)(vii) of this section.
(6) Mutual insurance companies and similar entities. Stock held by a
mutual insurance company, mutual savings bank, or similar entity
(including an association taxable as a corporation that does not issue
stock interests) shall be considered owned proportionately by the
policyholders, depositors, or other owners in the same proportion that
such persons share in the surplus of such entity upon liquidation or
dissolution.
(7) Computation of beneficial interests in nongovernment pension
funds. Stock held by a pension fund shall be considered owned by the
beneficiaries of the fund equally on a pro-rata basis if--
(i) The pension fund meets the requirements of paragraph (b)(5)(iii)
of this section;
(ii) The trustees, directors or other administrators of the pension
fund have no knowledge, and no reason to know, that a pro-rata
allocation of interests of the fund to all beneficiaries would differ
significantly from an actuarial allocation of interests in the fund (or,
if the beneficiaries' actuarial interest in the stock held directly or
indirectly by the pension fund differs from the beneficiaries' actuarial
interest in the pension fund, the actuarial interests computed by
reference to the beneficiaries' actuarial interest in the stock);
(iii) Either--
(A) Any overfunding of the pension fund would be payable, pursuant
to the governing instrument or the laws of the foreign country in which
the pension fund is administered, only to, or for the benefit of, one or
more corporations that are organized in the country in which the pension
fund is administered, individual beneficiaries of the pension fund or
their designated beneficiaries, or social or charitable causes (the
reduction of the obligation of the sponsoring company or companies to
make future contributions to the pension fund by reason of overfunding
shall not itself result in such overfunding being deemed to be payable
to 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
[[Page 561]]
the facts necessary to satisfy the Commissioner that such shares are
maintained in a dematerialized book-entry system, as described in Sec.
1.883-1(c)(3)(i)(G), for the benefit of the relevant shareholder.
(2) Application of general rule--(i) Ownership statements. Except as
provided in paragraph (d)(3) of this section, a person shall only be
treated as a qualified shareholder of a foreign corporation if--
(A) For the relevant period, the person completes an ownership
statement described in paragraph (d)(4) of this section or has a valid
ownership statement in effect under paragraph (d)(2)(ii) of this
section;
(B) In the case of a person owning stock in the foreign corporation
indirectly through one or more intermediaries (including mere legal
owners or recordholders acting as nominees), each intermediary in the
chain of ownership between that person and the foreign corporation
seeking qualified foreign corporation status completes an intermediary
ownership statement described in paragraph (d)(4)(v) of this section or
has a valid intermediary ownership statement in effect under paragraph
(d)(2)(ii) of this section; and
(C) The foreign corporation seeking qualified foreign corporation
status obtains the statements described in paragraphs (d)(2)(i)(A) and
(B) of this section.
(ii) Three-year period of validity. The ownership statements
required in paragraph (d)(2)(i) of this section shall remain valid until
the earlier of the last day of the third calendar year following the
year in which the ownership statement is signed, or the day that a
change of circumstance occurs that makes any information on the
ownership statement incorrect. For example, an ownership statement
signed on September 30, 2000, remains valid through December 31, 2003,
unless a change of circumstance occurs that makes any information on the
ownership statement incorrect.
(3) Special rules--(i) Substantiating residence of certain
shareholders. A foreign corporation seeking qualified foreign
corporation status or an intermediary that is a direct or indirect
shareholder of such foreign corporation may substantiate the residence
of certain shareholders, for purposes of paragraph (b)(2)(i)(B) of this
section, under one of the following special rules in paragraphs
(d)(3)(ii) through (viii) of this section, in lieu of obtaining the
ownership statements required in paragraph (d)(2)(i) of this section
from such shareholders.
(ii) Special rule for registered shareholders owning less than one
percent of widely-held corporations. A foreign corporation with at least
250 registered shareholders, that is not a publicly-traded corporation,
as described in Sec. 1.883-2 (a widely-held corporation), is not
required to obtain an ownership statement from an individual shareholder
owning less than one percent of the widely-held corporation at all times
during the taxable year if the requirements of paragraphs (d)(3)(ii)(A)
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
[[Page 562]]
section, may be treated as a resident of the country of the
beneficiary's address as it appears on the records of the fund, provided
it is not a nonresidential address, such as a post office box or an
address in care of a financial intermediary, and provided none of the
trustees, directors or other administrators of the pension fund know, or
have reason to know, that the beneficiary is not an individual resident
of such foreign country. The rules of this paragraph (d)(3)(iii)(B)
shall apply only if the nongovernment pension fund satisfies the
documentation requirements of paragraphs (d)(4)(v)(A) and (C)(2) of this
section.
(iv) Special rule for stock owned by publicly-traded corporations.
Any stock in a foreign corporation seeking qualified foreign corporation
status that is owned by a publicly-traded corporation will be treated as
owned by an individual resident in the country where the publicly-traded
corporation is organized if the foreign corporation receives the
statement described in paragraph (d)(4)(iii) of this section from the
publicly-traded corporation and copies of any relevant ownership
statements from shareholders of the publicly-traded corporation relied
on to satisfy the exception to the closely-held test of Sec. 1.883-
2(d)(3)(ii), as required in paragraph (d)(2)(i) of this section.
(v) Special rule for not-for-profit organizations. For purposes of
meeting the ownership requirements of paragraph (a) of this section, a
not-for-profit organization may rely on the addresses of record of its
individual beneficiaries and supporters to determine the residence of an
individual beneficiary or supporter, within the meaning of paragraph
(b)(2)(i)(B) of this section, to the extent required under paragraph
(b)(4) of this section, provided that--
(A) The addresses of record are not nonresidential addresses such as
a post office box or in care of a financial intermediary;
(B) The officers, directors or administrators of the organization do
not know or have reason to know that the individual beneficiaries or
supporters do not reside at that address; and
(C) The foreign corporation seeking qualified foreign corporation
status receives the statement required in paragraph (d)(4)(iv) of this
section from the not-for-profit organization.
(vi) Special rule for a foreign airline covered by an air services
agreement. A foreign airline that is covered by a bilateral Air Services
Agreement in force between the United States and the qualified foreign
country in which the airline is organized may rely exclusively on the
Air Services Agreement currently in effect and will not have to
otherwise substantiate its ownership under this section, provided that
the United States has not waived the ownership requirements in the
agreement or that the ownership requirements have not otherwise been
made ineffective. Such an airline will be treated as owned by qualified
shareholders resident in the country where the foreign airline is
organized.
(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
[[Page 563]]
stock is traded on an established securities market in the United States
may rely on current Schedule 13D and Schedule 13G filings with the
Securities and Exchange Commission to identify its 5-percent
shareholders in each class of stock relied upon to meet the regularly
traded test, without having to make any independent investigation to
determine the identity of the 5-percent shareholder. However, if any
class of stock is determined to be closely-held within the meaning of
Sec. 1.883-2(d)(3)(i), the publicly traded corporation cannot satisfy
the requirements of Sec. 1.883-2(e) unless it obtains sufficient
documentation described in this paragraph (d) to demonstrate that the
requirements of Sec. 1.883-2(d)(3)(ii) are met with respect to the 5-
percent shareholders.
(4) Ownership statements from shareholders--(i) Ownership statements
from individuals. An ownership statement from an individual is a written
statement signed by the individual under penalties of perjury stating--
(A) The individual's name, permanent address, and country where the
individual is fully liable to tax as a resident, if any;
(B) If the individual was not a resident of the country for the
entire taxable year of the foreign corporation seeking qualified foreign
corporation status, each of the foreign countries in which the
individual resided and the dates of such residence during the taxable
year of such foreign corporation;
(C) If the individual directly owns shares of stock in the
corporation seeking qualified foreign corporation status, the name of
the corporation, the number of shares in each class of stock of the
corporation owned by the individual, whether any such shares are issued
in bearer form and maintained in a dematerialized or immobilized book-
entry system, as described in Sec. 1.883-1(c)(3)(i)(G), and the period
(or periods) in the taxable year of the foreign corporation during which
the individual owned the shares;
(D) If the individual directly owns an interest in a corporation,
partnership, trust, estate, or other intermediary that directly or
indirectly owns stock in the corporation seeking qualified foreign
corporation status, the name of the intermediary, the number and class
of shares or the amount and nature of the interest that the individual
holds in such intermediary, and, if the intermediary is a corporation,
whether any such shares are issued in bearer form and maintained in a
dematerialized or immobilized book-entry system, as described in Sec.
1.883-1(c)(3)(i)(G), and the period (or periods) in the taxable year of
the foreign corporation seeking qualified foreign corporation status
during which the individual held such interest;
(E) To the extent known by the individual, a description of the
chain of ownership through which the individual owns stock in the
corporation seeking qualified foreign corporation status, including the
name and address of each intermediary standing between 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
[[Page 564]]
such government, or a bank or other financial institution licensed to do
business in such foreign country and having assets at least equivalent
to 50 million U.S. dollars and who is authorized to represent the
government or governmental authority; and
(B) That provides--
(1) The title of the official or other person signing the statement;
(2) The name and address of the government authority, agency or
office that has supervisory authority and, if applicable, the income tax
preparer which has prepared such ownership statement;
(3) The information described in paragraphs (d)(4)(i)(C) through (E)
of this section (as if the language applied ``government'' instead of
``individual'') with respect to the government's direct or indirect
ownership of stock in the corporation seeking qualified resident status;
(4) In the case of an ownership statement prepared by an income tax
return preparer, a statement under penalties of perjury identifying the
documentation relied upon in the conduct of due diligence for the
taxable year to determine the aggregate government investment in the
stock of the shipping or aircraft company in preparation of such
ownership statement attached to a valid power of attorney to represent
the taxpayer for the taxable year; and
(5) Any other information as specified in guidance published by the
Internal Revenue Service (see Sec. 601.601(d)(2) of this chapter).
(iii) Ownership statements from publicly-traded corporate
shareholders. An ownership statement from a publicly-traded corporation
that is a direct or indirect owner of the corporation seeking qualified
foreign corporation status is a written statement, signed under
penalties of perjury by a person that would be authorized to sign a tax
return on behalf of the shareholder corporation containing the following
information--
(A) The name of the country in which the stock is primarily traded;
(B) The name of the established securities market or markets on
which the stock is listed;
(C) A description of each class of stock relied upon to meet the
requirements of Sec. 1.883-2(d)(1), including the number of shares
issued and outstanding as of the close of the taxable year;
(D) For each class of stock relied upon to meet the requirements of
Sec. 1.883-2(d)(1), if one or more 5-percent shareholders, as defined
in Sec. 1.883-2(d)(3)(i), own in the aggregate 50 percent or more of
the vote and value of the outstanding shares of that class of stock for
more than half the number of days during the taxable year--
(1) The days during the taxable year of the corporation in which the
stock was closely-held without regard to the exception in paragraph
(d)(3)(ii) of this section and the percentage of the vote and value of
the class of stock that is owned by 5-percent shareholders during such
days;
(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
[[Page 565]]
a person authorized to sign a tax return on behalf of the organization
under penalties of perjury stating--
(A) The name, permanent address, and principal location of the
activities of the organization (if different from its permanent
address);
(B) The information described in paragraphs (d)(4)(i)(C) through (E)
of this section (as if the language applied ``not-for-profit
organization'' instead of ``individual'');
(C) A representation that the not-for-profit organization satisfies
the requirements of paragraph (b)(4) of this section; and
(D) Any other information as specified in guidance published by the
Internal Revenue Service (see Sec. 601.601(d)(2) of this chapter).
(v) Ownership statements from intermediaries--(A) General rule. The
foreign corporation seeking qualified foreign corporation status under
the shareholder stock ownership test must obtain an intermediary
ownership statement from each intermediary standing in the chain of
ownership between it and the qualified shareholders on whom it relies to
meet this test. An intermediary ownership statement is a written
statement signed under penalties of perjury by the intermediary (if the
intermediary is an individual) or a person who would be authorized to
sign a tax return on behalf of the intermediary (if the intermediary is
not an individual) containing the following information--
(1) The name, address, country of residence, and principal place of
business (in the case of a corporation or partnership) of the
intermediary, and, if the intermediary is a trust or estate, the name
and permanent address of all trustees or executors (or equivalent under
foreign law), or if the intermediary is a pension fund, the name and
permanent address of place of administration of the intermediary;
(2) The information described in paragraphs (d)(4)(i)(C) through (E)
of this section (as if the language applied ``intermediary'' instead of
``individual'');
(3) If the intermediary is a nominee for a shareholder or another
intermediary, the name and permanent address of the shareholder, or the
name and principal place of business of such other intermediary;
(4) If the intermediary is not a nominee for a shareholder or
another intermediary, the name and country of residence (within the
meaning of paragraph (b)(2) of this section) and the proportionate
interest in the intermediary of each direct shareholder, partner,
beneficiary, grantor, or other interest holder (or if the direct holder
is a nominee, of its beneficial shareholder, partner, beneficiary,
grantor, or other interest holder), on which the foreign corporation
seeking qualified foreign corporation status intends to rely to satisfy
the requirements of paragraph (a) of this section. In addition, such
intermediary must obtain from all such persons an ownership statement
that includes the period of time during the taxable year for which 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
[[Page 566]]
(8) Any other information as specified in guidance published by the
Internal Revenue Service (see Sec. 601.601(d)(2) of this chapter).
(B) Ownership statements from widely-held intermediaries with
registered shareholders owning less than one percent of such widely-held
intermediary. An ownership statement from an intermediary that is a
corporation with at least 250 registered shareholders, but that is not a
publicly-traded corporation within the meaning of Sec. 1.883-2, and
that relies on paragraph (d)(3)(ii) of this section, relating to the
special rule for registered shareholders owning less than one percent of
widely-held corporations, must provide the following information in
addition to the information required in paragraph (d)(4)(v)(A) of this
section--
(1) The aggregate proportionate interest by country of residence in
the widely-held corporation of such registered shareholders or other
interest holders whose address of record is a specific street address
and not a nonresidential address, such as a post office box or in care
of a financial intermediary or stock transfer agent; and
(2) A representation that the officers and directors of the widely-
held intermediary neither know nor have reason to know that the
individual shareholder does not reside at his or her address of record
in the corporate records; and
(3) Any other information as specified in guidance published by the
Internal Revenue Service (see Sec. 601.601(d)(2) of this chapter).
(C) Ownership statements from pension funds--(1) Ownership
statements from government pension funds. A government pension fund (as
defined in paragraph (b)(5)(ii) of this section) that relies on
paragraph (d)(3)(iii) of this section (relating to the special rules for
pension funds) generally must provide the documentation required in
paragraph (d)(4)(v)(A) of this section, and, in addition, the government
pension fund must also provide the following information--
(i) The name of the country in which the plan is administered;
(ii) A representation that the fund is established exclusively for
the benefit of employees or former employees of a foreign government, or
employees or former employees of a foreign government and
nongovernmental employees or former employees that perform or performed
governmental or social services;
(iii) A representation that the funds that comprise the trust are
managed by trustees who are employees of, or persons appointed by, the
foreign government;
(iv) A representation that the trust forming part of the pension
plan provides for retirement, disability, or death benefits in
consideration for prior services rendered;
(v) A representation that the income of the trust satisfies the
obligations of the foreign government to the participants under the
plan, rather than inuring to the benefit of a private person; and
(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;
[[Page 567]]
(v) The aggregate percentage interest of beneficiaries by country of
residence based on addresses shown on the books and records of the fund,
provided the addresses are not nonresidential addresses, such as a post
office box or an address in care of a financial intermediary, and
provided none of the trustees, directors or other administrators of the
pension fund know, or have reason to know, that the beneficiary is not a
resident of such foreign country;
(vi) A representation that the pension fund meets the requirements
of paragraph (b)(5)(iii) of this section;
(vii) A representation that the trustees, directors or other
administrators of the pension fund have no knowledge, and no reason to
know, that a pro-rata allocation of interests of the fund to all
beneficiaries would differ significantly from an actuarial allocation of
interests in the fund (or, if the beneficiaries' actuarial interest in
the stock held directly or indirectly by the pension fund differs from
the beneficiaries' actuarial interest in the pension fund, the actuarial
interests computed by reference to the beneficiaries' actuarial interest
in the stock);
(viii) A representation that any overfunding of the pension fund
would be payable, pursuant to the governing instrument or the laws of
the foreign country in which the pension fund is administered, only to,
or for the benefit of, one or more corporations that are organized in
the country in which the pension fund is administered, individual
beneficiaries of the pension fund or their designated beneficiaries, or
social or charitable causes (the reduction of the obligation of the
sponsoring company or companies to make future contributions to the
pension fund by reason of overfunding shall not itself result in such
overfunding being deemed to be payable to or for the benefit of such
company or companies); or that the foreign country in which the pension
fund is administered has laws that are designed to prevent overfunding
of a pension fund and the funding of the pension fund is within the
guidelines of such laws; or that the pension fund is maintained to
provide benefits to employees in a particular industry, profession, or
group of industries or professions, and that employees of at least 10
companies (other than companies that are owned or controlled, directly
or indirectly, by the same interests) contribute to the pension fund or
receive benefits from the pension fund; and
(ix) Any other information as specified in guidance published by the
Internal Revenue Service (see Sec. 601.601(d)(2) of this chapter).
(3) Time for making determinations. The determinations required to
be made under this paragraph (d)(4)(v)(C) shall be made using
information shown on the records of the pension fund for a date during
the foreign corporation's taxable year to which the determination is
relevant.
(D) Ownership statements from taxable nonstock corporations. An
ownership statement from an intermediary that is a taxable nonstock
corporation must provide the following information in 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
[[Page 568]]
this section must be retained by the corporation seeking qualified
foreign corporation status (the foreign corporation) until the
expiration of the statute of limitations for the taxable year of the
foreign corporation to which the documentation relates. Such
documentation must be made available for inspection by the Commissioner
at such time and place as the Commissioner may request in writing.
(e) Reporting requirements. A foreign corporation relying on the
qualified shareholder stock ownership test of this section to meet the
stock ownership test of Sec. 1.883-1(c)(2) must provide the following
information in addition to the information required in Sec. 1.883-
1(c)(3) to be included in its Form 1120-F, ``U.S. Income Tax Return of a
Foreign Corporation,'' for each taxable year. The information should be
current as of the end of the corporation's taxable year. The information
must include the following--
(1) A representation that more than 50 percent of the value of the
outstanding shares of the corporation is owned (or treated as owned by
reason of paragraph (c) of this section) by qualified shareholders for
each category of income for which the exemption is claimed;
(2) With respect to all qualified shareholders relied upon to
satisfy the 50 percent ownership test of paragraph (a) of this section,
the total number of such qualified shareholders as defined in paragraph
(b)(1) of this section; the total percentage of the value of the
outstanding shares owned, applying the attribution rules of paragraph
(c) of this section, by such qualified shareholders by country of
residence or organization, whichever is applicable; and the period
during the taxable year of the foreign corporation that such stock was
held by qualified shareholders; and
(3) Any other relevant information specified by the Form 1120-F,
``U.S. Income Tax Return of a Foreign Corporation,'' and its
accompanying instructions, or in published guidance by the Internal
Revenue Service (see Sec. 601.601(d)(2) of this chapter).
[T.D. 9087, 68 FR 51406, Aug. 26, 2003; 69 FR 7995, Feb. 20, 2004, as
amended by T.D. 9332, 72 FR 34608, June 25, 2007; T.D. 9502, 75 FR
56865, Sept. 17, 2010]
Sec. 1.883-5 Effective/applicability dates.
(a) General rule. Sections 1.883-1 through 1.883-4 apply to taxable
years of a foreign corporation seeking qualified foreign corporation
status beginning after September 24, 2004.
(b) Election for retroactive application. Taxpayers may elect to
apply Sec. Sec. 1.883-1 through 1.883-4 for any open taxable year of
the foreign corporation beginning after December 31, 1986, except that
the substantiation and reporting requirements of Sec. 1.883-1(c)(3)
(relating to the substantiation and reporting required to be treated as
a qualified foreign corporation) or Sec. Sec. 1.883-2(f), 1.883-3(d)
and 1.883-4(e) (relating to additional information to be included in the
return to demonstrate whether the foreign corporation satisfies the
stock ownership test) will not apply to any 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
[[Page 569]]
a foreign corporation beginning on or after September 17, 2010.
[T.D. 9218, 70 FR 45530, Aug. 8, 2005, as amended by T.D. 9332, 72 FR
34609, June 25, 2007; T.D. 9502, 75 FR 56865, Sept. 17, 2010; 75 FR
63380, Oct. 15, 2010]
Sec. 1.884-0 Overview of regulation provisions for section 884.
(a) Introduction. Section 884 consists of three main parts: a branch
profits tax on certain earnings of a foreign corporation's U.S. trade or
business; a branch-level interest tax on interest paid, or deemed paid,
by a foreign corporation's U.S. trade or business; and an anti-treaty
shopping rule. A foreign corporation is subject to section 884 by virtue
of owning an interest in a partnership, trust, or estate that is engaged
in a U.S. trade or business or has income treated as effectively
connected with the conduct of a trade or business in the United States.
An international organization (as defined in section 7701(a)(18)) is not
subject to the branch profits tax by reason of section 884(e)(5). A
foreign government treated as a corporate resident of its country of
residence under section 892(a)(3) shall be treated as a corporation for
purposes of section 884. The preceding sentence shall be effective for
taxable years ending on or after September 11, 1992, except that, for
the first taxable year ending on or after that date, the branch profits
tax shall not apply to effectively connected earnings and profits of the
foreign government earned prior to that date nor to decreases in the
U.S. net equity of a foreign government occurring after the close of the
preceding taxable year and before that date. Similarly, Sec. 1.884-4
shall apply, in the case of branch interest, only with respect to
amounts of interest accrued and paid by a foreign government on or after
that date, or, in the case of excess interest, only with respect to
amounts attributable to interest accrued by a foreign government on or
after that date and apportioned to ECI, as defined in Sec. 1.884-
1(d)(1)(iii). Except as otherwise provided, for purposes of the
regulations under section 884, the term ``U.S. trade or business''
includes all the U.S. trades or businesses of a foreign corporation.
(1) The branch profits tax. Section 1.884-1 provides rules for
computing the branch profits tax and defines various terms that affect
the computation of the tax. In general, section 884(a) imposes a 30-
percent branch profits tax on the after-tax earnings of a foreign
corporation's U.S. trade or business that are not reinvested in a U.S.
trade or business by the close of the taxable year, or are disinvested
in a later taxable year. Changes in the value of the equity of the
foreign corporation's U.S. trade or business are used as the measure of
whether earnings have been reinvested in, or disinvested form, a U.S.
trade or business. An increase in the equity during the taxable year is
generally treated as a reinvestment of the earnings for the current
taxable year; a decrease in the equity during the taxable year is
generally treated as a disinvestment of prior years' earnings that have
not previously been subject to the branch profits tax. The amount
subject to the branch profits tax for the taxable year is the dividend
equivalent amount. Section 1.884-2T contains special rules relating to
the effect on 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
[[Page 570]]
exemption or rate reduction with respect to the branch profits tax, the
branch-level interest tax, and the tax on dividends paid by the foreign
corporation.
(b) Special rules for U.S. possessions. (1) Section 884 does not
apply to a corporation created or organized in, or under the law of,
American Samoa, Guam, the Northern Mariana Islands, or the U.S. Virgin
Islands, provided that the conditions of Sec. 1.881-5(c)(1) through
(c)(3) are satisfied with respect to such corporation. The preceding
sentence applies for taxable years ending after April 9, 2008.
(2) Section 884 does not apply for purposes of determining tax
liability incurred to a section 935 possession or the U.S. Virgin
Islands by a corporation created or organized in, or under the law of,
such possession or the United States. The preceding sentence applies for
taxable years ending after April 9, 2008.
(c) Outline of major topics in Sec. Sec. 1.884-1 through 1.884-5.
Sec. 1.884-1 Branch profits tax.
(a) General rule.
(b) Dividend equivalent amount.
(1) Definition.
(2) Adjustment for increase in U.S. net equity.
(3) Adjustment for decrease in U.S. net equity.
(4) Examples.
(c) U.S. net equity.
(1) Definition.
(2) Definition of amount of a U.S. asset.
(3) Definition of determination date.
(d) U.S. assets.
(1) Definition of a U.S. asset.
(2) Special rules for certain assets.
(3) Interest in a partnership.
(4) Interest in a trust or estate.
(5) Property that is not a U.S. asset.
(6) E&P basis of a U.S. asset.
(e) U.S. liabilities.
(1) Liabilities based on Sec. 1.882-5.
(2) Insurance reserves.
(3) Election to reduce liabilities.
(4) Artificial decrease in U.S. liabilities.
(5) Examples.
(f) Effectively connected earnings and profits.
(1) In general.
(2) Income that does not produce ECEP.
(3) Allocation of deductions attributable to income that does not
produce ECEP.
(4) Examples.
(g) Corporations resident in countries with which the United States
has an income tax treaty.
(1) General rule.
(2) Special rules for foreign corporations that are qualified
residents on the basis of their ownership.
(3) Exemptions for foreign corporations resident in certain
countries with income tax treaties in effect on January 1, 1987.
(4) Modifications with respect to other income tax treaties.
(5) Benefits under treaties other than income tax treaties.
(h) Stapled entities.
(i) Effective date.
(1) General rule.
(2) Election to reduce liabilities.
(3) Separate election for installment obligations.
(4) Special rule for certain U.S. assets and liabilities.
(j) Transition rules.
(1) General rule.
(2) Installment obligations.
Sec. 1.884-2T Special rules for termination or incorporation of a U.S.
trade or business or liquidation or reorganization of a foreign
corporation or its domestic subsidiary (temporary).
(a) Complete termination of a U.S. trade or business.
(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.
[[Page 571]]
(5) Determination of U.S. net equity of a transferee that is a
foreign corporation.
(6) Special rules in the case of the disposition of stock or
securities in a domestic transferee or in the transferor.
(d) Incorporation under section 351.
(1) In general.
(2) Inapplicability of paragraph (a)(1) of this section to section
351 transactions.
(3) Transferor's dividend equivalent amount for the taxable year in
which a section 351 transaction occurs.
(4) Election to increase earnings and profits.
(5) Dispositions of stock or securities of the transferee by the
transferor.
(6) Example.
(e) Certain transactions with respect to a domestic subsidiary.
(f) Effective date.
Sec. 1.884-3T Coordination of branch profits tax with second-tier
withholding (temporary). [Reserved]
Sec. 1.884-4 Branch-level interest tax.
(a) General rule.
(1) Tax on branch interest.
(2) Tax on excess interest.
(3) Original issue discount.
(4) Examples.
(b) Branch interest.
(1) Definition of branch interest.
(2) [Reserved]
(3) Requirements relating to specifically identified liabilities.
(4) [Reserved]
(5) Increase in branch interest where U.S. assets constitute 80
percent or more of a foreign corporation's assets.
(6) Special rule where branch interest exceeds interest apportioned
to ECI of a foreign corporation.
(7) Effect of election under paragraph (c)(1) of this section to
treat interest as if paid in year of accrual.
(8) Effect of treaties.
(c) Rules relating to excess interest.
(1) Election to compute excess interest by treating branch interest
that is paid and accrued in different years as if paid in year of
accrual.
(2) Interest paid by a partnership.
(3) Effect of treaties.
(4) Examples.
(d) Stapled entities.
(e) Effective dates.
(1) General rule.
(2) Special rule.
(f) Transition rules.
(1) Election under paragraph (c)(1) of this section.
(2) Waiver of notification requirement for non-banks under Notice
89-80.
(3) Waiver of legending requirement for certain debt issued prior to
January 3, 1989.
Sec. 1.884-5 Qualified resident.
(a) Definition of qualified resident.
(b) Stock ownership requirement.
(1) General rule.
(2) Rules for determining constructive ownership.
(3) Required documentation.
(4) Ownership statements from qualifying shareholders.
(5) Certificate of residency.
(6) Intermediary ownership statement.
(7) Intermediary verification statement.
(8) Special rules for pension funds.
(9) Availability of documents for inspection.
(10) Examples.
(c) Base erosion.
(d) Publicly-traded corporations.
(1) General rule.
(2) Established securities market.
(3) Primary traded.
(4) Regularly traded.
(5) Burden of proof for publicly-traded corporations.
(e) Active trade or business.
(1) General rule.
(2) Active conduct of a trade or business.
(3) Substantial presence test.
(4) Integral part of an active trade or business in the foreign
corporation's country of residence.
(f) Qualified resident ruling.
(1) Basis for ruling.
(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
[[Page 572]]
this section for the application of the branch profits tax to
corporations that are residents of countries with which the United
States has an income tax treaty, and Sec. 1.884-2T for the effect on
the branch profits tax of the termination or incorporation of a U.S.
trade or business, or the liquidation or reorganization of a foreign
corporation or its domestic subsidiary.
(b) Dividend equivalent amount--(1) Definition. The term ``dividend
equivalent amount'' means a foreign corporation's effectively connected
earnings and profits (``ECEP'', as defined in paragraph (f)(1) of this
section) for the taxable year, adjusted pursuant to paragraph (b)(2) or
(3) of this section, as applicable. The dividend equivalent amount
cannot be less than zero.
(2) Adjustment for increase in U.S. net equity. If a foreign
corporation's U.S. net equity (as defined in paragraph (c) of this
section) as of the close of the taxable year exceeds the foreign
corporation's U.S. net equity as of the close of the preceding taxable
year, then, for purposes of computing the foreign corporation's dividend
equivalent amount for the taxable year, the foreign corporation's ECEP
for the taxable year shall be reduced (but not below zero) by the amount
of such excess.
(3) Adjustment for decrease in U.S. net equity--(i) In general.
Except as provided in paragraph (b)(3)(ii) of this section, if a foreign
corporation's U.S. net equity as of the close of the taxable year is
less than the foreign corporation's U.S. net equity as of the close of
the preceding taxable year, then, for purposes of computing the foreign
corporation's dividend equivalent amount for the taxable year, the
foreign corporation's ECEP for the taxable year shall be increased by
the amount of such difference.
(ii) Limitation based on accumulated ECEP. The increase of a foreign
corporation's ECEP under paragraph (b)(3)(i) of this section shall not
exceed the accumulated ECEP of the foreign corporation as of the
beginning of the taxable year. The term ``accumulated ECEP'' means the
aggregate amount of ECEP of a foreign corporation for preceding taxable
years beginning after December 31, 1986, minus the aggregate dividend
equivalent amounts for such preceding taxable years. Accumulated ECEP
may be less than zero.
(4) Examples. The principles of paragraph (b)(2) and (3) of this
section are illustrated by the following examples.
Example 1. Reinvestment of all ECEP. Foreign corporation A, a
calendar year taxpayer, had $1,000 U.S. net equity as of the close of
1986 and $100 of ECEP for 1987. A acquires $100 of additional U.S.
assets during 1987 and its U.S. net equity as of the close of 1987 is
$1,100. In computing A's dividend equivalent amount for 1987, A's ECEP
of $100 is reduced under paragraph (b)(2) of this section by the $100
increase in U.S. net equity between the close of 1986 and the close of
1987. A has no dividend equivalent amount for 1987.
Example 2. Partial reinvestment of ECEP. Assume the same facts as in
Example 1 except that A acquires $40 (rather than $100) of U.S. assets
during 1987 and its U.S. net equity as of the close of 1987 is $1,040.
In computing A's dividend equivalent amount for 1987, A's ECEP of $100
is reduced under paragraph (b)(2) of this section by the $40 increase in
U.S. net equity between the close of 1986 and the close of 1987. A has a
dividend equivalent amount of $60 for 1987.
Example 3. Disinvestment of prior year's ECEP. Assume the same facts
as in Example 1 for 1987. A has no ECEP for 1988. A's U.S. 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).
[[Page 573]]
Example 5. Effect of deficits in ECEP. Foreign corporation A, a
calendar year taxpayer, has $150 of accumulated ECEP as of the beginning
of 1991 ($200 aggregate ECEP less $50 aggregate dividend equivalent
amounts for years preceding 1991). A has U.S. net equity of $450 as of
the close of 1990, U.S. net equity of $350 as of the close of 1991
(i.e., a $100 decrease in U.S. net equity) and a $90 deficit in ECEP for
1991. A's dividend equivalent amount is $10 for 1991, i.e., A's deficit
of $90 in ECEP for 1991 increased by $100, the decrease in A's U.S. net
equity during 1991. A portion of the reduction in U.S. net equity in
1991 ($90) is attributable to A's deficit in ECEP for that year. The
reduction in U.S. net equity in 1991 ($100) triggers a dividend
equivalent amount only to the extent it exceeds the $90 current year
deficit in ECEP for 1991. As of the beginning of 1992, A has $50 of
accumulated ECEP (i.e., $110 aggregate ECEP less $60 aggregate dividend
equivalent amounts for years preceding 1992).
Example 6. Nimble dividend equivalent amount. Foreign corporation A,
a calendar year taxpayer, had a deficit in ECEP of $100 for 1987 and
$100 for 1988, and has $90 of ECEP for 1989. A had $2,000 U.S. net
equity as of the close of 1988 and has $2,000 U.S. net equity as of the
close of 1989. A has a dividend equivalent amount of $90 for 1989, its
ECEP for the year, even though it has a net deficit of $110 in ECEP for
the period 1987-1989.
(c) U.S. net equity--(1) Definition. The term ``U.S. net equity''
means the aggregate amount of the U.S. assets (as defined in paragraphs
(c)(2) and (d)(1) of this section) of a foreign corporation as of the
determination date (as defined in paragraph (c)(3) of this section),
reduced (including below zero) by the U.S. liabilities (as defined in
paragraph (e) of this section) of the foreign corporation as of the
determination date.
(2) Definition of the amount of a U.S. asset--(i) In general. For
purposes of this section, the term ``amount of a U.S. asset'' means the
U.S. asset's adjusted basis for purposes of computing earnings and
profits (``E&P basis'') multiplied by the proportion of the asset that
is treated as a U.S. asset under paragraphs (d) (1) through (4) of this
section. The amount of a U.S. asset that is money shall be its face
value. See paragraph (d)(6) of this section for rules concerning the
computation of the E&P basis of a U.S. asset.
(ii) Bad debt reserves. A bank described in section 585(a)(2)(B)
(without regard to the second sentence thereof) that uses the reserve
method of accounting for bad debts for U.S. federal income tax purposes
shall decrease the amount of loans that qualify as U.S. assets by any
reserve that is permitted under section 585.
(3) Definition of determination date. For purposes of this section,
the term ``determination date'' means the close of the day on which the
amount of U.S. net equity is required to be determined. Unless otherwise
provided, the U.S. net equity of a foreign corporation is required to be
determined as of the close of the foreign corporation's taxable year.
(d) U.S. assets--(1) Definition of a U.S. asset--(i) General rule.
Except as provided in paragraph (d)(5) of this section, the term ``U.S.
asset'' means an asset of a foreign corporation (other than an interest
in a partnership, trust, or estate) that is held by the corporation as
of the determination date if--
(A) All income produced by the asset on the determination date is
ECI (as defined in paragraph (d)(1)(iii) of this section) (or would be
ECI if the asset produced income on that date); and
(B) All gain from the disposition of the asset would be ECI if the
asset were disposed of on that date and the disposition produced gain.
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
[[Page 574]]
(within the meaning of section 865(e)(2)).
(ii) Special rules for assets not described in paragraph (d)(1)(i)
of this section. An asset of a foreign corporation that is held by the
corporation as of the determination date and is not described in
paragraph (d)(1)(i) of this section shall be treated as a U.S. asset to
the extent provided in paragraph (d)(2) of this section (relating to
special rules for certain assets, including assets that produce income
or gain at least a portion of which is ECI), and in paragraphs (d) (3)
and (4) of this section (relating to special rules for interests in a
partnership, trust, and estate).
(iii) Definition of ECI. For purposes of the regulations under
section 884, the term ``ECI'' means income that is effectively connected
with the conduct of a trade or business in the United States and income
that is treated as effectively connected with the conduct of a trade or
business in the United States under any provision of the Code. The term
``ECI'' also includes all income that is or is treated as effectively
connected with the conduct of a U.S. trade or business whether or not
the income is included in gross income (for example, interest income
earned with respect to tax-exempt bonds).
(2) Special rules for certain assets--(i) Depreciable and
amortizable property. An item of depreciable personal property or an
item of amortizable intangible property shall be treated as a U.S. asset
of a foreign corporation in the same proportion that the amount of the
depreciation or amortization with respect to the item of property that
is allowable as a deduction, or is includible in cost of goods sold, for
the taxable year in computing the effectively connected taxable income
of the foreign corporation bears to the total amount of depreciation or
amortization computed for the taxable year with respect to the item of
property.
(ii) Inventory. An item or pool of inventory property (as defined in
section 865(i)(1)) shall be treated as a U.S. asset in the same
proportion as the amount of gross receipts from the sale or exchange of
such property for the three preceding taxable years (or for such part of
the three-year period as the corporation has been in existence) that is
effectively connected with the conduct of a U.S. trade or business bears
to the total amount of gross receipts from the sale or exchange of such
property during such period (or part thereof). If a foreign corporation
has not sold or exchanged such property during such three-year period
(or part thereof), then the property shall be treated as a U.S. asset in
the same proportion that the anticipated amount of gross receipts from
the sale or exchange of the property that is reasonably anticipated to
be ECI bears to the anticipated total amount of gross receipts from the
sale or exchange of the property.
(iii) Installment obligations. An installment obligation received in
connection with an installment sale (as defined in section 453(b)) for
which an election under section 453(d) has not been made shall be
treated as a U.S. asset to the extent that it is received in connection
with the sale of a U.S. asset. If an obligation is received in
connection with the sale of an asset that is wholly a U.S. asset, it
shall be treated as a U.S. asset in its entirety. If a single obligation
is received in connection with the sale of an asset that is in part a
U.S. asset under the rules of paragraphs (d) (2) through (4) of this
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
[[Page 575]]
foreign corporation may elect to treat interest income or original issue
discount as ECI by reporting such interest income or original issue
discount as ECI on its income tax return or an amended return for the
taxable year. See paragraph (d)(6)(ii) of this section to determine the
E&P basis of an installment obligation for purposes of this paragraph
(d)(2)(iii).
(iv) Receivables--(A) Receivables arising from the sale or exchange
of inventory property. An account or note receivable (whether or not
bearing stated interest) with a maturity not exceeding six months that
arises from the sale or exchange of inventory property (as defined in
section 865(i)(1)) shall be treated as a U.S. asset in the proportion
determined under paragraph (d)(2)(iii) of this section as if the
receivable were an installment obligation.
(B) Receivables arising from the performance of services or leasing
of property. An account or note receivable (whether or not bearing
stated interest) with a maturity not exceeding six months that arises
from the performance of services or the leasing of property in the
ordinary course of a foreign corporation's trade or business shall be
treated as a U.S. asset in the same proportion that the amount of gross
income represented by the receivable that is ECI bears to the total
amount of gross income represented by the receivable. For purposes of
this paragraph (d)(2)(iv)(B), the amount of income represented by a
receivable shall not include interest income or original issue discount.
(v) Bank and other deposits. A deposit or credit balance with a
person described in section 871(i)(3) or a Federal Reserve Bank that is
interest-bearing shall be treated as a U.S. asset if all income derived
by the foreign corporation with respect to the deposit or credit balance
during the taxable year is ECI. Any other deposit or credit balance
shall only be treated as a U.S. asset if the deposit or credit balance
is needed in a U.S. trade or business within the meaning of Sec. 1.864-
4(c)(2)(iii)(a).
(vi) Debt instruments. A debt instrument, as defined in section
1275(a)(1) (other than an asset treated as a U.S. asset under any other
subdivision of this paragraph (d)) shall be treated as a U.S. asset,
notwithstanding the fact that gain from the sale or exchange of the
obligation on the determination date would not be ECI, if--
(A) All income derived by the foreign corporation from such
obligation during the taxable year is ECI; and
(B) The yield for the period that the instrument was held during the
taxable year equals or exceeds the Applicable Federal Rate for
instruments of similar type and maturity.
Shares in a regulated investment company that purchases solely
instruments that, under this paragraph (d)(2)(vi), would be U.S. assets
if held directly by the foreign corporation shall also be treated as a
U.S. asset.
(vii) Securities held by a foreign corporation engaged in a banking,
financing or similar business. Securities described in Sec. 1.864-
4(c)(5)(ii)(b)(3) held by a foreign corporation engaged in the active
conduct of a banking, financing, or similar business in the United
States during the taxable year shall be treated as U.S. assets in the
same proportion that income, gain, or loss from such securities is ECI
for the taxable year under Sec. 1.864-4(c)(5)(ii).
(viii) Federal income taxes. An overpayment of Federal income taxes
shall be treated as a U.S. asset to the extent 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
[[Page 576]]
the Commissioner for a ruling to determine its U.S. assets for the
taxable year of the involuntary conversion.
(xi) Examples. The principles of paragraphs (c) and (d) (1) and (2)
of this section are illustrated by the following examples.
Example 1. Depreciable property. Foreign corporation A, a calendar
year taxpayer, is engaged in a trade or business in the United States. A
owns equipment that is used in its manufacturing business in country X
and in the United States. Under Sec. 1.861-8, A's depreciation
deduction with respect to the equipment is allocated to sales income and
is apportioned 70 percent to ECI and 30 percent to income that is not
ECI. Under paragraph (d)(2)(ii) of this section, the equipment is 70
percent a U.S. asset. The equipment has an E&P basis of $100 at the
beginning of 1993. A's depreciation deduction (for purposes of computing
earnings and profits) with respect to the equipment is $10 for 1993. To
determine the amount of A's U.S. asset at the close of 1993, the
equipment's $90 E&P basis at the close of 1993 is multiplied by 70
percent (the proportion of the asset that is a U.S. asset). The amount
of the U.S. asset as of the close of 1993 is $63.
Example 2. U.S. real property interest connected to a U.S. business.
FC is a foreign corporation that is a bank, within the meaning of
section 585(a)(2)(B) (without regard to the second sentence thereof),
and is engaged in the business of taking deposits and making loans
through its branch in the United States. In 1996, FC makes a loan in the
ordinary course of its lending business in the United States, securing
the loan with a mortgage on the U.S. real property being financed by the
borrower. In 1997, after the borrower has defaulted on the loan, FC
takes title to the real property that secures the loan. On December 31,
1997, FC continues to hold the property, classifying it on its financial
statement as Other Real Estate Owned. Because all income and gain from
the property would be ECI to FC under the principles of section
864(c)(2), the U.S. real property constitutes a U.S. asset within the
meaning of paragraph (d) of this section.
Example 3. U.S. real property interest not connected to a U.S.
business. Foreign corporation A owns a condominium apartment in the
United States. Assume that holding the apartment does not constitute a
U.S. trade or business and the foreign corporation has not made an
election under section 882(d) to treat income with respect to the
property as ECI. The condominium apartment is not a U.S. asset of A
because the income, if any, from the asset would not be ECI. However,
the disposition by A of the condominium apartment at a gain will give
rise to ECEP.
Example 4. Stock in a domestically-controlled REIT. As an
investment, foreign corporation A owns stock in a domestically-
controlled REIT, within the meaning of section 897(h)(4)(B). Under
section 897(h)(2), gain on disposition of stock in the REIT is not
treated as ECI. For this reason the stock does not qualify as a U.S.
asset under paragraph (d)(1) of this section even if dividend
distributions from the REIT are treated as ECI. Thus, A will have a
dividend equivalent amount based on the ECEP attributable to a
distribution of ECI from the REIT, even if A invests the proceeds from
the dividend in additional stock of the REIT. (Stock in a REIT that is
not a domestically-controlled REIT is also not a U.S. asset. See Sec.
1.884-1(d)(5)).
Example 5. Section 864(c)(7) property. Foreign corporation A is
engaged in the equipment leasing business in the United States and
Canada. A transfers the equipment leased by its U.S. trade or business
to its Canadian business after the equipment is fully depreciated in the
United States. The Canadian business sells the equipment two years
later. Section 864(c)(7) would treat the gain on the disposition of the
equipment by A as taxable under section 882 as if the sale occurred
immediately before the equipment was transferred to the Canadian
business. The equipment would not be treated as a U.S. asset even if the
gain was ECI because the income from the equipment in the year of the
sale in Canada would not be ECI.
(3) Interest in a partnership--(i) In general. A foreign corporation
that is a partner in a partnership must take 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
[[Page 577]]
as its proportionate share of all items of income, gain, loss, and
deduction that may be generated by the asset.
(B) Non-uniform proportionate shares. If a partner's proportionate
share of all items of income, gain, loss, and deduction that may be
generated by a single asset of the partnership throughout the period
that includes the taxable year of the partner is not uniform, then, for
purposes of determining the partner's proportionate share of the
adjusted basis of that asset, a partner must take into account the
portion of the adjusted basis of the asset that reflects the partner's
economic interest in that asset. A partner's economic interest in an
asset of the partnership must be determined by applying the following
presumptions. These presumptions may, however, be rebutted if the
partner or the Internal Revenue Service shows that the presumption is
inconsistent with the partner's true economic interest in the asset
during the corporation's taxable year.
(1) If a partnership asset ordinarily generates directly
identifiable income, a partner's economic interest in the asset is
determined by reference to its proportionate share of income that may be
generated by the asset for the partnership's taxable year ending with or
within the partner's taxable year.
(2) If a partnership asset ordinarily generates current deductions
and ordinarily generates no directly identifiable income, for example
because the asset contributes equally to the generation of all the
income of the partnership (such as an asset used in general and
administrative functions), a partner's economic interest in the asset is
determined by reference to its proportionate share of the total
deductions that may be generated by the asset for the partnership's
taxable year ending with or within the partner's taxable year.
(3) For other partnership assets not described in paragraph
(d)(3)(ii)(B) (1) or (2) of this section, a partner's economic interest
in the asset is determined by reference to its proportionate share of
the total gain or loss to which it would be entitled if the asset were
sold at a gain or loss in the partnership's taxable year ending with or
within the partner's taxable year.
(C) Partnership election under section 754. If a partnership files
an election in accordance with section 754, then for purposes of this
paragraph (d)(3)(ii), the basis of partnership property shall reflect
adjustments made pursuant to sections 734 (relating to distributions of
property to a partner) and 743 (relating to the transfer of an interest
in a partnership). However, adjustments made pursuant to section 743 may
be made with respect to a transferee partner only.
(iii) Income method. Under the income method, a partner's interest
in a partnership shall be treated as a U.S. asset in the same proportion
that its distributive share of partnership ECI for the partnership's
taxable year that ends with or within the partner's taxable year bears
to its distributive share of all partnership income for that taxable
year.
(iv) Manner of election--(A) In general. In determining the
proportion of a foreign corporation's interest in a partnership that is
a U.S. asset, a foreign corporation must elect one of the methods
described in paragraph (d)(3) of this section on a timely filed return
for the first taxable year beginning on 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
[[Page 578]]
the asset method with respect to an interest in a partnership, and that
partnership is a partner in a lower-tier partnership, the foreign
corporation may apply either the asset method or the income method to
determine the proportion of the upper-tier partnership's interest in the
lower-tier partnership that is a U.S. asset.
(v) Failure to make proper election. If a foreign corporation, for
any reason, fails to make an election to use one of the methods required
by paragraph (d)(3) of this section in a timely fashion, the director of
field operations or the Assistant Commissioner (International) may make
the election on behalf of the foreign corporation and such election
shall be binding as if made by that corporation.
(vi) Special rule for determining a partner's adjusted basis in a
partnership interest. For purposes of paragraphs (d)(3) and (6) of this
section, a partner's adjusted basis in a partnership interest shall be
the partner's basis in such interest (determined under section 705)
reduced by the partner's share of the liabilities of the partnership
determined under section 752 and increased by a proportionate share of
each liability of the partnership equal to the partner's proportionate
share of the expense, for income tax purposes, attributable to such
liability for the taxable year. A partner's adjusted basis in a
partnership interest cannot be less than zero.
(vii) E&P basis of a partnership interest. See paragraph (d)(6)(iii)
of this section for special rules governing the calculation of a foreign
corporation's E&P basis in a partnership interest.
(viii) The application of this paragraph (d)(3) is illustrated by
the following examples:
Example 1. General rule. (i) Facts. Foreign corporation, FC, is a
partner in partnership ABC, which is engaged in a trade or business
within the United States. FC and ABC are both calendar year taxpayers.
ABC owns and manages two office buildings located in the United States,
each with an adjusted basis of $50. ABC also owns a non-U.S. asset with
an adjusted basis of $100. ABC has no liabilities. Under the partnership
agreement, FC has a 50 percent interest in the capital of ABC and a 50
percent interest in all items of income, gain, loss, and deduction that
may be generated by the partnership's assets. FC's adjusted basis in ABC
is $100. In determining the proportion of its interest in ABC that is a
U.S. asset, FC elects to use the asset method described in paragraph
(d)(3)(ii) of this section.
(ii) Analysis. FC's interest in ABC is treated as a U.S. asset in
the same proportion that the sum of FC's proportionate share of the
adjusted bases of all ABC's U.S. assets (50% of $100), bears to the sum
of FC's proportionate share of the adjusted bases of all of ABC's assets
(50% of $200). Under the asset method, the amount of FC's interest in
ABC that is a U.S. asset is $50 ($100 x $50/$100).
Example 2. Special allocation of gain with respect to real property.
(i) Facts. The facts are the same as in Example 1, except that under the
partnership agreement, FC is allocated 20 percent of the income from the
partnership property but 80 percent of the gain on disposition of the
partnership property.
(ii) Analysis. Assuming that the buildings ordinarily generate
directly identifiable income, there is a rebuttable presumption under
paragraph (d)(3)(ii)(B)(1) of this section that FC's proportionate share
of the adjusted basis of the buildings is FC's proportionate share of
the income generated by the buildings (20%) rather than the total gain
that it would be entitled to under the partnership agreement (80%) if
the buildings were sold at a gain on the determination date. Thus, the
sum of FC's proportionate share of the adjusted bases in ABC's U.S.
assets (the buildings) is presumed to be $20 [(20% of $50) + (20% of
$50)]. Assuming that the non-U.S. asset is not income-producing and does
not generate current deductions, 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
[[Page 579]]
(d)(3)(ii) of this section, it must determine what proportion of ABC's
partnership interest in DEF is a U.S. asset. As permitted by paragraph
(d)(3)(iv)(B) of this section, FC also elects to use the asset method
with respect to ABC's interest in DEF. ABC's interest in DEF is treated
as a U.S. asset in the same proportion that the sum of ABC's
proportionate share of the adjusted bases of all DEF's U.S. assets (50%
of $200), bears to the sum of ABC's proportionate share of the adjusted
bases of all of DEF's assets (50% of $300). Thus, the amount of ABC's
interest in DEF that is a U.S. asset is $100 ($150 x $100/$150). FC must
then apply the rules of paragraph (d)(3)(ii) of this section to all the
assets of ABC, including ABC's interest in DEF that is treated in part
as a U.S. asset ($100) and in part as a non-U.S. asset ($50). FC's
interest in ABC is treated as a U.S. asset in the same proportion that
the sum of FC's proportionate share of the adjusted bases of the U.S.
assets of ABC (including ABC's interest in DEF), bears to the sum of
FC's proportionate share of the adjusted bases of all ABC's assets
(including ABC's interest in DEF). Thus, the amount of FC's interest in
ABC that is a U.S. asset is $100 (FC's adjusted basis in ABC ($175)
multiplied by FC's proportionate share of the sum of the adjusted bases
of ABC's U.S. assets ($100)) over FC's proportionate share of the sum of
the adjusted bases of ABC's assets ($175)).
Example 4. Tiered partnerships (income method). (i) Facts. The facts
are the same as in Example 3, except that FC has elected to use the
income method described in paragraph (d)(3)(iii) of this section to
determine the proportion of its interest in ABC that is a U.S. asset.
The two office buildings located in the United States generate $60 of
income that is ECI for the taxable year. The non-U.S. asset is not-
income producing. In addition ABC's distributive share of income from
DEF consists of $40 of income that is ECI and $140 of income that is not
ECI.
(ii) Analysis. Because FC has elected to use the income method it
does need to determine what proportion of ABC's partnership interest in
DEF is a U.S. asset. FC's interest in ABC is treated as a U.S. asset in
the same proportion that its distributive share of ABC's income for the
taxable year that is ECI ($50) ($30 earned directly by ABC + $20
distributive share from DEF) bears to its distributive share of all
ABC's income for the taxable year ($55) ($30 earned directly by ABC +
$25 distributive share from DEF). Thus, FC's interest in ABC that is a
U.S. asset is $159 ($175 x $50/$55).
(4) Interest in a trust or estate--(i) Estates and non-grantor
trusts. A foreign corporation that is a beneficiary of a trust or estate
shall not be treated as having a U.S. asset by virtue of its interest in
the trust or estate.
(ii) Grantor trusts. If, under sections 671 through 678, a foreign
corporation is treated as owning a portion of a trust that includes all
the income and gain that may be generated by a trust asset (or pro rata
portion of a trust asset), the foreign corporation will be treated as
owning the trust asset (or pro rata portion thereof) for purposes of
determining its U.S. assets under this section.
(5) Property that is not a U.S. asset--(i) Property that does not
give rise to ECEP. Property described in paragraphs (d) (1) through (4)
of this section shall not be treated as a U.S. asset of a foreign
corporation if, on the determination date, income from the use of the
property, or gain or loss from the disposition of the property, would be
described in paragraph (f)(2) of this section (relating to certain
income that does not produce ECEP).
(ii) Assets acquired to increase U.S. net equity artificially. U.S.
assets shall not include assets acquired or used by a foreign
corporation if one of the principal purposes of such acquisition or use
is to increase artificially the U.S. assets of a foreign corporation on
the determination date. Whether assets are acquired or used for such
purpose will 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
[[Page 580]]
for purposes of this section is its adjusted basis for purposes of
computing the foreign corporation's earnings and profits. In determining
the E&P basis of a U.S. asset, the adjusted basis of the asset (for
purposes of computing taxable income) must be increased or decreased to
take into account inclusions of income or gain, and deductions or
similar charges, that affect the basis of the asset where such items are
taken into account in a different manner for purposes of computing
earnings and profits than for purposes of computing taxable income. For
example, if section 312 (k) requires that depreciation with respect to a
U.S. asset be determined using the straight line method for purposes of
computing earnings and profits, but depreciation with respect to the
asset is determined using a different method for purposes of computing
taxable income, the E&P basis of the property for purposes of this
section must be computed using the straight line method of depreciation.
(ii) Installment obligations--(A) Sales in taxable year beginning on
or after January 1, 1987. For purposes of this section, the E&P basis of
an installment obligation described in paragraph (d)(2)(iii) of this
section that arises in connection with an installment sale occurring in
a taxable year beginning on or after January 1, 1987, shall equal the
sum of the total amount of gain from the sale if the obligation were
satisfied in full and the adjusted basis of the property sold as of the
date of sale, reduced by payments received with respect to the
obligation that are not interest or original issue discount. See
paragraph (j)(2)(ii) of this section, however, for a special E&P basis
rule for an installment obligation arising in connection with a sale of
a U.S. asset by a foreign corporation described in section 312(k)(4),
where such sale occurs in a taxable year beginning in 1987.
(B) Sales in taxable year prior to January 1, 1987. For purposes of
this section, the E&P basis of an installment obligation described in
paragraph (d)(2)(iii) of this section that arises in connection with an
installment sale occurring in a taxable year beginning before January 1,
1987, shall equal zero.
(iii) Computation of E&P basis in a partnership. For purposes of
this section, a foreign corporation's E&P basis in a partnership
interest shall be the foreign corporation's adjusted basis in such
interest (as determined under paragraph (d)(3)(vi) of this section),
further adjusted to take into account any differences between the
foreign corporation's distributive share of items of partnership income,
gain, loss, and deduction for purposes of computing the taxable income
of the foreign corporation and the foreign corporation's distributive
share of items of partnership income, gain, loss, and deductions for
purposes of computing the earnings and profits of the foreign
corporation.
(iv) Computation of E&P basis of a loss property. The E&P basis of a
loss property (as defined in paragraph (d)(2)(ix) of this section) shall
equal the E&P basis, immediately before the loss, of the U.S. asset with
respect to which the loss was sustained, reduced (but not below zero)
by--
(A) The amount of any deduction claimed under section 165 by the
foreign corporation with respect to the loss for earnings and profits
purposes; and
(B) Any compensation received with respect to the loss.
(v) Computation of E&P basis of financial instruments. [Reserved]
(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
[[Page 581]]
section decreased by the amount of liabilities determined under
paragraph (e)(3) of this section, and increased by the amount of
liabilities determined under paragraph (e)(2) of this section.
(1) Liabilities based on Sec. 1.882-5. The amount of liabilities
determined under this paragraph (e)(1) is the amount of U.S.-connected
liabilities of a foreign corporation under Sec. 1.882-5 if the U.S.-
connected liabilities were computed using the assets and liabilities of
the foreign corporation as of the determination date (rather than the
average of such assets and liabilities for the taxable year) and without
regard to paragraph (e)(3) of this section.
(2) Additional liabilities--(i) Insurance reserves. The amount of
liabilities determined under this paragraph (e)(2)(i) is the amount (as
of the determination date) of the total insurance liabilities on United
States business (within the meaning of section 842(b)(2)(B)) of a
foreign corporation described in section 842(a) (relating to foreign
corporations carrying on an insurance business in the United States) to
the extent that such liabilities are not otherwise treated as U.S.
liabilities by reason of paragraph (e)(1) of this section.
(ii) Liabilities described in Sec. 1.882-5(a)(1)(ii). The amount of
liabilities determined under this paragraph (e)(2)(ii) is the amount (as
of the determination date) of liabilities described in Sec. 1.882-
5(a)(1)(ii) (relating to liabilities giving rise to interest expense
that is directly allocated to income from a U.S. asset).
(3) Election to reduce liabilities--(i) General rule. The amount of
liabilities determined under this paragraph (e)(3) is the amount by
which a foreign corporation elects to reduce its liabilities under
paragraph (e)(1) of this section.
(ii) Limitation. For any taxable year, a foreign corporation may
elect to reduce the amount of its liabilities determined under paragraph
(e)(1) of this section by an amount that does not exceed the lesser of
the amount of U.S. liabilities as of the determination date, or the
amount of U.S. liability reduction needed to reduce a dividend
equivalent amount as of the determination date to zero.
(iii) Effect of election on interest deduction and branch-level
interest tax. A foreign corporation that elects to reduce its
liabilities under this paragraph (e)(3) must, for purposes of computing
the amount of its interest apportioned to ECI under Sec. 1.882-5,
reduce its U.S.-connected liabilities for the taxable year of the
election by the amount of the reduction in liabilities under this
paragraph (e)(3). The reduction of its U.S.-connected liabilities will
also require a corresponding decrease in the amount of its interest
apportioned to ECI under Sec. 1.882-5 for purposes of Sec. 1.884-4(a)
and for all other Code sections for which the amount of interest
apportioned under Sec. 1.882-5 is relevant.
(iv) Method of election. A foreign corporation that elects the
benefits of this paragraph (e)(3) for a taxable year shall attach a
statement to its return for the taxable year that it has elected to
reduce its liabilities for the taxable year under this paragraph (e)(3)
and that it has reduced the amount of its U.S.-connected liabilities as
provided in paragraph (e)(3)(iii) of this section and shall indicate the
amount of such reductions on such attachment. The cumulative amount of
all U.S. liability reductions is shown on Schedule I (Form 1120-F) in
addition to the separate elections attached to the timely filed return.
An election under this paragraph (e)(3) 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
[[Page 582]]
for which an election was made, it would not be required to include an
amount as a dividend equivalent amount under this paragraph (e)(3)(v)
because any accumulated ECEP that it may have is not attributable to an
election to reduce liabilities.
(4) Artificial decrease in U.S. liabilities. If a foreign
corporation repays or otherwise decreases its U.S. liabilities and one
of the principal purposes of such decrease is to decrease artificially
its U.S. liabilities on the determination date, then such decrease shall
not be taken into account for purposes of computing the foreign
corporation's U.S. net equity. Whether the U.S. liabilities of a foreign
corporation are artificially decreased will depend on all the facts and
circumstances of each case. Factors to be considered in determining
whether one of the principal purposes for the repayment or decrease of
the liabilities is to decrease artificially the U.S. liabilities of a
foreign corporation shall include whether the aggregate liabilities are
temporarily decreased on or before the determination date by, for
example, the repayment of liabilities, or U.S. liabilities are
temporarily decreased on or before the determination date by the
acquisition with contributed funds of passive-type assets that are not
U.S. assets. For purposes of this paragraph (e)(4), to be one of the
principal purposes, a purpose must be important, but it is not necessary
that it be the primary purpose.
(5) Examples. The application of this paragraph (e) is illustrated
by the following examples.
Example 1. General rule for computation of U.S. liabilities. As of
the close of 1997, foreign corporation A, a calendar year taxpayer
computes its U.S.-connected liabilities under Sec. 1.882-5(c) using its
actual ratio of liabilities to assets. For purposes of computing its
U.S.- connected liabilities under Sec. 1.882-5(c), A must determine the
average total value of its assets that are U.S. assets. Assume that the
average value of such assets is $100, while the amount of such assets as
of the close of 1997 is $125. For purposes of Sec. 1.882-5(c)(2), A
must determine the ratio of the average of its worldwide liabilities for
the year to the average total value of worldwide assets for the taxable
year. Assume that A's average liabilities-to-assets ratio under Sec.
1.882-5(c)(2) is 55 percent, while its liabilities-to-assets ratio at
the close of 1997 is only 50 percent. Thus, assuming no further
adjustments under paragraph (e)(3) of this section, A's U.S.-connected
liabilities for purposes of Sec. 1.882-5 are $55 ($100 x 55%). However,
A's U.S. liabilities are $62.50 for purposes of this section, the value
of its assets determined under Sec. 1.882-5(b)(2) as of the close of
December ($125) multiplied by the liabilities-to-assets ratio of (50%)
as of such date.
Example 2. Election made to reduce liabilities. (i) As of the close
of 2007, foreign corporation A, a real estate company, owns U.S. assets
with an E&P basis of $1000. A has $800 of liabilities under paragraph
(e)(1) of this section. A has accumulated ECEP of $500 and in 2008, A
has $60 of ECEP that it intends to retain for future expansion of its
U.S. trade or business. A elects under paragraph (e)(3) of this section
to reduce its liabilities by $60 from $800 to $740. As a result of the
election, assuming A's U.S. assets and U.S. liabilities would otherwise
have remained constant, A's U.S. net equity as of the close of 2007 will
increase by the amount of the decrease in liabilities ($60) from $200 to
$260 and its ECEP will be reduced to zero. Under paragraph (e)(3)(iii)
of this section, A's interest expense for the taxable year is reduced by
the amount of interest attributable to $60 of liabilities and A's excess
interest is reduced by the same amount. A's taxable income and ECEP are
increased by the amount of the reduction in interest expense
attributable to the liabilities, and A may make an election under
paragraph (e)(3) of this section to further reduce its liabilities, thus
increasing its 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
[[Page 583]]
net equity of the trade or business within the United States.
(iii) If A terminates its U.S. trade or business in 2009 in
accordance with the rules in Sec. 1.884-2T(a), A would not be subject
to the branch profits tax on the $60 of ECEP earned in that year. Under
paragraph (e)(3)(v) of this section, however, it would be subject to the
branch profits tax on the portion of the $60 of ECEP that it earned in
2008 that became accumulated ECEP because of an election to reduce
liabilities.
(f) Effectively connected earnings and profits--(1) In general.
Except as provided in paragraph (f)(2) of this section and as modified
by Sec. 1.884-2T (relating to the incorporation or complete termination
of a U.S. trade or business or the reorganization or liquidation of a
foreign corporation or its domestic subsidiary), the term ``effectively
connected earnings and profits'' (``ECEP'') means the earnings and
profits (or deficits therein) determined under section 312 and this
paragraph (f) that are attributable to ECI (within the meaning of
paragraph (d)(1)(iii) of this section). Because the term ``ECI''
includes income treated as effectively connected, income that is ECI
under section 842(b) (relating to minimum net investment income of an
insurance business) or 864(c)(7) (relating to gain from property
formerly held for use in a U.S. trade or business) gives rise to ECEP.
ECEP also includes earnings and profits attributable to ECI of a foreign
corporation earned through a partnership, and through a trust or estate.
For purposes of section 884, gain on the sale of a U.S. real property
interest by a foreign corporation that has made an election to be
treated as a domestic corporation under section 897(i) will also give
rise to ECEP. ECEP is not reduced by distributions made by the foreign
corporation during any taxable year or by the amount of branch profits
tax or tax on excess interest (as defined in Sec. 1.884-4(a)(2)) paid
by the foreign corporation. Earnings and profits are treated as
attributable to ECI even if the earnings and profits are taken into
account under section 312 in an earlier or later taxable year than the
taxable year in which the ECI is taken into account.
(2) Income that does not produce ECEP. The term ``ECEP'' does not
include any earnings and profits attributable to--
(i) Income excluded from gross income under section 883(a)(1) or
883(a)(2) (relating to certain income derived from the operation of
ships or aircraft);
(ii) Income that is ECI by reason of section 921(d) or 926(b)
(relating to certain income of a FSC and certain dividends paid by a FSC
to a foreign corporation or nonresident alien) that is not otherwise
ECI;
(iii) Gain on the disposition of a U.S. real property interest
described in section 897(c)(1)(A)(ii) (relating to certain interests in
a domestic corporation);
(iv) Income that is ECI by reason of section 953(c)(3)(C) (relating
to certain income of a captive insurance company that a corporation
elects to treat as ECI) that is not otherwise ECI;
(v) Income that is exempt from tax under section 892 (relating to
certain income of foreign governments); and
(vi) Income that is ECI by reason of section 882(e) (relating to
certain interest income of banks organized under the laws of a
possession of the United States) that is not otherwise ECI.
(3) Allocation of deductions attributable to income that does not
produce ECEP. In determining the amount of a foreign corporation's ECEP
for the taxable year, deductions and other adjustments shall be
allocated and apportioned 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
[[Page 584]]
profits tax by reason of paragraph (g) of this section (relating to the
application of the branch profits tax to corporations that are residents
of countries with which the United States has an income tax treaty).
(g) Corporations resident in countries with which the United States
has an income tax treaty--(1) General rule. Except as provided in
paragraph (g)(2) of this section, a foreign corporation that is a
resident of a country with which the United States has an income tax
treaty in effect for a taxable year in which it has a dividend
equivalent amount and that meets the requirements, if any, of the
limitation on benefits provisions of such treaty with respect to the
dividend equivalent amount shall not be subject to the branch profits
tax on such amount (or will qualify for a reduction in the amount of tax
with respect to such amount) only if--
(i) The foreign corporation is a qualified resident of such country
for the taxable year, within the meaning of Sec. 1.884-5(a); or
(ii) The limitation on benefits provision, or an amendment to that
provision, entered into force after December 31, 1986.
If, after application of Sec. 1.884-5(e)(4)(iv), a foreign corporation
is a qualified resident under Sec. 1.884-5(e) (relating to the active
trade or business test) only with respect to one of its trades or
businesses in the United States, i.e., the trade or business that is an
integral part of its business conducted in its country of residence, and
not with respect to another, the rules of this paragraph shall apply
only to that portion of its dividend equivalent amount attributable to
the trade or business for which the foreign corporation is a qualified
resident.
(2) Special rules for foreign corporations that are qualified
residents on the basis of their ownership--(i) General rule. A foreign
corporation that, in any taxable year, is a qualified resident of a
country with which the United States has an income tax treaty in effect
solely by reason of meeting the requirements of Sec. 1.884-5 (b) and
(c) (relating, respectively, to stock ownership and base erosion) shall
be exempt from the branch profits tax or subject to a reduced rate of
branch profits tax under paragraph (g)(1) of this section with respect
to the portion of its dividend equivalent amount for the taxable year
attributable to accumulated ECEP only if the foreign corporation is a
qualified resident of such country within the meaning of Sec. 1.884-
5(a) for the taxable years includable, in whole or in part, in a
consecutive 36-month period that includes the taxable year of the
dividend equivalent amount. A foreign corporation that fails the 36-
month test described in the preceding sentence shall be exempt from the
branch profits tax or subject to the branch profits tax at a reduced
rate under paragraph (g)(1) of this section with respect to accumulated
ECEP (determined on a last-in-first-out basis) accumulated only during
prior years in which the foreign corporation was a qualified resident of
such country within the meaning of Sec. 1.884-5(a).
(ii) Rules of application. A foreign corporation that has not
satisfied the 36-month test as of the close of the taxable year of the
dividend equivalent amount but satisfies the test with respect to such
dividend equivalent amount by meeting the 36-month test by the close of
the second taxable year succeeding the taxable year of the dividend
equivalent amount shall be subject to the branch profits tax for the
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
[[Page 585]]
which the foreign corporation establishes that it has met the 36-month
test.
(iii) Example. The application of this paragraph (g)(2) is
illustrated by the following example.
Example. (i) Foreign corporation A, a calendar year taxpayer, is a
resident of the United Kingdom. A has a dividend equivalent amount for
its taxable year 1991 of $300, of which $100 is attributable to 1991
ECEP and $200 to accumulated ECEP. A is a qualified resident for its
taxable year 1991 because for that year it meets the requirements of
Sec. 1.884-5 (b) and (c), relating, respectively, to stock ownership
and base erosion. For 1991 A does not meet the requirements of Sec.
1.884-5 (d), (e), or (f) for qualified residence. A is not a qualified
resident of the United Kingdom for any taxable year prior to 1990 but is
a qualified resident for its taxable years 1990 and 1992.
(ii) Because A is a qualified resident for the 3-year period (1990,
1991, and 1992) that includes the taxable year of the dividend
equivalent amount (1991), A satisfies the 36-month test of this
paragraph (g)(2) and no branch profits tax is imposed on the total $300
dividend equivalent amount. However, since A was not a qualified
resident for any taxable year prior to 1990 and therefore cannot
establish that it has satisfied the 36-month test until the taxable year
following the year of the dividend equivalent amount, A must pay the
branch profits tax for its taxable year 1991 with respect to the portion
of the dividend equivalent amount attributable to accumulated ECEP
relating to years prior to 1990 without regard to paragraph (g)(1) of
this section. A may file for a refund of the branch profits tax paid
with respect to its 1991 taxable year at any time after it establishes
that it is a qualified resident for its 1992 taxable year.
(3) Exemptions for foreign corporations resident in certain
countries with income tax treaties in effect on January 1, 1987. The
branch profits tax shall not be imposed on the portion of the dividend
equivalent amount with respect to which a foreign corporation satisfies
the requirements of paragraphs (g) (1) and (2) of this section for a
country listed below, so long as the income tax treaty between the
United States and that country, as in effect on January 1, 1987, remains
in effect, except to the extent the treaty is modified on or after
January 1, 1987, to expressly provide for the imposition of the branch
profits tax:
Aruba
Austria
Belgium
People's Republic of China
Cyprus
Denmark
Egypt
Finland
Germany
Greece
Hungary
Iceland
Ireland
Italy
Jamaica
Japan
Korea
Luxembourg
Malta
Morocco
Netherlands
Netherlands Antilles
Norway
Pakistan
Philippines
Sweden
Switzerland
United Kingdom
(4) Modifications with respect to other income tax treaties--(i)
Limitation on rate of tax--(A) General rule. If, under paragraphs (g)
(1) and (2) of this section, a corporation qualifies for a reduction in
the amount of the branch profits tax and paragraph (g)(3) of this
section does not apply, the rate of tax shall be the rate of tax on
branch profits specified in the treaty between the United States and the
corporation's country of residence or, if no rate of tax on branch
profits is specified, the rate of tax that would apply under such treaty
to dividends paid to the foreign corporation by a wholly-owned domestic
corporation.
(B) Certain treaties in effect on January 1, 1987. The branch
profits tax shall generally be imposed at the following rates on the
portion of the dividend 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
[[Page 586]]
this section, a foreign corporation qualifies for a reduction in the
amount of branch profits tax and paragraph (g) (3) of this section does
not apply, then--
(A) The foreign corporation shall be entitled to the benefit of any
limitations on imposition of a tax on branch profits (in addition to any
limitations on the rate of tax) contained in the treaty; and
(B) No branch profits tax shall be imposed with respect to a
dividend equivalent amount out of ECEP or accumulated ECEP of the
foreign corporation unless the ECEP or accumulated ECEP is attributable
to a permanent establishment in the United States or, if not otherwise
prohibited under the treaty, to gain from the disposition of a U.S. real
property interest described in section 897(c)(1)(A)(i), except to the
extent the treaty specifically permits the imposition of the branch
profits tax on such earnings and profits.
No article in such treaty shall be construed to provide any
limitations on imposition of the branch profits tax other than as
provided in this paragraph (g)(4).
(iii) Computation of the dividend equivalent amount if a foreign
corporation has both ECEP attributable to a permanent establishment and
not attributable to a permanent establishment. To determine the dividend
equivalent amount of a foreign corporation out of ECEP that is
attributable to a permanent establishment, the foreign corporation may
only take into account its U.S. assets, U.S. liabilities, U.S. net
equity and ECEP attributable to its permanent establishment. Thus, a
foreign corporation may not reduce the amount of its ECEP attributable
to its permanent establishment by reinvesting all or a portion of that
amount in U.S. assets not attributable to the permanent establishment.
(iv) Limitations under the Canadian treaty. The limitations on the
imposition of the branch profits tax under the Canadian treaty include,
but are not limited to, those described in paragraphs (g)(4)(iv) (A) and
(B).
(A) Effect of deficits in earnings and profits. In the case of a
foreign corporation that is a qualified resident of Canada, the dividend
equivalent amount for any taxable year shall not exceed the foreign
corporation's accumulated ECEP as of the beginning of the taxable year
plus the corporation's ECEP for the taxable year. Thus, for example, if
a foreign corporation that is a qualified resident of Canada has a
deficit in accumulated ECEP of $200 as of the beginning of the taxable
year and ECEP of $100 for the taxable year, it will have no dividend
equivalent amount for the taxable year because it would have a
cumulative deficit in ECEP of $100 as of the close of the taxable year.
For purposes of this paragraph (g)(4)(iii)(A), any net deficit in
accumulated earnings and profits attributable to taxable years beginning
before January 1, 1987, shall be includible in determining accumulated
ECEP.
(B) One-time exemption of Canadian $500,000--(1) General rule. In
the case of a foreign corporation that is a qualified resident of
Canada, the branch profits tax shall be imposed only with respect to
that portion of the dividend equivalent amount for the taxable year
that, when translated into Canadian dollars and added to the dividend
equivalent amounts for preceding taxable years translated into Canadian
dollars, exceeds Canadian $500,000. The value of the dividend equivalent
amount in Canadian currency shall be determined by translating the ECEP
for each taxable 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
[[Page 587]]
the foreign corporation are stapled entities (within the meaning of
section 269B(c)(2)) or are effectively stapled entities. A business is
the same as or similar to another business if it involves the sale,
lease, or manufacture of the same or a similar type of property or the
provision of the same or a similar type of services. A U.S. real
property interest described in section 897(c)(1)(A)(i) shall be treated
as a business and all such U.S. real property interests shall be treated
as businesses that are the same or similar.
(3) Coordination with second-tier withholding tax. The value of the
dividend equivalent amount that is exempt from the branch profits tax by
reason of paragraph (g)(4)(iii)(B)(1) of this section shall not be
subject to tax under section 871(a) or 881, or to withholding under
section 1441 or 1442, when distributed by the foreign corporation.
(5) Benefits under treaties other than income tax treaties. A treaty
that is not an income tax treaty does not exempt a foreign corporation
from the branch profits tax or reduce the amount of the tax.
(h) Stapled entities. Any foreign corporation that is treated as a
domestic corporation by reason of section 269B (relating to stapled
entities) shall continue to be treated as a foreign corporation for
purposes of section 884 and the regulations thereunder, notwithstanding
section 269B or the regulations thereunder. Dividends paid by such
foreign corporation shall be treated as paid by a domestic corporation
and shall be subject to the tax imposed by section 871(a) or 881(a), and
to withholding under section 1441 or 1442, as applicable, to the extent
paid out of earnings and profits that are not subject to tax under
section 884(a). Dividends paid by such foreign corporation out of
earnings and profits subject to tax under section 884(a) shall be exempt
from the tax imposed by sections 871(a) and 881(a) and shall not be
subject to withholding under section 1441 or 1442. Whether dividends are
paid out of earnings and profits that are subject to tax under section
884(a) shall be determined under section 884(e)(3)(A) and the
regulations thereunder. The limitation on the application of treaty
benefits in section 884(e)(3)(B) (relating to qualified residents) shall
apply to a foreign corporation described in this paragraph (h).
(i) Effective date--(1) General rule. This section is effective for
taxable years beginning on or after October 13, 1992. With respect to a
taxable year beginning before October 13, 1992 and after December 31,
1986, a foreign corporation may elect to apply this section in lieu of
Sec. 1.884-1T of the temporary regulations (as contained in the CFR
edition revised as of April 1, 1992), but only if the foreign
corporation also makes an election under Sec. 1.884-4 (e) to apply
Sec. 1.884.4 in lieu of Sec. 1.884-4T (as contained in the CFR edition
revised as of April 1, 1992) for that taxable year, and the statute of
limitations for assessment of a deficiency has not expired for that
taxable year. Once an election has been made, an election under this
section shall apply to all subsequent taxable years. However, paragraph
(f)(2)(vi) of this section (relating to certain interest income of
Possessions banks) shall not apply for taxable years beginning before
January 1, 1990.
(2) Election to reduce liabilities. A foreign corporation may make
an election to reduce its liabilities under paragraph (e)(3) of this
section with respect to a taxable year for which an election under
paragraph (i)(1) of this section is 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
[[Page 588]]
(ii), (d)(3), (d)(4), (d)(5)(iii), (d)(6)(iii), (d)(6)(vi), (e)(2), and
(e)(3)(ii), of this section are effective for taxable years beginning on
or after June 6, 1996.
(j) Transition rules--(1) General rule. Except as provided in
paragraph (j)(2) of this section, in order to compute its dividend
equivalent amount in the first taxable year to which this section
applies (whether or not such year begins before October 13, 1992, a
foreign corporation must recompute its U.S. net equity as of close of
the preceding taxable year using the rules of this section and use such
recomputed amount, rather than the amount computed under Sec. 1.884-1T
(as contained in the CFR edition revised as of April 1, 1992), to
determine the amount of any increase or decrease in the U.S. net equity
as of the close of that taxable year.
(2) Installment obligations--(i) Interest election. In recomputing
its U.S. net equity as of the close of the preceding taxable year, a
foreign corporation that holds an installment obligation treated as a
U.S. asset under Sec. 1.884-1T(d)(7) (as contained in the CFR edition
revised as of April 1, 1992) as of such date may apply the rules of
paragraph (d)(2)(iii) of this section without regard to the rule in that
paragraph that requires interest or original issue discount on the
obligation to be treated as ECI in order for such obligation to be
treated as a U.S. asset.
(ii) 1987 sales by certain foreign corporations. The E&P basis of an
installment obligation arising in connection with a sale of property by
a foreign corporation described in section 312(k)(4), where such sale
occurs in a taxable year beginning in 1987, shall equal the E&P basis of
the property sold as of the determination date reduced by payments
received with respect to the obligation that do not represent gain for
earnings and profits purposes, interest or original issue discount.
[T.D. 8432, 57 FR 41651, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57
FR 60126, Dec. 18, 1992; 58 FR 17166, Apr. 1, 1993, as amended by T.D.
8657, 61 FR 9338, Mar. 8, 1996; 61 FR 14247, Apr. 1, 1996; T.D. 9281, 71
FR 47451, Aug. 17, 2006; T.D. 9465, 74 FR 49320, Sept. 28, 2009; 74 FR
57252, Nov. 5, 2009]
Sec. 1.884-2 Special rules for termination or incorporation of a U.S. trade or business or liquidation or reorganization of a foreign corporation or its
domestic subsidiary.
(a)-(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
[[Page 589]]
year notwithstanding any other provision of Sec. 1.884-2T(a).
(b) through (c)(2)(ii) [Reserved]. For further information, see
Sec. 1.884-2T (b) through (c)(2)(ii).
(c)(2)(iii) Waiver of period of limitations and transferee
agreement. In the case of a transferee that is a domestic corporation,
the provisions of Sec. 1.884-2T(c)(2)(i) shall not apply unless, as
part of the section 381(a) transaction, the transferee executes a Form
2045 (Transferee Agreement) and a waiver of period of limitations as
described in this paragraph (c)(2)(iii), and files both documents with
its timely filed (including extensions) income tax return for the
taxable year in which the section 381(a) transaction occurs. The waiver
shall be executed on Form 8848, or substitute form, and shall extend the
period for assessment of any additional branch profits tax for the
taxable year in which the section 381(a) transaction occurs to a date
not earlier than the close of the sixth taxable year following the
taxable year in which such transaction occurs. This form shall include
such information as is required by the form and accompanying
instructions. The waiver must be signed by the person authorized to sign
Form 2045. With respect to a complete termination occurring in a taxable
year ending prior to June 6, 1996 a foreign corporation may also satisfy
the requirements of this paragraph (c)(2)(iii) by applying Sec. 1.884-
2T(c)(2)(iii) of the temporary regulations (as contained in the CFR
edition revised as of April 1, 1995). A properly executed Form 8848,
substitute form, or other form of waiver authorized by this paragraph
(c)(2)(iii) shall be deemed to be consented to and signed by a Service
Center Director or the Assistant Commissioner (International) for
purposes of Sec. 301.6501(c)-1(d) of this chapter.
(c)(3) through (c)(6)(i)(A) [Reserved]. For further guidance, see
Sec. 1.884-2T(c)(3) through (c)(6)(i)(A).
(B) Shareholders of the transferee (or of the transferee's parent in
the case of a triangular reorganization described in section
368(a)(1)(C) or a reorganization described in sections 368(a)(1)(A) and
368(a)(2)(D) or (E)) who in the aggregate owned more than 25 percent of
the value of the stock of the transferor at any time within the 12-month
period preceding the close of the year in which the section 381(a)
transaction occurs sell, exchange or otherwise dispose of their stock or
securities in the transferee at any time during a period of three years
from the close of the taxable year in which the section 381(a)
transaction occurs.
(C) In the case of a triangular reorganization described in section
368(a)(1)(C) or a reorganization described in sections 368(a)(1)(A) and
368(a)(2)(D) or (E), the transferee's parent sells, exchanges, or
otherwise disposes of its stock or securities in the transferee at any
time during a period of three years from the close of the taxable year
in which the section 381(a) transaction occurs.
(D) A corporation related to any such shareholder or the shareholder
itself if it is a corporation (subsequent to an event described in
paragraph (c)(6)(i)(A) or (B) of this section) or the transferee's
parent (subsequent to an event described in paragraph (c)(6)(i)(C) of
this section), uses, directly or indirectly, the proceeds or property
received in such sale, exchange or disposition, or property attributable
thereto, in the conduct of a trade or business in the United States at
any time during a period of three years from the date of sale in the
case of a disposition of stock in the transferor, 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
[[Page 590]]
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 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
[[Page 591]]
business of the foreign corporation ceasing to have U.S. assets. Any
additional branch profits tax liability that may result, together with
interest thereon (charged at the underpayment rates determined under
section 6621(a)(2) with respect to the period between the date that was
prescribed for filing the foreign corporation's income tax return for
the taxable year with respect to which the branch profits tax liability
arises and the date on which the additional tax for that year is paid),
and applicable penalties, if any, shall be the liability of the foreign
corporation (or of any person who is a transferee of the foreign
corporation within the meaning of section 6901).
(ii) Waiver of period of limitations. [Reserved]. See Sec. 1.884-
2(a)(2)(ii) for rules relating to this paragraph.
(iii) Property subject to reinvestment prohibition rule. For
purposes of paragraph (a)(2)(i)(B) of this section--
(A) The term U.S. assets of the terminated U.S. trade or business
shall mean all the money and other property that qualified as U.S.
assets of the foreign corporation as of the close of the taxable year
immediately preceding the year of complete termination; and
(B) Property attributable to U.S. assets or to effectively connected
earnings and profits earned by the foreign corporation in the year of
complete termination shall mean money or other property into which any
part or all of such assets or effectively connected earnings and profits
are converted at any time before the expiration of the three-year period
specified in paragraph (a)(2)(i)(B) of this section by way of sale,
exchange, or other disposition, as well as any money or other property
attributable to the sale by a shareholder of the foreign corporation of
its interest in the foreign corporation (or a successor corporation) at
any time after a date which is 12 months before the close of the year of
complete termination (24 months in the case of a foreign corporation
that makes an election under paragraph (b) of this section).
(iv) Related corporation. For purposes of paragraph (a)(2)(i)(B) of
this section, a corporation shall be related to a foreign corporation if
either corporation is a 10-percent shareholder of the other corporation
or, where the foreign corporation completely liquidates, if either
corporation would have been a 10-percent shareholder of the other
corporation had the foreign corporation remained in existence. For this
purpose, the term 10-percent shareholder means any person described in
section 871(h)(3)(B) as well as any person who owns 10 percent or more
of the total value of the stock of the corporation, and stock ownership
shall be determined on the basis of the attribution rules described in
section 871(h)(3)(C).
(v) Direct or indirect use of U.S. assets. The use of any part or
all of the property referred to in paragraph (a)(2)(i)(B) of this
section shall include the loan thereof to a related corporation or the
use thereof as security (as a pledge, mortgage, or otherwise) for any
indebtedness of a related corporation.
(3) Complete termination in the case of a section 338 election. A
foreign corporation whose stock is acquired by another corporation that
makes (or is deemed to make) an election under section 338 with respect
to the stock of the foreign corporation shall be treated as having
completely liquidated as of the close of the acquisition date (as
defined in section 338(h)(2)) and to have completely terminated all of
its U.S. 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
[[Page 592]]
as effectively connected with the conduct of a trade or business in the
United States solely by reason of section 864(c)(6) or 864(c)(7) if--
(i) No income of the foreign corporation for the taxable year is, or
is treated as, effectively connected with the conduct of a trade or
business in the United States, without regard to section 864(c)(6) or
864(c)(7),
(ii) The foreign corporation has no U.S. assets as of the close of
the taxable year, and
(iii) Such effectively connected earnings and profits would not have
been subject to branch profits tax pursuant to the complete termination
provisions of paragraph (a)(1) of this section if income or gain subject
to section 864(c)(6) had not been deferred or if property subject to
section 864(c)(7) had been sold immediately prior to the date the
property ceased to have been used in the conduct of a trade or business
in the United States.
(5) Special rule if a foreign corporation terminates an interest in
a trust. [Reserved]. See Sec. 1.884-2(a)(5) for rules relating to this
paragraph.
(6) Coordination with second-level withholding tax. Effectively
connected earnings and profits and non-previously taxed accumulated
effectively connected earnings and profits of a foreign corporation that
are exempt from branch profits tax by reason of the provisions of
paragraph (a)(1) of this section shall not be subject to tax under
section 871(a), 881(a), 1441 or 1442 when paid as a dividend by such
foreign corporation (or a successor-in-interest).
(b) Election to remain engaged in a U.S. trade or business--(1)
General rule. A foreign corporation that would be considered to have
completely terminated all of its U.S. trade or business for the taxable
year under the provisions of paragraph (a)(2)(i) of this section, but
for the provisions of paragraph (a)(2)(i)(B) of this section that
prohibit reinvestment within a three-year period, may make an election
under this paragraph (b) for the taxable year in which it completely
terminates all its U.S. trade or business (as determined without regard
to paragraph (a)(2)(i)(B) of this section) and, if it so chooses, for
the following taxable year (but not for any succeeding taxable year).
The election under this paragraph (b) is an election by the foreign
corporation to designate an amount of marketable securities as U.S.
assets for purposes of Sec. 1.884-1. The marketable securities
identified pursuant to the election under paragraph (b)(3) of this
section shall be treated as being U.S. assets in an amount equal, in the
aggregate, to the lesser of the adjusted basis of the U.S. assets that
ceased to be U.S. assets during the taxable year in which the election
is made (determined on the date or dates the U.S. assets ceased to be
U.S. assets) or the adjusted basis of the marketable securities as of
the end of the taxable year. The securities must be held from the date
that they are identified until the end of the taxable year for which the
election is made, or if disposed of during the taxable year, must be
replaced on the date of disposition with other marketable securities
that are acquired on or before that date and that have a fair market
value as of the date of substitution not less than their adjusted basis.
(2) Marketable security. For purposes of this paragraph (b), the
term marketable security means a security (including stock) that is part
of an issue any portion of which is regularly traded on an established
securities market (within the meaning of Sec. 1.884-5(d)(2) and (4))
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
[[Page 593]]
treated as if they had been sold for their fair market value on the
earlier of the last business day of a taxable year for which an election
is in effect or the day immediately prior to the date of substitution by
the foreign corporation of a U.S. asset for the marketable security, and
any gain (but not loss) and accrued interest on the securities shall
also be treated as ECI. The adjusted basis of such property shall be
increased by the amount of any gain recognized by reason of this
paragraph (b).
(5) Method of election. A foreign corporation may make an election
under this paragraph (b) by attaching to its income tax return for the
taxable year a statement--
(i) Identifying the marketable securities treated as U.S. assets
under this paragraph (b);
(ii) Setting forth the E&P bases of such securities; and
(iii) Agreeing to treat any income, gain or loss as provided in
paragraph (b)(4) of this section.
Such statement must be filed on or before the due date (including
extensions) of the foreign corporation's income tax return for the
taxable year. A foreign corporation shall not be permitted to make an
election under this paragraph (b) more than once.
(6) Effective date. This paragraph (b) is effective for taxable
years beginning on or after October 13, 1992. However, if a foreign
corporation has made a valid election under Sec. 1.884-1(i) to apply
that section with respect to a taxable year beginning before October 13,
1992 and after December 31 1986, this paragraph (b) shall be effective
beginning with such taxable year.
(c) Liquidation, reorganization, etc. of a foreign corporation. The
following rules apply to the transfer by a foreign corporation engaged
(or deemed engaged) in the conduct of a U.S. trade or business (the
``transferor'') of its U.S. assets to another corporation (the
``transferee'') in a complete liquidation or reorganization described in
section 381(a) (a ``section 381(a) transaction'') if the transferor is
engaged (or deemed engaged) in the conduct of a U.S. trade or business
immediately prior to the section 381(a) transaction. For purposes of
this paragraph (c), a section 381(a) transaction is considered to occur
in the taxable year that ends on the date of distribution or transfer
(as defined in Sec. 1.381(b)-1(b)) pursuant to the section 381(a)
transaction.
(1) Inapplicability of paragraph (a)(1) of this section to section
381(a) transactions. Paragraph (a)(1) of this section (relating to the
complete termination of a U.S. trade or business of a foreign
corporation) does not apply to exempt the transferor from branch profits
tax liability for the taxable year in which the section 381(a)
transaction occurs or in any succeeding taxable year.
(2) Transferor's dividend equivalent amount for the taxable year in
which a section 381(a) transaction occurs. The dividend equivalent
amount for the taxable year, including a short taxable year, in which a
section 381(a) transaction occurs shall be determined under the
provisions of Sec. 1.884-1, as modified under the provisions of this
paragraph (c)(2).
(i) U.S. net equity. The transferor's U.S. net equity as of the
close of the taxable year shall be determined without regard to any
transfer in that taxable year of U.S. assets to or from the transferee
pursuant to a section 381(a) transaction, and without regard to any U.S.
liabilities assumed or acquired by the transferee from the transferor in
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
[[Page 594]]
determined without regard to the carryover to the transferee of the
transferor's earnings and profits under section 381 (a) and (c)(2) and
paragraph (c)(4) of this section. Effectively connected earnings and
profits for the taxable year in which a section 381(a) transaction
occurs shall be adjusted by the amount of any gain recognized to the
transferor in that year pursuant to the section 381(a) transaction (to
the extent taken into account for earnings and profits purposes).
(iii) Waiver of period of limitations and transferee agreement.
[Reserved]. See Sec. 1.884-2(c)(2)(iii) for rules relating to this
paragraph.
(3) Transferor's dividend equivalent amount for any taxable year
succeeding the taxable year in which the section 381(a) transaction
occurs. Any decrease in U.S. net equity in any taxable year succeeding
the taxable year in which the section 381(a) transaction occurs shall
increase the transferor's dividend equivalent amount for those years
without regard to the limitation in Sec. 1.884-1(b)(3)(ii), to the
extent such decrease in U.S. net equity does not exceed the balance of
effectively connected earnings and profits and non-previously taxed
accumulated effectively connected earnings and profits carried over to
the transferee pursuant to section 381 (a) and (c)(2), as determined
under paragraph (c)(4) of this section.
(4) Earnings and profits of the transferor carried over to the
transferee pursuant to the section 381(a) transaction--(i) Amount. The
amount of effectively connected earnings and profits and non-previously
taxed accumulated effectively connected earnings and profits of the
transferor that carry over to the transferee under section 381 (a) and
(c)(2) shall be the effectively connected earnings and profits and the
non-previously taxed accumulated effectively connected earnings and
profits of the transferor immediately before the close of the taxable
year in which the section 381(a) transaction occurs. For this purpose,
the provisions in Sec. 1.381(c)(2)-1 shall generally apply with proper
adjustments to reflect the fact that effectively connected earnings and
profits and non-previously taxed accumulated effectively connected
earnings and profits are not affected by distributions to shareholders
but, rather, by dividend equivalent amounts. Therefore, the amounts of
effectively connected earnings and profits and non-previously taxed
accumulated effectively connected earnings and profits that carry over
to the transferee pursuant to those provisions are reduced by the
transferor's dividend equivalent amount for the taxable year in which
the section 381(a) transaction occurs. Such amounts are also reduced to
the extent of any dividend equivalent amount determined for any
succeeding taxable year solely as a result of the provisions of
paragraph (c)(3) of this section. For purposes of this paragraph
(c)(4)(i), if the transferor accumulates non-previously taxed
effectively connected earnings and profits, or incurs a deficit in
effectively connected earnings and profits, attributable to a period
that is after the close of the taxable year in which the section 381(a)
transaction occurs and before the liquidation of the transferor, then
such effectively connected earnings and profits, or deficits therein,
shall be deemed to have been accumulated or incurred on or before the
close of the taxable year in which the section 381(a) transaction
occurs.
(ii) Retention of character. All of the transferor's effectively
connected earnings and profits and non-previously 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
[[Page 595]]
(A) if the distributee qualifies for the benefits under such treaty and
(B) to the extent that the transferor foreign corporation would have
qualified under the principles of Sec. 1.884-1(g) (1) and (2)(i) for an
exemption or reduction in rate with respect to the branch profits tax if
the non-previously taxed accumulated effectively connected earnings and
profits had been reflected in a dividend equivalent amount for the
taxable year in which the section 381(a) transaction occurs. (The tax
rate on dividends specified in the treaty between the distributee's
country of residence and the United States shall apply to any dividends
received by a distributee who qualifies for a treaty benefit under the
preceding sentence.) In addition, distributions out of such non-
previously taxed accumulated effectively connected earnings and profits
shall retain their character in the hands of any domestic distributee up
a chain of corporate shareholders for purposes of applying this
paragraph (c)(4)(iii) to distributions made by any such person to a
foreign distributee. If a domestic transferee has non-previously taxed
accumulated effectively connected earnings and profits carried over from
the transferor as well as accumulated earnings and profits, then each
category of earnings and profits shall be accounted for in two separate
pools, and any distribution of earnings and profits shall be treated as
a distribution out of each pool in proportion to the respective amount
of undistributed earnings and profits in each pool. Section 871(i)
(relating, in part, to dividends paid by a domestic corporation meeting
the 80-percent foreign business requirements of section 861(c)(1)) shall
not apply to any dividends paid by a domestic transferee out of its non-
previously taxed accumulated effectively connected earnings and profits.
(5) Determination of U.S. net equity of a transferee that is a
foreign corporation. In the event the transferee is a foreign
corporation, then for purposes of determining the transferee's increase
or decrease in U.S. net equity under Sec. 1.884-1 for its taxable year
during which the section 381(a) transaction occurs, its U.S. net equity
as of the close of its immediately preceding taxable year shall be
increased by the amount of U.S. net equity acquired by the transferee
from the transferor pursuant to the section 381(a) transaction, taking
into account the adjustments to the basis (for earnings and profits
purposes) of U.S. assets under the principles of section 362(b).
(6) Special rules in the case of the disposition of stock or
securities in a domestic transferee or in the transferor--(i) General
rule. This paragraph (c)(6)(i) shall apply where the transferee is a
domestic corporation, subdivision (A), (B), or (C) of this paragraph
applies and subdivision (D) of this paragraph applies.
(A) Shareholders of the transferor sell, exchange or otherwise
dispose of stock in the transferor at any time during a 12-month period
before the date of distribution or transfer (as defined in Sec.
1.381(b)-1(b)) and the aggregate amount of such stock sold, exchanged or
otherwise disposed of exceeds 25 percent of the value of the stock of
the transferor, determined on a date that is 12 months before the date
of distribution or transfer.
(B), (C), and (D) [Reserved]. For further guidance, see Sec. 1.884-
2(c)(6)(i)(B), (C), and (D).
Where this paragraph (c)(6)(i) applies, the transferor's branch profits
tax liability for the taxable year in which the section 381(a)
transaction occurs 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
[[Page 596]]
tax for that year is paid. Any such additional tax liability together
with interest thereon shall be the liability of the transferee within
the meaning of section 6901 pursuant to section 6901 and the regulations
thereunder.
(ii) Operating rule. For purposes of paragraph (c)(6)(i) of this
section paragraphs (a)(2) (iii)(B), (iv) and (v) of this section shall
apply for purposes of making the determinations under paragraph
(c)(6)(i)(D) of this section.
(d) Incorporation under section 351--(1) In general. The following
rules apply to the transfer by a foreign corporation engaged (or deemed
engaged) in the conduct of a U.S. trade or business (the ``transferor'')
of part or all of its U.S. assets to a U.S. corporation (the
``transferee'') in exchange for stock or securities in the transferee in
a transaction that qualifies under section 351(a) (a ``section 351
transaction''), provided that immediately after the transaction, the
transferor is in control (as defined in section 368(c)) of the
transferee, without regard to other transferors.
(2) Inapplicability of paragraph (a)(1) of this section to section
351 transactions. Paragraph (a)(1) of this section does not apply to
exempt the transferor from branch profits tax liability for the taxable
year in which a section 351 transaction described in paragraph (d)(1) of
this section occurs and shall not apply for any subsequent taxable year
of the transferor in which it, or a successor-in-interest, owns stock or
securities of a transferee as of the close of the transferor's taxable
year.
(3) Transferor's dividend equivalent amount for the taxable year in
which a section 351 transaction occurs. The dividend equivalent amount
of the transferor for the taxable year in which a section 351
transaction described in paragraph (d)(1) of this section occurs shall
be determined under the provisions of Sec. 1.884-1, as modified by the
provisions of this paragraph (d)(3) provided that the transferee elects
under paragraph (d)(4) of this section to be allocated a proportionate
amount of the transferor's effectively connected earnings and profits
and non-previously taxed accumulated effectively connected earnings and
profits and the foreign corporation files a statement as provided in
paragraph (d)(5)(i) of this section and complies with the agreement
included in such statement with respect to a subsequent disposition of
the transferee's stock.
(i) U.S. net equity. The transferor's U.S. net equity as of the
close of the taxable year shall be determined without regard to any
transfer in that taxable year of U.S. assets to or from the transferee
pursuant to a section 351 transaction, and without regard to any U.S.
liabilities assumed or acquired by the transferee from the transferor in
that taxable year pursuant to a section 351 transaction. The
transferor's adjusted basis for earnings and profits purposes in U.S.
assets transferred to the transferee pursuant to a section 351
transaction shall be the adjusted basis of those assets for earnings and
profits purposes immediately prior to the section 351 transaction,
increased by the amount of any gain recognized by the transferor on the
transfer of such assets in the section 351 transaction to the extent
taken into account for earnings and profits purposes.
(ii) Effectively connected earnings and profits. Subject to the
limitation in paragraph (d)(3)(iii) of this section, the calculation of
the transferor's dividend 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
[[Page 597]]
earnings and profits and non-previously taxed accumulated effectively
connected earnings and profits determined after taking into account the
allocation to the transferee of the transferor's earnings pursuant to an
election under paragraph (d)(4)(i) of this section.
(4) Election to increase earnings and profits--(i) General rule. The
election referred to in paragraph (d)(3) of this section is an election
by the transferee to increase its earnings and profits by the amount
determined under paragraph (d)(4)(ii) of this section. An election under
this paragraph (d)(4)(i) shall be effective only if the transferee
attaches a statement to its timely filed (including extensions) income
tax return for the taxable year in which the section 351 transaction
occurs, in which--
(A) It agrees to be subject to the rules of paragraph (c)(4) (ii)
and (iii) of this section with respect to the transferor's effectively
connected earnings and profits and non-previously taxed accumulated
effectively connected earnings and profits allocated to the transferee
pursuant to the election under this paragraph (d)(4)(i) in the same
manner as if such earnings and profits had been carried over to the
transferee pursuant to section 381 (a) and (c)(2), and
(B) It identifies the amount of effectively connected earnings and
profits and non-previously taxed accumulated effectively connected
earnings and profits that are allocated from the transferor.
An election with respect to a taxable year ending on or before December
1, 1988, may be made by filing an amended Form 1120F on or before
January 3, 1988, to which the statement described in this paragraph
(d)(4)(i) shall be attached.
(ii) Amount of the transferor's effectively connected earnings and
profits and non-previously taxed accumulated effectively connected
earnings and profits allocated to the transferee. The amount referred to
in paragraph (d)(4)(i) of this section is equal to the same proportion
of the transferor's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits
(determined immediately prior to the section 351 transaction and without
regard to this paragraph (d)(4) or any dividend equivalent amount for
the taxable year) that the adjusted bases for purposes of computing
earnings and profits in all the U.S. assets transferred to the
transferee by the transferor pursuant to the section 351 transaction
bear to the adjusted bases for purposes of computing earnings and
profits in all the U.S. assets of the transferor, determined immediately
prior to the section 351 transaction.
(iii) Effect of election on transferor. For purposes of computing
the transferor's dividend equivalent amount for the taxable year
succeeding the taxable year in which a section 351 transaction occurs,
the transferor's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits
as of the close of the taxable year in which the section 351 transaction
occurs shall be reduced by the amount of its effectively connected
earnings and profits and non-previously taxed accumulated effectively
connected earnings and profits allocated to the transferee pursuant to
the election under paragraph (d)(4)(i) of this section (and by its
dividend equivalent amount for the 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
[[Page 598]]
branch profits, tax purposes. The extent and manner in which such
dividend equivalent amount may be subject to the branch profits tax in
the taxable year of disposition shall be determined under the provisions
of section 884 and the regulations thereunder, including the provisions
of paragraph (a) of this section (relating to complete terminations), as
limited under paragraph (d)(2) of this section. Except as otherwise
provided in paragraph (d)(5)(ii) of this section, the term disposition
means any transfer that would constitute a disposition by the transferor
for any purpose of the Internal Revenue Code and the regulations
thereunder. This paragraph (d)(5)(i) shall apply regardless of whether
the stock or securities of the transferee are U.S. assets in the hands
of the transferor at the time of sale, exchange or disposition.
(ii) Exception for certain tax-free dispositions. For purposes of
paragraph (d)(5)(i) of this section, a disposition does not include a
transfer of stock or securities of the transferee by the transferor in a
transaction that qualifies as a transfer pursuant to a complete
liquidation described in section 332(b) or a transfer pursuant to a
reorganization described in section 368(a)(1)(F). Any other transfer
that qualifies for non-recognition of gain or loss shall be treated as a
disposition for purposes of paragraph (d)(5)(i) of this section, unless
the Commissioner has, by published guidance or by prior ruling issued to
the taxpayer upon its request, determined such transfer not to be a
disposition for purposes of paragraph (d)(5)(i) of this section.
(iii) Distributions governed by section 355. In the case of a
distribution or exchange of stock or securities of a transferee to which
section 355 applies (or so much of section 356 as relates to section
355) and that is not in pursuance of a plan meeting the requirements of
a reorganization as defined in section 368(a)(1)(D), Sec. 1.3l2-10(b)
(relating to the allocation of earnings and profits in certain corporate
separations) shall not apply to reduce the transferor's effectively
connected earnings and profits or non-previously taxed accumulated
effectively connected earnings and profits.
(iv) Filing of statement. The statement referred to in paragraph
(d)(5)(i) of this section shall be attached to a timely filed (including
extensions) income tax return of the transferor for the taxable year in
which the section 351 transaction occurs. An election with respect to a
taxable year ending on or before December 1, 1988, may be made by filing
an amended Form 1120F on or before January 3, 1988, to which the
statement described in this paragraph (d)(5)(iv) shall be attached.
(6) Example. The provisions of this paragraph (d) are illustrated by
the following example.
Example. Foreign corporation X has a calendar taxable year. X's only
assets are U.S. assets and X computes its interest deduction using the
actual ratio of liabilities to assets under Sec. 1.882-5(b)(2)(ii). X's
U.S. net equity as of the close of its 1988 taxable year is $2,000,
resulting from the following amounts of U.S. assets and liabilities:
------------------------------------------------------------------------
U.S. assets U.S. liabilities
------------------------------------------------------------------------
U.S. building A................. $l,000 Mortgage A........ 800
U.S. building B................. 2,500 Mortgage B........ 1,500
Other U.S. assets............... 800
---------- ---------
Total....................... 4,300 2,300
------------------------------------------------------------------------
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
[[Page 599]]
tax consequences to X and Y in the taxable year in which the section 351
transaction occurs and in subsequent taxable years are as follows:
(i) X's dividend equivalent amount for 1989. The determination of
X's dividend equivalent amount for 1989 is a three-step process:
determining X's U.S. net equity as of the close of its 1989 taxable year
under paragraph (d)(3)(i) of this section; determining the amount of X's
effectively connected earnings and profits and non-previously taxed
accumulated effectively connected earnings and profits for its 1989
taxable year under paragraph (d)(3)(ii) of this section; and applying
the limitation in paragraph (d)(3)(iii) of this section.
Step one: Pursuant to paragraph (d)(3)(i) of this section, X's U.S.
net equity as of the close of its 1989 taxable year is calculated
without regard to the section 351 transaction except that X's basis in
its U.S. assets is increased by the $170 amount of gain it has
recognized for earnings and profits purposes in connection with the
section 351 transaction. Thus, X's U.S. net equity as of the close of
its 1989 taxable year is $1,870, consisting of the following U.S. assets
and liabilities, taking into account the fact that X's other U.S. assets
have decreased to $500:
------------------------------------------------------------------------
U.S. assets U.S. liabilities
------------------------------------------------------------------------
Building A...................... $l,170 Mortgage A........ 800
Building B...................... 2,500 Mortgage B........ 1,500
Other U.S. assets............... 500
---------- ---------
Total....................... 4,170 2,300
------------------------------------------------------------------------
Thus, X's U.S. net equity as of the close of its 1989 taxable year
has decreased by $130 relative to its U.S. net equity as of the close of
its 1988 taxable year.
Step two: Pursuant to paragraph (d)(3)(ii) of this section, X's
effectively connected earnings and profits and non-previously taxed
accumulated effectively connected earnings and profits for the taxable
year are determined without taking into account the allocation to Y of
X's effectively connected earnings and profits and non-previously taxed
accumulated effectively connected earnings and profits pursuant to the
election under paragraph (d)(4)(i) of this section. Thus, X's
effectively connected earnings and profits for its 1989 taxable year are
$330 and X's non-previously taxed accumulated effectively connected
earnings and profits are $200. Thus, but for the limitation in paragraph
(d)(3)(iii) of this section, X's dividend equivalent amount for the
taxable year would be $460, equal to X's effectively connected earnings
and profits for the taxable year ($330), increased by the decrease in
X's U.S. net equity ($130).
Step three: Pursuant to paragraph (d)(3)(iii) of this section, X's
dividend equivalent amount for its 1989 taxable year may not exceed the
sum of the transferor's effectively connected earnings and profits and
non-previously taxed accumulated effectively connected earnings and
profits, determined as of the close of its 1989 taxable year, after
taking into account the allocation of the transferor's earnings and
profits pursuant to the election under paragraph (d)(4)(i) of this
section. Based upon subdivision (ii) of this example, X's dividend
equivalent amount for 1989 cannot exceed $423, which is equal to the
total amount of X's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits,
determined as of the close of its 1989 taxable year without regard to
the allocation of earnings and profits to Y pursuant to Y's election
under paragraph (d)(4)(i) of this section ($530), reduced by the amount
of X's effectively connected earnings and profits and non-previously
taxed accumulated effectively connected earnings and profits allocated
to Y pursuant to Y's election under paragraph (d)(4)(i) of this section
($107). Thus, X's dividend equivalent amount for its 1989 taxable year
is limited to $423.
(ii) Amount of X's effectively connected earnings and profits and
non-previously taxed accumulated effectively connected earnings and
profits transferred to Y. Pursuant to Y's election under paragraph
(d)(4)(i) of this section, Y increases its earnings and profits by the
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
[[Page 600]]
profits allocated to Y pursuant to paragraph (d)(4)(i) of this section
constitutes non-previously taxed accumulated effectively connected
earnings and profits of Y.
(iii) X's non-previously taxed accumulated effectively connected
earnings and profits for 1990. Pursuant to paragraph (d)(4)(iii) of this
section, X's non-previously taxed accumulated effectively connected
earnings and profits as of the close of its 1989 taxable year for
purposes of computing its dividend equivalent amount for its taxable
year 1990 are zero, i.e., $530 of effectively connected earnings and
profits and non-previously taxed accumulated effectively connected
earnings and profits reduced by $107 of effectively connected earnings
and profits and non-previously taxed accumulated effectively connected
earnings and profits allocated to Y, and further reduced by X's $423
dividend equivalent amount for its 1989 taxable year.
(iv) X's U.S. net equity for purposes of determining the dividend
equivalent amount for succeeding taxable years. For 1990, X must
determine its U.S. net equity as of December 31, 1989, in order to
determine whether there has been an increase or decrease in its U.S. net
equity as of December 31, 1990. For this purpose, X's U.S. net equity as
of December 31, 1989 is determined under the provisions of Sec. 1.884-1
without regard to the special rules in paragraph (d)(3)(i) of this
section. Thus, X.'s U.S. net equity as of December 31, 1989 is $1,500,
consisting of the following. U.S. assets and liabilities:
------------------------------------------------------------------------
U.S. assets U.S. liabilities
------------------------------------------------------------------------
Building B...................... $2,500 Mortgage B........ 1,500
Other U.S. assets............... 500
---------- ---------
Total....................... $3,000 1,500
------------------------------------------------------------------------
(e) Certain transactions with respect to a domestic subsidiary. In
the case of a section 381(a) transaction in which a domestic subsidiary
of a foreign corporation transfers assets to that foreign corporation or
to another foreign corporation with respect to which the first foreign
corporation owns stock (directly or indirectly) meeting the requirements
of section 1504(a)(2), the transferee's non-previously taxed accumulated
effectively connected earnings and profits for the taxable year in which
the section 381(a) transaction occurs shall be increased by all of the
domestic subsidiary's current earnings and profits and earnings and
profits accumulated after December 31, 1986, that carry over to the
transferee under sections 381(a) and (c)(1) (including non-previously
taxed accumulated effectively connected earnings and profits, if any,
transferred to the domestic subsidiary under paragraphs (c)(4) and
(d)(4) of this section and treated as earnings and profits under
paragraphs (c)(4)(ii) and (d)(4)(ii) of this section). For purposes of
determining the transferee's dividend equivalent amount for the taxable
year in which the section 381(a) transaction occurs, the transferee's
U.S. net equity as of the close of its taxable year immediately
preceding the taxable year during which the section 381(a) transaction
occurs shall be increased by the greater of
(1) The amount by which the transferee's U.S. net equity computed
immediately prior to the transfer would have increased due to the
transfer of the subsidiary's assets and liabilities if U.S. net equity
were computed immediately prior to the transfer and immediately after
the transfer (taking into account in the earnings and profits basis of
the assets transferred any gain recognized on the transfer to the extent
reflected in earnings and profits), or
(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
[[Page 601]]
861(c)(1), relating to a domestic corporation that meets the 80 percent
foreign business requirement). Thus, for example, whether such interest
is treated as income from sources within the United States by the person
who receives the interest shall be determined in the same manner as if
such interest were paid by a domestic corporation (other than a
corporation described in section 861(c)(1)). Such interest shall be
subject to tax under section 871(a) or 881, and to withholding under
section 1441 or 1442, in the same manner as interest paid by a domestic
corporation (other than a corporation described in section 861(c)(1)) if
received by a foreign person and not effectively connected with the
conduct by the foreign person of a trade or business in the United
States, unless the interest, if paid by a domestic corporation, would be
exempt under section 871(h) or 881(c) (relating to exemption for certain
portfolio interest received by a foreign person), section 871(i) or
881(d) (relating, in part, to exemption for certain bank deposit
interest received by a foreign person), or another provision of the
Code. Such interest shall also be treated as interest paid by a domestic
corporation (other than a corporation described in section 861(c)(1))
for purposes of sections 864(c), 871(b) and 882(a) (relating to income
that is effectively connected with the conduct of a trade or business
within the United States) and section 904 (relating to the limitation on
the foreign tax credit). For purposes of this section, a foreign
corporation also shall be treated as engaged in trade or business in the
United States if, at any time during the taxable year, it owns an asset
taken into account under Sec. 1.882-5(a)(1)(ii) or (b)(1) for purposes
of determining the amount of the foreign corporation's interest expense
allocated or apportioned to ECI. See paragraph (b)(8) of this section
for the effect of income tax treaties on branch interest.
(2) Tax on excess interest--(i) Definition of excess interest. For
purposes of this section, the term ``excess interest'' means--
(A) The amount of interest allocated or apportioned to ECI of the
foreign corporation under Sec. 1.882-5 for the taxable year, after
application of Sec. 1.884-1(e)(3); minus
(B) The foreign corporation's branch interest (as defined in
paragraph (b) of this section) for the taxable year, but not including
interest accruing in a taxable year beginning before January 1, 1987;
minus
(C) The amount of interest determined under paragraph (c)(2) of this
section (relating to interest paid by a partnership).
(ii) Imposition of tax. A foreign corporation shall be liable for
tax on excess interest under section 881(a) in the same manner as if
such excess interest were interest paid to the foreign corporation by a
wholly-owned domestic corporation (other than a corporation described in
section 861(c)(1)) on the last day of the foreign corporation's taxable
year. Excess interest shall be exempt from tax under section 881(a) only
as provided in paragraph (a)(2)(iii) of this section (relating to
treatment of certain excess interest of banks as interest on deposits)
or paragraph (c)(3) of this section (relating to income tax treaties).
(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
[[Page 602]]
under section 884(f) and this section with respect to excess interest of
a foreign corporation shall be reported on the foreign corporation's
income tax return for the taxable year in which the excess interest is
treated as paid to the foreign corporation under section 884(f)(1)(B)
and paragraph (a)(2) of this section, and shall not be subject to
withholding under section 1441 or 1442. The tax shall be due and payable
as provided in section 6151 and such other sections of Subtitle F of the
Internal Revenue Code as apply, and estimated tax payments shall be due
with respect to a foreign corporation's liability for the tax on excess
interest as provided in section 6655.
(3) Original issue discount. For purposes of this section, the term
``interest'' includes original issue discount, as defined in section
1273(a)(1).
(4) Examples. The application of this paragraph (a) is illustrated
by the following examples.
Example 1. Taxation of branch interest and excess interest. Foreign
corporation A, a calendar year taxpayer that is not a corporation
described in paragraph (a)(2)(iii) of this section (relating to banks),
has $120 of interest allocated or apportioned to ECI under Sec. 1.882-5
for 1997. A's branch interest (as defined in paragraph (b) of this
section) for 1997 is as follows: $55 of portfolio interest (as defined
in section 871(h)(2)) to B, a nonresident alien; $25 of interest to
foreign corporation C, which owns 15 percent of the combined voting
power of A's stock, with respect to bonds issued by A; and $20 to D, a
domestic corporation. B and C are not engaged in the conduct of a trade
or business in the United States. A, B and C are residents of countries
with which the United States does not have an income tax treaty. The
interest payments made to B and D are not subject to tax under section
871(a) or 881 and are not subject to withholding under section 1441 or
1442. The payment to C, which does not qualify as portfolio interest
because C owns at least 10 percent of the combined voting power of A's
stock, is subject to withholding of $7.50 ($25 x 30%). In addition,
because A's interest allocated or apportioned to ECI under Sec. 1.882-5
($120) exceeds its branch interest ($100), A has excess interest of $20,
which is subject to a tax of $6 ($20 x 30%) under section 881. The tax
on A's excess interest must be reported on A's income tax return for
1997.
Example 2. Taxation of excess interest of a bank. Foreign
corporation A, a calendar year taxpayer, is a corporation described in
paragraph (a)(2)(iii) of this section (relating to banks) and is a
resident of a country with which the United States does not have an
income tax treaty. A has excess interest of $100 for 1997. At the close
of 1997, A has $10,000 of interest-bearing liabilities (including
liabilities that give rise to branch interest), of which $8,700 are
interest-bearing deposits. For purposes of computing the tax on A's
excess interest, $87 of the excess interest ($100 excess interest x
($8,700 interest-bearing deposits/$10,000 interest-bearing liabilities))
is treated as interest on deposits. Thus, $87 of A's excess interest is
exempt from tax under section 881(a) and the remaining $13 of excess
interest is subject to a tax of $3.90 ($13 x 30%) under section 881(a).
(b) Branch interest--(1) Definition of branch interest. For purposes
of this section, the term ``branch interest'' means interest that is--
(i) Paid by a foreign corporation with respect to a liability that
is--
(A) A U.S. booked liability within the meaning of Sec. 1.882-
5(d)(2) (other than a U.S. booked liability of a partner within the
meaning of Sec. 1.882-5(d)(2)(vii)); or
(B) Described in Sec. 1.884-1(e)(2) (relating to insurance
liabilities on U.S. business and liabilities giving rise to interest
expense that is directly allocated to income from a U.S. asset); or
(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
[[Page 603]]
secured by foreign assets) or paragraph (b)(1)(i) of this section.
(2) [Reserved]
(3) Requirements relating to specifically identified liabilities--
(i) Method of identification. A liability described in paragraph
(b)(1)(ii) of this section is identified as a liability of a U.S. trade
or business only if the liability is shown on the records of the U.S.
trade or business, or is identified as a liability of the U.S. trade or
business on other records of the foreign corporation or on a schedule
established for the purpose of identifying the liabilities of the U.S.
trade or business. Each such liability must be identified with
sufficient specificity so that the amount of branch interest
attributable to the liability, and the name and address of the
recipient, can be readily identified from such records or schedule.
However, with respect to liabilities that give rise to portfolio
interest (as defined in sections 871(h) and 881(c)) or that are payable
183 days or less from the date of original issue, and form part of a
larger debt issue, such liabilities may be identified by reference to
the issue and maturity date, principal amount and interest payable with
respect to the entire debt issue. Records or schedules described in this
paragraph that identify liabilities that give rise to branch interest
must be maintained in the United States by the foreign corporation or an
agent of the foreign corporation for the entire period commencing with
the due date (including extensions) of the income tax return for the
taxable year to which the records or schedules relate and ending with
the expiration of the period of limitations for assessment of tax for
such taxable year. A foreign corporation that is subject to this section
may identify a liability under paragraph (b)(1)(ii) of this section
whether or not it is actually engaged in the conduct of a trade or
business in the United States.
(ii) Notification to recipient. Interest with respect to a liability
described in paragraph (b)(1)(ii) of this section shall not be treated
as branch interest unless the foreign corporation paying the interest
either--
(A) Makes a return, pursuant to section 6049, with respect to the
interest payment; or
(B) Sends a notice to the person who receives such interest in a
confirmation of the transaction, a statement of account, or a separate
notice, within two months of the end of the calendar year in which the
interest was paid, stating that the interest paid with respect to the
liability is from sources within the United States.
(iii) Liabilities that do not give rise to branch interest under
paragraph (b)(1)(ii) of this section. A liability is described in this
paragraph (b)(3)(iii) (and interest with respect to the liability may
not be treated as branch interest of a foreign corporation by reason of
paragraph (b)(1)(ii) of this section) if--
(A) The liability is directly incurred in the ordinary course of the
profit-making activities of a trade or business of the foreign
corporation conducted outside the United States, as, for example, an
account or note payable arising from the purchase of inventory or
receipt of services by such trade or business; or
(B) The liability is secured (during more than half the days during
the portion of the taxable year in which the interest accrues)
predominantly by 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
[[Page 604]]
amount of the foreign corporation's branch interest to exceed the amount
permitted by paragraph (b)(6)(i) of this section (relating to branch
interest in excess of a foreign corporation's interest allocated or
apportioned to ECI under Sec. 1.882-5) the amount of branch interest
arising by reason of this paragraph shall be reduced as provided in
paragraphs (b)(6) (ii) and (iii) of this section, as applicable.
(ii) Example. The application of this paragraph (b)(5) is
illustrated by the following example.
Example. Application of 80 percent test. Foreign corporation A, a
calendar year taxpayer, has $90 of interest allocated or apportioned to
ECI under Sec. 1.882-5 for 1993. Before application of this paragraph
(b)(5), A has $40 of branch interest in 1993. A pays $60 of other
interest during 1993, none of which is attributable to a liability
described in paragraph (b)(3)(iii) of this section (relating to
liabilities incurred in the ordinary course of a foreign business and
liabilities predominantly secured by foreign assets). As of the close of
1993, A has an amount of U.S. assets that exceeds 80 percent of the
money and E&P bases of all A's property. Before application of this
paragraph (b)(5), A would have $50 of excess interest (i.e., the $90
interest allocated or apportioned to its ECI under Sec. 1.882-5 less
$40 of branch interest). Under this paragraph (b)(5), the $60 of
additional interest paid by A is also treated as branch interest.
However, to the extent that treating the $60 of additional interest as
branch interest would create an amount of branch interest that would
exceed the amount of branch interest permitted under paragraph (b)(6) of
this section (relating to branch interest that exceeds a foreign
corporation's interest allocated or apportioned to ECI under Sec.
1.882-5) the amount of the additional branch interest is reduced under
paragraph (b)(6)(iii) of this section, which generally allows a foreign
corporation to specify certain liabilities that do not give rise to
branch interest or paragraph (b)(6)(ii) of this section, which generally
specifies liabilities that do not give rise to branch interest beginning
with the most-recently incurred liability.
(6) Special rule where branch interest exceeds interest allocated or
apportioned to ECI of a foreign corporation--(i) General rule. If the
amount of branch interest that is both paid and accrued by a foreign
corporation during the taxable year (including interest that the foreign
corporation elects under paragraph (c)(1) of this section to treat as
paid during the taxable year) exceeds the amount of interest allocated
or apportioned to ECI of a foreign corporation under Sec. 1.882-5 for
the taxable year, then the amount of the foreign corporation's branch
interest shall be reduced by the amount of such excess as provided in
paragraphs (b)(6)(ii) and (iii) of this section, as applicable. The
rules of paragraphs (b)(6)(ii) and (iii) of this section shall also
apply where the amount of branch interest with respect to liabilities
identified under paragraph (b)(1)(ii) of this section exceeds the
maximum amount that may be treated as branch interest under that
paragraph. This paragraph (b)(6) shall apply whether or not a reduction
in the amount of branch interest occurs as a result of adjustments made
during the examination of the foreign corporation's income tax return,
such as a reduction in the amount of interest allocated or apportioned
to ECI of the foreign corporation under Sec. 1.882-5.
(ii) Reduction of branch interest beginning with most-recently
incurred liability. Except as provided in paragraph (b)(6)(iii) of this
section (relating to an election to specify liabilities that do not give
rise to branch interest), the 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
[[Page 605]]
(b)(6)(ii), the reduction shall be made beginning with the last interest
payment made with respect to the liability during the taxable year and
continuing, in reverse chronological order, with the next-latest payment
until the amount of branch interest has been reduced by the amount
specified in paragraph (b)(6)(i) of this section. The amount of interest
that is not treated as branch interest by reason of this paragraph
(b)(6)(ii) shall not be treated as paid by a domestic corporation and
thus shall not be subject to tax under section 871(a) or 881(a).
(iii) Election to specify liabilities that do not give rise to
branch interest. For purposes of reducing the amount of branch interest
under paragraph (b)(6)(i) of this section, a foreign corporation may,
instead of using the method described in paragraph (b)(6)(ii) of this
section, elect for any taxable year to specify which liabilities will
not be treated as giving rise to branch interest or will be treated as
giving rise only in part to branch interest. Branch interest paid during
the taxable year with respect to a liability specified under this
paragraph (b)(6)(iii) must be reduced to zero before a reduction is made
with respect to branch interest attributable to the next-specified
liability. If all interest payments with respect to a specified
liability, when added to all interest payments with respect to other
liabilities specified under this paragraph (b)(6)(iii), would exceed the
amount of the reduction under paragraph (b)(6)(i) of this section, then
only a portion of the branch interest attributable to that specified
liability shall be reduced under this paragraph (b)(6)(iii), and the
reduction shall be made beginning with the last interest payment made
with respect to the liability during the taxable year and continuing, in
reverse chronological order, with the next-latest payment until the
amount of branch interest has been reduced by the amount of the
reduction under paragraph (b)(6)(i) of this section. A foreign
corporation that elects to have this paragraph (b)(6)(iii) apply shall
note on its books and records maintained in the United States that the
liability is not to be treated as giving rise to branch interest, or is
to be treated as giving rise to branch interest only in part. Such
notation must be made after the close of the taxable year in which the
foreign corporation pays the interest and prior to the due date (with
extensions) of the foreign corporation's income tax return for the
taxable year. However, if the excess interest in paragraph (b)(6)(i) of
this section occurs as a result of adjustments made during the
examination of the foreign corporation's income tax return, the election
and notation may be made at the time of examination. The amount of
interest that is not treated as branch interest by reason of this
paragraph (b)(6)(iii) shall not be treated as paid by a domestic
corporation and thus shall not be subject to tax under section 871 (a)
or 881 (a).
(iv) Examples. The application of this paragraph (b)(6) is
illustrated by the following examples.
Example 1. Branch interest exceeds interest apportioned to ECI with
no election in effect. Foreign corporation A, a calendar year, accrual
method taxpayer, has interest expense apportioned to ECI under Sec.
1.882-5 of $230 for 1997. A's branch interest for 1997 is as follows:
(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
[[Page 606]]
amount of A's branch interest in 1997 is limited under paragraph
(b)(6)(i) of this section to $230, the amount of the interest
apportioned to A's ECI for 1997. The amount of A's branch interest must
thus be reduced by $110 ($340-$230) under paragraph (b)(6)(ii) of this
section. The reduction is first made with respect to interest
attributable to liabilities described in paragraph (b)(1)(ii) of this
section (i.e., liabilities identified as giving rise to branch interest)
and, within the group of liabilities described in paragraph (b)(1)(ii)
of this section, is first made with respect to the latest-incurred
liability. Thus, the $70 of interest paid to E with respect to the bond
issued on March 1, 1997, and $40 of the $80 of interest paid to D with
respect to the note issued on February 15, 1997, are not treated as
branch interest. The interest paid to D is no longer subject to tax
under section 871(a), and D may claim a refund of amounts withheld with
respect to the interest payments. There is no change in the tax
consequences to E because the interest received by E was portfolio
interest and was not subject to tax when it was treated as branch
interest.
Example 2. Effect of election to specify liabilities. Assume the
same facts as in Example 1 except that A makes an election under
paragraph (b)(6)(iii) of this section to specify which liabilities are
not to be treated as giving rise to branch interest. A specifies the
liability to D, who would be taxable at a rate of 15 percent on interest
paid with respect to the liability, as a liability that does not give
rise to branch interest, and D is therefore not subject to tax under
section 871 (a) and is entitled to a refund of amounts withheld with
respect to the interest payments. A also specifies the liability to C as
a liability that gives rise to branch interest only in part. As a
result, $30 of the $60 of interest paid to C is not treated as branch
interest, and C is entitled to a refund with respect to the $30 of
interest that is not treated as branch interest.
(7) Effect of election under paragraph (c)(1) of this section to
treat interest as if paid in year of accrual. If a foreign corporation
accrues an interest expense in a taxable year earlier than the taxable
year of payment and elects under paragraph (c)(1) of this section to
compute its excess interest as if the interest expense were branch
interest paid in the year of accrual, the interest expense shall be
treated as branch interest that is paid at the close of such year (and
not in the actual year of payment) for all purposes of this section.
Such interest shall thus be subject to tax under section 871(a) or
881(a) and withholding under section 1441 or section 1442, as if paid on
the last day of the taxable year of accrual. Interest that is treated
under paragraph (c)(1) of this section as paid in a later year for
purposes of computing excess interest shall be treated as paid only in
the actual year of payment for all purposes of this section other than
paragraphs (a)(2) and (c)(1) of this section (relating to excess
interest).
(8) Effect of treaties--(i) Payor's treaty. In the case of a foreign
corporation's branch interest, relief shall be available under an
article of an income tax treaty between the United States and the
foreign corporation's country of residence relating to interest paid by
the foreign corporation only if, for the taxable year in which the
branch interest is paid (or if the branch interest is treated as paid in
an earlier taxable year under paragraph (b)(7) of this section, for the
earlier taxable year)--
(A) The foreign corporation meets the requirements of the limitation
on benefits provision, if any, in the treaty, and either--
(1) The corporation is a qualified resident (as defined in Sec.
1.884-5(a)) of that foreign country in such year; or
(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
[[Page 607]]
(for the period specified in paragraph (b)(8)(i) of this section) of a
foreign country with which the United States has an income tax treaty or
met the requirements of the limitation on benefits provision in a treaty
with respect to the interest payment and such provision entered into
force after December 31, 1986.
(iii) Presumption that a foreign corporation continues to be a
qualified resident. For purposes of this paragraph (b)(8), a foreign
corporation that was a qualified resident for the prior taxable year
because it fulfills the requirements of Sec. 1.884-5 shall be
considered a qualified resident with respect to branch interest that is
paid or received during the current taxable year if--
(A) In the case of a foreign corporation that met the stock
ownership and base erosion tests in Sec. 1.884-5(b) and (c) for the
preceding taxable year, the foreign corporation does not know, or have
reason to know, that either 50 percent of its stock (by value) is not
beneficially owned (or treated as beneficially owned by reason of Sec.
1.884-5(b)(2)) by qualifying shareholders at any time during the portion
of the taxable year that ends with the date on which the interest is
paid, or that the base erosion test is not met during the portion of the
taxable year that ends with the date on which the interest is paid;
(B) In the case of a foreign corporation that met the requirements
of Sec. 1.884-5(d) (relating to publicly-traded corporations) for the
preceding taxable year, the foreign corporation is listed on an
established securities exchange in the United States or its country of
residence at all times during the portion of the taxable year that ends
with the date on which the interest is paid and does not fail the
requirements of Sec. 1.884-5(d)(4)(iii) (relating to certain closely-
held corporations) at any time during such period; or
(C) In the case of a foreign corporation that met the requirements
of Sec. 1.884-5(e) (relating to the active trade or business test) for
the preceding taxable year, the foreign corporation continues to operate
(other than in a nominal degree), at all times during the portion of the
taxable year that ends with the date on which the interest is paid, the
same business in the U.S. and its country of residence that caused it to
meet such requirements for the preceding taxable year.
(iv) Treaties other than income tax treaties. A treaty that is not
an income tax treaty does not provide any benefits with respect to
branch interest.
(v) Effect of income tax treaties on interest paid by a partnership.
If a foreign corporation is a partner (directly or indirectly) in a
partnership that is engaged in a trade or business in the United States
and owns an interest of 10 percent or more (as determined under the
attribution rules of section 318) in the capital, profits, or losses of
the partnership at any time during the partner's taxable year, the
relief that may be claimed under an income tax treaty with respect to
the foreign corporation distributive share of interest paid or treated
as paid by the partnership shall not exceed the relief that would be
available under paragraphs (b)(8) (i) and (ii) of this section if such
interest were branch interest of the foreign corporation. See paragraph
(c)(2) of this section for the effect on a 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
[[Page 608]]
treaty in effect with the United States for a 5 percent rate of tax on
U.S. source interest paid to a resident of country Y. However, the bank
is not a qualified resident of country Y and the limitation on benefits
provision of the treaty has not been amended since December 31, 1986.
The partnership is required to withhold at a rate of 30 percent on $500
of the interest paid to the bank (i.e., A's 50 percent distributive
share of interest paid by the partnership) because the bank cannot,
under paragraph (b)(8)(iv) of this section, claim greater treaty
benefits by lending money to the partnership than it could claim, if it
lent money to A directly and the $500 were branch interest of A.
(c) Rules relating to excess interest--(1) Election to compute
excess interest by treating branch interest that is paid and accrued in
different years as if paid in year of accrual--(i) General rule. If
branch interest is paid in one or more taxable years before or after the
year in which the interest accrues, a foreign corporation may elect to
compute its excess interest as if such branch interest were paid on the
last day of the taxable year in which it accrues, and not in the taxable
year in which it is actually paid. The interest expense will thus reduce
the amount of the foreign corporation's excess interest in the year of
accrual rather than in the year of actual payment. Except as provided in
paragraph (c)(1)(ii) of this section, if an election is made for a
taxable year, this paragraph (c)(1)(i) shall apply to all branch
interest that is paid or accrued during that year. See paragraph (b)(7)
of this section for the effect of an election under this paragraph
(c)(1) on branch interest that accrues in a taxable year after the year
of payment.
(ii) Election not to apply in certain cases. An election under this
paragraph (c)(1) shall not apply to an interest expense that accrued in
a taxable year beginning before January 1, 1987, and shall not apply to
an interest expense that was paid in a taxable year beginning before
such date unless the interest was income from sources within the United
States. An election under this paragraph (c)(1) shall not apply to
branch interest that accrues during the taxable year and is paid in an
earlier taxable year if the branch interest reduced excess interest in
such earlier year. However, a foreign corporation may amend its income
tax return for such earlier taxable year so that the branch interest
does not reduce excess interest in such year.
(iii) Requirements for election. A foreign corporation that elects
to apply this paragraph (c)(1) shall attach to its income tax return (or
to an amended income tax return) a statement that it elects to have the
provisions of this paragraph (c)(1) apply, or shall provide written
notice to the Commissioner during an examination that it elects to apply
this paragraph (c)(1). The election shall be effective for the taxable
year to which the return relates and for all subsequent taxable years
unless the Commissioner consents to revocation of the election.
(iv) Examples. The following examples illustrate the application of
this paragraph (c)(1).
Example 1. Interest accrued before paid. Foreign corporation A, a
calendar year, accrual method taxpayer, has $100 of interest allocated
or apportioned to ECI under Sec. 1.882-5 for 1997. A has $60 of branch
interest in 1997 before application of this paragraph (c)(1). A has an
interest expense of $20 that properly accrues for tax purposes in 1997
but is not paid until 1998. When the interest is paid in 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
[[Page 609]]
excess interest for the year to the extent such interest is taken into
account by the foreign corporation in that year for purposes of
calculating the interest allocated or apportioned to the ECI of the
foreign corporation under Sec. 1.882-5. A foreign corporation's excess
interest shall not be reduced by its distributive share of partnership
interest that is attributable to a liability described in paragraph
(b)(3)(iii) of this section (relating to interest on liabilities
incurred in the ordinary course of a foreign business or secured
predominantly by assets that are not U.S. assets) or would be described
in paragraph (b)(3)(iii) of this section if entered on the partner's
books. See paragraph (b)(8)(v) of this section for the effect of income
tax treaties on interest paid by a partnership.
(ii) Special rule for interest that is paid and accrued in different
years. Paragraph (c)(2)(i) of this section shall not apply to any
portion of a foreign corporation's distributive share of partnership
interest that is paid and accrued in different taxable years unless the
foreign corporation has an election in effect under paragraph (c)(1) of
this section that is effective with respect to such interest and any tax
due under section 871(a) or 881(a) with respect to such interest has
been deducted and withheld at source in the earlier of the taxable year
of payment or accrual.
(3) Effect of treaties--(i) General rule. The rate of tax imposed on
the excess interest of a foreign corporation that is a resident of a
country with which the United States has an income tax treaty shall not
exceed the rate provided under such treaty that would apply with respect
to interest paid by a domestic corporation to that foreign corporation
if the foreign corporation meets, with respect to the excess interest,
the requirements of the limitation on benefits provision, if any, in the
treaty and either--
(A) The corporation is a qualified resident (as defined in Sec.
1.884-5(a)) of that foreign country for the taxable year in which the
excess interest is subject to tax; or
(B) The limitation on benefits provision, or an amendment to that
provision, entered into force after December 31, 1986.
(ii) Provisions relating to interest paid by a foreign corporation.
Any provision in an income tax treaty that exempts or reduces the rate
of tax on interest paid by a foreign corporation does not prevent
imposition of the tax on excess interest or reduce the rate of such tax.
(4) Example. The application of paragraphs (c)(2) and (3) of this
section is illustrated by the following example.
Example. Interest paid by a partnership. Foreign corporation A, a
calendar year taxpayer, is not a resident of a foreign country with
which the United States has an income tax treaty. A is engaged in the
conduct of a trade or business both in the United States and in foreign
countries, and owns a 50 percent interest in X, a calendar year
partnership engaged in the conduct of a trade or business in the United
States. For 1997, all of X's liabilities are of a type described in
paragraph (b)(1) of this section (relating to liabilities on U.S. books)
and none are described in paragraph (b)(3)(iii) of this section
(relating to liabilities that may not give rise to branch interest). A's
distributive share of interest paid by X in 1997 is $20. For 1997, A has
$150 of interest allocated or apportioned to its ECI under Sec. 1.882-
5, $120 of which is attributable to branch interest. Thus, the amount 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
[[Page 610]]
treated as made under paragraph (b)(7) of this section) during taxable
years of the payor beginning after such date. With respect to taxable
years beginning before October 13, 1992, and after December 31, 1986, a
foreign corporation may elect to apply this section in lieu of Sec.
1.884-4T of the temporary regulations (as contained in the CFR edition
revised as of April 1, 1992) as they applied to the foreign corporation
after issuance of Notice 89-80, 1989-2 C.B. 394, but only if the foreign
corporation has made an election under Sec. 1.884-1 (i) to apply Sec.
1.884-1 in lieu of Sec. 1.884-1T (as contained in the CFR edition
revised as of April 1, 1992) for that year, and the statute of
limitations for assessment of a deficiency has not expired for that
taxable year. Once an election has been made, an election under this
section shall apply to all subsequent taxable years.
(2) Special rule. Paragraphs (a)(1), (a)(2)(i)(A), (a)(2)(iii),
(b)(1), (b)(3), (b)(5)(i), (b)(6)(i), (b)(6)(ii), and (c)(2)(i) of this
section are effective for taxable years beginning on or after June 6,
1996.
(f) Transition rules--(1) Election under paragraph (c)(1) of this
section. If a foreign corporation has made an election described in
Sec. 1.884-4T(b)(7) (as contained in the CFR edition revised as of
April 1, 1992) with respect to interest that has accrued and been paid
in different taxable years, such election shall be effective for
purposes of paragraph (c)(1) of this section as if the corporation had
made the election under paragraph (c)(1) of this section of these
regulations.
(2) Waiver of notification requirement for non-banks under Notice
89-80. If a foreign corporation that is not a bank has made an election
under Notice 89-80 to apply the rules in part 2 of section I of the
Notice in lieu of the rules in Sec. 1.884-4T(b) (as contained in the
CFR edition revised as of April 1, 1992) to determine the amount of its
interest paid and excess interest in taxable years beginning prior to
1990, the requirement that the foreign corporation satisfy the
notification requirements described in paragraph (b)(3)(ii) of this
section is waived with respect to interest paid in taxable years ending
on or before the date the Notice was issued.
(3) Waiver of legending requirement for certain debt issued prior to
January 3, 1989. For purposes of sections 871(h), 881(c), and this
section, branch interest of a foreign corporation that would be treated
as portfolio interest under section 871(h) or 881(c) but for the fact
that it fails to meet the requirements of section 163(f)(2)(B)(ii)(II)
(relating to the legend requirement), shall nevertheless be treated as
portfolio interest provided the interest arises with respect to a
liability incurred by the foreign corporation before January 3, 1989,
and interest with respect to the liability was treated as branch
interest in a taxable year beginning before January 1, 1990.
[T.D. 8432, 57 FR 41660, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9341, Mar. 8,
1996]
Sec. 1.884-5 Qualified resident.
(a) Definition of qualified resident. A foreign corporation is a
qualified resident of a foreign country with which the United States has
an income tax treaty in effect if, for the taxable year, 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
[[Page 611]]
shareholders. A person shall be treated as a qualifying shareholder only
if such person meets the requirements of paragraph (b)(3) of this
section and is either--
(A) An individual who is either a resident of the foreign country of
which the foreign corporation is a resident or a citizen or resident of
the United States;
(B) The government of the country of which the foreign corporation
is a resident (or a political subdivision or local authority of such
country), or the United States, a State, the District of Columbia, or a
political subdivision or local authority of a State;
(C) A corporation that is a resident of the foreign country of which
the foreign corporation is a resident and whose stock is primarily and
regularly traded on an established securities market (within the meaning
of paragraph (d) of this section) in that country or the United States
or a domestic corporation whose stock is primarily and regularly traded
on an established securities market (within the meaning of paragraph (d)
of this section) in the United States;
(D) A not-for profit organization described in paragraph (b)(1)(iv)
of this section that is not a pension fund as defined in paragraph
(b)(8)(i)(A) of this section and that is organized under the laws of the
foreign country of which the foreign corporation is a resident or the
United States; or
(E) A beneficiary of certain pension funds (as defined in paragraph
(b)(8)(i)(A) of this section) administered in or by the country in which
the foreign corporation is a resident to the extent provided in
paragraph (b)(8) of this section.
Beneficial owners of an association taxable as a corporation shall be
treated as shareholders of such association for purposes of this
paragraph (b)(1). If stock of a foreign corporation is owned by a
corporation that is treated as a qualifying shareholder under paragraph
(b)(1)(i)(C) of this section, such stock shall not also be treated as
owned, directly or indirectly, by any qualifying shareholders of such
corporation for purposes of this paragraph (b). Notwithstanding the
above, a foreign corporation will not be treated as a qualified resident
unless it obtains the documentation described in paragraph (b)(3) of
this section to show that the requirements of this paragraph (b)(1)(i)
have been met and maintains the documentation as provided in paragraph
(b)(9) of this section. See also paragraph (b)(1)(iii) of this section,
which treats certain publicly-traded classes of stock as owned by
qualifying shareholders.
(ii) Special rules relating to qualifying shareholders. For purposes
of applying paragraph (b)(1)(i) of this section--
(A) Stock owned on any day shall be taken into account only if the
beneficial owner is a qualifying shareholder on that day or, in the case
of a corporation or not-for-profit organization that is a qualifying
shareholder under paragraph (b)(1)(i) (C) or (D) of this section, for a
one-year period that includes such day; and
(B) An individual, corporation or not-for-profit organization is a
resident of a foreign country if it is a resident of 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,
[[Page 612]]
foundation, league or other entity operated exclusively for religious,
charitable, educational, or recreational purposes, and it is not
organized for profit;
(B) It is generally exempt from tax in its country of organization
by virtue of its not-for-profit status; and
(C) Either--
(1) More than 50 percent of its annual support is expended on behalf
of persons described in paragraphs (b)(1)(i)(A) through (E) of this
section or on qualified residents of the country in which the
organization is organized; or
(2) More than 50 percent of its annual support is derived from
persons described in paragraphs (b)(1)(i) (A) through (E) of this
section or from persons who are qualified residents of the country in
which the organization is organized.
For purposes of meeting the requirements of paragraph (b)(1)(iv)(C) of
this section, a not-for-profit organization may rely on the addresses of
record of its individual beneficiaries and supporters to determine if
such persons are resident in the country in which the not-for-profit
organization is organized, provided that the addresses of record are not
nonresidential addresses such as a post office box or in care of a
financial intermediary, and the officers, directors or administrators of
the organization do not know or have reason to know that the individual
beneficiaries or supporters do not reside at that address.
(2) Rules for determining constructive ownership--(i) General rules
for attribution. For purposes of this section, stock owned by a
corporation, partnership, trust, estate, or mutual insurance company or
similar entity shall be treated as owned proportionately by its
shareholders, partners, beneficiaries, grantors or other interest
holders as provided in paragraph (b)(2)(ii) through (v) of this section.
The proportionate interest rules of this paragraph (b)(2) shall apply
successively upward through a chain of ownership, and a person's
proportionate interest shall be computed for the relevant days or period
that is taken into account in determining whether a foreign corporation
is a qualified resident. Except as otherwise provided, stock treated as
owned by a person by reason of this paragraph (b)(2) shall, for purposes
of applying this paragraph (b)(2), be treated as actually owned by such
person.
(ii) Partnerships. A partner shall be treated as having an interest
in stock of a foreign corporation owned by a partnership in proportion
to the least of--
(A) The partner's percentage distributive share of the partnership's
dividend income from the stock;
(B) The partner's percentage distributive share of gain from
disposition of the stock by the partnership;
(C) The partner's percentage distributive share of the stock (or
proceeds from the disposition of the stock) upon liquidation of the
partnership.
For purposes of this paragraph (b)(2)(ii), however, all qualifying
shareholders that are partners of a partnership shall be treated as one
partner. Thus, the percentage distributive 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
[[Page 613]]
(b)(2)(iii)(B) of this section. A substantially separate and independent
share of a trust, within the meaning of section 663(c), shall be treated
as a separate trust for purposes of this paragraph (b)(2)(iii)(A),
provided that payment of income, accumulated income or corpus of a share
of one beneficiary (or group of beneficiaries) cannot affect the
proportionate share of income, accumulated income or corpus of another
beneficiary (or group of beneficiaries).
(B) Grantor trusts. A person is treated as the owner of stock of a
foreign corporation owned by a trust to the extent that the stock is
included in the portion of the trust that is treated as owned by the
person under sections 671 to 679 (relating to grantors and others
treated as substantial owners).
(iv) Corporations that issue stock. A shareholder of a corporation
that issues stock shall be treated as owning stock of a foreign
corporation that is owned by such corporation on any day in a proportion
that equals the value of the stock owned by such shareholder to the
value of all stock of such corporation. If there is an agreement,
express or implied, that a shareholder of a corporation will not receive
distributions from the earnings of stock owned by the corporation, the
shareholder will not be treated as owning that stock owned by the
corporation.
(v) Mutual insurance companies and similar entities. Stock held by a
mutual insurance company, mutual savings bank, or similar entity
(including an association taxable as a corporation that does not issue
stock interests) shall be considered owned proportionately by the policy
holders, depositors, or other owners in the same proportion that such
persons share in the surplus of such entity upon liquidation or
dissolution.
(vi) Pension funds. See paragraphs (b)(8) (ii) and (iii) of this
section for the attribution of stock owned by a pension fund (as defined
in paragraph (b)(8)(i)(A)) to beneficiaries of the fund.
(vii) Examples. The rules of paragraph (b)(2)(ii) of this section
are illustrated by the following examples.
Example 1. Stock held solely by qualifying shareholders through a
partnership. A and B, residents of country X, are qualifying
shareholders, within the meaning of paragraphs (b)(1)(i) (A) through (E)
of this section, and the sole partners of partnership P. P's only asset
is the stock of foreign corporation Z, a country X corporation seeking
qualified resident status under this section. A's distributive share of
P's income and gain on the disposition of P's assets is 80 percent, but
A's distributive share of P's assets (or the proceeds therefrom) on P's
liquidation is 20 percent. B's distributive share of P's income and gain
is 20 percent and B is entitled to 80 percent of the assets (or proceeds
therefrom) on P's liquidation. Under the attribution rules of paragraph
(b)(2)(ii) of this section, A and B will be treated as a single partner
owning in the aggregate 100 percent of the stock of Z owned by P.
Example 2. Stock held by both qualifying and non-qualifying
shareholders through a partnership. Assume the same facts as in Example
1 except that C, an individual who is not a qualifying shareholder, is
also a partner in P and that C's distributive share of P's income is 60
percent. The distributive shares of A and B are the same as in Example 1
except that A's distributive share of income is 20 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
[[Page 614]]
(b)(8) of this section, a person shall only be treated as a qualifying
shareholder of a foreign corporation if--
(A) For the relevant period, the person completes an ownership
statement described in paragraph (b)(4) of this section and, in the case
of an individual who is not a U.S. citizen or resident, also obtains a
certificate of residency described in paragraph (b)(5) of this section;
(B) In the case of a person owning stock in the foreign corporation
indirectly through one or more intermediaries (including mere legal
owners or recordholders acting as nominees), each intermediary completes
an intermediary ownership statement described in paragraph (b)(6) of
this section; and
(C) Such ownership statements and certificates of residency are
received by the foreign corporation on or before the earlier of the date
it files its income tax return for the taxable year to which the
statements relate or the due date (including extensions) for filing such
return or, in the case of a foreign corporation claiming treaty benefits
under Sec. 1.884-4(b)(8) (i) or (ii) (relating to branch interest) on
or before the date on which such interest is paid.
(ii) Substitution of intermediary verification statement for
ownership statements and certificates of residency. If a qualifying
shareholder owns stock through an intermediary that is either a domestic
corporation, a resident of the United States, or a resident (for treaty
purposes) of a country with which the United States has an income tax
treaty in effect, the intermediary may provide an intermediary
verification statement (as described in paragraph (b)(7) of this
section) in place of any relevant ownership statements and certificates
of residency from qualifying shareholders, and in place of intermediary
ownership statements (or, where applicable, intermediary verification
statements) from all intermediaries standing in the chain of ownership
between the qualifying shareholders and the intermediary issuing the
intermediary verification statement. An intermediary verification
statement generally certifies that the verifying intermediary holds the
documentation described in the preceding sentence and agrees to make it
available to the District Director on request. Such intermediary
verification statements, along with an intermediary ownership statement
from the verifying intermediary, must be received by the foreign
corporation on or before the earlier of the date if files its income tax
return for the taxable year to which the statements relate or the due
date (including extensions) for filing such return. An indirect owner of
a foreign corporation is thus treated as a qualifying shareholder of a
foreign corporation if the foreign corporation receives, on or before
the time specified above, an intermediary verification statement and an
intermediary ownership statement from the verifying intermediary and an
intermediary ownership statement from all intermediaries standing in the
chain of the verifying intermediary's 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
[[Page 615]]
in paragraph (b)(8)(i)(A) of this section).
(v) Reasonable cause exception. If a foreign corporation does not
obtain the documentation described in this paragraph (b)(3) or (b)(8) of
this section in a timely manner but is able to show prior to
notification of an examination of the return for the taxable year that
the failure was due to reasonable cause and not willful neglect, the
foreign corporation may perfect the documentation after the deadlines
specified in this paragraph (b)(3) or (b)(8) of this section. It may
make such a showing by providing a written statement to the District
Director having jurisdiction over the taxpayer's return or the Office of
the Assistant Commissioner (International), as applicable, setting forth
the reasons for the failure to obtain the documentation in a timely
manner and describing the documentation that was received after the
deadline had passed. Whether a failure to obtain the documentation in a
timely manner was due to reasonable cause shall be determined by the
District Director or the Office of the Assistant Commissioner
(International), as applicable, under all the facts and circumstances.
(4) Ownership statements from qualifying shareholders--(i) Ownership
statements from individuals. An ownership statement from an individual
is a written statement signed by the individual under penalties of
perjury stating--
(A) The name, permanent address, and country of residence of the
individual and, if the individual was not a resident of the country for
the entire taxable year of the foreign corporation seeking qualified
resident status, the period during which it was a resident of the
foreign corporation's country of residence;
(B) If the individual is a direct beneficial owner of stock in the
foreign corporation, the name of the corporation, the number of shares
in each class of stock of the corporation that are so owned, and the
period of time during the taxable year of the foreign corporation during
which the individual owned the stock (or, in the case of an association
taxable as a corporation, the amount and nature of the owner's interest
in such association);
(C) If the individual directly owns an interest in a corporation,
partnership, trust, estate or other intermediary that owns (directly or
indirectly) stock in the foreign corporation, the name of the
intermediary, the number and class of shares or amount and nature of the
interest of the individual in such intermediary (that is relevant for
purposes of attributing ownership in paragraph (b)(2) of this section),
and the period of time during the taxable year of the foreign
corporation during which the individual held such interest; and
(D) To the extent known by the individual, a description of the
chain of ownership through which the individual owns stock in the
foreign corporation, including the name and address of each intermediary
standing between the intermediary described in paragraph (b)(4)(i)(C) of
this section and the foreign corporation.
(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--
[[Page 616]]
(A) The name, permanent address, and principal place of business of
the corporation (if different from its permanent address);
(B) The information described in paragraphs (b)(4)(i) (B) through
(D) of this section (substituting ``corporation'' for ``individual'');
and
(C) That the corporation's stock is primarily and regularly traded
on an established securities exchange (within the meaning of paragraph
(d) of this section) in the United States or its country of residence.
(iv) Ownership statements from not-for-profit organizations. An
ownership statement from a not-for-profit organization (other than a
pension fund as defined in paragraph (b)(8)(i)(A) of this section) is a
written statement signed by a person authorized to sign a tax return on
behalf of the organization under penalties of perjury stating--
(A) The name, permanent address, and principal location of the
activities of the organization (if different from its permanent
address);
(B) The information described in paragraphs (b)(4)(i) (B) through
(D) of this section (substituting ``not-for-profit organization'' for
``individual'') with respect to the not-for-profit organization's direct
or indirect ownership of stock in the foreign corporation seeking
qualified resident status; and
(C) That the not-for-profit organization satisfies the requirements
of paragraph (b)(1)(iv) of this section.
(v) Ownership through a nominee. For purposes of this paragraph
(b)(4) and paragraph (b)(6) of this section, a person who owns either
stock in a foreign corporation seeking qualified resident status or an
interest in an intermediary described in paragraph (b)(4)(i)(C) of this
section through a nominee shall be treated as owning such stock or
interest directly and must, therefore, provide the information described
in paragraphs (b)(4) (i) through (iv) of this section, as applicable.
Such person must also provide the name and address of the nominee.
(5) Certificate of residency. A certificate of residency must be
signed by the relevant authorities (as described below) of the country
of residence of the individual shareholder and must state that the
individual is a resident of that country for purposes of its income tax
laws or, if the authorities do not customarily make such a
determination, that the individual has filed a tax return claiming
resident status and subjecting the individual's income to tax on a
resident basis for the taxable year or period that ends with or within
the taxable year for which the corporation is seeking qualified resident
status. In the case of an individual who is not legally required to file
a tax return in his or her country of residence or in any other country,
a certificate of residency of a parent or guardian residing at such
individual's address shall be considered sufficient to meet that
individual's obligation under this paragraph (b)(5). The relevant
authorities shall be the competent authority of the foreign country of
which the foreign corporation is a resident, as defined in the income
tax 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
[[Page 617]]
intermediary's direct or indirect ownership in the stock in the foreign
corporation seeking qualified resident status;
(iii) If the intermediary is a nominee for a qualifying shareholder
or another intermediary, the name and permanent address of the
qualifying shareholder, or the name and principal place of business of
such other intermediary;
(iv) If the intermediary is not a nominee for a qualifying
shareholder or another intermediary, the proportionate interest in the
intermediary of each direct shareholder, partner, beneficiary, grantor,
or other interest holder (or if the direct holder is a nominee, of its
beneficial shareholder, partner, beneficiary, grantor, or other interest
holder) from which the intermediary received an ownership statement and
the period of time during the taxable year for which the interest in the
intermediary was owned by such shareholder, partner, beneficiary,
grantor or other interest holder. For purposes of this paragraph
(b)(6)(iv), the proportionate interest of a person in an intermediary is
the percentage interest (by value) held by such person, determined using
the principles for attributing ownership in paragraph (b)(2) of this
section. If an intermediary is not required to receive an ownership
statement from its individual registered shareholders or other interest
holders by reason of paragraph (b)(3)(iii) of this section, then it must
provide a list of the names and addresses of such registered
shareholders or other interest holders and the aggregate proportionate
interest in the intermediary of such registered shareholders or other
interest holders.
(7) Intermediary verification statement. An intermediary
verification statement that may be substituted for certain documentation
under paragraph (b)(3)(ii) of this section is a written statement signed
under penalties of perjury by the intermediary (if the intermediary is
an individual) or by a person that would be authorized to sign a tax
return on behalf of the intermediary (if the verifying intermediary is
not an individual) containing the following information--
(i) The name, principal place of business, and country of residence
of the verifying intermediary;
(ii) A statement that the verifying intermediary has obtained
either--
(A) An ownership statement and, if applicable, a certificate of
residency from a qualifying shareholder with respect to the foreign
corporation seeking qualified resident status, and an intermediary
ownership statement from each intermediary standing in the chain of
ownership between the verifying intermediary and the qualifying
shareholder; or
(B) An intermediary verification statement substituting for the
documentation described in paragraph (b)(7)(ii)(A) and an intermediary
ownership statement from such intermediary and each intermediary
standing in the chain of ownership between such intermediary and the
verifying intermediary;
(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
[[Page 618]]
exclusively for the benefit of employees or former employees of one or
more employers, the principal purpose of which is to provide retirement,
disability, and death benefits to beneficiaries of such entity and
persons designated by such beneficiaries in consideration for prior
services rendered.
(B) Beneficiary. For purposes of this section, the term
``beneficiary'' of a pension fund shall mean any person who has made
contributions to the pension fund, or on whose behalf contributions have
been made, and who is currently receiving retirement, disability, or
death benefits from the pension fund or can reasonably be expected to
receive such benefits in the future, whether or not the person's right
to receive benefits from the fund has vested.
(ii) Government pension funds. An individual who is a beneficiary of
a pension fund that would be a controlled entity of a foreign sovereign
within the principles of Sec. 1.892-2T(c)(1) of the regulations
(relating to pension funds established for the benefit of employees or
former employees of a foreign government) shall be treated as a
qualifying shareholder of a foreign corporation in which the pension
fund owns a direct or indirect interest without having to meet the
documentation requirements under paragraph (b)(3)(i)(A) of this section,
if the foreign corporation is resident in the country of the foreign
sovereign and the trustees, directors, or other administrators of the
pension fund provide, with the pension fund's intermediary ownership
statement described in paragraph (b)(6) of this section, a written
statement that the fund is a controlled entity described in this
paragraphs (b)(8)(ii). See paragraph (b)(4)(ii) of this section
regarding an ownership statement from a pension fund that is an integral
part of a foreign government.
(iii) Non-government pension funds. For purposes of this section, an
individual who is a beneficiary of a pension fund not described in
paragraph (b)(8)(ii) of this section shall be treated as a qualifying
shareholder of a foreign corporation owned directly or indirectly by
such pension fund without having to meet the documentation requirements
under paragraph (b)(3)(i)(A) of this section, if--
(A) The pension fund is administered in the foreign corporation's
country of residence and is subject to supervision or regulation by a
governmental authority (or other authority delegated to perform such
supervision or regulation by a governmental authority) in such country;
(B) The pension fund is generally exempt from income taxation in its
country of administration;
(C) The pension fund has 100 or more beneficiaries;
(D) The beneficiary's address, as it appears on the records of the
fund, is in the foreign corporation's country of residence or the United
States and is not a nonresidential address, such as a post office box or
in care of a financial intermediary, and none of the trustees, directors
or other administrators of the pension fund know, or have reason to
know, that the beneficiary is not an individual resident of such foreign
country or the United States;
(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
[[Page 619]]
of such beneficiaries to all beneficiaries of the pension fund (rather
than on the basis of the rules in paragraph (b)(2) of this section) if--
(A) The pension fund meets the requirements of paragraphs
(b)(8)(iii) (A), (B), and (C) of this section;
(B) The trustees, directors or other administrators of the pension
fund have no knowledge, and no reason to know, that the ratio of the
pension fund's beneficiaries who are residents of either the country in
which the pension fund is administered or of the United States to all
beneficiaries of the pension fund would differ significantly from the
ratio of the sum of the actuarial interests of such residents in the
pension fund to the actuarial interests of all beneficiaries in the
pension fund (or, if the beneficiaries' actuarial interest in the stock
held directly or indirectly by the pension fund differs from the
beneficiaries' actuarial interest in the pension fund, the ratio of
actuarial interests computed by reference to the beneficiaries'
actuarial interest in the stock);
(C) Either--
(1) Any overfunding of the pension fund would be payable, pursuant
to the governing instrument or the laws of the foreign country in which
the pension fund is administered, only to, or for the benefit of, one or
more corporations that are qualified residents of the country in which
the pension fund is administered, individual beneficiaries of the
pension fund or their designated beneficiaries, or social or charitable
causes (the reduction of the obligation of the sponsoring company or
companies to make future contributions to the pension fund by reason of
overfunding shall not itself result in such overfunding being deemed to
be payable to or for the benefit of such company or companies); or
(2) The foreign country in which the pension fund is administered
has laws that are designed to prevent overfunding of a pension fund and
the funding of the pension fund is within the guidelines of such laws;
or
(3) The pension fund is maintained to provide benefits to employees
in a particular industry, profession, or group of industries or
professions and employees of at least 10 companies (other than companies
that are owned or controlled, directly or indirectly, by the same
interests) contribute to the pension fund or receive benefits from the
pension fund; and
(D) The trustees, directors or other administrators provide, with
the pension fund's intermediary ownership statement described in
paragraph (b)(6) of this section, a written statement signed under
penalties of perjury certifying that the requirements in paragraphs
(b)(8)(iv) (A), (B), and either (C)(1), (C)(2) or (C)(3) of this section
have been met.
The statement described in paragraph (b)(8)(iv) (D) of this section may
be combined, in a single statement, with the information required in
paragraph (b)(8)(iv) (F) of this section.
(v) Time for making determinations. The determinations required to
be made under this paragraph (b)(8) shall be made using information
shown on the records of the pension fund for a date on or after the
beginning of the 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.
[[Page 620]]
Example 1. Foreign corporation A is a resident of country L, which
has an income tax treaty in effect with the United States. Foreign
corporation A has one class of stock issued and outstanding consisting
of 1,000 shares, which are beneficially owned by the following alien
individuals, directly or by application of paragraph (b)(2) of this
section:
------------------------------------------------------------------------
Shares
owned,
directly or
indirectly
by
Individual application Percentage
of
paragraph
(b)(2) of
this
section
------------------------------------------------------------------------
T--resident of the U.S......................... 200 20
U--resident of country L....................... 400 40
V--resident of country M....................... 100 10
W--resident of country L....................... 210 21
X--resident of country N....................... 90 9
------------------------
Total...................................... 1,000 100
------------------------------------------------------------------------
(i) T owns his 200 shares directly and is a beneficial owner.
(ii) U and V own, respectively, an 80 percent and a 20 percent
actuarial interest in foreign trust FT, (which interest does not differ
from their respective interests in the stock owned by FT), which
beneficially owns 100 percent of the stock of a foreign corporation B
with bearer shares, which beneficially owns 500 shares of foreign
corporation A. Foreign corporation B is incorporated in a country that
does not have an income tax treaty with the United States. The foreign
trust has deposited the bearer shares it owns in B with a bank in a
foreign country that has an income tax treaty with the United States.
(iii) W beneficially owns all the shares of foreign corporation C,
which are registered in the name of individual Z, a nominee, who resides
in country L; foreign corporation C beneficially owns a 70 percent
interest in foreign corporation D, which beneficially owns 300 shares of
A. D's shares are bearer shares that C (not a resident of a country with
which the United States has an income tax treaty) has deposited with a
bank in a foreign country that has an income tax treaty with the United
States.
(iv) X beneficially owns a 30 percent interest in foreign
corporation D.
(v) A is a qualified resident of country L if it obtains the
applicable documentation described in paragraph (b)(3) of this section
either with respect to ownership by individuals U and W or with respect
to ownership by individuals T and U, since either combination of
qualifying shareholders of foreign corporation A will exceed 50 percent.
Example 2. Assume the same facts as in Example 1 and assume that
foreign corporation A chooses to obtain documentation with respect to
individuals T and U.
(i) A must obtain, pursuant to paragraph (b)(3)(i) of this section,
an ownership statement (as described in paragraph (b)(4)(i) of this
section) signed by T. T is not required to furnish a certificate of
residency because T is a U.S. resident.
(ii) U must provide foreign trust FT with an ownership statement and
certificate of residency, as described in paragraphs (b)(4) and (b)(5)
of this section. The trustees of FT must provide the depository bank
holding foreign corporation B's bearer shares with an intermediary
ownership statement concerning its beneficial ownership of B's shares
and must attach to it the documentation provided by U. The depository
bank must provide B with an intermediary ownership statement regarding
its holding of B shares on behalf of FT and has the choice of
attaching--
(A) The documentation from U and the intermediary ownership
statement from FT; or
(B) An intermediary verification statement described in paragraph
(b)(7) of this section, in which case foreign corporation B would not be
provided with U's individual documentation or FT's intermediary
ownership statement, both of which are retained by the depository bank.
(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
[[Page 621]]
documentation regarding W and an intermediary ownership statement from
each intermediary standing in the chain of W's indirect beneficial
ownership of shares in A, i.e., from individual Z, foreign corporation
C, the depository bank in the foreign treaty country, and foreign
corporation D. In the alternative, A must obtain, under paragraph
(b)(3)(ii) of this section, either--
(i) An intermediary verification statement by the depository bank in
the foreign treaty country and an intermediary ownership statement from
the bank and from D; or
(ii) An intermediary verification statement from Z and an
intermediary ownership statement from Z and from each intermediary
standing in the chain of ownership of shares in foreign corporation A,
i.e., from C, the depository bank in the foreign treaty country and D. C
may not issue an intermediary verification statement because it is not a
resident of a country with which the United States has an income tax
treaty.
(c) Base erosion. A foreign corporation satisfies the requirement
relating to base erosion for a taxable year if it establishes that less
than 50 percent of its income for the taxable year is used (directly or
indirectly) to make deductible payments in the current taxable year to
persons who are not residents (or, in the case of foreign corporations,
qualified residents) of the foreign country of which the foreign
corporation is a resident and who are not citizens or residents (or, in
the case of domestic corporations, qualified residents) of the United
States. Whether a domestic corporation is a qualified resident of the
United States shall be determined under the principles of this section.
For purposes of this paragraph (c), the term ``deductible payments''
includes payments that would be ordinarily deductible under U.S. income
tax principles without regard to other provisions of the Code that may
require the capitalization of the expense, or disallow or defer the
deduction. Such payments include, for example, interest, rents,
royalties and reinsurance premiums. For purposes of this paragraph (c),
the income of a foreign corporation means the corporation's gross income
for the taxable year (or, if the foreign corporation has no gross income
for the taxable year, the average of its gross income for the three
previous taxable years) under U.S. tax principles, but not excluding
items of income otherwise excluded from gross income under U.S. tax
principles.
(d) Publicly-traded corporations--(1) General rule. A foreign
corporation that is a resident of a foreign country shall be treated as
a qualified resident of that country for any taxable year in which--
(i) Its stock is primarily and regularly traded (as defined in
paragraphs (d) (3) and (4) of this section) on one or more established
securities markets (as defined in paragraph (d)(2) of this section) in
that country, or in the United States, or both; or
(ii) At least 90 percent of the total combined voting power of all
classes of stock of such foreign corporation entitled to vote and at
least 90 percent of the total value of the stock of such foreign
corporation is owned, directly or by application of paragraph (b)(2) of
this section, by a foreign corporation that is a resident of the same
foreign country or a domestic corporation and the stock of such parent
corporation is primarily and regularly traded on an established
securities market in that foreign country or in the United States, or
both.
(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.
[[Page 622]]
(iii) Computation of dollar value of stock traded. For purposes of
paragraph (d)(2)(i)(A) of this section, the value in U.S. dollars of
shares traded during a calendar year shall be determined on the basis of
the dollar value of such shares traded as reported by the International
Federation of Stock Exchanges, located in Paris, or, if not so reported,
then by converting into U.S. dollars the aggregate value in local
currency of the shares traded using an exchange rate equal to the
average of the spot rates on the last day of each month of the calendar
year.
(iv) Definition of over-the-counter market. An over-the-counter
market is any market reflected by the existence of an interdealer
quotation system. An interdealer quotation system is any system of
general circulation to brokers and dealers that regularly disseminates
quotations of stocks and securities by identified brokers or dealers,
other than by quotation sheets that are prepared and distributed by a
broker or dealer in the regular course of business and that contain only
quotations of such broker or dealer.
(v) Discretion to determine that an exchange qualifies as an
established securities market. The Commissioner may, in his sole
discretion, determine in a published document that a securities exchange
that does not meet the requirements of paragraph (d)(2)(i)(A) of this
section qualifies as an established securities market. Such a
determination will be made only if it is established that--
(A) The exchange, in substance, has the attributes of an established
securities market (including adequate trading volume, and comparable
listing and financial disclosure requirements);
(B) The rules of the exchange ensure active trading of listed
stocks; and
(C) The exchange is a member of the International Federation of
Stock Exchanges.
(vi) Discretion to determine that an exchange does not qualify as an
established securities market. The Commissioner may, in his sole
discretion, determine in a published document that a securities exchange
that meets the requirements of paragraph (d)(2)(i) of this section does
not qualify as an established securities market. Such determination
shall be made if, in the view of the Commissioner--
(A) The exchange does not have adequate listing, financial
disclosure, or trading requirements (or does not adequately enforce such
requirements); or
(B) There is not clear and convincing evidence that the exchange
ensures the active trading of listed stocks.
(3) Primarily traded. For purposes of this section, stock of a
corporation is ``primarily traded'' on one or more established
securities markets in the corporation's country of residence or in the
United States in any taxable year if, with respect to each class
described in paragraph (d)(4)(l)(i)(A) of this section (relating to
classes of stock relied on to meet the regularly traded test)--
(i) The number of shares in each class that are traded during the
taxable year on all established securities markets in the corporation's
country of residence or in the United States during the taxable year
exceeds
(ii) The number of shares in each such class that are traded during
that year on established securities markets in any other single foreign
country.
(4) Regularly traded--(i) General rule. For purposes of this
section, stock of a 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
[[Page 623]]
year is at least 10 percent of the average number of shares outstanding
in that class during the taxable year (or, in the case of a short
taxable year, a percentage that equals at least 10 percent of the number
of days in the short taxable year divided by 365).
If stock of a foreign corporation fails the 80 percent requirement of
paragraph (d)(4)(i)(A) of this section, but a class of such stock meets
the trading requirements of paragraph (d)(4)(i)(B) of this section, such
class of stock may be taken into account under paragraph (b)(1)(iii) of
this section as owned by qualifying shareholders for purposes of meeting
the ownership test of paragraph (b)(1) of this section.
(ii) Classes of stock traded on a domestic established securities
market treated as meeting trading requirements. A class of stock that is
traded during the taxable year on an established securities market
located in the United States shall be treated as meeting the trading
requirements of paragraph (d)(4)(i)(B) of this section if the stock is
regularly quoted by brokers or dealers making a market in the stock. A
broker or dealer makes a market in a stock only if the broker or dealer
holds himself out to buy or sell the stock at the quoted price.
(iii) Closely-held classes of stock not treated as meeting trading
requirement--(A) General rule. A class of stock shall not be treated as
meeting the trading requirements of paragraph (d)(4)(i)(B) of this
section (or the requirements of paragraph (d)(4)(ii) of this section)
for a taxable year if, at any time during the taxable year, one or more
persons who are not qualifying shareholders (as defined in paragraph
(b)(1) of this section) and who each beneficially own 5 percent or more
of the value of the outstanding shares of the class of stock own, in the
aggregate, 50 percent or more of the outstanding shares of the class of
stock for more than 30 days during the taxable year. For purposes of the
preceding sentence, shares shall not be treated as owned by a qualifying
shareholder unless such shareholder provides to the foreign corporation,
by the time prescribed in paragraph (b)(3) of this section, the
documentation described in paragraph (b)(3) of this section necessary to
establish that it is a qualifying shareholder. For purposes of this
paragraph (d)(4)(iii)(A), shares of stock owned by a pension fund, as
defined in paragraph (b)(8)(i)(A) of this section, shall be treated as
beneficially owned by the beneficiaries of such fund, as defined in
paragraph (b)(8)(i)(B) of this section.
(B) Treatment of related persons. Persons related within the meaning
of section 267(b) shall be treated as one person for purposes of this
paragraph (d)(4)(iii). In determining whether two or more corporations
are members of the same controlled group under section 267(b)(3), a
person is considered to own stock owned directly by such person, stock
owned with the application of section 1563(e)(1), and stock owned with
the application of section 267(c). Further, in determining whether a
corporation is related to a partnership under section 267(b)(10), a
person is considered to own the partnership interest owned directly by
such person and the partnership interest owned with the application of
section 267(e)(3).
(iv) Anti-abuse rule. Trades between persons described in section
267(b) (as modified in paragraph (d)(4)(iii)(B) of 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
[[Page 624]]
bearer shares, will meet the burden of proof if it has no reason to know
and no actual knowledge of facts that would cause the corporation's
stock not to be treated as regularly traded under such paragraphs. A
foreign corporation that has shareholders of record must also maintain a
list of such shareholders and, on request, make available to the
District Director such list and any other relevant information known to
the foreign corporation.
(e) Active trade or business--(1) General rule. A foreign
corporation that is a resident of a foreign country shall be treated as
a qualified resident of that country with respect to any U.S. trade or
business if, during the taxable year--
(i) It is engaged in the active conduct of a trade or business (as
defined in paragraph (e)(2) of this section) in its country of
residence;
(ii) It has a substantial presence (within the meaning of paragraph
(e)(3) of this section) in its country of residence; and
(iii) Either--
(A) Such U.S. trade or business is an integral part (as defined in
paragraph (e)(4) of this section) of an active trade or business
conducted by the foreign corporation in its country of residence; or
(B) In the case of interest received by the foreign corporation for
which a treaty exemption or rate reduction is claimed pursuant to Sec.
1.884-4(b)(8)(ii), the interest is derived in connection with, or is
incidental to, a trade or business described in paragraph (e)(1)(i) of
this section.
A foreign corporation may determine whether it is a qualified resident
under this paragraph (e) by applying the rules of this paragraph (e) to
the entire affiliated group (as defined in section 1504 (a) without
regard to section 1504(b)(2) or (3)) of which the foreign corporation is
a member rather than to the foreign corporation separately. If a foreign
corporation chooses to apply the rules of this paragraph (e) to its
entire affiliated group as provided in the preceding sentence, then it
must apply such rules consistently to all of its U.S. trades or
businesses conducted during the taxable year.
(2) Active conduct of a trade or business. A foreign corporation is
engaged in the active conduct of a trade or business only if either--
(i) It is engaged in the active conduct of a trade or business
within the meaning of section 367(a)(3) and the regulations thereunder;
or
(ii) It qualifies as a banking or financing institution under the
laws of the foreign country of which it is a resident, it is licensed to
do business with residents of its country of residence, and it is
engaged in the active conduct of a banking, financing, or similar
business within the meaning of Sec. 1.864-4(c)(5)(i) in its country of
residence.
A foreign corporation that is an insurance company within the meaning of
Sec. 1.801-3 (a) or (b) is engaged in the active conduct of a trade or
business only if it is predominantly engaged in the active conduct of an
insurance business within the meaning of section 952(c)(1)(B)(v) and the
regulations thereunder.
(3) Substantial presence test--(i) General rule. Except as provided
in paragraph (e)(3)(ii) of this section, a foreign 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.
[[Page 625]]
(ii) Special rules--(A) Asset ratio. For purposes of paragraph
(e)(3)(i)(A) of this section, the value of an asset shall be determined
using the method used by the taxpayer in keeping its books for purposes
of financial reporting in its country of residence. An asset shall be
treated as used or held for use in a foreign corporation's trade or
business if it meets the requirements of Sec. 1.367(a)-2(d)(5). Stock
held by a foreign corporation shall not be treated as an asset of the
foreign corporation for purposes of paragraph (e)(3)i)(A) of this
section if the foreign corporation owns 10 percent or more of the total
combined voting power of all classes of stock of such corporation
entitled to vote. The rules of Sec. 1.954-2T(b)(3) (other than Sec.
1.954-2T(b)(3)(x)) shall apply to determine the location of assets used
or held for use in a trade or business. Loans originated or acquired in
the course of the normal customer loan activities of a banking,
financing or similar institution, and securities and derivative
financial instruments held by dealers, traders and insurance companies
for use in a trade or business shall be treated as located in the
country in which an office or other fixed place of business is primarily
responsible for the acquisition of the asset and the realization of
income, gain or loss with respect to the asset.
(B) Gross income ratio--(1) General rule. For purposes of paragraph
(e)(3)(i)(B) of this section, the term ``gross income'' means the gross
income of a foreign corporation for purposes of financial reporting in
its country of residence. Gross income shall not include, however,
dividends, interest, rent, or royalties unless such corporation derives
such dividends, interest, rents, or royalties in the active conduct of
its trade or business. Gross income shall also not include gain from the
disposition of stock if the foreign corporation owns 10 percent or more
of the total combined voting power of all classes of stock of such
corporation entitled to vote. Except as provided in this paragraph
(e)(3)(ii)(B), the principles of sections 861 through 865 shall apply to
determine the amount of gross income of a foreign corporation derived
within its country of residence.
(2) Banks, dealers and traders. Dividend income and gain from the
sale of securities, or from entering into or disposing of derivative
financial instruments by dealers and traders in such securities or
derivative financial instruments shall be treated as derived within the
country where the assets are located under paragraph (e)(3)(ii)(A) of
this section. Other income, including interest and fees, earned in the
active conduct of a banking, financing or similar business shall be
treated as derived within the country where the payor of such interest
or other income resides. For purposes of the preceding sentence, if a
branch or similar establishment outside the country in which the payor
resides makes a payment of interest or other income, such amounts shall
be treated as derived within the country in which the branch or similar
establishment is located.
(3) Insurance companies. The gross income of a foreign insurance
company shall include only gross premiums received by the country.
(4) Other corporations. Gross income from the performance of
services, including transportation services, shall 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,
[[Page 626]]
agent or a ``leased employee'' shall be treated as incurred where the
employee, agent or ``leased employee'' performs services on behalf of
the corporation.
(iii) Exception to gross income test for foreign corporations
engaged in certain trades or businesses. In determining whether a
foreign corporation engaged primarily in selling tangible property or in
manufacturing, producing, growing, or extracting tangible property has a
substantial presence in its country of residence for purposes of
paragraph (e)(3)(i) of this section, the foreign corporation may apply
the ratio provided in this paragraph (e)(3)(iii) instead of the ratio
described in paragraph (e)(3)(i)(B) of this section (relating to the
ratio of gross income derived from its country of residence). This ratio
shall be the ratio of the direct material costs of the foreign
corporation with respect to tangible property manufactured, produced,
grown, or extracted in the foreign corporation's country of residence to
the total direct material costs of the foreign corporation.
(4) Integral part of an active trade or business in a foreign
corporation's country of residence--(i) In general. A U.S. trade or
business of a foreign corporation is an integral part of an active trade
or business conducted by a foreign corporation in its country of
residence if the active trade or business conducted by the foreign
corporation in both its country of residence and in the United States
comprise, in principal part, complementary and mutually interdependent
steps in the United States and its country of residence in the
production and sale or lease of goods or in the provision of services.
Subject to the presumption and de minimis rule in paragraphs (e)(4)
(iii) and (iv) of this section, if a U.S. trade or business of a foreign
corporation sells goods that are not, in principal part, manufactured,
produced, grown, or extracted by the foreign corporation in its country
of residence, such business shall not be treated as an integral part of
an active trade or business conducted in the foreign corporation's
country of residence unless the foreign corporation takes physical
possession of the goods in a warehouse or other storage facility that is
located in its country of residence and in which goods of such type are
normally stored prior to sale to customers in such country.
(ii) Presumption for banks. A U.S. trade or business of a foreign
corporation that is described in Sec. 1.884-4(a)(2)(iii) shall be
presumed to be an integral part of an active banking business conducted
by the foreign corporation in its country of residence provided that a
substantial part of the business of the foreign corporation in both its
country of residence and the United States consists of receiving
deposits and making loans and discounts. This paragraph shall be
effective for taxable years beginning on or after June 6, 1996.
(iii) Presumption if business principally conducted in country of
residence. A U.S. trade or business of a foreign corporation shall be
treated as an integral part of an active trade or business of a foreign
corporation in its country or residence with respect to the sale or
lease of property (or the performance of services) if at least 50
percent of the foreign corporation's worldwide gross income from the
sale or lease of property of 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
[[Page 627]]
trades or businesses that meet the integral part test of this paragraph
(e)(4), all of the U.S. trades or businesses of the foreign corporation
shall be treated as an integral part of an active or business conducted
by the foreign corporation. If a foreign corporation has more than one
U.S. trade or business and does not meet the requirements of the
preceding sentence but otherwise meets the requirements of this
paragraph (e)(4) with regard to one or more trade or business, see Sec.
1.884-1(g)(1) to determine the extent to which treaty benefits apply to
such corporation.
(f) Qualified resident ruling--(1) Basis for ruling. In his or her
sole discretion, the Commissioner may rule that a foreign corporation is
a qualified resident of its country or residence if the Commissioner
determines that individuals who are not residents of the foreign country
of which the foreign corporation is a resident do not use the treaty
between that country and the United States in a manner inconsistent with
the purposes of section 884. The purposes of section 884 include, but
are not limited to, the prevention of treaty shopping by an individual
with respect to any article of an income tax treaty between the country
of residence of the foreign corporation and the United States.
(2) Factors. In order to make this determination, the Commissioner
may take into account the following factors, including, but not limited
to:
(i) The business reasons for establishing and maintaining the
foreign corporation in its country of residence;
(ii) The date of incorporation of the foreign corporation in
relation to the date that an income tax treaty between the United States
and the foreign corporation's country of residence entered into force;
(iii) The continuity of the historical business and ownership of the
foreign corporation;
(iv) The extent to which the foreign corporation meets the
requirements of one or more of the tests described in paragraphs (b)
through (e) of this section;
(v) The extent to which the U.S. trade or business is dependent on
capital, assets, or personnel of the foreign trade or business;
(vi) The extent to which the foreign corporation receives special
tax benefits in its country of residence;
(vii) Whether the foreign corporation is a member of an affiliated
group (as defined in section 1504(a) without regard to section
1504(b)(2) or (3)), that has no members resident outside the country of
residence of the foreign corporation; and
(viii) The extent to which the foreign corporation would be entitled
to comparable treaty benefits with respect to all articles of an income
tax treaty that would apply to that corporation if it had been
incorporated in the country or countries of residence of the majority of
its shareholders. For purposes of the preceding sentence, shareholders
taken into account shall generally be limited to persons described in
paragraph (b)(1)(i) of this section but for the fact that they are not
residents of the foreign corporation's country of residence.
(3) Procedural requirements. A request for a ruling under this
paragraph (f) must be submitted on or before the due date (including
extensions) of the foreign corporation's income tax return 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,
[[Page 628]]
1992. With respect to a taxable year beginning before October 13, 1992,
and after December 31, 1986, a foreign corporation may elect to apply
this section in lieu of the temporary regulations under 1.884-5T (as
contained in the CFR edition revised as of April 1, 1992), but only if
the statute of limitations for assessment of a deficiency has not
expired for that taxable year. Once an election has been made, an
election shall apply to all subsequent taxable years.
(h) Transition rule. If a foreign corporation elects to apply this
section in lieu of Sec. 1.884-5T (as contained in the CFR edition
revised as of April 1, 1992) as provided in paragraph (g) of this
section, and the application of paragraph (b) of this section results in
additional documentation requirements in order for the foreign
corporation to be treated as a qualified resident, the foreign
corporation must obtain the documentation required under that paragraph
on or before March 11, 1993.
[T.D. 8432, 57 FR 41666, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9343, Mar. 8,
1996; 61 FR 14248, Apr. 1, 1996; T.D. 9803, 81 FR 91030, Dec. 16, 2016]
miscellaneous provisions
Sec. 1.891 Statutory provisions; doubling of rates of tax on citizens and corporations of certain foreign countries.
Sec. 891. Doubling of rates of tax on citizens and corporations of
certain foreign countries. Whenever the President finds that, under the
laws of any foreign country, citizens or corporations of the United
States are being subjected to discriminatory or extraterritorial taxes,
the President shall so proclaim and the rates of tax imposed by sections
1, 3, 11, 802, 821, 831, 852, 871, and 881 shall, for the taxable year
during which such proclamation is made and for each taxable year
thereafter, be doubled in the case of each citizen and corporation of
such foreign country; but the tax at such doubled rate shall be
considered as imposed by such sections as the case may be. In no case
shall this section operate to increase the taxes imposed by such
sections (computed without regard to this section) to an amount in
excess of 80 percent of the taxable income of the taxpayer (computed
without regard to the deductions allowable under section 151 and under
part VIII of subchapter B). Whenever the President finds that the laws
of any foreign country with respect to which the President has made a
proclamation under the preceding provisions of this section have been
modified so that discriminatory and extraterritorial taxes applicable to
citizens and corporations of the United States have been removed, he
shall so proclaim, and the provisions of this section providing for
doubled rates of tax shall not apply to any citizen or corporation of
such foreign country with respect to any taxable year beginning after
such proclamation is made.
(Sec. 891 as amended by sec. 5(6), Life Insurance Company Tax Act 1955
(70 Stat. 49); sec. 3(f)(1), Life Insurance Company Income Tax Act 1959
(73 Stat. 140))
[T.D. 6610, 27 FR 8723, Aug. 31, 1962]
Sec. 1.892-1T Purpose and scope of regulations (temporary regulations).
(a) In general. These regulations provide guidance with respect to
the taxation of income derived by foreign governments and international
organizations from sources within the United 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
[[Page 629]]
amount of income shall be required to be deducted and withheld, by
reason of the amendment of section 892 by section 1247 of the Tax Reform
Act of 1986 (Pub. L. 99-514, 100 Stat. 2085, 2583) from any payment made
before October 22, 1986.
[T.D. 8211, 53 FR 24061, June 27, 1988; 53 FR 27595, July 21, 1988]
Sec. 1.892-2T Foreign government defined (temporary regulations).
(a) Foreign government--(1) Definition. The term ``foreign
government'' means only the integral parts or controlled entities of a
foreign sovereign.
(2) Integral part. An ``integral part'' of a foreign sovereign is
any person, body of persons, organization, agency, bureau, fund,
instrumentality, or other body, however designated, that constitutes a
governing authority of a foreign country. The net earnings of the
governing authority must be credited to its own account or to other
accounts of the foreign sovereign, with no portion inuring to the
benefit of any private person. An integral part does not include any
individual who is a sovereign, official, or administrator acting in a
private or personal capacity. Consideration of all the facts and
circumstances will determine whether an individual is acting in a
private or personal capacity.
(3) Controlled entity. The term ``controlled entity'' means an
entity that is separate in form from a foreign sovereign or otherwise
constitute a separate juridical entity if it satisfies the following
requirements:
(i) It is wholly owned and controlled by a foreign sovereign
directly or indirectly through one or more controlled entities;
(ii) It is organized under the laws of the foreign sovereign by
which owned;
(iii) Its net earnings are credited to its own account or to other
accounts of the foreign sovereign, with no portion of its income inuring
to the benefit of any private person; and
(iv) Its assets vest in the foreign sovereign upon dissolution.
A controlled entity does not include partnerships or any other entity
owned and controlled by more than one foreign sovereign. Thus, a foreign
financial organization organized and wholly owned and controlled by
several foreign sovereigns to foster economic, financial, and technical
cooperation between various foreign nations is not a controlled entity
for purposes of this section.
(b) Inurement to the benefit of private persons. For purposes of
this section, income will be presumed not to inure to the benefit of
private persons if such persons (within the meaning of section
7701(a)(1)) are the intended beneficiaries of a governmental program
which is carried on by the foreign sovereign and the activities of which
constitute governmental functions (within the meaning of Sec. 1.892-
4T(c)(4)). Income will be considered to inure to the benefit of private
persons if such income benefits:
(1) Private persons through the use of a governmental entity as a
conduit for personal investment; or
(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
[[Page 630]]
similar pension fund of an integral part or controlled entity (which is
not a separate pension trust as defined in this paragraph (c)(1)) is
subject to the rules that generally apply to a foreign sovereign. Such a
pension fund may also benefit non-governmental employees or former
employees that perform or performed governmental or social services.
(2) Illustrations. The following examples illustrate the application
of paragraph (c)(1).
Example 1. The Ministry of Welfare (MW), an integral part of foreign
sovereign FC, instituted a retirement plan for FC's employees and former
employees. Retirement benefits under the plan are based on a percentage
of the final year's salary paid to an individual, times the number of
years of government service. Pursuant to the plan, contributions are
made by MW to a pension trust managed by persons appointed by MW to the
extent actuarially necessary to fund accrued pension liabilities. The
pension trust in turn invests such contributions partially in United
States Treasury obligations. The income of the trust is credited to the
trust's account and subsequently used to satisfy the pension plan's
obligations to retired employees. Under these circumstances, the income
of the trust is not deemed to inure to the benefit of private persons.
Accordingly, the trust is considered a controlled entity of FC.
Example 2. The facts are the same as in Example 1, except that the
retirement plan also benefits employees performing governmental or
social services for the following non-government institutions: (i) A
university in a local jurisdiction; (ii) a harbor commission; and (iii)
a library system. The retirement benefits under the plan are based on
the total amounts credited to an individual's account over the term of
his or her employment. MW makes annual contributions to each covered
employee's account equal to a percentage of annual compensation. In
addition, the income derived from investment of the annual contributions
is credited annually to individual accounts. The annual contributions do
not exceed an amount that is determined to be actuarially necessary to
provide the employee with reasonable retirement benefits.
Notwithstanding that retirement benefits vary depending upon the
investment experience of the trust, no portion of the income of the
trust is deemed to inure to the benefit of private persons. Accordingly,
the trust is considered a controlled entity of FC.
Example 3. The facts are the same as in Example 1, except that
employees are allowed to make unlimited contributions to the trust, and
such contributions are credited to the employee's account as well as
interest accrued on such contributions. Retirement benefits will reflect
the amounts credited to the individual accounts in addition to the usual
annuity computation based on the final year's salary and years of
service. A pension plan established under these rules is in part acting
as an investment conduit. As a result, the income of the trust is deemed
to inure to the benefit of private persons. Accordingly, the trust is
not considered a controlled entity of FC.
Example 4. (a) The facts are the same as in Example 2, except that
MW establishes a pension fund rather than a separate pension trust. A
pension fund is merely assets of an integral part or controlled entity
allocated to a separate account and held and invested for purposes of
providing retirement benefits. Under these circumstances, the income of
the pension fund is not deemed to inure to the benefit of private
persons. Accordingly, income earned from the United States Treasury
obligations by the pension fund is considered to be received by a
foreign government and is exempt from taxation under section 892.
(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).
[[Page 631]]
(6) Dividend equivalents. Income from investments in stocks includes
the payment of a dividend equivalent described in section 871(m) and the
regulations thereunder.
(b) [Reserved] For further information, see Sec. 1.892-3T(b).
(c) Effective/applicability date. Paragraph (a)(6) of this section
applies to payments made on or after December 5, 2013.
[T.D. 9648, 78 FR 73080, Dec. 5, 2013]
Sec. 1.892-3T Income of foreign governments (temporary regulations).
(a) Types of income exempt--(1) In general. Subject to the
exceptions contained in Sec. Sec. 1.892-4T and 1.892-5T for income
derived from the conduct of a commercial activity or received from or by
a controlled commercial entity, the following types of income derived by
a foreign government (as defined in Sec. 1.892-2T) are not included in
gross income and are exempt:
(i) Income from investments in the United States in stocks, bonds,
or other securities;
(ii) Income from investments in the United States in financial
instruments held in the execution of governmental financial or monetary
policy; and
(iii) Interest on deposits in banks in the United States of moneys
belonging to such foreign government.
Income derived from sources other than described in this paragraph (such
as income earned from a U.S. real property interest described in section
897(c)(1)(A)(i)) is not exempt from taxation under section 892.
Furthermore, any gain derived from the disposition a U.S. real property
interest defined in section 897(c)(1)(A)(i) shall in no event qualify
for exemption under section 892.
(2) Income from investments. For purposes of paragraph (a) of this
section, income from investments in stocks, bonds or other securities
includes gain from their disposition and income earned from engaging in
section 1058 securities lending transactions. Gain on the disposition of
an interest in a partnership or a trust is not exempt from taxation
under section 892.
(3) Securities. For purposes of paragraph (a) of this section, the
term ``other securities'' includes any note or other evidence of
indebtedness. Thus, an annuity contract, a mortgage, a banker's
acceptance or a loan are securities for purposes of this section.
However, the term ``other securities'' does not include partnership
interests (with the exception of publicly traded partnerships within the
meaning of section 7704) or trust interests. The term also does not
include commodity forward or futures contracts and commodity options
unless they constitute securities for purposes of section 864(b)(2)(A).
(4) Financial instrument. For purposes of paragraph (a) of this
section, the term ``financial instrument'' includes any forward,
futures, options contract, swap agreement or similar instrument in a
functional or nonfunctional currency (see section 985(b) for the
definition of functional currency) or in precious metals when held by a
foreign government or central bank of issue (as defined in Sec. 1.895-
1(b)). Nonfunctional 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
[[Page 632]]
following items of income from investments in the United States: (i)
Dividends from a portfolio of publicly traded stocks in U.S.
corporations in which X owns less than 50 percent of the stock; (ii)
dividends from BTB Corporation, an automobile manufacturer, in which X
owns 50 percent of the stock; (iii) interest from bonds issued by
noncontrolled entities and from interest-bearing bank deposits in
noncontrolled entities; (iv) rents from a net lease on real property;
(v) gains from silver futures contracts; (vi) gains from wheat futures
contracts; (vii) gains from spot sales of nonfunctional foreign currency
in X's possession; (viii) gains from the disposition of a publicly
traded partnership interest, and (ix) gains from the disposition of the
stock of Z Corporation, a United States real property holding company as
defined in section 897, of which X owns 12 percent of the stock. Only
income derived from sources described in paragraph (a)(1) of this
section is treated as income of a foreign government eligible for
exemption from taxation. Accordingly, only income received by X from
items (i), (iii), (v) provided that the silver futures contracts are
held in the execution of governmental financial or monetary policy, and
(ix) is exempt from taxation under section 892.
Example 2. The facts are the same as in Example 1, except that X is
also a central bank of issue within the meaning of section 895. Since
physical possession of nonfunctional foreign currency when held by a
central bank of issue is considered a financial instrument, the item
(vii) gains from spot sales of nonfunctional foreign currency are exempt
from taxation under paragraph (a)(1) of this section, if physical
possession of the currency was an essential part of X's reserve policy
in the execution of its governmental financial or monetary policy.
Example 3. State Concert Bureau, an integral part of a foreign
sovereign within the meaning of Sec. 1.892-2T(a)(2), entered into an
agreement with a U.S. corporation engaged in the business of promoting
international cultural programs. Under the agreement the State Concert
Bureau agreed to send a ballet troupe on tour for 5 weeks in the United
States. The Bureau received approximately $60,000 from the performances.
Regardless of whether the performances themselves constitute commercial
activities under Sec. 1.892-4T, the income received by the Bureau is
not exempt from taxation under section 892 since the income is from
sources other than described in paragraph (a)(1) of this section.
[T.D. 8211, 53 FR 24062, June 27, 1988]
Sec. 1.892-4T Commercial activities (temporary regulations).
(a) Purpose. The exemption generally applicable to a foreign
government (as defined in Sec. 1.892-2T) for income described in Sec.
1.892-3T does not apply to income derived from the conduct of a
commercial activity or income received by a controlled commercial entity
or received (directly or indirectly) from a controlled commercial
entity. This section provides rules for determining whether income is
derived from the conduct of a commercial activity. These rules also
apply in determining under Sec. 1.892-5T whether an entity is a
controlled commercial entity.
(b) In general. Except as provided in paragraph (c) of this section,
all activities (whether conducted within or outside the United States)
which are ordinarily conducted by the taxpayer or by other persons with
a view towards the current or future production of income or gain are
commercial activities. An activity may be considered a commercial
activity even if such activity does not constitute the conduct of a
trade 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
[[Page 633]]
are effected by the foreign government through its employees or through
a broker, commission agent, custodian, or other independent agent and
regardless of whether or not any such employee or agent has
discretionary authority to make decisions in effecting the transactions.
An activity undertaken as a dealer, however, as defined in Sec. 1.864-
2(c)(2)(iv)(a) will not be an investment for purposes of this paragraph
(c)(1)(i). For purposes of this paragraph (c)(1)(ii), the term
``commodities'' means commodities of a kind customarily dealt in on an
organized commodity exchange but only if the transaction is of a kind
customarily consummated at such place.
(iii) Banking, financing, etc. Investments (including loans) made by
a banking, financing, or similar business constitute commercial
activities, even if the income derived from such investments is not
considered to be income effectively connected to the active conduct of a
banking, financing, or similar business in the U.S. by reason of the
application of Sec. 1.864-4(c)(5).
(2) Cultural events. Performances and exhibitions within or outside
the United States of amateur athletic events and events devoted to the
promotion of the arts by cultural organizations are not commercial
activities.
(3) Non-profit activities. Activities that are not customarily
attributable to or carried on by private enterprise for profit are not
commercial activities. The fact that in some instances Federal, State,
or local governments of the United States also are engaged in the same
or similar activity does not mean necessarily that it is a non-profit
activity. For example, even though the United States Government may be
engaged in the activity of operating a railroad, operating a railroad is
not a non-profit activity.
(4) Governmental functions. Governmental functions are not
commercial activities. The term ``governmental functions'' shall be
determined under U.S. standards. In general, activities performed for
the general public with respect to the common welfare or which relate to
the administration of some phase of government will be considered
governmental functions. For example, the operation of libraries, toll
bridges, or local transportation services and activities substantially
equivalent to the Federal Aviation Authority, Interstate Commerce
Commission, or United States Postal Service will all be considered
governmental functions for purposes of this section.
(5) Purchasing. The mere purchasing of goods for the use of a
foreign government is not a commercial activity.
[T.D. 8211, 53 FR 24063, June 27, 1988]
Sec. 1.892-5 Controlled commercial entity.
(a)-(a)(2) [Reserved]. For further information, see Sec. 1.892-
5T(a) through (a)(2).
(3) For purposes of section 892(a)(2)(B), the term entity means and
includes a corporation, a partnership, a trust (including a pension
trust described in Sec. 1.892-2T(c)) and an estate.
(4) Effective date. This section applies on or after January 14,
2002. See Sec. 1.892-5T(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).
[[Page 634]]
(b) Entities treated as engaged in commercial activity--(1) U.S.
real property holding corporations. A United States real property
holding corporation, as defined in section 897(c)(2) or a foreign
corporation that would be a United States real property holding
corporation if it was a United States corporation, shall be treated as
engaged in commercial activity and, therefore, is a controlled
commercial entity if the requirements of paragraph (a)(1) or (a)(2) of
this section are satisfied.
(2) Central banks. Notwithstanding paragraph (a) of this section, a
central bank of issue (as defined in Sec. 1.895-1(b)) shall be treated
as a controlled commercial entity only if it engages in commercial
activities within the United States.
(3) Pension trusts. A pension trust, described in Sec. 1.892-2T(c),
which engages in commercial activities within or outside the United
States, shall be treated as a controlled commercial entity. Income
derived by such a pension trust is not income of a foreign government
for purposes of the exemption from taxation provided in section 892. A
pension trust described in Sec. 1.892-2T(c) shall not be treated as a
controlled commercial entity if such trust solely earns income which
would not be unrelated business taxable income (as defined in section
512(a)(1)) if the trust were a qualified trust described in section
401(a). However, only income derived by a pension trust that is
described in Sec. 1.892-3T and which is not from commercial activities
as defined in Sec. 1.892-4T is exempt from taxation under section 892.
(c) Control--(1) Attribution--(i) Rule. In determining for purposes
of paragraph (a) of this section the interest held by a foreign
government, any interest in an entity (whether or not engaged in
commercial activity) owned directly or indirectly by an integral part or
controlled entity of a foreign sovereign shall be treated as actually
owned by such foreign sovereign.
(ii) Illustration. The following example illustrates the application
of paragraph (c)(1)(i) of this section.
Example. FX, a controlled entity of foreign sovereign FC, owns 20
percent of the stock of Corp 1. Neither FX nor Corp 1 is engaged in
commercial activity anywhere in the world. Corp 1 owns 60 percent of the
stock of Corp 2, which is engaged in commercial activity. The remaining
40 percent of Corp 2's stock is owned by Bureau, an integral part of
foreign sovereign FC. For purposes of determining whether Corp 2 is a
controlled commercial entity of FC, Bureau will be treated as actually
owning the 12 percent of Corp 2's stock indirectly owned by FX.
Therefore, since Bureau directly and indirectly owns 52 percent of the
stock of Corp 2, Corp 2 is a controlled commercial entity of FC within
the meaning of paragraph (a) of this section. Accordingly, dividends or
other income received, directly or indirectly, from Corp 2 by either
Bureau or FX will not be exempt from taxation under section 892.
Furthermore, dividends from Corp 1 to the extent attributable to
dividends from Corp 2 will not be exempt from taxation. Thus, a
distribution from Corp 1 to FX shall be exempt only to the extent such
distribution exceeds Corp 1's earnings and profits attributable to the
Corp 2 dividend amount received by Corp 1.
(2) Effective practical control. An entity engaged in commercial
activity may be treated as a controlled commercial 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
[[Page 635]]
notwithstanding the fact that such entity's brother/sister related
entity is a controlled commercial entity.
(2) Parent/subsidiary entities--(i) Subsidiary to parent
attribution. Commercial activities of a subsidiary controlled entity are
not attributed to its parent. Thus, investment income described in Sec.
1.892-3T that is derived by a parent controlled entity that is not
itself engaged in commercial activity within or outside the United
States is exempt from taxation notwithstanding the fact that its
subsidiary is a controlled commercial entity. Dividends or other
payments of income received by the parent controlled entity from the
subsidiary are not exempt under section 892, because it constitutes
income received from a controlled commercial entity. Furthermore,
dividends paid by the parent are not exempt to the extent attributable
to the dividends received by the parent from the subsidiary. Thus, a
distribution by the parent shall be exempt only to the extent such
distribution exceeds earnings and profits attributable to the dividend
received from its subsidiary.
(ii) Parent to subsidiary attribution. Commercial activities of a
parent controlled entity are attributed to its subsidiary. Thus,
investment income described in Sec. 1.892-3T that is derived by a
subsidiary controlled entity (not engaged in commercial activity within
or outside the United States) is not exempt from taxation under section
892 if its parent is a controlled commercial entity.
(3) Partnerships. Except for partners of publicly traded
partnerships, commercial activities of a partnership are attributable to
its general and limited partners for purposes of section 892. For
example, where a controlled entity is a general partner in a partnership
engaged in commercial activities, the controlled entity's distributive
share of partnership income (including income described in Sec. 1.892-
3T) will not be exempt from taxation under section 892.
(4) Illustrations. The principles of this section may be illustrated
by the following examples.
Example 1. (a) The Ministry of Industry and Development is an
integral part of a foreign sovereign under Sec. 1.892-2T(a)(2). The
Ministry is engaged in commercial activity within the United States. In
addition, the Ministry receives income from various publicly traded
stocks and bonds, soybean futures contracts and net leases on U.S. real
property. Since the Ministry is an integral part, and not a controlled
entity, of a foreign sovereign, it is not a controlled commercial entity
within the meaning of paragraph (a) of this section. Therefore, income
described in Sec. 1.892-3T is ineligible for exemption under section
892 only to the extent derived from the conduct of commercial
activities. Accordingly, the Ministry's income from the stocks and bonds
is exempt from U.S. tax.
(b) The facts are the same as in Example (1)(a), except that the
Ministry also owns 75 percent of the stock of R, a U.S. holding company
that owns all the stock of S, a U.S. operating company engaged in
commercial activity. Ministry's dividend income from R is income
received indirectly from a controlled commercial entity. The Ministry's
income from the stocks and bonds, with the exception of dividend income
from R, is exempt from U.S. tax.
(c) The facts are the same as in Example (1)(a), except that the
Ministry is a controlled entity of a foreign sovereign. Since 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
[[Page 636]]
its partners, T will be treated as engaged in commercial activity and
thus will be considered a controlled commercial entity. Accordingly,
none of T's income will be exempt from taxation under section 892.
(c) The facts are the same as Example (2)(a), except that Z is a
controlled commercial entity. The result is the same as in Example
(2)(a).
Example 3. (a) The Department of Interior, an integral part of
foreign sovereign FC, wholly owns corporations G and H. G, in turn,
wholly owns S. G, H and S are each controlled entities. G, which is not
engaged in commercial activity anywhere in the world, receives interest
income from deposits in banks in the United States. Both H and S do not
have any investments in the U.S. but are both engaged in commercial
activities. However, only S is engaged in commercial activities within
the United States. Because neither the commercial activities of H nor
the commercial activities of S are attributable to the Department of
Interior or G, G's interest income is exempt from taxation under section
892.
(b) The facts are the same as Example (3)(a), except that G rather
than S is engaged in commercial activities and S rather than G receives
the interest income from the United States. Since the commercial
activities of G are attributable to S, S's interest income is not exempt
from taxation.
Example 4. (a) K, a controlled entity of a foreign sovereign, is a
general partner in the Daj partnership. The Daj partnership has
investments in the U.S. in various stocks and bonds and also owns and
manages an office building in New York. K will be deemed to be engaged
in commercial activity by being a general partner in Daj even if K does
not actually make management decisions with regard to the partnership's
commercial activity, the operation of the office building. Accordingly
K's distributive share of partnership income (including income derived
from stocks and bonds) will not be exempt from taxation under section
892.
(b) The facts are the same as in Example (4)(a), except that the Daj
partnership has hired a real estate management firm to lease offices and
manage the building. Notwithstanding the fact that an independent
contractor is performing the activities, the partnership shall still be
deemed to be engaged in commercial activity. Accordingly, K's
distributive share of partnership income (including income derived from
stocks and bonds) will not be exempt from taxation under section 892.
(c) The facts are the same as in Example (4)(a), except that K is a
partner whose partnership interest is considered a publicly traded
partnership interest within the meaning of section 7704. Under paragraph
(d)(3) of this section, the partnership's commercial activity will not
be attributed to K. Since K will not be deemed to be engaged in
commercial activity, K's distributive share of partnership income
derived from stocks and bonds will be exempt from taxation under section
892.
[T.D. 8211, 53 FR 24064, June 27, 1988, as amended by T.D. 9012, 67 FR
49864, Aug. 1, 2002]
Sec. 1.892-6T Income of international organizations (temporary regulations).
(a) Exempt from tax. Subject to the provisions of section 1 of the
International Organizations Immunities Act (22 U.S.C. 288) (the
provisions of which are set forth in paragraph (b)(3) of Sec. 1.893-1),
the income of an international organization (as defined in section
7701(a)(18)) received from investments in the United States in stocks,
bonds, or other domestic securities, owned by such international
organization, or from interest on deposits 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
[[Page 637]]
(relating to the exemption for compensation of employees of foreign
governments) has the same meaning as given such term in Sec. 1.892-2T.
(b) Section 895. A foreign central bank of issue (as defined in
Sec. 1.895-1(b)) that fails to qualify for the exemption from tax
provided by this section (for example, it is not wholly owned by a
foreign sovereign) may nevertheless be exempt from tax on the items of
income described in section 895.
(c) Section 883(b). Nothing in section 892 or these regulations
shall limit the exemption provided under section 883(b) relating
generally to the exemption of earnings derived by foreign participants
from the ownership or operation of communications satellite systems.
(d) Section 884. Earnings and profits attributable to income of a
controlled entity of a foreign sovereign which is exempt from taxation
under section 892 shall not be subject to the tax imposed by section
884(a).
(e) Sections 1441 and 1442. No withholding is required under
sections 1441 and 1442 in the case of income exempt from taxation under
section 892.
[T.D. 8211, 53 FR 24066, June 27, 1988]
Sec. 1.893-1 Compensation of employees of foreign governments or international organizations.
(a) Employees of foreign governments--(1) Exempt from tax. Except to
the extent that the exemption is limited by the execution and filing of
the waiver provided for in section 247(b) of the Immigration and
Nationality Act (8 U.S.C. 1257(b)), all employees of a foreign
government (including consular or other officers, or nondiplomatic
representatives) who are not citizens of the United States, or are
citizens of the Republic of the Philippines (whether or not citizens of
the United States), are exempt from Federal income tax with respect to
wages, fees, or salaries received by them as compensation for official
services rendered to such foreign government, provided (i) the services
are of a character similar to those performed by employees of the
Government of the United States in that foreign country and (ii) the
foreign government whose employees are claiming exemption grants an
equivalent exemption to employees of the Government of the United States
performing similar services in that foreign country.
(2) Certificate by Secretary of State. Section 893(b) provides that
the Secretary of State shall certify to the Secretary of the Treasury
the names of the foreign countries which grant an equivalent exemption
to the employees of the Government of the United States performing
services in such foreign countries, and the character of the services
performed by employees of the Government of the United States in foreign
countries.
(3) Items not exempt. The income received by employees of foreign
governments from sources other than their salaries, fees, or wages,
referred to in subparagraph (1) of this paragraph, is subject to Federal
income tax.
(4) Immigration and Nationality Act. Section 247(b) of the
Immigration and Nationality Act provides as follows:
Sec. 247. Adjustment of status of certain resident aliens.* * *
(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.
[[Page 638]]
(b) Employees of international organizations--(1) Exempt from tax.
Except to the extent that the exemption is limited by the execution and
filing of the waiver provided for in section 247(b) of the Immigration
and Nationality Act and subject to the provisions of sections 1, 8, and
9 of the International Organizations Immunities Act (22 U.S.C. 288,
288e, 288f), wages, fees, or salary of any officer or employee of an
international organization (as defined in section 7701(a)(18)) received
as compensation for official services to that international organization
is exempt from Federal income tax, if that officer or employee (i) is
not a citizen of the United States or (ii) is a citizen of the Republic
of the Philippines (whether or not a citizen of the United States).
(2) Income earned prior to executive action. An individual of the
prescribed class who receives wages, fees, or salary as compensation for
official services to an organization designated by the President through
appropriate Executive order as entitled to enjoy the privileges,
exemptions, and immunities provided in the International Organizations
Immunities Act and who has been duly notified to, and accepted by, the
Secretary of State as an officer or employee of that organization, or
who has been designated by the Secretary of State, prior to formal
notification and acceptance, as a prospective officer or employee of
that organization, may enjoy the benefits of the exemption with respect
to compensation of the prescribed character earned by that individual,
either prior to the date of the Issuance of the Executive order, or
prior to the date of the acceptance or designation by the Secretary of
State, for official services to that organization, if (i) the Executive
order does not provide otherwise, (ii) the organization is a public
international organization in which the United States participates,
pursuant to a treaty or under the authority of an act of Congress
authorizing such participation or making an appropriation for such
participation, at the time the compensation is earned, and (iii) the
individual is an officer or employee of that organization at that time.
(3) International Organizations Immunities Act. Sections 1, 8, and 9
of the International Organizations Immunities Act (22 U.S.C. 288, 288e,
288f) provide in part as follows:
Section 1. For the purposes of this title [International
Organizations Immunities Act], the term ``international organization''
means a public international organization in which the United States
participates pursuant to any treaty or under the authority of any Act of
Congress authorizing such participation or making an appropriation for
such participation, and which shall have been designated by the
President through appropriate Executive order as being entitled to enjoy
the privileges, exemptions, and immunities herein provided. The
President shall be authorized, in the light of the functions performed
by any such international organization, by appropriate Executive order
to withhold or withdraw from any such organization or its officers or
employees any of the privileges, exemptions, and immunities provided for
in this title (including the amendments made by this title) or to
condition or limit the enjoyment by any such organization or its
officers or employees of any such privilege, exemption, or immunity. The
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.
[[Page 639]]
Sec. 9. The privileges, exemptions, and immunities of international
organizations and of their officers and employees * * * provided for in
this title [International Organizations Immunities Act], shall be
granted notwithstanding the fact that the similar privileges,
exemptions, and immunities granted to a foreign government, its
officers, or employees, may be conditioned upon the existence of
reciprocity by that foreign government: Provided, That nothing contained
in this title shall be construed as precluding the Secretary of State
from withdrawing the privileges, exemptions, and immunities herein
provided from persons who are nationals of any foreign country on the
ground that such country is failing to accord corresponding privileges,
exemptions, and immunities to citizens of the United States.
(4) Effect of waiver. An officer or employee of an international
organization who executes and files with the Attorney General the waiver
provided for in section 247(b) of the Immigration and Nationality Act (8
U.S.C. 1257(b)) thereby waives the exemption conferred by section 893 of
the Code. As a consequence, that exemption does not apply to income
received by that individual after the date of filing of the waiver.
(5) Citizens of the United States. The compensation of citizens of
the United States (other than those who are also citizens of the
Republic of the Philippines) who are officers or employees of an
international organization is not exempt from income tax pursuant to
this paragraph. But see section 911 and the regulations thereunder.
(c) Tax conventions, consular conventions, and international
agreements--(1) Exemption dependent upon internal revenue laws. A tax
convention or consular convention between the United States and a
foreign country, which provides that the United States may include in
the tax base of its residents all income taxable under the internal
revenue laws, and which makes no specific exception for the income of
the employees of that foreign government, does not provide any exemption
(with respect to residents of the United States) beyond that which is
provided by the internal revenue laws. Accordingly, the effect of the
execution and filing of a waiver under section 247(b) of the Immigration
and Nationality Act by an employee of a foreign government which is a
party to such a convention is to subject the employee to tax to the same
extent as provided in paragraph (a)(5) of this section with respect to
the waiver of exemption under section 893.
(2) Exemption not dependent upon internal revenue laws. If a tax
convention, consular convention, or international agreement provides
that compensation paid by the foreign government or international
organization to its employees is exempt from Federal income tax, and the
application of this exemption is not dependent upon the provisions of
the internal revenue laws, the exemption so conferred is not affected by
the execution and filing of a waiver under section 247(b) of the
Immigration and Nationality Act. For examples of exemptions which are
not affected by the Immigration and Nationality Act, see article X of
the income tax convention between the United States and the United
Kingdom (60 Stat. 1383); article IX, section 9(b), of the Articles of
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
[[Page 640]]
regard to section 894 and this paragraph, to the extent required by
section 819(a)(3)(A). See Sec. 1.871-12 for the manner of determining
the tax liability of a nonresident alien individual or foreign
corporation whose gross income includes income on which the tax is
reduced under a tax convention.
(b) Taxpayer treated as having no permanent establishment in the
United States--(1) In general. A nonresident alien individual or a
foreign corporation, that is engaged in trade or business in the United
States through a permanent establishment located therein at any time
during a taxable year beginning after December 31, 1966, shall be deemed
not to have a permanent establishment in the United States at any time
during that year for purposes of applying any exemption from, or
reduction in the rate of, any tax under Subtitle A of the Code which is
provided by any income tax convention with respect to income which is
not effectively connected for that year with the conduct of a trade or
business in the United States by the taxpayer. This paragraph applies to
all treaties or conventions entered into by the United States, whether
entered into before, on, or after November 13, 1966, the date of
enactment of the Foreign Investors Tax Act of 1966 (80 Stat. 1539). This
paragraph is not considered to be contrary to any obligation of the
United States under an income tax convention to which it is a party. The
benefit granted under section 894(b) and this paragraph applies only to
those items of income derived from sources within the United States
which are subject to the tax imposed by section 871(a) or 881(a), and
section 1441, 1442, or 1451, on the noneffectively connected income
received from sources within the United States by a nonresident alien
individual or a foreign corporation. The benefit does not apply to any
income from real property in respect of which an election is in effect
for the taxable year under Sec. 1.871-10 or in determining under
section 877(b) the tax of a nonresident alien individual who has lost
United States citizenship at any time after March 8, 1965. The benefit
granted by section 894(b) and this paragraph is not elective.
(2) Illustrations. The application of this paragraph may be
illustrated by the following examples:
Example 1. M, a corporation organized in foreign country X, uses the
calendar year as the taxable year. The United States and country X are
parties to an income tax convention which provides in part that
dividends received from sources within the United States by a
corporation of country X not having a permanent establishment in the
United States are subject to tax under Chapter 1 of the Code at a rate
not to exceed 15 percent. During 1967, M is engaged in business in the
United States through a permanent establishment located therein and
receives $100,000 in dividends from domestic corporation B, which under
section 861(a)(2)(A) constitute income from sources within the United
States. Under section 864(c)(2) and Sec. 1.864-4(c), the dividends
received from B are not effectively connected for 1967 with the conduct
of a trade or business in the United States by M. Although M has a
permanent establishment in the United States during 1967, it is deemed,
under section 894(b) and this paragraph, not to have a permanent
establishment in the United States during that year with respect to the
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
[[Page 641]]
operation of business B, both of which amounts are, under section
864(c)(2)(B) and Sec. 1.864-4(c)(3), effectively connected for that
year with the conduct of a trade or business in the United States by
that corporation. The service fees are considered to be industrial or
commercial profits under the tax convention with country X. Since T has
no income for 1967 which is not effectively connected for that year with
the conduct of a trade or business in the United States by that
corporation, section 894(b), this paragraph, and Sec. 1.871-12 do not
apply. Accordingly, for 1967 T's entire income of $70,000 from sources
within the United States is subject to tax, after allowance of
deductions, in accordance with section 882(a)(1) and paragraph (b)(2) of
Sec. 1.882-1.
Example 3. S, a corporation organized in foreign country W, uses the
calendar year as the taxable year. The United States and country W are
parties to an income tax convention which provides in part that a
corporation of country W is not subject to tax under Chapter 1 of the
Code in respect of its industrial or commercial profits unless it is
engaged in trade or business in the United States during the taxable
year through a permanent establishment located therein and that, if it
is so engaged, the tax may be imposed upon the entire income of that
corporation from sources within the United States. The convention also
provides that the tax imposed by Chapter 1 of the Code on dividends
received from sources within the United States by a corporation of
country W which is not engaged in trade or business in the United States
through a permanent establishment located therein shall not exceed 15
percent of the dividend. During 1967, S is engaged in business in the
United States through a permanent establishment located therein and
derives from sources within the United States $100,000 in service fees
which, under section 864(c)(2)(B) and Sec. 1.864-4(c)(3), are
effectively connected for that year with the conduct of a trade or
business in the United States by S and which are considered to be
industrial or commercial profits under the tax convention with country
W. During 1967, S also derives from sources within the United States,
through another business it carries on in foreign country X, $10,000 in
sales income which, under section 864(c)(3) and Sec. 1.864-4(b), is
effectively connected for that year with the conduct of a trade or
business in the United States by S and $5,000 in dividends which, under
section 864(c)(2)(A) and Sec. 1.864-4(c)(2), are not effectively
connected for that year with the conduct of a trade or business in the
United States by S. The sales income is considered to be industrial or
commercial profits under the tax convention with country W. Although S
is engaged in a trade or business in the United States during 1967
through a permanent establishment located therein, it is deemed, under
section 894(b) and this paragraph, not to have a permanent establishment
therein with respect to the $5,000 in dividends. Accordingly, in
accordance with paragraph (c) of Sec. 1.871-12, for 1967 S is subject
to a tax of $750 on the dividends ($5,000 x .15) and a tax, determined
under section 882(a) and Sec. 1.882-1, on its $110,000 industrial or
commercial profits.
Example 4. (a) N, a corporation organized in foreign country Z, uses
the calendar year as the taxable year. The United States and country Z
are parties to an income tax convention which provides in part that the
tax imposed by Chapter 1 of the Code on dividends received from sources
within the United States by a corporation of country Z shall not exceed
15 percent of the amount distributed if the recipient does not have a
permanent establishment in the United States or, where the recipient
does have a permanent establishment in the United States, if the shares
giving rise to the dividends are not effectively connected with the
permanent establishment. The tax convention also provides that if a
corporation of country Z is engaged in industrial or commercial activity
in the United States through a permanent establishment in the United
States, income tax may be imposed 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
[[Page 642]]
United States by that corporation, section 894(b) and this paragraph do
not apply. However, N is entitled to the reduced rate of tax under the
tax convention with country Z with respect to the dividends because the
shares of stock are not effectively connected with N's permanent
establishment in the United States. Accordingly, assuming that there are
no deductions connected with N's industrial or commercial profits, the
tax for 1967, determined as provided in paragraph (c) of Sec. 1.871-12,
is $46,900 as follows:
Tax on nontreaty income:
$80,000 x .48............................................... $38,400
Less $25,000 x .26.......................................... 6,500
---------
31,900
Tax on treaty income:
$100,000 (gross dividends) x .15............................ 15,000
=========
Total tax.................................................. 46,900
Example 5. M, a corporation organized in foreign country Z, uses the
calendar year as the taxable year. The United States and country Z are
parties to an income tax convention which provides in part that a
corporation of country Z is not subject to tax under Chapter 1 of the
Code in respect of its commercial and industrial profits except such
profits as are allocable to its permanent establishment in the United
States. The regulations in this chapter under the tax convention with
country Z provide that a corporation of country Z having a permanent
establishment in the United States is subject to U.S. tax upon its
industrial and commercial profits from sources within the United States
and that its industrial and commercial profits from such sources are
deemed to be allocable to the permanent establishment in the United
States. During 1967, M is engaged in a business (business A) in the
United States which is carried on through a permanent establishment in
the United States; in addition, M is engaged in a business (business B)
in foreign country X and none of such business is carried on in the
United States. During 1967, M receives from sources within the United
States $40,000 in sales income through the operation of business A and
$10,000 in sales income through the operation of business B, both of
which amounts are, under section 864(c)(3) and Sec. 1.864-4(b),
effectively connected for that year with the conduct of a trade or
business in the United States by that corporation. The sales income is
considered to be industrial and commercial profits under the tax
convention with country Z. Since M has no income for 1967 which is not
effectively connected for that year with the conduct of a trade or
business in the United States by that corporation, section 894(b) and
this paragraph do not apply. Accordingly, for 1967 M's entire income of
$50,000 from sources within the United States is subject to tax, after
allowance of deductions, in accordance with section 882(a)(1) and
paragraph (b)(2) of Sec. 1.882-1.
(c)(1) Substitute interest and dividend payments. The provisions of
an income tax convention dealing with interest or dividends paid to or
derived by a foreign person include substitute interest or dividend
payments that have the same character as interest or dividends under
Sec. 1.864-5(b)92)(ii), 1.871-7(b)(2) or 1.881-2(b)(2). The provisions
of this paragraph (c) shall apply for purposes of securities lending
transactions or sale-repurchase transactions as defined in Sec. 1.861-
2(a)(7) and Sec. 1.861-3(a)(6).
(2) Dividend equivalents. The provisions of an income tax convention
relating to dividends paid to or derived by a foreign person apply to
the payment of a dividend equivalent described in section 871(m) and the
regulations thereunder.
(d) Special rule for items of income received by entities--(1) In
general. The tax imposed by sections 871(a), 881(a), 1443, 1461, and
4948(a) on an item of income 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
[[Page 643]]
sentences, an item of income paid directly to a type of entity
specifically identified in a treaty as a resident of a treaty
jurisdiction shall be treated as derived by a resident of that treaty
jurisdiction.
(2) Application to domestic reverse hybrid entities--(i) In general.
An income tax treaty may not apply to reduce the amount of federal
income tax on U.S. source payments received by a domestic reverse hybrid
entity. Further, notwithstanding paragraph (d)(1) of this section, the
foreign interest holders of a domestic reverse hybrid entity are not
entitled to the benefits of a reduction of U.S. income tax under an
income tax treaty on items of income received from U.S. sources by such
entity. A domestic reverse hybrid entity is a domestic entity that is
treated as not fiscally transparent for U.S. tax purposes and as
fiscally transparent under the laws of the interest holder's
jurisdiction, with respect to the item of income received by the
domestic entity.
(ii) Payments by domestic reverse hybrid entities--(A) General rule.
Except as otherwise provided in paragraph (d)(2)(ii)(B) of this section,
an item of income paid by a domestic reverse hybrid entity to an
interest holder in such entity shall have the character of such item of
income under U.S. law and shall be considered to be derived by the
interest holder, provided the interest holder is not fiscally
transparent in its jurisdiction, as defined in paragraph (d)(3)(iii) of
this section, with respect to the item of income. In determining whether
the interest holder is fiscally transparent with respect to the item of
income under this paragraph (d)(2)(ii)(A), the determination under
paragraph (d)(3)(ii) of this section shall be made based on the
treatment that would have resulted had the item of income been paid by
an entity that is not fiscally transparent under the laws of the
interest holder's jurisdiction with respect to any item of income.
(B) Payment made to related foreign interest holder--(1) General
rule. If--
(i) A domestic entity makes a payment to a related domestic reverse
hybrid entity that is treated as a dividend under either the laws of the
United States or the laws of the jurisdiction of a related foreign
interest holder in the domestic reverse hybrid entity, and under the
laws of the jurisdiction of the related foreign interest holder in the
domestic reverse hybrid entity, the related foreign interest holder is
treated as deriving its proportionate share of the payment under the
principles of paragraph (d)(1) of this section; and
(ii) The domestic reverse hybrid entity makes a payment of a type
that is deductible for U.S. tax purposes to the related foreign interest
holder or to a person, wherever organized, the income and losses of
which are available, under the laws of the jurisdiction of the related
foreign interest holder, to offset the income and losses of the related
foreign interest holder, and for which a reduction in U.S. withholding
tax would be allowed under an applicable income tax treaty; then
(iii) To the extent the amount of the payment described in paragraph
(d)(2)(ii)(B)(1)(ii) of this section does not exceed the sum of the
portion of the payment described in paragraph (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
[[Page 644]]
paragraph (d)(2)(ii)(B)(1)(i) of this section treated as derived by the
related foreign interest holder shall be increased by the portion of the
payment derived by any other person described in paragraph
(d)(2)(ii)(B)(1)(ii), and shall be reduced by the amount of any prior
section 301(c) distributions made by the domestic reverse hybrid entity
to the related foreign interest holder or any other person described in
paragraph (d)(2)(ii)(B)(1)(ii) and by the amount of any payments from
the domestic reverse hybrid entity previously recharacterized under
paragraph (d)(2)(ii)(B)(1)(iii) of this section.
(3) Tiered entities. The principles of this paragraph (d)(2)(ii)(B)
also shall apply to payments referred to in this paragraph (d)(2)(ii)(B)
made among related entities when there is more than one domestic reverse
hybrid entity or other fiscally transparent entity involved.
(4) Definition of related. For purposes of this section, a person
shall be treated as related to a domestic reverse hybrid entity if it is
related by reason of the ownership requirements of section 267(b) or
707(b)(1), except that the language ``at least 80 percent'' applies
instead of ``more than 50 percent,'' where applicable. For purposes of
determining whether a person is related by reason of the ownership
requirements of section 267(b) or 707(b)(1), the constructive ownership
rules of section 318 shall apply, and the attribution rules of section
267(c) also shall apply to the extent they attribute ownership to
persons to whom section 318 does not attribute ownership.
(C) Payments to persons not described in paragraph
(d)(2)(ii)(B)(1)(ii)--(1) Related persons. The Commissioner may treat a
payment by a domestic reverse hybrid entity to a related person (who is
neither the related foreign interest holder nor otherwise described in
paragraph (d)(2)(ii)(B)(1)(ii) of this section), in whole or in part, as
being made to a related foreign interest holder for purposes of applying
paragraph (d)(2)(ii)(B) of this section, if--
(i) The payment to the related person is of a type that is
deductible by the domestic reverse hybrid entity; and
(ii) The payment is made in connection with one or more transactions
the effect of which is to avoid the application of paragraph
(d)(2)(ii)(B) of this section.
(2) Unrelated persons. The Commissioner may treat a payment by a
domestic reverse hybrid entity to an unrelated person, in whole or in
part, as being made to a related foreign interest holder for purposes of
applying paragraph (d)(2)(ii)(B) of this section, if--
(i) The payment to the unrelated person is of a type that is
deductible by the domestic reverse hybrid entity;
(ii) The unrelated person (or other person (whether related or not)
which receives a payment in a series of transactions that includes a
transaction involving such unrelated person) makes a payment to the
related foreign interest holder (or other person described in paragraph
(d)(2)(ii)(B)(1)(ii));
(iii) The foregoing payments are made in connection with a series of
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
[[Page 645]]
domestic corporation. A remains fully taxable under the U.S. tax laws as
a domestic corporation with regard to that item of income. Further,
pursuant to paragraph (d)(2)(i) of this section, notwithstanding the
fact that A is treated as fiscally transparent with respect to the
dividend income under the laws of Country X, FC may not claim a reduced
rate of taxation on its share of the U.S. source dividend income
received by A.
Example 2. Interest paid by domestic reverse hybrid entity to
related foreign interest holder where dividend is paid by unrelated
entity. (i) Facts. The facts are the same as in Example 1. Both the
United States and Country X characterize the payment by B in year 1 as a
dividend. In addition, in year 2, A makes a payment of $25 to FC that is
characterized under the Internal Revenue Code as interest on a loan from
FC to A. Under the U.S.-Country X income tax treaty, the rate of tax on
interest is zero. Under Country X laws, had the interest been paid by an
entity that is not fiscally transparent under Country X's laws with
respect to any item of income, FC would not be fiscally transparent as
defined in paragraph (d)(2)(ii) of this section with respect to the
interest.
(ii) Analysis. The analysis is the same as in Example 1 with respect
to the $100 payment from B to A. With respect to the $25 payment from A
to FC, paragraph (d)(2)(ii)(B) of this section will not apply because,
although FC is a related foreign interest holder in A, A is not related
to B, the payor of the dividend income it received. Under paragraph
(d)(2)(ii)(A) of this section, the $25 of interest paid by A to FC in
year 2 is characterized under U.S. law as interest. Accordingly, in year
2, A is entitled to an interest deduction with respect to the $25
interest payment from A to FC, and FC is entitled to the reduced rate of
withholding applicable to interest under the U.S.-Country X income tax
treaty, assuming all other requirements for claiming treaty benefits are
met.
Example 3. Interest paid by domestic reverse hybrid entity to
related foreign interest holder where dividend is paid by a related
entity. (i) Facts. The facts are the same as in Example 2, except the
$100 dividend income received by A in year 1 is from A's wholly-owned
subsidiary, S.
(ii) Analysis. The analysis is the same as in Example 1 with respect
to the $100 dividend payment from S to A. However, the $25 interest
payment in year 2 by A to FC will be treated as a dividend for all
purposes of the Internal Revenue Code and the U.S.-Country X income tax
treaty because $25 does not exceed FC's share of the $100 dividend
payment made by S to A ($85). Since FC is not fiscally transparent with
respect to the payment as determined under paragraph (d)(2)(ii)(A) of
this section, FC is entitled to the reduced rate applicable to dividends
under the U.S.-Country X income tax treaty with respect to the $25
payment. Because the $25 payment in year 2 is recharacterized as a
dividend for all purposes of the Internal Revenue Code and the U.S.-
Country X income tax treaty, A is not entitled to an interest deduction
with respect to that payment and FC is not entitled to claim the reduced
rate of withholding applicable to interest.
Example 4. Definition of related foreign interest holder. (i) Facts.
The facts are the same as in Example 3, except that A has two 50-percent
shareholders, FC1 and FC2. In year 2, A makes an interest payment of $25
to both FC1 and FC2. FC1 is a corporation organized under the laws of
Country X, which has an income tax treaty in effect with the United
States. FC2 is a corporation organized under the laws of Country Y,
which also has an income tax treaty in effect with the United States. FP
owns 100-percent of both FC1 and FC2, and is organized under the laws of
Country X. Under Country X law, FC1 is not fiscally transparent with
respect to the dividend, as defined in paragraph (d)(3)(ii) of this
section. Under Country X law, FC1 is treated as deriving $50 of the $100
dividend payment 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
[[Page 646]]
laws of Country Y, and FC2 is not treated as deriving any of the $100
dividend payment received by A. Thus, the U.S.-Country Y income tax
treaty is not implicated.
Example 5. Higher treaty withholding rate on dividends. (i) Facts.
The facts are the same as in Example 3, except that under the U.S.-
Country X income tax treaty, the rate of tax on interest is 10-percent
and the rate of tax on dividends is 5-percent.
(ii) Analysis. The analysis is the same as in Example 1 with respect
to the $100 dividend payment from S to A. The analysis is the same as in
Example 3 with respect to the $25 interest payment in year 2 from A to
FC.
Example 6. Foreign sister corporation the income and losses of which
may offset the income and losses of related foreign interest holder. (i)
Facts. The facts are the same as Example 3, except that in year 2, A
makes the interest payment of $25 to FS, a subsidiary of FC also
organized in Country X. Under the laws of Country X, FS is not fiscally
transparent with respect to the interest payment, and the income and
losses of FS may be used to offset the income and losses of FC.
(ii) Analysis. The analysis is the same as in Example 1 with respect
to the $100 dividend payment from S to A. With respect to the $25
interest payment from A to FS in year 2, FS is a person described in
paragraph (d)(2)(ii)(B)(1)(ii) of this section because the income and
losses of FS may be used under the laws of Country X to offset the
income and losses of FC, the related foreign interest holder that
derived its proportionate share of the payment from S to A. Therefore,
paragraph (d)(2)(ii)(B) of this section applies, and the $25 interest
payment in year 2 by A to FS is treated as a dividend for all purposes
of the Internal Revenue Code and the U.S.-Country X income tax treaty
because the $25 payment does not exceed FC's share of the $100 dividend
payment made by S to A ($85). Since FS is not fiscally transparent with
respect to the payment as determined under paragraph (d)(2)(ii)(A) of
this section, FS is entitled to obtain the rate applicable to dividends
under the U.S.-Country X income tax treaty with respect to the $25
payment. Because the $25 payment in year 2 is recharacterized as a
dividend for all purposes of the Internal Revenue Code and the U.S.-
Country X income tax treaty, A is not entitled to an interest deduction
with respect to the payment and FS is not entitled to claim the reduced
rate of withholding applicable to interest under the U.S.-Country X
income tax treaty.
Example 7. Interest paid by domestic reverse hybrid entity to
unrelated foreign bank. (i) Facts. The facts are the same as in Example
3, except that in year 2, A makes the interest payment of $25 to FB, a
Country Y unrelated foreign bank, on a loan from FB to A.
(ii) Analysis. The analysis is the same as in Example 1 with respect
to the $100 dividend payment from S to A. With respect to the payment
from A to FB, paragraph (d)(2)(ii)(B) of this section will not apply
because, although A is related to S, the payor of the dividend income it
received, A is not related to FB under paragraph (d)(2)(ii)(B)(4) of
this section. Under paragraph (d)(2)(ii)(A) of this section, the $25
interest payment made from A to FB in year 2 is characterized as
interest under the Internal Revenue Code.
Example 8. Interest paid by domestic reverse hybrid to an unrelated
entity pursuant to a financing arrangement. (i) Facts. The facts are the
same as in Example 7, except that in year 3, FB makes an interest
payment of $25 to FC on a deposit made by FC with FB.
(ii) Analysis. The analysis is the same as in Example 1 with respect
to the $100 dividend payment from S to A. With respect to the $25
payment from A to FB in year 2, because the payment is made in
connection with a transaction that 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.
[[Page 647]]
(ii) Fiscally transparent under the law of the entity's
jurisdiction--(A) General rule. For purposes of this paragraph (d), an
entity is fiscally transparent under the laws of the entity's
jurisdiction with respect to an item of income to the extent that the
laws of that jurisdiction require the interest holder in the entity,
wherever resident, to separately take into account on a current basis
the interest holder's respective share of the item of income paid to the
entity, whether or not distributed to the interest holder, and the
character and source of the item in the hands of the interest holder are
determined as if such item were realized directly from the source from
which realized by the entity. However, the entity will be fiscally
transparent with respect to the item of income even if the item of
income is not separately taken into account by the interest holder,
provided the item of income, if separately taken into account by the
interest holder, would not result in an income tax liability for that
interest holder different from that which would result if the interest
holder did not take the item into account separately, and provided the
interest holder is required to take into account on a current basis the
interest holder's share of all such nonseparately stated items of income
paid to the entity, whether or not distributed to the interest holder.
In determining whether an entity is fiscally transparent with respect to
an item of income in the entity's jurisdiction, it is irrelevant that,
under the laws of the entity's jurisdiction, the entity is permitted to
exclude such item from gross income or that the entity is required to
include such item in gross income but is entitled to a deduction for
distributions to its interest holders.
(B) Special definitions. For purposes of this paragraph (d)(3)(ii),
an entity's jurisdiction is the jurisdiction where the entity is
organized or incorporated or may otherwise be considered a resident
under the laws of that jurisdiction. An interest holder will be treated
as taking into account that person's share of income paid to an entity
on a current basis even if such amount is taken into account by the
interest holder in a taxable year other than the taxable year of the
entity if the difference is due solely to differing taxable years.
(iii) Fiscally transparent under the law of an interest holder's
jurisdiction--(A) General rule. For purposes of this paragraph (d), an
entity is treated as fiscally transparent under the law of an interest
holder's jurisdiction with respect to an item of income to the extent
that the laws of the interest holder's jurisdiction require the interest
holder resident in that jurisdiction to separately take into account on
a current basis the interest holder's respective share of the item of
income paid to the entity, whether or not distributed to the interest
holder, and the character and source of the item in the hands of the
interest holder are determined as if such item were realized directly
from the source from which realized by the entity. However, an entity
will be fiscally transparent with respect to the item of income even if
the 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
[[Page 648]]
where the interest holder is organized or incorporated or may otherwise
be considered a resident under the laws of that jurisdiction. An
interest holder will be treated as taking into account that person's
share of income paid to an entity on a current basis even if such amount
is taken into account by such person in a taxable year other than the
taxable year of the entity if the difference is due solely to differing
taxable years.
(iv) Applicable treaty jurisdiction. The term applicable treaty
jurisdiction means the jurisdiction whose income tax treaty with the
United States is invoked for purposes of reducing the rate of tax
imposed under sections 871(a), 881(a), 1461, and 4948(a).
(v) Resident. The term resident shall have the meaning assigned to
such term in the applicable income tax treaty.
(4) Application to all income tax treaties. Unless otherwise
explicitly agreed upon in the text of an income tax treaty, the rules
contained in this paragraph (d) shall apply in respect of all income tax
treaties to which the United States is a party. Notwithstanding the
foregoing sentence, the competent authorities may agree on a mutual
basis to depart from the rules contained in this paragraph (d) in
appropriate circumstances. However, a reduced rate under a tax treaty
for an item of U.S. source income paid will not be available
irrespective of the provisions in this paragraph (d) to the extent that
the applicable treaty jurisdiction would not grant a reduced rate under
the tax treaty to a U.S. resident in similar circumstances, as evidenced
by a mutual agreement between the relevant competent authorities or by a
public notice of the treaty jurisdiction. The Internal Revenue Service
shall announce the terms of any such mutual agreement or public notice
of the treaty jurisdiction. Any denial of tax treaty benefits as a
consequence of such a mutual agreement or notice shall affect only
payment of U.S. source items of income made after announcement of the
terms of the agreement or of the notice.
(5) Examples. This paragraph (d) is illustrated by the following
examples:
Example 1. Treatment of entity treated as partnership by U.S. and
country of organization. (i) Facts. Entity A is a business organization
formed under the laws of Country X that has an income tax treaty in
effect with the United States. A is treated as a partnership for U.S.
federal income tax purposes. A is also treated as a partnership under
the laws of Country X, and therefore Country X requires the interest
holders in A to separately take into account on a current basis their
respective shares of the items of income paid to A, whether or not
distributed to the interest holders, and the character and source of the
items in the hands of the interest holders are determined as if such
items were realized directly from the source from which realized by A. A
receives royalty income from U.S. sources that is not effectively
connected with the conduct of a trade or business in the United States.
(ii) Analysis. A is fiscally transparent in its jurisdiction within
the meaning of paragraph (d)(3)(ii) of this section with respect to the
U.S. source royalty income in Country X and, thus, A does not derive
such income for purposes of the U.S.-X income tax treaty.
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
[[Page 649]]
a corporation under the laws of Country X. Article 12 of the U.S.-X
income tax treaty provides for a source country reduced rate of taxation
on royalties of 5-percent. Article 12 of the U.S.-Y income tax treaty
provides that royalty income may only be taxed by the beneficial owner's
country of residence.
(ii) Analysis. A is treated as deriving the U.S. source royalty
income for purposes of the U.S.-X income tax treaty because it is not
fiscally transparent with respect to the item of income within the
meaning of paragraph (d)(3)(ii) of this section in Country X, its
country of organization. M is also treated as deriving its share of the
U.S. source royalty income for purposes of the U.S.-Y income tax treaty
because A is fiscally transparent under paragraph (d)(3)(iii) of this
section with respect to that income under the laws of Country Y. T is
not treated as deriving the U.S. source royalty income for purposes of
the U.S.-Z income tax treaty because under Country Z law A is not
fiscally transparent. Assuming all other requirements for eligibility
for treaty benefits have been satisfied, A is entitled to the 5-percent
treaty reduced rate on royalties under the U.S.-X income tax treaty with
respect to the entire royalty payment. Assuming all other requirements
for treaty benefits have been satisfied, M is also entitled to a zero
rate under the U.S.-Y income tax treaty with respect to its share of the
royalty income.
Example 4. Treatment of grantor trust. (i) Facts. Entity A is a
trust organized under the laws of Country X, which does not have an
income tax treaty in effect with the United States. M, the grantor and
owner of A for U.S. income tax purposes, is a resident of Country Y,
which has an income tax treaty in effect with the United States. M is
also treated as the grantor and owner of the trust under the laws of
Country Y. Thus, Country Y requires M to take into account all items of
A's income in the taxable year, whether or not distributed to M, and
determines the character of each item in M's hands as if such item was
realized directly from the source from which realized by A. Country X
does not treat M as the owner of A and does not require M to account for
A's income on a current basis whether or not distributed to M. A
receives interest income from U.S. sources that is neither portfolio
interest nor effectively connected with the conduct of a trade or
business in the United States.
(ii) Analysis. A is not fiscally transparent under the laws of
Country X within the meaning of paragraph (d)(3)(ii) of this section
with respect to the U.S. source interest income, but A may not claim
treaty benefits because there is no U.S.-X income tax treaty. M,
however, does derive the income for purposes of the U.S.-Y income tax
treaty because under the laws of Country Y, A is fiscally transparent.
Example 5. Treatment of complex trust. (i) Facts. The facts are the
same as in Example 4 except that M is treated as the owner of the trust
only under U.S. tax law, after application of section 672(f), but not
under the law of Country Y. Although the trust document governing A does
not require that A distribute any of its income on a current basis, some
distributions are made currently to M. There is no requirement under
Country Y law that M take into account A's income on a current basis
whether or not distributed to him in that year. Under the laws of
Country Y, with respect to current distributions, the character of the
item of income in the hands of the interest holder is determined as if
such item were realized directly from the source from which realized by
A. Accordingly, upon a current distribution of interest income to M, the
interest income retains its source as U.S. source income.
(ii) Analysis. M does not derive the U.S. source interest income
because A is not fiscally transparent under paragraph (d)(3)(ii) of this
section with respect to the U.S. source interest income under the laws
of Country Y. Although the character of the interest in the hands of M
is determined as if 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
[[Page 650]]
absence of legal personality in Country X of the arrangement, A is not
liable to tax as a person at the entity level in Country X and is thus
not a resident within the meaning of the Residence Article of the U.S.-X
income tax treaty. A is treated as a partnership for U.S. income tax
purposes and receives U.S. source dividend income. Under the laws of
Country X, however, investors in A only take into account their
respective share of A's income upon distribution from the Common Fund.
Some of A's interest holders are residents of Country X and some of
Country Y. Country Y has no income tax treaty in effect with the United
States.
(ii) Analysis. A is not fiscally transparent under paragraph
(d)(3)(ii) of this section with respect to the U.S. source dividend
income because the interest holders in A are not required to take into
account their respective shares of such income in the taxable year
whether or not distributed. Because A is an arrangement without a legal
personality that is not considered a person in Country X and thus not a
resident of Country X under the Residence Article of the U.S.-X income
tax treaty, however, A does not derive the income as a resident of
Country X for purposes of the U.S.-X income tax treaty. Further, because
A is not fiscally transparent under paragraph (d)(3)(iii) of this
section with respect to the U.S. source dividend income, A's interest
holders that are residents of Country X do not derive the income as
residents of Country X for purposes of the U.S.-X income tax treaty.
Example 8. Treatment of person specifically listed as resident in
applicable treaty. (i) Facts. The facts are the same as in Example 7
except that A (the Common Fund) is organized in Country Z and the
Residence Article of the U.S.-Z income tax treaty provides that ``the
term 'resident of a Contracting State' includes, in the case of Country
Z, Common Funds.* * *''
(ii) Analysis. A is treated, for purposes of the U.S.-Z income tax
treaty as deriving the dividend income as a resident of Country Z under
paragraph (d)(1) of this section because the item of income is paid
directly to A, A is a Common Fund under the laws of Country Z, and
Common Funds are specifically identified as residents of Country Z in
the U.S.-Z treaty. There is no need to determine whether A meets the
definition of fiscally transparent under paragraph (d)(3)(ii) of this
section.
Example 9. Treatment of investment company when entity receives
distribution deductions, and all distributions sourced by residence of
entity. (i) Facts. Entity A is a business organization formed under the
laws of Country X, which has an income tax treaty in effect with the
United States. A is treated as a partnership for U.S. income tax
purposes. Under the laws of Country X, A is an investment company
taxable at the entity level and a resident of Country X. It is also
entitled to a distribution deduction for amounts distributed to its
interest holders on a current basis. A distributes all its net income on
a current basis to its interest holders and, thus, in fact, has no
income tax liability to Country X. A receives U.S. source dividend
income. Under Country X law, all amounts distributed to interest holders
of this type of business entity are treated as dividends from sources
within Country X and Country X imposes a withholding tax on all payments
by A to foreign persons. Under Country X laws, the interest holders in A
do not have to separately take into account their respective shares of
A's income on a current basis if such income is not, in fact,
distributed.
(ii) Analysis. A is not fiscally transparent under paragraph
(d)(3)(ii) of this section with respect to the U.S. source dividends
because the interest holders in A do not have to take into account their
respective share of the U.S. source dividends on a current basis whether
or not distributed. A is also not fiscally transparent under paragraph
(d)(3)(ii) of this section because there is a change in source of the
income received by A when A distributes the income to its interest
holders 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
[[Page 651]]
income received by A on a current basis whether or not distributed.
(ii) Analysis. An item by item analysis is required under paragraph
(d) of this section. The analysis is the same as Example 9 with respect
to the dividend income. A is also not fiscally transparent under
paragraph (d)(3)(ii) of this section with respect to the interest income
because, although the character of the distributions attributable to the
interest income in the hands of A's interest holders is determined as if
realized directly from the source from which realized by A, under
Country X law the interest holders in A do not have to take into account
their respective share of the interest income received by A on a current
basis whether or not distributed. Accordingly, A derives the U.S. source
interest income for purpose of the U.S.-X treaty.
Example 11. Treatment of charitable organizations. (i) Facts. Entity
A is a corporation organized under the laws of Country X that has an
income tax treaty in effect with the United States. Entity A is
established and operated exclusively for religious, charitable,
scientific, artistic, cultural, or educational purposes. Entity A
receives U.S. source dividend income from U.S. sources. A provision of
Country X law generally exempts Entity A's income from Country X tax due
to the fact that Entity A is established and operated exclusively for
religious, charitable, scientific, artistic, cultural, or educational
purposes. But for such provision, Entity A's income would be taxed by
Country X.
(ii) Analysis. Entity A is not fiscally transparent under paragraph
(d)(3)(ii) of this section with respect to the U.S. source dividend
income because, under Country X law, the dividend income is treated as
an item of income of A and no other persons are required to take into
account their respective share of the item of income on a current basis,
whether or not distributed. Accordingly, Entity A is treated as deriving
the U.S. source dividend income.
Example 12. Treatment of pension trusts. (i) Facts. Entity A is a
trust established and operated in Country X exclusively to provide
pension or other similar benefits to employees pursuant to a plan.
Entity A receives U.S. source dividend income. A provision of Country X
law generally exempts Entity A's income from Country X tax due to the
fact that Entity A is established and operated exclusively to provide
pension or other similar benefits to employees pursuant to a plan. Under
the laws of Country X, the beneficiaries of the trust are not required
to take into account their respective share of A's income on a current
basis, whether or not distributed and the character and source of the
income in the hands of A's interest holders are not determined as if
realized directly from the source from which realized by A.
(ii) Analysis. A is not fiscally transparent under paragraph
(d)(3)(ii) of this section with respect to the U.S. source dividend
income because under the laws of Country X, the beneficiaries of A are
not required to take into account their respective share of A's income
on a current basis, whether or not distributed. A is also not fiscally
transparent under paragraph (d)(3)(ii) of this section with respect to
the U.S. source dividend income because under the laws of Country X, the
character and source of the income in the hands of A's interest holders
are not determined as if realized directly from the source from which
realized by A. Accordingly, A derives the U.S. source dividend income
for purposes of the U.S.-X income tax treaty.
(6) Effective dates. This paragraph (d) applies to items of income
paid on or after June 30, 2000, except paragraphs (d)(2)(ii) and
(d)(2)(iii) of this section apply to items of income paid by a domestic
reverse hybrid entity on or after June 12, 2002 with respect to 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
[[Page 652]]
the bank is the owner of the obligations or deposits and does not hold
the obligations or deposits for, or use them in connection with, the
conduct of a commercial banking function or other commercial activity by
such bank. For purposes of this section and paragraph (i) of Sec.
1.1441-4, obligations of the United States or of any agency or
instrumentality thereof include beneficial interests, participations,
and other instruments issued under section 302(c) of the Federal
National Mortgage Association Charter Act (12 U.S.C. 1717). See 24 CFR
part 1600 et seq.
(b) Foreign central bank of issue. (1) A foreign central bank of
issue is a bank which is by law or government sanction the principal
authority, other than the government itself, issuing instruments
intended to circulate as currency. Such a bank is generally the
custodian of the banking reserves of the country under whose law it is
organized. See also paragraph (b)(5) of Sec. 1.861-2.
(2) The exclusion granted by section 895 applies to an
instrumentality that is separate from a foreign government, whether or
not owned in whole or in part by a foreign government. For example,
foreign banks organized along the lines of, and performing functions
similar to, the Federal Reserve System qualify as foreign central banks
of issue for purposes of this section.
(3) The Bank for International Settlements shall be treated as
though it were a foreign central bank of issue for purposes of obtaining
the exclusion granted by section 895.
(c) Ownership of United States obligations or bank deposits. The
exclusion does not apply if the obligations or bank deposits from which
the income is derived are not owned by the foreign central bank of
issue. Obligations held, or deposits made, by a foreign central bank of
issue as agent, custodian, trustee, or in any other fiduciary capacity,
shall be considered as not owned by such bank for purposes of this
section.
(d) Commercial banking function or other commercial activity. The
exclusion applies only to obligations of the United States or of any
agency or instrumentality thereof, or to bank deposits, held for, or
used in connection with, the conduct of a central banking function and
not to obligations or deposits held for, or used in connection with, the
conduct of commercial banking functions or other commercial activities
by the foreign central bank.
(e) Other exclusions. See section 861(a)(1) (A) and (E) and Sec.
1.861-2(b)(1) and (4), for special rules relating to interest paid or
credited before January 1, 1977, on deposits and on similar amounts and
for rules on interest derived from bankers' acceptances. For exemption
from withholding under Sec. 1.1441-1 on income derived by a foreign
central bank of issue, or by the Bank of International Settlements, from
obligations of the United States or of any agency or instrumentality
thereof, or from bank deposits, see Sec. 1.1441-4(i).
(f) Effective date. This section shall apply with respect to taxable
years beginning after December 31, 1966. For 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) Applicability date. Except as otherwise provided in this
paragraph (a)(2), the regulations set forth in this section and
Sec. Sec. 1.897-2 through 1.897-4 apply to
[[Page 653]]
transactions occurring after June 18, 1980. Except as otherwise provided
in paragraph (c)(3)(vi) of this section, paragraphs (c)(3) and (4), (k),
and (l) of this section apply to transactions occurring on or after
April 25, 2024, and transactions occurring before April 25, 2024,
resulting from an entity classification election under Sec. 301.7701-3
of this chapter that was effective on or before April 25, 2024, but was
filed on or after April 25, 2024. For transactions occurring before
April 25, 2024, see paragraphs (c)(2)(i) and (l) of this section and
Sec. 1.897-9T(c) contained in 26 CFR part 1, as revised April 1, 2024.
(b) Real property--(1) In general. The term ``real property''
includes the following three categories of property: Land and unserved
natural products of the land, improvements, and personal property
associated with the use of real property. The three categories of real
property are defined in subparagraphs (2), (3), and (4) of this
paragraph (b). Local law definitions will not be controlling for
purposes of determining the meaning of the term ``real property'' as it
is used in sections 897, 1445, and 6039C and the regulations thereunder.
(2) Land and unserved natural products of the land. The term ``real
property'' includes land, growing crops and timber, and mines, wells,
and other natural deposits. Crops and timber cease to be real property
at the time that they are served from the land. Ores, minerals, and
other natural deposits cease to be real property when they are extracted
from the ground. The storage of severed or extracted crops, timber, or
minerals in or upon real property will not cause such property to be
recharacterized as real property.
(3) Improvements--(i) In general. The term ``real property''
includes improvements on land. An improvement is a building, any other
inherently permanent structure, or the structural components of either,
as defined in subdivisions (ii) through (iv) of this paragraph (b)(3).
(ii) Building. The term ``building'' generally means any structure
or edifice enclosing a space within its walls, and usually covered by a
roof, the purpose of which is, for example, to provide shelter or
housing or to provide working, office, parking, display, or sales space.
The term includes, for example, structures such as apartment houses,
factory and office buildings, warehouses, barns, garages, railway or bus
stations, and stores. Any structure that is classified as a building for
purposes of section 48(a)(1)(B) and Sec. 1.48-1 shall be treated as
such for purposes of this section.
(iii) Inherently permanent structure--(A) In general. The term
``inherently permanent structure'' means any property not otherwise
described in this paragraph (b)(3) that is affixed to real property and
that will ordinarily remain affixed for an indefinite period of time.
Property that is not classified as a building for purposes of section
48(a)(1)(B) and Sec. 1.48-1 may nevertheless constitute an inherently
permanent structure. For purposes of this section, affixation to real
property may be accomplished by weight alone.
(B) Use of precedents under section 48. Any property not otherwise
described 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
[[Page 654]]
such property constitutes an inherently permanent structure shall be
made in view of all the facts and circumstances. In particular, the
following factors must be taken into account:
(1) The manner in which the property is affixed to real property;
(2) Whether the property was designed to be easily removable or to
remain in place indefinitely;
(3) Whether the property has been moved since its initial
installation;
(4) Any circumstances that suggest the expected period of affixation
(e.g., a lease that requires removal of the property upon its
expiration);
(5) The amount of damage that removal of the property would cause to
the property itself or to the real property to which it is affixed; and
(6) The extent of the effort that would be required to remove the
property, in terms of time and expense.
(iv) Structural components of buildings and other inherently
permanent structures. Structural components of buildings and other
inherently permanent structures, as defined in Sec. 1.48-1 (e)(2),
themselves constitute improvements. Structural components include walls,
partitions, floors, ceilings, windows, doors, wiring, plumbing, central
heating and central air conditioning systems, lighting fixtures, pipes,
ducts, elevators, escalators, sprinkler systems, fire escapes and other
components relating to the operation or maintenance of a building.
However, the term ``structural components'' does not include machinery
the sole justification for the installation of which is the fact that
such machinery is required to meet temperature or humidity requirements
which are essential for the operation of other machinery or the
processing of materials or foodstuffs. Machinery may meet the ``sole
justification'' test provided by the preceding sentence even though it
incidentally provides for the comfort of employees or serves to an
insubstantial degree areas where such temperature or humidity
requirements are not essential.
(4) Personal property associated with the use of the real property--
(i) In general. The term ``real property'' includes movable walls,
furnishings, and other personal property associated with the use of the
real property. Personal property is associated with the use of real
property only if it is described in one of the categories set forth in
subdivisions (A) through (D) of this paragraph (b)(4)(i). ``Personal
property'' for purposes of this section means any property that
constitutes ``tangible personal property'' under the principles of Sec.
1.48-1(c), without regard to whether such property qualifies as section
38 property. Such property will be associated with the use of the real
property only where both the personal property and the United States
real property interest with which it is associated are held by the same
person or by related persons within the meaning of Sec. 1.897-1(i). For
purposes of this paragraph (b)(4)(i), property is used ``predominantly''
in a named activity if it is devoted to that activity during at least
half of the time in which it is in use during a calendar year.
(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
[[Page 655]]
with the operation of a lodging facility. Property that is used in
connection with the operation of a lodging facility includes property
used in the living quarters of such facility, such as beds and other
furniture, refrigerators, ranges and other equipment, as well as
property used in the common areas of such facility, such as lobby
furniture and laundry equipment. Such property constitutes personal
property associated with the use of real property in the hands of the
owner or operator of the facility, not of the tenant or guest. A lodging
facility is an apartment house or apartment, hotel, motel, dormitory,
residence, or any other facility (or part of a facility) predominantly
used to provide, at a charge, living and/or sleeping accommodations,
whether on daily, weekly, monthly, annual, or other basis. The term
``lodging facility'' does not include a personal residence occupied
solely by its owner, or a facility used primarily as a means of
transportation (such as an aircraft, vessel, or a railroad car) or used
primarily to provide medical or convalescent services, even though
sleeping accommodations are provided. Nor does the term include
temporary living quarters provided by an employer due to the
unavailability of lodgings within a reasonable distance of a work-site
(such as a mine or construction project). The term ``lodging facility''
does not include any portion of a facility that constitutes a nonlodging
commercial facility and that is available to persons not using the
lodging facility on the same basis that it is available to tenants of
the lodging facility. Examples of nonlodging commercial facilities
include restaurants, drug stores, and grocery stores located in a
lodging facility.
(D) Property used in the rental of furnished office and other work
space. Personal property is associated with the use of real property if
it is predominantly used by a lessor to provide furnished office or
other work space to lessees. Property that is so used includes office
furniture and equipment included in the rental of furnished space. Such
property constitutes personal property associated with the use of real
property in the hands of the lessor, not of the lessee.
(ii) Dispositions of associated personal property--(A) In general.
Personal property that has become associated with the use of a real
property interest shall itself be treated as a real property interest
upon its disposition, unless either:
(1) The personal property is disposed of more than one year before
the disposition of any present right to use or occupy the real property
with which it was associated (and subject to the provisions of
subdivision (B) of this paragraph (b)(4)(ii));
(2) The personal property is disposed of more than one year after
the disposition of all present rights to use or occupy the real property
with which it was associated (and subject to the provisions of
subdivision (C) of this paragraph (b)(4)(ii)); or
(3) The personal property and the real property with which it was
associated are separately sold to persons that are related neither to
the transferor 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
[[Page 656]]
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 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) [Reserved]
(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
[[Page 657]]
market value of that class of interests at any time during the five-year
period ending either on the date of disposition of such interest or
other applicable determination date (or the period since June 18, 1980,
in shorter), or
(B) [Reserved]
Separate non-regularly traded interests that were acquired in
transactions more than three years apart shall not be cumulated pursuant
to this rule. In determining whether a shareholder holds 5 percent of a
class of stock in a corporation (or any other interest of an equivalent
fair market value), section 318(a) shall apply (except that sections
318(a) (2)(C) and (3)(C) are applied by substituting the phrase ``5
percent'' for ``50 percent'').
(iv) Publicly traded partnerships and trusts. If any class of
interests in a partnership or trust is, within the meaning of Sec.
1.897-1(m) and (n), regularly traded on an established securities
market, then for purposes of sections 897(g) and 1445 and Sec. 1.897-2
(d) and (e) an interest in the entity shall not be treated as an
interest in a partnership or trust. Instead, such an interest shall be
subject to the rules applicable to interests in publicly traded
corporations pursuant to paragraph (c)(2)(iii) of this section. Such
interests can be real property interests in the hands of a person that
holds a greater than 5 percent interest. Therefore, solely for purposes
of determining whether greater than 5 percent interests in such an
entity constitute U.S. real property interests the disposition of which
is subject to tax, the entity is required to determine pursuant to the
provisions of Sec. 1.897-2 whether the assets it holds would cause it
to be classified as a U.S. real property holding corporation if it were
a corporation. The treatment of dispositions of U.S. real property
interests by publicly traded partnerships and trusts is not affected by
the rules of this paragraph (c)(2)(iv); by reason of the operation of
section 897(a), foreign partners or beneficiaries are subject to tax
upon their distributive share of any gain recognized upon such
dispositions by the partnership or trust. The rules of this paragraph
(c)(2)(iv) are illustrated by the following example.
Example. PTP is a partnership one class of interests in which is
regularly traded on an established securities market. A is a nonresident
alien individual who owns 1 percent of a class of limited partnership
interests in PTP. B is a nonresident alien individual who owns 10
percent of the same class of limited partnership interests in PTP. On
July 1, 1986, A and B sell their interests in PTP. Pursuant to the rules
of this paragraph (c)(2)(iv), neither disposition is treated as the
disposition of a partnership interest subject to the provisions of
section 897(g). Instead, A and B are treated as having disposed of
interests in a 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.
(3) Domestically controlled QIE--(i) In general. An interest in a
domestically controlled qualified investment entity (QIE) is not a
United States real property interest. A QIE is domestically controlled
if foreign persons hold directly or indirectly less than 50 percent of
the fair market value of the QIE's outstanding stock at all times during
the testing period. For rules that apply to distributions by a QIE
(including a domestically controlled QIE) attributable to gain from the
sale or exchange of a United States real property interest, see section
897(h)(1).
(ii) Look-through approach for determining QIE stock held directly
or indirectly. The following rules apply for purposes of determining
whether a QIE is domestically controlled:
(A) Non-look-through persons considered holders. Only a non-look-
through person is considered to hold directly or indirectly stock of the
QIE.
(B) Attribution from look-through persons. Stock of a QIE that, but
for the application of paragraph (c)(3)(ii)(A) of this section, would be
considered directly or indirectly held by a look-through person, is
instead considered held directly or indirectly by the look-through
person's shareholders, partners, or beneficiaries, as applicable, that
are non-look-through persons based on the non-look-through person's
proportionate interest in the look-through person. To the extent the
[[Page 658]]
shareholders, partners, or beneficiaries, as applicable, of the look-
through person are also look-through persons, this paragraph
(c)(3)(ii)(B) applies to such shareholders, partners, or beneficiaries
as if they directly or indirectly held, but for the application of
paragraph (c)(3)(ii)(A) of this section, their proportionate share of
the stock of the QIE.
(C) No attribution from non-look-through persons. Stock of a QIE
considered held directly or indirectly by a non-look-through person is
not considered held directly or indirectly by any other person.
(iii) Special rules for applying look-through approach. The
following additional special rules apply for purposes of determining
whether a QIE is domestically controlled:
(A) Certain holders of U.S. publicly traded QIE stock.
Notwithstanding any other provision of this paragraph (c)(3), a person
holding less than five percent of U.S. publicly traded stock of a QIE at
all times during the testing period, determined without regard to
paragraph (c)(3)(ii)(A) of this section, is treated as a United States
person that is a non-look-through person with respect to that stock,
unless the QIE has actual knowledge that such person is not a United
States person or has actual knowledge that such person is foreign
controlled as determined under paragraph (c)(3)(v)(B) of this section
(treating any person that is not a non-public domestic C corporation as
if it were a non-public domestic C corporation for this purpose). For an
example illustrating the application of this paragraph (c)(3)(iii)(A),
see paragraph (c)(3)(vii)(C) of this section (Example 3).
(B) Certain foreign-controlled domestic C corporations. A non-public
domestic C corporation is treated as a look-through-person if it is a
foreign-controlled domestic corporation. For an example illustrating the
application of this paragraph (c)(3)(iii)(B), see paragraph
(c)(3)(vii)(B) of this section (Example 2).
(C) Public QIEs. A public QIE is treated as a foreign person that is
a non-look-through person. The preceding sentence does not apply,
however, if the public QIE is a domestically controlled QIE as defined
in this paragraph (c)(3), determined after the application of this
paragraph (c)(3)(iii), in which case the public QIE is treated as a
United States person that is a non-look-through person. For an example
illustrating the application of this paragraph (c)(3)(iii)(C), see
paragraph (c)(3)(vii)(C) of this section (Example 3).
(iv) Treatment of certain persons as foreign persons--(A) Qualified
foreign pension fund or qualified controlled entity. For purposes of
this paragraph (c)(3), a qualified foreign pension fund (including any
part of a qualified foreign pension fund) or a qualified controlled
entity is treated as a foreign person, irrespective of whether the fund
or entity qualifies for the exception from section 897 provided in Sec.
1.897(l)-1(b)(1). For an example illustrating the application of this
paragraph (c)(3)(iv)(A), see paragraph (c)(3)(vii)(A) of this section
(Example 1). See also paragraph (k) of this section for a definition of
foreign person that applies for purposes of sections 897, 1445, and
6039C.
(B) International organization. For purposes of this paragraph
(c)(3), an international organization (as defined in section
7701(a)(18)) is treated as a foreign person. See Sec. 1.897-9T(e)
(regarding the treatment of international organizations under sections
897, 1445, and 6039C), which provides that an international organization
is not a foreign person with respect to United States real property
interests, and is not subject to sections 897, 1445, and 6039C on the
disposition of a United States real property interest.
(v) Definitions. The following definitions apply for purposes of
this paragraph (c)(3):
(A) A domestic C corporation is any domestic corporation other than
a regulated investment company (RIC) as defined in section 851, a real
estate investment trust (REIT) as defined in section 856, or an S
corporation as defined in section 1361.
(B) A foreign-controlled domestic corporation is any non-public
domestic C corporation if foreign persons hold directly or indirectly
more than 50 percent of the fair market value of the non-public domestic
C corporation's
[[Page 659]]
outstanding stock. For purposes of determining whether a non-public
domestic C corporation is a foreign-controlled domestic corporation, the
rules of paragraphs (c)(3)(ii)(A) through (C) and (c)(3)(iii)(C) of this
section apply with the following modifications--
(1) In paragraphs (c)(3)(ii)(A) through (C) of this section,
treating references to QIE as references to non-public domestic C
corporation; and
(2) A non-public domestic C corporation that is a foreign-controlled
domestic corporation under this paragraph (c)(3)(v)(B) is treated as a
look-through person for purposes of determining whether any other non-
public domestic C corporation is a foreign-controlled domestic
corporation.
(C) A look-through person is any person other than a non-look-
through person. Thus, for example, a look-through person includes a REIT
that is not a public QIE, an S corporation, a partnership (domestic or
foreign) that is not a publicly traded partnership, a RIC that is not a
public RIC, and a trust (domestic or foreign, whether or not the trust
is described in sections 671 through 679). For a special rule that
treats certain non-public domestic C corporations as look-through
persons, see paragraph (c)(3)(iii)(B) of this section.
(D) A non-look-through person is an individual, a domestic C
corporation (other than a foreign-controlled domestic corporation), a
nontaxable holder, a foreign corporation (including a foreign government
pursuant to section 892(a)(3)), a publicly traded partnership (domestic
or foreign), a public RIC, an estate (domestic or foreign), an
international organization (as defined in section 7701(a)(18)), a
qualified foreign pension fund (including any part of a qualified
foreign pension fund), or a qualified controlled entity. For special
rules that treat certain holders of QIE stock as non-look-through
persons, see paragraphs (c)(3)(iii)(A) and (C) of this section.
(E) A non-public domestic C corporation is any domestic C
corporation that is not a public domestic C corporation.
(F) A nontaxable holder is--
(1) Any organization that is exempt from taxation by reason of
section 501(a);
(2) The United States, any State (as defined in section
7701(a)(10)), any territory of the United States, or a political
subdivision of any State or any territory of the United States; or
(3) Any Indian Tribal government (as defined in section 7701(a)(40))
or its subdivision (determined in accordance with section 7871(d)).
(G) A public domestic C corporation is a domestic C corporation any
class of stock of which is regularly traded on an established securities
market within the meaning of Sec. Sec. 1.897-1(m) and 1.897-9T(d). A
domestic C corporation is not a public domestic C corporation, however,
if the QIE whose status as domestically controlled is being determined
under this paragraph (c)(3) has actual knowledge that the domestic C
corporation is foreign controlled as determined under paragraph
(c)(3)(v)(B) of this section (treating the domestic C corporation for
this purpose as if it were a non-public domestic C corporation).
(H) A public QIE is a QIE any class of stock of which is regularly
traded on an established securities market within the meaning of
Sec. Sec. 1.897-1(m) and 1.897-9T(d), or that is a RIC that issues
redeemable securities within the meaning of section 2 of the Investment
Company Act of 1940.
(I) A public RIC is a RIC that is not a QIE and any class of stock
of which is either regularly traded on an established securities market
within the meaning of Sec. Sec. 1.897-1(m) and 1.897-9T(d), or common
stock that is continuously offered pursuant to a public offering (within
the meaning of section 4 of the Securities Act of 1933, as amended (15
U.S.C. 77a to 77aa)) and held by or for no fewer than 500 persons. A RIC
is not a public RIC, however, if the QIE whose status as domestically
controlled is being determined under this paragraph (c)(3) has actual
knowledge that the RIC is foreign controlled as determined under
paragraph (c)(3)(v)(B) of this section (treating the RIC for this
purpose as if it were a non-public domestic C corporation).
(J) A publicly traded partnership is a partnership any class of
interest of which is regularly traded on an established securities
market within the meaning of Sec. Sec. 1.897-1(m) and 1.897-9T(d).
[[Page 660]]
A domestic partnership is not a publicly traded partnership, however, if
the QIE whose status as domestically controlled is being determined
under this paragraph (c)(3) has actual knowledge that the domestic
partnership is foreign controlled as determined under paragraph
(c)(3)(v)(B) of this section (treating the partnership for this purpose
as if it were a non-public domestic C corporation).
(K) A qualified controlled entity has the meaning set forth in Sec.
1.897(l)-1(e)(9).
(L) A qualified foreign pension fund has the meaning set forth in
Sec. 1.897(l)-1(c).
(M) A QIE is a qualified investment entity, as defined in section
897(h)(4)(A).
(N) Testing period has the meaning set forth in section
897(h)(4)(D).
(O) U.S. publicly traded QIE stock is any class of stock of a QIE
that is regularly traded on an established securities market within the
meaning of Sec. Sec. 1.897-1(m) and 1.897-9T(d), but only if the
established securities market is in the United States.
(vi) Transition rule for certain QIEs owned by foreign-controlled
domestic corporations--(A) General rule. Except as provided in paragraph
(c)(3)(vi)(B) of this section, paragraph (c)(3)(iii)(B) of this section
does not apply with respect to a QIE that is in existence as April 24,
2024, and satisfies the following requirements at all times on and after
April 24, 2024--
(1) The QIE is domestically controlled (as determined under this
paragraph (c)(3), but without regard to paragraph (c)(3)(iii)(B) of this
section);
(2) The aggregate fair market value of any United States real
property interests acquired by the QIE directly and indirectly after
April 24, 2024, is no more than 20 percent of the aggregate fair market
value of the United States real property interests held directly and
indirectly by the QIE as of April 24, 2024 (determined in accordance
with paragraph (c)(3)(vi)(D) of this section); and
(3) The percentage of the stock of the QIE held directly or
indirectly by one or more non-look-through persons (determined based on
fair market value and under the rules of paragraphs (c)(3)(ii) through
(v) of this section and this paragraph (c)(3)(vi), including paragraph
(c)(3)(iii)(B) of this section) does not increase by more than 50
percentage points in the aggregate over the percentage of stock of the
QIE owned directly or indirectly by such non-look-through persons on
April 24, 2024.
(B) Termination of transition rule. The transition rule described in
paragraph (c)(3)(vi)(A) of this section will cease to apply, and the
rule in paragraph (c)(3)(iii)(B) of this section will apply for purposes
of determining whether a QIE is domestically controlled, with respect to
transactions occurring on or after the earlier of:
(1) The date immediately following the date on which the QIE fails
to meet any of the requirements described in paragraph (c)(3)(vi)(A) of
this section; and
(2) April 24, 2034. For an example illustrating the application of
paragraph (c)(3)(vi)(A) of this section and this paragraph
(c)(3)(vi)(B), see paragraph (c)(3)(vii)(E) of this section (Example 5).
(C) Effect of transition rule on testing period. If the transition
rule described in paragraph (c)(3)(vi)(A) of this section ceases to
apply to a QIE under paragraph (c)(3)(vi)(B) of this section, the rule
in paragraph (c)(3)(iii)(B) of this section will not apply to the QIE
with respect to the portion of any testing period during which the
transition rule in this paragraph (c)(3)(vi) applied.
(D) Determination of fair market value of United States real
property interests. For purposes of paragraph (c)(3)(vi)(A)(2) of this
section, the fair market value of the United States real property
interests held directly and indirectly by a QIE on April 24, 2024, is
the value of such property interests as calculated under section
851(b)(3) or 856(c)(4) as of the close of the most recent quarter of the
QIE's taxable year before April 24, 2024. For purposes of paragraph
(c)(3)(vi)(A)(2) of this section, the fair market value of any property
acquired after the close of the most recent quarter of the QIE's taxable
year before April 24, 2024, whether acquired before or after April 24,
2024, is determined on the date of such acquisition using a reasonable
method, provided the QIE consistently uses the
[[Page 661]]
same method with respect to all of its United States real property
interests when applying this paragraph (c)(3)(vi).
(E) Binding commitments. For purposes of paragraphs (c)(3)(vi)(A)(2)
and (3) of this section, a direct or indirect acquisition of a United
States real property interest or of stock of a QIE pursuant to a written
agreement that was (subject to customary conditions) binding before
April 24, 2024, and all times thereafter, or pursuant to a tender offer
announced before April 24, 2024, that is subject to section 14(e) of the
Securities and Exchange Act of 1934 (15 U.S.C. 78n(e)) and 17 CFR
240.14e-1 through 240.14e-8 (Regulation 14E), is treated as occurring on
April 24, 2024.
(F) Ownership by certain successors under section 368(a)(1)(F). For
purposes of paragraph (c)(3)(vi)(A)(3) of this section, the transferor
corporation and the resulting corporation (as defined in Sec. 1.368-
2(m)(1)) in a reorganization described under section 368(a)(1)(F)
(whether engaged in by the QIE or by another corporation) are treated as
the same corporation.
(G) Ownership by less than five-percent public shareholders. For
purposes of paragraph (c)(3)(vi)(A)(3) of this section, in the case of
any class of stock of a QIE that is regularly traded on an established
securities market within the meaning of Sec. Sec. 1.897-1(m) and 1.897-
9T(d), all such stock owned by persons holding less than 5 percent of
that class of stock, determined without regard to paragraph
(c)(3)(ii)(A) of this section, is treated as stock owned by a single
non-look-through person except to the extent that the QIE has actual
knowledge regarding the ownership of any person.
(vii) Examples. The rules of this paragraph (c)(3) are illustrated
by the following examples. It is assumed that each entity has a single
class of stock or other ownership interests, that the ownership
described existed throughout the relevant testing period and that,
unless otherwise stated, a QIE is not a public QIE as defined under
paragraph (c)(3)(v)(H) of this section.
(A) Example 1: QIE stock held by public domestic C corporation--(1)
Facts. USR is a REIT, 51 percent of the stock of which is held by X, a
public domestic C corporation as defined in paragraph (c)(3)(v)(G) of
this section, and 49 percent of the stock of which is held by
nonresident alien individuals, which are foreign persons as defined in
paragraph (k) of this section.
(2) Analysis. Under paragraph (c)(3)(v)(M) of this section, USR is a
QIE. Because X is a public domestic C corporation, it cannot be a
foreign-controlled domestic corporation and, therefore, is a non-look-
through person as defined under paragraph (c)(3)(v)(D) of this section.
Thus, under paragraph (c)(3)(ii)(A) of this section X is considered as
holding directly or indirectly stock of USR for purposes of determining
whether USR is a domestically controlled QIE. Under paragraph
(c)(3)(ii)(C) of this section, the USR stock held directly or indirectly
by X is not considered held directly or indirectly by any other person,
including the shareholders of X. Because X is not a foreign person as
defined in paragraph (k) of this section and holds directly or
indirectly 51 percent of the single class of outstanding stock of USR,
foreign persons hold directly or indirectly less than 50 percent of the
fair market value of the stock of USR, and USR therefore is a
domestically controlled QIE under paragraph (c)(3)(i) of this section.
(3) Alternative facts: QIE stock held by domestic partnership. The
facts are the same as in paragraph (c)(3)(vii)(A)(1) of this section
(Example 1), except that, instead of being a public domestic C
corporation, X is a domestic partnership that is not a publicly traded
partnership as defined in paragraph (c)(3)(v)(J) of this section. In
addition, FC1, a foreign corporation, holds a 50 percent interest in X,
and the remaining interests in X are held by U.S. citizens. X is not a
non-look-through person as defined in paragraph (c)(3)(v)(D) of this
section and, therefore, is a look-through person as defined in paragraph
(c)(3)(v)(C) of this section. Accordingly, under paragraph (c)(3)(ii)(A)
of this section, X is not considered as holding directly or indirectly
stock of USR for purposes of determining whether USR is a domestically
controlled QIE. Under paragraph (c)(3)(ii)(B) of this section, the stock
of USR that, but for paragraph (c)(3)(ii)(A) of this section, is
considered held by X, a look-through
[[Page 662]]
person, is instead considered held proportionately by X's partners that
are non-look-through persons. Accordingly, because FC1 and the U.S.
citizen partners in X are non-look-through persons as defined in
paragraph (c)(3)(v)(D) of this section, 25.5 percent of the stock of USR
is considered as held directly or indirectly by FC1 (50% x 51%), a
foreign person as defined in paragraph (k) of this section, and 25.5
percent (in the aggregate) of the stock of USR is considered as held
directly or indirectly by the U.S. citizen partners in X (50% x 51%),
who are not foreign persons as defined in paragraph (k) of this section.
Foreign persons therefore hold directly or indirectly 74.5 percent of
the stock of USR (49 percent of the stock of USR held directly or
indirectly by nonresident alien individuals, who are non-look-through
persons as defined in paragraph (c)(3)(v)(D) of this section, plus the
25.5 percent held directly or indirectly by FC1), and USR is not a
domestically controlled QIE under paragraph (c)(3)(i) of this section.
The result described in this paragraph (c)(3)(vii)(A)(3) would be the
same if, instead of being a domestic partnership, X were a foreign
partnership.
(4) Alternative facts: QIE stock held by a qualified foreign pension
fund. The facts are the same as in paragraph (c)(3)(vii)(A)(3) of this
section (Example 1), except that, instead of being a foreign
corporation, FC1 is a qualified foreign pension fund. The analysis is
the same as in paragraph (c)(3)(vii)(A)(3) (Example 1) regarding the
treatment of X as a look-through person as defined in paragraph
(c)(3)(v)(C) of this section. In addition, FC1, a foreign person under
paragraph (c)(3)(iv)(A) of this section, is a non-look-through person as
defined in paragraph (c)(3)(v)(D) of this section. Because FC1 and the
U.S. citizen partners in X are non-look-through persons, 25.5 percent of
the stock of USR is considered as held directly or indirectly by FC1
(50% x 51%), and 25.5 percent (in the aggregate) of the stock of USR is
considered as held directly or indirectly by the U.S. citizen partners
in X (50% x 51%). Thus, for the same reasons described in paragraph
(c)(3)(vii)(A)(3) (Example 1), foreign persons hold directly or
indirectly 74.5 percent of the stock of USR, and USR is not a
domestically controlled QIE under paragraph (c)(3)(i) of this section.
(B) Example 2: QIE stock held by non-public domestic C corporation
that is a foreign-controlled domestic corporation--(1) Facts. USR is a
REIT, 51 percent of the stock of which is held by X, a non-public
domestic C corporation as defined in paragraph (c)(3)(v)(E) of this
section, and 49 percent of the stock of which is held by nonresident
alien individuals, which are foreign persons as defined in paragraph (k)
of this section. FC1, a foreign corporation, holds 40 percent of the
stock of X, and Y, a nonresident alien individual, holds 15 percent of
the stock of X. The remaining 45 percent of the stock of X is held by
U.S. citizens.
(2) Analysis. Under paragraph (c)(3)(v)(M) of this section, USR is a
QIE. X, a non-public domestic C corporation, is a non-look-through
person as defined under paragraph (c)(3)(v)(D) of this section, unless
paragraph (c)(3)(iii)(B) of this section applies to treat X as a look-
through person because X is a foreign-controlled domestic corporation.
FC1, Y, and the U.S. citizen shareholders of X are non-look-through
persons as defined under paragraph (c)(3)(v)(D). Under paragraph
(c)(3)(v)(B)(1) of this section, FC1, Y, and the U.S. citizen
shareholders are all considered as holding directly or indirectly stock
of X for purposes of determining whether X is a foreign-controlled
domestic corporation. Under paragraph (c)(3)(v)(B)(1) of this section,
the stock held directly or indirectly by FC1, Y, and the U.S. citizen
shareholders is not considered held directly or indirectly by any other
person. Because FC1 and Y, both foreign persons as defined in paragraph
(k) of this section, hold directly or indirectly 40 percent and 15
percent of the stock of X, respectively, foreign persons hold directly
or indirectly more than 50 percent of the fair market value of the stock
of X, and X is a foreign-controlled domestic corporation under paragraph
(c)(3)(v)(B) of this section. Accordingly, under paragraph
(c)(3)(iii)(B) of this section, X is a look-through person as defined in
paragraph
[[Page 663]]
(c)(3)(v)(C) of this section and, therefore, under paragraph
(c)(3)(ii)(A) of this section is not considered as holding directly or
indirectly stock of USR for purposes of determining whether USR is a
domestically controlled QIE. Under paragraph (c)(3)(ii)(B) of this
section, the stock of USR that, but for paragraph (c)(3)(ii)(A), is
considered held by X, a look-through person, is instead considered held
proportionately by X's shareholders that are non-look-through persons.
Accordingly, because FC1, Y, and the U.S. citizen shareholders of X are
non-look-through persons, 20.4 percent of the stock of USR is considered
as held directly or indirectly by FC1 (40% x 51%), 7.65 percent of the
stock of USR is considered as held directly or indirectly by Y (15% x
51%), and 22.95 percent (in the aggregate) of the stock of USR is
considered as held directly or indirectly by the U.S. citizen
shareholders (45% x 51%). Foreign persons therefore hold directly or
indirectly 77.05 percent of the stock of USR (49 percent of the stock of
USR held directly by nonresident alien individuals, who are foreign
persons and non-look-through persons as defined in paragraph
(c)(3)(v)(D), plus the 20.4 percent and 7.65 percent held indirectly by
FC1 and Y, respectively), and USR is not a domestically controlled QIE
under paragraph (c)(3)(i) of this section. The result described in this
paragraph (c)(3)(vii)(B)(2) would be different if Y were a U.S. citizen
instead of a nonresident alien individual, in which case X would be a
non-look-through person because it is not a foreign-controlled domestic
corporation under paragraph (c)(3)(v)(B) (the only foreign non-look-
through person to hold directly or indirectly stock in X is FC1, which
holds a 40-percent interest). Consequently, USR would be a domestically
controlled QIE under paragraph (c)(3)(i) of this section because foreign
persons hold directly or indirectly less than 50 percent of the stock of
USR.
(C) Example 3: QIE stock held by public QIE that is a domestically
controlled QIE--(1) Facts. USR2 is a REIT, 51 percent of the stock of
which is held by USR1, a REIT that is a public QIE as defined in
paragraph (c)(3)(v)(H) of this section, and 49 percent of the stock of
which is held by nonresident alien individuals, which are foreign
persons as defined in paragraph (k) of this section. The stock of USR1
is U.S. publicly traded QIE stock as defined in paragraph (c)(3)(v)(O)
of this section. FC1 and FC2, both foreign corporations, each hold 20
percent of the stock of USR1. The remaining 60 percent of the stock of
USR1 is held by persons that each hold less than 5 percent of the stock
of USR1 and with respect to which USR1 has no actual knowledge that such
person is not a United States person or is foreign controlled (as
determined under paragraph (c)(3)(v)(B) of this section by treating any
person that is not a non-public domestic C corporation as if it were a
non-public domestic C corporation for this purpose) (USR1 less than
five-percent public shareholders).
(2) Analysis. Under paragraph (c)(3)(v)(M) of this section, USR2 and
USR1 are QIEs. Under paragraph (c)(3)(iii)(A) of this section, each of
the USR1 less than five-percent public shareholders is treated as a
United States person that is a non-look-through person. Consequently,
under paragraph (c)(3)(i) of this section USR1 is a domestically
controlled QIE because FC1 and FC2, each a foreign person as defined in
paragraph (k) of this section that is a non-look-through person under
paragraph (c)(3)(v)(D) of this section, together hold directly or
indirectly only 40 percent of the stock of USR1 and, thus, foreign
persons hold directly or indirectly less than 50 percent of the fair
market value of the stock of USR1. In addition, the USR2 stock held by
USR1 is treated as held directly or indirectly by a United States person
that is a non-look-through person under paragraph (c)(3)(iii)(C) of this
section. Because USR1 holds directly or indirectly 51 percent of the
stock of USR2, foreign persons hold directly or indirectly less than 50
percent of the fair market value of the stock of USR2, and USR2 is a
domestically controlled QIE under paragraph (c)(3)(i) of this section.
(3) Alternative facts: QIE stock held by public QIE that is not a
domestically controlled QIE. The facts are the same as in paragraph
(c)(3)(vii)(C)(1) of this section (Example 3), except that 25 percent of
the stock of USR1 is held by each of
[[Page 664]]
FC1 and FC2, with the remaining 50 percent of the stock of USR1 held by
the USR1 less than five-percent public shareholders. Regardless of the
treatment of the USR1 less than five-percent public shareholders, USR1
is not a domestically controlled QIE under paragraph (c)(3)(i) of this
section because FC1 and FC2, each a foreign person as defined in
paragraph (k) of this section that is a non-look-through person under
paragraph (c)(3)(v)(D) of this section, together hold directly or
indirectly 50 percent of the stock of USR1 and, thus, foreign persons do
not hold directly or indirectly less than 50 percent of the fair market
value of the stock of USR1. In addition, the USR2 stock held by USR1 is
treated as held by a foreign person that is a non-look-through person
under paragraph (c)(3)(iii)(C) of this section. Because USR1 holds
directly or indirectly 51 percent of the stock of USR2, foreign persons
do not hold directly or indirectly less than 50 percent of the fair
market value of the stock of USR2, and USR2 is not a domestically
controlled QIE under paragraph (c)(3)(i) of this section.
(D) Example 4: QIE stock held by non-public QIE--(1) Facts. USR2 is
a REIT, 49 percent of the stock of which is held by nonresident alien
individuals, and 51 percent of the stock of which is held by USR1, a
REIT. USR1 is not a public QIE as defined in paragraph (c)(3)(v)(H) of
this section. U.S. citizens hold 50 percent of the stock of USR1. The
remaining 50 percent of the stock of USR1 is held by PRS, a domestic
partnership, 50 percent of the interests in which are held by DC, a
public domestic C corporation as defined in paragraph (c)(3)(v)(G) of
this section, and 50 percent of the interests in which are held by
nonresident alien individuals.
(2) Analysis. Under paragraph (c)(3)(v)(M) of this section, USR2 and
USR1 are QIEs. USR1 is not treated as a non-look-through person under
paragraph (c)(3)(iii)(C) of this section because USR1 is not a public
QIE as defined in paragraph (c)(3)(v)(H) of this section. Each of USR1
and PRS is a look-through person as defined in paragraph (c)(3)(v)(C) of
this section that is not treated as holding directly or indirectly stock
in USR2 for purposes of determining whether USR2 is a domestically
controlled QIE under paragraph (c)(3)(ii)(A) of this section. Because
the U.S. citizens who hold USR1 stock are non-look-through persons as
defined in paragraph (c)(3)(v)(D) of this section, those U.S. citizens
are treated under paragraph (c)(3)(ii)(B) of this section as holding
directly or indirectly 25.5 percent of the stock of USR2 through their
USR1 stock interest (50% x 51%) in accordance with paragraph
(c)(3)(ii)(A) of this section. Similarly, because DC and the nonresident
alien partners in PRS are non-look-through persons, each is treated
under paragraph (c)(3)(ii)(B) of this section as holding directly or
indirectly the stock of USR2 through its interest in PRS and PRS's
interest in USR1. Thus, DC is treated as holding directly or indirectly
12.75 percent of the stock of USR2 (50% x 50% x 51%) and the nonresident
alien individual partners, which are foreign persons as defined in
paragraph (k) of this section, are treated as directly or indirectly
holding a 12.75 percent aggregate interest in the stock of USR2 (50% x
50% x 51%). Foreign persons therefore hold directly or indirectly 61.75
percent of the stock of USR2 (the 49 percent stock in USR2 directly held
by nonresident alien individuals, who are foreign persons and non-look-
through persons as defined in paragraph (c)(3)(v)(D), plus the 12.75
percent in stock indirectly held by the nonresident alien individual
partners in PRS), and USR2 is not a domestically controlled QIE under
paragraph (c)(3)(i) of this section.
(E) Example 5: Transition rule asset requirement--(1) Facts. USR is
a REIT formed on January 1, 2018. From formation, 51 percent of the
stock of USR is held by X, a non-public domestic C corporation as
defined in paragraph (c)(3)(v)(E) of this section, 25 percent of the
stock of USR is held by FC1, a foreign corporation, and 24 percent of
the stock of USR is held by nonresident alien individuals. FC2, a
foreign corporation, and FC3, also a foreign corporation, each hold 50
percent of the stock of X. On April 24, 2024, USR's only property is
Asset 1, a United States real property interest. The value of Asset 1,
calculated under section 856(c)(4) as of the most recent
[[Page 665]]
quarter of USR's taxable year before 24, is $100x. On January 1, 2026,
USR borrows $30x and acquires Asset 2, a United States real property
interest, for $30x.
(2) Analysis. As of April 24, 2024, USR is a domestically controlled
QIE under paragraph (c)(3)(i) of this section, because, as determined
without regard to paragraph (c)(3)(iii)(B) of this section, X is a non-
look-through person and, consequently, foreign persons hold directly or
indirectly less than 50 percent of the stock of USR. Accordingly, USR
satisfies the requirement under paragraph (c)(3)(vi)(A)(1) of this
section. USR also satisfies the requirements under paragraphs
(c)(3)(vi)(A)(2) and (3) of this section, respectively, as of such date,
because USR has not acquired directly or indirectly any United States
real property interests, and the ownership of stock of USR has not
changed. Thus, as of April 24, 2024, USR qualifies for the transition
relief under paragraph (c)(3)(vi)(A) of this section. However, on
January 1, 2026, USR no longer meets the requirement for transition
relief in paragraph (c)(3)(vi)(A)(2) of this section because the fair
market value of Asset 2, $30x, is 30 percent (which is more than 20
percent) of $100x, which (as calculated in accordance with paragraphs
(c)(3)(vi)(A)(2) and (c)(3)(vi)(D) of this section) is the fair market
value of USR's United States real property interests, namely Asset 1, as
of April 24, 2024. Therefore, under paragraph (c)(3)(vi)(B)(1) of this
section the transition rule ceases to apply to USR and, thus, paragraph
(c)(3)(iii)(B) applies for purposes of determining whether USR is
domestically controlled with respect to transactions occurring after
January 1, 2026. Because FC2 and FC3 are non-look-through persons that
hold more than 50 percent of the stock of X, X is a foreign-controlled
domestic corporation under paragraph (c)(3)(iii)(B), and USR will not be
a domestically controlled QIE under paragraph (c)(3)(i) of this section
as of January 2, 2026, because foreign non-look-through persons (FC1, 25
percent, FC2, 25.5 percent, FC3, 25.5 percent, and the nonresident alien
individuals, 24 percent) directly or indirectly hold more than 50
percent of the stock of USR.
(3) Alternative facts: transition rule ownership requirement. The
facts are the same as in paragraph (c)(3)(vii)(E)(1) of this section
(Example 5), except that instead of USR borrowing funds and acquiring
Asset 2, FC3 sells its 50-percent stock interest in X to FC2 on June 1,
2024, and, on January 1, 2026, FC1 sells its 25-percent stock interest
in USR to FC4, a foreign corporation. Following FC3's sale of its X
stock to FC2 on June 1, 2024, FC2's stock interest in USR has increased
by 25.5 percentage points, from 25.5 percent on April 24, 2024 (which is
50 percent of 51 percent), to 51 percent. Following FC1's sale of its
USR stock to FC4 on January 1, 2026, FC4's stock interest in USR has
increased by 25 percentage points, from zero percent on April 24, 2024,
to 25 percent. Accordingly, in the aggregate, non-look-through persons
have increased their ownership in USR by 50.5 percentage points (25.5
percent and 25 percent for FC2 and FC4, respectively), and USR no longer
meets the requirement for transition relief in paragraph
(c)(3)(vi)(A)(3) of this section as of January 1, 2026. Therefore, under
paragraph (c)(3)(vi)(B)(1) of this section the transition rule ceases to
apply to USR and, thus, paragraph (c)(3)(iii)(B) of this section applies
for purposes of determining whether USR is domestically controlled with
respect to transactions occurring after January 1, 2026. Because FC2, a
non-look-through person, holds more than 50 percent of the stock of X, X
is a foreign-controlled domestic corporation under paragraph
(c)(3)(iii)(B) of this section, and USR will not be a domestically
controlled QIE under paragraph (c)(3)(i) of this section because foreign
non-look-through persons (FC2, 51 percent, FC4, 25 percent, and the
nonresident alien individuals, 24 percent) directly or indirectly hold
more than 50 percent of the stock of USR.
(4) Foreign ownership percentage. For purposes of calculating the
foreign ownership percentage under section 897(h)(4)(C), the
determination of the QIE stock that was held directly or indirectly by
foreign persons is made under the rules of paragraphs (c)(3)(ii) through
(vii) of this section.
[[Page 666]]
(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 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
[[Page 667]]
subsequently disposes of the obligation to an unrelated party and
recognizes gain or loss pursuant to section 453B, the obligation will
constitute an interest in real property solely as a creditor in the
hands of the subsequent holder. However, if the obligation is disposed
of to a related person and the full amount of gain realized upon the
disposition of the real property has not been recognized upon such
disposition of the installment obligation, then the obligation shall
continue to be an interest in real property other than solely as a
creditor in the hands of the subsequent holder subject to the rules of
this paragraph (d)(2)(ii)(A).
In addition, if the obligation is disposed of to any person for a
principal purpose of avoiding the provisions of sections 897, 1445, or
6039C, then the obligation shall continue to be an interest in real
property other than solely as a creditor in the hands of the subsequent
holder subject to the rules of this paragraph (d)(2)(ii)(A). However,
rights to payments arising from dispositions that took place before June
19, 1980, shall in no event constitute interests in real property other
than solely as a creditor, even if such payments are received after June
18, 1980. In addition, rights to payments arising from dispositions to
unrelated parties that took place before January 1, 1985, and that were
not subject to U.S. tax pursuant to the provisions of a U.S. income tax
treaty, shall not constitute interests in real property other than
solely as a creditor, even if such payments are received after December
31, 1984.
(B) Options. An option, a contract or a right of first refusal to
acquire any interest in real property (other than an interest solely as
a creditor) will itself constitute an interest in real property other
than solely as a creditor.
(C) Security interests. A right to repossess or foreclose on real
property under a mortgage, security agreement, financing statement, or
other collateral instrument securing a debt will not be considered a
reversionary interest in, or a right to share in the appreciation in
value of or gross or net proceeds or profits generated by, an interest
in real property. Thus, no such right of repossession or foreclosure
will of itself cause an interest in real property which is otherwise an
interest solely as a creditor to become an interest other than solely as
a creditor. In addition, a person acting as mortgagee in possession
shall not be considered to hold an interest in real property other than
solely as a creditor, if the mortgagee's interest in the property
otherwise constitutes an interest solely as a creditor.
(D) Indexed interest rates. An interest will not constitute a right
to share in the appreciation in the value of, or gross or net proceeds
or profits generated by, real property solely because it bears a rate of
interest that is tied to an index of any kind that is intended to
reflect general inflation or deflation of prices and interest rates
(e.g., the Consumer Price Index). However, where an interest in real
property bears a rate of interest that is tied to an index the principal
purpose of which is to reflect changes in real property values, the real
property interest will be considered an indirect right to share in the
appreciation in value of, or gross or net proceeds or profits generated
by, real property. Such an indirect right constitutes an interest in
real property other than solely as a creditor.
(E) Commissions. A right to payment of a commission, brokerage fee,
or similar charge for professional services rendered in connection with
the arrangement or financing of a purchase, sale, or lease of real
property does not constitute a right to share in the appreciation in
value of, or gross or net proceeds or profits of, real property solely
because it is based upon a percentage of the purchase price or rent.
Thus, a right to a commission earned 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
[[Page 668]]
of a real property interest that is contingent upon the amount of gain
ultimately realized by the purchaser will constitute an interest in real
property other than solely as a creditor.
(F) Trustees' fees, etc. A right to payment of reasonable
compensation for services rendered as a trustee, as an administrator of
an estate, or in a similar capacity does not constitute a right to share
in the appreciation in the value of, or gross or net proceeds or profits
of, real property solely because the assets of the trust or estate
include U.S. real property interests.
(3) Interest in an entity other than solely as a creditor--(i) In
general. For purposes of sections 897, 1445, and 6039C, an interest in
an entity other than an interest solely as a creditor is--
(A) Stock of a corporation;
(B) An interest in a partnership as a partner within the meaning of
section 761(b) and the regulations thereunder;
(C) An interest in a trust or estate as a beneficiary within the
meaning of section 643(c) and the regulations thereunder or an ownership
interest in any portion of a trust as provided in sections 671 through
679 and the regulations thereunder;
(D) An interest which is, in whole or in part, a direct or indirect
right to share in the appreciation in value of an interest in an entity
described in subdivision (A), (B), or (C) of this paragraph (d)(3)(i) or
a direct or indirect right to share in the appreciation in value of
assets of, or gross or net proceeds or profits derived by, the entity;
or
(E) A right (whether or not presently exercisable) directly or
indirectly to acquire, by purchase, conversion, exchange, or in any
other manner, an interest described in subdivision (A), (B), (C), or (D)
of this paragraph (d)(3) (i).
(ii) Special rules--(A) Installment obligations. A right to
installment or other deferred payments from the disposition of an
interest in an entity will constitute an interest solely as a creditor
if the transferor elects not to have the installment method of section
453(a) apply, any gain or loss is recognized in the year of disposition,
and tax due is timely paid. See section 1445 and regulations thereunder
for further guidance concerning the availability of installment sale
treatment under section 453. If an agreement for the payment of tax with
respect to an installment sale is entered into with the Internal Revenue
Service pursuant to section 1445, that agreement may specify whether or
not the installment obligation will constitute an interest solely as a
creditor. If an installment obligation constitutes an interest other
than solely as a creditor then the receipt of each payment shall be
treated as the disposition of such an interest and shall be subject to
section 897(a) to the extent that:
(1) It constitutes the disposition of a U.S. real property interest
and
(2) Gain or loss is required to be taken into account pursuant to
section 453. Such treatment shall apply to payments arising from
dispositions of interests in a corporation any class of the stock of
which is regularly traded on an established securities market, but only
in the case of a disposition of any portion of an interest described in
paragraph (c)(2)(iii)(A) or (B) of this section. If the original holder
of an installment obligation that constitutes an interest other than
solely as a creditor subsequently disposes of the obligation to an
unrelated party and recognizes gain or loss pursuant to section 453B,
the obligation will constitute an interest in the entity solely as a
creditor in the hands of the subsequent holder. However, if the
obligation is disposed of to a related person and the full amount of
gain realized upon the disposition of the interest in the entity has not
been recognized upon such disposition of the installment obligation,
then the obligation shall continue to be an interest in the entity other
than 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
[[Page 669]]
no event constitute interests in an entity other than solely as a
creditor, even if such payments are received after June 18, 1980. In
addition, such treatment shall not apply to payments arising from
dispositions to unrelated parties that took place before January 1,
1985, and that were not subject to U.S. tax pursuant to the provisions
of a U.S. income tax treaty, regardless of when such payments are
received.
(B) Contingent interests. The interests described in subdivision (D)
of paragraph (d)(3)(i) of this section include any right to a payment
from an entity the amount of which is contingent on the appreciation in
value of an interest described in subdivision (A), (B), or (C) of
paragraph (d)(3)(i) of this section or which is contingent on the
appreciation in value of assets of, or the general gross or net proceeds
or profits derived by, such entity. The right to such a payment is
itself an interest in the entity other than solely as a creditor,
regardless of whether the holder of such right actually holds an
interest in the entity described in subdivision (A), (B), or (C) of
paragraph (d)(3)(i) of this section. For example, a stock appreciation
right constitutes an interest in a corporation other than solely as a
creditor even if the holder of such right actually holds no stock in the
corporation. However, the interests described in subdivision (D) of
paragraph (d)(3)(i) of this section do not include any right to a
payment that is (1) exclusively contingent upon and exclusively paid out
of revenues from sales of personal property (whether tangible or
intangible) or from services, or (2) exclusively contingent upon the
resolution of a claim asserted against the entity by a person related
neither to the entity nor to the holder of the interest.
(C) Security interests. A right to repossess or foreclose on an
interest in an entity under a mortgage, security agreement, financing
statement, or other collateral instrument securing a debt will not of
itself cause an interest in an entity which is otherwise an interest
solely as a creditor to become an interest other than solely as a
creditor.
(D) Royalties. The interests described in subdivision (D) of
paragraph (d)(3)(i) of this section do not include rights to payments
representing royalties, license fees, or similar charges for the use of
patents, inventions, formulas, copyrights, literary, musical or artistic
compositions, trademarks, trade names, franchises, licenses, or similar
intangible property.
(E) Commissions. The interests described in subdivision (D) of
paragraph (d)(3)(i) of this section do not include a right to a
commission, brokerage fee or similar charge for professional services
rendered in connection with the purchase or sale of an interest in an
entity. However, a right to such a payment will constitute an interest
other than solely as a creditor if the total amount of the payment is
contingent upon appreciation in value of assets of, or proceeds or
profits derived by, the entity after the date of the transaction with
respect to which the payment was earned.
(F) Trustee's fees. The interests described in subdivision (D) of
paragraph (d)(3)(i) of this section do not include a right to payment
representing reasonable compensation for services rendered as a trustee,
as an administrator of an estate, or in a similar capacity.
(4) Aggregation of interests. If a person holds both interests
solely as a creditor and interests other than solely as a creditor in
real property or in an entity, those interests will generally be treated
as separate and distinct interests. However, such interests shall be
aggregated and treated as interests other than solely as a creditor in
their entirety if the interest solely as a creditor has been separated
from, or acquired separately from, the interest other than solely as a
creditor, for a principal purpose of avoiding the provisions of section
897, 1445, or 6039C by 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
[[Page 670]]
an arm's-length interest rate. For purposes of applying the rules of
this paragraph (d)(4), a person shall be treated as holding any
interests held by a related person within the meaning of Sec. 1.897-
1(i).
(5) ``Interest'' means ``interest other than solely as a creditor.''
Unless otherwise stated, the term ``interest'' as used with regard to
real property or with regard to an entity hereafter in the regulations
under sections 897, 1445, and 6039C, means an interest in such real
property or entity other than an interest solely as a creditor.
(e) Proportionate share of assets held by an entity--(1) In general.
A person that holds an interest in an entity is for certain purposes
treated as holding a proportionate or pro rata share of the assets held
by the entity. Such proportionate share must be calculated, in
accordance with the rules of this paragraph, for the following purposes.
(i) In determining whether a corporation is a U.S. real property
holding corporation--
(A) A person holding an interest in a partnership, trust, or estate
is treated as holding a proportionate share of the assets held by the
partnership, trust, or estate (see section 897-2(e)(2)), and
(B) A corporation that holds a controlling interest in a second
corporation is treated as holding a proportionate share of the assets
held by the second corporation (see Sec. 1.897-2(e)(3)).
(ii) In determining reporting obligations that may be imposed under
section 6039C, the holder of an interest in a partnership, trust, or
estate is treated as owning a proportionate share of the U.S. real
property interests held by the partnership, trust, or estate.
(2) Proportionate share of assets held by a corporation or
partnership--(i) In general. A person's proportionate or pro rata share
of assets held by a corporation or partnership is determined by
multiplying--
(A) The person's percentage ownership interest in the entity, by
(B) The fair market value of the assets held by the entity (or the
book value of such assets, in the case of a determination pursuant to
Sec. 1.897-2(b)(2)).
(ii) Percentage ownership interest. A person's percentage ownership
interest in a corporation or partnership is the percentage equal to the
ratio of (A) the sum of the liquidation values of all interests in the
entity held by the person to (B) the sum of the liquidation values of
all outstanding interest in the entity. The liquidation value of an
interest in an entity is the amount of cash and the fair market value of
any property that would be distributed with respect to such interest
upon the liquidation of the entity after satisfaction of liabilities to
persons having interests in the entity solely as creditors. With respect
to an entity that has interests outstanding that grant a presently-
exercisable option to acquire or right to convert into or otherwise
acquire an interest in the entity other than solely as a creditor, the
liquidation value of all interests in such entity shall be calculated as
though such option or right had been exercised, giving effect both to
the payment of any consideration required to exercise the option or
right and to the issuance of the additional interest.
The fair market value of the assets of the entity, the amount of cash
held by the entity, and the amount of liabilities to persons having
interests solely as creditors if determined for this purpose on the date
with respect to which the percentage ownership interest is determined.
(iii) Examples. The rules of this paragraph (e)(2) are illustrated
by the following examples.
Example 1. Corporation K's only assets are stock and securities with
a fair market value as of the applicable determination date of
$20,000,000 K's assets are subject to liabilities of $10,000,000. Among
K's liabilities are a $1,000,000 loan from L, under the terms of which L
is entitled, upon payment of the 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
[[Page 671]]
principal of the loan to K plus $200,000 (10 percent of the excess of
$20,000,000 over $18,000,000). The liquidation value of each of PS1's
and PS2's blocks of preferred stock is $1,000,000 ($10,000 times 100
shares each). The liquidation value of each of CS1's and CS2's blocks of
common stock is $3,900,000 [$20,000,000 (the total fair market value of
K's assets)--$9,000,000 (liabilities to creditors other than L)--
$1,200,000 (L's liquidation value)--$2,000,000 (PS1's and PS2's
liquidation value)) times 50 percent (the percentage of common stock
owned by each)]. The sum of the liquidation values of all of the
outstanding interests in K (i.e., interests other than solely as a
creditor) is $11,000,000 [$1,200,000 (L's liquidation value) +
$2,000,000 (PS1's and PS2's liquidation values) + $7,800,000 (CS1's and
CS2's liquidation values)]. Each of CS1's and CS2's percentage ownership
interests in K is 35.5 percent ($3,900,000 divided by $11,000,000). Each
of PS1's and PS2's percentage ownership interests in K is 9 percent
($1,000,000 divided by $11,000,000). L's percentage ownership interest
in K is 11 percent ($1,200,000 divided by $11,000,000).
Example 2. A, a U.S. person, and B, a foreign person are partners in
a partnership the only asset of which is a parcel of undeveloped land
located in the United States that was purchased by the partnership in
1980 for $300,000. The partnership has no liabilities, and its capital
is $300,000. A's and B's interests in the capital of the partnership are
25 percent and 75 percent, respectively, and A and B each has a 50
percent profit interest in the partnership. The partnership agreement
provides that upon liquidation any unrealized gain will be distributed
in accordance with the partners' profit interest. In 1984 the
partnership has no items of income or deduction, and the fair market
value of its parcel of undeveloped land is $500,000. In 1984 the
percentage ownership interest of A in the partnership is 35 percent [the
ratio of $100,000 (the liquidation value of A's profit interest in 1984)
plus $75,000 (the liquidation value of A's 25 percent interest in the
partnership's $300,000 capital) to $500,000 (the sum of the liquidation
values of all outstanding interests in the partnership)]. The percentage
ownership interest of B in the partnership in 1984 is 65 percent [the
ratio of $325,000 (B's $100,000 profit interest plus his $225,000
capital interest) to $500,000]
(3) Proportionate share of assets held by trusts and estates--(i) In
general. A person's proportionate or pro rata share of assets held by a
trust or estate is determined by multiplying--
(A) The person's percentage ownership interest in the trust or
estate, by
(B) The fair market value of the assets held by the trust or estate
(or the book value of such assets, in the case of a determination
pursuant to Sec. 1.897-2(b)(2)).
(ii) Percentage ownership interest--(A) General rule. A person's
percentage ownership interest in a trust or an estate--is the percentage
equal to the ratio of:
(1) The sum of the actuarial values of such person's interests in
the cash and other assets held by the trust or estate after satisfaction
of the liabilities of the trust or estate to persons holding interests
in the trust or estate solely as creditors, to (2) the entire amount of
such cash and other assets after satisfaction of liabilities to persons
holding interests in the trust or estate solely as creditors. For
purposes of calculating this ratio, the fair market value of the trust's
or estate's assets, the amount of cash held by the trust or estate, and
the amount of the liabilities to persons having interests solely as
creditors is determined on the date with respect to which the percentage
ownership interest is determined. With respect to a trust or estate that
has interests outstanding that grant a presently-exercisable option to
acquire or right to convert into or otherwise acquire an interest in the
trust or estate other than solely as a creditor, the liquidation value
of all interests in such entity shall be calculated as though such
option or right had been exercised, giving effect both to the payment of
any consideration required to exercise the option or right and to the
issuance of the additional interest. With respect to a trust or estate
that has interests outstanding that entitle any person to a distribution
of U.S. 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.
[[Page 672]]
(B) Discretionary trusts and estates. In determining percentage
ownership interest in a trust or an estate, the sum of the definitely
ascertainable actuarial values of interests in the cash and the other
assets of the trust or estate held by persons in existence on the date
with respect to which such determination is made must equal the amount
in paragraph (e)(3)(ii)(A)(2) of this section. If the amount in
paragraph (e)(3)(ii)(A)(2) of this section exceeds the sum of the
definitely ascertainable actuarial values of the interests held by
persons in existence on the determination date, the excess will be
considered to be owned in total by each beneficiary who is in existence
on such date, whose interest in the excess is not definitely
ascertainable and who is potentially entitled to such excess. However,
such excess shall not be considered to be owned in total by each
beneficiary if the discretionary terms of the trust or estate were
included for a principal purpose of avoiding the provisions of section
897, 1445, or 6039C by causing assets other than U.S. real property
interests to be attributed in total to each beneficiary. The rules of
this paragraph (e)(3) are illustrated by the following example.
Example. A, a U.S. person, established a trust on December 31, 1984,
and contributed real property with a fair market value of $10,000 to the
trust. The terms of that trust provided that the trustee, a bank that is
unrelated to A, at its discretion may retain trust income or may
distribute it to X, a foreign person, or to the head of state of any
country other than the United States. The remainder upon the death of X
is to go in equal shares to such of Y and Z, both foreign persons, as
survive X. On December 31, 1984, the total value of the trust's assets
is $10,000. On the same date, the actuarial values of the remainder
interests of Y and Z in the corpus of the trust are definitely
ascertainable. They are $1,000 and $500, respectively. Neither the
income interest of X nor of the head of state of any country other than
the United States has a definitely ascertainable actuarial value on
December 31, 1984. The interests of Y and Z in the income portion of the
trust similarly have no definitely ascertainable actuarial values on
such date since the income may be distributed rather than retained by
the trust. Since the sum of the actuarial values of definitely
ascertainable interests of persons in existence ($1,500) is less than
$10,000, the difference ($8,500) is treated as owned by each beneficiary
who is in existence on December 31, 1984, and who is potentially
entitled to such excess. Therefore, X, Y, Z, and the head of state of
any country other than the United States are each considered as owning
the entire $8,500 income interest in the trust. On December 31, 1984,
the total actuarial value of X's interest is $8,500, and his percentage
ownership interest is 85 percent. The total actuarial value of Y's
interest in the trust is $9,500 ($1,000 plus $8,500), and his percentage
ownership interest is 95 percent. The total actuarial value of Z's
interest is $9,000 ($500 plus $8,500), and his percentage ownership
interest is 90 percent. The actuarial value of the interest of the head
of state of each country other than the United States is $8,500, and his
percentage ownership interest is 85 percent.
(4) Dates with respect to which percentage ownership interests are
determined. The dates with respect to which percentage ownership
interests are determined are the applicable determination dates outlined
in Sec. 1.897-2 or in regulations under section 6039C.
(f) Asset used or held for use in a trade or business--(1) In
general. The term ``asset used or held for use in a trade or business''
means--
(i) Property, other than a U.S. real property interest, that is--
(A) Stock in trade of an entity or other property of a kind which
would properly be included in the inventory of the entity if on hand at
the close of the taxable year, or property held by the entity primarily
for sale to customers in the ordinary course of its trade or business,
or
(B) Depreciable property used or held for use in the trade or
business, as described in section 1231(b)(1) but without regard to the
holding period limitations of section 1231(b), or
(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
[[Page 673]]
to acquire any of the foregoing, and options or contracts to acquire
commodities, but only to the extent that such assets are used or held
for use in the corporation's trade or business and do not constitute
U.S. real property interests.
(2) Used or held for use in a trade or business. An asset is used or
held for use in an entity's trade or business if it is, under the
principles of Sec. 1.864-4(c)(2)--
(i) Held for the principal purpose of promoting the present conduct
of the trade or business,
(ii) Acquired and held in the ordinary course of the trade or
business, as, for example, in the case of an account or note receivable
arising from that trade or business (including the performance of
services), or
(iii) Otherwise held in a direct relationship to the trade or
business.
In determining whether an asset is held in a direct relationship to the
trade or business, consideration shall be given to whether the asset is
needed in that trade or business. An asset shall be considered to be
needed in a trade or business only if the asset is held to meet the
present needs of that trade or business and not its anticipated future
needs. An asset shall be considered as needed in the trade or business
if, for example, the asset is held to meet the operating expenses of
that trade or business. Conversely, an asset shall be considered as not
needed in the trade or business if, for example, the asset is held for
the purpose of providing for future diversification into a new trade or
business, future expansion of trade or business activities, future plant
replacement, or future business contingencies. An asset that is held to
meet reserve or capitalization requirements imposed by applicable law
shall be presumed to be held in a direct relationship to the trade or
business.
(3) Special rules concerning liquid assets--(i) Safe harbor amount.
Assets described in paragraph (f)(1)(iii) of this section shall be
presumed to be used or held for use in a trade or business, in an amount
up to 5 percent of the fair market value of other assets used or held
for use in the trade or business. However, the rule of this paragraph
(f)(3)(i) shall not apply with respect to any assets described in
paragraph (f)(1)(iii) of this section that are held or acquired for the
principal purpose of avoiding the provisions of section 897 or 1445.
(ii) Investment companies. Assets described in paragraph (f)(1)(iii)
of this section shall be presumed to be used or held for use in an
entity's trade or business if the principal business of the entity is
trading or investing in such assets for its own account. An entity's
principal business shall be presumed to be trading or investing in
assets described in paragraph (f)(1)(iii) of this section if the fair
market value of such assets held by the entity equals or exceeds 90
percent of the sum of the fair market values of the entity's U.S. real
property interests, interests in real property located outside the
United States, assets otherwise used or held for use in trade or
business, and assets described in paragraph (f)(1)(iii) of this section.
(4) Examples. The application of this paragraph (f) may be
illustrated by the following examples:
Example 1. M, a domestic corporation engaged in industrial
manufacturing, is required to hold a large current cash balance for the
purposes of purchasing materials and meeting its payroll. The amount of
the cash balance so required varies because of the fluctuating seasonal
nature of the corporation's business. In months when large cash balances
are not required, the 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
[[Page 674]]
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 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) 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 (l) of this
section, a foreign partnership, a foreign trust or a foreign estate, as
such persons are defined by section 7701 and the regulations in this
chapter under section 7701. A resident
[[Page 675]]
alien individual, including a nonresident alien individual 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 Sec. 1.897-9T(e). See paragraph (c)(3)(iv)(A) of
this section regarding the treatment of qualified foreign pension funds
and qualified controlled entities as foreign persons for purposes of
section 897(h)(4)(B).
(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 to be treated
as a domestic corporation. For purposes of section 897, the term does
not include a qualified holder described in Sec. 1.897(l)-1(d); see
paragraph (c)(3)(iv)(A) of this section regarding the treatment of
qualified foreign pension funds and qualified controlled entities as
foreign persons for purposes of section 897(h)(4)(B).
(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) Regularly traded cross-reference. See Sec. 1.897-9T(d) for a
definition of regularly traded for purposes of sections 897, 1445, and
6039C.
(o) Fair market value--(1) In general. For purposes of sections 897,
1445, and 6039C only, the term ``fair market value'' means the value of
the property determined in accordance with the rules, contained in this
paragraph (o). The definition of fair market value provided herein is
not to be used in the calculation of gain or loss from the disposition
of a U.S. real property interest pursuant to section 1001. An
independent professional appraisal of the value of property must be
submitted only if such an appraisal is specifically requested in
connection with the negotiation of a security agreement pursuant to
section 1445.
(2) Method of calculating fair market value--(i) In general. The
fair market value of property is its gross value (as defined in
paragraph (o)(2)(ii) of this section) reduced by the outstanding balance
of any debts secured by the property which are described in paragraph
(o)(2)(iii) of this section. See Sec. 1.897-2(b) for the alternative
use of book values in certain limited circumstances.
(ii) Gross value. Gross value is the price at which the property
would change hands between an unrelated willing buyer and willing
seller, neither being under any compulsion to buy or to sell and both
having reasonable knowledge of all relevant facts. Generally, with
respect to trade or business assets, going concern value should be used
as it will provide the most accurate reflection of such a price.
However, taxpayers may use other methods of valuation if they can
establish that such method will provide a more accurate determination of
gross value and if they consistently apply such method to all assets to
be valued. See subdivisions (3) and (4) of this paragraph (o) for
special rules with respect to the valuation of leases and of intangible
assets.
(iii) Debts secured by the property. The gross value of property
shall be reduced by the outstanding balance of debts that are:
(A) Secured by a mortgage or other security interest in the property
that is valid and enforceable under the law
[[Page 676]]
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 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
[[Page 677]]
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; T.D. 9992, 89 FR
31626, Apr. 25, 2024; T.D. 9992, 89 FR 105451, Dec. 27, 2024]
Sec. 1.897-2 United States real property holding corporations.
(a) Purpose and scope. This section provides rules regarding the
definition and consequences of U.S. real property holding corporation
status. U.S. real property holding corporation status is important for
determining whether gain from the disposition by a foreign person of an
interest in a domestic corporation is taxable. Such status is also
important for purposes of the withholding and reporting requirements of
sections 1445 and 6039C. For example, a person that buys stock of a U.S.
real property holding corporation from a foreign person is required to
withhold under section 1445. In addition, for purposes of determining
whether another corporation is a U.S. real property holding corporation,
an interest in a foreign corporation is a U.S. real property interest
unless it is established that the foreign corporation is not a U.S. real
property holding corporation. The general definition of a U.S. real
property holding corporation is provided in paragraph (b) of this
section. Paragraph (c) provides rules regarding the dates on which U.S.
real property holding corporation status must be determined. The assets
that must be included in making the determination of a corporation's
status are set forth in paragraph (d), while paragraph (e) provides
special rules regarding the treatment of interests held by a corporation
in partnerships, trusts, estates, and other corporations. Rules
regarding the termination of U.S. real property holding corporation
status are set forth in paragraph (f). Paragraph (g) explains the manner
in which an interest-holder can establish that a corporation is not a
U.S. real property holding corporation, and paragraph (h) provides rules
regarding certain notification requirements applicable to corporations.
(b) U.S. real property holding corporation--(1) In general. A
corporation is a U.S. real property holding corporation if the fair
market value of the U.S. real property interests held by the corporation
on any applicable determination date equals or exceeds 50 percent of the
sum of the fair market values of its--
(i) U.S. real property interests;
(ii) Interests in real property located outside the United States;
and
[[Page 678]]
(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 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
[[Page 679]]
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 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
[[Page 680]]
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. 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
[[Page 681]]
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 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
[[Page 682]]
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
(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
[[Page 683]]
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:
(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
[[Page 684]]
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)). 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
[[Page 685]]
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).
(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
[[Page 686]]
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 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
[[Page 687]]
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
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
[[Page 688]]
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 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).
[[Page 689]]
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) 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
[[Page 690]]
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
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
[[Page 691]]
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 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
[[Page 692]]
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:
(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
[[Page 693]]
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 qualified investment
entities, as defined in section 897(h)(4)(B). But see Sec. 1.1445-
2(c)(3) for rules providing that no withholding is required under
section 1445(a) in certain cases when a statement is voluntarily issued
by the corporation and otherwise complies with the requirements of this
paragraph (h). The requirements of this paragraph (h) 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 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
[[Page 694]]
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 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; T.D. 9992, 89
FR 31632, Apr. 25, 2024]
[[Page 695]]
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.
(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
[[Page 696]]
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, 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
[[Page 697]]
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.
(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
[[Page 698]]
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 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
[[Page 699]]
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 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
[[Page 700]]
``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 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
[[Page 701]]
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.
(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.
[[Page 702]]
(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
(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--
[[Page 703]]
(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 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,
[[Page 704]]
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 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
[[Page 705]]
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 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.
[[Page 706]]
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 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
[[Page 707]]
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 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
[[Page 708]]
(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 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.
[[Page 709]]
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 $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
[[Page 710]]
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 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--
[[Page 711]]
(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. 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
[[Page 712]]
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 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
[[Page 713]]
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, 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
[[Page 714]]
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 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
[[Page 715]]
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 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
[[Page 716]]
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. 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.
[[Page 717]]
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 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.
[[Page 718]]
(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 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
[[Page 719]]
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
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)
[[Page 720]]
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).
(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).
[[Page 721]]
(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]
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
[[Page 722]]
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) [Reserved]
(d) Regularly traded--(1) General rule--(i) Trading requirements. A
class of interests that is traded on one or more established securities
markets is considered to be regularly traded on such market or markets
for any calendar quarter during which--
(A) Trades in such class are effected, other than in de minimis
quantities, on at least 15 days during the calendar quarter;
(B) The aggregate number of the interests in such class traded is at
least 7.5 percent or more of the average number of interests in such
class outstanding during the calendar quarter; and
(C) The requirements of paragraph (d)(3) of this section are met.
(ii) Exceptions--(A) in the case of the class of interests which is
held by 2,500 or more record shareholders, the requirements of paragraph
(d)(1)(i)(B) of this section shall be applied by substituting ``2.5
percent'' for ``7.5 percent''.
(B) If at any time during the calendar quarter 100 or fewer persons
own 50 percent or more of the outstanding shares of a class of
interests, such class shall not be considered to be regularly traded for
purposes of sections 897, 1445 and 6039C. Related persons shall be
treated as one person for purposes of this paragraph (d)(1)(ii)(B).
(iii) Anti-abuse rule. Trades between related persons shall be
disregarded. In addition, a class of interests shall not be treated as
regularly traded if there is an arrangement or a pattern of trades
designed to meet the requirements of this paragraph (d)(1). For example,
trades between two persons that occur several times during the calendar
quarter may be treated as an arrangement or a pattern of trades designed
to meet the requirements of this paragraph (d)(1).
(2) Interests traded on domestic established securities markets. For
purposes of sections 897, 1445 and 6039C, a class of interests that is
traded on an established securities market located in the United States
is considered to be regularly traded for any calendar quarter during
which it is regularly quoted by brokers or dealers making a market in
such interests. A broker or dealer makes a market in a class of
interests only if the broker or dealer holds himself out to buy or sell
interests in such class at the quoted price. Stock of a corporation that
is described in section 851(a)(1) and units of a unit investment trust
registered under the Investment Company Act of 1940 (15 U.S.C. sections
80a-1 to 80a-2) shall be treated as regularly traded within the meaning
of this paragraph.
[[Page 723]]
(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 in this
chapter 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. See Sec.
1.897-1(c)(3)(iv)(B) regarding the treatment of international
organizations as foreign persons for purposes of section 897(h)(4)(B).
Buildings or parts of buildings and the land ancillary thereto
(including the residence of the head of the diplomatic mission) used by
the foreign government for a diplomatic mission shall not be a U.S. real
property interest in the hands of the respective foreign government.
(f) Effective date. Section 1.897-9T with the exception of paragraph
(e) shall be effective for transfers, exchanges, distributions and other
dispositions occurring on or after June 6, 1988. Paragraph (e) of this
section shall be effective for transfers, exchanges, distributions and
other dispositions occurring on or after July 1, 1986.
[T.D. 8198, 53 FR 16229, May 5, 1988, as amended by T.D. 9992, 89 FR
31632, Apr. 25, 2024]
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.
[[Page 724]]
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.
(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
[[Page 725]]
(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 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
[[Page 726]]
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 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
[[Page 727]]
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 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,
[[Page 728]]
(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 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-
[[Page 729]]
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
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
[[Page 730]]
(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 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
[[Page 731]]
(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 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.
[[Page 732]]
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.
(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.
[[Page 733]]
(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 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
[[Page 734]]
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 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,
[[Page 735]]
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 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
[[Page 736]]
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), 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,
[[Page 737]]
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 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
[[Page 738]]
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 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
[[Page 739]]
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).
(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
[[Page 740]]
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 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),
[[Page 741]]
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 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
[[Page 742]]
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 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
[[Page 743]]
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 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
[[Page 744]]
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 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
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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 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.
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(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 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
[[Page 747]]
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 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
[[Page 748]]
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 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
[[Page 749]]
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 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
[[Page 750]]
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.
(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.
[[Page 751]]
(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.
(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
[[Page 752]]
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 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
[[Page 753]]
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.
(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
[[Page 754]]
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 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
[[Page 755]]
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.
(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
[[Page 756]]
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 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
[[Page 757]]
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.
(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
[[Page 758]]
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
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
[[Page 759]]
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 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.
[[Page 760]]
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 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.
[[Page 761]]
(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.
(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
[[Page 762]]
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
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
[[Page 763]]
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 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
[[Page 764]]
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-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
[[Page 765]]
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 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.
[[Page 766]]
(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 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
[[Page 767]]
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 (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
[[Page 768]]
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 (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
[[Page 769]]
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--
(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
[[Page 770]]
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 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
[[Page 771]]
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 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
[[Page 772]]
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 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.
[[Page 773]]
(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, 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.
[[Page 774]]
(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 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
[[Page 775]]
$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, 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
[[Page 776]]
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 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
[[Page 777]]
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.
(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,
[[Page 778]]
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 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
[[Page 779]]
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 (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:
[[Page 780]]
(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 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
[[Page 781]]
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
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)
[[Page 782]]
(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. 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,
[[Page 783]]
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 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.
[[Page 784]]
(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 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:
[[Page 785]]
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 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
[[Page 786]]
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 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
[[Page 787]]
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 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:
[[Page 788]]
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 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.
[[Page 789]]
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 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
[[Page 790]]
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
(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
[[Page 791]]
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 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
[[Page 792]]
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 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
[[Page 793]]
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 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
[[Page 794]]
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 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
[[Page 795]]
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 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
[[Page 796]]
(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 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:
[[Page 797]]
----------------------------------------------------------------------------------------------------------------
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 levy,
and thus are 100%, not 105%, of actual gross receipts. Similarly, costs
and expenses include exploration interest expense. In accordance with
paragraph (e)(2)(i) of this section the difference between the general
tax and the qualifying levy in the timing of the deduction for wages,
other than wages of officers, is not considered to increase the
liability of dual capacity taxpayers because the general tax would not
have failed to be an income tax within the meaning of Sec. 1.901-
2(a)(1) if it had provided for 5-year amortization of such wages instead
of for current deduction. See Sec. 1.901-2(b)(4)(i). However,
amortization of wages paid to officers over a 50-year period is such a
deferred recovery of such wages that it effectively is a denial of the
deduction of the excess of such wages paid in any year over the
amortization of such cumulative wages permitted in such year. See Sec.
1.901-2(b)(4)(i). The different treatment of wages paid to officers
under the general tax and the qualifying levy is thus not merely a
difference in timing within the meaning of paragraph (e)(2)(i) of this
section. Accordingly, the difference between the amount of wages paid by
J to officers in any year and J's deduction (in computing the actual
payment amount) for amortization of such cumulative wages allowed in
such year is, pursuant to paragraph (e)(2) of this section, treated as a
cost and expense in computing J's qualifying amount for such year with
respect to the April 11 decree. The differences in the consolidation and
carryover provisions between the general tax and the qualifying levy are
of the types described in paragraph (e)(2)(ii) of this section and,
pursuant to paragraphs (b)(4)(ii) and (b)(4)(iii) of Sec. 1.901-2, the
general tax would not fail to be an income tax within the meaning of
Sec. 1.901-2(a)(i) even if it contained the consolidation and carryover
provisions of the qualifying levy. Thus, such differences are not
considered to increase the liability of dual capacity taxpayers pursuant
to the qualifying levy as compared to the general tax liability of
persons other than dual capacity taxpayers.
Accordingly, in applying the safe harbor formula to the qualifying
levy for 1985 and 1986, gross receipts and costs and expenses are
computed as follows:
Gross receipts
1985: 42,000u x (100/105) - 40,000u
1986: 105,000u x (100/105) - 100,000u
[[Page 798]]
costs and expenses
------------------------------------------------------------------------
Item 1985 1986
------------------------------------------------------------------------
1. Deductions other than wages (column C in 15,000u 20,000u
the preceding chart).........................
2. Amortization of cumulative wages paid in 60u 80u
1983 and thereafter other than to officers...
3. Deduction of wages to officers paid in 50u 50u
current year, instead of amortization allowed
in current year of such cumulative wages paid
in 1983 and thereafter.......................
4. Deduction of exploration interest expense.. 2,800u 2,800u
-------------------------
5. Costs and expenses before carryover of net 17,910u 22,930u
loss (sum of lines 1 through 4)..............
=========================
6. Recalculation of loss carryover by
recalculating 1983 and 1984 net income (loss)
to reflect current deduction of wages to
officers and exploration interest expense:
1983 adjusted net loss carryover: (13,021u) +
(49u) + (1000u) = (14,070u); 1984 adjusted
net loss carryover: (17,042u) + (48u) +
(2800u) = (19,890u)..........................
7. Recalculation of limitation on use of net
loss carryover deduction:
Gross receipts.............................. 40,000u 100,000u
Less costs and expenses..................... (17,910u) (22,930)
-------------------------
Total...................................... 22,090u 77,070u
Times 15 percent limitation................. 3,314u 11,561u
-------------------------
8. Costs and expenses including net loss 21,224u 34,491u
carryover deduction (line 5 plus line 7).....
------------------------------------------------------------------------
In years after 1986, costs and expenses for purposes of determining
the qualifying amount would reflect net loss carryforward deductions
based on the recomputed losses carried forward from 1983 and 1984
(14,070u and 19,890u, respectively) less the amounts thereof that were
utilized in determining costs and expenses for 1985 and 1986 (3,314u and
11,561u, respectively). The 1983 and 1984 loss carryforwards would be
considered utilized in accordance with the order of priority in which
such losses are utilized under the terms of the qualifying levy.
In applying the safe harbor formula, the tax rate to be used, in
accordance with paragraph (e)(3) of this section, is .50.
Accordingly, under the safe harbor method, J's qualifying amounts
with respect to the April 11 decree for 1985 and 1986 are computed as
follows:
1985: (40,000u - 21,224u - 17,172u) x .50 / (1 - .50) = 1604u
1986: (100,000u - 34,491u - 54,134u) x .50 / (1 - .50) = 11,375u
Under the safe harbor method J's qualifying amounts with respect to
the April 11 decree for 1985 and 1986 are thus 1604u and 11,375u,
respectively; and its specific economic benefit amounts are 15,568u
(17,172u-1604u) and 42,759u, (54,134u-11,375u), respectively. Pursuant
to paragraph (b) of this section, J's specific economic benefit amounts
are characterized according to the nature of J's transactions with
country L and of the specific economic benefit received by J as
additional royalties paid to country L with respect to the petroleum
extracted by J in country L in 1985 and 1986, and these amounts are so
treated for all purposes of chapter 1 of the Code.
Example 5. Country E, which has no generally imposed income tax,
imposes a levy called the country E income tax only on corporations
carrying on the banking business through a branch in country E and on
corporations engaged in the extraction of petroleum in country E. All of
the petroleum resources of country E are owned by the government of
country E, whose petroleum ministry licenses corporations to explore for
and extract petroleum in consideration of payment of royalties as
petroleum is extracted. The base of the country E income tax is a
corporation's actual gross receipts from sources in country E less all
expenses attributable, on reasonable principles, to such gross receipts;
the rate of tax is 29 percent.
A is a U.S corporation that carries on the banking business through
a branch in country E. B is a U.S. corporation (unrelated to A) that is
engaged in the extraction of petroleum in country E. In 1984 A receives
interest on loans it has made to 160 borrowers in country E, seven of
which are agencies and instrumentalities of the government of country E.
The economic benefits received by A and B (i.e., the interest received
by A from the government and B's license to extract petroleum owned by
the government) are not made available on substantially the same terms
to the population of country E in general.
A and B are dual capacity taxpayers. Each of them has validly
elected the safe harbor method for country E for 1984. A demonstrates
that the country E income tax as applied to it (a dual capacity
taxpayer) is not different by its terms or in practice from the country
E income tax as applied to persons (in this case other banks) that are
not dual capacity taxpayers. A has therefore established pursuant to
paragraph (a)(1) of this section and Sec. 1.901-2(d) that the country E
income tax as applied to it and the country E income tax as applied to
persons other than dual capacity taxpayers are together a single levy. A
establishes that such levy is an income tax within the meaning of Sec.
1.901-2(a)(1). In accordance with paragraph (a)(1) of this section, no
portion of the amount paid by A pursuant to such levy is considered to
[[Page 799]]
be paid in exchange for a specific economic benefit. Thus, the entire
amount paid by A pursuant to this levy is an amount of income tax paid.
B does not demonstrate that the country E income tax as applied to
corporations engaged in the extraction of petroleum in country E (dual
capacity taxpayers) is not different by its terms or in practice from
the country E income tax as applied to persons other than dual capacity
taxpayers (i.e., banks that are not dual capacity taxpayers).
Accordingly, pursuant to paragraph (a)(1) of this section and Sec.
1.901-2(d), the country E income tax as applied to corporations engaged
in the extraction of petroleum in country E is a separate levy from the
country E income tax as applied to other persons.
B demonstrates that all of the criteria of section 901 are satisfied
with respect to the country E income tax as applied to corporations
engaged in the exploration of petroleum in country E, except for the
determination of the distinct element of such levy that imposes a tax
and of B's qualifying amount with respect to the levy. Pursuant to
paragraph (e)(5) of this section, in applying the safe harbor formula to
B, ``A'' is the amount of B's gross receipts as determined under the
country E income tax as applied to B; ``B'' is the amount of B's costs
and expenses as determined thereunder; ``C'' is B's actual payment
amount; and ``D'' is .29, the lower of the rate (29 percent) of the
qualifying levy (the country E income tax as applied to corporations
engaged in the extraction of petroleum in country E) or the rate (46
percent) of tax specified for 1984 in section 11(b)(5) of the Internal
Revenue Code. Thus, B's qualifying amount is equal to its actual payment
amount.
Example 6. The facts are the same as in example 5, except that the
rate of the country E income tax is 55 percent. For the reasons stated
in example 5, the results with respect to A are the same as in example
5. In applying the safe harbor formula to B, ``A,'' ``B,'' and ``C'' are
the same as in example 5, but ``D'' is .46, as that rate is less than
.55. Thus, B's qualifying amount is less than B's actual payment amount,
and the difference is B's specific economic benefit amount.
Example 7. Country E imposes a tax (called the country E income tax)
on the realized net income derived by corporations from sources in
country E, except that, with respect to interest income received from
sources in country E and certain insurance income, nonresident
corporations are instead subject to other levies. With respect to such
interest income a levy (called the country E interest tax) requires
nonresident corporations to pay to country E 20 percent of such gross
interest income unless the nonresident corporation falls within a
specified category of corporations (``special corporations''), all of
which are dual capacity taxpayers, in which case the rate is instead 25
percent. With respect to such insurance income nonresident corporations
are subject to a levy (called the country E insurance tax), which is not
an income tax within the meaning of Sec. 1.901-2(a)(1).
The country E interest tax applies at the 20 percent rate by its
terms and in practice to persons other than dual capacity taxpayers. The
country E interest tax as applied at the 25 percent rate to special
corporations applies only to dual capacity taxpayers; therefore, the
country E interest tax as applied to special corporations is a separate
levy from the country E interest tax as applied at the 20 percent rate.
A is a U.S. corporation which is a special corporation subject to
the 25 percent rate of the country E interest tax. A does not have any
insurance income that is subject to the country E insurance tax. A, a
dual capacity taxpayer, has validly elected the safe harbor formula for
1984. In 1984 A receives 100u (units of country E currency) of gross
interest income subject to the country E interest tax and pays 25u to
country E.
A establishes that the country E income tax is the generally imposed
income tax of country E; that all of the criteria of section 903 are
satisfied with respect to the country E interest tax as applied to
special corporations except for the determination of the distinct
element of the levy that is a tax and of A's qualifying amount with
respect thereto. A has therefore demonstrated that the country E
interest tax as applied to special corporations is a qualifying levy. A
establishes that the country E interest tax at the 20 percent rate is a
tax in lieu of an income tax within the meaning of Sec. 1.903-1(a).
Pursuant to paragraph (e)(6) of this section the country E interest tax
at the 20 percent rate is treated as if it were an application of the
general tax for purposes of the safe harbor formula of this paragraph
(e), since that tax would actually have been required to have been paid
by A with respect to its interest income had A not been a dual capacity
taxpayer (special corporation) instead subject to the qualifying levy
(the country E interest tax at the 25 percent rate).
Even if the country E insurance tax is a tax in lieu of an income
tax within the meaning of Sec. 1.903-1(a), that tax is not treated as
if it were an application of the general tax for purposes of applying
the safe harbor formula to A since A had no insurance income in 1984 and
hence such tax would not actually have been required to be paid by A had
A not been a dual capacity taxpayer.
Example 8. Under a levy of country S called the country S income
tax, each corporation operating in country S is required to pay country
S 50 percent of its income from operations in country S. Income for
purposes of the country S income tax is computed by
[[Page 800]]
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, 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
[[Page 801]]
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 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
[[Page 802]]
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 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.
[[Page 803]]
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]
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
[[Page 804]]
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 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
[[Page 805]]
(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 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.
[[Page 806]]
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 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
[[Page 807]]
(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).
(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
[[Page 808]]
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:
------------------------------------------------------------------------
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
[[Page 809]]
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 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
[[Page 810]]
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 credit against the U.S. tax for 1971 is reduced to
$28,840, determined as follows:
Foreign income tax paid on foreign mineral income............. $37,000
Less reduction under sec. 901(e):
Smaller of $37,000 (tax paid to country Z on $33,600
foreign mineral income) or $33,600 (U.S. tax on
foreign mineral income of $70,000, as determined
under paragraph (d) of this example..............
Less: U.S. tax on foreign mineral income of 25,440 8,160
$53,000, as determined under paragraph (c) of
this example.....................................
-------------------
Foreign income tax allowable as a credit...................... $28,840
(f) After taking this section into account, R is allowed a foreign
tax credit for 1971 of $8,640 ($8,640 x $18,000/$18,000). The amount of
foreign income tax which may be first carried back to 1969 under section
904(d) is reduced from $28,360 to $20,200 ($28,840 less $8,640).
Example 6. (a) B, a single individual using the calendar year as the
taxable year, is an operator drilling for oil in foreign countries X and
Y. For 1972, B's gross income under chapter 1 of the Code is $250,000,
of which $150,000 is foreign mineral income from a property in country X
and $100,000 is foreign mineral income from a property in country Y, all
being subject to the allowance for depletion. The assumption is made
that B's earned taxable income for 1972 is insufficient to cause section
1348 to apply. During 1972, B incurs intangible drilling and development
costs of $16,000 in country X and of $9,000 in country Y, which are
currently deductible for purposes of both the U.S. tax and the tax of
countries X and Y, respectively. For purposes of both the U.S. tax and
the tax of countries X and Y, respectively, cost depletion in the case
of the X property amounts to $8,000, and in the case of Y property, to
$7,000; and only cost depletion is allowed as a deduction under the law
of countries X and Y. For 1972, B uses the overall limitation under
section 904(a)(2) on the foreign tax credit. Percentage depletion is not
allowed as a deduction under the law of countries X and Y. It is assumed
that the only other allowable deductions amount to $2,250. None of these
deductions is attributable to the income from the properties in
countries X and Y, and none is deductible under the laws of country X or
country Y. Based upon the facts assumed, the income tax paid to
countries X and Y on the foreign mineral income from each such country
is $71,820 and $25,200, respectively, and the U.S. tax on B's total
taxable income before allowance of the foreign tax credit is $99,990,
determined as follows:
[[Page 811]]
------------------------------------------------------------------------
U.S. Tax X tax Y tax
------------------------------------------------------------------------
Total income (including foreign mineral $250,000 $150,000 $100,000
income from countries X and Y)........
Intangible drilling and development 25,000 16,000 9,000
costs.................................
Cost depletion......................... ......... 8,000 7,000
Percentage depletion (22% of $150,000, 55,000 ......... .........
but not to exceed 50% of $134,000;
plus 22% of $100,000, but not to
exceed 50% of $91,000)................
Adjusted gross income.................. 170,000 ......... .........
Other deductions....................... 2,250 ......... .........
Personal exemption..................... 750 ......... .........
Taxable income......................... 167,000 126,000 84,000
Income tax rate........................ ......... 57% 30%
Foreign tax............................ ......... 71,820 25,200
U.S. tax ($53,090 plus 70% of $67,000). 99,990 ......... .........
------------------------------------------------------------------------
(b) Without taking this section into account, B would be allowed a
foreign tax credit for 1972 of $97,020 ($71,820 + $25,200), but not to
exceed the overall limitation under section 904(a)(2) of $99,990
($99,990 x $167,750/$167,750). There would be no foreign income tax
carried back to 1970 under section 904(d) since the allowable credit of
$97,020 does not exceed the limitation of $99,990.
(c) Under paragraph (a)(2)(ii) of this section, the amount of the
U.S. tax for 1972 with respect to foreign mineral income from sources
within country X is $69,760, which is the greater of the amounts of tax
determined under subparagraphs (1) and (2):
(1) U.S. tax on total taxable income in excess of U.S. tax on
taxable income excluding foreign mineral income from country X
(determined under paragraph (a)(2)(ii)(a) of this section):
U.S. tax on total taxable income.................. ......... $99,990
Less U.S. tax on taxable income other than foreign
mineral income from country X:
Foreign mineral income from country Y........... $100,000
Intangible drilling and development costs....... 9,000
Percentage depletion (22% of $100,000, but not 22,000
to exceed 50% of $91,000)......................
Adjusted gross income........................... 69,000
Other deductions................................ 2,250
Personal exemption.............................. 750
Taxable income.................................. 66,000
U.S. tax ($26,390 plus 64% of $6,000)............. ......... 30,230
----------
Excess tax........................................ ......... 69,760
(2) U.S. tax on foreign mineral income from country X (determined
under paragraph (a)(2)(ii)(b) of this section):
Foreign mineral income from country X...................... $150,000.00
Intangible drilling and development costs.................. 16,000.00
Percentage depletion (22% of $150,000, but not to exceed 33,000.00
50% of $134,000)..........................................
Adjusted gross income...................................... 101,000.00
Other deductions...........................................
Taxable income............................................. 101,000.00
U.S. tax ($53,090 plus 70% of excess over $100,000)........ 53,790.00
(d) Under paragraph (a)(2)(iii) of this section, and by applying the
principles of paragraph (a)(2)(ii)(a) of this section, the amount of the
U.S. tax which would be computed for 1972 (without regard to section
613) with respect to foreign mineral income from sources within country
X is $87,920, which is the excess of the U.S. tax ($127,990) determined
under subparagraph (1) over the U.S. tax ($40,070) determined under
subparagraph (2):
(1) U.S. tax on total taxable income determined without regard to
section 613:
Total income................................................. $250,000
Intangible drilling and development costs.................... 25,000
Cost depletion............................................... 15,000
Adjusted gross income........................................ 210,000
Other deductions............................................. 2,250
Personal exemption........................................... 750
Taxable income............................................... 207,000
U.S. tax ($53,090 plus 70% of $107,000)...................... 127,990
(2) U.S. tax on total taxable income other than foreign mineral
income from country X, determined without regard to section 613:
Foreign mineral income from country Y........................ $100,000
Intangible drilling and development costs.................... 9,000
Cost depletion............................................... 7,000
Adjusted gross income........................................ 84,000
Other deductions............................................. 2,250
Personal exemption........................................... 750
Taxable income............................................... 81,000
U.S. tax ($39,390 plus 68% of $1,000)........................ 40,070
(e) Under paragraph (a)(2)(i) of this section, the amount of income
tax paid to country X for 1972 with respect to foreign mineral income
from sources within such country is $71,820. This is the amount
determined under both (a) and (b) of paragraph (a)(2)(i) of this
section, since, in this case, there is no income from sources within
country X other than foreign mineral income, and there are no deductions
allowed under the law of country X which are not allocable to such
foreign mineral income.
(f) Pursuant to paragraph (a)(1) of this section, the foreign income
tax with respect to foreign mineral income from sources within country X
which is allowable as a credit against the U.S. tax for 1972 is reduced
to $69,760, determined as follows:
Foreign income tax paid to country X on foreign mineral income $71,820
Less reduction under sec. 901(e):
Smaller of $71,820 (tax paid to country X on $71,820
foreign mineral income) or $87,920 (U.S. tax on
foreign mineral income from sources within
country X, as determined under paragraph (d) of
this example)....................................
Less: U.S. tax on foreign mineral income from 69,760 2,060
sources within country X, determined under
paragraph (c) of this example....................
-------------------
[[Page 812]]
Foreign income tax of country X allowable as a ........ 69,760
credit.............................................
(g) Under paragraph (a)(2)(ii) of this section, the amount of the
U.S. tax for 1972 with respect to foreign mineral income from sources
within country Y is $48,280, which is the greater of the amounts of tax
determined under subparagraphs (1) and (2):
(1) U.S. tax on total taxable income in excess of U.S. tax on
taxable income excluding foreign mineral income from country Y
(determined under paragraph (a)(2)(ii)(a) of this section):
U.S. tax on total taxable income.............................. $99,990
Less U.S. tax on taxable income other than foreign mineral
income from country Y:
Foreign mineral income from country X............ $150,000
Intangible drilling and development costs........ 16,000
Percentage depletion (22% of $150,000, but not to 33,000
exceed 50% of $134,000).........................
Adjusted gross income............................ 101,000
Other deductions................................. 2,250
Personal exemption............................... 750
Taxable income................................... 98,000
U.S. tax ($46,190 plus 69% of $8,000)............ ......... 51,710
---------
Excess tax......................................... ......... 48,280
(2) U.S. tax on foreign mineral income from country Y (determined
under paragraph (a)(2)(ii)(b) of this section):
Foreign mineral income from country Y........................ $100,000
Intangible drilling and development costs.................... 9,000
Percentage depletion (22% of $100,000, but not to exceed 50% 22,000
of $91,000).................................................
Adjusted gross income........................................ 69,000
Other deductions............................................. .........
Taxable income............................................... 69,000
U.S. tax ($26,390 plus 64% of $9,000)........................ 32,150
(h) Under paragraph (a)(2)(iii) of this section, and by applying the
principles of paragraph (a)(2)(ii)(a) of this section, the amount of the
U.S. tax which would be computed for 1972 (without regard to section
613) with respect to foreign mineral income from sources within country
Y is $58,800, which is the excess of the U.S. tax ($127,990) determined
under paragraph (d)(1) of this example over the U.S. tax ($69,190) on
total taxable income other than foreign mineral income from country Y,
determined without regard to section 613, as follows:
Foreign mineral income from country X........................ $150,000
Intangible drilling and development costs.................... 16,000
Cost depletion............................................... 8,000
Adjusted gross income........................................ 126,000
Other deductions............................................. 2,250
Personal exemption........................................... 750
Taxable income............................................... 123,000
U.S. tax ($53,090 plus 70% of $23,000)....................... 69,190
(i) Under paragraph (a)(2)(i) of this section, the amount of income
tax paid to country Y for 1972 with respect to foreign mineral income
from sources within such country is $25,200. This is the amount
determined under both (a) and (b) of paragraph (a)(2)(i) of this
section, since, in this case, there is no income from sources within
country Y other than foreign mineral income, and there are no deductions
allowed under the law of country Y which are not allocable to such
foreign mineral income.
(j) Pursuant to paragraph (a)(1) of this section, the foreign income
tax with respect to foreign mineral income from sources within country Y
which is allowable as a credit against the U.S. tax for 1972 is not
reduced from $25,200, as follows:
Foreign income tax paid to country Y on foreign ........ $25,200
mineral income.....................................
Less reduction under sec. 901(e):
Smaller of $25,200 (tax paid to country Y on $25,200
foreign mineral income) or $58,800 (U.S. tax on
foreign mineral income from sources within
country Y, as determined under paragraph (h) of
this example)....................................
Less: U.S. tax on foreign mineral income from 48,280
sources within country Y, as determined under
paragraph (g) of this example....................
-------------------
Foreign income tax of country Y allowable as a ........ 25,200
credit.............................................
(k) After taking this section into account, B is allowed a foreign
tax credit for 1972 of $94,960 ($69,760 + $25,200), but not to exceed
the overall limitation under section 904 (a)(2) of $99,990 ($99,990 x
$167,750/$167,750). There would be no foreign income tax carried back to
1970 under section 904(d) since the allowable credit of $94,960 does not
exceed the limitation of $99,990.
Example 7. (a) P, a domestic corporation using the calendar year as
the taxable year, is an operator mining for iron ore in foreign country
X. For 1971, P's gross income under chapter 1 of the Code is $100,000,
all of which is foreign mineral income from a property in country X and
is subject to the allowance for depletion. For 1971, cost depletion
amounts to $5,000 for purposes of the tax of both countries, and only
cost depletion is allowed as a deduction under the law of country X. It
is assumed that deductions (other than for depletion) attributable to
the mineral property in country X amount to $8,000, and these deductions
are allowable under the law of both countries. Based upon the facts
assumed, the income tax paid to country X on such foreign mineral income
is $39,150, and the U.S. tax on such income before allowance of the
foreign tax credit is $37,440 determined as follows:
------------------------------------------------------------------------
U.S. tax X tax
------------------------------------------------------------------------
Foreign mineral income............................ $100,000 $100,000
Less:
Percentage depletion (14% of $100,000, but not 14,000 .........
to exceed 50% of $92,000)......................
Cost depletion.................................. ......... 5,000
Other deductions................................ 8,000 8,000
Taxable income.................................... 78,000 87,000
[[Page 813]]
Income tax rate................................... 48% 45%
Tax............................................... 37,440 39,150
------------------------------------------------------------------------
(b) Without taking this section into account, P would be allowed a
foreign tax credit for 1971 of $37,440 ($37,440 x $78,000/ $78,000), and
foreign income tax in the amount of $1,710 ($39,150 less $37,440) would
first be carried back to 1969 under section 904(d).
(c) Pursuant to paragraph (a)(1) of this section, however, the
foreign income tax allowable as a credit against the U.S. tax is reduced
to $37,440, determined as follows:
Foreign income tax paid on foreign mineral income............. $39,150
Less reduction under sec. 901(e):
Smaller of $39,150 (tax paid to country X on $39,150
foreign mineral income) or $41,760 (U.S. tax on
foreign mineral income of $87,000 ($87,000 x
48%), determined by deducting cost depletion of
$5,000 in lieu of percentage depletion of
$14,000).........................................
Less: U.S. tax on foreign mineral income (before 37,440 1,710
credit)..........................................
-------------------
Foreign income tax allowable as a credit...................... 37,440
(d) After taking this section into account, P is allowed a foreign
tax credit for 1971 of $37,440 ($37,440 x $78,000/$78,000), but no
foreign income tax is carried back to 1969 under section 904(d) since
the allowable credit of $37,440 does not exceed the limitation of
$37,440.
Example 8. (a) The facts are the same as in example 7, except that P
is assumed to have received dividends for 1971 of $25,000 from R, a
foreign corporation incorporated in country X which is not a less
developed country corporation within the meaning of section 902(d).
Income tax of $2,500 ($25,000 x 10%) on such dividends is withheld at
the source in country X. It is assumed that P is deemed under section
902(a)(1) and Sec. 1.902-1(h) to have paid income tax of $22,500 to
country X in respect of such dividends and that under paragraphs
(a)(2)(i) and (b)(2)(i) of this section such dividends are deemed to be
attributable to foreign mineral income from sources in country X and
that such tax is deemed to be paid with respect to such foreign mineral
income. Based upon the facts assumed, the U.S. tax on the foreign
mineral income from sources in country X is $60,240 before allowance of
the foreign tax credit, determined as follows:
Foreign mineral income from country X:
Income from mining property..................... $100,000
Dividends from R................................ 25,000
Sec. 78 dividend................................ 22,500 $147,500
-----------
Less:
Percentage depletion (14% of $100,000, but not to exceed $14,000
50% of $92,000)...........................................
Other deductions........................................... 8,000
Taxable income............................................... 125,500
Income tax rate.............................................. 48%
U.S. tax..................................................... 60,240
(b) Without taking this section into account, P would be allowed a
foreign tax credit for 1971 of $60,240 ($60,240 x $125,500/$125,500),
and foreign income tax in the amount of $3,910 ([$39,150 + $22,500 +
$2,500] less $60,240) would first be carried back to 1969 under section
904(d).
(c) Pursuant to paragraph (a)(1) of this section, however, the
foreign income tax allowable as a credit against the U.S. tax is reduced
from $64,150 to $60,240, determined as follows:
Foreign income tax paid, and deemed to be paid, to country X $64,150
on foreign mineral income ($39,150 + $22,500 + $2,500)......
Less reduction under sec. 901(e):
Smaller of $64,150 (tax paid and deemed paid to $64,150
country X on foreign mineral income) or $64,560
(U.S. tax on foreign mineral income of $134,500
($134,500 x 48%), determined by deducting cost
depletion of $5,000 in lieu of percentage
depletion of $14,000)..........................
Less: U.S. tax on foreign mineral income (before $60,240 $3,910
credit)........................................
---------------------
Foreign income tax allowable as a credit..................... 60,240
(d) After taking this section into account, P is allowed a foreign
tax credit for 1971 of $60,240 ($60,240 x $125,500/$125,500), but no
foreign income tax is carried back to 1969 under section 904(d) since
the allowable credit of $60,240 does not exceed the limitation of
$60,240.
[T.D. 7294, 38 FR 33074, Nov. 30, 1973, as amended by T.D. 7481, 42 FR
20130, Apr. 18, 1977]
Sec. 1.901(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:
[[Page 814]]
(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 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).
[[Page 815]]
(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 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
[[Page 816]]
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).
(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).
[[Page 817]]
(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 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
[[Page 818]]
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 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
[[Page 819]]
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 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,
[[Page 820]]
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]
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,
[[Page 821]]
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
(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
[[Page 822]]
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 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).
[[Page 823]]
(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 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,
[[Page 824]]
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 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
[[Page 825]]
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 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
[[Page 826]]
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 (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),
[[Page 827]]
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.
(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
[[Page 828]]
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.
(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
[[Page 829]]
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 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,
[[Page 830]]
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]
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)
[[Page 831]]
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 (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:
[[Page 832]]
(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 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
[[Page 833]]
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 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
[[Page 834]]
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 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
[[Page 835]]
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 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
[[Page 836]]
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 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
[[Page 837]]
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
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
[[Page 838]]
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. 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
[[Page 839]]
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).
(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
[[Page 840]]
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]
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
[[Page 841]]
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 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
[[Page 842]]
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 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
[[Page 843]]
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 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
[[Page 844]]
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 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
--------------------------------------------------------
[[Page 845]]
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 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
[[Page 846]]
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 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
[[Page 847]]
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.
(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
[[Page 848]]
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.
(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.
[[Page 849]]
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.
(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
[[Page 850]]
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
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
[[Page 851]]
(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 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
[[Page 852]]
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 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
[[Page 853]]
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.
(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
[[Page 854]]
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) 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.
[[Page 855]]
(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 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
[[Page 856]]
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
(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
[[Page 857]]
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 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
[[Page 858]]
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 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
[[Page 859]]
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
(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
[[Page 860]]
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 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.
[[Page 861]]
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.
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
[[Page 862]]
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).
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).
[[Page 863]]
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 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).
[[Page 864]]
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).
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:
[[Page 865]]
(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 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
[[Page 866]]
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.
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
[[Page 867]]
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.
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
[[Page 868]]
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 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
[[Page 869]]
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 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,
[[Page 870]]
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]
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
[[Page 871]]
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 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
[[Page 872]]
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 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.
[[Page 873]]
(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 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
[[Page 874]]
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 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
[[Page 875]]
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..........................................
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
[[Page 876]]
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
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
[[Page 877]]
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 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,
[[Page 878]]
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
---------
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).................
[[Page 879]]
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).
(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
[[Page 880]]
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 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
[[Page 881]]
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 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
[[Page 882]]
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 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.
[[Page 883]]
(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 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
[[Page 884]]
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, 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]
[[Page 885]]
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).
(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
[[Page 886]]
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 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
[[Page 887]]
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.
(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.govinfo.gov.
[[Page 888]]
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 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.
[[Page 889]]
(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 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
[[Page 890]]
(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 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
[[Page 891]]
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 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
[[Page 892]]
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 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
[[Page 893]]
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 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. For special rules relating to the allocation and
apportionment of foreign income taxes to section 987 items, see Sec.
1.987-6(b)(3).
(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,
[[Page 894]]
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 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
[[Page 895]]
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 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
[[Page 896]]
(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 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
[[Page 897]]
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 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
[[Page 898]]
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 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.
[[Page 899]]
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 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
[[Page 900]]
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 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
[[Page 901]]
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 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
[[Page 902]]
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.
(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.
[[Page 903]]
(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 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
[[Page 904]]
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 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
[[Page 905]]
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 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
[[Page 906]]
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 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
[[Page 907]]
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 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:
[[Page 908]]
(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 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).
(4) Multiple transfers of intangible property. If the same
intangible property is transferred in a series of transfers described in
paragraph (f)(2)(vi)(D)(1) of this section, each successive transfer is
separately subject to the provisions of paragraph (f)(2)(vi)(D)(1) and
will not terminate or otherwise affect the application of paragraph
(f)(2)(vi)(D)(1) to a prior transfer described in paragraph
(f)(2)(vi)(D)(1).
(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
[[Page 909]]
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-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
[[Page 910]]
(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 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
[[Page 911]]
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 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
[[Page 912]]
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.
(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
[[Page 913]]
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. 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
[[Page 914]]
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 ($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
[[Page 915]]
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 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
[[Page 916]]
(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 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
[[Page 917]]
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 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
[[Page 918]]
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 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)
[[Page 919]]
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 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
[[Page 920]]
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 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
[[Page 921]]
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 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-
[[Page 922]]
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'' 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)
[[Page 923]]
(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 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.
[[Page 924]]
(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 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
[[Page 925]]
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.
(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.
[[Page 926]]
(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).
(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-
[[Page 927]]
4(c)(7)(i) and (iii) as in effect on December 17, 2019.
(3) Except as provided in the following sentence, paragraph (f) of
this section applies to taxable years that begin after December 31,
2019, and end on or after November 2, 2020. Paragraph (f)(2)(vi)(D)(4)
of this section applies to taxable years that begin on or after October
10, 2024.
[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 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
[[Page 928]]
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 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
[[Page 929]]
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:
[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:
[[Page 930]]
[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).
(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
[[Page 931]]
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 ($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
[[Page 932]]
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).
(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
[[Page 933]]
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 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.
[[Page 934]]
(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 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.
[[Page 935]]
(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 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
[[Page 936]]
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 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
[[Page 937]]
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 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
[[Page 938]]
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 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;
[[Page 939]]
(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 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.
[[Page 940]]
(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 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
[[Page 941]]
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.
(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
[[Page 942]]
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
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
[[Page 943]]
(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 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
[[Page 944]]
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 (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
[[Page 945]]
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 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.
[[Page 946]]
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 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
[[Page 947]]
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 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-
[[Page 948]]
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 (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
[[Page 949]]
(the Act)) after application of the de minimis rule of former section
904(d)(3)(C) (prior to its amendment by the Act). When, in a taxable
year after the effective date of the Act, earnings and profits
attributable to such income are distributed to, or included in the gross
income of, a United States shareholder under section 951(a)(1) (A) (ii)
or (iii) or (B) (hereinafter in this section ``inclusions''), the
ordering rules of section 904(d)(3)(D) and Sec. 1.904-5(c)(4) shall be
applied in determining initially the character of the income of the
distributee or United States shareholder. Thus, a proportionate amount
of a distribution described in this paragraph initially will be
characterized as separate limitation interest income in the hands of the
distributee based on the ratio of the separate limitation interest
earnings and profits out of which the dividend was paid to the total
earnings and profits out of which the dividend was paid. The
distribution or inclusions must then be recharacterized in the hands of
the distributee or United States shareholder on the basis of the
following principles:
(i) Distributions and inclusions that initially are characterized as
separate limitation interest income shall be treated as passive income;
(ii) Distributions and inclusions that initially are characterized
as old general limitation income shall be treated as general limitation
income, unless the taxpayer establishes to the satisfaction of the
Commissioner that the distribution or inclusion is attributable to:
(A) Earnings and profits accumulated with respect to shipping
income, as defined in section 904(d)(2)(D) and Sec. 1.904-4(f); or
(B) In the case of a financial services entity, earnings and profits
accumulated with respect to financial services income, as defined in
section 904(d)(2)(C)(ii) and Sec. 1.904-4(e)(1); or
(C) Earnings and profits accumulated with respect to high
withholding tax interest, as defined in section 904(d)(2)(B) and Sec.
1.904-4(d).
(2) Limitation on establishing the character of earnings and
profits. In order for a taxpayer to establish that distributions or
inclusions that are attributable to general limitation earnings and
profits of a particular taxable year beginning before January 1, 1987,
are attributable to shipping, financial services or high withholding tax
interest earnings and profits, the taxpayer must establish the amounts
of foreign taxes paid or accrued with respect to income attributable to
those earnings and profits that are to be treated as taxes paid or
accrued with respect to shipping, financial services or high withholding
tax interest income, as the case may be, under section 904(d)(2)(I).
Conversely, in order for a taxpayer to establish the amounts of general
limitation taxes paid or accrued in a taxable year beginning before
January 1, 1987, that are to be treated as taxes paid or accrued with
respect to shipping, financial services or high withholding tax interest
income, as the case may be, the taxpayer must establish the amount of
any distributions or inclusions that are attributable to shipping,
financial services or high withholding tax interest earnings and
profits. For purposes of establishing the amounts of general limitation
taxes that are to be treated as taxes paid or accrued with respect to
shipping, financial services or high withholding tax interest income,
the principles of Sec. 1.904-6 shall be applied.
(b) Application of look-through rules to distributions (including
deemed distributions) and payments by an entity to a recipient when
one's taxable year begins before January 1, 1987 and the other's taxable
year begins after December 31, 1986--(1) In general. This paragraph
provides rules relating to the application of section 904(d)(3) to
payments made by a controlled foreign corporation or other entity to
which the look-through rules apply during its taxable year beginning
after December 31, 1986, but received in a taxable year of the recipient
beginning before January 1, 1987. The paragraph also provides rules
relating to distributions (including deemed distributions) or payments
made by a controlled foreign corporation to which 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
[[Page 950]]
subject to the Act. If interest, rents, or royalties are paid or accrued
on or after the start of the payor's first taxable year beginning on or
after January 1, 1987, but prior to the start of the recipient's first
taxable year beginning on or after January 1, 1987, such interest,
rents, or royalties shall initially be characterized in accordance with
section 904(d)(3) and Sec. 1.904-5. To the extent that interest
payments in the hands of the recipient are initially characterized as
passive income under these rules, they will be treated as separate
limitation interest in the hands of the recipient. To the extent that
rents or royalties in the hands of the recipient are initially
characterized as passive income under these rules, they will be
recharacterized as general limitation income in the hands of the
recipient.
(3) Recipient of interest, rents, or royalties is subject to the Act
and payor is not subject to the Act. If interest, rents, or royalties
are paid or accrued before the start of the payor's first taxable year
beginning on or after January 1, 1987, but on or after the start of the
recipient's first taxable year beginning after January 1, 1987, the
income in the recipient's hands shall be initially characterized in
accordance with former section 904(d)(3) (prior to its amendment by the
Act). To the extent interest income is characterized as separate
limitation interest income under these rules, that income shall be
recharacterized as passive income in the hands of the recipient. Rents
or royalties will be characterized as general limitation income.
(4) Recipient of dividends and subpart F inclusions is subject to
the Act and payor is not subject to the Act. If dividends are paid or
accrued or section 951(a)(1) inclusions occur before the start of the
first taxable year of a controlled foreign corporation beginning on or
after January 1, 1987, but on or after the start of the first taxable
year of the distributee or United States shareholder beginning on or
after January 1, 1987, the dividends or section 951(a)(1) inclusions in
the hands of the distributee or United States shareholder shall be
initially characterized in accordance with former section 904(d)(3)
(including the ordering rules of section 904(d)(3)(A). Therefore, under
former section 904(d)(3)(A), dividends are considered to be paid or
derived first from earnings attributable to separate limitation interest
income. To the extent the dividend or section 951(a)(1) inclusion is
initially characterized under these rules as separate limitation
interest income in the hands of the distributee or United States
shareholder, the dividend or section 951(a)(1) inclusion shall be
recharacterized as passive income in the hands of the distributee or
United States shareholder. The portion, if any, of the dividend or
section 951(a)(1) inclusion that is not characterized as passive income
shall be characterized according to the rules in paragraph (a) of this
section. Therefore, a taxpayer may establish that income that would
otherwise be characterized as general limitation income is shipping or
financial services income. Rules comparable to the rules contained in
section 904(d)(2)(I) shall be applied for purposes of characterizing
foreign taxes deemed paid with respect to distributions and section
951(a)(1) inclusions covered by this paragraph (b)(4).
(5) Examples. The following examples illustrate the application of
this paragraph (b).
Example 1. P is a domestic corporation that is a fiscal year
taxpayer (July 1-June 30). S, a controlled foreign corporation, is a
wholly-owned subsidiary of P and has a calendar taxable year. On June l,
1987, S makes a $100 interest payment to P. Because the payment is made
after January 1, 1987 (the first day of S's first taxable year beginning
after December 31, 1986), the look-through rules of section 904(d)(3)
apply to characterize the payment made by S. To the extent, however,
that the interest payment to P is allocable to passive income earned by
S, the payment will be included in P's separate limitation for interest
as provided in former section 904(d)(1)(A).
Example 2. P is a domestic corporation that is a calendar year
taxpayer. S, a controlled foreign corporation, is a wholly-owned
subsidiary of P and has a July 1-June 30 taxable year. On June 1, 1987,
S makes a $100 interest 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
[[Page 951]]
former section 904(d)(3), the interest payment would be characterized as
separate limitation interest income. For purposes of determining P's
foreign tax credit limitation, the interest payment will be passive
income as provided in section 904(d)(1)(A).
Example 3. The facts are the same as in Example 2 except that on
June 1, 1987, S makes a $100 dividend distribution to P. Because the
dividend is paid prior to July l, 1987 (the first day of S's first
taxable year beginning after December 31, 1986), the look-through rules
of section 904(d)(3) do not apply. Assume that, under former section
904(d)(3), S's earnings and profits for the taxable year ending June 30,
1987, consist of $200 of earnings attributable to general limitation
income and $75 of earnings attributable to separate limitation interest
income. The portion of the dividend that is attributable to S's separate
limitation interest and is treated as separate limitation interest
income under former section 904(d)(3) is $75. The remaining $25 of the
dividend is treated as general limitation income under former section
904(d)(3). For purposes of determining P's foreign tax credit
limitation, $75 of the dividend will be recharacterized as passive
income. The remaining $25 of the dividend will be characterized as
general limitation income, unless P can establish that the general
limitation portion is attributable to shipping or financial services
income.
(c) Installment sales. If income is received or accrued by any
person on or after the effective date of the Act (as applied to such
person) that is attributable to a disposition of property by such person
with regard to which section 453 or section 453A applies (installment
sale treatment), and the disposition occurred prior to the effective
date of the Act, that income shall be characterized according to the
rules of Sec. Sec. 1.904-4 through 1.904-7.
(d) Special effective date for high withholding tax interest earned
by persons with respect to qualified loans described in section
1201(e)(2) of the Act. For purposes of characterizing interest received
or accrued by any person, the definition of high withholding tax
interest in Sec. 1.904-4(d) shall apply to taxable years beginning
after December 31, 1986, except as provided in section 1201(e)(2) of the
Act.
(e) Treatment of certain recapture income. Except as otherwise
provided, if income is subject to recapture under section 585(c), the
income shall be general limitation income. If the income is recaptured
by a taxpayer that is a financial services entity, the entity may treat
the income as financial services income if the taxpayer establishes to
the satisfaction of the Secretary that the deduction to which the
recapture amount is attributable is allocable to financial services
income. If the taxpayer establishes to the satisfaction of the Secretary
that the deduction to which the recapture amount is attributable is
allocable to high-withholding tax interest income, the taxpayer may
treat the income as high-withholding tax interest.
(f) Treatment of non-look-through pools of a noncontrolled section
902 corporation or a controlled foreign corporation in post-2002 taxable
years--(1) Definition of non-look-through pools. The term non-look-
through pools means the pools of post-1986 undistributed earnings (as
defined in Sec. 1.902-1(a)(9)) that were accumulated, and post-1986
foreign income taxes (as defined in Sec. 1.902-1(a)(8)) paid, accrued,
or deemed paid, in and after the first taxable year in which the foreign
corporation had a domestic shareholder (as defined in Sec. 1.902-
1(a)(1)) but before any such shareholder was eligible for look-through
treatment with respect to dividends from the foreign corporation.
(2) Treatment of non-look-through pools of a noncontrolled section
902 corporation. Any undistributed earnings in the non-look-through pool
that were accumulated in taxable years beginning before January 1, 2003,
by a noncontrolled section 902 corporation as of the last day of the
corporation's last taxable year beginning before January 1, 2003, shall
be treated in taxable years beginning after December 31, 2002, as if
they were accumulated during a period when a dividend paid by the
noncontrolled section 902 corporation to a domestic shareholder would
have been eligible for look-through treatment under section 904(d)(4)
and Sec. 1.904-5. Post-1986 foreign income taxes paid, accrued or
deemed paid with respect to such earnings shall be treated as if they
were paid, accrued or deemed paid during a period when the related
earnings were eligible for look-through treatment. Any such earnings and
taxes in the non-look-through pools shall constitute the opening balance
of the noncontrolled section 902 corporation's
[[Page 952]]
pools of post-1986 undistributed earnings and post-1986 foreign income
taxes on the first day of the foreign corporation's first taxable year
beginning after December 31, 2002, in accordance with the rules of
paragraph (f)(4) of this section.
(3) Treatment of non-look-through pools of a controlled foreign
corporation. A controlled foreign corporation may have non-look-through
pools of post-1986 undistributed earnings and post-1986 foreign income
taxes that were accumulated and paid in a taxable year beginning before
January 1, 2003, in which it was a noncontrolled section 902
corporation. Any such undistributed earnings in the non-look-through
pool as of the last day of the controlled foreign corporation's last
taxable year beginning before January 1, 2003, shall be treated in
taxable years beginning on or after January 1, 2003, as if they were
accumulated during a period when a dividend paid by the controlled
foreign corporation out of such earnings, or an amount included in the
gross income of a United States shareholder under section 951 that is
attributable to such earnings, would have been eligible for look-through
treatment. Any post-1986 foreign income taxes paid, accrued, or deemed
paid with respect to such earnings shall be treated in taxable years
beginning on or after January 1, 2003, as if they were paid, accrued, or
deemed paid during a period when a dividend or inclusion out of such
earnings would have been eligible for look-through treatment. Any such
undistributed earnings and taxes in the non-look-through pools shall be
added to the pools of post-1986 undistributed earnings and post-1986
foreign income taxes of the controlled foreign corporation in the
appropriate separate categories on the first day of the controlled
foreign corporation's first taxable year beginning after December 31,
2002, in accordance with the rules of paragraph (f)(4) of this section.
Similar rules shall apply to characterize any previously-taxed earnings
and profits described in section 959(c)(1)(A) that are attributable to
earnings in the non-look-through pool.
(4) Substantiation of look-through character of undistributed
earnings and taxes in a non-look-through pool--(i) Reconstruction of
earnings and taxes pools. In order to substantiate the look-through
characterization of undistributed earnings and taxes in a non-look-
through pool under section 904(d)(4) and Sec. 1.904-5, the taxpayer
shall make a reasonable, good-faith effort to reconstruct the non-look-
through pools of post-1986 undistributed earnings and post-1986 foreign
income taxes (and previously-taxed earnings and profits, if any) on a
look-through basis for each year in the non-look-through period,
beginning with the first taxable year in which post-1986 undistributed
earnings were accumulated in the non-look-through pool. Reconstruction
shall be based on reasonably available books and records and other
relevant information, and it must account for earnings distributed and
taxes deemed paid in these years as if they were distributed and deemed
paid pro rata from the amounts that were added to the non-look-through
pools during the non-look-through period.
(ii) Safe harbor method. A taxpayer that was eligible for look-
through treatment with respect to a distribution from the foreign
corporation in the taxpayer's first taxable year ending after the first
day of the foreign corporation's first taxable year beginning after
December 31, 2002, may allocate the undistributed earnings and taxes in
the non-look-through pools to the foreign corporation's look-through
pools of post-1986 undistributed earnings and post-1986 foreign income
taxes in other separate categories on the first day of the foreign
corporation's first taxable year beginning after December 31, 2002, in
the same percentages as the taxpayer properly characterizes the stock of
the foreign corporation in the separate categories for purposes of
apportioning the taxpayer's interest expense in its first taxable year
ending after the first day of the foreign corporation's first taxable
year beginning after December 31, 2002, under Sec. 1.861-12T(c)(3) or
Sec. 1.861-12(c)(4), as the case may be. If the modified gross income
method described in Sec. 1.861-9T(j) is used 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-
[[Page 953]]
look-through pools to the foreign corporation's look-through pools of
post-1986 undistributed earnings and post-1986 foreign income taxes
based on an average of the foreign corporation's modified gross income
ratios for the foreign corporation's taxable years beginning in 2003 and
2004. A taxpayer may also use the safe harbor method described in this
paragraph (f)(4)(ii) to allocate to separate categories any previously-
taxed earnings and profits described in section 959(c)(1)(A) that are
attributable to the non-look-through pool. A taxpayer may choose to use
the safe harbor method on either a timely filed or amended tax return or
during an audit. However, a taxpayer that uses the safe harbor method on
an amended return or in the course of an audit must make appropriate
adjustments to eliminate any duplicate benefits arising from application
of the safe harbor method to taxable years that are not open for
assessment. A taxpayer's choice to use the safe harbor method is
evidenced by employing the method. The taxpayer need not file any
separate statement.
(iii) Inadequate substantiation. If a taxpayer does not use, or is
ineligible to use, the safe harbor method described in paragraph
(f)(4)(ii) of this section and the Commissioner determines that the
look-through characterization of earnings and taxes in the non-look-
through pools cannot reasonably be determined based on the available
information, the Commissioner shall allocate the undistributed earnings
and taxes in the non-look-through pools to the foreign corporation's
passive category.
(iv) Examples. The following examples illustrate the application of
this paragraph (f)(4):
Example 1. P, a domestic corporation, has owned 50 percent of the
voting stock of S, a foreign corporation, at all times since January 1,
1987, and S has been a noncontrolled section 902 corporation with
respect to P since that date. P and S use the calendar year as their
U.S. taxable year. The first year in which post-1986 undistributed
earnings were accumulated in the non-look-through pool of S was 1987. As
of December 31, 2002, S had 200u of post-1986 undistributed earnings and
$100 of post-1986 foreign income taxes in its non-look-through pools. P
does not use the safe harbor method under paragraph (f)(4)(ii) of this
section to allocate the earnings and taxes in the non-look-through pools
to S's other separate categories and does not attempt to substantiate
the look-through characterization of S's non-look-through pools. The
Commissioner, however, reasonably determines, based on information used
to characterize S's stock for purposes of apportioning P's interest
expense in P's 2003 and 2004 taxable years, that 100u of the earnings
and all $100 of the taxes in the non-look-through pools are properly
assigned on a look-through basis to the general limitation category, and
100u of earnings and no taxes are properly assigned on a look-through
basis to the passive category. Therefore, in accordance with the
Commissioner's look-through characterization of the earnings and taxes
in S's non-look-through pools, on January 1, 2003, S has 100u of post-
1986 undistributed earnings and $100 of post-1986 foreign income taxes
in the general limitation category and 100u of post-1986 undistributed
earnings and no post-1986 foreign income taxes in the passive category.
Example 2. The facts are the same as in Example 1, except that the
Commissioner cannot reasonably determine, based on the available
information, the proper look-through characterization of the 200u of
undistributed earnings and $100 of taxes in S's non-look-through pools.
Accordingly, the Commissioner will assign such earnings and taxes to the
passive category, so that as of January 1, 2003, S has 200u of post-1986
undistributed earnings and $100 of post-1986 foreign income taxes in the
passive category, and the Commissioner will treat S as a passive
category asset for purposes of apportioning P's interest expense.
(5) Treatment of a deficit accumulated in a non-look-through pool.
Any deficit in the non-look-through pool of a noncontrolled section 902
corporation or a controlled foreign corporation as of the end of its
last taxable year beginning before January 1, 2003, shall be treated in
taxable years beginning after December 31, 2002, as if the deficit had
been accumulated during a period in which a dividend paid by the foreign
corporation would have been eligible for look-through treatment. In the
case of a noncontrolled section 902 corporation, the deficit and taxes,
if any, in the non-look-through pools shall constitute the opening
balance of the look-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
[[Page 954]]
December 31, 2002. In the case of a controlled foreign corporation, the
deficit and taxes, if any, in the non-look-through pools shall be added
to the balance of the look-through pools of post-1986 undistributed
earnings and post-1986 foreign income taxes of the controlled foreign
corporation in the appropriate separate categories on the first day of
its first taxable year beginning after December 31, 2002. The taxpayer
must substantiate the look-through characterization of the deficit and
taxes in accordance with the rules of paragraph (f)(4) of this section.
If a taxpayer does not use the safe harbor method described in paragraph
(f)(4)(ii) of this section and the Commissioner determines that the
look-through characterization of the deficit and taxes cannot reasonably
be determined based on the available information, the Commissioner shall
allocate the deficit and taxes, if any, in the non-look-through pools to
the foreign corporation's passive category. If, as of the end of a
taxable year beginning after December 31, 2002, in which it pays a
dividend, the foreign corporation has zero or a deficit in post-1986
undistributed earnings (taking into account any earnings or a deficit
accumulated in taxable years beginning before January 1, 2003), the
deficit in post-1986 undistributed earnings shall be carried back to
reduce pre-1987 accumulated profits, if any, on a last-in first-out
basis. See Sec. 1.902-2(a)(1). If, as of the end of a taxable year
beginning after December 31, 2002, in which the foreign corporation pays
a dividend out of current earnings and profits, it has zero or a deficit
in post-1986 undistributed earnings (taking into account any earnings or
a deficit accumulated in taxable years beginning before January 1,
2003), and the sum of current plus accumulated earnings and profits is
zero or less than zero, no foreign taxes shall be deemed paid with
respect to the dividend. See Sec. 1.902-1(b)(4).
(6) Treatment of pre-1987 accumulated profits. Any pre-1987
accumulated profits (as defined in Sec. 1.902-1(a)(10)) of a controlled
foreign corporation or noncontrolled section 902 corporation shall be
treated in taxable years beginning after December 31, 2002, as if they
were accumulated during a period in which a dividend paid by the foreign
corporation would have been eligible for look-through treatment. Any
pre-1987 foreign income taxes (as defined in Sec. 1.902-1(a)(10)(iii))
shall be treated as if they were paid, accrued or deemed paid during a
year when a dividend out of the related pre-1987 accumulated profits
would have been eligible for look-through treatment. The taxpayer must
substantiate the look-through characterization of the pre-1987
accumulated profits and pre-1987 foreign income taxes in accordance with
the rules of paragraph (f)(4) of this section. If a taxpayer does not
use, or is ineligible to use, the safe harbor method described in
paragraph (f)(4)(ii) of this section and the Commissioner determines
that the look-through characterization of the pre-1987 accumulated
profits and pre-1987 foreign income taxes cannot reasonably be
determined based on the available information, the pre-1987 accumulated
profits and pre-1987 foreign income taxes shall be allocated to the
foreign corporation's passive category.
(7) Treatment of post-1986 undistributed earnings or a deficit of a
controlled foreign corporation attributable to dividends from a
noncontrolled section 902 corporation paid in taxable years beginning
before January 1, 2003--(i) Look-through treatment of post-1986
undistributed earnings at controlled foreign corporation level.
Dividends paid by a noncontrolled section 902 corporation to a
controlled foreign corporation in post-1986 taxable years of the
noncontrolled section 902 corporation beginning before January 1, 2003,
were assigned to a separate category for dividends from that
noncontrolled section 902 corporation. Beginning on the first day of the
controlled foreign corporation's first taxable year beginning on or
after the first day of the lower-tier corporation's first taxable year
beginning after December 31, 2002, any post-1986 undistributed earnings,
or previously-taxed earnings and profits described in section 959(c)(1)
or (2), of the controlled foreign corporation in such a separate
category shall 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
[[Page 955]]
category shall also be treated as if they were paid, accrued or deemed
paid during a period when such a dividend would have been eligible for
look-through treatment. Any such post-1986 undistributed earnings and
post-1986 foreign income taxes in a separate category for dividends from
a noncontrolled section 902 corporation shall be added to the opening
balance of the controlled foreign corporation's look-through pools of
post-1986 undistributed earnings and post-1986 foreign income taxes in
the appropriate separate categories on the first day of the controlled
foreign corporation's first taxable year beginning on or after the first
day of the lower-tier corporation's first taxable year beginning after
December 31, 2002. Any section 952(c)(2) recapture account with respect
to such a separate category shall be allocated in the same manner as the
associated post-1986 undistributed earnings. The taxpayer must
substantiate the look-through characterization of such earnings and
taxes in accordance with the rules of paragraph (f)(7)(iii) of this
section.
(ii) Look-through treatment of deficit in post-1986 undistributed
earnings at controlled foreign corporation level. If a controlled
foreign corporation has a deficit in a separate category for dividends
from a lower-tier noncontrolled section 902 corporation that is a member
of the controlled foreign corporation's qualified group as defined in
section 902(b)(2), such deficit shall be treated in taxable years of the
upper-tier corporation beginning on or after the first day of the lower-
tier corporation's first taxable year beginning after December 31, 2002,
as if the deficit had been accumulated during a period in which a
dividend from the lower-tier corporation would have been eligible for
look-through treatment. Any post-1986 foreign income taxes in the
separate category for dividends from the noncontrolled section 902
corporation shall also be treated as if they were paid, accrued or
deemed paid during a period when the dividends were eligible for look-
through treatment. The deficit and related post-1986 foreign income
taxes, if any, shall be added to the opening balance of the controlled
foreign corporation's look-through pools of post-1986 undistributed
earnings and post-1986 foreign income taxes in the appropriate separate
categories on the first day of the controlled foreign corporation's
first taxable year beginning on or after the first day of the lower-tier
corporation's first taxable year beginning after December 31, 2002. The
taxpayer must substantiate the look-through characterization of the
deficit and taxes in accordance with the rules of paragraph (f)(7)(iii)
of this section.
(iii) Substantiation required for look-through treatment. The
taxpayer must substantiate the look-through characterization of post-
1986 undistributed earnings, previously-taxed earnings and profits, or a
deficit in post-1986 undistributed earnings in a separate category for
dividends paid by a noncontrolled section 902 corporation in taxable
years beginning before January 1, 2003, by making a reasonable, good-
faith effort to reconstruct the earnings (or deficit) and taxes in the
separate category at the level of the controlled foreign corporation on
a look-through basis, in accordance with the principles of paragraph
(f)(4)(i) of this section. Alternatively, the taxpayer may allocate the
earnings (or deficit) and taxes to the controlled foreign corporation's
look-through pools under the safe harbor method described in paragraph
(f)(4)(ii) of this section at the level of the controlled foreign
corporation. If the taxpayer uses the safe harbor method, the earnings
(or deficit) and taxes shall be allocated to the controlled foreign
corporation's look-through pools in the appropriate separate categories
on the first day of the controlled foreign corporation's first taxable
year beginning on or after the first day of the lower-tier corporation's
first taxable year beginning after December 31, 2002. The allocation
shall be made in the same percentages as the controlled foreign
corporation would properly characterize the stock of the lower-tier
noncontrolled section 902 corporation in the separate categories 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.
[[Page 956]]
Under Sec. 1.861-12T(c)(3), the apportionment ratios properly used by
the controlled foreign corporation are in turn based on the
apportionment ratios properly used by the noncontrolled section 902
corporation to apportion its interest expense in its first taxable year
beginning after December 31, 2002. In the case of a taxpayer that uses
the safe harbor method where the lower-tier noncontrolled section 902
corporation uses the modified gross income method described in Sec.
1.861-9T(j) to apportion interest expense for its first taxable year
beginning after December 31, 2002, earnings (or a deficit) and taxes in
the separate category for dividends from the noncontrolled section 902
corporation shall be allocated to the look-through pools based on the
average of the noncontrolled section 902 corporation's modified gross
income ratios for its taxable years beginning in 2003 and 2004. In the
case of a controlled foreign corporation that has in its qualified group
a chain of lower-tier noncontrolled section 902 corporations, the safe
harbor applies first to characterize the stock of the third-tier
corporation and then to characterize the stock of the second-tier
corporation. Where a taxpayer uses the safe harbor method with respect
to a lower-tier noncontrolled section 902 corporation with respect to
which the taxpayer did not meet the requirements of section 902(a) as of
the end of the upper-tier controlled foreign corporation's last taxable
year beginning before January 1, 2003, the earnings (or deficit) and
taxes in the separate category for dividends from the lower-tier
corporation shall be allocated to the upper-tier corporation's look-
through pools in the separate categories in the same percentages as the
stock of the lower-tier corporation would have been characterized for
purposes of apportioning the upper-tier corporation's interest expense
in the last year the taxpayer met the ownership requirements of section
902(a) with respect to the lower-tier corporation if the look-through
rules had applied in that year. If a taxpayer does not use the safe
harbor method described in this paragraph (f)(7)(iii), and the
Commissioner determines that the look-through characterization of the
earnings (or deficit) and taxes cannot reasonably be determined based on
the available information, the Commissioner shall allocate the earnings
(or deficit) and associated foreign income taxes to the controlled
foreign corporation's passive category.
(8) Treatment of distributions received by an upper-tier corporation
from a lower-tier noncontrolled section 902 corporation, including when
the corporations do not have the same taxable years--(i) Rule. In the
case of dividends paid by a lower-tier noncontrolled section 902
corporation to an upper-tier corporation where both are members of the
same qualified group as defined in section 902(b)(2), the following
rules apply. Dividends paid by the lower-tier corporation in taxable
years beginning before January 1, 2003, are assigned to a separate
category for dividends from that corporation, regardless of whether the
corresponding taxable year of the recipient corporation began after
December 31, 2002. Post-1986 undistributed earnings, previously-taxed
earnings and profits, and post-1986 foreign income taxes in such a
separate category shall be treated, beginning on the first day of the
upper-tier corporation's first taxable year beginning on or after the
first day of the lower-tier corporation's first taxable year beginning
after December 31, 2002, as if they were accumulated during a period
when a dividend paid by the lower-tier corporation would have been
eligible for look-through treatment under section 904(d)(4) and Sec.
1.904-5. Dividends paid by a lower-tier corporation in taxable years
beginning after December 31, 2002, are eligible for look-through
treatment when paid, without regard to whether the corresponding taxable
year of the recipient upper-tier corporation began after December 31,
2002.
(ii) Example. The following example illustrates the application of
paragraph (f) of this section:
Example. M, a domestic corporation, has directly owned 50 percent of
the stock of foreign corporation X, and X has directly owned 50 percent
of the stock of foreign corporation 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.
[[Page 957]]
Under Sec. 1.904-4(g) and paragraph (f)(10) of this section, a dividend
paid to M by X on January 15, 2003 (during X's last pre-2003 taxable
year) is not eligible for look-through treatment in 2003. However, under
Sec. 1.861-12(c)(4), M will characterize the stock of X on a look-
through basis for purposes of interest expense apportionment in its 2003
taxable year. Under Sec. 1.904-2(h)(1), any unused foreign taxes in M's
separate category for dividends from X will be carried over to M's other
separate categories on a look-through basis for M's taxable years
beginning on and after January 1, 2004. Under paragraph (f)(2) of this
section, any undistributed earnings and taxes in X's non-look-through
pools will be allocated to X's other separate categories on July 1,
2003. Under Sec. 1.904-5(i)(4) and paragraphs (f)(8)(i) and (f)(10) of
this section, a dividend paid to X by Y on January 15, 2003 (during Y's
first post-2002 taxable year) is eligible for look-through treatment
when paid, notwithstanding that it is received in a pre-2003 taxable
year of X.
(9) Election to apply pre-AJCA rules to 2003 and 2004 taxable
years--(i) Definition. The term single category for dividends from all
noncontrolled section 902 corporations means the separate category
described in section 904(d)(1)(E) as in effect for taxable years
beginning after December 31, 2002, and prior to its repeal by the
American Jobs Creation Act (AJCA), Public Law 108-357, 118 Stat. 1418
(October 22, 2004).
(ii) Time, manner, and form of election. A taxpayer may elect not to
apply the provisions of section 403 of the AJCA and to apply the rules
of this paragraph (f)(9) to taxable years of noncontrolled section 902
corporations beginning after December 31, 2002, and before January 1,
2005, without regard to whether the corresponding taxable years of the
taxpayer or any upper-tier corporation begin before or after such dates.
A taxpayer shall be eligible to make such an election provided that--
(A) The taxpayer's tax liability as shown on an original or amended
tax return for each of its affected taxable years is consistent with the
rules of this paragraph (f)(9), the guidance set forth in Notice 2003-5
(2003-1 CB 294) (see Sec. 601.601(d)(2) of this chapter), and the
principles of Sec. 1.861-12(c)(4) for each such year for which the
statute of limitations does not preclude the filing of an amended
return;
(B) The taxpayer makes appropriate adjustments to eliminate any
duplicate benefits arising from the application of this paragraph (f)(9)
to taxable years that are not open for assessment; and
(C) The taxpayer attaches a statement to its next tax return for
which the due date (with extensions) is more than 90 days after April
25, 2006, indicating that the taxpayer elects not to apply the
provisions of section 403 of the AJCA to taxable years of its
noncontrolled section 902 corporations beginning in 2003 and 2004, and
that the taxpayer has filed original returns or will file amended
returns reflecting tax liabilities for each affected year that satisfy
the requirements described in this paragraph (f)(9)(ii).
(iii) Treatment of non-look-through pools in taxable years beginning
after December 31, 2004. Undistributed earnings (or a deficit) and taxes
in the non-look-through pools of a controlled foreign corporation or a
noncontrolled section 902 corporation as of the end of its last taxable
year beginning before January 1, 2005, shall be treated in taxable years
beginning after December 31, 2004, as if they were accumulated and paid
during a period in which a distribution out of earnings in the non-look-
through pool would have been eligible for look-through treatment. Such
earnings (or deficit) and taxes shall be added to the foreign
corporation's pools of post-1986 undistributed earnings and post-1986
foreign income taxes in the appropriate separate categories on the first
day of the foreign corporation's first taxable year beginning after
December 31, 2004. In accordance with the principles of paragraph (f)(4)
of this section, the taxpayer must reconstruct the non-look-through
pools or, if the taxpayer chooses to use the safe harbor method,
allocate the earnings and taxes in the non-look-through pools to the
foreign corporation's look-through pools in the appropriate separate
categories on the first day of the foreign corporation's first taxable
year beginning after December 31, 2004. Under the safe harbor method,
this allocation is made in the 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
[[Page 958]]
corporation's first taxable year beginning after December 31, 2002. See
Sec. 1.861-12T(c)(3) and Sec. 1.861-12(c)(4). If a taxpayer does not
use the safe harbor method described in paragraph (f)(4)(ii) of this
section and the Commissioner determines that the look-through
characterization of the earnings (or deficit) and taxes cannot
reasonably be determined based on the available information, the
earnings (or deficit) and taxes shall be allocated to the foreign
corporation's passive category.
(iv) Carryover of unused foreign tax. To the extent that a taxpayer
has unused foreign taxes in the single category for dividends from all
noncontrolled section 902 corporations, such taxes shall be carried
forward to the appropriate separate categories in the taxpayer's taxable
years beginning on or after the first day of the relevant noncontrolled
section 902 corporation's first taxable year beginning after December
31, 2004. Such unused taxes shall be carried forward in the same manner
as Sec. 1.904-2(h)(1) provides that unused foreign taxes in the
separate categories for dividends from each noncontrolled section 902
corporation are carried over to taxable years beginning on or after the
first day of the noncontrolled section 902 corporation's first taxable
year beginning after December 31, 2002, in the case of a taxpayer that
does not make the election under this paragraph (f)(9). The electing
taxpayer shall determine which noncontrolled section 902 corporations
paid the dividends to which the unused foreign taxes are attributable
and assign the taxes to the appropriate separate categories as if such
dividends had been eligible for look-through treatment when paid.
Accordingly, the taxpayer must substantiate the look-through
characterization of the unused foreign taxes in accordance with
paragraph (f)(4) of this section by reconstructing the non-look-through
pools or, if the taxpayer uses the safe harbor method, by allocating the
unused foreign taxes to other separate categories in the same
percentages as the taxpayer properly characterized the stock of the
noncontrolled section 902 corporation for purposes of apportioning the
taxpayer's interest expense for its first taxable year ending after the
first day of the noncontrolled section 902 corporation's first taxable
year beginning after December 31, 2002. The rule described in this
paragraph (f)(9)(iv) shall apply only to unused foreign taxes
attributable to dividends out of earnings that were accumulated by
noncontrolled section 902 corporations in taxable years of such
corporations beginning before January 1, 2003, because only unused
foreign taxes attributable to distributions out of pre-2003 earnings are
included in the single category for dividends from all noncontrolled
section 902 corporations. To the extent that unused foreign taxes
carried forward to the single category for dividends from all
noncontrolled section 902 corporations under the rules of Notice 2003-5
were either absorbed by low-taxed dividends paid by noncontrolled
section 902 corporations out of the non-look-through pool in taxable
years of such corporations beginning in 2003 or 2004, or expired unused,
the amount of taxes carried forward to the separate categories on a
look-through basis will be smaller than the aggregate amount of taxes
initially carried forward to the single category for dividends from all
noncontrolled section 902 corporations. In this case, the unused foreign
taxes arising in each taxable year shall be deemed attributable to each
noncontrolled section 902 corporation in the same ratio as the dividends
included in the separate category that were paid by such corporation in
such year bears to all such dividends paid by all noncontrolled section
902 corporations in such year. Unused foreign taxes carried forward from
the separate categories for dividends from each noncontrolled section
902 corporation to the single category for dividends from all
noncontrolled section 902 corporations will similarly be deemed to have
been utilized on a pro rata basis. The remaining unused foreign taxes
are then assigned to the appropriate separate categories under the rules
of paragraph (f)(4) of this section. Unused foreign taxes shall be
treated 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
[[Page 959]]
(f)(4)(iii) of this section, the Commissioner determines that the look-
through characterization cannot reasonably be determined based on the
available information.
(v) Carryback of unused foreign tax. To the extent that a taxpayer
has unused foreign taxes attributable to a dividend paid by a
noncontrolled section 902 corporation that was eligible for look-through
treatment under section 904(d)(4) and Sec. 1.904-5, any such unused
foreign taxes shall be carried back to prior taxable years within the
same separate category and not to the single category for dividends from
all noncontrolled section 902 corporations or any separate category for
dividends from a noncontrolled section 902 corporation. See Notice 2003-
5 for rules relating to the carryback of unused foreign taxes in the
single category for dividends from all noncontrolled section 902
corporations.
(vi) Recapture of overall foreign loss or separate limitation loss
in the single category for dividends from all noncontrolled section 902
corporations. To the extent that a taxpayer has a balance in a separate
limitation loss or overall foreign loss account in the single category
for dividends from all noncontrolled section 902 corporations under
section 904(d)(1)(E) (prior to its repeal by the AJCA), at the end of
the taxpayer's last taxable year beginning before January 1, 2005 (or a
later taxable year in which the taxpayer received a dividend subject to
the separate limitation for dividends from all noncontrolled section 902
corporations), the amount of such balance shall be allocated on the
first day of the taxpayer's next taxable year to the taxpayer's other
separate categories. The amount of such balance that is attributable to
each noncontrolled section 902 corporation shall be allocated in the
same percentages as the taxpayer properly characterized the stock of
such corporation for purposes of apportioning the taxpayer's interest
expense for its first taxable year ending after the first day of such
corporation's first taxable year beginning after December 31, 2002,
under Sec. 1.861-12T(c)(3) or Sec. 1.861-12(c)(4), as the case may be.
To the extent that a taxpayer has a balance in a separate limitation
loss account for the single category for dividends from all
noncontrolled section 902 corporations with respect to another separate
category, and the separate limitation loss account would otherwise be
assigned to that other category under this paragraph (f)(9)(vi), such
balance shall be eliminated.
(vii) Recapture of separate limitation losses in other separate
categories. To the extent that a taxpayer has a balance in any separate
limitation loss account in a separate category with respect to the
single category for dividends from all noncontrolled section 902
corporations at the end of the taxpayer's last taxable year with or
within which ends the last taxable year of the relevant noncontrolled
section 902 corporation beginning before January 1, 2005, such loss
shall be recaptured in subsequent taxable years as income in the
appropriate separate category. The separate limitation loss account
shall be deemed attributable on a pro rata basis to those noncontrolled
section 902 corporations that paid dividends out of earnings accumulated
in taxable years beginning before January 1, 2003, in the years in which
the separate limitation loss in the other separate category arose. The
ratable portions of the separate limitation loss account shall be
recaptured as income in the taxpayer's separate categories in the same
percentages as the taxpayer properly characterized the stock of the
relevant noncontrolled section 902 corporation for purposes of
apportioning the taxpayer's interest expense in its first taxable year
ending after the first day of such corporation's first taxable year
beginning after December 31, 2002, under Sec. 1.861-12T(c)(3) or Sec.
1.861-12(c)(4), as the case may be. To the extent that a taxpayer has a
balance in any separate limitation loss account in any separate category
that would have been recaptured as income in that same category under
this paragraph (f)(9)(vii), such balance shall be eliminated.
(viii) Treatment of undistributed earnings in an upper-tier
corporation-level single category for dividends from lower-tier
noncontrolled section 902 corporations. Where a controlled foreign
corporation or noncontrolled section 902 corporation has a single
category for
[[Page 960]]
dividends from all noncontrolled section 902 corporations containing
earnings attributable to dividends paid by one or more lower-tier
corporations, the following rules apply. The post-1986 undistributed
earnings, previously-taxed earnings and profits described in section
959(c)(1) or (2), if any, and associated post-1986 foreign income taxes
shall be allocated to the upper-tier corporation's other separate
categories in the same manner as earnings and taxes in a separate
category for dividends from each noncontrolled section 902 corporation
maintained by the upper-tier corporation are allocated under paragraph
(f)(7) of this section. Accordingly, post-1986 undistributed earnings,
previously-taxed earnings and profits, if any, and post-1986 foreign
income taxes in the single category for dividends from all noncontrolled
section 902 corporations shall be treated as if they were accumulated
and paid, accrued or deemed paid during a period when a dividend paid by
each lower-tier corporation that paid dividends included in the single
category would have been eligible for look-through treatment. If the
taxpayer uses the safe harbor method described in paragraph (f)(7)(iii)
of this section, the earnings and taxes shall be allocated based on the
apportionment ratios properly used by the lower-tier corporation to
apportion its interest expense for its first taxable year beginning
after December 31, 2002. Any section 952(c)(2) recapture account with
respect to the single category shall be allocated in the same manner as
the associated post-1986 undistributed earnings. The taxpayer must
substantiate the look-through characterization of the earnings and taxes
in accordance with the rules of paragraph (f)(7)(iii) of this section.
If the taxpayer does not use the safe harbor method and the Commissioner
determines that the look-through characterization of the earnings cannot
reasonably be determined based on the available information, the
earnings and taxes shall be assigned to the upper-tier corporation's
passive category.
(ix) Treatment of a deficit in the single category for dividends
from lower-tier noncontrolled section 902 corporations. Where a
controlled foreign corporation or noncontrolled section 902 corporation
had an aggregate deficit in the single category for dividends from all
noncontrolled section 902 corporations as of the end of the upper-tier
corporation's last taxable year beginning before January 1, 2005, such
deficit and the associated post-1986 foreign income taxes, if any, shall
be allocated to the upper-tier corporation's other separate categories
in the same percentages in which the non-look-through pools of each
lower-tier corporation to which the deficit is attributable were
assigned to such corporation's other separate categories in its first
taxable year beginning after December 31, 2002. If the taxpayer uses the
safe harbor method described in paragraph (f)(7)(iii) of this section,
the deficit and taxes shall be allocated based on how the taxpayer
properly characterized the stock of the lower-tier noncontrolled section
902 corporation for purposes of apportioning the upper-tier
corporation's interest expense for the upper-tier corporation's first
taxable year ending after the first day of the lower-tier corporation's
first taxable year beginning after December 31, 2002. The taxpayer must
substantiate the look-through characterization of the deficit and taxes
in accordance with the rules of paragraph (f)(7)(iii) of this section.
If the taxpayer does not use the safe harbor method and the Commissioner
determines that the look-through characterization of the deficit cannot
reasonably be determined based on the available information, the deficit
and taxes shall be assigned to the upper-tier corporation's passive
category.
(10) Effective/applicability date. This paragraph (f) shall apply to
dividends from a noncontrolled section 902 corporation that are paid in
taxable years of the noncontrolled section 902 corporation ending on or
after April 20, 2009. See 26 CFR Sec. 1.904-7T(f) (revised as of April
1, 2009) for rules applicable, except in the case of a taxpayer that
makes the election under paragraph (f)(9) of that section, to dividends
from a noncontrolled section 902 corporation 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
[[Page 961]]
1.904-7T(f) (revised as of April 1, 2009) for rules applicable, in the
case of a taxpayer that makes the election under paragraph (f)(9) of
that section, to dividends from a noncontrolled section 902 corporation
that are paid in taxable years of the noncontrolled section 902
corporation beginning after December 31, 2004, and ending before April
20, 2009. However, taxpayers may choose to apply paragraph (f) of this
section in its entirety in lieu of 26 CFR 1.904-7T(f) to all dividends
paid in periods covered by the temporary regulations, provided that
appropriate adjustments are made to eliminate duplicate benefits arising
from application of paragraph (f) to taxable years that are not open for
assessment.
(g) Treatment of earnings and foreign taxes of a controlled foreign
corporation or a noncontrolled section 902 corporation accumulated in
taxable years beginning before January 1, 2007--(1) Definitions--(i)
Pre-2007 pools means the pools in each separate category of post-1986
undistributed earnings (as defined in Sec. 1.902-1(a)(9)) that were
accumulated, and post-1986 foreign income taxes (as defined in Sec.
1.902-1(a)(8)) paid, accrued, or deemed paid, in taxable years beginning
before January 1, 2007.
(ii) Pre-2007 separate categories means the separate categories of
income described in section 904(d) as applicable to taxable years
beginning before January 1, 2007, and any other separate category of
income described in Sec. 1.904-4(m).
(iii) Post-2006 separate categories means the separate categories of
income described in section 904(d) as applicable to taxable years
beginning after December 31, 2006, and any other separate category of
income described in Sec. 1.904-4(m).
(2) Treatment of pre-2007 pools of a controlled foreign corporation
or a noncontrolled section 902 corporation. Any post-1986 undistributed
earnings in a pre-2007 pool of a controlled foreign corporation or a
noncontrolled section 902 corporation shall be treated in taxable years
beginning after December 31, 2006, as if they were accumulated during a
period in which the rules governing the determination of post-2006
separate categories applied. Post-1986 foreign income taxes paid,
accrued, or deemed paid with respect to such earnings shall be treated
as if they were paid, accrued, or deemed paid during a period in which
the rules governing the determination of post-2006 separate categories
(including the rules of section 904(d)(3)(E)) applied as well. Any such
earnings and taxes in pre-2007 pools shall constitute the opening
balance of the foreign corporation's post-1986 undistributed earnings
and post-1986 foreign income taxes on the first day of the foreign
corporation's first taxable year beginning after December 31, 2006, in
accordance with the rules of paragraph (g)(3) of this section. Similar
rules shall apply to characterize any deficits in the pre-2007 pools and
previously-taxed earnings and profits described in section 959(c)(1) and
(2) that are attributable to earnings in the pre-2007 pools. Any section
952(c)(2) recapture account with respect to a separate category shall be
allocated in the same manner as the post-1986 undistributed earnings in
the associated pre-2007 pool.
(3) Substantiation of post-2006 character of earnings and taxes in a
pre-2007 pool--(i) Reconstruction of earnings and taxes pools. In order
to substantiate the post-2006 characterization of post-1986
undistributed earnings (as well as deficits and previously-taxed
earnings, if any) and post-1986 foreign income taxes in pre-2007 pools
of a controlled foreign corporation or a noncontrolled section 902
corporation, the taxpayer shall make a reasonable, good-faith effort to
reconstruct the pre-2007 pools of post-1986 undistributed earnings (as
well as deficits and previously-taxed earnings, if any) and post-1986
foreign income taxes following the rules governing the determination of
post-2006 separate categories for each taxable year beginning before
January 1, 2007, beginning with the first year in which post-1986
undistributed earnings were accumulated in the pre-2007 pool.
Reconstruction shall be based on reasonably available books and records
and other relevant information. To the extent any pre-2007 separate
category includes earnings that would be allocated to 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
[[Page 962]]
if they were distributed and deemed paid pro rata from the amounts that
were added to that category during each taxable year beginning before
January 1, 2007.
(ii) Safe harbor method--(A) In general. Subject to the rules of
paragraph (g)(3)(iii) of this section, a taxpayer may allocate the post-
1986 undistributed earnings and post-1986 foreign income taxes in pre-
2007 pools of a controlled foreign corporation or a noncontrolled
section 902 corporation (as well as deficits and previously-taxed
earnings, if any) under one of the safe harbor methods described in
paragraphs (g)(3)(ii)(B) and (g)(3)(ii)(C) of this section. A taxpayer
may choose to use the safe harbor method on a timely filed (original or
amended) tax return or during an audit. A taxpayer that uses the safe
harbor method on an amended return or in the course of an audit must
make appropriate adjustments to eliminate any double benefit arising
from application of the safe harbor method to years that are not open
for assessment. A taxpayer's choice to use the safe harbor method is
evidenced by employing the method. The taxpayer need not file any
separate statement.
(B) General safe harbor method. (1) Any post-1986 undistributed
earnings (as well as deficits and previously-taxed earnings, if any) and
post-1986 foreign income taxes of a noncontrolled section 902
corporation or a controlled foreign corporation in a pre-2007 separate
category for passive income, certain dividends from a DISC or former
DISC, taxable income attributable to certain foreign trade income, or
certain distributions from a FSC or former FSC shall be allocated to the
post-2006 separate category for passive category income.
(2) Any post-1986 undistributed earnings (as well as deficits and
previously-taxed earnings, if any) and post-1986 foreign income taxes of
a noncontrolled section 902 corporation or a controlled foreign
corporation in a pre-2007 separate category for financial services
income, shipping income or general limitation income shall be allocated
to the post-2006 separate category for general category income.
(3) Except as provided in paragraph (g)(3)(ii)(B)(4) of this
section, any post-1986 undistributed earnings (as well as deficits and
previously-taxed earnings, if any) and post-1986 foreign income taxes of
a noncontrolled section 902 corporation or a controlled foreign
corporation in a pre-2007 separate category for high withholding tax
interest shall be allocated to the post-2006 separate category for
passive category income.
(4) If a controlled foreign corporation has positive post-1986
undistributed earnings and post-1986 foreign income taxes in a pre-2007
separate category for high withholding tax interest, such earnings and
taxes shall be allocated to the post-2006 separate category for general
category income if the earnings would qualify as income subject to high
foreign taxes under section 954(b)(4) if the entire amount of post-1986
undistributed earnings were treated as a net item of income subject to
the rules of Sec. 1.954-1(d). If the high withholding tax interest
earnings would not qualify as income subject to high foreign taxes under
section 954(b)(4), then the earnings and taxes shall be allocated to the
post-2006 separate category for passive category income.
(C) Interest apportionment safe harbor. A taxpayer may allocate the
post-1986 undistributed earnings (as well as deficits and previously-
taxed earnings, if any) and post-1986 foreign income taxes in pre-2007
pools of a controlled foreign corporation or a noncontrolled section 902
corporation following the principles of paragraph (f)(4)(ii) of this
section.
(iii) Consistency rule. The election to apply a safe harbor method
under paragraph (g)(3)(ii) of this section in lieu of the rules
described in paragraph (g)(3)(i) of this section may be made on a
separate category by separate category basis. However, if a taxpayer
elects to apply a safe harbor to allocate pre-2007 pools of more than
one pre-2007 separate category of a controlled foreign corporation or a
noncontrolled section 902 corporation, such safe harbor (the general
safe harbor described in paragraph (g)(3)(ii)(B) of this section or the
interest apportionment safe harbor described in paragraph (g)(3)(ii)(C)
of this section) shall apply to allocate
[[Page 963]]
post-1986 undistributed earnings (as well as deficits and previously-
taxed earnings, if any) and post-1986 foreign income taxes for the pre-
2007 pools in each pre-2007 separate category of the foreign corporation
for which the taxpayer elected to apply a safe harbor method in lieu of
reconstructing the pre-2007 pools.
(4) Treatment of pre-1987 accumulated profits. Any pre-1987
accumulated profits (as defined in Sec. 1.902-1(a)(10)) of a
noncontrolled section 902 corporation or a controlled foreign
corporation shall be treated in taxable years beginning after December
31, 2006, as if they had been accumulated during a period in which the
rules governing the determination of post-2006 separate categories
applied. Foreign income taxes paid, accrued, or deemed paid with respect
to such earnings shall be treated as if they were paid, accrued, or
deemed paid during a period in which the rules governing the
determination of post-2006 separate categories applied as well. The
taxpayer must substantiate the post-2006 characterization of the pre-
1987 accumulated profits and pre-1987 foreign income taxes in accordance
with the rules of paragraph (g)(3) of this section, including the safe
harbor provisions. Similar rules shall apply to characterize any
deficits or previously-taxed earnings and profits described in section
959(c)(1) and (2) that are attributable to pre-1987 accumulated profits.
(5) Treatment of earnings and foreign taxes in pre-2007 pools of a
lower-tier controlled foreign corporation or noncontrolled section 902
corporation. The rules of paragraphs (g)(1) through (4) of this section
apply to post-1986 undistributed earnings (as well as deficits and
previously-taxed earnings, if any) and post-1986 foreign income taxes in
pre-2007 pools, and pre-1987 accumulated profits and pre-1987 foreign
income taxes, of a lower-tier controlled foreign corporation or
noncontrolled section 902 corporation.
(6) Effective/applicability date. This paragraph (g) shall apply to
taxable years of United States persons and, for purposes of section 906,
foreign persons beginning after December 31, 2006 and ending on or after
December 21, 2007, and to taxable years of a foreign corporation which
end with or within taxable years of its domestic corporate shareholder
beginning after December 31, 2006 and ending on or after December 21,
2007.
[T.D. 8214, 53 FR 27034, July 18, 1988, as amended by T.D. 8412, 57 FR
20653, May 14, 1992; T.D. 9260, 71 FR 24533, Apr. 25, 2006; T.D. 9368,
72 FR 72590, Dec. 21, 2007; T.D. 9452, 74 FR 27881, June 11, 2009; T.D.
9521, 76 FR 19272, Apr. 7, 2011]
Sec. 1.904(b)-0 Outline of regulation provisions.
This section lists the headings for Sec. Sec. 1.904(b)-1 and
1.904(b)-2.
Sec. 1.904(b)-1 Special rules for capital gains and losses.
(a) Capital gains and losses included in taxable income from sources
outside the United States.
(1) Limitation on capital gain from sources outside the United
States when the taxpayer has net capital losses from sources within the
United States.
(i) In general.
(ii) Allocation of reduction to separate categories or rate groups.
(A) In general.
(B) Taxpayer with capital gain rate differential.
(2) Exclusivity of rules; no reduction by reason of net capital loss
from sources outside the United States in a different separate category.
(3) Capital losses from sources outside the United States in the
same separate category.
(4) Examples.
(b) Capital gain rate differential.
(1) Application of adjustments only if capital gain rate
differential exists.
(2) Determination of whether capital gain rate differential exists.
(3) Special rule for certain noncorporate taxpayers.
(c) Rate differential adjustment of capital gains.
(1) Rate differential adjustment of capital gains in foreign source
taxable income.
(i) In general.
(ii) Special rule for taxpayers with a net long-term capital loss
from sources within the United States.
(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.
[[Page 964]]
(1) In general.
(2) Exception.
(f) Definitions.
(1) Alternative tax rate.
(2) Net capital gain.
(3) Rate differential portion.
(4) Rate group.
(i) Short-term capital gains or losses.
(ii) Long-term capital gains.
(iii) Long-term capital losses.
(5) Terms used in sections 1(h), 904(b) or 1222.
(g) Examples.
(h) Coordination with section 904(f).
(1) In general.
(2) Examples.
(i) Effective date.
Sec. 1.904(b)-2 Special rules for application of section 904(b) to
alternative minimum tax foreign tax credit.
(a) Application of section 904(b)(2)(B) adjustments.
(b) Use of alternative minimum tax rates.
(1) Taxpayers other than corporations.
(2) Corporate taxpayers.
(c) Effective date.
[T.D. 9371, 72 FR 72596, Dec. 21, 2007]
Sec. 1.904(b)-1 Special rules for capital gains and losses.
(a) Capital gains and losses included in taxable income from sources
outside the United States--(1) Limitation on capital gain from sources
outside the United States when the taxpayer has net capital losses from
sources within the United States--(i) In general. Except as otherwise
provided in this section, for purposes of section 904 and this section,
taxable income from sources outside the United States (in all of the
taxpayer's separate categories in the aggregate) shall include capital
gain net income from sources outside the United States (determined by
considering all of the capital gain and loss items in all of the
taxpayer's separate categories in the aggregate) only to the extent of
capital gain net income from all sources. Thus, capital gain net income
from sources outside the United States (determined by considering all of
the capital gain and loss items in all of the taxpayer's separate
categories in the aggregate) shall be reduced to the extent such amount
exceeds capital gain net income from all sources.
(ii) Allocation of reduction to separate categories or rate groups--
(A) In general. If capital gain net income from sources outside the
United States exceeds capital gain net income from all sources, and the
taxpayer has capital gain net income from sources outside the United
States in only one separate category, such excess is allocated as a
reduction to that separate category. If a taxpayer has capital gain net
income from foreign sources in two or more separate categories, such
excess must be apportioned on a pro rata basis as a reduction to each
such separate category. For purposes of the preceding sentence, pro rata
means based on the relative amounts of the capital gain net income from
sources outside the United States in each separate category.
(B) Taxpayer with capital gain rate differential. If a taxpayer with
a capital gain rate differential for the year (within the meaning of
paragraph (b) of this section) has capital gain net income from foreign
sources in only one rate group within a separate category, any reduction
to such separate category pursuant to paragraph (a)(1)(ii)(A) of this
section must be allocated to such rate group. If a taxpayer with a
capital gain rate differential for the year (within the meaning of
paragraph (b) of this section) has capital gain net income from foreign
sources in two or more rate groups within a separate category, any
reduction to such separate category pursuant to paragraph (a)(1)(ii)(A)
of this section must be apportioned on a pro rata basis among such rate
groups. For purposes of the preceding sentence, pro rata means based on
the relative amounts of the capital gain net income from sources outside
the United States 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).
[[Page 965]]
(3) Capital losses from sources outside the United States in the
same separate category. Except as otherwise provided in paragraph (d) of
this section, taxable income from sources outside the United States in
each separate category shall be reduced by any capital loss that is
allocable or apportionable to income from sources outside the United
States in such separate category to the extent such loss is allowable in
determining taxable income for the taxable year.
(4) Examples. The following examples illustrate the application of
this paragraph (a) to taxpayers that do not have a capital gain rate
differential for the taxable year. See paragraph (g) of this section for
examples that illustrate the application of this paragraph (a) to
taxpayers that have a capital gain rate differential for the year. The
examples are as follows:
Example 1. Taxpayer A, a corporation, has a $3,000 capital loss from
sources outside the United States in the general limitation category, a
$6,000 capital gain from sources outside the United States in the
passive category, and a $2,000 capital loss from sources within the
United States. A's capital gain net income from sources outside the
United States in the aggregate, from all separate categories, is $3,000
($6,000 - $3,000). A's capital gain net income from all sources is
$1,000 ($6,000 - $3,000 - $2,000). Thus, for purposes of section 904,
A's taxable income from sources outside the United States in all of A's
separate categories in the aggregate includes only $1,000 of capital
gain net income from sources outside the United States. See paragraph
(a)(1)(i) of this section. Pursuant to paragraphs (a)(1)(i) and
(a)(1)(ii)(A) of this section, A must reduce the $6,000 of capital gain
net income from sources outside the United States in the passive
category by $2,000 ($3,000 of capital gain net income from sources
outside the United States - $1,000 of capital gain net income from all
sources). After the adjustment, A has $4,000 of capital gain from
sources outside the United States in the passive category and $3,000 of
capital loss from sources outside the United States in the general
limitation category.
Example 2. Taxpayer B, a corporation, has a $300 capital gain from
sources outside the United States in the general limitation category and
a $200 capital gain from sources outside the United States in the
passive category. B's capital gain net income from sources outside the
United States is $500 ($300 + $200). B also has a $150 capital loss from
sources within the United States and a $50 capital gain from sources
within the United States. Thus, B's capital gain net income from all
sources is $400 ($300 + $200 - $150 + $50). Pursuant to paragraph
(a)(1)(ii)(A) of this section, the $100 excess of capital gain net
income from sources outside the United States over capital gain net
income from all sources ($500 - $400) must be apportioned, as a
reduction, three-fifths ($300/$500 of $100, or $60) to the general
limitation category and two-fifths ($200/$500 of $100, or $40) to the
passive category. Therefore, for purposes of section 904, the general
limitation category includes $240 ($300 - $60) of capital gain net
income from sources outside the United States and the passive category
includes $160 ($200 - $40) of capital gain net income from sources
outside the United States.
Example 3. Taxpayer C, a corporation, has a $10,000 capital loss
from sources outside the United States in the general limitation
category, a $4,000 capital gain from sources outside the United States
in the passive category, and a $2,000 capital gain from sources within
the United States. C's capital gain net income from sources outside the
United States is zero, since losses exceed gains. C's capital gain net
income from all sources is also zero. C's capital gain net income from
sources outside the United States does not exceed its capital gain net
income from all sources, and therefore paragraph (a)(1) of this section
does not require any reduction of C's passive category capital gain. For
purposes of section 904, C's passive category includes $4,000 of capital
gain net income. C's general limitation category includes a capital loss
of $6,000 because only $6,000 of capital loss is allowable as a
deduction in the current year. The entire $4,000 of capital loss in
excess of the $6,000 of capital loss that offsets capital gain in the
taxable year is carried back or forward under section 1212(a), and none
of such $4,000 is taken into account under section 904(a) or (b) for the
current taxable year.
(b) Capital gain rate differential--(1) Application of adjustments
only if capital 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--
[[Page 966]]
(i) In the case of a taxpayer other than a corporation, tax is
imposed on the net capital gain at a reduced rate under section 1(h) for
the taxable year; or
(ii) In the case of a corporation, tax is imposed under section
1201(a) on the taxpayer at a rate less than any rate of tax imposed on
the taxpayer by section 11, 511, or 831(a) or (b), whichever applies
(determined without regard to the last sentence of section 11(b)(1)),
for the taxable year.
(3) Special rule for certain noncorporate taxpayers. A taxpayer that
has a capital gain rate differential for the taxable year under
paragraph (b)(2)(i) of this section and is not subject to alternative
minimum tax under section 55 for the taxable year may elect not to apply
the rate differential adjustments contained in section 904(b)(2)(B) and
paragraphs (c) and (d) of this section if the highest rate of tax
imposed on such taxpayer's taxable income (excluding net capital gain
and any qualified dividend income) for the taxable year under section 1
does not exceed the highest rate of tax in effect under section 1(h) for
the taxable year and the amount of the taxpayer's net capital gain from
sources outside the United States, plus the amount of the taxpayer's
qualified dividend income from sources outside the United States, is
less than $20,000. A taxpayer that has a capital gain rate differential
for the taxable year under paragraph (b)(2)(i) of this section and is
subject to alternative minimum tax under section 55 for the taxable year
may make such election if the rate of tax imposed on such taxpayer's
alternative minimum taxable income (excluding net capital gain and any
qualified dividend income) under section 55 does not exceed 26 percent,
the highest rate of tax imposed on such taxpayer's taxable income
(excluding net capital gain and any qualified dividend income) for the
taxable year under section 1 does not exceed the highest rate of tax in
effect under section 1(h) for the taxable year and the amount of the
taxpayer's net capital gain from sources outside the United States, plus
the amount of the taxpayer's qualified dividend income from sources
outside the United States, is less than $20,000. A taxpayer who makes
this election shall apply paragraph (a) of this section as if such
taxpayer does not have a capital gain rate differential for the taxable
year. An eligible taxpayer shall be presumed to have elected not to
apply the rate differential adjustments, unless such taxpayer applies
the rate differential adjustments contained in section 904(b)(2)(B) and
paragraphs (c) and (d) of this section in determining its foreign tax
credit limitation for the taxable year.
(c) Rate differential adjustment of capital gains--(1) Rate
differential adjustment of capital gains in foreign source taxable
income--(i) In general. Subject to paragraph (c)(1)(ii) of this section,
in determining taxable income from sources outside the United States for
purposes of section 904 and this section, capital gain net income from
sources outside the United States in each long-term rate group in each
separate category (separate category long-term rate group), shall be
reduced by the rate differential portion of such capital gain net
income. For purposes of paragraph (c)(1) of this section, references to
capital gain net income are references to capital gain net income
remaining after any reduction to such income pursuant to paragraph
(a)(1) of this section (i.e., paragraph (a)(1) of this section applies
before paragraphs (c) and (d) of this section).
(ii) Special rule for taxpayers with a net long-term capital loss
from sources within the United States. If a taxpayer has a net long-term
capital loss from sources within the United States (i.e., the taxpayer's
long-term capital losses from sources within the United States exceed
the taxpayer's long-term capital 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
[[Page 967]]
long-term capital loss from sources within the United States over the
amount, if any, by which the taxpayer reduced long-term capital gains
from sources without the United States pursuant to paragraph (a)(1) of
this section.
(B) Step 2: Determine the applicable rate differential amount. If a
taxpayer has capital gain net income from sources outside the United
States in only one separate category long-term rate group, the
applicable rate differential amount is the excess of such capital gain
net income over the U.S. long-term capital loss adjustment amount. If a
taxpayer has capital gain net income from sources outside the United
States in more than one separate category long-term rate group, the U.S.
long-term capital loss adjustment amount shall be apportioned on a pro
rata basis to each separate category long-term rate group with capital
gain net income. For purposes of the preceding sentence, pro rata means
based on the relative amounts of capital gain net income from sources
outside the United States in each separate category long-term rate
group. The applicable rate differential amount for each separate
category long-term rate group with capital gain net income is the excess
of such capital gain net income over the portion of the U.S. long-term
capital loss adjustment amount apportioned to the separate category
long-term rate group pursuant to this Step 2.
(iii) Examples. The following examples illustrate the provisions of
paragraph (c)(1)(ii) of this section. The taxpayers in the examples are
assumed to have taxable income (excluding net capital gain and qualified
dividend income) subject to a rate of tax under section 1 greater than
the highest rate of tax in effect under section 1(h) for the applicable
taxable year. The examples are as follows:
Example 1. (i) M, an individual, has $300 of long-term capital gain
from foreign sources in the passive category, $200 of which is subject
to tax at a rate of 15 percent under section 1(h) and $100 of which is
subject to tax at a rate of 28% under section 1(h). M has $150 of short-
term capital gain from sources within the United States. M has a $100
long-term capital loss from sources within the United States.
(ii) M's capital gain net income from sources outside the United
States ($300) does not exceed M's capital gain net income from all
sources ($350). Therefore, paragraph (a)(1) of this section does not
require any reduction of M's capital gain net income in the passive
category.
(iii) Because M has a net long-term capital loss from sources within
the United States ($100) and also has a short-term capital gain from
U.S. sources ($150), M must apply the provisions of paragraph (c)(1)(ii)
of this section to determine the amount of the $300 of capital gain net
income in the passive category that is subject to a rate differential
adjustment. Under Step 1, the U.S. long-term capital loss adjustment
amount is $100 ($100 - $0). Under Step 2, M must apportion this amount
to each rate group in the passive category pro rata based on the amount
of capital gain net income in each rate group. Thus, $66.67 ($200/$300
of $100) is apportioned to the 15 percent rate group and $33.33 ($100/
$300 of $100) is apportioned to the 28 percent rate group. The
applicable rate differential amount for the 15 percent rate group is
$133.33 ($200 - $66.67). Thus, $133.33 of the $200 of capital gain net
income in the 15 percent rate group is subject to a rate differential
adjustment pursuant to paragraph (c)(1) of this section. The remaining
$66.67 is not subject to a rate differential adjustment. The applicable
rate differential amount for the 28 percent rate group is $66.67 ($100 -
$33.33). Thus, $66.67 of the $100 of capital gain net income in the 28
percent rate group is subject to a rate differential adjustment pursuant
to paragraph (c)(1) of this section. The remaining $33.33 is not subject
to a rate differential adjustment.
Example 2. (i) N, an individual, has $300 of long-term capital gain
from foreign sources in the passive category, all of which is subject to
tax at a rate of 15 percent under section 1(h). N has $50 of short-term
capital gain from sources within the United States. N has a $100 long-
term capital loss from sources within the United States.
(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
[[Page 968]]
amount is $200 ($250 - $50). Thus, $200 of the capital gain in the
passive category is subject to a rate differential adjustment under
paragraph (c)(1) of this section. The remaining $50 is not subject to a
rate differential adjustment.
Example 3. (i) O, an individual, has a $100 short-term capital gain
from foreign sources in the passive category. O has $300 of long-term
capital gain from foreign sources in the passive category, all of which
is subject to tax at a rate of 15 percent under section 1(h). O has a
$100 long-term capital loss from sources within the United States.
(ii) O's capital gain net income from sources outside the United
States ($400) exceeds O's capital gain net income from all sources
($300). Pursuant to paragraph (a)(1) of this section, O must reduce the
$400 capital gain net income in the passive category by $100. Because C
has capital gain net income in two or more rate groups in the passive
category, O must apportion such amount, as a reduction, to each rate
group on a pro rata basis pursuant to paragraph (a)(1)(ii)(B) of this
section. Thus, $25 ($100/$400 of $100) is apportioned to the short-term
capital gain and $75 ($300/$400 of $100) is apportioned to the long-term
capital gain in the 15 percent rate group. After application of
paragraph (a)(1) of this section, O has $75 of short-term capital gain
in the passive category and $225 of long-term capital gain in the 15
percent rate group in the passive category.
(iii) Because O has a net long-term capital loss from sources within
the United States ($100) and also has a short-term capital gain from
foreign sources ($100), O must apply the provisions of paragraph
(c)(1)(ii) of this section to determine the amount of the $225 of long-
term capital gain in the 15 percent rate group that is subject to a rate
differential adjustment. Under Step 1, the U.S. long-term capital loss
adjustment amount is $25 ($100 - $75). Under Step 2, the applicable rate
differential amount is $200 ($225 - $25). Thus, $200 of the long-term
capital gain is subject to a rate differential adjustment under
paragraph (c)(1) of this section. The remaining $25 of long-term capital
gain is not subject to a rate differential adjustment.
(2) Rate differential adjustment of capital gains in entire taxable
income. For purposes of section 904 and this section, entire taxable
income shall include gains from the sale or exchange of capital assets
only to the extent of capital gain net income reduced by the sum of the
rate differential portions of each rate group of net capital gain.
(d) Rate differential adjustment of capital losses from sources
outside the United States--(1) In general. In determining taxable income
from sources outside the United States for purposes of section 904 and
this section, a taxpayer with a net capital loss in a separate category
rate group shall reduce such net capital loss by the sum of the rate
differential portions of the capital gain net income in each long-term
rate group offset by such net capital loss. A net capital loss in a
separate category rate group is the amount, if any, by which capital
losses in a rate group from sources outside the United States included
in a separate category exceed capital gains from sources outside the
United States in the same rate group and the same separate category.
(2) Determination of which capital gains are offset by net capital
losses from sources outside the United States. For purposes of paragraph
(d)(1) of this section, in order to determine the capital gain net
income offset by net capital losses from sources outside the United
States, the following rules shall apply in the following order:
(i) Net capital losses from sources outside the United States in
each separate category rate group shall be netted against capital gain
net income from sources outside the United States from the same rate
group in other separate categories.
(ii) Capital losses from sources within the United States shall be
netted against capital gains from sources within the United States in
the same rate group.
(iii) Net capital losses from sources outside the United States in
excess of the amounts netted against capital gains under paragraph
(d)(2)(i) of this 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:
[[Page 969]]
(1) A net capital loss in the short-term rate group is used first to
offset any capital gain net income in the 28 percent rate group, then to
offset capital gain net income in the 25 percent rate group, then to
offset capital gain net income in the 15 percent rate group, and finally
to offset capital gain net income in the 5 percent rate group.
(2) A net capital loss in the 28 percent rate group is used first to
offset capital gain net income in the 25 percent rate group, then to
offset capital gain net income in the 15 percent rate group, and finally
to offset capital gain net income in the 5 percent rate group.
(3) A net capital loss in the 15 percent rate group is used first to
offset capital gain net income in the 5 percent rate group, and then to
offset capital gain net income in the 28 percent rate group, and finally
to offset capital gain net income in the 25 percent rate group.
(iv) Net capital losses from sources outside the United States in
any rate group, to the extent netted against capital gains in any other
separate category under paragraph (d)(2)(i) of this section or against
capital gains in the same or any other rate group under paragraph
(d)(2)(iii) of this section, shall be treated as coming pro rata from
each separate category that contains a net capital loss from sources
outside the United States in that rate group. For example, assume that
the taxpayer has $20 of net capital losses in the 15 percent rate group
in the passive category and $40 of net capital losses in the 15 percent
rate group in the general limitation category, both from sources outside
the United States. Further assume that $50 of the total $60 net capital
losses from sources outside the United States are netted against capital
gain net income in the 28 percent rate group (from other separate
categories or from sources within the United States). One-third of the
$50 of such capital losses would be treated as coming from the passive
category, and two-thirds of such $50 would be treated as coming from the
general limitation category.
(v) In determining the capital gain net income offset by a net
capital loss from sources outside the United States pursuant to this
paragraph (d)(2), a taxpayer shall take into account any reduction to
capital gain net income from sources outside the United States pursuant
to paragraph (a) of this section and shall disregard any adjustments to
such capital gain net income pursuant to paragraph (c)(1) of this
section.
(vi) If at any time during a taxable year, tax is imposed under
section 1(h) at a rate other than a rate of tax specified in this
paragraph (d)(2), the principles of this paragraph (d)(2) shall apply to
determine the capital gain net income offset by any net capital loss in
a separate category rate group.
(vii) The determination of which capital gains are offset by capital
losses from sources outside the United States under this paragraph
(d)(2) is made solely in order to determine the appropriate rate-
differential-based adjustments to such capital losses under this section
and section 904(b), and does not change the source, allocation, or
separate category of any such capital gain or loss for purposes of
computing taxable income from sources within or outside the United
States or for any other purpose.
(e) Qualified dividend income--(1) In general. A taxpayer that has
taxable income (excluding net capital gain and qualified dividend
income) for the taxable year and that qualifies for a reduced rate of
tax under section 1(h) on its qualified dividend income (as defined in
section 1(h)(11)) for the taxable year shall adjust the amount of such
qualified dividend income in a manner consistent with the rules of
paragraphs (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
[[Page 970]]
the meaning of paragraph (b)(2) of this section may elect not to apply
paragraph (e)(1) of this section if such taxpayer would have qualified
for the election provided for in paragraph (b)(3) of this section had
such taxpayer had a capital gain rate differential for the taxable year.
Such a taxpayer shall be presumed to make the election provided for in
the preceding sentence unless such taxpayer applies the rate
differential adjustments provided for in paragraph (e)(1) of this
section to the qualified dividend income in determining its foreign tax
credit limitation for the taxable year.
(f) Definitions. For purposes of section 904(b) and this section,
the following definitions apply:
(1) Alternative tax rate. The term alternative tax rate means, with
respect to any rate group, the rate applicable to that rate group under
section 1(h) (for taxpayers other than corporations) or section 1201(a)
(for corporations). For example, the alternative tax rate for
unrecaptured section 1250 gain is 25 percent.
(2) Net capital gain. For purposes of this section, net capital gain
shall not include any qualified dividend income (as defined in section
1(h)(11)). See paragraph (e) of this section for rules relating to
qualified dividend income.
(3) Rate differential portion. The term rate differential portion
with respect to capital gain net income from sources outside the United
States in a separate category long-term rate group (or the applicable
portion of such amount), net capital gain in a rate group, or capital
gain net income in a long-term rate group, as the case may be, means the
same proportion of such amount as--
(i) The excess of the highest applicable tax rate (as defined in
section 904(b)(3)(E)(ii)) over the alternative tax rate; bears to
(ii) The highest applicable tax rate (as defined in section
904(b)(3)(E)(ii)).
(4) Rate group. For purposes of this section, the term rate group
means:
(i) Short-term capital gains or losses. With respect to a short-term
capital gain or loss, the rate group is the short-term rate group.
(ii) Long-term capital gains. With respect to a long-term capital
gain, the rate group is the particular rate of tax to which such gain is
subject under section 1(h). Such a rate group is a long-term rate group.
For example, the 28 percent rate group of capital gain net income from
sources outside the United States consists of the capital gain net
income from sources outside the United States that is subject to tax at
a rate of 28 percent under section 1(h). Such 28 percent rate group is a
long-term rate group. If a taxpayer has long-term capital gains that may
be subject to tax at more than one rate under section 1(h) and the
taxpayer's net capital gain attributable to such long-term capital gains
and any qualified dividend income are taxed at one rate of tax under
section 1(h), then all of such long-term capital gains shall be treated
as long-term capital gains in that one rate group. If a taxpayer has
long-term capital gains that may be subject to tax at more than one rate
of tax under section 1(h) and the taxpayer's net capital gain
attributable to such long-term capital gains and any qualified dividend
income are taxed at more than one rate pursuant to section 1(h), the
taxpayer shall determine the rate group for such long-term capital gains
from sources within or outside the United States (and, to the extent
from sources outside the United States, from each separate category)
ratably based on the proportions of net capital gain and any qualified
dividend income taxed at each applicable rate. For example, under the
section 1(h) rates in effect for tax years beginning in 2004, a long-
term capital gain (other than a 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)
[[Page 971]]
shall be treated as a loss in the 15 percent rate group.
(5) Terms used in sections 1(h), 904(b) or 1222. For purposes of
this section, any term used in this section and also used in section
1(h), section 904(b) or section 1222 shall have the same meaning given
such term by section 1(h), 904(b) or 1222, respectively, except as
otherwise provided in this section.
(g) Examples. The following examples illustrate the provisions of
this section. In these examples, the rate differential adjustment is
shown as a fraction, the numerator of which is the alternative tax rate
percentage and the denominator of which is 35 percent (assumed to be the
highest applicable tax rate for individuals under section 1). Finally,
all dollar amounts in the examples are abbreviated from amounts in the
thousands (for example, $50 represents $50,000). The examples are as
follows:
Example 1. (i) AA, an individual, has items from sources outside the
United States only in the passive category for the taxable year. AA has
$1000 of long-term capital gains from sources outside the United States
that are subject to tax at a rate of 15 percent under section 1(h). AA
has $700 of long-term capital losses from sources outside the United
States, which are not described in section 1(h)(4)(B)(i) or (iii). For
the same taxable year, AA has $800 of long-term capital gains from
sources within the United States that are taxed at a rate of 28 percent
under section 1(h). AA also has $100 of long-term capital losses from
sources within the United States, which are not described in section
1(h)(4)(B)(i) or (iii). AA also has $500 of ordinary income from sources
within the United States. The highest tax rate in effect under section
1(h) for the taxable year with respect to long-term capital gains other
than long-term capital gains described in section 1(h)(4)(A) or (h)(6)
is 15 percent. Accordingly, AA's long-term capital losses are in the 15
percent rate group.
(ii) AA's items of ordinary income, capital gain and capital loss
for the taxable year are summarized in the following table:
------------------------------------------------------------------------
Foreign
U.S. source:
source passive
------------------------------------------------------------------------
15% rate group................................... ($100) $1,000
(700)
28% rate group................................... 800
Ordinary income.................................. 500
------------------------------------------------------------------------
(iii) AA's capital gain net income from sources outside the United
States ($300) does not exceed AA's capital gain net income from all
sources ($1,000). Therefore, paragraph (a)(1) of this section does not
require any reduction of AA's capital gain net income in the passive
category.
(iv) In computing AA's taxable income from sources outside the
United States in the numerator of the section 904(a) foreign tax credit
limitation fraction for the passive category, AA's $300 of capital gain
net income in the 15 rate group in the passive category must be adjusted
as required under paragraph (c)(1) of this section. AA adjusts the $300
of capital gain net income using 15 percent as the alternative tax rate,
as follows: $300 (15%/35%).
(v) In computing AA's entire taxable income in the denominator of
the section 904(a) foreign tax credit limitation fraction, AA combines
the $300 of capital gain net income from sources outside the United
States and the $100 net capital loss from sources within the United
States in the same rate group (15 percent). AA must adjust the resulting
$200 ($300 - $100) of net capital gain in the 15 percent rate group as
required under paragraph (c)(2) of this section, using 15 percent as the
alternative tax rate, as follows: $200 (15%/35%). AA must also adjust
the $800 of net capital gain in the 28 percent rate group, using 28
percent as the alternative tax rate, as follows: $800 (28%/35%). AA must
also include ordinary income from sources outside the United States in
the numerator, and ordinary income from all sources in the denominator,
of the foreign tax credit limitation fraction.
(vi) AA's passive category foreign tax credit limitation fraction is
$128.58/$1225.72, computed as follows:
[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:
[[Page 972]]
------------------------------------------------------------------------
Foreign source
U.S. source --------------------------
General Passive
------------------------------------------------------------------------
15% rate group.................. $300 ($500) $100
25% rate group.................. 200 ............ ...........
28% rate group.................. 500 (300) ...........
Ordinary income................. 1,000 500 500
------------------------------------------------------------------------
(ii) BB's capital gain net income from sources outside the United
States in the aggregate (zero, since losses exceed gains) does not
exceed BB's capital gain net income from all sources ($300). Therefore,
paragraph (a)(1) of this section does not require any reduction of BB's
capital gain net income in the passive category.
(iii) In computing BB's taxable income from sources outside the
United States in the numerators of the section 904(a) foreign tax credit
limitation fractions for the passive and general limitation categories,
BB must adjust capital gain net income from sources outside the United
States in each separate category long-tem rate group and net capital
losses from sources outside the United States in each separate category
rate group as provided in paragraphs (c)(1) and (d) of this section.
(A) The $100 of capital gain net income in the 15 percent rate group
in the passive category is adjusted under paragraph (c)(1) of this
section as follows: $100 (15%/35%).
(B) BB must adjust the net capital losses in the 15 percent and 28
percent rate groups in the general limitation category in accordance
with the ordering rules contained in paragraph (d)(2) of this section.
Under paragraph (d)(2)(i) of this section, BB's net capital loss in the
15 percent rate group is netted against capital gain net income from
sources outside the United States in other separate categories in the
same rate group. Thus, $100 of the $500 net capital loss in the 15
percent rate group in the general limitation category offsets $100 of
capital gain net income in the 15 percent rate group in the passive
category. Accordingly, $100 of the $500 net capital loss is adjusted
under paragraph (d)(1) of this section as follows: $100 (15%/35%).
(C) Next, under paragraph (d)(2)(iii)(A) of this section, BB's net
capital losses from sources outside the United States in any separate
category rate group are netted against capital gain net income in the
same rate group from sources within the United States. Thus, $300 of the
$500 net capital loss in the 15 percent rate group in the general
limitation category offsets $300 of capital gain net income in the 15
percent rate group from sources within the United States. Accordingly,
$300 of the $500 net capital loss is adjusted under paragraph (d)(1) of
this section as follows: $300 (15%/35%). Similarly, the $300 of net
capital loss in the 28 percent rate group in the general limitation
category offsets $300 of capital gain net income in the 28 percent rate
group from sources within the United States. The $300 net capital loss
is adjusted under paragraph (d)(1) of this section as follows: $300
(28%/35%).
(D) Finally, under paragraph (d)(2)(iii)(B) of this section, the
remaining net capital losses in a separate category rate group are
netted against capital gain net income from other rate groups from
sources within and outside the United States. Thus, the remaining $100
of the $500 net capital loss in the 15 percent rate group in the general
limitation category offsets $100 of the remaining capital gain net
income in the 28 percent rate group from sources within the United
States. Accordingly, the remaining $100 of net capital loss is adjusted
under paragraph (d)(1) of this section as follows: $100 (28%/35%).
(iv) In computing BB's entire taxable income in the denominator of
the section 904(a) foreign tax credit limitation fractions, BB must
adjust net capital gain by netting all of BB's capital gains and losses,
from sources within and outside the United States, and adjusting any
remaining net capital gains, based on rate group, under paragraph (c)(2)
of this section. BB must also include foreign source ordinary income in
the numerators, and ordinary income from all sources in the denominator,
of the foreign tax credit limitation fractions. The denominator of BB's
foreign tax credit limitation fractions reflects $2,000 of ordinary
income from all sources, $100 of net capital gain 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
[[Page 973]]
(vi) BB's foreign tax credit limitation fraction for the passive
category is $542.86/$2222.86, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.003
Example 3. (i) CC, an individual, has the following items of
ordinary income, capital gain, and capital loss for the taxable year:
------------------------------------------------------------------------
Foreign source
U.S. source ---------------------------
General Passive
------------------------------------------------------------------------
15% rate group................. $300 ($720) ($80)
25% rate group................. 200 ............ ............
28% rate group................. 500 (150) 50
Ordinary income................ 1,000 1,000 500
------------------------------------------------------------------------
(ii) CC's capital gain net income from sources outside the United
States (zero, since losses exceed gains) does not exceed CC's capital
gain net income from all sources ($100). Therefore, paragraph (a)(1) of
this section does not require any adjustment.
(iii) In computing CC's taxable income from sources outside the
United States in the numerators of the section 904(a) foreign tax credit
limitation fractions for the passive and general limitation categories,
CC must adjust capital gain net income from sources outside the United
States in each separate category long-tem rate group and net capital
losses from sources outside the United States in each separate category
rate group as provided in paragraphs (c)(1) and (d) of this section.
(A) CC must adjust the $50 of capital gain net income in the 28
percent rate group in the passive category pursuant to paragraph (c)(1)
of this section as follows: $50 (28%/35%).
(B) Under paragraph (d)(2)(i) of this section, $50 of CC's $150 net
capital loss in the 28 percent rate group in the general limitation
category offsets $50 of capital gain net income in the 28 percent rate
group in the passive category. Thus, $50 of the $150 net capital loss is
adjusted as follows: $50 (28%/35%). Next, under paragraph (d)(2)(iii)(A)
of this section, the remaining $100 of net capital loss in the 28
percent rate group in the general limitation category offsets $100 of
capital gain net income in the 28 percent rate group from sources within
the United States. Thus, the remaining $100 of net capital loss is
adjusted as follows: $100 (28%/35%).
(C) Under paragraphs (d)(2)(iii)(A) and (d)(2)(iv) of this section,
the net capital losses in the 15 percent rate group in the passive and
general limitation categories offset on a pro rata basis the $300 of
capital gain net income in the 15 percent rate group from sources within
the United States. The proportionate amount of the $720 net capital loss
($720/$800 of $300, or $270) is adjusted as follows: $270 (15%/35%). The
proportionate amount of the $80 net capital loss ($80/$800 of $300, or
$30) is adjusted as follows $30 (15%/35%).
(D) Of the remaining $500 of net capital loss in the 15 percent rate
group in the general limitation and passive categories, $400 offsets the
remaining $400 of capital gain net income in the 28 percent rate group
from sources within the United States under paragraph (d)(2)(iii)(B)(3)
of this section. The proportionate amount of the $720 net capital 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
[[Page 974]]
States, and adjusting any remaining net capital gains, based on rate
group, under paragraph (c)(2) of this section. The denominator of CC's
foreign tax credit limitation fractions reflects $2,500 of ordinary
income from all sources and $100 of net capital gain taxed at the 25%
rate and adjusted as follows: $100 (25%/35%).
(v) CC's foreign tax credit limitation fraction for the general
limitation category is $412/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.004
(vi) CC's foreign tax credit limitation fraction for the passive
category is $488.00/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.005
Example 4. (i) DD, an individual, has the following items of
ordinary income, capital gain and capital loss for the taxable year:
------------------------------------------------------------------------
Foreign source
U.S. source --------------------------
General Passive
------------------------------------------------------------------------
15% rate group................. ($80) ($100) $300
Short-term..................... ............ 500 100
Ordinary income................ 500 ............ ...........
------------------------------------------------------------------------
(ii) DD's capital gain net income from outside the United States
($800) exceeds DD's capital gain net income from all sources ($720).
Pursuant to paragraph (a)(1)(ii)(A) of this section, DD must apportion
the $80 of excess of capital gain net income from sources outside the
United States between the general limitation and passive categories
based on the amount of capital gain net income in each separate
category. Thus, one-half ($400/$800 of $100, or $40) is apportioned to
the general limitation category and one-half ($400/$800 of $80, or $40)
is apportioned to the passive category. The $40 apportioned to the
general limitation category reduces DD's $500 short-term capital gain in
the general limitation category to $460. Pursuant to paragraph
(a)(1)(ii)(B) of this section, the $40 apportioned to the passive
category must be apportioned further between the capital gain net income
in the short-term rate group and the 15 percent rate group based on the
relative amounts of capital gain net income in each rate group. Thus,
one-fourth ($100/$400 of $40 or $10) is apportioned to the short-term
rate group and three-fourths ($300/$400 of $40 or $30) is apportioned to
the 15 percent rate group. DD's passive category includes $90 of short-
term capital gain and $270 of capital gain net income in the 15% rate
group.
(iii) Because DD has a net long-term capital loss from sources
within the United States ($80) and also has short-term capital 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
[[Page 975]]
and disregarding the adjustment pursuant to paragraph (c)(1) of this
section, is $270. Under paragraphs (d)(2)(i) and (d)(2)(v) of this
section, DD's $100 net capital loss in the 15% rate group in the general
limitation category offsets capital gain net income in the 15% rate
group in the passive category. Accordingly, the $100 of net capital loss
is adjusted as follows: $100 (15%/35%).
(v) In computing DD's entire taxable income in the denominator of
the section 904(a) foreign tax credit limitation fractions, DD must
adjust capital gain net income by netting all of DD's capital gains and
losses from sources within and outside the United States, and adjusting
the remaining net capital gain in each rate group pursuant to paragraph
(c)(2) of this section. The denominator of DD's foreign tax credit
limitation fraction reflects $500 of ordinary income from all sources,
$600 of short-term capital gain and $120 of net capital gain in the 15
percent rate group adjusted as follows: $120 (15%/35%).
(vi) DD's foreign tax credit limitation fraction for the general
limitation category is $417.14/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.006
(vii) DD's foreign tax credit limitation fraction for the passive
category is $234.29/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.007
Example 5. (i) EE, an individual, has the following items of
ordinary income, capital gain and capital loss for the taxable year:
------------------------------------------------------------------------
Foreign
U.S. source
source ----------
Passive
------------------------------------------------------------------------
15% rate group................................... ($150) $300
28% rate group................................... .......... 200
Short-term....................................... 30 100
Ordinary income.................................. 500 .........
------------------------------------------------------------------------
(ii) EE's capital gain net income from sources outside the United
States ($600) exceeds EE's capital gain net income from all sources
($480). Pursuant to paragraph (a)(1)(ii) of this section, the $120 of
excess capital gain net income from sources outside the United States is
allocated as a reduction to the passive category and must be apportioned
pro rata to each rate group within the passive category with capital
gain net income. Thus, $20 ($100/$600 of $120) is apportioned to the
short-term rate group, $60 ($300/$600 of $120) is apportioned to the 15
percent rate group and $40 ($200/$600 of $120) is apportioned to the 28
percent rate group. After application of paragraph (a)(1) of this
section, EE has $80 of capital gain net income in the short-term rate
group, $240 of capital gain net income in the 15 percent rate group and
$160 of capital gain net income in the 28 percent rate group.
(iii) Because EE has a net long-term capital loss from sources
within the United States ($150) and also has short-term capital gains,
EE must apply the provisions of paragraph (c)(1)(ii) of this section to
determine the amount of EE's remaining $400 ($240 + $160) of capital
gain net income in long-term rate groups in the passive category that is
subject to a rate differential adjustment to a rate differential
adjustment. Under Step 1, the U.S. long-term capital loss adjustment
amount is $50 ($150-$100). Under Step 2, EE must apportion this amount
pro rata to each long-term rate group within the passive category with
capital gain net income. Thus, $30 ($240/$400 of $50) is apportioned to
the 15 percent rate group and $20 ($160/$400 of $50) is apportioned to
the 28 percent rate group. The applicable rate differential amount for
the 15 percent rate group is $210 ($240 - $30). The applicable rate
differential amount for the 28 percent rate group is $140 ($160 - $20).
(iv) Pursuant to paragraph (c)(1)(ii) of this section, EE must
adjust $210 of the $240 capital gain in the 15 percent rate group as
follows: $210 (15%/35%). EE does not adjust the remaining $30. Pursuant
to paragraph (c)(1)(ii) of this section, EE must adjust $140 of the $160
capital gain in the 28 percent rate group as follows: $140 (28%/35%). EE
does not adjust the remaining $20.
(v) In computing EE's entire taxable income in the denominator of
the section 904(a) foreign tax credit limitation fractions, EE must
adjust capital gain net income by netting all of EE's capital gains and
losses from sources within and outside the United 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:
[[Page 976]]
[GRAPHIC] [TIFF OMITTED] TR20JY04.008
(h) Coordination with section 904(f)--(1) In general. Section 904(b)
and this section shall apply before the provisions of section 904(f) as
follows:
(i) The amount of a taxpayer's separate limitation income or loss in
each separate category, the amount of overall foreign loss, and the
amount of any additions to or recapture of separate limitation loss or
overall foreign loss accounts pursuant to section 904(f) shall be
determined after applying paragraphs (a), (c)(1), (d) and (e) of this
section to adjust capital gains and losses and qualified dividend income
from sources outside the United States in each separate category.
(ii) To the extent a capital loss from sources within the United
States reduces a taxpayer's foreign source taxable income under
paragraph (a)(1) of this section, such capital loss shall be disregarded
in determining the amount of a taxpayer's taxable income from sources
within the United States for purposes of computing the amount of any
additions to the taxpayer's overall foreign loss accounts.
(iii) In determining the amount of a taxpayer's loss from sources in
the United States under section 904(f)(5)(D) (section 904(f)(5)(D)
amount), the taxpayer shall make appropriate adjustments to capital
gains and losses from sources within the United States to reflect
adjustments pursuant to section 904(b)(2) and this section. Therefore,
for purposes of section 904, a taxpayer's section 904(f)(5)(D) amount
shall be equal to the excess of the taxpayer's foreign source taxable
income in all separate categories in the aggregate for the taxable year
(taking into account any adjustments pursuant to paragraphs (a)(1),
(c)(1), (d) and (e) of this section) over the taxpayer's entire taxable
income for the taxable year (taking into account any adjustments
pursuant to paragraphs (c)(2) and (e) of this section).
(2) Examples. The following examples illustrate the application of
paragraph (h) of this section:
Example 1. (i) W, an individual, has the following items of ordinary
income, capital gain, and capital loss for the taxable year:
------------------------------------------------------------------------
Foreign source
U.S. source -------------------------
General Passive
------------------------------------------------------------------------
15% rate group................... $500 $100 ($400)
Ordinary income.................. 900 100 ...........
------------------------------------------------------------------------
(ii) In computing W's taxable income from sources outside the United
States for purposes of section 904 and this section, W must adjust the
capital gain net income and net capital loss in each separate category
as provided in paragraphs (c)(1) and (d) of this section. Thus, W must
adjust the $100 of capital gain net income in the general limitation
category and the $400 of net capital loss in the passive category as
follows: $100 (15%/35%) and $400 (15%/35%).
(iii) After the adjustment to W's net capital loss in the passive
category, W has a $171.43 separate limitation loss in the passive
category. After the adjustment to W's capital gain in the general
limitation category, W has $142.86 of foreign source taxable income in
the general limitation category. Thus, $142.86 of the separate
limitation loss 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)
------------------------------------------------------------------------
[[Page 977]]
(ii) X's capital gain net income from sources outside the United
States ($700) exceeds X's capital gain net income from all sources
($200). Pursuant to paragraph (a)(1) of this section, X must reduce the
$700 capital gain in the general limitation category by $500. After the
adjustment, X has $200 of capital gain net income remaining in the
general limitation category. Thus, X has an overall foreign loss
attributable to the general limitation category of $800.
(iii) For purposes of computing the amount of the addition to X's
overall foreign loss account for the general limitation category, the
$500 capital loss from sources within the United States is disregarded
and X's taxable income from sources within the United States is $1100.
Accordingly, X must increase its overall foreign loss account for the
general limitation category by $800.
Example 3. (i) Y, a corporation, has the following items of ordinary
income, ordinary loss, capital gain and capital loss for the taxable
year:
------------------------------------------------------------------------
Foreign
U.S. source:
source passive
------------------------------------------------------------------------
Capital gain...................................... ($100) $200
Ordinary income................................... (200) 500
------------------------------------------------------------------------
(ii) Y's capital gain net income from sources outside the United
States ($200) exceeds Y's capital gain net income from all sources
($100). Pursuant to paragraph (a)(1) of this section, Y must reduce the
$200 capital gain in the passive category by $100. Y has $100 of capital
gain net income remaining in the passive category.
(iii) Y is not required to make adjustments pursuant to paragraph
(c), (d) or (e) of this section. See paragraphs (b) and (e) of this
section. Y's foreign source taxable income in the passive category after
the adjustment pursuant to paragraph (a)(1) of this section is $600. Y's
entire taxable income for the taxable year is $400.
(iv) Y's section 904(f)(5)(D) amount is the excess of Y's foreign
source taxable income in all separate categories in the aggregate for
the taxable year after taking into account the adjustment pursuant to
paragraph (a)(1) of this section ($600) over Y's entire taxable income
for the taxable year ($400). Therefore, Y's section 904(f)(5)(D) amount
is $200 and Y's foreign source taxable income in the passive category is
reduced to $400. See section 904(f)(5)(D).
Example 4. (i) Z, an individual, has the following items of ordinary
income, ordinary loss and capital gain for the taxable year:
------------------------------------------------------------------------
Foreign source:
U.S. source -------------------------
General Passive
------------------------------------------------------------------------
15% rate group.................. $100 ........... ...........
Ordinary income................. (200) $300 $300
------------------------------------------------------------------------
(ii) Z's foreign source taxable income in all of Z's separate
categories in the aggregate for the taxable year is $600. (There are no
adjustments to Z's foreign source taxable income pursuant to paragraph
(a)(1), (c)(1), (d) or (e) of this section.)
(iii) In computing Z's entire taxable income in the denominator of
the section 904(d) foreign tax credit limitation fractions, Z must
adjust the $100 of net capital gain in the 15 percent rate group
pursuant to paragraph (c)(2) of this section as follows: $100 (15%/35%).
Thus, Z's entire taxable income for the taxable year, taking into
account the adjustment pursuant to paragraph (c)(2) of this section, is
$442.86.
(iv) Z's section 904(f)(5)(D) amount is the excess of Z's foreign
source taxable income in all separate categories in the aggregate for
the taxable year ($600) over Z's entire taxable income for the taxable
year after the adjustment pursuant to paragraph (c)(2) of this section
($442.86). Therefore, Z's section 904(f)(5)(D) amount is $157.32. This
amount must be allocated pro rata to the passive and general limitation
categories in accordance with section 904(f)(5)(D).
Example 5. (i) O, an individual, has the following items of ordinary
income, ordinary loss and capital gain for the taxable year:
------------------------------------------------------------------------
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
[[Page 978]]
section. Taking this adjustment into account, O's foreign source taxable
income in all of O's separate categories in the aggregate is $1285.71
($1000 - $214.29 + $500).
(iii) In computing O's entire taxable income in the denominator of
the section 904(a) foreign tax credit limitation fraction, O must reduce
the $600 of net capital gain for the year to $257.14 ($600 x 15%/35%)
pursuant to paragraph (c)(2) of this section. Taking this adjustment
into account, O's entire taxable income for the year is $757.14 ($500 +
$257.14).
(iv) Therefore, O's section 904(f)(5)(D) amount is $528.57 ($1285.71
- $757.14). This amount must be allocated pro rata to O's $500 of income
in the passive category and O's $785.71 of adjusted income in the
general limitation category in accordance with section 904(f)(5)(D).
(i) Effective date. This section shall apply to taxable years
beginning after July 20, 2004. Taxpayers may choose to apply this
section and Sec. 1.904(b)-2 to taxable years ending after July 20,
2004.
[T.D. 9141, 69 FR 43308, July 20, 2004; 69 FR 61761, Oct. 21, 2004]
Sec. 1.904(b)-2 Special rules for application of section 904(b) to
alternative minimum tax foreign tax credit.
(a) Application of section 904(b)(2)(B) adjustments. Section
904(b)(2)(B) shall apply for purposes of determining the alternative
minimum tax foreign tax credit under section 59 (regardless of whether
or not the taxpayer has made an election under section 59(a)(4)).
(b) Use of alternative minimum tax rates--(1) Taxpayers other than
corporations. In the case of a taxpayer other than a corporation, for
purposes of determining the alternative minimum tax foreign tax credit
under section 59--
(i) Section 904(b)(3)(D)(i) shall be applied by using the language
``section 55(b)(3)'' instead of ``subsection (h) of section 1'';
(ii) Section 904(b)(3)(E)(ii)(I) shall be applied by using the
language ``section 55(b)(1)(A)(i)'' instead of ``subsection (a), (b),
(c), (d), or (e) of section 1 (whichever applies)''; and
(iii) Section 904(b)(3)(E)(iii)(I) shall be applied by using the
language ``the alternative rate of tax determined under section
55(b)(3)'' instead of ``the alternative rate of tax determined under
section 1(h)''.
(2) Corporate taxpayers. In the case of a corporation, for purposes
of determining the alternative minimum tax foreign tax credit under
section 59, section 904(b)(3)(E)(ii)(II) shall be applied by using the
language ``section 55(b)(1)(B)'' instead of ``section 11(b)''.
(c) Effective date. This section shall apply to taxable years
beginning after July 20, 2004. See Sec. 1.904(b)-1(i) for a rule
permitting taxpayers to choose to apply Sec. 1.904(b)-1 and this Sec.
1.904(b)-2 to taxable years ending after July 20, 2004.
[T.D. 9141, 69 FR 43316, July 20, 2004; 69 FR 61761, Oct. 21, 2004]
Sec. 1.904(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)
[[Page 979]]
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 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
[[Page 980]]
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)
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
[[Page 981]]
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.
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.
[[Page 982]]
(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.
(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.
[[Page 983]]
(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, 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
[[Page 984]]
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 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,
[[Page 985]]
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.
(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
[[Page 986]]
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 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
[[Page 987]]
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 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
[[Page 988]]
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, 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
[[Page 989]]
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 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
[[Page 990]]
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.
(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:
[[Page 991]]
(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 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
[[Page 992]]
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).
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
[[Page 993]]
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 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
[[Page 994]]
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
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
[[Page 995]]
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 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.
[[Page 996]]
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]
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
[[Page 997]]
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 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
[[Page 998]]
(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 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
[[Page 999]]
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, 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
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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 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]