[Federal Register Volume 60, Number 4 (Friday, January 6, 1995)]
[Proposed Rules]
[Pages 2049-2066]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-173]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-933-86]
RIN 1545-AL98


Computation of Foreign Taxes Deemed Paid Under Section 902 
Pursuant to a Pooling Mechanism for Undistributed Earnings and Foreign 
Taxes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed income tax regulations 
relating to the computation of foreign taxes deemed paid under section 
902. Changes to the applicable law were made by the Tax Reform Act of 
1986 and by the Technical and Miscellaneous Revenue Act of 1988 
(TAMRA). These regulations would provide guidance needed to comply with 
these changes and affect foreign corporations and their United States 
corporate shareholders.

DATES: Comments and requests for a public hearing must be received by 
April 6, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-933-86), room 
5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, D.C. 20044. In the alternative, submissions may be hand 
delivered to: CC:DOM:CORP:T:R (INTL-933-86), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Caren S. 
Shein (202) 622-3850, or Kristine K. Schlaman (202) 622-3840.

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act (44 U.S.C. 
3504(h)). Comments on the collection of information should be sent to 
the Office of Management and Budget, Attention: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attention: IRS Reports Clearance Officer PC:FP, Washington, DC 
20224.
    The collection of information requirement in this regulation is in 
Sec. 1.902-1(e). This information is required by the IRS to implement 
section 902 as amended by the Tax Reform Act of 1986. This information 
will be used by law enforcement authorities with respect to the 
enforcement of Federal laws. The likely respondents are businesses or 
other for-profit institutions.

Estimated total annual reporting burden: 225,520 hours.
Estimated total annual burden per respondent: 112.76 hours.
Estimated number of respondents: 2000.
Estimated annual frequency of response: one.

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under section 902 of the Internal Revenue 
Code of 1986. These amendments are proposed to conform the regulations 
to section 1202(a) of the Tax Reform Act of 1986 (Pub. L. 99-514, 100 
Stat. 1085), and to section 1012(b) of the Technical and Miscellaneous 
Revenue Act of 1988 (TAMRA) (Pub. L. 100-647, 102 Stat. 3242).

Proposed Effective Dates

    These regulations are proposed to be effective for taxable years 
beginning after December 31, 1986.

Explanation of Provisions

Section 1.902-1

    Section 902 provides a mechanism by which foreign income taxes paid 
by a foreign corporation are deemed paid by a domestic corporate 
shareholder owning at least 10 percent of the voting stock of the 
foreign corporation. Paragraphs (a) (1) through (12) of 
[[Page 2050]] Sec. 1.902-1 provide definitions applicable for purposes 
of section 902 and Secs. 1.902-1 and 1.902-2.
    Paragraph (a)(1) defines a domestic shareholder that is eligible 
for the section 902 credit as a domestic corporation that owns directly 
at least 10 percent of the voting stock of a foreign corporation at the 
time it receives a dividend.
    Revenue Ruling 71-141, 1971-1 C.B. 211, allows two 50 percent 
domestic corporate general partners of a domestic general partnership 
to claim a credit for taxes deemed paid under section 902 for foreign 
taxes paid by a foreign corporation in which the partnership owned 40 
percent of the voting stock. The Internal Revenue Service is 
considering under what other circumstances a section 902 credit with 
respect to stock held by a partnership or other pass-through entity 
should flow through to a domestic corporation. The Service requests 
comments on whether the holding of Rev. Rul. 71-141 should be expanded 
to allow taxes paid by a foreign corporation to be considered deemed 
paid by domestic corporations that are partners in domestic limited 
partnerships or foreign partnerships, shareholders in limited liability 
companies, and beneficiaries of domestic or foreign trusts and estates 
or interest holders in other pass-through entities. The comments should 
address how the Service would administer any proposed expansion of the 
revenue ruling to allow deemed paid credits through other pass-through 
entities.
    Paragraphs (a) (2) through (6) define the ownership requirements 
that must be met before foreign income taxes of a first-, second-, or 
third-tier foreign corporation will be deemed paid by an upper-tier 
foreign corporation or a domestic shareholder.
    Paragraph (a)(7) defines foreign income taxes as those creditable 
under sections 901 and 903. Paragraph (a)(8) defines post-1986 foreign 
income taxes generally as foreign income taxes paid, accrued, or deemed 
paid for the current year and any foreign income taxes paid, accrued, 
or deemed paid in prior taxable years beginning after December 31, 
1986, to the extent the foreign taxes were not paid or deemed paid on 
earnings previously distributed to or otherwise included in the income 
of a shareholder.
    Paragraph (a)(9) defines post-1986 undistributed earnings generally 
as the amount of earnings and profits accumulated by a foreign 
corporation in taxable years beginning after December 31, 1986, 
determined as of the close of the taxable year in which a dividend is 
distributed. Post-1986 undistributed earnings are not reduced by 
dividend distributions and deemed inclusions in the current year but 
are reduced by dividend distributions and deemed inclusions in prior 
post-1986 taxable years.
    Paragraph (a)(10) defines pre-1987 accumulated profits as earnings 
and profits accumulated in taxable years beginning before January 1, 
1987, and in later years if the special effective date of paragraph 
(a)(13) applies. Paragraph (a)(13) provides a special effective date 
applicable when the 10-percent ownership requirements of section 
902(c)(3)(B) and paragraphs (a) (1) through (4) are first met with 
respect to a foreign corporation in a taxable year of the foreign 
corporation beginning after December 31, 1986. For post-1986 years 
prior to the first year in which the ownership requirements of section 
902(c)(3)(B) are met, foreign taxes deemed paid must be computed under 
the rules of section 902 as in effect prior to the Tax Reform Act of 
1986. See section 902(c)(6).
    The proposed regulations specify that both post-1986 undistributed 
earnings and pre-1987 accumulated profits include a foreign 
corporation's entire earnings and profits. Further, for both post-1986 
undistributed earnings and pre-1987 accumulated profits that are 
distributed in a taxable year beginning after December 31, 1986, the 
proposed regulations state that special allocations of accumulated 
profits and taxes to particular shareholders, whether required or 
permitted under foreign law or an agreement among the shareholders, 
will be disregarded. See paragraphs (a)(9)(iv) and (a)(10)(ii).
    The intent of the proposed regulations is to reverse the Tax 
Court's decision in Vulcan v. Commissioner, 96 T.C. 410 (1991), affd. 
per curiam 959 F.2d 973 (11th Cir. 1992), for distributions in taxable 
years beginning after December 31, 1986, out of pre-1987 accumulated 
profits. In addition, the regulations are intended to make clear that 
the decision in Vulcan is not applicable to distributions out of post-
1986 undistributed earnings.
    In Vulcan, the Tax Court held that the term ``accumulated profits'' 
as used in the denominator of the section 902 deemed paid credit 
fraction prior to the Tax Reform Act of 1986 does not necessarily mean 
all of a foreign corporation's accumulated profits. The Tax Court 
concluded that the pre-1987 statute and regulations under section 902 
were unclear and based its decision on what it viewed as the policy 
behind section 902. The pre-Tax Reform Act of 1986 version of section 
902 described the creditable foreign tax as that levied ``on or with 
respect to the accumulated profits of the foreign corporation from 
which such dividends were paid.'' The Tax Court in Vulcan read this 
language as linking ``accumulated profits'' to the foreign tax paid by 
the subsidiary and, based in part on this reading, computed the section 
902 credit using only the amount of accumulated profits on which the 
foreign tax was levied.
    Contrary to the Tax Court's analysis, the term ``accumulated 
profits'' as used in pre-1987 section 902 generally is equated with, 
and determined in accordance with, United States tax principles 
relating to pre-tax earnings and profits. See United States v. Goodyear 
Tire and Rubber Company, 493 U.S. 132, 139 (1989). Earnings and profits 
are a measure of a corporation's ability to pay dividends. They 
generally are determined at the corporate level and include all income 
earned by the corporation, whether or not all or any portion of the 
income is subject to tax. The ``on or with respect to'' language on 
which the Tax Court focused simply reflects the annual nature of the 
section 902 credit calculation prior to 1986, and does not permit or 
require the computation of the deemed paid credit using less than all 
of the foreign corporation's accumulated profits.
    The 1986 Act changes to section 902(a) eliminated the language the 
Tax Court relied on in Vulcan to link the taxes to be credited to the 
particular profits on which they were paid. See H.R. Rep. (Conf.) 841, 
99th Cong., 2d Sess. II-589 (1986). As amended in 1986, section 902 
simply defines the pool of creditable taxes as ``any income, war 
profits, or excess profits taxes paid by the foreign corporation'' to 
the foreign taxing authority. See section 902(c)(4). The proposed 
regulations make clear that Vulcan does not apply for years to which 
the pooling rules of new section 902 apply.
    The proposed regulations would reverse Vulcan for distributions out 
of pre-1987 accumulated profits in post-1986 taxable years. The Vulcan 
reversal for distributions out of pre-1987 accumulated profits thus 
will have a continuing impact in post-1986 years. The Internal Revenue 
Service published this position in Rev. Rul. 87-14, 1987-1 C.B. 181. 
Thus, taxpayers had notice of the rule prior to the issuance of these 
proposed regulations.
    Paragraph (a)(10)(iii) provides that foreign income taxes of a 
particular year with pre-1987 accumulated profits must be reduced by 
the amount of foreign income taxes deemed paid on a distribution or 
inclusion out of pre-1987 accumulated profits of that year. Foreign 
income taxes paid or accrued on or with [[Page 2051]] respect to pre-
1987 accumulated profits must be translated into United States dollars 
under the rules in effect prior to the effective date of the Tax Reform 
Act of 1986. See The Bon Ami Company v. Commissioner, 39 B.T.A. 825 
(1939).
    Paragraph (b)(1) provides rules for computing the foreign income 
taxes deemed paid by a domestic shareholder, first-tier corporation or 
second-tier corporation for any taxable year in which a domestic 
shareholder receives a dividend from a first-tier corporation paid out 
of post-1986 undistributed earnings, or an upper-tier corporation 
receives a dividend from a lower-tier corporation paid out of post-1986 
undistributed earnings.
    Paragraph (b)(2) provides rules for allocating dividends to post-
1986 undistributed earnings and pre-1987 accumulated profits when a 
foreign corporation pays a dividend out of both post-1986 undistributed 
earnings and pre-1987 accumulated profits and out of more than one pre-
1987 taxable year. Paragraph (b)(3) provides that the amount of foreign 
taxes deemed paid on a dividend out of pre-1987 accumulated profits 
must be computed under section 902 as in effect prior to the effective 
date of the Tax Reform Act of 1986.
    Paragraph (b)(4) provides that if a foreign corporation makes a 
distribution out of current earnings and profits that is treated as a 
dividend under section 316(a)(2) in a taxable year in which the 
corporation has a deficit in post-1986 undistributed earnings and the 
sum of current plus accumulated earnings and profits is zero or less 
than zero, then no foreign income taxes shall be deemed paid with 
respect to the dividend. See S. Rep. No. 313, 99th Cong., 2d Sess. 321 
(1986). The dividend reduces post-1986 undistributed earnings and 
accumulated earnings and profits.
    Paragraph (c) provides special rules applicable in computing 
foreign taxes deemed paid by a domestic shareholder or upper-tier 
corporation. Paragraph (c)(1) provides that foreign taxes deemed paid 
must be computed separately for dividends received from each foreign 
corporation. Further, if a domestic shareholder receives a dividend 
from a first-tier corporation and in the same taxable year the first-
tier corporation receives a dividend from one or more lower-tier 
corporations, then foreign taxes deemed paid are computed by starting 
at the lowest tier and working upward.
    Paragraph (c)(2) requires a domestic shareholder to include in 
gross income as a dividend under section 78 all foreign taxes deemed 
paid for the taxable year. Foreign corporations are not required to 
include foreign taxes deemed paid in gross income under section 78.
    Paragraph (c)(9) incorporates the rules of section 905(c) to 
determine the effect of a section 482 adjustment on post-1986 
undistributed earnings and post-1986 foreign income taxes. In general, 
section 905(c) and the regulations under that section require a 
reduction in the pool of creditable foreign income taxes when a 
taxpayer fails to exhaust its administrative remedies to obtain a 
refund of foreign income taxes paid following a section 482 adjustment. 
See also Rev. Rul. 92-74, 1992-2 C.B. 156.
    Paragraph (d) provides rules relating to the computation of foreign 
taxes deemed paid with respect to dividends from controlled foreign 
corporations. Generally, dividend distributions are treated as made pro 
rata out of a controlled foreign corporation's earnings in each section 
904(d) separate category. Section 1.904-5(d). Paragraph (d)(3)(i) 
provides that dividends distributed out of earnings accumulated before 
a foreign corporation became a controlled foreign corporation are 
treated as dividends from a noncontrolled section 902 corporation, 
whether the earnings are post-1986 undistributed earnings or pre-1987 
accumulated profits.
    Pursuant to a grant of regulatory authority in section 
904(d)(2)(E)(i), and consistent with proposed amendments to Sec. 1.904-
4(g)(3), paragraph (d)(3)(ii) generally limits the application of the 
Technical and Miscellaneous Revenue Act of 1988 amendment of section 
904(d)(2)(E)(i) (restricting look-through treatment on dividends out of 
pre-acquisition earnings of a controlled foreign corporation) to U.S. 
shareholders that acquire more than 90% voting stock ownership in an 
existing controlled foreign corporation (including both U.S. 
shareholders who previously owned no voting stock in the controlled 
foreign corporation and U.S. shareholders that previously owned less 
than 10% of the controlled foreign corporation's voting stock). A U.S. 
shareholder that acquires more than 90% ownership of a controlled 
foreign corporation's voting stock must begin a new set of post-1986 
undistributed earnings and post-1986 foreign income taxes pools on the 
first day of the first taxable year in which it owns more than 90% of 
the voting stock. Earnings attributable to the pre-acquisition period 
are treated as post-1986 undistributed earnings or pre-1987 accumulated 
profits of a noncontrolled section 902 corporation. Distributions will 
be deemed to come first out of the post-acquisition earnings pools to 
the extent thereof, and then out of pre-acquisition earnings.
    A U.S. shareholder that acquires stock resulting in ownership of 
90% or less of an existing controlled foreign corporation's voting 
stock is entitled to look-through treatment on dividends paid out of 
pre-acquisition earnings of the controlled foreign corporation. The 
shareholder need not start new pools of earnings and taxes as a result 
of its acquisition of voting stock of the controlled foreign 
corporation.
    Paragraph (e) describes the information a domestic shareholder must 
furnish with respect to foreign income taxes for which it claims a 
deemed paid credit.
    Paragraph (f) provides examples illustrating the rules of 
Sec. 1.902-1, and paragraph (g) provides that Sec. 1.902-1 applies to 
distributions in and after a foreign corporation's first taxable year 
beginning on or after January 1, 1987.

Section 1.902-2

    Section 1.902-2 provides rules for computing foreign taxes deemed 
paid when there are deficits in post-1986 undistributed earnings or 
pre-1987 accumulated profits (determined under section 902) of a 
foreign corporation. Paragraph (a)(1) provides that if there is a 
deficit in post-1986 undistributed earnings of a first-,    second-, or 
third-tier corporation and the corporation makes a distribution to 
shareholders, then the deficit shall be carried back to the most recent 
pre-effective date taxable year of the first-, second-, or third-tier 
corporation with positive accumulated profits determined under section 
902. The amount carried back will be removed from post-1986 
undistributed earnings, but any foreign income taxes paid with respect 
to those earnings will not be carried back to a taxable year beginning 
before January 1, 1987 (or a later year if the special effective date 
of Sec. 1.902-1(a)(13) applies) and will not be removed from post-1986 
foreign income taxes.
    Paragraph (b)(1) provides that if there is a deficit in accumulated 
profits determined under section 902 of a
first-, second-, or third-tier corporation as of the end of its last 
pre-effective date taxable year, that deficit must be carried forward 
to the first taxable year of the foreign corporation beginning after 
December 31, 1986, or later if the special effective date of 
Sec. 1.902-1(a)(13) applies. The deficit carried forward is included in 
and reduces post-1986 undistributed earnings. Foreign income taxes paid 
with respect to pre-effective date years are not carried forward.
    Paragraph (b)(2) makes clear that if a corporation has a deficit in 
section 902 [[Page 2052]] accumulated profits at the end of its last 
pre-effective date year, then absent an adjustment that restores 
earnings to a pre-effective date taxable year (for example, a refund of 
foreign taxes) the corporation will never be able to pay a dividend out 
of pre-effective date earnings and profits, and thus will not be able 
to claim a credit for taxes deemed paid under section 902 for any 
foreign income taxes remaining in pre-effective date years.
    The regulations redesignate Secs. 1.902-1 and 1.902-2 of the 
existing final regulations as Secs. 1.902-3 and 1.902-4, respectively, 
and make conforming amendments to those regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Request for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments that are submitted 
timely (preferably a signed original and eight (8) copies) to the IRS. 
All comments will be available for public inspection and copying. A 
public hearing may be scheduled if requested in writing by a person 
that timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place for the hearing will be published 
in the Federal Register.

Drafting Information

    The principal author of these proposed regulations is Caren Silver 
Shein of the Office of Associate Chief Counsel (International), within 
the Office of Chief Counsel, IRS. However, other personnel from the IRS 
and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * * Section 1.902-1 also issued 
under 26 U.S.C. 902(c)(7). Section 1.902-2 also issued under 26 
U.S.C. 902(c)(7). * * *


Secs. 1.902-1 and 1.902-2  [Redesignated Secs. 1.902-3 and 1.902-4]

    Par. 2. Sections 1.902-1 and 1.902-2 are redesignated Secs. 1.902-3 
and 1.902-4, respectively.
    Par. 3. Sections 1.902-0, 1.902-1 and 1.902-2 are added to read as 
follows:


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-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, and second- 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) Credit for foreign taxes deemed paid in a section 304 
transaction.
    (9) Effect of section 482 adjustments on post-1986 foreign 
income taxes and post-1986 undistributed earnings.
(d) Dividends from controlled foreign corporations.
    (1) General rule.
    (2) Look-through.
    (i) Dividends.
    (ii) Coordination with section 960.
    (3) Special rules.
    (i) Dividends distributed out of earnings accumulated before a 
controlled foreign corporation became a controlled foreign 
corporation.
    (ii) Dividend distributions out of earnings and profits for a 
year during which a shareholder that is currently a more- than-90-
percent United States shareholder of a controlled foreign 
corporation was not a United States shareholder of the controlled 
foreign corporation.
    (iii) Intra-group acquisitions.
    (iv) Ordering rule.
    (v) Examples.
    (e) Information to be furnished.
    (f) Examples.
    (g) Effective date. [[Page 2053]] 


Sec. 1.902-2  Treatment of deficits in post-1986 undistributed earnings 
and pre-1987 accumulated profits of a first-, second-, or third-tier 
corporation for purposes of computing an amount of foreign taxes deemed 
paid Sec. 1.902-1.

(a) Carryback of deficits in post-1986 undistributed earnings of a 
first-,
    second-, or third-tier corporation to pre-effective date taxable 
years.
    (1) Rule.
    (2) Examples.
(b) Carryforward of deficits in pre-1987 accumulated profits of a 
first-,
    second-, or third-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.


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 and Secs. 1.902-1 and 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 directly 
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 means a DISC or former DISC, but only with 
respect to dividends from the DISC or former DISC that are treated 
under sections 861(a)(2)(D) and 862(a)(2) as income from sources 
without the United States.
    (3) Second-tier corporation. In the case of dividends paid to a 
first-tier corporation by a foreign corporation in a taxable year 
beginning after December 31, 1986, the foreign corporation is a second-
tier corporation if, at the time a first-tier corporation receives a 
dividend from that foreign corporation, the first-tier corporation owns 
at least 10 percent of the foreign corporation's voting stock and the 
product of the following equals at least 5 percent--
    (i) The percentage of voting stock owned by the domestic 
shareholder in the first-tier corporation; multiplied by
    (ii) The percentage of voting stock owned by the first-tier 
corporation in the second-tier corporation.
    (4) Third-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--
    (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; multiplied by
    (iii) The percentage of voting stock owned by the second-tier 
corporation in the third-tier 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 (a)(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 [[Page 2054]] dividend received from Corporation 
B on February 16, 1991.
    (iii) On January 20, 1992, Corporation M satisfies the 10-
percent stock ownership requirement of paragraphs (a)(1) and (2) of 
this section with respect to Corporation A. Therefore, Corporation A 
is a first-tier corporation within the meaning of paragraph (a)(2) 
of this section and Corporation M is a domestic shareholder within 
the meaning of paragraph (a)(1) of this section. Accordingly, for 
its taxable year ending on June 30, 1992, Corporation M is deemed to 
have paid a portion of the post-1986 foreign income taxes paid, 
accrued, or deemed to be paid, by Corporation A. Those taxes will 
include taxes paid by Corporation B that were deemed paid by 
Corporation A with respect to the dividend paid by Corporation B to 
Corporation A on February 16, 1991, even though Corporation B is no 
longer a second-tier corporation with respect to Corporations A and 
M on January 20, 1992, and has not been a second-tier corporation 
with respect to Corporations A and M at any time during the taxable 
years of Corporations A and M that include January 20, 1992.

    (6) Upper- and lower-tier corporations. In the case of a 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- 
or third-tier corporation. In the case of a second-tier corporation, 
the term lower-tier corporation means a third- 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 also paragraphs (c) (4) and (5) 
of this section (concerning foreign taxes paid with respect to foreign 
mineral income and in connection with the purchase or sale of oil and 
gas).
    (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, and 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 paid or deemed paid by the 
foreign corporation on or with respect to earnings that in prior 
taxable years were distributed to or otherwise included in the income 
of a foreign or domestic shareholder, for example under sections 304, 
367(b), 551, 951(a), 1248, or 1293 (whether or not the shareholder is 
deemed to have paid the foreign taxes). Thus, if a dividend is paid by 
a foreign corporation to a United States person that is not a domestic 
shareholder, or to a foreign person that is not a first- or second-tier 
corporation, then although no foreign income taxes shall be deemed paid 
under section 902 with respect to that dividend, foreign income taxes 
that would have been deemed paid had section 902 applied shall 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 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, 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 the 
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)) 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). 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 by 
the amount of earnings distributed or amounts otherwise included in 
income in prior taxable years beginning after December 31, 1986 
(whether or not the shareholder is deemed to have paid any foreign 
taxes). 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 
[[Page 2055]] 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)(7)(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. Post-1986 undistributed earnings is 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, there is 
an agreement to pay dividends only out of earnings in the separate 
categories for passive or high withholding tax interest income, then 
only taxes imposed on passive or high withholding tax interest earnings 
shall be treated as related to the dividend. See Sec. 1.904-6(a)(2).
    (10) Pre-1987 accumulated profits--(i) Definition. The term pre-
1987 accumulated profits means the amount of the earnings and profits 
of a foreign corporation computed in accordance with section 902 and 
attributable to its taxable years beginning before January 1, 1987. If 
the special effective date of paragraph (a)(13) of this section 
applies, pre-1987 accumulated profits also includes any earnings and 
profits (computed in accordance with sections 964(a) and 986) 
attributable to the foreign corporation's taxable years beginning after 
December 31, 1986, but before the first day of the first taxable year 
of the foreign corporation in which the ownership requirements of 
section 902(c)(3)(B) and paragraphs (a) (1) through (4) of this section 
are met with respect to that corporation.
    (ii) Computation of pre-1987 accumulated profits. Pre-1987 
accumulated profits must be computed under United States principles 
governing the computation of earnings and profits. Pre-1987 accumulated 
profits are determined at the corporate level. Special allocations of 
accumulated profits and taxes to particular shareholders with respect 
to distributions of pre-1987 accumulated profits in taxable years 
beginning after December 31, 1986, whether required or permitted by 
foreign law or a shareholder agreement, shall be disregarded. Pre-1987 
accumulated profits of a particular year shall be reduced by amounts 
distributed from those accumulated profits or otherwise included in 
income from those accumulated profits, for example, under sections 304, 
367(b), 551, 951(a), 1248, or 1293. If a deficit in post-1986 
undistributed earnings is carried back to offset pre-1987 accumulated 
profits, pre-1987 accumulated profits of a particular taxable year 
shall be reduced by the amount of the deficit carried back to that 
year. See Sec. 1.902-2. The amount of a distribution out of pre-1987 
accumulated profits, and the amount of foreign income taxes deemed paid 
under section 902, shall be determined and translated into United 
States dollars by applying the law as in effect prior to the effective 
date of the Tax Reform Act of 1986. See Secs. 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 on or with respect to 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 on or 
with respect to a distribution or inclusion out of pre-1987 accumulated 
profits of that year, and by the amount of taxes that would have been 
deemed paid had section 902 applied to a distribution or inclusion with 
respect to a person not eligible for a section 902 credit. 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. The term dividend also includes deemed dividends under 
sections 304, 367(b), 551, and 1248, but not deemed inclusions under 
sections 951(a) and 1293.
    (12) Dividend received. A dividend shall be considered received for 
purposes of section 902 when the cash or other property is 
unqualifiedly made subject to the demands of the distributee. See 
Sec. 1.301-1(b). A dividend also is considered received for purposes of 
section 902 when it is deemed received under section 304, 367(b), 551, 
or 1248.
    (13) Special effective date--(i) Rule. If the first day on which 
the ownership requirements of section 902(c)(3)(B) and paragraphs 
(a)(1) through (4) of this section are met with respect to a foreign 
corporation, without regard to whether a dividend is distributed, is in 
a taxable year of the foreign corporation beginning after December 31, 
1986, then--
    (A) The post-1986 undistributed earnings and post-1986 foreign 
income taxes of the foreign corporation shall be determined by taking 
into account only taxable years beginning on and after the first day of 
the first taxable year of the foreign corporation in which the 
ownership requirements are met, including subsequent taxable years in 
which the ownership requirements of section 902(c)(3)(B) and paragraphs 
(a)(1) through (4) of this section are not met; and
    (B) Earnings and profits accumulated prior to the first day of the 
first taxable year of the foreign corporation in which the ownership 
requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) 
of this section are met shall be considered pre-1987 accumulated 
profits.
    (ii) Example. The following example illustrates the special 
effective date rules of this paragraph (a)(13):

    Example. As of December 31, 1991, and since its incorporation, 
foreign corporation A has owned 100 percent of the stock of foreign 
corporation B. Corporation B is not a controlled foreign 
corporation. Corporation B uses the calendar year as its taxable 
year, and its functional currency is the u. Assume 1u equals $1 at 
all relevant times. On April 1, 1992, Corporation B pays a 200u 
dividend to Corporation A and the ownership requirements of section 
902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are 
not met 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 
[[Page 2056]] 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, and second-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:
    (2) Allocation rule for dividends attributable to post-1986 
undistributed earnings and pre-1987 accumulated profits--(i) Portion of 
dividend out of post-1986 undistributed earnings. Dividends will be 
deemed to be paid first out of post-1986 undistributed earnings to the 
extent thereof. If dividends exceed post-1986 undistributed earnings 
and dividends are paid to more than one shareholder, then the dividend 
to each shareholder shall be deemed to be paid pro rata out of post-
1986 undistributed earnings, computed as follows:
[GRAPHIC][TIFF OMITTED]TP06JA95.016


    (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]TP06JA95.017


[GRAPHIC][TIFF OMITTED]TP06JA95.018


    (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 Secs. 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) 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 [[Page 2057]] of 200u (net of 
foreign taxes) and paid 60u of foreign income taxes on those 
earnings. In 1992, Corporation A distributes 150u to Corporation M. 
Corporation A has 100u of post-1986 undistributed earnings and the 
dividend, therefore, is treated as paid out of post-1986 
undistributed earnings to the extent of 100u. The first 100u 
distribution is from post-1986 undistributed earnings, and, because 
the distribution exhausts those earnings, Corporation M is deemed to 
have paid the entire amount of post-1986 foreign income taxes of 
Corporation A ($40). The remaining 50u dividend is treated as a 
dividend out of 1986 accumulated profits under paragraph (b)(2) of 
this section. Corporation M is deemed to have paid $15 (60u x 50u/
200u, translated at the appropriate exchange rates) of Corporation 
A's foreign income taxes for 1986. As of January 1, 1993, 
Corporation A's post-1986 undistributed earnings and post-1986 
foreign income taxes are 0. Corporation A has 150u of accumulated 
profits and 45u of foreign income taxes remaining in 1986.
    Example 2. Domestic corporation M (incorporated on January 1, 
1987) owns 100 percent of foreign corporation A (incorporated on 
January 1, 1987). Both Corporation M and Corporation A use the 
calendar year as the taxable year, and Corporation A uses the u as 
its functional currency. Assume that 1u equals $1 at all relevant 
times. Corporation A has no pre-1987 accumulated profits. All of 
Corporation A's post-1986 undistributed earnings are non-subpart F 
general limitation earnings and profits under section 904(d)(1)(I). 
On January 1, 1992, Corporation A has a deficit in accumulated 
earnings and profits and a deficit in post-1986 undistributed 
earnings of (200u). No foreign taxes have been paid with respect to 
post-1986 undistributed earnings. During 1992, Corporation A earns 
100u (net of foreign taxes), pays $40 of foreign taxes on those 
earnings and distributes 50u to Corporation M. As of the end of 
1992, Corporation A has a deficit of (100u) ((200u) post-1986 
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 section 
902 (a) and (b) and paragraph (b) of this section shall be computed 
separately with respect to the dividends received from each first-tier 
corporation or lower-tier corporation. If a domestic shareholder 
receives dividend distributions from one or more first-tier 
corporations and in the same taxable year the first-tier corporation 
receives dividends from one or more lower-tier corporations, then the 
amount of foreign income taxes deemed paid shall be computed by 
starting with the lowest-tier corporation and working upward.
    (ii) Example. The following example illustrates the application of 
this paragraph (c)(1):

    Example. P, a domestic corporation, owns 40 percent of the 
voting stock of foreign corporation S. S owns 30 percent of the 
voting stock of foreign corporation T, and 30 percent of the voting 
stock of foreign corporation U. Neither S, T, nor U is a controlled 
foreign corporation. P, S, T and U all use the calendar year as 
their taxable year. In 1993, T and U both pay dividends to S and S 
pays a dividend to P. To compute foreign taxes deemed paid, 
paragraph (c)(1) of this section requires P to start with the lowest 
tier corporations and to compute foreign taxes deemed paid 
separately for dividends from each first-tier and lower-tier 
corporation. Thus, S first will compute foreign taxes deemed paid 
separately on its dividends from T and U. The deemed paid taxes will 
be added to S's post-1986 foreign income taxes, and the dividends 
will be added to S's post-1986 undistributed earnings. Next, P will 
compute foreign taxes deemed paid with respect to the dividend from 
S. This computation will take into account the taxes paid by T and U 
and deemed paid by S.

    (2) Section 78 gross-up--(i) Foreign income taxes deemed paid by a 
domestic shareholder. Except as provided in section 960(b) and the 
regulations under that section (relating to amounts excluded from gross 
income under section 959(b)), any foreign income taxes deemed paid by a 
domestic shareholder in any taxable year under section 902(a) and 
paragraph (b) of this section shall be included in the gross income of 
the domestic shareholder for the year as a dividend under section 78. 
Amounts included in gross income under section 78 shall, for purposes 
of section 904, be deemed to be derived from sources within the United 
States to the extent the earnings and profits on which the taxes were 
paid are treated under section 904(g) as United States source 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, 
[[Page 2058]] foreign income taxes actually paid and deemed paid by a 
domestic shareholder that receives a dividend from a first-tier 
corporation. Foreign income taxes deemed paid by a domestic shareholder 
under paragraph (b) of this section shall be deemed paid by the 
domestic shareholder only for purposes of computing the foreign tax 
credit allowed under section 901.
    (4) Foreign mineral income. Certain foreign income, war profits and 
excess profits taxes paid or accrued with respect to foreign mineral 
income will not be considered foreign income taxes for purposes of 
section 902. See section 901(e) and Sec. 1.901-3.
    (5) Foreign taxes paid or accrued in connection with the purchase 
or sale of certain oil and gas. Certain income, war profits, or excess 
profits taxes paid or accrued to a foreign country in connection with 
the purchase and sale of oil or gas extracted in that country will not 
be considered foreign income taxes for purposes of section 902. See 
section 901(f).
    (6) Foreign oil and gas extraction income. For rules relating to 
reduction of the amount of foreign income taxes deemed paid with 
respect to foreign oil and gas extraction income, see section 907(a) 
and the regulations under that section.
    (7) United States shareholders of controlled foreign corporations. 
See paragraph (d) of this section and sections 960 and 962 and the 
regulations under those sections for special rules relating to the 
application of section 902 in computing foreign income taxes deemed 
paid by United States shareholders of controlled foreign corporations.
    (8) Credit for foreign taxes deemed paid in a section 304 
transaction. [Reserved].
    (9) Effect of section 482 adjustments on post-1986 foreign income 
taxes and post-1986 undistributed earnings. For rules concerning the 
effect of a section 482 adjustment on post-1986 foreign income taxes 
and post-1986 undistributed earnings, see section 905(c) and the 
regulations under that section.
    (d) Dividends from controlled foreign corporations--(1) General 
rule. Except as provided in paragraph (d)(3) of this section, if a 
dividend is received by a domestic shareholder that is a United States 
shareholder (as defined in section 951(b) or section 953(c)(1)(A)) from 
a first-tier corporation that is a controlled foreign corporation (as 
defined in section 957(a) or section 953(c)(1)(B)), or by an upper-tier 
corporation from a lower-tier corporation if the corporations are 
related look-through entities within the meaning of Sec. 1.904-5(i), 
the following rule applies. If a dividend is paid out of post-1986 
undistributed earnings or pre-1987 accumulated profits of the upper- or 
lower-tier controlled foreign corporation attributable to more than one 
separate category under section 904(d), 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 paragraph 
(d)(2) of this section. The separately computed deemed paid taxes shall 
be added to other taxes paid by the U.S. shareholder or upper-tier 
corporation with respect to income in the appropriate separate 
category.
    (2) Look-through--(i) Dividends. Except as otherwise provided in 
paragraph (d)(3) of this section, any dividend distribution out of 
post-1986 undistributed earnings of a look-through entity to a related 
look-through entity shall be deemed to be paid pro rata out of each 
separate category of income. See Sec. 1.904-5(c)(4) and Sec. 1.904-7. 
The portion of the foreign income taxes attributable to a particular 
separate category that shall be deemed paid by the domestic shareholder 
or upper-tier corporation must be computed under the following formula:

Foreign taxes deemed paid by domestic shareholder or upper-tier 
corporation with respect to a separate category under section 904(d) 
= Post-1986 foreign income taxes of first-tier or lower-tier 
corporation allocated and apportioned to a separate category under 
Sec. 1.904-6 x  Dividend amount attributable to a separate category 
Post-1986 undistributed earnings of first-tier or lower-tier 
corporation attributable to the separate category

    (ii) Coordination with section 960. For purposes of coordinating 
the computation of foreign taxes deemed paid with respect to amounts 
included in gross income pursuant to section 951(a) and dividends 
distributed by a controlled foreign corporation, see section 960 and 
the regulations under that section.
    (3) Special rules--(i) Dividends distributed out of earnings 
accumulated before a controlled foreign corporation became a controlled 
foreign corporation. Any dividend distributed by a controlled foreign 
corporation out of earnings accumulated before the controlled foreign 
corporation became a controlled foreign corporation shall be treated as 
a dividend from a noncontrolled section 902 corporation regardless of 
whether the earnings were accumulated in a taxable year beginning 
before January 1, 1987, or after December 31, 1986.
    (ii) Dividend distributions out of earnings and profits for a year 
during which a shareholder that is currently a more-than-90-percent 
United States shareholder of a controlled foreign corporation was not a 
United States shareholder of the controlled foreign corporation. A 
dividend shall be treated as a dividend from a noncontrolled section 
902 corporation, and the look-through rules of section 904(d)(3) and 
Sec. 1.904-5 shall not apply if the following conditions are met--
    (A) The dividend is distributed by a controlled foreign corporation 
attributable to earnings and profits of a taxable year during which it 
was a controlled foreign corporation;
    (B) The distribution is received by an upper-tier controlled 
foreign corporation or a United States shareholder and at the time the 
upper-tier controlled foreign corporation or the United States 
shareholder receives the distribution, the United States shareholder 
owns directly or indirectly within the meaning of sections 958 and 318 
and the regulations under those sections, more than 90 percent of the 
total combined voting power of all classes of stock entitled to vote of 
the distributing controlled foreign corporation; and
    (C) The more than 90 percent United States shareholder was not a 
United States shareholder at the time the distributed earnings and 
profits were accumulated by the controlled foreign corporation (the 
pre-acquisition period).
    (iii) Intra-group acquisitions. If, however, the dividend recipient 
is a member of an affiliated group within the meaning of section 
1504(a) without regard to section 1504(b)(3) and acquired its interest 
in the controlled foreign corporation from a member or members of the 
affiliated group, and the previous owner or owners were entitled to 
look-through treatment on distributions from the controlled foreign 
corporation, then the dividend recipient also shall be entitled to 
look-through treatment on distributions out of pre-acquisition period 
earnings and profits.
    (iv) Ordering rule. The determination whether a distribution from a 
controlled foreign corporation is attributable to earnings and profits 
accumulated before the corporation was a controlled foreign corporation 
or during the pre-acquisition period shall be made on a last-in first-
out (LIFO) basis. Thus, for example, a distribution shall be deemed 
[[Page 2059]] made from the earnings and profits attributable to the 
period after the United States shareholder acquired more than 90 
percent ownership in an existing controlled foreign corporation (post-
acquisition earnings and profits) to the extent of those earnings, and 
then from the most recently accumulated pre-acquisition earnings and 
profits. Earnings and profits accumulated in the taxable year in which 
the corporation became a controlled foreign corporation or the United 
States shareholder acquired more than 90 percent ownership of the 
controlled foreign corporation shall be considered earnings and profits 
accumulated after the corporation became a controlled foreign 
corporation or the United States shareholder acquired more than 90 
percent ownership.
    (v) Examples. The following examples illustrate the application of 
this paragraph (d)(3):

    Example 1. S is a foreign corporation formed in 1980. S had no 
domestic shareholders until 1992, when P, a domestic corporation, 
acquired 60 percent of the stock of S. For 1992 and subsequent 
years, S is a controlled foreign corporation. In 1992, S has no 
income and pays a dividend out of prior years' earnings and profits. 
Pursuant to paragraph (d)(3)(i) of this section, because S was not a 
controlled foreign corporation before 1992, the dividend to P will 
be treated as a dividend from a noncontrolled section 902 
corporation. Further, because the 10-percent ownership requirement 
of paragraphs (a)(1) and (a)(2) of this section were not satisfied 
until 1992, the amount of foreign taxes deemed paid on any 
distribution out of earnings accumulated before P acquired S's stock 
will be computed under the rules of section 902 as in effect before 
the Tax Reform Act of 1986. See Secs. 1.902-3 and 1.902-4 and 
paragraphs (a) (10) and (13) of this section.
    Example 2. P, a domestic corporation, owns 100 percent of the 
stock of U, a controlled foreign corporation. In 1992, P sells 100 
percent of the stock of U to T, an unrelated domestic corporation. U 
has no income in 1992 and pays a dividend to T out of post-1986 
undistributed earnings attributable to prior years. T is not related 
to P and P's ownership of U will not be attributed to T. The 
dividend to T in 1992 thus will be treated as a dividend from a 
noncontrolled section 902 corporation. In 1993, U pays a dividend to 
T out of post-acquisition earnings and profits. T will be entitled 
to look-through treatment on the dividend. The amount of foreign 
taxes deemed paid on each distribution will be computed under the 
rules of this section.
    Example 3. Since its organization in 1980, S, a controlled 
foreign corporation, has been owned 60 percent by domestic 
corporation P and 40 percent by domestic corporation R. In 1992, T 
acquires R's 40 percent interest in the stock of S. S has no income 
in 1992 and pays a dividend out of prior years' earnings and 
profits. Paragraph (d)(3)(ii) of this section does not apply because 
T, which formerly owned no stock in S, acquired only 40 percent of 
the stock of S. Thus, T is entitled to look-through treatment on the 
dividend payment out of post-1986 undistributed earnings accumulated 
in years prior to 1992.

    (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 Sec. 1.902-1.

    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 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 section 902 applied to the dividend 
paid to Corporation Z. 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 Corporation   25u        
 A at start of 1992.                                                    
2. Assumed post-1986 foreign income taxes of Corporation A   $25        
 at start of 1992.                                                      
3. Assumed pre-tax earnings and profits of Corporation A     50u        
 for 1992.                                                              
4. Assumed foreign income taxes paid or accrued by           15u        
 Corporation A in 1992.                                                 
5. Post-1986 undistributed earnings in Corporation A for     60u        
 1992 (pre-dividend) (Line 1 plus Line 3 minus Line 4).                 
6. Post-1986 foreign income taxes in Corporation A for 1992  $40        
 (pre-dividend) (Line 2 plus Line 4 translated at the                   
 appropriate exchange rates).                                           
7. Dividends paid out of post-1986 undistributed earnings    3u         
 of Corporation A to Corporation M in 1992.                             
8. Percentage of Corporation A's post-1986 undistributed     5%         
 earnings paid to Corporation M (Line 7 divided by Line 5).             
9. Foreign income taxes of Corporation A deemed paid by      $2         
 Corporation M under section 902 (a) (Line 6 multiplied by              
 Line 8).                                                               
10. Total dividends paid out of post-1986 undistributed      30u        
 earnings of Corporation A to all shareholders in 1992.                 
11. Percentage of Corporation A's post-1986 undistributed    50%        
 earnings paid to all shareholders in 1992 (Line 10 divided             
 by Line 5).                                                            
12. Post-1986 foreign income taxes paid with respect to      $20        
 post-1986 undistributed earnings distributed to all                    
 shareholders in 1992 (Line 6 multiplied by Line 11).                   
13. Corporation A's post-1986 undistributed earnings at the  30u        
 start of 1993 (Line 5 minus Line 10).                                  
14. Corporation A's post-1986 foreign income taxes at the    $20        
 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 [[Page 2060]] in excess 
of 5 percent because these taxes are not eligible for the deemed 
paid credit. 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 credit 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 Corporation   (100u)     
 B at start of 1992.                                                    
2. Assumed post-1986 foreign income taxes of Corporation B   $0         
 at start of 1992.                                                      
3. Assumed pre-tax earnings and profits of Corporation B     302.50u    
 for 1992 (including 50u of high withholding tax interest               
 on which 5u of tax is withheld).                                       
4. Assumed foreign income taxes paid or accrued by           102.50u    
 Corporation B in 1992.                                                 
5. Post-1986 undistributed earnings in Corporation B for     100u       
 1992 (pre-dividend) (Line 1 plus Line 3 minus Line 4).                 
6. Amount of foreign income tax of Corporation B imposed on  2.50u      
 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 B for 1992  $100       
 (pre-dividend) (Line 2 plus [Line 4 minus Line 6                       
 translated at the appropriate exchange rate]).                         
8. Dividends paid out of post-1986 undistributed earnings    5u         
 to Corporation M in 1992.                                              
9. Percentage of Corporation B's post-1986 undistributed     5%         
 earnings paid to Corporation M (Line 8 divided by Line 5).             
10. Foreign income taxes of Corporation B deemed paid by     $5         
 Corporation M under section 902(a) (Line 7 multiplied by               
 Line 9).                                                               
11. Total dividends paid out of post-1986 undistributed      50u        
 earnings of Corporation B to all shareholders in 1992.                 
12. Percentage of Corporation B's post-1986 undistributed    50%        
 earnings paid to all shareholders in 1992 (Line 11 divided             
 by Line 5).                                                            
13. Post-1986 foreign income taxes of Corporation B paid on  $50        
 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 earnings at      50u        
 start of 1993 (Line 5 minus Line 11).                                  
15. Corporation B's post-1986 foreign income taxes at start  $50        
 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 deemed dividend 
under section 78. Both the income inclusion and the credit are 
subject to a separate limitation for dividends from Corporation A, a 
noncontrolled section 902 corporation. Corporation M also is deemed 
to have paid $5 of the post-1986 foreign income taxes paid by 
Corporation B and includes $5 in gross income as a deemed dividend 
under section 78. Both the income inclusion and the foreign taxes 
deemed paid are subject to a separate limitation for dividends from 
Corporation B, a noncontrolled section 902 corporation.
    Example 3. (i) Since 1987, domestic corporation M has owned 50 
percent of the one class of stock of foreign corporation A. The 
remaining 50 percent of Corporation A is owned by foreign 
corporation Z. For the same time period, Corporation A has owned 40 
percent of the one class of stock of foreign corporation B, and 
Corporation B has owned 30 percent of the one class of stock of 
foreign corporation C. The remaining 60 percent of Corporation B is 
owned by foreign corporation Y, and the remaining 70 percent of 
Corporation C is owned by foreign corporation X. Corporations A, B, 
and C are not controlled foreign corporations. Corporations A, B, 
and C use the u as their functional currency, and 1u equals $1 at 
all relevant times. Corporation B uses a fiscal year ending June 30 
as its taxable year; all other corporations use the calendar year as 
the taxable year. On February 1, 1992, Corporation C pays a 500u 
dividend out of post-1986 undistributed earnings, 150u to 
Corporation B and 350u to Corporation X. On February 15, 1992, 
Corporation B pays a 300u dividend out of post-1986 undistributed 
earnings computed as of the close of Corporation B's fiscal year 
ended June 30, 1992, 120u to Corporation A and 180u to Corporation 
Y. On August 15, 1992, Corporation A pays a 200u dividend out of 
post-1986 undistributed earnings, 100u to Corporation M and 100u to 
Corporation Z. In computing foreign taxes deemed paid by 
Corporations B and A, section 78 does not apply and Corporations B 
and A thus do not have to include the foreign taxes deemed paid in 
earnings and profits. See paragraph (c)(2)(ii) of this section. 
Foreign income taxes deemed paid by Corporations B, A and M, and the 
foreign corporations' opening balances in post-1986 undistributed 
earnings and post-1986 foreign income taxes for Corporation B's 
fiscal year beginning July 1, 1992, and Corporation C's and 
Corporation A's 1993 calendar years are computed as follows:


A. Corporation C (third-tier corporation):                              
    1. Assumed post-1986 undistributed earnings in           1300u      
     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 Corporation   500u       
     C for 1992.                                                        
    4. Assumed foreign income taxes paid or accrued in 1992  300u       
    5. Post-1986 undistributed earnings in Corporation C     1500u      
     for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line             
     4).                                                                
    6. Post-1986 foreign income taxes in Corporation C for   $800       
     1992 (pre-dividend) (Line 2 plus Line 4 translated at              
     the appropriate exchange rates).                                   
    7. Dividends paid out of post-1986 undistributed         150u       
     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 deemed paid by  $80        
     Corporation B under section 902(b)(2) (Line 6                      
     multiplied by Line 8).                                             
    10. Total dividends paid out of post-1986 undistributed  500u       
     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 respect to  $266.66    
     post-1986 undistributed earnings distributed to all                
     shareholders in 1992 (Line 6 multiplied by Line 11).               
    13. Post-1986 undistributed earnings in Corporation C    1000u      
     at start of 1993 (Line 5 minus Line 10).                           
    14. Post-1986 foreign income taxes in Corporation C at   $533.34    
     start of 1993 (Line 6 minus Line 12).                              
B. Corporation B (second-tier corporation):                             
    1. Assumed post-1986 undistributed earnings in           0          
     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 Corporation   1000u      
     B for fiscal year ended June 30, 1992, (including 150u             
     dividend from Corporation B).                                      
    4. Assumed foreign income taxes paid or accrued by       200u       
     Corporation B in fiscal year ended June 30, 1992.                  
[[Page 2061]]                                                           
                                                                        
    5. Foreign income taxes of Corporation C deemed paid by  $80        
     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 Corporation B     800u       
     for fiscal year ended June 30, 1992 (pre-dividend)                 
     (Line 1 plus Line 3 minus Line 4).                                 
    7. Post-1986 foreign income taxes in Corporation B for   $280       
     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 undistributed         120u       
     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 by         $42        
     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 undistributed  300u       
     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 deemed paid  $105       
     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 Corporation B    500u       
     as of July 1, 1992 (Line 6 minus Line 11).                         
    15. Post-1986 foreign income taxes in Corporation B as   $175       
     of July 1, 1992 (Line 7 minus Line 13).                            
C. Corporation A (first-tier corporation):                              
    1. Assumed post-1986 undistributed earnings in           250u       
     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 Corporation   250u       
     A for 1992 (including 120u dividend from Corporation               
     B).                                                                
    4. Assumed foreign income taxes paid or accrued by       100u       
     Corporation A in 1992.                                             
    5. Foreign income taxes paid or deemed paid by           $42        
     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 Corporation A     400u       
     for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line             
     4).                                                                
    7. Post-1986 foreign income taxes in Corporation A for   $242       
     1992 (pre-dividend) (Line 2 plus Line 4 translated at              
     the appropriate exchange rates plus Line 5).                       
    8. Dividends paid out of post-1986 undistributed         100u       
     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 by         $60.50     
     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 undistributed  200u       
     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 deemed paid  $121       
     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 Corporation A    200u       
     at start of 1993 (Line 6 minus Line 11).                           
    15. Post-1986 foreign income taxes in Corporation A at   $121       
     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.

A. Corporation B (second-tier corporation):                             
    1. Assumed post-1986 undistributed earnings in           200u       
     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 Corporation   150u       
     B for 1992.                                                        
    4. Assumed foreign income taxes paid or accrued in 1992  50u        
    5. Post-1986 undistributed earnings in Corporation B     300u       
     for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line             
     4).                                                                
    6. Post-1986 foreign income taxes in Corporation B for   $100       
     1992 (pre-dividend) (Line 2 plus Line 4 translated at              
     the appropriate exchange rates).                                   
    7. Dividends paid out of post-1986 undistributed         150u       
     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).                                                
[[Page 2062]]                                                           
                                                                        
    9. Foreign income taxes of Corporation B deemed paid by  $50        
     Corporation A under section 902(b)(1) (Line 6                      
     multiplied by Line 8).                                             
    10. Post-1986 undistributed earnings in Corporation B    150u       
     at start of 1993 (Line 5 minus Line 7).                            
    11. Post-1986 foreign income taxes in Corporation B at   $50        
     start of 1993 (Line 6 minus Line 9).                               
B. Corporation A (first-tier corporation):                              
    1. Assumed post-1986 undistributed earnings in           (200u)     
     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 Corporation   200u       
     A for 1992 (including 150u dividend from Corporation               
     B).                                                                
    4. Assumed foreign income taxes paid or accrued by       40u        
     Corporation A in 1992.                                             
    5. Foreign income taxes paid by Corporation B in 1992    $50        
     that are deemed paid by Corporation A (Part A, Line 9              
     of paragraph (i) of this Example 4).                               
    6. Post-1986 undistributed earnings in Corporation A     (40u)      
     for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line             
     4).                                                                
    7. Post-1986 foreign income taxes in Corporation A for   $90        
     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 profits    100u       
     of Corporation A for 1992.                                         
    9. Percentage of post-1986 undistributed earnings of     0          
     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 by         0          
     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 Corporation A    (140u)     
     at start of 1993 (line 6 minus line 8).                            
    12. Post-1986 foreign income taxes in Corporation A at   $90        
     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, that 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 Corporation A at  (140u)     
     start of 1993.                                                     
    2. Post-1986 foreign income taxes in Corporation A at    $90        
     start of 1993.                                                     
    3. Pre-tax earnings and profits of Corporation A for     500u       
     1993.                                                              
    4. Foreign income taxes paid or accrued by Corporation   160u       
     A in 1993.                                                         
    5. Post-1986 undistributed earnings in Corporation A     200u       
     for 1993 (pre-dividend) (Line 1 plus Line 3 minus Line             
     4).                                                                
    6. Post-1986 foreign income taxes in Corporation A for   $250       
     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 of     50%        
     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 Corporation A    100u       
     at start of 1994 (Line 5 minus Line 7).                            
    11. Post-1986 foreign income taxes in Corporation A at   $125       
     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 interest.  20u        
    (b) Section 904(d)(1)(I) general limitation income.....  55u        
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 interest.  $5         
    (b) Section 904(d)(1)(I) general limitation income.....  $20        
3. Assumed pre-tax earnings and profits of Corporation A                
 for 1992 attributable to:                                              
    (a) Section 904(d)(1)(B) high withholding tax interest.  20u        
    (b) Section 904(d)(1)(I) general limitation income.....  20u        
4. Assumed foreign income taxes paid or accrued in 1992 on              
 or with respect to:                                                    
    (a) Section 904(d)(1)(B) high withholding tax interest.  10u        
    (b) Section 904(d)(1)(I) general limitation income.....  5u         
5. Post-1986 undistributed earnings in Corporation A for                
 1992 (pre-dividend) attributable to:                                   
    (a) Section 904(d)(1)(B) high withholding tax interest   30u        
     (Line 1(a) + Line 3(a) minus Line 4(a)).                           
    (b) Section 904(d)(1)(I) general limitation income       70u        
     (Line 1(b) + Line 3(b) minus Line 4(b)).                           
                                                            ------------
        (c) Total..........................................  100u       
[[Page 2063]]                                                           
                                                                        
6. Post-1986 foreign income taxes in Corporation A for 1992             
 (pre-dividend) attributable to:                                        
    (a) Section 904(d)(1)(B) high withholding tax interest   $15        
     (Line 2(a) + Line 4(a) translated at the appropriate               
     exchange rates).                                                   
    (b) Section 904(d)(1)(I) general limitation income       $25        
     (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 interest   60%        
     (Line 8(a) divided by Line 5(a)).                                  
    (b) Section 904(d)(1)(I) general limitation income       60%        
     (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 deemed paid    $9         
     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 deemed paid    $15        
     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 interest   12u        
     (Line 5(a) minus Line 8(a)).                                       
    (b) Section 904(d)(1)(I) general limitation income       28u        
     (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 interest   $6         
     (Line 6(a) minus Line 10(a)).                                      
    (b) Section 904(d)(1)(I) general limitation income       $10        
     (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 date. This section applies to any distribution made 
in and after a foreign corporation's first taxable year beginning on or 
after January 1, 1987. Sec. 1.902-2 Treatment of deficits in post-1986 
undistributed earnings and pre-1987 accumulated profits of a first-, 
second-, or third-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-, second-, or third-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-, second-, or third-tier corporation when there is a deficit in 
the post-1986 undistributed earnings of that corporation and the 
corporation makes a distribution to shareholders that is a dividend or 
would be a dividend if there were current or accumulated earnings and 
profits, then the post-1986 deficit shall be carried back to the most 
recent pre-effective date taxable year of the first-, second-, or 
third-tier corporation with positive accumulated profits computed under 
section 902. See Sec. 1.902-3(c)(2). 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 Corp. A.....  150u        150u        (100u)      100u        -0-         -0-       
Current plus accumulated E & P of Corp.   150u        300u        200u        250u        250u        200u      
 A.                                                                                                             
Post-'86 undistributed earnings of Corp.  ..........  ..........  (100u)      100u        100u        50u       
 A.                                                                                                             
Post-'86 undistributed earnings of Corp.  ..........  ..........  -0-         100u        50u         50u       
 A reduced by current year dividend                                                                             
 distributions (increased by deficit                                                                            
 carryback).                                                                                                    
Foreign income taxes of Corp. A (annual)  120u        120u        $10         $50         -0-         -0-       
Post-'86 foreign income taxes of Corp. A  ..........  ..........  $10         $60         $60         $30       
12/31 distributions to Corp. M..........  -0-         -0-         5u          -0-         5u          -0-       
12/31 distributions to Corp. Z..........  -0-         -0-         45u         -0-         45u         -0-       
----------------------------------------------------------------------------------------------------------------

    (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 
[[Page 2064]] 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 earnings and profits 
remain in Corporation A with respect to 1986 after the carryback of 
the 1987 deficit and the December 31, 1987, dividend distributions 
to Corporations M and Z.
    (iii) On December 31, 1989, Corporation A distributes a 5u 
dividend to Corporation M and a 45u dividend to Corporation Z. At 
that time Corporation A has 100u of post-1986 undistributed earnings 
and $60 of post-1986 foreign income taxes. Therefore, the dividend 
is considered paid out of Corporation A's post-1986 undistributed 
earnings. Foreign taxes deemed paid by Corporation M with respect to 
the 5u dividend are $3 ($60 x 5%[5u/100u]). Corporation M must 
include $3 in gross income under section 78 as a dividend. Both the 
income inclusion and the foreign taxes deemed paid are subject to a 
separate limitation for dividends from noncontrolled section 902 
corporation A. Corporation A's post-1986 undistributed earnings as 
of January 1, 1990, are 50u (100u-50u). Corporation A's post-1986 
foreign income taxes must be reduced by the amount of foreign taxes 
that would have been deemed paid had section 902 applied to the 
entire 50u dividend to Corporations M and Z, even though Corporation 
Z was not entitled to compute foreign taxes deemed paid on its share 
of the dividend. Section 1.902-1(a)(8). The amount of foreign income 
taxes that would have been deemed paid had section 902 applied to 
the entire 50u dividend 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 earnings and profits and 80u (120u 
reduced by 40u[120u x 50u/150u] of foreign taxes that would have 
been deemed paid had section 902 applied to the total dividend paid 
to all shareholders 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 Corp. A.....  100u        (50u)       150u        75u         25u         -0-       
Current plus accumulated E & P of Corp.   100u        50u         200u        175u        200u        80u       
 A.                                                                                                             
Post-'86 undistributed earnings of Corp.  ..........  (50u)       100u        75u         100u        -0-       
 A.                                                                                                             
Post-'86 undistributed earnings of Corp.  ..........  (50u)       -0-         75u         -0-         -0-       
 A reduced by current year dividend                                                                             
 distributions (increased by deficit                                                                            
 carryback).                                                                                                    
Foreign income taxes (annual) of Corp. A  80u         -0-         $120        $20         $20         -0-       
Post-'86 foreign income taxes of Corp. A  ..........  -0-         $120        $20         $40         -0-       
12/31 distributions to Corp. M..........  -0-         -0-         10u         -0-         12u         -0-       
12/31 distributions to Corp. Z..........  -0-         -0-         90u         -0-         108u        -0-       
----------------------------------------------------------------------------------------------------------------

    (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 had section 902 applied to the entire 100u dividend 
distribution to Corporations M and Z ($120 x 100%[100u/100u]).
    (iii) On December 31, 1990, Corporation A distributes a 12u 
dividend to Corporation M and a 108u dividend to Corporation Z. At 
that time Corporation A has 100u in its post-1986 undistributed 
earnings and $40 in its post-1986 foreign income taxes. The dividend 
is paid out of post-1986 undistributed earnings to the extent 
thereof (100u), and the remainder of 20u is paid out of 1986 
accumulated profits. Under Sec. 1.902-1(b)(2), the 12u dividend to 
Corporation M is deemed to be paid out of post-1986 undistributed 
earnings to the extent of 10u (100u x 12u/120u) and the remaining 2u 
is deemed to be paid out of Corporation A's 1986 accumulated 
profits. Similarly, the 108u dividend to Corporation Z is deemed to 
be paid out of post-1986 undistributed earnings to the extent of 90u 
(100u x 108u/120u) and the remaining 18u is deemed to be paid out of 
Corporation A's 1986 accumulated profits. Foreign income taxes 
deemed paid by Corporation M under section 902 with respect to the 
portion of the dividend paid out of post-1986 undistributed earnings 
are $4 ($40 x 10%[10u/100u]), and foreign taxes deemed paid by 
Corporation M with respect to the portion of the dividend deemed 
paid out of 1986 accumulated profits are 1.6u (80u  x  2u/100u). 
Corporation M must include $4 plus 1.6u translated under the rule 
applicable to foreign income taxes paid on earnings accumulated in 
taxable years prior to the effective date of the Tax Reform Act of 
1986 in gross income as a dividend under section 78. The income 
inclusion and the foreign income taxes deemed paid are subject to a 
separate limitation for dividends from noncontrolled section 902 
Corporation A. As of January 1, 1991, Corporation A's post-1986 
undistributed earnings are -0- (100u - 100u). 80u (100u - 20u) of 
earnings and profits remain with respect to 1986. Post-1986 foreign 
taxes as of January 1, 1991, are -0-, $40 reduced by $40 of foreign 
income taxes paid that would have been deemed paid had section 902 
applied to the entire 100u dividend distribution out of post-1986 
undistributed earnings to Corporations M and Z ($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 had section 902 
applied to the entire 20u dividend distribution to Corporations M 
and Z out of 1986 accumulated profits.

    (b) Carryforward of deficits in pre-1987 accumulated profits of a 
first-, second-, or third-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-, second-, or third-tier 
[[Page 2065]] corporation out of post-1986 undistributed earnings, the 
amount of a deficit in accumulated profits determined under section 902 
of the foreign corporation as of the end of its last pre-effective date 
taxable year is carried forward and reduces post-1986 undistributed 
earnings on the first day of the foreign corporation's first taxable 
year beginning after December 31, 1986, or on the first day of the 
first taxable year in which the ownership requirements of section 
902(c)(3)(B) and Sec. 1.902-1(a)(1) through (4) are met if the special 
effective date of Sec. 1.902-1(a)(13) applies. Any foreign income taxes 
paid with respect to a pre-effective date year shall not be carried 
forward and included in post- 1986 foreign income taxes. Post-1986 
undistributed earnings may not be reduced by the amount of a pre-1987 
deficit in earnings and profits computed under section 964(a). See 
section 960 and the regulations under that section for rules governing 
the carryforward of deficits and the computation of foreign income 
taxes deemed paid with respect to deemed income inclusions from 
controlled foreign corporations. For translation rules governing 
carryforwards of deficits in pre-1987 accumulated profits to post-1986 
taxable years of a foreign corporation with a dollar functional 
currency, see Sec. 1.985-6(d)(2).
    (2) Effect of pre-effective date deficit. If a foreign corporation 
has a deficit in accumulated profits as of the end of its last pre-
effective date taxable year, then the foreign corporation cannot pay a 
dividend out of pre-effective date years unless there is an adjustment 
made (for example, a refund of foreign taxes paid) that restores 
section 902 accumulated profits to a pre-effective date taxable year or 
years. Moreover, if a foreign corporation has a deficit in section 902 
accumulated profits as of the end of its last pre-effective date 
taxable year, then no deficit in post-1986 undistributed earnings will 
be carried back under paragraph (a) of this section. For rules 
concerning carrybacks of eligible deficits from post-1986 undistributed 
earnings to reduce pre-1987 earnings and profits computed under section 
964(a), see section 960 and the regulations under that section.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (b).

    Example 1. (i) From 1984 through 1988, domestic corporation M 
owns 10 percent of the one class of stock of foreign corporation A. 
The remaining 90 percent of Corporation A's stock is owned by 
Corporation Z, a foreign corporation. Corporation A is not a 
controlled foreign corporation and uses the u as its functional 
currency. 1u equals $1 at all relevant times. Both Corporation A and 
Corporation M use the calendar year as the taxable year. Corporation 
A has pre-1987 accumulated profits or deficits in accumulated 
profits and post-1986 undistributed earnings, pays pre-1987 and 
post-1986 foreign income taxes, and pays dividends as summarized 
below:

----------------------------------------------------------------------------------------------------------------
                    Taxable year                         1984        1985        1986        1987        1988   
----------------------------------------------------------------------------------------------------------------
Current E & P (deficits) of Corp. A.................  25u         (100u)      (25u)       200u        100u      
Current Plus Accumulated E & P (Deficits) of Corp. A  25u         (75u)       (100u)      100u        50u       
Post-'86 Undistributed Earnings of Corp. A..........  ..........  ..........  ..........  100u        50u       
Post-'86 Undistributed Earnings of Corp. A Reduced    ..........  ..........  ..........  (50u)       50u       
 By Current Year Dividend Distributions (reduced by                                                             
 deficit carryforward).                                                                                         
Foreign Income Taxes (Annual) of Corp. A............  20u         5u          -0-         $100        $50       
Post-'86 Foreign Income Taxes of Corp. A............  ..........  ..........  ..........  $100        $50       
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 had section 902 applied 
to the entire 100u dividend distribution out of post-1986 
undistributed earnings to Corporations M and Z ($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 Corp. A.................  (100u)      150u        (150u)      100u        250u      
Current Plus Accumulated E & P (Deficits) of Corp. A  (100u)      50u         (200u)      (100u)      50u       
Post-'86 Undistributed Earnings of Corp. A..........  ..........  50u         (200u)      (100u)      50u       
Post-'86 Undistributed Earnings of Corp. A Reduced    ..........  (50u)       (200u)      (200u)      -0-       
 By Current Year Dividend Distributions (reduced by                                                             
 deficit carryforward).                                                                                         
Foreign Income Taxes (Annual) of Corp. A............  -0-         $120        -0-         $50         $100      
Post-'86 Foreign Income Taxes of Corp. A............  ..........  $120        -0-         $50         $150      
12/31 Distributions to Corp. M......................  -0-         10u         -0-         10u         5u        
12/31 Distributions to Corp. Z......................  -0-         90u         -0-         90u         45u       
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[[Page 2066]]


    (ii) On December 31, 1987, Corporation A distributes a 10u 
dividend to Corporation M and a 90u dividend to Corporation Z. At 
the time of the distribution, Corporation A has 50u of post-1986 
undistributed earnings and 150u of current earnings and profits. 
Thus, 50u of the dividend distribution (5u to Corporation M and 45u 
to Corporation Z) is a dividend out of post-1986 undistributed 
earnings. The remaining 50u is a dividend out of current earnings 
and profits under section 316(a)(2), but Corporation M is not deemed 
to have paid any additional foreign income taxes paid by Corporation 
A with respect to that 50u dividend out of current earnings and 
profits. See Sec. 1.902-1(b)(4). Note that even if there were no 
current earnings and profits in Corporation A, the remaining 50u of 
the 100u distribution cannot be deemed paid out of accumulated 
profits of a 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. 
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 had section 902 applied to the entire dividend 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, no portion of the dividend is deemed to be 
out of post-1986 undistributed earnings, and 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 had section 902 applied to the entire dividend of 
50u.


    Par. 4. Newly designated Sec. 1.902-3 is amended by revising the 
section heading, paragraph (a) introductory text, and paragraph (l) to 
read as follows:


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 Secs. 1.902-3 
through 1.902-4--
* * * * *
    (l) Effective date. Except as provided in Sec. 1.902-4, this 
section applies to any distribution received from a first-tier 
corporation by its domestic shareholder after December 31, 1964, and 
before the beginning of the foreign corporation's first taxable year 
beginning after December 31, 1986. If, however, the first day on which 
the ownership requirements of section 902(c)(3)(B) and Sec. 1.902-1(a) 
(1) through (4) are met with respect to the foreign corporation is in a 
taxable year of the foreign corporation beginning after December 31, 
1986, then this Sec. 1.902-3 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)(iii). 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 as of April 1, 1976.
Margaret Milner Richardson,
Commissioner of Internal Revenue
[FR Doc. 95-173 Filed 1-5-95; 8:45 am]
BILLING CODE 4830-01-U