[Federal Register Volume 60, Number 173 (Thursday, September 7, 1995)]
[Rules and Regulations]
[Pages 46500-46530]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-21838]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 4 and 602

[TD 8618]
RIN 1545-AM15


Definition of a Controlled Foreign Corporation, Foreign Base 
Company Income and Foreign Personal Holding Company Income of a 
Controlled Foreign Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final Income Tax Regulations governing 
the definition of a controlled foreign corporation and the definitions 
of foreign base company income and foreign personal holding company 
income of a controlled foreign corporation. These regulations are 
necessary because of changes made to the prior law by the Tax Reform 
Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the 
Revenue Reconciliation Act of 1989, and the Omnibus Budget 
Reconciliation Act of 1993. Certain conforming changes in the 
regulations were necessary because of changes made by the Deficit 
Reduction Act of 1984. The regulations will provide the public with the 
guidance to comply with those acts and will affect United States 
shareholders of controlled foreign corporations.

DATES: These regulations are effective September 7, 1995.
    For dates of applicability, see Sec. 1.954-0(a).

FOR FURTHER INFORMATION CONTACT: Valerie Mark of the Office of 
Associate Chief Counsel (International), within the Office of the Chief 
Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., 
Washington, DC 20224 (Attention CC:INTL:2 (INTL-0362-88). Telephone 
(202) 622-3840 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
(OMB) in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 
3504(h)) under control number 1545-1068. The estimated average burden 
per respondent associated with the collection of information in this 
regulation is one hour.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be directed to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.

Background

    This document contains final regulations amending the Income Tax 
Regulations (26 CFR Part 1) under sections 954(b), 954(c) and 957(a) of 
the Internal Revenue Code (Code). Sections 954 and 957 were amended by 
sections 1201, 1221, 1222 and 1223 of the Tax Reform Act of 1986 (Pub. 
L. 99-514), by section 1012 of the Technical and Miscellaneous Revenue 
Act of 1988 (Pub. L. 100-647), by section 7811 of the Revenue 
Reconciliation Act of 1989 (Pub. L. 101-239) and by section 13233 of 
the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66). These 
regulations are also issued under authority contained in section 7805 
of the Code.
    Temporary regulations (TD 8216) and a cross-referenced notice of 
proposed rulemaking (INTL-362-88) under sections 954 and 957 of the 
Code were published in the Federal Register on July 21, 1988 (53 FR 
27489 and 53 FR 27532, respectively). Numerous written comments on the 
proposed and temporary regulations were received from the public. As 
explained below, 

[[Page 46501]]
the comments were considered in the drafting of the final regulations.

Discussion of Major Comments and Changes to the Regulations

Section 1.954-1: Foreign Base Company Income

    Section 1.954-1T(a)(3) and (5) (temporary regulations) apply the de 
minimis and full inclusion tests of section 954(b)(3) before the high 
tax exception of section 954(b)(4). Commenters have expressed concern 
that, in certain cases, the only amounts required to be included in the 
gross income of the United States shareholders of a controlled foreign 
corporation may be full inclusion income. This result may occur when 
subpart F income, other than full inclusion foreign base company 
income, qualifies for the high tax exception. In response to these 
comments, Sec. 1.954-1(d)(6) provides that an amount that otherwise 
would be included as full inclusion foreign base company income, 
pursuant to the operation of the full inclusion test of section 
954(b)(3)(B), will be excluded from full inclusion foreign base company 
income if more than 90 percent of the adjusted gross foreign base 
company and adjusted gross insurance income qualifies for the high tax 
exception described in section 954(b)(4) and the high tax election is 
actually made.
    Section 1.954-1T(a)(4) provides that in computing net foreign base 
company income, foreign personal holding company income is reduced by 
related person interest expense before allocating and apportioning 
other expenses in accordance with Sec. 1.904(d)-5(c)(2). Commenters 
understood this rule to be at variance with Sec. 1.904(d)-5(c)(2), 
which requires related person interest expense to be allocated to 
passive foreign personal holding company income after the allocation of 
directly related expenses. In response to this comment, the rule 
regarding allocation of related person interest expense was removed 
from Sec. 1.954-1T(a)(4) and (c) was amended to clarify that foreign 
base company income is reduced by directly related expenses before 
passive foreign personal holding company income is reduced by related 
person interest expense.
    Section 1.954-1T(a)(7) treats amounts recharacterized as foreign 
base company income or insurance income under section 952(c) as 
adjusted net foreign base company income or adjusted net insurance 
income. Thus, these amounts are not included in net foreign base 
company income or net insurance income for purposes of applying the 
high tax exception. Commenters argued that the rules of paragraph 
(a)(7) should be amended to provide that amounts that are 
recharacterized under section 952(c)(2) should not be treated as 
adjusted net foreign base company income or adjusted net insurance 
income if the amounts would have qualified for the high tax exception. 
This comment was rejected because section 952(c)(2) does not 
incorporate the exclusions and special rules of section 954(b)(4). 
Additional rules regarding the coordination of sections 952(c) and 954 
are being proposed under section 952 in a separate document published 
elsewhere in this issue of the Federal Register.
    Several comments were made concerning the anti-abuse rules of 
Sec. 1.954-1T(b)(4), which require aggregation of gross income of 
related controlled foreign corporations for purposes of the de minimis 
and full inclusion tests. One comment suggested that the aggregation 
rules of paragraph (b)(4) should be applied only if a purpose of first 
importance (as opposed to a principal purpose) is to avoid the 
application of the de minimis or full inclusion tests described in 
section 954(b)(3). This comment was rejected because the standard 
suggested is significantly more subjective than that of the regulations 
and is therefore unadministrable. However, it was determined that it 
was unnecessary to make the aggregation rules of paragraph (b)(4) 
applicable to the full inclusion test, for which there is not the same 
opportunity for tax avoidance.
    One commenter suggested that the anti-abuse rules of Sec. 1.954-
1T(b)(4) should be amended to provide that the gross income of separate 
controlled foreign corporations is aggregated only if a substantial 
portion of the activities of the separate corporations would comprise a 
single branch, and that the presumptions described in paragraph 
(b)(4)(ii) should be eliminated. The commenter also suggested that the 
definition of related person for purposes of these rules should refer 
to the provisions of section 954(d)(3), rather than the broader 
provisions of section 267. These comments were rejected because the 
suggested amendments would unduly restrict the application of the anti-
abuse rules. The presumptions described in paragraph (b)(4)(ii) may be 
rebutted, for example, by establishing reliance on the requirements of 
foreign law. The anti-abuse rules are necessary to prevent the misuse 
of the de minimis rule of section 954(b)(3), and do not impose a 
significant limitation or burden on the activities of controlled 
foreign corporations.
    Section 1.954-1T(c) provides that in computing net foreign base 
company income, the gross amount in each category of foreign base 
company income may not be reduced below zero. Section 1.954-2T(e) 
provides that the excess of losses over gains from the sale or exchange 
of certain property may not be allocated to any other category of 
foreign personal holding company income. Section 1.954-2T (f) and (g) 
contain similar provisions with regard to excess losses from 
commodities and foreign currency transactions, respectively. Because 
the categories of foreign base company income described in section 
954(a) and the categories of foreign personal holding company income 
described in section 954(c)(1) (B), (C) and (D) are defined in terms of 
net income, the temporary regulations interpreted the statutory scheme 
as generally precluding the allocation of excess losses from categories 
of foreign personal holding company income described in paragraph (e), 
(f), or (g) against other foreign personal holding company income 
categories. Commenters contended that by preventing any category of 
subpart F income from being reduced below zero, paragraph (c) caused 
inappropriate tax credit results and failed to harmonize the subpart F 
provisions with section 904(f)(5). Commentators stated that paragraphs 
(e), (f) and (g) should be amended to allow excess losses described in 
those paragraphs to be allocated to other categories of foreign 
personal holding company income.
    Paragraph (c) has been amended to clarify that, in determining net 
income, if the amount in any category of foreign base company income 
(including any category of foreign personal holding company income) is 
less than zero, the loss may not reduce any other categories of foreign 
base company income (or foreign personal holding company income) except 
by operation of the earnings and profits limitation. Proposed 
regulations published elsewhere in this issue of the Federal Register 
will provide rules concerning the application of the earnings and 
profits limitation.
    Section 1.954-1T(d) provides that the effective rate of foreign 
income tax on an item of income is determined in a manner consistent 
with the existing foreign tax credit regime under sections 904 and 960. 
In some cases, the amount of an item of income for foreign law purposes 
with respect to which foreign income tax is paid will be different from 
the amount for United States tax purposes. As a result, the effective 
rate of tax with respect to the item of income may be affected. In 
addition, because 

[[Page 46502]]
pursuant to section 960 the foreign income taxes of a controlled 
foreign corporation more than three tiers below a United States 
shareholder are not considered, the high tax exception will never apply 
to items of income of such corporations.
    Commenters suggested that certain foreign law accounting practices 
should be considered in determining the effective rate of tax on an 
item of income, for purposes of applying the high tax exception of 
section 954(b)(4) and paragraph (d) of the regulations. Commenters also 
contended that it is inappropriate to use section 960 to determine the 
effective rate of foreign tax and thus prevent consideration of taxes 
paid by controlled foreign corporations more than three tiers below the 
United States shareholder.
    The comment that the high tax exception should not be limited to 
creditable taxes under section 960 was rejected. The high tax exception 
is not intended to apply to the extent that an item of income would be 
subject to residual United States tax if such item were included in the 
gross income of the United States shareholder. The taxes paid with 
respect to such item of income should be considered for purposes of the 
high tax exception only to the extent they are otherwise considered for 
United States taxing purposes. See Joint Committee on Taxation Staff, 
General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 
970-71 (1986).
    The comment that foreign law accounting practices should be 
considered in determining the effective rate of tax on an item of 
income, for purposes of applying the high tax exception, was also 
rejected. Such a rule would impose a significant burden on the IRS. It 
would require the IRS to monitor and apply foreign tax and accounting 
principles, and to reconcile their application with United States tax 
and accounting principles, both in the current tax year and in later 
tax years to prevent an item of income, deduction, credit, gain or loss 
from being duplicated or omitted. Further, the IRS would have to 
consider and identify the particular foreign tax and accounting 
principles that could be taken into account for purposes of these 
rules.
    Section 1.954-1T(d)(4) defines the term item of income for purposes 
of the high tax exception by reference to the foreign tax credit and 
subpart F income categories to which the income relates. Thus, it is 
possible that amounts attributable to separate transactions may be 
included in the same item of income. If the income from the separate 
transactions were subject to foreign income tax at different rates, the 
effective rate of tax for the income item would reflect an average of 
the two (or more) rates of tax. One commenter has suggested that 
additional categories of income be created within the existing foreign 
tax credit and subpart F income groups to limit the effect of this tax 
rate blending.
    The regulations rely on existing guidance under the foreign tax 
credit and subpart F provisions generally to define item of income for 
purposes of section 954(b)(4). To identify items of income on a 
transaction-by-transaction basis is inconsistent with the separate 
limitation categories of income described in section 904, and adds 
complexity by requiring different computations for purposes of these 
rules and the rules under the foreign tax credit provisions of the 
Code. Moreover, there is no bias in the existing rules toward a 
particular result.
    Commenters suggested that the consistency rule of Sec. 1.954-
1T(d)(4)(ii)(B) be eliminated, to allow taxpayers to apply the high tax 
exception on an item-by-item basis. The consistency rule prohibits a 
taxpayer from selectively applying the high tax exception with respect 
to foreign personal holding company income that is passive income under 
section 904(d). Elimination of the consistency rule would provide a 
result that is incompatible with the foreign tax credit provisions of 
the Code, and thus the comment was rejected.
    The final regulations clarify how the rules of paragraph (d) 
coordinate with the earnings and profits limitation of section 
952(c)(1). Under Sec. 1.954-1(d)(4)(ii), if the amount of income 
included in subpart F income for the taxable year is reduced by the 
earnings and profits limitation, the amount of income that is an item 
of income, for purposes of paragraph (d), is determined after the 
application of the rules of section 952(c)(1). An example was added to 
illustrate this rule.
    Section 1.954-1T(d)(5) provides that the election to apply the high 
tax exception must be made by the controlling United States 
shareholders and is binding on all United States shareholders of the 
controlled foreign corporation. Commenters argued that the Secretary 
does not have the authority to bind all United States shareholders to a 
single election. This comment was rejected because it was determined 
that section 954(b)(4) provides the authority. Further, allowing each 
United States shareholder to separately elect the high tax exception 
would add undue complexity to the operation of the foreign tax credit 
rules.
    Section 1.954-1(f) provides guidance on the definition of related 
person under section 954(d)(3).
Section 1.954-2: Foreign Personal Holding Company Income

    Section 1.954-2T(a)(2)(i) provides that amounts that fall within 
the definition of income equivalent to interest, under paragraph (h), 
will be so treated though such amounts may also fall within the 
definition of gain from certain property transactions under paragraph 
(e), gain from a commodities transaction under paragraph (f) or foreign 
currency gain under paragraph (g). Paragraph (a)(2)(i) provides that 
amounts will be treated as income equivalent to interest even if these 
amounts are excluded from the computation of foreign personal holding 
company income under paragraphs (e), (f), or (g) because they are 
derived from certain qualifying business transactions. A commenter 
suggested that paragraph (a)(2)(i) should not treat income from 
qualifying business transactions excluded under paragraphs (e), (f), or 
(g) as income equivalent to interest. This comment was rejected. The 
rules regarding qualifying business transactions in paragraphs (e), (f) 
and (g) do not operate to exclude interest income from characterization 
as foreign personal holding company income. Income equivalent to 
interest within the meaning of section 954(c)(1)(E) and paragraph (h) 
generally should be treated like interest for purposes of subpart F.
    Several commenters suggested that the test described in Sec. 1.954-
2T(a)(3) to determine the use for which property is held (for purposes 
of determining the character of the income, gain or loss realized from 
a disposition of such property) should not focus solely on the use of 
the property immediately prior to its disposition, but instead should 
consider the predominant use for which the property was held. This 
comment was accepted. Section 1.954-2(a)(3) provides that the use for 
which property is held is the use for which it was held for more than 
one-half of the period during which the controlled foreign corporation 
held the property. If there has been a change in use, however, and a 
principal purpose for such change in use was to avoid characterizing 
income or gain attributable to the property as foreign personal holding 
company income, then the change in use will be disregarded.
    Section 1.954-2T(a)(3)(ii), Examples 2 and 3 illustrate the rules 
regarding change in use for which property is 

[[Page 46503]]
held. The final regulations delete these examples because Example 1 
sufficiently illustrated the rules of this paragraph. Examples 4 and 5 
of paragraph (a)(3)(ii) illustrate the change in use rules with respect 
to hedging transactions. The final regulations delete these examples 
because the rules governing hedging transactions are now generally 
contained in paragraph (a)(4)(ii).
    Section 1.954-2T(a)(4)(i) lists some of the types of income that 
are included in the term interest. To clarify that this list was not 
meant to be exclusive, paragraph (a)(4)(i) has been amended to provide 
that the term interest includes all amounts that are treated as 
interest (including tax-exempt interest) under the Code and regulations 
or any other provision of law. A new sentence illustrates the types of 
income that would be treated as interest.
    Section 1.954-2T(a)(4)(ii) provides that certain hedging 
transactions that reduce the risk of price changes in the cost of 
inventory and similar property are included within the definition of 
inventory and similar property if certain requirements are met and if 
they are so identified by the fifth day after which they are entered 
into. Paragraphs (f)(4) and (g)(4) of the temporary regulations contain 
definitions of the term qualified hedging transaction that have similar 
five-day identification requirements. These several definitions of a 
hedging transaction have been consolidated in Sec. 1.954-2(a)(4)(ii) 
which contains a definition of bona fide hedging transaction and new 
identification requirements for bona fide hedging transactions that 
apply for purposes of computing foreign personal holding company income 
under Sec. 1.954-2.
    Section 1.954-2(a)(4)(ii)(A) generally defines a bona fide hedging 
transaction as a transaction that meets the requirements of 
Sec. 1.1221-2 (a) through (c) with two exceptions. First, the risk 
being hedged may be with respect to ordinary property, section 1231 
property or a section 988 transaction. Second, a transaction that 
hedges the liabilities, inventory or other assets of a related person, 
or that is entered into to assume or reduce risks of a related person, 
will not be treated as a bona fide hedging transaction. Several 
commenters had sought to expand the definition of qualified hedging 
transactions to include hedging transactions conducted by a controlled 
foreign corporation that is a currency coordination center, i.e., a 
controlled foreign corporation that aggregates the currency exposures 
of related controlled foreign corporations and hedges such exposures. 
The statute provides, however, that a transaction must satisfy the 
business needs of the particular controlled foreign corporation. See 
also Joint Committee on Taxation Staff, General Explanation of the Tax 
Reform Act of 1986, 99th Cong., 2d Sess. 976 (1986).
    Section 1.954-2(a)(4)(ii)(B) provides identification requirements 
for a bona fide hedging transaction. The same-day identification and 
the recordkeeping requirements of Sec. 1.1221-2 apply for transactions 
entered on or after March 7, 1996. For bona fide hedging transactions 
entered into prior to this date and after July 22, 1988, the 
transaction must be identified by the close of the fifth day after the 
day on which it is entered into. For bona fide hedging transactions 
entered into prior to July 22, 1988, the transaction must be identified 
reasonably contemporaneously with the date it is entered into but no 
later than within the normal period prescribed under the method of 
accounting of the controlled foreign corporation used for financial 
reporting purposes.
    Section 1.954-2(a)(4)(ii)(C) describes the treatment of 
transactions that are misidentified as hedging transactions, and 
hedging transactions that the taxpayer fails to identify as such. 
Paragraph (a)(4)(ii)(C) also provides relief for taxpayers that have 
identified, or failed to identify, a hedging transaction due to 
inadvertent error. These misidentification rules are substantially 
similar to the rules in Sec. 1.1221-2(f), modified for purposes of the 
subpart F regime.
    Section 1.954-2T(a)(4)(iii) defines regular dealer, and states 
that, ``purchasing and selling property through a regulated exchange or 
off-exchange market (for example, engaging in futures transactions) is 
not actively engaging as a merchant'' for purposes of these rules. This 
provision was intended to mean that such purchasing and selling 
activity alone, in the absence of other activities, will not qualify a 
controlled foreign corporation as a regular dealer within the meaning 
of paragraph (a)(4)(iii). Because commenters indicated that this 
reference to purchasing and selling through a regular exchange or off-
exchange market was confusing, this provision was removed. Further, the 
definition of regular dealer was amended. Section 1.954-2(a)(4)(iv) 
provides that a controlled foreign corporation will be a regular dealer 
if it regularly and actively offers to, and in fact does, engage in 
certain specified activities with customers who are not related persons 
(as defined in section 954(d)(3)) with respect to the CFC. Examples 
were added to clarify that a controlled foreign corporation that 
qualifies as a dealer under Sec. 1.954-2(a)(4)(iv) will not be 
disqualified from being treated as a regular dealer because it also 
engages in transactions with related persons.
    The temporary regulations define dealer property as property held 
by a controlled foreign corporation that is a regular dealer in 
property of such kind in its capacity as a dealer. The temporary 
regulations also state that property held for investment or speculation 
is not dealer property. A commenter suggested that property should be 
considered dealer property within the meaning of Sec. 1.954-
2T(a)(4)(iv) if the controlled foreign corporation holding the property 
is a regular dealer in such property. This comment was rejected because 
it proposes an unduly expansive definition of dealer property. 
Paragraph (a)(4), therefore, generally continues to define dealer 
property in the same manner as the temporary regulations.
    The final regulations do clarify, however, that if a controlled 
foreign corporation qualifies as a regular dealer, all of the property 
held in a dealer capacity by that corporation is treated as dealer 
property. Thus, dealer property includes property arising from a 
transaction entered into with a related person, as long as the 
controlled foreign corporation is a regular dealer and holds the 
property in its capacity as a dealer, and not for investment or 
speculation. The examples of Sec. 1.954-2(a)(4)(vi) illustrate this 
rule. A rule has been added for licensed securities dealers under which 
only securities identified as held for investment under section 475(b) 
or 1236 will be treated as held for investment or speculation. Also, to 
conform to amendments to section 954(c)(1)(B) made by the Technical and 
Miscellaneous Revenue Act of 1988, Sec. 1.954-2(a)(4)(v)(C) provides 
that a bona fide hedging transaction with respect to dealer property is 
treated as a transaction in dealer property.
    Section 954(c)(2)(B) and Sec. 1.954-2T(b)(2) exclude from foreign 
personal holding company income export financing interest that is 
derived in the active conduct of a banking business. A commenter 
suggested that paragraph (b)(2) should treat a controlled foreign 
corporation as engaged in the conduct of a banking business even if it 
transfers the servicing of loans to related or unrelated parties. This 
comment was rejected because servicing of loans is a fundamental 
element of banking activity that gives rise to export financing 
interest for which an exception from foreign personal holding company 
income is intended.

[[Page 46504]]

    Section 1.954-2T(b)(2) references the definition of export 
financing interest contained in section 904(d)(2)(G). Under section 
904(d)(2)(G), the property that is financed must be manufactured, 
produced, grown or extracted in the United States by the taxpayer or a 
related person. Section 1.954-2(b)(2) clarifies that Sec. 1.927(a)-
1T(c)(1) applies for purposes of determining whether property is 
manufactured, produced, grown or extracted in the United States.
    Section 1.954-2T(b)(2) also provides that the term export financing 
interest does not include income from related party factoring that is 
treated as interest under section 864(d)(1) or (6). The final 
regulations contain examples that clarify that if amounts are not 
treated as interest under section 864(d)(1) or (6) because the 
exception under section 864(d)(7) applies, these amounts may be export 
financing interest under paragraph (b)(2).
    Section 954(c)(3)(A) and Sec. 1.954-2T(b) (3) and (4) provide that 
certain dividend, interest, rent or royalty income received from 
related corporate payors is not included in foreign personal holding 
company income. To reflect amendments to section 954(c)(3)(A) by the 
Revenue Reconciliation Act of 1989, the final regulations provide that 
if a partnership with one or more corporate partners makes a payment of 
interest, rent or royalties, the interest, rent or royalty payment will 
be treated as paid by a corporate partner to the extent the payment 
gives rise to a partnership item of deduction that is allocable to the 
corporate partner or to the extent that a partnership item reasonably 
related to the payment would be allocated to the corporate partner 
under an existing allocation under the partnership agreement. To the 
extent the payment is treated as made by the corporate partner, it will 
be excluded from the foreign personal holding company income of the 
recipient if the corporate partner otherwise satisfies the conditions 
of section 954(c)(3)(A).
    Under Sec. 1.954-2T(b)(3)(ii), interest may not be excluded from 
foreign personal holding company income of the recipient to the extent 
the deduction for interest is allocated to the payor's subpart F 
income. To clarify how this rule is to be applied when a controlled 
foreign corporation is both the recipient and payor of interest, 
Sec. 1.954-2(b)(4)(ii)(B)(2) was added, which parallels the rule 
contained in Sec. 1.904-5(k)(2).
    Section 1.954-2T(b)(3) provides that, to exclude dividends and 
interest received from related corporate payors from foreign personal 
holding company income, a substantial part of the payor's assets must 
be used in a trade or business in the payor's country of incorporation. 
Section 1.954-2T(b)(3)(iv) provides that a substantial part of the 
payor's assets will be considered to be used in a trade or business in 
the payor's country of incorporation if, for each quarter of the 
taxable year, the average value of its assets which are so used is over 
50 percent of the average value of all of its assets (determined as of 
the beginning and end of the quarter). To simplify the application of 
this rule, Sec. 1.954-2(b)(4)(iv) provides that the average value of 
assets is to be determined on a yearly rather than a quarterly basis by 
averaging the values of assets as of the close of each quarter.
    Section 1.954-2T(b)(3)(vi)(A) provides that for purposes of the 
substantial assets test, tangible property (other than inventory) is 
generally considered located where it is physically located. Paragraph 
(b)(3)(vi)(B) contains an exception for property temporarily located 
elsewhere for inspection or repair. A commenter suggested that, in 
addition to this exception, the regulations should restore the 
exception contained in prior regulations that treated purchased 
property located abroad and intended for prompt shipment to the country 
of incorporation as property located in the country of incorporation. 
This comment was rejected because this provision would have been 
inconsistent with the rule that property purchased for use in a trade 
or business is not considered used in a trade or business until it is 
placed in service.
    Section 1.954-2T(b)(3)(vii)(A) provides that for purposes of the 
substantial assets test, the location of intangible property is 
determined based on the site of the activities conducted by the payor 
during the taxable year in connection with the use or exploitation of 
the property. The country in which services are performed is determined 
under the principles of section 954(e) and Sec. 1.954-4(c). This rule 
was amended to provide more comprehensive guidance to determine the 
situs of activities in connection with the use or exploitation of 
intangible property. Section 1.954-2(b)(4)(vii)(B) provides that the 
country in which the activities connected to the use or exploitation of 
property are conducted is the country in which the expenses associated 
with these activities are incurred by the payor or its agent or an 
independent contractor.
    Section 1.954-2T(b)(3)(vii)(A) provides that the intangible 
property is considered located in the payor's country of incorporation 
during each quarter of the taxable year if the activities connected 
with its use or exploitation are conducted in its country of 
incorporation during the entire taxable year. A commenter argued that 
this test is inconsistent with the quarterly determination required by 
the substantial assets test of Sec. 1.954-2T(b)(3)(iv). Changes were 
made to the location of property rules (Sec. 1.954-2(b)(4)(vi) through 
(ix)) so that relevant determinations are made for each quarter 
separately.
    The final regulations continue to reserve on the provision of 
special rules regarding the location of assets of banks and insurance 
companies for purposes of the same-country exception. Comments are 
invited regarding the need for special guidance on this issue.
    Several comments questioned the application of the rules of 
Sec. 1.954-2T(b)(6), pursuant to which interest income of a controlled 
foreign corporation that is described in section 103 is included in 
foreign personal holding company income but is characterized as tax-
exempt interest when included in the gross income of the United States 
shareholders. The purpose of this rule was to prevent a person from 
avoiding the consequences of the alternative minimum tax provisions by 
investing in tax-exempt obligations described in section 103 through a 
controlled foreign corporation.
    The final regulations reserve on the treatment of tax-exempt 
interest. The administrative complexity of applying the rule described 
in the temporary regulations, and the potential for double taxation 
that it creates, argue against its continued application. Proposed 
regulations, published elsewhere in this issue of the Federal Register, 
will provide rules regarding the treatment of tax-exempt interest. In 
the interim, the rules of the temporary regulations continue to apply.
    Section 1.954-2T(b)(5) provides that the determination whether 
rents and royalties are derived from the active conduct of a trade or 
business is made under the facts and circumstances of each case, and 
refers to paragraphs (c) and (d) for the application of its provisions. 
Commenters have asked whether only the facts and circumstances 
described in paragraphs (c) and (d) may be considered. The final 
regulations are clarified to reflect that whether rents or royalties 
are derived in the active conduct of a trade or business is determined 
solely under the provisions of paragraphs (c) and (d).
    Section 1.954-2T(c)(2)(iii) defines active leasing expenses for 
purposes of 

[[Page 46505]]
determining whether rental income is derived in the active conduct of a 
trade or business. A commenter suggested that paragraph (c)(2)(iii) be 
amended to state that if a corporation sells property of the same type 
as the property that is leased, the corporation's expenses that are of 
the type described in that paragraph may be pro-rated on any reasonable 
basis between the leasing and the sales function. It was determined 
that the change requested by this commenter was unnecessary because 
paragraph (c)(2)(iii) already defines active leasing expenses as 
deductions properly allocable to rental income.
    A commenter suggested that an example be added to Sec. 1.954-2T(c) 
to illustrate that expenses such as payments to third parties for 
insurance, utilities and repairs are considered active leasing expenses 
and not amounts paid to agents or independent contractors. The 
regulations were amended in response to this comment. Section 1.954-
2(c)(2)(iii)(D) provides that the term active leasing expenses does not 
include payments to agents or independent contractors other than 
payments for insurance, utilities and other expenses for like services 
or capitalized property. A similar change was made to the definition of 
the term adjusted leasing profit.
    Section 954(c)(1)(B) and Sec. 1.954-2T(e) include in foreign 
personal holding company income the excess of gains over losses from 
certain property transactions. Section 1.954-2T(e)(1)(i) provides that 
gain or loss that is treated as capital gain or loss under section 
988(a)(1)(B) is not foreign currency gain or loss but rather gain or 
loss from a property transaction under paragraph (e). A commenter 
contended that gain or loss from transactions described in section 
988(a)(1)(B) should be characterized as gain or loss described in 
section 954(c)(1)(C) and Sec. 1.954-2T(f) rather than in section 
954(c)(1)(B) and paragraph (e). This comment was rejected, because the 
capital transactions described in section 988(a)(1)(B) are more 
appropriately subject to the provisions of section 954(c)(1)(B) and 
paragraph (e). This provision is now contained in Sec. 1.954-2(g)(5).
    A commenter asked that gain from a disposition of stock of a 
subsidiary be excluded from foreign personal holding company income to 
the extent that gain from the subsidiary's disposition of its assets 
would be so excluded. There is no statutory authority for the position 
recommended by the commenter, however. In addition, the look-through 
treatment proposed by the commenter is inconsistent with the treatment 
prescribed for dispositions of interests in a partnership or trust 
under section 954(c)(1)(B)(ii). For these reasons, the comment was 
rejected.
    Pursuant to Sec. 1.954-2T(e)(3)(vi), gain from a disposition of 
non-depreciable intangible property or goodwill is characterized as 
foreign personal holding company income unless the intangible property 
is disposed of in connection with a disposition of the entire trade or 
business of the controlled foreign corporation. Commenters have argued 
that the gain should be excluded from foreign personal holding company 
income if such property is used in the trade or business of the 
controlled foreign corporation, without regard to whether an entire 
trade or business of the controlled foreign corporation is sold.
    The regulations were modified in response to this comment. Section 
1.952-2(e)(3)(iv) excludes from foreign personal holding company income 
any gain or loss of a controlled foreign corporation from a disposition 
of intangible property, goodwill or going concern value to the extent 
used or held for use in the trade or business of the controlled foreign 
corporation.
    Section 1.954-2T(e)(4) provides that gain or loss from the sale, 
exchange or retirement of a debt instrument is included in the 
computation of foreign personal holding company income under paragraph 
(e) with certain exceptions. However, a loss on a debt instrument taken 
in consideration for the sale or exchange of property is excluded from 
foreign personal holding company income if the gain or loss from that 
underlying sale or exchange is not includible in foreign base company 
income. This rule was eliminated from the final regulations because it 
was inconsistent to prevent a controlled foreign corporation from using 
these losses to offset subpart F income when gain from such debt 
instruments was not excepted from the general inclusion rule.
    Section 1.954-2T(e)(5) provides that rights to acquire property, 
other than certain property that is dealer property or inventory 
property, are characterized as property that does not give rise to 
income for purposes of section 954(c)(1)(B). One commenter has 
suggested that such rights should not be characterized as property that 
does not give rise to income. This comment was rejected because any 
gain that may arise upon a disposition of an option, warrant, or other 
right to acquire property, other than gain from a disposition of 
inventory or dealer property, is income of the type intended to be 
characterized as foreign personal holding company income for purposes 
of section 954(c)(1)(B). The provisions of Sec. 1.954-2T(e)(5) are now 
incorporated into the definition of property that does not give rise to 
income under Sec. 1.954-2(e)(3). However, the final regulations clarify 
that notional principal contracts are excluded from the definition of 
property that does not give rise to income. (But see Sec. 1.954-2 (f), 
(g) and (h).)
    Section 954(c)(1)(C) and Sec. 1.954-2T(f) provide rules for 
including the excess of gains over losses from commodities transactions 
in foreign personal holding company income. Several commenters argued 
that Sec. 1.954-2T(f)(2)(i) defines commodity too broadly, and that, 
like sections 553 and 864, the regulations should apply only to 
commodities that are actively traded on a regulated exchange. This 
comment was rejected because the statute and its legislative history 
make clear that section 954(c)(1)(C) is intended to apply broadly to 
any commodity of a kind that is actively traded. Thus, there is no 
reason to distinguish income from a disposition of a commodity actively 
traded on a regulated exchange from income from a disposition of a 
commodity of a kind that is otherwise actively traded.
    Although Sec. 1.954-2(f)(2)(i) no longer explicitly provides that 
nonfunctional currency is a commodity, nonfunctional currency continues 
to fall within the general definition of commodity. Consequently, 
foreign currency is still treated as a commodity if the currency is 
actively traded or if contractual interests in the currency are 
actively traded. Under the ordering rules of paragraph (a)(2), however, 
paragraph (g) (foreign currency transactions) continues to apply before 
paragraph (f). Thus, unless an election is made under section 
988(c)(1)(D)(ii), a currency futures contract is treated as a 
commodities transaction, while a currency forward contract is generally 
treated as a foreign currency transaction.
    Section 1.954-2T(f)(1) excludes gains and losses from qualified 
active sales and qualified hedging transactions from the computation of 
foreign personal holding company income under paragraph (f). In 
defining qualified active sale, paragraph (f)(3) requires substantially 
all of the controlled foreign corporation's business to be as an active 
producer, processor, merchant or handler of commodities of like kind. 
Commenters argued that by using the phrase ``of like kind,'' 
Sec. 1.954-2T(f)(3) defines qualified active sales too narrowly. The 
``of like kind'' language was not intended to require that all of the 
commodities be of one kind, but 

[[Page 46506]]
rather that the controlled foreign corporation must be an active 
producer, etc., with respect to each kind of commodity. To avoid 
confusion, the ``of like kind'' language has been eliminated from the 
definition of the term qualified active sale.
    Section 1.954-2T(f)(3)(ii) defines the term sale of commodities. 
Commenters questioned the requirement, incorporated in the definition 
of this term, that the corporation hold the commodity in physical form. 
This comment was accepted. The final regulations no longer require the 
controlled foreign corporation to hold the commodity in physical form. 
Section 1.954-2(f)(2)(iii)(B) requires only that the controlled foreign 
corporation hold the commodity directly and not through an independent 
contractor. The retention of this requirement is consistent with the 
legislative history of section 954(c)(1)(C), which makes clear that the 
exclusion from foreign personal holding company income was intended to 
apply only with respect to commodities for which controlled foreign 
corporations are active producers, processors, handlers or merchants. 
Section 1.954-2(f)(2)(iii)(D) provides that activities of employees of 
entities related to the controlled foreign corporation may be treated 
as activities directly engaged in by the controlled foreign corporation 
if the employees are paid and supervised by the controlled foreign 
corporation.
    Section 1.954-2(f)(2)(iii)(B) also amends the definition of the 
term active conduct of a commodities business by clarifying that the 
requirements specified in that paragraph must be satisfied with respect 
to each commodity and that property may be held either as dealer 
property or as inventory or similar property.
    Section 954(c)(1)(C)(ii) and Sec. 1.954-2T(f) (1) and (3) exclude 
income attributable to commodities transactions from foreign personal 
holding company income if substantially all of the business of a 
controlled foreign corporation is as an active producer, processor, 
merchant or handler of commodities. Section 1.954-2T(f)(3)(iv) provides 
that the controlled foreign corporation will satisfy the substantially 
all requirement if 85 percent of its taxable income for the taxable 
year is attributable to qualified active sales and qualified hedging 
transactions. Several commenters argued that this test could fail to 
reflect the nature of the controlled foreign corporation's business 
accurately in some years because of the volatility of certain 
commodities markets.
    To accommodate this concern, Sec. 1.954-2(f)(2)(iii)(C) modifies 
the definition of the term substantially all by applying the 85 percent 
test to gross receipts rather than taxable income. To prevent 
manipulation of this modified test, a provision was added under which 
the District Director may disregard any sale or hedging transaction 
that has as a principal purpose manipulation of the 85 percent test.
    Section 1.954-2T(f)(4) defines the term qualified hedging 
transaction as a bona fide hedging transaction that is entered into 
primarily to reduce the risk of price change with respect to 
commodities sold or to be sold in qualified active sales. A commenter 
argued that a bona fide hedging transaction should not be required to 
relate to a qualified active sale to be treated as a qualified hedging 
transaction. This comment was rejected because this provision is based 
on the statutory requirement that qualified hedging transactions must 
arise out of the business of the controlled foreign corporation as an 
active producer, processor, merchant or handler of commodities. Thus, 
the rule of the temporary regulations is retained.
    Section 954(c)(1)(D) and Sec. 1.954-2T(g) include in foreign 
personal holding company income the net foreign currency gains 
attributable to section 988 transactions. The rules in Sec. 1.954-
2T(g)(2)(i) governing the treatment of gain or loss attributable to 
foreign currency transactions in hyperinflationary currencies have been 
removed. Section 1.954-2(g)(5)(iii) provides that the applicable rules 
of section 985 will apply to such transactions.
    Section 1.954-2T(g)(2)(ii) excludes from foreign personal holding 
company income gain or loss from qualified business transactions that 
are separately identified, and gain or loss from qualified hedging 
transactions that are identified with, or traced to, a qualified 
business transaction. Many commenters argued that these rules are too 
cumbersome to apply. They contended that a controlled foreign 
corporation that has a large number of qualified business transactions 
may not hedge such transactions individually, and that it is difficult 
or impossible in such cases to relate a hedge to one or even several 
qualified business transactions. The commenters also argued that the 
alternative election to treat all currency gain (or loss) as foreign 
personal holding company income (or loss allocable to foreign personal 
holding company income) does not provide adequate relief for controlled 
foreign corporations whose hedging activities relate to qualified 
business transactions on a net basis but give rise to foreign currency 
gain that is treated as foreign personal holding company income.
    The regulations are modified in response to those comments. Section 
1.954-2(g)(2)(ii) excludes from foreign personal holding company income 
foreign currency gain or loss directly related to the business needs of 
the controlled foreign corporation. Foreign currency gain or loss is 
directly related to the business needs of the corporation, first, if it 
can be clearly determined that it arises from a transaction entered 
into or property used in the normal course of the corporation's trade 
or business and the transaction or property does not itself give rise 
to subpart F income (other than foreign currency gain or loss), or, 
second, if it arises from a bona fide hedging transaction with respect 
to such a transaction or property. To exclude gain or loss from a 
hedging transaction from foreign personal holding company income under 
this rule, corporations need not trace a hedging transaction to a 
specific transaction or property if all (or all but a de minimis 
amount) of the aggregate risks being hedged are within the business 
needs exception and the hedging transaction otherwise satisfies the 
requirements of section 1221, as modified for this purpose.
    Section 1.954-2(g)(2)(ii)(C) provides a specific dealer exception 
under which transactions described in section 988(c)(1)(B)(iii) and (C) 
that are entered into by a regular dealer, in its capacity as a dealer, 
are treated as directly related to its business needs for purposes of 
the exclusion under Sec. 1.954-2(g)(2)(ii). Because a corporation's 
borrowings support all of its activities, paragraph (g)(2)(iii) 
provides that foreign currency gain or loss attributable to an 
interest-bearing liability that is not covered by paragraph (g)(5)(iv) 
is characterized as subpart F income and non-subpart F income on the 
same basis as interest expense is allocated and apportioned. Thus, for 
example, exchange gain or loss from an unhedged interest-bearing 
liability may fall under this rule.
    Section 1.954-2T(g)(3) provides that a transaction will not be 
treated as a qualified business transaction if the foreign currency 
gain or loss from the transaction is attributable to property or an 
activity of a kind that gives rise to subpart F income. Commenters have 
argued that this requirement is too restrictive because it may cause 
the gain or loss from the underlying transaction, and the foreign 
currency gain or loss attributable to the transaction, to be in 

[[Page 46507]]
different separate categories for foreign tax credit purposes.
    In response to this comment, a new election was added to paragraph 
(g). Under Sec. 1.954-2(g)(3), the controlling United States 
shareholders may elect to have the controlled foreign corporation 
include foreign currency gain or loss that would otherwise be included 
in foreign personal holding company income under paragraph (g) in the 
category of subpart F income to which such gain or loss relates. This 
election works in conjunction with the general rules of paragraph 
(g)(2). Thus, for example, this election may apply to currency gain or 
loss that would otherwise be treated as foreign personal holding 
company income under paragraph (g) even if other currency gain or loss 
is excluded under the business needs exception of paragraph (g)(2)(ii).
    As described above, the temporary regulations permit taxpayers to 
elect to treat all foreign currency gain or loss as foreign personal 
holding company income. The final regulations retain this election, 
with modifications. Under Sec. 1.954-2(g)(4), the controlling United 
States shareholders of the controlled foreign corporation may elect to 
include in the computation of foreign personal holding company income 
net foreign currency gains or losses attributable to any section 988 
transaction and any section 1256 contract that would be a section 988 
transaction but for section 988(c)(1)(D). Shareholders are not 
permitted to make separate elections for section 1256 contracts and 
section 988 transactions. An election under paragraph (g)(4) supersedes 
an election under paragraph (g)(3).
    Section 1.954-2(g)(5)(iv) reserves on the treatment of gain or loss 
allocated under Sec. 1.861-9. It is anticipated that when Sec. 1.861-9 
is finalized, a provision will be added to this paragraph to indicate 
that gain or loss that is allocated or apportioned under section 861 in 
the same manner as interest expense is not foreign currency gain or 
loss under paragraph (g).
    Section 954(c)(1)(E) and Sec. 1.954-2T(h) include income equivalent 
to interest in foreign personal holding company income. A commenter 
argued that the term income equivalent to interest might be read to 
include income from a wide range of interest rate sensitive 
transactions entered into by a securities dealer or commodities 
producer, processor, merchant or handler in the ordinary course of its 
business. The commenter suggested that the regulations should be 
modified to confirm that such income is not income equivalent to 
interest.
    The final regulations do not contain a general dealer exception 
that applies to all income equivalent to interest because income 
equivalent to interest is generally treated like interest, for which no 
general dealer exception is provided. However, consistent with Notice 
89-90 (1989-2 C.B. 407), Sec. 1.954-2(h)(3)(ii) provides a specific 
dealer exception for income from notional principal contracts.
    Section 1.954-2T(h)(1) provides that income equivalent to interest 
does not include income attributable to notional principal contracts 
except to the extent that such contracts are part of an integrated 
transaction that gives rise to income equivalent to interest. Notice 
89-90 stated, however, that final regulations would provide that income 
equivalent to interest would include income from notional principal 
contracts regardless of whether the notional principal contract is 
integrated with an investment, because notional principal contracts 
generally affect the all-in cost of interest-bearing liabilities or the 
return on interest-bearing assets. Accordingly, Sec. 1.954-2(h)(3) 
provides that income from notional principal contracts based solely on 
interest rates or interest rate indices is income equivalent to 
interest, and paragraph (h)(1)(ii) provides that income from a notional 
principal contract covered by Sec. 1.861-9T is not income equivalent to 
interest. Paragraph (f) continues to apply to notional principal 
contracts based on commodities (or a commodities index), and paragraph 
(g) continues to apply to notional principal contracts covered by 
section 988.
    Section 1.954-2T(h)(3) treats factoring income as income equivalent 
to interest, with certain exceptions. Commenters have argued that 
income realized by a credit card company from factoring its receivables 
(which is attributable to the discount at which it acquires the 
receivables from the business establishments honoring its credit card) 
does not represent an interest equivalent amount, but instead 
represents other types of income, such as compensation for services.
    This comment was rejected. It is true that the income attributable 
to the discount at which a controlled foreign corporation acquires a 
receivable reflects not only the time value of money, but also certain 
other elements (for example, collection risk and cost). However, the 
factoring income derived by the controlled foreign corporation is 
analogous to interest income derived from a loan made by a bank, which 
reflects not only the time value of money, but also the other elements 
of the discount income received in the factoring transaction described 
above. The Tax Reform Act of 1986 repealed the exclusion from foreign 
personal holding company income of such interest income derived by a 
bank. The repeal of this provision indicates that interest income is 
not intended to be excluded from foreign personal holding company 
income merely because it may reflect more than the time value of money. 
Income equivalent to interest should not be treated differently.
    Some of the rules described in the final regulations are 
inconsistent with provisions of Secs. 1.954-3 through 1.954-8, as well 
as the regulations under other provisions of subpart F. In such cases, 
these final regulations are intended to apply instead of the 
regulations under other provisions of section 954 and of subpart F 
generally. Section 1.952-3 is removed because the rules of that section 
are replaced by Sec. 1.954-1. Other conforming changes are being 
considered in a separate regulations project.
    Many nonsubstantive structural and editorial changes were made to 
these final regulations for clarity.

Drafting Information

    The principal authors of these regulations are Valerie Mark and, 
with respect to financial products, Elissa Shendalman of the Office of 
the Associate Chief Counsel (International), IRS. However, personnel 
from other offices of the IRS and Treasury Department participated in 
developing the regulations.

List of Subjects

26 CFR Parts 1 and 4

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1, 4 and 602 are amended to read as 
follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority for part 1 is amended by removing the 
authority citation for ``Section 1.954-0T, 1.954-1T, 1.954-2T and 
1.957-1T'' and adding the following citations in numerical order to 
read as follows:

    Authority: 26 U.S.C. 7805. * * *

    Section 1.954-0 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.954-1 also issued under 26 U.S.C. 954 (b) and (c). 

[[Page 46508]]

    Section 1.954-2 also issued under 26 U.S.C. 954 (b) and (c).
* * * * *
    Section 1.957-1 also issued under 26 U.S.C. 957. * * *


Sec. 1.952-3  [Removed]

    Par. 2. Section 1.952-3 is removed.
    Par. 3. Sections 1.954-0, 1.954-1 and 1.954-2 are added to read as 
follows:


Sec. 1.954-0  Introduction.

    (a) Effective dates--(1) Final regulations--(i) In general. Except 
as otherwise specifically provided, the provisions of Secs. 1.954-1 and 
1.954-2 apply to taxable years of a controlled foreign corporation 
beginning after November 6, 1995. If any of the rules described in 
Secs. 1.954-1 and 1.954-2 are inconsistent with provisions of other 
regulations under subpart F, these final regulations are intended to 
apply instead of such other regulations.
    (ii) Election to apply final regulations retroactively--(A) Scope 
of election. An election may be made to apply the final regulations 
retroactively with respect to any taxable year of the controlled 
foreign corporation beginning on or after January 1, 1987. If such an 
election is made, these final regulations must be applied in their 
entirety for such taxable year and all subsequent taxable years. All 
references to section 11 in the final regulations shall be deemed to 
include section 15, where applicable.
    (B) Manner of making election. An election under this paragraph 
(a)(1)(ii) is binding on all United States shareholders of the 
controlled foreign corporation and must be made--
    (1) By the controlling United States shareholders, as defined in 
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their 
original or amended income tax returns for the taxable year of such 
United States shareholders in which or with which the taxable year of 
the CFC ends, and including any additional information required by 
applicable administrative pronouncements, or
    (2) In such other manner as may be prescribed in applicable 
administrative pronouncements.
    (C) Time for making election. An election may be made under this 
paragraph (a)(1)(ii) with respect to a taxable year of the controlled 
foreign corporation beginning on or after January 1, 1987 only if the 
time for filing a return or claim for refund has not expired for the 
taxable year of any United States shareholder of the controlled foreign 
corporation in which or with which such taxable year of the controlled 
foreign corporation ends.
    (D) Revocation of election. An election made under this paragraph 
(a)(1)(ii) may not be revoked.
    (2) Temporary regulations. The provisions of Secs. 4.954-1 and 
4.954-2 of this chapter apply to taxable years of a controlled foreign 
corporation beginning after December 31, 1986 and on or before November 
6, 1995. However, the provisions of Sec. 4.954-2(b)(6) of this chapter 
continue to apply. For transactions entered into on or before October 
10, 1995, taxpayers may rely on Notice 89-90, 1989-2 C.B. 407, in 
applying the temporary regulations.
    (3) Secs. 1.954A-1 and 1.954A-2. The provisions of Secs. 1.954A-1 
and 1.954A-2 (as contained in 26 CFR part 1 edition revised April 1, 
1995) apply to taxable years of a controlled foreign corporation 
beginning before January 1, 1987. All references therein to sections of 
the Code are to the Internal Revenue Code of 1954 prior to the 
amendments made by the Tax Reform Act of 1986.
    (b) Outline of regulation provisions for sections 954(b)(3), 
954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code.

Sec. 1.954-0  Introduction.
    (a) Effective dates.
    (1) Final regulations.
    (i) In general.
    (ii) Election to apply final regulations retroactively.
    (A) Scope of election.
    (B) Manner of making election.
    (C) Time for making election.
    (D) Revocation of election.
    (2) Temporary regulations.
    (3) Secs. 1.954A-1 and 1.954A-2.
    (b) Outline of regulation provisions for sections 954(b)(3), 
954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code.
Sec. 1.954-1  Foreign base company income.
    (a) In general.
    (1) Purpose and scope.
    (2) Gross foreign base company income.
    (3) Adjusted gross foreign base company income.
    (4) Net foreign base company income.
    (5) Adjusted net foreign base company income.
    (6) Insurance income.
    (7) Additional items of adjusted net foreign base company income 
or adjusted net insurance income by reason of section 952(c).
    (b) Computation of adjusted gross foreign base company income 
and adjusted gross insurance income.
    (1) De minimis and full inclusion tests.
    (i) De minimis test.
    (A) In general.
    (B) Currency translation.
    (C) Coordination with sections 864(d) and 881(c).
    (ii) Seventy percent full inclusion test.
    (2) Character of gross income included in adjusted gross foreign 
base company income.
    (3) Coordination with section 952(c).
    (4) Anti-abuse rule.
    (i) In general.
    (ii) Presumption.
    (iii) Related persons.
    (iv) Example.
    (c) Computation of net foreign base company income.
    (1) General rule.
    (i) Deductions against gross foreign base company income.
    (ii) Losses reduce subpart F income by operation of earnings and 
profits limitation.
    (iii) Items of income.
    (A) Income other than passive foreign personal holding company 
income.
    (B) Passive foreign personal holding company income.
    (2) Computation of net foreign base company income derived from 
same country insurance income.
    (d) Computation of adjusted net foreign base company income or 
adjusted net insurance income.
    (1) Application of high tax exception.
    (2) Effective rate at which taxes are imposed.
    (3) Taxes paid or accrued with respect to an item of income.
    (i) Income other than passive foreign personal holding company 
income.
    (ii) Passive foreign personal holding company income.
    (4) Special rules.
    (i) Consistency rule.
    (ii) Coordination with earnings and profits limitation.
    (iii) Example.
    (5) Procedure.
    (6) Coordination of full inclusion and high tax exception rules.
    (7) Examples.
    (e) Character of income.
    (1) Substance of the transaction.
    (2) Separable character.
    (3) Predominant character.
    (4) Coordination of categories of gross foreign base company 
income or gross insurance income.
    (i) In general.
    (ii) Income excluded from other categories of gross foreign base 
company income.
    (f) Definition of related person.
    (1) Persons related to controlled foreign corporation.
    (i) Individuals.
    (ii) Other persons.
    (2) Control.
    (i) Corporations.
    (ii) Partnerships.
    (iii) Trusts and estates.
    (iv) Direct or indirect ownership.
Sec. 1.954-2  Foreign personal holding company income.
    (a) Computation of foreign personal holding company income.
    (1) Categories of foreign personal holding company income.
    (2) Coordination of overlapping categories under foreign 
personal holding company provisions.
    (i) In general.
    (ii) Priority of categories.
    (3) Changes in the use or purpose for which property is held.
    (i) In general.
    (ii) Special rules. 

[[Page 46509]]

    (A) Anti-abuse rule.
    (B) Hedging transactions.
    (iii) Example.
    (4) Definitions and special rules.
    (i) Interest.
    (ii) Bona fide hedging transaction.
    (A) Definition.
    (B) Identification.
    (C) Effect of identification and non-identification.
    (1) Transactions identified.
    (2) Inadvertent identification.
    (3) Transactions not identified.
    (4) Inadvertent error.
    (5) Anti-abuse rule.
    (iii) Inventory and similar property.
    (A) Definition.
    (B) Hedging transactions.
    (iv) Regular dealer.
    (v) Dealer property.
    (A) Definition.
    (B) Securities dealers.
    (C) Hedging transactions.
    (vi) Examples.
    (vii) Debt instrument.
    (b) Dividends, interest, rents, royalties and annuities.
    (1) In general.
    (2) Exclusion of certain export financing interest.
    (i) In general.
    (ii) Exceptions.
    (iii) Conduct of a banking business.
    (iv) Examples.
    (3) Treatment of tax-exempt interest. [RESERVED.]
    (4) Exclusion of dividends or interest from related persons.
    (i) In general.
    (A) Corporate payor.
    (B) Payment by a partnership.
    (ii) Exceptions.
    (A) Dividends.
    (B) Interest paid out of adjusted foreign base company income or 
insurance income.
    (1) In general.
    (2) Rule for corporations that are both recipients and payors of 
interest.
    (C) Coordination with sections 864(d) and 881(c).
    (iii) Trade or business requirement.
    (iv) Substantial assets test.
    (v) Valuation of assets.
    (vi) Location of tangible property.
    (A) In general.
    (B) Exception.
    (vii) Location of intangible property.
    (A) In general.
    (B) Exception for property located in part in the payor's 
country of incorporation.
    (viii) Location of inventory and dealer property.
    (A) In general.
    (B) Inventory and dealer property located in part in the payor's 
country of incorporation.
    (ix) Location of debt instruments.
    (x) Treatment of certain stock interests.
    (xi) Treatment of banks and insurance companies. [Reserved]
    (5) Exclusion of rents and royalties derived from related 
persons.
    (i) In general.
    (A) Corporate payor.
    (B) Payment by a partnership.
    (ii) Exceptions.
    (A) Rents or royalties paid out of adjusted foreign base company 
income or insurance income.
    (B) Property used in part in the controlled foreign 
corporation's country of incorporation.
    (6) Exclusion of rents and royalties derived in the active 
conduct of a trade or business.
    (c) Excluded rents.
    (1) Active conduct of a trade or business.
    (2) Special rules.
    (i) Adding substantial value.
    (ii) Substantiality of foreign organization.
    (iii) Active leasing expenses.
    (iv) Adjusted leasing profit.
    (3) Examples.
    (d) Excluded royalties.
    (1) Active conduct of a trade or business.
    (2) Special rules.
    (i) Adding substantial value.
    (ii) Substantiality of foreign organization.
    (iii) Active licensing expenses.
    (iv) Adjusted licensing profit.
    (3) Examples.
    (e) Certain property transactions.
    (1) In general.
    (i) Inclusions.
    (ii) Exceptions.
    (iii) Treatment of losses.
    (iv) Dual character property.
    (2) Property that gives rise to certain income.
    (i) In general.
    (ii) Gain or loss from the disposition of a debt instrument.
    (3) Property that does not give rise to income.
    (f) Commodities transactions.
    (1) In general.
    (i) Inclusion in foreign personal holding company income.
    (ii) Exception.
    (iii) Treatment of losses.
    (2) Definitions.
    (i) Commodity.
    (ii) Commodities transaction.
    (iii) Qualified active sale.
    (A) In general.
    (B) Active conduct of a commodities business.
    (C) Substantially all.
    (D) Activities of employees of a related entity.
    (E) Financial activities.
    (iv) Qualified hedging transaction.
    (A) In general.
    (B) Exception.
    (g) Foreign currency gain or loss.
    (1) Scope and purpose.
    (2) In general.
    (i) Inclusion.
    (ii) Exclusion for business needs.
    (A) General rule.
    (B) Business needs.
    (C) Regular dealers.
    (D) Example.
    (iii) Special rule for foreign currency gain or loss from an 
interest-bearing liability.
    (3) Election to characterize foreign currency gain or loss that 
arises from a specific category of subpart F income as gain or loss 
in that category.
    (i) In general.
    (ii) Time and manner of election.
    (iii) Revocation of election.
    (iv) Example.
    (4) Election to treat all foreign currency gains or losses as 
foreign personal holding company income.
    (i) In general.
    (ii) Time and manner of election.
    (iii) Revocation of election.
    (5) Gains and losses not subject to this paragraph.
    (i) Capital gains and losses.
    (ii) Income not subject to section 988.
    (iii) Qualified business units using the dollar approximate 
separate transactions method.
    (iv) Gain or loss allocated under Sec. 1.861-9. [Reserved]
    (h) Income equivalent to interest.
    (1) In general.
    (i) Inclusion in foreign personal holding company income.
    (ii) Exceptions.
    (A) Liability hedging transactions.
    (B) Interest.
    (2) Definition of income equivalent to interest.
    (i) In general.
    (ii) Income from the sale of property.
    (3) Notional principal contracts.
    (i) In general.
    (ii) Regular dealers.
    (4) Income equivalent to interest from factoring.
    (i) General rule.
    (ii) Exceptions.
    (iii) Factored receivable.
    (iv) Examples.
    (5) Receivables arising from performance of services.
    (6) Examples.


Sec. 1.954-1  Foreign base company income.

    (a) In general--(1) Purpose and scope. Section 954 and Secs. 1.954-
1 and 1.954-2 provide rules for computing the foreign base company 
income of a controlled foreign corporation. Foreign base company income 
is included in the subpart F income of a controlled foreign corporation 
under the rules of section 952. Subpart F income is included in the 
gross income of a United States shareholder of a controlled foreign 
corporation under the rules of section 951 and thus is subject to 
current taxation under section 1, 11 or 55 of the Internal Revenue 
Code. The determination of whether a foreign corporation is a 
controlled foreign corporation, the subpart F income of which is 
included currently in the gross income of its United States 
shareholders, is made under the rules of section 957.
    (2) Gross foreign base company income. The gross foreign base 
company income of a controlled foreign corporation consists of the 
following categories of gross income (determined after the application 
of section 952(b))--
    (i) Foreign personal holding company income, as defined in section 
954(c);

[[Page 46510]]

    (ii) Foreign base company sales income, as defined in section 
954(d);
    (iii) Foreign base company services income, as defined in section 
954(e);
    (iv) Foreign base company shipping income, as defined in section 
954(f); and
    (v) Foreign base company oil related income, as defined in section 
954(g).
    (3) Adjusted gross foreign base company income. The term adjusted 
gross foreign base company income means the gross foreign base company 
income of a controlled foreign corporation as adjusted by the de 
minimis and full inclusion rules of paragraph (b) of this section.
    (4) Net foreign base company income. The term net foreign base 
company income means the adjusted gross foreign base company income of 
a controlled foreign corporation reduced so as to take account of 
deductions (including taxes) properly allocable or apportionable to 
such income under the rules of section 954(b)(5) and paragraph (c) of 
this section.
    (5) Adjusted net foreign base company income. The term adjusted net 
foreign base company income means the net foreign base company income 
of a controlled foreign corporation reduced, first, by any items of net 
foreign base company income excluded from subpart F income pursuant to 
section 952(c) and, second, by any items excluded from subpart F income 
pursuant to the high tax exception of section 954(b). See paragraph 
(d)(4)(ii) of this section. The term foreign base company income as 
used in the Internal Revenue Code and elsewhere in the Income Tax 
Regulations means adjusted net foreign base company income, unless 
otherwise provided.
    (6) Insurance income. The term gross insurance income includes all 
gross income taken into account in determining insurance income under 
section 953. The term adjusted gross insurance income means gross 
insurance income as adjusted by the de minimis and full inclusion rules 
of paragraph (b) of this section. The term net insurance income means 
adjusted gross insurance income reduced under section 953 so as to take 
into account deductions (including taxes) properly allocable or 
apportionable to such income. The term adjusted net insurance income 
means net insurance income reduced by any items of net insurance income 
that are excluded from subpart F income pursuant to section 952(b) or 
pursuant to the high tax exception of section 954(b). The term 
insurance income as used in subpart F of the Internal Revenue Code and 
in the regulations under that subpart means adjusted net insurance 
income, unless otherwise provided.
    (7) Additional items of adjusted net foreign base company income or 
adjusted net insurance income by reason of section 952(c). Earnings and 
profits of the controlled foreign corporation that are recharacterized 
as foreign base company income or insurance income under section 952(c) 
are items of adjusted net foreign base company income or adjusted net 
insurance income, respectively. Amounts subject to recharacterization 
under section 952(c) are determined after adjusted net foreign base 
company income and adjusted net insurance income are otherwise 
determined under subpart F and are not again subject to any exceptions 
or special rules that would affect the amount of subpart F income. 
Thus, for example, items of gross foreign base company income or gross 
insurance income that are excluded from adjusted gross foreign base 
company income or adjusted gross insurance income because the de 
minimis test is met are subject to recharacterization under section 
952(c). Further, the de minimis and full inclusion tests of paragraph 
(b) of this section, and the high tax exception of paragraph (d) of 
this section, for example, do not apply to such amounts.
    (b) Computation of adjusted gross foreign base company income and 
adjusted gross insurance income--(1) De minimis and full inclusion 
tests--(i) De minimis test--(A) In general. Except as provided in 
paragraph (b)(1)(i)(C) of this section, adjusted gross foreign base 
company income and adjusted gross insurance income are equal to zero if 
the sum of the gross foreign base company income and the gross 
insurance income of a controlled foreign corporation is less than the 
lesser of--
    (1) 5 percent of gross income; or
    (2) $1,000,000.
    (B) Currency translation. Controlled foreign corporations having a 
functional currency other than the United States dollar shall translate 
the $1,000,000 threshold using the exchange rate provided under section 
989(b)(3) for amounts included in income under section 951(a).
    (C) Coordination with sections 864(d) and 881(c). Adjusted gross 
foreign base company income or adjusted gross insurance income of a 
controlled foreign corporation always includes income from trade or 
service receivables described in section 864(d) (1) or (6), and 
portfolio interest described in section 881(c), even if the de minimis 
test of this paragraph (b)(1)(i) is otherwise satisfied.
    (ii) Seventy percent full inclusion test. Except as provided in 
section 953, adjusted gross foreign base company income consists of all 
gross income of the controlled foreign corporation other than gross 
insurance income and amounts described in section 952(b), and adjusted 
gross insurance income consists of all gross insurance income other 
than amounts described in section 952(b), if the sum of the gross 
foreign base company income and the gross insurance income for the 
taxable year exceeds 70 percent of gross income. See paragraph (d)(6) 
of this section, under which certain items of full inclusion foreign 
base company income may nevertheless be excluded from subpart F income.
    (2) Character of gross income included in adjusted gross foreign 
base company income. The gross income included in the adjusted gross 
foreign base company income of a controlled foreign corporation 
generally retains its character as foreign personal holding company 
income, foreign base company sales income, foreign base company 
services income, foreign base company shipping income, or foreign base 
company oil related income. However, gross income included in adjusted 
gross foreign base company income because the full inclusion test of 
paragraph (b)(1)(ii) of this section is met is termed full inclusion 
foreign base company income, and constitutes a separate category of 
adjusted gross foreign base company income for purposes of allocating 
and apportioning deductions under paragraph (c) of this section.
    (3) Coordination with section 952(c). Income that is included in 
subpart F income because the full inclusion test of paragraph 
(b)(1)(ii) of this section is met does not reduce amounts that, under 
section 952(c), are subject to recharacterization.
    (4) Anti-abuse rule--(i) In general. For purposes of applying the 
de minimis test of paragraph (b)(1)(i) of this section, the income of 
two or more controlled foreign corporations shall be aggregated and 
treated as the income of a single corporation if a principal purpose 
for separately organizing, acquiring, or maintaining such multiple 
corporations is to prevent income from being treated as foreign base 
company income or insurance income under the de minimis test. A purpose 
may be a principal purpose even though it is outweighed by other 
purposes (taken together or separately).
    (ii) Presumption. Two or more controlled foreign corporations are 
presumed to have been organized, acquired or maintained to prevent 
income from being treated as foreign 

[[Page 46511]]
base company income or insurance income under the de minimis test of 
paragraph (b)(1)(i) of this section if the corporations are related 
persons, as defined in paragraph (b)(4)(iii) of this section, and the 
corporations are described in paragraph (b)(4)(ii)(A), (B), or (C) of 
this section. This presumption may be rebutted by proof to the 
contrary.
    (A) The activities carried on by the controlled foreign 
corporations, or the assets used in those activities, are substantially 
the same activities that were previously carried on, or assets that 
were previously held, by a single controlled foreign corporation. 
Further, the United States shareholders of the controlled foreign 
corporations or related persons (as determined under paragraph 
(b)(4)(iii) of this section) are substantially the same as the United 
States shareholders of the one controlled foreign corporation in a 
prior taxable year. A presumption made in connection with the 
requirements of this paragraph (b)(4)(ii)(A) may be rebutted by proof 
that the activities carried on by each controlled foreign corporation 
would constitute a separate branch under the principles of 
Sec. 1.367(a)-6T(g)(2) if carried on directly by a United States 
person.
    (B) The controlled foreign corporations carry on a business, 
financial operation, or venture as partners directly or indirectly in a 
partnership (as defined in section 7701(a)(2) and Sec. 301.7701-3 of 
this chapter) that is a related person (as defined in paragraph 
(b)(4)(iii) of this section) with respect to each such controlled 
foreign corporation.
    (C) The activities carried on by the controlled foreign 
corporations would constitute a single branch operation under 
Sec. 1.367(a)-6T(g)(2) if carried on directly by a United States 
person.
    (iii) Related persons. For purposes of this paragraph (b), two or 
more persons are related persons if they are in a relationship 
described in section 267(b). In determining for purposes of this 
paragraph (b) whether two or more corporations are members of the same 
controlled group under section 267(b)(3), a person is considered to own 
stock owned directly by such person, stock owned with the application 
of section 1563(e)(1), and stock owned with the application of section 
267(c). In determining for purposes of this paragraph (b) whether a 
corporation is related to a partnership under section 267(b)(10), a 
person is considered to own the partnership interest owned directly by 
such person and the partnership interest owned with the application of 
section 267(e)(3).
    (iv) Example. The following example illustrates the application of 
this paragraph (b)(4).

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

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

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

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

[[Page 46512]]
passive) is the aggregate amount from all transactions that falls 
within a single separate category (as defined in Sec. 1.904-5(a)(1)), 
and either--
    (1) Falls within a single category of foreign personal holding 
company income as--
    (i) Dividends, interest, rents, royalties and annuities;
    (ii) Gain from certain property transactions;
    (iii) Gain from commodities transactions;
    (iv) Foreign currency gain; or
    (v) Income equivalent to interest; or
    (2) Falls within a single category of foreign base company income, 
other than foreign personal holding company income, as--
    (i) Foreign base company sales income;
    (ii) Foreign base company services income;
    (iii) Foreign base company shipping income;
    (iv) Foreign base company oil related income; or
    (v) Full inclusion foreign base company income.
    (B) Passive foreign personal holding company income. A single item 
of foreign personal holding company income that is passive is an amount 
of income that falls within a single group of passive income under the 
grouping rules of Sec. 1.904-4(c) (3), (4) and (5) and a single 
category of foreign personal holding company income described in 
paragraphs (c)(1)(iii)(A)(1) (i) through (v).
    (2) Computation of net foreign base company income derived from 
same country insurance income. Deductions relating to foreign base 
company income attributable to the issuing (or reinsuring) of any 
insurance or annuity contract in connection with risks located in the 
country under the laws of which the controlled foreign corporation is 
created or organized shall be allocated and apportioned in accordance 
with the rules set forth in section 953.
    (d) Computation of adjusted net foreign base company income or 
adjusted net insurance income--(1) Application of high tax exception. 
Adjusted net foreign base company income (or adjusted net insurance 
income) equals the net foreign base company income (or net insurance 
income) of a controlled foreign corporation, reduced by any net item of 
such income that qualifies for the high tax exception provided by 
section 954(b)(4) and this paragraph (d). Any item of income that is 
foreign base company oil related income, as defined in section 954(g), 
or portfolio interest, as described in section 881(c), does not qualify 
for the high tax exception. See paragraph (c)(1)(iii) of this section 
for the definition of the term item of income. For rules concerning the 
treatment for foreign tax credit purposes of amounts excluded from 
subpart F under section 954(b)(4), see Sec. 1.904-4(c). A net item of 
income qualifies for the high tax exception only if--
    (i) An election is made under section 954(b)(4) and paragraph 
(d)(5) of this section to exclude the income from the computation of 
subpart F income; and
    (ii) It is established that the net item of income was subject to 
foreign income taxes imposed by a foreign country or countries at an 
effective rate that is greater than 90 percent of the maximum rate of 
tax specified in section 11 for the taxable year of the controlled 
foreign corporation.
    (2) Effective rate at which taxes are imposed. The effective rate 
with respect to a net item of income shall be determined separately for 
each controlled foreign corporation in a chain of corporations through 
which a distribution is made. The effective rate at which taxes are 
imposed on a net item of income is--
    (i) The United States dollar amount of foreign income taxes paid or 
accrued (or deemed paid or accrued) with respect to the net item of 
income, determined under paragraph (d)(3) of this section; divided by
    (ii) The United States dollar amount of the net item of foreign 
base company income or insurance income, described in paragraph 
(c)(1)(iii) of this section, increased by the amount of foreign income 
taxes referred to in paragraph (d)(2)(i) of this section.
    (3) Taxes paid or accrued with respect to an item of income--(i) 
Income other than passive foreign personal holding company income. The 
amount of foreign income taxes paid or accrued with respect to a net 
item of income (other than an item of foreign personal holding company 
income that is passive) for purposes of section 954(b)(4) and this 
paragraph (d) is the United States dollar amount of foreign income 
taxes that would be deemed paid under section 960 with respect to that 
item if that item were included in the gross income of a United States 
shareholder under section 951(a)(1)(A) (determined, in the case of a 
United States shareholder that is an individual, as if an election 
under section 962 has been made, whether or not such election is 
actually made). For this purpose, in accordance with the regulations 
under section 960, the amounts that would be deemed paid under section 
960 shall be determined separately with respect to each controlled 
foreign corporation and without regard to the limitation applicable 
under section 904(a). The amount of foreign income taxes paid or 
accrued with respect to a net item of income, determined in the manner 
provided in this paragraph (d), will not be affected by a subsequent 
reduction in foreign income taxes attributable to a distribution to 
shareholders of all or part of such income.
    (ii) Passive foreign personal holding company income. The amount of 
income taxes paid or accrued with respect to a net item of foreign 
personal holding company income that is passive for purposes of section 
954(b)(4) and this paragraph (d) is the United States dollar amount of 
foreign income taxes that would be deemed paid under section 960 and 
that would be taken into account for purposes applying the provisions 
of Sec. 1.904-4(c) with respect to that net item of income.
    (4) Special rules--(i) Consistency rule. An election to exclude 
income from the computation of subpart F income for a taxable year must 
be made consistently with respect to all items of passive foreign 
personal holding company income eligible to be excluded for the taxable 
year. Thus, high-taxed passive foreign personal holding company income 
of a controlled foreign corporation must either be excluded in its 
entirety, or remain subject to subpart F in its entirety.
    (ii) Coordination with earnings and profits limitation. If the 
amount of income included in subpart F income for the taxable year is 
reduced by the earnings and profits limitation of section 952(c)(1), 
the amount of income that is a net item of income, within the meaning 
of paragraph (c)(1)(iii) of this section, is determined after the 
application of the rules of section 952(c)(1).
    (iii) Example. The following example illustrates the provisions of 
paragraph (d)(4)(ii) of this section. All of the taxes referred to in 
the following example are foreign income taxes. For simplicity, this 
example assumes that the amount of taxes that are taken into account as 
a deduction under section 954(b)(5) and the amount of the gross-up 
required under sections 960 and 78 are equal. Therefore, this example 
does not separately illustrate the deduction for taxes and gross-up.

    Example. During its 1995 taxable year, CFC, a controlled foreign 
corporation, earns $100 of royalty income that is foreign personal 
holding company income. CFC has no expenses associated with this 
royalty income. CFC pays $20 of foreign income taxes with respect to 
the royalty income. For 1995, CFC has current earnings and profits 
of $50. CFC's subpart F income, as determined 

[[Page 46513]]
prior to the application of this paragraph (d), exceeds its current 
earnings and profits. Thus, under paragraph (d)(4)(ii) of this 
section, the amount of CFC's only net item of income, the royalty 
income, will be limited to $50. The remaining $50 will be subject to 
recharacterization in a subsequent taxable year under section 
952(c)(2). Because the amount of foreign income taxes paid with 
respect to this net item of income is $20, the effective rate of tax 
on the item, for purposes of this paragraph (d), is 40 percent. 
Accordingly, an election under paragraph (d)(5) of this section may 
be made to exclude the item of income from the computation of 
subpart F income.

    (5) Procedure. An election made under the procedure provided by 
this paragraph (d)(5) is binding on all United States shareholders of 
the controlled foreign corporation and must be made--
    (i) By the controlling United States shareholders, as defined in 
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their 
original or amended income tax returns, and including any additional 
information required by applicable administrative pronouncements; or
    (ii) In such other manner as may be prescribed in applicable 
administrative pronouncements.
    (6) Coordination of full inclusion and high tax exception rules. 
Notwithstanding paragraph (b)(1)(ii) of this section, full inclusion 
foreign base company income will be excluded from subpart F income if 
more than 90 percent of the adjusted gross foreign base company income 
and adjusted gross insurance company income of a controlled foreign 
corporation (determined without regard to the full inclusion test of 
paragraph (b)(1) of this section) is attributable to net amounts 
excluded from subpart F income pursuant to an election to have the high 
tax exception described in section 954(b)(4) and this paragraph (d) 
apply.
    (7) Examples. (i) The following examples illustrate the rules of 
this paragraph (d). All of the taxes referred to in the following 
examples are foreign income taxes. For simplicity, these examples 
assume that the amount of taxes that are taken into account as a 
deduction under section 954(b)(5) and the amount of the gross-up 
required under sections 960 and 78 are equal. Therefore, these examples 
do not separately illustrate the deduction for taxes and gross-up. 
Except as otherwise stated, these examples assume there are no 
earnings, deficits, or foreign income taxes in the post-1986 pools of 
earnings and profits or foreign income taxes.

    Example 1. (i) Items of income. During its 1995 taxable year, 
controlled foreign corporation CFC earns from outside its country of 
operation portfolio dividend income of $100 and interest income, net 
of taxes, of $100 (consisting of a gross payment of $150 reduced by 
a third-country withholding tax of $50). For purposes of 
illustration, assume that CFC incurs no expenses. None of the income 
is taxed in CFC's country of operation. The dividend income was not 
subject to third-country withholding taxes. Pursuant to the 
operation of section 904, the interest income is high withholding 
tax interest and the dividend income is passive income. Accordingly, 
pursuant to paragraph (c)(1)(iii) of this section, CFC has two net 
items of income--
    (1) $100 of foreign personal holding company (FPHC)/passive 
income (the dividends); and
    (2) $100 of FPHC/high withholding tax income (the interest).
    (ii) Effective rates of tax. No foreign tax would be deemed paid 
under section 960 with respect to the net item of income described 
in paragraph (i)(1) of this Example 1. Therefore, the effective rate 
of foreign tax is 0, and the item may not be excluded from subpart F 
under the rules of this paragraph (d). Foreign tax of $50 would be 
deemed paid under section 960 with respect to the net item of income 
described in paragraph (i)(2) of this Example 1. Therefore, the 
effective rate of foreign tax is 33 percent ($50 of creditable taxes 
paid, divided by $150, consisting of the net item of foreign base 
company income ($100) plus creditable taxes paid thereon ($50)). The 
highest rate of tax specified in section 11 for the 1995 taxable 
year is 34 percent. Accordingly, the net item of income described in 
paragraph (i)(2) of this Example 1 may be excluded from subpart F 
income if an election under paragraph (d)(5) of this section is 
made, since it is subject to foreign tax at an effective rate that 
is greater than 30.6 percent (90 percent of 34 percent). However, 
for purposes of section 904(d), it remains high withholding tax 
interest.
    Example 2. (i) The facts are the same as in Example 1, except 
that CFC's country of operation imposes a tax of $50 with respect to 
CFC's dividend income (and thus CFC earns portfolio dividend income, 
net of taxes, of only $50). The interest income is still high 
withholding tax interest. The dividend income is still passive 
income (without regard to the possible applicability of the high tax 
exception of section 904(d)(2)). Accordingly, CFC has two items of 
income for purposes of this paragraph (d)--
    (1) $50 of FPHC/passive income (net of the $50 foreign tax); and
    (2) $100 of FPHC/high withholding tax interest income.
    (ii) Each item is taxed at an effective rate greater than 30.6 
percent. The net item of income described in paragraph (i)(1) of 
this Example 2: foreign tax ($50) divided by sum ($100) of net item 
of income ($50) plus creditable tax thereon ($50) equals 50 percent. 
The net item of income described in paragraph (i)(2) of this Example 
2: foreign tax ($50) divided by sum ($150) of income item ($100) 
plus creditable tax thereon ($50) equals 33 percent. Accordingly, an 
election may be made under paragraph (d)(5) of this section to 
exclude either or both of the net items of income described in 
paragraphs (i) (1) and (2) of this Example 2 from subpart F income. 
If no election is made the items would be included in the subpart F 
income of CFC.
    Example 3. (i) The facts are the same as in Example 1, except 
that the $100 of portfolio dividend income is subject to a third-
country withholding tax of $50, and the $150 of interest income is 
from sources within CFC's country of operation, is subject to a $10 
income tax therein, and is not subject to a withholding tax. 
Although the interest income and the dividend income are both 
passive income, under paragraph (c)(1)(iii)(B) of this section they 
constitute separate items of income pursuant to the application of 
the grouping rules of Sec. 1.904-4(c). Accordingly, CFC has two net 
items of income for purposes of this paragraph (d)--
    (1) $50 (net of $50 tax) of FPHC/non-country of operation/
greater than 15 percent withholding tax income; and
    (2) $140 (net of $10 tax) of FPHC/country of operation income.
    (ii) The item described in paragraph (i)(1) of this Example 3 is 
taxed at an effective rate greater than 30.6 percent, but Item 2 is 
not. The net item of income described in paragraph (i)(1) of this 
Example 3: Foreign tax ($50) divided by sum ($100) of net item of 
income ($50) plus creditable tax thereon ($50) equals 50 percent. 
The net item of income described in paragraph (i)(2) of this Example 
3: Foreign tax ($10) divided by sum ($150) of net item of income 
($140) plus creditable tax thereon ($10) equals 6.67 percent. 
Therefore, an election may be made under paragraph (d)(5) of this 
section to exclude the net item of income described in paragraph 
(i)(1) of this Example 3 but not the net item of income described in 
paragraph (i)(2) of this Example 3 from subpart F income.
    Example 4. The facts are the same as in Example 3, except that 
the $150 of interest income is subject to an income tax of $50 in 
CFC's country of operation. Accordingly, CFC's items of income are 
the same as in Example 3, but both items are taxed at an effective 
rate greater than 30.6 percent. The net item of income described in 
paragraph (i)(1) of Example 3: Foreign tax ($50) divided by sum 
($100) of net item of income ($50) plus creditable tax thereon ($50) 
equals 50 percent. The net item of income described in paragraph 
(i)(2) of Example 3: Foreign tax ($50) divided by sum ($150) of net 
item of income ($100) plus creditable tax thereon ($50) equals 33 
percent. Pursuant to the consistency rule of paragraph (d)(4)(i) of 
this section, an election made by CFC's controlling United States 
shareholders must exclude from subpart F income both items of FPHC 
income under the high tax exception of section 954(b)(4) and this 
paragraph (d). The election may not be made only with respect to one 
item.
    Example 5. The facts are the same as in Example 1, except that 
CFC earns $5 of portfolio dividend income and $150 of interest 
income. In addition, CFC earns $45 for performing consulting 
services within its country of operation for unrelated persons. 
CFC's gross foreign base company income for 1995 of $155 ($150 of 
gross interest income and $5 of portfolio dividend income) is 

[[Page 46514]]
greater than 70 percent of its gross income of $200. Therefore, under 
the full inclusion test of paragraph (b)(1)(ii) of this section, 
CFC's adjusted gross foreign base company income is $200, and under 
paragraph (b)(2) of this section, the $45 of consulting income is 
full inclusion foreign base company income. If CFC elects, under 
paragraph (d)(5) of this section, to exclude the interest income 
from subpart F income pursuant to the high tax exception, the $45 of 
full inclusion foreign base company income will be excluded from 
subpart F income under paragraph (d)(6) of this section because the 
$150 of gross interest income excluded under the high tax exception 
is more than 90 percent of CFC's adjusted gross foreign base company 
income of $155.


    (ii) The following examples generally illustrate the application of 
paragraph (c) of this section and this paragraph (d). Example 1 
illustrates the order of computations. Example 2 illustrates the 
computations required by sections 952 and 954 and this Sec. 1.954-1 if 
the full inclusion test of paragraph (b)(1)(ii) of this section is met 
and the income is not excluded from subpart F income under section 
952(b). Computations in these examples involving the operation of 
section 952(c) are included for purposes of illustration only and do 
not provide substantive rules concerning the operation of that section. 
For simplicity, these examples assume that the amount of taxes that are 
taken into account as a deduction under section 954(b)(5) and the 
amount of the gross-up required under sections 960 and 78 are equal. 
Therefore, these examples do not separately illustrate the deduction 
for taxes and gross-up.


    Example 1. (i) Gross income. CFC, a controlled foreign 
corporation, has gross income of $1000 for the current taxable year. 
Of that $1000 of income, $100 is interest income that is included in 
the definition of foreign personal holding company income under 
section 954(c)(1)(A) and Sec. 1.954-2(b)(1)(ii), is not income from 
a trade or service receivable described in section 864(d)(1) or (6), 
or portfolio interest described in section 881(c), and is not 
excluded from foreign personal holding company income under any 
provision of section 952(b) or section 954(c). Another $50 is 
foreign base company sales income under section 954(d). The 
remaining $850 of gross income is not included in the definition of 
foreign base company income or insurance income under sections 954 
(c), (d), (e), (f) or (g) or 953, and is foreign source general 
limitation income described in section 904(d)(1)(I).
     (ii) Expenses. For the current taxable year, CFC has expenses 
of $500. This amount includes $8 of interest paid to a related 
person that is allocable to foreign personal holding company income 
under section 904, and $2 of other expense that is directly related 
to foreign personal holding company income. Another $20 of expense 
is directly related to foreign base company sales. The remaining 
$470 of expenses is allocable to general limitation income that is 
not foreign base company income or insurance income.
     (iii) Earnings and losses. CFC has earnings and profits for the 
current taxable year of $500. In the prior taxable year, CFC had 
losses with respect to income other than gross foreign base company 
income or gross insurance income. By reason of the limitation 
provided under section 952(c)(1)(A), those losses reduced the 
subpart F income (consisting entirely of foreign source general 
limitation income) of CFC by $600 for the prior taxable year.
     (iv) Taxes. Foreign income tax of $30 is considered imposed on 
the interest income under the rules of section 954(b)(4), this 
paragraph (d), and Sec. 1.904-6. Foreign income tax of $14 is 
considered imposed on the foreign base company sales income under 
the rules of section 954(b)(4), paragraph (d) of this section, and 
Sec. 1.904-6. Foreign income tax of $177 is considered imposed on 
the remaining foreign source general limitation income under the 
rules of section 954(b)(4), this paragraph (d), and Sec. 1.904-6. 
For the taxable year of CFC, the maximum United States rate of 
taxation under section 11 is 34 percent.
    (v) Conclusion. Based on these facts, if CFC elects to exclude 
all items of income subject to a high foreign tax under section 
954(b)(4) and this paragraph (d), it will have $500 of subpart F 
income as defined in section 952(a) (consisting entirely of foreign 
source general limitation income) determined as follows:

Step 1--Determine gross income:                                         
  (1) Gross income.............................................    $1000
Step 2--Determine gross foreign base company income and gross           
 insurance income:                                                      
  (2) Interest income included in gross foreign personal                
   holding company income under section 954(c).................      100
  (3) Gross foreign base company sales income under section             
   954(d)......................................................       50
  (4) Total gross foreign base company income and gross                 
   insurance income as defined in sections 954 (c), (d), (e),           
   (f) and (g) and 953 (line (2) plus line (3))................      150
Step 3--Compute adjusted gross foreign base company income and          
 adjusted gross insurance income:                                       
  (5) Five percent of gross income (.05  x  line (1))..........       50
  (6) Seventy percent of gross income (.70  x  line (1)).......      700
  (7) Adjusted gross foreign base company income and adjusted           
   gross insurance income after the application of the de               
   minimis test of paragraph (b) (line (4), or zero if line (4)         
   is less than the lesser of line (5) or $1,000,000) (if the           
   amount on this line 7 is zero, proceed to Step 8)...........      150
  (8) Adjusted gross foreign base company income and adjusted           
   gross insurance income after the application of the full             
   inclusion test of paragraph (b) (line (4), or line (1) if            
   line (4) is greater than line (6))..........................      150
Step 4--Compute net foreign base company income:                        
  (9) Expenses directly related to adjusted gross foreign base          
   company sales income........................................       20
  (10) Expenses (other than related person interest expense)            
   directly related to adjusted gross foreign personal holding          
   company income..............................................        2
  (11) Related person interest expense allocable to adjusted            
   gross foreign personal holding company income under section          
   904.........................................................        8
  (12) Net foreign personal holding company income after                
   allocating deductions under section 954(b)(5) and paragraph          
   (c) of this section (line (2) reduced by lines (10) and              
   (11)).......................................................       90
  (13) Net foreign base company sales income after allocating           
   deductions under section 954(b)(5) and paragraph (c) of this         
   section (line (3) reduced by line (9))......................       30
  (14) Total net foreign base company income after allocating           
   deductions under section 954(b)(5) and paragraph (c) of this         
   section (line (12) plus line (13))..........................      120
Step 5--Compute net insurance income:                                   
  (15) Net insurance income under section 953..................        0
Step 6--Compute adjusted net foreign base company income:               
  (16) Foreign income tax imposed on net foreign personal               
   holding company income (as determined under section                  
   954(b)(4) and this paragraph (d))...........................       30
  (17) Foreign income tax imposed on net foreign base company           
   sales income (as determined under section 954(b)(4) and this         
   paragraph (d))..............................................       14
  (18) Ninety percent of the maximum United States corporate            
   tax rate....................................................    30.6%
  (19) Effective rate of foreign income tax imposed on net              
   foreign personal holding company income ($90 of interest)            
   under section 954(b)(4) and this paragraph (d) (line (16)            
   divided by line (12)).......................................      33%
  (20) Effective rate of foreign income tax imposed on $30 of           
   net foreign base company sales income under section                  
   954(b)(4) and this paragraph (d) (line (17) divided by line          
   (13)).......................................................     47% 

[[Page 46515]]
                                                                        
  (21) Net foreign personal holding company income subject to a         
   high foreign tax under section 954(b)(4) and this paragraph          
   (d) (zero, or line (12) if line (19) is greater than line            
   (18)).......................................................       90
  (22) Net foreign base company sales income subject to a high          
   foreign tax under section 954(b)(4) and this paragraph (d)           
   (zero, or line (13) if line (20) is greater than line (18)).       30
  (23) Adjusted net foreign base company income after applying          
   section 954(b)(4) and this paragraph (d) (line (14), reduced         
   by the sum of line (21) and line (22))......................        0
Step 7--Compute adjusted net insurance income:                          
  (24) Adjusted net insurance income...........................        0
Step 8--Additions to or reduction of adjusted net foreign base          
 company income by reason of section 952(c):                            
  (25) Earnings and profits for the current year...............      500
  (26) Amount subject to being recharacterized as subpart F             
   income under section 952(c)(2) (excess of line (25) over the         
   sum of lines (23) and (24)); if there is a deficit, then the         
   limitation of section 952(c)(1) may apply for the current            
   year........................................................      500
  (27) Amount of reduction in subpart F income for prior                
   taxable years by reason of the limitation of section                 
   952(c)(1)...................................................      600
  (28) Subpart F income as defined in section 952(a), assuming          
   section 952(a)(3), (4), and (5) do not apply (the sum of             
   line (23), line (24), and the lesser of line (26) or line            
   (27)).......................................................      500
  (29) Amount of prior year's deficit to be recharacterized as          
   subpart F income in later years under section 952(c) (excess         
   of line (27) over line (26).................................      100
                                                                        


    Example 2. (i) Gross income. CFC, a controlled foreign 
corporation, has gross income of $1000 for the current taxable year. 
Of that $1000 of income, $720 is interest income that is included in 
the definition of foreign personal holding company income under 
section 954(c) (1)(A) and Sec. 1.954-2(b)(1)(ii), is not income from 
trade or service receivables described in section 864(d)(1) or (6), 
or portfolio interest described in section 881(c), and is not 
excluded from foreign personal holding company income under any 
provision of section 954(c) and Sec. 1.954-2 or section 952(b). The 
remaining $280 is services income that is not included in the 
definition of foreign base company income or insurance income under 
sections 954 (c), (d), (e), (f), or (g) or 953, and is foreign 
source general limitation income for purposes of section 
904(d)(1)(I).
    (ii) Expenses. For the current taxable year, CFC has expenses of 
$650. This amount includes $350 of interest paid to related persons 
that is allocable to foreign personal holding company income under 
section 904, and $50 of other expense that is directly related to 
foreign personal holding company income. The remaining $250 of 
expenses is allocable to services income other than foreign base 
company income or insurance income.
    (iii) Earnings and losses. CFC has earnings and profits for the 
current taxable year of $350. In the prior taxable year, CFC had 
losses with respect to income other than foreign base company income 
or insurance income. By reason of the limitation provided under 
section 952(c)(1)(A), those losses reduced the subpart F income of 
CFC (consisting entirely of foreign source general limitation 
income) by $600 for the prior taxable year.
    (iv) Taxes. Foreign income tax of $120 is considered imposed on 
the $720 of interest income under the rules of section 954(b)(4), 
paragraph (d) of this section, and Sec. 1.904-6. Foreign income tax 
of $2 is considered imposed on the services income under the rules 
of section 954(b)(4), paragraph (d) of this section, and Sec. 1.904-
6. For the taxable year of CFC, the maximum United States rate of 
taxation under section 11 is 34 percent.
    (v) Conclusion. Based on these facts, if CFC elects to exclude 
all items of income subject to a high foreign tax under section 
954(b)(4) and this paragraph (d), it will have $350 of subpart F 
income as defined in section 952(a), determined as follows.

Step 1--Determine gross income:                                         
  (1) Gross income.............................................    $1000
Step 2--Determine gross foreign base company income and gross           
 insurance income:                                                      
  (2) Gross foreign base company income and gross insurance             
   income as defined in sections 954 (c), (d), (e), (f) and (g)         
   and 953 (interest income)...................................      720
Step 3--Compute adjusted gross foreign base company income and          
 adjusted gross insurance income:                                       
  (3) Seventy percent of gross income (.70  x  line (1)).......      700
  (4) Adjusted gross foreign base company income and adjusted           
   gross insurance income after the application of the full             
   inclusion rule of this paragraph (b)(1) (line (2), or line           
   (1) if line (2) is greater than line (3))...................     1000
  (5) Full inclusion foreign base company income under                  
   paragraph (b)(1)(ii) (line (4) minus line (2))..............      280
Step 4--Compute net foreign base company income:                        
  (6) Expenses (other than related person interest expense)             
   directly related to adjusted gross foreign personal holding          
   company income..............................................       50
  (7) Related person interest expense allocable to adjusted             
   gross foreign personal holding company income under section          
   904.........................................................      350
  (8) Deductions allocable to full inclusion foreign base               
   company income under section 954(b)(5) and paragraph (c) of          
   this section................................................      250
  (9) Net foreign personal holding company income after                 
   allocating deductions under section 954(b)(5) and paragraph          
   (c) of this section (line (2) reduced by line (6) and line           
   (7))........................................................      320
  (10) Full inclusion foreign base company income after                 
   allocating deductions under section 954(b)(5) and paragraph          
   (c) of this section (line (5) reduced by line (8))..........       30
  (11) Total net foreign base company income after allocating           
   deductions under section 954(b)(5) and paragraph (c) of this         
   section (line (9) plus line (10))...........................      350
Step 5--Compute net insurance income:                                   
  (12) Net insurance income under section 953..................        0
Step 6--Compute adjusted net foreign base company income:               
  (13) Foreign income tax imposed on net foreign personal               
   holding company income (interest)...........................      120
  (14) Foreign income tax imposed on net full inclusion foreign         
   base company income.........................................        2
  (15) Ninety percent of the maximum United States corporate            
   tax rate....................................................    30.6%
  (16) Effective rate of foreign income tax imposed on $320 of          
   net foreign personal holding company income under section            
   954(b)(4) and this paragraph (d) (line (13) divided by line          
   (9))........................................................      38%
  (17) Effective rate of foreign income tax imposed on $30 of           
   net full inclusion foreign base company income under section         
   954(b)(4) and this paragraph (d) (line (14) divided by line          
   (10)).......................................................       7%
  (18) Net foreign personal holding company income subject to a         
   high foreign tax under section 954(b)(4) and this paragraph          
   (d) (zero, or line (9) if line (16) is greater than line             
   (15)).......................................................      320
  (19) Net full inclusion foreign base company income subject           
   to a high foreign tax under section 954(b)(4) and this               
   paragraph (d) (zero, or line (10) if line (17) is greater            
   than line (15)).............................................        0
  (20) Adjusted net foreign base company income after applying          
   section 954(b)(4) and this paragraph (d) (line (11) reduced          
   by the sum of line (18) and line (19))......................       30
Step 7--Compute adjusted net insurance income:                          
  (21) Adjusted net insurance income...........................        0

[[Page 46516]]
                                                                        
Step 8--Reduction of adjusted net foreign base company income           
 or adjusted net insurance income by reason of paragraph (d)(6)         
 of this section:                                                       
  (22) Adjusted gross foreign base company income and adjusted          
   gross insurance income (determined without regard to the             
   full inclusion test of paragraph (b)(1) of this section)             
   (line (4) reduced by line (5))..............................      720
  (23) Ninety percent of adjusted gross foreign base company            
   income and adjusted gross insurance income (determined               
   without regard to the full inclusion test of paragraph               
   (b)(1)(ii) of this section) (90% of the amount on line (22))      648
  (24) Net foreign base company income and net insurance income         
   excluded from subpart F income under section 954(b)(4),              
   increased by the amount of expenses that reduced this income         
   under section 954(b)(5) and paragraph (c) of this section            
   (line (18) increased by the sum of line (6) and line (7))...      720
  (25) Adjusted net full inclusion foreign base company income          
   excluded from subpart F income under paragraph (d)(6) of             
   this section (zero, or line (10) reduced by line (19) if             
   line (24) is greater than line (23))........................       30
  (26) Adjusted net foreign base company income after                   
   application of paragraph (d)(6) of this section (line (20)           
   reduced by line (25)).......................................        0
Step 9--Additions to or reduction of subpart F income by reason         
 of section 952(c):                                                     
  (27) Earnings and profits for the current year...............      350
  (28) Amount subject to being recharacterized as subpart F             
   income under section 952(c)(2) (excess of line (27) over the         
   sum of line (21) and line (26)); if there is a deficit, then         
   the limitation of 952(c)(1) may apply for the current year..      350
  (29) Amount of reduction in subpart F income for prior                
   taxable years by reason of the limitation of section                 
   952(c)(1)...................................................      600
  (30) Subpart F income as defined in section 952(a), assuming          
   section 952(a) (3), (4), and (5) do not apply (the sum of            
   line (21) and line (26) plus the lesser of line (28) or line         
   (29)).......................................................      350
  (31) Amount of prior years' deficit remaining to be                   
   recharacterized as subpart F income in later years under             
   section 952(c) (excess of line (29) over line (28)).........      250
                                                                        


    (e) Character of income--(1) Substance of the transaction. For 
purposes of section 954, income shall be characterized in accordance 
with the substance of the transaction, and not in accordance with the 
designation applied by the parties to the transaction. For example, an 
amount that is designated as rent by the taxpayer but actually 
constitutes income from the sale of property, royalties, or income from 
services shall not be characterized as rent but shall be characterized 
as income from the sale of property, royalties or income from services, 
as the case may be. Local law shall not be controlling in 
characterizing income.
    (2) Separable character. To the extent the definitional provisions 
of section 953 or 954 describe the income or gain derived from a 
transaction, or any portion or portions thereof, that income or gain, 
or portion or portions thereof, is so characterized for purposes of 
subpart F. Thus, a single transaction may give rise to income in more 
than one category of foreign base company income described in paragraph 
(a)(2) of this section. For example, if a controlled foreign 
corporation, in its business of purchasing personal property and 
selling it to related persons outside its country of incorporation, 
also performs services outside its country of incorporation with 
respect to the property it sells, the sales income will be treated as 
foreign base company sales income and the services income will be 
treated as foreign base company services income for purposes of these 
rules.
    (3) Predominant character. The portion of income or gain derived 
from a transaction that is included in the computation of foreign 
personal holding company income is always separately determinable and 
thus must always be segregated from other income and separately 
classified under paragraph (e)(2) of this section. However, the portion 
of income or gain derived from a transaction that would meet a 
particular definitional provision under section 954 or 953 (other than 
the definition of foreign personal holding company income) in unusual 
circumstances may not be separately determinable. If such portion is 
not separately determinable, it must be classified in accordance with 
the predominant character of the transaction. For example, if a 
controlled foreign corporation engineers, fabricates, and installs a 
fixed offshore drilling platform as part of an integrated transaction, 
and the portion of income that relates to services is not accounted for 
separately from the portion that relates to sales, and is otherwise not 
separately determinable, then the classification of income from the 
transaction shall be made in accordance with the predominant character 
of the arrangement.
     (4) Coordination of categories of gross foreign base company 
income or gross insurance income--(i) In general. The computations of 
gross foreign base company income and gross insurance income are 
limited by the following rules:
    (A) If income is foreign base company shipping income, pursuant to 
section 954(f), it shall not be considered insurance income or income 
in any other category of foreign base company income.
    (B) If income is foreign base company oil related income, pursuant 
to section 954(g), it shall not be considered insurance income or 
income in any other category of foreign base company income, except as 
provided in paragraph (e)(4)(i)(A) of this section.
    (C) If income is insurance income, pursuant to section 953, it 
shall not be considered income in any category of foreign base company 
income except as provided in paragraph (e)(4)(i) (A) or (B) of this 
section.
    (D) If income is foreign personal holding company income, pursuant 
to section 954(c), it shall not be considered income in any other 
category of foreign base company income, other than as provided in 
paragraph (e)(4)(i) (A), (B) or (C) of this section.
    (ii) Income excluded from other categories of gross foreign base 
company income. Income shall not be excluded from a category of gross 
foreign base company income or gross insurance income under this 
paragraph (e)(4) by reason of being included in another category of 
gross foreign base company income or gross insurance income, if the 
income is excluded from that other category by a more specific 
provision of section 953 or 954. For example, income derived from a 
commodity transaction that is excluded from foreign personal holding 
company income under Sec. 1.954-2(f) as income from a qualified active 
sale may be included in gross foreign base company income if it also 
meets the definition of foreign base company sales income. See 
Sec. 1.954-2(a)(2) for the coordination of overlapping categories 
within the definition of foreign personal holding company income.
    (f) Definition of related person--(1) Persons related to controlled 
foreign corporation. Unless otherwise provided, for purposes of section 
954 and Secs. 1.954-1 through 1.954-8 inclusive, the following persons 
are considered under section 954(d)(3) to be related persons with 
respect to a controlled foreign corporation: 

[[Page 46517]]

    (i) Individuals. An individual, whether or not a citizen or 
resident of the United States, who controls the controlled foreign 
corporation.
    (ii) Other persons. A foreign or domestic corporation, partnership, 
trust or estate that controls or is controlled by the controlled 
foreign corporation, or is controlled by the same person or persons 
that control the controlled foreign corporation.
    (2) Control--(i) Corporations. With respect to a corporation, 
control means the ownership, directly or indirectly, of stock 
possessing more than 50 percent of the total voting power of all 
classes of stock entitled to vote or of the total value of the stock of 
the corporation.
    (ii) Partnerships. With respect to a partnership, control means the 
ownership, directly or indirectly, of more than 50 percent (by value) 
of the capital or profits interest in the partnership.
    (iii) Trusts and estates. With respect to a trust or estate, 
control means the ownership, directly or indirectly, of more than 50 
percent (by value) of the beneficial interest in the trust or estate.
    (iv) Direct or indirect ownership. For purposes of this paragraph 
(f), to determine direct or indirect ownership, the principles of 
section 958(a) shall be applied without regard to whether a 
corporation, partnership, trust or estate is foreign or domestic or 
whether or not an individual is a citizen or resident of the United 
States.


Sec. 1.954-2  Foreign personal holding company income.

    (a) Computation of foreign personal holding company income--(1) 
Categories of foreign personal holding company income. For purposes of 
subpart F and the regulations under that subpart, foreign personal 
holding company income consists of the following categories of income--
    (i) Dividends, interest, rents, royalties, and annuities as 
described in paragraph (b) of this section;
    (ii) Gain from certain property transactions as described in 
paragraph (e) of this section;
    (iii) Gain from commodities transactions as described in paragraph 
(f) of this section;
    (iv) Foreign currency gain as described in paragraph (g) of this 
section; and
    (v) Income equivalent to interest as described in paragraph (h) of 
this section.
    (2) Coordination of overlapping categories under foreign personal 
holding company provisions--(i) In general. If any portion of income, 
gain or loss from a transaction is described in more than one category 
of foreign personal holding company income (as described in paragraph 
(a)(2)(ii) of this section), that portion of income, gain or loss is 
treated solely as income, gain or loss from the category of foreign 
personal holding company income with the highest priority.
    (ii) Priority of categories. The categories of foreign personal 
holding company income, listed from highest priority (paragraph 
(a)(2)(ii)(A) of this section) to lowest priority (paragraph 
(a)(2)(ii)(E) of this section), are--
    (A) Dividends, interest, rents, royalties, and annuities, as 
described in paragraph (b) of this section;
    (B) Income equivalent to interest, as described in paragraph (h) of 
this section without regard to the exceptions in paragraph 
(h)(1)(ii)(A) of this section;
    (C) Foreign currency gain or loss, as described in paragraph (g) of 
this section without regard to the exclusion in paragraph (g)(2)(ii) of 
this section;
    (D) Gain or loss from commodities transactions, as described in 
paragraph (f) of this section without regard to the exclusion in 
paragraph (f)(1)(ii) of this section; and
    (E) Gain or loss from certain property transactions, as described 
in paragraph (e) of this section without regard to the exceptions in 
paragraph (e)(1)(ii) of this section.
    (3) Changes in the use or purpose for which property is held--(i) 
In general. Under paragraphs (e), (f), (g) and (h) of this section, 
transactions in certain property give rise to gain or loss included in 
the computation of foreign personal holding company income if the 
controlled foreign corporation holds that property for a particular use 
or purpose. The use or purpose for which property is held is that use 
or purpose for which it was held for more than one- half of the period 
during which the controlled foreign corporation held the property prior 
to the disposition.
    (ii) Special rules--(A) Anti-abuse rule. If a principal purpose of 
a change in use or purpose of property was to avoid including gain or 
loss in the computation of foreign personal holding company income, all 
the gain or loss from the disposition of the property is treated as 
foreign personal holding company income. A purpose may be a principal 
purpose even though it is outweighed by other purposes (taken together 
or separately).
    (B) Hedging transactions. The provisions of paragraph (a)(3)(i) of 
this section shall not apply to bona fide hedging transactions, as 
defined in paragraph (a)(4)(ii) of this section. A transaction will be 
treated as a bona fide hedging transaction only so long as it satisfies 
the requirements of paragraph (a)(4)(ii) of this section.
    (iii) Example. The following example illustrates the application of 
this paragraph (a)(3).

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

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

[[Page 46518]]
currency transactions, see paragraph (g)(2)(ii)(D) of this section.
    (B) Identification. The identification requirements of this section 
shall be satisfied if the taxpayer meets the identification and 
recordkeeping requirements of Sec. 1.1221-2(e). However, for bona fide 
hedging transactions entered into prior to March 7, 1996 the 
identification and recordkeeping requirements of Sec. 1.1221-2 shall 
not apply. Rather, for bona fide hedging transactions entered into on 
or after July 22, 1988 and prior to March 7, 1996 the identification 
and recordkeeping requirements shall be satisfied if such transactions 
are identified by the close of the fifth day after the day on which 
they are entered into. For bona fide hedging transactions entered into 
prior to July 22, 1988, the identification and recordkeeping 
requirements shall be satisfied if such transactions are identified 
reasonably contemporaneously with the date they are entered into, but 
no later than within the normal period prescribed under the method of 
accounting of the controlled foreign corporation used for financial 
reporting purposes.
    (C) Effect of identification and non-identification--(1) 
Transactions identified. If a taxpayer identifies a transaction as a 
bona fide hedging transaction for purposes of this section, the 
identification is binding with respect to any loss arising from such 
transaction whether or not all of the requirements of paragraph 
(a)(4)(ii)(A) of this section are satisfied. Accordingly, such loss 
will be allocated against income that is not subpart F income (or, in 
the case of an election under paragraph (g)(3) of this section, against 
the category of subpart F income to which it relates) and apportioned 
among the categories of income described in section 904(d)(1). If the 
transaction is not in fact a bona fide hedging transaction described in 
paragraph (a)(4)(ii)(A) of this section, however, then any gain 
realized with respect to such transaction shall not be considered as 
gain from a bona fide hedging transaction. Accordingly, such gain shall 
be treated as gain from the appropriate category of foreign personal 
holding company income. Thus, the taxpayer's identification of the 
transaction as a hedging transaction does not itself operate to exclude 
gain from the appropriate category of foreign personal holding company 
income.
    (2) Inadvertent identification. Notwithstanding paragraph 
(a)(4)(ii)(C)(1) of this section, if the taxpayer identifies a 
transaction as a bona fide hedging transaction for purposes of this 
section, the characterization of the loss is determined as if the 
transaction had not been identified as a bona fide hedging transaction 
if--
    (i) The transaction is not a bona fide hedging transaction (as 
defined in paragraph (a)(4)(ii)(A) of this section);
    (ii) The identification of the transaction as a bona fide hedging 
transaction was due to inadvertent error; and
    (iii) All of the taxpayer's transactions in all open years are 
being treated on either original or, if necessary, amended returns in a 
manner consistent with the principles of this section.
    (3) Transactions not identified. Except as provided in paragraphs 
(a)(4)(ii)(C) (4) and (5) of this section, the absence of an 
identification that satisfies the requirements of paragraph 
(a)(4)(ii)(B) of this section is binding and establishes that a 
transaction is not a bona fide hedging transaction. Thus, subject to 
the exceptions, the characterization of gain or loss is determined 
without reference to whether the transaction is a bona fide hedging 
transaction.
    (4) Inadvertent error. If a taxpayer does not make an 
identification that satisfies the requirements of paragraph 
(a)(4)(ii)(B) of this section, the taxpayer may treat gain or loss from 
the transaction as gain or loss from a bona fide hedging transaction 
if--
    (i) The transaction is a bona fide hedging transaction (as defined 
in paragraph (a)(4)(ii)(A) of this section);
    (ii) The failure to identify the transaction was due to inadvertent 
error; and
    (iii) All of the taxpayer's bona fide hedging transactions in all 
open years are being treated on either original or, if necessary, 
amended returns as bona fide hedging transactions in accordance with 
the rules of this section.
    (5) Anti-abuse rule. If a taxpayer does not make an identification 
that satisfies all the requirements of paragraph (a)(4)(ii)(B) of this 
section but the taxpayer has no reasonable grounds for treating the 
transaction as other than a bona fide hedging transaction, then loss 
from the transaction shall be treated as realized with respect to a 
bona fide hedging transaction. Thus, a taxpayer may not elect to 
exclude loss from its proper characterization as a bona fide hedging 
transaction. The reasonableness of the taxpayer's failure to identify a 
transaction is determined by taking into consideration not only the 
requirements of paragraph (a)(4)(ii)(A) of this section but also the 
taxpayer's treatment of the transaction for financial accounting or 
other purposes and the taxpayer's identification of similar 
transactions as hedging transactions.
    (iii) Inventory and similar property--(A) Definition. The term 
inventory and similar property (or inventory or similar property) means 
property that is stock in trade of the controlled foreign corporation 
or other property of a kind that would properly be included in the 
inventory of the controlled foreign corporation if on hand at the close 
of the taxable year (if the controlled foreign corporation were a 
domestic corporation), or property held by the controlled foreign 
corporation primarily for sale to customers in the ordinary course of 
its trade or business.
    (B) Hedging transactions. A bona fide hedging transaction with 
respect to inventory or similar property (other than a transaction 
described in section 988(c)(1) without regard to section 
988(c)(1)(D)(i)) shall be treated as a transaction in inventory or 
similar property.
    (iv) Regular dealer. The term regular dealer means a controlled 
foreign corporation that--
    (A) Regularly and actively offers to, and in fact does, purchase 
property from and sell property to customers who are not related 
persons (as defined in section 954(d)(3)) with respect to the 
controlled foreign corporation in the ordinary course of a trade or 
business; or
    (B) Regularly and actively offers to, and in fact does, enter into, 
assume, offset, assign or otherwise terminate positions in property 
with customers who are not related persons (as defined in section 
954(d)(3)) with respect to the controlled foreign corporation in the 
ordinary course of a trade or business.
    (v) Dealer property--(A) Definition. Property held by a controlled 
foreign corporation is dealer property if--
    (1) The controlled foreign corporation is a regular dealer in 
property of such kind (determined under paragraph (a)(4)(iv) of this 
section); and
    (2) The property is held by the controlled foreign corporation in 
its capacity as a dealer in property of such kind without regard to 
whether the property arises from a transaction with a related person 
(as defined in section 954(d)(3)) with respect to the controlled 
foreign corporation. The property is not held by the controlled foreign 
corporation in its capacity as a dealer if the property is held for 
investment or speculation on its own behalf or on behalf of a related 
person (as defined in section 954(d)(3)).
    (B) Securities dealers. If a controlled foreign corporation is a 
licensed securities dealer, only the securities that it has identified 
as held for investment in accordance with the provisions of section 
475(b) or section 1236 will be 

[[Page 46519]]
considered to be property held for investment or speculation under this 
section. A licensed securities dealer is a controlled foreign 
corporation that is both a securities dealer, as defined in section 
475, and a regular dealer, as defined in paragraph (a)(4)(iv) of this 
section, and that is either--
    (1) registered as a securities dealer under section 15(a) of the 
Securities Exchange Act of 1934 or as a Government securities dealer 
under section 15C(a) of such Act; or
    (2) licensed or authorized in the country in which it is chartered, 
incorporated, or organized to purchase and sell securities from or to 
customers who are residents of that country. The conduct of such 
securities activities must be subject to bona fide regulation, 
including appropriate reporting, monitoring, and prudential (including 
capital adequacy) requirements, by a securities regulatory authority in 
that country that regularly enforces compliance with such requirements 
and prudential standards.
    (C) Hedging transactions. A bona fide hedging transaction with 
respect to dealer property shall be treated as a transaction in dealer 
property.
    (vi) Examples. The following examples illustrate the application of 
paragraphs (a)(4)(ii), (iv) and (v) of this section.

    Example 1. (i) CFC1 and CFC2 are related controlled foreign 
corporations (within the meaning of section 954(d)(3)) located in 
Countries F and G, respectively. CFC1 and CFC2 regularly purchase 
securities from and sell securities to customers who are not related 
persons with respect to CFC1 or CFC2 (within the meaning of section 
954(d)(3)) in the ordinary course of their businesses and regularly 
and actively hold themselves out as being willing to, and in fact 
do, enter into either side of options, forward contracts, or other 
financial instruments. CFC1 uses securities that are traded in 
securities markets in Country G to hedge positions that it enters 
into with customers located in Country F. CFC1 is not a member of a 
securities exchange in Country G, so it purchases such securities 
from CFC2 and unrelated persons that are registered as securities 
dealers in Country G and that are members of Country G securities 
exchanges. Such hedging transactions qualify as bona fide hedging 
transactions under paragraph (a)(4)(ii) of this section.
    (ii) Transactions that CFC1 and CFC2 enter into with each other 
do not affect the determination of whether they are regular dealers. 
Because CFC1 and CFC2 regularly purchase securities from and sell 
securities to customers who are not related persons within the 
meaning of section 954(d)(3) in the ordinary course of their 
businesses and regularly and actively hold themselves out as being 
willing to, and in fact do, enter into either side of options, 
forward contracts, or other financial instruments, however, they 
qualify as regular dealers in such property within the meaning of 
paragraph (a)(4)(iv) of this section. Moreover, because CFC1 
purchases securities from CFC2 as bona fide hedging transactions 
with respect to dealer property, the securities are dealer property 
under paragraph (a)(4)(v)(C) of this section. Similarly, because 
CFC2 sells securities to CFC1 in the ordinary course of its business 
as a dealer, the securities are dealer property under paragraph 
(a)(4)(v)(A) of this section.
    Example 2. (i) CFC is a controlled foreign corporation located 
in Country B. CFC serves as the currency coordination center for the 
controlled group, aggregating currency risks incurred by the group 
and entering into hedging transactions that transfer those risks 
outside of the group. CFC regularly and actively holds itself out as 
being willing to, and in fact does, enter into either side of 
options, forward contracts, or other financial instruments with 
other members of the same controlled group. CFC hedges risks arising 
from such transactions by entering into transactions with persons 
who are not related persons (within the meaning of section 
954(d)(3)) with respect to CFC. However, CFC does not regularly and 
actively hold itself out as being willing to, and does not, enter 
into either side of transactions with unrelated persons.
    (ii) CFC is not a regular dealer in property under paragraph 
(a)(4)(iv) of this section and its options, forwards, and other 
financial instruments are not dealer property within the meaning of 
paragraph (a)(4)(v) of this section.

    (vii) Debt instrument. The term debt instrument includes bonds, 
debentures, notes, certificates, accounts receivable, and other 
evidences of indebtedness.
    (b) Dividends, interest, rents, royalties, and annuities--(1) In 
general. Foreign personal holding company income includes--
    (i) Dividends, except certain dividends from related persons as 
described in paragraph (b)(4) of this section and distributions of 
previously taxed income under section 959(b);
    (ii) Interest, except export financing interest as defined in 
paragraph (b)(2) of this section and certain interest received from 
related persons as described in paragraph (b)(4) of this section;
    (iii) Rents and royalties, except certain rents and royalties 
received from related persons as described in paragraph (b)(5) of this 
section and rents and royalties derived in the active conduct of a 
trade or business as defined in paragraph (b)(6) of this section; and
    (iv) Annuities.
    (2) Exclusion of certain export financing interest--(i) In general. 
Foreign personal holding company income does not include interest that 
is export financing interest. The term export financing interest means 
interest that is derived in the conduct of a banking business and is 
export financing interest as defined in section 904(d)(2)(G). Solely 
for purposes of determining whether interest is export financing 
interest, property is treated as manufactured, produced, grown, or 
extracted in the United States if it is so treated under Sec. 1.927(a)-
1T(c).
    (ii) Exceptions. Export financing interest does not include income 
from related party factoring that is treated as interest under section 
864(d) (1) or (6) after the application of section 864(d)(7).
    (iii) Conduct of a banking business. For purposes of this section, 
export financing interest is considered derived in the conduct of a 
banking business if, in connection with the financing from which the 
interest is derived, the corporation, through its own officers or staff 
of employees, engages in all the activities in which banks customarily 
engage in issuing and servicing a loan.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (b)(2).

    Example 1. (i) DS, a domestic corporation, manufactures property 
in the United States. In addition to selling inventory (property 
described in section 1221(1)), DS occasionally sells depreciable 
equipment it manufactures for use in its trade or business, which is 
property described in section 1221(2). Less than 50 percent of the 
fair market value, determined in accordance with section 
904(d)(2)(G), of each item of inventory or equipment sold by DS is 
attributable to products imported into the United States. CFC, a 
controlled foreign corporation with respect to which DS is a related 
person (within the meaning of section 954(d)(3)), provides loans 
described in section 864(d)(6) to unrelated persons for the purchase 
of property from DS. This property is purchased exclusively for use 
or consumption outside the United States and outside CFC's country 
of incorporation.
    (ii) If, in issuing and servicing loans made with respect to 
purchases from DS of depreciable equipment used in its trade or 
business, which is property described in section 1221(2) in the 
hands of DS, CFC engages in all the activities in which banks 
customarily engage in issuing and servicing loans, the interest 
accrued from these loans would be export financing interest meeting 
the requirements of this paragraph (b)(2) and, thus, not included in 
foreign personal holding company income. However, interest from the 
loans made with respect to purchases from DS of property that is 
inventory in the hands of DS cannot be export financing interest 
because it is treated as income from a trade or service receivable 
under section 864(d)(6) and the exception under section 864(d)(7) 
does not apply. Thus the interest from loans made with respect to 
this inventory is included in foreign personal holding company 
income under paragraph (b)(1)(ii) of this section.
    Example 2. (i) DS, a domestic corporation manufactures property 
in the United States. DS wholly owns two controlled foreign 

[[Page 46520]]
corporations organized in Country A, CFC1 and CFC2. CFC1 has a 
substantial part of its assets used in its trade or business in 
Country A. CFC1 purchases the property that DS manufactures and 
sells it without further manufacture for use or consumption within 
Country A. This property is inventory property, as described in 
section 1221(1), in the hands of CFC1. Less than 50 percent of the 
fair market value, determined in accordance with section 
904(d)(2)(G), of each item of inventory sold by CFC1 is attributable 
to products imported into the United States. CFC2 provides loans 
described in section 864(d)(6) to unrelated persons in Country A for 
the purchase of the property from CFC1.
    (ii) If, in issuing and servicing loans made with respect to 
purchases from CFC1 of the inventory property, CFC2 engages in all 
the activities in which banks customarily engage in issuing and 
servicing loans, the interest accrued from these loans would be 
export financing interest meeting the requirements of paragraph 
(b)(2) of this section. It is not treated as income from a trade or 
service receivable under section 864(d)(6) because the exception 
under section 864(d)(7) applies. Thus the interest is excluded from 
foreign personal holding company income.
    Example 3. The facts are the same as in Example 2 except that 
the property sold by CFC1 is manufactured by CFC1 in Country A from 
component parts that were manufactured by DS in the United States. 
The interest accrued from the loans by CFC2 is not export financing 
interest as defined in section 904(d)(2)(G) because the property is 
not manufactured in the United States under Sec. 1.927(a)-1T(c). No 
portion of the interest is export financing interest as defined in 
this paragraph (b)(2). The full amount of the interest is, 
therefore, included in foreign personal holding company income under 
paragraph (b)(1)(ii) of this section.

    (3) Treatment of tax-exempt interest. [Reserved] For guidance, see 
Sec. 4.954-2(b)(6) of this chapter.
    (4) Exclusion of dividends or interest from related persons--(i) In 
general--(A) Corporate payor. Foreign personal holding company income 
received by a controlled foreign corporation does not include dividends 
or interest if the payor--
    (1) Is a corporation that is a related person with respect to the 
controlled foreign corporation, as defined in section 954(d)(3);
    (2) Is created or organized under the laws of the same foreign 
country (the country of incorporation) as is the controlled foreign 
corporation; and
    (3) Uses a substantial part of its assets in a trade or business in 
its country of incorporation, as determined under this paragraph 
(b)(4).
    (B) Payment by a partnership. For purposes of this paragraph 
(b)(4), if a partnership with one or more corporate partners makes a 
payment of interest, a corporate partner will be treated as the payor 
of the interest--
    (1) If the interest payment gives rise to a partnership item of 
deduction under the Internal Revenue Code or Income Tax Regulations, to 
the extent that the item of deduction is allocable to the corporate 
partner under section 704(b); or
    (2) If the interest payment does not give rise to a partnership 
item of deduction under the Internal Revenue Code or Income Tax 
Regulations, to the extent that a partnership item reasonably related 
to the payment would be allocated to that partner under an existing 
allocation under the partnership agreement (made pursuant to section 
704(b)).
    (ii) Exceptions--(A) Dividends. Dividends are excluded from foreign 
personal holding company income under this paragraph (b)(4) only to the 
extent that they are paid out of earnings and profits that are earned 
or accumulated during a period in which--
    (1) The stock on which dividends are paid with respect to which the 
exclusion is claimed was owned by the recipient controlled foreign 
corporation directly, or indirectly through a chain of one or more 
subsidiaries each of which meets the requirements of paragraph 
(b)(4)(i)(A) of this section; and
    (2) Each of the requirements of paragraph (b)(4)(i)(A) of this 
section is satisfied or, to the extent earned or accumulated during a 
taxable year of the related foreign corporation ending on or before 
December 31, 1962, during a period in which the payor was a related 
corporation as to the controlled foreign corporation and the other 
requirements of paragraph (b)(4)(i)(A) of this section were 
substantially satisfied.
    (3) This paragraph (b)(4)(ii)(A) is illustrated by the following 
example:

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

    (B) Interest paid out of adjusted foreign base company income or 
insurance income--(1) In general. Interest may not be excluded from the 
foreign personal holding company income of the recipient under this 
paragraph (b)(4) to the extent that the deduction for the interest is 
allocated under Sec. 1.954-1(a)(4) and (c) to the payor's adjusted 
gross foreign base company income (as defined in Sec. 1.954-1(a)(3)), 
adjusted gross insurance income (as defined in Sec. 1.954-1(a)(6)), or 
any other category of income included in the computation of subpart F 
income under section 952(a).
    (2) Rule for corporations that are both recipients and payors of 
interest. If a controlled foreign corporation is both a recipient and 
payor of interest, the interest that is received will be characterized 
before the interest that is paid. In addition, the amount of interest 
paid or accrued, directly or indirectly, by the controlled foreign 
corporation to a related person (as defined in section 954(d)(3)) shall 
be offset against and eliminate any interest received or accrued, 
directly or indirectly, by the controlled foreign corporation from that 
related person. In a case in which the controlled foreign corporation 
pays or accrues interest to a related person, as defined in section 
954(d)(3), and also receives or accrues interest indirectly from the 
related person, the smallest interest payment is eliminated and the 
amounts of all other interest payments are reduced by the amount of the 
smallest interest payment.
    (C) Coordination with sections 864(d) and 881(c). Income of a 
controlled foreign corporation that is treated as interest under 
section 864(d) (1) or (6), or that is portfolio interest, as defined by 
section 881(c), is not excluded from foreign personal holding company 
income under section 954(c)(3)(A)(i) and this paragraph (b)(4).
    (iii) Trade or business requirement. Except as otherwise provided 
under this paragraph (b)(4), the principles of section 367(a) apply for 
purposes of determining whether the payor has a trade or business in 
its country of incorporation and whether its assets are used in that 
trade or business. Property purchased or produced for use in a trade or 
business is not considered used in a trade or business before it is 
placed in service or after it is retired from service as determined in 
accordance with the principles of sections 167 and 168.
    (iv) Substantial assets test. A substantial part of the assets of 
the payor will be considered to be used in a trade or business located 
in the payor's country of incorporation for a taxable year only if the 
average value of the payor's assets for such year that are used in the 
trade or business and are 

[[Page 46521]]
located in such country equals more than 50 percent of the average 
value of all the assets of the payor (including assets not used in a 
trade or business). The average value of assets for the taxable year is 
determined by averaging the values of assets at the close of each 
quarter of the taxable year. The value of assets is determined under 
paragraph (b)(4)(v) of this section, and the location of assets used in 
a trade or business of the payor is determined under paragraphs (b)(4) 
(vi) through (xi) of this section.
    (v) Valuation of assets. For purposes of determining whether a 
substantial part of the assets of the payor are used in a trade or 
business in its country of incorporation, the value of assets shall be 
their fair market value (not reduced by liabilities), which, in the 
absence of affirmative evidence to the contrary, shall be deemed to be 
their adjusted basis.
    (vi) Location of tangible property--(A) In general. Tangible 
property (other than inventory and similar property as defined in 
paragraph (a)(4)(iii) of this section, and dealer property as defined 
in paragraph (a)(4)(v) of this section) used in a trade or business is 
considered located in the country in which it is physically located.
    (B) Exception. An item of tangible personal property that is used 
in the trade or business of a payor in the payor's country of 
incorporation is considered located within the payor's country of 
incorporation while it is temporarily located elsewhere for inspection 
or repair if the property is not placed in service in a country other 
than the payor's country of incorporation and is not to be so placed in 
service following the inspection or repair.
    (vii) Location of intangible property--(A) In general. Intangible 
property (other than inventory and similar property as defined in 
paragraph (a)(4)(iii) of this section, dealer property as defined in 
paragraph (a)(4)(v) of this section, and debt instruments) is 
considered located entirely in the payor's country of incorporation for 
a quarter of the taxable year only if the payor conducts all of its 
activities in connection with the use or exploitation of the property 
in that country during that entire quarter. For this purpose, the 
country in which the activities connected to the use or exploitation of 
the property are conducted is the country in which the expenses 
associated with these activities are incurred. Expenses incurred in 
connection with the use or exploitation of an item of intangible 
property are included in the computation provided by this paragraph 
(b)(4) if they would be deductible under section 162 or includible in 
inventory costs or the cost of goods sold if the payor were a domestic 
corporation. If the payor conducts such activities through an agent or 
independent contractor, then the expenses incurred by the payor with 
respect to the agent or independent contractor shall be deemed to be 
incurred by the payor in the country in which the expenses of the agent 
or independent contractor were incurred by the agent or independent 
contractor.
    (B) Exception for property located in part in the payor's country 
of incorporation. If the payor conducts its activities in connection 
with the use or exploitation of an item of intangible property, 
including goodwill (other than inventory and similar property, dealer 
property and debt instruments) during a quarter of the taxable year 
both in its country of incorporation and elsewhere, then the value of 
the intangible considered located in the payor's country of 
incorporation during that quarter is a percentage of the value of the 
item as of the close of the quarter. That percentage equals the ratio 
that the expenses incurred by the payor (described in paragraph 
(b)(4)(vii)(A) of this section) during the entire quarter by reason of 
activities that are connected with the use or exploitation of the item 
of intangible property and are conducted in the payor's country of 
incorporation bear to all expenses incurred by the payor during the 
entire quarter by reason of all such activities worldwide.
    (viii) Location of inventory and dealer property--(A) In general. 
Inventory and similar property, as defined in paragraph (a)(4)(iii) of 
this section, and dealer property, as defined in paragraph (a)(4)(v) of 
this section, are considered located entirely in the payor's country of 
incorporation for a quarter of the taxable year only if the payor 
conducts all of its activities in connection with the production and 
sale, or purchase and resale, of such property in its country of 
incorporation during that entire quarter. If the payor conducts such 
activities through an agent or independent contractor, then the 
location of such activities is the place in which they are conducted by 
the agent or independent contractor.
    (B) Inventory and dealer property located in part in the payor's 
country of incorporation. If the payor conducts its activities in 
connection with the production and sale, or purchase and resale, of 
inventory or similar property or dealer property during a quarter of 
the taxable year both in its country of incorporation and elsewhere, 
then the value of the inventory or similar property or dealer property 
considered located in the payor's country of incorporation during each 
quarter is a percentage of the value of the inventory or similar 
property or dealer property as of the close of the quarter. That 
percentage equals the ratio that the costs and expenses incurred by the 
payor during the entire quarter by reason of activities connected with 
the production and sale, or purchase and resale, of inventory or 
similar property or dealer property that are conducted in the payor's 
country of incorporation bear to all costs or expenses incurred by the 
payor during the entire quarter by reason of all such activities 
worldwide. A cost incurred in connection with the production and sale 
or purchase and resale of inventory or similar property or dealer 
property is included in this computation if it--
    (1) Would be included in inventory costs or otherwise capitalized 
with respect to inventory or similar property or dealer property under 
section 61, 263A, 471, or 472 if the payor were a domestic corporation; 
or
    (2) Would be deductible under section 162 if the payor were a 
domestic corporation and is definitely related to gross income derived 
from such property (but not to all classes of gross income derived by 
the payor) under the principles of Sec. 1.861-8.
    (ix) Location of debt instruments. For purposes of this paragraph 
(b)(4), debt instruments, other than debt instruments that are 
inventory or similar property (as defined in paragraph (a)(4)(iii) of 
this section) or dealer property (as defined in paragraph (a)(4)(v) of 
this section) are considered to be used in a trade or business only if 
they arise from the sale of inventory or similar property or dealer 
property by the payor or from the rendition of services by the payor in 
the ordinary course of a trade or business of the payor, and only until 
such time as interest is required to be charged under section 482. Debt 
instruments that arise from the sale of inventory or similar property 
or dealer property during a quarter are treated as having the same 
location, proportionately, as the inventory or similar property or 
dealer property held during that quarter. Debt instruments arising from 
the rendition of services in the ordinary course of a trade or business 
are considered located on a proportionate basis in the countries in 
which the services to which they relate are performed.
    (x) Treatment of certain stock interests. Stock in a controlled 
foreign corporation (lower-tier corporation) that is incorporated in 
the same country as the payor and related to the payor 

[[Page 46522]]
within the meaning of section 954(d)(3) shall be considered located in 
the payor's country of incorporation in proportion to the value of the 
assets of the lower-tier corporation. The location of assets used in a 
trade or business of the lower-tier corporation shall be determined 
under the rules of this paragraph (b)(4).
    (xi) Treatment of banks and insurance companies. [Reserved]
    (5) Exclusion of rents and royalties derived from related persons--
(i) In general--(A) Corporate payor. Foreign personal holding company 
income received by a controlled foreign corporation does not include 
rents or royalties if--
    (1) The payor is a corporation that is a related person with 
respect to the controlled foreign corporation, as defined in section 
954(d)(3); and
    (2) The rents or royalties are for the use of, or the privilege of 
using, property within the country under the laws of which the 
controlled foreign corporation receiving the payments is created or 
organized (the country of incorporation).
    (B) Payment by a partnership. For purposes of this paragraph 
(b)(5), if a partnership with one or more corporate partners makes a 
payment of rents or royalties, a corporate partner will be treated as 
the payor of the rents or royalties--
    (1) If the rent or royalty payment gives rise to a partnership item 
of deduction under the Internal Revenue Code or Income Tax Regulations, 
to the extent the item of deduction is allocable to the corporate 
partner under section 704(b); or
    (2) If the rent or royalty payment does not give rise to a 
partnership item of deduction under the Internal Revenue Code or Income 
Tax Regulations, to the extent that a partnership item reasonably 
related to the payment would be allocated to that partner under an 
existing allocation under the partnership agreement (made pursuant to 
section 704(b)).
    (ii) Exceptions--(A) Rents or royalties paid out of adjusted 
foreign base company income or insurance income. Rents or royalties may 
not be excluded from the foreign personal holding company income of the 
recipient under this paragraph (b)(5) to the extent that deductions for 
the payments are allocated under section 954(b)(5) and Sec. 1.954-
1(a)(4) and (c) to the payor's adjusted gross foreign base company 
income (as defined in Sec. 1.954-1(a)(3)), adjusted gross insurance 
income (as defined in Sec. 1.954-1(a)(6)), or any other category of 
income included in the computation of subpart F income under section 
952(a).
    (B) Property used in part in the controlled foreign corporation's 
country of incorporation. If the payor uses the property both in the 
controlled foreign corporation's country of incorporation and 
elsewhere, the part of the rent or royalty attributable (determined 
under the principles of section 482) to the use of, or the privilege of 
using, the property outside such country of incorporation is included 
in the computation of foreign personal holding company income under 
this paragraph (b).
    (6) Exclusion of rents and royalties derived in the active conduct 
of a trade or business. Foreign personal holding company income shall 
not include rents or royalties that are derived in the active conduct 
of a trade or business and received from a person that is not a related 
person (as defined in section 954(d)(3)) with respect to the controlled 
foreign corporation. For purposes of this section, rents or royalties 
are derived in the active conduct of a trade or business only if the 
provisions of paragraph (c) or (d) of this section are satisfied.
    (c) Excluded rents--(1) Active conduct of a trade or business. 
Rents will be considered for purposes of paragraph (b)(6) of this 
section to be derived in the active conduct of a trade or business if 
such rents are derived by the controlled foreign corporation (the 
lessor) from leasing any of the following--
    (i) Property that the lessor has manufactured or produced, or has 
acquired and added substantial value to, but only if the lessor is 
regularly engaged in the manufacture or production of, or in the 
acquisition and addition of substantial value to, property of such 
kind;
    (ii) Real property with respect to which the lessor, through its 
own officers or staff of employees, regularly performs active and 
substantial management and operational functions while the property is 
leased;
    (iii) Personal property ordinarily used by the lessor in the active 
conduct of a trade or business, leased temporarily during a period when 
the property would, but for such leasing, be idle; or
    (iv) Property that is leased as a result of the performance of 
marketing functions by such lessor if the lessor, through its own 
officers or staff of employees located in a foreign country, maintains 
and operates an organization in such country that is regularly engaged 
in the business of marketing, or of marketing and servicing, the leased 
property and that is substantial in relation to the amount of rents 
derived from the leasing of such property.
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph (c)(1)(i) of this section, the performance of marketing 
functions will not be considered to add substantial value to property.
    (ii) Substantiality of foreign organization. For purposes of 
paragraph (c)(1)(iv) of this section, whether an organization in a 
foreign country is substantial in relation to the amount of rents is 
determined based on all of the facts and circumstances. However, such 
an organization will be considered substantial in relation to the 
amount of rents if active leasing expenses, as defined in paragraph 
(c)(2)(iii) of this section, equal or exceed 25 percent of the adjusted 
leasing profit, as defined in paragraph (c)(2)(iv) of this section.
    (iii) Active leasing expenses. The term active leasing expenses 
means the deductions incurred by an organization of the lessor in a 
foreign country that are properly allocable to rental income and that 
would be allowable under section 162 to the lessor if it were a 
domestic corporation, other than--
    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons (as defined in section 954(d)(3)) 
with respect to, the lessor;
    (B) Deductions for rents paid or accrued;
    (C) Deductions that, although generally allowable under section 
162, would be specifically allowable to the lessor (if the lessor were 
a domestic corporation) under any section of the Internal Revenue Code 
other than section 162; and
    (D) Deductions for payments made to agents or independent 
contractors with respect to the leased property other than payments for 
insurance, utilities and other expenses for like services, or for 
capitalized repairs.
    (iv) Adjusted leasing profit. The term adjusted leasing profit 
means the gross income of the lessor from rents, reduced by the sum 
of--
    (A) The rents paid or incurred by the lessor with respect to such 
rental income;
    (B) The amounts that would be allowable to such lessor (if the 
lessor were a domestic corporation) as deductions under sections 167 or 
168 with respect to such rental income; and
    (C) The amounts paid by the lessor to agents or independent 
contractors with respect to such rental income other than payments for 
insurance, utilities and other expenses for like services, or for 
capitalized repairs.
    (3) Examples. The application of this paragraph (c) is illustrated 
by the following examples.


[[Page 46523]]

    Example 1. Controlled foreign corporation A is regularly engaged 
in the production of office machines which it sells or leases to 
others and services. Under paragraph (c)(1)(i) of this section, the 
rental income of Corporation A from these leases is derived in the 
active conduct of a trade or business for purposes of section 
954(c)(2)(A).
    Example 2. Controlled foreign corporation D purchases motor 
vehicles which it leases to others. In the conduct of its short-term 
leasing of such vehicles in foreign country X, Corporation D owns a 
large number of motor vehicles in country X which it services and 
repairs, leases motor vehicles to customers on an hourly, daily, or 
weekly basis, maintains offices and service facilities in country X 
from which to lease and service such vehicles, and maintains therein 
a sizable staff of its own administrative, sales, and service 
personnel. Corporation D also leases in country X on a long-term 
basis, generally for a term of one year, motor vehicles that it 
owns. Under the terms of the long-term leases, Corporation D is 
required to repair and service, during the term of the lease, the 
leased motor vehicles without cost to the lessee. By the maintenance 
in country X of office, sales, and service facilities and its 
complete staff of administrative, sales, and service personnel, 
Corporation D maintains and operates an organization therein that is 
regularly engaged in the business of marketing and servicing the 
motor vehicles that are leased. The deductions incurred by such 
organization satisfy the 25-percent test of paragraph (c)(2)(ii) of 
this section; thus, such organization is substantial in relation to 
the rents Corporation D receives from leasing the motor vehicles. 
Therefore, under paragraph (c)(1)(iv) of this section, such rents 
are derived in the active conduct of a trade or business for 
purposes of section 954(c)(2)(A).
    Example 3. Controlled foreign corporation E owns a complex of 
apartment buildings that it has acquired by purchase. Corporation E 
engages a real estate management firm to lease the apartments, 
manage the buildings and pay over the net rents to Corporation E. 
The rental income of Corporation E from such leases is not derived 
in the active conduct of a trade or business for purposes of section 
954(c)(2)(A).
    Example 4. Controlled foreign corporation F acquired by purchase 
a twenty-story office building in a foreign country, three floors of 
which it occupies and the rest of which it leases. Corporation F 
acts as rental agent for the leasing of offices in the building and 
employs a substantial staff to perform other management and 
maintenance functions. Under paragraph (c)(1)(ii) of this section, 
the rents received by Corporation F from such leasing operations are 
derived in the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).
    Example 5. Controlled foreign corporation G owns equipment that 
it ordinarily uses to perform contracts in foreign countries to 
drill oil wells. For occasional brief and irregular periods it is 
unable to obtain contracts requiring immediate performance 
sufficient to employ all such equipment. During such a period it 
sometimes leases such idle equipment temporarily. After the 
expiration of such temporary leasing of the property, Corporation G 
continues the use of such equipment in the performance of its own 
drilling contracts. Under paragraph (c)(1)(iii) of this section, 
rents Corporation G receives from such leasing of idle equipment are 
derived in the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).

    (d) Excluded royalties--(1) Active conduct of a trade or business. 
Royalties will be considered for purposes of paragraph (b)(6) of this 
section to be derived in the active conduct of a trade or business if 
such royalties are derived by the controlled foreign corporation (the 
licensor) from licensing--
    (i) Property that the licensor has developed, created, or produced, 
or has acquired and added substantial value to, but only so long as the 
licensor is regularly engaged in the development, creation, or 
production of, or in the acquisition of and addition of substantial 
value to, property of such kind; or
    (ii) Property that is licensed as a result of the performance of 
marketing functions by such licensor if the licensor, through its own 
officers or staff of employees located in a foreign country, maintains 
and operates an organization in such country that is regularly engaged 
in the business of marketing, or of marketing and servicing, the 
licensed property and that is substantial in relation to the amount of 
royalties derived from the licensing of such property.
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph (d)(1)(i) of this section, the performance of marketing 
functions will not be considered to add substantial value to property.
    (ii) Substantiality of foreign organization. For purposes of 
paragraph (d)(1)(ii) of this section, whether an organization in a 
foreign country is substantial in relation to the amount of royalties 
is determined based on all of the facts and circumstances. However, 
such an organization will be considered substantial in relation to the 
amount of royalties if active licensing expenses, as defined in 
paragraph (d)(2)(iii) of this section, equal or exceed 25 percent of 
the adjusted licensing profit, as defined in paragraph (d)(2)(iv) of 
this section.
    (iii) Active licensing expenses. The term active licensing expenses 
means the deductions incurred by an organization of the licensor in a 
foreign country that are properly allocable to royalty income and that 
would be allowable under section 162 to the licensor if it were a 
domestic corporation, other than--
    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons (as defined in section 954(d)(3)) 
with respect to, the licensor;
    (B) Deductions for royalties paid or incurred;
    (C) Deductions that, although generally allowable under section 
162, would be specifically allowable to the licensor (if the controlled 
foreign corporation were a domestic corporation) under any section of 
the Internal Revenue Code other than section 162; and
    (D) Deductions for payments made to agents or independent 
contractors with respect to the licensed property.
    (iv) Adjusted licensing profit. The term adjusted licensing profit 
means the gross income of the licensor from royalties, reduced by the 
sum of--
    (A) The royalties paid or incurred by the licensor with respect to 
such royalty income;
    (B) The amounts that would be allowable to such licensor as 
deductions under section 167 or 197 (if the licensor were a domestic 
corporation) with respect to such royalty income; and
    (C) The amounts paid by the licensor to agents or independent 
contractors with respect to such royalty income.
    (3) Examples. The application of this paragraph (d) is illustrated 
by the following examples.

    Example 1. Controlled foreign corporation A, through its own 
staff of employees, owns and operates a research facility in foreign 
country X. At the research facility employees of Corporation A who 
are scientists, engineers, and technicians regularly perform 
experiments, tests, and other technical activities, that ultimately 
result in the issuance of patents that it sells or licenses. Under 
paragraph (d)(1)(i) of this section, royalties received by 
Corporation A for the privilege of using patented rights that it 
develops as a result of such research activity are derived in the 
active conduct of a trade or business for purposes of section 
954(c)(2)(A), but only so long as the licensor is regularly engaged 
in the development, creation, or production of, or in the 
acquisition of and addition of substantial value to, property of 
such kind.
    Example 2. Assume that Corporation A in Example 1, in addition 
to receiving royalties for the use of patents that it develops, 
receives royalties for the use of patents that it acquires by 
purchase and licenses to others without adding any value thereto. 
Corporation A generally consummates royalty agreements on such 
purchased patents as the result of inquiries received by it from 
prospective licensees when the fact becomes known in the business 
community, as a result of the filing of a patent, advertisements in 
trade journals, announcements, and contacts by employees of 
Corporation A, that Corporation A has acquired rights under a patent 
and is interested in licensing its rights. Corporation A does not, 
however, maintain and operate 

[[Page 46524]]
an organization in a foreign country that is regularly engaged in the 
business of marketing the purchased patents. The royalties received 
by Corporation A for the use of the purchased patents are not 
derived in the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).
    Example 3. Controlled foreign corporation B receives royalties 
for the use of patents that it acquires by purchase. The primary 
business of Corporation B, operated on a regular basis, consists of 
licensing patents that it has purchased raw from inventors and, 
through the efforts of a substantial staff of employees consisting 
of scientists, engineers, and technicians, made susceptible to 
commercial application. For example, Corporation B, after purchasing 
patent rights covering a chemical process, designs specialized 
production equipment required for the commercial adaptation of the 
process and, by so doing, substantially increases the value of the 
patent. Under paragraph (d)(1)(i) of this section, royalties 
received by Corporation B from the use of such patent are derived in 
the active conduct of a trade or business for purposes of section 
954(c)(2)(A).
    Example 4. Controlled foreign corporation C receives royalties 
for the use of a patent that it developed through its own staff of 
employees at its facility in country X. Corporation C has developed 
no other patents. It does not regularly employ a staff of 
scientists, engineers or technicians to create new products to be 
patented. Further, it does not purchase and license patents 
developed by others to which it has added substantial value. The 
royalties received by Corporation C are not derived from the active 
conduct of a trade or business for purposes of section 954(c)(2)(A).
    Example 5. Controlled foreign corporation D finances independent 
persons in the development of patented items in return for an 
ownership interest in such items from which it derives a percentage 
of royalty income, if any, subsequently derived from the use by 
others of the protected right. Corporation D also attempts to 
increase its royalty income from such patents by contacting 
prospective licensees and rendering to licensees advice that is 
intended to promote the use of the patented property. Corporation D 
does not, however, maintain and operate an organization in a foreign 
country that is regularly engaged in the business of marketing the 
patents. Royalties received by Corporation D for the use of such 
patents are not derived in the active conduct of a trade or business 
for purposes of section 954(c)(2)(A).

    (e) Certain property transactions--(1) In general--(i) Inclusions. 
Gain from certain property transactions described in section 
954(c)(1)(B) includes the excess of gains over losses from the sale or 
exchange of--
    (A) Property that gives rise to dividends, interest, rents, 
royalties or annuities, as described in paragraph (e)(2) of this 
section;
    (B) Property that is an interest in a partnership, trust or REMIC; 
and
    (C) Property that does not give rise to income, as described in 
paragraph (e)(3) of this section.
    (ii) Exceptions. Gain or loss from certain property transactions 
described in section 954(c)(1)(B) and paragraph (e)(1)(i) of this 
section does not include gain or loss from the sale or exchange of--
    (A) Inventory or similar property, as defined in paragraph 
(a)(4)(iii) of this section;
    (B) Dealer property, as defined in paragraph (a)(4)(v) of this 
section; or
    (C) Property that gives rise to rents or royalties described in 
paragraph (b)(6) of this section that are derived in the active conduct 
of a trade or business from persons that are not related persons (as 
defined in section 954(d)(3)) with respect to the controlled foreign 
corporation.
    (iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for 
the treatment of losses in excess of gains from the sale or exchange of 
property described in paragraph (e)(1)(i) of this section.
    (iv) Dual character property. Property may, in part, constitute 
property that gives rise to certain income as described in paragraph 
(e)(2) of this section or, in part, constitute property that does not 
give rise to any income as described in paragraph (e)(3) of this 
section. However, property that is described in paragraph (e)(1)(i)(B) 
of this section cannot be dual character property. Dual character 
property must be treated as two separate properties for purposes of 
paragraph (e)(2) or (3) of this section. Accordingly, the sale or 
exchange of such dual character property will give rise to gain or loss 
that in part must be included in the computation of foreign personal 
holding company income under paragraph (e)(2) or (3) of this section, 
and in part is excluded from such computation. Gain or loss from the 
disposition of dual character property must be bifurcated under this 
paragraph (e)(1)(iv) pursuant to the method that most reasonably 
reflects the relative uses of the property. Reasonable methods may 
include comparisons in terms of gross income generated or the physical 
division of the property. In the case of real property, the physical 
division of the property will in most cases be the most reasonable 
method available. For example, if a controlled foreign corporation owns 
an office building, uses 60 percent of the building in its trade or 
business, and rents out the other 40 percent, then 40 percent of the 
gain recognized on the disposition of the property would reasonably be 
treated as gain that is included in the computation of foreign personal 
holding company income under this paragraph (e)(1). This paragraph 
(e)(1)(iv) addresses the contemporaneous use of property for dual 
purposes. For rules concerning changes in the use of property affecting 
its classification for purposes of this paragraph (e), see paragraph 
(a)(3) of this section.
    (2) Property that gives rise to certain income--(i) In general. 
Property the sale or exchange of which gives rise to foreign personal 
holding company income under this paragraph (e)(2) includes property 
that gives rise to dividends, interest, rents, royalties or annuities 
described in paragraph (b) of this section, including--
    (A) Property that gives rise to export financing interest described 
in paragraph (b)(2) of this section; and
    (B) Property that gives rise to income from related persons 
described in paragraph (b) (4) or (5) of this section.
    (ii) Gain or loss from the disposition of a debt instrument. Gain 
or loss from the sale, exchange, or retirement of a debt instrument is 
included in the computation of foreign personal holding company income 
under this paragraph (e) unless--
    (A) In the case of gain--
    (1) It is interest (as defined in paragraph (a)(4)(i) of this 
section); or
    (2) It is income equivalent to interest (as described in paragraph 
(h) of this section); and
    (B) In the case of loss--
    (1) It is directly allocated to, or treated as an adjustment to, 
interest income (as described in paragraph (a)(4)(i) of this section) 
or income equivalent to interest (as defined in paragraph (h) of this 
section) under any provision of the Internal Revenue Code or Income Tax 
Regulations; or
    (2) It is required to be apportioned in the same manner as interest 
expense under section 864(e) or any other provision of the Internal 
Revenue Code or Income Tax Regulations.
    (3) Property that does not give rise to income. Except as otherwise 
provided in this paragraph (e)(3), for purposes of this section, the 
term property that does not give rise to income includes all rights and 
interests in property (whether or not a capital asset) including, for 
example, forwards, futures and options. Property that does not give 
rise to income shall not include--
    (i) Property that gives rise to dividends, interest, rents, 
royalties or annuities described in paragraph (e)(2) of this section;
    (ii) Tangible property (other than real property) used or held for 
use in the controlled foreign corporation's trade or business that is 
of a character that would be subject to the allowance for 

[[Page 46525]]
depreciation under section 167 or 168 and the regulations under those 
sections (including tangible property described in Sec. 1.167(a)-2);
    (iii) Real property that does not give rise to rental or similar 
income, to the extent used or held for use in the controlled foreign 
corporation's trade or business;
    (iv) Intangible property (as defined in section 936(h)(3)(B)), 
goodwill or going concern value, to the extent used or held for use in 
the controlled foreign corporation's trade or business;
    (v) Notional principal contracts (but see paragraphs (f)(2), (g)(2) 
and (h)(3) of this section for rules that include income from certain 
notional principal contracts in gains from commodities transactions, 
foreign currency gains and income equivalent to interest, 
respectively); or
    (vi) Other property that is excepted from the general rule of this 
paragraph (e)(3) by the Commissioner in published guidance. See 
Sec. 601.601(d)(2) of this chapter.
    (f) Commodities transactions--(1) In general--(i) Inclusion in 
foreign personal holding company income. Foreign personal holding 
company income includes the excess of gains over losses from 
commodities transactions.
    (ii) Exception. Gains and losses from qualified active sales and 
qualified hedging transactions are excluded from the computation of 
foreign personal holding company income under this paragraph (f).
    (iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for 
the treatment of losses in excess of gains from commodities 
transactions.
    (2) Definitions--(i) Commodity. For purposes of this section, the 
term commodity includes tangible personal property of a kind that is 
actively traded or with respect to which contractual interests are 
actively traded.
    (ii) Commodities transaction. The term commodities transaction 
means the purchase or sale of a commodity for immediate (spot) delivery 
or deferred (forward) delivery, or the right to purchase, sell, 
receive, or transfer a commodity, or any other right or obligation with 
respect to a commodity accomplished through a cash or off-exchange 
market, an interbank market, an organized exchange or board of trade, 
or an over-the-counter market, or in a transaction effected between 
private parties outside of any market. Commodities transactions 
include, but are not limited to--
    (A) A futures or forward contract in a commodity;
    (B) A leverage contract in a commodity purchased from a leverage 
transaction merchant;
    (C) An exchange of futures for physical transaction;
    (D) A transaction, including a notional principal contract, in 
which the income or loss to the parties is measured by reference to the 
price of a commodity, a pool of commodities, or an index of 
commodities;
    (E) The purchase or sale of an option or other right to acquire or 
transfer a commodity, a futures contract in a commodity, or an index of 
commodities; and
    (F) The delivery of one commodity in exchange for the delivery of 
another commodity, the same commodity at another time, cash, or 
nonfunctional currency.
    (iii) Qualified active sale--(A) In general. The term qualified 
active sale means the sale of commodities in the active conduct of a 
commodities business as a producer, processor, merchant, or handler of 
commodities if substantially all of the controlled foreign 
corporation's business is as an active producer, processor, merchant or 
handler of commodities. The sale of commodities held by a controlled 
foreign corporation other than in its capacity as an active producer, 
processor, merchant or handler of commodities is not a qualified active 
sale. For example, the sale by a controlled foreign corporation of 
commodities that were held for investment or speculation would not be a 
qualified active sale.
    (B) Active conduct of a commodities business. For purposes of this 
paragraph, a controlled foreign corporation is engaged in the active 
conduct of a commodities business as a producer, processor, merchant, 
or handler of commodities only with respect to commodities for which 
each of the following conditions is satisfied--
    (1) It holds the commodities directly, and not through an agent or 
independent contractor, as inventory or similar property (as defined in 
paragraph (a)(4)(iii) of this section) or as dealer property (as 
defined in paragraph (a)(4)(v) of this section); and
    (2) With respect to such commodities, it incurs substantial 
expenses in the ordinary course of a commodities business from engaging 
in one or more of the following activities directly, and not through an 
independent contractor--
    (i) Substantial activities in the production of the commodities, 
including planting, tending or harvesting crops, raising or 
slaughtering livestock, or extracting minerals;
    (ii) Substantial processing activities prior to the sale of the 
commodities, including the blending and drying of agricultural 
commodities, or the concentrating, refining, mixing, crushing, aerating 
or milling of commodities; or
    (iii) Significant activities as described in paragraph 
(f)(2)(iii)(B)(3) of this section.
    (3) For purposes of paragraph (f)(2)(iii)(B)(2)(iii) of this 
section, the significant activities must relate to--
    (i) The physical movement, handling and storage of the commodities, 
including preparation of contracts and invoices, arranging freight, 
insurance and credit, arranging for receipt, transfer or negotiation of 
shipping documents, arranging storage or warehousing, and dealing with 
quality claims;
    (ii) Owning and operating facilities for storage or warehousing; or
    (iii) Owning or chartering vessels or vehicles for the 
transportation of the commodities.
    (C) Substantially all. Substantially all of the controlled foreign 
corporation's business is as an active producer, processor, merchant, 
or handler of commodities if the sum of its gross receipts from all of 
its qualified active sales (as defined in this paragraph (f)(2)(iii) 
without regard to the substantially all requirement) of commodities and 
its gross receipts from all of its qualified hedging transactions (as 
defined in paragraph (f)(2)(iv) of this section, applied without regard 
to the substantially all requirement of this paragraph (f)(2)(iii)(C)) 
equals or exceeds 85 percent of its total gross receipts for the 
taxable year (computed as though the corporation were a domestic 
corporation). In computing gross receipts, the District Director may 
disregard any sale or hedging transaction that has as a principal 
purpose manipulation of the 85 percent gross receipts test. A purpose 
may be a principal purpose even though it is outweighed by other 
purposes (taken together or separately).
    (D) Activities of employees of a related entity. For purposes of 
this paragraph (f), activities of employees of an entity related to the 
controlled foreign corporation, who are made available to and 
supervised on a day-to-day basis by, and whose salaries are paid by (or 
reimbursed to the related entity by), the controlled foreign 
corporation, are treated as activities engaged in directly by the 
controlled foreign corporation.
    (E) Financial activities. For purposes of this paragraph (f), a 
corporation is not engaged in a commodities business as a producer, 
processor, merchant, or 

[[Page 46526]]
handler of commodities if its business is primarily financial. For 
example, the business of a controlled foreign corporation is primarily 
financial if its principal business is making a market in notional 
principal contracts based on a commodities index.
    (iv) Qualified hedging transaction--(A) In general. The term 
qualified hedging transaction means a bona fide hedging transaction, as 
defined in paragraph (a)(4)(ii) of this section, with respect to 
qualified active sales (other than transactions described in section 
988(c)(1) without regard to section 988(c)(1)(D)(i)).
    (B) Exception. The term qualified hedging transaction does not 
include transactions that are not reasonably necessary to the conduct 
of business of the controlled foreign corporation as a producer, 
processor, merchant or handler of a commodity in the manner in which 
such business is customarily and usually conducted by others.
    (g) Foreign currency gain or loss--(1) Scope and purpose. This 
paragraph (g) provides rules for the treatment of foreign currency 
gains and losses. Paragraph (g)(2) of this section provides the general 
rule. Paragraph (g)(3) of this section provides an election to include 
foreign currency gains or losses that would otherwise be treated as 
foreign personal holding company income under this paragraph (g) in the 
computation of another category of subpart F income. Paragraph (g)(4) 
of this section provides an alternative election to treat any net 
foreign currency gain or loss as foreign personal holding company 
income. Paragraph (g)(5) of this section provides rules for certain 
gains and losses not subject to this paragraph (g).
    (2) In general--(i) Inclusion. Except as otherwise provided in this 
paragraph (g), foreign personal holding company income includes the 
excess of foreign currency gains over foreign currency losses 
attributable to any section 988 transactions (foreign currency gain or 
loss). Section 1.954-1(c)(1)(ii) provides rules for the treatment of 
foreign currency losses in excess of foreign currency gains. However, 
if an election is made under paragraph (g)(4) of this section, the 
excess of foreign currency losses over foreign currency gains to which 
the election would apply may be apportioned to, and offset, other 
categories of foreign personal holding company income.
    (ii) Exclusion for business needs--(A) General Rule. Foreign 
currency gain or loss directly related to the business needs of the 
controlled foreign corporation is excluded from foreign personal 
holding company income.
    (B) Business needs. Foreign currency gain or loss is directly 
related to the business needs of a controlled foreign corporation if--
    (1) The foreign currency gain or loss--
    (i) Arises from a transaction (other than a hedging transaction) 
entered into, or property used or held for use, in the normal course of 
the controlled foreign corporation's trade or business;
    (ii) Arises from a transaction or property that does not itself 
(and could not reasonably be expected to) give rise to subpart F income 
other than foreign currency gain or loss;
    (iii) Does not arise from a transaction described in section 
988(c)(1)(B)(iii); and
    (iv) Is clearly determinable from the records of the controlled 
foreign corporation as being derived from such transaction or property; 
or
    (2) The foreign currency gain or loss arises from a bona fide 
hedging transaction, as defined in paragraph (a)(4)(ii) of this 
section, with respect to a transaction or property that satisfies the 
requirements of paragraph (g)(2)(ii)(B)(1)of this section. For purposes 
of this paragraph (g)(2)(ii)(B)(2), a hedging transaction will satisfy 
the aggregate hedging rules of Sec. 1.1221-2(c)(7) only if all (or all 
but a de minimis amount) of the aggregate risk being hedged arises in 
connection with transactions that satisfy the requirements of paragraph 
(g)(2)(ii)(B)(1) of this section.
    (C) Regular dealers. Transactions in dealer property (as defined in 
paragraph (a)(4)(v) of this section) described in section 988(c)(1) (B) 
or (C) that are entered into by a controlled foreign corporation that 
is a regular dealer (as defined in paragraph (a)(4)(iv) of this 
section) in such property in its capacity as a dealer will be treated 
as directly related to the business needs of the controlled foreign 
corporation under paragraph (g)(2)(ii)(A) of this section.
    (D) Example. The following example illustrates the provisions of 
this paragraph (g)(2).

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

    (iii) Special rule for foreign currency gain or loss from an 
interest-bearing liability. Except as provided in paragraph (g)(5)(iv) 
of this section, foreign currency gain or loss arising from an 
interest-bearing liability is characterized as subpart F income and 
non-subpart F income in the same manner that interest expense 
associated with the liability would be allocated and apportioned 
between subpart F income and non-subpart F income under Secs. 1.861-9T 
and 1.861-12T.
    (3) Election to characterize foreign currency gain or loss that 
arises from a specific category of subpart F income as gain or loss in 
that category--(i) In general. For taxable years of a controlled 
foreign corporation beginning on or after November 6, 1995, the 
controlling United States shareholders of the controlled foreign 
corporation may elect, under this paragraph (g)(3), to exclude foreign 
currency gain or loss otherwise includible in the computation of 
foreign personal holding company income under this paragraph (g) from 
the computation of foreign personal holding company income under this 
paragraph (g) and include such foreign currency gain or loss in the 
category (or categories) of subpart F income (described in section 
952(a), or, in the case of foreign base company income, described in 
Sec. 1.954-1(c)(1)(iii)(A) (1) or (2)) to which such gain or loss 
relates. If an election is made under this paragraph (g)(3) with 
respect to a category (or categories) of subpart F income described in 
section 952(a), or, 

[[Page 46527]]
in the case of foreign base company income, described in Sec. 1.954-
1(c)(1)(iii)(A) (1) or (2), the election shall apply to all foreign 
currency gain or loss that arises from--
    (A) A transaction (other than a hedging transaction) entered into, 
or property used or held for use, in the normal course of the 
controlled foreign corporation's trade or business that gives rise to 
income in that category (or categories) and that is clearly 
determinable from the records of the controlled foreign corporation as 
being derived from such transaction or property; and
    (B) A bona fide hedging transaction, as defined in paragraph 
(a)(4)(ii) of this section, with respect to a transaction or property 
described in paragraph (g)(3)(i)(A) of this section. For purposes of 
this paragraph (g)(3)(i)(B), a hedging transaction will satisfy the 
aggregate hedging rules of Sec. 1.1221-2(c)(7) only if all (or all but 
a de minimus amount) of the aggregate risk being hedged arises in 
connection with transactions or property that generate the same 
category of subpart F income described in section 952(a), or, in the 
case of foreign base company income, described in Sec. 1.954-
1(c)(1)(iii)(A) (1) or (2).
    (ii) Time and manner of election. The controlling United States 
shareholders, as defined in Sec. 1.954-1(c)(5), make the election on 
behalf of the controlled foreign corporation by filing a statement with 
their original income tax returns for the taxable year of such United 
States shareholders ending with or within the taxable year of the 
controlled foreign corporation for which the election is made, clearly 
indicating that such election has been made. If the controlling United 
States shareholders elect to apply these regulations retroactively, 
under Sec. 1.954-0(a)(1)(ii), the election under this paragraph (g)(3) 
may be made by the amended return filed pursuant to the election under 
Sec. 1.954-0(a)(1)(ii). The controlling United States shareholders 
filing the election statement described in this paragraph (g)(3)(ii) 
must provide copies of the election statement to all other United 
States shareholders of the electing controlled foreign corporation. 
Failure to provide copies of such statement will not cause an election 
under this paragraph (g)(3) to be voidable by the controlled foreign 
corporation or the controlling United States shareholders. However, the 
District Director has discretion to void the election if it is 
determined that three was no reasonable cause for the failure to 
provide copies of such statement. The statement shall include the 
following information--
    (A) The name, address, taxpayer identification number, and taxable 
year of such United States shareholder;
    (B) The name, address, and taxable year of the controlled foreign 
corporation for which the election is effective; and
    (C) Any additional information required by the Commission by 
administrative pronouncement.
    (iii) Revocation of election. This election is effective for the 
taxable year of the controlled foreign corporation for which it is made 
and all subsequent taxable years of such corporation unless revoked by 
or with the consent of the Commissioner.
    (iv) Example. The following example illustrates the provisions of 
this paragraph (g)(3).

    Example. (i) CFC, a controlled foreign corporation, is a sales 
company that earns foreign base company sales income under section 
954(d). CFC makes an election under this paragraph (g)(3) to treat 
foreign currency gains or losses that arise from a specific category 
(or categories) of subpart F income (as described in section 952(a), 
or, in the case of foreign base company income, as described in 
Sec. 1.954-1(c)(1)(iii)(A) (1) or (2)) as that type of income. CFC 
aggregates the currency risk on all of its transactions that 
generate foreign base company sales income and hedges this net 
currency exposure.
    (ii) Assuming no more than a de minimus amount of risk in the 
pool of risks being hedged arises from transactions or property that 
generate income other than foreign base company sales income, 
pursuant to its election under (g)(3), CFC's net foreign currency 
gain from the pool and the hedging transactions will be treated as 
foreign base company sales income under section 954(d), rather than 
as foreign personal holding company income under section 
954(c)(1)(D). If the pool of risks and the hedging transactions 
generate a net foreign currency loss, however, CFC must apply the 
rules of Sec. 1.954-1(c)(1)(ii).

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

[[Page 46528]]
interest as defined in paragraph (h)(2) of this section.
    (ii) Exceptions--(A) Liability hedging transactions. Income, gain, 
deduction or loss that is allocated and apportioned in the same manner 
as interest expense under the provisions of Sec. 1.861-9T is not income 
equivalent to interest for purposes of this paragraph (h).
    (B) Interest. Amounts treated as interest under section 
954(c)(1)(A) and paragraph (b) of this section are not income 
equivalent to interest for purposes of this paragraph (h).
    (2) Definition of income equivalent to interest--(i) In general. 
The term income equivalent to interest includes income that is derived 
from--
    (A) A transaction or series of related transactions in which the 
payments, net payments, cash flows, or return predominantly reflect the 
time value of money;
    (B) Transactions in which the payments (or a predominant portion 
thereof) are, in substance, for the use or forbearance of money;
    (C) Notional principal contracts, to the extent provided in 
paragraph (h)(3) of this section;
    (D) Factoring, to the extent provided in paragraph (h)(4) of this 
section;
    (E) Conversion transactions, but only to the extent that gain 
realized with respect to such a transaction is treated as ordinary 
income under section 1258;
    (F) The performance of services, to the extent provided in 
paragraph (h)(5) of this section;
    (G) The commitment by a lender to provide financing, whether or not 
such financing actually is provided;
    (H) Transfers of debt securities subject to section 1058; and
    (I) Other transactions, as provided by the Commissioner in 
published guidance. See Sec. 601.601(d)(2) of this chapter.
    (ii) Income from the sale of property. Income from the sale of 
property will not be treated as income equivalent to interest by reason 
of paragraph (h)(2)(i) (A) or (B) of this section. Income derived by a 
controlled foreign corporation will be treated as arising from the sale 
of property only if the corporation in substance carries out sales 
activities. Accordingly, an arrangement that is designed to lend the 
form of a sales transaction to a transaction that in substance 
constitutes an advance of funds will be disregarded. For example, if a 
controlled foreign corporation acquires property on 30-day payment 
terms from one person and sells that property to another person on 90-
day payment terms and at prearranged prices and terms such that the 
foreign corporation bears no substantial economic risk with respect to 
the purchase and sale other than the risk of non-payment, the foreign 
corporation has not in substance derived income from the sale of 
property.
    (3) Notional principal contracts--(i) In general. Income equivalent 
to interest includes income from notional principal contracts 
denominated in the functional currency of the taxpayer (or a qualified 
business unit of the taxpayer, as defined in section 989(a)), the value 
of which is determined solely by reference to interest rates or 
interest rate indices, to the extent that the income from such 
transactions accrues on or after August 14, 1989.
    (ii) Regular dealers. Income equivalent to interest does not 
include income earned by a regular dealer (as defined in paragraph 
(a)(4)(iv) of this section) from notional principal contracts that are 
dealer property (as defined in paragraph (a)(4)(v) of this section).
    (4) Income equivalent to interest from factoring--(i) General rule. 
Income equivalent to interest includes factoring income. Except as 
provided in paragraph (h)(4)(ii) of this section, the term factoring 
income includes any income (including any discount income or service 
fee, but excluding any stated interest) derived from the acquisition 
and collection or disposition of a factored receivable. The amount of 
income equivalent to interest realized with respect to a factored 
receivable is the difference (if a positive number) between the amount 
paid for the receivable by the foreign corporation and the amount that 
it collects on the receivable (or realizes upon its sale of the 
receivable). The rules of this paragraph (h)(4) apply only with respect 
to the tax treatment of factoring income derived from the acquisition 
and collection or disposition of a factored receivable and shall not 
affect the characterization of an expense or loss of either the person 
whose goods or services gave rise to a factored receivable or the 
obligor under a receivable.
    (ii) Exceptions. Factoring income shall not include--
    (A) Income treated as interest under section 864(d) (1) or (6) 
(relating to income derived from trade or service receivables of 
related persons), even if such income is treated as not described in 
section 864(d)(1) by reason of the same-country exception of section 
864(d)(7);
    (B) Income derived from a factored receivable if payment for the 
acquisition of the receivable is made on or after the date on which 
stated interest begins to accrue, but only if the rate of stated 
interest equals or exceeds 120 percent of the Federal short-term rate 
(as defined under section 1274) (or the analogous rate for a currency 
other than the dollar) as of the date on which the receivable is 
acquired by the foreign corporation; or
    (C) Income derived from a factored receivable if payment for the 
acquisition of the receivable by the foreign corporation is made only 
on or after the anticipated date of payment of all principal by the 
obligor (or the anticipated weighted average date of payment of a pool 
of purchased receivables).
    (iii) Factored receivable. For purposes of this paragraph (h)(4), 
the term factored receivable includes any account receivable or other 
evidence of indebtedness, whether or not issued at a discount and 
whether or not bearing stated interest, arising out of the disposition 
of property or the performance of services by any person, if such 
account receivable or evidence of indebtedness is acquired by a person 
other than the person who disposed of the property or provided the 
services that gave rise to the account receivable or evidence of 
indebtedness. For purposes of this paragraph (h)(4), it is immaterial 
whether the person providing the property or services agrees to 
transfer the receivable at the time of sale (as by accepting a third-
party charge or credit card) or at a later time.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (h)(4).

    Example 1. DP, a domestic corporation, owns all of the 
outstanding stock of FS, a controlled foreign corporation. FS 
acquires accounts receivable arising from the sale of property by 
unrelated corporation X. The receivables have a face amount of $100, 
and after 30 days bear stated interest equal to at least 120 percent 
of the applicable Federal short-term rate (determined as of the date 
the receivable is acquired by FS). FS purchases the receivables from 
X for $95 on Day 1 and collects $100 plus stated interest from the 
obligor under the receivable on Day 40. Income (other than stated 
interest) derived by FS from the factored receivables is factoring 
income within the meaning of paragraph (h)(4)(i) of this section 
and, therefore, is income equivalent to interest.
    Example 2. The facts are the same as in Example 1, except that, 
rather than collecting $100 plus stated interest from the obligor 
under the factored receivable on Day 40, FS sells the receivable to 
controlled foreign corporation Y on Day 15 for $97. Both the income 
derived by FS on the factored receivable and the income derived by Y 
(other than stated interest) on the receivable are factoring income 
within the meaning of paragraph (h)(4)(i) of this section, and 

[[Page 46529]]
therefore, constitute income equivalent to interest.
    Example 3. The facts are the same as in Example 1, except that 
FS purchases the receivables from X for $98 on Day 30. Income 
derived by FS from the factored receivables is excluded from 
factoring income under paragraph (h)(4)(ii)(B) of this section and, 
therefore, does not give rise to income equivalent to interest.
    Example 4. The facts are the same as in Example 3, except that 
it is anticipated that all principal will be paid by the obligor of 
the receivables by Day 30. Income derived by FS from this maturity 
factoring of the receivables is excluded from factoring income under 
paragraph (h)(4)(ii)(C) of this section and, therefore, does not 
give rise to income equivalent to interest.
    Example 5. The facts are the same as in Example 4, except that 
FS sells the factored receivable to Y for $99 on day 45, at which 
time stated interest is accruing on the unpaid balance of $100. 
Because interest was accruing at the time Y acquired the receivable 
at a rate equal to at least 120 percent of the applicable Federal 
short-term rate, income derived by Y from the factored receivable is 
excluded from factoring income under paragraph (h)(4)(ii)(B) of this 
section and, therefore, does not give rise to income equivalent to 
interest.
    Example 6. DP, a domestic corporation engaged in an integrated 
credit card business, owns all of the outstanding stock of FS, a 
controlled foreign corporation. On Day 1 individual A uses a credit 
card issued by DP to purchase shoes priced at $100 from X, a foreign 
corporation unrelated to DP, FS, or A. On Day 7, X transfers the 
receivable (which does not bear stated interest) arising from A's 
purchase to FS in exchange for $95. FS collects $100 from A on Day 
45. Income derived by FS on the factored receivable is factoring 
income within the meaning of paragraph (h)(4)(i) of this section 
and, therefore, is income equivalent to interest.

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

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

    Par. 4. Section 1.957-1 is amended by adding paragraphs (a), (c) 
Examples 8 through 10, and (d) to read as follows:


Sec. 1.957-1  Definition of controlled foreign corporation.

    (a) In general. The term controlled foreign corporation means any 
foreign corporation of which more than 50 percent (or such lesser 
amount as is provided in section 957(b) or section 953(c)) of either--
    (1) The total combined voting power of all classes of stock of the 
corporation entitled to vote; or
    (2) The total value of the stock of the corporation, is owned 
within the meaning of section 958(a), or (except for purposes of 
section 953(c)) is considered as owned by applying the rules of section 
958(b) and Sec. 1.958-2, by United States shareholders on any day 
during the taxable year of such foreign corporation. For the definition 
of the term United States shareholder, see sections 951(b) and 
953(c)(1)(A). For the definition of the term foreign corporation, see 
Sec. 301.7701-5 of this chapter (Procedure and Administration 
Regulations). For the treatment of associations as corporations, see 
section 7701(a)(3) and Secs. 301.7701-1 and 301.7701-2 of this chapter. 
For the definition of the term stock, see sections 958(a)(3) and 
7701(a)(7). For the classification of a member in an association, joint 
stock company, or insurance company as a shareholder, see section 
7701(a)(8).
* * * * *
    (c) * * *

    Example 8. For its prior taxable year, JV, a foreign 
corporation, had outstanding 1000 shares of class A stock, which is 
voting common, and 1000 shares of class B stock, which is nonvoting 
preferred. DP, a domestic corporation, and FP, a foreign 
corporation, each owned precisely 500 shares of both class A and 
class B stock, and each elected 5 of the 10 members of JV's board of 
directors. The other facts and circumstances were such that JV was 
not a controlled foreign corporation on any day of the prior taxable 
year. On the first day of the current taxable year, DP purchased one 
share of class B stock from FP. JV was a controlled foreign 
corporation on that day because over 50 percent of the total value 
in the corporation 

[[Page 46530]]
was held by a person that was a United States shareholder under section 
951(b).
    Example 9. The facts are the same as in Example 8 except that 
the stock of FP was publicly traded, FP had one class of stock, and 
on the first day of the current taxable year DP purchased one share 
of FP stock on the foreign stock exchange instead of purchasing one 
share of JV stock from FP. JV became a controlled foreign 
corporation on that day because over 50 percent of the total value 
in the corporation was held by a person that was a United States 
shareholder under section 951(b).
    Example 10. X, a foreign corporation, is incorporated under the 
laws of country Y. Under the laws of country Y, X is considered a 
mutual insurance company. X issues insurance policies that provide 
the policyholder with the right to vote for directors of the 
corporation, the right to a share of the assets upon liquidation in 
proportion to premiums paid, and the right to receive policyholder 
dividends in proportion to premiums paid. Only policyholders are 
provided with the right to vote for directors, share in assets upon 
liquidation, and receive distributions. United States policyholders 
contribute 25 percent of the premiums and have 25 percent of the 
outstanding rights to vote for the board of directors. Based on 
these facts, the United States policyholders are United States 
shareholders owning the requisite combined voting power and value. 
Thus, X is a controlled foreign corporation for purposes of taking 
into account related person insurance income under section 953(c).

    (d) Effective date. Paragraphs (a) and (c) Examples 8 through 10 of 
this section are effective for taxable years of a controlled foreign 
corporation beginning after November 6, 1995.


Sec. 1.954A-1 and 1.954A-2  [Removed]

    Par. 5. Sections 1.954A-1 and 1.954A-2 are removed.


Sec. 1.957-1T  [Removed]

    Par. 6. Section 1.957-1T is removed.

PART 4--[ADDED]

    Par. 7. 26 CFR part 4 is added to read as follows:

PART 4--TEMPORARY INCOME TAX REGULATIONS UNDER SECTION 954 OF THE 
INTERNAL REVENUE CODE

Sec.
4.954-0  Introduction.
4.954-1  Foreign base company income; taxable years beginning after 
December 31, 1986.
4.954-2  Foreign personal holding company income; taxable years 
beginning after December 31, 1986.

    Authority: 26 U.S.C. 7805.

Sec.
4.954-0  also issued under 26 U.S.C. 954 (b) and (c).
4.954-1  also issued under 26 U.S.C. 954 (b) and (c).
4.954-2  also issued under 26 U.S.C. 954 (b) and (c).
Secs. 1.954-0T, 1.954-1T and 1.954-2T  [Redesignated as Secs. 4.954-0, 
4.954-1 and 4.954-2]

    Par. 8. Sections 1.954-0T, 1.954-1T and 1.954-2T are redesignated 
as Secs. 4.954-0, 4.954-1 and 4.954-2, respectively, and the language 
``temporary'' is removed at the end of each section heading.
    Par. 9. Newly designated Sec. 4.954-0 is amended by:
    1. Removing the language ``Secs. 1.954-1T and 1.954-2T'' from the 
first sentence of paragraph (a)(1) and adding ``Secs. 4.954-1 and 
4.954-2'' in its place.
    2. Adding a sentence at the end of paragraph (a)(1) to read as set 
forth below.
    3. In paragraph (b) by removing the entries numbered (I), (II), and 
(III) and adding in their places entries for the headings of 
Secs. 4.954-0 through 4.954-2 as follows:


Sec. 4.954-0  Introduction.

    (a) * * * (1) * * * For further guidance, see Sec. 1.954-0(a) of 
this chapter.
    (b) * * *

Sec.

4.954-0  Introduction.
* * * * *
4.954-1  Foreign base company income.
* * * * *
4.954-2  Foreign personal holding company income.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 10. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 11. In Sec. 602.101, paragraph c is amended by:
    1. Removing the following entries from the table:


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
                                                                        
                  *        *        *        *        *                 
1.954-1T...................................................    1545-1068
1.954-2T...................................................    1545-1068
                                                                        
                  *        *        *        *        *                 
1.954A-2...................................................    1545-0755
------------------------------------------------------------------------

    2. Adding entries in numerical order to the table to read as 
follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
                                                                        
                  *        *        *        *        *                 
1.954-1....................................................    1545-1068
1.954-2....................................................    1545-1068
                                                                        
                  *        *        *        *        *                 
4.954-1....................................................    1545-1068
4.954-2....................................................    1545-1068
                                                                        
                  *        *        *        *        *                 
------------------------------------------------------------------------

Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: August 22, 1995.
Cynthia Gibson Beerbower,
Deputy Assistant Secretary of the Treasury.
[FR Doc. 95-21838 Filed 9-6-95; 8:45 am]
BILLING CODE 4830-01-U