[Federal Register Volume 60, Number 173 (Thursday, September 7, 1995)]
[Proposed Rules]
[Pages 46548-46553]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-21839]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0075-92]
RIN 1545-AR31


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed Income Tax Regulations 
relating to the definitions of subpart F income and foreign personal 
holding company income of a controlled foreign corporation and the 
allocation of deficits for purposes of computing the deemed-paid 
foreign tax credit. These proposed regulations are necessary to provide 
guidance that coordinates with guidance provided in final regulations 
under section 954, published elsewhere in this issue of the Federal 
Register. These regulations will affect United States shareholders of 
controlled foreign corporations. This document also contains a notice 
of hearing on these regulations.

DATES: Written comments must be received by December 6, 1995. Outlines 
of topics to be discussed at the public hearing scheduled for January 
4, 1996 at 10 a.m. must be received by December 14, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0075-92), room 
5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington DC 20044. In the alternative, submissions may be hand 
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R 
(INTL-0075-92), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington DC. The public hearing will be held 
in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue 
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Valerie 
Mark, (202) 622-3840; concerning submissions and the hearing, Michael 
Slaughter (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    This notice of proposed rulemaking does not contain collections of 
information and, therefore, it has not been submitted to the Office of 
Management and Budget for review under the Paperwork Reduction Act (44 
U.S.C. 3504(h)).

Background

    This document contains proposed regulations amending the Income Tax 
Regulations (26 CFR Part 1) under sections 952, 954(c) and 960 of the 
Internal Revenue Code. These regulations are also issued under 
authority contained in section 7805 of the Internal Revenue Code. In 
final regulations under section 954, published elsewhere in this issue 
of the Federal Register, the section relating to the treatment of tax-
exempt interest under the foreign personal holding company income rules 
was reserved. These proposed regulations would provide rules for the 
treatment of tax-exempt interest and would also provide guidance under 
sections 952 and 960 to coordinate with the final regulations.

Explanation of Provisions

Sections 1.952-1 (e) and (f) and 1.960-1(i)
    Section 1.954-1(c)(1)(ii), published elsewhere in this issue of the 
Federal Register, provides generally that if the amount in any category 
of foreign base company income or foreign personal holding company 
income is less than zero, the loss 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). The earnings and profits limitation will apply when subpart 
F income exceeds current earnings and profits. This notice of proposed 
rulemaking provides rules under section 952(c)(1)(A) to determine how 
the excess of subpart F income over current earnings and profits will 
reduce categories of foreign base company income or foreign personal 
holding company income.
    These rules apply both to determine the amount that is included in 
the U.S. shareholder's gross income in each category of subpart F 
income under section 951(a)(1)(A) from each section 904(d) separate 
category, and to determine the subpart F category and the section 
904(d) separate category from which an amount will be recharacterized 
as subpart F income under section 952(c)(2). Separate rules are 
provided in this notice of proposed rulemaking to compute post-1986 
undistributed earnings under section 960.
    Section 1.952-1(e) provides that for post-1986 years, when the 
subpart F income of a controlled foreign corporation exceeds its 
current earnings and profits, this excess, first, proportionately 
reduces subpart F income in each separate category in which current 
earnings and profits are zero or less than zero, second, 
proportionately reduces subpart F income in each separate category in 
which subpart F income exceeds current earnings and profits, and third, 
proportionately reduces subpart F income in other separate categories. 
If a single separate category contains more than one category of 
subpart F income, the categories of subpart F income in the separate 
category will be proportionately reduced.
    Section 1.952-1(f) provides that the amount and category of subpart 
F income in each separate category that is reduced by operation of the 
earnings and profits limitation, as determined under paragraph (e), 
constitutes a recapture account. In any year in which earnings and 
profits exceed subpart F income, the recapture accounts in each 
separate category of the corporation will be recharacterized, on a 
proportionate basis, as subpart F income to the extent of this excess. 
An amount that is recharacterized as subpart F income is treated as 
income in the same separate category as the recapture account from 
which it was derived. 

[[Page 46549]]

    Under paragraph (f), a recapture account is reduced either when 
amounts in the account are recharacterized as subpart F income or when 
the corporation makes an actual distribution from the separate category 
containing the recapture account. A distribution out of section 
959(c)(3) earnings and profits is treated as made first on a 
proportionate basis out of the recapture accounts in each separate 
category. If a distribution from earnings and profits described in 
section 959(c)(3) occurs in the same year that an amount is 
recharacterized, the recharacterization rules will apply first. 
Examples are provided to illustrate the rules of paragraphs (e) and 
(f).
    Regulations are proposed under section 960 that apply the 
principles of section 902 to determine the portion of the controlled 
foreign corporation's post-1986 foreign income taxes deemed to be paid 
by a United States corporate shareholder in connection with a subpart F 
inclusion. If the corporate shareholder computes an amount under both 
sections 902 and 960 for a taxable year, section 960 is applied first.
    These proposed regulations also provide rules to determine how 
deficits in post-1986 undistributed earnings are allocated for purposes 
of sections 902 and 960. In accordance with the approach of Notice 88-
70 (1988-2 C.B 369), Sec. 1.960-1(i)(4) provides that a post-1986 
accumulated deficit in a separate category is allocated pro rata 
against post-1986 undistributed earnings in other separate categories 
to compute post-1986 undistributed earnings. The deficit does not 
permanently reduce earnings in these other separate categories. Rather, 
after deemed-paid taxes are computed, it is carried forward in the same 
separate category in which it was incurred. Paragraph (i)(3) clarifies 
that the numerator of the deemed-paid credit fraction cannot exceed the 
denominator because deemed-paid taxes may not exceed taxes paid or 
accrued by the controlled foreign corporation. Examples are provided to 
illustrate these rules.
    The proposed regulations attempt to coordinate, to the extent 
possible, the allocation of deficits for purposes of determining the 
amounts of subpart F inclusions and deemed-paid taxes out of the 
controlled foreign corporation's separate foreign tax credit limitation 
categories under sections 952, 954, and 960. Complete coordination is 
not possible in all cases, because subpart F income and the earnings 
and profits limitation of section 952(c)(1)(A) are determined on the 
basis of earnings and profits of only the current year, whereas deemed-
paid taxes are calculated under section 960 on the basis of multi-year 
pools of earnings and profits and taxes. In addition, potential 
differences in the calculation of income and earnings and profits, cf. 
section 952(c)(3), complicate the coordination.
    The proposed rules attempt to minimize the incidence of subpart F 
inclusions out of separate categories with no current earnings which, 
in the absence of sufficient accumulated earnings, may carry no deemed-
paid taxes. Comments are requested as to whether the proposed 
allocation methods or some alternative approach would best achieve 
appropriate foreign tax credit results.
Section 1.954-2(b)(3)
    Under Sec. 1.954-2T(b)(6), interest income that is exempt from tax 
under section 103 is included in the foreign personal holding company 
income of the controlled foreign corporation. However, the net foreign 
base company income that is attributable to tax-exempt interest is 
treated as tax-exempt interest in the hands of the United States 
shareholder upon a deemed distribution under subpart F. Therefore, for 
regular tax purposes, the tax-exempt interest is not currently included 
in the gross income of the United States shareholder under subpart F. 
However, the deemed distribution of tax-exempt interest may subject the 
United States shareholder to the alternative minimum tax.
    Section 1.954-2(b)(3) of the proposed regulations would amend the 
rule in the temporary regulations to provide that foreign personal 
holding company income includes interest income that is exempt from tax 
under section 103. The tax-exempt interest would not retain its 
character as such in the hands of the United States shareholder upon a 
deemed distribution under subpart F. This proposed rule closely 
parallels the domestic rule for tax-exempt interest. The controlled 
foreign corporation realizes the tax benefit associated with the 
receipt of interest income described in section 103 because no United 
States withholding tax is collected on the income when it is paid to 
the controlled foreign corporation. As in the domestic context, 
however, this tax benefit is limited to the corporate level and is not 
retained when the tax-exempt interest is distributed to the United 
States shareholders or included in their gross income under subpart F. 
This rule simplifies the interaction of the tax-exempt interest and 
alternative minimum tax provisions, and avoids the double-taxation and 
administrative problems associated with the current rule.
    These regulations are proposed to be effective for taxable years of 
the foreign corporation beginning after 60 days after the date these 
regulations are published as final regulations in the Federal Register.

Special Analyses

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

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (signed original 
and eight (8) copies) that are timely submitted to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for January 4, 1996, at 10 a.m. 
in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue 
NW., Washington DC. Because of access restrictions, visitors will not 
be admitted beyond the building lobby more than 15 minutes before the 
hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons 
that wish to present oral comments at the hearing must submit written 
comments by December 6, 1995 and submit an outline of topics to be 
discussed and time to be devoted to each topic (signed original and 
eight (8) copies) by December 14, 1995.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

    Drafting Information. The principal authors of these regulations 
are Barbara Felker and Valerie Mark of the Office of the Associate 
Chief Counsel (International), IRS. However, other personnel from 
the IRS and Treasury Department participated in their development. 

[[Page 46550]]


List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

    Paragraph 1. The authority for Part 1 is amended by adding the 
following citation in numerical order to read as follows:

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


Section 1.960-1 also issued under 26 U.S.C. 960(a). * * *
    Par. 2. Section 1.952-1 is amended by adding paragraphs (e) and (f) 
to read as follows:


Sec. 1.952-1  Subpart F income defined.

* * * * *
    (e) Application of current earnings and profits limitation--(1) In 
general. If the subpart F income (as defined in section 952(a)) of a 
controlled foreign corporation exceeds the foreign corporation's 
earnings and profits for the taxable year, the subpart F income 
includible in the income of the corporation's United States 
shareholders is reduced under section 952(c)(1)(A) in accordance with 
the following rules. The excess of subpart F income over current year 
earnings and profits shall--
    (i) First, proportionately reduce subpart F income in each separate 
category of the controlled foreign corporation, as defined in 
Sec. 1.904-5(a)(1), in which current earnings and profits are zero or 
less than zero;
    (ii) Second, proportionately reduce subpart F income in each 
separate category in which subpart F income exceeds current earnings 
and profits; and
    (iii) Third, proportionately reduce subpart F income in other 
separate categories.
    (2) Allocation to a category of subpart F income. An excess amount 
that is allocated under paragraph (e)(1) of this section to a separate 
category must be further allocated to a category of subpart F income if 
the separate category contains more than one category of subpart F 
income described in section 952(a) or, in the case of foreign base 
company income, described in Sec. 1.954- 1(c)(1)(iii)(A) (1) or (2). In 
such case, the excess amount that is allocated to the separate category 
must be allocated to the various categories of subpart F income within 
that separate category on a proportionate basis.
    (3) Recapture of subpart F income reduced by operation of earnings 
and profits limitation. Any amount in a category of subpart F income 
described in section 952(a) or, in the case of foreign base company 
income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2) that is 
reduced by operation of the current year earnings and profits 
limitation of section 952(c)(1)(A) and this paragraph (e) shall be 
subject to recapture in a subsequent year under the rules of section 
952(c)(2) and paragraph (f) of this section.
    (4) Coordination with sections 953 and 954. The rules of this 
paragraph (e) shall be applied after the application of sections 953 
and 954 and the regulations under those sections, except as provided in 
Sec. 1.954-1(d)(4)(ii).
    (5) Earnings and deficits retain separate limitation character. The 
income reduction rules of paragraph (e)(1) of this section shall apply 
only for purposes of determining the amount of an inclusion under 
section 951(a)(1)(A) from each separate category as defined in 
Sec. 1.904-5(a)(1) and the separate categories in which recapture 
accounts are established under section 952(c)(2) and paragraph (f) of 
this section. For rules applicable in computing post-1986 undistributed 
earnings, see generally section 902 and the regulations under that 
section. For rules relating to the allocation of deficits for purposes 
of computing foreign taxes deemed paid under section 960 with respect 
to an inclusion under section 951(a)(1)(A), see Sec. 1.960-1(i).
    (f) Recapture of subpart F income in subsequent taxable year--(1) 
In general. If a controlled foreign corporation's subpart F income for 
a taxable year is reduced under the current year earnings and profits 
limitation of section 952(c)(1)(A) and paragraph (e) of this section, 
recapture accounts will be established and subject to 
recharacterization in any subsequent taxable year to the extent the 
recapture accounts were not previously recharacterized or distributed, 
as provided in paragraphs (f) (2) and (3) of this section.
    (2) Rules of recapture--(i) Recapture account. If a category of 
subpart F income described in section 952(a) or, in the case of foreign 
base company income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2) 
is reduced under the current year earnings and profits limitation of 
section 952(c)(1)(A) and paragraph (e) of this section for a taxable 
year, the amount of such reduction shall constitute a recapture 
account.
    (ii) Recapture. Each recapture account of the controlled foreign 
corporation will be recharacterized, on a proportionate basis, as 
subpart F income in the same separate category (as defined in 
Sec. 1.904-5(a)(1)) as the recapture account to the extent that current 
year earnings and profits exceed subpart F income in a taxable year. 
The United States shareholder must include his pro rata share 
(determined under the rules of Sec. 1.951-1(e)) of each recharacterized 
amount in income as subpart F income in such separate category for the 
taxable year.
    (iii) Reduction of recapture account and corresponding earnings. 
Each recapture account, and post-1986 undistributed earnings in the 
separate category containing the recapture account, will be reduced in 
any taxable year by the amount which is recharacterized under paragraph 
(f)(2)(ii) of this section. In addition, each recapture account, and 
post-1986 undistributed earnings in the separate category containing 
the recapture account, will be reduced in the amount of any 
distribution out of that account (as determined under the ordering 
rules of section 959(c) and paragraph (f)(3)(ii) of this section).
    (3) Distribution ordering rules--(i) Coordination of recapture and 
distribution rules. If a controlled foreign corporation distributes an 
amount out of earnings and profits described in section 959(c)(3) in a 
year in which current year earnings and profits exceed subpart F income 
and there is an amount in a recapture account for such year, the 
recapture rules will apply first.
    (ii) Distributions reduce recapture accounts first. Any 
distribution made by a controlled foreign corporation out of earnings 
and profits described in section 959(c)(3) shall be treated as made 
first on a proportionate basis out of the recapture accounts in each 
separate category to the extent thereof (even if the amount in the 
recapture account exceeds post-1986 undistributed earnings in the 
separate category containing the recapture account). Any remaining 
distribution shall be treated as made on a proportionate basis out of 
the remaining earnings and profits of the controlled foreign 
corporation in each separate category. See section 904(d)(3)(D).
    (4) Examples. The application of paragraphs (e) and (f) of this 
section may be illustrated by the following examples:


    Example 1. (i) A, a U.S. person, is the sole shareholder of CFC, 
a controlled foreign corporation formed on January 1, 1996, whose 
functional currency is the u. In 1996, CFC earns 100u of foreign 
base company sales income that is general limitation income 
described in section 904(d)(1)(I) and incurs a (200u) loss 
attributable to activities that would have produced general 
limitation income that is not subpart F income. In 1996 

[[Page 46551]]
CFC also earns 100u of foreign personal holding company income that is 
passive income described in section 904(d)(1)(A), and 100u of 
foreign personal holding company income that is dividend income 
subject to a separate limitation described in section 904(d)(1)(E) 
for dividends from a noncontrolled section 902 corporation. CFC's 
subpart F income for 1996, 300u, exceeds CFC's current earnings and 
profits, 100u, by 200u. Under section 952(c)(1)(A) and paragraph (e) 
of this section, subpart F income is limited to CFC's current 
earnings and profits of 100u, all of which is included in A's gross 
income under section 951(a)(1)(A). The 200u of CFC's 1996 subpart F 
income that is not included in A's income in 1996 by reason of 
section 952(c)(1)(A) is subject to recapture under section 952(c)(2) 
and paragraph (f) of this section.
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in 
CFC's recapture account, the rules of paragraphs (e)(1) and (2) of 
this section apply. Under paragraph (e)(1)(i), the amount by which 
CFC's subpart F income exceeds its earnings and profits for 1996, 
200u, first reduces from 100u to 0 CFC's subpart F income in the 
general limitation category, which has a current year deficit of 
(100u) in earnings and profits. Next, under paragraph (e)(1)(iii) of 
this section, the remaining 100u by which CFC's 1996 subpart F 
income exceeds earnings and profits is applied proportionately to 
reduce CFC's subpart F income in the separate categories for passive 
income (100u) and dividends from the noncontrolled section 902 
corporation (100u). Thus, A includes 50u of passive limitation/
foreign personal holding company income and 50u of dividends from 
the noncontrolled section 902 corporation/foreign personal holding 
company income in gross income in 1996. CFC has 100u in its general 
limitation/foreign base company sales income recapture account 
attributable to the 100u of foreign base company sales income that 
is not included in A's income by reason of the earnings and profits 
limitation of section 952(c)(1)(A). CFC also has 50u in its passive 
limitation recapture account, all of which is attributable to 
foreign personal holding company income, and 50u in its recapture 
account for dividends from the noncontrolled section 902 
corporation, all of which is attributable to foreign personal 
holding company income.
    (iii) For purposes of computing post-1986 undistributed 
earnings, the rules of sections 902 and 960, including the rules of 
Sec. 1.960-1(i), apply. Under Sec. 1.960-1(i), the general 
limitation deficit of (100u) is allocated proportionately to reduce 
passive limitation earnings of 100u and noncontrolled section 902 
dividend earnings of 100u. Thus, passive limitation earnings are 
reduced by 50u to 50u (100u passive limitation earnings/200u total 
earnings in positive separate categories  x (100u) general 
limitation deficit =50u reduction), and the noncontrolled section 
902 corporation earnings are reduced by 50u to 50u (100u 
noncontrolled section 902 corporation earnings/200u total earnings 
in positive separate categories  x (100u) general limitation 
deficit=50u reduction). All of CFC's post-1986 foreign income taxes 
with respect to passive limitation income and dividends from the 
noncontrolled section 902 corporation are deemed paid by A under 
section 960 with respect to the subpart F inclusions (50u inclusion/
50u earnings in each separate category). After the inclusion and 
deemed-paid taxes are computed, at the close of 1996 CFC has a 
(100u) deficit in general limitation earnings (100u subpart F 
earnings + (200u) nonsubpart F loss), 50u of passive limitation 
earnings (100u of earnings attributable to foreign personal holding 
company income -50u inclusion) with a corresponding passive 
limitation/foreign personal holding company income recapture account 
of 50u, and 50u of earnings subject to a separate limitation for 
dividends from the noncontrolled section 902 corporation (100u 
earnings -50u inclusion) with a corresponding noncontrolled section 
902 corporation/foreign personal holding company income recapture 
account of 50u.
    Example 2. (i) The facts are the same as in Example 1 with the 
addition of the following facts. In 1997, CFC earns 100u of foreign 
base company sales income that is general limitation income and 100u 
of foreign personal holding company income that is passive 
limitation income. In addition, CFC incurs (10u) of expenses that 
are allocable to its separate limitation for dividends from the 
noncontrolled section 902 corporation. Thus, CFC's subpart F income 
for 1997, 200u, exceeds CFC's current earnings and profits, 190u, by 
10u. Under section 952(c)(1)(A) and paragraph (e) of this section, 
subpart F income is limited to CFC's current earnings and profits of 
190u, all of which is included in A's gross income under section 
951(a)(1)(A).
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in 
CFC's recapture accounts, the rules of paragraphs (e) (1) and (2) of 
this section apply. While CFC's general limitation post-1986 
undistributed earnings for 1997 are 0 ((100u) opening balance + 100u 
subpart F income), CFC's general limitation subpart F income (100u) 
does not exceed its general limitation current earnings and profits 
(100u) for 1997. Accordingly, under paragraph (e)(1)(iii) of this 
section, the amount by which CFC's subpart F income exceeds its 
earnings and profits for 1997, 10u, is applied proportionately to 
reduce CFC's subpart F income in the separate categories for general 
limitation income, 100u, and passive income, 100u. Thus, A includes 
95u of general limitation foreign base company sales income and 95u 
of passive limitation foreign personal holding company income in 
gross income in 1997. At the close of 1997 CFC has 105u in its 
general limitation/foreign base company sales income recapture 
account (100u from 1996 + 5u from 1997), 55u in its passive 
limitation/foreign personal holding company income recapture account 
(50u from 1996 + 5u from 1997), and 50u in its dividends from the 
noncontrolled section 902 corporation/foreign personal holding 
company income recapture account (all from 1996).
    (iii) For purposes of computing post-1986 undistributed earnings 
in each separate category, the rules of sections 902 and 960, 
including the rules of Sec. 1.960-1(i), apply. Thus, post-1986 
undistributed earnings (or an accumulated deficit) in each separate 
category are increased (or reduced) by current earnings and profits 
or current deficits in each separate category. The accumulated 
deficit in CFC's general limitation earnings and profits (100u) is 
reduced to 0 by the addition of 100u of 1997 earnings and profits. 
CFC's passive limitation earnings of 50u are increased by 100u to 
150u, and CFC's noncontrolled section 902 corporation earnings of 
50u are decreased by (10u) to 40u. After the addition of current 
year earnings and profits and deficits to the separate categories 
there are no deficits remaining in any separate category. Thus, the 
allocation rules of Sec. 1.960-1(i)(4) do not apply in 1997. 
Accordingly, in determining the post-1986 foreign income taxes 
deemed paid by A, post-1986 undistributed earnings in each separate 
category are unaffected by earnings in the other categories. Foreign 
taxes deemed paid under section 960 for 1997 would be determined as 
follows for each separate category: with respect to the inclusion of 
95u of foreign base company sales income out of general limitation 
earnings, the section 960 fraction is 95u inclusion/0 total 
earnings; with respect to the inclusion of 95u of passive limitation 
income the section 960 fraction is 95u inclusion/150u passive 
earnings. Thus, no general limitation taxes would be associated with 
the inclusion of the general limitation earnings because there are 
no accumulated earnings in the general limitation category. After 
the deemed-paid taxes are computed, at the close of 1997 CFC has a 
(95u) deficit in general limitation earnings and profits ((100u) 
opening balance + 100u current earnings--95u inclusion), 55u of 
passive limitation earnings and profits (50u opening balance + 100u 
current foreign personal holding company income--95u inclusion), and 
40u of earnings and profits subject to the separate limitation for 
dividends from the noncontrolled section 902 corporation (50u 
opening balance + (10u) expense).
    Example 3. (i) A, a U.S. person, is the sole shareholder of CFC, 
a controlled foreign corporation whose functional currency is the u. 
At the beginning of 1996, CFC has post-1986 undistributed earnings 
of 275u, all of which are general limitation earnings described in 
section 904(d)(1)(I). CFC has no previously-taxed earnings and 
profits described in section 959 (c)(1) or (c)(2). In 1996, CFC has 
a (200u) loss in the shipping category described in section 
904(d)(1)(D), 100u of foreign personal holding company income that 
is passive income described in section 904(d)(1)(A), and 125u of 
general limitation manufacturing earnings that are not subpart F 
income. CFC's subpart F income for 1996, 100u, exceeds CFC's current 
earnings and profits, 25u, by 75u. Under section 952(c)(1)(A) and 
paragraph (e) of this section, subpart F income is limited to CFC's 
current earnings and profits of 25u, all of which is included in A's 
gross income under section 951(a)(1)(A). The 75u of CFC's 1996 
subpart F income that is not included in A's income in 1996 by 
reason of section 952(c)(1)(A) is subject to recapture under 

[[Page 46552]]
section 952(c)(2) and paragraph (f) of this section.
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in 
CFC's recapture account, the rules of paragraphs (e) (1) and (2) of 
this section apply. Under paragraph (e)(1) of this section, the 
amount of CFC's subpart F income in excess of earnings and profits 
for 1996, 75u, reduces the 100u of passive limitation foreign 
personal holding company income. Thus, A includes 25u of passive 
limitation foreign personal holding company income in gross income, 
and CFC has 75u in its passive limitation/foreign personal holding 
company income recapture account.
    (iii) For purposes of computing post-1986 undistributed earnings 
in each separate category the rules of sections 902 and 960, 
including the rules of Sec. 1.960-1(i), apply. Under Sec. 1.960-
1(i), the shipping limitation deficit of (200u) is allocated 
proportionately to reduce general limitation earnings of 400u and 
passive limitation earnings of 100u. Thus, general limitation 
earnings are reduced by 160u to 240u (400u general limitation 
earnings/500u total earnings in positive separate categories  x  
(200u) shipping deficit = 160u reduction), and passive limitation 
earnings are reduced by 40u to 60u (100u passive earnings/500u total 
earnings in positive separate categories  x  (200u) shipping deficit 
= 40u reduction). Five-twelfths of CFC's post-1986 foreign income 
taxes with respect to passive limitation earnings are deemed paid by 
A under section 960 with respect to the subpart F inclusion (25u 
inclusion/60u passive earnings). After the inclusion and deemed-paid 
taxes are computed, at the close of 1996 CFC has 400u of general 
limitation earnings (275u opening balance + 125u current earnings), 
75u of passive limitation earnings (100u of foreign personal holding 
company income -25u inclusion), and a (200u) deficit in shipping 
limitation earnings.
    Example 4. (i) The facts are the same as in Example 3 with the 
addition of the following facts. In 1997, CFC earns 50u of general 
limitation earnings that are not subpart F income and 75u of passive 
limitation income that is foreign personal holding company income. 
Thus, CFC has 125u of current earnings and profits. CFC distributes 
200u to A. Under paragraph (f)(3)(ii) of this section, the recapture 
rules are applied first. Thus, the amount by which 1997 current 
earnings and profits exceed subpart F income, 50u, is 
recharacterized as passive limitation foreign personal holding 
company income. CFC's total subpart F income for 1997 is 125u of 
passive limitation foreign personal holding company income (75u 
current earnings plus 50u recapture account), and the passive 
limitation/foreign personal holding company income recapture account 
is reduced from 75u to 25u.
    (ii) CFC has 150u of previously-taxed earnings and profits 
described in section 959(c)(2) (25u attributable to 1996 and 125u 
attributable to 1997), all of which is passive limitation earnings 
and profits. Under section 959(c), 150u of the 200u distribution is 
deemed to be made from earnings and profits described in section 
959(c)(2). The remaining 50u is deemed to be made from earnings and 
profits described in section 959(c)(3). Under paragraph (f)(3)(i) of 
this section, the dividend distribution is deemed to be made first 
out of the passive limitation recapture account to the extent 
thereof (25u). Under paragraph (f)(2)(iii) of this section, the 
passive limitation recapture account is reduced from 25u to 0. The 
remaining distribution of 25u is treated as made out of CFC's 
general limitation earnings and profits.
    (iii) For purposes of computing post-1986 undistributed 
earnings, the rules of section 902 and 960, including the rules of 
Sec. 1.960-1(i), apply. Thus, the shipping limitation accumulated 
deficit of (200u) reduces general limitation earnings and profits of 
450u and passive limitation earnings and profits of 150u on a 
proportionate basis. Thus, 100% of CFC's post-1986 foreign income 
taxes with respect to passive limitation earnings are deemed paid by 
A under section 960 with respect to the 1997 subpart F inclusion of 
125u (100u inclusion (numerator limited to denominator)/100u passive 
earnings). No post-1986 foreign income taxes remain to be deemed 
paid under section 902 in connection with the 25u distribution from 
the passive limitation/foreign personal holding company income 
recapture account. One-twelfth of CFC's post-1986 foreign income 
taxes with respect to general limitation earnings are deemed paid by 
A under section 902 with respect to the distribution of 25u general 
limitation earnings and profits described in section 959(c)(3) (25u 
inclusion/300u general limitation earnings). After the deemed-paid 
taxes are computed, at the close of 1997 CFC has 425u of general 
limitation earnings and profits (400u opening balance + 50u current 
earnings -25u distribution), 0 of passive limitation earnings (75u 
recapture account +75u current foreign personal holding company 
income -125u inclusion -25u distribution), and a (200u) deficit in 
shipping limitation earnings.

    Par. 3. In Sec. 1.952-2, paragraph (c)(1) is revised to read as 
follows:


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

* * * * *
    (c) Special rules for purposes of this section--(1) Nonapplication 
of certain provisions. Except where otherwise distinctly expressed, the 
provisions of section 103 and subchapters F, G, H, L, M, N, S, and T of 
chapter 1 of the Internal Revenue Code shall not apply.
* * * * *
    Par. 4. In Sec. 1.954-2, the text of paragraph (b)(3) is added to 
read as follows:


Sec. 1.954-2  Foreign personal holding company income.

* * * * *
    (b) * * *
    (3) Treatment of tax exempt interest. Foreign personal holding 
company income includes all interest income, including interest that is 
described in section 103 (see Sec. 1.952-2(c)(1)).
* * * * *
    Par. 5. In Sec. 1.960-1, paragraph (i) is added to read as follows:


Sec. 1.960-1  Foreign tax credit with respect to taxes paid on earnings 
and profits of controlled foreign corporations.

* * * * *
    (i) Computation of deemed-paid taxes in post-1986 taxable years--
(1) General rule. If a domestic corporation is eligible to compute 
deemed-paid taxes under section 960(a)(1) with respect to an amount 
included in gross income under section 951(a), then, such domestic 
corporation shall be deemed to have paid a portion of such foreign 
corporation's post-1986 foreign income taxes determined under section 
902 and the regulations under that section in the same manner as if the 
amount so included were a dividend paid by such foreign corporation 
(determined by applying section 902(c) in accordance with section 
904(d)(3)(B)).
    (2) Ordering rule for computing deemed-paid taxes under sections 
902 and 960. If a domestic corporation computes deemed-paid taxes under 
both section 902 and section 960 in the same taxable year, section 960 
shall be applied first. After the deemed-paid taxes are computed under 
section 960 with respect to a deemed income inclusion, post-1986 
undistributed earnings and post-1986 foreign income taxes in each 
separate category shall be reduced by the appropriate amounts before 
deemed-paid taxes are computed under section 902 with respect to a 
dividend distribution.
    (3) Computation of post-1986 undistributed earnings. Post-1986 
undistributed earnings (or an accumulated deficit in post-1986 
undistributed earnings) are computed under section 902 and the 
regulations under that section.
    (4) Allocation of accumulated deficits. For purposes of computing 
post-1986 undistributed earnings under sections 902 and 960, a post-
1986 accumulated deficit in a separate category shall be allocated 
proportionately to reduce post-1986 undistributed earnings in the other 
separate categories. However, a deficit in any separate category shall 
not permanently reduce earnings in other separate categories, but after 
the deemed-paid taxes are computed the separate limitation deficit 
shall be carried forward in the same separate category in which it was 
incurred. In addition, because deemed-paid taxes may not exceed taxes 
paid or accrued by the controlled foreign corporation, in computing 
deemed-paid taxes with 

[[Page 46553]]
respect to an inclusion out of a separate category that exceeds post-
1986 undistributed earnings in that separate category, the numerator of 
the deemed-paid credit fraction (deemed inclusion from the separate 
category) may not exceed the denominator (post-1986 undistributed 
earnings in the separate category).
    (5) Examples. The application of this paragraph (i) may be 
illustrated by the following examples. See Sec. 1.952-1(f)(4) for 
additional illustrations of these rules.

    Example 1. (i) A, a U.S. person, is the sole shareholder of CFC, 
a controlled foreign corporation formed on January 1, 1996, whose 
functional currency is the u. In 1996 CFC earns 100u of general 
limitation income described in section 904(d)(1)(I) that is not 
subpart F income and 100u of foreign personal holding company income 
that is passive income described in section 904(d)(1)(A). In 1996 
CFC also incurs a (50u) loss in the shipping category described in 
section 904(d)(1)(D). CFC's subpart F income for 1996, 100u, does 
not exceed CFC's current earnings and profits of 150u. Accordingly, 
all 100u of CFC's subpart F income is included in A's gross income 
under section 951(a)(1)(A). Under section 904(d)(3)(B) of the Code 
and paragraph (i)(1) of this section, A includes 100u of passive 
limitation income in gross income for 1996.
    (ii) For purposes of computing post-1986 undistributed earnings 
under sections 902, 904(d) and 960 with respect to the subpart F 
inclusion, the shipping limitation deficit of (50u) is allocated 
proportionately to reduce general limitation earnings of 100u and 
passive limitation earnings of 100u. Thus, general limitation 
earnings are reduced by 25u to 75u (100u general limitation 
earnings/200u total earnings in positive separate categories  x  
(50u) shipping deficit = 25u reduction), and passive limitation 
earnings are reduced by 25u to 75u (100u passive earnings/200u total 
earnings in positive separate categories  x  (50u) shipping deficit 
= 25u reduction). All of CFC's post-1986 foreign income taxes with 
respect to passive limitation earnings are deemed paid by A under 
section 960 with respect to the 100u subpart F inclusion of passive 
income (75u inclusion (numerator limited to denominator under 
paragraph (i)(4) of this section)/75u passive earnings). After the 
inclusion and deemed-paid taxes are computed, at the close of 1996 
CFC has 100u of general limitation earnings, 0 of passive limitation 
earnings (100u of foreign personal holding company income--100u 
inclusion), and a (50u) deficit in shipping limitation earnings.
    Example 2. (i) The facts are the same as in Example 1 with the 
addition of the following facts. In 1997, CFC distributes 150u to A. 
CFC has 100u of previously-taxed earnings and profits described in 
section 959(c)(2) attributable to 1996, all of which is passive 
limitation earnings and profits. Under section 959(c), 100u of the 
150u distribution is deemed to be made from earnings and profits 
described in section 959(c)(2). The remaining 50u is deemed to be 
made from earnings and profits described in section 959(c)(3). The 
entire dividend distribution of 50u is treated as made out of CFC's 
general limitation earnings and profits. See section 904(d)(3)(D).
    (ii) For purposes of computing post-1986 undistributed earnings 
under section 902 with respect to the 1997 dividend of 50u, the 
shipping limitation accumulated deficit of (50u) reduces general 
limitation earnings and profits of 100u to 50u. Thus, 100% of CFC's 
post-1986 foreign income taxes with respect to general limitation 
earnings are deemed paid by A under section 902 with respect to the 
1997 dividend of 50u (50u dividend/50u general limitation earnings). 
After the deemed-paid taxes are computed, at the close of 1997 CFC 
has 50u of general limitation earnings (100u opening balance -50u 
distribution), 0 of passive limitation earnings, and a (50u) deficit 
in shipping limitation earnings.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-21839 Filed 9-6-95; 8:45 am]
BILLING CODE 4830-01-P