[Federal Register Volume 62, Number 1 (Thursday, January 2, 1997)]
[Rules and Regulations]
[Pages 17-22]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-32378]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8704]
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: Final regulations.

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SUMMARY: This document contains final 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 regulations are necessary to provide guidance that coordinates 
with previously published guidance under section 954. These regulations 
will affect United States shareholders of controlled foreign 
corporations.

DATES: These regulations are effective January 2, 1997.
    For specific dates of applicability, see Secs. 1.952-1(f)(5), 
1.952-2(c)(1), 1.954-2(b)(3) and 1.960-1(i)(6).

FOR FURTHER INFORMATION CONTACT: Valerie Mark, (202) 622-3840 (not a 
toll-free call).

SUPPLEMENTARY INFORMATION:

Background

    On September 7, 1995, proposed regulations (IL-75-92) amending the 
Income Tax Regulations (26 CFR Part 1) under sections 952, 954(c) and 
960 of the Internal Revenue Code (Code) were published in the Federal 
Register (60 FR 46548). In final regulations under section 954 (TD 
8618), also published on that date (60 FR 46500), a provision relating 
to the treatment of tax-exempt interest under the foreign personal 
holding company income rules was reserved. The proposed regulations 
provided rules for the treatment of tax-exempt interest and also 
provided guidance under sections 952 and 960 to coordinate with the 
final regulations. No public hearing was requested or held. One written 
comment was received on the proposed regulations. After consideration 
of this comment, the proposed regulations are adopted as final 
regulations without amendment.

Explanation of Provisions

Sections 1.952-1(e) and (f) and 1.960-1(i)

    Sections 1.952-1(e) and (f) and 1.960-1(i) are unchanged from the 
proposed regulations.

Sections 1.952-2(c)(1) and 1.954-2(b)(3)

    Under Sec. 1.954-2T(b)(6), interest income that was exempt from tax 
under section 103 was included in the foreign personal holding company 
income of the controlled foreign corporation. However, the net foreign 
base company income that was attributable to tax-exempt interest was 
treated as tax-exempt interest in the hands of the United States 
shareholder upon a deemed distribution under subpart F and therefore 
excluded for regular tax purposes but potentially subject to the 
alternative minimum tax. Section 1.954-2(b)(3), as proposed and 
finalized, amends 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. As a result of 
the treatment of tax-exempt interest in these final regulations, Rev. 
Rul. 72-527 (1972-2 C.B. 456) is obsoleted.
    A commentator argued that treatment of tax-exempt interest in the 
proposed regulations was contrary to section 103. This comment was 
rejected. The Code does not specifically address how section 103 
applies in the context of subpart F. Although Sec. 1.952-2 provides 
that, in general, U.S. tax principles apply in computing subpart F 
income, this regulation makes certain Code provisions inapplicable when 
necessary to serve the purposes of subpart F. See Sec. 1.952-2(c)(1).

Section 1.954-1(d)(4)(iii)

    The example in Sec. 1.954-1(d)(4)(iii) is amended to correct a 
mathematical error.

Section 1.954-2(g)(2)

    The regulations are amended to clarify that income derived in the 
trade or business of trading foreign currency

[[Page 18]]

is not excluded from foreign personal holding company income under the 
business needs exception. A technical correction is made to Sec. 1.954-
2(g)(2)(ii)(B)(2).

Section 1.957-1(c)

    Technical corrections are made to Sec. 1.957-1(c) Examples 8 and 9.

Special Analyses

    It has been determined that this Treasury decision 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 Procedure Act (5 U.S.C. chapter 5) 
does not apply to these regulations, and because these regulations do 
not impose a collection of information on small entities, the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 
Pursuant to section 7805(f) of the Internal Revenue Code, the notice of 
proposed rulemaking preceding these regulations was submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

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.

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 amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry 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

[[Page 19]]

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, 1998, whose 
functional currency is the u. In 1998, 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 1998 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 1998, 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 1998 subpart F 
income that is not included in A's income in 1998 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) of this section, the 
amount by which CFC's subpart F income exceeds its earnings and 
profits for 1998, 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 1998 
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 1998. 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 1998 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 1999, 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 1999, 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 1999 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 1999. Accordingly, under paragraph (e)(1)(iii) of this 
section, the amount by which CFC's subpart F income exceeds its 
earnings and profits for 1999, 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 1999. At the close of 1999 CFC has 105u in its 
general limitation/foreign base company sales income recapture 
account (100u from 1998 + 5u from 1999), 55u in its passive 
limitation/foreign personal holding company income recapture account 
(50u from 1998 + 5u from 1999), and 50u in its dividends from the 
noncontrolled section 902 corporation/foreign personal holding 
company income recapture account (all from 1998).
    (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 1999 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 1999. 
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 1999 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

[[Page 20]]

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 1999 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 1998, 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 1998, 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 1998, 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 1998 
subpart F income that is not included in A's income in 1998 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) of this section, the 
amount of CFC's subpart F income in excess of earnings and profits 
for 1998, 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 1998 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 1999, 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)(i) of this section, the recapture 
rules are applied first. Thus, the amount by which 1999 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 1999 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 1998 and 125u 
attributable to 1999), 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)(ii) 
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 1999 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 1999 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.

    (5) Effective date. Paragraph (e) of this section and this 
paragraph (f) apply to taxable years of a controlled foreign 
corporation beginning after March 3, 1997.
    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 subchapters F, G, H, L, M, N, S, and T of chapter 1 of 
the Internal Revenue Code shall not apply and, for taxable years of a 
controlled foreign corporation beginning after March 3, 1997, the 
provisions of section 103 of the Internal Revenue Code shall not apply.
* * * * *
    Par. 4. In Sec. 1.954-1, the Example in paragraph (d)(4)(iii) is 
revised to read as follows:


Sec. 1.954-1   Foreign base company income.

* * * * *
    (d) * * *
    (4) * * *
    (iii) * * *

    Example. During its 1995 taxable year, CFC, a controlled foreign 
corporation, earns royalty income, net of taxes, of $100 that is 
foreign personal holding company income. CFC has no expenses 
associated with this royalty income. CFC pays $50 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 
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 $50, the effective rate of tax 
on the item, for purposes of this paragraph (d), is 50 percent ($50 
of taxes/$50 net item + $50 of taxes). Accordingly, an election 
under paragraph (d)(5) of this section may be made to exclude

[[Page 21]]

the item of income from the computation of subpart F income.
* * * * *
    Par. 5. In Sec. 1.954-2, paragraphs (b)(3), (g)(2)(ii)(B)(1)(i) and 
(g)(2)(ii)(B)(2) are revised to read as follows:


Sec. 1.954-2   Foreign personal holding company income.

* * * * *
    (b) * * *
    (3) Treatment of tax exempt interest. For taxable years of a 
controlled foreign corporation beginning after March 3, 1997, foreign 
personal holding company income includes all interest income, including 
interest that is described in section 103 (see Sec. 1.952-2(c)(1)).
* * * * *
    (g) * * *
    (2) * * *
    (ii) * * *
    (B) * * *
    (1) * * *
    (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, other than the 
trade or business of trading foreign currency;
* * * * *
    (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 paragraphs (g)(2)(ii)(B)(1) (i) through (iii) of this 
section, provided that any gain or loss arising from such transaction 
or property that is attributable to changes in exchange rates is 
clearly determinable from the records of the CFC as being derived from 
such transaction or property. 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 or property that satisfy the requirements of 
paragraphs (g)(2)(ii)(B)(1) (i) through (iii) of this section, provided 
that any gain or loss arising from such transactions or property that 
is attributable to changes in exchange rates is clearly determinable 
from the records of the CFC as being derived from such transactions or 
property.
* * * * *
    Par. 6. Section 1.957-1 is amended by:
    1. Removing the last sentence of paragraph (c) Example 8 and adding 
two sentences in its place.
    2. Revising the last sentence of paragraph (c) Example 9.
    The addition and revision read as follows:


Sec. 1.957-1   Definition of controlled foreign corporation.

* * * * *
    (c) * * *

    Example 8. * * * JV was a controlled foreign corporation on the 
following 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). See Sec. 1.951-1(f).
    Example 9. * * * JV became a controlled foreign corporation on 
the following 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).
* * * * *
    Par. 7. 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 the 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 sections 902 and 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 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, 1998, whose 
functional currency is the u. In 1998 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 1998 
CFC also incurs a (50u) loss in the shipping category described in 
section 904(d)(1)(D). CFC's subpart F income for 1998, 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 
Internal Revenue Code and paragraph (i)(1) of this section, A 
includes 100u of passive limitation income in gross income for 1998.
    (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

[[Page 22]]

under paragraph (i)(4) of this section)/75u passive earnings). After 
the inclusion and deemed-paid taxes are computed, at the close of 
1998 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 1999, CFC distributes 150u to A. 
CFC has 100u of previously-taxed earnings and profits described in 
section 959(c)(2) attributable to 1998, 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 1999 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 
1999 dividend of 50u (50u dividend/50u general limitation earnings). 
After the deemed-paid taxes are computed, at the close of 1999 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.

    (6) Effective date. This paragraph (i) applies to taxable years of 
a controlled foreign corporation beginning after March 3, 1997.
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved: December 11, 1996.
Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 97-32378 Filed 12-31-96; 8:45 am]
BILLING CODE 4830-01-U