[Federal Register Volume 66, Number 2 (Wednesday, January 3, 2001)]
[Rules and Regulations]
[Pages 268-279]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-32477]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8916]
RIN 1545-AY29


Application of Section 904 to Income Subject to Separate 
Limitations and Section 864(e) Affiliated Group Expense Allocation and 
Apportionment Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains Income Tax Regulations relating to the 
section 864(e)(5) and (6) rules on affiliated group interest and other 
expense allocation and apportionment and to the section 904(d) foreign 
tax credit limitation. Changes to the applicable laws were made by the 
Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 
1988, the Revenue Reconciliation Act of 1993, and the Taxpayer Relief 
Act of 1997. These regulations provide guidance needed to comply with 
those changes and affect individuals and corporations claiming foreign 
tax credits.

DATES: Effective Date: These regulations are effective January 3, 2001.
    Applicability Dates: The specific dates of applicability of these 
regulations are as follows:
    The amendments to Secs. 1.861-9, 1.861-11, and 1.861-14 generally 
apply to taxable years beginning after December 31, 1989. The dates of 
applicability are stated in Sec. 1.861-9(h)(5)(i) and (ii), Sec. 1.861-
11(d)(8), and Sec. 1.861-14(d)(1), (d)(2)(i), and (d)(2)(ii).
    The amendment to Sec. 1.904-4(b)(1)(i) applies to taxable years 
beginning after December 31, 1992.
    The amendments to Sec. 1.904-4(e)(3)(ii) and (e)(3)(iv) apply to 
taxable years beginning after December 31, 2000.
    The amendments to Sec. 1.902-1(d)(3)(ii), Sec. 1.904-4(c)(5)(v), 
(c)(6)(iv), (c)(7)(ii), (c)(7)(iii), (c)(8) Example 9, and (g)(3), and 
to Sec. 1.904-5(d)(2) and (m) apply to taxable years beginning after 
December 31, 1986. However, for taxable years beginning before January 
1, 2001, taxpayers may rely on Sec. 1.904-4(c)(6)(iv) and (g)(3)(ii), 
(iii), and (iv) of regulations project REG-209527-92, INTL-1-92, 
published at 1992-1 C.B. 1209. See Sec. 601.601(d)(2) of 26 CFR part 
601 revised April 1, 2000.
    The amendments to Sec. 1.904-5(a)(3), (g), (h)(4), and (i)(1), (3), 
and (4) apply to taxable years beginning after December 31, 2000. 
However, taxpayers may choose to apply the rule of Sec. 1.904-5(i)(3) 
in taxable years beginning after December 31, 1991, provided that the 
taxpayer makes appropriate adjustments to eliminate any double benefit 
arising from the application of the rule to taxable years that are not 
open for assessment.

ADDRESSES: Send submissions to: Regulations Unit CC (REG-106409-00), 
room 5226, 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 Regulations Unit CC 
(REG-106409-00), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue, NW., Washington, DC or sent electronically, via 
the IRS Internet site at: http://www.irs.gov/tax_regs/regslist.html.

FOR FURTHER INFORMATION CONTACT: Bethany A. Ingwalson at (202) 622-3850 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On May 14, 1992, a notice of proposed rulemaking (INTL-1-92,

[[Page 269]]

1992-1 C.B. 1209) was published in the Federal Register (57 FR 20660), 
proposing amendments to the temporary Income Tax Regulations (26 CFR 
part 1) under section 864(e)(5) and (6) and to the Income Tax 
Regulations (26 CFR part 1) under section 904(d). The proposed 
regulations under section 864(e)(5) and (6) concern the allocation and 
apportionment of interest expense and certain other expenses within an 
affiliated group for alternative minimum tax purposes. The proposed 
regulations under section 904(d) provide rules for determining a 
taxpayer's foreign tax credit limitation.
    Also on May 14, 1992, final regulations (TD 8412, 1992-1 C.B. 271) 
under section 904(d) of the Internal Revenue Code of 1986 (Code) were 
published in the Federal Register (57 FR 20639). The final regulations 
added provisions that were reserved in final regulations (TD 8214, 
1988-2 C.B. 220) published in the Federal Register (53 FR 27006) in 
1988 and also made other changes to the 1988 final regulations. Written 
comments were received with respect to the final and proposed 
regulations and a public hearing was held on September 24, 1992.
    On July 8, 1996, additional proposed amendments to the Income Tax 
Regulations under section 904 (REG-209750-95, 1996-2 C.B. 484) were 
published in the Federal Register (61 FR 35696), addressing the 
grouping rules under Sec. 1.904-4(c). On January 11, 1999, final 
regulations (TD 8805, 1999-1 C.B. 371) were published in the Federal 
Register (64 FR 1505) finalizing these amendments and portions of the 
1992 proposed regulations, with modifications.
    The significant points raised by the comments to the 1992 final and 
proposed regulations and at the hearing, and the changes made to the 
proposed, temporary, and final regulations, are discussed in the 
remainder of the preamble. After consideration of the comments 
received, the below-described amendments to the 1992 final regulations 
under section 904 and to the final regulations under section 864 are 
adopted as modified by this Treasury decision.

Explanation of Provisions

I. Sections 1.861-9, 1.861-11, and 1.861-14

    The proposed regulations under Secs. 1.861-9, 1.861-11, and 1.861-
14 are finalized substantially as proposed, and the corresponding 
provisions of the temporary regulations are removed. For purposes of 
the alternative minimum tax (AMT), for taxable years beginning after 
December 31, 1989, the dividends received deduction under section 243 
does not apply to the portion of a dividend attributable to income that 
is exempt from tax under section 936 or 30A. See section 56(g)(4)(C). 
Therefore, the exempt portion of the dividend is, in effect, included 
in adjusted current earnings (ACE) for purposes of computing the 
dividend recipient's alternative minimum taxable income. Dividends from 
a corporation with respect to which an election is in effect under 
section 936 or 30A (a section 936 corporation) are eligible for the 
dividends received deduction for regular tax purposes. Section 
243(b)(1)(B)(ii).
    To the extent included in income, dividends from a section 936 
corporation to an affiliated United States corporation do not qualify 
for look-through treatment under section 904(d)(3) and Sec. 1.904-5. 
Under sections 904, 861(a)(2)(A), and 862(a)(2), such amounts generally 
are treated as foreign source passive income (except as otherwise 
provided in section 904(g)). For taxable years beginning after December 
31, 1993, section 56(g)(4)(C)(iii)(IV), added to the Code as part of 
the Revenue Reconciliation Act of 1993 (Pub. L. 103-66, 107 Stat. 
312)(RRA 1993), creates an AMT foreign tax credit separate limitation 
for dividend income attributable to income that is exempt from tax 
under section 936 or 30A. The separate limitation applies solely for 
AMT purposes.
    Thus, for taxable years beginning after December 31, 1989, and 
before January 1, 1994, the portion of the dividends from section 936 
corporations that are added back into alternative minimum taxable 
income as ACE adjustments are subject to the separate limitation for 
passive income under section 904(d)(2) for AMT foreign tax credit 
purposes. For taxable years beginning after December 31, 1993, 
dividends from section 936 corporations are subject to a separate AMT 
foreign tax credit limitation. In addition, for taxable years beginning 
after December 31, 1995, corporations eligible for a credit under 
section 30A are treated as section 936 corporations, under sections 
30A(e) and 56(g)(4)(C)(iii)(VI).
    Treasury and the IRS proposed changes to the temporary regulations 
in order to exclude section 936 corporations from the affiliated group 
solely for purposes of allocating expenses in determining the amount of 
the group's foreign source alternative minimum taxable income, which 
affects the AMT foreign tax credit. This change has the effect of 
increasing the amount of interest and other expenses apportioned to 
dividend income from a section 936 corporation. The regulations were 
intended to mitigate the treatment, for AMT foreign tax credit 
purposes, of section 936 corporation dividends as passive income and 
would similarly mitigate the treatment of such dividends as separate 
limitation income in post-1993 taxable years.
    Commentators wrote and testified at the public hearing that 
Treasury and the IRS do not have statutory authority to issue 
regulations under section 864(e)(5) excluding section 936 corporations 
from the affiliated group solely for AMT purposes. They contended that 
the AMT and regular tax systems must remain parallel unless a deviation 
is appropriate for simplification purposes. However, the enactment of a 
separate limitation category for certain portions of dividends from 
section 936 corporations for AMT purposes, effective for taxable years 
beginning after 1993, demonstrates that, because of the ACE adjustment, 
the AMT and regular tax foreign tax credit systems cannot operate 
exactly alike with respect to dividend income from section 936 
corporations.
    The amendments were proposed to apply to taxable years beginning 
after December 31, 1991. In response to a comment, the applicability 
date of the amendments to the regulations under Secs. 1.861-9, 1.861-
11, and 1.861-14 has been changed to taxable years beginning after 
December 31, 1989, to conform to the effective date of the statutory 
change. The regulations also provide a definition of section 936 
corporations that reflects the enactment of section 30A.
    In addition, the regulations move the flush text at the end of 
Sec. 1.861-11T(d)(6) to a new Sec. 1.861-11(d)(7). The new paragraph 
(d)(7) provides, among other things, that the attribution rules of 
section 1563(e) rather than the rules of section 318 will apply to 
determine indirect ownership for purposes of Sec. 1.861-11T(d)(6). The 
change in the regulations to refer to section 1563(e) is consistent 
with paragraph 7 of Notice 89-91 (1989-2 C.B. 408), which stated that 
the IRS intends that the reference in Sec. 1.861-11T(d)(6) to section 
318 should instead be a reference to section 1563(e), effective for all 
post-1986 taxable years.

[[Page 270]]

II. Section 1.904

A. Changes to the 1992 Proposed Regulations

1. Distributions From Controlled Foreign Corporations That Are Not 
Eligible for Look-Through Treatment
    Section 1.904-4(g)(3)(i) provides that distributions made by a 
controlled foreign corporation (CFC) from earnings and profits 
accumulated before the distributing corporation became a CFC are 
treated as dividends from a noncontrolled section 902 corporation. The 
final regulations reorganize the provisions of Sec. 1.904-4(g)(3) and 
include a reserved paragraph at Sec. 1.904-4(g)(3)(i)(C). The 
regulations are proposed to be amended in a separate document (REG-
104683-00) published elsewhere in this issue of the Federal Register to 
address the effect of an intervening period when the corporation was 
not a CFC on the eligibility of the distributions for look-through 
treatment.
    Prior to amendment by the Taxpayer Relief Act of 1997 (Public Law 
105-34, 107 Stat. 312) (TRA 1997), section 904(d)(2)(E)(i) provided 
that a CFC would not be treated as a noncontrolled section 902 
corporation with respect to distributions from earnings and profits 
that were accumulated while the corporation was a CFC and, except as 
provided in regulations, the taxpayer was a United States shareholder 
in such corporation. The rule limiting look-through treatment to 
earnings and profits accumulated while the taxpayer was a United States 
shareholder was repealed by TRA 1997, applicable for distributions 
after August 5, 1997.
    With respect to distributions before August 6, 1997, Sec. 1.904-
4(g)(3)(ii) through (iv) of the proposed regulations significantly 
limited the circumstances under which a dividend paid to a new United 
States shareholder by a CFC out of earnings and profits accumulated 
while it was a CFC (but before the recipient became a United States 
shareholder) would be treated as dividends from a noncontrolled section 
902 corporation. The final regulations at Sec. 1.904-4(g)(3)(ii)(A) 
retain the proposed rule denying look-through treatment only to new 
United Sates shareholders that acquire more than 90 percent of a CFC. 
This rule relaxed the statutory limitation to the extent necessary to 
avoid the administrative burdens that would arise if more than one 
United States shareholder were entitled to look-through treatment on 
distributions of post-1986 undistributed earnings but the look-through 
pools for each new shareholder began in different years.
    Commentators argued that the regulations should be further expanded 
to allow look-through on pre-acquisition earnings for all new 
shareholders that acquire at least 10 percent of the voting power of 
the stock of a CFC, that is, to all new shareholders entitled to 
compute a credit for deemed-paid taxes under section 902 and section 
960. Treasury and the IRS declined to adopt the suggestion, because the 
proposed regulations already relaxed the statutory requirement to an 
appropriate extent.
    A commentator suggested that the intra-group acquisition rule in 
Sec. 1.904-4(g)(3)(ii)(C) of the proposed regulations (paragraph 
(g)(3)(ii)(B) of the final regulations) should be revised to apply when 
the new and old shareholders of a CFC are related under the attribution 
rules of sections 318 and 958, rather than only to transfers within an 
affiliated group. Other commentators requested that the exception be 
expanded to apply to nontaxable transfers of stock in which the new and 
old shareholders cease to be members of the same affiliated group. 
Treasury and the IRS decline to expand the scope of the intra-group 
exception to the 90-percent shareholder rule, which applies only for 
distributions prior to August 6, 1997. The final regulations clarify 
the rule of the proposed regulations that the dividend recipient and 
the immediately preceding owner (or owners) must be members of the same 
affiliated group both when the recipient acquires the stock of the 
distributing corporation from the immediately preceding owner and when 
the recipient receives the dividend.
    In response to a comment, the regulations clarify the LIFO ordering 
rule in Sec. 1.904-4(g)(3)(iii) of the proposed regulations (paragraph 
(g)(3)(ii)(C) of the final regulations) for determining whether a 
distribution from a CFC is attributable to the period after a more-
than-90-percent United States shareholder became a United States 
shareholder. The final regulations state that such a distribution comes 
first from the pool of post-acquisition undistributed earnings, next 
from the 10/50 pool of post-1986 undistributed earnings attributable to 
the pre-acquisition period, if any, and finally on a LIFO basis from 
any pre-acquisition earnings and profits attributable to pre-1987 
accumulated profits.
    To reflect the amendments made to section 904(d)(2)(E)(i) by TRA 
1997, the final regulations provide at Sec. 1.904-4(g)(3)(ii)(D) that 
the denial of look-through treatment to new more-than-90-percent 
shareholders for distributions of earnings and profits accumulated 
before the recipient became a United States shareholder applies only to 
distributions made before August 6, 1997. Section 1.904-4(g)(3) has 
been reorganized to separate the rules under section 904(d)(2)(E) that 
are applicable to distributions after August 5, 1997, from the rules 
that are applicable only to distributions on or before that date.
    Rules substantially identical to the proposed section 904 
regulations were proposed in 1995 under section 902. See Prop. Reg. 
Sec. 1.902-1(d)(2)(ii) through (iv) (69 FR 2049; 1995-1 C.B. 959, 970), 
and the reserved paragraph at Sec. 1.902-1(d)(3)(ii)(1997). A 
commentator noted that the effective date included in the proposed 
section 902 regulations applied to taxable years beginning after 
December 31, 1986, while the proposed applicability date for the 
substantially identical regulations proposed under section 904(d) 
applied to taxable years beginning after December 31, 1991. Since 
section 904(d)(2)(E)(i) applies to all taxable years beginning after 
1986, the final regulations adopt the earlier applicability date, and 
amend the reserved paragraph at Sec. 1.902-1(d)(3)(ii) to add a cross 
reference to the final section 904 regulations.
2. Succeeding Shareholders' Treatment of Additional Taxes on Previously 
Taxed Income Recognized by Prior Shareholders
    In response to a comment, Sec. 1.904-4(c)(6)(iv) of the proposed 
regulations is revised. Section 1.904-4(c)(6) provides rules for 
applying the high-tax kick-out from the passive limitation category 
when additional taxes are paid or deemed paid with respect to a 
distribution of previously taxed passive income that had been included 
in income in an earlier year under section 951(a)(1). Paragraph 
(c)(6)(iv) applies when a new shareholder acquires stock in a 
controlled foreign corporation after income has been included in the 
prior shareholder's income under section 951(a)(1) but before the 
income is distributed and subjected to additional foreign tax.
    As proposed, paragraph (c)(6)(iv) provided that new shareholders 
entitled to look-through treatment on distributions of pre-acquisition 
earnings (U.S. shareholders that acquired 90 percent or less of the 
distributing corporation) would place the additional taxes in the 
general limitation category. However, new shareholders who were not 
entitled to look-through treatment (because the shareholder acquired 
more than 90 percent of the distributing corporation) would place the 
taxes in the general limitation or noncontrolled

[[Page 271]]

section 902 corporation category, depending on whether or not the 
associated income inclusion of the prior shareholder was high-taxed 
income.
    A commentator argued that the latter rule's dependence on whether 
income was high-taxed or not in the hands of the previous shareholder, 
for purposes of determining the treatment of the taxes in the hands of 
a new 90-percent shareholder, added unnecessary complexity. In response 
to the comment, the regulations amend Sec. 1.904-4(c)(6)(iv) to provide 
that a shareholder not entitled to look-through on pre-acquisition 
earnings must treat the additional taxes as allocable to the 
noncontrolled section 902 corporation dividend category. The revised 
rule applies to taxable years beginning after December 31, 1991. 
However, taxpayers may rely on the proposed regulations for taxable 
years beginning before January 1, 2001.
    The final regulations adopt the proposed rule that a shareholder 
entitled to look-through treatment on pre-acquisition earnings treats 
additional taxes imposed on distributions of previously taxed passive 
income as allocable to the general limitation category. This rule 
applies to all distributions of previously taxed passive income after 
August 5, 1997.
3. Special Rules for Dividends Between CFCs
    Section 1.904-5(i)(3) of the proposed regulations, reducing to ten 
percent the common ownership threshold for dividends between CFCs to 
qualify for look-through treatment, is finalized as proposed, 
applicable to taxable years beginning after December 31, 2000. However, 
taxpayers may choose to apply the rule to taxable years beginning after 
December 31, 1991, so long as appropriate adjustments are made to 
eliminate any double benefit arising from the application of the rule 
to taxable years that are not open for assessment. Example 2 of 
proposed Sec. 1.904-5(i)(4) is also finalized, with modifications 
described in II B.4 of this preamble, below, relating to changes to 
correct errors in Example 1 in the 1992 final regulations.

B. Changes to the 1992 Final Regulations

1. Passive Limitation FOGEI Income
    Section 1.904-4(b)(1)(i) is amended to clarify that, for taxable 
years beginning after December 31, 1992, passive income does not 
exclude foreign oil and gas extraction income (as defined in section 
907(c)). This amendment reflects the repeal of section 
904(d)(2)(A)(iii)(IV), which excluded FOGEI from the definition of 
passive income, by section 13235(a)(2) of RRA 1993.
2. High-Tax Kickout
    Section 1.904-4(c)(4)(ii) is revised to reflect the addition of 
Sec. 1.904-4(c)(3)(iv).
3. Reduction in Tax on Distribution of Previously Taxed Income
    The 1992 final regulations, which generally look to foreign law 
rules for purposes of determining the year or years to which a 
reduction in foreign tax relates, were intended to apply LIFO default 
rules in order to avoid multiple redeterminations under section 905(c) 
in situations where a tax reduction applies to a distribution of 
previously taxed income that is treated under foreign law as made out 
of a multi-year pool of income. See Sec. 1.905-3T(f) (requiring a 
redetermination of deemed paid taxes, in lieu of a pooling adjustment, 
when corporate tax is reduced in connection with a distribution of 
previously taxed income).
    In response to a comment, Sec. 1.904-4(c)(7)(ii) and Sec. 1.904-
4(c)(8) Example 9 are revised to clarify that if a foreign country's 
law allocates a foreign tax reduction to a pool or group containing 
income from more than one taxable year, and that pool or group is 
defined based on a characteristic of the income (for example, the rate 
of tax paid with respect to the income) rather than based on the 
taxable year in which the income is derived, then foreign law is not 
considered to specify a year or years to which the tax reduction 
applies and the last-in first-out (LIFO) default rule applies.
    In response to a comment, a new paragraph (c)(5)(v) has been added 
to Sec. 1.904-4 to supply a cross-reference to the rule that, pursuant 
to the general rule of section 904(d)(3)(E), passive income excluded 
from foreign personal holding company income under the subpart F high 
tax exception of section 954(b)(4) will be treated as general 
limitation income at the CFC level unless the special rule in 
Sec. 1.904-4(c)(7)(iii) applies.
4. Examples Illustrating Look-Through Rules for Dividends and Interest
    In response to comments, Sec. 1.904-5(i)(4) Example 1 and Prop. 
Sec. 1.904-5(i)(4) Example 2 are revised. The 1992 version of Example 1 
was erroneous because, although the first-tier CFC in that example owns 
only 40 percent of the second-tier CFC, the second-tier CFC owns 100 
percent of the third-tier CFC. Therefore, the second- and third-tier 
CFCs are related look-through entities and the look-through rules of 
Sec. 1.904-5(i)(1) apply to interest payments between them. The section 
904(d)(3)(B) look-through rule for subpart F inclusions applies to the 
U.S. parent's recognition of subpart F income of the second-tier CFC, 
attributable to the interest paid by the third-tier CFC.
    Example 2 of the proposed regulations reached the correct result 
but applied an incorrect rationale. Just as in Example 1, on the facts 
of proposed Example 2, the related look-through entity rules of 
Sec. 1.904-5(i)(1) would apply to distributions between the second- and 
third-tier CFCs even without the application of the special rule for 
dividends in proposed Sec. 1.904-5(i)(3). Examples 1 and 2 are revised 
to illustrate the different ownership thresholds that are required in 
order for the look-through rules to apply to interest and dividends 
paid between CFCs. The regulations also add a new Example 3 to further 
clarify the application of Sec. 1.904-5(i).
5. Treatment of Section 951(a)(1)(B) Inclusions as Dividends
    Paragraph (m)(4) of Sec. 1.904-5 is amended to clarify that, for 
purposes of the section 904(g) re-sourcing rules, section 951(a)(1)(B) 
inclusions are treated as dividends sourced under the pro rata rule of 
section 904(g)(4) and Sec. 1.904-5(m)(4). Section 904(g)(2) provides a 
rule for sourcing section 951(a) inclusions, which literally include 
section 956 inclusions described in section 951(a)(1)(B). Section 
904(g)(2) treats an amount described in section 951(a) as U.S. source 
income to the extent it is attributable to items of U.S. source income 
of the foreign corporation. Inclusions under section 951(a)(1)(A) are 
measured by tracing the inclusion directly to the items of income 
received by a CFC. Like an actual dividend, an increase in earnings 
invested in U.S. property that is included in income under section 
951(a)(1)(B) is treated as paid pro rata out of all of the CFC's 
earnings and profits. See Sec. 1.904-5(c)(4)(i). The final regulations 
amend Sec. 1.904-5(m)(4)(i) to clarify that section 904(g)(2) sources 
section 951(a)(1)(B) inclusions by applying the pro rata rules of 
section 904(g)(4).
6. Treatment of Base Differences in the Case of Financial Services 
Entities
    A commentator requested that Sec. 1.904-6(a)(1)(iv) be revised to 
provide that, in the case of a financial services entity, if foreign 
taxes are imposed on amounts that are not income under United States 
tax rules (a base

[[Page 272]]

difference), the foreign taxes will be placed in the limitation 
category for financial services income rather than the general 
limitation category. The commentator argued that financial services 
entities typically have no general limitation income, and that the 
financial services category essentially serves as the residual basket 
for financial services entities.
    Treasury and the IRS decline to adopt the suggested change. 
Treasury and the IRS believe that most cases in which foreign tax is 
imposed in the absence of a concurrent associated income inclusion in 
the United States are properly analyzed as involving a timing 
difference rather than a base difference. A timing difference occurs 
when foreign tax is imposed on an item that would be income under 
United States tax principles if it were recognized for U.S. tax 
purposes in the same year. Treasury and the IRS believe that base 
differences (in which foreign tax is imposed on an amount that the 
United States would never recognize as income, such as a gift) rarely 
occur. Accordingly, a special rule for base differences of financial 
services entities is not required.
    However, Treasury and the IRS are considering whether additional 
rules are needed to clarify the operation of Sec. 1.904-6(a)(1)(iv). 
For example, Treasury and the IRS are considering whether the 
regulations should be revised to address explicitly situations in which 
a foreign country and the United States recognize different amounts of 
income or characterize the income differently, for example, as a result 
of differences in calculating basis. Other issues under consideration 
include the appropriate treatment of situations in which a timing 
difference occurs but there is more than one possible characterization 
of the income that might be recognized in the future for U.S. tax 
purposes, and situations in which the United States and another country 
perceive different taxpayers as realizing the same income (with or 
without a timing or characterization difference). Comments are 
requested on the appropriate scope and content of additional guidance 
on these types of issues.
    Treasury and the IRS are also considering clarifying Sec. 1.904-
6(a)(1), which provides rules for allocating foreign taxes to separate 
categories. The current regulations determine the income to which the 
foreign taxes relate by reference to foreign law (taxes are related to 
income if the income is included in the tax base upon which the foreign 
tax is imposed). Foreign taxes are allocated and apportioned to 
separate categories by reference to the separate categories to which 
the income taxed under foreign law would be assigned under U.S. tax 
principles. See Sec. 1.904-6(c) Example 5. Comments are requested on 
the manner in which the regulations could be made easier to understand 
and apply.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
notice of proposed rulemaking preceding the regulations was issued 
prior to March 29, 1996, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the 
notice of proposed rulemaking preceding these regulations was submitted 
to the Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal author of these final regulations is Rebecca I. 
Rosenberg of the Office of Associate Chief Counsel (International), 
within the Office of Chief Counsel, IRS. However, other personnel from 
the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

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 
citations for Secs. 1.861-9, 1,861-11, and 1.861-14 to read as follows:

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

    Section 1.861-9 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f). * * *
    Section 1.861-11 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f). Section 1.861-14 
also issued under 26 U.S.C. 863(a), 26 U.S.C. 864(e), 26 U.S.C. 
865(i), and 26 U.S.C. 7701(f). * * *


    Par. 2. Section 1.861-9 is added to read as follows:


Sec. 1.861-9  Allocation and apportionment of interest expense.

    (a) through (h)(4) [Reserved]. For further guidance, see 
Sec. 1.861-9T(a) through (h)(4).
    (h)(5) Characterizing stock in related persons--(i) General rule. 
Stock in a related person held by the taxpayer or by another related 
person shall be characterized on the basis of the fair market value of 
the taxpayer's pro rata share of assets held by the related person 
attributed to each statutory grouping and the residual grouping under 
the stock characterization rules of Sec. 1.861-12T(c)(3)(ii), except 
that the portion of the value of intangible assets of the taxpayer and 
related persons that is apportioned to the related person under 
Sec. 1.861-9T(h)(2) shall be characterized on the basis of the net 
income before interest expense of the related person within each 
statutory grouping or residual grouping (excluding income that is 
passive under Sec. 1.904-4(b)).
    (ii) Special rule for section 936 corporations regarding 
alternative minimum tax. For purposes of characterizing stock in a 
related section 936 corporation in determining foreign source 
alternative minimum taxable income within each separate category and 
the alternative minimum tax foreign tax credit pursuant to section 
59(a), the rules of Sec. 1.861-9T(g)(3) shall apply and Sec. 1.861-
9(h)(5)(i) shall not apply. Thus, for taxable years beginning after 
December 31, 1989, and before January 1, 1994, stock in a related 
section 936 corporation is characterized for alternative minimum tax 
purposes as a foreign source passive asset because the stock produces 
foreign source passive dividend income under sections 861(a)(2)(A), 
862(a)(2), and 904(d)(2)(A) and the regulations under those sections. 
For taxable years beginning after December 31, 1993, stock in a related 
section 936 corporation would be characterized for alternative minimum 
tax purposes as an asset subject to the separate limitation for section 
936 corporation dividends because the stock produces foreign source 
dividend income that, for alternative minimum tax purposes, is subject 
to a separate foreign tax credit limitation under section 
56(g)(4)(C)(iii)(IV). However, stock in a section 936 corporation is 
characterized as a U.S. source asset to the extent required by section 
904(g). For the definition of the term section 936 corporation see 
Sec. 1.861-11(d)(2)(ii).
    (iii) Effective date. This paragraph (h)(5) applies to taxable 
years beginning after December 31, 1989.

[[Page 273]]


    Par. 3. In Sec. 1.861-9T, paragraph (h)(5) is revised to read as 
follows:


Sec. 1.861-9T  Allocation and apportionment of interest expense 
(temporary).

* * * * *
    (h) * * *
    (5) [Reserved]. For further guidance, see Sec. 1.861-9(h)(5).
* * * * *

    Par. 4. Section 1.861-11 is added to read as follows:


Sec. 1.861-11  Special rules for allocating and apportioning interest 
expense of an affiliated group of corporations.

    (a) through (c) [Reserved]. For further guidance, see Sec. 1.861-
11T(a) through (c).
    (d) Definition of affiliated group--(1) General rule. For purposes 
of this section, in general, the term affiliated group has the same 
meaning as is given that term by section 1504, except that section 936 
corporations are also included within the affiliated group to the 
extent provided in paragraph (d)(2) of this section. Section 1504(a) 
defines an affiliated group as one or more chains of includible 
corporations connected through 80-percent stock ownership with a common 
parent corporation which is an includible corporation (as defined in 
section 1504(b)). In the case of a corporation that either becomes or 
ceases to be a member of the group during the course of the 
corporation's taxable year, only the interest expense incurred by the 
group member during the period of membership shall be allocated and 
apportioned as if all members of the group were a single corporation. 
In this regard, assets held during the period of membership shall be 
taken into account. Other interest expense incurred by the group member 
during its taxable year but not during the period of membership shall 
be allocated and apportioned without regard to the other members of the 
group.
    (2) Inclusion of section 936 corporations--(i) Rule--(A) In 
general. Except as otherwise provided in paragraph (d)(2)(i)(B) of this 
section, the exclusion of section 936 corporations from the affiliated 
group under section 1504(b)(4) does not apply for purposes of this 
section. Thus, a section 936 corporation that meets the ownership 
requirements of section 1504(a) is a member of the affiliated group.
    (B) Exception for purposes of alternative minimum tax. The 
exclusion from the affiliated group of section 936 corporations under 
section 1504(b)(4) shall be operative for purposes of the application 
of this section solely in determining the amount of foreign source 
alternative minimum taxable income within each separate category and 
the alternative minimum tax foreign tax credit pursuant to section 
59(a). Thus, a section 936 corporation that meets the ownership 
requirements of section 1504(a) is not a member of the affiliated group 
for purposes of determining the amount of foreign source alternative 
minimum taxable income within each separate category and the 
alternative minimum tax foreign tax credit pursuant to section 59(a).
    (ii) Section 936 corporation defined. For purposes of this section, 
Sec. 1.861-9, and Sec. 1.861-14, the term section 936 corporation 
means, for any taxable year, a corporation with an election in effect 
to be eligible for the credit provided under section 936(a)(1) or 
section 30A for the taxable year.
    (iii) Example. This example illustrates the provisions of paragraph 
(d)(2)(i) of this section:

    Example --(A) Facts. X owns all of the stock of Y. XY 
constitutes an affiliated group of corporations within the meaning 
of section 1504(a) and uses the tax book value method of 
apportionment. In 2000, Y owns all of the stock of Z, a section 936 
corporation. Z manufactures widgets in Puerto Rico. Y purchases 
these widgets and markets them exclusively in the United States. Of 
the three corporations, only Z has foreign source income, which 
includes both qualified possessions source investment income and 
general limitation income. For purposes of section 904, Z's 
qualified possessions source investment income constitutes foreign 
source passive income. In computing the section 30A benefit, Y and Z 
have elected the cost sharing method. Of the three corporations, 
only X has debt and, thus, only X incurs interest expense.
    (B) Analysis for regular tax. Assume first that X has no 
alternative minimum tax liability. Under paragraph (d)(2) of this 
section, Z is treated as a member of the XY affiliated group for 
purposes of allocating and apportioning interest expense for regular 
tax purposes. As provided in Sec. 1.861-11T(b)(2), section 864(e)(1) 
and (5) do not apply in computing the combined taxable income of Y 
and Z under section 936, but these rules do apply in computing the 
foreign source taxable income of the XY affiliated group. The effect 
of including Z in the affiliated group is that X, the only debtor 
corporation in the group, must, under the asset method described in 
Sec. 1.861-9T(g), apportion a part of its interest expense to 
foreign source passive income and foreign source general limitation 
income. This is because the assets of Z that generate qualified 
possessions source investment income and general limitation income 
are included in computing the group apportionment fractions. The 
result is that, under section 904(f), X has an overall foreign loss 
in both the passive and general limitation categories, which 
currently offsets domestic income and must be recaptured against any 
subsequent years' foreign passive income and general limitation 
income, respectively, under the rules of that section.
    (C) Analysis for alternative minimum tax. Assume, alternatively, 
that X is liable to pay the alternative minimum tax. Pursuant to 
section 59(a), X must compute its alternative minimum tax foreign 
tax credit as if section 904 were applied on the basis of 
alternative minimum taxable income instead of taxable income. Under 
paragraph (d)(2)(i)(B) of this section, for purposes of the 
apportionment of interest expense in determining alternative minimum 
taxable income within each limitation category, Z is not considered 
a member of the XY affiliated group. Thus, the stock (and not the 
assets) of Z are included in computing the group apportionment 
fractions. Pursuant to sections 59(g)(4)(C)(iii)(IV), 861(a)(2)(A), 
and 862(a)(2), dividends paid by a section 936 corporation are 
foreign source income subject to a separate foreign tax credit 
limitation for alternative minimum tax purposes. Thus, under 
Sec. 1.861-9T(g)(3), the stock of Z must be considered attributable 
solely to the statutory grouping consisting of foreign source 
dividends from Z. The effect of excluding Z from the affiliated 
group is that X must apportion a part of its interest expense to the 
separate category for foreign source dividends from Z in computing 
alternative minimum taxable income within each separate category. 
If, as a result, under section 904(f), X has a separate limitation 
loss or an overall foreign loss in the category for dividends from Z 
for alternative minimum tax purposes, then that loss must be 
allocated against X's other income (separate limitation or United 
States source, as the case may be). The loss must be recaptured in 
subsequent years under the rules of section 904(f) for purposes of 
the alternative minimum tax foreign tax credit. * * *

    (iv) Effective date. This paragraph (d)(2) applies to taxable years 
beginning after December 31, 1989.
    (d)(3) through (6) [Reserved]. For further guidance see Sec. 1.861-
11T(d)(3) through (6).
    (7) Special rules for the application of Sec. 1.861-11T(d)(6). The 
attribution rules of section 1563(e) and the regulations under that 
section shall apply in determining indirect ownership under Sec. 1.861-
11T(d)(6). The Commissioner shall have the authority to disregard 
trusts, partnerships, and pass-through entities that break affiliated 
status. Corporations described in Sec. 1.861-11T(d)(6) shall be 
considered to constitute members of an affiliated group that does not 
file a consolidated return and shall therefore be subject to the 
limitations imposed under Sec. 1.861-11T(g). The affiliated group 
filing a consolidated return shall be considered to constitute a single 
corporation for purposes of applying the rules of Sec. 1.861-11T(g). 
For taxable years beginning after December 31, 1989, Sec. 1.861-
11T(d)(6)(i) shall not apply in determining foreign source alternative 
minimum taxable income within each

[[Page 274]]

separate category and the alternative minimum tax foreign tax credit 
pursuant to section 59(a) to the extent that such application would 
result in the inclusion of a section 936 corporation within the 
affiliated group. This paragraph (d)(7) applies to taxable years 
beginning after December 31, 1986.
    (e) through (g) [Reserved]. For further guidance, see Sec. 1.861-
11T(e) through (g).

    Par. 5. Section 1.861-11T is amended by:
    1. Revising paragraphs (d)(1) and (d)(2).
    2. Removing the concluding text following (d)(6)(ii).
    3. Adding paragraph (d)(7).
    The revisions and additions read as follows:


Sec. 1.861-11T  Special rules for allocating and apportioning interest 
expense of an affiliated group of corporations (temporary).

* * * * *
    (d)(1) and (2) [Reserved]. For further guidance, see Sec. 1.861-
11(d)(1) and (2).
* * * * *
    (7) Special rules for the application of Sec. 1.861-11T(d)(6). 
[Reserved]. For special rules for the application of Sec. 1.861-
11T(d)(6), see Sec. 1.861-11(d)(7).
* * * * *

    Par. 6. Section 1.861-14 is added to read as follows:


Sec. 1.861-14  Special rules for allocating and apportioning certain 
expenses (other than interest expense) of an affiliated group of 
corporations.

    (a) through (c) [Reserved]. For further guidance, see Sec. 1.861-
14T(a) through (c).
    (d) Definition of affiliated group--(1) General rule. For purposes 
of this section, the term affiliated group has the same meaning as is 
given that term by section 1504, except that section 936 corporations 
(as defined in Sec. 1.861-11(d)(2)(ii)) are also included within the 
affiliated group to the extent provided in paragraph (d)(2) of this 
section. Section 1504(a) defines an affiliated group as one or more 
chains of includible corporations connected through 80% stock ownership 
with a common parent corporation which is an includible corporation (as 
defined in section 1504(b)). In the case of a corporation that either 
becomes or ceases to be a member of the group during the course of the 
corporation's taxable year, only the expenses incurred by the group 
member during the period of membership shall be allocated and 
apportioned as if all members of the group were a single corporation. 
In this regard, the apportionment factor chosen shall relate only to 
the period of membership. For example, if apportionment on the basis of 
assets is chosen, the average amount of assets (tax book value or fair 
market value) for the taxable year shall be multiplied by a fraction, 
the numerator of which is the number of months of the corporation's 
taxable year during which the corporation was a member of the 
affiliated group, and the denominator of which is the number of months 
within the corporation's taxable year. If apportionment on the basis of 
gross income is chosen, only gross income generated during the period 
of membership shall be taken into account. If apportionment on the 
basis of units sold or sales receipts is chosen, only units sold or 
sales receipts during the period of membership shall be taken into 
account. Expenses incurred by the group member during its taxable year, 
but not during the period of membership, shall be allocated and 
apportioned without regard to other members of the group. This 
paragraph (d)(1) applies to taxable years beginning after December 31, 
1989.
    (2) Inclusion of section 936 corporations--(i) General rule. Except 
as otherwise provided in paragraph (d)(2)(ii) of this section, the 
exclusion from the affiliated group of section 936 corporations under 
section 1504(b)(4) does not apply for purposes of this section. Thus, a 
section 936 corporation that meets the ownership requirements of 
section 1504(a) is a member of the affiliated group.
    (ii) Exception for purposes of alternative minimum tax. The 
exclusion from the affiliated group of section 936 corporations under 
section 1504(b)(4) shall be operative for purposes of the application 
of this section solely in determining the amount of foreign source 
alternative minimum taxable income within each separate category and 
the alternative minimum tax foreign tax credit pursuant to section 
59(a). Thus, a section 936 corporation that meets the ownership 
requirements of section 1504(a) is not a member of the affiliated group 
for purposes of determining the amount of foreign source alternative 
minimum taxable income within each separate category and the 
alternative minimum tax foreign tax credit pursuant to section 59(a).
    (iii) Effective date. This paragraph (d)(2) applies to taxable 
years beginning after December 31, 1989.
    (d)(3) through (j) [Reserved]. For further guidance see Sec. 1.861-
14T(d)(3) through (j).

    Par. 7. In Sec. 1.861-14T, paragraph (d) is revised to read as 
follows:


Sec. 1.861-14T  Special rules for allocating and apportioning certain 
expenses (other than interest expense) of an affiliated group of 
corporations (temporary).

* * * * *
    (d)(1) and (2) [Reserved]. For further guidance, see Sec. 1.861-
14(d)(1) and (2).
* * * * *

    Par. 8. Section 1.902-1(d)(3)(ii) is amended by adding text to read 
as follows:


Sec. 1.902-1  Credit for domestic corporate shareholder of a foreign 
corporation for foreign income taxes paid by the foreign corporation.

* * * * *
    (d) * * *
    (3) * * *
    (ii) * * * For rules regarding dividend distributions before August 
6, 1997, to certain more-than-90-percent United States shareholders of 
a controlled foreign corporation, see Sec. 1.904-4(g)(3)(ii).
* * * * *

    Par. 9. Section 1.904-0 is amended as follows:
    1. Amending the entries for Sec. 1.904-4 by:
    a. Adding entries for paragraphs (c)(5)(v), (c)(6)(iv)(A), and 
(c)(6)(iv)(B).
    b. Adding an entry for paragraph (g)(2)(v).
    c. Revising the entries for paragraphs (g)(3) and (g)(3)(i).
    d. Adding entries for paragraphs (g)(3)(i)(A), (g)(3)(i)(B), 
(g)(3)(i)(C), and (g)(3)(i)(D).
    e. Revising the entry for paragraph (g)(3)(ii).
    f. Adding entries for paragraphs (g)(3)(ii)(A), (g)(3)(ii)(B), 
(g)(3)(ii)(C), (g)(3)(ii)(D), and (g)(3)(ii)(E).
    g. Revising the entries for paragraphs (g)(3)(iii) and (g)(3)(iv).
    h. Adding an entry for paragraph (g)(3)(v).
    i. Removing the entry for paragraph (g)(4).
    The revisions and additions read as follows:

Sec. 1.904-0  Outline of regulation provisions for section 904.

* * * * *


Sec. 1.904-4  Separate application of section 904 with respect to 
certain categories of income.

* * * * *
    (c) * * *
    (5) * * *
    (v) Coordination with section 954(b)(4).
    (6) * * *
    (iv) * * *
    (A) General rule.
    (B) Exception for U.S. shareholders not entitled to look-
through.
* * * * *

[[Page 275]]

    (g) * * *
    (2) * * *
    (v) Examples.
    (3) Special rule for dividends paid by a controlled foreign 
corporation.
    (i) Distributions out of earnings and profits accumulated when 
the distributing corporation was not a controlled foreign 
corporation.
    (A) General rule.
    (B) Ordering rule.
    (C) Effect of intervening noncontrolled status.
    (D) Examples.
    (ii) Pre-August 6, 1997, dividend distributions out of earnings 
and profits accumulated before a more-than-90-percent United States 
shareholder became a United States shareholder.
    (A) General rule.
    (B) Exception for intra-group acquisitions.
    (C) Ordering rule.
    (D) Distributions after August 5, 1997.
    (E) Examples.
    (iii) Treatment of earnings and profits for transition year.
    (iv) Definitions.
    (v) Effective date.
* * * * *

    Par. 10. Section 1.904-4 is amended by:
    1. Revising the second sentence in paragraph (b)(1)(i)(B).
    2. Revising paragraph (c)(4)(ii).
    3. Adding a new paragraph (c)(5)(v).
    4. Adding the text to paragraph (c)(6)(iv).
    5. Adding a new sentence at the end of paragraph (c)(7)(ii).
    6. Revising the second sentence of paragraph (c)(7)(iii).
    7. Amending paragraph (c)(8) by revising the fifth sentence of 
paragraph (i) of Example 9, and the fifth sentence of paragraph (ii) of 
Example 9.
    8. Revising paragraph (e)(3)(ii).
    9. Adding the text to paragraph (e)(3)(iv) Example 2.
    10. Redesignating paragraph (g)(4) as paragraph (g)(2)(v).
    11. Revising the heading for paragraph (g)(3) and revising 
paragraph (g)(3)(i).
    12. Revising the paragraph headings and adding the text to 
paragraphs (g)(3)(ii) through (iv).
    13. Adding paragraph (g)(3)(v).
    The revisions and additions read as follows:


Sec. 1.904-4  Separate application of section 904 with respect to 
certain categories of income.

* * * * *
    (b) * * * (1) * * * (i) * * *
    (B) * * * Passive income does not include any income that is also 
described in section 904(d)(1)(B) through (H), any export financing 
interest (as defined in section 904(d)(2)(G) and paragraph (h) of this 
section), any high taxed income (as defined in section 904(d)(2)(F) and 
paragraph (c) of this section, or, for taxable years beginning before 
January 1, 1993, any foreign oil and gas extraction income (as defined 
in section 907(c)). * * *
* * * * *
    (c) * * *
    (4) * * *
    (ii) Income from sources without the QBU's country of operation. 
Passive income from sources without the QBU's country of operation 
shall be grouped on the basis of the tax imposed on that income as 
provided in paragraphs (c)(3)(i) through (iv) of this section.
* * * * *
    (5) * * *
    (v) Coordination with section 954(b)(4). For rules relating to 
passive income of a controlled foreign corporation that is exempt from 
subpart F treatment because the income is subject to high foreign tax, 
see section 904(d)(3)(E), Sec. 1.904-4(c)(7)(iii), and Sec. 1.904-
5(d)(2).
    (6) * * *
    (iv) Increase in taxes paid by successors--(A) General rule. Except 
as provided in paragraph (c)(6)(iv)(B) of this section, if passive 
earnings and profits previously included in income of a United States 
shareholder are distributed to a person that was not a United States 
shareholder of the distributing corporation in the year the earnings 
were included, any increase in foreign taxes paid or accrued, or deemed 
paid or accrued, on that distribution shall be treated as taxes related 
to general limitation income, regardless of whether the previously-
taxed income was considered high-taxed income under section 
904(d)(2)(F) in the year of inclusion.
    (B) Exception for U.S. shareholders not entitled to look-through. 
In the case of a United States shareholder that, by reason of paragraph 
(g)(3)(ii) of this section (relating to distributions prior to August 
6, 1997, to new shareholders acquiring more than 90 percent of a 
controlled foreign corporation), is not entitled to look-through 
treatment with respect to pre-acquisition earnings and profits of the 
distributing corporation, the increase in foreign taxes described in 
paragraph (c)(6)(iv)(A) of this section shall be treated as taxes 
related to the noncontrolled section 902 corporation income of the 
distributing corporation.
    (C) Effective date. This paragraph (c)(6)(iv) applies to taxable 
years beginning after December 31, 1986. However, for taxable years 
beginning before January 1, 2001, taxpayers may rely on Sec. 1.904-
4(c)(6)(iv) of regulations project INTL-1-92, published at 1992-1 C.B. 
1209. See Sec. 601.601(d)(2) of this chapter.
    (7) * * *
    (ii) * * * For purposes of this paragraph (c)(7)(ii), foreign law 
is not considered to attribute a reduction in tax to a particular year 
or years if foreign law attributes the tax reduction to a pool or group 
containing income from more than one taxable year and such pool or 
group is defined based on a characteristic of the income (for example, 
the rate of tax paid with respect to the income) rather than on the 
taxable year in which the income is derived.
    (iii) * * * If a taxpayer excludes passive income from a controlled 
foreign corporation's foreign personal holding company income under 
these circumstances, then, notwithstanding the general rule of 
Sec. 1.904-5(d)(2), the income shall be considered to be passive income 
until distribution of that income.* * *
    (8) * * *

    Example 9.  (i) * * * Under country G's law, distributions are 
treated as made out of a pool of undistributed earnings subject to 
the 50% tax rate. * * *
    (ii) * * * Country G treats the distribution of earnings as out 
of the 50% tax rate pool of earnings accumulated in 1987 and 1988. * 
* *
* * * * *
    (e) * * *
    (3) * * *
    (ii) Special rule for affiliated groups. In the case of any 
corporation that is not a financial services entity under paragraph 
(e)(3)(i) of this section, but is a member of an affiliated group, such 
corporation will be deemed to be a financial services entity if the 
affiliated group as a whole meets the requirements of paragraph 
(e)(3)(i) of this section. For purposes of this paragraph (e)(3)(ii), 
affiliated group means an affiliated group as defined in section 
1504(a), determined without regard to section 1504(b)(3). In counting 
the income of the group for purposes of determining whether the group 
meets the requirements of paragraph (e)(3)(i) of this section, the 
following rules apply. Only the income of group members that are United 
States corporations or foreign corporations that are controlled foreign 
corporations in which United States members of the affiliated group 
own, directly or indirectly, at least 80 percent of the total voting 
power and value of the stock shall be included. For purposes of this 
paragraph (e)(3)(ii), indirect ownership shall be determined under 
section 318 and the regulations under that section. The income of the 
group will not include any income from

[[Page 276]]

transactions with other members of the group. Passive income will not 
be considered to be active financing income merely because that income 
is earned by a member of the group that is a financial services entity 
without regard to the rule of this paragraph (e)(3)(ii). This paragraph 
(e)(3)(ii) applies to taxable years beginning after December 31, 2000.
* * * * *
    (iv) * * *

    Example 2. Foreign corporation A, which is not a controlled 
foreign corporation, owns 100 percent of the stock of domestic 
corporation B, which owns 100 percent of the stock of domestic 
corporation C. A also owns 100 percent of the stock of foreign 
corporation D. D owns 100 percent of the stock of domestic 
corporation E, which owns 100 percent of the stock of controlled 
foreign corporation F. All of the corporations are members of an 
affiliated group within the meaning of section 1504(a) (determined 
without regard to section 1504(b)(3)). Pursuant to paragraph 
(e)(3)(ii) of this section, however, only the income of B, C, E, and 
F is counted in determining whether the group meets the requirements 
of paragraph (e)(3)(i) of this section. For the 2001 taxable year, 
B's income consists of $95 of active financing income and $5 of 
passive non-active financing income. C has $40 of active financing 
income and $20 of passive non-active financing income. E has $70 of 
active financing income and $15 of passive non-active financing 
income. F has $10 of passive income. B and E qualify as financial 
services entities under the entity test of paragraph (e)(3)(i) of 
this section. Therefore, B and E are financial services entities 
without regard to whether the group as a whole is a financial 
services entity and all of the income of B and E shall be treated as 
financial services income. C and F do not qualify as financial 
services entities under the entity test of paragraph (e)(3)(i) of 
this section. However, under the affiliated group test of paragraph 
(e)(3)(ii) of this section, C and F are financial services entities 
because at least 80 percent of the group's total income consists of 
active financing income ($205 of active financing income is 80.4 
percent of $255 total income). B's and E's passive income is not 
treated as active financing income for purposes of the affiliated 
group test of paragraph (e)(3)(ii) of this section even though it is 
treated as financial services income without regard to whether the 
group satisfies the affiliated group test. Once C and F are 
determined to be financial services entities under the affiliated 
group test, however, all of the passive income of the group is 
treated as financial services income. Thus, 100 percent of the 
income of B, C, E, and F for 2001 is financial services income.
* * * * *
    (g) * * *
    (3) Special rule for dividends paid by a controlled foreign 
corporation--(i) Distributions out of earnings and profits accumulated 
when the distributing corporation was not a controlled foreign 
corporation--(A) General rule. Distributions from a controlled foreign 
corporation shall be treated as dividends from a noncontrolled section 
902 corporation, and therefore not subject to the look-through rules of 
Sec. 1.904-5, to the extent that the distribution is out of earnings 
and profits accumulated during periods when the distributing 
corporation was not a controlled foreign corporation.
    (B) Ordering rule. The determination of the earnings to which a 
distribution from a controlled foreign corporation is attributable 
shall be made on a last-in first-out (LIFO) basis. Thus, a distribution 
shall be deemed made first from post-1986 undistributed earnings 
attributable to the period after the distributing corporation became a 
controlled foreign corporation (look-through pools), next from the non-
look-through pool of post-1986 undistributed earnings, if any, and 
finally on a LIFO basis from pre-1987 accumulated profits.
    (C) Effect of intervening noncontrolled status. [Reserved]
    (D) Examples. The following examples illustrate the application of 
paragraph (g)(3)(i):

    Example 1. S is a foreign corporation formed in 1980. Until 
1992, S had no United States shareholders. In 1992, P, a domestic 
corporation, acquires 10 percent of the stock of S. Thus, for 1992 
and subsequent years, S is a noncontrolled section 902 corporation. 
Because the 10-percent ownership requirement of section 902(a) was 
not satisfied until 1992, earnings accumulated by S before 1992 will 
be treated as pre-1987 accumulated profits for purposes of section 
902, and the amount of foreign taxes deemed paid with respect to any 
distribution out of such pre-1987 accumulated profits will be 
computed on a year-by-year basis under the rules of section 
902(c)(6)(A) and Sec. 1.902-1(b)(3). In 2000, P acquires an 
additional 45% of the stock of S. Thus, for 2000 and subsequent 
years, S is a controlled foreign corporation. In 2000, S has no 
earnings and profits and pays a dividend out of prior years' 
earnings and profits. Pursuant to paragraph (g)(3)(i) of this 
section, because S was not a controlled foreign corporation before 
2000, the dividend to P will be treated as a dividend from a 
noncontrolled section 902 corporation. The dividend is treated as 
paid first out of S's non-look-through pool of post-1986 
undistributed earnings to the extent thereof, and then out of S's 
pre-1987 accumulated profits on a LIFO basis. The entire dividend 
will be subject to a single separate limitation for dividends from a 
noncontrolled section 902 corporation.
    Examples 2 through 4. [Reserved]

    (ii) Pre-August 6, 1997, dividend distributions out of earnings and 
profits accumulated before a more-than-90-percent United States 
shareholder became a United States shareholder--(A) General rule. Look-
through principles do not apply to distributions made before August 6, 
1997, to a more-than-90-percent United States shareholder in the 
distributing corporation, to the extent the distributions are made from 
earnings and profits accumulated before the taxpayer became a United 
States shareholder of the distributing corporation (pre-acquisition 
earnings). Therefore, in the case of a distribution made before August 
6, 1997, a dividend shall be treated as a dividend from a noncontrolled 
section 902 corporation, and the look-through rules of section 
904(d)(3) and Sec. 1.904-5 shall not apply, if--
    (1) The distribution is received by a United States shareholder, or 
by an upper-tier controlled foreign corporation of a United States 
shareholder, at a time when such United States shareholder is a more-
than-90-percent United States shareholder of the distributing 
corporation; and
    (2) The more-than-90-percent United States shareholder was not a 
United States shareholder at the time the distributed earnings and 
profits were accumulated by the distributing corporation.
    (B) Exception for certain intra-group acquisitions. Notwithstanding 
paragraph (g)(3)(ii)(A) of this section, a dividend recipient shall be 
entitled to look-through treatment on a distribution out of pre-
acquisition earnings if--
    (1) The dividend recipient is a United States shareholder of the 
distributing corporation;
    (2) The immediately preceding owner or owners were entitled to 
look-through treatment on distributions from the distributing 
corporation (determined after the application of paragraphs (g)(3)(i) 
and (g)(3)(ii)(A) of this section); and
    (3) Both at the time of such distribution and at the time that the 
dividend recipient acquired its interest from such immediately 
preceding owner or owners, such recipient and such preceding owner or 
owners are members of the same affiliated group (within the meaning of 
section 1504(a), determined without regard to section 1504(b)(3)).
    (C) Ordering rule. If, under paragraph (g)(3)(ii) of this section 
(or under paragraphs (g)(3)(i)(A) and (g)(3)(ii) of this section), a 
shareholder is not entitled to look-through treatment, the 
determination whether a distribution from its controlled foreign 
corporation is attributable to pre-acquisition earnings shall be made 
on a last-in first-out (LIFO) basis. Thus, a distribution shall be 
deemed made first from the post-1986 undistributed earnings

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attributable to the period after the shareholder became a United States 
shareholder in the distributing corporation, and then from pre-
acquisition earnings, in the order described in paragraph (g)(3)(i)(B) 
of this section.
    (D) Distributions after August 5, 1997. Look-through principles 
shall apply to distributions made after August 5, 1997, to a 
distribution from a controlled foreign corporation to a more-than-90-
percent United States shareholder out of pre-acquisition earnings that 
were accumulated in years during which the corporation was a controlled 
foreign corporation. Post-1986 undistributed earnings attributable to 
the period after the shareholder became a United States shareholder in 
the distributing corporation and other post-1986 undistributed earnings 
accumulated while the distributing corporation was a controlled foreign 
corporation shall be combined into a single set of post-1986 
undistributed earnings pools for each separate category described in 
Sec. 1.904-5(a)(1) as of August 6, 1997.
    (E) Examples. The following examples illustrate the application of 
this paragraph (g)(3)(ii):

    Example 1. (i) P, a domestic corporation, owns 100 percent of 
the stock of U, a controlled foreign corporation. In 1992, P sells 
100 percent of the stock of U to T, an unrelated domestic 
corporation. In 1992, U has no earnings and pays a dividend to T out 
of earnings and profits attributable to prior years. T is not 
related to P and P's ownership of U will not be attributed to T. 
Because the dividend to T in 1992 is out of post-1986 undistributed 
earnings that are pre-acquisition earnings, the dividend will be 
treated as a dividend from a noncontrolled section 902 corporation. 
In 1993, U pays a dividend to T out of current earnings and profits. 
T is entitled to look-through treatment on the dividend.
    (ii) In September 1997, U pays a dividend to T out of both post-
acquisition earnings and pre-acquisition earnings accumulated while 
U was a controlled foreign corporation. Under paragraph 
(g)(3)(ii)(D) of this section, T is entitled to look-through 
treatment on the full amount of the dividend.
    Example 2. (i) Domestic corporation P has owned 95 percent of 
the stock of S, a controlled foreign corporation, from the time of 
S's organization in 1990. Domestic corporation R owns the remaining 
5 percent of the stock of S. On December 1, 1996, T, an unrelated 
domestic corporation, acquires P's 95 percent interest in S. On 
December 31, 1996, S pays a dividend out of current and prior years' 
earnings and profits. T is a more-than-90-percent United States 
shareholder of S at the time it receives the dividend, but was not a 
United States shareholder at the time the distributed earnings were 
accumulated. Under this paragraph (g)(3)(ii), the portion of the 
dividend to T attributable to pre-acquisition earnings will be 
treated as a dividend from a noncontrolled section 902 corporation. 
Under paragraph (g)(3)(iii) of this section, T will be entitled to 
look-through treatment on the portion of the dividend attributable 
to 1996 earnings and profits. Under paragraph (g)(3)(ii)(C) of this 
section, the dividend received by T will be treated as coming first 
from S's post-1986 undistributed earnings attributable to 1996, and 
then from pre-acquisition earnings.
    (ii) On December 31, 1997, S pays a second dividend out of 
current and prior years' earnings and profits. Under paragraph 
(g)(3)(ii)(D) of this section, T will be entitled to look-through 
treatment on the full amount of the dividend because all of S's 
earnings and profits were accumulated in years during which S was a 
controlled foreign corporation. The dividends to R will be treated 
as passive income because R owns less than 10 percent of the stock 
of S and, therefore, is not entitled to look-through treatment.
    Example 3. The facts are the same as in Example 2 except that R, 
rather than T, acquires from P an 86 percent interest in S in 1996. 
Although R was a shareholder of S before the acquisition, it was not 
a United States shareholder because it did not own 10 percent of the 
voting stock of S. Thus, because R owns more than 90 percent of the 
stock of S, and received a distribution of earnings before August 7, 
1997, that were accumulated before it became a United States 
shareholder of S, this paragraph (g)(3)(ii) applies and R is not 
entitled to look-through treatment on the 1996 dividend. R is 
entitled to look-through treatment on the 1997 dividend.
    Example 4. Since its organization in 1980, S, a controlled 
foreign corporation, has been owned 60 percent by domestic 
corporation P and 40 percent by domestic corporation R. On November 
15, 1996, domestic corporation T acquires R's 40 percent interest in 
the stock of S. S has no income in 1996 and pays a dividend on 
December 15, 1996, out of prior years' earnings and profits. This 
paragraph (g)(3)(ii) does not apply because T acquired less than 90 
percent of the stock of S. Thus, T is entitled to look-through 
treatment on dividends distributed out of pre-acquisition earnings, 
because such earnings are attributable to periods in which S was a 
controlled foreign corporation.

    (iii) Treatment of earnings and profits accumulated in a transition 
year. Earnings and profits accumulated in the taxable year in which a 
corporation became a controlled foreign corporation or in which a more-
than-90-percent United States shareholder became a United States 
shareholder shall be considered earnings and profits accumulated after 
the corporation became a controlled foreign corporation or the 
shareholder became a United States shareholder, respectively.
    (iv) Definitions. The following definitions apply for purposes of 
this paragraph (g)(3):
    (A) More-than-90-percent United States shareholder. The term more-
than-90-percent United States shareholder means, with respect to any 
controlled foreign corporation, a United States shareholder that owns 
more than 90 percent of the total combined voting power of all classes 
of stock entitled to vote of the controlled foreign corporation. In 
determining ownership for purposes of this definition, the indirect 
stock ownership rules of sections 958 and 318 and the regulations under 
those sections shall apply.
    (B) Non-look-through pool. Except as otherwise provided, the term 
non-look-through pool means post-1986 undistributed earnings 
accumulated during periods in which the distributing corporation was a 
noncontrolled section 902 corporation that was not a controlled foreign 
corporation.
    (C) Post-1986 undistributed earnings. The term post-1986 
undistributed earnings has the meaning set forth in Sec. 1.902-1(a)(9).
    (D) Pre-1987 accumulated profits. The term pre-1987 accumulated 
profits has the meaning set forth in Sec. 1.902-1(a)(10).
    (E) Upper tier controlled foreign corporation. The term upper tier 
controlled foreign corporation of a United States shareholder means a 
controlled foreign corporation in which the taxpayer is a United States 
shareholder and which is an upper-tier corporation as defined in 
Sec. 1.902-1(a)(6) with respect to the distributing corporation.
    (v) Effective date. The provisions of this paragraph (g)(3) apply 
to taxable years beginning after December 31, 1986. However, for 
taxable years beginning before January 1, 2001, taxpayers may rely on 
Sec. 1.904-4(g)(3)(ii), (iii) and (iv) of regulations project INTL-1-
92, published at 1992-1 C.B. 1209. See Sec. 601.601(d)(2) of this 
chapter.
* * * * *

    Par. 11. Section 1.904-5 is amended as follows:
    1. The last sentence in paragraph (a)(3) is revised and one new 
sentence is added.
    2. Paragraph (d)(2) is amended by removing the word ``For'' at the 
beginning of the first sentence and adding the language ``Except as 
provided in Sec. 1.904-4(c)(7)(iii) (relating to reductions in tax upon 
distribution), for'' in its place.
    3. Paragraph (g) is revised.
    4. Paragraph (h)(4) is amended by adding three new sentences at the 
end.
    5. Paragraph (i)(1) is amended by:
    a. Revising the third sentence.
    b. Adding a new sentence at the end.
    6. The text to paragraph (i)(3) is added.

[[Page 278]]

    7. Paragraph (i)(4) Example 1 is revised.
    8. The text to paragraph (i)(4) Example 2 is added.
    9. Paragraph (i)(4) Example 3 is added.
    10. The second and third sentences of paragraph (m)(1) are revised.
    11. Paragraph (m)(4)(i) is revised.
    12. Paragraph (m)(5) is amended by removing the language ``951(a)'' 
from the first sentence and adding the language ``951(a)(1)(A)'' in its 
place.
    The revisions and additions read as follows:


Sec. 1.904-5  Look-through rules as applied to controlled foreign 
corporations and other entities.

    (a) * * *
    (3) * * * For this purpose the controlled group is any member of 
the affiliated group within the meaning of section 1504(a)(1) except 
that ``more than 50 percent'' shall be substituted for ``at least 80 
percent'' wherever it appears in section 1504(a)(2). For taxable years 
beginning before January 1, 2001, the preceding sentence shall be 
applied by substituting ``50 percent'' for ``more than 50 percent''.
* * * * *
    (g) Application of look-through rules to certain domestic 
corporations. The principles of section 904(d)(3) and this section 
shall apply to any foreign source interest, rents and royalties paid by 
a United States corporation to a related corporation. For this purpose, 
a United States corporation and another corporation are considered to 
be related if one owns, directly or indirectly, stock possessing more 
than 50 percent of the total voting power of all classes of stock of 
the other corporation or more than 50 percent of the total value of the 
other corporation. In addition, a United States corporation and another 
corporation shall be considered to be related if the same United States 
shareholders own, directly or indirectly, stock possessing more than 50 
percent of the total voting power of all classes of stock or more than 
50 percent of the total value of each corporation. For purposes of this 
paragraph, the constructive stock ownership rules of section 318 and 
the regulations under that section apply. For taxable years beginning 
before January 1, 2001, this paragraph (g) shall be applied by 
substituting ``50 percent or more'' for ``more than 50 percent'' each 
place it appears.
    (h) * * *
    (4) * * * Similarly, a partnership (first partnership) is 
considered as owning more than 50 percent of the value of another 
partnership (second partnership) if the first partnership owns more 
than 50 percent of the capital and profits interests of the second 
partnership. For this purpose, value will be determined at the end of 
the partnership's taxable year. For taxable years beginning before 
January 1, 2001, the second preceding sentence shall be applied by 
substituting ``50 percent'' for ``more than 50 percent''.
    (i) * * * (1) * * * In addition, two look-through entities are 
related if the same United States shareholders own, directly or 
indirectly, stock possessing more than 50 percent of the total voting 
power of all voting classes of stock (in the case of a corporation) or 
more than 50 percent of the total value of each look-through entity. * 
* * For taxable years beginning before January 1, 2001, the third 
sentence of this paragraph (i)(1) shall be applied by substituting ``50 
percent or more'' for ``more than 50 percent'' each place it appears.
* * * * *
    (3) Special rule for dividends. Solely for purposes of dividend 
payments between controlled foreign corporations in taxable years 
beginning after December 31, 2000, two controlled foreign corporations 
shall be considered related look-through entities if the same United 
States shareholder owns, directly or indirectly, at least 10 percent of 
the total voting power of all classes of stock of each foreign 
corporation. Taxpayers may choose to apply this paragraph (i)(3) in 
taxable years beginning after December 31, 1991, provided that 
appropriate adjustments are made to eliminate any double benefit 
arising from the application of this paragraph (i)(3) to taxable years 
that are not open for assessment.
    (4) Examples. * * *

    Example 1. P, a domestic corporation, owns all of the stock of 
S, a controlled foreign corporation. S owns 40 percent of the stock 
of T, a Country X corporation that is a controlled foreign 
corporation. The remaining 60 percent of the stock of T is owned by 
V, a domestic corporation. The percentages of value and voting power 
of T owned by S and V correspond to their percentages of stock 
ownership. T owns 40 percent (by vote and value) of the stock of U, 
a Country Z corporation that is a controlled foreign corporation. 
The remaining 60 percent of U is owned by unrelated U.S. persons. U 
earns exclusively general limitation non-subpart F income. In 2001, 
U makes an interest payment of $100 to T. Look-through principles do 
not apply because T and U are not related look-through entities 
under paragraph (i)(1) of this section (because T does not own more 
than 50 percent of the voting power or value of U). The interest is 
passive income to T, and is subpart F income to P and V. Under 
paragraph (c)(1) of this section, look-through principles determine 
P and V's characterization of the subpart F inclusion from T. P and 
V therefore must characterize the inclusion as passive income.
    Example 2. The facts are the same as in Example 1 except that 
instead of a $100 interest payment, U pays a $50 dividend to T in 
2001. P and V each own, directly or indirectly, more than 10 percent 
of the voting power of all classes of stock of both T and U. 
Pursuant to paragraph (i)(3) of this section, for purposes of 
applying this section to the dividend from U to T, U and T are 
treated as related look-through entities. Therefore, look-through 
principles apply to characterize the dividend income as general 
limitation income to T. The dividend is subpart F income of T that 
is taxable to P and V. The subpart F inclusions of P and V are also 
subject to look-through principles, under paragraph (c)(1) of this 
section, and are characterized as general limitation income to P and 
V because the income is general limitation income of T.
    Example 3. The facts are the same as in Example 1, except that U 
pays both a $100 interest payment and a $50 dividend to T, and T 
owns 80 percent (by vote and value) of U. Under paragraph (i)(1) of 
this section, T and U are related look-through entities, because T 
owns more than 50 percent (by vote and value) of U. Therefore, look-
through principles apply to both the interest and dividend income 
paid or accrued by U to T, and T treats both types of income as 
general limitation income. Under paragraph (c)(1) of this section, P 
and V apply look-through principles to the resulting subpart F 
inclusions, which therefore are also general limitation income to P 
and V.
* * * * *
    (m) * * * (1) * * * For purposes of determining the portion of a 
dividend paid or accrued (or amount treated as a dividend, including 
amounts described in section 951(a)(1)(B)) by a controlled foreign 
corporation that is treated as from sources within the United States 
under section 904(g)(4), the rules in paragraph (m)(4) of this section 
apply. For purposes of determining the portion of an amount included in 
gross income under section 951(a)(1)(A) that is attributable to income 
of the controlled foreign corporation from sources within the United 
States under section 904(g)(2), the rules in paragraph (m)(5) of this 
section apply. * * *
* * * * *
    (4) * * * (i) * * * Any dividend or distribution treated as a 
dividend under this section (including an amount included in gross 
income under section 951(a)(1)(B)) that is received or accrued by a 
United States shareholder from a controlled foreign corporation shall 
be treated as income in a separate category derived from sources within 
the United States in proportion to the ratio of the portion of the 
earnings and profits of the controlled foreign corporation in the 
corresponding separate category from United States sources to the total 
amount of earnings and profits of the

[[Page 279]]

controlled foreign corporation in that separate category.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: December 13, 2000.
Jonathan Talisman,
Acting Assistant Secretary (Tax Policy).
[FR Doc. 00-32477 Filed 12-29-00; 8:45 am]
BILLING CODE 4830-01-U