[Federal Register Volume 66, Number 2 (Wednesday, January 3, 2001)]
[Proposed Rules]
[Pages 319-334]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-32478]


-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-104683-00]
RIN 1545-AX88


Application of Section 904 to Income Subject to Separate 
Limitations and Computation of Deemed-Paid Credit Under Section 902

AGENCY: Internal Revenue Service (IRS), Treasury.

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

-----------------------------------------------------------------------

SUMMARY: This document contains proposed Income Tax Regulations 
relating to the computation of the section 902 deemed-paid credit, the 
section 904(d) foreign tax credit limitation, and to an example in the 
section 954 regulations relating to the exclusion of certain export 
financing interest from foreign personal holding company income. 
Changes to the applicable law were made by the Tax Reform Act of 1986, 
the Technical and Miscellaneous Revenue Act of 1988, and the Taxpayer 
Relief Act of 1997. These regulations would provide guidance needed to 
comply with these changes and would affect individuals and corporations 
reporting subpart F income and claiming foreign tax credits. This 
document also provides a notice of a public hearing on these proposed 
regulations.

DATES: Written or electronic comments must be received by April 3, 
2001. Outlines of topics to be discussed at the public hearing 
scheduled for April 26, 2001, at 10 a.m. must be received by April 5, 
2001.

ADDRESSES: Send submissions to: Regulations Unit CC (REG-104683-00), 
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. 
The public hearing will be held in the IRS Auditorium, 7th floor, 
Internal Revenue Building, 1111 Constitution Ave., NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Bethany A. Ingwalson (202) 622-3850; concerning submissions of 
comments, the hearing, and/or to be placed on the building access list 
to attend the hearing, Sonya Cruse, (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Background

    Treasury and the IRS provided guidance regarding section 904(d) 
(enacted in 1986) in TD 8214 (1988-2 C.B. 220), TD 8412 (1992-1 C.B. 
271), TD 8556 (1994-2 C.B. 165), TD 8805 (1999-1 C.B. 371), and in 
final regulations (TD 8916) published elsewhere in this issue of the 
Federal Register. Final regulations regarding the computation of the 
deemed paid credit under section 902 (also enacted in 1986) were 
published as TD 8708 (1997-1 C.B. 137). The proposed regulations 
provide further guidance with respect to the application of sections 
902 and 904(d).
    The proposed regulations also provide guidance regarding the 
application of section 904(j). The Taxpayer Relief Act of 1997 (Public 
Law 105-34, 111 Stat. 788) (TRA 1997) added section 904(j) to the 
Internal Revenue Code (Code). Section 904(j) exempts individuals from 
the foreign tax credit limitation of section 904(a) in certain limited 
circumstances, and provides that no foreign taxes may be carried to or 
from a year for which a taxpayer has elected to apply section 904(j).
    TRA 1997 also added to the Code section 904(b)(2)(C), which 
provides that the Secretary may issue regulations to modify the 
application of section 904(b)(2) and (3) to properly reflect capital 
gain rate differentials under sections 1(h) and 1201(a) and the 
computation of net capital gain. The proposed regulations provide 
guidance for the application of section 904(b), including the 
application of that section in years in which section 1(h) provides for 
more than one capital gains rate.

Explanation of Provisions

I. Effect of Loss of Domestic Corporate Shareholder on Pooling of 
Earnings and Taxes in Computing Deemed Paid Credits: Sec. 1.902-1

    Under section 902(c)(3), the multi-year pools of post-1986 
undistributed earnings and post-1986 foreign income taxes of a foreign 
corporation are determined by taking into account only periods 
beginning on and after the first day of the foreign corporation's first 
taxable year in which a domestic corporation (a ``qualifying 
shareholder'') owns 10 percent or more of its voting stock or, in the 
case of a lower-tier foreign corporation in a ``qualified group'' 
described in section 902(b)(2), owns indirectly at least 5 percent of 
its voting stock.
    Under section 902(c)(6)(B), dividends are treated as paid first out 
of the post-1986 pooled earnings. Pre-1987 accumulated profits (defined 
in section 902(c)(6)(A) and Sec. 1.902-1(a)(10) to include both 
earnings accumulated in pre-1987 years and earnings accumulated in 
post-1986 years preceding the year in which the section 902 ownership 
requirements are met) are treated as distributed only after the pools 
are exhausted, and then out of annual layers of earnings and taxes on a 
last-in, first-out basis. Distributions out of pre-1987 accumulated 
profits are governed by the section 902 rules in effect under pre-1987 
law. Section 902(c)(6)(A).
    The rule limiting the multi-year pools of earnings and taxes to 
post-1986 taxable years beginning with the year in which a foreign 
corporation first has a qualifying shareholder alleviates the 
administrative difficulties such shareholders face in reconstructing 
accumulated earnings and taxes accounts in connection with their 
acquisition of stock in a pre-existing foreign corporation. While 
section 902 provides that pooling of earnings and taxes begins only 
when the foreign corporation first has a qualifying

[[Page 320]]

shareholder entitled to compute a credit for deemed-paid taxes, the 
statute does not provide for any change in a foreign corporation's 
post-1986 undistributed earnings and taxes pools following a stock 
disposition or other transaction after which the foreign corporation no 
longer has a qualifying shareholder. Section 1.902-1(a)(13)(i) 
currently provides that, once a foreign corporation begins to maintain 
pools of earnings and taxes, the pools include periods during which the 
stock ownership requirements of section 902 are not met. Should such a 
corporation later again have a qualifying shareholder, such a 
shareholder would have to reconstruct the post-1986 undistributed 
earnings and taxes pools to include undistributed earnings and taxes 
for periods during which there was no qualifying shareholder, in order 
to compute deemed-paid credits with respect to distributions of 
earnings and profits accumulated during later periods in which the 
ownership requirements were met.
    Treasury and the IRS believe that the policy concerns underlying 
the rule deferring the start of pooling until the corporation has a 
qualifying shareholder also apply to the situation where a foreign 
corporation once had, but no longer has, such a shareholder. Therefore, 
Treasury and the IRS believe it is appropriate to stop the multi-year 
pooling of earnings and taxes at the foreign corporation level when a 
foreign corporation no longer has a qualifying shareholder.
    The proposed regulations would amend Sec. 1.902-1(a)(10) to provide 
that pre-1987 accumulated profits subject to the annual layering rules 
of pre-1987 law include not only the actual pre-1987 earnings and 
profits and pre-pooling earnings and profits described in the current 
final regulation, but also formerly pooled earnings and profits of a 
less-than-10%-U.S.-owned foreign corporation attributable to post-1986 
years during which the section 902 stock ownership requirements were 
met, and post-pooling earnings and profits accumulated during 
subsequent taxable years during which the foreign corporation did not 
have a qualifying shareholder. The formerly pooled earnings would be 
considered pre-1987 accumulated profits of the last taxable year of the 
foreign corporation as of the end of which the ownership requirements 
were met. Distributions out of formerly pooled earnings would be 
subject to the same pre-1987 law rules as distributions of other pre-
1987 accumulated profits, except that the formerly pooled foreign 
income taxes related to the formerly pooled earnings would continue to 
be maintained in U.S. dollars. The proposed regulations would also 
amend Sec. 1.902-1(a)(13) to provide that pooling of earnings and taxes 
would resume in the first subsequent taxable year as of the end of 
which the foreign corporation again has a qualifying shareholder. 
Formerly pooled earnings would continue to be treated as pre-1987 
accumulated profits even if the foreign corporation later began to 
maintain pools of earnings and taxes again.
    Treasury and the IRS believe the proposed rules would be easier for 
taxpayers to apply than the current regulations, which require pooling 
to continue through periods when the foreign corporation has no 
shareholders entitled to compute a deemed-paid credit. These proposed 
amendments complement the proposed amendments to the section 904 
regulations, described below, concerning the effect of intervening 
noncontrolled status on the look-through pools of post-1986 
undistributed earnings and taxes maintained by a controlled foreign 
corporation. The proposed regulations also would be consistent with the 
approach taken in recently proposed amendments to the regulations under 
section 367(b) relating to the carryover of earnings and taxes accounts 
in reorganizations involving foreign corporations (REG-116050-99, 
published in the Federal Register (65 FR 69138) on November 15, 2000).

II. Separate Categories: Sec. 1.904-4

A. The Active Rents and Royalties Exception
    Section 1.904-4(b)(2) sets forth the active rents and royalties 
exception to the separate limitation for passive income. This exception 
currently applies only to payments from unrelated payors. Several 
commentators have requested that Treasury and the IRS amend the 
regulations to provide that royalties received from a member of the 
recipient's affiliated group (including foreign affiliates) may qualify 
for the exception if the royalties are derived in the conduct of an 
active trade or business and the payor uses the underlying property in 
an active trade or business. As explained below, Treasury and the IRS 
propose to adopt a modified version of the suggested change.
    Section 904(d)(2)(A)(i) defines passive income as foreign personal 
holding company income, as defined in section 954(c). The section 
904(d) active rents and royalties exception derives from section 
954(c)(2)(A), which excludes from foreign personal holding company 
income, and thus from passive income, any rents or royalties derived in 
the active conduct of a trade or business and received from an 
unrelated person. The current final regulations at Sec. 1.904-
4(b)(2)(ii) modify this exception to take into account activities of 
members of the recipient's affiliated group in determining whether the 
recipient meets the active trade or business prong of the test for 
section 904(d) purposes.
    Treasury and the IRS have consistently declined to extend look-
through treatment to payments from foreign non-controlled payors. See 
TD 8412 (1992-1 C.B. 271, 273). Treasury and the IRS continue to 
believe that the nature of the income earned by a foreign non-
controlled payor from the use of the licensed property should not 
determine whether a rent or royalty payment constitutes income from the 
active conduct of a trade or business of the recipient.
    However, Treasury and the IRS have decided that it is appropriate 
to eliminate the distinction between royalties received from related 
and unrelated payors in applying the active rents and royalties 
exception for purposes of section 904(d). Therefore, these regulations 
propose to amend prospectively Sec. 1.904-4(b)(2) to provide that for 
purposes of section 904 (but not for purposes of section 954), the 
active rents and royalties exception will not require that the rents 
and royalties be received from an unrelated payor. This change is 
proposed to apply to rents and royalties paid or accrued more than 60 
days after the date that these regulations are published in final form.
B. Restriction of Affiliated Group Special Rule for Active Rents and 
Royalties Exception
    As noted, Sec. 1.904-4(b)(2)(ii) provides that, for purposes of the 
active rents and royalties exception from passive income under section 
904, rents or royalties will be treated as derived in the active 
conduct of a trade or business by a United States person or controlled 
foreign corporation if any member of the recipient's affiliated group 
(defined to include foreign corporations) meets the requirements of 
section 954(c)(2)(A) with respect to the licensed property. The 
proposed regulations would amend the definition of affiliated group for 
purposes of Sec. 1.904-4(b)(2)(ii) to include only U.S. corporations 
and controlled foreign corporations in which United States members of 
the affiliated group own, directly or indirectly, at least 80 percent 
of the stock (by vote and value). This requirement is consistent with 
the affiliated group rules of Sec. 1.904-4(e)(3)(ii), which consider 
the activities

[[Page 321]]

of other members of the affiliated group for purposes of determining 
whether an entity is a financial services entity. The proposed 
regulations revise the affiliated group rule in the active rents and 
royalties exception due to administrative concerns regarding the 
difficulty of determining whether related, but non-controlled, foreign 
corporations engage in the active conduct of a trade or business with 
respect to licensed property.
C. Effect of Intervening Noncontrolled or Less-Than-10%-U.S.-Owned 
Status on Distributions From a Controlled Foreign Corporation or Other 
Look-Through Corporation
    Under section 904(d)(2)(E)(i) and Sec. 1.904-4(g)(3)(i), dividends 
from a controlled foreign corporation (CFC) are treated as dividends 
from a noncontrolled section 902 corporation to the extent that the 
distribution is out of earnings and profits accumulated during periods 
in which the distributing corporation was not a CFC. Proposed 
Sec. 1.904-4(g)(3)(i)(C)(1) provides rules to address the effect of 
intervening noncontrolled status on the eligibility for look-through 
treatment of distributions of pre-2003 accumulations of pooled earnings 
and profits from a CFC. Consistent with the proposed amendments to 
Sec. 1.902-1(a) previously discussed, proposed Sec. 1.904-
4(g)(3)(i)(C)(2) provides rules to address the effect of intervening 
less-than-10%-U.S.-owned status on the post-1986 undistributed earnings 
and taxes pools and pre-1987 accumulated profits of a foreign 
corporation and the application of the look-through rules to 
distributions from such a foreign corporation. The proposed regulations 
anticipate to some extent, but do not provide comprehensive guidance, 
regarding the changes to the statutory look-through rules for 10/50 
companies that become effective for post-2002 taxable years. Additional 
conforming changes to the provisions of Secs. 1.904-4 and 1.904-5 will 
be required to reflect the changes in terminology reflected in the 
proposed regulations that are necessitated by these statutory changes.
    The proposed regulations provide that, when a CFC becomes a non-
look-through 10/50 corporation (because it ceases to be controlled by 
United States shareholders, but has at least one qualifying 
shareholder, in a taxable year beginning before January 1, 2003), post-
1986 undistributed earnings that were accumulated through the end of 
the taxable year preceding the taxable year in which the decontrolling 
event occurred and that were previously eligible for look-through 
treatment will be consolidated in, and constitute the opening balance 
of, a single non-look-through pool at the foreign corporation level. 
The regulations provide that distributions of the prior look-through 
earnings will continue to be treated as dividends from a non-look-
through 10/50 corporation, and will not be eligible for look-through 
treatment, even if the foreign corporation later becomes a CFC again or 
becomes eligible for look-through treatment with respect to earnings 
accumulated in post-2002 taxable years.
    Distributions of post-1986 undistributed earnings in the non-look-
through pool will be treated as dividends from a non-look-through 10/50 
corporation (10/50 dividend income) when distributed to a qualifying 
shareholder, or as passive income when distributed to any other 
shareholder. Pre-1987 accumulated profits distributed after a 
decontrolling event will similarly be treated as 10/50 dividend income 
or as passive income when distributed, depending on the status of, and 
the amount of stock owned by, the shareholder at the time of 
distribution. Because the separate limitation treatment of 
distributions during the taxable year is computed with reference to 
year-end pools of post-1986 undistributed earnings under section 902, 
the proposed regulations provide that distributions to a qualifying 
shareholder that are made in the taxable year in which a decontrolling 
event occurs are treated as 10/50 dividend income to qualifying 
shareholders, or passive income to other shareholders, whether made 
before or after the decontrolling event. Similarly, under Sec. 1.904-
4(g)(3)(iii), earnings and profits accumulated in the year in which a 
foreign corporation becomes a CFC are treated as accumulated after the 
corporation became a CFC. Such earnings will be eligible for look-
through treatment when distributed to a United States shareholder 
during the taxable year in which the distributing corporation becomes a 
CFC or during any subsequent taxable year until the distributing 
corporation ceases to be a CFC or other look-through corporation.
    As noted, the proposed regulations do not permit look-through 
treatment for earnings and profits accumulated in pre-2003 taxable 
years while the distributing corporation was a CFC if the earnings are 
distributed after an intervening period ending before 2003 during which 
the corporation was not a CFC, even if the corporation is a CFC or 
other look-through corporation at the time of distribution. Earnings 
and profits previously eligible for look-through treatment will be 
placed in a single non-look-through pool with new earnings accumulated 
in taxable years beginning before January 1, 2003, while the 
corporation is not a CFC. The proposed rule would eliminate the need to 
determine whether distributions made while the corporation is a non-
look-through 10/50 corporation (or, after 2002, a 10/50 look-through 
corporation) are made out of look-through earnings accumulated in pre-
2003 years prior to the decontrolling event or pre-2003 non-look-
through earnings accumulated afterwards. Treasury and the IRS believe 
this rule would be simpler to apply with respect to pre-2003 periods 
during which the records necessary to establish look-through treatment 
are less likely to be maintained by a foreign corporation that is not 
controlled by United States shareholders.
    This intervening noncontrolled status situation differs from the 
special situation described in Sec. 1.904-4(g)(3)(ii), which allows 
look-through treatment on distributions to a more-than-90-percent 
United States shareholder after August 6, 1997, of earnings and profits 
that were accumulated while the distributing corporation was a CFC. In 
the latter case, pre-acquisition post-1986 undistributed earnings of a 
CFC with a more-than-90-percent United States shareholder were required 
to be maintained in a non-look-through pool prior to the effective date 
of the amendment to section 904(d)(2)(E)(i) by TRA 1997. During the 
entire period the non-look-through pool was required to be maintained, 
the corporation was a CFC that was more-than-90-percent-owned by a 
single domestic corporation. Accordingly, the rules governing the 
effect of the 1997 repeal of the rule limiting look-through treatment 
to earnings accumulated while the more-than-90-percent United States 
shareholder was a United States shareholder of the distributing 
corporation do not provide an appropriate model for resolving the 
ongoing issue addressed by the proposed regulations.
    Section 904(d)(4) as amended by section 1105(b) of TRA 1997 
effective for taxable years beginning after December 31, 2002, will 
generally extend the look-through rules to distributions of earnings 
accumulated by a 10/50 company in post-2002 taxable years. Accordingly, 
non-look-through 10/50 corporations will not exist after 2002, although 
10/50 look-through corporations will continue to maintain non-look-
through pools of earnings and taxes accumulated in pre-2003 taxable 
years. Therefore, if the regulations are finalized prospectively, the 
effect of proposed Sec. 1.904-

[[Page 322]]

4(g)(3)(i)(C)(1) generally would be limited to situations involving a 
CFC that is decontrolled after the regulations become final but before 
January 1, 2003, and to earnings that are accumulated in taxable years 
beginning before January 1, 2003, and that are not treated as 
distributed to the CFC's U.S. shareholders under section 1248 in 
connection with the decontrolling event. Comments are requested as to 
whether the simplification objectives of the regulation could best be 
met by extending the effective date to cover decontrolling events that 
occurred in prior periods.
    Consistent with the proposed amendments to Sec. 1.902-1(a) and with 
the approach taken with respect to the pre-2003 decontrol situation, 
Sec. 1.904-4(g)(3)(i)(C)(2) of the proposed regulations provides that 
distributions out of formerly pooled earnings that are converted to an 
annual layer of pre-1987 accumulated profits when a foreign corporation 
no longer has a qualifying shareholder will be treated as distributions 
from a non-look-through 10/50 corporation, even if the foreign 
corporation later becomes a look-through corporation again.
    The proposed regulations reserve on the treatment of distributions 
from a 10/50 look-through corporation, including the treatment of 
distributions out of earnings and profits accumulated in periods before 
the taxpayer acquired its stock. Comments are requested on whether 
additional guidance is needed to clarify the rules governing 
distributions from CFCs, and on how the regulations should be modified 
to reflect the rules of section 1105(b) of TRA 1997, extending look-
through treatment to distributions from 10/50 corporations out of 
earnings and profits accumulated in post-2002 taxable years.
D. Additional Separate Categories
    Treasury and the IRS propose to add a new paragraph (m) to 
Sec. 1.904-4, to provide that if section 904(a), (b), and (c) are 
applied separately to any category of income under the Code (for 
example, under section 901(j), 865(h), or 904(g)(10)), that category of 
income (additional category) will be treated for purposes of the Code 
and regulations (including, for example, section 904(f)) as if it were 
a separate category listed in sections 904(d)(1) and 904(d)(3)(F)(i). 
This amendment is intended to clarify the treatment of such additional 
separate categories without the need for specific cross-references to 
such categories each time a provision refers to the separate categories 
listed in section 904(d). Sections 1.904-4(a) and 1.904-5(a)(1) are 
amended to include a reference to such additional separate categories.

III. Allocation and Apportionment of Taxes to Separate Categories: 
Sec. 1.904-6

    Treasury and the IRS propose to amend Sec. 1.904-6(a)(1) to clarify 
the rules for determining the amount of income (in each U.S. separate 
category) taxed by a foreign country, in situations in which foreign 
law does not provide expense allocation rules. In such cases, for 
purposes of determining the amount of income taxed by the foreign 
country in order to allocate and apportion foreign taxes to separate 
categories, a taxpayer must allocate the expenses that are deductible 
under foreign law using the same methods that the taxpayer uses to 
allocate expenses that are deductible under U.S. law for purposes of 
determining the amount of taxable income.

IV. Capital Gain and Loss Adjustments: Sec. 1.904(b)-1

A. Section 904(b) Capital Gain and Loss Adjustments
    The proposed regulations provide guidance regarding the rule of 
section 904(b)(2)(A) that foreign source capital gain may not exceed 
the lesser of capital gain net income from sources outside the United 
States or worldwide capital gain net income. A similar rule applies 
with respect to net capital gain. The regulations also provide guidance 
regarding the rule of section 904(b)(2)(B) that capital gains from 
foreign and U.S. sources, and capital losses from foreign sources, must 
be adjusted based on capital gain rate differential amounts. The 
proposed regulations exercise the regulatory authority granted under 
section 904(b)(2)(C) (authorizing regulations to modify the application 
of section 904(b)(2) and (3) to properly reflect capital gain rate 
differentials and the computation of net capital gain) and section 
904(d)(6) (authorizing such regulations as may be necessary and 
appropriate for the purposes of section 904(d)).
    The proposed regulations first provide guidance concerning the 
adjustments required when foreign source capital gains exceed the 
lesser of capital gain net income (or net capital gain) from sources 
outside the United States or capital gain net income (or net capital 
gain) from all sources. Section 904(b)(2)(A) and section 
904(b)(2)(B)(i) provide that, for purposes of section 904, foreign 
source capital gains that are included in foreign source taxable income 
may not exceed the lesser of capital gain net income from sources 
outside the United States or capital gain net income from all sources. 
Section 904(b)(2)(A), (3)(A). Similar rules apply for purposes of 
determining foreign source net capital gain. Section 904(b)(3)(B). 
After the 1986 enactment of separate limitation categories in section 
904(d), the issue arises as to the extent to which foreign source 
capital gains should be adjusted if the taxpayer has foreign source 
capital gains and losses in more than one separate category.
    The proposed regulations provide that foreign source capital gains 
included in foreign source taxable income in any separate category are 
reduced by reason of section 904(b)(2)(A) and section 904(b)(2)(B)(i) 
only by foreign source capital losses in the same separate category and 
by a ratable portion of the excess of capital gain net income from 
foreign sources (in the aggregate, considering all of the taxpayer's 
separate categories) over capital gain net income from all sources 
(considering capital gains and losses from sources within and outside 
the United States, from all of the taxpayer's separate categories). 
Thus, the proposed rule would reduce capital gain net income from 
foreign sources in any separate category only if the taxpayer has a net 
U.S.-source capital loss, and not in instances where foreign-source 
capital gains in one separate category are offset only by foreign-
source capital losses from another separate category. This rule 
implements Congress's intent that section 904(b)(2)(A) and section 
904(b)(2)(B)(i) should prevent foreign-source capital gains from 
inappropriately increasing the numerator of the foreign tax credit 
limitation fraction under section 904(a) if those capital gains were 
offset by U.S.-source capital losses, while avoiding the potential for 
double counting of foreign-source losses that might result if foreign-
source gains in one separate category were reduced by reason of 
foreign-source losses that reduce ordinary income in another separate 
category.
    The regulations further provide that if the taxpayer's capital gain 
net income from sources outside the United States exceeds the 
taxpayer's capital gain net income from all sources (i.e., where there 
is a net U.S. capital loss), a pro rata portion of such excess reduces 
the capital gain net income from sources outside the United States in 
each of the taxpayer's separate limitation categories and, within each 
separate category, in each rate group. The pro rata portion is 
determined based on the relative amounts of net capital gain from 
sources outside the United States in each separate category or rate 
group.

[[Page 323]]

    In addition, the proposed regulations provide guidance on adjusting 
capital gains and foreign capital losses to reflect capital gain rate 
differentials. Section 904(a) limits the foreign tax credit to the 
lesser of (1) foreign tax paid or accrued; or (2) pre-credit U.S. tax 
multiplied by a fraction equal to foreign source taxable income over 
worldwide taxable income (the limitation fraction). Multiplying the 
pre-credit U.S. tax by the limitation fraction is meant to determine 
the portion of U.S. taxes that are attributable to foreign source 
income. Section 904(b)(2)(B) adjusts capital gains in the numerator and 
denominator, and foreign source capital losses in the numerator, of the 
limitation fraction if capital gains are taxed at lower rates than 
ordinary income, as is often the case under current law for 
individuals. Unless capital gains and foreign capital losses are 
adjusted to account for this difference, the limitation fraction will 
not accurately reflect the portion of the total pre-credit U.S. tax 
that is properly attributable to foreign source income.
    The rate differential adjustments to capital gains and foreign 
source capital losses, under section 904(b) and the proposed 
regulations, apply only if the specific taxpayer has net capital gain 
that is subject to reduced tax rates for the taxable year. Treasury and 
the IRS request comments with respect to applying on an elective basis 
adjustments based on rate differentials for taxable years in which the 
Code applies reduced tax rates to capital gains generally, but the 
specific taxpayer has capital losses that equal or exceed capital 
gains. Any such elective rule would need to include ordering rules for 
determining the source, the separate category, and the rate group of 
the capital losses that are taken into account for the current taxable 
year, including those capital losses that are currently deductible to 
the extent of $3,000 under section 1211(b) against ordinary income, and 
those losses that are subject to the capital loss carryover rules.
    As noted, section 904(b)(2)(C) grants regulatory authority to 
modify the application of section 904(b)(2) and (3) ``to the extent 
necessary to properly reflect any capital gain rate differential under 
section 1(h) or 1201(a) and the computation of net capital gain.'' The 
proposed regulations exercise this authority and adjust the section 
904(b)(2)(B) calculations to reflect the fact that, for taxable years 
ending after May 6, 1997, section 1(h) contains multiple capital gains 
rates. The proposed regulations thus require that capital gain net 
income, from sources outside the United States and from all sources, 
must be adjusted pursuant to section 904(b)(2)(B)(i) and (ii) by the 
rate differential portion of each rate group of the taxpayer's net 
capital gain from sources outside the United States and from all 
sources, respectively.
    The proposed regulations also provide guidance on adjusting foreign 
source capital losses under section 904(b)(2)(B)(iii). The regulations 
clarify that such capital losses (after netting against foreign source 
capital gains in the same rate group, as defined in the regulations) 
should be reduced based on the tax rate applicable under section 1(h) 
to the net capital gains that are offset by such net capital losses in 
the determination of the taxpayer's taxable income. Although section 
904(b)(2)(B)(iii) provides for such adjustment in instances when net 
foreign losses have offset U.S. source capital gains, the existence of 
multiple separate categories after 1986 may result in foreign source 
capital gains and losses in separate categories offsetting one another. 
Therefore, the regulations require adjustment of foreign capital losses 
that offset foreign source capital gains associated with different 
capital gains rates, in addition to foreign capital losses that offset 
U.S. source capital gains.
    In determining which capital gains are offset by capital losses 
from sources outside the United States in different rate groups, the 
proposed regulations provide that net capital losses from sources 
within the United States will not be taken into account, in order to 
simplify this determination. Treasury and the IRS request comments 
regarding whether the regulations should take net capital losses from 
sources within the United States into account for such purposes, and, 
if so, what type of ordering rules should be applied.
    The IRS is considering providing a simplified worksheet for 
performing the section 904(b)(2)(B) adjustments in the Form 1116 
instructions, for taxpayers whose capital gains are subject only to 10 
or 20 percent tax rates under section 1(h) (similar to the simplified 
worksheet provided in the 1999 Form 1040 instructions as an alternative 
to Schedule D for taxpayers whose capital gains are subject only to 10 
and 20 percent tax rates under section 1(h)). Treasury and the IRS 
request comments on this approach.
B. Appropriate tax rates for AMT foreign tax credit calculation
    The proposed regulations provide that the alternative minimum tax 
(AMT) rates, rather than the regular tax rates, apply for purposes of 
carrying out the section 904(b) capital gains rates adjustments for the 
AMT foreign tax credit. Section 904(b) generally adjusts capital gains 
and foreign source capital losses based on the difference between the 
maximum U.S. tax rate and the tax applicable to capital gains under 
section 1(h). This adjustment is necessary to calculate more accurately 
the amount of U.S. tax that is attributable to foreign source income 
(as determined by application of the section 904(a) fraction). Section 
59(a)(1)(B) provides that the AMT foreign tax credit must be determined 
as if ``section 904 were applied on the basis of alternative minimum 
taxable income,'' and therefore requires the application of section 
904(b) in determining the AMT foreign tax credit. In order to reflect 
more accurately the amount of pre-credit tentative minimum tax 
attributable to foreign source AMT income, these regulations provide 
that, for purposes of applying section 904(b) in determining the AMT 
foreign tax credit, the maximum AMT rates should be used rather than 
the rates specified in section 1.
    In addition, the regulations clarify that section 904(b)(2)(B)(ii) 
(relating to capital gains from all sources), as well as section 
904(b)(2)(B)(i) and (iii) (relating to foreign source capital gains and 
losses, respectively) apply (in modified form, as provided in section 
59) to the determination of the AMT foreign tax credit. The regulations 
also clarify that section 904(b) applies to taxpayers electing to apply 
the simplified foreign tax credit limitation rules under section 
59(a)(4).

V. Coordination of Section 904(j) with Carryforward and Carryback 
Rules: Sec. 1.904(j)

    Section 904(j) allows a taxpayer to elect not to apply section 
904(a) (the foreign tax credit limitation fraction) if the taxpayer's 
creditable foreign taxes paid or accrued for the year are $300 or less 
($600 or less for joint filers), the taxpayer's foreign source gross 
income consists entirely of passive income, and such income and taxes 
are reported to the taxpayer on a payee statement. If a taxpayer elects 
to apply section 904(j) for any taxable year, no foreign taxes paid or 
accrued in such year may be carried over to any other year, and no 
foreign taxes paid or accrued in any other year may be carried over to 
the section 904(j) election year.
    The proposed regulations clarify that a taxpayer may elect to apply 
section 904(j) for a taxable year only if all of the taxes paid or 
accrued for the taxable year and for which a credit is allowable to the 
taxpayer under section 901 for the taxable year are creditable foreign 
taxes (as defined in section 904(j)(3)(B). For

[[Page 324]]

example, suppose that in year 2, the taxpayer accrues and pays foreign 
tax that was not shown on a payee statement furnished to the taxpayer 
and that is related to general limitation income that was recognized 
and included in income for U.S. tax purposes in year 1. If the foreign 
taxes in the general limitation category are creditable under section 
901 for year 2, the taxpayer may not elect to apply section 904(j) for 
year 2, even if all of the taxpayer's income in year 2 is qualified 
passive income.
    In addition, taxpayers requested clarification on the application 
of the carryover provisions in taxable years following section 904(j) 
election years. Because high-taxed income, as defined in section 
904(d)(2)(F), is calculated by reference to the highest rate of tax 
specified in section 1 or 11 (whichever is applicable), Treasury and 
the IRS expect that some individual taxpayers who are eligible to elect 
the application of section 904(j) may have foreign tax credit 
carryovers in the passive income category.
    The proposed regulations clarify that the amount of a foreign tax 
credit carryover to or from a non-section-904(j)-election year is not 
reduced to account for the part of the carryover that (but for section 
904(j)) could have been used in intervening section 904(j)-election 
years. Section 904(j) was intended to allow taxpayers to avoid 
computing the section 904(a) limitation fraction. See Committee on the 
Budget, U.S. House of Representatives, Report on Revenue Reconciliation 
Act of 1997, June 24, 1997, at 520-21. Requiring taxpayers to compute 
the amount of carryover that could have been used in the election year 
would be inconsistent with the statutory purpose of making the credit 
provisions less complex and less burdensome for taxpayers with small 
amounts of solely passive foreign-source income reported on payee 
statements. (Taxpayers may, of course, choose to perform the 
calculations to determine whether electing the application of section 
904(j) would be more advantageous for them, particularly for years in 
which a foreign tax credit carryover will expire.)
    However, the section 904(j) election does not extend the 
carryforward and carryback periods under section 904(c). For example, 
if a carryforward expires in 2000, and the taxpayer elects the 
application of section 904(j) for the 2000 taxable year, the 
carryforward cannot be used in 2000 (pursuant to section 904(j)(1)(C)) 
or in any later year (pursuant to the expiration of the carryforward 
period).
    Similarly, the determination of whether the taxpayer paid or 
accrued more than $300 (or $600) of creditable foreign taxes is made 
without regard to carryovers. For example, a single taxpayer who pays 
$300 of creditable foreign taxes in 2001, and has a $500 carryover to 
2001 from a previous year, is eligible to elect the application of 
section 904(j) for the 2001 year.
    However, if the election is made, the taxpayer cannot claim a 
credit in 2001 for the $500 otherwise treated as a carryover.

VI. Removal of Example in Sec. 1.954-2

    The proposed regulations remove Example 2 under Sec. 1.954-
2(b)(2)(iv), which was intended to illustrate the application of the 
rules under Sec. 1.954-2(b)(2) for the exception from foreign personal 
holding company for certain export financing interest. Treasury and the 
IRS are concerned that the example may be unintentionally confusing. 
For this reason, it is being removed. Comments are invited concerning 
whether a replacement example is necessary.

Special Analyses

    It has been determined that this notice of proposed rulemaking 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 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 Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on their impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for April 26, 2001, beginning 
at 10 a.m. in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the 10th Street entrance, located 
between Constitution and Pennsylvania Avenues, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 15 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by April 5, 2001. A period of 10 minutes will be allotted to each 
person for making comments. An agenda showing the scheduling of the 
speakers will be prepared after the deadline for receiving outlines has 
passed. Copies of the agenda will be available free of charge at the 
hearing.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entry for ``Section 1.902-1 and 902-2'' and ``1.094-4 
through 1.904-7'', and adding entries in numerical order to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.902-1 also issued under 26 U.S.C. 902(c)(7). * * *
    Section 1.904-4 also issued under 26 U.S.C. 904(b)(2)(C) and 
904(d)(5).
    Section 1.904-5 also issued under 26 U.S.C. 902(d)(5).
    Section 1.904-6 also issued under 26 U.S.C. 904(d)(5).

[[Page 325]]

    Section 1.904-7 also issued under 26 U.S.C. 902(d)(5). * * *

    Par. 2. Section 1.902-0 is amended by:
    1. Revising the entry for Sec. 1.902-1(a)(13)(ii).
    2. Adding an entry for Sec. 1.902-1(a)(13)(iii).
    The revisions and additions read as follows:


Sec. 1.902-0  Outline for regulations provisions for section 902.

* * * * *


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

    (a) * * *
    (13) * * *
    (ii) Resumption of pooling.
    (iii) Examples.
* * * * *
    Par 3. Section 1.902-1 is amended as follows:
    1. Paragraph (a)(8)(ii) is amended by revising the second sentence.
    2. Paragraph (a)(10)(i) is revised.
    3. Paragraph (a)(10)(iii) is amended by revising the last sentence 
and adding one sentence.
    4. Paragraphs (a)(13)(i)(A) and (a)(13)(i)(B) are revised.
    5. Paragraphs (a)(13)(i)(C) and (a)(13)(i)(D) are added.
    6. Paragraph (a)(13)(ii) is revised.
    7. Paragraph (a)(13)(iii) is added.
    The revisions and additions 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.

    (a) * * *
    (8) * * *
    (ii) * * * Foreign income taxes (other than taxes attributable to 
formerly pooled earnings that are maintained in United States dollars) 
that are deemed paid with respect to a distribution of pre-1987 
accumulated profits shall be translated from the functional currency of 
the lower-tier corporation into dollars at the spot exchange rate in 
effect on the date of the distribution. * * *
* * * * *
    (10) * * * (i) The term pre-1987 accumulated profits means the 
amount of the earnings and profits of a foreign corporation computed in 
accordance with section 902 and attributable to its taxable years 
beginning before January 1, 1987 (pre-1987 earnings). If the special 
effective date of paragraph (a)(13)(i) of this section applies, pre-
1987 accumulated profits also includes any earnings and profits 
(computed in accordance with section 964(a) and 986) attributable to 
the foreign corporation's taxable years beginning after December 31, 
1986, but before the first day of the first taxable year of the foreign 
corporation in which the ownership requirements of section 902(c)(3)(B) 
and paragraphs (a)(1) through (4) of this section are met with respect 
to that corporation (pre-pooling earnings). Pre-1987 accumulated 
profits also includes any post-1986 undistributed earnings formerly 
maintained by a less-than-10%-U.S.-owned foreign corporation (as 
defined in Sec. 1.904-4(g)(1)) that are attributable to the foreign 
corporation's taxable years beginning after December 31, 1986, as of 
the end of which such ownership requirements were met (formerly pooled 
earnings). Such formerly pooled earnings shall be considered pre-1987 
accumulated profits of the last taxable year of the foreign corporation 
in which such ownership requirements were met as of the end of the 
taxable year. Pre-1987 accumulated profits also includes earnings and 
profits accumulated during subsequent taxable years of such a less-
than-10%-U.S.-owned foreign corporation as of the end of which such 
ownership requirements were not met (post-pooling earnings). All four 
types of pre-1987 accumulated profits described in this paragraph 
(a)(10)(i) are also sometimes referred to as pre-pooling annual layers.
* * * * *
    (iii) * * * Foreign income taxes deemed paid with respect to a 
distribution of pre-1987 accumulated profits shall be translated from 
the functional currency of the distributing corporation into United 
States dollars at the spot exchange rate in effect on the date of the 
distribution, except that foreign income taxes attributable to formerly 
pooled earnings described in the third sentence of paragraph (a)(10)(i) 
of this section shall be maintained in United States dollars as 
originally translated in accordance with section 986(a). Post-1986 
foreign income taxes attributable to such formerly pooled earnings 
shall be treated as pre-1987 foreign income taxes.
* * * * *
    (13) * * * (i) * * *
    (A) The post-1986 undistributed earnings and post-1986 
undistributed foreign income taxes of the foreign corporation shall be 
determined by taking into account only consecutive taxable years 
beginning on and after the first day of the first taxable year of the 
foreign corporation as of the end of which the ownership requirements 
of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this 
section are met and ending before the first day of a subsequent taxable 
year in which such ownership requirements are not met as of the end of 
the taxable year;
    (B) Earnings and profits accumulated prior to the first day of the 
first taxable year of the foreign corporation as of the end of which 
such ownership requirements are met shall be considered pre-1987 
accumulated profits (which may include both pre-pooling earnings and 
pre-1987 earnings);
    (C) Formerly pooled earnings described in paragraph (a)(10)(i) of 
this section shall be considered pre-1987 accumulated profits of the 
taxable year ending immediately before the next taxable year in which 
such ownership requirements are not met as of the end of the taxable 
year; and
    (D) Earnings and profits accumulated on and after the first day of 
a taxable year of the foreign corporation as of the end of which such 
ownership requirements are not met shall be considered pre-1987 
accumulated profits (post-pooling earnings).
    (ii) Resumption of pooling. If the ownership requirements of 
section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section 
are again met with respect to a foreign corporation that originally 
maintained pools of post-1986 undistributed earnings and post-1986 
foreign income taxes but converted such pools to pre-1987 accumulated 
profits (formerly pooled earnings) and associated pre-1987 foreign 
income taxes because such ownership requirements were not met as of the 
close of a subsequent post-1986 taxable year, then the post-1986 
undistributed earnings and post-1986 foreign income taxes of the 
foreign corporation shall be determined by taking into account only 
taxable years beginning on and after the first day of the first such 
subsequent taxable year of the foreign corporation as of the end of 
which such ownership requirements are met and ending before the first 
day of a subsequent taxable year in which such ownership requirements 
are not met as of the end of the taxable year. The post-pool

[[Page 326]]

ing earnings, formerly pooled earnings, pre-pooling earnings, and pre-
1987 earnings of such a foreign corporation shall continue to be 
considered pre-1987 accumulated profits. The rules of paragraph 
(a)(13)(i)(B) through (D) of this section shall apply if such a foreign 
corporation again becomes a less-than-10%-U.S.-owned foreign 
corporation.
    (iii) Examples. The following examples illustrate the special 
effective date rules of this paragraph (a)(13):

    Example 1.  As of December 31, 1991, and since its 
incorporation, foreign corporation A has owned 100 percent of the 
stock of foreign corporation B. Corporation B is not a controlled 
foreign corporation. Corporation B uses the calendar year as its 
taxable year, and its functional currency is the u. Assume 1u equals 
$1 at all relevant times. On April 1, 1992, Corporation B pays a 
200u dividend to Corporation A and the ownership requirements of 
section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this 
section are not met at that time. On July 1, 1992, domestic 
corporation M purchases 10 percent of the Corporation B stock from 
Corporation A and, for the first time, Corporation B meets the 
ownership requirements of section 902(c)(3)(B) and paragraph (a)(2) 
of this section. Corporation M uses the calendar year as its taxable 
year. Corporation B does not distribute any dividends to Corporation 
M during 1992. For its taxable year ending December 31, 1992, 
Corporation B has 500u of earnings and profits (after foreign taxes 
but before taking into account the 200u distribution to Corporation 
A) and pays 100u of foreign income taxes that is equal to $100. 
Pursuant to paragraph (a)(13)(i) of this section, Corporation B's 
post-1986 undistributed earnings and post-1986 foreign income taxes 
will include earnings and profits and foreign income taxes 
attributable to Corporation B's entire 1992 taxable year and all 
subsequent taxable years beginning before the date these regulations 
are published as final regulations in the Federal Register, as well 
as later taxable years as of the end of which the ownership 
requirements of section 902(c)(3)(B) and paragraphs (a)(1) through 
(4) of this section are met. Thus, the April 1, 1992, dividend to 
Corporation A will reduce post-1986 undistributed earnings to 300u 
(500u--200u) under paragraph (a)(9)(i) of this section. The foreign 
income taxes attributable to the amount distributed as a dividend to 
Corporation A will not be creditable because Corporation A is not a 
domestic shareholder. Post-1986 foreign income taxes, however, will 
be reduced by the amount of foreign taxes attributable to the 
dividend. Thus, as of the beginning of 1993, Corporation B has $60 
($100-[$100 x 40% (200u/500u)]) of post-1986 foreign income taxes. 
See paragraphs (a)(8)(i) and (b)(1) of this section.
    Example 2.  The facts are the same as in Example 1, except that 
Corporation M sells five percent of the Corporation B stock to an 
unrelated buyer on July 1, 2003, so that Corporation B no longer 
meets the ownership requirements of section 902(c)(3)(B) and 
paragraphs (a)(1) through (4) of this section as of that date. Thus, 
as of December 31, 2003, Corporation B's earnings and profits all 
consist of pre-1987 accumulated profits, comprising pre-1987 
earnings for years beginning prior to January 1, 1987, pre-pooling 
earnings for taxable years 1987 through 1991, no earnings for 1992 
through 2001, formerly pooled earnings for 2002 (comprising 
Corporation B's post-1986 undistributed earnings for 1992 through 
2002), and post-pooling earnings for 2003. Dividends paid by 
Corporation B to Corporation M at any time during 2003 will be 
considered paid out of pre-1987 accumulated profits. See paragraphs 
(a)(10) and (a)(13)(i) of this section. However, Corporation M will 
be eligible to claim a deemed-paid credit only with respect to 
dividends received on or before July 1, 2003. See paragraphs (a)(1) 
and (12) of this section and Sec. 1.902-3(a)(1) and (7).
    Example 3.  The facts are the same as in Example 2, except that 
Corporation M purchases an additional five percent of the stock of 
Corporation B on July 1, 2004, so that Corporation B again meets the 
ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) 
through (4) of this section on December 31, 2004. As of the end of 
2004, assume Corporation B has 500u of post-1986 undistributed 
earnings (after foreign taxes but before taking into account 
distributions during 2004) and $100 of post-1986 foreign income 
taxes attributable to 2004, 500u of post-pooling earnings and 100u 
of pre-1987 foreign income taxes attributable to 2003, and 1500u of 
formerly pooled earnings and $250 of pre-1987 foreign income taxes 
attributable to 2002 (comprising Corporation B's post-1986 
undistributed earnings and post-1986 foreign income taxes for 1992 
through 2002). Corporation B pays dividends to its shareholders of 
500u on March 1, 2004, and 500u on September 1, 2004. The March 1, 
2004, dividend is out of Corporation B's post-1986 undistributed 
earnings in its entirety, and reduces Corporation B's post-1986 
undistributed earnings and post-1986 foreign income taxes to zero, 
even though no shareholder is eligible to claim a credit for deemed-
paid taxes. See paragraphs (a)(8)(i) and (b)(1) of this section. The 
September 1, 2004, dividend is out of 2003 post-pooling earnings, 
and reduces 2003 post-pooling earnings and foreign income taxes to 
zero. Corporation M, which is a 10% domestic shareholder of 
Corporation B on that date and receives a dividend of 50u, is deemed 
to have paid 10u of foreign income taxes (50u/500u  x  100u) with 
respect to the dividend. Both the dividend and the deemed-paid taxes 
are translated into dollars at the spot exchange rate on the 
dividend date, under the law in effect prior to the effective date 
of the Tax Reform Act of 1986. See paragraphs (a)(10)(i) and (ii) of 
this section.
    Par. 4. Section 1.904-0 is amended as follows:
    1. The entries for Sec. 1.904-4 are amended by:
    a. Revising the entry for paragraph (b)(2)(iii).
    b. Removing the entry for paragraph (b)(2)(iv).
    c. Revising the entries for paragraphs (g) and (g)(1), adding 
entries for paragraphs (g)(1)(i)-(iii), and revising the entry for 
paragraph (g)(3)(i)(C).
    d. Adding entries for paragraphs (g)(3)(i)(C)(1), (g)(3)(i)(C)(2), 
and (g)(4).
    e. Adding an entry for paragraph (m).
    2. The entries for Sec. 1.904(b)-1 are amended by:
    a. Revising section heading and the entries for all of paragraphs 
(a), (b), and (c).
    b. Adding entries for paragraphs (d), (e), (f), (g), and (h).
    3. Revising the entries for all of Sec. 1.904(b)-2.
    4. Removing all the entries for Secs. 1.904(b)-3 and 1.904(b)-4.
    5. Adding entries for Sec. 1.904(j)-1.
    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.

* * * * *
    (b) * * *
    (2) * * *
    (iii) Example.
* * * * *
    (g) Noncontrolled section 902 corporation and non-look-through 10/
50 corporation.
    (1) Corporate-level accounts and treatment of distributions to 
shareholders.
    (i) Definitions.
    (ii) Accounts at foreign corporation level.
    (iii) Inclusion at shareholder level.
* * * * *
    (3) * * *
    (i) * * *
    (C) Effect of intervening noncontrolled or less-than-10%-U.S.-owned 
status.
    (1) Pre-2003 decontrolling event.
    (2) Pool-terminating event.
* * * * *
    (4) Special rule for dividends paid by a 10/50 look-through 
corporation.
* * * * *
    (m) Income treated as allocable to an additional separate category.
* * * * *


Sec. 1.904(b)-1  Special rules for capital gains and losses.

    (a) Capital amounts included in taxable income from sources outside 
the United States.
    (1) Limitation on capital gain from sources outside the United 
States when the taxpayer has net capital losses from sources within the 
United States.
    (i) In general.
    (ii) Allocation of reduction among multiple separate categories or 
rate groups.
    (2) Capital losses from sources outside the United States in the 
same separate category.
    (3) Exclusivity of rules; no reduction by reason of net capital 
loss from sources outside the United States in a different separate 
category.
    (4) Examples.
    (b) Capital gain rate differential.
    (1) Application of adjustments only if capital gain rate 
differential exists.

[[Page 327]]

    (2) Determination of whether capital gain rate differential 
adjustment exists.
    (c) Rate differential adjustment of capital gains.
    (1) Rate differential adjustment of capital gains in foreign source 
taxable income.
    (2) Rate differential adjustment of capital gains in entire taxable 
income.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States.
    (1) In general.
    (2) Determination of which net capital gains are offset by net 
capital losses from sources outside the United States.
    (e) Definitions.
    (1) Alternative tax rate.
    (2) Capital gain net income.
    (3) Net capital gain.
    (4) Rate group.
    (i) Capital gains.
    (ii) Capital losses.
    (5) Terms used in sections 1(h), 904(b) or 1222.
    (f) Examples.
    (g) Coordination with overall foreign loss recapture rules.
    (h) Effective date.


Sec. 1.904(b)-2  Special rules for application of section 904(b) to 
alternative minimum tax foreign tax credit.

    (a) Application of section 904(b)(2)(B) adjustments.
    (b) Use of alternative minimum tax rates.
    (1) Taxpayers other than corporations.
    (2) Corporate taxpayers.
    (c) Effective date.
* * * * *


Sec. 1.904(j)-1  Certain individuals exempt from foreign tax credit 
limitation.

    (a) Election available only if all foreign taxes are creditable 
foreign taxes.
    (b) Coordination with carryover rules.
    (1) No carryovers to or from election year.
    (2) Carryovers to and from other years determined without regard to 
election years.
    (3) Determination of amount of creditable foreign taxes.
    (c) Examples.
    Par. 5. Section 1.904-4 is amended as follows:
    1. Paragraph (a) is amended by removing the period at the end and 
adding the language ``, or in Sec. 1.904-4(m) (additional separate 
categories).''
    2. The first sentence of paragraph (b)(2)(i) is revised.
    3. Paragraph (b)(2)(ii) is revised.
    4. Paragraph (b)(2)(iii) is removed.
    5. Paragraph (b)(2)(iv) is redesignated as paragraph (b)(2)(iii).
    6. The last three sentences of the Example in newly designated 
paragraph (b)(2)(iii) are revised and three new sentences are added at 
the end.
    7. The paragraph heading for paragraph (g) is revised.
    8. Paragraph (g)(1) is redesignated as paragraph (g)(1)(i) and a 
new heading is added for paragraph (g)(1).
    9. Five sentences are added at the end of newly designated 
paragraph (g)(1)(i).
    10. Paragraphs (g)(1)(ii) and (iii) are added.
    11. The heading of paragraph (g)(3)(i)(C) is revised and the text 
to paragraph (g)(3)(i)(C) is added.
    12. The text of Example 2 through Example 4 is added to paragraph 
(g)(3)(i)(D).
    13. Paragraph (g)(4) is added.
    14. The language ``and'' at the end of paragraph (l)(1)(v) is 
removed.
    15. The period at the end of paragraph (l)(1)(vi) is removed and 
``; and'' is added in its place.
    16. Paragraph (l)(1)(vii) is added.
    17. Paragraph (m) is added.
    The revisions and additions read as follows:


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

* * * * *
    (b) * * *
    (2) * * * (i) * * * For rents and royalties paid or accrued more 
than 60 days after the date these regulations are published as final 
regulations in the Federal Register, passive income does not include 
any rents or royalties that are derived in the active conduct of a 
trade or business, regardless of whether such rents or royalties are 
received from a related or an unrelated person. * * *
    (ii) Exception for certain rents and royalties. Rents and royalties 
are considered derived in the active conduct of a trade or business by 
a United States person or by a controlled foreign corporation (or other 
entity to which the look-through rules apply) for purposes of section 
904 (but not for purposes of section 954) if the requirements of 
section 954(c)(2)(A) are satisfied by one or more corporations that are 
members of an affiliated group of corporations (within the meaning of 
section 1504(a), determined without regard to section 1504(b)(3)) of 
which the recipient is a member. For purposes of this paragraph 
(b)(2)(ii), an affiliated group includes only United States 
corporations and 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. For purposes of this paragraph 
(b)(2)(ii), indirect ownership shall be determined under section 318 
and the regulations under that section.
    (iii) * * *

    Example. * * * Some of the franchisees are unrelated to S and P. 
Other franchisees are related to S or P and use the licensed 
property outside of S's country of incorporation. S does not 
satisfy, but P does satisfy, the active trade or business 
requirements of section 954(c)(2)(A) and the regulations thereunder. 
The royalty income earned by S with regard to both its related and 
unrelated franchisees is foreign personal holding company income 
because S does not satisfy the active trade or business requirements 
of section 954(c)(2)(A) and, in addition, the royalty income from 
the related franchisees does not qualify for the same country 
exception of section 954(c)(3). However, all of the royalty income 
earned by S is general limitation income to S under Sec. 1.904-
4(b)(2)(ii) because P, a member of S's affiliated group (as defined 
therein), satisfies the active trade or business test (which is 
applied without regard to whether the royalties are paid by a 
related person). S's royalty income that is taxable to P under 
subpart F and the royalties paid to P are general limitation income 
to P under the look-through rules of Sec. 1.904-5(c)(1)(i) and 
(c)(3), respectively.
* * * * *
    (g) Noncontrolled section 902 corporation and non-look-through 10/
50 corporation--(1) Corporate-level accounts and treatment of 
distributions to shareholders--(i) Definitions. * * * Except as 
otherwise provided, the term ``look-through corporation'' means a 
foreign corporation that is subject to the look-through rules of 
section 904(d)(3) or section 904(d)(4) (as in effect for taxable years 
beginning after December 31, 2002). The term ``non-look-through 10/50 
corporation'' means any foreign corporation that is not a look-through 
corporation and with respect to which a domestic corporation meets the 
stock ownership requirements of section 902(a), or, for purposes of 
applying the look-through rules described in section 904(d)(3) and 
Sec. 1.904-5, a domestic corporation meets the requirements of section 
902(b). The term ``less-than-10%-U.S.-owned foreign corporation'' means 
a foreign corporation that is neither a look-through corporation nor a 
non-look-through 10/50 corporation. The term ``look-through pool'' 
means the post-1986 undistributed earnings of a foreign corporation 
that are subject to the look-through provisions of section 904(d)(3) or 
section 904(d)(4) as in effect for taxable years beginning after 
December 31, 2002. The term ``non-look-through pool'' means the post-
1986 undistributed earnings of a foreign corporation that were 
accumulated (or treated as accumulated) while the foreign corporation 
was a non-look-through 10/50 corporation.

[[Page 328]]

    (ii) Accounts at foreign corporation level. The post-1986 
undistributed earnings of a controlled foreign corporation or other 
look-through corporation may consist of look-through pools (comprising 
post-1986 undistributed earnings accumulated during periods when the 
foreign corporation was, or was treated as, a look-through corporation, 
which may include post-1986 undistributed earnings in one or more non-
look-through pools attributable to dividends paid to the look-through 
corporation by each separate non-look-through 10/50 corporation), as 
well as one or more non-look-through pools (including post-1986 
undistributed earnings accumulated during periods when the foreign 
corporation was, or was treated as, a non-look-through 10/50 
corporation). Similarly, a look-through corporation's pre-pooling 
annual layers, as defined in Sec. 1.902-1(a)(10)(i), may or may not be 
subject to the look-through rules, depending on whether the corporation 
was, or was treated as, a look-through corporation at the time the 
earnings were accumulated.
    (iii) Inclusion at shareholder level. A particular dividend 
recipient will be entitled to look-through treatment with respect to a 
particular distribution from a controlled foreign corporation only if 
the recipient is a United States shareholder, as defined in section 
951(b) taking into account section 953(c), of the controlled foreign 
corporation at the time it receives the dividend. Therefore, a dividend 
distribution from a controlled foreign corporation to a United States 
shareholder will be characterized under the look-through rules, whereas 
a dividend distribution to a less-than-10% shareholder of the 
controlled foreign corporation will be treated as passive income. 
Similarly, under section 904(d)(1)(E), only a corporate shareholder 
calculates a separate foreign tax credit limitation for dividends from 
each noncontrolled section 902 corporation, and the look-through rules 
of section 904(d)(4) as in effect for taxable years beginning after 
December 31, 2002, apply only to applicable dividends out of post-2002 
earnings of a corporation that is a noncontrolled section 902 
corporation with respect to the taxpayer. Therefore, dividends paid to 
an individual shareholder by a non-look-through 10/50 corporation, or 
by a controlled foreign corporation out of a non-look-through pool, 
will be treated as passive income. Similarly, dividends paid to an 
individual shareholder by a look-through corporation that is not a 
controlled foreign corporation will be treated as passive income to 
such individual, even if the individual owns 10 percent or more of the 
distributing corporation's stock.
* * * * *
    (3) * * *
    (i) * * *
    (C) Effect of intervening noncontrolled or less-than-10%-U.S.-owned 
status--(1) Pre-2003 decontrolling event. If a controlled foreign 
corporation becomes a non-look-through 10/50 corporation, for example, 
by reason of the corporation's issuance of additional stock or the 
disposition of stock by the corporation's controlling United States 
shareholders to foreign persons in a taxable year of the controlled 
foreign corporation beginning before January 1, 2003, (a decontrolling 
event), and retains that status as of the end of the foreign 
corporation's taxable year, then earnings and profits that were 
accumulated before the decontrolling event during periods when the 
corporation was a controlled foreign corporation will at all times 
thereafter be treated as earnings and profits accumulated by a non-
look-through 
10/50 corporation. The corporation's post-1986 undistributed earnings 
(or deficits in post-1986 undistributed earnings) in each separate 
category shall be combined into, and constitute the opening balance of, 
a single non-look-through pool of post-1986 undistributed earnings 
accumulated in taxable years beginning before January 1, 2003. The 
corporation's post-1986 foreign income taxes in each separate category 
shall similarly be combined into a single category of post-1986 foreign 
income taxes attributable to the non-look-through pool. Distributions 
of such earnings and profits after the decontrolling event will not be 
subject to the look-through rules of Sec. 1.904-5, even if the 
corporation subsequently becomes a controlled foreign corporation or 
other look-through corporation again. The corporation's pre-1987 
accumulated profits will also be ineligible for look-through treatment 
if accumulated prior to, and distributed after, the decontrolling 
event. In determining whether the look-through rules apply to earnings 
and profits maintained at the distributing corporation level, earnings 
and profits accumulated or distributed in the taxable year in which a 
decontrolling event occurs shall be considered accumulated or 
distributed after the decontrolling event, respectively. However, in 
determining whether a dividend recipient is entitled to look-through 
treatment with respect to a particular distribution, only the 
shareholder's status and ownership of stock at the time it receives the 
dividend is relevant. See Sec. 1.902-1(a)(1) and paragraph (g)(1)(iii) 
of this section.
    (2) Pool-terminating event. If a look-through corporation or a non-
look-through 10/50 corporation becomes a less-than-10%-U.S.-owned 
foreign corporation, for example, by reason of the corporation's 
issuance of additional stock or the disposition of stock by the 
corporation's United States shareholders (a pool-terminating event), 
and retains that status as of the end of the foreign corporation's 
taxable year, then earnings and profits that were accumulated before 
the pool-terminating event will at all times thereafter be treated as 
pre-1987 accumulated profits accumulated by a non-look-through 10/50 
corporation in accordance with Sec. 1.902-1(a)(10) and (13). 
Distributions of such earnings and profits after the pool-terminating 
event will not be subject to the look-through rules of Sec. 1.904-5, 
even if the corporation subsequently becomes a look-through corporation 
again. Earnings and profits accumulated or distributed in the taxable 
year in which a pool-terminating event occurs shall be considered 
accumulated or distributed after the pool-terminating event, 
respectively. However, in determining whether a dividend recipient is 
entitled to look-through treatment with respect to a particular 
distribution, only the shareholder's status and ownership of stock at 
the time it receives the dividend is relevant. See Sec. 1.902-1(a)(1) 
and paragraph (g)(1)(iii) of this section.
* * * * *
    (D) * * *

    Example 2. (i) Facts. X, a domestic corporation, owns all of the 
stock of S, a controlled foreign corporation. On March 1, 2002, S 
pays a dividend to X. On July 1, 2002, S issues additional shares of 
stock to Z, a foreign person, in exchange for a capital 
contribution. The new stock issuance dilutes X's interest in S to 40 
percent. Thus, S is a non-look-through 10/50 corporation beginning 
on July 1, 2002.
    (ii) Result. The March 1, 2002, dividend to X is treated as a 
dividend from a non-look-through 10/50 corporation. X is not 
entitled to look-through treatment on the dividend under paragraph 
(g)(3)(i)(C) of this section.
    Example 3. (i) Facts. X, a domestic corporation, has owned all 
of the stock of S, a controlled foreign corporation, since S was 
organized in 1980. Both X and S use the calendar year as the taxable 
year. On July 1, 2002, X sells 60 percent of the stock of S to Z, a 
foreign person. On July 1, 2003, X repurchases all of the S stock 
that it sold to Z in 2002. Thus, S is a controlled foreign 
corporation for 1980 through June 30, 2002, a non-look-through 10/50 
corporation from July 1, 2002, through December 31, 2002, and a 
look-through corporation from January 1,

[[Page 329]]

2003, forward, as well as a controlled foreign corporation from July 
1, 2003, forward.
    (ii) Result. Pursuant to paragraph (g)(3)(i)(C) of this section, 
X is entitled to look-through treatment with respect to 
distributions before January 1, 2002, of S's post-1986 undistributed 
earnings accumulated through December 31, 2001, and of S's pre-1987 
accumulated profits. Distributions after December 31, 2001, of 
earnings and profits accumulated before January 1, 2003, will be 
treated as dividends from a non-look-through 10/50 corporation. X is 
entitled to look-through treatment on distributions of earnings and 
profits accumulated and distributed after December 31, 2002.
    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that X sells 95 percent, rather than 60 percent, of the stock 
of S to Z. Thus, S is a controlled foreign corporation for 1980 
through June 30, 2002, a less-than-10%-U.S.-owned foreign 
corporation from July 1, 2002, through June 30, 2003, and a 
controlled foreign corporation beginning on July 1, 2003.
    (ii) Result. The result is the same as in Example 3, except that 
distributions from S made between July 1, 2002, and June 30, 2003, 
will be treated as passive income to X because X owns less than 10 
percent of the stock of S during that period. Distributions from S 
to X made between January 1, 2002, and June 30, 2002, will be 
treated as dividends from a non-look-through 10/50 corporation. 
Distributions from S to X made after June 30, 2003, out of earnings 
and profits accumulated prior to January 1, 2003, will be treated as 
dividends from a non-look-through 10/50 corporation. X is entitled 
to look-through treatment of distributions after June 30, 2003, out 
of earnings and profits accumulated after December 31, 2002.
* * * * *
    (4) Special rule for dividends paid by a 10/50 look-through 
corporation. [Reserved]
* * * * *
    (l) * * * (1) * * *
    (vii) Income that meets the definitions of a separate category 
described in paragraph (m) of this section and of any other category of 
separate limitation income described in section 904(d)(1)(A) through 
(H) will be subject to the separate limitation described in paragraph 
(m) of this section and will not be treated as general limitation 
income described in section 904(d)(1)(I).
* * * * *
    (m) Income treated as allocable to an additional separate category. 
If section 904(a), (b), and (c) are applied separately to any category 
of income under the Internal Revenue Code (for example, under section 
56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), or 904(g)(10)), that 
category of income will be treated for all purposes of the Internal 
Revenue Code and regulations as if it were a separate category listed 
in section 904(d)(1) and section 904(d)(3)(F)(i).
    Par. 6. In Sec. 1.904-5, paragraph (a)(1) is revised to read as 
follows:


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

    (a) * * *
    (1) The term ``separate category'' means, as the context requires, 
any category of income described in section 904(d)(1)(A), (B), (C), 
(D), (E), (F), (G), (H), or (I) and in Sec. 1.904-4(b), (d), (e), (f), 
and (g), any category of income described in Sec. 1.904-4(m), or any 
category of earnings and profits to which income described in such 
provisions is attributable.
* * * * *
    Par. 7. In Sec. 1.904-6, paragraph (a)(1)(ii) is amended by adding 
two sentences at the end to read as follows:


Sec. 1.904-6  Allocation and apportionment of taxes.

    (a) * * * (1) * * *
    (ii) * * * If the taxpayer applies the principles of Secs. 1.861-8 
through 1.861-14T for purposes of allocating expenses at the level of 
the taxpayer (or at the level of the qualified business unit, foreign 
subsidiary, or other entity that paid or accrued the foreign taxes) 
under this paragraph (a)(1)(ii), such principles shall be applied (for 
such purposes) in the same manner as the taxpayer applies such 
principles in determining the income or earnings and profits for United 
States tax purposes of the taxpayer (or of the qualified business unit, 
foreign subsidiary, or other entity that paid or accrued the foreign 
taxes, as the case may be). For example, a taxpayer must use the 
modified gross income method under Sec. 1.861-9T when applying the 
principles of that section for purposes of this paragraph (a)(1)(ii) to 
determine the amount of a controlled foreign corporation's income, in 
each separate category, that is taxed by a foreign country, if the 
taxpayer applies the modified gross income method under Sec. 1.861-
9T(f)(3) when applying Sec. 1.861-9T to determine the income and 
earnings and profits of the controlled foreign corporation for United 
States tax purposes.
* * * * *
    Par. 8. Section 1.904(b)-1 is revised to read as follows:


Sec. 1.904(b)-1  Special rules for capital gains and losses.

    (a) Capital amounts included in taxable income from sources outside 
the United States--(1) Limitation on capital gain from sources outside 
the United States when the taxpayer has net capital losses from sources 
within the United States--(i) In general. Except as otherwise provided 
in this section, for purposes of section 904 and this section, taxable 
income from sources outside the United States (in all of the taxpayer's 
separate categories in the aggregate) shall include capital gain net 
income from sources outside the United States (determined by 
considering all of the capital gain and loss items in all of the 
taxpayer's separate categories in the aggregate) only to the extent of 
capital gain net income from all sources. Similarly, except as 
otherwise provided in this section, for purposes of section 904 and 
this section, net capital gain from sources outside the United States 
(determined by considering all of the capital gain and loss items in 
all of the taxpayer's separate categories in the aggregate) shall not 
exceed net capital gain from all sources.
    (ii) Allocation of reduction among multiple separate categories or 
rate groups. If capital gain net income (or net capital gain) from 
sources outside the United States exceeds capital gain net income (or 
net capital gain), and the taxpayer has capital gain net income (or net 
capital gain) from sources outside the United States in two or more 
separate categories or in two or more rate groups, such excess must be 
apportioned on a pro rata basis as a reduction to each such separate 
category, and then within each separate category, on a pro rata basis 
among rate groups. For purposes of the preceding sentence, pro rata 
means based on the relative amounts of the capital gain net income (or 
net capital gain) from sources outside the United States in each 
separate category, or in each rate group within a separate category.
    (2) Capital losses from sources outside the United States in the 
same separate category. Except as otherwise provided in paragraph (d) 
of this section, taxable income from sources outside the United States 
in each separate category shall be reduced by any capital loss that is 
allocable or apportionable to sources outside the United States in such 
separate category to the extent such loss is allowable in determining 
taxable income for the taxable year (taking into account losses 
allowable under section 1211(b)).
    (3) Exclusivity of rules; no reduction by reason of net capital 
losses from sources outside the United States in a different separate 
category. Capital gains from sources outside the United States in any 
separate category shall be limited by reason of section 904(b)(2)(A) 
and the comparable limitation of section 904(b)(2)(B)(i) only to the 
extent provided in paragraph (a)(1) of this section (relating to 
limitation on capital gain from sources outside the United

[[Page 330]]

States when taxpayer has net capital losses from sources within the 
United States) and paragraph (a)(2) of this section (relating to 
capital losses from sources outside the United States in the same 
separate category).
    (4) Examples. The following examples illustrate the application of 
this paragraph (a). The examples are as follows:

    Example 1. Taxpayer A, a corporation, has a general limitation 
category capital loss of $3,000 from sources outside the United 
States, a passive category capital gain of $3,000 from sources 
outside the United States, and a capital loss of $2,000 from sources 
within the United States. A has no capital gain net income from 
sources outside the United States (in the aggregate, from all 
separate categories), because the $3,000 passive capital gain less 
the $3,000 general limitation capital loss yields a net of zero. 
From all sources, A also has no capital gain net income. (The 
resulting $2,000 net capital loss is not currently allowable under 
section 1211(a) because A is a corporation.) Because A's capital 
gain net income from sources outside the United States does not 
exceed A's capital gain net income from all sources, paragraph 
(a)(1) of this section does not require any reduction of A's passive 
category capital gain.
    Example 2. Taxpayer B, a corporation, has $500 of capital gain 
net income from sources outside the United States, of which $300 is 
in the general limitation category and $200 is in the passive 
category. B's capital gain net income from sources outside the 
United States is $500 ($300 + $200). Because B also incurs a capital 
loss of $100 from sources within the United States, B's capital gain 
net income (from all sources) is $400 ($300 + $200--$100). Pursuant 
to paragraph (a)(1)(B) of this section, the $100 excess of capital 
gain net income from sources outside the United States over capital 
gain net income from all sources ($500--$400) must be apportioned, 
as a reduction, three-fifths ($300/$500 of $100, or $60) to the 
general limitation category and two-fifths ($200/$500 of $100, or 
$40) to the passive category. Therefore, for purposes of section 
904, the general limitation category includes $240 ($300--$60) of 
capital gain net income from sources outside the United States and 
the passive category includes $160 ($200--$40) of capital gain net 
income from sources outside the United States.
    Example 3. Taxpayer C, a corporation, has a $10,000 capital loss 
from sources outside the United States in the general limitation 
category, a $4,000 capital gain from sources outside the United 
States in the passive category, and a $2,000 capital gain from 
sources within the United States. C's capital gain net income from 
sources outside the United States is zero, since losses exceed 
gains. C's capital gain net income from all sources is also zero. 
C's capital gain net income from sources outside the United States 
does not exceed its capital gain net income from all sources, and 
therefore paragraph (a)(1) of this section does not require any 
reduction of C's passive category capital gain. For purposes of 
section 904, C's passive category includes $4,000 of capital gain 
net income. C's general limitation category includes a capital loss 
of $6,000 because only $6,000 of capital loss is allowable as a 
deduction in the current year. The entire $4,000 of capital loss in 
excess of the $6,000 of capital loss that offsets capital gain in 
the taxable year is carried back or forward under section 1212(a), 
and none of such $4,000 is taken into account under section 904(a) 
or (b) for the current taxable year.

    (b) Capital gain rate differential--(1) Application of adjustments 
only if capital gain rate differential exists. Section 904(b)(2)(B) and 
paragraphs (c) and (d) of this section apply only for taxable years in 
which the taxpayer has a capital gain rate differential.
    (2) Determination of whether capital gain rate differential exists. 
For purposes of section 904(b) and this section, a capital gain rate 
differential is considered to exist for the taxable year only if the 
taxpayer has a net capital gain for the taxable year and--
    (i) In the case of a taxpayer other than a corporation, tax is 
imposed at a reduced rate under section 1(h) for the taxable year; or
    (ii) In the case of a corporation, tax is imposed under section 
1201(a) on the taxpayer at a rate less than any rate of tax imposed on 
the taxpayer by section 11, 511, or 831(a) or (b), whichever applies 
(determined without regard to the last sentence of section 11(b)(1)), 
for the taxable year.
    (c) Rate differential adjustment of capital gains--(1) Rate 
differential adjustment of capital gains in foreign source taxable 
income. In determining taxable income from sources outside the United 
States for purposes of section 904 and this section, capital gain net 
income from sources outside the United States in each separate 
category, after any reduction pursuant to paragraph (a) of this 
section, shall be reduced by the sum of the rate differential portions 
(as defined in section 904(b)(3)(E)) of each rate group of net capital 
gain from sources outside the United States in such separate category.
    (2) Rate differential adjustment of capital gains in entire taxable 
income. For purposes of section 904 and this section, the entire 
taxable income shall include gains from the sale or exchange of capital 
assets only to the extent of capital gain net income reduced by the sum 
of the rate differential portions (as defined in section 904(b)(3)(E)) 
of each rate group of net capital gain.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States--(1) In general. In determining taxable 
income from sources outside the United States for purposes of section 
904 and this section, any net capital loss from sources outside the 
United States included in a separate category pursuant to paragraph (a) 
of this section shall be reduced by the sum of the rate differential 
portion of the net capital gains (from the same rate group in other 
separate categories, from other rate groups in the same or other 
separate categories, or from sources within the United States) that are 
offset by such net capital loss in determining the taxpayer's entire 
taxable income.
    (2) Determination of which net capital gains are offset by net 
capital losses from sources outside the United States. For purposes of 
paragraph (d)(1) of this section, in order to determine which net 
capital gains (from any rate group) are offset by net capital losses 
from sources outside the United States, the following rules shall apply 
in the following order:
    (i) Capital losses from sources outside the United States shall 
first be netted against capital gains from sources outside the United 
States in the same rate group and the same separate category as the 
foreign source capital losses.
    (ii) Net capital losses from each rate group from sources outside 
the United States shall be netted against net capital gains from 
sources outside the United States from the same rate group in other 
separate categories, ratably to the extent that net capital gains and 
losses in a particular rate group occur in two or more separate 
categories.
    (iii) Capital losses from sources within the United States shall be 
netted against capital gains from sources within the United States in 
the same rate group.
    (iv) The net foreign capital losses from each rate group, as 
determined under paragraph (d)(2)(ii) of this section, shall be netted 
against the taxpayer's remaining net capital gains from sources within 
and outside the United States in the following order, and without 
regard to any net capital losses, from any rate group, from sources 
within the United States--
    (A) First against net capital gains from sources within the United 
States in the same rate group;
    (B) Next, against net capital gains in other rate groups, in the 
order in which capital losses offset capital gains for purposes of 
determining the taxpayer's taxable income and without regard to whether 
such net capital gains derive from sources within or outside the United 
States, as follows:
    (1) A short-term capital loss (including any short-term capital 
loss carryover) is used first to offset short-term capital gain 
otherwise taxable at ordinary income rates. Any remaining

[[Page 331]]

net short-term capital loss is used first to offset any net long-term 
gain in the 28 percent rate group, then to offset net long-term gain in 
the 25 percent rate group, and finally to offset net long-term gain in 
the 20 percent rate group.
    (2) A net capital loss in the 28 percent rate group is used first 
to offset net capital gain in the 25 percent rate group, and then to 
offset net capital gain in the 20 percent rate group.
    (3) A net capital loss in the 20 percent rate group is used first 
to offset net capital gain in the 28 percent rate group, and then to 
offset net capital gain in the 25 percent rate group.
    (v) The net capital losses from sources outside the United States 
in any rate group, to the extent netted against net capital gains in 
any other separate category under paragraph (d)(2)(ii) of this section 
or against net capital gains in any other rate group under paragraph 
(d)(2)(iv) of this section, shall be treated as coming pro rata from 
each separate category that contains net capital losses from sources 
outside the United States in that rate group. For example, assume that 
the taxpayer has $20 of net capital losses in the 20 percent rate group 
in the passive category and $40 of net capital losses in the 20 percent 
rate group in the general limitation category, both from sources 
outside the United States. Further assume that $50 of the total $60 net 
capital losses from sources outside the United States are netted 
against net capital gains in the 28 percent rate group (from other 
separate categories or from sources within the United States). One-
third of the $50 of such capital losses would be treated as coming from 
the passive category, and two-thirds of such $50 would be treated as 
coming from the general limitation category.
    (vi) The determination of which capital gains are offset by capital 
losses from sources outside the United States under this paragraph is 
made solely in order to determine the appropriate rate-differential-
based adjustments to such capital losses under this section and section 
904(b), and does not change the source, allocation, or separate 
category of any such capital gain or loss for purposes of computing 
taxable income from sources within or outside the United States or for 
any other purpose.
    (e) Definitions. For purposes of section 904(b) and this section, 
the following definitions apply:
    (1) Alternative tax rate. The term alternative tax rate means, with 
respect to any rate group, the rate applicable to that rate group under 
section 1(h) (for taxpayers other than corporations) or 1201(a) (for 
corporations). For example, the alternative tax rate for unrecaptured 
section 1250 gain is 25 percent.
    (2) Capital gain net income. The term capital gain net income means 
the excess of the gains from the sales or exchanges of capital assets 
over the losses from such sales or exchanges. Such term shall include 
net section 1231 gain, but shall not include gains or losses from the 
sale or exchange of capital assets to the extent that such gains are 
not treated as capital gains. In determining capital gain net income, 
gains and losses which are not from the sale or exchange of capital 
assets but which are treated as capital gains and losses under the 
Internal Revenue Code are included.
    (3) Net capital gain. The term net capital gain means the excess of 
the net long-term capital gain (including net section 1231 gain) for 
the taxable year over the net short-term capital loss for such year, 
but shall not include gains or losses from the sale or exchange of 
capital assets to the extent that such gains are not treated as capital 
gains. In determining net capital gain, gains and losses which are not 
from the sale or exchange of capital assets but which are treated as 
capital gains and losses under the Internal Revenue Code are included.
    (4) Rate group. For purposes of this section--
    (i) Capital gains. With respect to capital gains, the term rate 
group means the amounts subject to a particular rate of tax under 
section 1(h). For example, the 20 percent rate group of capital gain 
net income from sources outside the United States consists of the 
capital gain net income from sources outside the United States that is 
subject to tax at a rate of 20 percent under section 1(h).
    (ii) Capital losses. With respect to capital losses, the rate group 
shall be determined as if the sale or exchange that produced the 
capital loss had instead produced a capital gain. For example, if the 
sale of an asset held for more than one year yields a capital loss, but 
any gain generated by the sale would have been subject to tax at a rate 
of 20 percent under section 1(h), the capital loss is allocated to the 
20 percent rate group for purposes of this section.
    (5) Terms used in sections 1(h), 904(b) or 1222. For purposes of 
this section, any term used in this section and also used in section 
1(h), section 904(b) or section 1222 shall have the same meaning given 
such term by section 1(h), 904(b) or 1222, respectively, except as 
otherwise provided in this section.
    (f) Examples. The following examples illustrate the provisions of 
this section. In these examples, the adjustment for the rate 
differential portion is shown as a fraction, the numerator of which is 
the alternative tax rate percentage and the denominator of which is 
39.6 percent (the current highest applicable tax rate for individuals 
under section 1). All of the examples assume that all capital gains and 
losses are long-term capital gains and losses. (Therefore, in these 
examples, capital gain net income equals net capital gain, and for 
convenience both are referred to in the examples as net capital gain in 
calculating the rate differential adjustments). In addition, all dollar 
amounts in the examples are abbreviated from amounts in the thousands 
(e.g., $50 represents $50,000). The examples are as follows:
    Example 1. (i) A, an individual, has foreign source items only 
in the passive category for the taxable year. A has $1,000 of 
capital gains from sources outside the United States, which would be 
taxed at a rate of 20 percent under section 1(h). A has $700 of 
capital losses from sources outside the United States, which 
resulted from the sale of capital assets held for more than one 
year. If the sale had resulted in gain rather than loss, the gain 
would have been taxed at a rate of 20 percent under section 1(h). 
For the same taxable year, A has $800 of capital gains from sources 
within the United States that are taxed at a rate of 28 percent 
under section 1(h). A also has $100 of capital losses from sources 
within the United States. If the sale or exchange generating such 
capital losses had instead yielded a capital gain, such gain would 
have been subject to tax a rate of 20 percent under section 1(h). A 
also has $500 of ordinary income from sources within the United 
States.
    (ii) A's items of ordinary income, capital gain and capital loss 
for the taxable year are summarized in the following table: foreign 
source:

------------------------------------------------------------------------
                                                                 Foreign
                                                         U.S.    source:
                                                        source   passive
------------------------------------------------------------------------
20% rate group.......................................   ($100)    $1,000
                                                                  ($700)
25% rate group.......................................
28% rate group.......................................      800
Ordinary income......................................      500
------------------------------------------------------------------------

    (iii) A's capital gain net income from sources outside the 
United States ($300) does not exceed A's capital gain net income 
from all sources ($1,000). Therefore, paragraph (a)(1) of this 
section does not require any reduction of A's capital gain net 
income in the passive category.
    (iv) In computing A's taxable income from sources outside the 
United States in the numerator of the section 904(a) foreign tax 
credit limitation fraction for the passive category, capital gains 
and losses from sources outside the United States are netted within 
rate groups and within separate categories. See paragraphs (a)(2), 
(c)(1), and (d)(1) of this section. The $1,000 of capital gain less 
the $700 of capital loss yields $300 of net capital gain in the 20 
percent rate group in the passive category. A must adjust the 
resulting net capital gain in the passive category as required under 
section 904(b)(2)(B)(i) and paragraph (c)(1) of this

[[Page 332]]

section, using 20 percent as the alternative tax rate, as follows: 
$300 (20%/39.6%).
    (v) In computing A's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fraction, A must 
combine the $300 net capital gain from sources outside the United 
States and the $100 net capital loss from sources within the United 
States in the same rate group (20 percent). A must adjust the 
resulting $200 ($300-$100) of net capital gain in the 20 percent 
rate group as required under section 904(b)(2)(B)(ii) and paragraph 
(c)(2) of this section, using 20 percent as the alternative tax 
rate, as follows: $200 (20%/39.6%). A must also adjust the $800 of 
net capital gain in the 28 percent rate group, using 28 percent as 
the alternative tax rate, as follows: $800 (28%/39.6%).
    (vi) A's passive category foreign tax credit limitation is 
computed as follows:
[GRAPHIC] [TIFF OMITTED] TP03JA01.015

    Example 2. (i) X, an individual, has the following items of 
ordinary income, capital gain, and capital loss for the taxable 
year:

----------------------------------------------------------------------------------------------------------------
                                                                                          Foreign source:
                                                                    U.S. source  -------------------------------
                                                                                      General         Passive
----------------------------------------------------------------------------------------------------------------
20% rate group..................................................            $300          ($500)            $100
25% rate group..................................................             200
28% rate group..................................................             500           (300)
Ordinary income.................................................           1,000             500             500
----------------------------------------------------------------------------------------------------------------

    (ii) X's capital gain net income from sources outside the United 
States in the aggregate (zero, since losses exceed gains) does not 
exceed X's capital gain net income from all sources ($300). 
Therefore, paragraph (a)(1) of this section does not require any 
reduction of X's capital gain net income in the passive category.
    (iii) In computing X's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax 
credit limitation fractions for the passive and general limitation 
categories, X must adjust capital gain net income and net capital 
losses as provided in section 904(b)(2)(B)(i) and (iii) and 
paragraphs (c)(1) and (d)(1) of this section.
    (A) First, capital gains and losses from sources outside the 
United States are netted within rate groups and within separate 
categories. There are no such amounts to be netted in this case.
    (B) Because X has net capital losses in the general limitation 
category, under paragraph (d)(2)(ii) of this section X's net capital 
losses from sources outside the United States in each rate group are 
netted against net capital gains from sources outside the United 
States in other separate categories in the same rate group. Thus, 
$100 of the $500 net capital loss in the 20 percent rate group in 
the general limitation category offsets $100 of net capital gain in 
the 20 percent rate group in the passive category. The $100 net 
capital gain remains in the passive category and is adjusted under 
paragraph (c)(1) of this section as follows: $100(20%/39.6%). The 
$100 net capital loss remains in the general limitation category and 
is adjusted under paragraph (d)(1) of this section as follows: 
$100(20%/39.6%).
    (C) Next, under paragraph (d)(2)(iv)(A) of this section, X's net 
capital losses from sources outside the United States in any rate 
group and in any separate category are netted against net capital 
gains in the same rate group from sources within the United States. 
Thus, $300 of the $500 net capital loss in the 20 percent rate group 
in the general limitation category offsets $300 of net capital gain 
in the 20 percent rate group from sources within the United States. 
The $300 of net capital loss remains in the general limitation 
category and is adjusted under paragraph (d)(1) of this section as 
follows: $300(20%/39.6%). Similarly, the $300 of net capital loss in 
the 28 percent rate group in the general limitation category offsets 
$300 of net capital gain in the 28 percent rate group from sources 
within the United States. The $300 net capital loss remains in the 
general limitation category and is adjusted under paragraph (d)(1) 
of this section as follows: $300(28%/39.6%).
    (D) Next, under paragraph (d)(2)(iv)(B) of this section, the 
remaining net capital losses in a rate group are netted against net 
capital gains from other rate groups from sources within and outside 
the United States. The remaining $100 of the $500 net capital loss 
in the 20 percent rate group in the general limitation category 
offsets $100 of the remaining net capital gain in the 28 percent 
rate group from sources within the United States. The $100 of net 
capital loss remains in the general limitation category and is 
adjusted under paragraph (d)(1) of this section as follows: 
$100(28%/39.6%).
    (iv) In computing X's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fractions, X 
must adjust capital gain net income by netting all of X's capital 
gains and losses, from sources within and outside the United States, 
and adjusting any remaining net capital gains, based on rate 
category, under section 904(b)(2)(B)(ii) and paragraph (c)(2) of 
this section. X must also include foreign source ordinary income in 
the numerators, and worldwide ordinary income in the denominator, of 
the foreign tax credit limitation fractions. The denominator of X's 
foreign tax credit limitation fractions reflects $2,000 of worldwide 
ordinary income, $100 of U.S.-source net capital gain taxed at the 
28% rate and adjusted as follows: $100(28%/39.6%), and $200 of U.S.-
source net capital gain taxed at the 25% rate and adjusted as 
follows: $200(25%/39.6%).
    (v) X's general limitation foreign tax credit limitation is 
computed as follows:
[GRAPHIC] [TIFF OMITTED] TP03JA01.016

    (vi) X's passive category foreign tax credit limitation is 
computed as follows:

[[Page 333]]

[GRAPHIC] [TIFF OMITTED] TP03JA01.017

    Example 3. (i) Y, an individual, has the following items of 
ordinary income, capital gain, and capital loss for the taxable 
year:

----------------------------------------------------------------------------------------------------------------
                                                                                          Foreign source
                                                                    U.S. source  -------------------------------
                                                                                      General         Passive
----------------------------------------------------------------------------------------------------------------
20% rate group..................................................            $300          ($720)           ($80)
25% rate group..................................................             200
28% rate group..................................................             500           (150)              50
Ordinary income.................................................           1,000           1,000             500
----------------------------------------------------------------------------------------------------------------

    (ii) Y's capital gain net income from sources outside the United 
States (zero, since losses exceed gains) does not exceed Y's capital 
gain net income from all sources ($100). Therefore, paragraph (a)(1) 
of this section does not require any adjustment.
    (iii) In computing Y's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax 
credit limitation fractions for the passive and general limitation 
categories, Y must adjust capital gain net income and net capital 
losses as provided in section 904(b)(2)(B)(i) and (iii) and 
paragraphs (c)(1) and (d)(1) of this section. Since Y has no capital 
gain net income in any separate category, the only adjustments are 
those required under section 904(b)(2)(B)(iii) and paragraph (d)(1) 
of this section.
    (A) Under paragraph (d)(2)(ii) of this section, $50 of Y's $150 
net capital loss in the 28 percent rate group in the general 
limitation category offsets $50 of net capital gain in the 28 
percent rate group in the passive category. The $50 of net capital 
loss remains in the general limitation category and is adjusted as 
follows: $50(28%/39.6%). The $50 of net capital gain remains in the 
passive category and is adjusted as follows: $50(28%/39.6%).
    (B) Under paragraph (d)(2)(iv)(A) of this section, the remaining 
$100 of net capital loss in the 28 percent rate group in the general 
limitation category offsets $100 of net capital gain in the 28 
percent rate group from sources within the United States. The $100 
of net capital loss remains in the general limitation category and 
is adjusted as follows: $100(28%/39.6%).
    (C) Under paragraph (d)(2)(iv)(A) of this section, the $300 of 
net capital gain in the 20 percent rate group from sources within 
the United States is reduced proportionately by the net capital 
losses in the 20 percent rate group in the passive and general 
limitation categories. The proportionate amount of the $720 net 
capital loss remains in the general limitation category, adjusted as 
follows: $300($720/$800)(20%/39.6%). The proportionate amount of the 
$80 net capital loss remains in the passive category, adjusted as 
follows: $300($80/$800)(20%/39.6%).
    (D) Of the remaining $500 of net capital loss in the 20 percent 
rate group (in the general limitation and passive categories), $400 
offsets the remaining $400 of net capital gain in the 28 percent 
rate group from sources within the United States under paragraph 
(d)(2)(iv)(B)(3) of this section. The proportionate amount of the 
$720 net capital loss remains in the general limitation category, 
adjusted as follows: $400($720/$800)(28%/39.6%). The proportionate 
amount of the $80 net capital loss remains in the passive category, 
adjusted as follows: $400($80/$800)(28%/39.6%).
    (E) Under paragraph (d)(2)(iv)(B)(3) of this section, the 
remaining $100 of net capital loss in the 20 percent rate group (in 
the general limitation and passive limitation categories) offsets 
$100 of net capital gain in the 25 percent rate group from sources 
within the United States. The proportionate amount of the $720 net 
capital loss remains in the general limitation category, adjusted as 
follows: $100($720/$800)(25%/39.6%). The proportionate amount of the 
$80 net capital loss remains in the passive category, adjusted as 
follows: $100($80/$800)(25%/39.6%).
    (iv) In computing Y's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fractions, Y 
must adjust capital gain net income by netting all of Y's capital 
gains and losses, from sources within and outside the United States, 
and adjusting any remaining net capital gains, based on rate 
category, under section 904(b)(2)(B)(ii) and paragraph (c)(2) of 
this section. Y must also include foreign source ordinary income in 
the numerators, and worldwide ordinary income in the denominator, of 
the foreign tax credit limitation fractions. The denominator of Y's 
foreign tax credit limitation fractions reflects $2,500 of worldwide 
ordinary income and $100 of U.S.-source net capital gain taxed at 
the 25% rate and adjusted as follows: $100(25%/39.6%).
    (v) Y's general limitation foreign tax credit limitation is 
computed as follows:
[GRAPHIC] [TIFF OMITTED] TP03JA01.018

    (vi) Y's passive category foreign tax credit limitation is 
computed as follows:
[GRAPHIC] [TIFF OMITTED] TP03JA01.019

    (g) Coordination with overall foreign loss recapture rules. Section 
904(b) and this section shall apply before the provisions of section 
904(f). Therefore, the amount of a taxpayer's separate limitation 
income or loss in each separate category, the amount of overall foreign 
loss, and the amount of any additions to or recapture of separate 
limitation loss or overall foreign loss accounts pursuant to section 
904(f) shall be determined after applying section 904(b) and this 
section to adjust capital gains and losses in each separate category.

[[Page 334]]

    (h) Effective date. This section shall apply to taxable years 
beginning after the date this regulation is published in the Federal 
Register as a final regulation.
    Par. 9. Section 1.904(b)-2 is revised to read as follows: 
Sec. 1.904(b)-2 Special rules for application of section 904(b) to 
alternative minimum tax foreign tax credit.
    (a) Application of section 904(b)(2)(B) adjustments. Section 
904(b)(2)(B) shall apply for purposes of determining the alternative 
minimum tax foreign tax credit under section 59 (regardless of whether 
or not the taxpayer has made an election under section 59(a)(4)).
    (b) Use of alternative minimum tax rates--(1) Taxpayers other than 
corporations. In the case of a taxpayer other than a corporation, for 
purposes of determining the alternative minimum tax foreign tax credit 
under section 59--
    (i) Section 904(b)(3)(D)(i) shall be applied by substituting 
``section 55(b)(3)'' for ``subsection (h) of section 1'';
    (ii) Section 904(b)(3)(E)(ii)(I) shall be applied by substituting 
``section 55(b)(1)(A)(i)'' for ``subsection (a), (b), (c), (d), or (e) 
of section 1 (whichever applies)''; and
    (iii) Section 904(b)(3)(E)(iii)(I) shall be applied by substituting 
``the alternative rate of tax determined under section 55(b)(3)'' for 
``the alternative rate of tax determined under section 1(h)''.
    (2) Corporate taxpayers. In the case of a corporation, for purposes 
of determining the alternative minimum tax foreign tax credit under 
section 59, section 904(b)(3)(E)(ii)(II) shall be applied by 
substituting ``section 55(b)(1)(B)'' for ``section 11(b)''.
    (c) Effective date. This section shall apply to taxable years 
beginning after the date this section is published as a final 
regulation in the Federal Register.


Secs. 1.904(b)-3 and 1.904(b)-4  [Removed]

    Par. 10. Sections 1.904(b)-3 and 1.904(b)-4 are removed.
    Par. 11. Section 1.904(j)-1 is added to read as follows:


Sec. 1.904(j)-1  Certain individuals exempt from foreign tax credit 
limitation.

    (a) Election available only if all foreign taxes are creditable 
foreign taxes. A taxpayer may elect to apply section 904(j) for a 
taxable year only if all of the taxes for which a credit is allowable 
to the taxpayer under section 901 for the taxable year (without regard 
to carryovers) are creditable foreign taxes (as defined in section 
904(j)(3)(B)).
    (b) Coordination with carryover rules--(1) No carryovers to or from 
election year. If the taxpayer elects to apply section 904(j) for any 
taxable year, then no taxes paid or accrued by the taxpayer during such 
taxable year may be deemed paid or accrued under section 904(c) in any 
other taxable year, and no taxes paid or accrued in any other taxable 
year may be deemed paid or accrued under section 904(c) in such taxable 
year.
    (2) Carryovers to and from other years determined without regard to 
election years. The amount of the foreign taxes paid or accrued, and 
the amount of the foreign source taxable income, in any year for which 
the taxpayer elects to apply section 904(j) shall not be taken into 
account in determining the amount of any carryover to or from any other 
taxable year. However, an election to apply section 904(j) to any year 
does not extend the number of taxable years to which unused foreign 
taxes may be carried under section 904(c) and Sec. 1.904-2(b). 
Therefore, in determining the number of such carryover years, the 
taxpayer must take into account years to which a section 904(j) 
election applies.
    (3) Determination of amount of creditable foreign taxes. Otherwise 
allowable carryovers of foreign tax credits from other taxable years 
shall not be taken into account in determining whether the amount of 
creditable foreign taxes paid or accrued by an individual during a 
taxable year exceeds $300 ($600 in the case of a joint return) for 
purposes of section 904(j)(2)(B).
    (c) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. In 2001, X, a single individual using the cash basis 
method of accounting for income and foreign tax credits, pays $100 
of foreign taxes with respect to general limitation income that was 
earned and included in income for United States tax purposes in 
2000. The foreign taxes would be creditable under section 901 but 
are not shown on a payee statement furnished to X. X's only income 
for 2001 from sources outside the United States is qualified passive 
income, with respect to which X pays $200 of creditable foreign 
taxes shown on a payee statement. X may not elect to apply section 
904(j) for 2001 because some of X's foreign taxes are not creditable 
foreign taxes within the meaning of section 904(j)(3)(B).
    Example 2. (i) In 2002, A, a single individual using the cash 
basis method of accounting for income and foreign tax credits, pays 
creditable foreign taxes of $250 attributable to passive income. 
Under section 904(c), A may also carry forward to 2002 $100 of 
unused foreign taxes paid in 1998 with respect to passive income, 
$300 of unused foreign taxes paid in 1998 with respect to general 
limitation income, $400 of unused foreign taxes paid in 1999 with 
respect to passive income, and $200 of unused foreign taxes paid in 
1999 with respect to general limitation income. In 2002, A's only 
foreign source income is passive income described in section 
904(j)(3)(A)(i), and this income is reported to A on a payee 
statement (within the meaning of section 6724(d)(2)). If A elects to 
apply section 904(j) for the 2002 taxable year, the unused foreign 
taxes paid in 1998 and 1999 are not deemed paid in 2002, and A 
therefore cannot claim a foreign tax credit for those taxes in 2002.
    (ii) In 2003, A again is eligible for and elects the application 
of section 904(j). The carryforwards from 1998 expire in 2003. The 
carryforward period established under section 904(c) is not extended 
by A's election under section 904(j). In 2004, A does not elect the 
application of section 904(j). The $600 of unused foreign taxes paid 
in 1999 on passive and general limitation income are deemed paid in 
2004, under section 904(c), without any adjustment for any portion 
of those taxes that might have been used as a foreign tax credit in 
2002 or 2003 if section 904(j) had not prevented A from carrying 
over taxes to those years.

    (d) Effective date. Section 1.904(j)-1 applies to taxable years 
beginning after December 31, 1997.
    Par. 12. Section 1.954-2 is amended by:
    1. Revising paragraph (b)(2)(iv), Example 2.
    2. Removing paragraph (b)(2)(iv), Example 3.
    The revision reads as follows:


Sec. 1.954-2  Foreign personal holding company income.

* * * * *
    (b) * * *
    (2) * * *
    (iv) * * *

    Example 2. (i) DS, a domestic corporation, wholly owns two 
controlled foreign corporations organized in Country A, CFC1 and 
CFC2. CFC1 purchases from DS property that DS manufactures in the 
United States. CFC1 uses the purchased property as a component part 
of property that CFC1 manufactures in Country A within the meaning 
of Sec. 1.954-3(a)(4). CFC2 provides loans described in section 
864(d)(6) to unrelated persons in Country A for the purchase of the 
property that CFC1 manufactures in Country A.
    (ii) The interest accrued from the loans by CFC2 is not export 
financing interest as defined in section 904(d)(2)(G) because the 
property sold by CFC1 is not manufactured in the United States under 
Sec. 1.927(a)-1T(c). No portion of the interest is export financing 
interest as defined in this paragraph (b)(2). The full amount of the 
interest is, therefore, included in foreign personal holding company 
income under paragraph (b)(1)(ii) of this section.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 00-32478 Filed 12-29-00; 8:45 am]
BILLING CODE 4830-01-P