[Federal Register Volume 66, Number 249 (Friday, December 28, 2001)]
[Rules and Regulations]
[Pages 67081-67086]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-31819]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8973]
RIN 1545-AW09


Allocation of Loss With Respect to Stock and Other Personal 
Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final Tax Regulations which remove 
temporary regulations relating to the allocation of loss recognized on 
the disposition of stock and other personal property. The loss 
allocation regulations primarily will affect taxpayers that claim the 
foreign tax credit and that incur losses with respect to personal 
property and are necessary to modify existing guidance with respect to 
loss allocation.

DATES: Effective dates: These regulations are effective January 8, 
2002.
    Applicability Dates: For dates of applicability, see Secs. 1.865-
1(f) and 1.865-2(e).

FOR FURTHER INFORMATION CONTACT: David A. Juster, (202) 622-3850 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 1. On January 11, 
1999, final regulations (TD 8805, 1999-1 C.B. 371, the 1999 final 
regulations) addressing the allocation of loss on the disposition of 
stock (Sec. 1.865-2) and amending the foreign tax credit passive 
limitation grouping rules under Sec. 1.904-4(c) were published in the 
Federal Register (64 FR 1505), together with temporary regulations 
relating to the allocation of loss on the disposition of personal 
property other than stock (Sec. 1.865-1T) and providing a special 
matching rule with respect to the allocation of certain stock losses 
(Sec. 1.865-2T). A notice of proposed rulemaking (REG-106905-98) cross-
referencing the temporary regulations was published in the Federal 
Register for the same day (64 FR 1571). No public hearing was requested 
or held. One written comment responding to the notice of proposed 
rulemaking was received. After consideration of the comment, the 
regulations are finalized substantially as proposed, and the 
corresponding temporary regulations are removed. This Treasury decision 
also

[[Page 67082]]

contains minor clarifying amendments to Sec. 1.865-2 of the 1999 final 
regulations. The revisions are discussed below.

Explanation of Provisions

Section 1.865-1: Loss With Respect to Personal Property Other Than 
Stock

Section 1.865-1(a): General Rules

    Taxpayers have inquired whether the regulations apply to section 
166 bad debt deductions. Section 1.865-1 is intended to apply to all 
recognized losses with respect to personal property, unless otherwise 
excepted, whether or not the loss results from an actual sale or 
disposition. Although section 166 does not use the term loss in the 
context of describing worthless debts giving rise to a deduction under 
the statute, worthlessness deductions reflect economically sustained 
losses similar to losses described in section 165(g) with respect to 
worthless securities. Section 1.865-1(a)(1) of the final regulations 
clarifies that the loss allocation rules of Sec. 1.865-1 apply to 
section 166 bad debt deductions, as well as losses on property that is 
marked-to-market (such as under section 475) and not excluded from the 
scope of these regulations (as are inventory property and certain 
derivative contracts).
    One commentator requested that the final regulations clarify the 
proper allocation of a loss from the disposition of a partnership 
interest. Treasury and the Service do not believe that a special rule 
is required. Instead, loss on the disposition of a partnership interest 
is subject to the general rule of Sec. 1.865-1(a) that allocates loss 
to the class of gross income to which gain from the sale of such 
property would give rise in the seller's hands, i.e., on a reciprocal-
to-gain basis.

Section 1.865-1(b)(2): Contingent Payment Debt Instruments

    Section 1.865-1(b)(2), explaining the particular application of the 
reciprocal-to-gain loss allocation rule to contingent payment debt 
instruments, provides that loss on an instrument to which Sec. 1.1275-
4(b) applies is allocated and apportioned to the class of interest 
income to which the instrument would give rise. The final regulation 
adopts the rule of the temporary regulation, reworded to clarify the 
interaction of this section with Sec. 1.1275-4(b)(9)(iv)(A).

Section 1.865-1(c)(4): Unamortized Bond Premium

    Section 1.865-1(c)(4) provides an exception from the general 
reciprocal-to-gain rule with respect to unamortized bond premium. The 
final regulations modify the text and add a new Example 3 in 
Sec. 1.865-1(e) to clarify that loss on a debt instrument is allocated 
against interest only to the extent of the amount of bond premium that 
could have been, but was not, amortized by the taxpayer before the loss 
was recognized.

Section 1.865-1(c)(6)(iii): Matching Rule

    For discussion of modifications to the matching rule in response to 
comments, see the discussion below in connection with the stock loss 
matching rule of Sec. 1.865-2(b)(4)(iii).

Section 1.865-1(f): Effective Dates

    The final regulations apply to losses recognized on or after 
January 8, 2002. A taxpayer may apply the regulations, however, to loss 
recognized in taxable years beginning on or after January 1, 1987, 
subject to certain conditions.

Section 1.865-2: Loss With Respect to Stock

Section 1.865-2(a)(1): General Rules

    A sentence is added to Sec. 1.865-2(a)(1) to clarify that the loss 
allocation rules of Sec. 1.865-2 apply to loss on stock (other than 
inventory) that is marked-to-market (such as under section 475).

Section 1.865-2(a)(3)(ii): Bona Fide Residents of Puerto Rico

    Under section 933, a U.S. citizen or resident alien that is a bona 
fide resident of Puerto Rico is generally exempt from U.S. tax with 
respect to Puerto Rican source income, but remains subject to U.S. tax 
with respect to income derived from other sources. Consistent with the 
general rule of the 1999 final regulations allocating losses against 
gains and taking account of the special source rule of section 
865(g)(3), Sec. 1.865-2(a)(3)(ii) provides that a loss recognized by a 
U.S. citizen or resident alien that is a bona fide resident of Puerto 
Rico with respect to stock of a corporation that is engaged in a trade 
or business within Puerto Rico shall be allocated to reduce foreign 
source income. The final regulation, however, did not specifically 
state whether the stock loss is allocated against Puerto Rican source 
income that is exempt from tax under section 933 or against all of the 
bona fide resident's foreign source income. Section 1.865-2(a)(3)(ii) 
is clarified to provide that if gain from the sale of such stock would 
be Puerto Rican source income that is exempt from tax under section 
933, the loss with respect to such stock shall be allocated to Puerto 
Rican source income. Under section 933(1), a loss allocated to Puerto 
Rican source income that is excluded from gross income under section 
933 is not allowed as a deduction. See Sec. 1.933-1(c).

Sections 1.865-1(c)(6)(iii) and 1.865-2(b)(4)(iii): Matching Rule

    The temporary regulations provided that, to the extent a taxpayer 
recognizes foreign source income for tax purposes that results in the 
creation of a corresponding loss with respect to stock or other 
personal property, as the case may be, the loss shall be allocated and 
apportioned against such income. The preamble to the temporary 
regulations explained that this rule is intended to prevent taxpayers 
from avoiding the dividend recapture rule of Sec. 1.865-2(b)(1) or from 
accelerating foreign source income and recognizing an offsetting U.S. 
loss.
    One commenter characterized the rule as overly broad and the 
examples as unrealistic. The commenter recommended that the matching 
rule be eliminated from the final regulations or revised to target 
identified abuses more narrowly.
    Taking these considerations into account, Secs. 1.865-1(c)(6)(iii) 
and 1.865-2(b)(4)(iii) are modified to provide that the matching rule 
will only apply if a taxpayer engages in a transaction or series of 
transactions with a principal purpose of recognizing foreign source 
income that results in the creation of a corresponding loss. As an 
anti-abuse rule, the matching rule targets transactions that are 
designed to produce an artificial or accelerated recognition of income 
that directly results in the creation of a corresponding built-in loss. 
The step-down preferred transactions described in Examples 4 and 5 of 
Sec. 1.865-2T(b)(4)(iv) are transactions of this type; however, because 
those transactions are now expressly addressed by regulations at 
Sec. 1.7701(l)-3, the final regulations omit Examples 4 and 5. In 
addition, Example 6 of Sec. 1.865-2T(b)(4)(iv) is revised and 
redesignated as Example 6 of paragraph (b)(1)(iv) of Sec. 1.865-2 to 
illustrate an amendment to the definition of the recapture period in 
Sec. 1.865-2(d)(3) discussed below.
    Section 1.865-2(b)(4)(iii) is also revised to clarify the 
interaction of the matching rule and the exceptions to the dividend 
recapture rule for de minimis or passive dividends. In the temporary 
regulations, the matching rule applied to amounts that otherwise were 
exempted from the dividend recapture rule under the passive or de 
minimis exceptions only if the taxpayer held the stock with a principal 
purpose of producing foreign source income and corresponding loss. 
Because the final regulations revise the matching rule to

[[Page 67083]]

incorporate a principal purpose test in all instances, the specific 
requirement of a principal purpose to apply the matching rule to de 
minimis or passive dividends is no longer necessary.

Section 1.865-2(d)(3): Recapture Period

    The dividend recapture period set forth in Sec. 1.865-2(d)(3) is 
revised to provide that the 24-month period ends on the date on which a 
taxpayer recognizes a loss with respect to stock. In addition, in 
connection with the revisions to the matching rule discussed above, the 
definition of the recapture period in Sec. 1.865-2(d)(3) is expanded to 
provide that the recapture period is extended if the assets of the 
corporation are converted to low-risk investments with a principal 
purpose of enabling the taxpayer to hold the stock without significant 
risk of loss until the recapture period has expired. As noted above, 
Example 6 of Sec. 1.865-2T(b)(4)(iv) has been redesignated as Example 6 
of Sec. 1.865-2(b)(1)(iv) and revised to illustrate the operation of 
this change to the definition of the recapture period. Finally, 
Sec. 1.865-2(d)(3) is revised to clarify that the dividend recapture 
rule applies to a dividend paid after the date a loss is recognized, if 
the loss is incurred after the dividend was declared (i.e., when the 
stock is sold ex-dividend).

Section 1.865-2(e): Effective Dates

    The final regulations retain the January 11, 1999 effective date of 
the identical provisions of the temporary regulations and provide that 
the amendments made by the final regulations apply to losses recognized 
on or after January 8, 2002. A taxpayer may apply the regulations, 
however, to loss recognized in any taxable year beginning on or after 
January 1, 1987, subject to certain conditions.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. A final regulatory 
flexibility analysis under 5 U.S.C. 604 has been prepared for the 
portion of this Treasury decision with respect to regulations issued 
under section 865 of the Internal Revenue Code. This analysis is set 
forth below.
    Pursuant to section 7805(f) of the Internal Revenue Code, the 
notice of proposed rulemaking preceding this regulation was submitted 
to the Small Business Administration for comment on its impact on small 
business.

Regulatory Flexibility Analysis

    It has been determined that a final regulatory flexibility analysis 
is required under 5 U.S.C. 604 with respect to this Treasury decision 
issued under section 865 of the Internal Revenue Code. These 
regulations will affect small entities such as small businesses but not 
other small entities, such as local government or tax exempt 
organizations, which do not pay taxes. The IRS and Treasury Department 
are not aware of any federal rules that duplicate, overlap or conflict 
with these regulations. The final regulations address the allocation of 
loss with respect to stock and other personal property. These 
regulations are necessary primarily for the proper computation of the 
foreign tax credit limitation under section 904 of the Internal Revenue 
Code. With respect to U.S. resident taxpayers, the regulations 
generally allocate losses against U.S. source income. Generally, this 
allocation simplifies the computation of the foreign tax credit 
limitation. None of the significant alternatives considered in drafting 
the regulations would have significantly altered the economic impact of 
the regulations on small entities. There are no alternative rules that 
are less burdensome to small entities but that accomplish the purposes 
of the statute.

Drafting Information

    Various personnel from the Office of Associate Chief Counsel 
(International) within the Office of Chief Counsel, the IRS and 
Treasury Department participated in developing these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by 
removing the entries for ``1.865-1T'' and ``1.865-2T'', revising the 
entry for ``1.865-2'', and adding entries in numerical order to read in 
part as follows:

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

    Section 1.861-8 also issued under 26 U.S.C. 882(c). * * *
    Section 1.865-1 also issued under 26 U.S.C. 863(a) and 
865(j)(1).
    Section 1.865-2 also issued under 26 U.S.C. 863(a) and 
865(j)(1). * * *


    Par. 2. Section 1.861-8 is amended by:
    1. Revising paragraphs (e)(7)(iii) and (e)(8).
    2. Removing the authority citation at the end of the section.
    The revisions read as follows:


Sec. 1.861-8  Computation of taxable income from sources within the 
United States and from other sources and activities.

* * * * *
    (e) * * *
    (7) * * *
    (iii) Allocation of loss recognized in taxable years after 1986. 
See Secs. 1.865-1 and 1.865-2 for rules regarding the allocation of 
certain loss recognized in taxable years beginning after December 31, 
1986.
    (8) Net operating loss deduction. A net operating loss deduction 
allowed under section 172 shall be allocated and apportioned in the 
same manner as the deductions giving rise to the net operating loss 
deduction.
* * * * *

    Par. 3. Section 1.861-8T is amended as follows:
    1. Paragraphs (e)(1) and (e)(3) through (e)(11) are revised.
    2. Paragraph (h) is amended by removing the last sentence of the 
concluding text.
    3. The authority citation at the end of the section is removed.
    The revisions read as follows:


Sec. 1.861-8T  Computation of taxable income from sources within the 
United States and for other sources and activities (temporary).

* * * * *
    (e) * * *
    (1) [Reserved]. For further guidance, see Sec. 1.861-8(e)(1).
* * * * *
    (3) through (11) [Reserved]. For further guidance, see Sec. 1.861-
8(e)(3) through (e)(11).
* * * * *

    Par. 4. Section 1.865-1 is added to read as follows:


Sec. 1.865-1  Loss with respect to personal property other than stock.

    (a) General rules for allocation of loss--(1) Allocation against 
gain. Except as otherwise provided in Sec. 1.865-2 and paragraph (c) of 
this section, loss recognized with respect to personal property shall 
be allocated to the class of gross income and, if necessary, 
apportioned between the statutory grouping of gross income (or among 
the statutory groupings) and the residual grouping of gross income, 
with respect to which gain from a sale of such property would give rise 
in the hands of the seller. For purposes of this section, loss includes 
bad debt deductions under section 166 and loss on property that is

[[Page 67084]]

marked-to-market (such as under section 475) and subject to the rules 
of this section. Thus, for example, loss recognized by a United States 
resident on the sale or worthlessness of a bond generally is allocated 
to reduce United States source income.
    (2) Loss attributable to foreign office. Except as otherwise 
provided in Sec. 1.865-2 and paragraph (c) of this section, and except 
with respect to loss subject to paragraph (b) of this section, in the 
case of loss recognized by a United States resident with respect to 
property that is attributable to an office or other fixed place of 
business in a foreign country within the meaning of section 865(e)(3), 
the loss shall be allocated to reduce foreign source income if a gain 
on the sale of the property would have been taxable by the foreign 
country and the highest marginal rate of tax imposed on such gains in 
the foreign country is at least 10 percent. However, paragraph (a)(1) 
of this section and not this paragraph (a)(2) will apply if gain on the 
sale of such property would be sourced under section 865(c), (d)(1)(B), 
or (d)(3).
    (3) Loss recognized by United States citizen or resident alien with 
foreign tax home. Except as otherwise provided in Sec. 1.865-2 and 
paragraph (c) of this section, and except with respect to loss subject 
to paragraph (b) of this section, in the case of loss with respect to 
property recognized by a United States citizen or resident alien that 
has a tax home (as defined in section 911(d)(3)) in a foreign country, 
the loss shall be allocated to reduce foreign source income if a gain 
on the sale of such property would have been taxable by a foreign 
country and the highest marginal rate of tax imposed on such gains in 
the foreign country is at least 10 percent.
    (4) Allocation for purposes of section 904. For purposes of section 
904, loss recognized with respect to property that is allocated to 
foreign source income under this paragraph (a) shall be allocated to 
the separate category under section 904(d) to which gain on the sale of 
the property would have been assigned (without regard to section 
904(d)(2)(A)(iii)(III)). For purposes of Sec. 1.904-4(c)(2)(ii)(A), any 
such loss allocated to passive income shall be allocated (prior to the 
application of Sec. 1.904-4(c)(2)(ii)(B)) to the group of passive 
income to which gain on a sale of the property would have been assigned 
had a sale of the property resulted in the recognition of a gain under 
the law of the relevant foreign jurisdiction or jurisdictions.
    (5) Loss recognized by partnership. A partner's distributive share 
of loss recognized by a partnership with respect to personal property 
shall be allocated and apportioned in accordance with this section as 
if the partner had recognized the loss. If loss is attributable to an 
office or other fixed place of business of the partnership within the 
meaning of section 865(e)(3), such office or fixed place of business 
shall be considered to be an office of the partner for purposes of this 
section.
    (b) Special rules of application--(1) Depreciable property. In the 
case of a loss recognized with respect to depreciable personal 
property, the gain referred to in paragraph (a)(1) of this section is 
the gain that would be sourced under section 865(c)(1) (depreciation 
recapture).
    (2) Contingent payment debt instrument. Loss described in the last 
sentence of Sec. 1.1275-4(b)(9)(iv)(A) that is recognized with respect 
to a contingent payment debt instrument to which Sec. 1.1275-4(b) 
applies (instruments issued for money or publicly traded property) 
shall be allocated to the class of gross income and, if necessary, 
apportioned between the statutory grouping of gross income (or among 
the statutory groupings) and the residual grouping of gross income, 
with respect to which interest income from the instrument (in the 
amount of the loss subject to this paragraph (b)(2)) would give rise.
    (c) Exceptions--(1) Foreign currency and certain financial 
instruments. This section does not apply to loss governed by section 
988 and loss recognized with respect to options contracts or derivative 
financial instruments, including futures contracts, forward contracts, 
notional principal contracts, or evidence of an interest in any of the 
foregoing.
    (2) Inventory. This section does not apply to loss recognized with 
respect to property described in section 1221(a)(1).
    (3) Interest equivalents and trade receivables. Loss subject to 
Sec. 1.861-9T(b) (loss equivalent to interest expense and loss on trade 
receivables) shall be allocated and apportioned under the rules of 
Sec. 1.861-9T and not under the rules of this section.
    (4) Unamortized bond premium. If a taxpayer recognizing loss with 
respect to a bond (within the meaning of Sec. 1.171-1(b)) did not 
amortize bond premium to the full extent permitted by section 171 and 
the regulations thereunder, then, to the extent of the amount of bond 
premium that could have been, but was not, amortized by the taxpayer, 
loss recognized with respect to the bond shall be allocated to the 
class of gross income and, if necessary, apportioned between the 
statutory grouping of gross income (or among the statutory groupings) 
and the residual grouping of gross income, with respect to which 
interest income from the bond was assigned.
    (5) Accrued interest. Loss attributable to accrued but unpaid 
interest on a debt obligation shall be allocated to the class of gross 
income and, if necessary, apportioned between the statutory grouping of 
gross income (or among the statutory groupings) and the residual 
grouping of gross income, with respect to which interest income from 
the obligation was assigned. For purposes of this section, whether loss 
is attributable to accrued but unpaid interest (rather than to 
principal) shall be determined under the principles of Secs. 1.61-7(d) 
and 1.446-2(e).
    (6) Anti-abuse rules--(i) Transactions involving built-in losses. 
If one of the principal purposes of a transaction is to change the 
allocation of a built-in loss with respect to personal property by 
transferring the property to another person, qualified business unit, 
office or other fixed place of business, or branch that subsequently 
recognizes the loss, the loss shall be allocated by the transferee as 
if it were recognized by the transferor immediately prior to the 
transaction. If one of the principal purposes of a change of residence 
is to change the allocation of a built-in loss with respect to personal 
property, the loss shall be allocated as if the change of residence had 
not occurred. If one of the principal purposes of a transaction is to 
change the allocation of a built-in loss on the disposition of personal 
property by converting the original property into other property and 
subsequently recognizing loss with respect to such other property, the 
loss shall be allocated as if it were recognized with respect to the 
original property immediately prior to the transaction. Transactions 
subject to this paragraph shall include, without limitation, 
reorganizations within the meaning of section 368(a), liquidations 
under section 332, transfers to a corporation under section 351, 
transfers to a partnership under section 721, transfers to a trust, 
distributions by a partnership, distributions by a trust, transfers to 
or from a qualified business unit, office or other fixed place of 
business, or branch, or exchanges under section 1031. A person may have 
a principal purpose of affecting loss allocation even though this 
purpose is outweighed by other purposes (taken together or separately).
    (ii) Offsetting positions. If a taxpayer recognizes loss with 
respect to personal property and the taxpayer (or any person described 
in section 267(b) (after

[[Page 67085]]

application of section 267(c)), 267(e), 318 or 482 with respect to the 
taxpayer) holds (or held) offsetting positions with respect to such 
property with a principal purpose of recognizing foreign source income 
and United States source loss, the loss shall be allocated and 
apportioned against such foreign source income. For purposes of this 
paragraph (c)(6)(ii), positions are offsetting if the risk of loss of 
holding one or more positions is substantially diminished by holding 
one or more other positions.
    (iii) Matching rule. If a taxpayer (or a person described in 
section 1059(c)(3)(C) with respect to the taxpayer) engages in a 
transaction or series of transactions with a principal purpose of 
recognizing foreign source income that results in the creation of a 
corresponding loss with respect to personal property (as a consequence 
of the rules regarding the timing of recognition of income, for 
example), the loss shall be allocated and apportioned against such 
income to the extent of the recognized foreign source income. For an 
example illustrating a similar rule with respect to stock loss, see 
Sec. 1.865-2(b)(4)(iv) Example 3.
    (d) Definitions--(1) Contingent payment debt instrument. A 
contingent payment debt instrument is any debt instrument that is 
subject to Sec. 1.1275-4.
    (2) Depreciable personal property. Depreciable personal property is 
any property described in section 865(c)(4)(A).
    (3) Terms defined in Sec. 1.861-8. See Sec. 1.861-8 for the meaning 
of class of gross income, statutory grouping of gross income, and 
residual grouping of gross income.
    (e) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. On January 1, 2000, A, a domestic corporation, 
purchases for $1,000 a machine that produces widgets, which A sells 
in the United States and throughout the world. Throughout A's 
holding period, the machine is located and used in Country X. During 
A's holding period, A incurs depreciation deductions of $400 with 
respect to the machine. Under Sec. 1.861-8, A allocates and 
apportions depreciation deductions of $250 against foreign source 
general limitation income and $150 against U.S. source income. On 
December 12, 2002, A sells the machine for $100 and recognizes a 
loss of $500. Because the machine was used predominantly outside the 
United States, under sections 865(c)(1)(B) and 865(c)(3)(B)(ii) gain 
on the disposition of the machine would be foreign source general 
limitation income to the extent of the depreciation adjustments. 
Therefore, under paragraph (b)(1) of this section, the entire $500 
loss is allocated against foreign source general limitation income.
    Example 2. On January 1, 2002, A, a domestic corporation, loans 
$2,000 to N, its wholly-owned controlled foreign corporation, in 
exchange for a contingent payment debt instrument subject to 
Sec. 1.1275-4(b). During 2002 through 2004, A accrues and receives 
interest income of $630, $150 of which is foreign source general 
limitation income and $480 of which is foreign source passive income 
under section 904(d)(3). Assume there are no positive or negative 
adjustments pursuant to Sec. 1.1275-4(b)(6) in 2002 through 2004. On 
January 1, 2005, A disposes of the debt instrument and recognizes a 
$770 loss. Under Sec. 1.1275-4(b)(8)(ii), $630 of the loss is 
treated as ordinary loss and $140 is treated as capital loss. Assume 
that $140 of interest income earned in 2005 with respect to the debt 
instrument would be foreign source passive income under section 
904(d)(3). Under Sec. 1.1275-4(b)(9)(iv), $150 of the ordinary loss 
is allocated against foreign source general limitation income and 
$480 of the ordinary loss is allocated against foreign source 
passive income. Under paragraph (b)(2) of this section, the $140 
capital loss is allocated against foreign source passive income.
    Example 3. (i) On January 1, 2003, A, a domestic corporation, 
purchases for $1,200 a taxable bond maturing on December 31, 2008, 
with a stated principal amount of $1,000, payable at maturity. The 
bond provides for unconditional payments of interest of $100, 
payable December 31 of each year. The issuer of the bond is a 
foreign corporation and interest on the bond is thus foreign source. 
Interest payments for 2003 and 2004 are timely made. A does not 
elect to amortize its bond premium under section 171 and the 
regulations thereunder, which would have permitted A to offset the 
$100 of interest income by $28.72 of bond premium in 2003, and by 
$30.42 in 2004. On January 1, 2005, A sells the bond and recognizes 
a $100 loss. Under paragraph (c)(4) of this section, $59.14 of the 
loss is allocated against foreign source income. Under paragraph 
(a)(1) of this section, the remaining $40.86 of the loss is 
allocated against U.S. source income.
    (ii) The facts are the same as in paragraph (i) of this Example 
3, except that A made the election to amortize its bond premium 
effective for taxable year 2004 (see Sec. 1.171-4(c)). Under 
paragraph (c)(4) of this section, $28.72 of the loss is allocated 
against foreign source income. Under paragraph (a)(1) of this 
section, the remaining $71.28 of the loss is allocated against U.S. 
source income.
    Example 4. On January 1, 2002, A, a domestic corporation, 
purchases for $1,000 a bond maturing December 31, 2014, with a 
stated principal amount of $1,000, payable at maturity. The bond 
provides for unconditional payments of interest of $100, payable 
December 31 of each year. The issuer of the bond is a foreign 
corporation and interest on the bond is thus foreign source. Between 
2002 and 2006, A accrues and receives foreign source interest income 
of $500 with respect to the bond. On January 1, 2007, A sells the 
bond and recognizes a $500 loss. Under paragraph (a)(1) of this 
section, the $500 loss is allocated against U.S. source income.
    Example 5. On January 1, 2002, A, a domestic corporation on the 
accrual method of accounting, purchases for $1,000 a bond maturing 
December 31, 2012, with a stated principal amount of $1,000, payable 
at maturity. The bond provides for unconditional payments of 
interest of $100, payable December 31 of each year. The issuer of 
the bond is a foreign corporation and interest on the bond is thus 
foreign source. On June 10, 2002, after A has accrued $44 of 
interest income, but before any interest has been paid, the issuer 
suddenly becomes insolvent and declares bankruptcy. A sells the bond 
(including the accrued interest) for $20. Assuming that A properly 
accrued $44 of interest income, A treats the $20 proceeds from the 
sale of the bond as payment of interest previously accrued and 
recognizes a $1,000 loss with respect to the bond principal and a 
$24 loss with respect to the accrued interest. See Sec. 1.61-7(d). 
Under paragraph (a)(1) of this section, the $1,000 loss with respect 
to the principal is allocated against U.S. source income. Under 
paragraph (c)(5) of this section, the $24 loss with respect to 
accrued but unpaid interest is allocated against foreign source 
interest income.

    (f) Effective date--(1) In general. Except as provided in paragraph 
(f)(2) of this section, this section is applicable to loss recognized 
on or after January 8, 2002. For purposes of this paragraph (f), loss 
that is recognized but deferred (for example, under section 267 or 
1092) shall be treated as recognized at the time the loss is taken into 
account.
    (2) Application to prior periods. A taxpayer may apply the rules of 
this section to losses recognized in any taxable year beginning on or 
after January 1, 1987, and all subsequent years, provided that--
    (i) The taxpayer's tax liability as shown on an original or amended 
tax return is consistent with the rules of this section for each such 
year for which the statute of limitations does not preclude the filing 
of an amended return on June 30, 2002; and
    (ii) The taxpayer makes appropriate adjustments to eliminate any 
double benefit arising from the application of this section to years 
that are not open for assessment.
    (3) Examples. See Sec. 1.865-2(e)(3) for examples illustrating an 
applicability date provision similar to the applicability date provided 
in this paragraph (f).


Sec. 1.865-1T  [Removed]

    Par. 5. Section 1.865-1T is removed.

    Par. 6. Section 1.865-2 is amended by:
    1. Adding a sentence after the first sentence of paragraph (a)(1).
    2. Adding two sentences at the end of paragraph (a)(3)(ii).
    3. Adding Example 6 to paragraph (b)(1)(iv).

[[Page 67086]]

    4. Revising paragraph (b)(4)(iii).
    5. Adding Example 3 to paragraph (b)(4)(iv).
    6. Revising paragraphs (d)(3), (e)(1), and (e)(2)(i).
    The revisions and additions read as follows:


Sec. 1.865-2  Loss with respect to stock.

    (a)(1) * * * For purposes of this section, loss includes loss on 
property that is marked-to-market (such as under section 475) and 
subject to the rules of this section. * * *
* * * * *
    (3) * * *
    (ii) * * * If gain from a sale of such stock would give rise to 
income exempt from tax under section 933, the loss with respect to such 
stock shall be allocated to amounts that are excluded from gross income 
under section 933(1) and therefore shall not be allowed as a deduction 
from gross income. See section 933(1) and Sec. 1.933-1(c).
* * * * *
    (b) * * *
    (1) * * *
    (iv) * * *

    Example 6. (i) On January 1, 1998, P, a domestic corporation, 
purchases N, a foreign corporation, for $1,000. On March 1, 1998, P 
causes N to sell its operating assets, distribute a $400 general 
limitation dividend to P, and invest its remaining $600 in short-
term government securities. P converted the N assets into low-risk 
investments with a principal purpose of holding the N stock without 
significant risk of loss until the recapture period expired. N earns 
interest income from the securities. The income constitutes subpart 
F income that is included in P's income under section 951, 
increasing P's basis in the N stock under section 961(a). On March 
1, 2002, P sells N and recognizes a $400 loss.
    (ii) Pursuant to paragraph (d)(3) of this section, the recapture 
period is increased by the period in which N's assets were held as 
low-risk investments because P caused N's assets to be converted 
into and held as low-risk investments with a principal purpose of 
enabling P to hold the N stock without significant risk of loss. 
Accordingly, under paragraph (b)(1)(i) of this section the $400 loss 
is allocated against foreign source general limitation income.
* * * * *
    (4) * * *
    (iii) Matching rule. If a taxpayer (or a person described in 
section 1059(c)(3)(C) with respect to the taxpayer) engages in a 
transaction or series of transactions with a principal purpose of 
recognizing foreign source income that results in the creation of a 
corresponding loss with respect to stock (as a consequence of the rules 
regarding the timing of recognition of income, for example), the loss 
shall be allocated and apportioned against such income to the extent of 
the recognized foreign source income. This paragraph (b)(4)(iii) 
applies to any portion of a loss that is not allocated under paragraph 
(b)(1)(i) of this section (dividend recapture rule), including a loss 
in excess of the dividend recapture amount and a loss that is related 
to a dividend recapture amount described in paragraph (b)(1)(ii) (de 
minimis exception) or (b)(1)(iii) (passive dividend exception) of this 
section.
    (iv) Examples. * * *

    Example 3. (i) Facts. On January 1, 2002, P and Q, domestic 
corporations, form R, a domestic partnership. The corporations and 
partnership use the calendar year as their taxable year. P 
contributes $900 to R in exchange for a 90-percent partnership 
interest and Q contributes $100 to R in exchange for a 10-percent 
partnership interest. R purchases a dance studio in country X for 
$1,000. On January 2, 2002, R enters into contracts to provide dance 
lessons in Country X for a 5-year period beginning January 1, 2003. 
These contracts are prepaid by the dance studio customers on 
December 31, 2002, and R recognizes foreign source taxable income of 
$500 from the prepayments (R's only income in 2002). P takes into 
income its $450 distributive share of partnership taxable income. On 
January 1, 2003, P's basis in its partnership interest is $1,350 
($900 from its contribution under section 722, increased by its $450 
distributive share of partnership income under section 705). On 
September 22, 2003, P contributes its R partnership interest to S, a 
newly-formed domestic corporation, in exchange for all the stock of 
S. Under section 358, P's basis in S is $1,350. On December 1, 2003, 
P sells S to an unrelated party for $1050 and recognizes a $300 
loss.
    (ii) Loss allocation. P recognized foreign source income for tax 
purposes before the income had economically accrued, and the 
accelerated recognition of income increased P's basis in R without 
increasing its value by a corresponding amount, which resulted in 
the creation of a built-in loss with respect to the S stock. Under 
paragraph (b)(4)(iii) of this section the $300 loss is allocated 
against foreign source income if P had a principal purpose of 
recognizing foreign source income and corresponding loss.
* * * * *
    (d) * * *
    (3) Recapture period. A recapture period is the 24-month period 
ending on the date on which a taxpayer recognized a loss with respect 
to stock. For example, if a taxpayer recognizes a loss on March 15, 
2002, the recapture period begins on and includes March 16, 2000, and 
ends on and includes March 15, 2002. A recapture period is increased by 
any period of time in which the taxpayer has diminished its risk of 
loss in a manner described in section 246(c)(4) and the regulations 
thereunder and by any period in which the assets of the corporation are 
hedged against risk of loss (or are converted into and held as low-risk 
investments) with a principal purpose of enabling the taxpayer to hold 
the stock without significant risk of loss until the recapture period 
has expired. In the case of a loss recognized after a dividend is 
declared but before such dividend is paid, the recapture period is 
extended through the date on which the dividend is paid.
* * * * *
    (e) Effective date--(1) In general. This section is applicable to 
loss recognized on or after January 11, 1999, except that paragraphs 
(a)(3)(ii), (b)(1)(iv) Example 6, (b)(4)(iii), (b)(4)(iv) Example 3, 
and (d)(3) of this section are applicable to loss recognized on or 
after January 8, 2002. For purposes of this paragraph (e), loss that is 
recognized but deferred (for example, under section 267 or 1092) shall 
be treated as recognized at the time the loss is taken into account.
    (2) * * *
    (i) The taxpayer's tax liability as shown on an original or amended 
tax return is consistent with the rules of this section for each such 
year for which the statute of limitations does not preclude the filing 
of an amended return on June 30, 2002; and
* * * * *


Sec. 1.865-2T  [Removed]

    Par. 7. Section 1.865-2T is removed.


Sec. 1.904-4  [Amended]

    Par. 8. In Sec. 1.904-4, paragraph (c)(2)(ii)(A), remove the 
language ``1.865-1T through 1.865-2T'' at the end of the first sentence 
and add ``1.865-1 and 1.865-2'' in its place.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.

    Approved: December 19, 2001.
Mark Weinberger,
Assistant Secretary of the Treasury.
[FR Doc. 01-31819 Filed 12-27-01; 8:45 am]
BILLING CODE 4830-01-P