[Federal Register Volume 67, Number 141 (Tuesday, July 23, 2002)]
[Rules and Regulations]
[Pages 48020-48025]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-18453]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9008]
RIN 1545-AY45


Guidance Under Subpart F Relating to Partnerships

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations providing guidance 
under subpart F relating to partnerships. The final regulations are 
necessary in order to clarify the treatment of a controlled foreign 
corporation's (CFC) distributive share of partnership income under 
subpart F. The final regulations will affect United States shareholders 
of CFCs that have an interest in a partnership.

DATES: Effective Dates: July 23, 2002.
    Applicability Dates: For dates of applicability, see Sec. 1.702-
1(a)(8)(ii), 1.952-1(g)(3), 1.954-1(g)(4), 1.954-2(a)(5)(v), 1.954-
3(a)(6)(iii), 1.954-4(b)(2)(iii), 1.956-2(a)(3).

FOR FURTHER INFORMATION CONTACT: Jonathan A. Sambur, (202) 622-3840 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On September 20, 2000, the IRS and Treasury published in the 
Federal Register (65 FR 56836) proposed amendments to the regulations 
(REG-112502-00) under section 702 and subpart F of the Internal Revenue 
Code (Code). Those proposed regulations substantially restated rules in 
former proposed regulations, REG-104537-97 (63 FR 14613), that were 
withdrawn in REG-113909-98 (64 FR 37727). Written comments were 
solicited and a public hearing was scheduled for December 5, 2000. 
Several comments were received and are discussed below. No public 
hearing was requested, therefore the hearing was cancelled. After 
consideration of all the comments, the proposed regulations under 
section 702 and subpart F are adopted as revised by this Treasury 
decision.

Summary of Public Comments and Explanation of Revisions

A. Sec. 1.702-1(a)(8)(ii) Characterization and Determination of Subpart 
F Income

    Under the proposed regulations, gross income is characterized at 
the partnership level. If any part of the partnership's gross income is 
a type of income that would be subpart F income if received directly by 
partners that are CFCs, that part of the partnership's gross income 
must be separately taken into account by each partner under section 
702. To the extent that the separately stated income results in subpart 
F income to the CFC partner, it will be taken into account in 
determining the CFC's total subpart F income for the taxable year.
    The proposed regulations under section 702 clarify that an item 
must be separately taken into account when, if separately taken into 
account by any partner, the item would result in an income tax 
liability for that partner, or any other person, different from that 
which would result if the partner did not take the item into account 
separately.
    One commentator noted that the proposed regulations are 
inconsistent with section 702(b), which requires that the character and 
source of an item of gross income be determined at the partnership 
level, because the proposed regulations require the determination of 
subpart F income as if the income had been earned by the CFC. That 
commentator asserted further that the addition of the phrase ``or for 
any other person'' in the first sentence of Sec. 1.702-1(a)(8)(ii) goes 
beyond the regulatory authority provided in section 702(a)(7).
    The IRS and Treasury believe there is ample statutory authority for 
these regulations. The regulations are based upon the authority of 
subchapter K and subpart F and the policies underlying those 
provisions. The legislative history of subchapter K provides that, for 
purposes of interpreting Internal Revenue Code provisions outside of 
subchapter K, a partnership may be treated as either an entity separate 
from its partners or an aggregate of its partners, depending on which 
characterization is more appropriate to carry out the purpose of the 
particular

[[Page 48021]]

Internal Revenue Code or regulation section under consideration. H.R. 
Conf. Rep. No. 2543, 83rd Cong. 2d. Sess. 59 (1954).
    To allow a CFC to avoid subpart F treatment for items of income 
through the simple expedient of receiving them as distributive shares 
of partnership income, rather than directly, is contrary to the intent 
of subpart F. Subpart F was intended to limit deferral of U.S. income 
tax on certain types of income received by CFCs. The IRS and Treasury 
believe that the approach set out in these regulations (which treats 
the partnership as an entity for certain purposes and as an aggregate 
for certain purposes) best achieves the purposes of subpart F and is 
consistent with the policies underlying subchapter K.
    Another commentator stated that the requirement of a separate 
statement of subpart F income by the partnership would be difficult to 
administer because a foreign partnership generally is not required to 
prepare a Schedule K for its foreign partners.
    The IRS and Treasury do not believe that applying the rules in the 
regulations will cause significant problems. Because the rules of 
subpart F target certain specific types of income (e.g., passive 
income, certain income earned from transactions with related persons), 
the IRS and Treasury believe that, in most cases, either the 
partnership, the CFC partner, or both, will be able to determine 
without significant difficulty the income earned by the partnership 
that must be separately stated by the CFC partner.

B. Sec. 1.952-1(g) Treatment of Distributive Share of Partnership 
Income by a CFC Partner

    The proposed regulations clarify that the definition of subpart F 
income includes a CFC's distributive share of any item of gross income 
of a partnership to the extent the income would have been subpart F 
income if received directly by the CFC partner. The proposed 
regulations apply to all partnership interests owned by CFC partners. 
In the preamble to the proposed regulations, comments were requested 
about whether these rules should apply for ownership interests that 
fall below a minimum threshold. This comment was requested because the 
IRS and Treasury were considering whether to provide that CFCs with a 
de minimis interest in a partnership should not be subject to the 
regulations (e.g., by analogy to the 10 percent ownership threshold 
that is used to determine a U.S. shareholder of a CFC).
    One comment was received in response to this request. The 
commentator suggested that the proposed regulations should apply only 
to controlling partners, i.e. partners that hold more than a 50 percent 
interest. The commentator stated further that this result would be 
consistent with the subpart F ownership rules and would limit the rule 
to circumstances where the CFC partner could easily obtain the 
necessary information to determine whether its distributive share was 
subpart F income.
    The commentator's suggestion of limiting the application of these 
rules to controlled partnerships was not adopted. The IRS and Treasury 
do not believe that the objective of the regulations (which, as noted 
above, is to prevent CFCs from avoiding subpart F by receiving items of 
income as distributive shares of partnership income, rather than 
directly) can be achieved by limiting the application of these rules 
only to controlled partnerships. Further, upon additional 
consideration, the IRS and Treasury believe that requiring all 
partnership interests held by a CFC to be subject to the rules of these 
regulations best effectuates the legislative intent of subpart F and 
generally should not give rise to significant difficulties for the CFC 
partner.

C. Sec. 1.954-1(g) Test for Activity and Related Persons

    Section 1.954-1(g) of the proposed regulations provides that, 
generally, in determining whether a distributive share of partnership 
income is subpart F income, whether an entity is a related person and 
whether an activity takes place in or outside the country under the 
laws of which the CFC is organized (e.g., for purposes of determining 
whether the income qualifies for a ``same country'' exception to 
subpart F), shall be determined with respect to the CFC partner and not 
the partnership.
    One commentator objected to the rules in Sec. 1.954-1(g)(1). This 
commentator stated that the rule represented a ``reverse'' application 
of the aggregate theory of partnerships, and was inconsistent with the 
principles of subchapter K. The IRS and Treasury disagree with this 
comment. As noted above, subchapter K contemplates applying either an 
aggregate theory or an entity theory of partnerships, based on the 
approach that best serves the underlying purposes of the Code or 
regulations at issue. For purposes of applying the policies of subpart 
F, which focus in part on whether income is being shifted between a CFC 
and a related entity in a different country, the IRS and Treasury 
believe it is appropriate to make the determination of whether an 
entity is a related person with respect to the CFC, and whether an 
activity takes place in or outside a CFC's country of incorporation, at 
the CFC partner level.
    The IRS and Treasury also have become aware that some uncertainty 
exists under the proposed regulations with respect to the application 
of the related person test to certain purchase and sales transactions 
occurring between a partnership and its CFC partner. Specifically, 
where a purchase or sales transaction occurs between the partnership 
and its CFC partner, including sales or purchases on behalf of the CFC 
by the partnership, the general rule fails to provide guidance on 
whether the CFC partner's distributive share of the partnership income 
is derived from a transaction with a related person. As a result, the 
final regulations add a new rule for purposes of making that 
determination. In general, the final regulations provide that where the 
partnership enters into a purchase or sales transaction with the CFC 
partner, the transaction will be treated as a purchase or sales 
transaction with a related person where the CFC purchased the property 
that it sells to the partnership from a person related to the CFC or 
sells the property that it purchased from the partnership to such a 
related person. This rule also applies to purchases or sales by the CFC 
on behalf of a related person.
    For example, if a partnership sells goods to its CFC partner that 
it bought from a person unrelated to the CFC, and the CFC partner then 
sells the goods to a person related to the CFC partner, the sale of 
goods by the partnership to the CFC will be treated as the sale of 
personal property to a related person for purposes of determining 
whether the CFC's distributive share of the partnership income relating 
to the sale of goods by the partnership is foreign base company sales 
income. An example has been included in the final regulations to 
illustrate this rule. In addition, the final regulations provide that 
when the CFC partner manufactures property that it sells to the 
partnership and the CFC conducts sales or manufacturing activities 
through a branch, if the CFC's income from the sale of property to the 
partnership is foreign base company sales income under the branch rule 
of section 954(d)(2), the partnership's purchase of this property from 
the CFC will be treated as the purchase of personal property from a 
related person. The effect of these two rules is to treat the CFC 
partner's distributive share of the income earned by the partnership as 
income earned from a related person

[[Page 48022]]

transaction if it would have been so treated if the CFC had purchased 
or sold the property directly, rather than through a partnership.

D. Sec. 1.954-2(a)(5)(ii) Exceptions Applicable to Foreign Personal 
Holding Company Income

    Section 1.954-2(a)(5)(ii) of the proposed regulations provide that 
only the activities of, and property owned by, the partnership will be 
taken into account in determining whether the exceptions from foreign 
personal holding company income contained in section 954(c)(2), (h) and 
(i) apply.
    One commentator argued that applying Sec. 1.954-2(a)(5)(ii) to a 
CFC with a qualified business unit (QBU) partnership that is seeking to 
qualify for the active financing exception under section 954(h) 
produces a result that is inconsistent with the intent of section 
954(h). Specifically, section 954(h)(2)(B)(i) provides that a CFC that 
is engaged in a lending or finance business will be considered an 
``eligible controlled foreign corporation'' for purposes of the active 
financing exception if the CFC derives more than 70 percent of its 
gross income directly from the active and regular conduct of a lending 
or finance business from transactions with unrelated customers. In 
addition, section 954(h)(3)(B) provides that, in the case of a CFC that 
conducts a lending or finance business (other than a banking or 
securities business), no income of the CFC (or QBU of the CFC) will 
qualify for the active financing exception unless more than 30 percent 
of the CFC's or QBU's gross income is derived directly from the active 
conduct of a financing business from transactions with unrelated 
customers in the CFC or QBU's home country. The commentator stated that 
section 954(h) appears to provide that the 70 percent test must be 
applied at the CFC level based on the CFC's income (including branches 
and partnerships) and the 30 percent test must be applied at the 
partnership or QBU level.
    The proposed regulations, however, require that the determination 
of whether the 70 percent test and the 30 percent test are met is based 
solely by reference to the activities of the partnership. The 
commentator concluded that the proposed regulations are inconsistent 
with the two-part test in section 954(h) and that applying the rule of 
the proposed regulations potentially could place a CFC that conducts a 
financial services business through a partnership in a significantly 
worse situation than a CFC that conducts a similar business through a 
branch or disregarded entity.
    In response to this comment, the IRS and Treasury have included a 
new rule in the final regulations that applies the ``eligible 
controlled foreign corporation'' requirement under section 954(h)(2), 
including the 70 percent test of section 954(h)(2)(B)(i), at the CFC 
partner level (by including in the gross income of the CFC partner any 
gross income earned by partnerships or other QBUs of the CFC partner), 
and applies the qualified banking and financing income test (the 30 
percent test) under section 954(h)(3) at the partnership level (by 
including only the gross income of the partnership). In addition, a new 
rule has been added under Sec. 1.954-2(a)(5)(ii) to clarify that for 
purposes of applying the special rule for income derived in the active 
conduct of an insurance business under section 954(i), the exception 
will apply only if the CFC partner is a qualifying insurance company, 
as defined in section 953(e)(3) (determined by examining premiums 
written by the CFC partner and any partnerships or other QBUs of the 
CFC partner), and the partnership generates qualified insurance income, 
as defined in section 954(i)(2) (determined by examining only the 
income earned by the partnership). Two examples have been included in 
the final regulations that illustrate the operation of these rules.
    Another comment was received suggesting that the proposed 
regulations inappropriately require the partnership, not the CFC 
partner, to satisfy the active trade or business tests to qualify for 
the exceptions to the foreign personal holding company rules. The 
commentator stated that such a rule allows a purely passive investor in 
a partnership to qualify for the exceptions, contrary to the purposes 
of subpart F. The commentator argued that, instead, the regulations 
should apply the active trade or business tests at the CFC partner 
level, but should provide a rule that limits the attribution of 
partnership activities to the CFC partners.
    This suggestion was not adopted. In general, the IRS and Treasury 
believe that the policies underlying subpart F are best served by 
applying the relevant active trade or business tests at the level of 
the entity that actually earns the income (i.e., the partnership). As 
noted above, however, the IRS and Treasury believe that, for purposes 
of determining whether a CFC qualifies for the active financing 
exception, applying the 70 percent test of section 954(h)(2) (and 
determining a CFC's qualification as a qualifying insurance company 
under section 954(i)(2)) at the CFC partner level is consistent with 
the statutory language of these provisions and best effectuates the 
legislative intent behind these provisions.

E. Sec. 1.954-4(b)(2)(iii) Application of the Substantial Assistance 
Rule

    The proposed regulations describe how the substantial assistance 
rules of Sec. 1.954-4(b)(1)(iv) apply when the CFC partner earns 
services income through the partnership. When the partnership is 
performing services for a person unrelated to the CFC partner, but the 
CFC partner, or a related person, provides substantial assistance to 
the partnership, the CFC partner and the partnership are regarded as 
separate entities and the substantial assistance provided to the 
partnership by the CFC partner, or a related person, cause the CFC 
partner's distributive share of the services income to be treated as 
foreign base company services income.
    Commentators argued that the proposed regulations should not treat 
the distributive share of the partnership's income as subpart F income 
if only the CFC partner provides substantial assistance to the 
partnership because, in that case, under an aggregate theory the CFC 
does not receive substantial assistance from a related person. This 
suggestion has not been adopted because the IRS and Treasury believe 
that excluding the CFC partner from the substantial assistance rule 
could potentially allow the CFC partner to circumvent the foreign base 
company service rules with respect to the services it is performing.

Special Analyses

    It has been determined that this final regulation is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) and (d) of the Administrative Procedures 
Act (5 U.S.C. chapter 5) does not apply to these regulations and, 
because the regulation does 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, the proposed 
regulations preceding these regulations were submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal author of these regulations is Jonathan A. Sambur of 
the Office of the Associate Chief Counsel (International), IRS. 
However, other personnel from the IRS and Treasury

[[Page 48023]]

Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for 26 CFR part 1 continues to read in 
part as follows:

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


    2. Section 1.702-1 is amended as follows:
    1. Paragraph (a)(8)(ii) is revised.
    2. Paragraph (c)(1)(iii) is amended by removing the word ``and'.
    3. Paragraph (c)(1)(iv) is amended by removing the period at the 
end and adding ``; and'' in its place.
    4. Paragraph (c)(1)(v) is added.
    The addition and revision read as follows:


Sec. 1.702-1  Income and credits of partner.

    (a) * * *
    (8) * * *
    (ii) Each partner must also take into account separately the 
partner's distributive share of any partnership item which, if 
separately taken into account by any partner, would result in an income 
tax liability for that partner, or for any other person, different from 
that which would result if that partner did not take the item into 
account separately. Thus, if any partner is a controlled foreign 
corporation, as defined in section 957, items of income that would be 
gross subpart F income if separately taken into account by the 
controlled foreign corporation must be separately stated for all 
partners. Under section 911(a), if any partner is a bona fide resident 
of a foreign country who may exclude from gross income the part of the 
partner's distributive share which qualifies as earned income, as 
defined in section 911(b), the earned income of the partnership for all 
partners must be separately stated. Similarly, all relevant items of 
income or deduction of the partnership must be separately stated for 
all partners in determining the applicability of section 183 (relating 
to activities not engaged in for profit) and the recomputation of tax 
thereunder for any partner. This paragraph (a)(8)(ii) applies to 
taxable years beginning on or after July 23, 2002.
* * * * *
    (c) * * *
    (1) * * *
    (v) In determining whether the de minimis or full inclusion rules 
of section 954(b)(3) apply.
* * * * *

    3. In Sec. 1.952-1, paragraph (g) is added to read as follows:


Sec. 1.952-1  Subpart F income defined.

* * * * *
    (g) Treatment of distributive share of partnership income--(1) In 
general. A controlled foreign corporation's distributive share of any 
item of income of a partnership is income that falls within a category 
of subpart F income described in section 952(a) to the extent the item 
of income would have been income in such category if received by the 
controlled foreign corporation directly. For specific rules regarding 
the treatment of a distributive share of partnership income under 
certain provisions of subpart F, see Secs. 1.954-1(g), 1.954-2(a)(5), 
1.954-3(a)(6), and 1.954-4(b)(2)(iii).
    (2) Example. The application of this paragraph (g) may be 
illustrated by the following example:

    Example. CFC, a controlled foreign corporation, is an 80-percent 
partner in PRS, a foreign partnership. PRS earns $100 of interest 
income that is not export financing interest as defined in section 
954(c)(2)(B), or qualified banking or financing income as defined in 
section 954(h)(3)(A), from a person unrelated to CFC. This interest 
income would have been foreign personal holding company income to 
CFC, under section 954(c), if it had received this income directly. 
Accordingly, CFC's distributive share of this interest income, $80, 
is foreign personal holding company income.

    (3) Effective date. This paragraph (g) applies to taxable years of 
a controlled foreign corporation beginning on or after July 23, 2002.
    4. In Sec. 1.954-1, paragraph (g) is added to read as follows:


Sec. 1.954-1  Foreign base company income.

* * * * *
    (g) Distributive share of partnership income--(1) Application of 
related person and country of organization tests. Unless otherwise 
provided, to determine the extent to which a controlled foreign 
corporation's distributive share of any item of gross income of a 
partnership would have been subpart F income if received by it 
directly, under Sec. 1.952-1(g), if a provision of subpart F requires a 
determination of whether an entity is a related person, within the 
meaning of section 954(d)(3), or whether an activity occurred within or 
outside the country under the laws of which the controlled foreign 
corporation is created or organized, this determination shall be made 
by reference to such controlled foreign corporation and not by 
reference to the partnership.
    (2) Application of related person test for sales and purchase 
transactions between a partnership and its controlled foreign 
corporation partner. For purposes of determining whether a controlled 
foreign corporation's distributive share of any item of gross income of 
a partnership is foreign base company sales income under section 
954(d)(1) when the item of income is derived from the sale by the 
partnership of personal property purchased by the partnership from (or 
sold by the partnership on behalf of) the controlled foreign 
corporation; or the sale by the partnership of personal property to (or 
the purchase of personal property by the partnership on behalf of) the 
controlled foreign corporation (CFC-partnership transaction), the CFC-
partnership transaction will be treated as a transaction with an entity 
that is a related person, within the meaning of section 954(d)(3), 
under paragraph (g)(1) of this section, if--
    (i) The controlled foreign corporation purchased such personal 
property from (or sold it to the partnership on behalf of), or sells 
such personal property to (or purchases it from the partnership on 
behalf of), a related person with respect to the controlled foreign 
corporation (other than the partnership), within the meaning of section 
954(d)(3); or
    (ii) The branch rule of section 954(d)(2) applies to treat as 
foreign base company sales income the income of the controlled foreign 
corporation from selling to the partnership (or a third party) personal 
property that the controlled foreign corporation has manufactured, in 
the case where the partnership purchases personal property from (or 
sells personal property on behalf of) the controlled foreign 
corporation.
    (3) Examples. The application of this paragraph (g) is illustrated 
by the following examples:

    Example 1.  CFC, a controlled foreign corporation organized in 
Country A, is an 80-percent partner in Partnership, a partnership 
organized in Country A. All of the stock of CFC is owned by USP, a 
U.S. corporation. Partnership earns commission income from 
purchasing Product O on behalf of USP, from unrelated manufacturers 
in Country B, for sale in the United States. To determine whether 
CFC's distributive share of Partnership's commission income is 
foreign base company sales income under section 954(d), CFC is 
treated as if it purchased Product O on behalf of USP. Under section 
954(d)(3), USP is a related person with respect to CFC. Thus, with 
respect to CFC, the sales income is deemed to be derived from the 
purchase of personal property on

[[Page 48024]]

behalf of a related person. Because the property purchased is both 
manufactured and sold for use outside of Country A, CFC's country of 
organization, CFC's distributive share of the sales income is 
foreign base company sales income.
    Example 2. (i) CFC1, a controlled foreign corporation organized 
in Country A, is an 80-percent partner in Partnership, a partnership 
organized in Country B. CFC2, a controlled foreign corporation 
organized in Country B, owns the remaining 20 percent interest in 
Partnership. CFC1 and CFC2 are owned by a common U.S. parent, USP. 
CFC2 manufactures Product A in Country B. Partnership earns sales 
income from purchasing Product A from CFC2 and selling it to third 
parties located in Country B that are not related persons with 
respect to CFC1 or CFC2. To determine whether CFC1's distributive 
share of Partnership's sales income is foreign base company sales 
income under section 954(d), CFC1 is treated as if it purchased 
Product A from CFC2 and sold it to third parties in Country B. Under 
section 954(d)(3), CFC2 is a related person with respect to CFC1. 
Thus, with respect to CFC1, the sales income is deemed to be derived 
from the purchase of personal property from a related person. 
Because the property purchased is both manufactured and sold for use 
outside of Country A, CFC1's country of organization, CFC1's 
distributive share of the sales income is foreign base company sales 
income.
    (ii) Because Product A is both manufactured and sold for use 
within CFC2's country of organization, CFC2's distributive share of 
Partnership's sales income is not foreign base company sales income.
    Example 3.  CFC, a controlled foreign corporation organized in 
Country A, is an 80 percent partner in MJK Partnership, a Country B 
partnership. CFC purchased goods from J Corp, a Country C 
corporation that is a related person with respect to CFC. CFC sold 
the goods to MJK Partnership. In turn, MJK Partnership sold the 
goods to P Corp, a Country D corporation that is unrelated to CFC. P 
Corp sold the goods to unrelated customers in Country D. The goods 
were manufactured in Country C by persons unrelated to J Corp . 
CFC's distributive share of the income of MJK Partnership from the 
sale of goods to P Corp will be treated as income from the sale of 
goods purchased from a related person for purposes of section 
954(d)(1) because CFC purchased the goods from J Corp, a related 
person. Because the goods were both manufactured and sold for use 
outside of Country A, CFC's distributive share of the income 
attributable to the sale of the goods is foreign base company sales 
income. Further, CFC's income from the sale of the goods to MJK 
Partnership will also be foreign base company sales income.
    Example 4. The facts are the same as Example 3, except that MJK 
Partnership purchased the goods from P Corp and sold those goods to 
CFC. CFC sold the goods to J Corp. J Corp sold the goods to 
unrelated customers in Country C. CFC's distributive share of the 
income of MJK Partnership from the sale of the goods by the 
partnership to itself will be treated as income from the sale of 
goods to a related person, for purposes of section 954(d)(1). 
Because the goods were both manufactured and sold for use outside of 
Country A, CFC's distributive share of income attributable to the 
sale of the goods is foreign base company sales income. Further, 
CFC's income from the sale of the goods to J Corp is also foreign 
base company sales income.

    (4) Effective date. This paragraph (g) applies to taxable years of 
a controlled foreign corporation beginning on or after July 23, 2002.

    5. In Sec. 1.954-2, paragraph (a)(5) is added to read as follows:


Sec. 1.954-2  Foreign personal holding company income.

    (a) * * *
    (5) Special rules applicable to distributive share of partnership 
income--(i) [Reserved].
    (ii) Certain other exceptions applicable to foreign personal 
holding company income. To determine the extent to which a controlled 
foreign corporation's distributive share of an item of income of a 
partnership is foreign personal holding company income --
    (A) The exceptions contained in section 954(c) that are based on 
whether the controlled foreign corporation is engaged in the active 
conduct of a trade or business, including section 954(c)(2) and 
paragraphs (b)(2) and (6), (e)(1)(ii) and (3)(ii), (iii) and (iv), 
(f)(1)(ii), (g)(2)(ii), and (h)(3)(ii) of this section, shall apply 
only if any such exception would have applied to exclude the income 
from foreign personal holding company income if the controlled foreign 
corporation had earned the income directly, determined by taking into 
account only the activities of, and property owned by, the partnership 
and not the separate activities or property of the controlled foreign 
corporation or any other person;
    (B) A controlled foreign corporation's distributive share of 
partnership income will not be excluded from foreign personal holding 
company income under the exception contained in section 954(h) unless 
the controlled foreign corporation is an eligible controlled foreign 
corporation within the meaning of section 954(h)(2) (taking into 
account the income of the controlled foreign corporation and any 
partnerships or other qualified business units, within the meaning of 
section 989(a), of the controlled foreign corporation, including the 
controlled foreign corporation's distributive share of partnership 
income) and the partnership, of which the controlled foreign 
corporation is a partner, generates qualified banking or financing 
income within the meaning of section 954(h)(3) (taking into account 
only the income of the partnership);
    (C) A controlled foreign corporation's distributive share of 
partnership income will not be excluded from foreign personal holding 
company income under the exception contained in section 954(i) unless 
the controlled foreign corporation partner is a qualifying insurance 
company, as defined in section 953(e)(3) (determined by examining 
premiums written by the controlled foreign corporation and any 
partnerships or other qualified business units, within the meaning of 
section 989(a), of the CFC partner), and the partnership, of which the 
controlled foreign corporation is a partner, generates qualified 
insurance income within the meaning of section 954(i)(2) (taking into 
account only the income of the partnership).
    (iii) Examples. The application of paragraph (a)(5)(ii) is 
demonstrated by the following examples:

    Example 1.  B Corp, a Country C corporation, is a controlled 
foreign corporation within the meaning of section 957(a). B Corp is 
an 80 percent partner of RKS Partnership, a Country D partnership 
whose principal office is located in Country D. RKS Partnership is a 
qualified business unit of B Corp, within the meaning of section 
989(a). B Corp, including income earned through RKS Partnership, 
derives more than 70 percent of its gross income directly from the 
active and regular conduct of a lending or finance business, within 
the meaning of section 954(h)(4), from transactions in various 
countries with customers which are not related persons. Thus, B Corp 
is predominantly engaged in the active conduct of a banking, 
financing, or similar business within the meaning of section 
954(h)(2)(A)(i). B Corp conducts substantial activity with respect 
to such business within the meaning of section 954(h)(2)(A)(ii). RKS 
Partnership derives more than 30 percent of its income from the 
active and regular conduct of a lending or finance business, within 
the meaning of section 954(h)(4), from transactions with customers 
which are not related persons and which are located solely within 
the home country of RKS Partnership, Country D. B Corp's 
distributive share of RKS Partnership's income from its lending or 
finance business will satisfy the special rule for income derived in 
the active conduct of banking, financing, or similar business of 
section 954(h). B Corp is an eligible controlled foreign corporation 
within the meaning of section 954(h)(2) and RKS Partnership 
generates qualified banking or financing income within the meaning 
of section 954(h)(3). B Corp does not have any foreign personal 
holding company income with respect to its distributive share of RKS 
Partnership income attributable to its lending or finance business 
income earned in Country D.
    Example 2.  D Corp, a Country F corporation, is a controlled 
foreign corporation within the meaning of section

[[Page 48025]]

957(a). D Corp satisfies the requirements of section 953(e)(3) and 
is a qualifying insurance company. D Corp is a 40 percent partner of 
DJ Partnership, a Country G partnership. DJ Partnership is a 
qualified business unit of D Corp, within the meaning of section 
989(a), and is licensed by the applicable insurance regulatory body 
for Country G to sell insurance to persons other than related 
persons in its home country within the meaning of section 
953(e)(4)(A). DJ Partnership receives income from persons who are 
not related persons, within the meaning of section 954(d)(3), from 
investments that satisfy the requirements of section 954(i)(2). D 
Corp's distributive share of DJ Partnership's income from 
investments that satisfy the requirements of section 954(i)(2) will 
not be treated as foreign personal holding company income because D 
Corp will satisfy the special rule of section 954(i) for income 
derived in the active conduct of insurance business. DJ Partnership 
is a qualifying insurance company branch within the meaning of 
section 953(e)(4) and its income is qualified insurance income 
within the meaning of section 954(i)(2). D Corp does not have any 
foreign personal holding company income as a result of its 
distributive share of DJ Partnership income that is attributable to 
the partnership's qualifying insurance income.

    (iv) [Reserved].
    (v) Effective date. This paragraph (a)(5) applies to taxable years 
of a controlled foreign corporation beginning on or after July 23, 
2002.
* * * * *

    6. In Sec. 1.954-3, paragraph (a)(6) is added to read as follows:


Sec. 1.954-3  Foreign base company sales income.

    (a) * * *
    (6) Special rule applicable to distributive share of partnership 
income--(i) In general. To determine the extent to which a controlled 
foreign corporation's distributive share of any item of gross income of 
a partnership would have been foreign base company sales income if 
received by it directly, under Sec. 1.952-1(g), the property sold will 
be considered to be manufactured, produced or constructed by the 
controlled foreign corporation, within the meaning of paragraph (a)(4) 
of this section, only if the manufacturing exception of paragraph 
(a)(4) of this section would have applied to exclude the income from 
foreign base company sales income if the controlled foreign corporation 
had earned the income directly, determined by taking into account only 
the activities of, and property owned by, the partnership and not the 
separate activities or property of the controlled foreign corporation 
or any other person.
    (ii) Example. The application of paragraph (a)(6)(i) of this 
section is illustrated by the following example:
    Example. CFC, a controlled foreign corporation organized under 
the laws of Country A, is an 80 percent partner in Partnership X, a 
partnership organized under the laws of Country B. Partnership X 
performs activities in Country B that would constitute the 
manufacture of Product O, within the meaning of paragraph (a)(4) of 
this section, if performed directly by CFC. Partnership X, through 
its sales offices in Country B, then sells Product O to Corp D, a 
corporation that is a related person with respect to CFC, within the 
meaning of section 954(d)(3), for use within Country B. CFC's 
distributive share of Partnership X's sales income is not foreign 
base company sales income because the manufacturing exception of 
paragraph (a)(4) of this section would have applied to exclude the 
income from foreign base company sales income if CFC had earned the 
income directly.

    (iii) Effective date. This paragraph (a)(6) applies to taxable 
years of a controlled foreign corporation beginning on or after July 
23, 2002.
* * * * *

    7. In Sec. 1.954-4, paragraph (b)(2)(iii) is added to read as 
follows:


Sec. 1.954-4  Foreign base company services income.

* * * * *
    (b) * * *
    (2) * * *
    (iii) Special rule applicable to distributive share of partnership 
income. A controlled foreign corporation's distributive share of a 
partnership's services income will be deemed to be derived from 
services performed for or on behalf of a related person, within the 
meaning of section 954(e)(1)(A), if the partnership is a related person 
with respect to the controlled foreign corporation, under section 
954(d)(3), and, in connection with the services performed by the 
partnership, the controlled foreign corporation, or a person that is a 
related person with respect to the controlled foreign corporation, 
provided assistance that would have constituted substantial assistance 
contributing to the performance of such services, under paragraph 
(b)(2)(ii) of this section, if furnished to the controlled foreign 
corporation by a related person. This paragraph (b)(2)(iii) applies to 
taxable years of a controlled foreign corporation beginning on or after 
July 23, 2002.
* * * * *

    8. In Sec. 1.956-2, paragraph (a)(3) is added to read as follows:


Sec. 1.956-2  Definition of United States property.

    (a) * * *
    (3) Property owned through partnership. For purposes of section 
956, if a controlled foreign corporation is a partner in a partnership 
that owns property that would be United States property, within the 
meaning of paragraph (a)(1) of this section, if owned directly by the 
controlled foreign corporation, the controlled foreign corporation will 
be treated as holding an interest in the property equal to its interest 
in the partnership and such interest will be treated as an interest in 
United States property. This paragraph (a)(3) applies to taxable years 
of a controlled foreign corporation beginning on or after July 23, 
2002.
* * * * *

David A. Mader,
Deputy Commissioner of Internal Revenue.
    Approved: July 16, 2002.
Pamela F. Olson,
Acting Assistant Secretary of the Treasury.
[FR Doc. 02-18453 Filed 7-22-02; 8:45 am]
BILLING CODE 4830-01-P