[Federal Register Volume 69, Number 77 (Wednesday, April 21, 2004)]
[Rules and Regulations]
[Pages 21405-21409]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-8704]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9121]
RIN 1545-BD11


Partner's Distributive Share: Foreign Tax Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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

SUMMARY: The temporary regulations provide rules for the proper 
allocation of partnership expenditures for foreign taxes. The temporary 
regulations affect partnerships and their partners. The text of the 
temporary regulations also serves as the text of the proposed 
regulations set forth in the notice of proposed rulemaking on this 
subject in the Proposed Rules section of this issue of the Federal 
Register. The final regulations consist of technical revisions to 
reflect the issuance of the temporary regulations.

DATES: Effective Date: These regulations are effective April 21, 2004.
    Applicability Date: For dates of applicability, see Sec.  1.704-
1(b)(1)(ii).

FOR FURTHER INFORMATION CONTACT: Beverly Katz at 202-622-3050 (not a 
toll-free number.

SUPPLEMENTARY INFORMATION:

Background

    Subchapter K is intended to permit taxpayers to conduct joint 
business activities through a flexible economic arrangement without 
incurring an entity-level tax. To achieve this goal of a flexible 
economic arrangement, partners are generally permitted to decide among 
themselves how a partnership's items will be allocated. Section 704(a) 
of the Internal Revenue Code (Code) provides that a partner's 
distributive share of income, gain, loss, deduction, or credit shall, 
except as otherwise provided, be determined by the partnership 
agreement.
    Section 704(b) places a significant limitation on the general 
flexibility of section 704(a). Specifically, section 704(b) provides 
that a partner's distributive share of income, gain, loss, deduction, 
or credit (or item thereof) shall be determined in accordance with the 
partner's interest in the partnership (determined by taking into 
account all facts and circumstances) if the allocation to a partner 
under the partnership agreement of income, gain, loss, deduction, or 
credit (or item thereof) does not have substantial economic effect. 
Thus, the statute provides that partnership allocations either must 
have substantial economic effect or must be in accordance with the 
partners' interests in the partnership.
    Section 1.704-1(b)(2)(i) provides that the determination of whether 
an allocation of income, gain, loss, or deduction to a partner has 
substantial economic effect involves a two-part analysis that is made 
as of the end of the partnership taxable year to which the allocation 
relates. First, the allocation must have economic effect within the 
meaning of Sec.  1.704-1(b)(2)(ii). Second,

[[Page 21406]]

the economic effect of the allocation must be substantial within the 
meaning of Sec.  1.704-1(b)(2)(iii).
    For an allocation to have economic effect, it must be consistent 
with the underlying economic arrangement of the partners. This means 
that, in the event that there is an economic benefit or burden that 
corresponds to the allocation, the partner to whom the allocation is 
made must receive such economic benefit or bear such economic burden. 
Sec.  1.704-1(b)(2)(ii). Generally, an allocation of income, gain, 
loss, or deduction (or item thereof) to a partner will have economic 
effect if, and only if, throughout the full term of the partnership, 
the partnership agreement provides: (1) For the determination and 
maintenance of the partners' capital accounts in accordance with Sec.  
1.704-1(b)(2)(iv); (2) for liquidating distributions to the partners to 
be made in accordance with the positive capital account balances of the 
partners; and (3) for each partner to be unconditionally obligated to 
restore the deficit balance in the partner's capital account following 
the liquidation of the partner's partnership interest. In lieu of 
satisfying the third criterion, the partnership may satisfy the 
qualified income offset rules set forth in Sec.  1.704-1(b)(2)(ii)(d).
    Section 1.704-1(b)(2)(iii)(a) provides as a general rule that the 
economic effect of an allocation (or allocations) is substantial if 
there is a reasonable possibility that the allocation (or allocations) 
will affect substantially the dollar amounts to be received by the 
partners from the partnership, independent of tax consequences. The 
section further provides that, even if the allocation affects 
substantially the dollar amounts, the economic effect of the allocation 
(or allocations) is not substantial if, at the time the allocation (or 
allocations) becomes part of the partnership agreement, (1) the after-
tax economic consequences of at least one partner may, in present value 
terms, be enhanced compared to such consequences if the allocation (or 
allocations) were not contained in the partnership agreement, and (2) 
there is a strong likelihood that the after-tax economic consequences 
of no partner will, in present value terms, be substantially diminished 
compared to such consequences if the allocation (or allocations) were 
not contained in the partnership agreement.
    The regulations under section 704(b) provide that the allocation of 
certain items cannot have substantial economic effect, and accordingly 
provide guidance on allocating those items in a manner that will be 
deemed to be in accordance with the partners' interests in the 
partnership. Items that cannot be allocated with substantial economic 
effect include tax credits, nonrecourse deductions, and recapture 
amounts. These items are addressed in Sec. Sec.  1.704-1(b)(4) and 
1.704-2.

Explanation of Provisions

1. Clarifying the Allocation of Expenditures for Foreign Taxes

    Section 901(b)(5) provides that an individual who is a partner 
will, subject to certain limitations, qualify for the foreign tax 
credit for his proportionate share of taxes of the partnership paid or 
accrued during the taxable year to a foreign country or to any 
possession of the United States. Section 702(a)(6) provides that each 
partner shall take into account separately his distributive share of 
the partnership's taxes, described in section 901, paid or accrued to 
foreign countries and to possessions of the United States. Section 
703(a)(2)(B) provides that the partnership is not entitled to the 
deduction for taxes provided in section 164(a) with respect to taxes, 
described in section 901, paid or accrued to foreign countries and to 
possessions of the United States. Section 703(b)(3) provides that 
elections affecting the computation of taxable income derived from a 
partnership shall be made by the partnership, except that any election 
under section 901 (relating to taxes of foreign countries and 
possessions of the United States), will be made by each partner 
separately.
    These temporary regulations clarify the application of the 
regulations under section 704 to creditable foreign tax expenditures 
for which the partnership bears legal liability as described in Sec.  
1.901-2(f). Unlike most other trade or business expenses, foreign taxes 
described in section 901 or 903 are fully creditable against a 
partner's U.S. tax liability, subject to certain limitations, including 
primarily the foreign tax credit limitation under section 904. For this 
reason, the temporary regulations provide that partnership allocations 
of creditable foreign tax expenditures cannot have substantial economic 
effect and, therefore, must be allocated in accordance with the 
partners' interests in the partnership. A creditable foreign tax is a 
foreign tax paid or accrued for U.S. tax purposes by a partnership and 
that is eligible for a credit under section 901(a). A foreign tax is a 
creditable foreign tax for these purposes without regard to whether a 
partner receiving an allocation of such foreign tax elects to claim a 
credit for such amount.
    The temporary regulations establish a safe harbor under which 
partnership allocations of foreign tax expenditures will be deemed to 
be in accordance with the partners' interests in the partnership. Under 
this safe harbor, if the partnership agreement satisfies the 
requirements of Sec.  1.704-1(b)(2)(ii)(b) or (d) (i.e., capital 
account maintenance, liquidation according to capital accounts, and 
either deficit restoration obligations or qualified income offsets), 
then an allocation of a foreign tax expenditure that is proportionate 
to a partner's distributive share of the partnership income to which 
such taxes relate (including income allocated pursuant to section 
704(c)) will be deemed to be in accordance with the partners' interests 
in the partnership. This rule is consistent with the underlying 
purposes of the foreign tax credit, which is to avoid double taxation 
of foreign source income, and the foreign tax credit limitation, which 
is to prevent foreign tax credits from offsetting tax liability on a 
taxpayer's U.S. source income. Also, this rule achieves greater parity 
between entities that are taxed under foreign law at the partner level 
and entities that are taxed under foreign law at the entity level. If a 
partnership were taxed under foreign law at the partner level, then the 
amount of foreign taxes imposed on a partner generally would be 
proportionate to the partner's share of the income subject to the 
foreign tax. The partner would take into account this amount of foreign 
tax in computing U.S. tax liability. Likewise, for partnerships that 
are taxed under foreign law at the entity level, the safe harbor 
provides that a partner is allowed to take into account in computing 
U.S. tax liability the share of the partnership's foreign tax 
expenditures that is proportionate to the partner's share of the income 
to which such taxes relate.
    If the taxpayer does not satisfy this safe harbor, then the 
taxpayer's allocations will be tested under the partners' interests in 
the partnership standard set forth in Sec.  1.704-1(b)(3). Under that 
standard, the determination of a partner's interest in a partnership is 
made by taking into account all facts and circumstances relating to the 
economic arrangement of the partners. Among the facts to be considered 
are: (a) The partners' relative contributions to the partnership; (b) 
the interests of the partners in economic profits and losses (if 
different than their interests in taxable income or loss); (c) the 
interests of the partners in cash flow and other non-liquidating 
distributions; and (d)

[[Page 21407]]

the rights of the partners to distributions of capital upon 
liquidation. Ultimately, the partners' interests in the partnership 
signify the manner in which the partners have agreed to share the 
economic benefit or burden (if any) corresponding to the income, gain, 
loss, deduction, or credit (or item thereof) that is allocated. The 
sharing arrangement with respect to a particular item may or may not 
correspond to the overall economic arrangement of the partners. Thus, a 
partnership's allocation of a foreign tax expenditure that does not 
satisfy the safe harbor contained in these temporary regulations, may, 
in unusual circumstances (such as where there is substantial certainty 
that U.S partners will deduct, rather than credit, foreign taxes) be in 
accordance with partners' interests in the partnership under Sec.  
1.704-1(b)(3).

2. Application of Sec.  1.704-1(b)(2)(iii) Substantiality Requirement 
Where Partnership Allocation Has Tax Effect on Owners of Partners

    As discussed above, in determining if the economic effect of a 
partnership allocation is substantial, the partnership must consider 
the after-tax economic consequences to the partners. The IRS and 
Treasury have become aware that some partnerships are taking the 
position that, in determining if the economic effect of a partnership 
allocation is substantial, they need not consider any tax consequences 
to an owner of the partner that result from the allocation. The IRS and 
Treasury believe that such a position is inconsistent with the policies 
underlying the substantial economic effect rules, because it would 
allow a partnership to make tax-advantaged allocations if the tax 
advantages of the allocations were to accrue to an owner of a partner, 
rather than to the partner itself. The IRS and Treasury are planning to 
issue guidance on the application of the section 704(b) regulations to 
these situations.

3. Effective Date

    The provisions of these regulations generally apply for partnership 
taxable years beginning on or after the date that the temporary 
regulations are published in the Federal Register. A transition rule is 
also provided for existing partnerships. Under the transition rule, if 
a partnership agreement was entered into before April 21, 2004, then 
the partnership may apply the provisions of Sec.  1.704-1(b), as if the 
amendments made by this temporary regulation had not occurred, until 
any subsequent material modification to the partnership agreement, 
which includes any change in ownership, occurs. This transition rule 
does not apply if, as of April 20, 2004, persons that are related to 
each other (within the meaning of section 267(b) and 707(b)) 
collectively have the power to amend the partnership agreement without 
the consent of any unrelated party. No inference regarding the 
treatment of allocations of foreign taxes under Sec.  1.704-1(b) (prior 
to the amendments made by this temporary regulation) is intended.

Special Analyses

    It has been determined that this Treasury Decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For the 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), 
refer to the Special Analyses section of the preamble to the notice of 
proposed rulemaking on this subject published in the Proposed Rules 
section of this issue of the Federal Register. Pursuant to section 
7805(f) of the Code, this notice of rulemaking will be 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 this regulation is Beverly M. Katz, Office 
of the Associate Chief Counsel (Passthroughs & Special Industries). 
However, other personnel from the IRS and Treasury Department 
participated in its development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
1. The authority citation for part 1 continues to read, in part, as 
follows:

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

0
2. Section 1.704-1 is amended as follows:
0
1. Paragraph (b)(0) is amended by adding entries for Sec. Sec.  1.704-
1(b)(1)(ii)(a), 1.704-1(b)(1)(ii)(b), 1.704-1(b)(4)(viii), 1.704-
1(b)(4)(ix), 1.704-1(b)(4)(x), and 1.704-1(b)(4)(xi).
0
2. The text of paragraph (b)(1)(ii) is redesignated as paragraph 
(b)(1)(ii)(a).
0
3. A heading is added to newly designated paragraph (b)(1)(ii)(a).
0
4. Paragraphs (b)(1)(ii)(b), (b)(4)(viii), (b)(4)(ix), (b)(4)(x), and 
(b)(4)(xi) are added.
0
5. Paragraph (b)(5) is amended by adding Example 20 through Example 28.
0
6. The additions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) Determination of partner's distributive share--(0) Cross-
references.
* * * * *

Generally...........................  1.704-1(b)(1)(ii)(a)
Foreign tax expenditures............  1.704-1(b)(1)(ii)(b)
 
                                * * * * *
[Reserved]..........................  1.704-1(b)(4)(viii)
[Reserved]..........................  1.704-1(b)(4)(ix)
[Reserved]..........................  1.704-1(b)(4)(x)
Allocation of creditable foreign      1.704-1(b)(4)(xi)
 taxes.
 

* * * * *
    (1) * * *
    (ii) * * * (a) Generally.
    (b) Foreign tax expenditures. [Reserved]. For further guidance, see 
Sec.  1.704-1T(b)(1)(ii)(b).
* * * * *
    (4) * * *
    (viii) [Reserved].
    (ix) [Reserved].
    (x) [Reserved].
    (xi) Allocation of creditable foreign taxes. [Reserved]. For 
further guidance, see Sec.  1.704-1T(b)(4)(xi).
    (5) * * *
    Examples (20) through (24). [Reserved].
    Examples (25) through (28). [Reserved]. For further guidance, see 
Sec.  1.704-1T(b)(5), Examples (25) through (28).
* * * * *

0
3. Section 1.704-1T is added to read as follows:


Sec.  1.704-1T  Partner's distributive share (temporary).

    (a) through (b)(1)(ii)(a) [Reserved]. For further guidance, see 
Sec.  1.704-1(a) through (b)(1)(ii)(a).
    (b)(1)(ii)(b) Rules relating to foreign tax expenditures--(1) In 
general. The provisions of paragraphs (b)(4)(xi) (regarding the 
allocation of foreign tax expenditures) apply for partnership taxable 
years beginning on or after April 21, 2004.
    (2) Transition rule. If a partnership agreement was entered into 
before April 21, 2004, then the partnership may apply the provisions of 
this paragraph (b) as if the amendments made by this temporary 
regulation had not occurred,

[[Page 21408]]

until any subsequent material modification to the partnership 
agreement, which includes any change in ownership, occurs. This 
transition rule does not apply if, as of April 20, 2004, persons that 
are related to each other (within the meaning of section 267(b) and 
707(b)) collectively have the power to amend the partnership agreement 
without the consent of any unrelated party.
    (b)(1)(iii) through (b)(4)(vii) [Reserved]. For further guidance, 
see Sec.  1.704-1(b)(1)(iii) through (b)(4)(vii).
    (b)(4)(viii) through (b)(4)(x) [Reserved].
    (b)(4)(xi) Allocations of creditable foreign taxes--(a) In general. 
Allocations of creditable foreign taxes cannot have substantial 
economic effect and, accordingly, such expenditures must be allocated 
in accordance with the partners' interests in the partnership. An 
allocation of a creditable foreign tax will be deemed to be in 
accordance with the partners' interests in the partnership if--
    (1) The requirements of either paragraph (b)(2)(ii)(b) or 
(b)(2)(ii)(d) of this section are satisfied (i.e., capital accounts are 
maintained in accordance with paragraph (b)(2)(iv) of this section, 
liquidating distributions are required to be made in accordance with 
positive capital account balances, and each partner either has an 
unconditional deficit restoration obligation or agrees to a qualified 
income offset); and
    (2) The partnership agreement provides for the allocation of the 
creditable foreign tax in proportion to the partners' distributive 
shares of income (including income allocated pursuant to section 
704(c)) to which the creditable foreign tax relates.
    (b) Creditable foreign taxes. A creditable foreign tax is a foreign 
tax paid or accrued for U.S. tax purposes by a partnership and that is 
eligible for a credit under section 901(a). A foreign tax is a 
creditable foreign tax for these purposes without regard to whether a 
partner receiving an allocation of such foreign tax elects to claim a 
credit for such amount.
    (c) Income related to foreign taxes. A foreign tax is related to 
income if the income is included in the base upon which the taxes are 
imposed, which determination must be made in accordance with the 
principles of Sec.  1.904-6. See Examples (25) through (28) of 
paragraph (b)(5) of this section.
    (b)(5) * * *
    Examples 1 through 19 [Reserved]. For further guidance, see Sec.  
1.704-1(b)(5), Examples 1 through 19.
    Examples 20 through 24 [Reserved].

    Example 25. (i) A and B form AB, an eligible entity (as defined 
in Sec.  301.7701-3(a) of this chapter), treated as a partnership 
for U.S. tax purposes. AB's partnership agreement (within the 
meaning of paragraph (b)(2)(ii)(j) of this section) provides that 
the partners' capital accounts will be determined and maintained in 
accordance with paragraph (b)(2)(iv) of this section, that 
liquidation proceeds will be distributed in accordance with the 
partners' positive capital account balances, and that any partner 
with a deficit balance in his capital account following the 
liquidation of his interest must restore that deficit to the 
partnership. AB operates business M and earns income from passive 
investments in country X. Assume that country X imposes a 40 percent 
tax on business M income, which tax is a creditable foreign tax, but 
exempts from tax income from passive investments. In year 1, AB 
earns $100 of income from business M and $30 from passive 
investments and pays or accrues $40 of country X taxes. For purposes 
of section 904(d), the income from business M is general limitation 
income and the income from the passive investments is passive 
income. Pursuant to the partnership agreement, all partnership 
items, including creditable foreign taxes, from business M are 
allocated 60 percent to A and 40 percent to B, and all partnership 
items, including creditable foreign taxes, from passive investments 
are allocated 80 percent to A and 20 percent to B. Accordingly, A is 
allocated 60 percent of the business M income ($60) and 60 percent 
of the country X taxes ($24), and B is allocated 40 percent of the 
business M income ($40) and 40 percent of the country X taxes ($16).
    (ii) Under paragraph (b)(4)(xi) of this section, the $40 of 
taxes is related to the $100 of general limitation income and no 
portion of the taxes is related to the passive income. Because AB's 
partnership agreement allocates the general limitation income 60/40 
and the country X taxes 60/40, the allocations of the country X 
taxes are in proportion to the allocation of the income to which the 
foreign tax relates. Because AB satisfies the requirement of 
paragraph (b)(4)(xi) of this section, the allocations of the country 
X taxes are deemed to be in accordance with the partners' interests 
in the partnership.
    Example 26. (i) A and B form AB, an eligible entity (as defined 
in Sec.  301.7701-3(a) of this chapter), treated as a partnership 
for U.S. tax purposes. AB's partnership agreement (within the 
meaning paragraph (b)(2)(ii)(j) of this section) provides that the 
partners' capital accounts will be determined and maintained in 
accordance with paragraph (b)(2)(iv) of this section, that 
liquidation proceeds will be distributed in accordance with the 
partners' positive capital account balances, and that any partner 
with a deficit balance in his capital account following the 
liquidation of his interest must restore that deficit to the 
partnership. AB operates business M in country X and business N in 
country Y. Assume that country X imposes a 40 percent tax on 
business M income, country Y imposes a 20 percent tax on business N 
income, and the country X and country Y taxes are creditable foreign 
taxes. In year 1, AB has $100 of income from business M and $50 of 
income from business N. Country X imposes $40 of tax on the income 
from business M and country Y imposes $10 of tax on the income of 
business N. Pursuant to the partnership agreement, all partnership 
items, including creditable foreign taxes, from business M are 
allocated 75 percent to A and 25 percent to B, and all partnership 
items, including creditable foreign taxes, from business N are split 
evenly between A and B (50/50). Accordingly, A is allocated 75 
percent of the income from business M ($75), 75 percent of the 
country X taxes ($30), 50 percent of the income from business N 
($25), and 50 percent of the country Y taxes ($5). B is allocated 25 
percent of the income from business M ($25), 25 percent of the 
country X taxes ($10), 50 percent of the income from business N 
($25), and 50 percent of the country Y taxes ($5).
    (ii) Because the income from business M and business N is 
general limitation income and the partnership agreement provides for 
different allocations with respect to such income, it is necessary 
to determine which foreign taxes are related to the business M 
income and which foreign taxes are related to the business N income. 
Under paragraph (b)(4)(xi) of this section, the $40 of country X 
taxes is related to business M and the $10 of country Y taxes is 
related to business N. Because AB's partnership agreement allocates 
the $40 of country X taxes in the same proportion as the general 
limitation income from business M, and the $10 of country Y taxes in 
the same proportion as the general limitation income from business 
N, the allocations of the country X taxes and the country Y taxes 
are in proportion to the allocation of the income to which the 
foreign taxes relate. Because AB satisfies the requirements of 
paragraph (b)(4)(xi), the allocations of the country X and country Y 
taxes are deemed to be in accordance with the partners' interests in 
the partnership.
    Example 27. (i) The facts are the same as in Example 26, except 
that AB does not actually receive the $50 accrued with respect to 
business N until year 2. Also assume that A, B and AB each report 
taxable income on an accrual basis for U.S. tax purposes and AB 
reports taxable income on a cash basis for country X and country Y 
purposes. In year 1, AB pays country X taxes of $40. In year 2, AB 
pays country Y taxes of $10. Pursuant to the partnership agreement, 
in year 1, A is allocated 75 percent of business M income ($75) and 
country X taxes ($30) and 50 percent of business N income ($25). B 
is allocated 25 percent of business M income ($25) and country X 
taxes ($10) and 50 percent of business N income ($25). In year 2, A 
and B will each be allocated 50 percent of the country Y taxes ($5).
    (ii) Because the income from business M and business N is 
general limitation income and the partnership agreement provides for 
different allocations with respect to such income, it is necessary 
to determine which foreign taxes are related to business M income 
and which foreign taxes are related to business N income. Under 
paragraph (b)(4)(xi) of this section, $40 of country X taxes is 
related to the $100 of general

[[Page 21409]]

limitation income from business M. Under paragraph (b)(4)(xi), the 
country Y tax imposed in year 2 is allocable to the $50 of business 
N income AB recognizes in year 2 under country Y law and is treated 
as paid in year 2 on the $50 of business N income recognized for 
U.S. tax purposes in year 1. See Sec.  1.904-6(a)(1)(iv) and (c), 
Example 5. Accordingly, the $10 of country Y taxes is related to the 
$50 of general limitation income from business N. Because AB's 
partnership agreement allocates the $40 of country X taxes in 
proportion to the general limitation income from business M, and the 
$10 of country X taxes from business N in proportion to the year 1 
general limitation income from business N, the allocations of the 
country X and country Y taxes are in proportion to the allocation of 
the income to which the foreign taxes relate. Therefore, AB's 
partnership agreement satisfies the requirement of paragraph 
(b)(4)(xi)(a)(2) of this section. Because AB also satisfies the 
requirements of paragraph (b)(4)(xi)(a)(1) of this section, the 
allocations of the country X and Y taxes are deemed to be in 
accordance with the partners' interests in the partnership under 
paragraph (b)(4)(xi) of this section.
    Example 28. (i) A and B form AB, an eligible entity (as defined 
in Sec.  301.7701-3(a) of this chapter), treated as a partnership 
for U.S. tax purposes. AB's partnership agreement provides that the 
partners' capital accounts will be determined and maintained in 
accordance with paragraph (b)(2)(iv) of this section, that 
liquidation proceeds will be distributed in accordance with the 
partners' positive capital account balances, and that any partner 
with a deficit balance in his capital account following the 
liquidation of his interest must restore that deficit to the 
partnership. AB operates business M in country X. Assume that 
country X imposes a 20 percent tax on the net income from business 
M, which tax is a creditable foreign tax. In year 1, AB earns $300 
of gross income, has deductible expenses, exclusive of creditable 
foreign taxes, of $100, and pays or accrues $40 of country X tax. 
For purposes of section 904(d), all income from business M is 
general limitation income. Pursuant to the partnership agreement, 
the first $100 of gross income each year is allocated to A as a 
return on excess capital contributed by A. All remaining partnership 
items, including creditable foreign taxes, are split evenly (50/50) 
between A and B. Assume that the gross income allocation is not 
deductible for country X purposes.
    (ii) Under paragraph (b)(4)(xi) of this section, the $40 of 
taxes is related to the $200 of general limitation net income. In 
year 1, AB's partnership agreement allocates $150 or 75 percent of 
the general limitation income to A ($100 attributable to the gross 
income allocation plus $50 of the remaining $100 of net income) and 
$50 or 25 percent of the net income to B. AB's partnership agreement 
allocates the country X taxes in accordance with the partners' 
shares of partnership items remaining after the $100 gross income 
allocation. Therefore, AB allocates the country X taxes 50 percent 
to A ($20) and 50 percent to B ($20). Under paragraph (b)(4)(xi) of 
this section, the allocation of country X taxes cannot have 
substantial economic effect and must be allocated in accordance with 
the partners' interests in the partnership. AB's allocations of 
country X taxes are not deemed to be in accordance with the 
partners' interests in the partnership under paragraph (b)(4)(xi) of 
this section, because they are not in proportion to the allocation 
of the income to which the country X taxes relates.

    (c) through (e)(4)(ii)(b) [Reserved]. For further guidance, see 
Sec.  1.704-1(c) through (e)(4)(ii)(b).

John M. Dalrymple,
Acting Deputy Commissioner for Services and Enforcement.
    Approved: March 25, 2004.
Gregory F. Jenner,
Acting Assistant Secretary of the Treasury.
[FR Doc. 04-8704 Filed 4-20-04; 8:45 am]
BILLING CODE 4830-01-P