[Federal Register Volume 69, Number 138 (Tuesday, July 20, 2004)]
[Rules and Regulations]
[Pages 43304-43317]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-16374]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9141]
RIN 1545-AX88


Application of Section 904 to Income Subject to Separate 
Limitations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final Income Tax Regulations relating 
to the section 904(d) foreign tax credit limitation and to the 
exclusion of certain export financing interest from foreign personal 
holding company income. Changes to the applicable law were made by the 
Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 
1988, the Taxpayer Relief Act of 1997, and the Jobs and Growth Tax 
Relief Reconciliation Act of 2003. These regulations provide guidance 
needed to comply with these changes and affect individuals and 
corporations claiming foreign tax credits and reporting subpart F 
income.

DATES: Effective Date: These regulations are effective July 20, 2004.
    Applicability Dates: These regulations generally apply for taxable 
years beginning on or after July 20, 2004. Section 1.904-4(b)(2)(i) 
applies with respect to rents and royalties paid or accrued more than 
60 days after July 20, 2004. Taxpayers may choose to apply Sec.  
1.904(b)-1 and Sec.  1.904(b)-2 to taxable years ending after July 20, 
2004.

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

SUPPLEMENTARY INFORMATION:

Background

    On January 3, 2001, the Treasury Department and the IRS published 
in the Federal Register (66 FR 319) a notice of proposed rulemaking 
(REG-104683-00) providing guidance with respect to the application of 
sections 902 and 904. Several comments were received, and a public 
hearing was held on April 26, 2001. After consideration of the 
comments, certain portions of the regulations are withdrawn and the 
remainder of the regulations are finalized substantially as proposed. 
The discussion below summarizes the comments received and describes the 
reasons for withdrawing portions of the proposed regulations and the 
modifications to the remainder of the regulations. A notice of 
withdrawal published in the Proposed Rules section in this issue of the 
Federal Register withdraws the proposed amendments to Sec. Sec.  1.902-
0, 1-902-1 and 1.904-4(g).

Summary of Comments Received and Changes Made

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

    Under the proposed amendments to Sec.  1.902-1(a), the multi-year 
pooling of a foreign corporation's post-1986 undistributed earnings and 
foreign income taxes would have terminated if the ownership 
requirements of section 902(c)(3)(B) were not met as of the end of any 
taxable year, and such earnings and earnings subsequently accumulated 
in periods during which the stock ownership requirements of section 902 
were not met would have been treated as pre-1987 accumulated profits 
subject to the annual layering rules of section 902(c)(6). Prop. Sec.  
1.902-1(a)(8), (10) and (13). The proposed amendments also provided for 
the pooling of earnings and taxes to resume in the first subsequent 
taxable year as of the end of which the foreign corporation again has a 
qualifying domestic corporate shareholder. The proposed regulations 
were intended to alleviate the difficulties of reconstructing 
accumulated earnings and taxes accounts in connection with a U.S. 
shareholder's acquisition of stock in a foreign corporation previously 
owned by U.S. shareholders after an intervening period of foreign 
ownership.
    The Treasury Department and the IRS have determined that the 
potential simplification benefits of the proposed regulations would be 
outweighed by other administrative difficulties, including those 
associated with redeterminations of deemed-paid foreign taxes under 
section 905(c). Accordingly, the Treasury Department and the IRS are 
withdrawing the proposed amendments to Sec.  1.902-1(a) in a notice of 
withdrawal published in the Proposed Rules section in this issue of the 
Federal Register.

II. Separate Categories: Sec.  1.904-4

A. The Active Rents and Royalties Exception
    The proposed regulations would have expanded the exception from 
passive income for active rents and royalties to include rents and 
royalties received from related payors. The proposed regulations 
provide that this change would apply to rents and royalties paid or 
accrued more than 60 days after the date that the final regulations are

[[Page 43305]]

published in the Federal Register. Several comments requested that the 
amendment to the rents and royalties exception apply retroactively. The 
Treasury Department and the IRS continue to believe this amendment, 
which modifies existing final regulations, should apply only 
prospectively. Therefore, the amendment is adopted without change, and 
the new final regulations are applicable to rents and royalties paid or 
accrued more than 60 days after the date that the final regulations are 
published in the Federal Register.
B. Effect of Intervening Period of Noncontrolled or Less-Than-10%-U.S.-
Owned Status on Distributions From a Controlled Foreign Corporation or 
Other Look-Through Corporation
    Under section 904(d)(3) and the Treasury regulations thereunder, a 
U.S. shareholder (as defined in section 951(b)) is allowed look-through 
treatment for dividends received from a controlled foreign corporation 
(CFC) if paid out of earnings and profits (E&P) accumulated during 
periods in which the foreign corporation was a CFC. Section 904(d)(4) 
allows look-through treatment for dividends paid by a noncontrolled 
section 902 corporation (10/50 corporation) to a domestic corporation 
that meets the ownership requirements of section 902(a) from E&P 
accumulated in a taxable year beginning after December 31, 2002. 
Section 904(d)(4) provides the Secretary with authority to issue 
regulations addressing the treatment of dividends paid by a 10/50 
corporation out of pre-acquisition E&P.
    The proposed regulations would not have provided look-through 
treatment for a dividend paid by a CFC or 10/50 corporation out of E&P 
accumulated during a post-2002 period in which the corporation was a 
CFC or 10/50 corporation if paid after an intervening period during 
which the corporation was a less-than-10%-U.S.-owned corporation. Prop. 
Sec.  1.904-4(g)(3)(i)(C)(2). Similarly, the proposed regulations would 
not have provided look-through treatment for a dividend from a CFC out 
of E&P accumulated during a pre-2003 period in which the corporation 
was a CFC if paid after an intervening pre-2003 period in which the CFC 
was a 10/50 corporation or less-than-10%-U.S.-owned corporation. Prop. 
Sec.  1.904-4(g)(3)(i)(C)(1) and (2). The proposed regulations also 
include a transition year rule that treated E&P accumulated and 
distributions made during the year in which a CFC or 10/50 corporation 
loses its look-through status (i.e., becomes a non-CFC for pre-2003 tax 
years or a less-than-10%-U.S.-owned corporation for post-2002 tax 
years) as E&P accumulated or distributions made after the loss of look-
through status. Prop. Sec.  1.904-4(g)(3)(i)(C). The effect of this 
transition year rule would be to deny look-through treatment for a 
dividend or an amount treated as a dividend under section 1248(a) from 
a CFC or 10/50 corporation out of E&P accumulated while the corporation 
was a look-through entity.
    Several comments suggested that the proposed regulations were 
inconsistent with section 904(d)(2)(E), which provides that a CFC is 
not treated as a 10/50 corporation with respect to any distribution out 
of its E&P for periods during which it was a CFC. Comments also 
criticized the effect of the transition year rule described above. 
After consideration of the comments, the Treasury Department and the 
IRS are withdrawing the proposed amendments to Sec.  1.904-4(g) in a 
notice of withdrawal published in the Proposed Rules section in this 
issue of the Federal Register.
C. High-Taxed Income
    The final regulations correct an error in an example relating to 
the grouping of items of income for purposes of determining whether the 
items are high-taxed income within the meaning of section 904(d)(2)(F).

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

A. In General
    The proposed regulations under section 904(b) provide guidance 
concerning the application of the capital gain net income limitation of 
section 904(b)(2)(A) and 904(b)(2)(B)(i). Prop. Sec.  1.904(b)-1(a). 
The proposed regulations require a taxpayer to reduce foreign source 
capital gains to the extent the taxpayer's capital gain net income from 
foreign sources (in the aggregate) exceeded the taxpayer's entire 
capital gain net income. A taxpayer with a capital gain rate 
differential for the year and capital gain net income in two or more 
rate groups within a separate category with capital gain net income 
would be required to allocate such reduction pro rata to each such rate 
group in the separate category. The proposed regulations do not provide 
specific guidance concerning short-term capital gains for these 
purposes. The final regulations clarify that short-term amounts are 
treated as a rate group for purposes of Sec.  1.904(b)-1. Specifically, 
the final regulations clarify that a taxpayer with capital gain net 
income from foreign sources in a separate category attributable to 
capital gain net income in the short-term rate group and in one or more 
long-term rate groups allocates any reduction pursuant to the capital 
gain net income limitation pro rata to the short-term rate group and 
each applicable long-term rate group. The final regulations add an 
example involving short-term capital gain to illustrate this rule.
    The proposed regulations also contain a rule limiting net capital 
gain from foreign sources (in the aggregate) to worldwide net capital 
gain. Prop. Sec.  1.904(b)-1(a). This rule is intended to limit the 
amount of capital gains from foreign sources (remaining after 
application of the capital gain net income limitation of section 
904(b)(2)(A) and (b)(2)(B)(i)) subject to the rate differential 
adjustments of section 904(b)(2)(B)(i) and paragraph (c)(1) of the 
regulations to the extent a taxpayer has a net long-term capital loss 
from sources within the United States that does not reduce long-term 
capital gains from foreign sources pursuant to the capital gain net 
income limitation. This can occur when a taxpayer has short-term 
capital gains. The final regulations clarify the operation of the net 
capital gain limitation. In addition, because the net capital gain 
limitation applies solely for purposes of determining the amount of 
capital gains from foreign sources subject to the rate differential 
adjustments of section 904(b)(2)(B)(i) and paragraph (c)(1) of the 
regulations, the provisions addressing the net capital gain limitation 
have been moved to paragraph (c)(1) in the final regulations.
B. Election for Certain Noncorporate Taxpayers
    The proposed regulations also provide guidance concerning the rate 
differential adjustments required by section 904(b)(2)(B). Prop. Sec.  
1.904(b)-1(c) and (d). The final regulations add a rule that permits 
qualifying noncorporate taxpayers to elect not to apply the rate 
differential adjustments for any taxable year. Under the final 
regulations, a noncorporate taxpayer that is not subject to tax under 
section 55 for the taxable year may elect not to apply the rate 
differential adjustments if the highest rate of tax imposed on the 
taxpayer's taxable income (excluding net capital gain and qualified 
dividend income) for the taxable year under section 1 does not exceed 
the highest rate of tax in effect under section 1(h) for the taxable 
year and the amount of the taxpayer's net capital gain from foreign 
sources, plus the amount of the taxpayer's qualified dividend income 
from foreign sources, is less than $20,000. Under the tax rates 
currently in

[[Page 43306]]

effect, an individual with less than $20,000 of net capital gain and 
qualified dividend income from foreign sources would be eligible to 
make the election if the highest rate of tax applicable to such 
individual's taxable income (excluding net capital gain and qualified 
dividend income) under section 1 is 28 percent. For example, taxpayers 
whose filing status is married filing jointly would be eligible to make 
the election for the 2004 taxable year if their taxable income 
(excluding net capital gain and qualified dividend income) for 2004 
does not exceed $178,650 and the total of their net capital gain and 
qualified dividend income, from foreign sources, is less than $20,000. 
A similar election applies to a noncorporate taxpayer subject to the 
alternative minimum tax for the taxable year. A qualifying taxpayer is 
presumed to elect out of the rate differential adjustments unless the 
taxpayer indicates otherwise on its return for the taxable year. The 
rule is intended to permit taxpayers to avoid the complexity of 
computing the rate differential adjustments in cases where the failure 
to make the adjustments does not result in a significant divergence 
from the results contemplated by section 904(b)(2)(B).
    Because capital gains of corporations are not eligible for reduced 
rates of tax, the eligibility for the election is limited to 
noncorporate taxpayers.
C. Coordination With Section 904(f)
    The proposed regulations contain rules for coordinating the 
adjustments pursuant to section 904(b)(2) with section 904(f). Prop. 
Sec.  1.904(b)-1(g). The final regulations provide additional guidance 
concerning the interaction between section 904(b)(2) and (f). First, 
the final regulations provide that a capital loss from sources within 
the United States that reduces capital gains from foreign sources 
pursuant to section 904(b)(2)(A) (or 904(b)(2)(B)(i)) and paragraph (a) 
of the regulations is disregarded in determining the amount of a 
taxpayer's taxable income from sources within the United States for 
purposes of computing the amount of any additions to the taxpayer's 
overall foreign loss accounts. This rule is intended to prevent the 
double-counting of capital losses from sources within the United 
States. Second, the final regulations provide that a taxpayer's loss 
from sources in the United States (within the meaning of section 
904(f)(5)(D)) is the amount by which the taxpayer's foreign source 
taxable income (in the aggregate after taking into account adjustments 
pursuant to section 904(b)(2) and the final regulations) exceeds the 
taxpayer's entire taxable income (after taking into account adjustments 
pursuant to section 904(b)(2)(B) and the final regulations). The rule 
is intended to prevent distortions to the foreign tax credit limitation 
fraction that would otherwise result when a taxpayer has capital gains 
or losses from sources within the United States. The final regulations 
add examples to illustrate the operation of these coordination rules.
D. Qualified Dividend Income
    The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), 
Public Law 108-27 (117 Stat. 752), extended the capital gain rates 
under section 1(h) to qualified dividend income of noncorporate 
taxpayers. JGTRRA provides that rules similar to the rules of section 
904(b)(2)(B) (the rate differential adjustment rules) apply with 
respect to such qualified dividend income. The final regulations 
implement the coordination rule contained in JGTRRA by requiring a 
taxpayer to make rate differential adjustments to the taxpayer's 
qualified dividend income in a manner similar to the adjustments for a 
taxpayer's capital gains. The final regulations contain an election for 
noncorporate taxpayers, similar to the election for capital gains and 
losses, allowing a qualifying taxpayer to elect out of the rate 
differential adjustments with respect to the taxpayer's qualified 
dividend income.

Special Analyses

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

Drafting Information

    The principal author of these final regulations is Bethany A. 
Ingwalson of the Office of Associate Chief Counsel (International), 
within the Office of Chief Counsel, Internal Revenue Service. However, 
other personnel from the IRS and the Treasury Department participated 
in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

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

0
Paragraph 1. The authority citation for part 1 is amended by removing 
the entries for ``1.904-4 through 1.904-7'' and the entry for 
``1.904(b)-3'', and by adding entries in numerical order to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.904-4 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904(b)-1 also issued under 26 U.S.C. 1(h)(11)(C)(iv) 
and 904(b)(2)(C).
    Section 1.904(b)-2 also issued under 26 U.S.C. 1(h)(11)(C)(iv) 
and 904(b)(2)(C).
    Section 1.904-5 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904-6 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904-7 also issued under 26 U.S.C. 904(d)(6). * * *

0
Par. 2. Section 1.904-0 is amended as follows:
0
1. The entries for Sec.  1.904-4 are amended by:
0
a. Revising the entry for paragraph (b)(2)(iii).
0
b. Removing the entry for paragraph (b)(2)(iv).
0
c. Adding an entry for paragraph (m).
0
2. The entries for Sec. Sec.  1.904(b)-1 and 1.904(b)-2 are revised.
0
3. Removing all the entries for Sec. Sec.  1.904(b)-3 and 1.904(b)-4.
0
4. Adding entries for Sec.  1.904(j)-1.
    The revisions and additions read as follows:


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

* * * * *

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

* * * * *
    (b) * * *
    (2) * * *
    (iii) Example.
* * * * *
    (m) Income treated as allocable to an additional separate 
category.
* * * * *

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

    (a) Capital gains and losses included in taxable income from 
sources outside the United States.
    (1) Limitation on capital gain from sources outside the United 
States when the taxpayer

[[Page 43307]]

has net capital losses from sources within the United States.
    (i) In general.
    (ii) Allocation of reduction to separate categories or rate 
groups.
    (A) In general.
    (B) Taxpayer with capital gain rate differential.
    (2) Exclusivity of rules; no reduction by reason of net capital 
loss from sources outside the United States in a different separate 
category.
    (3) Capital losses from sources outside the United States in the 
same separate category.
    (4) Examples.
    (b) Capital gain rate differential.
    (1) Application of adjustments only if capital gain rate 
differential exists.
    (2) Determination of whether capital gain rate differential 
exists.
    (3) Special rule for certain noncorporate taxpayers.
    (c) Rate differential adjustment of capital gains.
    (1) Rate differential adjustment of capital gains in foreign 
source taxable income.
    (i) In general.
    (ii) Special rule for taxpayers with a net long-term capital 
loss from sources within the United States.
    (iii) Examples.
    (2) Rate differential adjustment of capital gains in entire 
taxable income.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States.
    (1) In general.
    (2) Determination of which capital gains are offset by net 
capital losses from sources outside the United States.
    (e) Qualified dividend income.
    (1) In general.
    (2) Exception.
    (f) Definitions.
    (1) Alternative tax rate.
    (2) Net capital gain.
    (3) Rate differential portion.
    (4) Rate group.
    (i) Short-term capital gains or losses.
    (ii) Long-term capital gains.
    (iii) Long-term capital losses.
    (5) Terms used in sections 1(h), 904(b) or 1222.
    (g) Examples.
    (h) Coordination with section 904(f).
    (1) In general.
    (2) Examples.
    (i) Effective date.

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

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

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

    (a) Election available only if all foreign taxes are creditable 
foreign taxes.
    (b) Coordination with carryover rules.
    (1) No carryovers to or from election year.
    (2) Carryovers to and from other years determined without regard 
to election years.
    (3) Determination of amount of creditable foreign taxes.
    (c) Examples.
    (d) Effective date.


0
Par. 3. Section 1.904-4 is amended as follows:
0
1. Paragraph (a) is amended by removing the period at the end and 
adding the language '', or in Sec.  1.904-4(m) (additional separate 
categories).''
0
2. The first sentence of paragraph (b)(2)(i) is revised.
0
3. Paragraph (b)(2)(ii) is revised.
0
4. Paragraph (b)(2)(iii) is removed.
0
5. Paragraph (b)(2)(iv) is redesignated as paragraph (b)(2)(iii).
0
6. The last three sentences of the Example in newly designated 
paragraph (b)(2)(iii) are removed and six new sentences are added in 
their place.
0
7. The fifth sentence of Example 4 in paragraph (c)(8) is revised.
0
8. The language ``and'' at the end of paragraph (l)(1)(v) is removed.
0
9. The period at the end of paragraph (l)(1)(vi) is removed and ``; 
and'' is added in its place.
0
10. Paragraph (l)(1)(vii) is added.
0
11. Paragraph (m) is added.
    The revisions and additions read as follows:


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

* * * * *
    (b) * * *
    (2) * * * (i) * * * For rents and royalties paid or accrued after 
September 20, 2004, passive income does not include any rents or 
royalties that are derived in the active conduct of a trade or 
business, regardless of whether such rents or royalties are received 
from a related or an unrelated person. * * *
    (ii) Exception for certain rents and royalties. Rents and royalties 
are considered derived in the active conduct of a trade or business by 
a United States person or by a controlled foreign corporation (or other 
entity to which the look-through rules apply) for purposes of section 
904 (but not for purposes of section 954) if the requirements of 
section 954(c)(2)(A) are satisfied by one or more corporations that are 
members of an affiliated group of corporations (within the meaning of 
section 1504(a), determined without regard to section 1504(b)(3)) of 
which the recipient is a member. For purposes of this paragraph 
(b)(2)(ii), an affiliated group includes only domestic corporations and 
foreign corporations that are controlled foreign corporations in which 
domestic members of the affiliated group own, directly or indirectly, 
at least 80 percent of the total voting power and value of the stock. 
For purposes of this paragraph (b)(2)(ii), indirect ownership shall be 
determined under section 318 and the regulations under that section.
    (iii) * * *

    Example. * * * Some of the franchisees are unrelated to S and P. 
Other franchisees are related to S or P and use the licensed 
property outside of S's country of incorporation. S does not 
satisfy, but P does satisfy, the active trade or business 
requirements of section 954(c)(2)(A) and the regulations thereunder. 
The royalty income earned by S with regard to both its related and 
unrelated franchisees is foreign personal holding company income 
because S does not satisfy the active trade or business requirements 
of section 954(c)(2)(A) and, in addition, the royalty income from 
the related franchisees does not qualify for the same country 
exception of section 954(c)(3). However, all of the royalty income 
earned by S is general limitation income to S under Sec.  1.904-
4(b)(2)(ii) because P, a member of S's affiliated group (as defined 
therein), satisfies the active trade or business test (which is 
applied without regard to whether the royalties are paid by a 
related person). S's royalty income that is taxable to P under 
subpart F and the royalties paid to P are general limitation income 
to P under the look-through rules of Sec.  1.904-5(c)(1)(i) and 
(c)(3), respectively.
* * * * *
    (c) * * *
    (8) * * *

    Example 4. * * * The royalty income is not subject to a 
withholding tax, and is not taxed by Country X, and the interest and 
the rental income are subject to a 4 percent and 10 percent 
withholding tax, respectively. * * *
* * * * *
    (l) * * * (1) * * *
    (vii) Income that meets the definitions of a separate category 
described in paragraph (m) of this section and of any other category of 
separate limitation income described in section 904(d)(1)(A) through 
(H) will be subject to the separate limitation described in paragraph 
(m) of this section and will not be treated as general limitation 
income described in section 904(d)(1)(I).
* * * * *
    (m) Income treated as allocable to an additional separate category. 
If section 904(a), (b), and (c) are applied separately to any category 
of income under the Internal Revenue Code (for example, under section 
56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), or 904(g)(10)), that 
category of income will be treated for all purposes of the Internal 
Revenue Code and regulations as if it were a separate category listed 
in section 904(d)(1) and (d)(3)(F)(i).

0
Par. 4. In Sec.  1.904-5, paragraph (a)(1) is revised to read as 
follows:

[[Page 43308]]

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

    (a) * * *
    (1) The term separate category means, as the context requires, any 
category of income described in section 904(d)(1)(A), (B), (C), (D), 
(E), (F), (G), (H), or (I) and in Sec.  1.904-4(b), (d), (e), (f), and 
(g), any category of income described in Sec.  1.904-4(m), or any 
category of earnings and profits to which income described in such 
provisions is attributable.
* * * * *

0
Par. 5. In Sec.  1.904-6, paragraph (a)(1)(ii) is amended by adding two 
sentences at the end to read as follows:


Sec.  1.904-6  Allocation and apportionment of taxes.

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

0
Par. 6. Section 1.904(b)-1 is revised to read as follows:


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

    (a) Capital gains and losses included in taxable income from 
sources outside the United States--(1) Limitation on capital gain from 
sources outside the United States when the taxpayer has net capital 
losses from sources within the United States--(i) In general. Except as 
otherwise provided in this section, for purposes of section 904 and 
this section, taxable income from sources outside the United States (in 
all of the taxpayer's separate categories in the aggregate) shall 
include capital gain net income from sources outside the United States 
(determined by considering all of the capital gain and loss items in 
all of the taxpayer's separate categories in the aggregate) only to the 
extent of capital gain net income from all sources. Thus, capital gain 
net income from sources outside the United States (determined by 
considering all of the capital gain and loss items in all of the 
taxpayer's separate categories in the aggregate) shall be reduced to 
the extent such amount exceeds capital gain net income from all 
sources.
    (ii) Allocation of reduction to separate categories or rate 
groups--(A) In general. If capital gain net income from sources outside 
the United States exceeds capital gain net income from all sources, and 
the taxpayer has capital gain net income from sources outside the 
United States in only one separate category, such excess is allocated 
as a reduction to that separate category. If a taxpayer has capital 
gain net income from foreign sources in two or more separate 
categories, such excess must be apportioned on a pro rata basis as a 
reduction to each such separate category. For purposes of the preceding 
sentence, pro rata means based on the relative amounts of the capital 
gain net income from sources outside the United States in each separate 
category.
    (B) Taxpayer with capital gain rate differential. If a taxpayer 
with a capital gain rate differential for the year (within the meaning 
of paragraph (b) of this section) has capital gain net income from 
foreign sources in only one rate group within a separate category, any 
reduction to such separate category pursuant to paragraph (a)(1)(ii)(A) 
of this section must be allocated to such rate group. If a taxpayer 
with a capital gain rate differential for the year (within the meaning 
of paragraph (b) of this section) has capital gain net income from 
foreign sources in two or more rate groups within a separate category, 
any reduction to such separate category pursuant to paragraph 
(a)(1)(ii)(A) of this section must be apportioned on a pro rata basis 
among such rate groups. For purposes of the preceding sentence, pro 
rata means based on the relative amounts of the capital gain net income 
from sources outside the United States in each rate group within the 
applicable separate category.
    (2) Exclusivity of rules; no reduction by reason of net capital 
losses from sources outside the United States in a different separate 
category. Capital gains from sources outside the United States in any 
separate category shall be limited by reason of section 904(b)(2)(A) 
and the comparable limitation of section 904(b)(2)(B)(i) only to the 
extent provided in paragraph (a)(1) of this section (relating to 
limitation on capital gain from sources outside the United States when 
taxpayer has net capital losses from sources within the United States).
    (3) Capital losses from sources outside the United States in the 
same separate category. Except as otherwise provided in paragraph (d) 
of this section, taxable income from sources outside the United States 
in each separate category shall be reduced by any capital loss that is 
allocable or apportionable to income from sources outside the United 
States in such separate category to the extent such loss is allowable 
in determining taxable income for the taxable year.
    (4) Examples. The following examples illustrate the application of 
this paragraph (a) to taxpayers that do not have a capital gain rate 
differential for the taxable year. See paragraph (g) of this section 
for examples that illustrate the application of this paragraph (a) to 
taxpayers that have a capital gain rate differential for the year. The 
examples are as follows:

    Example 1. Taxpayer A, a corporation, has a $3,000 capital loss 
from sources outside the United States in the general limitation 
category, a $6,000 capital gain from sources outside the United 
States in the passive category, and a $2,000 capital loss from 
sources within the United States. A's capital gain net income from 
sources outside the United States in the aggregate, from all 
separate categories, is $3,000 ($6,000 - $3,000). A's capital gain 
net income from all sources is $1,000 ($6,000 - $3,000 - $2,000). 
Thus, for purposes of section 904, A's taxable income from sources 
outside the United States in all of A's separate categories in the 
aggregate includes only $1,000 of capital gain net income from 
sources outside the United States. See paragraph (a)(1)(i) of this 
section. Pursuant to paragraphs (a)(1)(i) and (a)(1)(ii)(A) of this 
section, A must reduce the $6,000 of capital gain net income from 
sources outside the United States in the passive category by $2,000 
($3,000 of capital gain net income from sources outside the United 
States - $1,000 of capital gain net income from all sources). After 
the adjustment, A has $4,000 of capital gain from sources outside 
the United States in the passive category and $3,000 of capital loss 
from sources outside the United States in the general limitation 
category.
    Example 2. Taxpayer B, a corporation, has a $300 capital gain 
from sources outside the United States in the general limitation 
category and a $200 capital gain from sources outside the United 
States in the passive category. B's capital gain net income from 
sources outside the United States is $500 ($300 + $200). B also has 
a $150 capital loss from sources within the United States and a $50 
capital gain from sources within the

[[Page 43309]]

United States. Thus, B's capital gain net income from all sources is 
$400 ($300 + $200 - $150 + $50). Pursuant to paragraph (a)(1)(ii)(A) 
of this section, the $100 excess of capital gain net income from 
sources outside the United States over capital gain net income from 
all sources ($500 - $400) must be apportioned, as a reduction, 
three-fifths ($300/$500 of $100, or $60) to the general limitation 
category and two-fifths ($200/$500 of $100, or $40) to the passive 
category. Therefore, for purposes of section 904, the general 
limitation category includes $240 ($300 - $60) of capital gain net 
income from sources outside the United States and the passive 
category includes $160 ($200 - $40) of capital gain net income from 
sources outside the United States.
    Example 3. Taxpayer C, a corporation, has a $10,000 capital loss 
from sources outside the United States in the general limitation 
category, a $4,000 capital gain from sources outside the United 
States in the passive category, and a $2,000 capital gain from 
sources within the United States. C's capital gain net income from 
sources outside the United States is zero, since losses exceed 
gains. C's capital gain net income from all sources is also zero. 
C's capital gain net income from sources outside the United States 
does not exceed its capital gain net income from all sources, and 
therefore paragraph (a)(1) of this section does not require any 
reduction of C's passive category capital gain. For purposes of 
section 904, C's passive category includes $4,000 of capital gain 
net income. C's general limitation category includes a capital loss 
of $6,000 because only $6,000 of capital loss is allowable as a 
deduction in the current year. The entire $4,000 of capital loss in 
excess of the $6,000 of capital loss that offsets capital gain in 
the taxable year is carried back or forward under section 1212(a), 
and none of such $4,000 is taken into account under section 904(a) 
or (b) for the current taxable year.

    (b) Capital gain rate differential--(1) Application of adjustments 
only if capital gain rate differential exists. Section 904(b)(2)(B) and 
paragraphs (c) and (d) of this section apply only for taxable years in 
which the taxpayer has a capital gain rate differential.
    (2) Determination of whether capital gain rate differential exists. 
For purposes of section 904(b) and this section, a capital gain rate 
differential is considered to exist for the taxable year only if the 
taxpayer has taxable income (excluding net capital gain and qualified 
dividend income) for the taxable year, a net capital gain for the 
taxable year and--
    (i) In the case of a taxpayer other than a corporation, tax is 
imposed on the net capital gain at a reduced rate under section 1(h) 
for the taxable year; or
    (ii) In the case of a corporation, tax is imposed under section 
1201(a) on the taxpayer at a rate less than any rate of tax imposed on 
the taxpayer by section 11, 511, or 831(a) or (b), whichever applies 
(determined without regard to the last sentence of section 11(b)(1)), 
for the taxable year.
    (3) Special rule for certain noncorporate taxpayers. A taxpayer 
that has a capital gain rate differential for the taxable year under 
paragraph (b)(2)(i) of this section and is not subject to alternative 
minimum tax under section 55 for the taxable year may elect not to 
apply the rate differential adjustments contained in section 
904(b)(2)(B) and paragraphs (c) and (d) of this section if the highest 
rate of tax imposed on such taxpayer's taxable income (excluding net 
capital gain and any qualified dividend income) for the taxable year 
under section 1 does not exceed the highest rate of tax in effect under 
section 1(h) for the taxable year and the amount of the taxpayer's net 
capital gain from sources outside the United States, plus the amount of 
the taxpayer's qualified dividend income from sources outside the 
United States, is less than $20,000. A taxpayer that has a capital gain 
rate differential for the taxable year under paragraph (b)(2)(i) of 
this section and is subject to alternative minimum tax under section 55 
for the taxable year may make such election if the rate of tax imposed 
on such taxpayer's alternative minimum taxable income (excluding net 
capital gain and any qualified dividend income) under section 55 does 
not exceed 26 percent, the highest rate of tax imposed on such 
taxpayer's taxable income (excluding net capital gain and any qualified 
dividend income) for the taxable year under section 1 does not exceed 
the highest rate of tax in effect under section 1(h) for the taxable 
year and the amount of the taxpayer's net capital gain from sources 
outside the United States, plus the amount of the taxpayer's qualified 
dividend income from sources outside the United States, is less than 
$20,000. A taxpayer who makes this election shall apply paragraph (a) 
of this section as if such taxpayer does not have a capital gain rate 
differential for the taxable year. An eligible taxpayer shall be 
presumed to have elected not to apply the rate differential 
adjustments, unless such taxpayer applies the rate differential 
adjustments contained in section 904(b)(2)(B) and paragraphs (c) and 
(d) of this section in determining its foreign tax credit limitation 
for the taxable year.
    (c) Rate differential adjustment of capital gains--(1) Rate 
differential adjustment of capital gains in foreign source taxable 
income--(i) In general. Subject to paragraph (c)(1)(ii) of this 
section, in determining taxable income from sources outside the United 
States for purposes of section 904 and this section, capital gain net 
income from sources outside the United States in each long-term rate 
group in each separate category (separate category long-term rate 
group), shall be reduced by the rate differential portion of such 
capital gain net income. For purposes of paragraph (c)(1) of this 
section, references to capital gain net income are references to 
capital gain net income remaining after any reduction to such income 
pursuant to paragraph (a)(1) of this section (i.e., paragraph (a)(1) of 
this section applies before paragraphs (c) and (d) of this section).
    (ii) Special rule for taxpayers with a net long-term capital loss 
from sources within the United States. If a taxpayer has a net long-
term capital loss from sources within the United States (i.e., the 
taxpayer's long-term capital losses from sources within the United 
States exceed the taxpayer's long-term capital gains from sources 
within the United States) and also has any short-term capital gains 
from sources within or without the United States, then capital gain net 
income from sources outside the United States in each separate category 
long-term rate group shall be reduced by the rate differential portion 
of the applicable rate differential amount. The applicable rate 
differential amount is determined as follows:
    (A) Step 1: Determine the U.S. long-term capital loss adjustment 
amount. The U.S. long-term capital loss adjustment amount is the 
excess, if any, of the net long-term capital loss from sources within 
the United States over the amount, if any, by which the taxpayer 
reduced long-term capital gains from sources without the United States 
pursuant to paragraph (a)(1) of this section.
    (B) Step 2: Determine the applicable rate differential amount. If a 
taxpayer has capital gain net income from sources outside the United 
States in only one separate category long-term rate group, the 
applicable rate differential amount is the excess of such capital gain 
net income over the U.S. long-term capital loss adjustment amount. If a 
taxpayer has capital gain net income from sources outside the United 
States in more than one separate category long-term rate group, the 
U.S. long-term capital loss adjustment amount shall be apportioned on a 
pro rata basis to each separate category long-term rate group with 
capital gain net income. For purposes of the preceding sentence, pro 
rata means based on the relative amounts of capital gain net income 
from sources outside the United States in each separate category long-
term rate group. The applicable rate differential amount for each 
separate category long-term rate group with

[[Page 43310]]

capital gain net income is the excess of such capital gain net income 
over the portion of the U.S. long-term capital loss adjustment amount 
apportioned to the separate category long-term rate group pursuant to 
this Step 2.
    (iii) Examples. The following examples illustrate the provisions of 
paragraph (c)(1)(ii) of this section. The taxpayers in the examples are 
assumed to have taxable income (excluding net capital gain and 
qualified dividend income) subject to a rate of tax under section 1 
greater than the highest rate of tax in effect under section 1(h) for 
the applicable taxable year. The examples are as follows:

    Example 1. (i) M, an individual, has $300 of long-term capital 
gain from foreign sources in the passive category, $200 of which is 
subject to tax at a rate of 15 percent under section 1(h) and $100 
of which is subject to tax at a rate of 28% under section 1(h). M 
has $150 of short-term capital gain from sources within the United 
States. M has a $100 long-term capital loss from sources within the 
United States.
    (ii) M's capital gain net income from sources outside the United 
States ($300) does not exceed M's capital gain net income from all 
sources ($350). Therefore, paragraph (a)(1) of this section does not 
require any reduction of M's capital gain net income in the passive 
category.
    (iii) Because M has a net long-term capital loss from sources 
within the United States ($100) and also has a short-term capital 
gain from U.S. sources ($150), M must apply the provisions of 
paragraph (c)(1)(ii) of this section to determine the amount of the 
$300 of capital gain net income in the passive category that is 
subject to a rate differential adjustment. Under Step 1, the U.S. 
long-term capital loss adjustment amount is $100 ($100 - $0). Under 
Step 2, M must apportion this amount to each rate group in the 
passive category pro rata based on the amount of capital gain net 
income in each rate group. Thus, $66.67 ($200/$300 of $100) is 
apportioned to the 15 percent rate group and $33.33 ($100/$300 of 
$100) is apportioned to the 28 percent rate group. The applicable 
rate differential amount for the 15 percent rate group is $133.33 
($200 - $66.67). Thus, $133.33 of the $200 of capital gain net 
income in the 15 percent rate group is subject to a rate 
differential adjustment pursuant to paragraph (c)(1) of this 
section. The remaining $66.67 is not subject to a rate differential 
adjustment. The applicable rate differential amount for the 28 
percent rate group is $66.67 ($100 - $33.33). Thus, $66.67 of the 
$100 of capital gain net income in the 28 percent rate group is 
subject to a rate differential adjustment pursuant to paragraph 
(c)(1) of this section. The remaining $33.33 is not subject to a 
rate differential adjustment.
    Example 2. (i) N, an individual, has $300 of long-term capital 
gain from foreign sources in the passive category, all of which is 
subject to tax at a rate of 15 percent under section 1(h). N has $50 
of short-term capital gain from sources within the United States. N 
has a $100 long-term capital loss from sources within the United 
States.
    (ii) N's capital gain net income from sources outside the United 
States ($300) exceeds N's capital gain net income from all sources 
($250). Pursuant to paragraph (a)(1) of this section, N must reduce 
the $300 capital gain in the passive category by $50. N has $250 of 
capital gain remaining in the passive category.
    (iii) Because N has a net long-term capital loss from sources 
within the United States ($100) and also has a short-term capital 
gain from U.S. sources ($50), N must apply the provisions of 
paragraph (c)(1)(ii) of this section to determine the amount of the 
$250 of capital gain in the passive category that is subject to a 
rate differential adjustment. Under Step 1, the U.S. long-term 
capital loss adjustment amount is $50 ($100 - $50). Under Step 2, 
the applicable rate differential amount is $200 ($250 - $50). Thus, 
$200 of the capital gain in the passive category is subject to a 
rate differential adjustment under paragraph (c)(1) of this section. 
The remaining $50 is not subject to a rate differential adjustment.
    Example 3. (i) O, an individual, has a $100 short-term capital 
gain from foreign sources in the passive category. O has $300 of 
long-term capital gain from foreign sources in the passive category, 
all of which is subject to tax at a rate of 15 percent under section 
1(h). O has a $100 long-term capital loss from sources within the 
United States.
    (ii) O's capital gain net income from sources outside the United 
States ($400) exceeds O's capital gain net income from all sources 
($300). Pursuant to paragraph (a)(1) of this section, O must reduce 
the $400 capital gain net income in the passive category by $100. 
Because C has capital gain net income in two or more rate groups in 
the passive category, O must apportion such amount, as a reduction, 
to each rate group on a pro rata basis pursuant to paragraph 
(a)(1)(ii)(B) of this section. Thus, $25 ($100/$400 of $100) is 
apportioned to the short-term capital gain and $75 ($300/$400 of 
$100) is apportioned to the long-term capital gain in the 15 percent 
rate group. After application of paragraph (a)(1) of this section, O 
has $75 of short-term capital gain in the passive category and $225 
of long-term capital gain in the 15 percent rate group in the 
passive category.
    (iii) Because O has a net long-term capital loss from sources 
within the United States ($100) and also has a short-term capital 
gain from foreign sources ($100), O must apply the provisions of 
paragraph (c)(1)(ii) of this section to determine the amount of the 
$225 of long-term capital gain in the 15 percent rate group that is 
subject to a rate differential adjustment. Under Step 1, the U.S. 
long-term capital loss adjustment amount is $25 ($100 - $75). Under 
Step 2, the applicable rate differential amount is $200 ($225 - 
$25). Thus, $200 of the long-term capital gain is subject to a rate 
differential adjustment under paragraph (c)(1) of this section. The 
remaining $25 of long-term capital gain is not subject to a rate 
differential adjustment.

    (2) Rate differential adjustment of capital gains in entire taxable 
income. For purposes of section 904 and this section, entire taxable 
income shall include gains from the sale or exchange of capital assets 
only to the extent of capital gain net income reduced by the sum of the 
rate differential portions of each rate group of net capital gain.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States--(1) In general. In determining taxable 
income from sources outside the United States for purposes of section 
904 and this section, a taxpayer with a net capital loss in a separate 
category rate group shall reduce such net capital loss by the sum of 
the rate differential portions of the capital gain net income in each 
long-term rate group offset by such net capital loss. A net capital 
loss in a separate category rate group is the amount, if any, by which 
capital losses in a rate group from sources outside the United States 
included in a separate category exceed capital gains from sources 
outside the United States in the same rate group and the same separate 
category.
    (2) Determination of which capital gains are offset by net capital 
losses from sources outside the United States. For purposes of 
paragraph (d)(1) of this section, in order to determine the capital 
gain net income offset by net capital losses from sources outside the 
United States, the following rules shall apply in the following order:
    (i) Net capital losses from sources outside the United States in 
each separate category rate group shall be netted against capital gain 
net income from sources outside the United States from the same rate 
group in other separate categories.
    (ii) Capital losses from sources within the United States shall be 
netted against capital gains from sources within the United States in 
the same rate group.
    (iii) Net capital losses from sources outside the United States in 
excess of the amounts netted against capital gains under paragraph 
(d)(2)(i) of this section shall be netted against the taxpayer's 
remaining capital gains from sources within and outside the United 
States in the following order, and without regard to any net capital 
losses, from any rate group, from sources within the United States--
    (A) First against capital gain net income from sources within the 
United States in the same rate group;
    (B) Next, against capital gain net income in other rate groups, in 
the order in which capital losses offset capital gains for purposes of 
determining the taxpayer's taxable income and without regard to whether 
such capital gain net income derives from sources within or outside the 
United States, as follows:

[[Page 43311]]

    (1) A net capital loss in the short-term rate group is used first 
to offset any capital gain net income in the 28 percent rate group, 
then to offset capital gain net income in the 25 percent rate group, 
then to offset capital gain net income in the 15 percent rate group, 
and finally to offset capital gain net income in the 5 percent rate 
group.
    (2) A net capital loss in the 28 percent rate group is used first 
to offset capital gain net income in the 25 percent rate group, then to 
offset capital gain net income in the 15 percent rate group, and 
finally to offset capital gain net income in the 5 percent rate group.
    (3) A net capital loss in the 15 percent rate group is used first 
to offset capital gain net income in the 5 percent rate group, and then 
to offset capital gain net income in the 28 percent rate group, and 
finally to offset capital gain net income in the 25 percent rate group.
    (iv) Net capital losses from sources outside the United States in 
any rate group, to the extent netted against capital gains in any other 
separate category under paragraph (d)(2)(i) of this section or against 
capital gains in the same or any other rate group under paragraph 
(d)(2)(iii) of this section, shall be treated as coming pro rata from 
each separate category that contains a net capital loss from sources 
outside the United States in that rate group. For example, assume that 
the taxpayer has $20 of net capital losses in the 15 percent rate group 
in the passive category and $40 of net capital losses in the 15 percent 
rate group in the general limitation category, both from sources 
outside the United States. Further assume that $50 of the total $60 net 
capital losses from sources outside the United States are netted 
against capital gain net income in the 28 percent rate group (from 
other separate categories or from sources within the United States). 
One-third of the $50 of such capital losses would be treated as coming 
from the passive category, and two-thirds of such $50 would be treated 
as coming from the general limitation category.
    (v) In determining the capital gain net income offset by a net 
capital loss from sources outside the United States pursuant to this 
paragraph (d)(2), a taxpayer shall take into account any reduction to 
capital gain net income from sources outside the United States pursuant 
to paragraph (a) of this section and shall disregard any adjustments to 
such capital gain net income pursuant to paragraph (c)(1) of this 
section.
    (vi) If at any time during a taxable year, tax is imposed under 
section 1(h) at a rate other than a rate of tax specified in this 
paragraph (d)(2), the principles of this paragraph (d)(2) shall apply 
to determine the capital gain net income offset by any net capital loss 
in a separate category rate group.
    (vii) The determination of which capital gains are offset by 
capital losses from sources outside the United States under this 
paragraph (d)(2) is made solely in order to determine the appropriate 
rate-differential-based adjustments to such capital losses under this 
section and section 904(b), and does not change the source, allocation, 
or separate category of any such capital gain or loss for purposes of 
computing taxable income from sources within or outside the United 
States or for any other purpose.
    (e) Qualified dividend income--(1) In general. A taxpayer that has 
taxable income (excluding net capital gain and qualified dividend 
income) for the taxable year and that qualifies for a reduced rate of 
tax under section 1(h) on its qualified dividend income (as defined in 
section 1(h)(11)) for the taxable year shall adjust the amount of such 
qualified dividend income in a manner consistent with the rules of 
paragraphs (c)(1)(i) (first sentence) and (c)(2) of this section 
irrespective of whether such taxpayer has a net capital gain for the 
taxable year. For purposes of making adjustments pursuant to this 
paragraph (e), the special rule in paragraph (c)(1)(ii) of this section 
for taxpayers with a net long-term capital loss from sources within the 
United States shall be disregarded.
    (2) Exception. A taxpayer that makes the election provided for in 
paragraph (b)(3) of this section shall not make adjustments pursuant to 
paragraph (e)(1) of this section. Additionally, a taxpayer other than a 
corporation that does not have a capital gain rate differential for the 
taxable year within the meaning of paragraph (b)(2) of this section may 
elect not to apply paragraph (e)(1) of this section if such taxpayer 
would have qualified for the election provided for in paragraph (b)(3) 
of this section had such taxpayer had a capital gain rate differential 
for the taxable year. Such a taxpayer shall be presumed to make the 
election provided for in the preceding sentence unless such taxpayer 
applies the rate differential adjustments provided for in paragraph 
(e)(1) of this section to the qualified dividend income in determining 
its foreign tax credit limitation for the taxable year.
    (f) Definitions. For purposes of section 904(b) and this section, 
the following definitions apply:
    (1) Alternative tax rate. The term alternative tax rate means, with 
respect to any rate group, the rate applicable to that rate group under 
section 1(h) (for taxpayers other than corporations) or section 1201(a) 
(for corporations). For example, the alternative tax rate for 
unrecaptured section 1250 gain is 25 percent.
    (2) Net capital gain. For purposes of this section, net capital 
gain shall not include any qualified dividend income (as defined in 
section 1(h)(11)). See paragraph (e) of this section for rules relating 
to qualified dividend income.
    (3) Rate differential portion. The term rate differential portion 
with respect to capital gain net income from sources outside the United 
States in a separate category long-term rate group (or the applicable 
portion of such amount), net capital gain in a rate group, or capital 
gain net income in a long-term rate group, as the case may be, means 
the same proportion of such amount as--
    (i) The excess of the highest applicable tax rate (as defined in 
section 904(b)(3)(E)(ii)) over the alternative tax rate; bears to
    (ii) The highest applicable tax rate (as defined in section 
904(b)(3)(E)(ii)).
    (4) Rate group. For purposes of this section, the term rate group 
means:
    (i) Short-term capital gains or losses. With respect to a short-
term capital gain or loss, the rate group is the short-term rate group.
    (ii) Long-term capital gains. With respect to a long-term capital 
gain, the rate group is the particular rate of tax to which such gain 
is subject under section 1(h). Such a rate group is a long-term rate 
group. For example, the 28 percent rate group of capital gain net 
income from sources outside the United States consists of the capital 
gain net income from sources outside the United States that is subject 
to tax at a rate of 28 percent under section 1(h). Such 28 percent rate 
group is a long-term rate group. If a taxpayer has long-term capital 
gains that may be subject to tax at more than one rate under section 
1(h) and the taxpayer's net capital gain attributable to such long-term 
capital gains and any qualified dividend income are taxed at one rate 
of tax under section 1(h), then all of such long-term capital gains 
shall be treated as long-term capital gains in that one rate group. If 
a taxpayer has long-term capital gains that may be subject to tax at 
more than one rate of tax under section 1(h) and the taxpayer's net 
capital gain attributable to such long-term capital gains and any 
qualified dividend income are taxed at more than one rate pursuant to 
section 1(h), the taxpayer shall determine the rate group for such 
long-term capital gains from sources within or outside the United 
States (and, to the extent from sources outside the United States, from 
each separate category) ratably based on the

[[Page 43312]]

proportions of net capital gain and any qualified dividend income taxed 
at each applicable rate. For example, under the section 1(h) rates in 
effect for tax years beginning in 2004, a long-term capital gain (other 
than a long-term capital gain described in section 1(h)(4)(A) or 
(h)(6)) may be subject to tax at 5 percent or 15 percent.
    (iii) Long-term capital losses. With respect to a long-term capital 
loss, a loss described in section 1(h)(4)(B)(i) (collectibles loss) or 
(iii) (long-term capital loss carryover) is a loss in the 28 percent 
rate group. All other long-term capital losses shall be treated as 
losses in the highest rate group in effect under section 1(h) for the 
tax year with respect to long-term capital gains other than long-term 
capital gains described in section 1(h)(4)(A) or (h)(6). For example, 
under the section 1(h) rates in effect for tax years beginning in 2004, 
a long-term capital loss not described in section 1(h)(4)(B)(i) or 
(iii) shall be treated as a loss in the 15 percent rate group.
    (5) Terms used in sections 1(h), 904(b) or 1222. For purposes of 
this section, any term used in this section and also used in section 
1(h), section 904(b) or section 1222 shall have the same meaning given 
such term by section 1(h), 904(b) or 1222, respectively, except as 
otherwise provided in this section.
    (g) Examples. The following examples illustrate the provisions of 
this section. In these examples, the rate differential adjustment is 
shown as a fraction, the numerator of which is the alternative tax rate 
percentage and the denominator of which is 35 percent (assumed to be 
the highest applicable tax rate for individuals under section 1). 
Finally, all dollar amounts in the examples are abbreviated from 
amounts in the thousands (for example, $50 represents $50,000). The 
examples are as follows:


    Example 1.  (i) AA, an individual, has items from sources 
outside the United States only in the passive category for the 
taxable year. AA has $1000 of long-term capital gains from sources 
outside the United States that are subject to tax at a rate of 15 
percent under section 1(h). AA has $700 of long-term capital losses 
from sources outside the United States, which are not described in 
section 1(h)(4)(B)(i) or (iii). For the same taxable year, AA has 
$800 of long-term capital gains from sources within the United 
States that are taxed at a rate of 28 percent under section 1(h). AA 
also has $100 of long-term capital losses from sources within the 
United States, which are not described in section 1(h)(4)(B)(i) or 
(iii). AA also has $500 of ordinary income from sources within the 
United States. The highest tax rate in effect under section 1(h) for 
the taxable year with respect to long-term capital gains other than 
long-term capital gains described in section 1(h)(4)(A) or (h)(6) is 
15 percent. Accordingly, AA's long-term capital losses are in the 15 
percent rate group.
    (ii) AA's items of ordinary income, capital gain and capital 
loss for the taxable year are summarized in the following table:

------------------------------------------------------------------------
                                                                Foreign
                                                      U.S.      source:
                                                     source     passive
------------------------------------------------------------------------
15% rate group...................................     ($100)     $1,000
                                                                   (700)
28% rate group...................................        800
Ordinary income..................................        500
------------------------------------------------------------------------

    (iii) AA's capital gain net income from sources outside the 
United States ($300) does not exceed AA's capital gain net income 
from all sources ($1,000). Therefore, paragraph (a)(1) of this 
section does not require any reduction of AA's capital gain net 
income in the passive category.
    (iv) In computing AA's taxable income from sources outside the 
United States in the numerator of the section 904(a) foreign tax 
credit limitation fraction for the passive category, AA's $300 of 
capital gain net income in the 15 rate group in the passive category 
must be adjusted as required under paragraph (c)(1) of this section. 
AA adjusts the $300 of capital gain net income using 15 percent as 
the alternative tax rate, as follows: $300 (15%/35%).
    (v) In computing AA's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fraction, AA 
combines the $300 of capital gain net income from sources outside 
the United States and the $100 net capital loss from sources within 
the United States in the same rate group (15 percent). AA must 
adjust the resulting $200 ($300 - $100) of net capital gain in the 
15 percent rate group as required under paragraph (c)(2) of this 
section, using 15 percent as the alternative tax rate, as follows: 
$200 (15%/35%). AA must also adjust the $800 of net capital gain in 
the 28 percent rate group, using 28 percent as the alternative tax 
rate, as follows: $800 (28%/35%). AA must also include ordinary 
income from sources outside the United States in the numerator, and 
ordinary income from all sources in the denominator, of the foreign 
tax credit limitation fraction.
    (vi) AA's passive category foreign tax credit limitation 
fraction is $128.58/$1225.72, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.001

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

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group..................         $300        ($500)         $100
25% rate group..................          200  ............  ...........
28% rate group..................          500         (300)  ...........
Ordinary income.................        1,000          500           500
------------------------------------------------------------------------

    (ii) BB's capital gain net income from sources outside the 
United States in the aggregate (zero, since losses exceed gains) 
does not exceed BB's capital gain net income from all sources 
($300). Therefore, paragraph (a)(1) of this section does not require 
any reduction of BB's capital gain net income in the passive 
category.
    (iii) In computing BB's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax 
credit limitation fractions for the passive and general limitation 
categories, BB must adjust capital gain net income from sources 
outside the United States in each separate category long-tem rate 
group and net capital losses from sources outside the United States 
in each separate category rate group as provided in paragraphs 
(c)(1) and (d) of this section.
    (A) The $100 of capital gain net income in the 15 percent rate 
group in the passive category is adjusted under paragraph (c)(1) of 
this section as follows: $100 (15%/35%).
    (B) BB must adjust the net capital losses in the 15 percent and 
28 percent rate groups in the general limitation category in 
accordance with the ordering rules contained in paragraph (d)(2) of 
this section. Under paragraph (d)(2)(i) of this section, BB's net 
capital loss in the 15 percent rate group is netted against capital 
gain net income from sources outside the United States in other 
separate categories in the same rate group. Thus, $100 of the $500 
net capital loss in the 15 percent rate group in the general 
limitation category offsets $100 of capital gain net income in the 
15 percent rate group in the passive category. Accordingly, $100 of 
the $500 net capital loss is adjusted under paragraph (d)(1) of this 
section as follows: $100 (15%/35%).
    (C) Next, under paragraph (d)(2)(iii)(A) of this section, BB's 
net capital losses from sources outside the United States in any 
separate category rate group are netted against capital gain net 
income in the same rate group from sources within the United States. 
Thus, $300 of the $500 net capital loss in the 15 percent rate group 
in the general limitation category offsets $300 of capital gain net 
income in the 15 percent rate group

[[Page 43313]]

from sources within the United States. Accordingly, $300 of the $500 
net capital loss is adjusted under paragraph (d)(1) of this section 
as follows: $300 (15%/35%). Similarly, the $300 of net capital loss 
in the 28 percent rate group in the general limitation category 
offsets $300 of capital gain net income in the 28 percent rate group 
from sources within the United States. The $300 net capital loss is 
adjusted under paragraph (d)(1) of this section as follows: $300 
(28%/35%).
    (D) Finally, under paragraph (d)(2)(iii)(B) of this section, the 
remaining net capital losses in a separate category rate group are 
netted against capital gain net income from other rate groups from 
sources within and outside the United States. Thus, the remaining 
$100 of the $500 net capital loss in the 15 percent rate group in 
the general limitation category offsets $100 of the remaining 
capital gain net income in the 28 percent rate group from sources 
within the United States. Accordingly, the remaining $100 of net 
capital loss is adjusted under paragraph (d)(1) of this section as 
follows: $100 (28%/35%).
    (iv) In computing BB's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fractions, BB 
must adjust net capital gain by netting all of BB's capital gains 
and losses, from sources within and outside the United States, and 
adjusting any remaining net capital gains, based on rate group, 
under paragraph (c)(2) of this section. BB must also include foreign 
source ordinary income in the numerators, and ordinary income from 
all sources in the denominator, of the foreign tax credit limitation 
fractions. The denominator of BB's foreign tax credit limitation 
fractions reflects $2,000 of ordinary income from all sources, $100 
of net capital gain taxed at the 28% rate and adjusted as follows: 
$100 (28%/35%), and $200 of net capital gain taxed at the 25% rate 
and adjusted as follows: $200 (25%/35%).
    (v) BB's foreign tax credit limitation fraction for the general 
limitation category is $8.56/$2222.86, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.002

    (vi) BB's foreign tax credit limitation fraction for the passive 
category is $542.86/$2222.86, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.003

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

------------------------------------------------------------------------
                                                    Foreign source
                                 U.S. source ---------------------------
                                                 General       Passive
------------------------------------------------------------------------
15% rate group.................         $300        ($720)         ($80)
25% rate group.................          200  ............  ............
28% rate group.................          500         (150)           50
Ordinary income................        1,000        1,000           500
------------------------------------------------------------------------

    (ii) CC's capital gain net income from sources outside the 
United States (zero, since losses exceed gains) does not exceed CC's 
capital gain net income from all sources ($100). Therefore, 
paragraph (a)(1) of this section does not require any adjustment.
    (iii) In computing CC's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax 
credit limitation fractions for the passive and general limitation 
categories, CC must adjust capital gain net income from sources 
outside the United States in each separate category long-tem rate 
group and net capital losses from sources outside the United States 
in each separate category rate group as provided in paragraphs 
(c)(1) and (d) of this section.
    (A) CC must adjust the $50 of capital gain net income in the 28 
percent rate group in the passive category pursuant to paragraph 
(c)(1) of this section as follows: $50 (28%/35%).
    (B) Under paragraph (d)(2)(i) of this section, $50 of CC's $150 
net capital loss in the 28 percent rate group in the general 
limitation category offsets $50 of capital gain net income in the 28 
percent rate group in the passive category. Thus, $50 of the $150 
net capital loss is adjusted as follows: $50 (28%/35%). Next, under 
paragraph (d)(2)(iii)(A) of this section, the remaining $100 of net 
capital loss in the 28 percent rate group in the general limitation 
category offsets $100 of capital gain net income in the 28 percent 
rate group from sources within the United States. Thus, the 
remaining $100 of net capital loss is adjusted as follows: $100 
(28%/35%).
    (C) Under paragraphs (d)(2)(iii)(A) and (d)(2)(iv) of this 
section, the net capital losses in the 15 percent rate group in the 
passive and general limitation categories offset on a pro rata basis 
the $300 of capital gain net income in the 15 percent rate group 
from sources within the United States. The proportionate amount of 
the $720 net capital loss ($720/$800 of $300, or $270) is adjusted 
as follows: $270 (15%/35%). The proportionate amount of the $80 net 
capital loss ($80/$800 of $300, or $30) is adjusted as follows $30 
(15%/35%).
    (D) Of the remaining $500 of net capital loss in the 15 percent 
rate group in the general limitation and passive categories, $400 
offsets the remaining $400 of capital gain net income in the 28 
percent rate group from sources within the United States under 
paragraph (d)(2)(iii)(B)(3) of this section. The proportionate 
amount of the $720 net capital loss ($720/$800 of $400, or $360) is 
adjusted as follows: $360 (28%/35%). The proportionate amount of the 
$80 net capital loss ($80/$800 of $400, or $40) is adjusted as 
follows: $40 (28%/35%).
    (E) Under paragraph (d)(2)(iii)(B)(3) of this section, the 
remaining $100 of net capital loss in the 15 percent rate group in 
the general limitation and passive limitation categories offsets 
$100 of capital gain net income in the 25 percent rate group from 
sources within the United States. The proportionate amount of the 
$720 net capital loss ($720/$800 of $100, or $90) is adjusted as 
follows: $90 (25%/35%). The proportionate amount of the $80 net 
capital loss ($80/$800 of $100 of $10) is adjusted as follows: $10 
(25%/35%).
    (iv) In computing CC's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fractions, CC 
must adjust capital gain net income by netting all of CC's capital 
gains and losses, from sources within and outside the United States, 
and adjusting any remaining net

[[Page 43314]]

capital gains, based on rate group, under paragraph (c)(2) of this 
section. The denominator of CC's foreign tax credit limitation 
fractions reflects $2,500 of ordinary income from all sources and 
$100 of net capital gain taxed at the 25% rate and adjusted as 
follows: $100 (25%/35%).
    (v) CC's foreign tax credit limitation fraction for the general 
limitation category is $424.87/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.004

    (vi) CC's foreign tax credit limitation fraction for the passive 
category is $488.00/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.005

    Example 4. (i) DD, an individual, has the following items of 
ordinary income, capital gain and capital loss for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group.................         ($80)        ($100)         $300
Short-term.....................  ............          500           100
Ordinary income................          500   ............  ...........
------------------------------------------------------------------------

    (ii) DD's capital gain net income from outside the United States 
($800) exceeds DD's capital gain net income from all sources ($720). 
Pursuant to paragraph (a)(1)(ii)(A) of this section, DD must 
apportion the $80 of excess of capital gain net income from sources 
outside the United States between the general limitation and passive 
categories based on the amount of capital gain net income in each 
separate category. Thus, one-half ($400/$800 of $100, or $40) is 
apportioned to the general limitation category and one-half ($400/
$800 of $80, or $40) is apportioned to the passive category. The $40 
apportioned to the general limitation category reduces DD's $500 
short-term capital gain in the general limitation category to $460. 
Pursuant to paragraph (a)(1)(ii)(B) of this section, the $40 
apportioned to the passive category must be apportioned further 
between the capital gain net income in the short-term rate group and 
the 15 percent rate group based on the relative amounts of capital 
gain net income in each rate group. Thus, one-fourth ($100/$400 of 
$40 or $10) is apportioned to the short-term rate group and three-
fourths ($300/$400 of $40 or $30) is apportioned to the 15 percent 
rate group. DD's passive category includes $90 of short-term capital 
gain and $270 of capital gain net income in the 15% rate group.
    (iii) Because DD has a net long-term capital loss from sources 
within the United States ($80) and also has short-term capital 
gains, DD must apply the provisions of paragraph (c)(1)(ii) of this 
section to determine the amount of DD's $270 of capital gain net 
income in the 15% rate group that is subject to a rate differential 
adjustment under paragraph (c)(1) of this section. Under Step 1, the 
U.S. long-term capital loss adjustment amount is $50 ($80 - $30). 
Under Step 2, the applicable rate differential amount is the excess 
of the remaining capital gain net income over the U.S. long-term 
adjustment amount. Thus, the applicable rate differential amount is 
$220 ($270 - $50). In computing DD's taxable income from sources 
outside the United States in the numerator of the section 904(a) 
foreign tax credit limitation fraction for the passive category, DD 
must adjust this amount as follows: $220 (15%/35%). DD does not 
adjust the remaining $50 of capital gain net income in the 15% rate 
group.
    (iv) The amount of capital gain net income in the 15% rate group 
in the passive category, taking into account the adjustment pursuant 
to paragraph (a)(1) of this section and disregarding the adjustment 
pursuant to paragraph (c)(1) of this section, is $270. Under 
paragraphs (d)(2)(i) and (d)(2)(v) of this section, DD's $100 net 
capital loss in the 15% rate group in the general limitation 
category offsets capital gain net income in the 15% rate group in 
the passive category. Accordingly, the $100 of net capital loss is 
adjusted as follows: $100 (15%/35%).
    (v) In computing DD's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fractions, DD 
must adjust capital gain net income by netting all of DD's capital 
gains and losses from sources within and outside the United States, 
and adjusting the remaining net capital gain in each rate group 
pursuant to paragraph (c)(2) of this section. The denominator of 
DD's foreign tax credit limitation fraction reflects $500 of 
ordinary income from all sources, $600 of short-term capital gain 
and $120 of net capital gain in the 15 percent rate group adjusted 
as follows: $120 (15%/35%).
    (vi) DD's foreign tax credit limitation fraction for the general 
limitation category is $417.14/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.006

    (vii) DD's foreign tax credit limitation fraction for the 
passive category is $234.29/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.007

    Example 5. (i) EE, an individual, has the following items of 
ordinary income, capital gain and capital loss for the taxable year:

------------------------------------------------------------------------
                                                                Foreign
                                                      U.S.       source
                                                     source   ----------
                                                                Passive
------------------------------------------------------------------------
15% rate group...................................      ($150)       $300
28% rate group...................................  ..........        200
Short-term.......................................         30         100
Ordinary income..................................        500   .........
------------------------------------------------------------------------

    (ii) EE's capital gain net income from sources outside the 
United States ($600) exceeds EE's capital gain net income from all 
sources ($480). Pursuant to paragraph (a)(1)(ii) of this section, 
the $120 of excess capital gain net income from sources outside the 
United States is allocated as a reduction to the passive category 
and must be apportioned pro rata to each rate group within the 
passive category with capital gain net income. Thus, $20 ($100/$600 
of $120) is apportioned to the short-term rate group, $60 ($300/$600 
of $120) is apportioned to the 15 percent rate group and $40 ($200/
$600 of

[[Page 43315]]

$120) is apportioned to the 28 percent rate group. After application 
of paragraph (a)(1) of this section, EE has $80 of capital gain net 
income in the short-term rate group, $240 of capital gain net income 
in the 15 percent rate group and $160 of capital gain net income in 
the 28 percent rate group.
    (iii) Because EE has a net long-term capital loss from sources 
within the United States ($150) and also has short-term capital 
gains, EE must apply the provisions of paragraph (c)(1)(ii) of this 
section to determine the amount of EE's remaining $400 ($240 + $160) 
of capital gain net income in long-term rate groups in the passive 
category that is subject to a rate differential adjustment. Under 
Step 1, the U.S. long-term capital loss adjustment amount is $50 
($150 - $100). Under Step 2, EE must apportion this amount pro rata 
to each long-term rate group within the passive category with 
capital gain net income. Thus, $30 ($240/$400 of $50) is apportioned 
to the 15 percent rate group and $20 ($160/$400 of $50) is 
apportioned to the 28 percent rate group. The applicable rate 
differential amount for the 15 percent rate group is $210 ($240 - 
$30). The applicable rate differential amount for the 28 percent 
rate group is $140 ($160 - $20).
    (iv) Pursuant to paragraph (c)(1)(ii) of this section, EE must 
adjust $210 of the $240 capital gain in the 15 percent rate group as 
follows: $210 (15%/35%). EE does not adjust the remaining $30. 
Pursuant to paragraph (c)(1)(ii) of this section, EE must adjust 
$140 of the $160 capital gain in the 28 percent rate group as 
follows: $140 (28%/35%). EE does not adjust the remaining $20.
    (v) In computing EE's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fractions, EE 
must adjust capital gain net income by netting all of EE's capital 
gains and losses from sources within and outside the United States, 
and adjusting the remaining net capital gain in each rate group 
pursuant to paragraph (c)(2) of this section. The denominator of 
EE's foreign tax credit limitation fraction reflects $500 of 
ordinary income from all sources, $130 of short-term capital gain, 
$150 of net capital gain in the 15 percent rate group adjusted as 
follows: $150 (15%/35%), and $200 of net capital gain in the 28 
percent rate group adjusted as follows: $200 (28%/35%).
    (vi) EE's foreign tax credit limitation fraction for the passive 
category is $332/$854.29, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.008

    (h) Coordination with section 904(f)--(1) In general. Section 
904(b) and this section shall apply before the provisions of section 
904(f) as follows:
    (i) The amount of a taxpayer's separate limitation income or loss 
in each separate category, the amount of overall foreign loss, and the 
amount of any additions to or recapture of separate limitation loss or 
overall foreign loss accounts pursuant to section 904(f) shall be 
determined after applying paragraphs (a), (c)(1), (d) and (e) of this 
section to adjust capital gains and losses and qualified dividend 
income from sources outside the United States in each separate 
category.
    (ii) To the extent a capital loss from sources within the United 
States reduces a taxpayer's foreign source taxable income under 
paragraph (a)(1) of this section, such capital loss shall be 
disregarded in determining the amount of a taxpayer's taxable income 
from sources within the United States for purposes of computing the 
amount of any additions to the taxpayer's overall foreign loss 
accounts.
    (iii) In determining the amount of a taxpayer's loss from sources 
in the United States under section 904(f)(5)(D) (section 904(f)(5)(D) 
amount), the taxpayer shall make appropriate adjustments to capital 
gains and losses from sources within the United States to reflect 
adjustments pursuant to section 904(b)(2) and this section. Therefore, 
for purposes of section 904, a taxpayer's section 904(f)(5)(D) amount 
shall be equal to the excess of the taxpayer's foreign source taxable 
income in all separate categories in the aggregate for the taxable year 
(taking into account any adjustments pursuant to paragraphs (a)(1), 
(c)(1), (d) and (e) of this section) over the taxpayer's entire taxable 
income for the taxable year (taking into account any adjustments 
pursuant to paragraphs (c)(2) and (e) of this section).
    (2) Examples. The following examples illustrate the application of 
paragraph (h) of this section:

    Example 1. (i) W, an individual, has the following items of 
ordinary income, capital gain, and capital loss for the taxable 
year:

------------------------------------------------------------------------
                                                     Foreign source
                                   U.S. source -------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group...................         $500         $100       ($400)
Ordinary income..................          900          100  ...........
------------------------------------------------------------------------

    (ii) In computing W's taxable income from sources outside the 
United States for purposes of section 904 and this section, W must 
adjust the capital gain net income and net capital loss in each 
separate category as provided in paragraphs (c)(1) and (d) of this 
section. Thus, W must adjust the $100 of capital gain net income in 
the general limitation category and the $400 of net capital loss in 
the passive category as follows: $100 (15%/35%) and $400 (15%/35%).
    (iii) After the adjustment to W's net capital loss in the 
passive category, W has a $171.43 separate limitation loss in the 
passive category. After the adjustment to W's capital gain in the 
general limitation category, W has $142.86 of foreign source taxable 
income in the general limitation category. Thus, $142.86 of the 
separate limitation loss reduces foreign source taxable income in 
the general limitation category. See section 904(f)(5)(B). W adds 
$142.86 to the separate limitation loss account for the passive 
category. The remaining $28.57 of the separate limitation loss 
reduces income from sources within the United States. See section 
904(f)(5)(A). Thus, W adds $28.57 to the overall foreign loss 
account for the passive category.
    Example 2. (i) X, a corporation, has the following items of 
ordinary income, ordinary loss, capital gain and capital loss for 
the taxable year: foreign source:

------------------------------------------------------------------------
                                                                Foreign
                                                     U.S.       source:
                                                    source      general
------------------------------------------------------------------------
Capital gain....................................      ($500)       $700
Ordinary income.................................       1100       (1000)
------------------------------------------------------------------------

    (ii) X's capital gain net income from sources outside the United 
States ($700) exceeds X's capital gain net income from all sources 
($200). Pursuant to paragraph (a)(1) of this section, X must reduce 
the $700 capital gain in the general limitation category by $500. 
After the adjustment, X has $200 of capital gain net income 
remaining in the general limitation category. Thus, X has an overall 
foreign loss attributable to the general limitation category of 
$800.
    (iii) For purposes of computing the amount of the addition to 
X's overall foreign loss account for the general limitation 
category, the $500 capital loss from sources within the United 
States is disregarded and X's taxable income from sources within the 
United States is $1100. Accordingly, X must increase its overall 
foreign loss account for the general limitation category by $800.
    Example 3. (i) Y, a corporation, has the following items of 
ordinary income, ordinary loss, capital gain and capital loss for 
the taxable year:

[[Page 43316]]



------------------------------------------------------------------------
                                                                Foreign
                                                       U.S.     source:
                                                      source    passive
------------------------------------------------------------------------
Capital gain......................................     ($100)       $200
Ordinary income...................................      (200)        500
------------------------------------------------------------------------

    (ii) Y's capital gain net income from sources outside the United 
States ($200) exceeds Y's capital gain net income from all sources 
($100). Pursuant to paragraph (a)(1) of this section, Y must reduce 
the $200 capital gain in the passive category by $100. Y has $100 of 
capital gain net income remaining in the passive category.
    (iii) Y is not required to make adjustments pursuant to 
paragraph (c), (d) or (e) of this section. See paragraphs (b) and 
(e) of this section. Y's foreign source taxable income in the 
passive category after the adjustment pursuant to paragraph (a)(1) 
of this section is $600. Y's entire taxable income for the taxable 
year is $400.
    (iv) Y's section 904(f)(5)(D) amount is the excess of Y's 
foreign source taxable income in all separate categories in the 
aggregate for the taxable year after taking into account the 
adjustment pursuant to paragraph (a)(1) of this section ($600) over 
Y's entire taxable income for the taxable year ($400). Therefore, 
Y's section 904(f)(5)(D) amount is $200 and Y's foreign source 
taxable income in the passive category is reduced to $400. See 
section 904(f)(5)(D).
    Example 4. (i) Z, an individual, has the following items of 
ordinary income, ordinary loss and capital gain for the taxable 
year:

------------------------------------------------------------------------
                                                     Foreign source:
                                   U.S. source -------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group..................         $100   ...........  ...........
Ordinary income.................         (200)         $300         $300
------------------------------------------------------------------------

    (ii) Z's foreign source taxable income in all of Z's separate 
categories in the aggregate for the taxable year is $600. (There are 
no adjustments to Z's foreign source taxable income pursuant to 
paragraph (a)(1), (c)(1), (d) or (e) of this section.)
    (iii) In computing Z's entire taxable income in the denominator 
of the section 904(d) foreign tax credit limitation fractions, Z 
must adjust the $100 of net capital gain in the 15 percent rate 
group pursuant to paragraph (c)(2) of this section as follows: $100 
(15%/35%). Thus, Z's entire taxable income for the taxable year, 
taking into account the adjustment pursuant to paragraph (c)(2) of 
this section, is $442.86.
    (iv) Z's section 904(f)(5)(D) amount is the excess of Z's 
foreign source taxable income in all separate categories in the 
aggregate for the taxable year ($600) over Z's entire taxable income 
for the taxable year after the adjustment pursuant to paragraph 
(c)(2) of this section ($442.86). Therefore, Z's section 
904(f)(5)(D) amount is $157.32. This amount must be allocated pro 
rata to the passive and general limitation categories in accordance 
with section 904(f)(5)(D).
    Example 5. (i) O, an individual, has the following items of 
ordinary income, ordinary loss and capital gain for the taxable 
year:

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group.................        $1100         ($500)  ...........
Ordinary income................        (1000)         1000          $500
------------------------------------------------------------------------

    (ii) In determining O's taxable income from sources outside the 
United States, O must reduce the $500 capital loss in the general 
limitation category to $214.29 ($500 x 15%/35%) pursuant to 
paragraph (d) of this section. Taking this adjustment into account, 
O's foreign source taxable income in all of O's separate categories 
in the aggregate is $1285.71 ($1000 - $214.29 + $500).
    (iii) In computing O's entire taxable income in the denominator 
of the section 904(a) foreign tax credit limitation fraction, O must 
reduce the $600 of net capital gain for the year to $257.14 ($600 x 
15%/35%) pursuant to paragraph (c)(2) of this section. Taking this 
adjustment into account, O's entire taxable income for the year is 
$757.14 ($500 + $257.14).
    (iv) Therefore, O's section 904(f)(5)(D) amount is $528.57 
($1285.71 - $757.14). This amount must be allocated pro rata to O's 
$500 of income in the passive category and O's $785.71 of adjusted 
income in the general limitation category in accordance with section 
904(f)(5)(D).

    (i) Effective date. This section shall apply to taxable years 
beginning after July 20, 2004. Taxpayers may choose to apply this 
section and Sec.  1.904(b)-2 to taxable years ending after July 20, 
2004.

0
Par. 7. Section 1.904(b)-2 is revised to read as follows:


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

    (a) Application of section 904(b)(2)(B) adjustments. Section 
904(b)(2)(B) shall apply for purposes of determining the alternative 
minimum tax foreign tax credit under section 59 (regardless of whether 
or not the taxpayer has made an election under section 59(a)(4)).
    (b) Use of alternative minimum tax rates--(1) Taxpayers other than 
corporations. In the case of a taxpayer other than a corporation, for 
purposes of determining the alternative minimum tax foreign tax credit 
under section 59--
    (i) Section 904(b)(3)(D)(i) shall be applied by using the language 
``section 55(b)(3)'' instead of ``subsection (h) of section 1'';
    (ii) Section 904(b)(3)(E)(ii)(I) shall be applied by using the 
language ``section 55(b)(1)(A)(i)'' instead of ``subsection (a), (b), 
(c), (d), or (e) of section 1 (whichever applies)''; and
    (iii) Section 904(b)(3)(E)(iii)(I) shall be applied by using the 
language ``the alternative rate of tax determined under section 
55(b)(3)'' instead of ``the alternative rate of tax determined under 
section 1(h)''.
    (2) Corporate taxpayers. In the case of a corporation, for purposes 
of determining the alternative minimum tax foreign tax credit under 
section 59, section 904(b)(3)(E)(ii)(II) shall be applied by using the 
language ``section 55(b)(1)(B)'' instead of ``section 11(b)''.
    (c) Effective date. This section shall apply to taxable years 
beginning after July 20, 2004. See Sec.  1.904(b)-1(i) for a rule 
permitting taxpayers to choose to apply Sec.  1.904(b)-1(i) and this 
Sec.  1.904(b)-2 to taxable years ending after July 20, 2004.


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

0
Par. 8. Sections 1.904(b)-3 and 1.904(b)-4 are removed.
0
Par. 9. Section 1.904(j)-1 is added to read as follows:


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

    (a) Election available only if all foreign taxes are creditable 
foreign taxes. A taxpayer may elect to apply section 904(j) for a 
taxable year only if all of the taxes for which a credit is allowable 
to the taxpayer under section 901 for the taxable year (without regard

[[Page 43317]]

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

    Example 1. In 2006, X, a single individual using the cash basis 
method of accounting for income and foreign tax credits, pays $100 
of foreign taxes with respect to general limitation income that was 
earned and included in income for United States tax purposes in 
2005. The foreign taxes would be creditable under section 901 but 
are not shown on a payee statement furnished to X. X's only income 
for 2006 from sources outside the United States is qualified passive 
income, with respect to which X pays $200 of creditable foreign 
taxes shown on a payee statement. X may not elect to apply section 
904(j) for 2006 because some of X's foreign taxes are not creditable 
foreign taxes within the meaning of section 904(j)(3)(B).
    Example 2.  (i) In 2009, A, a single individual using the cash 
basis method of accounting for income and foreign tax credits, pays 
creditable foreign taxes of $250 attributable to passive income. 
Under section 904(c), A may also carry forward to 2009 $100 of 
unused foreign taxes paid in 2005 with respect to passive income, 
$300 of unused foreign taxes paid in 2005 with respect to general 
limitation income, $400 of unused foreign taxes paid in 2006 with 
respect to passive income, and $200 of unused foreign taxes paid in 
2006 with respect to general limitation income. In 2009, A's only 
foreign source income is passive income described in section 
904(j)(3)(A)(i), and this income is reported to A on a payee 
statement (within the meaning of section 6724(d)(2)). If A elects to 
apply section 904(j) for the 2009 taxable year, the unused foreign 
taxes paid in 2005 and 2006 are not deemed paid in 2009, and A 
therefore cannot claim a foreign tax credit for those taxes in 2009.
    (ii) In 2010, A again is eligible for and elects the application 
of section 904(j). The carryforwards from 2005 expire in 2010. The 
carryforward period established under section 904(c) is not extended 
by A's election under section 904(j). In 2011, A does not elect the 
application of section 904(j). The $600 of unused foreign taxes paid 
in 2006 on passive and general limitation income are deemed paid in 
2011, under section 904(c), without any adjustment for any portion 
of those taxes that might have been used as a foreign tax credit in 
2009 or 2010 if A had not elected to apply section 904(j) to those 
years.

    (d) Effective date. Section 1.904(j)-1 applies to taxable years 
beginning after July 20, 2004.
0
Par. 10. Section 1.954-2 is amended by:
0
1. Revising paragraph (b)(2)(iv), Example 2.
0
2. Removing paragraph (b)(2)(iv), Example 3.
    The revision reads as follows:


Sec.  1.954-2  Foreign personal holding company income.

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

Mark E. Matthews,
Deputy Commissioner of Services and Enforcement.
    Approved: June 16, 2004.
Gregory F. Jenner,
Acting Assistant Secretary for Tax Policy.
[FR Doc. 04-16374 Filed 7-19-04; 8:45 am]
BILLING CODE 4830-01-P