[Federal Register Volume 69, Number 151 (Friday, August 6, 2004)]
[Proposed Rules]
[Pages 47822-47828]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-17907]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-129771-04]
RIN 1545-BD49


Guidance Under Section 951 for Determining Pro Rata Share

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations under section 
951(a) of the Internal Revenue Code (Code) that provide guidance for 
determining a United States shareholder's pro rata share of a 
controlled foreign corporation's (CFC's) subpart F income, previously 
excluded subpart F income withdrawn from

[[Page 47823]]

investment in less developed countries, previously excluded subpart F 
income withdrawn from foreign base company shipping operations, and 
amounts determined under section 956. This document also provides 
notice of a public hearing on the proposed regulations.

DATES: Written or electronic comments must be received by November 4, 
2004. Outlines of topics to be discussed at the public hearing 
scheduled for Thursday, November 18, 2004, at 10 a.m. must be received 
by November 4, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-129771-04), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered between the 
hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-129771-04), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., 
Washington, DC, or sent electronically, via the IRS Internet site at 
http://www.irs.gov/regs or via the Federal eRulemaking Portal at http://www.regulations.gov (IRS and REG-129771-04). If a public hearing is 
scheduled, notice of the date, time, and place for the hearing will be 
published in the Federal Register.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jonathan A. Sambur, (202) 622-3840; concerning submissions of comments, 
the hearing, and/or to be placed on the building access list to attend 
the hearing, Sonya Cruse (202) 622-4693 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 951(a) of the Code relating to the determination of a United 
States shareholder's pro rata share of a CFC's subpart F income, 
previously excluded subpart F income withdrawn from investment in less 
developed countries, previously excluded subpart F income withdrawn 
from foreign base company shipping operations, and amounts determined 
under section 956 (collectively, section 951(a)(1) amounts).
    In general, section 951(a)(1) requires a United States shareholder 
that owns stock in a CFC to include its pro rata share of such section 
951(a)(1) amounts in its gross income. Pro rata share is defined in 
section 951(a)(2) of the Code as the amount:

    (A) Which would have been distributed with respect to the stock 
which such shareholder owns (within the meaning of section 958(a)) 
in such corporation if on the last day, in its taxable year, on 
which the corporation is a [CFC] it had distributed pro rata to its 
shareholders an amount (i) which bears the same ratio to its subpart 
F income for the taxable year, as (ii) the part of such year during 
which the corporation is a [CFC] bears to the entire year, reduced 
by
    (B) The amount of distributions received by any other person 
during such year as a dividend with respect to such stock, but only 
to the extent of the dividend which would have been received if the 
distribution by the corporation had been the amount (i) which bears 
the same ratio to the subpart F income of such corporation for the 
taxable year, as (ii) the part of such year during which such 
shareholder did not own (within the meaning of section 958(a)) such 
stock bears to the entire year.

    The current regulations provide rules for determining a United 
States shareholder's pro rata share of a CFC's section 951(a)(1) 
amounts in the case where the CFC has more than one class of stock 
outstanding. These regulations have remained unchanged since 1965. In 
the 39 years since the rules were issued, international business 
arrangements have become much more complex than contemplated in 1965, 
reflecting in particular more complex structures for determining return 
on capital. The current regulations do not take into account these 
developments. The IRS and Treasury Department, therefore, believe that 
updated guidance is necessary to ensure results that are more 
consistent with the economic interests of shareholders in a CFC.

Explanation of Provisions

A. In General

    Section 1.951-1(e) defines pro rata share for purposes of section 
951(a) of the Code. These proposed regulations replace existing Sec.  
1.951-1(e)(2) through (4) and are intended to provide allocations that 
are more consistent with the economic interests of shareholders in a 
CFC. The proposed regulations also include a conforming change to Sec.  
1.951-1(e)(1) to reflect the 1993 legislative amendment to section 956 
of the Code.

B. Pro Rata Share Rules for CFCs With Only One Class of Stock

    Proposed Sec.  1.951-1(e)(2) adds an explicit rule to clarify the 
method by which a United States shareholder's pro rata share of a CFC's 
section 951(a)(1) amounts is determined in the case where the CFC has 
only one class of stock outstanding. In such a case, each United States 
shareholder's share of the CFC's section 951(a)(1) amounts shall be 
determined on a per share basis. Example 1 of proposed Sec.  1.951-
1(e)(6) illustrates the application of this rule.

C. Pro Rata Share Rules for CFCs With More Than One Class of Stock

1. In General
    Proposed Sec.  1.951-1(e)(3) provides rules for determining a 
United States shareholder's pro rata share of a CFC's section 951(a)(1) 
amounts in the case where the CFC has more than one class of stock 
outstanding. Proposed Sec.  1.951-1(e)(3)(i) retains the general rule 
in the current regulations, which provides that the amount of subpart F 
income, withdrawals, or amounts determined under section 956 which 
shall be taken into account with respect to any one class of stock 
shall be that amount which bears the same ratio to the total of such 
subpart F income, withdrawals, or amounts determined under section 956 
for such year as the earnings and profits which would be distributed 
with respect to such class of stock if all earnings and profits of such 
corporation for such year were distributed on the last day of such 
corporation's taxable year on which such corporation is a CFC (the 
hypothetical distribution date) bear to the total earnings and profits 
of such corporation for such taxable year. Examples 2 and 8 of proposed 
Sec.  1.951-1(e)(6) illustrate the application of this general rule.
    This general rule applies in cases where a CFC has more than one 
class of stock outstanding and where the allocation of the amount of 
the CFC's earnings and profits between or among different classes of 
stock does not depend upon the exercise of discretion by the board of 
directors or similar governing body of the CFC. The IRS and Treasury 
Department believe that this general rule, in practice, will apply in 
most cases in which a CFC has more than one class of stock outstanding.
2. Discretionary Power To Allocate Earnings to Different Classes of 
Stock
    In the case where the allocation of the amount of a CFC's earnings 
and profits for the taxable year between two or more classes of stock 
depends upon the exercise of discretion by the board of directors or a 
similar governing body of the CFC, proposed Sec.  1.951-1(e)(3)(ii)(A) 
provides a new general rule that determines the pro rata share of the 
CFC's section 951(a)(1) amounts. This new general rule allocates 
earnings and profits to classes of shares with discretionary 
distribution rights by reference to the relative values of such classes 
of shares on the hypothetical distribution date. Under this new rule, 
the allocation of earnings and profits to each class of stock with 
discretionary distribution rights generally will be the amount of 
earnings and profits that

[[Page 47824]]

bears the same ratio to the total earnings and profits allocated to all 
classes of stock with discretionary distribution rights as the value of 
all shares of such class determined on the hypothetical distribution 
date bears to the total value of all classes of stock with 
discretionary distribution rights. This allocation approach is 
analogous to the approach used for allocating adjustments among classes 
of stock for consolidated return purposes. See Sec.  1.1502-32(c). For 
guidance with respect to the valuation of stock, see, e.g., Framatome 
Connectors USA, Inc. v. Comm'r, 118 T.C. 32 (2002) (establishing 
factors to be used to value stock of a CFC for purposes of determining 
whether the foreign corporation was a CFC pursuant to the value test in 
section 957(a)(2)); compare Rev. Rul. 59-60, 1959-1 C.B. 237 (valuing 
privately held stock for estate tax purposes). (See Sec.  
601.601(d)(2)(ii)(b)). In cases where the value of each share of two or 
more classes of stock with discretionary distribution rights is 
substantially the same, the allocation of earnings and profits to each 
class of stock shall be made as if such classes constituted one class 
of stock. Examples 3 and 4 of proposed Sec.  1.951-1(e)(6) illustrate 
the application of these rules.
    The general rules of proposed Sec.  1.951-1(e)(3)(i) and (ii)(A) 
both apply in certain cases where a CFC has more than two classes of 
stock outstanding. Specifically, these rules both apply where a CFC has 
at least two classes of stock with discretionary distribution rights 
and at least one class of stock with non-discretionary distribution 
rights. In general, a United States shareholder's pro rata share of a 
CFC's section 951(a)(1) amounts is determined by allocating earnings 
and profits to classes of shares with non-discretionary distribution 
rights (e.g., nonparticipating preferred stock) in accordance with the 
rules of proposed paragraph (e)(3)(i), and then allocating the 
remaining earnings and profits, if any, to each remaining class of 
stock in accordance with the relative value rules of proposed paragraph 
(e)(3)(ii)(A).
    The new rule in proposed Sec.  1.951-1(e)(3)(ii)(A) is intended to 
ensure that the determination of a United States shareholder's pro rata 
share of a CFC's section 951(a)(1) amounts in cases where the United 
States shareholder's stock has discretionary distribution rights 
properly reflects the true economics of the shareholder's investment in 
the CFC. The IRS and Treasury Department believe that in the case of 
multiple classes of stock with discretionary distribution rights, the 
relative value of the classes of stock better reflects the economics of 
the investment in a CFC, and thus provides a better mechanism for 
determining a United States shareholder's pro rata share of a CFC's 
section 951(a)(1) amounts.
    Proposed Sec.  1.951-1(e)(3)(ii)(B) provides that the right to 
redeem stock of a CFC will not be considered a discretionary 
distribution right for purposes of determining a shareholder's pro rata 
share under proposed Sec.  1.951-1(e)(3)(ii)(A), even if the resulting 
redemption would be treated as a distribution of property to which 
section 301 applies pursuant to section 302(d). Example 7 of proposed 
Sec.  1.951-1(e)(6) illustrates the application of this rule.
3. Special Allocation Rule for Stock With Mixed Distribution Rights
    Proposed Sec.  1.951-1(e)(3)(iii) provides a specific rule that 
applies the general rules of proposed Sec.  1.951-1(e)(3)(i) and 
(ii)(A) in cases where a class of stock provides for both non-
discretionary distribution rights and discretionary distribution rights 
(e.g., participating preferred stock). In such a case, the proposed 
regulations require separate allocations of earnings and profits based 
upon the non-discretionary distribution rights and the relative value 
of the discretionary distribution rights. Example 5 of proposed Sec.  
1.951-1(e)(6) illustrates the application of this rule.
4. Dividend Arrearages
    Proposed Sec.  1.951-1(e)(3)(iv) retains the existing rule with 
respect to arrearages in dividends with respect to classes of preferred 
stock of the CFC. The earnings and profits for the taxable year shall 
be attributable to such arrearage only to the extent the arrearage 
exceeds the earnings and profits remaining from prior taxable years 
beginning after December 31, 1962.

D. Scope of Deemed Distribution

    Proposed Sec.  1.951-1(e)(4) sets forth a special rule that 
provides that no amount shall be considered to be distributed with 
respect to a particular class of stock under proposed Sec.  1.951-
1(e)(3) to the extent that such a distribution would constitute a 
distribution in redemption of stock, a distribution in liquidation, or 
a return of capital. This rule would apply notwithstanding the terms of 
any class of stock of the CFC or any arrangement involving the CFC. 
Thus, for purposes of determining the allocation of earnings and 
profits to a class of stock of a CFC based on the earnings and profits 
which would be distributed with respect to such class of stock if all 
earnings and profits were distributed pro rata to its shareholders on 
the hypothetical distribution date, taxpayers may not consider any part 
of the hypothetical distribution as a distribution in redemption of 
stock (even if such redemption would be treated as a distribution of 
property to which section 301 applies pursuant to section 302(d)), a 
distribution in liquidation, or a return of capital. The IRS and 
Treasury Department believe that such characterizations of the 
hypothetical distribution would not properly reflect a United States 
shareholder's economic interest in the CFC and thus should not be 
considered in determining a United States shareholder's pro rata share 
of section 951(a)(1) amounts. Example 7 of proposed Sec.  1.951-1(e)(6) 
illustrates the application of this rule.

E. Restrictions or Other Limitations on Distributions of Earnings and 
Profits by a CFC

    Proposed Sec.  1.951-1(e)(5) provides that, except in the case of a 
governmental restriction described in section 964(b) of the Code, a 
restriction or other limitation on the distribution of earnings and 
profits to a United States shareholder by a CFC will not be taken into 
account for purposes of determining the amount of earnings and profits 
allocated to a class of stock of a CFC or the amount of the United 
States shareholder's pro rata share of the CFC's section 951(a)(1) 
amounts. This rule applies in all cases, including cases where the 
restriction or limitation is the result of an arrangement between 
unrelated parties or an arrangement that has a non-tax motivated 
business purpose and economic substance. The IRS and Treasury 
Department believe that taking into account such restrictions or 
limitations in determining a United States shareholder's pro rata share 
is contrary to the purpose of section 951(a) and would not properly 
reflect a United States shareholder's economic interest in the CFC. 
Example 6 of proposed Sec.  1.951-1(e)(6) illustrates the application 
of this rule.
    Proposed Sec.  1.951-1(e)(5)(ii) provides a broad definition of 
restrictions or other limitations on distributions that are covered by 
this rule. Under proposed Sec.  1.951-1(e)(5)(iii), the right to 
receive a preferred dividend is not considered a restriction or other 
limitation on the distribution of earnings and profits with respect to 
other classes of stock. Proposed Sec.  1.951-1(e)(5)(iv) lists some 
instances where restrictions or other limitations will not be taken 
into account.

[[Page 47825]]

Proposed Effective Date

    These regulations are proposed to apply for taxable years of a 
controlled foreign corporation beginning on or after January 1, 2005.

Special Analyses

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

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying. A public 
hearing has been scheduled for November 18, 2004, at 10 a.m. in the 
auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC. Due to building security procedures, visitors must 
enter at the Constitution Avenue entrance. In addition, all visitors 
must present photo identification to enter the building. Because of 
access restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 30 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments and an outline of the topics to be discussed and 
the time to be devoted to each topic (signed original and eight (8) 
copies) by November 4, 2004. A period of 10 minutes will be allotted to 
each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.
    Comments are requested on all aspects of the proposed regulations, 
including those aspects for which specific requests for comments are 
set forth above.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.951-1 is amended by:
    1. Removing the language ``increase in earnings invested in United 
States property'' in paragraph (e)(1) and adding ``amount determined 
under section 956'' in its place.
    2. Revising paragraphs (e)(2) through (e)(4) and adding paragraphs 
(e)(5) through (e)(7).
    The revisions and additions read as follows:


Sec.  1.951-1  Amounts included in gross income of United States 
shareholders.

* * * * *
    (e) * * *
    (2) One class of stock. If a controlled foreign corporation for a 
taxable year has only one class of stock outstanding, each United 
States shareholder's pro rata share of such corporation's subpart F 
income, withdrawal, or amount determined under section 956, for the 
taxable year under paragraph (e)(1) of this section shall be determined 
by allocating the controlled foreign corporation's earnings and profits 
on a per share basis.
    (3) More than one class of stock--(i) In general. Subject to 
paragraphs (e)(3)(ii) and (e)(3)(iii) of this section, if a controlled 
foreign corporation for a taxable year has more than one class of stock 
outstanding, the amount of such corporation's subpart F income, 
withdrawal, or amount determined under section 956, for the taxable 
year taken into account with respect to any one class of stock for 
purposes of paragraph (e)(1) of this section shall be that amount which 
bears the same ratio to the total of such subpart F income, withdrawal, 
or amount determined under section 956 for such year as the earnings 
and profits which would be distributed with respect to such class of 
stock if all earnings and profits of such corporation for such year 
were distributed on the last day of such corporation's taxable year on 
which such corporation is a controlled foreign corporation (the 
hypothetical distribution date), bear to the total earnings and profits 
of such corporation for such taxable year.
    (ii) Discretionary power to allocate earnings to different classes 
of stock--(A) In general. Subject to paragraph (e)(3)(iii) of this 
section, the rules of this paragraph apply for purposes of paragraph 
(e)(1) of this section if the allocation of a controlled foreign 
corporation's earnings and profits for the taxable year between two or 
more classes of stock depends upon the exercise of discretion by that 
body of persons which exercises with respect to such corporation the 
powers ordinarily exercised by the board of directors of a domestic 
corporation (discretionary distribution rights). First, the earnings 
and profits of the corporation are allocated under paragraph (e)(3)(i) 
of this section to any class or classes of stock with non-discretionary 
distribution rights (e.g., preferred stock entitled to a fixed return). 
Second, the amount of earnings and profits allocated to a class of 
stock with discretionary distribution rights shall be that amount which 
bears the same ratio to the remaining earnings and profits of such 
corporation for such taxable year as the value of all shares of such 
class of stock, determined on the hypothetical distribution date, bears 
to the total value of all shares of all classes of stock with 
discretionary distribution rights of such corporation, determined on 
the hypothetical distribution date. For purposes of the preceding 
sentence, in the case where the value of each share of two or more 
classes of stock with discretionary distribution rights is 
substantially the same on the hypothetical distribution date, the 
allocation of earnings and profits to such classes shall be made as if 
such classes constituted one class of stock in which each share has the 
same rights to dividends as any other share.

[[Page 47826]]

    (B) Special rule for redemption rights. For purposes of paragraph 
(e)(3)(ii)(A) of this section, discretionary distribution rights do not 
include rights to redeem shares of a class of stock (even if such 
redemption would be treated as a distribution of property to which 
section 301 applies pursuant to section 302(d)).
    (iii) Special allocation rule for stock with mixed distribution 
rights. For purposes of paragraphs (e)(3)(i) and (e)(3)(ii) of this 
section, in the case of a class of stock with both discretionary and 
non-discretionary distribution rights, earnings and profits shall be 
allocated to the non-discretionary distribution rights under paragraph 
(e)(3)(i) of this section and to the discretionary distribution rights 
under paragraph (e)(3)(ii) of this section. In such a case, paragraph 
(e)(3)(ii) of this section will be applied such that the value used in 
the ratio will be the value of such class of stock solely attributable 
to the discretionary distribution rights of such class of stock.
    (iv) Dividend arrearages. For purposes of paragraph (e)(3)(i) of 
this section, if an arrearage in dividends for prior taxable years 
exists with respect to a class of preferred stock of such corporation, 
the earnings and profits for the taxable year shall be attributed to 
such arrearage only to the extent such arrearage exceeds the earnings 
and profits of such corporation remaining from prior taxable years 
beginning after December 31, 1962.
    (4) Scope of deemed distribution. Notwithstanding the terms of any 
class of stock of the controlled foreign corporation or any agreement 
or arrangement with respect thereto, no amount shall be considered to 
be distributed with respect to a particular class of stock for purposes 
of paragraph (e)(3) of this section to the extent that such 
distribution would constitute a distribution in redemption of stock 
(even if such redemption would be treated as a distribution of property 
to which section 301 applies pursuant to section 302(d)), as a 
distribution in liquidation, or as a return of capital.
    (5) Restrictions or other limitations on distributions--(i) In 
general. A restriction or other limitation on distributions of earnings 
and profits by a controlled foreign corporation will not be taken into 
account, for purposes of this section, in determining the amount of 
earnings and profits that shall be allocated to a class of stock of the 
controlled foreign corporation or the amount of the United States 
shareholder's pro rata share of the controlled foreign corporation's 
subpart F income, withdrawal, or amounts determined under section 956 
for the taxable year.
    (ii) Definition. For purposes of this section, a restriction or 
other limitation on distributions includes any limitation that has the 
effect of limiting the allocation or distribution of earnings and 
profits by a controlled foreign corporation to a United States 
shareholder, other than currency or other restrictions or limitations 
imposed under the laws of any foreign country as provided in section 
964(b).
    (iii) Exception for certain preferred distributions. The right to 
receive periodically a fixed amount (whether determined by a percentage 
of par value, a reference to a floating coupon rate, a stated return 
expressed in terms of a certain amount of dollars or foreign currency, 
or otherwise) with respect to a class of stock the distribution of 
which is a condition precedent to a further distribution of earnings or 
profits that year with respect to any class of stock (not including a 
distribution in partial or complete liquidation) is not a restriction 
or other limitation on the distribution of earnings and profits by a 
controlled foreign corporation under paragraph (e)(5) of this section.
    (iv) Illustrative list of restrictions and limitations. Except as 
provided in paragraph (e)(5)(iii) of this section, restrictions or 
other limitations on distributions include, but are not limited to--
    (A) An arrangement that restricts the ability of the controlled 
foreign corporation to pay dividends on a class of shares of the 
corporation owned by United States shareholders until a condition or 
conditions are satisfied (e.g., until another class of stock is 
redeemed);
    (B) A loan agreement entered into by a controlled foreign 
corporation that restricts or otherwise affects the ability to make 
distributions on its stock until certain requirements are satisfied; or
    (C) An arrangement that conditions the ability of the controlled 
foreign corporation to pay dividends to its shareholders on the 
financial condition of the controlled foreign corporation.
    (6) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. (i) Facts. FC1, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 100 shares of 
one class of stock. Corp E, a domestic corporation and a United 
States shareholder of FC1, within the meaning of section 951(b), 
owns 60 shares. Corp H, a domestic corporation and a United States 
shareholder of FC1, within the meaning of section 951(b), owns 40 
shares. FC1, Corp E, and Corp H each use the calendar year as a 
taxable year. Corp E and Corp H are shareholders of FC1 for its 
entire 2004 taxable year. For 2004, FC1 has $100x of earnings and 
profits, and income of $100x with respect to which amounts are 
required to be included in gross income of United States 
shareholders under section 951(a). FC1 makes no distributions during 
that year.
    (ii) Analysis. FC1 has one class of stock. Therefore, under 
paragraph (e)(2) of this section, FC1's earnings and profits are 
allocated on a per share basis. Accordingly, for the taxable year 
2004, Corp E's pro rata share of FC1's subpart F income is $60x (60/
100 x $100x) and Corp H's pro rata share of FC1's subpart F income 
is $40x (40/100 x $100x).
    Example 2. (i) Facts. FC2, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 70 shares of 
common stock and 30 shares of 4-percent, nonparticipating, voting, 
preferred stock with a par value of $10x per share. The common 
shareholders are entitled to dividends when declared by the board of 
directors of FC2. Corp A, a domestic corporation and a United States 
shareholder of FC2, within the meaning of section 951(b), owns all 
of the common shares. Individual B, a foreign individual, owns all 
of the preferred shares. FC2 and Corp A each use the calendar year 
as a taxable year. Corp A and Individual B are shareholders of FC2 
for its entire 2004 taxable year. For 2004, FC1 has $50x of earnings 
and profits, and income of $50x with respect to which amounts are 
required to be included in gross income of United States 
shareholders under section 951(a). In 2004, FC2 distributes as a 
dividend $12x to Individual B with respect to Individual B's 
preferred shares. FC2 makes no other distributions during that year.
    (ii) Analysis. FC2 has two classes of stock, and there are no 
restrictions or other limitations on distributions within the 
meaning of paragraph (e)(5) of this section. If the total $50x of 
earnings were distributed on December 31, 2004, $12x would be 
distributed with respect to Individual B's preferred shares and the 
remainder, $38x, would be distributed with respect to Corp A's 
common shares. Accordingly, under paragraph (e)(3)(i) of this 
section, Corp A's pro rata share of FC1's subpart F income is $38x 
for taxable year 2004.
    Example 3. (i) Facts. The facts are the same as in Example 2, 
except that the shares owned by Individual B are Class B common 
shares and the shares owned by Corp A are Class A common shares and 
the board of directors of FC2 may declare dividends with respect to 
one class of stock without declaring dividends with respect to the 
other class of stock. The value of the Class A common shares on the 
last day of FC2's 2004 taxable year is $680x and the value of the 
Class B common shares on that date is $300x. The board of directors 
of FC2 determines that FC2 will not make any distributions in 2004 
with respect to the Class A and B common shares of FC2.
    (ii) Analysis. The allocation of FC2's earnings and profits 
between its Class A and Class B common shares depends solely on the 
exercise of discretion by the board of directors of FC2. Therefore, 
under paragraph

[[Page 47827]]

(e)(3)(ii)(A) of this section, the allocation of earnings and 
profits between the Class A and Class B common shares will depend on 
the value of each class of stock on the last day of the controlled 
foreign corporation's taxable year. On the last day of FC2's taxable 
year 2004, the Class A common shares had a value of $9.71x/share and 
the Class B common shares had a value of $10x/share. Because each 
share of the Class A and Class B common stock of FC2 has 
substantially the same value on the last day of FC2's taxable year, 
under paragraph (e)(3)(ii)(A) of this section, for purposes of 
allocating the earnings and profits of FC2, the Class A and Class B 
common shares will be treated as one class of stock. Accordingly, 
for FC2's taxable year 2004, the earnings and profits of FC2 are 
allocated $35x (70/100 x $50x) to the Class A common shares and $15x 
(30/100 x $50x) to the Class B common shares. For its taxable year 
2004, Corp A's pro rata share of FC2's subpart F income will be 
$35x.
    Example 4. (i) Facts. FC3, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 100 shares of 
Class A common stock, 100 shares of Class B common stock and 10 
shares of 5-percent nonparticipating, voting preferred stock with a 
par value of $50x per share. The value of the Class A shares on the 
last day of FC3's 2004 taxable year is $800x. The value of the Class 
B shares on that date is $200x. The Class A and Class B shareholders 
each are entitled to dividends when declared by the board of 
directors of FC3, and the board of directors of FC3 may declare 
dividends with respect to one class of stock without declaring 
dividends with respect to the other class of stock. Corp D, a 
domestic corporation and a United States shareholder of FC3, within 
the meaning of section 951(b), owns all of the Class A shares. Corp 
N, a domestic corporation and a United States shareholder of FC3, 
within the meaning of section 951(b), owns all of the Class B 
shares. Corp S, a domestic corporation and a United States 
shareholder of FC3, within the meaning of section 951(b), owns all 
of the preferred shares. FC3, Corp D, Corp N, and Corp S each use 
the calendar year as a taxable year. Corp D, Corp N, and Corp S are 
shareholders of FC3 for all of 2004. For 2004, FC3 has $100x of 
earnings and profits, and income of $100x with respect to which 
amounts are required to be included in gross income of United States 
shareholders under section 951(a). In 2004, FC3 distributes as a 
dividend $25x to Corp S with respect to the preferred shares. The 
board of directors of FC3 determines that FC3 will make no other 
distributions during that year.
    (ii) Analysis. The distribution rights of the preferred shares 
are not a restriction or other limitation within the meaning of 
paragraph (e)(5) of this section. Pursuant to paragraph (e)(3)(i) of 
this section, if the total $100x of earnings were distributed on 
December 31, 2004, $25x would be distributed with respect to Corp 
S's preferred shares and the remainder, $75x would be distributed 
with respect to Corp D's Class A shares and Corp N's Class B shares. 
The allocation of that $75x between its Class A and Class B shares 
depends solely on the exercise of discretion by the board of 
directors of FC3. The value of the Class A shares ($8x/share) and 
the value of the Class B shares ($2x/share) are not substantially 
the same on the last day of FC3's taxable year 2004. Therefore for 
FC3's taxable year 2004, under paragraph (e)(3)(ii)(A) of this 
section, the earnings and profits of FC3 are allocated $60x ($800/
$1,000 x $75x) to the Class A shares and $15x ($200/$1,000 x $75x) 
to the Class B shares. For the 2004 taxable year, Corp D's pro rata 
share of FC3's subpart F income will be $60x, Corp N's pro rata 
share of FC3's subpart F income will be $15x and Corp S's pro rata 
share of FC3's subpart F income will be $25x.
    Example 5. (i) Facts. FC4, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 40 shares of 
participating, voting, preferred stock and 200 shares of common 
stock. The owner of a share of preferred stock is entitled to an 
annual dividend equal to 0.5-percent of FC4's retained earnings for 
the taxable year and also is entitled to additional dividends when 
declared by the board of directors of FC4. The common shareholders 
are entitled to dividends when declared by the board of directors of 
FC4. The board of directors of FC4 has discretion to pay dividends 
to the participating portion of the preferred shares (after the 
payment of the preference) and the common shares. The value of the 
preferred shares on the last day of FC4's 2004 taxable year is $600x 
($100x of this value is attributable to the discretionary 
distribution rights of these shares) and the value of the common 
shares on that date is $400x. Corp E, a domestic corporation and 
United States shareholder of FC4, within the meaning of section 
951(b), owns all of the preferred shares. FC5, a foreign corporation 
that is not a controlled foreign corporation within the meaning of 
section 957(a), owns all of the common shares. FC4 and Corp E each 
use the calendar year as a taxable year. Corp E and FC5 are 
shareholders of FC4 for all of 2004. For 2004, FC4 has $100x of 
earnings and profits, and income of $100x with respect to which 
amounts are required to be included in gross income of United States 
shareholders under section 951(a). In 2004, FC4's retained earnings 
are equal to its earnings and profits. FC4 distributes as a dividend 
$20x to Corp E that year with respect to Corp E's preferred shares. 
The board of directors of FC4 determines that FC4 will not make any 
other distributions during that year.
    (ii) Analysis. The non-discretionary distribution rights of the 
preferred shares are not a restriction or other limitation within 
the meaning of paragraph (e)(5) of this section. The allocation of 
FC4's earnings and profits between its preferred shares and common 
shares depends, in part, on the exercise of discretion by the board 
of directors of FC4 because the preferred shares are shares with 
both discretionary distribution rights and non-discretionary 
distribution rights. Paragraph (e)(3)(i) of this section is applied 
first to determine the allocation of earnings and profits of FC4 to 
the non-discretionary distribution rights of the preferred shares. 
If the total $100x of earnings were distributed on December 31, 
2004, $20x would be distributed with respect to the non-
discretionary distribution rights of Corp E's preferred shares. 
Accordingly, $20x would be allocated to such shares under paragraphs 
(e)(3)(i) and (iii) of this section. The remainder, $80x, would be 
allocated under paragraph (e)(3)(ii)(A) and (e)(3)(iii) of this 
section between the preferred and common shareholders by reference 
to the value of the discretionary distribution rights of the 
preferred shares and the value of the common shares. Therefore, the 
remaining $80x of earnings and profits of FC4 are allocated $16x 
($100x/$500x x $80x) to the preferred shares and $64x ($400x/$500x x 
$80) to the common shares. For its taxable year 2004, Corp E's pro 
rata share of FC4's subpart F income will be $36x ($20x + $16x).
    Example 6. (i) Facts. FC6, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 10 shares of 
common stock and 400 shares of 2-percent nonparticipating, voting, 
preferred stock with a par value of $1x per share. The common 
shareholders are entitled to dividends when declared by the board of 
directors of FC6. Corp M, a domestic corporation and a United States 
shareholder of FC6, within the meaning of section 951(b), owns all 
of the common shares. FC7, a foreign corporation that is not a 
controlled foreign corporation within the meaning of section 957(a), 
owns all of the preferred shares. Corp M and FC7 cause the governing 
documents of FC6 to provide that no dividends may be paid to the 
common shareholders until FC6 cumulatively earns $100,000x of 
income. FC6 and Corp M each use the calendar year as a taxable year. 
Corp M and FC7 are shareholders of FC6 for all of 2004. For 2004, 
FC6 has $50x of earnings and profits, and income of $50x with 
respect to which amounts are required to be included in gross income 
of United States shareholders under section 951(a). In 2004, FC6 
distributes as a dividend $8x to FC7 with respect to FC7's preferred 
shares. FC6 makes no other distributions during that year.
    (ii) Analysis. The agreement restricting FC6's ability to pay 
dividends to common shareholders until FC6 cumulatively earns 
$100,000x of income is a restriction or other limitation, within the 
meaning of paragraph (e)(5) of this section, and will be disregarded 
for purposes of calculating Corp M's pro rata share of subpart F 
income. The non-discretionary distribution rights of the preferred 
shares are not a restriction or other limitation within the meaning 
of paragraph (e)(5) of this section. If the total $50x of earnings 
were distributed on December 31, 2004, $8x would be distributed with 
respect to FC7's preferred shares and the remainder, $42x, would be 
distributed with respect to Corp M's common shares. Accordingly, 
under paragraph (e)(3)(i) of this section, Corp M's pro rata share 
of FC6's subpart F income is $42x for taxable year 2004.
    Example 7. (i) Facts. FC8, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 40 shares of 
common stock and 10 shares of 4-percent voting preferred stock with 
a par value of $50x per share. Pursuant to the terms of the 
preferred stock, FC8 has the right to redeem at any time, in whole 
or in part, the preferred stock. FP, a foreign corporation, owns all 
of the preferred shares. Corp G, a domestic corporation wholly owned 
by FP and a

[[Page 47828]]

United States shareholder of FC8, within the meaning of section 
951(b), owns all of the common shares. FC8 and Corp G each use the 
calendar year as a taxable year. FP and Corp G are shareholders of 
FC8 for all of 2004. For 2004, FC8 has $100x of earnings and 
profits, and income of $100x with respect to which amounts are 
required to be included in gross income of United States shareholder 
under section 951(a). In 2004, FC8 distributes as a dividend $20x to 
FP with respect to FP's preferred shares. FC8 makes no other 
distributions during that year.
    (ii) Analysis. Pursuant to paragraph (e)(3)(ii)(B) of this 
section, the redemption rights of the preferred shares will not be 
treated as a discretionary distribution right under paragraph 
(e)(3)(ii)(A) of this section. Further, if FC8 were treated as 
having redeemed any preferred shares under paragraph (e)(3)(i) of 
this section, the redemption would be treated as a distribution to 
which section 301 applies under section 302(d) due to FP's 
constructive ownership of the common shares. However, pursuant to 
paragraph (e)(4) of this section, no amount of earnings and profits 
would be allocated to the preferred shareholders on the hypothetical 
distribution date, under paragraph (e)(3)(i) of this section, as a 
result of FC8's right to redeem, in whole or in part, the preferred 
shares. FC8's redemption rights with respect to the preferred shares 
cannot affect the allocation of earnings and profits between FC8's 
shareholders. Therefore, the redemption rights are not restrictions 
or other limitations within the meaning of paragraph (e)(5) of this 
section. Additionally, the non-discretionary distribution rights of 
the preferred shares are not restrictions or other limitations 
within the meaning of paragraph (e)(5) of this section. Therefore, 
if the total $100x of earnings were distributed on December 31, 
2004, $20x would be distributed with respect to FP's preferred 
shares and the remainder, $80x, would be distributed with respect to 
Corp G's common shares. Accordingly, under paragraph (e)(3)(i) of 
this section, Corp G's pro rata share of FC8's subpart F income is 
$80 for taxable year 2004.
    Example 8. (i) Facts. FC9, a controlled foreign corporation 
within the meaning of section 957(a), has outstanding 40 shares of 
common stock and 60 shares of 6-percent, nonparticipating, 
nonvoting, preferred stock with a par value of $100x per share. 
Individual J, a United States shareholder of FC9, within the meaning 
of section 951(b), who uses the calendar year as a taxable year, 
owns 30 shares of the common stock, and 15 shares of the preferred 
stock during tax year 2004. The remaining 10 common shares and 45 
preferred shares of FC9 are owned by Foreign Individual N, a foreign 
individual. Individual J and Individual N are shareholders of FC9 
for all of 2004. For taxable year 2004, FC9 has $1,000x of earnings 
and profits, and income of $500x with respect to which amounts are 
required to be included in gross income of United States 
shareholders under section 951(a).
    (ii) Analysis. The non-discretionary distribution rights of the 
preferred shares are not a restriction or other limitation within 
the meaning of paragraph (e)(5) of this section. If the total 
$1,000x of earnings and profits were distributed on December 31, 
2004, $360x (0.06 x $100x x 60) would be distributed with respect to 
FC9's preferred stock and $640x ($1,000x minus $360x) would be 
distributed with respect to its common stock. Accordingly, of the 
$500x with respect to which amounts are required to be included in 
gross income of United States shareholders under section 951(a), 
$180x ($360x/$1,000x x $500x) is allocated to the outstanding 
preferred stock and $320x ($640x/$1,000x x $500x) is allocated to 
the outstanding common stock. Therefore, under paragraph (e)(3)(i) 
of this section, Individual J's pro rata share of such amounts for 
2004 is $285x [($180x x 15/60)+($320x x 30/40)].

    (7) Effective date. These regulations apply for taxable years of a 
controlled foreign corporation beginning on or after January 1, 2005.

    Approved: July 16, 2004.
Nancy Jardini,
Acting Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-17907 Filed 8-5-04; 8:45 am]
BILLING CODE 4830-01-P