[Federal Register Volume 71, Number 152 (Tuesday, August 8, 2006)]
[Rules and Regulations]
[Pages 44887-44914]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-6740]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9273]
RIN 1545-AX65


Stock Transfer Rules: Carryover of Earnings and Taxes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations addressing the 
carryover of certain tax attributes, such as earnings and profits and 
foreign income tax accounts, when two corporations combine in a 
corporate reorganization or liquidation that is described in both 
section 367(b) and section 381 of the Internal Revenue Code (Code).

DATES: Effective Date: These regulations are effective August 8, 2006.
    Applicability Date: These regulations apply to certain section 
367(b) exchanges that occur on or after November 6, 2006.

FOR FURTHER INFORMATION CONTACT: Jeffrey L. Parry at (202) 622-3850 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    The Treasury Department and the IRS issued final regulations 
''1.367(b)-1 through 1.367(b)-6, dealing with tax consequences of 
certain foreign-to-foreign and inbound corporate transactions, in June 
1998 and January 2000 (the January 2000 final regulations). The 
preamble to the January 2000 final regulations referred to proposed 
regulations that would be issued to address the carryover of certain 
corporate tax attributes in transactions involving one or more foreign 
corporations. Those proposed regulations were issued on November 15, 
2000, in the Federal Register ((65 FR 69138) (REG-116050-99)) (the 2000 
proposed regulations). The public hearing with respect to the 2000 
proposed regulations was cancelled because no request to speak was 
received. However, the Treasury Department and the IRS received and 
considered several written comments, which are discussed in this 
preamble.
    After consideration of the 2000 proposed regulations and the 
comments received, the Treasury Department and the IRS adopt 
substantial portions of those proposed regulations with significant 
modifications as final regulations under section 367(b).

Overview

A. General Policies of Section 367(b)

    In general, section 367 governs corporate restructurings under 
sections 332, 351, 354, 355, 356, and 361 (Subchapter C nonrecognition 
transactions) in which the status of a foreign corporation as a 
``corporation'' is necessary for the application of the relevant 
Subchapter C nonrecognition provisions. Other provisions in Subchapter 
C (Subchapter C carryover provisions) apply to such transactions in 
conjunction with the enumerated provisions and detail additional 
consequences that occur in connection with the transactions. For 
example, sections 362 and 381 govern the carryover of basis and 
earnings and profits from the transferor corporation to the transferee 
corporation in applicable transactions.
    The Subchapter C carryover provisions generally are drafted to 
apply to domestic corporations and U.S. shareholders. As a result, 
those provisions often do not fully take into account the relevant 
cross-border aspects of U.S. taxation. For example, section 381 does 
not specifically take into account source and foreign tax credit issues 
that arise when earnings and profits move from one corporation to 
another.
    Congress enacted section 367(b) to ensure that international tax 
considerations in the Code are adequately addressed when the Subchapter 
C provisions apply to an exchange involving a foreign corporation. A 
primary consideration in this regard is to prevent the avoidance of 
U.S. taxation. Because determining the proper interaction of the Code's 
international and Subchapter C provisions is ``necessarily highly 
technical,'' Congress granted the Secretary broad regulatory authority 
to provide the ``necessary or appropriate'' rules rather than enacting 
a more comprehensive statutory regime. H.R. Rep. No. 658, 94th Cong., 
1st Sess. 241 (1975). Thus, section 367(b)(2) provides in part that the 
regulations ``shall include (but shall not be limited to) regulations * 
* * providing * * * the extent to which adjustments shall be made to 
earnings and profits, basis of stock or securities, and basis of 
assets.''
    These final regulations address the carryover of foreign earnings 
and profits and foreign income taxes in tax-free corporate asset 
acquisitions by generally applying the principles of Subchapter C 
provisions such as section 381, which governs the carryover of earnings 
and profits (and other tax attributes) in certain tax-free corporate 
reorganizations described in section 368 and in corporate liquidations 
described in section 332. However, these regulations (like the 2000 
proposed regulations) modify certain of the mechanics of the Subchapter 
C rules as necessary or appropriate to ensure that those rules are as 
consistent as possible with key international tax policies of the Code 
and to prevent material distortions of income.
    These final regulations address the portions of the 2000 proposed 
regulations (Prop. Reg.) dealing with inbound nonrecognition 
transactions (Prop. Reg. Sec.  1.367(b)-3) and foreign section 381 
transactions (Prop. Reg. Sec.  1.367(b)-7). They also address the 
special rules of Prop. Reg. Sec.  1.367-9. The final regulations, 
however, do not address the portions of the 2000 proposed regulations 
involving corporate divisions of one or more foreign corporations 
(Prop. Reg. Sec.  1.367(b)-8). The Treasury Department and the IRS 
believe that relevant cross-border tax consequences of section 355 
transactions should be dealt with in a separate guidance project.

[[Page 44888]]

B. Specific Policies Related to Inbound Nonrecognition Transactions 
(Sec.  1.367(b)-3)

    Section 1.367(b)-3 addresses acquisitions by a domestic corporation 
(domestic acquiring corporation) of the assets of a foreign corporation 
(foreign acquired corporation) in a section 332 liquidation or an asset 
acquisition described in section 368(a)(1), such as an A, C, D, or F 
reorganization (inbound nonrecognition transaction). Regulations 
applying section 367 and section 368 to cross-border A reorganizations 
were recently issued. See TD 9242 (2006-7 I.R.B. 422).
    As a general policy matter, the importation of various tax 
attributes in inbound transactions is carefully scrutinized. In fact, 
inbound importation issues have been the subject of recent legislative 
reforms (see section 362(e)). The policy relating to importation of tax 
attributes also has been reflected in prior section 367 regulations. 
For example, the preamble to the January 2000 final regulations 
generally describes international policy issues that can arise in 
inbound nonrecognition transactions. The preamble states that the 
``principal policy consideration of section 367(b) with respect to 
inbound nonrecognition transactions is the appropriate carryover of 
attributes from foreign to domestic corporations. This consideration 
has interrelated shareholder-level and corporate-level components.'' 
The January 2000 final regulations clarify that a domestic acquiring 
corporation succeeds to those foreign taxes paid or accrued by a 
foreign target corporation only to the extent those taxes are eligible 
for credit under section 906.
    The preamble to the January 2000 final regulations also notes that 
it would be consistent with the policy considerations of section 367(b) 
for future regulations to provide additional rules with respect to the 
extent to which attributes carry over from a foreign corporation to a 
U.S. corporation. Accordingly, the 2000 proposed regulations provided 
rules concerning several attributes, specifically net operating loss 
and capital loss carryovers, and earnings and profits that are not 
included in income as an all earnings and profits amount (or a deficit 
in earnings and profits). The 2000 proposed regulations generally 
provided that these tax attributes carry over from a foreign acquired 
corporation to a domestic acquiring corporation only to the extent that 
they are effectively connected with a U.S. trade or business (or 
attributable to a permanent establishment, in the case of an applicable 
U.S. income tax treaty). These final regulations adopt the rules set 
forth in the 2000 proposed regulations.

C. Specific Policies Related to Foreign Section 381 Transactions (Sec.  
1.367(b)-7)

    Section 1.367(b)-7 applies to an acquisition by a foreign 
corporation (foreign acquiring corporation) of the assets of another 
foreign corporation (foreign target corporation) in a transaction 
described in section 381 (foreign section 381 transaction) and 
addresses the manner in which earnings and profits and foreign income 
taxes of the foreign acquiring corporation and foreign target 
corporation carry over to the surviving foreign corporation (foreign 
surviving corporation). These rules apply, for example, to A, C, D, or 
F reorganizations or section 332 liquidations between two foreign 
corporations.
    The principal Code sections implicated by the carryover of earnings 
and profits and foreign income taxes in a foreign section 381 
transaction are sections 381, 902, 904, and 959. Section 381 generally 
permits earnings and profits (or deficit in earnings and profits) to 
carry over to a surviving corporation, thus enabling ``the successor 
corporation to step into the `tax shoes' of its predecessor. * * * 
[and] represents the economic integration of two or more separate 
businesses into a unified business enterprise.'' H. Rep. No. 1337, 83rd 
Cong. 2nd Sess. 41 (1954). However, a deficit in earnings and profits 
of either the transferee or transferor corporation can only be used to 
offset earnings and profits accumulated after the date of transfer. 
Section 381(c)(2)(B). This is commonly known as the ``hovering deficit 
rule''. The hovering deficit rule is a legislative mechanism designed 
to deter the trafficking in favorable tax attributes that the IRS and 
courts had repeatedly encountered. See, for example, Commissioner v. 
Phipps, 336 U.S. 410 (1949) final regulations generally adopt the 
principles of section 381 in the cross-border context, but adapt the 
operation of those rules in consideration of the international 
provisions, such as sections 902, 904, and 959, that address foreign 
corporations' earnings and profits and their related foreign income 
taxes. Thus, for example, these final regulations apply the section 381 
earnings and profits combination and deficit rules by reference to the 
separate categories income described in section 904(d) and elsewhere 
(baskets) that are used to compute foreign tax credit limitations.
    Section 902 generally provides that a deemed paid foreign tax 
credit is available to a domestic corporation that receives a dividend 
from a foreign corporation in which it owns 10 percent or more of the 
voting stock. The Code computes deemed-paid taxes with regard to 
dividends from a relevant foreign corporation by looking first to the 
multi-year pools of earnings and profits accumulated (and related 
foreign income taxes paid or deemed paid) in taxable years beginning 
after December 31, 1986, or beginning with the first year in which a 
domestic corporation owns 10 percent or more of the voting stock of the 
foreign corporation, whichever is later. Section 902(c). (The Code and 
regulations refer to pooled earnings and profits and foreign income 
taxes as post-1986 undistributed earnings and post-1986 foreign income 
taxes even though a particular corporation may not begin to maintain 
multi-year pools until after 1986. Sections 902(c)(1) and (2), Sec.  
1.902-1(a)(8) and (9).)
    Congress enacted the pooling rules because it believed that 
blending foreign income taxes and earnings and profits into ``pools'' 
from which distributions are made was fairer and more appropriate than 
computing deemed-paid taxes with reference to annual layers of earnings 
and profits (and foreign income taxes). Joint Committee on Taxation, 
99th Cong., 2nd sess., General Explanation of the Tax Reform Act of 
1986 (JCS-10-87) (1986 Bluebook), at 870 (May 4, 1987). Averaging 
foreign income taxes through these blended pools prevents taxpayers 
from inflating their foreign subsidiary's effective tax rate for a 
particular year in order to obtain artificially enhanced foreign tax 
credits. Id. Averaging also prevents the loss of credits for foreign 
income taxes that are trapped in years in which a foreign subsidiary 
has no earnings and profits for U.S. tax purposes. Id.
    However, Congress enacted pooling on a limited basis. Earnings and 
profits accumulated (and related foreign income taxes paid or deemed 
paid) in taxable years before the first year a foreign corporation 
qualifies as a pooling corporation and pre-1987 earnings and profits 
accumulated (and related foreign income taxes paid or deemed paid) by a 
pooling corporation are not subject to the pooling rules. Rather, such 
earnings and profits (and related foreign income taxes) are maintained 
in separate annual layers. Section 902(c)(6). The Code and regulations 
refer to earnings and profits and foreign income taxes in annual layers 
as pre-1987 accumulated profits and pre-1987 foreign income taxes even

[[Page 44889]]

though a particular corporation may have annual layers for years after 
1986 (because of the absence of the requisite domestic corporate 
shareholder). Section 902(c)(6); Sec.  1.902-1(a)(10).
    A distribution of earnings and profits is treated as first out of 
pooled earnings and profits and then, only after all pooled earnings 
and profits have been distributed, out of annual layers of earnings and 
profits on a LIFO basis. Section 902(a) and (c). The retention of 
annual layers beneath pooled earnings and profits limits the need to 
recreate tax histories, an administrative burden that is more 
significant for periods during which a corporation had limited nexus to 
the U.S. taxing jurisdiction and for pre-1987 earnings and profits when 
pooling was not required.
    The foreign tax credit limitation ensures that taxpayers can use 
foreign tax credits only to offset U.S. tax on foreign source income. 
The limitation is computed separately with respect to different baskets 
of income derived from different types of activities. (From 1987 
through 2006, section 904 provides for eight different baskets of 
income; for tax years beginning after December 31, 2006, all but two 
section 904(d) baskets of income are eliminated. Separate baskets 
described in other Code sections such as sections 56(g)(4)(C)(iii)(IV), 
245(a)(10), 865(h), 901(j), and 904(g)(10) will continue in effect 
after 2006. The American Jobs Creation Act of 2004, Public Law 108-357, 
118 Stat. 1418 (AJCA), section 404(a).) The purpose of the baskets is 
to limit taxpayers' ability to cross-credit taxes imposed with respect 
to different categories of income. Congress was concerned that, without 
separate limitations, cross-crediting opportunities would distort 
economic incentives as to whether to invest in the United States or 
abroad. 1986 Bluebook at 862.
    Another international provision implicated by the movement of 
earnings and profits in foreign section 381 transactions is section 
959. Section 959 governs the distribution of earnings and profits that 
represent income that has been previously taxed to U.S. shareholders 
under section 951(a) (PTI). After studying the interaction of section 
367(b) and the PTI rules, the Treasury Department and the IRS 
determined that more guidance under section 959 would be useful before 
issuing regulations to address PTI issues that arise under section 
367(b). Accordingly, the Treasury Department and the IRS have opened a 
separate regulations project under section 959 and expect to issue 
regulations that address PTI issues under section 959 in the future. 
Because this project is still ongoing, these final regulations reserve 
on section 367(b) issues related to PTI. Guidance in this area will 
come in a separate project.

Summary of Comments Received and Changes Made

A. Inbound Nonrecognition Transactions

    A comment was received regarding the provision under the 2000 
proposed regulations that limits the carryover of earnings and profits 
(or deficit in earnings and profits) from a foreign corporation to a 
domestic corporation in an inbound nonrecognition transaction to those 
earnings and profits that are effectively connected with the conduct of 
a trade or business within the United States (or are attributable to a 
permanent establishment in the United States, in the context of an 
applicable U.S. income tax treaty). The comment suggests that there are 
better ways to avoid the two most significant problems of importing 
foreign earnings into domestic corporate solution: Potential dividends-
received deductions on subsequent distribution of the previously 
untaxed foreign earnings, and taxing distributions of previously taxed 
earnings and profits described in section 959. The comment goes on to 
state that, in particular, eliminating deficits but taxing positive 
earnings on an inbound nonrecognition transaction by way of the all 
earnings and profits inclusion under Sec.  1.367(b)-3 is inappropriate.
    The Treasury Department and the IRS have considered this comment. 
While the comment identifies asymmetries in the tax treatment of 
inbound reorganizations, on balance the Treasury Department and the IRS 
believe that the 2000 proposed regulations reached the appropriate 
result. As indicated above, the importation of favorable tax attributes 
has been subject to greater scrutiny in recent years. See, for example, 
section 362(e). In that context, it is not appropriate to provide for 
the carryover of deficits or of earnings and profits in excess of the 
all earnings and profits inclusion. This conclusion also has the 
benefit of administrative ease for taxpayers and the IRS. Accordingly, 
these final regulations do not modify the rules regarding inbound 
nonrecognition transactions as set forth in the 2000 proposed 
regulations, except to reserve on the treatment of PTI for further 
consideration.

B. Paradigm Based on Pooling Rather Than Look-Through

    The structure of the 2000 proposed regulations was based in large 
part on the categorization of foreign acquiring, target, and surviving 
corporations as look-through corporations, non-look-through 
corporations, or less-than-10%-U.S.-owned foreign corporations. Under 
the international provisions of the Code in effect at the time the 2000 
proposed regulations were published, a look-through-corporation 
included a controlled foreign corporation as defined in section 957 
(CFC) or a noncontrolled section 902 corporation as defined in section 
904(d)(2)(E) after 2003 (a look-through 10/50 corporation), the 
effective date of section 1105(b) of Public Law 105-34 (111 Stat. 788) 
(the 1997 Act). A non-look-through corporation was a noncontrolled 
section 902 corporation before 2003 (non-look-through 10/50 
corporation) and a less-than-10%-U.S.-owned foreign corporation was a 
foreign corporation that was neither a CFC nor a 10/50 corporation.
    The pools of earnings and profits and foreign taxes associated with 
these three categories of corporations were referred to as the look-
through pool, the non-look-through pool, and the pre-pooling annual 
layers, respectively. A number of statutory and regulatory changes that 
have occurred since the time the 2000 proposed regulations were 
published, however, have necessitated appropriate changes (and 
simplification) in the organizational paradigm for these final 
regulations.
    At the time the 2000 proposed regulations were issued (and 
continuing prior to the AJCA), the treatment of dividends from a 10/50 
corporation paid after 2002 varied according to the year in which the 
earnings and profits from which the dividend was paid were accumulated. 
The look-through approach applied to dividends paid out of earnings and 
profits accumulated after 2002, whereas dividends paid out of earnings 
and profits accumulated prior to 2003 were subject to a single separate 
limitation for dividends from all 10/50 corporations. Joint Committee 
on Taxation, 105th Cong., 1st sess., General Explanation of Tax 
Legislation enacted in 1997 (JCS-23-97), at 303 (December 17, 1997). 
The AJCA conference report indicates that Congress changed the 
treatment of dividends from 10/50 corporations for purposes of 
simplification. H.R. Rep. No. 108-548, pt. 1 at 192 (2004).
    In 2004, Congress amended the Code (the 2004 amendment) to provide 
that any dividend paid by a noncontrolled section 902 corporation (10/
50 corporation), as defined in section 904(d)(2)(E), to a 10 percent or 
greater U.S. corporate shareholder is treated as income in a basket 
based on the ratio of the earnings and profits attributable to income 
in such basket to the foreign

[[Page 44890]]

corporation's total earnings and profits (the ``look-through'' 
approach). AJCA, section 403. The 2004 amendment was effective 
retroactively, for taxable years beginning after December 31, 2002. 
Section 403(l) of the Gulf Opportunity Zone Act of 2005, Public Law 
109-135 (119 Stat. 2577), permitted taxpayers to elect to defer the 
effective date of the 2004 amendment to taxable years beginning after 
December 31, 2004.
    Also, as part of the 2004 amendment, dividends paid to 10% domestic 
corporate shareholders of a CFC are eligible for look-through 
treatment, even if they are paid out of earnings that were accumulated 
while the corporation was not a CFC. Section 904(d)(4); see also Sec.  
1.904-7T(f)(3) and (6). Prior to the effective date of the 2004 
amendment, dividends paid out of such earnings were subject to a 
separate limitation. See 26 CFR 1.904-4(g)(2)(ii) (revised as of April 
1, 2006).
    As a result of the 2004 amendment, the terms non-look-through 10/50 
corporation and the related non-look-through pool as defined in the 
2000 proposed regulations have become obsolete and therefore have been 
eliminated in these final regulations. More generally, in light of the 
broader availability of look-through treatment to earnings paid out of 
pre-pooling annual layers, the Treasury Department and the IRS believe 
that a paradigm centered on look-through or non-look-through status is 
less relevant. Accordingly, the organization of these final regulations 
is based on the categorization of foreign acquiring, target, and 
surviving corporations as pooling or nonpooling corporations. The 
relevant pools of earnings and profits and associated foreign taxes are 
referred to as post-1986 pools and pre-pooling annual layers. 
Qualifying shareholders are eligible for look-through treatment on 
dividends out of post-1986 pools and pre-pooling annual layers to the 
extent provided in section 904(d)(3) and (4).

C. Hovering Deficits and Section 316

    Comments were received regarding the application under the 2000 
proposed regulations of the hovering deficit rules on a ``basket-by-
basket'' basis. Under the 2000 proposed regulations, a pre-transaction 
deficit in a particular basket is generally subject to the hovering 
deficit rule of section 381. As a result, that deficit is not taken 
into account in determining the current or accumulated earnings and 
profits of the surviving corporation for any purpose, including for 
purposes of determining dividends under section 316 and for determining 
foreign tax credits under section 902. However, any such pre-
transaction deficits in earnings and profits may be used to offset a 
foreign surviving corporation's accumulated (but not current) post-
transaction earnings and profits in the same basket as the deficit.
    Several comments noted that, in certain circumstances, this rule 
can give rise to hovering deficits from one (or both) of the merging 
corporations even if it (or they) had aggregate positive earnings and 
profits immediately prior to the section 381 transaction. In addition, 
if one (or both) of the merging corporations' pre-transaction earnings 
consist both of positive earnings in one basket and a deficit in 
another basket, the earnings and profits of that corporation available 
to support a dividend under section 316 will increase solely as a 
result of entering into the section 381 transaction. This is because 
the hovering deficit will no longer offset the positive earnings in the 
other basket for purposes of section 316. As a result, even if a 
corporation has an aggregate deficit in earnings and profits, any 
positive baskets of earnings will be able to support the distribution 
of a dividend immediately after the transaction.
    The comments contend that the prohibition described above against 
the use of an earnings and profits deficit in one basket from 
offsetting positive earnings and profits in another basket can produce 
results that are inconsistent with the result of applying a pure 
section 381(c)(2)(B) approach in determining the amount of a 
distribution that is a ``dividend'' under section 316, and more 
generally are inconsistent with the principles and legislative history 
of the section 381(c)(2)(B) hovering deficit rule, which was adopted to 
preserve, but not create, the taxation of distributions by corporations 
that engage in tax-free reorganizations or liquidations.
    To address these concerns, the comments requested that (among other 
things) the proposed regulations be modified to conform to the 
principles contained in Notice 88-71 (1988-2 C.B. 374), and Sec.  
1.960-1(i)(4), which pro-rate an earnings and profits deficit in one 
basket against positive earnings and profits in other baskets for 
purposes of computing post-1986 undistributed earnings under section 
902. It was also requested that the rules under Sec.  1.960-1(i)(4) 
should be modified for purposes of the hovering deficit rules to 
eliminate the ``springing'' effect of an earnings and profits deficit. 
Section 1.960-1(i)(4) provides that a deficit in any basket does not 
permanently reduce earnings in other baskets, but after the deemed-paid 
taxes are computed, the deficit reverts to and is carried forward in 
the same basket in which it was incurred. It was asserted in the 
comments that once a hovering deficit is used to reduce earnings in 
another basket, it should not revert to its original basket in a 
subsequent taxable year because this deficit reincarnation results in 
unnecessary complexity in the calculation of earnings and profits.
    The Treasury Department and the IRS have carefully considered these 
comments. After this consideration, they have concluded that the 
arguments in these comments ultimately are not persuasive. The purpose 
of the hovering deficit rule in the domestic context is to prevent 
trafficking in deficits in earnings and profits. Absent this rule, a 
corporation with positive earnings and profits could acquire or be 
acquired by another corporation with a deficit in earnings and profits 
and immediately reduce the amount of its positive earnings and profits, 
thereby reducing the amount of potentially taxable distributions.
    In transactions involving foreign corporations, similar concerns 
exist regarding the possibility of trafficking in deficits in earnings 
and profits. In light of the foreign tax credit rules, unique tax 
benefits may arise from combining positive and deficit earnings and 
profits of different foreign corporations. In a reorganization 
involving two domestic corporations, the hovering deficit rule applies 
to a corporation with a net accumulated deficit in earnings and profits 
because the relevant statutory rules do not distinguish among classes 
of earnings and profits. In contrast, the foreign tax credit rules 
require categorization of earnings and profits according to the pooling 
and basket rules. Because of these distinctions, taxpayers may 
inappropriately benefit by trafficking in an earnings and profits 
deficit in a basket, pool, or particular annual layer, even though a 
corporation may have net positive earnings and profits. The Treasury 
Department and the IRS believe that these issues merit targeted 
differences in the application of the hovering deficit rule in this 
context. Accordingly, these final regulations retain the provisions of 
the 2000 proposed regulations that apply the hovering deficit rule on a 
basket-by-basket basis.
    The final regulations also include a clarification that post-
transaction earnings and profits that may be offset by hovering 
deficits do not include earnings and profits that are distributed or 
deemed distributed in the same taxable year that they are earned. That 
is, the hovering deficit rule does not permit deficits to be offset 
against post-

[[Page 44891]]

transaction earnings and profits until those earnings and profits 
become accumulated (as opposed to current) for tax purposes. This rule 
is consistent with a similar provision in the hovering deficit 
regulations under section 381. See Sec.  1.381(c)(2)-1(a)(5).

D. Hovering Deficits and Section 902

    Under section 902, the amount of foreign taxes that are deemed paid 
by a 10% domestic corporate shareholder receiving dividends from a 
foreign corporation is equal to the foreign corporation's post-1986 
foreign income taxes multiplied by a fraction, the numerator of which 
is the amount of the dividend, and the denominator of which is the 
foreign corporation's post-1986 undistributed earnings. Post-1986 
undistributed earnings include both accumulated and current year 
earnings and deficits, not taking into account current year 
distributions. The section 902 calculation is done on a basket-by-
basket basis. The 2000 proposed regulations provide that a pre-
transaction deficit will only be taken into account for purposes of 
determining the accumulated earnings and profits of the surviving 
corporation in the section 902 denominator to the extent of post-
transaction earnings that are accumulated in the same basket as the 
deficit.
    A comment was made requesting that the hovering deficit rule not 
apply for purposes of computing deemed-paid credits under section 902, 
particularly in the determination of accumulated earnings and profits 
in the denominator of the section 902 fraction. Under this approach, 
the effect of the inclusion of an otherwise hovering deficit on the 
section 902 calculation could be beneficial or detrimental to the 
taxpayer, depending on the particular taxpayer's facts. For example, 
the suggested approach would be detrimental to taxpayers if the 
unrestricted use of the otherwise hovering deficit reduced the 
denominator of the section 902 fraction to or below zero. See Sec.  
1.902-1(b)(4) (providing that no taxes are deemed paid with respect to 
a ``nimble dividend'' if post-1986 undistributed earnings are zero or 
less than zero). The rationale offered for this request is that it 
would more properly follow the intent of Congress when it amended 
section 902 in 1986 to average earnings and profits and foreign taxes 
under a pooling method.
    After consideration of the comment, the Treasury Department and the 
IRS have concluded that it would not be appropriate to allow a pre-
transaction hovering deficit from one corporation to offset pre-
transaction earnings and profits of another corporation for purposes of 
determining the denominator of the section 902 fraction. Such an offset 
could increase the ratio of foreign taxes to earnings and profits in 
the pool and thereby in certain cases could ``supercharge'' the amount 
of foreign taxes that could be drawn out by a given distribution. The 
Treasury Department and the IRS believe this is not an appropriate 
result and could encourage taxpayers to enter into section 381 
transactions to take advantage of the distortion that would result from 
accelerating foreign tax credits in certain cases. It is also possible 
that such a rule could be detrimental to taxpayers by otherwise denying 
them access to creditable foreign income taxes if their section 902 
denominator were eliminated. Moreover, the comment would further 
complicate an already complex area by mandating one set of hovering 
deficit treatment and calculations of earnings for section 316 and 
another for section 902.
    An alternative request was made to the effect that, if the hovering 
deficit rule is retained, it should be modified to allow a pre-
transaction earnings and profits deficit to offset the surviving 
corporation's post-transaction current year earnings and profits for 
purposes of determining the section 902 denominator, irrespective of 
whether such earnings are distributed during the taxable year.
    After considering this comment, the Treasury Department and the IRS 
concluded that on balance it would not be appropriate to modify the 
proposed regulations in this manner. In many cases, allowing the 
hovering deficit to offset current year distributed earnings and 
profits for purposes of the section 902 denominator would effectively 
allow an offset of pre-transaction earnings and profits. This is 
because the opening balance of post-1986 undistributed earnings in the 
year following the distribution would be reduced a second time (the 
first reduction having occurred as a result of offsetting the current 
year distributed earnings and profits by the hovering deficit) as 
required by section 902 and the regulations thereunder to account for 
the distribution itself. This second reduction would reduce pre-
transaction earnings and profits or, to the extent of any excess over 
that amount, create a deficit in accumulated earnings and profits. As 
described, the Treasury Department and the IRS believe that in order to 
minimize credit trafficking problems, pre-transaction deficits of one 
corporation should not be allowed to offset pre-transaction earnings of 
another corporation.
    Additionally, implementing the modification requested in the 
comment would create administrative burdens for taxpayers and the IRS. 
If hovering deficits offset current year distributed earnings solely 
for purposes of section 902 but not for purposes of section 316, dual 
accounts would be necessary to track hovering deficits as they are 
separately used under each section.
    Moreover, certain taxpayers would be disadvantaged under the 
requested modification as compared to how those taxpayers would be 
treated under the rule adopted in these final regulations. For example, 
if a foreign subsidiary has a hovering deficit in a separate basket 
that exceeds the sum of current plus accumulated earnings in the basket 
and the foreign subsidiary distributes current year post-transaction 
earnings in that same basket, under the requested modification, the 
hovering deficit would reduce the section 902 denominator to zero, with 
the result that no deemed-paid taxes could be claimed on the 
distribution. In fact, for this reason certain taxpayers have 
specifically requested that the hovering deficit rule apply for 
purposes of the section 902 fraction. Under the rules adopted by the 
final regulations, the hovering deficit would not reduce the section 
902 denominator and therefore taxpayers would have access to deemed-
paid taxes on the distribution.

E. Hovering Taxes

    Under the 2000 proposed regulations, taxes associated with a 
hovering deficit do not enter into the surviving corporation's post-
1986 foreign income taxes pool until the entire deficit has been offset 
against post-transaction accumulated earnings and profits. Comments 
were made requesting that the regulations be changed to provide that 
foreign taxes related to a hovering deficit enter the post-1986 foreign 
income taxes pool on a pro rata basis as the hovering deficit to which 
the foreign taxes relate is used to offset post-transaction accumulated 
earnings and profits. The Treasury Department and IRS agree that a pro 
rata approach of this nature more accurately ties the availability of 
the foreign income taxes with the use of the related hovering deficit. 
Accordingly, this requested change is reflected in the final 
regulations.

F. Zipping Rule

    The 2000 regulations provide that if the foreign target corporation 
or foreign acquiring corporation (or both) was a look-through 
corporation and the

[[Page 44892]]

foreign surviving corporation is a less-than-10%-U.S.-owned foreign 
corporation, the post-1986 pools of earnings and profits of the look-
through corporation in the separate baskets are recharacterized as a 
single, non-look-through pre-pooling annual layer which accumulated 
immediately prior to the 381 transaction (the zipping rule). In 
addition, the 2000 proposed regulations provide that if the foreign 
surviving corporation later changes to look-through status, any such 
recharacterized earnings and profits do not regain either their pooling 
or their look-through character.
    A comment was made that in a case where the foreign surviving 
corporation subsequently changes to look-through status, if the 
recharacterized earnings and profits do not revert to their look-
through character, a dividend paid out of those earnings would not be 
afforded look-through treatment. The comment argued that this would run 
counter to section 904(d)(2)(E)(i) which provides that look-through 
treatment applies to distributions by a CFC out of any earnings and 
profits accumulated during periods in which it was a CFC.
    The Treasury Department and IRS note that this concern has been 
addressed by intervening statutory and regulatory changes. All 
distributions from a look-through corporation now receive look-through 
treatment, regardless of whether they are paid out of earnings and 
profits from post-1986 pools or pre-pooling annual layers. As a result, 
the concern raised in the comment is now effectively moot, and look-
through treatment generally prevails. The final regulations otherwise 
retain the zipping rule, however, because with respect to the 
maintenance of pools or annual layers, this rule provides 
administrative advantages for both taxpayers and the IRS by not 
requiring subsequent U.S. shareholders of a foreign surviving 
corporation that continued to accumulate earnings on an annual layer 
basis to recreate post-1986 pools of pre-transaction earnings and 
profits carried over from a pooling foreign target corporation. 
Accordingly, the Treasury Department and the IRS decided to retain the 
general zipping rule provisions of the 2000 proposed regulations in 
these final regulations for pooling purposes, while allowing full 
preservation of look-through treatment.
    Moreover, it should be noted that these final regulations define a 
pooling corporation as one that has at any time met the requirements of 
section 902(c)(3)(B). Accordingly, even if the foreign surviving 
corporation does not meet those requirements immediately after the 
foreign section 381 transaction, it will still be a pooling corporation 
if it had met those requirements at any time prior to the transaction. 
See Sec.  1.902-1(a)(13)(i).

G. Qualified and Chain Deficit Rules Under Section 952(c)(1)(B) and (C)

    The section 952(c)(1)(B) subpart F qualified deficit rule and 
section 952(c)(1)(C) subpart F chain deficit rule allow the use of a 
CFC's deficit in earnings and profits to limit subpart F income 
inclusions for another year with respect to the stock of the same CFC 
or for the same year with respect to stock of another CFC in certain 
cases. Under the qualified deficit rule of section 952(c)(1)(B), a 
prior-year earnings and profits deficit may be used to limit a 
qualified shareholder's current year subpart F income in the same CFC 
if such deficit is attributable to the same qualified activity as the 
activity that gives rise to the current year subpart F income. Under 
the chain deficit rule of section 952(c)(1)(C), a current year earnings 
and profits deficit may be used to limit a related corporation's 
current year subpart F income subject to the same qualified activity 
restrictions.
    The 2000 proposed regulations provide that a pre-transaction 
deficit is not taken into account for purposes of calculating the 
earnings and profits limitation under the chain deficit rule. The 2000 
proposed regulations are silent, however, as to the qualified deficit 
rule. A comment was made requesting that pre-transaction deficits be 
taken into account for purposes of calculating the earnings and profits 
limitations under both the qualified deficit rules and the chain 
deficit rules.
    The Treasury Department and the IRS agree with this comment. The 
qualified deficit rule does not limit the amount of the subpart F 
income at the CFC level, but rather limits the amount of a particular 
shareholder's subpart F income inclusion under section 951(a). Because 
qualified deficits in earnings and profits are shareholder-level 
attributes and anti-trafficking provisions are already incorporated in 
the rules regarding qualified deficits under section 952(c)(1)(B), the 
Treasury Department and the IRS believe that it is appropriate to allow 
pre-transaction deficits to be taken into account for purposes of the 
calculation of qualified deficits. Though the Treasury Department and 
IRS believe this was already a reasonable position that could have been 
taken under the 2000 proposed regulations, the final regulations 
include a more explicit clarification of this position.
    The final regulations also provide that a current year pre-
transaction deficit may be taken into account for purposes of limiting 
subpart F income under the chain deficit rule. The Treasury Department 
and the IRS believe that the narrow restrictions that apply to 
application of the chain deficit rule are not subject to manipulation 
through entering into foreign section 381 transactions. Accordingly 
there is no policy reason for denying a qualified chain member access 
to a pre-transaction deficit that otherwise qualifies as a chain 
deficit solely because the CFC with the chain deficit engaged in a 
foreign section 381 transaction during the taxable year. Any such pre-
transaction deficit that qualifies as a chain deficit will nonetheless 
remain a hovering deficit of the surviving corporation for purposes of 
section 316 and section 902.

H. Allocation of Earnings and Profits, Deficits, and Taxes During the 
Transaction Year

    The 2000 proposed regulations include a rule that allocates the 
earnings and profits for the taxable year of a foreign surviving 
corporation in which a foreign section 381 transaction occurs as either 
pre-transaction earnings or post-transaction earnings on the basis of 
the number of days in the taxable year before and after the date of the 
foreign section 381 transaction. This rule parallels a similar rule 
found under Sec.  1.381(c)(2)-1(a)(6) and is necessary in order to 
determine the amount of post-transaction earnings that may be offset by 
hovering deficits. This rule is applied on a basket-by-basket basis for 
any basket in which there are positive earnings and profits for the 
taxable year in which the transaction occurred. No comments were 
received on this point, and the final regulations adopt this provision, 
extending it to related foreign income taxes as well.
    These final regulations also contain a rule for allocating 
deficits, and related foreign income taxes, for the taxable year in 
which a foreign section 381 transaction occurs as pre- and post-
transaction deficits. If the surviving corporation has a deficit in any 
basket for the taxable year in which the transaction occurred, unless 
the actual accumulated earnings and profits, or deficit, as of the date 
of the transaction can be shown, the deficit shall be allocated in the 
same pro rata manner described above for positive earnings and profits. 
This rule also parallels a similar rule found under Sec.  1.381(c)(2)-
1(a)(6) and is necessary in order to determine the amount of pre-
transaction deficits that will hover. This rule is applied on a basket-
by-basket basis for any basket in which there is a deficit in

[[Page 44893]]

earnings and profits for the taxable year in which the transaction 
occurred.
    The Treasury Department and the IRS believe that the addition of 
the allocation rule for deficits provides greater consistency with the 
principles and rules of section 381. It is a neutral provision and is 
consistent with appropriate results that could be reached under present 
law.

I. Special Rule for F Reorganizations and Similar Transactions

    The 2000 proposed regulations (Prop. Reg. Sec.  1.367(b)-9) provide 
that the hovering deficit rules do not apply in the case of a foreign 
section 381 transaction that is described in section 368(a)(1)(F) or in 
which either the foreign target corporation or the foreign acquiring 
corporation is newly created. This rule was intended to prevent 
inappropriate tax consequences that could result from application of 
the hovering deficit rules to the combination of two corporations where 
only one of those corporations has meaningful tax attributes. For 
example, under the generally applicable hovering deficit rules, a 
foreign corporation with significant deficits in earnings and profits 
could combine with a newly created foreign corporation and thereafter 
distribute dividends (along with deemed paid foreign income taxes under 
section 902), despite the presence of a significant deficit that would 
have precluded a dividend distribution before the transaction.
    The rule under the 2000 proposed regulations addressing newly 
created corporations was meant to capture any transactions that are 
functionally equivalent to F reorganizations. However, the Treasury 
Department and the IRS have determined that the newly-created 
corporation standard under the 2000 proposed regulations is both 
potentially underinclusive and overinclusive in scope. It is 
underinclusive in that it would not apply to include foreign section 
381 transactions that do not otherwise qualify as an F reorganization 
but that are between one foreign corporation with meaningful tax 
attributes and a shell corporation that is not newly created, but 
nevertheless has no meaningful tax attributes. In contrast, this 
standard is overinclusive in that it might be read to include a foreign 
section 381 transaction involving multiple foreign corporations with 
meaningful tax attributes as long as at least one party to the 
transaction is a newly created corporation. These transactions are 
neither F reorganizations nor are they functionally equivalent to F 
reorganizations.
    Accordingly, these final regulations clarify the 2000 proposed 
regulations by providing that the hovering deficit rules do not apply 
to a foreign section 381 transaction involving at least one corporation 
that does not own more than a nominal amount of property or does not 
have more than a nominal amount of tax attributes, but no more than one 
corporation that does own more than a nominal amount of property or 
have more than a nominal amount of tax attributes. In most cases the 
transactions covered by this special rule will be standard F 
reorganizations.

J. Anti-Abuse Rule

    The 2000 proposed regulations include an anti-abuse rule that gives 
the Commissioner the discretion to turn off the hovering deficit rules 
if a principal purpose of a foreign section 381 transaction is to gain 
a tax benefit from affirmative use of those rules. Comments have 
criticized the anti-abuse rule as overly broad and inconsistent with 
establishing objective rules regarding the taxation of earnings 
distributed (or deemed distributed) by foreign subsidiaries. Moreover, 
the point was raised in some comments that the proposed anti-abuse rule 
would prevent taxpayers from relying on the existing detailed set of 
rules for the calculation of earnings and profits following a corporate 
combination in any case in which a taxpayer receives a U.S. tax benefit 
related to the application of the hovering deficit rule.
    Upon consideration of these comments, the Treasury Department and 
the IRS have concluded that the anti-abuse rule in the 2000 proposed 
regulations should be eliminated. While the anti-abuse rule has been 
eliminated, the IRS will continue to examine the application of the 
regulations to transactions to which they apply, or potentially apply, 
and will be prepared to pursue issues where appropriate under the 
regulations and other established principles of existing law. The 
Treasury Department and the IRS may revisit the rules in light of 
experience and propose prospective changes as appropriate.

K. Miscellaneous

    A number of conforming revisions have been made to the 2000 
proposed regulations to account for relevant statutory and regulatory 
changes discussed above that have occurred in the intervening time 
period since the 2000 proposed regulations were issued. This includes 
the reduction of the number of baskets under section 904(d)(1), 
applicable for tax years beginning after December 31, 2006, as well as 
the fact that distributions by look-through corporations out of annual 
layers accumulated during a non-look-through period are now accorded 
look-through treatment.
    It is possible that special transition rules might be needed 
relating to the effect on hovering deficits in existence on the 
effective date of the reduction in the number of baskets under section 
904(d)(1). If it is determined that such rules are necessary, they 
would be provided as part of a broader guidance project currently under 
consideration to address generally transition issues relating to the 
reduction in baskets.

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 Jeffrey L. Parry 
of the Office of Chief Counsel (International). However, other 
personnel from the Treasury Department and the IRS participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

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

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by revising 
the entries for Sec. Sec.  1.367(b)-7 and 1.367(b)-9 to read in part as 
follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.367(b)-7 also issued under 26 U.S.C. 367(a) and (b), 
26 U.S.C. 902, and 26 U.S.C. 904.
    Section 1.367(b)-9 also issued under 26 U.S.C. 367(a) and (b), 
26 U.S.C. 902, and 26 U.S.C. 904. * * *


[[Page 44894]]



0
Par. 2. Section 1.367(b)-0 is amended by:
0
1. Revising the introductory text.
0
2. Adding entries for Sec.  1.367(b)-2(l).
0
3. Adding entries for Sec.  1.367(b)-3(e) and (f).
0
4. Adding entries for Sec. Sec.  1.367(b)-7 through 1.367(b)-9.
    The revisions and additions read as follows:


Sec.  1.367(b)-0  Table of contents.

    This section lists the paragraphs contained in Sec. Sec.  1.367(b)-
1 through 1.367(b)-9.
* * * * *


Sec.  1.367(b)-2  Definitions and special rules.

* * * * *
(l) Additional definitions.
(1) Foreign income taxes.
(2) Post-1986 undistributed earnings.
(3) Post-1986 foreign income taxes.
(4) Pre-1987 accumulated profits.
(5) Pre-1987 foreign income taxes.
(6) Pre-1987 section 960 earnings and profits.
(7) Pre-1987 section 960 foreign income taxes.
(8) Earnings and profits.
(9) Pooling corporation.
(10) Nonpooling corporation.
(11) Separate category.
(12) Passive category.
(13) General category.


Sec.  1.367(b)-3  Repatriation of foreign corporate assets in certain 
nonrecognition transactions.

* * * * *
(e) Net operating loss and capital loss carryovers.
(f) Carryover of earnings and profits.
(1) General rule.
(2) Previously taxed earnings and profits. [Reserved]
* * * * *


Sec.  1.367(b)-7  Carryover of earnings and profits and foreign income 
taxes in certain foreign-to-foreign nonrecognition transactions.

(a) Scope.
(b) General rules.
(1) Non-previously taxed earnings and profits and related taxes.
(2) Previously taxed earnings and profits. [Reserved]
(c) Ordering rule for post-transaction distributions.
(1) If foreign surviving corporation is a pooling corporation.
(2) If foreign surviving corporation is a nonpooling corporation.
(d) Post-1986 pool.
(1) In general.
(i) Qualifying earnings and taxes.
(ii) Carryover rule.
(2) Hovering deficit.
(i) In general.
(ii) Offset rule.
(iii) Related taxes.
(3) Examples.
(e) Pre-pooling annual layers.
(1) If foreign surviving corporation is a pooling corporation.
(i) Qualifying earnings and taxes.
(ii) Carryover rule.
(iii) Deficits.
(A) In general.
(B) Aggregate positive pre-1987 accumulated profits.
(C) Aggregate deficit in pre-1987 accumulated profits.
(D) Deficit and positive separate categories within annual layers
(iv) Pre-1987 section 960 earnings and profits and foreign income 
taxes.
(v) Examples.
(2) If foreign surviving corporation is a nonpooling corporation.
(i) Qualifying earnings and taxes.
(ii) Carryover rule.
(iii) Deficits.
(A) In general.
(B) Aggregate positive pre-1987 accumulated profits.
(C) Aggregate deficit in pre-1987 accumulated profits.
(D) Deficit and positive separate categories within annual layers.
(iv) Pre-1987 section 960 earnings and profits and foreign income 
taxes.
(v) Examples.
(f) Special rules.
(1) Treatment of deficit.
(i) General rule.
(ii) Exceptions.
(iii) Examples.
(2) Reconciling taxable years.
(3) Post-transaction change of status.
(4) Ordering rule for multiple hovering deficits.
(i) Rule.
(ii) Example.
(5) Pro rata rule for earnings and deficits during transaction year.
(g) Effective date.


Sec.  1.367(b)-8  Allocation of earnings and profits and foreign income 
taxes in certain foreign corporate separations. [Reserved]


Sec.  1.367(b)-9  Special rule for F reorganizations and similar 
transactions.

(a) Scope.
(b) Hovering deficit rules inapplicable.
(c) Foreign divisive transactions. [Reserved]
(d) Examples.
(e) Effective date.
* * * * *


0
Par. 3. Section 1.367(b)-1 is amended by:
0
1. Removing the language ``and'' at the end of paragraph (c)(2)(iii).
0
2. Removing the period at the end of paragraph (c)(2)(iv)(B) and adding 
``; and'' in its place.
0
3. Adding paragraph (c)(2)(v).
0
4. Revising paragraphs (c)(3)(ii)(A), (c)(4)(iv), and (c)(4)(v).
    The additions and revisions read as follows:


Sec.  1.367(b)-1  Other transfers.

* * * * *
    (c) * * *
    (2) * * *
    (v) A foreign surviving corporation described in Sec.  1.367(b)-
7(a).
    (3) * * *
    (ii) * * *
    (A) United States shareholders (as defined in Sec.  1.367(b)-
3(b)(2)) of foreign corporations described in paragraph (c)(2)(i) or 
(v) of this section; and
* * * * *
    (4) * * *
    (iv) A statement that describes any amount (or amounts) required, 
under the section 367(b) regulations, to be taken into account as 
income or loss or as an adjustment (including an adjustment under Sec.  
1.367(b)-7 or 1.367(b)-9) to basis, earnings and profits, or other tax 
attributes as a result of the exchange;
    (v) Any information that is or would be required to be furnished 
with a Federal income tax return pursuant to regulations under section 
332, 351, 354, 355, 356, 361, 368, or 381 (whether or not a Federal 
income tax return is required to be filed), if such information has not 
otherwise been provided by the person filing the section 367(b) notice;
* * * * *

0
Par. 4. Section 1.367(b)-2 is amended by:
0
1. Revising paragraph (j)(1)(i).
0
2. Adding paragraph (l).
    The revision and addition read as follows:


Sec.  1.367(b)-2  Definitions and special rules.

* * * * *
    (j) Sections 985 through 989--(1) Change in functional currency of 
a qualified business unit--(i) Rule. If, as a result of a section 
367(b) exchange described in section 381(a), a qualified business unit 
(as defined in section 989(a)) (QBU) has a different functional 
currency determined under the rules of section 985(b) than it used 
prior to the transaction, then the QBU shall be deemed to have 
automatically changed its functional currency immediately prior to the 
transaction. A QBU that is deemed to change its functional currency 
pursuant to this paragraph (j) must make the adjustments described in 
Sec.  1.985-5.
* * * * *
    (l) Additional definitions--(1) Foreign income taxes. The term 
foreign income taxes has the meaning set forth in Sec.  1.902-1(a)(7).
    (2) Post-1986 undistributed earnings. The term post-1986 
undistributed earnings has the meaning set forth in Sec.  1.902-
1(a)(9).
    (3) Post-1986 foreign income taxes. The term post-1986 foreign 
income taxes has the meaning set forth in Sec.  1.902-1(a)(8).
    (4) Pre-1987 accumulated profits. The term pre-1987 accumulated 
profits

[[Page 44895]]

means the earnings and profits described in Sec.  1.902-1(a)(10)(i), 
computed in accordance with the rules of Sec.  1.902-1(a)(10)(ii).
    (5) Pre-1987 foreign income taxes. The term pre-1987 foreign income 
taxes has the meaning set forth in Sec.  1.902-1(a)(10)(iii).
    (6) Pre-1987 section 960 earnings and profits. The term pre-1987 
section 960 earnings and profits means the earnings and profits of a 
foreign corporation accumulated in taxable years beginning before 
January 1, 1987, computed under Sec.  1.964-1(a) through (e), and 
translated into the functional currency (as determined under section 
985) of the foreign corporation at the spot rate on the first day of 
the foreign corporation's first taxable year beginning after December 
31, 1986. For further guidance, see Notice 88-70 (1988-2 C.B. 369, 370) 
(see also Sec.  601.601(d)(2) of this chapter). The term pre-1987 
section 960 earnings and profits does not include earnings and profits 
that represent previously taxed earnings and profits described in 
section 959.
    (7) Pre-1987 section 960 foreign income taxes. The term pre-1987 
section 960 foreign income taxes means the foreign income taxes related 
to pre-1987 section 960 earnings and profits, determined in accordance 
with the principles of Sec.  1.902-1(a)(10)(iii), except that the U.S. 
dollar amounts of pre-1987 section 960 foreign income taxes are 
determined by reference to the exchange rates in effect when the taxes 
were paid or accrued.
    (8) Earnings and profits. The term earnings and profits means post-
1986 undistributed earnings, pre-1987 accumulated profits, and pre-1987 
section 960 earnings and profits.
    (9) Pooling corporation. The term pooling corporation means a 
foreign corporation with respect to which the requirements of section 
902(c)(3)(B) have been met in the current taxable year or any prior 
taxable year.
    (10) Nonpooling corporation. The term nonpooling corporation means 
a foreign corporation that is not a pooling corporation.
    (11) Separate category. The term separate category has the meaning 
set forth in section 904(d)(1), and shall also include any other 
category of income to which section 904(a), (b), and (c) are applied 
separately under any other provision of the Internal Revenue Code 
(e.g., sections 56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), and 
904(h)(10) (or section 904(g)(10) for taxable years beginning on or 
before December 31, 2006).
    (12) Passive category. The term passive category means the separate 
category that includes income described in section 904(d)(1)(A).
    (13) General category. The term general category means the separate 
category that includes income described in section 904(d)(1)(B) (or 
section 904(d)(1)(I) for taxable years beginning on or before December 
31, 2006).

0
Par. 5. Section 1.367(b)-3 is amended by adding paragraphs (e) and (f) 
to read as follows:


Sec.  1.367(b)-3  Repatriation of foreign corporate assets in certain 
nonrecognition transactions.

* * * * *
    (e) Net operating loss and capital loss carryovers. A net operating 
loss or capital loss carryover of the foreign acquired corporation is 
described in section 381(c)(1) and (c)(3) and thus is eligible to carry 
over from the foreign acquired corporation to the domestic acquiring 
corporation only to the extent the underlying deductions or losses were 
allowable under chapter 1 of subtitle A of the Internal Revenue Code. 
Thus, only a net operating loss or capital loss carryover that is 
effectively connected with the conduct of a trade or business within 
the United States (or that is attributable to a permanent 
establishment, in the context of an applicable United States income tax 
treaty) is eligible to be carried over under section 381. For further 
guidance, see Rev. Rul. 72-421 (1972-2 C.B. 166) (see also Sec.  
601.601(d)(2) of this chapter).
    (f) Carryover of earnings and profits--(1) General rule. Except to 
the extent otherwise specifically provided (see, e.g., Notice 89-79 
(1989-2 C.B. 392) (see also Sec.  601.601(d)(2) of this chapter)), 
earnings and profits of the foreign acquired corporation that are not 
included in income as a deemed dividend under the section 367(b) 
regulations (or deficit in earnings and profits) are eligible to carry 
over from the foreign acquired corporation to the domestic acquiring 
corporation under section 381(c)(2) only to the extent such earnings 
and profits (or deficit in earnings and profits) are effectively 
connected with the conduct of a trade or business within the United 
States (or are attributable to a permanent establishment in the United 
States, in the context of an applicable United States income tax 
treaty). All other earnings and profits (or deficit in earnings and 
profits) of the foreign acquired corporation shall not carry over to 
the domestic acquiring corporation and, as a result, shall be 
eliminated.
    (2) Previously taxed earnings and profits. [Reserved]

0
Par. 6. In Sec.  1.367(b)-6, paragraph (a)(1) is revised to read as 
follows:


Sec.  1.367(b)-6  Effective dates and coordination rules.

    (a) Effective date--(1) In general. Sections 1.367(b)-1 through 
1.367(b)-3, and this section, apply to section 367(b) exchanges that 
occur on or after November 6, 2006. For guidance with respect to 
section 367(b) exchanges that occur prior to November 6, 2006, see 
Sec. Sec.  1.367(b)-1 through 1.367(b)-6 in effect prior to November 6, 
2006 (see 26 CFR part 1 revised as of April 1, 2006).
* * * * *
0
Par. 7. Section 1.367(b)-7 is added to read as follows:


Sec.  1.367(b)-7  Carryover of earnings and profits and foreign income 
taxes in certain foreign-to-foreign nonrecognition transactions.

    (a) Scope. This section applies to an acquisition by a foreign 
corporation (foreign acquiring corporation) of the assets of another 
foreign corporation (foreign target corporation) in a transaction 
described in section 381 (foreign section 381 transaction). This 
section describes the manner and extent to which earnings and profits 
and foreign income taxes of the foreign acquiring corporation and the 
foreign target corporation carry over to the surviving foreign 
corporation (foreign surviving corporation) and the ordering of 
distributions by the foreign surviving corporation. See Sec.  1.367(b)-
9 for special rules governing reorganizations described in section 
368(a)(1)(F) and foreign section 381 transactions involving foreign 
corporations that hold no property and have no tax attributes 
immediately before the transaction, other than a nominal amount of 
assets (and related tax attributes).
    (b) General rules--(1) Non-previously taxed earnings and profits 
and related taxes. Earnings and profits and related foreign income 
taxes of the foreign acquiring corporation and the foreign target 
corporation (pre-transaction earnings and pre-transaction taxes, 
respectively) shall carry over to the foreign surviving corporation in 
the manner described in paragraphs (d), (e), and (f) of this section. 
Dividend distributions by the foreign surviving corporation (post-
transaction distributions) shall be out of earnings and profits and 
shall reduce related foreign income taxes in the manner described in 
paragraph (c) of this section.
    (2) Previously taxed earnings and profits. [Reserved]
    (c) Ordering rule for post-transaction distributions. Dividend 
distributions out

[[Page 44896]]

of a foreign surviving corporation's earnings and profits shall be 
ordered in accordance with the rules of paragraph (c)(1) or (2) of this 
section, depending on whether the foreign surviving corporation is a 
pooling corporation or a nonpooling corporation.
    (1) If foreign surviving corporation is a pooling corporation. In 
the case of a foreign surviving corporation that is a pooling 
corporation, post-transaction distributions shall be first out of the 
post-1986 pool (as described in paragraph (d) of this section) and 
second out of the pre-pooling annual layers (as described in paragraph 
(e)(1) of this section) under an annual last-in, first-out (LIFO) 
method.
    (2) If foreign surviving corporation is a nonpooling corporation. 
In the case of a foreign surviving corporation that is a nonpooling 
corporation, post-transaction distributions shall be out of the pre-
pooling annual layers (as described in paragraph (e)(2) of this 
section) under the LIFO method.
    (d) Post-1986 pool. If the foreign surviving corporation is a 
pooling corporation, then the post-1986 pool shall be determined under 
the rules of this paragraph (d).
    (1) In general--(i) Qualifying earnings and taxes. The post-1986 
pool shall consist of the post-1986 undistributed earnings and related 
post-1986 foreign income taxes of the foreign acquiring corporation and 
the foreign target corporation.
    (ii) Carryover rule. Subject to paragraph (d)(2) of this section, 
the amounts described in paragraph (d)(1)(i) of this section 
attributable to the foreign acquiring corporation and the foreign 
target corporation shall carry over to the foreign surviving 
corporation and shall be combined on a separate category-by-separate 
category basis.
    (2) Hovering deficit--(i) In general. If immediately prior to the 
foreign section 381 transaction either the foreign acquiring 
corporation or the foreign target corporation has a deficit in one or 
more separate categories of post-1986 undistributed earnings or an 
aggregate deficit in pre-1987 accumulated profits, such deficit will be 
a hovering deficit of the foreign surviving corporation. The rules of 
this paragraph (d)(2) apply to hovering deficits in separate categories 
of post-1986 undistributed earnings. See paragraphs (e)(1)(iii) and 
(e)(2)(iii) of this section for rules that apply to hovering deficits 
in pre-1987 accumulated profits. If the foreign acquiring corporation 
and the foreign target corporation each have a post-1986 hovering 
deficit in the same separate category of post-1986 undistributed 
earnings, such deficits and their related post-1986 foreign income 
taxes shall be combined for purposes of applying this paragraph (d)(2). 
See also paragraphs (f)(1) and (4) of this section (describing other 
rules applicable to a deficit described in this paragraph (d)(2)).
    (ii) Offset rule. A hovering deficit in a separate category of 
post-1986 undistributed earnings shall offset only earnings and profits 
accumulated by the foreign surviving corporation after the foreign 
section 381 transaction (post-transaction earnings) in the same 
separate category of post-1986 undistributed earnings. For purposes of 
this rule, however, post-transaction earnings do not include post-1986 
undistributed earnings in the same category that are earned after the 
foreign section 381 transaction, but are distributed or deemed 
distributed in the same year they are earned (that is, that do not 
become accumulated). The offset shall occur as of the first day of the 
foreign surviving corporation's first taxable year following the year 
in which the post-transaction earnings accumulated.
    (iii) Related taxes. Post-1986 foreign income taxes that are 
related to a hovering deficit in a separate category of post-1986 
undistributed earnings shall only be added to the foreign surviving 
corporation's post-1986 foreign income taxes in that separate category 
on a pro rata basis as the hovering deficit is absorbed. Pro rata means 
in the same proportion as the portion of the hovering deficit that 
offsets post-transaction earnings in the separate category under 
paragraph (d)(2)(ii) of this section bears to the total amount of the 
hovering deficit.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (d). The examples assume the following facts: Foreign 
corporations A and B are controlled foreign corporations (CFCs) that 
were incorporated after December 31, 1986, have always been pooling 
corporations, and have always had calendar taxable years. None of the 
shareholders of foreign corporations A and B are required to include 
any amount in income under Sec.  1.367(b)-4 as a result of the foreign 
section 381 transaction. Foreign corporations A and B (and all of their 
respective qualified business units as defined in section 989) maintain 
a ``u'' functional currency. Finally, unless otherwise stated, any 
post-1986 undistributed earnings in the passive category resulted from 
a look-through dividend that was paid by a lower-tier CFC out of 
earnings accumulated when the CFC was a noncontrolled section 902 
corporation and that qualified for the subpart F same-country exception 
under section 954(c)(3)(A). The examples are as follows:

    Example 1. (i) Facts. (A) On December 31, 2006, foreign 
corporations A and B have the following post-1986 undistributed 
earnings and post-1986 foreign income taxes:

------------------------------------------------------------------------
                                                                Foreign
                Separate category                     E&P        taxes
------------------------------------------------------------------------
                          Foreign Corporation A
------------------------------------------------------------------------
General.........................................        300u         $60
Passive.........................................        100u          40
                                                 -----------------------
                                                        400u        $100
------------------------------------------------------------------------
                          Foreign Corporation B
------------------------------------------------------------------------
General.........................................        300u         $70
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraph (d)(1) of 
this section, foreign surviving corporation has the following post-
1986 undistributed earnings and post-1986 foreign income taxes:

------------------------------------------------------------------------
                                                                Foreign
                Separate category                     E&P        taxes
------------------------------------------------------------------------
General.........................................        600u        $130
Passive.........................................        100u          40
                                                 -----------------------
                                                        700u        $170
------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2007, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2007, 
foreign surviving corporation distributes 350u to its shareholders. 
Under the rules described in Sec.  1.902-1(d)(1) and paragraph 
(c)(1) of this section, the distribution is out of, and reduces, 
post-1986 undistributed earnings and post-1986 foreign income taxes 
in the separate categories on a pro rata basis, as follows:

------------------------------------------------------------------------
                                                                Foreign
                Separate category                     E&P        taxes
------------------------------------------------------------------------
General.........................................        300u         $65
Passive.........................................         50u          20
                                                 -----------------------
                                                        350u         $85
------------------------------------------------------------------------

    (B) The foreign income taxes deemed paid by qualifying 
shareholders of foreign surviving corporation upon the distribution 
are subject to generally applicable rules and limitations, such as 
those of sections 78, 902, and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following post-1986 undistributed earnings and 
post-1986 foreign income taxes:

[[Page 44897]]



------------------------------------------------------------------------
                                                                Foreign
                Separate category                     E&P        taxes
------------------------------------------------------------------------
General.........................................        300u         $65
Passive.........................................         50u          20
                                                 -----------------------
                                                        350u         $85
------------------------------------------------------------------------

    Example 2. (i) Facts. (A) On December 31, 2006, foreign 
corporations A and B have the following post-1986 undistributed 
earnings and post-1986 foreign income taxes:

------------------------------------------------------------------------
                                                                Foreign
                Separate category                     E&P        taxes
------------------------------------------------------------------------
                          Foreign Corporation A
------------------------------------------------------------------------
General.........................................        200u         $30
Passive.........................................      (100u)          10
                                                 -----------------------
                                                        100u         $40
------------------------------------------------------------------------
                          Foreign Corporation B
------------------------------------------------------------------------
General.........................................        300u         $60
Passive.........................................        100u          30
                                                 -----------------------
                                                        400u         $90
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraphs (d)(1) and 
(2) of this section, foreign surviving corporation has the following 
post-1986 undistributed earnings and post-1986 foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                         Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................         500u  ...........         $ 90  ...........
Passive.....................................................         100u       (100u)           30          $10
                                                             ---------------------------------------------------
                                                                     600u       (100u)         $120          $10
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2007, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2007, 
foreign surviving corporation distributes 300u to its shareholders. 
Under the rules described in Sec.  1.902-1(d)(1) and paragraph 
(c)(1) of this section, the distribution is out of, and reduces, 
post-1986 undistributed earnings and post-1986 foreign income taxes 
on a pro rata basis as follows:

------------------------------------------------------------------------
                                                                Foreign
                Separate category                     E&P        taxes
------------------------------------------------------------------------
General.........................................        250u         $45
Passive.........................................         50u          15
                                                 -----------------------
                                                        300u         $60
------------------------------------------------------------------------

    (B) The foreign income taxes deemed paid by qualifying 
shareholders of foreign surviving corporation upon the distribution 
are subject to generally applicable rules and limitations, such as 
those of sections 78, 902, and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following post-1986 undistributed earnings and 
post-1986 foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                         Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................         250u  ...........          $45  ...........
Passive.....................................................          50u       (100u)           15          $10
                                                             ---------------------------------------------------
                                                                     300u       (100u)          $60          $10
----------------------------------------------------------------------------------------------------------------

    (iv) Post-transaction earnings--(A) In its taxable year ending 
on December 31, 2008, foreign surviving corporation accumulates 
earnings and profits and pays related foreign income taxes as 
follows:

------------------------------------------------------------------------
                                                               Foreign
               Separate category                    E&P         taxes
------------------------------------------------------------------------
General.......................................         100u          $20
Passive.......................................          50u          $10
                                               -------------------------
                                                       150u          $40
------------------------------------------------------------------------

    (B) None of foreign surviving corporation's earnings and profits 
for its 2008 taxable year qualifies as subpart F income as defined 
in section 952(a). Under the rules described in paragraphs 
(d)(2)(ii) and (iii) of this section, the hovering deficit in the 
passive category will offset the post-transaction earnings in that 
category and a proportionate amount of the foreign taxes related to 
the hovering deficit will be added to the post-1986 foreign income 
taxes pool. Because the post-transaction earnings in the passive 
category are half of the amount of the hovering deficit, half of the 
related taxes are added to the post-1986 foreign income taxes pool. 
Accordingly, foreign surviving corporation has the following post-
1986 undistributed earnings

[[Page 44898]]

and post-1986 foreign income taxes on January 1, 2009:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                         Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................         350u  ...........          $65  ...........
Passive.....................................................          50u        (50u)           30           $5
                                                             ---------------------------------------------------
                                                                     400u        (50u)          $95           $5
----------------------------------------------------------------------------------------------------------------

    Example 3. (i) Facts. The facts are the same as Example 2, 
except that the 50u of earnings in the passive category accrued by 
foreign surviving corporation during 2008 is subpart F income, all 
of which is included in income under section 951(a) by United States 
shareholders (as defined in section 951(b)). This example assumes 
that none of the United States shareholders are able to reduce their 
subpart F income inclusion with a qualified deficit under section 
952(c)(1)(B).
    (ii) Result. (A) Under the rule described in paragraph (f)(1) of 
this section, the (100u) hovering deficit in the passive category 
does not reduce foreign surviving corporation's current passive 
earnings and profits for purposes of determining subpart F income or 
associated deemed paid credits. Thus, foreign surviving 
corporation's United States shareholders include their pro rata 
shares of 50u in taxable income for the year and are eligible for a 
deemed paid foreign tax credit under section 960, computed by 
reference to their pro rata shares of $12.50 (50u subpart F 
inclusion / (50u + 50u post-1986 undistributed earnings in the 
passive category = 100u) = 50%, x $25 post-1986 foreign income taxes 
in the passive category = $12.50). The United States shareholders 
will also include their pro rata shares of the deemed-paid taxes of 
$12.50 in taxable income for the year as a deemed dividend pursuant 
to section 78.
    (B) Immediately after the subpart F inclusion and section 960 
deemed paid taxes (and taking into account the taxable year 2008 
earnings and profits and related taxes in the general category), 
foreign surviving corporation has the following post-1986 
undistributed earnings and post-1986 foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits                    Foreign
                                                             --------------------------                 taxes
                                                                                                    ------------
                                                                                          Foreign      Foreign
                      Separate category                                                    taxes        taxes
                                                                Positive     Hovering    available    associated
                                                                  E&P        deficit                     with
                                                                                                       hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................         350u  ...........       $65.00  ...........
Passive.....................................................          50u       (100u)        12.50          $10
                                                             ---------------------------------------------------
                                                                     400u       (100u)        77.50           10
----------------------------------------------------------------------------------------------------------------

    (C) The 50u included as subpart F income constitutes previously 
taxed earnings and profits under section 959.
    Example 4. (i) Facts. (A) On December 31, 2006, foreign 
corporations A and B have the following post-1986 undistributed 
earnings and post-1986 foreign income taxes:

------------------------------------------------------------------------
                                                                Foreign
                Separate category                     E&P        taxes
------------------------------------------------------------------------
                          Foreign Corporation A
------------------------------------------------------------------------
General.........................................         50u         $10
------------------------------------------------------------------------
                          Foreign Corporation B
------------------------------------------------------------------------
General.........................................      (100u)         $20
------------------------------------------------------------------------
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. (A) Under the rules described in paragraphs (d)(1) 
and (2) of this section, foreign surviving corporation has the 
following post-1986 undistributed earnings and post-1986 foreign 
income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits                    Foreign
                                                             --------------------------                 taxes
                                                                                                    ------------
                                                                                          Foreign      Foreign
                      Separate category                                                    taxes        taxes
                                                                Positive     Hovering    available    associated
                                                                  E&P        deficit                     with
                                                                                                       hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................          50u       (100u)          $10          $20
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction earnings and distribution. (A) In its 
taxable year ending on December 31, 2007, foreign surviving 
corporation earns 100u in the general category and pays related 
foreign income taxes of $24. On December 31, 2007, foreign surviving 
corporation distributes 75u to its shareholders.
    (B) Result. For purposes of determining the dividend amount 
under section 316 and the foreign income taxes deemed paid with 
respect to that dividend under section 902, under paragraph 
(d)(2)(ii) of this section the hovering deficit does not offset the 
post-transaction current year earnings.

[[Page 44899]]

Accordingly, the full 75u will be a dividend under section 316. The 
deemed paid taxes on that dividend are $17 (75u distribution / (100u 
current earnings + 50u accumulated earnings) = 50%, x ($10 
accumulated foreign taxes + $24 current year foreign taxes) = $17). 
The 25u of undistributed earnings and profits in 2007 will be offset 
by (25u) of the hovering deficit for purposes of determining the 
opening balance of the post-1986 undistributed earnings pool in 
2008. Because the amount of earnings offset by the hovering deficit 
is 25% of the amount of the hovering deficit, under paragraph 
(d)(2)(iii) of this section $5 (25% of $20) of the related taxes are 
added to the post-1986 foreign income taxes pool at the beginning of 
the next taxable year. Accordingly, foreign surviving corporation 
has the following post-1986 undistributed earnings and post-1986 
foreign income taxes on January 1, 2008:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                         Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................          50u        (75u)          $22          $15
----------------------------------------------------------------------------------------------------------------

    (e) Pre-pooling annual layers--(1) If foreign surviving corporation 
is a pooling corporation. If the foreign surviving corporation is a 
pooling corporation, the pre-pooling annual layers shall be determined 
under the rules of this paragraph (e)(1).
    (i) Qualifying earnings and taxes. The pre-pooling annual layers 
shall consist of the pre-1987 accumulated profits and the pre-1987 
foreign income taxes of the foreign acquiring corporation and the 
foreign target corporation.
    (ii) Carryover rule. Subject to paragraph (e)(1)(iii) of this 
section, the amounts described in paragraph (e)(1)(i) of this section 
shall carry over to the foreign surviving corporation but shall not be 
combined. If the foreign acquiring corporation and the foreign target 
corporation have pre-1987 accumulated profits in the same year and a 
distribution is made therefrom, the rules of Sec.  1.902-1(b)(2)(ii) 
and (b)(3) shall apply separately to reduce pre-1987 accumulated 
profits and pre-1987 foreign income taxes of the foreign acquiring 
corporation and the foreign target corporation on a pro rata basis. For 
further guidance, see Rev. Rul. 68-351 (1968-2 C.B. 307); Rev. Rul. 70-
373 (1970-2 C.B. 152) (see also Sec.  601.601(d)(2) of this chapter); 
see also paragraph (f)(2) of this section (governing the reconciliation 
of taxable years).
    (iii) Deficit--(A) In general. The rules of this paragraph 
(e)(1)(iii) apply when, immediately prior to the foreign section 381 
transaction, the foreign acquiring corporation or the foreign target 
corporation (or both) has a deficit in earnings and profits for one or 
more of the years that comprise its pre-1987 accumulated profits (see 
also paragraphs (f)(1) and (4) of this section, describing other rules 
applicable to a deficit described in this paragraph (e)(1)(iii)).
    (B) Aggregate positive pre-1987 accumulated profits. If the foreign 
acquiring corporation or the foreign target corporation (or both) has 
an aggregate positive (or zero) amount of pre-1987 accumulated profits, 
but a deficit in earnings and profits for one or more years, then the 
rules otherwise applicable to such deficits shall apply separately to 
the pre-1987 accumulated profits and related pre-1987 foreign income 
taxes of such corporation. A deficit in pre-1987 accumulated profits 
for one or more years is applied to reduce pre-1987 accumulated profits 
on a LIFO basis. Any remaining deficit shall be applied to reduce pre-
1987 accumulated profits in succeeding years. See Rev. Rul. 74-550 
(1974-2 C.B. 209) (see also Sec.  601.601(d)(2) of this chapter); 
Champion Int'l Corp. v. Commissioner, 81 T.C. 424 (1983), acq. in 
result, 1987-2 C.B. 1; Rev. Rul. 87-72 (1987-2 C.B. 170) (see also 
Sec.  601.601(d)(2) of this chapter). As a result, no amount in excess 
of the aggregate positive amount of pre-1987 accumulated profits shall 
be distributed from the pre-transaction earnings of the foreign 
acquiring corporation or the foreign target corporation.
    (C) Aggregate deficit in pre-1987 accumulated profits. If the 
foreign acquiring corporation or the foreign target corporation (or 
both) has an aggregate deficit in pre-1987 accumulated profits, a 
hovering deficit as defined under paragraph (d)(2)(i) of this section, 
then the rules under Sec.  1.902-2(b) shall apply to such hovering 
deficit (and related pre-1987 foreign income taxes) immediately prior 
to the transaction, except that the aggregate hovering deficit that is 
carried forward into the foreign surviving corporation's post-1986 pool 
shall offset only post-transaction earnings accumulated by the foreign 
surviving corporation in the same separate category of post-1986 
undistributed earnings to which the relevant portion of the hovering 
deficit is attributable. Post-transaction earnings do not include 
earnings and profits that are earned after the foreign section 381 
transaction but distributed or deemed distributed in the same year they 
are earned.
    (D) Deficit and positive separate categories within annual layers. 
For purposes of applying the rules of paragraphs (e)(1)(iii)(B) and (C) 
of this section, if within a single pre-pooling annual layer, the 
foreign acquiring corporation or the foreign target corporation (or 
both) has a deficit in pre-1987 accumulated profits in a separate 
category and positive pre-1987 accumulated profits in another separate 
category, the deficit shall first be used to offset the positive pre-
1987 accumulated profits in the other separate category in the same 
pre-pooling annual layer. Any remaining deficit shall be carried 
forward or back to other years according to the rules of paragraph 
(e)(1)(iii)(B) or (C) of this section as applicable.
    (iv) Pre-1987 section 960 earnings and profits and foreign income 
taxes. The pre-1987 section 960 earnings and profits and pre-1987 
section 960 foreign income taxes of the foreign acquiring corporation 
and the foreign target corporation shall carry over to the foreign 
surviving corporation but shall not be combined. The rules otherwise 
applicable to such amounts shall apply separately to the pre-1987 
section 960 earnings and profits and pre-1987 section 960 foreign 
income taxes of the foreign acquiring corporation and the foreign 
target corporation on a pro rata basis. For further guidance, see 
Notice 88-70 (1988-2 C.B. 369) (see also Sec.  601.601(d)(2) of this 
chapter).
    (v) Examples. The following examples illustrate the rules of this 
paragraph (e)(1). The examples assume the following facts: Foreign 
corporation A was incorporated in 2003 and was a nonpooling corporation 
through December 31, 2004. Foreign corporation A became a CFC on 
January 1, 2005 and, as a result, began to maintain a pool of post-1986 
undistributed earnings on

[[Page 44900]]

that date. Foreign corporation B was incorporated in 2003 and has 
always been owned by foreign shareholders (and thus never has met the 
requirements of section 902(c)(3)(B)). Both foreign corporation A and 
foreign corporation B have always had calendar taxable years. Foreign 
corporations A and B (and all of their respective qualified business 
units as defined in section 989) maintain a ``u'' functional currency. 
Finally, unless otherwise stated, all earnings and profits of foreign 
corporations A and B are in the general category. The examples are as 
follows:

    Example 1. (i) Facts. (A) On December 31, 2006, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes:

------------------------------------------------------------------------
                                                                Foreign
                                                      E&P        taxes
------------------------------------------------------------------------
Foreign Corporation A:
  Post-1986 pool................................      1,000u        $350
  2004..........................................        400u        160u
  2003..........................................        100u          5u
                                                 -----------------------
                                                      1,500u  ..........
Foreign Corporation B:
    2006........................................        100u         20u
    2005........................................        150u         30u
    2004........................................          0u         50u
    2003........................................         50u          5u
                                                 -----------------------
                                                        300u        105u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraphs (e)(1)(i) 
and (ii) of this section, foreign surviving corporation has the 
following earnings and profits and foreign income taxes:

------------------------------------------------------------------------
                                                                Foreign
                                                      E&P        taxes
------------------------------------------------------------------------
Post-1986 Pool..................................      1,000u        $350
2006............................................        100u         20u
2005............................................        150u         30u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).........        400u        160u
    2004 layer 2 (from Corp B).........          0u         50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).........        100u          5u
    2003 layer 2 (from Corp B).........         50u          5u
                                                 -----------------------
                                                      1,800u  ..........
------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2007, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2007, 
foreign surviving corporation distributes 1,725u to its 
shareholders. Under the rules of paragraph (c)(1) of this section, 
the distribution is first out of the post-1986 pool, and then out of 
the pre-pooling annual layers under the LIFO method, as follows:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Post-1986 pool................................       1,000u         $350
2006..........................................         100u          20u
2005..........................................         150u          30u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1.....................         400u         160u
    2004 layer 2.....................           0u           0u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1.....................        * 50u         2.5u
    2003 layer 2.....................       ** 25u         2.5u
                                               -------------------------
                                                    1,725u
------------------------------------------------------------------------
* 100u in layer/150u aggregate 2003 earnings = 66.67% x 75u
  distribution.
** 50u in layer/150u aggregate 2003 earnings = 33.33% x 75u
  distribution.

    (B) The foreign income taxes deemed paid by qualifying 
shareholders of foreign surviving corporation upon the distribution 
are subject to generally applicable rules and limitations, such as 
those of sections 78, 902, and 904(d).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes:

[[Page 44901]]



------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
2004 layer 2.........................           0u          50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1.....................          50u         2.5u
    2003 layer 2.....................          25u         2.5u
ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½
                                                        75u          55u
------------------------------------------------------------------------

    (iv) Post-transaction earnings. For the taxable year ending on 
December 31, 2008, foreign surviving corporation has 500u of current 
earnings and profits in the general category, none of which qualify 
as subpart F income under section 952(a), and pays $70 in foreign 
income taxes. As of the close of the 2008 taxable year, foreign 
surviving corporation has the following earnings and profits and 
foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Post-1986 pool................................         500u          $70
2004..........................................           0u          50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1.....................          50u         2.5u
    2003 layer 2.....................          25u         2.5u
                                               -------------------------
                                                       575u
------------------------------------------------------------------------

    Example 2. (i) Facts. (A) On December 31, 2006, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation A:
  Post-1986 pool..............................       1,000u         $350
    2004......................................         100u          20u
    2003......................................        (50u)           5u
                                               -------------------------
                                                     1,050u
Foreign Corporation B:
    2006......................................         100u          20u
    2005......................................        (50u)           5u
    2004......................................           0u          50u
    2003......................................         100u          10u
                                               -------------------------
                                                       150u          85u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Because foreign corporations A and B have aggregate 
positive amounts of pre-1987 accumulated profits with a deficit in 
one or more years, the rules of paragraph (e)(1)(iii)(B) of this 
section apply. Accordingly, after the foreign section 381 
transaction, foreign surviving corporation has the following 
earnings and profits and foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                          Foreign       taxes
                                                                Positive   Deficit E&P     taxes      assoicated
                                                                  E&P                    available       with
                                                                                                     deficit E&P
----------------------------------------------------------------------------------------------------------------
Post-1986 pool..............................................       1,000u  ...........         $350  ...........
2006........................................................         100u  ...........          20u  ...........
2005........................................................  ...........        (50u)  ...........           5u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).....................         100u  ...........          20u  ...........
    2004 layer 2 (from Corp B).....................           0u  ...........          50u  ...........
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).....................  ...........        (50u)  ...........           5u
    2003 layer 2 (from Corp B).....................         100u  ...........          10u  ...........
                                                             ---------------------------------------------------

[[Page 44902]]

 
                                                                   1,300u       (100u)  ...........          10u
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2007, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2007, 
foreign surviving corporation distributes 1,175u to its 
shareholders. Under the rules described in paragraphs (c)(1) and 
(e)(1)(iii)(B) of this section, the distribution is first out of the 
post-1986 pool, and then out of the pre-pooling annual layers, as 
follows:

------------------------------------------------------------------------
                                                               Foreign
                 Distribution                       E&P         taxes
------------------------------------------------------------------------
Post-1986 pool................................       1,000u         $350
2006..........................................         100u          20u
2005..........................................           0u           0u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1.....................          50u          20u
    2004 layer 2.....................           0u           0u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1.....................           0u           0u
    2003 layer 2.....................          25u           5u
                                               -------------------------
                                                     1,175u  ...........
------------------------------------------------------------------------

    (B) Under paragraph (e)(1)(iii)(B) of this section, the rules 
otherwise applicable when a foreign corporation has an aggregate 
positive (or zero) amount of pre-1987 accumulated profits, but a 
deficit in one or more years, apply separately to the pre-1987 
accumulated profits and related foreign income taxes of foreign 
corporation A and foreign corporation B. As a result, distributions 
out of the pre-pooling annual layers of foreign corporation A and 
foreign corporation B cannot exceed the aggregate positive amount of 
pre-1987 accumulated profits of each corporation. Accordingly, only 
50u can be distributed from foreign corporation A's pre-pooling 
annual layers and is out of its 2004 layer 1 (after rolling 
forward the (50u) deficit in 2003 layer 1 to reduce 
earnings in 2004 layer 1 to 50u (100u -50u)). Under the 
principles of Sec.  1.902-1(b)(3), the full 20u of taxes related to 
2004 layer 1 is reduced or deemed paid ($20 x (50/50)). 
100u is distributed from foreign corporation B's 2006 annual layer. 
Foreign corporation B's (50u) deficit in 2005 is then rolled back to 
offset its 2003 annual layer to reduce earnings in that layer to 
50u, 25u of which is distributed. Thus, after the distribution, 25u 
remains in 2003 layer  2 along with 5u of foreign income 
taxes (10u x (25u/50u)).
    (C) The foreign income taxes deemed paid by qualifying 
shareholders of foreign surviving corporation upon the distribution 
are subject to generally applicable rules and limitations, such as 
those of sections 78, 902, and 904(d).
    (D) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
2005..........................................           0u           5u
2004 layer 2.........................           0u          50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1.....................           0u           5u
    2003 layer 2.....................          25u           5u
                                               -------------------------
                                                        25u          65u
------------------------------------------------------------------------

    (E) Under paragraph (e)(1)(iii)(B) of this section, the 5u, 50u, 
and 5u of pre-1987 foreign income taxes related to foreign surviving 
corporation's 2005 layer, 2004 layer 2, and 2003 layer 
1, respectively, remain in those layers. These foreign 
income taxes generally will not be reduced or deemed paid unless a 
foreign tax refund restores a positive balance to the associated 
earnings pursuant to section 905(c), and thus will be trapped. See 
Sec.  1.902-2(b)(2).
    Example 3. (i) Facts. (A) On December 31, 2006, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation A:
Post-1986 pool................................       1,000u         $350
    2004......................................         150u          20u
    2003......................................         100u           5u
                                               -------------------------
                                                     1,250u  ...........

[[Page 44903]]

 
Foreign Corporation B:
    2006......................................         100u          20u
    2005......................................       (250u)           5u
    2004......................................           0u          50u
    2003......................................         100u          10u
                                               -------------------------
                                                      (50u)          85u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. (A) Because foreign corporation B has an aggregate 
hovering deficit in pre-1987 accumulated profits, the rules of 
paragraph (e)(1)(iii)(C) of this section apply. Accordingly, Sec.  
1.902-2(b) applies immediately prior to the foreign section 381 
transaction, except that the hovering deficit is carried forward 
into the foreign surviving corporation's post-1986 undistributed 
earnings pool and will offset only post-transaction earnings 
accumulated by foreign surviving corporation in the general 
category. Accordingly, after the foreign section 381 transaction, 
foreign surviving corporation has the following earnings and profits 
and foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive     Hovering     Foreign     assoicated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Post-1986 pool..............................................       1,000u        (50u)         $350           $0
2006........................................................           0u  ...........          20u  ...........
2005........................................................           0u  ...........           5u  ...........
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).....................         150u  ...........          20u  ...........
    2004 layer 2 (from Corp B).....................           0u  ...........          50u  ...........
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).....................         100u  ...........           5u  ...........
    2003 layer 2 (from Corp B).....................           0u  ...........          10u  ...........
                                                             ---------------------------------------------------
                                                                   1,250u        (50u)  ...........           $0
----------------------------------------------------------------------------------------------------------------

    (B) Under paragraph (e)(1)(iii)(C) of this section, the 20u, 5u, 
50u, and 10u of pre-1987 foreign income taxes associated with 
foreign corporation B's pre-1987 accumulated profits for 2006, 2005, 
2004 layer 2, and 2003 layer 2, respectively, 
remain in those layers. These foreign income taxes generally will 
not be reduced or deemed paid unless a foreign tax refund restores a 
positive balance to the associated earnings pursuant to section 
905(c), and thus will be trapped. See Sec.  1.902-2(b)(2).

    (2) If foreign surviving corporation is a nonpooling corporation. 
If the foreign surviving corporation is a nonpooling corporation, then 
the pre-pooling annual layers shall be determined under the rules of 
this paragraph (e)(2).
    (i) Qualifying earnings and taxes. The pre-pooling annual layers 
shall consist of the pre-1987 accumulated profits and the pre-1987 
foreign income taxes of the foreign acquiring corporation and the 
foreign target corporation. If the foreign acquiring corporation or the 
foreign target corporation (or both) has post-1986 undistributed 
earnings or a deficit in post-1986 undistributed earnings, then those 
earnings or deficits and any related post-1986 foreign income taxes 
shall be recharacterized as pre-1987 accumulated profits or deficits 
and pre-1987 foreign income taxes of the foreign acquiring corporation 
or the foreign target corporation accumulated immediately prior to the 
foreign section 381 transaction.
    (ii) Carryover rule. Subject to paragraph (e)(2)(iii) of this 
section, the amounts described in paragraph (e)(2)(i) of this section 
shall carry over to the foreign surviving corporation but shall not be 
combined. If the foreign acquiring corporation and the foreign target 
corporation have pre-1987 accumulated profits in the same year and a 
distribution is made therefrom, the principles of Sec.  1.902-
1(b)(2)(ii) and (3) shall apply separately to reduce pre-1987 
accumulated profits and pre-1987 foreign income taxes of the foreign 
acquiring corporation and the foreign target corporation on a pro rata 
basis. For further guidance, see Rev. Rul. 68-351 (1968-2 C.B. 307); 
Rev. Rul. 70-373 (1970-2 C.B. 152) (see also Sec.  601.601(d)(2) of 
this chapter); see also paragraph (f)(2) of this section (governing the 
reconciliation of taxable years).
    (iii) Deficits--(A) In general. The rules of this paragraph 
(e)(2)(iii) apply when, immediately prior to the foreign section 381 
transaction (and after application of the last sentence of paragraph 
(e)(2)(i) of this section), the foreign acquiring corporation or the 
foreign target corporation (or both) has a deficit in one or more years 
that comprise its pre-1987 accumulated profits. See also paragraphs 
(f)(1) and (4) of this section (describing other rules applicable to a 
deficit described in this paragraph (e)(2)(iii)).
    (B) Aggregate positive pre-1987 accumulated profits. If the foreign 
acquiring corporation or the foreign target corporation (or both) has 
an aggregate positive (or zero) amount of pre-1987 accumulated profits, 
but a deficit in pre-1987 accumulated profits in one or more years, 
then the rules otherwise applicable to such deficits shall apply 
separately to the pre-1987 accumulated profits and related foreign 
income taxes of such corporation. A deficit in pre-1987 accumulated 
profits for one or more years is applied to reduce pre-1987 accumulated 
profits on a LIFO basis. Any remaining deficit

[[Page 44904]]

shall be applied to reduce pre-1987 accumulated profits in succeeding 
years. See Rev. Rul. 74-550 (1974-2 C.B. 209) (see also Sec.  
601.601(d)(2) of this chapter); Champion Int'l Corp. v. Commissioner, 
81 T.C. 424 (1983), acq. in result, 1987-2 C.B. 1; Rev. Rul. 87-72 
(1987-2 C.B. 170) (see also Sec.  601.601(d)(2) of this chapter). As a 
result, no amount in excess of the aggregate positive amount of pre-
1987 accumulated profits shall be distributed from the pre-transaction 
earnings of the foreign acquiring corporation or the foreign target 
corporation.
    (C) Aggregate deficit in pre-1987 accumulated profits. If the 
foreign acquiring corporation or the foreign target corporation (or 
both) has an aggregate deficit in pre-1987 accumulated profits, a 
hovering deficit as defined under paragraph (d)(2)(i) of this section, 
then the rules otherwise applicable to such hovering deficits shall 
apply separately to the pre-transaction earnings and profits and 
related taxes of the relevant corporation. See, e.g., sections 316(a) 
and 381(c)(2)(B). Thus, any hovering deficit shall offset only post-
transaction earnings accumulated by the foreign surviving corporation 
in the same separate category of earnings and profits to which the 
relevant portion of the hovering deficit is attributable. Post-
transaction earnings do not include earnings and profits that are 
earned after the foreign section 381 transaction but distributed or 
deemed distributed in the same year they are earned. Following the 
principles of Sec.  1.902-2(b), if there is an aggregate deficit in 
pre-1987 accumulated profits, any related pre-1987 foreign income taxes 
generally will not be reduced or deemed paid unless a foreign tax 
refund restores a positive balance to the associated earnings pursuant 
to section 905(c), and creates a pre-transaction aggregate positive 
balance for pre-1987 accumulated profits.
    (D) Deficit and positive separate categories within annual layers. 
For purposes of applying the rules of paragraphs (e)(2)(iii)(B) and (C) 
of this section, if within a single pre-pooling annual layer, the 
foreign acquiring corporation or the foreign target corporation (or 
both) has a deficit in pre-1987 accumulated profits in a separate 
category and positive pre-1987 accumulated profits in another separate 
category, the deficit shall first be used to offset the positive pre-
1987 accumulated profits in the other separate category in the same 
pre-pooling annual layer. Any remaining deficit shall be carried 
forward or back to other years according to the rules of paragraph 
(e)(2)(iii)(B) or (C) as applicable.
    (iv) Pre-1987 section 960 earnings and profits and foreign income 
taxes. The pre-1987 section 960 earnings and profits and pre-1987 
section 960 foreign income taxes of the foreign acquiring corporation 
and the foreign target corporation shall carry over to the foreign 
surviving corporation but shall not be combined. The rules otherwise 
applicable to such amounts shall apply separately to the pre-1987 
section 960 earnings and profits and pre-1987 section 960 foreign 
income taxes of the foreign acquiring corporation and the foreign 
target corporation on a pro rata basis. For further guidance, see 
Notice 88-70 (1988-2 C.B. 369) (see also Sec.  601.601(d)(2) of this 
chapter).
    (v) Examples. The following examples illustrate the rules of this 
paragraph (e)(2). The examples assume the following facts: Both foreign 
corporation A and foreign corporation B have always had calendar 
taxable years. Foreign corporations A and B (and all of their 
respective qualified business units as defined in section 989) maintain 
a ``u'' functional currency, and 1u = US$1 at all times. Finally, 
unless otherwise stated, all earnings and profits of foreign 
corporations A and B are in the general category. The examples are as 
follows:

    Example 1. (i) Facts. (A) Foreign corporations A and B both were 
incorporated in 2003. Nine percent of the voting stock of foreign 
corporation A is owned by domestic corporate shareholder C. Nine 
percent of the voting stock of foreign corporation B is owned by 
domestic corporate shareholder D. Shareholders C and D are 
unrelated. The remaining 91% of the voting stock of each foreign 
corporation is owned by unrelated foreign shareholders. Thus, 
neither corporation meets the requirements of section 902(c)(3)(B). 
On December 31, 2006, foreign corporations A and B have the 
following earnings and profits and foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation A:
    2006......................................         500u         350u
    2005......................................         400u         300u
    2004......................................         400u         160u
    2003......................................         100u           5u
                                               =============------------
                                                     1,400u         815u
 
Foreign Corporation B:
    2006......................................         100u          20u
    2005......................................         300u          60u
    2004......................................           0u          50u
    2003......................................          50u           5u
                                               -------------------------
                                                       450u         135u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a nonpooling 
corporation that does not meet the requirements of section 
902(c)(3)(B).
    (ii) Result. Under the rules described in paragraphs (e)(2)(i) 
and (ii) of this section, foreign surviving corporation has the 
following earnings and profits and foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2006 E&P:

[[Page 44905]]

 
    2006 layer 1 (from Corp A).......         500u         350u
    2006 layer 2 (from Corp B).......         100u          20u
Two Side-by-Side Layers of 2005 E&P:
    2005 layer 1 (from Corp A).......         400u         300u
    2005 layer 2 (from Corp B).......         300u          60u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).......         400u         160u
    2004 layer 2 (from Corp B).......           0u          50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).......         100u           5u
    2003 layer 2 (from Corp B).......          50u           5u
                                               -------------------------
                                                     1,850u         950u
------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2007, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2007, 
foreign surviving corporation distributes 600u to its shareholders. 
Under the rules of paragraph (c)(3) of this section, the 
distribution is out of pre-pooling annual layers under the LIFO 
method as follows:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2006 E&P:
    2006 layer 1 (from Corp A).......         500u         350u
    2006 layer 2 (from Corp B).......         100u          20u
                                               -------------------------
 
                                                       600u         370u
------------------------------------------------------------------------

    (B) Foreign surviving corporation's foreign income tax accounts 
are reduced to reflect the distribution of earnings and profits 
notwithstanding that no shareholders are eligible to claim deemed 
paid foreign income taxes under section 902. See Sec.  1.902-
1(a)(10)(iii).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2005 E&P:
    2005 layer 1 (from Corp A).......         400u         300u
    2005 layer 2 (from Corp B).......         300u          60u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).......         400u         160u
    2004 layer 2 (from Corp B).......           0u          50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).......         100u           5u
    2003 layer 2 (from Corp B).......          50u           5u
                                               -------------------------
                                                     1,250u         580u
------------------------------------------------------------------------


    Example 2. (i) Facts. (A) The facts are the same as in Example 1 
(i)(A), except that foreign corporation A met the requirements of 
section 902(c)(3)(B) on January 1, 2005, when U.S. corporate 
shareholder C acquired an additional 1% of voting stock for a total 
ownership interest of 10%; foreign corporation A thereby became a 
pooling corporation. On December 31, 2006, foreign corporations A 
and B have the following earnings and profits and foreign income 
taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Post-1986 pool............................         900u         $650
    2004......................................         400u         160u
    2003......................................         100u           5u
                                               -------------------------
                                                     1,400u  ...........
                                               =========================
Foreign Corporation B:
    2006......................................         100u          20u
    2005......................................         300u          60u

[[Page 44906]]

 
    2004......................................           0u          50u
    2003......................................          50u           5u
                                               -------------------------
                                                       450u         135u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a nonpooling 
corporation that does not meet the requirements of section 
902(c)(3)(B).
    (ii) Result. Under the rules described in paragraphs (e)(2)(i) 
and (ii) of this section, foreign surviving corporation has the 
following earnings and profits and foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Two Side-by-Side Layers of 2006 E&P:
    2006 layer 1 (from Corp A's pool)         900u         $650
    2006 layer 2 (from Corp B's               100u          20u
     layer)...................................
    2005 (from Corp B):.......................         300u          60u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).......         400u         160u
    2004 layer 2 (from Corp B).......           0u          50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).......         100u           5u
    2003 layer 2 (from Corp B).......          50u           5u
                                               -------------------------
                                                     1,850u
------------------------------------------------------------------------

    (iii) Subsequent ownership change. On July 1, 2010, USS (a 
domestic corporation) acquires 100% of the stock of foreign 
surviving corporation. Under the rules of paragraph (f)(3) of this 
section, foreign surviving corporation begins to pool its earnings 
and profits under section 902(c)(3) as of January 1, 2010. Foreign 
surviving corporation's earnings and profits and foreign income 
taxes accrued before January 1, 2010 retain their character as pre-
1987 accumulated profits and pre-1987 foreign income taxes.
    Example 3. (i) Facts. (A) The facts are the same as in Example 
2(i)(A), except that on December 31, 2006, foreign corporations A 
and B have the following earnings and profits and foreign income 
taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         Taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Post-1986 pool............................       1,000u         $500
    2004......................................       (200u)          10u
    2003......................................         400u           5u
                                               -------------------------
                                                     1,200u  ...........
                                               =========================
Foreign Corporation B
    2006......................................         300u          20u
    2005......................................       (100u)          60u
    2004......................................           0u          50u
    2003......................................          50u           5u
                                               -------------------------
                                                       250u         135u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a nonpooling 
corporation that does not meet the requirements of section 
902(c)(3)(B).
    (ii) Result. Because foreign corporations A and B have aggregate 
positive amounts of pre-1987 accumulated profits with a deficit in 
one or more years, the rules of paragraph (e)(2)(iii)(B) of this 
section apply. Accordingly, after the foreign section 381 
transaction, foreign surviving corporation has the following 
earnings and profits and foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                          Foreign       taxes
                                                                Positive   Deficit E&P     taxes      associated
                                                                  E&P                    available       with
                                                                                                     deficit E&P
----------------------------------------------------------------------------------------------------------------
Two Side-by-Side Layers of 2006 E&P:
    2006 layer 1 (from Corp A's pool)..............       1,000u  ...........         $500  ...........

[[Page 44907]]

 
    2006 layer 2 (from Corp B's layer).............         300u  ...........          20u
    2005 (from Corp B)......................................  ...........       (100u)  ...........          60u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).....................  ...........       (200u)  ...........          10u
    2004 layer 2 (from Corp B).....................           0u  ...........          50u  ...........
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).....................         400u  ...........           5u  ...........
    2003 layer 2 (from Corp B).....................          50u  ...........           5u  ...........
                                                             ---------------------------------------------------
                                                                   1,750u       (300u)  ...........          70u
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction distribution. (A) During 2007, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2007, 
foreign surviving corporation distributes 1,300u to its 
shareholders. Under the rules described in paragraphs (c)(3) and 
(e)(2)(iii)(B) of this section, the distribution is out of the pre-
pooling annual layers, as follows:

----------------------------------------------------------------------------------------------------------------
                                               E&P                            Foreign taxes
----------------------------------------------------------------------------------------------------------------
Two Side-by-Side Layers of 2006 E&P:
    2006 layer 1................       1,000u                                                      $500
    2006 layer 2................         250u                                                       20u
2003 E&P:
                                          ----------------------------------------------------------------------
    2003 layer 1................          50u                                   1.25u (25% of 5u taxes)
                                                1,300u  ........................................................
----------------------------------------------------------------------------------------------------------------

    (B) Under paragraph (e)(2)(iii)(B) of this section, the rules 
otherwise applicable when a foreign corporation has an aggregate 
positive (or zero) amount of pre-1987 accumulated profits, but a 
deficit in one or more years, apply separately to the pre-1987 
accumulated profits and related pre-1987 foreign income taxes of 
foreign corporation A and foreign corporation B. As a result, 
distributions out of the pre-pooling annual layers of foreign 
corporation A and foreign corporation B cannot exceed the aggregate 
positive amount of pre-1987 accumulated profits of each corporation. 
Accordingly, only 1,200u and 250u can be distributed out of foreign 
corporation A's and foreign corporation B's pre-pooling annual 
layers, respectively. Thus, 1,000u of the distribution is out of 
foreign corporation A's 2006 layer 1 and 250u is out of 
foreign corporation B's 2006 layer 2 (after rolling forward 
(50u) of the deficit in 2005 layer to reduce earnings in 2006 layer 
1 to 250u (300u-50u)). Under the principles of Sec.  1.902-
1(b)(3), all of the taxes in each of those respective layers are 
reduced. The remaining 50u is distributed from foreign corporation 
A's 2003 layer 1 (after rolling back the (200u) deficit in 
2004 layer 1 to reduce earnings in 2003 layer 1 to 
200u (400u-200u)). Thus, after the distribution, 150u remains in the 
2003 layer 1 along with 3.75u of foreign income taxes (5u x 
(150u/200u)).
    (C) Foreign surviving corporation's foreign income tax accounts 
are reduced to reflect the distribution of earnings and profits 
notwithstanding that no shareholders are eligible to claim a credit 
for deemed paid foreign income taxes under section 902. See Sec.  
1.902-1(a)(10)(iii).
    (D) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
2005..........................................           0u          60u
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1.....................           0u          10u
    2004 layer 2.....................           0u          50u
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1.....................         150u        3.75u
    2003 layer 2.....................           0u           5u
                                               -------------------------
                                                       150u      128.75u
------------------------------------------------------------------------

    (E) Under paragraph (e)(2)(iii)(B) of this section, the 60u, 10u, 
50u, and 5u of foreign income taxes related to foreign surviving 
corporation's 2005 layer, 2004 layer 1, 2004 layer 2, 
and 2003 layer 2, respectively, remain in those layers. These 
foreign income taxes generally will not be reduced or deemed paid 
unless a foreign tax refund restores a positive balance to the 
associated earnings pursuant to section 905(c), and thus will be 
trapped. See Sec.  1.902-2(b)(2).
    Example 4. (i) Facts. (A) The facts are the same as in Example 2 
(i)(A), except that on December 31, 2006, foreign corporations A and 
B have the following earnings and profits and foreign income taxes:

[[Page 44908]]



------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         Taxes
------------------------------------------------------------------------
Foreign Corporation A:
    Post-1986 pool............................     (1,000u)          $20
    2004......................................       (200u)          10u
    2003......................................         400u           5u
                                               -------------------------
                                                     (800u)
Foreign Corporation B:
                                               =========================
    2006......................................         100u          20u
    2005......................................         300u          60u
    2004......................................           0u          50u
    2003......................................          50u           5u
                                               -------------------------
                                                       450u         135u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation A acquires the 
assets of foreign corporation B in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a nonpooling 
corporation. 
    (ii) Result. (A) Under paragraph (e)(2)(i) of this section, 
foreign corporation A's post-1986 pool is recharacterized as a 2006 
layer of pre-1987 accumulated profits. Because after the foreign 
section 381 transaction foreign corporation A has an aggregate 
deficit in pre-1987 accumulated profits, the rules of paragraph 
(e)(2)(iii)(C) of this section apply and the rules otherwise 
applicable apply separately to the pre-1987 accumulated profits that 
carry over to foreign surviving corporation from foreign corporation 
A. The (800u) aggregate deficit in foreign corporation A's pre-1987 
accumulated profits is a hovering deficit that will offset only 
post-transaction earnings accumulated by foreign surviving 
corporation in the general category. Accordingly, after the foreign 
section 381 transaction, foreign surviving corporation has the 
following earnings and profits and foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                Positive                  Foreign       taxes
                                                                  E&P      Deficit E&P     taxes      associated
                                                                                         available   deficit E&P
----------------------------------------------------------------------------------------------------------------
Hovering deficit from Corp A's annual layers................  ...........       (800u)  ...........            0
Two Side-by-Side Layers of 2006 E&P:
    2006 layer 1 (from Corp A's pool)..............  ...........           0u  ...........          $20
    2006 layer 2 (from Corp B's layer).............         100u  ...........          20u  ...........
    2005 (from Corp B)......................................         300u  ...........          60u  ...........
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).....................  ...........           0u  ...........          10u
    2004 layer 2 (from Corp B).....................           0u  ...........          50u  ...........
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).....................           0u  ...........           5u  ...........
    2003 layer 2 (from Corp B).....................          50u  ...........           5u  ...........
                                                             ---------------------------------------------------
                                                                     450u       (800u)         140u  ...........
----------------------------------------------------------------------------------------------------------------

    (B) Under paragraph (e)(2)(iii)(C) of this section, the $20, 
10u, and 5u of pre-1987 foreign income taxes associated with foreign 
corporation A's pre-1987 accumulated profits for 2006 layer 
1, 2004 layer 1, and 2003 layer 1, 
respectively, remain in those layers. These foreign income taxes 
generally will not be reduced or deemed paid unless a foreign tax 
refund restores a positive balance to the associated earnings 
pursuant to section 905(c), and thus will be trapped. See Sec.  
1.902-2(b)(2).
    (iii) Post-transaction distribution. (A) During 2007, foreign 
surviving corporation does not accumulate any earnings and profits 
or pay or accrue any foreign income taxes. On December 31, 2007, 
foreign surviving corporation distributes 200u to its shareholders. 
Under the rules described in paragraph (e)(2)(iii)(C) of this 
section, no distribution can be made out of the pre-1987 accumulated 
profits of foreign corporation A (and the (800u) aggregate hovering 
deficit will offset only post-transaction earnings accumulated by 
foreign surviving corporation). Thus, the distribution is out of 
pre-pooling annual layers as follows:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P       taxes paid
------------------------------------------------------------------------
2006 layer 2.........................         100u          20u
2005..........................................         100u          20u
                                               -------------------------
                                                       200u          40u
------------------------------------------------------------------------


[[Page 44909]]

    (B) Foreign surviving corporation's foreign income tax accounts 
are reduced to reflect the distribution of earnings and profits 
notwithstanding that no shareholders are eligible to claim deemed 
paid foreign income taxes under section 902. See Sec.  1.902-
1(a)(10)(iii).
    (C) Immediately after the distribution, foreign surviving 
corporation has the following earnings and profits and foreign 
income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive   Deficit E&P     Taxes      associated
                                                                  E&P                    avaialable      with
                                                                                                     deficit E&P
----------------------------------------------------------------------------------------------------------------
Hovering deficit from Corp A's annual layers................  ...........       (800u)  ...........            0
Two Side-by-Side Layers of 2006 E&P:
    2006 layer 1 (from Corp A's pool)..............  ...........           0u  ...........          $20
    2006 layer 2 (from Corp B's layer).............           0u  ...........           0u  ...........
    2005 (from Corp B)......................................         200u  ...........          40u  ...........
Two Side-by-Side Layers of 2004 E&P:
    2004 layer 1 (from Corp A).....................  ...........           0u  ...........          10u
    2004 layer 2 (from Corp B).....................           0u  ...........          50u  ...........
Two Side-by-Side Layers of 2003 E&P:
    2003 layer 1 (from Corp A).....................           0u  ...........           5u  ...........
    2003 layer 2 (from Corp B).....................          50u  ...........           5u  ...........
                                                                     250u       (800u)         140u  ...........
----------------------------------------------------------------------------------------------------------------

    (f) Special rules--(1) Treatment of deficit--(i) General rule. 
Any deficit described in paragraph (d)(2), (e)(1)(iii), or 
(e)(2)(iii) of this section shall not be taken into account in 
determining current or accumulated earnings and profits of a foreign 
surviving corporation other than to offset post-transaction 
accumulated earnings, as defined in paragraph (d)(2)(ii) of this 
section, including for purposes of calculating--
    (A) The earnings and profits limitation of section 952(c)(1)(A); 
and
    (B) The amount of the foreign surviving corporation's subpart F 
income as defined in section 952(a).
    (ii) Exceptions. The rule in paragraph (i) shall not apply for 
purposes of calculating an earnings and profits limitation under 
section 952(c)(1)(B) or (C).
    (iii) Examples. The following examples illustrate the principles 
of this paragraph (f)(1). The examples assume the following facts: 
foreign corporation A, incorporated in 2002, is and always has been 
a wholly owned subsidiary of USP, a domestic corporation. Foreign 
corporation B, incorporated in 2004, is and always has been a wholly 
owned subsidiary of foreign corporation A. Both foreign corporation 
A and foreign corporation B are organized under the laws of foreign 
country X and have always had a calendar taxable year. Foreign 
corporations A and B (and all of their respective qualified business 
units as defined in section 989) maintain a ``u'' functional 
currency. Unless otherwise stated, any earnings and profits or 
deficit in earnings and profits of foreign corporation A and B in 
the general category are attributable to subpart F income derived 
from foreign base company sales income. Foreign corporation C is a 
wholly owned subsidiary of USP2 and was organized in 2004 under the 
laws of foreign country Y. Foreign corporation C (and all of its 
qualified business units as defined in section 989) maintains a 
``u'' functional currency. Earnings and profits of foreign 
corporation C in the general category are not attributable to 
subpart F income. The examples are as follows:
    Example 1. (i) Facts. (A) On December 31, 2007, foreign 
corporations A and B have the following post-1986 undistributed 
earnings and post-1986 foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation A Separate Category:
    General...................................       (100u)          $25
Foreign Corporation B Separate Category:
    General...................................           0u          $10
------------------------------------------------------------------------

    (B) On January 1, 2008, foreign corporation B elects under Sec.  
301.7701-3(c) of this chapter to be disregarded as an entity 
separate from foreign corporation A. Accordingly, foreign 
corporation B is deemed to have distributed all its property to 
foreign corporation A in a liquidation described in section 332.
    (ii) Result. Under the rules described in paragraphs (d)(1) and 
(2) of this section, foreign surviving corporation A has the 
following post-1986 undistributed earnings and post-1986 foreign 
income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits:         Foreign taxes:
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                         Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................           0u       (100u)          $10          $25
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction earnings and subpart F limitations. (A) 
In its taxable year ending on December 31, 2008, foreign surviving 
corporation A earns 300u of subpart F general category income with 
respect to which it pays $50 in foreign income taxes.

[[Page 44910]]

The hovering deficit of (100u) meets the requirements under section 
952(c)(1)(B) and therefore is taken into account as a qualified 
deficit that may be used by USP to offset a portion of its income 
inclusion related to foreign surviving corporation A's subpart F 
income of 300u in the 2008 taxable year. Accordingly, USP includes 
200u in taxable income for the year and is eligible for a deemed 
paid foreign tax credit under section 960 of $40 (200u subpart F 
inclusion/300 post-1986 undistributed earnings in the general 
category = 66.67%, x $60 foreign income taxes in the general 
category = $40). USP will also include the deemed paid foreign taxes 
of $40 in taxable income for the year as a deemed dividend pursuant 
to section 78. Though the (100u) hovering deficit of foreign 
surviving corporation A is taken into account for purposes of 
limiting USP's subpart F income inclusion under section 
952(c)(1)(B), the amount of the hovering deficit is not reduced for 
purposes of sections 316 and 902 and none of the associated foreign 
income taxes are included in the post-1986 foreign income taxes 
pool.
    (B) As of January 1, 2009, foreign surviving corporation A has 
the following post-1986 undistributed earnings and post-1986 foreign 
income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                         Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................         100u       (100u)          $20          $25
----------------------------------------------------------------------------------------------------------------

    (C) The 200u included as subpart F income constitutes previously 
taxed earnings under section 959.
    Example 2. (i) Facts. (A) On July 1, 2007, foreign corporation B 
elects under Sec.  301.7701-3(c) of this chapter to be disregarded 
as an entity separate from foreign corporation A. Accordingly, 
foreign corporation B is deemed to have distributed all of its 
property to foreign corporation A in a liquidation described in 
section 332.
    (B) Neither foreign corporation A nor B has any post-1986 
undistributed earnings or post-1986 foreign income taxes as of the 
beginning of the 2007 taxable year. For its short taxable year 
ending on June 30, 2007, foreign corporation B has the following 
post-1986 undistributed earnings and post-1986 foreign income taxes:

                          Foreign Corporation B
------------------------------------------------------------------------
                                                               Foreign
               Separate category                    E&P         taxes
------------------------------------------------------------------------
General.......................................       (200u)          $30
------------------------------------------------------------------------

    (C) For the 2007 taxable year, foreign surviving corporation A 
earns a total of 200u of subpart F foreign based company sales 
income in the general category with respect to which it pays $40 in 
foreign income taxes.
    (ii) Result. (A) Under paragraph (d)(2) of this section, foreign 
corporation B's (200u) deficit carries over to foreign surviving 
corporation A as a hovering deficit. Nevertheless, because it is a 
deficit of a qualified chain member for a taxable year ending within 
the 2007 taxable year of foreign surviving corporation A, the (200u) 
deficit meets the requirements under section 952(c)(1)(C) and 
therefore may still be taken into account for purposes of limiting 
foreign surviving corporation A's subpart F income. Accordingly, 
foreign surviving corporation A's 200u of subpart F income for the 
2007 taxable year is fully offset by the (200u) deficit of foreign 
corporation B, and USP will have no subpart F income inclusion for 
the 2007 taxable year. The offset under section 952(c)(1)(C) does 
not result in a reduction of the hovering deficit for purposes of 
section 316 or section 902. The hovering deficit may not also be 
taken into account under section 952(c)(1)(B).
    (B) Because USP has no subpart F income inclusion, foreign 
surviving corporation A's subpart F earnings of 200u will accumulate 
and be added to its post-1986 undistributed earnings as of the 
beginning of 2008. Under the rules of paragraph (f)(5) of this 
section, a pro rata amount, in this case 50% or 100u, will be deemed 
to have been accumulated prior to the foreign section 381 
transaction and the other 50%, or 100u, will be deemed to have been 
accumulated after the foreign section 381 transaction. The 100u of 
post-transaction earnings will be offset by (100u) of the hovering 
deficit for purposes of determining the opening balance of the post-
1986 undistributed earnings pool in 2008. Because the amount of 
earnings offset by the hovering deficit is 50% of the total amount 
of the hovering deficit, $15 (50% of $30) of the related taxes are 
added to the post-1986 foreign income taxes pool as well. The 100u 
of pre-transaction earnings remain in the post-1986 undistributed 
earnings pool. Accordingly, foreign surviving corporation A has the 
following post-1986 undistributed earnings and post-1986 foreign 
income taxes on January 1, 2008:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                         Positive    Hoverinig     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................         100u       (100u)          $55          $15
----------------------------------------------------------------------------------------------------------------

    Example 3. (i) Facts. (A) On January 1, 2007, foreign 
corporation B and foreign corporation C have the following post-1986 
undistributed earnings and post-1986 foreign income taxes:

[[Page 44911]]



------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation B Separate Category:
    General...................................       (100u)           $0
Foreign Corporation C Separate Category:
    General...................................           0u          $10
------------------------------------------------------------------------

    (B) On July 1, 2007, foreign corporation B acquires the assets 
of foreign corporation C in a reorganization described in section 
368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation B is a CFC.
    (C) During the 2007 taxable year foreign surviving corporation B 
has a current deficit of (400u) and $60 of related foreign income 
taxes. During its short taxable year ending on June 30, 2007, 
foreign corporation C has no additional earnings and pays or accrues 
no foreign income taxes.
    (ii) Result. (A) Under the rules of paragraph (f)(5) of this 
section, a pro rata amount, in this case 50% or (200u), of foreign 
surviving corporation B's (400u) current year deficit for the 2007 
taxable year will be deemed to have been accumulated prior to the 
foreign section 381 transaction and be treated as a hovering 
deficit. The other 50%, or (200u) of the deficit will be deemed to 
have been accumulated after the foreign section 381 transaction. The 
related foreign income taxes of $60 will also be allocated on a 
similar 50/50 basis.
    (B) Under the rules described in paragraphs (d)(1) and (2) of 
this section, foreign surviving corporation B has the following 
post-1986 undistributed earnings and post-1986 foreign income taxes 
as of January 1, 2008:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate category                                      Hovering     Foreign     assoicated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................       (200u)       (300u)          $40          $30
----------------------------------------------------------------------------------------------------------------

    (iii) Subpart F income limitations. Even though (200u) of the 
current year deficit is treated as a hovering deficit, the full 
(400u) current year deficit in 2007 of foreign surviving corporation 
B meets the requirements under section 952(c)(1)(C) and therefore is 
available as a limitation on subpart F income, to the extent foreign 
corporation A, which wholly owns foreign surviving corporation B, 
earns any subpart F income in the 2007 taxable year. Any such offset 
under section 952(c)(1)(C) will have no effect on the earnings and 
profits and foreign income tax accounts above of foreign surviving 
corporation B for purposes of sections 316 and 902. Moreover, to the 
extent the hovering deficit reduces subpart F income under section 
952(c)(1)(C), it may not also be taken into account under section 
952(c)(1)(B).

    (2) Reconciling taxable years. If a foreign acquiring corporation 
and a foreign target corporation had taxable years ending on different 
dates, then the pro rata distribution rules of paragraphs (e)(1)(ii) 
and (e)(2)(ii) of this section shall apply with respect to the taxable 
years that end within the same calendar year.
    (3) Post-transaction change of status. If a foreign surviving 
corporation that is subject to the rules of paragraph (c)(2) of this 
section subsequently becomes a pooling corporation (by reason, for 
example, of a reorganization, liquidation, or change of ownership), 
then post-1986 undistributed earnings and post-1986 foreign income 
taxes that were recharacterized as pre-1987 accumulated profits and 
pre-1987 foreign income taxes, respectively, under paragraph (e)(2)(i) 
of this section retain their characterization as a pre-pooling annual 
layer.
    (4) Ordering rule for multiple hovering deficits--(i) Rule. A 
foreign surviving corporation shall apply the deficit rules of 
paragraphs (d)(2), (e)(1)(iii), and (e)(2)(iii) of this section in that 
order if more than one of such rules applies to the foreign surviving 
corporation.
    (ii) Example. The following example illustrates the principles of 
this paragraph (f)(4). The example assumes the following facts: Foreign 
corporation A has been a pooling corporation since its incorporation on 
January 1, 1998. Foreign corporation B has been a nonpooling 
corporation since its incorporation on January 1, 2000. Foreign 
corporations A and B have always had calendar taxable years. Foreign 
corporations A and B (and all of their respective qualified business 
units as defined in section 989) maintain a ``u'' functional currency. 
All earnings and profits of foreign corporation B are in the general 
category. Finally, unless otherwise stated, any earnings and profits in 
the passive category resulted from a look-through dividend that was 
paid by a lower-tier CFC out of earnings accumulated when the CFC was a 
noncontrolled section 902 corporation and that qualified for the 
subpart F same-country exception under section 954(c)(3)(A). The 
example is as follows:

    Example--(i) Facts. (A) On December 31, 2006, foreign 
corporations A and B have the following earnings and profits and 
foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign Corporation A Post-1986 Pool Separate
 Category:
    Passive...................................         400u         $160
    General...................................       (300u)           25
                                               -------------------------
                                                       100u          185
Foreign Corporation B:
    2006......................................       (300u)          50u
    2005......................................         100u          25u
                                               -------------------------

[[Page 44912]]

 
                                                     (200u)          75u
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation B acquires the 
assets of foreign corporation A in a reorganization described in 
section 368(a)(1)(C). Immediately following the foreign section 381 
transaction, foreign surviving corporation is a CFC.
    (ii) Result. Under the rules described in paragraphs (d)(1), 
(d)(2), (e)(1)(i), (e)(1)(ii), and (e)(1)(iii) of this section, 
foreign surviving corporation has the following earnings and profits 
and foreign income taxes:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                          availabe     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Post-1986 pool separate category:
    Passive.................................................         400u  ...........         $160  ...........
    General.................................................  ...........       (300u)  ...........          $25
    Carryforward pre-pooling deficit from Corp B............  ...........       (200u)  ...........            0
    2006 (from Corp B)......................................           0u  ...........          50u  ...........
    2005 (from Corp B)......................................           0u  ...........          25u  ...........
                                                             ---------------------------------------------------
                                                                     400u       (500u)  ...........          $25
----------------------------------------------------------------------------------------------------------------

    (iii) Post-transaction earnings. (A) In the taxable year ending 
on December 31, 2007, foreign surviving corporation accumulates 
earnings and profits and pays related foreign income taxes as 
follows:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Post-1986 pool separate category:
    Passive...................................         150u          $40
    General...................................         400u           60
                                               -------------------------
                                                       550u          100
------------------------------------------------------------------------

    (B) None of the earnings and profits qualify as subpart F income 
as defined in section 952(a). Under paragraph (f)(4)(i) of this 
section, the rules of paragraph (d)(2) of this section apply before 
the rules of paragraph (e)(1)(iii) of this section. Accordingly, 
post-transaction earnings in a separate category are first offset by 
a hovering deficit in the same separate category in the post-1986 
pool. Thus, foreign surviving corporation's (300u) deficit in the 
general category offsets 300u of post-transaction earnings in the 
general category. After application of paragraph (d)(2) of this 
section, the (200u) deficit in the general category carried forward 
from foreign corporation B's pre-pooling aggregate deficit offsets 
the remaining 100u of post-transaction earnings in the general 
category. Accordingly, foreign surviving corporation has the 
following earnings and profits and foreign income taxes at the end 
of 2007:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                                                                Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
Post-1986 pool separate category:
    Passive.................................................         550u  ...........         $200  ...........
    General.................................................  ...........  ...........          $85  ...........
Carryforward pre-pooling deficit from Corp B................  ...........       (100u)  ...........           $0
2006 (from Corp B)..........................................           0u  ...........          50u  ...........
2005 (from Corp B)..........................................           0u  ...........          25u  ...........
                                                             ---------------------------------------------------
                                                                     550u       (100u)  ...........           $0
----------------------------------------------------------------------------------------------------------------

    (C) Under paragraph (d)(2)(iii) of this section, all of the $25 
of post-1986 foreign income taxes related to the (300u) hovering 
deficit in the general category is added to the foreign surviving 
corporation's post-1986 foreign income taxes of $60 in that category 
(because post-transaction earnings in the general category have 
exceeded the deficit in that category). Under paragraph 
(e)(1)(iii)(C) of this section, the 50u and 25u of foreign income 
taxes associated with foreign corporation B's pre-1987 accumulated 
profits for 2006 and 2005 remain in those layers. These foreign 
income taxes generally will not be reduced or deemed paid unless a 
foreign tax refund restores a positive balance to the associated 
earnings pursuant to section

[[Page 44913]]

905(c), and thus will be trapped. See Sec.  1.902-2(b)(2).

    (5) Pro rata rule for earnings and deficits during transaction 
year. (i) For purposes of offsetting post-transaction earnings of a 
foreign surviving corporation under the rules described in paragraphs 
(d)(2), (e)(1)(iii), and (e)(2)(iii) of this section, the earnings and 
profits, and any related foreign income taxes, in each separate 
category for the taxable year of the foreign surviving corporation in 
which the transaction occurs shall be deemed to have been accumulated 
after such transaction in an amount which bears the same ratio to the 
undistributed earnings and profits of the foreign surviving corporation 
for such taxable year (computed without regard to any earnings and 
profits carried over) as the number of days in the taxable year after 
the date of transaction bears to the total number of days in the 
taxable year. See, e.g., Sec.  1.381(c)(2)-1(a)(7) Example 2 
(illustrating application of this rule with respect to domestic 
corporations).
    (ii) For purposes of determining the amount of pre-transaction 
deficits described in paragraphs (d)(2), (e)(1)(iii), and (e)(2)(iii) 
of this section, of a foreign surviving corporation that has a deficit 
in earnings and profits in any separate category for its taxable year 
in which the transaction occurs, unless the actual accumulated earnings 
and profits, or deficit, as of such date can be shown, such pre-
transaction deficit, and any related foreign income taxes, shall be 
deemed to have accumulated in a manner similar to that described in 
paragraph (f)(5)(i) of this section. See, e.g., Sec.  1.381(c)(2)-
1(a)(7) Example 4 (illustrating application of this rule with respect 
to domestic corporations).
    (g) Effective date. This section shall apply to section 367(b) 
transactions that occur on or after November 6, 2006.

0
Par. 8. Section 1.367(b)-8 is added and reserved to read as follows:


Sec.  1.367(b)-8  Allocation of earnings and profits and foreign income 
taxes in certain foreign corporate separations. [Reserved]

0
Par. 9. Section 1.367(b)-9 is added to read as follows:


Sec.  1.367(b)-9  Special rule for F reorganizations and similar 
transactions.

    (a) Scope. This section applies to a foreign section 381 
transaction (as defined in Sec.  1.367(b)-7(a)) either--
    (1) That is described in section 368(a)(1)(F); or
    (2) That involves--
    (i) At least one foreign corporation that holds no property and has 
no tax attributes immediately before the transaction, other than a 
nominal amount of assets (and related tax attributes) to facilitate its 
organization or preserve its existence as a corporation; and
    (ii) No more than one foreign corporation that holds more than a 
nominal amount of property or has more than a nominal amount of tax 
attributes immediately before the transaction.
    (b) Hovering deficit rules inapplicable. If a transaction is 
described in paragraph (a) of this section, a foreign surviving 
corporation shall succeed to earnings and profits, deficits in earnings 
and profits, and foreign income taxes without regard to the hovering 
deficit rules of Sec.  1.367(b)-7(d)(2), (e)(1)(iii), and (e)(2)(iii).
    (c) Foreign divisive transactions. [Reserved]
    (d) Examples. The following examples illustrate the principles of 
this section:

    Example 1. (i) Facts. (A) Foreign corporation A is and always 
has been a wholly owned subsidiary of USP, a domestic corporation. 
Foreign corporation A was incorporated in 1995, and has always had a 
calendar taxable year. Foreign corporation A (and all of its 
respective qualified business units as defined in section 989) 
maintains a ``u'' functional currency. On December 31, 2006, foreign 
corporation A has the following post-1986 undistributed earnings and 
post-1986 foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
               Separate Category                    E&P         taxes
------------------------------------------------------------------------
Passive.......................................     (1,000u)           $5
General.......................................         200u          200
                                               -------------------------
                                                     (800u)          205
------------------------------------------------------------------------

    (B) On January 1, 2007, foreign corporation A moves its place of 
incorporation from Country 1 to Country 2 in a reorganization 
described in section 368(a)(1)(F).
    (ii) Result. Under Sec.  1.367(b)-7(d), as modified by paragraph 
(b) of this section, the pre-transaction deficit of foreign 
corporation A will not hover. Accordingly, foreign surviving 
corporation has the following post-1986 undistributed earnings and 
post-1986 foreign income taxes immediately after the foreign section 
381 transaction:

------------------------------------------------------------------------
                                                               Foreign
               Separate category                    E&P         taxes
------------------------------------------------------------------------
Passive.......................................     (1,000u)           $5
General.......................................         200u          200
                                               -------------------------
                                                     (800u)          205
------------------------------------------------------------------------

    Example 2. (i) Facts. (A) Foreign corporations B, C and D are 
and always have been wholly owned subsidiaries of USP, a domestic 
corporation. Foreign corporation B was incorporated in 2000 and 
foreign corporations C and D were incorporated in 2001. Foreign 
corporation B does not own any significant property and has no 
earnings and profits or foreign income taxes accounts. Both foreign 
corporations C and D have always had a calendar taxable year. 
Foreign corporations C and D (and all of their respective qualified 
business units as defined in section 989) maintain a ``u'' 
functional currency. On December 31, 2006, foreign corporations C 
and D have the following post-1986 undistributed earnings and post-
1986 foreign income taxes:

------------------------------------------------------------------------
                                                               Foreign
                                                    E&P         taxes
------------------------------------------------------------------------
Foreign corporation C Separate Category:
    Passive...................................       (900u)          $50

[[Page 44914]]

 
    General...................................       (200u)          100
                                               -------------------------
                                                    (1100u)          150
                                               =========================
Foreign corporation D Separate Category:
    Passive...................................        1200u          400
    General...................................         400u          100
                                               -------------------------
                                                      1600u          500
------------------------------------------------------------------------

    (B) On January 1, 2007, USP foreign corporations C and D merge 
into foreign corporation B in a reorganization described in section 
368(a)(1)(A).
    (ii) Result. Although the merger is a foreign section 381 
transaction involving a foreign corporation with no property or tax 
attributes, paragraph (b) of this section does not apply because 
more than one foreign corporation with significant tax attributes is 
involved in the foreign section 381 transaction. Accordingly, under 
Sec.  1.367(b)-7(d), foreign surviving corporation B has the 
following post-1986 undistributed earnings and post-1986 foreign 
income taxes immediately after the foreign section 381 transaction:

----------------------------------------------------------------------------------------------------------------
                                                                 Earnings & profits           Foreign taxes
                                                             ---------------------------------------------------
                                                                                                       Foreign
                                                                                                        taxes
                      Separate Category                         Positive     Hovering     Foreign     associated
                                                                  E&P        deficit       taxes         with
                                                                                         available     hovering
                                                                                                       deficit
----------------------------------------------------------------------------------------------------------------
General.....................................................        1200u       (900u)         $400          $50
Passive.....................................................         400u       (200u)          100          100
                                                             ---------------------------------------------------
                                                                    1600u      (1100u)          500          150
----------------------------------------------------------------------------------------------------------------


    (e) Effective date. This section shall apply to section 367(b) 
transactions that occur on or after November 6, 2006.

0
Par. 10. In Sec.  1.381(a)-1, paragraph (c) is revised to read as 
follows:


Sec.  1.381(a)-1  General rule relating to carryovers in certain 
corporate acquisitions.

* * * * *
    (c) Foreign corporations. For additional rules involving foreign 
corporations, see Sec. Sec.  1.367(b)-7 through 1.367(b)-9.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: July 20, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary (Tax Policy).
[FR Doc. 06-6740 Filed 8-7-06; 8:45 am]
BILLING CODE 4830-01-P