[Federal Register Volume 71, Number 202 (Thursday, October 19, 2006)]
[Rules and Regulations]
[Pages 61648-61662]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-17307]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9292]
RIN 1545-BB11


Partner's Distributive Share: Foreign Tax Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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SUMMARY: This document contains final regulations regarding the 
allocation of creditable foreign tax expenditures by partnerships. The 
regulations are necessary to clarify the application of

[[Page 61649]]

section 704(b) to allocations of creditable foreign tax expenditures. 
The final regulations affect partnerships and their partners.

DATES: Effective Date: These regulations are effective October 19, 
2006.
    Applicability Date: These regulations apply to partnership taxable 
years beginning on or after October 19, 2006.

FOR FURTHER INFORMATION CONTACT: Timothy J. Leska at 202-622-3050 or 
Michael I. Gilman at 202-622-3850 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to 26 CFR part 1 under section 
704 of the Internal Revenue Code (Code). On April 21, 2004, temporary 
regulations (TD 9121) relating to the proper allocation of partnership 
expenditures for foreign taxes were published in the Federal Register 
(69 FR 21405). A notice of proposed rulemaking (REG-139792-02) cross-
referencing the temporary regulations was also published in the Federal 
Register (69 FR 21454) on April 21, 2004. A public hearing was 
requested and held on September 14, 2004. The IRS received a number of 
written comments responding to the temporary and proposed regulations. 
After consideration of the comments, the proposed regulations are 
adopted as revised by this Treasury decision and the corresponding 
temporary regulations are removed.
    Section 704(a) provides that a partner's distributive share of 
income, gain, loss, deduction, or credit shall, except as otherwise 
provided, be determined by the partnership agreement. Section 704(b) 
provides that a partner's distributive share of income, gain, loss, 
deduction, or credit (or item thereof) shall be determined in 
accordance with the partner's interest in the partnership (determined 
by taking into account all facts and circumstances) if the allocation 
to a partner under the partnership agreement of income, gain, loss, 
deduction, or credit (or item thereof) does not have substantial 
economic effect. Thus, in order to be respected, partnership 
allocations either must have substantial economic effect or must be in 
accordance with the partners' interests in the partnership.
    In general, for an allocation to have economic effect, it must be 
consistent with the underlying economic arrangement of the partners. 
This means that, in the event there is an economic burden or benefit 
that corresponds to the allocation, the partner to whom the allocation 
is made must receive the economic benefit or bear such economic burden. 
See Sec.  1.704-1(b)(2)(ii). As a general rule, the economic effect of 
an allocation (or allocations) is substantial if there is a reasonable 
possibility that the allocation (or allocations) will affect 
substantially the dollar amounts to be received, independent of tax 
consequences. See Sec.  1.704-1(b)(2)(iii). Even if the allocation 
affects substantially the dollar amounts, the economic effect of the 
allocation (or allocations) is not substantial if, at the time the 
allocation (or allocations) becomes part of the partnership agreement, 
(1) The after-tax economic consequences of at least one partner may, in 
present value terms, be enhanced compared to such consequences if the 
allocation (or allocations) were not contained in the partnership 
agreement, and (2) there is a strong likelihood that the after-tax 
economic consequences of no partner will, in present value terms, be 
substantially diminished compared to such consequences if the 
allocation (or allocations) were not contained in the partnership 
agreement. See Sec.  1.704-1(b)(2)(iii).
    The temporary and proposed regulations clarified the application of 
the regulations under section 704 to foreign taxes paid or accrued by a 
partnership and eligible for credit under section 901(a) (creditable 
foreign tax expenditures or CFTEs). While allocations of CFTEs that are 
disproportionate to the related income may have economic effect in that 
they reduce the recipient partner's capital account and affect the 
amount the recipient partner is entitled to receive on liquidation, 
this effect will almost certainly not be substantial after taking U.S. 
tax consequences into account. For example, the after-tax economic 
consequences to a foreign or other tax-indifferent partner whose share 
of the tax expense is borne by a U.S. taxable partner will be enhanced 
by reason of the allocation, and there is a strong likelihood that the 
after-tax economic consequences to a U.S. partner will not be 
substantially diminished since the allocation of the CFTE increases the 
allowable foreign tax credit and results in a dollar-for-dollar 
reduction in the U.S. tax the partner would otherwise owe.
    The temporary and proposed regulations were based on the assumption 
that partnerships specially allocate foreign taxes where the recipient 
partner would elect to claim the CFTE as a credit, rather than as a 
deduction. As a matter of administrative convenience, the regulations 
applied to all allocations of CFTEs even though, in rare instances, a 
partner may instead elect to deduct the CFTEs. Thus, the temporary and 
proposed regulations provided that partnership allocations of CFTEs 
cannot have substantial economic effect and, therefore, must be 
allocated in accordance with the partners' interests in the 
partnership.
    The temporary and proposed regulations provided a safe harbor under 
which partnership allocations of CFTEs will be deemed to be in 
accordance with the partners' interests in the partnership. Under this 
safe harbor, if the partnership agreement satisfies the requirements of 
Sec.  1.704-1(b)(2)(ii)(b) or (d) (capital account maintenance, 
liquidation according to capital accounts, and either deficit 
restoration obligations or qualified income offsets), then an 
allocation of CFTEs that is proportionate to a partner's distributive 
share of the partnership income to which such taxes relate (including 
income allocated pursuant to section 704(c)) will be deemed to be in 
accordance with the partners' interests in the partnership. If the 
allocation of CFTEs does not satisfy this safe harbor, then the 
allocation of CFTEs will be tested under the partners' interests in the 
partnership standard set forth in Sec.  1.704-1(b)(3).

Summary of Comments and Explanation of Provisions

    These final regulations retain the provisions of the proposed and 
temporary regulations excluding allocations of CFTEs from the 
substantial economic effect safe harbor of Sec.  1.704-1(b)(2), and 
provide a safe harbor under which allocations of CFTEs will be deemed 
to be in accordance with the partners' interests in the partnership. As 
provided in the temporary and proposed regulations, the final 
regulations provide that allocations of CFTEs must be in proportion to 
the distributive shares of income to which the CFTEs relate in order to 
satisfy the safe harbor.
    The final regulations provide that the income to which a CFTE 
relates is the net income in the CFTE category to which the CFTE is 
allocated and apportioned. A CFTE category is a category of net income 
attributable to one or more activities of the partnership. The net 
income in a CFTE category is the net income determined for U.S. Federal 
income tax purposes (U.S. net income) attributable to each separate 
activity of the partnership that is included in the CFTE category. 
Income from separate activities is included in the same CFTE category 
only if the U.S. net income from the

[[Page 61650]]

activities is allocated among the partners in the same proportions. For 
this purpose, income from a divisible part of a single activity that is 
shared in a different ratio than other income from that activity is 
treated as income from a separate activity. CFTEs are allocated and 
apportioned to CFTE categories in accordance with Sec.  1.904-6 
principles, as modified by the final regulations. Therefore, CFTEs 
generally are allocated to a CFTE category if the income on which the 
CFTE is imposed (the net income recognized for foreign tax purposes) is 
in the CFTE category.
    Accordingly, the safe harbor of the final regulations requires a 
three-step process to determine the distributive share of income to 
which a CFTE relates. First, the partnership must determine its CFTE 
categories. Second, the partnership must determine the U.S. net income 
in each CFTE category. Third, the partnership must allocate and 
apportion CFTEs to the CFTE categories based on the net income in the 
CFTE categories that is recognized for foreign tax purposes. To satisfy 
the safe harbor, the partnership must allocate CFTEs among the partners 
in the same proportion as the allocations of U.S. net income in the 
applicable CFTE category.

Summary of Comments

    A number of comments were received on the temporary and proposed 
regulations. The comments included requests for clarification and 
recommendations relating to the following: (i) The definition of CFTEs, 
(ii) the CFTE categories, (iii) the distributive share of income to 
which a CFTE relates, (iv) the application of the principles of Sec.  
1.904-6, (v) the partners' interests in the partnership, (vi) the 
effective date and transition rule and (vii) certain other matters. The 
comments and final regulations are discussed in detail below.

A. Creditable Foreign Tax Expenditures (CFTEs)

    The temporary and proposed regulations provide that a CFTE is a 
foreign tax paid or accrued by a partnership that is eligible for a 
credit under section 901(a). A qualifying domestic corporate 
shareholder may claim a credit under section 901(a) for taxes paid or 
accrued by a foreign corporation and deemed paid by the shareholder 
under section 902 or 960 upon distribution or inclusion of the 
associated earnings. Several commentators requested guidance concerning 
whether taxes deemed paid under section 902 or 960 are subject to these 
regulations. Although a domestic corporation may be eligible to claim a 
credit for deemed-paid taxes with respect to stock of a foreign 
corporation it owns indirectly through a partnership, any such deemed-
paid taxes are determined directly by the corporate partner based on 
the partner's distributive share of dividend income or inclusion. Such 
deemed-paid taxes, therefore, are not partnership items and are not 
taxes paid or accrued (or deemed paid or accrued) by a partnership. 
Accordingly, foreign taxes deemed paid under section 902 or 960 are not 
subject to these regulations.
    The final regulations retain the definition of CFTE contained in 
the temporary and proposed regulations. In response to the comment, the 
final regulations clarify that a CFTE does not include foreign taxes 
deemed paid by a corporate partner under section 902 or 960. The final 
regulations also clarify that the regulations do not apply to foreign 
taxes paid or accrued by a partner (foreign taxes for which the partner 
has legal liability within the meaning of Sec.  1.901-2(f)). Finally, 
the final regulations clarify that a CFTE does include a foreign tax 
paid or accrued by a partnership that is eligible for a credit under an 
applicable U.S. income tax treaty.

B. CFTE Categories

    Examples in the temporary and proposed regulations illustrated that 
the determination of the income to which a CFTE relates must be made 
separately for certain categories of income when the partnership 
agreement provides for different allocations of such income. 
Commentators requested additional guidance regarding the relevant 
categories for purposes of the safe harbor, including clarification 
that the safe harbor does not require the partnership to determine its 
CFTE categories by reference to section 904(d) categories. Subject to 
the requirements of section 704(b) and other applicable provisions of 
U.S. law, partners are free to allocate income in any manner they 
choose. Although partners must assign their distributive shares of 
partnership items (along with their other items of income and expense) 
to section 904(d) categories to compute the applicable limitations on 
the foreign tax credit, the CFTE categories need not be determined by 
reference to section 904(d) categories. These principles were 
illustrated by the examples in the temporary and proposed regulations. 
However, the IRS and the Treasury Department agree with commentators 
that it is appropriate to provide additional guidance in determining a 
partnership's relevant categories of income. Accordingly, the final 
regulations provide additional guidance for purposes of making this 
determination. The additional guidance is also intended to assist in 
the determination of the distributive share of income to which a 
foreign tax relates. See the discussion at section C in this preamble. 
Consistent with the comments, the rules provided for in the final 
regulations rely to the extent possible on U.S. tax principles.
    The final regulations clarify that the relevant category of income 
is the CFTE category, defined in the final regulations as U.S. net 
income attributable to one or more activities of the partnership. In 
general, the final regulations provide that U.S. net income from all of 
the partnership's activities is treated as income in a single CFTE 
category. This general rule does not apply, however, if the partnership 
agreement provides for an allocation of U.S. net income from one or 
more activities that differs from the allocation of U.S. net income 
from other activities. In that case, U.S. net income from each activity 
or group of activities that is subject to a different allocation is 
treated as net income in a separate CFTE category. For this purpose, 
income from a divisible part of a single activity is treated as income 
from a separate activity if such income is shared in a different ratio 
than other income from the activity.
    Thus, if a partnership agreement allocates all partnership items in 
the same manner, the partnership will have a single CFTE category, 
regardless of the number of activities in which the partnership is 
engaged. Conversely, a partnership agreement that provides for 
different allocations of net income with respect to one or more 
activities will have multiple CFTE categories. For example, assume a 
partnership (AB) with two partners is engaged in two activities and 
that the partnership agreement provides that all partnership items are 
shared 50-50. In such a case, the partnership has a single CFTE 
category. However, the partnership would have two CFTE categories if 
the items from one activity were shared 50-50 and the items from the 
second activity were shared 80-20.
    Different allocations of the partnership's U.S. net income from 
separate activities and, thus, multiple CFTE categories may result if 
the partnership agreement contains special allocations. For example, 
assume that AB partnership agreement allocates all items other than 
depreciation 50-50, and that deductions for depreciation are allocated 
100 percent to one of the partners. In such a case, the allocations of 
U.S. net income from the two activities will differ if AB's deductions 
for depreciation relate solely to one

[[Page 61651]]

activity or if the deductions relate disproportionately to the 
activities. See paragraph (b)(5) Example 22. A preferential allocation 
of income will not result in multiple CFTE categories if the allocation 
relates to all of the partnership's net income. For example, assume 
partnership AB allocates $100 of gross income each year to one of the 
partners and all remaining items 50-50. In such a case, the special 
allocation of $100 of gross income affects the overall sharing ratio of 
partnership net income, but does not result in different sharing ratios 
with respect to income from the partnership's two activities. 
Accordingly, the U.S. net income attributable to the two activities is 
included in a single CFTE category. See paragraph (b)(5) Example 25.
    Whether the partnership has different sharing ratios with respect 
to income from one or more activities, and therefore has more than one 
CFTE category, depends on the facts and circumstances. Therefore, the 
final regulations provide that whether a partnership has one or more 
activities, and the scope of those activities, must be determined in a 
reasonable manner taking into account all the facts and circumstances. 
In evaluating whether aggregating or disaggregating income from 
particular business or investment operations constitutes a reasonable 
method of determining the scope of an activity, the principal 
consideration is whether or not the proposed determination has the 
effect of separating CFTEs from the related foreign income. 
Accordingly, relevant facts and circumstances include whether the 
partnership conducts business or investment operations in more than one 
geographic location or through more than one entity or branch, and 
whether certain types of income are exempt from foreign tax or subject 
to preferential foreign tax treatment. In addition, income from a 
divisible part of a single activity is treated as income from a 
separate activity if necessary to prevent the separation of CFTEs from 
the related foreign income. Finally, the final regulations provide that 
the partnership's activities must be determined consistently from year 
to year absent a material change in facts and circumstances.

C. Distributive Share of Income to Which a CFTE Relates

    The temporary and proposed regulations required the allocation of a 
CFTE to be in proportion to the partner's distributive share of income 
to which it relates. Several commentators requested that the final 
regulations provide additional guidance in determining a partner's 
distributive share of income for purposes of the safe harbor. Some 
commentators believed that it was unclear whether allocations of CFTEs 
must be proportionate to allocations of income as determined for U.S. 
tax purposes or as determined under foreign law. One comment 
recommended that, at least in cases where there is a preferential 
allocation of income, income as determined for U.S. tax purposes should 
control. Other commentators requested that the final regulations 
clarify whether allocations of CFTEs must follow allocations of gross 
or net income, and that the final regulations clarify the effect of 
special allocations and allocations of separately stated items on 
allocations of CFTEs under the safe harbor. Commentators also requested 
clarifications regarding section 704(c) allocations, income allocations 
that are deductible under foreign law, guaranteed payments, and 
situations in which certain partners' allocable shares of partnership 
income are excluded from the foreign tax base. In response to the 
comments, the final regulations provide several clarifications 
regarding the determination of a partner's distributive share of income 
to which a CFTE relates.
1. Net Income in a CFTE Category
    The final regulations clarify that the net income in a CFTE 
category is the net income for U.S. Federal income tax purposes, 
determined by taking into account all items attributable to the 
relevant activity or group of activities (or portion thereof). The 
final regulations provide that the items of gross income included in a 
CFTE category must be determined in a consistent manner under any 
reasonable method taking into account all the facts and circumstances. 
Expenses, losses or other deductions generally must be allocated and 
apportioned to gross income included in a CFTE category in accordance 
with the rules of Sec. Sec.  1.861-8 and 1.861-8T.
    Sections 1.861-8 and 1.861-8T require taxpayers to use special 
rules contained in Sec. Sec.  1.861-9 through 1.861-13T and Sec.  
1.861-17 to allocate and apportion deductions for interest expense and 
research and development (R&D) costs. See Sec. Sec.  1.861-8(e)(3) and 
1.861-8T(e)(2). Those provisions generally require taxpayers to 
allocate and apportion such deductions at the partner level and do not 
provide rules for allocating and apportioning the deductions at the 
partnership level. See Sec. Sec.  1.861-9T(e) and 1.861-17(f). 
Therefore, the final regulations permit a partnership to allocate and 
apportion deductions for interest and R&D costs for purposes of 
determining net income in a CFTE category under any reasonable method, 
including but not limited to the rules contained in Sec. Sec.  1.861-9 
through 1.861-13T and Sec.  1.861-17.
    The final regulations clarify that in applying U.S. Federal income 
tax principles to determine the net income attributable to an activity 
of a branch, the only items of gross income taken into account are 
items of gross income that are recognized by the branch for U.S. 
Federal income tax purposes. Therefore, a payment from one branch to 
another does not increase the gross income attributable to the activity 
of the recipient. See paragraph (b)(5) Example 24. Similarly, because 
U.S. tax principles apply to determine net income attributable to an 
activity of a branch, the inter-branch payment does not reduce the 
gross income of the payor. See paragraph (b)(4)(viii)(c)(3)(B) and 
paragraph (b)(5) Example 24.
    The discussion in this preamble addresses the effect of the 
following factors on the determination of net income in a CFTE 
category: (a) Section 704(c) allocations, (b) preferential income 
allocations and guaranteed payments, and (c) the exclusion of income of 
certain partners from the foreign tax base.
(a) Section 704(c) Allocations
    Several commentators requested clarification of when section 704(c) 
allocations should be taken into account. Some commentators believed 
that section 704(c) allocations should only be taken into account where 
the built-in gain or loss is also recognized in the foreign 
jurisdiction. A number of commentators suggested further that section 
704(c) allocations should be taken into account only upon the 
disposition of the section 704(c) property, while other commentators 
believed that section 704(c) allocations should also be taken into 
account as the section 704(c) property is depreciated or amortized over 
time.
    After consideration of these comments, the final regulations retain 
the general principle that all section 704(c) allocations must be taken 
into account when determining net income in the relevant category. The 
IRS and the Treasury Department concluded that any attempt to trace the 
impact of built-in gain (or loss) under foreign tax principles to 
corresponding items under U.S. tax principles would be difficult to do 
and impractical to administer. Because allocations of net income from a 
CFTE category are allocations of the net income recognized for U.S. tax

[[Page 61652]]

purposes, the IRS and the Treasury Department believe that all section 
704(c) allocations (including ``reverse'' section 704(c) allocations 
and section 704(c) allocations that are made prior to an asset's 
disposition) must be taken into account in determining a partner's 
distributive share of income. Thus, the final regulations provide that 
the net income in a CFTE category is the net income for U.S. income tax 
purposes, determined by taking into account all items attributable to 
the relevant activity, including, among other items, items allocated 
pursuant to section 704(c). See paragraph (b)(5) Example 26.
(b) Preferential Income Allocations and Guaranteed Payments
    Several commentators requested that the final regulations provide 
guidance regarding the treatment of preferential income allocations and 
guaranteed payments when applying the safe harbor. In particular, 
clarification was requested as to the relevance of the deductibility of 
such items under foreign law in determining whether CFTEs are related 
to such items.
    The final regulations generally provide that the income to which a 
CFTE relates is the net income in the CFTE category to which the CFTE 
is allocated and apportioned. However, if an allocation of partnership 
income is treated as a deductible payment under foreign law, then no 
CFTEs are related to that income because it is not included in the 
foreign tax base. To reflect this principle, the final regulations 
provide that income attributable to an activity shall not include an 
item of partnership income to the extent the allocation of such item of 
income (or payment thereof) to a partner results in a deduction under 
foreign law. By removing the income associated with a preferential 
income allocation that is deductible under foreign law from the net 
income in a CFTE category, this provision of the final regulations 
ensures that no CFTE will be related to such income, which is not 
included in the base upon which the creditable foreign tax is imposed.
    The principle that no CFTEs are related to income if the allocation 
of such income results in a deduction under foreign law applies with 
equal force to cases in which a guaranteed payment made by a 
partnership to a partner is deductible by the partnership under foreign 
law. Conversely, where a partner receives a guaranteed payment and the 
guaranteed payment is not deductible by the partnership under foreign 
law (and thus does not reduce the foreign tax base), CFTEs should 
relate to the guaranteed payment. Accordingly, the final regulations 
contain two provisions to reflect these principles. First, under the 
final regulations, a guaranteed payment is treated as income in a CFTE 
category to the extent that the payment is not deductible by the 
partnership under foreign law. Second, the final regulations provide 
that such a guaranteed payment is treated as a distributive share of 
income for purposes of the safe harbor. Consequently, the final 
regulations provide that CFTEs relate to income taken into account as a 
guaranteed payment to the extent the payment is not deductible under 
foreign law, and therefore CFTEs must be allocated to the partner 
receiving the guaranteed payment.
    One commentator requested guidance concerning the source and 
character of guaranteed payments for other U.S. tax purposes. These 
issues are clearly important, but they are beyond the scope of this 
project and are not addressed in these final regulations.
(c) Taxes Imposed on Certain Partners' Income
    A foreign jurisdiction may impose tax with respect to partnership 
income that is allocable to certain partners and not with respect to 
partnership income allocable to other partners. For example, as was the 
case in Vulcan Materials Co. v. Comm'r, 96 T.C. 410 (1991), aff'd in 
unpublished opinion, 959 F.2d 973 (11th Cir. 1992), nonacq. 1995-2 CB 
2, a foreign jurisdiction may impose tax solely with respect to the 
nonresident partners' shares of partnership income. One commentator 
suggested that the final regulations provide that in these situations, 
allocations of CFTEs satisfy the safe harbor if they are allocated to 
the partner or partners whose income is included in the foreign tax 
base. The final regulations adopt this comment, and provide that income 
in a CFTE category does not include net income that foreign law would 
exclude from the foreign tax base as a result of the status of the 
partner. By removing such income from a CFTE category, this provision 
of the final regulations ensures that CFTEs will be related only to 
income of those partners whose income is included in the base upon 
which the creditable foreign tax is imposed.
2. Distributive Share of Income
    The final regulations provide that a partner's distributive share 
of income generally is the portion of the net income in a CFTE category 
that is allocated to the partner. Therefore, a partner's distributive 
share of income is determined under U.S. tax principles, taking into 
account the modifications described in section C1 under ``Net income in 
a CFTE category.''
    The final regulations provide a special rule for cases in which 
more than one partner receives positive income allocations (income in 
excess of expenses) from a CFTE category and the aggregate of such 
positive income allocations exceeds the net income in the CFTE category 
because one or more other partners is allocated a net loss (expenses in 
excess of income). Because in this situation the sum of the positive 
income allocations from the CFTE category exceeds 100 percent of the 
net income in the category, an adjustment to the safe harbor formula is 
required to ensure that aggregate allocations of CFTEs do not exceed 
100 percent of the CFTEs in the category. Accordingly, solely for 
purposes of allocating CFTEs under the safe harbor, the final 
regulations limit the distributive share of income of each partner that 
receives a positive income allocation to the partner's positive income 
allocation attributable to the CFTE category, divided by the aggregate 
positive income allocations attributable to the CFTE category, 
multiplied by the net income in the CFTE category. For example, assume 
that the partnership has $100 of net income ($130 of gross income and 
$30 of expenses) in a CFTE category and that partner A is allocated $65 
of gross income, partner B is allocated $45 of gross income and partner 
C is allocated $20 of gross income and $30 of expenses. In this case, 
solely for purposes of the safe harbor, partner A's distributive share 
of income is $59 ($65/$110 x 100) and partner B's distributive share of 
income is $41 ($45/$110 x $100).
3. No Net Income
    The final regulations contain a special rule for cases in which 
CFTEs are allocated and apportioned to a CFTE category that does not 
have any net income for U.S. tax purposes in the year the foreign taxes 
are paid or accrued. In such cases, there is no net income in the CFTE 
category to which the CFTEs relate. In the absence of a special rule, 
allocations of such CFTEs among the partners would not fall within the 
general safe harbor of the final regulations and would be required to 
be allocated in accordance with the partners' interests in the 
partnership. To eliminate uncertainty in this situation, the final 
regulations include a rule that relates such CFTEs to net income 
recognized for U.S. tax purposes in other years or in other CFTE 
categories. (For rules relating to the allocation and

[[Page 61653]]

apportionment of CFTEs to a CFTE category, see section D below.)
    Under the final regulations, CFTEs allocated and apportioned to a 
CFTE category that has no net income for U.S. tax purposes will be 
deemed to relate to the aggregate net income (if any) recognized by the 
partnership in that CFTE category during the preceding three-year 
period (not taking into account years in which there is a net loss in 
the CFTE category for U.S. tax purposes). Accordingly, the CFTEs in 
these situations generally must be allocated among the partners in the 
same proportion as the allocations of such net income for the prior 
three-year period to satisfy the safe harbor. If the partnership does 
not have net income in the applicable CFTE category in either the 
current year or any of the previous three taxable years, the CFTEs must 
be allocated among the partners in the same proportion that the 
partnership reasonably expects to allocate net income in the applicable 
CFTE category over the succeeding three years. If the partnership does 
not reasonably expect to have net income in the applicable CFTE 
category in the succeeding three years, the CFTEs must be allocated 
among the partners in the same proportion as the total partnership net 
income for the year is allocated. If the CFTE cannot be allocated under 
any of the foregoing rules, it must be allocated in proportion to the 
partners' outstanding capital contributions.

D. Allocation and Apportionment of CFTEs to CFTE Categories

    The temporary and proposed regulations provided that the income to 
which a CFTE relates is determined in accordance with the principles of 
Sec.  1.904-6. Section 1.904-6, which contains rules for allocating and 
apportioning foreign taxes to the categories of income described in 
section 904(d), provides generally that a foreign tax is related to 
income if the income is included in the base upon which the foreign tax 
is imposed. Section 1.904-6(a)(1)(ii) contains special rules for 
apportioning taxes among categories of income when the income on which 
the foreign tax is imposed includes income in more than one category. 
It also provides special rules for allocating a foreign tax that is 
imposed on an item that would be income under U.S. tax principles in 
another year (timing difference) or an item that does not constitute 
income under U.S. tax principles (base differences).
    A number of comments were received requesting clarification of the 
Sec.  1.904-6 principles that apply for purposes of these regulations. 
In particular, commentators requested guidance concerning the 
applicability of the related party interest expense rule in Sec.  
1.904-6(a)(1)(ii), timing and base differences, and inter-branch 
payments.
    The final regulations retain the rule that the determination of the 
income to which a CFTE relates is made in accordance with the 
principles of Sec.  1.904-6. In response to the comments, however, the 
final regulations contain several clarifications and modifications 
regarding how the principles of Sec.  1.904-6 apply in allocating 
foreign taxes to CFTE categories. The final regulations clarify that in 
applying Sec.  1.904-6 for purposes of the safe harbor, the relevant 
categories are the CFTE categories determined under the rules described 
in section B in this preamble. Therefore, the final regulations clarify 
that application of the principles of Sec.  1.904-6 requires a CFTE to 
be allocated to a CFTE category if the net income on which the tax is 
imposed (the net income recognized for foreign tax purposes) is in the 
CFTE category. The final regulations also provide guidance on (a) the 
apportionment rule in Sec.  1.904-6(a)(1)(ii), (b) the rules for timing 
differences, (c) the rules for base differences and (d) the treatment 
of inter-branch payments.
1. Apportionment of CFTEs
    Section 1.904-6(a)(1)(ii) provides that where foreign taxes are 
imposed on income that relates to more than one separate category, the 
foreign taxes must be apportioned among the separate categories pro 
rata based on the amount of net income in each category. Subject to a 
special rule for related party interest expense, the net income in each 
category generally is determined under foreign law. If foreign law does 
not provide rules for the allocation and apportionment of expenses, 
losses or other deductions to a particular category of income, then 
such items must be allocated and apportioned in accordance with the 
rules of Sec. Sec.  1.861-8 through 1.861-14T.
    Commentators requested clarification that the apportionment rule in 
Sec.  1.904-6(a)(1)(ii), which apportions foreign taxes among 
categories based on relative amounts of net income as determined under 
foreign law, applies for purposes of apportioning taxes among the 
categories of income created by the partnership agreement. Commentators 
recommended that the related party interest expense rule be disregarded 
for purposes of the apportionment rule.
    In response to these comments, the final regulations clarify that 
the principles of Sec.  1.904-6(a)(1)(ii) require a taxpayer to 
apportion foreign taxes among the CFTE categories based on the relative 
amounts of net income as determined under foreign law in each CFTE 
category. In addition, the final regulations modify the apportionment 
rule in two respects. See Sec.  1.704-(b)(4)(viii)(d)(1).
    The final regulations adopt the recommendation to disregard the 
related party interest expense rule contained in Sec.  1.904-
6(a)(1)(ii) for purposes of apportioning taxes among the CFTE 
categories on the basis of foreign net income. The IRS and the Treasury 
Department agree that this rule, which coordinates the characterization 
of taxes and income for section 904(d) purposes, is not relevant for 
purposes of apportioning CFTEs to CFTE categories. Rather, the 
apportionment of CFTEs is based on the partnership income, as 
determined under foreign law, in the CFTE categories, which may include 
partnership items in one or more section 904(d) categories.
    The final regulations also provide that if foreign law does not 
provide rules for the allocation and apportionment of expenses, losses 
or other deductions allowed under foreign law to a CFTE category of 
income, then such expenses, losses or other deductions must be 
allocated and apportioned to gross income as determined under foreign 
law in a manner that is consistent with the allocation and 
apportionment of such items for purposes of determining the net income 
in the CFTE category for U.S. tax purposes.
2. Timing Differences
    A timing difference arises when an item subject to foreign tax is 
recognized as income under U.S. tax principles in a different year. The 
temporary and proposed regulations did not contain a specific textual 
rule regarding the application of the timing difference rule of Sec.  
1.904-6(a)(1)(iv) in the context of section 704(b). However, the 
temporary and proposed regulations included an example that involved a 
timing difference (Example 27), which indicated that a current year 
CFTE attributable to an item of income recognized in the prior year for 
U.S. tax purposes related to, and thus must be allocated in accordance 
with, the income allocated under the partnership agreement in the prior 
year.
    Upon further consideration, the IRS and the Treasury Department 
have concluded that relating foreign taxes paid or accrued in one year 
to income recognized for U.S. tax purposes in another year would be 
difficult for taxpayers to comply with and for the IRS to administer. 
In many instances, it

[[Page 61654]]

would be difficult to identify accurately the extent of timing 
differences and the years in which such differences would be reversed. 
Moreover, where income allocations change from year to year, it often 
would be impossible for partnerships to determine how the partners 
would share related U.S. income in subsequent years. Accordingly, the 
final regulations provide for a more administrable rule that requires 
the partnership to allocate a CFTE attributable to a timing difference 
among the partners in the same proportions as the allocations of income 
recognized for U.S. tax purposes in the relevant CFTE category in the 
year such taxes are paid or accrued. See paragraph (b)(5) Example 23 
(reflecting modifications to Example 27 in the temporary and proposed 
regulations). This approach should result in allocations of CFTEs that 
are generally in proportion to the partners' distributive shares of 
U.S. taxable income over time, and therefore is consistent with the 
underlying purposes of the foreign tax credit rules to mitigate double 
taxation. See the discussion at section E in this preamble under 
``Partners' Interests in the Partnership'' for cases in which the 
partnership agreement allocates CFTEs attributable to a timing 
difference among the partners in proportion to allocations of U.S. 
income in an earlier or later year when the income with respect to 
which the foreign tax is imposed is recognized for U.S. tax purposes.
    In addition, the final regulations expressly incorporate the timing 
difference rule of Sec.  1.904-6(a)(1)(iv). Therefore, a CFTE 
attributable to a timing difference is allocated to the CFTE category 
to which the income would be assigned if the income were recognized for 
U.S. tax purposes in the year in which the foreign tax is imposed.
3. Base Differences
    A base difference arises when an item subject to foreign tax is not 
income under U.S. tax principles. Several commentators observed that 
the base difference rule under Sec.  1.904-6(a)(1)(iv) provides little 
indication of how a CFTE attributable to a base difference should be 
allocated for purposes of the safe harbor. The IRS and the Treasury 
Department agree that this issue should be clarified. In the absence of 
any income to which such a CFTE relates, the final regulations provide 
that a CFTE attributable to a base difference is related to the income 
recognized for U.S. tax purposes in the relevant CFTE category in the 
year such taxes are paid or accrued. For this purpose, a CFTE 
attributable to a base difference is allocated and apportioned to the 
CFTE category that includes the partnership items attributable to the 
activity with respect to which the creditable foreign tax is imposed. 
Thus, the final regulations adopt similar rules for dealing with timing 
and base differences. These changes are intended to provide greater 
certainty for taxpayers and simplify the administration of the safe 
harbor.
4. Inter-Branch Transactions
    Several commentators requested additional guidance regarding the 
application of the final regulations to transactions between branches 
(including disregarded entities owned by the partnership) that are 
disregarded for U.S. tax purposes. In response to this comment, the 
final regulations provide that if a branch of the partnership 
(including a disregarded entity owned by the partnership) is required 
to include in income under foreign law a payment (inter-branch payment) 
it receives from the partnership or another branch of the partnership, 
any CFTE imposed with respect to the payment relates to the income in 
the CFTE category that includes the items attributable to the 
recipient. In cases where the partnership agreement results in more 
than one CFTE category with respect to the recipient, such tax is 
allocated to the CFTE category that includes the items attributable to 
the activity to which the inter-branch payment relates. A similar rule 
applies to payments received by the partnership from a branch of the 
partnership. This rule is consistent with the timing and base 
difference rules in the final regulations because it associates foreign 
tax imposed on the recipient with net income of the recipient as 
determined under U.S. tax principles, notwithstanding differences in 
U.S. and foreign tax rules. Like the timing and base difference rules, 
this rule avoids the need for complex tracing rules.
    It is possible that this approach might result in distortions of 
the effective foreign tax rates on the partners' distributive shares of 
income in certain cases. Nevertheless, the IRS and the Treasury 
Department have concluded that imposing a requirement to trace taxes 
imposed on the recipient with respect to such inter-branch payments to 
income recognized under U.S. tax principles by the payor would be 
difficult for taxpayers to comply with and for the IRS to administer.
    Some commentators recommended that at least in cases where the 
income allocations take such inter-branch payments into account in 
determining the partners' distributive shares of income, the allocation 
of CFTEs should be respected if made in proportion to income 
allocations that reflect such payments. The final regulations do not 
adopt this comment, as the approach suggested by these commentators 
would require taxpayers and the IRS to identify the inter-branch 
payments and relate such amounts to items of income of the payor and to 
CFTEs imposed on the recipient to substantiate that CFTEs of the payor 
and recipient were properly allocated. The IRS and the Treasury 
Department concluded that this approach would be difficult to 
administer and was therefore ill-suited to inclusion in a safe harbor. 
See the discussion at section E under ``Partners' Interests in the 
Partnership'' for cases in which the partnership agreement allocates 
partnership items of income to reflect inter-branch payments.

E. Partners' Interests in the Partnership

    Some commentators suggested that allocations of CFTEs that are not 
proportionate to allocations of the related income (and therefore fail 
to satisfy the safe harbor) will nevertheless be valid as in accordance 
with the partners' interests in the partnership standard of Sec.  
1.704-1(b)(3). According to these commentators, the partners' interests 
in the partnership with respect to a CFTE are conclusively determined 
by the manner in which the CFTE is allocated under the partnership 
agreement. The IRS and the Treasury Department believe that this view 
of the partners' interests in the partnership is incorrect, 
particularly in the context of a CFTE that is allocated to a partner 
who can use the associated foreign tax credit. In such a situation, the 
partner is relieved of a corresponding amount of U.S. tax, and thus 
does not bear the economic burden of the CFTE. Because of this lack of 
economic burden, the allocation of the CFTE is meaningless in the 
determination of the partners' interests in the partnership with 
respect to the CFTE and with respect to any other partnership item that 
has a material effect on the amount of CFTE that would be allocated to 
a partner under the safe harbor of the final regulations. Consequently, 
the final regulations clarify that in determining the partners' 
interests in the partnership with respect to an allocation of a 
partnership item, the allocation of the CFTE itself must be 
disregarded. This rule does not apply where the partners to whom the 
taxes are allocated reasonably expect to claim a deduction for such 
taxes in determining their U.S. tax liabilities.

[[Page 61655]]

    As indicated in the preamble to the temporary regulations, the IRS 
and the Treasury Department believe that only in unusual circumstances 
(such as where the CFTEs are deducted and not credited) will 
allocations that fail to satisfy the safe harbor be in accordance with 
the partners' interests in the partnership. As discussed in this 
preamble, for administrative reasons, the final regulations do not 
adopt a tracing approach for timing differences or inter-branch 
payments. Allocations of foreign taxes in such situations that are 
based on a tracing approach may constitute an unusual situation where 
the safe harbor is not satisfied, but the allocations are in accordance 
with the partners' interests in the partnership.
    When a CFTE is attributable to a timing difference, the CFTE 
category to which the CFTE is allocated may or may not have income for 
U.S. tax purposes in the year the foreign tax is paid or accrued. In 
either case, allocations of such CFTEs that are proportionate to 
allocations of the income at the time such income is recognized for 
U.S. tax purposes may not qualify for safe harbor treatment, but 
nonetheless be in accordance with the partners' interests in the 
partnership.
    Allocations of CFTEs imposed on the payor of an inter-branch 
payment may fail the safe harbor, but nonetheless be in accordance with 
the partners' interests in the partnership if the allocations of the 
CFTEs are in the same proportions as the allocations of the income of 
the payor, other than income that is eliminated from the foreign tax 
base because the inter-branch payment is deductible under foreign law. 
See paragraph (b)(5) Example 24 (iv). Similarly, allocations of CFTEs 
imposed on the recipient with respect to an inter-branch payment may 
fail the safe harbor, but nonetheless be in accordance with the 
partners' interests in the partnership, if such allocations are 
proportionate to the allocations of income recognized for U.S. tax 
purposes out of which the payment is made. See paragraph (b)(5) Example 
24 (iii).
    Several commentators also requested guidance regarding whether a 
reallocation of CFTEs will cause the IRS to reallocate other 
partnership items so that the partners' ending capital account balances 
will remain unchanged. If the reallocation of the CFTEs causes the 
partners' capital accounts not to reflect their contemplated economic 
arrangement, the partners may need to reallocate other partnership 
items to ensure the tax consequences of the partnership allocations are 
consistent with their contemplated economic arrangement. Consistent 
with the principles of the proposed and temporary regulations, the 
final regulations clarify that the IRS generally will not reallocate 
other partnership items in the year in which a CFTE is reallocated. See 
paragraph (b)(5) Example 25 (ii). This treatment is also consistent 
with the results arising from and approach taken with respect to 
reallocations of other items of income, gain, loss or deduction that 
are not sustained under section 704(b). The IRS and the Treasury 
Department believe the parties and not the government should determine 
what allocations should be changed to reflect their economic 
arrangement.

F. Effective Date and Transition Rule

    The provisions of these final regulations generally apply for 
partnership taxable years beginning on or after October 19, 2006. A 
transition rule is provided for existing partnerships. Under the 
transition rule, if a partnership agreement was entered into before 
April 21, 2004, then the partnership may apply the provisions of Sec.  
1.704-1(b) as if the amendments made by these final regulations had not 
occurred. If the partnership agreement is materially modified on or 
after April 21, 2004, however, transition relief is no longer afforded, 
and the rules of Sec.  1.704-1T(b)(4)(xi) or these final regulations 
apply, depending upon the date on which the material modification 
occurs and the tax year at issue. For this purpose, a material 
modification includes any change in ownership of the partnership. This 
transition rule does not apply if, as of April 20, 2004, persons that 
are related to each other (within the meaning of sections 267(b) and 
707(b)) collectively have the power to amend the partnership agreement 
without the consent of any unrelated party. However, taxpayers may rely 
on the provisions of paragraph (b)(4)(viii) of this section for 
partnership taxable years beginning on or after April 21, 2004.
    As stated in this preamble, the temporary and proposed regulations 
included a limited transition relief provision which ceases to apply 
upon a material modification of the partnership agreement, including 
any change in ownership. In addition, transition relief was not 
provided to partnerships owned by related parties who collectively have 
the power to amend the partnership agreement. One commentator requested 
that the IRS and the Treasury Department consider modifying the 
transition relief provision to indicate that a change in ownership is 
not a material modification unless there is more than a 50 percent 
change in ultimate beneficial ownership over a three-year period. The 
commentator also requested that the final regulations include a rule 
providing transition relief to partnerships owned by related parties 
who collectively have the power to amend the partnership agreement only 
in a way that does not adversely impact unrelated partners.
    After careful consideration of these comments, the IRS and the 
Treasury Department have decided not to expand the transition relief 
described in the proposed and temporary regulations. Accordingly, the 
final regulations do not adopt these comments.

G. Other Comments

    One commentator suggested that where the partners are unrelated, 
the safe harbor should permit the partnership to allocate CFTEs in the 
same proportion as all other partnership expenses (rather than in 
proportion to related income). Section 1.704-1(b)(4)(ii) requires 
partnership credits to be allocated in the same proportions as items 
giving rise to the credits. Allocating CFTEs in proportion to other 
partnership expenses would be inconsistent with Sec.  1.704-
1(b)(4)(ii). Moreover, such an approach would result in the 
inappropriate separation of CFTEs from the income to which such CFTEs 
relate. Thus, the final regulations do not incorporate this comment.
    The temporary and proposed regulations provided that the safe 
harbor is available if the partnership agreement satisfied the 
requirements of Sec.  1.704-1(b)(2)(ii)(b) or (d) (capital account 
maintenance, liquidation according to capital accounts, and either 
deficit restoration obligation or qualified income offsets) and the 
partnership agreement provided for the allocation of the CFTE in 
proportion to the partner's distributive share of partnership income. 
Commentators suggested that the safe harbor also should be available if 
the partnership allocations satisfy the economic effect equivalence 
standard of Sec.  1.704-1(b)(2)(ii)(i).
    The purpose of the safe harbor is to provide assurance that 
allocations of CFTEs will be respected if the CFTEs are allocated in 
proportion to the income to which such CFTEs relate. This purpose is 
satisfied as long as CFTEs are allocated in proportion to valid 
allocations of net income, regardless of whether the partnership 
maintains capital accounts or liquidates in accordance with them. 
Accordingly, the final regulations adopt these comments by eliminating 
the requirement that the partnership allocations satisfy the 
requirements of Sec.  1.704-1(b)(2)(ii)(b) or (d), and instead

[[Page 61656]]

condition eligibility for the safe harbor on the validity of income 
allocations, as described in this preamble.
    One commentator suggested that the final regulations clarify that 
the underlying allocation of income to which the foreign tax relates 
itself must be valid in order to qualify for the safe harbor. The 
commentator pointed out that an income allocation may be valid because 
it has substantial economic effect, or because it is in accordance with 
(or is deemed to be in accordance with) the partners' interests in the 
partnership. If income allocations are not valid, allocations of CFTEs 
based on such allocations will not be in proportion to the income to 
which the CFTEs relate. Accordingly, it is appropriate to clarify that 
the allocations of other items must be valid. However, the IRS and the 
Treasury Department believe that invalid allocations of other items 
should not disqualify allocations of CFTEs for safe harbor treatment 
unless the invalid allocations, in the aggregate, materially affect the 
allocation of CFTEs. Therefore, the final regulations provide that 
allocations of CFTEs may qualify for safe harbor treatment so long as 
allocations of all other partnership items that, in the aggregate, have 
a material effect on the amount of CFTEs allocated to the partners are 
valid.
    Commentators suggested that the safe harbor should be available if 
the partnership agreement is silent with regard to the allocation of 
CFTEs, but actual allocations of CFTEs are made in proportion to 
related income. The IRS and the Treasury Department agree. Accordingly, 
the final regulations allow safe harbor treatment if the CFTE is 
allocated (whether or not pursuant to an express provision in the 
partnership agreement) and reported on the partnership return in 
proportion to the distributive shares of income to which the CFTE 
relates.

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 
these regulations do not impose on small entities a collection of 
information requirement, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis 
is not required. Pursuant to section 7805(f) of the Internal Revenue 
Code, the notice of rulemaking preceding these regulations was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal authors of this regulation are Timothy J. Leska, 
Office of the Associate Chief Counsel (Passthroughs & Special 
Industries) and Michael I. Gilman, Office of the Associate Chief 
Counsel (International). However, other personnel from the IRS and the 
Treasury Department participated in its development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

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

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


0
Par. 2. Section 1.704-1 is amended as follows:
0
1. Paragraph (b)(0) is amended by redesignating the entry in the table 
of contents for Sec.  1.704-1(b)(4)(xi) as the entry for Sec.  1.704-
1(b)(4)(viii) and by adding entries following the entry for Sec.  
1.704-1(b)(4)(viii). The entries for Sec. Sec.  1.704-1(b)(4)(ix) and 
1.704-1(b)(4)(x) are removed.
0
2. The heading and text of paragraphs (b)(1)(ii)(b), and (b)(5) 
Examples 25 through 28 are revised.
0
3. Paragraphs (b)(3)(iv) and (b)(4)(viii), and paragraph (b)(5) 
Examples 20 through 24 are added.
0
4. Paragraph (b)(4)(xi) is removed.
    The additions and revisions read as follows:


Sec.  1.704-1  Partner's distributive share.

* * * * *
    (b) * * * (0) * * *

------------------------------------------------------------------------
            Heading                              Section
------------------------------------------------------------------------
 
                              * * * * * * *
Allocation of creditable         1.704-1(b)(4)(viii)
 foreign taxes.
    In general.................  1.704-1(b)(4)(viii)(a)
    Creditable foreign tax       1.704-1(b)(4)(viii)(b)
     expenditures (CFTEs).
    Income to which CFTEs        1.704-1(b)(4)(viii)(c)
     relate.
        In general.............  1.704-1(b)(4)(viii)(c)(1)
        CFTE category..........  1.704-1(b)(4)(viii)(c)(2)
        Net income in a CFTE     1.704-1(b)(4)(viii)(c)(3)
         category.
    Distributive shares of       1.704-1(b)(4)(viii)(c)(4)
     income.
    No net income in a CFTE      1.704-1(b)(4)(viii)(c)(5)
     category.
Allocation and apportionment of  1.704-1(b)(4)(viii)(d)
 CFTEs to CFTE categories.
    In general.................  1.704-1(b)(4)(viii)(d)(1)
    Timing and base differences  1.704-1(b)(4)(viii)(d)(2)
    Special rules for inter-     1.704-1(b)(4)(viii)(d)(3)
     branch payments.
------------------------------------------------------------------------

* * * * *
    (1) * * *
    (ii) * * *
    (b) Rules relating to foreign tax expenditures--(1) In general. The 
provisions of paragraphs (b)(3)(iv) and (b)(4)(viii) of this section 
(regarding the allocation of creditable foreign taxes) apply for 
partnership taxable years beginning on or after October 19, 2006. The 
rules that apply to allocations of creditable foreign taxes made in 
partnership taxable years beginning before October 19, 2006 are 
contained in Sec. Sec.  1.704-1T(b)(1)(ii)(b)(1) and 1.704-1T(b)(4)(xi) 
as in effect prior to October 19, 2006 (see 26 CFR part 1 revised as of 
April 1, 2005). However, taxpayers may rely on the provisions of 
paragraphs (b)(3)(iv) and (b)(4)(viii) of this section for partnership 
taxable years beginning on or after April 21, 2004.
    (2) Transition rule. Transition relief is provided herein to 
partnerships whose

[[Page 61657]]

agreements were entered into prior to April 21, 2004. In such case, if 
there has been no material modification to the partnership agreement on 
or after April 21, 2004, then the partnership may apply the provisions 
of paragraph (b) of this section as if the amendments made by 
paragraphs (b)(3)(iv) and (b)(4)(viii) of this section had not 
occurred. If the partnership agreement was materially modified on or 
after April 21, 2004, then the rules provided in paragraphs (b)(3)(iv) 
and (b)(4)(viii) of this section shall apply to the later of the 
taxable year beginning on or after October 19, 2006 or the taxable year 
within which the material modification occurred, and to all subsequent 
taxable years. If the partnership agreement was materially modified on 
or after April 21, 2004, and before a tax year beginning on or after 
October 19, 2006, see Sec. Sec.  1.704-1T(b)(1)(ii)(b)(1) and 1.704-
1T(b)(4)(xi) as in effect prior to October 19, 2006 (26 CFR part 1 
revised as of April 1, 2005). For purposes of this paragraph 
(b)(1)(ii)(b)(2), any change in ownership constitutes a material 
modification to the partnership agreement. This transition rule does 
not apply to any taxable year (and all subsequent taxable years) in 
which persons that are related to each other (within the meaning of 
section 267(b) and 707(b)) collectively have the power to amend the 
partnership agreement without the consent of any unrelated party.
* * * * *
    (3) * * *
    (iv) Special rule for creditable foreign tax expenditures. In 
determining whether an allocation of a partnership item is in 
accordance with the partners' interests in the partnership, the 
allocation of the creditable foreign tax expenditure (CFTE) (as defined 
in paragraph (b)(4)(viii)(b) of this section) must be disregarded. This 
paragraph (b)(3)(iv) shall not apply to the extent the partners to whom 
such taxes are allocated reasonably expect to claim a deduction for 
such taxes in determining their U.S. tax liabilities.
    (4) * * *
    (viii) Allocation of creditable foreign taxes--(a) In general. 
Allocations of creditable foreign taxes do not have substantial 
economic effect within the meaning of paragraph (b)(2) of this section 
and, accordingly, such expenditures must be allocated in accordance 
with the partners' interests in the partnership. See paragraph 
(b)(3)(iv) of this section. An allocation of a creditable foreign tax 
expenditure (CFTE) will be deemed to be in accordance with the 
partners' interests in the partnership if--
    (1) The CFTE is allocated (whether or not pursuant to an express 
provision in the partnership agreement) and reported on the partnership 
return in proportion to the distributive shares of income to which the 
CFTE relates; and
    (2) Allocations of all other partnership items that, in the 
aggregate, have a material effect on the amount of CFTEs allocated to a 
partner pursuant to paragraph (b)(4)(viii)(a)(1) of this section are 
valid.
    (b) Creditable foreign tax expenditures (CFTEs). For purposes of 
this section, a CFTE is a foreign tax paid or accrued by a partnership 
that is eligible for a credit under section 901(a) or an applicable 
U.S. income tax treaty. A foreign tax is a CFTE for these purposes 
without regard to whether a partner receiving an allocation of such 
foreign tax elects to claim a credit for such tax. Foreign taxes paid 
or accrued by a partner with respect to a distributive share of 
partnership income, and foreign taxes deemed paid under section 902 or 
960 by a corporate partner with respect to stock owned, directly or 
indirectly, by or for a partnership, are not taxes paid or accrued by a 
partnership and, therefore, are not CFTEs subject to the rules of this 
section. See paragraphs (e) and (f) of Sec.  1.901-2 for rules for 
determining when and by whom a foreign tax is paid or accrued.
    (c) Income to which CFTEs relate--(1) In general. For purposes of 
paragraph (b)(4)(viii)(a) of this section, CFTEs are related to net 
income in the partnership's CFTE category or categories to which the 
CFTE is allocated and apportioned in accordance with the rules of 
paragraph (b)(4)(viii)(d) of this section. Paragraph (b)(4)(viii)(c)(2) 
of this section provides rules for determining a partnership's CFTE 
categories. Paragraph (b)(4)(viii)(c)(3) of this section provides rules 
for determining the net income in each CFTE category. Paragraph 
(b)(4)(viii)(c)(4) of this section provides guidance in determining a 
partner's distributive share of income in a CFTE category. Paragraph 
(b)(4)(viii)(c)(5) of this section provides a special rule for 
allocating CFTEs when a partnership has no net income in a CFTE 
category.
    (2) CFTE category--(i) Income from activities. A CFTE category is a 
category of net income (or loss) attributable to one or more activities 
of the partnership. Net income (or loss) from all the partnership's 
activities shall be included in a single CFTE category unless the 
allocation of net income (or loss) from one or more activities differs 
from the allocation of net income (or loss) from other activities, in 
which case income from each activity or group of activities that is 
subject to a different allocation shall be treated as net income (or 
loss) in a separate CFTE category.
    (ii) Different allocations. Different allocations of net income (or 
loss) generally will result from provisions of the partnership 
agreement providing for different sharing ratios for net income (or 
loss) from separate activities. Different allocations of net income (or 
loss) from separate activities generally will also result if any 
partnership item is shared in a different ratio than any other 
partnership item. A guaranteed payment described in paragraph 
(b)(4)(viii)(c)(3)(ii) of this section, gross income allocation, or 
other preferential allocation will result in different allocations of 
net income (or loss) from separate activities only if the amount of the 
payment or the allocation is determined by reference to income from 
less than all of the partnership's activities. For purposes of this 
paragraph (b)(4)(viii)(c)(2), a partnership item shall not include any 
item that is excluded from income attributable to an activity pursuant 
to the second sentence of paragraph (b)(4)(viii)(c)(3)(ii) of this 
section (relating to allocations or payments that result in a deduction 
under foreign law).
    (iii) Activity. Whether a partnership has one or more activities, 
and the scope of each activity, shall be determined in a reasonable 
manner taking into account all the facts and circumstances. In 
evaluating whether aggregating or disaggregating income from particular 
business or investment operations constitutes a reasonable method of 
determining the scope of an activity, the principal consideration is 
whether the proposed determination has the effect of separating CFTEs 
from the related foreign income. Accordingly, relevant considerations 
include whether the partnership conducts business in more than one 
geographic location or through more than one entity or branch, and 
whether certain types of income are exempt from foreign tax or subject 
to preferential foreign tax treatment. In addition, income from a 
divisible part of a single activity shall be treated as income from a 
separate activity if necessary to prevent separating CFTEs from the 
related foreign income. The partnership's activities must be determined 
consistently from year to year absent a material change in facts and 
circumstances.
    (3) Net income in a CFTE category--(i) In general. The net income 
in a CFTE category means the net income for U.S. Federal income tax 
purposes, determined by taking into account all partnership items 
attributable to the

[[Page 61658]]

relevant activity or group of activities, including items of gross 
income, gain, loss, deduction, and expense and items allocated pursuant 
to section 704(c). The items of gross income attributable to an 
activity shall be determined in a consistent manner under any 
reasonable method taking into account all the facts and circumstances. 
Except as otherwise provided below, expenses, losses or other 
deductions shall be allocated and apportioned to gross income 
attributable to an activity in accordance with the rules of Sec. Sec.  
1.861-8 and 1.861-8T. Under these rules, if an expense, loss or other 
deduction is allocated to gross income from more than one activity, 
such expense, loss or deduction must be apportioned among each such 
activity using a reasonable method that reflects to a reasonably close 
extent the factual relationship between the deduction and the gross 
income from such activities. See Sec.  1.861-8T(c). For purposes of 
determining net income in a CFTE category, the partnership's interest 
expense and research and experimental expenditures described in section 
174 may be allocated and apportioned under any reasonable method, 
including but not limited to the methods prescribed in Sec.  1.861-9 
through Sec.  1.861-13T (interest expense) and Sec.  1.861-17 (research 
and experimental expenditures). For purposes of determining the net 
income attributable to any activity of a branch, the only items of 
gross income taken into account in applying this paragraph 
(b)(4)(viii)(c)(3) are those items of gross income recognized by the 
branch for U.S. income tax purposes. See paragraph (b)(5) Example 24 of 
this section (relating to inter-branch payments).
    (ii) Special rules. Income attributable to an activity shall 
include the amount included in a partner's income as a guaranteed 
payment (within the meaning of section 707(c)) from the partnership to 
the extent that the guaranteed payment is not deductible by the 
partnership under foreign law. See paragraph (b)(5) Example 25 (iv) of 
this section. Except for an inter-branch payment described in paragraph 
(b)(4)(viii)(d)(3) of this section, income attributable to an activity 
shall not include an item of partnership income to the extent the 
allocation of such item of income (or payment thereof) results in a 
deduction under foreign law. See paragraph (b)(5) Example 25 (iii) and 
(iv) of this section. Similarly, income attributable to an activity 
shall not include net income that foreign law would exclude from the 
foreign tax base as a result of the status of a partner. See paragraph 
(b)(5) Example 27 of this section.
    (4) Distributive shares of income. For purposes of paragraph 
(b)(4)(viii)(a)(1) of this section, distributive share of income means 
the net income from each CFTE category, determined in accordance with 
paragraph (b)(4)(viii)(c)(3) of this section, that is allocated to a 
partner. A guaranteed payment shall be treated as a distributive share 
of income for purposes of paragraph (b)(4)(viii)(a)(1) of this section 
to the extent that the guaranteed payment is treated as income 
attributable to an activity pursuant to paragraph 
(b)(4)(viii)(c)(3)(ii) of this section. See paragraph (b)(5) Example 25 
(iv) of this section. If more than one partner receives positive income 
allocations (income in excess of expenses) from a CFTE category, which 
in the aggregate exceed the total net income in the CFTE category, then 
for purposes of paragraph (b)(4)(viii)(a)(1) of this section such 
partner's distributive share of income from the CFTE category shall 
equal the partner's positive income allocation from the CFTE category, 
divided by the aggregate positive income allocations from the CFTE 
category, multiplied by the net income in the CFTE category.
    (5) No net income in a CFTE category. If a CFTE is allocated or 
apportioned to a CFTE category that does not have net income for the 
year in which the foreign tax is paid or accrued, the CFTE shall be 
deemed to relate to the aggregate of the net income (disregarding net 
losses) recognized by the partnership in that CFTE category in each of 
the three preceding taxable years. Accordingly, except as provided 
below, such CFTE must be allocated in the current taxable year in the 
same proportion as the allocation of the aggregate net income for the 
prior three-year period in order to satisfy the requirements of 
paragraph (b)(4)(viii)(a)(1) of this section. If the partnership does 
not have net income in the applicable CFTE category in either the 
current year or any of the previous three taxable years, the CFTE must 
be allocated in the same proportion that the partnership reasonably 
expects to allocate the aggregate net income (disregarding net losses) 
in the CFTE category for the succeeding three taxable years. If the 
partnership does not reasonably expect to have net income in the CFTE 
category for the succeeding three years and the partnership has net 
income in one or more other CFTE categories for the year in which the 
foreign tax is paid or accrued, the CFTE shall be deemed to relate to 
such other net income and must be allocated in proportion to the 
allocations of such other net income. If any CFTE is not allocated 
pursuant to the above provisions of this paragraph then the CFTE must 
be allocated in proportion to the partners' outstanding capital 
contributions.
    (d) Allocation and apportionment of CFTEs to CFTE categories--(1) 
In general. CFTEs are allocated and apportioned to CFTE categories in 
accordance with the principles of Sec.  1.904-6. Under these 
principles, a CFTE is related to income in a CFTE category if the 
income is included in the base upon which the foreign tax is imposed. 
In accordance with Sec.  1.904-6(a)(1)(ii) as modified by this 
paragraph (b)(4)(viii)(d), if the foreign tax base includes income in 
more than one CFTE category, the CFTEs are apportioned among the CFTE 
categories based on the relative amounts of taxable income computed 
under foreign law in each CFTE category. For purposes of this paragraph 
(b)(4)(viii)(d), references in Sec.  1.904-6 to a separate category or 
separate categories shall mean ``CFTE category'' or ``CFTE categories'' 
and the rules in Sec.  1.904-6(a)(1)(ii) are modified as follows:
    (i) The related party interest expense rule in Sec.  1.904-
6(a)(1)(ii) shall not apply in determining the amount of taxable income 
computed under foreign law in a CFTE category.
    (ii) If foreign law does not provide for the direct allocation or 
apportionment of expenses, losses or other deductions allowed under 
foreign law to a CFTE category of income, then such expenses, losses or 
other deductions must be allocated and apportioned to gross income as 
determined under foreign law in a manner that is consistent with the 
allocation and apportionment of such items for purposes of determining 
the net income in the CFTE categories for U.S. tax purposes pursuant to 
paragraph (b)(4)(viii)(c)(3) of this section.
    (2) Timing and base differences. A foreign tax imposed on an item 
that would be income under U.S. tax principles in another year (a 
timing difference) is allocated to the CFTE category that would include 
the income if the income were recognized for U.S. tax purposes in the 
year in which the foreign tax is imposed. A foreign tax imposed on an 
item that would not constitute income under U.S. tax principles in any 
year (a base difference) is allocated to the CFTE category that 
includes the partnership items attributable to the activity with 
respect to which the foreign tax is imposed. See paragraph (b)(5) 
Example 23 of this section.
    (3) Special rules for inter-branch payments. Notwithstanding any 
other

[[Page 61659]]

provision of this paragraph (d), the rules of this paragraph 
(b)(4)(viii)(d)(3) shall apply if a branch (including an entity 
described in Sec.  301.7701-2(c)(2)(i) of this chapter) of the 
partnership is required to include in income under foreign law a 
payment it receives from another branch of the partnership. The foreign 
tax imposed on such payments (``inter-branch payments'') is allocated 
to the CFTE category that includes the items attributable to the 
relevant activities of the recipient branch. In cases where the 
partnership agreement results in more than one CFTE category with 
respect to activities of the recipient branch, such tax is allocated to 
the CFTE category that includes the items attributable to the activity 
to which the inter-branch payment relates. The rules of this paragraph 
(b)(4)(viii)(d)(3) shall also apply to payments between a partnership 
and a branch of the partnership. See paragraph (b)(5) Example 24 of 
this section.
* * * * *
    (xi) [Reserved].
    (5) * * *

    Example 20. (i) A and B form AB, an eligible entity (as defined 
in Sec.  301.7701-3(a) of this chapter), treated as a partnership 
for U.S. tax purposes. AB operates business M in country X and earns 
income from passive investments in country X. Country X imposes a 40 
percent tax on business M income, which tax is a CFTE, but exempts 
from tax income from passive investments. In 2007, AB earns $100,000 
of income from business M and $30,000 from passive investments and 
pays or accrues $40,000 of country X taxes. For purposes of section 
904(d), the income from business M is general limitation income and 
the income from the passive investments is passive income. Pursuant 
to the partnership agreement, all partnership items, including 
CFTEs, from business M are allocated 60 percent to A and 40 percent 
to B, and all partnership items, including CFTEs, from passive 
investments are allocated 80 percent to A and 20 percent to B. 
Accordingly, A is allocated 60 percent of the business M income 
($60,000) and 60 percent of the country X taxes ($24,000), and B is 
allocated 40 percent of the business M income ($40,000) and 40 
percent of the country X taxes ($16,000). The income from the 
passive investments is allocated $24,000 to A and $6,000 to B. 
Assume that allocations of all items other than CFTEs are valid.
    (ii) Because the partnership agreement provides for different 
allocations of the net income attributable to business M and the 
passive investments, the net income attributable to each is income 
in a separate CFTE category. See paragraph (b)(4)(viii)(c)(2) of 
this section. AB must determine the net income in each CFTE category 
and the CFTEs allocable to each CFTE category. Under paragraph 
(b)(4)(viii)(c)(3) of this section, the net income in the business M 
CFTE category is the $100,000 attributable to business M and the net 
income in the passive investments CFTE category is the $30,000 
attributable to the passive investments. Under paragraph 
(b)(4)(viii)(d) of this section, the $40,000 of country X taxes is 
allocated to the business M CFTE category and no portion of the 
country X taxes is allocated to the passive investments CFTE 
category. Therefore, the $40,000 of country X taxes are related to 
the $100,000 of net income in the business M CFTE category. See 
paragraph (b)(4)(viii)(c)(1) of this section. Because AB's 
partnership agreement allocates the net income from the business M 
CFTE category 60 percent to A and 40 percent to B, and the country X 
taxes 60 percent to A and 40 percent to B, the allocations of the 
CFTEs are in proportion to the distributive shares of income to 
which the CFTEs relate. Because AB satisfies the requirement of 
paragraph (b)(4)(viii) of this section, the allocations of the 
country X taxes are deemed to be in accordance with the partners' 
interests in the partnership. Because the business M income is 
general limitation income, all $40,000 of taxes are attributable to 
the general limitation category. See Sec.  1.904-6.
    Example 21. (i) A and B form AB, an eligible entity (as defined 
in Sec.  301.7701-3(a) of this chapter), treated as a partnership 
for U.S. tax purposes. AB operates business M in country X and 
business N in country Y. Country X imposes a 40 percent tax on 
business M income, country Y imposes a 20 percent tax on business N 
income, and the country X and country Y taxes are CFTEs. In 2007, AB 
has $100,000 of income from business M and $50,000 of income from 
business N. Country X imposes $40,000 of tax on the income from 
business M and country Y imposes $10,000 of tax on the income of 
business N. Pursuant to the partnership agreement, all partnership 
items, including CFTEs, from business M are allocated 75 percent to 
A and 25 percent to B, and all partnership items, including CFTEs, 
from business N are split evenly between A and B (50 percent each). 
Accordingly, A is allocated 75 percent of the income from business M 
($75,000), 75 percent of the country X taxes ($30,000), 50 percent 
of the income from business N ($25,000), and 50 percent of the 
country Y taxes ($5,000). B is allocated 25 percent of the income 
from business M ($25,000), 25 percent of the country X taxes 
($10,000), 50 percent of the income from business N ($25,000), and 
50 percent of the country Y taxes ($5,000). Assume that allocations 
of all items other than CFTEs are valid. The income from business M 
and business N is general limitation income for purposes of section 
904(d).
    (ii) Because the partnership agreement provides for different 
allocations of the net income attributable to businesses M and N, 
the net income attributable to each business is income in a separate 
CFTE category even though all of the income is in the general 
limitation category for section 904(d) purposes. See paragraph 
(b)(4)(viii)(c)(2) of this section. Under paragraph 
(b)(4)(viii)(c)(3) of this section, the net income in the business M 
CFTE category is the $100,000 attributable to business M and the net 
income in the business N CFTE category is $50,000 attributable to 
business N. Under paragraph (b)(4)(viii)(d) of this section, the 
$40,000 of country X taxes is allocated to the business M CFTE 
category and the $10,000 of country Y taxes is allocated to the 
business N CFTE category. Therefore, the $40,000 of country X taxes 
are related to the $100,000 of net income in the business M CFTE 
category and the $10,000 of country Y taxes are related to the 
$50,000 of net income in the business N CFTE category. See paragraph 
(b)(4)(viii)(c)(1) of this section. Because AB's partnership 
agreement allocates the $40,000 of country X taxes in the same 
proportion as the net income in the business M CFTE category, and 
the $10,000 of country Y taxes in the same proportion as the net 
income in the business N CFTE category, the allocations of the 
country X taxes and the country Y taxes are in proportion to the 
distributive shares of income to which the foreign taxes relate. 
Because AB satisfies the requirements of paragraph (b)(4)(viii) of 
this section, the allocations of the country X and country Y taxes 
are deemed to be in accordance with the partners' interests in the 
partnership.
    Example 22. (i) The facts are the same as in Example 21, except 
that the partnership agreement provides for the following 
allocations. Depreciation attributable to machine X, which is used 
in business M, is allocated 100 percent to A. B is allocated the 
first $20,000 of gross income attributable to business N, which 
allocation does not result in a deduction under foreign law. All 
remaining items, except CFTEs, are allocated 50 percent to A and 50 
percent to B. For 2007, assume that business M generates $120,000 of 
income, before taking into account depreciation attributable to 
machine X. The total amount of depreciation attributable to machine 
X is $20,000, which results in $100,000 of net income attributable 
to business M for U.S. and country X tax purposes. Business N 
generates $70,000 of gross income and has $20,000 of expenses, 
resulting in $50,000 of net income for U.S. and country Y tax 
purposes. Pursuant to the partnership agreement, A is allocated 
$40,000 of the net income attributable to business M ($60,000 of 
business M income less $20,000 of depreciation attributable to 
machine X), and $15,000 of the net income attributable to business 
N. B is allocated $60,000 of the net income attributable to business 
M and $35,000 of the net income attributable to business N ($20,000 
of gross income, plus $15,000 of net income).
    (ii) As a result of the special allocations, the net income 
attributable to business M ($100,000) is allocated 40 percent to A 
and 60 percent to B. The net income attributable to business N 
($50,000) is allocated 30 percent to A and 70 percent to B. Because 
the partnership agreement provides for different allocations of the 
net income attributable to businesses M and N, the net income from 
each of businesses M and N is income in a separate CFTE category. 
See paragraph (b)(4)(viii)(c)(2) of this section. Under paragraph 
(b)(4)(viii)(c)(3) of this section, the net income in the business M 
CFTE category is the $100,000 of net income attributable to business 
M and the net income in the business N CFTE category is the $50,000 
of net income attributable to business N. Under

[[Page 61660]]

paragraph (b)(4)(viii)(d)(1) of this section, the $40,000 of country 
X taxes is allocated to the business M CFTE category and the $10,000 
of country Y taxes is allocated to the business N CFTE category. 
Therefore, the $40,000 of country X taxes relates to the $100,000 of 
net income in the business M CFTE and the $10,000 of country Y taxes 
relates to the $50,000 of net income in the business N CFTE 
category. See paragraph (b)(4)(viii)(c)(1) of this section. The 
allocations of the country X taxes will be in proportion to the 
distributive shares of income to which they relate and will be 
deemed to be in accordance with the partners' interests in the 
partnership if such taxes are allocated 40 percent to A and 60 
percent to B. The allocations of the country Y taxes will be in 
proportion to the distributive shares of income to which they relate 
and will be deemed to be in accordance with the partners' interests 
in the partnership if such taxes are allocated 30 percent to A and 
70 percent to B.
    (iii) Assume that for 2008, all the facts are the same as in 
paragraph (i) of this Example 22, except that business M generates 
$60,000 of income before taking into account depreciation 
attributable to machine X and country X imposes $16,000 of tax on 
the $40,000 of net income attributable to business M. Pursuant to 
the partnership agreement, A is allocated 25 percent of the income 
from business M ($10,000), and B is allocated 75 percent of the 
income from business M ($30,000). Allocations of the country X taxes 
will be in proportion to the distributive shares of income to which 
they relate and will be deemed to be in accordance with the 
partners' interests in the partnership if such taxes are allocated 
25 percent to A and 75 percent to B.
    Example 23. (i) The facts are the same as in Example 21, except 
that AB does not actually receive the $50,000 of income accrued in 
2007 with respect to business N until 2008 and AB accrues and 
receives an additional $100,000 with respect to business N in 2008. 
Also assume that A, B, and AB each report taxable income on an 
accrual basis for U.S. tax purposes and AB reports taxable income 
using the cash receipts and disbursements method of accounting for 
country X and country Y purposes. In 2007, AB pays or accrues 
country X taxes of $40,000. In 2008, AB pays or accrues country Y 
taxes of $30,000. Pursuant to the partnership agreement, in 2007, A 
is allocated 75 percent of business M income ($75,000) and country X 
taxes ($30,000) and 50 percent of business N income ($25,000). B is 
allocated 25 percent of business M income ($25,000) and country X 
taxes ($10,000) and 50 percent of business N income ($25,000). In 
2008, A and B are each allocated 50 percent of the business N income 
($50,000) and country Y taxes ($15,000).
    (ii) For 2007, the $40,000 of country X taxes paid or accrued by 
AB relates to the $100,000 of net income in the business M CFTE 
category. No portion of the country X taxes paid or accrued in 2007 
relates to the $50,000 of net income in the business N CFTE 
category. For 2008, the net income in the business N CFTE category 
is the $100,000 attributable to business N. See paragraph 
(b)(4)(viii)(c)(3) of this section. Under paragraph 
(b)(4)(viii)(d)(1) of this section, $20,000 of the country Y tax 
paid or accrued in 2008 is allocated to the business N CFTE 
category. The remaining $10,000 of country Y tax is allocated to the 
business N CFTE category under paragraph (b)(4)(viii)(d)(2) of this 
section (relating to timing differences). Therefore, the $30,000 of 
country Y taxes paid or accrued by AB in 2008 is related to the 
$100,000 of net income in the business N CFTE category for 2008. See 
paragraph (b)(4)(viii)(c)(1) of this section. Because AB's 
partnership agreement allocates the $40,000 of country X taxes and 
the $30,000 of country Y taxes in proportion to the distributive 
shares of income to which the taxes relate, the allocations of the 
country X and country Y taxes satisfy the requirements of paragraphs 
(b)(4)(viii)(a)(1) and (2) of this section and the allocations of 
the country X and Y taxes are deemed to be in accordance with the 
partners' interests in the partnership under paragraph (b)(4)(viii) 
of this section.
    Example 24. (i) The facts are the same as in Example 21, except 
that businesses M and N are conducted by entities (DE1 and DE2, 
respectively) that are corporations for country X and Y tax purposes 
and disregarded entities for U.S. tax purposes. Also, assume that 
DE1 makes payments of $75,000 during 2007 to DE2 that are deductible 
by DE1 for country X tax purposes and includible in income of DE2 
for country Y tax purposes. As a result of such payments, DE1 has 
taxable income of $25,000 for country X purposes on which $10,000 of 
taxes are imposed and DE2 has taxable income of $125,000 for country 
Y purposes on which $25,000 of taxes are imposed. For U.S. tax 
purposes, $100,000 of AB's income is attributable to the activities 
of DE1 and $50,000 of AB's income is attributable to the activities 
of DE2. Pursuant to the partnership agreement, all partnership 
items, including CFTEs, from business M are allocated 75 percent to 
A and 25 percent to B, and all partnership items, including CFTEs, 
from business N are split evenly between A and B (50 percent each). 
Accordingly, A is allocated 75 percent of the income from business M 
($75,000), 75 percent of the country X taxes ($7,500), 50 percent of 
the income from business N ($25,000), and 50 percent of the country 
Y taxes ($12,500). B is allocated 25 percent of the income from 
business M ($25,000), 25 percent of the country X taxes ($2,500), 50 
percent of the income from business N ($25,000), and 50 percent of 
the country Y taxes ($12,500).
    (ii) Because the partnership agreement provides for different 
allocations of the net income attributable to businesses M and N, 
the net income attributable to each of business M and business N is 
income in separate CFTE categories. See paragraph (b)(4)(viii)(c)(2) 
of this section. Under paragraph (b)(4)(viii)(c)(3) of this section, 
the $100,000 of net income attributable to business M is in the 
business M CFTE category and the $50,000 of net income attributable 
to business N is in the business N CFTE category. Under paragraph 
(b)(4)(viii)(d)(1) of this section, the $10,000 of country X taxes 
is allocated to the business M CFTE category and $10,000 of the 
country Y taxes is allocated to the business N CFTE category. Under 
paragraph (b)(4)(viii)(d)(3) of this section, the additional $15,000 
of country Y tax imposed with respect to the inter-branch payment is 
assigned to the business N CFTE category. Therefore, the $10,000 of 
country X taxes is related to the $100,000 of net income in the 
business M CFTE category and the $25,000 of country Y taxes is 
related to the $50,000 of net income in the business N CFTE 
category. See paragraph (b)(4)(viii)(c)(1) of this section. Because 
AB's partnership agreement allocates the $10,000 of country X taxes 
in the same proportion as the distributive shares of income to which 
the taxes relate and the $25,000 of country Y taxes in the same 
proportion as the distributive shares of income to which the taxes 
relate, AB satisfies the requirements of paragraph (b)(4)(viii) of 
this section and the allocations of the country X and country Y 
taxes are deemed to be in accordance with the partners' interests in 
the partnership. No inference is intended with respect to the 
application of other provisions to arrangements that involve 
disregarded payments. See paragraph (b)(1)(iii) of this section 
(relating to the effect of sections of the Internal Revenue Code 
other than section 704(b)).
    (iii) Assume that the facts are the same as paragraph (i) of 
this Example 24, except that the partnership agreement provides that 
the $15,000 of country Y tax imposed with respect to the inter-
branch payment is allocated 75 percent to A ($11,250) and 25 percent 
to B ($3,750) and that the remaining $10,000 of country Y tax is 
allocated 50 percent to A ($5,000) and 50 percent to B ($5,000). 
Thus, the country Y taxes are allocated 65 percent to A and 35 
percent to B while the income in the business N CFTE category is 
allocated 50 percent to A and 50 percent to B. The allocations of 
the country Y tax are not deemed to be in accordance with the 
partners' interests because they are not in proportion to the 
allocations of the distributive shares of income from the business N 
CFTE category. However, upon sufficient substantiation that $15,000 
of country Y tax paid by DE2 with respect to the $75,000 inter-
branch payment relates to income that is recognized by DE1 for U.S. 
tax purposes, the allocations of the country Y taxes may be 
established to be actually in accordance with the partners' 
interests in the partnership. The allocations of the $10,000 of 
country X taxes are deemed to be in accordance with the partners' 
interests in the partnership because the country X taxes are 
allocated in the same proportion as the distributive shares of 
income to which they relate.
    (iv) Assume that the facts are the same as in paragraph (i) of 
this Example 24, except that in order to reflect the $75,000 payment 
from DE1 to DE2, the partnership agreement allocates $75,000 of the 
income attributable to business M equally between A and B (50 
percent each). Therefore, the total income attributable to business 
M is allocated 56.25 percent to A (75 percent of $25,000 plus 50 
percent of $75,000) and 43.75 percent to B (25 percent of $25,000 
and 50 percent of $75,000). The allocation of the country X

[[Page 61661]]

taxes (75 percent to A and 25 percent to B) is not deemed to be in 
accordance with the partners' interests because it is not in 
proportion to the allocations of the distributive shares of income 
from the business M CFTE category. However, upon sufficient 
substantiation that all $10,000 of country X tax paid by DE1 relates 
to the $25,000 of DE1's income that is shared in the same 75-25 
ratio, the allocations of the country X taxes may be established to 
be actually in accordance with the partners' interests in the 
partnership. The allocations of the $25,000 of country Y taxes are 
deemed to be in accordance with the partners' interests in the 
partnership because the country Y taxes are allocated in the same 
proportion as the distributive shares of income to which they 
relate.
    Example 25. (i) A contributes $750,000 and B contributes 
$250,000 to form AB, an eligible entity (as defined in Sec.  
301.7701-3(a) of this chapter), treated as a partnership for U.S. 
tax purposes. AB operates business M in country X. Country X imposes 
a 20 percent tax on the net income from business M, which tax is a 
CFTE. In 2007, AB earns $300,000 of gross income, has deductible 
expenses of $100,000, and pays or accrues $40,000 of country X tax. 
Pursuant to the partnership agreement, the first $100,000 of gross 
income each year is allocated to A as a return on excess capital 
contributed by A. All remaining partnership items, including CFTEs, 
are split evenly between A and B (50 percent each). The gross income 
allocation is not deductible in determining AB's taxable income 
under country X law. Assume that allocations of all items other than 
CFTEs are valid.
    (ii) AB has a single CFTE category because all of AB's net 
income is allocated in the same ratio. See paragraph 
(b)(4)(viii)(c)(2). Under paragraph (b)(4)(viii)(c)(3) of this 
section, the net income in the single CFTE category is $200,000. The 
$40,000 of taxes is allocated to the single CFTE category and, thus, 
related to the $200,000 of net income in the single CFTE category. 
In 2007, AB's partnership agreement allocates $150,000 or 75 percent 
of the net income to A ($100,000 attributable to the gross income 
allocation plus $50,000 of the remaining $100,000 of net income) and 
$50,000 or 25 percent of the net income to B. AB's partnership 
agreement allocates the country X taxes in accordance with the 
partners' shares of partnership items remaining after the $100,000 
gross income allocation. Therefore, AB allocates the country X taxes 
50 percent to A ($20,000) and 50 percent to B ($20,000). AB's 
allocations of country X taxes are not deemed to be in accordance 
with the partners' interests in the partnership under paragraph 
(b)(4)(viii) of this section, because they are not in proportion to 
the allocations of the distributive shares of income to which the 
country X taxes relate. Accordingly, the country X taxes will be 
reallocated according to the partners' interest in the partnership. 
Assuming that the partners do not reasonably expect to claim a 
deduction for the CFTE in determining their U.S. tax liabilities, a 
reallocation of the CFTEs under paragraph (b)(3) of this section 
would be 75 percent to A ($30,000) and 25 percent to B ($10,000). If 
the reallocation of the CFTEs causes the partners' capital accounts 
not to reflect their contemplated economic arrangement, the partners 
may need to reallocate other partnership items to ensure that the 
tax consequences of the partnership's allocations are consistent 
with their contemplated economic arrangement over the term of the 
partnership. The Commissioner will not reallocate other partnership 
items after the reallocation of the CFTEs.
    (iii) The facts are the same as in paragraph (i) of this Example 
25, except that the $100,000 allocation of gross income is 
deductible under country X law and that AB pays or accrues $20,000 
of foreign tax. Under paragraph (b)(4)(viii)(c)(3) of this section, 
the net income in the single CFTE category is the $100,000 of net 
income, determined by disregarding the $100,000 of gross income that 
is allocated to A and deductible in determining AB's taxable income 
under the law of country X. See paragraph (b)(4)(viii)(c)(3)(ii) of 
this section. The $20,000 of country X tax is allocated to the 
single CFTE category, and, thus, related to the $100,000 of net 
income in the single CFTE category. See paragraphs 
(b)(4)(viii)(c)(1) and (d) of this section. No portion of the tax is 
related to the $100,000 of gross income allocated to A. Pursuant to 
the partnership agreement, AB allocates the country X taxes 50 
percent to A ($10,000) and 50 percent to B ($10,000). AB's 
allocations of country X taxes are deemed to be in accordance with 
the partners' interests in the partnership under paragraph 
(b)(4)(viii) of this section.
    (iv) The results in (ii) and (iii) of this Example 25 would be 
the same assuming all of the facts except that, rather than being a 
preferential gross income allocation, the $100,000 was a guaranteed 
payment to A within the meaning of section 707(c). See paragraph 
(b)(4)(viii)(c)(3) of this section.
    Example 26. (i) A and B form AB, an eligible entity (as defined 
in Sec.  301.7701-3(a) of this chapter), treated as a partnership 
for U.S. tax purposes. AB operates business M in country X and 
business N in country Y. A, a U.S. corporation, contributes a 
building with a fair market value of $200,000 and an adjusted basis 
of $50,000 for both U.S. and country X purposes. The building 
contributed by A is used in business M. B, a country X corporation, 
contributes $800,000 cash. The AB partnership agreement provides 
that AB will make allocations under section 704(c) using the 
traditional method under Sec.  1.704-3(b) and that all other items, 
excluding creditable foreign taxes, will be allocated 20 percent to 
A and 80 percent to B. The partnership agreement provides that 
creditable foreign taxes will be allocated in proportion to the 
partners' distributive shares of net income in each CFTE category, 
which shall be determined by taking into accounts items allocated 
pursuant to section 704(c). Country X and Country Y impose tax at a 
rate of 20 percent and 40 percent, respectively, and such taxes are 
CFTEs. In 2007, AB sells the building contributed by A for $200,000, 
thereby recognizing taxable income of $150,000 for U.S. and country 
X purposes, and recognizes $250,000 of other income from the 
operation of business M. AB pays or accrues $80,000 of country X tax 
on such income. Also in 2007, business N recognizes $100,000 of 
taxable income for U.S. and country Y purposes and pays or accrues 
$40,000 of country Y tax. Pursuant to the partnership agreement, A 
is allocated $200,000 of business M income ($150,000 of taxable 
income in accordance with section 704(c) and $50,000 of other 
business M income) and $40,000 of country X tax, and 20 percent of 
both business N income ($20,000) and country Y tax ($8,000). B is 
allocated $200,000 of business M income and $40,000 of country X tax 
and 80 percent of both the business N income ($80,000) and country Y 
tax ($32,000). Assume that allocations of all items other than CFTEs 
are valid.
    (ii) The net income attributable to business M ($400,000) is 
allocated 50 percent to A and 50 percent to B while the net income 
attributable to business N ($100,000) is allocated 20 percent to A 
and 80 percent to B. Because the partnership agreement provides for 
different allocations of the net income attributable to businesses M 
and N, the net income attributable to each activity is income in a 
separate CFTE category. See paragraph (b)(4)(viii)(c)(2) of this 
section. Under paragraph (b)(4)(viii)(c)(3) of this section, the net 
income in the business M CFTE category is the $400,000 of net income 
attributable to business M and the net income in the business N CFTE 
category is the $100,000 of net income attributable to business N. 
Under paragraph (b)(4)(viii)(d)(1) of this section, the $80,000 of 
country X tax is allocated to the business M CFTE category and the 
$40,000 of country Y tax is allocated to the business N CFTE 
category. Therefore, the $80,000 of country X tax relates to the 
$400,000 of net income in the business M CFTE category and the 
$40,000 of country Y tax relates to the $100,000 of net income in 
the business N CFTE category. See paragraph (b)(4)(viii)(c)(1) of 
this section. Because AB's partnership agreement allocates the 
$80,000 of country X taxes and $40,000 of country Y taxes in 
proportion to the distributive shares of income to which such taxes 
relate, the allocations are deemed to be in accordance with the 
partners' interest in the partnership under paragraph (b)(4)(viii) 
of this section.
    Example 27. (i) A, a U.S. citizen, and B, a country X citizen, 
form AB, a country X eligible entity (as defined in Sec.  301.7701-
3(a) of this chapter), treated as a partnership for U.S. tax 
purposes. AB's only activity is business M, which it operates in 
country X. Country X imposes a 40 percent tax on the portion of AB's 
business M income that is the allocable share of AB's owners that 
are not citizens of country X, which tax is a CFTE. The partnership 
agreement provides that all partnership items, excluding CFTEs, from 
business M are allocated 40 percent to A and 60 percent to B. CFTEs 
are allocated 100 percent to A. In 2007, AB earns $100,000 of net 
income from business M and pays or accrues $16,000 of country X 
taxes on A's allocable share of AB's income ($40,000). Pursuant to 
the partnership agreement, A is allocated 40 percent of the business 
M income ($40,000) and 100 percent of the country X taxes ($16,000), 
and B is allocated

[[Page 61662]]

60 percent of the business M income ($60,000) and no country X 
taxes. Assume that allocations of all items other than CFTEs are 
valid.
    (ii) AB has a single CFTE category because all of AB's net 
income is allocated in the same ratio. See paragraph 
(b)(4)(viii)(c)(2). Under paragraph (b)(4)(viii)(c)(3) of this 
section, the $40,000 of business M income that is allocated to A is 
included in the single CFTE category. Under paragraph 
(b)(4)(viii)(c)(3)(ii) of this section, no portion of the $60,000 
allocated to B is included in the single CFTE category. Under 
paragraph (b)(4)(viii)(d) of this section, the $16,000 of taxes is 
allocated to the single CFTE category.
    Therefore, the $16,000 of country X taxes is related to the 
$40,000 of net income in the single CFTE category that is allocated 
to A. See paragraph (b)(4)(viii)(c)(1) of this section. Because AB's 
partnership agreement allocates the country X taxes in proportion to 
the distributive share of income to which the taxes relate, AB 
satisfies the requirement of paragraph (b)(4)(viii) of this section, 
and the allocation of the country X taxes is deemed to be in 
accordance with the partners' interests in the partnership.
* * * * *


Sec.  1.704-1T  [Removed]

0
Par. 3. Section 1.704-1T is removed.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: September 12, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
 [FR Doc. E6-17307 Filed 10-18-06; 8:45 am]
BILLING CODE 4830-01-P