[Federal Register Volume 72, Number 245 (Friday, December 21, 2007)]
[Rules and Regulations]
[Pages 72582-72592]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-24782]


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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9368]
RIN 1545-BG55


Reduction of Foreign Tax Credit Limitation Categories Under 
Section 904(d)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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

SUMMARY: This document contains final and temporary Income Tax 
Regulations regarding the reduction of the number of separate foreign 
tax credit limitation categories under section 904(d) of the Internal 
Revenue Code (Code). Section 404 of the American Jobs Creation Act of 
2004 (AJCA) reduced the number of section 904(d) separate categories 
from eight to two, effective for taxable years beginning after December 
31, 2006. These temporary regulations affect taxpayers claiming foreign 
tax credits and provide guidance needed to comply with the statutory 
changes made by the AJCA. The text of these temporary regulations also 
serves as the text of the proposed regulations (REG-114126-07) set 
forth in the notice of proposed rulemaking on this subject published 
elsewhere in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective on December 21, 
2007.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.904-2T(i)(3), 1.904-4T(n), 1.904-5T(o)(3), 1.904-7T(g)(6), and 
1.904(f)-12T(h)(6). These regulations apply to taxable years of United 
States taxpayers beginning after December 31, 2006, and ending on or 
after December 21, 2007, and to taxable years of foreign corporations 
which end with or within taxable years of their domestic corporate 
shareholders beginning after December 31, 2006, and ending on or after 
December 21, 2007.

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

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to the regulations under section 
904 relating to the application of separate foreign tax credit 
limitations to certain categories of income under section 904(d), as 
amended by the AJCA. Prior to the effective date of the AJCA amendments 
(that is, for taxable years beginning before January 1, 2007 (``pre-
2007 taxable years'')), the foreign tax credit limitation applied 
separately to the following categories of income: passive income, high 
withholding tax interest, financial services income, shipping income, 
certain dividends from a DISC or former DISC, taxable income 
attributable to certain foreign trade income, certain distributions 
from a FSC or former FSC, and any other income not described in this 
sentence (``general limitation income''). Other provisions of the Code 
that subject other categories of income to separate foreign tax credit 
limitations were not amended by the AJCA. See, for example, sections 
56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), and 904(h)(10); see 
also H.R. Rep. No. 108-755, at 383 (October 7, 2004).
    Effective for taxable years beginning after December 31, 2006 
(``post-2006 taxable years''), the AJCA reduced the number of section 
904(d) separate categories to two categories for ``passive category 
income'' and ``general category income.'' New section 904(d)(2)(A) 
defines passive category income as passive income and specified passive 
category income, and general category income as income other than 
passive category income. In addition, new section 904(d)(2)(C) and (D) 
provides rules concerning the treatment of financial services income 
and companies.
    These temporary regulations modify the regulations under section 
904 to reflect the new separate categories for passive category income 
and general category income, and provide transition rules for the 
treatment of earnings and profits and foreign income taxes of 
controlled foreign corporations and noncontrolled section 902 
corporations accumulated in pre-2007 taxable years, overall foreign 
losses and separate limitation losses under section 904(f), and the 
carryover and carryback of excess foreign taxes under section 904(c).

Explanation of Provisions

I. Carryovers and Carrybacks of Excess Foreign Taxes Under Section 
904(c)

    Section 904(d)(2)(K)(i), as added by the AJCA, provides that excess 
taxes carried from a pre-2007 taxable year to a post-2006 taxable year 
shall be assigned to the post-2006 separate categories based on where 
the related income would have been assigned had such taxes been paid or 
accrued in a post-2006 taxable year.
    Consistent with this statutory amendment, Sec.  1.904-2T(i)(1)(i) 
provides that if a taxpayer carries over to a post-2006 taxable year 
any excess taxes that

[[Page 72583]]

were paid, accrued, or deemed paid with respect to income in any pre-
2007 separate category, the excess taxes are assigned to the 
appropriate post-2006 separate category as if the taxes had been paid 
or accrued in a post-2006 taxable year. For example, to the extent that 
any taxes were related to income that would have been treated as high-
taxed income under section 904(d)(2)(B)(iii)(II), such taxes will be 
assigned to the post-2006 separate category for general category 
income.
    Because the IRS and the Treasury Department recognize that 
taxpayers may face difficulties in reconstructing excess taxes 
accounts, Sec.  1.904-2T(i)(1)(ii) of the temporary regulations 
provides a safe harbor. Under the safe harbor, a taxpayer may assign 
excess taxes in any pre-2007 separate category, except the passive 
category, to the post-2006 separate category for general category 
income. The safe harbor provides that excess taxes in the pre-2007 
passive category will be assigned to the post-2006 separate category 
for passive category income.
    Section 904(d)(2)(K)(ii), as added by the AJCA, authorizes the 
Secretary to issue regulations for allocating carrybacks of excess 
taxes with respect to income from a post-2006 taxable year to a pre-
2007 taxable year for purposes of allocating the excess taxes among the 
separate categories in effect for the taxable year to which carried. 
The IRS and the Treasury Department believe that it is appropriate to 
allow a taxpayer to reconstruct separate categories of income earned 
and excess taxes paid or accrued in its first post-2006 taxable year as 
if the pre-2007 rules applied. Accordingly, Sec.  1.904-2T(i)(2)(i) 
provides that if a taxpayer carries back excess taxes paid, accrued, or 
deemed paid with respect to income in the post-2006 separate category 
for passive category income or general category income to a pre-2007 
taxable year, the excess taxes are assigned to the appropriate pre-2007 
separate category or categories as if the taxes had been paid or 
accrued in a pre-2007 taxable year. Section 1.904-2T(i)(2)(ii) provides 
that a taxpayer may, in lieu of reconstruction, assign excess taxes in 
the separate category for general category income to the pre-2007 
general category, and excess taxes in the separate category for passive 
category income to the pre-2007 passive category.

II. Definition of Passive Category Income

    New section 904(d)(2)(A)(i) defines passive category income as 
passive income and specified passive category income. New section 
904(d)(2)(B)(i) generally defines passive income as ``any income 
received or accrued by any person which is of a kind which would be 
foreign personal holding company income (as defined in section 
954(c)).'' Passive income includes amounts includible in gross income 
under section 1293, except as provided in section 904(d)(3)(H) 
(providing that look-through treatment applies to an amount included in 
gross income under section 1293 if the passive foreign investment 
company is a controlled foreign corporation (CFC) and the taxpayer is a 
United States shareholder in such CFC) and section 904(d)(2)(E)(ii) 
(providing that an inclusion under section 1293 with respect to a 
foreign corporation that is a noncontrolled section 902 corporation 
with respect to the taxpayer shall be treated as a dividend from such 
corporation). See section 904(d)(2)(B)(ii). Passive income does not 
include export financing interest and high-taxed income. See section 
904(d)(2)(B)(iii). New section 904(d)(2)(B)(iv) provides that in 
determining whether income is of a kind which would be foreign personal 
holding company income, the rules of section 864(d)(6) apply only in 
the case of income of a CFC.
    New section 904(d)(2)(B)(v) defines specified passive category 
income as dividends from a DISC or former DISC (as defined in section 
992(a)) to the extent such dividends are treated as income from sources 
without the United States, taxable income attributable to foreign trade 
income (FTI) within the meaning of section 923(b), and distributions 
from a FSC or former FSC out of earnings and profits attributable to 
FTI (within the meaning of section 923(b)) or interest or carrying 
charges (as defined in section 927(d)(1)) derived from a transaction 
which results in FTI (as defined in section 923(b)).
    The temporary regulations reflect the new definitions of passive 
category income, passive income, and specified passive category income. 
Section 1.904-4T(b)(3) incorporates the definition of specified passive 
category income in section 904(d)(2)(B)(v), which includes dividends 
from DISCs, distributions from FSCs, and FTI. Because these types of 
income constitute specified passive category income and not passive 
income, such income can never qualify as financial services income that 
could be treated as general category income.
    The final regulations at Sec.  1.904-5(h)(3) currently provide that 
gain from the sale of a partnership interest is assigned to the 
separate category for passive income. Section 954(c)(4), which was 
enacted by the AJCA, provides a look-through rule for sales of 25-
percent-owned partnerships. Because the definition of passive income in 
section 904(d)(2)(B) refers to section 954(c), these temporary 
regulations revise Sec.  1.904-5(h)(3) to reflect that gain on the sale 
of a partnership interest by a 25-percent partner is assigned to the 
separate category for general category income, to the extent that, 
under the section 954(c)(4) look-through rule, the gain is not 
classified as foreign personal holding company income.

III. Definition of Financial Services Income

    Section 904(d)(2)(C)(i), as amended by the AJCA, provides that 
financial services income shall be treated as general category income 
in the case of a member of a financial services group and any other 
person predominantly engaged in the active conduct of a banking, 
insurance, financing or similar business. New section 904(d)(2)(C)(ii) 
defines a financial services group as ``any affiliated group (as 
defined in section 1504(a) without regard to paragraphs (2) and (3) of 
section 1504(b)) which is predominantly engaged in the active conduct 
of a banking, insurance, financing or similar business.'' In 
determining whether a group is so engaged, only the income of members 
of the group that are U.S. corporations or CFCs in which U.S. 
corporations own, directly or indirectly, at least 80 percent of the 
vote or value of the stock are taken into account. Section 
904(d)(2)(C)(iii) provides that the Secretary ``shall by regulation 
specify for purposes of this subparagraph the treatment of financial 
services income received or accrued by partnerships and by other pass-
thru entities which are not members of a financial services group.''
    Section 904(d)(2)(D), as amended by the AJCA, generally adopts the 
definition of financial services income of former section 
904(d)(2)(C)(i) and (ii), except that it includes neither the rule 
providing that financial services income includes export financing 
interest that would be high withholding tax interest, nor the exception 
in former section 904(d)(2)(C)(iii) for high withholding tax interest 
and export financing interest that would not be high withholding tax 
interest. New section 904(d)(2)(D)(i) defines financial services income 
as ``any income which is received or accrued by any person 
predominantly engaged in the active conduct of a banking, insurance, 
financing or similar business,'' and which is either described in 
section 904(d)(2)(D)(ii) (which provides a general description of 
financial services income) or is passive income (determined without 
regard to

[[Page 72584]]

whether it is high-taxed). An item of income satisfies the general 
description of financial services income if such income is (1) derived 
in the active conduct of a banking, financing, or similar business; (2) 
derived from the investment by an insurance company of its unearned 
premiums or reserves ordinary and necessary for the proper conduct of 
its insurance business; or (3) of a kind which would be insurance 
income as defined in section 953(a) determined without regard to 
section 953(a)(1)(A), which limits insurance income to income from 
countries other than the country in which the corporation was created 
or organized. See section 904(d)(2)(D)(ii).
    The final regulations at Sec.  1.904-4(e) provide rules concerning 
the separate category for financial services income. Section 1.904-
4(e)(1) provides a general definition of financial services income. 
Section 1.904-4(e)(2) provides an exclusive list describing items of 
income that are treated as active financing income. Section 1.904-
4(e)(3)(i) provides that a person is considered to be predominantly 
engaged in the active financing business for any taxable year if for 
that year at least 80 percent of its gross income is active financing 
income, as defined in Sec.  1.904-4(e)(2).
    On June 26, 2007, the IRS and the Treasury Department issued Notice 
2007-58, 2007-29 IRB 88 (see Sec.  601.601(d)(2)(ii)(b)), in which the 
IRS and the Treasury Department announced that in light of the 
amendments to the foreign tax credit rules in the AJCA, they were 
reviewing the provisions relating to financial services income, active 
financing income, and financial services entities in Sec.  1.904-4(e). 
The Notice also solicited comments relating to these definitions. The 
IRS and the Treasury Department received several written comments and 
are continuing to study this issue. Accordingly, the rules of Sec.  
1.904-4(e) of the current final regulations are not being revised at 
this time.

IV. Pre-2007 Separate Categories

    To reflect the reduction of separate categories, Sec. Sec.  1.904-
4(d) (definition of high withholding tax interest), 1.904-4(f) 
(definition of shipping income), and 1.904-4(g) (treatment of dividends 
from a noncontrolled section 902 corporation) are reserved.
    It should be noted that the separate category for shipping income 
remained effective for taxable years beginning before January 1, 2007. 
Section 415 of the AJCA repealed the foreign base company shipping 
income rules of section 954(f), effective for taxable years of foreign 
corporations beginning after December 31, 2004, and taxable years of 
U.S. shareholders in which or with which such taxable years of the 
foreign corporations end. Notice 2007-13, 2007-5 IRB 410, stated that 
in light of the repeal of section 954(f), Sec.  1.954-1(e)(4)(i)(A) 
(providing a trump rule for income that qualifies as foreign base 
company shipping income) is obsolete, and Sec.  1.954-6 (providing 
rules for determining foreign base company shipping income) is 
effective only for purposes of applying the rules for the withdrawal of 
previously excluded subpart F income from qualified investments. 
However, a technical correction in the Tax Increase Prevention and 
Reconciliation Act of 2005 confirmed that the separate category for 
shipping income is defined by reference to shipping income as defined 
in section 954(f) prior to its repeal. Accordingly, the subpart F 
shipping regulations continued to apply for section 904(d) purposes, 
and the separate category for shipping income continued to exist, 
through the end of taxable years beginning before 2007. See Sec.  
601.601(d)(2)(ii)(b).
    The final regulations at Sec. Sec.  1.904-4(h) (definition of and 
rules relating to treatment of export financing interest), 1.904-4(i) 
(concerning the interaction of section 907(c) and Sec.  1.904-4), 
1.904-4(j) (concerning DASTM gain or loss), 1.904-4(l) (priority rules 
for income meeting the definitions of more than one pre-2007 separate 
category), and 1.904-5 have been revised to reflect the new separate 
categories for passive category income and general category income.

V. Post-1986 Undistributed Earnings and Post-1986 Foreign Income Taxes 
of a Foreign Corporation as of the End of the Corporation's Last Pre-
2007 Taxable Year

A. General Rule of Reconstruction

    If a dividend is paid, or an amount is included in the gross income 
of a U.S. shareholder under section 951, out of post-1986 undistributed 
earnings (or pre-1987 accumulated profits) of a foreign corporation 
attributable to more than one separate category, the amount of foreign 
income taxes deemed paid by the domestic shareholder or upper-tier 
corporation under section 902 or 960 is computed separately with 
respect to the post-1986 undistributed earnings (or pre-1987 
accumulated profits) in each separate category out of which the 
dividend is paid or to which the subpart F inclusion is attributable. 
See Sec. Sec.  1.902-1T(d)(1); 1.960-1(i)(1). The temporary regulations 
implement the reduction of separate categories under the AJCA by 
recharacterizing the foreign corporation's pools of post-1986 
undistributed earnings and post-1986 foreign income taxes in the pre-
2007 separate categories as pools of post-1986 undistributed earnings 
and post-1986 foreign income taxes in the separate categories for 
passive category income and general category income on the first day of 
the foreign corporation's first post-2006 taxable year.
    Section 1.904-7T(g)(2) of the temporary regulations provides that 
in the case of a CFC or noncontrolled section 902 corporation that has 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes in any pre-2007 separate category, the earnings and foreign 
income taxes that exist as of the end of the foreign corporation's last 
pre-2007 taxable year are treated as if they were accumulated and paid 
during a period when the post-2006 rules applied, including the rules 
under section 904(d)(3)(E). Recharacterized amounts of earnings and 
taxes are taken into account in determining the opening balance of the 
post-1986 undistributed earnings and post-1986 foreign income taxes 
pools in each of the foreign corporation's post-2006 separate 
categories on the first day of the foreign corporation's first post-
2006 taxable year.
    Section 1.904-7T(g)(3)(i) of the temporary regulations provides 
that in order to substantiate the recharacterization of the pools of 
post-1986 undistributed earnings and post-1986 foreign income taxes in 
any pre-2007 separate category, the pools must be reconstructed for 
each pre-2007 taxable year, beginning with the first year in which 
earnings were accumulated in the pool with respect to each such pre-
2007 separate category. Earnings are treated as if they were 
accumulated in a period when the post-2006 rules applied, taking into 
account earnings distributed and taxes deemed paid pro rata from the 
amounts that were added to the pools in each separate category in 
subsequent pre-2007 taxable years. As reconstructed, the pools of 
earnings and taxes in a pre-2007 separate category are assigned to the 
post-2006 separate categories on the first day of the foreign 
corporation's first post-2006 taxable year. (A hovering deficit is 
subject to the same rules for purposes of identifying the post-2006 
separate categories to which the deficit is assigned, but the hovering 
deficit is not included in determining the opening balance of the pool. 
See Sec.  1.367(b)-7.)
    Similar rules apply to assign to the post-2006 separate categories 
amounts

[[Page 72585]]

of previously-taxed earnings and profits described in section 
959(c)(1)(A), accumulated deficits, and pre-1987 accumulated profits in 
pre-2007 separate categories. For example, if there is an accumulated 
deficit in any pre-2007 separate category as of the end of a CFC's or 
noncontrolled section 902 corporation's last pre-2007 taxable year, the 
deficit and associated taxes (if any) are treated in the same manner as 
if there had been positive accumulated earnings and taxes in the 
separate category, that is, the deficit and taxes are treated as if the 
post-2006 rules applied in the year the deficit was accumulated and the 
taxes were paid. The earnings and deficits in earnings making up the 
accumulated deficit are assigned to the post-2006 separate categories 
based on where those items of income and expenses or losses would have 
been assigned had they been incurred when the post-2006 rules were in 
effect. As reconstructed, the deficit is taken into account in 
determining the opening balance of the post-1986 undistributed earnings 
pool in the appropriate post-2006 separate category or categories on 
the first day of the foreign corporation's first post-2006 taxable 
year.
    The IRS and the Treasury Department recognize that shareholders may 
face difficulties in reconstructing historical accumulated earnings and 
taxes accounts of a foreign corporation. Therefore, a reasonable 
approximation of the amounts properly included in the post-2006 
separate categories, based on available records obtained through 
reasonable, good-faith efforts by the taxpayer, will adequately 
substantiate reconstruction.

B. Safe Harbors

1. In General
    For pools of undistributed earnings and foreign income taxes in the 
pre-2007 separate categories of CFCs and noncontrolled section 902 
corporations, the temporary regulations provide that a taxpayer may 
elect to apply one of two safe harbors in lieu of reconstructing 
historical accumulated earnings and taxes accounts of the foreign 
corporation. See Sec.  1.904-7T(g)(3)(ii). The safe harbors apply to 
allocate post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and pre-1987 accumulated profits and 
associated foreign income taxes in a foreign corporation's pre-2007 
separate categories. Amounts allocated to the post-2006 separate 
categories under a safe harbor are taken into account in computing the 
opening balance of the post-1986 undistributed earnings and post-1986 
foreign income taxes pools, as well as pre-1987 accumulated profits and 
pre-1987 foreign income taxes, in each of the foreign corporation's 
post-2006 separate categories on the first day of the foreign 
corporation's first post-2006 taxable year.
2. General Safe Harbor
    Under Sec.  1.904-7T(g)(3)(ii)(B)(1) of the temporary regulations, 
the safe harbor for post-1986 undistributed earnings and post-1986 
foreign income taxes (as well as deficits and previously-taxed 
earnings, and pre-1987 accumulated profits, if any) in a CFC's or 
noncontrolled section 902 corporation's pre-2007 separate category for 
passive income, certain dividends from a DISC or former DISC, taxable 
income attributable to certain foreign trade income, or certain 
distributions from a FSC or former FSC provides that such earnings and 
taxes are allocated to the post-2006 separate category for passive 
category income. Under Sec.  1.904-7T(g)(3)(ii)(B)(2), the safe harbor 
for post-1986 undistributed earnings and post-1986 foreign income taxes 
(as well as deficits, previously-taxed earnings, and pre-1987 
accumulated profits, if any) in a CFC's or noncontrolled section 902 
corporation's pre-2007 separate category for financial services income, 
shipping income, or general limitation income provides that such 
earnings and taxes are allocated to the post-2006 separate category for 
general category income.
    Under Sec.  1.904-7T(g)(3)(ii)(B)(3), the safe harbor for post-1986 
undistributed earnings and post-1986 foreign income taxes (as well as 
deficits, previously-taxed earnings, and pre-1987 accumulated profits, 
if any) in a CFC's or noncontrolled section 902 corporation's pre-2007 
separate category for high withholding tax interest generally provides 
that such earnings and taxes are allocated to the post-2006 separate 
category for passive category income. However, Sec.  1.904-7T(g)(3)(ii) 
(B)(4) provides that if a CFC has positive post-1986 undistributed 
earnings or pre-1987 accumulated profits and foreign income taxes 
attributable to high-withholding tax interest, such earnings and taxes 
are allocated to the post-2006 separate category for general category 
income if the earnings would qualify as income subject to high foreign 
taxes under section 954(b)(4) if the entire amount of earnings in the 
pre-2007 pool in the separate category for high withholding tax 
interest were treated as a net item of income subject to the rules of 
Sec.  1.954-1(d). If the earnings would not qualify as income subject 
to high foreign taxes under section 954(b)(4), the earnings and taxes 
are allocated to the post-2006 separate category for passive category 
income. The IRS and the Treasury Department believe that, given that 
high withholding tax interest generally constitutes subpart F income 
unless it is high-taxed, this safe harbor is an appropriate alternative 
to reconstructing earnings and taxes in a CFC's separate category for 
high withholding tax interest.
3. Interest Apportionment Safe Harbor
    A second safe harbor is provided under Sec.  1.904-7T(g)(3)(ii)(C) 
which allows taxpayers to allocate the post-1986 undistributed earnings 
and post-1986 foreign taxes (and deficits, previously-taxed earnings, 
and pre-1987 accumulated profits, if any) in a CFC's or noncontrolled 
section 902 corporation's pre-2007 pools following the principles of 
the safe harbor method described in the transition rules under Sec.  
1.904-7T(f)(4)(ii) for post-1986 undistributed earnings and post-1986 
foreign income taxes in the non-look-through pool of a controlled 
foreign corporation or noncontrolled section 902 corporation.
4. Election of Safe Harbor
    To allocate pools of undistributed earnings (and deficits, 
previously-taxed earnings, and pre-1987 accumulated profits, if any) 
and foreign income taxes in the pre-2007 separate categories of a CFC 
or noncontrolled section 902 corporation to the foreign corporation's 
post-2006 separate categories, the temporary regulations at Sec.  
1.904-7T(g)(3)(iii) provide that a taxpayer may elect to apply a safe 
harbor in lieu of reconstruction on a separate-category-by-separate-
category basis. If a taxpayer elects to apply a safe harbor to allocate 
pre-2007 pools of more than one pre-2007 separate category of a foreign 
corporation, the same safe harbor (that is, the general safe harbor 
described in Sec.  1.904-7T(g)(3)(ii)(B) or the interest apportionment 
safe harbor described in Sec.  1.904-7T(g)(3)(ii)(C)) shall then apply 
to allocate the pre-2007 pools of all of the foreign corporation's pre-
2007 separate categories for which the taxpayer elects to apply a safe 
harbor method in lieu of reconstructing the pre-2007 pools.

C. Post-1986 Undistributed Earnings and Taxes of Lower-Tier Foreign 
Corporations

    The transition rules described in Sections V.A. and B in this 
preamble apply to post-1986 undistributed earnings and post-1986 
foreign income taxes (as well as deficits, previously-

[[Page 72586]]

taxed earnings, and pre-1987 accumulated profits, if any) not only of a 
first-tier foreign corporation but also of lower-tier foreign 
corporations as well. See Sec.  1.904-7T(g)(5). Accordingly, to the 
extent a lower-tier foreign corporation has pools of post-1986 
undistributed earnings (attributable to amounts not yet included in 
gross income by the U.S. shareholder) and foreign income taxes in a 
pre-2007 separate category, the rules of Sec.  1.904-7T(g) apply in 
treating the earnings and taxes as the opening balance of the foreign 
corporation's pools of post-1986 undistributed earnings and post-1986 
foreign income taxes in the appropriate post-2006 separate category or 
categories on the first day of the foreign corporation's first post-
2006 taxable year. Similarly, pre-1987 accumulated profits and pre-1987 
foreign income taxes in a pre-2007 separate category of a lower-tier 
foreign corporation are allocated to the appropriate post-2006 separate 
categories in accordance with the rules of Sec.  1.904-7T(g).

VI. Separate Limitation Losses and Overall Foreign Losses

    Because the AJCA reduced the number of section 904(d) separate 
categories from eight to two for post-2006 taxable years, the temporary 
regulations provide transition rules for recapture in a post-2006 
taxable year of an overall foreign loss (OFL) or separate limitation 
loss (SLL) in a pre-2007 separate category that offset U.S. source 
income or income in another pre-2007 separate category, respectively, 
in a pre-2007 taxable year.
    Section 1.904(f)-12T(h)(1) of the temporary regulations provides 
that to the extent a taxpayer has an OFL or SLL at the end of the 
taxpayer's last pre-2007 taxable year in the pre-2007 separate category 
for passive income, certain dividends from a DISC or former DISC, 
taxable income attributable to certain foreign trade income, or certain 
distributions from a FSC or former FSC, such OFL or SLL is allocated on 
the first day of the taxpayer's next taxable year to the taxpayer's 
post-2006 separate category for passive category income. Accordingly, 
such OFL or SLL will be subject to recapture in subsequent taxable 
years out of the taxpayer's passive category income. Where a taxpayer 
has an SLL in some other pre-2007 separate category (for example, a 
general limitation SLL) that offset passive income, certain dividends 
from a DISC or former DISC, taxable income attributable to certain 
foreign trade income, or certain distributions from a FSC or former 
FSC, the SLL will be recaptured in subsequent taxable years as passive 
category income.
    Section 1.904(f)-12T(h)(2) of the temporary regulations provides 
that to the extent a taxpayer has an OFL or SLL at the end of the 
taxpayer's last pre-2007 taxable year in the pre-2007 separate category 
for financial services income, shipping income, or general limitation 
income, such OFL or SLL is allocated on the first day of the taxpayer's 
next taxable year to the taxpayer's post-2006 separate category for 
general category income. Accordingly, such OFL or SLL will be subject 
to recapture in subsequent taxable years out of the taxpayer's general 
category income. Where a taxpayer has an SLL in some other pre-2007 
separate category (for example, a passive SLL) that offset financial 
services income, shipping income, or general limitation income, the SLL 
will be recaptured in subsequent taxable years as general category 
income.
    Section 1.904(f)-12T(h)(3) provides that to the extent a taxpayer 
has an OFL or SLL at the end of the taxpayer's last pre-2007 taxable 
year in the pre-2007 separate category for high withholding tax 
interest, the allocation of such OFL or SLL to the taxpayer's post-2006 
separate categories depends on the taxpayer's allocation of excess 
taxes in the high withholding tax interest loss category for carryover 
purposes. Accordingly, if the excess taxes are assigned to the 
appropriate post-2006 separate category or categories based on 
reconstruction (that is, treating the taxes as if they had been paid or 
accrued in a post-2006 taxable year under Sec.  1.904-2T(i)(1)(i)), the 
OFL or SLL is allocated pro rata to the taxpayer's post-2006 separate 
categories based on the proportions in which the excess high 
withholding taxes are assigned to the post-2006 separate categories. If 
instead the taxpayer elects to assign the excess taxes to the post-2006 
separate category for general category income under the safe harbor 
described in Sec.  1.904-2T(i)(1)(ii), the OFL or SLL is also allocated 
to the same post-2006 general category. If there are no excess taxes in 
the loss category that are carried over to post-2006 taxable years, an 
OFL or SLL in the pre-2007 separate category for high withholding tax 
interest is allocated to the post-2006 separate category for passive 
category income.
    Similarly, where a taxpayer has an SLL in a pre-2007 separate 
category that offset high withholding tax interest, the SLL will be 
recaptured in subsequent taxable years pro rata as income in the post-
2006 separate categories for general category income and passive 
category income based on how the taxpayer allocated excess taxes in the 
pre-2007 separate category for high withholding tax interest under 
Sec.  1.904-2T(i)(1). If no excess taxes in the pre-2007 separate 
category for high withholding tax interest are carried over to post-
2006 taxable years, the SLL will be recaptured in subsequent taxable 
years as income in the post-2006 separate category for passive category 
income.
    Section 1.904-12T(h)(4) provides that after application of 
paragraphs (1) through (3), any separate limitation loss account 
allocated to the post-2006 separate category for passive category 
income for which income is to be recaptured as passive category income 
will be eliminated, since ``recapture'' to and from the same category 
would be meaningless. For the same reason, any separate limitation loss 
accounts allocated to the post-2006 separate category for general 
category income for which income is to be recaptured as general 
category income will be eliminated.
    Section 1.904-12T(h)(5) provides that taxpayers may in the 
alternative determine the treatment of OFLs and SLLs in pre-2007 
separate categories following the principles of the transition rules of 
Sec.  1.904-12T(g)(1) and (2) concerning the treatment of OFLs and SLLs 
in the separate category for dividends from a noncontrolled section 902 
corporation.

Effective/Applicability Date

    The effective date for these regulations is December 21, 2007. The 
temporary regulations apply to taxable years of United States taxpayers 
beginning after December 31, 2006, and ending on or after December 21, 
2007, and to taxable years of a foreign corporation which end with or 
within a taxable year of its domestic corporate shareholder beginning 
after December 31, 2006, and ending on or after December 21, 2007.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For the 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), 
refer to the Special Analyses section of the preamble of the cross-
referenced notice of proposed rulemaking published in this issue of the 
Federal Register. Pursuant to section 7805(f) of the Internal Revenue 
Code, this regulation

[[Page 72587]]

has been submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on its impact on small businesses.

Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

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 1.904-0 is amended as follows:
0
1. Add the entry for Sec.  1.904-2(i).
0
2. Remove and reserve the entries for Sec.  1.904-4(a), (b), (d), (f), 
(g), (h)(3), and (l).
0
3. Remove and reserve the entry for Sec.  1.904-5(h)(3).
0
4. Add and reserve the entry for Sec.  1.904-5(o)(3).
0
5. Add the entry for Sec.  1.904-7(g).

0
6. Add the entry for Sec.  1.904(f)-12(h).
    The revisions and additions read as follows:


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

* * * * *

Sec.  1.904-2 Carryback and carryover of unused foreign tax.

* * * * *
    (i) [Reserved].
* * * * *

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

    (a) [Reserved].
    (b) [Reserved].
* * * * *
    (d) [Reserved].
* * * * *
    (f) [Reserved].
    (g) [Reserved].
* * * * *
    (h)(3) [Reserved].
* * * * *
    (l) [Reserved].
* * * * *

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

* * * * *
    (h) * * *
    (3) [Reserved].
* * * * *
    (o) * * *
    (3) [Reserved].

Sec.  1.904-7 Transition rules.

* * * * *
    (g) [Reserved].

Sec.  1.904(f)-12 Transition rules.

* * * * *
    (h) [Reserved].

0
Par. 3. Section 1.904-2 is amended by adding paragraph (i) to read as 
follows:


Sec.  1.904-2  Carryback and carryover of unused foreign tax.

* * * * *
    (i) [Reserved.] For further guidance, see Sec.  1.904-2T(i).
0
Par. 4. Section 1.904-2T is amended by adding paragraph (i) to read as 
follows:


Sec.  1.904-2T  Carryback and carryover of unused foreign tax 
(temporary).

* * * * *
    (i) Transition rules for carryovers and carrybacks of pre-2007 and 
post-2006 unused foreign tax--(1) Carryover of unused foreign tax--(i) 
General rule. For purposes of this paragraph (i), the terms post-2006 
separate category and pre-2007 separate category have the meanings set 
forth in Sec.  1.904-7T(g)(1)(ii) and (iii). The rules of this 
paragraph (i)(1) apply to reallocate to the taxpayer's post-2006 
separate categories for general category income and passive category 
income any unused foreign taxes (as defined in Sec.  1.904-2(b)(2)) 
that were paid or accrued or deemed paid under section 902 with respect 
to income in a pre-2007 separate category (other than a category 
described in Sec.  1.904-4(m)). To the extent any such unused foreign 
taxes are carried forward to a taxable year beginning after December 
31, 2006, such taxes shall be allocated to the taxpayer's post-2006 
separate categories to which those taxes would have been allocated if 
the taxes were paid or accrued in a taxable year beginning after 
December 31, 2006. For example, any foreign taxes paid or accrued or 
deemed paid with respect to financial services income in a taxable year 
beginning before January 1, 2007, that are carried forward to a taxable 
year beginning after December 31, 2006, will be allocated to the 
general category because the financial services income to which those 
taxes relate would have been allocated to the general category if it 
had been earned in a taxable year beginning after December 31, 2006.
    (ii) Safe harbor. In lieu of applying the rules of paragraph 
(i)(1)(i) of this section, a taxpayer may allocate all unused foreign 
taxes in the pre-2007 separate category for passive income to the post-
2006 separate category for passive category income, and allocate all 
other unused foreign taxes described in paragraph (i)(1)(i) of this 
section to the post-2006 separate category for general category income.
    (2) Carryback of unused foreign tax--(i) General rule. The rules of 
this paragraph (i)(2) apply to any unused foreign taxes that were paid 
or accrued or deemed paid under section 902 with respect to income in a 
post-2006 separate category (other than a category described in Sec.  
1.904-4(m)). To the extent any such unused foreign taxes are carried 
back to a taxable year beginning before January 1, 2007, a credit for 
such taxes shall be allowed only to the extent of the excess limitation 
in the pre-2007 separate category, or categories, to which the taxes 
would have been allocated if the taxes were paid or accrued in a 
taxable year beginning before January 1, 2007. For example, any foreign 
taxes paid or accrued or deemed paid with respect to income in the 
general category in a taxable year beginning after December 31, 2006, 
that are carried back to a taxable year beginning before January 1, 
2007, will be allocated to the same separate categories to which the 
income would have been allocated if it had been earned in a taxable 
year beginning before January 1, 2007.
    (ii) Safe harbor. In lieu of applying the rules of paragraph 
(i)(2)(i) of this section, a taxpayer may allocate all unused foreign 
taxes in the post-2006 separate category for passive category income to 
the pre-2007 separate category for passive income, and may allocate all 
other unused foreign taxes described in paragraph (i)(2)(i) of this 
section to the pre-2007 separate category for general limitation 
income.
    (3) Effective/applicability date. This paragraph (i) applies to 
taxable years of United States taxpayers beginning after December 31, 
2006 and ending on or after December 21, 2007.
    (4) Expiration date. The applicability of this paragraph (i) 
expires on December 20, 2010.
0
Par. 5. Section 1.904-4 is amended as follows:
0
1. In the table below, for each section listed in the left column, 
remove the language in the middle column and add the language in the 
right column.
0
2. Paragraphs (a),(b), (d), (f), (g), (h)(3) and (l) are revised.
0
3. Paragraph (h)(4) Example 2 is removed.

[[Page 72588]]

0
4. Paragraph (h)(4) Example 3 is redesignated as Example 2.
0
5. Paragraph (h)(4) (Example 4 is redesignated as Example 3 and in the 
last sentence the language ``general limitation'' is removed and the 
language ``general category'' is added in its place.

0
6. Paragraphs (h)(5)(iii) Example 2 and (h)(5)(iii) Example 4 are 
removed.
    7. Paragraph (h)(5)(iii) Example 3 is redesignated as Example 2 and 
in the last sentence the language ``general limitation'' is removed and 
the language ``general category.'' is added in its place.
    The revisions read as follows:

----------------------------------------------------------------------------------------------------------------
                Section                             Remove                                 Add
----------------------------------------------------------------------------------------------------------------
1.904-4(c)(1), third sentence.........  general limitation............  general category.
1.904-4(c)(1), third sentence.........  general limitation............  general category.
1.904-4(c)(1), fourth sentence........  general limitation............  general category.
1.904-4(c)(6)(iii), second sentence...  general limitation............  general category.
1.904-4(c)(6)(iii), fifth sentence....  general limitation............  general category.
1.904-4(c)(6)(iv)(A), first sentence..  general limitation............  general category.
1.904-4(c)(7)(i), second sentence.....  general limitation............  general category.
1.904-4(c)(7)(iii), third sentence....  general limitation............  general category.
1.904-4(c)(8) Example 1, last sentence  general limitation............  general category.
1.904-4(c)(8) Example 1, last sentence  general limitation............  general category.
1.904-4(c)(8) Example 2, last sentence  general limitation............  general category.
1.904-4(c)(8) Example 3, last sentence  general limitation............  general category.
1.904-4(c)(8) Example 5, last sentence  general limitation............  general category.
1.904-4(c)(8) Example 6, seventh        general limitation............  general category.
 sentence.
1.904-4(c)(8) Example 8, last sentence  general limitation............  general category.
1.904-4(c)(8) Example 9 (i), last       general limitation............  general category.
 sentence.
1.904-4(c)(8) Example 9 (ii), first     general limitation............  general category.
 sentence.
1.904-4(c)(8) Example 9 (ii), last      general limitation............  general category.
 sentence.
1.904-4(c)(8) Example 11, first         general limitation............  general category.
 sentence.
1.904-4(c)(8) Example 11, last          general limitation............  general category.
 sentence.
1.904-4(c)(8) Example 12, third         general limitation............  general category.
 sentence.
1.904-4(h)(2).........................  general limitation............  general category.
1.904-4(h)(5)(i), first sentence......  that is not a financial         ........................................
                                         services entity.
1.904-4(h)(5)(i), first sentence......  general limitation............  general category.
1.904-4(h)(5)(i), last sentence.......  If a financial services entity
                                         receives or accrues that
                                         income, the income shall not
                                         be considered to be export
                                         financing interest and,
                                         therefore, shall be treated
                                         as financial services income.
1.904-4(h)(5)(ii), first sentence.....  904(d)(2)(A)(iii)(II).........  904(d)(2)(B)(iii)(I).
1.904-4(h)(5)(ii), first sentence.....  general limitation............  general category.
1.904-4(h)(5)(ii), first sentence.....  unless the interest is
                                         received or accrued by a
                                         financial services entity.
1.904-4(h)(5)(ii), last sentence......  If that interest also would be  ........................................
                                         high withholding tax interest
                                         but for section
                                         904(d)(2)(B)(ii), then the
                                         interest shall be treated as
                                         financial services income.
1.904-4(h)(5)(iii) Example 1, last      general limitation............  general category.
 sentence.
1.904-4(i), second sentence...........  Thus, for example, if a         ........................................
                                         taxpayer receives or accrues
                                         a dividend distribution from
                                         two separate noncontrolled
                                         section 902 corporations out
                                         or earnings and profits
                                         attributable to income
                                         received or accrued by the
                                         noncontrolled section 902
                                         corporations that is income
                                         described in section 907(c),
                                         the rules provided in section
                                         907 shall apply separately to
                                         the dividends received from
                                         each noncontrolled section
                                         902 corporation..
1.904-4(j), last sentence.............  904(d)(2)(A)(iii)(III)........  904(d)(2)(B)(iii)(II).
1.904-4(m)............................  904(g)(10)....................  904(h)(10)
1.904-4(m)............................  and (d)(3)(F)(i)..............
----------------------------------------------------------------------------------------------------------------

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

    (a) [Reserved]. For further guidance, see Sec.  1.904-4T(a).
    (b) [Reserved]. For further guidance, see Sec.  1.904-4T(b).
* * * * *
    (d) [Reserved].
* * * * *
    (f) [Reserved]. For further guidance, see Sec.  1.904-4T(f).
    (g) [Reserved]. For further guidance, see Sec.  1.904-4T(g).
* * * * *
    (h) * * *
    (3) [Reserved]. For further guidance, see Sec.  1.904-4T(h)(3).
* * * * *
    (l) [Reserved]. For further guidance, see Sec.  1.904-4T(l).
* * * * *

0
Par. 6. Section 1.904-4T is amended as follows:
0
1. Revise paragraphs (a), (b), (c)(4)(i), (c)(4)(ii), (c)(4)(iii), 
(c)(5), (c)(6), (7), (c)(8), (d), (e), (f), (g), (h), (i), (j), (k), 
(l), and (m).
0
2. Add paragraphs (n) and (o).

    The revisions and additions read as follows:


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

    (a) In general. A taxpayer is required to compute a separate 
foreign tax credit limitation for income received or accrued in a 
taxable year that is described in section 904(d)(1)(A) (passive 
category income), 904(d)(1)(B)

[[Page 72589]]

(general category income), or Sec.  1.904-4(m) (additional separate 
categories).
    (b) Passive category income--(1) In general. The term passive 
category income means passive income and specified passive category 
income.
    (2) Passive income--(i) In general. The term passive income means 
any--
    (A) Income received or accrued by any person that is of a kind that 
would be foreign personal holding company income (as defined in section 
954(c)) if the taxpayer were a controlled foreign corporation, 
including any amount of gain on the sale or exchange of stock in excess 
of the amount treated as a dividend under section 1248; or
    (B) Amount includible in gross income under section 1293.
    (ii) Exceptions. Passive income does not include any export 
financing interest (as defined in section 904(d)(2)(G) and paragraph 
(h) of this section), any high-taxed income (as defined in section 
904(d)(2)(F) and paragraph (c) of this section), or any active rents 
and royalties (as defined in paragraph (b)(2)(iii) of this section). In 
addition, passive income does not include any income that would 
otherwise be passive but is characterized as income in another separate 
category under the look-through rules of section 904(d)(3), (d)(4), and 
(d)(6)(C) and the regulations under those provisions. In determining 
whether any income is of a kind that would be foreign personal holding 
company income, the rules of section 864(d)(5)(A)(i) and (6) (treating 
related person factoring income of a controlled foreign corporation as 
foreign personal holding company income that is not eligible for the 
export financing income exception to the separate limitation for 
passive income) shall apply only in the case of income of a controlled 
foreign corporation (as defined in section 957). Thus, income earned 
directly by a United States person that is related person factoring 
income may be eligible for the exception for export financing interest.
    (iii) Active rents or royalties--(A) In general. For rents and 
royalties paid or accrued after September 20, 2004, passive income does 
not include any rents or royalties that are derived in the active 
conduct of a trade or business, regardless of whether such rents or 
royalties are received from a related or an unrelated person. Except as 
provided in paragraph (b)(2)(iii)(B) of this section, the principles of 
section 954(c)(2)(A) and the regulations under that section shall apply 
in determining whether rents or royalties are derived in the active 
conduct of a trade or business. For this purpose, the term taxpayer 
shall be substituted for the term controlled foreign corporation if the 
recipient of the rents or royalties is not a controlled foreign 
corporation.
    (B) Active conduct of trade or business. Rents and royalties are 
considered derived in the active conduct of a trade or business by a 
United States person or by a controlled foreign corporation (or other 
entity to which the look-through rules apply) for purposes of section 
904 (but not for purposes of section 954) if the requirements of 
section 954(c)(2)(A) are satisfied by one or more corporations that are 
members of an affiliated group of corporations (within the meaning of 
section 1504(a), determined without regard to section 1504(b)(3)) of 
which the recipient is a member. For purposes of this paragraph 
(b)(2)(iii)(B), an affiliated group includes only domestic corporations 
and foreign corporations that are controlled foreign corporations in 
which domestic members of the affiliated group own, directly or 
indirectly, at least 80 percent of the total voting power and value of 
the stock. For purposes of this paragraph (b)(2)(iii)(B), indirect 
ownership shall be determined under section 318 and the regulations 
under that section.
    (iv) Examples. The following examples illustrate the application of 
paragraph (b)(2) of this section.

    Example 1. P is a domestic corporation with a branch in foreign 
country X. P does not have any financial services income. For 2008, 
P has a net foreign currency gain that would not constitute foreign 
personal holding company income if P were a controlled foreign 
corporation because the gain is directly related to the business 
needs of P. The currency gain is, therefore, general category income 
to P because it is not income of a kind that would be foreign 
personal holding company income.
    Example 2. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. S is regularly engaged in 
the restaurant franchise business. P licenses trademarks, 
tradenames, certain know-how, related services, and certain 
restaurant designs for which S pays P an arm's length royalty. P is 
regularly engaged in the development and licensing of such property. 
The royalties received by P for the use of its property are 
allocable under the look-through rules of Sec.  1.904-5 to the 
royalties S receives from the franchisees. Some of the franchisees 
are unrelated to S and P. Other franchisees are related to S or P 
and use the licensed property outside of S's country of 
incorporation. S does not satisfy, but P does satisfy, the active 
trade or business requirements of section 954(c)(2)(A) and the 
regulations under that section. The royalty income earned by S with 
regard to both its related and unrelated franchisees is foreign 
personal holding company income because S does not satisfy the 
active trade or business requirements of section 954(c)(2)(A) and, 
in addition, the royalty income from the related franchisees does 
not qualify for the same country exception of section 954(c)(3). 
However, all of the royalty income earned by S is general category 
income to S under Sec.  1.904-4(b)(2)(iii) because P, a member of 
S's affiliated group (as defined therein), satisfies the active 
trade or business test (which is applied without regard to whether 
the royalties are paid by a related person). S's royalty income that 
is taxable to P under subpart F and the royalties paid to P are 
general category income to P under the look-through rules of Sec.  
1.904-5(c)(1)(i) and (c)(3), respectively.

    (3) Specified passive category income means--
    (i) Dividends from a DISC or former DISC (as defined in section 
992(a)) to the extent such dividends are treated as income from sources 
without the United States;
    (ii) Taxable income attributable to foreign trade income (within 
the meaning of section 923(b)); or
    (iii) Distributions from a FSC (or a former FSC) out of earnings 
and profits attributable to foreign trade income (within the meaning of 
section 923(b)) or interest or carrying charges (as defined in section 
927(d)(1)) derived from a transaction which results in foreign trade 
income (as defined in section 923(b)).
* * * * *
    (c)(4)(i) through (h)(2) [Reserved]. For further guidance, see 
Sec.  1.904-4(c)(i) through (h)(2).
    (3) Exception. Unless it is received or accrued by a financial 
services entity, export financing interest shall be treated as passive 
category income if that income is also related person factoring income. 
For this purpose, related person factoring income is--
    (i) Income received or accrued by a controlled foreign corporation 
that is income described in section 864(d)(6) (income of a controlled 
foreign corporation from a loan for the purpose of financing the 
purchase of inventory property of a related person); or
    (ii) Income received or accrued by any person that is income 
described in section 864(d)(1) (income from a trade receivable acquired 
from a related person).
    (h)(4) through (k) [Reserved]. For further guidance, see Sec.  
1.904-4(h)(3)(iii) through (k).
    (l) Priority rule. Income that meets the definitions of a separate 
category described in paragraph (m) of this section and another 
category of income described in section 904(d)(2)(A)(i) and (ii) will 
be subject to the separate limitation described in paragraph (m) of 
this section and will not be treated as general category income 
described in section 904(d)(2)(A)(ii).

[[Page 72590]]

    (m) [Reserved]. For further guidance, see Sec.  1.904-4(m).
    (n) Effective/applicability date. Paragraphs (a), (b), (h)(3), and 
(l) of this section shall apply to taxable years of United States 
taxpayers beginning after December 31, 2006 and ending on or after 
December 21, 2007, and to taxable years of a foreign corporation which 
end with or within taxable years of its domestic corporate shareholder 
beginning after December 31, 2006 and ending on or after December 21, 
2007.
    (o) Expiration date. The applicability of paragraphs (a), (b), 
(h)(3)(ii) and (l) of this section expires on December 20, 2010.
0
Par. 7. Section 1.904-5 is amended by revising paragraph (h)(3) and 
adding paragraph (o)(3) to read as follows:


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

* * * * *
    (h) * * *
    (3) [Reserved]. For further guidance, see Sec.  1.904-5T(h)(3).
* * * * *
    (o) * * *
    (3) [Reserved]. For further guidance, see Sec.  1.904-5T(o)(3).

0
Par. 8. Section 1.904-5T is amended by revising paragraphs (c)(4)(iv), 
(d), (e), (f), (g), and (h) and adding paragraph (o)(3) to read as 
follows:


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

* * * * *
    (c)(4)(iv) through (h)(2) [Reserved]. For further guidance, see 
Sec.  1.904-5(c)(4)(iv) through (h)(2).
    (3) Income from the sale of a partnership interest--(i) In general. 
To the extent a partner recognizes gain on the sale of a partnership 
interest, that income shall be treated as passive category income to 
the partner, unless the income is considered to be high-taxed under 
section 904(d)(2)(B)(iii)(II) and Sec.  1.904-4(c).
    (ii) Exception for 25-percent owned partnership. In the case of a 
sale of an interest in a partnership by a partner that is a 25-percent 
owner of the partnership under the principles of section 954(c)(4)(B), 
income recognized on the sale of the partnership interest shall be 
treated as general category income to the extent that such gain would 
not be classified as foreign personal holding company income under the 
look-through rule of section 954(c)(4).
* * * * *
    (o) * * *
    (3) Rules for income from the sale of a partnership interest--(i) 
Effective/applicability date. Paragraph (h)(3) of this section shall 
apply to taxable years of United States taxpayers beginning after 
December 31, 2006 and ending on or after December 21, 2007, and to 
taxable years of a foreign corporation which end with or within taxable 
years of its domestic corporate shareholder beginning after December 
31, 2006 and ending on or after December 21, 2007.
    (ii) Expiration date. The applicability of paragraph (h)(3) of this 
section expires on December 20, 2010.
0
Par. 9. Section 1.904-7 is amended by adding paragraph (g) to read as 
follows:


Sec.  1.904-7  Transition rules.

* * * * *
    (g) [Reserved.] For further guidance, see Sec.  1.904-7T(g).
0
Par. 10. Section 1.904-7T is amended by adding paragraph (g) to read as 
follows:


Sec.  1.904-7T  Transition Rules (temporary).

* * * * *
    (g) Treatment of earnings and foreign taxes of a controlled foreign 
corporation or a noncontrolled section 902 corporation accumulated in 
taxable years beginning before January 1, 2007--(1) Definitions--(i) 
Pre-2007 pools means the pools in each separate category of post-1986 
undistributed earnings (as defined in Sec.  1.902-1(a)(9)) that were 
accumulated, and post-1986 foreign income taxes (as defined in Sec.  
1.902-1(a)(8)) paid, accrued, or deemed paid, in taxable years 
beginning before January 1, 2007.
    (ii) Pre-2007 separate categories means the separate categories of 
income described in section 904(d) as applicable to taxable years 
beginning before January 1, 2007, and any other separate category of 
income described in Sec.  1.904-4(m).
    (iii) Post-2006 separate categories means the separate categories 
of income described in section 904(d) as applicable to taxable years 
beginning after December 31, 2006, and any other separate category of 
income described in Sec.  1.904-4(m).
    (2) Treatment of pre-2007 pools of a controlled foreign corporation 
or a noncontrolled section 902 corporation. Any post-1986 undistributed 
earnings in a pre-2007 pool of a controlled foreign corporation or a 
noncontrolled section 902 corporation shall be treated in taxable years 
beginning after December 31, 2006, as if they were accumulated during a 
period in which the rules governing the determination of post-2006 
separate categories applied. Post-1986 foreign income taxes paid, 
accrued, or deemed paid with respect to such earnings shall be treated 
as if they were paid, accrued, or deemed paid during a period in which 
the rules governing the determination of post-2006 separate categories 
(including the rules of section 904(d)(3)(E)) applied as well. Any such 
earnings and taxes in pre-2007 pools shall constitute the opening 
balance of the foreign corporation's post-1986 undistributed earnings 
and post-1986 foreign income taxes on the first day of the foreign 
corporation's first taxable year beginning after December 31, 2006, in 
accordance with the rules of paragraph (g)(3) of this section. Similar 
rules shall apply to characterize any deficits in the pre-2007 pools 
and previously-taxed earnings and profits described in section 
959(c)(1)(A) that are attributable to earnings in the pre-2007 pools.
    (3) Substantiation of post-2006 character of earnings and taxes in 
a pre-2007 pool--(i) Reconstruction of earnings and taxes pools. In 
order to substantiate the post-2006 characterization of post-1986 
undistributed earnings (as well as deficits and previously-taxed 
earnings, if any) and post-1986 foreign income taxes in pre-2007 pools 
of a controlled foreign corporation or a noncontrolled section 902 
corporation, the taxpayer shall make a reasonable, good-faith effort to 
reconstruct the pre-2007 pools of post-1986 undistributed earnings (as 
well as deficits and previously-taxed earnings, if any) and post-1986 
foreign income taxes following the rules governing the determination of 
post-2006 separate categories for each taxable year beginning before 
January 1, 2007, beginning with the first year in which post-1986 
undistributed earnings were accumulated in the pre-2007 pool. 
Reconstruction shall be based on reasonably available books and records 
and other relevant information. To the extent any pre-2007 separate 
category includes earnings that would be allocated to more than one 
post-2006 separate category, the taxpayer must account for earnings 
distributed and taxes deemed paid in these years for such category as 
if they were distributed and deemed paid pro rata from the amounts that 
were added to that category during each taxable year beginning before 
January 1, 2007.
    (ii) Safe harbor method--(A) In general. Subject to the rules of 
paragraph (g)(3)(iii) of this section, a taxpayer may allocate the 
post-1986 undistributed earnings and post-1986 foreign income taxes in 
pre-2007 pools of a controlled foreign corporation or a noncontrolled 
section 902 corporation (as well as deficits and previously-taxed 
earnings, if any) under one of the safe harbor methods described in 
paragraphs

[[Page 72591]]

(g)(3)(ii)(B) and (g)(3)(ii)(C) of this section.
    (B) General safe harbor method--(1) Any post-1986 undistributed 
earnings (as well as deficits and previously-taxed earnings, if any) 
and post-1986 foreign income taxes of a noncontrolled section 902 
corporation or a controlled foreign corporation in a pre-2007 separate 
category for passive income, certain dividends from a DISC or former 
DISC, taxable income attributable to certain foreign trade income, or 
certain distributions from a FSC or former FSC shall be allocated to 
the post-2006 separate category for passive category income.
    (2) Any post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes 
of a noncontrolled section 902 corporation or a controlled foreign 
corporation in a pre-2007 separate category for financial services 
income, shipping income or general limitation income shall be allocated 
to the post-2006 separate category for general category income.
    (3) Except as provided in paragraph (g)(3)(ii)(B)(4) of this 
section, any post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes 
of a noncontrolled section 902 corporation or a controlled foreign 
corporation in a pre-2007 separate category for high withholding tax 
interest shall be allocated to the post-2006 separate category for 
passive category income.
    (4) If a controlled foreign corporation has positive post-1986 
undistributed earnings and post-1986 foreign income taxes in a pre-2007 
separate category for high withholding tax interest, such earnings and 
taxes shall be allocated to the post-2006 separate category for general 
category income if the earnings would qualify as income subject to high 
foreign taxes under section 954(b)(4) if the entire amount of post-1986 
undistributed earnings were treated as a net item of income subject to 
the rules of Sec.  1.954-1(d). If the high withholding tax interest 
earnings would not qualify as income subject to high foreign taxes 
under section 954(b)(4), then the earnings and taxes shall be allocated 
to the post-2006 separate category for passive category income.
    (C) Interest apportionment safe harbor. A taxpayer may allocate the 
post-1986 undistributed earnings (as well as deficits and previously-
taxed earnings, if any) and post-1986 foreign income taxes in pre-2007 
pools of a controlled foreign corporation or a noncontrolled section 
902 corporation following the principles of paragraph (f)(4)(ii) of 
this section.
    (iii) Consistency rule. The election to apply a safe harbor method 
under paragraph (g)(3)(ii) of this section in lieu of the rules 
described in paragraph (g)(3)(i) of this section may be made on a 
separate category by separate category basis. However, if a taxpayer 
elects to apply a safe harbor to allocate pre-2007 pools of more than 
one pre-2007 separate category of a controlled foreign corporation or a 
noncontrolled section 902 corporation, such safe harbor (the general 
safe harbor described in paragraph (g)(3)(ii)(B) of this section or the 
interest apportionment safe harbor described in paragraph (g)(3)(ii)(C) 
of this section) shall apply to allocate post-1986 undistributed 
earnings (as well as deficits and previously-taxed earnings, if any) 
and post-1986 foreign income taxes for the pre-2007 pools in each pre-
2007 separate category of the foreign corporation for which the 
taxpayer elected to apply a safe harbor method in lieu of 
reconstructing the pre-2007 pools.
    (4) Treatment of pre-1987 accumulated profits. Any pre-1987 
accumulated profits (as defined in Sec.  1.902-1(a)(10)) of a 
noncontrolled section 902 corporation or a controlled foreign 
corporation shall be treated in taxable years beginning after December 
31, 2006, as if they had been accumulated during a period in which the 
rules governing the determination of post-2006 separate categories 
applied. Foreign income taxes paid, accrued, or deemed paid with 
respect to such earnings shall be treated as if they were paid, 
accrued, or deemed paid during a period in which the rules governing 
the determination of post-2006 separate categories applied as well. The 
taxpayer must substantiate the post-2006 characterization of the pre-
1987 accumulated profits and pre-1987 foreign income taxes in 
accordance with the rules of paragraph (g)(3) of this section, 
including the safe harbor provisions. Similar rules shall apply to 
characterize any deficits or previously-taxed earnings and profits 
described in section 959(c)(1)(A) that are attributable to pre-1987 
accumulated profits.
    (5) Treatment of earnings and foreign taxes in pre-2007 pools of a 
lower-tier controlled foreign corporation or noncontrolled section 902 
corporation. The rules of paragraphs (g)(1) through (4) of this section 
apply to post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes 
in pre-2007 pools, and pre-1987 accumulated profits and pre-1987 
foreign income taxes, of a lower-tier controlled foreign corporation or 
noncontrolled section 902 corporation.
    (6) Effective/applicability date. This paragraph (g) shall apply to 
taxable years of United States taxpayers beginning after December 31, 
2006 and ending on or after December 21, 2007, and to taxable years of 
a foreign corporation which end with or within taxable years of its 
domestic corporate shareholder beginning after December 31, 2006 and 
ending on or after December 21, 2007.
    (7) Expiration date. The applicability of this paragraph (g) 
expires on December 20, 2010.

0
Par. 11. Section 1.904(f)-12 is amended by adding paragraph (h) to read 
as follows:


Sec.  1.904(f)-12  Transition rules.

* * * * *
    (h) [Reserved.] For further guidance, see Sec.  1.904(f)-12T(h).
0
Par. 12. Section 1.904(f)-12T is amended by adding paragraph (h) to 
read as follows:


Sec.  1.904(f)-12T  Transition rules (temporary).

* * * * *
    (h) Recapture in years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2007--(1) Losses related to pre-2007 
separate categories for passive income, certain dividends from a DISC 
or former DISC, taxable income attributable to certain foreign trade 
income or certain distributions from a FSC or former FSC--(i) Recapture 
of separate limitation loss or overall foreign loss incurred in a pre-
2007 separate category for passive income, certain dividends from a 
DISC or former DISC, taxable income attributable to certain foreign 
trade income or certain distributions from a FSC or former FSC. To the 
extent that a taxpayer has a balance in any separate limitation loss or 
overall foreign loss account in a pre-2007 separate category (as 
defined in Sec.  1.904-7T(g)(1)(ii)) for passive income, certain 
dividends from a DISC or former DISC, taxable income attributable to 
certain foreign trade income or certain distributions from a FSC or 
former FSC, at the end of the taxpayer's last taxable year beginning 
before January 1, 2007, the amount of such balance, or balances, shall 
be allocated on the first day of the taxpayer's next taxable year to 
the taxpayer's post-2006 separate category (as defined in Sec.  1.904-
7T(g)(1)(iii)) for passive category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate

[[Page 72592]]

category for passive income, certain dividends from a DISC or former 
DISC, taxable income attributable to certain foreign trade income or 
certain distributions from a FSC or former FSC. To the extent that a 
taxpayer has a balance in any separate limitation loss account in any 
pre-2007 separate category with respect to a pre-2007 separate category 
for passive income, certain dividends from a DISC or former DISC, 
taxable income attributable to certain foreign trade income or certain 
distributions from a FSC or former FSC at the end of the taxpayer's 
last taxable year beginning before January 1, 2007, such loss shall be 
recaptured in subsequent taxable years as income in the post-2006 
separate category for passive category income.
    (2) Losses related to pre-2007 separate categories for shipping, 
financial services income or general limitation income--(i) Recapture 
of separate limitation loss or overall foreign loss incurred in a pre-
2007 separate category for shipping income, financial services income 
or general limitation income. To the extent that a taxpayer has a 
balance in any separate limitation loss or overall foreign loss account 
in a pre-2007 separate category for shipping income, financial services 
income or general limitation income at the end of the taxpayer's last 
taxable year beginning before January 1, 2007, the amount of such 
balance, or balances, shall be allocated on the first day of the 
taxpayer's next taxable year to the taxpayer's post-2006 separate 
category for general category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for shipping income, financial services income 
or general limitation income. To the extent that a taxpayer has a 
balance in any separate limitation loss account in any pre-2007 
separate category with respect to a pre-2007 separate category for 
shipping income, financial services income or general limitation income 
at the end of the taxpayer's last taxable year beginning before January 
1, 2007, such loss shall be recaptured in subsequent taxable years as 
income in the post-2006 separate category for general category income.
    (3) Losses related to a pre-2007 separate category for high 
withholding tax interest--(i) Recapture of separate limitation loss or 
overall foreign loss incurred in a pre-2007 separate category for high 
withholding tax interest. To the extent that a taxpayer has a balance 
in any separate limitation loss or overall foreign loss account in a 
pre-2007 separate category for high withholding tax interest at the end 
of the taxpayer's last taxable year beginning before January 1, 2007, 
the amount of such balance shall be allocated on the first day of the 
taxpayer's next taxable year on a pro rata basis to the taxpayer's 
post-2006 separate categories for general category and passive category 
income, based on the proportion in which any unused foreign taxes in 
the same pre-2007 separate category for high withholding tax interest 
are allocated under Sec.  1.904-2T(i)(1). If the taxpayer has no unused 
foreign taxes in the pre-2007 separate category for high withholding 
tax interest, then any loss account balance in that category shall be 
allocated to the post-2006 separate category for passive category 
income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for high withholding tax interest. To the extent 
that a taxpayer has a balance in a separate limitation loss account in 
any pre-2007 separate category with respect to a pre-2007 separate 
category for high withholding tax interest at the end of the taxpayer's 
last taxable year beginning before January 1, 2007, such loss shall be 
recaptured in subsequent taxable years on a pro rata basis as income in 
the post-2006 separate categories for general category and passive 
category income, based on the proportion in which any unused foreign 
taxes in the pre-2007 separate category for high withholding tax 
interest are allocated under Sec.  1.904-2T(i)(1). If the taxpayer has 
no unused foreign taxes in the pre-2007 separate category for high 
withholding tax interest, then the loss account balance shall be 
recaptured in subsequent taxable years solely as income in the post-
2006 separate category for passive category income.
    (4) Elimination of certain separate limitation loss accounts. After 
application of paragraphs (h)(1) through (h)(3) of this section, any 
separate limitation loss account allocated to the post-2006 separate 
category for passive category income for which income is to be 
recaptured as passive category income, as determined under those same 
provisions, shall be eliminated. Similarly, after application of 
paragraphs (h)(1) through (h)(3) of this section, any separate 
limitation loss account allocated to the post-2006 separate category 
for general category income for which income is to be recaptured as 
general category income, as determined under those same provisions, 
shall be eliminated.
    (5) Alternative method. In lieu of applying the rules of paragraphs 
(h)(1) through (h)(3) of this section, a taxpayer may apply the 
principles of paragraphs (g)(1) and (g)(2) of this section to determine 
recapture in taxable years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in 
taxable years beginning before January 1, 2007.
    (6) Effective/applicability date. This paragraph (h) shall apply to 
taxable years of United States taxpayers beginning after December 31, 
2006 and ending on or after December 21, 2007.
    (7) Expiration date. The applicability of this paragraph (h) 
expires on December 20, 2010.

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
    Approved: December 14, 2007.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E7-24782 Filed 12-20-07; 8:45 am]
BILLING CODE 4830-01-P