[Federal Register Volume 85, Number 219 (Thursday, November 12, 2020)]
[Proposed Rules]
[Pages 72078-72156]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-21818]



[[Page 72077]]

Vol. 85

Thursday,

No. 219

November 12, 2020

Part III





 Department of the Treasury





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Internal Revenue Service





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26 CFR Part 1





 Guidance Related to the Foreign Tax Credit; Clarification of Foreign-
Derived Intangible Income; Proposed Rule

  Federal Register / Vol. 85 , No. 219 / Thursday, November 12, 2020 / 
Proposed Rules  

[[Page 72078]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-101657-20]
RIN 1545-BP70


Guidance Related to the Foreign Tax Credit; Clarification of 
Foreign-Derived Intangible Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations relating to the 
foreign tax credit, including guidance on the disallowance of a credit 
or deduction for foreign income taxes with respect to dividends 
eligible for a dividends-received deduction; the allocation and 
apportionment of interest expense, foreign income tax expense, and 
certain deductions of life insurance companies; the definition of a 
foreign income tax and a tax in lieu of an income tax; transition rules 
relating to the impact on loss accounts of net operating loss 
carrybacks allowed by reason of the Coronavirus Aid, Relief, and 
Economic Security Act; the definition of foreign branch category and 
financial services income; and the time at which foreign taxes accrue 
and can be claimed as a credit. This document also contains proposed 
regulations clarifying rules relating to foreign-derived intangible 
income. The proposed regulations affect taxpayers that claim credits or 
deductions for foreign income taxes, or that claim a deduction for 
foreign-derived intangible income.

DATES: Written or electronic comments and requests for a public hearing 
must be received by February 10, 2021.

ADDRESSES: Commenters are strongly encouraged to submit public comments 
electronically. Submit electronic submissions via the Federal 
eRulemaking Portal at www.regulations.gov (indicate IRS and REG-101657-
20) by following the online instructions for submitting comments. Once 
submitted to the Federal eRulemaking Portal, comments cannot be edited 
or withdrawn. The IRS expects to have limited personnel available to 
process public comments that are submitted on paper through mail. The 
Department of the Treasury (the ``Treasury Department'') and the IRS 
will publish for public availability any comment submitted 
electronically, and to the extent practicable on paper, to its public 
docket. Send paper submissions to: CC:PA:LPD:PR (REG-101657-20), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT:  Concerning the proposed regulations 
under Sec. Sec.  1.245A(d)-1, 1.336-2, 1.338-9, 1.861-3, 1.861-20, 
1.904-6, 1.960-1, and 1.960-2, Suzanne M. Walsh, (202) 317-4908; 
concerning Sec. Sec.  1.250(b)-1, 1.861-8, 1.861-9, and 1.861-14, 
Jeffrey P. Cowan, (202) 317-4924; concerning Sec.  1.250(b)-5, Brad 
McCormack, (202) 317-6911; concerning Sec. Sec.  1.164-2, 1.901-1, 
1.901-2, 1.903-1, 1.905-1, and 1.905-3, Tianlin (Laura) Shi, (202) 317-
6987; concerning Sec. Sec.  1.367(b)-3, 1.367(b)-4, and 1.367(b)-10, 
Logan Kincheloe, (202) 317-6075; concerning Sec. Sec.  1.367(b)-7, 
1.861-10, 1.904-2, 1.904-4, 1.904-5, and 1.904(f)-12, Jeffrey L. Parry, 
(202) 317-4916; concerning submissions of comments and requests for a 
public hearing, Regina Johnson, (202) 317-5177 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    On December 7, 2018, the Treasury Department and the IRS published 
proposed regulations (REG-105600-18) relating to foreign tax credits in 
the Federal Register (83 FR 63200) (the ``2018 FTC proposed 
regulations''). Those regulations addressed several significant changes 
that the Tax Cuts and Jobs Act (Pub. L. 115-97, 131 Stat. 2054, 2208 
(2017)) (the ``TCJA'') made with respect to the foreign tax credit 
rules and related rules for allocating and apportioning deductions in 
determining the foreign tax credit limitation. On December 17, 2019, 
portions of the 2018 FTC proposed regulations were finalized in TD 
9882, published in the Federal Register (84 FR 69022) (the ``2019 FTC 
final regulations''). On the same date, new proposed regulations were 
issued addressing changes made by the TCJA as well as other related 
foreign tax credit rules (the ``2019 FTC proposed regulations''). 
Correcting amendments to the 2019 FTC final regulations and the 2019 
FTC proposed regulations were published in the Federal Register on May 
15, 2020, see 85 FR 29323 (2019 FTC final regulations) and 85 FR 29368 
(2019 FTC proposed regulations). The 2019 FTC proposed regulations are 
finalized in the Rules and Regulations section of this issue of the 
Federal Register (the ``2020 FTC final regulations'').
    On July 15, 2020, the Treasury Department and the IRS finalized 
regulations under section 250 (the ``section 250 regulations'') in TD 
9901, published in the Federal Register (85 FR 43042).
    This document contains proposed regulations (the ``proposed 
regulations'') addressing: (1) The determination of foreign income 
taxes subject to the credit and deduction disallowance provision of 
section 245A(d); (2) the determination of oil and gas extraction income 
from domestic and foreign sources and of electronically supplied 
services under the section 250 regulations; (3) the impact of the 
repeal of section 902 on certain regulations issued under section 
367(b); (4) the sourcing of inclusions under sections 951, 951A, and 
1293; (5) the allocation and apportionment of interest deductions, 
including rules for allocating interest expense of foreign bank 
branches and certain regulated utility companies, an election to 
capitalize research and experimental expenditures and advertising 
expenses for purposes of calculating tax basis, and a revision to the 
controlled foreign corporation (``CFC'') netting rule; (6) the 
allocation and apportionment of section 818(f) expenses of life 
insurance companies that are members of consolidated groups; (7) the 
allocation and apportionment of foreign income taxes, including taxes 
imposed with respect to disregarded payments; (8) the definitions of a 
foreign income tax and a tax in lieu of an income tax, including the 
addition of a jurisdictional nexus requirement and changes to the net 
gain requirement, the treatment of certain tax credits, the treatment 
of foreign tax law elections for purposes of the noncompulsory payment 
rules, and the substitution requirement under section 903; (9) the 
allocation of the liability for foreign income taxes in connection with 
certain mid-year transfers or reorganizations; (10) transition rules to 
account for the effect on loss accounts of net operating loss 
carrybacks to pre-2018 taxable years that are allowed under the 
Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136, 
134 Stat. 281 (2020); (11) the foreign branch category rules in Sec.  
1.904-4(f) and the definition of a financial services entity for 
purposes of section 904; and (12) the time at which credits for foreign 
income taxes can be claimed pursuant to sections 901(a) and 905(a).

Explanation of Provisions

I. Foreign Income Taxes With Respect to Dividends for Purposes of 
Section 245A(d)

    Section 245A(d)(1) provides that no credit is allowed under section 
901 for any taxes paid or accrued (or treated as paid or accrued) with 
respect to any

[[Page 72079]]

dividend for which a deduction is allowed under that section. Section 
245A(d)(2) disallows a deduction under chapter 1 for any tax for which 
a credit is not allowable under section 901 by reason of section 
245A(d)(1). Section 245A(e)(3) also provides that no credit or 
deduction is allowed for foreign income taxes paid or accrued with 
respect to a hybrid dividend or a tiered hybrid dividend.
    Proposed Sec.  1.245A(d)-1(a) generally provides that neither a 
foreign tax credit under section 901 nor a deduction is allowed for 
foreign income taxes (as defined in Sec.  1.901-2(a)) that are 
``attributable to'' certain amounts. For this purpose, the proposed 
regulations rely on the rules in Sec.  1.861-20, contained in the 2020 
FTC final regulations and proposed to be modified in these proposed 
regulations, that allocate and apportion foreign income taxes to income 
for purposes of various operative sections, including sections 904, 
960, and 965(g). Specifically, proposed Sec.  1.245A(d)-1 provides that 
Sec.  1.861-20 (which includes portions contained in these proposed 
regulations as well as in the 2020 FTC final regulations) applies for 
purposes of determining foreign income taxes paid or accrued that are 
attributable to any dividend for which a deduction is allowed under 
section 245A(a), to a hybrid dividend or tiered hybrid dividend, or to 
previously taxed earnings and profits that arose as a result of a sale 
or exchange that by reason of section 964(e)(4) or 1248 gave rise to a 
deduction under section 245A(a) or as a result of a tiered hybrid 
dividend that by reason of section 245A(e)(2) gave rise to an inclusion 
in the gross income of a United States shareholder (collectively, such 
previously taxed earnings and profits are referred to as ``section 
245A(d) PTEP'').
    In addition, the rules apply to foreign income taxes that are 
imposed with respect to certain foreign taxable events, such as a 
deemed distribution under foreign law or an inclusion under a foreign 
law CFC inclusion regime, even though such event does not give rise to 
a distribution or inclusion for Federal income tax purposes. Proposed 
Sec.  1.245A(d)-1(a) provides that foreign income taxes that are 
attributable to ``specified earnings and profits'' are also subject to 
the disallowance under section 245A(d). Under proposed Sec.  1.245A(d)-
1(b), Sec.  1.861-20 applies to determine whether foreign income taxes 
are attributable to specified earnings and profits. Under Sec.  1.861-
20, foreign income taxes may be allocated and apportioned by reference 
to specified earnings and profits, even though the person paying or 
accruing the foreign income tax does not have a corresponding U.S. item 
in the form of a distribution of, or income inclusion with respect to, 
such earnings and profits. See, for example, Sec.  1.861-
20(d)(2)(ii)(B), (C), or (D) (foreign law distribution or foreign law 
disposition and certain foreign law transfers between taxable units), 
(d)(3)(i)(C) (income from a reverse hybrid), (d)(3)(iii) (foreign law 
inclusion regime), and proposed Sec.  1.861-20(d)(3)(v)(C)(1)(i) 
(disregarded payment treated as a remittance). Specified earnings and 
profits means earnings and profits that would give rise to a section 
245A deduction (without regard to the holding period requirement under 
section 246 or the rules under Sec.  1.245A-5 that disallow a deduction 
under section 245A(a) for certain dividends), a hybrid dividend, or a 
tiered hybrid dividend, or a distribution sourced from section 245A(d) 
PTEP if an amount of money equal to all of the foreign corporation's 
earnings and profits were distributed. Therefore, for example, a credit 
or deduction for foreign income taxes paid or accrued by a domestic 
corporation that is a United States shareholder (``U.S. shareholder'') 
with respect to a distribution that is not recognized for Federal 
income tax purposes (for example, in the case of a consent dividend 
under foreign tax law that is not regarded for Federal income tax 
purposes, or a distribution of stock that is excluded from gross income 
under section 305(a) but is treated as a taxable dividend under foreign 
tax law) is not allowed under section 245A(d) to the extent those 
foreign income taxes are attributable to specified earnings and 
profits.
    An anti-avoidance rule is included in proposed Sec.  1.245A(d)-1 to 
address situations in which taxpayers engage in transactions with a 
principal purpose of avoiding the purposes of section 245A(d), which is 
to disallow a foreign tax credit or deduction with respect to foreign 
income taxes imposed on income that is effectively exempt from tax (due 
to the availability of a deduction under section 245A(a)) or with 
respect to foreign income taxes imposed on a hybrid dividend or tiered 
hybrid dividend. Such transactions may include transactions to separate 
foreign income taxes from the income to which they relate in situations 
that are not explicitly covered under Sec.  1.861-20 (including, for 
example, loss sharing transactions under group relief regimes). Such 
transactions may also include successive distributions (under foreign 
law) out of earnings and profits that, under the rules in Sec.  1.861-
20, are treated as distributed out of previously taxed earnings and 
profits (and therefore foreign income taxes attributable to such 
amounts are not generally subject to the disallowance under section 
245A(d)), when there is no reduction of such previously taxed earnings 
and profits due to the absence of a distribution under Federal income 
tax law. See proposed Sec.  1.245A(d)-1(e)(4) (Example 3). The Treasury 
Department and the IRS are concerned that because the rules in Sec.  
1.861-20(d) addressing foreign law distributions and dispositions do 
not currently make adjustments to a foreign corporation's earnings and 
profits to reflect distributions that are not recognized for Federal 
income tax purposes, such foreign law transactions could be used to 
circumvent the purposes of section 245A(d). Comments are requested on 
potential revisions to Sec.  1.861-20(d) that could address these 
concerns, including the possibility of maintaining separate earnings 
and profits accounts, characterized with reference to the relevant 
statutory and residual groupings, for each taxable unit whereby the 
accounts would be adjusted annually to reflect transactions that 
occurred under foreign law but not under Federal income tax law.

II. Clarifications to Regulations Under Section 250

A. Definition of Domestic and Foreign Oil and Gas Extraction Income

    Section 250 provides a domestic corporation a deduction (``section 
250 deduction'') for its foreign-derived intangible income (``FDII'') 
as well as its global intangible low-taxed income (``GILTI'') inclusion 
amount and the amount treated as a dividend under section 78 that is 
attributable to its GILTI inclusion. The section 250 deduction 
attributable to FDII is calculated in part by determining the foreign-
derived portion of a corporation's deduction eligible income (``DEI''). 
DEI is defined as the excess of gross DEI over the deductions 
(including taxes) properly allocable to such gross income. See section 
250(b)(3)(A) and Sec.  1.250(b)-1(c)(2). Gross DEI is determined 
without regard to domestic oil and gas extraction income (``DOGEI''), 
which is defined as income described in section 907(c)(1) determined by 
substituting ``within the United States'' for ``without the United 
States.'' See section 250(b)(3)(B) and Sec.  1.250(b)-1(c)(7). 
Similarly, foreign oil and gas extraction income (``FOGEI'') as defined 
in section 907(c)(1) is excluded from the computation of gross tested

[[Page 72080]]

income which is used to determine a U.S. shareholder's GILTI inclusion 
amount. See Sec.  1.951A-2(c)(1)(v).
    The Treasury Department and the IRS have determined that it would 
be inappropriate for taxpayers to use inconsistent methods to determine 
the amounts of DOGEI and FOGEI from the sale of oil or gas that has 
been transported or processed. Taxpayers with both types of income may 
have an incentive to minimize their DOGEI in order to maximize their 
potential section 250 deduction attributable to FDII, while in contrast 
maximizing their FOGEI in order to minimize their gross tested income, 
even though this would also decrease the amount of the section 250 
deduction attributable to their GILTI inclusion amount. Accordingly, 
the proposed regulations provide that taxpayers must use a consistent 
method for purposes of determining both DOGEI and FOGEI. See proposed 
Sec.  1.250(b)-1(c)(7). Similarly, for purposes of allocating and 
apportioning deductions, taxpayers are already required under existing 
regulations to use the same method of allocation and the same 
principles of apportionment where more than one operative section, for 
example sections 250 and 904, apply. See Sec.  1.861-8(f)(2)(i).

B. Definition of Electronically Supplied Service

    Section 1.250(b)-5(c)(5) defines the term ``electronically supplied 
service'' to mean a general service (other than an advertising service) 
that is delivered primarily over the internet or an electronic network, 
and provides that such services include, by way of examples, cloud 
computing and digital streaming services.
    Since the publication of the section 250 regulations, the Treasury 
Department and the IRS have determined that the definition of 
electronically supplied services could be interpreted in a manner that 
includes services that were not primarily electronic and automated in 
nature but rather where the renderer applies human effort or judgment, 
such as professional services that are provided through the internet or 
an electronic network. Therefore, these proposed regulations clarify 
that the value of the service to the end user must be derived primarily 
from the service's automation or electronic delivery in order to be an 
electronically supplied service. The regulations further provide that 
services that primarily involve the application of human effort by the 
renderer to provide the service (not including the effort involved in 
developing or maintaining the technology to enable the electronic 
service) are not electronically supplied services. For example, certain 
services for which automation or electronic delivery is not a primary 
driver of value, such as legal, accounting, medical, or teaching 
services delivered electronically and synchronously, are not 
electronically supplied services.

III. Carryover of Earnings and Profits and Taxes When One Foreign 
Corporation Acquires Assets of Another Foreign Corporation in a Section 
381 Transaction

    Section 1.367(b)-7 provides rules regarding the manner and the 
extent to which earnings and profits and foreign income taxes of a 
foreign corporation carry over when one foreign corporation (``foreign 
acquiring corporation'') acquires the assets of another foreign 
corporation (``foreign target corporation'') in a transaction described 
in section 381 (the combined corporation, the ``foreign surviving 
corporation''). See Sec.  1.367(b)-7(a). Before the repeal of section 
902 in the TCJA, these rules were primarily relevant for determining 
the foreign income taxes of the foreign surviving corporation that were 
considered deemed paid by its U.S. shareholder with respect to a 
distribution or inclusion under section 902 or 960, respectively.
    Section 1.367(b)-7 applies differently with respect to ``pooling 
corporations'' and ``nonpooling corporations.'' A pooling corporation 
is a foreign corporation with respect to which certain ownership 
requirements were satisfied in pre-2018 taxable years and that, as a 
result, maintained ``pools'' of post-1986 undistributed earnings and 
related post-1986 foreign income taxes. See Sec.  1.367(b)-2(l)(9). In 
general, if the foreign surviving corporation was a pooling 
corporation, the post-1986 undistributed earnings and post-1986 foreign 
income taxes of the foreign acquiring corporation and the foreign 
target corporation were combined on a separate category-by-separate 
category basis. See Sec.  1.367(b)-7(d)(1). However, the regulations 
required the foreign surviving corporation to combine the taxes related 
to a deficit in a separate category of post-1986 undistributed earnings 
of one or both of the foreign acquiring corporation or foreign target 
corporation (a ``hovering deficit'') with other post-1986 foreign 
income taxes in that separate category only on a pro rata basis as the 
hovering deficit was absorbed by post-transaction earnings in the same 
separate category. See Sec.  1.367(b)-7(d)(2)(iii). Similarly, a 
hovering deficit in a separate category of post-1986 undistributed 
earnings could offset only earnings and profits accumulated by the 
foreign surviving corporation after the section 381 transaction. Under 
Sec.  1.367(b)-7(d)(2)(ii), the reduction or offset was generally 
deemed to occur as of the first day of the foreign surviving 
corporation's first taxable year following the year in which the post-
transaction earnings accumulated.
    A nonpooling corporation is a foreign corporation that is not a 
pooling corporation and, as a result, maintains ``annual layers'' of 
pre-1987 accumulated profits and pre-1987 foreign income taxes. See 
Sec.  1.367(b)-2(l)(10). In general, a foreign surviving corporation 
maintains the annual layers of pre-1987 accumulated profits and pre-
1987 foreign income taxes, and the taxes related to a deficit in an 
annual layer cannot be associated with post-section 381 transaction 
earnings of the foreign surviving corporation.
    As a result of the repeal of section 902 in the TCJA, post-1986 
foreign income taxes and pre-1987 foreign income taxes of foreign 
corporations are generally no longer relevant for taxable years 
beginning on or after January 1, 2018. In addition, consistent with the 
TCJA, the Treasury Department and the IRS issued regulations under 
section 960 clarifying that only current year taxes are taken into 
account in determining taxes deemed paid under section 960. See Sec.  
1.960-1(c)(2). Current year tax means certain foreign income tax paid 
or accrued by a controlled foreign corporation in a current taxable 
year. See Sec.  1.960-1(b)(4).
    In light of the changes made by the TCJA and subsequent 
implementing regulations, the proposed regulations provide rules to 
clarify the treatment of foreign income taxes of a foreign surviving 
corporation in taxable years of foreign corporations beginning on or 
after January 1, 2018, and for taxable years of U.S. shareholders in 
which or with which such taxable years of foreign corporations end 
(``post-2017 taxable years''). The proposed regulations provide that 
all foreign target corporations, foreign acquiring corporations, and 
foreign surviving corporations are treated as nonpooling corporations 
in post-2017 taxable years and that any amounts remaining in the post-
1986 undistributed earnings and post-1986 foreign income taxes of any 
such corporation as of the end of the foreign corporation's last 
taxable year beginning before January 1, 2018, are treated as earnings 
and taxes in a single pre-pooling annual layer in the foreign 
corporation's post-2017 taxable years.
    The proposed regulations also clarify that foreign income taxes 
that are

[[Page 72081]]

related to non-previously taxed earnings of a foreign acquiring 
corporation and a foreign target corporation that were accumulated in 
taxable years before the current taxable year of the foreign 
corporation, or in a foreign target corporation's taxable year that 
ends on the date of the section 381 transaction, are not treated as 
current year taxes (as defined in Sec.  1.960-1(b)(4)) of a foreign 
surviving corporation in any post-2017 taxable year. Furthermore, the 
proposed regulations clarify that foreign income taxes related to 
hovering deficits are not current year taxes in the year that the 
hovering deficit is absorbed, in part because the hovering deficit is 
not considered to offset post-1986 undistributed earnings until the 
first day of the foreign surviving corporation's first taxable year 
following the year in which the post-transaction earnings accumulated. 
In addition, because such taxes were paid or accrued by a foreign 
corporation in a prior taxable year, they are not considered paid or 
accrued by the foreign corporation in the current taxable year and 
therefore are not current year taxes under Sec.  1.960-1(b)(4). 
Finally, foreign income taxes related to a hovering deficit in pre-1987 
accumulated profits generally will not be reduced or deemed paid unless 
a foreign tax refund restores a positive balance to the associated 
earnings pursuant to section 905(c); therefore, such foreign income 
taxes are never included in current year taxes.
    In addition to the proposed changes to Sec.  1.367(b)-7, the 
proposed regulations remove some references to section 902 in other 
regulations issued under section 367(b) that are no longer relevant as 
a result of the repeal of section 902. For example, pursuant to Sec.  
1.367(b)-4(b)(2), a deemed dividend inclusion is required in certain 
cases upon the receipt of preferred stock by an exchanging shareholder, 
in order to prevent the excessive potential shifting of earnings and 
profits, notwithstanding that the exchanging shareholder's status as a 
section 1248 shareholder is preserved. One of the conditions for 
application of the rule requires a domestic corporation to meet the 
ownership threshold of section 902(a) or (b) and, thus, be eligible for 
a deemed paid credit on distributions from the transferee foreign 
corporation. Sec.  1.367(b)-4(b)(2)(i)(B). These proposed rules 
generally retain the substantive ownership threshold of this 
requirement, but without reference to section 902 and by modifying the 
ownership threshold requirement to consider not only voting power but 
value as well. Specifically, Sec.  1.367(b)-4(b)(2)(i)(B) is revised to 
require that a domestic corporation owns at least 10 percent of the 
transferee foreign corporation by vote or value.
    Comments are requested as to whether further changes to Sec.  
1.367(b)-4 or 1.367(b)-7, or any changes to other regulations issued 
under section 367, are appropriate in order to clarify their 
application after the repeal of section 902. In addition, the Treasury 
Department and the IRS are studying the interaction of Sec.  1.367(b)-
4(b)(2) with section 245A and other Code provisions and considering 
whether additional revisions to the regulation are appropriate in light 
of TCJA generally. Comments are specifically requested with respect to 
the proposed revisions to Sec.  1.367(b)-4(b)(2), including whether 
there is a continuing need to prevent excessive potential shifting of 
earnings and profits through the use of preferred stock in light of the 
TCJA generally. For example, the Treasury Department and the IRS are 
considering, and request comments on, the extent to which, in certain 
transactions described in Sec.  1.367(b)-4(b)(2), (1) an exchanging 
shareholder who would not qualify for a deduction under section 245A 
could potentially shift earnings and profits of a foreign acquired 
corporation to a transferee foreign corporation with a domestic 
corporate shareholder that would qualify for a deduction under section 
245A, or (2) a domestic corporate exchanging shareholder of a foreign 
acquired corporation with no earnings and profits could access the 
earnings and profits of a transferee foreign corporation.

IV. Source of Inclusions Under Sections 951, 951A, 1293, and Associated 
Section 78 Dividend

    Sections 861(a) and 862(a) contain rules to determine the source of 
certain items of gross income. Section 863(a) provides that the source 
of items of gross income not specified in sections 861(a) and 862(a) 
will be determined under regulations prescribed by the Secretary. As a 
result of changes to section 960 made by the TCJA, the Treasury 
Department and the IRS revised the regulations under section 960. As 
part of that revision, the Treasury Department and the IRS removed 
former Sec.  1.960-1(h)(1), which contained a source rule for the 
amount included in gross income under section 951 and the associated 
section 78 dividend. Section 1.960-1(h)(1) provided that, for purposes 
of section 904, the amount included in gross income of a domestic 
corporation under section 951 with respect to a foreign corporation, 
plus any section 78 dividend to which such section 951 inclusion gave 
rise by reason of taxes deemed paid by such domestic corporation, was 
derived from sources within the foreign country or possession of the 
United States under the laws of which such foreign corporation, or the 
first-tier corporation in the same chain of ownership as such foreign 
corporation, was created or organized.
    Although section 904(h)(1) treats as from sources within the United 
States certain amounts included in gross income under section 951(a) 
that otherwise would be treated as derived from sources without the 
United States, absent former Sec.  1.960-1(h)(1), no rule specifies the 
source of inclusions under section 951 before the application of 
section 904(h)(1). In addition, the rule in former Sec.  1.960-1(h)(1) 
only provided for the source of a domestic corporation's section 951 
inclusions for purposes of section 904. A similar lack of guidance 
exists with respect to the source of inclusions under section 951A. See 
section 951A(f)(1)(A) (requiring the application of section 904(h)(1) 
with respect to amounts included in gross income under section 951A(a) 
in the same manner as amounts included under section 951(a)(1)(A)). The 
removal of former Sec.  1.960-1(h)(1) also left uncertain the source of 
amounts included in gross income as a result of an election under 
section 1293(a), because under section 1293(f)(1), such amounts are 
treated for purposes of section 960 as amounts included in gross income 
under section 951(a).
    To clarify the source of income inclusions after the removal of 
former Sec.  1.960-1(h)(1), the proposed regulations include a new rule 
in Sec.  1.861-3(d), which provides that for purposes of the sourcing 
provisions an amount included in the gross income of a United States 
person under section 951 is treated as a dividend received by the 
United States person directly from the foreign corporation that 
generated the inclusion.
    This proposed rule differs from former Sec.  1.960-1(h)(1) in two 
respects. First, former Sec.  1.960-1(h)(1) provided that if the 
foreign corporation that generated the income included under section 
951 was held indirectly through other foreign corporations, the amount 
included was treated as if it had been paid through such intermediate 
corporations and as received from the first-tier foreign corporation. 
The Treasury Department and the IRS have determined that, in light of 
the repeal of section 902, and because a section 951 inclusion with 
respect to a lower-tier CFC is not treated as a deemed distribution 
through the first-tier CFC,

[[Page 72082]]

the source of the inclusion should be determined by reference to the 
lower-tier CFC.
    Second, former Sec.  1.960-1(h)(1) treated the entire amount of the 
inclusion under section 951 as derived from sources without the United 
States. However, the Treasury Department and the IRS have determined 
that because dividends and inclusions of the same earnings and profits 
should be sourced in the same manner, the general rule for inclusions 
under section 951 should be consistent with the rule in section 
861(a)(2)(B) and Sec.  1.861-3(a)(3) that treats dividends as derived 
from sources within the United States to the extent that the dividend 
is from a foreign corporation with significant income effectively 
connected with the conduct of a trade or business in the United States. 
This is particularly appropriate in circumstances in which effectively 
connected income is not excluded from subpart F income under section 
952(b) (which could arise as a result of a treaty obligation of the 
United States precluding the effectively connected income from being 
taxed by the United States in the hands of the CFC). In addition, the 
Treasury Department and the IRS have determined that the source of a 
taxpayer's gross income from an inclusion of CFC earnings that are 
subject to a high rate of foreign tax should be the same, regardless of 
whether the taxpayer includes the income under subpart F or elects the 
high-taxed exception of section 954(b)(4) and repatriates the earnings 
as a dividend. Therefore, the proposed regulations provide that the 
source of an inclusion under section 951 is determined under the same 
rules as those for dividends. However, the resourcing rules in section 
904(h) and Sec.  1.904-5(m) independently operate to ensure that 
dividends and inclusions under section 951(a) that are attributable to 
U.S. source income of the CFC retain that U.S. source in the hands of 
the United States shareholder.
    The proposed regulations also clarify that the source of section 78 
dividends associated with inclusions under section 951 follows the 
rules for sourcing dividends. See also Sec.  1.78-1(a).
    Finally, and consistent with sections 951A(f)(1)(A) and 1293(f)(1), 
the proposed regulations apply the same rules with respect to 
inclusions under sections 951A and 1293 and the associated section 78 
dividend.

V. Allocation and Apportionment of Expenses Under Section 861 
Regulations

A. Election To Capitalize R&E and Advertising Expenditures

    A taxpayer determines its foreign tax credit limitation under 
section 904, in part, based on the taxpayer's taxable income from 
sources without the United States. Taxable income from sources without 
the United States is determined by deducting from the items of gross 
income from sources without the United States the expenses, losses, and 
other deductions properly allocated and apportioned to that income, and 
a ratable part of any expenses, losses, or other deductions that cannot 
definitely be allocated to some item or class of gross income. See 
section 862(b). Section 864(e)(2) generally requires taxpayers to 
allocate and apportion interest expense on the basis of assets, rather 
than income. Under the asset method, a taxpayer apportions interest 
expense to the various statutory or residual groupings based on the 
average total value of assets within each grouping for the taxable year 
as determined under the asset valuation rules of Sec.  1.861-9T(g).
    The preamble to the 2019 FTC proposed regulations stated that the 
Treasury Department and the IRS continue to study the rules for 
allocating and apportioning interest deductions, and requested comments 
on a potential proposal to provide for the capitalization and 
amortization of certain expenses solely for purposes of Sec.  1.861-9 
to better reflect asset values under the tax book value method. One 
comment supported the adoption of such a rule.
    The Treasury Department and the IRS recognize that internally-
developed intangible assets (including intangible assets such as 
goodwill that are created as a result of advertising) that have no tax 
book value because the costs of generating them have been currently 
deducted may nevertheless have continuing economic value, and that debt 
financing may support the generation and maintenance of that value. 
Accordingly, proposed Sec.  1.861-9(k) provides an election for 
taxpayers to capitalize and amortize their research and experimental 
(``R&E'') and advertising expenditures incurred in a taxable year. This 
election is analogous to the election under Sec.  1.861-9(i) to 
determine asset values based on the alternative tax book value method, 
since both elections allow taxpayers to determine the tax book value of 
an asset in a manner that is different from the general rules that 
apply under Federal income tax law, but solely for purposes of 
allocating and apportioning interest expense under Sec.  1.861-9, and 
not for any other Federal income tax purpose (such as determining the 
amount of any deduction actually allowed for depreciation or 
amortization).
    Proposed Sec.  1.861-9(k)(1) and (2) generally provides that for 
purposes of allocating and apportioning interest expense under Sec.  
1.861-9, an electing taxpayer capitalizes and amortizes its R&E 
expenditures under the rules in section 174 as contained in Public Law 
115-97, title I, Sec.  13206(a), which generally requires that 
beginning in taxable years beginning in 2022, R&E expenditures must be 
capitalized and then amortized.
    Similarly, proposed Sec.  1.861-9(k)(1) and (3) generally requires 
an electing taxpayer to capitalize and amortize its advertising 
expenditures. The definition of advertising expenditures and the method 
of cost recovery contained in proposed Sec.  1.861-9(k)(3) is based on 
prior legislative proposals (which have not been enacted) proposing 
that certain advertising expenditures be capitalized. See, for example, 
H.R.1, 113th Cong. Section 3110 (2014). Comments are requested on 
whether a different definition of advertising expenditures or a 
different method of cost recovery should be adopted for purposes of the 
election in proposed Sec.  1.861-9(k).

B. Nonrecourse Debt of Certain Utility Companies

    Section 1.861-10T provides certain exceptions to the general asset-
based apportionment of interest expense requirement under section 
864(e)(2), including rules that directly allocate interest expense to 
the income generated by certain assets that are subject to ``qualified 
nonrecourse indebtedness.'' See Sec.  1.861-10T(b).
    A comment to the 2019 FTC proposed regulations asserted that 
interest expense incurred on certain debt of regulated utility 
companies should be directly allocated to income from assets of the 
utility business because the debt must be approved by a regulatory 
agency and relates directly to the underlying needs of the utility 
business. The comment suggested that the existing rules for qualified 
nonrecourse indebtedness were insufficient because utility indebtedness 
is often subject to guarantees and cross collateralizations that permit 
the lender to seek recovery beyond any identified property, and because 
the cash flows of a regulated utility company used to support utility 
indebtedness are broader than the permitted cash flows described in 
Sec.  1.861-10T(b).

[[Page 72083]]

    In response to this comment, the proposed regulations provide that 
certain interest expense of regulated utility companies is directly 
allocated to assets of the utility business. See proposed Sec.  1.861-
10(f). The type of utility companies that qualify for the rule, and the 
rules for tracing debt to assets, are modeled on similar rules provided 
in regulations under section 163(j). See Sec. Sec.  1.163(j)-1(b)(15) 
and 1.163(j)-10(d)(2). Consistent with the approach taken in Sec.  
1.163(j)-10(d)(2), the proposed regulations expand the scope of 
permitted cash flows under Sec.  1.861-10T(b) but do not modify the 
requirement that the creditor look to particular assets as security for 
payment on the loan because unsecured debt generally is supported by 
all of the assets of the borrower. See also Part XI.L.2 of the Summary 
of Comments and Explanation of Revisions to TD 9905 (85 FR 56686).

C. Revision to CFC Netting Rule Relating to CFC-to-CFC Loans

    Section 1.861-10(e)(8)(v) provides that for purposes of applying 
the CFC netting rule of Sec.  1.861-10(e), certain loans made by one 
CFC to another CFC are treated as loans made by a U.S. shareholder to 
the borrower CFC, to the extent the U.S. shareholder makes capital 
contributions directly or indirectly to the lender CFC, and are treated 
as related group indebtedness. No income derived from the U.S. 
shareholder's ownership of the lender CFC stock is treated as interest 
income derived from related group indebtedness, including subpart F 
inclusions related to the interest income earned by the lender CFC. As 
a result, no interest expense is generally allocated to income related 
to the CFC-to-CFC debt, but the debt may nevertheless increase the 
amount of allocable related group indebtedness for which a reduction in 
assets is required under Sec.  1.861-10(e)(7).
    The Treasury Department and the IRS have determined that the 
failure to account for income related to the CFC-to-CFC debt can 
distort the general allocation and apportionment of other interest 
expense under Sec.  1.861-9. Therefore, the proposed regulations revise 
Sec.  1.861-10(e)(8)(v) to provide that CFC-to-CFC debt is not treated 
as related group indebtedness for purposes of the CFC netting rule. 
Proposed Sec.  1.861-10(e)(8)(v) also provides that CFC-to-CFC debt is 
not treated as related group indebtedness for purposes of determining 
the foreign base period ratio, which is based on the average of related 
group debt-to-asset ratios in the five prior taxable years, even if the 
CFC-to-CFC debt was otherwise properly treated as related group 
indebtedness in a prior year. This is necessary to prevent distortions 
that would otherwise arise in comparing the ratio in a year in which 
CFC-to-CFC debt was treated as related group indebtedness to the ratio 
in a year in which the CFC-to-CFC debt is not treated as related group 
indebtedness.

D. Direct Allocation of Interest Expense for Foreign Bank Branches

    Under Sec. Sec.  1.861-8 through 1.861-13, the combined interest 
expense of a domestic corporation and its foreign branches is allocated 
and apportioned to income categories on the basis of the tax book value 
of their combined assets. Comments received with respect to the 2018 
and 2019 FTC proposed regulations asserted that special rules were 
needed for financial institutions for allocating and apportioning 
interest expense to foreign branch category income. The comments 
asserted that the general approach under Sec. Sec.  1.861-8 through 
1.861-13 fails to take into account the fact that foreign branches of 
financial institutions have assets and liabilities that reflect 
interest rates that differ from interest rates related to assets and 
liabilities of the home office held in the United States. As a result, 
the general approach results in over- or under-allocation of interest 
expense to the foreign branch category income.
    In response to this comment, the proposed regulations provide that 
interest expense reflected on a foreign banking branch's books and 
records is directly allocated against the foreign branch category 
income of that foreign branch, to the extent it has foreign branch 
category income. The proposed regulations also provide for a 
corresponding reduction in the value of the assets of the foreign 
branch for purposes of allocating other interest expense of the foreign 
branch owner. See proposed Sec.  1.861-10(g).
    Comments are requested as to whether additional rules are needed to 
account for disregarded interest payments between foreign branches and 
between a foreign branch and a foreign branch owner. Comments are also 
requested as to whether adjustments to the amount of foreign branch 
liabilities subject to this rule are necessary to account for differing 
asset-to-liability ratios in a foreign branch and a foreign branch 
owner.

E. Treatment of Section 818(f) Expenses for Consolidated Groups

    Section 818(f)(1) provides that a life insurance company's 
deduction for life insurance reserves and certain other deductions 
(``section 818(f) expenses'') are treated as items which cannot 
definitely be allocated to an item or class of gross income. Proposed 
Sec.  1.861-14(h) in the 2019 FTC proposed regulations provided that 
section 818(f) expenses are allocated and apportioned on a separate 
company basis instead of on a life subgroup basis. In the 2020 FTC 
final regulations, this rule was withdrawn in response to comments. As 
discussed in Part I.C of the Summary of Comments and Explanation of 
Revisions to the 2020 FTC final regulations, the Treasury Department 
and the IRS have determined that there are merits and drawbacks to both 
the separate company and the life subgroup approaches.
    These proposed regulations provide that section 818(f) expenses 
must be allocated and apportioned on a life subgroup basis, but that a 
one-time election is allowed for consolidated groups to choose instead 
to apply a separate company approach. A consolidated group's use of the 
separate entity method constitutes a binding choice to use the method 
chosen for that year for all members of the group and all taxable years 
thereafter.

F. Allocation and Apportionment of Foreign Income Taxes

1. Background
    These proposed regulations repropose certain of the 2019 FTC 
proposed regulations in order to provide more detailed and 
comprehensive guidance regarding the assignment of foreign gross 
income, and the allocation and apportionment of the associated foreign 
income tax expense, to the statutory and residual groupings in certain 
cases. Comments to the 2019 FTC proposed regulations had requested more 
detailed guidance regarding the assignment to the statutory and 
residual groupings of foreign gross income arising from transactions 
that are dispositions of stock under Federal income tax law. In 
response to these comments, the Treasury Department and IRS have 
determined that it is appropriate to propose a comprehensive set of 
rules for dispositions of both stock and partnership interests, as well 
as rules that, similar to rules in the 2020 FTC final regulations for 
distributions with respect to stock, provide detailed rules for 
transactions that are distributions with respect to a partnership 
interest under Federal income tax law. The proposed regulations also 
address comments requesting that the rules for the assignment to the 
statutory and residual groupings of foreign gross income arising from 
disregarded payments distinguish between disregarded payments that 
would be

[[Page 72084]]

deductible if regarded under Federal income tax law and disregarded 
payments that would, if the payor (or recipient) were a corporation 
under Federal income tax law, be distributions with respect to stock or 
contributions to capital. See also Part IV.B of the Summary of Comments 
and Explanation of Revisions in the 2020 FTC final regulations.
2. Dispositions of Stock
    Proposed Sec.  1.861-20(d)(3)(i)(D) contains rules assigning to 
statutory and residual groupings the foreign gross income and 
associated foreign tax that arise from a transaction that is treated 
for Federal income tax purposes as a sale or other disposition of 
stock. These rules assign the foreign gross income first to the 
statutory and residual groupings to which any U.S. dividend amount, a 
term that applies in the disposition context when there is an amount of 
gain to which section 1248(a) or 964(e) applies, is assigned, to the 
extent thereof. Foreign gross income is next assigned to the grouping 
to which the U.S. capital gain amount is assigned, to the extent 
thereof.
    Any excess of the foreign gross income recognized by reason of the 
transaction over the sum of the U.S. dividend amount and the U.S. 
capital gain amount is assigned to the statutory and residual groupings 
in the same proportions as the proportions in which the tax book value 
of the stock is (or would be if the taxpayer were a United States 
person) assigned to the groupings under the rules of Sec.  1.861-9(g) 
in the U.S. taxable year in which the disposition occurs. This rule, 
which uses the asset apportionment percentages of the tax book value of 
the stock as a surrogate for earnings of the corporation that are not 
recognized for U.S. tax purposes, associates foreign tax on a U.S. 
return of capital amount (that is, foreign tax on foreign gain in 
excess of the amount of gain recognized for U.S. tax purposes) with the 
same groupings to which the tax would be assigned under Sec.  1.861-
20(d)(3)(i)(B)(2) of the 2020 FTC final regulations if the item of 
foreign gross income arose from a distribution made by the corporation, 
rather than a sale or other disposition of the stock.
    As discussed in Part III.B of the Summary of Comments and 
Explanation of Revisions to the 2020 FTC final regulations, the 
Treasury Department and the IRS have determined that it is appropriate 
to treat foreign tax on a U.S. return of capital amount resulting from 
a distribution as a timing difference in the recognition of corporate 
earnings. The proposed regulations adopt the same rule in the case of a 
foreign tax on a U.S. return of capital amount resulting from a 
disposition of stock. The Treasury Department and the IRS have 
determined that this result is appropriate because a foreign country 
generally recognizes more gain on a disposition of stock than is 
recognized for U.S. tax purposes when the shareholder's tax basis in 
the stock is greater for U.S. tax purposes than for foreign tax 
purposes, and this disparity typically occurs when the shareholder's 
U.S. tax basis in the stock has been increased under section 961 to 
reflect subpart F or GILTI inclusions of earnings attributable to the 
stock. Comments are requested on whether other situations more commonly 
result in this disparity, such that different rules might be 
appropriate for distributions and sales in order to better match 
foreign tax on income included in the foreign tax base with income 
included in the U.S. tax base.
3. Partnership Transactions
    The proposed regulations contain new rules on the treatment of 
distributions from partnerships and sales of partnership interests, 
including partnerships that are treated as corporations for foreign law 
purposes. In general, these rules follow similar principles as the 
rules for distributions from corporations and sales of stock.
    The rule in proposed Sec.  1.861-20(d)(3)(ii)(B), like the rule for 
assigning foreign tax on a return of capital with respect to stock, 
uses the asset apportionment percentages of the tax book value of the 
partner's distributive share of the partnership's assets (or, in the 
case of a limited partner with less than a 10 percent interest, the tax 
book value of the partnership interest) as a surrogate for the 
partner's distributive share of earnings of the partnership that are 
not recognized in the year in which the distribution is made for U.S. 
tax purposes. Proposed Sec.  1.861-20(d)(3)(ii)(C) similarly associates 
foreign tax on a U.S. return of capital amount in connection with the 
sale or other disposition of a partnership interest with a hypothetical 
distributive share. The Treasury Department and the IRS have determined 
that this rule is appropriate because foreign tax on a return of 
capital distribution from a partnership most commonly occurs in the 
case of hybrid partnerships (that is, entities that are treated as 
partnerships for U.S. tax purposes but as corporations for foreign tax 
purposes). In this case, earnings that have been recognized and 
capitalized into basis by the partner for U.S. tax purposes as a 
distributive share of income in prior years are not subject to foreign 
tax until the earnings are distributed. Similarly, the higher U.S. tax 
basis in an interest in a hybrid partnership accounts for the most 
common cases where the amount of foreign gross income that results from 
a sale of a partnership interest exceeds the amount of taxable gain for 
U.S. tax purposes. Comments are requested on whether a different 
ordering rule or matching convention may better match foreign tax on 
income included in the foreign tax base with income included in the 
U.S. tax base. Comments are also requested on whether special rules are 
needed to associate foreign gross income and the associated foreign tax 
on distributions from partnerships and sales of partnership interests 
with items that are subject to special treatment for U.S. tax purposes 
(such as gain recharacterized as ordinary income under section 751).
4. Disregarded Payments
i. Background
    The proposed regulations contain a new comprehensive set of rules 
addressing the allocation and apportionment of foreign income taxes 
relating to disregarded payments. In general, the 2019 FTC proposed 
regulations assigned foreign gross income included by reason of a 
disregarded payment by a branch owner to the residual grouping and 
assigned foreign gross income included by reason of a disregarded 
payment by a branch to its owner by reference to the asset 
apportionment percentages of the tax book value of the branch assets in 
the statutory and residual groupings. Comments noted that this rule, in 
the context of section 960, could lead to the assignment of foreign 
income taxes to the residual grouping rather than a grouping to which 
an inclusion under section 951 or 951A is attributable, resulting in 
the disallowance of foreign tax credits. Comments requested that, for 
purposes of assigning foreign gross income included by reason of a 
disregarded payment to a statutory or residual grouping, the rule 
should identify disregarded payments that should be treated as made out 
of current earnings, and distinguish those payments from other types of 
disregarded payments.
ii. Reattribution Payments
    Proposed Sec.  1.861-20(d)(3)(v) contains new rules that generally 
assign foreign gross income arising from the receipt of disregarded 
payments and the associated foreign tax to the recipient's statutory 
and residual groupings based on the current or accumulated income

[[Page 72085]]

of the payor (as computed for U.S. tax purposes) out of which the 
disregarded payment is considered to be made. For this purpose, the 
regulations refer to disregarded payments made to or by a taxable unit. 
In the case of a taxpayer that is an individual or a domestic 
corporation, a taxable unit means a foreign branch, a foreign branch 
owner, or a non-branch taxable unit, as defined in proposed Sec.  
1.904-4(f)(3). In the case of a taxpayer that is a foreign corporation, 
a taxable unit means a tested unit as such term is defined in proposed 
Sec.  1.954-1(d)(2), as contained in proposed regulations (REG-127732-
19) addressing the high-tax exception under section 954(b)(4), 
published in the Federal Register (85 FR 44650) on July 23, 2020 (the 
``2020 HTE proposed regulations''). See proposed Sec.  1.861-
20(d)(3)(v)(A) and (d)(3)(v)(E)(10).
    Proposed Sec.  1.861-20(d)(3)(v)(B)(1) addresses the assignment of 
foreign gross income that arises from the portion of a disregarded 
payment that results in a reattribution of U.S. gross income from the 
payor taxable unit to the recipient taxable unit. Under proposed Sec.  
1.861-20(d)(3)(v)(B)(1), the foreign gross income is assigned to the 
statutory and residual groupings to which the amount of U.S. gross 
income that is reattributed (a ``reattribution amount'') is initially 
assigned upon receipt of the disregarded payment by a taxable unit, 
before taking into account reattribution payments made by the recipient 
taxable unit. For this purpose, under proposed Sec.  1.861-
20(d)(3)(v)(B)(2), in the case of a taxpayer that is an individual or a 
domestic corporation, the attribution rules in Sec.  1.904-4(f)(2) 
apply to determine the section 904 separate categories of reattribution 
amounts received by foreign branches, foreign branch owners, and non-
branch taxable units. In the case of a taxpayer that is a foreign 
corporation, the attribution rules in proposed Sec.  1.954-1(d)(1)(iii) 
(as contained in the 2020 HTE proposed regulations) \1\ apply to 
determine the reattribution amounts received by a tested unit in the 
tested income and subpart F income groupings of its tested units for 
purposes of the applying the high-tax exception of section 954(b)(4). 
Under proposed Sec.  1.861-20(d)(3)(v)(B)(2), the rules in the 2020 HTE 
proposed regulations for attributing U.S. gross income to tested units 
also apply to attribute items of foreign gross income to tested units 
for purposes of allocating and apportioning the associated foreign 
income taxes in computing the amount of an inclusion and deemed-paid 
taxes under sections 951, 951A, and 960.
---------------------------------------------------------------------------

    \1\ References to Sec.  1.954-1(d) in these proposed regulations 
are to proposed Sec.  1.954-1(d) as contained in the 2020 HTE 
proposed regulations.
---------------------------------------------------------------------------

    For purposes of applying all other operative sections, the U.S. 
gross income that is attributable to a taxable unit is determined under 
the principles of the foreign branch category rules (for U.S. 
taxpayers) or the high-tax exception rules (for foreign corporations). 
The foreign branch category rules of Sec.  1.904-4(f)(2) generally 
attribute U.S. gross income to taxable units on the basis of books and 
records, as modified to reflect Federal income tax principles, and 
reattribute U.S. gross income between the general category and the 
foreign branch category by reason of certain disregarded payments 
between a foreign branch and its owner, or another foreign branch, that 
would be deductible if regarded for Federal income tax purposes. The 
reattribution is made by reference to the statutory and residual 
groupings of the payor to which the disregarded payment would be 
allocated and apportioned if it were regarded for Federal income tax 
purposes.
    Proposed Sec.  1.954-1(d)(1)(iii), as contained in the 2020 HTE 
proposed regulations, generally adopts the principles of Sec.  1.904-
4(f)(2) for purposes of assigning U.S. gross income to tested units of 
a controlled foreign corporation for purposes of the high-tax 
exception. However, although Sec.  1.904-4(f)(2)(vi) does not treat 
disregarded interest payments as a disregarded reallocation 
transaction, under proposed Sec.  1.954-1(d)(1)(iii)(B) of the 2020 HTE 
proposed regulations, disregarded interest payments are treated as 
reattribution payments to the extent they are deductible for foreign 
law purposes in the country where the payor taxable unit is a tax 
resident. Proposed Sec.  1.954-1(d)(1)(iii)(B)(4) provides that these 
disregarded interest payments are treated as made ratably out of the 
payor's current year U.S. gross income to the extent thereof, and 
provides ordering rules when the same taxable unit both makes and 
receives disregarded interest payments. Comments are requested on 
additional ordering rules that should be included in the final 
regulations, including rules that apply when multiple taxable units 
both make and receive disregarded payments, such as rules for 
determining the starting point for assigning reattribution payments 
received by taxable units, and the order in which particular types of 
disregarded payments made by taxable units are allocated and 
apportioned to U.S. gross income (including income attributable to 
reattribution payments received by the payor taxable unit) of the payor 
taxable unit. In addition, because proposed Sec.  1.861-20(d)(3)(v) 
more clearly coordinates with the provisions in proposed Sec.  1.954-
1(d)(1), the proposed regulations propose to update proposed Sec.  
1.954-1(d)(1)(iv)(A) (as contained in the 2020 HTE proposed 
regulations) to clarify that the rules in Sec.  1.861-20 (rather than 
the principles of Sec.  1.904-6(b)(2)) apply in the case of disregarded 
payments. In order to achieve consistency with the new tested unit 
rules in proposed Sec.  1.954-1(d) and taxable unit rules in Sec.  
1.861-20(d)(3)(v), the proposed regulations also contain a modification 
to the high-tax kickout rules in Sec.  1.904-4(c)(4) to provide that 
the grouping rules at the CFC level are applied on a tested unit 
(instead of foreign QBU) basis.
    Proposed Sec.  1.861-20(d)(3)(v)(B)(3) provides that the statutory 
or residual grouping to which foreign gross income of a taxable unit 
(including foreign gross income that arises from the receipt of a 
disregarded payment) is assigned is determined without regard to 
reattribution payments made by the taxable unit, and that no item of 
foreign gross income is reassigned to another taxable unit by reason of 
a reattribution payment that reattributes U.S. gross income of the 
payor taxable unit to another taxable unit by reason of such 
reattribution payments. Under this rule, if foreign gross income is 
associated under Sec.  1.861-20(d)(1) with a corresponding U.S. item 
initially attributed to a payor taxable unit, that foreign gross income 
is always assigned to the grouping that includes the U.S. gross income 
of that payor taxable unit. The effect of this rule and proposed Sec.  
1.861-20(d)(3)(v)(B)(1) is to allocate and apportion foreign tax 
imposed on foreign gross income that is associated either with a 
corresponding U.S. item that is initially attributed to a payor taxable 
unit or with a reattribution amount that is attributed to a recipient 
taxable unit (before taking into account reattribution payments made by 
the recipient taxable unit) to the grouping that includes the U.S. 
gross income of the taxable unit that paid the foreign tax; no portion 
of the foreign tax is associated with U.S. gross income that is 
reattributed to another taxable unit by reason of a reattribution 
payment.
    In the case of foreign income tax imposed on the basis of foreign 
taxable income for a taxable period (that is, net basis taxes), this 
rule will generally produce appropriate results because foreign gross 
income of a taxable unit will generally be reduced by foreign law 
deductions for disregarded payments

[[Page 72086]]

made by that taxable unit, so that the amount of the payor's foreign 
taxable income will approximate the amount of U.S. taxable income 
attributed to the taxable unit after accounting for reattribution 
payments made and received by that taxable unit. Foreign gross basis 
taxes (such as withholding taxes) imposed on foreign gross income of a 
taxable unit, if not reassigned along with the associated U.S. gross 
income that is reattributed to another taxable unit as the result of a 
reattribution payment, however, may in some cases distort the effective 
foreign tax rate of the payor taxable unit. The Treasury Department and 
the IRS have determined that rules reattributing foreign gross basis 
taxes among taxable units by reason of reattribution payments would 
require complex ordering rules that would be unduly burdensome for 
taxpayers to apply and for the IRS to administer. Comments are 
requested on whether the final regulations should include different 
rules, including anti-abuse rules, to account for the assignment of 
foreign gross basis taxes paid by taxable units that make disregarded 
payments.
iii. Remittances and Contributions
    Similar to the rules in the 2019 FTC proposed regulations, proposed 
Sec.  1.861-20(d)(3)(v)(C)(1)(i) assigns foreign gross income that 
arises from a disregarded payment that is treated as a remittance for 
U.S. tax purposes by reference to the statutory and residual groupings 
to which the assets of the payor taxable unit are assigned (or would be 
assigned if the taxable unit were a United States person) under the 
rules of Sec.  1.861-9 for purposes of apportioning interest expense. 
This rule uses the payor's asset apportionment percentages as a proxy 
for the accumulated earnings of the payor taxable unit from which the 
remittance is made. Proposed Sec.  1.861-20(d)(3)(v)(C)(1)(ii) provides 
that for this purpose the assets of the taxable unit making the 
remittance are determined in accordance with the rules of Sec.  1.987-
6(b) that apply in determining the source and separate category of 
exchange gain or loss on a section 987 remittance, as modified in two 
respects.
    First, for purposes of Sec.  1.860-20(d)(3)(v)(C)(1)(i) the assets 
of the remitting taxable unit include stock owned by the taxable unit, 
even though for purposes of section 987 such stock may be treated as 
owned directly by the owner of the taxable unit. This rule helps to 
ensure that foreign tax on remittances are properly associated with 
earnings of corporations that may be distributed through the taxable 
unit.
    Second, proposed Sec.  1.861-20(d)(3)(v)(C)(1)(ii) modifies the 
determination of assets under Sec.  1.987-6(b)(2) to provide that the 
assets of a taxable unit that give rise to U.S. gross income that is 
assigned to another taxable unit by reason of a reattribution payment 
are treated as assets of the recipient taxable unit. The Treasury 
Department and the IRS have determined that reassigning the tax book 
value of assets among taxable units in proportion to the U.S. gross 
income attributed to a taxable unit, after taking into account all 
reattribution payments made and received by the taxable unit, for 
purposes of determining the statutory and residual groupings to which 
foreign tax on a remittance is assigned is appropriate to properly 
match the foreign tax with the accumulated earnings out of which the 
remittance is made. In addition, because it uses asset values that are 
already required to be computed and maintained for other Federal income 
tax purposes, this reattribution rule is less complicated to apply than 
a rule that would treat disregarded assets and liabilities as if they 
were regarded for U.S. tax purposes in applying this rule.
    However, the Treasury Department and the IRS acknowledge that any 
asset method for associating foreign gross income included by the 
remittance recipient with the payor's accumulated earnings may lead to 
inexact determinations of the groupings of the accumulated earnings out 
of which a remittance is paid, particularly when a taxable unit makes a 
remittance in conjunction with reattribution payments. The potential 
for distortions exist to the extent the tax book value of assets does 
not reflect their income-producing value, as in the case of self-
developed intangibles the costs of which are currently expensed, as 
well as to the extent the characterization of the tax book value of an 
asset based on the income generated by the asset in the current taxable 
year does not reflect the characterization of the income generated by 
the asset over time. Comments are requested on whether a different 
method of determining the statutory and residual groupings to which a 
remittance is assigned, such as the maintenance of historical accounts 
of accumulated earnings of taxable units, including adjustments to 
reflect disregarded payments among taxable units, could produce more 
accurate results without unduly increasing administrative burdens.
    Similar to the rule in the 2019 FTC proposed regulations, proposed 
Sec.  1.861-20(d)(3)(v)(C)(2) provides that foreign gross income and 
the associated foreign tax that arise from the receipt of a 
contribution are assigned to the residual category, except as provided 
under the rules for an operative section (such as under proposed Sec.  
1.904-6(b)(2)(ii), which assigns foreign tax on contributions to a 
foreign branch to the foreign branch category). Proposed Sec.  1.861-
20(d)(3)(v)(E)(2) defines a contribution as a disregarded transfer of 
property that would be treated as a transaction described in section 
118 or 351 if the recipient taxable unit were treated as a corporation 
for Federal income tax purposes, or the excess amount of a disregarded 
payment made to a taxable unit that the payor unit owns over the amount 
that is treated as a reattribution payment.
    Foreign tax paid by a foreign corporation that is allocated and 
apportioned to the residual category is not eligible to be deemed paid 
under section 960. See Sec.  1.960-1(e). However, because proposed 
Sec.  1.861-20(d)(3)(v) treats most disregarded payments as 
reattribution payments or remittances, and contributions (as 
characterized for corporate law purposes) are rarely subject to foreign 
tax, the Treasury Department and the IRS expect this rule will have 
limited application.
    Proposed Sec.  1.861-20(d)(3)(v)(C)(3) provides an ordering rule 
attributing the amount of foreign gross income that arises from the 
receipt of a disregarded payment that includes both a reattribution 
payment and a remittance or contribution first to the portion of the 
disregarded payment that is a reattribution payment. Any excess amount 
of the foreign gross income item is attributed to the portion of the 
disregarded payment that is a remittance or contribution.
    In addition, proposed Sec.  1.861-20(d)(2)(ii)(D) provides that if 
an item of foreign gross income arises from an event that for foreign 
law purposes is treated as a distribution, contribution, accrual, or 
payment between taxable units, but that is not treated as a disregarded 
payment for Federal income tax purposes (for example, a consent 
dividend from a disregarded entity), the foreign gross income and 
associated foreign tax are assigned in the same way as if a transfer of 
property in the amount of the foreign gross income item resulted in a 
disregarded payment in the year the foreign tax is paid or accrued.
    Finally, in light of the heightened importance of the rules in 
Sec.  1.904-4(f), which are being applied in connection with Sec.  
1.861-20 as well as the high-tax exception rules in Sec.  1.951A-
2(c)(7), the proposed regulations include some technical changes to the 
rules in Sec.  1.904-4(f) that will facilitate this

[[Page 72087]]

interaction. See Part XI.A of this Explanation of Provisions.
iv. Disregarded Payments With Respect to Disregarded Sales of Property
    Proposed Sec.  1.861-20(d)(3)(v)(D) clarifies that an item of 
foreign gross income attributable to gain recognized under foreign law 
by reason of a disregarded payment received in exchange for property is 
characterized and assigned under Sec.  1.861-20(d)(2)(ii)(A) of the 
2020 FTC final regulations, that is, as a timing difference in the 
taxation of the property's built-in gain. Proposed Sec.  1.861-
20(d)(3)(v)(D) further provides that if a taxpayer recognizes U.S. 
gross income as a result of a disposition of property that was 
previously received in exchange for a disregarded payment, any item of 
foreign gross income that the taxpayer recognizes as a result of that 
same disposition is assigned to a statutory or residual grouping under 
the U.S. corresponding item rules in Sec.  1.861-20(d)(1) of the 2020 
FTC final regulations. Because in this situation the seller's basis in 
the property initially acquired in a disregarded sale is not adjusted 
for U.S. tax purposes, but is assumed to reflect the purchase price for 
foreign tax purposes, the assignment of the foreign gross income 
resulting from the regarded sale of the property is made without regard 
to any reattribution of the gain that is recognized for U.S. tax 
purposes under Sec.  1.904-4(f)(2)(vi)(A) or (D), which apply to 
attribute U.S. gross income in the amount of the property's built-in 
gain at the time of the initial acquisition to the foreign branch or 
foreign branch owner that originally transferred the property in the 
disregarded sale. The same result obtains with respect to all taxable 
units under proposed Sec.  1.861-20(d)(3)(v)(B)(3).
5. Group-Relief Regimes
    The Treasury Department and the IRS are concerned about the use of 
certain foreign law group-relief regimes (that is, regimes that allow 
for the sharing of losses of one member of a group with another member) 
to create a mismatch in how foreign income taxes are characterized 
under Sec.  1.861-20 for purposes of various operative sections, 
including sections 245A(d), 904, and 960. Comments are requested on the 
appropriate treatment of foreign income taxes paid or accrued in 
connection with the sharing of losses.

VI. Creditability of Foreign Taxes Under Sections 901 and 903

A. Definition of Foreign Income Tax

1. Background and Overview
    Section 901 allows a credit for foreign income, war profits, and 
excess profits taxes, and section 903 provides that such taxes include 
a tax in lieu of a generally-imposed foreign income, war profits, or 
excess profits tax.\2\ Section 1.901-2, which was originally 
promulgated in 1983 in TD 7918 (the ``1983 final regulations''), sets 
forth conditions for determining when a foreign levy is a foreign 
income, war profits, and excess profits tax (collectively, an ``income 
tax'') that is creditable under section 901. Under the existing 
regulations, a foreign levy is an income tax if and only if (1) it is a 
tax, and (2) the predominant character of that tax is that of an income 
tax in the U.S. sense. See Sec.  1.901-2(a)(1). Under Sec.  1.901-
2(a)(3), the predominant character of a foreign tax is that of an 
income tax in the U.S. sense if it meets two requirements: (1) The 
foreign tax is likely to reach net gain in the normal circumstances in 
which it applies (the ``net gain requirement''), and (2) it is not a 
``soak-up'' tax. To satisfy the net gain requirement, a tax must meet 
the realization, gross receipts, and net income requirements in Sec.  
1.901-2(b)(2), (3), and (4), respectively. Under Sec.  1.901-2(a)(1), a 
foreign tax either is or is not a foreign income tax, in its entirety, 
for all persons subject to the foreign tax. This all-or-nothing rule 
ensures consistent outcomes for taxpayers and minimizes the 
administrative burdens on the IRS that would result if the 
creditability of a foreign tax instead varied depending on each 
taxpayer's particular facts.
---------------------------------------------------------------------------

    \2\ Taxpayers may generally claim a deduction instead of a 
credit for these foreign taxes, as well as for certain other foreign 
taxes that do not qualify for the foreign tax credit. See section 
164(a).
---------------------------------------------------------------------------

    The Treasury Department and the IRS have determined that it is 
necessary and appropriate to require that a foreign tax conform to 
traditional international norms of taxing jurisdiction as reflected in 
the Internal Revenue Code in order to qualify as an income tax in the 
U.S. sense, or as a tax in lieu of an income tax. As discussed in more 
detail in Part VI.A.2 of this Explanation of Provisions, this 
requirement will ensure that the foreign tax credit operates in 
accordance with its purpose to mitigate double taxation of income that 
is attributable to a taxpayer's activities or investment in a foreign 
country.
    In addition, the Treasury Department and the IRS have determined 
that it is necessary and appropriate to revise the net gain requirement 
in order to better align the regulatory tests with norms reflected in 
the Internal Revenue Code that define an income tax in the U.S. sense, 
as well as to simplify and clarify the application of the rules. In 
particular, the existing regulations provide that the net gain 
requirement is met if a foreign tax reaches net gain in the ``normal 
circumstances'' in which it applies. However, this rule leads to 
inappropriate results and presupposes an empirical analysis requiring 
access to information that is difficult for taxpayers and the IRS to 
obtain. Therefore, the proposed regulations narrow the situations in 
which an empirical analysis is relevant in analyzing the nature of a 
foreign tax. See Part VI.A.3 of this Explanation of Provisions.
    The proposed regulations make other changes to improve or clarify 
the rules, and to address issues that have arisen since the 1983 final 
regulations were issued. In particular, the proposed regulations 
introduce the term ``net income tax'' to describe foreign levies 
described in section 901 and the term ``foreign income tax'' to 
describe foreign levies described in section 901 or 903. See also Part 
X.F of this Explanation of Provisions (describing conforming changes 
made to Sec. Sec.  1.960-1 and 1.960-2). Conforming changes to the 
terms and definitions cross-referenced in other regulations will be 
made when the proposed regulations are finalized.
    The proposed regulations specifically address the treatment of 
surtaxes and the circumstances in which a source-based withholding tax 
on cross-border income can qualify as a foreign income tax. The 
proposed regulations also reorganize the existing regulations to 
address soak-up taxes as part of the determination of the amount of tax 
paid, rather than as part of the definition of a foreign income tax, 
and clarify the rules for determining when a foreign tax is a separate 
levy. The proposed regulations addressing the amount of tax paid also 
modify the treatment of refundable credits, clarify the interaction 
between the rules addressing refundable amounts and multiple levies, 
and clarify the application of the noncompulsory payment rules with 
respect to foreign tax law elections. Finally, the proposed regulations 
revise the definition of a tax in lieu of an income tax. These rules 
are described in more detail in Parts VI.A.3.v, VI.A.4, VI.A.5, VI.B, 
and VI.C of this Explanation of Provisions.
    The proposed regulations do not include proposed amendments to the 
rules in Sec.  1.901-2A addressing dual

[[Page 72088]]

capacity taxpayers. However, certain proposed changes to Sec. Sec.  
1.901-2 and 1.903-1 may impact Sec.  1.901-2A. For example, when the 
proposed regulations are finalized, certain terms that are defined in 
Sec.  1.901-2 and cross-referenced in Sec.  1.901-2A will need to be 
updated. Comments are requested on whether additional changes to Sec.  
1.901-2A are appropriate in light of the proposed revisions to 
Sec. Sec.  1.901-2 and 1.903-1.
2. Jurisdictional Nexus Requirement
    As a dollar-for-dollar credit against U.S. income tax, the foreign 
tax credit is intended to mitigate double taxation of foreign source 
income. This fundamental purpose is served most appropriately if there 
is substantial conformity in the principles used to calculate the base 
of the foreign tax and the base of the U.S. income tax. This conformity 
extends not just to ascertaining whether the foreign tax base 
approximates U.S. taxable income determined on the basis of realized 
gross receipts reduced by allocable expenses, but also to whether there 
is a sufficient nexus between the income that is subject to tax and the 
foreign jurisdiction imposing the tax. Although prior regulations under 
section 901 did contain jurisdictional limitations on the definition of 
an income tax, see Sec.  4.901-2(a)(1)(iii) (1980) (requiring that a 
foreign tax follow ``reasonable rules regarding source of income, 
residence, or other bases for taxing jurisdiction''), the existing 
regulations do not contain such a rule.
    In recent years, several foreign countries have adopted or are 
considering adopting a variety of novel extraterritorial taxes that 
diverge in significant respects from traditional norms of international 
taxing jurisdiction as reflected in the Internal Revenue Code. In 
addition, the Treasury Department and the IRS have received requests 
for guidance on whether the definition of foreign income tax includes a 
jurisdictional limitation, and recommending that the regulations adopt 
a rule requiring that income subject to foreign tax bear an appropriate 
connection to a foreign country for a foreign tax to be eligible for 
the foreign tax credit. In light of these developments, the Treasury 
Department and the IRS have determined that it is appropriate to 
revisit the regulatory definition of a foreign income tax to ensure 
that to be creditable, foreign taxes in fact have a predominant 
character of ``an income tax in the U.S. sense.''
    The Treasury Department and the IRS have determined that in order 
to qualify as a creditable income tax, the foreign tax law must require 
a sufficient nexus between the foreign country and the taxpayer's 
activities or investment of capital or other assets that give rise to 
the income being taxed. For example, a tax imposed by a foreign country 
on a taxpayer's income that lacks a sufficient nexus to such country 
(such as the lack of operations, employees, factors of production, or 
management in that foreign country) is not an income tax in the U.S. 
sense and should not be eligible for a foreign tax credit if paid or 
accrued by U.S. taxpayers. Such a nexus is required in order for 
persons and income to be subject to U.S. income tax, and so a similar 
nexus reflecting the foreign country's exercise of taxing jurisdiction 
consistent with Federal income tax principles should be required in 
order for foreign taxes to be eligible for a dollar-for-dollar credit 
against U.S. income tax.
    The proposed regulations therefore require that for a foreign tax 
to qualify as an income tax, the tax must conform with established 
international norms, reflected in the Internal Revenue Code and related 
guidance, for allocating profit between associated enterprises, for 
allocating business profits of nonresidents to a taxable presence in 
the foreign country, and for taxing cross-border income based on source 
or the situs of property (together, the ``jurisdictional nexus 
requirement''). Proposed Sec.  1.901-2(c)(1)(i) generally provides that 
in the case of a foreign country imposing tax on nonresidents, the 
foreign tax law must determine the amount of income subject to tax 
based on the nonresident's activities located in the foreign country 
(including its functions, assets, and risks located in the foreign 
country). Thus, for example, rules that are consistent with the rules 
under section 864(c) for taxing income effectively connected with a 
U.S. trade or business, or with Articles 5 and 7 of the U.S. Model 
Income Tax Convention for taxing profits attributable to a permanent 
establishment, will meet this requirement. However, foreign countries 
that, for example, impose tax by using as a significant factor the 
location of customers, users, or any other similar destination-based 
criterion to allocate profit (for example, by deeming a taxable 
presence based on the existence of customers) will not satisfy the 
jurisdictional nexus requirement.
    If the foreign tax law imposes tax on a nonresident's income based 
on the income arising from sources in the foreign country (for example, 
tax imposed on interest, rents, or royalties sourced in the foreign 
country and paid to a nonresident), proposed Sec.  1.901-2(c)(1)(ii) 
requires the sourcing rules of the foreign tax law to be reasonably 
similar to the sourcing rules that apply for Federal income tax 
purposes. For the avoidance of doubt, the proposed regulations provide 
that in the case of income from services, the income must be sourced 
based on the place of performance of the services, not the location of 
the services recipient.
    The jurisdictional nexus requirement for taxing gains from sales or 
other dispositions of property is separately addressed in proposed 
Sec.  1.901-2(c)(1)(iii), which provides that income from sales or 
other dispositions of property by nonresidents that do not meet the 
activities requirement in proposed Sec.  1.901-2(c)(1)(i) satisfy the 
jurisdictional nexus requirement only with respect to gains on the 
disposition of real property in the foreign country or movable property 
forming part of the business property of a taxable presence in the 
foreign country (or from interests in certain entities holding such 
property). This rule is consistent with the fact that Federal income 
tax law generally does not tax gains of nonresidents that do not have a 
trade or business in the United States. See, for example, section 
865(a)(2) and (e)(2); Sec.  1.871-7(a)(1); see also U.S. Model Income 
Tax Convention (2016), Art. 13.
    A similar rule applies under proposed Sec.  1.901-2(c)(2) with 
respect to determining the income of a resident taxpayer in cases where 
income of a related entity may be allocated under transfer pricing 
rules to the resident taxpayer. For the jurisdictional nexus 
requirement to be satisfied in such a case, the foreign tax law's 
transfer pricing rules must be determined under arm's length 
principles. Thus, for example, foreign tax laws that contain transfer 
pricing rules that are consistent with the arm's length standard under 
the section 482 regulations, or with the arm's length principle under 
the OECD Transfer Pricing Guidelines for Multinational Enterprises and 
Tax Administrations, will satisfy this requirement. However, foreign 
transfer pricing rules that allocate profits by taking into account as 
a significant factor the location of customers, users, or any other 
similar destination-based criterion will not satisfy the jurisdictional 
nexus requirement. Comments are requested on whether special rules are 
needed to address foreign transfer pricing rules that allocate profits 
to a resident on a formulary basis (rather than on the basis of arm's 
length prices), such as through the use of fixed margins in a manner 
that is not consistent with arm's length principles. The jurisdictional 
nexus

[[Page 72089]]

requirement is not violated when a foreign country imposes tax on the 
worldwide income of a resident taxpayer, including under controlled 
foreign corporation regimes that deem income to be included (or 
distributed) to a resident shareholder (as opposed to allocated 
directly to the resident under a transfer pricing adjustment). For this 
purpose, the terms resident and nonresident are defined in proposed 
Sec.  1.901-2(g)(6) and in the case of an entity, the classification is 
generally based on the entity's place of incorporation or management.
    As part of its response to the extraterritorial tax measures 
referred to in this Part VI.A.2 of the Explanation of Provisions, the 
Treasury Department has been actively engaged in negotiations with 
other countries, as part of the OECD/G20 Inclusive Framework on BEPS, 
to explore the possibility of a new international framework for 
allocating taxing rights.\3\ If an agreement is reached that includes 
the United States, the Treasury Department recognizes that changes to 
the foreign tax credit system may be required at that time.
---------------------------------------------------------------------------

    \3\ See Statement by the OECD/G20 Inclusive Framework on BEPS on 
the Two-Pillar Approach to Address the Tax Challenges Arising from 
the Digitalisation of the Economy (January 2020), available at 
https://www.oecd.org/tax/beps/statement-by-the-oecd-g20-inclusive-framework-on-beps-january-2020.pdf.
---------------------------------------------------------------------------

    No inference is intended as to the application of existing 
Sec. Sec.  1.901-2 and 1.903-1 to the treatment of novel 
extraterritorial foreign taxes such as digital services taxes, diverted 
profits taxes, or equalization levies. In addition, the proposed 
regulations, when finalized, would not affect the application of 
existing income tax treaties to which the United States is a party with 
respect to covered taxes (including any specifically identified taxes) 
that are creditable under the treaty. Comments are requested on the 
extent to which the new jurisdictional nexus requirement may impact the 
treatment of other types of foreign taxes, and on alternative 
approaches the Treasury Department and the IRS may consider to modify 
the rules to achieve the policy objectives described in this Part 
VI.A.2 of the Explanation of Provisions.
3. Net Gain Requirement
i. Use of Empirical Analysis
    The existing regulations provide that the net gain requirement is 
met if a foreign tax reaches net gain in the ``normal circumstances'' 
in which it applies. See Sec.  1.901-2(a)(1). As noted in the preamble 
to the 1983 final regulations, this rule is based on the standard set 
forth in Inland Steel Company v. United States, 677 F.2d 72 (Ct. Cl. 
1982), Bank of America Nat'l Trust and Savings Ass'n v. United States, 
459 F.2d 513 (Ct. Cl. 1972) (``Bank of America I''), and Bank of 
America Nat'l Trust and Savings Ass'n v. Comm'r, 61 T.C. 752 (1974), 
aff'd, 538 F.2d 334 (9th Cir.1976) (``Bank of America II''). See TD 
7918, 48 FR 46272-01 (1983).
    The Treasury Department and the IRS have determined that, in some 
respects, the empirical analysis contemplated by the existing 
regulations is unnecessary to identify the essential elements of an 
income tax in the U.S. sense. In addition, in the absence of specific 
rules and thresholds in the regulations on how to evaluate empirical 
data (if even available), both taxpayers and the IRS have had 
difficulties in applying the existing regulations to foreign taxes in a 
consistent and predictable manner. In some cases, the reliance on 
empirical data to determine whether the requirements of the existing 
regulations are met creates uncertainty and undue burdens for taxpayers 
and the IRS, considering challenges in obtaining the necessary 
information. Therefore, the proposed regulations limit the relevance of 
the ``normal circumstances'' in which the tax applies, as well as the 
role of the predominant character analysis, in determining whether a 
tax meets the various components of the net gain requirement. These 
changes will lead to more accurate and consistent outcomes and reduce 
the compliance and administrative burdens of the existing law 
requirement that taxpayers and the IRS obtain from the foreign 
government empirical information, such as tax return information for 
persons subject to the tax, to determine the normal circumstances in 
which the tax applies.
    Instead, proposed Sec.  1.901-2(b)(1) generally provides that 
whether a tax is a foreign income tax is determined under the terms of 
the foreign tax law, taking into account statutes, regulations, case 
law, and administrative rulings or other official pronouncements, as 
modified by treaties. Accordingly, whether a tax satisfies the net gain 
requirement is generally based on whether the terms of the foreign tax 
law governing the computation of the tax base meet the realization, 
gross receipts, and cost recovery requirements that make up the net 
gain requirement under Sec.  1.901-2(a)(3). This approach will better 
allow taxpayers and the IRS to evaluate the nature of the foreign tax 
based on objective and readily available information (that is, based on 
the terms of the foreign tax law, rather than how it is applied in 
practice), to achieve more consistent and predictable outcomes. 
Evaluation of the normal circumstances in which the tax applies is 
still a factor in determining whether specific elements of the net gain 
requirement are satisfied, but the proposed regulations specifically 
identify the elements of the requirement for which this type of 
empirical evidence is relevant.
ii. Realization Requirement
    Under the existing regulations, a foreign tax generally satisfies 
the realization requirement if, judged on the basis of its predominant 
character, it is imposed upon or after the occurrence of events 
(``realization events'') that would result in the realization of income 
under the Code, or in certain cases, it is imposed on the occurrence of 
a pre-realization event, such as in the case of a foreign law mark-to-
market regime. See Sec.  1.901-2(b)(2)(i).
    As discussed in Part VI.A.3.i of this Explanation of Provisions, 
due to the burdens resulting from the requirement to perform an 
empirical analysis to ascertain the nature of a tax, the proposed 
regulations provide more specific rules regarding the elements of the 
requirement for which this type of empirical evidence is relevant. In 
particular, the Treasury Department and the IRS have determined that 
the inclusion in the foreign tax base of insignificant amounts of gross 
receipts that do not meet the realization requirement should not 
prevent an otherwise-qualifying foreign tax from qualifying as an 
income tax. Accordingly, proposed Sec.  1.901-2(b)(2) provides that if 
a foreign tax generally meets the various realization requirements 
described in proposed Sec.  1.901-2(b)(2)(i)(A) through (C), except 
with respect to one or more specific and defined classes of 
nonrealization events, the tax may still be treated as meeting the 
realization requirement if the incidence and amounts of gross receipts 
attributable to the nonrealization events are minimal relative to the 
incidence and amounts of gross receipts attributable to events covered 
by the foreign tax that do meet the realization requirement. This 
determination is made based on the application of the foreign tax to 
all taxpayers subject to the foreign tax (rather than on a taxpayer-by-
taxpayer basis). Therefore, for example, if a foreign tax contains all 
of the same realization requirements as the Code, but also imposes tax 
on imputed rent with respect to owner-occupied housing, the foreign tax 
may still qualify as a foreign income tax if, relative to all of the 
income of all taxpayers that are subject to the tax, imputed rental

[[Page 72090]]

income comprises a relatively small amount (even if for some taxpayers, 
all of their income may constitute imputed rent). Comments are 
requested on whether the regulations could substitute a more objective 
standard for identifying acceptable deviations from the realization 
requirement that would avoid the need for empirical analysis.
    Proposed Sec.  1.901-2(b)(2)(i)(C) consolidates the rules relating 
to pre-realization timing differences, including the rule currently in 
Sec.  1.901-2(b)(2)(ii) that foreign taxes imposed on a shareholder on 
deemed distributions or inclusions (such as inclusions similar to those 
imposed by U.S. law under subpart F) of income realized by the 
distributing entity satisfy the realization requirement, so long as a 
second tax is not imposed on the shareholder on the same income upon 
the occurrence of a later event (such as an actual distribution). Under 
proposed Sec.  1.901-2(b)(2)(i)(C), because a shareholder-level tax on 
a distribution from a corporation is imposed on a different taxpayer, 
the shareholder-level tax is not treated as a second tax on the 
corporation's income (including income arising from a pre-realization 
event). For this purpose, proposed Sec.  1.901-2(b)(2)(i)(C) provides 
that a disregarded entity is treated as a taxpayer separate from its 
owner. Comments are requested on whether there are additional 
categories of pre-realization timing differences that should be 
included in the final regulations.
    Finally, the Treasury Department and the IRS expect to update the 
examples illustrating the realization requirement that are contained in 
Sec.  1.901-2(b)(2)(iv) and include them in the regulations when 
proposed Sec.  1.901-2(b)(2) is finalized.
iii. Gross Receipts Requirement
    Under existing Sec.  1.901-2(b)(3), a foreign tax satisfies the 
gross receipts requirement if, judged on the basis of its predominant 
character, it is imposed on the basis of (1) gross receipts; or (2) 
gross receipts computed under a method that is likely to produce an 
amount that is not greater than the fair market value of actual arm's 
length gross receipts (``the alternative gross receipts test''). See 
Sec.  1.901-2(b)(3)(ii) Examples 1 and 2.
    The proposed regulations modify the alternative gross receipts test 
to provide that it is satisfied in the case of tax imposed on deemed 
gross receipts arising from pre-realization timing difference events 
described in proposed Sec.  1.901-2(b)(2)(i)(C) (that is, a mark-to-
market regime, tax on the physical transfer, processing, or export of 
readily marketable property, or a deemed distribution or inclusion), or 
on the basis of gross receipts from a non-realization event that is 
insignificant and therefore does not cause the foreign tax to fail the 
realization requirement in proposed Sec.  1.901-2(b)(2). Therefore, 
taxes on insignificant non-realization events or pre-realization timing 
difference events that satisfy the realization requirement in proposed 
Sec.  1.901-2(b)(2)(i)(C) also satisfy the gross receipts test.
    However, the proposed regulations remove the provision referring to 
gross receipts computed under a method that is ``likely'' to produce an 
amount not greater than gross receipts. This rule purports to allow for 
foreign taxes to be imposed on an amount greater than the amount of 
income actually realized, or the value of the property being taxed, and 
the Treasury Department and the IRS have determined that such a tax 
should not be considered to be a tax on income, since it can be imposed 
on amounts in excess of actual gross receipts. In addition, the 
Treasury Department and the IRS have determined that the test is vague, 
unduly burdensome, and has given rise to controversies requiring 
taxpayers and the IRS to conduct an empirical evaluation to determine 
whether a nonconforming statutory method of determining alternative 
gross receipts is likely not to exceed the fair market value of actual 
gross receipts. See, for example, Phillips Petroleum v. Comm'r, 104 
T.C. 256 (1995) (applying the former Sec.  1.901-2T (1980) TD 7739). 
The Treasury Department and the IRS have determined that, other than in 
the case of insignificant non-realization events, only a tax base 
determined with reference to realized gross receipts or, in the case of 
a pre-realization timing difference event, the value or amount of a 
deemed inclusion or accrual (and not an approximation of gross 
receipts), should qualify as an income tax in the U.S. sense. In 
contrast, a tax based on alternative measurements of gross receipts, 
such as a foreign tax that requires gross receipts to be calculated by 
applying a markup to costs, fundamentally diverges from the measurement 
of realized gross receipts under the Internal Revenue Code, and could 
result in a taxable base that exceeds the amount of income properly 
attributable to the taxpayer's activities or investment in the foreign 
country. The revised rule will also minimize the need for empirical 
analyses, making it simpler for both taxpayers and the IRS to determine 
whether a tax satisfies the net gain requirement.
    This rule is not intended to implicate the allocation of gross 
income under transfer pricing or branch profit attribution rules, which 
are instead addressed under proposed Sec.  1.901-2(c). Proposed Sec.  
1.901-2(b)(3)(i) provides that in determining a taxpayer's actual gross 
receipts, amounts that are properly allocated to such taxpayer under 
the jurisdictional nexus rules in proposed Sec.  1.901-2(c), such as 
pursuant to transfer pricing rules that properly allocate income to a 
taxpayer on the basis of costs incurred by that entity, are treated as 
the taxpayer's actual gross receipts.
iv. Cost Recovery Requirement
    Under the net income requirement in the existing regulations, 
foreign tax law must permit the recovery of the significant costs and 
expenses attributable, under reasonable principles, to gross receipts 
included in the taxable base. A foreign tax law permits the recovery of 
significant costs and expenses even if such costs and expenses are 
recovered at a different time than they would be under the Code, unless 
the time of recovery is such that under the circumstances there is 
effectively a denial of recovery. Under the ``nonconfiscatory gross 
basis tax'' rule in Sec.  1.901-2(b)(4) of the existing regulations, 
which reflects the standard described in Bank of America I, a foreign 
tax whose base is gross receipts or gross income does not satisfy the 
net income requirement except in the ``rare situation'' when the tax is 
almost certain to reach some net gain in the normal circumstances in 
which it applies because costs and expenses will almost never be so 
high as to offset gross receipts or gross income, respectively, and the 
rate of the tax is such that after the tax is paid persons subject to 
the tax are almost certain to have net gain. Thus, a tax on the gross 
receipts or gross income of businesses can satisfy the net income 
requirement in the existing regulations if businesses subject to the 
tax are almost certain never to incur a loss (after payment of the 
tax).
    The Treasury Department and the IRS have determined that to 
constitute an income tax for U.S. tax purposes, that is, a tax on net 
gain, the base of a foreign tax should conform in essential respects to 
the determination of taxable income for Federal income tax purposes. 
See, for example, Keasbey & Mattison Co. v. Rothensies, 133 F.2d 894, 
895 (3d Cir. 1943) (holding that the criteria prescribed by U.S. 
revenue laws are determinative of the meaning of the term ``income 
taxes'' in applying the former version of section 901); and Comm'r v. 
American Metal Co., 221

[[Page 72091]]

F.2d 134, 137 (2d Cir. 1955) (providing that ``the determinative 
question is `whether the foreign tax is the substantial equivalent of 
an `income tax' as that term is understood in the United States' ''). 
The Treasury Department and the IRS have determined that any foreign 
tax imposed on a gross basis is by definition not an income tax in the 
U.S. sense, regardless of the rate at which it is imposed or the extent 
of the associated costs.
    In addition, the Treasury Department and the IRS have determined 
that the empirical standards contained in Bank of America I and that 
are contemplated by the nonconfiscatory gross basis tax rule in the 
existing regulations create substantial compliance and administrative 
burdens for taxpayers and the IRS when evaluating whether a foreign tax 
is an income tax in the U.S. sense. For example, the IRS and taxpayers 
must obtain foreign tax return information with respect to all persons 
subject to the tax to determine if persons subject to the tax are 
almost certain never to incur an after-tax loss. See, for example, PPL 
Corp. v. Comm'r, 135 T.C. 304 (2010), rev'd, 665 F.3d 60 (3d Cir. 
2011), rev'd, 569 U.S. 329 (2013); Texasgulf, Inc. v. Comm'r, 107 T.C. 
51 (1996), aff'd, 172 F.3d 209 (2d Cir. 1999); and Exxon Corp. v. 
Comm'r, 113 T.C. 338 (1999) (applying the empirical analysis required 
by the regulations).
    Therefore, the proposed regulations remove the nonconfiscatory 
gross basis tax rule. Instead, the proposed regulations provide that 
whether a tax meets the net gain requirement is made solely on the 
basis of the terms of the foreign tax law that define the foreign 
taxable base, without any consideration of the rate of tax imposed on 
that base. See proposed Sec.  1.901-2(b)(1). In addition, the cost 
recovery requirement in proposed Sec.  1.901-2(b)(4) requires the 
deductions allowed under the foreign tax law to approximate the cost 
recovery provisions of the Internal Revenue Code in order for the 
foreign tax to qualify as an income tax in the U.S. sense. Under 
proposed Sec.  1.901-2(b)(4)(i)(A), a tax that is imposed on gross 
receipts or gross income, without reduction for any costs or expenses 
attributable to earning that income, cannot qualify as a net income 
tax, without regard to whether the empirical impact of the tax is 
confiscatory, and even if in practice there are no or few costs and 
expenses attributable to all or particular types of gross receipts 
included in the foreign tax base. Under this rule, the cost recovery 
requirement is not satisfied for taxes such as payroll taxes on gross 
income from wages, but may be satisfied in the case of a personal 
income tax similar to that imposed under section 1 of the Code on all 
gross income (including wages), if the foreign country allows taxpayers 
to reduce such gross income by the substantial costs and expenses that 
are reasonably attributable to such gross income (taking into account 
any reasonable deduction disallowance provisions).
    Under the ``alternative allowance rule'' in Sec.  1.901-2(b)(4) of 
the existing regulations, a foreign tax that does not permit recovery 
of one or more significant costs or expenses, but that provides 
allowances that effectively compensate for nonrecovery of such 
significant costs or expenses, is considered to permit recovery of such 
costs or expenses. The Treasury Department and IRS have determined, 
however, that the alternative allowance rule fundamentally diverges 
from the approach to cost recovery in the Internal Revenue Code, and so 
is inconsistent with an essential element of an income tax in the U.S. 
sense. Moreover, it is unduly burdensome, and may be impossible as a 
practical matter, for taxpayers and the IRS to determine whether an 
alternative allowance under foreign tax law effectively compensates for 
the nonrecovery of significant costs or expenses attributable to 
realized gross receipts under that foreign law. The alternative 
allowance rule in the existing regulations has given rise to 
controversies between taxpayers and the IRS, and different 
interpretations by the courts, over whether the rule requires taxpayers 
to demonstrate that the alternative allowance exceeds disallowed 
expense deductions for a majority of persons potentially subject to the 
tax, a majority of persons that actually pay the tax, or for taxpayers 
in the aggregate, determined by comparing the aggregate amounts of 
disallowed deductions and alternative allowances reported on the 
foreign tax returns of all persons subject to the tax. See, for 
example, Texasgulf, Inc. v. Comm'r, 107 T.C. 51 (1996), aff'd, 172 F3d 
209 (2d Cir. 1999); and Exxon Corp. v. Comm'r, 113 T.C. 338 (1999). 
Therefore, the proposed regulations at Sec.  1.901-2(b)(4)(i)(A) modify 
the alternative allowance rule to treat alternative allowances as 
meeting the cost recovery requirement only if the foreign tax law 
expressly guarantees that the alternative allowance will equal or 
exceed actual costs (for example, under a provision identical to 
percentage depletion allowed under section 613).
    The proposed regulations at Sec.  1.901-2(b)(4)(i)(B)(1) retain the 
existing rule that foreign tax law is considered to permit the recovery 
of significant costs and expenses even if the costs and expenses are 
recovered at a different time than they would be if the Internal 
Revenue Code applied, unless the time of recovery is so much later (for 
example, after the property becomes worthless or is disposed of) as 
effectively to constitute a denial of such recovery. The regulations 
clarify that the different time can be either earlier or later than it 
would be if the Code applied, and that time value of money 
considerations relating to the economic cost (or value) of accelerating 
(or deferring) a foreign tax liability are not relevant in determining 
the amount of recovered costs and expenses.
    The proposed regulations also add a new rule to allow a tax to 
satisfy the cost recovery requirement even if recovery of all or a 
portion of certain costs or expenses is disallowed, if such 
disallowance is consistent with the types of disallowances required 
under the Internal Revenue Code. See proposed Sec.  1.901-
2(b)(4)(i)(B)(2). For example, foreign tax law is considered to permit 
the recovery of significant costs and expenses even if such law 
disallows interest deductions equal to a certain percentage of adjusted 
taxable income similar to the limitation under section 163(j) or 
disallows interest and royalty deductions in connection with hybrid 
transactions similar to those subject to section 267A. This new 
provision is consistent with the rule that principles of U.S. law apply 
to determine whether a tax is a creditable income tax. See Sec.  1.901-
2(a)(1)(ii); see also, for example, Keasbey, 133 F.2d at 897; and 
American Metal, 221 F.2d at 137.
    Finally, proposed Sec.  1.901-2(b)(4)(i)(B)(2) provides that an 
empirical analysis of a foreign tax is still pertinent, in part, in 
determining whether a cost or expense is significant for purposes of 
the cost recovery requirement. In particular, the significance of a 
cost or expense is determined based on whether, for all taxpayers to 
which the foreign tax applies, the item of cost or expense constitutes 
a significant portion of the total costs or expenses. However, proposed 
Sec.  1.901-2(b)(4)(i)(B)(2) adds certainty by providing that costs or 
expenses related to capital expenditures, interest, rents, royalties, 
services, and research and experimentation are always treated as 
significant costs or expenses. The Treasury Department and the IRS have 
determined that these types of costs represent a substantial portion of 
expenses typically deducted in computing taxable income for U.S. tax 
purposes. Requiring a foreign tax law to allow recovery of these costs 
will

[[Page 72092]]

increase assurances that the income subject to U.S. and foreign tax is 
actually subject to double taxation. Because interest expense in 
particular is a significant cost that under section 864(e)(2) is 
allocable to all of a taxpayer's worldwide income-producing activities 
regardless of where it is incurred, a foreign levy that allows, for 
example, no deduction for interest expense is not an income tax in the 
U.S. sense, even if U.S. taxpayers record minimal interest expense in 
foreign countries that restrict its deductibility.
v. Qualifying Surtax
    The Treasury Department and the IRS have received questions on the 
appropriate treatment of certain foreign taxes that are computed as a 
percentage of the tax due under a separate levy that is itself an 
income tax. To address the treatment of these taxes, proposed Sec.  
1.901-2(b)(5) adds a rule providing that a foreign tax satisfies the 
net gain requirement if the base of the foreign tax is the amount of a 
foreign income tax.
4. Soak-Up Taxes
    The proposed regulations move the soak-up tax rule from the rules 
that define a creditable levy to the rules for determining the amount 
of creditable tax that is considered paid. See proposed Sec.  1.901-
2(e)(6). Because the rules at existing Sec. Sec.  1.901-2(a)(3)(ii) and 
1.903-1(b)(2) treat an otherwise creditable levy as a soak-up tax only 
to the extent it would not be imposed but for the availability of a 
credit, this change is more consistent with the general structure of 
the regulations that determine whether a separate levy as a whole 
qualifies as a creditable tax, and then identifies the amount of a 
particular taxpayer's foreign tax liability that is paid or accrued and 
can be claimed as a foreign tax credit.
    In addition, the proposed regulations omit the special rule in 
Sec.  1.903-1(b)(2) that limits the portion of a tax in lieu of an 
income tax that is a soak-up tax to the amount by which the foreign tax 
exceeds the income tax that would have been paid if the taxpayer had 
instead been subject to the generally-imposed income tax. The Treasury 
Department and the IRS have determined that this rule is inconsistent 
with the rationale for making soak-up taxes not creditable, which is to 
ensure that the foreign country does not impose a soak-up tax liability 
that under the existing regulations could be allowed as a foreign tax 
credit to reduce the taxpayer's U.S. tax liability.
    Finally, the Treasury Department and the IRS are reconsidering the 
examples illustrating the soak-up tax rules that are contained in 
Sec. Sec.  1.901-2(c)(2) and 1.903-1(b)(3) (Examples 6 and 7) and 
expect to include updated examples in the regulations when proposed 
Sec.  1.901-2(e)(6) is finalized. Comments are requested on whether 
additional issues are presented by currently applicable soak-up taxes 
that should be addressed in the final regulations.
5. Separate Levy Determination
    Whether a foreign levy is an income tax is determined independently 
for each separate foreign levy. For purposes of sections 901 and 903, 
whether a single levy or separate levies are imposed by a foreign 
country depends on U.S. principles and not on whether foreign law 
imposes the levy or levies in a single or separate statutes. Section 
Sec.  1.901-2(d)(1) of the existing regulations provides that, where 
the base of a levy is different in kind, and not merely in degree, for 
different classes of persons subject to the levy, the levy is 
considered for purposes of sections 901 and 903 to impose separate 
levies for such classes of persons.
    The proposed regulations revise Sec.  1.901-2(d)(1) to clarify the 
determination of whether a foreign levy is separate from another 
foreign levy for purposes of determining if a levy meets the 
requirements of section 901 or 903. The Treasury Department and the IRS 
have determined that the standards under the existing regulations for 
making this determination are unclear. In one place the existing 
regulations state that the only differentiating factor is if the base 
of the levy is different in kind, as opposed to degree. See, for 
example, Sec.  1.901-2(d)(1) (``foreign levies identical to the taxes 
imposed by sections 11, 541, 881, 882, 1491, and 3111 of the Internal 
Revenue Code are each separate levies, because the base of each of 
those levies differs in kind, and not merely in degree''). However, in 
the same sentence, the regulations suggest that one levy may be 
separate from another levy if a different class of taxpayers is subject 
to each levy, regardless of whether the base of the two levies is 
different in kind. See, for example, id. (``a foreign levy identical to 
the tax imposed by section 871(b) of the Internal Revenue Code is a 
separate levy from a foreign levy identical to the tax imposed by 
section 1 of the Internal Revenue Code as it applies to persons other 
than those described in section 871(b)'' (emphasis added)).
    The proposed regulations modify the rules for determining whether a 
foreign levy is a separate levy to clarify how U.S. principles are 
relevant in determining whether one foreign levy is separate from 
another foreign levy. In general, the proposed regulations identify 
separate levies as those that include different items of income and 
expense in determining the base of the tax, but in certain 
circumstances separate levies may result even if the taxable base of 
each levy is the same. In particular, proposed Sec.  1.901-2(d)(1)(i) 
provides that a foreign levy is always separate from another foreign 
levy if the levy is imposed by a different foreign tax authority, even 
if the base of the tax is the same. Proposed Sec.  1.901-2(d)(1)(ii) 
provides the general rule that separate levies are imposed on 
particular classes of taxpayers if the taxable base is different for 
those taxpayers. For example, the proposed regulations provide that a 
foreign levy identical to the tax imposed by section 3101 (employee tax 
on wage income) is a separate levy from the foreign levy identical to 
the tax imposed by section 3111 (employer tax on wages paid). Proposed 
Sec.  1.901-2(d)(1)(ii) also provides that income included in the 
taxable base of a separate levy may also be included in the taxable 
base of another levy (which may or may not also include other items of 
income); and separate levies are considered to be imposed if the 
taxable bases are not combined as a single taxable base. Therefore, a 
foreign levy identical to the tax imposed by section 1411 is a separate 
levy from a foreign levy identical to the tax imposed by section 1 
because tax is separately imposed on the income included in each 
taxable base.
    Additionally, the proposed regulations at Sec.  1.901-2(d)(1)(iii) 
provide that a foreign levy imposed on nonresidents is treated as a 
separate levy from that imposed on residents of the taxing 
jurisdiction, even if the base is the same for both levies, and even if 
the levies are treated as a single levy under foreign tax law. These 
changes are intended to ensure that, in general, if a generally-imposed 
income tax on residents is also imposed on an extraterritorial basis on 
some nonresidents, in violation of the jurisdictional nexus 
requirement, only the portion of the levy that applies to nonresidents 
will not be treated as a foreign income tax. Otherwise, a foreign 
country's general income tax regime could fail to qualify as a net 
income tax if the tax was also imposed on an extraterritorial basis on 
some nonresidents.
    Finally, proposed Sec.  1.901-2(d)(1)(iii) provides that a 
withholding tax on gross income of nonresidents is treated as a 
separate levy with respect to each class of gross income (as listed in 
section 61) to which it applies. This special rule is

[[Page 72093]]

provided in order to allow withholding taxes that are imposed on 
several classes of income, based on sourcing rules that meet the 
jurisdictional nexus requirement with respect to only some of the 
classes of income, to be analyzed as separate levies under the covered 
withholding tax rule in Sec.  1.903-1(c)(2). See Part VI.C.3 of this 
Explanation of Provisions.

B. Amount of Tax That is Considered Paid

1. Background
    As discussed in more detail in Part X of this Explanation of 
Provisions, section 901 allows a credit for foreign income taxes in 
either the year the taxes are paid or the year the taxes accrue, 
according to the taxpayer's method of accounting for such taxes. See 
section 905(a). Regardless of the year in which the credit is allowed, 
the taxpayer must both owe and actually remit the foreign income tax to 
be entitled to a foreign tax credit for such tax. See section 905(b); 
Chrysler v. Comm'r, 116 T.C. 465, 469 n.2 (2001), aff'd, 436 F.3d. 644 
(6th Cir. 2006). The taxpayer's liability for the tax may become fixed 
and determinable in a different taxable year than that in which the tax 
is remitted, so that the taxpayer's entitlement to the credit may be 
perfected in a taxable year after the taxable year in which the credit 
is allowed.
    Section 1.901-2(e) of the existing regulations provides rules for 
determining the amount of foreign tax that is considered paid and 
eligible for credit under section 901. The existing regulations at 
Sec.  1.901-2(g)(1) and proposed Sec.  1.901-2(g)(5) clarify that the 
word ``paid'' as used in Sec.  1.901-2(e) means ``paid'' or 
``accrued,'' depending on whether the taxpayer claims the foreign tax 
credit for taxes paid (that is, remitted) or accrued (that is, for 
which the liability becomes fixed) during the taxable year. The 
proposed regulations clarify in several respects the amount of tax that 
is considered paid (or accrued, as the case may be) and eligible for 
credit. These clarifications are explained in Parts VI.B.2 and 3 of 
this Explanation of Provisions.
2. Refundable Amounts, Credits, and Multiple Levies
    Under Sec.  1.901-2(e)(2)(i) of the existing regulations, a payment 
to a foreign country is not treated as an amount of tax paid to the 
extent that it is reasonably certain that the amount will be refunded, 
credited, rebated, abated, or forgiven. That regulation further 
provides that it is not reasonably certain that an amount will be 
refunded, credited, rebated, abated, or forgiven if the amount is not 
greater than a reasonable approximation of the final tax liability to 
the foreign country.
    Current law is unclear whether an amount that is not treated as an 
amount of tax paid under Sec.  1.901-2(e)(5)(i) because it is 
reasonably certain to be credited against a taxpayer's tentative 
liability for a second foreign tax should be treated as a constructive 
refund of the credited amount from the foreign country, followed by a 
constructive payment by the taxpayer of the second foreign tax. The law 
is similarly unclear as to whether credits allowed under foreign tax 
law that are computed with reference to amounts other than foreign tax 
payments (such as, for example, investment tax credits) may be treated 
as a constructive receipt of cash by the taxpayer from the foreign 
country, followed by a constructive payment by the taxpayer of foreign 
income tax. The results have sometimes differed depending on whether 
the credit is refundable under foreign law, that is, whether taxpayers 
are entitled to receive a cash payment from the foreign country to the 
extent the credit exceeds the taxpayer's foreign income tax liability. 
See, for example, Rev. Rul. 86-134, 1986-2 C.B. 104 (investment 
incentives reduced tentative Dutch income tax liability during period 
in which such incentives could only be claimed as an offset against the 
income tax liability, rather than as a refundable credit).
    The Treasury Department and the IRS have determined that the 
current uncertainty as to how to properly account for tax credits leads 
to varying and inconsistent interpretations and that a single, clear 
rule regarding the treatment of tax credits would improve the 
consistency in outcomes for taxpayers. In addition, the Treasury 
Department and the IRS are concerned that if the use of tax credits can 
be treated as a means of payment of a foreign income tax for foreign 
tax credit purposes, then foreign countries, rather than reducing their 
tax rates, could instead offer tax credits that would have the same 
economic effect without reducing the amount of foreign income tax that 
is treated as paid by taxpayers for purposes of the foreign tax credit. 
The Treasury Department and the IRS have also determined it is too 
administratively challenging to determine whether a foreign country 
whose law provides for nominally refundable credits in practice 
actually issues cash payments to taxpayers that do not have income tax 
liabilities equal to the credit. In addition, the Treasury Department 
and the IRS have determined that the rule in Sec.  1.901-2(e)(2)(i) 
with respect to amounts that will be ``credited'' is ambiguous. Section 
1.901-2(e)(4)(i) of the existing regulations provides that if, under 
foreign law, a taxpayer's tentative liability for one levy (the ``first 
levy'') is or can be reduced by the amount of the taxpayer's liability 
for a different levy (the ``second levy''), then the amount considered 
paid by the taxpayer to the foreign country pursuant to the second levy 
is an amount equal to its entire liability for that levy, and the 
remainder of the amount paid is considered paid pursuant to the first 
levy. However, Sec.  1.901-2(e)(2)(i) suggests that the credited amount 
of the second levy is not considered paid.
    Therefore, proposed Sec.  1.901-2(e)(2)(i) provides certainty on 
the treatment of credited amounts by eliminating the provision that 
suggests that an amount of tax is not treated as paid if it is allowed 
as a credit. Instead, proposed Sec.  1.901-2(e)(2)(ii) provides that 
foreign income tax is not considered paid if it is reduced by a tax 
credit, regardless of whether the amount of the tax credit is 
refundable in cash. Therefore, an amount allowed as a credit 
(including, but not limited to, an amount paid under one levy that is 
credited against an amount due under another levy) is not treated as a 
constructive payment of cash from the foreign country (or a 
constructive refund of the levy that is paid) followed by a 
constructive payment of the levy that is reduced by the credit, even if 
the creditable amount is refundable in cash to the extent it exceeds 
the taxpayer's liability for the levy that is reduced by the credit. 
However, proposed Sec.  1.901-2(e)(2)(iii) provides that overpayments 
of tax (which exceed the taxpayer's liability and so are not treated as 
an amount of tax paid) that are refundable in cash at the taxpayer's 
option and that are applied in satisfaction of the taxpayer's liability 
for foreign income tax may qualify as an amount of such foreign income 
tax paid.
    Comments are requested on whether additional rules should be 
provided for government grants that are provided outside of the foreign 
tax system, and the circumstances in which such grants should also be 
treated as a reduction in the amount of tax paid.
    Finally, as noted in this Part VI.B.2, the multiple levy rule in 
Sec.  1.901-2(e)(4) of the existing regulations provides that when an 
amount of a second levy is applied as a credit to reduce the taxpayer's 
liability for a first levy, the full amount of the second levy (and not 
the amount of the first levy that is offset by the credit) is 
considered paid. The proposed regulations clarify the

[[Page 72094]]

multiple levy rule by referring to the first levy as the ``reduced 
levy'' and to the second levy as the ``applied levy.'' The proposed 
regulations also modify an existing example and add a new example to 
illustrate the application of proposed Sec.  1.901-2(e)(2) and (4). See 
proposed Sec.  1.901-2(e)(4)(ii).
3. Noncompulsory Payments
i. Background
    Section 1.901-2(e)(5) provides that an amount paid is not a 
compulsory payment, and thus is not an amount of tax paid, to the 
extent that the amount paid exceeds the amount of the taxpayer's 
liability under foreign law for tax (the ``noncompulsory payment 
rule''). Section 1.901-2(e)(5) further provides that if foreign tax law 
includes options or elections whereby a taxpayer's liability may be 
shifted, in whole or part, to a different year, the taxpayer's use or 
failure to use such options or elections does not result in a 
noncompulsory payment, and that a settlement by a taxpayer of two or 
more issues will be evaluated on an overall basis, not on an issue-by-
issue basis, in determining whether an amount is a compulsory amount. 
In addition, it provides that a taxpayer is not required to alter its 
form of doing business, its business conduct, or the form of any 
transaction in order to reduce its liability for tax under foreign law.
    On March 30, 2007, proposed regulations (REG-156779-06) were 
published in the Federal Register at 72 FR 15081 that, in part, would 
amend Sec.  1.901-2(e)(5) to treat as a single taxpayer all foreign 
entities in which the same United States person has a direct or 
indirect interest of 80 percent or more (a ``U.S.-owned foreign 
group''). The proposed rule (the ``2007 proposed regulations'') would 
apply for purposes of determining whether amounts paid are compulsory 
payments of foreign tax, for example, when one member of a U.S.-owned 
foreign group surrenders a loss to another member of the group that 
reduces the foreign tax due from the second member in that year but 
increases the amount of foreign tax owed by the loss member in a 
subsequent year. In Notice 2007-95, 2007-2 C.B. 1091, the Treasury 
Department and the IRS announced that, in reviewing comments received, 
it was determined that the proposed change may lead to inappropriate 
results in certain cases and that the proposed change would be 
effective for taxable years beginning after the publication of final 
regulations, but that taxpayers may rely on that portion of the 
proposed regulations for taxable years ending on or after March 29, 
2007, and beginning on or before the date on which final regulations 
are published.
    Section 1.909-2 provides an exclusive list of foreign tax credit 
splitter arrangements, including a loss-sharing splitter arrangement, 
which exists under a foreign group relief or other loss-sharing regime 
to the extent a ``usable shared loss'' of a ``U.S. combined income 
group'' (that is, an individual or corporation and all the entities 
with which it combines income and expense under Federal income tax law) 
is used to offset foreign taxable income of another U.S. combined 
income group. See Sec.  1.909-1(b)(2).
ii. Treatment of Elections and Other Clarifications
    Section 1.901-2(e)(5) currently applies on a taxpayer-by-taxpayer 
basis, obligating each taxpayer to minimize its liability for foreign 
taxes over time. The 2007 proposed regulations were intended to create 
a limited exception to the taxpayer-by-taxpayer approach, recognizing 
that the net effect of a loss surrender in the case of a group relief 
regime may be to minimize the amount of foreign taxes paid in the 
aggregate by the group over time. However, the 2007 proposed 
regulations were both overinclusive and underinclusive. Comments 
criticized the approach taken, including how the U.S.-owned foreign 
group was defined, and noted that the proposal had created uncertainty 
over the extent to which noncompulsory payment issues arise in 
situations not addressed by the proposed regulations. In addition, as 
noted in Notice 2007-95, the Treasury Department and the IRS have 
determined that the 2007 proposed regulations would lead to 
inappropriate results in certain cases. Furthermore, a comment received 
in connection with 2012 temporary regulations issued under section 909 
(TD 9597, 77 FR 8127) recommended that the 2007 proposed regulations be 
withdrawn in light of the coverage of loss-sharing splitter 
arrangements under the section 909 regulations.
    The Treasury Department and the IRS agree that the 2007 proposed 
regulations should be withdrawn. However, withdrawing the 2007 proposed 
regulations (which taxpayers were permitted to rely on under Notice 
2007-95) without providing additional guidance could result in a 
disallowance of all foreign tax credits related to loss-sharing 
arrangements because under Sec.  1.901-2(e)(5) the requirement to 
minimize foreign income tax liability applies on a taxpayer-by-taxpayer 
basis. To address this issue, proposed Sec.  1.901-2(e)(5)(ii)(B)(2) 
provides that when foreign law permits one foreign entity to join a 
consolidated group, or to surrender its loss to offset the income of 
another foreign entity pursuant to a foreign group relief or other 
loss-sharing regime, a taxpayer's decision to file as a consolidated 
group, to surrender or not to surrender a loss, or to use or not to use 
a surrendered loss, will not give rise to a noncompulsory payment.
    Although the proposed regulations will generally exempt loss 
surrender under group relief or other loss-sharing regimes from the 
noncompulsory payment regulations, the Treasury Department and the IRS 
remain concerned that in certain cases loss sharing arrangements, 
particularly when combined with hybrid arrangements, may be used to 
separate foreign taxes from the related income. For example, if passive 
category income of a CFC is offset for U.S. tax purposes by a loss 
recognized by a disregarded entity owned by that CFC, but that loss is 
surrendered to reduce general category tested income of an affiliated 
CFC for foreign tax purposes, under Sec.  1.909-3(a) the split taxes of 
the loss CFC may be eligible to be deemed paid if the affiliated CFC's 
related income is included in the U.S. shareholder's income in the same 
taxable year, but such taxes may not be properly associated with the 
related income. Therefore, the Treasury Department and the IRS are 
considering whether additional guidance on loss sharing arrangements, 
including for example under Sec.  1.861-20, is needed. Comments are 
requested on this and other aspects of the treatment of loss sharing 
arrangements.
    The existing regulations at Sec.  1.901-2(e)(5) provide that where 
foreign tax law includes options or elections whereby a taxpayer's 
foreign income tax liability may be shifted to a different year, the 
taxpayer's use or failure to use such options or elections does not 
result in a noncompulsory payment. However, the regulations are not 
clear as to whether the use or failure to use options or elections that 
result in an overall change in foreign income tax liability over time 
would result in a noncompulsory payment. For example, a taxpayer's 
choice to capitalize and amortize capital expenditures over time, 
rather than to claim a current expense deduction, does not result in a 
noncompulsory payment; in contrast, a taxpayer's election to compute 
its tax liability under one of two alternative regimes, one of which 
qualifies as an income tax and one of which qualifies as a tax in lieu 
of an income tax, may result in a noncompulsory payment if

[[Page 72095]]

the taxpayer does not choose the option that is reasonably calculated 
to minimize its liability for creditable foreign tax over time. 
Accordingly, proposed Sec.  1.901-2(e)(5)(ii) provides that the use or 
failure to use such an option or election is relevant to whether a 
taxpayer has minimized its liability for foreign income taxes. However, 
an exception is provided for elections to surrender losses under a 
foreign consolidation, group relief or other loss-surrender regime, as 
well as for an option or election to treat an entity as fiscally 
transparent or non-fiscally transparent for foreign tax purposes. 
Because these elections and options generally have the effect of 
shifting to another entity, rather than reducing in the aggregate, a 
taxpayer group's foreign income tax liability, the Treasury Department 
and the IRS have determined that foreign tax credit concerns related to 
the use or failure to use such an election or option are more 
appropriately addressed under other rules. The Treasury Department and 
IRS request comments on whether there are other foreign options or 
elections that should be excepted from the general rule.
    The Treasury Department and IRS are aware that some taxpayers have 
taken the position that because Sec.  1.901-2(e)(5) refers to payments 
of ``foreign taxes,'' rather than ``foreign income taxes,'' the 
noncompulsory payment regulations only require taxpayers to minimize 
their total liability for all foreign taxes in the aggregate (including 
non-income taxes such as excise taxes), as opposed to minimizing 
foreign income tax. The Treasury Department and IRS disagree with this 
interpretation, since Sec.  1.901-2(e) defines the amount of ``taxes 
paid'' for purposes of section 901, which only applies to creditable 
foreign income taxes. Accordingly, proposed Sec.  1.901-2(e)(5)(i) 
clarifies that taxpayers are obligated to minimize their foreign income 
tax liabilities. For example, if a taxpayer may choose to apply a tax 
credit to reduce either the amount of a creditable income tax or the 
amount of a non-creditable excise tax, then the proposed regulations 
require that the taxpayer choose to minimize its liability for the 
creditable income tax; if instead the taxpayer chooses to apply the 
credit against the excise tax, income tax in the amount of the applied 
credit is considered a noncompulsory payment.
    Finally, proposed Sec.  1.901-2(e)(5)(i) clarifies that the time 
value of money is not relevant in determining whether a taxpayer has 
met its obligation to minimize the amount of its foreign income tax 
liabilities over time. This rule is consistent with the rule in Sec.  
1.901-2(b)(4), providing that the amount of costs that are treated as 
recovered in computing the base of a foreign tax is the same, 
regardless of whether a taxpayer chooses to deduct currently, or to 
capitalize and amortize, a particular expense. Therefore, for example, 
if a taxpayer subject to foreign income tax at a rate of 20 percent 
chooses to capitalize a $100x cost and deduct it ratably over five 
years rather than to deduct the entire $100x cost in the first year, 
the full $100x cost is considered recovered under either option, and is 
not affected by the fact that as an economic matter the present value 
of the $20x reduction in tax liability by reason of the $100x deduction 
in the first year exceeds the discounted present value of the same $20x 
reduction in tax spread over five years. Similarly, under proposed 
Sec.  1.901-2(e)(5)(i), the taxpayer will be treated as paying the same 
amount of foreign income tax regardless of whether it chooses to pay 
that amount in the current tax year or in a later year.
    Although the Treasury Department and the IRS understand that time 
value of money considerations have economic effects, for Federal income 
tax purposes income and expenses (including taxes) generally are 
neither discounted nor indexed by reference to time value of money 
considerations. A regime that required taxpayers to minimize the 
discounted present value, rather than the nominal amount, of foreign 
income tax liabilities would be complex, requiring assumptions about 
future tax rates and appropriate discount rates. Similarly, a regime 
that required taxpayers to compare the discounted present value of a 
foreign tax credit for a foreign income tax to the discounted present 
value of a deduction for an alternative payment of non-creditable tax 
that would be incurred in a different year and select the option that 
minimized the cost to the U.S. fisc would be comparably complex and 
burdensome for taxpayers to apply and for the IRS to administer. 
Accordingly, the proposed regulations provide that economic 
considerations related to the discounted present value of U.S. and 
foreign tax benefits are not taken into account for purposes of 
determining the amount of cost recovery or the amount of foreign income 
tax that is, or would be under foreign tax law options available to the 
taxpayer, paid or accrued over time.

C. Tax in Lieu of Income Tax

1. In General
    Section 903 provides that, for purposes of the foreign tax credit, 
the term ``income, war profits, and excess profits taxes'' includes a 
tax paid in lieu of an income tax otherwise generally imposed by any 
foreign country or by any possession of the United States (an ``in lieu 
of tax''). The existing regulations clarify that the foreign country's 
purpose in imposing the foreign tax (for example, whether it imposes 
the foreign tax because of administrative difficulty in determining the 
base of the income tax otherwise generally imposed) is immaterial. See 
Sec.  1.903-1(a). The existing regulations further provide that it is 
immaterial whether the base of the foreign tax bears any relation to 
realized net income and that the base may, for example, be gross 
income, gross receipts or sales, or the number of units produced or 
sold. See Sec.  1.903-1(b)(1). The existing regulations also require 
that the foreign tax meet a substitution requirement, which is 
satisfied if the tax in fact operates as a tax imposed in substitution 
for, and not in addition to, an income tax or a series of income taxes 
otherwise generally imposed. See id.
    The proposed regulations revise the substitution requirement by 
more specifically defining the circumstances in which a foreign tax is 
considered ``in lieu of'' a generally-imposed income tax, consistent 
with the interpretation of the substitution requirement in prior 
judicial decisions. See, for example, Metro. Life Ins. Co. v. United 
States, 375 F.2d 835, 838-40 (Ct. Cl. 1967). In addition, the proposed 
regulations provide that an in lieu of tax under section 903, by virtue 
of the substitution requirement, must also satisfy the jurisdictional 
nexus requirement described in proposed Sec.  1.901-2(c). Although 
prior regulations under section 903 did contain a jurisdictional 
limitation with respect to in lieu of taxes, see Sec.  4.903-1(a)(4) 
(1980) (requiring that an in lieu of tax follow ``reasonable rules of 
taxing jurisdiction within the meaning of Sec.  4.901-2(a)(1)(iii)''), 
the existing regulations do not contain such a rule. The reasons for 
adopting a jurisdictional nexus requirement under Sec.  1.901-2, as 
described in Part VI.A.2 of this Explanation of Provisions, apply 
equally to in lieu of taxes described in section 903. In addition, this 
rule is necessary to ensure that a foreign tax that is imposed on net 
gain but that fails the jurisdictional nexus requirement in Sec.  
1.901-2 cannot be converted into a creditable tax under section 903 
simply by being imposed on a taxable base other than income (such as a 
tax on gross receipts).
    Furthermore, the proposed regulations include a special rule for

[[Page 72096]]

certain cross-border source-based withholding taxes in order to clarify 
the application of the substitution requirement to such taxes. The 
rules in proposed Sec.  1.903-1 apply independently to each separate 
levy. Therefore, if a separate levy is an in lieu of tax, and a second 
levy is later enacted by the same foreign country, such second levy may 
also qualify as an in lieu of tax if the requirements in proposed Sec.  
1.903-1 are met.
2. Substitution Requirement
    The foreign tax that is being analyzed under section 903 (the 
``tested foreign tax'') satisfies the substitution requirement only if, 
based on the foreign tax law, four tests are met. First, as under the 
existing regulations, a separate levy that is a foreign income tax 
described in Sec.  1.901-2(a)(3) (a ``foreign net income tax'') must be 
generally imposed by the same foreign country (a ``generally-imposed 
net income tax''). See proposed Sec.  1.903-1(c)(1)(i).
    Second, proposed Sec.  1.903-1(c)(1)(ii) requires that neither the 
generally-imposed net income tax nor any other separate levy that is a 
foreign net income tax imposed by the same foreign country that imposes 
the tested foreign tax is imposed with respect to any portion of the 
income to which the amounts (such as sales or units of production) that 
form the base of the tested foreign tax relate (the ``excluded 
income''). For example, if a tonnage tax regime applies with respect to 
a taxpayer engaged in shipping, income from shipping must be excluded 
from the foreign country's regular net income tax for the tonnage tax 
to qualify as an in lieu of tax. This requirement is not met if, under 
the foreign tax law, a net income tax imposed by the same foreign 
country applies to the excluded income of any persons that are subject 
to the tested foreign tax, even if not all of the persons subject to 
the tested foreign tax are subject to the net income tax.
    Third, proposed Sec.  1.903-1(c)(1)(iii) requires that, but for the 
existence of the tested foreign tax, the generally-imposed net income 
tax would be imposed on the excluded income. For example, if a tonnage 
tax regime applies with respect to a taxpayer engaged in shipping, it 
must be shown that, but for the existence of such regime, the regular 
income tax would apply to income from shipping. This ``but for'' 
requirement is met only if the imposition of the tested foreign tax 
bears a ``close connection'' to the failure to impose the generally-
imposed net income tax on the excluded income. See Metro. Life Ins. Co, 
375 F.2d at 840.
    The proposed regulations provide that the close connection 
requirement is satisfied if the generally-imposed net income tax would 
apply by its terms to the excluded income but for the fact that it is 
expressly excluded. For example, if a corporate income tax regime 
would, by its terms, apply to all corporations, but income of insurance 
companies is expressly excluded by law under such regime and taxed 
under a separate regime, then the close connection requirement is met.
    Otherwise, a close connection must be established with proof that 
the foreign country made a ``cognizant and deliberate choice'' to 
impose the tested foreign tax instead of the generally-imposed net 
income tax. Id. Such proof may take into account the legislative 
history of either the tested foreign tax or the generally-imposed net 
income tax for purposes of ascertaining the intent and purpose of the 
two taxes in order to determine the relationship between them.
    Not all income derived by persons subject to the tested foreign tax 
need be excluded income, as long as the tested foreign tax applies only 
to amounts that relate to the excluded income. For example, if a 
taxpayer that earns income from operating restaurants and hotels is 
subject to a generally-imposed net income tax except that, pursuant to 
an agreement with the foreign country, the taxpayer's income from 
restaurants is subject to a tax based on number of tables and not to 
the income tax, the table tax can meet the substitution requirement 
notwithstanding that the hotel income is subject to the generally-
imposed net income tax.
    Fourth, proposed Sec.  1.903-1(c)(1)(iv) requires that, if the 
generally-imposed net income tax were applied to the excluded income, 
the generally-imposed net income tax would either continue to qualify 
as a foreign net income tax, or would itself constitute a separate levy 
that is a foreign net income tax. This rule is intended to ensure that 
a foreign tax can qualify as an in lieu of tax only if the foreign 
country imposing the tax could instead have subjected the excluded 
income to a tax on net gain that would satisfy the jurisdictional nexus 
requirement in Sec.  1.901-2(c).
    Finally, proposed Sec.  1.861-20(h) provides a rule for allocating 
and apportioning foreign taxes described in section 903 (other than 
withholding taxes) to statutory and residual groupings. In general, the 
rule provides that the in lieu of tax is allocated and apportioned in 
the same proportions as the excluded income.
3. Covered Withholding Tax
    Gross-basis taxes, such as withholding taxes, do not satisfy the 
net gain requirement under proposed Sec.  1.901-2(b). While such 
withholding taxes may be treated as in lieu of taxes under section 903, 
the analysis under section 903 and existing Sec.  1.903-1 is unclear. 
Therefore, proposed Sec.  1.903-1(c)(2) provides a special rule for 
applying the substitution requirement to certain ``covered withholding 
taxes'' imposed by a foreign country that also has a generally-imposed 
net income tax.
    First, the tax must be a withholding tax (as defined in section 
901(k)(1)(B)) that is imposed on gross income of persons who are 
nonresidents of the foreign country imposing the tax. See proposed 
Sec.  1.903-1(c)(2)(i).
    Second, the tax cannot be in addition to a net income tax that is 
imposed by the foreign country on any portion of the income subject to 
the withholding tax. See proposed Sec.  1.903-1(c)(2)(ii). Thus, for 
example, if a withholding tax applies by its terms to certain gross 
income of nonresidents that is also subject to the generally-imposed 
net income tax if it is attributable to a taxable presence of the 
nonresident in the foreign country imposing the tax, the withholding 
tax cannot meet the substitution requirement, including as to 
nonresidents that do not have a taxable presence in that country.
    Third, the withholding tax must meet the source-based 
jurisdictional nexus requirement in proposed Sec.  1.901-2(c)(1)(ii), 
requiring that rules for sourcing income to the foreign country are 
reasonably similar to the sourcing rules that apply for Federal income 
tax purposes (including that services income is sourced to the place of 
performance). Similar to the rule in proposed Sec.  1.903-1(c)(1)(iv) 
requiring that the generally-imposed net income tax, if expanded to 
cover the excluded income, would continue to qualify as a net income 
tax under Sec.  1.901-2, proposed Sec.  1.903-1(c)(2)(iii) requires 
that the income subject to the withholding tax satisfies the source 
requirement described in Sec.  1.901-2(c)(1)(ii).

VII. Rules for Allocating Taxes After Certain Ownership and Entity 
Classification Changes

A. Background

    On February 14, 2012, the Federal Register published final 
regulations (77 FR 8124, TD 9576) under section 901 concerning the 
determination of the person who pays a tax for foreign tax credit 
purposes (the ``2012 final regulations''). The 2012 final regulations

[[Page 72097]]

address the inappropriate separation of foreign income taxes from the 
income on which the tax was imposed in certain circumstances. The 2012 
final regulations provide rules for allocating foreign tax imposed on 
the combined income of multiple persons, as well as rules for 
allocating entity-level foreign tax imposed on partnerships and 
disregarded entities that undergo ownership or certain entity 
classification changes that do not cause the foreign taxable year of 
the partnership or disregarded entity (the ``continuing foreign taxable 
year'') to close.
    Section 1.901-2(f)(4)(i) of the 2012 final regulations addresses 
partnership terminations under section 708(b)(1) that do not cause the 
foreign taxable year to close. Under this provision, foreign tax paid 
or accrued with respect to the continuing foreign taxable year (for 
example, in the case of a section 708(b)(1) termination, foreign tax 
paid or accrued by a successor corporation or owner of a disregarded 
entity) is allocated between each terminating partnership and successor 
entity (or, in the case of a partnership that becomes a disregarded 
entity, the owner of the disregarded entity). The allocation is based 
upon the respective portions of the foreign tax base that are 
attributable under the principles of Sec.  1.1502-76(b) to the period 
of existence of the terminating partnership and successor entity or the 
period of ownership by a disregarded entity owner during the continuing 
foreign taxable year. Section 1.901-2(f)(4)(i) also provides similar 
rules for allocating foreign tax paid or accrued by a partnership among 
the respective portions of the partnership's U.S. taxable year that end 
with, and begin after, a change in a partner's interest in the 
partnership that does not result in a partnership termination (a 
variance).
    Section 1.901-2(f)(4)(ii) of the 2012 final regulations addresses a 
change in the ownership of a disregarded entity that does not cause the 
foreign taxable year of the entity to close. Under this rule, foreign 
tax paid or accrued with respect to the foreign taxable year is 
allocated between the transferor and transferee of the disregarded 
entity. The allocation is made based on the respective portions of the 
foreign tax base that are attributable under the principles of Sec.  
1.1502-76(b) to the period of ownership of each transferor and 
transferee.

B. Covered Events

    The proposed regulations move the Sec.  1.901-2(f)(4) allocation 
rules that apply in the case of partnership terminations and variances 
and other ownership and entity classification changes to new Sec.  
1.901-2(f)(5), and modify those rules to ensure that they cover any 
entity classification change under U.S. tax law that does not cause the 
entity's foreign taxable year to close. The proposed regulations also 
clarify certain aspects of the 2012 final regulations. The general 
legal liability rules for taxes imposed on partnerships and disregarded 
entities are now contained in proposed Sec.  1.901-2(f)(4) and are 
generally unchanged from the 2012 final regulations.
    Proposed Sec.  1.901-2(f)(5)(i) provides a single allocation rule 
that applies to a partnership, disregarded entity, or corporation that 
undergoes one or more ``covered events'' during its foreign taxable 
year that do not result in a closing of the foreign taxable year. Under 
proposed Sec.  1.901-2(f)(5)(ii), a covered event is a partnership 
termination under section 708(b)(1), a transfer of a disregarded 
entity, or a change in the entity classification of a disregarded 
entity or a corporation. These proposed regulations therefore apply to 
allocate foreign tax paid or accrued with respect to the continuing 
foreign taxable year of a partnership that terminates under section 
708(b)(1), a disregarded entity that becomes a partnership or a 
corporation, and a corporation that becomes a partnership or a 
disregarded entity. In addition, proposed Sec.  1.901-2(f)(5)(iv) 
allocates foreign tax paid or accrued with respect to certain changes 
in a partner's interest in a partnership (a ``variance'') by treating 
the variance as a covered event.
    These proposed regulations also ensure that the allocation rules 
apply not just in the case of one or more covered events of the same 
type within a continuing foreign taxable year, but also in the case of 
any combination of covered events. For example, proposed Sec.  1.901-
2(f)(5) applies to foreign tax that is paid or accrued with respect to 
a continuing foreign taxable year in which a corporation elects to be 
treated as a disregarded entity and the disregarded entity subsequently 
becomes a partnership. A portion of foreign tax is allocated among all 
persons that were predecessor entities (namely, a terminating 
partnership or corporation undergoing an entity classification change) 
or prior owners (namely, the owner of a disregarded entity that is 
transferred or undergoes an entity classification change) during the 
continuing foreign taxable year. Like the rules provided in the 2012 
final regulations, the allocation is made based on the respective 
portions of the foreign tax base for the continuing foreign taxable 
year that are attributable under the principles of Sec.  1.1502-76(b) 
to the period of existence or ownership of each predecessor entity or 
prior owner during such year.

C. Timing of the Payment or Accrual of an Allocated Tax

    These proposed regulations also provide consistent rules for when 
allocated tax is treated as paid or accrued. Proposed Sec.  1.901-
2(f)(5)(i) provides that tax allocated to a predecessor entity is 
treated as paid or accrued as of the close of the last day of its last 
U.S. taxable year, and that tax allocated to the prior owner of a 
disregarded entity is treated as paid or accrued as of the close of the 
last day of its U.S. taxable year in which the change in ownership 
occurs.

D. Treatment of Withholding Taxes

    The 2012 final regulations do not clearly state whether foreign 
withholding taxes are subject to the allocation rules. As explained in 
Part VI.A of this Explanation of Provisions, foreign taxes are 
allocated based on the portion of the foreign tax base that is 
attributed to the period of existence or ownership of each predecessor 
or prior owner during the foreign taxable year, applying the principles 
of Sec.  1.1502-76(b). The principles of Sec.  1.1502-76(b) allow 
taxpayers to use either a closing of the books method or a ratable 
allocation method in attributing the foreign tax base to these periods.
    If the ratable allocation method is used, foreign tax is generally 
allocated to a predecessor entity or prior owner based on its ratable 
share of the foreign tax base for the continuing foreign taxable year. 
In the case of net basis foreign tax paid or accrued by a new owner or 
successor entity with respect to a continuing foreign taxable year, the 
resulting allocation of a portion of the tax to a predecessor entity or 
prior owner is appropriate because the predecessor entity or prior 
owner generally took into account for U.S. tax purposes a portion of 
the related income on which the net basis tax was imposed. However, in 
the case of withholding tax that is imposed on an amount that accrues 
for U.S. tax purposes when it is paid, such as a dividend, an 
allocation of a portion of the withholding tax based on ratably 
allocating the dividend income over the foreign taxable year to a 
predecessor entity or prior owner is not appropriate because the 
predecessor entity or prior owner will not have taken any of the 
related dividend income into account for U.S. tax purposes. Even if 
withholding tax is imposed on income, such as interest,

[[Page 72098]]

that accrues for U.S. tax purposes ratably over a period, an allocation 
of a portion of the withholding tax to a predecessor entity or prior 
owner based on ratably allocating the interest income over the foreign 
taxable year may not be appropriate if the foreign taxable year is not 
the same period as the accrual period under the terms of the instrument 
that generated the interest.
    Because applying the ratable allocation method under proposed Sec.  
1.901-2(f)(5) to allocate withholding taxes to a predecessor entity or 
prior owner may separate withholding taxes from income that accrues 
when paid, and may not achieve appropriate matching of withholding 
taxes and related income in the case of withholding tax imposed on 
income that accrues over a period, these proposed regulations provide 
that withholding taxes paid in the foreign taxable year of a covered 
event are not subject to allocation under proposed Sec.  1.901-2(f)(5).

E. Elections Under Sections 336(e) and 338

    Sections 1.336-2(g)(3)(ii) and 1.338-9(d) provide rules for 
allocating foreign tax between old target and new target where a 
section 336(e) election or 338 election, respectively, is in effect 
with respect to the sale, exchange, or distribution of the target and 
the transaction does not cause old target's foreign taxable year to 
close. The proposed regulations clarify that, in the case of a section 
338 election, the allocation is made with respect to the portions of 
the foreign tax base that are attributable under Sec.  1.1502-76(b) 
principles to old target and new target, and clarify how the allocation 
is made if there are multiple transfers of the stock of target that are 
each subject to a separate section 338 election during the foreign 
taxable year. The proposed regulations also provide that if a section 
338 election is made for target and target holds an interest in a 
disregarded entity or partnership, the rules of Sec.  1.901-2(f)(4) and 
(5) apply to determine the person who is considered for Federal income 
tax purposes to pay foreign income tax imposed at the entity level on 
the income of the disregarded entity or partnership. In addition, the 
proposed regulations clarify that withholding tax is not subject to 
allocation. Finally, the proposed regulations make a conforming change 
to the allocation rules that apply where a section 336(e) election is 
in effect by providing that withholding taxes are not subject to 
allocation.

VIII. Transition Rules Accounting for NOL Carrybacks

A. Background

    The 2019 FTC final regulations provide transition rules for 
assigning any separate limitation loss (``SLL'') or overall foreign 
loss (``OFL'') accounts in a pre-2018 separate category to a post-2017 
separate category. The regulations also provide transition rules for 
how an SLL or OFL that reduced pre-2018 general category income is 
recaptured in post-2017 years, and for how to treat foreign losses that 
are part of general category net operating losses (``NOLs'') incurred 
in pre-2018 taxable years that are carried forward to post-2017 taxable 
years. See Sec.  1.904(f)-12(j).
    The transition rules included in the 2019 FTC final regulations did 
not address post-2017 NOL carrybacks to pre-2018 taxable years because 
section 172 generally did not allow for NOL carrybacks when the 2019 
FTC final regulations were issued. However, on March 27, 2020, Congress 
enacted the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. 
116-136, 134 Stat. 281 (2020) (the ``CARES Act''), which revised 
section 172(b) to allow taxpayers to carry back, for five years, NOLs 
incurred in 2018 through 2020.

B. Rule for Post-2017 NOL Carrybacks

    The proposed regulations provide rules analogous to the existing 
transition rules in Sec.  1.904(f)-12(j) to situations involving an NOL 
arising in a post-2017 taxable year that is carried back to a pre-2018 
taxable year. In particular, proposed Sec.  1.904(f)-12(j)(5)(i) 
confirms that the rules of Sec.  1.904(g)-3(b) apply to the NOL 
carryback, and provides that income in a pre-2018 separate category in 
the taxable year to which the NOL is carried back is generally treated 
as if it included only income that would be assigned to the same 
separate category in post-2017 taxable years. Therefore, any SLL 
created by reason of a passive category component of a post-2017 NOL 
that is carried back to offset pre-2018 general category income will be 
recaptured in post-2017 taxable years as general category income, and 
not as a combination of post-2017 general, foreign branch, or section 
951A category income.
    However, in order to reduce the potential for creating SLLs by 
reason of the carryback of a post-2017 NOL component in the foreign 
branch category or section 951A category to a pre-2018 taxable year, 
the proposed regulations provide that such losses will first ratably 
offset a taxpayer's general category income in the carryback year, to 
the extent thereof, and that no SLL account will be created as a result 
of that offset. The amount of income in the general category available 
to be offset under this rule is determined after first offsetting the 
general category income in the carryback year by a post-2017 NOL 
component in the general category that is carried back to the same 
year.

IX. Foreign Tax Credit Limitation Under Section 904

A. Revisions to Definition of Foreign Branch Category Income

    The proposed regulations revise certain aspects of the foreign 
branch category income rules in Sec.  1.904-4(f) to account for a 
broader range of disregarded payments, as well as to better coordinate 
with the rules in Sec.  1.861-20 and the elective high-tax exception 
rules in proposed Sec.  1.954-1(d) of the 2020 HTE proposed regulations 
(85 FR 44650).
    Section 904(d)(2)(J)(i) defines foreign branch category income as 
business profits of a United States person that are attributable to 
qualified business units in foreign countries. Section 1.904-
4(f)(2)(ii) and (iii) of the 2019 FTC final regulations provide that 
income attributable to a foreign branch does not include income arising 
from activities carried out in the United States or income arising from 
stock that is not dealer property. Section 1.904-4(f)(1)(ii) of the 
2019 FTC final regulations, reflecting section 904(d)(2)(J)(ii), 
provides that passive category income is excluded from foreign branch 
category income. These rules exclude from foreign branch category 
income for purposes of section 904 income generated by assets that may 
be owned through the foreign branch and reflected on its books and 
records, but that is not properly characterized as business profits 
attributable to foreign branch activities.
    In contrast, in the different context of applying the disregarded 
payment rules in proposed Sec.  1.861-20(d)(3)(v) or proposed Sec.  
1.954-1(d), which rely on the rules in Sec.  1.904-4(f), such income is 
properly attributed to a taxable unit or a tested unit, respectively, 
for purposes of those provisions. In order to facilitate the 
incorporation by cross-reference of the rules and principles in Sec.  
1.904-4(f) for attributing income to taxable units for purposes of 
other provisions, the proposed regulations move the exclusions for 
income arising from U.S. activities and stock to Sec.  1.904-
4(f)(1)(iii) and (iv), respectively, and modify the language to provide 
that such income may be attributable to a foreign branch but is always 
excluded from foreign branch category income. See also Part

[[Page 72099]]

V.F.4 of this Explanation of Provisions (discussing the rules in 
proposed Sec.  1.861-20(d)(3)(v)(B)(2) for attributing income to 
taxable units). This technical change does not reflect any 
reconsideration by the Treasury Department and the IRS of the 
determination in the 2019 FTC final regulations that income arising 
from U.S. activities and stock do not constitute business profits that 
are attributable to foreign branches within the meaning of section 
904(d)(2)(J).
    Proposed Sec.  1.904-4(f)(2)(vi)(G) provides that the disregarded 
reallocation payment rules generally apply in the case of disregarded 
payments made to and from a ``non-branch taxable unit'' (as defined in 
proposed Sec. Sec.  1.904-4(f)(3) and 1.904-6(b)(2)(i)(B)), which 
includes certain persons and interests that do not meet the definition 
of a foreign branch or foreign branch owner. This change accounts for 
the fact that disregarded payments may occur among, for example, 
foreign branches, foreign branch owners, and disregarded entities that 
have no trade or business (and are therefore not foreign branches). In 
order to attribute gross income to a foreign branch or a foreign branch 
owner, disregarded payments to and from non-branch taxable units must 
cause the reattribution of current gross income to the same extent as 
disregarded payments to and from foreign branches and foreign branch 
owners. The gross income attributed to a non-branch taxable unit after 
taking into account all the disregarded payments that it makes and 
receives must then be further attributed to a foreign branch (if it is 
part of a ``foreign branch group''), or foreign branch owner (if it is 
part of a ``foreign branch owner group''), to the extent of its 
ownership of the non-branch taxable unit. For this purpose, a non-
branch taxable unit is part of either a foreign branch group or a 
foreign branch owner group to the extent it is owned, including 
indirectly through other non-branch taxable units, by a foreign branch 
or a foreign branch owner, respectively. The gross income that is 
attributed to the members of a foreign branch group is attributed to 
the foreign branch that owns the group, and the gross income that is 
attributed to the members of a foreign branch owner group is attributed 
to the foreign branch owner that owns the group.
    The proposed regulations also clarify that the reattribution of 
gross income by reason of disregarded payments is capped at the amount 
of current gross income in the payor foreign branch or foreign branch 
owner. See proposed Sec.  1.904-4(f)(2)(vi)(A).
    Finally, the proposed regulations include more detailed rules on 
the treatment of payments between foreign branches, and provide an 
example illustrating the application of the matching rule in Sec.  
1.1502-13 to the rules in Sec.  1.904-4(f)(2)(vi) in response to a 
comment received with respect to the 2019 FTC proposed regulations. See 
proposed Sec.  1.904-4(f)(4)(xiii) through (xv) (Examples 13 through 
15).

B. Financial Services Entities

    Section 904(d)(2)(D)(i) provides that financial services income can 
only be received or accrued by a person ``predominantly engaged in the 
active conduct of a banking, insurance, financing, or similar 
business.'' The 2019 FTC proposed regulations modified the definition 
of a financial services entity (``FSE'') by adopting a definition of 
``predominantly engaged in the active conduct of a banking, insurance, 
financing, or similar business'' and ``income derived in the active 
conduct of a banking, insurance, financing, or similar business.'' As 
discussed in the preamble to the 2020 FTC final regulations, in 
response to comments made in response to the 2019 FTC proposed 
regulations, the Treasury Department and the IRS determined that these 
provisions of the 2019 FTC proposed regulations should be revised and 
reproposed to provide an additional opportunity for comment.
    The proposed regulations retain the general approach of the 
existing Sec.  1.904-4(e) final regulations by providing a numerical 
test whereby an entity is a financial services entity if more than a 
threshold percentage of its gross income is derived directly from 
active financing income, and the regulations continue to contain a list 
of income that qualifies as active financing income. However, the 
proposed regulations lower the threshold from 80 percent to 70 percent, 
and further provide that active financing income must generally be 
earned from customers or other counterparties that are not related 
parties. These changes will promote simplification and greater 
consistency between Code provisions that have complementary policy 
objectives, while still taking into account the differences between 
sections 954 and 904. The modified rule also makes clear that internal 
financing companies do not qualify as financial services entities if 70 
percent or less of their gross income meets the unrelated customer 
requirement. In addition, the proposed regulations modify Sec.  1.904-
5(b)(2) to provide that the look-through rules in Sec.  1.904-5 apply 
in all cases to assign related party payments attributable to passive 
category income to the passive category, including in the case of 
related party payments made to a financial services entity. Comments 
are requested on the treatment of related party payments in the 
numerator and denominator of the 70-percent gross income test, and 
whether related party payments should in some cases constitute active 
financing income.
    In the case of an insurance company's income from investments, the 
Treasury Department and the IRS recognize that an insurance company 
must hold passive investment assets to support its insurance 
obligations, including capital and surplus in addition to insurance 
reserves, to ensure the company's ability to satisfy insurance 
liabilities if claims are greater than anticipated or investment 
returns are less than anticipated. However, the Treasury Department and 
the IRS have determined that limits on the amount of an insurance 
company's investment income that may be treated as active financing 
income are appropriate in cases where an insurance company holds 
substantially more investment assets and earns substantially more 
passive investment income than necessary to support its insurance 
business. Thus, proposed Sec.  1.904-4(e)(2)(ii) imposes a cap on the 
amount of an insurance company's income from investments that may be 
treated as active financing income. The cap is determined based on an 
applicable percentage of the insurance company's total insurance 
liabilities. If investment income exceeds the insurance company's 
investment income limitation, investment income in excess of the 
limitation is not considered ordinary and necessary to the proper 
conduct of the company's insurance business and will not qualify as 
active financing income.
    The Treasury Department and the IRS request comments on the 
investment income limitation rule and in particular on whether the 
applicable percentages selected for life and nonlife insurance 
companies are reasonable.

X. Sections 901(a) and 905(a)--Rules Regarding When the Foreign Tax 
Credit Can Be Claimed

A. Background

    Section 901(a) provides that a taxpayer has the option, for each 
taxable year, to claim a credit for foreign income taxes paid or 
accrued to a foreign country in such taxable year, subject to the 
limitations under section 904. Alternatively, a taxpayer may deduct the 
foreign income taxes under section 164(a)(3). The deduction and credit 
for

[[Page 72100]]

foreign income taxes are mutually exclusive; section 275(a)(4) provides 
that no deduction shall be allowed for foreign income taxes if the 
taxpayer chooses to take to any extent the benefits of section 901. 
Section 1.901-1(c) of the existing regulations, which clarifies the 
application of section 275(a)(4), provides that if a taxpayer chooses 
with respect to any taxable year to claim a credit for taxes to any 
extent, such choice will be considered to apply to all taxes paid or 
accrued in such taxable year to all foreign countries, and no portion 
shall be allowed as a deduction in such taxable year or any succeeding 
taxable year.
    Section 901(a) further provides that the choice to claim the 
foreign tax credit for any taxable year ``may be made or changed at any 
time before the expiration of the period prescribed for making a claim 
for credit or refund of the tax imposed by this chapter for such 
taxable year.'' Section 6511 prescribes the periods for making a claim 
for credit or refund of U.S. tax. The default period under section 
6511(a) is three years from the time the taxpayer filed the relevant 
return or two years from when the tax is paid, whichever is later. 
Section 6511(d) sets forth special periods of limitation for making a 
claim of credit or refund of U.S. tax that is attributable to 
particular attributes. Under section 6511(d)(3), if the refund relates 
to an overpayment attributable to any taxes paid or accrued to any 
foreign country for which credit is allowed under section 901, the 
taxpayer has 10 years from the un-extended due date of the return for 
the taxable year in which the foreign taxes are paid or accrued to file 
the claim. See Sec.  301.6511(d)-3. Section 6511(d)(2) sets out a 
special limitations period for refund claims ``attributable to a net 
operating loss carryback'' of three years from the due date of the 
return for the year in which the net operating loss originated. The 
existing regulations at Sec.  1.901-1(d) provide that a taxpayer can 
claim the benefits of section 901 (or claim a deduction in lieu of a 
foreign tax credit) at any time before the expiration of the period 
prescribed by section 6511(d)(3)(A).
    Section 905(a) and Sec.  1.905-1(a) of the existing regulations 
provide that a taxpayer may claim a credit for foreign income taxes 
either in the year the taxes accrue or in the year the taxes are paid, 
depending on the taxpayer's method of accounting. Sections 1.446-1(c) 
and 1.461-1 provide rules for when income and liabilities are taken 
into account for taxpayers using the cash receipts and disbursement 
method of accounting (cash method) and for taxpayers using the accrual 
method of accounting. Under Sec.  1.461-1(a)(1), cash method taxpayers 
generally take into account allowable deductions in the taxable year in 
which paid. For accrual method taxpayers, Sec.  1.461-1(a)(2) provides 
that liabilities are taken into account in the taxable year in which 
all the events have occurred that establish the fact of the liability, 
the amount of the liability can be determined with reasonable accuracy, 
and economic performance has occurred with respect to the liability. If 
the liability of a taxpayer is to pay a tax, economic performance 
occurs as the tax is paid to the governmental authority that imposed 
the tax. See Sec.  1.461-4(g)(6)(i). However, in the case of foreign 
income taxes, economic performance occurs when the requirements of the 
all events test, other than economic performance, are met, whether or 
not the taxpayer elects to credit such taxes under section 901. See 
Sec.  1.461-4(g)(6)(iii)(B). In the case of foreign income taxes 
imposed on the basis of a taxable period, because all of the events 
that fix the fact and amount of liability for the foreign tax with 
reasonable accuracy do not occur until the end of the foreign taxable 
year, such foreign income taxes accrue and are creditable in the U.S. 
tax year within which the taxpayer's foreign taxable year ends. See 
Sec.  1.960-1(b)(4); Revenue Ruling 61-93, 1961-1 C.B. 390.
    Section 905(a) also provides that, regardless of the taxpayer's 
method of accounting, a taxpayer can elect to claim the foreign tax 
credit in the year in which the taxes accrue. Once made, this election 
is irrevocable and must be followed in all subsequent years. In 
addition, courts have held that the election to claim the foreign tax 
credit on the accrual basis cannot be made on an amended return. See 
Strong v. Willcuts, 17 AFTR 1027 (D. Minn.) (1935) (holding that 
taxpayer may not change to accrual basis on an amended return because 
when the taxpayer made an election that the Government has accepted, 
the rights of the parties became fixed); see also Rev. Rul. 59-101, 
1959-1 C.B. 189 (holding that a taxpayer who elected on his original 
return to claim credit for foreign income tax accrued may not change 
this election and file amended returns to claim credit for foreign 
taxes in the year paid). However, for the year the election is made, a 
taxpayer can claim a credit both for taxes that accrue in that year as 
well as taxes paid in such year that had accrued in prior years. See 
Ferrer v. Comm'r, 35 T.C. 617 (1961) (holding that a cash method 
taxpayer is entitled, in the year he elects pursuant to section 905(a) 
to claim foreign tax credits on the accrual basis, to claim a credit 
for prior years' foreign income taxes paid as well as foreign income 
taxes accrued in that year), rev'd on other grounds, 304 F.2d 125 (2d 
Cir. 1962).
    With respect to the accrual of a contested tax, the Supreme Court 
held in Dixie Pine Products Co. v. Comm'r, 320 U.S. 516 (1944), that a 
state income tax that is contested is not fixed, and so does not 
accrue, until the contest is resolved. See also section 461(f) (rule 
permitting taxpayers to deduct contested taxes in the year in which 
they are paid does not apply to foreign income taxes). The contested 
tax doctrine, however, does not apply in determining when foreign taxes 
accrue for purposes of the foreign tax credit. See Cuba Railroad Co. v. 
United States, 124 F. Supp. 182, 185 (S.D.N.Y. 1954) (holding that 
taxes with respect to taxpayer's 1943 income accrued for purposes of 
the foreign tax credit in 1943 even though the tax was contested and 
paid in a later year). In Revenue Ruling 58-55, 1958-1 C.B. 266, the 
IRS examined Dixie Pine and Cuba Railroad, as well as the legislative 
history and purpose of the foreign tax credit provisions, and concluded 
that a contested foreign tax does not accrue until the contest is 
resolved and the liability becomes finally determined, but for foreign 
tax credit purposes, the foreign tax, once finally determined, is 
considered to accrue in the taxable year to which it relates. The 
revenue ruling further clarified that this ``relation back'' rule does 
not apply for purposes of determining the taxable year in which foreign 
taxes may be deducted under section 164, which is governed by the 
contested tax doctrine.
    The relation back rule has since been consistently applied by 
courts. See, for example, United States v. Campbell, 351 F.2d 336, 338 
(2d Cir. 1965) (explaining that if a taxpayer contests his liability 
for a foreign tax imposed on income in 1960, and the liability is 
finally adjudicated in 1965, the taxpayer may not claim the credit 
until 1965, but at that time the credit relates back to offset U.S. tax 
imposed on taxpayer's 1960 income); Albemarle Corp. & Subsidiaries v. 
United States, 797 F.3d 1011, 1019 (Fed. Cir. 2015) (holding that in 
the context of determining in what year a taxpayer is eligible to claim 
a foreign tax credit, the relation back doctrine applies, and thus the 
10-year limitations period for filing a refund claim started to run 
from the un-extended due date for the return for the year to which the 
tax relates, not the later year in which the contest was resolved). In 
Revenue Ruling 70-290,

[[Page 72101]]

1970-1 C.B. 160, the IRS held that contested taxes that have been paid 
to the foreign country may be provisionally accrued and claimed as a 
foreign tax credit, even if the liability has not actually accrued 
because the taxpayer continues to contest its liability for the tax in 
the foreign country. The revenue ruling reasons that this is 
permissible because section 905(c) would require a redetermination of 
U.S. tax liability if the taxpayer's contest is successful, and the 
foreign tax is refunded to the taxpayer by the foreign government. 
Revenue Ruling 84-125, 1984-2 C.B. 125, similarly held that a taxpayer 
is eligible to claim a credit for the portion of contested taxes that 
have actually been paid for the taxable year in which the contested 
liability relates because such taxes are accruable at the time of 
payment, even though the amount of the liability is not finally 
determined.
    The Treasury Department and the IRS received comments in response 
to the 2019 FTC proposed regulations asking for clarification on when 
contested taxes accrue for purposes of the foreign tax credit and for 
clarification regarding whether the special period of limitations in 
section 6511(d)(3)(A) applies in the case of a refund claim relating to 
foreign income taxes that a taxpayer chose to deduct. Questions have 
also arisen regarding whether taxpayers can make an election to claim 
the foreign tax credit or revoke such an election (in order to deduct 
the foreign taxes) on an amended return when making or revoking such 
election results in a time-barred U.S. tax deficiency in one or more 
intervening years because the assessment statute under section 6501 
does not align with the time for making or changing the election under 
Sec.  1.901-1(d).
    These proposed regulations provide rules clarifying when a foreign 
tax credit may be taken for both cash method taxpayers and for accrual 
method taxpayers, and in the case of accrual method taxpayers, clarify 
the application of the relation-back doctrine. The proposed regulations 
also modify the period during which a taxpayer can change the choice to 
claim a credit or a deduction for foreign income taxes on an amended 
return to align with the different refund periods under section 6511. 
The proposed regulations also clarify that a change from claiming a 
deduction to claiming a credit, or vice versa, for foreign income taxes 
results in a foreign tax redetermination under section 905(c). In 
addition, the proposed regulations address mismatch and time-barred 
deficiency issues resulting from the application of the relation-back 
doctrine for the accrual of foreign income taxes for purposes of the 
foreign tax credit, and the application of the contested tax doctrine 
for purposes of determining when foreign income taxes can be deducted.

B. Rules for Choosing To Deduct or Credit Foreign Income Taxes

1. Application of Section 275(a)(4)
    Section 1.901-1(c) of the existing regulations, interpreting 
section 275(a)(4), provides that if a taxpayer chooses to claim a 
foreign tax credit to any extent with respect to the taxable year, such 
choice applies to all creditable taxes and no deduction for any such 
taxes is allowed in such taxable year or in any succeeding taxable 
year. Questions have arisen as to whether this rule prevents taxpayers 
from claiming either the benefit of a credit or a deduction with 
respect to additional taxes that are paid in a taxable year in which a 
taxpayer claims a foreign tax credit if those additional taxes relate 
(under the relation-back doctrine) to an earlier year in which taxpayer 
claimed a deduction. As described in Part X.A of this Explanation of 
Provisions, additional tax paid by an accrual method taxpayer (or a 
cash method taxpayer that has elected to claim foreign tax credits 
using the accrual method) as a result of a foreign tax audit or at the 
end of a contest relate back and are considered to accrue in the 
taxable year to which the taxes relate. Thus, the additional taxes are 
not creditable in the year they are paid and would only be creditable 
in the relation-back year. However, if a taxpayer deducted foreign 
income taxes in the relation-back year, the taxpayer cannot claim an 
additional deduction in the earlier year because the additional taxes 
accrue for deduction purposes in the year the additional taxes are 
paid.
    The Treasury Department and the IRS have determined that this 
result is not intended by section 275(a)(4), the purpose of which is to 
prevent taxpayers from claiming the benefits of both a credit and a 
deduction with respect to the same taxes. Thus, the proposed 
regulations provide an exception which allows a taxpayer that is 
claiming credits on an accrual basis to claim, in a year in which it 
has elected to claim a credit for foreign income taxes that accrue in 
that year, also to deduct additional taxes paid in that year that, for 
foreign tax credit purposes, relate back and are considered to accrue 
in a prior year in which the taxpayer deducted foreign income taxes. 
See proposed Sec.  1.901-1(c)(3).
2. Period Within Which an Election To Claim a Foreign Tax Credit Can Be 
Made or Changed
    The proposed regulations also modify Sec.  1.901-1(d), which sets 
forth the period during which a taxpayer can make or change its 
election to claim a foreign tax credit. Existing Sec.  1.901-1(d), 
which was amended in 1987 under TD 8160 (52 FR 33930-02), provides that 
a taxpayer can, for a particular taxable year, claim the benefits of 
section 901 or claim a deduction in lieu of a foreign tax credit at any 
time before the expiration of the period prescribed by section 
6511(d)(3)(A) (or section 6511(c) if the period is extended by 
agreement). The 1987 amendment was preceded by cases in which courts 
determined that the applicable period of limitations for making an 
initial election to claim a foreign tax credit under section 901 is the 
special 10-year period in section 6511(d)(3)(A). See Woodmansee v. 
United States, 578 F.2d 1302 (9th Cir. 1978); Hart v. United States, 
585 F.2d 1025 (Ct. Cl. 1978) (also holding that prior regulations, 
which required taxpayers to make the election to claim a foreign tax 
credit within the three-year period prescribed by 6511(a), were 
invalid).
    However, as recent court decisions have made clear, the 10-year 
statute of limitations in section 6511(d)(3)(A) applies only to claims 
for credit or refund of U.S. taxes attributable to foreign income taxes 
for which the taxpayer was allowed a credit; it does not apply in the 
case of a claim for credit or refund of U.S. taxes attributable to 
foreign income taxes for which a taxpayer claimed a deduction under 
section 164(a)(3). See, for example, Trusted Media Brands, Inc. v. 
United States, 899 F.3d 175 (2d Cir. 2018). In addition, the reason for 
the special period of limitations provided by section 6511(d)(3) is to 
allow taxpayers to seek a refund of U.S. tax if foreign taxes were 
assessed or increased after the regular three-year statute of 
limitations period has run, and to better align with the IRS' ability 
to assess additional U.S. tax under section 905(c) when a taxpayer 
receives a refund of the foreign income tax claimed as a credit. The 
special period of limitations is not needed when a taxpayer instead 
claims a deduction, because accrued foreign income taxes do not relate 
back for deduction purposes, and the additional tax paid as a result of 
the foreign assessment can be claimed as a deduction in the year the 
contest is resolved.
    Therefore, the Treasury Department and the IRS have determined that 
the

[[Page 72102]]

better interpretation of section 901(a) is that the period for choosing 
or changing the election to claim a credit or a deduction is based on 
the applicable refund period, depending on the choice made. Thus, an 
election to claim a credit, or to change from claiming a deduction to 
claiming a credit, for taxes paid or accrued in a particular year must 
be made before the expiration of the 10-year period prescribed by 
section 6511(d)(3)(A) within which a claim for refund attributable to 
foreign tax credits may be made, but a choice to claim a deduction, or 
to change from claiming a credit to claiming a deduction, for taxes 
paid or accrued in a particular year must be made before the expiration 
of the three-year period prescribed by section 6511(a) within which a 
claim for refund attributable to a section 164 deduction may be made. 
See proposed Sec.  1.901-1(d). This proposed rule eliminates the 
mismatch between the election and refund periods that exists under the 
existing regulations, whereby a taxpayer who makes a timely election to 
change from claiming a credit to claiming a deduction within a 10-year 
period may in some cases be time-barred from obtaining a refund of U.S. 
taxes attributable to the resulting decrease in taxable income for the 
deduction year. In addition, the proposed rule is consistent with the 
court's decision in each of Hart and Woodmansee, since it allows 
taxpayers to elect to claim a credit within the 10-year period provided 
by section 6511(d)(3)(A).
3. Change in Election Treated as a Foreign Tax Redetermination Under 
Section 905(c)
    As part of the 2019 FTC final regulations, the Treasury Department 
and the IRS issued final regulations under Sec.  1.905-3 to provide 
guidance on when foreign tax redeterminations occur. Section 1.905-3(a) 
provides that a foreign tax redetermination means a change in the 
liability for a foreign income tax or certain other changes that affect 
a taxpayer's foreign tax credit. Consistent with section 905(c), this 
includes when foreign income taxes for which a taxpayer claimed a 
credit are refunded, foreign income taxes when paid or later adjusted 
differ from amounts a taxpayer claimed as a credit or added to PTEP 
group taxes, and when accrued taxes are not paid within 24 months of 
the close of the taxable year to which the taxes relate. The 2020 FTC 
final regulations further modify the definition of foreign tax 
redetermination to include changes to foreign income tax liability that 
affect a taxpayer's U.S. tax liability even when there is no change to 
the amount of foreign tax credits claimed, such as when a change to 
foreign taxes affects subpart F and GILTI inclusion amounts or affects 
whether or not a CFC's subpart F income and tested income is eligible 
for the high-tax exception under section 954(b)(4) in the year to which 
the redetermined foreign tax relates.
    These proposed regulations further amend Sec.  1.905-3 to provide 
that a foreign tax redetermination includes a change by a taxpayer in 
its decision to claim a credit or a deduction for foreign income taxes 
that may affect a taxpayer's U.S. tax liability. Section 905(c)(1)(A) 
provides that a foreign tax redetermination is required ``if accrued 
taxes when paid differ from the amounts claimed as credits by the 
taxpayer.'' When a taxpayer changes its election from claiming a credit 
to claiming a deduction, or vice versa, with respect to foreign income 
taxes paid or accrued in a particular year, the amount of tax that was 
accrued and paid differs from the amount that has been claimed as a 
credit by the taxpayer. Accordingly, a change in a taxpayer's election 
to claim a credit or a deduction for foreign income taxes is described 
in section 905(c)(1)(A) even if the foreign income tax liability 
remains unchanged.
    This interpretation is consistent with the purpose of section 
905(c) and within the constraints courts have placed in interpreting 
the provision. As noted by the court in Texas Co. (Caribbean) Ltd. v. 
Comm'r, 12 T.C. 925 (1949), section 905(c) addresses problems for which 
the relevant information might not be available within the general 
period of limitations or ones where the taxpayer has exclusive control 
of the information, which justify removing these situations from the 
generally-applicable period of limitations on assessment. The court in 
Texas Co. held that a U.S. tax deficiency that results from a 
computational error, which was discoverable by the IRS within the 
normal assessment period, is not within the scope of section 905(c). A 
taxpayer's decision to change its election can occur outside the normal 
assessment period under section 6501(a) and is information that is 
under the exclusive control of the taxpayer. Thus, the Treasury 
Department and the IRS have determined that it is appropriate to treat 
a change in election as a foreign tax redetermination that requires a 
redetermination of U.S. tax liability for the affected years and 
notification of the IRS to the extent required under Sec.  1.905-4.
    The effect of treating a change in a taxpayer's decision to claim a 
credit or a deduction for foreign income taxes as a foreign tax 
redetermination is that the IRS may assess and collect any U.S. tax 
deficiencies in intervening years that result from the taxpayer's 
change in election, even if the generally-applicable three-year 
assessment period under section 6501(a) has expired. See section 
6501(c)(5). This can occur, for example, if a timely change to switch 
from deductions originally claimed in a loss year (to increase a net 
operating loss) to credits (in order to claim a carryforward of excess 
foreign taxes in a later year) would result in a time-barred deficiency 
in a year to which the net operating loss that was increased by the 
deductions for foreign taxes was originally carried. Currently, the law 
is unclear how section 274(a)(4), equitable doctrines such as the duty 
of consistency, or the mitigation provisions under sections 1311 
through 1314 operate to prevent taxpayers from obtaining a double 
benefit (through both a deduction and a credit) for a single amount of 
foreign income tax paid. These uncertainties have led taxpayers to 
request guidance from the IRS to clarify the effect of a timely change 
in election on their U.S. tax liabilities. The proposed regulations 
provide a clear and efficient process by which taxpayers can eliminate 
uncertainty with respect to the tax consequences of changing from 
claiming a credit to claiming a deduction, or vice versa, for foreign 
income taxes, within the time period allowed.

C. Rules for When a Cash Method Taxpayer Can Claim the Foreign Tax 
Credit

    Proposed Sec.  1.905-1(c) provides rules on when foreign income 
taxes are creditable for taxpayers using the cash method of accounting. 
Consistent with Sec.  1.461-1(a)(1), which provides that for taxpayers 
using the cash method, amounts representing allowable deductions are 
taken into account in the taxable year in which they are paid, proposed 
Sec.  1.905-1(c)(1) provides that foreign income taxes are creditable 
in the taxable year in which they are paid. Foreign income taxes are 
generally considered paid in the year the taxes are remitted to the 
foreign country. However, foreign income taxes that are withheld from 
gross income by the payor are considered paid in the year withheld. See 
proposed Sec.  1.905-1(c)(1). As discussed in Part VI.B of this 
Explanation of Provisions, taxes that are not paid within the meaning 
of Sec.  1.901-2(e) because they exceed a reasonable approximation of 
the taxpayer's final foreign income tax liability are not eligible for 
a foreign tax credit.
    The regulations at Sec.  1.905-3(a) further provide that a refund 
of foreign income taxes that have been claimed as a credit

[[Page 72103]]

in the year paid, or a subsequent determination that the amount paid 
exceeds the taxpayer's liability for foreign income tax, is a foreign 
tax redetermination under section 905(c), and the taxpayer must file an 
amended return and redetermine its U.S. tax liability for the affected 
years. However, additional taxes that are paid by a cash method 
taxpayer in a later year with respect to a prior year do not relate 
back to the prior year, nor do they result in a redetermination of 
foreign income taxes paid and U.S. tax lability under section 905(c) 
for the prior year; instead, those additional taxes are creditable in 
the year in which they are paid.
    Proposed 1.905-1(e) sets forth rules for cash method taxpayers 
electing to claim foreign tax credits on an accrual basis. As provided 
by section 905(a), this election is irrevocable, and once made, must be 
followed in all subsequent years, and consistent with the holding in 
Strong v. Willcuts, the election generally cannot be made on an amended 
return. See proposed Sec.  1.905-1(e)(1). However, the proposed 
regulations provide exceptions to these general rules in order to 
ensure that a taxpayer who makes this election to switch from claiming 
credits on a cash basis to an accrual basis is not double taxed in 
certain situations. First, proposed Sec.  1.905-1(e)(2) provides that a 
taxpayer who has previously never claimed a foreign tax credit may make 
the election to claim the foreign tax credit on an accrual basis when 
the taxpayer claims the credit, even if such initial claim for credit 
is made on an amended return. In addition, following the decision in 
Ferrer v. CIR, proposed Sec.  1.905-1(e)(3) provides that, for the 
taxable year in which the accrual election is made and for the 
subsequent years in which a taxpayer claims a foreign tax credit on an 
accrual basis, that taxpayer can claim a foreign tax credit for taxes 
paid in the year, if pursuant to the rules for accrual method taxpayers 
that are described in Part X.D of this Explanation of Provisions, those 
taxes paid relate to a taxable year before the taxpayer elected to 
claim credits on an accrual basis. The Treasury Department and the IRS 
have determined that this result is appropriate because otherwise 
taxpayers that make the accrual election would, in effect, have to 
forego a credit for prior year taxes, unless the election is made for 
the very first year in which a credit is claimed.

D. Rules for Accrual Method Taxpayers

1. In General
    Proposed Sec.  1.905-1(d)(1) provides general rules for when 
taxpayers using the accrual method of accounting can claim a foreign 
tax credit. This determination requires applying the all events test 
contained in Sec.  1.461-1. In accordance with Sec.  1.461-1(a)(2)(i), 
foreign income taxes accrue in the taxable year in which all the events 
have occurred that establish the fact of liability, and the amount of 
the liability can be determined with reasonable accuracy. See also 
Sec.  1.461-4(g)(6)(iii)(B) (economic performance with respect to 
foreign income taxes occurs when the requirements of the all events 
test, other than the payment prong of the economic performance 
requirement, are met). The proposed regulations confirm that where the 
all events test has not been met with respect to a foreign income tax 
liability, such as in the case where the tax liability is contingent 
upon a distribution of earnings, such taxes have not accrued and may 
not be claimed as a credit. See proposed Sec.  1.905-1(d)(1)(i).
    Proposed Sec.  1.905-1(d)(1)(ii) incorporates the relation-back 
doctrine, and provides that, for foreign tax credit purposes, once the 
all events test is met, the foreign income taxes relate back and are 
considered to accrue in the year to which the taxes relate, the 
``relation-back year.'' For example, additional taxes paid as a result 
of a foreign adjustment relate back and are considered to accrue at the 
end of the foreign taxable year(s) with respect to which the taxes were 
adjusted. Thus, the additional taxes paid in the later year are 
creditable in the relation-back year, not in the year in which the 
additional taxes are paid. See proposed Sec.  1.905-1(d)(6)(iii) 
(Example 3); see also Sec.  1.905-3(b)(1)(ii)(A) (Example 1). Moreover, 
in the case of foreign income taxes which are treated as refunded 
pursuant to Sec.  1.905-3(a) because they were not paid within 24 
months of the close of the taxable year in which they first accrued, 
proposed Sec.  1.905-1(d)(1)(ii) provides that when payment is later 
made, the taxes are considered to accrue in the relation-back year.
2. Special Rule for 52-53 Week Taxable Years
    Consistent with Revenue Ruling 61-93, the proposed regulations 
provide that the liability for a foreign tax becomes fixed on the last 
day of the taxpayer's foreign taxable year; thus, foreign income taxes 
generally accrue and are creditable in the taxpayer's U.S. taxable year 
with or within which its foreign taxable year ends. However, the 
Treasury Department and the IRS have determined that it is appropriate 
to provide a limited exception to this rule in order to address 
mismatches that occur for taxpayers that elect to use a 52-53 week 
taxable year for U.S. tax purposes under Sec.  1.441-2. Section 1.441-2 
permits certain eligible taxpayers to elect to use a fiscal year that 
(i) varies from 52 to 53 weeks in length, (ii) always ends on the same 
day of the week, and (iii) ends either on the same day of the week that 
last occurs in a calendar month or on whatever date the same day of the 
week falls that is nearest to the last day of the calendar month.
    A taxpayer that adopts a 52-53 week year, or that changes from a 
52-53 week year to another fiscal year, without changing its foreign 
taxable year, will often have a short taxable year that does not 
include the foreign year-end. That short U.S. taxable year would 
include substantially all of the foreign income but none of the related 
foreign taxes. Similarly, a taxpayer that uses a 52-53 week year for 
U.S. tax purposes but that uses a foreign tax year that ends on a fixed 
month-end will in some years have a U.S. taxable year that does not 
include a foreign year-end and in other years have a U.S. taxable year 
that includes two foreign year-ends. For example, a taxpayer who uses a 
52-53 week year that ends on the last Friday of December for U.S. tax 
purposes would have a tax year that begins Saturday, December 26, 2020, 
and that ends Friday, December 31, 2021, which includes two calendar 
year-ends. The following taxable year, which begins on Saturday, 
January 1, 2022, and ends on Friday, December 30, 2022, would not 
include a calendar year-end.
    Proposed Sec.  1.905-1(d)(2) addresses these mismatches by 
providing that where a U.S. taxpayer uses a 52-53 week taxable year 
that ends by reference to the same calendar month as its foreign 
taxable year, and the U.S taxable year closes within 6 days of the 
close of the foreign taxable year, then for purposes of determining the 
amount of foreign income tax that accrues during the U.S. taxable year, 
the U.S. taxable year will be deemed to end on the last day of its 
foreign taxable year.
3. Accrual of Contested Foreign Income Taxes
    The Treasury Department and IRS have determined that the 
administrative rulings that allow an accrual method taxpayer to claim a 
foreign tax credit for a contested tax that has been remitted to a 
foreign country, notwithstanding the fact that the contest is ongoing, 
are inconsistent with the all events test

[[Page 72104]]

(specifically, the test's requirement that all the events must have 
occurred that establish the fact and amount of the liability with 
reasonable accuracy).\4\ In addition, permitting taxpayers to claim a 
credit for contested taxes before the contest is resolved reduces the 
incentive for taxpayers to continue to pursue the contest and exhaust 
all effective and practical remedies, as required under Sec.  1.901-
2(e)(5)(i), if the period of assessment for the year to which the taxes 
relate has closed and the IRS would be time-barred from disallowing the 
foreign tax credit claimed with respect to the contested tax paid on 
noncompulsory payment grounds. The Treasury Department and the IRS have 
determined that this is an inappropriate result that undermines the 
longstanding policy for requiring an amount of foreign income tax to be 
a compulsory payment in order to be creditable.
---------------------------------------------------------------------------

    \4\ See Rev. Rul. 70-290, 1970-1 C.B. 160, and Rev. Rul. 84-125, 
1984-2 C.B. 125, discussed in Part X.A of this Explanation of 
Provisions.
---------------------------------------------------------------------------

    Therefore, the proposed regulations provide new rules for when a 
credit for contested foreign income taxes can be claimed. Following the 
Supreme Court's holding in Dixie Pine, and consistent with the 
exception to section 461(f) and Sec.  1.461-2(a)(2)(i) for foreign 
income taxes, proposed Sec.  1.905-1(d)(3) provides that contested 
foreign income taxes do not accrue until the contest is resolved, 
because only then is the amount of the foreign income tax liability 
finally determined. Thus, contested foreign income taxes accrue and are 
creditable only when resolution of the contest establishes the fact and 
the amount of a liability with reasonable accuracy, even if the 
taxpayer remits the contested taxes to the foreign country in an 
earlier year. When the contest is resolved, the liability accrues and, 
for foreign tax credit purposes, relates back and is considered to 
accrue in the earlier year to which the liability relates. Once the 
finally determined liability has been paid, as required by section 
905(c)(2)(B) and Sec.  1.905-3(a), the taxpayer can claim a foreign tax 
credit in the relation-back year.
    However, the Treasury Department and the IRS recognize that a 
taxpayer may be placed in a difficult position if it pays the contested 
tax to the foreign country (which it may do, for example, to toll the 
accrual of interest owed to the foreign country) but cannot be made 
whole until the contest is resolved, possibly years later. Thus, the 
proposed regulations provide that a taxpayer may elect to claim a 
provisional credit for the portion of the taxes paid, even though the 
contest is not resolved and the amount of the liability is not yet 
fixed. See proposed Sec.  1.905-1(d)(4). As a condition for making this 
election, a taxpayer must agree to give the IRS an opportunity to 
examine whether the taxpayer exhausted all effective and practical 
remedies when the contest is concluded by agreeing to notify the IRS 
when the contest concludes and by agreeing to not assert the statute of 
limitations as a defense to the assessment of additional taxes and 
interest if the IRS determines that the tax was not a compulsory 
payment. The proposed regulations require taxpayers making this 
election to file with their amended return (for the year in which the 
credit is claimed) a provisional foreign tax credit agreement meeting 
the conditions under proposed Sec.  1.905-1(d)(4)(ii) through (iv) and 
to file annual certifications notifying the IRS of the status of the 
contest.
    The Treasury Department and the IRS intend to withdraw Revenue 
Ruling 70-290 and Revenue Ruling 84-125 when the proposed regulations 
are finalized. Taxpayers can make the election under proposed Sec.  
1.905-1(d)(4) for contested taxes remitted in taxable years beginning 
on or after the date the proposed regulations are finalized but that 
relate to an earlier taxable year. See proposed Sec.  1.905-1(h).
4. Correction of Improper Accruals
    The proposed regulations address issues that arise when an accrual 
method taxpayer, including a foreign corporation or a partnership or 
other pass-through entity, has established an improper method of 
accounting for accruing foreign income taxes. A taxpayer generally 
establishes an improper method of accounting for an item once it has 
treated the item consistently in two consecutive tax years (see Rev. 
Rul. 90-38, 1990-1 CB 57). Proposed Sec.  1.905-1(d)(5)(i) provides 
that the time at which a taxpayer accrues a foreign income tax expense 
generally is treated as a method of accounting, regardless of whether 
the taxpayer or the owners of the foreign corporation, partnership or 
other pass-through entity claim credits or deductions for those taxes. 
Therefore, taxpayers must comply with the procedures set forth in 
Revenue Procedure 2015-13, 2015-5 I.R.B. 419, or successor 
administrative procedures, to obtain the Commissioner's consent before 
changing from an improper method to a proper method of accruing foreign 
income taxes.
    The proposed regulations provide specific rules, under a ``modified 
cut-off'' approach, for adjusting the amount of foreign income taxes 
that can be claimed as a credit or deduction in the year that a 
taxpayer changes from an improper to a proper method of accruing 
foreign income taxes (and in subsequent years, if applicable) in order 
to prevent a duplication or omission of any amount of foreign income 
tax paid. Proposed Sec.  1.905-1(d)(5)(ii) requires taxpayers to adjust 
the amount of foreign income tax that is assigned under Sec.  1.861-20 
to each statutory or residual grouping (such as separate categories) 
and that properly accrues in the year of change, accounted for in the 
currency in which the foreign tax liability is denominated, (1) 
downward by the amount of foreign income tax in the same grouping that 
was improperly accrued and claimed as a credit or a deduction in a 
taxable year before the year of change (``pre-change year'') and that 
did not properly accrue in any pre-change year, and (2) upward by the 
amount of foreign income tax in the same grouping that properly accrued 
in a pre-change year but which the taxpayer, under its improper method 
of accounting, failed to accrue and claim as either a credit or a 
deduction in any pre-change year. To the extent that the required 
amount of the downward adjustment exceeds the amount of properly-
accrued foreign income tax in the year of change, the balance carries 
forward to offset properly-accrued taxes in subsequent years.
    Proposed Sec.  1.905-1(d)(5)(iii) provides rules coordinating the 
application of the rules under section 905(c) with the rules in 
proposed Sec.  1.905-1(d)(5). Under proposed Sec.  1.905-1(d)(5)(iii), 
the determination of whether an improperly-accrued foreign income tax 
was paid within 24 months of the close of the taxable year to which the 
taxes relate for purposes of section 905(c)(2) will be measured from 
the close of the taxable year(s) in which the taxpayer accrued the tax. 
Any payment of properly-accrued tax in and after the year of change 
that is offset by the downward adjustment required by proposed Sec.  
1.905-1(d)(5)(ii) and so not allowed as a foreign tax credit or 
deduction in that year is treated as a payment of the foreign income 
tax improperly accrued in pre-change years, in order, based on the most 
recently-accrued amounts.
    Finally, proposed Sec.  1.905-1(d)(5)(iv) provides that when a 
foreign corporation, partnership, or other pass-through entity changes 
from an improper method of accruing foreign income taxes, the rules in 
Sec.  1.905-1(d)(5) apply as if the foreign corporation, partnership or 
other pass-through entity were eligible to, and did, claim foreign tax 
credits. Comments are

[[Page 72105]]

requested on additional adjustments that may be required to prevent an 
omission or duplication of a tax benefit for foreign income taxes that 
have been improperly accrued (or which the taxpayer has improperly 
failed to accrue) under the taxpayer's improper method of accounting. 
Comments are also requested on alternative methods for implementing a 
method change involving the improper accrual of foreign income taxes.

E. Creditable Foreign Tax Expenditures of Partnerships and Other Pass-
Through Entities

    The proposed regulations provide rules that clarify when foreign 
income taxes paid or accrued by a partnership or other pass-through 
entity (that is, foreign income taxes for which the pass-through entity 
is considered to be legally liable under Sec.  1.901-2(f)) can be 
claimed as a credit or deduction by such entity's partners, 
shareholders, or beneficiaries. Consistent with the rules in Sec. Sec.  
1.702-1(a)(6) and 1.703-1(b)(2), proposed Sec.  1.905-1(f) provides 
that a partner that elects to claim a foreign tax credit in a taxable 
year may claim its distributive share of foreign income taxes that the 
partnership paid or accrued (as determined under the partnership's 
method of accounting) during the partnership's taxable year that ends 
with or within the partner's taxable year. Thus, the pass-through 
entity's method of accounting for foreign income taxes generally 
controls for purposes of determining the taxable year in which a 
partner is considered to pay or accrue its distributive share of those 
taxes. Therefore, a cash method taxpayer may claim a credit for its 
distributive share of an accrual method partnership's foreign income 
taxes even if the partnership has not paid (that is, remitted) the 
taxes to the foreign country during the partner's taxable year with or 
within which the partnership's tax expense accrued, so long as those 
taxes otherwise qualify for the credit, and subject to the rules of 
section 905(c)(2)(A) (treating accrued foreign taxes as refunded if not 
paid within 24 months). The rules in proposed Sec.  1.905-1(f) also 
apply in the case of shareholders of a S corporation, beneficiaries of 
an estate or trust, or other owners of a pass-through entity with 
respect to foreign income taxes paid or accrued by such entities.
    With respect to a contested foreign tax liability of a pass-through 
entity, the proposed regulations provide that the entity takes into 
account and reports a contested foreign income tax to its partners, 
shareholders, beneficiaries, or other owners only when the contest 
concludes and the finally determined amount of the liability has been 
paid by the entity. This rule takes into account the requirement in 
section 905(c)(2)(B) and Sec.  1.905-3(a) that a foreign tax that first 
accrues more than 24 months after the close of the taxable year to 
which the tax relates can only be claimed as a credit once the tax has 
been paid. See proposed Sec.  1.905-1(f)(1). However, proposed Sec.  
1.905-1(f)(2) allows a partner or other owner of a pass-through entity 
to claim a provisional foreign tax credit for its share of a contested 
foreign income tax liability that the entity has paid to the foreign 
country pursuant to the procedures in proposed Sec.  1.905-1(d)(4). As 
required by Sec. Sec.  1.905-3(a) and 1.905-4(b), a pass-through entity 
is required to notify the IRS and its partners, shareholders, or 
beneficiaries if there is a foreign tax redetermination with respect to 
foreign income tax previously reported to its partners, shareholders, 
or beneficiaries.

F. Conforming Changes to Regulations Under Section 960

    Existing regulations under section 960 provide a definition of a 
current year tax that includes language regarding the timing of accrual 
of a foreign income tax, including the timing of accrual of additional 
payments of foreign income tax resulting from a foreign tax 
redetermination. These proposed regulations revise this definition to 
cross-reference the proposed rules in Sec.  1.905-1 regarding when 
foreign income taxes are considered to be paid or accrued for foreign 
tax credit purposes.
    In addition, existing rules exclude from the definition of a 
foreign income tax a levy for which a credit is disallowed at the level 
of a controlled foreign corporation. The proposed regulations revise 
the definition of a foreign income tax in Sec.  1.960-1(b) to include a 
levy that is a foreign income tax within the meaning of proposed Sec.  
1.901-2(a), including a levy for which a credit is disallowed at the 
level of the controlled foreign corporation. These changes are 
necessary to clarify that a foreign income tax for which a credit is 
disallowed is nonetheless an item of expense that must be allocated and 
apportioned to an income group under the rules of Sec.  1.960-1(d) in 
order to determine the amount of net income in each income group.
    Finally, proposed Sec.  1.960-1(b)(5) introduces a new defined 
term, ``eligible current year taxes,'' that refers to current year 
taxes for which a foreign tax credit may be allowed. This change is 
necessary to ensure that the current year taxes that are deemed paid 
under sections 960(a) and (d) comprise only current year taxes that are 
eligible for a foreign tax credit. Conforming changes to Sec.  1.960-2 
are proposed to provide that deemed paid computations are made only 
with respect to eligible current year taxes. Additional conforming 
changes will be proposed to Sec.  1.960-3 to address the computation of 
deemed paid taxes under section 960(b) as part of future proposed 
regulations under section 959.

XI. Applicability Dates

    The rules in Sec. Sec.  1.164-2(d), 1.336-2(g)(3)(ii) and (iii), 
1.338-9(d), 1.368(b)-10(c)(1), 1.861-9(k), 1.861-10(f) and (g), 1.861-
14(h), 1.861-20(h), 1.901-1, 1.901-2, 1.903-1, 1.904-4(e)(1)(ii) and 
(e)(2) and (3), 1.904-5(b)(2), 1.905-1, 1.905-3(a) and (b)(4), 1.960-
1(b)(4) through (6), and 1.960-1(c)(1)(ii) through (iv) and 
(d)(3)(ii)(B) generally apply to taxable years beginning on or after 
the date final regulations adopting these rules are filed with the 
Federal Register.
    Consistent with the prospective applicability date in the section 
250 regulations, the revisions to Sec. Sec.  1.250(b)-1(c)(7) and 
1.250(b)-5(c)(5) apply to taxable years beginning on or after January 
1, 2021. See Sec.  1.250-1(b).
    The rules in proposed Sec. Sec.  1.367(b)-4(b)(2)(i)(B), 1.367(b)-
7(g), 1.367(b)-10(c)(1), 1.861-3(d), 1.861-8(e)(4)(i), and 1.861-
10(e)(8)(v) generally apply to taxable years ending on or after 
November 2, 2020.
    Proposed Sec. Sec.  1.245A(d)-1, 1.861-20 (other than proposed 
Sec.  1.861-20(h)), 1.904-4(f), and 1.904-6(b)(2) apply to taxable 
years that begin after December 31, 2019, and end on or after November 
2, 2020.
    Finally, proposed Sec.  1.904(f)-12(j)(5) applies to carrybacks of 
net operating losses incurred in taxable years beginning after December 
31, 2017, which is consistent with the applicability date in the CARES 
Act with respect to net operating loss carrybacks. See Public Law 116-
136, 134 Stat. 355, section 2303(d), (2020); see also section 
7805(b)(2).

Special Analyses

I. Regulatory Planning and Review

    Executive Orders 13771, 13563 and 12866 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits (including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity). Executive 
Order 13563

[[Page 72106]]

emphasizes the importance of quantifying both costs and benefits, 
reducing costs, harmonizing rules, and promoting flexibility. The 
Executive Order 13771 designation for any final rule resulting from 
these proposed regulations will be informed by comments received.
    The proposed regulations have been designated by the Office of 
Information and Regulatory Affairs (OIRA) as subject to review under 
Executive Order 12866 pursuant to the Memorandum of Agreement (MOA, 
April 11, 2018) between the Treasury Department and the Office of 
Management and Budget regarding review of tax regulations. The Office 
of Information and Regulatory Affairs has designated these regulations 
as economically significant under section 1(c) of the MOA. Accordingly, 
the OMB has reviewed these regulations.

A. Background and Need for the Proposed Regulations

    The U.S. foreign tax credit (FTC) regime alleviates potential 
double taxation by allowing a non-refundable credit for foreign income 
taxes paid or accrued that could be applied to reduce the U.S. tax on 
foreign source income. Although the Tax Cuts and Jobs Act (TCJA) 
eliminated the U.S. tax on some foreign source income by enacting a 
dividends received deduction, the United States continues to tax other 
foreign source income, and to provide foreign tax credits against this 
U.S. tax. The calculation of how foreign taxes can be credited against 
U.S. tax operates by defining different categories of foreign source 
income (a ``separate category'') based on the type of income.\5\ 
Foreign taxes paid or accrued, as well as deductions for expenses borne 
by U.S. parents and domestic affiliates that support foreign 
operations, are allocated to the separate categories based on the 
income to which such taxes or deductions relate. These allocations of 
deductions reduce foreign source taxable income and therefore reduce 
the allowable FTCs for the separate category, since FTCs are limited to 
the U.S. income tax on the foreign source taxable income (that is, 
foreign source gross income less allocated expenses) in that separate 
category. Therefore, these expense allocations help to determine how 
much foreign tax credit is allowable, and the taxpayer can then use 
allowable foreign tax credits allocated to each separate category 
against the U.S. tax owed on income in that category.
---------------------------------------------------------------------------

    \5\ Before the TCJA, these categories were primarily the passive 
income and general income categories. The TCJA added new separate 
categories for global intangible low-taxed income (the section 951A 
category) and foreign branch income.
---------------------------------------------------------------------------

    The Code and existing regulations further provide definitions of 
the foreign taxes that constitute creditable foreign taxes. Section 901 
allows a credit for foreign income taxes, war profits taxes, and excess 
profits taxes. The existing regulations under section 901 define these 
``foreign income taxes'' such that a foreign levy is an income tax if 
it is a tax whose predominant character is that of an income tax in the 
U.S. sense. Under the existing regulations, this requires that the 
foreign tax is likely to reach net gain in the normal circumstances in 
which it applies (the ``net gain requirement''), and that it is not a 
so-called soak-up tax.
    The ``net gain requirement'' is made up of the realization, gross 
receipts, and net income requirements, and the existing regulations 
define in detail their meaning. Generally, the creditability of the 
foreign tax under the existing regulations relies on the definition of 
an income tax under U.S. principles, and on several aggregate empirical 
tests designed to determine if in practice the tax base upon which the 
tax is levied is an income tax base. However, compliance and 
administrative challenges faced by taxpayers and the IRS in 
implementing the existing definition of an income tax under these 
regulations necessitate changes to the existing structure. These 
proposed regulations set forth such changes.
    Additionally, as a dollar-for-dollar credit against United States 
income tax, the foreign tax credit is intended to mitigate double 
taxation of foreign source income. This fundamental purpose is most 
appropriately served if there is substantial conformity in the 
principles used to calculate the base of the foreign tax and the base 
of the U.S. income tax, not only with respect to the definition of the 
income tax base, but also with respect to the jurisdictional nexus upon 
which the tax is levied. The Treasury Department and the IRS have 
received requests for guidance with respect to a jurisdictional 
limitation, and recommending that the regulations adopt a rule 
necessitating some form of nexus rule for creditable taxes. Further, 
countries, including the United States, have traditionally adhered to 
consensus-based norms governing jurisdictional nexus for the imposition 
of tax. However, the adoption or potential adoption by foreign 
countries of novel extraterritorial foreign taxes that diverge in 
significant respects from these norms of taxing jurisdiction now 
suggests that further guidance is appropriate to ensure that creditable 
foreign taxes in fact have a predominant character of ``an income tax 
in the U.S. sense.''
    Finally, these regulations are necessary in order to respond to 
outstanding comments raised with respect to other regulations and in 
order to address a variety of issues arising from the interaction of 
provisions in other regulations.
    The Treasury Department and the IRS issued final regulations in 
2019 (84 FR 69022) (2019 FTC final regulations) and proposed 
regulations (84 FR 69124) (2019 FTC proposed regulations), which are 
being finalized in this issue of the Federal Register as part of the 
2020 FTC final regulations. The Treasury Department and the IRS 
received comments with respect to the 2019 FTC proposed regulations, 
some of which are addressed in these proposed regulations (instead of 
the 2020 FTC final regulations) in order to allow further opportunity 
for notice and comment.
    The following analysis provides an overview of the regulations, 
discussion of the costs and benefits of these regulations as compared 
with the baseline, and a discussion of alternative policy choices that 
were considered.

B. Overview of the Structure of and Need for Proposed Regulations

    These proposed regulations address a variety of outstanding issues, 
most importantly with respect to the existing definition of an income 
tax. Section 901 allows a credit for foreign income taxes, and the 
existing regulations define the conditions under which foreign taxes 
will be considered income taxes. These proposed regulations revise 
aspects of this definition in light of challenges that taxpayers and 
the IRS have faced in applying the rules. In particular, the 
requirements in the existing regulations presuppose conclusions based 
on country-level or other aggregated data that can be difficult for 
taxpayers and the IRS to analyze for purposes of determining net gain, 
causing both administrative and compliance burdens and difficulties 
resolving disputes. Therefore, the proposed regulations revise the net 
gain requirements such that, in cases where data-driven conclusions 
have been difficult to establish historically, the requirements rely 
less on data of the effects of the foreign tax, and instead rely more 
on the terms of the foreign tax law (See Part VI.A.3 of the Explanation 
of Provisions for additional detail, and Part I.C.3.i. of this Special 
Analyses for alternatives considered and affected taxpayers). For 
example, a foreign tax, to be creditable, must generally be levied on 
gross receipts (and certain deemed gross receipts) net of deductions. 
Under these

[[Page 72107]]

proposed regulations, the use of data to demonstrate that an 
alternative receipts base upon which the tax is levied is in practice a 
gross receipts equivalent cannot be used to satisfy the gross receipts 
portion of the net gain requirement.
    In addition to these changes, the proposed regulations introduce a 
jurisdictional limitation for purposes of determining whether a foreign 
tax is an income tax in the U.S. sense; that is, the foreign tax law 
must require a sufficient nexus between the foreign country and the 
taxpayer's activities or investment of capital or other assets that 
give rise to the income being taxed. Therefore, a tax imposed by a 
foreign country on income that lacks sufficient nexus to activity in 
the foreign country (such as operations, employees, factors of 
production) in a country is not creditable. This limitation is designed 
to ensure that the foreign tax is an income tax in the U.S. sense by 
requiring that there is an appropriate nexus between the taxable amount 
and the taxing foreign jurisdiction (see Part VI.A.2 of the Explanation 
of Provisions for additional detail, and Part I.C.3.ii of this Special 
Analyses for discussion of alternatives considered and taxpayers 
affected). Together, the clarifications and changes introduced in the 
net gain requirement and the jurisdictional nexus requirement will 
tighten the rules governing the creditability of foreign taxes and will 
likely restrict creditability of foreign taxes to some extent relative 
to the existing regulations.
    Finally, these proposed regulations address other issues raised in 
comments or resulting from other legislation. For example, comments 
asked for clarification of uncertainty regarding the appropriate level 
of aggregation (affiliated group versus subgroup) at which expenses of 
life insurance companies should be allocated to foreign source income, 
and comments asked for clarification on when contested taxes (that is, 
taxes owed to a foreign government which a taxpayer disputes) accrue 
for purposes of the foreign tax credit. With respect to the life 
insurance issue, the 2019 FTC proposed regulations specified an 
allocation method, but requested comments regarding whether another 
method might be superior. Subsequent comments supported both methods 
for different reasons, and the Treasury Department and the IRS found 
both methods to have merit. Therefore, the proposed regulations allow 
taxpayers to choose the most appropriate method for their 
circumstances. (See Part V.E of the Explanation of Provisions for 
additional detail, and Part I.C.3.iii of this Special Analyses for 
alternatives considered and affected taxpayers).
    With respect to the contested tax issue, the proposed regulations 
establish that contested taxes do not accrue (and therefore cannot be 
claimed as a credit) until the contest is resolved; however, the 
proposed regulations will allow taxpayers to claim a provisional credit 
for the portion of taxes already paid to the foreign government, if the 
taxpayer agrees to notify the IRS when the contest concludes and agrees 
not to assert the statute of limitations as a defense to assessment of 
U.S. tax if the IRS determines that the taxpayer failed to take 
appropriate steps to secure a refund of the foreign tax. (See Part X.D 
of the Explanation of Provisions for additional detail, and Part 
I.C.3.iv of this Special Analyses for alternatives considered and 
affected taxpayers). In this way, the proposed regulations alleviate 
taxpayer cash flow constraints that could result from temporary double 
taxation during the period of dispute resolution, while still providing 
the taxpayer with the incentive to resolve the tax dispute and 
providing the IRS with the ability to ensure that appropriate action 
was taken regarding dispute resolution.
    The guidance and specificity provided by these regulations clarify 
which foreign taxes are creditable as income taxes, and (with respect 
to contested taxes) when they are creditable. The guidance also helps 
to resolve uncertainty and more generally to address issues raised in 
comments.

C. Economic Analysis

1. Baseline
    In this analysis, the Treasury Department and the IRS assess the 
benefits and costs of these proposed regulations relative to a no-
action baseline reflecting anticipated Federal income tax-related 
behavior in the absence of these regulations.
2. Summary of Economic Effects
    The proposed regulations provide certainty and clarity to taxpayers 
regarding the creditability of foreign taxes. In the absence of the 
enhanced specificity provided by these regulations, similarly situated 
taxpayers might interpret the creditability of taxes differently, 
particularly with respect to new extraterritorial taxes, potentially 
resulting in inefficient patterns of economic activity. For example, 
some taxpayers may forego specific economic projects, foreign or 
domestic, that other taxpayers deem worthwhile based on different 
interpretations of the tax consequences alone. The guidance provided in 
these regulations helps to ensure that taxpayers face more uniform 
incentives when making economic decisions. In general, economic 
performance is enhanced when businesses face more uniform signals about 
tax treatment.
    In addition, these regulations generally reduce the compliance and 
administrative burdens associated with information collection and 
analysis required to claim foreign tax credits, relative to the no-
action baseline. The regulations achieve this reduction because they 
rely to a significantly lesser extent on data-driven conclusions than 
the regulatory approach provided in the existing regulations and 
instead rely more on the terms and structure of the foreign tax law.
    To the extent that taxpayers, in the absence of further guidance, 
would generally interpret the existing foreign tax credit rules as 
being more favorable to the taxpayer than the proposed regulations 
provide, the proposed regulations may result in reduced international 
activity relative to the no-action baseline. This reduced activity may 
have included both activities that could have been beneficial to the 
U.S. economy (perhaps because the activities would have represented 
enhanced international opportunities for businesses with U.S. owners) 
and activities that may not have been beneficial (perhaps because the 
activities would have been accompanied by reduced activity in the 
United States). Thus, the Treasury Department and the IRS recognize 
that foreign economic activity by U.S. taxpayers may be a complement or 
substitute to activity within the United States and that to the extent 
these regulations lead to a reduction in foreign economic activity 
relative to the no-action baseline, a mix of results may occur. To the 
extent that foreign governments, in response to these proposed 
regulations, alter their tax regimes to reduce their reliance on taxes 
that are not income taxes in the U.S. sense, any such reduction in 
foreign economic activity by U.S. taxpayers as a result of these 
proposed regulations, relative to the no-action baseline, will be 
mitigated.
    The Treasury Department and the IRS project that the regulations 
will have economic effects greater than $100 million per year ($2020) 
relative to the no-action baseline. This determination is based on the 
substantial size of many of the businesses potentially affected by 
these regulations and the general responsiveness of business activity 
to

[[Page 72108]]

effective tax rates,\6\ one component of which is the creditability of 
foreign taxes. Based on these two magnitudes, even modest changes in 
the treatment of foreign taxes, relative to the no-action baseline, can 
be expected to have annual effects greater than $100 million ($2020).
---------------------------------------------------------------------------

    \6\ See E. Zwick and J. Mahon, ``Tax Policy and Heterogeneous 
Investment Behavior,'' at American Economic Review 2017, 107(1): 
217-48 and articles cited therein.
---------------------------------------------------------------------------

    The Treasury Department and the IRS have not undertaken 
quantitative estimates of the economic effects of these regulations. 
The Treasury Department and the IRS do not have readily available data 
or models to estimate with reasonable precision (i) the tax stances 
that taxpayers would likely take in the absence of the proposed 
regulations or under alternative regulatory approaches; (ii) the 
difference in business decisions that taxpayers might make between the 
proposed regulations and the no-action baseline or alternative 
regulatory approaches; or (iii) how this difference in those business 
decisions will affect measures of U.S. economic performance.
    In the absence of such quantitative estimates, the Treasury 
Department and the IRS have undertaken a qualitative analysis of the 
economic effects of the proposed regulations relative to the no-action 
baseline and relative to alternative regulatory approaches. This 
analysis is presented in Part I.C.3 of this Special Analyses.
    The Treasury Department and the IRS solicit comments on this 
economic analysis and particularly solicit data, models, or other 
evidence that may be used to enhance the rigor with which the final 
regulations might be developed.
3. Options Considered and Number of Affected Taxpayers, by Specific 
Provisions
i. ``Net Gain Requirement'' for Determining a Creditable Foreign Tax
a. Summary
    Under existing rules, a foreign tax is creditable if it reaches 
``net gain,'' which is determined based in part on data-driven 
analysis. Therefore, under the existing rules, a gross basis tax can in 
certain cases be creditable if it can be shown that the tax as applied 
does not result in taxing more than the taxpayer's profit. In certain 
cases, in order to determine creditability, the IRS requests country-
level or other aggregate data to analyze whether the tax reaches net 
gain. The creditability determination is made based on data with 
respect to a foreign tax in its entirety, as it is applied for all 
taxpayers. In other words, the tax is creditable or not creditable 
based on its application to all taxpayers rather than on a taxpayer-by-
taxpayer basis. However, different taxpayers can and do take different 
positions with respect to what the language of the existing regulations 
and the empirical tests imply about creditability.
b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS considered three options to 
address concerns with the ``net gain'' test. The first option is not to 
implement any changes and to continue to determine the definition of a 
foreign income tax based in part on conclusions based on country-level 
or other aggregate data. This option would mean that the determination 
of whether a tax satisfies the definition of foreign income tax would 
continue to be administratively difficult for taxpayers and the IRS, in 
part because it requires the IRS and the taxpayer to obtain information 
from the foreign country to determine how the tax applies in practice 
to taxpayers subject to the tax. The existing regulations apply a 
``predominant character'' analysis such that deviations from the net 
gain requirement do not cause a tax to fail this requirement if the 
predominant character of the tax is that of an income tax in the U.S. 
sense. For example, the existing regulations allow a credit for a 
foreign tax whose base, judged on its predominant character, is 
computed by reducing gross receipts by significant costs and expenses, 
even if gross receipts are not reduced by all allocable costs and 
expenses. This requires some judgment in determining whether the 
exclusion of some costs and expenses causes the tax to fail the net 
gain requirement.
    The second option considered is not to use data-driven conclusions 
for any portion of the net gain requirement and rely only on foreign 
tax law to make the determination. This rule would be easier to apply 
compared with the first option because it requires looking only at 
foreign law, regulations, and rulings. However, this option could 
result in an overly harsh outcome, to the extent the rules determine 
whether a levy is an income tax in its entirety (that is, not on a 
taxpayer-by-taxpayer basis). For example, if a country had a personal 
income tax that satisfied all the requirements, except that the country 
also included imputed rental income in the tax base, the Treasury 
Department and the IRS would not necessarily want to disallow as a 
credit the entire personal income tax system of that country due to the 
one deviation from U.S. tax law definitions of income tax. As part of 
this option, the Treasury Department and the IRS therefore considered 
also allowing a parsing of each tax for conforming and non-conforming 
parts. For example, in the prior example, only a portion of the income 
tax could be disallowed (that is, the portion attributable to imputed 
rental income). However, this approach would be extremely complicated 
to administer since there would need to be special rules for 
determining which portion of the tax relates to the non-conforming 
parts and which do not. It would also imply that taxpayers could not 
know from the outset whether a particular levy is an income tax but 
would instead have to analyze the tax in each fact and circumstances in 
which it applied to a particular taxpayer.
    The third option considered is to use data-driven conclusions only 
for portions of the net gain requirement. The net gain requirement 
consists of three requirements: The realization requirement, the gross 
receipts requirement, and the cost recovery requirement. The Treasury 
Department and the IRS considered retaining data-based conclusions in 
portions of the realization requirement and the cost-recovery 
requirement but removing them in the gross receipts requirement. This 
is the approach taken in these regulations. In these regulations, the 
cost recovery requirement retains the rule that the tax base must allow 
for recovery of significant costs and expenses. Data are still used in 
the cost recovery analysis to determine whether a cost or expense is 
significant with respect to all taxpayers.
    Because these options differ in terms of the creditability of 
foreign taxes, they may increase or decrease foreign activity by U.S. 
taxpayers. The Treasury Department and the IRS have not projected the 
differences in economic activity across the three alternatives because 
they do not have readily available data or models that capture these 
effects. It is anticipated that the proposed regulations will reduce 
taxpayer compliance costs relative to the baseline by significantly 
reducing the circumstances in which taxpayers must incur costs to 
obtain data (which may or may not be readily available) in order to 
evaluate the creditability of a tax.
    The Treasury Department and the IRS do not have data or models that 
would allow them to quantify the reduced administrative burden 
resulting from these final regulations relative to alternative 
regulatory approaches. The Treasury Department and the IRS expect

[[Page 72109]]

that the regulations will reduce administrative burden and compliance 
burdens because the collection and analysis of empirical data is time 
consuming for taxpayers and the IRS, and the existing regulations have 
resulted in a variety of disputes. Hence a reduction in required data 
collection should reduce burdens. Further, greater reliance on legal 
definitions rather than empirical review of available data has the 
potential to reduce the number of disputes, which also should reduce 
burdens.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS have determined that the 
population of taxpayers potentially affected by the net gain provisions 
of the proposed regulations includes any taxpayer with foreign 
operations claiming foreign tax credits (or with the potential to claim 
foreign tax credits). Based on currently available tax filings for tax 
year 2018, there were about 9.3 million Form 1116s filed by U.S. 
individuals to claim foreign tax credits with respect to foreign taxes 
paid on individual, partnership, or S corporation income. There were 
17,500 Form 1118s filed by C corporations to claim foreign tax credits 
with respect to foreign taxes paid. In addition, there were about 
16,500 C corporations with CFCs that filed at least one Form 5471 with 
their Form 1120 return, indicating a potential to claim a foreign tax 
credit even if no credit was claimed in 2018. Similarly, in these data 
there were about 41,000 individuals with CFCs that e-filed at least one 
Form 5471 with their Form 1040 return. In 2018, there were about 3,250 
S corporations with CFCs that filed at least one Form 5471 with their 
Form 1120S return. The identified S corporations had an estimated 
23,000 shareholders. Finally, the Treasury Department and the IRS 
estimate that there were approximately 7,500 U.S. partnerships with 
CFCs that e-filed at least one Form 5741 in 2018. The identified 
partnerships had approximately 1.7 million partners, as indicated by 
the number of Schedules K-1 filed by the partnerships; however, this 
number includes both domestic and foreign partners. Furthermore, there 
is, likely to be some overlap between the Form 5471 and the Form 1116 
and/or 1118 filers.
    These numbers suggest that between 9.3 million (under the 
assumption that all Form 5471 filers or shareholders of filers also 
filed Form 1116 or 1118) and 11 million (under the assumption that 
filers or shareholders of filers of Form 5471 are a separate pool from 
Form 1116 and 1118 filers) taxpayers will potentially be affected by 
these regulations. Based on Treasury tabulations of Statistics of 
Income data, the total volume of foreign tax credits reported on Form 
1118 in 2016 was about 90 billion dollars. Data do not exist that would 
allow the Treasury Department or the IRS to identify how this total 
volume might change as a result of these regulations; however, the 
Treasury Department and the IRS anticipate that only a small fraction 
of existing FTCs would be impacted by these regulations.
ii. Jurisdictional Nexus
a. Summary
    Rules under existing Sec.  1.901-2 do not explicitly require, for 
purposes of determining whether a foreign tax is a creditable foreign 
income tax, the tax to be imposed only on income that has a 
jurisdictional nexus (or adequate connection) to the country imposing 
the tax. In order ensure that creditable taxes under section 901 
conform to traditional international norms of taxing jurisdiction and 
therefore are income taxes in the U.S. sense, these regulations add a 
jurisdictional nexus requirement.
b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS considered the following three 
options for designing a nexus requirement. The first option considered 
is to create a jurisdictional nexus requirement based on Articles 5 
(Permanent Establishment) and 7 (Business Profits) in the U.S. Model 
Income Tax Convention (the ``U.S. Convention''). The U.S. Convention 
includes widely accepted and understood standards with respect to a 
country's right to tax a nonresident's income. The relevant articles of 
the U.S. Convention generally require a certain presence or level of 
activity before the country can impose tax on business income, and the 
tax can only be imposed on income that is attributable to the business 
activity. This option was rejected due to concerns that this standard 
would be too rigid and prescriptive, and such a rigid standard is not 
necessary; there are numerous departures from the U.S. Convention in 
both domestic laws and bilateral treaties, which are not considered 
problematic because they are not considered significant deviations from 
international norms.
    The second option considered was to create a jurisdictional nexus 
requirement based on Code section 864, which contains a standard for 
income effectively connected with the conduct of a U.S. trade or 
business (ECI). The Code does not provide a definition of U.S. trade or 
business; it is instead defined in case law, and the definition is 
therefore not strictly delineated. This option was therefore rejected 
as potentially being too broad, and not necessarily targeting the 
primary concern with respect to the new extraterritorial taxes, which 
is that, in contrast to traditional international income tax norms 
governing the creditability of taxes, they are imposed based on the 
location of customers or users, or other destination-based criteria.
    The third option considered was to require that foreign tax imposed 
on a nonresident must be based on the nonresident's activities located 
in the foreign country (including its functions, assets, and risks 
located in the foreign country) without taking into account as a 
significant factor the location of customers, users, or similar 
destination-based criteria. This more narrowly tailored approach better 
addresses the concern that extraterritorial taxes that are imposed on 
the basis of location of customers, users, or similar criteria should 
not be creditable under traditional norms reflected in the Internal 
Revenue Code that govern nexus and taxing rights and therefore should 
be excluded from creditable income taxes. Taxes imposed on nonresidents 
that would meet the Code-based ECI requirement could qualify, as well 
as taxes that would meet the permanent establishment and business 
profit standard under the U.S. Convention. This is the option adopted 
by the Treasury Department and the IRS.
    This approach is consistent with the fact that under traditional 
norms reflected in the Internal Revenue Code, income tax is generally 
imposed taking into account the location of the operations, employees, 
factors of production, residence, or management of the taxpayer. In 
contrast, consumption taxes such as sales taxes, value-added taxes, or 
so-called destination based income taxes are generally imposed on the 
basis of location of customers, users, or similar destination-based 
criteria. Although the tax incidence of these two groups of taxes may 
vary, tax incidence does not play a role in the definition of an income 
tax in general, or an income tax in the U.S. sense. Therefore, the 
choice among regulatory options was based on which option most closely 
aligned the definition of foreign income taxes to taxes that are income 
taxes in the U.S. sense.
    The Treasury Department and the IRS have not attempted to estimate 
the

[[Page 72110]]

differences in economic activity that might result under each of these 
regulatory options because they do not have readily available data or 
models that capture (i) the jurisdictional nexus of taxpayers' 
activities under the different regulatory approaches and (ii) the 
economic activities that taxpayers might undertake under different 
jurisdictional nexus criteria. The Treasury Department and the IRS 
further have not attempted to estimate the difference in compliance 
costs under each of these regulatory options.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS have determined that the 
population of taxpayers potentially affected by the jurisdictional 
nexus provisions of the proposed regulations includes any taxpayer with 
foreign operations claiming foreign tax credits (or with the potential 
to claim foreign tax credits). Based on currently available tax filings 
for tax year 2018, there were about 9.3 million Form 1116s filed by 
U.S. individuals to claim foreign tax credits with respect to foreign 
taxes paid on individual, partnership, or S corporation income. There 
were 17,500 Form 1118s filed by C corporations to claim foreign tax 
credits with respect to foreign taxes paid. In addition, there were 
about 16,500 C corporations with CFCs that filed at least one Form 5471 
with their Form 1120 return, indicating a potential to claim a foreign 
tax credit, even if no credit was claimed in these years. Similarly, 
for the same period, there were about 41,000 individuals with CFCs that 
e-filed at least one Form 5471 with their Form 1040 return. In 2018, 
there were about 3,250 S corporations with CFCs that filed at least one 
Form 5471 with their Form 1120S return. The identified S corporations 
had an estimated 23,000 shareholders. Finally, the Treasury Department 
and the IRS estimate that there were approximately 7,500 U.S. 
partnerships with CFCs that e-filed at least one Form 5471 in 2018. The 
identified partnerships had approximately 1.7 million partners, as 
indicated by the number of Schedules K-1 filed by the partnerships; 
however, this number includes both domestic and foreign partners. 
Furthermore, there is likely to be overlap between the Form 5471 and 
the Form 1116 and/or 1118 filers.
    These numbers suggest that between 9.3 million (under the 
assumption that all Form 5471 filers or shareholders of filers also 
filed Form 1116 or 1118) and 11 million (under the assumption that 
filers or shareholders of filers of Form 5471 are a separate pool from 
Form 1116 and 1118 filers) taxpayers will potentially be affected by 
these regulations. Based on Treasury Department tabulations of 
Statistics of Income data, the total volume of foreign tax credits 
reported on Form 1118 in 2016 was about 90 billion dollars. Data do not 
exist that would allow us to identify how this total volume might 
change as a result of these regulations; however, the Treasury 
Department and the IRS anticipate that only a small fraction of 
existing FTCs would be impacted by these regulations.
iii. Allocation and Apportionment of Expenses for Insurance Companies
a. Summary
    Section 818(f) provides that for purposes of applying the expense 
allocation rules to a life insurance company, the deduction for 
policyholder dividends, reserve adjustments, death benefits, and 
certain other amounts (``section 818(f) expenses'') are treated as 
items that cannot be definitely allocated to an item or class of gross 
income. That means, in general, that the expenses are apportioned 
ratably across all of the life insurance company's gross income.
    Under the expense allocation rules, for most purposes, affiliated 
groups are treated as a single entity, although there are exceptions 
for certain expenses. The statute is unclear, however, about how 
affiliated groups are to be treated with respect to the allocation of 
section 818(f) expenses of life insurance companies. Depending on how 
section 818(f) expenses are allocated across an affiliated group, the 
results could be different because the gross income categories across 
the affiliated group could be calculated in multiple ways. The Treasury 
Department and the IRS received comments and are aware that in the 
absence of further guidance taxpayers are taking differing positions on 
this treatment. Some taxpayers argue that the expenses described in 
section 818(f) should be apportioned based on the gross income of the 
entire affiliated group, while others argue that expenses should be 
apportioned on a separate company or life subgroup basis taking into 
account only the gross income of life insurance companies.
b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS are aware of at least five 
potential methods for allocating section 818(f) expenses in a life-
nonlife consolidated group. First, the expenses might be allocated 
solely among items of the life insurance company that has the reserves 
(``separate entity method''). Second, to the extent the life insurance 
company has engaged in a reinsurance arrangement that constitutes an 
intercompany transaction (as defined in Sec.  1.1502-13(b)(1)), the 
expenses might be allocated in a manner that achieves single entity 
treatment between the ceding member and the assuming member (``limited 
single entity method''). Third, the expenses might be allocated among 
items of all life insurance members (``life subgroup method''). Fourth, 
the expenses might be allocated among items of all members of the 
consolidated group (including both life and non-life members) (``single 
entity method''). Fifth, the expenses might be allocated based on a 
facts and circumstances analysis (``facts and circumstances method'').
    The 2019 FTC proposed regulations proposed adopting the separate 
entity method because it is consistent with section 818(f) and with the 
separate entity treatment of reserves under Sec.  1.1502-13(e)(2). The 
Treasury Department and the IRS recognized, however, that this method 
may create opportunities for consolidated groups to use intercompany 
transactions to shift their section 818(f) expenses and achieve a more 
advantageous foreign tax credit result. Accordingly, the Treasury 
Department and the IRS requested comments on whether a life subgroup 
method more accurately reflects the relationship between section 818(f) 
expenses and the income producing activities of the life subgroup as a 
whole, and whether the life subgroup method is less susceptible to 
abuse because it might prevent a consolidated group from inflating its 
foreign tax credit limitation through intercompany transfers of assets, 
reinsurance transactions, or transfers of section 818(f) expenses. 
Comments received supported both methods and the Treasury Department 
and the IRS have concluded that the life subgroup method should 
generally be used, because it minimizes opportunities for abuse and is 
more consistent with the general rules allocating expenses among 
affiliated group members. However, recognizing that the single entity 
method also has merit, the proposed regulations permit a taxpayer to 
make a one-time election to use the separate entity method for all life 
insurance members in the affiliated group. This election is binding for 
all future years and may not be revoked without the consent of the 
Commissioner. Because the election is binding and applies to all 
members of the group, taxpayers will not be able to change allocation

[[Page 72111]]

methods from year to year depending on which is most advantageous. The 
Treasury Department and the IRS may consider future proposed 
regulations to address any additional anti-abuse concerns (such as 
under section 845), if needed.
    The Treasury Department and the IRS have not attempted to assess 
the differences in economic activity that might result under each of 
these regulatory options because they do not have readily available 
data or models that capture activities at this level of specificity. 
The Treasury Department and the IRS further have not estimated the 
difference in compliance costs under each of these regulatory options 
because they lack adequate data.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS have determined that the 
population of taxpayers potentially affected by these insurance expense 
allocation rules consists of life insurance companies that are members 
of an affiliated group. The Treasury Department and the IRS have 
established that there are approximately 60 such taxpayers.
iv. Creditability of Contested Foreign Income Taxes
a. Summary
    Section 901 allows a taxpayer to claim a foreign tax credit for 
foreign income taxes paid or accrued (depending on the taxpayer's 
method of accounting) in a taxable year. Foreign income taxes accrue in 
the taxable year in which all the events have occurred that establish 
the fact of the liability and the amount of the liability can be 
determined with reasonable accuracy (``all events test''). When a 
taxpayer disputes or contests a foreign tax liability with a foreign 
country, that contested tax does not accrue until the contest concludes 
because only then can the amount of the liability be finally 
determined. However, under two IRS revenue rulings (Rev. Ruls. 70-290 
and 84-125), a taxpayer is allowed to claim a credit for the portion of 
a contested tax that the taxpayer has actually paid to the foreign 
country, even though the taxpayer continues to dispute the liability. 
While this alleviates taxpayer cash flow constraints associated with 
temporary double taxation, it is not fully consistent with the all 
events test. In addition, it potentially disincentivizes the taxpayer 
from continuing to contest the foreign tax, since the tax is already 
credited and the dispute could be time-consuming and costly, which 
could result in U.S. tax being reduced by foreign tax in excess of 
amounts properly due.
b. Options Considered for the Proposed Regulations
    The Treasury Department and the IRS considered three options for 
the treatment of contested foreign taxes. The first option considered 
is to not make any changes to the existing rule and to continue to 
allow taxpayers to claim a credit for a foreign tax that is contested 
but that has been paid to the foreign country. The Treasury Department 
and the IRS determined that this option is inconsistent with the all 
events test. It would also result in a taxpayer potentially having two 
foreign tax redeterminations (FTRs) with respect to one contested 
liability: One FTR at the time the taxpayer pays the contested tax to 
the foreign country, and a second FTR when the contest concludes (if 
the finally determined liability differs from the amount that was paid 
and claimed as a credit). Furthermore, this option impinges on the 
IRS's ability to enforce the requirement in existing Sec.  1.902-1(e) 
that a tax has to be a compulsory payment in order to be creditable--if 
a taxpayer claims a credit for a contested tax, then surrenders the 
contest once the assessment statute closes, the IRS would be time-
barred from challenging that the tax was not creditable on the grounds 
that the taxpayer failed to exhaust all practical remedies.
    The second option considered is to only allow taxpayers to claim a 
credit when the contest concludes. In some cases, the taxpayer must pay 
the tax to the foreign country in order to contest the tax or in order 
to stop the running of interest in the foreign country. This option 
would leave the taxpayer out of pocket to two countries (potentially 
giving rise to cash flow issues for the taxpayer) while the contest is 
pending, which could take several years. The Treasury Department and 
the IRS determined that this outcome is unduly harsh.
    The third option considered is to allow taxpayers the option to 
claim a provisional credit for an amount of contested tax that is 
actually paid, even though in general, taxpayers can only claim a 
credit when the contest resolves. This is the option adopted in 
proposed Sec.  1.905-1(d)(3) and (4). As a condition for making this 
election, the taxpayer must enter into a provisional foreign tax credit 
agreement in which it agrees to notify the IRS when the contest 
concludes and agrees to not assert the expiration of the assessment 
statute (for a period of three years from the time the contest 
resolves) as a defense to assessment, so that the IRS is able to 
challenge the foreign tax credit claimed with respect to the contested 
tax if the IRS determines that the taxpayer failed to exhaust all 
practical remedies.
    The Treasury Department and the IRS have not attempted to assess 
the differences in economic activity that might result under each of 
these regulatory options because they do not have readily available 
data or models that capture taxpayers' activities under the different 
treatments of contested taxes. The Treasury Department and the IRS 
further have not attempted to estimate the difference in compliance 
costs under each of these regulatory options.
c. Number of Affected Taxpayers
    The Treasury Department and the IRS have determined that the 
proposed regulations potentially affect U.S. taxpayers that claim 
foreign tax credits on an accrual basis and that contest a foreign 
income tax liability with a foreign country. Although data reporting 
the number of taxpayers that claim a credit for contested foreign 
income tax in a given year are not readily available, the potentially 
affected population of taxpayers would, under existing Sec.  1.905-3, 
have a foreign tax redetermination for the year to which the contested 
tax relates. Data reporting the number of taxpayers subject to a 
foreign tax redetermination in a given year are not readily available, 
however some taxpayers currently subject to such redetermination will 
file amended returns. Based on currently available tax filings for tax 
year 2018, the Treasury Department and the IRS have determined that 
approximately 1,500 filers would be affected by these proposed 
regulations. This estimate is based on the number of U.S. corporations 
that filed an amended return that had a Form 1118 attached to the Form 
1120; S corporations that filed an amended return with a Form 5471 
attached to the Form 1120S or that reported an amount of foreign tax 
accrued on the Form 1120S, Schedule K; partnerships that filed an 
amended return with a Form 5471 attached to Form 1065 or that reported 
an amount of foreign tax accrued on Schedule K; U.S. individuals that 
filed an amended return and had a Form 1116 attached to the Form 1040. 
Because only taxpayers that claim foreign tax credits on an accrual 
basis could potentially be subject to the proposed regulations, only 
taxpayers that checked the accrual box on the Form 1116 or Form 1118, 
or that indicated on Schedule K that an amount of foreign income tax 
accrued, were taken into account for the estimate.

[[Page 72112]]

II. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3520) 
(``Paperwork Reduction Act'') requires that a federal agency obtain the 
approval of the OMB before collecting information from the public, 
whether such collection of information is mandatory, voluntary, or 
required to obtain or retain a benefit.

A. Overview

    The proposed regulations include new collection of information 
requirements in proposed Sec. Sec.  1.905-1(d)(4) and (5), 1.901-
1(d)(2), and 1.905-3. The collections of information in proposed Sec.  
1.905-1(d)(4) apply to taxpayers that elect to claim a provisional 
credit for contested foreign income taxes before the contest resolves. 
Taxpayers making this election are required to file an agreement 
described in proposed Sec.  1.905-1(d)(4)(ii) as well as an annual 
certification described in proposed Sec.  1.905-1(d)(4)(iii). The 
collection of information in Sec.  1.905-1(d)(5) requires taxpayers 
that are correcting an improper method of accruing foreign income tax 
expense to file a Form 3115, Application for Change in Accounting 
Method, with their return. Proposed Sec. Sec.  1.901-1(d)(2) and 1.905-
3 require taxpayers that make a change between claiming a credit and a 
deduction for foreign income taxes to comply with the notification and 
reporting requirements in Sec.  1.905-4, which is being finalized in a 
Treasury Decision published concurrently with this notice of proposed 
rulemaking. The collection of information in Sec.  1.905-4 generally 
requires taxpayers to file an amended return for the year or years 
affected by a foreign tax redetermination (FTR), along with an updated 
Form 1116 or Form 1118, and a written statement providing specific 
information relating to the FTR. The burdens associated with 
collections of information in proposed Sec. Sec.  1.905-1(d)(4)(iii) 
and (d)(5), 1.901-1(d)(2), and 1.905-3, which will be conducted through 
existing IRS forms, is described in Part II.B of this Special Analyses. 
The burden for a new collection of information in proposed Sec.  1.905-
1(d)(4)(ii), which will be conducted on a new IRS form, is described in 
Part II.C of this Special Analyses.

B. Collections of Information--Proposed Sec. Sec.  1.905-1(d)(4)(iii), 
1.905-1(d)(5), 1.901-1(d)(2), and 1.905-3

    The Treasury Department and the IRS intend that the information 
collection requirements described in this Part II.B will be set forth 
in the forms and instructions identified in Table 1.

                  Table 1--Table of Tax Forms Impacted
------------------------------------------------------------------------
                           Tax forms impacted
-------------------------------------------------------------------------
                                    Number of        Forms to which the
   Collection of information       respondents       information may be
                                   (estimated)            attached
------------------------------------------------------------------------
Sec.   1.905-1(d)(4)(iii).....              1,500  Form 1116, Form 1118.
Sec.   1.905-1(d)(5)..........    465,500-514,500  Form 3115.
Sec.   1.901-1(d)(2), Sec.          10,400-13,500  Form 1065 series,
 1.905-3.                                           Form 1040 series,
                                                    Form 1041 series,
                                                    and Form 1120
                                                    series.
------------------------------------------------------------------------
Source: [MeF, DCS, and IRS's Compliance Data Warehouse].

    As indicated in Table 1, the Treasury Department and the IRS intend 
the annual certification requirement in proposed Sec.  1.905-
1(d)(4)(iii), which applies to taxpayers that elect to claim a 
provisional credit for contested taxes, will be conducted through 
amendment of existing Form 1116, Foreign Tax Credit (Individual, 
Estate, or Trust) (covered under OMB control numbers 1545-0074 for 
individuals, and 1545-0121 for estates and trusts) and existing Form 
1118, Foreign Tax Credit (Corporations) (covered under OMB control 
number 1545-0123). The collection of information in proposed Sec.  
1.905-1(d)(4)(iii) will be reflected in the Paperwork Reduction Act 
submission that the Treasury Department and the IRS will submit to OMB 
for these forms. The current status of the Paperwork Reduction Act 
submissions related to these forms is summarized in Table 2. The 
estimate for the number of impacted filers with respect to the 
collection of information in proposed Sec.  1.905-1(d)(4)(iii), as well 
as with respect to the collection of information in proposed Sec.  
1.905-1(d)(4)(ii) (described in Part II.C), is based on the number of 
U.S. corporations that filed an amended return that had a Form 1118 
attached to the Form 1120; S corporations that filed an amended return 
with a Form 5471 attached to the Form 1120S or that reported an amount 
of foreign tax accrued on the Form 1120S, Schedule K; partnerships that 
filed an amended return with a Form 5471 attached to Form 1065 or that 
reported an amount of foreign tax accrued on Schedule K; and U.S. 
individuals that filed an amended return and had a Form 1116 attached 
to the Form 1040.
    The Treasury Department and the IRS expect that the collection of 
information in proposed Sec.  1.905-1(d)(5) will be reflected in the 
Paperwork Reduction Act submission that the Treasury Department and the 
IRS will submit to OMB for Form 3115 (covered under OMB control numbers 
1545-0123 and 1545-0074). See Table 2 for current status of the 
Paperwork Reduction Act submission for Form 3115. Exact data is not 
available to estimate the number of taxpayers that have used an 
incorrect method of accounting for accruing foreign income taxes, and 
that are potentially subject to the collection of information in 
proposed Sec.  1.905-1(d)(5). The estimate in Table 1 of number of 
taxpayers potentially affected by this collection of information is 
based on the total number of filers in the Form 1040, Form 1041, Form 
1120, Form 1120S, and Form 1065 series that indicated on their return 
that they use an accrual method of accounting, and that either claimed 
a foreign tax credit or claimed a deduction for taxes (which could 
include foreign income taxes). This represents an upper bound of 
potentially affected taxpayers. The Treasury Department and the IRS 
expect that only a small percentage of this population of taxpayers 
will be subject to the collection of information in proposed Sec.  
1.905-1(d)(5), because only taxpayers that have used an improper method 
of accounting are subject to proposed Sec.  1.905-1(d)(5).
    The collection of information resulting from proposed Sec. Sec.  
1.901-1(d)(2) and 1.905-3, which is contained in Sec.  1.905-4, will be 
reflected in the Paperwork Reduction Act submission that the Treasury 
Department and the IRS will submit for OMB control numbers 1545-0123, 
1545-0074 (which cover the reporting burden for filing an amended 
return and amended Form

[[Page 72113]]

1116 and Form 1118 for individual and business filers), OMB control 
number 1545-0092 (which covers the reporting burden for filing an 
amended return for estate and trust filers), OMB control number 1545-
0121 (which covers the reporting burden for filing a Form 1116 for 
estate and trust filers), and OMB control number 1545-1056 (which 
covers the reporting burden for the written statement for FTRs). Exact 
data are not available to estimate the additional burden imposed by 
proposed Sec. Sec.  1.901-1(d)(2) and 1.905-3, which propose to amend 
the definition of foreign tax redetermination in Sec.  1.905-3 to 
include a taxpayer's change from claiming a deduction to claiming a 
credit, or vice versa, for foreign income taxes. Taxpayers making or 
changing their election to claim a foreign tax credit, under existing 
regulations, must already file amended returns and, if applicable, a 
Form 1116 or Form 1118, for the affected years. The Treasury Department 
and the IRS do not anticipate that proposed regulations, which would 
require taxpayers making this change to comply with the collection of 
information and reporting burden in Sec.  1.905-4, will substantially 
change the reporting requirement. Exact data are not available to 
estimate the number of taxpayers potentially subject to proposed 
Sec. Sec.  1.901-1(d)(2) and 1.905-3. The estimate in Table 1 is based 
upon the total number of filers in the Form 1040, Form 1041, and Form 
1120 series that either claimed a foreign tax credit or claimed a 
deduction for taxes (which could include foreign income taxes), and 
filed an amended return. This estimate represents an upper bound of 
potentially affected taxpayers.
    OMB control number 1545-0123 represents a total estimated burden 
time for all forms and schedules for corporations of 3.344 billion 
hours and total estimated monetized costs of $61.558 billion ($2019). 
OMB control number 1545-0074 represents a total estimated burden time, 
including all other related forms and schedules for individuals, of 
1.717 billion hours and total estimated monetized costs of $33.267 
billion ($2019). OMB control number 1545-0092 represents a total 
estimated burden time, including related forms and schedules, but not 
including Form 1116, for trusts and estates, of 307,844,800 hours and 
total estimated monetized costs of $14.077 billion ($2018). OMB control 
number 1545-0121 represents a total estimated burden time for all 
estate and trust filers of Form 1116, of 25,066,693 hours and total 
estimated monetized costs of $1.744 billion ($2018). OMB control number 
1545-1056 has an estimated number of respondents in a range from 8,900 
to 13,500 and total estimated burden time of 56,000 hours and total 
estimated monetized costs of $2,583,840 ($2017).
    The overall burden estimates provided for OMB control numbers 1545-
0123, 1545-0074, and 1545-0092 are aggregate amounts that relate to the 
entire package of forms associated with these OMB control numbers and 
will in the future include but not isolate the estimated burden of the 
tax forms that will be revised as a result of the information 
collections in the proposed regulations. The difference between the 
burden estimates reported here and those future burden estimates will 
therefore not provide an estimate of the burden imposed by the proposed 
regulations. The burden estimates reported here have been reported for 
other regulations related to the taxation of cross-border income. The 
Treasury Department and IRS urge readers to recognize that many of the 
burden estimates reported for regulations related to taxation of cross-
border income are duplicates and to guard against overcounting the 
burden that international tax provisions impose. The Treasury 
Department and the IRS have not identified the estimated burdens for 
the collections of information in proposed Sec. Sec.  1.905-
1(d)(4)(iii) and (d)(5), 1.901-1(d)(2), and 1.905-3 because no burden 
estimates specific to proposed Sec. Sec.  1.905-1(d)(4)(iii) and 
(d)(5), 1.901-1(d)(2), and 1.905-3 are currently available. The 
Treasury Department and the IRS estimate burdens on a taxpayer-type 
basis rather than a provision-specific basis.
    The Treasury Department and the IRS request comments on all aspects 
of information collection burdens related to the proposed regulations, 
including estimates for how much time it would take to comply with the 
paperwork burdens described above for each relevant form and ways for 
the IRS to minimize the paperwork burden. Any proposed revisions to 
these forms that reflect the information collections contained in 
proposed Sec. Sec.  1.905-1(d)(4)(iii) and (d)(5), 1.901-1(d)(2), and 
1.905-3 will be made available for public comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.html and will not be 
finalized until after these forms have been approved by OMB under the 
Paperwork Reduction Act.

                           Table 2--Status of Current Paperwork Reduction Submissions
----------------------------------------------------------------------------------------------------------------
                 Form                         Type of filer          OMB No.(s)                Status
----------------------------------------------------------------------------------------------------------------
Form 1116.............................  Trusts & estates (NEW           1545-0121  Approved by OMB through 10/31/
                                         Model).                                    2020.
                                       -------------------------------------------------------------------------
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201704-1545-023
                                       -------------------------------------------------------------------------
                                        Individual (NEW Model)...       1545-0074  Approved by OMB through 1/31/
                                                                                    2021.
                                       -------------------------------------------------------------------------
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201909-1545-021
                                       -------------------------------------------------------------------------
Form 1118.............................  Business (NEW Model).....       1545-0123  Approved by OMB through 1/31/
                                                                                    2021.
                                       -------------------------------------------------------------------------
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201907-1545-001
                                       -------------------------------------------------------------------------
Form 3115.............................  Business (NEW Model).....       1545-0123  Approved by OMB through 1/31/
                                                                                    2021.
                                       -------------------------------------------------------------------------
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201907-1545-001
                                       -------------------------------------------------------------------------
                                        Individual (NEW Model)...       1545-0074  Approved by OMB through 1/31/
                                                                                    2021.
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201909-1545-021
                                       -------------------------------------------------------------------------
Notification of FTRs..................  .........................       1545-1056  Approved by OMB through 12/31/
                                                                                    2020.
                                       -------------------------------------------------------------------------

[[Page 72114]]

 
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201703-1545-008
                                       -------------------------------------------------------------------------
Amended returns.......................  Business (NEW Model).....       1545-0123  Approved by OMB through 1/31/
                                                                                    2021.
                                       -------------------------------------------------------------------------
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201907-1545-001
                                       -------------------------------------------------------------------------
                                        Individual (NEW Model)...       1545-0074  Approved by OMB through 1/31/
                                                                                    2021.
                                       -------------------------------------------------------------------------
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201909-1545-021
                                       -------------------------------------------------------------------------
                                        Trusts & estates.........       1545-0092  Approved by OMB through 5/31/
                                                                                    2022.
                                       -------------------------------------------------------------------------
                                          https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201806-1545-014
----------------------------------------------------------------------------------------------------------------

C. Collections of Information--Proposed Sec.  1.905-1(d)(4)(ii)

    The collection of information contained in Sec.  1.905-1(d)(4)(ii) 
have been submitted to the Office of Management and Budget (OMB) for 
review in accordance with the Paperwork Reduction Act. Commenters are 
strongly encouraged to submit public comments electronically. Comments 
and recommendations for the proposed information collection should be 
sent to http://www.reginfo.gov/public/do/PRAMain, with electronic 
copies emailed to the IRS at [email protected] (indicate REG-101657-20 
on the subject line). This particular information collection can be 
found by selecting ``Currently under Review--Open for Public Comments'' 
then by using the search function. Comments can also be mailed to OMB, 
Attn: Desk Officer for the Department of the Treasury, Office of 
Information and Regulatory Affairs, Washington, DC 20503, with copies 
mailed to the IRS, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collections 
of information should be received by January 11, 2021.
    The likely respondents are: U.S. persons who pay or accrue foreign 
income taxes:
    Estimated total annual reporting burden: 3,000 hours.
    Estimated average annual burden per respondent: 2 hours.
    Estimated number of respondents: 1,500.
    Estimated frequency of responses: Annually.

III. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that the proposed regulations will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act.
    The proposed regulations provide guidance needed to comply with 
statutory changes and affect individuals and corporations claiming 
foreign tax credits. The domestic small business entities that are 
subject to the foreign tax credit rules in the Code and in the proposed 
regulations are generally those domestic small business entities that 
are at least 10 percent corporate shareholders of foreign corporations, 
and so are eligible to claim dividends received deductions or compute 
foreign taxes deemed paid under section 960 with respect to inclusions 
under subpart F and section 951A from CFCs. Other provisions of these 
proposed regulations might also affect domestic small business entities 
that operate in foreign jurisdictions or that have income from sources 
outside of the United States.
    Based on 2018 Statistics of Income data, the Treasury Department 
and the IRS computed the fraction of taxpayers owning a CFC by gross 
receipts size class. The smaller size classes have a relatively small 
fraction of taxpayers that own CFCs, which suggests that many domestic 
small business entities would be unaffected by these regulations. Many 
of the important aspects of the proposed regulations, including the 
rules in proposed Sec. Sec.  1.245A(d)-1(a), 1.367(b)-4, 1.367(b)-7, 
1.367(b)-10, 1.861-3, and 1.960-1 apply only to U.S. persons that 
operate a foreign business in corporate form, and, in most cases, only 
if the foreign corporation is a CFC.
    Other provisions in the proposed regulations, specifically the 
rules in proposed Sec. Sec.  1.861-14 and 1.904-4, generally apply only 
to members of an affiliated group and insurance companies or other 
members of the financial services industry earning income from sources 
outside of the United States. It is infrequent for domestic small 
entities to operate as part of an affiliated group, to be taxed as an 
insurance company, or to constitute a financial services entity, and 
also earn income from sources outside of the United States. 
Consequently, the Treasury Department and the IRS expect that the 
proposed regulations are unlikely to affect a substantial number of 
domestic small business entities. However, adequate data are not 
available at this time to certify that a substantial number of small 
entities would be unaffected.
    The Treasury Department and the IRS have determined that the 
proposed regulations will not have a significant economic impact on 
domestic small business entities. Based on information from the 
Statistics of Income 2017 Corporate File, foreign tax credits as a 
percentage of three different tax-related measures of annual receipts 
(see Table for variables) by corporations are substantially less than 
the 3 to 5 percent threshold for significant economic impact.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                               $500,000   $1,000,000   $5,000,000  $10,000,000   $50,000,000  $100,000,000
          Size  (by business receipts)               Under       under       under       under        under         under         under     $250,000,000
                                                   $500,000   $1,000,000  $5,000,000  $10,000,000  $50,000,000  $100,000,000  $250,000,000     or more
--------------------------------------------------------------------------------------------------------------------------------------------------------
FTC/Total Receipts..............................       0.12%       0.00%       0.00%        0.00%        0.01%         0.01%         0.02%         0.28%
FTC/(Total Receipts-Total Deductions)...........       0.61%       0.03%       0.09%        0.05%        0.35%         0.71%         1.38%         9.89%

[[Page 72115]]

 
FTC/Business Receipts...........................       0.84%       0.00%       0.00%        0.00%        0.01%         0.01%         0.02%         0.05%
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Statistics of Income (2017) Form 1120.

    Although proposed Sec. Sec.  1.905-1(d)(4) and (5), 1.901-1(d)(2), 
and 1.905-3 contain a collection of information requirement, the small 
businesses that are subject to these requirements are domestic small 
entities with significant foreign operations. The data to assess 
precise counts of small entities affected by proposed Sec. Sec.  1.905-
1(d)(4) and (5), 1.901-1(d)(2), and 1.905-3 are not readily available. 
As demonstrated in the table in this Part III of the Special Analyses, 
foreign tax credits do not have a significant economic impact for any 
gross-receipts class of business entities.\7\ Therefore, the proposed 
regulations do not have a significant economic impact on small business 
entities. Accordingly, it is hereby certified that the requirements of 
proposed Sec. Sec.  1.905-1(d)(4) and (5), 1.901-1(d)(2), and 1.905-3 
will not have a significant economic impact on a substantial number of 
small entities.
---------------------------------------------------------------------------

    \7\ Although proposed Sec. Sec.  1.905-1(d)(5), 1.901-1(d)(2), 
and 1.905-3 also impact taxpayers that claim a deduction, instead of 
a credit, for foreign income taxes, the Treasury Department and the 
IRS expect that the vast majority of taxpayers that have creditable 
foreign income taxes would choose a dollar-for-dollar credit instead 
of a deduction; thus, the data in this table measuring foreign tax 
credit against various variables is a reasonable estimate of the 
economic impact of these proposed regulations.
---------------------------------------------------------------------------

    Pursuant to section 7805(f), these proposed regulations will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small businesses. The 
Treasury Department and the IRS also request comments from the public 
on the certifications in this Part III of the Special Analyses.

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA) 
requires that agencies assess anticipated costs and benefits and take 
certain other actions before issuing a final rule that includes any 
Federal mandate that may result in expenditures in any one year by a 
state, local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. This proposed rule does not include any Federal mandate that 
may result in expenditures by state, local, or tribal governments, or 
by the private sector in excess of that threshold.

V. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive order. This proposed rule does not have 
federalism implications and does not impose substantial direct 
compliance costs on state and local governments or preempt state law 
within the meaning of the Executive order.

Comments and Request for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ADDRESSES section. 
The Treasury Department and the IRS request comments on all aspects of 
the proposed rules. See also the specific requests for comments in the 
following Parts of the Explanation of Provisions: I (on potential 
revisions to Sec.  1.861-20(d) to address concerns regarding foreign 
law transactions that may circumvent the purpose of section 245A(d)), 
III (on the proposed revisions to Sec.  1.367(b)-4(b)(2) and on whether 
further changes to regulations issued under section 367 are appropriate 
in order to clarify their application after the repeal of section 902), 
V.A (on the definition of advertising expenditures and the method of 
cost recovery for purposes of the election in proposed Sec.  1.861-
9(k)), V.D (regarding the rules on direct allocation of interest 
expense incurred by foreign banking branches), V.F.2 (regarding the 
assignment of foreign tax on a U.S. return of capital amount resulting 
from a disposition of stock), V.F.3 (regarding the assignment of 
foreign tax on partnership distributions and sales of partnership 
interests), V.F.4.ii (regarding ordering rules for assignment of 
foreign taxes with respect to multiple disregarded payments and 
regarding the assignment of foreign gross basis taxes paid by taxable 
units that make disregarded payments), V.F.4.iii (regarding the method 
of determining the statutory and residual groupings to which a 
remittance is assigned), V.F.5 (regarding the appropriate treatment of 
foreign income taxes paid or accrued in connection with the sharing of 
losses and foreign law group-relief regimes), VI.A.1 (on whether 
additional revisions to Sec.  1.901-2A are needed in light of the 
proposed revisions to Sec. Sec.  1.901-2 and 1.903-1), VI.A.2 
(regarding the jurisdictional nexus requirement in proposed Sec.  
1.901-2(c), including whether special rules are needed to address 
foreign transfer pricing rules that allocate profits to a resident on a 
formulary basis), VI.A.3.ii (on whether a more objective standard for 
identifying acceptable deviations from the realization requirement 
should be adopted in the final regulations and on whether additional 
categories of pre-realization timing differences are needed), VI.A.4 
(regarding additional issues related to soak-up taxes), VI.B.2 
(regarding additional rules for government grants that are provided 
outside the foreign tax system), VI.B.3.ii (on the treatment of loss 
sharing arrangements and on other foreign options and elections that 
should be excepted from the general rule in Sec.  1.901-2(e)(5)(ii)), 
IX.B (on the treatment of related party payments in the 70-percent 
gross income test, on whether related party payments should in some 
cases constitute active financing income, and on the investment income 
limitation rule), and X.D.4 (on alternative methods and additional 
adjustments for implementing a method change involving the improper 
accrual of foreign income taxes).
    Any electronic comments submitted, and to the extent practicable 
any paper comments submitted, will be made available at 
www.regulations.gov or upon request.
    A public hearing will be scheduled if requested in writing by any 
person who timely submits electronic or written comments. Requests for 
a public hearing are also encouraged to be made electronically. If a 
public hearing is scheduled, notice of the date and time for the public 
hearing will be published in the Federal Register. Announcement 2020-4, 
2020-17 IRB 1, provides that until further notice, public hearings 
conducted by the IRS will be held telephonically. Any telephonic 
hearing

[[Page 72116]]

will be made accessible to people with disabilities.

Drafting Information

    The principal authors of the proposed regulations are Corina Braun, 
Karen J. Cate, Jeffrey P. Cowan, Logan M. Kincheloe, Brad McCormack, 
Jeffrey L. Parry, Tianlin (Laura) Shi, and Suzanne M. Walsh of the 
Office of Associate Chief Counsel (International), as well as Sarah K. 
Hoyt and Brian R. Loss of Associate Chief Counsel (Corporate). However, 
other personnel from the Treasury Department and the IRS participated 
in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry for Sec.  1.245A(d)-1 in numerical order to read in part as 
follows:

    Authority:  26 U.S.C. 7805.
* * * * *
    Section 1.245A(d)-1 also issued under 26 U.S.C. 245A(g).
* * * * *
0
Par. 2. Section 1.164-2 is amended by revising paragraph (d) and adding 
paragraph (i) to read as follows:


Sec.  1.164-2  Deduction denied in case of certain taxes.

* * * * *
    (d) Foreign income taxes. Except as provided in Sec.  1.901-1(c)(2) 
and (3), all foreign income taxes as defined in Sec.  1.901-2(a) paid 
or accrued (as the case may be, depending on the taxpayer's method of 
accounting for such taxes) in such taxable year, if the taxpayer 
chooses to take to any extent the benefits of section 901, relating to 
the credit for taxes of foreign countries and possessions of the United 
States, for taxes that are paid or accrued (according to the taxpayer's 
method of accounting for such taxes) in such taxable year.
* * * * *
    (i) Applicability dates. Paragraph (d) of this section applies to 
foreign taxes paid or accrued in taxable years beginning on or after 
[date final regulations are filed with the Federal Register].
0
Par. 3. Section 1.245A(d)-1 is added to read as follows:


Sec.  1.245A(d)-1  Disallowance of foreign tax credit or deduction.

    (a) In general. With respect to a domestic corporation for which a 
deduction under section 245A(a) is allowable, neither a foreign tax 
credit under section 901 nor a deduction is allowed for foreign income 
taxes that are attributable to a specified distribution or specified 
earnings and profits of a foreign corporation. In addition, if a 
domestic corporation is a United States shareholder of a foreign 
corporation (``upper-tier foreign corporation'') that itself owns 
(including indirectly through a pass-through entity) stock of another 
foreign corporation (``lower-tier foreign corporation''), no foreign 
tax credit under section 901 (including by reason of section 960) is 
allowed to the domestic corporation, and no deduction is allowed to the 
upper-tier foreign corporation, for foreign income taxes paid or 
accrued by the upper-tier foreign corporation that are attributable to 
a specified distribution or specified earnings and profits of the 
lower-tier foreign corporation. Moreover, neither a foreign tax credit 
under section 901 nor a deduction is allowed to a successor (including 
an individual who is a citizen or resident of the United States) of a 
corporation described in this paragraph (a) for foreign income taxes 
that are attributable to the portion of a foreign corporation's 
specified earnings and profits that constitute section 245A(d) PTEP.
    (b) Attribution of foreign income taxes to specified distributions 
and specified earnings and profits--(1) In general. Foreign income 
taxes are attributable to a specified distribution from a foreign 
corporation to the extent such taxes are allocated and apportioned 
under Sec.  1.861-20 to foreign taxable income arising from the 
specified distribution. Foreign income taxes are attributable to 
specified earnings and profits of a foreign corporation to the extent 
such taxes are allocated and apportioned under Sec.  1.860-20 to 
foreign taxable income arising from a distribution or inclusion under 
foreign law of specified earnings and profits if the event giving rise 
to such distribution or inclusion does not give rise to a specified 
distribution. See, for example, Sec. Sec.  1.861-20(d)(2)(ii)(B), (C), 
or (D) (foreign law distribution or disposition and certain foreign law 
transfers between taxable units), 1.861-20(d)(3)(i)(C) (income from a 
reverse hybrid), 1.861-20(d)(3)(iii) (foreign law inclusion regime), 
and 1.861-20(d)(3)(v)(C)(1)(i) (disregarded payment treated as a 
remittance). For purposes of this paragraph (b), Sec.  1.861-20 is 
applied by treating foreign gross income in an amount equal to the 
amount of a distribution (under Federal income tax law) that is a 
specified distribution, or the amount of a distribution or inclusion 
under foreign law that would if recognized for Federal income tax 
purposes be a distribution out of, or inclusion with respect to, 
specified earnings and profits, as a statutory grouping, and any 
remaining portion of the foreign gross income arising from the 
distribution or inclusion under foreign law as the residual grouping. 
See also Sec.  1.960-1(e) (foreign income tax paid or accrued by a 
controlled foreign corporation that is assigned to the residual 
grouping cannot be deemed paid under section 960).
    (2) Anti-avoidance rule. Foreign income taxes are treated as 
attributable to a specified distribution from, or the specified 
earnings and profits of, a foreign corporation if a transaction, series 
of related transactions, or arrangement is undertaken with a principal 
purpose of avoiding the purposes of section 245A(d) and this section, 
including, for example, by separating foreign income taxes from the 
income, or earnings and profits, to which such foreign income taxes 
relate or by making distributions (or causing inclusions) under foreign 
law in multiple years that give rise to foreign income taxes that are 
allocated and apportioned with reference to the same previously taxed 
earnings and profits. See paragraph (e)(4) of this section (Example 3).
    (c) Definitions. The following definitions apply for purposes of 
this section.
    (1) Foreign income tax. The term foreign income tax has the meaning 
set forth in Sec.  1.901-2(a).
    (2) Hybrid dividend. The term hybrid dividend has the meaning set 
forth in Sec.  1.245A(e)-1(b)(2).
    (3) Pass-through entity. The term pass-through entity has the 
meaning set forth in Sec.  1.904-5(a)(4).
    (4) Section 245A(d) PTEP. The term section 245A(d) PTEP means 
previously taxed earnings and profits described in Sec.  1.960-
3(c)(2)(v) or (ix) to the extent such previously taxed earnings and 
profits arose as a result of a sale or exchange that by reason of 
section 964(e)(4) or 1248 gave rise to a deduction under section 
245A(a) or as a result of a tiered hybrid dividend that by reason of 
section 245A(e)(2) and Sec.  1.245A(e)-1(c)(1) gave rise to an 
inclusion in the gross income of a United States shareholder.
    (5) Specified distribution. With respect to a domestic corporation, 
the term specified distribution means, in the case of a distribution to 
the domestic corporation (including indirectly through a pass-through 
entity), the portion of the distribution that is a

[[Page 72117]]

dividend for which a deduction under section 245A(a) is allowed or that 
is a hybrid dividend or that is attributable to section 245A(d) PTEP. 
In addition, the term specified distribution means, in the case of a 
distribution from a foreign corporation to another foreign corporation 
(including indirectly through a pass-through entity), the portion of 
the distribution that is attributable to section 245A(d) PTEP or that 
is a tiered hybrid dividend that gives rise to an inclusion in the 
gross income of a United States shareholder of the second foreign 
corporation by reason of section 245A(e)(2) and Sec.  1.245A(e)-
1(c)(1).
    (6) Specified earnings and profits. With respect to a domestic 
corporation, the term specified earnings and profits means the portion 
of earnings and profits of the foreign corporation that would give rise 
to a specified distribution (determined without regard to section 246 
or Sec.  1.245A-5) if an amount of money equal to all of the foreign 
corporation's earnings and profits were distributed with respect to the 
stock of the foreign corporation owned by all the shareholders on any 
date on which the domestic corporation has an item of foreign gross 
income as the result of a distribution from or inclusion with respect 
to the foreign corporation under foreign law. In addition, for purposes 
of applying Sec.  1.861-20(d)(3)(i)(B) or (D) to assign foreign gross 
income arising from a distribution with respect to, or a disposition 
of, stock of the foreign corporation, earnings and profits in the 
amount of the U.S. return of capital amount (as defined in Sec.  1.861-
20(b)) that are deemed to arise in a section 245A subgroup (after 
applying the asset method in Sec.  1.861-9) are also treated as 
specified earnings and profits.
    (7) Tiered hybrid dividend. The term tiered hybrid dividend has the 
meaning set forth in Sec.  1.245A(e)-1(c)(2).
    (d) Effect on earnings and profits. The disallowance of a credit or 
deduction for foreign income taxes under paragraph (a) of this section 
does not affect whether the foreign income taxes reduce earnings and 
profits of a corporation.
    (e) Examples. The following examples illustrate the application of 
this section.
    (1) Presumed facts. Except as otherwise provided, the following 
facts are presumed for purposes of the examples:
    (i) USP is a domestic corporation;
    (ii) CFC is a controlled foreign corporation organized in Country 
A, and is not a reverse hybrid (as defined in Sec.  1.861-20(b));
    (iii) USP would be allowed a deduction under section 245A(a) to the 
extent of dividends received from CFC;
    (iv) All parties have a U.S. dollar functional currency and a U.S. 
taxable year and foreign taxable year that correspond to the calendar 
year;
    (v) No party has deductions for Country A tax purposes or 
deductions for Federal income tax purposes (other than foreign income 
tax expense); and
    (vi) Section 245A(d) is the operative section.
    (2) Example 1: Distribution for foreign and Federal income tax 
purposes--(i) Facts. USP owns all of the outstanding stock of CFC. As 
of December 31, Year 1, CFC has $800x of section 951A PTEP (as defined 
in Sec.  1.960-3(c)(2)(viii)) in a single annual PTEP account (as 
defined in Sec.  1.960-3(c)(1)), and $500x of earnings and profits 
described in section 959(c)(3). On December 31, Year 1, CFC distributes 
$1,000x of cash to USP. For Country A tax purposes, the distribution is 
treated entirely as a dividend to USP, and Country A imposes a 
withholding tax on USP of $150x with respect to the $1,000x of foreign 
gross income. For Federal income tax purposes, $800x of the 
distribution is excluded from USP's gross income and not treated as a 
dividend under section 959(a) and (d), respectively; the remaining 
$200x of the distribution gives rise to a dividend to USP.
    (ii) Analysis--(A) Identification of specified distribution. With 
respect to USP, $200x of the distribution gives rise to a dividend for 
which a deduction under section 245A(a) is allowed. Accordingly, the 
distribution results in a $200x specified distribution. See paragraph 
(c)(5) of this section.
    (B) Foreign income taxes attributable to specified distribution. 
For purposes of allocating and apportioning the $150x of Country A 
foreign income tax, Sec.  1.861-20 is applied by first assigning the 
$1,000x of Country A gross income to the relevant statutory and 
residual groupings for purposes of applying section 245A(d) as the 
operative section. Under paragraph (b)(1) of this section, the 
statutory grouping is foreign gross income in the amount of the 
specified distribution and the residual grouping is the remaining 
amount of foreign gross income. Under Sec.  1.861-20(d)(3)(i)(B)(2), 
the foreign dividend amount ($1,000x) is, to the extent of the U.S. 
dividend amount ($1,000x), assigned to the same statutory or residual 
groupings to which the distribution of the U.S. dividend amount is 
assigned under Federal income tax law. Thus, $200x of the foreign 
dividend amount is assigned to the statutory grouping, and the 
remaining $800x is assigned to the residual grouping. Under Sec.  
1.861-20(f), $30x ($150x x $200x/$1,000x) of the Country A foreign 
income tax is apportioned to the statutory grouping, and $120x ($150x x 
$800x/$1,000x) of the Country A foreign income tax is apportioned to 
the residual grouping.
    (C) Disallowance. USP is allowed neither a foreign tax credit nor a 
deduction for the $30x of Country A foreign income tax that is 
allocated and apportioned to, and therefore attributable to, the $200x 
specified distribution. See paragraphs (a) and (b) of this section.
    (3) Example 2: Distribution for foreign law purposes--(i) Facts. 
USP owns all of the outstanding stock of CFC. On December 31, Year 1, 
CFC distributes $1,000x of its stock to USP. For Country A tax 
purposes, the stock distribution is treated entirely as a dividend to 
USP, and Country A imposes a withholding tax on USP of $150x with 
respect to the $1,000x of foreign gross income. For Federal income tax 
purposes, USP recognizes no U.S. gross income as a result of the stock 
distribution pursuant to section 305(a). As of December 31, Year 1, the 
date of the stock distribution, CFC has $800x of section 951A PTEP (as 
defined in Sec.  1.960-3(c)(2)(viii)) in a single annual PTEP account 
(as defined in Sec.  1.960-3(c)(1)), and $500x of earnings and profits 
described in section 959(c)(3).
    (ii) Analysis--(A) Identification of specified earnings and 
profits. With respect to USP, CFC has $500x of specified earnings and 
profits because if, on December 31, Year 1, CFC were to distribute 
$1,300x of money (an amount equal to all of CFC's earnings and profits) 
with respect to its stock to USP, $500x of the distribution would be a 
dividend for which USP would be allowed a deduction under section 
245A(a) and, therefore, would give rise to a specified distribution. 
See paragraphs (c)(5) and (6) of this section. The remaining $800x of 
the distribution would not be included in USP's gross income or treated 
as a dividend and, thus, would not give rise to a deduction under 
section 245A(a). See section 959(a) and (d), respectively.
    (B) Foreign income taxes attributable to specified earnings and 
profits. For purposes of allocating and apportioning the $150x of 
Country A foreign income tax, Sec.  1.861-20 is applied by first 
assigning the $1,000x of Country A gross income to the relevant 
statutory and residual groupings for purposes of applying section 
245A(d) as the operative section. Under paragraph (b)(1) of this 
section, the statutory grouping is the amount of foreign gross income 
arising from the foreign law

[[Page 72118]]

distribution that would if recognized for Federal income tax purposes 
be a distribution out of CFC's specified earnings and profits, and the 
residual grouping is the remaining amount of the foreign gross income. 
There is no corresponding U.S. item because under section 305(a) USP 
recognizes no U.S. gross income with respect to the stock distribution. 
Under Sec.  1.861-20(d)(2)(ii)(B), the item of foreign gross income 
(the $1,000x dividend) is assigned under the rules of Sec.  1.861-
20(d)(3)(i)(B) to the same statutory or residual groupings to which the 
foreign gross income would be assigned if a distribution of the same 
amount were made for Federal income tax purposes on December 31, Year 
1, the date the stock distribution occurs for Country A tax purposes. 
If recognized for Federal income tax purposes, a $1,000x distribution 
on December 31, Year 1, would result in a U.S. dividend amount (which 
as defined in Sec.  1.861-20(b) includes distributions of previously 
taxed earnings and profits) of $1,000x. Under Sec.  1.861-
20(d)(3)(i)(B)(2), the foreign dividend amount ($1,000x) is, to the 
extent of the U.S. dividend amount ($1,000x), assigned to the same 
statutory or residual groupings from which a distribution of the U.S. 
dividend amount would be made under Federal income tax law. Thus, $200x 
of foreign gross income related to the foreign dividend amount is 
assigned to the statutory grouping for the gross income that would 
arise from a distribution of CFC's specified earnings and profits, and 
$800x is assigned to the residual grouping. Under Sec.  1.861-20(f), 
$30x ($150x x $200x/$1,000x) of the Country A foreign income tax is 
apportioned to the statutory grouping, and $120x ($150x x $800x/
$1,000x) of the Country A foreign income tax is apportioned to the 
residual grouping.
    (C) Disallowance. USP is allowed neither a foreign tax credit nor a 
deduction for the $30x of Country A foreign income tax that is 
allocated and apportioned to, and therefore attributable to, the $500x 
of specified earnings and profits of CFC. See paragraphs (a) and (b) of 
this section.
    (4) Example 3: Successive foreign law distributions subject to 
anti-abuse rule--(i) Facts. During Year 1, CFC generates $500x of 
subpart F income that is included in USP's income under section 951(a), 
and $500x of foreign oil and gas extraction income (as defined in 
section 907(c)(1)) in Country A. As of December 31, Year 1, CFC has 
$500x of earnings and profits described in section 959(c)(3) and $500x 
of section 951(a)(1)(A) PTEP (as defined in Sec.  1.960-3(c)(2)(x)). 
CFC generates no income in Years 2 through 4. In each of Years 2 and 3, 
USP makes a consent dividend election under Country A law that, for 
Country A tax purposes, deems CFC to distribute to USP, and USP 
immediately to contribute to CFC, $500x on December 31 of each year. 
For Country A tax purposes, each deemed distribution and contribution 
is treated as a dividend of $500x to USP, followed immediately by a 
contribution to CFC of $500x, and Country A imposes a withholding tax 
on USP of $150x with respect to $500x of foreign gross income in each 
of Years 2 and 3. For Federal income tax purposes, the Country A 
consent dividend is disregarded, and USP recognizes no U.S. gross 
income. In Year 4, CFC distributes $1,000x to USP, which for Country A 
tax purposes is treated as a return of contributed capital on which no 
withholding tax is imposed. For Federal income tax purposes, $500x of 
the $1,000x distribution is excluded from USP's gross income and not 
treated as a dividend under section 959(a) and (d), respectively; the 
remaining $500x of the distribution gives rise to a dividend to USP for 
which USP is allowed a deduction under section 245A(a). The Country A 
consent dividend elections in Years 2 and 3 are made with a principal 
purpose of avoiding the application of section 245A(d) and this section 
to disallow a credit or deduction for Country X withholding tax 
incurred with respect to CFC's specified earnings and profits.
    (ii) Analysis--(A) Identification of specified earnings and 
profits. With respect to USP, CFC has $500x of specified earnings and 
profits in Years 2 and 3 because if, on the date of each foreign law 
distribution, CFC were to distribute $1,000x of money (an amount equal 
to all of CFC's earnings and profits) with respect to its stock owned 
by USP, $500x of the distribution would be a dividend for which USP 
would be allowed a deduction under section 245A(a) and, therefore, 
would give rise to a specified distribution. See paragraphs (c)(5) and 
(6) of this section.
    (B) Foreign income taxes attributable to specified earnings and 
profits. For purposes of allocating and apportioning the $150x of 
Country A foreign income tax incurred by USP in each of Years 2 and 3, 
Sec.  1.861-20 is applied by first assigning the $500x of Country A 
gross income to the relevant statutory and residual groupings for 
purposes of applying section 245A(d) as the operative section. Under 
paragraph (b)(1) of this section, the statutory grouping is the amount 
of foreign gross income arising from the foreign law distribution that 
would if recognized for Federal income tax purposes be a distribution 
out of CFC's specified earnings and profits, and the residual grouping 
is the remaining amount of the foreign gross income. The $500x of 
foreign gross income is not included in the U.S. gross income of USP, 
and thus, there is no corresponding U.S. item. The Country A consent 
dividends in Years 2 and 3 meet the definition of a foreign law 
distribution in Sec.  1.861-20(b) because Country A treats them as a 
taxable distribution but Federal income tax law does not. Under Sec.  
1.861-20(d)(2)(ii)(B), the $500x item of foreign law dividend income is 
assigned to a statutory or residual grouping by treating CFC as making 
an actual distribution (for Federal income tax purposes) of $500x on 
December 31 of each of Years 2 and 3. Accordingly, in each of Years 2 
and 3, the $500x of foreign gross income arising from the foreign law 
distribution is assigned to the residual grouping because the 
hypothetical distribution is treated as distributed out of section 
951(a)(1)(A) PTEP, which are not characterized as specified earnings 
and profits. Under Sec.  1.861-20(f), none of the $150x of Country A 
foreign income tax incurred by USP in each of Years 2 and 3 is 
apportioned to the statutory grouping relating to specified earnings 
and profits.
    (C) Disallowance pursuant to anti-avoidance rule. By electing to 
make two successive foreign law distributions in Years 2 and 3 that 
were subject to Country A withholding tax and that did not individually 
exceed, but in the aggregate did exceed, the section 951(a)(1)(A) PTEP 
of CFC, and then making an actual distribution of property equal to all 
of the earnings and profits of CFC in Year 4 that was not subject to 
Country A withholding tax (because the previous consent dividends 
converted CFC's earnings and profits to capital for Country A tax 
purposes), USP would have avoided the disallowance under section 
245A(d) (but for the application of the anti-avoidance rule in 
paragraph (b)(2) of this section) despite having received a $500x 
dividend that gave rise to a deduction under section 245A(a), and 
incurring withholding tax related to the earnings and profits that gave 
rise to that dividend. However, the Country A consent dividend 
elections in Years 2 and 3 were made with a principal purpose of 
avoiding the purposes of section 245A(d) and this section. Therefore, 
USP is allowed neither a foreign tax credit nor a deduction for $150x 
of Country A foreign income tax, which is treated as being attributable 
to

[[Page 72119]]

the $500x of specified earnings and profits of CFC. See paragraphs (a) 
and (b)(2) of this section.
    (f) Applicability date. This section applies to taxable years of a 
foreign corporation that begin after December 31, 2019, and end on or 
after November 2, 2020, and with respect to a United States person, 
taxable years in which or with which such taxable years of the foreign 
corporation end.


Sec.  1.245A(e)-1  [Amended]

0
Par. 4. Section 1.245A(e)-1 is amended by adding the language ``and 
Sec.  1.245A(d)-1'' after the language ``rules of section 245A(d)'' in 
paragraphs (b)(1)(ii), (c)(1)(iii), (g)(1)(ii) introductory text, 
(g)(1)(iii) introductory text, and (g)(2)(ii) introductory text.
0
Par. 5. Section 1.250(b)-1 is amended by adding two sentences to the 
end of paragraph (c)(7) to read as follows:


Sec.  1.250(b)-1  Computation of foreign-derived intangible income 
(FDII).

* * * * *
    (c) * * *
    (7) * * * A taxpayer must use a consistent method to determine the 
amount of its domestic oil and gas extraction income (``DOGEI'') and 
its foreign oil and gas extraction income (``FOGEI'') from the sale of 
oil or gas that has been transported or processed. For example, a 
taxpayer must use a consistent method to determine the amount of FOGEI 
from the sale of gasoline from foreign crude oil sources in computing 
the exclusion from gross tested income under Sec.  1.951A-2(c)(1)(v) 
and the amount of DOGEI from the sale of gasoline from domestic crude 
oil sources in computing its section 250 deduction.
* * * * *
0
Par. 6. Section 1.250(b)-5 is amended by revising paragraph (c)(5) to 
read as follows:


Sec.  1.250(b)-5  Foreign-derived deduction eligible income (FDDEI) 
services.

* * * * *
    (c) * * *
    (5) Electronically supplied service. The term electronically 
supplied service means, with respect to a general service other than an 
advertising service, a service that is delivered primarily over the 
internet or an electronic network and for which value of the service to 
the end user is derived primarily from automation or electronic 
delivery. Electronically supplied services include the provision of 
access to digital content (as defined in Sec.  1.250(b)-3), such as 
streaming content; on-demand network access to computing resources, 
such as networks, servers, storage, and software; the provision or 
support of a business or personal presence on a network, such as a 
website or a web page; online intermediation platform services; 
services automatically generated from a computer via the internet or 
other network in response to data input by the recipient; and similar 
services. Electronically supplied services do not include services that 
primarily involve the application of human effort by the renderer (not 
considering the human effort involved in the development or maintenance 
of the technology enabling the electronically supplied services). 
Accordingly, electronically supplied services do not include, for 
example certain services (such as legal, accounting, medical, or 
teaching services) provided electronically and synchronously.
* * * * *
0
Par. 7. Section 1.336-2 is amended:
0
1. By revising the heading of paragraph (g)(3)(ii).
0
2. In paragraph (g)(3)(ii)(A), by revising the first sentence and 
removing the language ``foreign tax'' and adding in its place the 
language ``foreign income tax'' in the second sentence.
0
3. By revising paragraphs (g)(3)(ii)(B) and (g)(3)(iii).
0
4. By removing both occurrences of paragraph (h) at the end of the 
section.
    The revisions read as follows:


Sec.  1.336-2  Availability, mechanics, and consequences of section 
336(e) election.

* * * * *
    (g) * * *
    (3) * * *
    (ii) Allocation of foreign income taxes--(A) * * * Except as 
provided in paragraph (g)(3)(ii)(B) of this section, if a section 
336(e) election is made for target and target's taxable year under 
foreign law (if any) does not close at the end of the disposition date, 
foreign income tax as defined in Sec.  1.960-1(b)(5) (other than a 
withholding tax as defined in section 901(k)(1)(B)) paid or accrued by 
new target with respect to such foreign taxable year is allocated 
between old target and new target. * * *
    (B) Foreign income taxes imposed on partnerships and disregarded 
entities. If a section 336(e) election is made for target and target 
holds an interest in a disregarded entity (as described in Sec.  
301.7701-2(c)(2)(i) of this chapter) or partnership, the rules of Sec.  
1.901-2(f)(4) and (5) apply to determine the person who is considered 
for Federal income tax purposes to pay foreign income tax imposed at 
the entity level on the income of the disregarded entity or 
partnership.
    (iii) Disallowance of foreign tax credits under section 901(m). For 
rules that may apply to disallow foreign tax credits by reason of a 
section 336(e) election, see section 901(m) and Sec. Sec.  1.901(m)-1 
through 1.901(m)-8.
* * * * *
0
Par. 8. Section 1.336-5 is revised to read as follows:


Sec.  1.336-5  Applicability dates.

    Except as otherwise provided in this section, the provisions of 
Sec. Sec.  1.336-1 through 1.336-4 apply to any qualified stock 
disposition for which the disposition date is on or after May 15, 2013. 
The provisions of Sec.  1.336-1(b)(5)(i)(A) relating to section 1022 
apply on and after January 19, 2017. The provisions of Sec.  1.336-
2(g)(3)(ii) and (iii) apply to foreign income taxes paid or accrued in 
taxable years beginning on or after [date final regulations are filed 
with the Federal Register].
0
Par. 9. Section 1.338-9 is amended by revising paragraph (d) to read as 
follows:


Sec.  1.338-9   International aspects of section 338.

* * * * *
    (d) Allocation of foreign income taxes--(1) In general. Except as 
provided in paragraph (d)(3) of this section, if a section 338 election 
is made for target (whether foreign or domestic), and target's taxable 
year under foreign law (if any) does not close at the end of the 
acquisition date, foreign income tax as defined in Sec.  1.901-2(a)(1)) 
(other than a withholding tax as defined in section 901(k)(1)(B)) paid 
or accrued by new target with respect to such foreign taxable year is 
allocated between old target and new target. If there is more than one 
section 338 election with respect to target during target's foreign 
taxable year, foreign income tax paid or accrued with respect to that 
foreign taxable year is allocated among all old targets and new 
targets. The allocation is made based on the respective portions of the 
taxable income (as determined under foreign law) for the foreign 
taxable year that are attributable under the principles of Sec.  
1.1502-76(b) to the period of existence of each old target and new 
target during the foreign taxable year.
    (2) Foreign income taxes imposed on partnerships and disregarded 
entities. If a section 338 election is made for target and target holds 
an interest in a disregarded entity (as described in Sec.  301.7701-
2(c)(2)(i) of this chapter) or partnership, the rules of Sec.  1.901-
2(f)(4) and (5) apply to determine the person who is considered for 
Federal income tax purposes to pay foreign income tax imposed at the 
entity level on the

[[Page 72120]]

income of the disregarded entity or partnership.
    (3) Disallowance of foreign tax credits under section 901(m). For 
rules that may apply to disallow foreign tax credits by reason of a 
section 338 election, see section 901(m) and Sec. Sec.  1.901(m)-1 
through 1.901(m)-8.
    (4) Applicability date. This paragraph (d) applies to foreign 
income taxes paid or accrued in taxable years beginning on or after 
[date final regulations are filed with the Federal Register].
* * * * *


Sec.  1.367(b)-2  [Amended]

0
Par. 10. Section 1.367(b)-2 is amended by removing the last sentence of 
paragraph (e)(4), Example 1.


Sec.  1.367(b)-3  [Amended]

0
Par. 11. Section 1.367(b)-3 is amended:
0
1. In paragraph (b)(3)(ii):
0
i. By removing the last sentence of Example 1.(ii).
0
ii. By removing the last sentence of Example 2.(ii).
0
2. By removing the last sentence of paragraph (c)(5), Example 1.(iii).
0
Par. 12. Section 1.367(b)-4 is amended:
0
1. By revising paragraph (b)(2)(i)(B).
0
2. By adding a sentence to the end of paragraph (h).
    The revision and addition read as follows:


Sec.  1.367(b)-4  Acquisition of foreign corporate stock or assets by a 
foreign corporation in certain nonrecognition transactions.

* * * * *
    (b) * * *
    (2) * * *
    (i) * * *
    (B) Immediately after the exchange, a domestic corporation directly 
or indirectly owns 10 percent or more of the voting power or value of 
the transferee foreign corporation; and
* * * * *
    (h) * * * Paragraph (b)(2)(i)(B) of this section applies to 
exchanges completed in taxable years of exchanging shareholders ending 
on or after November 2, 2020, and to taxable years of exchanging 
shareholders ending before November 2, 2020 resulting from an entity 
classification election made under Sec.  301.7701-3 of this chapter 
that was effective on or before November 2, 2020 but was filed on or 
after November 2, 2020.
0
Par. 13. Section 1.367(b)-7 is amended:
0
1. By adding a sentence to the end of paragraph (b)(1).
0
2. By revising paragraph (g).
0
3. By adding paragraph (h).
    The revisions and additions read as follows:


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

* * * * *
    (b) * * *
    (1) * * * See paragraph (g) of this section for rules applicable to 
taxable years of foreign corporations beginning on or after January 1, 
2018, and taxable years of United States shareholders in which or with 
which such taxable years of foreign corporations end (``post-2017 
taxable years'').
* * * * *
    (g) Post-2017 taxable years. As a result of the repeal of section 
902 effective for taxable years of foreign corporations beginning on or 
after January 1, 2018, all foreign target corporations, foreign 
acquiring corporations, and foreign surviving corporations are treated 
as nonpooling corporations in post-2017 taxable years. Any amounts 
remaining in post-1986 undistributed earnings and post-1986 foreign 
income taxes of any such corporation in any separate category as of the 
end of the foreign corporation's last taxable year beginning before 
January 1, 2018, are treated as earnings and taxes in a single pre-
pooling annual layer in the foreign corporation's post-2017 taxable 
years for purposes of this section. Foreign income taxes that are 
related to non-previously taxed earnings of a foreign acquiring 
corporation and a foreign target corporation that were accumulated in 
taxable years before the current taxable year of the foreign 
corporation, or in a foreign target's taxable year that ends on the 
date of the section 381 transaction, are not treated as current year 
taxes (as defined in Sec.  1.960-1(b)(4)) of a foreign surviving 
corporation in any post-2017 taxable year. In addition, foreign income 
taxes that are related to a hovering deficit are not treated as current 
year taxes of the foreign surviving corporation in any post-2017 
taxable year, regardless of whether the hovering deficit is absorbed.
    (h) Applicability dates. Except as otherwise provided in this 
paragraph (h), this section applies to foreign section 381 transactions 
that occur on or after November 6, 2006. Paragraph (g) of this section 
applies to taxable years of foreign corporations ending on or after 
November 2, 2020, and to taxable years of United States shareholders in 
which or with which such taxable years of foreign corporations end.
0
Par. 14. Section 1.367(b)-10 is amended:
0
1. In paragraph (c)(1), by removing the language ``sections 902 or'' 
and adding in its place the language ``section''.
0
2. By revising the heading and adding a sentence to the end of 
paragraph (e).
    The revision and addition read as follows:


Sec.  1.367(b)-10  Acquisition of parent stock or securities for 
property in triangular reorganizations.

* * * * *
    (e) Applicability dates. * * * Paragraph (c)(1) of this section 
applies to deemed distributions that occur in taxable years ending on 
or after November 2, 2020.


Sec.  1.461-1  [Amended]

0
Par. 15. Section 1.461-1 is amended by removing the language 
``paragraph (b)'' and adding in its place the language ``paragraph 
(g)'' in the last sentence of paragraph (a)(4).
0
Par. 16. Section 1.861-3 is amended:
0
1. By revising the section heading.
0
2. By redesignating paragraph (d) as paragraph (e).
0
3. By adding a new paragraph (d).
0
4. In newly redesignated paragraph (e):
0
i. By revising the heading.
0
ii. By removing ``this paragraph'' and adding ``this paragraph (e),'' 
in its place.
0
iii. By adding a sentence to the end of the paragraph.
    The revisions and additions read as follows:


Sec.  1.861-3  Dividends and income inclusions under sections 951, 
951A, and 1293 and associated section 78 dividends.

* * * * *
    (d) Source of income inclusions under sections 951, 951A, and 1293 
and associated section 78 dividends. For purposes of sections 861 and 
862 and Sec. Sec.  1.861-1 and 1.862-1, and for purposes of applying 
this section, the amount included in gross income of a United States 
person under sections 951, 951A, and 1293 and the associated section 78 
dividend for the taxable year with respect to a foreign corporation are 
treated as dividends received directly by the United States person from 
the foreign corporation that generated the inclusion. See section 
904(h) and Sec.  1.904-5(m) for rules concerning the resourcing of 
inclusions under sections 951, 951A, and 1293.
    (e) Applicability dates. * * * Paragraph (d) of this section 
applies to taxable years ending on or after November 2, 2020.
0
Par. 17. Section 1.861-8, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal

[[Page 72121]]

Register, is further amended by revising paragraph (e)(4)(i) and adding 
paragraph (h)(4) to read as follows:


Sec.  1.861-8  Computation of taxable income from sources within the 
United States and from other sources and activities.

* * * * *
    (e) * * *
    (4) * * *
    (i) Expenses attributable to controlled services. If a taxpayer 
performs a controlled services transaction (as defined in Sec.  1.482-
9(l)(1)), which includes any activity by one member of a group of 
controlled taxpayers (the renderer) that results in a benefit to a 
controlled taxpayer (the recipient), and the renderer charges the 
recipient for such services, section 482 and Sec.  1.482-1 provide for 
an allocation where the charge is not consistent with an arm's length 
result. The deductions for expenses of the taxpayer attributable to the 
controlled services transaction are considered definitely related to 
the amounts so charged and are to be allocated to such amounts.
* * * * *
    (h) * * *
    (4) Paragraph (e)(4)(i) of this section applies to taxable years 
ending on or after November 2, 2020.
0
Par. 18. Section 1.861-9, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is further amended:
0
1. By adding a sentence to the end of paragraph (g)(3).
0
2. By redesignating paragraph (k) as paragraph (l).
0
3. By adding a new paragraph (k).
0
4. By revising newly redesignated paragraph (l).
    The additions and revision read as follows:


Sec.  1.861-9  Allocation and apportionment of interest expense and 
rules for asset-based apportionment.

* * * * *
    (g) * * *
    (3) * * * For purposes of applying section 904 as the operative 
section, the statutory or residual grouping of income that assets 
generate, have generated, or may reasonably be expected to generate is 
determined after taking into account any reallocation of income 
required under Sec.  1.904-4(f)(2)(vi).
* * * * *
    (k) Election to capitalize certain expenses in determining tax book 
value of assets--(1) In general. Solely for purposes of apportioning 
interest expenses under the asset method described in paragraph (g) of 
this section, a taxpayer may elect to determine the tax book value of 
its assets by capitalizing and amortizing its research and experimental 
and advertising expenditures incurred in each taxable year under the 
rules described in paragraphs (k)(2) and (3) of this section. Any 
election made pursuant to this paragraph (k)(1) by a taxpayer must also 
be made by or on behalf of all members of an affiliated group of 
corporations as defined in Sec. Sec.  1.861-11(d) and 1.861-11T(d) that 
includes the taxpayer. A taxpayer that makes an election under this 
paragraph (k)(1) for a taxable year must determine the tax book value 
of its assets for the taxable year as if it had capitalized its 
research and experimental and advertising expenditures under paragraphs 
(k)(2) and (3) of this section in every prior taxable year. Any 
election made pursuant to this paragraph (k)(1) applies to all 
subsequent taxable years of the taxpayer unless revoked by the 
taxpayer. Revocation of such an election requires the consent of the 
Commissioner.
    (2) Research and experimental expenditures--(i) In general. A 
taxpayer making an election under paragraph (k)(1) of this section must 
capitalize its specified research or experimental expenditures paid or 
incurred during the taxable year (for purposes of apportioning interest 
expense under the asset method described in paragraph (g) of this 
section) under the rules in section 174, as contained in Pub. L. 115-
97, title I, section 13206(a), except that the 15-year amortization 
period that applies to foreign research applies to all research whether 
conducted within or outside the United States.
    (ii) Character of asset. The tax book value of the asset created as 
a result of capitalizing and amortizing specified research or 
experimental expenditures is apportioned to statutory and residual 
groupings by first assigning the asset to SIC code categories based on 
the SIC code categories of the specified research or experimental 
expenditures used to generate the asset, and then apportioning the tax 
book value of the asset in proportion to the taxpayer's sales in each 
statutory and residual grouping in the SIC code group for the taxable 
year in which the expenditures are or were incurred. The rules in Sec.  
1.861-17 (without regard to the exclusive apportionment rule in Sec.  
1.861-17(c)) apply for purposes of the preceding sentence.
    (iii) Effect of section 13206(a) of Public Law 115-97, title I. 
Beginning with the first taxable year in which the rules in section 
13206(a) of Public Law 115-97, title I, for capitalizing specified 
research or experimental expenditures for Federal income tax purposes 
become effective, the election in paragraph (k)(1) of this section will 
no longer apply to research and experimental expenditures incurred in 
that taxable year and subsequent taxable years, and the general rules 
for capitalizing and amortizing specified research or experimental 
expenditures under section 174 will apply instead in determining the 
tax book value of assets attributable to such expenditures for purposes 
of apportioning expenses under the asset method.
    (3) Advertising expenditures--(i) In general. A taxpayer making an 
election under paragraph (k)(1) of this section must capitalize and 
amortize fifty percent of its specified advertising expenses in each 
taxable year for purposes of apportioning expenses under the asset 
method described in paragraph (g) of this section. The share of 
specified advertising expenses that are charged to the capital account 
is treated as being amortized ratably over the 10-year period beginning 
with the midpoint of the taxable year in which such expenses are paid 
or incurred. The tax book value of the asset created as a result of 
capitalizing specified advertising expenses is apportioned once, in the 
taxable year that the expenses are incurred, to the statutory and 
residual groupings based on the character of the gross income that 
would be generated by selling products to, or performing services for, 
the persons to whom the specified advertising expenses are directed, 
and ratably apportioning the tax book value of the asset based on a 
reasonable estimate of the number of such persons with respect to each 
such grouping in such taxable year. Therefore, for example, if 80 
percent of specified advertising expenses incurred in Year 1 for 
promoting Product X relate to advertising viewed by persons within the 
United States and 20 percent relate to advertising viewed by persons 
outside the United States, and sales of Product X to persons within the 
United States would be U.S. source general category income and sales of 
Product X to persons outside the United States would be foreign source 
general category income, then for purposes of section 904 as the 
operative section, 80 percent of the asset is treated as a U.S. source 
general category asset and 20 percent of the asset is treated as a 
foreign source general category asset (regardless of the actual amount 
of sales or gross income generated from product sales in the taxable 
year). In subsequent years, the amortizable portion of the asset 
created from specified advertising expenses is treated as being 
amortized

[[Page 72122]]

ratably among the statutory and residual groupings to which the tax 
book value of the asset was assigned in the taxable year that it was 
created.
    (ii) Specified advertising expenses. The term specified advertising 
expenses means any amount paid or incurred in a taxable year (but only 
to the extent otherwise deductible in such taxable year), for the 
development, production, or placement (including any form of 
transmission, broadcast, publication, display, or distribution) of any 
communication to the general public (or portions thereof) which is 
intended to promote the taxpayer (or any related person under Sec.  
1.861-8(c)(4)) or a trade or business of the taxpayer (or any related 
person), or any service, facility, or product provided pursuant to such 
trade or business.
    (l) Applicability dates. (1) Except as provided in paragraphs 
(l)(2) and (3) of this section, this section applies to taxable years 
that both begin after December 31, 2017, and end on or after December 
4, 2018.
    (2) Paragraphs (b)(1)(i), (b)(8), and (e)(9) of this section apply 
to taxable years that end on or after December 16, 2019. For taxable 
years that both begin after December 31, 2017, and end on or after 
December 4, 2018, and also end before December 16, 2019, see Sec.  
1.861-9T(b)(1)(i) as contained in 26 CFR part 1 revised as of April 1, 
2019.
    (3) Paragraph (k) of this section applies to taxable years 
beginning on or after [date final regulations are filed with the 
Federal Register].
0
Par. 19. Section 1.861-10 is amended:
0
1. By adding paragraph (a).
0
2. By revising paragraphs (e)(8)(v) and (f).
0
3. By adding paragraphs (g) and (h).
    The additions and revisions read as follows:


Sec.  1.861-10  Special allocations of interest expense.

    (a) In general. This section applies to all taxpayers and provides 
exceptions to the rules of Sec.  1.861-9 that require the allocation 
and apportionment of interest expense on the basis of all assets of all 
members of the affiliated group. Section 1.861-10T(b) describes the 
direct allocation of interest expense to the income generated by 
certain assets that are subject to qualified nonrecourse indebtedness. 
Section 1.861-10T(c) describes the direct allocation of interest 
expense to income generated by certain assets that are acquired in an 
integrated financial transaction. Section 1.861-10T(d) provides special 
rules that apply to all transactions described in Sec.  1.861-10T(b) 
and (c). Paragraph (e) of this section requires the direct allocation 
of third-party interest expense of an affiliated group to such group's 
investment in related controlled foreign corporations in cases 
involving excess related person indebtedness (as defined therein). See 
also Sec.  1.861-9T(b)(5), which requires the direct allocation of 
amortizable bond premium. Paragraph (f) of this section provides a 
special rule for certain regulated utility companies. Paragraph (g) of 
this section requires the direct allocation of interest expense in the 
case of certain foreign banking branches. Paragraph (h) of this section 
sets forth applicability dates.
* * * * *
    (e) * * *
    (8) * * *
    (v) Classification of loans between controlled foreign 
corporations. In determining the amount of related group indebtedness 
for any taxable year, loans outstanding from one controlled foreign 
corporation to a related controlled foreign corporation are not treated 
as related group indebtedness. For purposes of determining the foreign 
base period ratio under paragraph (e)(2)(iv) of this section for a 
taxable year that ends on or after November 2, 2020, the rules of this 
paragraph (e)(8)(v) apply to determine the related group debt-to-asset 
ratio in each taxable year included in the foreign base period, 
including in taxable years that end before November 2, 2020.
* * * * *
    (f) Indebtedness of certain regulated utilities. If an 
automatically excepted regulated utility trade or business (as defined 
in Sec.  1.163(j)-1(b)(15)(i)(A)) has qualified nonrecourse 
indebtedness within the meaning of the second sentence in Sec.  
1.163(j)-10(d)(2), interest expense from the indebtedness is directly 
allocated to the taxpayer's assets in the manner and to the extent 
provided in Sec.  1.861-10T(b).
    (g) Direct allocation of interest expense incurred by foreign 
banking branches--(1) In general. The foreign banking branch interest 
expense of a foreign banking branch is directly allocated to the 
foreign banking branch income of that foreign banking branch, to the 
extent of the foreign banking branch income. For rules that may apply 
to foreign banking branch interest expense in excess of amounts 
allocated under this paragraph (g), see Sec.  1.861-9.
    (2) Adjustments to asset value. For purposes of applying Sec.  
1.861-9 to apportion interest expense in excess of the interest expense 
directly allocated under paragraph (g)(1) of this section, the value of 
the assets of the foreign banking branch for the year (as determined 
under Sec.  1.861-9T(g)(3)) is reduced (but not below zero) by an 
amount equal to the liabilities of that branch with respect to which 
the interest expense was directly allocated under paragraph (g)(1) of 
this section. For purposes of this paragraph (g), the amount of a 
liability with respect to a foreign currency hedge described in Sec.  
1.861-9T(b)(2) or derivative financial product described in Sec.  
1.861-9T(b)(6) is zero.
    (3) Definitions. The following definitions apply for purposes of 
this paragraph (g).
    (i) Bank. The term bank means a bank, as defined by section 2(c) of 
the Bank Holding Company Act of 1956 (12 U.S.C. 1841(c)) without regard 
to 12 U.S.C. 1841(c)(2)(C) and (G)), that is licensed or otherwise 
authorized to accept deposits, and accepts deposits in the ordinary 
course of business.
    (ii) Foreign banking branch. The term foreign banking branch means 
a foreign branch as defined in Sec.  1.904-4(f)(3), other than a 
disregarded entity (as defined in Sec.  1.904-4(f)(3)), that is owned 
by a bank and gives rise to a taxable presence in a foreign country.
    (iii) Foreign banking branch income. The term foreign banking 
branch income means gross income assigned to foreign branch category 
income (within the meaning of Sec.  1.904-4(f)(1)) that is attributable 
to a foreign banking branch. Foreign banking branch income also 
includes gross income attributable to a foreign banking branch that 
would be assigned to the foreign branch category but is assigned to a 
separate category for foreign branch category income that is resourced 
under an income tax treaty. See Sec.  1.904-4(k).
    (iv) Foreign banking branch interest expense. The term foreign 
banking branch interest expense means the interest expense that is 
regarded for Federal income tax purposes and that is recorded on the 
separate books and records (as defined in Sec.  1.989(a)-1(d)(1) and 
(2)) of a foreign banking branch.
    (v) Liability. The term liability means a deposit or other debt 
obligation, transaction, or series of transactions resulting in expense 
or loss described in Sec.  1.861-9T(b)(1)(i).
    (h) Applicability dates. Except as provided in this paragraph (h), 
this section applies to taxable years ending on or after December 4, 
2018. Paragraph (e)(8)(v) of this section applies to taxable years 
ending on or after November 2, 2020, and paragraphs (f) and (g) of this 
section apply to taxable years beginning on or after [date final 
regulations are filed with the Federal Register].
0
Par. 20. Section 1.861-14, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal

[[Page 72123]]

Register, is further amended by revising paragraphs (h) and (k) to read 
as follows:


Sec.  1.861-14  Special rules for allocating and apportioning certain 
expenses (other than interest expense) of an affiliated group of 
corporations.

* * * * *
    (h) Special rule for the allocation and apportionment of section 
818(f)(1) items of a life insurance company--(1) In general. Except as 
provided in paragraph (h)(2) of this section, life insurance company 
items specified in section 818(f)(1) (``section 818(f)(1) items'') are 
allocated and apportioned as if all members of the life subgroup were a 
single corporation (``life subgroup method''). See also Sec.  1.861-
8(e)(16) for rules on the allocation of reserve expenses with respect 
to dividends received by a life insurance company.
    (2) Alternative separate entity treatment. A consolidated group may 
choose not to apply the life subgroup method and may instead allocate 
and apportion section 818(f)(1) items solely among items of the life 
insurance company that generated the section 818(f)(1) items 
(``separate entity method''). A consolidated group indicates its choice 
to apply the separate entity method by applying this paragraph (h)(2) 
for purposes of the allocation and apportionment of section 818(f)(1) 
items on its Federal income tax return filed for its first taxable year 
to which this section applies. A consolidated group's use of the 
separate entity method constitutes a binding choice to use the method 
chosen for that year for all members of the consolidated group and all 
taxable years of such members thereafter. The taxpayer's choice of a 
method may not be revoked without the prior consent of the 
Commissioner.
* * * * *
    (k) Applicability date. Except as provided in this paragraph (k), 
this section applies to taxable years beginning after December 31, 
2019. Paragraph (h) of this section applies to taxable years beginning 
on or after [date final regulations are filed with the Federal 
Register].
0
Par. 21. Section 1.861-20, as added in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is amended:
0
1. In paragraph (b)(4), by removing the language ``301(c)(3)(A)'' and 
adding in its place the language ``301(c)(3)(A) or section 731(a)''.
0
2. By revising paragraphs (b)(7), (19), and (23).
0
3. By revising the first and second sentences in paragraph (c) 
introductory text.
0
4. In paragraph (d)(2)(ii)(B), by adding the text ``, and paragraph 
(d)(3)(ii)(B) of this section for rules regarding the assignment of 
foreign gross income arising from a distribution by a partnership'' at 
the end of the paragraph.
0
5. By adding paragraph (d)(2)(ii)(D).
0
6. In paragraph (d)(3)(i)(A), by removing the text ``or an inclusion of 
foreign law pass-through income'' and adding the language ``, an 
inclusion of foreign law pass-through income, or gain from a 
disposition under both foreign and Federal income tax law'' in its 
place.
0
7. By adding paragraphs (d)(3)(i)(D), (d)(3)(ii) and (v), (g)(10) 
through (13), and (h).
0
8. By revising paragraph (i).
    The additions and revisions read as follows:


Sec.  1.861-20  Allocation and apportionment of foreign income taxes.

* * * * *
    (b) * * *
    (7) Foreign income tax. The term foreign income tax has the meaning 
provided in Sec.  1.901-2(a).
* * * * *
    (19) U.S. capital gain amount. The term U.S. capital gain amount 
means gain recognized by a taxpayer on the sale, exchange, or other 
disposition of stock or an interest in a partnership or, in the case of 
a distribution with respect to stock or a partnership interest, the 
portion of the distribution to which section 301(c)(3)(A) or 731(a)(1), 
respectively, applies. A U.S. capital gain amount includes gain that is 
subject to section 751 and Sec.  1.751-1, but does not include any 
portion of the gain recognized by a taxpayer that is included in gross 
income as a dividend under section 964(e) or 1248.
* * * * *
    (23) U.S. return of capital amount. The term U.S. return of capital 
amount means, in the case of the sale, exchange, or other disposition 
of either stock or an interest in a partnership, the taxpayer's 
adjusted basis of the stock or partnership interest, or in the case of 
a distribution with respect to stock or a partnership interest, the 
portion of the distribution to which section 301(c)(2) or 733, 
respectively, applies.
* * * * *
    (c) * * * A foreign income tax (other than certain in lieu of taxes 
described in paragraph (h) of this section) is allocated and 
apportioned to the statutory and residual groupings that include the 
items of foreign gross income included in the base on which the tax is 
imposed. Each such foreign income tax (that is, each separate levy) is 
allocated and apportioned separately under the rules in paragraphs (c) 
through (f) of this section. * * *
* * * * *
    (d) * * *
    (2) * * *
    (ii) * * *
    (D) Foreign law transfers between taxable units. An item of foreign 
gross income arising from an event that foreign law treats as a 
transfer of property, or as giving rise to an item of accrued income, 
gain, deduction, or loss with respect to a transaction, between taxable 
units (as defined in paragraph (d)(3)(v)(E) of this section) of the 
same taxpayer, but that is not treated as a disregarded payment (as 
defined in paragraph (d)(3)(v)(E) of this section) for Federal income 
tax purposes in the same U.S. taxable year in which the foreign income 
tax is paid or accrued, is characterized and assigned to the grouping 
to which a disregarded payment in the amount of the item of foreign 
gross income (or the gross receipts giving rise to the item of foreign 
gross income) would be assigned under the rules of paragraph (d)(3)(v) 
of this section if the event giving rise to the foreign gross income 
resulted in a disregarded payment in the U.S. taxable year in which the 
foreign income tax is paid or accrued. For example, an item of foreign 
gross income that a taxpayer recognizes by reason of a foreign law 
distribution (such as a stock dividend or a consent dividend) from a 
disregarded entity is assigned to the same statutory or residual 
groupings to which the foreign gross income would be assigned if a 
distribution of property in the amount of the taxable distribution 
under foreign law were made for Federal income tax purposes on the date 
on which the foreign law distribution occurred.
* * * * *
    (3) * * *
    (i) * * *
    (D) Foreign gross income items arising from a disposition of stock. 
An item of foreign gross income that arises from a transaction that is 
treated as a sale, exchange, or other disposition of stock in a 
corporation for Federal income tax purposes is assigned first, to the 
extent of any U.S. dividend amount that results from the disposition, 
to the same statutory or residual grouping (or ratably to the 
groupings) to which the U.S. dividend amount is assigned under Federal 
income tax law. If the foreign gross income item exceeds the U.S.

[[Page 72124]]

dividend amount, the foreign gross income item is next assigned, to the 
extent of the U.S. capital gain amount, to the statutory or residual 
grouping (or ratably to the groupings) to which the U.S. capital gain 
amount is assigned under Federal income tax law. Any excess of the 
foreign gross income item over the sum of the U.S. dividend amount and 
the U.S. capital gain amount is assigned to the same statutory or 
residual grouping (or ratably to the groupings) to which earnings equal 
to such excess amount would be assigned if they were recognized for 
Federal income tax purposes in the U.S. taxable year in which the 
disposition occurred. These earnings are deemed to arise in the 
statutory and residual groupings in the same proportions as the 
proportions in which the tax book value of the stock is (or would be if 
the taxpayer were a United States person) assigned to the groupings 
under the asset method in Sec.  1.861-9 in the U.S. taxable year in 
which the disposition occurs. See paragraph (g)(10) of this section 
(Example 9).
    (ii) Items of foreign gross income included by a taxpayer by reason 
of its ownership of an interest in a partnership--(A) Scope. The rules 
of this paragraph (d)(3)(ii) apply to assign to a statutory or residual 
grouping certain items of foreign gross income that a taxpayer includes 
in foreign taxable income by reason of its ownership of an interest in 
a partnership. See paragraphs (d)(1) and (2) of this section for rules 
that apply in characterizing items of foreign gross income that are 
attributable to a partner's distributive share of income of a 
partnership. See paragraph (d)(3)(iii) of this section for rules that 
apply in characterizing items of foreign gross income that are 
attributable to an inclusion under a foreign law inclusion regime.
    (B) Foreign gross income items arising from a distribution with 
respect to an interest in a partnership. If a partnership makes a 
distribution that is treated as a distribution of property for both 
foreign law and Federal income tax purposes, the foreign gross income 
arising from the distribution (including foreign gross income 
attributable to a distribution from a partnership that foreign law 
classifies as a dividend from a corporation) is, to the extent of the 
U.S. capital gain amount, assigned to the statutory and residual 
groupings to which the U.S. capital gain amount is assigned under 
Federal income tax law. If the foreign gross income arising from the 
distribution exceeds the U.S. capital gain amount, such excess amount 
is assigned to the statutory and residual groupings to which earnings 
equal to such excess amount would be assigned if they were recognized 
in the U.S. taxable year in which the distribution is made. These 
earnings are deemed to arise in the statutory and residual groupings in 
the same proportions as the proportions in which the tax book value of 
the partnership interest or the partner's pro rata share of the 
partnership assets, as applicable, is assigned (or would be assigned if 
the partner were a United States person) for purposes of apportioning 
the partner's interest expense under Sec.  1.861-9(e) in the U.S. 
taxable year in which the distribution is made.
    (C) Foreign gross income items arising from the disposition of an 
interest in a partnership. An item of foreign gross income arising from 
the sale, exchange, or other disposition of an interest in a 
partnership for Federal income tax purposes is assigned first, to the 
extent of the U.S. capital gain amount, to the statutory or residual 
grouping (or ratably to the groupings) to which the U.S. capital gain 
amount is assigned. Any excess of the foreign gross income item over 
the U.S. capital gain amount is assigned to the statutory and residual 
grouping (or ratably to the groupings) to which a distributive share of 
income of the partnership in the amount of such excess would be 
assigned if such income was recognized for Federal income tax purposes 
in the U.S. taxable year in which the disposition occurred. The items 
constituting this distributive share of income are deemed to arise in 
the statutory and residual groupings in the same proportions as the 
proportions in which the tax book value of the partnership interest, or 
the partner's pro rata share of the partnership assets, as applicable, 
is assigned (or would be assigned if the partner were a United States 
person) for purposes of apportioning the partner's interest expense 
under Sec.  1.861-9(e) in the U.S. taxable year in which the 
disposition occurred.
* * * * *
    (v) Disregarded payments--(A) In general. This paragraph (d)(3)(v) 
applies to assign to a statutory or residual grouping a foreign gross 
income item that a taxpayer includes by reason of the receipt of a 
disregarded payment. In the case of a taxpayer that is an individual or 
a domestic corporation, this paragraph (d)(3)(v) applies to a 
disregarded payment made between a taxable unit that is a foreign 
branch, a foreign branch owner, or a non-branch taxable unit, and 
another such taxable unit of the same taxpayer. In the case of a 
taxpayer that is a foreign corporation, this paragraph (d)(3)(v) 
applies to a disregarded payment made between taxable units that are 
tested units of the same taxpayer. For purposes of this paragraph 
(d)(3)(v), an individual or corporation is treated as the taxpayer with 
respect to its distributive share of foreign income taxes paid or 
accrued by a partnership, estate, trust or other pass-through entity. 
The rules of paragraph (d)(3)(v)(B) of this section apply to attribute 
U.S. gross income comprising the portion of a disregarded payment that 
is a reattribution payment to a taxable unit, and to associate the 
foreign gross income item arising from the receipt of the reattribution 
payment with the statutory and residual groupings to which that U.S. 
gross income is assigned. The rules of paragraph (d)(3)(v)(C) of this 
section apply to assign to statutory and residual groupings items of 
foreign gross income arising from the receipt of the portion of a 
disregarded payment that is a remittance or a contribution. The rules 
of paragraph (d)(3)(v)(D) of this section apply to assign to statutory 
and residual groupings items of foreign gross income arising from 
disregarded payments in connection with disregarded sales or exchanges 
of property. Paragraph (d)(3)(v)(E) of this section provides 
definitions that apply for purposes of this paragraph (d)(3)(v) and 
paragraph (g) of this section.
    (B) Reattribution payments--(1) In general. This paragraph 
(d)(3)(v)(B) assigns to a statutory or residual grouping a foreign 
gross income item that a taxpayer includes by reason of the receipt by 
a taxable unit of the portion of a disregarded payment that is a 
reattribution payment. The foreign gross income item is assigned to the 
statutory or residual groupings to which one or more reattribution 
amounts that constitute the reattribution payment are assigned upon 
receipt by the taxable unit. If a reattribution payment comprises 
multiple reattribution amounts and the amount of the foreign gross 
income item that is attributable to the reattribution payment differs 
from the amount of the reattribution payment, foreign gross income is 
apportioned among the statutory and residual groupings in proportion to 
the reattribution amounts in each statutory and residual grouping. The 
statutory or residual grouping of a reattribution amount received by a 
taxable unit is the grouping that includes the U.S. gross income 
attributed to the taxable unit by reason of its receipt of the gross 
reattribution amount, regardless of whether, after taking into account 
disregarded payments made by the

[[Page 72125]]

taxable unit, the taxable unit has an attribution item as a result of 
its receipt of the reattribution amount. See paragraph (g)(13) of this 
section (Example 12).
    (2) Attribution of U.S. gross income to a taxable unit. This 
paragraph (d)(3)(v)(B)(2) provides attribution rules to determine the 
reattribution amounts received by a taxable unit in the statutory and 
residual groupings in order to apply paragraph (d)(3)(v)(B)(1) of this 
section to assign foreign gross income items arising from a 
reattribution payment to the groupings. In the case of a taxpayer that 
is an individual or a domestic corporation, the attribution rules in 
Sec.  1.904-4(f)(2) apply to determine the reattribution amounts 
received by a taxable unit in the separate categories (as defined in 
Sec.  1.904-5(a)(4)(v)) in order to apply paragraph (d)(3)(v)(B)(1) of 
this section for purposes of Sec.  1.904-6(b)(2)(i). In the case of a 
taxpayer that is a foreign corporation, the attribution rules in Sec.  
1.954-1(d)(1)(iii) apply to determine the reattribution amounts 
received by a taxable unit in the statutory and residual groupings in 
order to apply paragraph (d)(3)(v)(B)(1) of this section for purposes 
of Sec. Sec.  1.951A-2(c)(3), 1.954-1(c)(1)(i) and (d)(1)(iv), and 
1.960-1(d)(3)(ii). For purposes of other operative sections (as 
described in Sec.  1.861-8(f)(1)), the principles of Sec.  1.904-
4(f)(2)(vi) or Sec.  1.954-1(d)(1)(iii), as applicable, apply to 
determine the reattribution amounts received by a taxable unit in the 
statutory and residual groupings. The rules and principles of Sec.  
1.904-4(f)(2)(vi) or Sec.  1.954-1(d)(1)(iii), as applicable, apply to 
determine the extent to which a disregarded payment made by the taxable 
unit is a reattribution payment and the reattribution amounts that 
constitute a reattribution payment, and to adjust the U.S. gross income 
initially attributed to each taxable unit to reflect the reattribution 
payments that the taxable unit makes and receives. The rules in this 
paragraph (d)(3)(v)(B)(2) limit the amount of a disregarded payment 
that is a reattribution payment to the U.S. gross income of the payor 
taxable unit that is recognized in the U.S. taxable year in which the 
disregarded payment is made.
    (3) Effect of reattribution payment on foreign gross income items 
of payor taxable unit. The statutory or residual grouping to which an 
item of foreign gross income of a taxable unit is assigned is 
determined without regard to reattribution payments made by the taxable 
unit, and without regard to whether the taxable unit has one or more 
attribution items after taking into account such reattribution 
payments. No portion of the foreign gross income of the payor taxable 
unit is treated as foreign gross income of the payee taxable unit by 
reason of the reattribution payment, notwithstanding that U.S. gross 
income of the payor taxable unit that is used to assign foreign gross 
income of the payor taxable unit to statutory and residual groupings is 
reattributed to the payee taxable unit under paragraph (d)(3)(v)(B)(1) 
of this section by reason of the reattribution payment. See paragraph 
(e) of this section for rules reducing the amount of a foreign gross 
income item of a taxable unit by deductions allowed under foreign law, 
including deductions by reason of disregarded payments made by a 
taxable unit that are included in the foreign gross income of the payee 
taxable unit.
    (C) Remittances and contributions--(1) Remittances--(i) In general. 
An item of foreign gross income that a taxpayer includes by reason of 
the receipt of a remittance by a taxable unit is assigned to the 
statutory or residual groupings of the recipient taxable unit that 
correspond to the groupings out of which the payor taxable unit made 
the remittance under the rules of this paragraph (d)(3)(v)(C)(1)(i). A 
remittance paid by a taxable unit is considered to be made ratably out 
of all of the accumulated after-tax income of the taxable unit. The 
accumulated after-tax income of the taxable unit that pays the 
remittance is deemed to have arisen in the statutory and residual 
groupings in the same proportions as the proportions in which the tax 
book value of the assets of the taxable unit are (or would be if the 
owner of the taxable unit were a United States person) assigned for 
purposes of apportioning interest expense under the asset method in 
Sec.  1.861-9 in the taxable year in which the remittance is made. See 
paragraph (g)(11) and (12) of this section (Example 10 and 11). If the 
payor taxable unit is determined to have no assets under paragraph 
(d)(3)(v)(C)(1)(ii) of this section, then the foreign gross income that 
is included by reason of the receipt of the remittance is assigned to 
the residual grouping.
    (ii) Assets of a taxable unit. The assets of a taxable unit are 
determined in accordance with Sec.  1.987-6(b), except that for 
purposes of applying Sec.  1.987-6(b)(2) under this paragraph 
(d)(3)(v)(C)(1)(ii), a taxable unit is deemed to be a section 987 QBU 
(within the meaning of Sec.  1.987-1(b)(2)) and assets of the taxable 
unit include stock held by the taxable unit and the portion of the tax 
book value of a reattribution asset that is assigned to the taxable 
unit. The portion of the tax book value of a reattribution asset that 
is assigned to a taxable unit is an amount that bears the same ratio to 
the total tax book value of the reattribution asset as the sum of the 
attribution items of that taxable unit arising from gross income 
produced by the reattribution asset bears to the total gross income 
produced by the reattribution asset. The portion of a reattribution 
asset that is assigned to a taxable unit under this paragraph 
(d)(3)(v)(C)(1)(ii) is not treated as an asset of the taxable unit 
making the reattribution payment for purposes of applying paragraph 
(d)(3)(v)(C)(1)(i) of this section.
    (2) Contributions. An item of foreign gross income that a taxpayer 
includes by reason of the receipt of a contribution by a taxable unit 
is assigned to the residual grouping. See, however, Sec.  1.904-
6(b)(2)(ii) (assigning certain items of foreign gross income to the 
foreign branch category for purposes of applying section 904 as the 
operative section).
    (3) Disregarded payment that comprises both a reattribution payment 
and a remittance or contribution. If both a reattribution payment and 
either a remittance or a contribution result from a single disregarded 
payment, the foreign gross income is first attributed to the portion of 
the disregarded payment that is a reattribution payment to the extent 
of the amount of the reattribution payment, and any excess of the 
foreign gross income item over the amount of the reattribution payment 
is then to attributed to the portion of the disregarded payment that is 
a remittance or contribution.
    (D) Disregarded payments in connection with disregarded sales or 
exchanges of property. An item of foreign gross income attributable to 
gain recognized under foreign law by reason of a disregarded payment 
received in exchange for property is characterized and assigned under 
the rules of paragraph (d)(2) of this section. If a taxpayer recognizes 
U.S. gross income as a result of a disposition of property that was 
previously received in exchange for a disregarded payment, any item of 
foreign gross income that the taxpayer recognizes as a result of that 
same disposition is assigned to a statutory or residual grouping under 
paragraph (d)(1) of this section, without regard to any reattribution 
of the U.S. gross income under Sec.  1.904-4(f)(2)(vi)(A) (or the 
principles of Sec.  1.904-4(f)(2)(vi)(A)) by reason of a disregarded 
payment described in Sec.  1.904-4(f)(2)(vi)(B)(2) (or by reason of 
Sec.  1.904-4(f)(2)(vi)(D)). See paragraph (d)(3)(v)(B)(3) of this 
section.

[[Page 72126]]

    (E) Definitions. The following definitions apply for purposes of 
this paragraph (d)(3)(v) and paragraph (g) of this section.
    (1) Attribution item. The term attribution item means the portion 
of an item of gross income, computed under Federal income tax law, that 
is attributed to a taxable unit after taking into account all 
reattribution payments made and received by the taxable unit.
    (2) Contribution. The term contribution means:
    (i) A transfer of property (within the meaning of section 317(a)) 
to a taxable unit that is disregarded for Federal income tax purposes 
and that would be treated as a contribution to capital described in 
section 118 or a transfer described in section 351 if the taxable unit 
were a corporation under Federal income tax law; or
    (ii) The excess of a disregarded payment made by a taxable unit to 
another taxable unit that the first taxable unit owns over the portion 
of the disregarded payment that is a reattribution payment.
    (3) Disregarded entity. The term disregarded entity means an entity 
described in Sec.  301.7701-2(c)(2) of this chapter that is disregarded 
as an entity separate from its owner for Federal income tax purposes.
    (4) Disregarded payment. The term disregarded payment means an 
amount of property (within the meaning of section 317(a)) that is 
transferred to or from a taxable unit, including a payment in exchange 
for property or in satisfaction of an account payable, or a remittance 
or contribution, in connection with a transaction that is disregarded 
for Federal income tax purposes and that is reflected on the separate 
set of books and records of the taxable unit. A disregarded payment 
also includes any other amount that is reflected on the separate set of 
books and records of a taxable unit in connection with a transaction 
that is disregarded for Federal income tax purposes and that would 
constitute an item of accrued income, gain, deduction, or loss of the 
taxable unit if the transaction to which the amount is attributable 
were regarded for Federal income tax purposes.
    (5) Reattribution amount. The term reattribution amount means an 
amount of gross income, computed under Federal income tax law, that is 
initially assigned to a single statutory or residual grouping that 
includes gross income of a taxable unit but that is, by reason of a 
disregarded payment made by that taxable unit, attributed to another 
taxable unit under paragraph (d)(3)(v)(B)(2) of this section.
    (6) Reattribution asset. The term reattribution asset means an 
asset that produces one or more items of gross income, computed under 
Federal income tax law, to which a disregarded payment is allocated 
under the rules of paragraph (d)(3)(v)(B)(2) of this section.
    (7) Reattribution payment. The term reattribution payment means the 
portion of a disregarded payment equal to the sum of all reattribution 
amounts that are attributed to the recipient of the disregarded 
payment.
    (8) Remittance. The term remittance means:
    (i) A transfer of property (within the meaning of section 317(a)) 
by a taxable unit that would be treated as a distribution by a 
corporation to a shareholder with respect to its stock if the taxable 
unit were a corporation under Federal income tax law; or
    (ii) The excess of a disregarded payment made by a taxable unit to 
a second taxable unit (including a second taxable unit that shares the 
same owner as the payor taxable unit) over the portion of the 
disregarded payment that is a reattribution payment, other than an 
amount that is treated as a contribution under paragraph 
(d)(3)(v)(E)(2)(i) of this section.
    (9) Taxable unit. In the case of a taxpayer that is an individual 
or a domestic corporation, the term taxable unit means a foreign 
branch, a foreign branch owner, or a non-branch taxable unit, as 
defined in Sec.  1.904-6(b)(2)(i)(B). In the case of a taxpayer that is 
a foreign corporation, the term taxable unit means a tested unit, as 
defined in Sec.  1.954-1(d)(2).
* * * * *
    (g) * * *
    (10) Example 9: Gain on disposition of stock--(i) Facts. USP owns 
all of the outstanding stock of CFC, which conducts business in Country 
A. In Year 1, USP sells all of the stock of CFC to US2 for $1,000x. For 
Country A tax purposes, USP's basis in the stock of CFC is $200x. 
Accordingly, USP recognizes $800x of gain on which Country A imposes 
$80x of foreign income tax based on its rules for taxing capital gains 
of nonresidents. For Federal income tax purposes, USP's basis in the 
stock of CFC is $400x. Accordingly, USP recognizes $600x of gain on the 
sale of the stock of CFC, of which $150x is included in the gross 
income of USP as a dividend under section 1248(a) that, as provided in 
section 1248(j), is treated as a dividend eligible for the deduction 
under section 245A(a). Under paragraphs (b)(20) and (19) of this 
section, respectively, the sale of CFC stock by USP gives rise to a 
$150x U.S. dividend amount and a $450x U.S. capital gain amount. Under 
Sec. Sec.  1.904-4(d) and 1.904-5(c)(4), the $150x U.S. dividend amount 
is general category section 245A subgroup income, and the $450x U.S. 
capital gain amount is passive category income to USP. For purposes of 
allocating and apportioning its interest expense under Sec. Sec.  
1.861-9(g)(2)(i)(B) and 1.861-13, USP's stock in CFC is characterized 
as general category stock in the section 245A subgroup.
    (ii) Analysis. For purposes of allocating and apportioning the $80x 
of Country A foreign income tax, the $800x of Country A gross income 
from the sale of the stock of CFC is first assigned to separate 
categories. Under paragraph (d)(3)(i)(D) of this section, the $800x of 
Country A gross income is first assigned to the separate category to 
which the $150x U.S. dividend amount is assigned, to the extent 
thereof, and is next assigned to the separate category to which the 
$450x U.S. capital gain amount is assigned, to the extent thereof. 
Accordingly, $150x of Country A gross income is assigned to the general 
category in the section 245A subgroup, and $450x of Country A gross 
income is assigned to the passive category. Under paragraph 
(d)(3)(i)(D) of this section, the remaining $200x of Country A gross 
income is assigned to the statutory and residual groupings to which 
earnings of CFC in that amount would be assigned if they were 
recognized for Federal income tax purposes in the U.S. taxable year in 
which the disposition occurred. These earnings are all deemed to arise 
in the section 245A subgroup of the general category, based on USP's 
characterization of its stock in CFC. Thus, under paragraph 
(d)(3)(i)(D) of this section the $800x of foreign gross income, and 
therefore the foreign taxable income, is characterized as $350x ($150x 
+ $200x) of income in the general category section 245A subgroup and 
$450x of income in the passive category. This is the result even though 
for Country A tax purposes all $800x of Country A gross income is 
characterized as gain from the sale of stock, which would be passive 
category income under section 904(d)(2)(B)(i), because the income is 
assigned to a separate category based on the characterization of the 
gain under Federal income tax law. Under paragraph (f) of this section, 
the $80x of Country A tax is ratably apportioned between the general 
category section 245A subgroup and the passive category based on the 
relative amounts of foreign taxable income in each grouping. 
Accordingly, $35x ($80x

[[Page 72127]]

x $350x / $800x) of the Country A tax is apportioned to the general 
category section 245A subgroup, and $45x ($80x x $450x / $800x) of the 
Country A tax is apportioned to the passive category. See also Sec.  
1.245A(d)-1 for rules that may disallow a foreign tax credit or 
deduction for the $35x of Country A tax apportioned to the general 
category section 245A subgroup.
    (11) Example 10: Disregarded transfer of built-in gain property--
(i) Facts. USP owns FDE, a disregarded entity that is treated for 
Federal income tax purposes as a foreign branch operating in Country A. 
FDE transfers Asset F, equipment used in FDE's trade or business in 
Country A, for no consideration to USP in a transaction that is a 
remittance described in paragraph (d)(3)(v)(E)(8)(i) of this section 
for Federal income tax purposes but is treated as a distribution of 
Asset F from a corporation to its shareholder, USP, for Country A tax 
purposes. At the time of the transfer, Asset F has a fair market value 
of $250x and an adjusted basis of $100x for both Federal and Country A 
income tax purposes. Country A imposes $30x of tax on FDE with respect 
to the $150x of built-in gain on a deemed sale of Asset F, which is 
recognized for Country A tax purposes by reason of the transfer to USP. 
If FDE had sold Asset F for $250x in a transaction that was regarded 
for Federal income tax purposes, FDE would also have recognized gain of 
$150x for Federal income tax purposes, and that gain would have been 
characterized as foreign branch category income as defined in Sec.  
1.904-4(f). Country A also imposes $25x of withholding tax, a separate 
levy, on USP by reason of the distribution of Asset F, valued at $250x, 
to USP.
    (ii) Analysis--(A) Net income tax on built-in gain. For purposes of 
allocating and apportioning the $30x of Country A foreign income tax 
imposed on FDE by reason of the deemed sale of Asset F for Country A 
tax purposes, under paragraph (c)(1) of this section the $150x of 
Country A gross income from the deemed sale of Asset F is first 
assigned to a separate category. Because the transaction is disregarded 
for Federal income tax purposes, there is no corresponding U.S. item. 
However, FDE would have recognized gain of $150x, which would have been 
a corresponding U.S. item, if the deemed sale had been recognized for 
Federal income tax purposes. Therefore, under paragraph (d)(2)(i) of 
this section, the item of foreign gross income is characterized and 
assigned to the grouping to which such corresponding U.S. item would 
have been assigned if the deemed sale were recognized under Federal 
income tax law. Because the sale of Asset F in a regarded transaction 
would have resulted in foreign branch category income, the foreign 
gross income is characterized as foreign branch category income. Under 
paragraph (f) of this section, the $30x of Country A tax is also 
allocated to the foreign branch category, the statutory grouping to 
which the $150x of Country A gross income is assigned. No apportionment 
of the $30x is necessary because the class of gross income to which the 
foreign gross income is allocated consists entirely of a single 
statutory grouping, foreign branch category income.
    (B) Withholding tax on distribution. For purposes of allocating and 
apportioning the $25x of Country A withholding tax imposed on USP by 
reason of the transfer of Asset F, under paragraph (c)(1) of this 
section the $250x of Country A gross income from the distribution of 
Asset F is first assigned to a separate category. The transfer of Asset 
F is a remittance from FDE to USP, and thus there is no corresponding 
U.S. item. Under paragraph (d)(3)(v)(C)(1)(i) of this section, the item 
of foreign gross income is assigned to the groupings to which the 
income out of which the payment is made is assigned; the payment is 
considered to be made ratably out of all of the accumulated after-tax 
income of FDE, as computed for Federal income tax purposes; and the 
accumulated after-tax income of FDE is deemed to have arisen in the 
statutory and residual groupings in the same proportions as those in 
which the tax book value of FDE's assets in the groupings, determined 
in accordance with paragraph (d)(3)(v)(C)(1)(ii) of this section, are 
assigned for purposes of apportioning USP's interest expense. Because 
all of FDE's assets produce foreign branch category income, under 
paragraph (d)(3)(v)(C)(1) of this section the foreign gross income is 
characterized as foreign branch category income. Under paragraph (f) of 
this section, the $25x of Country A withholding tax is also allocated 
entirely to the foreign branch category, the statutory grouping to 
which the $250x of Country A gross income is assigned. No apportionment 
of the $25x is necessary because the class of gross income to which the 
foreign gross income is allocated consists entirely of a single 
statutory grouping, foreign branch category income.
    (12) Example 11: Disregarded payment that is a remittance--(i) 
Facts. USP owns all of the outstanding stock of CFC1. CFC1, a tested 
unit within the meaning of Sec.  1.954-1(d)(2) (the ``CFC1 tested 
unit''), owns all of the interests in FDE, a disregarded entity that is 
organized in Country B. CFC1's interests in FDE are also a tested unit 
within the meaning of Sec.  1.954-1(d)(2) (the ``FDE tested unit''). 
The sole assets of FDE (determined in accordance with paragraph 
(d)(3)(v)(C)(1)(ii) of this section) consist of all of the outstanding 
stock of CFC3, a controlled foreign corporation organized in Country B. 
In Year 1, CFC3 pays a $400x dividend to FDE that is excluded from 
CFC1's foreign personal holding company income (``FPHCI'') by reason of 
section 954(c)(6). FDE makes no payments to CFC1 and pays no Country B 
tax in Year 1. In Year 2, FDE makes a $400x payment to CFC1 that is a 
remittance (as defined in paragraph (d)(3)(v)(E) of this section). 
Under the laws of Country B, the remittance gives rise to a $400x 
dividend. Country B imposes a 5% ($20x) withholding tax (which is an 
eligible current year tax as defined in Sec.  1.960-1(b)) on CFC1 on 
the dividend. In Year 2, CFC3 pays no dividends to FDE, and FDE earns 
no income. For Federal income tax purposes, the $400x payment from FDE 
to CFC1 is a disregarded payment and results in no income to CFC1. For 
purposes of this paragraph (g)(12) (Example 11), section 960(a) is the 
operative section and the income groups described in Sec.  1.960-
1(d)(2) are the statutory and residual groupings. See Sec.  1.960-
1(d)(3)(ii)(A) (applying Sec.  1.960-1 to allocate and apportion 
current year taxes to income groups). For Federal income tax purposes, 
in Year 2 the stock of CFC3 owned by FDE has a tax book value of 
$1,000x, $750x of which is assigned under the asset method in Sec.  
1.861-9 (as applied by treating CFC1 as a United States person) to the 
general category tested income group described in Sec.  1.960-
1(d)(2)(ii)(C), and $250x of which is assigned to a passive category 
FPHCI group described in Sec.  1.960-1(d)(2)(ii)(B)(2)(i).
    (ii) Analysis. (A) The $20x Country B withholding tax on the 
remittance from FDE is imposed on a $400x item of foreign gross income 
that CFC1 includes in income by reason of its receipt of a disregarded 
payment. In order to allocate and apportion the $20x of Country B 
withholding tax under paragraph (c) of this section for purposes of 
Sec.  1.960-1(d)(3)(ii)(A), paragraph (d)(3)(v) of this section applies 
to assign the $400x item of foreign gross dividend income to a 
statutory or residual grouping. Under paragraph (d)(3)(v)(C)(1) of this 
section, the $400x item of foreign gross income is assigned to the 
statutory or residual

[[Page 72128]]

groupings that include the U.S. gross income that is attributable to 
the CFC1 tested unit under the attribution rules in Sec.  1.954-
1(d)(1)(iii) and that correspond to the statutory and residual 
groupings out of which FDE made the remittance.
    (B) Under paragraph (d)(3)(v)(C)(1)(i) of this section, FDE is 
considered to pay the remittance ratably out of all of its accumulated 
after-tax income, which is deemed to have arisen in the statutory and 
residual groupings in the same proportions as the proportions in which 
the tax book value of FDE's assets would be assigned (if CFC1 were a 
United States person) for purposes of apportioning interest expense 
under the asset method in Year 2, the taxable year in which FDE made 
the remittance. Accordingly, $300x ($400x x $750x / $1,000x) of the 
remittance is deemed to be made out of the general category tested 
income of the FDE tested unit, and $100x ($400x x $250x / $1,000x) of 
the remittance is deemed to be made out of the passive category FPHCI 
of the FDE tested unit.
    (C) Under paragraph (d)(3)(v)(C)(1)(i) of this section, $300x of 
the $400x item of foreign gross income from the remittance, and 
therefore an equal amount of foreign taxable income, is assigned to the 
income group that includes general category tested income attributable 
to the CFC1 tested unit, and $100x of this foreign gross income item, 
and therefore an equal amount of foreign taxable income, is assigned to 
the income group that includes passive category FPHCI attributable to 
the CFC1 tested unit. Under paragraph (f) of this section, the $20x of 
Country B withholding tax is ratably apportioned between the income 
groups based on the relative amounts of foreign taxable income in each 
grouping. Accordingly, $15x ($20x x $300x / $400x) of the Country B 
withholding tax is apportioned to the income group that includes 
general category tested income attributable to the CFC1 tested unit, 
and $5x ($20x x $100x / $400x) of the Country B withholding tax is 
apportioned to the income group that includes passive category FPHCI 
attributable to the CFC1 tested unit. See Sec.  1.960-2 for rules on 
determining the amount of such taxes that may be deemed paid under 
section 960(a) and (d).
    (13) Example 12: Disregarded payment that is a reattribution 
payment--(i) Facts. (A) USP owns all of the outstanding stock of CFC1, 
a tested unit within the meaning of Sec.  1.954-1(d)(2) (the ``CFC1 
tested unit''). CFC1 owns all of the interests in FDE1, a disregarded 
entity organized in Country B. CFC1's interests in FDE1 are also a 
tested unit within the meaning of Sec.  1.954-1(d)(2) (the ``FDE1 
tested unit''). Country B imposes a 20 percent net income tax on its 
residents. CFC1 also owns all of the interests in FDE2, a disregarded 
entity organized in Country C. CFC1's interests in FDE2 are also a 
tested unit within the meaning of Sec.  1.954-1(d)(2) (the ``FDE2 
tested unit''). Country C imposes a 15 percent net income tax on its 
residents. Each of the taxes imposed by Countries B and C is a foreign 
income tax within the meaning of Sec.  1.901-2(a) and a separate levy 
within the meaning of Sec.  1.901-2(d). For purposes of this paragraph 
(g)(13) (Example 12), the operative section is the high-tax exception 
of Sec.  1.954-1(d), and the statutory groupings are the general gross 
item groupings of each tested unit, as defined in Sec.  1.954-
1(d)(1)(ii)(A).
    (B) FDE2 owns Asset A, which is intangible property that has a tax 
book value of $10,000x and is properly reflected on the separate set of 
books and records of FDE2. In Year 1, pursuant to a license agreement 
between FDE1 and FDE2 for the use of Asset A, FDE1 makes a disregarded 
royalty payment to FDE2 of $1,000x that would be a deductible royalty 
payment if regarded for Federal income tax purposes. Because it is 
disregarded for Federal income tax purposes, the $1,000x disregarded 
royalty payment by FDE1 to FDE2 results in no income to CFC1 for 
Federal income tax purposes. Also in Year 1, pursuant to a sub-license 
agreement between FDE1 and a third party for the use of Asset A, FDE1 
earns $1,000x of royalty income for Federal income tax purposes (the 
``U.S. gross royalty'') that is gross tested income (as defined in 
Sec.  1.951A-2(c)(1)) and properly reflected on the separate set of 
books and records of FDE1.
    (C) Under the laws of Country B, the transaction that gives rise to 
the $1,000x item of U.S. gross royalty income causes FDE1 to include a 
$1,200x item of gross royalty income in its Country B taxable income 
(the ``Country B gross royalty''). In addition, FDE1 deducts its 
$1,000x disregarded royalty payment to FDE2 for Country B tax purposes. 
For Country B tax purposes, FDE1 therefore has $200x ($1,200x-$1,000x) 
of taxable income on which Country B imposes $40x (20% x $200x) of net 
income tax.
    (D) Under the laws of Country C, the $1,000x disregarded royalty 
payment from FDE1 to FDE2 causes FDE2 to include a $1,000x item of 
gross royalty income in its Country C taxable income (the ``Country C 
gross royalty''). FDE2 makes no deductible payments under the laws of 
Country C. For Country C tax purposes, FDE2 therefore has $1,000x of 
taxable income on which Country C imposes $150x (15% x $1,000x) of net 
income tax.
    (ii) Analysis--(A) Country B net income tax. (1) The Country B net 
income tax is imposed on foreign taxable income of FDE1 that consists 
of a $1,200x item of Country B gross royalty income and a $1,000x item 
of royalty expense. For Federal income tax purposes, the FDE1 tested 
unit has a $1,000x item of U.S. gross royalty income that is initially 
attributable to it under paragraph (d)(3)(v)(B)(2) of this section and 
Sec.  1.954-1(d)(1)(iii). The transaction that produced the $1,000x 
item of U.S. gross royalty income also produced the $1,200x item of 
Country B gross royalty income. Under paragraph (b)(2) of this section, 
the $1,000x item of U.S. gross royalty income is therefore the 
corresponding U.S. item for the $1,200x item of Country B gross royalty 
income of FDE1.
    (2) The $1,000x disregarded royalty payment from FDE1 to FDE2 is 
allocated under paragraph (d)(3)(v)(B)(2) of this section and Sec.  
1.954-1(d)(1)(iii) to the $1,000x of U.S. gross income of the FDE1 
tested unit to the extent of that gross income. As a result, the 
$1,000x disregarded royalty payment causes the $1,000x item of U.S. 
gross royalty income to be reattributed from the FDE1 tested unit to 
the FDE2 tested unit, and results in a $1,000x reattribution amount 
that is also a reattribution payment.
    (3) The $1,200x Country B gross royalty item that is included in 
the Country B taxable income of FDE1 is assigned under paragraph (d)(1) 
of this section to the statutory or residual grouping to which the 
$1,000x corresponding U.S. item is initially assigned under Sec.  
1.954-1(d)(1)(iii), namely, the general gross item grouping of the FDE1 
tested unit. This assignment is made without regard to the $1,000x 
reattribution payment from the FDE1 tested unit to the FDE2 tested unit 
or to the fact that the FDE1 tested unit has no attribution item 
arising from its $1,000x item of U.S. gross royalty income, which is 
all reattributed to the FDE2 tested unit; none of the FDE1 tested 
unit's $1,200x Country B gross royalty income is reattributed to the 
FDE2 tested unit for this purpose. See paragraph (d)(3)(v)(B)(3) of 
this section. Under paragraph (f) of this section, all of the $40x of 
Country B net income tax is allocated to the general gross item group 
of the FDE1 tested unit, the statutory grouping to which the $1,200x 
item of Country B gross royalty income of FDE1 is assigned. No 
apportionment of the $40x is necessary because the class of gross 
income to which the foreign gross

[[Page 72129]]

income is allocated consists entirely of a single statutory grouping.
    (B) Country C net income tax. The Country C net income tax is 
imposed on foreign taxable income of FDE2 that consists of a $1,000x 
item of Country C gross royalty income. For Federal income tax 
purposes, under paragraph (d)(3)(v)(B)(2) of this section and Sec.  
1.954-1(d)(1)(iii), the FDE2 tested unit has a reattribution amount of 
$1,000x of U.S. gross royalty income by reason of its receipt of the 
$1,000x reattribution payment from FDE1. The $1,000x item of U.S. gross 
royalty income that is included in the taxable income of the FDE2 
tested unit by reason of the $1,000x reattribution payment is assigned 
under paragraph (d)(3)(v)(B)(1) of this section to the statutory or 
residual grouping to which the $1,000x reattribution amount of U.S. 
gross royalty income that constitutes the reattribution payment is 
assigned upon receipt by the FDE2 tested unit under Sec.  1.954-
1(d)(1)(iii), namely, the general gross item group of the FDE2 tested 
unit. Under paragraph (d)(3)(v)(B)(1) of this section, the $1,000x item 
of Country C gross royalty income is assigned to the statutory grouping 
to which the $1,000x corresponding U.S. item is assigned. Accordingly, 
under paragraph (f) of this section, all of the $150x of Country C net 
income tax is allocated to the general gross item group of the FDE2 
tested unit, the statutory grouping to which the $1,000x item of 
Country C gross royalty income of FDE2 is assigned. No apportionment of 
the $150x is necessary because the class of gross income to which the 
foreign gross income is allocated consists entirely of a single 
statutory grouping.
    (h) Allocation and apportionment of certain foreign in lieu of 
taxes described in section 903. A tax that is a foreign income tax by 
reason of Sec.  1.903-1(c)(1) is allocated and apportioned to statutory 
and residual groupings in the same proportions as the foreign taxable 
income that comprises the excluded income (as defined in Sec.  1.903-
1(c)(1)). See paragraph (f) of this section for rules on allocating and 
apportioning certain withholding taxes described in Sec.  1.903-
1(c)(2).
    (i) Applicability date. Except as provided in this paragraph (i), 
this section applies to taxable years beginning after December 31, 
2019. Paragraphs (b)(19) and (23) and (d)(3)(i), (ii), and (v) of this 
section apply to taxable years that begin after December 31, 2019, and 
end on or after November 2, 2020. Paragraph (h) of this section applies 
to taxable years beginning after [date final regulations are filed with 
the Federal Register].
0
Par. 22. Section 1.901-1 is amended:
0
1. By revising the section heading and paragraphs (a) through (d).
0
2. In paragraph (e), by removing the language ``a husband and wife'' 
and adding the language ``spouses'' in its place.
0
3. By revising paragraphs (f) and (h)(1).
0
4. By removing paragraph (h)(2).
0
5. By redesignating paragraph (h)(3) as paragraph (h)(2).
0
6. By revising the heading and second sentence in paragraph (j).
    The revisions and additions read as follows:


Sec.  1.901-1  Allowance of credit for foreign income taxes.

    (a) In general. Citizens of the United States, domestic 
corporations, certain aliens resident in the United States or Puerto 
Rico, and certain estates and trusts may choose to claim a credit, as 
provided in section 901, against the tax imposed by chapter 1 of the 
Internal Revenue Code (Code) for certain taxes paid or accrued to 
foreign countries and possessions of the United States, subject to the 
conditions prescribed in this section.
    (1) Citizen of the United States. An individual who is a citizen of 
the United States, whether resident or nonresident, may claim a credit 
for--
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the 
individual's method of accounting for such taxes) during the taxable 
year;
    (ii) The individual's share of any such taxes of a partnership of 
which the individual is a member, or of an estate or trust of which the 
individual is a beneficiary; and
    (iii) In the case of an individual who has made an election under 
section 962, the taxes deemed to have been paid under section 960 (see 
Sec.  1.962-1(b)(2)).
    (2) Domestic corporation. A domestic corporation may claim a credit 
for--
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the 
corporation's method of accounting for such taxes) during the taxable 
year;
    (ii) The corporation's share of any such taxes of a partnership of 
which the corporation is a member, or of an estate or trust of which 
the corporation is a beneficiary; and
    (iii) The taxes deemed to have been paid under section 960.
    (3) Alien resident of the United States or Puerto Rico. Except as 
provided in a Presidential proclamation described in section 901(c), an 
individual who is a resident alien of the United States (as defined in 
section 7701(b)), or an individual who is a bona fide resident of 
Puerto Rico (as defined in section 937(a)) during the entire taxable 
year, may claim a credit for--
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the 
individual's method of accounting for such taxes) during the taxable 
year;
    (ii) The individual's share of any such taxes of a partnership of 
which the individual is a member, or of an estate or trust of which the 
individual is a beneficiary; and
    (iii) In the case of an individual who has made an election under 
section 962, the taxes deemed to have been paid under section 960 (see 
Sec.  1.962-1(b)(2)).
    (4) Estates and trusts. An estate or trust may claim a credit for:
    (i) The amount of any foreign income taxes, as defined in Sec.  
1.901-2(a), paid or accrued (as the case may be, depending on the 
estate or trust's method of accounting for such taxes) during the 
taxable year to the extent not allocable to and taken into account by 
its beneficiaries under paragraph (a)(1)(ii), (a)(2)(ii), or (a)(3)(ii) 
of this section (see section 642(a)); and
    (ii) In the case of an estate or trust that has made an election 
under section 962, the taxes deemed to have been paid under section 960 
(see Sec.  1.962-1(b)(2)).
    (b) Limitations. Certain Code sections, including sections 245A(d) 
and (e)(3), 814, 901(e) through (m), 904, 906, 907, 908, 909, 911, 
965(g), 999, and 6038, reduce, defer, or otherwise limit the credit 
against the tax imposed by chapter 1 of the Code for certain amounts of 
foreign income taxes.
    (c) Deduction denied if credit claimed--(1) In general. Except as 
provided in paragraphs (c)(2) and (3) of this section, if a taxpayer 
chooses with respect to any taxable year to claim a foreign tax credit 
to any extent, such choice will be considered to apply to all of the 
foreign income taxes paid or accrued (as the case may be, depending on 
the taxpayer's method of accounting for such taxes) in such taxable 
year, and no portion of any such taxes is allowed as a deduction from 
gross income in any taxable year. See section 275(a)(4).
    (2) Exception for taxes not subject to section 275. Foreign income 
taxes for which a credit is disallowed and to which section 275 does 
not apply may be allowed as a deduction under section 164(a)(3). See, 
for example, sections 901(f), 901(j)(3), 901(k)(7), 901(l)(4), 
901(m)(6), and 908(b). For rules on the year in which a deduction for 
foreign income taxes is allowed under section

[[Page 72130]]

164(a)(3), see Sec. Sec.  1.446-1(c)(1)(ii), 1.461-2(a)(2), and 1.461-
4(g)(6)(iii)(B).
    (3) Exception for additional taxes paid by an accrual basis 
taxpayer that relate to a prior year for which the taxpayer deducted 
foreign income taxes. In a taxable year in which a taxpayer chooses to 
claim a credit for foreign income taxes accrued in that year (including 
a cash method taxpayer who has made an election under section 905(a) to 
claim credits in the year the taxes accrue), additional foreign income 
taxes that are finally determined and paid as a result of a foreign tax 
redetermination in that taxable year may be claimed as a deduction in 
such taxable year, if the additional foreign income taxes relate to a 
prior taxable year in which the taxpayer chose to claim a deduction, 
rather than a credit, for foreign income taxes paid or accrued (as the 
case may be, depending on the taxpayer's overall method of accounting) 
in that prior year.
    (4) Example. The following example illustrates the application of 
paragraph (c)(3) of this section.
    (i) Facts. USC is a domestic corporation that is engaged in a trade 
or business in Country X through a branch. USC uses an accrual method 
of accounting and uses the calendar year as its taxable year for U.S. 
and Country X tax purposes. For taxable years 1 through 3, USC chooses 
to deduct foreign income taxes, including Country X income taxes, for 
Federal income tax purposes in the U.S. taxable year in which the taxes 
accrue. In years 4 through 6, USC chooses to claim a credit under 
section 901 for foreign income taxes that accrued in those years. In 
year 6, USC pays an additional $50x in tax to Country X with respect to 
year 1 as a result of a Country X tax audit.
    (ii) Analysis. The additional $50x of Country X tax for year 1 that 
is paid by USC in year 6 cannot be claimed as a deduction on an amended 
return for year 1, because those taxes did not accrue until year 6. See 
section 461(f) (flush language); Sec. Sec.  1.461-1(a)(2)(i) and 1.461-
2(a)(2). In addition, because the additional $50x of Country X tax 
liability relates to and is considered to accrue in year 1 for foreign 
tax credit purposes, USC cannot claim a credit for the $50x on its 
Federal income tax return for year 6. See Sec.  1.905-1(d)(1). However, 
pursuant to paragraph (c)(3) of this section, USC can claim a deduction 
for the additional $50x of year 1 Country X tax on its Federal income 
tax return for year 6, in addition to claiming a credit for foreign 
income taxes that accrued in year 6.
    (d) Period during which election can be made or changed--(1) In 
general. The taxpayer may, for a particular taxable year, elect to 
claim the benefits of section 901 (or claim a deduction in lieu of 
electing a foreign tax credit) at any time before the expiration of the 
period within which a claim for credit or refund of Federal income tax 
for such taxable year that is attributable to such credit or deduction, 
as the case may be, may be made or, if longer, the period prescribed by 
section 6511(c) if the refund period for that taxable year is extended 
by an agreement to extend the assessment period under section 
6501(c)(4). Thus, an election to claim a credit for foreign income 
taxes paid or accrued (as the case may be, depending on the taxpayer's 
method of accounting for such taxes) in a particular taxable year can 
be made within the period prescribed by section 6511(d)(3)(A) for 
claiming a credit or refund of Federal income tax for that taxable year 
that is attributable to a credit for the foreign income taxes paid or 
accrued in that particular taxable year or, if longer, the period 
prescribed by section 6511(c) with respect to that particular taxable 
year. A choice to claim a deduction under section 164(a)(3), rather 
than a credit, for foreign income taxes paid or accrued in a particular 
taxable year can be made within the period prescribed by section 
6511(a) or 6511(c), as applicable, for claiming a credit or refund of 
Federal income tax for that particular taxable year.
    (2) Manner in which election is made or changed. A taxpayer claims 
a deduction or elects to claim a credit for foreign income taxes paid 
or accrued in a particular taxable year by filing an original or 
amended return for that taxable year within the relevant period 
specified in paragraph (d)(1) of this section. A claim for credit shall 
be accompanied by Form 1116 in the case of an individual, estate or 
trust, and by Form 1118 in the case of a corporation (and an 
individual, estate or trust making an election under section 962). See 
Sec. Sec.  1.905-3 and 1.905-4 for rules requiring the filing of 
amended returns for all affected years when a timely change in the 
taxpayer's election results in U.S. tax deficiencies.
* * * * *
    (f) Taxes against which credit not allowed. The credit for foreign 
income taxes is allowed only against the tax imposed by chapter 1 of 
the Code, except that it is not allowed against tax that, under section 
26(b)(2), is treated as a tax not imposed under such chapter.
* * * * *
    (h) * * *
    (1) Except as provided in paragraphs (c)(2) and (3) of this 
section, a taxpayer who deducts foreign income taxes paid or accrued 
(as the case may be, depending on the taxpayer's method of accounting 
for such taxes) for that taxable year (see sections 164 and 275); and
* * * * *
    (j) Applicability date. * * * This section applies to foreign taxes 
paid or accrued in taxable years beginning on or after [date final 
regulations are filed with the Federal Register].
0
Par. 23. Section 1.901-2 is amended:
0
1. By revising paragraphs (a) heading and (a)(1).
0
2. By removing the undesignated paragraph following paragraph (a)(1).
0
3. By revising paragraphs (a)(3), (b) heading, (b)(1), (b)(2) heading, 
and (b)(2)(i).
0
4. By removing the undesignated paragraph following paragraph (b)(2)(i) 
and paragraph (b)(2)(ii).
0
5. By redesignating paragraphs (b)(2)(iii) and (iv) as paragraphs 
(b)(2)(ii) and (iii), respectively.
0
6. By revising paragraphs (b)(3), (b)(4) heading, and (b)(4)(i).
0
7. By removing the undesignated paragraph following paragraph 
(b)(4)(i).
0
8. By revising paragraph (b)(4)(iv).
0
9. By adding paragraph (b)(5).
0
10. By revising paragraphs (c) and (d)(1).
0
11. By removing the last sentence of paragraph (d)(2).
0
12. By revising paragraphs (e) heading, (e)(1), and (e)(2)(i).
0
13. By redesignating paragraph (e)(2)(ii) as paragraph (e)(2)(iv).
0
14. By adding a new paragraph (e)(2)(ii) and paragraph (e)(2)(iii).
0
15. By removing the undesignated sentence after paragraph 
(e)(3)(iii)(C) and paragraph (e)(3)(v).
0
16. By revising paragraphs (e)(4) and (e)(5)(i).
0
17. By redesignating paragraph (e)(5)(ii) as paragraph (e)(5)(iii).
0
18. By adding a new paragraph (e)(5)(ii) and paragraph (e)(6).
0
19. In paragraph (f)(3)(ii)(A), by removing the language ``Sec.  1.909-
2T(b)(2)(vi)'' and adding the language ``Sec.  1.909-2(b)(2)(vi)'' in 
its place.
0
20. In paragraph (f)(3)(iii)(B)(2), by removing the language ``Sec.  
1.909-2T(b)(3)(i)'' and adding the language ``Sec.  1.909-2(b)(3)(i)'' 
in its place.
0
21. By revising paragraph (f)(4).
0
22. By redesignating paragraphs (f)(5) and (6) as paragraphs (f)(6) and 
(7), respectively.
0
23. By adding a new paragraph (f)(5).
0
24. By revising newly redesignated paragraph (f)(6).
0
25. In newly redesignated paragraph (f)(7) introductory text, by 
removing the

[[Page 72131]]

language ``paragraphs (f)(3) and (f)(4)'' and adding the language 
``paragraphs (f)(3) through (6)'' in its place.
0
26. In newly redesignated paragraph (f)(7), by removing Example 3.
0
27. By revising paragraphs (g) and (h).
    The revisions and additions read as follows:


Sec.  1.901-2  Income, war profits, or excess profits tax paid or 
accrued.

    (a) Definition of foreign income tax--(1) Overview and scope. 
Paragraphs (a), (b), and (c) of this section define a foreign income 
tax for purposes of section 901. Paragraph (d) of this section contains 
rules describing what constitutes a separate levy. Paragraph (e) of 
this section provides rules for determining the amount of foreign 
income tax paid by a person. Paragraph (f) of this section contains 
rules for determining by whom foreign income tax is paid. Paragraph (g) 
of this section defines the terms used in this section. Paragraph (h) 
of this section provides the applicability date for this section.
    (i) In general. Section 901 allows a credit for the amount of 
income, war profits, and excess profits taxes paid during the taxable 
year to any foreign country, and section 903 provides that for purposes 
of Part III of subchapter N of the Code and sections 164(a) and 275(a), 
such taxes include a tax paid in lieu of a tax on income, war profits 
or excess profits that is otherwise generally imposed by a foreign 
country (collectively, for purposes of this section, a ``foreign income 
tax''). Whether a foreign levy is a foreign income tax is determined 
independently for each separate levy. A foreign tax either is or is not 
a foreign income tax, in its entirety, for all persons subject to the 
foreign tax.
    (ii) Requirements. A foreign levy is a foreign income tax only if--
    (A) It is a foreign tax; and
    (B) Either:
    (1) The foreign tax is a net income tax, as defined in paragraph 
(a)(3) of this section; or
    (2) The foreign tax is a tax in lieu of an income tax, as defined 
in Sec.  1.903-1(b).
* * * * *
    (3) Net income tax. A foreign tax is a net income tax only if the 
foreign tax meets the net gain and jurisdictional nexus requirements in 
paragraphs (b) and (c) of this section.
    (b) Net gain requirement--(1) In general. A foreign tax satisfies 
the net gain requirement only if the tax satisfies the realization, 
gross receipts, and cost recovery requirements in paragraphs (b)(2), 
(3), and (4) of this section, respectively, or if the foreign tax is a 
surtax described in paragraph (b)(5) of this section. Paragraphs (b)(2) 
through (5) of this section are applied with respect to a foreign tax 
solely on the basis of the foreign tax law governing the calculation of 
the foreign taxable base, unless otherwise provided, and without any 
consideration of the rate of tax imposed on the foreign taxable base.
    (2) Realization requirement--(i) In general. A foreign tax 
satisfies the realization requirement if it is imposed upon one or more 
of the events described in paragraphs (b)(2)(i)(A) through (C) of this 
section. If a foreign tax meets the realization requirements in 
paragraphs (b)(2)(i)(A) through (C) of this section except with respect 
to one or more specific and defined classes of nonrealization events 
(such as, for example, imputed rental income from a personal residence 
used by the owner), and as judged based on the application of the 
foreign tax to all taxpayers subject to the foreign tax, the incidence 
and amounts of gross receipts attributable to such nonrealization 
events is insignificant relative to the incidence and amounts of gross 
receipts attributable to events covered by the foreign tax that do meet 
the realization requirement, then the foreign tax is treated as meeting 
the realization requirement in paragraph (b)(2) of this section 
(despite the fact that the foreign tax is also imposed on the basis of 
some nonrealization events, and that some persons subject to the 
foreign tax may only be taxed on nonrealization events).
    (A) Realization events. The foreign tax is imposed upon or after 
the occurrence of events (``realization events'') that result in the 
realization of income under the income tax provisions of the Internal 
Revenue Code.
    (B) Pre-realization recapture events. The foreign tax is imposed 
upon the occurrence of an event before a realization event (a ``pre-
realization event'') that results in the recapture (in whole or part) 
of a tax deduction, tax credit, or other tax allowance previously 
accorded to the taxpayer (for example, the recapture of an incentive 
tax credit if required investments are not completed within a specified 
period).
    (C) Pre-realization timing difference events. The foreign tax is 
imposed upon the occurrence of a pre-realization event, other than one 
described in paragraph (b)(2)(i)(B) of this section, but only if the 
foreign country does not, upon the occurrence of a later event, impose 
tax under the same or a separate levy (a ``second tax'') on the same 
taxpayer (for purposes of this paragraph (b)(2)(i)(C), treating a 
disregarded entity as defined in Sec.  301.7701-3(b)(2)(i)(C) of this 
chapter as a taxpayer separate from its owner), with respect to the 
income on which tax is imposed by reason of such pre-realization event 
(or, if it does impose a second tax, a credit or other comparable 
relief is available against the liability for such a second tax for tax 
paid on the occurrence of the pre-realization event) and--
    (1) The imposition of the tax upon such pre-realization event is 
based on the difference in the fair market value of property at the 
beginning and end of a period;
    (2) The pre-realization event is the physical transfer, processing, 
or export of readily marketable property (as defined in paragraph 
(b)(2)(ii) of this section) and the imposition of the tax upon the pre-
realization event is based on the fair market value of such property; 
or
    (3) The pre-realization event relates to a deemed distribution (for 
example, by a corporation to a shareholder) or inclusion (for example, 
under a controlled foreign corporation inclusion regime) of amounts 
(such as earnings and profits) that meet the realization requirement in 
paragraph (b)(2) of this section in the hands of the person that, under 
foreign tax law, is deemed to distribute such amounts.
* * * * *
    (3) Gross receipts requirement--(i) Rule. A foreign tax satisfies 
the gross receipts requirement if it is imposed on the basis of actual 
gross receipts, on the basis of the amount of deemed gross receipts 
arising from pre-realization timing difference events described in 
paragraph (b)(2)(i)(C) of this section, or on the basis of gross 
receipts from an insignificant non-realization event that is described 
in the second sentence of paragraph (b)(2) of this section. A 
taxpayer's actual gross receipts are determined taking into account the 
gross receipts that are properly allocated to such taxpayer under a 
foreign tax meeting the jurisdictional nexus requirements of paragraph 
(c)(1)(i) or (c)(2) of this section.
    (ii) Examples. The following examples illustrate the rules of 
paragraph (b)(3)(i) of this section.
    (A) Example 1: Cost-plus tax--(1) Facts. Country X imposes a 
``cost-plus tax'' on country X corporations that serve as regional 
headquarters for affiliated nonresident corporations, and this tax is a 
separate levy (within the meaning of paragraph (d) of this section). A 
headquarters company for purposes of this tax is a corporation that 
performs administrative, management or coordination functions solely 
for nonresident affiliated entities. Due to the difficulty of 
determining on a case-

[[Page 72132]]

by-case basis the arm's length gross receipts that headquarters 
companies would charge affiliates for such services, gross receipts of 
a headquarters company are deemed, for purposes of this tax, to equal 
110 percent of the business expenses incurred by the headquarters 
company.
    (2) Analysis. Because the cost-plus tax is based on costs and not 
on gross receipts, under paragraph (b)(3)(i) of this section the cost-
plus tax does not satisfy the gross receipts requirement.
    (B) Example 2: Petroleum taxed on extraction--(1) Facts. Country X 
imposes a tax that is a separate levy (within the meaning of paragraph 
(d) of this section) on income from the extraction of petroleum. Under 
the terms of that tax, gross receipts from extraction income are deemed 
to equal 105 percent of the fair market value of petroleum extracted.
    (2) Analysis. Because it is imposed on deemed gross receipts that 
exceed the fair market value of the petroleum extracted, the tax on 
extraction income does not satisfy the gross receipts requirement of 
paragraph (b)(3)(i) of this section.
    (4) Cost recovery requirement--(i) In general--(A) Requirement. A 
foreign tax satisfies the cost recovery requirement if the base of the 
tax is computed by reducing gross receipts (as described in paragraph 
(b)(3) of this section) to permit recovery of the significant costs and 
expenses (including significant capital expenditures) attributable, 
under reasonable principles, to such gross receipts. In addition, a 
foreign tax satisfies the cost recovery requirement if the foreign tax 
law permits recovery of an amount that by its terms may be greater, but 
can never be less, than the actual amounts of such significant costs 
and expenses (for example, under a provision identical to percentage 
depletion allowed under section 613). A foreign tax whose base is gross 
receipts or gross income for which no reduction is allowed under 
foreign tax law for costs and expenses does not satisfy the cost 
recovery requirement, even if in practice there are few costs and 
expenses attributable to all or particular types of gross receipts 
included in the foreign tax base. See paragraph (b)(4)(iv) of this 
section (Example 3).
    (B) Significant costs and expenses--(1) Timing of recovery. A 
foreign tax law permits recovery of significant costs and expenses even 
if such costs and expenses are recovered earlier or later than they are 
recovered under the Internal Revenue Code, unless the time of recovery 
is so much later (for example, after the property becomes worthless or 
is disposed of) as effectively to constitute a denial of such recovery. 
The amount of costs and expenses that are considered to be recovered 
under the foreign tax law is neither discounted nor augmented by taking 
into account the time value of money attributable to any acceleration 
or deferral of a tax benefit resulting from the foreign law cost 
recovery method compared to when tax would be paid under the Internal 
Revenue Code. Therefore, the cost recovery requirement is satisfied 
where items deductible under the Internal Revenue Code are capitalized 
under the foreign tax law and recovered either immediately, on a 
recurring basis over time, or upon the occurrence of some future event, 
or where the recovery of items capitalized under the Internal Revenue 
Code occurs more or less rapidly than under the foreign tax law.
    (2) Amounts that must be recovered. Whether a cost or expense is 
significant for purposes of this paragraph (b)(4)(i) is determined 
based on whether, for all taxpayers in the aggregate to which the 
foreign tax applies, the item of cost or expense constitutes a 
significant portion of the taxpayers' total costs and expenses. 
However, costs and expenses related to capital expenditures, interest, 
rents, royalties, services, or research and experimentation are always 
treated as significant costs or expenses for purposes of this paragraph 
(b)(4)(i). Foreign tax law is considered to permit recovery of 
significant costs and expenses even if recovery of all or a portion of 
certain costs or expenses is disallowed, if such disallowance is 
consistent with the types of disallowances required under the Internal 
Revenue Code. For example, foreign tax law is considered to permit 
recovery of significant costs and expenses if such law disallows 
interest deductions equal to a certain percentage of adjusted taxable 
income similar to the limitation under section 163(j), disallows 
interest and royalty deductions in connection with hybrid transactions 
similar to those described in section 267A, or disallows certain 
expenses based on public policy considerations similar to those 
disallowances contained in section 162. A foreign tax law that does not 
permit recovery of one or more significant costs or expenses does not 
meet the cost recovery requirement, even if it provides alternative 
allowances that in practice equal or exceed the amount of nonrecovered 
costs or expenses. However, in determining whether a foreign tax (the 
``tested foreign tax'') meets the cost recovery requirement, it is 
immaterial whether the tested foreign tax allows a deduction for other 
taxes that would qualify as foreign income taxes (determined without 
regard to whether such other tax allows a deduction for the tested 
foreign tax). See paragraph (b)(4)(iv) of this section (Example 5).
    (3) Attribution of costs and expenses to gross receipts. Principles 
used in the foreign tax law to attribute costs and expenses to gross 
receipts may be reasonable even if they differ from principles that 
apply under the Internal Revenue Code (for example, principles that 
apply under section 265, 465 or 861(b) of the Internal Revenue Code).
* * * * *
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (b)(4).
    (A) Example 1: Tax on gross interest income of certain residents; 
no deductions allowed--(1) Facts. Country X imposes a net income tax on 
corporations resident in Country X; however, that income tax is not 
applicable to banks. Country X also imposes a tax (the ``bank tax'') of 
1 percent on the gross amount of interest income derived by banks 
resident in Country X; no deductions are allowed. Banks resident in 
Country X incur substantial costs and expenses (for example, interest 
expense) attributable to their interest income.
    (2) Analysis. Because the terms of the bank tax do not permit 
recovery of significant costs and expenses attributable to the gross 
receipts included in the tax base, under paragraph (b)(4)(i) of this 
section the bank tax does not satisfy the cost recovery requirement.
    (B) Example 2: Tax on gross interest income of nonresidents; no 
deductions allowed--(1) Facts. Country X imposes a net income tax on 
nonresident persons engaged in a trade or business in Country X. 
Country X also imposes a tax (the ``bank tax'') of 1 percent on the 
gross amount of interest income earned by nonresident banks from loans 
to residents of Country X if such banks are not engaged in a trade or 
business in Country X or if such interest income is not considered 
attributable to a trade or business conducted in Country X. Under 
Country X tax law, no deductions are allowed in determining the base of 
the bank tax. Banks incur substantial costs and expenses (for example, 
interest expense) attributable to their interest income.
    (2) Analysis. Because no deductions are allowed in determining the 
base of the bank tax, under paragraph (b)(4)(i) of this section the 
bank tax does not satisfy the cost recovery requirement.

[[Page 72133]]

    (C) Example 3: Payroll tax--(1) Facts. A foreign country imposes 
payroll tax at the rate of 10 percent on the amount of gross wages 
realized by resident employees; no deductions are allowed in computing 
the base of the payroll tax.
    (2) Analysis. Because the foreign tax law does not allow for the 
recovery of any costs and expenses attributable to gross receipts 
included in the taxable base, under paragraph (b)(4)(i) of this section 
the payroll tax does not satisfy the cost recovery requirement.
    (D) Example 4: Tax on gross wages reduced by allowable deductions-
(1) Facts. A foreign country imposes a tax at the rate of 40 percent on 
the realized gross receipts of its residents, including gross income 
from wages, reduced by deductions for significant costs and expenses 
attributable to the gross receipts included in the taxable base.
    (2) Analysis. Because foreign tax law allows for the recovery of 
significant costs and expenses attributable to gross receipts included 
in the taxable base, under paragraph (b)(4)(i) of this section the tax 
satisfies the cost recovery requirement.
    (E) Example 5: No deduction for another net income tax--(1) Facts. 
Each of Country X and Province Y (a political subdivision of Country X) 
imposes a tax on resident corporations, called the ``Country X income 
tax'' and the ``Province Y income tax,'' respectively. Each tax has an 
identical base, which is computed by reducing a corporation's realized 
gross receipts by deductions that, based on the laws of Country X and 
Province Y, generally permit recovery of the significant costs and 
expenses (including significant capital expenditures) that are 
attributable under reasonable principles to such gross receipts. 
However, the Country X income tax does not allow a deduction for the 
Province Y income tax for which a taxpayer is liable, nor does the 
Province Y income tax allow a deduction for the Country X income tax 
for which a taxpayer is liable.
    (2) Analysis. Under paragraph (d)(1)(i) of this section, each of 
the Country X income tax and the Province Y income tax is a separate 
levy. Without regard to whether the Province Y income tax may allow a 
deduction for the Country X income tax, and without regard to whether 
the Country X income tax may allow a deduction for the Province Y 
income tax, both taxes would qualify as net income taxes under 
paragraph (a)(3) of this section. Therefore, under paragraph 
(b)(4)(i)(B)(2) of this section the fact that neither levy's base 
allows a deduction for the other levy is immaterial, and both levies 
satisfy the cost recovery requirement.
    (5) Surtax on net income tax. A foreign tax satisfies the net gain 
requirement in this paragraph (b) if the base of the foreign tax is the 
amount of a net income tax. For example, if a tax (surtax) is computed 
as a percentage of a separate levy that is itself a net income tax, 
then such surtax is considered to satisfy the net gain requirement.
    (c) Jurisdictional nexus requirement. A foreign tax meets the 
jurisdictional nexus requirement only if the tax satisfies the 
requirements of paragraph (c)(1) of this section (with respect to a 
separate levy imposed on nonresidents of the foreign country) or 
paragraph (c)(2) of this section (with respect to a separate levy 
imposed on residents of the foreign country).
    (1) Tax on nonresidents. Each of the items of income of 
nonresidents of a foreign country that is subject to the foreign tax 
must satisfy the requirements of paragraph (c)(1)(i), (ii), or (iii) of 
this section.
    (i) Income attribution based on activities nexus. The income that 
is taxable in the foreign country is limited to income that is 
attributable, under reasonable principles, to the nonresident's 
activities within the foreign country (including the nonresident's 
functions, assets, and risks located in the foreign country), without 
taking into account as a significant factor the location of customers, 
users, or any other similar destination-based criterion. For purposes 
of the preceding sentence, attribution of income under reasonable 
principles includes rules similar to those for determining effectively 
connected income under section 864(c).
    (ii) Nexus based on source of income. The amount of income (other 
than income from sales or other dispositions of property) that is 
taxable in the foreign country on the basis of source (instead of on 
the basis of activities as described in paragraph (c)(1)(i) of this 
section) is based on income arising from sources within the foreign 
country that imposes the tax, but only if the sourcing rules of the 
foreign tax law are reasonably similar to the sourcing rules that apply 
for Federal income tax purposes. In particular, a foreign tax on income 
from services must be sourced based on where the services are 
performed, and not based on the location of the service recipient.
    (iii) Nexus based on situs of property. The amount of income from 
sales or dispositions of property that is taxable in the foreign 
country on the basis of the situs of real or movable property (instead 
of on the basis of activities as described in paragraph (c)(1)(i) of 
this section) includes only gains that are attributable to the 
disposition of real property situated in the foreign country or movable 
property forming part of the business property of a taxable presence in 
the foreign country (including, for purposes of this paragraph 
(c)(1)(iii), interests in a company or other entity to the extent 
attributable to such real property or business property).
    (2) Tax on residents. A foreign tax imposed on residents of the 
foreign country imposing the foreign tax may be imposed on the 
worldwide income of the resident, but must provide that any allocation 
to or from the resident of income, gain, deduction, or loss with 
respect to transactions between such resident and organizations, 
trades, or businesses owned or controlled directly or indirectly by the 
same interests (that is, any allocation made pursuant to the foreign 
country's transfer pricing rules) is determined under arm's length 
principles, without taking into account as a significant factor the 
location of customers, users, or any other similar destination-based 
criterion.
    (3) Example. The following example illustrates the rules of this 
paragraph (c).
    (i) Facts. Country X imposes a separate levy on nonresident 
companies that furnish specified types of electronically supplied 
services to users located in Country X (the ``ESS tax''). The base of 
the ESS tax is computed by taking the nonresident company's overall net 
income (determined under rules consistent with paragraph (b) of this 
section) related to supplying electronically supplied services, and 
deeming a portion of such net income to be attributable to a deemed 
permanent establishment of the nonresident company in Country X. The 
amount of the nonresident company's net income attributable to the 
deemed permanent establishment is determined on a formulary basis based 
on the percentage of the nonresident company's total users that are 
located in Country X.
    (ii) Analysis. The taxable base of the ESS tax is not computed 
based on a nonresident company's activities located in Country X, but 
instead takes into account the location of the nonresident company's 
users. Therefore, the ESS tax does not meet the requirement in 
paragraph (c)(1)(i) of this section. The ESS tax also does not meet the 
requirement in paragraph (c)(1)(ii) of this section because it is not 
imposed on the basis of source, and it does not meet the requirement in 
paragraph (c)(1)(iii) of this section because it is not imposed on the 
sale or other disposition of property.
    (iii) Alternative facts. Instead of imposing the ESS tax by deeming

[[Page 72134]]

nonresident companies to have a permanent establishment in Country X, 
Country X treats gross income from electronically supplied services 
provided to users located in Country X as sourced in Country X. The 
gross income sourced to Country X is reduced by costs that are 
reasonably attributed to such gross income, to arrive at the taxable 
base of the ESS tax. The amount of the nonresident's gross income that 
is sourced to Country X is determined by multiplying the nonresident's 
total gross income by the percentage of its total users that are 
located in Country X.
    (iv) Analysis. Country X tax law's rule for sourcing electronically 
supplied services is not based on where the services are performed, but 
is based on the location of the service recipient. Therefore, the ESS 
tax, which is imposed on the basis of source, does not meet the 
requirement in paragraph (c)(1)(ii) of this section. The ESS tax also 
does not meet the requirement in paragraph (c)(1)(i) of this section 
because it is not imposed on the basis of a nonresident's activities 
located in Country X, and it does not meet the requirement in paragraph 
(c)(1)(iii) of this section because it is not imposed on the sale or 
other disposition of property.
    (d) * * *
    (1) In general. Each foreign levy must be analyzed separately to 
determine whether it is a net income tax within the meaning of 
paragraph (a)(3) of this section and whether it is a tax in lieu of an 
income tax within the meaning of Sec.  1.903-1(b)(2). Whether a single 
levy or separate levies are imposed by a foreign country depends on 
U.S. principles and not on whether foreign tax law imposes the levy or 
levies pursuant to a single or separate statutes. A foreign levy is a 
separate levy described in this paragraph (d)(1) if it is described in 
paragraph (d)(1)(i), (ii), or (iii) of this section. In the case of 
levies that apply to dual capacity taxpayers, see also Sec.  1.901-
2A(a).
    (i) Taxing authority. A levy imposed by one taxing authority (for 
example, the national government of a foreign country) is always 
separate from a levy imposed by another taxing authority (for example, 
a political subdivision of that foreign country), even if the base of 
the levy is the same.
    (ii) Different taxable base. Where the base of a foreign levy is 
computed differently for different classes of persons subject to the 
levy, the levy is considered to impose separate levies with respect to 
each such class of persons. For example, foreign levies identical to 
the taxes imposed by sections 1, 11, 541, 871(a), 871(b), 881, 882, 
3101 and 3111 of the Internal Revenue Code are each separate levies, 
because the levies are imposed on different classes of taxpayers, and 
the base of each of those levies contains different items than the base 
of each of the others. A taxable base of a separate levy may consist of 
a particular type of income (for example, wage income, investment 
income, or income from self-employment). The taxable base of a separate 
levy may also consist of an amount unrelated to income (for example, 
wage expense or assets). A separate levy may provide that items 
included in the base of the tax are computed separately merely for 
purposes of a preliminary computation and are then combined as a single 
taxable base. Income included in the taxable base of a separate levy 
may also be included in the taxable base of another levy (which may or 
may not also include other items of income); separate levies are 
considered to be imposed if the taxable bases are not combined as a 
single taxable base. For example, a foreign levy identical to the tax 
imposed by section 1 is a separate levy from a foreign levy identical 
to the tax imposed by section 1411, because tax is imposed under each 
levy on a separate taxable base that is not combined with the other as 
a single taxable base. Where foreign tax law imposes a levy that is the 
sum of two or more separately computed amounts of tax, and each such 
amount is computed by reference to a different base, separate levies 
are considered to be imposed. Levies are not separate merely because 
different rates apply to different classes of taxpayers that are 
subject to the same provisions in computing the base of the tax. For 
example, a foreign levy identical to the tax imposed on U.S. citizens 
and resident alien individuals by section 1 of the Internal Revenue 
Code is a single levy notwithstanding that the levy has graduated rates 
and applies different rate schedules to unmarried individuals, married 
individuals who file separate returns, and married individuals who file 
joint returns. In addition, in general, levies are not separate merely 
because some provisions determining the base of the levy apply, by 
their terms or in practice, to some, but not all, persons subject to 
the levy. For example, a foreign levy identical to the tax imposed by 
section 11 of the Internal Revenue Code is a single levy even though 
some provisions apply by their terms to some but not all corporations 
subject to the section 11 tax (for example, section 465 is by its terms 
applicable to corporations described in sections 465(a)(1)(B), but not 
to other corporations), and even though some provisions apply in 
practice to some but not all corporations subject to the section 11 tax 
(for example, section 611 does not, in practice, apply to any 
corporation that does not have a qualifying interest in the type of 
property described in section 611(a)).
    (iii) Tax imposed on nonresidents. A foreign levy imposed on 
nonresidents is always treated as a separate levy from that imposed on 
residents, even if the base of the tax as applied to residents and 
nonresidents is the same, and even if the levies are treated as a 
single levy under foreign tax law. In addition, a withholding tax (as 
defined in section 901(k)(1)(B)) that is imposed on gross income of 
nonresidents is treated as a separate levy as to each separate class of 
income described in section 61 (for example, interest, dividends, 
rents, or royalties) subject to the withholding tax.
* * * * *
    (e) Amount of foreign income tax that is creditable--(1) In 
general. Credit is allowed under section 901 for the amount of foreign 
income tax that is paid by the taxpayer. The amount of foreign income 
tax paid by the taxpayer is determined separately for each taxpayer.
    (2) * * *
    (i) Refundable amounts. An amount remitted to a foreign country is 
not an amount of foreign income tax paid to the extent that it is 
reasonably certain that the amount will be refunded, rebated, abated, 
or forgiven. It is reasonably certain that an amount will be refunded, 
rebated, abated, or forgiven to the extent the amount exceeds a 
reasonable approximation of final foreign income tax liability to the 
foreign country. See section 905(c) and Sec.  1.905-3 for the required 
redeterminations if amounts claimed as a credit (on either the cash or 
accrual basis) exceed the amount of the final foreign income tax 
liability.
    (ii) Credits. Except as provided in paragraph (e)(2)(iii) of this 
section, an amount of foreign income tax liability is not an amount of 
foreign income tax paid to the extent the foreign income tax is 
reduced, satisfied or otherwise offset by a tax credit, regardless of 
whether the amount of the tax credit is refundable in cash to the 
extent it exceeds the taxpayer's liability for foreign income tax.
    (iii) Overpayments of tax applied as a credit. An amount of foreign 
income tax paid is not reduced (or treated as constructively refunded) 
solely by reason of the fact that the amount paid is allowed (or may be 
allowed) as a credit to reduce the amount of a

[[Page 72135]]

different separate levy owed by the taxpayer. See paragraphs (e)(2)(ii) 
and (e)(4) of this section. However, under paragraph (e)(2)(i) of this 
section (and taking into account any redetermination required under 
section 905(c) and Sec.  1.905-3), an amount remitted with respect to a 
separate levy for a foreign taxable period that constitutes an 
overpayment of the taxpayer's final liability for that levy for that 
period, and that is refundable in cash at the taxpayer's option, is not 
an amount of tax paid. Therefore, if such an overpayment of one tax is 
applied as a credit against a different foreign income tax liability 
owed by the taxpayer for the same or a different taxable period, the 
credited amount may qualify as an amount of that different foreign 
income tax paid, if it does not exceed a reasonable approximation of 
the taxpayer's final foreign income tax liability for the taxable 
period to which the overpayment is applied.
* * * * *
    (4) Multiple levies--(i) In general. If, under foreign law, a 
taxpayer's tentative liability for one levy (the ``reduced levy'') is 
or can be reduced by the amount of the taxpayer's liability for a 
different levy (the ``applied levy''), then the amount considered paid 
by the taxpayer to the foreign country pursuant to the applied levy is 
an amount equal to its entire liability for that applied levy (not 
limited to the amount applied to reduce the reduced levy), and the 
remainder of the total amount paid is considered paid pursuant to the 
reduced levy. See also paragraphs (e)(2)(ii) and (iii) of this section.
    (ii) Examples. The following examples illustrate the rules of 
paragraphs (e)(2)(ii) and (iii) and (e)(4)(i) of this section.
    (A) Example 1: Tax reduced by credits--(1) Facts. A's tentative 
liability for foreign income tax imposed by Country X is 100u (units of 
Country X currency). However, under Country X tax law, in determining 
A's final foreign income tax liability its tentative liability is 
reduced by a 15u credit for a separate Country X levy that does not 
qualify as a foreign income tax and that A accrued and paid on its 
gross services income, and is also reduced by a 5u credit for 
charitable contributions. Under Country X tax law, the amount of the 
charitable contributions credit is refundable in cash to the extent the 
credit exceeds the taxpayer's Country X income tax liability after 
applying the credit for the tax on gross services income. A timely 
remits the 80u due to Country X.
    (2) Analysis. Under paragraphs (e)(2)(ii) and (e)(4) of this 
section, the amount of Country X income tax paid by A is 80u (100u 
tentative liability-20u tax credits), and the amount of Country X tax 
on gross services income paid by A is 15u.
    (B) Example 2: Tax paid by credit for overpayment--(1) Facts. The 
facts are the same as in paragraph (e)(4)(ii)(A)(1) of this section 
(the facts in Example 1), except that A's final Country X income tax 
liability of 80u is satisfied by applying a credit for an otherwise 
refundable 60u overpayment from the previous taxable year of A's 
liability for a separate levy imposed by Country X that is also a 
foreign income tax and remitting the balance due of 20u.
    (2) Analysis. The result is the same as in paragraph 
(e)(4)(ii)(A)(2) of this section (the analysis in Example 1). Under 
paragraph (e)(2)(iii) of this section, the portion of A's Country X 
income tax liability that was satisfied by applying the 60u overpayment 
of A's different foreign income tax liability for the previous taxable 
year qualifies as an amount of Country X income tax paid, because that 
refundable overpayment exceeded (and so is not treated as a payment of) 
A's different foreign income tax liability for the previous taxable 
year.
    (5) * * *
    (i) In general. An amount remitted to a foreign country (a 
``foreign payment'') is not a compulsory payment, and thus is not an 
amount of foreign income tax paid, to the extent that the foreign 
payment exceeds the amount of liability for foreign income tax under 
the foreign tax law (as defined in paragraph (g) of this section). A 
foreign payment does not exceed the amount of such liability if the 
foreign payment is determined by the taxpayer in a manner that is 
consistent with a reasonable interpretation and application of the 
substantive and procedural provisions of foreign tax law (including 
applicable tax treaties) in such a way as to reduce, over time, the 
taxpayer's reasonably expected liability under foreign law for foreign 
income tax, and if the taxpayer exhausts all effective and practical 
remedies, including invocation of competent authority procedures 
available under applicable tax treaties, to reduce, over time, the 
taxpayer's liability for foreign income tax (including liability 
pursuant to a foreign tax audit adjustment). See paragraph (e)(5)(ii) 
of this section for the effect of options and elections under foreign 
tax law. An interpretation or application of foreign law is not 
reasonable if there is actual notice or constructive notice (for 
example, a published court decision) to the taxpayer that the 
interpretation or application is likely to be erroneous. In 
interpreting foreign tax law, a taxpayer may generally rely on advice 
obtained in good faith from competent foreign tax advisors to whom the 
taxpayer has disclosed the relevant facts. Whether a taxpayer has 
satisfied its obligation to minimize the aggregate amount of its 
liability for foreign income taxes over time is determined without 
regard to the present value of a deferred tax liability or other time 
value of money considerations. In determining whether a taxpayer has 
exhausted all effective and practical remedies, a remedy is effective 
and practical only if the cost of pursuing it (including the risk of 
incurring an offsetting or additional tax liability) is reasonable in 
light of the amount at issue and the likelihood of success. An 
available remedy is considered effective and practical if an 
economically rational taxpayer would pursue it whether or not a 
compulsory payment of the amount at issue would be eligible for a U.S. 
foreign tax credit. A settlement by a taxpayer of two or more issues 
will be evaluated on an overall basis, not on an issue-by-issue basis, 
in determining whether an amount is a compulsory payment. A taxpayer is 
not required to alter its form of doing business, its business conduct, 
or the form of any business transaction in order to reduce its 
liability under foreign law for foreign income tax.
    (ii) Effect of foreign tax law elections--(A) In general. Where 
foreign tax law includes options or elections whereby a taxpayer's 
foreign income tax liability may be shifted, in whole or part, to a 
different year or years, the taxpayer's use or failure to use such 
options or elections does not result in a foreign payment in excess of 
the taxpayer's liability for foreign income tax. Except as provided in 
paragraph (e)(5)(ii)(B) of this section, where foreign tax law provides 
for options or elections whereby a taxpayer's foreign income tax 
liability may be permanently decreased in the aggregate over time, the 
taxpayer's failure to use such options or elections results in a 
foreign payment in excess of the taxpayer's liability for foreign 
income tax.
    (B) Exception for certain options or elections--(1) Entity 
classification elections. If foreign tax law provides an option or 
election to treat an entity as fiscally transparent or non-fiscally 
transparent, a taxpayer's decision to use or not use such option or 
election is not considered to increase the taxpayer's liability for 
foreign income tax over time for purposes of this paragraph (e)(5).
    (2) Foreign consolidation, group relief, or other loss sharing 
regime. If foreign tax law provides an option or election for one 
foreign entity to join in the filing

[[Page 72136]]

of a consolidated return with another foreign entity, or to surrender 
its loss in order to offset the income of another foreign entity 
pursuant to a foreign group relief or other loss-sharing regime, a 
taxpayer's decision whether to file a consolidated return, whether to 
surrender a loss, or whether to use a surrendered loss, is not 
considered to increase the taxpayer's liability for foreign income tax 
over time for purposes of this paragraph (e)(5).
* * * * *
    (6) Soak-up taxes--(i) In general. An amount remitted to a foreign 
country is not an amount of foreign income tax paid to the extent that 
liability for the foreign income tax is dependent (by its terms or 
otherwise) on the availability of a credit for the tax against income 
tax liability to another country. Liability for foreign income tax is 
dependent on the availability of a credit for the foreign income tax 
against income tax liability to another country only if and to the 
extent that the foreign income tax would not be imposed on the taxpayer 
but for the availability of such a credit.
    (ii) [Reserved]
    (f) * * *
    (4) Taxes imposed on partnerships and disregarded entities--(i) 
Partnerships. If foreign law imposes tax at the entity level on the 
income of a partnership, the partnership is considered to be legally 
liable for such tax under foreign law and therefore is considered to 
pay the tax for Federal income tax purposes. The rules of this 
paragraph (f)(4)(i) apply regardless of which person is obligated to 
remit the tax, which person actually remits the tax, or which person 
the foreign country could proceed against to collect the tax in the 
event all or a portion of the tax is not paid. See Sec. Sec.  1.702-
1(a)(6) and 1.704-1(b)(4)(viii) for rules relating to the determination 
of a partner's distributive share of such tax.
    (ii) Disregarded entities. If foreign law imposes tax at the entity 
level on the income of an entity described in Sec.  301.7701-2(c)(2)(i) 
of this chapter (a disregarded entity), the person (as defined in 
section 7701(a)(1)) who is treated as owning the assets of the 
disregarded entity for Federal income tax purposes is considered to be 
legally liable for such tax under foreign law. Such person is 
considered to pay the tax for Federal income tax purposes. The rules of 
this paragraph (f)(4)(ii) apply regardless of which person is obligated 
to remit the tax, which person actually remits the tax, or which person 
the foreign country could proceed against to collect the tax in the 
event all or a portion of the tax is not paid.
    (5) Allocation of taxes in the case of certain ownership changes--
(i) In general. If a partnership, disregarded entity, or corporation 
undergoes one or more covered events during its foreign taxable year 
that do not result in a closing of the foreign taxable year, then a 
portion of the foreign income tax (other than a withholding tax 
described in section 901(k)(1)(B)) paid or accrued by a person under 
paragraphs (f)(1) through (4) of this section with respect to the 
continuing foreign taxable year in which such change or changes occur 
is allocated to and among all persons that were predecessor entities or 
prior owners during such foreign taxable year. The allocation is made 
based on the respective portions of the taxable income (as determined 
under foreign law) for the continuing foreign taxable year that are 
attributable under the principles of Sec.  1.1502-76(b) to the period 
of existence or ownership of each predecessor entity or prior owner 
during the continuing foreign taxable year. Foreign income tax 
allocated to a person that is a predecessor entity is treated (other 
than for purposes of section 986) as paid or accrued by the person as 
of the close of the last day of its last U.S. taxable year. Foreign 
income tax allocated to a person that is a prior owner, for example a 
transferor of a disregarded entity, is treated (other than for purposes 
of section 986) as paid or accrued by the person as of the close of the 
last day of its U.S. taxable year in which the covered event occurred.
    (ii) Covered event. For purposes of this paragraph (f)(5), a 
covered event is a partnership termination under section 708(b)(1), a 
transfer of a disregarded entity, or a change in the entity 
classification of a disregarded entity or a corporation.
    (iii) Predecessor entity and prior owner. For purposes of this 
paragraph (f)(5), a predecessor entity is a partnership or a 
corporation that undergoes a covered event as described in paragraph 
(f)(5)(ii) of this section. A prior owner is a person that either 
transfers a disregarded entity or owns a disregarded entity immediately 
before a change in the entity classification of the disregarded entity 
as described in paragraph (f)(5)(ii) of this section.
    (iv) Partnership variances. In the case of a change in any 
partner's interest in the partnership (a variance), except as otherwise 
provided in section 706(d)(2) (relating to certain cash basis items) or 
706(d)(3) (relating to tiered partnerships), foreign tax paid or 
accrued by the partnership during its U.S. taxable year in which the 
variance occurs is allocated between the portion of the U.S. taxable 
year ending on, and the portion of the U.S. taxable year beginning on 
the day after, the day of the variance. The allocation is made under 
the principles of this paragraph (f)(5) as if the variance were a 
covered event.
    (6) Allocation of foreign taxes in connection with elections under 
section 336(e) or 338 or Sec.  1.245A-5(e). For rules relating to the 
allocation of foreign taxes in connection with elections made pursuant 
to section 336(e), see Sec.  1.336-2(g)(3)(ii). For rules relating to 
the allocation of foreign taxes in connection with elections made 
pursuant to section 338, see Sec.  1.338-9(d). For rules relating to 
the allocation of foreign taxes in connection with elections made 
pursuant to Sec.  1.245A-5(e)(3)(i), see Sec.  1.245A-5(e)(3)(i)(B).
* * * * *
    (g) Definitions. For purposes of this section and Sec. Sec.  1.901-
2A and 1.903-1, the following definitions apply.
    (1) Foreign country and possession (territory) of the United 
States. The term foreign country means any foreign state, any 
possession (territory) of the United States, and any political 
subdivision of any foreign state or of any possession (territory) of 
the United States. The term possession (or territory) of the United 
States includes American Samoa, Guam, the Commonwealth of the Northern 
Mariana Islands, the Commonwealth of Puerto Rico, and the U.S. Virgin 
Islands.
    (2) Foreign levy. The term foreign levy means a levy imposed by a 
foreign country.
    (3) Foreign tax. The term foreign tax means a foreign levy that is 
a tax as defined in paragraph (a)(2) of this section.
    (4) Foreign tax law. The term foreign tax law means the laws of the 
foreign country imposing a foreign tax, as modified by applicable tax 
treaties. The foreign tax law is construed on the basis of the foreign 
country's statutes, regulations, case law, and administrative rulings 
or other official pronouncements, as modified by applicable income tax 
treaties.
    (5) Paid, payment, and paid by. The term paid means ``paid'' or 
``accrued''; the term payment means ``payment'' or ``accrual''; and the 
term paid by means ``paid by'' or ``accrued by or on behalf of,'' 
depending on whether the taxpayer claims the foreign tax credit for 
taxes paid (that is, remitted) or taxes accrued (as determined under 
Sec.  1.905-1(d)) during the taxable year.
    (6) Resident and nonresident. The terms resident and nonresident, 
when used in the context of the foreign tax law of a foreign country, 
have the meaning provided in paragraphs (g)(6)(i) and (ii) of this 
section.

[[Page 72137]]

    (i) Resident. An individual is a resident of a foreign country if 
the individual is liable to income tax in such country by reason of the 
individual's residence, domicile, citizenship, or similar criterion 
under such country's foreign tax law. An entity (including a 
corporation, partnership, trust, estate, or an entity that is 
disregarded as an entity separate from its owner for Federal income tax 
purposes) is a resident of a foreign country if the entity is liable to 
tax on its income (regardless of whether tax is actually imposed) under 
the laws of the foreign country by reason of the entity's place of 
incorporation or place of management in that country (or in a political 
subdivision or local authority thereof), or by reason of a criterion of 
similar nature, or if the entity is of a type that is specifically 
identified as a resident in an income tax treaty with the United States 
to which the foreign country is a party. If an individual or entity is 
a resident of more than one country, a single country of residence will 
be determined based upon applicable rules for resolving dual residency 
under the foreign tax law of the foreign country or countries; if no 
resolution is reached, the individual or entity is treated as a 
resident of each country.
    (ii) Nonresident. A nonresident with respect to a foreign country 
is any individual or entity that is not a resident of such foreign 
country.
    (h) Applicability date. This section applies to foreign taxes paid 
or accrued in taxable years beginning on or after [date final 
regulations are filed with the Federal Register].
* * * * *
0
Par. 24. Section 1.903-1 is revised to read as follows:


Sec.  1.903-1  Taxes in lieu of income taxes.

    (a) Overview. Section 903 provides that the term ``income, war 
profits, and excess profits taxes'' includes a tax paid in lieu of a 
tax on income, war profits, or excess profits that is otherwise 
generally imposed by any foreign country. Paragraphs (b) and (c) of 
this section define a tax described in section 903. Paragraph (d) of 
this section provides examples illustrating the application of this 
section. Paragraph (e) of this section sets forth the applicability 
date of this section. For purposes of this section and Sec. Sec.  
1.901-2 and 1.901-2A, a tax described in section 903 is referred to as 
a ``tax in lieu of an income tax'' or an ``in lieu of tax''; and the 
definitions in Sec.  1.901-2(g) apply for purposes of this section. 
Determinations of the amount of a tax in lieu of an income tax that is 
paid by a person and determinations of the person by whom such tax is 
paid are made under Sec.  1.901-2(e) and (f), respectively. Section 
1.901-2A contains additional rules applicable to dual capacity 
taxpayers (as defined in Sec.  1.901-2(a)(2)(ii)(A)).
    (b) Definition of tax in lieu of an income tax--(1) In general. 
Paragraphs (b)(2) and (c) of this section provide the requirements for 
a foreign levy to qualify as a tax in lieu of an income tax. The rules 
of this section are applied independently to each separate levy (within 
the meaning of Sec. Sec.  1.901-2(d) and 1.901-2A(a)). A foreign tax 
either is or is not a tax in lieu of an income tax in its entirety for 
all persons subject to the tax. It is immaterial whether the base of 
the in lieu of tax bears any relation to realized net gain. The base of 
the foreign tax may, for example, be gross income, gross receipts or 
sales, or the number of units produced or exported. The foreign 
country's reason for imposing a foreign tax on a base other than net 
income (for example, because of administrative difficulty in 
determining the amount of income that would otherwise be subject to a 
net income tax) is immaterial, although paragraph (c)(1) of this 
section generally requires a showing that the foreign country made a 
deliberate and cognizant choice to impose the in lieu of tax instead of 
a net income tax (see paragraph (c)(1)(iii) of this section).
    (2) Requirements. A foreign levy is a tax in lieu of an income tax 
only if--
    (i) It is a foreign tax; and
    (ii) It satisfies the substitution requirement of paragraph (c) of 
this section.
    (c) Substitution requirement--(1) In general. A foreign tax (the 
``tested foreign tax'') satisfies the substitution requirement if, 
based on the foreign tax law, the requirements in paragraphs (c)(1)(i) 
through (iv) of this section are satisfied with respect to the tested 
foreign tax, or the tested foreign tax is a covered withholding tax 
described in paragraph (c)(2) of this section.
    (i) Existence of generally-imposed net income tax. A separate levy 
that is a net income tax (as described in Sec.  1.901-2(a)(3)) is 
generally imposed by the same foreign country (the ``generally-imposed 
net income tax'') that imposes the tested foreign tax.
    (ii) Non-duplication. Neither the generally-imposed net income tax 
nor any other separate levy that is a net income tax is also imposed, 
in addition to the tested foreign tax, by the same foreign country on 
any persons with respect to any portion of the income to which the 
amounts (such as sales or units of production) that form the base of 
the tested foreign tax relate (the ``excluded income''). Therefore, a 
tested foreign tax does not meet the requirement of this paragraph 
(c)(1)(ii) if a net income tax imposed by the same foreign country 
applies to the excluded income of any persons that are subject to the 
tested foreign tax, even if not all of the persons subject to the 
tested foreign tax are subject to the net income tax.
    (iii) Close connection to excluded income. But for the existence of 
the tested foreign tax, the generally-imposed net income tax would 
otherwise have been imposed on the excluded income. The requirement in 
the preceding sentence is met only if the imposition of such tested 
foreign tax bears a close connection to the failure to impose the 
generally-imposed net income tax on the excluded income; the 
relationship cannot be merely incidental, tangential, or minor. A close 
connection exists if the generally-imposed net income tax would apply 
by its terms to the income, but for the fact that the excluded income 
is expressly excluded. Otherwise, a close connection must be 
established with proof that the foreign country made a cognizant and 
deliberate choice to impose the tested foreign tax instead of the 
generally-imposed net income tax. Such proof must be based on foreign 
tax law, or the legislative history of either the tested foreign tax or 
the generally-imposed net income tax that describes the provisions 
excluding taxpayers subject to the tested foreign tax from the 
generally-imposed net income tax. If one tested foreign tax meets the 
requirements in this paragraph (c)(1), and another tested foreign tax 
that applies to the same class of taxpayers and relates to the same 
excluded income as the first tested foreign tax is enacted later in 
time (and not contemporaneously with the first tested foreign tax), 
there is a rebuttable presumption that such second tested foreign tax 
does not meet the close connection requirement in this paragraph 
(c)(1)(iii). Not all income derived by persons subject to the tested 
foreign tax need be excluded income, as long as the tested foreign tax 
applies only to amounts that relate to the excluded income.
    (iv) Jurisdiction to tax excluded income. If the generally-imposed 
net income tax were applied to the excluded income, the generally-
imposed net income tax would either continue to qualify as a net income 
tax described in Sec.  1.901-2(a)(3), or would constitute a separate 
levy from the generally-imposed net income tax that would itself be a 
net income tax described in Sec.  1.901-2(a)(3).

[[Page 72138]]

    (2) Covered withholding tax. A tested foreign tax is a covered 
withholding tax if, based on the foreign tax law, the requirements in 
paragraphs (c)(1)(i) and (c)(2)(i) through (iii) of this section are 
met with respect to the tested foreign tax. See also Sec.  1.901-
2(d)(1)(iii) for rules treating withholding taxes as separate levies 
with respect to each class of income subject to the tax.
    (i) Withholding tax on nonresidents. The tested foreign tax is a 
withholding tax (as defined in section 901(k)(1)(B)) that is imposed on 
gross income of persons who are nonresidents of the foreign country 
imposing the tested foreign tax. It is immaterial whether the tested 
foreign tax is withheld by the payor or is imposed directly on the 
nonresident taxpayer.
    (ii) Non-duplication. The tested foreign tax is not in addition to 
any net income tax that is imposed by the foreign country on any 
portion of the net income attributable to the gross income that is 
subject to the tested foreign tax. Therefore, a tested foreign tax does 
not meet the requirement of this paragraph (c)(2)(ii) if by its terms 
it applies to gross income of nonresidents that are also subject to a 
net income tax imposed by the same foreign country on the same income, 
even if not all nonresidents subject to the tested foreign tax are also 
subject to the net income tax.
    (iii) Source-based jurisdictional nexus. The income subject to the 
tested foreign tax satisfies the source requirement described in Sec.  
1.901-2(c)(1)(ii).
    (d) Examples. The following examples illustrate the rules of this 
section.
    (1) Example 1: Tax on gross income from services; non-duplication 
requirement--(i) Facts. Country X imposes a tax at the rate of 3 
percent on the gross receipts of companies, wherever resident, from 
furnishing specified types of electronically supplied services to 
customers located in Country X (the ``ESS tax''). No deductions are 
allowed in determining the taxable base of the ESS tax. In addition to 
the ESS tax, Country X imposes a net income tax within the meaning of 
Sec.  1.901-2(a)(3) on resident companies (the ``net income tax'') and 
also imposes a net income tax within the meaning of Sec.  1.901-2(a)(3) 
on the income of nonresident companies that is attributable, under 
reasonable principles, to the nonresident's activities within Country X 
(the ``permanent establishment tax''). Both the net income tax and the 
permanent establishment tax, which are each separate levies under Sec.  
1.901-2(d)(1)(iii), qualify as generally-imposed net income taxes. The 
ESS tax applies to both resident and nonresident companies regardless 
of whether the company is also subject to the net income tax or 
permanent establishment tax, respectively.
    (ii) Analysis. Under Sec.  1.901-2(d)(1)(iii), the ESS tax 
comprises two separate levies, one imposed on resident companies (the 
``resident ESS tax''), and one imposed on nonresident companies (the 
``nonresident ESS tax''). Under paragraph (c)(1)(ii) of this section, 
neither the resident ESS tax nor the nonresident ESS tax satisfies the 
substitution requirement, because by its terms the income subject to 
the ESS tax is also subject to a generally-imposed net income tax 
imposed by Country X. Similarly, under paragraph (c)(2)(ii) of this 
section, the nonresident ESS tax is not a covered withholding tax 
because it is imposed in addition to the permanent establishment tax. 
It is immaterial that some nonresident taxpayers that are subject to 
the nonresident ESS tax are not also subject to the permanent 
establishment tax on the gross receipts included in the base of the 
nonresident ESS tax. Therefore, neither the resident ESS tax nor the 
nonresident ESS tax is a tax in lieu of an income tax.
    (2) Example 2: Tax on gross income from services; jurisdictional 
nexus--(i) Facts. The facts are the same as in paragraph (d)(1)(i) of 
this section (the facts in Example 1), except that under Country X tax 
law, the nonresident ESS tax is imposed only if the nonresident company 
does not have a permanent establishment in Country X under domestic law 
or an applicable income tax treaty. In addition, the text of and 
legislative history to the nonresident ESS tax demonstrate that Country 
X made a cognizant and deliberate choice to impose the nonresident ESS 
tax instead of the permanent establishment tax with respect to the 
gross receipts that are subject to the nonresident ESS tax.
    (ii) Analysis--(A) General application of substitution requirement. 
The nonresident ESS tax meets the requirements in paragraphs (c)(1)(i) 
and (ii) of this section because Country X has a generally-imposed net 
income tax, the permanent establishment tax, and neither the permanent 
establishment tax nor any other separate levy is imposed by Country X 
on a nonresident's gross income that forms the base of the nonresident 
ESS tax (which is the excluded income) in addition to the nonresident 
ESS tax. The text of and legislative history to the nonresident ESS tax 
demonstrate that Country X made a cognizant and deliberate choice to 
exclude the excluded income from the base of the generally-imposed 
permanent establishment tax. Therefore, the nonresident ESS tax meets 
the requirement in paragraph (c)(1)(iii) of this section because but 
for the existence of the tested foreign tax, the generally-imposed 
permanent establishment tax would otherwise have been imposed on the 
excluded income. However, if Country X had modified the permanent 
establishment tax to also apply to the excluded income, the modified 
permanent establishment tax would not qualify as a net income tax 
described in Sec.  1.901-2(a)(3), because it would fail the 
jurisdictional nexus requirement in Sec.  1.901-2(c)(1). First, the 
modified tax would not satisfy Sec.  1.901-2(c)(1)(i) because the 
modified tax would not apply to income attributable under reasonable 
principles to the nonresident's activities within the foreign country, 
since the modified tax is determined by taking into account the 
location of customers. Second, the modified tax would not satisfy Sec.  
1.901-2(c)(1)(ii) because the excluded income is from services 
performed outside of Country X. Third, the modified tax would not 
satisfy the property nexus in Sec.  1.901-2(c)(1)(iii) because the 
excluded income is not from sales of property located in Country X. 
Because if the Country X generally-imposed net income tax applied to 
excluded income it would not qualify as a net income tax described in 
Sec.  1.901-2(a)(3), the nonresident ESS tax does not meet the 
requirement in paragraph (c)(1)(iv) of this section. Therefore, the 
nonresident ESS tax does not satisfy the substitution requirement in 
paragraph (c)(1) of this section.
    (B) Covered withholding tax analysis. The nonresident ESS tax meets 
the requirement in paragraph (c)(1)(i) of this section, because there 
exists a generally-imposed net income tax (the permanent establishment 
tax), and it also meets the requirements in paragraphs (c)(2)(i) and 
(ii) of this section, because it is a withholding tax on gross income 
of nonresidents that is not also subject to the permanent establishment 
tax. However, the nonresident ESS tax does not meet the requirement in 
paragraph (c)(2)(iii) of this section because the services income 
subject to the nonresident ESS tax is from electronically supplied 
services performed outside of Country X. See Sec.  1.901-2(c)(1)(ii). 
Therefore, the nonresident ESS tax is not a covered withholding tax 
under paragraph (c)(2) of this section. Because the nonresident ESS tax 
does not meet the substitution requirement of paragraph (c) of this

[[Page 72139]]

section, it is not a tax in lieu of an income tax.
    (e) Applicability date. This section applies to foreign taxes paid 
or accrued in taxable years beginning on or after [date final 
regulations are filed with the Federal Register].


Sec.  1.904-2  [Amended]

0
Par. 25. Section 1.904-2(j)(1)(iii)(D) is amended by removing the 
language ``Sec.  1.904(f)-12(j)(5)'' and adding the language ``Sec.  
1.904(f)-12(j)(6)'' in its place.
0
Par. 26. Section 1.904-4, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is further amended:
0
1. By revising paragraph (b)(2)(i)(A).
0
2. By revising the third sentence of paragraph (c)(4).
0
3. By revising paragraphs (e)(1)(ii) and (e)(2) and (3).
0
4. In paragraph (f)(1)(i) introductory text, by removing the language 
``paragraph (f)(1)(ii) of this section'' and adding in its place the 
language ``paragraph (f)(1)(ii), (iii), or (iv) of this section''.
0
5. By adding paragraphs (f)(1)(iii) and (iv).
0
6. By removing and reserving paragraphs (f)(2)(ii) and (iii).
0
7. By revising paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(1)(ii).
0
8. By adding paragraph (f)(2)(vi)(G).
0
9. By revising paragraph (f)(3)(v).
0
10. By redesignating paragraphs (f)(3)(viii) and (ix) as paragraphs 
(f)(3)(ix) and (xii), respectively.
0
11. By adding a new paragraph (f)(3)(viii).
0
12. In newly redesignated paragraph (f)(3)(ix), by removing the 
language ``paragraph (f)(3)(viii)'' and adding the language ``paragraph 
(f)(3)(ix)'' in its place.
0
13. By redesignating paragraph (f)(3)(x) as paragraph (f)(3)(xiii).
0
14. By adding a new paragraph (f)(3)(x) and paragraph (f)(3)(xi).
0
15. In paragraphs (f)(4)(i)(B)(1) and (2), by removing the language 
``paragraph (f)(3)(viii)'' and adding the language ``paragraph 
(f)(3)(ix)'' in its place.
0
16. In paragraphs (f)(4)(iv)(B)(1) and (f)(4)(v)(B)(2), by removing the 
language ``paragraph (f)(3)(x)'' and adding the language ``paragraph 
(f)(3)(xiii)'' in its place.
0
17. By adding paragraphs (f)(4)(xiii) through (xvi) and (q)(3).
    The additions and revisions read as follows:


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

* * * * *
    (b) * * *
    (2) * * *
    (i) * * *
    (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), taking into account any exceptions or exclusions to section 
954(c), including, for example, section 954(c)(3), (c)(6), (h), or (i)) 
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;
* * * * *
    (c) * * *
    (4) * * * The grouping rules of paragraphs (c)(3)(i) through (iv) 
of this section also apply separately to income attributable to each 
tested unit described in Sec.  1.954-1(d)(2)(i) of a controlled foreign 
corporation, and to each foreign QBU of a noncontrolled 10-percent 
owned foreign corporation or any other look-through entity defined in 
Sec.  1.904-5(i), or of any United States person.
* * * * *
    (e) * * *
    (1) * * *
    (ii) Definition of financial services income. The term financial 
services income means income derived by a financial services entity, as 
defined in paragraph (e)(3) of this section, that is:
    (A) Income derived in the active conduct of a banking, insurance, 
financing, or similar business (active financing income) as defined in 
paragraph (e)(2) of this section; or
    (B) Passive income as defined in section 904(d)(2)(B) and paragraph 
(b) of this section as determined before the application of the 
exception for high-taxed income but after the application of the 
exception for export financing interest, but not including payments 
from a related person that is not a financial services entity 
(determined after the application of the financial services group rule 
of paragraph (e)(3)(ii) of this section) that are attributable to 
passive category income under the look-through rules of Sec.  1.904-5.
    (2) Active financing income--(i) Income included. For purposes of 
paragraph (e)(1) and (3) of this section, income is active financing 
income only if it is income from--
    (A) Regularly making personal, mortgage, industrial, or other loans 
to customers in the ordinary course of the corporation's trade or 
business;
    (B) Factoring evidences of indebtedness for customers;
    (C) Purchasing, selling, discounting, or negotiating for customers 
notes, drafts, checks, bills of exchange, acceptances, or other 
evidences of indebtedness;
    (D) Issuing letters of credit and negotiating drafts drawn 
thereunder for customers;
    (E) Performing trust services, including as a fiduciary, agent, or 
custodian, for customers, provided such trust activities are not 
performed in connection with services provided by a dealer in stock, 
securities or similar financial instruments;
    (F) Arranging foreign exchange transactions for, or engaging in 
foreign exchange transactions with, customers;
    (G) Arranging interest rate, currency or commodities futures, 
forwards, options or notional principal contracts for, or entering into 
such transactions with, customers;
    (H) Underwriting issues of stock, debt instruments or other 
securities under best efforts or firm commitment agreements for 
customers;
    (I) Engaging in finance leasing (that is, is any lease that is a 
direct financing lease or a leveraged lease for accounting purposes and 
is also a lease for tax purposes) for customers;
    (J) Providing charge and credit card services for customers or 
factoring receivables obtained in the course of providing such 
services;
    (K) Providing traveler's check and money order services for 
customers;
    (L) Providing correspondent bank services for customers;
    (M) Providing paying agency and collection agency services for 
customers;
    (N) Maintaining restricted reserves (including money or securities) 
in a segregated account in order to satisfy a capital or reserve 
requirement imposed by a local banking or securities regulatory 
authority;
    (O) Engaging in hedging activities directly related to another 
activity described in this paragraph (e)(2)(i);
    (P) Repackaging mortgages and other financial assets into 
securities and servicing activities with respect to such assets 
(including the accrual of interest incidental to such activity);
    (Q) Engaging in financing activities typically provided in the 
ordinary course by an investment bank, such as project financing 
provided in connection with construction projects, structured finance 
(including the extension of a loan and the sale of participations or 
interests in the loan to other financial institutions or investors), 
and leasing activities to the extent incidental to such financing 
activities;
    (R) Providing financial or investment advisory services, investment 
management services, fiduciary

[[Page 72140]]

services, or custodial services to customers;
    (S) Purchasing or selling stock, debt instruments, interest rate or 
currency futures or other securities or derivative financial products 
(including notional principal contracts) from or to customers and 
holding stock, debt instruments and other securities as inventory for 
sale to customers, unless the relevant securities or derivative 
financial products are not held in a dealer capacity;
    (T) Effecting transactions in securities for customers as a 
securities broker;
    (U) Investing funds in circumstances in which the taxpayer holds 
itself out as providing a financial service by the acceptance or the 
investment of such funds, including income from investing deposits of 
money and income earned investing funds received for the purchase of 
traveler's checks or face amount certificates;
    (V) Investments by an insurance company of its unearned premiums or 
reserves ordinary and necessary to the proper conduct of the insurance 
business (as defined in paragraph (e)(2)(ii) of this section);
    (W) Activities generating income of a kind that would be insurance 
income as defined in section 953(a)(1) (including related person 
insurance income as defined in section 953(c)(2) and without regard to 
the exception in section 953(a)(2) for income that is exempt insurance 
income under section 953(e)), but with respect to investment income 
includible in section 953(a)(1) insurance income, only to the extent 
ordinary and necessary to the proper conduct of the insurance business 
(as defined in paragraph (e)(2)(ii) of this section); or
    (X) Providing services as an insurance underwriter, insurance 
brokerage or agency services, or loss adjuster and surveyor services.
    (ii) Ordinary and necessary investment income of an insurance 
company. For purposes of paragraphs (e)(2)(i)(V) and (W) of this 
section, income from investments by an insurance company is not 
ordinary and necessary to the proper conduct of the insurance business 
to the extent that the investment income component of paragraphs 
(e)(2)(i)(V) and (W) of this section exceeds the insurance company's 
investment income limitation. Any item of investment income falling 
under both paragraphs (e)(2)(i)(V) and (W) of this section is only 
counted once.
    (A) Insurance company investment income limitation. An insurance 
company's investment income limitation for a taxable year is equal to 
the company's passive category income (as defined in section 
904(d)(2)(B) and paragraph (b) of this section, but including income 
excluded from foreign personal holding company income under section 
954(i)) multiplied by the proportion that the company's investment 
asset limitation (as determined under paragraph (e)(2)(ii)(B) of this 
section) bears to the value of the company's passive category assets 
(as determined under Sec.  1.861-9(g)(2)) for such taxable year. For 
purposes of this paragraph (e)(2)(ii), the term passive category asset 
means an asset that is characterized as a passive category asset, under 
the rules of Sec. Sec.  1.861-9 through 1.861-13.
    (B) Insurance company investment asset limitation. For purposes of 
paragraph (e)(2)(ii)(A) of this section, the investment asset 
limitation equals the applicable percentage of the company's total 
insurance liabilities. The applicable percentage is--
    (1) 200 percent of total insurance liabilities, for a domestic 
corporation taxable under part I of subchapter L of the Code or a 
foreign corporation that would be taxable under part I of subchapter L 
if it were a domestic corporation.
    (2) 400 percent of total insurance liabilities, for a domestic 
corporation taxable under part II of subchapter L or a foreign 
corporation that would be taxable under part II of subchapter L if it 
were a domestic corporation.
    (C) Total insurance liabilities. For purposes of paragraph 
(e)(2)(ii)(B) of this section--
    (1) Corporations taxable under part I of subchapter L. In the case 
of a corporation taxable under part I of subchapter L (including a 
foreign corporation that is a section 953(d) company), the term total 
insurance liabilities means the sum of the total reserves (as defined 
in section 816(c)) plus (to the extent not included in total reserves) 
the items referred to in paragraphs (3), (4), (5), and (6) of section 
807(c).
    (2) Corporations taxable under part II of subchapter L. In the case 
of a corporation taxable under part II of subchapter L (including a 
foreign corporation that is a section 953(d) company), the term total 
insurance liabilities means the sum of unearned premiums (determined 
under Sec.  1.832-4(a)(8)) and unpaid losses.
    (3) Controlled foreign insurance corporations. In the case of a 
controlled foreign corporation that would be taxable under subchapter L 
if it were a domestic corporation, the term total insurance liabilities 
means the reserve determined in accordance with section 953(b)(3).
    (D) Example. The following example illustrates the application of 
this paragraph (e)(2)(ii).
    (1) Facts. X is a domestic nonlife insurance company taxable under 
part II of subchapter L. X has passive category assets valued under 
Sec.  1.861-9(g)(2) at $1,000x, total insurance liabilities of $200x, 
and passive category income of $100x.
    (2) Analysis--Investment income limitation. Pursuant to paragraph 
(e)(2)(ii)(B) of this section, the applicable percentage for nonlife 
insurance companies is 400 percent, and X has an investment asset 
limitation of $800x, which is equal to its total insurance liabilities 
of $200x multiplied by 400 percent. The proportion of its investment 
asset limitation ($800x) to its passive category assets ($1,000x) is 80 
percent. Pursuant to paragraph (e)(2)(ii)(A) of this section, X has an 
investment income limitation equal to its passive category income 
($100x) multiplied by 80 percent, or $80x. Under paragraph (e)(2)(ii) 
of this section, no more than $80x of X's $100x of income from 
investments qualifies as ordinary and necessary to the proper conduct 
of X's insurance business.
    (3) Financial services entities--(i) Definition of financial 
services entity--(A) In general. The term financial services entity 
means an individual or corporation that is predominantly engaged in the 
active conduct of a banking, insurance, financing, or similar business 
(active financing business) for any taxable year. Except as provided in 
paragraph (e)(3)(ii) of this section, a determination of whether an 
individual or corporation is a financial services entity is done on an 
individual or entity-by-entity basis. An individual or corporation is 
predominantly engaged in the active financing business for any year if 
for that year more than 70 percent of its gross income is derived 
directly from active financing income under paragraph (e)(2) of this 
section with customers, or counterparties, that are not related to such 
individual or corporation under section 267(b) or 707 (except in the 
case of paragraph (e)(2)(i)(W) of this section which permits related 
party insurance).
    (B) Certain gross income included and excluded. For purposes of 
applying the rules in paragraph (e)(3)(i)(A) of this section (including 
by reason of paragraph (e)(3)(ii) of this section), gross income 
includes interest on State and local bonds described in section 103(a), 
but does not include income from a distribution of previously taxed 
earnings and profits described in section 959(a) or (b). In addition, 
total gross income (for purposes of the

[[Page 72141]]

denominator of the 70-percent test) includes income received from 
related persons.
    (C) Treatment of partnerships and other pass-through entities. For 
purposes of applying the rules in paragraph (e)(3)(i)(A) of this 
section (including by reason of paragraph (e)(3)(ii) of this section) 
with respect to an individual or corporation that is a direct or 
indirect partner in a partnership, the partner's distributive share of 
partnership income is characterized as if each partnership item of 
gross income were realized directly by the partner. For example, in 
applying section 954(h)(2)(B) under paragraph (e)(3)(i)(A) of this 
section, a customer with respect to a partnership is treated as a 
related person with respect to an individual or corporation that is a 
partner in the partnership if the customer is related to the individual 
or corporation under section 954(d)(3). The principles of this 
paragraph (e)(3)(i)(C) apply for an individual or corporation's share 
of income from any other pass-through entities.
    (ii) Financial services group. A corporation that is a member of a 
financial services group is deemed to be a financial services entity 
regardless of whether it is a financial services entity under paragraph 
(e)(3)(i) of this section. For purposes of this paragraph (e)(3)(ii), a 
financial services group means an affiliated group as defined in 
section 1504(a) (but determined without regard to paragraphs (2) or (3) 
of section 1504(b)) if more than 70 percent of the affiliated group's 
gross income is active financing income under paragraph (e)(2) of this 
section. For purposes of determining whether an affiliated group is a 
financial services group under the previous sentence, only the income 
of group members that are domestic corporations, or foreign 
corporations that are controlled foreign corporations in which U.S. 
members of the affiliated group own, directly or indirectly, at least 
80 percent of the total voting power and value of the stock, is 
included. In addition, indirect ownership is determined under section 
318, and the income of the group does not include any income from 
transactions with other members of the group. Passive income will not 
be considered to be active financing income merely because that income 
is earned by a member of the group that is a financial services entity 
without regard to the rule of this paragraph (e)(3)(ii).
* * * * *
    (f) * * *
    (1) * * *
    (iii) Income arising from U.S. activities excluded from foreign 
branch category income. Gross income that is attributable to a foreign 
branch and that arises from activities carried out in the United States 
by any foreign branch, including income that is reflected on a foreign 
branch's separate books and records, is not assigned to the foreign 
branch category. Instead, such income is assigned to the general 
category or a specified separate category under the rules of this 
section. However, under paragraph (f)(2)(vi) of this section, gross 
income (including U.S. source gross income) attributable to activities 
carried on outside the United States by the foreign branch may be 
assigned to the foreign branch category by reason of a disregarded 
payment to a foreign branch from a foreign branch owner or another 
foreign branch that is allocable to income recorded on the books and 
records of the payor foreign branch or foreign branch owner.
    (iv) Income arising from stock excluded from foreign branch 
category income--(A) In general. Except as provided in paragraph 
(f)(1)(iv)(B) of this section, gross income that is attributable to a 
foreign branch and that comprises items of income arising from stock of 
a corporation (whether foreign or domestic), including gain from the 
disposition of such stock or any inclusion under section 951(a), 
951A(a), 1248, or 1293(a), is not assigned to the foreign branch 
category. Instead, such income is assigned to the general category or a 
specified separate category under the rules of this section.
    (B) Exception for dealer property. Paragraph (f)(1)(iv)(A) of this 
section does not apply to gain recognized from dispositions of stock in 
a corporation, if the stock would be dealer property (as defined in 
Sec.  1.954-2(a)(4)(v)) if the foreign branch were a controlled foreign 
corporation.
* * * * *
    (2) * * *
    (vi) * * *
    (A) In general. If a foreign branch makes a disregarded payment to 
its foreign branch owner or a second foreign branch, and the 
disregarded payment is allocable to gross income that would be 
attributable to the foreign branch under the rules in paragraphs 
(f)(2)(i) through (v) of this section, the gross income attributable to 
the foreign branch is adjusted downward (but not below zero) to reflect 
the allocable amount of the disregarded payment, and the gross income 
attributable to the foreign branch owner or the second foreign branch 
is adjusted upward by the same amount as the downward adjustment, 
translated (if necessary) from the foreign branch's functional currency 
to U.S. dollars (or the second foreign branch's functional currency, as 
applicable) at the spot rate (as defined in Sec.  1.988-1(d)) on the 
date of the disregarded payment. For rules addressing multiple 
disregarded payments in a taxable year, see paragraph (f)(2)(vi)(F) of 
this section. Similarly, if a foreign branch owner makes a disregarded 
payment to its foreign branch and the disregarded payment is allocable 
to gross income attributable to the foreign branch owner, the gross 
income attributable to the foreign branch owner is adjusted downward 
(but not below zero) to reflect the allocable amount of the disregarded 
payment, and the gross income attributable to the foreign branch is 
adjusted upward by the same amount as the downward adjustment, 
translated (if necessary) from U.S. dollars to the foreign branch's 
functional currency at the spot rate on the date of the disregarded 
payment. An adjustment to the attribution of gross income under this 
paragraph (f)(2)(vi) does not change the total amount, character, or 
source of the United States person's gross income; does not change the 
amount of a United States person's income in any separate category 
other than the foreign branch and general categories (or a specified 
separate category associated with the foreign branch and general 
categories); and has no bearing on the analysis of whether an item of 
gross income is eligible to be resourced under an income tax treaty.
    (B) * * *
    (1) * * *
    (ii) Disregarded payments from a foreign branch to its foreign 
branch owner or to another foreign branch are allocable to gross income 
attributable to the payor foreign branch to the extent a deduction for 
that payment or any disregarded cost recovery deduction relating to 
that payment, if regarded, would be allocated and apportioned to gross 
income attributable to the payor foreign branch under the principles of 
Sec. Sec.  1.861-8 through 1.861-14T and 1.861-17 (without regard to 
exclusive apportionment) by treating foreign source gross income and 
U.S. source gross income in each separate category (determined before 
the application of this paragraph (f)(2)(vi) to the disregarded payment 
at issue) each as a statutory grouping.
* * * * *
    (G) Effect of disregarded payments made and received by non-branch 
taxable units--(1) In general. For purposes of determining the amount,

[[Page 72142]]

source, and character of gross income attributable to a foreign branch 
and its foreign branch owner under paragraph (f)(2) of this section, 
the rules of paragraph (f)(2) of this section apply to a non-branch 
taxable unit as though the non-branch taxable unit were a foreign 
branch or a foreign branch owner, as appropriate, to attribute gross 
income to the non-branch taxable unit and to further attribute, under 
this paragraph (f)(2)(vi)(G), the income of a non-branch taxable unit 
to one or more foreign branches or to a foreign branch owner. See 
paragraph (f)(4)(xvi) of this section (Example 16).
    (2) Foreign branch group income. The income of a foreign branch 
group is attributed to the foreign branch that owns the group. The 
income of a foreign branch group is the aggregate of the U.S. gross 
income that is attributed, under the rules of this paragraph (f)(2), to 
each member of the foreign branch group, determined after taking into 
account all disregarded payments made and received by each member.
    (3) Foreign branch owner group income. The income of a foreign 
branch owner group is attributed to the foreign branch owner that owns 
the group. The income of a foreign branch owner group income is the 
aggregate of the U.S. gross income that is attributed, under the rules 
of this paragraph (f)(2), to each member of the foreign branch owner 
group, determined after taking into account all disregarded payments 
made and received by each member.
    (3) * * *
    (v) Disregarded payment. A disregarded payment includes an amount 
of property (within the meaning of section 317(a)) that is transferred 
to or from a non-branch taxable unit, foreign branch, or foreign branch 
owner, including a payment in exchange for property or in satisfaction 
of an account payable, or a remittance or contribution, in connection 
with a transaction that is disregarded for Federal income tax purposes 
and that is reflected on the separate set of books and records of a 
non-branch taxable unit (other than an individual or domestic 
corporation) or a foreign branch. A disregarded payment also includes 
any other amount that is reflected on the separate set of books and 
records of a non-branch taxable unit (other than an individual or a 
domestic corporation) or a foreign branch in connection with a 
transaction that is disregarded for Federal income tax purposes and 
that would constitute an item of accrued income, gain, deduction, or 
loss of the non-branch taxable unit (other than an individual or a 
domestic corporation) or the foreign branch if the transaction to which 
the amount is attributable were regarded for Federal income tax 
purposes.
* * * * *
    (viii) Foreign branch group. The term foreign branch group means a 
foreign branch and one or more non-branch taxable units (other than an 
individual or a domestic corporation), to the extent that the foreign 
branch owns the non-branch taxable unit directly or indirectly through 
one or more other non-branch taxable units.
* * * * *
    (x) Foreign branch owner group. The term foreign branch owner group 
means a foreign branch owner and one or more non-branch taxable units 
(other than an individual or a domestic corporation), to the extent 
that the foreign branch owner owns the non-branch taxable unit directly 
or indirectly through one or more other non-branch taxable units.
    (xi) Non-branch taxable unit. The term non-branch taxable unit has 
the meaning provided in Sec.  1.904-6(b)(2)(i)(B).
* * * * *
    (4) * * *
    (xiii) Example 13: Disregarded payment from domestic corporation to 
foreign branch--(A) Facts. P, a domestic corporation, owns FDE, a 
disregarded entity that is a foreign branch. FDE's functional currency 
is the U.S. dollar. In Year 1, P accrues and records on its books and 
records for Federal income tax purposes $400x of gross income from the 
license of intellectual property to unrelated parties that is not 
passive category income, all of which is U.S. source income. P also 
accrues $600x of foreign source passive category interest income. P 
compensates FDE for services that FDE performs in a foreign country 
with an arm's length payment of $350x, which FDE records on its books 
and records; the transaction is disregarded for Federal income tax 
purposes. Absent the application of paragraph (f)(2)(vi) of this 
section, the $400x of gross income earned by P from the license would 
be general category income that would not be attributable to FDE. If 
the payment were regarded for Federal income tax purposes, the 
deduction for the payment of $350x from P to FDE would be allocated and 
apportioned entirely to P's $400x of general category gross licensing 
income under the principles of Sec. Sec.  1.861-8 and 1.861-8T 
(treating U.S. source general category gross income and foreign source 
passive category gross income each as a statutory grouping). There are 
no other expenses incurred by P or FDE.
    (B) Analysis. The disregarded payment from P, a United States 
person, to FDE, its foreign branch, is not recorded on FDE's separate 
books and records (as adjusted to conform to Federal income tax 
principles) under paragraph (f)(2)(i) of this section because it is 
disregarded for Federal income tax purposes. The disregarded payment is 
allocable to gross income attributable to P because a deduction for the 
payment, if it were regarded, would be allocated and apportioned to the 
$400x of P's U.S. source licensing income. Accordingly, under 
paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(3) of this section, the 
amount of gross income attributable to the FDE foreign branch (and the 
gross income attributable to P) is adjusted in Year 1 to take the 
disregarded payment into account. Accordingly, $350x of P's $400x U.S. 
source general category gross income from the license is attributable 
to the FDE foreign branch for purposes of this section. Therefore, 
$350x of the U.S. source gross income that P earned with respect to its 
license in Year 1 constitutes U.S. source gross income that is assigned 
to the foreign branch category and $50x remains U.S. source general 
category income. P's $600x of foreign source passive category interest 
income is unchanged.
    (xiv) Example 14: Regarded payment from non-consolidated domestic 
corporation to a foreign branch--(A) Facts. The facts are the same as 
in paragraph (f)(4)(xiii)(A) of this section (the facts of Example 13), 
except P wholly owns USS, and USS (rather than P) owns FDE. P and USS 
do not file a consolidated return. USS has no gross income other than 
the $350x foreign source services income it receives from P, through 
FDE, for Federal income tax purposes.
    (B) Analysis. P has $400x of U.S. source general category gross 
income from the license and $600x of foreign source passive category 
interest income. The $350x services payment from P, a United States 
person, to FDE, a foreign branch of USS, is not a disregarded payment 
because the transaction is regarded for Federal income tax purposes. 
Under Sec. Sec.  1.861-8 and 1.861-8T, P's $350x deduction for the 
services payment is allocated and apportioned to its U.S. source 
general category gross income. The payment of $350x from P to USS is 
services income attributable to FDE, and foreign branch category income 
of USS under paragraph (f)(2)(i) of this section. Accordingly, USS has 
$350x of foreign source foreign branch category gross income. P has 
$600x of foreign source passive category income and $400x of U.S. 
source general category gross income and a $350x deduction for the 
services payment,

[[Page 72143]]

resulting in $50x of U.S. source general category taxable income to P.
    (xv) Example 15: Regarded payment from a member of a consolidated 
group to a foreign branch of another member of the group--(A) Facts. 
The facts are the same as in paragraph (f)(4)(xiv)(A) of this section 
(the facts of Example 14), except that P and USS are members of an 
affiliated group that files a consolidated return pursuant to section 
1502 (P group).
    (B) Analysis--(1) Definitions under Sec.  1.1502-13. Under Sec.  
1.1502-13(b)(1), the $350x services payment from P, a United States 
person, to FDE, a foreign branch of USS, is an intercompany transaction 
between P and USS; USS is the selling member, P is the buying member, P 
has a corresponding deduction of $350x for the services payment, and 
USS has $350x of intercompany income. The payment is not a disregarded 
payment because the transaction is regarded for Federal income tax 
purposes.
    (2) Timing and attributes under Sec.  1.1502-13--(i) Separate 
entity versus single entity analysis. Under a separate entity analysis, 
the result is the same as in paragraph (f)(4)(xiv)(B) of this section 
(the analysis in Example 14), whereby P has $600x of foreign source 
passive category income and $50x of U.S. source general category 
income, and USS has $350x of foreign source foreign branch category 
income. In contrast, under a single entity analysis, the result is the 
same as in paragraph (f)(4)(xiii)(B) of this section (the analysis in 
Example 13), whereby P has $600x of foreign source passive category 
income, $50x of U.S. source general category income, and $350x of U.S. 
source foreign branch category income.
    (ii) Application of the matching rule. Under the matching rule in 
Sec.  1.1502-13(c), the timing, character, source, and other attributes 
of USS's $350x intercompany income and P's corresponding $350x 
deduction are redetermined to produce the effect of transactions 
between divisions of a single corporation, as if the services payment 
had been made to a foreign branch of that corporation. Accordingly, all 
of USS's foreign source income of $350x is redetermined to be U.S. 
source, rather than foreign source, income. Therefore, for purposes of 
Sec.  1.1502-4(c)(1), the P group has $600x of foreign passive category 
income, $50x of U.S. source general category income, and $350x of U.S. 
source foreign branch category income.
    (xvi) Example 16: Disregarded payment made from non-branch taxable 
unit--(A) Facts. The facts are the same as in paragraph (f)(4)(xiii)(A) 
of this section (the facts of Example 13), except that P also wholly 
owns FDE1, a disregarded entity that is a non-branch taxable unit. In 
addition, FDE1 (rather than P) is the entity that properly accrues and 
records on its books and records the $400x of U.S. source general 
category income from the license of intellectual property and the $600x 
of foreign source passive category interest income, and FDE1 (rather 
than P) is the entity that makes the $350x payment, which is 
disregarded for Federal income tax purposes, to FDE in compensation for 
services.
    (B) Analysis. Under paragraph (f)(2)(vi)(G) of this section, the 
rules of paragraph (f)(2) of this section apply to attribute gross 
income to FDE1, a non-branch taxable unit, as though FDE1 were a 
foreign branch. Under these rules, the $400x of licensing income and 
the $600 of interest income are initially attributable to FDE1. This 
income is adjusted in Year 1 to take into account the $350x disregarded 
payment, which is allocable to the $400x of licensing income of FDE1. 
Accordingly, $50x of the $400x of U.S. source general category 
licensing income is attributable to FDE1 and $350x of this income is 
attributable to the FDE foreign branch. In order to determine the 
income that is attributable to P, the foreign branch owner, and FDE, 
the foreign branch, the income that is attributed to FDE1, after taking 
into account all of the disregarded payments that it makes and 
receives, must be further attributed to one or more foreign branches or 
a foreign branch owner under paragraph (f)(2)(vi)(G) of this section. 
Under paragraph (f)(2)(vi)(G) of this section, the income of FDE1 is 
attributed to the foreign branch group or foreign branch owner group of 
which it is a member. Because FDE1 is wholly owned by P, FDE is a 
member solely of the foreign branch owner group that is owned by P. See 
definition of ``foreign branch owner group'' in Sec.  1.904-4(f)(3). 
All of the income that is attributed to FDE1 under paragraph (f)(2) of 
this section, namely, the $50x of U.S. source general category 
licensing income and the $600x of foreign source passive category 
interest income, is further attributed to P. See Sec.  1.904-
4(f)(2)(vi)(G)(3). Therefore, the result is the same as in paragraph 
(f)(4)(xiii)(B) of this section (the analysis in Example 13).
* * * * *
    (q) * * *
    (3) Paragraphs (e)(1)(ii) and (e)(2) and (3) of this section apply 
to taxable years beginning on or after [date final regulations are 
filed with the Federal Register]. Paragraph (f) of this section applies 
to taxable years that begin after December 31, 2019, and end on or 
after November 2, 2020.
0
Par. 27. Section 1.904-5 is amended by revising paragraphs (b)(2) and 
(o) as follows:


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

* * * * *
    (b) * * *
    (2) Priority and ordering of look-through rules. To the extent the 
look-through rules assign income to a separate category, the income is 
assigned to that separate category rather than the separate category to 
which the income would have been assigned under Sec.  1.904-4 (not 
taking into account Sec.  1.904-4(l)). See paragraph (k) of this 
section for ordering rules for applying the look-through rules.
* * * * *
    (o) Applicability dates. Except as provided in this paragraph (o), 
this section is applicable for taxable years that both begin after 
December 31, 2017, and end on or after December 4, 2018. Paragraph 
(b)(2) of this section applies to taxable years beginning on or after 
[date final regulations are filed with the Federal Register].
0
Par. 28. Section 1.904-6, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is further amended by 
adding paragraph (b)(2) and revising paragraph (g) to read as follows:


Sec.  1.904-6  Allocation and apportionment of foreign income taxes.

* * * * *
    (b) * * *
    (2) Disregarded payments--(i) In general--(A) Assignment of foreign 
gross income. Except as provided in paragraph (b)(2)(ii) of this 
section, if a taxpayer that is an individual or a domestic corporation 
includes an item of foreign gross income by reason of the receipt of a 
disregarded payment by a foreign branch or foreign branch owner (as 
those terms are defined in Sec.  1.904-4(f)(3)), or a non-branch 
taxable unit, the foreign gross income item is assigned to a separate 
category under Sec.  1.861-20(d)(3)(v).
    (B) Definition of non-branch taxable unit. The term non-branch 
taxable unit means a person or interest that is described in paragraph 
(b)(2)(i)(B)(1) or (2) of this section, respectively.
    (1) Persons. A non-branch taxable unit described in this paragraph 
(b)(2)(i)(B)(1) means a person that is not otherwise a foreign branch 
owner and that is a U.S. individual, a domestic corporation, or a 
foreign or domestic

[[Page 72144]]

partnership (or other pass-through entity, as defined in Sec.  1.904-
5(a)(4)) an interest in which is owned, directly or indirectly through 
one or more other partnerships (or other pass-through entities), by a 
U.S. individual or a domestic corporation.
    (2) Interests. A non-branch taxable unit described in this 
paragraph (b)(2)(i)(B)(2) means an interest of a foreign branch owner 
or an interest of a person described in paragraph (b)(2)(i)(B)(1) of 
this section that is not otherwise a foreign branch, and that is either 
a disregarded entity or a branch, as defined in Sec.  1.267A-5(a)(2), 
including a branch described in Sec.  1.954-1(d)(2)(i)(C) (modified by 
substituting the term ``person'' for ``controlled foreign 
corporation'').
    (ii) Foreign branch group contributions--(A) In general. If a 
taxpayer includes an item of foreign gross income by reason of a 
foreign branch group contribution, the foreign gross income is assigned 
to the foreign branch category, or, in the case of a foreign branch 
owner that is a partnership, to the partnership's general category 
income that is attributable to the foreign branch. See, however, 
Sec. Sec.  1.861-20(d)(3)(v)(C)(2) and 1.960-1(d)(3)(ii)(A) and (e) for 
rules providing that foreign income tax on a disregarded payment that 
is a contribution from a controlled foreign corporation to a taxable 
unit is assigned to the residual grouping and cannot be deemed paid 
under section 960.
    (B) Foreign branch group contribution. A foreign branch group 
contribution is a contribution (as defined in Sec.  1.861-
20(d)(3)(v)(E)) made by a member of a foreign branch owner group to a 
member of a foreign branch group that the payor owns, made by a member 
of a foreign branch group to another member of that group that the 
payor owns, or made by a member of a foreign branch group to a member 
of a different foreign branch group that the payor owns. For purposes 
of this paragraph (b)(2)(ii)(B), the terms foreign branch group and 
foreign branch owner group have the meanings provided in Sec.  1.904-
4(f)(3).
* * * * *
    (g) Applicability date. Except as otherwise provided in this 
paragraph (g), this section applies to taxable years that begin after 
December 31, 2019. Paragraph (b)(2) of this section applies to taxable 
years that begin after December 31, 2019, and end on or after November 
2, 2020.
0
Par. 29. Section 1.904(f)-12 is amended by:
0
1. Removing paragraph (j)(6).
0
2. Redesignating paragraph (j)(5) as paragraph (j)(6).
0
3. Adding a new paragraph (j)(5) and paragraph (j)(7).
    The additions read as follows:


Sec.  1.904(f)-12  Transition rules.

* * * * *
    (j) * * *
    (5) Treatment of net operating losses incurred in post-2017 taxable 
years that are carried back to pre-2018 taxable years--(i) In general. 
Except as provided in paragraph (j)(5)(ii) of this section, a net 
operating loss (NOL) incurred in a taxable year beginning after 
December 31, 2017 (a ``post-2017 taxable year''), which is carried 
back, pursuant to section 172, to a taxable year beginning before 
January 1, 2018 (a ``pre-2018 carryback year''), will be carried back 
under the rules of Sec.  1.904(g)-3(b). For purposes of applying the 
rules of Sec.  1.904(g)-3(b), income in a pre-2018 separate category in 
the taxable year to which the net operating loss is carried back is 
treated as if it included only income that would be assigned to the 
post-2017 general category. Therefore, any separate limitation loss 
created by reason of a passive category component of an NOL from a 
post-2017 taxable year that is carried back to offset general category 
income in a pre-2018 carryback year will be recaptured in post-2017 
taxable years as general category income, and not as a combination of 
general, foreign branch, and section 951A category income.
    (ii) Foreign source losses in the post-2017 separate categories for 
foreign branch category income and section 951A category income. Net 
operating losses attributable to a foreign source loss in the post-2017 
separate categories for foreign branch category income and section 951A 
category income are treated as first offsetting general category income 
in a pre-2018 carryback year to the extent available to be offset by 
the net operating loss carryback. If the sum of foreign source losses 
in the taxpayer's separate categories for foreign branch category 
income and section 951A category income in the year the net operating 
loss is incurred exceeds the amount of general category income that is 
available to be offset in the carryback year, then the amount of 
foreign source loss in each of the foreign branch and section 951A 
categories that is treated as offsetting general category income under 
this paragraph (j)(5)(ii), is determined on a proportionate basis. 
General category income in the pre-2018 carryback year is first offset 
by foreign source loss in the taxpayer's post-2017 separate category 
for general category income in the year the net operating loss is 
incurred before any foreign source loss in that year in the separate 
categories for foreign branch category income and section 951A category 
income is carried back to reduce general category income. To the extent 
a foreign source loss in a post-2017 separate category for foreign 
branch category income or section 951A category income offsets general 
category income in a pre-2018 taxable year under the rules of this 
paragraph (j)(5)(ii), no separate limitation loss account is created.
* * * * *
    (7) Applicability date. Except as otherwise provided in this 
paragraph (j)(7), this paragraph (j) applies to taxable years ending on 
or after December 31, 2017. Paragraph (j)(5) of this section applies to 
carrybacks of net operating losses incurred in taxable years beginning 
on or after January 1, 2018.
0
Par. 30. Section 1.905-1 is amended by:
0
1. Revising the section heading and paragraph (a).
0
2. Redesignating paragraph (b) as paragraph (g).
0
3. Adding a new paragraph (b) and paragraphs (c), (d), (e), and (f).
0
4. Revising the heading of newly redesignated paragraph (g).
0
5. Adding paragraph (h).
    The revisions and additions read as follows:


Sec.  1.905-1   When credit for foreign income taxes may be taken.

    (a) Scope. This section provides rules regarding when the credit 
for foreign income taxes (as defined in Sec.  1.901-2(a)) may be taken, 
based on a taxpayer's method of accounting for such taxes. Paragraph 
(b) of this section provides the general rule. Paragraph (c) of this 
section sets forth rules for determining the taxable year in which 
taxpayers using the cash receipts and disbursement method of accounting 
for income (``cash method'') may claim a foreign tax credit. Paragraph 
(d) of this section sets forth rules for determining the taxable year 
in which taxpayers using the accrual method of accounting for income 
(``accrual method'') may claim a foreign tax credit. Paragraph (e) of 
this section provides rules for taxpayers using the cash method to 
claim foreign tax credits on the accrual basis pursuant to the election 
provided under section 905(a). Paragraph (f) of this section provides 
rules for when foreign income tax expenditures of a pass-through entity 
can be taken as a credit by the entity's partners, shareholders, or 
owners. Paragraph (g) of this section provides rules for when a foreign 
tax credit can be taken with

[[Page 72145]]

respect to blocked income. Paragraph (h) provides the applicability 
dates for this section.
    (b) General rule. The credit for taxes provided in subpart A, part 
III, subchapter N, chapter 1 of the Code (the ``foreign tax credit'') 
may be taken either on the return for the year in which the taxes 
accrued or on the return for the year in which the taxes were paid, 
depending on whether the taxpayer uses the accrual or the cash receipts 
and disbursements method of accounting for purposes of computing 
taxable income and filing returns. However, regardless of the year in 
which the credit is claimed under the taxpayer's method of accounting 
for foreign income taxes, the foreign tax credit is allowed only to the 
extent the foreign income taxes are ultimately both owed and actually 
remitted to the foreign country (in the case of a taxpayer claiming the 
foreign tax credit on the accrual basis, within the time prescribed by 
section 905(c)(2)). See section 905(b) and Sec. Sec.  1.901-1(a) and 
1.901-2(e). Because the taxpayer's liability for foreign income tax may 
accrue (that is, become fixed and determinable) in a different taxable 
year than that in which the tax is paid (that is, remitted), the 
taxpayer's entitlement to the credit may be perfected, or become 
subject to adjustment, by reason of events that occur in a taxable year 
after the taxable year in which the credit is allowed. See section 
905(c) and Sec.  1.905-3(a) for rules relating to changes to the 
taxpayer's foreign income tax liability that require a redetermination 
of the allowable foreign tax credit and the taxpayer's U.S. tax 
liability.
    (c) Rules for cash method taxpayers--(1) Credit allowed in year 
paid. Except as provided in paragraph (e) of this section, a taxpayer 
who uses the cash method may claim a foreign tax credit only in the 
taxable year in which the foreign income taxes are paid. Generally, 
foreign income taxes are considered paid in the taxable year in which 
the taxes are remitted to the foreign country. However, foreign 
withholding taxes described in section 901(k)(1)(B), as well as foreign 
net income taxes described in Sec.  1.901-2(a)(3)(i) that are withheld 
from the taxpayer's gross income by the payor, are treated as paid in 
the year in which they are withheld. Foreign income taxes that have 
been withheld or remitted but which are not considered an amount of tax 
paid for purposes of section 901 under the rules of Sec.  1.901-2(e) 
(for example, because the amount withheld or remitted was not a 
compulsory payment), however, are not eligible for a foreign tax 
credit. See Sec. Sec.  1.901-2(e) and 1.905-3(b)(1)(ii)(B) (Example 2).
    (2) Adjustments to taxes claimed as a credit in the year paid. A 
refund of foreign income taxes for which a foreign tax credit has been 
claimed on the cash basis, or a subsequent determination that the 
amount paid exceeds the taxpayer's liability for foreign income tax, 
requires a redetermination of foreign income taxes paid and the 
taxpayer's U.S. tax liability pursuant to section 905(c) and Sec.  
1.905-3. See Sec.  1.905-3(a) and (b)(1)(ii)(G) (Example 7). Additional 
foreign income taxes paid that relate back to a prior year in which 
foreign income taxes were claimed as a credit on the cash basis, 
including by reason of the settlement of a dispute with the foreign tax 
authority, may only be claimed as a credit in the year the additional 
taxes are paid. The payment of such additional taxes does not result in 
a redetermination pursuant to section 905(c) or Sec.  1.905-3 of the 
foreign income taxes paid in any prior year, although a redetermination 
of U.S. tax liability may be required due, for example, to a carryback 
of unused foreign tax under section 904(c) and Sec.  1.904-2.
    (d) Rules for accrual method taxpayers--(1) Credit allowed in year 
accrued--(i) In general. A taxpayer who uses the accrual method may 
claim a foreign tax credit only in the taxable year in which the 
foreign income taxes are considered to accrue for foreign tax credit 
purposes under the rules of this paragraph (d). Foreign income taxes 
accrue in the taxable year in which all the events have occurred that 
establish the fact of the liability and the amount of the liability can 
be determined with reasonable accuracy. See Sec. Sec.  1.446-
1(c)(1)(ii)(A) and 1.461-4(g)(6)(iii)(B). For purposes of the preceding 
sentence, a foreign income tax that is contingent on a future 
distribution of earnings does not meet the all events test until the 
earnings are distributed. A foreign income tax liability determined on 
the basis of a foreign taxable year becomes fixed and determinable at 
the close of the taxpayer's foreign taxable year. Therefore, foreign 
income taxes that are computed based on items of income, deduction, and 
loss that arise in a foreign taxable year accrue in the United States 
taxable year with or within which the taxpayer's foreign taxable year 
ends. Foreign withholding taxes that are paid with respect to a foreign 
taxable year and that represent advance payments of a foreign net 
income tax liability determined on the basis of that foreign taxable 
year accrue at the close of the foreign taxable year. Foreign 
withholding taxes imposed on a payment giving rise to an item of 
foreign gross income accrue on the date the payment from which the tax 
is withheld is made (or treated as made under foreign tax law).
    (ii) Relation-back rule for adjustments to taxes claimed as a 
credit in year accrued. Additional tax paid as a result of a change in 
the foreign tax liability, including additional taxes paid when a 
contest with a foreign tax authority is resolved, relate back and are 
considered to accrue at the end of the foreign taxable year with 
respect to which the taxes were imposed (the ``relation-back year''). 
Additional withholding tax paid as a result of a change in the amount 
of an item of foreign gross income (such as pursuant to a foreign 
transfer pricing adjustment), also relate back and are considered to 
accrue in the year in which the payment from which the additional tax 
is withheld is made (or considered to have been made under foreign tax 
law). Foreign income taxes that are not paid within 24 months after the 
close of the taxable year in which they were accrued are treated as 
refunded pursuant to Sec.  1.905-3(a); when subsequently paid, the 
foreign income taxes are allowed as a credit in the relation-back year. 
See Sec.  1.905-3(b)(1)(ii)(E) (Example 5). For special rules that 
apply to determine when foreign income tax is considered to accrue in 
the case of certain ownership and entity classification changes, see 
Sec. Sec.  1.336-2(g)(3)(ii), 1.338-9(d), 1.901-2(f)(5), and 1.1502-76.
    (2) Special rule for 52-53 week U.S. taxable years. If a taxpayer 
has elected pursuant to section 441(f) to use a U.S. taxable year 
consisting of 52-53 weeks, and such U.S. taxable year closes within six 
calendar days of the end of the taxpayer's foreign taxable year, the 
determination of when foreign income taxes accrue under paragraph 
(d)(1) of this section is made by deeming the taxpayer's U.S. taxable 
year to end on the last day of its foreign taxable year.
    (3) Accrual of contested foreign tax liability. A contested foreign 
income tax liability is finally determined and accrues for purposes of 
paragraph (d)(1) of this section when the contest is resolved. However, 
pursuant to section 905(c)(2), no credit is allowed for any accrued tax 
that is not paid within 24 months of the close of the relation-back 
year until the tax is actually remitted and considered paid. Thus, 
except as provided in paragraph (d)(4) of this section, a foreign tax 
credit for a contested foreign income tax liability cannot be claimed 
until such time as both the contest is resolved and the tax is actually 
paid, even if the contested liability (or portion thereof) has

[[Page 72146]]

previously been remitted to the foreign country. Once the contest is 
resolved and the foreign income tax liability is finally determined and 
paid, the tax liability accrues, and is considered actually to accrue 
in the relation-back year for purposes of the foreign tax credit. See 
paragraph (d)(1) of this section; see also section 6511(d)(3) and Sec.  
301.6511(d)-3 of this chapter for a special 10-year period of 
limitations for claiming a credit or refund of U.S. tax that is 
attributable to foreign income taxes for which a credit is allowed 
under section 901, which runs from the unextended due date of the 
return for the taxable year in which the foreign income taxes are paid 
(within the meaning of paragraph (c) of this section, for taxpayers 
claiming credits on the cash basis) or accrued (within the meaning of 
this paragraph (d)), for taxpayers claiming credits on the accrual 
basis).
    (4) Election to claim a provisional credit for contested taxes 
remitted before accrual--(i) Conditions of election. A taxpayer may, 
under the conditions provided in this paragraph (d)(4), elect to claim 
a foreign tax credit (but not a deduction) for a contested foreign 
income tax liability (or a portion thereof) in the relation-back year 
when the contested amount (or a portion thereof) is remitted to the 
foreign country, notwithstanding that the liability is not finally 
determined and so has not accrued. To make the election, a taxpayer 
must file an amended return for the taxable year to which the contested 
tax relates, together with a Form 1116 (Foreign Tax Credit (Individual, 
Estate, or Trust)) or Form 1118 (Foreign Tax Credit--Corporations), and 
the agreement described in paragraph (d)(4)(ii) of this section. In 
addition, the taxpayer must, for each subsequent taxable year up to and 
including the taxable year in which the contest is resolved, file the 
annual certification described in paragraph (d)(4)(iii) of this 
section. Any portion of a contested foreign income tax liability for 
which a provisional credit is claimed under this paragraph (d)(4) that 
is subsequently refunded by the foreign country results in a foreign 
tax redetermination under Sec.  1.905-3(a).
    (ii) Contents of provisional foreign tax credit agreement. The 
provisional foreign tax credit agreement must contain the following:
    (A) A statement that the document is an election and an agreement 
under the provisions of paragraph (d)(4) of this section;
    (B) A description of contested foreign income tax liability, 
including the name of the foreign tax or taxes being contested, the 
name of the country imposing the tax, the amount of the contested tax, 
and the U.S. taxable year(s) and the income to which the contested 
foreign income tax liability relates;
    (C) The amount of the contested foreign income tax liability in 
paragraph (d)(4)(ii)(B) of this section that has been remitted to the 
foreign country and the date of the remittance(s);
    (D) An agreement by the taxpayer, for a period of three years from 
the later of the filing or the due date (with extensions) of the return 
for the taxable year in which the taxpayer notifies the Internal 
Revenue Service of the resolution of the contest, not to assert the 
statute of limitations on assessment as a defense to the assessment of 
additional taxes or interest related to the contested foreign income 
tax liability described in paragraph (d)(4)(ii)(B) of this section that 
may arise from a determination that the taxpayer failed to exhaust all 
effective and practical remedies to minimize its foreign income tax 
liability, so that the amount of the contested foreign income tax is 
not a compulsory payment and is not considered paid within the meaning 
of Sec.  1.901-2(e)(5);
    (E) A statement that the taxpayer agrees to comply with all the 
conditions and requirements of paragraph (d)(4) of this section, 
including to provide notice to the Internal Revenue Service upon the 
resolution of the contest, and to treat the failure to comply with such 
requirement as a refund of the contested foreign income tax liability 
that requires a redetermination of the taxpayer's U.S. tax liability 
pursuant to Sec.  1.905-3(b); and
    (F) Any additional information as may be prescribed by the 
Commissioner of Internal Revenue in Internal Revenue Service forms or 
instructions.
    (iii) Annual certification. For each taxable year following the 
year in which an election pursuant to paragraph (d)(4) of this section 
is made up to and including the taxable year in which the contest is 
resolved, the taxpayer must include with its timely-filed return a 
certification containing the information described in paragraphs 
(d)(4)(iii)(A) through (C) of this section in the form or manner 
prescribed by the Commissioner of Internal Revenue in Internal Revenue 
Service forms or instructions.
    (A) A description of the contested foreign income tax liability, 
including the name of the foreign tax or taxes, the country imposing 
the tax, the amount of the contested tax, and a description of the 
status of the contest.
    (B) With the return for the taxable year in which the contest is 
resolved, notification that the contest has been resolved. Such 
notification must include the date of final resolution and the amount 
of the finally determined foreign income tax liability.
    (C) Any additional information, which may include a copy of the 
final judgment, order, settlement, or other documentation of the 
contest resolution, as may be prescribed by the Commissioner of 
Internal Revenue in Internal Revenue Service forms or instructions.
    (iv) Signatory. The provisional foreign tax credit agreement and 
the annual certification must be signed under penalties of perjury by a 
person authorized to sign the return of the taxpayer.
    (v) Failure to comply. A taxpayer that fails to comply with the 
requirements for filing a provisional foreign tax credit agreement 
under paragraphs (d)(4)(i) and (ii) of this section will not be allowed 
a provisional credit for the contested foreign income tax liability. A 
taxpayer that fails to comply with the annual certification requirement 
of paragraph (d)(4)(iii) of this section will be treated as receiving a 
refund of the amount of the contested foreign income tax liability on 
the date the annual certification is required to be filed under 
paragraph (d)(4)(iii) of this section, resulting in a redetermination 
of the taxpayer's U.S. tax liability pursuant to Sec.  1.905-3(b).
    (5) Correction of improper accruals--(i) In general. The accrual of 
a foreign income tax expense generally involves the determination of 
the proper timing for recognizing the expense for Federal income tax 
purposes. Thus, foreign income tax expense is a material item within 
the meaning of section 446. See Sec.  1.446-1(e)(2)(ii). As a material 
item, a change in the timing of accruing a foreign income tax expense 
is generally a change in method of accounting. See section 446(e). A 
change from an improper method of accruing foreign income taxes to the 
proper method of accrual described in this paragraph (d) is treated as 
a change in a method of accounting, regardless of whether the taxpayer 
(or a partner or beneficiary taking into account a distributive share 
of foreign income taxes paid by a partnership or other pass-through 
entity) chooses to claim a deduction or a credit for such taxes in any 
taxable year. For purposes of this paragraph (d)(5), an improper method 
of accruing foreign income taxes includes a method under which foreign 
income tax is accrued in a taxable year other than the taxable year in 
which the requirements

[[Page 72147]]

of the all events test in Sec. Sec.  1.446-1(c)(1)(ii)(A) and 1.461-
4(g)(6)(iii)(B) are met, or which fails to apply the relation-back rule 
in paragraph (d)(1) of this section that applies for purposes of the 
foreign tax credit, but does not include corrections to estimated 
accruals or errors in computing the amount of foreign income tax that 
is allowed as a deduction or credit in any taxable year. Taxpayers must 
file a Form 3115, Application for Change in Accounting Method, in 
accordance with Revenue Procedure 2015-13 (or any successor 
administrative procedure prescribed by the Commissioner) to obtain the 
Commissioner's permission to change from an improper method of accruing 
foreign income taxes to the proper method described in this paragraph 
(d). In order to prevent a duplication or omission of a benefit for 
foreign income taxes that accrue in any taxable year (whether through 
the double allowance or double disallowance of either a deduction or a 
credit, the allowance of both a deduction and a credit, or the 
disallowance of either a deduction or a credit, for the same amount of 
foreign income tax), the rules in paragraphs (d)(5)(ii) through (iv) of 
this section, describing a modified cut-off approach, apply if the 
Commissioner grants permission for the taxpayer to change to the proper 
method of accrual. Under the modified cut-off approach, a section 
481(a) adjustment is neither required nor permitted with respect to the 
amounts of foreign income tax that were improperly accrued (or 
improperly not accrued) under the taxpayer's improper method in taxable 
years before the taxable year of change.
    (ii) Adjustments required to implement a change in method of 
accounting for accruing foreign income taxes. A change from an improper 
method of accruing foreign income taxes to the proper method described 
in this paragraph (d) is made under the modified cut-off approach 
described in this paragraph (d)(5)(ii). Under the modified cut-off 
approach, the amount of foreign income tax in a statutory or residual 
grouping (such as a separate category as defined in Sec.  1.904-
5(a)(4)) that properly accrues in the taxable year of change (accounted 
for in the currency in which the foreign tax liability is denominated) 
is adjusted downward (but not below zero) by the amount of foreign 
income tax in the same grouping that the taxpayer improperly accrued in 
a prior taxable year and for which the taxpayer claimed a credit or a 
deduction in such prior taxable year, but only if the improperly-
accrued amount of foreign income tax did not properly accrue in a 
taxable year before the taxable year of change. Conversely, under the 
modified cut-off approach, the amount of foreign income tax in any 
statutory or residual grouping that properly accrues in the taxable 
year of change (accounted for in the currency in which the foreign tax 
liability is denominated) is adjusted upward by the amount of foreign 
income tax in the same grouping that properly accrued in a taxable year 
before the taxable year of change but which, under the taxpayer's 
improper method of accounting, the taxpayer failed to accrue and claim 
as either a credit or a deduction in any taxable year before the 
taxable year of change. For purposes of the foreign tax credit, the 
adjusted amounts of accrued foreign income taxes, including any upward 
adjustment, are translated into U.S. dollars under Sec.  1.986(a)-1 as 
if those amounts properly accrued in the taxable year of change. To the 
extent that the downward adjustment in any grouping required under this 
modified cut-off approach exceeds the amount of foreign income tax 
properly accruing in that grouping in the year of change, such excess 
will carry forward to each subsequent taxable year and reduce properly-
accrued amounts of foreign income tax in the same grouping to the 
extent of those properly-accrued amounts, until all improperly-accrued 
amounts included in the downward adjustment are accounted for. See 
Sec.  1.861-20 for rules that apply to assign foreign income taxes to 
statutory and residual groupings.
    (iii) Application of section 905(c)--(A) Two-year rule. Except as 
otherwise provided in this paragraph (d)(5)(iii), if the taxpayer 
claimed a credit for improperly-accrued amounts in a taxable year 
before the taxable year of change, no adjustment is required under 
section 905(c)(2) and Sec.  1.905-3(a) solely by reason of the improper 
accrual. For purposes of applying section 905(c)(2) and Sec.  1.905-
3(a) to improperly-accrued amounts of foreign income tax that were 
claimed as a credit in any taxable year before the taxable year of 
change, the 24-month period runs from the close of the U.S. taxable 
year(s) in which those amounts were accrued under the taxpayer's 
improper method and claimed as a credit. To the extent any improperly-
accrued amounts remain unpaid as of the date 24 months after the close 
of the taxable year in which the amounts were improperly accrued and 
claimed as a credit, an adjustment is required under section 905(c)(2) 
and Sec.  1.905-3(a) as if the improperly-accrued amounts were refunded 
as of the date 24 months after the close of such taxable year. See 
Sec.  1.986(a)-1(c) (a refund or other downward adjustment to foreign 
income taxes paid or accrued on more than one date reduces the foreign 
income taxes paid or accrued on a last-in, first-out basis, starting 
with the amounts most recently paid or accrued).
    (B) Application of payments. Amounts of foreign income tax that a 
taxpayer accrued and claimed as a credit or a deduction in a taxable 
year before the taxable year of change under the taxpayer's improper 
method, but that had properly accrued either in the taxable year the 
credit or deduction was claimed or in a different taxable year before 
the taxable year of change, are not included in the downward adjustment 
required by paragraph (d)(5)(ii) of this section. Remittances to the 
foreign country of such amounts (accounted for in the currency in which 
the foreign tax liability is denominated) are treated first as payments 
of the amounts of tax that had properly accrued in the taxable year 
claimed as a credit or deduction to the extent thereof, and then as 
payments of the amounts of tax that were improperly accrued in a 
different taxable year, on a last-in, first-out basis, starting with 
the most recent improperly-accrued amounts. Remittances to the foreign 
country of amounts of foreign income tax that properly accrue in or 
after the taxable year of change (accounted for in the foreign currency 
in which the foreign tax liability is denominated) but that are offset 
by the amounts included in the downward adjustment required by 
paragraph (d)(5)(ii) of this section are treated as payments of the 
amounts of tax that were improperly accrued before the taxable year of 
change and included in the downward adjustment on a last-in, first-out 
basis, starting with the most recent improperly-accrued amounts. 
Additional amounts of foreign income tax that first accrue in or after 
the taxable year of change but that relate to a taxable year before the 
taxable year of change are taken into account in the earlier of the 
taxable year of change or the taxable year or years in which they would 
have been considered to accrue based upon the taxpayer's improper 
method. Additional amounts of foreign income tax that first accrue in 
or after the taxable year of change and that relate to the taxable year 
of change or a taxable year after the year of change are taken into 
account in the proper relation-back year, but may then be subject to 
the downward adjustment required by paragraph (d)(5)(ii) of this 
section.
    (iv) Foreign income tax expense improperly accrued by a foreign 
corporation, partnership, or other pass-

[[Page 72148]]

through entity. Foreign income tax expense of a foreign corporation 
reduces both the corporation's taxable income and its earnings and 
profits, and may give rise to an amount of foreign taxes deemed paid 
under section 960 that may be claimed as a credit by a United States 
shareholder that is a domestic corporation or that is a person that 
makes an election under section 962. If the Commissioner grants 
permission for a foreign corporation to change its method of accounting 
for foreign income tax expense, the duplication or omission of those 
expenses (accounted for in the functional currency of the foreign 
corporation) and the associated foreign income taxes (translated into 
dollars in accordance with Sec.  1.986(a)-1) are accounted for by 
applying the rules in paragraph (d)(5)(ii) of this section as if the 
foreign corporation were itself eligible to, and did, claim a credit 
under section 901 for such amounts. In the case of a partnership or 
other pass-through entity that is granted permission to change its 
method of accounting for accruing foreign income taxes to a proper 
method as described in this paragraph (d), such partnership or other 
pass-through entity must provide its partners or other owners with the 
information needed for the partners or other owners to properly account 
for the improperly-accrued or unaccrued amounts under the rules in 
paragraph (d)(5)(ii) of this section as if their proportionate shares 
of foreign income tax expense were directly paid or accrued by them.
    (6) Examples. The following examples illustrate the application of 
paragraph (d) of this section. Unless otherwise stated, for purposes of 
these examples it is presumed that the local currency in each of 
Country X and Country Y and the functional currency of any foreign 
branch is the Euro ([euro]), and at all relevant times the exchange 
rate is $1:[euro]1.
    (i) Example 1: Accrual of foreign income tax--(A) Facts. A, a U.S. 
citizen, resides and works in Country X. A uses the calendar year as 
the U.S. taxable year, and has made an election under paragraph (e) of 
this section to claim foreign tax credits on an accrual basis. Country 
X has a tax year that begins on April 1 and ends on March 31. A's wages 
are subject to net income tax, at graduated rates, under Country X tax 
law and are subject to withholding on a monthly basis by A's employer 
in Country X. In the period between April 1, Year 1, and March 31, Year 
2, A earns $50,000x in Country X wages, from which A's employer 
withholds $10,000x in tax. On December 1, Year 1, A receives a dividend 
distribution from a Country Y corporation, from which the corporation 
withheld $500x of tax. Country Y imposes withholding tax on dividends 
paid to nonresidents solely based on the gross amount of the dividend 
payment; A is not required to file a tax return in Country Y.
    (B) Analysis. Under paragraph (d)(1) of this section, A's liability 
for Country X net income tax accrues on March 31, Year 2, the last day 
of the Country X taxable year. The Country X net income tax withheld by 
A's employer from A's wages is a reasonable approximation of, and 
represents an advance payment of, A's final net income tax liability 
for the year, which becomes fixed and determinable only at the close of 
the Country X taxable year. Thus, A cannot claim a credit for any 
portion of the Country X net income tax on A's Federal income tax 
return for Year 1, and may claim a credit for the entire Country X net 
income tax that accrues on March 31, Year 2, on A's Federal income tax 
return for Year 2. A may claim a credit for the Country Y withholding 
tax on A's Federal income tax return for Year 1, because the 
withholding tax accrued on December 1, Year 1.
    (ii) Example 2: 52-53 week taxable year--(A) Facts. U.S.C., an 
accrual method taxpayer, is a domestic corporation that operates in 
branch form in Country X. U.S.C. uses the calendar year for Country X 
tax purposes. For Federal income tax purposes, U.S.C. elects pursuant 
to Sec.  1.441-2(a) to use a 52-53 week taxable year that ends on the 
last Friday of December. In Year 1, U.S.C.'s U.S. taxable year ends on 
Friday, December 25; in Year 2, U.S.C.'s U.S. taxable year ends Friday, 
December 31. For its foreign taxable year ending December 31, Year 1, 
U.S.C. earns $10,000x of foreign source income through its Country X 
branch and incurs Country X foreign income tax of $500x; for Year 2, 
U.S.C. earns $12,000x and incurs Country X foreign income tax of $600x.
    (B) Analysis. Under paragraph (d)(1) of this section, the $500x of 
Country X foreign income tax becomes fixed and determinable at the 
close of U.S.C.'s foreign taxable year, on December 31, Year 1, which 
is after the close of its U.S. taxable year (December 25, Year 1). The 
$600x of Country X foreign income tax becomes fixed and determinable on 
December 31, Year 2. Thus, both the Year 1 and Year 2 Country X foreign 
income taxes accrue in U.S.C.'s U.S. taxable year ending December 31, 
Year 2. However, pursuant to paragraph (d)(2) of this section, for 
purposes of determining the amount of foreign income taxes accrued in 
each taxable year for foreign tax credit purposes, U.S.C.'s U.S. 
taxable year is deemed to end on December 31, the end of U.S.C.'s 
Country X taxable year. U.S.C. may therefore claim a foreign tax credit 
for $500x of Country X foreign income tax on its Federal income tax 
return for Year 1 and a credit for $600x of Country X foreign income 
tax on its Federal income tax return for Year 2.
    (iii) Example 3: Contested tax--(A) Facts. U.S.C. is a domestic 
corporation that operates in branch form in Country X. U.S.C. uses an 
accrual method of accounting and uses the calendar year as its U.S. and 
Country X taxable year. In Year 1, when the average exchange rate 
described in Sec.  1.986(a)-1(a)(1) is $1:[euro]1, U.S.C. earns 
[euro]20,000x = $20,000x through its Country X branch for U.S. and 
Country X tax purposes and accrues Country X foreign income taxes of 
[euro]500x = $500x, which U.S.C. claims as a credit on its Federal 
income tax return for Year 1. In Year 3, when the average exchange rate 
is $1:[euro]1.2, Country X asserts that U.S.C. owes additional foreign 
income taxes of [euro]100x with respect to U.S.C.'s Year 1 income. 
U.S.C. contests the liability but remits [euro]40x to Country X with 
respect to the contested liability in Year 3. U.S.C. does not make an 
election under paragraph (d)(4) of this section to claim a provisional 
credit with respect to the [euro]40x. In Year 6, after exhausting all 
effective and practical remedies, it is finally determined that U.S.C. 
is liable for [euro]50x of additional Country X foreign income taxes 
with respect to its Year 1 income. U.S.C. pays an additional [euro]10x 
to Country X on September 15, Year 6, when the spot rate described in 
Sec.  1.986(a)-1(a)(2)(i) is $1:[euro]2.
    (B) Analysis. Pursuant to paragraph (d)(3) of this section, the 
additional liability asserted by Country X with respect to U.S.C.'s 
Year 1 income does not accrue until the contest is resolved in Year 6. 
U.S.C.'s remittance of [euro]40x of contested tax in Year 3 is not a 
payment of accrued tax, and so is not a foreign tax redetermination. 
Both the [euro]40x of Country X taxes paid in Year 3 and the [euro]10x 
of Country X taxes paid in Year 6 accrue in Year 6, when the contest is 
resolved. Once accrued and paid, the [euro]50x relates back for foreign 
tax credit purposes to Year 1, and can be claimed as a credit by U.S.C. 
on a timely-filed amended return for Year 1. Under Sec.  1.986(a)-1(a), 
for foreign tax credit purposes the [euro]40x paid in Year 3 is 
translated into dollars at the average exchange rate for Year 1 
([euro]40x x $1 / [euro]1 = $40x), and the [euro]10x paid in Year 6 is 
translated into dollars at the spot rate on the date paid ([euro]10x x 
$1 / [euro]2 = $5x). Accordingly, after the [euro]50x of Country

[[Page 72149]]

X income tax is paid in Year 6 U.S.C. may claim an additional foreign 
tax credit of $45x for Year 1.
    (iv) Example 4: Provisional credit for contested tax--(A) Facts. 
The facts are the same as in paragraph (d)(6)(iii)(A) of this section 
(the facts of Example 3), except that U.S.C. pays the entire contested 
tax liability of [euro]100x to Country X in Year 3 and elects under 
paragraph (d)(4) of this section to claim a provisional foreign tax 
credit on an amended return for Year 1. In Year 6, upon resolution of 
the contest, U.S.C. receives a refund of [euro]50x from Country X.
    (B) Analysis. In Year 3, U.S.C. may claim a provisional foreign tax 
credit for $100x ([euro]100x translated at the average exchange rate 
for Year 1) of contested foreign tax paid to Country X by filing an 
amended return for Year 1, with Form 1118 attached, and a provisional 
foreign tax credit agreement described in paragraph (d)(4)(ii) of this 
section. In each year for Years 4 through 6, U.S.C. must attach the 
certification described in paragraph (d)(4)(iii) of this section to its 
timely-filed Federal income tax return. In Year 6, as a result of the 
[euro]50x refund, U.S.C. must redetermine its U.S. tax liability for 
Year 1 and for any other affected year pursuant to Sec.  1.905-3, 
reducing the Year 1 foreign tax credit by $50x (from $600x to $550x), 
and comply with the notification requirements in Sec.  1.905-4. See 
Sec.  1.986(a)-1(c) (refunds of foreign income tax translated into U.S. 
dollars at the rate used to claim the credit).
    (v) Example 5: Improperly accelerated accrual--(A) Facts--(1) 
Foreign income tax accrued and paid. U.S.C. is a domestic corporation 
that operates a foreign branch in Country X. All of U.S.C.'s gross and 
taxable income is foreign source foreign branch category income, and 
all of its foreign income taxes are properly allocated and apportioned 
under Sec.  1.861-20 to the foreign branch category. U.S.C. uses the 
accrual method of accounting and uses the calendar year as its U.S. 
taxable year. For Country X tax purposes, U.S.C. uses a fiscal year 
that ends on March 31. U.S.C. accrued [euro]200x = $200x of Country X 
net income tax (as defined in Sec.  1.901-2(a)(3)) for its foreign 
taxable year ending March 31, Year 2. It timely filed its Country X tax 
return and paid the [euro]200x on January 15, Year 3. U.S.C. accrued 
and paid with its timely filed Country X tax returns [euro]280x and 
[euro]240x of Country X net income tax for its foreign taxable years 
ending on March 31 of Year 3 and Year 4, respectively, on January 15 of 
Year 4 and Year 5, respectively.
    (2) Improper accrual. On its Federal income tax return for Year 1, 
U.S.C. improperly pro-rated and accelerated the accrual of Country X 
net income tax and claimed a credit for $150x, equal to three-fourths 
of the Country X net income tax of $200x that relates to U.S.C.'s 
foreign taxable year ending March 31, Year 2. Continuing with this 
improper method of accruing foreign income taxes, U.S.C. claimed a 
foreign tax credit of $260x on its U.S. tax return for Year 2, 
comprising $50x (one-fourth of the $200x of net income tax relating to 
its foreign taxable year ending March 31, Year 2) plus $210x (three-
fourths of the $280x of net income tax relating to its foreign taxable 
year ending March 31, Year 3). Similarly, U.S.C. improperly accrued and 
claimed a foreign tax credit on its U.S. tax return for Year 3 for 
$250x of Country X net income tax, comprising $70x (one-fourth of the 
$280x that properly accrued in Year 3) plus $180x (three-fourths of the 
$240x that properly accrued in Year 4). In Year 4, U.S.C. realizes its 
mistake and, as provided in paragraph (d)(5)(i) of this section, files 
Form 3115 with the IRS to seek permission to change from an improper 
method to a proper method of accruing foreign income taxes.

                                      Table 1 to Paragraph (d)(6)(v)(A)(2)
----------------------------------------------------------------------------------------------------------------
 Country X taxable year ending in    Net income tax  properly accrued    Net income tax accrued  under improper
    U.S. calendar taxable year               ($1 = [euro]1))                     method  ($1 = [euro]1))
----------------------------------------------------------------------------------------------------------------
3/31/Y1 ends in Year 1...........  0..................................  \3/4\ (200x) = 150x.
3/31/Y2 ends in Year 2...........  200x...............................  \1/4\ (200x) + \3/4\ (280x) = 260x.
3/31/Y3 ends in Year 3...........  280x...............................  \1/4\ (280x) + \3/4\ (240x) = 250x.
3/31/Y4 ends in Year 4...........  240x...............................  [year of change].
----------------------------------------------------------------------------------------------------------------

    (B) Analysis--(1) Downward adjustment. Under paragraph (d)(5)(ii) 
of this section, in Year 4, the year of change, U.S.C. must reduce (but 
not below zero) the amount (in Euros) of Country X net income tax in 
the foreign branch category that properly accrues in Year 4, 
[euro]240x, by the amount of foreign income tax that was accrued and 
claimed as either a deduction or a credit in a year before the year of 
change, and that had not properly accrued in either the year in which 
the tax was accrued under U.S.C.'s improper method or in any other 
taxable year before the taxable year of change. For all taxable years 
before the taxable year of change, under its improper method U.S.C. had 
accrued and claimed as a credit a total of [euro]660x = $660x of 
foreign income tax, of which only [euro]480x = $480x had properly 
accrued. Therefore, the downward adjustment required by paragraph 
(d)(5)(ii) of this section is [euro]180x ([euro]660x-[euro]480x = 
[euro]180x). In Year 4, U.S.C.'s foreign tax credit in the foreign 
branch category is reduced by $180x ([euro]180x downward adjustment 
translated into dollars at $1:[euro]1, the average exchange rate for 
Year 4), from $240x to $60x.
    (2) Application of section 905(c)--(i) Year 1. Under paragraph 
(d)(5)(iii) of this section, the [euro]200x U.S.C. paid on January 15, 
Year 3, that relates to its Country X taxable year ending on March 31, 
Year 2, is first treated as a payment of the [euro]50x of that Country 
X net income tax liability that properly accrued and was claimed as a 
credit by U.S.C. in Year 2, and next as a payment of the [euro]150x of 
that Country X net income tax liability that U.S.C. improperly accrued 
and claimed as a credit in Year 1. Because all [euro]150x of the 
Country X net income tax that was improperly accrued and claimed as a 
credit in Year 1 was paid within 24 months of December 31, Year 1, no 
foreign tax redetermination occurs, and no redetermination of U.S. tax 
liability is required, for Year 1.
    (ii) Year 2. Under paragraph (d)(5)(iii) of this section, the 
[euro]280x U.S.C. paid on January 15, Year 4, that relates to its 
Country X taxable year ending on March 31, Year 3, is first treated as 
a payment of the [euro]70x = $70x of that Country X net income tax 
liability that properly accrued and was claimed as a credit by U.S.C. 
in Year 3, and next as a payment of the [euro]210x = $210x of that 
Country X net income tax liability that U.S.C. improperly accrued and 
claimed as a credit in Year 2. Together with the [euro]50x = $50x of 
U.S.C.'s Country X net income

[[Page 72150]]

tax liability that properly accrued and was claimed as a credit in Year 
2, all [euro]260x of the Country X net income tax that was accrued and 
claimed as a credit in Year 2 under U.S.C.'s improper method was paid 
within 24 months of December 31, Year 2. Accordingly, no foreign tax 
redetermination occurs, and no redetermination of U.S. tax liability is 
required, for Year 2.
    (iii) Year 3. Under paragraph (d)(5)(iii) of this section, the 
[euro]240x U.S.C. paid on January 15, Year 5, that relates to its 
Country X taxable year ending on March 31, Year 4, is first treated as 
a payment of the [euro]60x = $60x of that Country X net income tax 
liability that properly accrued and was claimed as a credit by U.S.C. 
in Year 4, and next as a payment of the [euro]180x = $180x of that 
Country X net income tax liability that U.S.C. improperly accrued and 
claimed as a credit in Year 3. Together with the [euro]70x = $70x of 
U.S.C.'s Country X net income tax liability that properly accrued and 
was claimed as a credit by U.S.C. in Year 3, all [euro]250x of the 
Country X net income tax that was accrued and claimed as a credit in 
Year 3 under U.S.C.'s improper method was paid within 24 months of 
December 31, Year 3. Accordingly, no foreign tax redetermination 
occurs, and no redetermination of U.S. tax liability is required, for 
Year 3.
    (iv) Year 4. Under paragraph (d)(5)(iii) of this section, [euro]60x 
= $60x of U.S.C.'s January 15, Year 5 payment of [euro]240x with 
respect to its Country X net income tax liability for Year 4 is treated 
as a payment of [euro]60x = $60x of Country X net income tax that, 
after application of the downward adjustment required by paragraph 
(d)(5)(ii) of this section, was accrued and claimed as a credit in Year 
4, the year of change.
    (vi) Example 6: Failure to pay improperly-accrued tax within 24 
months--(A) Facts. The facts the same as in paragraph (d)(6)(v) of this 
section (the facts in Example 5), except that U.S.C. does not pay its 
[euro]240x tax liability for its Country X taxable year ending on March 
31, Year 4, until January 15 of Year 6, when the spot rate described in 
Sec.  1.986(a)-1(a)(2)(i) is $1:[euro]1.5.
    (B) Analysis. The results are the same as in paragraphs 
(d)(6)(v)(B)(2)(i) and (ii) of this section (the analysis in Example 5 
for Year 1 and Year 2). With respect to Year 3, because the [euro]180x 
= $180x of Year 4 foreign income tax that was improperly accrued and 
credited in Year 3 was not paid within 24 months of the end of Year 3, 
under section 905(c)(2) and Sec.  1.905-3(a) that [euro]180x = $180x is 
treated as refunded on December 31, Year 5, requiring a redetermination 
of U.S.C.'s Federal income tax liability for Year 3 (to reverse out the 
credit claimed). When in Year 6 U.S.C. pays the [euro]240x of Country X 
income tax liability for Year 4, however, under paragraph (d)(5)(iii) 
of this section that payment is first treated as a payment of the 
[euro]60x = $60x that was properly accrued and claimed as a credit in 
Year 4, and then as a payment of the [euro]180x that was improperly 
accrued and claimed as a credit in Year 3 and that was treated as 
refunded in Year 5. Under section 905(c)(2)(B) and Sec.  1.905-3(a), 
that Year 6 payment of accrued but unpaid tax is a second foreign tax 
redetermination for Year 3 that also requires a redetermination of 
U.S.C.'s U.S. tax liability. Under Sec.  1.986(a)-1(a)(2), the 
[euro]180x of redetermined tax for Year 3 is translated into dollars at 
the spot rate on January 15, Year 6, when the tax is paid ([euro]180x x 
$1 / [euro]1.5 = $120x). Under Sec.  1.905-4(b)(1)(iv), U.S.C. may file 
one amended return accounting for both foreign tax redeterminations 
(which occur in two consecutive taxable years) with respect to Year 3, 
which taken together result in a reduction in U.S.C.'s foreign tax 
credit for Year 3 from $250x to $190x ($250x originally accrued-$180x 
unpaid after 24 months + $120x paid in Year 6).
    (vii) Example 7: Additional payment of improperly-accrued tax--(A) 
Facts. The facts are the same as in paragraph (d)(6)(v)(A) of this 
section (the facts in Example 5), except that in Year 6, Country X 
assessed additional net income tax of [euro]100x with respect to 
U.S.C.'s Country X taxable year ending March 31, Year 3, and after 
exhausting all effective and practical remedies to reduce its liability 
for Country X income tax, U.S.C. pays the additional assessed tax on 
September 15, Year 7, when the spot rate described in Sec.  1.986(a)-
1(a)(2)(i) is $1:[euro]0.5.
    (B) Analysis. Under paragraph (d)(3) of this section, the 
additional [euro]100x of Country X income tax U.S.C. paid in Year 7 
with respect to its foreign taxable year that ended March 31, Year 3, 
relates back and is considered to accrue in Year 3. However, under its 
improper method of accounting U.S.C. had accrued and claimed foreign 
tax credits for Country X net income tax that related to Year 3 on its 
Federal income tax returns for both Year 2 and Year 3. Accordingly, 
under paragraph (d)(5)(iii)(B) of this section U.S.C. must redetermine 
its U.S. tax liability for both Year 2 and Year 3 (and any other 
affected years) to account for the additional [euro]100x of Country X 
net income tax liability, using the improper method it used to accrue 
foreign income taxes before the year of change. Therefore, [euro]75x = 
$150x of the [euro]100x of additional tax is treated as if it accrued 
in Year 2, and [euro]25x = $50x of the additional tax is treated as if 
it accrued in Year 3. Under Sec.  1.905-4(b)(1)(iii), U.S.C. may claim 
a refund for any resulting overpayment of U.S. tax for Year 2 or Year 3 
or any other affected year by filing an amended return within the 
period provided in section 6511.
    (viii) Example 8: Tax improperly accrued before year of change 
exceeds tax properly accrued in year of change--(A) Facts. U.S.C. owns 
all of the stock in CFC, a controlled foreign corporation organized in 
Country X. Country X imposes net income tax on Country X corporations 
at a rate of 10% only in the year its earnings are distributed to its 
shareholders, rather than in the year the income is earned. Both U.S.C. 
and CFC use the calendar year as their taxable year for both Federal 
and Country X income tax purposes and CFC uses the Euro as its 
functional currency. In each of Years 1-3, CFC earns [euro]1,000x for 
both Federal and Country X income tax purposes of general category 
foreign base company sales income (before reduction for foreign income 
taxes). CFC improperly accrues [euro]100x of Country X net income tax 
with respect to [euro]1,000x of income at the end of each of Years 1 
and 2, even though no distribution is made in those years. In Year 1, 
for which the average exchange rate is $1:[euro]1, U.S.C. computes and 
includes in income with respect to CFC $900x of subpart F income, 
claims a deemed paid foreign tax credit of $100x under section 960(a), 
and has a section 78 dividend of $100x. In Year 2, for which the 
average exchange rate is $1:[euro]0.5, U.S.C. computes and includes in 
income with respect to CFC $1,800x of subpart F income, claims a deemed 
paid foreign tax credit of $200x under section 960(a), and has a 
section 78 dividend of $200x. In Year 2, CFC makes a distribution to 
U.S.C. of [euro]400x of earnings and pays [euro]40x of net income tax 
to Country X. In Year 3, for which the average exchange rate is 
$1:[euro]1, CFC makes another distribution to U.S.C. of [euro]500x of 
earnings and pays [euro]50x in net income tax to Country X. In Year 3, 
U.S.C. realizes its mistake and seeks permission from the IRS for CFC 
to change to a proper method of accruing foreign income taxes. In Year 
4, for which the average exchange rate is $1:[euro]2, CFC makes a 
distribution of [euro]700x of earnings and pays [euro]70x of net income 
tax to Country X.

[[Page 72151]]



                                      Table 2 to Paragraph (d)(6)(viii)(A)
----------------------------------------------------------------------------------------------------------------
                                       Foreign income tax  properly         Foreign income tax accrued under
       Taxable year ending                       accrued                             improper method
----------------------------------------------------------------------------------------------------------------
12/31/Y1 ($1:[euro]1)............  0..................................  [euro]100x = $100x.
12/31/Y2 ($1:[euro]0.5)..........  [euro]40x = $80x...................  [euro]100x = $200x.
12/31/Y3 ($1:[euro]1)............  [euro]50x = $50x...................  [year of change].
12/31/Y4 ($1:[euro]2)............  [euro]70x = $35x...................
----------------------------------------------------------------------------------------------------------------

    (B) Analysis--(1) Downward adjustment. Under paragraph (d)(5)(iv) 
of this section, CFC applies the rules of paragraph (d)(5) of this 
section as if it claimed a foreign tax credit under section 901 for 
Country X taxes. Under paragraph (d)(5)(ii) of this section, in Year 3, 
the year of change, CFC must reduce (but not below zero) the amount (in 
Euros) of Country X net income tax allocated and apportioned to its 
general category foreign base company sales income group that properly 
accrues in Year 3, [euro]50x, by the amount of foreign income tax (in 
Euros) that was improperly accrued in that statutory grouping in a year 
before the year of change, and that had not properly accrued in either 
the year accrued or in another taxable year before the year of change. 
For all taxable years before the year of change, under its improper 
method CFC had accrued a total of [euro]200x of foreign income tax with 
respect to its general category foreign base company sales income 
group, of which only [euro]40x had properly accrued. Therefore, the 
downward adjustment required by paragraph (d)(5)(ii) of this section is 
[euro]160x ([euro]200x-[euro]40x = [euro]160x). In Year 3, CFC's 
[euro]50x of eligible foreign income taxes in the general category 
foreign base company sales income group is reduced by [euro]50x to 
zero. The [euro]110x balance of the downward adjustment carries forward 
to Year 4, and reduces CFC's [euro]70x of eligible foreign income taxes 
in the general category foreign base company sales income group by 
[euro]70x to zero. The remaining [euro]40x balance of the downward 
adjustment carries forward to later years and will reduce CFC's 
eligible foreign income taxes in the general category foreign base 
company sales income group until all improperly-accrued amounts are 
accounted for.
    (2) Application of section 905(c)--(i) Year 2. Under paragraph 
(d)(5)(iii) of this section, CFC's payment in Year 2 of the [euro]40x 
of Country X net income tax that properly accrued in Year 2, before the 
year of change, is treated as a payment of [euro]40x of foreign income 
tax that CFC properly accrued in Year 2. The [euro]60x of foreign 
income tax that CFC improperly accrued in Year 2 that remains unpaid at 
the end of Year 2 is not adjusted in Year 2. Under paragraph 
(d)(5)(iii) of this section, CFC's payment in Year 3 of [euro]50x of 
Country X net income tax that properly accrued but was offset by the 
downward adjustment in Year 3 is treated as a payment of [euro]50x of 
the [euro]60x of Country X net income tax most recently improperly 
accrued in Year 2. In addition, CFC's payment in Year 4 of [euro]70x of 
Country X net income tax that properly accrued but was offset by the 
downward adjustment in Year 4 is treated first as a payment of the 
remaining [euro]10x of Country X net income tax that was improperly 
accrued in Year 2. Because all [euro]100x of foreign income tax accrued 
in Year 2 under CFC's improper method of accounting is treated as paid 
within 24 months of December 31, Year 2, no foreign tax redetermination 
occurs, and no redetermination of CFC's foreign base company sales 
income, earnings and profits, and eligible foreign income taxes, or of 
U.S.C.'s $1,800x subpart F inclusion, $200x deemed paid credit, and 
$200x section 78 dividend or its U.S. tax liability is required, for 
Year 2.
    (ii) Year 1. Because all [euro]100x of the tax CFC improperly 
accrued in Year 1 remained unpaid as of December 31, Year 3, the date 
24 months after the end of Year 1, under section 905(c)(2) and Sec.  
1.905-3(a) that [euro]100x is treated as refunded on December 31, Year 
3. Under Sec.  1.905-3(b)(2)(ii), U.S.C. must redetermine its Federal 
income tax liability for Year 1 to account for the foreign tax 
redetermination, increasing CFC's foreign base company sales income and 
earnings and profits by [euro]100x, and decreasing its eligible foreign 
income taxes by $100x. However, under paragraph (d)(5)(iii)(B) of this 
section [euro]60x = $30x of CFC's payment in Year 4 of [euro]70x of 
Country X net income tax that properly accrued but was offset by the 
downward adjustment in Year 4 is treated as a payment of [euro]60x of 
the [euro]100x of Country X net income tax that was improperly accrued 
in Year 1 and treated as refunded in Year 3. Under Sec.  1.905-
4(b)(1)(iv), U.S.C. may account for the two foreign tax 
redeterminations that occurred in Years 3 and 4 on a single amended 
Federal income tax return for Year 1. CFC's foreign base company sales 
income (taking into account the reduction for foreign income taxes) and 
earnings and profits for Year 1 are recomputed as [euro]1,000x-
[euro]100x + [euro]100x-[euro]60x = [euro]940x, and its eligible 
foreign income taxes are recomputed as $100x-$100x + $30x = $30x. 
U.S.C.'s subpart F inclusion with respect to CFC for Year 1 (translated 
at the average exchange rate for Year 1 of $1:[euro]1) is increased 
from $900x to $940x ([euro]940x x $1/[euro]1), and the amount of 
foreign taxes deemed paid under section 960(a) and the amount of the 
section 78 dividend are reduced from $100x to $30x.
    (iii) Summary. As of the end of Year 4, CFC and U.S.C. have been 
allowed a $30x foreign tax credit for Year 1, and a $200x foreign tax 
credit for Year 2. If in a later taxable year CFC distributes 
additional earnings to U.S.C. and accrues [euro]40x of additional 
Country X net income tax that is offset by the balance of the [euro]40x 
downward adjustment, CFC's payment of that [euro]40x Country X net 
income tax liability will be treated as a payment of the remaining 
[euro]40x of Country X net income tax that was improperly accrued in 
Year 1 and treated as refunded as of the end of Year 3.
    (ix) Example 9: Improperly deferred accrual--(A) Facts--(1) Foreign 
income tax accrued and paid. U.S.C. is a domestic corporation that 
operates a foreign branch in Country X. All of U.S.C.'s gross and 
taxable income is foreign source foreign branch category income, and 
all of its foreign income taxes are properly allocated and apportioned 
under Sec.  1.861-20 to the foreign branch category. U.S.C. uses the 
accrual method of accounting and uses the calendar year as its taxable 
year for both Federal and Country X income tax purposes. U.S.C. accrued 
[euro]160x of Country X net income tax (as defined in Sec.  1.901-
2(a)(3)) with respect to Year 1. U.S.C. filed its Country X tax return 
and paid the [euro]160x on June 30, Year 2. U.S.C. accrued [euro]180x, 
[euro]240x, and [euro]150x of Country X tax for Years 2, 3, and 4, 
respectively, and paid with its timely filed Country X tax returns 
these tax liabilities on June 30 of Years 3, 4, and 5, respectively. 
The average exchange rate described in Sec.  1.986(a)-1(a)(1) is

[[Page 72152]]

$1:[euro]0.5 in Year 1, $1:[euro]1 in Year 2, $1:[euro]1.25 in Year 3, 
and $1:[euro]1.5 in Year 4.
    (2) Improper accrual. On its Federal income tax return for Year 1, 
U.S.C. claimed no foreign tax credit. On its Federal income tax return 
for Year 2, U.S.C. improperly accrued and claimed a credit for $160x 
([euro]160x of Country X tax for Year 1 that it paid in Year 2, 
translated into dollars at the average exchange rate for Year 2). 
Continuing with this improper method of accounting, U.S.C. improperly 
accrued and claimed a credit in Year 3 for $144x ([euro]180x of Country 
X tax for Year 2 that it paid in Year 3, translated into dollars at the 
average exchange rate for Year 3). In Year 4, U.S.C. realizes its 
mistake and seeks permission from the IRS to change to a proper method 
of accruing foreign income taxes.

                                      Table 3 to Paragraph (d)(6)(ix)(A)(2)
----------------------------------------------------------------------------------------------------------------
                                       Foreign income tax  properly         Foreign income tax accrued  under
       Taxable year ending                       accrued                             improper method
----------------------------------------------------------------------------------------------------------------
12/31/Y1 ($1:[euro]0.5)..........  [euro]160x = $320x.................  0.
12/31/Y2 ($1:[euro]1)............  [euro]180x = $180x.................  [euro]160x = $160x.
12/31/Y3 ($1:[euro]1.25).........  [euro]240x = $192x.................  [euro]180x = $144x.
12/31/Y4 ($1:[euro]1.5)..........  [euro]150x = $100x.................  [year of change].
----------------------------------------------------------------------------------------------------------------

    (B) Analysis--(1) Upward adjustment. Under paragraph (d)(5)(ii) of 
this section, in Year 4, the year of change, U.S.C. increases the 
amount of Country X net income tax allocated and apportioned to its 
foreign branch category that properly accrues in Year 4, [euro]150x, by 
the amount of foreign income tax in that same grouping that properly 
accrued in a taxable year before the taxable year of change, but which, 
under its improper method of accounting, U.S.C. failed to accrue and 
claim as either a credit or deduction before the taxable year of 
change. For all taxable years before the taxable year of change, under 
a proper method, U.S.C. would have accrued a total of [euro]580x of 
foreign income tax, of which it accrued and claimed a credit for only 
[euro]340x under its improper method. Thus, in Year 4, U.S.C. increases 
its [euro]150x of properly accrued foreign income taxes in the foreign 
branch category by [euro]240x ([euro]580x-[euro]340x), and may claim a 
credit in that year for the total, [euro]390x, or $260x (translated 
into dollars at the average exchange rate for Year 4, as if the total 
amount properly accrued in Year 4).
    (2) Application of section 905(c). Under paragraph (d)(5)(iii) of 
this section, U.S.C.'s payment of the [euro]160x of Year 1 tax that 
U.S.C. accrued and claimed as a credit in Year 2 under its improper 
method of accounting is first treated as a payment of the amount of 
that (Year 1) tax liability that properly accrued in Year 2. Since none 
of the [euro]160x properly accrued in Year 2, the [euro]160x is treated 
as a payment of that (Year 1) tax liability that U.S.C. improperly 
accrued and claimed as a credit in Year 2, [euro]160x. Because all 
[euro]160x of the Country X net income tax that was improperly accrued 
and claimed as a credit in Year 2 was paid within 24 months of the end 
of Year 2, no foreign tax redetermination occurs, and no 
redetermination of U.S.C.'s $160x foreign tax credit and U.S. tax 
liability is required, for Year 2. Similarly, because all [euro]180x of 
the Year 2 Country X net income tax that was improperly accrued and 
claimed as a credit in Year 3 was paid within 24 months of the end of 
Year 3, no foreign tax redetermination occurs, and no redetermination 
of U.S.C.'s $144x foreign tax credit and U.S. tax liability is 
required, for Year 3.
    (e) Election by cash method taxpayer to take credit on the accrual 
basis--(1) In general. A taxpayer who uses the cash method of 
accounting for income may elect to take the foreign tax credit in the 
taxable year in which the taxes accrue in accordance with the rules in 
paragraph (d) of this section. Except as provided in paragraph (e)(2) 
of this section, an election pursuant to this paragraph (e)(1) must be 
made on a timely-filed original return, by checking the appropriate box 
on Form 1116 (Foreign Tax Credit (Individual, Estate, or Trust)) or 
Form 1118 (Foreign Tax Credit--Corporations) indicating the cash method 
taxpayer's choice to claim the foreign tax credit in the year the 
foreign income taxes accrue. Once made, the election is irrevocable and 
must be followed for purposes of claiming a foreign tax credit for all 
subsequent years. See section 905(a).
    (2) Exception for cash method taxpayers claiming a foreign tax 
credit for the first time. If the year with respect to which an 
election pursuant to paragraph (e)(1) of this section to claim the 
foreign tax credit on an accrual basis is made (the ``election year'') 
is the first year for which a taxpayer has ever claimed a foreign tax 
credit, the election to claim the foreign tax credit on an accrual 
basis can also be made on an amended return filed within the period 
permitted under Sec.  1.901-1(d)(1). The election is binding in the 
election year and all subsequent taxable years in which the taxpayer 
claims a foreign tax credit.
    (3) Treatment of taxes that accrued in a prior year. In the 
election year and subsequent taxable years, a cash method taxpayer that 
claimed foreign tax credits on the cash basis in a prior taxable year 
may claim a foreign tax credit not only for foreign income taxes that 
accrue in the election year, but also for foreign income taxes that 
accrued (or are considered to accrue) in a taxable year preceding the 
election year but that are paid in the election year or subsequent 
taxable year, as applicable. Under paragraph (c) of this section, 
foreign income taxes paid with respect to a taxable year that precedes 
the election year may be claimed as a credit only in the year the taxes 
are paid and do not require a redetermination under section 905(c) or 
Sec.  1.905-3 of U.S. tax liability in any prior year.
    (4) Examples. The following examples illustrate the application of 
paragraph (e) of this section.
    (i) Example 1--(A) Facts. A, a U.S. citizen who is a resident of 
Country X, is a cash method taxpayer who uses the calendar year as the 
taxable year for both U.S. and Country X tax purposes. In Year 1 
through Year 5, A claims foreign tax credits for Country X foreign 
income taxes on the cash method, in the year the taxes are paid. For 
Year 6, A makes a timely election to claim foreign tax credits on the 
accrual basis. In Year 6, A accrues $100x of Country X foreign income 
taxes with respect to Year 6. Also in Year 6, A pays $80x in foreign 
income taxes that had accrued in Year 5.
    (B) Analysis. Pursuant to paragraph (e)(3) of this section, A can 
claim a foreign tax credit in Year 6 for the $100x of Country X taxes 
that accrued in Year 6 and for the $80x of Country X taxes

[[Page 72153]]

that accrued in Year 5 but that are paid in Year 6.
    (ii) Example 2--(A) Facts. The facts are the same as in paragraph 
(e)(4)(i)(A) of this section (the facts of Example 1), except that in 
Year 7, A is assessed an additional $10x of foreign income tax by 
Country X with respect to A's income in Year 3. After exhausting all 
effective and practical remedies, A pays the additional $10x to Country 
X in Year 8.
    (B) Analysis. Pursuant to paragraph (e)(3) of this section, A can 
claim a foreign tax credit in Year 8 for the additional $10x of foreign 
income tax paid to Country X in Year 8 with respect to Year 3.
    (f) Rules for creditable foreign tax expenditures of partners, 
shareholders, or beneficiaries of a pass-through entity--(1) Effect of 
pass-through entity's method of accounting on when foreign tax credit 
or deduction can be claimed. Each partner that elects to claim the 
foreign tax credit for a particular taxable year may treat its 
distributive share of the creditable foreign tax expenditures (as 
defined in Sec.  1.704-1(b)(4)(viii)(b)) of the partnership that are 
paid or accrued by the partnership, under the partnership's method of 
accounting, during the partnership's taxable year ending with or within 
the partner's taxable year, as foreign income taxes paid or accrued (as 
the case may be, according to the partner's method of accounting for 
such taxes) by the partner in that particular taxable year. See 
Sec. Sec.  1.702-1(a)(6) and 1.703-1(b)(2). Under Sec. Sec.  1.905-3(a) 
and 1.905-4(b)(2), additional creditable foreign tax expenditures of 
the partnership that result from a change in the partnership's foreign 
tax liability for a prior taxable year, including additional taxes paid 
when a contest with a foreign tax authority is resolved, must be 
identified by the partnership as a prior year creditable foreign tax 
expenditure in the information reported to its partners for its taxable 
year in which the additional tax is actually paid. Subject to the rules 
in paragraphs (c) and (e) of this section, a partner using the cash 
method of accounting for foreign income taxes may claim a credit (or a 
deduction) for its distributive share of such additional taxes in the 
partner's taxable year with or within which the partnership's taxable 
year ends. Subject to the rules in paragraph (d) of this section, a 
partner using the accrual method of accounting for foreign income taxes 
may claim a credit for the partner's distributive share of such 
additional taxes in the relation-back year, or may claim a deduction in 
its taxable year with or within which the partnership's taxable year 
ends. The principles of this paragraph (f)(1) apply to determine the 
year in which a shareholder of a S corporation, or the grantor or 
beneficiary of an estate or trust, may claim a foreign tax credit (or a 
deduction) for its proportionate share of foreign income taxes paid or 
accrued by the S corporation, estate or trust. See sections 642(a), 
671, 901(b)(5), and 1373(a) and Sec. Sec.  1.1363-1(c)(2)(iii) and 
1.1366-1(a)(2)(iv). See Sec. Sec.  1.905-3 and 1.905-4 for 
notifications and adjustments of U.S. tax liability that are required 
if creditable foreign tax expenditures of a partnership or S 
corporation, or foreign income taxes paid or accrued by a trust or 
estate, are refunded or otherwise reduced.
    (2) Provisional credit for contested taxes. Under paragraph (d)(3) 
of this section, a contested foreign tax liability does not accrue 
until the contest is resolved and the amount of the liability has been 
finally determined. In addition, under section 905(c)(2), a foreign 
income tax that is not paid within 24 months of the close of the 
taxable year to which the tax relates may not be claimed as a credit 
until the tax is actually paid. Thus, a partnership or other pass-
through entity cannot take the contested tax into account as a 
creditable foreign tax expenditure until both the contest is resolved 
and the tax is actually paid. However, to the extent that a partnership 
or other pass-through entity remits a contested foreign tax liability 
to a foreign country, a partner or other owner of such pass-through 
entity that claims foreign tax credits on the accrual basis, may, by 
complying with the rules in paragraph (d)(4) of this section, elect to 
claim a provisional credit for its distributive share of such contested 
tax liability in the relation-back year.
    (3) Example. The following example illustrates the application of 
paragraph (f) of this section.
    (i) Facts. ABC is a U.S. partnership that is engaged in a trade or 
business in Country X. ABC has two U.S. partners, A and B. For Federal 
income tax purposes, ABC and partner A both use the accrual method of 
accounting and utilize a taxable year ending on September 30. ABC uses 
a taxable year ending on September 30 for Country X tax purposes. B is 
a calendar year taxpayer that uses the cash method of accounting. For 
its taxable year ending September 30, Year 1, ABC accrues $500x in 
foreign income tax to Country X; each partner's distributive share of 
the foreign income tax is $250x. In its taxable year ending September 
30, Year 5, ABC settles a contest with Country X with respect to its 
Year 1 tax liability and, as a result of such settlement, accrues an 
additional $100x in foreign income tax for Year 1. ABC remits the 
additional tax to Country X in January of Year 6. A and B both elect to 
claim foreign tax credits for their respective taxable Years 1 through 
6.
    (ii) Analysis. For its taxable year ending September 30, Year 1, A 
can claim a credit for its $250x distributive share of foreign income 
taxes paid by ABC with respect to ABC's taxable year ending September 
30, Year 1. Pursuant to paragraph (f)(1) of this section, B can claim 
its distributive share of $250x of foreign income tax for its taxable 
year ending December 31, Year 1, even if ABC does not remit the Year 1 
taxes to Country X until Year 2. Although the additional $100x of 
Country X foreign income tax owed by ABC with respect to Year 1 accrued 
in its taxable year ending September 30, Year 5, upon conclusion of the 
contest, because ABC uses the accrual method of accounting, it does not 
take the additional tax into account until the tax is actually paid, in 
its taxable year ending September 30, Year 6. See section 905(c)(2)(B) 
and paragraph (f)(1) of this section. Pursuant to Sec.  1.905-4(b)(2), 
ABC is required to notify the IRS and its partners of the foreign tax 
redetermination. A's distributive share of the additional tax relates 
back, is considered to accrue, and may be claimed as a credit for Year 
1; however, A cannot claim a credit for the additional tax until Year 
6, when ABC remits the tax to Country X. See Sec.  1.905-3(a). B's 
distributive share of the additional tax does not relate back to Year 1 
and is creditable in B's taxable year ending December 31, Year 6.
    (g) Blocked income. * * *
    (h) Applicability dates. This section applies to foreign income 
taxes paid or accrued in taxable years beginning on or after [date 
final regulations are filed in the Federal Register]. In addition, the 
election described in paragraph (d)(4) of this section may be made with 
respect to amounts of contested tax that are remitted in taxable years 
beginning on or after [date final regulations are filed in the Federal 
Register] and that relate to a taxable year beginning before [date 
final regulations are filed in the Federal Register].
0
Par. 31. Section 1.905-3, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is further amended:
0
1. In paragraph (a), by revising the first two sentences.
0
2. By adding paragraph (b)(4).
0
3. By revising paragraph (d).
    The revisions and addition read as follows:

[[Page 72154]]

Sec.  1.905-3  Adjustments to U.S. tax liability and to current 
earnings and profits as a result of a foreign tax redetermination.

    (a) * * * For purposes of this section and Sec.  1.905-4, the term 
foreign tax redetermination means a change in the liability for foreign 
income taxes (as defined in Sec.  1.901-2(a)) or certain other changes 
described in this paragraph (a) that may affect a taxpayer's U.S. tax 
liability, including by reason of a change in the amount of its foreign 
tax credit, a change to claim a foreign tax credit for foreign income 
taxes that it previously deducted, a change to claim a deduction for 
foreign income taxes that it previously credited, a change in the 
amount of its distributions or inclusions under sections 951, 951A, or 
1293, a change in the application of the high-tax exception described 
in Sec.  1.954-1(d), or a change in the amount of tax determined under 
sections 1291(c)(2) and 1291(g)(1)(C)(ii). In the case of a taxpayer 
that claims the credit in the year the taxes are paid, a foreign tax 
redetermination occurs if any portion of the tax paid is subsequently 
refunded, or if the taxpayer's liability is subsequently determined to 
be less than the amount paid and claimed as a credit. * * *
    (b) * * *
    (4) Change in election to claim a foreign tax credit. A 
redetermination of U.S. tax liability is required to account for the 
effect of a timely change by the taxpayer to claim a foreign tax credit 
or a deduction for foreign income taxes paid or accrued in any taxable 
year as permitted under Sec.  1.901-1(d).
* * * * *
    (d) Applicability dates. Except as provided in this paragraph (d), 
this section applies to foreign tax redeterminations occurring in 
taxable years ending on or after December 16, 2019, and to foreign tax 
redeterminations of foreign corporations occurring in taxable years 
that end with or within a taxable year of a United States shareholder 
ending on or after December 16, 2019 and that relate to taxable years 
of foreign corporations beginning after December 31, 2017. The first 
two sentences of paragraph (a) of this section, and paragraph (b)(4) of 
this section, apply to foreign tax redeterminations occurring in 
taxable years beginning on or after [date final regulations are filed 
with the Federal Register].


Sec.  1.954-1  [Amended]

0
Par. 32. Section 1.954-1, as proposed to be amended in 85 FR 44650 
(July 23, 2020), is further amended by removing the second sentence in 
paragraph (d)(1)(iv)(A).
0
Par. 33. Section 1.960-1, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is further amended:
0
1. By revising paragraph (b)(4).
0
2. By redesignating paragraphs (b)(5) through (37) as paragraphs (b)(6) 
through (38), respectively.
0
3. By adding a new paragraph (b)(5).
0
4. By revising newly redesignated paragraph (b)(6) and paragraph 
(c)(1)(ii).
0
5. By redesignating paragraphs (c)(1)(iii) through (vi) as paragraphs 
(c)(1)(iv) through (vii).
0
6. By adding a new paragraph (c)(1)(iii).
0
7. In newly redesignated paragraph (c)(1)(iv), by removing the language 
``Third, current year taxes'' in the first sentence adding the language 
``Fourth, eligible current year taxes'' in its place.
0
8. In newly redesignated paragraph (c)(1)(v), by removing the language 
``Fourth,'' from the first sentence and adding the language ``Fifth,'' 
in its place.
0
9. In newly redesignated paragraph (c)(1)(vi), by removing the language 
``Fifth,'' from the first sentence and adding the language ``Sixth,'' 
in its place.
0
10. In newly redesignated paragraph (c)(1)(vii), by removing the 
language ``Sixth,'' from the first sentence and adding the language 
``Seventh,'' in its place.
0
11. In paragraph (d)(1), by removing the language ``the U.S. dollar 
amount of current year taxes'' from the first sentence and adding the 
language ``the U.S. dollar amount of eligible current year taxes'' in 
its place.
0
12. In paragraph (d)(3)(i) introductory text, by removing the language 
``current year taxes'' from the second sentence and adding the language 
``eligible current year taxes'' in its place.
0
13. In paragraph (d)(3)(ii)(A), by revising the last sentence.
0
14. In paragraph (d)(3)(ii)(B), by removing the language ``a current 
year tax'' from the first sentence and adding the language ``an 
eligible current year tax'' in its place.
0
15. In paragraph (f)(1)(ii), by removing the language ``tax'' from the 
fifth sentence and adding the language ``eligible current year tax'' in 
its place.
0
16. In paragraph (f)(2)(ii)(B)(1), by removing the language ``current 
year taxes'' from the last sentence and adding the language ``eligible 
current year taxes'' in its place.
0
17. In paragraph (f)(2)(ii)(B)(2), by removing the language ``current 
year taxes'' from the fifth sentence and adding the language ``eligible 
current year taxes'' in its place.
    The additions and revisions read as follows:


Sec.  1.960-1  Overview, definitions, and computational rules for 
determining foreign income taxes deemed paid under section 960(a), (b), 
and (d).

* * * * *
    (b) * * *
    (4) Current year tax. The term current year tax means a foreign 
income tax that is paid or accrued by a controlled foreign corporation 
in a current taxable year (taking into account any adjustments 
resulting from a foreign tax redetermination (as defined in Sec.  
1.905-3(a)). See Sec.  1.905-1 for rules on when foreign income taxes 
are considered paid or accrued for foreign tax credit purposes; see 
also Sec.  1.367(b)-7(g) for rules relating to foreign income taxes 
associated with foreign section 381 transactions and hovering deficits.
    (5) Eligible current year tax. The term eligible current year tax 
means a current year tax, except that an eligible current year tax does 
not include a current year tax paid or accrued by a controlled foreign 
corporation for which a credit is disallowed or suspended at the level 
of the controlled foreign corporation. See, for example, sections 
245A(e)(3), 901(k)(1), (l), and (m), 909, and 6038(c)(1)(B). Eligible 
current year tax, however, includes a current year tax that may be 
deemed paid but for which a credit is reduced or disallowed at the 
level of the United States shareholder. See, for example, sections 
901(e), 901(j), 901(k)(2), 908, 965(g), and 6038(c)(1)(A).
    (6) Foreign income tax. The term foreign income tax has the meaning 
provided in Sec.  1.901-2(a).
* * * * *
    (c) * * *
    (1) * * *
    (ii) Second, deductions (other than for current year taxes) of the 
controlled foreign corporation for the current taxable year are 
allocated and apportioned to reduce gross income in the section 904 
categories and the income groups within a section 904 category. See 
paragraph (d)(3)(i) of this section. Deductions for current year taxes 
(other than eligible current year taxes) of the controlled foreign 
corporation for the current taxable year are allocated and apportioned 
to reduce gross income in the section 904 categories and the income 
groups within a section 904 category. Additionally, the functional 
currency amounts of eligible current year taxes are allocated and 
apportioned to reduce gross income in the section 904 categories and 
the income groups within a section 904 category, and to reduce earnings 
and profits in the PTEP groups that were increased as provided in 
paragraph (c)(1)(i) of this section. No deductions other than eligible 
current year taxes

[[Page 72155]]

may be allocated and apportioned to PTEP groups. See paragraph 
(d)(3)(ii) of this section.
    (iii) Third, for purposes of computing foreign taxes deemed paid, 
eligible current year taxes that were allocated and apportioned to 
income groups and PTEP groups in the section 904 categories are 
translated into U.S. dollars in accordance with section 986(a).
* * * * *
    (d) * * *
    (3) * * *
    (ii) * * *
    (A) * * * For purposes of determining foreign income taxes deemed 
paid under the rules in Sec. Sec.  1.960-2 and 1.960-3, the U.S. dollar 
amount of eligible current year taxes is assigned to the section 904 
categories, income groups, and PTEP groups (to the extent provided in 
paragraph (d)(3)(ii)(B) of this section) to which the eligible current 
year taxes are allocated and apportioned.
* * * * *
0
Par. 34. Section 1.960-2, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is further amended:
0
1. In paragraph (b)(2), by removing the language ``current year taxes'' 
and adding the language ``eligible current year taxes'' in its place.
0
2. In paragraph (b)(3)(i), by removing the language ``current year 
taxes'' each place it appears and adding the language ``eligible 
current year taxes'' in its place.
0
3. In paragraph (b)(5)(i), by revising the seventh sentence.
0
4. In paragraph (b)(5)(ii)(A), by revising the first and second 
sentences.
0
5. In paragraph (b)(5)(ii)(B), by revising the first and second 
sentences.
0
6. In paragraph (c)(4), by removing the language ``current year taxes'' 
and adding the language ``eligible current year taxes'' in its place.
0
7. In paragraph (c)(5), by removing the language ``current year taxes'' 
each place it appears and adding the language ``eligible current year 
taxes'' in its place.
0
8. In paragraph (c)(7)(i)(A), by revising the fifth sentence.
0
9. In paragraph (c)(7)(i)(B), by revising the first and second 
sentences.
0
10. In paragraph (c)(7)(ii)(A)(1), by revising the ninth and eleventh 
sentences.
0
11. In paragraph (c)(7)(ii)(B)(1)(i), by revising the first and second 
sentences.
0
12. In paragraph (c)(7)(ii)(B)(1)(ii), by removing the language 
``foreign income taxes'' in the first sentence and adding the language 
``eligible current year taxes'' in its place.
    The additions and revisions read as follows:


Sec.  1.960-2  Foreign income taxes deemed paid under sections 960(a) 
and (d).

* * * * *
    (b) * * *
    (5) * * *
    (i) * * * CFC has current year taxes, all of which are eligible 
current year taxes, translated into U.S. dollars, of $740,000x that are 
allocated and apportioned as follows: $50,000x to subpart F income 
group 1; $240,000x to subpart F income group 2; and $450,000x to 
subpart F income group 3. * * *
    (ii) * * *
    (A) * * * Under paragraphs (b)(2) and (3) of this section, the 
amount of CFC's foreign income taxes that are properly attributable to 
items of income in subpart F income group 1 to which a subpart F 
inclusion is attributable equals USP's proportionate share of the 
eligible current year taxes that are allocated and apportioned under 
Sec.  1.960-1(d)(3)(ii) to subpart F income group 1, which is $40,000x 
($50,000x x 800,000u/1,000,000u). Under paragraphs (b)(2) and (3) of 
this section, the amount of CFC's foreign income taxes that are 
properly attributable to items of income in subpart F income group 2 to 
which a subpart F inclusion is attributable equals USP's proportionate 
share of the eligible current year taxes that are allocated and 
apportioned under Sec.  1.960-1(d)(3)(ii) to subpart F income group 2, 
which is $192,000x ($240,000x x 1,920,000u/2,400,000u). * * *
    (B) * * * Under paragraphs (b)(2) and (3) of this section, the 
amount of CFC's foreign income taxes that are properly attributable to 
items of income in subpart F income group 3 to which a subpart F 
inclusion is attributable equals USP's proportionate share of the 
eligible current year taxes that are allocated and apportioned under 
Sec.  1.960-1(d)(3)(ii) to subpart F income group 3, which is $360,000x 
($450,000x x 1,440,000u/1,800,000u). CFC has no other subpart F income 
groups within the general category. * * *
* * * * *
    (c) * * *
    (7) * * *
    (i) * * *
    (A) * * * CFC1 has current year taxes, all of which are eligible 
current year taxes, translated into U.S. dollars, of $400x that are all 
allocated and apportioned to the tested income group. * * *
    (B) * * * Under paragraph (c)(5) of this section, USP's 
proportionate share of the eligible current year taxes that are 
allocated and apportioned under Sec.  1.960-1(d)(3)(ii) to CFC1's 
tested income group is $400x ($400x x 2,000u/2,000u). Therefore, under 
paragraph (c)(4) of this section, the amount of foreign income taxes 
that are properly attributable to tested income taken into account by 
USP under section 951A(a) and Sec.  1.951A-1(b) is $400x. * * *
    (ii) * * *
    (A) * * *
    (1) * * * CFC1 has current year taxes, all of which are eligible 
current year taxes, translated into U.S. dollars, of $100x that are all 
allocated and apportioned to CFC1's tested income group. * * * CFC2 has 
current year taxes, all of which are eligible current year taxes, 
translated into U.S. dollars, of $20x that are allocated and 
apportioned to CFC2's tested income group.
* * * * *
    (B) * * *
    (1) * * *
    (i) * * * Under paragraphs (c)(5) and (6) of this section, US1's 
proportionate share of the eligible current year taxes that are 
allocated and apportioned under Sec.  1.960-1(d)(3)(ii) to CFC1's 
tested income group is $95x ($100x x 285u/300u). Therefore, under 
paragraph (c)(4) of this section, the amount of the foreign income 
taxes that are properly attributable to tested income taken into 
account by US1 under section 951A(a) and Sec.  1.951A-1(b) is $95x. * * 
*
* * * * *
0
Par. 35. Section 1.960-7, as amended in FR Doc. 2020-21819, published 
elsewhere in this issue of the Federal Register, is further amended by 
revising paragraph (b) to read as follows:


Sec.  1.960-7  Applicability dates.

* * * * *
    (b) Section 1.960-1(c)(2) and (d)(3)(ii) apply to taxable years of 
a foreign corporation beginning after December 31, 2019, and to each 
taxable year of a domestic corporation that is a United States 
shareholder of the foreign corporation in which or with which such 
taxable year of such foreign corporation ends. For taxable years of a 
foreign corporation that end on or after December 4, 2018, and also 
begin before January 1, 2020, see Sec.  1.960-1(c)(2) and (d)(3)(ii) as 
in effect on December 17, 2019. Paragraphs (b)(4), (5), and (6), 
(c)(1)(ii), (iii), and (iv), and (d)(3)(ii)(A) and (B) of Sec.  1.960-
1, and paragraphs (b)(2), (b)(3)(i), (b)(5)(i), (b)(5)(iv)(A), and 
(c)(4), (5), and (7) of Sec.  1.960-2, apply to taxable years of 
foreign corporations beginning on or after [date final regulations are 
filed in the Federal Register], and to each taxable year of a

[[Page 72156]]

domestic corporation that is a United States shareholder of the foreign 
corporation in which or with which such taxable year of such foreign 
corporation ends. For taxable years of foreign corporations beginning 
before [date final regulations are filed in the Federal Register], with 
respect to the paragraphs described in the preceding sentence, see 
Sec. Sec.  1.960-1 and 1.960-2 as in effect on November 12, 2020.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2020-21818 Filed 11-2-20; 11:15 am]
 BILLING CODE 4830-01-P