[Federal Register Volume 87, Number 2 (Tuesday, January 4, 2022)]
[Rules and Regulations]
[Pages 276-376]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2021-27887]



[[Page 275]]

Vol. 87

Tuesday,

No. 2

January 4, 2022

Part II





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; Final Rule

  Federal Register / Vol. 87 , No. 2 / Tuesday, January 4, 2022 / Rules 
and Regulations  

[[Page 276]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9959]
RIN 1545-BP70


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
foreign tax credit, including 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; the definition of foreign branch category 
income; and the time at which foreign taxes accrue and can be claimed 
as a credit. This document also contains final regulations clarifying 
rules relating to foreign-derived intangible income (FDII). The final 
regulations affect taxpayers that claim credits or deductions for 
foreign income taxes, or that claim a deduction for FDII.

DATES: 
    Effective date: These regulations are effective on March 7, 2022.
    Applicability dates: For dates of applicability, see Sec. Sec.  
1.164-2(i), 1.245A(d)-1(f), 1.336-5, 1.338-9(d)(4), 1.367(b)-7(h), 
1.367(b)-10(e), 1.861-3(e), 1.861-9(k), 1.861-10(h), 1.861-14(k), 
1.861-20(i), 1.901-1(j), 1.901-2(h), 1.903-1(e), 1.904-6(g), 1.905-
1(h), 1.905-3(d), 1.951A-7, and 1.960-7.

FOR FURTHER INFORMATION CONTACT: Concerning 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, and 1.904-4, Jeffrey L. 
Parry, (202) 317-4916; concerning Sec. Sec.  1.951A-2 and 1.951A-7, 
Jorge M. Oben and Larry Pounders, (202) 317-6934 (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 (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. Certain portions of the 2018 FTC 
proposed regulations were finalized as part of TD 9866, published in 
the Federal Register (84 FR 29288) on June 21, 2019. The remaining 
portions of the 2018 FTC proposed regulations were finalized in TD 
9882, published in the Federal Register on December 17, 2019 (84 FR 
69022) (the ``2019 FTC final regulations''). On the same date, new 
proposed regulations (REG-105495-19) addressing changes made by the 
TCJA as well as other related foreign tax credit rules were published 
in the Federal Register (84 FR 69124) (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 were finalized as part of TD 9922, published in the Federal 
Register (85 FR 71998) on November 12, 2020 (the ``2020 FTC final 
regulations''). On the same date, the Treasury Department and the IRS 
published proposed regulations (REG-101657-20) in the Federal Register 
(85 FR 72078) (the ``2020 FTC proposed regulations''). The 2020 FTC 
proposed regulations addressed changes made by the TCJA and other 
foreign tax credit issues. Correcting amendments to the 2020 FTC final 
regulations were published in the Federal Register on October 1, 2021. 
See 86 FR 54367. A public hearing on the 2020 FTC proposed regulations 
was held on April 7, 2021.
    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). The 2020 FTC 
proposed regulations also included revisions to the section 250 
regulations.
    This document contains final regulations (the ``final 
regulations'') addressing the following: (1) The determination of 
foreign income taxes subject to the credit and deduction disallowance 
provisions 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 of certain regulated utilities; (6) a revision to the 
controlled foreign corporation (``CFC'') netting rule; (7) the 
allocation and apportionment of section 818(f)(1) items of life 
insurance companies that are members of consolidated groups; (8) the 
allocation and apportionment of foreign income taxes, including taxes 
imposed with respect to disregarded payments; (9) the definitions of a 
foreign income tax and a tax in lieu of an income tax, including 
changes to the net gain requirement, the replacement of the 
jurisdictional nexus rule with an attribution rule contained in 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; (10) the 
allocation of the liability for foreign income taxes in connection with 
certain mid-year transfers or reorganizations; (11) the foreign branch 
category rules in Sec.  1.904-4(f); and (12) the time at which credits 
for foreign income taxes can be claimed pursuant to sections 901(a) and 
905(a).
    This rulemaking finalizes, without substantive change, certain 
provisions in the 2020 FTC proposed regulations with respect to which 
the Treasury Department and IRS did not receive any comments. See 
Sec. Sec.  1.164-2(d), 1.250(b)-1(c), 1.250(b)-5, 1.336-2(g)(3), 1.338-
9(d), 1.367(b)-2, 1.367(b)-3, 1.367(b)-4, 1.367(b)-7, 1.367(b)-10, 
1.461-1, 1.861-3(d), 1.861-8(e)(4), 1.861-8(e)(8)(v), 1.861-9(g)(3), 
1.861-10(e)(8)(v), 1.861-10(f), 1.901-1, 1.901-2(e)(4), 1.901-2(f), 
1.904-4(b), 1.904-4(c), 1.904-6, 1.905-3, 1.954-1, 1.960-1, and 1.960-
2. These provisions are generally not discussed in this preamble.
    No comments were received with respect to the transition rules 
contained in the 2020 FTC proposed regulations 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). 
Section 1.904(f)-12(j) was finalized without

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change in TD 9956, published in the Federal Register (86 FR 52971) on 
September 24, 2021.
    Comments that do not pertain to the 2020 FTC proposed regulations, 
or that are otherwise outside the scope of this rulemaking, are 
generally not addressed in this preamble but may be considered in 
connection with future guidance projects.
    The rules contained in proposed Sec.  1.861-9(k) (election to 
capitalize certain expenses in determining tax book value of assets), 
Sec.  1.861-10(g) (requiring the direct allocation of interest expense 
in the case of certain foreign banking branches), and Sec. Sec.  1.904-
4(e)(1)(ii) and 1.904-5(b)(2) (relating to the definition of financial 
services income) are not finalized in this document. The Treasury 
Department and the IRS are continuing to study the comments received in 
connection with those provisions.

Summary of Comments and Explanation of Revisions

I. Disallowance of Foreign Tax Credit or Deduction for Foreign Income 
Taxes Under Section 245A(d)

    Proposed Sec.  1.245A(d)-1(a) generally provided that neither a 
credit under section 901 nor a deduction is allowed for foreign income 
taxes (as defined in Sec.  1.901-2(a)) paid or accrued by a domestic or 
foreign corporation that are attributable to a specified distribution 
or specified earnings and profits of a foreign corporation. The 
proposed rule defined a specified distribution--in the case of a 
distribution to a domestic corporation--as the portion of a dividend 
for which a deduction under section 245A(a) is allowed, a hybrid 
dividend, or a distribution of certain previously taxed earnings 
(``PTEP'') related to section 245A(d) (``section 245A(d) PTEP''). In 
the case of a distribution to another foreign corporation, a specified 
distribution included the portion of the distribution attributable to 
section 245A(d) PTEP, or a tiered hybrid dividend that gives rise to a 
U.S. shareholder inclusion by reason of section 245A(e)(2) and Sec.  
1.245A(e)-1(c)(1). Specified earnings and profits included the portion 
of the earnings and profits of a foreign corporation that would give 
rise to a specified distribution if an amount equal to the entire 
earnings and profits of the foreign corporation were distributed. 
Specified earnings and profits also included an amount equal to the 
portion of a U.S. return of capital amount, as that term is defined in 
Sec.  1.861-20(b), that is treated as arising in a section 245A 
subgroup, after the application of the asset method in Sec.  1.861-9. 
Proposed Sec.  1.245A(d)-1(a) relied upon the rules in Sec.  1.861-20 
to associate gross income included in the foreign tax base (``foreign 
gross income'') with these amounts and to allocate foreign income taxes 
to the foreign gross income. The proposed regulations also included an 
anti-avoidance rule to, for example, prevent taxpayers from using 
successive foreign law distributions to inappropriately associate 
withholding tax on the distributions with PTEP arising from inclusions 
under sections 951(a) and 951A(a). See proposed Sec.  1.245A(d)-
1(b)(2). The Treasury Department and the IRS requested comments on 
possible revisions to Sec.  1.861-20 to address these concerns, 
including rules to require the maintenance of separate accounts that 
would reflect the effect of foreign law transactions on the earnings 
and profits of a foreign corporation. 85 FR at 72079.
    A comment noted that proposed Sec.  1.245A(d)-1(a) explicitly 
treated as specified earnings and profits the portion of a U.S. return 
of capital amount that is deemed to arise pursuant to Sec.  1.861-
20(d)(3)(i) in a section 245A subgroup under the asset method of Sec.  
1.861-9, yet did not explicitly treat any amount as specified earnings 
and profits when the asset method of Sec.  1.861-9 applies under 
proposed Sec.  1.861-20(d)(3)(v) to characterize a disregarded payment 
that is a remittance as made from a section 245A subgroup. The comment 
also expressed concerns that proposed Sec.  1.245A(d)-1 did not 
adequately clarify the treatment of foreign tax imposed on a 
distribution received by a domestic or foreign corporation with respect 
to its interest in a partnership, or on the proceeds of a disposition 
of such an interest.
    The comment also noted the uncertainty in proposed Sec.  1.245A(d)-
1(a) over the use of the asset method of Sec.  1.861-9 to characterize 
foreign taxable income of a CFC and apply the disallowance rules of 
section 245A(d), including when a CFC receives a distribution that is a 
U.S. return of capital amount. The comment stated that, if the U.S. 
return of capital amount is treated as made from earnings in a section 
245A subgroup of the distributing CFC, the disallowance under section 
245A(d) of foreign taxes associated with the portion of the specified 
earnings and profits attributable to tested income of the recipient CFC 
not included by a United States shareholder has the inappropriate 
effect of double-counting the inclusion percentage of section 960(d).
    With respect to the anti-avoidance rule of proposed Sec.  
1.245A(d)-1(b)(2), the comment acknowledged the need to address 
successive foreign law distributions and discussed three alternative 
approaches. One approach would revise Sec.  1.861-20(d)(2)(ii)(A) to 
treat a foreign law distribution as made ratably out of all of a 
foreign corporation's earnings and profits, including PTEP, if the 
amount of its earnings and profits exceeds the foreign gross income 
arising from the foreign law distribution. The second approach would 
maintain separate E&P accounts to track the effect of foreign law 
distributions; the comment viewed this option as overly complex and 
burdensome. The third approach would maintain the anti-avoidance rule 
of proposed Sec.  1.245A(d)-1(b)(2) and make no substantive changes to 
the operative rules. The comment indicated that a flexible, well-
articulated anti-avoidance rule could be more effective at policing 
attempts to avoid section 245A(d) than a series of potentially 
manipulable mechanical rules.
    The Treasury Department and the IRS agree that proposed Sec.  
1.245A(d)-1 did not clearly describe the income under Federal income 
tax law to which foreign gross income should be treated as 
corresponding for purposes of allocating and apportioning foreign 
income taxes under Sec.  1.860-20. This lack of clarity resulted in 
uncertainty in determining the extent to which foreign income taxes on 
a U.S. return of capital amount, which can arise in a variety of 
transactions involving both stock and partnership interests, should be 
treated as attributable to income of a foreign corporation that would 
give rise to a deduction under section 245A(a) when distributed.
    In response to these comments, Sec.  1.245A(d)-1(a) is revised to 
eliminate references to specified distributions and specified earnings 
and profits. Instead, Sec.  1.245A(d)-1(a) of the final regulations 
provides that no credit or deduction is allowed for foreign income 
taxes attributable to (1) ``section 245A(d) income'' of a domestic 
corporation, a successor of a domestic corporation, or a foreign 
corporation (see Sec.  1.245A(d)-1(a)(1)(i)-(ii) and (a)(2)), or (2) 
``non-inclusion income'' of a foreign corporation (see Sec.  1.245A(d)-
1(a)(1)(iii)).
    Section 245A(d) income means, in the case of a domestic 
corporation, dividends or inclusions for which a deduction under 
section 245A(a) is allowed, a distribution of section 245A(d) PTEP, and 
hybrid dividends and inclusions related to tiered hybrid dividends 
under section 245A(e). In the case of a successor of a domestic 
corporation, section 245A(d) income

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means a distribution of section 245A(d) PTEP. In the case of a foreign 
corporation, section 245A(d) income means an item of subpart F income 
that gives rise to an inclusion for which a deduction under section 
245A(a) is allowed, a tiered hybrid dividend, and a distribution of 
section 245A(d) PTEP. Under Sec.  1.245A(d)-1(b)(1), foreign income 
taxes are attributable to section 245A(d) income if the taxes are 
allocated and apportioned under Sec.  1.861-20 to the statutory 
grouping within each section 904 category (the ``section 245A(d) income 
group'') to which section 245A(d) income is assigned.
    Accordingly, the disallowance under Sec.  1.245A(d)-1(a) applies 
not only to foreign income taxes that are paid or accrued with respect 
to certain distributions and inclusions, but also to taxes paid or 
accrued by reason of the receipt of a foreign law distribution with 
respect to stock, a foreign law disposition, ownership of a reverse 
hybrid, a foreign law inclusion regime, or the receipt of a disregarded 
payment described in Sec.  1.861-20(d)(3)(v)(B), to the extent the 
foreign income taxes are attributable to section 245A(d) income. The 
disallowance also applies where a foreign corporation pays or accrues 
foreign income taxes that are attributable to section 245A(d) income of 
the foreign corporation, in which case such taxes are not eligible to 
be deemed paid under section 960 in any taxable year. For example, the 
disallowance applies to foreign income taxes paid or accrued by reason 
of the receipt by the foreign corporation of a tiered hybrid dividend.
    These revised rules ensure that Sec.  1.861-20, including the rules 
of Sec.  1.861-20(d)(2) for allocating and apportioning foreign income 
tax to a statutory or residual grouping in a year in which there is no 
income for Federal income tax purposes in the grouping, apply 
consistently to allocate and apportion foreign income taxes to the 
section 245A(d) income group. The rules of Sec.  1.861-20(d)(3) apply 
to determine the circumstances under which foreign gross income 
included by reason of a dividend or other distribution with respect to 
stock, a partnership distribution, a sale or exchange of stock, or a 
sale or exchange of a partnership interest is assigned to the section 
245A(d) income group.
    Non-inclusion income is defined as income other than subpart F 
income, tested income, or income described in section 245(a)(5), 
without regard to section 245(a)(12), (items of income constituting 
post-1986 undistributed U.S. earnings) of a foreign corporation. 
Section 1.245A(d)-1(b)(2)(ii) attributes foreign income taxes to non-
inclusion income of a foreign corporation to the extent the foreign 
income taxes are allocated and apportioned to the domestic 
corporation's section 245A subgroup category of stock when applying 
Sec.  1.861-20 for purposes of section 904 as the operative section. 
The final rules also attribute foreign income taxes to the non-
inclusion income of a reverse hybrid or foreign law CFC to the extent 
that they are allocated and apportioned to the non-inclusion income 
group under Sec.  1.861-20. See Sec.  1.245A(d)-1(b)(2)(iii).
    The disallowance under Sec.  1.245A(d)-1(a)(1)(iii) therefore 
applies to foreign income taxes paid or accrued by a domestic 
corporation that are attributable to non-inclusion income of a foreign 
corporation in which the domestic corporation is a United States 
shareholder. For example, paragraph (a)(1)(iii) applies to foreign 
income taxes that a domestic corporation that is a United States 
shareholder of a foreign corporation pays or accrues by reason of its 
receipt from the foreign corporation of a distribution that is a U.S. 
return of capital amount to the extent the foreign income taxes are 
attributable to non-inclusion income of the foreign corporation. The 
final regulations at Sec.  1.245A(d)-1(b)(2)(ii) clarify that this rule 
extends to foreign income taxes the domestic corporation pays or 
accrues by reason of a remittance, a distribution that is a U.S. return 
of partnership basis amount, or a disposition that gives rise to a U.S. 
return of capital amount or a U.S. return of partnership basis amount. 
The disallowance under paragraph (a)(1)(iii) also applies to foreign 
income taxes that a domestic corporation that is a United States 
shareholder pays or accrues by reason of its ownership of a reverse 
hybrid or foreign law CFC, to the extent the foreign income taxes are 
attributable to non-inclusion income of the reverse hybrid or foreign 
law CFC and not otherwise disallowed under paragraph (a)(1)(i) or (ii).
    The proposed anti-avoidance rule in Sec.  1.245A(d)-1(b)(2) is 
finalized without substantive change at Sec.  1.245A(d)-1(b)(3). While 
revising Sec.  1.861-20(d)(2)(ii)(A) to treat a foreign law 
distribution as made ratably out of all of a foreign corporation's 
earnings and profits would be a potentially feasible alternative 
approach, the Treasury Department and the IRS have determined that on 
balance the anti-avoidance rule provides an appropriate framework and 
the necessary flexibility to address section 245A(d) avoidance.
    Finally, for the avoidance of doubt, the final regulations clarify 
that section 245A(d) operates to deny the credit or deduction for 
foreign taxes paid or accrued with respect to dividends for which a 
domestic corporation could claim a deduction under section 245A, 
regardless of whether the corporation claims the deduction on its 
return. See Sec.  1.245A(d)-1(c)(19) and (21) (defining section 245A(d) 
income and section 245A(d) PTEP). See also H.R. Rep. No. 115-466, at 
600 (2017) (Conf. Rep.) (``No foreign tax credit or deduction is 
allowed for any taxes paid or accrued with respect to any portion of a 
distribution treated as a dividend that qualifies for the DRD.''); id. 
at 598 (describing section 245A as ``an exemption for certain foreign 
income by means of a 100-percent deduction'').

II. Section 250 Regulations--Definition of Electronically Supplied 
Service

    Section 1.250(b)-5 provides rules for determining whether a service 
is provided to a person, or with respect to property, located outside 
the United States and therefore gives rise to foreign-derived deduction 
eligible income (``FDDEI service''). The rules identify specific 
enumerated categories, including a category for general services 
provided to either consumers or business recipients. For purposes of 
determining whether such a general service constitutes a FDDEI service, 
the rules require the location of the recipient to be identified.
    The regulations contain special rules in Sec.  1.250(b)-5(d)(2) and 
Sec.  1.250(b)-5(e)(2)(iii) for determining the location at which 
``electronically supplied services'' are provided. 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 cloud computing and digital streaming services. 
Proposed Sec.  1.250(b)-5(c)(5) revised that definition to clarify 
that, to qualify as an electronically supplied service, the value of 
the service to the end user must be derived primarily from the 
service's automation and electronic delivery and would not include, for 
example, legal, accounting, medical or teaching services ``delivered 
electronically and synchronously.'' No comments were received on the 
proposed revised definition of an electronically supplied service.
    By providing the example of professional or teaching services 
provided in real time (synchronously) as not constituting 
electronically supplied services, proposed Sec.  1.250(b)-5(c)(5) was 
intended to illustrate cases where

[[Page 279]]

the primary value of the service was not in its automation and 
electronic delivery. However, this example may have implied that the 
temporal aspect of when the service is rendered, relative to when the 
end user accesses that service, is a determinative factor in 
constituting an ``electronically supplied service.'' The Treasury 
Department and the IRS had intended that services accessed by an end 
user outside of real time (asynchronously) also will not constitute an 
``electronically supplied service'' if, under all the facts and 
circumstances, they primarily involve human effort. Therefore, the 
final regulations remove the reference to ``and synchronously'' from 
the fourth sentence of Sec.  1.250(b)-5(c)(5) to clarify that the 
definition does not depend on whether the services are rendered 
synchronously or asynchronously but rather depend on whether the 
services primarily involve human effort.

III. Allocation and Apportionment of Expenses Under Section 861 
Regulations

A. Treatment of Section 818(f)(1) Items for Consolidated Groups
    Proposed Sec.  1.861-14(h) provided that certain items of life 
insurance companies described in section 818(f)(1) that are members of 
a consolidated group are allocated and apportioned on a life subgroup 
basis but provided a one-time election to allocate and apportion these 
items on a separate company basis. The one comment received endorsed 
the approach in the 2020 FTC proposed regulations, which are finalized 
without change.
B. Allocation and Apportionment of Foreign Income Taxes
1. In General
    The 2020 FTC proposed regulations provided more detailed and 
comprehensive guidance regarding the assignment of foreign gross 
income, and the allocation and apportionment of the associated foreign 
income taxes, to the statutory and residual groupings in certain cases. 
This guidance included rules for dispositions of stock and partnership 
interests, and rules for transactions that are distributions with 
respect to a partnership interest, under Federal income tax law. It 
also included new rules addressing the allocation and apportionment of 
foreign income taxes imposed by reason of disregarded payments.
2. Dispositions of Stock
    Proposed Sec.  1.861-20(d)(3)(i)(D) provided that the foreign gross 
income arising from a transaction that is treated as a sale, exchange, 
or other disposition of stock for Federal income tax purposes is 
assigned first to the statutory and residual groupings to which any 
U.S. dividend amount is assigned under Federal income tax law, 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 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 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.
    A comment recommended that, to the extent of any basis in the stock 
attributable to a previous increase under section 961, foreign gross 
income in excess of the U.S. dividend amount be assigned to the same 
statutory grouping as the PTEP that gave rise to the basis increase. 
The comment noted that assigning foreign gross income in excess of the 
U.S. dividend amount to the grouping that produced the underlying PTEP 
would better conform the tax attribution consequences of a disposition 
of stock with the tax attribution consequences of a pre-sale 
distribution with respect to the stock.
    Under Sec.  1.861-20(d)(1), Federal income tax law applies to 
characterize the transaction that gives rise to foreign gross income. 
The sale of stock may result in a U.S. dividend amount, a U.S. return 
of capital amount, and a U.S. capital gain amount for U.S. tax 
purposes. As noted in the preamble to the 2020 FTC proposed 
regulations, when a controlled foreign corporation has retained PTEP, 
the usual consequence will be to increase the portion of the amount 
realized on the sale of the corporation's stock that is treated as a 
return of capital for U.S. tax purposes, as a result of the basis 
adjustments under section 961. Accordingly, it is reasonable to 
conceive of foreign gross income in the amount of the basis 
attributable to retained PTEP as a timing difference associated with 
the earnings represented by the PTEP, just as an amount of foreign 
gross income equal to a section 1248 amount that is included in the 
U.S. dividend amount is treated as a timing difference associated with 
those non-previously taxed earnings.
    However, the approach suggested in the comment would create an 
additional compliance burden for taxpayers and administrative burdens 
for the IRS by requiring the separate tracking of basis in the stock 
attributable to a previous increase under section 961, which is not 
otherwise required for U.S. tax purposes. Additional rules would be 
required to associate PTEP with the particular shares of stock being 
sold, such as in the case of a taxpayer with PTEP in different 
statutory groupings who sells one class of stock but retains a 
different class of stock. The Treasury Department and the IRS have 
determined that the groupings to which the tax book value of the stock 
is assigned is an administrable and reasonably accurate surrogate for 
both the PTEP and the future, unrealized earnings of the corporation 
with which the foreign gross income is properly associated when foreign 
tax is imposed on a U.S. return of capital amount. For these reasons, 
the final regulations retain the rule in proposed Sec.  1.861-
20(d)(3)(i)(D).
3. Partnership Transactions
    Proposed Sec.  1.861-20(d)(3)(ii)(B) assigned foreign gross income 
arising from a partnership distribution in excess of the U.S. capital 
gain amount by reference to 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), 
which are 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. This approach is based on 
principles similar to those underlying the rule in proposed Sec.  
1.861-20(d)(3)(i)(D) for allocating and apportioning foreign tax 
imposed on an amount that is a return of capital with respect to stock 
for Federal income tax purposes. Similarly, the 2020 FTC proposed 
regulations associated foreign gross income from the disposition of a 
partnership interest in excess of the U.S. capital gain amount with a 
hypothetical distributive share that is determined by reference to the 
tax book value 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). See proposed Sec.  1.861-
20(d)(3)(ii)(C).
    A comment recommended that, in the case of either a distribution 
with respect to a partnership or a disposition of a partnership 
interest, foreign gross income in excess of the U.S. capital gain 
amount be characterized instead by reference to the statutory and 
residual groupings of amounts maintained in partner-level accounts that 
track the partners' distributive shares of

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partnership earnings in prior years. According to the comment, the tax 
book value method potentially distorts the allocation of tax to U.S. 
income items in cases in which the amount of income produced by the 
asset is disproportionate to its basis. For this reason, the comment 
recommended tracing foreign gross income to amounts in the partner's 
cumulative distributive share account in order to provide for more 
accurate matching of foreign gross income to partners' distributive 
shares of partnership income for the current and prior years. The 
comment recommended that these new partner-level accounts be increased 
as a partner includes a distributive share of partnership income and 
decreased as the partnership makes distributions. Under this multi-year 
account approach, foreign gross income arising from partnership 
distributions would be characterized by reference to the earnings in 
the account out of which the distribution is made, and foreign gross 
income arising from a disposition of a partnership interest would be 
characterized by reference to the earnings in the account at the time 
of disposition. In either case, additional rules (such as providing for 
the use of a pro rata, last-in-first-out, or other approach) would be 
required to determine the earnings in the account out of which a 
distribution is considered to be made, and for cases in which the 
amount in the partner-level account exceeds the foreign gross income 
arising from a disposition of that partner's partnership interest.
    Recognizing the additional record-keeping requirements and 
complexity required by this approach, the comment suggested in the 
alternative that foreign gross income in excess of a U.S. capital gain 
amount recognized by reason of a partnership distribution or 
disposition of a partnership interest be characterized based on the 
partner's distributive share of the partnership's current year income, 
to the extent thereof, with any excess assigned based on the tax book 
value method provided for in the 2020 FTC proposed regulations.
    The final regulations retain the approach from the 2020 FTC 
proposed regulations for characterizing foreign gross income arising 
from a partnership distribution or disposition. The Treasury Department 
and the IRS do not agree that it is appropriate to treat a partnership 
distribution as made out of a partner's distributive share of 
partnership income. Contrary to the ordering rules that apply to 
distributions by a corporation, under Federal income tax law 
partnership distributions are not sourced from current or accumulated 
partnership income. Similarly, under Federal income tax law, a 
partnership distribution reduces a partner's basis in its partnership 
interest without differentiating between basis from capital 
contributions and basis from a partner's distributive share of 
partnership income.
    A common principle of the rules in Sec.  1.861-20 is that Federal 
income tax law applies to characterize foreign gross income. To the 
extent a partnership distribution or disposition is treated as a return 
of basis for Federal income tax purposes, Sec.  1.861-20(d)(3)(ii)(B) 
and (C) appropriately reflect this principle by allocating and 
apportioning any foreign tax imposed on the partnership distribution in 
the same manner as foreign tax on a return of capital with respect to 
stock. Furthermore, this approach to characterizing foreign gross 
income arising from a partnership distribution is consistent with the 
approach in Sec.  1.861-20(d)(3)(v)(C)(1) that applies to a 
distribution that is a remittance by a taxable unit.
    As acknowledged by the comment, characterizing foreign gross income 
by reference to a partner's distributive share of partnership income in 
prior years would require creating new partner-level accounts to track 
the partner's aggregate distributive share of unremitted partnership 
income. That type of partner-level account is not otherwise required to 
be maintained to characterize partnership distributions for Federal 
income tax purposes and would be unduly burdensome for both taxpayers 
and the IRS, as well as being generally inconsistent with the Federal 
income tax rules for characterizing partnership distributions. In 
addition, the Treasury Department and the IRS have determined that the 
suggested alternative approach of characterizing foreign gross income 
by reference to a partner's distributive share of current year 
partnership income would be susceptible to manipulation by timing 
partnership distributions to maximize foreign tax credit benefits. 
Therefore, the comment is not adopted.
4. Disregarded Payments
    The 2020 FTC proposed regulations addressed the allocation and 
apportionment of foreign income taxes that are imposed by reason of a 
disregarded payment between taxable units. In the case of foreign 
income taxes paid or accrued by an individual or domestic corporation, 
the rules defined a taxable unit as a foreign branch, foreign branch 
owner, or non-branch taxable unit as defined in proposed Sec.  1.904-
6(b)(2)(i)(B). In the case of foreign income taxes paid by a foreign 
corporation, the rules defined a taxable unit by reference to the 
tested unit definition 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)(E)(9).
    In general, the 2020 FTC proposed regulations characterized a 
disregarded payment as either a payment out of the current income 
attributable to a taxable unit (a ``reattribution payment''), a 
contribution to a taxable unit, or a remittance out of accumulated 
earnings of a taxable unit. See proposed Sec.  1.861-20(d)(3)(v). The 
rules assigned foreign gross income arising from a reattribution 
payment to the statutory and residual groupings of the recipient 
taxable unit based on the groupings to which the current income out of 
which the reattribution payment was made is assigned. See proposed 
Sec.  1.861-20(d)(3)(v)(B). The rules assigned foreign gross income 
arising from a contribution received by a taxable unit to the residual 
grouping, and assigned foreign gross income arising from a remittance 
by reference to the statutory and residual groupings to which the 
assets of the payor taxable unit were assigned for purposes of 
apportioning interest expense, which served as a proxy for the 
accumulated earnings of the payor taxable unit. See proposed Sec.  
1.861-20(d)(3)(v)(C). For this purpose, the assets of a payor taxable 
unit were determined under the rules of Sec.  1.987-6(b), modified to 
include in a taxable unit's assets any stock that it owned, and in 
certain circumstances reattributed another taxable unit's assets to the 
taxable unit or reattributed the taxable unit's assets to another 
taxable unit. See proposed Sec.  1.861-20(d)(3)(v)(C)(1)(ii).
    Comments criticized the tax book value method as an inaccurate 
surrogate for accumulated earnings of a taxable unit in the case of an 
asset with a basis that is disproportionate to the income produced by 
the asset and requested that foreign gross income arising from a 
remittance be assigned to the statutory and residual groupings based on 
the current earnings of a taxable unit. In addition, comments requested 
that, rather than trace foreign gross income arising from disregarded 
payments to current or accumulated earnings of a taxable unit, the 
definition of which generally includes disregarded entities, the rules 
should only trace such foreign

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gross income to current or accumulated income of a qualified business 
unit (``QBU'') to reduce the complexity and compliance burden of the 
rules. Finally, a comment suggested that the modifications to the rules 
of Sec.  1.987-6(b) for purposes of determining the assets of a taxable 
unit should be expanded to include not only stock, but any interest of 
a taxable unit in another taxable unit, including a partnership.
    The Treasury Department and the IRS do not agree that current 
earnings of a taxable unit, rather than the tax book value of its 
assets, should be the basis for characterizing foreign gross income 
included by reason of a remittance. The Treasury Department and the IRS 
have determined that, although the tax book value of the assets of a 
taxable unit may not be a perfect surrogate for the accumulated 
earnings of that taxable unit, it is a better surrogate than current-
year earnings of the taxable unit. The use of current-year earnings is 
rejected because the current-year earnings may already have been 
accounted for through reattribution payments, may not reflect all of a 
taxable unit's assets, and could be subject to manipulation through the 
timing of disregarded payments, depending on the character of the 
earnings attributed to a taxable unit for a particular taxable year. 
Although a more accurate matching of foreign gross income to 
accumulated income for Federal income tax purposes could be achieved 
through the maintenance of multi-year accounts tracking accumulated 
earnings of a taxable unit, characterizing the accumulated earnings of 
a taxable unit by reference to the tax book value of its assets 
appropriately balances concerns about administrability, compliance 
burdens, manipulability, and accuracy.
    The Treasury Department and the IRS do not agree that foreign gross 
income should be traced to income only when disregarded payments are 
made by a QBU, rather than a taxable unit. The purpose of this rule in 
the 2020 FTC proposed regulations was to implement a tracing regime for 
foreign income tax imposed on disregarded payments that more accurately 
distinguished payments made out of current income from those made out 
of accumulated income, rather than treating all disregarded payments as 
either remittances or contributions. Tracing cannot achieve the policy 
goal of improved accuracy in matching disregarded payments to the 
current or accumulated earnings out of which the payment is made if it 
does not fully account for all disregarded payments. Accordingly, this 
recommendation is not adopted.
    The Treasury Department and the IRS agree that for purposes of 
Sec.  1.861-20 the assets of a taxable unit should include not only 
stock that it owns, but also its interests in other taxable units. 
Asset tax book values serve as a surrogate for the accumulated earnings 
from which a taxable unit made a remittance; including a taxable unit's 
interests in all other taxable units appropriately reflects all of the 
income-producing assets of a taxable unit that could produce earnings. 
Accordingly, Sec.  1.861-20(d)(3)(v)(C)(1)(ii) of the final regulations 
provides that a taxable unit's assets include its pro rata share of the 
assets of another taxable unit in which it owns an interest.
    The definitions of the terms ``contribution'' and ``remittance'' in 
Sec.  1.861-20(d)(3)(v)(E) of the final regulations are revised so 
that, together, they describe all payments that are not reattribution 
payments. The proposed regulations defined a ``contribution'' as a 
transfer of property to a taxable unit 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 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. The proposed regulations defined a ``remittance'' as a 
transfer of property 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 for Federal income tax law, or the excess of a 
disregarded payment made by a taxable unit to a second taxable unit 
over the portion of the disregarded payment that is a reattribution 
payment, other than an amount treated as a contribution. The proposed 
definition of ``contribution'' did not encompass a disregarded payment 
that is neither a reattribution payment nor a transfer that would be 
described in section 351, such as, in some circumstances, disregarded 
interest payments. To fill this gap, Sec.  1.861-20(d)(3)(v)(E) of the 
final regulations defines a ``contribution'' as 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, if any, that is a reattribution payment. This definition 
encompasses a transfer of property to a taxable unit 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. In addition, Sec.  1.861-20(d)(3)(v)(E) of the final 
regulations defines a ``remittance'' as a disregarded payment that is 
neither a contribution nor a reattribution payment. This definition 
encompasses a transfer of property 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. These changes ensure that 
the final regulations provide rules for allocating foreign income taxes 
attributable to all disregarded payments.
    In addition, the final regulations define a ``taxable unit'' by 
reference to the tested unit definition in Sec.  1.951A-2(c)(7)(iv)(A), 
a final regulation, instead of by reference to the definition of a 
taxable unit in proposed Sec.  1.954-1(d)(2). See Sec.  1.861-
20(d)(3)(v)(E)(9).
    The final regulations provide a special rule at Sec.  1.861-
20(d)(3)(vi) for allocating and apportioning foreign income tax on 
foreign gross income included by a taxpayer by reason of its ownership 
of a U.S. equity hybrid instrument (defined in Sec.  1.861-20(b)(22) as 
an instrument that is stock or a partnership interest under Federal 
income tax law but that is debt or otherwise gives rise to the accrual 
of income that is not treated as a dividend or a distributive share of 
partnership income under foreign law). This special rule, which 
generally allocates foreign income tax on foreign gross interest income 
with respect to a U.S. equity hybrid instrument to the grouping to 
which distributions with respect to the instrument are assigned, 
clarifies how section 245A(d) and Sec.  1.245A(d)-1 apply to foreign 
income tax that is attributable to a hybrid dividend. As discussed in 
part I of this Summary of Comments and Explanation of Revisions, Sec.  
1.245A(d)-1 relies upon the rules of Sec.  1.861-20 to determine 
whether foreign income tax is attributable to income described in 
section 245A, including a hybrid dividend described in section 245A(e), 
in which case a credit or deduction for the foreign income tax is 
disallowed.
    Section 1.861-20(d)(3)(vi)(A) treats foreign gross income included 
by reason of an accrual of income with respect to a U.S. equity hybrid 
instrument as a distribution. Accordingly, it assigns the foreign gross 
income to the statutory and residual groupings as though the accrual 
were a foreign law distribution that was made on the date of the 
accrual. Section 1.861-20(d)(3)(vi)(B) provides an identical rule for a 
payment of interest under foreign law with respect to the U.S. equity 
hybrid instrument; therefore, withholding tax on the payment is also 
attributed to income (determined under Federal income tax law) from the 
instrument.

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    Finally, as part of finalizing the rules in Sec.  1.861-
20(d)(3)(v), conforming changes are made to Sec.  1.951A-2(c)(7) and 
(8). In particular, Sec.  1.951A-2(c)(7)(iii)(B) is deleted and 
Examples 1 and 3 in Sec.  1.951A-2(c)(8)(iii)(A) and (C) are revised 
accordingly while Example 2 in Sec.  1.951A-2(c)(8)(iii)(B) is removed 
as obsolete. Section 1.951A-2(c)(7)(iii)(B) is removed from the final 
regulations because the special rules in that paragraph for allocating 
and apportioning current year taxes imposed by reason of a disregarded 
payment are rendered obsolete by the final rules in Sec.  1.861-
20(d)(3)(v). Under Sec.  1.951A-2(c)(7)(iii)(A), deductible expenses 
(including expenses for current year taxes) are allocated and 
apportioned under the principles of Sec.  1.960-1(d)(3) and the rules 
in Sec.  1.861-20.
5. Applicability Date
    Section 1.861-20 (other than Sec.  1.861-20(h)) applies to taxable 
years that begin after December 31, 2019, and end on or after November 
2, 2020. Section 1.861-20(h) applies to taxable years beginning on or 
after December 28, 2021. In addition, the revisions to Sec.  1.951A-
2(c)(7) and (8) apply to taxable years that begin after December 28, 
2021; however, taxpayers may choose to apply the final rules to taxable 
years that begin after December 31, 2019, and on or before December 28, 
2021, consistent with the applicability date of Sec.  1.861-
20(d)(3)(v).
    Several comments asked the Treasury Department and the IRS to 
provide a delayed applicability date for Sec.  1.861-20. The rules in 
proposed Sec.  1.861-20 revised the corresponding provisions in the 
2019 FTC proposed regulations, which were not finalized with the 2020 
FTC final regulations to provide an additional opportunity for comment. 
Because the regulations are finalized substantially as proposed, with 
primarily clarifying changes in response to comments, the Treasury 
Department and the IRS have determined that it is not appropriate to 
modify the proposed applicability date.

IV. Creditability of Foreign Taxes Under Sections 901 and 903

A. Jurisdictional Nexus Requirement
1. In General
    The 2020 FTC proposed regulations added a jurisdictional nexus 
requirement for determining whether a foreign tax qualifies as a 
foreign income tax for purposes of section 901. Proposed Sec.  1.901-
2(a)(3) and (c) generally required that, for a foreign tax to be a 
foreign income tax, the foreign country imposing the tax must have 
sufficient nexus to the taxpayer's activities or investment of capital 
or other assets that give rise to the income base on which the foreign 
tax is imposed. In the case of a foreign tax imposed by a foreign 
country on nonresident taxpayers, the 2020 FTC proposed regulations 
provided that a foreign tax satisfies the jurisdictional nexus 
requirement if it meets one of three nexus tests.
    First, under proposed Sec.  1.901-2(c)(1)(i), a foreign tax meets 
the jurisdictional nexus requirement if it is imposed only on income 
that is attributable, under reasonable principles, to the nonresident's 
activities located in the foreign country (for this purpose, the 
nonresident's activities include its functions, assets, and risks) 
(``activities-based nexus''). To meet the activities-based nexus test, 
the allocation of a nonresident's income to the nonresident's 
activities in the foreign country cannot take into account, as a 
significant factor, the location of customers, users, or any similar 
destination-based criterion. Proposed Sec.  1.901-2(c)(1)(i) further 
provided that reasonable principles for determining income attributable 
to a nonresident's activities include rules similar to those for 
determining effectively connected income under section 864(c).
    Second, under proposed Sec.  1.901-2(c)(1)(ii), a foreign tax 
imposed on the nonresident's income arising in the foreign country 
meets the jurisdictional nexus requirement only if the foreign tax law 
sourcing rules are reasonably similar to the sourcing rules that apply 
for Federal income tax purposes (``source-based nexus'').
    Third, under proposed Sec.  1.901-2(c)(1)(iii), a foreign tax 
imposed on income or gain from sales or other dispositions of property 
that is subject to tax in the foreign country on the basis of the situs 
of real or movable property meets the jurisdictional nexus requirement 
only if it is imposed with respect to income or gain from 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 (or from interests in certain entities holding such 
property) (``property-based nexus'').
    In the case of a foreign tax imposed by a foreign country on its 
residents, proposed Sec.  1.901-2(c)(2) provided that in determining 
whether the foreign tax meets the jurisdictional nexus requirement, any 
allocation of income, gain, deduction or loss between a resident 
taxpayer and a related or controlled entity under the foreign country's 
transfer pricing rules must follow arm's length principles, without 
taking into account as a significant factor the location of customers, 
users, or any other similar destination-based criterion.
    Under the 2020 FTC proposed regulations, the jurisdictional nexus 
requirement also applied to determine whether a foreign levy is a tax 
in lieu of an income tax under section 903 (an ``in lieu of tax''). 
Specifically, the 2020 FTC proposed regulations modified the 
substitution requirement to add proposed Sec.  1.903-1(c)(1)(iv), which 
required that the generally-imposed net income tax would either 
continue to qualify as a net income tax under proposed Sec.  1.901-
2(a)(3), or would itself constitute a separate levy that is a net 
income tax if it were to be imposed on the excluded income that is 
covered by the tested in lieu of tax. This modification was 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 proposed Sec.  1.901-2(c). In 
addition, proposed Sec.  1.903-1(c)(2)(iii) provided that, to satisfy 
the substitution requirement, a withholding tax must meet the source-
based jurisdictional nexus requirement in proposed Sec.  1.901-
2(c)(1)(ii) to qualify as a ``covered withholding tax.'' Comments 
regarding the jurisdictional nexus test of the substitution requirement 
are discussed in this part IV.A of this Summary of Comments and 
Explanation of Revisions; other comments regarding the proposed 
modifications to the in lieu of tax provisions are discussed in part 
IV.C of this Summary of Comments and Explanation of Revisions.
2. Reasonableness of Jurisdictional Nexus Requirement
i. Text and History of the Relevant Statutory Provisions
a. Income Tax in the U.S. Sense
    Comments questioned the validity of the jurisdictional nexus 
requirement, stating that the requirement is inconsistent with the 
plain language, structure, and legislative history of the statutory 
foreign tax credit provisions. Comments stated that the plain meaning 
of ``income tax'' refers solely to whether the base of the tax is net 
income and does not require a justification (nexus) for the imposition 
of the tax. Some comments stated that the term ``income tax'' should 
not be interpreted to encompass U.S. rules or international norms 
regarding jurisdiction to tax

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because, according to those comments, when the foreign tax credit 
provisions were first enacted there were limited source rules in the 
Code and international norms for determining the source of income were 
still developing. Other comments stated that the inclusion of a 
jurisdictional nexus requirement would require Congressional action and 
noted that other exceptions to creditability have been enacted by 
Congress (see, for example, section 901(f), (i) and (m)). Some comments 
stated that the Supreme Court in Biddle v. Comm'r, 302 U.S. 573 (1938), 
made only a passing reference to ``an income tax in the U.S. sense,'' 
and that neither Biddle nor any other case has interpreted the statute 
to include a jurisdictional nexus requirement.
    The Treasury Department and the IRS have determined that the 
addition of a jurisdictional nexus requirement is a valid exercise of 
the government's rulemaking authority. The Treasury Department and the 
IRS have determined that it is reasonable and appropriate to interpret 
the terms ``income tax'' and ``tax in lieu of an income tax'' in 
sections 901 and 903, respectively, to incorporate a jurisdictional 
nexus requirement. Judicial decisions and administrative guidance over 
the past century have interpreted the term ``income, war profits, and 
excess profits tax,'' which is not defined in section 901 or by the 
limited initial explanation in the early legislative history. These 
interpretations have consistently followed the principle, introduced by 
the Biddle court, that the determination of whether a foreign tax is 
creditable under section 901 is made by evaluating whether such tax, if 
enacted in the United States, would be an income tax (in other words, 
whether the foreign tax is ``an income tax in the U.S. sense''). See 
PPL Corp. v. Comm'r, 569 U.S. 329, 335 (2013). See also Inland Steel 
Co. v. United States, 230 Ct. Cl. 314, 325 (1982) (``Whether a foreign 
tax is an income tax under I.R.C. Sec.  901(b)(1) is to be decided 
under criteria established by United States revenue laws and court 
decisions.''). It is well-settled that U.S. tax provisions should 
generally be interpreted with reference to domestic tax concepts absent 
a clear Congressional expression that foreign concepts control. United 
States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 145 (1989). The 
jurisdictional nexus requirement is consistent with the principle that 
U.S. tax principles, not varying foreign tax law policies, should 
control the determination of whether a foreign tax is an income tax (or 
a tax in lieu of an income tax) that is eligible for a U.S. foreign tax 
credit.
    U.S. tax law has long incorporated a jurisdictional nexus 
limitation in taxing income of foreign persons. For example, the United 
States only taxes income of foreign persons that have income that is 
effectively connected with a U.S. trade or business or attributable to 
U.S. real property, or have income that is fixed or determinable, 
annual or periodic (FDAP) income sourced in the United States. See 
sections 871, 881, 882, and 897. In addition, U.S. foreign tax credit 
rules reflect international norms of taxing jurisdiction that assign 
the primary right to tax to the source country, the secondary right to 
tax to the country where the taxpayer is a resident or engaged in a 
trade or business, and the residual right to tax to the country of 
citizenship or place of incorporation. See sections 904(a) (limiting 
foreign tax credits to U.S. tax on foreign source income) and 906(b)(1) 
(limiting foreign tax credits allowed to foreign persons engaged in a 
U.S. trade or business to foreign taxes on foreign source effectively 
connected income). In keeping with these traditional U.S. taxing rules, 
international taxing norms (such as provisions included in the OECD 
Model Tax Convention), and the longstanding approach of the courts to 
apply U.S. tax principles in determining whether a foreign tax is an 
income tax in the U.S. sense, it is appropriate for the definition of a 
creditable tax to incorporate the concept of jurisdictional nexus from 
the U.S. tax law. The fact that U.S. tax rules have changed since the 
foreign tax credit provisions were first enacted does not preclude an 
interpretation of the term ``income tax'' to reflect U.S. norms, 
because the principle of ``an income tax in the U.S. sense'' 
incorporates an evolving standard of what constitutes an income tax in 
the U.S. sense.
    In addition, the net gain requirement in existing Sec.  1.901-2(b), 
which prescribes the elements of gross receipts and costs that must 
comprise the base of a foreign income tax, has historically reflected 
jurisdictional norms in limiting creditable taxes to those imposed on 
net income. The jurisdictional nexus requirement clarifies the limits 
on the scope of the items of gross receipts and costs that may properly 
be taken into account in computing the taxable base of a creditable 
foreign income tax. Absent this rule, U.S. tax on net income could be 
reduced by credits for a foreign levy whose taxable base was improperly 
inflated by unreasonably assigning income to a taxpayer, or by not 
appropriately taking into account significant costs that are 
attributable to gross receipts properly included in the taxable base.
    Existing Sec.  1.901-2(b)(4)(i)(A) has long contained a form of a 
nexus rule, by requiring recovery of significant costs and expenses 
that are ``attributable, under reasonable principles'' to gross 
receipts included in the foreign tax base. A rule providing the extent 
to which gross receipts and costs are within the scope of a 
jurisdiction's right to tax is therefore necessary to determine which 
items of gross receipts and costs a foreign levy must include to 
satisfy the net gain rules.
    To better reflect the role of the jurisdictional nexus rule as an 
element of the net gain requirement, the rule in proposed Sec.  1.901-
2(c) is incorporated in the net gain requirement as new paragraph Sec.  
1.901-2(b)(5). In addition, the term ``jurisdictional nexus 
requirement'' is replaced with ``attribution requirement'' to more 
clearly reflect that the rule provides limits on the scope of gross 
receipts and costs that are attributable to a taxpayer's activities and 
thus appropriately included in the foreign tax base for purposes of 
applying the other components of the net gain requirement.
b. Relationship to Foreign Tax Credit Limitation
    Some comments asserted that Congress explicitly removed a 
jurisdictional nexus requirement from the predecessor to section 901 in 
1921, and since then, Congress has addressed concerns regarding 
jurisdiction to tax through the foreign tax credit limitation under 
section 904 (and its predecessor provisions). The comments pointed out 
that the foreign tax credit provision, when first enacted under the 
Revenue Act of 1918, provided that U.S. tax was ``credited with . . . 
the amount of any income, war-profits and excess-profits taxes paid 
during the taxable year to any foreign country, upon income derived 
from sources therein, or to any possession of the United States.'' 
Public Law 65-254, Sec.  222(a)(1) and 238(a), 40 Stat. 1057, 1073, 
1080-81 (emphasis added). The comments stated that the phrase ``upon 
income derived from sources therein'' served as a jurisdictional nexus 
limit, which Congress eliminated and replaced by enacting the foreign 
tax credit limitation in the Revenue Act of 1921. The comments asserted 
that this legislative history shows that Congress has rejected 
including a jurisdictional nexus requirement in section 901. The 
comments also stated that the only concern regarding jurisdiction to 
tax

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discussed in the legislative history to the 1918 and 1921 Revenue Acts 
was Congress' desire to preserve U.S. primary taxing rights over U.S. 
source income.
    The Treasury Department and the IRS disagree with the comments' 
conclusion that Congress has expressly rejected a jurisdictional nexus 
requirement for creditable foreign taxes. Although source-based taxing 
rights are an appropriate element of jurisdictional nexus, tax 
residence and conducting business in a foreign country also provide 
jurisdictional nexus. The Treasury Department and the IRS view the 
introduction of the foreign tax credit limitation in 1921 as merely 
refining the 1918 Revenue Act's limitation of credits to tax imposed 
upon foreign source income. The legislative history does not explain 
why Congress removed the phrase ``upon income from sources therein'' in 
1921, nor does it suggest that Congress believed it was removing a 
jurisdictional nexus requirement and replacing it with a foreign tax 
credit limitation.
    The Treasury Department and the IRS also disagree with the 
comments' assertion that statutory policy regarding jurisdiction to tax 
is confined to the section 904 foreign tax credit limitation. Congress 
has not explicitly addressed jurisdictional nexus with respect to the 
foreign tax credit. There is no statutory provision that addresses 
whether the foreign tax credit should be allowed for taxes imposed 
outside of traditional U.S. taxing norms. Section 904 does not address 
the threshold question of whether a foreign tax is an income tax in the 
U.S. sense. It only limits the allowable credit to the amount of pre-
credit U.S. tax on particular categories of foreign source income, as 
revised by Congress from time to time. The foreign tax credit 
limitation preserves residual U.S. tax on foreign source income subject 
to a foreign rate of tax that is lower than the U.S. rate, but does not 
ensure that the foreign tax has an appropriate jurisdictional basis. 
The statute is silent with respect to jurisdictional nexus, and it is 
reasonable and appropriate for regulations to apply U.S. tax concepts 
in addressing the creditability of extraterritorial foreign levies that 
Congress could not have anticipated when the foreign tax credit 
provisions were first enacted.
c. Legislative Re-Enactment Doctrine
    Some comments argued that the addition of a jurisdictional nexus 
requirement is precluded by the legislative re-enactment doctrine. 
These comments noted that the 1980 temporary and proposed section 901 
regulations, which contained similar nexus requirements, drew numerous 
adverse comments and were the subject of Congressional hearings, and 
that the Treasury Department and the IRS did not finalize those 
provisions in TD 7918 (48 FR 46276) (``the 1983 regulations''). These 
comments asserted that in passing the Tax Reform Act of 1986, Public 
Law 99-514, 100 Stat. 2085 (1986), and the Tax Cuts and Jobs Act, 
Public Law 115-97, 131 Stat 2054 (2017) (``TCJA''), Congress was aware 
of the 1983 regulations (which do not contain a jurisdictional nexus 
requirement) and did not amend the statute to add one, with the result 
that Congress implicitly endorsed the 1983 regulations and precluded 
the Treasury Department and the IRS from modifying them.
    The Treasury Department and the IRS disagree with these comments. 
The legislative re-enactment doctrine does not preclude an agency from 
changing its regulatory interpretation of a statute if Congress amends 
related provisions. See Helvering v. Reynolds, 313 U.S. 428, 432 (1941) 
(``[The doctrine of legislative reenactment] does not mean that the 
prior construction has become so imbedded in the law that only Congress 
can effect a change.''). See also Helvering v. Wilshire Oil Co., 308 
U.S. 90, 100 (1939) (holding that the legislative reenactment doctrine 
applies where ``it does not appear that the rule or practice has been 
changed by the administrative agency through exercise of its continuing 
rule-making power''); McCoy v. U.S., 802 F.2d 762 (4th Cir. 1986); 
Interstate Drop Forge Co. v. Com., 326 F2d 743 (7th Cir. 1964).
    Additionally, while a purported legislative re-enactment may 
indicate that Congress was aware of, and implicitly endorsed, the prior 
regulatory interpretation, a regulation or administrative ruling 
promulgated under a re-enacted statute is not treated as binding unless 
other evidence clearly manifests such a purpose. See Oklahoma Tax Com. 
v. Texas Co., 336 U.S. 342 (1949); Jones v. Liberty Glass Co., 332 U.S. 
524 (1947). There is no indication that Congress intended to preclude 
the amendment of the section 901 and 903 regulations to add a 
jurisdictional nexus requirement. None of the comments identified any 
aspect of either the Tax Reform Act of 1986 or the TCJA that suggests 
that Congress intended to limit future regulations addressing the 
definition of creditable foreign taxes under sections 901 and 903. 
Therefore, the Treasury Department and the IRS have determined that the 
legislative re-enactment doctrine does not preclude the adoption of 
prospective regulations that include a jurisdictional nexus 
requirement.
ii. Policy and Purpose of the Statutory Foreign Tax Credit Provisions
    Comments stated that adding a jurisdictional nexus requirement is 
contrary to the policy of the foreign tax credit, which is to mitigate 
double taxation of foreign source income. These comments asserted that 
double taxation results when the United States imposes tax on income 
that is taxed by another country, regardless of whether the other 
country had a proper jurisdictional basis for imposing the tax, and 
unrelieved double taxation could discourage foreign investment. The 
comments asserted that Congress enacted the foreign tax credit to 
enhance the competitiveness of American companies operating abroad, and 
the jurisdictional nexus requirement in the 2020 FTC proposed 
regulations would impede this competitiveness. The comments asserted 
that the policy goal of sections 901 and 903 is not to influence 
international norms or change the behavior of foreign governments.
    However, another comment stated that the jurisdictional nexus 
requirement may reasonably be viewed as consistent with the underlying 
principles and purposes of the foreign tax credit regime. This comment 
asserted that the allowance of a foreign tax credit for a tax levied on 
amounts that do not have a significant connection to the foreign 
jurisdiction taxing such income, particularly U.S. source income, could 
effectively convert the foreign tax credit regime into a means of 
subsidizing foreign jurisdictions at the expense of the U.S. fisc. 
Similarly, one comment that questioned the government's authority to 
include a jurisdictional nexus requirement also acknowledged that taxes 
that have no nexus whatsoever to the taxing jurisdiction would not 
properly be considered taxes.
    The Treasury Department and the IRS agree with the comment that the 
jurisdictional nexus requirement is consistent with the policy goals of 
the foreign tax credit. The foreign tax credit is not intended to 
subsidize foreign jurisdictions at the expense of the U.S. fisc. The 
legislative history to the predecessor provisions to section 901, as 
well as subsequent statutory amendments, reflect Congress' consistent 
concern that foreign tax credits should not be allowed to offset U.S. 
tax on income that does not have a significant connection to the 
foreign jurisdiction taxing such income. See, for example, S. Rep. No. 
67-275, at 17 (1921) (describing the need to avoid

[[Page 285]]

allowing a foreign tax credit to ``wipe out'' tax properly attributable 
to U.S. source income); Senate Comm. on Finance, 98th Cong., 2d Sess., 
Deficit Reduction Act of 1984, Explanation of Provisions Approved by 
the Committee on March 21, 1984, at 392 (Comm. Print 1984) (describing 
the need for separate foreign tax credit limitation categories to 
prevent the U.S. Treasury from inappropriately ``bear[ing] the burden'' 
of foreign taxes).
    The 2020 FTC proposed regulations are also consistent with the 
statutory purpose of the foreign tax credit to relieve double taxation 
of income through the United States ceding its own taxing rights only 
where the foreign country has the primary right to tax income. See 
Bowring v. Comm'r, 27 B.T.A. 449, 459 (1932) (``In the case of the 
citizen and resident alien, the United States recognizes the primary 
right of the foreign government to tax income from sources therein . . 
. and accordingly, grants a credit.''). To ensure that the United 
States provides a foreign tax credit only where the foreign country 
appropriately asserts jurisdiction to tax income, creditable foreign 
levies must incorporate norms similar to those in U.S. tax law that 
limit the scope of income subject to the tax.
    Some comments asserted that double taxation meriting relief exists 
in every case in which a foreign tax is not allowed as a foreign tax 
credit against U.S. tax. However, that assertion is inconsistent not 
only with the foreign tax credit limitation in section 904, but with 
the plain text of section 901. Section 901 allows a credit only for 
income, war profits, and excess profits taxes, and not for all foreign 
taxes that may be imposed by a foreign jurisdiction (such as value 
added taxes or sales taxes, which may qualify for a deduction under 
section 164), or for other levies such as tariffs. As explained in part 
IV.A.2.i.a of this Summary of Comments and Explanation of Revisions, 
determining which items of gross receipts and costs are properly 
included in a foreign taxable base is inherent to the determination of 
whether the foreign tax is an income tax in the U.S. sense.
    As noted in the preamble to the 2020 FTC proposed regulations, the 
fundamental purpose of the foreign tax credit--to mitigate double 
taxation with respect to taxes imposed on income--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 costs and 
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. Therefore, the final regulations retain the requirement in the 
2020 FTC proposed regulations that for a foreign tax to qualify as an 
income tax, the tax must conform with established international 
jurisdictional 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.
    Recently, many foreign jurisdictions have disregarded international 
taxing norms to claim additional tax revenue, resulting in the adoption 
of novel extraterritorial taxes that diverge in significant respects 
from U.S. tax rules and traditional norms of international taxing 
jurisdiction. These extraterritorial assertions of taxing authority 
often target digital services, where countries seeking additional 
revenue have chosen to abandon international norms to assert taxing 
rights over digital service providers.\1\
---------------------------------------------------------------------------

    \1\ See OECD Inclusive Framework on BEPS, Tax Challenges Arising 
from Digitalisation--Report on Pillar One Blueprint, at 10 (Oct. 14, 
2020) (``Globalisation and digitalisation have challenged 
fundamental features of the international income tax system, such as 
the traditional notions of permanent establishment and the arm's 
length principle (ALP), and brought to the fore the need for higher 
levels of enhanced tax certainty through more extensive multilateral 
tax co-operation. These transformational developments have taken 
place against a background of increasing public attention on the 
taxation of highly digitalised global businesses.'').
---------------------------------------------------------------------------

    The Treasury Department and the IRS have determined that it is 
necessary and appropriate to adapt the regulations under sections 901 
and 903 to address this change in circumstances, especially in relation 
to the taxation of the digital economy--a sector that did not exist 
when the foreign tax credit provisions were first enacted. Accordingly, 
regulations are necessary and appropriate to more clearly delineate the 
circumstances in which a tax does not qualify as an income tax in the 
U.S. sense due to the foreign jurisdiction's unreasonable assertion of 
jurisdictional taxing authority.
    Some comments asserted that the jurisdictional nexus requirement in 
the 2020 FTC proposed regulations is inconsistent with Congressional 
policy reflected in the repeal of the per-country foreign tax credit 
limitation in favor of an overall foreign tax credit limitation. These 
comments suggested that the proposed jurisdictional nexus requirement 
would effectively revert to the more limited per-country limitation 
and, more generally, that the repeal of the per-country limitation 
reflects a general policy favoring broader availability of foreign tax 
credits. The Treasury Department and the IRS disagree with these 
comments. The jurisdictional nexus requirement does not prevent cross-
crediting within a particular separate category described in section 
904, which has been amended numerous times by Congress. For example, 
the nexus requirement does not preclude a foreign tax credit against 
U.S. tax on foreign source general category income derived from one 
country for a foreign tax imposed by another country that is assigned 
to the general category, whereas under the former per-country 
limitation, such cross-crediting would not be allowed.
    Additionally, while comments frame the per-country limitation as 
more restrictive than the overall limitation, the debate concerning the 
limitation also highlighted circumstances in which the overall 
limitation is in fact the more restrictive of the two.\2\ In 1960, when 
adding back the overall limitation, but retaining the per-country 
limitation, Congress explained that the overall limitation may not be 
appropriate based on the business model of a particular taxpayer. See 
S. Rep. No. 86-1393, at 3773-74 (1960). Thus, the Treasury Department 
and the IRS do not agree with the comments' assertion that Congress' 
choice in 1976 to retain only the overall limitation supports the 
broadest allowance of foreign tax credits, because either the per-
country or overall limitation may more significantly restrict the 
amount of foreign tax credit, depending on the circumstances of a 
particular taxpayer.
---------------------------------------------------------------------------

    \2\ For example, both houses of Congress, in retreating from the 
overall limitation in 1954, explained that ``[t]he effect of the 
[overall] limitation is unfortunate because it discourages a company 
operating profitably in one foreign country from going into another 
country where it may expect to operate at a loss for a few years. 
Consequently your committee has removed the overall limitation.'' 
H.R. Rep. No. 83-1337, at 4103 (1954); see also S. Rep. No. 83-1622, 
at 4739 (1954).
---------------------------------------------------------------------------

    Similarly, the choice in 1976 to add back the overall limitation 
and make it the only limitation did not represent Congress's definitive 
choice to allow unlimited cross-crediting of high-rate foreign taxes 
against U.S. tax on foreign source income subject to a lower rate of 
foreign tax. S. Rep. No. 86-1393, at 3773-74. Rather, Congress has 
continually amended and debated the appropriate scope of the foreign 
tax

[[Page 286]]

credit limitation since 1962. The ongoing Congressional amendments to 
the foreign tax credit limitation show that Congress had not 
definitively resolved the permissible scope of cross-crediting when it 
enacted the predecessor provision to section 901.
    In addition, Congress did not repeal the per-country limitation in 
1976 primarily as a policy choice to allow cross-crediting. Rather, 
Congress repealed the per-country limitation because it allowed a 
taxpayer to reduce U.S. tax on U.S. source income by application of a 
foreign source loss, and later to reduce U.S. tax on foreign source 
income through a foreign tax credit. See S. Rep. No. 94-938, at 236 
(1976); H.R. Rep. No. 94-658, at 225 (1975); Joint Comm. on Taxation, 
General Explanation of the Tax Reform Act of 1976, at 236 (1976). In 
conclusion, the comments' claim that the jurisdictional nexus 
requirement in the 2020 FTC proposed regulations is inconsistent with 
the Congressional policy reflected in the repeal of the per-country 
limitation is not supported by the legislative history and is 
contradicted by subsequent amendments to section 904.
    Comments also stated that section 904(d)(2)(H)(i), which provides a 
rule for assigning to a separate category foreign tax imposed by a 
foreign country on an amount that does not constitute income under U.S. 
tax principles, provides further support for the view that foreign tax 
credit provisions should be construed broadly, with limited reference 
to U.S. rules. One comment pointed to cases, including Schering Corp. 
v. Comm'r, 69 T.C. 579 (1978) and Helvering v. Campbell, 139 F.2d 865 
(1944), in which courts allowed a credit for foreign taxes on amounts 
that the U.S. does not tax due to timing or base differences, for 
example, as a result of characterization differences.
    The Treasury Department and the IRS find these comments 
unpersuasive, because the jurisdictional nexus requirement in the 2020 
FTC proposed regulations would not preclude a credit for foreign taxes 
imposed on an amount of taxable income that exceeds taxable income 
computed under U.S. tax law rules due to base or timing differences. 
The nexus rule requires that the activity subject to the tax have 
sufficient connection to the foreign country imposing the tax. It does 
not require that every item included in the foreign tax base conform in 
timing or amount to items included in U.S. taxable income. Consistent 
with section 904(d)(2)(H)(i), the jurisdictional nexus requirement in 
the 2020 FTC proposed regulations does not preclude a credit for 
foreign income taxes imposed on base difference amounts.
3. Other Policy Considerations
    Several comments questioned the policy reasons discussed in the 
preamble to the 2020 FTC proposed regulations that motivated the 
Treasury Department and the IRS to add the jurisdictional nexus 
requirement. Comments disagreed with the notion that destination-based 
taxing rights lack sufficient connection to a jurisdiction. They noted 
that Congress's deliberations of alternative approaches to the U.S. 
corporate income tax and the current multilateral negotiations by the 
OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting 
(``Inclusive Framework'') with respect to reallocating taxing rights 
under the ``Pillar 1'' proposal demonstrate that there is a legitimate 
debate about claims to destination-based taxing rights. This ongoing 
debate, the comments stated, indicates that market-based or 
destination-based taxes are income taxes. As such, some comments 
asserted that the jurisdictional nexus rule in the 2020 FTC proposed 
regulations is inconsistent with changes that have occurred in how 
income can be generated through technology and changes that various 
taxing jurisdictions, including U.S. states, have made to their taxing 
regimes in response to those changes. The comments recommended that if 
the jurisdictional nexus requirement is not eliminated in the final 
regulations, the requirement should be modified such that it is more 
flexible and takes into account evolving jurisdictional norms. One 
comment asked that the requirement be expansive enough to allow credits 
for taxes imposed on income sourced to a jurisdiction based on the 
situs of users or customers, as well as taxes imposed on a taxpayer 
that generates income from customers in a jurisdiction without having a 
physical presence in that jurisdiction.
    One comment pointed out that U.S. income tax principles incorporate 
destination-based taxing rights. As an example, the comment noted that 
proposed Sec.  1.861-18(f)(2)(ii) provided that when a copyrighted 
article is sold and transferred through an electronic medium, the sale 
is deemed to have occurred at the location of download or installation 
onto the end-user's device. As another example, the comment cited Sec.  
1.250(b)-4(d)(1)(ii)(D), which provides that a sale of certain property 
that primarily contains digital content is for a foreign use if the end 
user downloads, installs, receives, or accesses the purchased digital 
content on the end user's device outside the United States. Another 
comment noted that Congress considered imposing a destination-based 
income tax as part of the 2017 tax reform.
    In addition, comments stated that over half of U.S. states with a 
corporate income tax determine the amount of a taxpayer's income 
subject to the state's corporate income tax by apportioning the 
taxpayer's federal taxable income using sales as the single factor. The 
comments stated that under the proposed jurisdictional nexus 
requirements, these state income taxes would fail to be an ``income 
tax'' in the U.S. sense even though the income subject to the state 
corporate income taxes is based in significant respects on the 
taxpayer's taxable income determined under the Code. The comments also 
questioned whether this policy means that a foreign country can deny a 
foreign tax credit for otherwise eligible U.S. state corporate income 
taxes simply because the states rely on sales-based apportionment 
factors to source income and a market-based jurisdictional nexus 
standard.
    In general, the Treasury Department and the IRS disagree with these 
comments. As explained in part IV.A.2 of this Summary of Comments and 
Explanation of Revisions, whether a foreign tax is creditable under 
section 901 depends on whether the tax is an ``income tax in the U.S. 
sense.'' Neither prior unenacted legislative proposals nor potential 
future (yet undetermined) changes to the Code with respect to U.S. 
jurisdictional limits are determinative of what constitutes an income 
tax in the U.S. sense under current law.
    The Treasury Department and the IRS acknowledged in the preamble to 
the 2020 FTC proposed regulations that future changes in U.S. law may 
necessitate rethinking the rules for determining creditable foreign 
income taxes. It is nevertheless important that these final regulations 
be issued promptly to address novel extraterritorial taxes. Existing 
law is unclear on the extent to which foreign taxes that are 
inconsistent with existing jurisdictional norms meet the definition of 
an income tax under section 901, and the Treasury Department and the 
IRS had previously received comments requesting guidance on this 
matter.\3\ In addition, to the extent these novel extraterritorial 
taxes, which many foreign jurisdictions have already adopted, are being 
paid by taxpayers

[[Page 287]]

and claimed as a foreign tax credit, this would have an immediate and 
detrimental impact on the U.S. fisc. Therefore, the Treasury Department 
and the IRS disagree with the suggestion in comments that the potential 
for future law changes necessitates a delay in the issuance of these 
necessary and appropriate regulations.
---------------------------------------------------------------------------

    \3\ See New York State Bar Association Tax Section, Report on 
Issues Relating to the Definition of a Creditable tax for Purposes 
of Sections 901 and 903 of the Code, Rep't No. 1332 (Nov. 24, 2015).
---------------------------------------------------------------------------

    The Treasury Department and the IRS also disagree that the manner 
in which U.S. states determine the amount of income that is taxable in 
a particular state has any bearing on whether a foreign tax is an 
income tax in the U.S. sense. See, for example, Heiner v. Mellon, 304 
U.S. 271, 279 (1937) (``It is well settled that in the interpretation 
of the words used in a federal revenue act, local law is not 
controlling unless the federal statute by express language or necessary 
implication, makes its own operation dependent upon state law.''). 
Nothing in the Code, legislative history, or case law suggests that 
whether a tax is an income tax in the U.S. sense should be determined 
by reference to state, as opposed to Federal, income tax principles. 
Furthermore, it is immaterial whether a foreign country would provide a 
foreign tax credit under its own law for U.S. state income taxes.
    In addition, U.S. tax law imposing U.S. tax on income of 
nonresidents is not based on notions of destination or customer 
location. See sections 864(c), 871, 881, and 882. Moreover, the comment 
citing section 250 is inapposite, as that provision merely defines the 
scope of sales and services that constitute income from export activity 
that qualifies for a special U.S. tax deduction; it does not operate to 
assert taxing jurisdiction over income of nonresidents. Similarly, 
while proposed Sec.  1.861-18(f)(2)(ii) interprets the place of sale as 
being the place of download solely for the purpose of determining the 
source of certain types of income from the sale or exchange of digital 
property in cases where the statutory source rule looks to the place 
where the sale occurs, this rule does not expand the scope of U.S. tax 
on income derived by nonresidents. U.S. law does not tax income from 
the sale or exchange of property by a nonresident unless the 
nonresident conducts a trade or business in the United States (if 
applicable, through a U.S. permanent establishment) or disposes of a 
United States real property interest as provided under section 897.
    One comment stated that the jurisdictional nexus requirement may be 
reasonably viewed as consistent with the policy of the foreign tax 
credit regime, which, as discussed in part IV.A.2 of this Summary of 
Comments and Explanation of Revisions, is not intended to subsidize 
foreign jurisdictions at the expense of the U.S. fisc. However, the 
comment also asserted that defining what are acceptable standards of 
taxing jurisdiction based upon U.S. principles may be unduly 
restrictive and may result in non-creditability of foreign taxes even 
when the foreign tax law is mostly aligned with U.S. principles. As an 
example, the comment posited that if a foreign country's generally-
imposed net income tax on its residents could in certain instances 
apply in a manner that is inconsistent with traditional arm's length 
principles, that tax would be non-creditable with respect to all 
resident taxpayers, even for taxpayers to which income would be 
allocated in a manner consistent with arm's length principles.
    Comments also pointed out that the jurisdictional nexus requirement 
that was included in the 1980 temporary and proposed regulations at 
Sec.  4.901-2(a)(1) (flush language) was a more flexible standard 
because it required only that the foreign tax follow reasonable rules 
regarding source of income, residence, or other bases for tax 
jurisdiction, and did not require specific rules that are similar to 
Federal income tax rules. In addition, one comment noted that the 1980 
temporary regulations also provided that a foreign tax may satisfy the 
definition of an income tax even if the foreign tax law differs 
substantially from the income tax provisions of the Code. That comment 
recommended that the final regulations should provide flexibility to 
accommodate the continued evolution of international tax policy 
consensus, which may diverge from the U.S. view of traditional taxing 
norms.
    Comments also asserted that certain U.S. sourcing rules reflect 
domestic policies other than jurisdiction to tax. As an example, one 
comment noted that the title passage rule for inventory in sections 
861(a)(6) and 862(a)(6) reflects administrative simplification 
concerns, and former section 863(b) served as an incentive for certain 
activities. The comments argued that foreign countries that adopt a 
rule different from U.S. source rules due to different choices among 
competing policies should not cause the foreign tax to be non-
creditable. One comment argued that diverging views of taxing rights, 
especially as between developed and developing countries, have long 
existed outside the context of novel extraterritorial taxes. The 
comment asserted that diverging views on taxing rights is what makes 
relief from double taxation necessary; it is not a reason to deny 
creditability of a foreign tax.
    The Treasury Department and the IRS generally agree that different 
countries may diverge in their approach to asserting jurisdictional 
taxing rights, just as countries may have different approaches in 
determining the amounts of realized gross receipts and recoverable 
costs and expenses included in the foreign taxable base. As a result, 
the net gain requirement in existing Sec.  1.901-2, as well as in these 
final regulations, does not require strict conformity between foreign 
and U.S. tax law. However, the final regulations do require that a 
foreign tax must be consistent with the general principles of income 
taxation reflected in the Code for it to be an ``income tax in the U.S. 
sense.'' These principles include not only those related to determining 
realization, gross receipts, and cost recovery, but also principles 
related to assertion of taxing rights. The purpose of section 901 is 
not to provide double tax relief in all cases in which foreign tax is 
imposed on income of a U.S. taxpayer, but rather, to relieve double 
taxation only in the case of foreign taxes that are ``income, war 
profits, and excess profits taxes''. Accordingly, the purpose of the 
regulations under section 901 is to provide clarity and certainty as to 
which income tax principles reflected in the Code the foreign tax law 
must have for a tax to be an income tax in the U.S. sense within the 
meaning of section 901. However, the Treasury Department and the IRS 
agree with the comments asserting that certain aspects of the source 
requirement can appropriately be revised to be more flexible; these 
changes are described in part IV.A.4 of this Summary of Comments and 
Explanation of Revisions.
    Several comments recommended that the Treasury Department and the 
IRS address the policy concerns regarding extraterritorial taxes 
through alternative approaches. These comments recommended that the 
Treasury Department utilize international forums, such as the Inclusive 
Framework and bilateral treaty negotiations, to dissuade foreign 
jurisdictions from enacting or imposing these taxes. Comments argued 
that the denial of foreign tax credits is unlikely to prevent foreign 
jurisdictions from imposing extraterritorial taxes and will instead 
harm the U.S. taxpayers operating in those foreign jurisdictions.

[[Page 288]]

One comment asserted that the foreign tax credit regulations should not 
be used as a tool to further U.S. foreign policy goals. Another comment 
recommended that, instead of adopting the jurisdictional nexus 
requirement, the Treasury Department and the IRS consider an 
alternative approach for defining what exceeds appropriate taxing 
jurisdiction by reference to the criteria that the U.S. Trade 
Representative has used to evaluate whether these taxes are 
discriminatory and burden U.S. commerce. Finally, one comment asserted 
that the jurisdictional nexus requirement would disproportionately 
disallow credits for taxes imposed by developing countries, which are 
more likely to assert taxing rights in a manner that is inconsistent 
with international norms, as compared to taxes imposed by developed 
countries.
    The Treasury Department and the IRS agree that international forums 
can be an effective way of discouraging foreign jurisdictions from 
enacting extraterritorial taxes; indeed, the Treasury Department is 
actively engaged in and supporting negotiations under the auspices of 
the Inclusive Framework that would result in their elimination.\4\ 
However, contrary to the comments' assertion, the Treasury Department 
and the IRS's determination that regulations are necessary and 
appropriate to ensure that the U.S. fisc does not bear the costs of 
such taxes derives from the text, purpose, and policy of section 901, 
and not from any foreign policy goals. The Treasury Department and the 
IRS have concluded that these novel extraterritorial taxes (some of 
which are currently in force and being levied on U.S. taxpayers) are 
contrary to the text and purpose of section 901 and therefore must be 
addressed now. Furthermore, nothing in the text, structure, or history 
of section 901 suggests that the Treasury Department or the IRS should 
consider the level of economic development of a country in determining 
whether a foreign tax imposed by that country meets the standards in 
section 901. Lastly, the Treasury Department and the IRS have 
considered the recommendation to use the criteria used by the U.S. 
Trade Representative but have determined that those criteria are 
designed for a different purpose (that of evaluating whether the 
foreign tax is unreasonable or discriminatory and burdens or restricts 
U.S. commerce under U.S. trade laws), and are not suitable for purposes 
of defining whether a tax is an income tax in the U.S. sense for 
purposes of U.S. tax laws.
---------------------------------------------------------------------------

    \4\ See OECD/G20 Base Erosion and Profit Shifting Project, 
Statement on a Two-Pillar Solution to Address the Tax Challenges 
Arising from the Digitalisation of the Economy (October 8, 2021) 
(describing agreement reached by 136 countries to ``remove all 
Digital Services Taxes and other relevant similar measures with 
respect to all companies, and to commit not to introduce such 
measures in the future.'').
---------------------------------------------------------------------------

    Finally, one comment recommended that the Treasury Department and 
the IRS develop a list of per se creditable and non-creditable taxes to 
provide taxpayers certainty and reduce compliance burdens. A per se 
list of creditable and non-creditable taxes would require significant 
government resources to analyze foreign taxes and maintain such a list, 
which would need to be updated every time foreign tax laws change. 
Therefore, the final regulations do not adopt this comment.
4. Modifications to the Source-Based Nexus Requirement
    Comments argued that the determination of whether foreign sourcing 
rules are reasonably similar to U.S. sourcing rules would be complex 
and result in significant uncertainty because U.S. sourcing rules are 
not sufficiently well-defined. Comments pointed out that the preamble 
to the 2020 FTC proposed regulations acknowledged that the U.S. rules 
for determining income effectively connected with a U.S. trade or 
business have been developed through case law, are not strictly 
delineated, and thus were not used as the standard for the activities-
based nexus requirement. The comments suggested that the U.S. sourcing 
rules for royalties and services are similarly addressed only in case 
law and not well-developed. They contended that it would be difficult 
to apply the sparse and inconsistent U.S. case law on royalty sourcing 
to determine if a foreign tax law's sourcing rules for royalties are 
reasonably similar to U.S. rules. In addition, comments asserted that 
the U.S. sourcing rules are designed to distinguish between U.S. and 
foreign source income, and are not well-suited for determining, for 
example, whether a royalty paid from one CFC to another is specifically 
sourced to the payor CFC's jurisdiction of residence. With respect to 
services income, one comment noted that it is unclear whether services 
should be sourced solely based on the source of the labor or by also 
taking into account the location of capital, especially when 
significant intangible property is involved. Another comment asked for 
clarification on how to evaluate whether a foreign withholding tax that 
is imposed both on services performed in the country imposing the tax 
and on technical service fees paid by a resident of such foreign 
country (regardless of where the services are performed) meets the 
source-based nexus requirement; this comment asked whether the 
determination of ``reasonably similar'' would depend on how important 
technical services are relative to that foreign country's economy.
    In response to these comments, the final regulations modify the 
source-based nexus requirement to provide additional flexibility and 
clarity. Section 1.901-2(b)(5)(i)(B) continues to require that the 
foreign sourcing rules must be reasonably similar to the sourcing rules 
under the Code. However, in recognition that the Code does not provide 
detailed sourcing rules addressing every category of income, or every 
type of income within that category, and that the interpretation and 
application of the Code sourcing rules are sometimes addressed only in 
case law and sub-regulatory guidance, Sec.  1.901-2(b)(5)(i)(B) also 
provides that the foreign tax law's application of sourcing rules need 
not conform in all respects to the interpretation that applies for 
Federal income tax purposes. Thus, for example, the final regulations 
require that in the case of gross income arising from gross receipts 
from royalties, the foreign tax law must impose tax on such royalties 
based on the place of use of, or the right to use, the intangible 
property. However, the final regulations do not require that the 
foreign law, in determining the place of use of an intangible in a 
particular transaction or fact pattern, reach the same conclusion as 
the IRS in a particular revenue ruling or a U.S. court in a particular 
case.
    The final regulations provide additional certainty by specifying 
the source principles that foreign tax law must apply to be considered 
reasonably similar to U.S. source rules. With respect to income from 
services, Sec.  1.901-2(b)(5)(i)(B)(1) provides that gross income 
arising from services must be sourced based on where the services are 
performed, as determined under reasonable principles, which do not 
include determining the place of performance based on the location of 
the service recipient. Thus, a withholding tax that is imposed on 
payments for services performed in the country imposing the tax would 
meet the source-based nexus requirement, but a withholding tax on fees 
for technical services performed outside of that country would not meet 
the source-based nexus requirement. In addition, the separate levy 
rules at Sec.  1.901-2(d)(1)(iii) are modified to provide that 
withholding taxes that apply different

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sourcing rules to subsets of a single class of gross income of 
nonresidents are treated as separate levies. Therefore, a withholding 
tax that applies a nonqualifying source rule to a subset of service 
income would not be creditable, but because it is treated as a separate 
levy the nonqualifying source rule would not prevent a withholding tax 
on other services that satisfies the source-based nexus requirement 
from qualifying as a creditable tax.
    Several comments also pointed out that the United States and the 
foreign jurisdiction may disagree on how to characterize the income 
from a particular transaction, making it more difficult to determine 
whether the foreign tax meets the jurisdictional nexus requirement. The 
comments noted that issues of characterization are particularly 
prevalent with respect to cross border payments for digital goods. The 
comments stated that in respect of software transactions that are 
treated as sales of copyrighted articles under Sec.  1.861-18, some 
foreign countries regard some or all payments by their resident 
taxpayers for software copies as royalties, and accordingly, impose a 
royalty withholding tax on those payments. The comments also asserted 
that even in cases where a foreign country may not consider the payment 
subject to royalty withholding tax, the foreign country may nonetheless 
tax other copyrighted article transactions as royalties. As such, the 
comments argued, cross border payments for digital goods should be 
excepted from the jurisdictional nexus requirement. Another comment 
noted that similar characterization questions may arise when 
distinguishing between technical service fees and royalties; the 
comment queried whether a foreign withholding tax imposed on royalties 
that the United States would view as a payment for services would be 
determined to be non-creditable or would require an evaluation of the 
magnitude of the services relative to the royalty.
    Comments also argued that the United States lacks guidance on the 
classification and sourcing of income from cloud computing 
transactions, noting that the Treasury Department and the IRS have not 
yet finalized the proposed cloud computing regulations that were issued 
in 2019. The comments asserted that given the evolving U.S. guidance on 
the character and source of cloud computing transactions, the 
creditability of a foreign tax imposed on such transactions should not 
depend on whether foreign law is reasonably similar to U.S. law.
    In response to these comments, the final regulations provide that, 
in general, foreign tax law applies for purposes of determining the 
character of the gross income or gross receipts that arise from a 
transaction. See Sec.  1.901-2(b)(5)(i)(B). The determination of 
whether the foreign law source rule is reasonably similar to the source 
rules under the Code will follow from the foreign law characterization 
of that income. If there is no statutory source rule in the Code for a 
particular amount that is subject to foreign tax, then the foreign law 
source rule will satisfy the source-based nexus requirement if it is 
reasonably similar to the U.S. source rule that applies by closest 
analogy. However, the final regulations also clarify that in the case 
of copyrighted articles, to satisfy the source-based nexus requirement, 
the foreign tax law must treat a transaction that is considered the 
sale of a copyrighted article under Sec.  1.861-18 (where the acquirer 
receives only the right to use a copyrighted article and not, for 
example, the right to duplicate and publicly distribute, or the right 
to publicly display the article) as a sale of tangible property and not 
as a license. See Sec.  1.901-2(b)(5)(i)(B)(3). This rule is consistent 
with established U.S. law and international norms. See Sec.  1.861-
18(c); see also OECD Model Tax Convention (2017), commentary to art. 
12. The Treasury Department and the IRS have determined that this rule 
is necessary to ensure that foreign jurisdictions cannot reclassify 
income from sales of copyrighted articles as royalties to assert taxing 
rights that are extraterritorial in nature and outside the scope of 
what is an income tax in the U.S. sense.
    Comments recommended that, if the jurisdictional nexus requirement 
is not withdrawn entirely in the final regulations, then payments for 
services and payments for digital goods should be excepted from the 
source-based nexus requirement. With respect to payment for services, 
the comments argued that the U.S. source rule for services is not the 
international norm; many countries impose withholding tax on payment 
for services made by a resident in the country (or by a nonresident 
with a permanent establishment in the country). Comments noted that the 
UN Model Tax Convention allows contracting states to impose withholding 
taxes on a variety of services fees, and that the United States has 
income tax treaties with foreign jurisdictions that allow the foreign 
country to withhold tax on payments for services not performed in that 
country. Several comments also asserted that withholding taxes on 
payments for services are not novel taxes, but rather are long-standing 
taxes that are also creditable under existing Sec.  1.903-1. 
Specifically, comments pointed to Example 3 of existing Sec.  1.903-
1(b)(3), which concludes that a gross basis tax imposed on a 
nonresident for technical services performed outside the country 
imposing the tax are creditable. As such, the comments stated, these 
withholding taxes are consistent with international norms and the final 
regulations should continue to allow these taxes to be creditable.
    In addition, comments expressed concern about the increased 
incidence of unrelieved double taxation in respect of cross-border 
payments for digital services. The comments suggested that under 
proposed Sec.  1.861-19, essentially all cloud transactions, as defined 
in those proposed regulations, will be classified as services for 
Federal income tax purposes. As such, foreign withholding taxes imposed 
on payments for those services, if not imposed on the basis that the 
services are performed in the country, would be non-creditable under 
the proposed source-based nexus requirement. Comments also pointed out 
that the effect of the source-based nexus requirement in the 2020 FTC 
proposed regulations is to create disparate treatment for software 
suppliers based on the approach a supplier adopts to commercializing 
the software. As an example, comments pointed out that a software 
supplier that makes software available through limited time 
subscription is treated under Federal income tax rules as receiving 
payments of service fees, whereas a software supplier that provides 
software to users through downloads under limited-time licenses is 
treated as receiving payments of rents. If a foreign country imposes 
withholding taxes on both payments, the withholding tax paid by the 
first software supplier would not be creditable (because the U.S. 
source rules would not permit the service payment to be sourced based 
on the location of the user) whereas the taxes paid by the second 
supplier would be creditable (because U.S. source rules would permit 
the rental payment to be sourced based on where the user installs the 
software copy). The comments argued that there is no policy 
justification for such disparate results.
    The Treasury Department and the IRS have determined that it is 
necessary and appropriate to narrow the circumstances under existing 
law (for example, as illustrated in Example 3 of Sec.  1.901-1(b)(3)) 
in which withholding taxes on payment for services are creditable. The 
taxation of services performed by

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nonresidents, under U.S. tax law, is clearly limited to cases in which 
the services are performed in the United States. Nothing in the Code, 
legislative history, or case law indicates that a different approach is 
appropriate for technical or digital services. The Treasury Department 
and the IRS have determined that the assertion of foreign withholding 
taxes on income from services that are not performed within the foreign 
jurisdiction is not consistent with an income tax in the U.S. sense and 
therefore should not qualify for a credit under section 901.
    Furthermore, the Code provides for disparate treatment of classes 
of income depending on whether the transaction that gives rise to the 
income is characterized as a service, license, sale, or something else. 
This different treatment is also reflected in existing international 
norms, including the OECD Model Tax Convention. Seeking to conform the 
treatment of digital transactions under the Code, or to anticipate 
possible future changes to the treatment or classification of digital 
transactions, is beyond the scope of these regulations. Instead, the 
Treasury Department and the IRS have determined that analyzing whether 
a foreign tax is an income tax based on how such income is 
characterized under foreign law and comparing the foreign tax law 
sourcing rule to U.S. tax principles, provides adequate flexibility to 
account for differences between U.S. and foreign law, while adhering to 
the requirement that a foreign tax be an income tax in the U.S. sense 
to be creditable. Thus, the final regulations do not adopt the 
recommendation to except digital services from the jurisdictional nexus 
requirement.
    One comment noted that the 2020 FTC proposed regulations could 
create different results for sales of software, depending on whether 
the software is delivered on tangible media or delivered by way of 
digital download because there are different U.S. source rules for such 
transactions. As an example, the comment explained that a sale of a 
software copy that is delivered on tangible media is sourced, under 
U.S. income tax principles, based on title passage, whereas the sale of 
a copyrighted article delivered through an electronic medium is deemed 
to occur, under proposed Sec.  1.861-18(f)(2)(ii), at the location of 
download or installation. The comment further noted that if proposed 
Sec.  1.861-18(f)(2)(ii) is not finalized, and the title passage rule 
continues to apply to digital deliveries, then for U.S. income tax 
purposes, the source of the income would be determined based upon where 
the servers from which the software copy is made available is located. 
The comment argued that these distinctions should not be the basis for 
causing the supplier of the software to be eligible or ineligible for a 
foreign tax credit.
    The Treasury Department and the IRS have determined that it is 
unnecessary to require a foreign tax law's sourcing rule for income 
derived from the sale or other disposition of property to conform with 
U.S. source rules. This is because under the Code, the United States 
imposes tax on such income of a nonresident only if the nonresident 
conducts a U.S. trade or business (if applicable, through a U.S. 
permanent establishment) or the income is derived from real or movable 
property situated in the United States. Thus, the final regulations 
provide that, with respect to foreign tax imposed on income derived 
from the sale or other disposition of property, including copyrighted 
articles sold through an electronic medium, the tax meets the 
attribution requirement only if the inclusion of the income in the 
foreign tax base meets the activities-based nexus requirement in Sec.  
1.901-2(b)(5)(i)(A) or the property-based nexus requirement in 1.901-
2(b)(5)(i)(C).
5. Activities-Based Nexus Requirement
    One comment stated that the physical presence and permanent 
establishment standard is not an inherent part of the U.S. tax system; 
rather, it is a political invention in the 1920s that was the result of 
bargaining between the United States and its treaty partners. The 
comment stated that by adopting this standard in the 2020 FTC proposed 
regulations, the Treasury Department and the IRS ignored the economic 
realities of digital economies and lacked reasoned decision-making. The 
comment recommended that the final regulations provide that the 
jurisdictional nexus requirement is satisfied when consumers of a 
service rendered by a foreign corporation are located in the taxing 
jurisdiction.
    The Treasury Department and the IRS disagree with the comment's 
assertion that the physical presence and permanent establishment 
standard is not an appropriate measure for nexus. The permanent 
establishment standard is a critical part of the U.S. Model Income Tax 
Convention, existing U.S. bilateral tax treaties, and the OECD Model 
Tax Convention. Furthermore, a physical presence standard is consistent 
with the nexus rules in section 864, which provide that only income 
effectively connected with a trade or business that a foreign resident 
conducts in the United States is subject to U.S. tax. Contrary to the 
comment's contention, the 2020 FTC proposed regulations did not ignore 
the economic realities of digital economies; rather, they adopted a 
standard based on the existing Code and traditional international 
taxing norms. The Treasury Department and the IRS have determined that 
the income tax principles in the Code do not allow for the assertion of 
taxing rights based solely on the existence of consumers in a 
jurisdiction.
    One comment asserted that, where the foreign law includes elements 
in common with the effectively connected income standard under section 
864(c), a broader standard for attributing income to nonresidents on 
the basis of the nonresidents' activities as well as activities of the 
nonresident's related parties should satisfy the activities-based nexus 
requirement of the 2020 FTC proposed regulations. The Treasury 
Department and the IRS disagree with this comment. Taking into account 
activities of the nonresident's related parties would be inconsistent 
with the principles reflected in the U.S. Model Income Tax Convention, 
and the OECD Model Tax Convention, as well as in section 864 (unless 
the other party is acting on behalf of the nonresident). Accordingly, 
the final regulations at Sec.  1.901-2(b)(5)(i)(A) clarify that the 
activities-based attribution requirement is not met when the 
nonresident is deemed to have a trade or business in the taxing 
jurisdiction by reason of activities conducted by another person, or 
when the foreign tax law attributes profits to the nonresident based 
upon the activities of another person, other than in the case of a 
party acting on behalf of the nonresident or in the case of a pass-
through entity of which the nonresident is an owner. In addition, the 
final regulations clarify in Sec.  1.901-2(b)(5)(i)(A) that foreign tax 
law that attributes income to a nonresident by taking into account as a 
significant factor the mere location of persons from which a 
nonresident makes purchases does not meet the activities-based nexus 
requirement.
    Comments requested that taxes paid to Puerto Rico be exempted from 
the application of the jurisdictional nexus requirement because, as a 
U.S. territory, its taxes should not be treated in the same manner as 
taxes imposed by a foreign country. For Federal income tax purposes, a 
credit is allowed for income taxes paid or accrued to any foreign 
country or United States territory. See section 901(b)(1); see also 
section 903. As no distinction is made between taxes imposed by foreign 
countries and those imposed by U.S. territories, the final regulations 
follow the 2020 FTC

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proposed regulations in applying the same standards in defining what is 
a creditable income tax regardless of whether the tax is imposed by a 
foreign country or a U.S. territory. However, as described in more 
detail in part IV.F.2 of this Summary of Comments and Explanation of 
Revisions, a special transition rule applies to defer for one year the 
applicability date of the final regulations under section 903 with 
respect to certain taxes paid to Puerto Rico.
    Another comment recommended that the example in proposed Sec.  
1.901-2(c)(3) (Sec.  1.901-2(b)(5)(iii) of the final regulations) be 
expanded to illustrate the application of the attribution requirement 
in the case where a nonresident taxpayer is earning income from 
electronically supplied services in a country that imposes tax on such 
services (ESS tax) and the taxpayer either (1) maintains its own branch 
in the foreign country imposing the tax, with employees of the branch 
conducting routine sales, marketing, and customer support functions or 
(2) uses a related party disregarded entity resident in that country to 
perform local marketing, customer support, and other routine functions. 
With respect to the second scenario, the comment noted that where the 
ESS tax is imposed on the resident disregarded entity, if the entity's 
tax base 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, then the ESS tax 
would meet the residence-based nexus requirement and would be 
creditable. The comment suggested that in the first scenario, although 
the ESS tax is not imposed on the basis of a nonresident's activities 
located in the country, the portion of the ESS tax that corresponds to 
the portion of a separate nonresident corporate income tax imposed on 
the branch's effectively-connected income that would meet the 
activities-based requirement (based on the actual activities performed 
by the branch) should be considered to meet the activities-based nexus 
requirement if the country does not impose the tax on the branch's 
effectively-connected income.
    The Treasury Department and the IRS agree with the comment's 
analysis and conclusion in the second scenario but disagree with the 
analysis and conclusion in the first scenario. Whether a foreign tax 
meets the requirements of Sec.  1.901-2(b), including the attribution 
requirement, is determined based solely on the terms of the foreign tax 
law, and not on a taxpayer's specific facts. Thus, the fact that a 
separate levy that the foreign country could have imposed on 
nonresident taxpayers with respect to their branch operations in the 
foreign country could meet the attribution requirement in a particular 
factual circumstance does not mean that a different tax that is an ESS 
tax, or any portion of an ESS tax, would be deemed to meet the 
attribution requirement.
6. Property-Based Nexus Requirement
    One comment requested clarification on whether a foreign tax law 
similar to the U.S. Foreign Investment in Real Property Tax Act 
(FIRPTA) regime under section 897 would satisfy the proposed property-
based nexus requirement. It noted that under the 2020 FTC proposed 
regulations, a foreign tax law identical to FIRPTA may not meet the 
proposed property-based nexus rule if (consistent with section 897) it 
included in the tax base a portion of the gain from the sale of shares 
in a foreign real property holding corporation (within the meaning of 
section 897(c)(2)) that does not correspond to foreign real property 
interests. The comment further noted that a foreign levy imposed on a 
nonresident's gain from the sale of shares of a corporation 
attributable to real property in the taxing jurisdiction would be 
creditable under the proposed property-based nexus rule, even if 
(inconsistent with section 897) the corporation is not a resident of 
the taxing jurisdiction.
    In response to this comment, the final regulations at Sec.  1.901-
2(b)(5)(i)(C) clarify that a foreign tax may include in its base gross 
receipts that are attributable to the sale or disposition of real 
property situated in the foreign country, or to the disposition of an 
interest in a corporation or other entity that is a resident of the 
foreign country that owns real property situated in the foreign 
country, under rules reasonably similar to those in section 897. In 
addition, a foreign tax imposed on the basis of the situs of property 
may include in its base gains derived from the sale or other 
disposition of property forming part of the business property of a 
taxable presence in the foreign country as well as gains from the 
disposition of an interest in a partnership or other passthrough entity 
that has a taxable presence in the foreign country to the extent the 
gains are attributable to the entity's business property in that 
foreign country, under rules that are reasonably similar to those in 
section 864(c). A foreign tax on any other gains of a nonresident will 
not satisfy the property-based attribution requirement.
7. Interaction With Income Tax Treaties
    The preamble to the 2020 FTC proposed regulations confirmed that 
the proposed regulations in Sec. Sec.  1.901-2 and 1.903-1, 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.
    One comment recommended that the final regulations expressly 
provide that the regulations will not affect the creditability of 
foreign taxes covered by an existing income tax treaty. The comment 
also argued, however, that relying on the U.S. treaty network as the 
sole mechanism for relieving double tax for companies operating in 
foreign countries with source or other jurisdictional taxing norms that 
differ from U.S. taxing norms is not equitable. It noted that the 
United States only has income tax treaties with 68 countries, and that 
the United States has few treaties with countries in South America and 
Africa. The comment stated that the treaty negotiation process is 
laborious and that the Treasury Department considers the level of trade 
and investment between the countries in determining with which 
countries it engages in treaty negotiations, with the result being that 
the United States has historically declined to negotiate treaties with 
countries that have smaller economies, including developing countries.
    Another comment requested that the Treasury Department and the IRS 
specifically address the interaction of the jurisdictional nexus 
requirement with U.S. income tax treaties that have allowed the treaty 
partner to impose a capital gains tax on a nonresident taxpayer on the 
sale of stock of a corporation resident in the treaty country 
regardless of whether the shares constitute a real property interest or 
are attributable to a permanent establishment in the treaty country. 
The comment noted that, despite the statement in the preamble to the 
2020 FTC proposed regulations, it is unclear how the double taxation 
articles of U.S. income tax treaties, which often provide that the 
United States agrees to allow a foreign tax credit subject to the 
limitations of U.S. law, would be interpreted in light of these 
regulations. The comment recommended that the Treasury Department and 
the IRS modify the jurisdictional nexus requirement such that foreign 
taxes imposed on gains from the disposition of stock of a corporation 
sourced on the

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basis of residence of the corporation continue to be creditable.
    Comments also asked for clarification regarding the effect the 
final regulations would have on a foreign tax that is a covered tax 
under an existing U.S. income tax treaty if the foreign tax is paid by 
a CFC, which is not eligible for the benefits given to U.S. residents 
under the treaty. One comment noted that because CFCs are not U.S. 
residents, taxes paid by the CFC on a foreign-to-foreign payment would 
not be creditable under the U.S. income tax treaty with the source 
country. The comment questioned whether this means that a foreign tax 
would not be creditable when paid or accrued by a CFC even though it 
would be creditable if paid or accrued directly by a U.S. taxpayer.\5\ 
The comment pointed out that in this case, the United States has 
already acknowledged the legitimacy of the treaty partner's claim to 
taxing rights, even if it conflicts with U.S. principles; thus, the tax 
should be creditable even if paid by a CFC. Another comment similarly 
noted that, in respect of foreign taxes imposed on gains from the 
disposition of stock of a resident corporation that are creditable 
under certain U.S. treaties, such treaties would ensure creditability 
of those taxes only when paid by U.S. persons, and not, for example, 
when paid by an upper-tier CFC upon the disposition of lower-tier CFC 
stock.
---------------------------------------------------------------------------

    \5\ Another comment made a similar point in connection with 
recommending that all proposed revisions to the net gain requirement 
be withdrawn. That comment noted that taxpayers that are operating 
in a country with which the United States has an income tax treaty 
may not be insulated from uncertainty regarding the creditability of 
foreign taxes because the treaties are unclear as to the 
creditability of foreign taxes listed in the treaty that are 
incurred by foreign subsidiaries and deemed paid by U.S. taxpayers 
under section 960. That comment is addressed in this part IV.A.7. of 
the Summary of Comments and Explanation of Revisions.
---------------------------------------------------------------------------

    In response to these comments, the final regulations clarify in 
Sec.  1.901-2(a)(1)(iii) that a foreign tax that is treated as an 
income tax under the relief from double taxation article of an income 
tax treaty that the United States has entered into with the country 
imposing the tax meets the definition of a foreign income tax as to 
U.S. citizens and residents of the United States that elect to claim 
benefits under that treaty. However, as the comments noted, CFCs are 
not treated as U.S. residents under U.S. income tax treaties, so CFCs 
resident in a third country do not qualify for benefits under U.S. 
income tax treaties. Because U.S. income tax treaties do not limit the 
application of the treaty partner's taxes imposed on third-country 
CFCs, the final regulations clarify that taxes paid to a U.S. treaty 
partner by a third-country CFC are treated as a separate levy that must 
independently satisfy the requirements of section 901 or 903 to be 
creditable.
    However, the final regulations clarify that any limitations that a 
foreign country has agreed to under its treaties with other 
jurisdictions that apply to nonresident CFCs would be taken into 
account in determining whether such levy meets the requirements of 
Sec.  1.901-2(b) or Sec.  1.903-1(b) when paid by the CFC. See Sec.  
1.901-2(a)(1)(iii). Thus, for example, in determining whether a foreign 
country's nonresident corporate income tax meets the activities-based 
jurisdictional requirement of Sec.  1.901-2(b)(5)(i)(A), when the tax 
is paid by a CFC that is resident in a third country, any limitations 
or modifications that the first foreign country has agreed to under the 
permanent establishment and business profits articles of an income tax 
treaty with the third country are taken into account. The final 
regulations make corresponding modifications to the separate levy rules 
to provide that a foreign levy that is modified by a particular treaty 
is treated as a separate levy. See Sec.  1.901-2(d)(1)(iv).
B. Net Gain Requirement
1. In General
    The 2020 FTC proposed regulations modified the net gain requirement 
to limit the role of the predominant character analysis in determining 
whether a tax meets each of the components of the net gain 
requirement--the realization requirement, the gross receipts 
requirement, and the net income requirement (which under the 2020 FTC 
proposed regulations is referred to as the cost recovery requirement). 
The 2020 FTC proposed regulations also limited the prevalence of the 
empirical analysis required by the existing regulations, which asks 
whether a foreign tax is likely to reach net gain in the ``normal 
circumstances'' in which it applies. Instead, the 2020 FTC proposed 
regulations generally provided that the determination of whether a tax 
satisfies each of the realization, gross receipts, and cost recovery 
requirements under the net gain requirement is based on the terms of 
the foreign tax law governing the computation of the tax base. See 
proposed Sec.  1.901-2(a)(3). The preamble to the 2020 FTC proposed 
regulations explained that reduced reliance on empirical analysis would 
allow taxpayers and the IRS to evaluate the nature of the foreign tax 
based on objective and readily available information and would lead to 
more consistent and predictable outcomes.
    Several comments recommended that instead of finalizing the 
proposed modifications to the net gain requirement, the Treasury 
Department and the IRS should either retain the predominant character 
test of the existing regulations or propose less extensive changes to 
the net gain requirement and provide transition rules. Some of these 
comments stated that the proposed rules would create too rigid a 
standard that would lead to increased instances of double taxation, 
putting U.S. companies at a competitive disadvantage. One comment 
stated that under the proposed standard, a credit may not be allowed 
for a foreign tax that is an income tax in the U.S. sense based on the 
actual operation of the foreign tax. Another comment asserted that the 
proposed standard would place U.S. multinationals operating in 
developing countries at a significant competitive disadvantage compared 
with foreign competitors operating in the same developing countries 
that do not face the same risk of double taxation because they are 
subject to a participation exemption or a less restrictive foreign tax 
credit regime.
    Comments stated that the predominant character and facts and 
circumstances analysis of the existing regulations is a better approach 
because there is a lack of uniformity in the income tax systems across 
different jurisdictions and because a particular country's tax system 
can regularly change over time. Comments stated that the existing 
regulations provide the necessary flexibility to allow a credit to be 
claimed for foreign taxes that are calculated with variations from U.S. 
tax principles. In addition, several comments questioned whether 
administrative difficulties with applying the predominant character 
test of the existing regulations was a legitimate or sufficient 
justification for removing the test, noting that the controversies over 
creditability of foreign taxes have not been pervasive or unresolved 
enough to justify the new more objective standard.\6\ Several comments 
stated that instead of reducing administrative burdens the proposed 
changes add complexity and reduce certainty

[[Page 293]]

because they require taxpayers to compare foreign and U.S. tax law, 
including statutes, regulations, case law, rulings, and pronouncements, 
with any subsequent changes to either foreign or U.S. law requiring re-
evaluation of whether there is sufficient conformity.
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    \6\ One comment made this assertion specifically with respect to 
the removal of the alternative gross receipts test of the existing 
regulation, noting that there have been only three court cases 
involving the gross receipts test over the past four decades. That 
comment is addressed in this part IV.B.1 of the Summary of Comments 
and Explanation of Revisions; other comments regarding the gross 
receipts requirement are discussed in part IV.B.2 of the Summary of 
Comments and Explanation of Revisions.
---------------------------------------------------------------------------

    Comments also asserted that it is not realistic for the Treasury 
Department and the IRS to expect foreign tax law to conform 
substantially to U.S. tax law. These comments noted that different 
jurisdictions use different means to protect their tax base and that 
some countries may have a relatively simple tax regime and choose to 
protect their base through disallowance of deductions. Comments 
suggested that a foreign tax should not have to strictly conform to 
U.S. rules; it should be creditable if it has the essential elements of 
an income tax in the U.S. sense. Comments also asserted that the Code 
definition of gross income and allowable deductions reflect evolving 
priorities of Congress and should not serve as the determinative 
standard of a model income tax that other countries should follow. 
Finally, another comment stated that the significant changes made by 
the 2020 FTC proposed regulations would fundamentally change existing 
U.S. tax laws and policies to a degree that only Congress can implement 
through legislation.
    As explained in part IV.A.2 of this Summary of Comments and 
Explanation of Revisions, Congress did not prescribe a fixed definition 
of the term ``income tax'' for purposes of section 901 or 903. As a 
result, the meaning of the term has been developed and refined through 
administrative guidance and case law since 1919. This body of law has 
followed the guiding principle that the determination of whether a 
foreign tax is an income tax for purposes of sections 901 and 903 is 
made by reference to U.S. tax law. The 1983 final regulations followed 
this principle and, influenced by court opinions decided in the years 
preceding those regulations, adopted an approach that required a 
foreign tax to be examined in the normal circumstances in which the tax 
is applied to determine whether the predominant character of the tax is 
that of an income tax in the U.S. sense. As explained in the preamble 
to the 2020 FTC proposed regulations, the IRS's experience over the 
past 40 years has highlighted the significant administrative 
difficulties with applying the predominant character test, the 
ambiguities inherent in the empirical analysis required to apply the 
test, and the inconsistent outcomes that may result from applying the 
predominant character test. See 85 FR 72089-72092. In addition, the 
courts that applied the 1983 regulations further brought into focus the 
type of quantitative empirical evidence, such as private financial data 
on the extent of disallowed expenses, that the IRS and the taxpayer may 
need to obtain and analyze to determine whether a foreign tax is an 
income tax under the empirical tests of the existing regulations. See, 
for example, Texasgulf Inc. v. Comm'r, 172 F.3d 209, 216 (2d Cir. 1999) 
(court examined statistics for claimed processing allowances and for 
nonrecoverable expenses across a 13-year period derived from a study 
conducted by taxpayer's expert to determine if alternative allowance 
provided under the Ontario Mining Tax effectively compensated for 
nonrecovery of significant expenses); Exxon Corp. v. Comm'r, 113 T.C. 
338 (1999) (both parties relied heavily on expert witnesses from the 
petroleum industry, the U.K. government, and from legal, tax, 
accounting, and economic professions).
    The comments that recommended against the approach in the 2020 FTC 
proposed regulations did not suggest any alternative approaches that 
would not require the empirical analysis necessitated by the existing 
regulations. Due to the difficulty that taxpayers and the IRS face in 
properly applying the existing regulations, the Treasury Department and 
the IRS have determined that it is necessary and appropriate to 
finalize the rule in the 2020 FTC proposed regulations that the 
determination of whether a foreign tax meets the net gain requirement 
is primarily based on the terms of the foreign tax law governing the 
computation of the tax base. This approach allows taxpayers and the IRS 
to evaluate the nature of the foreign tax based on more objective and 
readily available information.
    The Treasury Department and the IRS disagree with the comments that 
suggested that the existing regulations entail minimal administrative 
burdens or that the rules in the 2020 FTC proposed regulations will 
increase administrative burdens. Although the final regulations require 
a comparison of foreign law to U.S. law, that comparison is generally 
done by examining the terms of the foreign tax law, which taxpayers 
must do in any case in order to compute their foreign tax liability, 
rather than by examining difficult-to-obtain foreign tax return and 
private financial data to determine the effect of the tax (as is 
required under the existing regulations).
    In addition, the Treasury Department and the IRS disagree that the 
final regulations will add complexity or create more disputes. The fact 
that relatively few court cases have addressed the definition of an 
income tax under Sec.  1.901-2 does not suggest that the existing 
regulations are clear and easy to apply, but rather that they are 
challenging for the IRS to administer. It is unclear whether taxpayers 
are correctly applying the existing requirements in Sec.  1.901-2 by 
performing the empirical analysis required by the regulations. Because 
the existing regulations are difficult for taxpayers to apply and for 
the IRS to administer, there is potential for the requirements in 
existing Sec.  1.901-2 to be applied incorrectly, a result that is 
detrimental to sound tax administration.
    The Treasury Department and the IRS have determined that the 
changes made in the final regulations will increase certainty and will 
prevent the need for the IRS to gather and evaluate data that are not 
readily available in order to ensure that taxpayers are appropriately 
applying the relevant empirical analysis--particularly in the case of 
novel extraterritorial taxes that are generally imposed on a gross 
basis (such as digital services taxes) and that would meet the 
requirements of the existing regulations only if the nonrecoverable 
costs and expenses attributable to that gross income, together with the 
tax paid by all persons subject to the tax, can empirically be proven 
almost never to result in a loss. The Treasury Department and the IRS 
disagree with comments that suggest that administrative concerns are 
not a sufficient reason for revising the regulations. Having clear, 
administrable rules that can be consistently applied is critical to 
sound tax administration.
    The Treasury Department and the IRS also disagree with the comments 
suggesting that the 2020 FTC proposed regulations reflect a fundamental 
change to existing foreign tax credit policies or that the existing 
regulations do not require taxpayers to compare foreign and U.S. tax 
law (including statutes, regulations, case law, rulings, and 
pronouncements) to determine whether a tax is creditable. In fact, for 
a foreign taxable base that deviates from the U.S. computational norm 
of realized gross receipts reduced by significant costs and expenses, 
the predominant character test by its terms requires taxpayers to 
perform an empirical analysis every year to determine whether a tax is 
creditable, such that changes in the empirical impact of a foreign tax 
(despite no change in the terms of the tax) could impact the 
creditability analysis. The final regulations will simplify the 
determination of whether a

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foreign levy is an income tax in the U.S. sense by eliminating this 
burdensome inquiry.
    Furthermore, the Treasury Department and the IRS disagree that the 
final regulations will result in additional double taxation in a manner 
that is inconsistent with the statute, or that they inappropriately 
place U.S. multinationals at a competitive disadvantage compared to 
foreign competitors from a country with a participation exemption 
regime or a less-restrictive foreign tax credit system. Section 901 
allows credits only for foreign taxes that are income taxes in the U.S. 
sense, and this standard is met only if there is substantial conformity 
in the principles used to calculate the foreign tax base and the U.S. 
tax base. Absent such conformity, no credit is appropriate under 
section 901. Finally, the manner in which foreign countries relieve 
double taxation for its resident taxpayers does not have any bearing on 
the appropriate interpretation of section 901, which provides a credit 
only for foreign income taxes, not all foreign taxes.
    In addition, some comments stated that the proposed rules, which 
focus on the terms of the foreign law in determining whether the net 
gain requirement is met, inappropriately shift the analysis from the 
substance to the form of a foreign levy. In particular, some comments 
asserted that this is inconsistent with court cases, including PPL 
Corp. v. Comm'r, 569 U.S. 329 (2013), in which courts have stated that 
the substantive effects of a tax should be considered when determining 
whether a tax constitutes a foreign income tax. Other comments stated 
that the predominant character analysis of the existing regulations 
better reflects the guidance from cases such as Biddle and Keasbey & 
Mattison Co. v. Rothensies, 133 F.2d 894 (3rd Cir. 1943), which confirm 
that whether a foreign tax is creditable should be determined on the 
basis of its substantive resemblance to an income tax in the U.S. 
sense.
    The Treasury Department and the IRS disagree with comments 
suggesting that the approach adopted in the 2020 FTC proposed 
regulations to minimize the role of empirical analysis is inconsistent 
with the principles applied by the courts in PPL, Biddle, or Keasbey to 
determine whether a foreign tax is an income tax in the U.S. sense. The 
Supreme Court in Biddle established that statutory terms such as 
``income tax'' are properly interpreted to have the meaning understood 
under U.S. tax law; the Keasbey court, citing Biddle, stated that ``a 
tax paid [to] a foreign country is not an income tax within the meaning 
of [section 901] unless it conf[o]rms in its substantive elements to 
the criteria established under our revenue laws.'' Keasbey, 133 F.2d at 
897. The Supreme Court in PPL determined the creditability of the U.K. 
windfall tax by applying the predominant character test of the existing 
regulations, which evaluates the substantive effect of the tax by 
resort to empirical analysis of the effect of alternative methods of 
determining gross receipts and deductible expenses. Citing Biddle, the 
Supreme Court stated that ``instead of the foreign government's 
characterization of the tax, the crucial inquiry is the tax's economic 
effect. In other words, foreign tax creditability depends on whether 
the tax, if enacted in the U.S., would be an income, war profits, or 
excess profits tax.'' PPL, 569 U.S. at 335.
    Consistent with the guiding principle that a creditable tax must be 
an income tax in the U.S. sense, the 2020 FTC proposed regulations 
required a comparison of the foreign tax law to the U.S. tax law to 
determine whether the provisions for computing the base on which the 
foreign tax is imposed conforms with U.S. criteria for an income tax 
(that is, a tax imposed on realized gross receipts reduced by allocable 
costs and expenses). Under the 2020 FTC proposed regulations, the 
foreign government's characterization of the tax or the name given to 
the tax do not control the determination of creditability; rather, the 
determination involves an examination of the substantive provisions of 
the foreign tax law that govern the computation of the income that is 
subject to tax. The Supreme Court in PPL was applying the predominant 
character test in the existing regulations and was not interpreting the 
statute. Because the final regulations modify the standard for 
determining whether a foreign levy is an income tax in the U.S. sense, 
the final regulations do not conflict with the PPL decision. Thus, the 
Treasury Department and the IRS disagree with the comments' contentions 
that the 2020 FTC proposed regulations have inappropriately shifted the 
inquiry away from the substance, or the substantive economic effect, of 
the foreign tax.
2. Alternative Gross Receipts Test
    The 2020 FTC proposed regulations removed the ``alternative gross 
receipts test'' in existing Sec.  1.901-2(b)(3), which provided that a 
foreign tax meets the gross receipts requirement if it is 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. Under 
proposed Sec.  1.901-2(b)(3)(i), a foreign tax meets the gross receipts 
tests only if the tax is imposed on actual gross receipts, or is 
imposed on deemed gross receipts arising from pre-realization timing 
difference events (for example, a mark-to-market regime, tax on the 
physical transfer, processing, or export of readily marketable 
property, or a deemed distribution or inclusion), or is imposed on the 
basis of gross receipts from an insignificant non-realization event. In 
addition, proposed Sec.  1.901-2(b)(3)(i) provided that, for purposes 
of the gross receipts test, amounts that are properly allocated to a 
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.
    Several comments criticized the removal of the alternative gross 
receipts test and asked that it be retained. Comments stated that 
eliminating the alternative gross receipts test creates an overly 
restrictive gross receipts requirement that can cause foreign taxes to 
not qualify as income taxes due to small or formalistic differences in 
how foreign law measures gross receipts as compared to U.S. law. One 
comment noted that it is not unusual for taxing jurisdictions to 
provide alternate measures of gross receipts to avoid compliance 
difficulties. The comment also noted that U.S. tax law uses alternative 
gross receipts, such as using the applicable Federal rate (determined 
by the IRS) to determine interest deemed to be received by certain 
lenders. Other comments noted that the U.S. standards for measuring 
gross receipts and gross income have changed over time, and there is no 
static view of gross receipts against which to measure foreign law. One 
such comment pointed to realized cash receipts, the accrual method, 
financial statement income, and in limited instances mark-to-market as 
examples of varying ways to compute gross receipts. Another comment 
pointed to the changes to the rules for determining the taxable year 
for income inclusions under section 451 from 2012 to 2018.
    One comment asserted that the proposed regulation's treatment of 
alternative measures of gross receipts determined by applying a markup 
to costs (which does not meet the gross receipts requirement) is 
irreconcilable with the rule in proposed Sec.  1.901-2(b)(3)(i) that 
treated allocations of gross income under transfer pricing methods to a 
taxpayer as actual gross receipts. The comment contended that there is 
no

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logical reason for treating a foreign law that allows taxpayers to use 
a cost-plus transfer pricing methodology as meeting the gross receipts 
test, but not a foreign law that uses a measurement of gross receipts 
based on costs, and that the 2020 FTC proposed regulations will result 
in significant controversy in distinguishing the two situations. The 
comment recommended that the Treasury Department and the IRS continue 
to treat foreign income taxes based on alternative measurements of 
gross receipts as meeting the gross receipts test, so long as the 
taxpayer can show that the alternative is likely to produce an amount 
not greater than fair market value.
    One comment requested clarification on how the proposed rules would 
apply in situations where the foreign jurisdiction imposes a levy on a 
combination of actual gross receipts and receipts computed based on 
some other method.
    In addition, comments pointed out that the Treasury Department and 
the IRS previously proposed to eliminate the alternative gross receipts 
test in the 1980 proposed and temporary regulations under sections 901 
and 903, but after extensive consideration decided to retain it in the 
1983 final regulations. The comments asked the Treasury Department and 
the IRS to justify the reconsideration of the elimination of the 
alternative gross receipts test, given that such elimination was 
previously rejected.
    The Treasury Department and the IRS have determined that it is 
necessary and appropriate to remove the alternative gross receipts test 
because, in general, a tax that is imposed on an amount greater than 
actual realized gross receipts, or greater than the value of property, 
is not an income tax in the U.S. sense. In addition, the decision to 
provide an alternative gross receipts test in the 1983 final 
regulations, even if made in response to comments, does not preclude 
the Treasury Department and the IRS from later re-evaluating and 
removing the rule. The IRS' experience with applying the alternative 
gross receipts test has shown that the test is vague and unduly 
burdensome to administer because of the empirical evaluation needed to 
determine whether the alternative method is likely to produce an amount 
that is not greater than fair market value.
    However, in response to comments received, the final regulations 
provide that deemed gross receipts resulting from deemed realization 
events or insignificant non-realization events that meet the 
realization requirement in Sec.  1.901-2(b)(2) will meet the gross 
receipts requirement if the deemed gross receipts are reasonably 
calculated to produce an amount that is not greater than fair market 
value. For example, deemed gross receipts resulting from a mark-to-
market regime or foreign tax law that imputes interest income under a 
provision similar to section 7872 would satisfy the gross receipts 
requirement.
    The Treasury Department and the IRS disagree with the comment that 
seems to conflate a situation when actual gross receipts arise from a 
transaction between related parties that is priced under a cost-plus 
transfer pricing methodology with the transactions contemplated in the 
2020 FTC proposed regulations. Such a related-party transaction is 
distinct from a foreign levy that imposes tax on deemed gross receipts 
that are determined based upon a markup of costs rather than the actual 
gross receipts from the transaction among unrelated parties. The former 
involves using a transfer pricing methodology to determine the 
appropriate payment (that is, the actual gross receipts as reported or 
adjusted for tax purposes) that a taxpayer in a transaction with a 
related party should receive based upon arm's length principles. In 
contrast, in the context of transactions between unrelated parties, 
using a measure of deemed gross receipts based on costs may have no 
relationship to the actual gross receipts.
    However, the Treasury Department and the IRS have determined that 
the reference in proposed Sec.  1.901-2(b)(3)(i) to gross receipts that 
are properly allocated to a taxpayer under a foreign tax meeting the 
jurisdictional nexus requirement was potentially confusing and 
unnecessary, because such a related party transfer pricing methodology 
would result in actual gross receipts, either by means of an actual 
payment or a constructive payment resulting from a receivable recorded 
on the taxpayer's books and records. Accordingly, the reference to 
gross receipts determined under a transfer pricing methodology is 
removed from the final regulations, and an example is added to the 
final regulations at Sec.  1.901-2(b)(3)(ii)(B) to illustrate the 
intended application of the rule.
3. Cost Recovery Requirement
    The 2020 FTC proposed regulations modified various aspects of the 
net income test of the existing regulations (referred to as the ``cost 
recovery requirement'' under the 2020 FTC proposed regulations) to 
ensure that a foreign tax is a creditable tax only if the determination 
of the foreign tax base conforms in essential respects to the 
determination of taxable income under the Code.
    Several comments recommended against adopting the proposed changes 
to the cost recovery requirement out of concern that the proposed 
changes will result in more instances of unrelieved double taxation. 
One comment asserted that the effect of the revisions to the cost 
recovery requirement would be to limit creditability of foreign levies 
that have been traditionally characterized as income taxes based solely 
on minor deviations between U.S. tax principles and the foreign law. 
The comment asserted that the revised standard is stricter than the 
standard traditionally applied by the courts, and unreasonably narrows 
the standard since the term ``foreign income, war profits, and excess 
profits taxes'' in the statute has not been changed.
    In general, the Treasury Department and the IRS disagree with 
comments that the revised cost recovery standard will result in 
additional unrelieved double taxation in a manner that is inconsistent 
with the policies underlying section 901. This is because double 
taxation that merits relief under section 901 occurs only if there is 
substantial conformity in the principles used to calculate the foreign 
tax base and the U.S. tax base. However, the final regulations modify 
certain aspects of the cost recovery requirement in order to provide 
additional flexibility and to reduce instances where minor deviations 
between U.S. principles and foreign tax law could cause a foreign levy 
to be non-creditable; these changes are described in part IV.B.3.ii and 
iii of this Summary of Comments and Explanation of Revisions.
i. Gross Basis Taxes
    The 2020 FTC proposed regulations removed the nonconfiscatory gross 
basis tax rule of the existing regulations. That rule provided that a 
foreign levy whose base is gross receipts is treated as meeting the 
cost recovery requirement if the foreign levy is almost certain to 
reach 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, 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. Instead, proposed Sec.  1.901-2(b)(4)(i)(A) provided that a 
foreign levy must permit recovery of the significant costs and expenses 
attributable to such gross receipts, or permit recovery of an 
alternative amount that by its terms may be greater, but will never be 
less, than the actual amounts of such significant costs and

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expenses. Proposed Sec.  1.901-2(b)(4)(i)(A) further provided that a 
foreign tax that is imposed on gross receipts or gross income and that 
does not permit recovery of any costs or expenses does not meet the 
cost recovery requirement, 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.
    One comment stated that the removal of the nonconfiscatory gross 
basis tax rule is inconsistent with court decisions that predate the 
1983 regulations and that have concluded that a tax on gross receipts 
may qualify as a creditable income tax so long as it reaches net 
income. The comment specifically cited Seatrain Lines, Inc. v. Comm'r, 
46 B.T.A. 1076 (1942), Santa Eulalia Mining Co. v. Comm'r, 2 T.C. 24 
(1943), and Bank of America Nat. Trust & Sav. Ass'n v. U. S., 459 F.2d 
513 (Ct. Cl. 1972). The comment stated that in determining whether a 
foreign levy is an income tax, the courts focus on the nature of the 
income that is the subject of the tax and whether that type of income 
is likely to involve significant expenses that could result in a net 
loss being realized from the activity being taxed. The comment further 
contended that digital services taxes would qualify as creditable 
income taxes under this analysis, because the amounts of costs and 
expenses associated with the type of gross receipts subject to the 
digital services taxes are never so high as to cause businesses subject 
to the tax to incur a loss after payment of the tax. No explanation or 
evidence (whether empirical or anecdotal) was provided to support this 
assertion.
    The comment further asserted that the explanation for the proposed 
change in the preamble to the 2020 FTC proposed regulations is 
unpersuasive. It contended that the court decisions involving the net 
gain requirement have not reflected any administrative difficulties. As 
such, the comment stated that the removal of the nonconfiscatory gross 
basis tax rule in the 2020 FTC proposed regulations is unjustified and 
recommended that the existing rule be retained.
    The Treasury Department and the IRS have determined that foreign 
taxes that do not permit recovery of significant costs and expenses are 
not income taxes in the U.S. sense. Although some cases preceding the 
1983 regulations, such as those cited in the comment, determined that a 
gross basis tax could be an income tax in the U.S. sense, other cases 
reached a different conclusion. See C.I.R. v. American Metal Co., 221 
F.2d 134 (1955) (a Mexican Production Tax was not creditable because it 
applied regardless of whether miners made a profit or sales); Keasbey, 
133 F.2d 894 (tax imposed under the Quebec Mining Act was not an income 
tax in the U.S. sense because the levy permitted deductions only for 
costs incurred in the mining operation, and not for expenses incident 
to the general conduct of the business); Bank of America, 459 F.2d 513 
(gross basis tax on income of banks did not qualify as an income tax 
under section 901). The Treasury Department and the IRS do not agree 
that a tax is properly considered a tax on net income so long as 
empirical evidence demonstrates that the nonrecoverable costs and 
expenses attributable to the gross receipts or gross income are almost 
never so high as to eliminate any profit after the tax is paid. It is 
unlikely, as a practical matter, that the data required to make such an 
empirical showing of the amounts of disallowed expenses of all 
taxpayers subject to the tax will be available to either taxpayers or 
the IRS other than in the context of a targeted tax of narrow 
application such as the levies considered in Texasgulf or Exxon. In any 
event, such a gross basis tax is so dissimilar to the U.S. income tax 
against which the foreign tax credit is allowed that the Treasury 
Department and the IRS have determined it should not qualify as an 
income tax in the U.S. sense. With respect to the comment that asserted 
that gross basis digital services taxes never result in a loss to 
affected companies, the fact that the comment failed to provide any 
evidence may be indicative of the difficulty of making this empirical 
showing. Furthermore, comments made by the affected industries have 
made clear that gross basis taxes are inconsistent with the fundamental 
nature of an income tax, and could in fact result in taxation of 
companies that are in a loss position.\7\ Accordingly, the final 
regulations largely maintain the approach of the 2020 FTC proposed 
regulations in eliminating the nonconfiscatory gross basis tax rule.
---------------------------------------------------------------------------

    \7\ United States Trade Representative, Section 301 
Investigation, Report on France's Digital Services Tax at 57-58 
(Dec. 2, 2019), available at https://ustr.gov/sites/default/files/Report_On_France%27s_Digital_Services_Tax.pdf (quoting numerous 
comments from digital companies and industry groups attesting that 
the digital service taxes' application to revenue rather than income 
is inconsistent with prevailing principles of international 
taxation). In particular, a member from National Foreign Trade 
Council stated that a ``tax imposed on gross revenue has no 
relationship to net income or profits, which are the only proper 
bases for a corporate income tax.'' Id. at 57. Another industry 
representative stated that a ``tax on ordinary business profits, 
imposed on gross revenue, has no relationship to net income. . . . 
Gross revenue has no relationship to net income, and therefore such 
taxes are not limited to taxing the gains of an enterprise, and will 
drive companies into deeper losses if they are not profitable. Thus, 
such a tax is likely to harm growing companies. . . .''). Id. at 58.
---------------------------------------------------------------------------

    However, upon consideration of the comments, the Treasury 
Department and the IRS agree that a gross basis tax may meet the cost 
recovery requirement if in fact there are no significant costs and 
expenses attributable to the gross receipts included in the taxable 
base. Accordingly, the final regulations at Sec.  1.901-2(b)(4)(i)(A) 
remove the rule in the 2020 FTC proposed regulations that provided that 
a gross basis tax could never meet the cost recovery requirement, even 
if in practice there are no significant costs and expenses attributable 
to the gross receipts included in the foreign tax base. Instead, Sec.  
1.901-2(b)(4)(i)(A) provides that a gross basis tax satisfies the cost 
recovery requirement if there are no significant costs and expenses 
attributable to the gross receipts included in the foreign tax base 
that must be recovered under the rules of Sec.  1.901-2(b)(4)(i)(C)(1). 
In addition, the Treasury Department and the IRS recognize that the 
Code contains various limitations on the recovery of non-business 
expenses that have been modified from time to time. For example, 
miscellaneous itemized deductions, including unreimbursed employee 
expenses, are generally not deductible. Thus, the final regulations 
provide in Sec.  1.901-2(b)(4)(i)(C)(2) that a foreign tax law that 
does not permit recovery of costs and expenses attributable to wages 
and investment income not derived from a trade or business satisfies 
the cost recovery requirement. Furthermore, the final regulations 
clarify in Sec.  1.901-2(b)(4)(i)(A) that a foreign tax need not permit 
recovery of costs and expenses, such as certain personal expenses, that 
are not attributable, under reasonable principles, to gross receipts 
included in the foreign taxable base.
ii. Significant Costs
    Proposed Sec.  1.901-2(b)(4)(i)(A) provided that the cost recovery 
requirement is satisfied if the foreign tax law permits recovery of 
significant costs and expenses attributable to the gross receipts 
included in the foreign tax base. The significance of the cost 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. See 
proposed Sec.  1.901-2(b)(4)(i)(B)(2). In addition, proposed Sec.  
1.901-2(b)(4)(i)(B)(2) specified that certain costs--such as costs or 
expenses related to capital expenditures, interest,

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rents, royalties, services, and research and experimentation--are 
always treated as significant, and thus, must be recoverable.
    The 2020 FTC proposed regulations also addressed foreign expense 
disallowance provisions. Proposed Sec.  1.901-2(b)(4)(i)(B)(2) provided 
that a foreign levy that disallows recovery of all or a portion of a 
significant cost or expense meets the cost recovery requirement if such 
disallowance is consistent with the types of disallowances reflected in 
the Code.
    Several comments recommended that the Treasury Department and the 
IRS retain the standard in the existing regulations and withdraw the 
list of ``per se'' significant costs and expenses in proposed Sec.  
1.901-2(b)(4)(i)(B)(2). Although some comments acknowledged the 
rationale for adding the list of expenses that are always treated as 
significant and thus must be recoverable, they also asserted that this 
rule would create complexities because it would require continued 
evaluation and re-evaluation of U.S. and foreign tax rules. One comment 
noted that there could be changes to either the foreign tax law or the 
U.S. tax law that could cause a foreign tax to be no longer creditable. 
It suggested, as an example, that a foreign tax that includes rules 
identical to current section 163(j), which took effect in 2018, would 
have likely failed the cost recovery requirement in 2017 but would have 
met the cost recovery requirement in 2018.
    One comment recommended that if the per se list of recoverable 
expenses is retained, it should apply only to taxpayers that in fact 
incur a significant amount of such cost or expense, for example, 
amounts in excess of a certain percentage of the particular taxpayer's 
gross receipts. The comment recognized that its recommendation 
conflicts with the rule in the existing and proposed regulations that a 
foreign tax either satisfies or does not satisfy the definition of a 
foreign income tax in its entirety, for all persons subject to the 
foreign tax, but asserted that such a deviation is appropriate because 
a taxpayer should not be denied a credit for a foreign tax because the 
foreign law does not permit or limits recovery of an expense if the 
particular taxpayer does not incur a significant amount of that 
expense.
    One comment questioned why the Treasury Department and the IRS 
retained the empirical analysis in the definition of significance, 
noting that it is contrary to the stated overall purpose of the 
proposed modifications of the net gain requirement to minimize reliance 
on empirical evidence.
    Comments also disagreed with the policy of the 2020 FTC proposed 
regulations of requiring foreign expense disallowance rules to be 
consistent with U.S. disallowances. Comments noted that foreign 
countries have different ways of structuring deduction disallowances 
and different policy goals that they want to achieve through deduction 
disallowances. One comment pointed to interest deduction disallowance 
rules as an example, noting that the U.S. rules have a myriad of 
restrictions on interest deductions, including because in certain 
circumstances interest payments may reflect a return on capital. The 
comment stated that if a foreign jurisdiction prohibits deductions for 
interest payments in some or most circumstances because it views 
interest as a return on capital, that could cause the foreign tax to be 
no longer creditable. The comment asserted that a foreign levy should 
not be non-creditable simply because the foreign jurisdiction has more 
restrictive limitations on interest deductibility. Comments also 
pointed to deduction disallowances for related-party interest payments, 
noting that foreign governments may significantly restrict deductions 
for interest incurred on related party debt. The comments contended 
that such limitations would not be unreasonable, but that it is unclear 
whether a foreign levy with such restrictions would be creditable under 
the 2020 FTC proposed regulations. One comment further asserted that it 
is unfair to disallow foreign tax credits when a foreign country adopts 
disallowance provisions different from U.S. rules, because denial of 
the credit results in double taxation of U.S. taxpayers that have no 
control over the foreign country's policy decisions. Another comment 
stated that the statute does not require strict conformity with U.S. 
tax principles for a foreign tax to be creditable. Thus, foreign tax 
law deviations from U.S. tax law should not cause a foreign levy to be 
non-creditable unless the foreign law expense disallowances are so 
pervasive as to make the foreign base not related to net income.
    Comments also stated that the requirement that foreign cost 
disallowances must be consistent with the types of disallowances in the 
Code will lead to additional administrative burdens for the IRS and 
compliance burdens for taxpayers because the 2020 FTC proposed 
regulations provide insufficient guidance on the application of the 
rule. Comments noted it is unclear the degree to which the foreign tax 
disallowance rule must be similar to U.S. disallowance rules. The 
comment also asked how temporary changes to the U.S. tax rules that are 
intended to ameliorate shorter-term economic or policy concerns, such 
as the changes to section 163(j) under the Coronavirus Aid, Relief, and 
Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020), are 
intended to affect the application of the rule. Similarly, another 
comment noted that foreign countries may have a similar policy goal as 
the United States but may adopt limitations, for example as part of the 
BEPS initiative, on a different timeline than the United States.
    Other comments noted that it is unclear if foreign expense 
disallowance provisions that are not similar to disallowances under the 
Code but that are necessitated by sound tax policy would cause a 
foreign levy to be non-creditable under the 2020 FTC proposed 
regulations. For example, one comment asked whether a foreign country 
that permits full expensing of capital expenditures but disallows any 
deduction for interest expense (which the comment asserts only avoids 
economically duplicative deductions in the case of debt-financed 
investments) would run afoul of the proposed rules because it is not 
consistent with the disallowances in section 162 of the Code. A comment 
queried whether disallowance of deductions under an alternative minimum 
tax regime similar to section 55 or section 59A would be deemed 
consistent with Federal income tax principles for purposes of the cost 
recovery requirement. Comments recommended that if the proposed 
modifications to the cost recovery requirement are finalized, the 
Treasury Department and the IRS should provide additional examples 
illustrating the application of the rule, including examples of 
permissible disallowances as well as examples of disallowances that are 
not identical to Federal income tax rules but are considered consistent 
with U.S. tax principles.
    After consideration of the comments, the Treasury Department and 
the IRS have determined that the final regulations should generally 
maintain the approach of the 2020 FTC proposed regulations, which 
reflects the appropriate balance between accuracy and administrability 
in determining whether the foreign tax law permits recovery of the 
significant costs and expenses attributable to the gross receipts 
included in the foreign taxable base. The costs and expenses that are 
deemed significant under the 2020 FTC proposed regulations are those 
costs and

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expenses that represent substantial deductions claimed by U.S. 
taxpayers in computing the base of the U.S. income tax. Therefore, it 
is reasonable to presume that those enumerated costs also reflect 
substantial costs and expenses of taxpayers operating abroad. The 
Treasury Department and the IRS have determined that it would be 
impossible, as a practical matter, for either taxpayers or the IRS to 
obtain both the private financial data and tax return data, for all 
taxpayers subject to a generally-imposed foreign tax, that would be 
needed to apply the empirical test of the existing regulations to 
determine whether in fact all such taxpayers in the aggregate incurred 
substantial costs and expenses for which deductions were not allowed in 
determining the foreign taxable base. Accordingly, the final 
regulations at Sec.  1.901-2(b)(4)(i)(C)(1) retain the requirement that 
the foreign tax law by its terms must allow recovery of significant 
costs and expenses, including recovery of costs and expenses related to 
capital expenditures, interest, rents, royalties, wages or other 
payments for services, and research and experimentation. In addition, 
Sec.  1.901-2(b)(4)(i)(C)(1) clarifies that the foreign tax law applies 
to determine the character of a particular deduction. For example, if a 
foreign country denies a deduction for a payment made on an instrument 
that is treated as equity for foreign tax purposes, the cost recovery 
requirement is met even if the instrument is treated as debt for U.S. 
tax purposes. In response to comments, Sec.  1.901-2(b)(4)(i)(C)(1) 
also clarifies that foreign tax law that does not permit recovery of a 
significant cost or expense (such as interest expense) is not 
considered to allow recovery of such significant cost or expense by 
reason of the time value of money attributable to the acceleration of a 
tax benefit for a different expense (such as current expensing of 
capital expenditures).
    However, the Treasury Department and the IRS agree that the final 
regulations should clarify the scope of permissible foreign tax law 
expense disallowance rules. Accordingly, the final regulations include 
additional rules and examples at Sec.  1.901-2(b)(4)(i)(C)(1) and Sec.  
1.901-2(b)(4)(iv), respectively, illustrating that foreign tax law 
rules need not mirror U.S. expense disallowance rules, but need only be 
consistent with the principles reflected in U.S. tax law. For example, 
Sec.  1.901-2(b)(4)(i)(C)(1) provides that a rule limiting interest 
deductions to 10 percent of a reasonable measure of taxable income 
(determined either before or after deductions for depreciation and 
amortization) based on principles similar to those underlying section 
163(j) would qualify.
iii. Alternative Allowance Rule
    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 treated as meeting the cost recovery 
requirement. The 2020 FTC proposed regulations modified the alternative 
allowance rule to provide that an alternative allowance meets the cost 
recovery requirement only if the foreign tax law, by its terms, permits 
recovery of an amount that equals or exceeds the actual amounts of such 
significant costs and expenses. See proposed Sec.  1.901-2(b)(4)(i)(A).
    Several comments criticized the modification of the alternative 
allowance rule and recommended that the Treasury Department and the IRS 
retain the standard of the existing regulations. One comment asserted 
that the proposed rules would cause a foreign levy to be non-creditable 
even if the foreign levy provides an allowance that in fact equals or 
exceeds the taxpayer's actual expenses; the comment contends that this 
is arguably inconsistent with the language of the statute. Some 
comments asserted that foreign levies are unlikely to meet the 
requirement that the foreign tax law expressly guarantee that the 
alternative allowance will equal or exceed actual costs because 
alternative allowances are generally designed to avoid compliance 
burdens related to the determination of actual costs. Thus, the 
comments stated, the proposed rules could cause alternative tax regimes 
that foreign countries impose to be non-creditable, even if those 
regimes allow equivalent recovery of expenses in most if not all 
circumstances.
    Some comments disagreed with the statement in the preamble of the 
2020 FTC proposed regulations that alternative allowances fundamentally 
diverge from the approach to cost recovery in the Code; the comments 
pointed out that the Code also has examples of alternative allowances 
(citing to rules regarding travel expense reimbursement, the return on 
intangible income for global intangible low tax income (``GILTI'') and 
foreign-derived intangible income (``FDII''), the standard deduction, 
and certain safe harbor methods for determining home office 
deductions). Comments further stated that U.S. tax rules have allowed 
the use of estimates of expenses in certain circumstances through, for 
example, application of the ``Cohan rule'' (Cohan v. Comm'r, 39 F.2d 
540 (2d Cir. 1930)), which permits courts to allow a tax benefit, such 
as a deduction, if a taxpayer proves entitlement to a tax benefit but 
fails to substantiate the exact amount of the benefit.
    Some comments questioned the preamble's assertion that it is 
difficult in practice 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, noting that the 
taxpayer was able to do so in Texasgulf. One comment asserted that many 
court decisions show that a foreign levy that provides alternative 
allowances for deductions can still be an income tax in the U.S. sense. 
The comment did not cite any court decisions in support of this 
assertion.
    For the reasons explained in part IV.B.1 of this Summary of 
Comments and Explanation of Revisions, the Treasury Department and the 
IRS disagree with comments that the alternative allowance rule of the 
existing regulations is an appropriate or administrable rule. In 
addition, the use of percentages of the basis of certain tangible 
property to compute income for GILTI and FDII purposes is 
distinguishable from providing an alternative allowance in lieu of 
actual costs and expenses to compute the taxable base because these 
allowances are in addition to, and not in substitution for, provisions 
in the Code that allow deductions for the actual costs and expenses 
attributable to gross receipts included in the U.S. tax base. Moreover, 
nothing in the final regulations precludes a foreign tax law from 
allowing deductions in excess of those needed to recover the actual, 
significant costs and expenses of earning taxable gross receipts. 
Finally, the Cohan rule is a judicial doctrine that permits 
approximating actual costs and expenses in limited circumstances where 
the taxpayer demonstrates that it incurred a business expense but kept 
inadequate records to substantiate the exact amounts of such expense. 
Where a taxpayer can substantiate the actual amounts of its business 
expenses, the Code allows those expenses as deductions. Thus, the Cohan 
rule establishes a substantiation standard, but does not modify the 
Code rule allowing actual costs and expenses to be recovered. 
Accordingly, the final regulations retain the rule that a foreign

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tax law must permit the recovery of significant costs and expenses to 
be an income tax in the U.S. sense.
    However, the Treasury Department and the IRS recognize that some 
foreign jurisdictions, in order to relieve administrative and 
compliance burdens on certain small businesses, may provide an 
alternative method for determining deductible costs attributable to 
gross receipts, either as an optional alternative method or as the sole 
method. As the comments noted, the Code contains alternative allowances 
or safe-harbor rules for determining deductible business expenses in 
limited circumstances. As a result, the final regulations at Sec.  
1.901-2(b)(4)(i)(B)(1) provide that the cost recovery requirement is 
satisfied if the foreign tax law allows the taxpayer to choose between 
deducting actual costs or expenses or an optional allowance in lieu of 
actual costs and expenses. In addition, the Treasury Department and the 
IRS have determined that additional flexibility is warranted to 
accommodate alternative allowances in lieu of actual cost recovery, if 
the alternative measures are designed to minimize administrative or 
compliance burdens with respect to small taxpayers. Accordingly, the 
final regulations at Sec.  1.901-2(b)(4)(i)(B)(2) provide an exception 
for these types of alternative allowances.
C. Tax in Lieu of Income Tax
1. In General
    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. Under the 2020 FTC proposed regulations, 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. See proposed Sec.  
1.903-1(b)(2). A foreign tax (the ``tested foreign tax'') satisfies the 
substitution requirement, if based on the foreign tax law, it meets the 
four requirements in proposed Sec.  1.903-1(c)(1): The generally-
imposed net income tax requirement, the non-duplication requirement, 
the close connection requirement, and the jurisdiction-to-tax 
requirement.
2. Generally-Imposed Net Income Tax Requirement
    To meet the generally-imposed net income tax requirement, a 
separate levy that is a net income tax (as defined in proposed Sec.  
1.901-2(a)(3)) must be generally imposed by the same foreign country 
(the ``generally-imposed net income tax'') that imposed the tested 
foreign tax. Comments stated that the 2020 FTC proposed regulations 
would unduly limit a foreign levy's qualification as a creditable ``in 
lieu of tax'' by requiring the generally-imposed net income tax to 
satisfy proposed Sec.  1.901-2, particularly as it has been revised to 
require more similarity to U.S. tax principles. One comment further 
explained that a tested foreign tax would not satisfy the generally-
imposed net income tax requirement with respect to a foreign 
jurisdiction that limits the deductibility of interest under rules that 
are inconsistent with the Code. Because these comments request 
relaxation of the rules in proposed Sec.  1.901-2, as opposed to 
changes to proposed Sec.  1.903-1, the responses to these comments are 
addressed above at part IV.A of this Summary of Comments and 
Explanation of Revisions, with respect to the jurisdictional nexus 
requirement, and at part IV.B, with respect to the net gain 
requirement.
3. Non-Duplication Requirement
    Under the non-duplication requirement, neither the generally-
imposed net income tax nor any other net income tax imposed by the 
foreign country may be imposed with respect to any portion of the 
income to which the amounts that form the base of the tested foreign 
tax relate (the ``excluded income''). A tested foreign tax does not 
meet this requirement if a net income tax imposed by the same country 
applies to the excluded income of any persons that are subject to the 
tested foreign tax, even if not all persons subject to the tested 
foreign tax are subject to the net income tax.
    Comments asserted that the non-duplication requirement is 
inconsistent with the interpretation of the substitution requirement in 
Metropolitan Life Ins. Co. v. United States, 375 F. 2d 835 (Ct. Cl. 
1967), which held that the Canadian premiums tax was ``in lieu of'' the 
income tax for mutual life insurance companies, which were only subject 
to the premiums tax, even though other types of insurance businesses 
were subject to both the Canadian premiums tax and the generally-
imposed net income tax. As such, comments recommended that the non-
duplication requirement apply on a taxpayer-by-taxpayer basis, and any 
loss of creditability of taxes paid should be limited to income that is 
actually subject to both the generally-imposed net income tax and the 
tested foreign tax.
    Under the existing regulations, a foreign levy is either creditable 
or not creditable for all taxpayers subject to the levy. This ``all or 
nothing rule'' applies under existing Sec.  1.903-1 to the 
determination of whether a foreign tax is an in lieu of tax. The 2020 
FTC proposed regulations similarly provided as part of the non-
duplication requirement that a foreign levy that is imposed in addition 
to the generally-imposed net income tax with respect to some taxpayers 
is not a tax that is imposed in substitution for, or in lieu of, a 
generally-imposed net income tax. The Treasury Department and the IRS 
have determined that analyzing each tested foreign tax based on how it 
applies to each taxpayer (instead of analyzing the tax as a whole) 
would significantly increase compliance and administrative burdens for 
taxpayers and the IRS. Moreover, allowing a tested foreign tax to 
qualify as an in lieu of tax for any taxpayer when some taxpayers pay 
both the tested foreign tax and the generally-imposed income tax on 
income from the same activity is inconsistent with the notion that the 
foreign country made a deliberate choice to create and impose a 
separate levy instead of imposing the generally-imposed net income tax 
on the excluded income. Accordingly, the final regulations retain the 
``all or nothing'' rule in the non-duplication requirement.
    Comments stated that it would be difficult for both the IRS and 
taxpayers to determine how a tested foreign tax would apply to all 
taxpayers subject to the levy, given that the tax can be applied on a 
basis other than income. The 2020 FTC proposed regulations apply based 
on the terms of the foreign tax law, not how the tax applies in 
practice. To determine whether a tested foreign tax is creditable, the 
taxpayer is not required to analyze how the tested foreign tax applies 
on a taxpayer-by-taxpayer basis in practice, but instead is required 
only to analyze the foreign tax law. Therefore, the provision is 
finalized without change.
4. Close Connection Requirement
    The close connection requirement in the 2020 FTC proposed 
regulations requires that, 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 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. 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

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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. This 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.
    One comment suggested that the close connection requirement can be 
read to be met only if the tested foreign tax applies to activities 
that were initially subject to the generally-imposed net income tax and 
then expressly excluded from its scope, and not if the activities 
subject to the tested foreign tax were never within the scope of the 
generally-imposed net income tax. The Treasury Department and the IRS 
did not intend for the regulations to apply in this manner. Therefore, 
the final regulations at Sec.  1.903-1(c)(1)(iii) clarify that a close 
connection also exists if the generally-imposed net income tax by its 
terms does not apply to the excluded income, and the tested foreign tax 
is enacted contemporaneously with the generally-imposed net income tax.
    Comments asserted that the close connection requirement goes beyond 
the language of section 903, which comments maintained requires only 
that the tested foreign tax be imposed in place of the generally-
imposed net income tax; not that the generally-imposed net income tax 
would otherwise apply to the taxpayer. Comments also asserted that the 
close connection requirement should be removed because the non-
duplication requirement is sufficient for ensuring that the tested 
foreign tax does not duplicate the tax base of the generally-imposed 
net income tax. Some comments also stated that the requirement that the 
taxpayer provide proof that the generally-imposed net income tax 
``would be imposed'' absent the tested foreign tax contradicts the 
court's finding in Metropolitan Life.
    The Treasury Department and the IRS have determined that the close 
connection requirement is consistent with a reasonable construction of 
the term ``in lieu of'' in section 903. According to Black's Law 
Dictionary, ``in lieu of'' means ``to be instead of'' which implies a 
connection between the imposition of the tested foreign tax and the 
absence of a generally-imposed net income tax. Otherwise, the statute 
would have provided that a credit would be allowed for any tax paid by 
persons not subject to a generally-imposed net income tax. The mere 
fact that two taxes may be mutually exclusive with respect to some 
subset of taxpayers does not demonstrate that one is ``in lieu'' of the 
other.
    Furthermore, the requirement that taxpayers demonstrate a close 
connection is consistent with the text of section 903 as well as court 
decisions interpreting section 903. The Treasury Department and the IRS 
disagree that the close connection requirement contradicts the court's 
finding in Metropolitan Life. Rather, the ``close connection'' 
requirement is taken directly from Metropolitan Life, 375 F.2d at 839-
40 (``We have found `a very close connection between the imposition of 
the Canadian premiums taxes involved here and the failure to impose 
income taxes.' . . . The Canadian jurisdictions, we also found, made `a 
cognizant and deliberate choice . . . between the application of 
premiums taxes or income taxes for mutual life insurance companies.''). 
Therefore, the comments are not adopted.
    Other comments stated that the close connection requirement would 
result in significant administrative burdens and uncertainties because 
jurisdictions with less sophisticated legislative processes and tax 
regimes may lack specific statutory language or legislative histories 
to determine whether there was a close connection between the tested 
foreign tax and the generally-imposed net income tax.
    In response to the comments, the final regulations at Sec.  1.903-
1(c)(1)(iii) clarify that a close connection also exists if the 
generally-imposed net income tax by its terms does not apply to the 
excluded income, and the tested foreign tax is enacted 
contemporaneously with the generally-imposed net income tax. Therefore, 
legislative history is not always required to establish that the tested 
foreign tax satisfies the close connection requirement.
5. Jurisdiction-to-Tax Requirement
    The jurisdiction-to-tax requirement provides 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 
net income tax under proposed 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 under proposed Sec.  1.901-2(a)(3). One 
comment noted that the reference to proposed Sec.  1.901-2(a)(3) 
incorporates both the jurisdictional nexus requirement and the net gain 
requirement. The comment questioned how a taxpayer can determine 
whether a hypothetical generally-imposed net income tax would reach net 
gain.
    In response to the comment, the final regulations clarify that if 
the generally-imposed net income tax, or a hypothetical new tax that is 
a separate levy with respect to the generally-imposed net income tax, 
were applied to the excluded income, such generally-imposed net income 
tax or separate levy must meet the attribution requirement in Sec.  
1.901-2(b)(5) but does not need to meet the other net gain requirements 
contained in Sec.  1.901-2(b).
D. Separate Levy Determination
    The 2020 FTC proposed regulations retained the general rule of the 
existing regulations, which provides that whether a foreign levy is an 
income tax for purposes of sections 901 and 903 is determined 
independently for each separate foreign levy, but modified the rules to 
clarify the principles used to determine whether one foreign levy is 
separate from another foreign levy. See proposed Sec.  1.901-2(d)(1). 
Proposed Sec.  1.901-2(d)(1)(ii) provided that separate levies are 
imposed on particular classes of taxpayers if the taxable base is 
different for those taxpayers.
    One comment requested clarification of the treatment of a foreign 
tax imposed on a distribution that is, in part, a dividend and, in 
part, gives rise to capital gain. The comment noted that Sec.  1.861-
20(g)(5) includes an example that treats the tax imposed on the 
dividend amount as a separate levy from the tax imposed on the capital 
gain amount of the distribution, but it is unclear whether the separate 
levy determination results from the fact that two different tax rates 
apply to the same distribution, or because the taxes apply to two 
different types of income. The comment recommended that the final rules 
clarify the analysis for identifying separate levies in the case of 
different taxable bases, or to elaborate on the policy considerations 
underlying the separate levy rules.
    One comment recommended that the Treasury Department and the IRS 
further consider the application of the separate levy rules to minimum 
tax regimes to ensure they do not prevent creditability of amounts that 
would otherwise be treated as foreign income taxes. The comment noted 
that if a regime imposes an incremental alternative minimum tax that 
would not be creditable under section 901 or section 903, creditability 
of the net income tax could depend on whether the two amounts are 
considered separate levies.
    Another comment stated that because the 2020 FTC proposed 
regulations require separate determinations of

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creditability for each class of taxpayers for which the application of 
the foreign levy results in a significantly different tax base (rather 
than determining whether a foreign levy applies to net income in the 
normal instance), the application of the separate levy rules and the 
net gain requirements is complex. It stated that the determination of a 
separate levy is both fact intensive and nuanced because all deviations 
from the ``pure'' income tax system of the Code will have to be 
identified and some deviations will create a separate class of 
taxpayers (and therefore a separate levy) while other deviations would 
simply have to be weighed for significance.
    The Treasury Department and the IRS have determined that additional 
clarification of the separate levy rules is not needed in connection 
with the example in Sec.  1.861-20(g)(5), because the rules for 
allocating and apportioning the foreign income tax on the facts of the 
example would be the same whether the tax on the foreign law dividend 
and capital gain amounts was imposed pursuant to a single levy or 
separate levies. However, in response to comments, the final 
regulations at Sec.  1.901-2(d)(3) provide additional examples to 
illustrate the application of the separate levy rules to minimum tax 
regimes and other foreign tax regimes involving separate levies that 
include some common elements. In particular, Sec.  1.901-2(d)(3)(ix) 
(Example 9) illustrates that a foreign tax containing a limitation on 
interest deductions that applies only to one class of taxpayers subject 
to the tax does not cause the tax to be treated as a separate levy as 
to that class of taxpayers.
E. Amount of Tax That Is Considered Paid
1. Refundable Credits
    The 2020 FTC proposed regulations modified Sec.  1.901-2(e)(2)(ii) 
of the existing regulations to provide explicit rules regarding the 
effect of foreign law tax credits in determining the amount of tax a 
taxpayer is considered to pay or accrue. Proposed Sec.  1.901-
2(e)(2)(ii) provided that a tax credit allowed under foreign law is 
considered to reduce the amount of foreign income tax paid, 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. 
Proposed Sec.  1.901-2(e)(2)(iii) provided an exception to this rule 
for credits in respect of overpayments of a different tax liability 
that are refundable in cash at the taxpayer's option and applied to 
satisfy the taxpayer's foreign income tax liability.
    While one comment agreed with the rule in proposed Sec.  1.901-
2(e)(2), other comments disagreed with the proposed rule, including the 
example illustrating these rules in proposed Sec.  1.901-
2(e)(4)(ii)(A), asserting that refundable tax credits should be treated 
as government grants administered through the foreign country's tax 
system. Under that view, refundable tax credits should be treated as a 
constructive payment of cash to the taxpayer that the taxpayer uses to 
constructively pay the amount of foreign income tax liability that is 
offset or satisfied by application of the tax credit. These comments 
argue that refundable tax credits provide an economic benefit that is 
not tied to taxable income or tax liability, which is similar to a 
government grant and unlike non-refundable tax credits or subsidies 
described in section 901(i). They further argue that accounting 
standards under IFRS and GAAP, as well as OECD commentary, treat 
refundable tax credits as a government expenditure, and that the IRS 
has issued guidance in the past that suggests that refundable tax 
credits may be deemed to satisfy, rather than reduce, a foreign tax 
liability (TAM 200146001; Rev. Rul. 86-134, 1986-2 C.B. 104).
    Comments also stated that the IRS's administrative concerns about 
the difficulty of distinguishing between refundable and non-refundable 
tax credits could be addressed through additional guidance, through 
data collection, or by requiring that any excess of a tax credit over a 
taxpayer's cumulative foreign income tax liability cannot be 
indefinitely carried forward but must be paid to the taxpayer in cash 
after a certain period. Comments argued that the proposed treatment of 
refundable tax credits would increase taxpayers' worldwide tax costs by 
reducing effective foreign tax rates of taxpayers' controlled foreign 
corporations and thereby subjecting more taxpayers to residual U.S. tax 
on GILTI inclusions. Finally, one comment requested guidance on the 
treatment of transferable tax credits, which are tax credits that are 
acquired by a taxpayer from another taxpayer and used to satisfy the 
acquiring taxpayer's tax liability. The comment suggested that 
transferable tax credits should be treated similarly to refundable tax 
credits.
    The Treasury Department and the IRS generally disagree that 
refundable tax credits are appropriately treated as offsetting 
constructive payments of cash to the taxpayer followed by a 
constructive payment of an (unreduced) foreign income tax liability. 
Refundable tax credits that are payable in cash only to the extent they 
exceed a taxpayer's foreign income tax liability, either in the current 
year or over a period of years, are not similar to unrestricted cash 
grants. Tax revenue foregone by a foreign taxing jurisdiction by means 
of such a tax credit reflects a policy choice to forego revenue, and 
that may be viewed as a tax expenditure, but a tax expenditure is 
distinct from a cash outlay. Revenue foregone by granting a tax credit 
that the taxpayer does not have the option to receive in cash reduces 
its tax liability in exactly the same manner whether the credit is 
fully nonrefundable or potentially refundable only to the extent the 
credit exceeds the taxpayer's tax liability. In both cases, the 
taxpayer does not have the option to receive the applied amount of the 
credit in cash. No comments suggested that a nonrefundable credit 
should be treated as constructively received in cash by the taxpayer 
and used to pay an unreduced tax liability. The Treasury Department and 
the IRS have determined that it is inappropriate to treat the 
nonrefundable portion of a refundable credit differently from a fully 
nonrefundable credit.
    In addition, a rule that required the IRS to obtain empirical data 
on the refundability in practice of nominally refundable tax credits 
would be too difficult for taxpayers and the IRS to apply. Because the 
foreign law rules governing such credits often limit the refundable 
portion to the amount by which the credit exceeds the taxpayer's tax 
liability over a period of years, taxpayers would have to make 
speculative determinations, or post-hoc adjustments based on whether 
the excess portion of credits granted in one year actually became 
refundable in later years, in order to determine whether the 
application of the credit could be treated as a payment (rather than a 
reduction) of foreign tax.
    The Treasury Department and the IRS generally agree with the 
comment that transferable tax credits granted by a foreign country, 
which presumably are never fully refundable in cash at the taxpayer's 
option since that option would eliminate the benefit taxpayers derive 
from selling tax credits to other taxpayers, should be analyzed under 
the same rules as other foreign law tax credits. The application of a 
purchased tax credit to satisfy a foreign tax liability, similar to 
other tax credits that are not fully refundable in cash at the 
taxpayer's option, represents foregone revenue that is not received or 
retained by the foreign country. In order to constitute an amount of 
foreign income tax paid for purposes of section 901, an

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amount must be both owed and remitted to the foreign country, and not 
used to provide a benefit to the taxpayer, to a related person, to any 
party to the transaction, or to any party to a related transaction. See 
section 901(i) and Sec.  1.901-2(e)(3). Accordingly, Sec.  1.901-
2(e)(2)(ii) of the final regulations confirms that applying a foreign 
law tax credit, including credits that are refundable in cash only to 
the extent they exceed tax liability and credits that are transferred 
from another taxpayer, to reduce a foreign income tax liability is not 
considered a payment of foreign tax that is eligible for a credit.
    These regulations do not address whether the use of a transferred 
tax credit to satisfy a foreign (or other) income tax liability may 
constitute the payment of a liability for purposes of other provisions 
of the Code, such as section 164. However, section 275 generally 
disallows a deduction for foreign income taxes paid or accrued in a 
taxable year for which the taxpayer claims to any extent the benefit of 
the foreign tax credit.
    However, the Treasury Department and the IRS agree that refundable 
tax credits may appropriately be treated as a means of paying, rather 
than reducing, a foreign income tax liability if the taxpayer has the 
option to receive in cash the full amount of the tax credit, rather 
than just the portion that exceeds the taxpayer's foreign income tax 
liability. Accordingly, the final regulations expand the tax 
overpayment exception in proposed Sec.  1.901-2(e)(2)(iii) to apply to 
any tax credit that is fully refundable in cash at the taxpayer's 
option. The final regulations also clarify that a tax credit will not 
be considered not fully refundable solely by reason of the fact that 
the amount of the tax credit could be subject to seizure or garnishment 
to satisfy a different, pre-existing debt of the taxpayer to the 
government or a third party.
2. Noncompulsory Payments
    The 2020 FTC proposed regulations clarified that the references to 
a ``foreign tax'' in Sec.  1.901-2(e)(5)(i) of the existing final 
regulations, defining the amount of tax paid for purposes of sections 
901 and 903, are only to creditable foreign income taxes (and in lieu 
of taxes). As under the existing final regulations, the 2020 FTC 
proposed regulations provided that an amount remitted is not a 
compulsory payment, and so is not an amount of foreign income tax paid, 
to the extent the taxpayer failed to minimize the amount of foreign 
income tax due over time. Comments disagreed with the clarification, 
arguing that when taxpayers settle tax controversies with foreign tax 
authorities, a credit should be allowed for foreign income taxes that 
were paid in exchange for a greater reduction in foreign non-income 
taxes. A comment argued that foreign non-income taxes should be treated 
like litigation costs or any other costs of pursuing a remedy in 
determining whether a taxpayer has acted reasonably to minimize its 
foreign income tax liability.
    The final regulations retain the clarification that Sec.  1.901-
2(e)(5) requires taxpayers to take reasonable steps to minimize their 
liability for foreign income taxes, including by exhausting remedies 
that an economically rational taxpayer would pursue whether or not the 
amount at issue was eligible for the foreign tax credit. However, the 
Treasury Department and the IRS agree that this requirement is met if 
the reasonably expected, arm's length costs of reducing foreign income 
tax liability would exceed the amount of the potential reduction, and 
that reasonably expected costs may include the cost of a reasonably 
anticipated offsetting foreign non-income tax liability. In addition, 
the Treasury Department and the IRS have determined that this 
reasonable cost analysis should apply not only in the exhaustion of 
remedies context, but also in evaluating whether a taxpayer has 
appropriately applied foreign tax law to minimize its foreign income 
tax liabilities even in the absence of a foreign tax controversy. The 
final regulations are modified to reflect these changes. In addition, 
an example is added to the final regulations at Sec.  1.901-
2(e)(5)(vi)(G) (Example 7) to illustrate that where a taxpayer has a 
choice to claim or forgo a deduction that would reduce its foreign 
income tax liability but increase its foreign non-income tax liability 
by a greater amount, the taxpayer can choose not to claim the income 
tax deduction without violating the noncompulsory payment requirement.
    The 2020 FTC proposed regulations added provisions clarifying the 
scope of a taxpayer's obligation under the noncompulsory payment rules 
to take advantage of foreign law options and elections that may 
minimize the taxpayer's foreign income tax liability. The final 
regulations clarify that a taxpayer must take advantage of foreign law 
options and elections that relate to the computation of tax liability 
as applied to the facts that affect the taxpayer's liability, but do 
not require taxpayers to modify any other conduct that may have tax 
consequences, including, for example, choices relating to business form 
or the maintenance of books and records on which income is reported, or 
the terms of contracts or other business arrangements.
    The 2020 FTC proposed regulations also exempted foreign law options 
or elections relating to loss sharing and entity classification from 
the noncompulsory payment rules. One comment suggested that the final 
regulations should also include an exception for options and elections 
that have the effect of increasing the tax liability of the taxpayer 
while also reducing the tax liability of a related person by a greater 
amount and provided an example related to foreign law anti-hybrid 
regimes. The Treasury Department and the IRS have determined that 
applying the noncompulsory payment rule on a group-wide basis would be 
too difficult for taxpayers to comply with and for the IRS to 
administer, due to the difficulty of defining the related group in a 
way that properly accounts for differences in U.S. and foreign tax law 
and prevents abuse. However, the final regulations at Sec.  1.901-
2(e)(5)(iv) include an additional limited exception for certain 
transactions that increase one person's foreign income tax liability 
but result in a reduction in another person's foreign income tax 
liability through the application of foreign law hybrid mismatch rules, 
provided that such reduction in the second person's liability is 
greater than the increase in the first person's liability.
F. Applicability Date
1. In General
    Proposed Sec.  1.901-2(h) provided that the revised rules in 
proposed Sec.  1.901-2 apply to foreign taxes paid or accrued in 
taxable years beginning on or after the date that the final regulations 
adopting the rules are filed with the Federal Register. Proposed Sec.  
1.903-1(e) similarly provided that proposed Sec.  1.903-1 applies to 
foreign taxes paid or accrued in taxable years beginning on or after 
the date that the final regulations are filed with the Federal 
Register.
    One comment asked that the final regulations include a delayed 
applicability date. The comment stated that, given the potentially 
significant impact of the jurisdictional nexus requirement discussed in 
part IV.A of this Summary of Comments and Explanation of Revisions on 
the creditability of foreign levies and uncertainty regarding whether 
the proposed amendments to the section 901 and 903 regulations would be 
finalized, it is unreasonable to expect that taxpayers would modify 
their business operations before the

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regulations are finalized. The comment recommended that the final 
regulations should delay the applicability date to allow taxpayers 
ample time to assess the impact of the regulations on their business 
and to adjust their operations accordingly. Another comment recommended 
that the Treasury Department and the IRS defer finalizing the 
regulations and provide an additional extended comment period.
    The Treasury Department and the IRS have determined that it is not 
appropriate to delay the applicability date of Sec. Sec.  1.901-2 and 
1.903-1 beyond the date indicated in the 2020 FTC proposed regulations. 
The Treasury Department and the IRS recognized the potentially 
significant impact of the jurisdictional nexus requirement, and thus, 
provided a fully prospective applicability date in the 2020 FTC 
proposed regulations. The 2020 FTC proposed regulations provided ample 
notice to taxpayers that extraterritorial taxes that are not an income 
tax in the U.S. sense would not be creditable, and these final 
regulations largely adopt Sec.  1.901-2 and Sec.  1.903-1 as proposed. 
The Treasury Department and the IRS disagree with the comment's 
assertion that applicability dates of significant final regulations 
should be deferred to allow time for taxpayers to modify their business 
operations to take into account the new rules. The Treasury Department 
and the IRS have also determined that sufficient time has been afforded 
for stakeholders to provide comments. Ten comments were received in 
relation to the jurisdictional nexus requirement, all of which were 
carefully considered in finalizing the regulations. In addition, the 
Treasury Department and the IRS have determined that it is essential to 
finalize these regulations and to retain the applicability date 
announced in the 2020 FTC proposed regulations to avoid the detrimental 
impact to the U.S. fisc if, due to ambiguities under existing 
regulations, novel extraterritorial taxes are inappropriately allowed 
as a foreign tax credit against U.S. tax.
    Comments asked for confirmation that foreign taxes paid or accrued 
in a taxable year before the regulations are finalized but that are 
carried forward and claimed as a credit (and thus ``deemed'' paid or 
accrued under section 904(c)) in a taxable year after the final 
regulations become applicable will not be subject to the final 
regulations.
    For the avoidance of doubt, the final regulations clarify that the 
term ``paid,'' which for purposes of Sec. Sec.  1.901-2 and 1.903-1 
means ``paid'' or ``accrued'' depending on whether the taxpayer is 
claiming a foreign tax credit on the cash or accrual basis, does not 
refer to foreign taxes that are carried over and ``deemed'' paid or 
accrued under section 904(c) or to taxes paid by CFCs that are ``deemed 
paid'' by a U.S. shareholder under section 960. See Sec.  1.901-
2(g)(5). The applicability date provisions in Sec. Sec.  1.901-2(h) and 
1.903-1(e) have been conformed to cross-reference the revised 
definition of ``paid'' in Sec.  1.901-2(g)(5). Because the Treasury 
Department and the IRS view the revised definition to be a 
clarification, not a change, to existing law, no inference is intended 
with respect to the proper interpretation of the applicability date of 
existing foreign tax credit regulations that are not modified by these 
final regulations.
2. Deferred Application to Certain Puerto Rican Taxes
    Notice 2011-29, 2011-16 IRB 663, announced that the IRS and the 
Treasury Department were evaluating the novel issues raised by 
legislation enacted by Puerto Rico on October 25, 2010. The legislation 
added new rules (``Expanded ECI Rules'') to section 1123 of the Puerto 
Rico Internal Revenue Code of 1994 (``1994 PR IRC'') that characterize 
certain income of nonresident corporations, partnerships, and 
individuals as effectively connected with the conduct of a trade or 
business in Puerto Rico. The legislation also added section 2101 to the 
1994 PR IRC, which imposes an excise tax (``Puerto Rico Excise Tax'') 
on a controlled group member's acquisition from another group member of 
certain personal property manufactured or produced in Puerto Rico and 
certain services performed in Puerto Rico.\8\ Pending the resolution of 
the novel issues involved in the determination of the creditability of 
the Puerto Rico Excise Tax, Notice 2011-29 announced that the IRS will 
not challenge a taxpayer's position that the Puerto Rico Excise Tax is 
a tax in lieu of an income tax under section 903, and that any change 
in the foreign tax credit treatment of the Puerto Rico Excise Tax would 
be prospective.
---------------------------------------------------------------------------

    \8\ The provisions implementing the Expanded ECI Rules and the 
Puerto Rico Excise Tax were incorporated into sections 1035.05 and 
3070.01, respectively, of the Puerto Rico Internal Revenue Code of 
2011 (13 L.P.R.A Sec. Sec.  30155, 31771).
---------------------------------------------------------------------------

    Notwithstanding the general applicability of Sec. Sec.  1.901-2 and 
1.903-1 to foreign taxes paid or accrued in taxable years beginning on 
or after the date these final regulations are filed with the Federal 
Register, the final regulations provide that Sec.  1.901-2 will apply 
to Puerto Rico income tax paid by reason of the Expanded ECI Rules, and 
Sec.  1.903-1 will apply to Puerto Rico Excise Tax, paid or accrued in 
taxable years beginning on or after January 1, 2023. The Treasury 
Department and the IRS have determined that a delayed applicability 
date is necessary and appropriate in light of the status of Puerto Rico 
as a territory of the United States, the special treatment of the 
Puerto Rico Excise Tax under Notice 2011-29 that has been in place 
since 2011, and with respect to the Expanded ECI Rules, the 
interconnectedness between such rules and the Puerto Rico Excise Tax 
under Puerto Rico's statutory scheme. Notice 2011-29 will continue to 
apply until the final regulations are applicable with respect to the 
Puerto Rico Excise Tax.

V. Definition of Foreign Branch Category Income in Connection With 
Intercompany Payments

    Proposed Sec.  1.904-4(f)(4)(xv) (Example 15) illustrated the 
application of the matching rule in Sec.  1.1502-13 to a regarded 
intercompany payment between one affiliated group member and a foreign 
branch of a different member. One comment noted that the example does 
not illustrate how Sec.  1.1502-13(b)(2) would apply to limit the 
amount of an intercompany item taken into account under Sec.  1.1502-
13(c). The comment also suggested that additional examples would help 
clarify how intercompany payments for R&D services required to be taken 
into account under Sec.  1.1502-13, or disregarded payments for such 
services, are accounted for in determining the amount and source of 
foreign branch category income.
    The 2020 FTC proposed regulations did not modify the application of 
Sec.  1.1502-13(b) in the foreign branch category context, and 
additional examples illustrating the application of the intercompany 
transaction regulations, the R&E expense allocation rules, and the 
foreign branch category are beyond the scope of the issues considered 
in the 2020 FTC proposed regulations. Accordingly, the foreign branch 
examples are finalized without substantive change. However, the 
Treasury Department and the IRS may address these issues in a future 
guidance project.

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

A. Timing of Foreign Tax Accruals
    The 2020 FTC proposed regulations provided rules regarding when a 
taxpayer can claim a credit for foreign income taxes paid or accrued, 
depending on the taxpayer's method of accounting. For taxpayers that 
use the

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accrual method of accounting or that have made an election under 
section 905(a) to claim foreign tax credits on the accrual basis, 
proposed Sec.  1.905-1(d)(1)(i) provided that foreign income taxes 
accrue and can be claimed as a credit 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 
(that is, in the taxable year when the all events test under Sec.  
1.446-1(c)(1)(ii)(A) has been met). Proposed Sec.  1.905-1(d)(1)(i) 
further provided that in the case of a foreign income tax that is 
computed based on items of income, deduction, and loss that arise in a 
foreign taxable year (``foreign net income tax''), the tax accrues at 
the close of the foreign taxable year and can be claimed as a credit in 
the U.S. taxable year with or within which the taxpayer's foreign 
taxable year ends. Foreign withholding taxes that represent advance 
payments of a foreign net income tax liability determined on the basis 
of a foreign taxable year accrue at the close of the foreign taxable 
year. See proposed Sec.  1.905-1(d)(1)(i). In contrast, foreign 
withholding taxes that are imposed on a payment giving rise to an item 
of gross income accrue on the date the payment from which the tax is 
withheld is made. Id.
    One comment argued that the rule in proposed Sec.  1.905-1(d)(1)(i) 
providing that foreign net income tax accrues at the close of the 
foreign taxable year is an incorrect application of the all events test 
in section 461. The comment acknowledged that the proposed rule 
incorporated the long-standing position of the Treasury Department and 
the IRS reflected in Revenue Ruling 61-93, 1961-1 C.B. 390, but argued 
that that ruling reached the wrong conclusion because it asserted that 
the liability accrues when all events have occurred to establish the 
fact of the liability and the amount of the liability, whereas section 
461(h) only requires that the amount of the liability can be determined 
with reasonable accuracy. The comment argued that in cases where the 
foreign and U.S. taxable years do not coincide, the fact of the 
liability for foreign taxes on income earned during the U.S. taxable 
year is established, and, in normal circumstances, the amount of the 
liability should be determinable with reasonable accuracy at the end of 
the U.S. taxable year, because both the amount of income and applicable 
foreign tax rate will be known. The comment further noted that in the 
case of taxpayers employed in a foreign country, the employer will also 
withhold and remit foreign tax on the taxpayer's salary to the foreign 
country throughout the year. The comment further argued that the 
proposed rule would result in instances where the taxpayer has to pay 
U.S. tax on foreign source income in a U.S. taxable year earlier than 
the year in which the foreign taxable year ends and the credit for 
foreign tax on the income may be claimed, creating a mismatch that may 
not be addressed by section 904(c) carryback rules.
    The Treasury Department and the IRS disagree with the comment's 
contention that proposed Sec.  1.905-1(d)(1)(i) is inconsistent with 
the all events test in section 461 and that the all events test can be 
satisfied, in the case of a foreign net income tax, before the close of 
the foreign taxable year. First, the comment's contention that Revenue 
Ruling 61-93 reached the wrong conclusion because it misapplied the all 
events test is incorrect. The revenue ruling was issued before Congress 
codified in section 461(h)(4) the all events test that had developed 
through case law. The ruling's statement of the all events test is 
consistent with the Supreme Court's description of the standard in 
Dixie Pine Products Co. v. Comm'r, 320 U.S. 516, 519 (1944) (``all the 
events must occur in that year which fix the amount and the fact of the 
taxpayer's liability for items of indebtedness deducted though not 
paid.'').
    Second, the comment's argument regarding whether the all events 
test requires the amount of the liability to be fixed or only to be 
determinable with reasonable accuracy is misplaced, because in the case 
of a foreign net income tax, neither the fact of the liability nor the 
amount due can be determined with reasonable accuracy until the 
accounting period closes and the amount of the taxpayer's taxable 
income for that period can be computed. An estimate does not meet the 
standard required by the all events test to accrue a foreign tax 
expense; all events through the close of the taxable year must have 
occurred before the fact and amount of the liability can be determined 
with reasonable accuracy. See Rev. Rul. 72-490, 1972-2 C.B. 100. Before 
the accounting period closes, any number of events, such as a large 
loss incurred late in the foreign taxable year, could occur that could 
affect the taxpayer's taxable income and resulting foreign income tax 
liability for that period. Although withholding taxes or estimated 
payments made to satisfy a projected net income tax liability are 
readily determinable by a taxpayer, the basis for the calculation of 
the final foreign income tax liability is not knowable until the 
foreign taxable year ends. For these reasons, the final regulations do 
not adopt the comment and confirm that foreign net income taxes accrue 
at the end of the foreign taxable year and can be claimed as a credit 
by an accrual basis taxpayer only in the U.S. taxable year with or 
within which the taxpayer's foreign taxable year ends.
B. Cash to Accrual Basis Election
    Proposed Sec.  1.905-1(e) provided rules related to the election in 
section 905(a) for a cash method taxpayer to claim foreign tax credits 
on the accrual basis. Proposed Sec.  1.905-1(e)(1) provided that, in 
general, the election 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. 
However, the 2020 FTC proposed regulations also provided an exception 
in proposed Sec.  1.905-1(e)(2), which permitted a taxpayer who has 
never previously claimed a foreign tax credit to elect to claim the 
foreign tax credit on an accrual basis, even if such initial claim for 
credit is made on an amended return.
    One comment asserted that an election to change from the cash to 
the accrual method under section 905(a) should be allowed to be made on 
an amended return. In support of that assertion, the comment argued 
that the purpose of the election is to allow better matching between 
the credit for the foreign tax and the U.S. tax on the foreign income. 
The comment further argued that cases such as Dougherty v. CIR, 60 T.C. 
917 (1973), support the principle that elections should be allowed to 
be made on an amended return when circumstances that are not known at 
the time of the filing of the initial return are material to the 
decision for making the election. The comment further argued that the 
case discussed in the preamble of the 2020 FTC proposed regulations in 
support of the rule not allowing an election change to be made on an 
amended return, Strong v. Willcuts, 17 AFTR 1027 (D. Minn. 1935), did 
not hold that the election cannot be made on an amended return, and 
that the court's discussion of the issue was dictum and does not 
represent legal authority.
    The Treasury Department and the IRS disagree with this comment. 
First, section 905(a) requires that if a cash basis taxpayer elects to 
claim foreign tax

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credits on the accrual basis, ``the credits for all subsequent years 
shall be taken on the same basis.'' This statutory language plainly 
allows only a one-time change from the cash to the accrual method for 
determining the year in which the credit is taken and precludes a 
taxpayer from ever again changing that choice. If the one-time choice 
to switch from the cash to the accrual method were permitted to be made 
retroactively on an amended return, then the taxpayer would have to 
file amended returns for intervening years in which credits had been 
originally claimed on the cash basis to comply with the statutory 
mandate and prevent duplicative credits for foreign taxes that accrued 
in one year and were paid (and claimed as credits on the cash basis) in 
a different year. Because the applicable statutes of limitation for 
assessments and refunds relating to foreign tax credits may expire at 
different times, in the absence of a foreign tax redetermination any 
retroactive revisions to the year in which foreign tax credits are 
properly claimed could result in time-barred U.S. tax deficiencies. The 
Treasury Department and the IRS have determined that the compliance 
burdens and administrative complexity that would follow from deviating 
from the rule requiring the election to be made prospectively outweigh 
the benefits for taxpayers of any flexibility that would follow from 
allowing the accrual basis election to be made on an amended return for 
a year in which the taxpayer originally claimed foreign tax credits on 
the cash basis.
    In addition, although the legislative history indicates that 
Congress, in enacting the predecessor to the section 905(a) election, 
was concerned with better matching of U.S. and foreign taxes on the 
same income, that does not mean that Congress intended taxpayers to be 
able to make the election on an amended return. See S. Rep. No. 68-398 
(1924); H.R. Rep. No. 68-179 (1924). Cases from the 1940s examined 
whether section 131(a), which between 1932 and 1942 provided that the 
election to claim a foreign tax credit was made ``[i]f the taxpayer 
signifies in his return his desire to have the benefits of this 
section,'' allowed taxpayers to change their choice from deducting to 
crediting foreign taxes after they filed their original return. In one 
such case, the Second Circuit noted that:

    Section 131(a) was intended, we think, to prevent a taxpayer, 
fully cognizant of the facts when making its return, from 
subsequently changing its position, but not to hold a taxpayer to a 
choice made when unaware that its choice had practical consequences. 
That such was the legislative purpose is emphasized by Sec. 131(d) 
which does preclude a shift of position by a taxpayer, knowingly 
electing to claim a credit, as to a cash or accrual basis.

    W.K. Buckley, Inc., v. Comm'r, 158 F.2d 158, 162 (2d Cir. 1946) 
(emphasis added). Congress amended section 131(a) in the Revenue Act of 
1942 to provide that the election to claim a credit can be made or 
changed before the expiration of the refund period. See Revenue Act of 
1942, Public Law 77-753, 158, 56 Stat. 798, 857. Notably, Congress has 
never amended section 905(a) to prescribe a time by which the section 
905(a) election must be made.
    The Treasury Department and the IRS also disagree with the 
comment's assertion that Strong v. Willcuts does not support the 
position that the accrual basis election cannot be made on an amended 
return. In that case, the court denied the taxpayer's claim on two 
bases. The first was that, in the court's view, the statute 
contemplates that the election must be made when the return is 
originally filed and that there is no basis to assume that a taxpayer 
can shift his position after the filing of his return. Strong v. 
Willcuts, 17 AFTR 1027. The court addressed ``another and even more 
formidable obstacle'' to taxpayer's claim, but that did not mean that 
the first issue was not relevant to the court's decision. Id.
    In addition, although the Dougherty court held that the taxpayer 
could make a section 962 election on an amended return, it acknowledged 
that there are limits on when a taxpayer can make a late election. The 
court reviewed prior case law and concluded that ``the critical 
question involved in determining the timeliness of a delayed election 
is whether the original action (or the failure to act) on the part of 
the taxpayer did not amount to an election against, and was not 
inconsistent with, the position which the taxpayer ultimately did 
adopt.'' Dougherty, 60 T.C. at 940. In addition, the court noted that 
it was significant that the granting of a right of late election did 
not permit the taxpayer, in effect, to play both ends against the 
middle as the result of hindsight. Id. Proposed Sec.  1.905-1(e)(2) 
already provided an exception that, consistent with the above 
principles, permitted a taxpayer who is claiming a foreign tax credit 
for the first time to make the election on an amended return, because 
in that case, the taxpayer has not taken an action (claiming a foreign 
tax credit on the cash basis) that is inconsistent with the position 
the taxpayer seeks to adopt by making a section 905(a) election 
(claiming a foreign tax credit on the accrual basis). For the above 
reasons, the final regulations do not adopt the comment's 
recommendation.
C. Provisional Credit for Contested Taxes
1. In General
    The 2020 FTC proposed regulations provided that, in general, 
contested foreign income taxes do not accrue and cannot be claimed as a 
credit in the relation-back year until the contest is resolved, even if 
the taxpayer remits the contested taxes to the foreign country in an 
earlier year. See proposed Sec.  1.905-1(d)(3). Proposed Sec.  1.905-
1(d)(4), however, provided an elective exception for accrual basis 
taxpayers to claim a provisional credit for the portion of the 
contested taxes that the taxpayer has paid, even though the contest has 
not been resolved and the taxes have not yet accrued. As a condition 
for making this election, a taxpayer must agree to not assert the 
statute of limitations as a defense to the assessment of additional 
taxes and interest if, after the contest has been concluded, the IRS 
determines that the tax was not a compulsory payment. The taxpayer must 
also agree to comply with annual reporting requirements.
    Proposed Sec.  1.905-1(d)(4)(i) provided that a taxpayer may make 
an election to claim a foreign tax credit, but not a deduction, for 
contested foreign income taxes. One comment asked for clarification on 
whether this limitation on deducting a contested tax applies to CFC-
level deductions, or whether this limitation was intended to apply only 
to a U.S. taxpayer claiming a deduction, rather than a foreign tax 
credit, for the contested foreign taxes. The comment recommended that 
the final regulations address the application of the contested tax 
liability rules to the deductions of CFC taxpayers and argued that if a 
provisional credit election is made, the CFC should be allowed a 
deduction for the relation-back year in advance of the accrual. In 
response to this comment, the final regulations clarify that the 
provisional foreign tax credit can only be made for contested foreign 
income taxes that relate to a taxable year in which the taxpayer has 
made the election under section 901 to claim a credit (instead of a 
deduction) for foreign income taxes that accrue in such year. See Sec.  
1.905-1(d)(4)(i). The final regulations also clarify that if an 
election is made by the U.S. taxpayer with respect to a contested 
foreign income tax liability incurred by a CFC, the taxpayer may claim 
the deemed paid credit in the relation-back year; in addition, the CFC 
can take the

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deduction for the contested foreign income tax into account in 
computing its taxable income in the relation-back year. Id.
2. Annual Reporting
    Proposed Sec.  1.905-1(d)(4)(iii) provided annual reporting 
requirements associated with the election to claim a provisional 
foreign tax credit for contested foreign income taxes. Proposed Sec.  
1.905-1(d)(4)(v) provided that a taxpayer that fails to comply with 
those annual reporting requirements will be treated as receiving a 
refund of the amount of the contested foreign income tax liability, 
resulting in a redetermination of the taxpayer's U.S. tax liability 
pursuant to Sec.  1.905-3(b). Comments argued that an annual reporting 
requirement is unnecessary because taxpayers must waive the assessment 
statute to make the election and recommended instead that taxpayers 
should be required to file an amended return notifying the IRS when the 
contest is resolved. Alternatively, if the final regulations retain an 
annual reporting requirement, comments recommended that the deemed 
refund consequence for failure to comply be removed because it is 
overly harsh.
    The Treasury Department and the IRS have determined that annual 
reporting is necessary and appropriate to ensure that taxpayers and the 
IRS properly track ongoing contests for which a provisional foreign tax 
credit has been allowed. However, the Treasury Department and the IRS 
agree that an inadvertent failure to timely report an ongoing contest 
or the conclusion of a contest need not result in a deemed refund, 
because the government's interests are adequately protected by the 
statute waiver required by the election. The terms of the election 
guarantee the IRS sufficient time after being notified of the 
conclusion of the contest to evaluate whether the taxpayer failed to 
exhaust effective and practical remedies to minimize its foreign income 
tax if it fails to secure a refund of the contested tax, and to assess 
any resulting underpayment of U.S. tax. Accordingly, the final 
regulations omit the deemed refund rule.
D. Creditable Foreign Tax Expenditures of Partnerships and Other Pass-
Through Entities
1. Foreign Tax Redeterminations for Cash Method Partners
    Proposed Sec.  1.905-1(f)(1) provided 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. Under this rule, 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. 
However, proposed Sec.  1.905-1(f)(1) further provided that if 
additional foreign taxes result from a redetermination of the 
partnership's foreign tax liability for a prior taxable year, a cash-
method partner may only take into account its distributive share of 
such additional taxes for foreign tax credit purposes in the partner's 
taxable year with or within which the taxable year of the partnership 
in which it pays the taxes ends.
    One comment recommended that the final regulations extend the 
application of the principles of the relation-back rule in proposed 
Sec.  1.905-1(d)(1)(ii) to partners of an accrual method partnership by 
treating a cash method partner's distributive share of additional tax 
paid by the partnership as a result of a change in the foreign tax 
liability as paid or accrued by the partner in its taxable year with or 
within which the partnership's relation-back year ends. The comment 
stated that this would be more consistent with the principle espoused 
in proposed Sec.  1.905-1(f)(1) that the partnership'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.
    The Treasury Department and the IRS disagree with the comment's 
suggestion that proposed Sec.  1.905-1(f)(1) should essentially cause a 
partner's method of accounting to be the same as the partnership's 
method with regard to any partnership items of foreign income tax. The 
proposed regulation is consistent with Sec. Sec.  1.702-1(a)(6) and 
1.703-1(b)(2)(i), which provide that when a partnership takes into 
account a creditable foreign tax expenditure under its method of 
accounting, the partner takes its distributive share of the foreign tax 
into account as if it was properly taken into account under the 
partner's method of accounting in the partner's year with or within 
which the partnership's taxable year ends. These rules do not change 
the partner's method of accounting to conform to the partnership's 
method of accounting with respect to its distributive share of the 
partnership's taxes. Thus, for example, in the case of an accrual 
method partnership and a cash method partner, if the partnership 
accrues, but has not yet paid, an amount of foreign income tax, the 
cash method partner takes into account its distributive share of the 
foreign tax expense as if it had been paid in the partner's taxable 
year with or within which the partnership's taxable year ends. 
Similarly, if the partnership later accrues and pays an additional 
amount of foreign income tax with respect to the same taxable year 
pursuant to a foreign tax redetermination described in section 
905(c)(2)(B), a cash method partner takes its distributive share of the 
additional amount of foreign tax into account in its taxable year with 
or within which ends the partnership's taxable year in which the 
foreign tax redetermination occurs, because the additional foreign tax 
is considered to be paid by the partner in that year, not in the former 
taxable year to which additional foreign tax of the accrual-basis 
partnership relates. Therefore, the final regulations do not adopt the 
comment's recommendation.
2. Provisional Credit for Cash Method Taxpayers
    Proposed Sec.  1.905-1(f)(2) provided that a partnership takes into 
account and reports a contested foreign income tax to its partners only 
when the contest concludes and the finally determined amount of the 
liability has been paid by the partnership. However, proposed Sec.  
1.905-1(f)(2) allowed an accrual method partner to elect to claim a 
provisional foreign tax credit, in the relation-back year, for its 
share of a contested foreign income tax liability that the partnership 
has remitted to the foreign country, even though the contested tax has 
not yet accrued. The procedures for making this election were set forth 
in proposed Sec.  1.905-1(d)(4).
    One comment recommended the same election be made available for 
cash method partners. The Treasury Department and the IRS agree that a 
cash method partner should be allowed to elect to claim a provisional 
foreign tax credit for its share of a contested foreign income tax 
liability that the partnership has paid to the same extent as an 
accrual basis partner, even though under Sec.  1.901-2(e)(2) a 
contested tax is not a reasonable approximation of the final tax 
liability to the foreign country and so in the absence of the election 
is not treated as an amount of tax paid. The final regulations, at 
Sec.  1.905-1(c)(3), extend the election provided for in proposed Sec.  
1.905-1(d)(4) to allow cash

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method taxpayers to claim a provisional foreign tax credit for a 
contested foreign income tax in the year the contested tax is remitted. 
The election is available for contested foreign income taxes paid 
directly by the taxpayer or paid by a partnership in which the taxpayer 
is a partner. The procedure and requirements for making this election 
are the same as those that apply under proposed Sec.  1.905-1(d)(4), 
which is being finalized with the modifications discussed in part 
VI.D.1 of this Summary of Comments and Explanation of Revisions.
E. Correction of Improper Accrual
    Proposed Sec.  1.905-1(d)(5) provided rules for accrual method 
taxpayers that are changing from an improper method to a proper method 
for accruing foreign income taxes. Proposed Sec.  1.905-1(d)(5)(ii) 
provided a modified cutoff approach under which taxpayers were required 
to adjust the amount of foreign income taxes that can be claimed as a 
credit or deduction in the taxable year of the method change (and, if 
applicable, in subsequent years) to prevent duplication or omission of 
any amount of foreign income tax paid. Specifically, proposed Sec.  
1.905-1(d)(5)(ii) provided that the amount of foreign income tax in a 
statutory or residual grouping that properly accrues in the taxable 
year of change is adjusted either downward, but not below zero, by the 
amount of foreign income tax in the same grouping that the taxpayer 
improperly accrued and deducted or credited in a prior taxable year, or 
conversely, adjusted upward by the amount of foreign income tax that 
properly accrued but that had not been taken as a deduction or credit 
by the taxpayer in a taxable year before the year of change.
    No comments were received regarding the rules in proposed Sec.  
1.905-1(d)(5) and they are generally finalized as proposed. However, 
the Treasury Department and the IRS have determined that there are 
circumstances in which a taxpayer may have both a downward and an 
upward adjustment to the properly accrued foreign income taxes in a 
statutory or residual grouping in the taxable year of change, and that 
in those circumstances, proposed Sec.  1.905-1(d)(5)(ii) was unclear 
whether the rule provided that the downward adjustment alone could not 
reduce the properly accrued taxes below zero, or that the downward 
adjustment, net of the upward adjustment, could not reduce the properly 
accrued taxes below zero. Section 1.905-1(d)(5)(ii) has been revised to 
clarify that, under the modified cutoff approach, the amount of 
properly accrued foreign income tax in each statutory and residual 
grouping is first adjusted upward and then adjusted downward (but not 
below zero), and that any downward adjustment in excess of the amount 
of properly accrued foreign income tax in any grouping, as increased by 
the upward adjustment, is carried forward and reduces the properly 
accrued foreign income tax in the grouping in subsequent years.
    In addition, the Treasury Department and the IRS determined that 
proposed Sec.  1.905-1(d)(5)(ii) was unclear regarding the treatment of 
foreign income taxes for which a credit is never allowed under section 
901, but for which a deduction under section 164(a)(3) is allowed 
because section 275 does not apply. See, for example, sections 901(j), 
(k), (l), and (m). Accordingly, the final regulations clarify that the 
modified cut-off approach is applied separately with respect to amounts 
of these foreign income taxes. See Sec.  1.905-1(d)(5)(ii).

Special Analyses

I. Regulatory Planning and Review

    Executive Orders 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 
emphasizes the importance of quantifying both costs and benefits, 
reducing costs, harmonizing rules, and promoting flexibility.
    The final 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 Final 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.\9\ 
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.
---------------------------------------------------------------------------

    \9\ 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'' of the existing regulations is made up 
of the realization, gross receipts, and net income requirements. 
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

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the existing definition of an income tax necessitate changes to the 
existing structure. These final 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. 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 in 2019 issued final 
regulations (84 FR 69022) (2019 FTC final regulations) and proposed 
regulations (84 FR 69124) (2019 FTC proposed regulations), which were 
finalized in 2020 (85 FR 71998) (2020 FTC final regulations). The 
Treasury Department and the IRS received comments with respect to the 
2019 FTC proposed regulations, some of which were addressed in proposed 
regulations (85 FR 72078) published in 2020 (2020 FTC proposed 
regulations) instead of in the 2020 FTC final regulations in order to 
allow further opportunity for notice and comment. The 2020 FTC proposed 
regulations, which also addressed additional issues, are finalized in 
these final regulations.
    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 Final Regulations
    These final regulations address a variety of outstanding issues, 
most importantly with respect to the existing definition of a foreign 
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 foreign income taxes. These final regulations 
revise aspects of this definition in light of challenges that taxpayers 
and the IRS have faced in applying the rules of the existing 
regulations. 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 
obtain and analyze for purposes of determining whether the foreign tax 
is imposed on net gain, causing both administrative and compliance 
burdens and difficulties resolving disputes. Therefore, the final 
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 
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 realized gross receipts (and certain deemed 
gross receipts) net of deductions for expenses. Under these final 
regulations, the use of data to demonstrate that an alternative 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 final regulations adopt the 
jurisdictional nexus requirement introduced by the 2020 FTC proposed 
regulations (renamed the ``attribution requirement'' in the final 
regulations) for purposes of determining whether a foreign tax is an 
income tax in the U.S. sense. Under this requirement, 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 
that foreign country (such as operations, employees, factors of 
production) 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 
foreign taxing jurisdiction (see Part I.C.3.ii of this Special Analyses 
for discussion of alternatives considered and taxpayers affected). 
Together, the clarifications and changes to the net gain requirement 
and the attribution 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 final regulations address other issues raised in 
comments to the 2019 FTC proposed regulations or resulting from other 
legislation. For example, comments on the 2019 FTC proposed regulations 
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 2020 FTC proposed 
regulations and the final regulations allow taxpayers to choose the 
most appropriate method for their circumstances. (See Part I.C.3.iii of 
this Special Analyses for alternatives considered and affected 
taxpayers).
    With respect to the contested tax issue, the final regulations 
establish that contested taxes do not accrue (and therefore cannot be 
claimed as a credit) until the contest is resolved. However, the final 
regulations will allow taxpayers to claim a provisional credit for the 
portion of taxes already remitted 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 
I.C.3.iv of this Special Analyses for alternatives considered and 
affected taxpayers). In this way, the final 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.

[[Page 309]]

    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 final 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 final 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 foreign 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 final regulations 
provide, the final 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 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 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 ($2021) 
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 effective tax rates,\10\ 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 ($2021).
---------------------------------------------------------------------------

    \10\ 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 final 
regulations or under alternative regulatory approaches; (ii) the 
difference in business decisions that taxpayers might make between the 
final 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 final 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.
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 regulations, a foreign tax is creditable if it 
reaches ``net gain,'' which is determined based in part on data-driven 
analysis. Therefore, under the existing regulations, 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 to 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 Final 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

[[Page 310]]

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 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 limited 
circumstances as part of the cost recovery analysis to determine 
whether a cost or expense is significant with respect to all taxpayers; 
however, in order to provide clarity and certainty to taxpayers, the 
final regulations contain a non-exclusive per se list of significant 
costs and expenses.
    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 final 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 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 final 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. 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 foreign tax credits 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, that the tax be imposed only on income that has a 
jurisdictional nexus (or adequate connection) to the country imposing 
the tax. In order to 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 Final 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.

[[Page 311]]

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 in 
light of the fact that the Code contains a broader rule for determining 
when a nonresident is taxed on its income attributable to a activity in 
the United States.
    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 ambiguous, 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 the 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 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. In addition, the Treasury Department and 
the IRS 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 requirement of the 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. 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 foreign tax credits 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.

[[Page 312]]

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 Final 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 2020 FTC proposed 
regulations provided that the life subgroup method should generally be 
used, because it minimizes opportunities for abuse and is more 
consistent with the general rules for allocating expenses among 
affiliated group members. However, recognizing that the separate entity 
method also has merit, the 2020 FTC proposed regulations and the final 
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 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 remitted to the foreign country, 
even though the taxpayer continues to dispute the liability. While this 
alleviates cash flow constraints associated with temporary double 
taxation, it is not 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.
    The final regulations clarify the treatment of contested foreign 
taxes of accrual basis taxpayers. As described in part VI.D.2 of the 
Summary of Comments and Explanation of Revisions, the final regulations 
also clarify, in response to comments, the circumstances in which cash 
method taxpayers may claim a foreign tax credit for contested taxes 
that are remitted before the contest has been concluded.
b. Options Considered for the Final 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 being 
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 for accrual method taxpayers and with the Sec.  
1.901-2(e) compulsory payment requirement. It would also result in an 
accrual basis 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

[[Page 313]]

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 is resolved. This is the option adopted in 
Sec.  1.905-1(c)(3) and (d)(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 final 
regulations potentially affect U.S. taxpayers that claim foreign tax 
credits 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, generally have a foreign tax 
redetermination. 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 11,400 filers would be affected by these 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 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 on Schedule K; U.S. individuals that filed an amended return and 
had a Form 1116 attached to the Form 1040.

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 collections of information in these final regulations are in 
Sec. Sec.  1.905-1(c)(3), (d)(4) and (d)(5), 1.901-1(d)(2), and 1.905-
3. These collections of information are generally the same as the 
collections of information in the 2020 FTC proposed regulations, except 
for the addition of Sec.  1.905-1(c)(3), which extends the election and 
filing requirements in Sec.  1.905-1(d)(4) for claiming a provisional 
foreign tax credit for contested foreign income to cash method 
taxpayers. See Part VI.D.2 of the Summary of Comments and Explanation 
of Revisions for explanation of this change.
    The collections of information in Sec. Sec.  1.905-1(c)(3) and 
(d)(4) apply to taxpayers that elect to claim a provisional credit for 
contested foreign income taxes before the contest resolves. Under the 
final regulations, both cash and accrual method taxpayers making this 
election are required to file an agreement described in Sec.  1.905-
1(d)(4)(ii) as well as an annual notification described in Sec.  1.905-
1(d)(4)(iv). 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, to obtain the Commissioner's permission to make 
the change. Sections 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 generally require taxpayers to file an amended 
return for the year or years affected, along with an updated Form 1116 
or Form 1118 if foreign tax credits are claimed, and a written 
statement providing specific information.
    The burdens associated with collections of information in 
Sec. Sec.  1.905-1(d)(4)(iv) and (d)(5), 1.901-1(d)(2), and 1.905-3, 
which will be conducted through existing IRS forms, are described in 
Part II.B of this Special Analyses. The burden associated with the 
collection of information in 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--Sec. Sec.  1.905-1(d)(4)(iv), 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 of this Special 
Analyses 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)(iv)........  11,400............  Form 1116, Form
                                                       1118.
Sec.   1.905-1(d)(5)............  465,500-514,500...  Form 3115.

[[Page 314]]

 
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 notification requirement in Sec.  1.905-1(d)(4)(iv), 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 Sec.  1.905-1(d)(4)(iv) 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 Sec.  1.905-
1(d)(4)(iv), as well as with respect to the collection of information 
in 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 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 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 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 the 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 Sec.  
1.905-1(d)(5). The estimate in Table 1 of the 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 portion of this population of taxpayers will be subject to 
the collection of information in Sec.  1.905-1(d)(5), because only 
taxpayers that have used an improper method of accounting are subject 
to Sec.  1.905-1(d)(5).
    The collection of information resulting from 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 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 Sec. Sec.  1.901-1(d)(2) and 1.905-3, which amend the 
definition of a 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 regulations that will 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 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 1.085 billion 
hours and total estimated monetized costs of $44.279 billion ($2021). 
OMB control number 1545-0074 represents a total estimated burden time, 
including all other related forms and schedules for individuals, of 
2.14 billion hours and total estimated monetized costs of $37.960 
billion ($2021). 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 2,506,600 hours and total 
estimated monetized costs of $1.744 billion ($2018). OMB control number 
1545-1056 has an estimated number of 13,000 respondents and total 
estimated burden time of 54,000 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

[[Page 315]]

will be revised as a result of the information collections in the final 
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 final 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 Sec. Sec.  1.905-1(d)(4)(iv) and (d)(5), 1.901-1(d)(2), 
and 1.905-3 because no burden estimates specific to Sec. Sec.  1.905-
1(d)(4)(iv) 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.

                           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
                                       Model).                                            12/31/2023.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202010-1545-010.
                                      Individual (NEW Model).  1545-0074...............  Approved by OMB through
                                                                                          12/31/2021.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202108-1545-001.
Form 1118...........................  Business (NEW Model)...  1545-0123...............  Approved by OMB through
                                                                                          12/31/2021.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202012-1545-012.
Form 3115...........................  Business (NEW Model)...  1545-0123...............  Approved by OMB through
                                                                                          12/31/2021.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202012-1545-012.
                                      Individual (NEW Model).  1545-0074...............  Approved by OMB through
                                                                                          12/31/2021.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202108-1545-001.
Notification of FTRs................  .......................  1545-1056...............  Approved by OMB through
                                                                                          7/31/2024.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202105-1545-005.
Amended returns.....................  Business (NEW Model)...  1545-0123...............  Approved by OMB through
                                                                                          12/31/2021.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202012-1545-012.
                                      Individual (NEW Model).  1545-0074...............  Approved by OMB through
                                                                                          12/31/2021.
                                      https://www.reginfo.gov/public/do/PRAViewICR?ref_nbr=202108-1545-001.
                                      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--Sec. Sec.  1.905-1(c)(3) and 1.905-
1(d)(4)(ii)
    The collection of information contained in Sec.  1.905-
1(d)(4)(ii)--relating to the provisional foreign tax credit agreement 
that taxpayers electing to claim a provisional credit for contested 
foreign income taxes must file--was submitted to the OMB for review in 
accordance with the Paperwork Reduction Act and was approved under OMB 
control number 1545-2296. No comments regarding this collection of 
information were received. As described in Part II.A of this Special 
Analyses, the final regulations, under Sec.  1.905-1(c)(3), extend the 
provisional credit election and associated collection of information in 
Sec.  1.905-1(d)(4)(ii) to cash method taxpayers. The burden estimates 
for control number 1545-2296 will be updated to reflect this change.
    The likely respondents are U.S. persons who pay or accrue foreign 
income taxes.
    Estimated total annual reporting burden: 22,800 hours.
    Estimated average annual burden per respondent: 2 hours.
    Estimated number of respondents: 11,400.
    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 final 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 final regulations provide guidance needed to comply with the 
statutory rules under sections 245A(d), 861, 901, 903, 904, 905, and 
960 and affect U.S. individuals and corporations that claim a credit or 
a deduction for foreign taxes. The domestic small business entities 
that are subject to these Code provisions and to the rules in the final 
regulations are those that operate in foreign jurisdictions or that 
have income from sources outside of the United States and pay foreign 
taxes. The final regulations also contain clarifying

[[Page 316]]

rules relating to foreign derived intangible income (FDII) under 
section 250. Specifically, Sec.  1.250(b)-1(c)(7) provides a 
clarification regarding the determination of domestic oil and gas 
extraction income and Sec.  1.250(b)-5(c)(5) clarifies the meaning of 
the term ``electronically supplied services'' as used in the section 
250 regulations. Because these rules only clarify the intended meaning 
of terms in the section 250 regulations, they do not change the 
economic impact that the section 250 regulations have on small business 
entities. See the Regulatory Flexibility Act analysis of TD 9901, 85 FR 
43078-79.
    Many of the important aspects of the final regulations, including 
the rules in Sec. Sec.  1.245A(d)-1, 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 are at least 
10 percent shareholders of foreign corporations, and thus 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 the final regulations, 
specifically the rules in Sec.  1.861-14, apply only to members of an 
affiliated group of insurance companies 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 operate as an 
insurance company, or to operate outside the United States in corporate 
form. Consequently, the Treasury Department and the IRS do not expect 
that the final regulations will likely affect a substantial number of 
domestic small business entities. However, the Treasury Department and 
the IRS do not have adequate data readily available to assess the 
number of small entities potentially affected by the final regulations.
    The Treasury Department and the IRS have determined that the final 
regulations will not have a significant economic impact on domestic 
small business entities. A significant part of the final regulations is 
the modification of the requirements in Sec. Sec.  1.901-2 and 1.903-1 
for determining whether a foreign tax is a creditable ``foreign income 
tax'' or a creditable ``tax in lieu of an income tax'' under sections 
901 and 903, respectively. Of particular note, the final regulations 
add a jurisdictional nexus requirement to the existing creditability 
requirements. A principal reason for adding the jurisdictional nexus 
requirement is to ensure that certain novel extraterritorial foreign 
taxes, such as digital services taxes, are not creditable. Many of 
these novel extraterritorial taxes only apply to large multinational 
corporations; as such, small business entities are unlikely to be 
impacted by the denial of credits for such extraterritorial taxes. In 
addition, as described in Part I.C.3.i of this Special Analysis, the 
final regulations remove the empirical analysis required by the 
existing creditability requirements under Sec.  1.901-2 in favor a 
creditability analysis based principally on the terms of foreign tax 
law. The Treasury Department and the IRS anticipate that the final 
regulations will reduce taxpayer compliance costs relative to the 
existing regulations by significantly reducing the circumstances in 
which taxpayers must incur costs to obtain data in order to evaluate 
the creditability of a tax.
    To provide an upper bound estimate of the impact these final 
regulations could have on business entities, the Treasury Department 
and the IRS calculated, based on information from the Statistics of 
Income 2017 Corporate File, foreign tax credits \11\ as a percentage of 
three different tax-related measures of annual receipts (see Table for 
variables) by corporations. As demonstrated by the data in the table 
below, foreign tax credits as a percentage of all three measures of 
annual receipts is substantially less than the 3 to 5 percent threshold 
for significant economic impact for corporations with business receipts 
less than $250 million. The Treasury Department and the IRS anticipate 
that only a small fraction of existing foreign tax credits would be 
impacted by these regulations, and thus, the economic impact of these 
regulations will be considerably smaller than the effects shown in the 
table.
---------------------------------------------------------------------------

    \11\ Although certain parts of the final regulations, such as 
the rules under Sec.  1.901-1(d) and Sec.  1.905-1, 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, for 
such taxes. In addition, a significant aspect of these final 
regulations, specifically the rules under Sec. Sec.  1.901-2 and 
1.903-1 regarding the definition of a foreign income tax and a tax 
in lieu of an income tax, only impact taxpayers that elect to claim 
a foreign tax credit. Thus, the data in this table measuring foreign 
tax credit against various variables is a reasonable estimate of the 
economic impact of these final regulations.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                    $500,000     $1,000,000    $5,000,000    $10,000,000    $50,000,000    $100,000,000
                                        Under         under         under         under         under          under           under       $250,000,000
    Size (by business receipts)       $500,000     $1,000,000    $5,000,000    $10,000,000   $50,000,000   $100,000,000    $250,000,000       or more
                                      (percent)     (percent)     (percent)     (percent)     (percent)      (percent)       (percent)       (percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
FTC/Total Receipts................          0.12          0.00          0.00          0.00          0.01            0.01            0.02            0.28
FTC/(Total Receipts--Total                  0.61          0.03          0.09          0.05          0.35            0.71            1.38            9.89
 Deductions)......................
FTC/Business Receipts.............          0.84          0.00          0.00          0.00          0.01            0.01            0.02            0.05
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: RAAS: (Tax Year 2017 SOI Data).

    A portion of the economic impact of these final regulations derive 
from the collection of information requirements in Sec. Sec.  1.905-
1(c)(3), (d)(4), and (d)(5), 1.901-1(d)(2), and 1.905-3. The data to 
assess precise counts of small entities affected by Sec. Sec.  1.905-
1(c)(3), (d)(4), and (d)(5), 1.901-1(d)(2), and 1.905-3 are not readily 
available. However, the Treasury Department and the IRS do not 
anticipate that these collections of information significantly add to 
the burden on small entities, compared to the existing regulatory and 
statutory requirements. The rules in Sec. Sec.  1.901-1(d)(2), and 
1.905-3, which treat a taxpayer's change between claiming a deduction 
and a credit for foreign income taxes as a foreign tax redetermination 
and thus require the taxpayer to comply with reporting requirements in 
Sec.  1.905-4, do not significantly add to the taxpayer's burden 
because taxpayers making this change must already file amended returns, 
along with Forms 1116 or 1118, if applicable, for the affected years. 
In fact, these rules reduce the uncertainty faced by taxpayers seeking 
to make the change but that have a time-barred deficiency in one or 
more intervening years and provide an efficient process by which 
taxpayers can change between crediting and deducting foreign income 
taxes. Similarly, under the existing rules, taxpayers that remit a 
contested foreign tax liability to a foreign country and seek to claim 
a foreign tax credit for such liability would be subject to the

[[Page 317]]

reporting requirements related to foreign tax redeterminations under 
Sec.  1.905-4, and may have a second foreign tax redetermination when 
the contest is resolved if the taxpayer receives a refund of any of the 
taxes claimed as a credit. Under Sec. Sec.  1.905-1(c) and (d) of these 
final regulations, taxpayers do not claim a credit for the foreign 
taxes until the contest is resolved (and thus, would generally only 
have one foreign tax redetermination). The reporting requirements in 
Sec. Sec.  1.905-1(c)(3) and (d)(4), relating to taxpayers claiming a 
provisional credit for contested foreign income taxes, apply only if 
the taxpayer elects to claim the foreign tax credit early. If a 
taxpayer makes this election, it must file a provisional foreign tax 
credit agreement described in Part II.C of this Special Analysis and 
comply with annual reporting requirements described in Part II.B of 
this Special Analysis. The Treasury Department and the IRS estimate 
that the average burden of the provisional foreign tax credit agreement 
will be 2 hours per response. In addition, the Treasury Department and 
the IRS expect that the annual reporting requirement, which will be 
added to the existing Forms 1116 and 1118, will only marginally 
increase the burden for completing those forms. Finally, the Treasury 
Department and the IRS expect that the collection of information in 
Sec.  1.905-1(d)(5), which requires taxpayers seeking to change their 
method of accounting for foreign income taxes to file a Form 3115, will 
not significantly impact small business entities because only taxpayers 
that have deducted or credited foreign income taxes and that have used 
an improper method of accounting for such taxes are subject to the 
rules in Sec.  1.905-1(d)(5).
    The Treasury Department and the IRS do not have readily available 
data to determine the incremental burdens these collections of 
information will have on small business entities. However, 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. Therefore, the final 
regulations do not have a significant economic impact on small business 
entities. Accordingly, it is hereby certified that the final 
regulations will not have a significant economic impact on a 
substantial number of small entities.

IV. Section 7805(f)

    Pursuant to section 7805(f), the proposed regulations preceding 
these final regulations (REG-101657-20) were submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small businesses. The proposed regulations also 
request comments from the public regarding the RFA certification. No 
comments were received.

V. 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 final 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.

VI. 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 final 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.

Drafting Information

    The principal authors of the final regulations are Corina Braun, 
Karen J. Cate, Jeffrey P. Cowan, Moshe A. Dlott, Logan M. Kincheloe, 
Brad McCormack, Jeffrey L. Parry, Teisha M. Ruggiero, 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.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by 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), 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 a 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 
December 28, 2021.

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) No foreign tax credit or deduction allowed under section 
245A(d)-(1) Foreign income taxes paid or accrued by domestic 
corporations or successors. No credit under section 901 or deduction is 
allowed in any taxable year for:
    (i) Foreign income taxes paid or accrued by a domestic corporation 
that are attributable to section 245A(d) income of the domestic 
corporation;
    (ii) Foreign income taxes paid or accrued by a successor to a 
domestic corporation that are attributable to section 245A(d) income of 
the successor; and
    (iii) Foreign income taxes paid or accrued by a domestic 
corporation that is a United States shareholder of a foreign 
corporation, other than a foreign corporation that is a passive foreign 
investment company (as defined in section 1297) with respect to the 
domestic corporation and that is not a controlled foreign corporation, 
that are attributable to non-inclusion income of

[[Page 318]]

the foreign corporation and are not otherwise disallowed under 
paragraph (a)(1)(i) or (ii) of this section.
    (2) Foreign income taxes paid or accrued by foreign corporations. 
No credit under section 901 or deduction is allowed in any taxable year 
for foreign income taxes paid or accrued by a foreign corporation that 
are attributable to section 245A(d) income, and such taxes are not 
eligible to be deemed paid under section 960 in any taxable year.
    (3) Effect of disallowance on earnings and profits. The 
disallowance of a credit or deduction for foreign income taxes under 
this paragraph (a) does not affect whether the foreign income taxes 
reduce earnings and profits of a corporation.
    (b) Attribution of foreign income taxes--(1) Section 245A(d) 
income. Foreign income taxes are attributable to section 245A(d) income 
to the extent that the foreign income taxes are allocated and 
apportioned under Sec.  1.861-20 to the section 245A(d) income group. 
For purposes of this paragraph (b)(1), Sec.  1.861-20 is applied by 
treating the section 245A(d) income group in each section 904 category 
of a domestic corporation, successor, or foreign corporation as a 
statutory grouping and treating all other income, including the receipt 
of a distribution of previously taxed earnings and profits other than 
section 245A(d) PTEP, as income in the residual grouping. See Sec.  
1.861-20(d)(2) through (3) for rules regarding the allocation and 
apportionment of foreign income taxes to the statutory and residual 
groupings if the taxpayer does not realize, recognize, or take into 
account a corresponding U.S. item in the U.S. taxable year in which the 
foreign income taxes are paid or accrued. In the case of a foreign law 
distribution or foreign law disposition, a corresponding U.S. item is 
assigned to the statutory and residual groupings under Sec.  1.861-
20(d)(2)(ii)(B) and (C) without regard to the application of section 
246(c), the holding periods described in sections 964(e)(4)(A) and 
1248(j), and Sec.  1.245A-5.
    (2) Non-inclusion income of a foreign corporation--(i) Scope. This 
paragraph (b)(2) provides rules for attributing foreign income taxes 
paid or accrued by a domestic corporation that is a United States 
shareholder of a foreign corporation to non-inclusion income of the 
foreign corporation. It applies only in cases in which the foreign 
income taxes are allocated and apportioned under Sec.  1.861-20 by 
reference to the characterization of the tax book value of stock, 
whether the stock is held directly or indirectly through a partnership 
or other passthrough entity, for purposes of allocating and 
apportioning the domestic corporation's interest expense, or by 
reference to the income of a foreign corporation that is a reverse 
hybrid or foreign law CFC.
    (ii) Foreign income taxes on a remittance, U.S. return of capital 
amount, or U.S. return of partnership basis amount. This paragraph 
(b)(2)(ii) applies to foreign income taxes paid or accrued by a 
domestic corporation that is a United States shareholder of a foreign 
corporation with respect to foreign taxable income that the domestic 
corporation includes by reason of a remittance, a distribution 
(including a foreign law distribution) that is a U.S. return of capital 
amount or U.S. return of partnership basis amount, or a disposition 
(including a foreign law disposition) that gives rise to a U.S. return 
of capital amount or a U.S. return of partnership basis amount. These 
foreign income taxes are attributable to non-inclusion income of the 
foreign corporation to the extent that they are allocated and 
apportioned to the domestic corporation's section 245A subgroup of 
general category stock, section 245A subgroup of passive category 
stock, or section 245A subgroup of U.S. source category stock in 
applying Sec.  1.861-20 for purposes of section 904 as the operative 
section. For purposes of this paragraph (b)(2)(ii), Sec.  1.861-20 is 
applied by treating the domestic corporation's section 245A subgroup of 
general category stock, section 245A subgroup of passive category 
stock, and section 245A subgroup of U.S. source category stock as the 
statutory groupings and treating the tax book value of the non-section 
245A subgroup of stock for each separate category as tax book value in 
the residual grouping.
    (iii) Foreign income taxes on income of a reverse hybrid or a 
foreign law CFC. This paragraph (b)(2)(iii) applies to foreign income 
taxes paid or accrued by a domestic corporation, other than a regulated 
investment company (as defined in section 851), real estate investment 
trust (as defined in section 856), or S corporation (as defined in 
section 1361), that is a United States shareholder of a foreign 
corporation that is a reverse hybrid or foreign law CFC with respect to 
the foreign law pass-through income or foreign law inclusion regime 
income of the reverse hybrid or foreign law CFC, respectively. These 
taxes are attributable to the non-inclusion income of a reverse hybrid 
or foreign law CFC to the extent that they are allocated and 
apportioned to the non-inclusion income group under Sec.  1.861-20. For 
purposes of this paragraph (b)(2)(iii), Sec.  1.861-20 is applied by 
treating the non-inclusion income group in each section 904 category of 
the domestic corporation and the foreign corporation as a statutory 
grouping and treating all other income as income in the residual 
grouping.
    (3) Anti-avoidance rule. Foreign income taxes are treated as 
attributable to section 245A(d) income of a domestic corporation or 
foreign corporation, or non-inclusion income 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 with respect to such foreign income taxes, 
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 (d)(4) of this section (Example 3).
    (c) Definitions. The following definitions apply for purposes of 
this section.
    (1) Corresponding U.S. item. The term corresponding U.S. item has 
the meaning set forth in Sec.  1.861-20(b).
    (2) Foreign income tax. The term foreign income tax has the meaning 
set forth in Sec.  1.901-2(a).
    (3) Foreign law CFC. The term foreign law CFC has the meaning set 
forth in Sec.  1.861-20(b).
    (4) Foreign law disposition. The term foreign law disposition has 
the meaning set forth in Sec.  1.861-20(b).
    (5) Foreign law distribution. The term foreign law distribution has 
the meaning set forth in Sec.  1.861-20(b).
    (6) Foreign law inclusion regime. The term foreign law inclusion 
regime has the meaning set forth in Sec.  1.861-20(b).
    (7) Foreign law inclusion regime income. The term foreign law 
inclusion regime income has the meaning set forth in Sec.  1.861-20(b).
    (8) Foreign law pass-through income. The term foreign law pass-
through income has the meaning set forth in Sec.  1.861-20(b).
    (9) Foreign taxable income. The term foreign taxable income has the 
meaning set forth in Sec.  1.861-20(b).
    (10) Gross included tested income. The term gross included tested 
income means, with respect to a foreign corporation that is described 
in paragraph (b)(2)(iii) of this section, an item of gross tested 
income multiplied by the inclusion percentage of a domestic corporation 
that is described

[[Page 319]]

in paragraph (b)(2)(iii) of this section for the domestic corporation's 
U.S. taxable year with or within which the foreign corporation's 
taxable year described in Sec.  1.861-20(d)(3)(i)(C) or Sec.  1.861-
20(d)(3)(iii) ends.
    (11) Hybrid dividend. The term hybrid dividend has the meaning set 
forth in Sec.  1.245A(e)-1(b)(2).
    (12) Inclusion percentage. The term inclusion percentage has the 
meaning set forth in Sec.  1.960-1(b).
    (13) Non-inclusion income. The term non-inclusion income means the 
items of gross income of a foreign corporation other than the items 
that are described in Sec.  1.960-1(d)(2)(ii)(B)(2) (items of income 
assigned to the subpart F income groups) and section 245(a)(5) (without 
regard to section 245(a)(12)), and other than gross included tested 
income.
    (14) Non-inclusion income group. The term non-inclusion income 
group means the income group within a section 904 category that 
consists of non-inclusion income.
    (15) Non-section 245A subgroup. The term non-section 245A subgroup 
means each non-section 245A subgroup determined under Sec.  1.861-
13(a)(5), applied as if the foreign corporation whose stock is being 
characterized were a controlled foreign corporation.
    (16) Pass-through entity. The term pass-through entity has the 
meaning set forth in Sec.  1.904-5(a)(4).
    (17) Remittance. The term remittance has the meaning set forth in 
Sec.  1.861-20(d)(3)(v)(E).
    (18) Reverse hybrid. The term reverse hybrid has the meaning set 
forth in Sec.  1.861-20(b).
    (19) Section 245A subgroup. The term section 245A subgroup means 
each section 245A subgroup determined under Sec.  1.861-13(a)(5), 
applied as if the foreign corporation whose stock is being 
characterized were a controlled foreign corporation.
    (20) Section 245A(d) income. With respect to a domestic 
corporation, the term section 245A(d) income means a dividend 
(including a section 1248 dividend and a dividend received indirectly 
through a pass-through entity) or an inclusion under section 
951(a)(1)(A) for which a deduction under section 245A(a) is allowed, a 
distribution of section 245A(d) PTEP, a hybrid dividend, or an 
inclusion under section 245A(e)(2) and Sec.  1.245A(e)-1(c)(1) by 
reason of a tiered hybrid dividend. With respect to a successor of a 
domestic corporation, the term section 245A(d) income means the receipt 
of a distribution of section 245A(d) PTEP. With respect to a foreign 
corporation, the term section 245A(d) income means an item of subpart F 
income that gave rise to a deduction under section 245A(a), a tiered 
hybrid dividend or a distribution of section 245A(d) PTEP. An item 
described in this paragraph (c)(20) that qualifies for the deduction 
under section 245A(a) is considered section 245A(d) income regardless 
of whether the domestic corporation claims the deduction on its return 
with respect to the item.
    (21) Section 245A(d) income group. The term section 245A(d) income 
group means an income group within a section 904 category that consists 
of section 245A(d) income.
    (22) 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) if such previously taxed earnings and profits arose 
either as a result of a dividend that 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. For 
purposes of this paragraph (c)(22), a dividend that qualifies for the 
deduction under section 245A(a) is considered to have given rise to a 
deduction under section 245A(a) regardless of whether the domestic 
corporation claims the deduction on its return with respect to the 
dividend.
    (23) Section 904 category. The term section 904 category has the 
meaning set forth in Sec.  1.960-1(b).
    (24) Section 1248 dividend. The term section 1248 dividend means an 
amount of gain that is treated as a dividend under section 1248.
    (25) Successor. The term successor means a person, including an 
individual who is a citizen or resident of the United States, that 
acquires from any person any portion of the interest of a United States 
shareholder in a foreign corporation for purposes of section 959(a).
    (26) Tested income. The term tested income has the meaning set 
forth Sec.  1.960-1(b).
    (27) Tiered hybrid dividend. The term tiered hybrid dividend has 
the meaning set forth in Sec.  1.245A(e)-1(c)(2).
    (28) U.S. capital gain amount. The term U.S. capital gain amount 
has the meaning set forth in Sec.  1.861-20(b).
    (29) U.S. return of capital amount. The term U.S. return of capital 
amount has the meaning set forth in Sec.  1.861-20(b).
    (30) U.S. return of partnership basis amount. The term U.S. return 
of partnership basis amount means, with respect to a partnership in 
which a domestic corporation is a partner, the portion of a 
distribution by the partnership to the domestic corporation, or the 
portion of the proceeds of a disposition of the domestic corporation's 
interest in the partnership, that exceeds the U.S. capital gain amount.
    (d) 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 or a foreign law CFC;
    (iii) USP owns all of the outstanding stock of CFC;
    (iv) USP would be allowed a deduction under section 245A(a) for 
dividends received from CFC;
    (v) 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; and
    (vi) References to income are to gross items of income, and no 
party has deductions for Country A tax purposes or deductions for 
Federal income tax purposes (other than foreign income tax expense).
    (2) Example 1: Distribution for foreign and Federal income tax 
purposes--(i) Facts. 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 entire $1,000x distribution is a dividend and is 
therefore a foreign dividend amount (as defined in Sec.  1.861-20(b)). 
Country A imposes a withholding tax on USP of $150x with respect to the 
$1,000x of foreign gross dividend income under Country A law. For 
Federal income tax purposes, USP includes in gross income $200x of the 
distribution as a dividend for which a deduction is allowable under 
section 245A(a). The remaining $800x of the distribution is a 
distribution of PTEP that is excluded from USP's gross income and not 
treated as a dividend under section 959(a) and (d), respectively. The 
entire $1,000x dividend is a U.S. dividend amount (as defined in Sec.  
1.861-20(b)).
    (ii) Analysis--(A) In general. The rules of this section are 
applied by first determining the portion of the $150x Country A 
withholding tax that is attributable under paragraph (b)(1) of this 
section to the section 245A(d) income of USP, and then by

[[Page 320]]

determining the portion of the $150x Country A withholding tax that is 
described in paragraph (b)(2)(i) of this section and that is 
attributable under either paragraph (b)(2)(ii) or (b)(2)(iii) of this 
section to the non-inclusion income of CFC. No credit or deduction is 
allowed in any taxable year under paragraph (a)(1)(i) of this section 
for any portion of the $150x Country A withholding tax that is 
attributable to the section 245A(d) income of USP, or, under paragraph 
(a)(1)(iii) of this section, for any portion of that tax that is 
attributable to the non-inclusion income of CFC, to the extent the tax 
is not disallowed under paragraph (a)(1)(i) of this section.
    (B) Attribution of foreign income taxes to section 245A(d) income. 
Under paragraph (b)(1) of this section, the $150x Country A withholding 
tax is attributable to the section 245A(d) income of USP to the extent 
that it is allocated and apportioned to the section 245A(d) income 
group (the statutory grouping) under Sec.  1.861-20. Section 1.861-
20(c) allocates and apportions foreign income tax to the statutory and 
residual groupings to which the items of foreign gross income that were 
included in the foreign tax base are assigned under Sec.  1.861-20(d). 
Section 1.861-20(d)(3)(i) assigns foreign gross income that is a 
foreign dividend amount, to the extent of the U.S. dividend amount, to 
the statutory and residual groupings to which the U.S. dividend amount 
is assigned. The $1,000x foreign dividend amount is therefore assigned 
to the statutory and residual groupings to which the $1,000x U.S. 
dividend amount is assigned under Federal income tax law. The $1,000x 
U.S. dividend amount comprises a $200x dividend for which a deduction 
under section 245A(a) is allowed, which is an item of section 245A(d) 
income, and $800x of section 951A PTEP, the receipt of which is income 
in the residual grouping. Accordingly, $200x of the $1,000x of foreign 
gross dividend income is assigned to the section 245A(d) income group, 
and $800x is assigned to the residual grouping. Under Sec.  1.861-
20(f), $30x ($150x x $200x/$1,000x) of the $150x Country A withholding 
tax is apportioned to the section 245A(d) income group and is 
attributable to the section 245A(d) income of USP. The remaining $120x 
($150x x $800x/$1,000x) of the tax is apportioned to the residual 
grouping.
    (C) Attribution of foreign income taxes to non-inclusion income. 
Under paragraph (b)(2) of this section, the $150x Country A withholding 
tax may be attributed to non-inclusion income of CFC if the tax is 
allocated and apportioned under Sec.  1.861-20 by reference to either 
the characterization of the tax book value of stock under Sec.  1.861-9 
or the income of a foreign corporation that is a reverse hybrid or 
foreign law CFC. CFC is neither a reverse hybrid nor a foreign law CFC. 
In addition, no portion of the $150x Country A withholding tax is 
allocated and apportioned under Sec.  1.861-20 by reference to the 
characterization of the tax book value of CFC's stock. See Sec.  1.861-
20(d)(3)(i). Therefore, none of the tax is attributable to non-
inclusion income of CFC.
    (D) Disallowance. Under paragraph (a)(1)(i) of this section, no 
credit under section 901 or deduction is allowed in any taxable year to 
USP for the $30x portion of the Country A withholding tax that is 
attributable to section 245A(d) income of USP.
    (3) Example 2: Distribution for foreign law purposes--(i) Facts. 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 its stock to USP. For Country A tax purposes, the entire 
$1,000x stock distribution is treated as a dividend to USP and is 
therefore a foreign dividend amount (as defined in Sec.  1.861-20(b)). 
Country A imposes a withholding tax on USP of $150x with respect to the 
$1,000x of foreign gross dividend income that USP includes under 
Country A law. For Federal income tax purposes, USP does not recognize 
gross income as a result of the stock distribution under section 
305(a). The $1,000x stock distribution is therefore a foreign law 
distribution.
    (ii) Analysis--(A) In general. The rules of this section are 
applied by first determining the portion of the $150x Country A 
withholding tax that is attributable under paragraph (b)(1) of this 
section to the section 245A(d) income of USP, and then by determining 
the portion of the $150x Country A withholding tax that is described in 
paragraph (b)(2)(i) of this section and that is attributable under 
either paragraph (b)(2)(ii) or (b)(2)(iii) of this section to the non-
inclusion income of CFC. No credit or deduction is allowed in any 
taxable year under paragraph (a)(1)(i) of this section for any portion 
of the $150x Country A withholding tax that is attributable to the 
section 245A(d) income of USP or, under paragraph (a)(1)(iii) of this 
section, for any portion of that tax that is attributable to the non-
inclusion income of CFC, to the extent the tax is not disallowed under 
paragraph (a)(1)(i) of this section.
    (B) Attribution of foreign income taxes to section 245A(d) income. 
Under paragraph (b)(1) of this section, the $150x Country A withholding 
tax is attributable to the section 245A(d) income of USP to the extent 
that it is allocated and apportioned to the section 245A(d) income 
group (the statutory grouping) under Sec.  1.861-20. Section 1.861-
20(c) allocates and apportions foreign income tax to the statutory and 
residual groupings to which the items of foreign gross income that were 
included in the foreign tax base are assigned under Sec.  1.861-20(d). 
In general, Sec.  1.861-20(d) assigns foreign gross income to the 
statutory and residual groupings to which the corresponding U.S. item 
is assigned. If a taxpayer does not recognize a corresponding U.S. item 
in the year in which it pays or accrues foreign income tax with respect 
to foreign gross income that it includes by reason of a foreign law 
dividend, Sec.  1.861-20(d)(2)(ii)(B) assigns the foreign dividend 
amount to the same statutory or residual groupings to which the foreign 
dividend amount would be assigned if a distribution were made for 
Federal income tax purposes in the amount of, and on the date of, the 
foreign law distribution. Further, Sec.  1.861-20(d)(2)(ii)(B) computes 
the U.S. dividend amount (as defined in Sec.  1.861-20(b)) as if the 
distribution occurred on the date the distribution occurs for foreign 
law purposes. Therefore, the foreign dividend amount is assigned to the 
same statutory and residual groupings to which it would be assigned if 
a $1,000x distribution occurred on December 31, Year 1 for Federal 
income tax purposes. If such a distribution occurred, it would result 
in a $200x dividend to USP for which a deduction would be allowed under 
section 245A(a). The remaining $800x of the distribution would be 
excluded from USP's gross income and not treated as a dividend under 
section 959(a) and (d), respectively. Under paragraphs (c)(20) and 
(b)(1) of this section, the $1,000x U.S. dividend amount comprises a 
$200x dividend for which a deduction under section 245A(a) would be 
allowed, which is an item of section 245A(d) income, and $800x of 
section 951A PTEP, which is income in the residual grouping. 
Accordingly, $200x of the $1,000x foreign gross dividend income is 
assigned to the section 245A(d) income group, 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 
section

[[Page 321]]

245A(d) income group and is attributable to the section 245A(d) income 
of USP. The remaining $120x ($150x x $800x/$1,000x) of the tax is 
apportioned to the residual grouping.
    (C) Attribution of foreign income taxes to non-inclusion income. 
Under paragraph (b)(2) of this section, the $150x Country A withholding 
tax may be attributed to non-inclusion income of CFC if the tax is 
allocated and apportioned under Sec.  1.861-20 by reference to either 
the characterization of the tax book value of stock under Sec.  1.861-9 
or the income of a foreign corporation that is a reverse hybrid or 
foreign law CFC. CFC is neither a reverse hybrid nor a foreign law CFC. 
In addition, no portion of the $150x Country A withholding tax is 
allocated and apportioned under Sec.  1.861-20 by reference to the 
characterization of the tax book value of CFC's stock. See Sec.  1.861-
20(d)(3)(i). Therefore, none of the tax is attributable to non-
inclusion income of CFC.
    (D) Disallowance. Under paragraph (a)(1)(i) of this section, no 
credit under section 901 or deduction is allowed in any taxable year to 
USP for the $30x portion of the Country A withholding tax that is 
attributable to section 245A(d) income of USP.
    (4) Example 3: Successive foreign law distributions subject to 
anti-avoidance rule--(i) Facts. For Year 1, CFC earns $500x of subpart 
F income that gives rise to a $500x gross income inclusion to USP under 
section 951(a), and income that creates $500x of earnings and profits 
described in section 959(c)(3). CFC earns no income in Years 2 through 
4. As of January 1, Year 2, and through December 31, Year 4, 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)) in 
a single annual PTEP account (as defined in Sec.  1.960-3(c)(1))). 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 is a 
dividend of $500x to USP, and each deemed contribution is a non-taxable 
contribution of $500x to the capital of CFC. Each $500x deemed 
distribution is therefore a foreign dividend amount (as defined in 
Sec.  1.861-20(b)). Country A imposes $150x of withholding tax on USP 
in each of Years 2 and 3 with respect to the $500x of foreign gross 
dividend income that USP includes in income under Country A law. For 
Federal income tax purposes, the Country A deemed distributions in 
Years 2 and 3 are disregarded such that USP recognizes no income, and 
the deemed distributions are therefore foreign law distributions. On 
December 31, 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 a dividend to USP for which a deduction 
under section 245A(a) is allowed; the remaining $500x of the 
distribution is a distribution of section 951(a)(1)(A) PTEP that is 
excluded from USP's gross income and not treated as a dividend under 
section 959(a) and (d), respectively. The entire $1,000x dividend is a 
U.S. dividend amount (as defined in Sec.  1.861-20(b)). The Country A 
consent dividend elections in Years 2 and 3 are made with a principal 
purpose of avoiding the purposes of section 245A(d) and this section to 
disallow a credit or deduction for Country A withholding tax incurred 
with respect to USP's section 245A(d) income.
    (ii) Analysis--(A) In general. The rules of this section are 
applied by first determining the portion of the $150x Country A 
withholding tax paid by USP in each of Years 2 and 3 that is 
attributable under paragraph (b)(1) of this section to the section 
245A(d) income of USP, and then by determining the portion of the $150x 
Country A withholding tax paid by USP in each of Years 2 and 3 that is 
described in paragraph (b)(2)(i) of this section and that is 
attributable under either paragraph (b)(2)(ii) or (b)(2)(iii) of this 
section to the non-inclusion income of CFC. Finally, the anti-avoidance 
rule under paragraph (b)(3) of this section applies to treat any 
portion of the $150x Country A withholding tax paid by USP in each of 
Years 2 and 3 as attributable to section 245A(d) income of USP or non-
inclusion income of CFC, 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. No credit or 
deduction is allowed in any taxable year under paragraph (a)(1)(i) of 
this section for any portion of the $150x Country A withholding tax 
paid by USP in each of Years 2 and 3 that is attributable to the 
section 245A(d) income of USP or, under paragraph (a)(1)(iii) of this 
section, for any portion of that tax that is attributable to the non-
inclusion income of CFC, to the extent the tax is not disallowed under 
paragraph (a)(1)(i) of this section.
    (B) Attribution of foreign income taxes to section 245A(d) income. 
Under paragraph (b)(1) of this section, the $150x Country A withholding 
tax paid by USP in each of Years 2 and 3 is attributable to the section 
245A(d) income of USP to the extent that it is allocated and 
apportioned to the section 245A(d) income group (the statutory 
grouping) under Sec.  1.861-20. Section 1.861-20(c) allocates and 
apportions foreign income tax to the statutory and residual groupings 
to which the items of foreign gross income that were included in the 
foreign tax base are assigned under Sec.  1.861-20(d). In general, 
Sec.  1.861-20(d) assigns foreign gross income to the statutory and 
residual groupings to which the corresponding U.S. item is assigned. If 
a taxpayer does not recognize a corresponding U.S. item in the year in 
which it pays or accrues foreign income tax with respect to foreign 
gross income that it includes by reason of a foreign law dividend, 
Sec.  1.861-20(d)(2)(ii)(B) assigns the foreign dividend amount to the 
same statutory or residual groupings to which the foreign dividend 
amount would be assigned if a distribution were made for Federal income 
tax purposes in the amount of, and on the date of, the foreign law 
distribution. Therefore, the $500x foreign dividend amount in each of 
Years 2 and 3 is assigned to the same statutory and residual groupings 
to which it would be assigned if a $500x distribution occurred on 
December 31 of each of those years for Federal income tax purposes.
    (1) Year 2 $500x deemed distribution. CFC made no distributions in 
Year 1 and earned no income and made no distributions in Year 2 for 
Federal income tax purposes. As of December 31, Year 2, CFC has $500x 
of earnings and profits described in section 959(c)(3) and $500x of 
section 951(a)(1)(A) PTEP. If CFC distributed $500x on that date, the 
distribution would be a distribution of section 951(a)(1)(A) PTEP. A 
distribution of previously taxed earnings and profits is a U.S. 
dividend amount. Section 1.861-20(d)(3)(i) assigns the foreign dividend 
amount, to the extent of the U.S. dividend amount, to the statutory and 
residual groupings to which the U.S. dividend amount is assigned. The 
receipt of a distribution of previously taxed earnings and profits is 
assigned to the residual grouping under paragraph (b)(1) of this 
section. Therefore, all $500x foreign dividend amount would be assigned 
to the residual grouping, and none of the $150x withholding tax paid or 
accrued by USP in Year 2 would

[[Page 322]]

be treated as attributable to section 245A(d) income of USP.
    (2) Year 3 $500x deemed distribution. CFC made no distributions in 
Year 1 and earned no income and made no distributions in Year 2 or Year 
3 for Federal income tax purposes. Consequently, as of December 31, 
Year 3, CFC has $500x of earnings and profits described in section 
959(c)(3) and $500x of section 951(a)(1)(A) PTEP. If CFC distributed 
$500x on that date, the distribution would be a distribution of section 
951(a)(1)(A) PTEP. For the reasons described in paragraph 
(d)(4)(ii)(B)(1) of this section, all $500x of the foreign dividend 
amount would be assigned to the residual grouping, and none of the 
$150x withholding tax paid or accrued by USP in Year 2 would be treated 
as attributable to section 245A(d) income of USP.
    (3) Year 4 $1,000x distribution. The Year 4 $1,000x distribution 
is, for Country A purposes, a return of capital distribution that is 
not subject to withholding tax. For Federal income tax purposes, it 
comprises a $500x dividend for which a deduction under section 245A(a) 
is allowed, which is an item of section 245A(d) income of USP, and a 
$500x distribution of section 951(a)(1)(A) PTEP, the receipt of which 
is income in the residual grouping.
    (C) Attribution of foreign income taxes to non-inclusion income. 
Under paragraph (b)(2) of this section, the $150x Country A withholding 
tax paid by USP in each of Years 2 and 3 may be attributed to non-
inclusion income of CFC if the tax is allocated and apportioned under 
Sec.  1.861-20 by reference to either the characterization of the tax 
book value of stock under Sec.  1.861-9 or the income of a foreign 
corporation that is a reverse hybrid or foreign law CFC. CFC is neither 
a reverse hybrid nor a foreign law CFC. In addition, no portion of the 
Country A withholding tax is allocated and apportioned under Sec.  
1.861-20 by reference to the characterization of the tax book value of 
CFC's stock. See Sec.  1.861-20(d)(3)(i). Therefore, none of the tax is 
attributable to non-inclusion income of CFC.
    (D) Attribution of foreign income taxes pursuant to anti-avoidance 
rule. USP made 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 together exceeded, the section 951(a)(1)(A) 
PTEP of CFC. The Country A withholding tax on each consent dividend is 
allocated to the residual grouping rather than to the statutory 
grouping of section 245A(d) income under Sec. Sec.  1.861-20(d)(2)(ii) 
and 1.861-20(d)(3)(i). USP paid no Country A withholding tax on the 
Year 4 distribution as a result of the Country A consent dividends in 
Years 2 and 3. If CFC had distributed its earnings and profits in Year 
4 without the prior consent dividends, the distribution would have been 
subject to withholding tax, a portion of which would have been 
attributable to the section 245A(d) income arising from the 
distribution. But for the application of the anti-avoidance rule in 
paragraph (b)(3) of this section, USP would avoid the disallowance 
under section 245A(d) with respect to this portion of the withholding 
tax. Because USP made foreign law distributions that caused withholding 
tax from multiple foreign law distributions to be associated with the 
same previously taxed earnings and profits with a principal purpose of 
avoiding the purposes of section 245A(d) and this section, the $150x 
Country A withholding tax paid by USP in each of Years 2 and 3 is 
treated as being attributable to section 245A(d) income of USP.
    (E) Disallowance. Under paragraph (a)(1)(i) of this section, no 
credit under section 901 or deduction is allowed in any taxable year to 
USP for the $150x Country A withholding tax paid by USP in each of 
Years 2 and 3 that is attributable to section 245A(d) income of USP.
    (5) Example 4: Distribution that is in part a dividend and in part 
a return of capital--(i) Facts. CFC uses the modified gross income 
method to allocate and apportion its interest expense, and its stock 
has a tax book value of $10,000x. For Year 1, CFC earns $500x of income 
that is specified foreign source general category gross income as that 
term is defined in Sec.  1.861-13(a)(1)(i)(A)(9) and is therefore 
neither tested income nor subpart F income of CFC. As of December 31, 
Year 1, CFC has $500x of earnings and profits described in section 
959(c)(3). On that date, CFC distributes $1,000x of cash to USP. For 
Country A tax purposes, the entire $1,000x distribution is a dividend 
to USP and is therefore a foreign dividend amount (as defined in Sec.  
1.861-20(b)). Country A imposes a withholding tax on USP of $150x with 
respect to the $1,000x of foreign gross dividend income that USP 
includes under the law of Country A. For Federal income tax purposes, 
USP includes $500x of the distribution in its gross income as a 
dividend for which a $500x deduction is allowed to USP under section 
245A(a); the remaining $500x of the distribution is applied against and 
reduces USP's basis in its CFC stock under section 301(c)(2). The 
portion of the distribution that is a $500x dividend is a U.S. dividend 
amount (as defined in Sec.  1.861-20(b)). The remaining $500x of the 
distribution is a U.S. return of capital amount.
    (ii) Analysis--(A) In general. The rules of this section are 
applied by first determining the portion of the $150x Country A 
withholding tax that is attributable under paragraph (b)(1) of this 
section to the section 245A(d) income of USP, and then by determining 
the portion of the $150x Country A withholding tax that is described in 
paragraph (b)(2)(i) of this section and that is attributable under 
either paragraph (b)(2)(ii) or (b)(2)(iii) of this section to the non-
inclusion income of CFC. No credit or deduction is allowed under 
paragraph (a)(1)(i) of this section for any portion of the $150x 
Country A withholding tax that is attributable to the section 245A(d) 
income of USP or, under paragraph (a)(1)(iii) of this section, for any 
portion of that tax that is attributable to the non-inclusion income of 
CFC, to the extent the tax is not disallowed under paragraph (a)(1)(i) 
of this section.
    (B) Attribution of foreign income taxes to section 245A(d) income. 
Under paragraph (b)(1) of this section, the $150x Country A withholding 
tax is attributable to the section 245A(d) income of USP to the extent 
that it is allocated and apportioned to the section 245A(d) income 
group (the statutory grouping) under Sec.  1.861-20. Section 1.861-
20(c) allocates and apportions foreign income tax to the statutory and 
residual groupings to which the items of foreign gross income that were 
included in the foreign tax base are assigned under Sec.  1.861-20(d). 
Section 1.861-20(d)(3)(i) assigns foreign gross income that is a 
foreign dividend amount, to the extent of the U.S. dividend amount, to 
the statutory and residual groupings to which the U.S. dividend amount 
is assigned. Of the $1,000x foreign dividend amount, $500x is therefore 
assigned to the statutory and residual groupings to which the $500x 
U.S. dividend amount is assigned under Federal income tax law. The 
entire $500x U.S. dividend amount is a dividend for which a section 
245A(a) deduction is allowed and is therefore section 245A(d) income 
that is assigned to the section 245A(d) income group. Accordingly, 
$500x of the foreign dividend amount is assigned to the section 245A(d) 
income group. Under Sec.  1.861-20(f), $75x ($150x x $500x/$1,000x) of 
the Country A withholding tax is allocated to the section 245A(d) 
income group and so under paragraph (b)(1) of this section is 
attributable to the section 245A(d) income of USP.

[[Page 323]]

    (C) Attribution of foreign income taxes to non-inclusion income. 
The remaining $75x of the Country A withholding tax is described in 
paragraph (b)(2)(i) of this section because the $500x of foreign 
dividend amount that corresponds to the $500x U.S. return of capital 
amount is assigned, and the remaining withholding tax imposed on that 
foreign dividend amount is allocated and apportioned, by reference to 
the characterization of the tax book value of the stock of CFC. Under 
paragraph (b)(2)(ii) of this section, the remaining $75x Country A 
withholding tax is attributable to non-inclusion income of CFC to the 
extent that the tax is allocated and apportioned under Sec.  1.861-20 
to USP's section 245A subgroup of general category stock, section 245A 
subgroup of passive category stock, and section 245A subgroup of U.S. 
source category stock (the statutory groupings) for purposes of section 
904 as the operative section. Under Sec.  1.861-20(d)(3)(i), the $500x 
portion of the foreign dividend amount that corresponds to the $500x 
U.S. return of capital amount is assigned to the statutory and residual 
groupings to which $500x of earnings of CFC would be assigned if CFC 
recognized them in Year 1. Those earnings are deemed to arise in the 
statutory and residual groupings in the same proportions as the 
proportions of the tax book value of CFC's stock in the groupings for 
Year 1 for purposes of applying the asset method of expense allocation 
and apportionment under Sec.  1.861-9. Under Sec.  1.861-9, Sec.  
1.861-9T(f), and Sec.  1.861-13, for purposes of section 904 as the 
operative section, all of the tax book value of the stock of CFC is 
assigned to USP's section 245A subgroup of general category stock 
because CFC uses the modified gross income method to allocate and 
apportion its interest expense and earns only specified foreign source 
general category gross income for Year 1. Under Sec.  1.861-
20(d)(3)(i), if CFC recognized $500x of earnings in Year 1 these 
earnings would be deemed to arise in the section 245A subgroup of 
general category stock. Accordingly, the remaining $500x of foreign 
dividend amount is assigned to USP's section 245A subgroup of general 
category stock. Under Sec.  1.861-20(f), the remaining $75x of 
withholding tax is allocated to the section 245A subgroup and, under 
paragraph (b)(2)(ii) of this section, is attributable to the non-
inclusion income of CFC.
    (D) Disallowance. Under paragraph (a)(1)(i) of this section, no 
credit under section 901 or deduction is allowed in any taxable year to 
USP for the $75x portion of the Country A withholding tax that is 
attributable to section 245A(d) income of USP. Under paragraph 
(a)(1)(iii) of this section, no credit under section 901 or deduction 
is allowed in any taxable year to USP for the $75x portion of the 
Country A withholding tax that is attributable to non-inclusion income 
of CFC.
    (6) Example 5: Income of a reverse hybrid--(i) Facts. CFC is a 
reverse hybrid. In Year 1, CFC earns a $500x item of services income 
that is non-inclusion income. CFC also earns for Federal income tax 
purposes and Country A tax purposes a $1,000x item of royalty income, 
of which $500x is gross included tested income and $500x is non-
inclusion income. USP includes the $500x item of foreign gross services 
income and the $1,000x item of foreign gross royalty income in its 
Country A taxable income, and the items are foreign law pass-through 
income. If CFC included these items under Country A tax law, its 
$1,000x of royalty income for Federal income tax purposes would be the 
corresponding U.S. item for the foreign gross royalty income, and its 
$500x of services income for Federal income tax purposes would be the 
corresponding U.S. item for the foreign gross services income. Country 
A imposes a $150x foreign income tax on USP with respect to $1,500x of 
foreign gross income.
    (ii) Analysis--(A) In general. The rules of this section are 
applied by first determining the portion of the $150x Country A tax 
that is attributable under paragraph (b)(1) of this section to the 
section 245A(d) income of USP, and then by determining the portion of 
the $150x Country A tax that is described in paragraph (b)(2)(i) of 
this section and that is attributable under either paragraph (b)(2)(ii) 
or (iii) of this section to the non-inclusion income of CFC. No credit 
or deduction is allowed under paragraph (a)(1)(i) of this section for 
any portion of the $150x Country A tax that is attributable to the 
section 245A(d) income of USP or, under paragraph (a)(1)(iii) of this 
section, for any portion of that tax that is attributable to the non-
inclusion income of CFC, to the extent the tax is not disallowed under 
paragraph (a)(1)(i) of this section.
    (B) Attribution of foreign income taxes to section 245A(d) income. 
Under paragraph (b)(1) of this section, the $150x Country A tax is 
attributable to section 245A(d) income to the extent the tax is 
allocated and apportioned to the section 245A(d) income group (the 
statutory grouping) under Sec.  1.861-20. Section 1.861-20(c) allocates 
and apportions foreign income tax to the statutory and residual 
groupings to which the items of foreign gross income that were included 
in the foreign tax base are assigned under Sec.  1.861-20(d). In 
general, Sec.  1.861-20(d) assigns foreign gross income to the 
statutory and residual groupings to which the corresponding U.S. item 
is assigned. Section 1.861-20(d)(3)(i)(C) assigns the foreign law pass-
through income that USP includes by reason of its ownership of CFC to 
the statutory and residual groupings by treating USP's foreign law 
pass-through income as foreign gross income of CFC, and by treating CFC 
as paying the $150x of Country A tax in CFC's U.S. taxable year within 
which its foreign taxable year ends (Year 1). CFC is therefore treated 
as including a $1,000x foreign gross royalty item and a $500x foreign 
gross services income item and paying $150x of Country A tax in Year 1. 
These foreign gross income items are assigned to the statutory and 
residual groupings to which the corresponding U.S. items are assigned 
under Federal income tax law. No foreign gross income is assigned to 
the section 245A(d) income group because neither the corresponding U.S. 
item of royalty income nor the corresponding U.S. item of services 
income is assigned to the section 245A(d) income group. Therefore, none 
of USP's Country A tax is allocated to the section 245A(d) income 
group.
    (C) Attribution of foreign income taxes to non-inclusion income. 
The $150x Country A tax is described in paragraph (b)(2) of this 
section because USP is a United States shareholder of CFC, CFC is a 
reverse hybrid, and Sec.  1.861-20(d)(3)(i)(C) allocates and apportions 
the tax by reference to the income of CFC. Under paragraph (b)(2)(iii) 
of this section, the $150x Country A tax is attributable to the non-
inclusion income of CFC to the extent that the foreign income taxes are 
allocated and apportioned to the non-inclusion income group under Sec.  
1.861-20. For the reasons described in paragraph (d)(6)(ii)(B) of this 
section, under Sec.  1.861-20(d)(3)(i)(C) CFC is treated as including a 
$1,000x foreign gross royalty item and a $500x foreign gross services 
income item and paying $150x of Country A tax in Year 1. These foreign 
gross income items are assigned to the statutory and residual groupings 
to which the corresponding U.S. items are assigned under Federal income 
tax law. For Federal income tax purposes, the $500x item of services 
income and $500x of the $1,000x item of royalty income are items of 
non-inclusion income that are therefore assigned to the non-inclusion 
income group. The remaining $500x of the foreign gross

[[Page 324]]

royalty income item is assigned to the residual grouping. Under Sec.  
1.861-20(f), $100x ($150x x $1,000x/$1,500x) of the Country A tax is 
apportioned to the non-inclusion income group, and $50x ($150x x $500x/
$1,500x) is apportioned to the residual grouping. Under paragraph 
(b)(2)(iii) of this section, the $100x of Country A tax that is 
apportioned to the non-inclusion income group under Sec.  1.861-
20(d)(3)(i)(C) is attributable to non-inclusion income of CFC.
    (D) Disallowance. Under paragraph (a)(1)(iii) of this section, no 
credit under section 901 or deduction is allowed in any taxable year to 
USP for the $100x of Country A foreign income tax that is attributable 
to non-inclusion income of CFC.
    (e) 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 certain 
services (such as legal, accounting, medical, or teaching services) 
involving primarily human effort that are provided electronically.
* * * * *

0
Par. 7. Section 1.336-2 is amended by:
0
1. Revising the paragraph (g)(3)(ii) heading.
0
2. In paragraph (g)(3)(ii)(A):
0
a. Revising the first sentence; and
0
b. In the second sentence, removing the language ``foreign tax'' and 
adding in its place the language ``foreign income tax''.
0
3. Revising paragraphs (g)(3)(ii)(B) and (g)(3)(iii).
0
4. 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) (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 December 28, 2021.

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

[[Page 325]]

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 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 
December 28, 2021.
* * * * *


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), by removing the last sentence of paragraph 
(ii) of Example 1 and paragraph (ii) of Example 2.
0
2. In paragraph (c)(5), by removing the last sentence of paragraph 
(iii) of Example 1.

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 revision 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. In paragraph (e), by revising the heading and adding a sentence to 
the end of the paragraph.
    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

[[Page 326]]

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 is amended:
0
1. By removing the language ``and example (17) of paragraph (g) of this 
section'' from the third sentence of paragraph (b)(2).
0
2. By revising paragraph (e)(4)(i).
0
3. By adding paragraph (h)(4).
    The revision and addition 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 incurred by the renderer in 
performing such services 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 is amended by adding a sentence to the end of 
paragraph (g)(3) and revising paragraph (k) to read as follows:


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

* * * * *
    (g) * * *
    (3) * * * In applying Sec.  1.861-9T(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) Applicability dates. (1) Except as provided in paragraphs 
(k)(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) The last sentence of paragraph (g)(3) of this section applies 
to taxable years beginning on or after December 28, 2021.

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 based on all assets of all 
members of the affiliated group. Section 1.861-10T(b) provides rules 
for 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) provides rules for 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 investments 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 is reserved. 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) [Reserved]
    (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 paragraph (f) of this section 
applies to taxable years beginning on or after December 28, 2021.


Sec.  1.861-13(a)   [AMENDED]

0
Par. 20. Section 1.861-13(a) is amended by removing the language 
``section 904,'' and adding the language ``sections 245A and 904,'' in 
its place.

0
Par. 21. Section 1.861-14 is 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 (as

[[Page 327]]

defined in Sec.  1.1502-47(b)(8)) 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 choice to use the 
separate entity method may not be revoked without the prior consent of 
the Commissioner.
* * * * *
    (k) Applicability dates. 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 December 28, 2021.

0
Par. 22. Section 1.861-20 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 paragraph (b)(7).
0
3. By redesignating the paragraphs in the first column as the 
paragraphs in the second column:

------------------------------------------------------------------------
           Old paragraph                        New paragraph
------------------------------------------------------------------------
(b)(17)............................  (b)(18)
(b)(18)............................  (b)(19)
(b)(19)............................  (b)(20)
(b)(20)............................  (b)(21)
(b)(21)............................  (b)(23)
(b)(22)............................  (b)(24)
(b)(23)............................  (b)(25)
(b)(24)............................  (b)(26)
------------------------------------------------------------------------

0
4. By adding new paragraph (b)(17).
0
5. By revising newly-redesignated paragraph (b)(20).
0
6. By adding new paragraph (b)(22).
0
7. By revising newly-redesignated paragraph (b)(25).
0
8. By revising the first and second sentences in paragraph (c) 
introductory text.
0
9. In paragraph (d)(2)(ii)(B), by adding the language ``, 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
10. By adding paragraph (d)(2)(ii)(D).
0
11. In paragraph (d)(3)(i)(A), by removing the language ``foreign and 
Federal income tax law or an inclusion of foreign law pass-through 
income'' and adding the language ``foreign law and Federal income tax 
law, an inclusion of foreign law pass-through income, or a disposition 
under both foreign law and Federal income tax law'' in its place.
0
12. In the first sentence of paragraph (d)(3)(i)(B)(2), by removing the 
language ``from which a distribution of the U.S. dividend amount is 
made'' and adding the language ``to which a distribution of the U.S. 
dividend amount is assigned'' in its place.
0
13. In the second sentence of paragraph (d)(3)(i)(B)(2), by removing 
the language ``to which earnings equal to the U.S. return of capital 
amount'' and adding the language ``to which earnings of the 
distributing corporation'' in its place.
0
14. By adding paragraphs (d)(3)(i)(D), (d)(3)(ii), (v) and (vi), 
(g)(10) through (14), and (h).
0
15. 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).
* * * * *
    (17) Previously taxed earnings and profits. The term previously 
taxed earnings and profits has the meaning provided in Sec.  1.960-
1(b).
* * * * *
    (20) 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 the 
portion of any gain recognized by a taxpayer that is included in gross 
income as a dividend under section 964(e) or 1248.
* * * * *
    (22) U.S. equity hybrid instrument. The term U.S. equity hybrid 
instrument means an instrument that is treated as stock or a 
partnership interest for Federal income tax purposes but for foreign 
income tax purposes is treated as indebtedness or otherwise gives rise 
to the accrual of income to the holder with respect to such instrument 
that is not characterized as a dividend or distributive share of 
partnership income for foreign tax law purposes.
* * * * *
    (25) 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 stock, the taxpayer's adjusted basis of the stock, or in the case of 
a distribution with respect to stock, the portion of the distribution 
to which section 301(c)(2) 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. This paragraph 
(d)(2)(ii) applies to 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, and that 
would be treated as a disregarded payment (as defined in paragraph 
(d)(3)(v)(E) of this section) if the transfer of property occurred, or 
the item accrued, for Federal income tax purposes in the same U.S. 
taxable year in which the foreign income tax is paid or accrued. An 
item of foreign gross income to which this paragraph (d)(2)(ii) applies 
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

[[Page 328]]

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 for both foreign law 
and Federal income tax purposes of an interest that is 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. 
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, any foreign gross income 
item 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 arising from the distribution, 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 
item arising from the distribution exceeds the U.S. capital gain 
amount, such excess amount is assigned to the statutory and residual 
groupings to which a distributive share of income of the partnership in 
the amount of such excess would be assigned if such income were 
recognized for Federal income tax purposes in the U.S. taxable year in 
which the distribution is made. 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 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 
a transaction that is treated as a sale, exchange, or other disposition 
for both foreign law and Federal income tax purposes of an interest 
that is an interest in a partnership for Federal income tax purposes is 
assigned first, to the extent of the U.S. capital gain amount arising 
from the disposition, to the statutory or residual grouping (or ratably 
to the groupings) to which the U.S. capital gain amount is assigned. If 
the foreign gross income item arising from the disposition exceeds the 
U.S. capital gain amount, such excess 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 were 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

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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 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.  
1.951A-2(c)(7)(ii)(B) 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), 1.951A-2(c)(7), 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.  1.951A-
2(c)(7)(ii)(B), 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.  
1.951A-2(c)(7)(ii)(B), 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 (Examples 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, the portion of the tax 
book value of a reattribution asset that is assigned to the taxable 
unit, and the taxable unit's pro rata share of the assets of another 
taxable unit (other than a corporation or a partnership), including the 
portion of any reattribution assets assigned to the other taxable unit, 
in which it owns an interest. If a taxable unit owns an interest in a 
taxable unit that is a partnership, the assets of the taxable unit that 
is the owner include its interest in the partnership or its pro rata 
share of the partnership assets, as applicable, determined under the 
principles of Sec.  1.861-9(e). 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

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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.
    (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 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, if any, 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 transfer of property 
that would be 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, a transfer of property that 
would be 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 a payment in exchange for property or in 
satisfaction of an account payable, 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 the excess of a 
disregarded payment, other than an amount that is treated as a 
contribution under paragraph (d)(3)(v)(E)(2) of this section, 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, if any, that is a reattribution payment.
    (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.  1.951A-2(c)(7)(iv)(A).
    (vi) Foreign gross income included by reason of U.S. equity hybrid 
instrument ownership--(A) Foreign gross income included by reason of an 
accrual. Foreign gross income included by reason of an accrual under 
foreign law with respect to a U.S. equity hybrid instrument is 
considered to arise from the same transaction or realization event as a 
distribution of property described in paragraph (d)(3)(i) or (ii) of 
this section and is assigned to the statutory and residual groupings by 
treating each amount accrued as a foreign law distribution made on the 
date of the accrual under foreign law.
    (B) Foreign gross income included by reason of a payment. Foreign 
gross income included by reason of a payment of interest under foreign 
law with respect to a U.S. equity hybrid instrument is considered to 
arise from the same transaction or realization event as a distribution 
of property described in paragraph (d)(3)(i) or (ii) of this section 
and is assigned to the statutory and residual groupings by treating 
each payment as a distribution made on the date of the payment.
* * * * *
    (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

[[Page 331]]

recognizes $800x of gain on which Country A imposes $80x of foreign 
income tax based on its rules for taxing capital gains of nonresidents, 
which satisfy the requirement in Sec.  1.901-2(b)(5)(i)(C). 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 (21) of this section, respectively, the 
sale of CFC stock by USP gives rise to a $450x U.S. capital gain amount 
and a $150x U.S. dividend 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 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 
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) 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 under 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 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 transfer of Asset F to USP for Country 
A tax purposes, under paragraph (c)(1) of this section the $150x of 
Country A gross income is first assigned to a separate category. 
Because the transfer does not result in a deemed sale for Federal 
income tax purposes, there is no corresponding U.S. item. However, FDE 
would have recognized gain of $150x, which would have been the 
corresponding U.S. item, if the deemed sale had been recognized for 
Federal income tax purposes. Therefore, under paragraph (d)(2)(ii) of 
this section, the $150x 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 of Country A tax is necessary because the 
class of gross income to which the foreign gross income is allocated 
consists entirely of a single statutory grouping.
    (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 arising from the transfer 
of Asset F is first assigned to a separate category. For Federal income 
tax purposes, 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

[[Page 332]]

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.
    (12) Example 11: Disregarded payment that is a remittance--(i) 
Facts. USP wholly owns CFC1, which is a tested unit within the meaning 
of Sec.  1.951A-2(c)(7)(iv)(A) (the ``CFC1 tested unit''). CFC1 wholly 
owns FDE, a disregarded entity that is organized in Country B, which is 
a tested unit within the meaning of Sec.  1.951A-2(c)(7)(iv)(A) (the 
``FDE tested unit''). The sole assets of FDE (determined in accordance 
with paragraph (d)(3)(v)(C)(1)(ii) of this section) are all 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 
remittance to CFC1 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 Year 2 
remittance from FDE is imposed on a $400x item of foreign gross income 
that CFC1 includes in foreign gross 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 groupings of the CFC1 tested 
unit 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 have made 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 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 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 CFC1 tested unit's general 
category tested income group, and $5x ($20x x $100x/$400x) of the 
Country B withholding tax is apportioned to the CFC1 tested unit's 
passive category FPHCI income group. 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 wholly owns CFC1, a tested unit within the 
meaning of Sec.  1.951A-2(c)(7)(iv)(A)(1) (the ``CFC1 tested unit''). 
CFC1 wholly owns FDE1, a disregarded entity organized in Country B, 
that is a tested unit within the meaning of Sec.  1.951A-
2(c)(7)(iv)(A)(2) (the ``FDE1 tested unit''). Country B imposes a 20 
percent net income tax on its residents. CFC1 also wholly owns FDE2, a 
disregarded entity organized in Country C, that is a tested unit within 
the meaning of Sec.  1.951A-2(c)(7)(iv)(A)(2) (the ``FDE2 tested 
unit''). Country C imposes a 15 percent net income tax on its 
residents. The net income tax imposed by each of Country B and Country 
C on their tax residents 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 exclusion of section 
951A(c)(2)(A)(i)(III) and Sec.  1.951A-2(c)(7), and the statutory 
groupings are the tested income groups of each tested unit, as defined 
in Sec.  1.951A-2(c)(7)(iv)(A).
    (B) FDE2 owns Asset A, which is intangible property with a tax book 
value of $12,000x that 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 deductible 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 
an unrelated third party for the use of Asset A, FDE1 earns $1,200x of 
royalty income for Federal income tax purposes (the ``U.S. gross 
royalty'') for the use of Asset A. The $1,200 of royalty income 
received by FDE1 from the unrelated third party is excluded from CFC1's 
foreign personal holding company income by reason of the active 
business exception in section 954(c)(2) because CFC1 satisfies the 
requirements of Sec.  1.954-2(d)(1). As a result, the $1,200x of 
royalty income that FDE1 earns from the sub-license agreement is gross 
tested income (as defined in Sec.  1.951A-2(c)(1)), which is properly 
reflected on the separate set of books and records of FDE1.

[[Page 333]]

    (C) Under the laws of Country B, the transaction that gives rise to 
the $1,200x 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 therefore has $1,000x of taxable income for 
Country C tax purposes, 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 $1,200x 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.  1.951A-2(c)(7)(ii)(B). The transaction that produced the $1,200x 
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 $1,200x 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.  
1.951A-2(c)(7)(ii)(B) to the $1,200x 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 $1,000x of the $1,200x 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 
$1,200x corresponding U.S. item is initially assigned under Sec.  
1.951A-2(c)(7)(ii), namely, the FDE1 income group. This assignment is 
made without regard to the $1,000x reattribution payment from the FDE1 
tested unit 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 on the $200x of Country B taxable income is 
allocated to the FDE1 income group, 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 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.  
1.951A-2(c)(7)(ii)(B), 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.  1.951A-
2(c)(7)(ii), namely, the FDE2 income group. 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 FDE2 income group, 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.
    (14) Example 13: Assets of a taxable unit that owns an interest in 
a lower-tier taxable unit--(i) Facts. USP wholly owns CFC1, a tested 
unit within the meaning of Sec.  1.951A-2(c)(7)(iv)(A) (the ``CFC1 
tested unit''). CFC1 wholly owns FDE1, a disregarded entity that is 
organized in Country A, and FDE2, a disregarded entity that is 
organized in Country B. CFC1's interests in FDE1 and FDE2 are each 
tested units within the meaning of Sec.  1.951A-2(c)(7)(iv)(A) (the 
``FDE1 tested unit'' and ``FDE2 tested unit'', respectively). The FDE1 
tested unit and FDE2 tested unit each own 50% of the interests in FDE3, 
a disregarded entity that is organized in Country C. CFC1's indirect 
interests in FDE3 are also a tested unit within the meaning of Sec.  
1.951A-2(c)(7)(iv)(A) (the ``FDE3 tested unit''). The FDE2 tested unit 
owns Asset A with a tax book value of $10,000x, and makes a 
reattribution payment to FDE3 that causes $5,000x of the tax book value 
of Asset A to be assigned to FDE3 under paragraph (d)(3)(v)(C)(1)(ii) 
of this section. FDE3 owns Asset B, which has a tax book value of 
$5,000x.
    (ii) Analysis--(A) Assets of the FDE3 tested unit. The assets of 
the FDE3 tested unit consist of the portion of Asset A that is assigned 
to it under paragraph (d)(3)(v)(C)(1)(ii) of this section and any other 
assets determined in accordance with Sec.  1.987-6(b). The assets of 
the FDE3 tested unit thus consist of $5,000x of the tax book value of 
Asset A and all $5,000x of the tax book value of Asset B.
    (B) Assets of the FDE2 tested unit. The assets of the FDE2 tested 
unit consist of the tax book value of any assets that it owns directly 
plus its pro rata share of the assets of the FDE3 tested unit, 
including the portion of reattribution assets assigned to the FDE3 
tested unit. Asset A is a reattribution asset under paragraphs 
(d)(3)(v)(C)(1)(ii) and (d)(3)(v)(E) of this section. The assets of the 
FDE2 tested unit therefore consist of the portion of Asset A that it 
owns directly and that was not assigned to the FDE3 tested unit (or 
$5,000x) plus its pro rata share of the portion of Asset A that was 
assigned to the FDE3 tested unit, or $2,500x (50% of $5,000x). In 
addition, the assets of the FDE2 tested unit include its pro rata share 
of the tax book value of Asset B, or $2,500x (50% of $5,000x).
    (C) Assets of the FDE1 tested unit. The assets of the FDE1 tested 
unit consist of its pro rata share of the assets of the FDE3 tested 
unit, including the portion of reattribution assets assigned to the 
FDE3 tested unit. Asset A is a reattribution asset under paragraphs 
(d)(3)(v)(C)(1)(ii) and (d)(3)(v)(E) of this section. The assets of the 
FDE1 tested unit therefore consist of its pro rata share of the portion 
of Asset A that was reattributed to the FDE3 tested unit, or $2,500x 
(50% of $5,000x), plus its pro rata share of the tax book value of 
Asset B, or $2,500x (50% of $5,000x).
    (h) Allocation and apportionment of certain foreign in lieu of 
taxes described in section 903. A tax that is a foreign

[[Page 334]]

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 dates. 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 December 28, 2021.

0
Par. 23. Section 1.901-1 is amended:
0
1. By revising the section heading.
0
2. By revising paragraphs (a) through (d).
0
3. In paragraph (e), by removing the language ``a husband and wife'' 
and adding the language ``spouses'' in its place.
0
4. By revising paragraphs (f) and (h)(1).
0
5. By removing paragraph (h)(2).
0
6. By redesignating paragraph (h)(3) as paragraph (h)(2).
0
7. 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 credit under 
section 901 to any extent, such choice will 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) by the taxpayer in such 
taxable year, and no deduction from gross income is allowed for any 
portion of such taxes in any taxable year. See section 275(a)(4).
    (2) Exception for taxes not subject to section 275. A deduction may 
be allowed under section 164(a)(3) for foreign income tax for which a 
credit is disallowed under any Code section and to which section 275 
does not apply. 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 taxable 
year in which a deduction for foreign income taxes is allowed under 
section 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 taxes paid by an accrual basis taxpayer that 
relate to a prior year in which the taxpayer deducted foreign income 
taxes. If a taxpayer claims a credit for foreign income taxes accrued 
in a taxable year (including a cash method taxpayer that elects under 
section 905(a) to claim a credit in the year the taxes accrue), a 
deduction may be claimed in that taxable year for additional foreign 
income taxes that are finally determined and paid as a result of a 
foreign tax redetermination in that taxable year if the additional 
foreign income taxes relate to a prior taxable year in which the 
taxpayer claimed 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. U.S.C. is a domestic corporation that is engaged in a 
trade or business in Country X through a branch. U.S.C. uses the 
accrual method of accounting and a calendar year for U.S. and Country X 
tax purposes. For taxable Years 1 through 3, U.S.C. deducted foreign 
income taxes accrued in those years. In Years 4 through 6, U.S.C. 
claimed a credit for foreign income taxes accrued in those years. In 
Year 6, U.S.C. paid an additional $50x tax to Country X that relates to 
Year 1 because of the close of a Country X tax audit.
    (ii) Analysis. The additional $50x Country X tax paid by U.S.C. in 
Year 6 that relates to Year 1 cannot be claimed by U.S.C. as a 
deduction on an amended return for Year 1 because the additional tax 
accrued in Year 6. See section 461(f)

[[Page 335]]

(flush language); Sec. Sec.  1.461-1(a)(2)(i) and 1.461-2(a)(2). In 
addition, because the additional $50x Country X tax relates to and is 
considered to accrue in Year 1 for foreign tax credit purposes, U.S.C. 
cannot claim a credit for the additional $50x Country X tax 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, U.S.C. can claim a 
deduction for the additional $50x Country X tax that relates to Year 1 
on its Federal income tax return for Year 6, even though it claims a 
credit for foreign income taxes that accrue in Year 6 and that relate 
to 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 a credit under section 901 (or claim a deduction in lieu of 
electing to claim a 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 under section 901, 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 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 a 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 to claim 
a deduction or credit results in U.S. tax deficiencies.
* * * * *
    (f) Taxes against which credit is allowed. The credit for foreign 
income taxes is allowed only against the tax imposed by chapter 1 of 
the Code. The credit is not allowed against a tax that, under section 
26(b)(2), is not treated as a tax imposed by such chapter.
* * * * *
    (h) * * *
    (1) Except as provided in paragraphs (c)(2) and (3) of this 
section, a taxpayer that claims a deduction for 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 December 28, 
2021.

0
Par. 24. Section 1.901-2 is amended:
0
1. By revising paragraph (a) heading and paragraph (a)(1).
0
2. By revising paragraph (a)(3).
0
3. By revising paragraph (b).
0
4. By removing and reserving paragraph (c).
0
5. By revising paragraphs (d) and (e).
0
6. By revising paragraph (f)(2)(ii).
0
7. 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
8. 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 and by removing the language ``or accrued''.
0
9. By revising paragraphs (f)(4) through (6) and adding paragraph 
(f)(7).
0
10. 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) and (b) of this section define a foreign income tax for 
purposes of section 901. Paragraph (c) of this section is reserved. 
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 
taxpayer. 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, and in particular provides that 
the term ``paid'' means ``paid'' or ``accrued,'' depending on the 
taxpayer's method of accounting for foreign income taxes. 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).
    (iii) Coordination with treaties. A foreign levy that is treated as 
an income tax under the relief from double taxation article of an 
income tax treaty entered into by the United States and the foreign 
country imposing the tax is a foreign income tax if paid by a citizen 
or resident of the United States (as determined under such income tax 
treaty) that elects benefits under the treaty. In addition, a foreign 
levy paid by a controlled foreign corporation that is modified by an 
applicable income tax treaty between the foreign jurisdiction of which 
the controlled foreign corporation is a resident and the foreign 
jurisdiction imposing the tax may qualify as a foreign income tax 
notwithstanding that the unmodified foreign levy does not satisfy the 
requirements in paragraph (b) of this section or the requirements of 
Sec.  1.903-1(b) if the levy, as modified by such treaty, satisfies the 
requirements of paragraph (b) of this section or the requirements of 
Sec.  1.903-1(b). See paragraph (d)(1)(iv) of this section for rules 
treating as a separate levy a foreign tax that is limited in its 
application or otherwise modified by the terms of an

[[Page 336]]

income tax treaty to which the foreign country imposing the tax is a 
party.
* * * * *
    (3) Net income tax. A foreign tax is a net income tax only if the 
foreign tax meets the net gain requirement in paragraph (b) 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, cost recovery, and attribution requirements in 
paragraphs (b)(2), (3), (4), and (5) of this section, respectively, or 
if the foreign tax is a surtax described in paragraph (b)(6) of this 
section. Paragraphs (b)(2) through (6) 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 requirement 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.
    (ii) Readily marketable property. Property is readily marketable 
if--
    (A) It is stock in trade or other property of a kind that properly 
would be included in inventory if on hand at the close of the taxable 
year or if it is held primarily for sale to customers in the ordinary 
course of business, and
    (B) It can be sold on the open market without further processing or 
it is exported from the foreign country.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (b)(2) of this section:
    (A) Example 1. Residents of Country X are subject to a tax of 10 
percent on the aggregate net appreciation in fair market value during 
the calendar year of all shares of stock held by them at the end of the 
year. In addition, all such residents are subject to a Country X tax 
that qualifies as a net income tax within the meaning of paragraph 
(a)(3) of this section. Included in the base of the net income tax are 
gains and losses realized on the sale of stock, and the basis of stock 
for purposes of determining such gain or loss is its cost. The 
operation of the stock appreciation tax and the net income tax as 
applied to sales of stock is exemplified as follows: A, a resident of 
Country X, purchases stock in June of Year 1 for 100u (units of Country 
X currency) and sells it in May of Year 3 for 160u. On December 31, 
Year 1, the stock is worth 120u and on December 31, Year 2, it is worth 
155u. Pursuant to the stock appreciation tax, A pays 2u for Year 1 (10 
percent of (120u-100u)), 3.5u for Year 2 (10 percent of (155u-120u)), 
and nothing for Year 3 because no stock was held at the end of that 
year. For purposes of the net income tax, A must include 60u (160u-
100u) in his income for Year 3, the year of sale. Pursuant to paragraph 
(b)(2)(i)(C) of this section, the stock appreciation tax does not 
satisfy the realization requirement because Country X imposes a second 
tax upon the occurrence of a later event (that is, the sale of stock) 
with respect to the income that was taxed by the stock appreciation tax 
and no credit or comparable relief is available against such second tax 
for the stock appreciation tax paid.
    (B) Example 2. The facts are the same as those in paragraph 
(b)(2)(iii)(A) of this section (the facts in Example 1), except that if 
stock was held on the December 31 last preceding the date of its sale, 
the basis of such stock for purposes of computing gain or loss under 
the net income tax is the value of the stock on such December 31. Thus, 
in Year 3, A includes only 5u (160u-155u) as income from the sale for 
purposes of the net income tax. Because the net income tax imposed upon 
the occurrence of a later event (the sale) does not impose a tax with 
respect to the income that was taxed by the stock appreciation tax, 
under paragraph (b)(2)(i)(C) of this section, the stock appreciation 
tax satisfies the realization requirement. The result would be the same 
if, instead of a basis adjustment to reflect taxation pursuant to the 
stock appreciation tax, the Country X net income tax allowed a credit 
(or other comparable relief) to take account of the stock appreciation 
tax. If a credit mechanism is used, see also paragraph (e)(4)(i) of 
this section.
    (C) Example 3. Country X imposes a tax on the realized net income 
of corporations that do business in Country X. Country X also imposes a 
branch profits tax on corporations organized under the law of a country

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other than Country X that do business in Country X. The branch profits 
tax is imposed when realized net income is remitted or deemed to be 
remitted by branches in Country X to home offices outside of Country X. 
Because the branch profits tax is imposed subsequent to the occurrence 
of events that would result in realization of income by corporations 
subject to such tax under the income tax provisions of the Internal 
Revenue Code, under paragraph (b)(2)(i)(A) of this section the branch 
profits tax satisfies the realization requirement.
    (D) Example 4. Country X imposes a tax on the realized net income 
of corporations that do business in Country X (the ``Country X 
corporate tax''). Country X also imposes a separate tax on shareholders 
of such corporations (the ``Country X shareholder tax''). The Country X 
shareholder tax is imposed on the sum of the actual distributions 
received during the taxable year by such a shareholder from the 
corporation's realized net income for that year (that is, income from 
past years is not taxed in a later year when it is actually 
distributed) plus the distributions deemed to be received by such a 
shareholder. Deemed distributions are defined as a shareholder's pro 
rata share of the corporation's realized net income for the taxable 
year, less such shareholder's pro rata share of the corporation's 
Country X corporate tax for that year, less actual distributions made 
by such corporation to such shareholder from such net income. A 
shareholder's receipt of actual distributions is a realization event 
within the meaning of paragraph (b)(2)(i)(A) of this section. The 
deemed distributions are not realization events, but they are described 
in paragraph (b)(2)(i)(C)(3) of this section. Accordingly, the Country 
X shareholder tax satisfies the realization requirement.
    (3) Gross receipts requirement--(i) Rule. A foreign tax satisfies 
the gross receipts requirement if it is imposed on the basis of the 
amounts described in paragraphs (b)(3)(i)(A) through (D) of this 
section.
    (A) Actual gross receipts.
    (B) In the case of either an insignificant nonrealization event 
described in the second sentence of paragraph (b)(2)(i) of this section 
or a realization event described in paragraph (b)(2)(i)(A) of this 
section that does not result in actual gross receipts, deemed gross 
receipts in an amount that is reasonably calculated to produce an 
amount that is not greater than fair market value.
    (C) Deemed gross receipts in the amount of a tax deduction that is 
recaptured by reason of a pre-realization recapture event described in 
paragraph (b)(2)(i)(B) of this section.
    (D) The amount of deemed gross receipts arising from pre-
realization timing difference events described in paragraph 
(b)(2)(i)(C) 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 companies for affiliated nonresident corporations, and 
this tax is a separate levy (within the meaning of paragraph (d)(1) 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-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 actual gross receipts, the cost-plus tax does not satisfy the gross 
receipts requirement of paragraph (b)(3)(i) of this section.
    (B) Example 2: Actual gross receipts determined under appropriate 
transfer pricing methodology--(1) Facts. Country X imposes a tax on 
resident corporations that meets the attribution requirement of 
paragraph (b)(5)(ii) of this section. The Country X tax is based on 
actual gross receipts, including gross receipts recorded on the 
taxpayer's books and records as due from related and unrelated persons. 
Corporation A, a resident of Country X, properly determines the arm's 
length transfer price for services provided to related persons using a 
cost-plus methodology, recording on its books and records receivables 
for the arm's length amounts due from those related persons and using 
those amounts to determine the realized gross receipts included in the 
base of the Country X tax.
    (2) Analysis. Because the Country X tax is based on actual gross 
receipts, it satisfies the gross receipts requirement of paragraph 
(b)(3)(i) of this section.
    (C) Example 3: Petroleum taxed on extraction--(1) Facts. Country X 
imposes a tax that is a separate levy (within the meaning of paragraph 
(d)(1) 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) Costs and expenses that must be 
recovered--(A) In general. 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) described in paragraph (b)(4)(i)(C) of this 
section attributable, under reasonable principles, to such gross 
receipts. A foreign tax need not permit recovery of significant costs 
and expenses, such as certain personal expenses, that are not 
attributable, under reasonable principles, to gross receipts included 
in the foreign taxable base. A foreign tax whose base is gross 
receipts, with no reduction for costs and expenses, satisfies the cost 
recovery requirement only if there are no significant costs and 
expenses attributable to the gross receipts included in the foreign tax 
base that must be recovered under the rules of paragraph 
(b)(4)(i)(C)(1) of this section. See paragraph (b)(4)(iv)(A) of this 
section (Example 1). A foreign tax that provides an alternative cost 
allowance satisfies the cost recovery requirement only as provided in 
paragraph (b)(4)(i)(B) of this section. See paragraph (b)(4)(i)(D) of 
this section for rules regarding principles for attributing costs and 
expenses to gross receipts.
    (B) Alternative cost allowances--(1) In general. Except as provided 
in paragraph (b)(4)(i)(B)(2) of this section, if foreign tax law does 
not permit recovery of one or more significant costs and expenses in 
computing the base of the foreign tax but provides an alternative cost 
allowance, the foreign tax satisfies the cost recovery requirement only 
if the alternative allowance 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). If 
foreign tax law provides an optional alternative cost allowance or an 
election to recover costs and expenses under an alternative method, the 
foreign tax satisfies the cost recovery requirement if the foreign tax 
law also expressly

[[Page 338]]

provides an option to recover actual costs and expenses. See Sec.  
1.901-2(e)(5) for rules limiting the amount of foreign income tax paid 
to the amount due under the option that minimizes the taxpayer's 
liability for foreign income tax over time. If foreign tax law provides 
an alternative cost allowance that does not by its terms permit 
recovery of an amount equal to or greater than the actual amounts of 
significant costs and expenses, the foreign tax does not satisfy the 
cost recovery requirement, even if, in practice, the amounts recovered 
under the alternative allowance equal or exceed the amount of actual 
costs and expenses.
    (2) Small business exception. If foreign tax law provides an 
alternative method for determining the amount of costs and expenses 
allowed in computing the taxable base of small business enterprises, 
the foreign tax satisfies the cost recovery requirement if the foreign 
tax law contains reasonable limits on the maximum size of business 
enterprises to which the alternative cost allowance applies (for 
example, business enterprises having asset values or annual gross 
revenues below specified thresholds). See paragraph (b)(4)(iv)(B) of 
this section (Example 2).
    (C) Significant costs and expenses--(1) 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. Costs and expenses (as characterized under 
foreign law) related to capital expenditures, interest, rents, 
royalties, wages or other payments for services, and research and 
experimentation are always treated as significant costs or expenses for 
purposes of this paragraph (b)(4)(i). Significant costs and expenses 
(such as interest expense) are not considered to be recovered by reason 
of the time value of money attributable to the acceleration of a tax 
benefit or other economic benefit attributable to the timing of the 
recovery of other costs and expenses (such as the current expensing of 
debt-financed capital expenditures). 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 principles underlying the 
disallowances required under the Internal Revenue Code, including 
disallowances intended to limit base erosion or profit shifting. For 
example, a foreign tax is considered to permit recovery of significant 
costs and expenses if the foreign tax law limits interest deductions so 
as not to exceed 10 percent of a reasonable measure of taxable income 
(determined either before or after depreciation and amortization) based 
on principles similar to those underlying section 163(j), disallows 
interest and royalty deductions in connection with hybrid transactions 
based on principles similar to those underlying section 267A, disallows 
deductions attributable to gross receipts that in whole or in part are 
excluded, exempt or eliminated from taxable income, or disallows 
certain expenses based on public policy considerations similar to those 
disallowances contained in section 162. See paragraph (b)(4)(iv)(C) of 
this section (Example 3).
    (2) Amounts that need not be recovered. A foreign tax is considered 
to permit recovery of significant costs and expenses even if the 
foreign tax law does not permit recovery of any costs and expenses 
attributable to wage income or to investment income that is not derived 
from a trade or business. In addition, 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)(D) and (E) of this 
section (Examples 4 and 5).
    (3) 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 is 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, a foreign 
tax satisfies the cost recovery requirement if 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 if the recovery of items 
capitalized under the Internal Revenue Code occurs more or less rapidly 
than under the foreign tax law.
    (D) 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). 
See also paragraph (b)(5) of this section for additional requirements 
relating to foreign tax law rules for attributing costs and expenses to 
gross receipts.
    (ii) Consolidation of profits and losses. In determining whether a 
foreign tax satisfies the cost recovery requirement, one of the factors 
to be taken into account is whether, in computing the base of the tax, 
a loss incurred in one activity (for example, a contract area in the 
case of oil and gas exploration) in a trade or business is allowed to 
offset profit earned by the same person in another activity (for 
example, a separate contract area) in the same trade or business. If 
such an offset is allowed, it is immaterial whether the offset may be 
made in the taxable period in which the loss is incurred or only in a 
different taxable period, unless the period is such that under the 
circumstances there is effectively a denial of the ability to offset 
the loss against profit. In determining whether a foreign tax satisfies 
the cost recovery requirement, it is immaterial that no such offset is 
allowed if a loss incurred in one such activity may be applied to 
offset profit earned in that activity in a different taxable period, 
unless the period is such that under the circumstances there is 
effectively a denial of the ability to offset such loss against profit. 
In determining whether a foreign tax satisfies the cost recovery 
requirement, it is immaterial whether a person's profits and losses 
from one trade or business (for example, oil and gas extraction) are 
allowed to offset its profits and losses from another trade or business 
(for example, oil and gas refining and processing), or whether a 
person's business profits and losses and its passive investment profits 
and losses are allowed to offset each other in computing the base of 
the foreign tax. Moreover, it is immaterial whether foreign tax law 
permits or prohibits consolidation of profits and losses of related 
persons, unless foreign tax law requires separate entities to be used 
to carry on separate activities in the same trade or business. If 
foreign tax law requires that separate entities carry on such separate 
activities, the determination whether the cost recovery requirement is 
satisfied is made by applying the same considerations as if

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such separate activities were carried on by a single entity.
    (iii) Carryovers. In determining whether a foreign tax satisfies 
the cost recovery requirement, it is immaterial, except as otherwise 
provided in paragraph (b)(4)(ii) of this section, whether losses 
incurred during one taxable period may be carried over to offset 
profits incurred in different taxable periods.
    (iv) Examples. The following examples illustrate the rules of 
paragraph (b)(4) of this section.
    (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. Country X imposes a second 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 in 
determining the base of the bank tax. Banks resident in Country X incur 
substantial costs and expenses, including 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, the bank tax does not satisfy the 
cost recovery requirement of paragraph (b)(4)(i) of this section.
    (B) Example 2: Small business alternative allowance--(1) Facts. 
Country X imposes a tax on the income of corporations resident in 
Country X. Under Country X tax law, corporations are generally allowed 
to deduct actual costs and expenses attributable to the realized gross 
receipts included in the Country X tax base. However, in lieu of 
deductions for actual costs and expenses, businesses with gross 
revenues of less than the Country X currency equivalent of $500,000 are 
allowed a flat cost allowance of 50 percent of gross revenues.
    (2) Analysis. Under paragraph (b)(4)(i)(B)(2) of this section, the 
alternative cost allowance for small businesses provided under Country 
X tax law satisfies the cost recovery requirement.
    (C) Example 3: Permissible deduction disallowance--(1) Facts. 
Country X imposes a tax on the income of corporations resident in 
Country X. Under Country X tax law, deductions for the significant 
costs and expenses attributable to the gross receipts included in the 
Country X tax base are allowed, except that deductions for interest 
expense incurred by corporations are limited to 30 percent of the 
corporation's earnings before income taxes, depreciation, and 
amortization, and unused interest expense may be carried forward for a 
period of 5 years. In addition, Country X tax law contains anti-hybrid 
rules that deny deductions for interest, royalties, rents, and services 
payments made by a Country X resident to a related entity outside 
Country X that is treated as a transparent entity in the jurisdiction 
in which it is organized but as a separate entity in the jurisdiction 
of the entity's owners (a ``reverse hybrid entity'') to the extent that 
the payment is not included in the income of the reverse hybrid entity 
or its owners.
    (2) Analysis. Under paragraph (b)(4)(i)(C)(1) of this section, 
costs and expenses related to interest, rents, royalties, and payments 
for services are treated as significant costs or expenses that must be 
recoverable under Country X tax law. However, because the interest 
expense limitation rule and the anti-hybrid rules in Country X tax law 
are consistent with the principles underlying the disallowances 
required under the Internal Revenue Code (namely, section 163(j) and 
section 267A), the Country X tax satisfies the cost recovery 
requirement.
    (D) Example 4: Gross basis tax on wages--(1) Facts. A foreign 
country imposes payroll tax on resident employees at the rate of 10 
percent of the amount of gross wages; no deductions are allowed in 
computing the base of the payroll tax.
    (2) Analysis. Although 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)(C)(2) of this 
section, because the only gross receipts included in the taxable base 
are from wages, the payroll 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)(C)(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) Attribution requirement. A foreign tax satisfies the 
attribution requirement if the amount of gross receipts and costs that 
are included in the base of the foreign tax are determined based on 
rules described in paragraph (b)(5)(i) of this section (with respect to 
a separate levy imposed on nonresidents of the foreign country) or 
paragraph (b)(5)(ii) of this section (with respect to a separate levy 
imposed on residents of the foreign country).
    (i) Tax on nonresidents. The gross receipts and costs attributable 
to each of the items of income of nonresidents of a foreign country 
that is included in the base of the foreign tax must satisfy the 
requirements of paragraph (b)(5)(i)(A), (B), or (C) of this section.
    (A) Income attribution based on activities. The gross receipts and 
costs that are included in the base of the foreign tax are limited to 
gross receipts and costs that are attributable, under reasonable 
principles, to the nonresident's activities within the foreign country 
imposing the foreign tax (including the nonresident's functions, 
assets, and risks located in the foreign country). For purposes of the 
preceding sentence, attribution of gross receipts under reasonable 
principles includes rules similar to those for determining effectively 
connected income under section 864(c) but does not include rules that 
take into account as a significant factor the mere location of 
customers, users, or any other similar destination-based criterion, or 
the mere location of persons from whom the nonresident makes purchases 
in the foreign country. In addition, for purposes of the first sentence 
of this paragraph (b)(5)(i)(A), reasonable principles do not include 
rules that deem the existence of a trade or business or permanent 
establishment based on the activities of another person (other than an 
agent or other person acting on behalf of the nonresident or a pass-
through entity of which the

[[Page 340]]

nonresident is an owner), or that attribute gross receipts or costs to 
a nonresident based upon the activities of another person (other than 
an agent or other person acting on behalf of the nonresident or a pass-
through entity of which the nonresident is an owner).
    (B) Income attribution based on source. The amount of gross income 
arising from gross receipts (other than gross receipts from sales or 
other dispositions of property) that is included in the base of the 
foreign tax on the basis of source (instead of on the basis of 
activities or the situs of property as described in paragraphs 
(b)(5)(i)(A) and (C) of this section) is limited to gross income 
arising from sources within the foreign country that imposes the tax, 
and the sourcing rules of the foreign tax law are reasonably similar to 
the sourcing rules that apply under the Internal Revenue Code. A 
foreign tax law's application of such sourcing rules need not conform 
in all respects to the application of those sourcing rules for Federal 
income tax purposes. For purposes of determining whether the sourcing 
rules of the foreign tax law are reasonably similar to the sourcing 
rules that apply under the Internal Revenue Code, the character of 
gross income arising from gross receipts is determined under the 
foreign tax law (except as provided in paragraph (b)(5)(i)(B)(3) of 
this section), and the following rules apply:
    (1) Services. Under the foreign tax law, gross income from services 
must be sourced based on where the services are performed, as 
determined under reasonable principles (which do not include 
determining the place of performance of the services based on the 
location of the service recipient).
    (2) Royalties. A foreign tax on gross income from royalties must be 
sourced based on the place of use of, or the right to use, the 
intangible property.
    (3) Sales of property. Gross income arising from gross receipts 
from sales or other dispositions of property (including copyrighted 
articles sold through an electronic medium) must be included in the 
foreign tax base on the basis of the rules in paragraph (b)(5)(i)(A) or 
(C) of this section, and not on the basis of source. In the case of 
sales of copyrighted articles (as determined under rules similar to 
Sec.  1.861-18), a foreign tax satisfies the attribution requirement of 
paragraph (b)(5) of this section only if the transaction is treated as 
a sale of tangible property and not as a license of intangible 
property.
    (C) Attribution based on situs of property. A foreign tax on gains 
of nonresidents from the sale or disposition of property, including 
shares in a corporation or an interest in a partnership or other pass-
through entity, based on the situs of property satisfies the 
attribution requirement only as provided in this paragraph 
(b)(5)(i)(C). The amount of gross receipts from the sale or disposition 
of property that is included in the base of the foreign tax on the 
basis of the situs of real property (instead of on the basis of 
activities as described in paragraph (b)(5)(i)(A) of this section) may 
only include gross receipts that are attributable to the disposition of 
real property situated in the foreign country imposing the foreign tax 
(or an interest in a resident corporation or other entity that owns 
such real property) under rules reasonably similar to the rules in 
section 897. The amount of gross receipts from the sale or disposition 
of property other than shares in a corporation, including an interest 
in a partnership or other pass-through entity, that is included in the 
base of the foreign tax on the basis of the situs of property other 
than real property may only include gross receipts that are 
attributable to property forming part of the business property of a 
taxable presence in the foreign country imposing the foreign tax under 
rules that are reasonably similar to the rules in section 864(c).
    (ii) Tax on residents. The base of a foreign tax imposed on 
residents of the foreign country imposing the foreign tax may include 
all of the worldwide gross receipts 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.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (b)(5) of this section.
    (A) Example 1--(1) Facts. Country X imposes a separate levy on 
nonresident companies that furnish, from a location outside of Country 
X, 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 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.
    (2) 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 
(b)(5)(i)(A) of this section. The ESS tax also does not meet the 
requirement in paragraph (b)(5)(i)(B) of this section because it is not 
imposed on the basis of source, and it does not meet the requirement in 
paragraph (b)(5)(i)(C) of this section because it is not imposed on the 
sale or other disposition of property.
    (B) Example 2--(1) Facts. The facts are the same as those in 
paragraph (b)(5)(iii)(A)(1) of this section (the facts in Example 1), 
except that instead of imposing the ESS tax by deeming 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 and costs that are sourced to 
Country X is determined by multiplying the nonresident's total gross 
income and costs by the percentage of its total users that are located 
in Country X.
    (2) Analysis. Country X tax law's rule for sourcing electronically 
supplied services is not based on where the services are performed and 
is instead 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 (b)(5)(i)(B) of this section. The ESS tax also 
does not meet the requirement in paragraph (b)(5)(i)(A) 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 
(b)(5)(i)(C) of this section because it is not imposed on the sale or 
other disposition of property.
    (6) 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

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a separate levy that is itself a net income tax, then such surtax is 
considered to satisfy the net gain requirement.
* * * * *
    (d) Separate levies--(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), (iii), or (iv) 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, even if the taxable bases are determined using the 
same computational rules. 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. If two or more 
subsets of a separate class of income are subject to a withholding tax 
based on different income attribution rules (for example, if technical 
services are subject to tax based on the residence of the payor and 
other services are subject to tax based on where the services are 
performed), separate levies are considered to be imposed with respect 
to each subset of that separate class of income.
    (iv) Foreign levy modified by an applicable income tax treaty. A 
foreign levy that is limited in its application by, or is otherwise 
modified by, an income tax treaty to which the foreign country imposing 
the levy is a party is a separate levy from the levy imposed under the 
domestic law (without regard to the treaty) of the foreign country, and 
is also a separate levy from the foreign levy as modified by a 
different income tax treaty to which the foreign country imposing the 
levy is a party, even if the two treaties modify the foreign levy in 
exactly the same manner. Accordingly, a foreign levy paid by taxpayers 
that qualify for and claim benefits under an income tax treaty is a 
separate levy from the levy as applied to taxpayers that are ineligible 
for, or that do not claim, benefits under that treaty, even if the two 
foreign levies would apply in the same manner to a particular taxpayer, 
and regardless of whether the unmodified foreign levy is a foreign 
income tax within the meaning of paragraph (a)(1)(ii) of this section.
    (2) Contractual modifications. Notwithstanding paragraph (d)(1) of 
this section, if foreign tax law imposing a levy is modified for one or 
more persons subject to the levy by a contract entered into by such 
person or persons and the foreign country, then the foreign tax law is 
considered for purposes of sections 901 and 903 to impose a separate 
levy for all persons to whom such contractual modification of the levy 
applies, as contrasted to the levy as applied to all persons to whom 
such contractual modification does not apply.
    (3) Examples. The following examples illustrate the rules of 
paragraph (d)(1) of this section.
    (i) Example 1: Separate taxable bases--(A) Facts. A foreign statute 
imposes a levy on corporations equal to the sum of 15% of the 
corporation's realized net income plus 3% of its net worth.
    (B) Analysis. As the levy is the sum of two separately computed 
amounts, each of which is computed by reference to a separate base, 
under paragraph (d)(1)(ii) of this section each of the portion of the 
levy based on income and the portion of the levy based on net worth is 
considered, for purposes of sections 901 and 903, to be a separate 
levy.

[[Page 342]]

    (ii) Example 2: Separate taxable bases--(A) Facts. A foreign 
statute imposes a levy on nonresident alien individuals analogous to 
the taxes imposed by section 871 of the Internal Revenue Code.
    (B) Analysis. As the levy is imposed on separately computed 
amounts, each of which is computed by reference to a separate taxable 
base and portions of which comprise withholding tax on gross income of 
nonresidents, under paragraphs (d)(1)(ii) and (iii) of this section, 
each of the portions of the foreign levy imposed on each separate class 
of gross income analogous to the tax imposed by section 871(a) and the 
portion of the foreign levy analogous to the tax imposed by sections 
871(b) and 1 is considered, for purposes of sections 901 and 903, to be 
a separate levy.
    (iii) Example 3: Separate taxable bases--(A) Facts--(1) A single 
foreign statute or separate foreign statutes impose a foreign levy that 
is the sum of the products of specified rates applied to specified 
bases, as follows:

                 Table 1 to paragraph (d)(3)(iii)(A)(1)
------------------------------------------------------------------------
                                                                 Rate
                            Base                               (percent)
------------------------------------------------------------------------
Net income from mining......................................          45
Net income from manufacturing...............................          50
Net income from technical services..........................          50
Net income from other services..............................          45
Net income from investments.................................          15
All other net income........................................          50
------------------------------------------------------------------------

    (2) In computing each such base, deductible expenditures are 
allocated to the type of income they generate. If allocated deductible 
expenditures exceed the gross amount of a specified type of income, the 
excess may not be applied against income of a different specified type.
    (B) Analysis. The levy is the sum of several separately computed 
amounts, each of which is computed by reference to a separate base. 
Accordingly, under paragraph (d)(1)(ii) of this section, each of the 
levies on mining net income, manufacturing net income, technical 
services net income, other services net income, investment net income 
and other net income is considered, for purposes of sections 901 and 
903, to be a separate levy.
    (iv) Example 4: Combined taxable base after preliminary separate 
computation--(A) Facts. The facts are the same as those in paragraph 
(d)(3)(iii)(A) of this section (the facts in Example 3), except that 
excess deductible expenditures allocated to one type of income are 
applied against other types of income to which the same rate applies.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the 
levies on mining net income and other services net income together are 
considered, for purposes of sections 901 and 903, to be a single levy 
since, despite a separate preliminary computation of the bases, by 
reason of the permitted application of excess allocated deductible 
expenditures the bases are not separately computed. For the same 
reason, the levies on manufacturing net income, technical services net 
income and other net income together are considered, for purposes of 
sections 901 and 903, to be a single levy. The levy on investment net 
income is considered, for purposes of sections 901 and 903, to be a 
separate levy. These results are not dependent on whether the 
application of excess allocated deductible expenditures to a different 
type of income is permitted in the same taxable period in which the 
expenditures are taken into account for purposes of the preliminary 
computation, or only in a different (for example, later) taxable 
period.
    (v) Example 5: Combined taxable base with income subject to 
different rates--(A) Facts. The facts are the same as those in 
paragraph (d)(3)(iii)(A) of this section (the facts in Example 3), 
except that excess deductible expenditures allocated to any type of 
income other than investment income are applied against the other types 
of income (including investment income) according to a specified set of 
priorities of application. Excess deductible expenditures allocated to 
investment income are not applied against any other type of income.
    (B) Analysis. For the same reasons as those set forth in paragraph 
(d)(3)(iv)(B) of this section (the analysis in Example 4), all of the 
levies are together considered, for purposes of sections 901 and 903, 
to be a single levy.
    (vi) Example 6: Minimum Tax--(A) Facts. Country X imposes a net 
income tax (``Income Tax'') and a minimum tax (``Minimum Tax'') on its 
residents. Under Country X tax law, alternative minimum taxable income 
for purposes of the Minimum Tax equals the taxable income under the 
Income Tax increased by certain disallowed deductions. The Minimum Tax 
equals the excess, if any, of the alternative minimum taxable income 
times the Minimum Tax rate over the amount of the Income Tax.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the 
Minimum Tax is a separate levy from the Income Tax, because the taxable 
base of each levy is separately computed and not combined as a single 
taxable base. The result would be the same if under Country X tax law 
the Minimum Tax equaled the alternative minimum taxable income times 
the Minimum Tax rate, and residents of Country X were required to pay 
the greater of the Income Tax or the Minimum Tax (rather than the 
Income Tax plus the excess, if any, of the Minimum Tax over the Income 
Tax).
    (vii) Example 7: Diverted Profits Tax--(A) Facts. Country X imposes 
a 20% net income tax (``Income Tax'') and a 25% ``Diverted Profits 
Tax'' on nonresident corporations. Under Country X tax law, taxable 
income under the Diverted Profits Tax is determined first by 
attributing gross receipts of the nonresident corporation to a 
hypothetical permanent establishment in Country X. Country X applies 
the same computational rules that apply under the Income Tax to 
determine the taxable income attributable to a hypothetical permanent 
establishment under the Diverted Profits Tax.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the 
Diverted Profits Tax is a separate levy from the Income Tax, because 
the taxable income under the Diverted Profits Tax is not combined with 
the taxable income under the Income Tax as a single taxable base.
    (viii) Example 8: Modified Income Tax--(A) Facts. Country X imposes 
a net income tax (``Income Tax'') on nonresident corporations that 
carry on a trade or business in Country X through a permanent 
establishment. Under Country X tax law, the taxable base of the Income 
Tax as initially enacted is determined by attributing profits of the 
nonresident corporation to its permanent establishment in Country X 
based upon rules similar to Articles 5 and 7 of the 2016 U.S. Model 
Income Tax Convention. However, Country X later amends the Income Tax 
to provide that nonresident corporations that are engaged in certain 
digital transactions in Country X and earning revenues above certain 
thresholds are deemed to have a permanent establishment; under the 
Income Tax as originally enacted, such activities would not have 
created a permanent establishment in Country X.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the 
Income Tax as applied to nonresident corporations engaged in digital 
transactions and deemed to have a permanent establishment under the 
modified Income Tax is not a separate levy from the Income Tax as 
applied to the same or other nonresident corporations that would have 
permanent establishments

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under the Income Tax as originally enacted, because income attributable 
to both actual and deemed permanent establishments is combined as a 
single taxable base.
    (ix) Example 9: Disallowed deductions--(A) Facts. Country X imposes 
a net income tax (``Income Tax'') on resident corporations. In 
determining the taxable base for the Income Tax, Country X tax law has 
a cap on allowed interest deductions for companies engaged in the 
extraction, production, or refinement of oil or natural gas.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the 
Income Tax as applied to corporations engaged in the extraction, 
production, or refinement of oil or natural gas is not a separate levy 
from the Income Tax as applied to other corporations subject to the 
levy. The Income Tax is a single levy even though the cap on allowed 
interest expense deductions applies by its terms to some, but not all, 
corporations subject to the Income Tax.
    (x) Example 10: Different taxable base for class of taxpayers--(A) 
Facts. Country X imposes a net income tax (``Income Tax'') and an oil 
tax. The oil tax applies only to resident corporations engaged in the 
extraction, production, or refinement of oil, and resident corporations 
subject to the oil tax are not subject to the Income Tax. The taxable 
base under the oil tax is the taxable income under the Income Tax 
increased by disallowed interest expense.
    (B) Analysis. Under paragraph (d)(1)(ii) of this section, the oil 
tax is a separate levy from the Income Tax, because the taxable income 
under the oil tax is not combined with the taxable income under the 
Income Tax as a single taxable base. The levies are imposed on 
different classes of taxpayers (resident taxpayers engaged in the 
extraction, production, or refinement of oil, in the case of the oil 
tax, and all other resident corporations, in the case of the Income 
Tax), and the base of each of those levies contains different items.
    (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. Under paragraph (g) of this 
section, the term ``paid'' means ``paid'' or ``accrued,'' depending on 
the taxpayer's method of accounting for such taxes. The amount of 
foreign income tax paid by the taxpayer is determined separately for 
each taxpayer under the rules in this paragraph (e).
    (2) Refunds and credits--(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 liability 
is reduced, satisfied, or otherwise offset by a tax credit, including a 
tax credit that under the foreign tax law is payable in cash only to 
the extent it exceeds the taxpayer's liability for foreign income tax 
or a tax credit acquired from another taxpayer.
    (iii) Exception for overpayments and other fully refundable 
credits. An amount of foreign income tax paid is not reduced (or 
treated as constructively refunded) solely by reason of the fact that a 
credit is allowed (or may be allowed) for the amount paid to reduce the 
amount of a 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 of the taxpayer for the same or 
a different taxable period, the credited amount of the overpayment may 
qualify as an amount paid of that different foreign income tax, if the 
credited amount 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. Similarly, if under the foreign tax 
law, the full amount of a tax credit is payable in cash at the 
taxpayer's option, the taxpayer's choice to apply all or a portion of 
the tax credit in satisfaction of a foreign income tax liability of the 
taxpayer is treated as a constructive payment of cash to the taxpayer 
in the amount so applied, followed by a constructive payment of the 
foreign income tax liability against which the credit is applied. An 
overpayment or other tax credit that under the foreign tax law is 
otherwise fully payable in cash at the taxpayer's option and that is 
applied in part in satisfaction of a foreign income tax liability is 
treated as an amount of foreign income tax paid notwithstanding that a 
portion of the amount otherwise payable in cash to the taxpayer is 
subject to a lien or otherwise seized in order to satisfy a different, 
pre-existing liability of the taxpayer to the foreign government or to 
a third party.
    (iv) Examples. The following examples illustrate the rules of 
paragraph (e)(2) of this section.
    (A) Example 1. The domestic law of Country X imposes a 25 percent 
tax described in Sec.  1.903-1(b) on the gross amount of interest from 
sources in Country X that is received by a nonresident of Country X. 
Country X imposes the tax on the nonresident recipient and requires any 
resident of Country X that pays such interest to a nonresident to 
withhold and pay over to Country X 25 percent of such interest, which 
is applied to offset the recipient's liability for the 25 percent tax. 
A tax treaty between the United States and Country X modifies domestic 
law of Country X and provides that Country X may not tax interest 
received by a resident of the United States from a resident of Country 
X at a rate in excess of 10 percent of the gross amount of such 
interest. A resident of the United States may claim the benefit of the 
treaty only by applying for a refund of the excess withheld amount (15 
percent of the gross amount of interest income) after the end of the 
taxable year. A, a resident of the United States, receives a gross 
amount of 100u (units of Country X currency) of interest income from a 
resident of Country X from sources in Country X in Year 1, from which 
25u of Country X tax is withheld. A files a timely claim for refund of 
the 15u excess withheld amount. 15u of the amount withheld (25u - 10u) 
is reasonably certain to be refunded; therefore, under paragraph 
(e)(2)(i) of this section 15u is not considered an amount of foreign 
income tax paid to Country X.
    (B) Example 2. A's initial foreign income tax liability under 
Country X tax law is 100u (units of Country X currency). However, under 
Country X tax law A's initial income tax liability is reduced in order 
to compute A's final tax liability by an investment credit of 15u and a 
credit for charitable contributions of 5u. Under paragraph

[[Page 344]]

(e)(2)(ii) of this section, the amount of foreign income tax paid by A 
is 80u.
    (C) Example 3. A computes foreign income tax liability in Country X 
for Year 1 of 100u (units of Country X currency), files a tax return on 
that basis, and remits 100u of tax. The day after A files that return, 
A files a claim for refund of 90u. The difference between the 100u of 
liability reflected in A's original return and the 10u of liability 
reflected in A's refund claim depends on whether a particular 
expenditure made by A is nondeductible or deductible, respectively. 
Based on an analysis of the Country X tax law, A's Country X tax 
advisors have advised A that it is not clear whether or not that 
expenditure is deductible. In view of the uncertainty as to the proper 
treatment of the item in question under Country X tax law, no portion 
of the 100u paid by A is reasonably certain to be refunded. If A 
receives a refund, A must treat the refund as required by section 
905(c) of the Internal Revenue Code.
    (D) Example 4. A levy of Country X, which qualifies as a foreign 
income tax within the meaning of paragraph (a)(1)(ii) of this section, 
provides that each person who makes payment to Country X pursuant to 
the levy will receive a bond to be issued by Country X with an amount 
payable at maturity equal to 10 percent of the amount paid pursuant to 
the levy. A remits 38,000u (units of Country X currency) to Country X 
and is entitled to receive a bond with an amount payable at maturity of 
3,800u. It is reasonably certain that a refund in the form of property 
(the bond) will be made. The amount of that refund is equal to the fair 
market value of the bond. Therefore, only the portion of the 38,000u 
payment in excess of the fair market value of the bond is an amount of 
foreign income tax paid.
    (3) Subsidies--(i) General rule. An amount of foreign income tax is 
not an amount of foreign income tax paid by a taxpayer to a foreign 
country to the extent that--
    (A) The amount is used, directly or indirectly, by the foreign 
country imposing the tax to provide a subsidy by any means (including, 
but not limited to, a rebate, a refund, a credit, a deduction, a 
payment, a discharge of an obligation, or any other method) to the 
taxpayer, to a related person (within the meaning of section 482), to 
any party to the transaction, or to any party to a related transaction; 
and
    (B) The subsidy is determined, directly or indirectly, by reference 
to the amount of the tax or by reference to the base used to compute 
the amount of the tax.
    (ii) Subsidy. The term ``subsidy'' includes any benefit conferred, 
directly or indirectly, by a foreign country to one of the parties 
enumerated in paragraph (e)(3)(i)(A) of this section. Substance and not 
form shall govern in determining whether a subsidy exists. The fact 
that the U.S. taxpayer may derive no demonstrable benefit from the 
subsidy is irrelevant in determining whether a subsidy exists.
    (iii) Official exchange rate. A subsidy described in paragraph 
(e)(3)(i)(B) of this section does not include the actual use of an 
official foreign government exchange rate converting foreign currency 
into dollars where a free exchange rate also exists if--
    (A) The economic benefit represented by the use of the official 
exchange rate is not targeted to or tied to transactions that give rise 
to a claim for a foreign tax credit;
    (B) The economic benefit of the official exchange rate applies to a 
broad range of international transactions, in all cases based on the 
total payment to be made without regard to whether the payment is a 
return of principal, gross income, or net income, and without regard to 
whether it is subject to tax; and
    (C) Any reduction in the overall cost of the transaction is merely 
coincidental to the broad structure and operation of the official 
exchange rate.
    (iv) Examples. The following examples illustrate the rules of 
paragraph (e)(3) of this section.
    (A) Example 1--(1) Facts. Country X imposes a 30 percent tax on 
nonresident lenders with respect to interest which the nonresident 
lenders receive from borrowers who are residents of Country X, and it 
is established that this tax is a tax in lieu of an income tax within 
the meaning of Sec.  1.903-1(b). Country X provides the nonresident 
lenders with receipts upon their payment of the 30 percent tax. Country 
X remits to resident borrowers an incentive payment for engaging in 
foreign loans, which payment is an amount equal to 20 percent of the 
interest paid to nonresident lenders.
    (2) Analysis. Because the incentive payment is based on the 
interest paid, it is determined by reference to the base used to 
compute the tax that is imposed on the nonresident lender. The 
incentive payment is a subsidy under paragraph (e)(3)(i) of this 
section since it is provided to a party (the borrower) to the 
transaction and is based on the amount of tax that is imposed on the 
lender with respect to the transaction. Therefore, two-thirds (20 
percent/30 percent) of the amount withheld by the resident borrower 
from interest payments to the nonresident lender is not an amount of 
foreign income tax paid.
    (B) Example 2--(1) Facts. A U.S. bank lends money to a development 
bank in Country X. The development bank relends the money to companies 
resident in Country X. A withholding tax is imposed by Country X on the 
U.S. bank with respect to the interest that the development bank pays 
to the U.S. bank, and appropriate receipts are provided. On the date 
that the tax is withheld, fifty percent of the tax is credited by 
Country X to an account of the development bank. Country X requires the 
development bank to transfer the amount credited to the borrowing 
companies.
    (2) Analysis. The amount successively credited to the account of 
the development bank and then to the account of the borrowing companies 
is determined by reference to the amount of the tax and the tax base. 
Since the amount credited to the borrowing companies is a subsidy 
provided to a party (the borrowing companies) to a related transaction 
and is based on the amount of tax and the tax base, under paragraph 
(e)(3)(i) of this section it is not an amount of foreign income tax 
paid.
    (C) Example 3--(1) Facts. A U.S. bank lends dollars to a Country X 
borrower. Country X imposes a withholding tax on the lender with 
respect to the interest. The tax is to be paid in Country X currency, 
although the interest is payable in dollars. Country X has a dual 
exchange rate system, comprised of a controlled official exchange rate 
and a free exchange rate. Priority transactions such as exports of 
merchandise, imports of merchandise, and payments of principal and 
interest on foreign currency loans payable abroad to foreign lenders 
are governed by the official exchange rate which yields more dollars 
per unit of Country X currency than the free exchange rate. The Country 
X borrower remits the net amount of dollar interest due to the U.S. 
bank (interest due less withholding tax), pays the tax withheld in 
Country X currency to the Country X government, and provides to the 
U.S. bank a receipt for payment of the Country X taxes.
    (2) Analysis. Under paragraph (e)(3)(iii) of this section, the use 
of the official exchange rate by the U.S. bank to determine foreign 
taxes with respect to interest is not a subsidy described in paragraph 
(e)(3)(i)(B) of this section. The official exchange rate is not 
targeted to or tied to transactions that give rise to a claim for a 
foreign tax credit. The use of the official exchange rate applies to 
the interest paid and to the principal

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paid. Any benefit derived by the U.S. bank through the use of the 
official exchange rate is merely coincidental to the broad structure 
and operation of the official exchange rate.
    (D) Example 4--(1) Facts. B, a U.S. corporation, is engaged in the 
production of oil and gas in Country X pursuant to a production sharing 
agreement among B, Country X, and the state petroleum authority of 
Country X. The agreement is approved and enacted into law by the 
Legislature of Country X. Both B and the petroleum authority are 
subject to the Country X income tax. Each entity files an annual income 
tax return and pays, to the tax authority of Country X, the amount of 
income tax due on its annual income. B is a dual capacity taxpayer as 
defined in Sec.  1.901-2(a)(2)(ii)(A). Country X has agreed to return 
to the petroleum authority one-half of the income taxes paid by B by 
allowing it a credit in calculating its own tax liability to Country X.
    (2) Analysis. The petroleum authority is a party to a transaction 
with B and the amount returned by Country X to the petroleum authority 
is determined by reference to the amount of the tax imposed on B. 
Therefore, under paragraph (e)(3)(i) of this section the amount 
returned is a subsidy, and one-half of the tax imposed on B is not an 
amount of foreign income tax paid.
    (E) Example 5--(1) Facts. The facts are the same as those in 
paragraph (e)(3)(iv)(D)(1) of this section (the facts in Example 4), 
except that the state petroleum authority of Country X does not receive 
amounts from Country X related to tax paid by B. Instead, the authority 
of Country X receives a general appropriation from Country X which is 
not calculated with reference to the amount of tax paid by B.
    (2) Analysis. Because the general appropriation is not calculated 
with reference to the amount of tax paid by B, it is not a subsidy 
described in paragraph (e)(3)(i) of this section.
    (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 (which is 
not considered to be reduced by the amount applied against the reduced 
levy), and the remainder of the total amount paid, if any, 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 those 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) Noncompulsory amounts--(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 
tax 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 
paragraphs (e)(5)(ii) through (v) of this section. 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. However, a taxpayer is not required to 
reduce its foreign income tax liability to the extent the reasonably 
expected, arm's length costs of reducing the liability would exceed the 
amount by which the liability could be reduced. For this purpose, such 
costs may include an additional liability for a different foreign tax 
(but not U.S. taxes) that is not a foreign income tax only to the 
extent the amount of the additional liability is determined in a manner 
consistent with the rules of this paragraph (e)(5). 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) Reasonable application of foreign tax law. An interpretation 
or application of foreign tax 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. Except 
as provided in paragraphs (e)(5)(i) and (e)(5)(iv) of this section, 
voluntarily forgoing a tax benefit to which a taxpayer is entitled 
under the foreign tax law results in a foreign payment in excess of the 
taxpayer's liability for foreign income tax.
    (iii) Effect of foreign tax law elections--(A) In general. Where 
foreign tax law includes options or elections whereby a taxpayer's 
foreign income tax

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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)(iii)(B) of this section, where foreign tax law provides a 
taxpayer with options or elections in computing its liability for 
foreign income tax 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 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).
    (C) Alternative creditable levies. If under foreign tax law a 
taxpayer has the option to determine its foreign income tax liability 
under only one of multiple separate levies, each of which qualifies as 
a foreign income tax, then the amount of foreign income tax paid equals 
the smallest liability of the amounts that would be due under each of 
the alternative levies, regardless of which levy the taxpayer uses to 
determine its foreign income tax liability.
    (iv) Exception for increase in liability in connection with anti-
hybrid rules--(A) In general. If a taxpayer (the ``first taxpayer'') 
that makes a payment to another taxpayer (the ``second taxpayer'') is 
permitted to increase the first taxpayer's liability for foreign income 
tax (for example, by waiving an otherwise allowable deduction), and 
doing so results in a greater decrease in the amount of liability for 
foreign income tax of the second taxpayer by reason of the deactivation 
of a hybrid mismatch rule that would otherwise apply to the second 
taxpayer, then the increase in the first taxpayer's liability is not 
considered to result in a foreign payment in excess of the first 
taxpayer's liability for foreign income tax for purposes of this 
paragraph (e)(5).
    (B) Definition of hybrid mismatch rule. The term hybrid mismatch 
rule means foreign tax law rules substantially similar to sections 
245A(e) and 267A and includes rules the purpose of which is to 
eliminate the deduction/no-inclusion outcome of hybrid and branch 
mismatch arrangements. Examples of such rules include rules based on, 
or substantially similar to, the recommendations contained in OECD/G-
20, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2: 
2015 Final Report (October 2015), and OECD/G-20, Neutralising the 
Effects of Branch Mismatch Arrangements, Action 2: Inclusive Framework 
on BEPS (July 2017).
    (v) Exhaustion of remedies. 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 reasonably 
expected risk of incurring an offsetting or additional foreign income 
tax or other tax liability) is reasonable considering 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.
    (vi) Examples. The following examples illustrate the rules of 
paragraph (e)(5) of this section.
    (A) Example 1. A, a corporation organized and doing business solely 
in the United States, owns all of the stock of B, a corporation 
organized in Country X. In Year 1, A buys merchandise from unrelated 
persons for $1,000,000, and shortly thereafter resells that merchandise 
to B for $600,000. Later in Year 1, B resells the merchandise to 
unrelated persons for $1,200,000. Under the Country X income tax, which 
is a net income tax within the meaning of paragraph (a)(3) of this 
section, all corporations organized in Country X are subject to a tax 
equal to 3 percent of their net income. In computing its Year 1 Country 
X income tax liability, B reports $600,000 ($1,200,000 - $600,000) of 
profit from the purchase and resale of merchandise. The Country X tax 
law requires that transactions between related persons be reported at 
arm's length prices, and a reasonable interpretation of this 
requirement, as it has been applied in Country X, would consider B's 
arm's length purchase price of the merchandise purchased from A to be 
$1,050,000. When it computes its Country X tax liability B is aware 
that $600,000 is not an arm's length price (by Country X standards). 
B's knowing use of a non-arm's length price (by Country X standards) of 
$600,000, instead of a price of $1,050,000 (an arm's length price under 
Country X's law), is not consistent with a reasonable interpretation 
and application of Country X tax law, determined in such a way as to 
reduce over time B's reasonably expected liability for Country X income 
tax. Accordingly, $13,500 (3 percent of $450,000 ($1,050,000 - 
$600,000)), the amount of Country X income tax remitted by B to Country 
X that is attributable to the purchase of the merchandise from B's 
parent at less than an arm's length price, is in excess of the amount 
of B's liability for Country X income tax, and thus is not an amount of 
foreign income tax paid.
    (B) Example 2. A, a corporation organized and doing business solely 
in the United States, owns all of the stock of B, a corporation 
organized in Country X. Country X has in force an income tax treaty 
with the United States. The tax treaty provides that the profits of 
related persons shall be determined as if the persons were not related. 
A and B deal extensively with each other. A and B, with respect to a 
series of transactions involving both of them, treat A as having 
$300,000 of income and B as having $700,000 of income for purposes of 
A's United States income tax and B's Country X income tax, 
respectively. B has no actual or constructive notice that its treatment 
of these transactions under Country X tax law is likely to be 
erroneous. Subsequently, the Internal Revenue Service reallocates 
$200,000 of this income from B to A under the authority of section 482 
and the tax treaty. This reallocation constitutes actual notice to A 
and constructive notice to B that B's interpretation and application of 
Country X's tax law and the tax treaty is likely to be erroneous. B 
does not exhaust all effective and practical remedies to obtain a 
refund of the amount remitted by B to Country X that is attributable to 
the reallocated $200,000 of income. Under paragraph (e)(5)(i) of this 
section, this amount is in excess of the amount of B's liability for 
Country X income tax and thus is not an amount of foreign income tax 
paid.

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    (C) Example 3. The facts are the same as those in paragraph 
(e)(5)(vi)(B) of this section (the facts in Example 2), except that B 
files a claim for refund (an administrative proceeding) of Country X 
tax and A or B invokes the competent authority procedures of the tax 
treaty, the cost of which is reasonable in view of the amount at issue 
and the likelihood of success. Nevertheless, B does not obtain any 
refund of Country X income tax. The cost of pursuing any judicial 
remedy in Country X would be unreasonable in light of the amount at 
issue and the likelihood of B's success, and B does not pursue any such 
remedy. Under paragraph (e)(5)(i) of this section, the entire amount 
paid by B to Country X is a compulsory payment and thus is an amount of 
foreign income tax paid by B.
    (D) Example 4. The facts are the same as those in paragraph 
(e)(5)(vi)(B) of this section (the facts in Example 2), except that, 
when the Internal Revenue Service makes the reallocation, the Country X 
statute of limitations on refunds has expired, and neither the internal 
law of Country X nor the tax treaty authorizes the Country X tax 
authorities to pay a refund that is barred by the statute of 
limitations. B does not file a claim for refund, and neither A nor B 
invokes the competent authority procedures of the tax treaty. Because 
the Country X tax authorities would be barred by the statute of 
limitations from paying a refund, B has no effective and practical 
remedies. Under paragraph (e)(5)(i) of this section, the entire amount 
paid by B to Country X is a compulsory payment and thus is an amount of 
foreign income tax paid by B.
    (E) Example 5. A is a U.S. person doing business in Country X. In 
computing its income tax liability to Country X, A is permitted, at its 
election, to recover the cost of machinery used in its business either 
by deducting that cost in the year of acquisition or by depreciating 
that cost on the straight-line method over a period of 2, 4, 6 or 10 
years. A elects to depreciate machinery over 10 years. This election 
merely shifts A's tax liability to different years (compared to the 
timing of A's tax liability under a different depreciation period); it 
does not result in a payment in excess of the amount of A's liability 
for Country X income tax in any year since the amount of Country X 
income tax paid by A is consistent with a reasonable interpretation of 
Country X tax law in such a way as to reduce over time A's reasonably 
expected liability for Country X income tax. Because the standard of 
paragraph (e)(5)(i) of this section refers to A's reasonably expected 
liability, not its actual liability, events actually occurring in 
subsequent years (for example, whether A has sufficient profit in such 
years so that such depreciation deductions actually reduce A's Country 
X tax liability or whether the Country X tax rates change) are 
immaterial.
    (F) Example 6. The domestic law of Country X imposes a 25 percent 
tax described in Sec.  1.903-1(b) on the gross amount of interest from 
sources in Country X that is received by a nonresident of Country X. 
Country X tax law imposes the tax on the nonresident recipient and 
requires any resident of Country X that pays such interest to a 
nonresident to withhold and pay over to Country X 25 percent of such 
interest, which is applied to offset the recipient's liability for the 
25 percent tax. A tax treaty between the United States and Country X 
overrides domestic law of Country X and provides that Country X may not 
tax interest received by a resident of the United States from a 
resident of Country X at a rate in excess of 10 percent of the gross 
amount of such interest. A resident of the United States may claim the 
benefit of the tax treaty only by applying for a refund of the excess 
withheld amount (15 percent of the gross amount of interest income) 
after the end of the taxable year. A, a resident of the United States, 
receives a gross amount of 100u (units of Country X currency) of 
interest income from a resident of Country X from sources in Country X 
in Year 1, from which 25u of Country X tax is withheld. A does not file 
a timely claim for refund. Under paragraph (e)(5)(i) of this section, 
15u of the amount withheld (25u - 10u) is not a compulsory payment and 
thus is not an amount of foreign income tax paid.
    (G) Example 7: Reasonable steps to minimize creditable tax--larger 
noncreditable tax cost--(1) Facts. Corporations resident in Country X 
are subject to a 20% generally applicable net income tax, which 
qualifies as a foreign income tax under paragraph (a)(1)(ii) of this 
section (``Income Tax''), and a separate levy equal to 25% of certain 
deductible payments above a specified threshold made to related parties 
that are not residents of Country X, which does not qualify as a 
foreign income tax under paragraph (a)(1)(ii) of this section (``Base 
Erosion Tax''). CFC, a Country X corporation, makes payments to 
nonresident related parties that exceed the specified threshold of the 
Base Erosion Tax by 100u (units of Country X currency), which if 
claimed as deductions would result in a Base Erosion Tax of 25u (.25 x 
100u), and would also result in 300u of taxable income for purposes of 
the Income Tax, thus resulting in Income Tax of 60u (.20 x 300u). If in 
computing its liability for Income Tax CFC does not claim deductions 
for the 100u of excess related party payments, its liability for the 
Base Erosion Tax would be zero, and its liability for Income Tax would 
be 80u (.20 x 400u).
    (2) Analysis. If CFC chooses not to deduct the 100u of excess 
related party payments that would subject it to the Base Erosion Tax 
and pays 80u of Income Tax, the amount of foreign income tax paid under 
paragraph (e)(5) of this section is 80u. Under paragraph (e)(5)(i) of 
this section, although CFC could reduce its liability for Income Tax 
from 80u to 60u by claiming the deductions, no portion of the Income 
Tax remitted is a noncompulsory payment because reducing the Income Tax 
by 20u would incur a Base Erosion Tax of 25u, which exceeds the amount 
of the potential reduction.
    (H) Example 8: Reasonable steps to minimize creditable tax--smaller 
noncreditable tax cost--(1) Facts. The facts are the same as those in 
paragraph (e)(5)(vi)(G)(1) of this section (the facts in Example 7) 
except that the rate of the Base Erosion Tax is 20% and the rate of the 
Income Tax is 25%. Accordingly, if CFC claims the 100u of excess 
deductions its liability for Base Erosion Tax would be 20u (.20 x 
100u), and its liability for Income Tax would be 75u (.25 x 300u). If 
CFC chooses not to claim the 100u of excess deductions its liability 
for Base Erosion Tax would be zero, and its liability for Income Tax 
would be 100u (.25 x 400u).
    (2) Analysis. If CFC chooses not to claim the 100u of excess 
deductions in computing its liability for Income Tax and pays 100u of 
Income Tax, the amount of foreign income tax paid under paragraph 
(e)(5) of this section is 75u. CFC's additional payment of 25u is not 
an amount of Income Tax paid, because CFC could have reduced its Income 
Tax liability by 25u by claiming the excess deductions and paying 20u 
of Base Erosion Tax.
    (I) Example 9: Alternative creditable taxes--(1) Facts. The facts 
are the same as those in paragraph (e)(5)(vi)(G)(1) of this section 
(the facts in Example 7), except that Country X does not have a Base 
Erosion Tax, and it allows resident corporations to elect to pay either 
the Income Tax or a separate levy using an alternative cost allowance 
(the ``Alternative Tax''), which qualifies as a tax in lieu of an 
income tax under Sec.  1.903-1(b)(2). CFC's liability under the Income 
Tax is 80u, and its liability under the Alternative Tax is 100u. CFC 
chooses to pay the 100u of Alternative Tax rather than the 80u of 
Income Tax.

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    (2) Analysis. Under paragraph (e)(5)(iii)(C) of this section, the 
amount of foreign income tax paid by CFC is 80u, the smaller of the 
amounts due under the two alternative foreign income taxes.
    (vii) Structured passive investment arrangements--(A) In general. 
Notwithstanding paragraph (e)(5)(i) of this section, an amount paid to 
a foreign country (a ``foreign payment'') is not a compulsory payment, 
and thus is not an amount of foreign income tax paid, if the foreign 
payment is attributable (within the meaning of paragraph 
(e)(5)(vii)(B)(1)(ii) of this section) to a structured passive 
investment arrangement (as described in paragraph (e)(5)(vii)(B) of 
this section).
    (B) Conditions. An arrangement is a structured passive investment 
arrangement if all of the following conditions are satisfied:
    (1) Special purpose vehicle (SPV). An entity that is part of the 
arrangement meets the following requirements:
    (i) Substantially all of the gross income (for U.S. tax purposes) 
of the entity, if any, is passive investment income, and substantially 
all of the assets of the entity are assets held to produce such passive 
investment income.
    (ii) There is a foreign payment attributable to income of the 
entity (as determined under the laws of the foreign country to which 
such foreign payment is made), including the entity's share of income 
of a lower-tier entity that is a branch or pass-through entity under 
the laws of such foreign country, that, if the foreign payment were an 
amount of foreign income tax paid, would be paid in a U.S. taxable year 
in which the entity meets the requirements of paragraph 
(e)(5)(vii)(B)(1)(i) of this section. A foreign payment attributable to 
income of an entity includes a foreign payment attributable to income 
that is required to be taken into account by an owner of the entity, if 
the entity is a branch or pass-through entity under the laws of such 
foreign country. A foreign payment attributable to income of the entity 
also includes a withholding tax (within the meaning of section 
901(k)(1)(B)) imposed on a dividend or other distribution (including 
distributions made by a pass-through entity or an entity that is 
disregarded as an entity separate from its owner for U.S. tax purposes) 
with respect to the equity of the entity.
    (2) U.S. party. A person would be eligible to claim a credit under 
section 901(a) (including a credit for foreign taxes deemed paid under 
section 960) for all or a portion of the foreign payment described in 
paragraph (e)(5)(vii)(B)(1)(ii) of this section if the foreign payment 
were an amount of foreign income tax paid.
    (3) Direct investment. The U.S. party's proportionate share of the 
foreign payment or payments described in paragraph 
(e)(5)(vii)(B)(1)(ii) of this section is (or is expected to be) 
substantially greater than the amount of credits, if any, that the U.S. 
party reasonably would expect to be eligible to claim under section 
901(a) for foreign income taxes attributable to income generated by the 
U.S. party's proportionate share of the assets owned by the SPV if the 
U.S. party directly owned such assets. For this purpose, direct 
ownership shall not include ownership through a branch, a permanent 
establishment or any other arrangement (such as an agency arrangement 
or dual resident status) that would result in the income generated by 
the U.S. party's proportionate share of the assets being subject to tax 
on a net basis in the foreign country to which the payment is made. A 
U.S. party's proportionate share of the assets of the SPV shall be 
determined by reference to such U.S. party's proportionate share of the 
total value of all of the outstanding interests in the SPV that are 
held by its equity owners and creditors. A U.S. party's proportionate 
share of the assets of the SPV, however, shall not include any assets 
that produce income subject to gross basis withholding tax.
    (4) Foreign tax benefit. The arrangement is reasonably expected to 
result in a credit, deduction, loss, exemption, exclusion or other tax 
benefit under the laws of a foreign country that is available to a 
counterparty or to a person that is related to the counterparty 
(determined under the principles of paragraph (e)(5)(vii)(C)(7) of this 
section by applying the tax laws of a foreign country in which the 
counterparty is subject to tax on a net basis). However, a foreign tax 
benefit in the form of a credit is described in this paragraph 
(e)(5)(vii)(B)(4) only if the amount of any such credit corresponds to 
10 percent or more of the amount of the U.S. party's share (for U.S. 
tax purposes) of the foreign payment referred to in paragraph 
(e)(5)(vii)(B)(1)(ii) of this section. In addition, a foreign tax 
benefit in the form of a deduction, loss, exemption, exclusion or other 
tax benefit is described in this paragraph (e)(5)(vii)(B)(4) only if 
such amount corresponds to 10 percent or more of the foreign base with 
respect to which the U.S. party's share (for U.S. tax purposes) of the 
foreign payment is imposed. For purposes of the preceding two 
sentences, if an arrangement involves more than one U.S. party or more 
than one counterparty or both, the aggregate amount of foreign tax 
benefits available to all of the counterparties and persons related to 
such counterparties is compared to the aggregate amount of all of the 
U.S. parties' shares of the foreign payment or foreign base, as the 
case may be. Where a U.S. party indirectly owns interests in an SPV 
that are treated as equity interests for both U.S. and foreign tax 
purposes, a foreign tax benefit available to a foreign entity in the 
chain of ownership that begins with the SPV and ends with the first-
tier entity in the chain does not correspond to the U.S. party's share 
of the foreign payment attributable to income of the SPV to the extent 
that such benefit relates to earnings of the SPV that are distributed 
with respect to equity interests in the SPV that are owned directly or 
indirectly by the U.S. party for purposes of both U.S. and foreign tax 
law.
    (5) Counterparty. The arrangement involves a counterparty. A 
counterparty is a person that, under the tax laws of a foreign country 
in which the person is subject to tax on the basis of place of 
management, place of incorporation or similar criterion or otherwise 
subject to a net basis tax, directly or indirectly owns or acquires 
equity interests in, or assets of, the SPV. However, a counterparty 
does not include the SPV or a person with respect to which for U.S. tax 
purposes the same domestic corporation, U.S. citizen or resident alien 
individual directly or indirectly owns more than 80 percent of the 
total value of the stock (or equity interests) of each of the U.S. 
party and such person. A counterparty also does not include a person 
with respect to which for U.S. tax purposes the U.S. party directly or 
indirectly owns more than 80 percent of the total value of the stock 
(or equity interests), but only if the U.S. party is a domestic 
corporation, a U.S. citizen or a resident alien individual. In 
addition, a counterparty does not include an individual who is a U.S. 
citizen or resident alien.
    (6) Inconsistent treatment. The United States and an applicable 
foreign country treat one or more of the aspects of the arrangement 
listed in paragraph (e)(5)(vii)(B)(6)(i) through (iv) of this section 
differently under their respective tax systems, and for one or more tax 
years when the arrangement is in effect one or both of the following 
two conditions applies; either the amount of income attributable to the 
SPV that is recognized for U.S. tax purposes by the SPV, the U.S. party 
or parties, and persons related to a U.S. party or parties is 
materially less than the amount of income that would be

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recognized if the foreign tax treatment controlled for U.S. tax 
purposes; or the amount of credits claimed by the U.S. party or parties 
(if the foreign payment described in paragraph (e)(5)(vii)(B)(1)(ii) of 
this section were an amount of foreign income tax paid) is materially 
greater than it would be if the foreign tax treatment controlled for 
U.S. tax purposes:
    (i) The classification of the SPV (or an entity that has a direct 
or indirect ownership interest in the SPV) as a corporation or other 
entity subject to an entity-level tax, a partnership or other flow-
through entity or an entity that is disregarded for tax purposes.
    (ii) The characterization as debt, equity or an instrument that is 
disregarded for tax purposes of an instrument issued by the SPV (or an 
entity that has a direct or indirect ownership interest in the SPV) to 
a U.S. party, a counterparty or a person related to a U.S. party or a 
counterparty.
    (iii) The proportion of the equity of the SPV (or an entity that 
directly or indirectly owns the SPV) that is considered to be owned 
directly or indirectly by a U.S. party and a counterparty.
    (iv) The amount of taxable income that is attributable to the SPV 
for one or more tax years during which the arrangement is in effect.
    (C) Definitions. The following definitions apply for purposes of 
paragraph (e)(5)(vii) of this section.
    (1) Applicable foreign country. An applicable foreign country means 
each foreign country to which a foreign payment described in paragraph 
(e)(5)(vii)(B)(1)(ii) of this section is made or which confers a 
foreign tax benefit described in paragraph (e)(5)(vii)(B)(4) of this 
section.
    (2) Counterparty. The term counterparty means a person described in 
paragraph (e)(5)(vii)(B)(5) of this section.
    (3) Entity. The term entity includes a corporation, trust, 
partnership or disregarded entity described in Sec.  301.7701-
2(c)(2)(i).
    (4) Indirect ownership. Indirect ownership of stock or another 
equity interest (such as an interest in a partnership) shall be 
determined in accordance with the principles of section 958(a)(2), 
regardless of whether the interest is owned by a U.S. or foreign 
entity.
    (5) Passive investment income--(i) In general. The term passive 
investment income means income described in section 954(c), as modified 
by this paragraph (e)(5)(vii)(C)(5)(i) and paragraph 
(e)(5)(vii)(C)(5)(ii) of this section. In determining whether income is 
described in section 954(c), paragraphs (c)(1)(H), (c)(3), and (c)(6) 
of section 954 shall be disregarded. Sections 954(c), 954(h), and 
954(i) shall be applied at the entity level as if the entity (as 
defined in paragraph (e)(5)(vii)(C)(3) of this section) were a 
controlled foreign corporation (as defined in section 957(a)). For 
purposes of determining if sections 954(h) and 954(i) apply for 
purposes of this paragraph (e)(5)(vii)(C)(5)(i) and paragraph 
(e)(5)(vii)(C)(5)(ii) of this section, any income of an entity 
attributable to transactions that, assuming the entity is an SPV, are 
with a person that is a counterparty, or with persons that are related 
to a counterparty within the meaning of paragraph (e)(5)(vii)(B)(4) of 
this section, shall not be treated as qualified banking or financing 
income or as qualified insurance income, and shall not be taken into 
account in applying sections 954(h) and 954(i) for purposes of 
determining whether other income of the entity is excluded from section 
954(c)(1) under section 954(h) or 954(i), but only if any such person 
(or a person that is related to such person within the meaning of 
paragraph (e)(5)(vii)(B)(4) of this section) is eligible for a foreign 
tax benefit described in paragraph (e)(5)(vii)(B)(4) of this section. 
In addition, in applying section 954(h) for purposes of this paragraph 
(e)(5)(vii)(C)(5)(i) and paragraph (e)(5)(vii)(C)(5)(ii) of this 
section, section 954(h)(3)(E) shall not apply, section 954(h)(2)(A)(ii) 
shall be satisfied only if the entity conducts substantial activity 
with respect to its business through its own employees, and the term 
``any foreign country'' shall be substituted for ``home country'' 
wherever it appears in section 954(h).
    (ii) Income attributable to lower-tier entities; holding company 
exception. Income of an upper-tier entity that is attributable to an 
equity interest in a lower-tier entity, including dividends, an 
allocable share of partnership income, and income attributable to the 
ownership of an interest in an entity that is disregarded as an entity 
separate from its owner is passive investment income unless 
substantially all of the upper-tier entity's assets consist of 
qualified equity interests in one or more lower-tier entities, each of 
which is engaged in the active conduct of a trade or business and 
derives more than 50 percent of its gross income from such trade or 
business, and substantially all of the upper-tier entity's opportunity 
for gain and risk of loss with respect to each such interest in a 
lower-tier entity is shared by the U.S. party (or persons that are 
related to a U.S. party) and, assuming the entity is an SPV, a 
counterparty (or persons that are related to a counterparty) (``holding 
company exception''). If an arrangement involves more than one U.S. 
party or more than one counterparty or both, then substantially all of 
the upper-tier entity's opportunity for gain and risk of loss with 
respect to its interest in any lower-tier entity must be shared 
(directly or indirectly) by one or more U.S. parties (or persons 
related to such U.S. parties) and, assuming the upper-tier entity is an 
SPV, one or more counterparties (or persons related to such 
counterparties). Substantially all of the upper-tier entity's 
opportunity for gain and risk of loss with respect to its interest in 
any lower-tier entity is not shared if the opportunity for gain and 
risk of loss is borne (directly or indirectly) by one or more U.S. 
parties (or persons related to such U.S. party or parties) or, assuming 
the upper-tier entity is an SPV, by one or more counterparties (or 
persons related to such counterparty or counterparties). Whether and 
the extent to which a person is considered to share in an upper-tier 
entity's opportunity for gain and risk of loss is determined based on 
all the facts and circumstances, provided, however, that a person does 
not share in an upper-tier entity's opportunity for gain and risk of 
loss if its equity interest in the upper-tier entity was acquired in a 
sale-repurchase transaction or if its interest is treated as debt for 
U.S. tax purposes. If a U.S. party owns an interest in an entity 
indirectly through a chain of entities, the application of the holding 
company exception begins with the lowest-tier entity in the chain that 
may satisfy the holding company exception and proceeds upward; 
provided, however, that the opportunity for gain and risk of loss borne 
by any upper-tier entity in the chain that is a counterparty shall be 
disregarded to the extent borne indirectly by a U.S. party. An upper-
tier entity that satisfies the holding company exception is itself 
considered to be engaged in the active conduct of a trade or business 
and to derive more than 50 percent of its gross income from such trade 
or business for purposes of applying the holding company exception to 
the owners of such entity. A lower-tier entity that is engaged in a 
banking, financing, or similar business shall not be considered to be 
engaged in the active conduct of a trade or business unless the income 
derived by such entity would be excluded from section 954(c)(1) under 
section 954(h) or 954(i)

[[Page 350]]

as modified by paragraph (e)(5)(vii)(C)(5)(i) of this section.
    (6) Qualified equity interest. With respect to an interest in a 
corporation, the term qualified equity interest means stock 
representing 10 percent or more of the total combined voting power of 
all classes of stock entitled to vote and 10 percent or more of the 
total value of the stock of the corporation or disregarded entity, but 
does not include any preferred stock (as defined in section 351(g)(3)). 
Similar rules shall apply to determine whether an interest in an entity 
other than a corporation is a qualified equity interest.
    (7) Related person. Two persons are related if--
    (i) One person directly or indirectly owns stock (or an equity 
interest) possessing more than 50 percent of the total value of the 
other person; or
    (ii) The same person directly or indirectly owns stock (or an 
equity interest) possessing more than 50 percent of the total value of 
both persons.
    (8) Special purpose vehicle (SPV). The term SPV means the entity 
described in paragraph (e)(5)(vii)(B)(1) of this section.
    (9) U.S. party. The term U.S. party means a person described in 
paragraph (e)(5)(vii)(B)(2) of this section.
    (D) Examples. The following examples illustrate the rules of 
paragraph (e)(5)(vii) of this section. No inference is intended as to 
whether a taxpayer would be eligible to claim a credit under section 
901(a) if a foreign payment were an amount of foreign income tax paid. 
The examples set forth below do not limit the application of other 
principles of existing law to determine the proper tax consequences of 
the structures or transactions addressed in the regulations.
    (1) Example 1: U.S. borrower transaction--(i) Facts. A domestic 
corporation (USP) forms a Country M corporation (Newco), contributing 
$1.5 billion in exchange for 100% of the stock of Newco. Newco, in 
turn, loans the $1.5 billion to a second Country M corporation (FSub) 
wholly owned by USP. USP then sells its entire interest in Newco to a 
Country M corporation (FP) for the original purchase price of $1.5 
billion, subject to an obligation to repurchase the interest in five 
years for $1.5 billion. The sale has the effect of transferring 
ownership of the Newco stock to FP for Country M tax purposes. Assume 
the sale-repurchase transaction is structured in a way that qualifies 
as a collateralized loan for U.S. tax purposes. Therefore, USP remains 
the owner of the Newco stock for U.S. tax purposes. All of FSub's 
income is subpart F income. In Year 1, FSub pays Newco $120 million of 
interest. Newco pays $36 million to Country M with respect to such 
interest income and distributes the remaining $84 million to FP. Under 
Country M law, the $84 million distribution is excluded from FP's 
income. None of FP's stock is owned, directly or indirectly, by USP or 
any shareholders of USP that are domestic corporations, U.S. citizens, 
or resident alien individuals. Under an income tax treaty between 
Country M and the United States, Country M does not impose Country M 
tax on interest received by U.S. residents from sources in Country M.
    (ii) Result. The $36 million payment by Newco to Country M is not a 
compulsory payment, and thus is not an amount of foreign income tax 
paid because the foreign payment is attributable to a structured 
passive investment arrangement. First, Newco is an SPV because all of 
Newco's income is passive investment income described in paragraph 
(e)(5)(iv)(C)(5) of this section; Newco's only asset, a note, is held 
to produce such income; the payment to Country M is attributable to 
such income; and if the payment were an amount of foreign income tax 
paid it would be paid in a U.S. taxable year in which Newco meets the 
requirements of paragraph (e)(5)(vii)(B)(1)(i) of this section. Second, 
if the foreign payment were treated as an amount of foreign income tax 
paid, USP would be deemed to pay the foreign payment under section 
960(a) and, therefore, would be eligible to claim a credit for such 
payment under section 901(a). Third, USP would not pay any Country M 
tax if it directly owned Newco's loan receivable. Fourth, the 
distribution from Newco to FP is exempt from tax under Country M law, 
and the exempt amount corresponds to more than 10% of the foreign base 
with respect to which USP's share (which is 100% under U.S. tax law) of 
the foreign payment was imposed. Fifth, FP is a counterparty because FP 
owns stock of Newco under Country M law and none of FP's stock is owned 
by USP or shareholders of USP that are domestic corporations, U.S. 
citizens, or resident alien individuals. Sixth, FP is the owner of 100% 
of Newco's stock for Country M tax purposes, while USP is the owner of 
100% of Newco's stock for U.S. tax purposes, and the amount of credits 
claimed by USP if the payment to Country M were an amount of foreign 
income tax paid is materially greater than it would be if Country M tax 
treatment controlled for U.S. tax purposes such that FP, rather than 
USP, owned 100% of Newco's stock. Because the payment to Country M is 
not an amount of foreign income tax paid, USP is not deemed to pay any 
Country M tax under section 960(a). USP includes $84 million in income 
under subpart F with respect to Newco and also has interest expense of 
$84 million. FSub's income and earnings and profits are reduced by $120 
million of interest expense.
    (2) Example 2: U.S. borrower transaction--(i) Facts. The facts are 
the same as those in paragraph (e)(5)(vii)(D)(1)(i) of this section 
(the facts in Example 1), except that FSub is a wholly-owned subsidiary 
of Newco. In addition, assume FSub is engaged in the active conduct of 
manufacturing and selling widgets and derives more than 50% of its 
gross income from such business.
    (ii) Result. The result is the same as in paragraph 
(e)(5)(vii)(D)(1)(ii) of this section (the result in Example 1), except 
that Newco's income is tested income rather than subpart F income, and 
if the $36 million foreign payment were an amount of foreign income tax 
paid USP would be deemed to pay a portion of the foreign payment under 
section 960(d), rather than 960(a). Although Newco wholly owns FSub, 
which is engaged in the active conduct of manufacturing and selling 
widgets and derives more than 50% of its income from such business, 
Newco's income that is attributable to Newco's equity interest in FSub 
is passive investment income because the sale-repurchase transaction 
limits FP's interest in Newco and its assets to that of a creditor, so 
that substantially all of Newco's opportunity for gain and risk of loss 
with respect to its stock in FSub is borne by USP. See paragraph 
(e)(5)(vii)(C)(5)(ii) of this section. Accordingly, Newco's stock in 
FSub is held to produce passive investment income. Thus, Newco is an 
SPV because all of Newco's income is passive investment income 
described in paragraph (e)(5)(vii)(C)(5) of this section, Newco's 
assets are held to produce such income, the payment to Country M is 
attributable to such income, and if the payment were an amount of 
foreign income tax paid it would be paid in a U.S. taxable year in 
which Newco meets the requirements of paragraph (e)(5)(vii)(B)(1)(i) of 
this section.
    (3) Example 3: U.S. borrower transaction--(i) Facts. A domestic 
corporation (USP) loans $750 million to its wholly-owned domestic 
subsidiary (Sub). USP and Sub form a Country M partnership 
(Partnership) to which each contributes $750 million. Partnership loans 
all of its $1.5 billion of capital to Issuer, a wholly-owned Country M

[[Page 351]]

affiliate of USP, in exchange for a note and coupons providing for the 
payment of interest at a fixed rate over a five-year term. Partnership 
sells all of the coupons to Coupon Purchaser, a Country N partnership 
owned by a Country M corporation (Foreign Bank) and a wholly-owned 
Country M subsidiary of Foreign Bank, for $300 million. At the time of 
the coupon sale, the fair market value of the coupons sold is $290 
million and, pursuant to section 1286(b)(3), Partnership's basis 
allocated to the coupons sold is $290 million. Several months later and 
prior to any interest payments on the note, Foreign Bank and its 
subsidiary sell all of their interests in Coupon Purchaser to an 
unrelated Country O corporation for $280 million. None of Foreign 
Bank's stock or its subsidiary's stock is owned, directly or 
indirectly, by USP or Sub or by any shareholders of USP or Sub that are 
domestic corporations, U.S. citizens, or resident alien individuals. 
Assume that both the United States and Country M respect the sale of 
the coupons for tax law purposes. In the year of the coupon sale, for 
Country M tax purposes USP's and Sub's shares of Partnership's profits 
total $300 million, a payment of $60 million to Country M is made with 
respect to those profits, and Foreign Bank and its subsidiary, as 
partners of Coupon Purchaser, are entitled to deduct the $300 million 
purchase price of the coupons from their taxable income. For U.S. tax 
purposes, USP and Sub recognize their distributive shares of the $10 
million premium income and claim a direct foreign tax credit for their 
shares of the $60 million payment to Country M. Country M imposes no 
additional tax when Foreign Bank and its subsidiary sell their 
interests in Coupon Purchaser. Country M also does not impose Country M 
tax on interest received by U.S. residents from sources in Country M.
    (ii) Result. The payment to Country M is not a compulsory payment, 
and thus is not an amount of foreign income tax paid, because the 
foreign payment is attributable to a structured passive investment 
arrangement. First, Partnership is an SPV because all of Partnership's 
income is passive investment income described in paragraph 
(e)(5)(vii)(C)(5) of this section; Partnership's only asset, Issuer's 
note, is held to produce such income; the payment to Country M is 
attributable to such income; and if the payment were an amount of 
foreign income tax paid, it would be paid in a U.S. taxable year in 
which Partnership meets the requirements of paragraph 
(e)(5)(vii)(B)(1)(i) of this section. Second, if the foreign payment 
were an amount of tax paid, USP and Sub would be eligible to claim a 
credit for such payment under section 901(a). Third, USP and Sub would 
not pay any Country M tax if they directly owned Issuer's note. Fourth, 
for Country M tax purposes, Foreign Bank and its subsidiary deduct the 
$300 million purchase price of the coupons and are exempt from Country 
M tax on the $280 million received upon the sale of Coupon Purchaser, 
and the deduction and exemption correspond to more than 10% of the $300 
million base with respect to which USP's and Sub's 100% share of the 
foreign payments was imposed. Fifth, Foreign Bank and its subsidiary 
are counterparties because they indirectly acquired assets of 
Partnership, the interest coupons on Issuer's note, and are not 
directly or indirectly owned by USP or Sub or shareholders of USP or 
Sub that are domestic corporations, U.S. citizens, or resident alien 
individuals. Sixth, the amount of taxable income of Partnership for one 
or more years is different for U.S. and Country M tax purposes, and the 
amount of income attributable to USP and Sub for U.S. tax purposes is 
materially less than the amount of income they would recognize if the 
Country M tax treatment of the coupon sale controlled for U.S. tax 
purposes. Because the payment to Country M is not an amount of foreign 
income tax paid, USP and Sub are not considered to pay tax under 
section 901. USP and Sub have income of $10 million in the year of the 
coupon sale.
    (4) Example 4: Active business; no SPV--(i) Facts. A, a domestic 
corporation, wholly owns B, a Country X corporation engaged in the 
manufacture and sale of widgets. On January 1, Year 1, C, also a 
Country X corporation, loans $400 million to B in exchange for an 
instrument that is debt for U.S. tax purposes and equity in B for 
Country X tax purposes. As a result, C is considered to own stock of B 
for Country X tax purposes. B loans $55 million to D, a Country Y 
corporation wholly owned by A. In year 1, B has $166 million of net 
income attributable to its sales of widgets and $3.3 million of 
interest income attributable to the loan to D. Substantially all of B's 
assets are used in its widget business. Country Y does not impose tax 
on interest paid to nonresidents. B makes a payment of $50.8 million to 
Country X with respect to B's net income. Country X does not impose tax 
on dividend payments between Country X corporations. None of C's stock 
is owned, directly or indirectly, by A or by any shareholders of A that 
are domestic corporations, U.S. citizens, or resident alien 
individuals.
    (ii) Result. B is not an SPV within the meaning of paragraph 
(e)(5)(vii)(B)(1) of this section because the amount of interest income 
received from D does not constitute substantially all of B's income and 
the $55 million note from D does not constitute substantially all of 
B's assets. Accordingly, the $50.8 million payment to Country X is not 
attributable to a structured passive investment arrangement.
    (5) Example 5: U.S. lender transaction--(i) Facts. A Country X 
corporation (Foreign Bank) contributes $2 billion to a newly-formed 
Country X company (Newco) in exchange for 90% of the common stock of 
Newco and securities that are treated as debt of Newco for U.S. tax 
purposes and preferred stock of Newco for Country X tax purposes. A 
domestic corporation (USP) contributes $1 billion to Newco in exchange 
for 10% of Newco's common stock and securities that are treated as 
preferred stock of Newco for U.S. tax purposes and debt of Newco for 
Country X tax purposes. Newco loans the $3 billion to a wholly-owned, 
Country X subsidiary of Foreign Bank (FSub) in return for a $3 billion, 
seven-year note paying interest currently. The Newco securities held by 
USP represent more than 50% of the voting power in Newco and more than 
50% of the value of the securities in Newco that are treated as equity 
for U.S. tax purposes. The Newco securities held by USP entitle the 
holder to fixed distributions of $4 million per year, and the Newco 
securities held by Foreign Bank entitle the holder to receive $82 
million per year, payable only on maturity of the $3 billion FSub note 
in Year 7. At the end of Year 5, pursuant to a prearranged plan, 
Foreign Bank acquires USP's Newco stock and securities for a 
prearranged price of $1 billion. Country X does not impose tax on 
dividends received by one Country X corporation from a second Country X 
corporation. Under an income tax treaty between Country X and the 
United States, Country X does not impose Country X tax on interest 
received by U.S. residents from sources in Country X. None of Foreign 
Bank's stock is owned, directly or indirectly, by USP or any 
shareholders of USP that are domestic corporations, U.S. citizens, or 
resident alien individuals. In each of Years 1 through 7, FSub pays 
Newco $124 million of interest on the $3 billion note. Newco 
distributes $4 million to USP in each of Years 1 through 5. The 
distributions are deductible for Country X tax purposes, and Newco pays 
Country X $36 million with respect to $120 million of taxable income 
from the

[[Page 352]]

FSub note in each year. For U.S. tax purposes, in each year Newco's 
subpart F income and earnings and profits are increased by $124 million 
of interest income and reduced by accrued interest expense with respect 
to the Newco securities held by Foreign Bank.
    (ii) Result. The $36 million payment to Country X is not a 
compulsory payment, and thus is not an amount of foreign income tax 
paid, because the foreign payment is attributable to a structured 
passive investment arrangement. First, Newco is an SPV because all of 
Newco's income is passive investment income described in paragraph 
(e)(5)(vii)(C)(5) of this section; Newco's only asset, a note of FSub, 
is held to produce such income; the payment to Country X is 
attributable to such income; and if the payment were an amount of 
foreign income tax paid it would be paid in a U.S. taxable year in 
which Newco meets the requirements of paragraph (e)(5)(vii)(B)(1)(i) of 
this section. Second, if the foreign payment were an amount of foreign 
income tax paid, USP would be deemed to pay its pro rata share of the 
foreign payment under section 960(a) in each of Years 1 through 5 and, 
therefore, would be eligible to claim a credit under section 901(a). 
Third, USP would not pay any Country X tax if it directly owned its 
proportionate share of Newco's assets, a note of FSub. Fourth, for 
Country X tax purposes, Foreign Bank is eligible to receive a tax-free 
distribution of $82 million attributable to each of Years 1 through 5, 
and that amount corresponds to more than 10% of the foreign base with 
respect to which USP's share of the foreign payment was imposed. Fifth, 
Foreign Bank is a counterparty because it owns stock of Newco for 
Country X tax purposes and none of Foreign Bank's stock is owned, 
directly or indirectly, by USP or shareholders of USP that are domestic 
corporations, U.S. citizens, or resident alien individuals. Sixth, the 
United States and Country X treat various aspects of the arrangement 
differently, including whether the Newco securities held by Foreign 
Bank and USP are debt or equity. The amount of credits claimed by USP 
if the payment to Country X were an amount of foreign income tax paid 
is materially greater than it would be if the Country X tax treatment 
controlled for U.S. tax purposes such that the securities held by USP 
were treated as debt or the securities held by Foreign Bank were 
treated as equity, and the amount of income recognized by Newco for 
U.S. tax purposes is materially less than the amount of income 
recognized for Country X tax purposes. Because the payment to Country X 
is not an amount of foreign income tax paid, USP is not deemed to pay 
any Country X tax under section 960(a). USP has a subpart F inclusion 
of $4 million in each of Years 1 through 5.
    (6) Example 6: Holding company; no SPV--(i) Facts. A, a Country X 
corporation, and B, a domestic corporation, each contribute $1 billion 
to a newly-formed Country X entity (C) in exchange for 50% of the 
common stock of C. C is treated as a corporation for Country X purposes 
and a partnership for U.S. tax purposes. C contributes $1.95 billion to 
a newly-formed Country X corporation (D) in exchange for 100% of D's 
common stock. C loans its remaining $50 million to D. Accordingly, C's 
sole assets are stock and debt of D. D uses the entire $2 billion to 
engage in the business of manufacturing and selling widgets. In Year 1, 
D derives $300 million of income from its widget business and derives 
$2 million of interest income. Also in Year 1, C has dividend income of 
$200 million and interest income of $3.2 million with respect to its 
investment in D. Country X does not impose tax on dividends received by 
one Country X corporation from a second Country X corporation. C makes 
a payment of $960,000 to Country X with respect to C's net income.
    (ii) Result. C qualifies for the holding company exception 
described in paragraph (e)(5)(vii)(C)(5)(ii) of this section because C 
holds a qualified equity interest in D, D is engaged in an active trade 
or business and derives more than 50% of its gross income from such 
trade or business, C's interest in D constitutes substantially all of 
C's assets, and A and B share in substantially all of C's opportunity 
for gain and risk of loss with respect to D. As a result, C's dividend 
income from D is not passive investment income and C's stock in D is 
not held to produce such income. Accordingly, C is not an SPV within 
the meaning of paragraph (e)(5)(vii)(B)(1) of this section, and the 
$960,000 payment to Country X is not attributable to a structured 
passive investment arrangement.
    (7) Example 7: Holding company; no SPV--(i) Facts. The facts are 
the same as those in paragraph (e)(5)(vii)(D)(6)(i) of this section 
(the facts in Example 6), except that instead of loaning $50 million to 
D, C contributes the $50 million to E in exchange for 10% of the stock 
of E. E is a Country Y corporation that is not engaged in the active 
conduct of a trade or business. Also in Year 1, D pays no dividends to 
C, E pays $3.2 million in dividends to C, and C makes a payment of 
$960,000 to Country X with respect to C's net income.
    (ii) Result. C qualifies for the holding company exception 
described in paragraph (e)(5)(vii)(C)(5)(ii) of this section because C 
holds a qualified equity interest in D, D is engaged in an active trade 
or business and derives more than 50% of its gross income from such 
trade or business, C's interest in D constitutes substantially all of 
C's assets, and A and B share in substantially all of C's opportunity 
for gain and risk of loss with respect to D. As a result, less than 
substantially all of C's assets are held to produce passive investment 
income. Accordingly, C is not an SPV because it does not meet the 
requirements of paragraph (e)(5)(vii)(B)(1) of this section, and the 
$960,000 payment to Country X is not attributable to a structured 
passive investment arrangement.
    (8) Example 8: Holding company; no SPV--(i) Facts. The facts are 
the same as those in paragraph (e)(5)(vii)(D)(6)(i) of this section 
(the facts in Example 6), except that B's $1 billion investment in C 
consists of 30% of C's common stock and 100% of C's preferred stock. 
A's $1 billion investment in C consists of 70% of C's common stock. B 
sells its preferred stock to F, a Country X corporation, subject to a 
repurchase obligation. Assume that under Country X tax law, but not 
U.S. tax law, F is treated as the owner of the preferred shares and 
receives a distribution in Year 1 of $50 million. The remaining 
earnings are distributed 70% to A and 30% to B.
    (ii) Result. C qualifies for the holding company exception 
described in paragraph (e)(5)(vii)(C)(5)(ii) of this section because C 
holds a qualified equity interest in D, D is engaged in an active trade 
or business and derives more than 50% of its gross income from such 
trade or business, and C's interest in D constitutes substantially all 
of C's assets. Additionally, although F does not share in C's 
opportunity for gain and risk of loss with respect to C's interest in D 
because F acquired its interest in C in a sale-repurchase transaction, 
B (the U.S. party) and in the aggregate A and F (who would be 
counterparties assuming C were an SPV) share in substantially all of 
C's opportunity for gain and risk of loss with respect to D and such 
opportunity for gain and risk of loss is not borne exclusively either 
by B or by A and F in the aggregate. Accordingly, C's shares in D are 
not held to produce passive investment income and the $200 million 
dividend from D is not passive investment income. C is not an SPV 
within the meaning of paragraph (e)(5)(vii)(B)(1) of

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this section, and the $960,000 payment to Country X is not attributable 
to a structured passive investment arrangement.
    (9) Example 9: Asset holding transaction--(i) Facts. A domestic 
corporation (USP) contributes $6 billion of Country Z debt obligations 
to a Country Z entity (DE) in exchange for all of the class A and class 
B stock of DE. DE is a disregarded entity for U.S. tax purposes and a 
corporation for Country Z tax purposes. A corporation unrelated to USP 
and organized in Country Z (FC) contributes $1.5 billion to DE in 
exchange for all of the class C stock of DE. DE uses the $1.5 billion 
contributed by FC to redeem USP's class B stock. The terms of the class 
C stock entitle its holder to all income from DE, but FC is obligated 
immediately to contribute back to DE all distributions on the class C 
stock. USP and FC enter into a contract under which USP agrees to buy 
after five years the class C stock for $1.5 billion and an agreement 
under which USP agrees to pay FC periodic payments on $1.5 billion. The 
transaction is structured in such a way that, for U.S. tax purposes, 
there is a loan of $1.5 billion from FC to USP, and USP is the owner of 
the class C stock and the class A stock. In Year 1, DE earns $400 
million of interest income on the Country Z debt obligations. DE makes 
a payment to Country Z of $100 million with respect to such income and 
distributes the remaining $300 million to FC. FC contributes the $300 
million back to DE. None of FC's stock is owned, directly or 
indirectly, by USP or shareholders of USP that are domestic 
corporations, U.S. citizens, or resident alien individuals. Assume that 
Country Z imposes a withholding tax on interest income derived by U.S. 
residents. Country Z treats FC as the owner of the class C stock. 
Pursuant to Country Z tax law, FC is required to report the $400 
million of income with respect to the $300 million distribution from 
DE, but is allowed to claim credits for DE's $100 million payment to 
Country Z. For Country Z tax purposes, FC is entitled to current 
deductions equal to the $300 million contributed back to DE.
    (ii) Result. The payment to Country Z is not a compulsory payment, 
and thus is not an amount of foreign income tax paid, because the 
payment is attributable to a structured passive investment arrangement. 
First, DE is an SPV because all of DE's income is passive investment 
income described in paragraph (e)(5)(vii)(C)(5) of this section; all of 
DE's assets are held to produce such income; the payment to Country Z 
is attributable to such income; and if the payment were an amount of 
tax paid it would be paid in a U.S. taxable year in which DE meets the 
requirements of paragraph (e)(5)(vii)(B)(1)(i) of this section. Second, 
if the payment were an amount of foreign income tax paid, USP would be 
eligible to claim a credit for such amount under section 901(a). Third, 
USP's proportionate share of DE's foreign payment of $100 million is 
substantially greater than the amount of credits USP would be eligible 
to claim if it directly held its proportionate share of DE's assets, 
excluding any assets that would produce income subject to gross basis 
withholding tax if directly held by USP. Fourth, FC is entitled to 
claim a credit under Country Z tax law for the payment and recognizes a 
deduction for the $300 million contributed to DE under Country Z law. 
The credit claimed by FC corresponds to more than 10% of USP's share 
(for U.S. tax purposes) of the foreign payment and the deductions 
claimed by FC correspond to more than 10% of the base with respect to 
which USP's share of the foreign payment was imposed. Fifth, FC is a 
counterparty because FC is considered to own equity of DE under Country 
Z law and none of FC's stock is owned, directly or indirectly, by USP 
or shareholders of USP that are domestic corporations, U.S. citizens, 
or resident alien individuals. Sixth, the United States and Country Z 
treat certain aspects of the transaction differently, including the 
proportion of equity owned in DE by USP and FC, and the amount of 
credits claimed by USP if the Country Z payment were an amount of tax 
paid is materially greater than it would be if the Country Z tax 
treatment controlled for U.S. tax purposes such that FC, rather than 
USP, owned the class C stock. Because the payment to Country Z is not 
an amount of foreign income tax paid, USP is not considered to pay tax 
under section 901. USP has $400 million of interest income.
    (10) Example 10: Loss surrender--(i) Facts. The facts are the same 
as those in paragraph (e)(5)(vii)(D)(9)(i) of this section (the facts 
in Example 9), except that the deductions attributable to the 
arrangement contribute to a loss recognized by FC for Country Z tax 
purposes, and pursuant to a group relief regime in Country Z FC elects 
to surrender the loss to its Country Z subsidiary.
    (ii) Result. The results are the same as in paragraph 
(e)(5)(vii)(D)(9)(ii) of this section (the results in Example 9). The 
surrender of the loss to a related party is a foreign tax benefit that 
corresponds to the base with respect to which USP's share of the 
foreign payment was imposed.
    (11) Example 11: Joint venture; no foreign tax benefit--(i) Facts. 
FC, a Country X corporation, and USC, a domestic corporation, each 
contribute $1 billion to a newly-formed Country X entity (C) in 
exchange for stock of C. FC and USC are entitled to equal 50% shares of 
all of C's income, gain, expense and loss. C is treated as a 
corporation for Country X purposes and a partnership for U.S. tax 
purposes. In Year 1, C earns $200 million of net passive investment 
income, makes a payment to Country X of $60 million with respect to 
that income, and distributes $70 million to each of FC and USC. Country 
X does not impose tax on dividends received by one Country X 
corporation from a second Country X corporation.
    (ii) Result. FC's tax-exempt receipt of $70 million, or its 50% 
share of C's profits, is not a foreign tax benefit within the meaning 
of paragraph (e)(5)(vii)(B)(4) of this section because it does not 
correspond to any part of the foreign base with respect to which USC's 
share of the foreign payment was imposed. Accordingly, the $60 million 
payment to Country X is not attributable to a structured passive 
investment arrangement.
    (12) Example 12: Joint venture; no foreign tax benefit--(i) Facts. 
The facts are the same as those in paragraph (e)(5)(vii)(D)(11)(i) of 
this section (the facts in Example 11), except that C in turn 
contributes $2 billion to a wholly-owned and newly-formed Country X 
entity (D) in exchange for stock of D. D is treated as a corporation 
for Country X purposes and disregarded as an entity separate from its 
owner for U.S. tax purposes. C has no other assets and earns no other 
income. In Year 1, D earns $200 million of passive investment income, 
makes a payment to Country X of $60 million with respect to that 
income, and distributes $140 million to C.
    (ii) Result. C's tax-exempt receipt of $140 million is not a 
foreign tax benefit within the meaning of paragraph (e)(5)(vii)(B)(4) 
of this section because it does not correspond to any part of the 
foreign base with respect to which USC's share of the foreign payment 
was imposed. Fifty percent of C's foreign tax exemption is not a 
foreign tax benefit within the meaning of paragraph (e)(5)(vii)(B)(4) 
of this section because it relates to earnings of D that are 
distributed with respect to an equity interest in D that is owned 
indirectly by USC under both U.S. and foreign tax law. The remaining 
50% of C's foreign tax exemption, as well as FC's tax-

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exempt receipt of $70 million from C, is also not a foreign tax benefit 
because it does not correspond to any part of the foreign base with 
respect to which USC's share of the foreign payment was imposed. 
Accordingly, the $60 million payment to Country X is not attributable 
to a structured passive investment arrangement.
    (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 but for the 
availability of such a credit.
    (ii) Examples. The following examples illustrate the application of 
paragraph (e)(6)(i) of this section.
    (A) Example 1: Tax rates dependent on availability of credit--(1) 
Facts. Country X imposes a tax on the receipt of royalties from sources 
in Country X by nonresidents of Country X. The tax is 15% of the gross 
amount of such royalties unless the recipient is a resident of the 
United States or of country A, B, C, or D, in which case the tax is 20% 
of the gross amount of such royalties. Like the United States, each of 
countries A, B, C, and D allows its residents a credit against the 
income tax otherwise payable to it for income taxes paid to other 
countries.
    (2) Analysis. Because the 20% rate applies only to residents of 
countries that allow a credit for taxes paid to other countries and the 
15% rate applies to residents of countries that do not allow such a 
credit, one-fourth of the Country X tax would not be imposed on 
residents of the United States but for the availability of such a 
credit. One-fourth of the Country X tax imposed on residents of the 
United States who receive royalties from sources in Country X is 
dependent on the availability of a credit for the Country X tax against 
income tax liability to another country and, accordingly, under 
paragraph (e)(6)(i) of this section that amount is not an amount of 
foreign income tax paid.
    (B) Example 2: Tax not dependent on availability of credit--(1) 
Facts. Country X imposes a net income tax on the realized net income of 
nonresidents of Country X from carrying on a trade or business in 
Country X. Although Country X tax law does not prohibit other 
nonresidents from carrying on business in Country X, United States 
persons are the only nonresidents of Country X that carry on business 
in Country X. The Country X tax would be imposed in its entirety on a 
nonresident of Country X irrespective of the availability of a credit 
for the Country X tax against income tax liability to another country.
    (2) Analysis. Because no portion of the Country X tax liability is 
dependent on the availability of a credit for such tax in another 
country, under paragraph (e)(6)(i) of this section no portion of the 
Country X tax is a soak-up tax.
    (C) Example 3: Tax holiday denied to corporations with shareholders 
eligible for credit--(1) Facts. Country X imposes a net income tax on 
the realized net income of all corporations incorporated in Country X. 
Country X allows a tax holiday to qualifying corporations incorporated 
in Country X that are owned by nonresidents of Country X, pursuant to 
which no Country X tax is imposed on the net income of a qualifying 
corporation for the first 10 years of its operations in Country X. A 
corporation qualifies for the tax holiday if it meets certain minimum 
investment criteria and if the development office of Country X 
certifies that in its opinion the operations of the corporation will be 
consistent with specified development goals of Country X. The 
development office will not issue this certification to any corporation 
owned by persons resident in countries that allow a credit to 
shareholders (such as a deemed paid credit under section 960) for 
Country X tax paid by a corporation incorporated in Country X. In 
practice, tax holidays are granted to a large number of corporations, 
but the Country X net income tax is imposed on a significant number of 
other corporations incorporated in Country X (for example, those owned 
by Country X persons and those which have had operations for more than 
10 years) in addition to corporations denied a tax holiday because 
their shareholders qualify for a credit for the Country X tax against 
income tax liability to another country.
    (2) Analysis. Under paragraph (e)(6)(i) of this section, no portion 
of the Country X tax paid by Country X corporations denied a tax 
holiday because they have U.S. shareholders is dependent on the 
availability of a credit for the Country X tax against income tax 
liability to another country, because a significant number of other 
Country X corporations pay the Country X tax irrespective of the 
availability of a credit to their shareholders.
    (D) Example 4: Tax deferral allowed for corporations with 
shareholders eligible for credit--(1) Facts. The facts are the same as 
those in paragraph (e)(6)(ii)(C)(1) of this section (the facts of 
Example 3), except that Country X corporations owned by persons 
resident in countries that allow a credit for Country X tax when 
dividends are distributed by the corporations are granted a provisional 
tax holiday. Under the provisional tax holiday, instead of relieving 
such a corporation from Country X tax for 10 years, liability for such 
tax is deferred until the Country X corporation distributes dividends.
    (2) Analysis. Because a significant number of other Country X 
corporations pay the Country X tax irrespective of the availability of 
a credit to their shareholders, the result is the same as in paragraph 
(e)(6)(ii)(C)(2) of this section.
    (E) Example 5: Tax based on greater of tax in lieu of income tax or 
amount eligible for credit--(1) Facts. Pursuant to a contract with 
Country X, A, a domestic corporation engaged in manufacturing 
activities in Country X, must pay tax to Country X equal to the greater 
of 5u (units of Country X currency) per item produced, or the maximum 
amount creditable by A against its U.S. income tax liability for that 
year with respect to income from its Country X operations. Also 
pursuant to the contract, A is exempted from Country X's otherwise 
generally-imposed net income tax. The contractual tax is a tax in lieu 
of income tax as defined in Sec.  1.903-1(b). In Year 1, A produces 16 
items, which would result in Country X tax of 16 x 5u = 80u, and taking 
into account the section 904 limitation, the maximum amount of Country 
X tax that A can claim as a credit against its U.S. income tax 
liability is 125u. Accordingly, A's contractual liability for Country X 
tax in lieu of income tax is 125u, the greater of the two amounts.
    (2) Analysis. Under paragraph (e)(6)(i) of this section, the amount 
of tax paid by A that is dependent on the availability of a credit 
against income tax of another country is 125u-80u = 45u, the amount 
that would not be imposed but for the availability of a credit.
    (f) * * *
    (2) * * *
    (ii) Examples. The following examples illustrate the rules of 
paragraphs (f)(1) and (2)(i) of this section.
    (A) Example 1. Under a loan agreement between A, a resident of 
Country X, and B, a United States person, A agrees to pay B a certain 
amount of interest net of any tax that Country X may impose on B with 
respect to its interest income. Country X

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imposes a 10 percent tax on the gross amount of interest income 
received by nonresidents of Country X from sources in Country X, and it 
is established that this tax is a tax in lieu of an income tax within 
the meaning of Sec.  1.903-1(b). Under the law of Country X this tax is 
imposed on the nonresident recipient, and any resident of Country X 
that pays such interest to a nonresident is required to withhold and 
pay over to Country X 10 percent of the amount of such interest, which 
is applied to offset the recipient's liability for the tax. Because 
legal liability for the tax is imposed on the recipient of such 
interest income, B is the taxpayer with respect to the Country X tax 
imposed on B's interest income from B's loan to A. Accordingly, B's 
interest income for Federal income tax purposes includes the amount of 
Country X tax that is imposed on B with respect to such interest income 
and that is paid on B's behalf by A pursuant to the loan agreement, 
and, under paragraph (f)(2)(i) of this section, such tax is considered 
for purposes of section 903 to be paid by B.
    (B) Example 2. The facts are the same as those in paragraph 
(f)(2)(ii)(A) of this section (the facts in Example 1), except that in 
collecting and receiving the interest B is acting as a nominee for, or 
agent of, C, who is a United States person. Because C (not B) is the 
beneficial owner of the interest, legal liability for the tax is 
imposed on C, not B (C's nominee or agent). Thus, C is the taxpayer 
with respect to the Country X tax imposed on C's interest income from 
C's loan to A. Accordingly, C's interest income for Federal income tax 
purposes includes the amount of Country X tax that is imposed on C with 
respect to such interest income and that is paid on C's behalf by A 
pursuant to the loan agreement. Under paragraph (f)(2)(i) of this 
section, such tax is considered for purposes of section 903 to be paid 
by C. No such tax is considered paid by B.
    (C) Example 3. Country X imposes a tax called the ``Country X 
income tax.'' A, a United States person engaged in construction 
activities in Country X, is subject to that tax. Country X has 
contracted with A for A to construct a naval base. A is a dual capacity 
taxpayer (as defined in paragraph (a)(2)(ii)(A) of this section) and, 
in accordance with paragraphs (a)(1) and (c)(1) of Sec.  1.901-2A, A 
has established that the Country X income tax as applied to dual 
capacity persons and the Country X income tax as applied to persons 
other than dual capacity persons together constitute a single levy. A 
has also established that that levy is a net income tax within the 
meaning of paragraph (a)(3) of this section. Pursuant to the terms of 
the contract, Country X has agreed to assume any Country X tax 
liability that A may incur with respect to A's income from the 
contract. For Federal income tax purposes, A's income from the contract 
includes the amount of tax liability that is imposed by Country X on A 
with respect to its income from the contract and that is assumed by 
Country X; and for purposes of section 901 the amount of such tax 
liability assumed by Country X is considered to be paid by A. By reason 
of paragraph (f)(2)(i) of this section, Country X is not considered to 
provide a subsidy, within the meaning of paragraph (e)(3) of this 
section, to A.
* * * * *
    (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 or 
classification 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 by a person 
under paragraphs (f)(1) through (4) of this section with respect to the 
continuing foreign taxable year in which such covered event or events 
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 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 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 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

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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).
    (7) Examples. The following examples illustrate the rules of 
paragraphs (f)(3) through (6) of this section.
    (i) Example 1--(A) Facts. A, a United States person, owns 100 
percent of B, an entity organized in Country X. B owns 100 percent of 
C, also an entity organized in Country X. B and C are corporations for 
U.S. and foreign tax purposes that use the ``u'' as their functional 
currency. Pursuant to a consolidation regime, Country X imposes a net 
income tax described in paragraph (a)(3) of this section on the 
combined income of B and C within the meaning of paragraph (f)(3)(ii) 
of this section. In year 1, C pays 25u of interest to B. If B and C did 
not report their income on a combined basis for Country X tax purposes, 
the interest paid from C to B would result in 25u of interest income to 
B and 25u of deductible interest expense to C. For purposes of 
reporting the combined income of B and C, Country X first requires B 
and C to determine their own income (or loss) on a separate schedule. 
For this purpose, however, neither B nor C takes into account the 25u 
of interest paid from C to B because the income of B and C is included 
in the same combined base. The separate income of B and C reported on 
their Country X schedules for year 1, which do not reflect the 25u 
intercompany payment, is 100u and 200u, respectively. The combined 
income reported for Country X purposes is 300u (the sum of the 100u 
separate income of B and 200u separate income of C).
    (B) Result. On the separate schedules described in paragraph 
(f)(3)(iii)(A) of this section, B's separate income is 100u and C's 
separate income is 200u. Under paragraph (f)(3)(iii)(B)(1) of this 
section, the 25u interest payment from C to B is taken into account for 
purposes of determining B's and C's portions of the combined income 
under paragraph (f)(3)(iii) of this section, because B and C would have 
taken the items into account if they did not compute their income on a 
combined basis. Thus, B's portion of the combined income is 125u (100u 
plus 25u) and C's portion of the combined income is 175u (200u less 
25u). The result is the same regardless of whether the 25u interest 
payment from C to B is deductible for U.S. Federal income tax purposes. 
See paragraph (f)(3)(iii)(B)(2) of this section.
    (ii) Example 2--(A) Facts. A, a United States person, owns 100 
percent of B, an entity organized in Country X. B is a corporation for 
Country X tax purposes, and a disregarded entity for U.S. income tax 
purposes. B owns 100 percent of C and D, entities organized in country 
X that are corporations for both U.S. and Country X tax purposes. B, C, 
and D use the ``u'' as their functional currency and file on a combined 
basis for Country X income tax purposes. Country X imposes a net income 
tax described in paragraph (a)(3) of this section at the rate of 30 
percent on the taxable income of corporations organized in Country X. 
Under the Country X combined reporting regime, income (or loss) of C 
and D is attributed to, and treated as income (or loss) of, B. B has 
the sole obligation to pay Country X income tax imposed with respect to 
income of B and income of C and D that is attributed to, and treated as 
income of, B. Under Country X tax law, Country X may proceed against B, 
but not C or D, if B fails to pay over to Country X all or any portion 
of the Country X income tax imposed with respect to such income. In 
year 1, B has income of 100u, C has income of 200u, and D has a net 
loss of (60u). Under Country X tax law, B is considered to have 240u of 
taxable income with respect to which 72u of Country X income tax is 
imposed. Country X does not provide mandatory rules for allocating D's 
loss.
    (B) Result. Under paragraph (f)(3)(ii) of this section, the 72u of 
Country X tax is considered to be imposed on the combined income of B, 
C, and D. Because Country X tax law does not provide mandatory rules 
for allocating D's loss between B and C, under paragraph (f)(3)(iii)(C) 
of this section D's (60u) loss is allocated pro rata: 20u to B ((100u/
300u) x 60u) and 40u to C ((200u/300u) x 60u). Under paragraph 
(f)(3)(i) of this section, the 72u of Country X tax must be allocated 
pro rata among B, C, and D. Because D has no income for Country X tax 
purposes, no Country X tax is allocated to D. Accordingly, 24u (72u x 
(80u/240u)) of the Country X tax is allocated to B, and 48u (72u x 
(160u/240u)) of such tax is allocated to C. Under paragraph (f)(4)(ii) 
of this section, A is considered to have legal liability for the 24u of 
Country X tax allocated to B under paragraph (f)(3) of this section.
    (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 means 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, including a separate levy that 
is modified by an applicable income tax treaty. 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 an applicable income tax treaty.
    (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 the taxpayer's method of accounting for foreign income 
taxes. In the case of a taxpayer that claims a foreign tax credit, the 
taxpayer's method of accounting for foreign income taxes refers to 
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. The term paid does not include foreign taxes 
deemed paid under section 904(c) or section 960.
    (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.
    (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

[[Page 357]]

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.
    (ii) Nonresident. A nonresident with respect to a foreign country 
is any individual or entity that is not a resident of such foreign 
country.
    (7) Taxpayer. The term taxpayer has the meaning set forth in 
paragraph (f)(1) of this section.
    (h) Applicability dates. Except as otherwise provided in this 
paragraph (h), this section applies to foreign taxes paid (within the 
meaning of paragraph (g) of this section) in taxable years beginning on 
or after December 28, 2021. For foreign taxes paid to Puerto Rico by 
reason of section 1035.05 of the Puerto Rico Internal Revenue Code of 
2011, as amended (13 L.P.R.A. Sec.  30155) (treating certain income, 
gain or loss as effectively connected with the active conduct of a 
trade or business with Puerto Rico), this section applies to foreign 
taxes paid (within the meaning of paragraph (g) of this section) in 
taxable years beginning on or after January 1, 2023. For foreign taxes 
described in the preceding sentence that are paid in taxable years 
beginning before January 1, 2023, see Sec.  1.901-2 as contained in 26 
CFR part 1 revised as of April 1, 2021.

0
Par. 25. 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 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 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. Thus, a close 
connection exists if the generally-imposed net income tax would apply 
by its terms to the excluded income, but for the fact that the excluded 
income is expressly excluded, and the tested foreign tax is enacted 
contemporaneously with the generally-imposed net income tax. A close 
connection also exists if the generally-imposed net income tax by its 
terms does not apply to, but does not expressly exclude, the excluded 
income, and the tested foreign tax is enacted contemporaneously with 
the generally-imposed net income tax. Where the tested foreign tax is 
not enacted contemporaneously with the generally-imposed net income tax 
and the generally-imposed net income tax is not amended 
contemporaneously with the enactment of the tested foreign tax to 
exclude the excluded income or to narrow the scope of the generally-
imposed net income tax so as not to apply to the excluded income, a 
close connection can be established only by reference to the 
legislative history of the tested foreign tax (or a predecessor in lieu 
of tax). Not all income derived by persons subject to the tested 
foreign tax need be excluded income, provided 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, or a hypothetical new tax that is a separate levy with 
respect to the generally-imposed net income tax, were applied to the 
excluded income, such generally-imposed net income tax or separate levy 
would meet the

[[Page 358]]

attribution requirement described in Sec.  1.901-2(b)(5).
    (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 or with respect 
to each subset of a class of income that is subject to different income 
attribution rules.
    (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 attribution requirement. The income subject to 
the tested foreign tax satisfies the attribution requirement described 
in Sec.  1.901-2(b)(5)(i)(B).
    (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 ``resident 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 permanent 
establishment within Country X (the ``nonresident income tax''). Under 
Country X tax law, a permanent establishment is defined in the same 
manner as under the 2016 U.S. Model Income Tax Convention. Both the 
resident income tax and the nonresident income tax, which are separate 
levies under Sec.  1.901-2(d)(1)(iii), qualify as generally-imposed net 
income taxes. Under Country X tax law, the ESS tax applies to both 
resident and nonresident companies regardless of whether the company is 
also subject to the resident income tax or the nonresident income 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 to which the 
gross receipts subject to the ESS tax relate is also subject to one of 
the two generally-imposed net income taxes imposed by Country X. 
Similarly, under paragraph (c)(2)(ii) of this section, the nonresident 
ESS tax is not a covered withholding tax because by its terms it is 
imposed in addition to the nonresident income tax. The fact that 
nonresident taxpayers that do not have a permanent establishment in 
Country X are in practice subject to the nonresident ESS tax but not to 
the nonresident income tax on the gross receipts included in the base 
of the nonresident ESS tax is not relevant to the determination of 
whether the ESS tax meets the substitution requirement under paragraph 
(c)(1) of this section. 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; attribution of 
income--(i) Facts. The facts are the same as those 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. If the nonresident company has a Country X permanent establishment, 
the nonresident income tax applies to the profits attributable to that 
permanent establishment. In addition, the statutory language 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 nonresident income 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 two generally-imposed 
net income taxes and neither generally-imposed net income tax nor any 
other separate levy that is a net income tax is imposed by Country X on 
a nonresident's income to which gross receipts that form the base of 
the nonresident ESS tax relate (which is the excluded income). The 
statutory language and legislative history to the nonresident ESS tax 
demonstrate that Country X made a cognizant and deliberate choice not 
to impose the nonresident income tax on the excluded income. 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 nonresident income tax would otherwise have been imposed on 
the excluded income. However, the nonresident ESS tax does not meet the 
requirement in paragraph (c)(1)(iv) of this section, because if Country 
X had chosen to apply the nonresident income tax (rather than the 
nonresident ESS tax) to the excluded income, the modified nonresident 
income tax would fail the attribution requirement in Sec.  1.901-
2(b)(5). First, the modified tax would not satisfy the requirement in 
Sec.  1.901-2(b)(5)(i)(A) 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 the requirement in Sec.  1.901-
2(b)(5)(i)(B) because the excluded income is from services performed 
outside of Country X. Third, the modified tax would not satisfy the 
requirement in Sec.  1.901-2(b)(5)(i)(C) because the excluded income is 
not from sales or dispositions of real property located in Country X or 
from property forming part of the business property of a taxable 
presence in Country X. Because the Country X nonresident income tax as 
applied to the excluded income would fail to meet the attribution 
requirement in Sec.  1.901-2(b)(5), as required by paragraph (c)(1)(iv) 
of this section, 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. It also meets the 
requirements in paragraphs (c)(2)(i)

[[Page 359]]

and (ii) of this section because it is a withholding tax on gross 
receipts of nonresidents and the income attributable to those gross 
receipts is not subject to a net income 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(b)(5)(i)(B). 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 satisfy the substitution 
requirement of paragraph (c) of this section, it is not a tax in lieu 
of an income tax.
    (3) Example 3: Withholding tax on royalties; attribution 
requirement--(i) Facts. YCo, a resident of Country Y, is a controlled 
foreign corporation wholly-owned by USP, a domestic corporation. In 
Year 1, YCo grants a license to XCo, a resident of Country X unrelated 
to YCo or USP, for the right to use YCo's intangible property (IP) 
throughout the world, including in Country X. Under Country X's 
domestic tax law, all royalties paid by a resident of Country X to a 
nonresident are sourced in Country X and are subject to a 30% 
withholding tax on the gross income, regardless of whether the 
nonresident payee has a taxable presence in Country X. Country X's 
withholding tax on royalties is a separate levy under Sec.  1.901-
2(d)(1)(iii). In Year 1, XCo withholds 30u (units of Country X 
currency) tax from 100u of royalties owed and paid to YCo under the 
licensing arrangement, of which 50u is attributable to XCo's use of the 
YCo IP in Country X and 50u is attributable to use of the YCo IP 
outside Country X. The United States and Country X have an income tax 
treaty (U.S.-Country X treaty); under the royalties article of the 
treaty, Country X agreed to impose its withholding tax on royalties 
paid to a U.S. resident only on royalties paid for IP used in Country 
X. Country X and Country Y do not have an income tax treaty.
    (ii) Analysis. Under Sec.  1.901-2(d)(1)(iv), the Country X 
withholding tax on royalties, as modified by the U.S.-Country X treaty, 
is a separate levy from the unmodified Country X withholding tax to 
which YCo was subject (because YCo is not a U.S. resident eligible for 
benefits under the U.S.-Country X treaty). The Country X withholding 
tax on royalties, unmodified by the U.S.-Country X treaty, does not 
meet the attribution requirement in Sec.  1.901-2(b)(5)(i)(B) because 
Country X's source rule for royalties (based upon residence of the 
payor) is not reasonably similar to the sourcing rules that apply under 
the Internal Revenue Code. Thus, under paragraph (c)(2)(iii) of this 
section, the Country X withholding tax paid by YCo is not a covered 
withholding tax, and none of the 30u of Country X withholding tax paid 
by YCo with respect to the 100u of royalties for the use of the IP is a 
payment of foreign income tax.
    (4) Example 4: Withholding tax on royalties; attribution 
requirement--(i) Facts. The facts are the same as in paragraph 
(d)(3)(i) of this section (the facts of Example 3), except that XCo 
only uses the IP in Country X and the 100u of royalties paid to YCo in 
Year 1 is all attributable to XCo's use of the IP in Country X.
    (ii) Analysis. The result is the same as in paragraph (d)(3) of 
this section (the analysis of Example 3). Because Country X's source 
rule for royalties (based upon residence of the payor) is not 
reasonably similar to the sourcing rules that apply under the Internal 
Revenue Code, the withholding tax paid by YCo does not meet the 
attribution requirement in Sec.  1.901-2(b)(5)(i)(B). Under paragraph 
(c)(2)(iii) of this section, the Country X withholding tax paid by YCo 
is not a covered withholding tax, and none of the 30u of Country X 
withholding tax paid by YCo with respect to the 100u of royalties for 
IP used in Country X is a payment of foreign income tax.
    (5) Example 5: Multiple in-lieu-of taxes--(i) Facts. Country X 
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 ``trade or business tax''). The trade or business tax applies to 
all nonresident corporations that engage in business in Country X 
except for nonresident corporations that engage in insurance 
activities, which are instead subject to two different taxes 
(``insurance taxes''). The insurance taxes apply to nonresident 
corporations that engage in insurance activities that are attributable, 
under reasonable principles, to the nonresident's activities within 
Country X. The insurance taxes do not satisfy the cost recovery 
requirement in Sec.  1.901-2(b)(4). The trade or business tax and the 
two insurance taxes were enacted contemporaneously, and the statutory 
language of the trade or business tax expressly excludes gross income 
derived by nonresident corporations engaged in insurance activities 
from the trade or business tax.
    (ii) Analysis. The insurance taxes meet the requirements in 
paragraphs (c)(1)(i) and (ii) of this section because Country X has a 
generally-imposed net income tax, the trade or business tax, and 
neither the trade or business tax nor any other separate levy that is a 
net income tax is imposed by Country X on a nonresident's gross income 
to which the amounts that form the base of the insurance taxes (the 
``excluded income'') relate. The Country X tax law expressly provides 
that the trade or business tax does not apply to nonresident 
corporations engaged in insurance activities. In addition, the two 
insurance taxes were enacted contemporaneously with the trade or 
business tax. Therefore, it is demonstrated that Country X made a 
cognizant and deliberate choice to impose the insurance taxes in lieu 
of the generally-imposed trade or business tax, and the insurance taxes 
meet the requirement in paragraph (c)(1)(iii) of this section. If the 
trade or business tax also applied to the excluded income, the trade or 
business tax would meet the requirement in Sec.  1.901-2(b)(5)(i)(A), 
because it would apply only to income attributable, under reasonable 
principles, to the nonresident's activities within the foreign country. 
Thus, the insurance taxes meet the requirement in paragraph (c)(1)(iv) 
of this section. Therefore, the insurance taxes satisfy the 
substitution requirement in paragraph (c)(1) of this section.
    (6) Example 6: Later-enacted in-lieu-of tax; close connection 
requirement--(i) Facts. The facts are the same as those in paragraph 
(d)(5)(i) of this section (the facts in Example 5), except that one of 
the two insurance taxes applies only to nonresident corporations 
engaged in the life insurance business in Country X and was enacted 
five years after the enactment of the trade or business tax and the 
other insurance tax enacted contemporaneously with the trade or 
business tax. The legislative history to the later-enacted insurance 
tax shows that Country X intended to increase the tax imposed on 
nonresident corporations engaged in life insurance activities and, 
instead of amending the first insurance tax to increase the rate 
applicable to life insurance companies, it enacted the second insurance 
tax that only applies to life insurance corporations.
    (ii) Analysis. The later-enacted insurance 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 trade or business 
tax, and neither the trade or business tax nor any other separate levy 
that is a net income tax is imposed by Country X on the income

[[Page 360]]

attributable to the activities that form the base of the later-enacted 
insurance tax. The later-enacted insurance tax meets the requirement in 
paragraph (c)(1)(iii) of this section because the legislative history 
to the later-enacted insurance tax demonstrates that Country X made a 
cognizant and deliberate choice to impose the later-enacted insurance 
tax on life insurance companies instead of the trade or business tax. 
The later-enacted insurance tax also meets the requirement of paragraph 
(c)(1)(iv) of this section for the reasons set forth in paragraph 
(d)(5)(ii) of this section. Therefore, the later-enacted insurance tax 
satisfies the substitution requirement in paragraph (c)(1) of this 
section.
    (7) Example 7: Excise tax creditable against net income tax--(i) 
Facts. Country X imposes an excise tax that does not satisfy the cost 
recovery requirement in Sec.  1.901-2(b)(4), and a net income tax 
within the meaning of Sec.  1.901-2(a)(3). The excise tax, which is 
payable independently of the net income tax, is allowed as a credit 
against the net income tax. In Year 1, A has a tentative net income tax 
liability of 100u (units of Country X currency) but is allowed a credit 
for 30u of excise tax that it paid that year.
    (ii) Analysis. Pursuant to Sec.  1.901-2(e)(4), the amount of 
excise tax A has paid to Country X is 30u and the amount of net income 
tax A has paid to Country X is 70u. The excise tax paid by A does not 
satisfy the substitution requirement set forth in paragraph (c)(1) of 
this section because the excise tax is imposed in addition to, and not 
in substitution for, the generally-imposed net income tax.
    (e) Applicability dates. Except as otherwise provided in this 
paragraph (e), this section applies to foreign taxes paid (within the 
meaning of Sec.  1.901-2(g)(5)) in taxable years beginning on or after 
December 28, 2021. For foreign taxes paid to Puerto Rico under section 
3070.01 of the Puerto Rico Internal Revenue Code of 2011, as amended 
(13 L.P.R.A. Sec.  31771) (imposing an excise tax on a controlled group 
member's acquisition from another group member of certain personal 
property manufactured or produced in Puerto Rico and certain services 
performed in Puerto Rico), this section applies to foreign taxes paid 
(within the meaning of Sec.  1.901-2(g)(5)) in taxable years beginning 
on or after January 1, 2023. For foreign taxes described in the 
preceding sentence that are paid in taxable years beginning before 
January 1, 2023, see Sec.  1.903-1 as contained in 26 CFR part 1 
revised as of April 1, 2021.

0
Par. 26. Section 1.904-4 is amended:
0
1. By revising paragraph (b)(2)(i)(A).
0
2. By revising the last sentence of paragraph (c)(4).
0
3. 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
4. By adding paragraphs (f)(1)(iii) and (iv).
0
5. By removing and reserving paragraphs (f)(2)(ii) and (iii).
0
6. By revising paragraphs (f)(2)(vi)(A) and (f)(2)(vi)(B)(1)(ii).
0
7. By adding paragraph (f)(2)(vi)(G).
0
8. By revising paragraph (f)(3)(v).
0
9. In the second sentence of paragraph (f)(3)(vii)(B), by removing the 
language ``treated as carried out pursuant to'' and adding in its place 
the language ``carried out constitute''.
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 new paragraphs (f)(3)(x) and (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, as defined in Sec.  1.951A-2(c)(7)(iv), 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.
* * * * *
    (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 of 
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.
* * * * *

[[Page 361]]

    (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 amount of attributable 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, 
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 accounting 
for all disregarded payments made and received by each member of the 
foreign branch group.
    (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 accounting for all disregarded payments made 
and received by each member of the foreign branch owner group.
    (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

[[Page 362]]

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 $350x disregarded payment from P to FDE 
were regarded for Federal income tax purposes, the deduction for the 
payment 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). P and FDE incur no other expenses.
    (B) Analysis. The $350x 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 
those in paragraph (f)(4)(xiii)(A) of this section (the facts in 
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 from the 
$350x payment it receives from P, through FDE.
    (B) Analysis. 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, 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 consolidated group--
(A) Facts. The facts are the same as those in paragraph (f)(4)(xiv)(A) 
of this section (the facts in 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 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 deduction of $350x 
for the services payment that is a corresponding item, and USS has 
$350x of income that is an intercompany item. 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 item and P's $350x corresponding item 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 those in paragraph 
(f)(4)(xiii)(A) of this section (the facts in 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 account for 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. 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 the income that is attributed to FDE1 under

[[Page 363]]

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) 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 1.904-6 is 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 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.  1.951A-2(c)(7)(iv)(A)(3) 
(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), 1.960-1(d)(3)(ii)(A), and 1.960-
1(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 dates. 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. 28. Revise 1.905-1 to 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 respect to blocked income. Paragraph (h) 
provides the applicability dates for this section.
    (b) General rule. The credit for foreign income 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 foreign income taxes accrued or on the return for the year in which 
the foreign income taxes were paid (that is, remitted), 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 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 of accounting 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-

[[Page 364]]

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) Payment of contested foreign tax liability. Under Sec.  1.901-
2(e)(2)(i), a foreign income tax liability that is contested by the 
taxpayer is not a reasonable approximation of the taxpayer's final 
foreign income tax liability and, therefore, is not considered an 
amount of tax paid for purposes of section 901 until the contest is 
resolved. Thus, except as provided in paragraph (c)(3) of this section, 
a foreign tax credit for a contested foreign income tax liability (or 
portion thereof) that has been remitted to the foreign country cannot 
be claimed until such time as the contest is resolved and the tax is 
considered paid. Once the contest is resolved and the foreign income 
tax liability is finally determined, the tax liability is treated as 
paid in the taxable year in which the foreign tax was remitted. See 
paragraph (c)(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 for taxpayers claiming credits on the cash 
basis 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).
    (3) Election to claim a provisional credit for contested taxes 
remitted before contest is resolved. A taxpayer claiming foreign tax 
credits on the cash basis may, under the conditions provided in this 
paragraph (c)(3), elect to claim a foreign tax credit for a contested 
foreign income tax liability (or a portion thereof) in the year the 
contested amount (or a portion thereof) is remitted to the foreign 
country, notwithstanding that the liability is not finally determined 
and so is not considered an amount of tax paid. Such election applies 
only for contested foreign income taxes that are remitted in a taxable 
year in which the taxpayer elects under section 901(a) to claim a 
credit, instead of a deduction under section 164(a)(3), for taxes paid 
in such year. To make the election, a taxpayer must file a Form 1116 
(Foreign Tax Credit (Individual, Estate, or Trust)) or Form 1118 
(Foreign Tax Credit--Corporations), and the agreement described in 
paragraphs (d)(4)(ii) and (iii) 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 notice 
described in paragraph (d)(4)(iv) of this section. Any portion of a 
contested foreign income tax liability for which a provisional credit 
is claimed under this paragraph (c)(3) that is subsequently refunded by 
the foreign country results in a foreign tax redetermination under 
Sec.  1.905-3(a).
    (4) 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 1.905-3(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 be claimed as a credit only in the year the 
additional taxes are paid (within the meaning of paragraph (c) of this 
section). 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 of 
accounting 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 tax paid when a contest 
with a foreign tax authority is resolved, relates back and is 
considered to accrue at the end of the foreign taxable year with 
respect to which the tax is 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 relates back and is 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

[[Page 365]]

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 
considered paid, even if the contested liability (or portion thereof) 
has 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 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 for taxpayers claiming credits on the accrual 
basis runs from the unextended due date of the return for the taxable 
year in which the foreign income taxes accrued (within the meaning of 
this paragraph (d)).
    (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 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. This election is available only for contested foreign 
income taxes that relate to a taxable year in which the taxpayer has 
elected under section 901(a) to claim a credit, instead of a deduction 
under section 164(a)(3), for foreign income taxes that accrue in such 
year. If the election is made by a taxpayer with respect to contested 
foreign income taxes of a controlled foreign corporation, such taxes 
are treated as deemed paid in the relation-back year and the controlled 
foreign corporation may deduct the taxes in computing its taxable 
income in the relation-back year. 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 notice 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 the contested foreign income tax liability, 
including the name (or other identifier) of the foreign tax or taxes 
being contested, the name of the country imposing the tax, the name and 
identifying number of the payor of the contested 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
    (F) Any additional information as may be prescribed by the 
Commissioner of Internal Revenue in Internal Revenue Service forms or 
instructions.
    (iii) Signatory. The provisional foreign tax credit agreement must 
be signed under penalties of perjury by a person authorized to sign the 
return of the taxpayer.
    (iv) Annual notice. 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 the information 
described in paragraphs (d)(4)(iii)(A) through (C) of this section on 
Form 1116 or Form 1118 or in such other 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 (or other identifier) of the foreign tax or taxes, 
the name of the country imposing the tax, the name and identifying 
number of the payor of the contested 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.
    (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

[[Page 366]]

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 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 first 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, and next, adjusted downward (but not below zero) by the amount 
of foreign income tax in the same grouping that the taxpayer improperly 
accrued in a taxable year before the year of change 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. 
The modified cut-off approach is applied separately with respect to 
amounts of foreign income tax for which the foreign tax credit is 
disallowed and to which section 275 does not apply. See, for example, 
section 901(m)(6). 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, as increased 
by the upward adjustment, if any, 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. See paragraphs (d)(6)(v) through (d)(6)(ix) of this 
section for examples illustrating the application of the modified cut-
off approach.
    (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

[[Page 367]]

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-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, the local 
currency 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

[[Page 368]]

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 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 those in paragraph (d)(6)(iii)(A) of this 
section (the facts in 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 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, for which the average exchange rate was 
$1:[euro]1. 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)
------------------------------------------------------------------------
                                    Net income tax     Net income tax
 Country X taxable year ending in      properly         accrued under
    U.S. calendar taxable year       accrued ($1 =   improper method ($1
                                       [euro]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

[[Page 369]]

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 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 are the same as those 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). In Year 6, when U.S.C. pays the [euro]240x of Country 
X income tax liability for Year 4, 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 those 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, three-
fourths of the [euro]100x of additional tax, or [euro]75x, is treated 
as if it accrued in Year 2, and one-fourth of the additional tax, or 
[euro]25x, is treated as if it accrued in Year 3. Pursuant to Sec.  
1.986(a)-1(a)(2)(i), the [euro]75x of tax treated as if it accrued in 
Year 2 and the [euro]25x of tax treated as if it accrued in Year 3 are 
converted into dollars using the September 15, Year 7, spot rate of 
$1:[euro]0.5, to $150x and $50x, respectively. 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

[[Page 370]]

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.

                  Table 2 to Paragraph (d)(6)(viii)(A)
------------------------------------------------------------------------
                                    Foreign income   Foreign income tax
        Taxable year ending          tax properly       accrued under
                                        accrued        improper method
------------------------------------------------------------------------
12/31/Y1 ($1:[euro]1).............               0  [euro]100x = $100x.
12/31/Y2 ($1:[euro]0.5)...........     [euro]40x =  [euro]100x = $200x.
                                              $80x
12/31/Y3 ($1:[euro]1).............     [euro]50x =  [year of change].
                                              $50x
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 remaining [euro]60x of Country X net income tax that CFC improperly 
accrued in Year 2, the most recent improper accrual. 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 CFC 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, $200x section 78 
dividend and 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 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 of 
foreign base company sales income--[euro]100x foreign income tax 
improperly accrued in Year 1 + [euro]100x improperly accrued foreign 
income tax treated as refunded on December 31, Year 3--[euro]60x 
improperly accrued foreign income tax treated as paid in Year 4 = 
[euro]940x. CFC's eligible foreign income taxes for Year 1 are 
translated into dollars at the applicable exchange rate and recomputed 
as $100x foreign income tax improperly accrued in Year 1--$100x 
improperly accrued foreign income tax treated as refunded on December 
31, Year 3 + $30x improperly accrued foreign income tax treated as paid 
in Year 4 = $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

[[Page 371]]

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 
$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
       Taxable year ending        Foreign income tax     accrued under
                                   properly 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 in Year 2 of [euro]160x of Country X net 
income tax that properly accrued in Year 1 but 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 the 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 the 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

[[Page 372]]

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 a 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 that accrued 
in Year 5 but that are paid in Year 6.
    (ii) Example 2--(A) Facts. The facts are the same as those in 
paragraph (e)(4)(i)(A) of this section (the facts in 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 may, by complying with the rules 
in paragraph (c)(3) or (d)(4) of this section, as applicable, elect to 
claim a provisional credit for its distributive share of such contested 
tax liability in the year the pass-through entity remits the tax (for 
owners claiming foreign tax credits on the cash basis) or in the 
relation-back year (for owners claiming foreign tax credits on the 
accrual basis).
    (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

[[Page 373]]

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. If, under the provisions of the regulations 
under section 461, an amount otherwise constituting gross income for 
the taxable year from sources without the United States is, owing to 
monetary, exchange, or other restrictions imposed by a foreign country, 
not includible in gross income of the taxpayer for such year, the 
credit for foreign income taxes imposed by such foreign country with 
respect to such amount shall be taken proportionately in any subsequent 
taxable year in which such amount or portion thereof is includible in 
gross income.
    (h) Applicability dates. This section applies to foreign income 
taxes paid or accrued in taxable years beginning on or after December 
28, 2021. In addition, the election described in paragraphs (c)(3) and 
(d)(4) of this section may be made (including by a partner or other 
owner of a pass-through entity described in paragraph (f)(2) of this 
section) with respect to amounts of contested tax that are remitted in 
taxable years beginning on or after December 28, 2021 and that relate 
to a taxable year beginning before December 28, 2021.

0
Par. 29. Section 1.905-3 is amended:
0
1. In paragraph (a), by revising the first two sentences.
0
2. In paragraph (b)(1)(ii)(B)(1), by removing the language ``U.S.C. 
Effective'' and adding the language ``U.S.C.. Effective'' in its place.
0
3. By adding paragraph (b)(4).
0
4. By revising paragraph (d).
    The revisions and addition read as follows:


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 section 954(b)(4) (including for purposes of determining amounts 
excluded from gross tested income under section 951A(c)(2)(A)(i)(III) 
and Sec.  1.951A-2(c)(1)(iii)), 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 December 28, 2021.

0
Par. 30. Section 1.951A-2 is amended:
0
1. In paragraph (c)(7)(iii)(A), by adding the language ``and the rules 
of Sec.  1.861-20'' at the end of the first sentence.
0
2. By removing paragraph (c)(7)(iii)(B).
0
3. By redesignating paragraph (c)(7)(iii)(C) as paragraph 
(c)(7)(iii)(B).
0
4. In newly redesignated paragraph (c)(7)(iii)(B), by removing the 
language ``(c)(7)(iii)(C)'' from the first sentence and adding the 
language ``(c)(7)(iii)(B)'' in its place.
0
5. By adding paragraph (c)(8)(ii)(M).
0
6. By revising paragraph (c)(8)(iii)(A)(2)(ii).
0
7. By removing and reserving paragraph (c)(8)(iii)(B).
0
8. In paragraph (c)(8)(iii)(C)(2)(iii):
0
i. By removing the language ``the principles of Sec. Sec.  1.960-
1(d)(3)(ii) and 1.904-6(a)(1)'' from the first and second sentences and 
adding the language ``Sec.  1.861-20'' in its place.
0
ii. By removing the language ``Under these principles, the'' from the 
third sentence and adding the language ``Under Sec.  1.861-20,'' in its 
place.
    The additions and revisions read as follows:


Sec.  1.951A-2  Tested income and tested loss.

* * * * *
    (c) * * *
    (8) * * *
    (ii) * * *
    (M) The same amounts of regarded items of income and deduction that 
are accrued under federal income tax law are also accrued under foreign 
law.
    (iii) * * *
    (A) * * *
    (2) * * *
    (ii) * * * Under paragraph (c)(7)(iii)(A) of this section, CFC1X's 
tentative tested income items are computed by treating the CFC1X 
tentative gross tested income item and the FDE1Y tentative gross tested 
income item each as income in a separate tested income group (the 
``CFC1X income group'' and the ``FDE1Y income group'') and by 
allocating and apportioning CFC1X's deductions for current year taxes 
under Sec.  1.861-20 (CFC1X has no other deductions to allocate and 
apportion). Under paragraph (c)(7)(iii)(A) of this section and Sec.  
1.861-20(d)(3)(v), the [euro]20x deduction for Country Y income taxes 
is allocated and apportioned solely to the FDE1Y income group (the 
``FDE1Y group tax'') and none of the Country Y taxes are allocated and 
apportioned to the CFC1X income group.
* * * * *

0
Par. 31. Section 1.951A-7(b) is amended:

[[Page 374]]

0
1. By removing the language ``Section'' from the first sentence and 
adding the language ``Except as otherwise provided in this paragraph 
(b), section,'' in its place.
0
2. Adding three sentences after the second sentence.
    The addition reads as follows:


Sec.  1.951A-7  Applicability dates.

* * * * *
    (b) * * * Section 1.951A-2(c)(7)(iii)(B), (c)(8)(ii), 
(c)(8)(iii)(A)(2)(ii), and (c)(8)(iii)(B) apply to taxable years of 
foreign corporations beginning on or after December 28, 2021, and to 
taxable years of United States shareholders in which or with which such 
taxable years of the foreign corporations end. In addition, taxpayers 
may choose to apply the rules in Sec.  1.951A-2(c)(7)(iii)(B), 
(c)(8)(iii)(A)(2)(ii), and (c)(8)(iii)(B)(2)(iii) to taxable years of 
foreign corporations that begin after December 31, 2019, and before 
December 28, 2021, and to taxable years of U.S. shareholders in which 
or with which such taxable years of the foreign corporations end. For 
taxable years of foreign corporations beginning before December 28, 
2021, see Sec.  1.951A-2(c)(7)(iii)(B), (c)(8)(iii)(A)(2)(ii), and 
(c)(8)(iii)(B)(2)(iii) as contained in 26 CFR part 1 revised as of 
April 1, 2021.

0
Par. 32. Section 1.960-1 is 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 paragraphs (b)(6) and (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 and 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)(i):
0
i. By removing the language ``paragraphs (c)(1)(i) through (iv)'' from 
the third sentence and adding the language ``paragraphs (c)(1)(i) 
through (v)'' in its place.
0
ii. By removing the language ``Under paragraph (c)(1)(v) of this 
section, the rules in paragraph (c)(1)(i) through (iv)'' from the 
fourth sentence and adding the language ``Under paragraph (c)(1)(vi) of 
this section, the rules in paragraph (c)(1)(i) through (v)'' in its 
place.
0
17. 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
18. In paragraph (f)(2)(ii)(B)(2):
0
i. By removing the language ``current year taxes'' from the fifth 
sentence and adding the language ``eligible current year taxes'' in its 
place.
0
ii. By removing the last two sentences.
0
19. By redesignating paragraphs (f)(2)(ii)(C) through (F) as paragraphs 
(f)(2)(ii)(D) through (G), respectively.
0
20. By adding a new paragraph (f)(2)(ii)(C).
0
21. In newly-redesignated paragraph (f)(2)(ii)(D):
0
i. By removing the language ``Step 3. Under paragraph (c)(1)(iii)'' 
from the first sentence and adding the language ``Step 4. Under 
paragraph (c)(1)(iv)'' in its place.
0
ii. By removing the language ``paragraph (c)(1)(iii)'' from the fifth 
sentence and adding the language ``paragraph (c)(1)(iv)'' in its place.
0
21. In newly-redesignated paragraph (f)(2)(ii)(E), by removing the 
language ``Step 4. Under paragraph (c)(1)(iv)'' from the first sentence 
and adding the language ``Step 5. Under paragraph (c)(1)(v)'' in its 
place.
0
22. In newly-redesignated paragraph (f)(2)(ii)(F), by removing the 
language ``Step 5. Paragraph (c)(1)(v)'' and adding the language ``Step 
6. Paragraph (c)(1)(vi)'' in its place.
0
23. In newly-redesignated paragraph (f)(2)(ii)(G), by removing the 
language ``Step 6. Paragraph (c)(1)(vi)'' and adding the language 
``Step 7. Paragraph (c)(1)(vii)'' 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, other than a current year tax for which a 
credit is disallowed or suspended at the level of the controlled 
foreign corporation. See, for example, section 245A(e)(3) and Sec.  
1.245A(d)-1(a)(2) and sections 901(k)(1), (l), and (m), 909, and 
6038(c)(1)(B). An 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

[[Page 375]]

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 are 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.
* * * * *
    (f) * * *
    (2) * * *
    (ii) * * *
    (C) Step 3. Under paragraph (c)(1)(iii) of this section, for 
purposes of computing foreign taxes deemed paid under section 960, CFC1 
has $600,000x of foreign income taxes in the PTEP group within the 
general category and $300,000x of current year taxes in the residual 
income group within the general category. Under paragraph (e) of this 
section, the United States shareholders of CFC1 cannot claim a credit 
with respect to the $300,000x of taxes on CFC1's income in the residual 
income group.
* * * * *

0
Par. 33. Section 1.960-2 is 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. 34. Section 1.960-7 is amended by revising paragraph (b) to read 
as follows:


Sec.  1.960-7  Applicability dates.

* * * * *

[[Page 376]]

    (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 December 28, 2021, 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 
foreign corporations beginning before December 28, 2021, 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.

Douglas W. O'Donnell,
Deputy Commissioner for Services and Enforcement.
    Approved: December 9, 2021
Lily Batchelder,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2021-27887 Filed 12-28-21; 4:15 pm]
BILLING CODE 4830-01-P