Computation of Foreign Taxes Deemed Paid Under Section 902 Pursuant to a Pooling Mechanism for Undistributed Earnings and Foreign Taxes

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-933-86]

RIN 1545-AL98

Computation of Foreign Taxes Deemed Paid Under Section 902

Pursuant to a Pooling Mechanism for Undistributed Earnings and Foreign

Taxes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed income tax regulations

relating to the computation of foreign taxes deemed paid under section

902. Changes to the applicable law were made by the Tax Reform Act of

1986 and by the Technical and Miscellaneous Revenue Act of 1988

(TAMRA). These regulations would provide guidance needed to comply with

these changes and affect foreign corporations and their United States

corporate shareholders.

DATES: Comments and requests for a public hearing must be received by

April 6, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-933-86), room

5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, D.C. 20044. In the alternative, submissions may be hand

delivered to: CC:DOM:CORP:T:R (INTL-933-86), Courier's Desk, Internal

Revenue Service, 1111 Constitution Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Caren S.

Shein (202) 622-3850, or Kristine K. Schlaman (202) 622-3840.

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act (44 U.S.C.

3504(h)). Comments on the collection of information should be sent to

the Office of Management and Budget, Attention: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attention: IRS Reports Clearance Officer PC:FP, Washington, DC

20224.

The collection of information requirement in this regulation is in

Sec. 1.902-1(e). This information is required by the IRS to implement

section 902 as amended by the Tax Reform Act of 1986. This information

will be used by law enforcement authorities with respect to the

enforcement of Federal laws. The likely respondents are businesses or

other for-profit institutions.

Estimated total annual reporting burden: 225,520 hours.

Estimated total annual burden per respondent: 112.76 hours.

Estimated number of respondents: 2000.

Estimated annual frequency of response: one.

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) under section 902 of the Internal Revenue

Code of 1986. These amendments are proposed to conform the regulations

to section 1202(a) of the Tax Reform Act of 1986 (Pub. L. 99-514, 100

Stat. 1085), and to section 1012(b) of the Technical and Miscellaneous

Revenue Act of 1988 (TAMRA) (Pub. L. 100-647, 102 Stat. 3242).

Proposed Effective Dates

These regulations are proposed to be effective for taxable years

beginning after December 31, 1986.

Explanation of Provisions

Section 1.902-1

Section 902 provides a mechanism by which foreign income taxes paid

by a foreign corporation are deemed paid by a domestic corporate

shareholder owning at least 10 percent of the voting stock of the

foreign corporation. Paragraphs (a) (1) through (12) of

[[Page 2050]] Sec. 1.902-1 provide definitions applicable for purposes

of section 902 and Secs. 1.902-1 and 1.902-2.

Paragraph (a)(1) defines a domestic shareholder that is eligible

for the section 902 credit as a domestic corporation that owns directly

at least 10 percent of the voting stock of a foreign corporation at the

time it receives a dividend.

Revenue Ruling 71-141, 1971-1 C.B. 211, allows two 50 percent

domestic corporate general partners of a domestic general partnership

to claim a credit for taxes deemed paid under section 902 for foreign

taxes paid by a foreign corporation in which the partnership owned 40

percent of the voting stock. The Internal Revenue Service is

considering under what other circumstances a section 902 credit with

respect to stock held by a partnership or other pass-through entity

should flow through to a domestic corporation. The Service requests

comments on whether the holding of Rev. Rul. 71-141 should be expanded

to allow taxes paid by a foreign corporation to be considered deemed

paid by domestic corporations that are partners in domestic limited

partnerships or foreign partnerships, shareholders in limited liability

companies, and beneficiaries of domestic or foreign trusts and estates

or interest holders in other pass-through entities. The comments should

address how the Service would administer any proposed expansion of the

revenue ruling to allow deemed paid credits through other pass-through

entities.

Paragraphs (a) (2) through (6) define the ownership requirements

that must be met before foreign income taxes of a first-, second-, or

third-tier foreign corporation will be deemed paid by an upper-tier

foreign corporation or a domestic shareholder.

Paragraph (a)(7) defines foreign income taxes as those creditable

under sections 901 and 903. Paragraph (a)(8) defines post-1986 foreign

income taxes generally as foreign income taxes paid, accrued, or deemed

paid for the current year and any foreign income taxes paid, accrued,

or deemed paid in prior taxable years beginning after December 31,

1986, to the extent the foreign taxes were not paid or deemed paid on

earnings previously distributed to or otherwise included in the income

of a shareholder.

Paragraph (a)(9) defines post-1986 undistributed earnings generally

as the amount of earnings and profits accumulated by a foreign

corporation in taxable years beginning after December 31, 1986,

determined as of the close of the taxable year in which a dividend is

distributed. Post-1986 undistributed earnings are not reduced by

dividend distributions and deemed inclusions in the current year but

are reduced by dividend distributions and deemed inclusions in prior

post-1986 taxable years.

Paragraph (a)(10) defines pre-1987 accumulated profits as earnings

and profits accumulated in taxable years beginning before January 1,

1987, and in later years if the special effective date of paragraph

(a)(13) applies. Paragraph (a)(13) provides a special effective date

applicable when the 10-percent ownership requirements of section

902(c)(3)(B) and paragraphs (a) (1) through (4) are first met with

respect to a foreign corporation in a taxable year of the foreign

corporation beginning after December 31, 1986. For post-1986 years

prior to the first year in which the ownership requirements of section

902(c)(3)(B) are met, foreign taxes deemed paid must be computed under

the rules of section 902 as in effect prior to the Tax Reform Act of

1986. See section 902(c)(6).

The proposed regulations specify that both post-1986 undistributed

earnings and pre-1987 accumulated profits include a foreign

corporation's entire earnings and profits. Further, for both post-1986

undistributed earnings and pre-1987 accumulated profits that are

distributed in a taxable year beginning after December 31, 1986, the

proposed regulations state that special allocations of accumulated

profits and taxes to particular shareholders, whether required or

permitted under foreign law or an agreement among the shareholders,

will be disregarded. See paragraphs (a)(9)(iv) and (a)(10)(ii).

The intent of the proposed regulations is to reverse the Tax

Court's decision in Vulcan v. Commissioner, 96 T.C. 410 (1991), affd.

per curiam 959 F.2d 973 (11th Cir. 1992), for distributions in taxable

years beginning after December 31, 1986, out of pre-1987 accumulated

profits. In addition, the regulations are intended to make clear that

the decision in Vulcan is not applicable to distributions out of post-

1986 undistributed earnings.

In Vulcan, the Tax Court held that the term ``accumulated profits''

as used in the denominator of the section 902 deemed paid credit

fraction prior to the Tax Reform Act of 1986 does not necessarily mean

all of a foreign corporation's accumulated profits. The Tax Court

concluded that the pre-1987 statute and regulations under section 902

were unclear and based its decision on what it viewed as the policy

behind section 902. The pre-Tax Reform Act of 1986 version of section

902 described the creditable foreign tax as that levied ``on or with

respect to the accumulated profits of the foreign corporation from

which such dividends were paid.'' The Tax Court in Vulcan read this

language as linking ``accumulated profits'' to the foreign tax paid by

the subsidiary and, based in part on this reading, computed the section

902 credit using only the amount of accumulated profits on which the

foreign tax was levied.

Contrary to the Tax Court's analysis, the term ``accumulated

profits'' as used in pre-1987 section 902 generally is equated with,

and determined in accordance with, United States tax principles

relating to pre-tax earnings and profits. See United States v. Goodyear

Tire and Rubber Company, 493 U.S. 132, 139 (1989). Earnings and profits

are a measure of a corporation's ability to pay dividends. They

generally are determined at the corporate level and include all income

earned by the corporation, whether or not all or any portion of the

income is subject to tax. The ``on or with respect to'' language on

which the Tax Court focused simply reflects the annual nature of the

section 902 credit calculation prior to 1986, and does not permit or

require the computation of the deemed paid credit using less than all

of the foreign corporation's accumulated profits.

The 1986 Act changes to section 902(a) eliminated the language the

Tax Court relied on in Vulcan to link the taxes to be credited to the

particular profits on which they were paid. See H.R. Rep. (Conf.) 841,

99th Cong., 2d Sess. II-589 (1986). As amended in 1986, section 902

simply defines the pool of creditable taxes as ``any income, war

profits, or excess profits taxes paid by the foreign corporation'' to

the foreign taxing authority. See section 902(c)(4). The proposed

regulations make clear that Vulcan does not apply for years to which

the pooling rules of new section 902 apply.

The proposed regulations would reverse Vulcan for distributions out

of pre-1987 accumulated profits in post-1986 taxable years. The Vulcan

reversal for distributions out of pre-1987 accumulated profits thus

will have a continuing impact in post-1986 years. The Internal Revenue

Service published this position in Rev. Rul. 87-14, 1987-1 C.B. 181.

Thus, taxpayers had notice of the rule prior to the issuance of these

proposed regulations.

Paragraph (a)(10)(iii) provides that foreign income taxes of a

particular year with pre-1987 accumulated profits must be reduced by

the amount of foreign income taxes deemed paid on a distribution or

inclusion out of pre-1987 accumulated profits of that year. Foreign

income taxes paid or accrued on or with [[Page 2051]] respect to pre-

1987 accumulated profits must be translated into United States dollars

under the rules in effect prior to the effective date of the Tax Reform

Act of 1986. See The Bon Ami Company v. Commissioner, 39 B.T.A. 825

(1939).

Paragraph (b)(1) provides rules for computing the foreign income

taxes deemed paid by a domestic shareholder, first-tier corporation or

second-tier corporation for any taxable year in which a domestic

shareholder receives a dividend from a first-tier corporation paid out

of post-1986 undistributed earnings, or an upper-tier corporation

receives a dividend from a lower-tier corporation paid out of post-1986

undistributed earnings.

Paragraph (b)(2) provides rules for allocating dividends to post-

1986 undistributed earnings and pre-1987 accumulated profits when a

foreign corporation pays a dividend out of both post-1986 undistributed

earnings and pre-1987 accumulated profits and out of more than one pre-

1987 taxable year. Paragraph (b)(3) provides that the amount of foreign

taxes deemed paid on a dividend out of pre-1987 accumulated profits

must be computed under section 902 as in effect prior to the effective

date of the Tax Reform Act of 1986.

Paragraph (b)(4) provides that if a foreign corporation makes a

distribution out of current earnings and profits that is treated as a

dividend under section 316(a)(2) in a taxable year in which the

corporation has a deficit in post-1986 undistributed earnings and the

sum of current plus accumulated earnings and profits is zero or less

than zero, then no foreign income taxes shall be deemed paid with

respect to the dividend. See S. Rep. No. 313, 99th Cong., 2d Sess. 321

(1986). The dividend reduces post-1986 undistributed earnings and

accumulated earnings and profits.

Paragraph (c) provides special rules applicable in computing

foreign taxes deemed paid by a domestic shareholder or upper-tier

corporation. Paragraph (c)(1) provides that foreign taxes deemed paid

must be computed separately for dividends received from each foreign

corporation. Further, if a domestic shareholder receives a dividend

from a first-tier corporation and in the same taxable year the first-

tier corporation receives a dividend from one or more lower-tier

corporations, then foreign taxes deemed paid are computed by starting

at the lowest tier and working upward.

Paragraph (c)(2) requires a domestic shareholder to include in

gross income as a dividend under section 78 all foreign taxes deemed

paid for the taxable year. Foreign corporations are not required to

include foreign taxes deemed paid in gross income under section 78.

Paragraph (c)(9) incorporates the rules of section 905(c) to

determine the effect of a section 482 adjustment on post-1986

undistributed earnings and post-1986 foreign income taxes. In general,

section 905(c) and the regulations under that section require a

reduction in the pool of creditable foreign income taxes when a

taxpayer fails to exhaust its administrative remedies to obtain a

refund of foreign income taxes paid following a section 482 adjustment.

See also Rev. Rul. 92-74, 1992-2 C.B. 156.

Paragraph (d) provides rules relating to the computation of foreign

taxes deemed paid with respect to dividends from controlled foreign

corporations. Generally, dividend distributions are treated as made pro

rata out of a controlled foreign corporation's earnings in each section

904(d) separate category. Section 1.904-5(d). Paragraph (d)(3)(i)

provides that dividends distributed out of earnings accumulated before

a foreign corporation became a controlled foreign corporation are

treated as dividends from a noncontrolled section 902 corporation,

whether the earnings are post-1986 undistributed earnings or pre-1987

accumulated profits.

Pursuant to a grant of regulatory authority in section

904(d)(2)(E)(i), and consistent with proposed amendments to Sec. 1.904-

4(g)(3), paragraph (d)(3)(ii) generally limits the application of the

Technical and Miscellaneous Revenue Act of 1988 amendment of section

904(d)(2)(E)(i) (restricting look-through treatment on dividends out of

pre-acquisition earnings of a controlled foreign corporation) to U.S.

shareholders that acquire more than 90% voting stock ownership in an

existing controlled foreign corporation (including both U.S.

shareholders who previously owned no voting stock in the controlled

foreign corporation and U.S. shareholders that previously owned less

than 10% of the controlled foreign corporation's voting stock). A U.S.

shareholder that acquires more than 90% ownership of a controlled

foreign corporation's voting stock must begin a new set of post-1986

undistributed earnings and post-1986 foreign income taxes pools on the

first day of the first taxable year in which it owns more than 90% of

the voting stock. Earnings attributable to the pre-acquisition period

are treated as post-1986 undistributed earnings or pre-1987 accumulated

profits of a noncontrolled section 902 corporation. Distributions will

be deemed to come first out of the post-acquisition earnings pools to

the extent thereof, and then out of pre-acquisition earnings.

A U.S. shareholder that acquires stock resulting in ownership of

90% or less of an existing controlled foreign corporation's voting

stock is entitled to look-through treatment on dividends paid out of

pre-acquisition earnings of the controlled foreign corporation. The

shareholder need not start new pools of earnings and taxes as a result

of its acquisition of voting stock of the controlled foreign

corporation.

Paragraph (e) describes the information a domestic shareholder must

furnish with respect to foreign income taxes for which it claims a

deemed paid credit.

Paragraph (f) provides examples illustrating the rules of

Sec. 1.902-1, and paragraph (g) provides that Sec. 1.902-1 applies to

distributions in and after a foreign corporation's first taxable year

beginning on or after January 1, 1987.

Section 1.902-2

Section 1.902-2 provides rules for computing foreign taxes deemed

paid when there are deficits in post-1986 undistributed earnings or

pre-1987 accumulated profits (determined under section 902) of a

foreign corporation. Paragraph (a)(1) provides that if there is a

deficit in post-1986 undistributed earnings of a first-, second-, or

third-tier corporation and the corporation makes a distribution to

shareholders, then the deficit shall be carried back to the most recent

pre-effective date taxable year of the first-, second-, or third-tier

corporation with positive accumulated profits determined under section

902. The amount carried back will be removed from post-1986

undistributed earnings, but any foreign income taxes paid with respect

to those earnings will not be carried back to a taxable year beginning

before January 1, 1987 (or a later year if the special effective date

of Sec. 1.902-1(a)(13) applies) and will not be removed from post-1986

foreign income taxes.

Paragraph (b)(1) provides that if there is a deficit in accumulated

profits determined under section 902 of a

first-, second-, or third-tier corporation as of the end of its last

pre-effective date taxable year, that deficit must be carried forward

to the first taxable year of the foreign corporation beginning after

December 31, 1986, or later if the special effective date of

Sec. 1.902-1(a)(13) applies. The deficit carried forward is included in

and reduces post-1986 undistributed earnings. Foreign income taxes paid

with respect to pre-effective date years are not carried forward.

Paragraph (b)(2) makes clear that if a corporation has a deficit in

section 902 [[Page 2052]] accumulated profits at the end of its last

pre-effective date year, then absent an adjustment that restores

earnings to a pre-effective date taxable year (for example, a refund of

foreign taxes) the corporation will never be able to pay a dividend out

of pre-effective date earnings and profits, and thus will not be able

to claim a credit for taxes deemed paid under section 902 for any

foreign income taxes remaining in pre-effective date years.

The regulations redesignate Secs. 1.902-1 and 1.902-2 of the

existing final regulations as Secs. 1.902-3 and 1.902-4, respectively,

and make conforming amendments to those regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Request for a Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments that are submitted

timely (preferably a signed original and eight (8) copies) to the IRS.

All comments will be available for public inspection and copying. A

public hearing may be scheduled if requested in writing by a person

that timely submits written comments. If a public hearing is scheduled,

notice of the date, time, and place for the hearing will be published

in the Federal Register.

Drafting Information

The principal author of these proposed regulations is Caren Silver

Shein of the Office of Associate Chief Counsel (International), within

the Office of Chief Counsel, IRS. However, other personnel from the IRS

and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.902-1 also issued

under 26 U.S.C. 902(c)(7). Section 1.902-2 also issued under 26

U.S.C. 902(c)(7). * * *

Secs. 1.902-1 and 1.902-2 [Redesignated Secs. 1.902-3 and 1.902-4]

Par. 2. Sections 1.902-1 and 1.902-2 are redesignated Secs. 1.902-3

and 1.902-4, respectively.

Par. 3. Sections 1.902-0, 1.902-1 and 1.902-2 are added to read as

follows:

Sec. 1.902-0 Outline of regulations provisions for section 902.

This section lists the provisions under section 902.

Sec. 1.902-1 Credit for domestic corporate shareholder of a foreign

corporation for foreign income taxes paid by the foreign corporation.

(a) Definitions and special effective date.

(1) Domestic shareholder.

(2) First-tier corporation.

(3) Second-tier corporation.

(4) Third-tier corporation.

(5) Example.

(6) Upper- and lower-tier corporations.

(7) Foreign income taxes.

(8) Post-1986 foreign income taxes.

(i) In general.

(ii) Distributions out of earnings and profits accumulated by a

lower-tier corporation in its taxable years beginning before January

1, 1987, and included in the gross income of an upper-tier

corporation in its taxable year beginning after December 31, 1986.

(iii) Foreign income taxes paid or accrued with respect to high

withholding tax interest.

(9) Post-1986 undistributed earnings.

(i) In general.

(ii) Distributions out of earnings and profits accumulated by a

lower-tier corporation in its taxable years beginning before January

1, 1987, and included in the gross income of an upper-tier

corporation in its taxable year beginning after December 31, 1986.

(iii) Reduction for foreign income taxes paid or accrued.

(iv) Special allocations.

(10) Pre-1987 accumulated profits.

(i) Definition.

(ii) Computation of pre-1987 accumulated profits.

(iii) Foreign income taxes attributable to pre-1987 accumulated

profits.

(11) Dividend.

(12) Dividend received.

(13) Special effective date.

(i) Rule.

(ii) Example.

(b) Computation of foreign income taxes deemed paid by a domestic

shareholder, first-tier corporation, and second- tier corporation.

(1) General rule.

(2) Allocation rule for dividends attributable to post-1986

undistributed earnings and pre-1987 accumulated profits.

(i) Portion of dividend out of post-1986 undistributed earnings.

(ii) Portion of dividend out of pre-1987 accumulated profits.

(3) Dividends paid out of pre-1987 accumulated profits.

(4) Deficits in accumulated earnings and profits.

(5) Examples.

(c) Special rules.

(1) Separate computations required for dividends from each

first-tier and lower-tier corporation.

(i) Rule.

(ii) Example.

(2) Section 78 gross-up.

(i) Foreign income taxes deemed paid by a domestic shareholder.

(ii) Foreign income taxes deemed paid by an upper-tier

corporation.

(iii) Example.

(3) Creditable foreign income taxes.

(4) Foreign mineral income.

(5) Foreign taxes paid or accrued in connection with the

purchase or sale of certain oil and gas.

(6) Foreign oil and gas extraction income.

(7) United States shareholders of controlled foreign

corporations.

(8) Credit for foreign taxes deemed paid in a section 304

transaction.

(9) Effect of section 482 adjustments on post-1986 foreign

income taxes and post-1986 undistributed earnings.

(d) Dividends from controlled foreign corporations.

(1) General rule.

(2) Look-through.

(i) Dividends.

(ii) Coordination with section 960.

(3) Special rules.

(i) Dividends distributed out of earnings accumulated before a

controlled foreign corporation became a controlled foreign

corporation.

(ii) Dividend distributions out of earnings and profits for a

year during which a shareholder that is currently a more- than-90-

percent United States shareholder of a controlled foreign

corporation was not a United States shareholder of the controlled

foreign corporation.

(iii) Intra-group acquisitions.

(iv) Ordering rule.

(v) Examples.

(e) Information to be furnished.

(f) Examples.

(g) Effective date. [[Page 2053]]

Sec. 1.902-2 Treatment of deficits in post-1986 undistributed earnings

and pre-1987 accumulated profits of a first-, second-, or third-tier

corporation for purposes of computing an amount of foreign taxes deemed

paid Sec. 1.902-1.

(a) Carryback of deficits in post-1986 undistributed earnings of a

first-,

second-, or third-tier corporation to pre-effective date taxable

years.

(1) Rule.

(2) Examples.

(b) Carryforward of deficits in pre-1987 accumulated profits of a

first-,

second-, or third-tier corporation to post-1986 undistributed

earnings for purposes of section 902.

(1) General rule.

(2) Effect of pre-effective date deficit.

(3) Examples.

Sec. 1.902-3 Credit for domestic corporate shareholder of a foreign

corporation for foreign income taxes paid with respect to accumulated

profits of taxable years of the foreign corporation beginning before

January 1, 1987.

(a) Definitions.

(1) Domestic shareholder.

(2) First-tier corporation.

(3) Second-tier corporation.

(4) Third-tier corporation.

(5) Foreign income taxes.

(6) Dividend.

(7) Dividend received.

(b) Domestic shareholder owning stock in a first-tier corporation.

(1) In general.

(2) Amount of foreign taxes deemed paid by a domestic

shareholder.

(c) First-tier corporation owning stock in a second-tier

corporation.

(1) In general.

(2) Amount of foreign taxes deemed paid by a first-tier

corporation.

(d) Second-tier corporation owning stock in a third-tier

corporation.

(1) In general.

(2) Amount of foreign taxes deemed paid by a second-tier

corporation.

(e) Determination of accumulated profits of a foreign corporation.

(f) Taxes paid on or with respect to accumulated profits of a

foreign corporation.

(g) Determination of earnings and profits of a foreign corporation.

(1) Taxable year to which section 963 does not apply.

(2) Taxable year to which section 963 applies.

(3) Time and manner of making choice.

(4) Determination by district director.

(h) Source of income from first-tier corporation and country to

which tax is deemed paid.

(1) Source of income.

(2) Country to which taxes deemed paid.

(i) United Kingdom income taxes paid with respect to royalties.

(j) Information to be furnished.

(k) Illustrations.

(l) Effective date.

Sec. 1.902-4 Rules for distributions attributable to accumulated

profits for taxable years in which a first-tier corporation was a less

developed country corporation.

(a) In general.

(b) Combined distributions.

(c) Distributions of a first-tier corporation attributable to

certain distributions from second- or third-tier corporations.

(d) Illustrations.

Sec. 1.902-1 Credit for domestic corporate shareholder of a foreign

corporation for foreign income taxes paid by the foreign corporation.

(a) Definitions and special effective date. For purposes of section

902 and Secs. 1.902-1 and 1.902-2, the definitions provided in

paragraphs (a) (1) through (12) of this section and the special

effective date of paragraph (a)(13) of this section apply.

(1) Domestic shareholder. In the case of dividends received by a

domestic corporation from a foreign corporation after December 31,

1986, the term domestic shareholder means a domestic corporation, other

than an S corporation as defined in section 1361(a), that owns directly

at least 10 percent of the voting stock of the foreign corporation at

the time the domestic corporation receives a dividend from that foreign

corporation.

(2) First-tier corporation. In the case of dividends received by a

domestic shareholder from a foreign corporation in a taxable year

beginning after December 31, 1986, the term first-tier corporation

means a foreign corporation, at least 10 percent of the voting stock of

which is owned by a domestic shareholder at the time the domestic

shareholder receives a dividend from that foreign corporation. The term

first-tier corporation also means a DISC or former DISC, but only with

respect to dividends from the DISC or former DISC that are treated

under sections 861(a)(2)(D) and 862(a)(2) as income from sources

without the United States.

(3) Second-tier corporation. In the case of dividends paid to a

first-tier corporation by a foreign corporation in a taxable year

beginning after December 31, 1986, the foreign corporation is a second-

tier corporation if, at the time a first-tier corporation receives a

dividend from that foreign corporation, the first-tier corporation owns

at least 10 percent of the foreign corporation's voting stock and the

product of the following equals at least 5 percent--

(i) The percentage of voting stock owned by the domestic

shareholder in the first-tier corporation; multiplied by

(ii) The percentage of voting stock owned by the first-tier

corporation in the second-tier corporation.

(4) Third-tier corporation. In the case of dividends paid to a

second-tier corporation by a foreign corporation in a taxable year

beginning after December 31, 1986, a foreign corporation is a third-

tier corporation if, at the time a second-tier corporation receives a

dividend from that foreign corporation, the second-tier corporation

owns at least 10 percent of the foreign corporation's voting stock and

the product of the following equals at least 5 percent--

(i) The percentage of voting stock owned by the domestic

shareholder in the first-tier corporation; multiplied by

(ii) The percentage of voting stock owned by the first-tier

corporation in the second-tier corporation; multiplied by

(iii) The percentage of voting stock owned by the second-tier

corporation in the third-tier corporation.

(5) Example. The following example illustrates the ownership

requirements of paragraphs (a)(1) through (4) of this section.

Example. (i) Domestic corporation M owns 30 percent of the

voting stock of foreign corporation A on January 1, 1991, and for

all periods thereafter. Corporation A owns 40 percent of the voting

stock of foreign corporation B on January 1, 1991, and continues to

own that stock until June 1, 1991, when Corporation A sells its

stock in Corporation B. Both Corporation A and Corporation B use the

calendar year as the taxable year. Corporation B pays a dividend out

of its post-1986 undistributed earnings to Corporation A, which

Corporation A receives on February 16, 1991. Corporation A pays a

dividend out of its post-1986 undistributed earnings to Corporation

M, which Corporation M receives on January 20, 1992. Corporation M

uses a fiscal year ending on June 30 as the taxable year.

(ii) On February 16, 1991, when Corporation B pays a dividend to

Corporation A, Corporation M satisfies the 10- percent stock

ownership requirement of paragraphs (a)(1) and (a)(2) of this

section with respect to Corporation A. Therefore, Corporation A is a

first-tier corporation within the meaning of paragraph (a)(2) of

this section and Corporation M is a domestic shareholder of

Corporation A within the meaning of paragraph (a)(1) of this

section. Also on February 16, 1991, Corporation B is a second-tier

corporation within the meaning of paragraph (a)(3) of this section

because Corporation A owns at least 10 percent of its voting stock,

and the percentage of voting stock owned by Corporation M in

Corporation A on February 16, 1991 (30 percent) multiplied by the

percentage of voting stock owned by Corporation A in Corporation B

on February 16, 1991 (40 percent) equals 12 percent. Corporation A

shall be deemed to have paid foreign income taxes of Corporation B

with respect to the [[Page 2054]] dividend received from Corporation

B on February 16, 1991.

(iii) On January 20, 1992, Corporation M satisfies the 10-

percent stock ownership requirement of paragraphs (a)(1) and (2) of

this section with respect to Corporation A. Therefore, Corporation A

is a first-tier corporation within the meaning of paragraph (a)(2)

of this section and Corporation M is a domestic shareholder within

the meaning of paragraph (a)(1) of this section. Accordingly, for

its taxable year ending on June 30, 1992, Corporation M is deemed to

have paid a portion of the post-1986 foreign income taxes paid,

accrued, or deemed to be paid, by Corporation A. Those taxes will

include taxes paid by Corporation B that were deemed paid by

Corporation A with respect to the dividend paid by Corporation B to

Corporation A on February 16, 1991, even though Corporation B is no

longer a second-tier corporation with respect to Corporations A and

M on January 20, 1992, and has not been a second-tier corporation

with respect to Corporations A and M at any time during the taxable

years of Corporations A and M that include January 20, 1992.

(6) Upper- and lower-tier corporations. In the case of a third-tier

corporation, the term upper-tier corporation means a first- or second-

tier corporation. In the case of a second-tier corporation, the term

upper-tier corporation means a first-tier corporation. In the case of a

first-tier corporation, the term lower-tier corporation means a second-

or third-tier corporation. In the case of a second-tier corporation,

the term lower-tier corporation means a third- tier corporation.

(7) Foreign income taxes. The term foreign income taxes means

income, war profits, and excess profits taxes as defined in Sec. 1.901-

2(a), and taxes included in the term income, war profits, and excess

profits taxes by reason of section 903, that are imposed by a foreign

country or a possession of the United States, including any such taxes

deemed paid by a foreign corporation under this section. Foreign

income, war profits, and excess profits taxes shall not include amounts

excluded from the definition of those taxes pursuant to section 901 and

the regulations under that section. See also paragraphs (c) (4) and (5)

of this section (concerning foreign taxes paid with respect to foreign

mineral income and in connection with the purchase or sale of oil and

gas).

(8) Post-1986 foreign income taxes--(i) In general. Except as

provided in paragraphs (a)(10) and (13) of this section, the term post-

1986 foreign income taxes of a foreign corporation means the sum of the

foreign income taxes paid, accrued, or deemed paid in the taxable year

of the foreign corporation in which it distributes a dividend, and the

foreign income taxes paid, accrued, or deemed paid in the foreign

corporation's prior taxable years beginning after December 31, 1986, to

the extent the foreign taxes were not paid or deemed paid by the

foreign corporation on or with respect to earnings that in prior

taxable years were distributed to or otherwise included in the income

of a foreign or domestic shareholder, for example under sections 304,

367(b), 551, 951(a), 1248, or 1293 (whether or not the shareholder is

deemed to have paid the foreign taxes). Thus, if a dividend is paid by

a foreign corporation to a United States person that is not a domestic

shareholder, or to a foreign person that is not a first- or second-tier

corporation, then although no foreign income taxes shall be deemed paid

under section 902 with respect to that dividend, foreign income taxes

that would have been deemed paid had section 902 applied shall be

removed from post-1986 foreign income taxes. In the case of a foreign

corporation the foreign income taxes of which are determined based on

an accounting period of less than one year, the term year means that

accounting period. See sections 441(b)(3) and 443.

(ii) Distributions out of earnings and profits accumulated by a

lower-tier corporation in its taxable years beginning before January 1,

1987, and included in the gross income of an upper-tier corporation in

its taxable year beginning after December 31, 1986. Post-1986 foreign

income taxes shall include foreign income taxes that are deemed paid by

an upper-tier corporation with respect to distributions from a lower-

tier corporation out of non- previously taxed pre-1987 accumulated

profits, as defined in paragraph (a)(10) of this section, that are

received by an upper-tier corporation in any taxable year of the upper-

tier corporation beginning after December 31, 1986, provided the upper-

tier corporation's earnings and profits in that year are included in

its post-1986 undistributed earnings under paragraph (a)(9) of the

section. Foreign income taxes deemed paid with respect to a

distribution of pre-1987 accumulated profits shall be translated from

the functional currency of the lower-tier corporation into dollars at

the spot exchange rate in effect on the date of the distribution. To

determine the character of the earnings and profits and associated

taxes for foreign tax credit limitation purposes, see section 904 and

Sec. 1.904-7(a).

(iii) Foreign income taxes paid or accrued with respect to high

withholding tax interest. Post-1986 foreign income taxes shall not

include foreign income taxes paid or accrued by a noncontrolled section

902 corporation (as defined in section 904(d)(2)(E)(i)) with respect to

high withholding tax interest (as defined in section 904(d)(2)(B)) to

the extent the foreign tax rate imposed on such interest exceeds 5

percent. See section 904(d)(2)(E)(ii) and Sec. 1.904-4(g)(2)(iii). The

reduction in foreign income taxes paid or accrued by the amount of tax

in excess of 5 percent imposed on high withholding tax interest income

must be computed in functional currency before foreign income taxes are

translated into U.S. dollars and included in post-1986 foreign income

taxes.

(9) Post-1986 undistributed earnings--(i) In general. Except as

provided in paragraphs (a) (10) and (13) of this section, the term

post-1986 undistributed earnings means the amount of the earnings and

profits of a foreign corporation (computed in accordance with sections

964(a) and 986) accumulated in taxable years of the foreign corporation

beginning after December 31, 1986, determined as of the close of the

taxable year of the foreign corporation in which it distributes a

dividend. Post-1986 undistributed earnings shall not be reduced by

reason of any earnings distributed or otherwise included in income, for

example, under section 304, 367(b), 551, 951(a), 1248, or 1293, during

the taxable year. Post-1986 undistributed earnings shall be reduced by

the amount of earnings distributed or amounts otherwise included in

income in prior taxable years beginning after December 31, 1986

(whether or not the shareholder is deemed to have paid any foreign

taxes). For rules on carrybacks and carryforwards of deficits and their

effect on post-1986 undistributed earnings, see Sec. 1.902-2. In the

case of a foreign corporation the foreign income taxes of which are

computed based on an accounting period of less than one year, the term

year means that accounting period. See sections 441(b)(3) and 443.

(ii) Distributions out of earnings and profits accumulated by a

lower-tier corporation in its taxable years beginning before January 1,

1987, and included in the gross income of an upper-tier corporation in

its taxable year beginning after December 31, 1986. Distributions by a

lower-tier corporation out of non-previously taxed pre-1987 accumulated

profits, as defined in paragraph (a)(10) of this section, that are

received by an upper-tier corporation in any taxable year of the upper-

tier corporation beginning after December 31, 1986, shall be treated as

post-1986 undistributed earnings of the upper-tier corporation,

provided the upper-tier corporation's earnings and profits for

[[Page 2055]] that year are included in its post-1986 undistributed

earnings under paragraph (a)(9)(i) of this section. To determine the

character of the earnings and profits and associated taxes for foreign

tax credit limitation purposes, see section 904 and Sec. 1.904-7(a).

(iii) Reduction for foreign income taxes paid or accrued. In

computing post-1986 undistributed earnings, earnings and profits shall

be reduced by foreign income taxes paid or accrued regardless of

whether the taxes are creditable. Thus, earnings and profits shall be

reduced by foreign income taxes paid with respect to high withholding

tax interest even though a portion of the taxes is not creditable

pursuant to section 904(d)(2)(E)(ii) and is not included in post-1986

foreign income taxes under paragraph (a)(7)(iii) of this section.

Earnings and profits of an upper-tier corporation, however, shall not

be reduced by foreign income taxes paid by a lower-tier corporation and

deemed to have been paid by the upper-tier corporation.

(iv) Special allocations. Post-1986 undistributed earnings is the

total amount of the earnings of the corporation determined at the

corporate level. Special allocations of earnings and taxes to

particular shareholders, whether required or permitted by foreign law

or a shareholder agreement, shall be disregarded. If, however, there is

an agreement to pay dividends only out of earnings in the separate

categories for passive or high withholding tax interest income, then

only taxes imposed on passive or high withholding tax interest earnings

shall be treated as related to the dividend. See Sec. 1.904-6(a)(2).

(10) Pre-1987 accumulated profits--(i) Definition. The term pre-

1987 accumulated profits means the amount of the earnings and profits

of a foreign corporation computed in accordance with section 902 and

attributable to its taxable years beginning before January 1, 1987. If

the special effective date of paragraph (a)(13) of this section

applies, pre-1987 accumulated profits also includes any earnings and

profits (computed in accordance with sections 964(a) and 986)

attributable to the foreign corporation's taxable years beginning after

December 31, 1986, but before the first day of the first taxable year

of the foreign corporation in which the ownership requirements of

section 902(c)(3)(B) and paragraphs (a) (1) through (4) of this section

are met with respect to that corporation.

(ii) Computation of pre-1987 accumulated profits. Pre-1987

accumulated profits must be computed under United States principles

governing the computation of earnings and profits. Pre-1987 accumulated

profits are determined at the corporate level. Special allocations of

accumulated profits and taxes to particular shareholders with respect

to distributions of pre-1987 accumulated profits in taxable years

beginning after December 31, 1986, whether required or permitted by

foreign law or a shareholder agreement, shall be disregarded. Pre-1987

accumulated profits of a particular year shall be reduced by amounts

distributed from those accumulated profits or otherwise included in

income from those accumulated profits, for example, under sections 304,

367(b), 551, 951(a), 1248, or 1293. If a deficit in post-1986

undistributed earnings is carried back to offset pre-1987 accumulated

profits, pre-1987 accumulated profits of a particular taxable year

shall be reduced by the amount of the deficit carried back to that

year. See Sec. 1.902-2. The amount of a distribution out of pre-1987

accumulated profits, and the amount of foreign income taxes deemed paid

under section 902, shall be determined and translated into United

States dollars by applying the law as in effect prior to the effective

date of the Tax Reform Act of 1986. See Secs. 1.902-3, 1.902-4, and

1.964-1.

(iii) Foreign income taxes attributable to pre-1987 accumulated

profits. The term pre-1987 foreign income taxes means any foreign

income taxes paid, accrued or deemed paid on or with respect to pre-

1987 accumulated profits. Pre-1987 foreign income taxes of a particular

year shall be reduced by the amount of taxes paid or deemed paid on or

with respect to a distribution or inclusion out of pre-1987 accumulated

profits of that year, and by the amount of taxes that would have been

deemed paid had section 902 applied to a distribution or inclusion with

respect to a person not eligible for a section 902 credit. Foreign

income taxes deemed paid with respect to a distribution of pre-1987

accumulated profits shall be translated from the functional currency of

the distributing corporation into United States dollars at the spot

exchange rate in effect on the date of the distribution.

(11) Dividend. For purposes of section 902, the definition of the

term dividend in section 316 and the regulations under that section

applies. The term dividend also includes deemed dividends under

sections 304, 367(b), 551, and 1248, but not deemed inclusions under

sections 951(a) and 1293.

(12) Dividend received. A dividend shall be considered received for

purposes of section 902 when the cash or other property is

unqualifiedly made subject to the demands of the distributee. See

Sec. 1.301-1(b). A dividend also is considered received for purposes of

section 902 when it is deemed received under section 304, 367(b), 551,

or 1248.

(13) Special effective date--(i) Rule. If the first day on which

the ownership requirements of section 902(c)(3)(B) and paragraphs

(a)(1) through (4) of this section are met with respect to a foreign

corporation, without regard to whether a dividend is distributed, is in

a taxable year of the foreign corporation beginning after December 31,

1986, then--

(A) The post-1986 undistributed earnings and post-1986 foreign

income taxes of the foreign corporation shall be determined by taking

into account only taxable years beginning on and after the first day of

the first taxable year of the foreign corporation in which the

ownership requirements are met, including subsequent taxable years in

which the ownership requirements of section 902(c)(3)(B) and paragraphs

(a)(1) through (4) of this section are not met; and

(B) Earnings and profits accumulated prior to the first day of the

first taxable year of the foreign corporation in which the ownership

requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4)

of this section are met shall be considered pre-1987 accumulated

profits.

(ii) Example. The following example illustrates the special

effective date rules of this paragraph (a)(13):

Example. As of December 31, 1991, and since its incorporation,

foreign corporation A has owned 100 percent of the stock of foreign

corporation B. Corporation B is not a controlled foreign

corporation. Corporation B uses the calendar year as its taxable

year, and its functional currency is the u. Assume 1u equals $1 at

all relevant times. On April 1, 1992, Corporation B pays a 200u

dividend to Corporation A and the ownership requirements of section

902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are

not met at that time. On July 1, 1992, domestic corporation M

purchases 10 percent of the Corporation B stock from Corporation A

and, for the first time, Corporation B meets the ownership

requirements of section 902(c)(3)(B) and paragraph (a)(2) of this

section. Corporation M uses the calendar year as its taxable year.

Corporation B does not distribute any dividends to Corporation M

during 1992. For its taxable year ending December 31, 1992,

Corporation B has 500u of earnings and profits (after foreign taxes

but before taking into account the 200u distribution to Corporation

A) and pays 100u of foreign income taxes that is equal to $100.

Pursuant to paragraph (a)(13)(i) of this section, Corporation B's

post-1986 undistributed earnings and post-1986 foreign

[[Page 2056]] income taxes will include earnings and profits and

foreign income taxes attributable to Corporation B's entire 1992

taxable year and all taxable years thereafter. Thus, the April 1,

1992, dividend to Corporation A will reduce post-1986 undistributed

earnings to 300u (500u-200u) under paragraph (a)(9)(i) of this

section. The foreign income taxes attributable to the amount

distributed as a dividend to Corporation A will not be creditable

because Corporation A is not a domestic shareholder. Post-1986

foreign income taxes, however, will be reduced by the amount of

foreign taxes attributable to the dividend. Thus, as of the

beginning of 1993, Corporation B has $60 ($100 - [$100 x 40% (200u/

500u)]) of post-1986 foreign income taxes. See paragraphs (a)(8)(i)

and (b)(1) of this section.

(b) Computation of foreign income taxes deemed paid by a domestic

shareholder, first-tier corporation, and second-tier corporation--(1)

General rule. If a foreign corporation pays a dividend in any taxable

year out of post-1986 undistributed earnings to a shareholder that is a

domestic shareholder or an upper-tier corporation at the time it

receives the dividend, the recipient shall be deemed to have paid the

same proportion of any post-1986 foreign income taxes paid, accrued or

deemed paid by the distributing corporation on or with respect to post-

1986 undistributed earnings which the amount of the dividend out of

post-1986 undistributed earnings (determined without regard to the

gross-up under section 78) bears to the amount of the distributing

corporation's post-1986 undistributed earnings. An upper-tier

corporation shall not be entitled to compute an amount of foreign taxes

deemed paid on a dividend from a lower-tier corporation, however,

unless the ownership requirements of paragraphs (a)(1) through (4) of

this section are met at each tier at the time the upper-tier

corporation receives the dividend. Foreign income taxes deemed paid by

a domestic shareholder or an upper-tier corporation must be computed

under the following formula:

(2) Allocation rule for dividends attributable to post-1986

undistributed earnings and pre-1987 accumulated profits--(i) Portion of

dividend out of post-1986 undistributed earnings. Dividends will be

deemed to be paid first out of post-1986 undistributed earnings to the

extent thereof. If dividends exceed post-1986 undistributed earnings

and dividends are paid to more than one shareholder, then the dividend

to each shareholder shall be deemed to be paid pro rata out of post-

1986 undistributed earnings, computed as follows:

[GRAPHIC][TIFF OMITTED]TP06JA95.016

(ii) Portion of dividend out of pre-1987 accumulated profits. After

the portion of the dividend attributable to post-1986 undistributed

earnings is determined under paragraph (b)(2)(i) of this section, the

remainder of the dividend received by a shareholder is attributable to

pre-1987 accumulated profits to the extent thereof. That part of the

dividend attributable to pre-1987 accumulated profits will be treated

as paid first from the most recently accumulated earnings and profits.

See Sec. 1.902-3. If dividends paid out of pre-1987 accumulated profits

are attributable to more than one pre-1987 taxable year and are paid to

more than one shareholder, then the dividend to each shareholder

attributable to earnings and profits accumulated in a particular pre-

1987 taxable year shall be deemed to be paid pro rata out of

accumulated profits of that taxable year, computed as follows:

[GRAPHIC][TIFF OMITTED]TP06JA95.017

[GRAPHIC][TIFF OMITTED]TP06JA95.018

(3) Dividends paid out of pre-1987 accumulated profits. If

dividends are paid by a first-tier corporation or a lower-tier

corporation out of pre-1987 accumulated profits, the domestic

shareholder or upper-tier corporation that receives the dividends shall

be deemed to have paid foreign income taxes to the extent provided

under section 902 and the regulations thereunder as in effect prior to

the effective date of the Tax Reform Act of 1986. See paragraphs

(a)(10) and (13) of this section and Secs. 1.902-3 and 1.902-4.

(4) Deficits in accumulated earnings and profits. No foreign income

taxes shall be deemed paid with respect to a distribution from a

foreign corporation out of current earnings and profits that is treated

as a dividend under section 316(a)(2) if, as of the end of the taxable

year in which the dividend is paid or accrued, the corporation has zero

or a deficit in post-1986 undistributed earnings and the sum of current

plus accumulated earnings and profits is zero or less than zero. The

dividend shall reduce post-1986 undistributed earnings and accumulated

earnings and profits.

(5) Examples. The following examples illustrate the rules of this

paragraph (b).

Example 1. Domestic corporation M owns 100 percent of foreign

corporation A. Both Corporation M and Corporation A use the calendar

year as the taxable year, and Corporation A uses the u as its

functional currency. Assume that 1u equals $1 at all relevant times.

All of Corporation A's pre-1987 accumulated profits and post-1986

undistributed earnings are non-subpart F general limitation earnings

and profits under section 904(d)(1)(I). As of December 31, 1992,

Corporation A has 100u of post-1986 undistributed earnings and $40

of post-1986 foreign income taxes. For its 1986 taxable year,

Corporation A has accumulated profits [[Page 2057]] of 200u (net of

foreign taxes) and paid 60u of foreign income taxes on those

earnings. In 1992, Corporation A distributes 150u to Corporation M.

Corporation A has 100u of post-1986 undistributed earnings and the

dividend, therefore, is treated as paid out of post-1986

undistributed earnings to the extent of 100u. The first 100u

distribution is from post-1986 undistributed earnings, and, because

the distribution exhausts those earnings, Corporation M is deemed to

have paid the entire amount of post-1986 foreign income taxes of

Corporation A ($40). The remaining 50u dividend is treated as a

dividend out of 1986 accumulated profits under paragraph (b)(2) of

this section. Corporation M is deemed to have paid $15 (60u x 50u/

200u, translated at the appropriate exchange rates) of Corporation

A's foreign income taxes for 1986. As of January 1, 1993,

Corporation A's post-1986 undistributed earnings and post-1986

foreign income taxes are 0. Corporation A has 150u of accumulated

profits and 45u of foreign income taxes remaining in 1986.

Example 2. Domestic corporation M (incorporated on January 1,

1987) owns 100 percent of foreign corporation A (incorporated on

January 1, 1987). Both Corporation M and Corporation A use the

calendar year as the taxable year, and Corporation A uses the u as

its functional currency. Assume that 1u equals $1 at all relevant

times. Corporation A has no pre-1987 accumulated profits. All of

Corporation A's post-1986 undistributed earnings are non-subpart F

general limitation earnings and profits under section 904(d)(1)(I).

On January 1, 1992, Corporation A has a deficit in accumulated

earnings and profits and a deficit in post-1986 undistributed

earnings of (200u). No foreign taxes have been paid with respect to

post-1986 undistributed earnings. During 1992, Corporation A earns

100u (net of foreign taxes), pays $40 of foreign taxes on those

earnings and distributes 50u to Corporation M. As of the end of

1992, Corporation A has a deficit of (100u) ((200u) post-1986

undistributed earnings + 100u current earnings and profits) in post-

1986 undistributed earnings. Corporation A, however, has current

earnings and profits of 100u. Therefore, the 50u distribution is

treated as a dividend in its entirety under section 316(a)(2). Under

paragraph (b)(4) of this section, Corporation M is not deemed to

have paid any of the foreign taxes paid by Corporation A because

post-1986 undistributed earnings and the sum of current plus

accumulated earnings and profits are (100u). The dividend reduces

both post-1986 undistributed earnings and accumulated earnings and

profits. Therefore, as of January 1, 1993, Corporation A's post-1986

undistributed earnings are (150u) and its accumulated earnings and

profits are (150u). Corporation A's post-1986 foreign income taxes

at the start of 1993 are $40.

(c) Special rules--(1) Separate computations required for dividends

from each first-tier and lower-tier corporation--(i) Rule. If in a

taxable year dividends are received by a domestic shareholder or an

upper-tier corporation from two or more first-tier corporations or two

or more lower-tier corporations, the foreign income taxes deemed paid

by the domestic shareholder or the upper-tier corporation under section

902 (a) and (b) and paragraph (b) of this section shall be computed

separately with respect to the dividends received from each first-tier

corporation or lower-tier corporation. If a domestic shareholder

receives dividend distributions from one or more first-tier

corporations and in the same taxable year the first-tier corporation

receives dividends from one or more lower-tier corporations, then the

amount of foreign income taxes deemed paid shall be computed by

starting with the lowest-tier corporation and working upward.

(ii) Example. The following example illustrates the application of

this paragraph (c)(1):

Example. P, a domestic corporation, owns 40 percent of the

voting stock of foreign corporation S. S owns 30 percent of the

voting stock of foreign corporation T, and 30 percent of the voting

stock of foreign corporation U. Neither S, T, nor U is a controlled

foreign corporation. P, S, T and U all use the calendar year as

their taxable year. In 1993, T and U both pay dividends to S and S

pays a dividend to P. To compute foreign taxes deemed paid,

paragraph (c)(1) of this section requires P to start with the lowest

tier corporations and to compute foreign taxes deemed paid

separately for dividends from each first-tier and lower-tier

corporation. Thus, S first will compute foreign taxes deemed paid

separately on its dividends from T and U. The deemed paid taxes will

be added to S's post-1986 foreign income taxes, and the dividends

will be added to S's post-1986 undistributed earnings. Next, P will

compute foreign taxes deemed paid with respect to the dividend from

S. This computation will take into account the taxes paid by T and U

and deemed paid by S.

(2) Section 78 gross-up--(i) Foreign income taxes deemed paid by a

domestic shareholder. Except as provided in section 960(b) and the

regulations under that section (relating to amounts excluded from gross

income under section 959(b)), any foreign income taxes deemed paid by a

domestic shareholder in any taxable year under section 902(a) and

paragraph (b) of this section shall be included in the gross income of

the domestic shareholder for the year as a dividend under section 78.

Amounts included in gross income under section 78 shall, for purposes

of section 904, be deemed to be derived from sources within the United

States to the extent the earnings and profits on which the taxes were

paid are treated under section 904(g) as United States source earnings

and profits. Section 1.904-5(m)(6). Amounts included in gross income

under section 78 shall be treated for purposes of section 904 as income

in a separate category to the extent that the foreign income taxes were

allocated and apportioned to income in that separate category. See

section 904(d)(3)(G) and Sec. 1.904-6(b)(3).

(ii) Foreign income taxes deemed paid by an upper-tier corporation.

Foreign income taxes deemed paid by an upper- tier corporation on a

distribution from a lower-tier corporation are not included in the

earnings and profits of the upper-tier corporation. For purposes of

section 904, foreign income taxes shall be allocated and apportioned to

income in a separate category to the extent those taxes were allocated

to the earnings and profits of the lower-tier corporation in that

separate category. See section 904(d)(3)(G) and Sec. 1.904-6(b)(3). To

the extent that section 904(g) treats the earnings of the lower-tier

corporation on which those foreign income taxes were paid as United

States source earnings and profits, the foreign income taxes deemed

paid by the upper-tier corporation on the distribution from the lower-

tier corporation shall be treated as attributable to United States

source earnings and profits. See section 904(g) and Sec. 1.904-5(m)(6).

(iii) Example. The following example illustrates the rules of this

paragraph (c)(2):

Example. P, a domestic corporation, owns 100 percent of the

voting stock of controlled foreign corporation S. Corporations P and

S use the calendar year as their taxable year, and S uses the u as

its functional currency. Assume that 1u equals $1 at all relevant

times. As of January 1, 1992, S has -0- post-1986 undistributed

earnings and -0- post-1986 foreign income taxes. In 1992, S earns

150u of non-subpart F general limitation income net of foreign taxes

and pays 60u of foreign income taxes. As of the end of 1992, but

before dividend payments, S has 150u of post-1986 undistributed

earnings and $60 of post-1986 foreign income taxes. Assume that 50u

of S's earnings for 1992 are from United States sources. S pays P a

dividend of 75u which P receives in 1992. Under Sec. 1.904-5(m)(4),

one-third of the dividend, or 25u (75u x 50u/150u), is United States

source income to P. P computes foreign taxes deemed paid on the

dividend under paragraph (b)(1) of this section of $30

($60 x 50%[75u/150u]) and includes that amount in gross income under

section 78 as a dividend. Because 25u of the 75u dividend is United

States source income to P, $10 ($30 x 33.33%[25u/75u]) of the

section 78 dividend will be treated as United States source income

to P under this paragraph (c)(2).

(3) Creditable foreign income taxes. The amount of creditable

foreign income taxes under section 901 shall include, subject to the

limitations and conditions of sections 902 and 904,

[[Page 2058]] foreign income taxes actually paid and deemed paid by a

domestic shareholder that receives a dividend from a first-tier

corporation. Foreign income taxes deemed paid by a domestic shareholder

under paragraph (b) of this section shall be deemed paid by the

domestic shareholder only for purposes of computing the foreign tax

credit allowed under section 901.

(4) Foreign mineral income. Certain foreign income, war profits and

excess profits taxes paid or accrued with respect to foreign mineral

income will not be considered foreign income taxes for purposes of

section 902. See section 901(e) and Sec. 1.901-3.

(5) Foreign taxes paid or accrued in connection with the purchase

or sale of certain oil and gas. Certain income, war profits, or excess

profits taxes paid or accrued to a foreign country in connection with

the purchase and sale of oil or gas extracted in that country will not

be considered foreign income taxes for purposes of section 902. See

section 901(f).

(6) Foreign oil and gas extraction income. For rules relating to

reduction of the amount of foreign income taxes deemed paid with

respect to foreign oil and gas extraction income, see section 907(a)

and the regulations under that section.

(7) United States shareholders of controlled foreign corporations.

See paragraph (d) of this section and sections 960 and 962 and the

regulations under those sections for special rules relating to the

application of section 902 in computing foreign income taxes deemed

paid by United States shareholders of controlled foreign corporations.

(8) Credit for foreign taxes deemed paid in a section 304

transaction. [Reserved].

(9) Effect of section 482 adjustments on post-1986 foreign income

taxes and post-1986 undistributed earnings. For rules concerning the

effect of a section 482 adjustment on post-1986 foreign income taxes

and post-1986 undistributed earnings, see section 905(c) and the

regulations under that section.

(d) Dividends from controlled foreign corporations--(1) General

rule. Except as provided in paragraph (d)(3) of this section, if a

dividend is received by a domestic shareholder that is a United States

shareholder (as defined in section 951(b) or section 953(c)(1)(A)) from

a first-tier corporation that is a controlled foreign corporation (as

defined in section 957(a) or section 953(c)(1)(B)), or by an upper-tier

corporation from a lower-tier corporation if the corporations are

related look-through entities within the meaning of Sec. 1.904-5(i),

the following rule applies. If a dividend is paid out of post-1986

undistributed earnings or pre-1987 accumulated profits of the upper- or

lower-tier controlled foreign corporation attributable to more than one

separate category under section 904(d), the amount of foreign income

taxes deemed paid by the domestic shareholder or the upper-tier

corporation under section 902 and paragraph (b) of this section shall

be computed separately with respect to the post-1986 undistributed

earnings or pre-1987 accumulated profits in each separate category out

of which the dividend is paid. See Sec. 1.904-5(c)(4) and paragraph

(d)(2) of this section. The separately computed deemed paid taxes shall

be added to other taxes paid by the U.S. shareholder or upper-tier

corporation with respect to income in the appropriate separate

category.

(2) Look-through--(i) Dividends. Except as otherwise provided in

paragraph (d)(3) of this section, any dividend distribution out of

post-1986 undistributed earnings of a look-through entity to a related

look-through entity shall be deemed to be paid pro rata out of each

separate category of income. See Sec. 1.904-5(c)(4) and Sec. 1.904-7.

The portion of the foreign income taxes attributable to a particular

separate category that shall be deemed paid by the domestic shareholder

or upper-tier corporation must be computed under the following formula:

Foreign taxes deemed paid by domestic shareholder or upper-tier

corporation with respect to a separate category under section 904(d)

= Post-1986 foreign income taxes of first-tier or lower-tier

corporation allocated and apportioned to a separate category under

Sec. 1.904-6 x Dividend amount attributable to a separate category

Post-1986 undistributed earnings of first-tier or lower-tier

corporation attributable to the separate category

(ii) Coordination with section 960. For purposes of coordinating

the computation of foreign taxes deemed paid with respect to amounts

included in gross income pursuant to section 951(a) and dividends

distributed by a controlled foreign corporation, see section 960 and

the regulations under that section.

(3) Special rules--(i) Dividends distributed out of earnings

accumulated before a controlled foreign corporation became a controlled

foreign corporation. Any dividend distributed by a controlled foreign

corporation out of earnings accumulated before the controlled foreign

corporation became a controlled foreign corporation shall be treated as

a dividend from a noncontrolled section 902 corporation regardless of

whether the earnings were accumulated in a taxable year beginning

before January 1, 1987, or after December 31, 1986.

(ii) Dividend distributions out of earnings and profits for a year

during which a shareholder that is currently a more-than-90-percent

United States shareholder of a controlled foreign corporation was not a

United States shareholder of the controlled foreign corporation. A

dividend shall be treated as a dividend from a noncontrolled section

902 corporation, and the look-through rules of section 904(d)(3) and

Sec. 1.904-5 shall not apply if the following conditions are met--

(A) The dividend is distributed by a controlled foreign corporation

attributable to earnings and profits of a taxable year during which it

was a controlled foreign corporation;

(B) The distribution is received by an upper-tier controlled

foreign corporation or a United States shareholder and at the time the

upper-tier controlled foreign corporation or the United States

shareholder receives the distribution, the United States shareholder

owns directly or indirectly within the meaning of sections 958 and 318

and the regulations under those sections, more than 90 percent of the

total combined voting power of all classes of stock entitled to vote of

the distributing controlled foreign corporation; and

(C) The more than 90 percent United States shareholder was not a

United States shareholder at the time the distributed earnings and

profits were accumulated by the controlled foreign corporation (the

pre-acquisition period).

(iii) Intra-group acquisitions. If, however, the dividend recipient

is a member of an affiliated group within the meaning of section

1504(a) without regard to section 1504(b)(3) and acquired its interest

in the controlled foreign corporation from a member or members of the

affiliated group, and the previous owner or owners were entitled to

look-through treatment on distributions from the controlled foreign

corporation, then the dividend recipient also shall be entitled to

look-through treatment on distributions out of pre-acquisition period

earnings and profits.

(iv) Ordering rule. The determination whether a distribution from a

controlled foreign corporation is attributable to earnings and profits

accumulated before the corporation was a controlled foreign corporation

or during the pre-acquisition period shall be made on a last-in first-

out (LIFO) basis. Thus, for example, a distribution shall be deemed

[[Page 2059]] made from the earnings and profits attributable to the

period after the United States shareholder acquired more than 90

percent ownership in an existing controlled foreign corporation (post-

acquisition earnings and profits) to the extent of those earnings, and

then from the most recently accumulated pre-acquisition earnings and

profits. Earnings and profits accumulated in the taxable year in which

the corporation became a controlled foreign corporation or the United

States shareholder acquired more than 90 percent ownership of the

controlled foreign corporation shall be considered earnings and profits

accumulated after the corporation became a controlled foreign

corporation or the United States shareholder acquired more than 90

percent ownership.

(v) Examples. The following examples illustrate the application of

this paragraph (d)(3):

Example 1. S is a foreign corporation formed in 1980. S had no

domestic shareholders until 1992, when P, a domestic corporation,

acquired 60 percent of the stock of S. For 1992 and subsequent

years, S is a controlled foreign corporation. In 1992, S has no

income and pays a dividend out of prior years' earnings and profits.

Pursuant to paragraph (d)(3)(i) of this section, because S was not a

controlled foreign corporation before 1992, the dividend to P will

be treated as a dividend from a noncontrolled section 902

corporation. Further, because the 10-percent ownership requirement

of paragraphs (a)(1) and (a)(2) of this section were not satisfied

until 1992, the amount of foreign taxes deemed paid on any

distribution out of earnings accumulated before P acquired S's stock

will be computed under the rules of section 902 as in effect before

the Tax Reform Act of 1986. See Secs. 1.902-3 and 1.902-4 and

paragraphs (a) (10) and (13) of this section.

Example 2. P, a domestic corporation, owns 100 percent of the

stock of U, a controlled foreign corporation. In 1992, P sells 100

percent of the stock of U to T, an unrelated domestic corporation. U

has no income in 1992 and pays a dividend to T out of post-1986

undistributed earnings attributable to prior years. T is not related

to P and P's ownership of U will not be attributed to T. The

dividend to T in 1992 thus will be treated as a dividend from a

noncontrolled section 902 corporation. In 1993, U pays a dividend to

T out of post-acquisition earnings and profits. T will be entitled

to look-through treatment on the dividend. The amount of foreign

taxes deemed paid on each distribution will be computed under the

rules of this section.

Example 3. Since its organization in 1980, S, a controlled

foreign corporation, has been owned 60 percent by domestic

corporation P and 40 percent by domestic corporation R. In 1992, T

acquires R's 40 percent interest in the stock of S. S has no income

in 1992 and pays a dividend out of prior years' earnings and

profits. Paragraph (d)(3)(ii) of this section does not apply because

T, which formerly owned no stock in S, acquired only 40 percent of

the stock of S. Thus, T is entitled to look-through treatment on the

dividend payment out of post-1986 undistributed earnings accumulated

in years prior to 1992.

(e) Information to be furnished. If the credit for foreign income

taxes claimed under section 901 includes foreign income taxes deemed

paid under section 902 and paragraph (b) of this section, the domestic

shareholder must furnish the same information with respect to the

foreign income taxes deemed paid as it is required to furnish with

respect to the foreign income taxes it directly paid or accrued and for

which the credit is claimed. See Sec. 1.905-2. For other information

required to be furnished by the domestic shareholder for the annual

accounting period of certain foreign corporations ending with or within

the shareholder's taxable year, and for reduction in the amount of

foreign income taxes paid, accrued, or deemed paid for failure to

furnish the required information, see section 6038 and the regulations

under that section.

(f) Examples. The following examples illustrate the application of

this Sec. 1.902-1.

Example 1. Since 1987, domestic corporation M has owned 10

percent of the one class of stock of foreign corporation A. The

remaining 90 percent of Corporation A's stock is owned by Z, a

foreign corporation. Corporation A is not a controlled foreign

corporation. Corporation A uses the u as its functional currency,

and 1u equals $1 at all relevant times. Both Corporation A and

Corporation M use the calendar year as the taxable year. In 1992,

Corporation A pays a 30u dividend out of post-1986 undistributed

earnings, 3u to Corporation M and 27u to Corporation Z. Corporation

M is deemed, under paragraph (b) of this section, to have paid a

portion of the post-1986 foreign income taxes paid by Corporation A

and includes the amount of foreign taxes deemed paid in gross income

under section 78 as a dividend. Both the foreign taxes deemed paid

and the dividend would be subject to a separate limitation for

dividends from Corporation A, a noncontrolled 902 corporation. Under

paragraph (a)(9)(i) of this section, Corporation A must reduce its

post-1986 undistributed earnings as of January 1, 1993, by the total

amount of dividends paid to Corporation M and Corporation Z in 1992.

Under paragraph (a)(8)(i) of this section, Corporation A must reduce

its post-1986 foreign income taxes as of January 1, 1993, by the

amount of foreign income taxes that were deemed paid by Corporation

M and by the amount of foreign income taxes that would have been

deemed paid by Corporation Z had section 902 applied to the dividend

paid to Corporation Z. Foreign income taxes deemed paid by

Corporation M and Corporation A's opening balances in post-1986

undistributed earnings and post-1986 foreign income taxes for 1993

are computed as follows:

1. Assumed post-1986 undistributed earnings of Corporation 25u

A at start of 1992.

2. Assumed post-1986 foreign income taxes of Corporation A $25

at start of 1992.

3. Assumed pre-tax earnings and profits of Corporation A 50u

for 1992.

4. Assumed foreign income taxes paid or accrued by 15u

Corporation A in 1992.

5. Post-1986 undistributed earnings in Corporation A for 60u

1992 (pre-dividend) (Line 1 plus Line 3 minus Line 4).

6. Post-1986 foreign income taxes in Corporation A for 1992 $40

(pre-dividend) (Line 2 plus Line 4 translated at the

appropriate exchange rates).

7. Dividends paid out of post-1986 undistributed earnings 3u

of Corporation A to Corporation M in 1992.

8. Percentage of Corporation A's post-1986 undistributed 5%

earnings paid to Corporation M (Line 7 divided by Line 5).

9. Foreign income taxes of Corporation A deemed paid by $2

Corporation M under section 902 (a) (Line 6 multiplied by

Line 8).

10. Total dividends paid out of post-1986 undistributed 30u

earnings of Corporation A to all shareholders in 1992.

11. Percentage of Corporation A's post-1986 undistributed 50%

earnings paid to all shareholders in 1992 (Line 10 divided

by Line 5).

12. Post-1986 foreign income taxes paid with respect to $20

post-1986 undistributed earnings distributed to all

shareholders in 1992 (Line 6 multiplied by Line 11).

13. Corporation A's post-1986 undistributed earnings at the 30u

start of 1993 (Line 5 minus Line 10).

14. Corporation A's post-1986 foreign income taxes at the $20

start of 1993 (Line 6 minus Line 12).

Example 2. (i) The facts are the same as in Example 1, except

that Corporation M has also owned 10 percent of the one class of

stock of foreign corporation B since 1987. Corporation B uses the

calendar year as the taxable year. The remaining 90 percent of

Corporation B's stock is owned by Corporation Z. Corporation B is

not a controlled foreign corporation. Corporation B uses the u as

its functional currency, and 1u equals $1 at all relevant times. In

1992, Corporation B has earnings and profits and pays foreign income

taxes, a portion of which are attributable to high withholding tax

interest, as defined in section 904(d)(2)(B)(i). Corporation B must

reduce its pool of post-1986 foreign income taxes by the amount of

tax imposed on high withholding tax interest [[Page 2060]] in excess

of 5 percent because these taxes are not eligible for the deemed

paid credit. See section 904(d)(2)(E)(ii) and paragraph (a)(8)(iii)

of this section. Corporation B pays 50u in dividends in 1992, 5u to

Corporation M and 45u to Corporation Z. Corporation M must compute

its section 902(a) deemed paid credit separately for the dividends

it receives in 1992 from Corporation A (as computed in Example 1)

and from Corporation B. Foreign income taxes of Corporation B deemed

paid by Corporation M, and Corporation B's opening balances in post-

1986 undistributed earnings and post-1986 foreign income taxes for

1993 are computed as follows:

1. Assumed post-1986 undistributed earnings of Corporation (100u)

B at start of 1992.

2. Assumed post-1986 foreign income taxes of Corporation B $0

at start of 1992.

3. Assumed pre-tax earnings and profits of Corporation B 302.50u

for 1992 (including 50u of high withholding tax interest

on which 5u of tax is withheld).

4. Assumed foreign income taxes paid or accrued by 102.50u

Corporation B in 1992.

5. Post-1986 undistributed earnings in Corporation B for 100u

1992 (pre-dividend) (Line 1 plus Line 3 minus Line 4).

6. Amount of foreign income tax of Corporation B imposed on 2.50u

high withholding tax interest in excess of 5% (5u

withholding tax--[5% x 50u high withholding tax interest]).

7. Post-1986 foreign income taxes in Corporation B for 1992 $100

(pre-dividend) (Line 2 plus [Line 4 minus Line 6

translated at the appropriate exchange rate]).

8. Dividends paid out of post-1986 undistributed earnings 5u

to Corporation M in 1992.

9. Percentage of Corporation B's post-1986 undistributed 5%

earnings paid to Corporation M (Line 8 divided by Line 5).

10. Foreign income taxes of Corporation B deemed paid by $5

Corporation M under section 902(a) (Line 7 multiplied by

Line 9).

11. Total dividends paid out of post-1986 undistributed 50u

earnings of Corporation B to all shareholders in 1992.

12. Percentage of Corporation B's post-1986 undistributed 50%

earnings paid to all shareholders in 1992 (Line 11 divided

by Line 5).

13. Post-1986 foreign income taxes of Corporation B paid on $50

or with respect to post-1986 undistributed earnings

distributed to all shareholders in 1992 (Line 7 multiplied

by Line 12).

14. Corporation B's post-1986 undistributed earnings at 50u

start of 1993 (Line 5 minus Line 11).

15. Corporation B's post-1986 foreign income taxes at start $50

of 1993 (Line 7 minus Line 13).

(ii) For 1992, as computed in Example 1, Corporation M is deemed

to have paid $2 of the post-1986 foreign income taxes paid by

Corporation A and includes $2 in gross income as a deemed dividend

under section 78. Both the income inclusion and the credit are

subject to a separate limitation for dividends from Corporation A, a

noncontrolled section 902 corporation. Corporation M also is deemed

to have paid $5 of the post-1986 foreign income taxes paid by

Corporation B and includes $5 in gross income as a deemed dividend

under section 78. Both the income inclusion and the foreign taxes

deemed paid are subject to a separate limitation for dividends from

Corporation B, a noncontrolled section 902 corporation.

Example 3. (i) Since 1987, domestic corporation M has owned 50

percent of the one class of stock of foreign corporation A. The

remaining 50 percent of Corporation A is owned by foreign

corporation Z. For the same time period, Corporation A has owned 40

percent of the one class of stock of foreign corporation B, and

Corporation B has owned 30 percent of the one class of stock of

foreign corporation C. The remaining 60 percent of Corporation B is

owned by foreign corporation Y, and the remaining 70 percent of

Corporation C is owned by foreign corporation X. Corporations A, B,

and C are not controlled foreign corporations. Corporations A, B,

and C use the u as their functional currency, and 1u equals $1 at

all relevant times. Corporation B uses a fiscal year ending June 30

as its taxable year; all other corporations use the calendar year as

the taxable year. On February 1, 1992, Corporation C pays a 500u

dividend out of post-1986 undistributed earnings, 150u to

Corporation B and 350u to Corporation X. On February 15, 1992,

Corporation B pays a 300u dividend out of post-1986 undistributed

earnings computed as of the close of Corporation B's fiscal year

ended June 30, 1992, 120u to Corporation A and 180u to Corporation

Y. On August 15, 1992, Corporation A pays a 200u dividend out of

post-1986 undistributed earnings, 100u to Corporation M and 100u to

Corporation Z. In computing foreign taxes deemed paid by

Corporations B and A, section 78 does not apply and Corporations B

and A thus do not have to include the foreign taxes deemed paid in

earnings and profits. See paragraph (c)(2)(ii) of this section.

Foreign income taxes deemed paid by Corporations B, A and M, and the

foreign corporations' opening balances in post-1986 undistributed

earnings and post-1986 foreign income taxes for Corporation B's

fiscal year beginning July 1, 1992, and Corporation C's and

Corporation A's 1993 calendar years are computed as follows:

A. Corporation C (third-tier corporation):

1. Assumed post-1986 undistributed earnings in 1300u

Corporation C at start of 1992.

2. Assumed post-1986 foreign income taxes in $500

Corporation C at start of 1992.

3. Assumed pre-tax earnings and profits of Corporation 500u

C for 1992.

4. Assumed foreign income taxes paid or accrued in 1992 300u

5. Post-1986 undistributed earnings in Corporation C 1500u

for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line

4).

6. Post-1986 foreign income taxes in Corporation C for $800

1992 (pre-dividend) (Line 2 plus Line 4 translated at

the appropriate exchange rates).

7. Dividends paid out of post-1986 undistributed 150u

earnings of Corporation C to Corporation B in 1992.

8. Percentage of Corporation C's post-1986 10%

undistributed earnings paid to Corporation B (Line 7

divided by Line 5).

9. Foreign income taxes of Corporation C deemed paid by $80

Corporation B under section 902(b)(2) (Line 6

multiplied by Line 8).

10. Total dividends paid out of post-1986 undistributed 500u

earnings of Corporation C to all shareholders in 1992.

11. Percentage of Corporation C's post-1986 33.33%

undistributed earnings paid to all shareholders in

1992 (Line 10 divided by Line 5).

12. Post-1986 foreign income taxes paid with respect to $266.66

post-1986 undistributed earnings distributed to all

shareholders in 1992 (Line 6 multiplied by Line 11).

13. Post-1986 undistributed earnings in Corporation C 1000u

at start of 1993 (Line 5 minus Line 10).

14. Post-1986 foreign income taxes in Corporation C at $533.34

start of 1993 (Line 6 minus Line 12).

B. Corporation B (second-tier corporation):

1. Assumed post-1986 undistributed earnings in 0

Corporation B as of July 1, 1991.

2. Assumed post-1986 foreign income taxes in 0

Corporation B as of July 1, 1991.

3. Assumed pre-tax earnings and profits of Corporation 1000u

B for fiscal year ended June 30, 1992, (including 150u

dividend from Corporation B).

4. Assumed foreign income taxes paid or accrued by 200u

Corporation B in fiscal year ended June 30, 1992.

[[Page 2061]]

5. Foreign income taxes of Corporation C deemed paid by $80

Corporation B in its fiscal year ended June 30, 1992

(Part A, Line 9 of paragraph (i) of this Example 3).

6. Post-1986 undistributed earnings in Corporation B 800u

for fiscal year ended June 30, 1992 (pre-dividend)

(Line 1 plus Line 3 minus Line 4).

7. Post-1986 foreign income taxes in Corporation B for $280

fiscal year ended June 30, 1992 (pre-dividend) (Line 2

plus Line 4 translated at the appropriate exchange

rates plus Line 5).

8. Dividends paid out of post-1986 undistributed 120u

earnings of Corporation B to Corporation A on February

15, 1992.

9. Percentage of Corporation B's post-1986 15%

undistributed earnings for fiscal year ended June 30,

1992, paid to Corporation A (Line 8 divided by Line 6).

10. Foreign income taxes paid and deemed paid by $42

Corporation B as of June 30, 1992, deemed paid by

Corporation A under section 902(b)(1) (Line 7

multiplied by Line 9).

11. Total dividends paid out of post-1986 undistributed 300u

earnings of Corporation B for fiscal year ended June

30, 1992.

12. Percentage of Corporation B's post-1986 37.5%

undistributed earnings for fiscal year ended June 30,

1992, paid to all shareholders (Line 11 divided by

Line 6).

13. Post-1986 foreign income taxes paid and deemed paid $105

with respect to post-1986 undistributed earnings

distributed to all shareholders during Corporation B's

fiscal year ended June 30, 1992 (Line 7 multiplied by

Line 12).

14. Post-1986 undistributed earnings in Corporation B 500u

as of July 1, 1992 (Line 6 minus Line 11).

15. Post-1986 foreign income taxes in Corporation B as $175

of July 1, 1992 (Line 7 minus Line 13).

C. Corporation A (first-tier corporation):

1. Assumed post-1986 undistributed earnings in 250u

Corporation A at start of 1992.

2. Assumed post-1986 foreign income taxes in $100

Corporation A at start of 1992.

3. Assumed pre-tax earnings and profits of Corporation 250u

A for 1992 (including 120u dividend from Corporation

B).

4. Assumed foreign income taxes paid or accrued by 100u

Corporation A in 1992.

5. Foreign income taxes paid or deemed paid by $42

Corporation B as of June 30, 1992, that are deemed

paid by Corporation A in 1992 (Part B, Line 10 of

paragraph (i) of this Example 3).

6. Post-1986 undistributed earnings in Corporation A 400u

for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line

4).

7. Post-1986 foreign income taxes in Corporation A for $242

1992 (pre-dividend) (Line 2 plus Line 4 translated at

the appropriate exchange rates plus Line 5).

8. Dividends paid out of post-1986 undistributed 100u

earnings of Corporation A to Corporation M on August

15, 1992.

9. Percentage of Corporation A's post-1986 25%

undistributed earnings paid to Corporation M in 1992

(Line 8 divided by Line 6).

10. Foreign income taxes paid and deemed paid by $60.50

Corporation A in 1992 that are deemed paid by

Corporation M under section 902(a) (Line 7 multiplied

by Line 9).

11. Total dividends paid out of post-1986 undistributed 200u

earnings of Corporation A to all shareholders in 1992.

12. Percentage of Corporation A's post-1986 50%

undistributed earnings paid to all shareholders in

1992 (Line 11 divided by Line 6).

13. Post-1986 foreign income taxes paid and deemed paid $121

by Corporation A with respect to post-1986

undistributed earnings distributed to all shareholders

in 1992 (Line 7 multiplied by Line 12).

14. Post-1986 undistributed earnings in Corporation A 200u

at start of 1993 (Line 6 minus Line 11).

15. Post-1986 foreign income taxes in Corporation A at $121

start of 1993 (Line 7 minus Line 13).

(ii) Corporation M is deemed, under section 902(a) and paragraph

(b) of this section, to have paid $60.50 of post-1986 foreign income

taxes paid, or deemed paid, by Corporation A on or with respect to

its post-1986 undistributed earnings (Part C, Line 10) and

Corporation M includes that amount in gross income as a dividend

under section 78. Both the income inclusion and the credit are

subject to a separate limitation for dividends from Corporation A, a

noncontrolled section 902 corporation.

Example 4. (i) Since 1987, domestic corporation M has owned 100

percent of the voting stock of controlled foreign corporation A, and

Corporation A has owned 100 percent of the voting stock of

controlled foreign corporation B. Corporations M, A and B use the

calendar year as the taxable year. Corporations A and B are

organized in the same foreign country and use the u as their

functional currency. 1u equals $1 at all relevant times. Assume that

all of the earnings of Corporations A and B are general limitation

earnings and profits within the meaning of section 904(d)(2)(I), and

that neither Corporation A nor Corporation B has any previously

taxed income accounts. In 1992, Corporation B pays a dividend of

150u to Corporation A out of post-1986 undistributed earnings, and

Corporation A computes an amount of foreign taxes deemed paid under

section 902(b)(1). The dividend is not subpart F income to

Corporation A because section 954(c)(3)(B)(i) (the same country

dividend exception) applies. Pursuant to paragraph (c)(2)(ii) of

this section, Corporation A is not required to include the deemed

paid taxes in earnings and profits. Corporation A has no pre-1987

accumulated profits and a deficit in post-1986 undistributed

earnings for 1992. In 1992, Corporation A pays a dividend of 100u to

Corporation M out of its earnings and profits for 1992 (current

earnings and profits). Under paragraph (b)(4) of this section,

Corporation M is not deemed to have paid any of the foreign income

taxes paid or deemed paid by Corporation A because Corporation A has

a deficit in post-1986 undistributed earnings as of December 31,

1992, and the sum of its current plus accumulated profits is less

than zero. Note that if instead of paying a dividend to Corporation

A in 1992, Corporation B had made an additional investment of $150

in United States property under section 956, that amount would have

been included in gross income by Corporation M under section

951(a)(1)(B) and Corporation M would have been deemed to have paid

$50 of foreign income taxes paid by Corporation B. See sections

951(a)(1)(B) and 960.

A. Corporation B (second-tier corporation):

1. Assumed post-1986 undistributed earnings in 200u

Corporation B at start of 1992.

2. Assumed post-1986 foreign income taxes in $50

Corporation B at start of 1992.

3. Assumed pre-tax earnings and profits of Corporation 150u

B for 1992.

4. Assumed foreign income taxes paid or accrued in 1992 50u

5. Post-1986 undistributed earnings in Corporation B 300u

for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line

4).

6. Post-1986 foreign income taxes in Corporation B for $100

1992 (pre-dividend) (Line 2 plus Line 4 translated at

the appropriate exchange rates).

7. Dividends paid out of post-1986 undistributed 150u

earnings of Corporation B to Corporation A in 1992.

8. Percentage of Corporation B's post-1986 50%

undistributed earnings paid to Corporation A (Line 7

divided by Line 5).

[[Page 2062]]

9. Foreign income taxes of Corporation B deemed paid by $50

Corporation A under section 902(b)(1) (Line 6

multiplied by Line 8).

10. Post-1986 undistributed earnings in Corporation B 150u

at start of 1993 (Line 5 minus Line 7).

11. Post-1986 foreign income taxes in Corporation B at $50

start of 1993 (Line 6 minus Line 9).

B. Corporation A (first-tier corporation):

1. Assumed post-1986 undistributed earnings in (200u)

Corporation A at start of 1992.

2. Assumed post-1986 foreign income taxes in 0

Corporation A at start of 1992.

3. Assumed pre-tax earnings and profits of Corporation 200u

A for 1992 (including 150u dividend from Corporation

B).

4. Assumed foreign income taxes paid or accrued by 40u

Corporation A in 1992.

5. Foreign income taxes paid by Corporation B in 1992 $50

that are deemed paid by Corporation A (Part A, Line 9

of paragraph (i) of this Example 4).

6. Post-1986 undistributed earnings in Corporation A (40u)

for 1992 (pre-dividend) (Line 1 plus Line 3 minus Line

4).

7. Post-1986 foreign income taxes in Corporation A for $90

1992 (pre-dividend) (Line 2 plus Line 4 translated at

the appropriate exchange rates plus Line 5).

8. Dividends paid out of current earnings and profits 100u

of Corporation A for 1992.

9. Percentage of post-1986 undistributed earnings of 0

Corporation A paid to Corporation M in 1992 (Line 8

divided by the greater of Line 6 or zero).

10. Foreign income taxes paid and deemed paid by 0

Corporation A in 1992 that are deemed paid by

Corporation M under section 902(a) (Line 7 multiplied

by Line 9).

11. Post-1986 undistributed earnings in Corporation A (140u)

at start of 1993 (line 6 minus line 8).

12. Post-1986 foreign income taxes in Corporation A at $90

start of 1993 (Line 7 minus Line 10).

(ii) For 1993, Corporation A has 500u of earnings and profits on

which it pays 160u of foreign income taxes. Corporation A receives

no dividends from Corporation B, and pays a 100u dividend to

Corporation M. The 100u dividend to Corporation M carries with it

some of the foreign income taxes paid and deemed paid by Corporation

A in 1992, that were not deemed paid by Corporation M in 1992

because Corporation A had no post-1986 undistributed earnings. Thus,

for 1993, Corporation M is deemed to have paid $125 of post-1986

foreign income taxes paid and deemed paid by Corporation A and

includes that amount in gross income as a dividend under section 78,

determined as follows:

1. Post-1986 undistributed earnings in Corporation A at (140u)

start of 1993.

2. Post-1986 foreign income taxes in Corporation A at $90

start of 1993.

3. Pre-tax earnings and profits of Corporation A for 500u

1993.

4. Foreign income taxes paid or accrued by Corporation 160u

A in 1993.

5. Post-1986 undistributed earnings in Corporation A 200u

for 1993 (pre-dividend) (Line 1 plus Line 3 minus Line

4).

6. Post-1986 foreign income taxes in Corporation A for $250

1993 (pre-dividend) (Line 2 plus Line 4 translated at

the appropriate exchange rates).

7. Dividends paid out of post-1986 undistributed 100u

earnings of Corporation A to Corporation M in 1993.

8. Percentage of post-1986 undistributed earnings of 50%

Corporation A paid to Corporation M in 1993 (Line 7

divided by Line 5).

9. Foreign income taxes paid and deemed paid by $125

Corporation A that are deemed paid by Corporation M in

1993 (Line 6 multiplied by Line 8).

10. Post-1986 undistributed earnings in Corporation A 100u

at start of 1994 (Line 5 minus Line 7).

11. Post-1986 foreign income taxes in Corporation A at $125

start of 1994 (Line 6 minus Line 9).

Example 5. (i) Since 1987, domestic corporation M has owned 100

percent of the voting stock of controlled foreign corporation A.

Corporation M also conducts operations through a foreign branch.

Both Corporation A and Corporation M use the calendar year as the

taxable year. Corporation A uses the u as its functional currency

and 1u equals $1 at all relevant times. Corporation A has no subpart

F income, as defined in section 952, and no increase in earnings

invested in United States property under section 956 for 1992.

Corporation A also has no previously taxed income accounts.

Corporation A has general limitation income and high withholding tax

interest income that, by operation of section 954(b)(4), does not

constitute foreign base company income under section 954(a). Because

Corporation A is a controlled foreign corporation, it is not

required to reduce post-1986 foreign income taxes by foreign taxes

paid or accrued with respect to high withholding tax interest in

excess of 5 percent. See Sec. 1.902-1(a)(8)(iii). Corporation A pays

a 60u dividend to Corporation M in 1992. For 1992, Corporation M is

deemed, under paragraph (b) of this section, to have paid $24 of the

post-1986 foreign income taxes paid by Corporation A and includes

that amount in gross income under section 78 as a dividend,

determined as follows:

1. Assumed post-1986 undistributed earnings in Corporation

A at start of 1992 attributable to:

(a) Section 904(d)(1)(B) high withholding tax interest. 20u

(b) Section 904(d)(1)(I) general limitation income..... 55u

2. Assumed post-1986 foreign income taxes in Corporation A

at start of 1992 attributable to:

(a) Section 904(d)(1)(B) high withholding tax interest. $5

(b) Section 904(d)(1)(I) general limitation income..... $20

3. Assumed pre-tax earnings and profits of Corporation A

for 1992 attributable to:

(a) Section 904(d)(1)(B) high withholding tax interest. 20u

(b) Section 904(d)(1)(I) general limitation income..... 20u

4. Assumed foreign income taxes paid or accrued in 1992 on

or with respect to:

(a) Section 904(d)(1)(B) high withholding tax interest. 10u

(b) Section 904(d)(1)(I) general limitation income..... 5u

5. Post-1986 undistributed earnings in Corporation A for

1992 (pre-dividend) attributable to:

(a) Section 904(d)(1)(B) high withholding tax interest 30u

(Line 1(a) + Line 3(a) minus Line 4(a)).

(b) Section 904(d)(1)(I) general limitation income 70u

(Line 1(b) + Line 3(b) minus Line 4(b)).

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

(c) Total.......................................... 100u

[[Page 2063]]

6. Post-1986 foreign income taxes in Corporation A for 1992

(pre-dividend) attributable to:

(a) Section 904(d)(1)(B) high withholding tax interest $15

(Line 2(a) + Line 4(a) translated at the appropriate

exchange rates).

(b) Section 904(d)(1)(I) general limitation income $25

(Line 2(b) + Line 4(b) translated at the appropriate

exchange rates).

7. Dividends paid to Corporation M in 1992................. 60u

8. Dividends paid to Corporation M in 1992 attributable to

section 904(d) separate categories pursuant to Sec. 1.904-

5(d):

(a) Dividends paid to Corporation M in 1992 18u

attributable to section 904(d)(1)(B) high withholding

tax interest (Line 7 multiplied by Line 5(a) divided

by Line 5(c).

(b) Dividends paid to Corporation M in 1992 42u

attributable to section 904(d)(1)(I) general

limitation income (Line 7 multiplied by Line 5(b)

divided by Line 5(c).

9. Percentage of Corporation A's post-1986 undistributed

earnings for 1992 paid to Corporation M attributable to:

(a) Section 904(d)(1)(B) high withholding tax interest 60%

(Line 8(a) divided by Line 5(a)).

(b) Section 904(d)(1)(I) general limitation income 60%

(Line 8(b) divided by Line 5(b).

10. Foreign income taxes of Corporation A deemed paid by

Corporation M under section 902(a) attributable to:

(a) Foreign income taxes of Corporation A deemed paid $9

by Corporation M under section 902(a) with respect to

section 904(d)(1)(B) high withholding tax interest

(Line 6(a) multiplied by Line 9(a)).

(b) Foreign income taxes of Corporation A deemed paid $15

by Corporation M under section 902(a) with respect to

section 904(d)(1)(I) general limitation income (Line

6(b) multiplied by Line 9(b).

11. Post-1986 undistributed earnings in Corporation A at

start of 1993 attributable to:

(a) Section 904(d)(1)(B) high withholding tax interest 12u

(Line 5(a) minus Line 8(a)).

(b) Section 904(d)(1)(I) general limitation income 28u

(Line 5(b) minus Line 8(b)).

12. Post-1986 foreign income taxes in Corporation A at

start of 1989 allocable to:

(a) Section 904(d)(1)(B) high withholding tax interest $6

(Line 6(a) minus Line 10(a)).

(b) Section 904(d)(1)(I) general limitation income $10

(Line 6(b) minus Line 10(b)).

(ii) For purposes of computing Corporation M's foreign tax

credit limitation, the post-1986 foreign income taxes of Corporation

A deemed paid by Corporation M with respect to income in separate

categories will be added to the foreign income taxes paid or accrued

by Corporation M associated with income derived from Corporation M's

branch operation in the same separate categories. The dividend (and

the section 78 inclusion with respect to the dividend) will be

treated as income in separate categories and added to Corporation

M's other income, if any, attributable to the same separate

categories. See section 904(d) and Sec. 1.904-6.

(g) Effective date. This section applies to any distribution made

in and after a foreign corporation's first taxable year beginning on or

after January 1, 1987. Sec. 1.902-2 Treatment of deficits in post-1986

undistributed earnings and pre-1987 accumulated profits of a first-,

second-, or third-tier corporation for purposes of computing an amount

of foreign taxes deemed paid under Sec. 1.902-1.

(a) Carryback of deficits in post-1986 undistributed earnings of a

first-, second-, or third-tier corporation to pre-effective date

taxable years--(1) Rule. For purposes of computing foreign income taxes

deemed paid under Sec. 1.902-1(b) with respect to dividends paid by a

first-, second-, or third-tier corporation when there is a deficit in

the post-1986 undistributed earnings of that corporation and the

corporation makes a distribution to shareholders that is a dividend or

would be a dividend if there were current or accumulated earnings and

profits, then the post-1986 deficit shall be carried back to the most

recent pre-effective date taxable year of the first-, second-, or

third-tier corporation with positive accumulated profits computed under

section 902. See Sec. 1.902-3(c)(2). For purposes of this Sec. 1.902-2,

a pre-effective date taxable year is a taxable year beginning before

January 1, 1987, or a taxable year beginning after December 31, 1986,

if the special effective date of Sec. 1.902-1(a)(13) applies. The

deficit shall reduce the section 902 accumulated profits in the most

recent pre-effective date year to the extent thereof and any remaining

deficit shall be carried back to the next preceding year or years until

the deficit is completely allocated. The amount carried back shall

reduce the deficit in post-1986 undistributed earnings. Any foreign

income taxes paid in a post-effective date year will not be carried

back to pre-effective date taxable years or removed from post-1986

foreign income taxes. See section 960 and the regulations under that

section for rules governing the carryback of deficits and the

computation of foreign income taxes deemed paid with respect to deemed

income inclusions from controlled foreign corporations.

(2) Examples. The following examples illustrate the rules of this

paragraph (a):

Example 1. (i) From 1985 through 1990, domestic corporation M

owns 10 percent of the one class of stock of foreign corporation A.

The remaining 90 percent of Corporation A's stock is owned by Z, a

foreign corporation. Corporation A is not a controlled foreign

corporation and uses the u as its functional currency. 1u equals $1

at all relevant times. Both Corporation A and Corporation M use the

calendar year as the taxable year. Corporation A has pre-1987

accumulated profits and post-1986 undistributed earnings or deficits

in post-1986 undistributed earnings, pays pre-1987 and post-1986

foreign income taxes, and pays dividends as summarized below:

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

Taxable year 1985 1986 1987 1988 1989 1990

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

Current E & P (deficits) of Corp. A..... 150u 150u (100u) 100u -0- -0-

Current plus accumulated E & P of Corp. 150u 300u 200u 250u 250u 200u

A.

Post-'86 undistributed earnings of Corp. .......... .......... (100u) 100u 100u 50u

A.

Post-'86 undistributed earnings of Corp. .......... .......... -0- 100u 50u 50u

A reduced by current year dividend

distributions (increased by deficit

carryback).

Foreign income taxes of Corp. A (annual) 120u 120u $10 $50 -0- -0-

Post-'86 foreign income taxes of Corp. A .......... .......... $10 $60 $60 $30

12/31 distributions to Corp. M.......... -0- -0- 5u -0- 5u -0-

12/31 distributions to Corp. Z.......... -0- -0- 45u -0- 45u -0-

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

(ii) On December 31, 1987, Corporation A distributes a 5u

dividend to Corporation M and a 45u dividend to Corporation Z. At

that time Corporation A has a deficit of (100u) in post-1986

undistributed earnings and $10 of post-1986 foreign income taxes.

The (100u) deficit (but not the post-1986 foreign income taxes) is

carried back to offset the accumulated profits of 1986 and removed

[[Page 2064]] from post-1986 undistributed earnings. The accumulated

profits for 1986 are reduced to 50u (150u-100u). The dividend is

paid out of the reduced 1986 accumulated profits. Foreign taxes

deemed paid by Corporation M with respect to the 5u dividend are 12u

(120u x (5u/50u)). See Sec. 1.902-1(b)(3). Corporation M must

include 12u in gross income (translated under the rule applicable to

foreign income taxes paid on earnings accumulated in pre-effective

date years) under section 78 as a dividend. Both the income

inclusion and the foreign taxes deemed paid are subject to a

separate limitation for dividends from Corporation A, a

noncontrolled section 902 corporation. No earnings and profits

remain in Corporation A with respect to 1986 after the carryback of

the 1987 deficit and the December 31, 1987, dividend distributions

to Corporations M and Z.

(iii) On December 31, 1989, Corporation A distributes a 5u

dividend to Corporation M and a 45u dividend to Corporation Z. At

that time Corporation A has 100u of post-1986 undistributed earnings

and $60 of post-1986 foreign income taxes. Therefore, the dividend

is considered paid out of Corporation A's post-1986 undistributed

earnings. Foreign taxes deemed paid by Corporation M with respect to

the 5u dividend are $3 ($60 x 5%[5u/100u]). Corporation M must

include $3 in gross income under section 78 as a dividend. Both the

income inclusion and the foreign taxes deemed paid are subject to a

separate limitation for dividends from noncontrolled section 902

corporation A. Corporation A's post-1986 undistributed earnings as

of January 1, 1990, are 50u (100u-50u). Corporation A's post-1986

foreign income taxes must be reduced by the amount of foreign taxes

that would have been deemed paid had section 902 applied to the

entire 50u dividend to Corporations M and Z, even though Corporation

Z was not entitled to compute foreign taxes deemed paid on its share

of the dividend. Section 1.902-1(a)(8). The amount of foreign income

taxes that would have been deemed paid had section 902 applied to

the entire 50u dividend is $30 ($60 x 50%[50u/100u]). Thus, post-

1986 foreign income taxes as of January 1, 1990, are $30 ($60-$30).

Example 2. The facts are the same as in Example 1, except that

Corporation A has a deficit in its post-1986 undistributed earnings

of (150u) on December 31, 1987. The deficit is carried back to 1986

and reduces accumulated profits for that year to -0-. Thus, the

foreign income taxes paid with respect to the 1986 accumulated

profits will never be deemed paid. The 1987 dividend is deemed to be

out of Corporation A's 1985 accumulated profits. Foreign taxes

deemed paid by Corporation M under section 902 with respect to the

5u dividend paid on December 31, 1987, are 4u (120u x 5u/150u). See

Sec. 1.902-1(b)(3). As a result of the December 31, 1987, dividend

distributions, 100u (150u-50u) of earnings and profits and 80u (120u

reduced by 40u[120u x 50u/150u] of foreign taxes that would have

been deemed paid had section 902 applied to the total dividend paid

to all shareholders out of 1985 accumulated profits) remain in

Corporation A with respect to 1985.

Example 3. (i) From 1986 through 1991, domestic corporation M

owns 10 percent of the one class of stock of foreign corporation A.

The remaining 90 percent of Corporation A's stock is owned by

Corporation Z, a foreign corporation. Corporation A is not a

controlled foreign corporation and uses the u as its functional

currency. 1u equals $1 at all relevant times. Both Corporation A and

Corporation M use the calendar year as the taxable year. Corporation

A has pre-1987 accumulated profits and post-1986 undistributed

earnings or deficits in post-1986 undistributed earnings, pays pre-

1987 and post-1986 foreign income taxes, and pays dividends as

summarized below:

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

Taxable year 1986 1987 1988 1989 1990 1991

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

Current E & P (deficits) of Corp. A..... 100u (50u) 150u 75u 25u -0-

Current plus accumulated E & P of Corp. 100u 50u 200u 175u 200u 80u

A.

Post-'86 undistributed earnings of Corp. .......... (50u) 100u 75u 100u -0-

A.

Post-'86 undistributed earnings of Corp. .......... (50u) -0- 75u -0- -0-

A reduced by current year dividend

distributions (increased by deficit

carryback).

Foreign income taxes (annual) of Corp. A 80u -0- $120 $20 $20 -0-

Post-'86 foreign income taxes of Corp. A .......... -0- $120 $20 $40 -0-

12/31 distributions to Corp. M.......... -0- -0- 10u -0- 12u -0-

12/31 distributions to Corp. Z.......... -0- -0- 90u -0- 108u -0-

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

(ii) On December 31, 1988, Corporation A distributes a 10u

dividend to Corporation M and a 90u dividend to Corporation Z. At

that time Corporation A has 100u in its post-1986 undistributed

earnings and $120 in its post-1986 foreign income taxes. Corporation

M is deemed, under Sec. 1.902-1(b)(1), to have paid $12

($120 x 10%[10u/100u]) of the post-1986 foreign income taxes paid by

Corporation A and includes that amount in gross income under section

78 as a dividend. Both the income inclusion and the foreign taxes

deemed paid are subject to a separate limitation for dividends from

noncontrolled section 902 Corporation A. Corporation A's post-1986

undistributed earnings as of January 1, 1989, are -0- (100u - 100u).

Its post-1986 foreign taxes as of January 1, 1989, also are -0-,

$120 reduced by $120 of foreign income taxes paid that would have

been deemed paid had section 902 applied to the entire 100u dividend

distribution to Corporations M and Z ($120 x 100%[100u/100u]).

(iii) On December 31, 1990, Corporation A distributes a 12u

dividend to Corporation M and a 108u dividend to Corporation Z. At

that time Corporation A has 100u in its post-1986 undistributed

earnings and $40 in its post-1986 foreign income taxes. The dividend

is paid out of post-1986 undistributed earnings to the extent

thereof (100u), and the remainder of 20u is paid out of 1986

accumulated profits. Under Sec. 1.902-1(b)(2), the 12u dividend to

Corporation M is deemed to be paid out of post-1986 undistributed

earnings to the extent of 10u (100u x 12u/120u) and the remaining 2u

is deemed to be paid out of Corporation A's 1986 accumulated

profits. Similarly, the 108u dividend to Corporation Z is deemed to

be paid out of post-1986 undistributed earnings to the extent of 90u

(100u x 108u/120u) and the remaining 18u is deemed to be paid out of

Corporation A's 1986 accumulated profits. Foreign income taxes

deemed paid by Corporation M under section 902 with respect to the

portion of the dividend paid out of post-1986 undistributed earnings

are $4 ($40 x 10%[10u/100u]), and foreign taxes deemed paid by

Corporation M with respect to the portion of the dividend deemed

paid out of 1986 accumulated profits are 1.6u (80u x 2u/100u).

Corporation M must include $4 plus 1.6u translated under the rule

applicable to foreign income taxes paid on earnings accumulated in

taxable years prior to the effective date of the Tax Reform Act of

1986 in gross income as a dividend under section 78. The income

inclusion and the foreign income taxes deemed paid are subject to a

separate limitation for dividends from noncontrolled section 902

Corporation A. As of January 1, 1991, Corporation A's post-1986

undistributed earnings are -0- (100u - 100u). 80u (100u - 20u) of

earnings and profits remain with respect to 1986. Post-1986 foreign

taxes as of January 1, 1991, are -0-, $40 reduced by $40 of foreign

income taxes paid that would have been deemed paid had section 902

applied to the entire 100u dividend distribution out of post-1986

undistributed earnings to Corporations M and Z ($40 x 100%[100u/

100u]). Corporation A has 64u of foreign income taxes remaining with

respect to 1986, 80u reduced by 16u [80u x 20u/100u] of foreign

income taxes that would have been deemed paid had section 902

applied to the entire 20u dividend distribution to Corporations M

and Z out of 1986 accumulated profits.

(b) Carryforward of deficits in pre-1987 accumulated profits of a

first-, second-, or third-tier corporation to post-1986 undistributed

earnings for purposes of section 902--(1) General rule. For purposes of

computing foreign income taxes deemed paid under Sec. 1.902-1(b) with

respect to dividends paid by a first-, second-, or third-tier

[[Page 2065]] corporation out of post-1986 undistributed earnings, the

amount of a deficit in accumulated profits determined under section 902

of the foreign corporation as of the end of its last pre-effective date

taxable year is carried forward and reduces post-1986 undistributed

earnings on the first day of the foreign corporation's first taxable

year beginning after December 31, 1986, or on the first day of the

first taxable year in which the ownership requirements of section

902(c)(3)(B) and Sec. 1.902-1(a)(1) through (4) are met if the special

effective date of Sec. 1.902-1(a)(13) applies. Any foreign income taxes

paid with respect to a pre-effective date year shall not be carried

forward and included in post- 1986 foreign income taxes. Post-1986

undistributed earnings may not be reduced by the amount of a pre-1987

deficit in earnings and profits computed under section 964(a). See

section 960 and the regulations under that section for rules governing

the carryforward of deficits and the computation of foreign income

taxes deemed paid with respect to deemed income inclusions from

controlled foreign corporations. For translation rules governing

carryforwards of deficits in pre-1987 accumulated profits to post-1986

taxable years of a foreign corporation with a dollar functional

currency, see Sec. 1.985-6(d)(2).

(2) Effect of pre-effective date deficit. If a foreign corporation

has a deficit in accumulated profits as of the end of its last pre-

effective date taxable year, then the foreign corporation cannot pay a

dividend out of pre-effective date years unless there is an adjustment

made (for example, a refund of foreign taxes paid) that restores

section 902 accumulated profits to a pre-effective date taxable year or

years. Moreover, if a foreign corporation has a deficit in section 902

accumulated profits as of the end of its last pre-effective date

taxable year, then no deficit in post-1986 undistributed earnings will

be carried back under paragraph (a) of this section. For rules

concerning carrybacks of eligible deficits from post-1986 undistributed

earnings to reduce pre-1987 earnings and profits computed under section

964(a), see section 960 and the regulations under that section.

(3) Examples. The following examples illustrate the rules of this

paragraph (b).

Example 1. (i) From 1984 through 1988, domestic corporation M

owns 10 percent of the one class of stock of foreign corporation A.

The remaining 90 percent of Corporation A's stock is owned by

Corporation Z, a foreign corporation. Corporation A is not a

controlled foreign corporation and uses the u as its functional

currency. 1u equals $1 at all relevant times. Both Corporation A and

Corporation M use the calendar year as the taxable year. Corporation

A has pre-1987 accumulated profits or deficits in accumulated

profits and post-1986 undistributed earnings, pays pre-1987 and

post-1986 foreign income taxes, and pays dividends as summarized

below:

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

Taxable year 1984 1985 1986 1987 1988

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

Current E & P (deficits) of Corp. A................. 25u (100u) (25u) 200u 100u

Current Plus Accumulated E & P (Deficits) of Corp. A 25u (75u) (100u) 100u 50u

Post-'86 Undistributed Earnings of Corp. A.......... .......... .......... .......... 100u 50u

Post-'86 Undistributed Earnings of Corp. A Reduced .......... .......... .......... (50u) 50u

By Current Year Dividend Distributions (reduced by

deficit carryforward).

Foreign Income Taxes (Annual) of Corp. A............ 20u 5u -0- $100 $50

Post-'86 Foreign Income Taxes of Corp. A............ .......... .......... .......... $100 $50

12/31 Distributions to Corp. M...................... -0- -0- -0- 15u -0-

12/31 Distributions to Corp. Z...................... -0- -0- -0- 135u -0-

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

(ii) On December 31, 1987, Corporation A distributes a 150u

dividend, 15u to Corporation M and 135u to Corporation Z.

Corporation A has 200u of current earnings and profits for 1987, but

its post-1986 undistributed earnings are only 100u as a result of

the reduction for pre-1987 accumulated deficits required under

paragraph (b)(1) of this section. Corporation A has $100 of post-

1986 foreign income taxes. Only 100u of the 150u distribution is a

dividend out of post-1986 undistributed earnings. Foreign income

taxes deemed paid by Corporation M in 1987 with respect to the 10u

dividend attributable to post-1986 undistributed earnings, computed

under Sec. 1.902-1(b), are $10 ($100 x 10%[10u/100u]). Corporation M

includes this amount in gross income under section 78 as a dividend.

Both the income inclusion and the foreign taxes deemed paid are

subject to a separate limitation for dividends from noncontrolled

section 902 corporation A. After the distribution, Corporation A has

(50u) of post-1986 undistributed earnings (100u-150u) and -0- post-

1986 foreign income taxes, $100 reduced by $100 of foreign income

taxes paid that would have been deemed paid had section 902 applied

to the entire 100u dividend distribution out of post-1986

undistributed earnings to Corporations M and Z ($100 x 100%[100u/

100u]).

(iii) The remaining 50u of the 150u distribution cannot be

deemed paid out of accumulated profits of a pre-1987 year because

Corporation A has an accumulated deficit as of the end of 1986 that

eliminated all pre-1987 accumulated profits. See paragraph (b)(2) of

this section. The 50u is a dividend out of current earnings and

profits under section 316(a)(2), but Corporation M is not deemed to

have paid any additional foreign income taxes paid by Corporation A

with respect to that 50u dividend out of current earnings and

profits. See Sec. 1.902-1(b)(4).

Example 2. (i) From 1986 through 1991, domestic corporation M

owns 10 percent of the one class of stock of foreign corporation A.

The remaining 90 percent of Corporation A's stock is owned by

Corporation Z, a foreign corporation. Corporation A is not a

controlled foreign corporation and uses the u as its functional

currency. 1u equals $1 at all relevant times. Both Corporation A and

Corporation M use the calendar year as the taxable year. Corporation

A has pre-1987 accumulated profits or deficits in accumulated

profits and post-1986 undistributed earnings, pays post-1986 foreign

income taxes, and pays dividends as summarized below:

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

Taxable year 1986 1987 1988 1989 1990

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

Current E & P (Deficits) of Corp. A................. (100u) 150u (150u) 100u 250u

Current Plus Accumulated E & P (Deficits) of Corp. A (100u) 50u (200u) (100u) 50u

Post-'86 Undistributed Earnings of Corp. A.......... .......... 50u (200u) (100u) 50u

Post-'86 Undistributed Earnings of Corp. A Reduced .......... (50u) (200u) (200u) -0-

By Current Year Dividend Distributions (reduced by

deficit carryforward).

Foreign Income Taxes (Annual) of Corp. A............ -0- $120 -0- $50 $100

Post-'86 Foreign Income Taxes of Corp. A............ .......... $120 -0- $50 $150

12/31 Distributions to Corp. M...................... -0- 10u -0- 10u 5u

12/31 Distributions to Corp. Z...................... -0- 90u -0- 90u 45u

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

[[Page 2066]]

(ii) On December 31, 1987, Corporation A distributes a 10u

dividend to Corporation M and a 90u dividend to Corporation Z. At

the time of the distribution, Corporation A has 50u of post-1986

undistributed earnings and 150u of current earnings and profits.

Thus, 50u of the dividend distribution (5u to Corporation M and 45u

to Corporation Z) is a dividend out of post-1986 undistributed

earnings. The remaining 50u is a dividend out of current earnings

and profits under section 316(a)(2), but Corporation M is not deemed

to have paid any additional foreign income taxes paid by Corporation

A with respect to that 50u dividend out of current earnings and

profits. See Sec. 1.902-1(b)(4). Note that even if there were no

current earnings and profits in Corporation A, the remaining 50u of

the 100u distribution cannot be deemed paid out of accumulated

profits of a pre-1987 year because Corporation A has an accumulated

deficit as of the end of 1986 that eliminated all pre-1987

accumulated profits. See paragraph (b)(2) of this section.

Corporation A has $120 of post-1986 foreign income taxes. Foreign

taxes deemed paid by Corporation M under section 902 with respect to

the 5u dividend out of post-1986 undistributed earnings are $12

($120 x 10%[5u/50u]). Corporation M includes this amount in gross

income as a dividend under section 78. Both the foreign taxes deemed

paid and the deemed dividend are subject to a separate limitation

for dividends from noncontrolled section 902 Corporation A. As of

January 1, 1988, Corporation A has (50u) in its post-1986

undistributed earnings (50u-100u) and -0- in its post-1986 foreign

income taxes, $120 reduced by $120 of foreign taxes that would have

been deemed paid had section 902 applied to the entire dividend out

of post-1986 undistributed earnings ($120 x 100%[50u/50u]).

(iii) On December 31, 1989, Corporation A distributes a 10u

dividend to Corporation M and a 90u dividend to Corporation Z.

Although the distribution is considered a dividend in its entirety

out of 1989 earnings and profits pursuant to section 316(a)(2),

post-1986 undistributed earnings are (100u). Accordingly, for

purposes of section 902, no portion of the dividend is deemed to be

out of post-1986 undistributed earnings, and Corporation M is deemed

to have paid no post-1986 foreign income taxes. See Sec. 1.902-

1(b)(4). Corporation A's post-1986 undistributed earnings as of

January 1, 1990, are (200u) ((100u)-100u). Corporation A's post-1986

foreign income taxes are not reduced because no taxes were deemed

paid.

(iv) On December 31, 1990, Corporation A distributes a 5u

dividend to Corporation M and a 45u dividend to Corporation Z. At

that time Corporation A has 50u of post-1986 undistributed earnings,

and $150 of post-1986 foreign income taxes. Foreign taxes deemed

paid by Corporation M under section 902 with respect to the 5u

dividend are $15 ($150 x 10%[5u/50u]). Post-1986 undistributed

earnings as of January 1, 1991, are -0- (50u-50u). Post-1986 foreign

income taxes as of January 1, 1991, also are -0-, $150 reduced by

$150 ($150 x 100%[50u/50u]) of foreign income taxes that would have

been deemed paid had section 902 applied to the entire dividend of

50u.

Par. 4. Newly designated Sec. 1.902-3 is amended by revising the

section heading, paragraph (a) introductory text, and paragraph (l) to

read as follows:

Sec. 1.902-3 Credit for domestic corporate shareholder of a foreign

corporation for foreign income taxes paid with respect to accumulated

profits of taxable years of the foreign corporation beginning before

January 1, 1987.

(a) Definitions. For purposes of section 902 and Secs. 1.902-3

through 1.902-4--

* * * * *

(l) Effective date. Except as provided in Sec. 1.902-4, this

section applies to any distribution received from a first-tier

corporation by its domestic shareholder after December 31, 1964, and

before the beginning of the foreign corporation's first taxable year

beginning after December 31, 1986. If, however, the first day on which

the ownership requirements of section 902(c)(3)(B) and Sec. 1.902-1(a)

(1) through (4) are met with respect to the foreign corporation is in a

taxable year of the foreign corporation beginning after December 31,

1986, then this Sec. 1.902-3 shall apply to all taxable years beginning

after December 31, 1964, and before the year in which the ownership

requirements are first met. See Sec. 1.902-1(a)(13)(iii). For

corresponding rules applicable to distributions received by the

domestic shareholder prior to January 1, 1965, see Sec. 1.902-5 as

contained in the 26 CFR part 1 edition revised as of April 1, 1976.

Margaret Milner Richardson,

Commissioner of Internal Revenue

[FR Doc. 95-173 Filed 1-5-95; 8:45 am]

BILLING CODE 4830-01-U