Definition of a Controlled Foreign Corporation, Foreign Base Company Income and Foreign Personal Holding Company Income of a Controlled Foreign Corporation

Federal RegisterSep 7, 1995

Ask Donna

What actually matters in this document.

Text

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 4 and 602

[TD 8618]

RIN 1545-AM15

Definition of a Controlled Foreign Corporation, Foreign Base

Company Income and Foreign Personal Holding Company Income of a

Controlled Foreign Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

SUMMARY: This document contains final Income Tax Regulations governing

the definition of a controlled foreign corporation and the definitions

of foreign base company income and foreign personal holding company

income of a controlled foreign corporation. These regulations are

necessary because of changes made to the prior law by the Tax Reform

Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the

Revenue Reconciliation Act of 1989, and the Omnibus Budget

Reconciliation Act of 1993. Certain conforming changes in the

regulations were necessary because of changes made by the Deficit

Reduction Act of 1984. The regulations will provide the public with the

guidance to comply with those acts and will affect United States

shareholders of controlled foreign corporations.

DATES: These regulations are effective September 7, 1995.

For dates of applicability, see Sec. 1.954-0(a).

FOR FURTHER INFORMATION CONTACT: Valerie Mark of the Office of

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

Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW.,

Washington, DC 20224 (Attention CC:INTL:2 (INTL-0362-88). Telephone

(202) 622-3840 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations

has been reviewed and approved by the Office of Management and Budget

(OMB) in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C.

3504(h)) under control number 1545-1068. The estimated average burden

per respondent associated with the collection of information in this

regulation is one hour.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be directed to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,

Washington, DC 20224, and to the Office of Management and Budget, Attn:

Desk Officer for the Department of the Treasury, Office of Information

and Regulatory Affairs, Washington, DC 20503.

Background

This document contains final regulations amending the Income Tax

Regulations (26 CFR Part 1) under sections 954(b), 954(c) and 957(a) of

the Internal Revenue Code (Code). Sections 954 and 957 were amended by

sections 1201, 1221, 1222 and 1223 of the Tax Reform Act of 1986 (Pub.

L. 99-514), by section 1012 of the Technical and Miscellaneous Revenue

Act of 1988 (Pub. L. 100-647), by section 7811 of the Revenue

Reconciliation Act of 1989 (Pub. L. 101-239) and by section 13233 of

the Omnibus Budget Reconciliation Act of 1993 (Pub. L. 103-66). These

regulations are also issued under authority contained in section 7805

of the Code.

Temporary regulations (TD 8216) and a cross-referenced notice of

proposed rulemaking (INTL-362-88) under sections 954 and 957 of the

Code were published in the Federal Register on July 21, 1988 (53 FR

27489 and 53 FR 27532, respectively). Numerous written comments on the

proposed and temporary regulations were received from the public. As

explained below,

[[Page 46501]]

the comments were considered in the drafting of the final regulations.

Discussion of Major Comments and Changes to the Regulations

Section 1.954-1: Foreign Base Company Income

Section 1.954-1T(a)(3) and (5) (temporary regulations) apply the de

minimis and full inclusion tests of section 954(b)(3) before the high

tax exception of section 954(b)(4). Commenters have expressed concern

that, in certain cases, the only amounts required to be included in the

gross income of the United States shareholders of a controlled foreign

corporation may be full inclusion income. This result may occur when

subpart F income, other than full inclusion foreign base company

income, qualifies for the high tax exception. In response to these

comments, Sec. 1.954-1(d)(6) provides that an amount that otherwise

would be included as full inclusion foreign base company income,

pursuant to the operation of the full inclusion test of section

954(b)(3)(B), will be excluded from full inclusion foreign base company

income if more than 90 percent of the adjusted gross foreign base

company and adjusted gross insurance income qualifies for the high tax

exception described in section 954(b)(4) and the high tax election is

actually made.

Section 1.954-1T(a)(4) provides that in computing net foreign base

company income, foreign personal holding company income is reduced by

related person interest expense before allocating and apportioning

other expenses in accordance with Sec. 1.904(d)-5(c)(2). Commenters

understood this rule to be at variance with Sec. 1.904(d)-5(c)(2),

which requires related person interest expense to be allocated to

passive foreign personal holding company income after the allocation of

directly related expenses. In response to this comment, the rule

regarding allocation of related person interest expense was removed

from Sec. 1.954-1T(a)(4) and (c) was amended to clarify that foreign

base company income is reduced by directly related expenses before

passive foreign personal holding company income is reduced by related

person interest expense.

Section 1.954-1T(a)(7) treats amounts recharacterized as foreign

base company income or insurance income under section 952(c) as

adjusted net foreign base company income or adjusted net insurance

income. Thus, these amounts are not included in net foreign base

company income or net insurance income for purposes of applying the

high tax exception. Commenters argued that the rules of paragraph

(a)(7) should be amended to provide that amounts that are

recharacterized under section 952(c)(2) should not be treated as

adjusted net foreign base company income or adjusted net insurance

income if the amounts would have qualified for the high tax exception.

This comment was rejected because section 952(c)(2) does not

incorporate the exclusions and special rules of section 954(b)(4).

Additional rules regarding the coordination of sections 952(c) and 954

are being proposed under section 952 in a separate document published

elsewhere in this issue of the Federal Register.

Several comments were made concerning the anti-abuse rules of

Sec. 1.954-1T(b)(4), which require aggregation of gross income of

related controlled foreign corporations for purposes of the de minimis

and full inclusion tests. One comment suggested that the aggregation

rules of paragraph (b)(4) should be applied only if a purpose of first

importance (as opposed to a principal purpose) is to avoid the

application of the de minimis or full inclusion tests described in

section 954(b)(3). This comment was rejected because the standard

suggested is significantly more subjective than that of the regulations

and is therefore unadministrable. However, it was determined that it

was unnecessary to make the aggregation rules of paragraph (b)(4)

applicable to the full inclusion test, for which there is not the same

opportunity for tax avoidance.

One commenter suggested that the anti-abuse rules of Sec. 1.954-

1T(b)(4) should be amended to provide that the gross income of separate

controlled foreign corporations is aggregated only if a substantial

portion of the activities of the separate corporations would comprise a

single branch, and that the presumptions described in paragraph

(b)(4)(ii) should be eliminated. The commenter also suggested that the

definition of related person for purposes of these rules should refer

to the provisions of section 954(d)(3), rather than the broader

provisions of section 267. These comments were rejected because the

suggested amendments would unduly restrict the application of the anti-

abuse rules. The presumptions described in paragraph (b)(4)(ii) may be

rebutted, for example, by establishing reliance on the requirements of

foreign law. The anti-abuse rules are necessary to prevent the misuse

of the de minimis rule of section 954(b)(3), and do not impose a

significant limitation or burden on the activities of controlled

foreign corporations.

Section 1.954-1T(c) provides that in computing net foreign base

company income, the gross amount in each category of foreign base

company income may not be reduced below zero. Section 1.954-2T(e)

provides that the excess of losses over gains from the sale or exchange

of certain property may not be allocated to any other category of

foreign personal holding company income. Section 1.954-2T (f) and (g)

contain similar provisions with regard to excess losses from

commodities and foreign currency transactions, respectively. Because

the categories of foreign base company income described in section

954(a) and the categories of foreign personal holding company income

described in section 954(c)(1) (B), (C) and (D) are defined in terms of

net income, the temporary regulations interpreted the statutory scheme

as generally precluding the allocation of excess losses from categories

of foreign personal holding company income described in paragraph (e),

(f), or (g) against other foreign personal holding company income

categories. Commenters contended that by preventing any category of

subpart F income from being reduced below zero, paragraph (c) caused

inappropriate tax credit results and failed to harmonize the subpart F

provisions with section 904(f)(5). Commentators stated that paragraphs

(e), (f) and (g) should be amended to allow excess losses described in

those paragraphs to be allocated to other categories of foreign

personal holding company income.

Paragraph (c) has been amended to clarify that, in determining net

income, if the amount in any category of foreign base company income

(including any category of foreign personal holding company income) is

less than zero, the loss may not reduce any other categories of foreign

base company income (or foreign personal holding company income) except

by operation of the earnings and profits limitation. Proposed

regulations published elsewhere in this issue of the Federal Register

will provide rules concerning the application of the earnings and

profits limitation.

Section 1.954-1T(d) provides that the effective rate of foreign

income tax on an item of income is determined in a manner consistent

with the existing foreign tax credit regime under sections 904 and 960.

In some cases, the amount of an item of income for foreign law purposes

with respect to which foreign income tax is paid will be different from

the amount for United States tax purposes. As a result, the effective

rate of tax with respect to the item of income may be affected. In

addition, because

[[Page 46502]]

pursuant to section 960 the foreign income taxes of a controlled

foreign corporation more than three tiers below a United States

shareholder are not considered, the high tax exception will never apply

to items of income of such corporations.

Commenters suggested that certain foreign law accounting practices

should be considered in determining the effective rate of tax on an

item of income, for purposes of applying the high tax exception of

section 954(b)(4) and paragraph (d) of the regulations. Commenters also

contended that it is inappropriate to use section 960 to determine the

effective rate of foreign tax and thus prevent consideration of taxes

paid by controlled foreign corporations more than three tiers below the

United States shareholder.

The comment that the high tax exception should not be limited to

creditable taxes under section 960 was rejected. The high tax exception

is not intended to apply to the extent that an item of income would be

subject to residual United States tax if such item were included in the

gross income of the United States shareholder. The taxes paid with

respect to such item of income should be considered for purposes of the

high tax exception only to the extent they are otherwise considered for

United States taxing purposes. See Joint Committee on Taxation Staff,

General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess.

970-71 (1986).

The comment that foreign law accounting practices should be

considered in determining the effective rate of tax on an item of

income, for purposes of applying the high tax exception, was also

rejected. Such a rule would impose a significant burden on the IRS. It

would require the IRS to monitor and apply foreign tax and accounting

principles, and to reconcile their application with United States tax

and accounting principles, both in the current tax year and in later

tax years to prevent an item of income, deduction, credit, gain or loss

from being duplicated or omitted. Further, the IRS would have to

consider and identify the particular foreign tax and accounting

principles that could be taken into account for purposes of these

rules.

Section 1.954-1T(d)(4) defines the term item of income for purposes

of the high tax exception by reference to the foreign tax credit and

subpart F income categories to which the income relates. Thus, it is

possible that amounts attributable to separate transactions may be

included in the same item of income. If the income from the separate

transactions were subject to foreign income tax at different rates, the

effective rate of tax for the income item would reflect an average of

the two (or more) rates of tax. One commenter has suggested that

additional categories of income be created within the existing foreign

tax credit and subpart F income groups to limit the effect of this tax

rate blending.

The regulations rely on existing guidance under the foreign tax

credit and subpart F provisions generally to define item of income for

purposes of section 954(b)(4). To identify items of income on a

transaction-by-transaction basis is inconsistent with the separate

limitation categories of income described in section 904, and adds

complexity by requiring different computations for purposes of these

rules and the rules under the foreign tax credit provisions of the

Code. Moreover, there is no bias in the existing rules toward a

particular result.

Commenters suggested that the consistency rule of Sec. 1.954-

1T(d)(4)(ii)(B) be eliminated, to allow taxpayers to apply the high tax

exception on an item-by-item basis. The consistency rule prohibits a

taxpayer from selectively applying the high tax exception with respect

to foreign personal holding company income that is passive income under

section 904(d). Elimination of the consistency rule would provide a

result that is incompatible with the foreign tax credit provisions of

the Code, and thus the comment was rejected.

The final regulations clarify how the rules of paragraph (d)

coordinate with the earnings and profits limitation of section

952(c)(1). Under Sec. 1.954-1(d)(4)(ii), if the amount of income

included in subpart F income for the taxable year is reduced by the

earnings and profits limitation, the amount of income that is an item

of income, for purposes of paragraph (d), is determined after the

application of the rules of section 952(c)(1). An example was added to

illustrate this rule.

Section 1.954-1T(d)(5) provides that the election to apply the high

tax exception must be made by the controlling United States

shareholders and is binding on all United States shareholders of the

controlled foreign corporation. Commenters argued that the Secretary

does not have the authority to bind all United States shareholders to a

single election. This comment was rejected because it was determined

that section 954(b)(4) provides the authority. Further, allowing each

United States shareholder to separately elect the high tax exception

would add undue complexity to the operation of the foreign tax credit

rules.

Section 1.954-1(f) provides guidance on the definition of related

person under section 954(d)(3).

Section 1.954-2: Foreign Personal Holding Company Income

Section 1.954-2T(a)(2)(i) provides that amounts that fall within

the definition of income equivalent to interest, under paragraph (h),

will be so treated though such amounts may also fall within the

definition of gain from certain property transactions under paragraph

(e), gain from a commodities transaction under paragraph (f) or foreign

currency gain under paragraph (g). Paragraph (a)(2)(i) provides that

amounts will be treated as income equivalent to interest even if these

amounts are excluded from the computation of foreign personal holding

company income under paragraphs (e), (f), or (g) because they are

derived from certain qualifying business transactions. A commenter

suggested that paragraph (a)(2)(i) should not treat income from

qualifying business transactions excluded under paragraphs (e), (f), or

(g) as income equivalent to interest. This comment was rejected. The

rules regarding qualifying business transactions in paragraphs (e), (f)

and (g) do not operate to exclude interest income from characterization

as foreign personal holding company income. Income equivalent to

interest within the meaning of section 954(c)(1)(E) and paragraph (h)

generally should be treated like interest for purposes of subpart F.

Several commenters suggested that the test described in Sec. 1.954-

2T(a)(3) to determine the use for which property is held (for purposes

of determining the character of the income, gain or loss realized from

a disposition of such property) should not focus solely on the use of

the property immediately prior to its disposition, but instead should

consider the predominant use for which the property was held. This

comment was accepted. Section 1.954-2(a)(3) provides that the use for

which property is held is the use for which it was held for more than

one-half of the period during which the controlled foreign corporation

held the property. If there has been a change in use, however, and a

principal purpose for such change in use was to avoid characterizing

income or gain attributable to the property as foreign personal holding

company income, then the change in use will be disregarded.

Section 1.954-2T(a)(3)(ii), Examples 2 and 3 illustrate the rules

regarding change in use for which property is

[[Page 46503]]

held. The final regulations delete these examples because Example 1

sufficiently illustrated the rules of this paragraph. Examples 4 and 5

of paragraph (a)(3)(ii) illustrate the change in use rules with respect

to hedging transactions. The final regulations delete these examples

because the rules governing hedging transactions are now generally

contained in paragraph (a)(4)(ii).

Section 1.954-2T(a)(4)(i) lists some of the types of income that

are included in the term interest. To clarify that this list was not

meant to be exclusive, paragraph (a)(4)(i) has been amended to provide

that the term interest includes all amounts that are treated as

interest (including tax-exempt interest) under the Code and regulations

or any other provision of law. A new sentence illustrates the types of

income that would be treated as interest.

Section 1.954-2T(a)(4)(ii) provides that certain hedging

transactions that reduce the risk of price changes in the cost of

inventory and similar property are included within the definition of

inventory and similar property if certain requirements are met and if

they are so identified by the fifth day after which they are entered

into. Paragraphs (f)(4) and (g)(4) of the temporary regulations contain

definitions of the term qualified hedging transaction that have similar

five-day identification requirements. These several definitions of a

hedging transaction have been consolidated in Sec. 1.954-2(a)(4)(ii)

which contains a definition of bona fide hedging transaction and new

identification requirements for bona fide hedging transactions that

apply for purposes of computing foreign personal holding company income

under Sec. 1.954-2.

Section 1.954-2(a)(4)(ii)(A) generally defines a bona fide hedging

transaction as a transaction that meets the requirements of

Sec. 1.1221-2 (a) through (c) with two exceptions. First, the risk

being hedged may be with respect to ordinary property, section 1231

property or a section 988 transaction. Second, a transaction that

hedges the liabilities, inventory or other assets of a related person,

or that is entered into to assume or reduce risks of a related person,

will not be treated as a bona fide hedging transaction. Several

commenters had sought to expand the definition of qualified hedging

transactions to include hedging transactions conducted by a controlled

foreign corporation that is a currency coordination center, i.e., a

controlled foreign corporation that aggregates the currency exposures

of related controlled foreign corporations and hedges such exposures.

The statute provides, however, that a transaction must satisfy the

business needs of the particular controlled foreign corporation. See

also Joint Committee on Taxation Staff, General Explanation of the Tax

Reform Act of 1986, 99th Cong., 2d Sess. 976 (1986).

Section 1.954-2(a)(4)(ii)(B) provides identification requirements

for a bona fide hedging transaction. The same-day identification and

the recordkeeping requirements of Sec. 1.1221-2 apply for transactions

entered on or after March 7, 1996. For bona fide hedging transactions

entered into prior to this date and after July 22, 1988, the

transaction must be identified by the close of the fifth day after the

day on which it is entered into. For bona fide hedging transactions

entered into prior to July 22, 1988, the transaction must be identified

reasonably contemporaneously with the date it is entered into but no

later than within the normal period prescribed under the method of

accounting of the controlled foreign corporation used for financial

reporting purposes.

Section 1.954-2(a)(4)(ii)(C) describes the treatment of

transactions that are misidentified as hedging transactions, and

hedging transactions that the taxpayer fails to identify as such.

Paragraph (a)(4)(ii)(C) also provides relief for taxpayers that have

identified, or failed to identify, a hedging transaction due to

inadvertent error. These misidentification rules are substantially

similar to the rules in Sec. 1.1221-2(f), modified for purposes of the

subpart F regime.

Section 1.954-2T(a)(4)(iii) defines regular dealer, and states

that, ``purchasing and selling property through a regulated exchange or

off-exchange market (for example, engaging in futures transactions) is

not actively engaging as a merchant'' for purposes of these rules. This

provision was intended to mean that such purchasing and selling

activity alone, in the absence of other activities, will not qualify a

controlled foreign corporation as a regular dealer within the meaning

of paragraph (a)(4)(iii). Because commenters indicated that this

reference to purchasing and selling through a regular exchange or off-

exchange market was confusing, this provision was removed. Further, the

definition of regular dealer was amended. Section 1.954-2(a)(4)(iv)

provides that a controlled foreign corporation will be a regular dealer

if it regularly and actively offers to, and in fact does, engage in

certain specified activities with customers who are not related persons

(as defined in section 954(d)(3)) with respect to the CFC. Examples

were added to clarify that a controlled foreign corporation that

qualifies as a dealer under Sec. 1.954-2(a)(4)(iv) will not be

disqualified from being treated as a regular dealer because it also

engages in transactions with related persons.

The temporary regulations define dealer property as property held

by a controlled foreign corporation that is a regular dealer in

property of such kind in its capacity as a dealer. The temporary

regulations also state that property held for investment or speculation

is not dealer property. A commenter suggested that property should be

considered dealer property within the meaning of Sec. 1.954-

2T(a)(4)(iv) if the controlled foreign corporation holding the property

is a regular dealer in such property. This comment was rejected because

it proposes an unduly expansive definition of dealer property.

Paragraph (a)(4), therefore, generally continues to define dealer

property in the same manner as the temporary regulations.

The final regulations do clarify, however, that if a controlled

foreign corporation qualifies as a regular dealer, all of the property

held in a dealer capacity by that corporation is treated as dealer

property. Thus, dealer property includes property arising from a

transaction entered into with a related person, as long as the

controlled foreign corporation is a regular dealer and holds the

property in its capacity as a dealer, and not for investment or

speculation. The examples of Sec. 1.954-2(a)(4)(vi) illustrate this

rule. A rule has been added for licensed securities dealers under which

only securities identified as held for investment under section 475(b)

or 1236 will be treated as held for investment or speculation. Also, to

conform to amendments to section 954(c)(1)(B) made by the Technical and

Miscellaneous Revenue Act of 1988, Sec. 1.954-2(a)(4)(v)(C) provides

that a bona fide hedging transaction with respect to dealer property is

treated as a transaction in dealer property.

Section 954(c)(2)(B) and Sec. 1.954-2T(b)(2) exclude from foreign

personal holding company income export financing interest that is

derived in the active conduct of a banking business. A commenter

suggested that paragraph (b)(2) should treat a controlled foreign

corporation as engaged in the conduct of a banking business even if it

transfers the servicing of loans to related or unrelated parties. This

comment was rejected because servicing of loans is a fundamental

element of banking activity that gives rise to export financing

interest for which an exception from foreign personal holding company

income is intended.

[[Page 46504]]

Section 1.954-2T(b)(2) references the definition of export

financing interest contained in section 904(d)(2)(G). Under section

904(d)(2)(G), the property that is financed must be manufactured,

produced, grown or extracted in the United States by the taxpayer or a

related person. Section 1.954-2(b)(2) clarifies that Sec. 1.927(a)-

1T(c)(1) applies for purposes of determining whether property is

manufactured, produced, grown or extracted in the United States.

Section 1.954-2T(b)(2) also provides that the term export financing

interest does not include income from related party factoring that is

treated as interest under section 864(d)(1) or (6). The final

regulations contain examples that clarify that if amounts are not

treated as interest under section 864(d)(1) or (6) because the

exception under section 864(d)(7) applies, these amounts may be export

financing interest under paragraph (b)(2).

Section 954(c)(3)(A) and Sec. 1.954-2T(b) (3) and (4) provide that

certain dividend, interest, rent or royalty income received from

related corporate payors is not included in foreign personal holding

company income. To reflect amendments to section 954(c)(3)(A) by the

Revenue Reconciliation Act of 1989, the final regulations provide that

if a partnership with one or more corporate partners makes a payment of

interest, rent or royalties, the interest, rent or royalty payment will

be treated as paid by a corporate partner to the extent the payment

gives rise to a partnership item of deduction that is allocable to the

corporate partner or to the extent that a partnership item reasonably

related to the payment would be allocated to the corporate partner

under an existing allocation under the partnership agreement. To the

extent the payment is treated as made by the corporate partner, it will

be excluded from the foreign personal holding company income of the

recipient if the corporate partner otherwise satisfies the conditions

of section 954(c)(3)(A).

Under Sec. 1.954-2T(b)(3)(ii), interest may not be excluded from

foreign personal holding company income of the recipient to the extent

the deduction for interest is allocated to the payor's subpart F

income. To clarify how this rule is to be applied when a controlled

foreign corporation is both the recipient and payor of interest,

Sec. 1.954-2(b)(4)(ii)(B)(2) was added, which parallels the rule

contained in Sec. 1.904-5(k)(2).

Section 1.954-2T(b)(3) provides that, to exclude dividends and

interest received from related corporate payors from foreign personal

holding company income, a substantial part of the payor's assets must

be used in a trade or business in the payor's country of incorporation.

Section 1.954-2T(b)(3)(iv) provides that a substantial part of the

payor's assets will be considered to be used in a trade or business in

the payor's country of incorporation if, for each quarter of the

taxable year, the average value of its assets which are so used is over

50 percent of the average value of all of its assets (determined as of

the beginning and end of the quarter). To simplify the application of

this rule, Sec. 1.954-2(b)(4)(iv) provides that the average value of

assets is to be determined on a yearly rather than a quarterly basis by

averaging the values of assets as of the close of each quarter.

Section 1.954-2T(b)(3)(vi)(A) provides that for purposes of the

substantial assets test, tangible property (other than inventory) is

generally considered located where it is physically located. Paragraph

(b)(3)(vi)(B) contains an exception for property temporarily located

elsewhere for inspection or repair. A commenter suggested that, in

addition to this exception, the regulations should restore the

exception contained in prior regulations that treated purchased

property located abroad and intended for prompt shipment to the country

of incorporation as property located in the country of incorporation.

This comment was rejected because this provision would have been

inconsistent with the rule that property purchased for use in a trade

or business is not considered used in a trade or business until it is

placed in service.

Section 1.954-2T(b)(3)(vii)(A) provides that for purposes of the

substantial assets test, the location of intangible property is

determined based on the site of the activities conducted by the payor

during the taxable year in connection with the use or exploitation of

the property. The country in which services are performed is determined

under the principles of section 954(e) and Sec. 1.954-4(c). This rule

was amended to provide more comprehensive guidance to determine the

situs of activities in connection with the use or exploitation of

intangible property. Section 1.954-2(b)(4)(vii)(B) provides that the

country in which the activities connected to the use or exploitation of

property are conducted is the country in which the expenses associated

with these activities are incurred by the payor or its agent or an

independent contractor.

Section 1.954-2T(b)(3)(vii)(A) provides that the intangible

property is considered located in the payor's country of incorporation

during each quarter of the taxable year if the activities connected

with its use or exploitation are conducted in its country of

incorporation during the entire taxable year. A commenter argued that

this test is inconsistent with the quarterly determination required by

the substantial assets test of Sec. 1.954-2T(b)(3)(iv). Changes were

made to the location of property rules (Sec. 1.954-2(b)(4)(vi) through

(ix)) so that relevant determinations are made for each quarter

separately.

The final regulations continue to reserve on the provision of

special rules regarding the location of assets of banks and insurance

companies for purposes of the same-country exception. Comments are

invited regarding the need for special guidance on this issue.

Several comments questioned the application of the rules of

Sec. 1.954-2T(b)(6), pursuant to which interest income of a controlled

foreign corporation that is described in section 103 is included in

foreign personal holding company income but is characterized as tax-

exempt interest when included in the gross income of the United States

shareholders. The purpose of this rule was to prevent a person from

avoiding the consequences of the alternative minimum tax provisions by

investing in tax-exempt obligations described in section 103 through a

controlled foreign corporation.

The final regulations reserve on the treatment of tax-exempt

interest. The administrative complexity of applying the rule described

in the temporary regulations, and the potential for double taxation

that it creates, argue against its continued application. Proposed

regulations, published elsewhere in this issue of the Federal Register,

will provide rules regarding the treatment of tax-exempt interest. In

the interim, the rules of the temporary regulations continue to apply.

Section 1.954-2T(b)(5) provides that the determination whether

rents and royalties are derived from the active conduct of a trade or

business is made under the facts and circumstances of each case, and

refers to paragraphs (c) and (d) for the application of its provisions.

Commenters have asked whether only the facts and circumstances

described in paragraphs (c) and (d) may be considered. The final

regulations are clarified to reflect that whether rents or royalties

are derived in the active conduct of a trade or business is determined

solely under the provisions of paragraphs (c) and (d).

Section 1.954-2T(c)(2)(iii) defines active leasing expenses for

purposes of

[[Page 46505]]

determining whether rental income is derived in the active conduct of a

trade or business. A commenter suggested that paragraph (c)(2)(iii) be

amended to state that if a corporation sells property of the same type

as the property that is leased, the corporation's expenses that are of

the type described in that paragraph may be pro-rated on any reasonable

basis between the leasing and the sales function. It was determined

that the change requested by this commenter was unnecessary because

paragraph (c)(2)(iii) already defines active leasing expenses as

deductions properly allocable to rental income.

A commenter suggested that an example be added to Sec. 1.954-2T(c)

to illustrate that expenses such as payments to third parties for

insurance, utilities and repairs are considered active leasing expenses

and not amounts paid to agents or independent contractors. The

regulations were amended in response to this comment. Section 1.954-

2(c)(2)(iii)(D) provides that the term active leasing expenses does not

include payments to agents or independent contractors other than

payments for insurance, utilities and other expenses for like services

or capitalized property. A similar change was made to the definition of

the term adjusted leasing profit.

Section 954(c)(1)(B) and Sec. 1.954-2T(e) include in foreign

personal holding company income the excess of gains over losses from

certain property transactions. Section 1.954-2T(e)(1)(i) provides that

gain or loss that is treated as capital gain or loss under section

988(a)(1)(B) is not foreign currency gain or loss but rather gain or

loss from a property transaction under paragraph (e). A commenter

contended that gain or loss from transactions described in section

988(a)(1)(B) should be characterized as gain or loss described in

section 954(c)(1)(C) and Sec. 1.954-2T(f) rather than in section

954(c)(1)(B) and paragraph (e). This comment was rejected, because the

capital transactions described in section 988(a)(1)(B) are more

appropriately subject to the provisions of section 954(c)(1)(B) and

paragraph (e). This provision is now contained in Sec. 1.954-2(g)(5).

A commenter asked that gain from a disposition of stock of a

subsidiary be excluded from foreign personal holding company income to

the extent that gain from the subsidiary's disposition of its assets

would be so excluded. There is no statutory authority for the position

recommended by the commenter, however. In addition, the look-through

treatment proposed by the commenter is inconsistent with the treatment

prescribed for dispositions of interests in a partnership or trust

under section 954(c)(1)(B)(ii). For these reasons, the comment was

rejected.

Pursuant to Sec. 1.954-2T(e)(3)(vi), gain from a disposition of

non-depreciable intangible property or goodwill is characterized as

foreign personal holding company income unless the intangible property

is disposed of in connection with a disposition of the entire trade or

business of the controlled foreign corporation. Commenters have argued

that the gain should be excluded from foreign personal holding company

income if such property is used in the trade or business of the

controlled foreign corporation, without regard to whether an entire

trade or business of the controlled foreign corporation is sold.

The regulations were modified in response to this comment. Section

1.952-2(e)(3)(iv) excludes from foreign personal holding company income

any gain or loss of a controlled foreign corporation from a disposition

of intangible property, goodwill or going concern value to the extent

used or held for use in the trade or business of the controlled foreign

corporation.

Section 1.954-2T(e)(4) provides that gain or loss from the sale,

exchange or retirement of a debt instrument is included in the

computation of foreign personal holding company income under paragraph

(e) with certain exceptions. However, a loss on a debt instrument taken

in consideration for the sale or exchange of property is excluded from

foreign personal holding company income if the gain or loss from that

underlying sale or exchange is not includible in foreign base company

income. This rule was eliminated from the final regulations because it

was inconsistent to prevent a controlled foreign corporation from using

these losses to offset subpart F income when gain from such debt

instruments was not excepted from the general inclusion rule.

Section 1.954-2T(e)(5) provides that rights to acquire property,

other than certain property that is dealer property or inventory

property, are characterized as property that does not give rise to

income for purposes of section 954(c)(1)(B). One commenter has

suggested that such rights should not be characterized as property that

does not give rise to income. This comment was rejected because any

gain that may arise upon a disposition of an option, warrant, or other

right to acquire property, other than gain from a disposition of

inventory or dealer property, is income of the type intended to be

characterized as foreign personal holding company income for purposes

of section 954(c)(1)(B). The provisions of Sec. 1.954-2T(e)(5) are now

incorporated into the definition of property that does not give rise to

income under Sec. 1.954-2(e)(3). However, the final regulations clarify

that notional principal contracts are excluded from the definition of

property that does not give rise to income. (But see Sec. 1.954-2 (f),

(g) and (h).)

Section 954(c)(1)(C) and Sec. 1.954-2T(f) provide rules for

including the excess of gains over losses from commodities transactions

in foreign personal holding company income. Several commenters argued

that Sec. 1.954-2T(f)(2)(i) defines commodity too broadly, and that,

like sections 553 and 864, the regulations should apply only to

commodities that are actively traded on a regulated exchange. This

comment was rejected because the statute and its legislative history

make clear that section 954(c)(1)(C) is intended to apply broadly to

any commodity of a kind that is actively traded. Thus, there is no

reason to distinguish income from a disposition of a commodity actively

traded on a regulated exchange from income from a disposition of a

commodity of a kind that is otherwise actively traded.

Although Sec. 1.954-2(f)(2)(i) no longer explicitly provides that

nonfunctional currency is a commodity, nonfunctional currency continues

to fall within the general definition of commodity. Consequently,

foreign currency is still treated as a commodity if the currency is

actively traded or if contractual interests in the currency are

actively traded. Under the ordering rules of paragraph (a)(2), however,

paragraph (g) (foreign currency transactions) continues to apply before

paragraph (f). Thus, unless an election is made under section

988(c)(1)(D)(ii), a currency futures contract is treated as a

commodities transaction, while a currency forward contract is generally

treated as a foreign currency transaction.

Section 1.954-2T(f)(1) excludes gains and losses from qualified

active sales and qualified hedging transactions from the computation of

foreign personal holding company income under paragraph (f). In

defining qualified active sale, paragraph (f)(3) requires substantially

all of the controlled foreign corporation's business to be as an active

producer, processor, merchant or handler of commodities of like kind.

Commenters argued that by using the phrase ``of like kind,''

Sec. 1.954-2T(f)(3) defines qualified active sales too narrowly. The

``of like kind'' language was not intended to require that all of the

commodities be of one kind, but

[[Page 46506]]

rather that the controlled foreign corporation must be an active

producer, etc., with respect to each kind of commodity. To avoid

confusion, the ``of like kind'' language has been eliminated from the

definition of the term qualified active sale.

Section 1.954-2T(f)(3)(ii) defines the term sale of commodities.

Commenters questioned the requirement, incorporated in the definition

of this term, that the corporation hold the commodity in physical form.

This comment was accepted. The final regulations no longer require the

controlled foreign corporation to hold the commodity in physical form.

Section 1.954-2(f)(2)(iii)(B) requires only that the controlled foreign

corporation hold the commodity directly and not through an independent

contractor. The retention of this requirement is consistent with the

legislative history of section 954(c)(1)(C), which makes clear that the

exclusion from foreign personal holding company income was intended to

apply only with respect to commodities for which controlled foreign

corporations are active producers, processors, handlers or merchants.

Section 1.954-2(f)(2)(iii)(D) provides that activities of employees of

entities related to the controlled foreign corporation may be treated

as activities directly engaged in by the controlled foreign corporation

if the employees are paid and supervised by the controlled foreign

corporation.

Section 1.954-2(f)(2)(iii)(B) also amends the definition of the

term active conduct of a commodities business by clarifying that the

requirements specified in that paragraph must be satisfied with respect

to each commodity and that property may be held either as dealer

property or as inventory or similar property.

Section 954(c)(1)(C)(ii) and Sec. 1.954-2T(f) (1) and (3) exclude

income attributable to commodities transactions from foreign personal

holding company income if substantially all of the business of a

controlled foreign corporation is as an active producer, processor,

merchant or handler of commodities. Section 1.954-2T(f)(3)(iv) provides

that the controlled foreign corporation will satisfy the substantially

all requirement if 85 percent of its taxable income for the taxable

year is attributable to qualified active sales and qualified hedging

transactions. Several commenters argued that this test could fail to

reflect the nature of the controlled foreign corporation's business

accurately in some years because of the volatility of certain

commodities markets.

To accommodate this concern, Sec. 1.954-2(f)(2)(iii)(C) modifies

the definition of the term substantially all by applying the 85 percent

test to gross receipts rather than taxable income. To prevent

manipulation of this modified test, a provision was added under which

the District Director may disregard any sale or hedging transaction

that has as a principal purpose manipulation of the 85 percent test.

Section 1.954-2T(f)(4) defines the term qualified hedging

transaction as a bona fide hedging transaction that is entered into

primarily to reduce the risk of price change with respect to

commodities sold or to be sold in qualified active sales. A commenter

argued that a bona fide hedging transaction should not be required to

relate to a qualified active sale to be treated as a qualified hedging

transaction. This comment was rejected because this provision is based

on the statutory requirement that qualified hedging transactions must

arise out of the business of the controlled foreign corporation as an

active producer, processor, merchant or handler of commodities. Thus,

the rule of the temporary regulations is retained.

Section 954(c)(1)(D) and Sec. 1.954-2T(g) include in foreign

personal holding company income the net foreign currency gains

attributable to section 988 transactions. The rules in Sec. 1.954-

2T(g)(2)(i) governing the treatment of gain or loss attributable to

foreign currency transactions in hyperinflationary currencies have been

removed. Section 1.954-2(g)(5)(iii) provides that the applicable rules

of section 985 will apply to such transactions.

Section 1.954-2T(g)(2)(ii) excludes from foreign personal holding

company income gain or loss from qualified business transactions that

are separately identified, and gain or loss from qualified hedging

transactions that are identified with, or traced to, a qualified

business transaction. Many commenters argued that these rules are too

cumbersome to apply. They contended that a controlled foreign

corporation that has a large number of qualified business transactions

may not hedge such transactions individually, and that it is difficult

or impossible in such cases to relate a hedge to one or even several

qualified business transactions. The commenters also argued that the

alternative election to treat all currency gain (or loss) as foreign

personal holding company income (or loss allocable to foreign personal

holding company income) does not provide adequate relief for controlled

foreign corporations whose hedging activities relate to qualified

business transactions on a net basis but give rise to foreign currency

gain that is treated as foreign personal holding company income.

The regulations are modified in response to those comments. Section

1.954-2(g)(2)(ii) excludes from foreign personal holding company income

foreign currency gain or loss directly related to the business needs of

the controlled foreign corporation. Foreign currency gain or loss is

directly related to the business needs of the corporation, first, if it

can be clearly determined that it arises from a transaction entered

into or property used in the normal course of the corporation's trade

or business and the transaction or property does not itself give rise

to subpart F income (other than foreign currency gain or loss), or,

second, if it arises from a bona fide hedging transaction with respect

to such a transaction or property. To exclude gain or loss from a

hedging transaction from foreign personal holding company income under

this rule, corporations need not trace a hedging transaction to a

specific transaction or property if all (or all but a de minimis

amount) of the aggregate risks being hedged are within the business

needs exception and the hedging transaction otherwise satisfies the

requirements of section 1221, as modified for this purpose.

Section 1.954-2(g)(2)(ii)(C) provides a specific dealer exception

under which transactions described in section 988(c)(1)(B)(iii) and (C)

that are entered into by a regular dealer, in its capacity as a dealer,

are treated as directly related to its business needs for purposes of

the exclusion under Sec. 1.954-2(g)(2)(ii). Because a corporation's

borrowings support all of its activities, paragraph (g)(2)(iii)

provides that foreign currency gain or loss attributable to an

interest-bearing liability that is not covered by paragraph (g)(5)(iv)

is characterized as subpart F income and non-subpart F income on the

same basis as interest expense is allocated and apportioned. Thus, for

example, exchange gain or loss from an unhedged interest-bearing

liability may fall under this rule.

Section 1.954-2T(g)(3) provides that a transaction will not be

treated as a qualified business transaction if the foreign currency

gain or loss from the transaction is attributable to property or an

activity of a kind that gives rise to subpart F income. Commenters have

argued that this requirement is too restrictive because it may cause

the gain or loss from the underlying transaction, and the foreign

currency gain or loss attributable to the transaction, to be in

[[Page 46507]]

different separate categories for foreign tax credit purposes.

In response to this comment, a new election was added to paragraph

(g). Under Sec. 1.954-2(g)(3), the controlling United States

shareholders may elect to have the controlled foreign corporation

include foreign currency gain or loss that would otherwise be included

in foreign personal holding company income under paragraph (g) in the

category of subpart F income to which such gain or loss relates. This

election works in conjunction with the general rules of paragraph

(g)(2). Thus, for example, this election may apply to currency gain or

loss that would otherwise be treated as foreign personal holding

company income under paragraph (g) even if other currency gain or loss

is excluded under the business needs exception of paragraph (g)(2)(ii).

As described above, the temporary regulations permit taxpayers to

elect to treat all foreign currency gain or loss as foreign personal

holding company income. The final regulations retain this election,

with modifications. Under Sec. 1.954-2(g)(4), the controlling United

States shareholders of the controlled foreign corporation may elect to

include in the computation of foreign personal holding company income

net foreign currency gains or losses attributable to any section 988

transaction and any section 1256 contract that would be a section 988

transaction but for section 988(c)(1)(D). Shareholders are not

permitted to make separate elections for section 1256 contracts and

section 988 transactions. An election under paragraph (g)(4) supersedes

an election under paragraph (g)(3).

Section 1.954-2(g)(5)(iv) reserves on the treatment of gain or loss

allocated under Sec. 1.861-9. It is anticipated that when Sec. 1.861-9

is finalized, a provision will be added to this paragraph to indicate

that gain or loss that is allocated or apportioned under section 861 in

the same manner as interest expense is not foreign currency gain or

loss under paragraph (g).

Section 954(c)(1)(E) and Sec. 1.954-2T(h) include income equivalent

to interest in foreign personal holding company income. A commenter

argued that the term income equivalent to interest might be read to

include income from a wide range of interest rate sensitive

transactions entered into by a securities dealer or commodities

producer, processor, merchant or handler in the ordinary course of its

business. The commenter suggested that the regulations should be

modified to confirm that such income is not income equivalent to

interest.

The final regulations do not contain a general dealer exception

that applies to all income equivalent to interest because income

equivalent to interest is generally treated like interest, for which no

general dealer exception is provided. However, consistent with Notice

89-90 (1989-2 C.B. 407), Sec. 1.954-2(h)(3)(ii) provides a specific

dealer exception for income from notional principal contracts.

Section 1.954-2T(h)(1) provides that income equivalent to interest

does not include income attributable to notional principal contracts

except to the extent that such contracts are part of an integrated

transaction that gives rise to income equivalent to interest. Notice

89-90 stated, however, that final regulations would provide that income

equivalent to interest would include income from notional principal

contracts regardless of whether the notional principal contract is

integrated with an investment, because notional principal contracts

generally affect the all-in cost of interest-bearing liabilities or the

return on interest-bearing assets. Accordingly, Sec. 1.954-2(h)(3)

provides that income from notional principal contracts based solely on

interest rates or interest rate indices is income equivalent to

interest, and paragraph (h)(1)(ii) provides that income from a notional

principal contract covered by Sec. 1.861-9T is not income equivalent to

interest. Paragraph (f) continues to apply to notional principal

contracts based on commodities (or a commodities index), and paragraph

(g) continues to apply to notional principal contracts covered by

section 988.

Section 1.954-2T(h)(3) treats factoring income as income equivalent

to interest, with certain exceptions. Commenters have argued that

income realized by a credit card company from factoring its receivables

(which is attributable to the discount at which it acquires the

receivables from the business establishments honoring its credit card)

does not represent an interest equivalent amount, but instead

represents other types of income, such as compensation for services.

This comment was rejected. It is true that the income attributable

to the discount at which a controlled foreign corporation acquires a

receivable reflects not only the time value of money, but also certain

other elements (for example, collection risk and cost). However, the

factoring income derived by the controlled foreign corporation is

analogous to interest income derived from a loan made by a bank, which

reflects not only the time value of money, but also the other elements

of the discount income received in the factoring transaction described

above. The Tax Reform Act of 1986 repealed the exclusion from foreign

personal holding company income of such interest income derived by a

bank. The repeal of this provision indicates that interest income is

not intended to be excluded from foreign personal holding company

income merely because it may reflect more than the time value of money.

Income equivalent to interest should not be treated differently.

Some of the rules described in the final regulations are

inconsistent with provisions of Secs. 1.954-3 through 1.954-8, as well

as the regulations under other provisions of subpart F. In such cases,

these final regulations are intended to apply instead of the

regulations under other provisions of section 954 and of subpart F

generally. Section 1.952-3 is removed because the rules of that section

are replaced by Sec. 1.954-1. Other conforming changes are being

considered in a separate regulations project.

Many nonsubstantive structural and editorial changes were made to

these final regulations for clarity.

Drafting Information

The principal authors of these regulations are Valerie Mark and,

with respect to financial products, Elissa Shendalman of the Office of

the Associate Chief Counsel (International), IRS. However, personnel

from other offices of the IRS and Treasury Department participated in

developing the regulations.

List of Subjects

26 CFR Parts 1 and 4

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1, 4 and 602 are amended to read as

follows:

PART 1--INCOME TAXES

Paragraph 1. The authority for part 1 is amended by removing the

authority citation for ``Section 1.954-0T, 1.954-1T, 1.954-2T and

1.957-1T'' and adding the following citations in numerical order to

read as follows:

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

Section 1.954-0 also issued under 26 U.S.C. 954 (b) and (c).

Section 1.954-1 also issued under 26 U.S.C. 954 (b) and (c).

[[Page 46508]]

Section 1.954-2 also issued under 26 U.S.C. 954 (b) and (c).

* * * * *

Section 1.957-1 also issued under 26 U.S.C. 957. * * *

Sec. 1.952-3 [Removed]

Par. 2. Section 1.952-3 is removed.

Par. 3. Sections 1.954-0, 1.954-1 and 1.954-2 are added to read as

follows:

Sec. 1.954-0 Introduction.

(a) Effective dates--(1) Final regulations--(i) In general. Except

as otherwise specifically provided, the provisions of Secs. 1.954-1 and

1.954-2 apply to taxable years of a controlled foreign corporation

beginning after November 6, 1995. If any of the rules described in

Secs. 1.954-1 and 1.954-2 are inconsistent with provisions of other

regulations under subpart F, these final regulations are intended to

apply instead of such other regulations.

(ii) Election to apply final regulations retroactively--(A) Scope

of election. An election may be made to apply the final regulations

retroactively with respect to any taxable year of the controlled

foreign corporation beginning on or after January 1, 1987. If such an

election is made, these final regulations must be applied in their

entirety for such taxable year and all subsequent taxable years. All

references to section 11 in the final regulations shall be deemed to

include section 15, where applicable.

(B) Manner of making election. An election under this paragraph

(a)(1)(ii) is binding on all United States shareholders of the

controlled foreign corporation and must be made--

(1) By the controlling United States shareholders, as defined in

Sec. 1.964-1(c)(5), by attaching a statement to such effect with their

original or amended income tax returns for the taxable year of such

United States shareholders in which or with which the taxable year of

the CFC ends, and including any additional information required by

applicable administrative pronouncements, or

(2) In such other manner as may be prescribed in applicable

administrative pronouncements.

paragraph (a)(1)(ii) with respect to a taxable year of the controlled

foreign corporation beginning on or after January 1, 1987 only if the

time for filing a return or claim for refund has not expired for the

taxable year of any United States shareholder of the controlled foreign

corporation in which or with which such taxable year of the controlled

foreign corporation ends.

(D) Revocation of election. An election made under this paragraph

(a)(1)(ii) may not be revoked.

(2) Temporary regulations. The provisions of Secs. 4.954-1 and

4.954-2 of this chapter apply to taxable years of a controlled foreign

corporation beginning after December 31, 1986 and on or before November

6, 1995. However, the provisions of Sec. 4.954-2(b)(6) of this chapter

continue to apply. For transactions entered into on or before October

10, 1995, taxpayers may rely on Notice 89-90, 1989-2 C.B. 407, in

applying the temporary regulations.

(3) Secs. 1.954A-1 and 1.954A-2. The provisions of Secs. 1.954A-1

and 1.954A-2 (as contained in 26 CFR part 1 edition revised April 1,

1995) apply to taxable years of a controlled foreign corporation

beginning before January 1, 1987. All references therein to sections of

the Code are to the Internal Revenue Code of 1954 prior to the

amendments made by the Tax Reform Act of 1986.

(b) Outline of regulation provisions for sections 954(b)(3),

954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code.

Sec. 1.954-0 Introduction.

(a) Effective dates.

(1) Final regulations.

(i) In general.

(ii) Election to apply final regulations retroactively.

(A) Scope of election.

(B) Manner of making election.

(D) Revocation of election.

(2) Temporary regulations.

(3) Secs. 1.954A-1 and 1.954A-2.

(b) Outline of regulation provisions for sections 954(b)(3),

954(b)(4), 954(b)(5) and 954(c) of the Internal Revenue Code.

Sec. 1.954-1 Foreign base company income.

(a) In general.

(1) Purpose and scope.

(2) Gross foreign base company income.

(3) Adjusted gross foreign base company income.

(4) Net foreign base company income.

(5) Adjusted net foreign base company income.

(6) Insurance income.

(7) Additional items of adjusted net foreign base company income

or adjusted net insurance income by reason of section 952(c).

(b) Computation of adjusted gross foreign base company income

and adjusted gross insurance income.

(1) De minimis and full inclusion tests.

(i) De minimis test.

(A) In general.

(B) Currency translation.

(ii) Seventy percent full inclusion test.

(2) Character of gross income included in adjusted gross foreign

base company income.

(3) Coordination with section 952(c).

(4) Anti-abuse rule.

(i) In general.

(ii) Presumption.

(iii) Related persons.

(iv) Example.

(1) General rule.

(i) Deductions against gross foreign base company income.

(ii) Losses reduce subpart F income by operation of earnings and

profits limitation.

(iii) Items of income.

(A) Income other than passive foreign personal holding company

income.

(B) Passive foreign personal holding company income.

(2) Computation of net foreign base company income derived from

same country insurance income.

(d) Computation of adjusted net foreign base company income or

adjusted net insurance income.

(1) Application of high tax exception.

(2) Effective rate at which taxes are imposed.

(3) Taxes paid or accrued with respect to an item of income.

(i) Income other than passive foreign personal holding company

income.

(ii) Passive foreign personal holding company income.

(4) Special rules.

(i) Consistency rule.

(ii) Coordination with earnings and profits limitation.

(iii) Example.

(5) Procedure.

(6) Coordination of full inclusion and high tax exception rules.

(7) Examples.

(e) Character of income.

(1) Substance of the transaction.

(2) Separable character.

(3) Predominant character.

(4) Coordination of categories of gross foreign base company

income or gross insurance income.

(i) In general.

(ii) Income excluded from other categories of gross foreign base

company income.

(f) Definition of related person.

(1) Persons related to controlled foreign corporation.

(i) Individuals.

(ii) Other persons.

(2) Control.

(i) Corporations.

(ii) Partnerships.

(iii) Trusts and estates.

(iv) Direct or indirect ownership.

Sec. 1.954-2 Foreign personal holding company income.

(a) Computation of foreign personal holding company income.

(1) Categories of foreign personal holding company income.

(2) Coordination of overlapping categories under foreign

personal holding company provisions.

(i) In general.

(ii) Priority of categories.

(3) Changes in the use or purpose for which property is held.

(i) In general.

(ii) Special rules.

[[Page 46509]]

(A) Anti-abuse rule.

(B) Hedging transactions.

(iii) Example.

(4) Definitions and special rules.

(i) Interest.

(ii) Bona fide hedging transaction.

(A) Definition.

(B) Identification.

(1) Transactions identified.

(2) Inadvertent identification.

(3) Transactions not identified.

(4) Inadvertent error.

(5) Anti-abuse rule.

(iii) Inventory and similar property.

(A) Definition.

(B) Hedging transactions.

(iv) Regular dealer.

(v) Dealer property.

(A) Definition.

(B) Securities dealers.

(vi) Examples.

(vii) Debt instrument.

(b) Dividends, interest, rents, royalties and annuities.

(1) In general.

(2) Exclusion of certain export financing interest.

(i) In general.

(ii) Exceptions.

(iii) Conduct of a banking business.

(iv) Examples.

(3) Treatment of tax-exempt interest. [RESERVED.]

(4) Exclusion of dividends or interest from related persons.

(i) In general.

(A) Corporate payor.

(B) Payment by a partnership.

(ii) Exceptions.

(A) Dividends.

(B) Interest paid out of adjusted foreign base company income or

insurance income.

(1) In general.

(2) Rule for corporations that are both recipients and payors of

interest.

(iii) Trade or business requirement.

(iv) Substantial assets test.

(v) Valuation of assets.

(vi) Location of tangible property.

(A) In general.

(B) Exception.

(vii) Location of intangible property.

(A) In general.

(B) Exception for property located in part in the payor's

country of incorporation.

(viii) Location of inventory and dealer property.

(A) In general.

(B) Inventory and dealer property located in part in the payor's

country of incorporation.

(ix) Location of debt instruments.

(x) Treatment of certain stock interests.

(xi) Treatment of banks and insurance companies. [Reserved]

(5) Exclusion of rents and royalties derived from related

persons.

(i) In general.

(A) Corporate payor.

(B) Payment by a partnership.

(ii) Exceptions.

(A) Rents or royalties paid out of adjusted foreign base company

income or insurance income.

(B) Property used in part in the controlled foreign

corporation's country of incorporation.

(6) Exclusion of rents and royalties derived in the active

conduct of a trade or business.

(1) Active conduct of a trade or business.

(2) Special rules.

(i) Adding substantial value.

(ii) Substantiality of foreign organization.

(iii) Active leasing expenses.

(iv) Adjusted leasing profit.

(3) Examples.

(d) Excluded royalties.

(1) Active conduct of a trade or business.

(2) Special rules.

(i) Adding substantial value.

(ii) Substantiality of foreign organization.

(iii) Active licensing expenses.

(iv) Adjusted licensing profit.

(3) Examples.

(e) Certain property transactions.

(1) In general.

(i) Inclusions.

(ii) Exceptions.

(iii) Treatment of losses.

(iv) Dual character property.

(2) Property that gives rise to certain income.

(i) In general.

(ii) Gain or loss from the disposition of a debt instrument.

(3) Property that does not give rise to income.

(f) Commodities transactions.

(1) In general.

(i) Inclusion in foreign personal holding company income.

(ii) Exception.

(iii) Treatment of losses.

(2) Definitions.

(i) Commodity.

(ii) Commodities transaction.

(iii) Qualified active sale.

(A) In general.

(B) Active conduct of a commodities business.

(D) Activities of employees of a related entity.

(E) Financial activities.

(iv) Qualified hedging transaction.

(A) In general.

(B) Exception.

(g) Foreign currency gain or loss.

(1) Scope and purpose.

(2) In general.

(i) Inclusion.

(ii) Exclusion for business needs.

(A) General rule.

(B) Business needs.

(D) Example.

(iii) Special rule for foreign currency gain or loss from an

interest-bearing liability.

(3) Election to characterize foreign currency gain or loss that

arises from a specific category of subpart F income as gain or loss

in that category.

(i) In general.

(ii) Time and manner of election.

(iii) Revocation of election.

(iv) Example.

(4) Election to treat all foreign currency gains or losses as

foreign personal holding company income.

(i) In general.

(ii) Time and manner of election.

(iii) Revocation of election.

(5) Gains and losses not subject to this paragraph.

(i) Capital gains and losses.

(ii) Income not subject to section 988.

(iii) Qualified business units using the dollar approximate

separate transactions method.

(iv) Gain or loss allocated under Sec. 1.861-9. [Reserved]

(h) Income equivalent to interest.

(1) In general.

(i) Inclusion in foreign personal holding company income.

(ii) Exceptions.

(A) Liability hedging transactions.

(B) Interest.

(2) Definition of income equivalent to interest.

(i) In general.

(ii) Income from the sale of property.

(3) Notional principal contracts.

(i) In general.

(ii) Regular dealers.

(4) Income equivalent to interest from factoring.

(i) General rule.

(ii) Exceptions.

(iii) Factored receivable.

(iv) Examples.

(5) Receivables arising from performance of services.

(6) Examples.

Sec. 1.954-1 Foreign base company income.

(a) In general--(1) Purpose and scope. Section 954 and Secs. 1.954-

1 and 1.954-2 provide rules for computing the foreign base company

income of a controlled foreign corporation. Foreign base company income

is included in the subpart F income of a controlled foreign corporation

under the rules of section 952. Subpart F income is included in the

gross income of a United States shareholder of a controlled foreign

corporation under the rules of section 951 and thus is subject to

current taxation under section 1, 11 or 55 of the Internal Revenue

Code. The determination of whether a foreign corporation is a

controlled foreign corporation, the subpart F income of which is

included currently in the gross income of its United States

shareholders, is made under the rules of section 957.

(2) Gross foreign base company income. The gross foreign base

company income of a controlled foreign corporation consists of the

following categories of gross income (determined after the application

of section 952(b))--

(i) Foreign personal holding company income, as defined in section

954(c);

[[Page 46510]]

(ii) Foreign base company sales income, as defined in section

954(d);

(iii) Foreign base company services income, as defined in section

954(e);

(iv) Foreign base company shipping income, as defined in section

954(f); and

(v) Foreign base company oil related income, as defined in section

954(g).

(3) Adjusted gross foreign base company income. The term adjusted

gross foreign base company income means the gross foreign base company

income of a controlled foreign corporation as adjusted by the de

minimis and full inclusion rules of paragraph (b) of this section.

(4) Net foreign base company income. The term net foreign base

company income means the adjusted gross foreign base company income of

a controlled foreign corporation reduced so as to take account of

deductions (including taxes) properly allocable or apportionable to

such income under the rules of section 954(b)(5) and paragraph (c) of

this section.

(5) Adjusted net foreign base company income. The term adjusted net

foreign base company income means the net foreign base company income

of a controlled foreign corporation reduced, first, by any items of net

foreign base company income excluded from subpart F income pursuant to

section 952(c) and, second, by any items excluded from subpart F income

pursuant to the high tax exception of section 954(b). See paragraph

(d)(4)(ii) of this section. The term foreign base company income as

used in the Internal Revenue Code and elsewhere in the Income Tax

Regulations means adjusted net foreign base company income, unless

otherwise provided.

(6) Insurance income. The term gross insurance income includes all

gross income taken into account in determining insurance income under

section 953. The term adjusted gross insurance income means gross

insurance income as adjusted by the de minimis and full inclusion rules

of paragraph (b) of this section. The term net insurance income means

adjusted gross insurance income reduced under section 953 so as to take

into account deductions (including taxes) properly allocable or

apportionable to such income. The term adjusted net insurance income

means net insurance income reduced by any items of net insurance income

that are excluded from subpart F income pursuant to section 952(b) or

pursuant to the high tax exception of section 954(b). The term

insurance income as used in subpart F of the Internal Revenue Code and

in the regulations under that subpart means adjusted net insurance

income, unless otherwise provided.

(7) Additional items of adjusted net foreign base company income or

adjusted net insurance income by reason of section 952(c). Earnings and

profits of the controlled foreign corporation that are recharacterized

as foreign base company income or insurance income under section 952(c)

are items of adjusted net foreign base company income or adjusted net

insurance income, respectively. Amounts subject to recharacterization

under section 952(c) are determined after adjusted net foreign base

company income and adjusted net insurance income are otherwise

determined under subpart F and are not again subject to any exceptions

or special rules that would affect the amount of subpart F income.

Thus, for example, items of gross foreign base company income or gross

insurance income that are excluded from adjusted gross foreign base

company income or adjusted gross insurance income because the de

minimis test is met are subject to recharacterization under section

952(c). Further, the de minimis and full inclusion tests of paragraph

(b) of this section, and the high tax exception of paragraph (d) of

this section, for example, do not apply to such amounts.

(b) Computation of adjusted gross foreign base company income and

adjusted gross insurance income--(1) De minimis and full inclusion

tests--(i) De minimis test--(A) In general. Except as provided in

paragraph (b)(1)(i)(C) of this section, adjusted gross foreign base

company income and adjusted gross insurance income are equal to zero if

the sum of the gross foreign base company income and the gross

insurance income of a controlled foreign corporation is less than the

lesser of--

(1) 5 percent of gross income; or

(2) $1,000,000.

(B) Currency translation. Controlled foreign corporations having a

functional currency other than the United States dollar shall translate

the $1,000,000 threshold using the exchange rate provided under section

989(b)(3) for amounts included in income under section 951(a).

foreign base company income or adjusted gross insurance income of a

controlled foreign corporation always includes income from trade or

service receivables described in section 864(d) (1) or (6), and

portfolio interest described in section 881(c), even if the de minimis

test of this paragraph (b)(1)(i) is otherwise satisfied.

(ii) Seventy percent full inclusion test. Except as provided in

section 953, adjusted gross foreign base company income consists of all

gross income of the controlled foreign corporation other than gross

insurance income and amounts described in section 952(b), and adjusted

gross insurance income consists of all gross insurance income other

than amounts described in section 952(b), if the sum of the gross

foreign base company income and the gross insurance income for the

taxable year exceeds 70 percent of gross income. See paragraph (d)(6)

of this section, under which certain items of full inclusion foreign

base company income may nevertheless be excluded from subpart F income.

(2) Character of gross income included in adjusted gross foreign

base company income. The gross income included in the adjusted gross

foreign base company income of a controlled foreign corporation

generally retains its character as foreign personal holding company

income, foreign base company sales income, foreign base company

services income, foreign base company shipping income, or foreign base

company oil related income. However, gross income included in adjusted

gross foreign base company income because the full inclusion test of

paragraph (b)(1)(ii) of this section is met is termed full inclusion

foreign base company income, and constitutes a separate category of

adjusted gross foreign base company income for purposes of allocating

and apportioning deductions under paragraph (c) of this section.

(3) Coordination with section 952(c). Income that is included in

subpart F income because the full inclusion test of paragraph

(b)(1)(ii) of this section is met does not reduce amounts that, under

section 952(c), are subject to recharacterization.

(4) Anti-abuse rule--(i) In general. For purposes of applying the

de minimis test of paragraph (b)(1)(i) of this section, the income of

two or more controlled foreign corporations shall be aggregated and

treated as the income of a single corporation if a principal purpose

for separately organizing, acquiring, or maintaining such multiple

corporations is to prevent income from being treated as foreign base

company income or insurance income under the de minimis test. A purpose

may be a principal purpose even though it is outweighed by other

purposes (taken together or separately).

(ii) Presumption. Two or more controlled foreign corporations are

presumed to have been organized, acquired or maintained to prevent

income from being treated as foreign

[[Page 46511]]

base company income or insurance income under the de minimis test of

paragraph (b)(1)(i) of this section if the corporations are related

persons, as defined in paragraph (b)(4)(iii) of this section, and the

corporations are described in paragraph (b)(4)(ii)(A), (B), or (C) of

this section. This presumption may be rebutted by proof to the

contrary.

(A) The activities carried on by the controlled foreign

corporations, or the assets used in those activities, are substantially

the same activities that were previously carried on, or assets that

were previously held, by a single controlled foreign corporation.

Further, the United States shareholders of the controlled foreign

corporations or related persons (as determined under paragraph

(b)(4)(iii) of this section) are substantially the same as the United

States shareholders of the one controlled foreign corporation in a

prior taxable year. A presumption made in connection with the

requirements of this paragraph (b)(4)(ii)(A) may be rebutted by proof

that the activities carried on by each controlled foreign corporation

would constitute a separate branch under the principles of

Sec. 1.367(a)-6T(g)(2) if carried on directly by a United States

person.

(B) The controlled foreign corporations carry on a business,

financial operation, or venture as partners directly or indirectly in a

partnership (as defined in section 7701(a)(2) and Sec. 301.7701-3 of

this chapter) that is a related person (as defined in paragraph

(b)(4)(iii) of this section) with respect to each such controlled

foreign corporation.

corporations would constitute a single branch operation under

Sec. 1.367(a)-6T(g)(2) if carried on directly by a United States

person.

(iii) Related persons. For purposes of this paragraph (b), two or

more persons are related persons if they are in a relationship

described in section 267(b). In determining for purposes of this

paragraph (b) whether two or more corporations are members of the same

controlled group under section 267(b)(3), a person is considered to own

stock owned directly by such person, stock owned with the application

of section 1563(e)(1), and stock owned with the application of section

267(c). In determining for purposes of this paragraph (b) whether a

corporation is related to a partnership under section 267(b)(10), a

person is considered to own the partnership interest owned directly by

such person and the partnership interest owned with the application of

section 267(e)(3).

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

this paragraph (b)(4).

Example. (i)(1) USP is the sole United States shareholder of

three controlled foreign corporations: CFC1, CFC2 and CFC3. The

three controlled foreign corporations all have the same taxable

year. The three controlled foreign corporations are partners in FP,

a foreign entity classified as a partnership under section

7701(a)(2) and Sec. 301.7701-3 of the regulations. For their current

taxable years, each of the controlled foreign corporations derives

all of its income other than foreign base company income from

activities conducted through FP, and its foreign base company income

from activities conducted both jointly through FP and separately

without FP. Based on the facts in the table below, the foreign base

company income derived by each controlled foreign corporation for

its current taxable year, including income derived from FP, is less

than five percent of the gross income of each controlled foreign

corporation and is less than $1,000,000:

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

CFC1 CFC2 CFC3

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

Gross income............ $4,000,000 $8,000,000 $12,000,000

Five percent of gross

income................. 200,000 400,000 600,000

Foreign base company

income................. 199,000 398,000 597,000

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

(2) Thus, without the application of the anti-abuse rule of this

paragraph (b)(4), each controlled foreign corporation would be

treated as having no foreign base company income after the

application of the de minimis test of section 954(b)(3)(A) and

paragraph (b)(1)(i) of this section.

(ii) However, under these facts, the requirements of paragraph

(b)(4)(i) of this section are met unless the presumption of

paragraph (b)(4)(ii) of this section is successfully rebutted. The

sum of the foreign base company income of the controlled foreign

corporations is $1,194,000. Thus, the amount of gross foreign base

company income of each controlled foreign corporation will not be

reduced by reason of the de minimis rule of section 954(b)(3)(A) and

this paragraph (b).

rule. The net foreign base company income of a controlled foreign

corporation (as defined in paragraph (a)(4) of this section) is

computed under the rules of this paragraph (c)(1). The principles of

Sec. 1.904-5(k) shall apply where payments are made between controlled

foreign corporations that are related persons (within the meaning of

section 954(d)(3)). Consistent with these principles, only payments

described in Sec. 1.954-2(b)(4)(ii)(B)(2) may be offset as provided in

Sec. 1.904-5(k)(2).

(i) Deductions against gross foreign base company income. The net

foreign base company income of a controlled foreign corporation is

computed first by taking into account deductions in the following

manner:

(A) First, the gross amount of each item of income described in

paragraph (c)(1)(iii) of this section is determined.

(B) Second, any expenses definitely related to less than all gross

income as a class shall be allocated and apportioned under the

principles of sections 861, 864 and 904(d) to the gross income

described in paragraph (c)(1)(i)(A) of this section.

within the meaning of section 904 (determined before the application of

the high-taxed income rule of Sec. 1.904-4(c)) is reduced by related

person interest expense allocable to passive income under Sec. 1.904-

5(c)(2); such interest must be further allocated and apportioned to

items described in paragraph (c)(1)(iii)(B) of this section.

(D) Fourth, the amount of each item of income described in

paragraph (c)(1)(iii) of this section is reduced by other expenses

allocable and apportionable to such income under the principles of

sections 861, 864 and 904(d).

(ii) Losses reduce subpart F income by operation of earnings and

profits limitation. Except as otherwise provided in Sec. 1.954-2(g)(4),

if after applying the rules of paragraph (c)(1)(i) of this section, the

amount remaining in any category of foreign base company income or

foreign personal holding company income is less than zero, the loss in

that category may not reduce any other category of foreign base company

income or foreign personal holding company income except by operation

of the earnings and profits limitation of section 952(c)(1).

(iii) Items of income--(A) Income other than passive foreign

personal holding company income. A single item of income (other than

foreign personal holding company income that is

[[Page 46512]]

passive) is the aggregate amount from all transactions that falls

within a single separate category (as defined in Sec. 1.904-5(a)(1)),

and either--

(1) Falls within a single category of foreign personal holding

company income as--

(i) Dividends, interest, rents, royalties and annuities;

(ii) Gain from certain property transactions;

(iii) Gain from commodities transactions;

(iv) Foreign currency gain; or

(v) Income equivalent to interest; or

(2) Falls within a single category of foreign base company income,

other than foreign personal holding company income, as--

(i) Foreign base company sales income;

(ii) Foreign base company services income;

(iii) Foreign base company shipping income;

(iv) Foreign base company oil related income; or

(v) Full inclusion foreign base company income.

(B) Passive foreign personal holding company income. A single item

of foreign personal holding company income that is passive is an amount

of income that falls within a single group of passive income under the

grouping rules of Sec. 1.904-4(c) (3), (4) and (5) and a single

category of foreign personal holding company income described in

paragraphs (c)(1)(iii)(A)(1) (i) through (v).

(2) Computation of net foreign base company income derived from

same country insurance income. Deductions relating to foreign base

company income attributable to the issuing (or reinsuring) of any

insurance or annuity contract in connection with risks located in the

country under the laws of which the controlled foreign corporation is

created or organized shall be allocated and apportioned in accordance

with the rules set forth in section 953.

(d) Computation of adjusted net foreign base company income or

adjusted net insurance income--(1) Application of high tax exception.

Adjusted net foreign base company income (or adjusted net insurance

income) equals the net foreign base company income (or net insurance

income) of a controlled foreign corporation, reduced by any net item of

such income that qualifies for the high tax exception provided by

section 954(b)(4) and this paragraph (d). Any item of income that is

foreign base company oil related income, as defined in section 954(g),

or portfolio interest, as described in section 881(c), does not qualify

for the high tax exception. See paragraph (c)(1)(iii) of this section

for the definition of the term item of income. For rules concerning the

treatment for foreign tax credit purposes of amounts excluded from

subpart F under section 954(b)(4), see Sec. 1.904-4(c). A net item of

income qualifies for the high tax exception only if--

(i) An election is made under section 954(b)(4) and paragraph

(d)(5) of this section to exclude the income from the computation of

subpart F income; and

(ii) It is established that the net item of income was subject to

foreign income taxes imposed by a foreign country or countries at an

effective rate that is greater than 90 percent of the maximum rate of

tax specified in section 11 for the taxable year of the controlled

foreign corporation.

(2) Effective rate at which taxes are imposed. The effective rate

with respect to a net item of income shall be determined separately for

each controlled foreign corporation in a chain of corporations through

which a distribution is made. The effective rate at which taxes are

imposed on a net item of income is--

(i) The United States dollar amount of foreign income taxes paid or

accrued (or deemed paid or accrued) with respect to the net item of

income, determined under paragraph (d)(3) of this section; divided by

(ii) The United States dollar amount of the net item of foreign

base company income or insurance income, described in paragraph

(c)(1)(iii) of this section, increased by the amount of foreign income

taxes referred to in paragraph (d)(2)(i) of this section.

(3) Taxes paid or accrued with respect to an item of income--(i)

Income other than passive foreign personal holding company income. The

amount of foreign income taxes paid or accrued with respect to a net

item of income (other than an item of foreign personal holding company

income that is passive) for purposes of section 954(b)(4) and this

paragraph (d) is the United States dollar amount of foreign income

taxes that would be deemed paid under section 960 with respect to that

item if that item were included in the gross income of a United States

shareholder under section 951(a)(1)(A) (determined, in the case of a

United States shareholder that is an individual, as if an election

under section 962 has been made, whether or not such election is

actually made). For this purpose, in accordance with the regulations

under section 960, the amounts that would be deemed paid under section

960 shall be determined separately with respect to each controlled

foreign corporation and without regard to the limitation applicable

under section 904(a). The amount of foreign income taxes paid or

accrued with respect to a net item of income, determined in the manner

provided in this paragraph (d), will not be affected by a subsequent

reduction in foreign income taxes attributable to a distribution to

shareholders of all or part of such income.

(ii) Passive foreign personal holding company income. The amount of

income taxes paid or accrued with respect to a net item of foreign

personal holding company income that is passive for purposes of section

954(b)(4) and this paragraph (d) is the United States dollar amount of

foreign income taxes that would be deemed paid under section 960 and

that would be taken into account for purposes applying the provisions

of Sec. 1.904-4(c) with respect to that net item of income.

(4) Special rules--(i) Consistency rule. An election to exclude

income from the computation of subpart F income for a taxable year must

be made consistently with respect to all items of passive foreign

personal holding company income eligible to be excluded for the taxable

year. Thus, high-taxed passive foreign personal holding company income

of a controlled foreign corporation must either be excluded in its

entirety, or remain subject to subpart F in its entirety.

(ii) Coordination with earnings and profits limitation. If the

amount of income included in subpart F income for the taxable year is

reduced by the earnings and profits limitation of section 952(c)(1),

the amount of income that is a net item of income, within the meaning

of paragraph (c)(1)(iii) of this section, is determined after the

application of the rules of section 952(c)(1).

(iii) Example. The following example illustrates the provisions of

paragraph (d)(4)(ii) of this section. All of the taxes referred to in

the following example are foreign income taxes. For simplicity, this

example assumes that the amount of taxes that are taken into account as

a deduction under section 954(b)(5) and the amount of the gross-up

required under sections 960 and 78 are equal. Therefore, this example

does not separately illustrate the deduction for taxes and gross-up.

Example. During its 1995 taxable year, CFC, a controlled foreign

corporation, earns $100 of royalty income that is foreign personal

holding company income. CFC has no expenses associated with this

royalty income. CFC pays $20 of foreign income taxes with respect to

the royalty income. For 1995, CFC has current earnings and profits

of $50. CFC's subpart F income, as determined

[[Page 46513]]

prior to the application of this paragraph (d), exceeds its current

earnings and profits. Thus, under paragraph (d)(4)(ii) of this

section, the amount of CFC's only net item of income, the royalty

income, will be limited to $50. The remaining $50 will be subject to

recharacterization in a subsequent taxable year under section

952(c)(2). Because the amount of foreign income taxes paid with

respect to this net item of income is $20, the effective rate of tax

on the item, for purposes of this paragraph (d), is 40 percent.

Accordingly, an election under paragraph (d)(5) of this section may

be made to exclude the item of income from the computation of

subpart F income.

(5) Procedure. An election made under the procedure provided by

this paragraph (d)(5) is binding on all United States shareholders of

the controlled foreign corporation and must be made--

(i) By the controlling United States shareholders, as defined in

Sec. 1.964-1(c)(5), by attaching a statement to such effect with their

original or amended income tax returns, and including any additional

information required by applicable administrative pronouncements; or

(ii) In such other manner as may be prescribed in applicable

administrative pronouncements.

(6) Coordination of full inclusion and high tax exception rules.

Notwithstanding paragraph (b)(1)(ii) of this section, full inclusion

foreign base company income will be excluded from subpart F income if

more than 90 percent of the adjusted gross foreign base company income

and adjusted gross insurance company income of a controlled foreign

corporation (determined without regard to the full inclusion test of

paragraph (b)(1) of this section) is attributable to net amounts

excluded from subpart F income pursuant to an election to have the high

tax exception described in section 954(b)(4) and this paragraph (d)

apply.

(7) Examples. (i) The following examples illustrate the rules of

this paragraph (d). All of the taxes referred to in the following

examples are foreign income taxes. For simplicity, these examples

assume that the amount of taxes that are taken into account as a

deduction under section 954(b)(5) and the amount of the gross-up

required under sections 960 and 78 are equal. Therefore, these examples

do not separately illustrate the deduction for taxes and gross-up.

Except as otherwise stated, these examples assume there are no

earnings, deficits, or foreign income taxes in the post-1986 pools of

earnings and profits or foreign income taxes.

Example 1. (i) Items of income. During its 1995 taxable year,

controlled foreign corporation CFC earns from outside its country of

operation portfolio dividend income of $100 and interest income, net

of taxes, of $100 (consisting of a gross payment of $150 reduced by

a third-country withholding tax of $50). For purposes of

illustration, assume that CFC incurs no expenses. None of the income

is taxed in CFC's country of operation. The dividend income was not

subject to third-country withholding taxes. Pursuant to the

operation of section 904, the interest income is high withholding

tax interest and the dividend income is passive income. Accordingly,

pursuant to paragraph (c)(1)(iii) of this section, CFC has two net

items of income--

(1) $100 of foreign personal holding company (FPHC)/passive

income (the dividends); and

(2) $100 of FPHC/high withholding tax income (the interest).

(ii) Effective rates of tax. No foreign tax would be deemed paid

under section 960 with respect to the net item of income described

in paragraph (i)(1) of this Example 1. Therefore, the effective rate

of foreign tax is 0, and the item may not be excluded from subpart F

under the rules of this paragraph (d). Foreign tax of $50 would be

deemed paid under section 960 with respect to the net item of income

described in paragraph (i)(2) of this Example 1. Therefore, the

effective rate of foreign tax is 33 percent ($50 of creditable taxes

paid, divided by $150, consisting of the net item of foreign base

company income ($100) plus creditable taxes paid thereon ($50)). The

highest rate of tax specified in section 11 for the 1995 taxable

year is 34 percent. Accordingly, the net item of income described in

paragraph (i)(2) of this Example 1 may be excluded from subpart F

income if an election under paragraph (d)(5) of this section is

made, since it is subject to foreign tax at an effective rate that

is greater than 30.6 percent (90 percent of 34 percent). However,

for purposes of section 904(d), it remains high withholding tax

interest.

Example 2. (i) The facts are the same as in Example 1, except

that CFC's country of operation imposes a tax of $50 with respect to

CFC's dividend income (and thus CFC earns portfolio dividend income,

net of taxes, of only $50). The interest income is still high

withholding tax interest. The dividend income is still passive

income (without regard to the possible applicability of the high tax

exception of section 904(d)(2)). Accordingly, CFC has two items of

income for purposes of this paragraph (d)--

(1) $50 of FPHC/passive income (net of the $50 foreign tax); and

(2) $100 of FPHC/high withholding tax interest income.

(ii) Each item is taxed at an effective rate greater than 30.6

percent. The net item of income described in paragraph (i)(1) of

this Example 2: foreign tax ($50) divided by sum ($100) of net item

of income ($50) plus creditable tax thereon ($50) equals 50 percent.

The net item of income described in paragraph (i)(2) of this Example

2: foreign tax ($50) divided by sum ($150) of income item ($100)

plus creditable tax thereon ($50) equals 33 percent. Accordingly, an

election may be made under paragraph (d)(5) of this section to

exclude either or both of the net items of income described in

paragraphs (i) (1) and (2) of this Example 2 from subpart F income.

If no election is made the items would be included in the subpart F

income of CFC.

Example 3. (i) The facts are the same as in Example 1, except

that the $100 of portfolio dividend income is subject to a third-

country withholding tax of $50, and the $150 of interest income is

from sources within CFC's country of operation, is subject to a $10

income tax therein, and is not subject to a withholding tax.

Although the interest income and the dividend income are both

passive income, under paragraph (c)(1)(iii)(B) of this section they

constitute separate items of income pursuant to the application of

the grouping rules of Sec. 1.904-4(c). Accordingly, CFC has two net

items of income for purposes of this paragraph (d)--

(1) $50 (net of $50 tax) of FPHC/non-country of operation/

greater than 15 percent withholding tax income; and

(2) $140 (net of $10 tax) of FPHC/country of operation income.

(ii) The item described in paragraph (i)(1) of this Example 3 is

taxed at an effective rate greater than 30.6 percent, but Item 2 is

not. The net item of income described in paragraph (i)(1) of this

Example 3: Foreign tax ($50) divided by sum ($100) of net item of

income ($50) plus creditable tax thereon ($50) equals 50 percent.

The net item of income described in paragraph (i)(2) of this Example

3: Foreign tax ($10) divided by sum ($150) of net item of income

($140) plus creditable tax thereon ($10) equals 6.67 percent.

Therefore, an election may be made under paragraph (d)(5) of this

section to exclude the net item of income described in paragraph

(i)(1) of this Example 3 but not the net item of income described in

paragraph (i)(2) of this Example 3 from subpart F income.

Example 4. The facts are the same as in Example 3, except that

the $150 of interest income is subject to an income tax of $50 in

CFC's country of operation. Accordingly, CFC's items of income are

the same as in Example 3, but both items are taxed at an effective

rate greater than 30.6 percent. The net item of income described in

paragraph (i)(1) of Example 3: Foreign tax ($50) divided by sum

($100) of net item of income ($50) plus creditable tax thereon ($50)

equals 50 percent. The net item of income described in paragraph

(i)(2) of Example 3: Foreign tax ($50) divided by sum ($150) of net

item of income ($100) plus creditable tax thereon ($50) equals 33

percent. Pursuant to the consistency rule of paragraph (d)(4)(i) of

this section, an election made by CFC's controlling United States

shareholders must exclude from subpart F income both items of FPHC

income under the high tax exception of section 954(b)(4) and this

paragraph (d). The election may not be made only with respect to one

item.

Example 5. The facts are the same as in Example 1, except that

CFC earns $5 of portfolio dividend income and $150 of interest

income. In addition, CFC earns $45 for performing consulting

services within its country of operation for unrelated persons.

CFC's gross foreign base company income for 1995 of $155 ($150 of

gross interest income and $5 of portfolio dividend income) is

[[Page 46514]]

greater than 70 percent of its gross income of $200. Therefore, under

the full inclusion test of paragraph (b)(1)(ii) of this section,

CFC's adjusted gross foreign base company income is $200, and under

paragraph (b)(2) of this section, the $45 of consulting income is

full inclusion foreign base company income. If CFC elects, under

paragraph (d)(5) of this section, to exclude the interest income

from subpart F income pursuant to the high tax exception, the $45 of

full inclusion foreign base company income will be excluded from

subpart F income under paragraph (d)(6) of this section because the

$150 of gross interest income excluded under the high tax exception

is more than 90 percent of CFC's adjusted gross foreign base company

income of $155.

(ii) The following examples generally illustrate the application of

paragraph (c) of this section and this paragraph (d). Example 1

illustrates the order of computations. Example 2 illustrates the

computations required by sections 952 and 954 and this Sec. 1.954-1 if

the full inclusion test of paragraph (b)(1)(ii) of this section is met

and the income is not excluded from subpart F income under section

952(b). Computations in these examples involving the operation of

section 952(c) are included for purposes of illustration only and do

not provide substantive rules concerning the operation of that section.

For simplicity, these examples assume that the amount of taxes that are

taken into account as a deduction under section 954(b)(5) and the

amount of the gross-up required under sections 960 and 78 are equal.

Therefore, these examples do not separately illustrate the deduction

for taxes and gross-up.

Example 1. (i) Gross income. CFC, a controlled foreign

corporation, has gross income of $1000 for the current taxable year.

Of that $1000 of income, $100 is interest income that is included in

the definition of foreign personal holding company income under

section 954(c)(1)(A) and Sec. 1.954-2(b)(1)(ii), is not income from

a trade or service receivable described in section 864(d)(1) or (6),

or portfolio interest described in section 881(c), and is not

excluded from foreign personal holding company income under any

provision of section 952(b) or section 954(c). Another $50 is

foreign base company sales income under section 954(d). The

remaining $850 of gross income is not included in the definition of

foreign base company income or insurance income under sections 954

(c), (d), (e), (f) or (g) or 953, and is foreign source general

limitation income described in section 904(d)(1)(I).

(ii) Expenses. For the current taxable year, CFC has expenses

of $500. This amount includes $8 of interest paid to a related

person that is allocable to foreign personal holding company income

under section 904, and $2 of other expense that is directly related

to foreign personal holding company income. Another $20 of expense

is directly related to foreign base company sales. The remaining

$470 of expenses is allocable to general limitation income that is

not foreign base company income or insurance income.

(iii) Earnings and losses. CFC has earnings and profits for the

current taxable year of $500. In the prior taxable year, CFC had

losses with respect to income other than gross foreign base company

income or gross insurance income. By reason of the limitation

provided under section 952(c)(1)(A), those losses reduced the

subpart F income (consisting entirely of foreign source general

limitation income) of CFC by $600 for the prior taxable year.

(iv) Taxes. Foreign income tax of $30 is considered imposed on

the interest income under the rules of section 954(b)(4), this

paragraph (d), and Sec. 1.904-6. Foreign income tax of $14 is

considered imposed on the foreign base company sales income under

the rules of section 954(b)(4), paragraph (d) of this section, and

Sec. 1.904-6. Foreign income tax of $177 is considered imposed on

the remaining foreign source general limitation income under the

rules of section 954(b)(4), this paragraph (d), and Sec. 1.904-6.

For the taxable year of CFC, the maximum United States rate of

taxation under section 11 is 34 percent.

(v) Conclusion. Based on these facts, if CFC elects to exclude

all items of income subject to a high foreign tax under section

954(b)(4) and this paragraph (d), it will have $500 of subpart F

income as defined in section 952(a) (consisting entirely of foreign

source general limitation income) determined as follows:

Step 1--Determine gross income:

(1) Gross income............................................. $1000

Step 2--Determine gross foreign base company income and gross

insurance income:

(2) Interest income included in gross foreign personal

holding company income under section 954(c)................. 100

(3) Gross foreign base company sales income under section

954(d)...................................................... 50

(4) Total gross foreign base company income and gross

insurance income as defined in sections 954 (c), (d), (e),

(f) and (g) and 953 (line (2) plus line (3))................ 150

Step 3--Compute adjusted gross foreign base company income and

adjusted gross insurance income:

(5) Five percent of gross income (.05 x line (1)).......... 50

(6) Seventy percent of gross income (.70 x line (1))....... 700

(7) Adjusted gross foreign base company income and adjusted

gross insurance income after the application of the de

minimis test of paragraph (b) (line (4), or zero if line (4)

is less than the lesser of line (5) or $1,000,000) (if the

amount on this line 7 is zero, proceed to Step 8)........... 150

(8) Adjusted gross foreign base company income and adjusted

gross insurance income after the application of the full

inclusion test of paragraph (b) (line (4), or line (1) if

line (4) is greater than line (6)).......................... 150

Step 4--Compute net foreign base company income:

(9) Expenses directly related to adjusted gross foreign base

company sales income........................................ 20

(10) Expenses (other than related person interest expense)

directly related to adjusted gross foreign personal holding

company income.............................................. 2

(11) Related person interest expense allocable to adjusted

gross foreign personal holding company income under section

904......................................................... 8

(12) Net foreign personal holding company income after

allocating deductions under section 954(b)(5) and paragraph

(11))....................................................... 90

(13) Net foreign base company sales income after allocating

deductions under section 954(b)(5) and paragraph (c) of this

section (line (3) reduced by line (9))...................... 30

(14) Total net foreign base company income after allocating

deductions under section 954(b)(5) and paragraph (c) of this

section (line (12) plus line (13)).......................... 120

Step 5--Compute net insurance income:

(15) Net insurance income under section 953.................. 0

Step 6--Compute adjusted net foreign base company income:

(16) Foreign income tax imposed on net foreign personal

holding company income (as determined under section

954(b)(4) and this paragraph (d))........................... 30

(17) Foreign income tax imposed on net foreign base company

sales income (as determined under section 954(b)(4) and this

paragraph (d)).............................................. 14

(18) Ninety percent of the maximum United States corporate

tax rate.................................................... 30.6%

(19) Effective rate of foreign income tax imposed on net

foreign personal holding company income ($90 of interest)

under section 954(b)(4) and this paragraph (d) (line (16)

divided by line (12))....................................... 33%

(20) Effective rate of foreign income tax imposed on $30 of

net foreign base company sales income under section

954(b)(4) and this paragraph (d) (line (17) divided by line

(13))....................................................... 47%

[[Page 46515]]

(21) Net foreign personal holding company income subject to a

high foreign tax under section 954(b)(4) and this paragraph

(d) (zero, or line (12) if line (19) is greater than line

(18))....................................................... 90

(22) Net foreign base company sales income subject to a high

foreign tax under section 954(b)(4) and this paragraph (d)

(zero, or line (13) if line (20) is greater than line (18)). 30

(23) Adjusted net foreign base company income after applying

section 954(b)(4) and this paragraph (d) (line (14), reduced

by the sum of line (21) and line (22))...................... 0

Step 7--Compute adjusted net insurance income:

(24) Adjusted net insurance income........................... 0

Step 8--Additions to or reduction of adjusted net foreign base

company income by reason of section 952(c):

(25) Earnings and profits for the current year............... 500

(26) Amount subject to being recharacterized as subpart F

income under section 952(c)(2) (excess of line (25) over the

sum of lines (23) and (24)); if there is a deficit, then the

limitation of section 952(c)(1) may apply for the current

year........................................................ 500

(27) Amount of reduction in subpart F income for prior

taxable years by reason of the limitation of section

952(c)(1)................................................... 600

(28) Subpart F income as defined in section 952(a), assuming

section 952(a)(3), (4), and (5) do not apply (the sum of

line (23), line (24), and the lesser of line (26) or line

(27))....................................................... 500

(29) Amount of prior year's deficit to be recharacterized as

subpart F income in later years under section 952(c) (excess

of line (27) over line (26)................................. 100

Example 2. (i) Gross income. CFC, a controlled foreign

corporation, has gross income of $1000 for the current taxable year.

Of that $1000 of income, $720 is interest income that is included in

the definition of foreign personal holding company income under

section 954(c) (1)(A) and Sec. 1.954-2(b)(1)(ii), is not income from

trade or service receivables described in section 864(d)(1) or (6),

or portfolio interest described in section 881(c), and is not

excluded from foreign personal holding company income under any

provision of section 954(c) and Sec. 1.954-2 or section 952(b). The

remaining $280 is services income that is not included in the

definition of foreign base company income or insurance income under

sections 954 (c), (d), (e), (f), or (g) or 953, and is foreign

source general limitation income for purposes of section

904(d)(1)(I).

(ii) Expenses. For the current taxable year, CFC has expenses of

$650. This amount includes $350 of interest paid to related persons

that is allocable to foreign personal holding company income under

section 904, and $50 of other expense that is directly related to

foreign personal holding company income. The remaining $250 of

expenses is allocable to services income other than foreign base

company income or insurance income.

(iii) Earnings and losses. CFC has earnings and profits for the

current taxable year of $350. In the prior taxable year, CFC had

losses with respect to income other than foreign base company income

or insurance income. By reason of the limitation provided under

section 952(c)(1)(A), those losses reduced the subpart F income of

CFC (consisting entirely of foreign source general limitation

income) by $600 for the prior taxable year.

(iv) Taxes. Foreign income tax of $120 is considered imposed on

the $720 of interest income under the rules of section 954(b)(4),

paragraph (d) of this section, and Sec. 1.904-6. Foreign income tax

of $2 is considered imposed on the services income under the rules

of section 954(b)(4), paragraph (d) of this section, and Sec. 1.904-

6. For the taxable year of CFC, the maximum United States rate of

taxation under section 11 is 34 percent.

(v) Conclusion. Based on these facts, if CFC elects to exclude

all items of income subject to a high foreign tax under section

954(b)(4) and this paragraph (d), it will have $350 of subpart F

income as defined in section 952(a), determined as follows.

Step 1--Determine gross income:

(1) Gross income............................................. $1000

Step 2--Determine gross foreign base company income and gross

insurance income:

(2) Gross foreign base company income and gross insurance

income as defined in sections 954 (c), (d), (e), (f) and (g)

and 953 (interest income)................................... 720

Step 3--Compute adjusted gross foreign base company income and

adjusted gross insurance income:

(3) Seventy percent of gross income (.70 x line (1))....... 700

(4) Adjusted gross foreign base company income and adjusted

gross insurance income after the application of the full

inclusion rule of this paragraph (b)(1) (line (2), or line

(1) if line (2) is greater than line (3))................... 1000

(5) Full inclusion foreign base company income under

paragraph (b)(1)(ii) (line (4) minus line (2)).............. 280

Step 4--Compute net foreign base company income:

(6) Expenses (other than related person interest expense)

directly related to adjusted gross foreign personal holding

company income.............................................. 50

(7) Related person interest expense allocable to adjusted

gross foreign personal holding company income under section

904......................................................... 350

(8) Deductions allocable to full inclusion foreign base

company income under section 954(b)(5) and paragraph (c) of

this section................................................ 250

(9) Net foreign personal holding company income after

allocating deductions under section 954(b)(5) and paragraph

(7))........................................................ 320

(10) Full inclusion foreign base company income after

allocating deductions under section 954(b)(5) and paragraph

(11) Total net foreign base company income after allocating

deductions under section 954(b)(5) and paragraph (c) of this

section (line (9) plus line (10))........................... 350

Step 5--Compute net insurance income:

(12) Net insurance income under section 953.................. 0

Step 6--Compute adjusted net foreign base company income:

(13) Foreign income tax imposed on net foreign personal

holding company income (interest)........................... 120

(14) Foreign income tax imposed on net full inclusion foreign

base company income......................................... 2

(15) Ninety percent of the maximum United States corporate

tax rate.................................................... 30.6%

(16) Effective rate of foreign income tax imposed on $320 of

net foreign personal holding company income under section

954(b)(4) and this paragraph (d) (line (13) divided by line

(9))........................................................ 38%

(17) Effective rate of foreign income tax imposed on $30 of

net full inclusion foreign base company income under section

954(b)(4) and this paragraph (d) (line (14) divided by line

(10))....................................................... 7%

(18) Net foreign personal holding company income subject to a

high foreign tax under section 954(b)(4) and this paragraph

(d) (zero, or line (9) if line (16) is greater than line

(15))....................................................... 320

(19) Net full inclusion foreign base company income subject

to a high foreign tax under section 954(b)(4) and this

paragraph (d) (zero, or line (10) if line (17) is greater

than line (15))............................................. 0

(20) Adjusted net foreign base company income after applying

section 954(b)(4) and this paragraph (d) (line (11) reduced

by the sum of line (18) and line (19))...................... 30

Step 7--Compute adjusted net insurance income:

(21) Adjusted net insurance income........................... 0

[[Page 46516]]

Step 8--Reduction of adjusted net foreign base company income

or adjusted net insurance income by reason of paragraph (d)(6)

of this section:

(22) Adjusted gross foreign base company income and adjusted

gross insurance income (determined without regard to the

full inclusion test of paragraph (b)(1) of this section)

(line (4) reduced by line (5)).............................. 720

(23) Ninety percent of adjusted gross foreign base company

income and adjusted gross insurance income (determined

without regard to the full inclusion test of paragraph

(b)(1)(ii) of this section) (90% of the amount on line (22)) 648

(24) Net foreign base company income and net insurance income

excluded from subpart F income under section 954(b)(4),

increased by the amount of expenses that reduced this income

under section 954(b)(5) and paragraph (c) of this section

(line (18) increased by the sum of line (6) and line (7))... 720

(25) Adjusted net full inclusion foreign base company income

excluded from subpart F income under paragraph (d)(6) of

this section (zero, or line (10) reduced by line (19) if

line (24) is greater than line (23))........................ 30

(26) Adjusted net foreign base company income after

application of paragraph (d)(6) of this section (line (20)

reduced by line (25))....................................... 0

Step 9--Additions to or reduction of subpart F income by reason

of section 952(c):

(27) Earnings and profits for the current year............... 350

(28) Amount subject to being recharacterized as subpart F

income under section 952(c)(2) (excess of line (27) over the

sum of line (21) and line (26)); if there is a deficit, then

the limitation of 952(c)(1) may apply for the current year.. 350

(29) Amount of reduction in subpart F income for prior

taxable years by reason of the limitation of section

952(c)(1)................................................... 600

(30) Subpart F income as defined in section 952(a), assuming

section 952(a) (3), (4), and (5) do not apply (the sum of

line (21) and line (26) plus the lesser of line (28) or line

(29))....................................................... 350

(31) Amount of prior years' deficit remaining to be

recharacterized as subpart F income in later years under

section 952(c) (excess of line (29) over line (28))......... 250

(e) Character of income--(1) Substance of the transaction. For

purposes of section 954, income shall be characterized in accordance

with the substance of the transaction, and not in accordance with the

designation applied by the parties to the transaction. For example, an

amount that is designated as rent by the taxpayer but actually

constitutes income from the sale of property, royalties, or income from

services shall not be characterized as rent but shall be characterized

as income from the sale of property, royalties or income from services,

as the case may be. Local law shall not be controlling in

characterizing income.

(2) Separable character. To the extent the definitional provisions

of section 953 or 954 describe the income or gain derived from a

transaction, or any portion or portions thereof, that income or gain,

or portion or portions thereof, is so characterized for purposes of

subpart F. Thus, a single transaction may give rise to income in more

than one category of foreign base company income described in paragraph

(a)(2) of this section. For example, if a controlled foreign

corporation, in its business of purchasing personal property and

selling it to related persons outside its country of incorporation,

also performs services outside its country of incorporation with

respect to the property it sells, the sales income will be treated as

foreign base company sales income and the services income will be

treated as foreign base company services income for purposes of these

rules.

(3) Predominant character. The portion of income or gain derived

from a transaction that is included in the computation of foreign

personal holding company income is always separately determinable and

thus must always be segregated from other income and separately

classified under paragraph (e)(2) of this section. However, the portion

of income or gain derived from a transaction that would meet a

particular definitional provision under section 954 or 953 (other than

the definition of foreign personal holding company income) in unusual

circumstances may not be separately determinable. If such portion is

not separately determinable, it must be classified in accordance with

the predominant character of the transaction. For example, if a

controlled foreign corporation engineers, fabricates, and installs a

fixed offshore drilling platform as part of an integrated transaction,

and the portion of income that relates to services is not accounted for

separately from the portion that relates to sales, and is otherwise not

separately determinable, then the classification of income from the

transaction shall be made in accordance with the predominant character

of the arrangement.

(4) Coordination of categories of gross foreign base company

income or gross insurance income--(i) In general. The computations of

gross foreign base company income and gross insurance income are

limited by the following rules:

(A) If income is foreign base company shipping income, pursuant to

section 954(f), it shall not be considered insurance income or income

in any other category of foreign base company income.

(B) If income is foreign base company oil related income, pursuant

to section 954(g), it shall not be considered insurance income or

income in any other category of foreign base company income, except as

provided in paragraph (e)(4)(i)(A) of this section.

shall not be considered income in any category of foreign base company

income except as provided in paragraph (e)(4)(i) (A) or (B) of this

section.

(D) If income is foreign personal holding company income, pursuant

to section 954(c), it shall not be considered income in any other

category of foreign base company income, other than as provided in

paragraph (e)(4)(i) (A), (B) or (C) of this section.

(ii) Income excluded from other categories of gross foreign base

company income. Income shall not be excluded from a category of gross

foreign base company income or gross insurance income under this

paragraph (e)(4) by reason of being included in another category of

gross foreign base company income or gross insurance income, if the

income is excluded from that other category by a more specific

provision of section 953 or 954. For example, income derived from a

commodity transaction that is excluded from foreign personal holding

company income under Sec. 1.954-2(f) as income from a qualified active

sale may be included in gross foreign base company income if it also

meets the definition of foreign base company sales income. See

Sec. 1.954-2(a)(2) for the coordination of overlapping categories

within the definition of foreign personal holding company income.

(f) Definition of related person--(1) Persons related to controlled

foreign corporation. Unless otherwise provided, for purposes of section

954 and Secs. 1.954-1 through 1.954-8 inclusive, the following persons

are considered under section 954(d)(3) to be related persons with

respect to a controlled foreign corporation:

[[Page 46517]]

(i) Individuals. An individual, whether or not a citizen or

resident of the United States, who controls the controlled foreign

corporation.

(ii) Other persons. A foreign or domestic corporation, partnership,

trust or estate that controls or is controlled by the controlled

foreign corporation, or is controlled by the same person or persons

that control the controlled foreign corporation.

(2) Control--(i) Corporations. With respect to a corporation,

control means the ownership, directly or indirectly, of stock

possessing more than 50 percent of the total voting power of all

classes of stock entitled to vote or of the total value of the stock of

the corporation.

(ii) Partnerships. With respect to a partnership, control means the

ownership, directly or indirectly, of more than 50 percent (by value)

of the capital or profits interest in the partnership.

(iii) Trusts and estates. With respect to a trust or estate,

control means the ownership, directly or indirectly, of more than 50

percent (by value) of the beneficial interest in the trust or estate.

(iv) Direct or indirect ownership. For purposes of this paragraph

(f), to determine direct or indirect ownership, the principles of

section 958(a) shall be applied without regard to whether a

corporation, partnership, trust or estate is foreign or domestic or

whether or not an individual is a citizen or resident of the United

States.

Sec. 1.954-2 Foreign personal holding company income.

(a) Computation of foreign personal holding company income--(1)

Categories of foreign personal holding company income. For purposes of

subpart F and the regulations under that subpart, foreign personal

holding company income consists of the following categories of income--

(i) Dividends, interest, rents, royalties, and annuities as

described in paragraph (b) of this section;

(ii) Gain from certain property transactions as described in

paragraph (e) of this section;

(iii) Gain from commodities transactions as described in paragraph

(f) of this section;

(iv) Foreign currency gain as described in paragraph (g) of this

section; and

(v) Income equivalent to interest as described in paragraph (h) of

this section.

(2) Coordination of overlapping categories under foreign personal

holding company provisions--(i) In general. If any portion of income,

gain or loss from a transaction is described in more than one category

of foreign personal holding company income (as described in paragraph

(a)(2)(ii) of this section), that portion of income, gain or loss is

treated solely as income, gain or loss from the category of foreign

personal holding company income with the highest priority.

(ii) Priority of categories. The categories of foreign personal

holding company income, listed from highest priority (paragraph

(a)(2)(ii)(A) of this section) to lowest priority (paragraph

(a)(2)(ii)(E) of this section), are--

(A) Dividends, interest, rents, royalties, and annuities, as

described in paragraph (b) of this section;

(B) Income equivalent to interest, as described in paragraph (h) of

this section without regard to the exceptions in paragraph

(h)(1)(ii)(A) of this section;

this section without regard to the exclusion in paragraph (g)(2)(ii) of

this section;

(D) Gain or loss from commodities transactions, as described in

paragraph (f) of this section without regard to the exclusion in

paragraph (f)(1)(ii) of this section; and

(E) Gain or loss from certain property transactions, as described

in paragraph (e) of this section without regard to the exceptions in

paragraph (e)(1)(ii) of this section.

(3) Changes in the use or purpose for which property is held--(i)

In general. Under paragraphs (e), (f), (g) and (h) of this section,

transactions in certain property give rise to gain or loss included in

the computation of foreign personal holding company income if the

controlled foreign corporation holds that property for a particular use

or purpose. The use or purpose for which property is held is that use

or purpose for which it was held for more than one- half of the period

during which the controlled foreign corporation held the property prior

to the disposition.

(ii) Special rules--(A) Anti-abuse rule. If a principal purpose of

a change in use or purpose of property was to avoid including gain or

loss in the computation of foreign personal holding company income, all

the gain or loss from the disposition of the property is treated as

foreign personal holding company income. A purpose may be a principal

purpose even though it is outweighed by other purposes (taken together

or separately).

(B) Hedging transactions. The provisions of paragraph (a)(3)(i) of

this section shall not apply to bona fide hedging transactions, as

defined in paragraph (a)(4)(ii) of this section. A transaction will be

treated as a bona fide hedging transaction only so long as it satisfies

the requirements of paragraph (a)(4)(ii) of this section.

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

this paragraph (a)(3).

Example. At the beginning of taxable year 1, CFC, a controlled

foreign corporation, purchases a building for investment. During

taxable years 1 and 2, CFC derives rents from the building that are

included in the computation of foreign personal holding company

income under paragraph (b)(1)(iii) of this section. At the beginning

of taxable year 3, CFC changes the use of the building by

terminating all leases and using it in an active trade or business.

At the beginning of taxable year 4, CFC sells the building at a

gain. The building was not used in an active trade or business of

CFC for more than one-half of the period during which it was held by

CFC. Therefore, the building is considered to be property that gives

rise to rents, as described in paragraph (e)(2) of this section, and

gain from the sale is included in the computation of CFC's foreign

personal holding company income under paragraph (e) of this section.

(4) Definitions and special rules. The following definitions and

special rules apply for purposes of computing foreign personal holding

company income under this section.

(i) Interest. The term interest includes all amounts that are

treated as interest income (including interest on a tax-exempt

obligation) by reason of the Internal Revenue Code or Income Tax

Regulations or any other provision of law. For example, interest

includes stated interest, acquisition discount, original issue

discount, de minimis original issue discount, market discount, de

minimis market discount, and unstated interest, as adjusted by any

amortizable bond premium or acquisition premium.

(ii) Bona fide hedging transaction--(A) Definition. The term bona

fide hedging transaction means a transaction that meets the

requirements of Sec. 1.1221-2 (a) through (c) and that is identified in

accordance with the requirements of paragraph (a)(4)(ii)(B) of this

section, except that in applying Sec. 1.1221-2(b)(1), the risk being

hedged may be with respect to ordinary property, section 1231 property,

or a section 988 transaction. A transaction that hedges the

liabilities, inventory or other assets of a related person (as defined

in section 954(d)(3)), that is entered into to assume or reduce risks

of a related person, or that is entered into by a person other than a

person acting in its capacity as a regular dealer (as defined in

paragraph (a)(4)(iv) of this section) to reduce risks assumed from a

related person, will not be treated as a bona fide hedging transaction.

For an illustration of how this rule applies with respect to foreign

[[Page 46518]]

currency transactions, see paragraph (g)(2)(ii)(D) of this section.

(B) Identification. The identification requirements of this section

shall be satisfied if the taxpayer meets the identification and

recordkeeping requirements of Sec. 1.1221-2(e). However, for bona fide

hedging transactions entered into prior to March 7, 1996 the

identification and recordkeeping requirements of Sec. 1.1221-2 shall

not apply. Rather, for bona fide hedging transactions entered into on

or after July 22, 1988 and prior to March 7, 1996 the identification

and recordkeeping requirements shall be satisfied if such transactions

are identified by the close of the fifth day after the day on which

they are entered into. For bona fide hedging transactions entered into

prior to July 22, 1988, the identification and recordkeeping

requirements shall be satisfied if such transactions are identified

reasonably contemporaneously with the date they are entered into, but

no later than within the normal period prescribed under the method of

accounting of the controlled foreign corporation used for financial

reporting purposes.

Transactions identified. If a taxpayer identifies a transaction as a

bona fide hedging transaction for purposes of this section, the

identification is binding with respect to any loss arising from such

transaction whether or not all of the requirements of paragraph

(a)(4)(ii)(A) of this section are satisfied. Accordingly, such loss

will be allocated against income that is not subpart F income (or, in

the case of an election under paragraph (g)(3) of this section, against

the category of subpart F income to which it relates) and apportioned

among the categories of income described in section 904(d)(1). If the

transaction is not in fact a bona fide hedging transaction described in

paragraph (a)(4)(ii)(A) of this section, however, then any gain

realized with respect to such transaction shall not be considered as

gain from a bona fide hedging transaction. Accordingly, such gain shall

be treated as gain from the appropriate category of foreign personal

holding company income. Thus, the taxpayer's identification of the

transaction as a hedging transaction does not itself operate to exclude

gain from the appropriate category of foreign personal holding company

income.

(2) Inadvertent identification. Notwithstanding paragraph

(a)(4)(ii)(C)(1) of this section, if the taxpayer identifies a

transaction as a bona fide hedging transaction for purposes of this

section, the characterization of the loss is determined as if the

transaction had not been identified as a bona fide hedging transaction

if--

(i) The transaction is not a bona fide hedging transaction (as

defined in paragraph (a)(4)(ii)(A) of this section);

(ii) The identification of the transaction as a bona fide hedging

transaction was due to inadvertent error; and

(iii) All of the taxpayer's transactions in all open years are

being treated on either original or, if necessary, amended returns in a

manner consistent with the principles of this section.

(3) Transactions not identified. Except as provided in paragraphs

(a)(4)(ii)(C) (4) and (5) of this section, the absence of an

identification that satisfies the requirements of paragraph

(a)(4)(ii)(B) of this section is binding and establishes that a

transaction is not a bona fide hedging transaction. Thus, subject to

the exceptions, the characterization of gain or loss is determined

without reference to whether the transaction is a bona fide hedging

transaction.

(4) Inadvertent error. If a taxpayer does not make an

identification that satisfies the requirements of paragraph

(a)(4)(ii)(B) of this section, the taxpayer may treat gain or loss from

the transaction as gain or loss from a bona fide hedging transaction

if--

(i) The transaction is a bona fide hedging transaction (as defined

in paragraph (a)(4)(ii)(A) of this section);

(ii) The failure to identify the transaction was due to inadvertent

error; and

(iii) All of the taxpayer's bona fide hedging transactions in all

open years are being treated on either original or, if necessary,

amended returns as bona fide hedging transactions in accordance with

the rules of this section.

(5) Anti-abuse rule. If a taxpayer does not make an identification

that satisfies all the requirements of paragraph (a)(4)(ii)(B) of this

section but the taxpayer has no reasonable grounds for treating the

transaction as other than a bona fide hedging transaction, then loss

from the transaction shall be treated as realized with respect to a

bona fide hedging transaction. Thus, a taxpayer may not elect to

exclude loss from its proper characterization as a bona fide hedging

transaction. The reasonableness of the taxpayer's failure to identify a

transaction is determined by taking into consideration not only the

requirements of paragraph (a)(4)(ii)(A) of this section but also the

taxpayer's treatment of the transaction for financial accounting or

other purposes and the taxpayer's identification of similar

transactions as hedging transactions.

(iii) Inventory and similar property--(A) Definition. The term

inventory and similar property (or inventory or similar property) means

property that is stock in trade of the controlled foreign corporation

or other property of a kind that would properly be included in the

inventory of the controlled foreign corporation if on hand at the close

of the taxable year (if the controlled foreign corporation were a

domestic corporation), or property held by the controlled foreign

corporation primarily for sale to customers in the ordinary course of

its trade or business.

(B) Hedging transactions. A bona fide hedging transaction with

respect to inventory or similar property (other than a transaction

described in section 988(c)(1) without regard to section

988(c)(1)(D)(i)) shall be treated as a transaction in inventory or

similar property.

(iv) Regular dealer. The term regular dealer means a controlled

foreign corporation that--

(A) Regularly and actively offers to, and in fact does, purchase

property from and sell property to customers who are not related

persons (as defined in section 954(d)(3)) with respect to the

controlled foreign corporation in the ordinary course of a trade or

business; or

(B) Regularly and actively offers to, and in fact does, enter into,

assume, offset, assign or otherwise terminate positions in property

with customers who are not related persons (as defined in section

954(d)(3)) with respect to the controlled foreign corporation in the

ordinary course of a trade or business.

(v) Dealer property--(A) Definition. Property held by a controlled

foreign corporation is dealer property if--

(1) The controlled foreign corporation is a regular dealer in

property of such kind (determined under paragraph (a)(4)(iv) of this

section); and

(2) The property is held by the controlled foreign corporation in

its capacity as a dealer in property of such kind without regard to

whether the property arises from a transaction with a related person

(as defined in section 954(d)(3)) with respect to the controlled

foreign corporation. The property is not held by the controlled foreign

corporation in its capacity as a dealer if the property is held for

investment or speculation on its own behalf or on behalf of a related

person (as defined in section 954(d)(3)).

(B) Securities dealers. If a controlled foreign corporation is a

licensed securities dealer, only the securities that it has identified

as held for investment in accordance with the provisions of section

475(b) or section 1236 will be

[[Page 46519]]

considered to be property held for investment or speculation under this

section. A licensed securities dealer is a controlled foreign

corporation that is both a securities dealer, as defined in section

475, and a regular dealer, as defined in paragraph (a)(4)(iv) of this

section, and that is either--

(1) registered as a securities dealer under section 15(a) of the

Securities Exchange Act of 1934 or as a Government securities dealer

under section 15C(a) of such Act; or

(2) licensed or authorized in the country in which it is chartered,

incorporated, or organized to purchase and sell securities from or to

customers who are residents of that country. The conduct of such

securities activities must be subject to bona fide regulation,

including appropriate reporting, monitoring, and prudential (including

capital adequacy) requirements, by a securities regulatory authority in

that country that regularly enforces compliance with such requirements

and prudential standards.

respect to dealer property shall be treated as a transaction in dealer

property.

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

paragraphs (a)(4)(ii), (iv) and (v) of this section.

Example 1. (i) CFC1 and CFC2 are related controlled foreign

corporations (within the meaning of section 954(d)(3)) located in

Countries F and G, respectively. CFC1 and CFC2 regularly purchase

securities from and sell securities to customers who are not related

persons with respect to CFC1 or CFC2 (within the meaning of section

954(d)(3)) in the ordinary course of their businesses and regularly

and actively hold themselves out as being willing to, and in fact

do, enter into either side of options, forward contracts, or other

financial instruments. CFC1 uses securities that are traded in

securities markets in Country G to hedge positions that it enters

into with customers located in Country F. CFC1 is not a member of a

securities exchange in Country G, so it purchases such securities

from CFC2 and unrelated persons that are registered as securities

dealers in Country G and that are members of Country G securities

exchanges. Such hedging transactions qualify as bona fide hedging

transactions under paragraph (a)(4)(ii) of this section.

(ii) Transactions that CFC1 and CFC2 enter into with each other

do not affect the determination of whether they are regular dealers.

Because CFC1 and CFC2 regularly purchase securities from and sell

securities to customers who are not related persons within the

meaning of section 954(d)(3) in the ordinary course of their

businesses and regularly and actively hold themselves out as being

willing to, and in fact do, enter into either side of options,

forward contracts, or other financial instruments, however, they

qualify as regular dealers in such property within the meaning of

paragraph (a)(4)(iv) of this section. Moreover, because CFC1

purchases securities from CFC2 as bona fide hedging transactions

with respect to dealer property, the securities are dealer property

under paragraph (a)(4)(v)(C) of this section. Similarly, because

CFC2 sells securities to CFC1 in the ordinary course of its business

as a dealer, the securities are dealer property under paragraph

(a)(4)(v)(A) of this section.

Example 2. (i) CFC is a controlled foreign corporation located

in Country B. CFC serves as the currency coordination center for the

controlled group, aggregating currency risks incurred by the group

and entering into hedging transactions that transfer those risks

outside of the group. CFC regularly and actively holds itself out as

being willing to, and in fact does, enter into either side of

options, forward contracts, or other financial instruments with

other members of the same controlled group. CFC hedges risks arising

from such transactions by entering into transactions with persons

who are not related persons (within the meaning of section

954(d)(3)) with respect to CFC. However, CFC does not regularly and

actively hold itself out as being willing to, and does not, enter

into either side of transactions with unrelated persons.

(ii) CFC is not a regular dealer in property under paragraph

(a)(4)(iv) of this section and its options, forwards, and other

financial instruments are not dealer property within the meaning of

paragraph (a)(4)(v) of this section.

(vii) Debt instrument. The term debt instrument includes bonds,

debentures, notes, certificates, accounts receivable, and other

evidences of indebtedness.

(b) Dividends, interest, rents, royalties, and annuities--(1) In

general. Foreign personal holding company income includes--

(i) Dividends, except certain dividends from related persons as

described in paragraph (b)(4) of this section and distributions of

previously taxed income under section 959(b);

(ii) Interest, except export financing interest as defined in

paragraph (b)(2) of this section and certain interest received from

related persons as described in paragraph (b)(4) of this section;

(iii) Rents and royalties, except certain rents and royalties

received from related persons as described in paragraph (b)(5) of this

section and rents and royalties derived in the active conduct of a

trade or business as defined in paragraph (b)(6) of this section; and

(iv) Annuities.

(2) Exclusion of certain export financing interest--(i) In general.

Foreign personal holding company income does not include interest that

is export financing interest. The term export financing interest means

interest that is derived in the conduct of a banking business and is

export financing interest as defined in section 904(d)(2)(G). Solely

for purposes of determining whether interest is export financing

interest, property is treated as manufactured, produced, grown, or

extracted in the United States if it is so treated under Sec. 1.927(a)-

1T(c).

(ii) Exceptions. Export financing interest does not include income

from related party factoring that is treated as interest under section

864(d) (1) or (6) after the application of section 864(d)(7).

(iii) Conduct of a banking business. For purposes of this section,

export financing interest is considered derived in the conduct of a

banking business if, in connection with the financing from which the

interest is derived, the corporation, through its own officers or staff

of employees, engages in all the activities in which banks customarily

engage in issuing and servicing a loan.

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

this paragraph (b)(2).

Example 1. (i) DS, a domestic corporation, manufactures property

in the United States. In addition to selling inventory (property

described in section 1221(1)), DS occasionally sells depreciable

equipment it manufactures for use in its trade or business, which is

property described in section 1221(2). Less than 50 percent of the

fair market value, determined in accordance with section

904(d)(2)(G), of each item of inventory or equipment sold by DS is

attributable to products imported into the United States. CFC, a

controlled foreign corporation with respect to which DS is a related

person (within the meaning of section 954(d)(3)), provides loans

described in section 864(d)(6) to unrelated persons for the purchase

of property from DS. This property is purchased exclusively for use

or consumption outside the United States and outside CFC's country

of incorporation.

(ii) If, in issuing and servicing loans made with respect to

purchases from DS of depreciable equipment used in its trade or

business, which is property described in section 1221(2) in the

hands of DS, CFC engages in all the activities in which banks

customarily engage in issuing and servicing loans, the interest

accrued from these loans would be export financing interest meeting

the requirements of this paragraph (b)(2) and, thus, not included in

foreign personal holding company income. However, interest from the

loans made with respect to purchases from DS of property that is

inventory in the hands of DS cannot be export financing interest

because it is treated as income from a trade or service receivable

under section 864(d)(6) and the exception under section 864(d)(7)

does not apply. Thus the interest from loans made with respect to

this inventory is included in foreign personal holding company

income under paragraph (b)(1)(ii) of this section.

Example 2. (i) DS, a domestic corporation manufactures property

in the United States. DS wholly owns two controlled foreign

[[Page 46520]]

corporations organized in Country A, CFC1 and CFC2. CFC1 has a

substantial part of its assets used in its trade or business in

Country A. CFC1 purchases the property that DS manufactures and

sells it without further manufacture for use or consumption within

Country A. This property is inventory property, as described in

section 1221(1), in the hands of CFC1. Less than 50 percent of the

fair market value, determined in accordance with section

904(d)(2)(G), of each item of inventory sold by CFC1 is attributable

to products imported into the United States. CFC2 provides loans

described in section 864(d)(6) to unrelated persons in Country A for

the purchase of the property from CFC1.

(ii) If, in issuing and servicing loans made with respect to

purchases from CFC1 of the inventory property, CFC2 engages in all

the activities in which banks customarily engage in issuing and

servicing loans, the interest accrued from these loans would be

export financing interest meeting the requirements of paragraph

(b)(2) of this section. It is not treated as income from a trade or

service receivable under section 864(d)(6) because the exception

under section 864(d)(7) applies. Thus the interest is excluded from

foreign personal holding company income.

Example 3. The facts are the same as in Example 2 except that

the property sold by CFC1 is manufactured by CFC1 in Country A from

component parts that were manufactured by DS in the United States.

The interest accrued from the loans by CFC2 is not export financing

interest as defined in section 904(d)(2)(G) because the property is

not manufactured in the United States under Sec. 1.927(a)-1T(c). No

portion of the interest is export financing interest as defined in

this paragraph (b)(2). The full amount of the interest is,

therefore, included in foreign personal holding company income under

paragraph (b)(1)(ii) of this section.

(3) Treatment of tax-exempt interest. [Reserved] For guidance, see

Sec. 4.954-2(b)(6) of this chapter.

(4) Exclusion of dividends or interest from related persons--(i) In

general--(A) Corporate payor. Foreign personal holding company income

received by a controlled foreign corporation does not include dividends

or interest if the payor--

(1) Is a corporation that is a related person with respect to the

controlled foreign corporation, as defined in section 954(d)(3);

(2) Is created or organized under the laws of the same foreign

country (the country of incorporation) as is the controlled foreign

corporation; and

(3) Uses a substantial part of its assets in a trade or business in

its country of incorporation, as determined under this paragraph

(b)(4).

(B) Payment by a partnership. For purposes of this paragraph

(b)(4), if a partnership with one or more corporate partners makes a

payment of interest, a corporate partner will be treated as the payor

of the interest--

(1) If the interest payment gives rise to a partnership item of

deduction under the Internal Revenue Code or Income Tax Regulations, to

the extent that the item of deduction is allocable to the corporate

partner under section 704(b); or

(2) If the interest payment does not give rise to a partnership

item of deduction under the Internal Revenue Code or Income Tax

Regulations, to the extent that a partnership item reasonably related

to the payment would be allocated to that partner under an existing

allocation under the partnership agreement (made pursuant to section

704(b)).

(ii) Exceptions--(A) Dividends. Dividends are excluded from foreign

personal holding company income under this paragraph (b)(4) only to the

extent that they are paid out of earnings and profits that are earned

or accumulated during a period in which--

(1) The stock on which dividends are paid with respect to which the

exclusion is claimed was owned by the recipient controlled foreign

corporation directly, or indirectly through a chain of one or more

subsidiaries each of which meets the requirements of paragraph

(b)(4)(i)(A) of this section; and

(2) Each of the requirements of paragraph (b)(4)(i)(A) of this

section is satisfied or, to the extent earned or accumulated during a

taxable year of the related foreign corporation ending on or before

December 31, 1962, during a period in which the payor was a related

corporation as to the controlled foreign corporation and the other

requirements of paragraph (b)(4)(i)(A) of this section were

substantially satisfied.

(3) This paragraph (b)(4)(ii)(A) is illustrated by the following

example:

Example. A, a domestic corporation, owns all of the stock of B,

a corporation created and organized under the laws of Country Y, and

C, a corporation created and organized under the laws of Country X.

The taxable year of each of the corporations is the calendar year.

In Year 1, B earns $100 of income from the sale of products in

Country Y that it manufactured in Country Y. C had no earnings and

profits in Year 1. On January 1 of Year 2, A contributes all of the

stock of B and C to Newco, a Country Y corporation, in exchange for

all of the stock of Newco. Neither B nor C earns any income in Year

2, but at the end of Year 2 B distributes the $100 accumulated

earnings and profits to Newco. Newco's income from the distribution,

$100, is foreign personal holding company income because the

earnings and profits distributed by B were not earned or accumulated

during a period in which the stock of B was owned by Newco and in

which each of the requirements of paragraph (b)(4)(i)(A) of this

section was satisfied.

(B) Interest paid out of adjusted foreign base company income or

insurance income--(1) In general. Interest may not be excluded from the

foreign personal holding company income of the recipient under this

paragraph (b)(4) to the extent that the deduction for the interest is

allocated under Sec. 1.954-1(a)(4) and (c) to the payor's adjusted

gross foreign base company income (as defined in Sec. 1.954-1(a)(3)),

adjusted gross insurance income (as defined in Sec. 1.954-1(a)(6)), or

any other category of income included in the computation of subpart F

income under section 952(a).

(2) Rule for corporations that are both recipients and payors of

interest. If a controlled foreign corporation is both a recipient and

payor of interest, the interest that is received will be characterized

before the interest that is paid. In addition, the amount of interest

paid or accrued, directly or indirectly, by the controlled foreign

corporation to a related person (as defined in section 954(d)(3)) shall

be offset against and eliminate any interest received or accrued,

directly or indirectly, by the controlled foreign corporation from that

related person. In a case in which the controlled foreign corporation

pays or accrues interest to a related person, as defined in section

954(d)(3), and also receives or accrues interest indirectly from the

related person, the smallest interest payment is eliminated and the

amounts of all other interest payments are reduced by the amount of the

smallest interest payment.

controlled foreign corporation that is treated as interest under

section 864(d) (1) or (6), or that is portfolio interest, as defined by

section 881(c), is not excluded from foreign personal holding company

income under section 954(c)(3)(A)(i) and this paragraph (b)(4).

(iii) Trade or business requirement. Except as otherwise provided

under this paragraph (b)(4), the principles of section 367(a) apply for

purposes of determining whether the payor has a trade or business in

its country of incorporation and whether its assets are used in that

trade or business. Property purchased or produced for use in a trade or

business is not considered used in a trade or business before it is

placed in service or after it is retired from service as determined in

accordance with the principles of sections 167 and 168.

(iv) Substantial assets test. A substantial part of the assets of

the payor will be considered to be used in a trade or business located

in the payor's country of incorporation for a taxable year only if the

average value of the payor's assets for such year that are used in the

trade or business and are

[[Page 46521]]

located in such country equals more than 50 percent of the average

value of all the assets of the payor (including assets not used in a

trade or business). The average value of assets for the taxable year is

determined by averaging the values of assets at the close of each

quarter of the taxable year. The value of assets is determined under

paragraph (b)(4)(v) of this section, and the location of assets used in

a trade or business of the payor is determined under paragraphs (b)(4)

(vi) through (xi) of this section.

(v) Valuation of assets. For purposes of determining whether a

substantial part of the assets of the payor are used in a trade or

business in its country of incorporation, the value of assets shall be

their fair market value (not reduced by liabilities), which, in the

absence of affirmative evidence to the contrary, shall be deemed to be

their adjusted basis.

(vi) Location of tangible property--(A) In general. Tangible

property (other than inventory and similar property as defined in

paragraph (a)(4)(iii) of this section, and dealer property as defined

in paragraph (a)(4)(v) of this section) used in a trade or business is

considered located in the country in which it is physically located.

(B) Exception. An item of tangible personal property that is used

in the trade or business of a payor in the payor's country of

incorporation is considered located within the payor's coun

This text is long and has been trimmed here. Open the source document for the complete record.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.