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

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0075-92]

RIN 1545-AR31

Definition of Foreign Base Company Income and Foreign Personal

Holding Company Income of a Controlled Foreign Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed Income Tax Regulations

relating to the definitions of subpart F income and foreign personal

holding company income of a controlled foreign corporation and the

allocation of deficits for purposes of computing the deemed-paid

foreign tax credit. These proposed regulations are necessary to provide

guidance that coordinates with guidance provided in final regulations

under section 954, published elsewhere in this issue of the Federal

Register. These regulations will affect United States shareholders of

controlled foreign corporations. This document also contains a notice

of hearing on these regulations.

DATES: Written comments must be received by December 6, 1995. Outlines

of topics to be discussed at the public hearing scheduled for January

4, 1996 at 10 a.m. must be received by December 14, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (INTL-0075-92), room

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

Washington DC 20044. In the alternative, submissions may be hand

delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R

(INTL-0075-92), Courier's Desk, Internal Revenue Service, 1111

Constitution Avenue NW., Washington DC. The public hearing will be held

in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue

NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Valerie

Mark, (202) 622-3840; concerning submissions and the hearing, Michael

Slaughter (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

This notice of proposed rulemaking does not contain collections of

information and, therefore, it has not been submitted to the Office of

Management and Budget for review under the Paperwork Reduction Act (44

U.S.C. 3504(h)).

Background

This document contains proposed regulations amending the Income Tax

Regulations (26 CFR Part 1) under sections 952, 954(c) and 960 of the

Internal Revenue Code. These regulations are also issued under

authority contained in section 7805 of the Internal Revenue Code. In

final regulations under section 954, published elsewhere in this issue

of the Federal Register, the section relating to the treatment of tax-

exempt interest under the foreign personal holding company income rules

was reserved. These proposed regulations would provide rules for the

treatment of tax-exempt interest and would also provide guidance under

sections 952 and 960 to coordinate with the final regulations.

Explanation of Provisions

Sections 1.952-1 (e) and (f) and 1.960-1(i)

Section 1.954-1(c)(1)(ii), published elsewhere in this issue of the

Federal Register, provides generally that if the amount in any category

of foreign base company income or foreign personal holding company

income is less than zero, the loss 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). The earnings and profits limitation will apply when subpart

F income exceeds current earnings and profits. This notice of proposed

rulemaking provides rules under section 952(c)(1)(A) to determine how

the excess of subpart F income over current earnings and profits will

reduce categories of foreign base company income or foreign personal

holding company income.

These rules apply both to determine the amount that is included in

the U.S. shareholder's gross income in each category of subpart F

income under section 951(a)(1)(A) from each section 904(d) separate

category, and to determine the subpart F category and the section

904(d) separate category from which an amount will be recharacterized

as subpart F income under section 952(c)(2). Separate rules are

provided in this notice of proposed rulemaking to compute post-1986

undistributed earnings under section 960.

Section 1.952-1(e) provides that for post-1986 years, when the

subpart F income of a controlled foreign corporation exceeds its

current earnings and profits, this excess, first, proportionately

reduces subpart F income in each separate category in which current

earnings and profits are zero or less than zero, second,

proportionately reduces subpart F income in each separate category in

which subpart F income exceeds current earnings and profits, and third,

proportionately reduces subpart F income in other separate categories.

If a single separate category contains more than one category of

subpart F income, the categories of subpart F income in the separate

category will be proportionately reduced.

Section 1.952-1(f) provides that the amount and category of subpart

F income in each separate category that is reduced by operation of the

earnings and profits limitation, as determined under paragraph (e),

constitutes a recapture account. In any year in which earnings and

profits exceed subpart F income, the recapture accounts in each

separate category of the corporation will be recharacterized, on a

proportionate basis, as subpart F income to the extent of this excess.

An amount that is recharacterized as subpart F income is treated as

income in the same separate category as the recapture account from

which it was derived.

[[Page 46549]]

Under paragraph (f), a recapture account is reduced either when

amounts in the account are recharacterized as subpart F income or when

the corporation makes an actual distribution from the separate category

containing the recapture account. A distribution out of section

959(c)(3) earnings and profits is treated as made first on a

proportionate basis out of the recapture accounts in each separate

category. If a distribution from earnings and profits described in

section 959(c)(3) occurs in the same year that an amount is

recharacterized, the recharacterization rules will apply first.

Examples are provided to illustrate the rules of paragraphs (e) and

(f).

Regulations are proposed under section 960 that apply the

principles of section 902 to determine the portion of the controlled

foreign corporation's post-1986 foreign income taxes deemed to be paid

by a United States corporate shareholder in connection with a subpart F

inclusion. If the corporate shareholder computes an amount under both

sections 902 and 960 for a taxable year, section 960 is applied first.

These proposed regulations also provide rules to determine how

deficits in post-1986 undistributed earnings are allocated for purposes

of sections 902 and 960. In accordance with the approach of Notice 88-

70 (1988-2 C.B 369), Sec. 1.960-1(i)(4) provides that a post-1986

accumulated deficit in a separate category is allocated pro rata

against post-1986 undistributed earnings in other separate categories

to compute post-1986 undistributed earnings. The deficit does not

permanently reduce earnings in these other separate categories. Rather,

after deemed-paid taxes are computed, it is carried forward in the same

separate category in which it was incurred. Paragraph (i)(3) clarifies

that the numerator of the deemed-paid credit fraction cannot exceed the

denominator because deemed-paid taxes may not exceed taxes paid or

accrued by the controlled foreign corporation. Examples are provided to

illustrate these rules.

The proposed regulations attempt to coordinate, to the extent

possible, the allocation of deficits for purposes of determining the

amounts of subpart F inclusions and deemed-paid taxes out of the

controlled foreign corporation's separate foreign tax credit limitation

categories under sections 952, 954, and 960. Complete coordination is

not possible in all cases, because subpart F income and the earnings

and profits limitation of section 952(c)(1)(A) are determined on the

basis of earnings and profits of only the current year, whereas deemed-

paid taxes are calculated under section 960 on the basis of multi-year

pools of earnings and profits and taxes. In addition, potential

differences in the calculation of income and earnings and profits, cf.

section 952(c)(3), complicate the coordination.

The proposed rules attempt to minimize the incidence of subpart F

inclusions out of separate categories with no current earnings which,

in the absence of sufficient accumulated earnings, may carry no deemed-

paid taxes. Comments are requested as to whether the proposed

allocation methods or some alternative approach would best achieve

appropriate foreign tax credit results.

Section 1.954-2(b)(3)

Under Sec. 1.954-2T(b)(6), interest income that is exempt from tax

under section 103 is included in the foreign personal holding company

income of the controlled foreign corporation. However, the net foreign

base company income that is attributable to tax-exempt interest is

treated as tax-exempt interest in the hands of the United States

shareholder upon a deemed distribution under subpart F. Therefore, for

regular tax purposes, the tax-exempt interest is not currently included

in the gross income of the United States shareholder under subpart F.

However, the deemed distribution of tax-exempt interest may subject the

United States shareholder to the alternative minimum tax.

Section 1.954-2(b)(3) of the proposed regulations would amend the

rule in the temporary regulations to provide that foreign personal

holding company income includes interest income that is exempt from tax

under section 103. The tax-exempt interest would not retain its

character as such in the hands of the United States shareholder upon a

deemed distribution under subpart F. This proposed rule closely

parallels the domestic rule for tax-exempt interest. The controlled

foreign corporation realizes the tax benefit associated with the

receipt of interest income described in section 103 because no United

States withholding tax is collected on the income when it is paid to

the controlled foreign corporation. As in the domestic context,

however, this tax benefit is limited to the corporate level and is not

retained when the tax-exempt interest is distributed to the United

States shareholders or included in their gross income under subpart F.

This rule simplifies the interaction of the tax-exempt interest and

alternative minimum tax provisions, and avoids the double-taxation and

administrative problems associated with the current rule.

These regulations are proposed to be effective for taxable years of

the foreign corporation beginning after 60 days after the date these

regulations are published as final regulations in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

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

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

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

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

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

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

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

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (signed original

and eight (8) copies) that are timely submitted to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for January 4, 1996, at 10 a.m.

in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue

NW., Washington DC. Because of access restrictions, visitors will not

be admitted beyond the building lobby more than 15 minutes before the

hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons

that wish to present oral comments at the hearing must submit written

comments by December 6, 1995 and submit an outline of topics to be

discussed and time to be devoted to each topic (signed original and

eight (8) copies) by December 14, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information. The principal authors of these regulations

are Barbara Felker and Valerie Mark of the Office of the Associate

Chief Counsel (International), IRS. However, other personnel from

the IRS and Treasury Department participated in their development.

[[Page 46550]]

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. The authority for Part 1 is amended by adding the

following citation in numerical order to read as follows:

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

Section 1.960-1 also issued under 26 U.S.C. 960(a). * * *

Par. 2. Section 1.952-1 is amended by adding paragraphs (e) and (f)

to read as follows:

Sec. 1.952-1 Subpart F income defined.

* * * * *

(e) Application of current earnings and profits limitation--(1) In

general. If the subpart F income (as defined in section 952(a)) of a

controlled foreign corporation exceeds the foreign corporation's

earnings and profits for the taxable year, the subpart F income

includible in the income of the corporation's United States

shareholders is reduced under section 952(c)(1)(A) in accordance with

the following rules. The excess of subpart F income over current year

earnings and profits shall--

(i) First, proportionately reduce subpart F income in each separate

category of the controlled foreign corporation, as defined in

Sec. 1.904-5(a)(1), in which current earnings and profits are zero or

less than zero;

(ii) Second, proportionately reduce subpart F income in each

separate category in which subpart F income exceeds current earnings

and profits; and

(iii) Third, proportionately reduce subpart F income in other

separate categories.

(2) Allocation to a category of subpart F income. An excess amount

that is allocated under paragraph (e)(1) of this section to a separate

category must be further allocated to a category of subpart F income if

the separate category contains more than one category of subpart F

income described in section 952(a) or, in the case of foreign base

company income, described in Sec. 1.954- 1(c)(1)(iii)(A) (1) or (2). In

such case, the excess amount that is allocated to the separate category

must be allocated to the various categories of subpart F income within

that separate category on a proportionate basis.

(3) Recapture of subpart F income reduced by operation of earnings

and profits limitation. Any amount in a category of subpart F income

described in section 952(a) or, in the case of foreign base company

income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2) that is

reduced by operation of the current year earnings and profits

limitation of section 952(c)(1)(A) and this paragraph (e) shall be

subject to recapture in a subsequent year under the rules of section

952(c)(2) and paragraph (f) of this section.

(4) Coordination with sections 953 and 954. The rules of this

paragraph (e) shall be applied after the application of sections 953

and 954 and the regulations under those sections, except as provided in

Sec. 1.954-1(d)(4)(ii).

(5) Earnings and deficits retain separate limitation character. The

income reduction rules of paragraph (e)(1) of this section shall apply

only for purposes of determining the amount of an inclusion under

section 951(a)(1)(A) from each separate category as defined in

Sec. 1.904-5(a)(1) and the separate categories in which recapture

accounts are established under section 952(c)(2) and paragraph (f) of

this section. For rules applicable in computing post-1986 undistributed

earnings, see generally section 902 and the regulations under that

section. For rules relating to the allocation of deficits for purposes

of computing foreign taxes deemed paid under section 960 with respect

to an inclusion under section 951(a)(1)(A), see Sec. 1.960-1(i).

(f) Recapture of subpart F income in subsequent taxable year--(1)

In general. If a controlled foreign corporation's subpart F income for

a taxable year is reduced under the current year earnings and profits

limitation of section 952(c)(1)(A) and paragraph (e) of this section,

recapture accounts will be established and subject to

recharacterization in any subsequent taxable year to the extent the

recapture accounts were not previously recharacterized or distributed,

as provided in paragraphs (f) (2) and (3) of this section.

(2) Rules of recapture--(i) Recapture account. If a category of

subpart F income described in section 952(a) or, in the case of foreign

base company income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2)

is reduced under the current year earnings and profits limitation of

section 952(c)(1)(A) and paragraph (e) of this section for a taxable

year, the amount of such reduction shall constitute a recapture

account.

(ii) Recapture. Each recapture account of the controlled foreign

corporation will be recharacterized, on a proportionate basis, as

subpart F income in the same separate category (as defined in

Sec. 1.904-5(a)(1)) as the recapture account to the extent that current

year earnings and profits exceed subpart F income in a taxable year.

The United States shareholder must include his pro rata share

(determined under the rules of Sec. 1.951-1(e)) of each recharacterized

amount in income as subpart F income in such separate category for the

taxable year.

(iii) Reduction of recapture account and corresponding earnings.

Each recapture account, and post-1986 undistributed earnings in the

separate category containing the recapture account, will be reduced in

any taxable year by the amount which is recharacterized under paragraph

(f)(2)(ii) of this section. In addition, each recapture account, and

post-1986 undistributed earnings in the separate category containing

the recapture account, will be reduced in the amount of any

distribution out of that account (as determined under the ordering

rules of section 959(c) and paragraph (f)(3)(ii) of this section).

(3) Distribution ordering rules--(i) Coordination of recapture and

distribution rules. If a controlled foreign corporation distributes an

amount out of earnings and profits described in section 959(c)(3) in a

year in which current year earnings and profits exceed subpart F income

and there is an amount in a recapture account for such year, the

recapture rules will apply first.

(ii) Distributions reduce recapture accounts first. Any

distribution made by a controlled foreign corporation out of earnings

and profits described in section 959(c)(3) shall be treated as made

first on a proportionate basis out of the recapture accounts in each

separate category to the extent thereof (even if the amount in the

recapture account exceeds post-1986 undistributed earnings in the

separate category containing the recapture account). Any remaining

distribution shall be treated as made on a proportionate basis out of

the remaining earnings and profits of the controlled foreign

corporation in each separate category. See section 904(d)(3)(D).

(4) Examples. The application of paragraphs (e) and (f) of this

section may be illustrated by the following examples:

Example 1. (i) A, a U.S. person, is the sole shareholder of CFC,

a controlled foreign corporation formed on January 1, 1996, whose

functional currency is the u. In 1996, CFC earns 100u of foreign

base company sales income that is general limitation income

described in section 904(d)(1)(I) and incurs a (200u) loss

attributable to activities that would have produced general

limitation income that is not subpart F income. In 1996

[[Page 46551]]

CFC also earns 100u of foreign personal holding company income that is

passive income described in section 904(d)(1)(A), and 100u of

foreign personal holding company income that is dividend income

subject to a separate limitation described in section 904(d)(1)(E)

for dividends from a noncontrolled section 902 corporation. CFC's

subpart F income for 1996, 300u, exceeds CFC's current earnings and

profits, 100u, by 200u. Under section 952(c)(1)(A) and paragraph (e)

of this section, subpart F income is limited to CFC's current

earnings and profits of 100u, all of which is included in A's gross

income under section 951(a)(1)(A). The 200u of CFC's 1996 subpart F

income that is not included in A's income in 1996 by reason of

section 952(c)(1)(A) is subject to recapture under section 952(c)(2)

and paragraph (f) of this section.

(ii) For purposes of determining the amount and type of income

included in A's gross income and the amount and type of income in

CFC's recapture account, the rules of paragraphs (e)(1) and (2) of

this section apply. Under paragraph (e)(1)(i), the amount by which

CFC's subpart F income exceeds its earnings and profits for 1996,

200u, first reduces from 100u to 0 CFC's subpart F income in the

general limitation category, which has a current year deficit of

(100u) in earnings and profits. Next, under paragraph (e)(1)(iii) of

this section, the remaining 100u by which CFC's 1996 subpart F

income exceeds earnings and profits is applied proportionately to

reduce CFC's subpart F income in the separate categories for passive

income (100u) and dividends from the noncontrolled section 902

corporation (100u). Thus, A includes 50u of passive limitation/

foreign personal holding company income and 50u of dividends from

the noncontrolled section 902 corporation/foreign personal holding

company income in gross income in 1996. CFC has 100u in its general

limitation/foreign base company sales income recapture account

attributable to the 100u of foreign base company sales income that

is not included in A's income by reason of the earnings and profits

limitation of section 952(c)(1)(A). CFC also has 50u in its passive

limitation recapture account, all of which is attributable to

foreign personal holding company income, and 50u in its recapture

account for dividends from the noncontrolled section 902

corporation, all of which is attributable to foreign personal

holding company income.

(iii) For purposes of computing post-1986 undistributed

earnings, the rules of sections 902 and 960, including the rules of

Sec. 1.960-1(i), apply. Under Sec. 1.960-1(i), the general

limitation deficit of (100u) is allocated proportionately to reduce

passive limitation earnings of 100u and noncontrolled section 902

dividend earnings of 100u. Thus, passive limitation earnings are

reduced by 50u to 50u (100u passive limitation earnings/200u total

earnings in positive separate categories x (100u) general

limitation deficit =50u reduction), and the noncontrolled section

902 corporation earnings are reduced by 50u to 50u (100u

noncontrolled section 902 corporation earnings/200u total earnings

in positive separate categories x (100u) general limitation

deficit=50u reduction). All of CFC's post-1986 foreign income taxes

with respect to passive limitation income and dividends from the

noncontrolled section 902 corporation are deemed paid by A under

section 960 with respect to the subpart F inclusions (50u inclusion/

50u earnings in each separate category). After the inclusion and

deemed-paid taxes are computed, at the close of 1996 CFC has a

(100u) deficit in general limitation earnings (100u subpart F

earnings + (200u) nonsubpart F loss), 50u of passive limitation

earnings (100u of earnings attributable to foreign personal holding

company income -50u inclusion) with a corresponding passive

limitation/foreign personal holding company income recapture account

of 50u, and 50u of earnings subject to a separate limitation for

dividends from the noncontrolled section 902 corporation (100u

earnings -50u inclusion) with a corresponding noncontrolled section

902 corporation/foreign personal holding company income recapture

account of 50u.

Example 2. (i) The facts are the same as in Example 1 with the

addition of the following facts. In 1997, CFC earns 100u of foreign

base company sales income that is general limitation income and 100u

of foreign personal holding company income that is passive

limitation income. In addition, CFC incurs (10u) of expenses that

are allocable to its separate limitation for dividends from the

noncontrolled section 902 corporation. Thus, CFC's subpart F income

for 1997, 200u, exceeds CFC's current earnings and profits, 190u, by

10u. Under section 952(c)(1)(A) and paragraph (e) of this section,

subpart F income is limited to CFC's current earnings and profits of

190u, all of which is included in A's gross income under section

951(a)(1)(A).

(ii) For purposes of determining the amount and type of income

included in A's gross income and the amount and type of income in

CFC's recapture accounts, the rules of paragraphs (e) (1) and (2) of

this section apply. While CFC's general limitation post-1986

undistributed earnings for 1997 are 0 ((100u) opening balance + 100u

subpart F income), CFC's general limitation subpart F income (100u)

does not exceed its general limitation current earnings and profits

(100u) for 1997. Accordingly, under paragraph (e)(1)(iii) of this

section, the amount by which CFC's subpart F income exceeds its

earnings and profits for 1997, 10u, is applied proportionately to

reduce CFC's subpart F income in the separate categories for general

limitation income, 100u, and passive income, 100u. Thus, A includes

95u of general limitation foreign base company sales income and 95u

of passive limitation foreign personal holding company income in

gross income in 1997. At the close of 1997 CFC has 105u in its

general limitation/foreign base company sales income recapture

account (100u from 1996 + 5u from 1997), 55u in its passive

limitation/foreign personal holding company income recapture account

(50u from 1996 + 5u from 1997), and 50u in its dividends from the

noncontrolled section 902 corporation/foreign personal holding

company income recapture account (all from 1996).

(iii) For purposes of computing post-1986 undistributed earnings

in each separate category, the rules of sections 902 and 960,

including the rules of Sec. 1.960-1(i), apply. Thus, post-1986

undistributed earnings (or an accumulated deficit) in each separate

category are increased (or reduced) by current earnings and profits

or current deficits in each separate category. The accumulated

deficit in CFC's general limitation earnings and profits (100u) is

reduced to 0 by the addition of 100u of 1997 earnings and profits.

CFC's passive limitation earnings of 50u are increased by 100u to

150u, and CFC's noncontrolled section 902 corporation earnings of

50u are decreased by (10u) to 40u. After the addition of current

year earnings and profits and deficits to the separate categories

there are no deficits remaining in any separate category. Thus, the

allocation rules of Sec. 1.960-1(i)(4) do not apply in 1997.

Accordingly, in determining the post-1986 foreign income taxes

deemed paid by A, post-1986 undistributed earnings in each separate

category are unaffected by earnings in the other categories. Foreign

taxes deemed paid under section 960 for 1997 would be determined as

follows for each separate category: with respect to the inclusion of

95u of foreign base company sales income out of general limitation

earnings, the section 960 fraction is 95u inclusion/0 total

earnings; with respect to the inclusion of 95u of passive limitation

income the section 960 fraction is 95u inclusion/150u passive

earnings. Thus, no general limitation taxes would be associated with

the inclusion of the general limitation earnings because there are

no accumulated earnings in the general limitation category. After

the deemed-paid taxes are computed, at the close of 1997 CFC has a

(95u) deficit in general limitation earnings and profits ((100u)

opening balance + 100u current earnings--95u inclusion), 55u of

passive limitation earnings and profits (50u opening balance + 100u

current foreign personal holding company income--95u inclusion), and

40u of earnings and profits subject to the separate limitation for

dividends from the noncontrolled section 902 corporation (50u

opening balance + (10u) expense).

Example 3. (i) A, a U.S. person, is the sole shareholder of CFC,

a controlled foreign corporation whose functional currency is the u.

At the beginning of 1996, CFC has post-1986 undistributed earnings

of 275u, all of which are general limitation earnings described in

section 904(d)(1)(I). CFC has no previously-taxed earnings and

profits described in section 959 (c)(1) or (c)(2). In 1996, CFC has

a (200u) loss in the shipping category described in section

904(d)(1)(D), 100u of foreign personal holding company income that

is passive income described in section 904(d)(1)(A), and 125u of

general limitation manufacturing earnings that are not subpart F

income. CFC's subpart F income for 1996, 100u, exceeds CFC's current

earnings and profits, 25u, by 75u. Under section 952(c)(1)(A) and

paragraph (e) of this section, subpart F income is limited to CFC's

current earnings and profits of 25u, all of which is included in A's

gross income under section 951(a)(1)(A). The 75u of CFC's 1996

subpart F income that is not included in A's income in 1996 by

reason of section 952(c)(1)(A) is subject to recapture under

[[Page 46552]]

section 952(c)(2) and paragraph (f) of this section.

(ii) For purposes of determining the amount and type of income

included in A's gross income and the amount and type of income in

CFC's recapture account, the rules of paragraphs (e) (1) and (2) of

this section apply. Under paragraph (e)(1) of this section, the

amount of CFC's subpart F income in excess of earnings and profits

for 1996, 75u, reduces the 100u of passive limitation foreign

personal holding company income. Thus, A includes 25u of passive

limitation foreign personal holding company income in gross income,

and CFC has 75u in its passive limitation/foreign personal holding

company income recapture account.

(iii) For purposes of computing post-1986 undistributed earnings

in each separate category the rules of sections 902 and 960,

including the rules of Sec. 1.960-1(i), apply. Under Sec. 1.960-

1(i), the shipping limitation deficit of (200u) is allocated

proportionately to reduce general limitation earnings of 400u and

passive limitation earnings of 100u. Thus, general limitation

earnings are reduced by 160u to 240u (400u general limitation

earnings/500u total earnings in positive separate categories x

(200u) shipping deficit = 160u reduction), and passive limitation

earnings are reduced by 40u to 60u (100u passive earnings/500u total

earnings in positive separate categories x (200u) shipping deficit

= 40u reduction). Five-twelfths of CFC's post-1986 foreign income

taxes with respect to passive limitation earnings are deemed paid by

A under section 960 with respect to the subpart F inclusion (25u

inclusion/60u passive earnings). After the inclusion and deemed-paid

taxes are computed, at the close of 1996 CFC has 400u of general

limitation earnings (275u opening balance + 125u current earnings),

75u of passive limitation earnings (100u of foreign personal holding

company income -25u inclusion), and a (200u) deficit in shipping

limitation earnings.

Example 4. (i) The facts are the same as in Example 3 with the

addition of the following facts. In 1997, CFC earns 50u of general

limitation earnings that are not subpart F income and 75u of passive

limitation income that is foreign personal holding company income.

Thus, CFC has 125u of current earnings and profits. CFC distributes

200u to A. Under paragraph (f)(3)(ii) of this section, the recapture

rules are applied first. Thus, the amount by which 1997 current

earnings and profits exceed subpart F income, 50u, is

recharacterized as passive limitation foreign personal holding

company income. CFC's total subpart F income for 1997 is 125u of

passive limitation foreign personal holding company income (75u

current earnings plus 50u recapture account), and the passive

limitation/foreign personal holding company income recapture account

is reduced from 75u to 25u.

(ii) CFC has 150u of previously-taxed earnings and profits

described in section 959(c)(2) (25u attributable to 1996 and 125u

attributable to 1997), all of which is passive limitation earnings

and profits. Under section 959(c), 150u of the 200u distribution is

deemed to be made from earnings and profits described in section

959(c)(2). The remaining 50u is deemed to be made from earnings and

profits described in section 959(c)(3). Under paragraph (f)(3)(i) of

this section, the dividend distribution is deemed to be made first

out of the passive limitation recapture account to the extent

thereof (25u). Under paragraph (f)(2)(iii) of this section, the

passive limitation recapture account is reduced from 25u to 0. The

remaining distribution of 25u is treated as made out of CFC's

general limitation earnings and profits.

(iii) For purposes of computing post-1986 undistributed

earnings, the rules of section 902 and 960, including the rules of

Sec. 1.960-1(i), apply. Thus, the shipping limitation accumulated

deficit of (200u) reduces general limitation earnings and profits of

450u and passive limitation earnings and profits of 150u on a

proportionate basis. Thus, 100% of CFC's post-1986 foreign income

taxes with respect to passive limitation earnings are deemed paid by

A under section 960 with respect to the 1997 subpart F inclusion of

125u (100u inclusion (numerator limited to denominator)/100u passive

earnings). No post-1986 foreign income taxes remain to be deemed

paid under section 902 in connection with the 25u distribution from

the passive limitation/foreign personal holding company income

recapture account. One-twelfth of CFC's post-1986 foreign income

taxes with respect to general limitation earnings are deemed paid by

A under section 902 with respect to the distribution of 25u general

limitation earnings and profits described in section 959(c)(3) (25u

inclusion/300u general limitation earnings). After the deemed-paid

taxes are computed, at the close of 1997 CFC has 425u of general

limitation earnings and profits (400u opening balance + 50u current

earnings -25u distribution), 0 of passive limitation earnings (75u

recapture account +75u current foreign personal holding company

income -125u inclusion -25u distribution), and a (200u) deficit in

shipping limitation earnings.

Par. 3. In Sec. 1.952-2, paragraph (c)(1) is revised to read as

follows:

Sec. 1.952-2 Determination of gross income and taxable income of a

foreign corporation.

* * * * *

(c) Special rules for purposes of this section--(1) Nonapplication

of certain provisions. Except where otherwise distinctly expressed, the

provisions of section 103 and subchapters F, G, H, L, M, N, S, and T of

chapter 1 of the Internal Revenue Code shall not apply.

* * * * *

Par. 4. In Sec. 1.954-2, the text of paragraph (b)(3) is added to

read as follows:

Sec. 1.954-2 Foreign personal holding company income.

* * * * *

(b) * * *

(3) Treatment of tax exempt interest. Foreign personal holding

company income includes all interest income, including interest that is

described in section 103 (see Sec. 1.952-2(c)(1)).

* * * * *

Par. 5. In Sec. 1.960-1, paragraph (i) is added to read as follows:

Sec. 1.960-1 Foreign tax credit with respect to taxes paid on earnings

and profits of controlled foreign corporations.

* * * * *

(i) Computation of deemed-paid taxes in post-1986 taxable years--

(1) General rule. If a domestic corporation is eligible to compute

deemed-paid taxes under section 960(a)(1) with respect to an amount

included in gross income under section 951(a), then, such domestic

corporation shall be deemed to have paid a portion of such foreign

corporation's post-1986 foreign income taxes determined under section

902 and the regulations under that section in the same manner as if the

amount so included were a dividend paid by such foreign corporation

(determined by applying section 902(c) in accordance with section

904(d)(3)(B)).

(2) Ordering rule for computing deemed-paid taxes under sections

902 and 960. If a domestic corporation computes deemed-paid taxes under

both section 902 and section 960 in the same taxable year, section 960

shall be applied first. After the deemed-paid taxes are computed under

section 960 with respect to a deemed income inclusion, post-1986

undistributed earnings and post-1986 foreign income taxes in each

separate category shall be reduced by the appropriate amounts before

deemed-paid taxes are computed under section 902 with respect to a

dividend distribution.

(3) Computation of post-1986 undistributed earnings. Post-1986

undistributed earnings (or an accumulated deficit in post-1986

undistributed earnings) are computed under section 902 and the

regulations under that section.

(4) Allocation of accumulated deficits. For purposes of computing

post-1986 undistributed earnings under sections 902 and 960, a post-

1986 accumulated deficit in a separate category shall be allocated

proportionately to reduce post-1986 undistributed earnings in the other

separate categories. However, a deficit in any separate category shall

not permanently reduce earnings in other separate categories, but after

the deemed-paid taxes are computed the separate limitation deficit

shall be carried forward in the same separate category in which it was

incurred. In addition, because deemed-paid taxes may not exceed taxes

paid or accrued by the controlled foreign corporation, in computing

deemed-paid taxes with

[[Page 46553]]

respect to an inclusion out of a separate category that exceeds post-

1986 undistributed earnings in that separate category, the numerator of

the deemed-paid credit fraction (deemed inclusion from the separate

category) may not exceed the denominator (post-1986 undistributed

earnings in the separate category).

(5) Examples. The application of this paragraph (i) may be

illustrated by the following examples. See Sec. 1.952-1(f)(4) for

additional illustrations of these rules.

Example 1. (i) A, a U.S. person, is the sole shareholder of CFC,

a controlled foreign corporation formed on January 1, 1996, whose

functional currency is the u. In 1996 CFC earns 100u of general

limitation income described in section 904(d)(1)(I) that is not

subpart F income and 100u of foreign personal holding company income

that is passive income described in section 904(d)(1)(A). In 1996

CFC also incurs a (50u) loss in the shipping category described in

section 904(d)(1)(D). CFC's subpart F income for 1996, 100u, does

not exceed CFC's current earnings and profits of 150u. Accordingly,

all 100u of CFC's subpart F income is included in A's gross income

under section 951(a)(1)(A). Under section 904(d)(3)(B) of the Code

and paragraph (i)(1) of this section, A includes 100u of passive

limitation income in gross income for 1996.

(ii) For purposes of computing post-1986 undistributed earnings

under sections 902, 904(d) and 960 with respect to the subpart F

inclusion, the shipping limitation deficit of (50u) is allocated

proportionately to reduce general limitation earnings of 100u and

passive limitation earnings of 100u. Thus, general limitation

earnings are reduced by 25u to 75u (100u general limitation

earnings/200u total earnings in positive separate categories x

(50u) shipping deficit = 25u reduction), and passive limitation

earnings are reduced by 25u to 75u (100u passive earnings/200u total

earnings in positive separate categories x (50u) shipping deficit

= 25u reduction). All of CFC's post-1986 foreign income taxes with

respect to passive limitation earnings are deemed paid by A under

section 960 with respect to the 100u subpart F inclusion of passive

income (75u inclusion (numerator limited to denominator under

paragraph (i)(4) of this section)/75u passive earnings). After the

inclusion and deemed-paid taxes are computed, at the close of 1996

CFC has 100u of general limitation earnings, 0 of passive limitation

earnings (100u of foreign personal holding company income--100u

inclusion), and a (50u) deficit in shipping limitation earnings.

Example 2. (i) The facts are the same as in Example 1 with the

addition of the following facts. In 1997, CFC distributes 150u to A.

CFC has 100u of previously-taxed earnings and profits described in

section 959(c)(2) attributable to 1996, all of which is passive

limitation earnings and profits. Under section 959(c), 100u of the

150u distribution is deemed to be made from earnings and profits

described in section 959(c)(2). The remaining 50u is deemed to be

made from earnings and profits described in section 959(c)(3). The

entire dividend distribution of 50u is treated as made out of CFC's

general limitation earnings and profits. See section 904(d)(3)(D).

(ii) For purposes of computing post-1986 undistributed earnings

under section 902 with respect to the 1997 dividend of 50u, the

shipping limitation accumulated deficit of (50u) reduces general

limitation earnings and profits of 100u to 50u. Thus, 100% of CFC's

post-1986 foreign income taxes with respect to general limitation

earnings are deemed paid by A under section 902 with respect to the

1997 dividend of 50u (50u dividend/50u general limitation earnings).

After the deemed-paid taxes are computed, at the close of 1997 CFC

has 50u of general limitation earnings (100u opening balance -50u

distribution), 0 of passive limitation earnings, and a (50u) deficit

in shipping limitation earnings.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-21839 Filed 9-6-95; 8:45 am]

BILLING CODE 4830-01-P