Allocation of Loss on Disposition of Stock

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-4-95]

RIN 1545-AT41

Allocation of Loss on Disposition of Stock

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 allocation of loss realized on the disposition of

stock. These regulations will affect United States and foreign

shareholders of stock in domestic and foreign corporations. The

regulations are necessary to modify existing guidance with respect to

stock losses. This document also contains a notice of public hearing on

the regulations.

DATES: Written comments must be received by October 7, 1996. Outlines

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

6, 1996, at 10 a.m. must be received by October 16, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-4-95), 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:R (INTL-4-95), Courier's

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

Washington, DC. The public hearing will be held in room 2615, Internal

[[Page 35697]]

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

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Seth B.

Goldstein, (202) 622-3850; concerning submissions and the hearing,

Evangelista Lee, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507).

Comments on the collection of information should be sent to the

Office of Management and Budget, Attn: Desk Officer for the Department

of Treasury, Office of Information and Regulatory Affairs, Washington,

DC 20503, with copies to the Internal Revenue Service, Attn: IRS

Reports Clearance Officer, T:FP, Washington, DC 20224. Comments on the

collection of information should be received by September 6, 1996.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The collection of information under section 865(j)(1) is in

Sec. 1.865-2(e)(2)(ii). The proposed regulations provide that in order

for taxpayers to elect retroactive application of the regulations,

taxpayers must comply with the reporting requirements contained in

Sec. 1.865-2(e)(2)(ii). This information is required by the IRS as a

condition for a taxpayer to elect to apply the rules of Sec. 1.865-2

retroactively. This information will be used to determine whether a

taxpayer properly applied the regulations. The respondents generally

will be U.S. corporations or individuals that sell or otherwise dispose

of stock in a foreign corporation of which the seller owns more than

10% of the vote or value.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Estimated total annual reporting burden: 4,000 hours. The estimated

annual burden per respondent varies from 1 hour to 5 hours, depending

on individual circumstances, with an estimated average of 2 hours.

Estimated number of respondents: 2,000.

Estimated annual frequency of responses: Once.

Background

This document contains proposed regulations amending the Income Tax

Regulations (26 CFR Part 1) under sections 861, 865, and 904 of the

Internal Revenue Code. These regulations are also issued under

authority contained in section 7805 of the Internal Revenue Code.

Explanation of Provisions

This notice of proposed rulemaking provides rules under section

865(j) relating to the treatment of losses from the sale or other

disposition of stock.

Section 1.865-1 provides that the allocation of loss on the

disposition of property not governed by Sec. 1.865-2 continues to be

governed by the generally applicable rules of Sec. 1.861-8, except as

provided in other administrative pronouncements. For example, Notice

89-58 (1989-1 C.B. 699) remains in effect with respect to losses

described in that Notice. The treatment of portfolio stock, which is

excluded from Sec. 1.865-2, will be reviewed in the context of a

broader project dealing with similar portfolio investments, including

debt instruments and derivative financial products. Allocation of loss

on the disposition of stock of a regulated investment company and stock

of an S corporation also will continue to be governed by Secs. 1.861-

8(e)(7)(i) and (ii).

Section 1.865-2(a) provides the general rule that stock losses are

allocated in the same manner as stock gains (determined without regard

to sections 1248 and 865(f)). Thus, stock loss generally is allocated

to the residence of the seller. Loss recognized by a United States

resident on the disposition of stock attributable to a foreign branch

is allocated to foreign source income if a gain would have been taxable

by the foreign country and the highest marginal rate of tax imposed in

that foreign country is at least 10 percent. Loss recognized by a

nonresident alien individual or foreign corporation with respect to

stock constituting a United States real property interest reduces

United States source income, in accordance with section 897.

Section 1.865-2(b) provides exceptions to the general rule. Section

1.865-2(b)(1) provides a dividend recapture rule that applies to losses

realized on a disposition of stock within 24 months following the

inclusion of a dividend or similar amount. To the extent of the

dividend recapture amount, the loss shall be allocated to the same

class of income as the dividend. Under a de minimis rule, the recapture

rule will not apply if the sum of all dividend recapture amounts is

less than 10 percent of the realized loss.

A dividend recapture amount includes an actual dividend, a subpart

F or qualified electing fund inclusion attributable to a dividend

received by a controlled foreign corporation in a separate limitation

category other than that for passive income, and an inclusion

attributable to section 956 or 956A. Dividends from foreign

corporations, which often are sheltered from United States tax by

foreign tax credits and do not reduce the shareholder's basis in the

stock, may reduce the selling price of the stock, thereby creating or

increasing a loss on sale. Similarly, the identified subpart F

inclusions may increase the shareholder's stock basis without

substantially affecting the value of the stock, offering similar

opportunities to create a tax mismatch from an economic ``wash'' by

pairing tax-sheltered foreign source inclusions and United States

source loss.

Section 1.865-2(b)(2) provides a consistency rule requiring

generally that loss recognized on the disposition of an 80%-owned

foreign affiliate reduces foreign source passive income if, within the

past five years, the seller or any member of its consolidated group

recognized gain on the disposition of a foreign affiliate that was

sourced under section 865(f). In order to provide relief for taxpayers

that could have taken steps to avoid section 865(f) treatment on gain

sales occurring prior to the publication of these proposed regulations,

the five-year lookback period will be phased in so that losses will be

tainted only by reason of gains recognized after September 6, 1996.

Section 1.865-2(b)(3) provides anti-abuse rules designed to prevent

taxpayers from changing the allocation of a loss with respect to stock

or other property by entering into certain transactions.

Section 1.865-2(c) provides rules of general application. Section

1.865-2(c)(1) provides that a partner's distributive share of loss

resulting from a disposition of stock by a partnership is allocated as

if the partner disposed of the stock. In an appropriate case the loss

may be attributable to a fixed place of business of the partnership

rather than to the partner's residence.

Section 1.865-2(c)(2) provides that worthlessness shall be treated

as a disposition for purposes of the stock loss allocation rules.

Section 1.865-2(d) provides definitions.

[[Page 35698]]

Under Sec. 1.865-2(e), the regulations are proposed to be effective

for taxable years beginning after 60 days after the date final

regulations are published in the Federal Register. However, a taxpayer

may elect to apply the regulations retroactively to stock losses in all

open post-1986 taxable years. A taxpayer generally may make the

election by attaching a statement to an original or amended federal

income tax return filed after final regulations are published in the

Federal Register. However, the election will not be effective unless

amended returns are filed within 120 days of the date final regulations

are published in the Federal Register.

Section 1.904-4(c) is proposed to be amended to provide rules

specifically addressing the treatment of loss allocated to the section

904(d) separate category for passive income. The proposed amendments

provide that, for purposes of the grouping rules relating to the high-

tax kick-out described in section 904(d)(2)(F), a passive loss is

initially allocated to a group based on the foreign tax that was, or

would have been, imposed on the transaction had the sale resulted in a

gain under foreign law. If, after allocation and apportionment of all

deductions, net income in a group is less than zero, any taxes imposed

with respect to the group are considered related to general limitation

income. The net loss is not considered related to general limitation

income, but proportionately reduces income in the other passive income

groups. The determination of whether income in the positive income

groups is high-taxed is made after this allocation of loss groups. Any

net loss in the section 904(d) separate category for passive income

constitutes a separate limitation loss governed by section 904(f)(5).

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in Executive Order

12866. Therefore, a regulatory assessment is not required. It is hereby

certified that these regulations do not have a significant economic

impact on a substantial number of small entities. This certification is

based on the fact that these regulations will primarily affect U.S.

owners of significant interests in foreign corporations, which owners

generally are large multinational corporations. This certification is

also based upon the fact that, even in cases in which the regulation

applies to small entities, the burden imposed by the collection of

information in the regulation, which is merely an election to apply the

regulation to prior taxable years, is not substantial and, therefore,

the collection of information will not impose a significant economic

impact on such entities. Therefore, a Regulatory Flexibility Analysis

under the Regulatory Flexibility Act (5 U.S.C. chapter 6) 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 their 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 November 6, 1996, at 10

a.m., in room 2615, 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 October 7, 1996 and submit an outline of topics to be

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

eight (8) copies) by October 16, 1996.

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 author of these regulations is Seth B. Goldstein, of

the Office of the Associate Chief Counsel (International), IRS.

However, other personnel from the IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

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 citation for part 1 is amended by adding

entries in numerical order to read as follows:

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

Section 1.865-1 is also issued under 26 U.S.C. 865(j)(1).

Section 1.865-2 is also issued under 26 U.S.C. 865(j)(1).

Par. 2. Section 1.861-8 is amended by adding paragraph (e)(7)(iii)

to read as follows:

Sec. 1.861-8 Computation of taxable income from sources within the

United States and from other sources and activities.

* * * * *

(e) * * *

(7) * * *

(iii) Special rules for allocation of loss from disposition of

stock. See Sec. 1.865-2 for special rules regarding the allocation of

loss recognized on certain dispositions of stock in taxable years

beginning after December 31, 1986.

Par. 3. Sections 1.865-1 and 1.865-2 are added under the

undesignated center heading ``Determination of Sources of Income'' to

read as follows:

Sec. 1.865-1 Loss from the disposition of personal property.

Allocation of loss on the sale or other disposition of portfolio

stock, stock of a regulated investment company (as defined in section

851), stock of an S corporation (as defined in section 1361), and other

personal property not governed by Sec. 1.865-2 is governed by

Sec. 1.861-8 or other administrative pronouncements. Portfolio stock

is, with respect to a taxpayer, stock in a corporation in which the

taxpayer owns, or is considered to own under the rules of section

267(c), less than 10 percent of the total combined voting power of all

classes of stock entitled to vote of such corporation and less than 10

percent of the total value of the stock of such corporation.

Sec. 1.865-2 Loss from the disposition of certain stock.

(a) General rules for allocation of loss on disposition of stock--

(1) Allocation against gain. Except as otherwise provided in

Sec. 1.865-1 and paragraph (b) of this section, loss recognized on the

sale or other disposition of stock shall be allocated to the class of

gross income and, if necessary, apportioned between the statutory

grouping of gross income (or among the statutory groupings) and the

residual grouping of gross income, with respect to which gain (other

than gain treated as a dividend under section 1248) from the sale of

such stock would give rise in the hands of the seller

[[Page 35699]]

(without regard to section 865(f)). For purposes of section 904, any

such loss shall be allocated to the separate category to which such

gain would have been assigned (without regard to section

904(d)(2)(A)(iii)(III)). For purposes of Sec. 1.904-4(c)(2)(ii)(A), any

loss allocated to passive income shall be allocated (prior to the

application of Sec. 1.904-4(c)(2)(ii)(B)) to the group of passive

income to which gain on the sale would have been assigned if the sale

of the stock had resulted in the recognition of a gain under the law of

the relevant foreign jurisdiction or jurisdictions. See section

904(f)(5) and the regulations under that section for rules regarding

the treatment of separate limitation losses.

(2) Stock attributable to foreign office. Except as otherwise

provided in Sec. 1.865-1 and paragraph (b) of this section, in the case

of loss on the sale or other disposition of stock (other than stock

constituting inventory) by a United States resident that is

attributable to an office or other fixed place of business in a foreign

country within the meaning of section 865(e)(3), the loss shall be

allocated to reduce foreign source income if a gain would have been

taxable by the foreign country and the highest marginal rate of tax

imposed in the foreign country is at least 10 percent.

(3) Stock constituting a United States real property interest. Loss

recognized by a nonresident alien individual or a foreign corporation

on the sale or other disposition of stock that constitutes a United

States real property interest shall be allocated to reduce United

States source income. For additional rules governing the treatment of

such loss, see section 897 and the regulations thereunder.

(b) Exceptions--(1) Dividend recapture exception--(i) In general.

Except as otherwise provided in Sec. 1.865-1, if a taxpayer realizes a

loss on a disposition of stock, and the taxpayer included in income a

dividend recapture amount (or amounts) with respect to such stock at

any time during the recapture period, then, to the extent of the

dividend recapture amount (or amounts), the loss shall be allocated and

apportioned on a proportionate basis to the class or classes of gross

income or the statutory or residual grouping or groupings of gross

income to which the dividend recapture amount was assigned.

(ii) Exception for de minimis amounts. Paragraph (b)(1)(i) of this

section shall not apply to a loss realized by a taxpayer on the

disposition of stock if the sum of all dividend recapture amounts

included in income by the taxpayer with respect to such stock during

the recapture period is less than 10 percent of the realized loss.

(2) Consistency exception--(i) In general. Except to the extent

provided in paragraph (b)(1) of this section, loss recognized by a

taxpayer with respect to the sale or other disposition of stock of a

foreign affiliate (or of a corporation that was a foreign affiliate

within the five-year period preceding the date of the sale) or a

foreign affiliate holding company shall be allocated to reduce foreign

source income if the taxpayer (or, in the case of a taxpayer that is a

member of a consolidated group (within the meaning of Sec. 1.1502-1(h))

at the time the loss is recognized, the consolidated group) recognized

gain on the disposition of any stock that was sourced under section

865(f) within the five-year period ending on the last day of the

taxable year in which the loss was recognized. See paragraph (a)(1) of

this section for rules relating to the allocation of the loss to

separate categories described in section 904(d).

(ii) Phased-in lookback period. The rule of paragraph (b)(2)(i) of

this section shall apply only if gain sourced under section 865(f) was

recognized after September 6, 1996.

(3) Anti-abuse rules. If one of the principal purposes of a

reorganization within the meaning of section 368(a), liquidation under

section 332, transfer to a corporation under section 351, transfer to a

partnership under section 721, transfer to a trust, distribution by a

partnership, distribution by a trust, or transfer to or from a

qualified business unit (within the meaning of section 989(a)) is to

change the allocation of a built-in loss on the disposition of stock

(or other personal property), the loss shall be allocated as if it were

recognized on the disposition of the stock (or other personal property)

immediately prior to the reorganization, liquidation, transfer, or

distribution. In addition, if a loss recognized by a taxpayer with

respect to the sale or other disposition of stock in a corporation is

primarily attributable to loss with respect to one or more financial

instruments held by the corporation, and one of the taxpayer's

principal purposes for holding the financial instrument or instruments

through the corporation is to allocate loss under Sec. 1.865-2, the

stock loss shall be allocated under Sec. 1.865-1 as if it were

recognized on the disposition of such financial instrument or

instruments. Whether a taxpayer has a principal purpose to allocate

loss under Sec. 1.865-2 shall be determined by taking into account all

the facts and circumstances, including whether the corporation engages

in business activities (other than trading financial instruments) and

whether the taxpayer or any related person or persons (within the

meaning of section 267(b) or 954(d)(3)) hold positions that offset loss

positions held by the corporation. For purposes of this paragraph

(b)(3), positions are offsetting if the risk of loss of holding one or

more positions is substantially diminished by holding one or more other

positions. A person may have a principal purpose of affecting loss

allocation even though this purpose is outweighed by other purposes

(taken together or separately).

(4) Example. The application of this paragraph (b) may be

illustrated by the following example:

Example. (i) P, a domestic corporation, is a United States

shareholder of N, a controlled foreign corporation. N has never had

any subpart F income and all of its earnings and profits are

described in section 959(c)(3). On August 5, 1997, N distributes a

dividend to P in the amount of $100. The dividend gives rise to a $5

foreign withholding tax, and P is deemed to have paid an additional

$45 of foreign income tax with respect to the dividend under section

902. Under section 904(d)(3) the dividend is general limitation

income described in section 904(d)(1)(I).

(ii) On February 6, 1998, P sells its shares of N and recognizes

a $110 loss. In 1998, P has the following taxable income, excluding

the loss on the sale of N:

(A) $1,000 of foreign source income that is general limitation

income described in section 904(d)(1)(I), which is subject to

foreign taxes of $400;

(B) $1,000 of foreign source capital gain that is passive income

described in section 904(d)(1)(A) attributable to gain on the sale

of stock in a foreign affiliate that is sourced under section

865(f), which is subject to foreign taxes of $30.

(iii) The $100 dividend paid in 1997 is a dividend recapture

amount that was included in P's income within the recapture period

preceding the disposition of the N stock. The de minimis exception

of paragraph (b)(1)(ii) of this section does not apply because the

$100 dividend recapture amount exceeds 10 percent of the $110 loss.

Therefore, to the extent of the $100 dividend recapture amount, the

loss must be allocated under paragraph (b)(1)(i) of this section to

the separate limitation category to which the dividend was assigned

(general limitation income).

(iv) Because P recognized gain on the sale of stock in a foreign

affiliate that was sourced under section 865(f) within the period

described in paragraph (b)(2)(i) of this section, P's remaining $10

loss on the disposition of the N stock is allocated to foreign

source passive income under paragraph (b)(2)(i) of this section.

(v) After allocation of the stock loss, P's taxable income in

1998 consists of $900 of foreign source general limitation income

and $990 of foreign source passive income.

(c) Rules of application--(1) Loss recognized by partnership. A

partner's

[[Page 35700]]

distributive share of loss resulting from the sale or other disposition

of stock by a partnership shall be allocated and apportioned in

accordance with this section as if the partner had disposed of the

stock. If a sale of stock is attributable to an office or other fixed

place of business of the partnership within the meaning of section

865(e)(3), such office or fixed place of business shall be considered

to be an office of the partner for purposes of this section.

(2) Worthless stock. For purposes of this section, worthlessness

giving rise to a deduction under section 165(g) (including section

165(g)(3)) with respect to stock shall be treated as a disposition.

(d) Definitions--(1) Terms defined in Sec. 1.861-8. See Sec. 1.861-

8 for the meaning of class of gross income, statutory grouping of gross

income, and residual grouping of gross income.

(2) Dividend recapture amount. A dividend recapture amount is a

dividend (except for an amount treated as a dividend under section 78),

an inclusion described in section 951(a)(1)(A)(i) (but only to the

extent attributable to a dividend included in the earnings of a

controlled foreign corporation that is included in foreign personal

holding company income under section 954(c)(1)(A) and that, pursuant to

section 904(d)(3)(B), is treated as income in a separate category other

than the separate category for passive income described in section

904(d)(2)(A)), an inclusion described in section 951(a)(1)(B) or (C),

and an inclusion described in section 1293(a)(1) (but only to the

extent attributable to a dividend that is included in the earnings of a

qualified electing fund and that, pursuant to section 904(d)(3)(I), is

treated as income in a separate category other than the separate

category for passive income described in section 904(d)(2)(A)).

(3) Foreign affiliate. A foreign affiliate is a foreign corporation

that is a member of the affiliated group (within the meaning of section

1504(a) without regard to section 1504(b)) that includes the taxpayer.

(4) Foreign affiliate holding company. A foreign affiliate holding

company is any corporation, substantially all the assets of which

consist of stock of one or more foreign affiliates, held directly or

indirectly. For purposes of this paragraph, any assets acquired or held

by a corporation with a principal purpose of avoiding foreign affiliate

holding company status shall be disregarded.

(5) Recapture period. A recapture period is the 24-month period

preceding the date on which a taxpayer realizes a loss on a disposition

of stock, increased by any period of time in which the taxpayer has

diminished its risk of loss in a manner described in section 246(c)(4)

and the regulations thereunder.

(6) Taxpayer. A taxpayer shall include all predecessors or

successors of the taxpayer.

(7) United States resident. See section 865(g) and the regulations

thereunder for the definition of United States resident.

(e) Effective date--(1) In general. This section is effective for

taxable years beginning after the date that is 60 days after the date

these regulations are published as final regulations in the Federal

Register.

(2) Prior year election--(i) In general. A taxpayer may elect to

apply the rules of this section to all (but not less than all) of its

taxable years that begin after December 31, 1986, and on or before the

date that is 60 days after the date these regulations are published as

final regulations in the Federal Register, and with respect to which

the statute of limitations expires after the date that is 120 days

after the date these regulations are published as final regulations in

the Federal Register. The election shall be effective only if the

taxpayer satisfies all the applicable requirements specified in

paragraph (e)(2)(ii) of this section.

(ii) Requirements for election--(A) Statement filed with original

or amended return. For each taxable year subject to the election, a

taxpayer shall file an original or amended federal income tax return

that reflects the rules of this section and includes the statement

described in paragraph (e)(2)(ii)(C) of this section. Amended returns

filed pursuant to this section must be filed on or before the date that

is 120 days after the date these regulations are published as final

regulations in the Federal Register.

(B) Presentation of statement upon audit. A taxpayer that is under

examination with respect to any taxable year subject to the election on

the date that is 120 days after the date these regulations are

published as final regulations in the Federal Register must furnish a

copy of the statement described in paragraph (e)(2)(ii)(C) of this

section for all years subject to the election to the revenue agent

responsible for examining its federal income tax returns on or before

the date that is 140 days after the date these regulations are

published as final regulations in the Federal Register. For purposes of

this paragraph (e)(2)(ii)(B), a taxpayer is under examination beginning

on the date the taxpayer (or any member of the consolidated group of

which the taxpayer is a member) has been contacted in any manner by a

representative of the Internal Revenue Service for the purpose of

scheduling any type of examination of any of its federal income tax

returns and ending on the earliest of the date: the taxpayer (or

consolidated group of which the taxpayer is a member) receives a ``no

change'' letter; the taxpayer (or consolidated group of which the

taxpayer is a member) pays the deficiency (or proposed deficiency); or

on which a deficiency, jeopardy, termination, bankruptcy, or

receivership assessment is made. An electing taxpayer that is not under

examination with respect to any taxable year subject to the election on

the date that is 120 days after the date these regulations are

published as final regulations in the Federal Register and is contacted

thereafter by a representative of the Internal Revenue Service for the

purpose of scheduling any type of examination of any of its federal

income tax returns for a year subject to the election must furnish a

copy of the statement described in paragraph (e)(2)(ii)(C) of this

section for all years subject to the election to the revenue agent

responsible for examining its federal income tax returns within 20 days

of being contacted.

(C) Contents of statement. The statement shall be entitled

``ELECTION UNDER Sec. 1.865-2(e)(2) TO APPLY RETROACTIVELY Sec. 1.865-2

STOCK LOSS ALLOCATION RULES.'' The statement shall identify, for the

taxable year subject to the election, each loss from the disposition of

stock that is subject to this section and that was incurred by the

taxpayer or by any controlled foreign corporation (within the meaning

of section 953(c)(1)(B) or 957) with respect to which the taxpayer is a

United States shareholder (within the meaning of section 951(b) or

953(c)(1)(A)). For each such loss, the statement shall provide the name

and identifying number of the entity that incurred the loss, the amount

of the loss, and the paragraph of this section under which the loss is

allocated. Each loss subject to paragraph (b)(1) of this section shall

be separately identified with a notation stating ``Subject to dividend

recapture under Sec. 1.865-2(b)(1).'' The statement shall also include

the following declaration: ``No losses, other than those so identified

herein, are subject to Sec. 1.865-2(b)(1).'' The statement shall

indicate whether the taxpayer or any controlled foreign corporation

(within the meaning of section 953(c)(1)(B) or 957) with respect to

which the taxpayer is a United States

[[Page 35701]]

shareholder (within the meaning of section 951(b) or 953(c)(1)(A))

acquired the stock after July 8, 1996 as a result of a transaction

described in paragraph (b)(3) of this section (regardless of the

purpose or purposes of the transaction). An election shall not be

effective unless each statement required by this paragraph (e)(2)(ii)

contains all the information specified herein.

Par. 4. Section 1.904-0 is amended by revising the entry for

Sec. 1.904-4(c)(2)(ii) and adding entries for paragraphs (c)(2(ii)(A)

and (B) of that section to read as follows:

Sec. 1.904-0 Outline of regulation provisions for section 904.

* * * * *

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

certain categories of income.

* * * * *

(c) * * *

(2) * * *

(ii) Grouping rules.

(A) Initial allocation and apportionment of deductions.

(B) Reallocation of loss groups.

Par. 5. Section 1.904-4 is amended by revising paragraphs (c)(1)

and (c)(2) and adding paragraph (c)(8) Example 11 and Example 12 to

read as follows:

(c) High-taxed income--(1) In general. Income received or accrued

by a United States person that would otherwise be passive income shall

not be treated as passive income if the income is determined to be

high-taxed income. Income shall be considered to be high-taxed income

if, after allocating expenses, losses and other deductions of the

United States person to that income under paragraph (c)(2)(ii) of this

section, the sum of the foreign income taxes paid or accrued by the

United States person with respect to such income and the foreign taxes

deemed paid or accrued by the United States person with respect to such

income under section 902 or section 960 exceeds the highest rate of tax

specified in section 1 or section 11, whichever applies (and with

reference to section 15 if applicable), multiplied by the amount of

such income (including the amount treated as a dividend under section

78). If, after application of this paragraph (c), income that would

otherwise be passive income is determined to be high-taxed income, such

income shall be treated as general limitation income, and any taxes

imposed on that income shall be considered related to general

limitation income under Sec. 1.904-6. If, after application of this

paragraph (c), passive income is less than zero, the loss shall

constitute a passive separate limitation loss (subject to the rules of

section 904(f)(5) and the regulations under that section), but any

taxes imposed on passive income shall be considered related to general

limitation income under Sec. 1.904-6. For additional rules regarding

losses related to passive income, see paragraph (c)(2) of this section.

Income and taxes shall be translated at the appropriate rates, as

determined under sections 986, 987 and 989 and the regulations under

those sections, before application of this paragraph (c). For purposes

of allocating taxes to groups of income, United States source passive

income is treated as any other passive income. In making the

determination whether income is high-taxed, however, only foreign

source income, as determined under United States tax principles, is

relevant. See paragraph (c)(8) Examples (10), (11) and (12) of this

section for examples illustrating the application of this paragraph

(c)(1) and paragraph (c)(2) of this section.

(2) Grouping of items of income in order to determine whether

passive income is high-taxed income--(i) Effective date. For purposes

of determining whether passive income is high-taxed income, the

grouping rules of paragraphs (c)(3), (c)(4), and (c)(5) of this section

apply to taxable years beginning after December 31, 1987. See notice

87-6 for the grouping rules applicable to taxable years beginning after

December 31, 1986 and before January 1, 1988. Paragraph (2)(ii)(B) of

this section is effective for taxable years beginning after the date

that is 60 days after the date these regulations are published as final

regulations in the Federal Register.

(ii) Grouping rules--(A) Initial allocation and apportionment of

deductions. For purposes of determining whether passive income is high-

taxed, expenses, losses and other deductions shall be allocated and

apportioned initially to each of the groups of passive income

(described in paragraphs (c)(3), (4), and (5) of this section) under

the rules of Secs. 1.861-8 through 1.861-14T, 1.865-1, and 1.865-2.

Taxpayers that allocate and apportion interest expense on an asset

basis may nevertheless apportion passive interest expense among the

groups of passive income on a gross income basis. If loss from the

disposition of property gives rise to foreign tax (e.g., the

transaction giving rise to the loss is treated under foreign law as

having given rise to a gain), the foreign tax shall be allocated to the

group of passive income to which the loss is allocated under this

paragraph (c)(2)(ii)(A), without regard to paragraph (c)(2)(ii)(B) of

this section. A determination of whether passive income is high-taxed

shall be made only after application of paragraph (c)(2)(ii)(B) of this

section (if applicable).

(B) Reallocation of loss groups. If, after allocation and

apportionment of expenses, losses and other deductions under paragraph

(c)(2)(ii)(A) of this section, the sum of the allocable deductions

exceeds the gross income in one or more groups, the excess deductions

shall proportionately reduce income in the other groups (but not below

zero), and any taxes imposed with respect to such loss group or groups

shall be considered related to general limitation income.

* * * * *

(8) * * *

Example 11. P, a domestic corporation, earns the following items

of gross income: $100 of foreign source, passive limitation interest

income not subject to any foreign tax, $200 of foreign source,

passive limitation royalty income subject to a 5 percent foreign

withholding tax (foreign tax paid is $10), $1300 of foreign source,

passive limitation rental income subject to a 25 percent foreign

withholding tax (foreign tax paid is $325), $500 of foreign source,

general limitation income that gives rise to a $250 foreign tax, and

$2000 of U.S. source capital gain that is not subject to any foreign

tax. P has a $700 deduction allocable to its passive rental income.

P's only other deduction is a $500 capital loss on a sale of stock

that is allocated to foreign source passive limitation income under

Sec. 1.865-2(b)(2). If P had recognized a gain on the stock sale

under foreign law, the gain would not have been subject to foreign

tax. The $500 capital loss is initially allocated to the group of

passive income not subject to any foreign tax, and the $400 amount

by which the capital loss exceeds the income in the group must be

reapportioned to the other groups under paragraph (c)(2)(ii)(B) of

this section. The net royalty income is thus reduced by $100 to $100

($200-($400 x (200/800))) and the net rental income is reduced by

$300 to $300 ($1300-$700-($400 x (600/800))). The $100 net royalty

income is not high-taxed and remains passive income. The $300 net

rental income is high-taxed because the foreign taxes exceed the

highest United States rate of tax on that income. Under the high-tax

kick-out, the $300 of net rental income (the gross rental income and

expenses allocated and apportioned thereto) and the $325 of

associated foreign tax are assigned to the general limitation

category.

Example 12. The facts are the same as in Example 11 except the

amount of the capital loss that is allocated under Sec. 1.865-

2(b)(2) and paragraph (c)(2) of this section to the group of foreign

source passive income subject to no foreign tax is $1100. Under

paragraph (c)(2)(ii)(B) of this section, the excess deductions of

$1000 must be reapportioned to the $200 of net royalty income

subject to a 5% withholding tax and the $600 of net rental income

subject to a

[[Page 35702]]

25% withholding tax. The income in each of these groups is reduced

to zero, and the foreign taxes imposed on the rental and royalty

income are considered related to general limitation income. The

remaining loss of ($200) constitutes a separate limitation loss with

respect to passive income.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-17004 Filed 7-5-96; 8:45 am]

BILLING CODE 4830-01-P