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

Federal RegisterJan 7, 1997

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8708]

RIN 1545-AL98

Computation of Foreign Taxes Deemed Paid Under Section 902

Pursuant to a Pooling Mechanism for Undistributed Earnings and Foreign

Taxes

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final income tax regulations relating

to the computation of foreign taxes deemed paid under section 902.

Changes to the applicable law were made by the Tax Reform Act of 1986

and by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).

These regulations provide guidance needed to comply with these changes

and affect foreign corporations and their United States corporate

shareholders.

DATES: These regulations are effective January 7, 1997.

Applicability: For the specific dates of applicability of these

regulations, see Secs. 1.902-1(g) and 1.902-3(l).

FOR FURTHER INFORMATION CONTACT: Caren S. Shein (202) 622-3850 (not a

toll free number).

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

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 15451458. Responses to these collections of information

are required by the IRS to implement the section 902 pooling regime

enacted in the Tax Reform Act of 1986.

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.

[[Page 924]]

The burden for the collection of information is reflected in the

burden for Form 1118.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attention: IRS Reports Clearance Officer T:FP,

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

Attention: Desk Officer for the Department of the Treasury, Office of

Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to the collections 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.

Background

Section 902 (26 CFR part 1) was amended by section 1202(a) of the

Tax Reform Act of 1986 (Public Law 99-514, 100 Stat. 1085), and section

1012(b) of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA)

(Public Law 100-647, 102 Stat. 3242). On January 6, 1995, the IRS

published a notice of proposed rulemaking in the Federal Register (60

FR 2049 [INTL-933-86 (1995-1 C.B. 959)]). The proposed regulations

provide guidance needed to comply with section 902 as amended in 1986

and 1988. No public hearing was requested or held, but numerous written

comments were received. The proposed regulations, with certain changes

made in response to comments, are adopted in this Treasury decision as

final regulations. The principal changes to the regulations, as well as

the major comments and suggestions, are discussed below.

Explanation of Provisions

Section 1.902-1

In the preamble to the proposed regulations, the IRS requested

comments on whether the holding of Revenue Ruling 71-141 (1971-1 C.B.

211) should be expanded to allow taxes paid by a foreign corporation to

be considered deemed paid by domestic corporations that are partners in

domestic limited partnerships or foreign partnerships, shareholders in

limited liability companies, beneficiaries of domestic or foreign

trusts and estates, or interest holders in other pass-through entities.

The revenue ruling held that two 50-percent domestic corporate general

partners of a domestic general partnership that owned 40 percent of a

foreign corporation were entitled to compute an amount of foreign taxes

deemed paid under section 902 with respect to dividends they received

from the foreign corporation through the partnership.

The IRS received numerous comments in response to the request in

the preamble. The commenters uniformly argue that the aggregate theory

of partnerships should apply to allow domestic corporate partners to

compute an amount of foreign taxes deemed paid with respect to

dividends paid to any partnership by a foreign corporation, provided

that the partner owns at least 10 percent of the voting stock of the

foreign corporation through the partnership.

The final regulations do not resolve under what circumstances a

domestic corporate partner may compute an amount of foreign taxes

deemed paid with respect to dividends received from a foreign

corporation by a partnership or other pass-through entity. That issue

will be the subject of a future proposed regulations project. However,

in recognition of the holding in Revenue Ruling 71-141 (1971-1 C.B.

211) that a general partner of a domestic general partnership may

compute an amount of foreign taxes deemed paid with respect to a

dividend distribution from a foreign corporation to the partnership,

Sec. 1.902-1(a)(1) is amended to define a domestic shareholder as a

domestic corporation that ``owns'' the requisite voting stock in a

foreign corporation rather than one that ``owns directly'' the voting

stock. The IRS is still considering under what other circumstances the

revenue ruling should apply.

Section 1.902-1(a)(8) is amended to clarify under what

circumstances the pool of post-1986 foreign income taxes must be

reduced to account for distributions made in prior post-1986 taxable

years. The regulations require a reduction in the taxes pool for taxes

attributable to earnings distributed to shareholders ineligible for the

deemed paid credit (for example, a foreign shareholder, a U.S.

individual shareholder, or a domestic corporate shareholder that owns

less than 10 percent of the foreign corporation's voting stock) and to

shareholders that are eligible for the credit but that choose to deduct

foreign taxes under section 164(a) in the year of the distribution

rather than claim a credit.

The IRS understands that some taxpayers have taken the position,

contrary to the position taken in Sec. 1.902-1(a)(8) of the proposed

regulations, that although post-1986 undistributed earnings must be

reduced to account for all distributions out of current or accumulated

earnings and profits, post-1986 foreign income taxes should be reduced

only to account for taxes attributable to distributions with respect to

which a shareholder both is eligible to claim a credit for foreign

taxes deemed paid under section 902(a) and in fact elects to credit

foreign taxes for the taxable year under section 901(a). These

taxpayers argue that only in those circumstances are foreign taxes

``deemed paid'' and thus required to be removed from the taxes pool

under a literal reading of sections 902(a) and 902(c)(2)(B).

The IRS has not changed its position as reflected in Sec. 1.902-

1(a)(8)(i) of the proposed regulations that the foreign taxes pool must

be reduced to account for foreign taxes attributable to all

distributions and deemed distributions or inclusions to all

shareholders. However, the text of the final regulations has been

amended to clarify the rule. The requirement that the foreign taxes

pool must be reduced proportionately as the earnings pool is reduced is

consistent with the legislative history of the Tax Reform Act of 1986

(Public Law 99-514). The House Report states that under the pooling

regime, ``[a] dividend or subpart F inclusion is considered to bring

with it a pro rata share of the accumulated foreign taxes paid by the

subsidiary.'' H.R. Rep. No. 426, 99th Cong., 1st Sess. 357 (1985). In

addition, removing taxes attributable to distributions to ineligible

shareholders and eligible shareholders that choose to deduct foreign

taxes is supported by the general matching principles of section 902,

which presume that a dividend distribution will carry with it a ratable

share of the foreign corporation's taxes. If taxes paid with respect to

distributed earnings remained in the pool, eligible shareholders

eventually could receive credits for more than their ratable share of

the foreign corporation's taxes, a result at odds with the statutory

scheme.

Section 1.902-1(a)(8)(i) is amended to correct an oversight in the

proposed regulation. In the case of a distribution out of current

earnings and profits that is treated as a ``nimble'' dividend under

section 316(a)(2) when there is a deficit in accumulated earnings and

profits, post-1986 foreign income taxes are not reduced. This rule is

not inconsistent with the general rule of paragraph (a)(8)(i) that the

foreign taxes pool must be reduced to account for taxes attributable to

all distributions and deemed distributions out of post-1986

undistributed earnings. Rather, it reflects the fact that under section

902 and these regulations, no taxes are deemed paid with respect to a

nimble

[[Page 925]]

dividend under section 316(a)(2) because the post-1986 undistributed

earnings pool is zero or less than zero.

Section 1.902-1(a)(9), defining post-1986 undistributed earnings,

is amended to clarify that the earnings pool is reduced only to account

for distributions or deemed distributions that reduce earnings and

profits and inclusions that result in previously-taxed amounts

described in sections 959(c)(1) and (c)(2) or 1293(c). Thus, for

example, in the case of a controlled foreign corporation owned 60

percent by a domestic corporate shareholder and 40 percent by a foreign

shareholder, the earnings and taxes pools are reduced only to account

for 60 percent of the foreign corporation's subpart F income.

The rules precluding special allocations of earnings and taxes in

Sec. 1.902-1(a)(9)(iv) and (10)(ii) of the proposed regulations have

been retained in the final regulations. These regulations are intended

to reverse the result in Vulcan v. Commissioner, 96 T.C. 410 (1991),

aff'd per curiam, 959 F.2d 973 (11th Cir. 1992), nonacq. 1995-1 C.B. 1,

for post-1986 taxable years. Several commenters argued that the Vulcan

decision was correct and should be applied to both pre-1987 and post-

1986 taxable years, and the regulations should be revised to reflect

the decision. For the reasons stated in the preamble to the proposed

regulations, the IRS declines to do so.

Commenters also argued that the rule precluding special allocations

of earnings and taxes is inconsistent with Sec. 1.904-6(a)(2). Section

1.904-6(a)(2) is an anti-abuse rule designed to prevent the use of

accommodation parties to improve a United States taxpayer's foreign tax

credit position. The rule states that if a taxpayer receives or accrues

a dividend from a noncontrolled section 902 corporation and the

Commissioner establishes the existence of an express or implied

agreement that the dividend is paid out of the foreign corporation's

passive or high withholding tax interest earnings, then only taxes

imposed on passive or high withholding tax interest earnings will be

considered related to the dividend. The IRS may invoke this rule to

prevent a shareholder from sheltering investment income from tax by

investing it through a noncontrolled section 902 corporation that

distributes only the investment earnings to the shareholder, which then

treats the distribution as a dividend sheltered by taxes paid on the

corporation's hightaxed active business income. The IRS believes that

this narrowly defined anti-abuse rule is an appropriate exception to

the general rule of Sec. 1.902-1(a)(9)(iv) and (a)(10)(ii) barring

special allocations of earnings and taxes.

Section 1.902-1(a)(11) has been amended to clarify that the

definition of a dividend in section 316(a) applies for purposes of

section 902, and that the section 902 definition of a dividend also

includes deemed dividends under sections 551 and 1248. Deemed

inclusions under sections 951(a) and 1293 are not dividends for

purposes of section 902. However, sections 960(a)(1) and 1293(f)

provide that deemed paid taxes with respect to inclusions under

sections 951(a) and 1293 are determined under section 902 in the same

manner as if a dividend was paid.

Paragraph (a)(11) also has been amended to add a crossreference to

section 1291 and Sec. 1.1291-5 of the proposed regulations, which

provide special rules for computing foreign taxes deemed paid with

respect to distributions from section 1291 funds. These distributions

are treated as dividends solely for foreign tax credit purposes, but

the general section 902 computational rules do not apply.

A commenter correctly pointed out that the regulation's inclusion

of deemed distributions under section 551 as dividends for purposes of

section 902 is contrary to the holding in Revenue Ruling 74-59 (1974-1

C.B. 183) that an amount includible in gross income under section 551

is not considered a dividend received for purposes of the allowance of

a foreign tax credit under section 902. The holding of the revenue

ruling is based on language in the 1937 legislative history of the

foreign personal holding company provisions. The Report of the Joint

Committee on Tax Evasion and Avoidance of the Congress of the United

States, H.R. Doc. No. 337, 75th Cong., 1st Sess. 18 (1937), recommended

that shareholders of foreign personal holding companies not be allowed

a credit for foreign income taxes paid by the foreign corporation with

respect to amounts deemed distributed. The Report goes on to state that

the committee recommended against allowing a credit because ``it is not

administratively feasible, although it might seem equitable under the

circumstances.''

Section 551(b) provides that amounts required to be included in the

gross income of a U.S. shareholder under section 551(a) are treated as

dividends, and under current law it is administratively feasible to

allow deemed paid taxes to be computed with respect to deemed

dividends. In addition, the Code now includes other anti-deferral

regimes, e.g., the subpart F and passive foreign investment company

provisions, the application of which may overlap with the foreign

personal holding company rules. Shareholders are permitted to compute

deemed paid taxes with respect to subpart F and passive foreign

investment company inclusions.

The IRS, therefore, has concluded the revenue ruling is not

supported by current law. A shareholder of a foreign personal holding

company should be entitled to compute deemed paid taxes with respect to

amounts required to be included in gross income as dividends under

section 551(a). Revenue Ruling 74-59 (1974-1 C.B. 183) is hereby

revoked effective as of the date these regulations are published in the

Federal Register.

A commenter argued that the rule in Sec. 1.902-1(b)(4), providing

that no taxes are deemed paid with respect to dividends out of current

earnings and profits when the foreign corporation has no post-1986

undistributed earnings and no accumulated earnings and profits (so-

called ``nimble'' dividends) conflicts with the general purpose of the

foreign tax credit to prevent double taxation. The rule is retained in

the final regulations for two reasons. First, the legislative history

of the Tax Reform Act of 1986 (Public Law 99-514) clearly indicates

that Congress was aware of the issue and agreed with the position

stated in the regulation. See S. Rep. No. 313, 99th Cong., 2d Sess. 321

(1986). Second, because no taxes can be deemed paid under the

computational rules of section 902 when post-1986 undistributed

earnings are zero or less than zero, no taxes are removed from the

post-1986 foreign income taxes pool. Thus, all of the foreign

corporation's taxes remain in its post-1986 foreign income taxes pool

and are available to be credited if the corporation pays another

dividend in a later year in which the post-1986 undistributed earnings

pool is positive.

Section 1.902-1(c)(8) of the proposed regulations reserved on the

application of section 902 in section 304 exchanges. Commenters

suggested that the regulations should address this area by

incorporating the holdings in Revenue Ruling 91-5 (1991-1 C.B. 114),

and Revenue Ruling 92-86 (1992-1 C.B. 199). In addition, the commenters

argued that the regulations should state that a deemed paid credit is

available in a section 304 exchange involving a foreign parent

corporation. The IRS is still studying the area and the regulations

thus continue to reserve on the application of section 902 in a section

304 exchange.

Section 1.902-1(c)(9) of the proposed regulations is reserved in

these final regulations. The proposed regulation

[[Page 926]]

provided a cross-reference to regulations under section 905(c) with

respect to adjustments to post-1986 undistributed earnings and taxes

that result from a section 482 allocation of income. There currently

are no regulations under section 905(c) addressing section 482

allocations and the IRS, therefore, has reserved this paragraph pending

issuance of final regulations under section 905(c).

Section 1.902-1(d)(3) (ii) through (iv) of the proposed regulations

is not included in the final regulations. Paragraph (d)(3) set out

rules and examples exercising a grant of regulatory authority under the

last sentence of section 904(d)(2)(E)(i) to limit beyond the statute

the circumstances under which a dividend paid to a new U.S. shareholder

by a controlled foreign corporation out of earnings accumulated while

it was a controlled foreign corporation will be treated as dividends

from a noncontrolled section 902 corporation. Identical rules were

proposed in 1992 under section 904(d). See Sec. 1.904-4(g)(3) (ii)

through (iv) of the proposed regulations. The rules address the

character of a dividend distribution under section 904(d) and are more

appropriately placed in the regulations under that section. After

considering the comments received, the rule will be finalized as part

of the section 904 regulations.

Section 1.902-2

A commenter suggested that the deficit carryback rules in

Sec. 1.902-2(a)(1) should be amended to provide that a deficit in post-

1986 undistributed earnings will not be carried back to pre-1987 years

on a return of capital or capital gain distribution. The rule states

that a deficit will be carried back when ``* * * a corporation makes a

distribution to shareholders that is a dividend or would be a dividend

if there were current or accumulated earnings and profits, * * * .''

The commenter suggests that the rule in the proposed regulation can

result in ``locked-in'' taxes when earnings attributable to one or more

pre-1987 years are eliminated by the deficit carryback. If the deficit

stays in the post-1986 pool there is a chance it can be absorbed by

future earnings, leaving the pre-1987 earnings and taxes intact. In

support of its position, the commenter argues that section 902

establishes rules that minimize double taxation by allowing a taxpayer

to compute a deemed paid credit on a taxable dividend. The legislative

history indicates that the pooling provisions of section 902 are to

apply solely for purposes of computing the deemed paid credit. Because

a return of capital or capital gain distribution is not a taxable

dividend and no section 902 credit is allowable, the commenter argues

that the pooling rules (including the deficit carryback rules) should

not apply.

The IRS declines to adopt the commenter's suggestion. When an

amount is distributed in a post-1986 taxable year and there is a

deficit in post-1986 undistributed earnings, the deficit must be

carried back and reduce earnings and profits in pre-1987 years to

determine whether any earnings remain to support treatment of the

distribution as a dividend. To the extent there are earnings remaining

in one or more pre-1987 years after a deficit is carried back, the

distribution is a dividend. Any remaining amount is a return of capital

and capital gain. It would be incongruous to adopt a rule providing a

different result if a single dollar of pre-1987 accumulated profits

remains in a pre-1987 year after a post-1986 deficit is carried back

than if the deficit carryback eliminated all pre-1987 accumulated

profits and the entire distribution were treated as a return of

capital.

Another commenter argued that the interplay among Sec. 1.902-

2(b)(1) (pre-1987 accumulated deficit carries over to become the

opening balance of post-1986 undistributed earnings pool) and

Sec. 1.902-1(b)(4) (no taxes deemed paid if a dividend is a nimble

dividend) of the proposed regulations, and section 960 (incorporating

the section 902 rules with respect to deemed inclusions under subpart

F) results in a denial of deemed paid taxes to a U.S. shareholder if a

controlled foreign corporation has both a pre-1987 accumulated deficit

and post-1986 earnings and profits that are entirely subpart F income.

The commenter suggests that regulations be issued under section 960 to

provide, solely for purposes of that section, that accumulated deficits

in pre-1987 accumulated profits will not carry over into the post-1986

pool.

The IRS cannot adopt the rule the commenter suggests. Congress

amended sections 902 and 960 in 1986 specifically to eliminate

different earnings and profits and deemed paid taxes computations for

purposes of sections 902 and 960. Further, in the situation the

commenter posits, the credits are deferred but not permanently

disallowed. If the controlled foreign corporation earns enough post-

1986 income to eliminate the accumulated deficit, any distribution or

deemed distribution will carry with it a ratable share of post-1986

foreign income taxes.

A commenter argued that Sec. 1.902-2(b)(2) and (3), Example 1, are

incorrect because they imply that annual deficits in pre-1987

accumulated profits were required to be carried back under pre-1987

section 902 regardless of how foreign income taxes were determined. The

commenter argues that pre-1987 section 902 requires a ``correlation''

between accumulated profits as determined under U.S. law and the

foreign law method by which foreign taxes were determined.

The IRS disagrees with the comment and the proposed regulation has

not been amended. The regulation reflects the IRS' longstanding

position that in the case of a deficit in accumulated profits of a

foreign corporation for a particular pre-1987 year, the deficit first

reduces prior years' accumulated profits on a LIFO basis to the extent

thereof, and then the remaining deficit reduces accumulated profits in

subsequent years. That rule applies regardless of whether foreign law

permits or requires the carryback or carryforward of losses. See

Revenue Ruling 74-550 (1974-2 C.B. 209) and Revenue Ruling 87-72 (1987-

2 C.B. 170).

Effect on Other Documents

The following revenue ruling is revoked as of January 7, 1997:

Revenue Ruling 74-59, 1974-1 C.B. 183.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

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

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

does not apply to these regulations, and because the notice of proposed

rulemaking preceding the regulations was issued prior to March 29,

1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, the

notice of proposed rulemaking preceding these regulations was submitted

to the Small Business Administration for comment on its impact on small

business.

Drafting Information

The principal author of these final regulations is Caren Silver

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

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

and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

[[Page 927]]

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

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

entries in numerical order to read as follows:

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

Section 1.902-1 also issued under 26 U.S.C. 902(c)(7).

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

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

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

and 1.902-4, respectively.

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

follows:

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

This section lists the provisions under section 902.

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

foreign corporation for foreign income taxes paid by the foreign

corporation.

(a) Definitions and special effective date.

(1) Domestic shareholder.

(2) First-tier corporation.

(3) Second-tier corporation.

(4) Third-tier corporation.

(5) Example.

(6) Upper- and lower-tier corporations.

(7) Foreign income taxes.

(8) Post-1986 foreign income taxes.

(i) In general.

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

lower-tier corporation in its taxable years beginning before January

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

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

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

withholding tax interest.

(9) Post-1986 undistributed earnings.

(i) In general.

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

lower-tier corporation in its taxable years beginning before January

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

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

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

(iv) Special allocations.

(10) Pre-1987 accumulated profits.

(i) Definition.

(ii) Computation of pre-1987 accumulated profits.

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

profits.

(11) Dividend.

(12) Dividend received.

(13) Special effective date.

(i) Rule.

(ii) Example.

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

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

(1) General rule.

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

undistributed earnings and pre-1987 accumulated profits.

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

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

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

(4) Deficits in accumulated earnings and profits.

(5) Examples.

(1) Separate computations required for dividends from each

first-tier and lower-tier corporation.

(i) Rule.

(ii) Example.

(2) Section 78 gross-up.

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

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

corporation.

(iii) Example.

(3) Creditable foreign income taxes.

(4) Foreign mineral income.

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

purchase or sale of certain oil and gas.

(6) Foreign oil and gas extraction income.

(7) United States shareholders of controlled foreign

corporations.

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

transaction.

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

income taxes and post-1986 undistributed earnings.

(d) Dividends from controlled foreign corporations.

(1) General rule.

(2) Look-through.

(i) Dividends.

(ii) Coordination with section 960.

(3) Dividends distributed out of earnings accumulated before a

controlled foreign corporation became a controlled foreign

corporation.

(i) General rule.

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

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

percent United States shareholder of a controlled foreign

corporation was not a United States shareholder of the controlled

foreign corporation.

(e) Information to be furnished.

(f) Examples.

(g) Effective date.

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

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

third-tier corporation for purposes of computing an amount of

foreign taxes deemed paid Sec. 1.902-1.

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

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

taxable years.

(1) Rule.

(2) Examples.

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

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

undistributed earnings for purposes of section 902.

(1) General rule.

(2) Effect of pre-effective date deficit.

(3) Examples.

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

foreign corporation for foreign income taxes paid with respect to

accumulated profits of taxable years of the foreign corporation

beginning before January 1, 1987.

(a) Definitions.

(1) Domestic shareholder.

(2) First-tier corporation.

(3) Second-tier corporation.

(4) Third-tier corporation.

(5) Foreign income taxes.

(6) Dividend.

(7) Dividend received.

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

(1) In general.

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

shareholder.

corporation.

(1) In general.

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

corporation.

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

corporation.

(1) In general.

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

corporation.

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

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

foreign corporation.

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

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

(2) Taxable year to which section 963 applies.

(3) Time and manner of making choice.

(4) Determination by district director.

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

which tax is deemed paid.

(1) Source of income.

(2) Country to which taxes deemed paid.

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

(j) Information to be furnished.

(k) Illustrations.

(l) Effective date.

[[Page 928]]

Sec. 1.902-4 Rules for distributions attributable to accumulated

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

less developed country corporation.

(a) In general.

(b) Combined distributions.

certain distributions from second- or third-tier corporations.

(d) Illustrations.

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

corporation for foreign income taxes paid by the foreign corporation.

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

902, this section, and Sec. 1.902-2, the definitions provided in

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

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

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

domestic corporation from a foreign corporation after December 31,

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

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

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

the domestic corporation receives a dividend from that foreign

corporation.

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

domestic shareholder from a foreign corporation in a taxable year

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

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

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

shareholder receives a dividend from that foreign corporation. The term

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

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

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

without the United States.

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

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

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

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

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

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

product of the following equals at least 5 percent--

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

shareholder in the first-tier corporation; multiplied by

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

corporation in the second-tier corporation.

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

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

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

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

dividend from that foreign corporation, the second-tier corporation

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

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

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

shareholder in the first-tier corporation; multiplied by

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

corporation in the second-tier corporation; multiplied by

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

corporation in the third-tier corporation.

(5) Example. The following example illustrates the ownership

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

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

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

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

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

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

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

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

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

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

dividend out of its post-1986 undistributed earnings to Corporation

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

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

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

Corporation A, Corporation M satisfies the 10 percent stock

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

with respect to Corporation A. Therefore, Corporation A is a first-

tier corporation within the meaning of paragraph (a)(2) of this

section and Corporation M is a domestic shareholder of Corporation A

within the meaning of paragraph (a)(1) of this section. Also on

February 16, 1991, Corporation B is a second-tier corporation within

the meaning of paragraph (a)(3) of this section because Corporation

A owns at least 10 percent of its voting stock, and the percentage

of voting stock owned by Corporation M in Corporation A on February

16, 1991 (30 percent) multiplied by the percentage of voting stock

owned by Corporation A in Corporation B on February 16, 1991 (40

percent) equals 12 percent. Corporation A shall be deemed to have

paid foreign income taxes of Corporation B with respect to the

dividend received from Corporation B on February 16, 1991.

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

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

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

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

of this section and Corporation M is a domestic shareholder within

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

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

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

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

include taxes paid by Corporation B that were deemed paid by

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

deemed paid by a foreign corporation under this section. Foreign

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

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

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

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

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

gas).

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

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

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

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

of the foreign corporation in which it distributes a dividend plus the

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

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

[[Page 929]]

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

foreign corporation on or with respect to earnings that in prior

taxable years were distributed to, or otherwise included (e.g., under

sections 304, 367(b), 551, 951(a), 1248 or 1293) in the income of, a

foreign or domestic shareholder. Except as provided in paragraph (b)(4)

of this section, foreign taxes paid or deemed paid by the foreign

corporation on or with respect to earnings that were distributed or

otherwise removed from post-1986 undistributed earnings in prior post-

1986 taxable years shall be removed from post-1986 foreign income taxes

regardless of whether the shareholder is eligible to compute an amount

of foreign taxes deemed paid under section 902, and regardless of

whether the shareholder in fact chose to credit foreign income taxes

under section 901 for the year of the distribution or inclusion. Thus,

if an amount is distributed or deemed distributed by a foreign

corporation to a United States person that is not a domestic

shareholder within the meaning of paragraph (a)(1) of this section

(e.g., an individual or a corporation that owns less than 10% of the

foreign corporation's voting stock), or to a foreign person that does

not meet the definition of a first- or second-tier corporation under

paragraph (a)(2) or (3) of this section, then although no foreign

income taxes shall be deemed paid under section 902, foreign income

taxes attributable to the distribution or deemed distribution that

would have been deemed paid had the shareholder met the ownership

requirements of paragraphs (a)(1) through (4) of this section shall be

removed from post-1986 foreign income taxes. Further, if a domestic

shareholder chooses to deduct foreign taxes paid or accrued for the

taxable year of the distribution or inclusion, it shall nonetheless be

deemed to have paid a proportionate share of the foreign corporation's

post-1986 foreign income taxes under section 902(a), and the foreign

taxes deemed paid must be removed from post-1986 foreign income taxes.

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

are determined based on an accounting period of less than one year, the

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

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

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

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

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

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

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

tier corporation out of nonpreviously taxed pre-1987 accumulated

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

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

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

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

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

section. Foreign income taxes deemed paid with respect to a

distribution of pre-1987 accumulated profits shall be translated from

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

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

determine the character of the earnings and profits and associated

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

Sec. 1.904-7(a).

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

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

include foreign income taxes paid or accrued by a noncontrolled section

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

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

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

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

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

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

must be computed in functional currency before foreign income taxes are

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

taxes.

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

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

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

profits of a foreign corporation (computed in accordance with sections

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

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

taxable year of the foreign corporation in which it distributes a

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

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

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

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

account for distributions or deemed distributions that reduced earnings

and profits and inclusions that resulted in previously-taxed amounts

described in section 959(c) (1) and (2) or section 1293(c) in prior

taxable years beginning after December 31, 1986. Thus, post-1986

undistributed earnings shall not be reduced to the extent of the

ratable share of a controlled foreign corporation's subpart F income,

as defined in section 952, attributable to a shareholder that is not a

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

section 953(c)(1)(A), because that amount has not been included in a

shareholder's gross income. Post-1986 undistributed earnings shall be

reduced as provided herein regardless of whether any shareholder is

deemed to have paid any foreign taxes, and regardless of whether any

domestic shareholder chose to claim a foreign tax credit under section

901(a) for the year of the distribution. For rules on carrybacks and

carryforwards of deficits and their effect on post-1986 undistributed

earnings, see Sec. 1.902-2. In the case of a foreign corporation the

foreign income taxes of which are computed based on an accounting

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

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

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

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

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

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

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

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

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

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

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

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

year are included in its post-1986 undistributed earnings under

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

earnings and profits and associated taxes for foreign tax credit

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

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

computing post-1986 undistributed earnings, earnings and profits shall

be reduced by foreign income taxes paid or accrued regardless of

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

reduced by foreign income taxes paid with respect to high withholding

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

[[Page 930]]

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

foreign income taxes under paragraph (a)(8)(iii) of this section.

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

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

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

(iv) Special allocations. The term post-1986 undistributed earnings

means the total amount of the earnings of the corporation determined at

the corporate level. Special allocations of earnings and taxes to

particular shareholders, whether required or permitted by foreign law

or a shareholder agreement, shall be disregarded. If, however, the

Commissioner establishes that there is an agreement to pay dividends

only out of earnings in the separate categories for passive or high

withholding tax interest income, then only taxes imposed on passive or

high withholding tax interest earnings shall be treated as related to

the dividend. See Sec. 1.904-6(a)(2).

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

1987 accumulated profits means the amount of the earnings and profits

of a foreign corporation computed in accordance with section 902 and

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

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

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

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

attributable to the foreign corporation's taxable years beginning after

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

of the foreign corporation in which the ownership requirements of

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

are met with respect to that corporation.

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

accumulated profits must be computed under United States principles

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

profits are determined at the corporate level. Special allocations of

accumulated profits and taxes to particular shareholders with respect

to distributions of pre-1987 accumulated profits in taxable years

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

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

accumulated profits of a particular year shall be reduced by amounts

distributed from those accumulated profits or otherwise included in

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

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

undistributed earnings is carried back to offset pre-1987 accumulated

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

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

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

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

under section 902, shall be determined and translated into United

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

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

1.964-1.

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

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

income taxes paid, accrued, or deemed paid by a foreign corporation on

or with respect to its pre-1987 accumulated profits. Pre-1987 foreign

income taxes of a particular year shall be reduced by the amount of

taxes paid or deemed paid by the foreign corporation on or with respect

to amounts distributed or otherwise included in income from pre-1987

accumulated profits of that year. Thus, pre-1987 foreign income taxes

shall be reduced by the amount of taxes deemed paid by a domestic

shareholder (regardless of whether the shareholder chose to credit

foreign income taxes under section 901 for the year of the distribution

or inclusion) or a first-tier or second-tier corporation, and by the

amount of taxes that would have been deemed paid had any other

shareholder been eligible to compute an amount of foreign taxes deemed

paid under section 902. Foreign income taxes deemed paid with respect

to a distribution of pre-1987 accumulated profits shall be translated

from the functional currency of the distributing corporation into

United States dollars at the spot exchange rate in effect on the date

of the distribution.

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

term dividend in section 316 and the regulations under that section

applies. Thus, for example, distributions and deemed distributions

under sections 302, 304, 305(b) and 367(b) that are treated as

dividends within the meaning of section 301(c)(1) also are dividends

for purposes of section 902. In addition, the term dividend includes

deemed dividends under sections 551 and 1248, but not deemed inclusions

under sections 951(a) and 1293. For rules concerning excess

distributions from section 1291 funds that are treated as dividends

solely for foreign tax credit purposes, (see Regulation Project INTL-

656-87 published in 1992-1 C.B. 1124; see Sec. 601.601(d)(2)(ii)(b) of

this chapter).

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

purposes of section 902 when the cash or other property is

unqualifiedly made subject to the demands of the distributee. See

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

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

or 1248.

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

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

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

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

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

1986, then--

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

income taxes of the foreign corporation shall be determined by taking

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

the first taxable year of the foreign corporation in which the

ownership requirements are met, including subsequent taxable years in

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

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

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

first taxable year of the foreign corporation in which the ownership

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

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

profits.

(ii) Example. The following example illustrates the special

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

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

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

corporation B. Corporation B is not a controlled foreign

corporation. Corporation B uses the calendar year as its taxable

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

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

dividend to Corporation A and the ownership requirements of section

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

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

purchases 10 percent of the Corporation B stock from Corporation A

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

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

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

Corporation B does not distribute any dividends to Corporation M

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

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

but before taking into account the 200u

[[Page 931]]

distribution to Corporation A) and pays 100u of foreign income taxes

that is equal to $100. Pursuant to paragraph (a)(13)(i) of this

section, Corporation B's post-1986 undistributed earnings and post-

1986 foreign income taxes will include earnings and profits and

foreign income taxes attributable to Corporation B's entire 1992

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

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

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

section. The foreign income taxes attributable to the amount

distributed as a dividend to Corporation A will not be creditable

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

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

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

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

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

and (b)(1) of this section.

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

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

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

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

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

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

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

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

1986 undistributed earnings which the amount of the dividend out of

post-1986 undistributed earnings (determined without regard to the

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

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

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

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

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

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

corporation receives the dividend. Foreign income taxes deemed paid by

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

under the following formula:

Dividend paid to domestic

shareholder (or upper-tier

corporation) by first-tier

corporation (or lower-tier

Foreign income taxes deemed paid by Post-1986 foreign income taxes corporation)

domestic shareholder (or upper-tier = of first-tier corporation (or x -------------------------------

corporation) lower-tier corporation) Post-1986 undistributed

earnings of first-tier

corporation (or lower-tier

corporation)

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

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

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

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

extent thereof. If dividends exceed post-1986 undistributed earnings

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

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

1986 undistributed earnings, computed as follows:

Dividends to

Portion of Dividend to a Shareholder

Shareholder Attributable to = Post-1986 Undistributed Earnings x -----------------------

Post-1986 Undistributed Total Dividends Paid

Earnings To all Shareholders

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

the portion of the dividend attributable to post-1986 undistributed

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

remainder of the dividend received by a shareholder is attributable to

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

dividend attributable to pre-1987 accumulated profits will be treated

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

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

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

more than one shareholder, then the dividend to each shareholder

attributable to earnings and profits accumulated in a particular pre-

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

accumulated profits of that taxable year, computed as follows:

(Dividend Paid Out of Pre-1987 Dividend to Shareholder

Portion of Dividend to a Shareholder Accumulated Profits with -------------------------------

Attributable to Accumulated Profits of = Respect to the Particular Pre- x Total Dividends Paid to all

a Particular Pre-1987 Taxable Year 1987 Taxable Year Shareholders

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

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

corporation out of pre-1987 accumulated profits, the domestic

shareholder or upper-tier corporation that receives the dividends shall

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

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

the effective date of the Tax Reform Act of 1986. See paragraphs (a)

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

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

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

foreign corporation out of current earnings and profits that is treated

as a dividend under section 316(a)(2), and post-1986 foreign income

taxes shall not be reduced, if as of the end of the taxable year in

which the dividend is paid or accrued, the corporation has zero or a

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

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

dividend shall reduce post-

[[Page 932]]

1986 undistributed earnings and accumulated earnings and profits.

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

paragraph (b):

Example 1. Domestic corporation M owns 100 percent of foreign

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

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

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

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

undistributed earnings are non-subpart F general limitation earnings

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

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

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

Corporation A has accumulated profits of 200u (net of foreign taxes)

and paid 60u of foreign income taxes on those earnings. In 1992,

Corporation A distributes 150u to Corporation M. Corporation A has

100u of post-1986 undistributed earnings and the dividend,

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

earnings to the extent of 100u. The first 100u distribution is from

post-1986 undistributed earnings, and, because the distribution

exhausts those earnings, Corporation M is deemed to have paid the

entire amount of post-1986 foreign income taxes of Corporation A

($40). The remaining 50u dividend is treated as a dividend out of

1986 accumulated profits under paragraph (b)(2) of this section.

Corporation M is deemed to have paid $15 (60u x 50u/200u, translated

at the appropriate exchange rates) of Corporation A's foreign income

taxes for 1986. As of January 1, 1993, Corporation A's post-1986

undistributed earnings and post-1986 foreign income taxes are 0.

Corporation A has 150u of accumulated profits and 45u of foreign

income taxes remaining in 1986.

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

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

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

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

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

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

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

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

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

earnings and profits and a deficit in post-1986 undistributed

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

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

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

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

1992, Corporation A has a deficit of (100u) ((200u) post1986

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

1986 undistributed earnings. Corporation A, however, has current

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

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

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

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

post-1986 undistributed earnings and the sum of current plus

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

both post-1986 undistributed earnings and accumulated earnings and

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

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

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

at the start of 1993 are $40.

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

taxable year dividends are received by a domestic shareholder or an

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

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

by the domestic shareholder or the upper-tier corporation under

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

computed separately with respect to the dividends received from each

first-tier corporation or lower-tier corporation. If a domestic

shareholder receives dividend distributions from one or more first-tier

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

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

amount of foreign income taxes deemed paid shall be computed by

starting with the lowest-tier corporation and working upward.

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

this paragraph (c)(1):

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

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

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

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

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

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

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

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

tier corporations and to compute foreign taxes deemed paid

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

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

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

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

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

compute foreign taxes deemed paid with respect to the dividend from

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

and deemed paid by S.

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

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

regulations under that section (relating to amounts excluded from gross

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

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

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

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

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

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

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

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

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

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

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

allocated and apportioned to income in that separate category. See

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

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

Foreign income taxes deemed paid by an uppertier corporation on a

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

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

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

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

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

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

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

corporation on which those foreign income taxes were paid as United

States source earnings and profits, the foreign income taxes deemed

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

tier corporation shall be treated as attributable to United States

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

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

paragraph (c)(2):

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

voting stock of controlled foreign corporation S. Corporations P and

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

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

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

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

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

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

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

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

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

dividend of 75u

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which P receives in 1992. Under Sec. 1.904-5(m)(4), one-third of the

dividend, or 25u (75u x 50u/150u), is United States source income to

P. P computes foreign taxes deemed paid on the dividend under

paragraph (b)(1) of this section of $30 ($60 x 50%[75u/150u]) and

includes that amount in gross income under section 78 as a dividend.

Because 25u of the 75u dividend is United States source income to P,

$10 ($30 x 33.33%[25u/75u]) of the section 78 dividend will be

treated as United States source income to P under this paragraph

(c)(2).

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

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

limitations and conditions of sections 902 and 904, foreign income

taxes actually paid and deemed paid by a domestic shareholder that

receives a dividend from a first-tier corporation. Foreign income taxes

deemed paid by a domestic shareholder under paragraph (b) of this

section shall be deemed paid by the domestic shareholder only for

purposes of computing the foreign tax credit allowed under section 901.

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

excess profits taxes paid or accrued with respect to foreign mineral

income will not be considered foreign income taxes for purposes of

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

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

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

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

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

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

section 901(f).

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

reduction of the amount of foreign income taxes deemed paid with

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

and the regulations under that section.

(7) United States shareholders of controlled foreign corporations.

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

regulations under those sections for special rules relating to the

application of section 902 in computing foreign income taxes deemed

paid by United States shareholders of controlled foreign corporations.

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

transaction. [Reserved].

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

taxes and post-1986 undistributed earnings. [Reserved].

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

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

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

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

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

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

corporation from a lower-tier corporation if the corporations are

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

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

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

lower-tier controlled foreign corporation attributable to more than one

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

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

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

be computed separately with respect to the post-1986 undistributed

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

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

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

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

corporation with respect to income in the appropriate separate

category.

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

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

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

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

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

portion of the foreign income taxes attributable to a particular

separate category that shall be deemed paid by the domestic shareholder

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

Dividend amount

attributable to

a separate