Allocation of Loss With Respect to Stock and Other Personal Property; Application of Section 904 to Income Subject to Separate Limitations

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8805]

RIN 1545-AQ43; 1545-AT41

Allocation of Loss With Respect to Stock and Other Personal

Property; Application of Section 904 to Income Subject to Separate

Limitations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary Income Tax

Regulations relating to the allocation of loss recognized on the

disposition of stock and other personal property and the computation of

the foreign tax credit limitation. The loss allocation regulations

primarily will affect taxpayers that claim the foreign tax credit and

that incur losses with respect to personal property and are necessary

to modify existing guidance with respect to loss allocation. The

foreign tax credit limitation regulations will affect taxpayers

claiming foreign tax credits that have passive income or losses and are

necessary to modify existing guidance with respect to the computation

of the limitation.

DATES: Effective dates: These regulations are effective January 11,

1999, except that Sec. 1.904-4(c)(2)(ii) (A) and (B) are effective

March 12, 1999 and Sec. 1.904-4(c)(3)(iv) is effective December 31,

1998.

Dates of applicability: For dates of applicability of Secs. 1.865-

1T, 1.865-2, and 1.865-2T, see Secs. 1.865-1T(f), 1.865-2(e), and

1.865-2T(e), respectively. For dates of applicability of Sec. 1.904-

4(c), see Sec. 1.904-4(c)(2)(i).

FOR FURTHER INFORMATION CONTACT: Seth B. Goldstein, (202) 622-3810,

regarding section 865(j); and Rebecca Rosenberg, (202) 622-3850,

regarding section 904(d) (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On May 14, 1992, the IRS published a notice of proposed rulemaking

in the Federal Register (REG-209527-92, formerly INTL-1-92 (1992-1 C.B.

1209), 57 FR 20660), proposing amendments to the Income Tax Regulations

(26 CFR part 1) under section 904(d). The regulations included proposed

amendments to the grouping rules under Sec. 1.904-4(c)(3) for purposes

of determining whether passive income is high taxed. The amendments

were proposed to be effective for taxable years beginning after

December 31, 1991. A public hearing was held on September 24, 1992, but

no written or oral comments were received with respect to these

provisions. These regulations are finalized as proposed. However, as

described below, the effective date of the regulations has been

modified.

On July 8, 1996, the IRS published proposed amendments (REG-209750-

95, formerly INTL-4-95 (1996-2 C.B. 484), 61 FR 35696) to the Income

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

Internal Revenue Code in the Federal Register. The regulations

addressed the allocation of loss on the disposition of stock

(Sec. 1.865-2) and other personal property (Sec. 1.865-1) and also

contained proposed amendments to the grouping rules under Sec. 1.904-

4(c). The proposed regulations generally allocate loss with respect to

stock based upon the residence of the seller (reciprocal to gain), but

allocate loss on other personal property based upon the income

generated by the property. A public hearing was held on November 6,

1996, and several written comments were received. The written comments

endorsed the regulations' general approach with respect to the

allocation of stock loss. In addition, on June 18, 1997, the Tax Court

held in International Multifoods Corporation v. Commissioner, 108 T.C.

579 (1997), that loss on the disposition of stock is generally

allocated based on the residence of the seller, consistent with the

approach of the proposed regulations. After consideration of all the

comments, the regulations proposed by INTL-4-95 with respect to stock

loss and with respect to the grouping rules are adopted as amended by

this Treasury decision. The principal changes to these regulations, as

well as the major comments and suggestions, are discussed below. An

additional anti-abuse rule, not previously proposed, is issued as a

proposed and temporary regulation.

The written comments criticized the proposed regulation concerning

the allocation of loss on other personal property (Sec. 1.865-1). This

proposed regulation is withdrawn and replaced with a new proposed and

temporary regulation that is more consistent with the approach of the

stock loss allocation rules. The new rules are issued as a temporary

regulation because of the need for immediate guidance following the

International Multifoods opinion.

Explanation of Provisions

Section 1.861-8T(e)(8): Net Operating Loss

Section 1.861-8T(e)(8) clarifies that a net operating loss

deduction allowed under section 172 is allocated and apportioned in the

same manner as the deductions giving rise to the net operating loss

deduction.

Section 1.865-1T: Loss With Respect to Personal Property Other Than

Stock

Section 1.865-1T(a) provides the general rule that loss with

respect to personal property is allocated in the same manner in which

gain on the sale of the property would be sourced. Thus, for example,

loss on the sale or worthlessness of a foreign bond held by a U.S.

resident generally would be allocated against U.S. source income.

Notice 89-58 (1989-1 C.B. 699), which addressed the allocation of loss

with respect to certain bank loans, is revoked as inconsistent with

this approach. Taxpayers may rely on the Notice for loss recognized

prior to the effective date of the temporary regulations (see

discussion of effective dates, below). Following the general rule, loss

attributable to a foreign office of a U.S. resident is allocated

against foreign source income where gain would be foreign source under

the foreign branch rule of section 865(e)(1).

Section 1.865-1T(b) provides special rules of application. Loss on

depreciable property generally is allocated based upon the allocation

of depreciation deductions taken with respect to the property,

consistent with the depreciation-recapture source rule of section

865(c)(1). Similarly, loss with respect to a contingent payment debt

instrument subject to Reg. Sec. 1.1275-4(b) is allocated against

interest income because gain on the instrument generally is treated as

interest income.

Section 1.865-1T(c) provides exceptions from the reciprocal-to-gain

rule. The regulations do not apply to certain financial products (to be

addressed in a future guidance project), loss governed by section 988,

inventory (which is not governed by section 865), or trade receivables

and certain interest equivalents (which are governed by Sec. 1.861-

9T(b)). When Prop. Sec. 1.863-3(h) (the global dealing sourcing

regulation) is finalized, Sec. 1.865-1T will not apply to any loss

sourced under that regulation. Loss attributable to accrued-but-unpaid

interest income is allocated against interest income. Also, loss on a

debt instrument is allocated against interest income to the extent the

taxpayer did not amortize bond premium to the full extent permitted by

the Code. Anti-abuse exceptions are also provided. Section 1.865-

1T(c)(6)(i), which prevents taxpayers from manipulating loss allocation

through related-party transfers, reorganizations, or similar

transactions, and Sec. 1.865-1T(c)(6)(ii), which addresses offsetting

positions, are similar to the anti-abuse rules previously proposed with

respect to stock losses. In addition, section 1.865-1T(c)(6)(iii) has

been included to prevent taxpayers from accelerating foreign source

income with respect to property and claiming an offsetting U.S. loss.

The temporary regulations are effective for loss recognized on or

after January 11, 1999. A taxpayer may apply the regulations, however,

to loss

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recognized in any taxable year beginning on or after January 1, 1987,

subject to certain conditions.

Section 1.865-2: Stock Loss

The proposed regulations issued in 1996 provide that generally loss

with respect to stock is allocated to the residence of the seller, but

contain three major exceptions: an exclusion for dispositions of

portfolio stock and stock in regulated investment companies (RICs) and

S corporations, a dividend recapture rule, and a consistency rule for

certain dispositions of foreign affiliates. The final regulations

modify these exceptions. The principal comments and changes to the

regulations are discussed below.

Section 1.865-2(a): General Rule for Allocation of Stock Loss

Commentators criticized the exclusion of portfolio stock and RIC

stock from the general residence-based rule, arguing that the rationale

for residence-based allocation applies equally to these classes of

stock. The final regulations eliminate the exception for portfolio

stock and RIC stock.

In response to a comment, the final regulations clarify that

Sec. 1.865-2 does not apply to stock that constitutes inventory.

The proposed regulations allocate loss recognized on the ``sale or

other disposition'' of stock. Proposed Sec. 1.865-2(c)(2) provides that

worthlessness giving rise to a deduction under section 165(g)(3) with

respect to stock is treated as a disposition. Questions have been

raised as to whether the regulations apply to other recognized losses

that are not the result of a sale or disposition (for example, loss

recognized under the mark-to-market rules of section 475). The final

regulations are intended to apply to all recognized stock losses. To

avoid confusion, the reference to sales or other dispositions has been

deleted in the final regulations. The special reference to

worthlessness deductions is therefore unnecessary and also has been

deleted.

Section 1.865-2(b)(1): Dividend Recapture Exception

Some commentators questioned the dividend recapture rule of

Sec. 1.865-2(b)(1) and suggested that the rule should be limited to

cases in which the dividends were fully sheltered from U.S. tax by

foreign tax credits or the taxpayer did not meet a minimum holding

period. Others suggested that the two-year recapture period defined in

Sec. 1.865-2(d)(5) of the proposed regulations should be shortened.

Sections 1.865-2(b)(1)(i) and 1.865-2(d)(3) of the final regulations

retain the two-year rule.

Section 1.865-2(b)(1)(iii) of the final regulations provides an

exception from dividend recapture for passive-basket dividends. This

new exception will exempt most portfolio investors (other than

financial services entities) from the dividend recapture rule. The

rule, which will reduce administrative burdens, reflects the fact that

passive income is generally subject to residual U.S. tax and the high-

tax kick-out of section 904(d)(2)(A)(iii)(III) limits the potential for

cross-crediting in the passive basket, thus reducing the need for

recapture. In addition, allocation of loss to the passive basket may

lead to investment incentives that violate the policies underlying the

passive basket. For example, where a loss allocated to the passive

basket creates a separate limitation loss under section 904(f)(5) that

reduces high-taxed income in other baskets, this creates an incentive

in subsequent years for the taxpayer to earn low-taxed foreign passive

income to utilize the foreign tax credits in the high-taxed basket (due

to the recharacterization rules of section 904(f)(5)(C)).

Commentators also suggested alternatives to the de minimis rule of

Sec. 1.865-2(b)(1)(ii), which exempts from recapture dividends that are

less than 10 percent of the recognized loss. The proposed de minimis

rule is retained in the final regulations. The de minimis rule is

intended to exempt from recapture, as a matter of administrative

convenience, dividends that are relatively insignificant in comparison

to the loss.

Two commentators questioned why the dividend recapture rule and the

definition of the recapture period in Sec. 1.865-2(d)(5) of the

proposed regulations refer to realized, rather than recognized, loss.

The wording was intended to avoid confusion over the application of the

rule to loss that is deferred under section 267(f). The final

regulation refers to ``recognized'' loss, but examples have been added

in Sec. 1.865-2(b)(1)(iv) of the final regulations to illustrate the

application of the dividend recapture rule in the context of section

267(f) and how the result differs in the context of a consolidated

group.

Proposed Sec. 1.865-2(b)(2): Consistency Rule

Proposed Sec. 1.865-2(b)(2) requires a taxpayer to allocate loss on

the sale of a foreign affiliate to passive-basket foreign source income

if the taxpayer recognized foreign source gain under section 865(f) at

any time during the 5-year period preceding the loss sale. Commentators

criticized this rule as producing disproportionate results where the

foreign source gain is small in comparison to the subsequent loss.

Furthermore, even where the gain and loss are of similar magnitude, the

results may be disproportionate because sourcing the gain foreign may

provide the taxpayer with minimal tax benefits (because the gain is

assigned to the passive basket) but the loss may reduce (sometimes as a

separate limitation loss) income that is otherwise sheltered by foreign

tax credits. In addition, allocating loss to the passive basket raises

the policy concerns described above with respect to passive-basket

dividend recapture. After consideration of the comments, the

consistency rule has been eliminated from the final regulations.

Section 1.865-2(b)(2): Anti-Abuse Rules

The anti-abuse rules of Sec. 1.865-2(b)(3) of the proposed

regulations, finalized as Sec. 1.865-2(b)(4), have been refined and

modified. One commentator requested examples illustrating the anti-

abuse rules. Examples have been provided. An additional rule is

provided in Sec. 1.865-2T, discussed below.

Section 1.865-2(e): Effective Date and Retroactive Election

The proposed regulations are proposed to be effective for taxable

years beginning 61 days after final regulations are promulgated.

Because of the immediate need for guidance following the International

Multifoods opinion, the final regulations are effective for losses

recognized on or after January 11, 1999.

Several commentators requested that the regulations clarify the

scope of the retroactive election and reduce the administrative burden

of making the election. In response to these comments, Sec. 1.865-

2(e)(2) is amended to provide that a taxpayer need not make a formal

election to retroactively apply the regulations to losses recognized in

any post-1986 year and all subsequent pre-effective date years. An

amended return will be required only if retroactive application results

in a change in tax liability.

One commentator urged that the overall foreign loss transition rule

in Sec. 1.904(f)-12 be modified to provide that an overall foreign loss

account attributable to a stock loss recognized in a pre-1987 year be

recomputed under the new regulations in the first election year. This

suggestion was rejected because the allocation of a stock loss is

governed by the rules in effect in the year the loss is recognized, and

the

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retroactive election is available only with respect to post-1986 years.

Section 1.865-2(e)(3) provides examples to illustrate the effect of the

retroactive application of the regulations on overall foreign loss

accounts, capital loss carryovers, and foreign tax credit carryovers.

Section 1.865-2T: Stock Loss Matching Rule

Section 1.865-2T(b)(4)(iii) provides a rule intended to prevent

taxpayers from avoiding the dividend recapture rule of Sec. 1.865-

2(b)(1) or from accelerating foreign source income and recognizing an

offsetting U.S. loss. This rule is substantially the same as the

matching rule of Sec. 1.865-1T(c)(6)(iii). The rule is promulgated as a

temporary regulation because it is necessary to prevent abuse of the

residence-based general allocation rule.

Section 1.904-4(c): Grouping Rules

The high-tax kick-out grouping rules of Sec. 1.904-4(c) provide

rules for determining when particular groups of passive income are

high-taxed and, therefore, treated as general limitation income under

sections 904(d)(2)(A)(iii)(III) and 904(d)(2)(F). As described above,

the proposed amendments to these rules that were proposed in 1992 are

finalized as proposed, but taxpayers are afforded some flexibility with

respect to the effective date. The amendments were proposed to be

effective for taxable years beginning after December 31, 1991. The

final regulations are effective for taxable years ending on or after

December 31, 1998, but taxpayers may apply the amended regulations to

any taxable year beginning after December 31, 1991 and all subsequent

years. An example is also added to clarify that foreign taxes that are

not creditable (e.g., under section 901(k)) are not withholding taxes

for purposes of the grouping rules.

The proposed amendments to the grouping rules that were proposed in

1996 are finalized with two clarifications. Proposed Sec. 1.904-

4(c)(2)(ii)(B) provides guidance where deductions allocated to a group

of passive income exceed the income in that group (i.e., a loss group).

A question has been raised as to the proper treatment of foreign taxes

in a group that has no taxable income or loss (either because the

deductions allocated to the group exactly equal the income in the group

or because the foreign taxes assigned to the group are imposed on U.S.

source income or income that is not currently taken into account under

U.S. tax principles). Consistent with the approach taken in the

proposed regulations with respect to loss groups, the final regulations

clarify that foreign taxes allocated to a group with no foreign source

income are ``kicked out'' and treated as related to general limitation

income.

Proposed Sec. 1.904-4(c)(2)(ii)(A) provides that foreign tax

imposed on sales that result in loss for U.S. tax purposes is allocated

to the group of passive income to which the loss is allocated. While

this correctly states the result where loss on the disposition of

property is allocated to passive income under a reciprocal-to-gain

rule, under the temporary and final regulations loss may be allocated

to reduce the group of passive income where income from the property

was assigned (for example, dividends or interest under the anti-abuse

rules or the accrued-but-unpaid interest rule) or a separate category

of income other than passive income. Accordingly, Sec. 1.904-

4(c)(2)(ii)(A) of the final regulations is clarified to state that

foreign tax imposed on a loss sale is allocated to the group of passive

income to which a gain would have been assigned. The examples in

Sec. 1.904-4(c)(8) of the final regulations are modified to reflect the

fact that the consistency rule of Sec. 1.865-2(b)(2) of the proposed

regulations has been deleted.

One commentator inquired whether the rule of Sec. 1.904-

4(c)(2)(ii)(A) allocating foreign tax on a loss sale to a group of

passive income is consistent with the tax allocation rule of

Sec. 1.904-6(a)(1)(iv). The latter rule provides that a foreign tax

imposed on an item of income that does not constitute income under U.S.

tax principles (a base difference) shall be treated as imposed with

respect to general limitation income, whereas a foreign tax imposed on

an item that would be income under U.S. tax principles in another year

(a timing difference) will be allocated to the appropriate separate

category as if the U.S. recognized the income in the same year.

Treasury and the Service believe that a base difference exists within

the meaning of Sec. 1.904-6(a)(1)(iv) only when a foreign country taxes

items that the United States would never treat as taxable income, for

example, gifts or life insurance proceeds. A sale that results in gain

under foreign law but in loss for U.S. tax purposes is attributable to

differences in basis calculations rather than to a difference in the

concept of taxable income and, therefore, does not constitute a base

difference. The tax allocation rule of Sec. 1.904-4(c)(2)(ii)(A),

allocating foreign taxes on a loss sale to the same group of passive

income to which gain would have been assigned had the United States

recognized gain on the sale, is conceptually consistent with the

treatment of timing differences in Sec. 1.904-6(a)(1)(iv).

Effect on Other Documents

The following document is obsolete as of January 11, 1999:

Notice 89-58, 1989-1 C.B. 699.

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.

This Treasury Decision finalizes notices of proposed rulemaking

published May 14, 1992 (57 FR 20660) and July 8, 1996 (61 FR 35696). It

has been determined that section 553(b) of the Administrative Procedure

Act (5 U.S.C. chapter 5) does not apply to the final regulations issued

pursuant to the notice of proposed rulemaking published on May 14,

1992. Furthermore, the Regulatory Flexibility Act (5 U.S.C. chapter 6)

does not apply to those regulations, because the notice of proposed

rulemaking was issued prior to March 29, 1996.

It also has been determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to the

portion of the notice of proposed rulemaking published on July 8, 1996,

relating to section 904 of the Internal Revenue Code. Because the

regulation does not impose a collection of information on small

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

apply.

A final regulatory flexibility analysis under 5 U.S.C. Sec. 604 has

been prepared for the final regulations portion of this Treasury

Decision with respect to the regulations issued under section 865 of

the Internal Revenue Code. A summary of the analysis is set forth below

under the heading ``Summary of Regulatory Flexibility Analysis.''

Because no preceding notice of proposed rulemaking is required for the

temporary regulations portion of this Treasury Decision relating to

sections 861 and 865 of the Code, the provisions of the Regulatory

Flexibility Act do not apply. However, an initial Regulatory

Flexibility Analysis was prepared for the proposed regulations

published elsewhere in this issue of the Federal Register.

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

notices of proposed rulemaking preceding these regulations were

submitted to the Small Business Administration for comment on their

impact on small business.

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Summary of Regulatory Flexibility Analysis

It has been determined that a final regulatory flexibility analysis

is required under 5 U.S.C. Sec. 604 with respect to the final

regulations portion of this Treasury Decision with respect to the

regulations issued under section 865 of the Internal Revenue Code.

These regulations will affect small entities such as small businesses

but not other small entities, such as local government or tax exempt

organizations, which do not pay taxes. The IRS and Treasury Department

are not aware of any federal rules that duplicate, overlap or conflict

with these regulations. The final regulations address the allocation of

loss with respect to stock. These regulations are necessary primarily

for the proper computation of the foreign tax credit limitation under

section 904 of the Internal Revenue Code. With respect to U.S. resident

taxpayers, the regulations generally allocate losses against U.S.

source income. Generally, this allocation simplifies the computation of

the foreign tax credit limitation. None of the significant alternatives

considered in drafting the regulations would have significantly altered

the economic impact of the regulations on small entities. There are no

alternative rules that are less burdensome to small entities but that

accomplish the purposes of the statute.

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

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

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

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

and revising paragraph (e)(8) 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) Allocation of loss recognized in taxable years after 1986.

See Secs. 1.865-1T, 1.865-2, and 1.865-2T for rules regarding the

allocation of certain loss recognized in taxable years beginning after

December 31, 1986.

(8) Net operating loss deduction. [Reserved.] For guidance, see

Sec. 1.861-8T(e)(8).

* * * * *

Par. 3. Section 1.861-8T is amended by adding paragraph (e)(8) and

a sentence at the end of paragraph (h) to read as follows:

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

United States and from other sources and activities (Temporary).

* * * * *

(e) * * *

(8) Net operating loss deduction. A net operating loss deduction

allowed under section 172 shall be allocated and apportioned in the

same manner as the deductions giving rise to the net operating loss

deduction.

* * * * *

(h) * * * Paragraph (e)(8) of this section shall cease to be

effective January 8, 2002.

Par. 4. Section 1.865-1T is added immediately following Sec. 1.864-

8T, to read as follows:

Sec. 1.865-1T Loss with respect to personal property other than stock

(Temporary).

(a) General rules for allocation of loss--(1) Allocation against

gain. Except as otherwise provided in Secs. 1.865-2 and 1.865-2T and

paragraph (c) of this section, loss recognized with respect to personal

property 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 from a sale of such property would

give rise in the hands of the seller. Thus, for example, loss

recognized by a United States resident on the sale of a bond generally

is allocated to reduce United States source income.

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

provided in Secs. 1.865-2 and 1.865-2T and paragraph (c) of this

section, and except with respect to loss subject to paragraph (b) of

this section, in the case of loss recognized by a United States

resident with respect to property 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 on the sale of the property would have been

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

imposed on such gains in the foreign country is at least 10 percent.

However, paragraph (a)(1) of this section and not this paragraph (a)(2)

will apply if gain on the sale of such property would be sourced under

section 865(c), (d)(1)(B), or (d)(3).

(3) Loss recognized by United States citizen or resident alien with

foreign tax home. Except as otherwise provided in Secs. 1.865-2 and

1.865-2T and paragraph (c) of this section, and except with respect to

loss subject to paragraph (b) of this section, in the case of loss with

respect to property recognized by a United States citizen or resident

alien that has a tax home (as defined in section 911(d)(3)) in a

foreign country, the loss shall be allocated to reduce foreign source

income if a gain on the sale of such property would have been taxable

by a foreign country and the highest marginal rate of tax imposed on

such gains in the foreign country is at least 10 percent.

(4) Allocation for purposes of section 904. For purposes of section

904, loss recognized with respect to property that is allocated to

foreign source income under this paragraph (a) shall be allocated to

the separate category under section 904(d) to which gain on the sale of

the property 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

such 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 a sale of the property would have been assigned

had a sale of the property resulted in the recognition of a gain under

the law of the relevant foreign jurisdiction or jurisdictions.

(5) Loss recognized by partnership. A partner's distributive share

of loss recognized by a partnership with respect to personal property

shall be allocated and apportioned in accordance with this section as

if the partner had recognized the loss. If loss 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.

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(b) Special rules of application--(1) Depreciable property. In the

case of a loss recognized with respect to depreciable personal

property, the gain referred to in paragraph (a)(1) of this section is

the gain that would be sourced under section 865(c)(1) (depreciation

recapture).

(2) Contingent payment debt instrument. Except to the extent

provided in Sec. 1.1275-4(b)(9)(iv), loss recognized with respect to a

contingent payment debt instrument to which Sec. 1.1275-4(b) applies

(instruments issued for money or publicly traded property) 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 interest income from the instrument (in the amount of the loss

subject to this paragraph (b)(2)) would give rise.

(c) Exceptions--(1) Foreign currency and certain financial

instruments. This section does not apply to loss governed by section

988 and loss recognized with respect to options contracts or derivative

financial instruments, including futures contracts, forward contracts,

notional principal contracts, or evidence of an interest in any of the

foregoing.

(2) Inventory. This section does not apply to loss recognized with

respect to property described in section 1221(1).

(3) Interest equivalents and trade receivables. Loss subject to

Sec. 1.861-9T(b) (loss equivalent to interest expense and loss on trade

receivables) shall be allocated and apportioned under the rules of

Sec. 1.861-9T and not under the rules of this section.

(4) Unamortized bond premium. To the extent a taxpayer recognizing

loss with respect to a bond (within the meaning of Sec. 1.171-1(b)) did

not amortize bond premium to the full extent permitted by Secs. 1.171-2

or 1.171-3 (or Sec. 1.171-1, as contained in the 26 CFR part 1 edition

revised as of April 1, 1997) (as applicable), loss recognized with

respect to the bond 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 interest income from the bond was

assigned.

(5) Accrued interest. Loss attributable to accrued but unpaid

interest on a debt obligation 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 interest income from

the obligation was assigned. For purposes of this section, whether loss

is attributable to accrued but unpaid interest (rather than to

principal) shall be determined under the principles of Secs. 1.61-7(d)

and 1.446-2(e).

(6) Anti-abuse rules--(i) Transactions involving built-in losses.

If one of the principal purposes of a transaction is to change the

allocation of a built-in loss with respect to personal property by

transferring the property to another person, qualified business unit,

office or other fixed place of business, or branch that subsequently

recognizes the loss, the loss shall be allocated by the transferee as

if it were recognized by the transferor immediately prior to the

transaction. If one of the principal purposes of a change of residence

is to change the allocation of a built-in loss with respect to personal

property, the loss shall be allocated as if the change of residence had

not occurred. If one of the principal purposes of a transaction is to

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

property by converting the original property into other property and

subsequently recognizing loss with respect to such other property, the

loss shall be allocated as if it were recognized with respect to the

original property immediately prior to the transaction. Transactions

subject to this paragraph shall include, without limitation,

reorganizations within the meaning of section 368(a), liquidations

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

transfers to a partnership under section 721, transfers to a trust,

distributions by a partnership, distributions by a trust, transfers to

or from a qualified business unit, office or other fixed place of

business, or branch, or exchanges under section 1031. A person may have

a principal purpose of affecting loss allocation even though this

purpose is outweighed by other purposes (taken together or separately).

(ii) Offsetting positions. If a taxpayer recognizes loss with

respect to personal property and the taxpayer (or any person described

in section 267(b) (after application of section 267(c), 267(e), 318 or

482 with respect to the taxpayer) holds (or held) offsetting positions

with respect to such property with a principal purpose of recognizing

foreign source income and United States source loss, the loss shall be

allocated and apportioned against such foreign source income. For

purposes of this paragraph (c)(6)(ii), positions are offsetting if the

risk of loss of holding one or more positions is substantially

diminished by holding one or more other positions.

(iii) Matching rule. To the extent a taxpayer (or a person

described in section 1059(c)(3)(C) with respect to the taxpayer)

recognizes foreign source income for tax purposes that results in the

creation of a corresponding loss with respect to personal property, the

loss shall be allocated and apportioned against such income. For

examples illustrating a similar rule with respect to stock loss, see

Examples 3 through 6 of Sec. 1.865-2T(b)(4)(iv).

(d) Definitions--(1) Contingent payment debt instrument. A

contingent payment debt instrument is any debt instrument that is

subject to Sec. 1.1275-4.

(2) Depreciable personal property. Depreciable personal property is

any property described in section 865(c)(4)(A).

(3) 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.

(e) Examples. The application of this section may be illustrated by

the following examples:

Example 1. On January 1, 1997, A, a domestic corporation,

purchases for $1,000 a machine that produces widgets, which A sells

in the United States and throughout the world. Throughout A's

holding period, the machine is located and used in Country X. During

A's holding period, A incurs depreciation deductions of $400 with

respect to the machine. Under Sec. 1.861-8, A allocates and

apportions depreciation deductions of $250 against foreign source

general limitation income and $150 against U.S. source income. On

December 12, 1999, A sells the machine and recognizes a loss of

$500. Because the machine was used predominantly outside the United

States, under section 865(c)(1)(B) and (c)(3)(B)(ii), gain on the

disposition of the machine would be foreign source general

limitation income to the extent of the depreciation adjustments.

Therefore, under paragraph (b)(1) of this section, the entire $500

loss is allocated against foreign source general limitation income.

Example 2. On January 1, 1997, A, a domestic corporation, loans

$2,000 to N, its wholly-owned controlled foreign corporation, in

exchange for a contingent payment debt instrument subject to

Sec. 1.1275-4(b). During 1997 through 1999, A accrues and receives

interest income of $630, $150 of which is foreign source general

limitation income and $480 of which is foreign source passive income

under section 904(d)(3). Assume there are no positive or negative

adjustments pursuant to Sec. 1.1275-4(b)(6) in 1997 through 1999. On

January 1, 2000, A disposes of the debt instrument and recognizes a

$770 loss. Under Sec. 1.1275-4(b)(8)(ii), $630 of the loss is

treated as ordinary loss and $140 is treated as capital loss. Assume

that $140 of interest income earned in 2000 with respect to the debt

[[Page 1511]]

instrument would be foreign source passive income under section

904(d)(3). Under Sec. 1.1275-4(b)(9)(iv), $150 of the ordinary loss

is allocated against foreign source general limitation income and

$480 of the ordinary loss is allocated against foreign source

passive income. Under paragraph (b)(2) of this section, the $140

capital loss is allocated against foreign source passive income.

Example 3. On January 1, 1997, A, a domestic corporation,

purchases for $1,000 a bond maturing January 1, 2009, with a stated

principal amount of $1,000, payable at maturity. The bond provides

for unconditional payments of interest of $100, payable December 31

of each year. The issuer of the bond is a foreign corporation and

interest on the bond is thus foreign source. Between 1997 and 2001,

A accrues and receives foreign source interest income of $500 with

respect to the bond. On January 1, 2002, A sells the bond and

recognizes a $500 loss. Under paragraph (a)(1) of this section, the

$500 loss is allocated against U.S. source income. Paragraph

(c)(6)(iii) of this section is not applicable because A's

recognition of the foreign source income did not result in the

creation of a corresponding loss with respect to the bond.

Example 4. On January 1, 1999, A, a domestic corporation on the

accrual method of accounting, purchases for $1,000 a bond maturing

January 1, 2009, with a stated principal amount of $1,000, payable

at maturity. The bond provides for unconditional payments of

interest of $100, payable December 31 of each year. The issuer of

the bond is a foreign corporation and interest on the bond is thus

foreign source. On June 10, 1999, after A has accrued $44 of

interest income, but before any interest has been paid, the issuer

suddenly becomes insolvent and declares bankruptcy. A sells the bond

(including the accrued interest) for $20. Assuming that A properly

accrued $44 interest income, A treats the $20 proceeds from the sale

of the bond as payment of interest previously accrued and recognizes

a $1000 loss with respect to the bond principal and a $24 loss with

respect to the accrued interest. See Sec. 1.61-7(d). Under paragraph

(a)(1) of this section, the $1000 loss with respect to the principal

is allocated against U.S. source income. Under paragraph (c)(5) of

this section, the $24 loss with respect to accrued but unpaid

interest is allocated against foreign source interest income.

(f) Effective date--(1) In general. Except as provided in paragraph

(f)(2) of this section, this section is effective for loss recognized

on or after January 11, 1999. For purposes of this paragraph (f), loss

that is recognized but deferred (for example, under section 267 or

1092) shall be treated as recognized at the time the loss is taken into

account. This section shall cease to be effective January 8, 2002.

(2) Application to prior periods. A taxpayer may apply the rules of

this section to losses recognized in any taxable year beginning on or

after January 1, 1987, and all subsequent years, provided that--

(i) The taxpayer's tax liability as shown on an original or amended

tax return is consistent with the rules of this section for each such

year for which the statute of limitations does not preclude the filing

of an amended return on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any

double benefit arising from the application of this section to years

that are not open for assessment.

(3) Examples. See Sec. 1.865-2(e)(3) for examples illustrating an

effective date provision similar to the effective date provided in this

paragraph (f).

Par. 5. Section 1.865-2 is added immediately after Sec. 1.865-1T,

to read as follows:

Sec. 1.865-2 Loss with respect to stock.

(a) General rules for allocation of loss with respect to stock--(1)

Allocation against gain. Except as otherwise provided in paragraph (b)

of this section, loss recognized with respect to 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

964(e)(1) or 1248) from a sale of such stock would give rise in the

hands of the seller (without regard to section 865(f)). Thus, for

example, loss recognized by a United States resident on the sale of

stock generally is allocated to reduce United States source income.

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

provided in paragraph (b) of this section, in the case of loss

recognized by a United States resident with respect to stock 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 on the sale of the

stock would have been taxable by the foreign country and the highest

marginal rate of tax imposed on such gains in the foreign country is at

least 10 percent.

(3) Loss recognized by United States citizen or resident alien with

foreign tax home--(i) In general. Except as otherwise provided in

paragraph (b) of this section, in the case of loss with respect to

stock that is recognized by a United States citizen or resident alien

that has a tax home (as defined in section 911(d)(3)) in a foreign

country, the loss shall be allocated to reduce foreign source income if

a gain on the sale of the stock would have been taxable by a foreign

country and the highest marginal rate of tax imposed on such gains in

the foreign country is at least 10 percent.

(ii) Bona fide residents of Puerto Rico. Except as otherwise

provided in paragraph (b) of this section, in the case of loss with

respect to stock in a corporation described in section 865(g)(3)

recognized by a United States citizen or resident alien that is a bona

fide resident of Puerto Rico during the entire taxable year, the loss

shall be allocated to reduce foreign source income.

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

recognized by a nonresident alien individual or a foreign corporation

with respect to 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.

(5) Allocation for purposes of section 904. For purposes of section

904, loss recognized with respect to stock that is allocated to foreign

source income under this paragraph (a) shall be allocated to the

separate category under section 904(d) to which gain on a sale of the

stock 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

such 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 a sale of the stock would have been assigned

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

law of the relevant foreign jurisdiction or jurisdictions.

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

If a taxpayer recognizes a loss with respect to shares of stock, and

the taxpayer (or a person described in section 1059(c)(3)(C) with

respect to such shares) included in income a dividend recapture amount

(or amounts) with respect to such shares 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 recognized by a taxpayer on the

disposition of stock if the sum of all dividend recapture amounts

(other than dividend recapture amounts eligible for

[[Page 1512]]

the exception described in paragraph (b)(1)(iii) of this section

(passive limitation dividends)) included in income by the taxpayer (or

a person described in section 1059(c)(3)(C)) with respect to such stock

during the recapture period is less than 10 percent of the recognized

loss.

(iii) Exception for passive limitation dividends. Paragraph

(b)(1)(i) of this section shall not apply to the extent of a dividend

recapture amount that is treated as income in the separate category for

passive income described in section 904(d)(2)(A) (without regard to

section 904(d)(2)(A)(iii)(III)). The exception provided for in this

paragraph (b)(1)(iii) shall not apply to any dividend recapture amount

that is treated as income in the separate category for financial

services income described in section 904(d)(2)(C).

(iv) Examples. The application of this paragraph (b)(1) may be

illustrated by the following examples:

Example 1. (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 May 5, 1998, 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 the look-through rules of section 904(d)(3) the dividend

is general limitation income described in section 904(d)(1)(I).

(ii) On February 6, 2000, P sells its shares of N and recognizes

a $110 loss. In 2000, 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);

(B) $1,000 of foreign source capital gain from the sale of stock

in a foreign affiliate that is sourced under section 865(f) and is

passive income described in section 904(d)(1)(A); and

(C) $1,000 of U.S. source income.

(iii) The $100 dividend paid in 1998 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) P's remaining $10 loss on the disposition of the N stock is

allocated to U.S. source income under paragraph (a)(1) of this

section.

(v) After allocation of the stock loss, P's foreign source

taxable income in 2000 consists of $900 of foreign source general

limitation income and $1,000 of foreign source passive income.

Example 2. (i) P, a domestic corporation, owns all of the stock

of N1, which owns all of the stock of N2, which owns all of the

stock of N3. N1, N2, and N3 are controlled foreign corporations. All

of the corporations use the calendar year as their taxable year. On

February 5, 1997, N3 distributes a dividend to N2. The dividend is

foreign personal holding company income of N2 under section

954(c)(1)(A) that results in an inclusion of $100 in P's income

under section 951(a)(1)(A)(i) as of December 31, 1997. Under section

904(d)(3)(B) the inclusion is general limitation income described in

section 904(d)(1)(I). The income inclusion to P results in a

corresponding increase in P's basis in the stock of N1 under section

961(a).

(ii) On March 5, 1999, P sells its shares of N1 and recognizes a

$110 loss. The $100 1997 subpart F inclusion is a dividend recapture

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

preceding the disposition of the N1 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 recapture

amount was assigned (general limitation income). The remaining $10

loss is allocated to U.S. source income under paragraph (a)(1) of

this section.

Example 3. (i) P, a domestic corporation, owns all of the stock

of N1, which owns all of the stock of N2. N1 and N2 are controlled

foreign corporations. All the corporations use the calendar year as

their taxable year and the U.S. dollar as their functional currency.

On May 5, 1998, N2 pays a dividend of $100 to N1 out of general

limitation earnings and profits.

(ii) On February 5, 2000, N1 sells its N2 stock to an unrelated

purchaser. The sale results in a loss to N1 of $110 for U.S. tax

purposes. In 2000, N1 has the following current earnings and

profits, excluding the loss on the sale of N2:

(A) $1,000 of non-subpart F foreign source general limitation

earnings and profits described in section 904(d)(1)(I);

(B) $1,000 of foreign source gain from the sale of stock that is

taken into account in determining foreign personal holding company

income under section 954(c)(1)(B)(i) and which is passive limitation

earnings and profits described in section 904(d)(1)(A);

(C) $1,000 of foreign source interest income received from an

unrelated person that is foreign personal holding company income

under section 954(c)(1)(A) and which is passive limitation earnings

and profits described in section 904(d)(1)(A).

(iii) The $100 dividend paid in 1998 is a dividend recapture

amount that was included in N1's income within the recapture period

preceding the disposition of the N2 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 earnings and profits).

(iv) N1's remaining $10 loss on the disposition of the N2 stock

is allocated to foreign source passive limitation earnings and

profits under paragraph (a)(1) of this section.

(v) After allocation of the stock loss, N1's current earnings

and profits for 1998 consist of $900 of foreign source general

limitation earnings and profits and $1,990 of foreign source passive

limitation earnings and profits.

(vi) After allocation of the stock loss, N1's subpart F income

for 2000 consists of $1,000 of foreign source interest income that

is foreign personal holding company income under section

954(c)(1)(A) and $890 of foreign source net gain that is foreign

personal holding company income under section 954(c)(1)(B)(i). P

includes $1,890 in income under section 951(a)(1)(A)(i) as passive

income under sections 904(d)(1)(A) and 904(d)(3)(B).

Example 4. P, a foreign corporation, has two wholly-owned

subsidiaries, S, a domestic corporation, and B, a foreign

corporation. On January 1, 2000, S purchases a one-percent interest

in N, a foreign corporation, for $100. On January 2, 2000, N

distributes a $20 dividend to S. The $20 dividend is foreign source

financial services income. On January 3, 2000, S sells its N stock

to B for $80 and recognizes a $20 loss that is deferred under

section 267(f). On June 10, 2008, B sells its N stock to an

unrelated person for $55. Under section 267(f) and Sec. 1.267(f)-

1(c)(1), S's $20 loss is deferred until 2008. Under this paragraph

(b)(1), the $20 loss is allocated to reduce foreign source financial

services income in 2008 because the loss was recognized (albeit

deferred) within the 24-month recapture period following the receipt

of the dividend. See Secs. 1.267(f)-1(a)(2)(i)(B) and 1.267(f)-

1(c)(2).

Example 5. The facts are the same as in Example 4, except P, S,

and B are domestic corporations and members of the P consolidated

group. Under the matching rule of Sec. 1.1502-13(c)(1), the separate

entity attributes of S's intercompany items and B's corresponding

items are redetermined to the extent necessary to produce the same

effect on consolidated taxable income as if S and B were divisions

of a single corporation and the intercompany transaction was a

transaction between divisions. If S and B were divisions of a single

corporation, the transfer of N stock on January 3, 2000 would be

ignored for tax purposes, and the corporation would be treated as

selling that stock only in 2008. Thus, the corporation's entire $45

loss would have been allocated against U.S. source income under

paragraph (a)(1) of this section because a dividend recapture amount

was not received during the corporation's recapture period.

Accordingly, S's $20 loss and B's $25 loss are allocated to reduce

U.S. source income.

(2) Exception for inventory. This section does not apply to loss

[[Page 1513]]

recognized with respect to stock described in section 1221(1).

(3) Exception for stock in an S corporation. This section does not

apply to loss recognized with respect to stock in an S corporation (as

defined in section 1361).

(4) Anti-abuse rules--(i) Transactions involving built-in losses.

If one of the principal purposes of a transaction is to change the

allocation of a built-in loss with respect to stock by transferring the

stock to another person, qualified business unit (within the meaning of

section 989(a)), office or other fixed place of business, or branch

that subsequently recognizes the loss, the loss shall be allocated by

the transferee as if it were recognized with respect to the stock by

the transferor immediately prior to the transaction. If one of the

principal purposes of a change of residence is to change the allocation

of a built-in loss with respect to stock, the loss shall be allocated

as if the change of residence had not occurred. If one of the principal

purposes of a transaction is to change the allocation of a built-in

loss with respect to stock (or other personal property) by converting

the original property into other property and subsequently recognizing

loss with respect to such other property, the loss shall be allocated

as if it were recognized with respect to the original property

immediately prior to the transaction. Transactions subject to this

paragraph shall include, without limitation, reorganizations within the

meaning of section 368(a), liquidations under section 332, transfers to

a corporation under section 351, transfers to a partnership under

section 721, transfers to a trust, distributions by a partnership,

distributions by a trust, or transfers to or from a qualified business

unit, office or other fixed place of business. A person may have a

principal purpose of affecting loss allocation even though this purpose

is outweighed by other purposes (taken together or separately).

(ii) Offsetting positions. If a taxpayer recognizes loss with

respect to stock and the taxpayer (or any person described in section

267(b) (after application of section 267(c)), 267(e), 318 or 482 with

respect to the taxpayer) holds (or held) offsetting positions with

respect to such stock with a principal purpose of recognizing foreign

source income and United States source loss, the loss will be allocated

and apportioned against such foreign source income. For purposes of

this paragraph (b)(4)(ii), positions are offsetting if the risk of loss

of holding one or more positions is substantially diminished by holding

one or more other positions.

(iii) Matching rule. [Reserved] For further guidance, see

Sec. 1.865-2T(b)(4)(iii).

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

illustrated by the following examples. No inference is intended

regarding the application of any other Internal Revenue Code section or

judicial doctrine that may apply to disallow or defer the recognition

of loss. The examples are as follows:

Example 1. (i) Facts. On January 1, 2000, P, a domestic

corporation, owns all of the stock of N1, a controlled foreign

corporation, which owns all of the stock of N2, a controlled foreign

corporation. N1's basis in the stock of N2 exceeds its fair market

value, and any loss recognized by N1 on the sale of N2 would be

allocated under paragraph (a)(1) of this section to reduce foreign

source passive limitation earnings and profits of N1. In

contemplation of the sale of N2 to an unrelated purchaser, P causes

N1 to liquidate with principal purposes of recognizing the loss on

the N2 stock and allocating the loss against U.S. source income. P

sells the N2 stock and P recognizes a loss.

(ii) Loss allocation. Because one of the principal purposes of

the liquidation was to transfer the stock to P in order to change

the allocation of the built-in loss on the N2 stock, under paragraph

(b)(4)(i) of this section the loss is allocated against P's foreign

source passive limitation income.

Example 2. (i) Facts. On January 1, 2000, P, a domestic

corporation, forms N and F, foreign corporations, and contributes

$1,000 to the capital of each. N and F enter into offsetting

positions in financial instruments that produce financial services

income. Holding the N stock substantially diminishes P's risk of

loss with respect to the F stock (and vice versa). P holds N and F

with a principal purpose of recognizing foreign source income and

U.S. source loss. On March 31, 2000, when the financial instrument

held by N is worth $1,200 and the financial instrument held by F is

worth $800, P sells its F stock and recognizes a $200 loss.

(ii) Loss allocation. Because P held an offsetting position with

respect to the F stock with a principal purpose of recognizing

foreign source income and U.S. source loss, the $200 loss is

allocated against foreign source financial services income under

paragraph (b)(4)(ii) of this section.

(c) Loss recognized by partnership. A partner's distributive share

of loss recognized by a partnership shall be allocated and apportioned

in accordance with this section as if the partner had recognized the

loss. If loss 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.

(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 (including a dividend under section

964(e)(1)) included in the earnings of a controlled foreign corporation

(held directly or indirectly by the person recognizing the loss) that

is included in foreign personal holding company income under section

954(c)(1)(A)) and an inclusion described in section 951(a)(1)(B).

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

preceding the date on which a taxpayer recognizes a loss with respect

to 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 and by any period in which the assets of

the corporation are hedged against risk of loss with a principal

purpose of enabling the taxpayer to hold the stock without significant

risk of loss until the recapture period has expired.

(4) 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

loss recognized on or after January 11, 1999. For purposes of this

paragraph (e), loss that is recognized but deferred (for example, under

section 267 or 1092) shall be treated as recognized at the time the

loss is taken into account.

(2) Application to prior periods. A taxpayer may apply the rules of

this section to losses recognized in any taxable year beginning on or

after January 1, 1987, and all subsequent years, provided that--

(i) The taxpayer's tax liability as shown on an original or amended

tax return is consistent with the rules of this section and Sec. 1.865-

2T for each such year for which the statute of limitations does not

preclude the filing of an amended return on June 30, 1999; and

(ii) The taxpayer makes appropriate adjustments to eliminate any

double benefit arising from the application of this section to years

that are not open for assessment.

(3) Examples. The rules of this paragraph (e) may be illustrated by

the following examples:

Example 1. (i) P, a domestic corporation, has a calendar taxable

year. On March 10, 1985, P recognizes a $100 capital loss on the

sale of N, a foreign corporation. Pursuant to sections 1211(a) and

1212(a), the loss is not allowed in 1985 and is carried over to the

1990 taxable year. The loss is allocated

[[Page 1514]]

against foreign source income under Sec. 1.861-8(e)(7). In 1999, P

chooses to apply this section to all losses recognized in its 1987

taxable year and in all subsequent years.

(ii) Allocation of the loss on the sale of N is not affected by

the rules of this section because the loss was recognized in a

taxable year that did not begin after December 31, 1986.

Example 2. (i) P, a domestic corporation, has a calendar taxable

year. On March 10, 1988, P recognizes a $100 capital loss on the

sale of N, a foreign corporation. Pursuant to sections 1211(a) and

1212(a), the loss is not allowed in 1988 and is carried back to the

1985 taxable year. The loss is allocated against foreign source

income under Sec. 1.861-8(e)(7) on P's federal income tax return for

1985 and increases an overall foreign loss account under

Sec. 1.904(f)-1.

(ii) In 1999, P chooses to apply this section to all losses

recognized in its 1987 taxable year and in all subsequent years.

Consequently, the loss on the sale of N is allocated against U.S.

source income under paragraph (a)(1) of this section. Allocation of

the loss against U.S. source income reduces P's overall foreign loss

account and increases P's tax liability in 2 years: 1990, a year

that will not be open for assessment on June 30, 1999, and 1997, a

year that will be open for assessment on June 30, 1999. Pursuant to

paragraph (e)(2)(i) of this section, P must file an amended federal

income tax return that reflects the rules of this section for 1997,

but not for 1990.

Example 3. (i) P, a domestic corporation, has a calendar taxable

year. On March 10, 1989, P recognizes a $100 capital loss on the

sale of N, a foreign corporation. The loss is allocated against

foreign source income under Sec. 1.861-8(e)(7) on P's federal income

tax return for 1989 and results in excess foreign tax credits for

that year. The excess credit is carried back to 1988, pursuant to

section 904(c). In 1999, P chooses to apply this section to all

losses recognized in its 1989 taxable year and in all subsequent

years. On June 30, 1999, P's 1988 taxable year is closed for

assessment, but P's 1989 taxable year is open with respect to claims

for refund.

(ii) Because P chooses to apply this section to its 1989 taxable

year, the loss on the sale of N is allocated against U.S. source

income under paragraph (a)(1) of this section. Allocation of the

loss against U.S. source income would have permitted the foreign tax

credit to be used in 1989, reducing P's tax liability in 1989.

Nevertheless, under paragraph (e)(2)(ii) of this section, because

the credit was carried back to 1988, P may not claim the foreign tax

credit in 1989.

Par. 6. Section 1.865-2T is added immediately after Sec. 1.865-2,

to read as follows:

Sec. 1.865-2T Loss with respect to stock (Temporary).

(a) through (b)(4)(ii) [Reserved] For further guidance, see

Sec. 1.865-2(a) through (b)(4)(ii).

(b)(4)(iii) Matching rule. To the extent a taxpayer (or a person

described in section 1059(c)(3)(C) with respect to the taxpayer)

recognizes foreign source income for tax purposes that results in the

creation of a corresponding loss with respect to stock, the loss shall

be allocated and apportioned against such income. This paragraph

(b)(4)(iii) shall not apply to the extent a loss is related to a

dividend recapture amount and Sec. 1.865-2(b)(1)(ii) (de minimis

exception) or (b)(1)(iii) (passive dividend exception) exempts the loss

from Sec. 1.865-2(b)(1)(i) (dividend recapture rule), unless the stock

is held with a principal purpose of producing foreign source income and

corresponding loss.

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

illustrated by the following examples. No inference is intended

regarding the application of any other Internal Revenue Code section or

judicial doctrine that may apply to disallow or defer the recognition

of loss. The examples are as follows:

Examples 1 and 2. [Reserved] For further guidance, see

Sec. 1.865-2(b)(4)(iv).

Example 3. (i) Facts. On January 1, 1999, P and Q, domestic

corporations, form R, a domestic partnership. The corporations and

partnership use the calendar year as their taxable year. P

contributes $900 to R in exchange for a 90-percent partnership

interest and Q contributes $100 to R in exchange for a 10-percent

partnership interest. R purchases a dance studio in country X for

$1,000. On January 2, 1999, R enters into contracts to provide dance

lessons in Country X for a 5-year period beginning January 1, 2000.

These contracts are prepaid by the dance studio customers on

December 31, 1999, and R recognizes foreign source taxable income of

$500 from the prepayments (R's only income in 1999). P takes into

income its $450 distributive share of partnership taxable income. On

January 1, 2000, P's basis in its partnership interest is $1,350

($900 from its contribution under section 722, increased by its $450

distributive share of partnership income under section 705). On

September 22, 2000, P contributes its R partnership interest to S, a

newly-formed domestic corporation, in exchange for all the stock of

S. Under section 358, P's basis in S is $1,350. On December 1, 2000,

P sells S to an unrelated party for $1050 and recognizes a $300

loss.

(ii) Loss allocation. Because P recognized foreign source income

for tax purposes that resulted in the creation of a corresponding

loss with respect to the S stock, the $300 loss is allocated against

foreign source income under paragraph (b)(4)(iii) of this section.

Example 4. (i) Facts. On January 1, 2000, P, a domestic

corporation that uses the calendar year as its taxable year forms N,

a foreign corporation. P contributes $1,000 to the capital of N in

exchange for 100 shares of common stock. P contributes an additional

$1,000 to the capital of N in exchange for 100 shares of preferred

stock. Each preferred share is entitled to 15-percent dividend but

is redeemable by N on or after January 1, 2010, for $1. Prior to

January 10, 2005, P receives a total of $750 of distributions from N

with respect to its preferred shares, which P treats as foreign

source general limitation dividends. On January 10, 2005, P sells

its 100 preferred shares in N to an unrelated purchaser for $600.

Assume that this arrangement is not recharacterized under Notice 97-

21 (1997-1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income

for tax purposes that resulted in the creation of a corresponding

loss with respect to the N stock, the $400 loss is allocated against

foreign source general limitation income under paragraph (b)(4)(iii)

of this section.

Example 5. (i) Facts. On January 1, 2000, P, a domestic

corporation that uses the calendar year as its taxable year, and F,

a newly-formed controlled foreign corporation wholly-owned by P,

form N, a foreign corporation. P contributes $1,000 to the capital

of N in exchange for 100 shares of common stock and $1,000 to the

capital of F in exchange for 100 shares of common stock. F

contributes LC1,000 to the capital of N in exchange for 100 shares

of preferred stock. Each preferred share is entitled to a 65-percent

LC dividend. At the time of the contributions, $1=LC1. The LC is

expected to depreciate significantly in relation to the U.S. dollar.

Prior to June 10, 2005, P receives a total of $1,900 of

distributions from F, which it treats as foreign source general

limitation dividends. On June 10, 2005, the N preferred stock has a

fair market value of $25 and P sells F for $25 to an unrelated

person. Assume that this arrangement is not recharacterized under

Notice 97-21 (1997-1 C.B. 407).

(ii) Loss allocation. Because P recognized foreign source income

for tax purposes that resulted in the creation of a corresponding

loss with respect to the F stock, the $975 loss is allocated against

foreign source general limitation income under paragraph (b)(4)(iii)

of this section.

Example 6. (i) Facts. On January 1, 1998, P, a domestic

corporation, purchases N, a foreign corporation, for $1000. On March

1, 1998, N sells its operating assets, distributes a $400 general

limitation dividend to P, and invests its remaining $600 in short

term government securities. N earns interest income from the

securities. The income constitutes subpart F income that is included

in P's income under section 951, increasing P's basis in the N stock

under section 961(a). On March 1, 2002, P sells N and recognizes a

$400 loss.

(ii) Loss allocation. The $400 dividend received by P resulted

in a $400 built-in loss in the N stock, which was locked in for P's

four-year holding period. Because P recognized foreign source income

for tax purposes that resulted in the creation of a corresponding

loss with respect to the N stock, under paragraph (b)(4)(iii) of

this section the $400 loss is allocated against foreign source

general limitation income.

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

for loss recognized on or after January 11, 1999. For purposes of

this paragraph (e), loss that is recognized but deferred (for

example, under section 267 or 1092) shall be treated as recognized

at the time the loss is taken into account. This

[[Page 1515]]

section shall cease to be effective January 8, 2002.

(2) Application to prior periods. A taxpayer may apply the rules

of this section to losses recognized in any taxable year beginning

on or after January 1, 1987, and all subsequent years, provided

that--

(i) The taxpayer's tax liability as shown on an original or

amended tax return is consistent with the rules of this section and

Sec. 1.865-2 for each such year for which the statute of limitations

does not preclude the filing of an amended return on June 30, 1999;

and

(ii) The taxpayer makes appropriate adjustments to eliminate any

double benefit arising from the application of this section to years

that are not open for assessment.

Par. 7. Section 1.904-0 is amended by revising the entry for

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

(c)(2)(i)(A), (c)(2)(i)(B), (c)(2)(ii)(A) and (c)(2)(ii)(B) 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) * * *

(i) Effective dates.

(A) In general.

(B) Application to prior periods.

(ii) Grouping rules.

(A) Initial allocation and apportionment of deductions and

taxes.

(B) Reallocation of loss groups.

* * * * *

Par. 8. Section 1.904-4 is amended by:

1. Revising paragraphs (c)(1) and (c)(2),

2. Revising paragraph (c)(3)(iii),

3. Adding paragraph (c)(3)(iv), and

4. Amending paragraph (c)(8) by adding Example 11, Example 12 and

Example 13.

5. The additions and revisions read as follows:

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

certain categories of income.

* * * * *

(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 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 zero or less than zero, any taxes imposed on the passive

income shall be considered related to general limitation income. 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 through

13 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 dates--(A) In

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

taxed income, the grouping rules of paragraphs (c)(3)(i) and (ii),

(c)(4), and (c)(5) of this section apply to taxable years beginning

after December 31, 1987. Except as provided in paragraph (c)(2)(i)(B)

of this section, the rules of paragraph (c)(3)(iii) apply to taxable

years beginning after December 31, 1987, and ending before December 31,

1998, and the rules of paragraph (c)(3)(iv) apply to taxable years

ending on or after December 31, 1998. See Notice 87-6 (1987-1 C.B.417)

for the grouping rules applicable to taxable years beginning after

December 31, 1986 and before January 1, 1988. The fourth sentence of

paragraph (c)(2)(ii)(A) and paragraph (c)(2)(ii)(B) of this section are

effective for taxable years beginning after March 12, 1999.

(B) Application to prior periods. A taxpayer may apply the rules of

paragraph (c)(3)(iv) to any taxable year beginning after December 31,

1991, and all subsequent years, provided that--

(1) The taxpayer's tax liability as shown on an original or amended

tax return is consistent with the rules of this section for each such

year for which the statute of limitations does not preclude the filing

of an amended return on June 30, 1999; and

(2) The taxpayer makes appropriate adjustments to eliminate any

double benefit arising from the application of this section to years

that are not open for assessment.

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

deductions and taxes. 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 and 1.865-1T through

1.865-2T. 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. Foreign taxes are

allocated to groups under the rules of Sec. 1.904-6(a)(iii). If a loss

on a disposition of property gives rise to foreign tax (i.e., 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 gain on the sale would have been

assigned under paragraph (c)(3) or (4) 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).

(3) * * *

(iii) For taxable years ending before December 31, 1998 (except as

provided in paragraph (c)(2)(i)(B) of this section), all passive income

received during the taxable year that is subject to no withholding tax

shall be treated as one item of income.

[[Page 1516]]

(iv) For taxable years ending on or after December 31, 1998, all

passive income received during the taxable year that is subject to no

withholding tax or other foreign tax shall be treated as one item of

income, and all passive income received during the taxable year that is

subject to no withholding tax but is subject to a foreign tax other

than a withholding tax shall be treated as one item of income.

* * * * *

(8) * * *

Example 11. In 2001, P, a U.S. citizen with a tax home in

Country X, earns the following items of gross income: $400 of

foreign source, passive limitation interest income not subject to

foreign withholding tax but subject to Country X income tax of $100,

$200 of foreign source, passive limitation royalty income subject to

a 5 percent foreign withholding tax (foreign tax paid is $10),

$1,300 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 $2,000 of U.S. source capital gain that is

not subject to any foreign tax. P has a $900 deduction allocable to

its passive rental income. P's only other deduction is a $700

capital loss on the sale of stock that is allocated to foreign

source passive limitation income under Sec. 1.865-2(a)(3)(i). The

$700 capital loss is initially allocated to the group of passive

income subject to no withholding tax but subject to foreign tax

other than withholding tax. The $300 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

royalty income is thus reduced by $100 to $100 ($200 - ($300 x

(200/600))) and the rental income is thus reduced by $200 to $200

($400 - ($300 x (400/600))). The $100 royalty income is not high-

taxed and remains passive income because the foreign taxes do not

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

the high-tax kick-out, the $200 of rental income 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(a)(3)(i) and paragraph (c)(2) of this section to the group of

foreign source passive income subject to no withholding tax but

subject to foreign tax other than withholding tax is $1,200. Under

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

$800 must be reapportioned to the $200 of net royalty income subject

to a 5 percent withholding tax and the $400 of net rental income

subject to a 15 percent or greater 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.

Example 13. In 2001, P, a domestic corporation, earns a $100

dividend that is foreign source passive limitation income subject to

a 30-percent withholding tax. A foreign tax credit for the

withholding tax on the dividend is disallowed under section 901(k).

A deduction for the tax is allowed, however, under sections 164 and

901(k)(7). In determining whether P's passive income is high-taxed,

the $100 dividend and the $30 deduction are allocated to the first

group of income described in paragraph (c)(3)(iv) of this section

(passive income subject to no withholding tax or other foreign tax).

* * * * *

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

Approved: December 15, 1998.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 99-149 Filed 1-8-99; 8:45 am]

BILLING CODE 3830-01-U