Application of Section 904 to Income Subject to
Separate Limitations & Computation of
Deemed-Paid Credit under Section 902

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-104683-00] RIN 1545-AX88

TITLE: Application of Section 904 to Income Subject to Separate
Limitations and Computation of Deemed-Paid Credit under Section 902

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document contains proposed Income Tax Regulations
relating to the computation of the section 902 deemed-paid credit,
the section 904(d) foreign tax credit limitation, and to an example
in the section 954 regulations relating to the exclusion of certain
export financing interest from foreign personal holding company
income. Changes to the applicable law were made by the Tax Reform
Act of 1986, the Technical and Miscellaneous Revenue Act of 1988,
and the Taxpayer Relief Act of 1997. These regulations would provide
guidance needed to comply with these changes and would affect
individuals and corporations reporting subpart F income and claiming
foreign tax credits. This document also provides a notice of a
public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by April 2,
2001. Outlines of topics to be discussed at the public hearing
scheduled for April 26, 2001, at 10 a.m. must be received by April
5, 2001.

ADDRESSES: Send submissions to: Regulations Unit CC (REG-104683-
00), room 5226, Internal Revenue Service, POB 7604, Ben Franklin
Station, Washington, DC 20044. In the alternative, submissions may
be hand-delivered between the hours of 8 a.m. and 5 p.m. to
Regulations Unit CC (REG-104683-00), Courier's Desk, Internal
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC or
sent electronically, via the IRS Internet site at:
http://www.irs.gov/tax_regs/regslist.html The public hearing will be
held in the IRS Auditorium, 7 floor, Internal Revenue Building, 1111
Constitution Ave., NW., Washington, DC. FOR FURTHER INFORMATION
CONTACT: Concerning the proposed regulations, Bethany A. Ingwalson
(202) 622-3850; concerning submissions of comments, the hearing,
and/or to be placed on the building access list to attend the
hearing, Sonya Cruse, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Treasury and the IRS provided guidance regarding section 904(d)
(enacted in 1986) in TD 8214 (1988-2 C.B. 220), TD 8412 (1992-1 C.B.
271), TD 8556 (1994-2 C.B. 165), TD 8805 (1999-1 C.B. 371), and in
final regulations (TD 8916) published elsewhere in this issue of the
Federal Register. Final regulations regarding the computation of the
deemed paid credit under section 902 (also enacted in 1986) were
published as TD 8708 (1997-1 C.B. 137). The proposed regulations
provide further guidance with respect to the application of sections
902 and 904(d). The proposed regulations also provide guidance
regarding the application of section 904(j). The Taxpayer Relief Act
of 1997 (Public Law 105-34, 111 Stat. 788) (TRA 1997) added section
904(j) to the Internal Revenue Code (Code). Section 904(j) exempts
individuals from the foreign tax credit limitation of section 904(a)
in certain limited circumstances, and provides that no foreign taxes
may be carried to or from a year for which a taxpayer has elected to
apply section 904(j). TRA 1997 also added to the Code section 904(b)
(2)(C), which provides that the Secretary may issue regulations to
modify the application of section 904(b)(2) and (3) to properly
reflect capital gain rate differentials under sections 1(h) and
1201(a) and the computation of net capital gain. The proposed
regulations provide guidance for the application of section 904(b),
including the application of that section in years in which section
1(h) provides for more than one capital gains rate.

Explanation of Provisions

I. Effect of Loss of Domestic Corporate Shareholder on Pooling of
Earnings and Taxes in Computing Deemed Paid Credits: §1.902-1
Under section 902(c)(3), the multi-year pools of post-1986
undistributed earnings and post-1986 foreign income taxes of a
foreign corporation are determined by taking into account only
periods beginning on and after the first day of the foreign
corporation's first taxable year in which a domestic corporation
owns 10 percent or more of its. Voting stock or, in the case of a
lower-tier foreign corporation in a qualified group described in
section 902(b)(2), owns indirectly at least 5 percent of its voting
stock.

Under section 902(c)(6)(B), dividends are treated as paid first out
of the post-1986 pooled earnings. Pre-1987 accumulated profits
(defined in section 902(c)(6)(A) and §1.902-1(a)(10) to include
both earnings accumulated in pre-1987 years and earnings accumulated
in post-1986 years preceding the year in which the section 902
ownership requirements are met) are treated as distributed only
after the pools are exhausted, and then out of annual layers of
earnings and taxes on a last-in, first-out basis. Distributions out
of pre-1987 accumulated profits are governed by the section 902
rules in effect under pre-1987 law. Section 902(c)(6)(A).

The rule limiting the multi-year pools of earnings and taxes to
post-1986 taxable years beginning with the year in which a foreign
corporation first has a qualifying shareholder alleviates the
administrative difficulties such shareholders face in reconstructing
accumulated earnings and taxes accounts in connection with their
acquisition of stock in a pre-existing foreign corporation. While
section 902 provides that pooling of earnings and taxes begins only
when the foreign corporation first has a qualifying shareholder
entitled to compute a credit for deemed-paid taxes, the statute does
not provide for any change in a foreign corporation's post-1986
undistributed earnings and taxes pools following a stock disposition
or other transaction. After which the foreign corporation no longer
has a qualifying shareholder. Section 1.902-1(a)(13)(i) currently
provides that, once a foreign corporation begins to maintain pools
of earnings and taxes, the pools include periods during which the
stock ownership requirements of section 902 are not met. Should such
a corporation later again have a qualifying shareholder, such a
shareholder would have to reconstruct the post-1986 undistributed
earnings and taxes pools to include undistributed earnings and taxes
for periods during which there was no qualifying shareholder, in
order to compute deemed-paid credits with respect to distributions
of earnings and profits accumulated during later periods in which
the ownership requirements were met. Treasury and the IRS believe
that the policy concerns underlying the rule deferring the start of
pooling until the corporation has a qualifying shareholder also
apply to the situation where a foreign corporation once had, but no
longer has, such a shareholder. Therefore, Treasury and the IRS
believe it is appropriate to stop the multi-year pooling of earnings
and taxes at the foreign corporation level when a foreign
corporation no longer has a qualifying shareholder.

The proposed regulations would amend §1.902-1(a)(10) to provide
that pre-1987 accumulated profits subject to the annual layering
rules of pre-1987 law include not only the actual pre-1987 earnings
and profits and pre-pooling earnings and profits described in the
current final regulation, but also formerly pooled earnings and
profits of a less-than-10%-U.S.-owned foreign corporation
attributable to post-1986 years during which the section 902 stock
ownership requirements were met, and post-pooling earnings and
profits accumulated during subsequent taxable years during which the
foreign corporation did not have a qualifying shareholder. The
formerly pooled earnings would be considered pre-1987 accumulated
profits of the last taxable year of the foreign corporation as of
the end of which the ownership requirements were met. Distributions
out of formerly pooled earnings would be subject to the same
pre-1987 law rules as distributions of other pre-1987 accumulated
profits, except that the formerly pooled foreign income taxes
related to the formerly pooled earnings would continue to be
maintained in U.S. dollars. The proposed regulations would also
amend §1.902-1(a)(13) to provide that pooling of earnings and
taxes would resume in the first subsequent taxable year as of the
end of which the foreign corporation again has a qualifying
shareholder. Formerly pooled earnings would continue to be treated
as pre-1987 accumulated profits even if the foreign corporation
later began to maintain pools of earnings and taxes again.

Treasury and the IRS believe the proposed rules would be easier for
taxpayers to apply than the current regulations, which require
pooling to continue through periods when the foreign corporation has
no shareholders entitled to compute a deemed-paid credit. These
proposed amendments complement the proposed amendments to the
section 904 regulations, described below, concerning the effect of
intervening noncontrolled status on the look-through pools of
post-1986 undistributed earnings and taxes maintained by a
controlled foreign corporation. The proposed regulations also would
be consistent with the approach taken in recently proposed
amendments to the regulations under section 367(b) relating to the
carryover of earnings and taxes accounts in reorganizations
involving foreign corporations (REG-116050-99, published in the
Federal Register (65 FR 69138) on November 15, 2000).

II. Separate Categories: §1.904-4

A. The active rents and royalties exception Section 1.904-4(b)(2)
sets forth the active rents and royalties exception to the separate
limitation for passive income. This exception currently applies only
to payments from unrelated payors. Several commentators have
requested that Treasury and the IRS amend the regulations to provide
that royalties received from a member of the recipient's affiliated
group (including foreign affiliates) may qualify for the exception
if the royalties are derived in the conduct of an active trade or
business and the pay or use the underlying property in an active
trade or business. As explained below, Treasury and the IRS propose
to adopt a modified version of the suggested change.

Section 904(d)(2)(A)(i) defines passive income as foreign personal
holding company income, as defined in section 954(c). The section
904(d) active rents and royalties exception derives from section
954(c)(2)(A), which excludes from foreign personal holding company
income, and thus from passive income, any rents or royalties derived
in the active conduct of a trade or business and received from an
unrelated person. The current final regulations at §1.904-4(b)
(2) (ii) modify this exception to take into account activities of
members of the recipient's affiliated group in determining whether
the recipient meets the active trade or business prong of the test
for section 904(d) purposes. Treasury and the IRS have consistently
declined to extend look-through treatment to payments from foreign
non-controlled mayors. See TD 8412 (1992-1 C.B. 271, 273). Treasury
and the IRS continue to believe that the nature of the income earned
by a foreign non-controlled pair from the use of the licensed
property should not determine whether a rent or royalty payment
constitutes income from the active conduct of a trade or business of
the recipient.

However, Treasury and the IRS have decided that it is appropriate to
eliminate the distinction between royalties received from related
and unrelated mayors in applying the active rents and royalties
exception for purposes of section 904(d). Therefore, these
regulations propose to amend prospectively §1.904-4(b)(2) to
provide that for purposes of section 904 (but not for purposes of
section 954), the active rents and royalties exception will not
require that the rents and royalties be received from an unrelated
mayor. This change is proposed to apply to rents and royalties paid
or accrued more than 60 days after the date that these regulations
are published in final form.

B. Restriction of affiliated group special rule for active rents and
royalties exception

As noted, §1.904-4(b)(2)(ii) provides that, for purposes of the
active rents and royalties exception from passive income under
section 904, rents or royalties will be treated as derived in the
active conduct of a trade or business by a United States person or
controlled foreign corporation if any member of the recipient's
affiliated group (defined to include foreign corporations) meets the
requirements of section 954(c)(2)(A) with respect to the licensed
property. The proposed regulations would amend the definition of
affiliated group for purposes of §1.904- 4(b)(2)(ii) to include
only U.S. corporations and controlled foreign corporations in which
United States members of the affiliated group own, directly or
indirectly, at least 80 percent of the stock (by vote and value).

This requirement is consistent with the affiliated group rules of
§1.904-4(e)(3)(ii), which consider the activities of other
members of the affiliated group for purposes of determining whether
an entity is a financial services entity. The proposed regulations
revise the affiliated group rule in the active rents and royalties
exception due to administrative concerns regarding the difficulty of
determining whether related, but non-controlled, foreign
corporations engage in the active conduct of a trade or business
with respect to licensed property.

C. Effect of intervening no controlled or less-than-10%-U.S.-owned
status on distributions from a controlled foreign corporation or
other look-through corporation Under section 904(d)(2)(E)(i) and
§1.904-4(g)(3)(i), dividends from a controlled foreign
corporation (CFC) are treated as dividends from a no controlled
section 902 corporation to the extent that the distribution is out
of earnings and profits accumulated during periods in which the
distributing corporation was not a CFC. Proposed §1.904-4(g)(3)
(i)(C)(1) provides rules to address the effect of intervening no
controlled status on the eligibility for look-through treatment of
distributions of pre-2003 accumulations of pooled earnings and
profits from a CFC. Consistent with the proposed amendments to
§1.902-1(a) previously discussed, proposed §1.904-4(g)(3)
(i)(C)(2) provides rules to address the effect of intervening less-
than-10%-U.S.-owned status on the post-1986 undistributed earnings
and taxes pools and pre-1987 accumulated profits of a foreign
corporation and the application of the look-through rules to
distributions from such a foreign corporation. The proposed
regulations anticipate to some extent, but do not provide
comprehensive guidance, regarding the changes to the statutory look-
through rules for 10/50 companies that become effective for
post-2002 taxable years. Additional conforming changes to the
provisions of §§1.904-4 and 1.904-5 will be required to
reflect the changes in terminology reflected in the proposed
regulations that are necessitated by these statutory changes.

The proposed regulations provide that, when a CFC becomes a non-
look-through 10/50 corporation (because it ceases to be controlled
by United States shareholders, but has at least one qualifying
shareholder, in a taxable year beginning before January 1, 2003),
post-1986 undistributed earnings that were accumulated through the
end of the taxable year preceding the taxable year in which the
decontrolling event occurred and that were previously eligible for
look-through treatment will be consolidated in, and constitute the
opening balance of, a single non-look-through pool at the foreign
corporation level. The regulations provide that distributions of the
prior look-through earnings will continue be treated as dividends
from a non-look-through 10/50 corporation, and will not be eligible
for look-through treatment, even if the foreign corporation later
becomes a CFC again or becomes eligible for look-through treatment
with respect to earnings accumulated in post-2002 taxable years.

Distributions of post-1986 undistributed earnings in the non-look-
through pool will be treated as dividends from a non-look- through
10/50 corporation (10/50 dividend income) when distributed to a
qualifying shareholder, or as passive income when distributed to any
other shareholder. Pre-1987 accumulated profits distributed after a
decontrolling event will similarly be treated as 10/50 dividend
income or as passive income when distributed, depending on the
status of, and the amount of stock owned by, the shareholder at the
time of distribution. Because the separate limitation treatment of
distributions during the taxable year is computed with reference to
year-end pools of post-1986 undistributed earnings under section
902, the proposed regulations provide that distributions to a
qualifying shareholder that are made in the taxable year in which a
decontrolling event occurs are treated as 10/50 dividend income to
qualifying shareholders, or passive income to other shareholders,
whether made before or after the decontrolling event. Similarly,
under §1.904-4(g)(3)(iii), earnings and profits accumulated in
the year in which a foreign corporation becomes a CFC are treated as
accumulated after the corporation became a CFC. Such earnings will
be eligible for look-through treatment when distributed to a United
States shareholder during the taxable year in which the distributing
corporation becomes a CFC or during any subsequent taxable year
until the distributing corporation ceases to be a CFC or other look-
through corporation.

As noted, the proposed regulations do not permit look-through
treatment for earnings and profits accumulated in pre-2003 taxable
years while the distributing corporation was a CFC if the earnings
are distributed after an intervening period ending before 2003
during which the corporation was not a CFC, even if the corporation
is a CFC or other look-through corporation at the time of
distribution. Earnings and profits previously eligible for look-
through treatment will be placed in a single non-look-through pool
with new earnings accumulated in taxable years beginning before
January 1, 2003, while the corporation is not a CFC. The proposed
rule would eliminate the need to determine whether distributions
made while the corporation is a non-look-through 10/50 corporation
(or, after 2002, a 10/50 look-through corporation) are made out of
look- through earnings accumulated in pre-2003 years prior to the
decontrolling event or pre-2003 non-look-through earnings
accumulated afterwards. Treasury and the IRS believe this rule would
be simpler to apply with respect to pre-2003 periods during which
the records necessary to establish look-through treatment are less
likely to be maintained by a foreign corporation that is not
controlled by United States shareholders.

This intervening no controlled status situation differs from the
special situation described in §1.904-4(g)(3)(ii), which allows
look-through treatment on distributions to a more-than-90- percent
United States shareholder after August 6, 1997, of earnings and
profits that were accumulated while the distributing corporation was
a CFC. In the latter case, pre-acquisition post-1986 undistributed
earnings of a CFC with a more-than-90-percent United States
shareholder were required to be maintained in a non-look-through
pool prior to the effective date of the amendment to section 904(d)
(2)(E)(i) by TRA 1997. During the entire period the non-look-through
pool was required to be maintained, the corporation was a CFC that
was more-than-90- percent-owned by a single domestic corporation.
Accordingly, the rules governing the effect of the 1997 repeal of
the rule limiting look-through treatment to earnings accumulated
while the more-than-90-percent United States shareholder was a
United States shareholder of the distributing corporation do not
provide an appropriate model for resolving the ongoing issue
addressed by the proposed regulations.

Section 904(d)(4) as amended by section 1105(b) of TRA 1997
effective for taxable years beginning after December 31, 2002, will
generally extend the look-through rules to distributions of earnings
accumulated by a 10/50 company in post-2002 taxable years.
Accordingly, non-look-through 10/50 corporations will not exist
after 2002, although 10/50 look-through corporations will continue
to maintain non-look-through pools of earnings and taxes accumulated
in pre-2003 taxable years. Therefore, if the regulations are
finalized prospectively, the effect of proposed §1.904-4(g)(3)
(i)(C) (1) generally would be limited to situations involving a CFC
that is decontrolled after the regulations become final but before
January 1, 2003, and to earnings that are accumulated in taxable
years beginning before January 1, 2003, and that are not treated as
distributed to the CFC's U.S. shareholders under section 1248 in
connection with the decontrolling event. Comments are requested as
to whether the simplification objectives of the regulation could
best be met by extending the effective date to cover decontrolling
events that occurred in prior periods.

Consistent with the proposed amendments to §1.902-1(a) and with
the approach taken with respect to the pre-2003 decontrol situation,
§1.904-4(g)(3)(i)(C)(2) of the proposed regulations provides
that distributions out of formerly pooled earnings that are
converted to an annual layer of pre-1987 accumulated profits when a
foreign corporation no longer has a qualifying shareholder will be
treated as distributions from a non-look-through 10/50 corporation,
even if the foreign corporation later becomes a look-through
corporation again.

The proposed regulations reserve on the treatment of distributions
from a 10/50 look-through corporation, including the treatment of
distributions out of earnings and profits accumulated in periods
before the taxpayer acquired its stock. Comments are requested on
whether additional guidance is needed to clarify the rules governing
distributions from CFCs, and on how the regulations should be
modified to reflect the rules of section 1105(b) of TRA 1997,
extending look-through treatment to distributions from 10/50
corporations out of earnings and profits accumulated in post-2002
taxable years.

D. Additional separate categories

Treasury and the IRS propose to add a new paragraph (m) to
§1.904-4, to provide that if section 904(a), (b), and (c) are
applied separately to any category of income under the Code (for
example, under section 901(j), 865(h), or 904(g)(10)), that category
of income (additional category) will be treated for purposes of the
Code and regulations (including, for example, section 904(f)) as if
it were a separate category listed in sections 904(d)(1) and 904(d)
(3)(F)(i). This amendment is intended to clarify the treatment of
such additional separate categories without the need for specific
cross-references to such categories each time a provision refers to
the separate categories listed in section 904(d). Sections
1.904-4(a) and 1.904-5(a)(1) are amended to include a reference to
such additional separate categories.

III. Allocation and Apportionment of Taxes to Separate Categories:
§1.904-6

Treasury and the IRS propose to amend §1.904-6(a)(1) to clarify
the rules for determining the amount of income (in each U.S.
separate category) taxed by a foreign country, in situations in
which foreign law does not provide expense allocation rules. In such
cases, for purposes of determining the amount of income taxed by the
foreign country in order to allocate and apportion foreign taxes to
separate categories, a taxpayer must allocate the expenses that are
deductible under foreign law using the same methods that the
taxpayer uses to allocate expenses that are deductible under U.S.
law for purposes of determining the amount of taxable income.

IV. Capital Gain and Loss Adjustments: §1.904(b)-1

A. Section 904(b) capital gain and loss adjustments

The proposed regulations provide guidance regarding the rule of
section 904(b)(2)(A) that foreign source capital gain may not exceed
the lesser of capital gain net income from sources outside the
United States or worldwide capital gain net income. A similar rule
applies with respect to net capital gain. The regulations also
provide guidance regarding the rule of section 904(b)(2)(B) that
capital gains from foreign and U.S. sources, and capital losses from
foreign sources, must be adjusted based on capital gain rate
differential amounts. The proposed regulations exercise the
regulatory authority granted under section 904(b)(2)(C) (authorizing
regulations to modify the application of section 904(b)(2) and (3)
to properly reflect capital gain rate differentials and the
computation of net capital gain) and section 904(d)(6) (authorizing
such regulations as may be necessary and appropriate for the
purposes of section 904(d)).

The proposed regulations first provide guidance concerning the
adjustments required when foreign source capital gains exceed the
lesser of capital gain net income (or net capital gain) from sources
outside the United States or capital gain net income (or net capital
gain) from all sources. Section 904(b)(2)(A) and section 904(b)(2)
(B)(i) provide that, for purposes of section 904, foreign source
capital gains that are included in foreign source taxable income may
not exceed the lesser of capital gain net income from sources
outside the United States or capital gain net income from all
sources. Section 904(b)(2)(A), (3)(A). Similar rules apply for
purposes of determining foreign source net capital gain. Section
904(b)(3)(B). After the 1986 enactment of separate limitation
categories in section 904(d), the issue arises as to the extent to
which foreign source capital gains should be adjusted if the
taxpayer has foreign source capital gains and losses in more than
one separate category.

The proposed regulations provide that foreign source capital gains
included in foreign source taxable income in any separate category
are reduced by reason of section 904(b)(2)(A) and section 904(b)(2)
(B)(i) only by foreign source capital losses in the same separate
category and by a ratable portion of the excess of capital gain net
income from foreign sources (in the aggregate, considering all of
the taxpayer's separate categories) over capital gain net income
from all sources (considering capital gains and losses from sources
within and outside the United States, from all of the taxpayer's
separate categories). Thus, the proposed rule would reduce capital
gain net income from foreign sources in any separate category only
if the taxpayer has a net U.S.-source capital loss, and not in
instances where foreign-source capital gains in one separate
category are offset only by foreign-source capital losses from
another separate category. This rule implements Congress's intent
that section 904(b)(2)(A) and section 904(b)(2)(B)(i) should prevent
foreign-source capital gains from inappropriately increasing the
numerator of the foreign tax credit limitation fraction under
section 904(a) if those capital gains were offset by U.S.-source
capital losses, while avoiding the potential for double counting of
foreign-source losses that might result if foreign-source gains in
one separate category were reduced by reason of foreign- source
losses that reduce ordinary income in another separate category.

The regulations further provide that if the taxpayer's capital gain
net income from sources outside the United States exceeds the
taxpayer's capital gain net income from all sources (i.e., where
there is a net U.S. capital loss), a pro rata portion of such excess
reduces the capital gain net income from sources outside the United
States in each of the taxpayer's separate limitation categories and,
within each separate category, in each rate group. The pro rata
portion is determined based on the relative amounts of net capital
gain from sources outside the United States in each separate
category or rate group.

In addition, the proposed regulations provide guidance on adjusting
capital gains and foreign capital losses to reflect capital gain
rate differentials. Section 904(a) limits the foreign tax credit to
the lesser of 1) foreign tax paid or accrued; or 2) pre-credit U.S.
tax multiplied by a fraction equal to foreign source taxable income
over worldwide taxable income (the limitation fraction). Multiplying
the pre-credit U.S. tax by the limitation fraction is meant to
determine the portion of U.S. taxes that are attributable to foreign
source income. Section 904(b)(2)(B) adjusts capital gains in the
numerator and denominator, and foreign source capital losses in the
numerator, of the limitation fraction if capital gains are taxed at
lower rates than ordinary income, as is often the case under current
law for individuals. Unless capital gains and foreign capital losses
are adjusted to account for this difference, the limitation fraction
will not accurately reflect the portion of the total pre-credit U.S.
tax that is properly attributable to foreign source income.

The rate differential adjustments to capital gains and foreign
source capital losses, under section 904(b) and the proposed
regulations, apply only if the specific taxpayer has net capital
gain that is subject to reduced tax rates for the taxable year.
Treasury and the IRS request comments with respect to applying on an
elective basis adjustments based on rate differentials for taxable
years in which the Code applies reduced tax rates to capital gains
generally, but the specific taxpayer has capital losses that equal
or exceed capital gains. Any such elective rule would need to
include ordering rules for determining the source, the separate
category, and the rate group of the capital losses that are taken
into account for the current taxable year, including those capital
losses that are currently deductible to the extent of $3,000 under
section 1211(b) against ordinary income, and those losses that are
subject to the capital loss carryover rules.

As noted, section 904(b)(2)(C) grants regulatory authority to modify
the application of section 904(b)(2) and (3) "to the extent
necessary to properly reflect any capital gain rate differential
under section 1(h) or 1201(a) and the computation of net capital
gain." The proposed regulations exercise this authority and adjust
the section 904(b)(2)(B) calculations to reflect the fact that, for
taxable years ending after May 6, 1997, section 1(h) contains
multiple capital gains rates. The proposed regulations thus require
that capital gain net income, from sources outside the United States
and from all sources, must be adjusted pursuant to section 904(b)(2)
(B)(i) and (ii) by the rate differential portion of each rate group
of the taxpayer's net capital gain from sources outside the United
States and from all sources, respectively.

The proposed regulations also provide guidance on adjusting foreign
source capital losses under section 904(b)(2)(B)(iii). The
regulations clarify that such capital losses (after netting against
foreign source capital gains in the same rate group, as defined in
the regulations) should be reduced based on the tax rate applicable
under section 1(h) to the net capital gains that are offset by such
net capital losses in the determination of the taxpayer's taxable
income. Although section 904(b)(2)(B)(iii) provides for such
adjustment in instances when net foreign losses have offset U.S.
source capital gains, the existence of multiple separate categories
after 1986 may result in foreign source capital gains and losses in
separate categories offsetting one another. Therefore, the
regulations require adjustment of foreign capital losses that offset
foreign source capital gains associated with different capital gains
rates, in addition to foreign capital losses that offset U.S. source
capital gains. In determining which capital gains are offset by
capital losses from sources outside the United States in different
rate groups, the proposed regulations provide that net capital
losses from sources within the United States will not be taken into
account, in order to simplify this determination. Treasury and the
IRS request comments regarding whether the regulations should take
net capital losses from sources within the United States into
account for such purposes, and, if so, what type of ordering rules
should be applied.

The IRS is considering providing a simplified worksheet for
performing the section 904(b)(2)(B) adjustments in the Form 1116
instructions, for taxpayers whose capital gains are subject only to
10 or 20 percent tax rates under section 1(h) (similar to the
simplified worksheet provided in the 1999 Form 1040 instructions as
an alternative to Schedule D for taxpayers whose capital gains are
subject only to 10 and 20 percent tax rates under section 1(h)).
Treasury and the IRS request comments on this approach. B.
Appropriate tax rates for AMT foreign tax credit calculation The
proposed regulations provide that the alternative minimum tax (AMT)
rates, rather than the regular tax rates, apply for purposes of
carrying out the section 904(b) capital gains rates adjustments for
the AMT foreign tax credit. Section 904(b) generally adjusts capital
gains and foreign source capital losses based on the difference
between the maximum U.S. tax rate and the tax applicable to capital
gains under section 1(h). This adjustment is necessary to calculate
more accurately the amount of U.S. tax that is attributable to
foreign source income (as determined by application of the section
904(a) fraction). Section 59(a)(1)(B) provides that the AMT foreign
tax credit must be determined as if "section 904 were applied on the
basis of alternative minimum taxable income," and therefore requires
the application of section 904(b) in determining the AMT foreign tax
credit. In order to reflect more accurately the amount of pre-credit
tentative minimum tax attributable to foreign source AMT income,
these regulations provide that, for purposes of applying section
904(b) in determining the AMT foreign tax credit, the maximum AMT
rates should be used rather than the rates specified in section 1.

In addition, the regulations clarify that section 904(b)(2)(B)(ii)
(relating to capital gains from all sources), as well as section
904(b)(2)(B)(i) and (iii) (relating to foreign source capital gains
and losses, respectively) apply (in modified form, as provided in
section 59) to the determination of the AMT foreign tax credit. The
regulations also clarify that section 904(b) applies to taxpayers
electing to apply the simplified foreign tax credit limitation rules
under section 59(a)(4).

V. Coordination of Section 904(j) with Carryforward and Carryback
Rules: §1.904(j)

Section 904(j) allows a taxpayer to elect not to apply section
904(a) (the foreign tax credit limitation fraction) if the
taxpayer's creditable foreign taxes paid or accrued for the year are
$300 or less ($600 or less for joint filers), the taxpayer's foreign
source gross income consists entirely of passive income, and such
income and taxes are reported to the taxpayer on a payee statement.
If a taxpayer elects to apply section 904(j) for any taxable year,
no foreign taxes paid or accrued in such year may be carried over to
any other year, and no foreign taxes paid or accrued in any other
year may be carried over to the section 904(j) election year.

The proposed regulations clarify that a taxpayer may elect to apply
section 904(j) for a taxable year only if all of the taxes paid or
accrued for the taxable year and for which a credit is allowable to
the taxpayer under section 901 for the taxable year are creditable
foreign taxes (as defined in section 904(j)(3)(B). For example,
suppose that in year 2, the taxpayer accrues and pays foreign tax
that was not shown on a payee statement furnished to the taxpayer
and that is related to general limitation income that was recognized
and included in income for U.S. tax purposes in year 1. If the
foreign taxes in the general limitation category are creditable
under section 901 for year 2, the taxpayer may not elect to apply
section 904(j) for year 2, even if all of the taxpayer's income in
year 2 is qualified passive income.

In addition, taxpayers requested clarification on the application of
the carryover provisions in taxable years following section 904(j)
election years. Because high-taxed income, as defined in section
904(d)(2)(F), is calculated by reference to the highest rate of tax
specified in section 1 or 11 (whichever is applicable), Treasury and
the IRS expect that some individual taxpayers who are eligible to
elect the application of section 904(j) may have foreign tax credit
carryovers in the passive income category.

The proposed regulations clarify that the amount of a foreign tax
credit carryover to or from a non-section-904(j)-election year is
not reduced to account for the part of the carryover that (but for
section 904(j)) could have been used in intervening section 904(j)-
election years. Section 904(j) was intended to allow taxpayers to
avoid computing the section 904(a) limitation fraction. See
Committee on the Budget, U.S. House of Representatives, Report on
Revenue Reconciliation Act of 1997, June 24, 1997, at 520-21.
Requiring taxpayers to compute the amount of carryover that could
have been used in the election year would be inconsistent with the
statutory purpose of making the credit provisions less complex and
less burdensome for taxpayers with small amounts of solely passive
foreign-source income reported on payee statements. (Taxpayers may,
of course, choose to perform the calculations to determine whether
electing the application of section 904(j) would be more
advantageous for them, particularly for years in which a foreign tax
credit carryover will expire.)

However, the section 904(j) election does not extend the carry
forward and carry back periods under section 904(c). For example, if
a carry forward expires in 2000, and the taxpayer elects the
application of section 904(j) for the 2000 taxable year, the carry
forward cannot be used in 2000 (pursuant to section 904(j)(1)(C)) or
in any later year (pursuant to the expiration of the carry forward
period).

Similarly, the determination of whether the taxpayer paid or accrued
more than $300 (or $600) of creditable foreign taxes is made without
regard to carryovers. For example, a single taxpayer who pays $300
of creditable foreign taxes in 2001, and has a $500 carryover to
2001 from a previous year, is eligible to elect the application of
section 904(j) for the 2001 year. However, if the election is made,
the taxpayer cannot claim a credit in 2001 for the $500 otherwise
treated as a carryover.

VI. Removal of Example in §1.954-2

The proposed regulations remove Example 2 under §1.954- 2(b)(2)
(iv), which was intended to illustrate the application of the rules
under §1.954-2(b)(2) for the exception from foreign personal
holding company for certain export financing interest. Treasury and
the IRS are concerned that the example may be unintentionally
confusing. For this reason, it is being removed. Comments are
invited concerning whether a replacement example is necessary.

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It 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 regulations do not impose a collection
of information on small entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the
Code, this notice of proposed rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small Business Administration for
comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic or written comments (a
signed original and eight (8) copies) that are submitted timely to
the IRS. The IRS and Treasury Department request comments on the
clarity of the proposed rules and how they can be made easier to
understand. All comments will be available for public inspection and
copying. A public hearing has been scheduled for April 26, 2001,
beginning at 10 a.m. in the IRS Auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC. Due to
building security procedures, visitors must enter at the 10
th Street entrance, located between Constitution and
Pennsylvania Avenues, NW. In addition, all visitors must present
photo identification to enter the building. Because of access
restrictions, visitors will not be admitted beyond the immediate
entrance area more than 15 minutes before the hearing starts. For
information about having your name placed on the building access
list to attend the hearing, see the section of this preamble. The
rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish
to present oral comments at the hearing must submit electronic or
written comments and an outline of the topics to be discussed and
the time to be devoted to each topic (signed original and eight (8)
copies) by April 5, 2001. A period of 10 minutes will be allotted to
each person for making comments. An agenda showing the scheduling of
the speakers will be prepared after the deadline for receiving
outlines has passed. Copies of the agenda will be available free of
charge at the hearing.

Drafting Information

The principal author of these proposed regulations is Rebecca I.
Rosenberg of the Office of Associate Chief Counsel (International),
within the Office of Chief Counsel, Internal Revenue Service.
However, other personnel from the IRS and Treasury participated in
their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Proposed
Amendments to the Regulations

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

PART 1--INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

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

Section 1.902-1 and 902-2" and A 1.904- 4 through 1.904-7", and
adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.902-1 also issued under 26
U.S.C. 902(c)(7). * * * Section 1.904-4 also issued under 26 U.S.C.
904(b)(2)(C) and 904(d)(5). Section 1.904-5 also issued under 26
U.S.C. 904(d)(5). Section 1.904-6 also issued under 26 U.S.C. 904(d)
(5). Section 1.904-7 also issued under 26 U.S.C. 904(d)(5). * * *

Par. 2. Section 1.902-0 is amended by:

1. Revising the entry for §1.902-1(a)(13)(ii).

2. Adding an entry for §1.902-1(a)(13)(iii).

The revisions and additions read as follows:

§1.902-0 Outline for regulations provisions for section 902. *
* * * *

§1.902-1 Credit for domestic corporate shareholder of a foreign
corporation for foreign income taxes paid by the foreign
corporation.

(a) * * *

(13) * * *

(ii) Resumption of pooling.

(iii) Examples.

* * * * *

Par 3. Section 1.902-1 is amended as follows:

1. Paragraph (a)(8)(ii) is amended by revising the second sentence.

2. Paragraph (a)(10)(i) is revised.

3. Paragraph (a)(10)(iii) is amended by revising the last sentence
and adding one sentence.

4. Paragraphs (a)(13)(i)(A) and (a)(13)(i)(B) are revised.

5. Paragraphs (a)(13)(i)(C) and (a)(13)(i)(D) are added.

6. Paragraph (a)(13)(ii) is revised.

7. Paragraph (a)(13)(iii) is added.

The revisions and additions read as follows:

§1.902-1 Credit for domestic corporate shareholder of a foreign
corporation for foreign income taxes paid by the foreign
corporation.

(ii) * * * Foreign income taxes (other than taxes attributable to
formerly pooled earnings that are maintained in United States
dollars) that are 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. * * *

* * * * *

(10) * * * (i) 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 (pre-1987 earnings). If the special
effective date of paragraph (a)(13)(i) of this section applies,
pre-1987 accumulated profits also includes any earnings and profits
(computed in accordance with section 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 (pre-pooling earnings).
Pre-1987 accumulated profits also includes any post-1986
undistributed earnings formerly maintained by a less-than-10%-U.S.-
owned foreign corporation (as defined in §1.904-4(g)(1)) that
are attributable to the foreign corporation's taxable years
beginning after December 31, 1986, as of the end of which such
ownership requirements were met (formerly pooled earnings). Such
formerly pooled earnings shall be considered pre-1987 accumulated
profits of the last taxable year of the foreign corporation in which
such ownership requirements were met as of the end of the taxable
year. Pre-1987 accumulated profits also includes earnings and
profits accumulated during subsequent taxable years of such a less-
than-10%- U.S.-owned foreign corporation as of the end of which such
ownership requirements were not met (post-pooling earnings). All
four types of pre-1987 accumulated profits described in this
paragraph (a)(10)(i) are also sometimes referred to as pre-pooling
annual layers.

* * * * *

(iii) * * * 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, except that foreign income taxes
attributable to formerly pooled earnings described in the third
sentence of paragraph (a)(10)(i) of this section shall be maintained
in United States dollars as originally translated in accordance with
section 986(a). Post-1986 foreign income taxes attributable to such
formerly pooled earnings shall be treated as pre-1987 foreign income
taxes.

* * * * *

(13) * * *

(i) * * *

(A) The post-1986 undistributed earnings and post-1986 undistributed
foreign income taxes of the foreign corporation shall be determined
by taking into account only consecutive taxable years beginning on
and after the first day of the first taxable year of the foreign
corporation as of the end of which the ownership requirements of
section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this
section are met and ending before the first day of a subsequent
taxable year in which such ownership requirements are not met as of
the end of the taxable year;

(B) Earnings and profits accumulated prior to the first day of the
first taxable year of the foreign corporation as of the end of which
such ownership requirements are met shall be considered pre-1987
accumulated profits (which may include both pre-pooling earnings and
pre-1987 earnings);

(C) Formerly pooled earnings described in paragraph (a)(10)(i) of
this section shall be considered pre-1987 accumulated profits of the
taxable year ending immediately before the next taxable year in
which such ownership requirements are not met as of the end of the
taxable year; and

(D) Earnings and profits accumulated on and after the first day of a
taxable year of the foreign corporation as of the end of which such
ownership requirements are not met shall be considered pre-1987
accumulated profits (post-pooling earnings).

(ii) Resumption of pooling. If the ownership requirements of section
902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are
again met with respect to a foreign corporation that originally
maintained pools of post-1986 undistributed earnings and post-1986
foreign income taxes but converted such pools to pre-1987
accumulated profits (formerly pooled earnings) and associated
pre-1987 foreign income taxes because such ownership requirements
were not met as of the close of a subsequent post-1986 taxable year,
then 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 such subsequent taxable year of the foreign
corporation as of the end of which such ownership requirements are
met and ending before the first day of a subsequent taxable year in
which such ownership requirements are not met as of the end of the
taxable year. The post-pooling earnings, formerly pooled earnings,
pre-pooling earnings, and pre-1987 earnings of such a foreign
corporation shall continue to be considered pre-1987 accumulated
profits. The rules of paragraph (a)(13)(i)(B) through (D) of this
section shall apply if such a foreign corporation again becomes a
less-than-10%-U.S.-owned foreign corporation.

(iii) Examples. The following examples illustrate the special
effective date rules of this paragraph (a)(13): Example 1. 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.34
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 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 subsequent taxable years beginning
before the date these regulations are published as final regulations
in the Federal Register, as well as later taxable years as of the
end of which the ownership requirements of section 902(c)(3)(B) and
paragraphs (a)(1) through (4) of this section are met. 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. Example 2. The facts are the same
as in Example 1, except that Corporation M sells five percent of the
Corporation B stock to an unrelated buyer on July 1, 2003, so that
Corporation B no longer meets the ownership requirements of section
902(c)(3)(B) and paragraphs (a)(1) through (4) of this section as of
that date. Thus, as of December 31, 2003, Corporation B's earnings
and profits all consist of pre-1987 accumulated profits, comprising
pre-1987 earnings for years beginning prior to January 1, 1987, pre-
pooling earnings for taxable years 1987 through 1991, no earnings
for 1992 through 2001, formerly pooled earnings for 2002 (comprising
Corporation B's post-1986 undistributed earnings for 1992 through
2002), and post-pooling earnings for 2003. Dividends paid by
Corporation B to Corporation M at any time during 2003 will be
considered paid out of pre-1987 accumulated profits. See paragraphs
(a)(10) and (a)(13)(i) of this section. However, Corporation M will
be eligible to claim a deemed-paid credit only with respect to
dividends received on or before July 1, 2003. See paragraphs (a)(1)
and (12) of this section and §1.902-3(a)(1) and (7).

Example 3. The facts are the same as in Example 2, except that
Corporation M purchases an additional five percent of the stock of
Corporation B on July 1, 2004, so that Corporation B again meets the
ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1)
through (4) of this section on December 31, 2004. As of the end of
2004, assume Corporation B has 500u of post-1986 undistributed
earnings (after foreign taxes but before taking into account
distributions during 2004) and $100 of post-1986 foreign income
taxes attributable to 2004, 500u of post-pooling earnings and 100u
of pre-1987 foreign income taxes attributable to 2003, and 1500u of
formerly pooled earnings and $250 of pre-1987 foreign income taxes
attributable to 2002 (comprising Corporation B's post-1986
undistributed earnings and post-1986 foreign income taxes for 1992
through 2002). Corporation B pays dividends to its shareholders of
500u on March 1, 2004, and 500u on September 1, 2004. The March 1,
2004, dividend is out of Corporation B's post-1986 undistributed
earnings in its entirety, and reduces Corporation B's post-1986
undistributed earnings and post-1986 foreign income taxes to zero,
even though no shareholder is eligible to claim a credit for deemed-
paid taxes. See paragraphs (a)(8)(i) and (b)(1) of this section. The
September 1, 2004, dividend is out of 2003 post-pooling earnings,
and reduces 2003 post-pooling earnings and foreign income taxes to
zero. Corporation M, which is a 10% domestic shareholder of
Corporation B on that date and receives a dividend of 50u, is deemed
to have paid 10u of foreign income taxes (50u/500u x 100u) with
respect to the dividend. Both the dividend and the deemed-paid taxes
are translated into dollars at the spot exchange rate on the
dividend date, under the law in effect prior to the effective date
of the Tax Reform Act of 1986. See paragraphs (a)(10)(i) and (ii) of
this section.

Par. 4. Section 1.904-0 is amended as follows:

1. The entries for §1.904-4 are amended by:

a. Revising the entry for paragraph (b)(2)(iii).

b. Removing the entry for paragraph (b)(2)(iv).

c. Revising the entries for paragraph (g) and (g)(1), adding entries
for paragraph (g)(1)(i) through (g)(1)(iii), and revising the entry
for paragarph (g)(3)(i)(C).

d. Adding entries for paragraphs (g)(3)(i)(C)(1), (g)(3)(i)(C)(2),
and (g)(4).

e. Adding an entry for paragraph (m).

2. The entries for §1.904(b)-1 are amended by:

a. Revising section heading and the entries for all of paragraphs
(a), (b), and (c).

b. Adding entries for paragraphs (d), (e), (f), (g), and (h).

3. Revising the entries for all of §1.904(b)-2.

4. Removing all the entries for §§1.904(b)-3 and
1.904(b)-4.

5. Adding entries for §1.904(j)-1.

The revisions and additions read as follows:

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

* * * * *

§1.904-4 Separate application of section 904 with respect to
certain categories of income.

* * * * *

(b) * * *

(2) * * *

(iii) Example.

* * * * *

(g) Noncontrolled section 902 corporation and non-look-through 10/50
corporation.

(1) Corporate-level accounts and treatment of distributions to
shareholders.

(i) Definitions.

(ii) Accounts at foreign corporation level. (iii) Inclusion at
shareholder level.

* * * * *

(3) * * *

(i) * * *

(C) Effect of intervening no controlled or less-than-10%-U. S.-owned
status.

(1) Pre-2003 decontrolling event.

(2) Pool-terminating event.

* * * * *

(4) Special rule for dividends paid by a 10/50 look-through
corporation.

* * * * *

(m) Income treated as allocable to an additional separate category.

* * * * *

§1.904(b)-1 Special rules for capital gains and losses.

(a) Capital amounts included in taxable income from sources outside
the United States.

(1) Limitation on capital gain from sources outside the United
States when the taxpayer has net capital losses from sources within
the United States.

(i) In general.

(ii) Allocation of reduction among multiple separate categories or
rate groups.

(2) Capital losses from sources outside the United States in the
same separate category.

(3) Exclusivity of rules; no reduction by reason of net capital loss
from sources outside the United States in a different separate
category.

(4) Examples.

(b) Capital gain rate differential.

(1) Application of adjustments only if capital gain rate
differential exists.

(2) Determination of whether capital gain rate differential
adjustment exists.

(c) Rate differential adjustment of capital gains.

(1) Rate differential adjustment of capital gains in foreign source
taxable income.

(2) Rate differential adjustment of capital gains in entire taxable
income.

(d) Rate differential adjustment of capital losses from sources
outside the United States.

(1) In general.

(2) Determination of which net capital gains are offset by net
capital losses from sources outside the United States.

(e) Definitions.

(1) Alternative tax rate.

(2) Capital gain net income.

(3) Net capital gain.

(4) Rate group.

(i) Capital gains.

(ii) Capital losses.

(5) Terms used in sections 1(h), 904(b) or 1222.

(f) Examples.

(g) Coordination with overall foreign loss recapture rules.

(h) Effective date.

§1.904(b)-2 Special rules for application of section 904(b) to
alternative minimum tax foreign tax credit.

(a) Application of section 904(b)(2)(B) adjustments.

(b) Use of alternative minimum tax rates.

(1) Taxpayers other than corporations.

(2) Corporate taxpayers.

(c) Effective date.

* * * * *

§1.904(j)-1 Certain individuals exempt from foreign tax credit
limitation.

(a) Election available only if all foreign taxes are creditable
foreign taxes.

(b) Coordination with carryover rules.

(1) No carryovers to or from election year.

(2) Carryovers to and from other years determined without regard to
election years.

(3) Determination of amount of creditable foreign taxes.

(c) Examples.

Par. 5. Section 1.904-4 is amended as follows:

1. Paragraph (a) is amended by removing the period at the end and
adding the language ", or in §1.904-4(m) (additional separate
categories)."

2. The first sentence of paragraph (b)(2)(i) is revised.

3. Paragraph (b)(2)(ii) is revised.

4. Paragraph (b)(2)(iii) is removed.

5. Paragraph (b)(2)(iv) is redesignated as paragraph (b)(2)(iii).

6. The last three sentences of the Example in newly designated
paragraph (b)(2)(iii) are revised and three new sentences are added
at the end.

7. The paragraph heading for paragraph (g) is revised.

8. Paragraph (g)(1) is redesignated as paragraph (g)(1)(i) and a new
heading is added for paragraph (g)(1).

9. Five sentences are added at the end of newly designated paragraph
(g)(1)(i).

10. Paragraphs (g)(1)(ii) and (iii) are added.

11. The heading of paragraph (g)(3)(i_(C) is revised and the text to
paragraph (g)(3)(i)(C) is added.

12. The text of Example 2 through Example 4 is added to paragraph
(g)(3)(i)(D).

13. Paragraph (g)(4) is added.

14. The language "and" at the end of paragraph (l)(1)(v) is removed.

15. The period at the end of paragraph (l)(1)(vi) is removed and " ;
and" is added in its place.

16. Paragraph (l)(1)(vii) is added.

17. Paragraph (m) is added.

The revisions and additions read as follows:

§1.904-4 Separate application of section 904 with respect to
certain categories of income. * * * * *

(b) * * *

(2) * * *

(i) * * * For rents and royalties paid or accrued more than 60 days
after the date these regulations are published as final regulations
in the Federal Register, passive income does not include any rents
or royalties that are derived in the active conduct of a trade or
business, regardless of whether such rents or royalties are received
from a related or an unrelated person. * * *

(ii) Exception for certain rents and royalties. Rents and royalties
are considered derived in the active conduct of a trade or business
by a United States person or by a controlled foreign corporation (or
other entity to which the look-through rules apply) for purposes of
section 904 (but not for purposes of section 954) if the
requirements of section 954(c)(2)(A) are satisfied by one or more
corporations that are members of an affiliated group of corporations
(within the meaning of section 1504(a), determined without regard to
section 1504(b)(3)) of which the recipient is a member. For purposes
of this paragraph (b)(2)(ii), an affiliated group includes only
United States corporations and foreign corporations that are
controlled foreign corporations in which United States members of
the affiliated group own, directly or indirectly, at least 80
percent of the total voting power and value of the stock. For
purposes of this paragraph (b)(2)(ii), indirect ownership shall be
determined under section 318 and the regulations under that section.

(iii) * * *

Example. * * * Some of the franchisees are unrelated to S and P.
Other franchisees are related to S or P and use the licensed
property outside of S's country of incorporation. S does not
satisfy, but P does satisfy, the active trade or business
requirements of section 954(c)(2)(A) and the regulations thereunder.
The royalty income earned by S with regard to both its related and
unrelated franchisees is foreign personal holding company income
because S does not satisfy the active trade or business requirements
of section 954(c)(2)(A) and, in addition, the royalty income from
the related franchisees does not qualify for the same country
exception of section 954(c)(3). However, all of the royalty income
earned by S is general limitation income to S under §1.904-4(b)
(2) (ii) because P, a member of S's affiliated group (as defined
therein), satisfies the active trade or business test (which is
applied without regard to whether the royalties are paid by a
related person). S's royalty income that is taxable to P under
subpart F and the royalties paid to P are general limitation income
to P under the look-through rules of §1.904-5(c)(1)(i) and (c)
(3), respectively.

* * * * *

(g) Noncontrolled section 902 corporation and non-look-through 10/50
corporation--(1) Corporate-level accounts and treatment of
distributions to shareholders--

(i) Definitions. * * * Except as otherwise provided, the term "look-
through corporation" means a foreign corporation that is subject to
the look-through rules of section 904(d)(3) or section 904(d)(4) (as
in effect for taxable years beginning after December 31, 2002). The
term "non-look-through 10/50 corporation" means any foreign
corporation that is not a look- through corporation and with respect
to which a domestic corporation meets the stock ownership
requirements of section 902(a), or, for purposes of applying the
look-through rules described in section 904(d)(3) and §1.904-5,
a domestic corporation meets the requirements of section 902(b). The
term "less-than-10%-U.S.-owned foreign corporation" means a foreign
corporation that is neither a look-through corporation nor a non-
look-through 10/50 corporation. The term means the post-1986
undistributed earnings of a foreign corporation that are subject to
the look-through provisions of section 904(d)(3) or section 904(d)
(4) as in effect for taxable years beginning after December 31,
2002. The term means the post-1986 undistributed earnings of a
foreign corporation that were accumulated (or treated as
accumulated) while the foreign corporation was a non-look-through
10/50 corporation.

(ii) Accounts at foreign corporation level. The post-1986
undistributed earnings of a controlled foreign corporation or other
look-through corporation may consist of look-through pools
(comprising post-1986 undistributed earnings accumulated during
periods when the foreign corporation was, or was treated as, a look-
through corporation, which may include post-1986 undistributed
earnings in one or more non-look-through pools attributable to
dividends paid to the look-through corporation by each separate non-
look-through 10/50 corporation), as well as one or more non-look-
through pools (including post-1986 undistributed earnings
accumulated during periods when the foreign corporation was, or was
treated as, a non-look-through 10/50 corporation). Similarly, a
look-through corporation's pre-pooling annual layers, as defined in
§1.902-1(a)(10)(i), may or may not be subject to the look-
through rules, depending on whether the corporation was, or was
treated as, a look-through corporation at the time the earnings were
accumulated.

(iii) Inclusion at shareholder level. A particular dividend
recipient will be entitled to look-through treatment with respect to
a particular distribution from a controlled foreign corporation only
if the recipient is a United States shareholder, as defined in
section 951(b) taking into account section 953(c), of the controlled
foreign corporation at the time it receives the dividend. Therefore,
a dividend distribution from a controlled foreign corporation to a
United States shareholder will be characterized under the look-
through rules, whereas a dividend distribution to a less-than-10%
shareholder of the controlled foreign corporation will be treated as
passive income. Similarly, under section 904(d)(1)(E), only a
corporate shareholder calculates a separate foreign tax credit
limitation for dividends from each no controlled section 902
corporation, and the look-through rules of section 904(d)(4) as in
effect for taxable years beginning after December 31, 2002, apply
only to applicable dividends out of post-2002 earnings of a
corporation that is a no controlled section 902 corporation with
respect to the taxpayer. Therefore, dividends paid to an individual
shareholder by a non-look-through 10/50 corporation, or by a
controlled foreign corporation out of a non-look-through pool, will
be treated as passive income. Similarly, dividends paid to an
individual shareholder by a look-through corporation that is not a
controlled foreign corporation will be treated as passive income to
such individual, even if the individual owns 10 percent or more of
the distributing corporation's stock.

* * * * *

(3) * * *

(i) * * *

(C) Effect of intervening no controlled or less-than-10%-U. S.-owned
status--(1) Pre-2003 decontrolling event. If a controlled foreign
corporation becomes a non-look-through 10/50 corporation, for
example, by reason of the corporation's issuance of additional stock
or the disposition of stock by the corporation's controlling United
States shareholders to foreign persons in a taxable year of the
controlled foreign corporation beginning before January 1, 2003, (a
decontrolling event), and retains that status as of the end of the
foreign corporation's taxable year, then earnings and profits that
were accumulated before the decontrolling event during periods when
the corporation was a controlled foreign corporation will at all
times thereafter be treated as earnings and profits accumulated by a
non-look-through 10/50 corporation. The corporation's post- 1986
undistributed earnings (or deficits in post-1986 undistributed
earnings) in each separate category shall be combined into, and
constitute the opening balance of, a single non-look-through pool of
post-1986 undistributed earnings accumulated in taxable years
beginning before January 1, 2003. The corporation's post-1986
foreign income taxes in each separate category shall similarly be
combined into a single category of post-1986 foreign income taxes
attributable to the non-look-through pool. Distributions of such
earnings and profits after the decontrolling event will not be
subject to the look-through rules of §1.904-5, even if the
corporation subsequently becomes a controlled foreign corporation or
other look-through corporation again. The corporation's pre-1987
accumulated profits will also be ineligible for look-through
treatment if accumulated prior to, and distributed after, the
decontrolling event. In determining whether the look-through rules
apply to earnings and profits maintained at the distributing
corporation level, earnings and profits accumulated or distributed
in the taxable year in which a decontrolling event occurs shall be
considered accumulated or distributed after the decontrolling event,
respectively. However, in determining whether a dividend recipient
is entitled to look-through treatment with respect to a particular
distribution, only the shareholder's status and ownership of stock
at the time it receives the dividend is relevant. See
§1.902-1(a)(1) and paragraph (g)(1)(iii) of this section.

(2) Pool-terminating event. If a look-through corporation or a non-
look-through 10/50 corporation becomes a less-than-10%-U. S.-owned
foreign corporation, for example, by reason of the corporation's
issuance of additional stock or the disposition of stock by the
corporation's United States shareholders (a pool- terminating
event), and retains that status as of the end of the foreign
corporation's taxable year, then earnings and profits that were
accumulated before the pool-terminating event will at all times
thereafter be treated as pre-1987 accumulated profits accumulated by
a non-look-through 10/50 corporation in accordance with
§1.902-1(a) (10) and (13). Distributions of such earnings and
profits after the pool-terminating event will not be subject to the
look-through rules of §1.904-5, even if the corporation
subsequently becomes a look- through corporation again. Earnings and
profits accumulated or distributed in the taxable year in which a
pool-terminating event occurs shall be considered accumulated or
distributed after the pool-terminating event, respectively. However,
in determining whether a dividend recipient is entitled to look-
through treatment with respect to a particular distribution, only
the shareholder's status and ownership of stock at the time it
receives the dividend is relevant. See §1.902-1(a)(1) and
paragraph (g)(1)(iii) of this section.

* * * * *

(D) * * *

Example 2.

      (i) Facts.

     X, a domestic corporation, owns all of the stock of S, a
controlled foreign corporation. On March 1, 2002, S pays a dividend
to X. On July 1, 2002, S issues additional shares of stock to Z, a
foreign person, in exchange for a capital contribution. The new
stock issuance dilutes X's interest in S to 40 percent. Thus, S is a
non-look-through 10/50 corporation beginning on July 1, 2002.

(ii) Result. The March 1, 2002, dividend to X is treated as a
dividend from a non-look-through 10/50 corporation. X is not
entitled to look-through treatment on the dividend under paragraph
(g)(3)(i)(C) of this section.

Example 3.

      (i) Facts.

     X, a domestic corporation, has owned all of the stock of S, a
controlled foreign corporation, since S was organized in 1980. Both
X and S use the calendar year as the taxable year. On July 1, 2002,
X sells 60 percent of the stock of S to Z, a foreign person. On July
1, 2003, X repurchases all of the S stock that it sold to Z in 2002.
Thus, S is a controlled foreign corporation for 1980 through June
30, 2002, a non-look-through 10/50 corporation from July 1, 2002,
through December 31, 2002, and a look-through corporation from
January 1, 2003, forward, as well as a controlled foreign
corporation from July 1, 2003, forward.

(ii) Result. Pursuant to paragraph (g)(3)(i)(C) of this section, X
is entitled to look-through treatment with respect to distributions
before January 1, 2002, of S's post-1986 undistributed earnings
accumulated through December 31, 2001, and of S's pre-1987
accumulated profits. Distributions after December 31, 2001, of
earnings and profits accumulated before January 1, 2003, will be
treated as dividends from a non-look-through 10/50 corporation. X is
entitled to look-through treatment on distributions of earnings and
profits accumulated and distributed after December 31, 2002.

Example 4.

      (i) Facts.

     The facts are the same as in Example 3, except that X sells 95
percent, rather than 60 percent, of the stock of S to Z. Thus, S is
a controlled foreign corporation for 1980 through June 30, 2002, a
less-than-10%-U.S.-owned foreign corporation from July 1, 2002,
through June 30, 2003, and a controlled foreign corporation
beginning on July 1, 2003.

(ii) Result. The result is the same as in Example 3, except that
distributions from S made between July 1, 2002, and June 30, 2003,
will be treated as passive income to X because X owns less than 10
percent of the stock of S during that period. Distributions from S
to X made between January 1, 2002, and June 30, 2002, will be
treated as dividends from a non-look-through 10/50 corporation.
Distributions from S to X made after June 30, 2003, out of earnings
and profits accumulated prior to January 1, 2003, will be treated as
dividends from a non-look-through 10/50 corporation. X is entitled
to look-through treatment of distributions after June 30, 2003, out
of earnings and profits accumulated after December 31, 2002.

* * * * *

(4) Special rule for dividends paid by a 10/50 look-through
corporation. [Reserved]

* * * * *

(l) * * *

(1) * * *

(vii) Income that meets the definitions of a separate category
described in paragraph (m) of this section and of any other category
of separate limitation income described in section 904(d)(1)(A)
through (H) will be subject to the separate limitation described in
paragraph (m) of this section and will not be treated as general
limitation income described in section 904(d)(1)(I).

* * * * *

(m) Income treated as allocable to an additional separate category.
If section 904(a), (b), and (c) are applied separately to any
category of income under the Internal Revenue Code (for example,
under section 56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), or
904(g)(10)), that category of income will be treated for all
purposes of the Internal Revenue Code and regulations as if it were
a separate category listed in section 904(d)(1) and section 904(d)
(3)(F)(i).

Par. 6. In §1.904-5, paragraph (a)(1) is revised to read as
follows:

§1.904-5 Look-through rules as applied to controlled foreign
corporations and other entities.

(a) * * *

(1) The term "separate category" means, as the context requires, any
category of income described in section 904(d)(1)(A), (B), (C), (D),
(E), (F), (G), (H), or (I) and in §1.904-4(b), (d), (e), (f),
and (g), any category of income described in §1.904-4(m), or
any category of earnings and profits to which income described in
such provisions is attributable.

* * * * *

Par. 7. In §1.904-6, paragraph (a)(1)(ii) is amended by adding
two sentences at the end to read as follows: §1.904-6
Allocation and apportionment of taxes.

(a) * * *

(1) * * *

(ii) * * * If the taxpayer applies the principles of
§§1.861-8 through 1.861-14T for purposes of allocating
expenses at the level of the taxpayer (or at the level of the
qualified business unit, foreign subsidiary, or other entity that
paid or accrued the foreign taxes) under this paragraph (a)(1)(ii),
such principles shall be applied (for such purposes) in the same
manner as the taxpayer applies such principles in determining the
income or earnings and profits for United States tax purposes of the
taxpayer (or of the qualified business unit, foreign subsidiary, or
other entity that paid or accrued the foreign taxes, as the case may
be). For example, a taxpayer must use the modified gross income
method under §1.861-9T when applying the principles of that
section for purposes of this paragraph (a)(1)(ii) to determine the
amount of a controlled foreign corporation's income, in each
separate category, that is taxed by a foreign country, if the
taxpayer applies the modified gross income method under
§1.861-9T(f)(3) when applying §1.861-9T to determine the
income and earnings and profits of the controlled foreign
corporation for United States tax purposes.

* * * * *

Par. 8. Section 1.904(b)-1 is revised to read as follows:
§1.904(b)-1 Special rules for capital gains and losses. (a)
Capital amounts included in taxable income from sources outside the
United States--(1) Limitation on capital gain from sources outside
the United States when the taxpayer has net capital losses from
sources within the United States--

(i) In general. Except as otherwise provided in this section, for
purposes of section 904 and this section, taxable income from
sources outside the United States (in all of the taxpayer's separate
categories in the aggregate) shall include capital gain net income
from sources outside the United States (determined by considering
all of the capital gain and loss items in all of the taxpayer's
separate categories in the aggregate) only to the extent of capital
gain net income from all sources. Similarly, except as otherwise
provided in this section, for purposes of section 904 and this
section, net capital gain from sources outside the United States
(determined by considering all of the capital gain and loss items in
all of the taxpayer's separate categories in the aggregate) shall
not exceed net capital gain from all sources.

(ii) Allocation of reduction among multiple separate categories or
rate groups. If capital gain net income (or net capital gain) from
sources outside the United States exceeds capital gain net income
(or net capital gain), and the taxpayer has capital gain net income
(or net capital gain) from sources outside the United States in two
or more separate categories or in two or more rate groups, such
excess must be apportioned on a pro rata basis as a reduction to
each such separate category, and then within each separate category,
on a pro rata basis among rate groups. For purposes of the preceding
sentence, pro rata means based on the relative amounts of the
capital gain net income (or net capital gain) from sources outside
the United States in each separate category, or in each rate group
within a separate category.

(2) Capital losses from sources outside the United States in the
same separate category. Except as otherwise provided in paragraph
(d) of this section, taxable income from sources outside the United
States in each separate category shall be reduced by any capital
loss that is allocable or apportionable to sources outside the
United States in such separate category to the extent such loss is
allowable in determining taxable income for the taxable year (taking
into account losses allowable under section 1211(b)).

(3) Exclusivity of rules; no reduction by reason of net capital
losses from sources outside the United States in a different
separate category. Capital gains from sources outside the United
States in any separate category shall be limited by reason of
section 904(b)(2)(A) and the comparable limitation of section 904(b)
(2)(B)(i) only to the extent provided in paragraph (a)(1) of this
section (relating to limitation on capital gain from sources outside
the United States when taxpayer has net capital losses from sources
within the United States) and paragraph (a)(2) of this section
(relating to capital losses from sources outside the United States
in the same separate category).

(4) Examples. The following examples illustrate the application of
this paragraph (a). The examples are as follows: Example 1. Taxpayer
A, a corporation, has a general limitation category capital loss of
$3,000 from sources outside the United States, a passive category
capital gain of $3,000 from sources outside the United States, and a
capital loss of $2,000 from sources within the United States. A has
no capital gain net income from sources outside the United States
(in the aggregate, from all separate categories), because the $3,000
passive capital gain less the $3,000 general limitation capital loss
yields a net of zero. From all sources, A also has no capital gain
net income. (The resulting $2,000 net capital loss is not currently
allowable under section 1211(a) because A is a corporation.) Because
A's capital gain net income from sources outside the United States
does not exceed A's capital gain net income from all sources,
paragraph (a)(1) of this section does not require any reduction of
A's passive category capital gain.

Example 2. Taxpayer B, a corporation, has $500 of capital gain net
income from sources outside the United States, of which $300 is in
the general limitation category and $200 is in the passive category.
B's capital gain net income from sources outside the United States
is $500 ($300 + $200). Because B also incurs a capital loss of $100
from sources within the United States, B's capital gain net income
(from all sources) is $400 ($300 + $200 - $100). Pursuant to
paragraph (a)(1)(B) of this section, the $100 excess of capital gain
net income from sources outside the United States over capital gain
net income from all sources ($500 - $400) must be apportioned, as a
reduction, three- fifths ($300/$500 of $100, or $60) to the general
limitation category and two-fifths ($200/$500 of $100, or $40) to
the passive category. Therefore, for purposes of section 904, the
general limitation category includes $240 ($300 - $60) of capital
gain net income from sources outside the United States and the
passive category includes $160 ($200 - $40) of capital gain net
income from sources outside the United States.

Example 3. Taxpayer C, a corporation, has a $10,000 capital loss
from sources outside the United States in the general limitation
category, a $4,000 capital gain from sources outside the United
States in the passive category, and a $2,000 capital gain from
sources within the United States. C's capital gain net income from
sources outside the United States is zero, since losses exceed
gains. C's capital gain net income from all sources is also zero.
C's capital gain net income from sources outside the United States
does not exceed its capital gain net income from all sources, and
therefore paragraph (a)(1) of this section does not require any
reduction of C's passive category capital gain. For purposes of
section 904, C's passive category includes $4,000 of capital gain
net income. C's general limitation category includes a capital loss
of $6,000 because only $6,000 of capital loss is allowable as a
deduction in the current year. The entire $4,000 of capital loss in
excess of the $6,000 of capital loss that offsets capital gain in
the taxable year is carried back or forward under section 1212(a),
and none of such $4,000 is taken into account under section 904(a)
or (b) for the current taxable year.

(b) Capital gain rate differential--(1) Application of adjustments
only if capital gain rate differential exists. Section 904(b)(2)(B)
and paragraphs (c) and (d) of this section apply only for taxable
years in which the taxpayer has a capital gain rate differential.

(2) Determination of whether capital gain rate differential exists.
For purposes of section 904(b) and this section, a capital gain rate
differential is considered to exist for the taxable year only if the
taxpayer has a net capital gain for the taxable year and--

(i) In the case of a taxpayer other than a corporation, tax is
imposed at a reduced rate under section 1(h) for the taxable year;
or

(ii) In the case of a corporation, tax is imposed under section
1201(a) on the taxpayer at a rate less than any rate of tax imposed
on the taxpayer by section 11, 511, or 831(a) or (b), whichever
applies (determined without regard to the last sentence of section
11(b)(1)), for the taxable year.

(c) Rate differential adjustment of capital gains--(1) Rate
differential adjustment of capital gains in foreign source taxable
income. In determining taxable income from sources outside the
United States for purposes of section 904 and this section, capital
gain net income from sources outside the United States in each
separate category, after any reduction pursuant to paragraph (a) of
this section, shall be reduced by the sum of the rate differential
portions (as defined in section 904(b)(3)(E)) of each rate group of
net capital gain from sources outside the United States in such
separate category.

(2) Rate differential adjustment of capital gains in entire taxable
income. For purposes of section 904 and this section, the entire
taxable income shall include gains from the sale or exchange of
capital assets only to the extent of capital gain net income reduced
by the sum of the rate differential portions (as defined in section
904(b)(3)(E)) of each rate group of net capital gain.

(d) Rate differential adjustment of capital losses from sources
outside the United States--

(1) In general. In determining taxable income from sources outside
the United States for purposes of section 904 and this section, any
net capital loss from sources outside the United States included in
a separate category pursuant to paragraph (a) of this section shall
be reduced by the sum of the rate differential portion of the net
capital gains (from the same rate group in other separate
categories, from other rate groups in the same or other separate
categories, or from sources within the United States) that are
offset by such net capital loss in determining the taxpayer's entire
taxable income.

(2) Determination of which net capital gains are offset by net
capital losses from sources outside the United States. For purposes
of paragraph (d)(1) of this section, in order to determine which net
capital gains (from any rate group) are offset by net capital losses
from sources outside the United States, the following rules shall
apply in the following order:

(i) Capital losses from sources outside the United States shall
first be netted against capital gains from sources outside the
United States in the same rate group and the same separate category
as the foreign source capital losses.

(ii) Net capital losses from each rate group from sources outside
the United States shall be netted against net capital gains from
sources outside the United States from the same rate group in other
separate categories, ratably to the extent that net capital gains
and losses in a particular rate group occur in two or more separate
categories.

(iii) Capital losses from sources within the United States shall be
netted against capital gains from sources within the United States
in the same rate group.

(iv) The net foreign capital losses from each rate group, as
determined under paragraph (d)(2)(ii) of this section, shall be
netted against the taxpayer's remaining net capital gains from
sources within and outside the United States in the following order,
and without regard to any net capital losses, from any rate group,
from sources within the United States--

(A) First against net capital gains from sources within the United
States in the same rate group;

(B) Next, against net capital gains in other rate groups, in the
order in which capital losses offset capital gains for purposes of
determining the taxpayer's taxable income and without regard to
whether such net capital gains derive from sources within or outside
the United States, as follows:

(1) A short-term capital loss (including any short-term capital loss
carryover) is used first to offset short-term capital gain otherwise
taxable at ordinary income rates. Any remaining net short-term
capital loss is used first to offset any net long-term gain in the
28 percent rate group, then to offset net long-term gain in the 25
percent rate group, and finally to offset net long-term gain in the
20 percent rate group.

(2) A net capital loss in the 28 percent rate group is used first to
offset net capital gain in the 25 percent rate group, and then to
offset net capital gain in the 20 percent rate group.

(3) A net capital loss in the 20 percent rate group is used first to
offset net capital gain in the 28 percent rate group, and then to
offset net capital gain in the 25 percent rate group.

(v) The net capital losses from sources outside the United States in
any rate group, to the extent netted against net capital gains in
any other separate category under paragraph (d)(2)(ii) of this
section or against net capital gains in any other rate group under
paragraph (d)(2)(iv) of this section, shall be treated as coming pro
rata from each separate category that contains net capital losses
from sources outside the United States in that rate group. For
example, assume that the taxpayer has $20 of net capital losses in
the 20 percent rate group in the passive category and $40 of net
capital losses in the 20 percent rate group in the general
limitation category, both from sources outside the United States.
Further assume that $50 of the total $60 net capital losses from
sources outside the United States are netted against net capital
gains in the 28 percent rate group (from other separate categories
or from sources within the United States). One-third of the $50 of
such capital losses would be treated as coming from the passive
category, and two-thirds of such $50 would be treated as coming from
the general limitation category.

(vi) The determination of which capital gains are offset by capital
losses from sources outside the United States under this paragraph
is made solely in order to determine the appropriate rate-
differential-based adjustments to such capital losses under this
section and section 904(b), and does not change the source,
allocation, or separate category of any such capital gain or loss
for purposes of computing taxable income from sources within or
outside the United States or for any other purpose.

(e) Definitions. For purposes of section 904(b) and this section,
the following definitions apply:

(1) Alternative tax rate. The term alternative tax rate means, with
respect to any rate group, the rate applicable to that rate group
under section 1(h) (for taxpayers other than corporations) or
1201(a) (for corporations). For example, the alternative tax rate
for unrecaptured section 1250 gain is 25 percent.

(2) Capital gain net income. The term capital gain net income means
the excess of the gains from the sales or exchanges of capital
assets over the losses from such sales or exchanges. Such term shall
include net section 1231 gain, but shall not include gains or losses
from the sale or exchange of capital assets to the extent that such
gains are not treated as capital gains. In determining capital gain
net income, gains and losses which are not from the sale or exchange
of capital assets but which are treated as capital gains and losses
under the Internal Revenue Code are included.

(3) Net capital gain. The term net capital gain means the excess of
the net long-term capital gain (including net section 1231 gain) for
the taxable year over the net short-term capital loss for such year,
but shall not include gains or losses from the sale or exchange of
capital assets to the extent that such gains are not treated as
capital gains. In determining net capital gain, gains and losses
which are not from the sale or exchange of capital assets but which
are treated as capital gains and losses under the Internal Revenue
Code are included.

(4) Rate group. For purposes of this section--

(i) Capital gains. With respect to capital gains, the term rate
group means the amounts subject to a particular rate of tax under
section 1(h). For example, the 20 percent rate group of capital gain
net income from sources outside the United States consists of the
capital gain net income from sources outside the United States that
is subject to tax at a rate of 20 percent under section 1(h).

(ii) Capital losses. With respect to capital losses, the rate group
shall be determined as if the sale or exchange that produced the
capital loss had instead produced a capital gain. For example, if
the sale of an asset held for more than one year yields a capital
loss, but any gain generated by the sale would have been subject to
tax at a rate of 20 percent under section 1(h), the capital loss is
allocated to the 20 percent rate group for purposes of this section.

(5) Terms used in sections 1(h), 904(b) or 1222. For purposes of
this section, any term used in this section and also used in section
1(h), section 904(b) or section 1222 shall have the same meaning
given such term by section 1(h), 904(b) or 1222, respectively,
except as otherwise provided in this section.

(f) Examples. The following examples illustrate the provisions of
this section. In these examples, the adjustment for the rate
differential portion is shown as a fraction, the numerator of which
is the alternative tax rate percentage and the denominator of which
is 39.6 percent (the current highest applicable tax rate for
individuals under section 1). All of the examples assume that all
capital gains and losses are long-term capital gains and losses.
(Therefore, in these examples, capital gain net income equals net
capital gain, and for convenience both are referred to in the
examples as net capital gain in calculating the rate differential
adjustments). In addition, all dollar amounts in the examples are
abbreviated from amounts in the thousands (e.g., $50 represents
$50,000). The examples are as follows:

Example 1.

(i) A, an individual, has foreign source items only in the passive
category for the taxable year. A has $1,000 of capital gains from
sources outside the United States, which would be taxed at a rate of
20 percent under section 1(h). A has $700 of capital losses from
sources outside the United States, which resulted from the sale of
capital assets held for more than one year. If the sale had resulted
in gain rather than loss, the gain would have been taxed at a rate
of 20 percent under section 1(h). For the same taxable year, A has
$800 of capital gains from sources within the United States that are
taxed at a rate of 28 percent under section 1(h). A also has $100 of
capital losses from sources within the United States. If the sale or
exchange generating such capital losses had instead yielded a
capital gain, such gain would have been subject to tax at a rate of
20 percent under section 1(h). A also has $500 of ordinary income
from sources within the United States.

(ii) A's items of ordinary income, capital gain and capital loss for
the taxable year are summarized in the following table:

                |                |  foreign source:
                |  U.S. source   |      passive
----------------+----------------+----------------------
20% rate group  |    ($100)      |        $1,000
                |                |        ($700)
----------------+----------------+----------------------
25% rate group  |                |
----------------+----------------+----------------------
28% rate group  |     $800       |
----------------+----------------+----------------------
ordinary income |     $500       |
----------------+----------------+----------------------


(iii) A's capital gain net income from sources outside the United
States ($300) does not exceed A's capital gain net income from all
sources ($1,000). Therefore, paragraph (a)(1) of this section does
not require any reduction of A's capital gain net income in the
passive category.

(iv) In computing A's taxable income from sources outside the United
States in the numerator of the section 904(a) foreign tax credit
limitation fraction for the passive category, capital gains and
losses from sources outside the United States are netted within rate
groups and within separate categories. See paragraphs (a)(2), (c)
(1), and (d)(1) of this section. The $1,000 of capital gain less the
$700 of capital loss yields $300 of net capital gain in the 20
percent rate group in the passive category. A must adjust the
resulting net capital gain in the passive category as required under
section 904(b)(2)(B)(i) and paragraph (c)(1) of this section, using
20 percent as the alternative tax rate, as follows: $300(20%/39.6%).

(v) In computing A's entire taxable income in the denominator of the
section 904(a) foreign tax credit limitation fraction, A must
combine the $300 net capital gain from sources outside the United
States and the $100 net capital loss from sources within the United
States in the same rate group (20 percent). A must adjust the
resulting $200 ($300 - $100) of net capital gain in the 20 percent
rate group as required under section 904(b)(2)(B)(ii) and paragraph
(c)(2) of this section, using 20 percent as the alternative tax
rate, as follows: $200(20%/39.6%). A must also adjust the $800 of
net capital gain in the 28 percent rate group, using 28 percent as
the alternative tax rate, as follows: $800(28%/39.6%).

(vi) A's passive category foreign tax credit limitation is computed
as follows:

               $300(20%/39.6%)
   ----------------------------------------
   $500 + $200(20%/39.6%) + $800(28%/39.6%)

Example 2.

(i) X, an individual, has the following items of ordinary
income, capital gain, and capital loss for the taxable year:

                |                 |    foreign source:
                |                 +---------------------------
                |  U.S. source    |   general  |   passive
----------------+-----------------+------------+--------------
20% rate group  |     $300        |   ($500)   |    $100
----------------+-----------------+------------+--------------
25% rate group  |     $200        |            |
----------------+-----------------+------------+--------------
28% rate group  |     $500        |   ($300)   |
----------------+-----------------+------------+--------------
ordinary income |    $1,000       |    $500    |    $500
----------------+-----------------+------------+--------------

(ii) X's capital gain net income from sources outside the United
States in the aggregate (zero, since losses exceed gains) does not
exceed X's capital gain net income from all sources ($300).
Therefore, paragraph (a)(1) of this section does not require any
reduction of X's capital gain net income in the passive category.

(iii) In computing X's taxable income from sources outside the
United States in the numerators of the section 904(a) foreign tax
credit limitation fractions for the passive and general limitation
categories, X must adjust capital gain net income and net capital
losses as provided in section 904(b)(2)(B)(i) and

(iii) and paragraphs (c)(1) and (d)(1) of this section.

(A) First, capital gains and losses from sources outside the United
States are netted within rate groups and within separate categories.
There are no such amounts to be netted in this case.

(B) Because X has net capital losses in the general limitation
category, under paragraph (d)(2)(ii) of this section X's net capital
losses from sources outside the United States in each rate group are
netted against net capital gains from sources outside the United
States in other separate categories in the same rate group. Thus,
$100 of the $500 net capital loss in the 20 percent rate group in
the general limitation category offsets $100 of net capital gain in
the 20 percent rate group in the passive category. The $100 net
capital gain remains in the passive category and is adjusted under
paragraph (c)(1) of this section as follows: $100(20%/39.6%). The
$100 net capital loss remains in the general limitation category and
is adjusted under paragraph (d)(1) of this section as follows:
$100(20%/39.6%).

(C) Next, under paragraph (d)(2)(iv)(A) of this section, X's net
capital losses from sources outside the United States in any rate
group and in any separate category are netted against net capital
gains in the same rate group from sources within the United States.
Thus, $300 of the $500 net capital loss in the 20 percent rate group
in the general limitation category offsets $300 of net capital gain
in the 20 percent rate group from sources within the United States.
The $300 of net capital loss remains in the general limitation
category and is adjusted under paragraph (d)(1) of this section as
follows: $300(20%/39.6%). Similarly, the $300 of net capital loss in
the 28 percent rate group in the general limitation category offsets
$300 of net capital gain in the 28 percent rate group from sources
within the United States. The $300 net capital loss remains in the
general limitation category and is adjusted under paragraph (d)(1)
of this section as follows: $300(28%/39.6%).

(D) Next, under paragraph (d)(2)(iv)(B) of this section, the
remaining net capital losses in a rate group are netted against net
capital gains from other rate groups from sources within and outside
the United States. The remaining $100 of the $500 net capital loss
in the 20 percent rate group in the general limitation category
offsets $100 of the remaining net capital gain in the 28 percent
rate group from sources within the United States. The $100 of net
capital loss remains in the general limitation category and is
adjusted under paragraph (d)(1) of this section as follows:
$100(28%/39.6%).

(iv) In computing X's entire taxable income in the denominator of
the section 904(a) foreign tax credit limitation fractions, X must
adjust capital gain net income by netting all of X's capital gains
and losses, from sources within and outside the United States, and
adjusting any remaining net capital gains, based on rate category,
under section 904(b)(2)(B)(ii) and paragraph (c)(2) of this section.
X must also include foreign source ordinary income in the
numerators, and worldwide ordinary income in the denominator, of the
foreign tax credit limitation fractions. The denominator of X's
foreign tax credit limitation fractions reflects $2,000 of worldwide
ordinary income, $100 of U.S.-source net capital gain taxed at the
28% rate and adjusted as follows: $100(28%/39.6%), and $200 of U.S.-
source net capital gain taxed at the 25% rate and adjusted as
follows: $200(25%/39.6%).

(v) X's general limitation foreign tax credit limitation is computed
as follows:

$500 - $100(20%/39.6%) - $300(20%/39.6%) - $300(28%/39.6%) -
$100(28%/39.6%)
------------------------------------------------------------
$1,000 + $500 + $500 + $100(28%/39.6%) + $200(25%/39.6%)

(vi) X's passive category foreign tax credit limitation is
computed as follows:

                  $500 + $100(20%/39.6%)
------------------------------------------------------------
  $1,000 + $500 + $500 + $100(28%/39.6%) + $200(25%/39.6%)

Example 3.

(i) Y, an individual, has the following items of ordinary
income, capital gain, and capital loss for the taxable year:

                |                 |    foreign source:
                |                 +---------------------------
                |  U.S. source    |   general  |   passive
----------------+-----------------+------------+--------------
20% rate group  |      $300       |   ($720)   |    ($80)
----------------+-----------------+------------+--------------
25% rate group  |      $200       |            |
----------------+-----------------+------------+--------------
28% rate group  |      $500       |   ($150)   |     $50
----------------+-----------------+------------+--------------
ordinary income |     $1,000      |   $1,000   |     $500
----------------+-----------------+------------+--------------

(ii) Y's capital gain net income from sources outside the United
States (zero, since losses exceed gains) does not exceed Y's capital
gain net income from all sources ($100). Therefore, paragraph (a)(1)
of this section does not require any adjustment.

(iii) In computing Y's taxable income from sources outside the
United States in the numerators of the section 904(a) foreign tax
credit limitation fractions for the passive and general limitation
categories, Y must adjust capital gain net income and net capital
losses as provided in section 904(b)(2)(B)(i) and (iii) and
paragraphs (c)(1) and (d)(1) of this section. Since Y has no capital
gain net income in any separate category, the only adjustments are
those required under section 904(b)(2)(B)(iii) and paragraph (d)(1)
of this section.

(A) Under paragraph (d)(2)(ii) of this section, $50 of Y's $150 net
capital loss in the 28 percent rate group in the general limitation
category offsets $50 of net capital gain in the 28 percent rate
group in the passive category. The $50 of net capital loss remains
in the general limitation category and is adjusted as follows:
$50(28%/39.6%). The $50 of net capital gain remains in the passive
category and is adjusted as follows: $50(28%/39.6%).

(B) Under paragraph (d)(2)(iv)(A) of this section, the remaining
$100 of net capital loss in the 28 percent rate group in the general
limitation category offsets $100 of net capital gain in the 28
percent rate group from sources within the United States. The $100
of net capital loss remains in the general limitation category and
is adjusted as follows: $100(28%/39.6%).

(C) Under paragraph (d)(2)(iv)(A) of this section, the $300 of net
capital gain in the 20 percent rate group from sources within the
United States is reduced proportionately by the net capital losses
in the 20 percent rate group in the passive and general limitation
categories. The proportionate amount of the $720 net capital loss
remains in the general limitation category, adjusted as follows:
$300($720/$800)(20%/39.6%). The proportionate amount of the $80 net
capital loss remains in the passive category, adjusted as follows:
$300($80/$800)(20%/39.6%).

(D) Of the remaining $500 of net capital loss in the 20 percent rate
group (in the general limitation and passive categories), $400
offsets the remaining $400 of net capital gain in the 28 percent
rate group from sources within the United States under paragraph (d)
(2)(iv)(B)(3) of this section. The proportionate amount of the $720
net capital loss remains in the general limitation category,
adjusted as follows: $400($720/$800)(28%/39.6%). The proportionate
amount of the $80 net capital loss remains in the passive category,
adjusted as follows: $400($80/$800)(28%/39.6%).

(E) Under paragraph (d)(2)(iv)(B)(3) of this section, the remaining
$100 of net capital loss in the 20 percent rate group (in the
general limitation and passive limitation categories) offsets $100
of net capital gain in the 25 percent rate group from sources within
the United States. The proportionate amount of the $720 net capital
loss remains in the general limitation category, adjusted as
follows: $100($720/$800)(25%/39.6%). The proportionate amount of the
$80 net capital loss remains in the passive category, adjusted as
follows: $100($80/$800)(25%/39.6%).

(iv) In computing Y's entire taxable income in the denominator of
the section 904(a) foreign tax credit limitation fractions, Y must
adjust capital gain net income by netting all of Y's capital gains
and losses, from sources within and outside the United States, and
adjusting any remaining net capital gains, based on rate category,
under section 904(b)(2)(B)(ii) and paragraph (c)(2) of this section.
Y must also include foreign source ordinary income in the
numerators, and worldwide ordinary income in the denominator, of the
foreign tax credit limitation fractions. The denominator of Y's
foreign tax credit limitation fractions reflects $2,500 of worldwide
ordinary income and $100 of U.S.-source net capital gain taxed at
the 25% rate and adjusted as follows: $100(25%/39.6%).

(v) Y's general limitation foreign tax credit limitation is computed
as follows:

$1,000 - $50 (28%/39.6) - $100(28%/39.6%) -
$300($720/$800)(20%/39.6%) - $400($720/$800)(28%/39.6%) -
$100($720/$800)(25%/39.6%)
----------------------------------------------------------
       $1,000 + $1,000 + $500 + $100(25%/39.6%)

(vi) Y's passive category foreign tax credit limitation is computed
as follows:

   $500 + $50(28%/39.6%) - $300($80/$800)(20%/39.6%) -
   $400($80/$800)(28%/39.6%) - $100($80/$800)(25%/39.6%)
----------------------------------------------------------
         $1,000 + $1,000 + $500 + $100(25%/39.6%)

(g) Coordination with overall foreign loss recapture rules. Section
904(b) and this section shall apply before the provisions of section
904(f). Therefore, the amount of a taxpayer's separate limitation
income or loss in each separate category, the amount of overall
foreign loss, and the amount of any additions to or recapture of
separate limitation loss or overall foreign loss accounts pursuant
to section 904(f) shall be determined after applying section 904(b)
and this section to adjust capital gains and losses in each separate
category.

(h) Effective date. This section shall apply to taxable years
beginning after the date this regulation is published in the Federal
Register as a final regulation. Par. 9. Section 1.904(b)-2 is
revised to read as follows: §1.904(b)-2 Special rules for
application of section 904(b) to alternative minimum tax foreign tax
credit.

(a) Application of section 904(b)(2)(B) adjustments. Section 904(b)
(2)(B) shall apply for purposes of determining the alternative
minimum tax foreign tax credit under section 59 (regardless of
whether or not the taxpayer has made an election under section 59(a)
(4)).

(b) Use of alternative minimum tax rates--(1) Taxpayers other than
corporations. In the case of a taxpayer other than a corporation,
for purposes of determining the alternative minimum tax foreign tax
credit under section 59--

(i) Section 904(b)(3)(D)(i) shall be applied by substituting
"section 55(b)(3)" for "subsection (h) of section 1";

(ii) Section 904(b)(3)(E)(ii)(I) shall be applied by substituting
"section 55(b)(1)(A)(i)" for "subsection (a), (b), (c), (d), or (e)
of section 1 (whichever applies)"; and (iii) Section 904(b)(3)(E)
(iii)(I) shall be applied by substituting "the alternative rate of
tax determined under section 55(b)(3)" for "the alternative rate of
tax determined under section 1(h)."

(2) Corporate taxpayers. In the case of a corporation, for purposes
of determining the alternative minimum tax foreign tax credit under
section 59, section 904(b)(3)(E)(ii)(II) shall be applied by
substituting" section 55(b)(1)(B)" for "section 11(b)."

(c) Effective date. This section shall apply to taxable years
beginning after the date this section is published as a final
regulation in the Federal Register.

§§1.904(b)-3 and 1.904(b)-4 [Removed]

Par. 10. Sections 1.904(b)-3 and 1.904(b)-4 are removed.

Par. 11. Section 1.904(j)-1 is added to read as follows:

§1.904(j)-1 Certain individuals exempt from foreign tax credit
limitation.

(a) Election available only if all foreign taxes are creditable
foreign taxes. A taxpayer may elect to apply section 904(j) for a
taxable year only if all of the taxes for which a credit is
allowable to the taxpayer under section 901 for the taxable year
(without regard to carryovers) are creditable foreign taxes (as
defined in section 904(j)(3)(B)).

(b) Coordination with carryover rules--(1) No carryovers to or from
election year. If the taxpayer elects to apply section 904(j) for
any taxable year, then no taxes paid or accrued by the taxpayer
during such taxable year may be deemed paid or accrued under section
904(c) in any other taxable year, and no taxes paid or accrued in
any other taxable year may be deemed paid or accrued under section
904(c) in such taxable year.

(2) Carryovers to and from other years determined without regard to
election years. The amount of the foreign taxes paid or accrued, and
the amount of the foreign source taxable income, in any year for
which the taxpayer elects to apply section 904(j) shall not be taken
into account in determining the amount of any carryover to or from
any other taxable year. However, an election to apply section 904(j)
to any year does not extend the number of taxable years to which
unused foreign taxes may be carried under section 904(c) and
§1.904-2(b). Therefore, in determining the number of such carryover
years, the taxpayer must take into account years to which a section
904(j) election applies.

(3) Determination of amount of creditable foreign taxes. Otherwise
allowable carryovers of foreign tax credits from other taxable years
shall not be taken into account in determining whether the amount of
creditable foreign taxes paid or accrued by an individual during a
taxable year exceeds $300 ($600 in the case of a joint return) for
purposes of section 904(j)(2)(B).

(c) Examples. The following examples illustrate the provisions of
this section:

Example 1. In 2001, X, a single individual using the cash basis
method of accounting for income and foreign tax credits, pays $100
of foreign taxes with respect to general limitation income that was
earned and included in income for United States tax purposes in
2000. The foreign taxes would be creditable under section 901 but
are not shown on a payee statement furnished to X. X's only income
for 2001 from sources outside the United States is qualified passive
income, with respect to which X pays $200 of creditable foreign
taxes shown on a payee statement. X may not elect to apply section
904(j) for 2001 because some of X's foreign taxes are not creditable
foreign taxes within the meaning of section 904(j)(3)(B).

Example 2.

(i) In 2002, A, a single individual using the cash basis
method of accounting for income and foreign tax credits, pays
creditable foreign taxes of $250 attributable to passive income.
Under section 904(c), A may also carry forward to 2002 $100 of
unused foreign taxes paid in 1998 with respect to passive income,
$300 of unused foreign taxes paid in 1998 with respect to general
limitation income, $400 of unused foreign taxes paid in 1999 with
respect to passive income, and $200 of unused foreign taxes paid in
1999 with respect to general limitation income. In 2002, A's only
foreign source income is passive income described in section 904(j)
(3)(A)(i), and this income is reported to A on a payee statement
(within the meaning of section 6724(d)(2)). If A elects to apply
section 904(j) for the 2002 taxable year, the unused foreign taxes
paid in 1998 and 1999 are not deemed paid in 2002, and A therefore
cannot claim a foreign tax credit for those taxes in 2002.

(ii) In 2003, A again is eligible for and elects the application of
section 904(j). The carry forwards from 1998 expire in 2003. The
carry forward period established under section 904(c) is not
extended by A's election under section 904(j). In 2004, A does not
elect the application of section 904(j). The $600 of unused foreign
taxes paid in 1999 on passive and general limitation income are
deemed paid in 2004, under section 904(c), without any adjustment
for any portion of those taxes that might have been used as a
foreign tax credit in 2002 or 2003 if section 904(j) had not
prevented A from carrying over taxes to those years.

(d) Effective date. Section 1.904(j)-1 applies to taxable years
beginning after December 31, 1997.

Par. 12. Section 1.954-2 is amended by:

1. Revising paragraph (b)(2)(iv), Example 2. 2. Removing paragraph
(b)(2)(iv), Example 3.

The revision reads as follows: §1.954-2 Foreign personal holding
company income.

* * * * *

(b) * * *

(2) * * *

(iv) * * *

Example 2.

(i) DS, a domestic corporation, wholly owns two
controlled foreign corporations organized in Country A, CFC1 and
CFC2. CFC1 purchases from DS property that DS manufactures in the
United States. CFC1 uses the purchased property as a component part
of property that CFC1 manufactures in Country A within the meaning
of §1.954-3(a)(4). CFC2 provides loans described in section 864(d)
(6) to unrelated persons in Country A for the purchase of the
property that CFC1 manufactures in Country A.

(ii) The interest accrued from the loans by CFC2 is not export
financing interest as defined in section 904(d)(2)(G) because the
property sold by CFC1 is not manufactured in the United States under
§1.927(a)-1T(c). No portion of the interest is export financing
interest as defined in this paragraph (b)(2). The full amount of the
interest is, therefore, included in.foreign personal holding company
income under paragraph (b)(1)(ii) of this section.

* * * * *

Robert E. Wenzel
Deputy Commissioner of Internal Revenue.

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