Application of Section 904 to Income Subject to
Separate Limitations & Section 864(e) Affiliated Group
Expense Allocation & Apportionment Rules

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8916] RIN 1545-AY29

TITLE: Application of Section 904 to Income Subject to Separate
Limitations and Section 864(e) Affiliated Group Expense Allocation
and Apportionment Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains Income Tax Regulations relating to
the section 864(e)(5) and (6) rules on affiliated group interest and
other expense allocation and apportionment and to the section 904(d)
foreign tax credit limitation. Changes to the applicable laws were
made by the Tax Reform Act of 1986, the Technical and Miscellaneous
Revenue Act of 1988, the Revenue Reconciliation Act of 1993, and the
Taxpayer Relief Act of 1997. These regulations provide guidance
needed to comply with those changes and affect individuals and
corporations claiming foreign tax credits..

DATES: Effective Date: These regulations are effective January 3,
2001. Applicability DATES: The specific dates of applicability of
these regulations are as follows: The amendments to
§§1.861-9, 1.861-11, and 1.861-14 generally apply to
taxable years beginning after December 31, 1989. The dates of
applicability are stated in §1.861- 9(h)(5)(iii),
§1.861-11(d)(2)(iv), and (d)(7), and §1.861-14 (d)(1) and
(d)(2)(iii).

The amendment to §1.904-4(b)(1)(i) applies to taxable years
beginning after December 31, 1992.

The amendments to §1.904-4(e)(3)(ii) and (e)(3)(iv) apply to
taxable years beginning after December 31, 2000. The amendments to
§1.902-1(d)(3)(ii), §1.904- 4(c)(5)(v), (c)(6)(iv), (c)(7)
(ii), (c)(7)(iii), (c)(8) Example 9, and (g)(3), and to
§1.904-5(d)(2) and (m) apply to taxable years beginning after
December 31, 1986.

However, for taxable years beginning before January 1, 2001,
taxpayers may rely on §1.904-4(c)(6)(iv) and (g)(3)(ii), (iii),
and (iv) of regulations project REG-209527-92, INTL-1- 92, published
at 1992-1 C.B. 1209. See §601.601(d)(2) of 26 CFR part 601
revised April 1, 2000.

The amendments to §1.904-5(a)(3), (g), (h)(4), and (i)(1), (3),
and (4) apply to taxable years beginning after December 31, 2000.
However, taxpayers may choose to apply the rule of §1.904-5(i)
(3) in taxable years beginning after. December 31, 1991, provided
that the taxpayer makes appropriate adjustments to eliminate any
double benefit arising from the application of the rule to taxable
years that are not open for assessment.

ADDRESSES: Send submissions to: Regulations Unit CC (REG-106409-
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-106409- 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.

FOR FURTHER INFORMATION CONTACT: Bethany A. Ingwalson at (202)
622-3850 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On May 14, 1992, a notice of proposed rulemaking (INTL-1- 92, 1992-1
C.B. 1209) was published in the Federal Register (57 FR 20660),
proposing amendments to the temporary Income Tax Regulations (26 CFR
part 1) under section 864(e)(5) and (6) and to the Income Tax
Regulations (26 CFR part 1) under section 904(d). The proposed
regulations under section 864(e)(5) and (6) concern the allocation
and apportionment of interest expense and certain other expenses
within an affiliated group for alternative. minimum tax purposes.
The proposed regulations under section 904(d) provide rules for
determining a taxpayer's foreign tax credit limitation.

Also on May 14, 1992, final regulations (TD 8412, 1992- 1 C.B. 271)
under section 904(d) of the Internal Revenue Code of 1986 (Code)
were published in the Federal Register (57 FR 20639). The final
regulations added provisions that were reserved in final regulations
(TD 8214, 1988-2 C.B. 220) published in the Federal Register (53 FR
27006) in 1988 and also made other changes to the 1988 final
regulations. Written comments were received with respect to the
final and proposed regulations and a public hearing was held on
September 24, 1992.

On July 8, 1996, additional proposed amendments to the Income Tax
Regulations under section 904 (REG-209750-95, 1996-2 C.B. 484) were
published in the Federal Register (61 FR 35696), addressing the
grouping rules under §1.904-4(c). On January 11, 1999, final
regulations (TD 8805, 1999-1 C.B. 371) were published in the Federal
Register (64 FR 1505) finalizing these amendments and portions of
the 1992 proposed regulations, with modifications.

The significant points raised by the comments to the 1992 final and
proposed regulations and at the hearing, and the changes made to the
proposed, temporary, and final regulations, are discussed in the
remainder of the preamble. After consideration of the comments
received, the below-. described amendments to the 1992 final
regulations under section 904 and to the final regulations under
section 864 are adopted as modified by this Treasury decision.

Explanation of Provisions

I. §§1.861-9, 1.861-11, and 1.861-14 The proposed
regulations under §§1.861-9, 1.861-11, and 1.861-14 are
finalized substantially as proposed, and the corresponding
provisions of the temporary regulations are removed. For purposes of
the alternative minimum tax (AMT), for taxable years beginning after
December 31, 1989, the dividends received deduction under section
243 does not apply to the portion of a dividend attributable to
income that is exempt from tax under section 936 or 30A. See section
56(g)(4)(C). Therefore, the exempt portion of the dividend is, in
effect, included in adjusted current earnings (ACE) for purposes of
computing the dividend recipient's alternative minimum taxable
income. Dividends from a corporation with respect to which an
election is in effect under section 936 or 30A (a section 936
corporation) are eligible for the dividends received deduction for
regular tax purposes. Section 243(b)(1)(B)(ii).

To the extent included in income, dividends from a section 936
corporation to an affiliated United States corporation do not
qualify for look-through treatment under section 904(d)(3) and
§1.904-5. Under sections 904, 861(a)(2)(A), and 862(a)(2), such
amounts generally are. treated as foreign source passive income
(except as otherwise provided in section 904(g)). For taxable years
beginning after December 31, 1993, section 56(g)(4)(C)(iii)(IV),
added to the Code as part of the Revenue Reconciliation Act of 1993
(Public Law 103-66, 107 Stat. 312)(RRA 1993), creates an AMT foreign
tax credit separate limitation for dividend income attributable to
income that is exempt from tax under section 936 or 30A.

The separate limitation applies solely for AMT purposes. Thus, for
taxable years beginning after December 31, 1989, and before January
1, 1994, the portion of the dividends from section 936 corporations
that are added back into alternative minimum taxable income as ACE
adjustments are subject to the separate limitation for passive
income under section 904(d)(2) for AMT foreign tax credit purposes.
For taxable years beginning after December 31, 1993, dividends from
section 936 corporations are subject to a separate AMT foreign tax
credit limitation. In addition, for taxable years beginning after
December 31, 1995, corporations eligible for a credit under section
30A are treated as section 936 corporations, under sections 30A(e)
and 56(g)(4)(C)(iii)(VI).

Treasury and the IRS proposed changes to the temporary regulations
in order to exclude section 936 corporations from the affiliated
group solely for purposes of allocating expenses in determining the
amount of the group's foreign.7 source alternative minimum taxable
income, which affects the AMT foreign tax credit. This change has
the effect of increasing the amount of interest and other expenses
apportioned to dividend income from a section 936 corporation. The
regulations were intended to mitigate the treatment, for AMT foreign
tax credit purposes, of section 936 corporation dividends as passive
income and would similarly mitigate the treatment of such dividends
as separate limitation income in post-1993 taxable years.

Commentators wrote and testified at the public hearing that Treasury
and the IRS do not have statutory authority to issue regulations
under section 864(e)(5) excluding section 936 corporations from the
affiliated group solely for AMT purposes. They contended that the
AMT and regular tax systems must remain parallel unless a deviation
is appropriate for simplification purposes. However, the enactment
of a separate limitation category for certain portions of dividends
from section 936 corporations for AMT purposes, effective for
taxable years beginning after 1993, demonstrates that, because of
the ACE adjustment, the AMT and regular tax foreign tax credit
systems cannot operate exactly alike with respect to dividend income
from section 936 corporations.

The amendments were proposed to apply to taxable years beginning
after December 31, 1991. In response to a comment, the applicability
date of the amendments to the. regulations under
§§1.861-9, 1.861-11, and 1.861-14 has been changed to
taxable years beginning after December 31, 1989, to conform to the
effective date of the statutory change. The regulations also provide
a definition of section 936 corporations that reflects the enactment
of section 30A.

In addition, the regulations move the flush text at the end of
§1.861-11T(d)(6) to a new §1.861-11(d)(7). The new
paragraph (d)(7) provides, among other things, that the attribution
rules of section 1563(e) rather than the rules of section 318 will
apply to determine indirect ownership for purposes of
§1.861-11T(d)(6). The change in the regulations to refer to
section 1563(e) is consistent with paragraph 7 of Notice 89-91
(1989-2 C.B. 408), which stated that the IRS intends that the
reference in §1.861-11T(d)(6) to section 318 should instead be
a reference to section 1563(e), effective for all post-1986 taxable
years.

II. §1.904

A. Changes to the 1992 Proposed Regulations.

1. Distributions From Controlled Foreign Corporations That are not
Eligible for Look-Through Treatment Section 1.904-4(g)(3)(i)
provides that distributions made by a controlled foreign corporation
(CFC) from earnings and profits accumulated before the distributing
corporation became a CFC are treated as dividends from a
noncontrolled section 902 corporation. The final regulations
reorganize the provisions of §1.904-4(g)(3) and include a
reserved paragraph at §1.904-4(g)(3)(i)(C). The regulations
are. proposed to be amended in a separate document (REG-104683- 00)
published elsewhere in this issue of the Federal Register to address
the effect of an intervening period when the corporation was not a
CFC on the eligibility of the distributions for look-through
treatment.

Prior to amendment by the Taxpayer Relief Act of 1997 (Public Law
105-34, 107 Stat. 312)(TRA 1997), section 904(d)(2)(E)(i) provided
that a CFC would not be treated as a noncontrolled section 902
corporation with respect to distributions from earnings and profits
that were accumulated while the corporation was a CFC and, except as
provided in regulations, the taxpayer was a United States
shareholder in such corporation. The rule limiting look-through
treatment to earnings and profits accumulated while the taxpayer was
a United States shareholder was repealed by TRA 1997, applicable for
distributions after August 5, 1997.

With respect to distributions before August 6, 1997,
§1.904-4(g)(3)(ii) through (iv) of the proposed regulations
significantly limited the circumstances under which a dividend paid
to a new United States shareholder by a CFC out of earnings and
profits accumulated while it was a CFC (but before the recipient
became a United States shareholder) would be treated as dividends
from a noncontrolled section 902 corporation. The final regulations
at §1.904-4(g)(3)(ii)(A) retain the proposed rule denying look-
through treatment only to new United Sates. shareholders that
acquire more than 90 percent of a CFC. This rule relaxed the
statutory limitation to the extent necessary to avoid the
administrative burdens that would arise if more than one United
States shareholder were entitled to look-through treatment on
distributions of post-1986 undistributed earnings but the look-
through pools for each new shareholder began in different years.

Commentators argued that the regulations should be further expanded
to allow look-through on pre-acquisition earnings for all new
shareholders that acquire at least 10 percent of the voting power of
the stock of a CFC, that is, to all new shareholders entitled to
compute a credit for deemed-paid taxes under section 902 and section
960. Treasury and the IRS declined to adopt the suggestion, because
the proposed regulations already relaxed the statutory requirement
to an appropriate extent.

A commentator suggested that the intra-group acquisition rule in
§1.904-4(g)(3)(ii)(C) of the proposed regulations (paragraph
(g)(3)(ii)(B) of the final regulations) should be revised to apply
when the new and old shareholders of a CFC are related under the
attribution rules of sections 318 and 958, rather than only to
transfers within an affiliated group. Other commentators requested
that the exception be expanded to apply to nontaxable transfers of
stock in which the new and old shareholders cease to be members of
the same affiliated group. Treasury. and the IRS decline to expand
the scope of the intra-group exception to the 90-percent shareholder
rule, which applies only for distributions prior to August 6, 1997.
The final regulations clarify the rule of the proposed regulations
that the dividend recipient and the immediately preceding owner (or
owners) must be members of the same affiliated group both when the
recipient acquires the stock of the distributing corporation from
the immediately preceding owner and when the recipient receives the
dividend.

In response to a comment, the regulations clarify the LIFO ordering
rule in §1.904-4(g)(3)(iii) of the proposed regulations
(paragraph (g)(3)(ii)(C) of the final regulations) for determining
whether a distribution from a CFC is attributable to the period
after a more-than-90- percent United States shareholder became a
United States shareholder. The final regulations state that such a
distribution comes first from the pool of post-acquisition
undistributed earnings, next from the 10/50 pool of post-1986
undistributed earnings attributable to the pre-acquisition period,
if any, and finally on a LIFO basis from any pre-acquisition
earnings and profits attributable to pre-1987 accumulated profits.

To reflect the amendments made to section 904(d)(2)(E)(i) by TRA
1997, the final regulations provide at §1.904-4(g)(3)(ii)(D)
that the denial of look-through treatment to new more-than-90-
percent shareholders for.12 distributions of earnings and profits
accumulated before the recipient became a United States shareholder
applies only to distributions made before August 6, 1997. Section
1.904- 4(g)(3) has been reorganized to separate the rules under
section 904(d)(2)(E) that are applicable to distributions after
August 5, 1997, from the rules that are applicable only to
distributions on or before that date.

Rules substantially identical to the proposed section 904
regulations were proposed in 1995 under section 902. See Prop. Reg.
§1.902-1(d)(2)(ii) through (iv) (69 FR 2049; 1995-1 C.B. 959,
970), and the reserved paragraph at §1.902- 1(d)(3)(ii)(1997).
A commentator noted that the effective date included in the proposed
section 902 regulations applied to taxable years beginning after
December 31, 1986, while the proposed applicability date for the
substantially identical regulations proposed under section 904(d)
applied to taxable years beginning after December 31, 1991. Since
section 904(d)(2)(E)(i) applies to all taxable years beginning after
1986, the final regulations adopt the earlier applicability date,
and amend the reserved paragraph at §1.902-1(d)(3)(ii) to add a
cross reference to the final section 904 regulations.

2. Succeeding Shareholders' Treatment of Additional Taxes on
Previously Taxed Income Recognized by Prior Shareholders In response
to a comment, §1.904-4(c)(6)(iv) of the proposed regulations is
revised. Section 1.904-4(c)(6). provides rules for applying the
high-tax kick-out from the passive limitation category when
additional taxes are paid or deemed paid with respect to a
distribution of previously taxed passive income that had been
included in income in an earlier year under section 951(a)(1).
Paragraph (c)(6)(iv) applies when a new shareholder acquires stock
in a controlled foreign corporation after income has been included
in the prior shareholder's income under section 951(a)(1) but before
the income is distributed and subjected to additional foreign tax.

As proposed, paragraph (c)(6)(iv) provided that new shareholders
entitled to look-through treatment on distributions of pre-
acquisition earnings (U.S. shareholders that acquired 90 percent or
less of the distributing corporation) would place the additional
taxes in the general limitation category. However, new shareholders
who were not entitled to look-through treatment (because the
shareholder acquired more than 90 percent of the distributing
corporation) would place the taxes in the general limitation or
noncontrolled section 902 corporation category, depending on whether
or not the associated income inclusion of the prior shareholder was
high-taxed income.

A commentator argued that the latter rule's dependence on whether
income was high-taxed or not in the hands of the previous
shareholder, for purposes of determining the treatment of the taxes
in the hands of a new 90-percent. shareholder, added unnecessary
complexity. In response to the comment, the regulations amend
§1.904-4(c)(6)(iv) to provide that a shareholder not entitled
to look-through on pre-acquisition earnings must treat the
additional taxes as allocable to the noncontrolled section 902
corporation dividend category. The revised rule applies to taxable
years beginning after December 31, 1991. However, taxpayers may rely
on the proposed regulations for taxable years beginning before
January 1, 2001.

The final regulations adopt the proposed rule that a shareholder
entitled to look-through treatment on pre-acquisition earnings
treats additional taxes imposed on distributions of previously taxed
passive income as allocable to the general limitation category. This
rule applies to all distributions of previously taxed passive income
after August 5, 1997.

3. Special Rules for Dividends Between CFCs

Section 1.904-5(i)(3) of the proposed regulations, reducing to ten
percent the common ownership threshold for dividends between CFCs to
qualify for look-through treatment, is finalized as proposed,
applicable to taxable years beginning after December 31, 2000.
However, taxpayers may choose to apply the rule to taxable years
beginning after December 31, 1991, so long as appropriate
adjustments are made to eliminate any double benefit arising from
the application of the rule to taxable years that are not open. for
assessment. Example 2 of proposed §1.904-5(i)(4) is also
finalized, with modifications described in II B.4 of this preamble,
below, relating to changes to correct errors in Example 1 in the
1992 final regulations.

B. Changes to the 1992 Final Regulations.

1. Passive Limitation FOGEI Income

Section 1.904-4(b)(1)(i) is amended to clarify that, for taxable
years beginning after December 31, 1992, passive income does not
exclude foreign oil and gas extraction income (as defined in section
907(c)). This amendment reflects the repeal of section 904(d)(2)(A)
(iii)(IV), which excluded FOGEI from the definition of passive
income, by section 13235(a)(2) of RRA 1993.

2. High-tax Kickout

Section 1.904-4(c)(4)(ii) is revised to reflect the addition of
§1.904-4(c)(3)(iv).

3. Reduction in Tax on Distribution of Previously Taxed Income

The 1992 final regulations, which generally look to foreign law
rules for purposes of determining the year or years to which a
reduction in foreign tax relates, were intended to apply LIFO
default rules in order to avoid multiple redeterminations under
section 905(c) in situations where a tax reduction applies to a
distribution of previously taxed income that is treated under
foreign law as made out of a multi-year pool of income. See
§1.905-3T(f) (requiring a redetermination of deemed paid taxes,
in lieu. of a pooling adjustment, when corporate tax is reduced in
connection with a distribution of previously taxed income).

In response to a comment, §1.904-4(c)(7)(ii) and
§1.904-4(c)(8) Example 9 are revised to clarify that if a
foreign country's law allocates a foreign tax reduction to a pool or
group containing income from more than one taxable year, and that
pool or group is defined based on a characteristic of the income
(for example, the rate of tax paid with respect to the income)
rather than based on the taxable year in which the income is
derived, then foreign law is not considered to specify a year or
years to which the tax reduction applies and the last-in first-out
(LIFO) default rule applies.

In response to a comment, a new paragraph (c)(5)(v) has been added
to §1.904-4 to supply a cross-reference to the rule that,
pursuant to the general rule of section 904(d)(3)(E), passive income
excluded from foreign personal holding company income under the
subpart F high tax exception of section 954(b)(4) will be treated as
general limitation income at the CFC level unless the special rule
in §1.904-4(c)(7)(iii) applies.

4. Examples Illustrating Look-Through Rules for Dividends and
Interest

In response to comments, §1.904-5(i)(4) Example 1 and Prop.
§1.904-5(i)(4) Example 2 are revised. The 1992 version of
Example 1 was erroneous because, although the first-tier CFC in that
example owns only 40 percent of the. second-tier CFC, the second-
tier CFC owns 100 percent of the third-tier CFC. Therefore, the
second- and third-tier CFCs are related look-through entities and
the look-through rules of §1.904-5(i)(1) apply to interest
payments between them. The section 904(d)(3)(B) look-through rule
for subpart F inclusions applies to the U.S. parent's recognition of
subpart F income of the second-tier CFC, attributable to the
interest paid by the third-tier CFC.

Example 2 of the proposed regulations reached the correct result but
applied an incorrect rationale. Just as in Example 1, on the facts
of proposed Example 2, the related look-through entity rules of
§1.904-5(i)(1) would apply to distributions between the second-
and third-tier CFCs even without the application of the special rule
for dividends in proposed §1.904-5(i)(3). Examples 1 and 2 are
revised to illustrate the different ownership thresholds that are
required in order for the look-through rules to apply to interest
and dividends paid between CFCs. The regulations also add a new
Example 3 to further clarify the application of §1.904-5(i).

5. Treatment of Section 951(a)(1)(B) Inclusions as Dividends

Paragraph (m)(4) of §1.904-5 is amended to clarify that, for
purposes of the section 904(g) re-sourcing rules, section 951(a)(1)
(B) inclusions are treated as dividends sourced under the pro rata
rule of section 904(g)(4) and §1.904-5(m)(4). Section 904(g)(2)
provides a rule for.18 sourcing section 951(a) inclusions, which
literally include section 956 inclusions described in section 951(a)
(1)(B). Section 904(g)(2) treats an amount described in section
951(a) as U.S. source income to the extent it is attributable to
items of U.S. source income of the foreign corporation. Inclusions
under section 951(a)(1)(A) are measured by tracing the inclusion
directly to the items of income received by a CFC. Like an actual
dividend, an increase in earnings invested in U.S. property that is
included in income under section 951(a)(1)(B) is treated as paid pro
rata out of all of the CFC's earnings and profits. See
§1.904-5(c)(4)(i). The final regulations amend §1.904-
5(m)(4)(i) to clarify that section 904(g)(2) sources section 951(a)
(1)(B) inclusions by applying the pro rata rules of section 904(g)
(4).

6. Treatment of Base Differences in the Case of Financial Services
Entities

A commentator requested that §1.904-6(a)(1)(iv) be revised to
provide that, in the case of a financial services entity, if foreign
taxes are imposed on amounts that are not income under United States
tax rules (a base difference), the foreign taxes will be placed in
the limitation category for financial services income rather than
the general limitation category. The commentator argued that
financial services entities typically have no general limitation
income, and that the financial services category essentially serves
as the residual basket for financial services.19 entities.

Treasury and the IRS decline to adopt the suggested change. Treasury
and the IRS believe that most cases in which foreign tax is imposed
in the absence of a concurrent associated income inclusion in the
United States are properly analyzed as involving a timing difference
rather than a base difference. A timing difference occurs when
foreign tax is imposed on an item that would be income under United
States tax principles if it were recognized for U.S. tax purposes in
the same year. Treasury and the IRS believe that base differences
(in which foreign tax is imposed on an amount that the United States
would never recognize as income, such as a gift) rarely occur.
Accordingly, a special rule for base differences of financial
services entities is not required.

However, Treasury and the IRS are considering whether additional
rules are needed to clarify the operation of §1.904-6(a)(1)
(iv). For example, Treasury and the IRS are considering whether the
regulations should be revised to address explicitly situations in
which a foreign country and the United States recognize different
amounts of income or characterize the income differently, for
example, as a result of differences in calculating basis. Other
issues under consideration include the appropriate treatment of
situations in which a timing difference occurs but there is more
than one possible characterization of the income that. might be
recognized in the future for U.S. tax purposes, and situations in
which the United States and another country perceive different
taxpayers as realizing the same income (with or without a timing or
characterization difference). Comments are requested on the
appropriate scope and content of additional guidance on these types
of issues.

Treasury and the IRS are also considering clarifying
§1.904-6(a)(1), which provides rules for allocating foreign
taxes to separate categories. The current regulations determine the
income to which the foreign taxes relate by reference to foreign law
(taxes are related to income if the income is included in the tax
base upon which the foreign tax is imposed). Foreign taxes are
allocated and apportioned to separate categories by reference to the
separate categories to which the income taxed under foreign law
would be assigned under U.S. tax principles. See §1.904-6(c)
Example 5. Comments are requested on the manner in which the
regulations could be made easier to understand and apply.

Special Analyses

It has been determined that this Treasury decision 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 notice. of proposed rulemaking preceding the regulations
was issued prior to March 29, 1996, the Regulatory Flexibility Act
(5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of
the Code, the notice of proposed rulemaking preceding these
regulations was submitted to the Small Business Administration for
comment on its impact on small business.

Drafting Information

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

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Adoption of
Amendments to the Regulations Accordingly, 26 CFR part 1 is amended
as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
citations for §§1.861-9, 1.861-ll and

1.861-14 to read as follows:

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

Section 1.861-9 also issued under 26 U.S.C. 863(a), 26 U.S.C.
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f). * * *

Section 1.861-11 also issued under 26 U.S.C. 863(a), 26.22 U.S.C.
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).

Section 1.861-14 also issued under 26 U.S.C. 863(a), 26 U.S.C.
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).* * *

Par. 2. Section 1.861-9 is added to read as follows: §1.861-9
Allocation and apportionment of interest expense.

(a) through (h)(4) [Reserved]. For further guidance, see
§1.861-9T(a) through (h)(4).

(h)(5) Characterizing stock in related persons--

(i)General rule. Stock in a related person held by the taxpayer or
by another related person shall be characterized on the basis of the
fair market value of the taxpayer's pro rata share of assets held by
the related person attributed to each statutory grouping and the
residual grouping under the stock characterization rules of
§1.861-12T(c)(3)(ii), except that the portion of the value of
intangible assets of the taxpayer and related persons that is
apportioned to the related person under §1.861-9T(h)(2) shall
be characterized on the basis of the net income before interest
expense of the related person within each statutory grouping or
residual grouping (excluding income that is passive under
§1.904-4(b)).

(ii) Special rule for section 936 corporations regarding alternative
minimum tax. For purposes of characterizing stock in a related
section 936 corporation in determining foreign source alternative
minimum taxable income within each separate category and the
alternative. minimum tax foreign tax credit pursuant to section
59(a), the rules of §1.861-9T(g)(3) shall apply and
§1.861- 9(h)(5)(i) shall not apply. Thus, for taxable years
beginning after December 31, 1989, and before January 1, 1994, stock
in a related section 936 corporation is characterized for
alternative minimum tax purposes as a foreign source passive asset
because the stock produces foreign source passive dividend income
under sections 861(a)(2)(A), 862(a)(2), and 904(d)(2)(A) and the
regulations under those sections. For taxable years beginning after
December 31, 1993, stock in a related section 936 corporation would
be characterized for alternative minimum tax purposes as an asset
subject to the separate limitation for section 936 corporation
dividends because the stock produces foreign source dividend income
that, for alternative minimum tax purposes, is subject to a separate
foreign tax credit limitation under section 56(g)(4)(C)(iii)(IV).
However, stock in a section 936 corporation is characterized as a
U.S. source asset to the extent required by section 904(g). For the
definition of the term section 936 corporation see §1.861-11(d)
(2)(ii).

(iii) Effective date. This paragraph (h)(5) applies to taxable years
beginning after December 31, 1989. Par. 3. In §1.861-9T,
paragraph (h)(5) is revised to read as follows:

§1.861-9T Allocation and apportionment of interest expense
(temporary).

* * * * *

(h) * * *

(5) [Reserved]. For further guidance, see §1.861- 9(h)(5).

* * * * *

Par. 4. Section 1.861-11 is added to read as follows: §1.861-11
Special rules for allocating and apportioning interest expense of an
affiliated group of corporations.

(a) through (c) [Reserved]. For further guidance, see
§1.861-11T(a) through (c).

(d) Definition of affiliated group--(1) General rule. For purposes
of this section, in general, the term affiliated group has the same
meaning as is given that term by section 1504, except that section
936 corporations are also included within the affiliated group to
the extent provided in paragraph (d)(2) of this section. Section
1504(a) defines an affiliated group as one or more chains of
includible corporations connected through 80-percent stock ownership
with a common parent corporation which is an includible corporation
(as defined in section 1504(b)). In the case of a corporation that
either becomes or ceases to be a member of the group during the
course of the corporation's taxable year, only the interest expense
incurred by the group member during the period of membership shall
be allocated and apportioned as if all members of the group were a
single corporation. In this regard, assets. held during the period
of membership shall be taken into account. Other interest expense
incurred by the group member during its taxable year but not during
the period of membership shall be allocated and apportioned without
regard to the other members of the group.

(2) Inclusion of section 936 corporations--

(i) Rule--(A) In general. Except as otherwise provided in paragraph
(d)(2)(i)(B) of this section, the exclusion of section 936
corporations from the affiliated group under section 1504(b)(4) does
not apply for purposes of this section. Thus, a section 936
corporation that meets the ownership requirements of section 1504(a)
is a member of the affiliated group.

(b) Exception for purposes of alternative minimum tax. The exclusion
from the affiliated group of section 936 corporations under section
1504(b)(4) shall be operative for purposes of the application of
this section solely in determining the amount of foreign source
alternative minimum taxable income within each separate category and
the alternative minimum tax foreign tax credit pursuant to section
59(a). Thus, a section 936 corporation that meets the ownership
requirements of section 1504(a) is not a member of the affiliated
group for purposes of determining the amount of foreign source
alternative minimum taxable income within each separate category and
the alternative minimum tax foreign tax credit pursuant to section
59(a).

(ii) Section 936 corporation defined. For purposes of this section,
§1.861-9, and §1.861-14, the term section 936 corporation
means, for any taxable year, a corporation with an election in
effect to be eligible for the credit provided under section 936(a)
(1) or section 30A for the taxable year.

(iii) Example. This example illustrates the provisions of paragraph
(d)(2)(i) of this section: Example--(A) Facts. X owns all of the
stock of Y. XY constitutes an affiliated group of corporations
within the meaning of section 1504(a) and uses the tax book value
method of apportionment. In 2000, Y owns all of the stock of Z, a
section 936 corporation. Z manufactures widgets in Puerto Rico. Y
purchases these widgets and markets them exclusively in the United
States. Of the three corporations, only Z has foreign source income,
which includes both qualified possessions source investment income
and general limitation income. For purposes of section 904, Z's
qualified possessions source investment income constitutes foreign
source passive income. In computing the section 30A benefit, Y and Z
have elected the cost sharing method. Of the three corporations,
only X has debt and, thus, only X incurs interest expense.

(b) Analysis for regular tax. Assume first that X has no alternative
minimum tax liability. Under paragraph (d)(2) of this section, Z is
treated as a member of the XY affiliated group for purposes of
allocating and apportioning interest expense for regular tax
purposes. As provided in §1.861-11T(b)(2), section 864(e)(1)
and (5) do not apply in computing the combined taxable income of Y
and Z under section 936, but these rules do apply in computing the
foreign source taxable income of the XY affiliated group. The effect
of including Z in the affiliated group is that X, the only debtor
corporation in the group, must, under the asset method described in
§1.861-9T(g), apportion a part of its interest expense to
foreign source passive income and foreign source general limitation
income. This is because the assets of Z that generate qualified
possessions source investment income and general limitation income
are included in computing the group apportionment fractions. The
result is that, under section 904(f), X has an overall foreign loss
in both the passive and general limitation categories, which
currently offsets domestic income and must be recaptured against any
subsequent years' foreign passive income and general limitation
income, respectively, under the rules of. that section.

(c) Analysis for alternative minimum tax. Assume, alternatively,
that X is liable to pay the alternative minimum tax. Pursuant to
section 59(a), X must compute its alternative minimum tax foreign
tax credit as if section 904 were applied on the basis of
alternative minimum taxable income instead of taxable income. Under
paragraph (d)(2)(i)(B) of this section, for purposes of the
apportionment of interest expense in determining alternative minimum
taxable income within each limitation category, Z is not considered
a member of the XY affiliated group. Thus, the stock (and not the
assets) of Z are included in computing the group apportionment
fractions. Pursuant to sections 59(g)(4)(C)(iii)(IV), 861(a)(2)(A),
and 862(a)(2), dividends paid by a section 936 corporation are
foreign source income subject to a separate foreign tax credit
limitation for alternative minimum tax purposes. Thus, under
§1.861-9T(g)(3), the stock of Z must be considered attributable
solely to the statutory grouping consisting of foreign source
dividends from Z. The effect of excluding Z from the affiliated
group is that X must apportion a part of its interest expense to the
separate category for foreign source dividends from Z in computing
alternative minimum taxable income within each separate category.
If, as a result, under section 904(f), X has a separate limitation
loss or an overall foreign loss in the category for dividends from Z
for alternative minimum tax purposes, then that loss must be
allocated against X's other income (separate limitation or United
States source, as the case may be). The loss must be recaptured in
subsequent years under the rules of section 904(f) for purposes of
the alternative minimum tax foreign tax credit. * * * (iv) Effective
date. This paragraph (d)(2) applies to taxable years beginning after
December 31, 1989. (d)(3) through (6) [Reserved]. For further
guidance see §1.861-11T(d)(3) through (6).

(7) Special rules for the application of §1.861- 11T(d)(6). The
attribution rules of section 1563(e) and the regulations under that
section shall apply in determining indirect ownership under
§1.861-11T(d)(6). The Commissioner shall have the authority to
disregard trusts, partnerships,. and pass-through entities that
break affiliated status. Corporations described in
§1.861-11T(d)(6) shall be considered to constitute members of
an affiliated group that does not file a consolidated return and
shall therefore be subject to the limitations imposed under
§1.861-11T(g). The affiliated group filing a consolidated
return shall be considered to constitute a single corporation for
purposes of applying the rules of §1.861-11T(g). For taxable
years beginning after December 31, 1989, §1.861-11T(d)(6)(i)
shall not apply in determining foreign source alternative minimum
taxable income within each separate category and the alternative
minimum tax foreign tax credit pursuant to section 59(a) to the
extent that such application would result in the inclusion of a
section 936 corporation within the affiliated group. This paragraph
(d)(7) applies to taxable years beginning after December 31, 1986.

(e) through (g) [Reserved]. For further guidance, see
§1.861-11T(e) through (g). Par. 5. Section 1.861-11T is amended
by:

1. Revising paragraphs (d)(1) and (d)(2).

2. Removing the concluding text following (d)(6)(ii).

3. Adding paragraph (d)(7).

The revisions and additions read as follows: §1.861-11T Special
rules for allocating and apportioning interest expense of an
affiliated group of corporations (temporary).

* * * * *

(d) (1) and (2) [Reserved]. For further guidance, see
§1.861-11(d)(1) and (2).

* * * * *

(7) Special rules for the application of §1.861- 11T(d)(6).
[Reserved]. For special rules for the application of
§1.861-11T(d)(6), see §1.861-11(d)(7).

* * * * *

Par. 6. Section 1.861-14 is added to read as follows: §1.861-14
Special rules for allocating and apportioning certain expenses
(other than interest expense) of an affiliated group of
corporations.

(a) through (c) [Reserved]. For further guidance, see
§1.861-14T(a) through (c).

(d) Definition of affiliated group--(1) General rule. For purposes
of this section, the term affiliated group has the same meaning as
is given that term by section 1504, except that section 936
corporations (as defined in §1.861- 11(d)(2)(ii)) are also
included within the affiliated group to the extent provided in
paragraph (d)(2) of this section. Section 1504(a) defines an
affiliated group as one or more chains of includible corporations
connected through 80% stock ownership with a common parent
corporation which is an includible corporation (as defined in
section 1504(b)). In the case of a corporation that either becomes
or ceases to be a member of the group during the course of the.30
corporation's taxable year, only the expenses incurred by the group
member during the period of membership shall be allocated and
apportioned as if all members of the group were a single
corporation. In this regard, the apportionment factor chosen shall
relate only to the period of membership. For example, if
apportionment on the basis of assets is chosen, the average amount
of assets (tax book value or fair market value) for the taxable year
shall be multiplied by a fraction, the numerator of which is the
number of months of the corporation's taxable year during which the
corporation was a member of the affiliated group, and the
denominator of which is the number of months within the
corporation's taxable year. If apportionment on the basis of gross
income is chosen, only gross income generated during the period of
membership shall be taken into account. If apportionment on the
basis of units sold or sales receipts is chosen, only units sold or
sales receipts during the period of membership shall be taken into
account. Expenses incurred by the group member during its taxable
year, but not during the period of membership, shall be allocated
and apportioned without regard to other members of the group. This
paragraph (d)(1) applies to taxable years beginning after December
31, 1989.

(2) Inclusion of section 936 corporations--

(i) General rule. Except as otherwise provided in paragraph (d)(2)
(ii) of this section, the exclusion from the.31 affiliated group of
section 936 corporations under section 1504(b)(4) does not apply for
purposes of this section. Thus, a section 936 corporation that meets
the ownership requirements of section 1504(a) is a member of the
affiliated group.

(ii) Exception for purposes of alternative minimum tax. The
exclusion from the affiliated group of section 936 corporations
under section 1504(b)(4) shall be operative for purposes of the
application of this section solely in determining the amount of
foreign source alternative minimum taxable income within each
separate category and the alternative minimum tax foreign tax credit
pursuant to section 59(a). Thus, a section 936 corporation that
meets the ownership requirements of section 1504(a) is not a member
of the affiliated group for purposes of determining the amount of
foreign source alternative minimum taxable income within each
separate category and the alternative minimum tax foreign tax credit
pursuant to section 59(a).

(iii) Effective date. This paragraph (d)(2) applies to taxable years
beginning after December 31, 1989. (d)(3) through (j) [Reserved].
For further guidance see §1.861-14T(d)(3) through (j). Par. 7.
In §1.861-14T, paragraph (d) is revised to read as follows:
§1.861-14T Special rules for allocating and apportioning
certain expenses (other than interest expense) of an.32 affiliated
group of corporations (temporary).

* * * * *

(d)(1) and (2) [Reserved]. For further guidance, see
§1.861-14(d)(1) and (2).

* * * * *

Par. 8. Section 1.902-1(d)(3)(ii) is amended by adding text to read
as follows: §1.902-1 Credit for domestic corporate shareholder
of a foreign corporation for foreign income taxes paid by the
foreign corporation.

* * * * *

(d) * * *

(3) * * *

(ii) * * * For rules regarding dividend distributions before August
6, 1997, to certain more-than-90-percent United States shareholders
of a controlled foreign corporation, see §1.904-4(g)(3)(ii).

* * * * *

Par. 9. Section 1.904-0 is amended as follows:

1. Amending the entries for §1.904-4 by:

a. Adding entries for paragraphs (c)(5)(v), (c)(6)(iv)(A), and (c)
(6)(iv)(B).

b. Adding an entry for paragraph (g)(2)(v).

c. Revising the entries for paragraphs (g)(3) and (g)(3)(i)..33

d. Adding entries for paragraphs (g)(3)(i)(A), (g)(3)(i)(B), (g)(3)
(i)(C), and (g)(3)(i)(D).

e. Revising the entry for paragraph (g)(3)(ii).

f. Adding entries for paragraphs (g)(3)(ii)(A), (g)(3)(ii)(B), (g)
(3)(ii)(C), (g)(3)(ii)(D), and (g)(3)(ii)(E).

g. Revising the entries for paragraphs (g)(3)(iii) and (g)(3)(iv).

h. Adding an entry for paragraph (g)(3)(v).

i. Removing the entry for paragraph (g)(4). 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.

* * * * *

(c) * * *

(5) * * *

(v) Coordination with section 954(b)(4).

(6) * * *

(iv) * * *

(A) General rule.

(b) Exception for U.S. shareholders not entitled to look-through.

* * * * *

(g) * * *

(2) * * *

(v) Examples.

(3) Special rule for dividends paid by a controlled foreign
corporation.

(i) Distributions out of earnings and profits accumulated when the
distributing corporation was not a controlled foreign corporation.

(a) General rule.

(b) Ordering rule.

(c) Effect of intervening noncontrolled status.

(d) Examples..34

(ii) Pre-August 6, 1997, dividend distributions out of earnings and
profits accumulated before a more-than-90- percent United States
shareholder became a United States shareholder.

(a) General rule.

(b) Exception for intra-group acquisitions.

(c) Ordering rule.

(d) Distributions after August 5, 1997.

(e) Examples.

(iii) Treatment of earnings and profits for transition year.

(iv) Definitions.

(v) Effective date. * * * * * Par. 10. Section 1.904-4 is amended
by:

1. Revising the second sentence in paragraph (b)(1)(i)(B).

2. Revising paragraph (c)(4)(ii).

3. Adding a new paragraph (c)(5)(v).

4. Adding the text to paragraph (c)(6)(iv).

5. Adding a new sentence at the end of paragraph (c)(7)(ii).

6. Revising the second sentence of paragraph (c)(7)(iii).

7. Amending paragraph (c)(8) by revising the fifth sentence of
paragraph (i) of Example 9, and the fifth sentence of paragraph (ii)
of Example 9.

8. Revising paragraph (e)(3)(ii).

9. Adding the text to paragraph (e)(3)(iv) Example 2.

10. Redesignating paragraph (g)(4) as paragraph (g)(2)(v).

11. Revising the heading for paragraph (d)(3) and revising paragraph
(g)(3)(i)..35

12. Revising the paragraph headings and adding the text to
paragraphs (g)(3)(ii) through (iv).

13. Adding paragraph (g)(3)(v). The revisions and additions read as
follows: §1.904-4 Separate application of section 904 with
respect to certain categories of income.

* * * * *

(b) * * * (1) * * * (i) * * *

(B) * * * Passive income does not include any income that is also
described in section 904(d)(1)(B) through (H), any export financing
interest (as defined in section 904(d)(2)(G) and paragraph (h) of
this section), any high taxed income (as defined in section 904(d)
(2)(F) and paragraph (c) of this section, or, for taxable years
beginning before January 1, 1993, any foreign oil and gas extraction
income (as defined in section 907(c)). * * *

* * * * *

(c) * * *

(4) * * *

(ii) Income from sources without the QBU's country of operation.
Passive income from sources without the QBU's country of operation
shall be grouped on the basis of the tax imposed on that income as
provided in paragraphs (c)(3)(i) through (iv) of this section.

* * * * *

(5) * * *

(v) Coordination with section 954(b)(4). For rules relating to
passive income of a controlled foreign corporation that is exempt
from subpart F treatment because the income is subject to high
foreign tax, see section 904(d)(3)(E), §1.904-4(c)(7)(iii), and
§1.904-5(d)(2).

(6) * * *

(iv) Increase in taxes paid by successors--(A) General rule. Except
as provided in paragraph (c)(6)(iv)(B) of this section, if passive
earnings and profits previously included in income of a United
States shareholder are distributed to a person that was not a United
States shareholder of the distributing corporation in the year the
earnings were included, any increase in foreign taxes paid or
accrued, or deemed paid or accrued, on that distribution shall be
treated as taxes related to general limitation income, regardless of
whether the previously-taxed income was considered high-taxed income
under section 904(d)(2)(F) in the year of inclusion.

(b) Exception for U.S. shareholders not entitled to look-through. In
the case of a United States shareholder that, by reason of paragraph
(g)(3)(ii) of this section (relating to distributions prior to
August 6, 1997, to new shareholders acquiring more than 90 percent
of a controlled foreign corporation), is not entitled to look-
through treatment with respect to pre-acquisition earnings and
profits of the distributing corporation, the increase in.37 foreign
taxes described in paragraph (c)(6)(iv)(A) of this section shall be
treated as taxes related to the noncontrolled section 902
corporation income of the distributing corporation.

(c) Effective date. This paragraph (c)(6)(iv) applies to taxable
years beginning after December 31, 1986. However, for taxable years
beginning before January 1, 2001, taxpayers may rely on
§1.904-4(c)(6)(iv) of regulations project INTL-1-92, published
at 1992-1 C.B. 1209. See §601.601(d)(2) of this chapter.

(7) * * *

(ii) * * * For purposes of this paragraph (c)(7)(ii), foreign law is
not considered to attribute a reduction in tax to a particular year
or years if foreign law attributes the tax reduction to a pool or
group containing income from more than one taxable year and such
pool or group is defined based on a characteristic of the income
(for example, the rate of tax paid with respect to the income)
rather than on the taxable year in which the income is derived.

(iii) * * * If a taxpayer excludes passive income from a controlled
foreign corporation's foreign personal holding company income under
these circumstances, then, notwithstanding the general rule of
§1.904-5(d)(2), the income shall be considered to be passive
income until distribution of that income.* * *

(8) * * *

Example 9.

(i) * * * Under country G's law, distributions are treated as made
out of a pool of undistributed earnings subject to the 50% tax rate.
* * *

(ii) * * * Country G treats the distribution of earnings as out of
the 50% tax rate pool of earnings accumulated in 1987 and 1988. * *
*

* * * * *

(e) * * *

(3) * * *

(ii) Special rule for affiliated groups. In the case of any
corporation that is not a financial services entity under paragraph
(e)(3)(i) of this section, but is a member of an affiliated group,
such corporation will be deemed to be a financial services entity if
the affiliated group as a whole meets the requirements of paragraph
(e)(3)(i) of this section. For purposes of this paragraph (e)(3)
(ii), affiliated group means an affiliated group as defined in
section 1504(a), determined without regard to section 1504(b)(3). In
counting the income of the group for purposes of determining whether
the group meets the requirements of paragraph (e)(3)(i) of this
section, the following rules apply. Only the income of group members
that are United States corporations or 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 shall be
included. For purposes of this paragraph (e)(3)(ii), indirect
ownership shall be.39 determined under section 318 and the
regulations under that section. The income of the group will not
include any income from transactions with other members of the
group. Passive income will not be considered to be active financing
income merely because that income is earned by a member of the group
that is a financial services entity without regard to the rule of
this paragraph (e)(3)(ii). This paragraph (e)(3)(ii) applies to
taxable years beginning after December 31, 2000.

* * * * *

(iv) * * *

Example 2. Foreign corporation A, which is not a controlled foreign
corporation, owns 100 percent of the stock of domestic corporation
B, which owns 100 percent of the stock of domestic corporation C. A
also owns 100 percent of the stock of foreign corporation D. D owns
100 percent of the stock of domestic corporation E, which owns 100
percent of the stock of controlled foreign corporation F. All of the
corporations are members of an affiliated group within the meaning
of section 1504(a) (determined without regard to section 1504(b)
(3)). Pursuant to paragraph (e)(3)(ii) of this section, however,
only the income of B, C, E, and F is counted in determining whether
the group meets the requirements of paragraph (e)(3)(i) of this
section. For the 2001 taxable year, B's income consists of $95 of
active financing income and $5 of passive non-active financing
income. C has $40 of active financing income and $20 of passive non-
active financing income. E has $70 of active financing income and
$15 of passive non-active financing income. F has $10 of passive
income. B and E qualify as financial services entities under the
entity test of paragraph (e)(3)(i) of this section. Therefore, B and
E are financial services entities without regard to whether the
group as a whole is a financial services entity and all of the
income of B and E shall be treated as financial services income. C
and F do not qualify as financial services entities under the entity
test of paragraph (e)(3)(i) of this section. However, under the
affiliated group test of paragraph (e)(3)(ii) of this section, C and
F are financial services entities because at least 80 percent of the
group's total income consists of.40 active financing income ($205 of
active financing income is 80.4 percent of $255 total income). B's
and E's passive income is not treated as active financing income for
purposes of the affiliated group test of paragraph (e)(3)(ii) of
this section even though it is treated as financial services income
without regard to whether the group satisfies the affiliated group
test. Once C and F are determined to be financial services entities
under the affiliated group test, however, all of the passive income
of the group is treated as financial services income. Thus, 100
percent of the income of B, C, E, and F for 2001 is financial
services income.

* * * * *

(g) * * *

(3) Special rule for dividends paid by a controlled foreign
corporation--

(i) Distributions out of earnings and profits accumulated when the
distributing corporation was not a controlled foreign corporation--

(A) General rule. Distributions from a controlled foreign
corporation shall be treated as dividends from a noncontrolled
section 902 corporation, and therefore not subject to the look-
through rules of §1.904-5, to the extent that the distribution
is out of earnings and profits accumulated during periods when the
distributing corporation was not a controlled foreign corporation.

(b) Ordering rule. The determination of the earnings to which a
distribution from a controlled foreign corporation is attributable
shall be made on a last-in first-out (LIFO) basis. Thus, a
distribution shall be deemed made first from post-1986 undistributed
earnings attributable to the period after the distributing.41
corporation became a controlled foreign corporation (look-through
pools), next from the non-look-through pool of post-1986
undistributed earnings, if any, and finally on a LIFO basis from
pre-1987 accumulated profits.

(c) Effect of intervening noncontrolled status. [Reserved]

(D) Examples. The following examples illustrate the application of
paragraph (g)(3)(i): Example 1. S is a foreign corporation formed in
1980. Until 1992, S had no United States shareholders. In 1992, P, a
domestic corporation, acquires 10 percent of the stock of S. Thus,
for 1992 and subsequent years, S is a noncontrolled section 902
corporation. Because the 10- percent ownership requirement of
section 902(a) was not satisfied until 1992, earnings accumulated by
S before 1992 will be treated as pre-1987 accumulated profits for
purposes of section 902, and the amount of foreign taxes deemed paid
with respect to any distribution out of such pre-1987 accumulated
profits will be computed on a year-by-year basis under the rules of
section 902(c)(6)(A) and §1.902-1(b)(3). In 2000, P acquires an
additional 45% of the stock of S.

Thus, for 2000 and subsequent years, S is a controlled foreign
corporation. In 2000, S has no earnings and profits and pays a
dividend out of prior years' earnings and profits. Pursuant to
paragraph (g)(3)(i) of this section, because S was not a controlled
foreign corporation before 2000, the dividend to P will be treated
as a dividend from a noncontrolled section 902 corporation. The
dividend is treated as paid first out of S's non-look-through pool
of post-1986 undistributed earnings to the extent thereof, and then
out of S's pre-1987 accumulated profits on a LIFO basis. The entire
dividend will be subject to a single separate limitation for
dividends from a noncontrolled section 902 corporation.

Examples 2 through 4. [Reserved] (ii) Pre-August 6, 1997, dividend
distributions out of earnings and profits accumulated before a more-
than-90- percent United States shareholder became a United States
shareholder--

(A) General rule. Look-through principles do.42 not apply to
distributions made before August 6, 1997, to a more-than-90-percent
United States shareholder in the distributing corporation, to the
extent the distributions are made from earnings and profits
accumulated before the taxpayer became a United States shareholder
of the distributing corporation (pre-acquisition earnings).
Therefore, in the case of a distribution made before August 6, 1997,
a dividend shall be treated as a dividend from a noncontrolled
section 902 corporation, and the look-through rules of section
904(d)(3) and §1.904-5 shall not apply, if--

(1) The distribution is received by a United States shareholder, or
by an upper-tier controlled foreign corporation of a United States
shareholder, at a time when such United States shareholder is a
more-than-90-percent United States shareholder of the distributing
corporation; and

(2) The more-than-90-percent United States shareholder was not a
United States shareholder at the time the distributed earnings and
profits were accumulated by the distributing corporation.

(b) Exception for certain intra-group acquisitions. Notwithstanding
paragraph (g)(3)(ii)(A) of this section, a dividend recipient shall
be entitled to look-through treatment on a distribution out of pre-
acquisition earnings if--

(1) The dividend recipient is a United States shareholder of the
distributing corporation;

(2) The immediately preceding owner or owners were entitled to look-
through treatment on distributions from the distributing corporation
(determined after the application of paragraphs (g)(3)(i) and (g)(3)
(ii)(A) of this section); and

(3) Both at the time of such distribution and at the time that the
dividend recipient acquired its interest from such immediately
preceding owner or owners, such recipient and such preceding owner
or owners are members of the same affiliated group (within the
meaning of section 1504(a), determined without regard to section
1504(b)(3)).

(c) Ordering rule. If, under paragraph (g)(3)(ii) of this section
(or under paragraphs (g)(3)(i)(A) and (g)(3)(ii) of this section), a
shareholder is not entitled to look-through treatment, the
determination of whether a distribution from its controlled foreign
corporation is attributable to pre-acquisition earnings shall be
made on a last-in first-out (LIFO) basis. Thus, a distribution shall
be deemed made first from the post-1986 undistributed earnings
attributable to the period after the shareholder became a United
States shareholder in the distributing corporation, and then from
pre-acquisition earnings, in the order described in paragraph (g)(3)
(i)(B) of this section.

(d) Distributions after August 5, 1997. Look-through.44 principles
shall apply to distributions made after August 5, 1997, to a
distribution from a controlled foreign corporation to a more-
than-90-percent United States shareholder out of pre-acquisition
earnings that were accumulated in years during which the corporation
was a controlled foreign corporation. Post-1986 undistributed
earnings attributable to the period after the shareholder became a
United States shareholder in the distributing corporation and other
post-1986 undistributed earnings accumulated while the distributing
corporation was a controlled foreign corporation shall be combined
into a single set of post-1986 undistributed earnings pools for each
separate category described in §1.904-5(a)(1) as of August 6,
1997.

(e) Examples. The following examples illustrate the application of
this paragraph (g)(3)(ii): Example 1.

(i) P, a domestic corporation, owns 100 percent of the stock of U, a
controlled foreign corporation. In 1992, P sells 100 percent of the
stock of U to T, an unrelated domestic corporation. In 1992, U has
no earnings and pays a dividend to T out of earnings and profits
attributable to prior years. T is not related to P and P's ownership
of U will not be attributed to T. Because the dividend to T in 1992
is out of post-1986 undistributed earnings that are pre-acquisition
earnings, the dividend will be treated as a dividend from a
noncontrolled section 902 corporation. In 1993, U pays a dividend to
T out of current earnings and profits. T is entitled to look-through
treatment on the dividend.

(ii) In September 1997, U pays a dividend to T out of both post-
acquisition earnings and pre-acquisition earnings accumulated while
U was a controlled foreign corporation. Under paragraph (g)(3)(ii)
(D) of this section, T is entitled to look-through treatment on the
full amount of the dividend. Example 2.

(i) Domestic corporation P has owned 95 percent of the stock of S, a
controlled foreign corporation, from the time of S's organization in
1990. Domestic corporation R owns the remaining 5 percent of the
stock of S. On December 1, 1996, T, an unrelated domestic
corporation, acquires P's 95 percent interest in S. On December 31,
1996, S pays a dividend out of current and prior years' earnings and
profits. T is a more-than-90- percent United States shareholder of S
at the time it receives the dividend, but was not a United States
shareholder at the time the distributed earnings were accumulated.
Under this paragraph (g)(3)(ii), the portion of the dividend to T
attributable to pre-acquisition earnings will be treated as a
dividend from a noncontrolled section 902 corporation. Under
paragraph (g)(3)(iii) of this section, T will be entitled to look-
through treatment on the portion of the dividend attributable to
1996 earnings and profits. Under paragraph (g)(3)(ii)(C) of this
section, the dividend received by T will be treated as coming first
from S's post-1986 undistributed earnings attributable to 1996, and
then from pre-acquisition earnings.

(ii) On December 31, 1997, S pays a second dividend out of current
and prior years' earnings and profits. Under paragraph (g)(3)(ii)(D)
of this section, T will be entitled to look-through treatment on the
full amount of the dividend because all of S's earnings and profits
were accumulated in years during which S was a controlled foreign
corporation. The dividends to R will be treated as passive income
because R owns less than 10 percent of the stock of S and,
therefore, is not entitled to look-through treatment.

Example 3. The facts are the same as in Example 2 except that R,
rather than T, acquires from P an 86 percent interest in S in 1996.
Although R was a shareholder of S before the acquisition, it was not
a United States shareholder because it did not own 10 percent of the
voting stock of S. Thus, because R owns more than 90 percent of the
stock of S, and received a distribution of earnings before August 7,
1997, that were accumulated before it became a United States
shareholder of S, this paragraph (g)(3)(ii) applies and R is not
entitled to look-through treatment on the 1996 dividend. R is
entitled to look-through treatment on the 1997 dividend.

Example 4. Since its organization in 1980, S, a controlled foreign
corporation, has been owned 60 percent by domestic corporation P and
40 percent by domestic corporation R. On November 15, 1996, domestic
corporation T acquires R's 40 percent interest in the stock of S. S
has no income in 1996 and pays a dividend on December 15, 1996, out
of prior years' earnings and profits. This paragraph.46 (g)(3)(ii)
does not apply because T acquired less than 90 percent of the stock
of S. Thus, T is entitled to look-through treatment on dividends
distributed out of pre-acquisition earnings, because such earnings
are attributable to periods in which S was a controlled foreign
corporation.

(iii) Treatment of earnings and profits accumulated in a transition
year. Earnings and profits accumulated in the taxable year in which
a corporation became a controlled foreign corporation or in which a
more-than-90-percent United States shareholder became a United
States shareholder shall be considered earnings and profits
accumulated after the corporation became a controlled foreign
corporation or the shareholder became a United States shareholder,
respectively.

(iv) Definitions. The following definitions apply for purposes of
this paragraph (g)(3):

(A) More-than-90-percent United States shareholder. The term more-
than-90-percent United States shareholder means, with respect to any
controlled foreign corporation, a United States shareholder that
owns more than 90 percent of the total combined voting power of all
classes of stock entitled to vote of the controlled foreign
corporation. In determining ownership for purposes of this
definition, the indirect stock ownership rules of sections 958 and
318 and the regulations under those sections shall apply.

(b) Non-look-through pool. Except as otherwise provided, the term
non-look-through pool means post-1986 undistributed earnings
accumulated during periods in which.47 the distributing corporation
was a noncontrolled section 902 corporation that was not a
controlled foreign corporation.

(c) Post-1986 undistributed earnings. The term post-1986
undistributed earnings has the meaning set forth in §1.902-1(a)
(9).

(d) Pre-1987 accumulated profits. The term pre-1987 accumulated
profits has the meaning set forth in §1.902- 1(a)(10).

(e) Upper tier controlled foreign corporation. The term upper tier
controlled foreign corporation of a United States shareholder means
a controlled foreign corporation in which the taxpayer is a United
States shareholder and which is an upper-tier corporation as defined
in §1.902-1(a)(6) with respect to the distributing corporation.

(v) Effective date. The provisions of this paragraph (g)(3) apply to
taxable years beginning after December 31, 1986. However, for
taxable years beginning before January 1, 2001, taxpayers may rely
on §1.904-4(g)(3)(ii), (iii) and (iv) of regulations project
INTL-1-92, published at 1992-1 C.B. 1209. See §601.601(d)(2) of
this chapter.

* * * * *

Par. 11. Section 1.904-5 is amended as follows:

1. The last sentence in paragraph (a)(3) is revised and one new
sentence is added.

2. Paragraph (d)(2) is amended by removing the word For at the
beginning of the first sentence and adding the.48 language Except as
provided in §1.904-4(c)(7)(iii) (relating to reductions in tax
upon distribution), for in its place.

3. Paragraph (g) is revised.

4. Paragraph (h)(4) is amended by adding three new sentences at the
end.

5. Paragraph (i)(1) is amended by:

a. Revising the third sentence.

b. Adding a new sentence at the end.

6. The text to paragraph (i)(3) is added.

7. Paragraph (i)(4) Example 1 is revised.

8. The text to paragraph (i)(4) Example 2 is added.

9. Paragraph (i)(4) Example 3 is added.

10. The second and third sentences of paragraph (m)(1) are revised.

11. Paragraph (m)(4)(i) is revised.

12. Paragraph (m)(5) is amended by removing the language "951(a)"
from the first sentence and adding the language "951(a)(1)(A)" in
its place. The revisions and additions read as follows:
§1.904-5 Look-through rules as applied to controlled foreign
corporations and other entities.

(a) * * *

(3) * * * For this purpose the controlled group is any member of the
affiliated group within the meaning of section 1504(a)(1) except
that more than 50 percent shall be substituted for at least 80
percent wherever it appears in section 1504(a)(2). For taxable years
beginning before January 1, 2001, the preceding sentence shall be
applied by substituting 50 percent for more than 50 percent.

* * * * *

(g) Application of look-through rules to certain domestic
corporations. The principles of section 904(d)(3) and this section
shall apply to any foreign source interest, rents and royalties paid
by a United States corporation to a related corporation. For this
purpose, a United States corporation and another corporation are
considered to be related if one owns, directly or indirectly, stock
possessing more than 50 percent of the total voting power of all
classes of stock of the other corporation or more than 50 percent of
the total value of the other corporation. In addition, a United
States corporation and another corporation shall be considered to be
related if the same United States shareholders own, directly or
indirectly, stock possessing more than 50 percent of the total
voting power of all classes of stock or more than 50 percent of the
total value of each corporation. For purposes of this paragraph, the
constructive stock ownership rules of section 318 and the
regulations under that section apply. For taxable years beginning
before January 1, 2001, this paragraph (g) shall be applied by
substituting 50 percent or more for more than 50 percent each place
it appears.

(h) * * *

(4) * * * Similarly, a partnership (first partnership) is considered
as owning more than 50 percent of the value of another partnership
(second partnership) if the first partnership owns more than 50
percent of the capital and profits interests of the second
partnership. For this purpose, value will be determined at the end
of the partnership's taxable year. For taxable years beginning
before January 1, 2001, the second preceding sentence shall be
applied by substituting 50 percent for more than 50 percent.

(i) * * * (1) * * * In addition, two look-through entities are
related if the same United States shareholders own, directly or
indirectly, stock possessing more than 50 percent of the total
voting power of all voting classes of stock (in the case of a
corporation) or more than 50 percent of the total value of each
look-through entity. * * * For taxable years beginning before
January 1, 2001, the third sentence of this paragraph (i)(1) shall
be applied by substituting 50 percent or more for more than 50
percent each place it appears.

* * * * *

(3) Special rule for dividends. Solely for purposes of dividend
payments between controlled foreign corporations in taxable years
beginning after December 31, 2000, two controlled foreign
corporations shall be considered related.51 look-through entities if
the same United States shareholder owns, directly or indirectly, at
least 10 percent of the total voting power of all classes of stock
of each foreign corporation. Taxpayers may choose to apply this
paragraph (i)(3) in taxable years beginning after December 31, 1991,
provided that appropriate adjustments are made to eliminate any
double benefit arising from the application of this paragraph (i)(3)
to taxable years that are not open for assessment.

(4) Examples. * * * Example 1. P, a domestic corporation, owns all
of the stock of S, a controlled foreign corporation. S owns 40
percent of the stock of T, a Country X corporation that is a
controlled foreign corporation. The remaining 60 percent of the
stock of T is owned by V, a domestic corporation. The percentages of
value and voting power of T owned by S and V correspond to their
percentages of stock ownership. T owns 40 percent (by vote and
value) of the stock of U, a Country Z corporation that is a
controlled foreign corporation. The remaining 60 percent of U is
owned by unrelated U.S. persons. U earns exclusively general
limitation non-subpart F income. In 2001, U makes an interest
payment of $100 to T. Look-through principles do not apply because T
and U are not related look-through entities under paragraph (i)(1)
of this section (because T does not own more than 50 percent of the
voting power or value of U). The interest is passive income to T,
and is subpart F income to P and V. Under paragraph (c)(1) of this
section, look-through principles determine P and V's
characterization of the subpart F inclusion from T. P and V
therefore must characterize the inclusion as passive income.

Example 2. The facts are the same as in Example 1 except that
instead of a $100 interest payment, U pays a $50 dividend to T in
2001. P and V each own, directly or indirectly, more than 10 percent
of the voting power of all classes of stock of both T and U.
Pursuant to paragraph (i)(3) of this section, for purposes of
applying this section to the dividend from U to T, U and T are
treated as related look-through entities. Therefore, look-through
principles apply to characterize the dividend income as general
limitation income to T. The dividend is subpart F.52 income of T
that is taxable to P and V. The subpart F inclusions of P and V are
also subject to look-through principles, under paragraph (c)(1) of
this section, and are characterized as general limitation income to
P and V because the income is general limitation income of T.

Example 3. The facts are the same as in Example 1, except that U
pays both a $100 interest payment and a $50 dividend to T, and T
owns 80 percent (by vote and value) of U. Under paragraph (i)(1) of
this section, T and U are related look-through entities, because T
owns more than 50 percent (by vote and value) of U. Therefore, look-
through principles apply to both the interest and dividend income
paid or accrued by U to T, and T treats both types of income as
general limitation income. Under paragraph (c)(1) of this section, P
and V apply look-through principles to the resulting subpart F
inclusions, which therefore are also general limitation income to P
and V.

* * * * *

(m) * * * (1) * * * For purposes of determining the portion of a
dividend paid or accrued (or amount treated as a dividend, including
amounts described in section 951(a)(1)(B)) by a controlled foreign
corporation that is treated as from sources within the United States
under section 904(g)(4), the rules in paragraph (m)(4) of this
section apply. For purposes of determining the portion of an amount
included in gross income under section 951(a)(1)(A) that is
attributable to income of the controlled foreign corporation from
sources within the United States under section 904(g)(2), the rules
in paragraph (m)(5) of this section apply. * * *

* * * * *

(4) * * * (i) * * * Any dividend or distribution treated as a
dividend under this section (including an amount included in gross
income under section 951(a)(1)(B)).53 that is received or accrued by
a United States shareholder from a controlled foreign corporation
shall be treated as income in a separate category derived from
sources within the United States in proportion to the ratio of the
portion of the earnings and profits of the controlled foreign
corporation in the corresponding separate category from United
States sources to the total amount of earnings and.profits of the
controlled foreign corporation in that separate category.

* * * * *

Robert E. Wenzel
Deputy Commissioner of Internal Revenue

Approved: 12-13-00

Jonathan Talisman
Acting Assistant Secretary (Tax Policy)

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