SERVICE ANNOUNCES ORDERING RULES FOR FOREIGN TAX CREDIT ALLOCATIONS AND LIMITATIONS.

Notice 89-3

This notice provides guidance relating to the amendments made to section 904(f) of the Internal Revenue Code of 1986 by the Tax Reform Act of l986, l986-3 (Vol. 1) C.B. 1 (the Act). Specifically, this notice provide ordering rules for the allocation of separate limitation losses, the recapture of overall foreign losses, the recharacterization of separate limitation losses, and the allocation of U.S. source losses to separate limitation income.

The rules in this notice will be incorporated in regulations to be issued under the Act. In addition, those regulations will provide rules concerning the operation of the loss allocation and recapture provisions. This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied on to the same extent as a revenue ruling or revenue procedure.

LAW

Prior to the Act, if a taxpayer sustained a foreign source loss in a separate limitation income category, the loss reduced the taxpayer's U.S. source income before reducing foreign source income subject to another separate limitation. Section 1203 of the Act amended section 904(f) of the Code by adding paragraph (5), which changed the order in which U.S. and foreign source income are reduced by a foreign source loss. In general, section 904(f) provides that a foreign source loss with respect to any income category (a separate limitation loss) is to be allocated on a proportionate basis among (and operates to reduce) separate limitation income in other income categories for the taxable year before reducing U.S. source income. Section 904(f)(5) also provides that, if a separate limitation loss from an income category ("the loss category") was allocated to separate limitation income in any other category in a taxable year, and there is income in the loss category in a subsequent taxable year, then the income shall be recharacterized as separate limitation income in such other category in an amount equal to the prior reduction. In addition, section 904(f)(5) provides that a U.S. source loss shall be allocated to the separate limitation income of the taxpayer in each income category on a proportionate basis.

The amendments to section 904(f) of the Code made by the Act did not change the prior law requirement under section 904(f)(1) for the recapture of overall foreign losses.

ANALYSIS

ORDERING RULE FOR ALLOCATION OF SEPARATE LIMITATION LOSSES, RECAPTURE OF OVERALL FOREIGN LOSSES, RECHARACTERIZATION OF SEPARATE LIMITATION INCOME, AND ALLOCATION OF U.S. SOURCE LOSSES. For taxable years beginning after December 31, l986 (post-1986 taxable years), the following ordering rule shall apply for purposes of allocating separate limitation losses, recapturing overall foreign losses, recharacterizing separate limitation income, and allocating U.S. source losses.

(1) Net operating losses from a current taxable year are carried forward or back to a post-1986 taxable year in the following manner. Net operating losses that are carried forward, pursuant to section 172 of the Code, are combined with income or loss in the carryover year in the manner described in this paragraph (1). Net operating losses that are carried back, pursuant to section 172, shall be allocated to income in the earlier year in a manner consistent with the principles of paragraph (1)(b). The income in the carryback year is the foreign source income in each separate limitation category and the U.S. source income after the application of section 904(f) to income and loss in that previous year, including as a result of net operating loss carryforwards or carrybacks from taxable years prior to the current taxable year.

(a) This paragraph (1)(a) applies if the full net operating loss (that remains after carryovers to other taxable years) can be carried forward in its entirety to a particular taxable year. U.S. source losses and foreign source losses in separate limitation categories that are part of a net operating loss from a particular taxable year that is carried forward in its entirety shall be combined with the U.S. income or loss and the foreign source income or loss in the same separate limitation categories in the carryover year; the combined amounts shall then be subject to the ordering rules provided in paragraphs (2) through (5).

(b) This paragraph (1)(b) applies if the full net operating loss (that remains after carryovers to other taxable years) cannot be carried forward in its entirety to a particular taxable year.

(i) First, any U.S. source loss (not to exceed the net operating loss carryover) shall be carried over to the extent of any U.S. source income in the carryover year.

(ii) If the net operating loss carryover exceeds the U.S. source loss carryover determined under paragraph (1)(b)(i), then separate limitation losses that are part of the net operating loss shall be tentatively carried over to the extent of separate limitation income in the same category. If the sum of the separate limitation loss carryovers determined under the preceding sentence exceeds the amount of the net operating loss carryover reduced by any U.S. source loss carried over under paragraph (1)(b)(i), then the separate limitation loss carryovers shall be reduced pro rata so that their sum equals such amount.

(iii) If the net operating loss carryover exceeds the sum of the U.S. and separate limitation loss carryovers determined under paragraph (1)(b)(i) and (ii), then a proportionate part of the remaining loss from each separate limitation category shall be carried over to the extent of such excess. Any separate limitation losses carried over under this paragraph (1)(b)(iii) shall be allocated in accordance with section 904(f)(5).

(iv) If the net operating loss carryover exceeds the sum of all the loss carryovers determined under paragraph (1)(b)(i), (ii), and (iii) then any U.S. source loss not carried over under paragraph (1)(b)(i) shall be carried over to the extent of such excess and allocated in accordance with section 904(f)(5)(D).

(2) The taxpayer shall allocate separate limitation losses sustained during the taxable year (increased, if appropriate, by any net operating loss carryover computed under paragraph (1)), to its separate limitation income in other income categories on a proportionate basis.

(3) The taxpayer's U.S. source income shall be increased or decreased in the following manner:

(a) If the taxpayer's separate limitation losses for the year (including losses carried over under paragraph (1)) exceed the taxpayer's separate limitation income for the year, so that the taxpayer has separate limitation losses remaining after the application of paragraph (2), those losses shall be allocated to the taxpayer's U.S. source income for the taxable year, to the extent thereof. The taxpayer shall increase its overall foreign loss accounts appropriately.

(b) If the taxpayer's foreign source separate limitation income for the year (reduced by any losses carried over under paragraph (1)) exceeds the taxpayer's foreign source separate limitation losses for the year, so that the taxpayer has foreign source separate limitation income remaining after the application of paragraph (2), then the taxpayer shall recapture prior year overall foreign losses, if any. See generally section 1.904(f)-1 through 1.904(f)-6 and section 1.904(f)-13T of the regulations and the Conference Agreement to the Tax Reform Act of l986 (H.R. Conf. Rep. 99-841, 99th Cong., 2nd Sess. 591 (1986)), which provides that foreign source separate limitation income shall be recaptured as U.S. source income under section 904(f) of the Code only to the extent that an overall foreign loss relates to that income category (that is, to the extent that U.S. source income was reduced by losses in that income category).

(4) The taxpayer shall recharacterize foreign source separate limitation income as income in other separate limitation categories to the extent that income in those other separate limitation categories was reduced by losses in the first category in a previous taxable year.

(5) The taxpayer shall allocate U.S. source losses sustained during the taxable year (increased, if appropriate, by any net operating loss carryover determined under paragraph (1) and decreased, if appropriate, by any recapture of an overall foreign loss determined under paragraph (3)) to foreign source separate limitation income on a proportionate basis.

DRAFTING INFORMATION

The principal author of this notice is Willard W. Yates of the Office of the Associate Chief Counsel (International). For further information, contact Mr. Yates at 202-566-3896 (not a toll-free call).