IRS PROVIDES TRANSITION RULES TO TRANSLATE PRE-1987 E&P OF FOREIGN FIRMS FOR DEEMED INCOME INCLUSIONS & DEEMED-PAID FOREIGN TAX CREDITS.

Notice 88-70

This notice provides guidance relating to several aspects of the amendments made by the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 1 (the Act). First, transition rules for translating pre-1987 earnings and profits of a foreign corporation as computed under section 964(a) of the Internal Revenue Codes of 1954 and 1986 are provided for purposes of determining the amount of certain deemed income inclusions on transactions occurring in post-1986 taxable years of the corporation. Second, additional transition rules are provided concerning the treatment of accumulated deficits in earnings and profits for purposes of computing deemed-paid foreign tax credits under sections 902 and 960. In Notice 87-54, 1987-31 I.R.B. 21, transition rules under section 902 were provided concerning the carryforward and carryback of deficits in earnings and profits between pre-1987 and post-1986 taxable years in situations where there is an actual dividend paid in a post-1986 taxable year of a foreign corporation. This notice provides transition rules under sections 902 and 960 concerning the carryforward and carryback of deficits in earnings and profits between pre-1987 and post-1986 taxable years in those situations where there is a deemed income inclusion occurring in a post-1986 taxable year of a foreign corporation.

The rules in this notice will be incorporated in regulations to be issued under the Act. 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

In general, section 1202(a) of the Act amended the Code to conform the methods for determining post-1986 earnings and profits for purposes of computing the foreign taxes deemed paid under sections 902 and 960 of the Code. Prior to the Act, a controlled foreign corporation could have different earnings and profits depending upon whether the foreign taxes deemed paid were computed under section 902 or section 960. For example, under prior law, a controlled foreign corporation was allowed to take into account certain unrealized exchange gains and losses in determining its section 960, but not its section 902, earnings and profits. Compare section 1.964-1(a)-(e) of the regulations, which generally applied in computing earnings and profits under section 960, with sections 1.902-1(g) and 1.964-1(a)-(c), which generally applied in computing earnings and profits under section 902. This meant that an income inclusion from the same foreign corporation could result in different foreign income taxes deemed paid depending on whether section 902 or section 960 applied. The purpose of the amendments made by section 1202(a) of the Act is to equate the foreign taxes deemed paid under sections 902 and 960 on amounts included in income attributable to post-1986 earnings and profits (i.e., attributable to the post-1986 undistributed earnings pool) of a foreign corporation.

Section 1202(b) of the Act amended section 960 of the Code by replacing the annual ordering rules applicable to the deemed-paid foreign tax credit under prior law with ordering rules for post-1986 earnings and taxes based on perpetual pools as determined under section 902. Thus, unless otherwise provided in regulations, a foreign corporation will have one pool of post-1986 undistributed earnings and one pool of post-1986 foreign income taxes with respect to each separate category defined in section 1.904-5(a)(1) of the regulations for purposes of both sections 902 and 960. See Notice 87-54, discussing the pooling amendments made to section 902 by Act section 1202(a).

Section 1261 of the Act added sections 985 through 989 of the Code to provide comprehensive rules for the tax treatment of foreign currency. Section 985 provides rules for determining a taxpayer's functional currency and requires that, unless otherwise provided in regulations, all determinations under Subtitle A of the Code shall be made in the taxpayer's functional currency. Section 986(a) states that earnings and profits of a foreign corporation are determined in the corporation's functional currency. Section 986(a) provides further that, when earnings and profits are distributed, included in income under subpart F, or otherwise taken into account, they are translated into United States dollars, if necessary, at the appropriate exchange rate as defined in section 989(b). Section 986(c) provides generally that, when previously-taxed earnings and profits (as described in section 959 or 1293(c)) are distributed, the difference between the dollar value of the earnings and profits at the time of the actual distribution and the dollar value of the earnings when included under subpart F is recognized and taxed separately as ordinary income or loss. Finally, section 986(b) provides a single rule for translating foreign income taxes paid by a foreign corporation. Foreign income taxes are translated into United States dollars using the exchange rate as of the time of payment.

Generally, the currency rules of sections 985 through 989 the Code are effective for taxable years beginning after December 31, 1986. However, a special transition rule in section 1261(e)(2) of the Act provides that for purposes of sections 902 and 960 the amendments made by Act section 1261 apply only to earnings and profits of a foreign corporation for taxable years beginning after December 31, 1986, and foreign taxes paid or accrued by the foreign corporation with respect to such earnings and profits. Thus, except as provided in this notice or by regulations, the currency rules of prior law will continue to apply in post-1986 years in computing deemed-paid credits with respect to distributions out of pre-1987 earnings and profits.

ANALYSIS

The rules set forth in this notice will apply with respect to the translation of pre-1987 earnings and profits under section 964(a) of the Code and with respect to the computation of the foreign taxes deemed paid under sections 902 and 960 on those earnings. However, these rules apply only with respect to earnings and profits of, and dividends and deemed inclusions from, foreign corporations (including 2nd-tier and 3rd-tier foreign corporations) whose functional currency is the same after the effective date of the Act as it was under prior law. For purposes of the preceding sentence, a controlled foreign corporation will be considered to have the same functional currency only if its functional currency under section 1.902-1 and section 1.964-1(a)-(c) (or section 1.964-1(f)) of the regulations, as in effect prior to the Act, is the same as its functional currency under section 985 after the Act. Transition rules applicable to foreign corporations whose functional currency is different before and after the effective date of the Act will be provided later but will be based on principles similar to those set forth in this notice. A taxpayer whose functional currency in its first taxable year beginning in 1987 differs from that of its last taxable year beginning in 1986 should not request (or have requested on its behalf) a change in accounting method.

The examples in this notice assume that: (1) all earnings and profits and deficits in earnings and profits are attributable to the general limitation category of income of the taxpayer under section 904(d) of the Code; (2) the foreign corporation's earnings and profits and deficits in earnings and profits are computed under section 1.902-1 and section 1.964-1(a)-(c) of the regulations in the corporation's foreign functional currency ("u"), which did not change from pre-1987 taxable years to post-1986 taxable years; (3) the foreign income taxes attributable to post-1986 taxable years have been translated into United States dollars at the exchange rate as of the date of payment, as required by section 986(b); (4) unless provided otherwise, one dollar equals one "u" for all years; and (5) P, a United States corporation, is the sole shareholder of S, a foreign corporation.

1. TRANSLATION OF PRE-1987 SECTION 964(a) EARNINGS AND PROFITS INTO FUNCTIONAL CURRENCY. Earnings and profits and deficits in earnings and profits of a foreign corporation under section 964(a) of the Code accumulated in taxable years beginning prior to January 1, 1987 (including earnings and profits that represent previously taxed income (PTI) for purposes of section 959) shall be translated into the functional currency (as determined under section 985) of-the foreign corporation at the spot rate on the first day of the first taxable year of the foreign corporation beginning after December 31, 1986. Once translated into functional currency, the pre-1987 section 964(a) earnings and profits and deficits in earnings and profits shall (absent a change in functional currency) remain in the functional currency units translated for all other federal income tax determinations, including the translation rules of section 989(b). For illustrations of this rule, see the examples in paragraphs 2 and 3 below.

2. CARRYFORWARD OF ACCUMULATED DEFICITS IN EARNINGS AND PROFITS FROM PRE-1987 TAXABLE YEARS TO POST-1986 TAXABLE YEARS.

(a) COMPUTATION OF DEEMED-PAID FOREIGN TAXES UNDER SECTIONS 902 AND 960 OF THE CODE. For purposes of computing the denominator of the section 902 or section 960 deemed-paid foreign tax credit formula on a deemed income inclusion (e. g., an inclusion under section 951(a), 1248, or 367(b)) occurring in a taxable year of the foreign corporation beginning after December 31, 1986, only the amount of the pre-1987 deficit in earnings and profits of the foreign corporation accumulated as of the end of the foreign corporation's last pre- effective date taxable year determined under section 902(a) (and the rules of section 1.902-1 of the regulations), if any, is carried forward and included in the post-1986 undistributed earnings pool. (This is the amount under Notice 87-54 that is carried forward for purposes of computing the section 902 deemed-paid credit on an actual dividend. As stated in Notice 87-54, such amount is carried forward as of the first day of the foreign corporation's first taxable year beginning after December 31, 1986.) Thus, the amount of any pre-1987 accumulated deficit in earnings and profits as determined under section 964(a) (and the rules of section 1.964-1(a)-(e)) is not taken into account for purposes of determining the denominator of the section 902 or 960 deemed-paid credit formula on a deemed income inclusion of post-1986 earnings and profits.

(b) COMPUTATION OF INCOME INCLUSION USING SECTION 964(a) OF THE CODE. For purposes of determining the amount of any deemed income inclusion computed using section 964(a), a deficit in earnings and profits accumulated as of the end of the last pre-effective date taxable year determined under section 964(a) shall be taken into account as provided by the applicable Code or regulation provision. Thus, for example, for purposes of determining the amount of a section 951(a) inclusion, a section 1248 dividend or a section 367(b) inclusion, the pre-1987 section 964(a) deficit is taken into account as provided by those provisions. The deficit is translated into the foreign corporation's functional currency as provided in paragraph 1.

(c) EXAMPLES. The rules of this paragraph are illustrated by the following examples.

                               EXAMPLE 1

(ii) Assume that in 1988 S invests 150u in United States property (within the meaning of section 956) instead of distributing the 150u, and that S has no previous investments in United States property. S's section 964(a) pre-1987 accumulated earnings and profits deficit is taken into account in determining the amount of S's section 951(a)(1)(B) inclusion for 1988 because the inclusion cannot be greater than the amount of section 964(a) earnings and profits that constitute a dividend under section 316 of the Code. Pursuant to paragraph 1, S's section 964(a) pre-1987 accumulated deficit of $50 is translated into S's functional currency at the spot rate on January 1, 1987 ($1:1u). Thus, for purposes of determining the amount of S's section 951(a)(1)(B) inclusion, S's section 316 current plus accumulated earnings and profits for 1988 is 150u (50u accumulated pre-1987 deficit under section 964(a) plus 200u, the post-1986 earnings and profits). Accordingly, the entire 150u investment in United States property would be included in P's gross income under section 951(a)(1)(B) because it would constitute a dividend under section 316 if distributed and represents a 150u increase in earnings invested in United States property for 1988. For purposes of determining the foreign income taxes deemed paid under section 960 on the 150u section 951(a)(1)(B) inclusion, however, only a pre-1987 accumulated deficit computed under section 902(a) is taken into account. Since there is no accumulated deficit in S's pre-1987 section 902 earnings and profits, no deficit is carried forward into the post-1986 undistributed earnings pool for purposes of determining the denominator of the section 960 deemed-paid credit formula. Since distributions or inclusions are considered to come out of post-1986 earnings and profits first, the 150u deemed inclusion is attributable solely to the 200u post-1986 undistributed earnings pool, and the foreign income taxes deemed paid under section 960 are $67.50 (150u/200u x $90). After the section 956 transaction, the amount remaining in the post-1986 undistributed earnings pool would be 50u; the amount remaining in the post-1986 pool of foreign income taxes would be $22.50; and under section 959 there would be 150u of earnings and profits attributable to the PTI. The amount of current plus accumulated earnings and profits available for distribution is not affected by the transaction. Generally, see section 960 and sections 1.960-1 and -2 of the regulations, section 956 and section 1.956-1, and section 1248 and section 1.1248-2 and -3 for the effect of earnings and profits attributable to amounts of PTI on computations under those sections.

(iii) Assume that in 1990, P sells its S stock. For purposes of section 1.1248-2 or -3 of the regulations, there would be a deficit of 25u in S's 1985 section 964(a) earnings and profits and a deficit of 25u in S's 1986 section 964(a) earnings and profits. This is because S's pre-1987 accumulated earnings and profits and deficits in earnings and profits under section 964(a) of the Code are, pursuant to paragraph 1, translated into S's functional currency as of January 1, 1987, and remain so translated for all federal income tax determinations for which section 964(a) earnings and profits are relevant.

                               EXAMPLE 2

(ii) Assume that in 1989 S invests 150u in United States property (within the meaning of section 956 of the Code) instead of distributing it, and that S has no previous investments in United States property. There would be no inclusion under section 951(a)(1)(B) because the 1989 current plus accumulated earnings and profits under section 316 as determined under section 964(a) are zero. The current plus accumulated earnings and profits equal zero because the post-1986 earnings and profits equal 200u and the $200 deficit in accumulated earnings and profits from 1986 equals 200u when translated from dollars into functional currency at the spot rate on January 1, 1987 ($1:1u). The amount of current plus accumulated earnings and profits available for distribution is not affected by the transaction.

                               EXAMPLE 3

In 1988 the pool of post-1986 undistributed earnings is negative 100u. This is because the amount of any post-1986 inclusion that is solely attributable to current earnings and profits (i.e., a "nimble dividend" determined under section 316 of the Code) is removed from the pool. Because the 100u section 951(a)(1)(A) inclusion in 1987 is solely attributable to 100u of 1987 current earnings and profits, 100u is removed from the pool of post-1986 undistributed earnings. The same result would obtain if none of the 100u earned by S in 1987 was subpart F income and on December 31, 1987, S made an actual distribution to P of 100u.

Under section 959 of the Code there are 100u of earnings and profits attributable to the section 951(a)(1)(A) inclusion. The amount of current plus accumulated earnings and profits is not affected by the transaction. Generally, see section 960 and sections 1.960-1 and -2 of the regulations, section 956 and section 1.956-1, and section 1248 and section 1.1248-2 and -3 for the effect of earnings and profits attributable to amounts of PTI on computations under those sections.

                               EXAMPLE 4

If S had invested 250u in United States property, instead of 150u, the result would be different. The foreign income taxes deemed paid under section 960 of the Code resulting from the 50u inclusion in excess of the post-1986 earnings and profits of 200u would be determined under the law in effect prior to the Act, except that the $50 of 1986 section 964(a) earnings and profits would be 50u because of the January 1, 1987 translation required by paragraph 1. Accordingly, 50u of the inclusion would be attributable to 1986 earnings and profits, and the additional foreign income taxes deemed paid under section 960 would be $10 (50u/50u x $10).

The amount of current plus accumulated earnings and profits available for distribution is not affected by the 150u (or 250u) inclusion. Generally, see section 960 of the Code and sections 1.960- 1 and -2 of the regulations, section 956 and section 1.956-1, and section 1248 and section 1.1248-2 and -3 for the effect of earnings and profits attributable to amounts of PTI on computations under those sections.

3. CARRYBACK OF DEFICITS IN EARNINGS AND PROFITS FROM POST-1986 TAXABLE YEARS TO PRE-1987 TAXABLE YEARS FOR PURPOSES OF SECTIONS 902 AND 960 OF THE CODE.

(a) COMPUTATION OF DEEMED-PAID FOREIGN TAXES UNDER SECTIONS 902 AND 960 OF THE CODE. In computing the section 902 or section 960 deemed-paid foreign tax credit on a deemed income inclusion (e.g., an inclusion under section 951(a), 1248, or 367(b)) occurring in a taxable year of the foreign corporation in which there is a deficit in the post-1986 undistributed earnings pool, the "eligible deficit" of the foreign corporation is carried back to pre-effective date taxable years. The eligible deficit equals the deficit in the post- 1986 undistributed earnings pool of the foreign corporation reduced by the accumulated pre-1987 deficit under section 902, if any, that was carried forward and included in the post-1986 undistributed earnings pool. The eligible deficit carried back reduces both the section 902 and the section 964(a) earnings and profits of such pre- effective date taxable years. In addition, the amount of the eligible deficit that is carried back is removed from the post-1986 undistributed earnings pool. For purposes of computing the section 960 credit on a deemed inclusion, any deficit in the post-1986 undistributed earnings pool that was carried back to pre-effective date taxable years pursuant to Notice 87-54 also reduces the section 964(a) pre-1987 earnings and profits.

(b) COMPUTATION OF INCOME INCLUSION USING SECTION 964(a) OF THE CODE. For purposes of determining the amount of any deemed income inclusion computed using section 964(a), a deficit in earnings and profits from post-1986 taxable years shall be taken into account under the applicable Code or regulation provision. Thus, for purposes of determining the amount of a section 951(a) inclusion, a section 1248 dividend, or a section 367(b) inclusion, the post-1986 section 964(a) deficit is taken into account as provided by those provisions.

(c) EXAMPLE. The rules of this paragraph are illustrated by the following example.

                               EXAMPLE 5

(ii) Assume the facts in (i) above are the same except that (1) S did not make an investment in United States property in 1988 but made a 10u investment, equal to $10, in United States property on December 31, 1986, and a 40u investment on December 31, 1987, and (2) throughout 1987 $1 equals 2u. Assuming S's adjusted basis in its United States property equals its cost basis throughout the period involved, the aggregate amount of S's investment in United States property at the end of 1986 is $10, and S's earnings invested in United States property at the end of 1986 that would constitute a dividend if distributed are $10 (S's 1986 section 964(a) earnings and profits equal $50). Since S has no previous investment in United States property, the $10 is included in P's 1986 gross income under section 951(a)(1)(B) of the Code. For purposes of determining the amount of P's income inclusion under section 951(a)(1)(B) for 1987, the aggregate amount of investment in United States property must be computed at the end of 1987. For this purpose, the investment of $10 in United States property in 1986 is translated into the functional currency of S at the spot rate on January 1, 1987 ($1:2u), and thus equals 20u. The adjusted basis of the United States property invested in 1986 equals 20u for purposes of section 956 only. For other purposes, the adjusted basis of such property will be its historical functional currency adjusted basis, i.e., 10u. Consequently, the aggregate amount of investment in United States property at the end of 1987 is 60u (the 20u 1986 investment plus the 40u 1987 investment). S's 1987 section 964(a) earnings and profits for section 316 purposes, as adjusted under section 1.956-1 of the regulations, are 130u, computed as follows: pre-1987 earnings and profits of 100u ($50 translated at the spot rate on January 1, 1987) minus 20u (the $10 1986 section 951(a)(1)(B) inclusion translated at the January 1, 1987 spot rate) plus 1987 earnings and profits of 50u. Because this amount exceeds 60u, S has 60u of earnings invested in United States property as of the end of 1987. To determine S's increase in earnings invested in United States property as of the end of 1987 (P's section 951(a)(1)(B) inclusion), the $10 of earnings invested in United States property as of the end of 1986 must also be translated into S's functional currency at the spot rate on January 1, 1987 ($1:2u). Accordingly, S's increase in earnings invested in United States property for 1987 is 40u (60u minus 20u).

DRAFTING INFORMATION

The principal authors of this notice are F. Scott Farmer and Kenneth Wood of the Office of the Associate Chief Counsel (International). For further information about the notice, call Mr. Wood at (202) 566-6276 or Barbara Felker or Carol DuPuy at (202) 634- 5406 (not a toll-free call).