SERVICE PROVIDES TRANSITIONAL RULES FOR RESOLUTION OF FOREIGN CURRENCY ISSUES RELATING TO THE DEEMED-PAID FOREIGN TAX CREDIT.

Notice 87-54

This notice provides guidance relating to several aspects of the amendments made to the foreign tax credit rules by the Tax Reform Act of 1986 (the "Act") [1986-3 C.B. Vol. 1]. The rules contained in this notice will be incorporated in regulations to be issued under the Act. Taxpayers may rely on the rules provided herein for the purposes specified until regulations are issued.

Specifically, this notice provides guidance with respect to the carryforward and carryback of deficits between post-1986 and pre-1987 earnings and profits, and the foreign currency issues with respect thereto, for purposes of computing the deemed-paid foreign tax credit of section 902 of the Code.

A separate notice will provide guidance with respect to the carryforward and carryback of deficits between post-1986 and pre-1987 earnings and profits for purposes of computing the deemed-paid foreign tax credit of section 960 of the Code.

TRANSITIONAL ISSUES AFFECTING THE COMPUTATION OF THE DEEMED-PAID FOREIGN TAX CREDIT OF SECTION 902

Section 1202(a) of the Act amends section 902 of the Code by replacing the annual ordering rules of prior law for the deemed-paid foreign tax credit with ordering rules for post-1986 earnings and taxes based on perpetual pools. Subject to qualifications similar to those of prior law, post-1986 foreign income taxes paid by a foreign corporation may be treated as paid by a 10 percent domestic corporate shareholder in the same proportion as dividends that are paid out of post-1986 earnings bear to the foreign corporation's post-1986 undistributed earnings pool. As under prior law, post-1986 foreign income taxes paid by 2nd-tier or 3rd-tier foreign corporations are also deemed paid by a domestic corporate shareholder if certain qualifications contained in section 902(b) are met.

Section 902(c)(1) of the Code defines the term "post-1986 undistributed earnings" as the amount of earnings and profits of the foreign corporation (computed in accordance with sections 964(a) and 986) accumulated in taxable years beginning after December 31, 1986, determined as of the close of the taxable year of the foreign corporation in which the dividend is distributed without diminution by reason of dividends distributed during the taxable year. Section 902(c)(2) defines the term "post-1986 foreign income taxes" as the sum of (1) the foreign income taxes with respect to the taxable year of the foreign corporation in which the dividend is distributed and (2) the foreign income taxes with respect to prior taxable years beginning after December 31, 1986, to the extent such foreign taxes were not deemed paid with respect to dividends distributed by the foreign corporation in prior taxable years.

Section 1261 of the Act added sections 985 through 989 to the Code to provide rules for the treatment of foreign currency transactions. Section 985 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) specifically states that the earnings and profits of a foreign corporation are determined in the corporation's functional currency. When such earnings and profits are distributed, deemed distributed, or otherwise taken into account, they are translated into U.S. dollars, if necessary, using the appropriate exchange rate as defined in section 989. Section 986(b) provides that, in determining the amount of foreign taxes deemed paid under section 902, any foreign income taxes paid by a foreign corporation shall be translated into U.S. dollars using the exchange rate of the time of payment.

Generally, the currency rules of sections 985 through 989 of 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 section 902 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.

The following rules will apply with respect to the computation of the deemed-paid foreign tax credit under section 902 of the Code as amended by the Act. These rules, however, apply only with respect to dividends 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. Transition rules applicable to foreign corporations whose functional currency is different before and after the effective date of the Act will be provided later.

The examples in paragraphs (a) and (b) of this notice assume that: (1) all earnings and profits and deficits in earnings and profits are attributable to the taxpayer's general limitation category (section 904(d)(1)(I)); (2) the foreign corporation's earnings and profits and related tax amounts are computed in the corporation's foreign functional currency ("u"), which did not change from pre-1987 to post-1986 taxable years; and (3) the foreign income taxes attributable to post-1986 taxable years have been translated into U.S. dollars at the exchange rate as of the date of payment, as required by section 986(b).

(a) CARRYBACK OF DEFICITS FROM POST-1986 EARNINGS AND PROFITS TO PRE-1987 EARNINGS AND PROFITS FOR PURPOSES OF SECTION 902 OF THE CODE. In computing the section 902 deemed-paid foreign tax credit for dividends paid in a taxable year of the foreign corporation in which there is a deficit in the post-1986 undistributed earnings pool, the deficit is carried back to pre-effective date taxable year(s). The amount carried back will reduce the earnings and profits of such pre- effective date taxable year(s) for purposes of calculating the deemed-paid credit and will be removed from the pool of post-1986 undistributed earnings. The following examples illustrate this rule.

                               EXAMPLE 1

If a foreign corporation pays a dividend in a year when it has a deficit in its post-1986 undistributed earnings pool, carrying back the deficit may prevent the crediting of foreign income taxes paid with respect to earnings and profits of a pre-effective date taxable year. Thus, if in example 1 the foreign corporation had a deficit in earnings and profits in 1987 of 150u (instead of 100u), the 1987 distribution of 50u would still be a dividend. However, the dividend would be deemed to be made out of the 1985 earnings and profits, because the 150u deficit in the post-1986 undistributed earnings pool would be carried back to offset all the 1986 earnings and profits (150u). Cf. Rev. Rul. 74-550 and Rev. Rul. 87-72, page 170, this bulletin. Because no future distribution would be treated as made out of the 1986 earnings and profits, the foreign income taxes with respect to the 1986 earnings and profits would never be creditable. The denominator of the section 902 credit for 1985 would be 150u (the 1985 earnings and profits), and the section 902 credit would be 40u. The 150u deficit would be removed from the post-1986 undistributed earnings pool by the 1987 distribution because the deficit was carried back to offset pre-1987 earnings and profits.

A deficit in the post-1986 undistributed earnings pool will not, however, be carried back to pre-effective date year(s) unless and until there is a dividend.

                               EXAMPLE 2

For the 1990 dividend of 120u, only 100u can be made out of the post-1986 undistributed earnings pool because the pool contains only 100u. The additional 20u will be deemed to be made out of the 1986 earnings and profits of 100u. The denominator of the section 902 fraction for the portion of the dividend made out of the post-1986 undistributed earnings pool is 100u, and the section 902 credit derived from that portion of the dividend is $40. The denominator of the section 902 fraction for the portion of the dividend deemed to be made out of the 1986 earnings and profits is 100u, and the section 902 credit derived from that portion of the dividend is 16u.

(b) CARRY FORWARD OF DEFICITS FROM PRE-1987 EARNINGS AND PROFITS TO POST-1986 EARNINGS AND PROFITS FOR PURPOSES OF SECTION 902. In computing the section 902 deemed-paid foreign tax credit for dividends paid in a taxable year of the foreign corporation beginning after the effective date of the Act, the amount of a deficit in earnings and profits (or after-tax accumulated profits) of the foreign corporation accumulated as of the end of the last pre- effective date taxable year is carried forward and included in the post-1986 undistributed earnings pool. Such amount is carried forward as of the first day of the foreign corporation's first taxable year beginning after December 31, 1986. The following examples illustrate this rule.

                               EXAMPLE 3

If a dividend is paid out of current earnings and profits and there is a deficit in current plus accumulated earnings and profits, then the results will be modified.

                               EXAMPLE 4

After determination of the section 902 credit for 1987, the 1987 nimble dividend of 100u reduces the current earnings and profits for 1987 of 150u to 50u, which is added to the accumulated earnings and profits of (100u) from the previous year. At the end of 1987 (after the distribution), the corporation has a deficit of (50u) in accumulated earnings and profits.

In 1989, the 100u distribution will be taxed as a dividend because there are current earnings and profits in 1989 of 100u. The post-1986 undistributed earnings pool for 1989 is (100u), which is the sum of (50u) (the deficit in accumulated earnings and profits at the end of 1987), plus (150u) (the deficit in current earnings and profits for 1988), plus 100u (the current earnings and profits for 1989). Because there is a deficit in the corporation's post-1986 pool of undistributed earnings and profits, and foreign income taxes of $50 will not be creditable in 1989. The taxes will, however, remain in the pool of post-1986 foreign income taxes not previously credited. The 100u dividend in 1989 eliminates the current earnings and profits of 100u for that year; therefore, at the end of 1989 (after the distribution), accumulated earnings and profits are exactly what they were at the end of 1988, that is (200u), which is the sum of (50u) (the deficit in accumulated earnings and profits at the end of 1987) plus (150u) (the deficit in current earnings and profits for 1988).

Since there are 250u of current earnings and profits in 1990, the 50u distribution in that year will be taxed as a dividend. The post-1986 undistributed earnings pool for 1990 is 50u which equals the total of (200u) (the post-1986 undistributed earnings pool at the end of 1989, after the 1989 distribution), plus 250u (the current earnings and profits for 1990). Thus, the section 902 credit is 50u/50u times $150 (the pool of foreign income taxes not previously credited), or $150.