SERVICE PROVIDES TEMPORARY GUIDANCE ON NEW FOREIGN TAX CREDIT RULES

Notice 87-6

The Internal Revenue Service today announced guidance relating to several aspects of the amendments made to the foreign tax credit rules by the Tax Reform Act of 1986 (the Act). The rules contained in this announcement will be incorporated in regulations to be issued under the 1986 Act. Taxpayers may rely on the rules provided herein for the purposes specified until regulations are issued.

Specifically, this announcement provides guidance with respect to: (1) the effective date of the amendments to section 904(d) generally; (2) the characterization of distributions and section 951(a)(1)(B) inclusions out of earnings and profits of a foreign corporation accumulated in a taxable year beginning before January l, 1987, during taxable years of both the payor and the recipient beginning after December 31, 1986, and the application of the rules for characterizing associated taxes paid or accrued by a foreign corporation; (3) the application of the effective date provisions and the look-through rules under section 904(d)(3) to distributions (including deemed distributions) and payments by a foreign corporation to a recipient during a taxable year of either the payor or the recipient that begins after December 31, 1986, and a taxable year of the other that begins before January l, 1987; (4) transitional issues affecting the computation of the indirect foreign tax credit; (5) the grouping of items of income for purposes of determining whether income is high-taxed income under section 9O4(d)(2)(A)(iii)(III); and (6) clarification of the U.S. tax rate to be used in order to determine whether income is high-taxed income.

1. APPLICATION OF THE EFFECTIVE DATE PROVISION OF SECTION 904(d)

Section 1201(e) of the Act provides that the amendments to section 904(d) are generally applicable to taxable years beginning after December 31, 1986. FFr purposes of applying the look-through rules under section 904(d)(3), the amendments to section 904(d) shall apply to distributions and section 951 inclusions of earnings and profits of a controlled foreign corporation derived during the first taxable year of the controlled foreign corporation beginning after December 31, 1986, and thereafter, and to payments made by a controlled foreign corporation during such taxable years, without regard to whether the corresponding taxable year of the recipient of the distribution or payment or of one or more of the U.S. shareholders of the controlled foreign corporation begins after December 31, 1986.

2. CHARACTERIZATION OF DISTRIBUTIONS AND SECTION 951(a)(1)(B) INCLUSIONS OF EARNINGS OF A FOREIGN CORPORATION ACCUMULATED IN TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1987 DURING TAXABLE YEARS OF BOTH THE PAYOR FOREIGN CORPORATION AND THE RECIPIENT WHICH BEGIN AFTER DECEMBER 31, 1986

Section 904(d)(2)(I) provides transition rules relating to the treatment of foreign tax credit carryovers from taxable years beginning before January l, 1987. In general, those rules provide that pre-effective date unused foreign taxes on income subject to the general limitation shall be carried over to post-effective date years to reduce U.S. tax only on income subject to the general limitation. A special rule provides, however, that pre-effective date foreign taxes unused in pre-effective date years by reason of the general limitation may be used to reduce U.S. tax on post-effective date financial services income or shipping income, as the case may be, if the taxpayer establishes that these taxes were in fact paid or accrued with respect to that type of income. Taxes paid or accrued with respect to pre-effective date separate limitation interest income shall be carried over to offset U.S. tax on post-effective date income in the passive category. Taxes paid or accrued on any other type of pre-effective date separate limitation income (e.g., DISC or FSC distributions) shall be carried over to offset U.S. tax on that type of income.

The effective date provisions of section 1201(e) of the Act do not provide rules relating to the characterization of distributions or section 951(a)(1)(B) inclusions out of earnings and profits accumulated in taxable years of a foreign corporation beginning before January l, 1987, that occur after the effective date of the Act as applied to both the foreign corporation and the distributee or U.S. shareholder. Rules comparable to the rules contained in section 904(d)(2)(I) shall be applied for purposes of characterizing such distributions and section 951(a)(1)(B) inclusions and for purposes of characterizing foreign taxes deemed paid with respect to such distributions or section 951(a)(1)(B) inclusions.

As an initial matter, income derived by a foreign corporation in taxable years beginning before January l, 1987, is characterized in the foreign corporation's hands under subparagraphs (A) or (E) of section 904(d)(1) (as in effect prior to the effective date of the Act) after application of the de minimis rule of section 904(d)(3)(C) (as in effect prior to the effective date of the Act). When, in a taxable year after the effective date of the Act, earnings and profits attributable to such income are distributed, or included in the gross income of a U.S. shareholder under section 951(a)(1)(B), the ordering rules of section 904(d)(3)(D), as in effect after the effective date, shall be applied to determine initially the character of the income of the distributee or U.S. shareholder. Thus, a proportionate amount of a distribution described in this section will be initially characterrzed as separate limitation interest income in the hands of the distributee based on the ratio of the separate interest limitation earnings and profiis out of which the dividend was paid to the total earnings and profits out of which the dividend was paid. The distribution or section 951(a)(1)(B) inclusion must then be recharacterized in the hands of the distributee or U.S. shareholder on the basis of the following principles:

(a) Distributions and section 951(a)(1)(B) inclusions that are initially characterized as income described in section 904(d)(1)(A) (as in effect prior to the date of enactment of the Act) shall be treated as income described in section 904(d)(1)(A) (as in effect on and after the date of enactment of the Act).

(b) Distributions and section 951(a)(1)(B) inclusions that are initially characterized as income described in section 904(d)(1)(E) (as in effect prior to the effective date of the Act) shall be treated as income described in section 904(d)(1)(I) (as in effect on and after the effective date of the Act), unless the taxpayer establishes to the satisfaction of the Commissioner that the distribution or section 951(a)(1)(B) inclusion is attributable to: (i) earnings and profits accumulated with respect to shipping income, as defined in section 904(d)(2)(D) (as in effect on and after the effective date of the Act); or (ii) in the case of an entity meeting the requirements of section 904(d)(2)(C)(ii) (an entity that is predominantly engaged in the active conduct of a banking, insurance, financing, or similar business), earnings and profits accumulated with respect to financial services income, as defined in section 904(d)(2)(C)(ii) (as in effect on and after the effective date of the Act).

(c) In order for a taxpayer to establish that distributions or section 951(a)(1)(B) inclusions that are attributable to earnings and profits that would otherwise be considered accumulated with respect to the general limitation in a particular taxable year beginning before January l, 1987, are attributable to earnings and profits accumulated with respect to shipping or financial services income, the taxpayer must establish the amounts of foreign taxes paid or accrued with respect to those earnings and profits that are to be treated as taxes subject to the separate limitation for shipping or financial services income, as the case may be, under section 904(d)(2)(I) (as in effect on and after the effective date of the Act). Conversely, in order for a taxpayer to establish the amounts of general limitation taxes paid or accrued in a taxable year beginning before January l, 1987, that are to be treated as taxes paid or accrued with respect to shipping or financial services earnings and profits, as the case may be, the taxpayer must establish the amount of any distributions or section 951(a)(1)(B) inclusions that are attributable to the earnings and profits that are accumulated with respect to shipping or financial services income.

3. APPLICATION OF LOOK-THROUGH RULES TO DISTRIBUTIONS (INCLUDING DEEMED DISTRIBUTIONS) AND PAYMENTS BY A FOREIGN CORPORATION TO A RECIPIENT WHEN ONE'S TAXABLE YEAR BEGINS BEFORE JANUARY 1, 1987 AND THE OTHER'S TAXABLE YEAR BEGINS AFTER DECEMBER 31, 1986

The effective date provisions of section 1201(e) of the Act do not include rules relating to the application of the look-through rules under section 904(d)(3) to payments made by a controlled foreign corporation during its taxable year beginning after December 31, 1986, but received in a taxable year of the recipient beginning before January 1, 1987. The provisions also do not address distributions (including deemed distributions) or payments made by a foreign corporation during its taxable year beginning before January 1, 1987, and received in a taxable year of the recipient beginning after December 31, 1986. This section provides rules toobe applied in characterizing such distributions or payments.

(a) If interest, rents, or royalties are paid or accrued on or after the effective date of the look-through rules under new section 904(d)(3) as applied to the payor, but prior to the start of the recipient's first taxable year beginning after January 1, 1987, such interest, rents, or royalties shall initially be characterized in accordance with the new look-through rules. To the extent that interest payments in the hands of the recipient are initially characterized as passive income under these rules, they will be treated as separate limitation interest in the hands of the recipient. To the extent that rents or royalties in the hands of the recipient are initially characterized as passive income under these rules, they will be recharacterized as general limitation income in the hands of the recipient.

(b) If interest, rents, or royalties are paid or accrued before the effective date of the new look-through rules of section 904(d)(3) as applied to the payor, but on or after the start of the recipient's first taxable year beginning after January 1, 1987, the income in the recipient's hands shall be initially characterized in accordance with section 904(d)(3) as in effect prior to the effective date of the Act. To the extent interest income is characterized as separate limitation interest income under these rules, that income shall be recharacterized as passive income in the hands of the recipient. Rents or royalties will be characterized as general limitation income.

(c) If dividends are paid or accrued or section 951(a)(1) inclusions occur before the effective date of the new look-through rules of section 904(d)(3) as applied to the payor, but on or after the start of the first taxable year of the distributee or U.S. shareholder beginning after January 1, 1987, the dividends or section 951(a)(1) inclusions in the hands of the distributee or U.S. shareholder shall be initially characterized in accordance with section 904(d)(3) as in effect prior to the effective date of the Act, including the ordering rules of section 904(d)(3)(A) and (G). Therefore, under section 904(d)(3)(A) of prior law, dividends and section 951(a)(1) inclusions are considered to be paid or derived first from earnings attributable to separate limitation interest income. To the extent the dividend or section 951(a)(1) inclusion is initially characterized under these rules as separate limitation interest in the hands of the distributee or U.S. shareholder, the dividend or section 951(a)(1) inclusion shall be recharacterized as passive income in the hands of the distributee or U.S. shareholder. The portion, if any, of the dividend or section 951(a)(1) inclusion that is not characterized as passive income shall be characterized according to the rules in section (2). Therefore, a taxpayer may establish that income that would otherwise be characterized as general limitation income is shipping or financial services income. Rules comparable to the rules contained in section 904(d)(2)(I) shall be applied for purposes of characterizing foreign taxes deemed paid with respect to distributions and section 951(a)(1) inclusions covered by this section.

The following examples illustrate the application of these principles:

EXAMPLE (1). X is a domestic corporation that is a fiscal year taxpayer (July 1-June 30). FS, a controlled foreign corporation, is a wholly-owned subsidiary of X and has a calendar taxable year. On June l, 1987, FS makes a $100 interest payment to X.

Because the payment is made after January 1, 1987 (the first day of FS's first taxable year beginning after December 31, 1986), the look-through rules of new section 904(d)(3) apply to characterize the payment made by FS. To the extent, however, that the interest payment to X is allocable to passive income earned by FS, the payment will be included in X's separate limitation for interest as provided in section 904(dd(1)(A) before the 1986 Act.

EXAMPLE (2). X is a domestic corporation that is a calendar year taxpayer. FS, a controlled foreign corporation, is a wholly-owned subsidiary of X and has a July l-June 30 taxable year. On June l, 1987, FS makes a $100 interest payment to X.

Because the payment is made prior to July 1, 1987 (the first day of FS's first taxable year beginning after December 31, 1986), the look-through rules of new section 904(d)(3) do not apply. Assume that, under old section 904(d)(3), the interest payment would be characterized as separate limitation interest income. For purposes of determining X's foreign tax credit limitation, the interest payment will be included in X's separate limitation for passive income as provided in section 904(d)(1)(A) as amended by the 1986 Act.

EXAMPLE (3). The facts are the same as in example (2) except that on June 1, 1987, FS makes a $100 dividend distribution to X.

Because the dividend is paid prior to July 1, 1987 (the first day of FS's first taxable year beginning after December 31, 1986), the look-through rules of new section 904(d)(3) do not apply. Assume that, under old section 904(d)(3), FS's earnings and profits for the taxable year ending June 30, 1987 consist of $200 of earnings attributable to general limitation income and $75 of earnings attributable to separate limitation interest income. The portion of the dividend that is attributable to FS's separate limitation interest and is treated as separate limitation interest income under old section 904(d)(3) is $75. The remaining $25 of the dividend is treated as general limitation income under old section 904(d)(3). For purposes of determining X's foreign tax credit limitation, $75 of the dividend will be recharacterized as passive income. The remaining $25 of the dividend will be characterized as general limitation income, unless X can establish that the general limitation portion is attributable to shipping or financial services income.

Although, in certain instances, income may be treated as passive or separate limitation interest income under this section, the rules provided in section 1205(b) of the Act operate independently of the rules discussed in this section. Section 1205(b) of the Act provides rules relating to foreign tax credit carrybacks with regard to taxes paid in taxable years beginning after 1986. Foreign taxes paid or accrued in a taxable year beginning after 1986 with respect to income other than high withholding tax interest that are carried back to a taxable year beginning before 1987 are treated as imposed on general limitation income without regard to whether the underlying income is, in fact, general limitation income.

4. TRANSITIONAL ISSUES AFFECTING THE COMPUTATION OF THE INDIRECT FOREIGN TAX CREDIT

Section 1202(a) and (b) of the Act amends sections 902 and 960 of the Code by replacing the annual ordering rules of prior law 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. 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) defines the term "post-1986 undistributed earnings" as the amount of earnings and profits of the foreign corporation (computed in accordance with sections 964 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) 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 1202(e) of the Act provides that the amendments made by section 1202 of the Act shall apply to distributions by foreign corporations out of, and to inclusions under section 951(a) of the Code attributable to, earnings and profits for taxable years beginning after December 31, 1986.

The following rules will apply with respect to the computation of the deemed-paid foreign tax credit under sections 902 and 960 as amended by the Act.

(a) SIXTY-DAY RULE. The sixty-day rule set forth in section 902(c) of the Internal Revenue Code, as in effect prior to the date of enactment of the Act, is not applicable to dividends paid during the first sixty days of a foreign corporation's first taxable year beginning after December 31, 1986.

(b) EFFECTIVE DATE RULES FOR TRANSLATING INTO U.S. DOLLARS CERTAIN INCLUSIONS AND INDIRECT FOREIGN TAX CREDITS. For purposes of establishing the amount or character of income under sections 902, 951(a)(1)(B), and 1248, and the amount of indirect foreign tax credits under sections 902 and 960, earnings and profits of a foreign corporation accumulated in taxable years of the foreign corporation beginning before January 1, 1987, and foreign taxes deemed paid or accrued with respect to such earnings and profits under section 902 or 960, shall be determined and translated into dollars under the law in effect before the enactment of the Act. This rule applies regardless of the taxable year such amount is included in gross income by any shareholder of the foreign corporation.

(c) TRANSITION RULES FOR CERTAIN DISTRIBUTIONS THROUGH TIERS OF FOREIGN CORPORATIONS. For purposes of sections 902 and 960--

(i) Distributions by a 2nd-tier corporation with a functional currency (as defined in section 985(b)) other than the U.S. dollar that are out of earnings and profits accumulated in taxable years beginning after December 31, 1986, and included in the gross income of a 1st-tier corporation for any taxable year of the 1st-tier corporation beginning before January 1, 1987, shall be translated as necessary into the appropriate currency under the law in effect before the enactment of the Act. The foreign taxes paid or accrued by the 2nd-tier corporation with respect to such earnings and profits which are deemed paid by the 1st-tier corporation shall also be translated under the law in effect before the enactment of the Act.

(ii) Distributions by a 2nd-tier corporation that are out of earnings and profits accumulated in its taxable years beginning before January 1, 1987, and included in gross income of a 1st-tier corporation for any taxable year of the 1st-tier corporation beginning after December 31, 1986, shall be treated as post-1986 undistributed earnings (as defined in section 902(c)(1)) of the 1st- tier corporation. If the books and records of the 2nd-tier corporation are not kept in U.S. dollars, the foreign taxes paid or accrued by the 2nd-tier corporation with respect to such earnings and profits which are deemed paid by the 1st-tier corporation shall be translated into U.S. dollars at the spot rate for the date of distribution by the 2nd-tier corporation and treated as post-1986 foreign income taxes (as defined in section 902(c)(2)) of the 1st- tier corporation.

(iii) The rules in (i) and (ii) apply to a distribution from a 3rd-tier corporation to a 2nd-tier corporation by substituting "3rd- tier" for "2nd-tier" and "2nd-tier" for "1st-tier" in the preceding sentences.

5. GROUPING OF ITEMS OF INCOME FOR PURPOSES OF THE HIGH-TAX "KICK OUT"

Section 1201(a) of the Act amends section 904(d) of the Code by replacing the separate limitation for interest income with a separate limitation for passive income generally. Under section 904(d)(2)(A)(iii)(III), high-taxed income is excluded from the category of passive income. Section 904(d)(2)(F) defines high-taxed income as any income which would otherwise be passive income but is not so treated because the sum of the foreign income taxes paid and deemed paid by the taxpayer with respect to that income exceeds the highest rate of tax specified in section 1 or 11 of the Code multiplied by the amount of such income. Income is to be tested after allocation of expenses at the taxpayer level.

The following rules apply for purposes of grouping items of income in order to determine whether the items of income as grouped are high-taxed income:

(a) All interest, rents, and royalty payments received or accrued by the taxpayer from a particular controlled foreign corporation during the taxable year that are characterized (after application of the look-through rules of section 904(d)(3)) as passive income shall be treated as one item of income;

(b) All passive income (determined after application of the look-through rules of section 904(d)(3)) included in the gross income of a U.S. shareholder under section 951(a)(1)(A) for a particular taxable year from each separate controlled foreign corporation shall be treated as a separate item of income;

(c) All passive rents and royalties not described in (a) or (b) that are received or accrued by a taxpayer during the taxable year shall be treated as one item of income; and

(d) All other passive income not described in (a), (b), or (c) that is received or accrued by a taxpayer during the taxable year shall be treated as one item of income.

The grouping rules described in (c) and (d) shall apply separately with respect to income attributable to each qualified business unit (as defined in section 989(a)) of a taxpayer if a taxpayer has more than one qualified business unit.

6. APPLICABLE UNITED STATES TAX RATE FOR 1987 WITH RESPECT TO DETERMINATION OF HIGH-TAXED INCOME

Section 904(d)(2)(F) defines high-taxed income with reference to the highest rate of tax specified in section 1 or section 11 of the Code. Similarly, section 954(b)(4) defines high-taxed income with reference to the section 1 or section 11 rates. For 1987, the tax rates in section 1 and section 11 are "blended"" by virtue of the operation of section 15. Therefore, for purposes of sections 904(d)(2)(F) and 954(b)(4), the applicable tax rate for 1987 is the highest blended rate that applies to the taxpayer.

For further information contact Carol DuPuy (202-566-3289) or Marnie Carro (202-566-3499) regarding sections (1), (2), (3), (5) and (6), Kenneth Wood (202-566-6276) regarding section (4)(a) and Scott Farmer (202-566-3407) regarding sections (4)(b) and (c).