GUIDANCE PROVIDED ON 1986 ACT'S FOREIGN TAX CREDITS AND FOREIGN CURRENCY PROVISIONS.

Notice 88-71

This notice provides guidance relating to several aspects of the amendments made to the foreign tax credit rules and the foreign currency rules by the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 1 (the Act). The rules contained in this announcement 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.

Specifically, this notice provides guidance with respect to: (1) computing foreign taxes deemed paid on section 951(a)(1) inclusions and determining the ordering of distributions out of previously taxed earnings and profits (PTI) for purposes of sections 959(c) and 960(b) of the Code; (2) computing the currency gain or loss on distributions of PTI; (3) the pooling and ordering of distributions following a reorganization; and (4) determining the treatment of pre-1987 deficits in earnings and profits in reducing post-1986 earnings and profits in the appropriate section 904(d) limitation categories, and the treatment of post-1986 deficits in earnings and profits in reducing pre-1987 earnings and profits in the appropriate section 904(d) limitation categories.

LAW

Section 1202(a) and (b) of the Act amended sections 902 and 960 of the Code by replacing the annual ordering rules of prior law for the computation of foreign taxes deemed paid 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, including a controlled 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, or section 951(a) inclusions attributable to 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) 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 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 1202(e) of the Act provides that the amendments made by section 1202 shall apply to distributions by foreign corporations out of, and to inclusions under section 951(a) of the Code attributable to, earnings and profits accumulated in taxable years beginning after December 31, 1986:

Section 1261 of the Act added sections 985 through 989 of 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 as of the time of payment. Section 986(c) provides that foreign currency gain or loss with respect to distributions of previously taxed earnings and profits attributable to movements in exchange rates between the times of deemed and actual distributions shall be recognized and treated as ordinary income or loss from the same source as the associated income inclusion.

ANALYSIS

1. COMPUTATION OF FOREIGN TAXES DEEMED PAID UNDER SECTIONS 902 AND 960 OF THE CODE AND ORDERING OF DISTRIBUTIONS OUT OF PTI. For purposes of computing the foreign taxes deemed paid under section 902 with respect to dividend distributions and under section 960(a) on amounts included in income under section 951(a)(1), the following rules apply.

(a) The foreign taxes deemed paid shall be computed on the basis of multi-year pools of earnings and profits computed with respect to each separate category of income listed in section 904(d)(1) of the Code ("separate category").

(b) Solely for purposes of determining the separate category out of which a distribution, deemed distribution, or section 951(a)(1)(B) inclusion is made and for purposes of computing post-1986 undistributed earnings in the denominator of the deemed paid credit fraction under sections 902 and 960 of the Code in the year of a distribution or deemed income inclusion, a post-1986 foreign source accumulated deficit incurred with respect to a separate category shall be allocated pro rata against post-1986 foreign source undistributed earnings in the other separate categories. However, a deficit in any separate category shall not permanently reduce other separate categories, but shall be carried forward in the same separate category in which it was incurred. Thus, for purposes of sections 902 and 960, post-1986 undistributed earnings in a separate category cannot under any circumstances exceed the sum of post-1986 undistributed earnings and deficits in all of the separate categories. If a post-1986 foreign source accumulated deficit incurred with respect to a separate category exceeds the sum of all post-1986 pools of foreign source undistributed earnings in all separate categories, then the deficit shall be allocated to, and reduce, post-1986 U.S. source undistributed earnings in the separate category with respect to which the deficit was incurred. If a post- 1986 foreign source accumulated deficit incurred with respect to a separate category exceeds the sum of (1) all post- 1986 pools of foreign source undistributed earnings in all separate categories and (2) the pool of post-1986 U.S. source undistributed earnings with respect to which the deficit was incurred, then the deficit shall be allocated pro rata to, and reduce, post-1986 U.S. source undistributed earnings in the other separate categories. The allocation rules of this section 1(b) apply only when there is a distribution or deemed income inclusion in a post-1986 taxable year.

(c) Earnings and profits attributable to amounts included in income under section 951(a)(1) of the Code shall be removed from the pool of post-1986 undistributed earnings, and taxes associated with these inclusions (previously creditable taxes or PCT) shall be removed from the pool of foreign taxes. (But see Notice 88-70 for rules relating to the effect of section 951(a)(1) inclusions on the post-1986 undistributed earnings pool with respect to foreign corporations with deficits in earnings and profits attributable to taxable years beginning before January 1, 1987.) A separate annual account of PTI shall be established within each separate category (e.g. for purposes of determining the increase in the section 904 limitation permitted under section 960(b)). PTI shall be considered distributed on a last-in, first-out basis within each section 959(c) category of earnings and profits. Thus, PTI, when distributed, shall be considered first attributable to earnings, if any, in the appropriate section 959(c) category derived from the current taxable year and then from prior taxable years beginning with the most recent prior taxable year. For this purposes PTI described in section 959(c)(1) and (2) may be combined so that taxpayers do not have to maintain separate PTI accounts for the PTI described, respectively, in section 959(c)(1) and section 959(c)(2). The regulations will provide guidance regarding the manner in which the election to combine accounts may be made by a controlled foreign corporation (a CFC). Once made, the election will apply to all U.S. shareholders of the CFC for all future taxable years. The regulations will also require consistency with respect to all CFCs that are controlled by one or more members of the same U.S. affiliated group.

If a CFC distributes PTI that is attributable to earnings in a particular taxable year, then the PTI shall be considered distributed pro rata out of earnings within each separate category on the basis of the following formula:

 Distribution of PTI                PTI in each separate

EXAMPLE 1

Assume that a domestic corporation (DC) owns 100% of a controlled foreign corporation (CFC), that CFC is organized on January 1, 1987, and that CFC has only post-1986 foreign source earnings and profits included within the general limitation of section 904(d)(1)(I), as follows:

      Current Year Info (col. 1 - 5)         Pre-Credit Pools

On December 31, 1988, CFC's pool of post-1986 undistributed earnings is 200u (the column (6) amount), consisting of 50u of the undistributed earnings pool reduced by subpart F inclusions (the 1987 column (11) amount) and 150u of current earnings (the column (4) amount). CFC's pool of post-1986 foreign income taxes is $30 (the column (7) amount), consisting of $10 of prior year taxes not already deemed paid (the 1987 column (9) amount) and $20 of taxes paid in the current year (the column (5) amount). In 1988 the subpart F inclusion of DC is 50u and the amount of foreign taxes deemed paid is $7.50 (50u/200u x ($20 + $10)). CFC has 200u of PTI (150u attributable to 1987 and 50u attributable to 1988), to which $37.50 ($30.00 and $7.50, respectively) of foreign income taxes have been allocated. On December 31, 1988, CFC has post-1986 earnings and profits of 350u, consisting of 200u PTI (the column (10) amount) and 150u of other non-subpart F earnings that remain in the post-1986 undistributed earnings pool (the column (11) amount). CFC's pool of post-1986 foreign income taxes reduced by foreign taxes allocated to PTI is $22.50 ($30 -$7.50).

On December 31, 1989, CFC's pool of post-1986 undistributed earnings is 350u, consisting of the 150u of earnings that remained in the pool at the end of 1988 and 200u of current earnings. CFC's pool of post-1986 foreign income taxes is $82.50, consisting of the $22.50 that remained in the pool at the end of 1988 and the current year taxes of $60. In 1989 the subpart F inclusion of DC is 200u and the amount of foreign taxes deemed paid is $47.14 (200u/350u x $82.50). CFC has 400u of PTI (150u attributable to 1987, 50u attributable to 1988, and 200u attributable to 1989), to which $84.64 ($30.00, $7.50, and $47.14, respectively) of foreign income taxes have been allocated. On December 31, 1989, CFC has post-1986 earnings and profits of 550u, consisting of 400u PTI and 150u of other non-subpart F earnings that remain in the post-1986 undistributed earnings pool. CFC's pool of post-1986 foreign income taxes reduced by foreign taxes allocated to PTI is $35.36 ($82.50 - $47.14).

In 1990, CFC distributes 100u of PTI to DC. Such distribution is deemed to be entirely out of PTI attributable to 1989, leaving 100u (200u - 100u) of 1989 PTI and 300u PTI remaining with respect to all taxable years.

In 1991, CFC distributes 200u of PTI to DC. Such distribution is deemed to be out of PTI attributable to 1989 (100u), 1988 (50u), and 1987 (50u), leaving 100u (150u - 50u) of 1987 PTI.

EXAMPLE 2

Assume the same facts as in Example 1 except that CFC distributes 500u in 1991 (rather than 200u) and also has passive income resulting in additional section 951(a)(1)(A) inclusions, as follows:

      Current Year Info (col. 1 - 5)         Pre-Credit Pools

On December 31, 1987, CFC's pool of post-1986 undistributed passive earnings is 100u, consisting entirely of subpart F income. CFC's pool of post-1986 passive foreign income taxes is $10. The amount of foreign taxes deemed paid with respect to the section 951(a)(1)(A) inclusion of passive earnings is $10 (100u/100u x $10). CFC has 100u of passive PTI, to which is allocated $10 of foreign income taxes. CFC's pool of post-1986 passive foreign income taxes not already deemed paid (the column (9) amount) is 0.

On December 31, 1988, CFC's pool of post-1986 undistributed passive earnings is 50u (the column (6) amount), consisting entirely of current earnings (the column (4) amount). CFC's pool of post-1986 passive foreign income taxes is $5 (the column (7) amount), consisting entirely of taxes paid in the current year (the column (5) amount). In 1988, the passive subpart F inclusion of DC is 50u and the amount of foreign taxes deemed paid is $5 (50u/50u x $5). CFC has 150u of passive PTI (100u attributable to 1987 and 50u attributable to 1988), to which $15 ($10 and $5, respectively) of foreign income taxes have been allocated. On December 31, 1988, CFC has post-1986 passive earnings and profits of 150u, consisting entirely of 150u PTI (the column (10) amount). CFC's pool of post-1986 passive foreign income taxes reduced by foreign taxes allocated to PTI is 0.

On December 31, 1989, CFC's pool of post-1986 undistributed passive earnings is 200u (the column (6) amount), consisting entirely of current earnings (the column (4) amount). CFC's pool of post-1986 passive foreign income taxes is $20 (the column (7) amount), consisting entirely of taxes paid in the current year (the column (5) amount). In 1989, the passive subpart F inclusion of DC is 200u, and the amount of foreign taxes deemed paid is $20 (200u/200u x $20). CFC has 350u of passive PTI (100u attributable to 1987, 50u attributable to 1988, and 200u attributable to 1989), to which $35 ($10, $5, and $20, respectively) of foreign income taxes have been allocated. On December 31, 1989, CFC has post-1986 passive earnings and profits of 350u, consisting entirely of PTI (the column (10) amount). CFC's pool of post-1986 foreign income taxes reduced by foreign taxes allocated to PTI is 0.

In 1990, CFC distributes 100u of PTI to DC. That distribution is deemed to be entirely out of the 400u of PTI attributable to 1989 (200u 1989 general limitation PTI + 200u 1989 passive PTI), leaving 300u (400u -100u) of 1989 PTI. Since CFC has 200u of PTI in each of the general limitation and passive categories, the distribution of 100u out of PTI is equally attributable to the general limitation category (200u/400u x 100u = 50u) and the passive category (200u/400u x 100u = 50u). After the distribution CFC has 150u of PTI attributable to 1989 in each of the general limitation and passive categories, leaving 350u of PTI allocable to the general limitation category with respect to all taxable years, and 300u of PTI allocable to the passive category with respect to all taxable years.

In 1991, CFC distributes 500u of PTI to DC. That distribution is deemed to be out of PTI attributable to 1989 (300u), 1988 (100u), and 1987 (100u), leaving 150u of 1987 PTI (150u of general limitation PTI plus 100u of passive PTI minus 100u distributed). The distributions from 1989 and 1988 PTI are equally out of passive earnings and profits and general limitation earnings and profits, since CFC has 150u of 1989 PTI and 50u of 1988 PTI in each category. The 100u of PTI attributable to 1987 is allocated 60u (150u/250u x 100u) to general limitation PTI and 40u (100u/250u x 100u) to passive PTI, leaving 90u (150u - 60u) general limitation PTI for all prior taxable years, and 60u (100u - 40u) passive PTI for all prior taxable years.

EXAMPLE 3

Z is a domestic corporation that owns 100% of CFC, a controlled foreign corporation incorporated on January 1, 1987, in Country D. The functional currency of CFC is the U.S. dollar. Pursuant to section 954(b)(4) of the Code, CFC has no subpart F income in 1987, 1988, or 1989. CFC has no U.S. source earnings and profits and has post-1986 foreign source earnings and profits, and deficits in foreign source earnings and profits, in various separate categories, as follows:

      Shipping       General       Noncontrolled

In 1989, CFC makes a dividend distribution to Z of $100. Because CFC's earnings and profits in the general limitation category of $300 in 1989 exceed the accumulated deficit in that category, CFC has earnings and profits at the end of 1989 and before the distribution is taken into account as follows: $300 in the shipping category, $100 in the general limitation category, and $100 in the noncontrolled 902 category. The dividend is considered paid pro rata out of earnings and profits in the shipping category ($100 x 300/500 = $60), earnings and profits in the general limitation category (S10O x 100/500 = $20), and earnings and profits in the noncontrolled 902 category ($100 x 100/500 = $20). After the 1989 dividend is characterized, $240 ($300 - $60) remains in the shipping category, $80 ($100 - $20) remains in the general limitation category, and $80 ($100 - $20) remains in the noncontrolled 902 category.

2. DETERMINATION OF EXCHANGE GAIN OR LOSS ON DISTRIBUTIONS OF PREVIOUSLY TAXED EARNINGS AND PROFITS.

(a) SECTION 986(C) GAIN OR LOSS ON DISTRIBUTIONS TO A U.S. SHAREHOLDER. For purposes of determining the amount of foreign currency gain or loss under section 986(c) of the Code that must be recognized by a U.S. shareholder with respect to a distribution of post-1986 earnings attributable to PTI (as described in section 959 or 1293(c)), the distribution will not be considered related to a particular post-1986 taxable year. Rather, the amount of the section 986(c) foreign currency gain or loss shall be determined using the following formula for each separate category (as defined in section 1.904-5(a)(1) of the regulations) of a shareholder:

 Total dollar   x  Units of foreign corporation's    =  Dollar basis

Thus, to compute foreign currency gain or loss under section 986(c) of the Code, a shareholder must determine for each of its separate categories the shareholder's functional currency account of PTI and the shareholder's dollar basis in such account. (Amounts distributed in any taxable year are removed from the accounts before calculating foreign currency gain or loss in a later taxable year.) A distribution of earnings attributable to PTI shall be allocated among the shareholder's PTI accounts in separate categories under the rules in section 1 above (i.e., on an annual LIFO basis with the distribution allocated within each year among the separate categories on a pro rata basis). This rule is illustrated by the following example.

EXAMPLE 4

Assume the same facts as in Example 1, except that the exchange rates are $1:1u in 1987 and 1988, $.9:1u in 1989, $.8:1u in 1990, and $.7:1u in 1991. The section 986(c) foreign currency gain or loss on the 100u distribution in 1990 is computed with reference to each separate category of DC's PTI to which the distribution is attributable. Because DC has only general limitation PTI, the distribution is attributable only to that PTI account. If more than one account exists, such as in Example 2, the distribution must be allocated to each account under the rules of section 1 of this notice.

The total dollar basis in each account is computed by adding together the "u" amounts of PTI for each year translated into dollars as provided in section 989(b)(3) of the Code. (This is the same rate used to determine DC's income inclusion.) Thus, the total dollar basis in DC's general limitation PTI account before any distribution is made is $380 ((150u of 1987 PTI x $1/1u) + (50u of 1988 PTI x $1/1u) + (200u of 1989 PTI x $.9/1u)). The dollar value of the PTI distribution is computed by translating the distribution at the spot rate on the date of distribution as required by section 989(b)(1). The section 986(c) foreign currency gain or loss with respect to the 100u distribution of PTI in 1990 is computed as follows:

 $380 (Total dollar  x  100u (Functional          = $95 (Dollar basis

(b) SECTION 986(c) FOREIGN CURRENCY GAIN OR LOSS ON DISTRIBUTIONS THROUGH FOREIGN ENTITIES. On the distribution of PTI through a chain of ownership described in section 958(a)(2) of the Code, the PTI account with respect to the distributee corporation is reduced by the amount of any additional foreign taxes paid on or with respect to the distribution. See section 1.959-3(d) of the regulations. For purposes of determining foreign currency gain or loss under section 986(c), a shareholder's functional currency account of PTI attributable to a particular upper-tier foreign corporation shall be reduced by the functional currency amount of such taxes imposed on or with respect to such previously taxed earnings when distributed through a chain of ownership described in section 958(a)(2). See section 1.959-3(d). In addition, the shareholder's dollar basis in the functional currency account of PTI with respect to the upper-tier foreign corporation will be reduced by the dollar value of the taxes when paid or accrued (taking into account any section 905(c) adjustment). The regulations will provide for allocation where there is more than one shareholder to whom PTI is attributable. This rule is illustrated by the following example.

EXAMPLE 5

P, a domestic corporation, is the sole shareholder of S1, which is the sole shareholder of S2. Both S1 and S2 began operations in 1987 and are foreign corporations with the "u" as their functional currency. P, S1, and S2 are calendar year taxpayers. For 1987, P included under section 951(a)(1)(A) of the Code 100u of subpart F income of S2 equal to $100. S2 had no other earnings and profits in 1987. The subpart F income constituted passive income under section 904(d). In 1988, S2 distributed 100u to S1, reducing the earnings and profits of S2 to 0. A 5u withholding tax was imposed on the distribution. The dollar value of the 5u taxes when paid was equal to $10. For 1987, S1 had no earnings and profits. For 1988, S1 had no earnings and profits other than the 100u distributed by S2. Pursuant to section 1.959-3(d) of the regulations, the amount of PTI for P with respect to the earnings and profits of S1 is reduced to 95u (100u minus 5u). For purposes of determining the amount of any foreign currency gain or loss under section 986(c) with respect to distributions attributable to PTI of S1, P's functional currency account of passive PTI is reduced by 5u to 95u (100u minus 5u) and its dollar basis in such account is reduced by $10 to $90 ($100 minus $10). Thus, if S1 distributes 95u to P in 1988 when the exchange rate is $2:1u, P will recognize $100 of foreign currency gain under section 986(c) ($190 value of distribution (95u x $2/1u) minus $90 basis attributable to the PTI distribution (95u/95u x $90)). The exchange gain will be foreign source and passive.

(c) APPLICATION OF SECTION 986(c) OF THE CODE TO SECTIONS 1248 AND 1291 TRANSACTIONS. Solely for purposes of computing any exchange gain or loss under section 986(c), the following rules apply. PTI (as described in section 959 or section 1293(c)) attributable to stock with respect to which a section 1248 transaction or section 1291 transaction is relevant shall be treated as if it were distributed immediately prior to the transaction for purposes of computing exchange gain or loss on the PTI. The dollar value of the PTI shall be computed using the spot rate on the date of the transaction as required by section 989(b)(2). The exchange gain or loss will be recognized by the U.S. shareholder. The exchange gain (or loss) so recognized will increase (or decrease) the U.S. shareholder's adjusted basis in the stock of the foreign corporation for purposes of computing gain or loss with respect to the stock on the transaction. The shareholder's dollar basis with respect to each account of PTI shall be increased (or decreased) by the exchange gain or loss recognized. This rule is illustrated by the following example.

EXAMPLE 6

P, a domestic corporation, is the sole shareholder of S, a controlled foreign corporation with the "u" as its functional currency. Both P and S are calendar year taxpayers. S began operations in 1987, at which time P had a $100 basis in its S stock. From 1987 through 1989, all of S's earnings constituted subpart F income, as follows:

         General      Exchange Rate       Section 959(c)(1)/(2)

3. POOLING AND ORDERING OF DISTRIBUTIONS. The ordering rules for distributions occurring after certain reorganizations and other nonrecognition transactions, as provided in section 7.367(b)-12 of the regulations, are inconsistent with the rules of the Act concerning the pooling of earnings and profits and the ordering of distributions in several respects. Among other things, section 7.367(b)-12 could, for purposes of sections 902 and 960 of the Code, be interpreted to preclude the pooling of post-1986 post- reorganization earnings and profits with post-1986 pre-reorganization earnings and profits, and to require post-reorganization earnings and profits to be deemed distributed before pre-reorganization PTI. The Service is examining the extent to which section 7.367(b)-12 has been superceded by the Act. To the extent that the rules of section 7.367(b)-12 are superceded by the Act, those rules are not effective for taxable years beginning after December 31, 1986.

4. TREATMENT OF PRE-1987 AND POST-1986 DEFICITS IN EARNINGS AND PROFITS FOR PURPOSES OF SECTION 904(d) OF THE CODE.

(a) CARRYOVER OF PRE-1987 FOREIGN SOURCE DEFICITS IN EARNINGS AND PROFITS OF A CONTROLLED FOREIGN CORPORATION. If a CFC has a pre- 1987 foreign source accumulated deficit in earnings and profits determined under section 902 or section 964(a) of the Code, then the principles of section 1.904-13T(b) of the regulations (concerning allocation of overall foreign losses that are part of net operating losses incurred in taxable years beginning before 1987, and that are carried forward to taxable years beginning after 1986) shall, except as provided below, be applied to allocate such deficits to the appropriate separate category of post-1986 earnings and profits. See Notice 88-70 regarding the effect of a deficit in pre-1987 earnings and profits computed under section 964(a) in determining the amount of any deemed income inclusion.

The pre-1987 foreign source accumulated deficit in a pre- effective date separate category other than the pre-effective date general limitation category shall offset earnings and profits in the post-effective date separate category that is analogous to the pre- effective date separate category with respect to which the deficit was incurred. See section 1.904-13T(a) of the regulations for analogous categories. If the CFC can demonstrate that a pre-1987 foreign source accumulated deficit incurred with respect to the pre- effective date general limitation category is attributable to foreign source earnings and profits in a particular post-effective date separate category, the deficit shall offset post-1986 foreign source earnings and profits in that particular separate category; otherwise, the deficit shall offset post-1986 foreign source earnings and profits in the post-effective date general limitation category. If the CFC cannot demonstrate the pre-effective date category with respect to which the pre-1987 foreign source accumulated deficit was incurred, it will be presumed that the deficit was incurred with respect to the pre-effective date general limitation category and, therefore, the rules relating to a pre-effective date deficit in the general limitation category that cannot be traced to a particular post-effective date separate category shall apply to such a deficit. The carryover of a CFC's pre-1987 foreign source accumulated deficit in earnings and profits described in this section 4(a) shall occur as of the first day of the foreign corporation's first taxable year beginning in 1987. Rules governing the carryover of pre-1987 U.S. source accumulated deficits in earnings and profits will be provided later.

Solely for purposes of determining the separate category out of which a distribution, deemed distribution, or section 951(a)(1)(B) inclusion is made and for purposes of computing earnings and profits in the denominator of the deemed paid credit fractions under sections 902 and 960 of the Code with respect to a distribution or deemed income inclusion in a post-1986 taxable year, a foreign source accumulated deficit in any separate category shall be allocated to, and reduce, post-1986 undistributed earnings in the separate categories in accordance with the rules of section 1 above.

The following examples illustrate the application of this section 4(a). For purposes of each example, assume that (1) Z is a domestic corporation that owns 100% of CFC, a controlled foreign corporation incorporated in Country D; (2) both Z and CFC use the calendar year as their taxable year; (3) the functional currency of CFC is the U.S. dollar; (4) unless otherwise specified, all of CFC's earnings and profit and deficits in earnings and profits are foreign source, non-subpart F earnings and deficits; and (5) CFC has no PTI.

EXAMPLE 7

Assume that CFC has $100 in its post-1986 pool of shipping earning and profits, to which $40 of foreign taxes have been allocated, and $200 in its post-1986 pool of general limitation earnings and profits, to which $80 of foreign taxes have been allocated. CFC also has a pre-1987 accumulated deficit of ($60) determined under section 902 of the Code. The deficit is attributable to general limitation earnings and profits. CFC makes a distribution of $120 to Z in 1987. CFC must allocate the pre-1987 accumulated deficit to its post-1986 pools of earnings and profits in order to determine the pools from which the $120 distribution is derived and the amount attributable to each pool. CFC cannot demonstrate that the deficit is associated with a particular post-effective date separate category. Therefore, the entire deficit of ($60) will be allocated to CFC's post-effective date general limitation earnings and profits. Accordingly, CFC's post-1986 pools of earnings and profits are as follows: $100 of shipping earnings and profits and $140 of general limitation earnings and profits. The $120 distribution to Z is a dividend in its entirety. The dividend is considered paid pro rata out of CFC's post-1986 earnings and profits. Therefore, the dividend to Z is out of shipping earnings and profits to the extent of $50 ($120 x 100/240), with respect to which $20 ($40 x 50/100) of foreign taxes will be deemed paid, and out of general limitation earnings and profits to the extent of $70 ($120 x 140/240), with respect to which $40 ($80 x 70/140) of foreign taxes will be deemed paid. CFC's post- 1986 pools of earnings and profitsafter the distribution are $50 of shipping earnings and profits and $70 of general limitation earnings and profits, and its post-1986 pools of foreign taxes after the distribution are $20 and $40, respectively.

EXAMPLE 8

Assume that the amount of CFC's pre-1987 accumulated deficit is $150 and CFC can demonstrate that the deficit was attributable to the shipping category. In 1987, CFC has shipping earnings and profits of $50, to which $25 of foreign taxes have been allocated, and general limitation earnings and profits of $50, to which $15 of foreign taxes have been allocated. In 1988, CFC has no earnings and profits and makes a distribution of $25 to Z. In 1989, CFC has shipping earnings and profits of $50, to which $25 of foreign taxes have been allocated, and general limitation earnings and profits of $150, to which $50 of foreign taxes have been allocated. CFC makes a distribution of $120 to Z in 1989. In 1990, CFC has shipping earnings and profits of $100, to which $50 of foreign taxes have been allocated, and general limitation earnings and profits of $70, to which $20 of foreign taxes have been allocated, and makes a distribution of $100.

          Shipping     Foreign     General     Foreign

The $100 dividend distribution in 1990 is considered paid pro rata out of shipping earnings and profits ($100 + ($50) = $50) and general limitation earnings and profits ($70 + $80 = $150). Accordingly, the $100 dividend is considered to be paid $25 ($100 x 50/200) out of shipping earnings and profits and $75 ($100 x 150/200) out of general limitation earnings and profits. Foreign taxes of $50 ($100 x 25/50) are deemed paid with respect to shipping earnings and profits and foreign taxes of $16.50 ($33 x 75/150) are deemed paid with respect to general limitation earnings and profits. CFC's post- 1986 pool of shipping earnings and profits after the distribution is $25 ($50 - $25), with respect to which its pool of foreign taxes is $50 ($100 - $50), and its post-1986 pool of general limitation earnings and profits after the distribution is $75 ($150 - $75), with respect to which its pool of foreign taxes is $16.50 ($33 - $16.50).

EXAMPLE 9

Assume that the amount of CFC's pre-1987 accumulated deficit is $200 and CFC can demonstrate that the deficit was attributable to the shipping category. In 1987, CFC has foreign source shipping earnings and profits of $100, foreign source general limitation earnings and profits of $150, and U.S. source general limitation earnings and profits of $150. In 1988, CFC has no earnings and profits and makes a distribution of $50 to Z. CFC's $100 shipping deficit ($200 pre-1987 deficit + $100 1987 earnings) is allocated to foreign source general limitation earnings and profits, thereby reducing it to $50 ($150 - $100), and none of the deficit remains to be allocated to U.S. source general limitation earnings and profits. Accordingly, the 1988 dividend of $50 is considered paid pro rata out of foreign source general limitation earnings and profits ($50 x 50/200 = $12.50) and U.S. source general limitation earnings and profits ($50 x 150/200 = $37.50).

(b) CARRYBACK OF POST-1986 DEFICITS IN EARNINGS AND PROFITS OF A CONTROLLED FOREIGN CORPORATION. When a CFC makes (or is deemed to have made) a dividend distribution or has a section 951(a)(1)(B) inclusion in a post-1986 taxable year that is attributable to pre- 1987 earnings and profits, and the sum of the post-1986 pools of earnings and profits and deficits in earnings and profits is negative, the post-1986 deficit shall be allocated to pre-effective date accumulated earnings and profits (as computed under both section 902 and section 964(a) of the Code) under the principles of section 1.904-13T(c) of the regulations. See Notice 88-70.

(1) A post-1986 deficit shall be allocated first to foreign source earnings and profits in the pre-effective date separate category that is analogous to the post-effective date separate category in which the deficit occurred. Except for the general limitation category, the pre-effective date separate category that is analogous to a post-effective date separate category shall be determined under section 1.904-13T(a)(1)(i) through (iv) of the regulations. The general limitation category for pre-effective date taxable years shall be treated as the category that is analogous to post-effective date general limitation income, financial services income, shipping income, dividends from each noncontrolled section 902 corporation, and high withholding tax interest income.

(2) If the post-1986 deficit exceeds the foreign source earnings and profits in the analogous category for pre-1987 taxable years, the remaining deficit shall be allocated against U.S. source earnings and profits in all separate categories for pre-1987 taxable years.

(3) To the extent that the post-1986 deficit exceeds the separate limitation earnings and profits to which it is allocated and the U.S. source earnings and profits for the taxable year, the deficit shall be allocated pro rata to other foreign source separate limitation earnings and profits for pre-1987 taxable years.

Rules governing the carryback of post-1986 U.S. source accumulated deficits will be provided later. The following example illustrates the application of this section 4(b).

EXAMPLE 10

X is a domestic corporation that owns 100% of CFC, a controlled foreign corporation incorporated in Country A. Both X and CFC are calendar year taxpayers. Unless otherwise indicated, the following amounts of income are foreign source. As of the end of 1987, CFC has a post-1986 deficit of $60 in earnings and profits in the shipping category. CFC has no other post-1986 earnings and profits. For 1986, CFC had $20 of general limitation earnings and profits, $40 of separate limitation interest earnings and profits, and $10 of U.S. source earnings and profits. In 1987, CFC distributes $10 to X. CFC must allocate the $60 deficit to pre-effective date earnings and profits for purposes of determining the year's earnings from which the distribution is derived and for purposes of applying section 904 (d) and (g) of the Code to distributions attributable to pre- effective date years. The $60 deficit is allocated first to CFC's 1986 general limitation earnings and profits to the extent thereof ($20) because the pre-effective date general limitation category is the separate category that is analogous to the shipping category. Therefore, CFC has no general limitation earnings and profits for its 1986 taxable year. Next, the remaining $40 of the deficit is allocated first to CFC's $10 of U.S. source earnings and profits and then to $30 of CFC's separate limitation interest earnings and profits for its 1986 taxable year. Accordingly, CFC has no U.S. source earnings and profits and has $10 of separate limitation interest income earnings and profits for its 1986 taxable year after allocation of the deficit. Thus, the dividend to X would first be characterized as separate limitation interest income and then would be recharacterized as passive income under section 1.904-7(a)(1) of the regulations. Pursuant to Notice 88-70, the $60 deficit is removed from the post-1986 undistributed shipping earnings pool.

DRAFTING INFORMATION

The principal author of this notice is Kenneth Wood of the Office of the Associate Chief Counsel (International). For further information contact Mr. Wood (202-566-6276), Carolyn DuPuy (202-634- 5406), or Barbara Felker (202-634-5406) (not a toll-free call).